The last two days have been a period when the recent political turmoil in the euro zone and the sovereign debt crisis finally came home to roost in world equity markets. Over the past two days we have seen heavy falls with the Dow Jones Industrial Average falling by around 500 points. You might reasonably ask why markets which are supposed to be rational had not picked up on these facts and issues before, after all they have hardly been a secret. But the truth is that markets often progress in their own what I call “thought bubble” until they reach some sort of tipping point and are shaken out of it. World equity markets had been (happily) following forecasts of world economic recovery and improved individual company performance until three things impacted on them.
1. Officials and regulators began to impact on their zone of interest. For example the ban by Germany’s regulator BarFin on naked short-selling. In itself this was a small issue as professional investors will simply go offshore but the principle is more important. The US Senate vote on the IMF (to restrict the IMF’s ability to help countries who’s national debt exceeds 100% of its GDP) would have troubled them on two counts. The first is the 94-0 vote, after all you probably couldn’t get a 94-0 vote on a motion saying apple pie is nice! Also as this is an issue the US Senate has no power to decide on anyway, grandstanding by politicians is the face of a crisis is a continual theme at the moment.
In such a time even what I would call “favourable” official intervention such as the reform bill for the US banking sector passed by the US Senate last night gets an unwelcome tinge as it comes at the same time as other less well thought-out moves. This is something of an irony as the US banking sector badly needs reform as do many others around the world and this bill is a step along the way.
2. The increased number and severity of the austerity plans in Europe have made investors wonder about the prospects for world growth. Here we have one of life’s conundrums what is good for one country individually may not be good if several or more do it. A particular trigger here I think has been Spain’s passing of her 15 billion Euro plan to improve her public sector finances and the likely impact of this on her economic growth prospects. For example they are wondering what the impact on Spain will be of a planned reduction in her fiscal deficit from 11.2% of GDP in 2009 to 6% in 2011 on a country which already has 20% unemployment. We have already seen the beginnings of a severe austerity plan for Greece but Spain is a larger and more systemically important economy and we are expecting austerity plans in Europe from other countries for example the UK on June 22nd and also France and we have already had one from Portugal. Just to really add to the mix at a difficult time Germany is proposing the following for euro zone countries.
Failing to comply with deficit reduction means temporary loss of EU Structural Funds.
Possible irrevocable loss of EU Structural Funds.
For serious budget failure voting rights in the European Council could be withdrawn.
As a last resort, a managed insolvency proceeding for bankrupt states
Just to put this into perspective one might expect Spain’s austerity plan to knock around 2/3% off her economic output over its period.
3. Currency markets have got more and more volatile with quite extreme short-term movements and rumours of central bank intervention abounding. If you look at the action of the Euro over the past week there have been some extraordinary movements. A technical analyst (chartist) friend of mine contacted me on Thursday to say that he expected a short-term bounce in the Euro from 1.2130 against the US dollar and that the bounce would reach 1.245/1.25 and could go as far as 1.27. Ordinarily one might expect days for this to happen not about 3/4 hours for a sharp rally! Well played to him by the way. As to my view on this rally it is quite possible that central banks have intervened but also I have seen many other sharp short-covering rallies of this type where central banks were not involved.So far in its existence the European Central Bank has officially intervened in currency markets three times. There is a phrase for this in financial markets and it is called a dead cat bounce. But other currencies including the Australian Dollar have been caught up in this and bring it closer to home so has UK sterling.
4. There is a fear that goes as follows. The banks of the world have been bailed out by sovereign government’s at great expense.This when combined with the credit crunch recession has led to some governments particularly peripheral ones in the euro zone feeling the strain. They are now in effect being bailed out by the prudent countries of the euro zone. This leads to the question what about the prudent ones are they being destabilised by this?
4. Something odd has been happening in government bond markets which for anyone which analyses it is another sign of fear and uncertainty. Let me explain what has happened. I have written before about this subject with reference to Germany but it has carried on for example Germany’s ten-year government bond yield closed last night at 2.68% down from an average around 3.1% before this crisis accelerated. Another example of this has been the US Treasury bond market (or government debt) where here ten-year yields were at the beginning of this month 3.91% and are now 3.26% and also the UK where our equivalent yield was 3.91% at the beginning of this month and is now 3.53%.
If you remember this is the same US government which is the world’s largest debtor (and acclerating) and the same UK government which has not addressed its own fiscal deficit. You might quite reasonably feel that Greece has in a way been unfairly treated in the way her government bond yields shot up for not entirely dissimilar reasons and in a way you would be right. Fear, risk aversion and flight to (perceived) quality make for some strange bedfellows and not entirely rational results.
An irony is that economists use long-term bond yields in their equations so on their own these moves would be seen as something likely to improve economic growth. Of course in the current situation nobody is focusing on or really believes that, but as a stand-alone feature it is still there.
The truth is that long-term bond yields at these levels are exhibiting a fear of further recession and possible depression. That is what is contributing to the problems in equity markets. If you look at anything else none of these yield levels are justified. Let me turn the question around and ask you to consider the United States. Exactly what economic scenario would make you invest for ten years in her government bonds for a return of 3.26% per year? You might be thinking along the lines of one or two members of the US Federal Reserve who have been muttering about deflation again according to the official records. Yes that same deflation that all the official intervention was supposed to have saved us from…..
6. Something disturbing appears to be happening in China. Yes this is the same China who’s surging economic growth is supposed to help rescue us all. China’s major stock market indices appear to have entered bear market terrain and there is no great confidence that air can be let out of the property bubble/froth gently. I have been asked about China before and have not fully responded because I have no great confidence in individual figures and statistics from there but I think there has been enough news to venture the opinion above.
What has happened over the past couple of days has highlighted the fear and uncertainty that surrounds world investors at this time. Now markets ebb and flow and we will see rallies and falls but the uncertainty will remain and I think will continue to trouble investors. There has been a loss of faith in official bodies and their ability to influence events just as their expenditure and exposure has reached a maximum and this is not a good combination. There have been some odd and unexpected corollaries of this. For example examined on its own merits I would have expected UK government bond yields to have risen and not fallen over this period. So we have had an exogenous influence of enough fear and risk aversion to counter-act this.
I have recorded themes of the past few months of moral hazard and political grandstanding and these if anything are getting worse in my view. For example point 4 above is full of moral hazards. In terms of political grandstanding somebody commenting in the Financial Times referred to a quote by Albert Einstein which I believe sums up the situation and poses an intriguing question.
The definition of insanity is doing the same thing over and over again and expecting different results
I hadn’t thought before reading that of questioning their sanity.
As to today there are plenty of significant events to come. There is the vote in the German Bundestag on the Greek rescue package and also an Ecofin meeting of European Finance Ministers. After all European news at a weekend to give a market rally makes me think of groundhog day! But whilst I do not know what these events will imply I do know that the themes above will still be there at the end of today.