“Eurogeddon” averted or just more can-kicking?

March 9th, 2012

Nick Hays

Dhaka, Bangladesh

Today - on The Long and the Short:

* Largest sovereign default in history confirmed: "Uncharted territory"

* “Eurogeddon” averted? Or just more can-kicking?

* The law of unintended consequences

* “No way out”

Tuesday’s sharp sell-off in equities, driven by a combination of ‘fear-factors’ which I wrote about here, reversed on Wednesday and Thursday, with the S&P 500 up 1.6% during those two trading sessions, recovering all of Tuesday’s losses in the process. 

In the same time frame the VIX ‘fear index’ has taken a solid beating, giving up all its Tuesday gains and suggesting that I may have been too soon in identifying a possible breakout. (I will be writing more about the VIX and S&P 500 in my next post.)

News flow out of Europe has been the dominant driver behind the price movements during the last couple of days, with fears of a disorderly default in Greece receding as negotiations for the PSI (Private Sector Involvement) reach a  conclusion. The PSI involves holders of E206bn in Greek government debt agreeing to trade in their existing bonds for newly issued ones of lower value. This write-down, or “hair cut”, equates to a loss of over 70% in Net Present Value terms for the bond holders.

Today it was confirmed that investors holding 83% of holders of Greek government debt have accepted the proposed bond swap. This beats the 75% below which the deal would have failed, triggering a disorderly default and likely financial chaos across the Eurozone.

The largest ever sovereign debt default, and the first for a Western European country in 50 years, this is huge news and analyst commentary on the deal is pouring in. The short-term market reaction is likely to be one of mild relief. However the longer-term picture remains far from certain and I expect it will not be long before doubts begin to resurface – to be sure, this has been the cycle for at least the past 12 months.

What comes next is very much up for debate as, in the words of Berenberg Bank’s Chief Economist, “We are in uncharted territory”.

Eurogeddon averted? Or just more can-kicking?

The aim of the debt deal is to reduce Greece’s sovereign debt burden from more than 165% of GDP to a more manageable level. Best-case scenarios project this deal will set Greece on track to reduce its debt levels to 120.5% of GDP, just above the maximum threshold of 120% considered sustainable by the IMF.

Longer term, however, considerable risk remains that this deal is little more than the latest in a series of can-kicking exercises, simply buying more time before the next crisis inevitably rears its ugly head. In fact the IMF itself sees Greece’s debt to GDP ratio on an “ever-increasing trajectory” and much doubt remains as to whether the debt burden can be reduced in the long-term. In fact, the new bonds are already trading at steep discounts to face value, indicating that the market still does not expect Greece to be able to pay back in full. 

The severe austerity measures ongoing in Greece are a painful but necessary step towards debt reduction for the country; but most economists agree that these measures must be accompanied by much-needed market reforms to improve its trade competitiveness. Deprived of the option to de-value its currency (aside from the ‘nuclear’ Euro-exit option) Greek competitiveness will have to be restored through a combination of a painful reduction in wages (making Greek exports more attractive) and removing the market-unfriendly policies and red-tape which currently throttle the private sector.

The scale of the reform required and the difficulty to implement it should not be underestimated. In this respect, Greece is like a patient requiring double heart bypass surgery, a lung and kidney transplant and chemotherapy all at once. Carrying out the necessary treatment to get Greece back on its feet undoubtedly means a lot more pain ahead for the country and its people: expect to see more urban violence, tyre-burning and pitched battles with riot police in the months ahead.

Street thuggery aside, the upcoming elections in May will provide a more constructive outlet for the Greek electorate to voice its frustration - and perhaps to vote in a new government on the back of promises to 'ease the pain'. This could mean scaling back on austerity measures, further debt default, a Eurozone exit or all three.

The road ahead for Greece will not be free of challenges, that much is clear, and the market’s relief resulting from the debt resolution will probably not last long. In fact I believe the deal itself sets a dangerous precedent and may result in a number of unintended consequences.

Unintended Consequences

Risk 1: Greek debt deal may encourage other sovereigns to follow the same path.

If Greece can reduce its debt burden by imposing a 'voluntary' default on its creditors, what is to say other nations won't also look to this approach? The other PIIGS nations - Portugal, Italy, Ireland and Spain - may well calculate default to be a more politically acceptable route to debt reduction than the programme of grinding austerity measures to which they have currently subscribed.

Anticipating this, credit markets would demand higher yields to compensate for the additional risk of default. Higher yields make the governments’ debt harder to service, with more and more output being consumed by interest payments. Hence their fiscal position becomes less sustainable and this in turn makes default all the more likely - a downwards spiral ensues.

Risk 2: Greek deal undermines the value of CDSs (Credit Default Swaps)

CDSs are essentially insurance premiums which investors and speculators can purchase to profit from a default on the debt obligations of a corporation or a government. One key difference between a CDS and an ordinary insurance premium is that you don’t have to own the underlying asset in order to buy the CDS – an analogy would be insuring a house against fire damage when you don’t actually own the house.

CDSs are economically useful because they enable bond investors to hedge their exposure, with the aim of reducing their overall risk. This ability to hedge their position and reduce risk makes investors more willing to invest in the bonds in the first place – all else equal, this increases demand, raising the bond prices and reducing the yield (yields go down as bond prices go up). The corollary of this is obvious: undercut the value of sovereign CDS and you raise the yields on government debt. When this happens, governments find it more expensive to raise capital or to roll-over maturing debt.

This is exactly the risk facing us today. Let me explain.

For all the talk of this being a "voluntary" write-down, the reality is that the private sector has been strong-armed into the deal, and was left with little choice but to take it. The message from the Greek Finance Ministry essentially boiled down to, "it's this or nothing": in other words, either everyone takes the "voluntary" PSI deal now or we proceed with an outright default and you get nothing.

The short-term consequences of an outright disorderly default would have been nothing short of catastrophic, certainly dwarfing any hedging gains from CDS payouts. Hence it should probably come as no surprise that today’s debt deal demonstrates the fact that Greek bondholders (on aggregate) have calculated that a 70% "voluntary" haircut and no CDS pay-out is preferable to a 100%  disorderly cut with a CDS payout.

But to call this "voluntary" is stretching the definition. The decision facing bondholders was like a man being given a choice between being hit by a car or by a freight train. Pausing for just a moment, the man responds, “Neither option sounds good to me, but on balance I'll take my chances and go with the first one...”

Essentially bondholders have not been given a choice at all. And what is more, in the process of accepting the "voluntary" default, bondholders may have surrendered their rights to any CDS payouts.

Whether to pay out on CDSs or not is the subject of discussion at an ISDA meeting (International Swaps and Derivatives Association) this afternoon. The committee (made up entirely of investment banks  and asset managers) requires a super majority (12 out of 15) to make a ruling. However regardless of the outcome of that meeting, the mere existence of doubt as to whether CDS payouts should or should not  be made in itself trashes the value of that instrument as a future hedge. To re-use the analogy, why waste your money insuring your house against fire when you expect the insurance firm will wriggle out of its obligation?

By undermining the value of default insurance (and all else remaining equal) bond yields will rise as traders price in the higher risk associated with holding a position which cannot be directly hedged. This has the potential to lead us to the same downwards spiral which I highlighted in Risk 1.

The long and the short of it?

Any relief rally associated with the Greek deal will be short-lived as questions of the country’s fiscal position resurface and investors begin to get to grips with the longer-term implications of today’s events.

Odds-on bet: we have not seen the last of easy monetary policy from central banks worldwide and we are likely to see a lot more of this in future. Governments and investors alike have become addicted to liquidity courtesy of the Fed, ECB, BoE and BoJ and, like an addiction, each time a bigger ‘hit’ is needed to have the same effect. As the Wall Street Journal wrote on 27^th February:

“All of the available signals point to the likelihood that the Fed will have to turn to more vigorous creation of new money (inflation) at some point—or face the possibility of rising market rates on government securities that sharply raise the Treasury's borrowing costs and devalue the Fed's enormous balance sheet.

No way out. No way out.”

EDIT:
Related Bloomberg article:
 “The rules have been changed here,” Gross, co-chief investment officer at Pimco, said in a radio interview on “Bloomberg Surveillance” with Tom Keen and Ken Prewitt. “The sanctity of their contracts is certainly lessened. Bondholders have that to look forward to going into the future.”

 

Fear Returns

March 7th, 2012

Nick Hays

Dhaka, Bangladesh

Today - on The Long and the Short:

* Fear returns

* VIX break-out?

Major stock indices took a nose dive yesterday while the VIX “fear index” spiked over 15% during the biggest one day equities sell off of 2012 to date.

After two weeks of relatively calm and flat trading, some of the risks I identified in my earlier post here appear to have bubbled to the surface. Amongst them are renewed doubts regarding the finalization of the Greek debt deal, the increased probability of slower Chinese economic growth in future, and signs that the Fed will press "pause" on any further monetary easing for the time being.

Whether this is the start of a larger correction or not remains to be seen. What is clear to me is that risk had been significantly under priced and yesterday was a much needed splash of cold water on the markets.

What is more, one chart that I'm watching closely is indicating that things could be about to get worse:

As you can see in the above chart, since late December the VIX has been trading in a downwards sloping channel, indicated by the red lines. Technical analysts use charts to work out possible areas of ‘resistance’ and ‘support’ for prices. The trading channel I’ve identified is not perfect but yesterday’s price action on the VIX may suggest that it has broken out of this channel and is poised to go higher. Given the negative correlation between the VIX and risky assets such as stocks, a spike in the VIX would point to lower prices for the major indices.

Much will depend on the outcome of this week’s Greek PSI (Private Sector Involvement) negotiation. The Iran situation also remains very much a wildcard event with the ability to send major shockwaves through the markets. Recent Obama rhetoric in my view has increased the probability of an escalation in the Middle East. (Interestingly from a local perspective here in Dhaka, a Saudi diplomat was shot dead at close range yesterday in my neighbourhood - perhaps inevitably, media speculation of an "Iran connection" is rife.)

Very interesting times indeed, let’s keep watching…

Market sweet spot or sugar rush rally?

February 24^th, 2012

Nick Hays
Dhaka, Bangladesh

Today - on The Long and the Short:

* Market sweet spot or sugar rush rally?

* The VIX - is the market underpricing risk?

* Forever blowing bubbles

Markets in the Sweet Spot?

The last two months have seen markets stage a powerful rally. Markets for risk assets have been buoyed by the convergence of three key factors: improved US economic data, reduced probability of a ‘disorderly’ default in the Eurozone and continued injections of massive amounts of liquidity by central banks.

The ECB, BoE and BoJ have all participated in recent bouts of liquidity since December 2011:

· ECB - €489 billion LTRO programme (December 2011)

· BoE - £50bn quantitative easing, or “QE3” (February 2012)

· BoJ - ¥10 trillion (US$129bn) (February 2012)

Future sources of additional central bank ‘pump priming’ will come in the form of the ECB’s second LTRO this week, which is expected to be worth an additional €500-750 billion according to Standard Chartered; the Fed is also widely anticipated to launch its own version of “QE3” later this year. Furthermore the Fed’s recent commitment to low interest rates through to 2014 has been another prop to risk assets.

It's a potent mixture. The result? Major equity indices are now up 20% or more since October. Yields on the sovereign debt of ‘peripheral’ European economies such as Portugal and Italy are down sharply since late January. In summary the risk-on rally has been very much back in play (see charts below).

S&P 500 index – 6 month chart (click to enlarge)

(The red arrow I’ve added highlights declining trading volume, demonstrating that the rally lacks broad market participation. For some this is an indicator that the rally lacks ‘conviction’. A major driver of this is in fact that average retail investors have been largely sitting on the sidelines and have missed the recent gains. Incidentally, a rush of retail investors to the market is a popular contrarian indicator. The AAII's Sentiment Survey can provide clues) 

   

Italian Government 10yr Bonds
(click to enlarge)

    

Portugese Government 10yr Bonds
(click to enlarge)

Sugar Rush Rally 

How much longer can we expect to remain in the market “sweet spot”?

Continued cheap money courtesy of central banks and the simultaneous improvement in the economic outlook surely will not continue in parallel indefinitely. One of these factors seems likely to reverse: either the economic data continue to improve and central banks reign in the easy money, or the data worsen. Either one of these events will result in the market losing a major prop to current prices.

For now, however, markets seem to be having their cake and eating it too. Are we approaching a come down after the sugar rush rally?

To help answer that question, one indicator I’m watching closely is the VIX, aka the ‘Fear Index’.

The Fear Index…and what it’s telling us

The VIX is a measure of volatility as implied by the price of options contracts for the S&P 500 index - essentially this is the cost to insure against large moves in future market prices. The VIX tends to spike during times of market volatility as investors seek to hedge positions, and drops during periods of relative calm. For this reason it is commonly known as the ‘Fear Index’.

Below is a 5 year chart of the VIX:

And here’s the VIX going back to 1990:

  

As you can see from the above charts, the VIX has dropped more than 50% since October 2011. Looking longer term, the VIX’s Friday close of 17.31 is below the average closing price from 1990-2012 of 20.56. (Excluding the period since the onset of the financial crisis, the average price from 1990-2007 was 18.97).

This tells us that the market is pricing in a relatively low probability of future volatility. While this may be a rational response to the current ‘sweet spot’ conditions described above, I believe that the market is betting on an overly benign outlook and there is a considerably fatter “tail risk” than is currently being priced in.

Fat tails and known unknowns…

A number of economic and geopolitical risks exist, each of which is capable of delivering a sharp dose of reality to the markets.

1. Good news is bad  news – continued improvement in US economic data would reduce the probability of the Fed launching another round of money printing (QE3). An uptick in inflation would likely have a similar effect.

      2. Europe not out of the woods yet - History suggests that the Greece bail-out announced last week is not the last we’ll hear on the Euro zone crisis. The recent Greece deal was met with little enthusiasm by the markets and analysts are already questioning the viability of the recent deal, including the IMF whose assessment is that the balance of risks is “mostly tilted to the downside”. Furthermore, the hard line being taken by Draghi and the ECB (i.e. the focus on austerity measures to achieve debt reduction) risks exacerbating the current slump in European output. The IMF’s view is that the current stance risks sending Greece’s debt  “on an ever-increasing trajectory”.

      3. China hard landing - efforts to cool an overheated economy in 2010/2011 appear to be taking effect, in particular dampening activity in the real estate sector.  Preliminary March data from HSBC’s Purchasing Managers Index indicates declining activity for the 4^th straight month. The risk remains that China will fail to engineer a ‘soft landing’.




HSBC China PMI

  4. Middle East conflict – Syria develops into a full-blown civil war, perhaps spreading into Lebanon and destabilising the region. Iran/Israel conflict. Oil prices surge, acting as a brake on a fragile economic recovery in the US.

Forever blowing bubbles

Is risk underpriced and are assets overinflated? That depends on your perspective. Examining the fundamentals alone, the answer may be yes. Among the signals that prices are a little rich at these levels, the Cyclically Adjusted PE ratio (CAPE) is now above the long-run average, and US corporate profit margins are showing signs of having peaked.

It seems that markets are increasingly reflections of central bank policy, rather than the long term underlying fundamentals. As PIMCO’s Mohamed El-Erian puts it:

Unusual policy activism on the part of central banks...has inserted multiple wedges between valuations and the underlying fundamentals. It has also altered liquidity conditions and affected the functioning of certain markets.

http://www.cnbc.com/id/46517952

Are central banks in the process of blowing yet another asset price bubble?

That may be so, but it may also be unwise to bet against the current tidal wave of cheap money. In the words of Warren Buffett , markets can remain irrational for longer than you can remain solvent. In other words, ‘don’t fight the Fed’.

Furthermore, can we even argue that the current market is pricing ‘irrationally’? To an extent, the market today is merely a rational response to two powerful trends: socialisation of risk by governments and loose monetary policy. These trends have been in place at least since the bursting of the dot com bubble, but have accelerated since the onset of the GFC in 2008.

For all the talk of ‘no more bailouts’ and breaking up the ‘too big to fail’ banks, banks are now larger and more concentrated than ever. The climate of moral hazard is alive and well and we must be alert to the effect on investment behaviour that this has.

The takeaway?

Markets may well be exhibiting some signs of ‘irrational exuberance’ in the short term and it may therefore be wise to tread carefully before committing any new funds to risk assets. My expectation is that lower equity prices will materialise in the near future.

However any correction which does come may be short lived. The current climate of easy monetary policy means that investors may need to accept a ‘decoupling’ of asset prices from fundamentals for some time ahead.

In the meantime, I will be keeping an eye on the VIX as a possible hedge against future volatility.

Constructive comments and feedback are very welcome below, or else you can contact me at nicholashays1@gmail.com