Market exhaustion?
It’s curious to see so many asset managers reaffirm their faith in a bullish 2012 for world markets just as a buzzing first quarter comes to a close on Friday with hefty gains in equities and risk assets. Whether or not there is a mechanical review of portfolios at quarter end, it’s certainly a reasonable time for review. The euro zone crisis has of course eased, the ECB has pumped the banks full of cash and the U.S. recovery continues. So, no impending disaster then (unless you subscribe to the increasingly-prevalent hard-landing fears in China). But after 11+ percent gains in world equities in just three months on the back of all this information, you have to wonder where the “new news” is going to come from here. The surprise factor looks over and we’re highly unlikely to get 10%+ gains in global stocks every quarter this year. So, is it time for tired markets to sober up for a while or maybe even reconsider the risk of reversal again? Strategists at JPMorgan Asset Management, at least, reckon the economic news has just lost its oomph.
There are broad signs of exhaustion in markets, which is coinciding with a softening in the data, suggesting that in the short term the moderation in the “risk on” environment may continue.
JPMAM cite the rollover in the Citigroup economic surprises indices, shown below, and also say their own propietary Risk Measurement index — a 39-factor model built on data from money markets, equities, economic data, commodities etc — is flagging more caution.
Time for a pause and bit of a think then, at least until the first-quarter corporate earnings season kicks in next month. And it’s here the next leg of any equities story may have to play out, rather than in the corridors of central banks and finance ministries. Gavyn Davies, Fulcrum Asset Management chairman and formerly BBC chairman and Goldman Sachs economist, reckons the valuation case for equities is pretty strong after a lousy decade — even if government bond yields continue rising. What’s less certain, he says, is whether the historically high share of nominal GDP commanded by after-tax corporate profits can persist. This requires a paradigm shift, one he reckons is bridged by globalisaton trends. One quarter won’t solve that puzzle, but attention may shift in that direction over the coming weeks.
Three snapshots for Monday
The NAHB U.S. homebuilder sentiment index held at 28, below economists’ expectations for 30.
Apple will initiate a regular quarterly dividend of $2.65 a share in July and will buy back up to $10 billion of its stock starting in fiscal 2013.
Energy leads the way for commodities this year, but with a big divergence between the components – gasoline sitting at the top while natural gas sits near the bottom.
Iran looms larger on Gulf radar screens
Tensions over Iran may be helping to push up oil prices as traders worry about a widespread embargo on the country’s crude oil but markets in neighbouring Gulf energy-rich economies are not benefiting.
One year after the Arab Spring started in Tunisia, investors remain sensitive to political risk in the Middle East.
Debt insurance costs have risen sharply this month for gas exporter Qatar and oil giant Saudi Arabia, just as global worries appear to be easing about the euro zone crisis.
In Qatar, five-year credit default swaps have jumped 30 basis points in the past 10 days to 150 bps, according to Markit — their highest since July 2009. Saudi CDS have had a similar upward trajectory, while CDS in Israel have reached two-month highs.
Traders say some of this move is just a switching of earlier positions, as Gulf markets performed relatively well at the back end of last year, due to their perceived insulation from euro zone worries.
But as Chavan Bhogaita, head of the markets strategy unit at National Bank of Abu Dhabi, notes:
It has nothing to do with the fundamentals or the credit quality of these sovereigns, but simply about investors getting nervous due to the Iran situation. By buying protection through sovereign CDS, investors are trying to protect themselves against any possible sell-off in the event of an escalation in geopolitical tensions.
If China catches a cold…
China has defied predictions of a hard economic landing for some time now so it is somewhat unsettling to see investors positioning for a sharp slowdown in the world’s second-largest economy.
Over the last 10 years, the world has become accustomed to Chinese annual GDP growth of above 9 percent. A seemingly insatiable demand for commodities from soya beans to iron ore has catapulted the Asian giant to near the top of the global trade table. China is the biggest trading partner for countries on nearly every continent, from Angola to Australia.
But many are now fretting that an unhappy coincidence between stuttering global demand and domestic strains in the property and banking sectors could knock Chinese growth to below 7 percent (the level commonly identified as a ‘hard landing’), with grave implications for the rest of the world.
“It used to be the case that if the US sneezes, the rest of the world catches a cold. But with the US already confined to the emergency room since 2008 thequestion is what happens if China catches a cold,” says Citi in a recent report.
Many are now preparing for the first sneeze.
Commodity exporters are expected to bear the brunt of a sharp Chinese slowdown. Investors have pared back exposure to Brazil, Russia, Chile and South Africa, citing fears over China.
On the flipside, Turkey, Mexico, Israel and India have been identified as less vulnerable.
Venezuela — high risk, higher yield
Which bond would you rather buy — one issued by a country with an unpredictable leader but huge oil reserves, or one with a dictatorial president as well as empty coffers? The answer should be a no brainer. Not so. The countries are Venezuela and Belarus, and a basic comparison of their debt profiles shows how strangely risk can be priced in emerging markets.
Venezuela’s 2022 dollar bond yields 15.5 percent while the 2022 issue from state oil firm PDVSA trades at 17 percent yield. Venezuelan debt pays a 1200 basis point premium to U.S. Treasuries, according to the EMBI Global bond index.
Now check out Belarus. Dire public finances, a huge recent currency devaluation, and seeking an $8 billion bailout from the IMF, yet able to pay 11 percent on its 2018 issue. Its yield premium to Treasuries is 900 bps or three percentage points less than Venezuela.
Is such a huge risk premium on Venezuela justified? RBC analyst Paul Biszko says Venezuelan yields should logically be 300-400 bps lower than current levels, given the strong recent track record in servicing debt — it did not miss a payment even when oil prices fell to $10 a barrel a decade back. Oil is well over $100 a barrel now, yet investors seem unwilling to trust in President Hugo Chavez’ willingness to keep up payments.
“People see him as one day saying he won’t pay so there is limited sponsorship externally for the bonds,” Biszko says. “Meanwhile those who do hold it get rewarded with high premiums…it doesn’t make sense that the premium is double that of Argentina.”
Sure, Venezuela’s economy isn’t in great shape. Inflation is running at 30 percent a year. There is an election coming up. Also, PDVSA has a $2.5 billion bond maturing mid-July. But Chavez is a shoo-in for the election while PDVSA has enough money to pay the bond. And no one can doubt Venezuela’s ability to pay — Barclays estimates its trade surplus this year may hit $90 billion.
Exotix economist Stuart Culverhouse suggests buying the 2019 and 2022 Venezuelan bonds, citing the high yield. ”Concerns over willingness to pay…to some extent overstate Venezuela’s default risk,” he says.
The long term problems with Venezuelan debt are aren’t insignificant. The country has used massive amounts of future oil supplies as collateral for loans from China, so long term ability to pay is diminished. Additionally, the underinvestment in the country’s oil infrastructure is starting to reduce output. Granted, proven reserves are immense but twelve years of Chavez rule have turned the country into a basket case. The country imports everything at this point and the government has turned to complete control over the currency market to cover up what I believe is a coming crisis in forex reserves.
Yes, Chavez will play the safe game with the debt until his reelection next year (an almost certitude). After the election, he’ll have much less incentive to pay on good terms. Given the decision to pay debt payments or pay for absolutely necessary improvements in infrastructure I wouldn’t bet on payments. He may not immediately default the bonds, but a threat of nonpayment is not so unimaginable. Here is the real danger in Venezuelan debt, with hightened levels of risk must come higher yields. As yields increase, prices must decrease. Unless you are planning on holding the debt to maturity you will not realize your expected yield if you have to sell the bonds for a discounted price.
I would not invest in Venezuelan debt but I probably would not invest in Belorussian debt either. At minimum, the investment should be hedged with some kind of default swap or option relevant to your holding period.
Joseph Hogue is a Research Economist for the State of Iowa. He is a candidate for the level III CFA exam and sits on the board of the CFA Society of Iowa.
Bad economic data, please
Interesting twist at the moment – how are financial markets going to view not-so-bad or good data out of the United States in the run-up to the next Federal Reserve meeting.
Investors have been pricing in a chunky operation by the Fed to feed the markets with cheap cash – look at the gold, silver, the Australian dollar and the Canadian dollar. Bad data from the United States will keep investors confident of such Fed action and support the flows into high yielding assets.
But any data showing the pace of recovery in the world’s largest economy is not in such a bad shape. Investors will adjust their expectations and positions, causing a sell-off in equities, speculative-grade credit and high-yielding currencies.
Maybe bad data is what investors want over the next few weeks.
from Commodity Corner:
Why are commodities risky assets for investors?
Recently I received an email asking me to explain why commodities are risky assets. "I would think energy and raw materials would still be in demand, even if Dubai defaults," the writer said.
It's a good point. People need to eat, drink, drive and live. They can't do it without commodities.
But for investors commodities are risky. That is because they mostly invest using commodity futures, which are subject to wild price swings because they react strongly and immediately to demand and supply news and changing expectations for the future. Since commodities became more popular with investors they have also become highly influenced by market sentiment and macro economic indicators and that's why they have been moving alongside equities.
More investors in commodity futures markets is also why the link between equities and commodities has become much stronger over the past year to 18 months.
But that's an aside. Ultimately commodities are risky because they are volatile. Institutional investors don't like volatility whether its price volatility or return volatility.
When is a speculator not a speculator?
A lot of fuss is made about the dangers of speculators in commodity markets. But who is a speculator and who isn’t is based on a definition drawn up in the early part of the last century in the United States. The definition is no longer valid and anybody looking at those reports should be wary of drawing any firm conclusions.
For a start the word “speculator” with negative connotations is applied to pension funds, which invest over the long term to provide retirement income for many people around the world. Hedge funds are normally speculators but if they have hold the physical commodity then they can say they are commercial hedgers. Taking this theme a little further many natural resource companies run their Treasuries as profit making centres, which encourages them to trade the commodities they produce.
The London Metal Exchange has said it won’t go down the route the CFTC has and publish a weekly report detailing speculative long and short positions because there is no clear definition.
The CFTC bowing to popular pressure has continued to provide these weekly reports detailing long and short speculative positions, which ultimately could be misleading and make scapegoats of all investors whatever their ilk.
When is a speculator not a speculator? When the fed stops giving away free money.
Investors break commodities link with equities
Investors smelling profits in commodities are using the sector as an early cycle play, alongside equities, because a lack of production capacity means higher prices sooner rather than later.
Historically, prices of natural resources lag equities, which typically front run the economic cycle by between 18 to 24 months. The change is also partly due to the tumbling dollar, a major driver in recent weeks.
The natural resources sector is also one of the last to price in economic expansion. But not this time.
Global capacity utilisation rates in petroleum products and mining between 2002 and 2007 averaged more than 90 percent. Analysts estimate those levels fell to 80 percent — still very high — in July 2009.
In contrast, utilisation rates among manufacturing companies was estimated at around 65 percent last July from about 80 percent between 2002 and 2007. Equivalent numbers for the auto sector were 45 percent and 80 percent respectively.
The large output gap in manufacturing and the auto sector means production can ramp up easily without any bottlenecks when the global economy sees stronger growth, albeit from low levels.
Not so in commodities, where firms are running a tight ship.
Start building the bunker
They keep telling us that the recession is over so maybe now’s the time to start worrying about inflation. That’s the view many wealthy investors are already taking, reasoning that a little bit of the yellow shiny stuff will provide some comfort as we start piling our cash into wheelbarrows to do the weekly groceries shop.
It is gold exchange traded commodities (ETCs) that have seen the biggest investor inflows this year so perhaps it’s not surprising that the gold price broke through $1,000 an ounce this week.
“Investors are concerned about sovereign risk, quantitative easing, government deficits and the outlook for the US dollar,” said Nicholas Brooks, head of research and investment strategy at ETF Securities, at a Dow Jones Indexes commodities briefing on Tuesday. “They are using gold as an insurance policy.”
Physically-backed gold ETC holdings are now 8 million ounces, up 33 percent versus end-2008 levels, he said. Gold inflows have been relatively steady, even when the price has corrected, with the biggest flows coming not when Lehman went bust, but when the scale of US quantitative easing and the fiscal cost of the financial bailout became apparent. This supports the view that gold is being used as a hedge against sovereign and inflation risk, Brooks said.
Billionaire hedge fund manager John Paulson has been building up a large exposure to gold this year, seemingly as part of an inflation hedge.
John Reade, head of markets strategy at UBS Investment Bank, also confirmed that UBS clients were showing an interest in assets that would provide inflation protection. “You don’t need high inflation for gold to perform well – you only need an increase in the number of people who expect inflation to rise.”
Over the last 30 years the returns from gold have been reasonable but not great, with high volatility, he said. But in an environment where the US dollar is weakening, the Fed Funds rate is rising and inflation is rising, gold can be expected to perform, with returns of over 40 percent per annum if CPI increases. This suggests that an investor’s tactical allocation to gold should rise in the coming months, Reade said.
Well I suspect some people will want to put money in gold. If there is a big push to inflation then real estate should be snapped up a bargain prices and unloaded at the top. Gold is a steady safe investment and I believe it should be kept by those who desire to keep their money in this form. I do not think we will see runaway inflation, but I do think we will see a substantial increase in real estate prices.
