Monday, May 24, 2010

The new order is chaos

The new order is chaos
By Chan Akya

I saw a wonderful cartoon this week, which had two kids (one of whom is holding a needle close to a balloon) approaching a balding middle-aged man reading one of the financial newspapers, with the caption "Watch him jump". Replace the adolescents with today's politicians (actually scratch that, most politicians are still adolescent at least as far as their mental growth is concerned) and the balloon as burst; you have the perfect picture of what happened in the markets.

Anyone looking for the "new normal" doesn't have to look too far from the events that drove this week's trading so far. In summary, academics and economists (reportedly there is a difference between the two) have been searching for a "new normal" for the world economy as it attempts to recover from the crisis of 2007.

What they are missing is that the "new normal" isn't going to be

defined by the relative economic growth of various countries or the dynamics of inflation; what will define it (as is increasingly becoming clear) is the return of absolute, gut-wrenching volatility that makes investing a permanent state of siege. In that environment, investor behavior is reactive rather than proactive and surprises abound on both the up and down directions.

Welcome to a new world where the definition of order is a state of continued chaos.

What caused this meltdown?

The primary policy response globally since October 2008 has been Keynesian, that is, to throw good money after bad in the fervent hope that any resulting inflation would help to reduce the present value of debts while creating new asset bubbles that could encourage consumers to return to their big spending ways. For a while, the strategy seemed to have worked, what with all manner of risk assets rising over the course of 2009. The indicator that the financial media are most obsessed with is the stock market; and unfortunately for the headline-writers and other cheerleaders for the global economic "V-shaped-recovery" malarkey, that isn't looking in good health now.

As things stand today (May 20), European stocks (Euro Stoxx) are down 13.35% on average for the year (25% down in US dollar terms) within which there is a significant variance across the various countries - Germany's DAX index is only down 1.5% (15% in US dollar terms) while Greece (-27%) and Madrid (22%) have done horribly. In Asia, the Nikkei is barely flat for the year in US dollar terms while being down 5% or so in the local currency; for the Hang Seng index in Hong Kong the decline is 10.6% for the year. The US stock markets, which led the rally last year, were basically flat for the year on Wednesday; declines on Thursday pushed the S&P index down about 2% for the year.

The first polemic: Buyers of risk have the power in the markets today precisely because governments have abrogated fiscal responsibility. In that context, when you are in charge of a government that needs to borrow tens of billions of dollars from the markets every day, it may be a good idea neither to startle people nor indeed to lecture them. It doesn't look to me that German Chancellor Angela Merkel or President Barack Obama have got this particular memo, for they have done precisely the opposite thing.

The second polemic: Governments around the world and particularly in Europe can pretend that this bout of crisis is all about the evils of hedge funds, speculators, short-sellers and whatever have you; the truth is closer to home. Over-leveraged institutions and indeed instruments are prone to rapid bouts of volatility. Any solutions that fail to address excessive leverage would likely buy time and do nothing else. Governments cannot get away with this bluster much as they try to paint new villains into their own ghastly policy responses.

The third polemic: This relates to the political classes - no offense but do shut up. Buyers of risk (see polemic number one) have no appetite for lectures and have been forced to do more work on ensuring that whatever they buy is worth the trouble from a risk perspective. Add a whole bunch of unrelated political noise to these complex equations - and that means your speeches, my dear politicians - and what you have is the makings of a buyer's strike. And if that happens ... oh well, let's not consider that, okay?

Recent developments
This week would certainly never be categorized as "slow news" by any stretch of the imagination. Financial markets were abuzz with developments most of which proved extremely expensive for investors who owned risk (or "long" in the market parlance).

To be sure, there were enough other events that were non-financial: the continued oil spill in the Gulf of Mexico, the tragic events in Thailand, the escalation of rhetoric between North and South Korea over the torpedo incident and the new nuclear deal signed by Iran to defuse tensions. Unfortunately for investors, all of these events were considered strictly with the jaundiced eyes of those who panic; in other words, all of the above compounded the negative tone of the markets (admittedly most of the above is actually bad news).

A look here at the main developments from a financial perspective:
German short-selling ban
The biggest mover of the markets was the announcement by Germany on Tuesday to disallow short sales of European government bonds, "naked" credit default swaps (CDS) and the short positions in the stocks of Germany's 10 biggest financial institutions.

Market reaction ranged from the incredulous to the irreverent (example - a popular e-mail carried a fake headline as its subject "Germany bans goals against its team in the World Cup"). There were a lot of details left to be ironed out by the announcement made by the BaFin agency; not the least of which was how the new rules were going to be enforced and its geographical scope. The confusion only deepened when other European countries, including France and the United Kingdom, denied that the rules were applicable across the region.

As things stand, the rules, if adopted across Europe, would carry significant but unintended consequences. Bear with me for a moment here, but the complexity below is necessary to drive home the point about how clueless today's government officials are with respect to the market.

Take the ban on "naked" CDS; under the rules, no one may purchase protection on a European government without owning underlying bonds. Assuming that everyone complies, there is still a very big problem, that is, that while bonds carry pretty much any maturity date, most CDS contracts are set to mature in quarterly intervals (20th of March, June, September and December).

So if you owned a bond that matured on say February 10, 2015, you would want to buy protection close enough to that date; hence to March 20, 2015 - technically, the rules would disallow this CDS because your contract has a "naked short" exposure on the European government for a month longer than its maturity. Well, why couldn't you get a CDS to mature on February 10, 2015 - because the dealers would consider it illiquid and prefer not to trade with you for the date. Your other alternative would be to purchase protection until December 20, 2014; however, in that event, you as the investor would be left with a "naked long" position for 40 days (which, given this year's meltdown in European government debt, would be unacceptable).

The solution then would be for you to purchase a bond that matured exactly on the CDS rollover dates. This would in turn force governments around Europe to issue bonds that only matured on the appropriate CDS contract dates. Imagine a government having maturities of say 50 billion euros in a given year; that would mean going to the markets on just four days of the year with 12.5 billion euros each time (and remember that all other European governments would also be approaching the market for funding on those same days). The net result is that volatility in the bond markets would increase, not decrease due to such maturity concentrations.

(Yes, I am aware that there are many other solutions, but the point here is to highlight linear interpretations of ill-considered laws).

Other regulatory risks
Just to make things interesting, regulatory risk has increased manifold over the past week:
# The European Union is proposing a comprehensive hedge fund regulation that would target the operations of hedge funds across the continent and also limit the ability of European citizens to invest in hedge funds alongside. This is part of the political noise from Europe in recent days but is thought to have significant (adverse) consequences for market liquidity if it is adopted across Europe and particularly by the UK.
# There is the much-discussed financial reform bill in the US that is making its way through the process with more than its share of headlines; it was finally approved in the senate on Thursday and must now be merged with a House of Representatives version. It is expected to be signed off by early July. Among other things, the bill calls for new ways to watch for risks in the financial system and writes new rules for complex securities. It would also impose restraints on the large, interconnected banks and call for proof that borrowers could pay for the simplest of mortgages.
# The impetus towards a global bank tax has gathered momentum, with both Germany and the UK proposing different variations of the idea. This is a straightforward negative for the share prices of banks but as it highlights the notion of governments scrambling to impose retrospective taxes obviously to improve their fiscal positions the markets are looking at other sectors, including metals, mining, energy et al.

Poor economic data
Forget all the market noise; one can always depend on fundamentals, right? Oh well, not this week. Even as the US produced a surprise deflation print that suggested that sales were only happening at the expense of margins (thereby rendering questionable the market expectations of profits), there was worse news from employment, when claims increased a surprising amount for the week. Elsewhere, the UK produced a surprisingly aggressive inflation print that suggested the counter-effects of the marked decline in the pound sterling for the past few months as the country effectively imported its inflation; this has negative consequences for Europe, where much the same combination of fiscal/quantitative expansion and currency devaluation is happening now.

Commodities, Australia, miners and metals
Following from an Australian government's initiative to tax commodity exports in order to buttress its finances, prices have become more volatile both for companies operating in the business and for the actual commodities as financial markets grapple with the potential consequences. There is now elevated risk that other major exporting countries such as Chile, Brazil and Canada may follow suit, in turn making commodity prices more volatile.

The volatility itself is being fed by the decline in stock markets that has created a negative spiral of wealth for individuals, a postponement of large initial public offerings and share placements, including potentially the $25 billion deal mooted by Petrobras; and a general re-rating towards a negative view.

In credit markets, this has translated into significant bouts of panic. A number of large commodity-based companies have large outstanding lines of credit from global banks under which they would be able to draw down billions in funding whenever required. Given that banks are now paying much more for their funding - particularly if they are based in Europe - and the commodity companies have less illustrious future earnings (apparently), the urge to hedge has vastly increased, thereby driving CDS levels sharply wider.

Zero-sum game exposed
One of the factors keeping the US and emerging markets ticking away in the beginning of the European sovereign crisis was the notion that market flows represented a zero-sum game, ie that outflows from Europe would help market performance elsewhere.

This has now been exposed as a lie as markets have become more cognizant of two constraining factors - firstly, the economic effect of fiscal tightening being imposed across the continent, which would reduce aggregate demand for exports from the US and emerging markets; and secondly, the collapse of the euro, which dramatically escalates the competitive position of exports from the continent (at the expense of the US and emerging markets).

Thus, rather than a zero-sum game, the decline of Europe simply transmits itself to the rest of the markets as a negative.

The way forward
Much as this may seem counter-intuitive, the lesson for governments globally is to do as Germany did, not as they say. If one considers the experience of the country embracing real wage deflation from 2000 to improve its competitiveness and eschewing leverage in favor of a gradual build-up of productivity, it appears almost logical for a number of other countries that have similar demographic situations (much of Europe, the US and others) to follow.

The trick is to avoid listening to the German government as it stands today; where meaningful reforms are being sacrificed at the altar of political expediency in favor of some neighboring countries, such as France. With Germans voting against the current political equations, the rhetoric has become shriller as the attacks on hedge funds and naked shorts make clear.

Markets have woken up to the risks of the excessive debt build-up by governments globally. This will have credit consequences (ie some countries will have to restructure their debts) that then flow to interest rates (as bond yields become steeper or rise) and from there to the rest of the economy (savings will be forced higher, consumption down). These are precisely the objectives that policy responses should have focused on since the beginning of the crisis - it just so happens that when governments avoid tough action, markets go in and do it for them.

The larger lesson is that thanks to the counter-intuitive and eventually counter-productive actions of the Keynesians running global governments today, chaos is the new order; a constant state of crisis is the new normal.

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