An independent professional's take on the latest news and trends in global financial markets

Cyprus and beyond: more thoughts

As usual it will take a day or two for the markets to decide which of their initial reactions to the Cyprus bailout – relief that a deal has been struck, or concern at the implications of the terms imposed by the troika – will prove dominant. Some things do seem clear from what we have learnt already:

  • This was the most acrimonious bailout negotiation yet, with little love lost between the Cypriot negotiators and the troika representatives on the other. Talks came close to breakdown on several occasions over the course of the past week. Apparently tipped off in advance that the Russians would not come riding to the rescue, the troika played hardball – and eventually won, although not before the Cypriot President had threatened to resign and/or take Cyprus out of the euro – a desperate course of action which the influential Archbishop of Cyprus, for one, has openly advocated.
  • Although the deal will avoid the outcome of Cyprus leaving the euro for now, that still remains a possibility. The bailout creates a number of important precedents, raising the possibility that bondholders and depositors in troubled banks elsewhere in the Eurozone could be forced to pick up the tab if their bank needs to be rescued in future. The Dutch finance minister who now heads the Eurogroup said as much yesterday, and subsequent attempts to smooth over his remarks – which were remarkably explicit – have been less than convincing.

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Written by Jonathan Davis

March 26, 2013 at 2:01 PM

Cyprus: new fault lines in the Eurozone

What to make of the Cyprus rescue deal announced this morning? Is it necessary? Absolutely: the Cypriot banking system is insolvent, and has been ever since the Greek rescue deal last year, if not before. Is it fair? Probably not. Knowing how weak the Cypriots’ bargaining position was, the troika (EU, ECB and IMF) has played hardball with one of the EU’s smallest member countries, which makes it certain that for every irate mobster or money launderer who loses a chunk of their capital, there will also be many hard luck cases.

The deal administers rough and ready treatment to bank depositors in the country’s two largest banks, while preserving – belatedly, and at the second attempt – the general principle that depositors with less than $100,000 euros are still protected from loss by state guarantee. (Important to note that while the EU has enshrined this principle as a political objective, the guarantees are only as good as the individual state that provides them. Cross-border deposit insurance, under which the EU would collectively guarantee bank deposits in all member states, is necessary if the banking union which the EU is trying to edge towards is ever to become a reality, but it remains so electorally toxic that it won’t be introduced any time soon). Read the rest of this entry »

Written by Jonathan Davis

March 25, 2013 at 4:12 PM

Reality and euphoria in the equity market

In the modern era strong equity market performance in January is not, as used to be believed in days gone by, a reliable forerunner of a good year ahead for the stock market, which is a pity as 2013 has certainly got off to a roaring start, with both the S&P 500 and the world index up by 5.0%, and the main Japanese indices up by nearly twice that amount.  After its lacklustre performance in 2012 the UK equity market produced an impressive 6.4% and China, a dark horse favourite for top performing stock market, a tad more.  However, as this useful corrective note from Soc Gen’s top-rated resident quant Andrew Lapthorne makes clear, there are some curious features of the markets’ generally impressive performance that give cause to doubt quite how enduring this rally will in practice prove to be.

Firstly debt issuance by companies is riding high and a large chunk of this debt is being used to buy back shares. This creates a virtuous circle, where increasing debt issuance supports share prices, pushing down implied leverage and volatility at the same time, which in turn supports ever cheaper credit for the corporate. So, once again, with one of the key marginal buyers of equities the corporate, using capital raised in the debt market means that, as ever, the fate of the corporate bond and equity market are intertwined and as such last week\’s weakness in the high yield bond market is worth keeping tabs on. Read the rest of this entry »

Change on the way at the Bank of England?

I have always liked the pragmatic approach to economics of the Financial Times Economics Editor Chris Giles, whose balanced pieces are a useful corrective to the doctrinally-driven work of most economists. His recent article in the Financial Times included this sensible comment on the most recent speech by Sir Mervyn King, Governor of the Bank of England, which I think was a significant milestone on the road towards what increasingly looks like a coming change in emphasis in UK monetary policy.

On Tuesday evening, Sir Mervyn King completed his slow conversion from being an activist on what economists call the “demand side” to a “supply side” pessimist. Where the Bank of England governor once saw monetary policy as a simple tool to reinvigorate spending and bring the level of output back to its previous trend, his speech indicates he now sees the pre-crisis period as infected by unsustainably overexposed bank lending and “unsustainable paths of consumption”. Read the rest of this entry »

Written by Jonathan Davis

January 27, 2013 at 8:29 PM

Hold on to your hats in Japan

The dramatic upwards move in the Japanese equity market since the autumn has plenty further to go, according to Jonathan Ruffer, the founder of the private client fund management group Ruffer LLP, one of the professionals whose latest thinking I (and many others) like to follow closely.  Ruffer as a firm has held an overweight position in Japan for quite a long time, and now stands ready to be vindicated if Japan’s new reflation policy takes hold, as the markets now seem to be assuming. Writing in his latest quarterly review, he comments as follows:

We hold roughly half of portfolios in equities, in the UK, Europe, US and Asia, but the largest geographic position is in Japan. This market was broadly flat when we last wrote to you, although we had made good money in financial and property stocks. In the last quarter these and other holdings surged further, providing a strong finish to a dull year. The rationale in Japan remains intact; it is the warrant on world economic growth, and so more of the same in terms of monetary stimulus should favour Japan without the rest of the world’s downside. The stability of Japan, its lack of overcapacity, and the absence of financial or labour fragilities, give some protection, and afford it the ability to generate a self-sustaining economic recovery. The low expectations built into the possibility of a Japanese economic recovery provide the opportunity for further sharp market rises. The major obstacle to a more bullish backcloth has disappeared with the appointment of Abe as Prime Minister, and the forthcoming retirement of Shirikawa as Governor of the Bank of Japan. In this new world, the investment danger for foreigners is a weak yen (we have been fully hedged), but this is a benefit to the equity market. Read the rest of this entry »

Written by Jonathan Davis

January 21, 2013 at 3:33 PM

Fools rush in while wise men take their time?

The New Year has started well, with plenty of evidence that professional investors are continuing to rediscover their appetite for risk assets, with the price of equities, corporate bonds and high yield debt all heading higher. The charts for leading equity indices, including the S&P 500 and the FTSE All-Share, have been trending higher ever since Mario Draghi, the head of the European Central Bank, announced last summer his intention to “do whatever it takes” to prevent the eurozone from falling apart. He has every reason to be pleased with the response to his intervention, which to date has been effectively cost-free. Would it were always so easy! European stock markets, having been priced for disaster before, have led the way up as fears of the euro’s fragmentation recede. Volatility, as measured by the VIX, has meanwhile fallen to multi-year low levels. Read the rest of this entry »

The eurozone’s fundamental problem

For those with an interest in the interminable eurozone saga, this syndicated interview with the French president Francois Hollande is well worth reading. It sets out clearly the main current differences in approach between M. Hollande and Mrs Merkel as they set off for the latest European summit, which starts today.  As always the meeting will attempt to paper over the cracks between these two very different ideas of how greater political and fiscal union in Europe should be achieved. There is still a long way to go before a really durable solution that can guarantee the euro’s survival is reached (if indeed that proves to be possible).

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Written by Jonathan Davis

October 18, 2012 at 11:26 AM

Myopia in the stock market

We all know that private investors are typically scarred and scared out of owning equities by their aversion to incurring losses. Yet the scale of that aversion is staggering, according to some research recently reported by the Franklin Templeton fund management group.  Its annual survey of investor sentiment allows it to ask investors what they think has happened to the stock market each year, and then compare that perception to the reality.

So for example the proportion of the 1000-investor sample which thought stocks had fallen in 2009 was 66%. Yet the S&P 500 index in that year was actually up 26%. The comparable figures for 2010 were 48% (who thought the market had fallen) and 15% (the actual market rise). More than half the survey also thought stocks had fallen in 2011, when the market in practice was flat.

The fund manager’s theory is that these figures are testament to the behavioural bias which prompts humans to give undue importance to one bad experience – the 2008 crisis, which sent the S&P index down 40% – and ignore more favourable outcomes. Whatever the explanation, the data certainly helps to explain why so much money has flowed out of equity funds into bond funds since the crisis broke, in apparent contradicton to common sense and historical experience.

Written by Jonathan Davis

October 17, 2012 at 3:59 PM

A dissenting view on inflation

Has the Bank of England lost control of interest rates? You won’t hear that view from any official source, but it is worth listening to the economist Peter Warburton, the founder of the consultancy Economic Perspectives, whose often dissenting opinions have been more right than wrong over the past couple of decades. He argues differently in this contribution to the Shadow Monetary Policy Committee’s latest review of economic conditions, in which he warns about the incipient threat of price inflation. It is well worth reading: I suspect it will look very prescient when we look back in years to come.

It is becoming increasingly obvious that the Bank of England has lost control of UK retail borrowing costs. During the three years-plus that Bank Rate has been set at ½%, the average interest rate paid on banks’ and building societies’ notice deposit accounts has risen from a low of 0.17% in February 2009 to 1.83% in July 2012.

Admittedly, the quoted monthly rates have bounced around, but the average for 2012 is 1.41%. This is a measure of the average cost of retail funds to the banking sector; the marginal cost is closer to 3%. On the other side of the balance sheet, Santander UK has recently announced a 50 basis point increase in its standard variable mortgage rate, to 4.74% from October. Clearly, the level of Bank Rate has played no role in the evolution of market rates for the past three years. The MPC’s consideration of a cut in Bank Rate is perverse and farcical in this context. As and when the UK economic news flow permits, Bank Rate should be raised in order to reconnect it to the structure of market rates. However, with UK activity indicators currently erratic and weak, now is not a good time to do this. Read the rest of this entry »

Written by Jonathan Davis

September 4, 2012 at 9:41 AM

The risk of a short circuit in markets

Richard Burns, until recently the senior partner at Baillie Gifford, is now chairman of a range of the firm’s investment trusts, including Mid Wynd International, a special situations fund that holds positions in interesting companies that are too small to make a difference to its flagship funds. This is his most recent take on the investment environment, taken from the trust’s annual report. With the Eurozone crisis continuing to cast a shadow over events, and equity markets not obviously cheap, cautious and pragmatic investors (a type much in evidence in Edinburgh) are mostly marking time for now.

Repeated central bank stimuli have managed to contain, for now, what would otherwise have been a combination of Western debt deflation and deep recession. These interventions buy time, but not an indefinite amount. Policy making in the afflicted parts of the Western world appears to be running up against the laws of diminishing returns. Underlying sovereign balance sheets are deteriorating further meantime. What has happened is akin to stripping insulation from the bare economic wire – governments and central banks are that insulation. As time goes on, and in the absence of a more potent recovery, the risk of short-circuit increases.

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Written by Jonathan Davis

August 30, 2012 at 9:04 AM

An illusion of safety in bonds

Bruce Stout, the manager of Murray International investment trust, is another fund manager whose conservatism and preference for defensive high yielding equities has rewarded his shareholders well over the past few years. Earlier this year I heard him tell an investment trust conference that the most positive thing to be said about financial markets was they were becoming more realistic about the prospects for an early resumption of growth.

He sees little prospect however of any immediate improvement in the macro environment. These are his most recent comments on the markets, as reported by Citywire:

Recent respite in financial markets must be viewed with great scepticism. At the current time, when transparency is low, when harsh deflationary economic conditions are new to policymakers steeped in the past, and when the political establishment is clearly willing to indulge in perpetual bailouts regardless of the consequences, this is no time to let hopeful expectations cloud reality. We remain very cautious, defensively positioned and focused on capital preservation.

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Written by Jonathan Davis

August 27, 2012 at 5:20 PM

Ruffer: the right question to ask

The estimable and splendidly ideosyncratic private client fund manager Jonathan Ruffer, whom I profiled a couple of years ago in The Spectator, has some thoughtful points on the prospects for Europe in his most recent monthly investment review. Here is a short extract, in which he points to the underlying frailty of the European project, about whose future he is not optimistic:

The Treaty of Rome in 1957 was a great moment for the peacemakers, but now its architects are dead, as are pretty much all those who felt the visceral despair in the darkness of the late 1940s. That hope has been replaced with a sort of Communism: power divorced from economics. Just as Russia could not keep control when the figures didn’t add up, nor can Europe. It is only a question of time. So, when does it all end? I think it is a mistake to try and guess. Observers of 1980s Russia fell into two categories: those who thought things would continue as they were forever, and those who could see the pressure, the inconsistencies, and imagined that the crisis would strike a week on Thursday. Nevertheless, it is striking on my return to find how far the status quo has shifted in Europe since March. It’s the same tune, to be sure, but the violins have been replaced by cellos.

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Written by Jonathan Davis

August 20, 2012 at 4:39 PM

Why quality stocks pay off

It is no accident that some of the best performing fund managers of the last few years have been those who have stuck to investing in powerful global equities with a consistent history of profitability and sustainable earnings and dividends. In the UK those who fall into this camp include Neil Woodford at Invesco Pereptual, Nick Train of Lindsell Train, Sebastian Lyon at Troy Asset Management (mentioned in my last post) and Terry Smith, whose equity funds solely buy and hold this kind of high return on equity stock. It is also of course at the root of Warren Buffett’s long success as an equity investor.

But why do so-called quality equities (defined as stocks which have low leverage, high returns on equity and consistent earnings) perform so well, yet are so regularly overlooked by the majority of investors in favour of more speculative growth stories? A recent research note from Jeremy Grantham’s team at GMO uses long run US data to highlight the persistently superior performance of quality stocks and their particular attractions in today’s binary (“risk on, risk off”) market conditions. The primary driver behind this superior performance is the ability of these companies to preserve and grow capital, not to lose or squander it as many do, either through incompetence or normal competitive pressures.

Here are a couple of short extracts from the GMO research paper:

True competitive equilibrium is a rarity in the global economy. Instead, we find persistent winners and persistent losers. The competitive paradigm says that highly profitable activities attract capital, and that capital flees those with low profits. This is the market mechanism behind mean reversion, which is supposed to close the profitability gap. In reality, certain companies earn persistently high returns on equity. Superior returns are delivered to investors in the form of dividends, stock buybacks, and accretive growth.

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Written by Jonathan Davis

August 18, 2012 at 12:17 PM

An invidious choice

I find it hard to disagree with these comments from Sebastian Lyon, the CEO of Troy Asset Management, writing in the annual report of Personal Assets, the investment trust to which he and his colleagues now act as Investment Adviser, following the death of Ian Rushbrook four years ago.

The secular bear market in UK and US equities is now in its thirteenth year. How much longer must we wait until we can again be fully invested (or even geared!) and reap the double-digit returns we long for? Ask the policy makers! Stocks would be considerably lower were central banks not keeping stock prices artificially high by means of zero interest rates and quantitative easing. Despite these interferences, stock markets have gone sideways during the past year. Savers have not been rewarded for taking risk and hence our cautious strategy has paid off, for now, although we are likely to lag short term rises in the market should further monetary interventions be forthcoming.

Politicians in Europe are confronted with the invidious choice between severe austerity, which is likely to lead to periodic recessions and declining tax revenues, or incautious borrowing in the hope of buying growth. Both approaches will eventually force governments to pay higher rates of interest on debts. The maths do not stack up. No wonder governments are looking to extricate themselves from an intractable problem by leaning on central bankers to pull their inflationary strings. But our greatest concern is that the European challenges that have dogged markets since early 2010 are merely the dress rehearsal for the main event – a US fiscal crisis. While the UK and Europe have at least tried to tame their budget deficits, the United States has pushed ever harder on the fiscal accelerator. Stock markets swooned last August when they got a shock preview of what might happen should the brakes be applied. Following the public disagreement in Washington over increasing the public debt ceiling, the Dow Jones Industrials Index fell 13% in seven trading days. Read the rest of this entry »

Written by Jonathan Davis

August 16, 2012 at 7:56 PM

La commedia e finita?

Don Coxe, the Canadian investment strategist, whose monthly publication Basic Points is required reading for anyone who follows financial markets, has a wonderfully mordant turn of phrase which from time to time he uses to devestating effect in illuminating current issues. This is Don on the Eurozone crisis, as seen from four thousand miles across the pond:

We remain of the view that no new promises, no new money creation, no new bailouts, and no new debts will resolve the basic problem – that only a few eurozone members have soundly functioning, globally competitive economies. That these nations should continue to subsidise their dysfunctional co-believers in Europeanism would be OK if it were not inflicting such damage on so many millions of unemployed young people, let alone the global capital markets and the global economy. During the last two years, the rest of the world has watched with growing impatience as leaders strutted and fretted their hour upon the stage and then, in many cases, were heard no more, becuase their own voters, in an overdue spasm of good sense, rejected them. There is an Orwellian aspect to the emerging nomenclature of the emerging institutions in this process of illusions and disilusions. The latest bailout banking entity is called The European Stability Mechanism, which is eurospeak for a lender that allows deadbeats to get even more hopelessly indebted in the name of stability”.

According to the most recent estimate I have seen, Europe’s leaders have so far “invested” something like three trillion euros, in loans, bailout funds, transfer payments etc, to try and keep the Eurozone going in its current 17-member format – and the results to date have been dismal. Now, with the region slipping into recession, and Spain hovering on the brink of joining Greece, Portugal, Ireland and Cyprus in requiring a sovereign bailout to avoid bankruptcy, they are gearing up to throw even more money at the problem. Don’s view is that “the euroelites should have declared La commedia e finita and rung down the curtain two trillion euros or so ago”. Future historians, I fear, will have little option but to pass a similar verdict.

Written by Jonathan Davis

August 9, 2012 at 9:23 AM

Posted in Don Coxe, Eurozone

The truth about future economic growth

Rob Arnott, the chairman of Research Affiliates, is one of the most articulate and interesting market analysts in the States, and someone whose ideas and research I have followed for a number of years. In my latest 30-minute podcast, I discuss with him the outlook for investment returns – and how they will be dramatically influenced by what he calls the three Ds now hanging over the world – debt, deficits and demographics. All three are conspiring to drag down likely future rates of economic growth in the developed world. Investors need not despair however, Rob argues: better returns are available if investors switch their focus from conventional benchmarks to a multi-asset strategy based on broad economic, rather than purely financial, criteria. Before listening in, click the link below to download a copy of the slides he used to develop his arguments at a recent presentation to a London Stock Exchange seminar. The podcast can be downloaded from here. Recommended.

Arnott LSE Presentation July 2012

Written by Jonathan Davis

July 29, 2012 at 5:30 PM

The Eurozone revisited

The latest Eurozone summit, the19th or 20th, depending how you count, has so far been well received by the financial markets. As always, however, this is not quite what it appears. The biggest mistake you can make is to impute approval or disapproval of recent developments to instant market reactions. You always need to take into account the context.

In this case the context was that few observers expected anything postiive to emerge from the summit and therefore the limited progress that was made can be classified as some sort of success, if only when compared to those low original expectations. The truth is that nothing much has changed, despite the optimistic noises coming out of various interested European parties.

Mrs Merkel made some apparent concessions at the summit, but they do not amount to much, when examined in the cold light of day. She is confident that she had not conceded much, and while subject to a range of domestic political pressures, there is no sign that Germany is ready to give in on the substantive measures that would be needed to give the Eurozone a chance of survival in its present form.

And that of course is to make the heroic assumption that even if Germany did agree to mutualisation of sovereign debt across Europe, and the fiscal and banking integration that would be needed to make that enforceable, it still might not solve the problems of banking weakness and lack of competitiveness that are the underlying causes of the current crisis. There is no magic wand to put those things right and it will take years for the necessary reforms to be shown to work in Italy, Spain and Greece.

Written by Jonathan Davis

July 5, 2012 at 8:03 PM

Posted in Debt Crisis, Eurozone

The cost of Europe’s deal

The latest Greek deal appears to have a fair chance of working in the short term, but it has not been without significant costs, especially for investors in European sovereign debt, as Jim Leaviss of M&G explains in this latest comment on the firm’s always excellent Bond Vigilantes blog. Of the five lessons he draws from the latest deal, his last is probably the most important from a long term perspective.

This was a bad deal, not because bond investors took losses, but because the losses they took were too small.  Even under heroic growth assumptions Greek debt to GDP will barely get down to 120 percent. The population will live with austerity for years and Greece will probably default again anyway.  And as others implement extreme austerity too, we’ll see the rise of extreme politics across the Eurozone. One lesson that policy makers across the world keep missing is that imposing punishment on moral hazard “sinners” is a luxury we don’t have in the middle of this series of crises. There have rightly been comparisons made between the terms of the Greek restructuring and the reparation terms that Germany was forced to accept after the First World War.  The biggest wave of defaults has yet to happen – not in the bond markets, but with the breaking of promises (retirement ages, pension entitlements, healthcare) made to complacent western populations.

Whether the Greeks default sooner rather than later, we will all be living with the consequences for a long time. The security of European sovereign debt has been downgraded, without yet solving the problem the deal is designed to address. It may have.prevented a short-term crisis, in other words, for which investors could be grateful, but at what longer term cost we don’t yet know. More government promises will inevitably be reneged on in the years ahead.

Written by Jonathan Davis

March 2, 2012 at 1:25 PM

Looking beyond Greece

We don’t know whether the Eurozone agreement on Greece will hold – let alone for how long. My guess is not for long. In any case, for investors this long-awaited deal looks like a classic case of buy on the story, sell on the news. Financial markets have run up so strongly in anticipation of such an outcome that equities now look massively overbought, implying that the short-term reaction is more likely to be negative than positive. Longer term it is still impoosible to know for certain how this great drama reaches its endgame.

My view remains, as it has done for some time, that the best outcome now, as Bill Emmott was saying in The Times yesterday, is for a managed default (and probable exit) by Greece at some point in the course of this year, as it becomes apparent that the country cannot meet the demands which have now been placed on it. I suspect that this is the outcome which the Germans have been after for quite a while now, without of course being able to say so in so many words. It is also in the best interests of the Greeks themselves over time.

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Written by Jonathan Davis

February 21, 2012 at 9:45 AM

New Year hopes

My suspicions back in the autumn that a market rally was on the way have, I am happy to say, been borne our by events. Not for the first time, the peak of rhetorical despair – this time about the dire outlook for the world economy should the Eurozone crisis not be resolved – has turned out to be the moment to turn bullish. The rally since the failure of the Cannes summit has been impressive.

The MSCI world index is up by more than 20 per cent since its October low and has risen for seven straight weeks in a row, something that has not happened since the spring of 2009, according to the equity strategists at Societe Generale. Equity markets have made an even stronger start in 2012, with January producing one of its best monthly returns for many years. Contrarian sentiment indicators, such as the venerable Investors Intelligence survey of investment advisors in the United States, once again proved invaluable in identifying a turning point back in the autumn.

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