Banking Stress Indicators Are Still Elevated

This week, most economic commentators are focusing on the prospects of QE3 and, on the positive news regarding the abating of some of the peripheral Eurozone bond yields. Indeed, equity markets have rallied somewhat and it appears that the World is feeling a little better about prospects.  However, are all the economic indicators pointing in the same direction? Is it time to buy back into equities?

The suspicion is that, right now, this isn’t a widespread ‘risk on’ trade and, the market badly needs this. Sentiment needs to turn around with regards the sustainability of Italian and Spanish bond yields or there will be further turmoil ahead. The recent statements by Merkel regarding rejecting Eurobonds as the immediate answer and in rejecting expansion of the EFSF have actually upped the ante and downside risk is considerable. What is the market telling us?

Firstly, the ECB has been successful in reducing Spanish and Italian bond yields…

 

…but unfortunately, this is only on an absolute level. It certainly hasn’t stopped investors piling into the ‘safe havens’ of Gilts, Bunds and US Treasuries. This is important because it indicates that investor sentiment hasn’t really turned round, its just that the ECB has managed to manipulate the bonds markets for a while. For example, the spread between German and Italian bond yields hasn’t come down much after the ECB action…

 

…moreover, other indicators of banking stress are still looking elevated. Looking at the 3 month Libor-OIS spread chart…

 

…and the good ol’ chart of the TED spread….

…and what about a chart of the PIIGS CDS prices…

 

…. 3 month Euribor chart itself….

 

The EUR/USD swap...

5 Year Euro Swaps...

..and recourse to the ECB deposit facility

This is definitely not a ‘risk on’ marketplace yet and these indicators are showing stress.  Well worth keeping an eye on.

Hedge Funds Delivering Performance

Hedge Funds get a lot of criticism from a market that is still predominantly focused on long only strategies. However, one of the severest criticisms levied against them is that they are largely long only strategies, whose use of leverage, means that do not protect investors from downside equity market risk. This is an understandable worry, and indeed, 2008 saw losses across nearly all hedge fund strategies bar something like short-side biased funds. Therefore, it is worth looking more closely at performance. In particular, do hedge funds tend to make directional punts? Moreover, is it worth giving up the discipline to allow them to be discretionary as opposed to a fixed market neutral approach?

Hedge Funds Performance

In order to gauge this here is a regression analysis with the monthly hedge fund results from Dow Jones Credit Suisse Index for Equity Market Neutral and Long/Short Equity Indices. Both indices are US Dollar based and are measured against the S & P 500.

2000-June 2011	Equity Market Neutral	Long/Short Equity
Alpha (annualized)	3.41	7.44
Beta	-.03	.09
R2	.0016	.026
Cumulative Return	29.3%	93.4%
Standard Deviation	3.65%	2.72%

Source: Dow Jones Credit Suisse

Firstly, it is worth noting that returns are not really correlated as both r-squared numbers are low and, as could be expected, the market neutral index has lower correlation. Secondly, both indices reveal positive alpha generation although this means little given that correlation is low. Both cumulative returns are good, with long/short equity notably outperforming. All of which suggests that the greater discretionary element implied in long/short equity does not result in investors losing money. A point which is especially relevant when it is noted that the S & P 500 lost 5.3% over this period!

Hedge Funds Investment

Hedge funds work over the long term and, investors might well be tempted to allow hedge fund managers the latitude to adopt a discretionary strategy rather than be bound by market neutral. Having said that, the dispersion of results within long/short is far larger than equity market neutral. All of which suggest a strategy of a diversified holdings of long/short equity funds is likely to be optimal. Alternatively, a few core holdings of market neutral funds surrounded by a collection of satellite holdings in long/short equity funds.

The Short Selling Ban

A number of European countries decided to ban short selling for a period of 15 days and the light of introspection deserves to be thrown upon what these measures actually mean for the functioning of global financial markets. It is understandable that Governments should be concerned about the downward spiral in stock prices because they do have a direct effect on the economy. For example, lower equity markets affect shareholders net worth and their propensity to consume. In addition, low equity values will affect companies’ abilities to raise cash and, particularly, banks balance sheets.

Short Selling and Hedge Funds

All of the above is a concern, so stopping shorting can be seen in a positive light, particularly when long only investors are facing losses and, all manner of pejorative language is being used against the ‘evil’ short sellers. The common perception of short selling is of an art practiced in the ‘shady’ and lightly regulated world of hedge funds.

 ‘Shorters’ are seen as short term speculators who are preying on the misfortunes of others, and some are even seen as promulgators of false rumours and media speculation around their targets. This negative perception has hardly been helped by the criminal activities of Madoff and Rajaratnam. Moreover, the ludicrous amounts of money that some hedge fund managers earn is an easy target for criticism from the tabloid press.

Why Banning Short Selling is Wrong

The principle arguments against banning short selling are that it is not really efficacious (it did little to stop banking stocks sliding in the financial crisis of 2008) and, that it helps to create inefficiently priced stocks. Both of these points make perfect sense and the importance of pricing signals in a market economy should never be underestimated, but there is a deeper, more important, reason why shorting should not be banned.  Simply put, shorting creates the opportunity for myriad and diversified investment strategies which help to hedge risk away. However, this argument should not be restricted to investment strategies on a micro-economic level. Its true import is related to the global economy!

Increasing Globalisation and Correlation in the Global Economy

Essentially, the problems of the financial last few years have been created by a World that is becoming increasingly interlinked and whose asset classes and economies are synchronised to such a degree that economic cycles are creating super-positional peaks and troughs. In plain English, this means that if all the economies are dependent on one variable (ex mortgage bonds on banks’ balance sheets) then the potential for disaster is that much larger.

Moreover, these risks tend to be directional because vested interests snowball to create these scenarios. For example, banks start issuing sub-prime debt to NINJA’s (no income no job), then structuring CDO’s, other banks buy the debt, and suddenly everyone (homeowners, banks, politicians, bank debtors) becomes reliant upon the debt not collapsing. The rest is history. Unfortunately, the economic consequences are not. 

How Short Selling Helps Markets

The one caveat to the above scenario is if some economic agents are diversified in the direction of their profitability. So, for example, if there had been significant numbers of banks who had been short sub-prime mortgages or had diversified away from this directional risk then they would have able to buy up the failing banks or at least support the underlying assets. The banks were very vocal in criticising the necessity of marking their assets to market during the financial crash, but the real problem was that none of them had the financial position to buy these assets of each other. This is what happens when all the financial institutions profitability is dependent upon the same direction. Increased correlation intensifies systemic risk, whilst diversification helps to mitigate it.

If the authorities persist in trying to ban short selling all they will, de-facto, be doing is encouraging more correlation of asset classes and interests. This is likely to create more risk and stop –at source- the nascence of diversified strategies that should be seen as helping, not hindering, global growth.

ECB Buying Spanish Debt

At least according to reports in a couple of leading Spanish newspapers. For what it's worth, I think the market evidence shows their could be some credibility to these reports. For example, whilst Italian debt yields continue to rise...

....Spanish yields have mysteriously come down a bit...

However, I think it is really not enough to fight sentiment at this stage. Frankly, there is little that Trichet and the ECB can do with the EFSF. The EFSF has 30% of its guarantee commitments coming from Italy & Spain and the idea of the EFSF issuing debt in order to loan Italy & Spain money is too ludicrous to contemplate.

The key to understanding the market panic comes from a cursory view at the debt exposure of European banks to Italian debt...

 ...it's not hard to see that if Italy continues on an unsustainable debt path then the consequences could be dire for European Banks and they will have to raise capital. Taxpayers need to brace themselves although I doubt Bob Diamond will be taking a pay cut.

As to the country specific exposure to Italian and Spanish debt, I have tabulated some data here from the Bank of International Settlements (BIS). Firstly, Italy...

 

Claims on Italy Debt (m)	France	Germany	UK	USA	Non-Europe
Public Sector	105,045	50,982	12,734	14,380	48,144
Banks	49,088	52,516	9,188	16,121	21,390
Non-Bank Private Sector	256,105	61,434	46,949	13,564	23,391
Total	410,238	164,932	68,871	44,065	92,925

and then Spain...

Claims on Spain Debt (m)	France	Germany	UK	USA	Non-Europe
Public Sector	32,581	29,389	8,629	6,060	19,101
Banks	36,473	69,149	14,974	24,696	30,936
Non-Bank Private Sector	77,031	79,321	77,199	27,162	39,065
Total	146,085	177,859	100,802	57,918	89,102

 ...so the problem is substantial and I can't quite understand why investors are piling into bunds and French debt because Italy and/or Spain really are too big to fail. If this all ends up with the creation of a 'Eurozone bond' and a movement towards fiscal union, then German and French yields will have to rise to  price in the adoption of risk over peripheral debt. Bunds aren't as safe an option as most investors think!

Source:

EFSF Guarantee Commitments

BIS data

Why Increasing Government Spending Won't Work

A number of politicians and journalists are increasingly putting forward the case for increasing Government spending rather than cutting it. I thought I'd outline a few points on the issue. I will throw forth a few bullet points for consideration here because this is far too large a subject matter to effectively deal with succinctly...

• It is precisely because Cameron/Clegg have managed to sell their austerity programs, that the UK is able to borrow money at low levels. If they had indulged in more spending than, in my humble opinion, the market would have punished the UK. Moreover, the UK has a system of 'elected dictatorship' which means that the market is not pricing in the likelihood of Ed Balls getting anywhere near the public finances

• Corporate cash balances have helped hold back market rates because traditionally in recoveries (and I accept this one is anaemic) they push up yields as they search for capital

• Promulgating Government investment requires you to be unencumbered with any notions of inherent efficacy differences between public and private sector investment. I am not free of such prejudices; in fact, I think less Government spending is usually a good thing. Who is doing the investment is arguably more important than the absolute level

• Throughout history, whenever Governments have cut deficits (Sweden, Canada et al) it has always been through cutting spending rather than raising revenue. This doesn't tally well with raising expenditure.

• In my opinion, the expansion of Commercial & Industrial loans and business investment usually follow a cyclical upturn in consumer expenditures. I think what is different, this time around, is that the banking sector (the issuers of capital) has faced significant challenges this year.

• It was a mistake not to allow the forces of creative destruction to eradicate the leadership of the banks and destroy their perverse incentive structure. The management are clearly not fit for purpose, are only interested in siphoning off the assets of the banks at the expense of the shareholders, and have thus far demonstrated no ability whatsoever to generate shareholder value when the taxpayer isn't supporting the direction of their underlying assets by buying them up 

• Japan has undergone an experiment in stimulating expenditure and supporting 'Zombie industries' with the aim of sustaining employment and growth and, it has failed miserably. Governments simply aren't the best authorities when it comes to productive investment.

• The US underwent a significant expansion of public sector spending without raising the revenues to pay for it. This is why their deficit is so large. Noticeably, it was the Republican administrations of Reagan and George 'W' Bush than engaged in expanding spending whilst cutting taxes.

So frankly, the idea that the UK or any other Government should actually be increasing public expenditures is folly of the highest order. The key is to cut spending yet seek ways in which to encourage the private sector to invest, by rolling back the frontiers of the state. In the UK this might involve things like relaxing planning restrictions on new house build in the South East or encouraging research into genetically modified foods. There are many ways to promote growth, but the worst of which, is wanton Government expenditures. It's been tried. It doesn't work.

Let's Hear it for Nick Clegg

I’m serious. The much maligned Nick Clegg, leader of the Liberal Democratic Party- the smaller coalition partner in the UK Government- is actually deserving of praise for his role in supporting the Government sell its austerity efforts to a fretful bond market. Well, at least, in the view of this blogger!

Government Austerity Plans and Bond Markets

There are two issues with Governments being able to convince investors that they have put together a credible plan to deal with their deficits. The first is the plan itself, and the second is the credibility of their ability and willingness to carry out the plan. For a British observer, the latter point can be seen as a display of the lack of fortitude and consistency that categorises Continental European style coalition politics.  All it takes is the opposition of a few extremists within a coalition Government and significant resistance can be generated. 

Greece has had to deal with its main opposition leader (Antonis Samaras) opposing austerity programs. Angela Merkel is constantly engaging with mounting opposition to ‘bailing’ out the rest of Europe. Berlusconi appears to be at loggerheads with Economy Minister Giulio Tremonti (the most credible austerity hardliner in Italy) and the opposition parties are calling for his head. The list goes on and on in Continental Europe, however, the British system is seen as being a kind of ‘elected dictatorship’ whereby the Government can-more or less- get legislation through parliament with ease. Or can it?

Ed Balls the Most Dangerous Man in Britain?

The fact is that, the UK Government is a Conservative/Liberal Democrat coalition. The election did not deliver any one party as a decisive victor. Moreover, for the benefit of non British readers, the Liberal Democratic party has- in recent years- been seen as even more willing to ‘tax and spend’ then the former Labour Government. In addition, the shadow chancellor in the UK is Ed Balls, a man widely seen as the architect behind Labour’s failed economic policies which lead to the UK’s public finances looking as weak as, say Italy’s.

 If we put these ingredients together, it’s not hard to envisage a nightmare scenario where a failing coalition Government causes the market to start pricing in the return of Ed Balls. Frankly, I think it is a disgrace that Balls has been appointed the shadow chancellor and, I regard him as the most dangerous man in Britain. I suspect that the slightest notion of Ed Balls in Dowing Streeet would cause a significant hike in market yields for UK debt. You could call this event a ‘Balls Up’.

Let’s Hear it For Nick Clegg

So what of Nick Clegg? Frankly, I think Clegg has behaved admirably. He is a sitting duck for criticism from his own party, yet he has supported Cameron in his efforts at selling the austerity program. Unlike so many others, he has rarely played Party political games which act as a detriment to his country. I’m not so naïve as to not understand that towing the Cameron line is the best way for the Liberal Democrats to exert some influence (at the cost of devaluing some of the principles of some in his Party) but in his support for Cameron, he has displayed a willingness to do the right thing for his country even at his own expense. A quality which Berlusconi, Samaras et al would do well to emulate.