3/5/21: Margin Debt: Things are FOMOing up...

 Debt, debt and more FOMO...

Source: topdowncharts.com and my annotations

Ratio of leveraged longs to shorts is at around 3.5, which is 2014-2019 average of around 2.2. Bad news (common signal of upcoming correction or sell-off). Basically, we are witnessing a FOMO-fueled chase of every-rising hype and risk appetite. Meanwhile, margin debt is up 70% y/y in March 2021, although from low base back in March 2020, now back to levels of growth comparable only to pre-dot.com crash in 1999-2000. Adjusting for market cap - some say this is advisable, though I can't see why moderating one boom-craze indicator with another boom-craze indicator is any better - things are more moderate. 

My read-out: we are seeing margin debt acceleration that is now outpacing the S&P500 acceleration, even with all the rosy earnings projections being factored in. This isn't 'fundamentals'. It is behavioral. And as such, it is a dry powder keg sitting right next to a campfire. 

8/6/20: 30 years of Financial Markets Manipulation

Students in my course Applied Investment and Trading in TCD would be familiar with the market impact of the differential bid-ask spreads in intraday trading. For those who might have forgotten, and those who did not take my course, here is the reminder: early in the day (at and around market opening times), spreads are wide and depths of the market are thin (liquidity is low); late in the trading day (closer to market close), spreads are narrow and depths are thick (liquidity is higher). Hence, a trading order placed near market open times tends to have stronger impact by moving the securities prices more; in contrast, an equally-sized order placed near market close will have lower impact.

Now, you will also remember that, in general, investment returns arise from two sources: 

1. Round-trip trading gains that arise from buying a security at P(1) and selling it one period later at P(2), net of costs of buy and sell orders execution; and 
2. Mark-to-market capital gains that arise from changes in the market-quoted price for security between times P(1) and P(2+).

The long-running 'Strategy' used by some institutional investors is, therefore as follows: 

Here is the illustration of the 'Strategy' via Bruce Knuteson paper "Celebrating Three Decades of Worldwide Stock Market Manipulation", available here: https://arxiv.org/pdf/1912.01708.pdf.

• Step 1: Accumulate a large long portfolio of assets;
• Step 2: At the start of the day, buy some more assets dominating your portfolio at P(1) - generating larger impact of your buy orders, even if you are carrying a larger cost adverse to your trade;
• Step 3: At the end of the day, sell at P(2) - generating lower impact from your sell orders, again carrying the cost.

On a daily basis, you generate losses in trading account, as you are paying higher costs of buy and sell orders (due to buy-sell asymmetry and intraday bid-ask spreads differences), but you are also generating positive impact of buy trades, net of sell trades, so you are triggering positive mark-to-market gains on your original portfolio at the start of the day.

Knuteson shows that, over the last 30 years, overnight returns in the markets vastly outstrip intraday returns. 

Per author, "The obvious, mechanical explanation of the highly suspicious return patterns shown in Figures 2 and 3 is someone trading in a way that pushes prices up before or at market open, thus causing the blue curve, and then trading in a way that pushes prices down between market open (not including market open) and market close (including market close), thus causing the green curve. The consistency with which this is done points to the actions of a few quantitative trading firms rather than

the uncoordinated, manual trading of millions of people."

Sounds bad? It is. Again, per Knuteson: "The tens of trillions of dollars your use of the Strategy has created out of thin air have mostly gone to the already-wealthy: 

• Company executives and existing shareholders benefi tting directly from rising stock prices; 
• Owners of private companies and other assets, including real estate, whose values tend to rise and fall with the stock market; and 
• Those in the financial industry and elsewhere with opportunities to privatize the gains and socialize the losses."

These gains to capital over the last three decades have contributed directly and signi ficantly to the current level of wealth inequality in the United States and elsewhere. As a general matter, widespread mispricing leads to misallocation of capital and human effort, and widespread inequality negatively a effects our social structure and the perceived social contract."

6/5/20: S&P500 Earnings and Revenues Growth 1Q 2020

With early effects of COVID19 pandemic in:

Both charts via Factset.

7/1/20: Euromoney on 2020 Risk Outlook for the Eurozone

Euromoney on Eurozone risks into 2020, with some comments from me: https://www.euromoney.com/article/b1js9nd289vtm9/country-risk-2020-vision-brings-the-eurozones-risks-into-focus. 

5/1/20: EU's Latest Financial Transactions Tax Agreement

My article on the proposed EU-10 plan for the Financial Transaction Tax via The Currency:

Link: https://www.thecurrency.news/articles/5471/a-potential-risk-growth-hormone-what-the-financial-transaction-tax-would-mean-for-ireland-irish-banks-and-irish-investors or https://bit.ly/2QnVDjN.

Key takeaways:

"Following years of EU-wide in-fighting over various FTT proposals, ten European Union member states are finally approaching a binding agreement on the subject... Ireland, The Netherlands, Luxembourg, Malta and Cyprus – the five countries known for aggressively competing for higher value-added services employers and tax optimising multinationals – are not interested."

"The rate will be set at 0.2 per cent and apply to the sales of shares in companies with market capitalisation in excess of €1 billion. This will cover also equity sales in European banks." Pension funds, trading in bonds and derivatives, and new rights issuance will be exempt.

One major fall out is that FTT "can result in higher volumes of sales at the times of markets corrections, sharper flash crashes and deeper markets sell-offs. In other words, lower short-term volatility from reduced speculation can be traded for higher longer-term volatility, and especially pronounced volatility during the crises. ... FTT is also likely to push more equities trading off-exchange, into the ‘dark pools’ and proprietary venues set up offshore, thereby further reducing pricing transparency and efficiency in the public markets."

20/9/19: New paper: Systematic risk contagion from cyber events

Our new paper, "What the hack: Systematic risk contagion from cyber events" is now available at International Review of Financial Analysis in pre-print version here: https://www.sciencedirect.com/science/article/pii/S1057521919300274.

Highlights include:

• We examine the impact of cybercrime and hacking events on equity market volatility across publicly traded corporations.
• The volatility generated due to cybercrime events is shown to be dependent on the number of clients exposed.
• Significantly large volatility effects are presented for companies who find themselves exposed to hacking events.
• Corporations with large data breaches are punished substantially in the form of stock market volatility and significantly reduced abnormal stock returns.
• Companies with lower levels of market capitalisation are found to be most susceptible to share price reductions.
• Minor data breaches appear to be relatively unpunished by the stock market.

19/12/18: From Goldilocks to Humpty-Dumpty Markets

As noted in the post above, I am covering the recent volatility and uncertainty in the financial markets for the Sunday Business Post : https://www.businesspost.ie/business/goldilocks-humpty-dumpty-markets-2018-433053.

Below is the un-edited version of the article:

2018 has been a tough year for investors. Based on the data compiled by the Deutsche Bank AG research team, as of November 2018, 65.7 percent of all globally-traded assets were posting annual losses in gross (non-risk adjusted) terms. This marks 2018 as the third worst year on record since 1901, after 1920 (67.6 percent) and 1994 (67.2 percent), as Chart 1 below illustrates. Adjusting Deutsche Bank’s data for the last thirty days, by mid-December 2018, 66.3 percent of all assets traded in the markets are now in the red on the annual returns basis.

CHART 1: Percentage of Assets with Negative Total Returns in Local Currency

Source: Deutsche Bank AG

Note: The estimates are based on a varying number of assets, with 30 assets included in 1901, rising to 70 assets in 2018

Of the 24 major asset classes across the Advanced Economies and Emerging Markets, only three, the U.S. Treasury Bills (+19.5% YTD through November 15), the U.S. Leveraged Loans (+7.45%), and the U.S. Dollar (+0.78%) offer positive risk-adjusted returns, based on the data from Bloomberg. S&P 500 equities are effectively unchanged on 2017. Twenty other asset classes are in the red, as shown in the second chart below, victims of either negative gross returns, high degree of volatility in prices (high risk), or both.


CHART 2: Risk-Adjusted Returns, YTD through mid-December 2018, percent

Source: Data from Bloomberg, TradingView, and author own calculations

Note: Risk-adjusted returns take into account volatility in prices. IG = Investment Grade, HY = High Yield, EM = Emerging Markets

The causes of this abysmal performance are both structural and cyclical.


Cyclical Worries

The cyclical side of the markets is easier to deal with. Here, concerns are that the U.S., European and global economies have entered the last leg of the current expansion cycle that the world economy has enjoyed since 2009 (the U.S. since 2010, and the Eurozone since 2014). Although the latest forecasts from the likes of the IMF and the World Bank indicate only a gradual slowdown in the economic activity across the world in 2019-2023, majority of the private sector analysts are expecting a U.S. recession in the first half of 2020, following a slowdown in growth in 2019. For the Euro area, many analysts are forecasting a recession as early as late-2019.

The key cyclical driver for these expectations is tightening of monetary policies that sustained the recovery post-Global Financial Crisis and the Great Recession. And the main forward-looking indicators for cyclical pressures to be watched by investors is the U.S. Treasury yield curve and the 10-year yield and the money velocity.

The yield curve is currently at a risk of inverting (a situation when the long-term interest rates fall below short-term interest rates). The 10-year yields are trading at below 3 percent marker – a sign of the financial markets losing optimism over the sustainability of the U.S. growth rates. Money velocity is falling across the Advanced Economies – a dynamic only partially accounted for by the more recent monetary policies.

CHART 3: 10-Year Treasury Constant Maturity Rate, January 2011-present, percent

Source: FRED database, Federal reserve bank of St. Louis. 

Structural Pains

While cyclical pressures can be treated as priceable risks, investors’ concerns over structural problems in the global economy are harder to assess and hedge.

The key concerns so far have been the extreme uncertainty and ambiguity surrounding the impact of the U.S. Presidential Administration policies on trade, geopolitical risks, and fiscal expansionism. Compounding factor has been a broader rise in political opportunism and the accompanying decline in the liberal post-Cold War world order.

The U.S. Federal deficit have ballooned to USD780 billion in the fiscal 2018, the highest since 2012. It is now on schedule to exceed USD1 trillion this year. Across the Atlantic, since mid-2018, a new factor has been adding to growing global uncertainty: the structural weaknesses in the Euro area financial services sector (primarily in the German, Italian and French banking sectors), and the deterioration in fiscal positions in Italy (since Summer 2018) and France (following November-December events). The European Central Bank’s pivot toward unwinding excessively accommodating monetary policies of the recent past, signaled in Summer 2018, and re-confirmed in December, is adding volatility to structural worries amongst the investors.

Other long-term worries that are playing out in the investment markets relate to the ongoing investors’ unease about the nature of economic expansion during 2010-2018 period. As evident in longer term financial markets dynamics, the current growth cycle has been dominated by one driver: loose monetary policies of quantitative easing. This driver fuelled unprecedented bubbles across a range of financial assets, from real estate to equities, from corporate debt to Government bonds, as noted earlier.

However, the same driver also weakened corporate balance sheets in Europe and the U.S. As the result, key corporate risk metrics, such as the degree of total leverage, the cyclically-adjusted price to earnings ratios, and the ratio of credit growth to value added growth in the private economy have been flashing red for a good part of two decades. Not surprisingly, U.S. velocity of money has been on a continuous downward trend from 1998, with Eurozone velocity falling since 2007. Year on year monetary base in China, Euro Area, Japan and United States grew at 2.8 percent in October 2018, second lowest reading since January 2016, according to the data from Yardeni Research.

Meanwhile, monetary, fiscal and economic policies of the first two decades of this century have failed to support to the upside both the labour and technological capital productivity growth. In other words, the much-feared spectre of the broad secular stagnation (the hypothesis that long-term changes in both demand and supply factors are leading to a structural long-term slowdown in global economic growth) remains a serious concern for investors. The key leading indicator that investors should be watching with respect to this risk is the aggregate rate of investment growth in non-financial private sector, net of M&As and shares repurchases – the rate that virtually collapsed in post-2008 period and have not recovered to its 1990s levels since.

The second half of 2018 has been the antithesis to the so-called ‘Goldolocks markets’ of 2014-2017, when all investment asset classes across the Advanced Economies were rising in valuations. At the end of 3Q 2018, U.S. stock markets valuations relative to GDP have topped the levels previously seen only in 1929 and 2000. Since the start of October, however, we have entered a harmonised ‘Humpty-Dumpty market’, characterised by spiking volatility, rising uncertainty surrounding the key drivers of markets dynamics. Adding to this high degree of coupling across various asset classes, the recent developments in global markets suggest a more structural rebalancing in investors’ attitudes to risk that is likely to persist into 2019.

3/10/18: Dumping Ice bags into Overheating Reactor: Bonds & Stocks Bubbles

Wading through the ever-excellent Yardeni Research notes of recent, I have stumbled on a handful of charts worth highlighting and a related blog post from my friends at the Global Macro Monitor that I want to share with you all.

Let's start with the stark warning regarding the U.S. Treasuries market from the Global Macro Monitor, accessible here: https://macromon.wordpress.com/2018/10/03/alea-iacta-est/.  To give you my sense from reading this, two quotes with my quick takes:

"Supply shortages, induced mainly by central bank quantitative easing have been a major factor driving asset markets, in our opinion.  Not all, but a big part." So forget the 'not all' and think about risks pairings in a complex financial system of today: equities and bonds are linked through demand for yield (gains) and demand for safety. If both are underpricing true risks (and bond markets are underpricing risks, as the quote implies), it takes one to scratch for the other to blow. Systems couplings get more fragile the tighter they become.

"The float of total U.S. equities has shrunk dramatically, in part, due to cheap financing to fund share buybacks.   The technical shortage of stocks have helped boost U.S. equity markets and killed off most bears and short sellers." In other words, as I have warned repeatedly for years now, U.S. equity markets are now dangerously concentrated (see this blog for posts involving concentration risks). This concentration is driven by three factors: M&As and shares buy-backs, plus declined IPOs activity. The former two are additional links to monetary policies and, thus to the bond markets (coupling is getting even tighter), the latter is structural decline in enterprise formation and acceleration rates (secular stagnation). This adds complexity to tight coupling of risk systems. Bad, very bad combination if you are running a nuclear power plant or a major dam, or any other system prone to catastrophic risk exposures.

How bad the things are?

Since 1Q 2009, total cumulative shares buy-backs for S&P500 amounted (through 2Q 2018) to USD 4.2769 trillion.

Now, those charts.

Chart 1, via Yardeni Research's "Stock Market Indicators: S&P 500 Buybacks & Dividends" book from October 3rd (https://www.yardeni.com/pub/buybackdiv.pdf)

What am I looking at here? The signals revealing flow of corporate earnings toward investment, or, the signs of the build up in the future economic capacity of the private sector. The red line in the lower panel puts this into proportional terms, the gap between the yellow line and the green line in the top panel puts it into absolute terms. And both are frightening. Corporate earnings are on a healthy trend and at healthy levels. But corporate investment is not and has not been since 1Q 2014. This chart under-reports the extent of corporate under-investment through two things not included in the red line: (1) M&As - high risk 'investment' strategies by corporates that, if adjusted for that risk, would have pushed the actual investment growth even lower than it is implied by the red line; and (2) Risk-adjustments to the organic investments by companies. In simple terms, there is no meaningful translation from higher earnings into new investment in the U.S. economy so far in 2018 and there has not been one since 2014. Put differently, U.S. economy has been starved of organic investment for a good part of the 'boom' years.

Chart 2, via the same note:

Spot something new in the charts? That's right: buybacks are accelerating in 1H 2018, with 2Q 2018 marking an absolute historical high at USD 1.0803 trillion (annualized rate) of buybacks. Guess what does this mean for the markets? Well, this:

And what causes the latest spike in buybacks? No, not growing earnings (which are appreciating, but moderately). The fiscal policy under the Tax Cuts and Jobs Act 2017, or Trump Tax Cuts.

Let's circle back: monetary policy madness of the past has been holding court in bond markets and stock markets, pushing mispricing of risks to absolutely astronomical highs. We have just added to that already risky equation fiscal policy push for more mispricing of risks in equity markets.

This is like dumping picnic-sized bags of ice into the cooling system to run the reactor hotter. And no one seems to care that the bags of ice are running low in the delivery truck... You can light a smoke and watch ice melt. Or you can run for the parking lot to drive away. As an investor, you always have a right choice to make. Until you no longer have any choices left.

7/4/18: Markets Message Indicator: Ouuuuch... it hurts

An interesting chart from the VUCA family, courtesy of @Business:

'Markets Message Indicator', created by Jim Paulsen, chief investment strategist at Leuthold Weeden Capital Management, takes 5 different data ratios: stock market relative performance compared to the bond market, cyclical stocks performance relative to defensive stocks, corporate bond spreads, the copper-to-gold price ratio, and a U.S. dollar index. The idea is to capture broad stress build up across a range of markets and asset classes, or, in VUCA terms - tallying up stress on all financial roads that investors my use to escape pressure in one of the asset markets.

Bloomberg runs some analysis of these five components here: https://www.bloomberg.com/news/articles/2018-04-03/paulsen-says-proceed-with-caution-across-many-asset-classes. And it is a scary read through the charts. But...

... the real kicker comes from looking back at the chart above. The red oval puts emphasis on the most recent market correction, the downturn and increased volatility that shattered the myth of the Goldilocks Markets. And it barely makes a splash in drawing down the excess stress built across the 'Markets Message Indicator'.

Now, that is a scary thought.

9/2/18: Markets Mess: Sunday Business Post

My Sunday Business Post article from last week on the beginnings of the stock markets troubles: https://www.businesspost.ie/business/markets-mess-unable-take-decisive-much-needed-downward-correction-yet-equally-unable-push-valuations-much-higher-408224.

As predicted: we had a messy week, with no catalyst to inflict a real, much needed and deeper correction onto grossly overvalued markets.

My next instalment on the continued mess is due this Sunday. Stay tuned.

16/12/17: Long-Term Stock Market Volatility and the Influence of Terrorist Attacks in Europe

Our paper

Corbet, Shaen and Gurdgiev, Constantin and Meegan, Andrew, Long-Term Stock Market Volatility and the Influence of Terrorist Attacks in Europe (August 2017). Available in working paper format at SSRN: https://ssrn.com/abstract=3033951

Was published in the Quarterly Review of Economics and Finance, https://www.sciencedirect.com/science/article/pii/S1062976917302958.

7/9/17: What the Hack: Systematic Risk Contagion from Cyber Events

We just posted three new research papers on SSRN covering a range of research topics.

The second paper is "What the Hack: Systematic Risk Contagion from Cyber Events", available here: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3033950.

Abstract:

This paper examines the impact of cybercrime and hacking events on equity market volatility across publicly traded corporations. The volatility influence of these cybercrime events is shown to be dependent on the number of clients exposed across all sectors and the type of the cyber security breach event, with significantly large volatility effects presented for companies who find themselves exposed to cybercrime in the form of hacking. Evidence is presented to suggest that corporations with large data breaches are punished substantially in the form of stock market volatility and significantly reduced abnormal stock returns. Companies with lower levels of market capitalisation are found to be most susceptible. In an environment where corporate data protection should be paramount, minor breaches appear to be relatively unpunished by the stock market. We also show that there is a growing importance in the contagion channel from cyber security breaches to markets volatility. Overall, our results support the proposition that acting in a controlled capacity from within a ring-fenced incentives system, hackers may in fact provide the appropriate mechanism for discovery and deterrence of weak corporate cyber security practices. This mechanism can help alleviate the systemic weaknesses in the existent mechanisms for cyber security oversight and enforcement.

30/6/17: Manning Financial: The End of the Trump Boom?

My recent contribution to Manning Financial for Summer 2017 is available here: http://issuu.com/publicationire/docs/mf__summer_2017?e=16572344/49275504

7/6/17: Markets, Investors Exuberance and Fundamentals

Latest data from FactSet on S&P500 core metrics is an interesting read. Here are a couple of charts that caught my attention:

Look first at the last 6 months worth of EPS data through estimated 2Q 2017 (based on 99% of companies reporting). The trend continues: EPS is declining, while prices are rising. On a longer time scale, EPS have been virtually flat in 2014-2016, but are forecast to rise nicely in 2017 and 2018. Whatever the forecast might be for 2018, 2017 increase would do little to generate a meaningful reversion in EPS to price trend

However, the good news is, expectations on rising EPS are driven by rising sales for 2017, and to a lesser extent in 2018. This would be (if materialised) an improvement on the 2014-2016 core drivers, including shares repurchases (chart below).

Next, consider P/E ratios:

As the chart above indicates, P/E ratios are expected to continue rising in the next 12 months. In other words, the markets are going to get more expensive, relative to underlying earnings. Worse, on a 5-year average basis, all sectors, excluding Financials, are at above x14. Hardly a comfort zone for 'go long' investors. The overvalued nature of the market is clearly confirmed by both forward and trailing P/E ratios over the last 10 years:

Forward expectations are now literally a run-away train, relative to the past 10 years record (chart above), while trailing (lagged) P/Es are dangerously close to crisis-triggering levels of exuberance (chart below).

In summary, thus, latest data (through end-of-May) shows continued buildup of risks in the equity markets. At what point the dam will crack is not something I can attempt to answer, but the lake of investors' expectations is now breaching the top, and the spillways aren't doing the trick on abating them.

2/1/16: Financial digital disruptors and cyber-security risks

My and Shaen Corbet's new paper titled Financial digital disruptors and cyber-security risks: paired and systemic (January 2, 2017), forthcoming in Journal of Terrorism & Cyber Insurance, Volume 1 Issue 2, 2017 is now available at SSRN: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2892842.

Abstract:
The scale and intensity of digital financial criminality has become more apparent and audacious over the past fifteen years. To counteract this escalating threat, financial technology (FinTech) and monetary and financial institutions (MFI) have attempted to upgrade their internal technological infrastructures to mitigate the risk of a catastrophic technological collapse. However, these attempts have been hampered through the financial stresses generated from the recent international banking crises. Significant contagion channels in the aftermath of cybercriminal events have also been recently uncovered, indicating that a single major event may generate sectoral and industry-wide volatility spillovers. As the skillset and variety of tactics used by cybercriminals develops further in an environment of stagnating and underfunded defensive technological structures, the probability of a devastating hacking event increases, along with the necessity for regulatory intervention. This paper explores and discusses the range of threats and consequences emanating from financial digital disruptors through cybercrime and potential avenues that may be utilised to counteract such risk.

2/1/16: The Future of Global Finance: Moscow 2015

Back at the start of December, I spoke at an international finance conference in Moscow covering developing trends in global finance.  You can find the conference archive (in English) here: http://cmconference.ru/en/about including videos of presentations. My interview relating to the conference is available here: https://www.youtube.com/watch?v=g7Og2yIDaGY. Some coverage of the conference in the press here: http://www.vestifinance.ru/articles/65070.

2-я Международная финансовая конференция «Валютные рынки. Мировые практики» проходила в Москве 18-19 ноября. Она была организована ГК Teletrade, совместно с Dow Jones, Google и Московской школой управления «Сколково». Архив конференции, включая видео презентаций (Русская версия): http://cmconference.ru/ru/about.

16/11/15: IG Insights Summit: Markets Outlook

Recently, I took part at the IG Summit in Dublin on a panel covering the future direction of financial markets. Here is the link to the panel video: https://www.youtube.com/watch?v=iYFRnOCE4Mk.

My interview on the topic is available here: http://trueeconomics.blogspot.ie/2015/10/281015-flatter-growth-trend.html.

16/10/15: Gold and Bitcoin: Adjacency and Hedging Properties

This week, I spoke at a joint Markets Technicians Association and CAIA seminar hosted by Bloomberg, covering two recent research projects I was involved with on the role of Gold and Bitcoin as safe havens and hedges for other assets.

Here are my slides (omitting section division slides):

The first section was based on the following paper: http://www.sciencedirect.com/science/article/pii/S1057521912001226

A caveat to the above, we are seeing increasing evidence that Gold's hedging properties may be changing over time, especially due to increased financialisation of the asset. In this context, it is worth referencing a recent working paper by Brian M. Lucey et al linked here that I also cited at the seminar.

The Bitcoin section is based on a work-in-progress paper with Cormac Ennis: "Is Bitcoin like Gold? Hedging and Safe Haven Properties of the Virtual Currency". The results of presented below should be treated with serious caution as they are extremely preliminary.

Note: we are extending data set to cover longer period, although even with this extension data coverage for Bitcoin is still suboptimal in both duration and quality. Many thanks to the seminar participant for pointing out two key caveats to the overall data coverage:

1. The 'lumpy' nature of demand around Cypriot banking crisis; and
2. Potential effects on data quality reported for Bitcoin from a small number of high profile pricing events, such as technical glitches and supply/demand shifts linked to large exchanges-linked events (e.g. MtGox).

 Summarising the two papers findings:

28/5/15: ECB does a "Funny Me, Tearful You" Macro Risks Assessment

You have to love ECB analysts… if not for the depth of their insights, then for their humour.

Here are two charts, posted back to back in the latest (May edition) of the ECB's Financial Stability Review.

The above says what it says: risks are low in financial markets, in fiscal policy and in the banks.

Now, Chart 2:

The above says risk-taking is high in financial markets, sovereign debt markets (fiscal side), and the economy's real investment is weak (to which the banks are exposed just as much as to the Government bonds).

So which one is the true chart? Or is there even a concept of coherent analysis in any of this?

"The sharp increases in asset prices relative to the fundamentals have pushed valuations up, particularly in the fixed income market, but increasingly also in markets for other financial assets. Nonetheless, a broad-based stretch in euro area asset valuations is not evident. Moreover, the recent increases in asset prices have been accompanied neither by growing leverage in the banking sector nor by rapid private sector credit expansion."

Now we have it: things are fine, because there is little leverage. And they are even extra-specially-fine in fixed income (aka bonds) markets. Because there is little leverage. The ECB won't tell us that this 'fine' is down to ECB itself buying bonds, pushing valuations of debt up, and incentivising risk-taking in the financial markets by its own policies. Oh no… all is just down to relatively sound fundamentals. But, guess what: even though things are fine, there is a "rise in financial risk-taking". But bad news is that there is no corresponding rise in "economic risk-taking".

"Financial system vulnerabilities continue to stem not only from the financial markets, but also from financial institutions, spanning banks, insurers and – increasingly – the shadow banking sector." But, wait… there is little leverage in the system. So how can financial institutions be responsible for the rise in financial system 'vulnerabilities' (which are at any rate negligible, based on Chart 1 'evidence'). Ah, of course they can, because the whole pyramid of debt valuations in the secondary markets is down to the ECB-own QE buying up of sovereign debt and years of Central Banks' printing of easy money for the financial institutions, including via LTROs and TLTROs and the rest of the ECB's alphabet soup of 'measures'.

Stay tuned for more analysis of the ECB's latest 'stability' missive...

16/4/15: QE and Negative Rates: It's So Good, It Hurts...

Here is an unedited version of my article for Manning Financial on the upcoming pain in the global markets from the Central Banks activism.


With spring sunshine, the glowing warmth of the overheating bonds markets is bringing about the scent of optimism to the macro-analysts' desks. On March 19th, the NTMA issued EUR500 million worth of 6mo notes with a yield of -0.01%. With a few strokes of the 'buy' keys, the markets welcomed Ireland to the ever-expanding club of nations that enjoy the privilege of being paid to borrow from private investors.

In a way, this is the story of Ireland's recovery distilled to a singular event: with the Government borrowing costs at their historical lows, the memory of the recent crises is fading fast from the pages of our newspapers. Alas, the drivers of this recovery are illusory. All are temporary, none are structural or sustainable, in the long run. In fact, the current markets reprieve is concealing the real dangers for domestic investors – dangers of new asset bubbles and potential future losses.

Take a look at the euro area sovereigns at large.

After years of austerity, 2015 is shaping up to be a year of broadly-speaking neutral public spending. In other words, as the euro area Governments' debt remains sky high, public deficits are unlikely to shrink by any appreciable amount. Why bother with reforms, when you can be paid by the markets to borrow? Aptly, as the chart below shows, European economic policy uncertainty remains at crisis period averages, well above the safety range of pre-crisis years.


European Policy Uncertainty Index  (including period averages confidence intervals)

Source: data from PolicyUncertainty.com


Although the Government is usually quick to claim credit for the massive improvements in Irish yields, in reality, Dublin has little to do with these. At every point from Q3 2011 through today, large scale declines in the Government cost of borrowing came courtesy of the ECB. The latest gains are no exception: the ECB has just launched a sizeable bonds-buying programme and with it, the quantum of negative yield debt in the global markets has gone from roughly USD3.6 trillion in January to USD4.2 trillion by mid-March. As of now, 19 percent of the Global Bond Index-listed debt is trading in negative rates territory.

This, by far, represents the largest long term challenge for investors and the greatest risk to the global economies. Expansionary monetary policy pursued by the central banks around the world, including the ECB aims to push up economic growth and reduce the risks of deflation. It also attempts to repair the monetary policy transmission mechanism: that cheap ECB-supplied liquidity is being lent by the banks to companies and households in the forms of new credit.


TANGIBLE RISKS

However, from the investors’ perspective, this monetary activism can end up backfiring. For a number of reasons.

Firstly, as shown in Chart 2 below, monetary policy-driven credit expansion is propelling stock markets and debt markets valuations to all-time highs across the advanced economies with absolutely no tangible connection to real fundamentals, such as growth in economic activity, household incomes, employment, and even capital investment. By the very definition of the financial bubbles, current monetary policies activism is inflating returns expectations unanchored in reality.

Secondly, monetary expansion means that households and firms struggling with debt are given a short-run reprieve from facing the true costs of their borrowings. But the day of reckoning awaits in the future. This means that households and corporates are likely to continue engaging in precautionary savings even as the Central Banks drop rates and bonds markets bid the cost of issuing debt down. Meanwhile, households and companies with low debt exposures are likely to save more to offset declines in their returns on deposits. Taken together, these factors are likely to further suppress domestic demand, while setting us up for a major crisis once the cost of debt starts rising in the future.

Thirdly, negative yields are, like all bubble-generating factors, self-reinforcing in their nature. With central banks increasingly charging commercial banks for deposits, banks prefer buying bonds even in the presence of the negative yields. This means that negative policy rates are reinforcing the dysfunctional monetary mechanism, locking in more liquidity into government bonds and driving yields on government paper further down. The resulting increases in bonds prices incentivise commercial banks to gamble on future capital gains by buying even more bonds. This spiral of demand for government debt depresses banks future profitability as investors bid bonds prices up and loads more risk of significant future losses that will materialise once QE policies begin to unwind.

Another pesky side effect of this is the banking sector stability. Negative interest rates on Central Bank deposits lead to lower deposit rates for banks' customers. Banking sector loans-to-deposits ratios rise, making banks more dependent on the shadow banking system for funding and more levered. Interestingly, in the U.S. at least one large bank, J.P. Morgan has already announced that it will be charging customers for large deposits up to 5.5 percent annual fee.

Fourthly, negative rates and yields are increasing the probability of monetary policy misfires - a scenario where one or several Central Banks around the world can tighten policy too fast and/or too early, completely derailing economic recovery. This problem is global and contagious. Investment grade government bonds are effectively substitutes for each other in majority of investment portfolios. As the result, negative yields in the euro area today are keeping yields low in other advanced economies. This is already causing discomfort in the U.S. where dollar rise relative to other currencies is being driven by a combination of two factors: the expected mismatch between U.S. and euro area policy rates, and investors' fear of Fed policy errors over the next 3-6 months.

Fifthly, the demand for negative yield bonds appears to be setting the unsuspecting investors for a fall. In a recent research note, the investment bank Jefferies discovered that much of the demand for such paper comes from indexed funds. Investors in these extremely popular funds simply have no idea that the strategy the funds pursue is not designed for the world where top-rated bonds are paying negative yields. And as funds start posting losses, the same investors are likely to rush for safety into other asset classes – namely equity. Yet, with equities already at historical highs, the safety-minded investors will be left with buying even more assets at bubble valuations.

Sixthly, negative yields on Government bonds are a disaster waiting to happen for insurance, asset management and pension sector as they create huge risks at the heart of these companies long-term investment portfolios. As insurance companies and pensions funds chase the yield, premia will have to rise, risks embedded in pensions portfolios will jump and returns on longer term contracts will fall. As the result, some financial analysts are warning of not only economic, but also political consequences of the monetary policy activism.

The bankers' regulatory body, the Bank for International Settlements is not amused. In a recent statement, Claudio Borio, the head of the BIS monetary and economic department said it is simply impossible to tell how investors, consumers, voters and the governments are going to react to the negative yields and interest rates. "…technical, economic, legal and even political boundaries may well be tested. The consequences should be watched closely, as the repercussions are bound to be significant, on the financial system and beyond," Mr Borio said.


IRISH INVESTOR PERSPECTIVE

From Irish investors point of view, the risks arising from the euro area negative rates and yields environment are significant.

In a study published in 2005 (http://www.bis.org/publ/work186.pdf), BIS researchers found asset price busts, especially those associated with large property markets adjustments, to have much more painful economic impacts than deflation. The study covered all advanced economies over the period from 1873 through 2004 and included analysis of deflation effects on Government debt and growth. The same results were on firmed by another BIS study published earlier this year (http://www.bloomberg.com/news/articles/2015-03-18/the-central-bank-of-central-banks-says-keep-calm-about-deflation).


Global Markets, Irish Problems

Source: Author own calculations based on data from CSO, Central Bank of Ireland and Bloomberg

As of today (see Chart 2), Ireland is still experiencing property prices that are 38 percent below the pre-crisis peak (in Dublin 39 percent), private debt that is, once controlled for sales of mortgages, and Nama and bank loans to non-banking investors, stuck around mid-2005 levels, and growth predominantly driven by the multinational corporations' tax optimisation strategies. In this environment, negative rates are masking the extent of the problems still present in the economy, while euro devaluation, coupled with exports growth concentration in the MNCs-led sectors, are creating a false impression of improved productivity and competitiveness.

For domestic investors, this means that both equity, corporate and government debt markets  in Ireland and across the euro area are simply out of touch with macroeconomic reality on the ground. The global Central Banks-led policies are pushing our traditional investment and pensions portfolios into the high risks, low returns corner, commonly associated with financial assets bubbles. While some speculative exposure to the US and Emerging Markets assets is always welcome, the bulk of investment allocation today should be focused on conservative view of key risks presented by the negative rates and yields environment. Tax planning, portfolio cost minimisation, low gearing and high liquidity of investment allocations should take priority over pursuit of short term yields and capital gains.