ANALYSIS:Uncertainty appears to have gripped all debt players. Triple-A rating for G7 may be history
THE ESCALATING euro zone debt crisis, deteriorating global economic prospects and the sense that authorities are fast running out of ammunition has catalysed the worst stock market downturn since the international banking crisis peaked in early 2009.
Markets are tanking everywhere, especially in Europe. The German Dax’s 5 per cent fall on Wednesday was its 11th consecutive decline, the longest losing streak in 33 years, while Italy’s MIB index was 6 per cent lower. Banks, particularly in France, have been in freefall. Société Générale lost as much as 22 per cent of its value on Wednesday and early gains yesterday morning were quickly lost as rumours of its financial health continued to circulate.
The cost of credit default swaps (CDS) that protect against the risk of a SocGen default have more than doubled this year, with BNP Paribas, Spain’s Bankinter and Italy’s Banco Popolare seeing similar rises. Suggestions that banks may suffer serious losses on some European sovereign debt are triggering fears of a Lehman-like lending freeze.
Sovereign debt fears, too, are no longer confined to Europe’s peripheral states. Spiralling Italian and Spanish bond yields forced the European Central Bank to begin a round of bond buying this week, but now AAA-rated France is under attack. Spreads on French CDS hit 168 basis points this week – that’s three times the level of US swaps and greater even than countries like South Africa and the Slovak Republic. French CDS are trading at the same level as Italian swaps in July.
Rating agencies have reiterated that France’s AAA status is stable, but markets think otherwise. Currently, French and German contributions to the European Financial Stability Fund (EFSF) stand at 22 per cent and 29 per cent respectively. If Italy and Spain pull their contributions – they are effectively providing cheap funds to Greece, Ireland and Portugal while paying through the nose to borrow themselves – then French and German contributions would rise to 32 per cent and 43 per cent.
No single trigger explains the recent about-turn in financial markets. As Citigroup’s influential chief economist Willem Buiter noted this week, there has been a “growing recognition that the irreducible quantum of risk is larger than previously thought”. Buiter envisages a future where no G7 country will be AAA-rated.
Economic activity will slow in G7 countries as austerity programmes begin to bite, Buiter argues, echoing Gluskin Sheff’s David Rosenberg, a long-term market bear. “History shows that downgrades light a fire under policymakers and the belt-tightening budget cuts ensue, taking a big chunk out of demand growth and hence profits,” Rosenberg said this week. Uncertainty has led to a so-called flight to quality, away from equities and into US bonds, which the market continues to perceive as a safe haven, despite Standard and Poor’s recent downgrade.
According to Stanford economics professor Nicholas Bloom, a US recession is almost unavoidable. He studied 16 previous “uncertainty shocks” (events like the Cuban missile crisis and the 9/11 attacks) and concluded that “large short-run recessions” invariably result. “When people are uncertain about the future, they wait and do nothing,” Bloom cautioned.
So what do markets want? “More drugs from the Fed,” snorts Peter Boockvar, a strategist at Miller Tabak. Markets were accustomed to being soothed by Alan Greenspan during his tenure as head of the Federal Reserve.
“At the first sign of trouble, the Fed stood ready to flood the system with liquidity,” US blogger and market strategist Barry Ritholtz said this week. He cited the massive responses to the Asian contagion in 1997, the Russian bond default and collapse of Long Term Capital Management hedge fund in 1998, the dotcom implosion of 2000 and the 9/11 attacks. The low interest rates that followed the tech crash resulted in the housing boom and bust, which continues to reverberate. “The Fed gave us a hair of the dog that bit us: more cheap money, and another liquidity driven rally,” he said.
Today, however, the Federal Reserve and the US government are nearly out of bullets. The response to the dotcom collapse was to slash rates from 6.5 per cent to 1 per cent. When the global financial crisis hit, rates were cut from 5.25 per cent to 0.25 per cent, where they remain today.
Ben Bernanke promised this rate would hold until 2013, and some market participants are hoping for a third round of quantitative easing. However, despite two rounds of quantitative easing, fiscal stimulus and record low interest rates, US unemployment remains high at 9.2 per cent and economic activity is slowing. Bernanke’s monetary options are limited, while fiscal retrenchment is coming. Rosenberg’s view the US had “a nice two-year rally in risk assets and something close to an economic recovery” that was ultimately “built on sticks and straw, not bricks” is increasingly shared by fearful investors.
It’s certainly shared by Société Générale’s famously bearish Albert Edwards, who has long warned of an “Ice Age” for equities. “The simple fact is that the global economy is falling back into recession or indeed is already in recession,” he wrote in a letter to clients this week. “A fragile recovery undermined by private sector deleveraging collapses as a semi-bankrupt government tries to rein in runaway deficits”; we are entering the next phase of the Ice Age “when another cyclical failure combines with a secular derating of equities and rerating of government bonds”.
It’s not all gloom. Oil prices are falling, US companies are fortified by large mountains of cash, previously cautious company directors are snapping up company shares at the fastest pace since 2009, European and emerging market equities are below historical norms and some kind of oversold rally – even if a temporary one – is overdue.
Furthermore, the recent escalation in volatility has hit levels that have marked market nadirs in the past. The Vix, the so-called “fear index” that measures market volatility, hit 48 this week. The only period where higher readings were recorded was during the banking crisis in 2008/2009, when it hit a height of 89 and remained elevated for months. During “ordinary” market crises, however, 48/49 have been magic numbers, marking volatility peaks during the Asian financial crisis in October 1997, the hedge fund crisis in October 1998, the 9/11 attacks, the dotcom crash, the WorldCom bankruptcy in July 2002 and the European sovereign debt crisis in May 2010.
What might soothe current market woes? The Fed’s commitment to continued low rates hasn’t done the trick, nor has the ECB’s bond-buying exercise. Markets appear to be pushing policymakers towards something dramatic – a “bazooka”, to use former US treasury secretary Henry Paulson’s phrase. That might be a massive increase in the EFSF or the kind of pooling of fiscal authority that a monetary union typically requires.
“Papering over” economic weakness will no longer do, Nobel economist Joseph Stiglitz warned this week: “a new confidence has emerged: confidence that matters will get worse, whatever action we take”. Time will tell if policymakers can change that sentiment.
