Tuesday, 23 February 2010

Curious enough

A month ago, I wrote that I thought we were in for a round of general re-rating of risk. It proved more right than I had expected it to be in the short run. But it happened in a quite different way than I expected it. Under normal circumstances, the bond markets would be where the clearest indications would show up and then the stock market would latch on at a later stage. That is what happened from early 2007 and onwards to August 2008. But this is not a replay of August 2008.

I find it quite obvious that fears of the looming debt crisis are playing havoc with the markets. It is equally obvious that there most market players have no idea what is really at stake and when and how it will strike. So all we have to relate to is a general feeling of uneasiness.

This time around we have seen a rather muted reaction in the bond markets and a strong reaction in the stock markets. It could be explained as follows: after the stock market collapse and a good run in 2009, probably the reactions from the risk management departments have become a good deal quicker. Faced with a mounting uncertainty about sovereign debt, probably quite a number of risk managers have strongly recommended to reduce portfolio risk, i.e. to cut exposure to the stock markets. This appears to be done broadly and not with reference to any specific countries. Probably a wise move given that once this kind of broad-based panics occur, it does not matter a lot what kind of stocks you happen to have in the portfolio.

Adjusting the bond market risk appears to be done using CDS's and not much else. The bond market appears to have the most muted response, being steeped in the tradition of evaluating individual default risks. We have simply seen a dramatic widening in spreads reflecting the apparently increased default risk in Greece.

This could be interpreted in a way, not particularly gentle on the stock markets. They reacted quickly to a rumour, to an unconfirmed story, and to facts that are not yet known.

The recent euro trend is more interesting. Since March last year Euro had gained against most other currencies, and as a result European exports have suffered. Now the markets – and the perennially Euro-critic camp in London - use the Mediterranean debt crisis as an excuse to sell Euro. We are now supposed to believe that the Euro is coming apart in the seams, as it has weakened some 10 per cent against dollar.

Most of the English language press chose to ignore the dramatic increase in Euro, but focused on the dollar's weakening instead. It was not a good story that Europe's economic recovery would be hampered by a stronger Euro.

Contrary to what one would believe reading the reports about Euro's terminal decline, its weakening is welcomed in most European quarters. A weaker Euro will support an economic recovery in the growth and reverse the beggar-thy-neighbour policy quietly supported by Washington and London. Instead of fearing a weaker Euro, we should celebrate it.