Wednesday, 26 October 2011

Contagion defined

While we wait for the all-encompassing, gold-plated solution to EU's institutional problems, one could reflect on the term "contagion”. The concept has been used so often in recent months that we have almost become immune to its possible meaning.

Progressive distrust
I suppose it means that distrust of one kind of assets (Greek government bonds, for example) leads the financial markets to lose confidence in other assets - such as Italian government bonds. In the financial markets it means that the price of the suspected asset drops to reflect the new perceived risk of owning the asset. Completely logical, this.

So "contagion" means that investors reassess risk on assets one by one, and it implies that prices adjust - mostly downward. Contagion is therefore a sign that the markets have begun to think. This should create some concern, since the markets not exactly known for composure when they find out that they have been wrong.

Risk reassessed
Since 1998 it has been Standard Operating Procedure that when something went wrong in the world economy, interest rates were lowered and ample liquidity was supplied to the market. Since Asia during the same period took over the production of industrial goods, this policy did not stoke inflation.

Yields on government bonds fell, and in an attempt to achieve higher returns, institutional investors around the world dramatically increased holdings of low-quality bonds and equities. As a result risk premiums fell dramatically.

A clear example is that the Italian government bond yield was less than 20bp higher than German government bonds back in 2005. A clear sign that the risk was severely underestimated and the risk premiums had fallen too far.

We think and we re-think
The banking crisis in 2008 meant that market participants again are thinking about the correct price of risk. With usual decorum and restraint, the financial markets have entered into a permanent state of catatonic shock.

In other words, the "contagion" translates into a progressive understanding that risk should be reassessed. It seems that politicians everywhere find that such knowledge must be stopped by all means before it goes too far.

A potential victim of risk re-pricing : U.S. overconsumption
Now think what could happen if the markets began to ask critical questions about the World’s largest debtor by far, the US of A.

It would mean sharply higher U.S. bond yields. The burden of debt service would force a reform of public spending and taxation. Consumers would be forced to save instead of borrowing. Businesses would have to rely more on labour instead of cheap capital.

The road to get us there would certainly not be smooth and without obstacles. But "contagion" might ultimately not be the worst outcome. 

Monday, 17 October 2011

Risk willingness increases

Despite the continued uncertainty over what will actually be done in order to stabilise Greece and the European banks, G20 meeting in the weekend 15/16 October delivered enough details and pointers that the financial markets will begin taking the risk premium out of the market. Later on, it could develop into some kind of euphoria that will turn upside down everything that has happened in the past few months. It started two weeks ago as the first rumours of a comprehensive solution began to circulate and it can continue for a while, at least.

Bank crisis solution
Our often repeated take on the situation is that at least two crises overlay each other: Greece, and a general debt crisis, which in turn reflects itself in a very unhealthy banking sector. As I have stated earlier, Greece must have a debt restructuring in order to get out of the mess, and that will lead to some serious cash injections to the banks. The US banks already got their no-strings-attached social help three years ago, and the European banks will probably receive their gift vouchers over the coming six months. 

A classic “risk-on” reaction
In concrete talk, “taking the risk premium out” means: 
  • Stocks will gain, possibly lead by the bank stocks, and primarily in Europe. 
  • Bond yields on higher-rated sovereigns will increase, the yield curve will steepen.
  • Yield spreads of lower rated sovereigns over higher-rated sovereigns will narrow, in some cases sharply. 
  • High yield bonds will see the their yield spreads over government bonds narrow but at a slower pace than what happens in the spread between high and low rated sovereigns.
  • Dollar will weaken against the Euro and so will other “safe” currencies.
  • Commodity currencies will increase against the USD.
  • Commodities (primarily industrial commodities) will rise moderately, and oil will receive a boost.
  • Gold may fall further, as the “safe haven effect” vanishes.

It may look like an asset rotation, but we not yet seen market volumes corresponding to a major move of capital between asset classes.

A new divergence is building
A bit further out another theme is building. The markets had not seen the sharp slowing of the global economy as late as one week before the stock markets fell out of bed in early August. “The End of the World” is still very much on everybody’s mind.

At some point the markets will realise that apocalypse is not now! Nor indeed anytime soon. The risk-on scenario will then be followed by a proper risk-rally. It will probably last for some months before the underlying longer-term problems again are taken seriously. The debt crisis has not gone away, and it will continue to subdue growth for the coming years. It will be uncomfortable (particularly if you work in a bank), but not disastrous. 

Tuesday, 11 October 2011

Inching closer?

It could very well be that we are in the last weeks before the Greek debt restructuring. At least we hear more and more noise from the Euro-group about the terms of the haircut private sector bond holders will have to take.

On 21 July the Euro-group members presented an agreement whereby the Greek debt would be written down by 21 per cent. It did not take long time to calculate that even with the economic reforms agreed by Greek government at that time, it would not be enough. Greece needs a combination of spending reductions and debt reduction in order to get back from the dead.

With the 21% debt write-off, it would take very optimistic assumptions about future Greek economic growth in order believe that the “primary” surplus (government revenue minus expenditure ex debt service) could be sufficient to cover the servicing of debts to the tune of 170 per cent of GDP.

Several sober estimates have consistently pointed to a haircut between 50% and 70% in order for Greece to get a fresh start. That matches exactly what we now hear from the Euro-zone, namely that “more than 50%” of the debt will have to be written off. It is a great step forward that the truth is finally being tabled.

But, it is not over yet. ECB apparently is against the idea of a Greek haircut of 66%. Instead ECB insists that the 21% “voluntary” haircut must be implemented. One could wonder why, given that a haircut of 50-70% is the only thing that makes sense. Probably it has a lot to do with politics (I will not be so mean as to suggest it could have something to do with the Greek bonds held by ECB itself!).

Let us assume that the banks take the 21% haircut. In that case they would probably need only a minor capital increase, and it would possibly be possible to find that money in the market. Shareholders would be happy and the interbank market would unfreeze rapidly. No wonder the banks endorse this strongly. It would be a carbon copy of the US “money-for-nothing” program, called TARP.

The problem is that in order to arrive at a debt reduction of 66%, EFSF and the Euro-zone countries somehow would have to finance the difference between the bank’s losses and the necessary debt reduction. One could imagine that EFSF simply would underwrite difference or take over the Greek government bonds at artificially inflated prices. This would amount to a de facto gift to Greece and/or the banks.

That would be just about the worst thing that could happen for Chancellor Merkel and the other European leaders. Their electorates could rightly claim that their governments had just rewarded Greece and the banks for their recklessness.

Let us instead assume that the haircut is fixed at 66%. The banks for sure would need capital injections from their governments. In that case the governments will be able to present the expenses as a help to domestic banks and not as a rescue of the reckless Greek. The governments would for an extended period of time take control of the banks. That would be far more palatable for the electorate.

Either way, Europe’s governments will end up having to foot the bill. The difference is in the resulting relationship to the banks and the electorate. It is easy to see why politicians prefer the larger haircut. It is equally easy to see why the banks prefer the 21% haircut.