Riskelia's blog

Banks stress tests have proved to be a non event. Everyone knew the results in advance: overall the solidity of the banking sector has been supposedly established and only seven banks out of 91 failed the exam. The stress tests were not too stringent as sovereign bonds held to maturity have been excluded from the tests since « no sovereign bonds defaults » will occur according to the Committee of European Banking Supervisors (CEBS). Meanwhile, sovereign stress scenarios have been applied to traded bonds only. Lenders hold about 90 percent of their Greek government bonds in their banking book and 10 percent in their trading book, according to a survey by Morgan Stanley.

Besides, the Basel Committee softened banking capital rules: minority interests will be included in required shareholder capital and last but not least, liquidity requirements on cash securities to cover short term funding have been lightened, constraint on leverage ratio will be reported to Hellenic Calendars (i.e. as of 2018!). The banking lobby has worked pretty well and markets have been pleased with complacency from European politics and banking authorities.

In both regards of risk aversion and stocks markets trends, the dynamic has significantly improved.

Risk aversion has come in negative territory and the red spot light of G10 sovereign debt and the banking sector have evolved positively.

Overall, Riskelia’s estimated probability crash has receded thanks to a decrease in risk aversion as demonstrated in the chart below. This positive development may last long enough to sustain a rally on equities but the sovereign solvency sword of damocles is still looming.

The past month has seen a surprising dollar bearish move across the board. The dollar drop has been particularly acute against European currencies but has concerned every currency from yen to Latam. Nevertheless, this move must not be interpreted as a positive liquidity move since the most pro-cyclical currencies, i.e. commodities currencies and emerging currencies have experienced lackluster appreciation.

In turn, US yields experienced sharp drops with respect to other regions because of consistent downward revisions of the US economic outlook. Manufacturing surveys (ISM, Philly Fed, Empire Manuf) has consolidated as forecast by our predictive industrial cycle indicator, jobs creation have been poor, and real estate prices traded sideways to say the least. Globally, the economic activity surprised to the downside, China leading the way. All these bad surprises translated into deflationary pressures which have been more pronounced on US bonds than on any other.

US 2 years yields have lost ground against German and Japanese yields and both spreads have a very high explanatory power of currencies variations.

Therefore, the dollar move must be interpreted as a crisis of defiance towards the US economy and its ability to recover in the long run. Indeed, new talks of quantitative easing have resurfaced within the Federal Reserve and deflation becomes a credible scenario given the plunge in yields: 0.60% in a 2 years maturity, 2.9% in 10 years.

Moreover, risk aversion, while being still elevated, has clearly receded in European sovereign debt. Recent Greek and Spanish debt issues have been successful. These developments are new signs that the liquidity crisis has been managed as reflected by the relief of the CDS of most vulnerable European countries:

However, solvency risk is now reinforced by the recent dollar depreciation as it prevents Club Med countries from improving their trade balance and in turn reducing their public deficit. The consequence is a higher deflationary pressure with a negative impact on the public debt burden and on the domestic banks’ balance sheets.

The sharp dollar depreciation is not an automatic stabilizer but an endogenous explosive process that reinforces European vulnerabilities. An imminent sharp EUR/USD reversal is a likely outcome, the banks stress tests results on July 23 may be the trigger…

The configuration of risky asset classes has been highly interesting these last weeks. Equities have experienced series of daily run ups and falls. As a matter of fact, the Euro Stoxx 50 made 6 consecutive bullish closes in a row twice in the same month.

The probability of observing 6 consecutive closes in the same direction followed by 6 consecutive closes  in the opposite direction equals: 2*1/(2)^12=(1/2)^11=0.05% or 1 chance every 2048 observations, i.e. once every 8 years in the context of efficient markets. We have observed comparable events twice this year!

The inescapable conclusion is that we have entered a period of high turbulence, with a higher than usual probability of sharp run ups and drawdowns.

Another sign supporting this view is our cumulated risk aversion index, which has resumed a bullish trend since the Global Risk Index has turned positive. In the past, such periods have been the stage of major liquidity crises (LTCM debacle in 1998, corporate credit crisis in 2002, subprime crisis in August 2007, Lehman’s debacle in 2008). ..

The frontier between crash and run up is tighter than ever. The publishing of banks’ stress test will be a key event in this regard as it could push the markets in either direction, as stated by the European Commission.

In the last two days, risky asset classes have rebounded sharply from their lows following the release of the European stress tests methodologies. The latter will assume a loss of 17% (relative to face value) on Greek bonds and 3% on Spanish Bonds. From January 2010, total return performances have been -16.5% on Greek Bonds and -2.5% on Spanish Bonds. These are not stress tests, they just match actual prices! Nevertheless, the news trigger a coordinated rally across Oil, Equities, carry trades, credit indices.

Is the crisis over? No, it is not as risk aversion remains elevated across the board on essential links of the financial system network: the high level of risk of the G10 sovereign and the EUR banks debts. Actually, Greek yields have gone above 10% in the last few days without any respite. This high risk premium is revealing of the level of political uncertainty surrounding the feasibility of the European bailout plan.

Is the economic situation better? Nothing has changed in the US and in China regarding the current slowdown in the industrial outlook. We could say that the Eurozone economic outlook is even worse with a EUR/USD rate at 1.27 than 1.20 as reducing the public deficit with a private sector that cannot take more debt requires reducing the current account deficit which seems a remote scenario with such a currency rate.

Riskelia’s global trend indicator on risky asset classes has moved on negative territory. It did so on three occasions in the past 10 years: before September 2001, in June 2002 and in August 2007. In every instance, the financial system went through a major turmoil in the subsequent months.

We can therefore predict more financial problems and a severe financial crash when the markets realize that the banks’ stress tests are faked.

The issues in financial markets are multidimensional, which makes the crisis more and more severe.

G10 sovereign solvency

The G10 sovereign solvency problem takes its roots into the 2007/2008 financial crisis. Indeed, the banking system failures required Governments bailouts and massive fiscal stimulus to foster growth. Governments have substituted public debt for private debt. As a result, G10 governments, already structurally indebted, have entered unsustainable debt paths, as illustrated by the chart below:

These paths have no chance to reverse in the medium term as the nominal growth in G10 will be far below budget deficits in the next 3 years. This sovereign debt crisis has degenerated into a banking crisis in the Eurozone for at least three reasons we have mentioned here. So far, a global liquidity crisis has been averted thanks to the unlimited liquidity injected by the ECB. But the sources of uncertainty are now social and political: will the European peoples accept the austerity cures imposed to them? Will Germany accept a devaluation of its currency, long-term inflation threats and the provision of unlimited guarantees to the insolvent states of the Eurozone?

The possible Chinese hard landing in real estate

We have already stated that several signals related to China (copper and base metals, Shanghai stocks indices, Shanghai property index, Baltic Dry Index) have turned negative since March-April 2010.

The risk of US double dip

Our advanced indicator of the business cycle (composed of e.g. base metals, emerging currencies and depletable commodities) has stopped its rally a few months ago and has begun a sharp drop since then, which we have interpreted as a negative signal for the industrial activity… The industrial activity eventually slowed down sharply, in accordance with our forecast:

Our guess is that the slowdown will go on as cyclical markets are still undergoing a massive deleveraging.

These three rogue waves are intertwined: as G10 indebtedness reduces Governments’ action margins and in turn increases the likelihood of a double dip while China is clearly vulnerable to a slowdown in Europe, Japan and the US, which still account for 60% of global GDP.

The reflexivity theory advocated by Georges Soros has never been more valid than today. Financial markets shape the economic fundamentals they are supposed to reflect. Former Federal Reserve Chairman Greenspan himself acknowledged this reality several days ago:

“While ordinarily we’re seeing the stock market driven by economic events, I think it’s more the reverse,” Greenspan said in an interview on CNBC. “What we do know is stock prices are a leading indicator.”

We have predicted market vulnerabilities since the end of April. And as market dislocations materialize, let us tackle the issue of hedging the risk of future rounds of defiance towards risky asset classes.

The answer can be inferred from a proprietary indicator called the “crash risk beta”. The latter expresses the sensitivity of an asset class to a major downward shock in worldwide equities. It is computed as the average return of each market conditional on equities returns being below their 10% quantile over a window of 100 days., This average “crash day” return is the expressed in numbers of  standard deviations.

The present dashboard leads to somewhat surprising results:

Actually, the most crash sensitive assets appear to be liquidity plays: hedge funds, European stocks indices, emerging bonds, PGM and … Greek Bonds. A special award for the “diversification benefits” of hedge funds!

Meanwhile, at the other side of the spectrum, stand the “crash-friendly” or “safe haven” assets, rising during stock market crashes, hence providing portfolio protection. These are the “safest” sovereign bonds and the yen effective exchange rate against a basket of currencies.

Looking at Riskelia’s trend and global indicator, we can see that safe havens share a common positive trend whereas ”crash sensitive” assets have contrasted long-term price behavior. For instance, Emerging Markets bonds still pursue a rising trend while being strongly related to downward drifting European Equities during crash periods.

The positive trend among “safe havens” is a reward for the political risk involved in the financing the guarantors of the financial system, as the latter strive to find their way in dangerous cliffs,  swinging between two opposite types of dangers: be trapped into the deflationary spiral that has already set off in the most insolvent countries –which would probably lead to political and social outbursts and eventually a partial default on their debt-  or resort to money creation as a last recourse to pay their liabilities –another type of default through currency devaluation.

Providing an efficient hedge against liquidity risk but carrying instead long-term political risk, the face of “safe havens” have considerably changed since the good old times when sovereign solvency risk was confined to Argentina, Mexico, and other ‘remote’ places of the emerging world…

Trends remain slightly negative on risky asset classes, the weakest links are markets related to Chinese growth: Shanghai Composite, Oil and Base Metals. Several sovereign bonds, such as Spanish and Greek debts, remain in a clear downtrend, a worrying sign for the monetary and political stability of the Eurozone as a whole.

Financial bubbles are present on French and German debts, which served as safe heavens in the recent ‘flight to quality’ episode. A bubble indicator over 70% foreshadows a possible sharp reversal. Meanwhile the Radar recommends long positions on US and UK bonds which are in a clear uptrend without signs of price exaggeration.

Risk Aversion indicators highlight persistent signs of vulnerabilities within the financial system. The weaknesses are focused on G10 Sovereign Debt and the Euro Banking system. As the interconnection network demonstrates, the slightest fragility can spread to the whole system through strong relationships between the liquidity outlook across different asset classes. The positive global Risk Aversion announces more frequent and serious financial disruptions. Hence, we recommend prudent risk taking in a context of global financial uncertainty.

Trends and Bubbles Radar

The greatest financial bubbles

Risk aversion Radar

The MSCI World, a gauge of equities in 24 developed markets, increased 0.2 percent for an eighth straight gain, the EUR/USD increased from 1.20 to 1.24, Spanish 10 years bonds yield tightened 40 bps to 4.6%. Similarly, an index of European banks sharply rose 8% from the start of the month.

As a matter of fact, the meeting of European leaders who pledged to reduce the deficits through austerity plans while sharing the burdens of debt through systematic bonds buying program. Last but not least, the decision to publish stress tests institution by institution as of July contributed to reassure the markets.

Just like the US stress tests, no one believed in macro-economic stress tests. The default mechanism of a bank is much more endogenous and mostly provoked by financial liquidity dry up. Indeed, Nothern Rock default in September 2007 and subsequent bailout by the British Government showed that a bank financing assets resting on wholesale financing was highly vulnerable to capital markets liquidity crisis. This is exactly what happened to Spanish banks in May as they borrowed 86 Billions EUR from ECB. This was double the amount lent to them before the collapse of Lehman Brothers in September 2008 and 16.5 per cent of net eurozone loans offered by the central bank. Meanwhile, stress test is a very important path to transparency which may be a turnaround in restoring confidence. Then the critical question “is it over?” deserves to be raised.

Let’s have a look at Riskelia’s Risk Aversion radar to assess the health of the whole financial system:

As we can see, the process of return to confidence is going through equities, then emerging debt and carry trades. Nevertheless, G10 sovereign debt and the European banks remain highly vulnerable. As the global risk index is still in positive territory we still cannot remove the systemic financial alert.

What is more worrying is that another economic weakness develops into the whole system. There is an apparent Chinese weakness which has never receded since we first underlined it.

Just looking at month to date performance of a basket of risky assets (comprising equities, commodities, carry trades and credit) can help figure out the remaining financial weakness:

All markets related to China (e.g. the Shanghai composite and base metals) are strongly negative month to date despite the recent decision of China to allow a more flexible renminbi against a basket of currencies.

As always, in a global financial route, resolving an issue may become a following one more apparent. Is an industrial slowdown lead by China at play?

As we have commented upon in our previous posts, all risky asset classes have been subject to a global deleveraging process since May 2010. Riskelia’s global trend indicator (which watches equities, corporate debt, hedge funds, depletable commodities and emerging currencies) has switched from highly positive to slightly negative in only a few weeks :

In our post Is there any safe haven left?, we had tried to examine whether an asset class could play the role of a “safe haven” in today’s markets. And our answer was NOT REALLY, as the German and French bonds which have benefited the most from the recent deleveraging are presently subject to dangerous manias and offer too low returns to be considered a good deal in today’s turbulent waters. In this post, we try to analyze this issue under a different perspective and ask the question: are there any havens within the equity asset class itself?

A sector and country analysis  leads to very instructive conclusions regarding equities prospects:

It appears that equities are differentiated according to the macroeconomic prospects in the domestic country. The higher the current account balance and the healthier the budget balance, the better the trend dynamics. For example, the German DAX, the Sweden OMX and the South Korean KOSPI remain in positive bullish trends while the Spanish IBEX and the Italian MIB experience very strong negative trends.

Another interesting picture  comes from the emerging stock markets. Particularly impressive are the downward trends in the Brazilian Bovespa or the Chinese Shanghai Composite. Maybe these vulnerabilities are the results of the implosion of the financial bubbles observed since 2009 (recall that the Brazilian and Chinese stock indices grew by more than 80% in 2009). In any case, it is worth following the dynamics to see if they develop into long-term bearish trends, in which case a hard landing of the emerging economies would be expected.

The sector Radar on European stocks gives a very contrasted picture:

While the weakest sectors are those exposed to external financing such as banking, insurance and utilities, some sectors have benefited from the the euro’s fall (travel and leisure, auto & parts, technology). The differentiation across sectors remains very strong, to the point that some sectors, which have been used as havens in the deleveraging process, are still subject to financial bubbles (food and beverage and personal & household)!

As is clear from this analysis, some equities have resisted nicely to the recent selloff, some remaining sharply up year to date. It is worth following this resisting bastion as the genuine sign of a bear market is when the top performers enter themselves in bearish trend. As we can see, it is far from being the case for now.

Two Commodities Indices have been designed to play a role in enhancing and diversifying global diversified portfolio returns: the GSCI and the DJ UBS (ex DJ AIG).

Both arguments are contradicted by the new financial reality.

Myth 1: diversification

Commodities are not any more a diversifier as the new zero rate paradigm makes them more similar to other risky asset classes: equities, corporate credit, emerging credit, hedge funds… Indeed, in this context, all assets yielding a premium are closely related in to global liquidity cycles and their successions of manias and panics. The network of connections between commodities and risky asset classes is very dense as demonstrated by the figure below:

When S&P returns are within the 10% lowest quantile, the network is even denser, which means that diversification is the lowest when we most need it:

Nevertheless, gold proves to be a powerful diversifying alternative to zero rate cash during financial crises.

Myth 2: return enhancement

Commodities index investment consists in buying commodities futures and rolling them to the following maturity before the contracts expire so that there is no physical delivery. This process provides very different returns from holding commodities and storing it in a facility, the differential coming from the commodities curve being either upward sloping (i.e. in contango) or downward sloping (i.e. in backwardation). Commodities financialization has led to a rise in commodities prices, which in turn has stimulated production (the new discovered price being more often than not above the production cost). In turn, commodities have been more often well supplied than they used to be, hence a higher and more frequent contango than before.

As a matter of fact, the contango is now structural on agriculture and energy markets. It will remain contained in base metals, precious metals as storage capacity is not costly and virtually unlimited. This consistent contango proved to be very costly over time mostly on agriculture and energy as demonstrated by the following data:

In the long run, consistent positive returns may be achieved through an active exposure to commodities (Riskelia could help in this regard) but certainly not through passive rolled long futures positions, whether they are managed under the GSCI or the DJ UBS.

When the diversification and return enhancement myths collapse, investors will brutally withdraw money from commodity indices. It is likely to happen in a deleveraging mode (such as the one we are experiencing today) when investors realize that these badly designed commodities indices don’t diversify portfolio and lose even more than other assets due to the contango.

So far, index investors have not lost their appetite for commodities… But should oil and base metals enter into a bearish trend, the index flows may reverse sharply, as already experienced after August 2008:

And if they do reverse, commodities will lose an important price support as Commodities Index Traders (CIT) account for 30% to 50% of Open Interests on most exchange-traded commodities…