Markets priced for perfection imperiled by rising risks

Global asset markets are priced as if the world economy is in perfectly upward trajectory, but a rising raft of risks suggests the best bet for investors could be on a secular recovery for the safe haven US dollar.

The threat of protracted economic slowdown, gnawing geopolitical tensions and an imminent end to nonstop easy money are there for all to see. Markets can only shrug it off for so long.

Market fear gauges like the VIX market volatility index have begun to trend higher from historically low levels. 

Investors should be looking for higher returns to compensate for implied higher risk. Instead complacency seems to have set in.

The world's major stock benchmarks are locked in a five year-long rally and US Treasury bonds are charging along in a 33 year super bull market. 

That has encouraged investors to turn to more esoteric assets to boost returns - commodities, exotic derivatives, structured products and hedge funds.

It is no surprise that the likes of the International Monetary Fund are warning about excessive risk-taking in financial markets.

The world's major central banks are getting nervous too.

They have craved a return to healthy and exuberant markets since 2008 when they were forced down the path of unconvential monetary policy and quantitative easing (QE). That would signal a return to more normal economic conditions.

What they now face is a monster of their own creation - a market in which animal spirits run wild, fed by excessively cheap money that has papered over the cracks of the legacy problems that remain in the international banking system six years after the global financial system almost fell apart.

Make no mistake though, a change is in the air.

Investors will feel it most from the United States. Five years into its asset buying programme – QE – the Federal Reserve is about to turn off the monetary printing presses. 

The Fed is calling time on zero interest rates and paving the way for higher interest rates that will halt the hitherto endless flow of easy money to US consumers, businesses and markets.

Without a doubt it will be a shock to the system and is bound to have adverse effects on economic confidence. The 4.6 per cent GDP growth rate notched up by the US economy in the second quarter of this year could well mark the peak in the present recovery cycle.

As the Fed wrestles to contain its massively inflated balance sheet - quadrupled in size in the last five years - it is not only domestic growth potential that will be affected. 

Much of the Fed’s funding trove has found its way overseas into emerging markets and high yield assets. The end of US QE could mark a significant sea-change in global investor sentiment.

Near-zero interest rates elsewhere also have nowhere left to go other than up in the long run. Bank of England Governor Mark Carney has already started warning that rates could go up more quickly than previously anticipated. 

The spectre of higher rates is not good news for investor confidence, which will also take a hit when markets inevitably start to look at the global economy with a sharper eye. 

The euro zone is sliding back down into a spiral of recession and deflation. The European Central Bank is dragging its feet so much that whatever policy response it comes up with will probably deliver far too little, too late. Political risks are also becoming deeply embedded. The survival of European Monetary Union and euro cannot be guaranteed in the long run.

Asian fundamentals fare no better. Japan’s economic stimulus strategy – ‘Abenomics’ – appears to be losing its edge. Growth potential has lost momentum and inflation seems to be slipping back again, threatening the government’s long run economic agenda.

None of this is being lost on China’s economy. The downturn in global growth prospects is already casting a much chillier wind on China’s outlook. Growth has plateaued out to a level well below the meteoric expansion rates enjoyed in the early 2000s. 

As investors look for more assured performance in an uncertain world, the US dollar will inevitably be rediscovering its roots as a reserve currency. 

The prospect of higher US rates, stronger relative growth and better safe haven protection make a compelling case for dollar bulls. The dollar’s secular recovery looks set to extend.

Reprinted courtesy of South China Morning Post 29 September 2014

Scotland's separatist legacy continues to haunt Europe

The people of Scotland have spoken and said ‘no’ to independence from the United Kingdom. In the immediate aftermath last week, there was a palpable sense of relief in financial markets. Market fear gauges settled down and risk trades were put back on. But it had a hollow ring to it. Market optimism has proven short-lived.

After years of closer integration in Europe, political fissures are starting to re-open again. The Scottish independence debate has been a rallying point for European separatist movements - especially in Spain, but in Italy and Belgium too. There is growing anger about Europe’s dire economic outlook. Unless some quick economic fixes come along soon, the future of the Eurozone and the euro are at stake.

Scotland will remain in the union of Britain, but the key issue for UK investors is whether Britain stays in the European Union. Political domination by ‘Westminster’ parties was at the heart of Scotland’s independence debate. Many UK voters feel the same way about autocratic and unaccountable EU bureaucracy in Brussels. These sentiments will come to a head at next year’s UK general election. A referendum on a future UK exit from the EU will be a key theme.

It is a trend unfolding in Europe too. At the national level, mainstream pro-EU parties are losing support to the political fringes thanks to growing anger over economic austerity and deepening voter distrust. At a regional level, it is leading to a shift in support for the pro-independence parties in a number of countries.

In Spain, attention continues to focus on the Catalan separatists who are calling for an independence referendum of their own in November. The poll is not recognized by the Spanish government but it could mark an important litmus test for growing disillusion with central government policies. Spain has been bowed under the yoke of tough fiscal austerity after the country opted for an EU bail-out in 2012.

Catalonia accounts for around a fifth of Spain’s economic output and tax revenues from the region make up a major slice of government finances. Spain’s ability to service its large public debt mountain – accounting for over 110% of GDP – would come under serious threat in the event of separation. It is no wonder that the central government is so opposed to giving Catalan independence a voice.

Spanish stocks and bonds were among Europe’s top performers in the wake of Scotland’s ‘No’ vote. But Spanish markets are not off the hook yet, especially if the Catalan referendum goes ahead in early November. It could still present Spanish and European markets with a nasty surprise.

The ‘No’ vote in Scotland does not signal the end of separatism in Europe – but it may change the rules of the game. Independence parties will be encouraged by how Scotland managed to secure pledges of new powers and extra economic concessions from the UK government on the eve of the referendum. This will not be lost on separatists in Spain, Northern Italy and in Belgium. Playing the independence card to extract more regional funding will simply deepen Europe’s budget mess.

There is a more worrying dimension. With the Eurozone economy overshadowed by recession and deflation, handicapped by austerity and high unemployment and saddled with crippling debts, there are still high odds that countries could dump the euro and leave EMU. Any country leaving EMU would spell out the deathnell for the single currency. It would unleash a domino effect among other countries.

At a time when Europe needs closer political, economic, monetary and fiscal co-operation to deal with the economic crisis, political cracks are becoming more apparent. Eurozone policymakers need to make a stand. A plan for structured reflation needs to be carefully crafted. Eurozone policy needs to be more cohesive and mutually inclusive for all economies on an equal footing.

For a start, Germany needs to drop its opposition to quantitative easing and give a free-rein to the European Central Bank to begin buying bonds to release a major new wave of cash into the economy. The scale of any QE programme needs to be at least three times greater than the one trillion euros plan recently hinted at by the ECB.

The Eurozone needs to abandon the Stability and Growth pact and loosen fiscal policy. France has implicitly already done this by suspending its budget deficit targets for two years. A mix of tax cuts and public investment spending initiatives should be channeled into promoting growth across the Eurozone.

The ECB should actively target getting inflation back to 2% and aim to boost domestic credit expansion. Eurozone bank should be forced to meet new lending targets. ECB interest rates should be pushed further into negative territory to force banks to lend.

The euro should be encouraged to weaken in order to boost export competitiveness and stimulate demand.

Europe has a choice – to let the economy sink or swim. Greater policy cohesion can stop the slide towards economic rot and the political disintegration that would accompany it. Europe needs to pull together rather than pull apart.

US dollar renaissance

The US dollar is enjoying something of a renaissance. Dollar fundamentals are on the mend and the currency is winning back investors’ hearts and minds. US growth is surging, job creation is in full swing and monetary policy is about to tighten. Interest rates and bond yields are set to rise. This week’s Federal Reserve meeting will be pivotal.

Other major currencies – the euro, yen and sterling – are fast falling out of favour with investors. Safe haven flows are flooding back into the dollar thanks to growing geo-political uncertainties. This could be the US currency’s defining moment.

The markets certainly stand in thrall and the dollar is showing a spirited recovery. It has notched up a straight 9-week winning streak – its best performance in 17 years. There should be more to come. The dollar seems set for long term secular recovery.

This week’s US monetary policy meeting will see crucial changes to Fed thinking. The Fed’s forward guidance for interest rate expectations and the Fed’s asset buyback programme are bound to come under scrutiny. Monetary policy is stuck in excessive overdrive.  The Fed’s key priority must be to stop over revving the economy.

Against mighty odds, the Fed has beaten off recession, defeated deflation and stopped the slide into financial meltdown. Animal spirits of recovery have been rekindled. US growth has surged to 4.2%, inflation is bang on the Fed’s 2% CPI target and the equity bull market is running at full kilter.

There are few signs of economic overheating yet, but policy needs to be normalised as soon as possible. US interest rates at zero per cent are hardly consistent with a healthy economy in the long run.

The Fed will turn hawkish this week. As a result, expectations for the first Fed rate tightening will be brought forward – probably sooner than next March. The Fed’s asset buying programme, which has quadrupled the Fed’s balance sheet in the last five years, will be closed within the next month.

This will have a seismic shift on interest rate expectations along the US curve. Short term interest rate futures should anticipate a faster tightening profile. As the Fed’s asset-buying fest dries up, the effects will be felt along the US Treasury curve in higher long term yields. This will be manna from heaven for US dollar currency bulls.

US dollar debasement has reached the end of the road. The Fed’s dogged commitment to zero interest rates and a seemingly inexhaustible appetite for Treasury debt has been the bane of the dollar in recent years. Artificially depressed US bond yields are now free to rise. The US Treasury market’s 33-year bull rally has come to an end.

Higher bond yields will be a powerful spur for US dollar longs. Ten year US government bonds already offer much better yield appeal relative to the Eurozone and Japan – and it looks set to get better as US yields continue to rise. Ten year US Treasury yields have hit a two-month high of 2.60%, 200-basis points over the Eurozone and 150-basis points over Japan.

On a relative basis the dollar looks a much better bet than many of its major currency rivals. The dollar stands head and shoulders above the euro, yen and pound.

The euro remains deeply affected by major uncertainties surrounding EMU – and whether the currency can even survive in the long run. The threat of recession, deflation and the impact of deep austerity cuts are forcing the European Central Bank into more super-stimulative monetary policy. Eurozone interest rates have dipped into negative territory and the ECB stands ready to bring out the Big Bazooka – quantitative easing. This is bad news for the euro. A slide back down towards parity against the US dollar is a very real possibility.

In Japan, the yen remains bowed by ‘Abenomics’, the government’s action plan to restore the economy to better health. As part of this, a weaker yen is aimed to boost exports and help meet the Bank of Japan’s 2% inflation target. The yen has already fallen 40% against the dollar in the last two years. A further 10%-15% yen slide could still be in the pipeline.

Investor perceptions towards sterling are being pummelled by the threat of Scottish independence and a possible future UK exit from the European Union. In the worst case scenario, an economically divided Britain, marginalised outside the EU, could lead to a very serious run on the pound.

Set against this backdrop, it is no surprise currency investors are turning to the dollar as a better safe haven hedge in uncertain times. With global political tensions heating up over the Middle East, Russian sanctions and the crisis in Ukraine, investors will increasingly turn to the dollar for sanctuary.

Emerging from six years of financial turmoil, US economic fortunes are in a much stronger position. This will not be lost on the Fed this week. And it will not be lost on the markets. The stronger dollar’s time has arrived.

Sterling risks becoming a doomed currency

Financial markets have a deep aversion to uncertainty. In the coming months, the UK economy and sterling will both be sucked into a vortex of the unknown. It is not just a possible shock from Scotland’s independence vote on September 18^th that is weighing on the pound. Further out there is a much bigger risk in store for UK markets.

UK politics are shaping up for a huge seismic shift in attitudes towards Europe. Next year’s UK general election could mark a High Noon for Britain’s future in the European Union. The stakes are extremely high and the threat to the UK’s future economic prosperity is considerable. Sterling stands at a crossroads. And it is no surprise global currency markets are starting to give the pound a wider berth.

Thanks to growing market worries, the pound has already sunk to a seven month low, losing 7% of its face value two months after hitting the peak of a six year cyclical rally in early July. The currency is likely to feel more pain in the short term – and over the long term too.

Next week’s Scottish independence vote will be cathartic for UK currency perceptions. There is so much at stake – not just for the pound, but for the UK economy and for Britain’s long term political future.

At this stage Scotland’s referendum vote is too close to call. Last minute polls suggest only a 2% swing to the Yes-camp would be enough to win independence for Scotland.

An outright win for independence opens up a Pandora’s Box of deep economic, social and political risks ahead. The only positive outcome for the pound would be for Scotland to reject independence. A short term relief rally would probably follow, but the damage has already been done.

Whatever next week’s outcome, Scottish independence is already a done deal at some stage. The momentum for change and self-determination in Scotland has been so great in recent weeks that the bandwagon effect is bound to carry over.

The economic consequences of Scottish secession are huge. UK GDP would shrink by 8% at a stroke. The UK economy will be deprived of key oil revenues - worth up to £6.5bn in taxes paid to the UK government last year. The crisis in UK public sector finances, already in serious trouble as a result of the post-2008 financial crisis, would deepen even further.

There are no contingency plans for separation. Deep uncertainties remain over Scotland’s currency intentions. Central bank supervisory authority is in serious doubt. There are major question marks over Scotland assuming any share of UK national debt. There are serious risks of a max exodus of Scotland’s financial services sector – major banks and fund managers – seeking cross-border refuge in the UK in the event of a split.

Political and economic divorce would be a very messy, long drawn out affair. Increased uncertainty will have serious consequences for investment, employment and growth prospects for years to come.

The structural shock to UK public sector finances would have grave implications for UK credit-worthiness. UK sovereign debt ratings would be badly affected. The risk of a run on sterling and a sharp sell-off in UK government bonds could lead to a very damaging rise in interest rates and higher long term yields.

Question marks over the pound would play into the Bank of England’s hands short term. The UK economy is well down the road to recovery and looks set to expand by 3.5% this year. The BOE are keen to ‘normalise’ interest rates as soon as possible. Raising UK interest rates from zero back towards a 3%-4% target in the next two years would help stabilise sterling in the event of a market run on the currency. More importantly, the BOE needs to keep a steady hand on the tiller in uncertain times.

There is a much more deep-rooted danger for the UK further ahead – the risk of the UK voting to leave the European Union at some stage over the future. This will come to a head at next year’s general election – due to be held by 7^th May 2015.

Recent polls show the majority of UK public opinion supporting an EU exit. It could be a self-fulfilling prospect. British Prime Minister David Cameron, under pressure from rebels in his own Conservative Party, has already pledged to hold a referendum on the EU by 2017 – if re-elected next year.

If the UK leaves the EU, the consequences for the economy would be cataclysmic. The UK economy could be ruined beyond repair. UK trade would be jeopardised, since the EU is Britain’s biggest trading partner. Major foreign companies would desert the UK’s shores for Europe. Output and employment would collapse – UK depression could be on the cards.

Britain without Scotland and marginalised outside Europe would become an economic backwater. There would be a very serious run on the pound. The odds of sterling testing parity against the US dollar would be very high. Sterling would be a doomed currency.