Despite unimpressive and often mixed economic data, market prices in a wide range of financial assets have continued to grind higher. And the results that cheered pundits are hard to square. For instance, Floyd Norris in the New York Times today scratches his head over how inconsistent recent employment gains are with the first quarter GDP contraction at an annualized 2/9% rate. It’s also hard to reconcile with reports of weak retail sales and falling in-store traffic. Similarly, China has become concerned enough about growth that it’s started pump priming again. Even so, car sales dropped by 3.4% in June. And in Japan, machinery orders plunged by 19% in May. And despite the recent discussion of Eurozone recovery, recent reports have put a dent in cheery forecasts. As Ambrose Evans-Pritchard noted:
Data released on Thursday showed that industrial output for May fell 1.7pc in France and 1.2pc in Italy. It has fallen for three months in a row in Germany, hit by Russia’s recession and weakness in China and Japan.
“The German economy is highly leveraged to world trade and that is in contraction,” said Dario Perkins, from Lombard Street Research. “The CPB’s World Trade Monitor has been negative for the past two months on a three-month moving average, and we haven’t seen anything like that since the collapse before the Lehman crisis.”
But financial markets have brushed off all sorts of causes for concern: the confrontation over Ukraine, rising hostilities in the Middle East, first in Iraq, and now in Gaza as well, the simmering tension in Asia as China’s expanding territorial claims put it more and more at odds with its neighbors. But the prospect of the failure of a bank in Portugal that is part of a larger conglomerate structure rattled investors yesterday. Even US markets swooned early in the day but staged a partial reversal later on.
While the bank, Banco Espírito Santo SA, isn’t systemically important, its rapid deterioration spooked investors. As the Wall Street Journal noted:
The broad, sharp market moves were reminiscent of the euro zone’s debt crisis in 2011: A shock in a small country spread across the continent, pulling down every major stock index in Europe, trickling over into Wall Street and sending investors scurrying for the perceived safety of gold and U.S. and German government bonds. The 10-year German Bund traded at its strongest level since May 2013.
Portugal’s benchmark index led the declines, falling 4.2%. Exchanges in Spain and Italy were each off close to 2%, and the broad Stoxx Europe 600 fell 1.1%. The Dow Jones Industrial Average closed down 70.54 points, or 0.4%, at 16915.07, after falling as much as 1.1% earlier. Amid the market turmoil, some southern European companies postponed planned stock and bond offerings, and investors were left wondering whether the problems were confined to Portugal or presaged a wider reassessment of Europe’s recovering but still fragile banking system.There is worry about contagion,” said Thomas Roth, a government bond trader at Mitsubishi UFJ Securities (USA) Inc. “The theory is that it could lead to bank failures and throw us back into recession,” he added. Nick Lawson, a London-based stock trader at Deutsche Bank AG, spoke of “the memories of 2011 coming back.”….
It has been more than a year since fears about the health of a European bank rattled markets, and investors, bankers and regulators have been growing increasingly confident about the continent’s financial system. Regulators have hoped the banking industry’s improving health would shine through on so-called stress tests they are conducting on more than 120 large banks.
I’m still amazed that anyone takes the stress test exercise seriously; the market reaction may be a tacit acknowledgement that investors understand their limits quite well.
Today, markets in Europe are in better shape, but the Wall Street Journal today pointed out that issuers had had to postpone both bond and stock offerings, indicating that investors are still nervous. And Bloomberg described the size of the moves in credit instruments:
The events are triggering turmoil in debt markets from London to New York, renewing concern the financial system remains vulnerable six years after central banks began flooding their economies with cheap cash to break free from the global credit crisis. The same policy makers that helped drive bond yields to unprecedented lows, have warned investors are becoming too complacent about risks…
A derivatives index that gauges the credit risk of banks and insurers in Europe jumped yesterday for a fifth day after a company linked to Portugal’s second-biggest bank missed payments on commercial paper. Shares in Espirito Santo were suspended after dropping 17 percent as investors shunned risk assets on concern that financial problems within the Espirito Santo group would spread.
The Markit iTraxx Europe Senior Financial Index of credit-default swaps insuring 25 banks and insurers rose to 72 basis points yesterday from a more than six-year low of 57 basis points last month. Yields on 10-year Portuguese and Greek government bonds surged at least 20 basis points.
In the U.S., credit swaps tied to the nation’s six-biggest banks reached the highest in almost three months. The average cost of the contracts has climbed 9.7 basis points to 68.1 basis points since June 25, the day Puerto Rico’s governor proposed the law allowing public utilities such as the commonwealth’s main power authority to negotiate with bondholders to reduce their debt loads.
Now this is all fairly standard market patter. But based on a reading of the major financial press organs, several elements are striking. One is that most acknowledge complacency about risk, and how widely used measures of risk like the VIX are at unheard-of low levels. That of course is correctly attributed to the tender ministrations of central banks, which have labored mightily to sever the connection between financial asset prices and real economy performance, in the hopes that goosing the former would help the latter. We haven’t seen much evidence of that. There’s also ample discussion of the obvious trigger, concerns about bank risk in Europe.
But what was in surprisingly short supply was the obvious reason why investors should be concerned about risk: that valuations are strained. The continued appreciation of financial assets shows the impact of bad incentives among asset managers. Even though the risk/return tradeoff in many financial markets has looked more and more dubious, institutional investors feel that can’t afford to exit a successful momentum trade early due to the impact on their competitive standing. Trying to eke out the last bit of performance is more important than preserving capital, particularly since investors are measured on a relative basis. Better to get whacked along with everyone else than stand out in a bad way by selling too early.
The second “this ought to be obvious” issue that was sorely absent from the commentary I saw was the failure to acknowledge that austerity is the reason for the weakness of the so-called recover, and low-at-best economic growth means debt burdens remain high, keeping states and banks unhealthy. But the neoliberal orthodoxy is so deeply entrenched you see perilous little questioning of it in our supposedly balanced reporting.
In 2007, it was obvious that things were going to end badly and that virtually all credit instruments were in a bubble. Here, with the Fed acting as if it is committed to an exit from QE and eventual tightening, but widely understood to be unwilling to take too much in the way of adverse market reactions, we are in truly uncharted territory. When investors finally recognize that and sober up a bit, however, remains to be seen.