US-Europe Decoupling At All Time Record As SovX - Implied Correlation Spread Indicates Historic Domestic Complacency
In last night daily report by BofA's Jeffrey Rosenberg, one chart stands out: the spread between the 12 month S&P 500 top 50 Implied Correlation (generically a proxy of broad US equity risk) and the Sov X, or the blended sovereign risk as indicated by CDS, which recently hit an all time high. In a nutshell: the spread has never been bigger, confirming that US domestic complacency over all things European (and the continuing levitation in stocks) has reached unprecedented levels, as absolutely no fundamentals can stand in the path of the hedge fund levered beta year end rally. In other words the China-US fatally flawed "decoupling" of 2007 has been replaced with a decoupling between the US and Europe. This will also end in tears. And this is happening even as European markets are unraveling, and as the EURUSD is tumbling, guaranteeing a drop in both US exports and the top line for US MNCs. But why worry: as 58 year old Valerie Whelan yesterday summarized it best: "It's capitalism gone mad." Every move in risk assets higher is merely a bet that central bankers can kick the can down the road for one more day. Nothing else. That it is unsustainable is guaranteed. Willem Buiter makes the case all too clearly that Europe will go bankrupt soon. We expect someone to make the same argument about the US very soon, especially if China does in fact commence tightening, leaving the chairman no other choice than to open the liquidity floodgates in one last attempt to preserve the dying economic system, however, this time without the benefit of being able to export inflation to China.
The chart in question:
Figure 1 shows that while sovereign credit risk in Europe earlier this year was associated with greater systemic risk (as judged by the implied correlation of S&P 500 top 50 constituent returns), the latest expansion in sovereign risk since mid-October has seen generally stable indications of systemic risk (albeit with some increases in recent days).
And while the US may pretend it can decouple from China and Europe, things in Europe, especially in the Sr-Sub Fin relationship continue to deteriorate (we will have more to say on this soon).
Longer than expected maturities for the Irish (and Greek) financing packages (7.5 years) were designed to alleviate restructuring concerns in the market - but both Irish and Greek sovereign CDS spreads actually widened on the day, as shown above in Figure 2. That suggests doubts in the market that the two countries have sufficient political willingness to make the required fiscal adjustments over a long period of time. The remaining peripheral countries (including now Belgium) underperformed while there was some spillover to the core as bailouts imply a transfer of credit risk from weak to strong economies. European senior bank CDS widened significantly led by Portuguese banks - despite the absence of haircuts for senior debt in the Irish bailout. Subordinated bank CDS underperformed as substantial haircuts will be taken by subordinated debt in the Irish bank bailout.
Also, as Zero Hedge pointed out recently, the IG-iTraxx spread has hit all time highs. BofA noticed. But ignore that, and note the ridicuous decoupling between the S&P and the Stoxx 50! (right chart)
And some last observations on why if the stock market falls now, it will likely result in the collapse of part or whole of Europe:
During the earlier episode of the sovereign crisis in April-June the Euro was in freefall and increasing dollar LIBOR rates indicated strains in the funding markets. This time Europe has funding mechanisms - such as the EFSM and the EFSF - in place to help contain the sovereign crisis within Europe. While the Euro has also declined in response to the sovereign crisis this time, the magnitude of declines so far is smaller, and additional factors such as geopolitical issues and stronger than expected US economic data have helped strengthen the USD against the EUR. For example, while the Euro has declined nearly 8% against the dollar since November 4th, the currency has declined only 3-4% against the JPY and GBP. Also, the recent widening in forward LIBOR-OIS spreads appears related more to increases in bank credit risk than expected renewed funding strains.
Decoupling was the big thesis in 2007. It worked... for a while... then it all came crashing down. The same thing is happening with Europe right now. And again, it will definitely end in tears when decoupling in an intimately interconnected world is once again proven to be a myth.