Via Mark J. Grant, author of Out of the Box,
The removal of “event risk” is the bottom line which defines the markets currently and which is why there is such a large disparity between economic fundamentals and the markets’ collective reaction. Short and sweet; risk has subsided or at least that is the common perception. Now this is the conclusion and one that has been long in precise comprehension as I have struggled for clarity to understand why equities and bonds have behaved in one way, gone up, while the financial and economic conditions in America and Europe have deteriorated. The markets were first driven the giant slosh of money created by the world’s central banks resulting in higher stock markets, lower absolute yields of Treasuries and our extended bout of fixed income compression but now that is only one part of the equation, a fourth of the equation to be exact, and understanding the entire construct will be useful for many of you as we proceed into the days ahead. The world has shifted and it should be noted!
The markets are now being driven by the giant pond of capital provided by the FED, the ECB and others. Next it is that each and every problem is being met by the same response which is to toss more money at it and hope that it goes away. This can be defined as a governmental response across the globe which is to “defer, delay and postpone” everything. The third part of the formula for Europe is that no country will leave the Euro under any circumstances so not only is money thrown about but deficit goals are relaxed, relaxed and ignored as demonstrated quite clearly in Spain, Greece, Portugal, Italy and Cyprus. The actual financials in these European countries have gone from bad to worse but it is irrelevant as there has been a change in mindset of the Europeans which is being reflected in the minds of investors which is that “it just does not matter.” The European deficit targets now have all of the value of a sieve for holding water. Worthless in all but the sound of the words bandied about by the European politicians. The Draghi promise continues to function and so the fear factor, the fear of some unwieldy event or another, has diminished to the point that now the Dollar is worth less against the Euro, Treasury yields are heading higher day by day and money is flowing with ever greater volumes into riskier assets because it is perceived that “event risk” has evaporated. “Nothing bad is going to happen.”
It is not just America and Europe where this is taking place either but also in Asia. This can be exemplified by the recent actions in China where local governmental loans cannot be repaid and so the central government has instructed the banks in China to extend the loans for several years or to modify the terms and so “defer, delay and postpone” is the global mandate. It is always an interesting time, which I have seen before, when fundamental economics are ignored and the markets rest upon other propositions which is clearly the case at present.
Soon, however, “relative value” is going to come into play, as Treasury yields rise, and it will have an effect, no doubt, upon the equity markets. The common belief that there is no “event risk” also has another possibility which is that if some event does occur that the markets’ reaction will be much more severe and steep than before when “event risk” was still part of the mass psychology. Put another way, the “fear factor” has all but evaporated.
Having then grasped the reality of our present circumstances by its shoulders and stared into its face; understanding becomes clearer as well as the course ahead. The Dollar’s decline against the Euro will cause even more fiscal issues for Europe while the rise in Treasury yields will cause dislocation in the bond markets. Equity dividends will be reassessed against bond yields and the lower sovereign yields in Europe will not only relax the tension but allow for an ever increasing amount of money to be borrowed which will have consequences if some “event” does wind its way onto our horizon. Even without an “event” however higher yields for Treasuries will have an impact upon the sovereign debt yields in Europe as comparison comes to the fore and overshadows the perceived lack of risk.
Having said that; some sort of pin prick would be more disastrous now than before it is wise to try and identify if any such “event risk” could be forthcoming. More money, without doubt, will be demanded again by Spain, Cyprus, Greece and Portugal this year while the Italian election might toss up some rather unsavory pasta. It is less likely now that some nation would refuse to fund but nothing is certain when twenty-seven nations are bound together in such a fragile manner. Deteriorating economies in the Southern European nations, while ignored now by the markets, may spill over into the streets and cause social unrest with the advent of Spring and there is some cause for wondering if there will be an “event” in this category. In America, where “defer, delay and postpone” have also been the watchwords of the faith we face a March 1 deadline for our “Sequester” where 1.2 trillion in automatic spending cuts may come into play. The Republicans have backed up or folded at each opportunity to date but there seems to be a new spirit in their ranks where they will not back down on this issue and so the possibility of a political “event risk” is heightened.
It may be that the “Sequester” would be a quite good thing for the country as it cuts spending and the Democrats could blame it on the Republicans while secretly rejoicing that social programs and entitlements were reined in without having to be accountable to their support base. If the “Sequester” occurs it will no doubt have a negative effect on the American economy but it would probably not increase “event risk” unless contagion caused unknown ripples effects. While I am on this subject, for those of you owning BABS, I suggest that you carefully review your portfolios with concentration on the review of the “default language.” The Office of Management and Budget (OMB) has published several papers stating that any “Sequester” would have a direct effect on BABS bonds resulting in a 7.60% loss of Federal revenues which would result in a $225mm hit to BABS funding and $322mm for all of the related issuances in the various programs. This is not the main issue of concern however as the issuers could fill the gap but what is of concern is that, as defined by the Recovery Act, some extraordinary redemption provisions could be triggered by any reduction, elimination or change to the Federal subsidy. Some language identifies a change in the IRS rules while other language, especially in the Texas BABS, is far broader so that in certain circumstances some outstanding BABS, virtually all at large premiums, could be called at par and create some very unpleasant losses. A careful review of many issues leads me to the conclusion that not all BABS could be called if the subsidy is changed but that some certainly could be and so I advise you to carefully review what you own and then decide if some early exits are not beneficial. At least, now, you will not be blindsided if some BABS were called so forewarned is forearmed.
Let me be clear about the lack of “event risk” in the markets. First it does not mean that the collective thinking is correct or even that it will be the “collective thinking” for long. Second the lack of a “fear factor” will push “relative valuations” in new directions which will impact the Dollar/Euro ratio causing even greater financial issues for Europe and higher Treasury yields will impact not just bonds with credit risk but equities as a matter of comparison. Yields in Europe, which went down because of the Draghi promise coupled with our great slosh of capital and the “delay, defer and postpone” mindset of the Europeans may begin to rise again because of other factors which primarily would be their “relative valuations” against their American counterparts. The lack of “event risk” has two sides and two sets of consequences.
“Just at the exact moment when you think that the risk has passed the rascal shows up, smiles and says ,‘Good Morning.’ It happens every time.”