Cognitive Dissonance Reigns As Risk Sentiment And Positioning Diverge
It seems everywhere we look, talking heads are arguing that they expect a positive resolution to the EU debacle and yet market positioning does not suggest this is the case at all. Of course, we have seen snap-back rallies and sell-offs but the dissonance between the seeming consensus of unbridled optimism that European policy-makers 'get it' and the market's anxiety should be very worrisome - especially for the 'money-where-your-mouth-is' crowd. Morgan Stanley put it best recently as they noted their sense that most investors assume there will be some solution found (or put another way, very few assume that the alternative - a catastrophe of disorderly banking and sovereign defaults - is a base case) but few investors seem willing now to position for that benign outcome (most evidently seen in European Sovereign debt markets currently). Deutsche's Jim Reid is less optimistic but sees the same disconnect as he argues that at this point: "Who can honestly say they know exactly what rescue plans the EU governments are still discussing...".
Giving some broader context to the market's dissonance, Morgan Stanley (in their 2012 Cross-Asset Navigator) noted:
First, our sense is that most investors assume there will be some solution found – most likely with fiscal union and ECB support. Put another way, very few assume that the alternative – a catastrophe of disorderly banking and sovereign defaults – is a base case.
Second, despite the widely held view that catastrophe will be avoided, few investors seem willing now to position for that benign outcome. The most obvious example is European sovereign debt. Timing may be uncertain, but if the crisis is resolved, the outcome is not: yields on under-pressure sovereigns will be materially lower in a year. Conversely, bund yields would probably be higher. In short, a widely held consensus view is demonstrably not priced into asset markets because conviction levels are now so low.
Third, the consensus view that catastrophe will be avoided implicitly assumes that policy-makers – notably, Germany and the ECB – can and will do what it takes to preserve the union and avoid disorderly default. Anything that rattles those assumptions would be unequivocally bearish. That would include, for example, markets questioning Germany’s financial strength or the ECB ultimately refusing to provide the backstop to sovereign markets. More to the point, policy-makers have been reactive, not proactive, throughout the crisis. This has typically added to the cost of finding a solution. If events cascade – because of, say, downgrades to other important European countries – then markets may question whether policy-makers can retrieve control.
Fourth, as it stands now, we expect recession in Europe as a base case. Our macro colleagues believe that if there is not a fairly quick move to fiscal union, with ECB expanding its support for under-pressure sovereigns, then the recession will be deep – something not in the price. The tail risk to that bear scenario would be depression.
Finally, while Europe’s current situation reflects in part its peculiar institutional structure, it is not unique in terms of its leverage.
That has two follow-on implications. First, even if the European crisis is ‘resolved’, it’s only in the sense that Europe would look more like other highly leveraged regions: still facing a difficult end-game, but without the fragilities that frustrated policy-makers’ ability to kick the can down the road, as has happened elsewhere. Second, with markets now generally more alert to sovereign stress, and global growth slowing, it may be that the surprise of 2012 is that sovereign stress spreads beyond Europe to other developed economies.
And From Deutsche's Early Morning Reid:
Before we start today, who can honestly say they know exactly what rescue plans the European Governments are still discussing and which ones have fallen by the wayside never to be seen again. It’s extremely hard to keep up at the moment and extremely hard to analyse as even if ideas never see the light of day their mere discussion seems to have the ability to move markets. For example the four times levered EFSF package and insurance scheme of two months has been gradually fading from view and any remaining hopes probably subsided with S&P's negative credit rating watch listing on the EFSF yesterday following the previous night's negative rating watches on 15 EU sovereigns. This potential bailout plan was huge news at the time. Since then we've had speculation about Chinese/EM involvement, the IMF, ECB loans to the IMF, bilateral agreements, creating a central financial authority, joint Euro-area bonds, AAA-only ‘Elite Bonds’, making the EFSF a bank, making the EFSF co-invest in a SPV that could access ECB liquidity, using the EIB as a SPV, the Fed being involved, ongoing debates about the role of the ECB and now a slow march towards treaty changes. If we've left any out please let us know.
We admit to being fairly confused as to where we stand at the moment and the latest plan reported in the FT late in the US session yesterday is for there to be a package based around the EFSF, the ESM and maybe then the IMF. It is reported that allowing the ESM to run alongside the EFSF could strengthen Europe’s financial firewall when combined with new eurozone funds from the IMF. Under the plans being considered, the ESM is unlikely to have its headline €500bn from the start but the hope is that combining this with new IMF resources and a leveraged EFSF (to about €600bn) could create the “bazooka” effect leaders have been searching for.
We keep moving in circles trying out different permutations and combinations but in reality where is all this money going to come from? Is this all just a distraction to the fact that the ECB is the only agent with the financial flexibility to ensure that all nation states can refinance?
We don't think there is any chance of a quick fix to all of this. Although the market is getting more optimistic, even Merkel commented last Friday that the only real solution to Europe’s debt crisis was a fuller fiscal union, a process that will take years.
Investors are rightly confused and we agree with Reid that we don't think there is any chance of a quick fix to all of this. Furthermore, we fear that any belief in a reversion to pre-crisis levels of sovereign risk on the back of a solution is a pipe-dream as it is clear that risk premia are embedded now (like skews in options prices post 1987) and it is far more likely that Europe stabilizes at much wider levels - more like other leveraged regions.
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