Wednesday, August 28th, 2013

Cruise Control

Listening to the BBC discuss how many Cruise missiles can be deployed in the Eastern Mediterranean brings on a certain sense of déjà vu. As we write the UK Parliament has been recalled for a special session to debate a “clear government motion” regarding possible military intervention in Syria. The US Secretary of State says there is “undeniable proof” that the regime used chemical weapons and the Secretary of Defence says that US forces are “ready”. The most likely outcome is therefore that there will be some sort of intervention within the next few days.

We shall have to hope that the intervention does not last long enough to have material economic effects, and for now we will focus on the immediate market impact, which most investors can readily predict. The haven trade has already led to a stronger dollar and stronger US Treasuries, with most of the strength coming at the long end of the curve because that is where most of the selling pressure was previously. Geo-political risk is yet another reason to sell those EM currencies which are already in trouble. If the currencies are in trouble, it is very likely that local equity markets will continue to suffer as well. It’s not exactly fair, given that most of these countries (apart from Turkey) have nothing to do with the conflict, but fairness plays little part in these calculations.

Unless there is a sudden upsurge in diplomatic opposition to a strike on Syria (unlikely given French support and German elections) we do not think there will be much impact on European currencies. The comparable is Libya, not Iraq. However rising volatility will affect Eurozone equities. Although there has been welcome news on the economic front, we think most of the recent rally has been driven by a gradual reduction de-risking of the Eurozone, especially as regards international investors (volatility down from 17% in November 2012 to 11% in August 2013). We often talk about the inverse relationship between returns and risk (falling risk associated with rising returns) and the performance of Eurozone equities over the last four months has been a very good example of this.

Unfortunately the process also works in reverse. This means that any increase in risk, whatever the source, is likely to lead to negative returns. Using the current data, the Eurozone equities are more vulnerable to rising volatility than either the UK or the US, and the extent of the sell-off may surprise many people. Some commentators may attempt to explain this in terms of a threat to the nascent recovery in Europe, or greater sensitivity to contagion from emerging markets. In our view these explanations are unnecessary. This relationship between risk and return is hard-wired into the main developed equity markets and it means that the Eurozone is likely to suffer more than the UK or the US. It’s as if equity markets were on automatic pilot, just like the missiles they are so worried about.

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