Tuesday, August 5th, 2014

Summer Lightning

This is going to be a gloomy piece. We will spend the next 500 words discussing war, disaster and bankruptcy, so let us start by saying that none of what follows is our central scenario. We are Overweight equities in our US dollar and sterling portfolios, and Neutral in our euro portfolio.

The first and most obvious threat is the Ukraine. Most of the Western press now agrees (1) that Russia was complicit in the supply of ground to air missiles to the rebels, and (2) that other sophisticated weaponry has also been supplied together with “advisers” whose reports are relayed back to Russia. There have also been reports of Russia artillery being been fired into the Ukraine from Russian territory, all of which have been denied. Evidence of this happening on a regular basis would constitute a major escalation. The nightmare scenario is Russian ground troops directly engaging Ukrainian ground troops, with one set on the wrong side of the border.

Something along these lines is most definitely not priced-in, but we do think that the threat and imposition of sanctions has already had a significant impact on Eurozone equities. Although the economic data have not been good, it is worth noting that the start of the Eurozone’s slide down the rankings coincides with the annexation of Crimea. The underperformance of Eurozone Industrials dates from May, when sanctions by the EU first came under serious discussion. By contrast, we do not believe that any of the conflicts in the Middle East have the capacity to disturb financial markets. Gaza, Syria and Northern Iraq have been rumbling on at greater or lesser intensity for years and are all more or less priced-in.

In the financial world, stories which are hitting the headlines now are by definition priced-in. “If it’s in the press, it’s in the price,” is still a good principle – even in August. Therefore anything to do with Argentine default or Portuguese bank insolvency is unlikely to move the markets. Similarly, the ECB’s bank stress-tests can safely be ignored until nearer the time of their publication in October. The market “knows” that some banks are going to fail; the question is how many and how much fresh equity will be required.

The issue which worries us most is the rather arcane topic of secondary market liquidity in corporate bonds. All banks acknowledge that the amount of capital devoted to this activity has fallen. Exactly how much is difficult to know, because volatility in these instruments is at multi-year lows. However the reasons for this low volatility are not sustainable indefinitely. A much higher percentage of these bonds are now held by ETFs, most of which are owned by retail investors. Once in an ETF there is very little trading in the underlying bond, providing it stays in the benchmark index. The growth of these funds has supported a surge in issuance across all grades of credit-quality. This means that no-one has had to use the secondary market to acquire their desired exposure. So far, not many people have wanted to sell.

August is often the month when thinly-traded markets break down. In 2007, the financial crisis started when various money market funds “broke the buck”. Let us hope that 2014 is not the year when bid-offer spreads on “safe” ETFs suddenly blow out.

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