23rd July 2010 by Shaun Richards
After a Wednesday which was dominated by Ben Bernanke (head of the Federal Reserve,America’s Central Bank) and his use of the words “downside” and “unusually uncertain” we saw something of a change yesterday. Equity markets surged regaining all the ground lost the day before and indeed more. You might wonder why they bothered falling in the first place but that is one of the wonders of market behaviour. The Dow Jones Industrial Average rallied some 201 points, the German Dax index surged some 152 points (2.53%) and not to miss out the Japanese Nikkei index something of a laggard recently rose 210 points. These sort of moves intrigue me when they happen as we are given an insight into market psychology which appears to have been itching for a rally almost regardless of logic or what news occurs. There was some better news for example the European Purchasing Mangers Index produced some numbers which were better than expected for both manufacturing and services and UK retail sales also surprised on the upside. However I am always cautious about survey results (PMI) and retail sales is a rather erratic series, but apparently equity markets had other ideas.
Equity and Government Bond Markets
It is often true that these markets operate in opposite directions. To explain this imagine an economy that is growing strongly and think of its equity and government bond markets. In such a scenario one would expect equities to be doing well as hopes for the future will be high leading to expectations of higher dividends and capital gains but the attractions of receiving fixed coupons from a government bond every 6 months are likely to be less attractive and so bond prices are likely to fall until the yield received is more attractive. In a slowdown for the economy then government bonds are likely to rally as fixed coupons (a fixed interest rate) look more attractive whereas an uncertain or declining outlook will encourage people to sell shares. Some investment house will explicitly trade this argument as in switching from one asset class to the other. If I may add an additional level of complexity in the real world then such investment decisions will be affected by expectations and opinions as much as reality but the principles remain clear.
There are scenarios when both assets classes may rally or decline together. For example in recent times Greece has suffered periods where her equity and government bond markets have fallen together. In essence at times her outlook has looked so poor that all Greek financial assets have been sold. It is possible for both to rally too for example imagine say the discovery of a new advance, for example if cold nuclear fusion was discovered to actually work ,which would project the world onto a higher growth lower inflation scenario and be good for both asset classes.
I have explained these concepts because yesterday reminded me again that at the moment the relationship between equities and bonds appears to me to have broken down. In essence they are telling us quite different things and both cannot be correct. This of course leads to the question which one is? Or of course neither!
If we look at the US government bond market then let us start with her 2 year bond. This is yielding 0.56%. Please consider the implications of this from the standpoint of the person who is buying these. For whatever reason they must have quite an apocalyptic view of the US economy over the next two years to accept this as a return. In real terms even accepting official figures for US inflation (which I challenged on July 2nd) you will have a negative return, if you take my suggestion for US inflation your return is even more negative. I suppose if you are a foreign investor you may hope for a return based on a rally in the US dollar exchange rate but any domestic investors have no such refuge. If we move further down the yield curve then even when we get to the ten-year maturity currently you only get 2.94%. Investors are accepting these yields and just as an example the US Treasury plans to issue some 38 billion dollars of two-year bonds on Tuesday the 27th.
For UK readers the situation may well be even more concerning. Our two-year government bond yield is 0.76% and any complacency that this is at least a little higher than that of the US is immediately punctured when you look at our inflation performance. This was described yesterday in an interview with the Independent newspaper as “higher than expected” by the Bank of England’s Chief Economist Spencer Dale and is either just over 3% if you believe in our CPI measure or 5% if you are still a fan of the retail price index. Even Mr.Dale is predicting that inflation will remain higher than target through the next eighteen months, although cynics who look at his forecasting record may see signs of hope in this.
On the other side of the coin we have equities rallying. Having seen an extreme example of this yesterday it reminded me of the levels we are now at. If one considers the whole equity rally since the falls at the height of the credit crunch it has gone quite a distance and yet it must be driven by quite different views to those in the bond paragraph above. If we consider this from the perspective of the German Dax equity index it fell to below 3600 back at the height of the panic in spring 2009 and as I type is at 6184 an increase of the order of 70%. Other equity markets have also surged over this period although maybe not to the same extent. Put the thoughts behind this into the bond paragraph and there is a clear dichotomy in my view. We are in a period where there is a major dislocation between the views implied by these two asset classes. This is troubling at best and is a clear amber light for our current situation.
Stress Tests in Europe
Today at 6pm in Europe and 5pm in the UK will see the results of the stress tests that have been conducted on 91 banks in 20 countries in Europe which represent around 65% of the European banking system. I counsel some caution on these as the tests have been constructed by a European organisation (CEBS) which appears to be more civil servant than market participant based. So far this has shown signs of being badly handled as for example.
1. It should be released outside market hours not inside them, America will still be open and some equities trade there.
2. There has been leak and counter-leak during the run-up to this including some particularly shameful efforts by euro zone ministers (Elena Salgado of Spain comes to mind). Security in future needs to be improved.
3. Generic information will be released first with specific individual bank data released a little later. To my mind if you are going to swamp people with data you may as well completely swamp them and let them pick and choose what they read.
4. The criteria should have been announced in advance. This would increase credibility and transparency.
Dangers of such an experiment
The obvious danger is that the tests are set so that everybody passes. Such a result would make the whole operation valueless in my view as even the most credulous would not believe that. There are clear outliers in European banking on whom eyes will fall very quickly for example Hypo bank in Germany,some of the Spanish cajas and the Greek banks. Because of the leaks this picture is somewhat muddy and has already eroded some credibility for if what the Spanish Finance Minister said on Tuesday is true then the 8 private banks and 18 cajas tested in Spain all passed.
There is a more fundamental problem with the whole concept which goes as follows. The last couple of years have seen stresses on banks and economies arise which are dynamic,fast-moving and have impacts in many areas at once. By their very nature stress tests are static and partial. So if you are a believer in “Black Swan” events or what I was taught as the serially uncorrelated error term at the LSE then a stress test will be of little help to you I am afraid and in fact can never be. In the world in which we live unexpected events appear to be occurring more frequently and their impacts appear to be becoming more dynamic. Even so I will be taking a look at the figures as they will provide (hopefully) some useful information.
UK Growth figures surprise on the upside
In general figures for UK growth were expected to be good. Many felt that they were as likely to be as good as we will get as they predate the austerity measures which have more recently been imposed. In the event I cannot think of anybody who expected growth in the 2nd quarter of 2010 to be as good as it turned out. The initial estimate from the Office of National Statistics (ONS) is for growth of 1.1%. Particularly strong performances came from services and construction each of whom contributed some 0.4% to the growth.
I am always cautious about economic figures and first estimates on GDP growth can be unreliable. They represent two months (out of the 3 in the period) information on 40% of the data set and three months data for around 20% of the data set. Also remember that the ONS had recently to delay the issue of the final estimate of 1st quarter GDP because of problems it has failed to properly explain.If you break the numbers down then the improvement in construction which looked at as a segment on its own grew by 6.6% is explainable by the cold weather and snow we had in the first quarter. So without the snow maybe some growth would have taken place in the first quarter that is now being recorded in the 2nd. Such an exchange would make the figures look more balanced.
Personally I would rather enjoy the figures for now and hope that they are true as we will need every scrap of economic growth we can get over the next year or two. I will try to ignore the concern ticking around in the back of my mind that over the years things which look too good to be true usually turn out to be so.
The figures add to the dilemma faced by the Bank of England and indeed her Chief Economist Spencer Dale. For the MPC in its minutes of its last monthly meeting which were released only on Wednesday did discuss further expansionary measures (“modest easing”) as it felt economic growth would be lower.
The prospects for GDP growth had probably deteriorated a little over the month……..In the light of the news over the month, it seemed likely that growth would be weaker than previously expected
In his interview with the Independent newspaper printed yesterday Spencer Dale suggested this.
there are some signs that growth may be softening
Not quite Paul the Octopus is he?
As I final thought I wonder what those who own shorter dated UK government bonds think of these figures..