In our last few letters, we have discussed the extraordinary measures undertaken by governments across the world to support aggregate demand, and the extensive borrowing required to do this. Over the past three months, both of these issues have been thrown into stark relief by events.
The dramatic and extremely sudden deterioration of Greek sovereign credit in the marketplace forced the European Central Bank (ECB) into a rapid about-face. Germany’s elected representatives blinked and committed to a vast fund to support Mediterranean nations. Very few people expected to see the IMF lead a rescue package for European Monetary Union member-states in their life-times. Eroding confidence in the ECB and EMU led to a deterioration in the value of the Euro as talk of this currency supplanting the US Dollar as the new global reserve currency did a sharp 180 degree turn and even sober commentators began to talk of a break-up of the European monetary union and the Euro’s death. Meanwhile, bond-holders have turned their sights on the increasingly precarious state of sovereign balance sheets in most of the developed world. Shocked by the speed with which Greek bonds lost value, most bond buyers are thinking seriously about sovereign credit risk in the developed world, awakening from a period that lasted two generations during which these risks were largely ignored. Meanwhile, treasury officials the world over review the results of their bond auctions nervously, wary of any sign of demand slacking. In many cases, their own central banks are becoming the most reliable buyers or financiers of new debt.
Three months ago, we wrote in an earlier post:
Numerous stimulus programs across the world will also be removed over the course of this year, including bank loan fueled infrastructure spending in China. As the global economy has these crutches removed, we will watch with great interest to see how severe the damage to core private enterprise has been.
We believe this process has begun and the initial signs do not augur well for the global economy. We have seen a debate re-kindled recently about whether the withdrawal of stimulus at this juncture is a repeat of “errors” made in the 1930s, when stimulus spending was reduced to control deficits. However, with aggregate debt levels in the developed world as high as they are, we see few alternatives to a steady reduction of the extraordinary fiscal and monetary measures undertaken to control the crisis.
We also feel it’s necessary to discuss the “Flash Crash” of May 6th. In our blog post the next day, we wrote that:
Since US equity market prices are far higher than underlying valuation (according to our measures) we were not surprised by the extent of the drop. But we were very surprised by the speed at which the drop occurred, as well as the speed of the partial recovery. It reminded us of the precipitous declines and partial reversals we saw during the height of the credit crisis in 2008 and 2009. …
Though the US equity markets are receiving most of the attention, they are not the only source of the current volatility. Numerous other markets saw immense turbulence yesterday, including, but not limited to, overnight funding (libor), treasuries and particularly currency markets. …
The major conclusions we draw from the trading action of the past week is that:
- Numerous market participants have limited conviction and their default stance is to step aside quickly in a falling market.
- The Euro-zone crisis will continue to roil markets until it is properly addressed.
- There are many underlying concerns about commodity prices, Chinese real-estate prices, credit-worthiness, etc. and they can manifest themselves very quickly.
Given the information we have, and our view of overall valuations, we caution investors to remain extremely vigilant and maintain a defensive posture.
All three major indices, Dow Jones Industrials, S&P 500 and Nasdaq composite closed out this quarter below the intraday lows reached that day. The ten-year treasury is now below 3%, and no amount of commentary on US federal and municipal debt-levels appear to impact the decline. Meanwhile, the Baltic Dry Index has dipped below 2500 again (amidst talk of expanding fleets and falling Chinese imports). Speaking of China, we see more commentators openly questioning the solvency of Chinese banks and the reasons behind big IPOs. All of this underpinned by the fact that unemployment and underemployment rates in western countries remain stubbornly high.
Not only is it increasingly difficult to write off the events of May 6th as a mere technicality, we believe that sudden decline has lead to deep distrust and uncertainty amongst investors. Investors were already wary of fundamental economic and market conditions, the flash crash gave them reason to cast suspicion on the technical organization of the market. This coupled with the SEC’s indictment of the premier US Bank, Goldman Sachs on charges of fraud, has fueled suspicion of large player’s motives and methods. Many individual investors now believe the market is rigged against them, for the benefit of the largest trading firms and their most senior traders. In our view, it was always thus. Professional traders, whether they be electronic market-makers or specialists on the trading floor have always enjoyed a privileged position, which is completely appropriate given their role as liquidity providers and their responsibility to maintain orderly markets. What we find difficult to accept is the extension of these privileges new players, without them being asked to shoulder the same responsibilities.
We do not see many silver linings amidst a climate of mutual suspicion and bad news.