Carsten Valgreen, Paris, Markets, Contagion Risk
February 16, 2014
“Just a correction … or something more sinister?” That is the title of a February 12 financial market briefing by Carsten Valgreen.
Carsten is a skilled economist, a global strategist, and a partner with Applied Global Macro Research. His colleagues include Jason Benderly, a personal friend of many years. Over those years, I have visited AGMR in their Colorado and Copenhagen offices. Their research is backed by solid mathematical models and is impressive. Carsten is scheduled to speak on March 11, 2014, at the GIC (Global Interdependence Center) meeting’s round-table discussion in Paris, France. The title of his session is “Banks: Bail-In vs. Bailout Regime.”
Readers who want details about the GIC meeting in Paris can visit http://www.interdependence.org. Details are on the home page. Spaces are still available. The dates are March 9-10-11.
Carsten’s work suggests that the ongoing stimulus applied by central banks, coupled with a reduction in risk premia, is leading to a gradual improvement in worldwide economic growth. Furthermore, Carsten expects that growth to show up in additional momentum in the profit shares of economies and hence their respective markets. Summarizing his outlook, Carsten notes, “We continue to expect the positive global equity market outcome for 2014 although the S&P 500 is likely to be up 5% to 15% in 2014 – and not 30% as in 2013. We continue to have stronger signals for the European market, which should be up 20% to 25%, and emerging markets should begin to perform in 2014 as the Asian manufacturing cycle picks up.”
His research then dissects the January corrections in various markets worldwide, analyzes growth aspects in greater detail, and supports these conclusions. We would suggest that interested, serious readers explore AGMR’s website: http://www.appliedglobalmacroresearch.com. If you happen to be in Paris on March 9-11, you can meet Carsten as well as our other participants in the GIC program.
Cumberland raised a cash reserve in January 2014. We were worried about contagion spreading out of emerging-market transactions as well as about uncertainties in the US policy arena. It quickly became apparent that the contagion risk persists but is being addressed in a piecemeal fashion worldwide. It also became apparent that central bank policy has achieved greater clarity.
Janet Yellen was successfully sworn in as Fed chair, testified, and established the new direction of our US central bank. The German court decision afforded greater clarity with regard to the European Central Bank’s position and was then supported by Mario Draghi’s commentary. The Bank of Japan continues on its trajectory of expansive monetary policy as a tool to encourage Japanese economic recovery and, secondarily, to weaken the yen. The Bank of England has clarified its policy, which includes not raising interest rates as the UK housing recovery develops.
For 2014, investors around the world can look at the G4 central banks and conclude that the issue of central bank policy can be taken off the table. We do not have to fret about monetary policy from an investor’s point of view. We can pretty much determine what interest rates will be at the front end of yield curves in the mature economies worldwide. Therefore, we can project how those factors will impact financial markets in the G-4 economies and in those smaller economies that are linked to the larger ones.
There is still plenty to worry about. There is still a contagion risk. When interest rates are raised sharply in Turkey, an economic slowdown in the Turkish economy can be projected. The financing of the Turkish economy is in part linked to European banks since the Turkish government’s borrowings took place in currencies other than the Turkish lira. The abrupt change in Turkey’s currency value and the much higher cost of servicing debt in the local currency has extended the repayment jeopardy of those loans. Contagion risk still exists. It may evidence itself in a shock at any time. For the moment, however, the risk of contagion seems to have abated.
How to measure such risks is a very difficult question. In stock markets we can look at the pricing of options. In the US, the most prominent measure is the VIX. It spiked for a brief time but has clamed down in recent trading days. Markets reflected the change and have been rising.
In the credit markets, one can look at spreads as a market-based indicator of risk and sentiment as evidenced by the actions of market agents. Puerto Rico’s debt is a good example. Compare Guam and Puerto Rico, whose credit ratings are similar. Both have an identical tax-free status in all jurisdictions within the US. Both have holders that include a number of mutual funds. So if the credit rating, tax status, and holders are nearly the same, then why is one issuer trading in the marketplace at an interest rate of 300 to 400 basis points higher than the other? The market’s assessment is clear: Puerto Rico might experience a liquidity shortage or solvency issue, while Guam appears insulated from that risk.
There is nothing a central bank’s abundant liquidity can do when a single issuer of debt has a liquidity and solvency problem. Central bank tools are applied in the broad macro sense. They can reduce interest rates, make excess reserves available to banking systems, or acquire high-grade, high-quality, special issues and sovereign debt, as they have done. But the central bank of the US cannot bail out Puerto Rico. The central bank of the Eurozone cannot bail out Greece. Greece and Puerto Rico have to fix their own chronic problems. They have spent years in a deteriorating economic framework, increasing their risky profile by piling on a debt load that cannot be sustained. At some point, the laws of economic physics prevail, and the house of cards collapses.
Greece’s house of cards finally crumbled. It is still going through aftershocks as it negotiates yet another round of assistance. Now Puerto Rico confronts similar challenges as it faces an enormously complex reconstruction. There is a reason that Puerto Rico was recently called “the Greece of the Caribbean” on the front page of a global publication. Similarities between the two countries, their relative sizes within their currency zones, and the practice of using debt instead of discipline to manage their economies have resulted in similar economic outcomes. Note Greece and Puerto Rico are both sovereign debt issuers. Both lack provisions for bankruptcy. Greek bondholders took haircuts. PR bondholders are taking them in the marketplace as resolution proceeds. The February 18 investor’s call will prove interesting.
Every time there is a financial shock anywhere in the world, whether in Puerto Rico, Greece, Thailand, or Turkey, there is a contagion risk. That is the nature of a truly global, increasingly interdependent financial system. We live with that risk and measure risk premia to see how markets are reacting to it. Note that each of the markets associated with a recent center of contagion risk has been badly hurt. But a sufficiently contained contagion means that nearby or distant markets do not get hurt.
Currently, in the US stock market, market agents are looking beyond the contagion risk. They are focused on the (1) assumed-to-be-predictable characteristics of the Federal Reserve policy direction, (2) the settlement of the debt-limit debate and (3) the more quiescent behavior of our Washington, DC, politicians in this election year. Market agents also see the decline in the federal deficit as a reduction of financing pressures for US dollar-denominated debt. And markets seem to accept the outlook for slow growth, given our gradual and tepid recovery. Those factors mean non-pressured cost in the labor markets and low, docile inflation.
Such an outlook presents marvelous opportunities for the astute investor. Contagion risks have not diminished, but those risks help make the investments that market agents pursue worthwhile. The risks continue to permit pricing such that disparities in risk premia present opportunities savvy investors can seize.
An example persists in the tax-free municipal bond market. The 30-year US Treasury obligation is fully taxable at a federal level to a tax-paying US investor. It yields approximately 3.7%. The very-highest-grade 30-year tax-free bonds of a type that have had a zero default history over the last century yield more. There is no way to justify this inverted yield unless investors happen to believe that the income tax of the US is going to be repealed. Absent a repeal of taxation, one can say the Treasury security is richly priced versus the tax-free bond. Or one can say that the tax-free bond is cheaply priced versus the Treasury security. An individual American has the option to hold either, both, or neither. Or the investor can hold the cheap one and sell the richly priced one short and position the spread. The question for the investor is, “Where is the bargain?”
If we are going to have a protracted period, measured in years, during which inflation will remain low, US labor markets will heal gradually, and central banks will provide liquidity to sustain this fragile and tepid but continuing economic recovery. In such a scenario, stock markets will remain upwardly biased. Selected bonds are attractive to investors. Cash earning zero is not the most desirable structure unless contagion risk flares its ugly head and converts risk into reality.
At this writing, Cumberland is fully invested in the US stock market using ETFs. Our international accounts are deployed in selected economies, countries, and markets where we believe results will be positive. Our bond accounts remain favorably invested toward higher-grade municipal credits that we believe are bargains.
David R. Kotok, Chairman and Chief Investment Officer
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