Calamatta Cuschieri Weekly Commentary – 30 November 2012

Eurozone

With this weeks’ agreement of the Eurogroup of finance ministers on the long-awaited deal for Greece removing a significant risk factor, peripheral yield spreads have compressed further throughout the week. The willingness of those involved in the negotiations to reach a compromise on Greece has contributed to a more ‘risk-on’ mood in the markets. However, the uncertainty over Greece and other issues are not gone for good. The specifics of the Greek deal leave some questions unanswered, most notably if whether the issue of official debt relief will come back on the agenda further down the line. Market consensus is that it will, but that Germany is most likely to postpone such talk to election time towards the end of September 2013

Another uncertainty is the debt buyback. The inclusion of a buyback operation in the package was not a surprise, as it had been publicised as a means of satisfying both the IMF’s demands for immediate debt relief and the eurozone’s objections to any haircuts on loans to Greece. Still, the uncertainty over how it will work in practice is similar to that of the Greek PSI operation, when the Troika would only approve the second Greek programme once the latter had been successfully completed. Despite significant concessions being made to Greece, there will need to be more. This is unlikely to be the end of the Greek saga.

The improvement in eurozone market conditions seems to be infiltrating through to the economy, as evident in recent business surveys. The new orders-to-inventory ratio of the manufacturing PMI has been edging higher since May. The decline in the Ifo towards recessionary levels has also lost steam. The upcoming run of survey data should be also surprise to the upside, albeit with consumer sentiment underperforming against a backdrop of rising unemployment, fiscal adjustment and squeezed income growth. The eurozone remains in recession after all; however, with headwinds to growth in the monetary and fiscal channel easing somewhat as we move into 2013, there is scope for a gradual recovery, led by global trade-sensitive Germany. Q4 should prove to be the bottom of the eurozone cycle, barring any further shocks.

The ECB will probably take a similar view at next week’s press conference, leaning towards a wait-and-see policy approach. The staff economic projections, which will include 2014 for the first time, will be a key input to the Governing Council’s deliberations. The tone of the economic assessment accompanying the projections, however, is unlikely to change so radically. The ECB is likely to stick with its central scenario of a gradual return to modest growth over the course of next year, albeit a later one than previously assumed, and will probably cite the recent pickup in sentiment surveys.

US

In the US, the outlook remains unclear, both on the political and economic front. Market sentiment will obviously be heavily influenced by the likelihood of avoiding the fiscal cliff. The politics of the process are now going to become more complicated. Markets are probably under-pricing the risk of the US temporarily going over the proverbial cliff. Indeed, recent suggest it is unlikely there will be a deal by the end of the year. President Obama is using familiar rhetoric, insisting on the expiration of the Bush-era tax cuts on higher income earners, to which top Republican and House Speaker John Boehner remains opposed. Despite this, leading market analysts believe that a deal will still be done, albeit very late in the day, indicating a US growth outperformance versus the eurozone and a wider Treasury-Bund spread heading into 2013.

The best case scenario for markets would be a bilateral plan in mid-2013 involving tax reform, higher revenues as well as reform of entitlement programs, which scenario could prove to be positive for risky assets. However, the effect on USD is more uncertain; a long-term fiscal plan may yield only far-off benefits and would entail an extended period of headwinds to growth from fiscal austerity.

Failure to address the long-term debt problem would likely lead to further downgrades of US sovereign debt. But the effect on the USD in 2013, is unclear. Divesting into EUR does not look particularly attractive, and China does not have a freely convertible currency or accessible sovereign bond markets. Furthermore, smaller alternative safe havens such as Switzerland, Australia, Canada or various emerging economies do not have bond markets large enough to accommodate large investment flows.

Meanwhile, the full financial and economic impacts of Hurricane Sandy are still hazy, but becoming a little clearer. Early estimates of damage from the super-storm were dramatically underestimated and the final bill will include damages whose costs are borne by households, those covered by private insurance, many that fall under relief programs operated by the Federal Emergency Management Agency (FEMA), and a supplemental package of federal aid that is beginning to take shape and looks like it will total close to $100bn.

Forex

Declining volatility, tighter trading ranges, falling yields and higher valuations in ‘high-yield’ currencies give the appearance of serene currency markets. That is, however, only because near-zero rates in the US, Europe and Japan are showing up in asset inflation which policymakers choose to ignore. Pressure is building in the foreign exchange market; these trends can continue for a while as new themes are expected to emerge in 2013.

The biggest of these will be US economic divergence from Europe and Japan. The Fed is not scheduled to tighten policy in 2013; above-trend growth in H2 is however expected and the market is going to contemplate the notion that the Fed might consider the possibility that they just might raise rates earlier than they have indicated. If the link between better growth and tighter monetary policy is restored, the correlation between ‘good news’ and a weak dollar is likely to break. Economic divergence, monetary policy divergence, and a gradual change in the balance of payments position in the US all argue for dollar strength. The need for a longer period of monetary offset to de-leveraging in Europe, and Japan’s toxic mix of deteriorating balance of payments and persistent deflation, argue for a weaker euro and a weaker yen.

The world has far too many FX reserves, largely because the Fed and ECB cut rates to a much lower level than those in other countries and neither the dollar nor the euro appealed to investors. But as rates fall elsewhere and the global payments imbalance shrinks a bit, most of the growth in currency reserves is now due to the Swiss National Bank. Even that has slowed dramatically in recent months. With EUR and USD assets offering ultra-low yields, the markets should prepare for slower reserve growth as well as further diversification out of both the EUR and USD.

The next big move in the EUR/USD however will come from the US, not Europe. Both the Fed and ECB are on hold for ‘a really long time’, but the ECB faces bigger economic problems and growth divergence will favour earlier Fed tightening and a stronger dollar from H213 onwards, giving the dollar wider-based appeal. As for the euro, how much it lags other currencies in a dollar rebound will depend on whether political solutions to the crisis can be put in place.

Corporate Credit

Financial institutions, corporates and investors are currently flooded with liquidity, despite the recent flows in credit markets. This abundance of liquidity suffices to keep refinancing and default rates at low levels. The problem is there is not enough new issue supply to help absorb it from a credit investor’s perspective. Secondary market liquidity in euro-denominated credit is diminishing, heightening the frustration of investors; the best way to add risk in any size hoping one is allocated well in primary. Even as structural changes suggest higher levels of issuance in the euro-denominated credit markets as corporate funding dis-intermediates from its traditional funding dynamic, they are unlikely to help over the next couple of years.

Fairly modest total and excess returns driven by continued strong technical demand, punctuated by periods of volatility seem to be the themes to look out for in 2013. Broad-based tightening or widening from current levels seems unlikely. Political developments seem likely to drive market sentiment and volatility next year, similar to how central bank activities were instrumental during 2012. Several of these political events are expected to create bouts of risk-off modes.

In 2012, the crisis changed from a rapid domino effect losing steam into the second half of the year. Europe as a whole does not face the tail risk of an accelerated credit crunch and of contagion from the periphery, as we now have a framework to deal with each crisis and central banks have put many backstops in place to make it work. Europe faces a slow process of separation, which threatens to make its financial markets isolated as they were two decades ago. The problem is that the currency union is not accompanied by banking and fiscal unions. It is for this reason that capital flight continues, shifting funds out of the periphery and forcing peripheral banks to raise deposit rates to retain funds.

In 2013, European policymakers have the chance to move towards a solution. We believe that Europe needs a banking union with a common resolution mechanism, a supervisory authority and a deposit guarantee fund, as strongly argued by the IMF. This will offer a chance to stop the core-periphery financial divergence and to stabilise Europe’s banking system. The European Commission plans for the ECB to take on supervisory authority for large banks in July 2013 and for all banks by the start of 2014.

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