TAIB Bank: Navigating Turbulent MarketsBy Taib Bank, PRNE
Tuesday, October 25, 2011
MANAMA, Bahrain, October 26, 2011 -
Since US GDP was revised down and the political impasse over debt ceiling talks in the US, the financial markets have been particularly volatile. Asset classes that ordinarily would exhibit low volatility have been exhibiting extreme volatility including foreign exchange rates, commodities and government bond markets. Correlations between asset prices have also moved to an extremely high level, making optimal investment decisions difficult. The markets move from one extreme to another; from hope of a resolution to the Greek debt question and Eurozone exit and hope of further stimulus in the form of QE on the one hand to fears of global recession and deflation on the other.
Fears of a Greek default and thereafter the question as to whether Greece can remain in the Eurozone has meant that the focus of the market has been reflected in the EUR/USD relationship. Greece may either be forced to leave the Eurozone due to an inability to meet the requisite criteria for any bailouts or alternatively may voluntarily choose to leave, although this is without precedent. The precedent (should it be set) and consequent possibility of further Eurozone countries leaving seems to be a fear that is afflicting the EUR/USD exchange rate. There appears to be “sell the rally” behaviour to the EUR/USD exchange rate for the past few months and a strong correlation between a rising Euro and a rise in risk assets like equities and commodities, whilst days on which the Euro falls tends to drive a fall in equities and commodities.
Notable this year has been the dramatic falls in European equities as compared to US equities; the S&P 500 is currently down about 9% whilst the German DAX is down 18% for 2011. The reason for this is that investors believe that Eurozone issues are more of a drag on Europe’s economic outlook than that of the US. Emerging market equities have already reflected to some extent a slow-down in China, and significant falls have been registered in Russia, Brazil, Hong Kong and other emerging markets. The risks to the equity market remain to the downside in the near-term and until there is some resolution or finality to the Greek and Eurozone question. Investors who wish to retain equity exposure would be well advised to stick with the “ultra-defensive” stocks rather than high dividend yield stocks per se. Ultra-defensives include some large-cap consumer staple stocks and some pharmaceuticals as well as a select few utilities.
The commodity complex has fallen significantly since peaking in the summer of 2011. This includes agricultural, energy, industrial metals and precious metals. The initial fall in commodities was driven by energy commodities, followed by agricultural commodities more recently. Base metals prices exhibited some differences in behaviour in that copper did not fall significantly until more recently. Interesting in 2011 has been the dramatically widened spread between NYMEX WTI light sweet crude oil and Brent crude. The shut-in of some Libyan production has supported Brent crude above $100/bbl whilst a new pipeline from Canada to the USA meant that the delivery location for WTI crude oil in the USA was oversupplied with crude oil thereby depressing US crude oil prices. With WTI light sweet crude oil around $75/bbl, the differential between Brent and WTI remains elevated at around $24/bbl. Until this year, WTI tended to trade at a small premium of $1/bbl to Brent crude, so the current spread is highly unusual. The current spread however, does reflect a weakening in the relevance of WTI compared to Brent crude oil as the reference for global oil markets.
The behaviour of gold and silver recently, whereby both metals exhibited dramatic falls of 5% and 10% per day respectively appears to be driven by selling to pay for losses by investors in other markets, expectations of exchange margin increases and that the market was “crowded” by “weak longs” that were speculating on a rise in gold to $2,000/oz. Last month, gold prices dropped more than $300/oz, the largest short-term fall in more than 20 years. Gold’s recent volatility has had the effect of reducing the demand for gold as a safe haven from nervous investors.
The Federal Reserve “Operation Twist” was widely telegraphed to the market although the size being $400 billion rather than $300 billion anticipated by the market. What did surprise the market was the Fed’s explicit acknowledgement of a heightened level of risk to the U.S. economy (”significant downside risks to the economic outlook”). The “Twist” programme involves the Federal Reserve selling shorter-term US Treasuries on its balance sheet into the market whilst simultaneously purchasing longer-term US Treasuries, in particular the 10 to 30 year maturities. The current yield of around 2.05% and 3.00% for the generic 10 and 30 year US Treasuries reflects investor perception that there will be a slowdown in the US economy and that inflation will remain subdued or that investors are expecting a period of deflation.
The expectation from the investor community is that the Federal Reserve would be minded to do something should the S&P 500 fall below 1000 to support deflating risk asset markets to avoid a damaging bout of deflation leading to a depression in the US. Should the S&P 500 break or go to near 1000, and in anticipation of new QE from the Federal Reserve, it would be prudent to start accumulating risk assets selectively, perhaps through the use of capital-protected participation structures in commodities and equities with a time horizon of one to three years.
In our opinion, should the US Federal Reserve announce a new round of quantitative easing before the end of the year, this will be positive for risk assets and the Euro in particular. Energy commodities, equities and precious metals should benefit from any new monetary stimulus measures taken by the Federal Reserve, whilst defensive assets like US government bonds and the US dollar will decline or underperform. GCC equity markets and bonds should benefit from any such action and therefore any opportunities to accumulate such assets at depressed prices should be taken in our view. One way that investors can protect against the current volatility in the markets is to use the concept of “dollar-cost averaging”, buying more units of an asset as it falls and selling units more aggressively as they rise. Investors can also consider capital-protected notes issued by banks that allow the investor upside in the relevant asset whilst offering a partial or full degree of capital protection.
FTI Consulting Bahrain +973-17-537-072
Khaldoon Bin Latif,
Email: Khaldoon.BinLatif at taib.com
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