WILLIAM DE VIJLDER Blog - in English

‘Buying a bazooka’: market consequences

Investors have been waiting impatiently for the ‘definitive answers’ to address the eurozone crisis. Interestingly, the recent delays have not had a very negative impact on the markets, which would seem to indicate that investors think that there might be a positive surprise after all.

Without assessing the likelihood and possible shape of such a positive surprise, let’s think of how strong the market reaction could be and how long the party would last. Let’s suppose that a ‘bazooka’, as it is now commonly called, is put in place, i.e. the firepower of the EFSF is increased considerably directly or indirectly (via insurance wrappers). This would mean that countries which hitherto have had difficulty in accessing capital markets would now be able to meet their gross funding requirements (budget deficit + rolling over maturing debt) at less onerous interest rates. It would halt the negative feedback loop we have seen in past months. In this loop, the prospect of a gradual rise in the average interest rate charged on the entire debt (whereby the speed of the increase is a function of the size of the net funding requirement and the maturity structure of the debt, which dictates at which speed debt is “rolled over”) led to increased worries about solvency and hence pushed up interest rates. This in turn hurt private credit demand and the growth outlook. Bank share prices and equity markets in general also suffered.

To be more precise, one can argue that this negative feedback loop will not just be halted, but it will go into reverse. The prospect of financing the gross funding requirements at a lower interest rate than today’s market levels means that the solvency worries will decline. Even with unchanged fiscal policy, the exponential increase in the debt/GDP ratio will be slower. Moreover, countries benefiting from EFSF support will need to conduct an appropriate fiscal policy so this will help in getting the debt/GDP dynamics under control. Tying this all together, this would justify a reduction in spreads. The questions are by how much and how fast? Let’s start from an extreme assumption: all investors take the stance that “the proof is in the pudding”. This would imply that although the gross funding need would be met at lower rates via the EFSF, secondary market bond prices would not rise and spreads would not narrow because investors want to see confirmation that the negative feedback loop described above has been stopped and that fiscal frugality will be applied. By the way, it’s for this very reason that Spain’s decision to commit itself to sound fiscal policy by putting this as an objective in the country’s constitution was a good idea because it enhanced credibility. Undoubtedly, the assumption that investors would adopt a wait-and-see attitude is extreme.

Would the opposite assumption hold? Would investors be tempted to come back en masse to lock in attractive spreads? This assumption seems equally extreme because a lot of them will take the view of “once bitten, twice shy”. It’s hard to imagine that investors who have suffered greatly from their PIIGS exposure would now return as if nothing had happened. The target country allocation in their bond portfolio may have changed structurally because of worries about tail risk. Would this imply that spread contraction would be limited and slow? On the extent of the contraction, this will very much depend on the yields at which “EFSF-protected bonds” would be issued, because these yields would set a floor for the market. On the speed, I think it could be surprisingly quick. Mutual fund investors who manage against a benchmark and who would be underweight at this stage will be tempted to move to a benchmark weight if only to avoid underperformance during a rally. Some might even go overweight, at least for a while, thinking that underweight investors will increase their position and push up prices. From a spread perspective, we might also see a scissors effect with people selling Bunds because the “risk off” trade would switch to “risk on”, thereby pushing up Bund yields.

What about equities? Here again the reaction should be swift and short. Markets will basically re-price future cash flow by revising it upwards moderately and discounting it at a slightly less demanding rate because the eurozone had become a less risky place, warranting a lower required risk premium. At the extreme, such a re-pricing could happen in one shot (a bit like the reaction to positive surprises in US payrolls), although one would expect a rally to attract follow-through buyers to the market and hence last a bit longer. Once this adjustment has taken place, it will be back to business as usual with a focus on a slowing European economy, the prospect of a hostile growth environment in 2012  in view of a synchronised tightening of fiscal policy in the eurozone and question marks about where the US is heading. Get ready for a “flash rally”, but it’s not the beginning of a new trend.

William De Vijlder
21 October 2011

A world of contrasts

Yesterday and today I was in Moscow for meetings at our joint venture. In the evening I had dinner with clients at one of the city’s upmarket hotels. Lined up outside the entrance was a fleet of expensive German luxury cars, all identical in type and colour (brown), waiting to drive hotel guests around the city. But everyone entering the hotel must go through a metal detector. The dinner was fascinating. The Russian economy is booming, there is huge potential for infrastructure development (Moscow is a great place to start with its round-the-clock traffic congestion), the land is overflowing with resources, and earnings multiples are low. What are foreign investors waiting for? (Answer: for the global risk appetite to rebound). The West came in for severe criticism: the insatiable quest for more has led to a ‘debt boom’ followed by a ‘bust’ in the US and the eurozone.

This afternoon I caught a plane to London Heathrow, a train to Paddington and the underground to St Paul’s. The cathedral was surrounded by small tents. One banner read “capitalism is crisis”; another “give me lolly because I can’t fill my trolley”. Things seem calm, but the despair is palpable. The United Kingdom is in a deep crisis and is now acting as a guinea pig to test the right economic policy mix: an extremely tight budgetary policy combined with an extremely loose monetary policy and the umpteenth wave of money creation by the old lady of Threadneedle Street (the central bank). In the lobby of my hotel three hundred metres down the road, two private receptions are in full swing. Groups of champagne-swilling twenty-somethings are waiting for the elevator to the top floor, presumably en route to the bar.

I have dinner with a colleague from Hong Kong who happens to be in London. The economy in Hong Kong is slowing and banks have hiked their lending rates. Fewer Chinese carrying suitcases bulging with banknotes are descending upon Hong Kong. “How are the casinos in Macao faring,” I asked, because I had once read that their share prices closely tracked Hong Kong property prices (both are driven by China). Evidently, the big spenders (who can spend HKD 1 million per visit) are still good customers, but the ordinary man is staying away. Casino operators have resorted to offering cut-price chips in hotels in a bid to lure gamblers back to their tables. The discount is already 5%. I wonder what the discount in Las Vegas is.

William De Vijlder
20 October 2011