Why and when “equity duration” matters

March 23, 2013

A new HSBC report suggests that if and when Quantitative Easing is being reversed it could be a watershed event for sectoral equity performance. Their view is based on the concept of “equity duration”. The long-standing outperformance of low-beta and high-quality stocks, which have longest duration and benefited most from three decades of falling yields, should come to an end and be replaced by relative strength of cyclical, financial and materials stocks.

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The FX carry-equity nexus

March 16, 2013

Galsband and Nitschka claim that the outperformance of high-carry currency trades over the past 30 years reflects a premium for correlation with shocks to equity cash flows. While the finding may sound trivial, its implications are important. In particular, in connection with the negative impact of currency strength on local equity, the fx carry-equity nexus would imply that carry countries’ local-currency equity returns should outperform in crisis times, as they are buffered by the exchange rate and become a better diversifier, when all other correlation increase.

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The unpleasant dynamics of fiscal tightening

March 12, 2013

A new IMF paper argues that the short-term negative feedback of fiscal consolidation on economic growth is particularly strong at present, because of lending constraints, limits to monetary easing, and the global scope of restriction. As a result, fiscal tightening in today’s developed countries may, by itself, initially raise debt ratios over and above their trajectory without fiscal action. While the effect may not be lasting, it can lead to dangerous dynamics if financial markets fixate on debt dynamics and governments engage in multiple rounds of tightening.

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Asset overvaluation and bubbles

March 9, 2013

Ever wondered why an asset or asset class maintains an implausibly high price? A new IMF paper summarizes research on “bubbles”, the phenomenon of a lasting overvaluation. It suggests, for example, that the focus on relative performance among asset managers and the presumption of informed decisions by peers causes herding. Also, limited liability of managers and leveraged institutions encourages upside risk taking. Meanwhile, sell-side research, rating agencies, and accountants often lack the incentives to pre-emptively reveal downside risks. Political and institutional aversion to short selling aggravates overvaluation bias.

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A Fed view on low long-term yields

March 9, 2013

Federal Reserve Chairman Bernanke recently explained globally low long-term yields as a combination of anchored inflation expectations, negative real policy rates, and a compressed term premium. The latter is seen as the key development since 2010 resulting from (i) the surge in private demand in the wake of reduced nominal volatility and negative correlation with risk markets and (ii) a surge in public demand resulting from asset purchase programs and FX reserves replenishing. Bernanke emphasizes that the Fed, markets, and forecasters all expect long-term yields to drift higher by 50-75bps per year through 2017. Yet, actually his reasoning would make a sustained directional change in yields contingent on fading crisis and deflation fears.

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Large currency moves and equity performance

March 2, 2013

Citi equity research investigates the relation between currencies and equity markets. It suggests that typically large currency appreciation (depreciation) coincides with underperformance (outperformance) of the equity market in local currency terms. However, the currency moves tend to be larger than the equity moves. This supports the case for hedging local-currency equity exposure against currency strength and USD-based equity exposure against currency weakness. Hedge ratios should be diverse across countries, as correlation with currency weakness is a function of industry structure. Emerging market equities have historically not always correlated negatively with currencies due to the prevalence of crisis events.

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CS on systemic risks of China’s shadow banking

February 25, 2013

Credit Suisse’s Dong Tao and Weishen Deng nicely summarize causes, size, and systemic risks arising from China’s rapidly growing shadown banking sector. Low regulated bank interest rates and rationed supply of credit have created ample incentives to by-pass the regular banking channels. By end-2012 the shadow banking sector has soared to about 44% of GDP and continues expanding at a torrid pace. Meanwhile, poor transparency and lack of risk management and regulation bode ill for credit and liquidity risks, and even a state bailout could involve a drastic deterioration of credit conditions.

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Discrediting euro area crisis-driven austerity

February 23, 2013

Paul de Grauwe and Yuemei Ji have produced disarmingly simple charts that show why the euro area’s 2010-12 crisis response is being discredited. Essentially they illustrate that (i) market conditions rather than fundamentals have driven large absolute changes of credit spreads, (ii) fiscal tightening has been a mechanical response to credit spreads, and (iii) austerity has largely been self-defeating. Such evidence of failed excessive austerity dovetails anti-euro populism, underpinning euro area policy change towards more accommodation.

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On the risks of a new U.S. credit overheating

February 17, 2013

An interesting speech by Jeremy Stein emphasizes the ingrained tendency of financial institutions to boost earnings by selling tail risk insurance in forms not covered by covered risk measures and regulation. Hence, financial innovation, changes in regulation, and macroeconomic changes often result in credit market overheating through implicit subordination in conjunction with excessive maturity transformation. At present such tendencies may materialize in the rising share of low-grade credit issuance, the rapid expansion of agency mortgage REITs, and the increasing maturity of securities in bank portfolios. For the future, the expansion of collateral swaps and other forms of collateral transformation deserves attention.

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IMF reminder of incomplete euro area banking union

February 16, 2013

A new IMF Staff Discussion Note provides opinion and advice on the euro area banking union. It reiterates the urgent need for a single regulatory, resolution, and deposit insurance mechanism. The present legal and institutional reality falls well short of it and even last year’s adopted directives and plans only deal with the harmonization of rules and the creation of a single supervisory mechanism (SSM). A credible euro area-wide resolution and deposit insurance seems to be still a distant goal. The ESM’s ability to bear recapitalization losses, whether from “legacy assets” or not, remains uncertain.

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