Thursday, 3 November 2011

Why is the Stock Market so Reslient?

First there was an agreement, to widespread euphoria, then Greece (all but) rejected it and the market fell. Then the ECB cut rates this morning, and the stock markets rose. What’s coming up in the next few days? Well most importantly US unemployment numbers called the non-farm Payrolls are tomorrow. I expect these to be good, given the strong (these things are relative…) GDP numbers from the USA last week. Either way they could Move the market significantly.

Compared to August, the market’s looking pretty resilient. This is because of continued strong corporate earnings, backed by mainly strong cash-flows. Many companies have little debt on their balance sheets, and most UK banks are well-capitalised, even if the Government owned ones are merely stable in intensive care.

I expected last Thursday’s Eurozone deal to kick the can a little farther down the road than 4 days, and now Italy is in the market’s sights. While Greece, whose government has collapsed, and who appeared threaten a military coup at one point may dominate the evening news, it is the relentless rise of Italian bond yields that is the main cause for concern. Financially speaking, Greece, 1.6% of Eurozone GDP doesn’t matter, and the banks (or at least all but the French banks) have already written down their Greek debt to 50% - they have ALREADY taken the loss. The Eurozone tax-payers through the ECB and the EFSF have yet to do so, mainly because politicians don’t want to explain how they set fire to €1tn to their electorates. This is politics. As far as the markets are concerned, Greece HAS defaulted. It’s over bar the shouting.

Italy on the other hand has the Worlds’ third largest bond market and much of this is held by systemically important financial institutions. A default could spell a run on Italian banks, and the complete failure of the Eurozone. 10y Yields are now 6.5%. Even Spain is holding steady at 5.45% and Portugal at 5%. Ireland is Yielding 8.5% and falling. Worse, French bond yields have started to rise. That we are talking about an Italian default is remarkable given they are running a primary surplus – that is to say the Italian budget is balanced before financing the debt. They have, by this one measure a stronger set of public finances than the UK. The difference? The UK can print any money necessary to service its debts and our debt is of much longer maturity meaning less falls due needing refinance in the near future.

So far the European Central Bank has ruled out the one course of action it could take to isolate the bankrupt countries: indicate that they are standing behind (French – though this is already assumed) Italian and Spanish debt with printing presses if needs be. It is just a matter of time. Until they do, there will continue to be bad news and the longer they leave it the worse it will be.

Finally, it should be remembered that the UK economy and even more so its stock market is tied to the USA, not the Eurozone. Our economic correlation to the USA is .95, almost as high as such things could possibly be. Thus even the disaster of Italian bond yields is probably less important than the Employment numbers from the USA, and the USA is recovering steadily as is the UK whose Q3 GDP numbers indicated a slight pick up from a summer stall.

This is why the UK stock market is 15% off August lows. Bankrupt governments in Athens and Rome just don’t affect business that much. Yet. A stagnant US economy would be much more worrying.


Sean said...

markets have the greek loss at much greater than 50% (reality v politics?)

In anycase the ecb and imf debts are not being written down, thus its 28% not 50%.

John Galt said...

Apologies Dude, but as it stands Italy isn't currently in a primary budget surplus, although it is expected to be over the next 18-months to 2-years.

It is when they get into this zone that things become very dangerous for holders of Italian debt, because the Italian government has the ever hanging option of reneging on the old debt.

Sure, it would be a default pure and simple, but since they wouldn't need the money to finance the government it would be an easy default.

Long term, they would (as have all the other defaulting countries), be able to repair their credit and slowly get back into the market as Argentina has done.

Sure - this would mean all sorts of economic fiddles and buying the debt from vultures, but this could be accommodated at a fraction of the par value of the debt.

Twenty years from now, Italy could be a much better functioning economy after a default as opposed to it continuing to carry the burden.

Sure, lots of people would be pretty fucked off with this, but most of them are foreigners.

Cazzo Li!

Jeff Wood said...

John is right. In fact we suspect here in Italy - of course the Press are not saying a word - that a sort of default is part of the plan.

The economies currently being fought over, if implemented in full, would create a fiscal surplus sufficient to pay down the debt, if slowly.

Of course the measures will not be won in full, so two results are possible.

First, that there is enough of a surplus to pay reasonable interest, so that the creditors can be invited to turn over the debt, and receive just that reasonable interest.

Alternatively, the austerity plan passed would allow only a primary surplus, so that the government can meet its day to day needs without borrowing. At that point the creditors can be told to take a hike until the world economy recovers.

I should guess that the second course would also entail a return to the Lira. Fair enough: my earnings are in Sterling.

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