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Protecting against downside risk

It is frustrating that half measures and the ideological gap that exists amongst eurozone nations have led us to the point where markets appear now to have given up hope that Greece can remain inside the European monetary project without solutions that require catharsis. Attention is turning to Spain again and recent price action in bunds and US dollar is unsettling.

This leaves the door open to another round of potential volatility spikes that so far have led to sustained sell-offs in the commodity complex, Emerging Markets equities and selected emerging markets currencies. It is tempting to call a bottom to the decline in Russian equities and the Brazilian Real — both certainly look oversold on a technical basis — but current market conditions are given to prudent risk management rather than risk-taking in arenas which are extremely sensitive to global growth and commodity price movements.

From an emerging markets perspective, this phenomenon makes for a more volatile outlook, rather than one which points decisively in one direction rather than another. Arising US dollar is traditionally bad for EM local currency assets as it undermines commodity-sensitive markets (Russia this month) and leads to capital reversal out of risk markets. Hence we continue to recommend using market rallies to reduce beta in risk markets and sectors and concentrate on low-beta and/or markets with sound fundamentals and the prospects of medium-term returns protected behind capital controls. In this respect we still see value in Russian fixed income, short-duration hard currency investment grade bonds and in Chinese on-shore equities on prospective People’s Bank of China (PBOC) policy loosening.

In developed markets, signals from Europe continue to deteriorate even as US data starts to imply stability, if not rapacious recovery. While many in the market seem content to hum on broad macro data trends, the really important numbers come from Europe’s financial sector. In valuation terms, banks across the union are trading well below tangible book value, but the initial signs of capital withdrawal are now evident in Spain. Greece’s savers have been withdrawing deposits from their banks for almost a year as faith in the country’s financial institutions has waned. Deposits in Spain, excluding those of monetary institutions and the central bank, have fallen by only five per cent, or €86 billion from €1.741 trillion since the recent peak in June 2011. But the pace of withdrawal is accelerating with deposit growth of minus five per cent (-5% y/y) in March of this year.

Certainly, the €19 billion bailout of Bankia (effective nationalisation), Spain’s third largest lender, is unlikely to instill bond market confidence given that we have now had three Europe-wide bank solvency tests and none of them have proven to be even remotely credible. In the absence of either a full-blown Europe-wide deposit guarantee programme or more rapid moves towards the issuance of Eurobonds to under-write Resolution Trust Corporation-style bad bank solutions, deposits held in national banks in the southern half of Europe will remain as key a statistic for market watchers as the yield on German bunds. Recent price action shows a clear preference for high-grade German debt over European equities.

Meanwhile, US data has surprised to the upside in the last few weeks. Home sales have increased again, the latest confidence and consumer spending data have all come in ahead of expectations and there is renewed evidence of an improving outlook for the demand for and supply of credit from the Federal Reserve’s Senior Officer Loan Survey and the National Federation of Independent Business’ survey of conditions faced by the SME sector. The major disappointment in US terms since the end of April seems to be mostly confined to those who believed that a social networking company could command an IPO price of almost 70 times trailing earnings and thus be competitively priced against a NASDAQ average of 10 times. Even the ubiquitous Apple is only priced at 20 times. It is highly unlikely, in the opinion of most market players, that social networking is a business model that defies the lessons of the late 1990s.

The writer is chief investment strategist at EmiratesNBD. 
Views expressed by the author 
are his own and do not reflect the newspaper’s policy