While the US spent yesterday celebrating its unity by devouring herds of minced cattle in a bun and with firework displays which must have cost the GDP of a small African state, Europe gave a prize demonstration of how its own much heralded union is creaking all over.
Italy is in uproar over the never-ending migrant crisis, which has seen between 80,000 and 95,000 migrants – the number varies depending on the source but it is, irrespective, big – land on its shores so far this year and is threatening to close its ports. The Italians argue, not entirely without reason, that the presence of rescue boats encourages migrants, virtually none of whom are now actual refugees, and that the €90m that the EU is promising to help stop the flow might just as well be spent on ice cream. Austria, meanwhile, is itself threatening to close its borders to Italy in order to prevent any more of the migrants spilling over onto its territory and a diplomatic war of words has broken out with Rome with respect to the convention on the free movement of people.
Meanwhile, Italy itself is in the dock for its bail-out of Monte dei Paschi di Sienna, supposedly the world’s oldest bank, founded in 1472. To be frank, there isn’t much more than the plaque on the door that has anything to do with the real Monte dei Paschi. I trained at Barclays when it was active in 72 countries and was, by balance sheet, the world’s largest bank. The Barclays I see today has nothing to do with the proud, world leading institution I once worked for and I suspect that some of the older members of Monte dei Paschi feel very much the same. Alas, it has been bailed out at taxpayers’ expense and in total contravention of any of the EU’s rules on failing banks. Once the €5.4bn of new capital have been injected, the state will own 70% of the bank, which means that the bulk of losses taken on the sale of €28.6bn of bad loans will be borne by taxpayers while bondholders escape with a black eye.
Finally, Jean-Claude Juncker, the muppet-in-chief, is in uproar after only 30 of the 751 MEPs turned up in Strasbourg for a plenary session of the European parliament, the centrepiece of which was a presentation by Maltese Prime Minister Joseph Muscat in which he summarised the events of his country’s six-month presidency of the EU. Juncker took a swing at the parliament, calling it “totally ridiculous” while forgetting that MEPs might have better things to do than to take a couple of days out of their life to go to Strasbourg, the anachronistic co-capital of the EU, in order to hear somebody they don’t care about tell them something they already know. Though not on the front pages, the EU will have to do some big thinking in light of 13% of its budget disappearing when the UK leaves and, more to the point, facing the future of its unfunded pension liabilities that are coming to light as Brussels bids to bill London for its share of them. Brandy for breakfast, anyone?
The Borrowers
The only good news in Europe seems to be a report that European sovereign borrowing in H1 2017 amounted to an equivalent of US$193bn, which leaves only US$86bn to be raised in H2. Where, one wonders, did all these bonds go and why would anybody have bought them, given the low underlying yields and the silly tight risk premia for lesser quality borrowers? The answer is as simple as it is scary.
If, say, the asset allocation on an investment profile asks for 50% bonds and 50% equities, then every time the stock market rises the asset manager has to buy an equivalent amount of bonds in order to remain within the asset allocation guidelines. Whether he or she likes yields at these levels or not is not the point. Bonds must be bought … and where there are buyers, there are always issuers to match. But what if equities tank in a major way, just as pretty much everybody with a Reuters or a Bloomberg screen is forecasting for sometime between now and the end of the year? The logical answer is that they will have to chuck all of those bonds out again.
During the 2007/2008 crisis I wrote a piece that likened the Street to the overflow pool of a reservoir and assumed that the Street’s capacity to take bonds down from investors needed to be something in the region of 10%-15% of the total of all outstanding debt, were orderly markets to be maintained under all circumstances. During the financial crisis, for those who might have forgotten, the Street was hugely liquid. It acted exactly as I had been taught during my apprenticeship on a trading floor: “You will always get a bid; you might not like it but you will always get a bid.” The price of liquidity rose dramatically and those who provided it made out like bandits. It was actually quite embarrassing to see investment banks reporting record trading profits in their fixed income divisions while credit markets were going to hell in a handcart and the parent banks’ balance sheets were collapsing and taxpayers were picking up the pieces. All the while, for better or worse, investors could restructure their portfolios according to their own wishes.
That has now changed. Where there always used to be a bid, whether one liked it or not, there is no bid any more. The area of no man’s land between the market makers’ bids and the bid by distressed debt funds has become much larger and the gap, the vacuum space where there are no bids from the Street and where vulture buyers step in, will be much more pronounced.
With their pronounced low interest rate policy the central banks have driven investors into ever-more adventurous credit exposure while their alter egos, the regulatory authorities, have done all they can to prevent the maintenance of an orderly market around those risks. Heaven help the fixed income – that’s rates and credit – index trackers if, as, and when the brown stuff hits the propeller. And please not, the big downside risks to the bond markets are not to be found in the monetary policy committee rooms of the central banks but in the levels of equity markets and in the straitjacketing of investment dollars in quantitative investment models.
What price liquidity risk?
It was in 2008 or 2009 when I first observed that the principal lesson to be learnt from the crisis was that liquidity risk needed to be priced into every asset. From where I am sitting, the first page of that book has not even been written, let alone read. Between them, the central banks with their easy money and the banking regulators who worshipped at the altar of the Volker rule have created a monster that most analysts and strategists are looking for in the equity space while in reality it is to be found in the bond market complex and in the fouled-up and asymmetric interplay between investors and the Street.
Whereas stock markets always have buyers and sellers, bond markets are habitually either bid only or offer only. The one-way traffic can last minutes, hours or days but it is very rare that the markets are actually in equilibrium. The equalisation pool that the Street used to provide to these one-way flows has been largely removed and without it the next big surge could break the dam. If it does the last vestiges of the myth of bonds being the defensive investment play will finally be flushed away with it.
When things go quiet over the summer – in a couple of weeks schools will have broken up for the holidays – investors would be well advised to sit back and reassess their portfolios and their investment strategies for liquidity risk in the event that universally predicted collapse in risk asset prices actually happens any time after St Leger’s Day.