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Sunday, 22 October 2017

Teenage Scribblers' effort to put the world to rights comes up short

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The issue of liquidity mismatch is back

While risk asset markets were having their rear ends handed to them on a plate on Friday, I was enjoying a highly convivial luncheon with some of the “Teenage Scribblers” including, among others, the delightfully incisive Billy Blain of Mint Partners, but also Russell Taylor, MBE, the writer of that central feature of City life, the Alex cartoon.

Russell apparently reads our stuff with the same intense delight with which we read his.

I mention this not to gloat that we were on our umpteenth glass of wine while you were trying to make head or tail of the glum news from the high-yield market but because Russell, himself a veteran observer of our species, has found himself accused of giving too much credence to and being too deeply influenced by the musings of a few superannuated bond market gits and not being “with it”.

Yet while we were enjoying a late glass of Sauternes, the very issues which we have placed at the centre of our assessment of the main risks to stability in our markets were busily rearing their ugly heads.

News was of Stone Lion, the US high-yield fund, suspending redemptions on the coat tails of Third Avenue announcing the closure of its fund. It would be fatuous to declare that the high-yield credit market went into meltdown - veterans of 2008 have a very different idea of what constitutes a melt-down - but the S24 iTraxx Cross-Over index, the canary in the junk bond mine, jumped by 23pts to 343¾pts at the close.

As recently as December 2nd it was at 284pts. There was a very clear smell of panic with the risk of mass redemptions hanging over both the cash fund industry and the ETF market which is still being sold by providers as the safest way to play the asset class.

If folks didn’t learn during the financial crisis that the derivative can ultimately NEVER do better than the underlying cash product, I’m afraid they deserve no better than they get.

The issue of liquidity mismatch is back in the headlines - Third Avenue had promised daily liquidity which it had found hard to deliver without filleting remaining investors - although I still believe fervently that the real issue of the mismatch has yet to be grasped.

It’s not just about funds offering higher levels of liquidity to their investors than they are receiving from the Street. But also about credit markets having grown like topsy since the banks have been as good as regulated out of the lending process, while the Street’s capacity to hold the size of free-float of securities which is necessary in order to guarantee an orderly market continues to decline.

I have in my mind the image of one of those over-loaded, un-seaworthy tubs full of tired migrants crossing the Mediterranean and sailing into a storm.

It should never be forgotten that the real purpose behind much of the regulation emanates from the civil servants trying to make sure that if anything were to go wrong again, they would have their arses covered and that nobody would ever be able to accuse them of having been asleep on the job.

The fact is that in doing so they have pushed significant chunks of credit risk into areas outside of their regulatory control (so not really their problem) while wrecking the self-levelling mechanism which the market is supposed to offer (apparently also not their problem).

Many years ago I coined the phrase that risk is like energy; it can be converted but it can’t be destroyed. If it’s not on the banks’ balance sheets, where is it? Last time round, it was packed into off-balance sheet credit conduits and CDOs where the leverage was also concentrated. That leverage is now not with the commercial or investment banks but, to be quite blunt, on the central banks’ balance sheets.

The actual credit and market risks are still out there … somewhere.

Billy and I and the other well-oiled Teenage Scribblers might be grumpy old men but I fear that spraying the risks yellow or pink instead of brown or green doesn’t make them any less potent. Watch the risk-asset markets and take nothing for granted.

All this, of course, and the Fed tightening on Wednesday is seen as a done deal. For over a year the FOMC has shilly-shallied around, having missed the best opportunity to tighten in late summer 2014. Money markets are still pricing in a 20% chance that they might not move but if there was ever a better opportunity for the FOMC to cash in the last shreds of its credibility, it can do so this week, should it wish.

The tightening should be fully discounted; if not, I wonder why the parents of investors and dealers alike wasted their money sending their progeny to university.

I simply can’t believe that all those PhDs, MBAs and CFAs are again going to miss an open goal … but as PT Barnum had it, “there’s a sucker born every minute”.

Back in Japan, we today got the Bank of Japan’s quarterly Tankan Survey. The key headline number, the ” Business Conditions Large Enterprises Manufacturing” reported at 12 which is not bad in itself but unchanged from the September reading.

In fact, since hitting 12 in September 2013, this index has remained remarkably stable. For some the glass is half full, for some it is half empty. It’s not getting better but at least it’s not getting worse. Capex is looking broadly okay but if one drills down into the medium and small business areas, optimism is still hard to find.

Not only that but the forecast for Q1/16 isn’t great with the large manufacturers predicted to fall from 12 to 7, the medium manufacturers down from 5 to 0 and small manufacturers from 0 to -5.

In order to crash, Japan needs to first lift off. As we stand, a broad-based lift-off is still remains some way away.

The Nikkei didn’t like the Tankan much although the near 2% sell-off is being blamed on the weak close in New York where the Dow lost 1.76% on Friday, the S&P shed 1.94% and the Nasdaq 2.21%.

That has US indices retreating 4% over the week. Santa Claus rally? Where?

China had a brighter day on rising optimism that the world is not coming to an end on Wednesday … especially not with the PBoC fixing the yuan lower again.

Finally, Le Pen didn’t achieve the break-through in yesterday’s second round of regional elections. The mainstream parties’ voters went the tactical route which froze out the Front National.

Marine must surely be enviously eyeing the British first-past-the-post system which would have her in clear control as of last Sunday. What is important now is that the Republicans and the Socialists don’t get too excited by how well they did but reflect on why so many of their fellow citizens - a good third - are prepared to vote FN.

The next test of right/left politics is due next Sunday in Spain. Marine declared it to be a contest between internationalists and patriots. That sounds to me like the Trumpster. Shifting sands …

Hard week ahead. Tread carefully.

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