Thursday 29 August 2013

Macro Risks Loom in September

Volatility has returned to markets this week and it seems set to escalate in September. Aside from events in Syria and behavioral factors such as September being the worst month for US stocks, there are a variety of macro developments that could heighten market instability.

Fed Tapering

The most dominant issue over the summer has been speculation surrounding the Federal Reserve’s tapering of its monthly $85 billion asset purchases. The consensus among economists is for tapering to begin in September after the Fed concludes its meeting on the 18th, but that is not yet a certainty. Between now and then US economic data will be scrutinized, and possibly overreacted to by markets, as analysts try to gauge the mindset of Fed officials. Better-than-expected data is likely to boost expectations of Fed tapering in September, while weak data could influence the central bank to refrain from a reduction.

Debt Ceiling

The return of Congress will also bring drama as the issue of the $16.69 trillion US debt ceiling must be addressed. The US Treasury warned on Monday that it will reach its borrowing limit in mid-October, earlier than many analysts had expected. But for the limit to be raised, Republicans want significant new spending cuts and constrictions on Obamacare. President Obama said he will not negotiate on the debt limit, while House speaker John Boehner stoked the flames this week by saying he is ready for “a whale of a fight”.

It was initially hoped that agreement could be achieved without the type of last-minute wrangling in August 2011 that resulted in the downgrade of US debt and stock market sell-offs. The US budget deficit has decreased significantly, with the Congressional Budget Office forecasting $642 billion for 2013, which will likely equate to 4% of GDP, down from 2009 when the deficit was $1.4 trillion or 10.1%. But the recent rhetoric implies that despite budgetary and economic improvements the upcoming negotiations could be just as fractious as two years ago.

Eurozone Politics

Europe is also set for political anxiety. German elections take place on September 22nd and the outcome is significant given that current chancellor Angela Merkel is effectively the eurozone leader. The upcoming elections resulted in a quiet summer for the eurozone, but the calm is not indicative of looming threats.

Strong German performance saw the eurozone economy grow in Q2 but this followed six quarters of contraction. There is still no lasting solution to the region’s problems. Little has been done regarding bank reform while Greece, Cyprus, and Portugal will need additional financial aid later this year. Moreover, Italian bond yields have jumped recently as an imminent vote on whether to expel former prime minister Silvio Berlusconi from parliament may threaten the stability of the coalition government.

Angela Merkel’s approval ratings in Germany are high and she will likely be re-elected to lead a coalition, but celebrations will be muted by thoughts of the eurozone periphery.

Japan: Pillars of Abenomics

The Japanese government has been meeting with economists and business leaders this week to gauge opinion on whether a series of planned sales tax hikes should be implemented. Last year it was agreed that sales tax would rise to 8% from 5% next April and then to 10% in October 2015. The tax hike is necessary to ease the government debt burden, helping to pay for the aging population’s welfare costs. But now the government is trying to ascertain if the economy is strong enough to handle the tax increases. Economic data will be watched carefully before prime minister Shinzo Abe makes the final decision, expected before October 7th.

Implementing the tax hikes would be a sign that Japan is serious about enacting structural reforms, in effect the “third pillar of Abenomics”, following on from the previous two measures of renewed fiscal stimulus and aggressive monetary easing. If Abe reneges on the tax hikes he risks casting doubt on whether his government is committed to reducing public debt, which is projected to reach 230% of GDP by 2014. Japan needs to address its finances to avoid potential ratings downgrades; an outcome that could result in a sharp Japanese bond sell-off. Given that Japan’s financial institutions hold significant amounts of government debt, a spike in bond yields will result in severe losses for the banking sector.

VIX Volatility

Earlier in August the VIX, a gauge of the market’s expectation of future volatility based on the premium for S&P 500 options, was trading near six-year lows. However, the VIX has historically been a very imperfect measure of future market volatility. Still, the financial media regularly referenced how the low VIX or “fear gauge” reading implied that investors were anticipating low volatility over the next 30 days. But what most outlets didn’t report was a significant rise in the volume of VIX calls; options that are profitable if the VIX index rises. So while the VIX was at relatively low levels, the buying of options to protect against a rise in the VIX was rising sharply, and ignored by much of the media.

In effect, many investors were positioning for future volatility, even if this was not reflected in the VIX price. This is an example of the disconnect that can exist between markets and the dangers of reading too much into a single measurement. It brings to mind the Malayan proverb: Don't think there are no crocodiles because the water is calm.

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