Asset management

23 April 2012

Economist Insights Twice bitten, thrice shy

Both 2010 and 2011 started with relatively positive economic data and a low level of market volatility. Investors went long risk and got hurt badly as the Eurozone sovereign crisis worsened over the course of the year. This year also started in a similar way: low market volatility and moderate US economic data. So markets may now be wondering what the catalyst for a sell off this year will be. Europe still remains the best candidate. Nevertheless, it seems unlikely that 2012 will be a repeat of the last two years. Very little optimism is priced into markets. Investors have so far remained very cautious and this makes the kind of unwinding of risk positions seen in 2010 and 2011 unlikely. Joshua McCallum Senior Fixed Income Economist UBS Global Asset Management joshua.mccallum@ubs.com

Gianluca Moretti Fixed Income Economist UBS Global Asset Management gianluca.moretti@ubs.com

The market loves a pattern. Spot a pattern, and you can trade it. Spot a pattern, and you can make some money. Given the benefits of spotting patterns, it is no surprise that more patterns are spotted than actually exist. The big pattern that many market participants are discussing at the moment is the similarity between the beginning of this year and the beginnings of both 2010 and 2011. In 2010 the recovery appeared to be under way in the first quarter, so much so that the Federal Reserve was even talking about how it could remove policy accommodation. Then the Eurozone crisis really kicked off with Greece coming under pressure. The economic data continued to be good right up until the summer (see chart 1), but by that point all that anyone was looking at was the spreading contagion from the Eurozone crisis. Risk sold off. In 2011 the first quarter was once again an oasis of calm. Data came in solid but not outstanding, right up until the tragic earthquake in Japan. This was a shock but risk appetite held up fairly well until the summer. Once again it was the Greek situation that provided the trigger, as Eurozone politicians delivered ultimatums to Greece and Chancellor Merkel first indicated that a private sector haircut was on the cards. Risk assets took a nose dive. For many investors the lesson is one of twice bitten, thrice shy. Starting optimistically in 2010 they went long risk and got hurt badly. In 2011 they tried again but once more they were mauled by the market. It may well be coincidence, but

2012 once again began the year with low levels of market volatility (see chart 2) and improving data out of the US. Perhaps it is no wonder many investors are feeling nervous. A lot of noise has been generated by the fading flow of the LTRO, weather-related distortions in the US data and the Spanish budget (as discussed in last weeks Economist Insights). Ignoring this noise, what nervous investors really want to know is where this years big shock could come from, if it comes.
Chart 1: Surprise, surprise? Cumulative change in the Citigroup G10 Economic Surprise Index since the start of the year. Positive figures denote data coming in better than expected. 60 40 20 0 -20 -40 -60 -80 -100 Jan Feb Mar Apr May Jun 2010
Source: Citigroup

Jul Aug Sep Oct Nov Dec Jan

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2012

Europe is still the biggest source of risk. The European Financial Stability Facility (EFSF) failed to stem the crisis in the last two years, and the LTRO is not going to fix it this year. Even the ECB freely admits that the LTRO is only intended as a temporary fix and as a way to prevent a banking liquidity crisis. Europe is not really any closer to a proper, sustainable solution. The combination of the EFSF and funds from the IMF has removed the smaller periphery countries from the market (they borrow directly from these funds instead of selling debt in the open market). This means that any further stage of the crisis, if it comes, will be in Spain or Italy. At a stretch, the combined resources of the EFSF, the new European Stabilisation Mechanism and the ECB bond buying programme might be enough to fund Spain if the market freezes up. Italy is an altogether different order of magnitude. And if Spain were demanding all of the available resource there would be none left for Italy, which would make Italian debt riskier and could generate a crisis all on its own. Clearly there needs to be a more robust policy response, but none seems to be forthcoming. European leaders act as if lower bond yields signified that they had solved the problem. Unfortunately, addressing the symptoms is not the same as curing the disease. A lasting solution will need more than just austerity. Eventually there will need to be some mutual sharing of the debt burden. What continues to scare investors is that most politicians are still unwilling to admit to this necessity. Until politicians do so the markets will remain vulnerable to the kind of shocks that hit in 2010 and 2011. Elections could be another source of shock that sends us into a repeat of the past. The market has been remarkably sanguine about the French election, given the anti-capitalist rhetoric from some candidates. They may be waiting to see how the second round between Hollande and Sarkozy

shapes up, or markets may simply have decided that election rhetoric will not last past the election. Of more concern are the Greek elections on May 6 and the Irish referendum on the new European fiscal compact later that month. Adverse results in either of these could be the catalyst for another sell-off in risk assets. Despite all these risks, there is one good reason to expect 2012 not to be a repeat of the last two years. This is simply that investors have learned to be cautious so there is very little optimism priced into markets, at least in Europe. The ten-year US treasury note is still trading close to all time lows at two percent, and spreads of periphery debt remain wide. With so few investors taking any big positions, it is much harder to see an unwind of risk positions of the type seen in 2010 and 2011.
Chart 2: VIX-ing it up VIX index of market volatility (higher denotes greater volatility as expressed by S&P 500 index options)

50 40 30 20 10 Jan Feb Mar Apr May Jun 2010

Source: Bloomberg

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