TWN Info Service on Finance and Development (Jan13/01)
3 January 2013
Third World Network

Easing of near-term risks, looser policies rallied markets - BIS
Published in SUNS #7506 dated 21 December 2012

Geneva, 20 Dec (Kanaga Raja) - Despite forecasters cutting their projections for global economic growth in the three months to early December, prices of most growth-sensitive assets rose, benefiting from further loosening of monetary policies and perceptions that some major near-term downside risks to the world economy had diminished, the Bank for International Settlements (BIS) has said.

In providing this assessment in its latest Quarterly Review of international banking and financial market developments, BIS said last week that in particular, "asset valuations reacted positively to new policy measures aimed at tackling the euro area crisis. They were also supported by news suggesting that a sharp and prolonged fall in Chinese economic growth was less likely."

[Meanwhile, in its latest projection of World Economic Prospects released this week, the UN warned that growth of the world economy "weakened considerably during 2012 and is expected to remain subdued in the coming two years."]

However, cautioned BIS, downside risks remained and uncertainty about fiscal policy in the United States, which was on course to tighten substantially in the near term, encouraged cash hoarding and weighed on the prices of assets most vulnerable to budget cuts.

Yet, equity implied volatilities, including those with longer horizons, fell close to the historically low levels of the mid-2000s. Similarly, some asset prices started to appear highly valued in historical terms relative to indicators of their riskiness. For example, global high-yield corporate bond spreads fell to levels comparable to those of late 2007, but with the default rate on these bonds running at around 3%, whereas it was closer to 1% in late 2007. The same was true of investment grade corporate bond spreads, but with respective default rates of a little over 1% and around 0.5%.

"Indeed, numerous bond investors said that they felt less well compensated for risk than in the past, but that they had little alternative with rates on many bank deposits close to zero and the supply of other low-risk investments in decline."

According to the BIS Quarterly Review, the prices of most risky assets increased between early September and early December. In the advanced economies, yields on both investment grade and sub-investment grade corporate bonds fell to their lowest levels since before the 2008 financial crisis. The same was true of yields on emerging market bonds, whether issued by sovereigns or corporates, or denominated in local or international currencies. And yields on bonds backed by mortgages and other collateral fell to their lowest levels ever. Meanwhile, equity prices mostly rose during the early part of the period, although they fell back somewhat later on.

Unusually, BIS found that equity and fixed income gains coincided with a weakening of the global economic outlook. Forecasters cut their projections for 2012 and 2013 global economic growth. Without any significant offsetting upward revisions, they substantially reduced their forecasts for Greece, Italy and Spain in Europe, as well as for Brazil, China and India in the emerging world.

In the past, it noted, falling growth forecasts have usually been associated with rising expected default rates and higher bond yields. But this time, bond yields fell. Similarly, most equity prices ended the period a little above their starting levels, despite weakening corporate earnings expectations. Earnings expectations for US companies in the S&P 500 Index dropped particularly sharply following a decline in reported earnings - the first in 11 quarters - and as an unusually high proportion of firms warned that future profits could fall short of analysts' forecasts.

Market participants attributed a significant part of the rally in asset prices to further loosening by central banks, notably the Federal Reserve. On 13 September, the Fed announced that it would immediately begin expanding its balance sheet through monthly purchases of $40 billion worth of mortgage-backed securities. In contrast to previous rounds of asset buying, US policymakers left the size of the programme open-ended, stating that it would continue until the labour market outlook had substantially improved.

At the same time, the Fed pushed its forward guidance several months further into the future, saying that it expected to maintain its policy rate at exceptionally low levels until at least mid-2015, even if the US economic recovery had strengthened by then.

[In its latest policy statement of 12 December, the Fed's Open Market Committee has announced its intention to keep its current federal rate at 0 to 1/4, as long as the unemployment rate remains above 6-1/2 percent. According to the Fed, for the period between one and two years ahead, US inflation is projected to be no more than a half percentage point above the Committee's 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored. - SUNS]

The Bank of Japan also extended its asset purchasing programme, both in September and October, raising purchases of Japanese government securities and other assets planned before the end of 2013 by 21 trillion Yen. Meanwhile, policy rates were cut in Australia, Brazil, Colombia, the Czech Republic, Hungary, Israel, Korea, the Philippines, Sweden and Thailand.

The Fed's measures had significant, if short-lived, effects on US financial markets. Most directly, they compressed yields on mortgage-backed securities, which led to reductions in mortgage rates. As the gap between these two metrics widened, US bank equity prices increased relative to the equity market as a whole. In addition, the Federal Reserve's new commitment to potentially unlimited balance sheet expansion boosted both market-based indicators of expected inflation and the prices of precious metals used as inflation hedges.

BIS noted that with this rise in expected inflation, the US dollar depreciated slightly. Within a few weeks, however, both expected inflation and the value of the dollar returned to the levels seen before the 13 September announcement, possibly because incoming economic data suggested less monetary easing than originally expected.

"More broadly, further quantitative stimulus by the major central banks appeared to nudge investors into taking on more risk. In particular, developed market corporate bond funds and emerging market government and corporate bond funds each attracted net inflows."

With investors' demand for risky assets increasing, bond issuers were able to place more debt than in previous months. This included the sale of some relatively risky types of bond. For example, non-financial corporate bond issuance rose to and remained near its year-to-date peak in September, October and November, with disproportionate increases in sub-investment grade issuance.

Also during these three months, emerging market bond issuance outpaced that of the previous year, with placements of corporate bonds rising by more than those of government bonds. And, over the same period, European subordinated bond issuance was distinctly stronger than earlier in the year, not only for financial borrowers, who brought forward some planned 2013 issuance owing to forthcoming regulatory changes, but also for non-financial borrowers.

According to BIS, easier monetary policies in advanced economies raised expectations that capital would flow into emerging market economies, causing their currencies to appreciate. When this happened in November 2010 and June 2011, the US dollar fell by more than 5%. Yet this time, the US dollar appreciated in the three months from the beginning of September, both against a number of individual emerging market currencies and on a trade-weighted basis.

"Softer growth prospects in emerging markets partly explain why their currencies and capital flows reacted differently to monetary easing in advanced economies. They also put downward pressure on commodity prices."

Several emerging market economies used policy measures in an attempt to stop their currencies from appreciating during the period.

The Brazilian central bank intervened in foreign exchange markets, and currency traders gained the impression that other central banks in Latin America and East Asia were also in action. In addition, the Czech central bank said that it might consider intervention, depending on how its currency moved. In Korea, the authorities launched an investigation into compliance with restrictions on banks' foreign exchange positions that would gain from an appreciation of the local currency. Moreover, they tightened limits on banks' exposure to currency derivatives.

All these measures were generally associated with more stable currency values, as evidenced by option implied volatilities.

Asset prices also received support during the period from a perceived reduction in some major downside risks to the world economy. In particular, the prospect of a near-term worsening of the euro area crisis appeared to decline following new policy announcements. Also, the risk of a sharp and prolonged fall in Chinese growth seemed to recede after better than expected October economic data were released.

"However, the risk of an abrupt tightening of US fiscal policy from the beginning of 2013 lingered and even increased, according to some commentators, after federal elections again delivered a balance of political power vulnerable to stalemates."

According to the Quarterly Review, changes in the prices of options insuring against sharp declines in equity prices supported the perceived evolution of these risks. The cost of insuring against falls of 20% or more in the EURO STOXX 50 Index, a proxy for a sharp economic crisis in the euro area, fell in the three months from the beginning of September, although the price of protection against smaller price declines dropped by a similar amount.

The cost of insurance against large falls in the Hang Seng Index, which might occur if Chinese economic growth were to slow sharply, also declined. The price of protection against smaller price drops fell by a lesser amount.

By contrast, there was some increase in the cost of insuring against a fall of 20% or more in the S&P 500 Index, which might accompany an abrupt tightening of US fiscal policy. This rise slightly outpaced the cost of insuring against smaller price declines.

In the euro area, BIS noted, the European Central Bank's (ECB) plans to buy government bonds substantially boosted debt markets and underpinned financial markets more broadly.

After ECB President Mario Draghi had alluded to these moves in a speech in London on 26 July, the Governing Council provided details on 6 September. The ECB would buy bonds issued by euro area governments with residual maturities of one to three years, with the intention of accepting equal status to other creditors, conditional on those governments first agreeing to follow an economic adjustment programme. Yields on bonds of financially strained governments in the region subsequently fell, having already declined significantly since Mr Draghi's speech, especially at purchase-eligible maturities.

However, Spanish bond yields soon rebounded. This coincided with upward revisions to 2011 and anticipated 2012 budget deficits, clarification that European funds would not be available to finance legacy bank support programmes and a push for independence by the president of Catalonia. In contrast, Italian bond yields remained at much lower levels and in October the government issued a record amount of debt for a single European offering.

Asset prices rose particularly strongly in Greece, where the government eventually received further loan disbursements from its IMF/EU programme. These were due in September, but Greece had slipped behind some of the programme's economic targets. The government subsequently negotiated an adjusted programme, which included lower and later payments on Greece's official debt, transfer to Athens of profits on the Euro-system's holdings of Greek government bonds and plans for a private sector debt buyback.

According to press reports, many hedge funds bought Greek bonds in anticipation of such an outcome. This helped to drive yields lower in the three months to early December. The Athens Stock Exchange equity price index rose by almost one third over the same period.

Capital flows also seemed to reflect the view that the euro crisis was less likely to intensify. With investors perceiving a reduced risk of currency re-denomination, portfolio investments flowed into Spain and Italy on a net basis in September. At the same time, outflows of deposits and other funding from banks in these countries slowed or levelled off.

Separate data show that deposits at these banks also held up in October. Some of the net capital inflows to Spain and Italy probably came from Germany, as the Bundesbank saw a reduction in its claims on the ECB that were generated by net payments from other euro area countries. Conversely, the Spanish and Italian central banks' liabilities to the ECB generated by net payments to other euro area countries registered a decrease. These changes ran counter to the trend of the previous year or so, said BIS.

Despite this renewed support for the financially strained countries in the euro area, yields on bonds issued by the financially more robust governments were essentially unchanged. Yields on two-year bonds issued by France, Germany and the Netherlands remained close to zero, while yields on their 10-year debt also hovered at historically very low levels. Moody's downgrading of France from AAA had little effect on these yields.

Financial markets also drew support from news suggesting that a sharp and prolonged slowdown in Chinese economic growth seemed less likely. Fears of a "hard landing" in China were allayed, in particular, by rebounds in industrial production and export growth during October as well as a survey of purchasing managers. This reduced perceived default risk for assets vulnerable to a severe economic slowdown, such as bank loans. Reflecting this, Chinese bank equity prices outperformed non-bank equity prices in the three months to early December.

Although perceptions of major downside risks may have diminished, BIS stressed, the effects of weakening economic growth in China nevertheless spread to other emerging markets, notably in Asia.

Here, exchange rate movements in 2012 had already highlighted the importance of China to investors in several economies in the region. In particular, the exchange rates of economies highly dependent on exporting to China have moved almost in step, suggesting that they are driven largely by news from China, while those of less dependent economies have moved more idiosyncratically.

However, not all near-term economic risks diminished, notably in the United States. Here, the government remained on course to cut its budget deficit by around 4% of GDP from the beginning of 2013, which most economists agreed would push the economy into recession. Uncertainty about whether and how this fiscal drag would be mitigated weighed on the prices of certain equities.

In particular, said BIS, prices of stocks with high dividend yields and from the defence sector fell relative to the broader US market. Such stocks are particularly vulnerable to higher dividend taxes and spending cuts, respectively. Fiscal uncertainty also prompted US companies to keep more liquidity on hand in assets such as bank deposits and marketable securities. This put further downward pressure on the yields of those assets.

However, BIS added, this near-term uncertainty had almost no effect between the beginning of September and the end of November on the future path of medium-term US interest rates as implied by derivatives prices. This suggests that investors remained confident that the government would ultimately lower the trajectory of its debt.

[Meanwhile, in its "World Economic Situation and Prospects 2013" released this week, the UN warned that growth of the world economy "weakened considerably during 2012 and is expected to remain subdued in the coming two years". Growth of world gross product (WGP) is expected to reach 2.2 percent in 2012 and is forecast to remain well below potential at 2.4 percent in 2013 and 3.2 percent in 2014. Weaknesses in the major developed economies are at the root of continued global economic woes. Most of them, but particularly those in Europe, are dragged into a downward spiral as high unemployment, continued de-leveraging by firms and households, continued banking fragility, heightened sovereign risks, fiscal tightening, and slower growth viciously feed into one another, it added.

[In the baseline outlook for the euro area, GDP is expected to grow by only 0.3 per cent in 2013 and 1.4 per cent in 2014, a feeble recovery from a decline of 0.5 per cent in 2012. Because of the dynamics of the vicious circle, the risk for a much worse scenario remains high. The United States economy weakened notably during 2012, and growth prospects for 2013 and 2014 remain sluggish. In the baseline outlook, gross domestic product (GDP) growth in the United States is forecast to decelerate to 1.7 per cent in 2013 from an already anaemic pace of 2.1 per cent in 2012.

[The UN further said that risks remain high for a much bleaker scenario, emanating from the "fiscal cliff " which would entail a drop in aggregate demand of as much as 4 per cent of GDP during 2013 and 2014. Adding to the already sombre scenario are anticipated spillover effects from possible intensification of the euro area crisis, a "hard landing" of the Chinese economy and greater weakening of other major developing economies. Unless Congress can reach an agreement to avert it, the United States will face a sharp change in its government spending and tax policy at the end of 2012. The tax cuts endorsed during the Administration of George W. Bush worth $280 billion per year (often referred to as the "Bush tax cuts"), the 2 percentage point payroll tax reduction worth $125 billion, and the emergency unemployment compensation worth $40 billion introduced during the first term of the Obama Administration, were all designed to expire at the end of 2012. More specifically, the expiration of the Bush tax cuts would imply an increase in income tax rates across all income levels by about 5 percentage points in 2013.

[Among the other changes associated with the expiration of Bush tax cuts are the phasing out of the reduction in the Federal Child Tax Credit and an increase in the maximum tax rate for long-term capital gains by about 5 percentage points. The expiration of the 2-percentage-point reduction in employee payroll taxes would imply a decline in aggregate disposable income by about $125 billion. Moreover, the expiration of emergency unemployment compensation, which was first passed into law in 2008 and has been extended in the past four years, would imply a reduction in consumption spending by about $40 billion. On the expenditure side, automatic budget cuts will be activated, cutting expenditure by $98 billion. Together these actions amount to a downward adjustment in aggregate demand of no less than 4 per cent of GDP. In the worst case, political gridlock would prevent Congress from reaching any agreement, leading to a full-scale drop in government spending by about $98 billion and substantial hikes in taxes amounting to $450 billion in 2013.

["It is reasonable to assume that after realizing the costs to the economy, policymakers will feel compelled to reach an agreement on reinstating those tax reduction measures and on ceasing the automatic spending cuts in the second half of 2013", said the UN.]