Dean Curnutt, president and CEO, Macro Risk Advisors
Investors have long evaluated opportunities in markets based on some combination of micro and macro factors. For fundamentally oriented investors, it is company specific fundamentals that matter most. Management quality, earnings consistency and growth, balance sheet integrity and an attractive valuation multiple are among the many metrics used by investors in choosing single name equity and credits to buy or sell. Other investors take a more top-down approach to deploying capital. For those whose process is macro focused, it is factors such as the pace of global economic growth and the path of interest rates and inflation that motivate the allocation of capital across geographies and asset classes.
The 2008 credit crisis has complicated traditional bottom up and top down investing styles. Whether approaching risk on a micro or macro basis, today an investor must now incorporate two additional classes of risk in evaluating opportunities. First, the deleveraging event that toppled major banking institutions globally has illustrated that the system itself is a risk that must be carefully monitored. Systemic risk, as was added to Merriam-Webster’s dictionary this year, reflects the notion that in a vastly interwoven system of financial counterparties, the failure of one entity can be quickly transmitted throughout the system at large, with potentially destabilizing consequences.
A second, related form of risk that investors must now contemplate is the manner in which policy decisions impact the direction of market prices. In seeking to rescue the system in 2008 and early 2009, central banks and governments worldwide crafted a string of facilities designed to backstop systemically important financial institutions and boost market confidence. Four years later, while markets have largely stabilized, governments remain a key player in determining market outcomes. Policymakers now use these ongoing concerns about another financial crisis to justify such an active level of market intervention.
Of course, nowhere is the interaction between governments, the financial system and market risk so prominent today than it is in Europe. The degree of dysfunction in Europe cannot be understated: markets have rightly questioned the solvency of both banks and certain governments.
In some cases, like Ireland, governments have sought to stabilize banks, with disastrous consequences. In others like Greece, banks have invested significant capital in the government bonds of their home country. A default by the sovereign would instantly cause a run on the banking system. The severity of the bank/sovereign feedback loop has left the European Central Bank (ECB) with little choice but to explore the use of unconventional and controversial policy tools that seek to stem the self-fulfilling increase in the financing spreads of weaker Euro zone countries and their banks.
In a late July press conference, ECB President Mario Draghi provided the market with the strong words that, “within our mandate the ECB is prepared to do whatever it takes to preserve the Euro.” The forceful rhetoric has inspired a tremendous rally in the assets of most concern in the Euro zone, namely bank equities and government bond spreads for Spain. To illustrate this point, the chart below shows the performance of the SX7E index (Eurostoxx Banks index), as well as the spread of 2-year Spanish sovereign bonds to those in Germany since July of 2012. The actual date of the press conference, July 26th, is highlighted through the vertical line.
Further insight can be gained on the strengthening role that government intervention is playing on markets through the table below. Here, the 2012 top five largest one-day gains and losses in the S&P 500 are shown along with an assessment of what drove the price movement that day.
While there is an array of complex factors at work every day in markets, the big picture take-away from the table should be clear: it appears that down days in the markets have been driven by disappointing economic data while the large up days in markets are often linked to promises from European policymakers to alleviate worsening financial conditions. This mix is extraordinarily unhealthy.
In an environment where the sovereign debt crisis may transmit contagion to other markets, investors have rightly focused their attention on gauging the extent to which Angela Merkel and Mario Draghi will backstop the Euro zone. That said, investors must now devote time to understanding the impact that US policymakers may have on market prices as well. The politics of the so-called “fiscal cliff” in the US are very real and are vastly complicated by the upcoming Presidential and Congressional elections.
As markets learned in August 2011 with the brinksmanship that characterized the negotiations on raising the US debt ceiling, policy uncertainty can play a damaging role in investors risk perceptions. Recently, House Speaker John Boehner was quoted as saying that he’s “not confident at all” that a bi-partisan agreement on deficit reduction could be reached. Adding another dimension to the fiscal cliff is the role of ratings agencies. Moody’s recently warned that it would expect to lower its rating of US government debt should the negotiations on the fiscal cliff not be successful. In the US, this policy-driven risk factor must be watched closely.
Traditionally, investors have sought to identify investment opportunities through some combination of bottoms-up and top down analysis. In today’s risk paradigm, however, these micro and macro techniques need to be augmented with some assessment of the impact that policymakers may have on markets. This is certainly non-traditional risk management, but as governments have become an increasing part of the risk/reward dynamic, investors must keep a close eye on the words and actions of policymakers. The polarized US political climate means that consensus is elusive and creates more potential that market volatility will arise from the uncertain path of policy.
Dean Curnutt is CEO of Macro Risk Advisors LLC, an equity derivatives strategy and execution firm which specializes in translating proprietary market intelligence into actionable trade ideas for institutional clients. The New York-based firm is a registered broker/dealer with the FINRA.