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"BULL", "BEAR" OR "PANDA"? The market may be bullish or bearish. For the moment it looks rather like a giant panda in captivity. No one disputes the thesis of investments. This change in faced with the threat of a a market rally powered by preferences could become a collapsing Euro system, and expansionary durable trend, and this is why. the skyrocketing safe haven monetary policies. Some are hoping that a sustained macro- assets, like the Swiss Franc. A WELL BRED BEAST economic growth and a very Then, the ultra-expansionist progressive ascend of interest First there were the long series Japanese policy of PM Abe rates will support current of Easing's” to emerge from 20 years of prices. Others which pulled down US interest deflation propelled the Nikkei anticipated a dive of the rates and the Dollar, while the by bond market which did not perception of country risk in depreciated the Yen by 20%. happen yet. But no one really America knows intact. securities how exactly unprecedented the transition from of a policy of long “Quantitative was These more than 60% and remaining interventions Finally, the phasing out of the biased the risk and return "Quantitative relationship reassured investors about a and pushed Easing" lasting negative real rates durable resumption of growth towards a more conventional in the United States, and policy will work. A wait-and- The giant panda is a interest rates hit 2% again in see stance prevails among mammal, pampered by the May 2013. The free fall of gold shareholders and bondholders, who had their equity gaining months and 14% their in 12 bonds indices rising 3% in the same Chinese and Japanese. In captivity, it is bred with bamboo despite its price last year was in part rationally related to the anticipations of a tapering. Nevertheless, the opened investigations and complaints carnivorous nature. period. Nonetheless, since the against many banks (Société first announcement by the investors to accommodate Générale, FED of a tapering, in June investments more Barclays, Bank of Nova Scotia 2013, some trend reversals risky, like emerging countries, and HSBC) confirm that the appeared in different market while justifying their sudden magnitude sectors. appetite the decline was also linked to a growth massive price manipulation, These described further simultaneous deemed for risk argument of events, which are apparently differentials independent regions(however from each other, may have a common denominator: with between valid over the very long term). we had the reassuring statements and the appetite measures safe haven based of trade. Then, and consequently the reborn for we European taken Central of had on gold Bank, price suspected improbable intraday quotes and volumes the normalization of risk aversion which Deutsche by the Bank, Paolo Campolo, CFA 03 June 2014 JUNE 2014 SIGNS OF WEAKNESS Margin trades are leveraged securities purchases by borrowing from the brokers. Margin debt moving averages ratios formed similar peaks months before the bursting of the internet and subprime bubbles. Beyond any hazardous prediction of a crack, this is surely another valid proof of a decreasing risk appetite. After May 2013, some curious market trends also started, indicating all but market confidence: Increasing risk aversion: (Figure 1) The emerging bonds and their currencies tumbled. If the returns of US Treasury securities increase for the same level of risk, the return of emerging countries must do the same. Thus, the current price of emerging countries securities must go down. The normalization of the risk and return relationship in Treasury securities was transferred immediately to other asset classes. (Figure 3) In May 2013 the Swiss Franc started a rally against the Euro and the Dollar. (Figure 2) in January 2014 gold reversed its downtrend. Strangely enough, the safe haven investments were gaining ground again. (Figure 6) While the 10year Treasury rates started to go down in May 2014, utilities and staple, the non-cyclical sectors, suddenly had the preference over technology or discretionary goods, as doubt was mounting about the coming economic cycle. (Figure 7) We discovered a recent sharp contraction of the aggregated margin debt volumes in the New York Stock Exchange after reaching historic highs. Lower rates expectations: (Figure 2) From early 2014 the 10-year US Treasury interest rate undertook a descent, which means that investors doubt that long term rates are due to increase systematically as a consequence of an economic recovery. (Figure 5) In Japan, despite the return of inflation hitting 3% in the first quarter of 2014 under the effects of the monetary policy and the increase in VAT, the JGB interest rates remained virtually unchanged. This reflects a clear distrust of the Japanese themselves, main buyers of their own debt, regarding future rate hikes under the recovered inflation. (Figure 4) The evolution between the commodity and S&P500 indices became convergent and decorrelated. This configuration was observable during periods between 1997 and 2000 and between 2006 and 2008, prior to the bursting of the internet and subprime bubbles. It says that the interest for raw materials assets is growing among investors at the expense of income assets. Meaning a revision of expected fixed and variable income returns. By evidence, the markets are pricing in both low long term investment rates and a higher risk aversion. THE GIANT PANDA, AN ENDANGERED SPECIES How can we explain these hesitations while the consensus among financial remains very analysts optimistic concerning the future growth, especially regarding the USA and China? The Ukrainian conflict or the threat of deflation in Europe (with price growth of only 0.5% in May requiring ECB action) do not suffice to explain the flat interest rates in the USA and in Japan or between the decoupling margin debt and stock market indices. Therefore, we may need to seek the reasons of this mistrust elsewhere. There must be a recognized systemic risk factor that creates uncertainty because monetary authorities may be forced to keep rates low in spite of ramping inflation and growth. Since 2008, governments and central banks were fighting against systemic risks in the banks sector. It is still hard to say whether some dead cats remained in the closets. The recent outrageous JUNE 2014 manipulations of gold price, between foreign exchange and Libor and the anvil. one deal rates casted doubts about the hand, rising interest rates could With integrity large jeopardize their chances to demographics, the fear of a institutions. There may still be a meet their bond obligations. bursting bubble in China and significant but On the other hand, inflation is Asian partners who purchase that the lesser of two evils, as it 35% of Japanese exports (the reduces the burden of debt. last 'Global financial of these systemic players risk, know nowadays massive injections of the hammer On the liquidity are commonly used broad-spectrum with these obligations. a moribund Housing Watch' report by the IMF reveals the to (Figure 8) When we simulate risks of the current global real avoid domino effects within the the impact of an interest rate estate interbank system. hike of 2%, based on the Hong existing debt and budgets of Malaysia, Some point an accusing finger the USA, Japan, France and and Indonesia at the top of at the derivatives market. But Spain, countries with the largest price only a minority recognized yet seriousness of the problem. The escalation the simulation of the capacity to unbearable pay interest, takes into account dependence the following parameters: and 1. A growth rate of national expenditure and revenues equal to the currently budgeted GDP growth. A sudden increase in interest rates of 2% in the first year. The current structure and average maturity of the national debt maturity. expensive things we consequences that go beyond Obviously, there will be a limit calculate the evolution over 10 the economy. The financial sometimes. this years of Interests to revenues, world question is not yet a widely debt to GDP and Deficit to Japanese politicians on their shared concern topic. On the GDP ratios assuming that debt achievement other hand interest rates could increases with the prior year monetary policy, well be the true source of deficit: breeding and huge therapies imagine a stifling tax burden to systemic risk it represents. There is however a major risk known to all. It is the impact of the dizzying debt, as a direct consequence of the multiple bailouts and 2. economic stimulus. It has been extensively 3. discussed whether the USA will be able to national increase debt their indefinitely. However, All we realize being equal, the concern because it poses a risk to the stability of the markets. The direct effects of rising interest rates on the cost of national debts, is worrisome. The rates hikes are the corollary of inflation much sought by central bankers, according to their mission of price stability. Sadly, most economies that developed tested the monetary expansion are now bubble Kong, the with China, New Zealand, Australia, Thailand in 2013), an energy after Fukujima reminiscences militarization, of the end would more resemble the Sepukku of the Emperor than the last sighs of the giant panda. Japan is still the third biggest economy in terms of GDP. A Japanese shipwreck would have immeasurable may congratulate through but raising their after the market beast in captivity, this Japan: Japan entered a budgetary impasse. Already half of the income is used to pay the is masking the destruction of the species' natural habitat. USA: interest on the debt. A sudden The 2% rate hike increase would capital factors in the USA mark force Japan to dedicate all of them out as a very resilient its revenue to the service of economy debt in 8 years, with a debt to GDB ratio of 300%. One can flexibility . of work However, and an interest rate increase could plunge US into costs of debt JUNE 2014 equivalent to 20% revenues. The of the numbers of Well before the deadline of an imbalance of a national Spain, two years ago in the treasury, the citizens will protest middle of the “PIGS” crisis. for the withdrawal of public services and foreign investors France: which Despite a cost of debt which could reach 40% of revenues in 8 years and a galloping debt ratio, it still proudly bears the AA rating from Standard & Poor's. With characteristics, a these sneeze of global growth would put this country at the edge of the precipice. due to the 100% increase of public debt in 12 months and despite a structural deficit of 3%, 3 times lower than France. The simulation shows that, all other things being equal, the service of the Spanish national debt could total 50% of the revenues in 8 years, which is the situation of bigger simulation does not taken into account the vicious circle of the growing risk premiums. Therefore, under this additional effect Japan would go bankrupt in much less than 8 years. All these elements highlight the of recovery Spain still suffers a BBB credit require guarantees for lending. Our fragility Spain: rating, will in the economic the developed countries and the imminence of the problem of the sustainability of national debt. The investors do not ignore the problem. They are progressively pricing in this risk and anticipating that rates will stay low to avoid the fatal outcome. Equity and bonds which have not yet been affected by the re-pricing may well be the next on the list. All Japan today. The estimate is were expecting a decrease of conservative because we do obligations prices under the not take into effect of controlled rate hikes. regions debt. account the Now, they would better focus on increasing risk premiums. JUNE 2014 Figure 1 Figure 2 June 2014 Figure 3 Figure 4 June 2014 Figure 5 Figure 6 June 2014 Figure 7 Figure 8 Sources: NYSE, Bloomberg, Financial Times, Standar & Poors, International Monetary Fund, Trésor Francais, Sénat, Ministry of finance Japan, Heritage Foundation, OECD, Ministerio de Hacienda, Tesoro, Lombard Odier