SA Financial Markets – Page 7

Volatility update and what it means for the JSE

Investors will be well aware of the extremely wide daily moves on the JSE and other equity markets, such as the benchmark S&P. We show such daily moves below. It may be seen how volatile the markets became during the height of the credit market crisis in September 2008 and have become only partially less volatile since then.

Daily percentage moves in the S&P 500 and the JSE

Cont_9.jpe

Source: I-Net Bridge and Investec Securities

The average moves can only tell part of the story, especially when the movements higher are cancelled by falls in the market. It is the movements about this average that tell us about the extremely volatile conditions with which investors have had to cope recently. Movements about the average are captured by the statistic known as the standard deviation (SD) of a series about its average.

Measuring volatility

Between June 2005 and June 2008 the SD of the S&P 500 Index was less than one per cent per day on average, (0.08011 per day) to be exact. The SD of the JSE ALSI moved on average by 1.1% per day over the same period. Since then the SD of daily moves on the S&P 500 have more than doubled to 2.5% per day on average while the SD of the average daily move on the JSE have almost doubled to 2.1%.

In the figure below we show the volatility of the S&P, the JSE and the MSCI Emerging Market Index since 2005. We measure volatility as the 30-day moving average of the Standard Deviation of the Index. As may be seen the volatility on the different markets are highly correlated indicating just how well integrated global financial markets are. There are no places to hide in equity markets.

It should also be noticed that volatility has receded sharply from the extreme levels of September 2008. Volatility picked up again in January 2009 only to recede again in March. While now significantly lower than it was, volatility is still well above what might be regarded as normal levels, as may be seen below.

Global equity market volatilities

Cont_10.jpe

Source: I-Net Bridge and Investec Securities

Risks and returns – economic theory vindicated

Clearly the more volatile the markets the more risks faced by investors for which they will seek compensation in the form of higher returns. And so as we show below, as the risks increased dramatically so the markets fell away equally dramatically. The recent recovery in the ALSI and all the other equity markets – from their lows of early March – have clearly been associated with less risk. We show below the relationship between the JSE ALSI and the 30-day moving average of the standard deviation of its daily returns. The reduction in volatility has been very helpful for the market. Indeed, without the company of consistently lower volatility it is difficult to predict further consistent advances in the equity markets.

The JSE and its volatility

Cont_11.jpe

Source: I-Net Bridge and Investec Securities

Implicit and actual volatility compared

Another method for measuring volatility is to calculate the volatilities implied in the prices of options bought and sold on the equity market. In Chicago such an index known as the Vix is actively traded – so that volatility itself can be bought and sold. A similar measure of implied volatility is calculated for the JSE and published as the Savi. These measures may be regarded as forward looking measures of expected volatility, and can be compared to the actual volatility registered by the standard deviation of recent daily moves in the Index. As we show below these two measures of expected volatility that influence today’s share prices are also highly correlated, providing further evidence of the integration of global equity markets.

Implied equity market volatility – the Vix and the Savi

Cont_12.jpe

Source: I-Net Bridge and Investec Securities

In this case past performance of volatility does seem to be a very good guide to expected volatility. The 30-day moving average of the SD of the daily moves on the S&P 500 and the JSE Alsi tell very much the same story about volatility as we show below.

Volatility compared – SD of daily returns Vs the Savi

Cont_13.jpe

Source: I-Net Bridge and Investec Securities

Explaining volatility

Clearly returns and risk as measured by actual or implied volatility will move in consistently opposite directions as economic theory would predict. Higher returns after all are the expected rewards for bearing higher expected risks.

The cause of the surge in volatility in mid 2008 is obvious enough. The credit crisis made it near impossible to estimate with any degree of confidence the outlook for real economic growth and so for the earnings of listed companies. The economic outlook had obviously deteriorated but by just how much was impossible to say. Furthermore the credit market crisis itself did more than collateral damage to companies via the state of demand for their products. It made it much more difficult for them to raise finance and when finance was available it had become much more expensive. Thus risks of default and al it cold mean for the value of debt and equity capital increased markedly.

The issue of how to value the future income to be generated by a listed company became subject to most unusual difficulty. The difficulty the market has in estimating value shows up in sharp daily and even sharp intraday moves in share prices. Economic news in such circumstances becomes especially difficult to interpret and consensus about what it all means becomes especially difficult to reach. Hence much reason for changing opinions about the outlook for economies and firms that are reflected in volatile share prices.

Why volatility has receded

Volatility has receded in recent months because, while the outlook for the global economy has not improved greatly, there is much more confidence in economic forecasts. The downside seems now to have a bound to it compared with a few months ago when the downside seemed so difficult to estimate. The recovery in the credit markets has contributed greatly to this. Capital markets have not frozen. The appetite for corporate paper, offering perhaps only temporarily high yields, has been recovered. Companies are raising both debt and equity capital in a very much a normal way. Default risks have receded.

One senses that there is further scope for improvements in both the confidence with which the economic outlook can be forecast. Even if the news about the economy does not show any marked improvement, a stronger sense of what the future holds will reduce fear of the future and the volatilities associated with such fears. It will be much more helpful for equity investors when the forecasts themselves can predict economic recovery with a degree of confidence. If economic recovery comes more firmly into sight, default risks implicit in the still large interest rate spreads paid by corporate borrowers over governments, will recede further to the advantage of their bottom lines. With economic recovery confidence in the survival prospects of the will improve further to the advantage of the equity investor.

The interest rate outlook has become very clouded

One of the uncertainties to be resolved with any sustained economic recovery will be the future of government interest rates themselves. Short term interest rates will rise as economies recover and long term government bond rates will take their cue as always from the outlook for inflation. The outlook for inflation has become particularly difficult to estimate. Central banks in the US and Europe are pumping cash into their banking and credit systems to help encourage lending and spending. The cash in large measure is being hoarded rather than lent or spent. And so deflation rather than inflation remains the immediate threat to the US economy.

The path from deflation to inflation will be a difficult journey

But at some point with recovery, inflation will become the danger to be addressed by the Fed. The issue of whether the Fed can get its timing right to prevent actual inflation from rising is a live one. Good timing – from fighting deflation to fighting inflation – will be made all the more difficult by the surge in US government borrowing that will continue for years putting pressure on long term interest rates. Such pressure, when it occurs, will add temptation in the form of monetising the debt as a temporary alternative to the sting of higher interest rates.

Interest rate volatility

We show below just how much more volatile US long term government bond yields government have become. These volatilities also measured by the 30 day moving average of the SD of daily interest rate moves increased greatly in the midst of the credit crisis. They increased even as government interest rates fell which was result of the greatly increased demand for default free safe havens. But these volatilities remain highly elevated and such risks will not only influence the government debt markets, they will also make it harder for the equity markets to perform well. It is of interest to note that US bond yields have been a lot more volatile than long dated RSA yields

The volatility of long term government bond yields. USA and RSA

Cont_14.jpe

Source: I-Net Bridge and Investec Securities

Interest rates and the equity markets

In our view the uncertainty about the inflation outlook in the US and elsewhere and the direction of interest rates has already entered the equity markets, to its disadvantage. To be equity market bulls now would require optimism about the outlook for economic recovery and optimism in the ability of the Fed to negotiate successfully the fork in the road when it points to inflation rather than deflation. Furthermore the bond market will have to share this confidence in the excellence of Fed timing. This confidence would show up in lower volatility of interest rates. We will be watching trends in the volatility of equity markets and debt markets very closely as a guide to the direction of the equity markets.

The US dollar as a reserve currency – the jury is out on this one

Reserve currencies – what they are

A much discussed topic lately is the role of the US dollar as a reserve currency. The US dollar is held as a reserve of international purchasing power or liquidity by governments, banks and firms. The US dollar is mostly nominated as the basis of contracts, as the unit for transacting and accounting purposes, across borders between parties outside the US. It was because of the large role played by US firms in global trade and finance that the US dollar became the reserve currency of choice in the twentieth century increasingly replacing the pound sterling as the predominant unit of account in international transactions. The pound sterling had gained this role because of the earlier dominance of the UK in nineteenth century global trade and financial flows.

Until the early seventies the US dollars held by foreign central banks could be exchanged for gold at the rate of 35 dollars per Troy ounce of gold. Since many other central banks also kept their gold at Fort Knox in Kentucky such transactions would take the convenient form of moving gold from one part of the fort to another. The US unilaterally went off the gold standard in 1971. The UK gave up its willingness to exchange gold for pounds finally in 1932 after earlier phases of inconvertibility during the Napoleonic and First World Wars and their aftermaths. Gold is still held as a minor source of international purchasing power by governments and their central banks – still often safely stored for them in Fort Knox.

Reserve currencies emerge in response to market forces

Reserve currencies are not declared by some international agency – they emerge in response to the global needs of trade and finance. The possibility of one reserve currency increasingly replacing another is clearly always possible given the freedom contracting parties have to nominate a convenient unit of account in which to conclude a contract. Governments and banks also have the freedom to choose the most helpful currency or currencies in which to hold their reserves of international purchasing power. These reserves are mostly kept in the form of US dollar deposits in foreign banks including other central banks. Reserves of liquidity are also kept by in the bills and bonds issued by the US government that pay higher rates of interest tan bank deposits.

The advantages to the issuer of a reserve currency

The advantage to the issuer of a currency or bonds or bills held as reserves by others is that these demands reduce their costs of funding government expenditure. The notes issued by a central bank are the non-interest bearing liabilities of the issuing central bank. That foreign holders of these notes, in addition to their domestic holders, are prepared to forgo interest on the their cash – for the convenience it offers – including the ability to evade surveillance by tax authorities – makes issuing notes a particularly cheap source of finance for the government. A large proportion of the actual greenbacks are in fact held outside of the US so helping to fund US government spending.

The costs of issuing notes

Not that issuing the notes is without its costs – the costs are incurred in the protections the issuing government that have to take against counterfeiters as well as highjackers of cash in transit. Government have to insure the safety of the notes issue if economic actors are to be willing to hold them. The difference between the interest governments save by issuing notes rather than bills and bonds and their costs – including the costs of staffing their central banks – is called seignorage and is implicit in the dividends central banks declare to their governments. In South Africa unusually, this central banks income from issuing non interest bearing notes, is still shared in small part with some private owners of Reserve Bank debt in the form of a fixed coupon payment.

The essence of a well respected unit of account and reserve currency

Domestic currencies serve perfectly usefully as the unit of account for the many contracts entered into between domestic parties. Both domestic parties will be well aware of the real value of the contract when fulfilled. Clearly for a foreign currency to be nominated as the unit of account in a contract indicates that something must be considered unsuitable in the domestic currency by one or other of the parties involved. This unsuitability presumably arises out of the relative unpredictability of the exchange value of the domestic currency. Presumably reserve currencies must offer predictability in the rate they can be exchanged for domestic currencies.

Does the US dollar meet the criteria – does any other currency?

An essential quality of a reserve currency must be the predictability of its rate of exchange for all other currencies. It is surely this lack of predictability of the exchange value of the US dollar that calls into question its continued role as the predominant reserve currency. Clearly if a reserve currency strengthens this will be highly acceptable to its holders and vice versa will be uncomfortable when it generally weakens against other currencies. However even unpredictable strength will make the currency less useful for purposes of trade or finance. The requirement is rather predictability of value though predictable strength rather than predictable weakness will clearly to be preferred by holders of a reserve currency.

The US dollar has not been very predictable – not that it has been a one way bet

We show the exchange value of the US dollar against the other major currencies in recent years. Higher numbers indicate strength. As may be seen the US dollar was very strong in the mid eighties. It weakened sharply in the late eighties and traded at these weaker levels more or less stably until the mid nineties when a further period of pronounced strength emerged that was reversed over much of the past decade.

The US is extremely reluctant to commit itself to policies that would stabilise the US dollar at the possible expense of the US economy. But unless its attempts to stabilise the US economy help co-incidentally to stabilise the US dollar far better than has been the case over the past 30 years, the suitability of the US dollar or other US government liabilities as a reserve will remain a live issue. But no other currency has presented itself as suitable as is the US dollar for the purposes of undertaking global trade and finance.

Gold is still making a case as a reserve

No other country, or in the case of the euro, the European governments collectively, seem willing to commit to currency stability while also allowing currency convertibility. The Chinese may offer predictability in the yuan – but not easy convertibility. They fear how such a commitment could qualify them for reserve currency status. They are aware that such a commitment, even when believed, may constrain their freedom to manage their domestic economies. The contest for global currency supremacy can however never be regarded as decided as over. It remains up to the market place and government policies to decide the outcome. While the outcomes remain particularly uncertain as they now are gold is likely to retain its appeal as a contingency against the unpredictability s of other stores of value

FRED Graph

Long term interest rates in the US: What they tell us about growth and inflation

The big story last week

The big market news last week was about the extraordinary volatility of long term interest rates in the US. The yield on the 10 year Treasury bond began the week at 3.4% then reached 3.8% on the Wednesday only to fall back again to 3.4% by the week end. Their current yield is 3.55%. The similarly dated inflation protected bonds moved broadly in the same direction though as may be seen the compensation for inflation risk assumed by the investor in vanilla bonds increased by 10bps to 1.9% in mid week to then fall back again and also end the week largely unchanged.

US 10 year Treasury Bond Yields – Inflation linked (LHS) and Nominal (RHS)

Source: Bloomberg and Investec Securities

Inflation compensation in the US government bond market – May 2009

Source: Bloomberg and Investec Securities

What happened to nominal and real yields these past twelve turbulent months

In the figures below we show these trends over the past turbulent year. As may be seen the gap between ordinary bond and inflation linked bond yields in the US closed almost completely at year end. Thereafter the inflation protected (TIPS) yields fell away while that of the ordinary bonds rose from their lows of 2%. Thus inflation compensation of 2.5% pa provided by nominal bond yields shrunk to about zero at year end from which they have recovered to their current levels that are still below 2%.

Explaining real and nominal yields

Ordinarily these real bond yields reveal the real state of the global capital markets. When the global economy is expected to grow strongly the extra demands for real plant and equipment and the capital to finance growth in the real capital stock pushes up real benchmark yields (these are well represented in the global capital market by the yield on US TIPS). When the economy is expected to slow down, demand for capital falls away and real yields decline again. Thus these real yields ordinarily are a very good indicator of the expected state of the global economy.

The increase in real yields that occurred at the height of the credit crisis surely requires a different explanation. It suggests that only the safest haven, vanilla bonds, issued by the US government escaped the liquidity pressures of that time. It may be seen below that nominal Treasury bond yields fell away while initially the TIPS yields rose again. That these yields came together again by year end suggests that fears of deflation rather than inflation came to dominate market sentiment.

US T bond yields May 2008- May 2009

Source: Bloomberg and Investec Securities

US bond market; inflation compensation 2008-2009

Source: Bloomberg and Investec Securities

Interpreting the bond market in normal times

Thus we may summarise the evidence provided by bond markets in normal times. The real yields provided by the inflation protected securities (TIPS) tell us about the state of the economy. The higher these yields the more promising is the global economic outlook. Thus the modest increase in real yields recorded recently does help confirm an improvement from the depressed state of the global economy.

The yields on vanilla bonds have to offer compensation for the inflation expected by bond holders. Any increase in inflation detracts from the purchasing power of the interest income bond investors depend upon. Therefore they seek protection from such losses in the form of higher yields. The difference between the higher yields on ordinary bonds and the lower yields on inflation protected bonds issued by the US government tells us just how much inflation protection or compensation the holder of vanilla bonds is receiving.

Winners and losers from unexpected inflation and growth

If inflation expected over the long term tenure of the bonds rises unexpectedly the holders of ordinary bonds lose out while the holders of the inflation protected bonds will gain. Vice versa when long term inflation turns out to have been overestimated by bond investors, and ordinary bond yields decline with real yields on the TIPS unlikely to be much affected by the inflation outlook alone.

These real yields will be affected however if more or less inflation expected is combined with changing expectations of for real economic growth. If more inflation is expected to slow the economy down, that is fears of stagnation with inflation (stagflation) become pronounced, ordinary bond yields will go up and real bond yields will retreat.

The holders of vanilla bonds will lose as the search for protection against more inflation forces nominal bond yields higher and the prices of bonds lower. The holders of TIPS will at the same time benefit from downward pressure on real bond yields and upward pressure on the market value of the TIPS, as the stagnating economy is expected to reduce the demand for capital and so the returns to be expected from all classes of financial securities, including equities. Vice versa less inflation should be associated with faster growth as economic theory suggests.

Thus holders of vanilla bonds fear inflation eroding their incomes. Holders of inflation linked bonds are completely protected against the risks of more or less inflation. However the costs of this protection will depend on the ever changing outlook for real growth and inflation. A combination of faster economic growth with very low inflation will drive real yields higher and so the value of the long dated TIPS lower.

With large government deficits the outlook for inflation and growth remains unusually uncertain – expect volatility

The outlook for global inflation is particularly uncertain at present – hence the extreme volatility of long dated government bond yields. The US government is planning to spend far more than the tax revenues it expects to collect – at the rate equivalent to 12%-13% of GDP over the next two years. This means a great deal more government borrowing and the government debt to GDP ratio is expected to double from its current ratio of 40% of GDP over the next ten years. This means an ever increasing share of US government spending will have to go to paying interest rather than providing for much more popular other forms of government spending.

Getting back to comfort levels is going to take a long time

Getting this debt to GDP ratio back to more comfortable levels any time soon is very unlikely. It will take a combination of a smaller government relative to the economy and higher government revenues. Given the weak expected state of the economy, cutting government spending will seem a particularly unpopular direction to take. Current spending increases inevitably become permanent entitlements. Furthermore, given the weakness of the economy any higher tax revenue to be raised would have to come from higher tax rates rather than a more buoyant economy. And higher tax rates in turn threaten the growth outlook. Thus the pressures on the US government to print money to fund its spending rather than face up to tough choices will mount.

The Fed will be called upon to act with determination and excellent judgment

It is the task of the independent US central bank, the Fed, to very actively resist monetising the debt. There is every good reason to expect the Fed to resist with all the powers at its disposal. However the Fed has already been printing money on a vast scale, not to fund the government but to help the credit and money markets overcome their liquidity fears. Overcoming these fears and the preference of the banks to hoard rather than lend the cash made available to them is essential if the economy is to recover.

The Fed therefore has unusually difficult seas to navigate successfully over the next few years. It must be able to resist monetising government borrowing that will be growing rapidly and borrowing that in time will come to crowd out private borrowers and capital formation by the private sector – diminishing growth prospects. It must also be able to withdraw cash form circulation as the propensity of households and firms to spend more gains momentum. Getting the timing right here so as not to nip any incipient recovery in the bud, while remaining steadfast in the face of higher levels of government spending and higher long term nominal interest rates, will not be easy for the Fed.

Expect volatility in government bond markets and for inflation linkers to be attractive

For all these reasons US and global inflation expected over the next ten years will prove very difficult to forecast with any degree of accuracy. Accordingly nominal government bond yields are likely to remain volatile, while the outlook for real growth remains subject to above normal degrees of uncertainty. If so inflation linkers issued by governments provide an unusual degree of comfort for potentially troubled and inflationary times.

Encouraging declines in risk aversion

It was not a good week for global equity investors with the Emerging Market Index down 2.4%, the S&P 500 down 5% and the small US cap Russell 2000 off nearly 7% by the weekend. The SA component of the MSCI EM Index fared relatively well and was 1.5% weaker in US dollars. The rand investor on the JSE suffered only marginal weakness with Industrials up 2% and Resources off a little more than 2%. The rand ended the week nearly 5% weaker vs the USD and on a trade weighted basis.

Continue reading Encouraging declines in risk aversion