TWN Info Service on Finance and Development (Mar17/02)
13 March 2017
Third World Network

Swings in investor risk appetite play less of a role in driving valuations
Published in SUNS #8418 dated 9 March 2017

Geneva, 8 Mar (Kanaga Raja) -- Asset returns have become less correlated across classes, regions and sectors, suggesting that during the period under review, central bank decisions and the associated swings in investor risk appetite were less of a driver of overall valuations, the Bank for International Settlements (BIS) has said.

In its latest Quarterly Review of March 2017, the Basel-based central bank for the world's central banks pointed out that the close co-movements that characterised markets during much of the period following the Great Financial Crisis (GFC) seem to have broken down.

Many asset prices have traded sideways since the release of its previous Quarterly Review in early December, while investors waited for clues on a number of sources of uncertainty, said BIS.

"Market participants expected a change in the policy mix in the United States, with a greater role for fiscal policy, continued gradual tightening of monetary policy, a push for deregulation, and a more protectionist trade stance."

However, said BIS, the precise nature and timing of policy changes and their impact remained unclear. In February, stock markets rallied in the United States, while sovereign yields in a number of euro area countries came under pressure as investors shifted their focus towards political uncertainties in Europe.

At a media briefing in Basel on 3 March (posted on the BIS website), Mr Claudio Borio, Head of the Monetary & Economic Department, said that politics tightened its grip on financial markets in the past quarter, reasserting its supremacy over economics.

He said: "We left markets in December just as they had turned on a dime following the US presidential election, shrugging off previous long-standing concerns about a future of stagnant growth and stubbornly low inflation. All the talk was about a revival of ‘animal spirits' and ‘reflation'. The mood hardly changed thereafter, supported by better economic data."

But with market participants waiting with bated breath for concrete new evidence of policy measures, asset prices moved without a clear direction.

"It was as if, after an unexpectedly rich meal, investors had to take their time to digest it. As a result, central banks once more stepped back from the limelight," he said.

Against this backdrop, the precipitous decline in correlations across asset classes, sectors and regions intensified. In line with the reflation trade, US equities surged and Treasury yields stayed high, while the dollar sustained its November gains.

Even as the US stock market posted a strong performance relative to those elsewhere - to the point of reigniting familiar debates about possible overvaluation - there were clear winners and losers across sectors, reflecting expectations of the new administration's policy choices.

"The breakdown in correlations stands in stark contrast to most of the post-crisis experience, when successive waves of risk-on/risk-off behaviour tended to raise and lower all boats. This break with the past is yet another sign that the markets' close dependence - dare I say over-dependence - on central banks' utterances and actions was at least temporarily weakened during the quarter," said Mr Borio.

He added that political events cast a shadow in the euro area too, influencing asset prices there and promoting divergence.

Reflecting growing political uncertainty about future election outcomes, sovereign spreads widened, including the all-important spread between French and German government bonds.

"Political events in advanced economies have put the spotlight on vulnerabilities in emerging market economies (EMEs). These countries have been caught between a rock and a hard place, the rock being the prospect of a tightening of US monetary policy (even if gradual), an appreciating dollar and their FX currency debt, and the hard place the threat of rising protectionism."

According to Mr Borio, this sensitivity is evident from the relative performance of their exchange rates, which has been closely tied to their US trade exposure.

Still, during the period under review, market sentiment improved, with exchange rates, equity prices and credit spreads recovering further from the losses incurred in November, on the back of renewed flows into EME funds.

"In more ways than one, the long shadow of the Great Financial Crisis (GFC) is still hanging over us. All this underlines the importance of understanding developments in US dollar funding markets, given the dominance of the currency in the international monetary and financial system," he said.

According to the BIS report, a salient feature of recent market developments was the broad dispersion of returns across asset classes, economic sectors and geographical regions.

Cross-asset correlations, which had gradually been declining since late 2015, plummeted after the US election in November.

This contrasts with much of the period that followed the GFC when stock markets in advanced and emerging economies, EME sovereign spreads, AE (Advanced Economies) long-term yields, the dollar, and corporate spreads in both advanced and emerging economies seemed to move in parallel.

"In a global environment devoid of growth but plentiful in liquidity, central bank decisions appeared to draw investors into common, successive phases of buying or selling risk. The recent collapse suggests that the common factors that had until recently been driving returns further weakened their grip on markets during the period under review."

Returns became less correlated as policy uncertainty jumped to the foreground. Uncertainty persisted about the timing and quantum of a number of policy adjustments in the United States, even though the incoming administration reaffirmed its commitment to an agenda of deregulation, fiscal expansion and trade deficit reduction.

The range of possible policy outcomes also appeared to widen in the euro area as a busy electoral year got under way.

All this contributed to a surge in indicators of policy uncertainty both in the United States and globally. Despite this uncertain backdrop, stock markets in AEs held the ground gained after the US election, and even moved upwards in February.

But significant differences across sectors and countries became apparent. In the United States, there were clear winners (defence, construction, financials, manufacturing, small firms) and losers (import-intensive sectors) even as the overall indices reached new highs.

In Europe and Japan, stock markets stayed relatively flatter throughout this period. In EMEs, equity valuations recovered substantially, offsetting and in many cases reversing the losses suffered in the immediate aftermath of 8 November. But the upturn was uneven across EME regions.

BIS said the solid performance of stock markets was buoyed by convincing signs of sustained improvement in the global economy.

Market sentiment indicators improved in major AEs following the US election. This echoed strengthening consumer and business confidence, which in the United States reached levels not seen since late 2014, when the Fed was winding down its last programme of asset purchases amid market buoyancy.

The improvement in confidence was more modest in other AEs, but it was enough to overcome the negative impact of Brexit.

With an improved growth outlook, and as expectations of changes in fiscal and other policies took centre stage, monetary policy moved to the background.

The FOMC (Federal Open Market Committee) increased the target range of the fed funds rate by 25 basis points in early December, while the "dot-plots" suggested that FOMC members anticipated three more 25 bp (basis points) hikes during 2017. Investors seemed to expect one rise in the policy rate by May or June, followed possibly by a second in September, with a third remaining a distant prospect.

Meanwhile, the ECB (European Central Bank) and the BoJ (Bank of Japan) stayed the course of "lower for longer".

In mid-December, the ECB announced that, starting the following April, it would slow the pace of its asset purchases from 80 billion euros to 60 billion euros, but also extended the duration of its purchase programme until December 2017.

The BoJ upgraded its assessment of the economy, but maintained all policy settings unchanged: a negative rate on excess bank reserves, a zero target for the 10-year Japanese government bond yield and purchases of 80 trillion yen per year.

Short-term rates reflected the divergence in monetary policy expectations: the spread between the dollar's forward short-term rates and those of the euro and yen, which had surged after the election, jumped again when the Fed increased its target range.

Subsequently, the gap between the rates moderated.

Core fixed income markets stabilised after their broad November rout. In Germany, the United Kingdom and the United States, the spread between 10-year and one-year yields see-sawed from December to February.

The initial increases in long-term rates were driven in large part by a decompression of the term premium, with the estimated premium returning to positive levels in the US and becoming less negative in the euro area, said BIS.

Some signals of tension resurfaced in the euro area sovereign bond markets. Spreads in government bond yields vis-a-vis German bunds widened sharply in the initial weeks of the year.

"While there were heightened tensions about the implementation of the Greek adjustment programme, the pressure on sovereign spreads seemed more related to heightened political uncertainty. In particular, investors appeared unnerved by the possible policy implications of electoral contests in some euro area members in the year ahead."

The US dollar, which had strengthened significantly in November and December, weakened on a broad basis in January despite the support provided by existing and expected interest rate differentials. The partial reversal seemed related to the impasse besetting the economic policy pipeline amid the political transition process.

The Fed's concerns about the detrimental impact on the economy of a stronger dollar, as expressed in the minutes of the December FOMC meeting, may have played a role as well, said BIS.

Still, the US currency kept a large fraction of the gains made since the election, especially vis-a-vis the yen.

Sterling received a small boost from the strong performance of the UK economy towards the end of the year, and it seemed to benefit from greater clarity about the expected outcome of the Brexit process.

Equity market rallies in the large economies were matched by lower spreads in credit markets. After narrowing in November, the spreads of European and US corporate investment grade credit remained essentially unchanged thereafter. High-yield spreads continued to fall throughout the review period, and US high-yields trimmed the differential with their European peers, to a large extent because of the improvement in credit spreads for firms in oil-related businesses.

BIS further pointed out that money markets also stabilised. As money market fund reform was implemented in the United States, the Libor-OIS spread steadied around 35 bp, some 20 bp above the pre-reform level. The five- year euro/dollar cross-currency basis swap spread fluctuated around the 45 bp level, as it has since the end of Q1 2016.

Funding conditions continued to be a bit more stretched in the yen market, where the longer-term basis reflected Japanese banks' structural need for cross-currency swaps to fund long-term dollar assets.

In shorter tenors, however, the yen/dollar basis fell significantly, in part because of calendar effects.


BIS said investor sentiment towards EME assets improved during the period under review, reversing the sell-off that followed the US presidential election.

In line with the dispersion in asset returns, the extent of the reversal differed across major emerging market regions and countries, reflecting differentiated expected impacts from prospective US policies.

"Ultimately, however, many EMEs appeared caught between the prospects of heightened protectionism and the financial fallout of a significantly stronger dollar."

From late November, said BIS, depreciation pressure on EME currencies eased and stock prices rebounded, while sovereign spreads narrowed, retracing all the increases posted in November.

Central and eastern European markets were least affected, due possibly to their limited trade and financial connections to the United States. Latin American countries - excluding Mexico - also did well, possibly benefiting from higher commodity prices.

On the other hand, the currencies and equities of Asian countries, which have closer direct and indirect trade links with the US, did not improve as much.

Capital outflows moderated in December and turned to inflows in January and February, resulting in a net inflow of $14 billion into EME funds after two consecutive months of losses. The cumulative net outflow in the last two months of 2016 was slightly over $29 billion.

BIS said: "Judging from exchange rate movements, market participants seemed to fear that a sharp reduction in international trade flows could bring heightened stress to some EMEs."

The size of the bilateral trade surplus vis-a-vis the United States has been a relevant factor in explaining the difference in the recent depreciation of EME currencies vis-a-vis the dollar, said BIS.

While large exporters to the US, such as China and Mexico, were in the spotlight, a shock to global trade could spread more widely through the disruption of global value chains, it cautioned.

"Moreover, market developments reflected concerns that a stronger dollar and higher interest rates, on the expectation of fiscal stimulus and monetary normalisation in the United States, could put pressure on EME borrowers' balance sheets."

The amount of outstanding US dollar-denominated securities issued by EMEs rose from $509 billion in 2008 to $1.25 trillion as of end-September 2016 on a residence basis.

Around 40% of these were issued by non-financial corporations. Total US dollar debt (including bank loans) of EME non-bank borrowers stood at $3.6 trillion at end-September 2016.

As a fraction of GDP, however, total EME debt denominated in foreign currency is still below the levels observed just before the Asian financial crisis.

And its composition has changed, as bank debt has been partially replaced by longer-term debt securities issuance.

"In addition, EMEs have in general much larger international reserve buffers now compared with the 1990s. Even so, the higher debt burden on the back of a stronger dollar and higher interest rates could turn into a financial headwind that could outweigh potential trade gains, especially if AEs became less open to trade."

BIS also said that Chinese FX and bond markets went through substantial swings at the turn of the year.

The gradual tightening of domestic financial conditions, amid continued capital outflows and depreciation pressures, sparked temporal dislocations in the provision of liquidity throughout the financial system, it added. +