Asset Allocator: February 2016

 The content of Asset Allocator is provided by David Stevenson, an independent financial journalist. The views expressed in this page are those of David Stevenson only, and Societe Generale takes no responsibility for his views. The views expressed are David Stevenson's views as of the date of publication only.

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ASSET ALLOCATOR: 25th February, 2016

 

What a difference a few days make. Just a few weeks back and investors were in terminal despair. Now as we cruise towards the end of February, everyone seems to have stopped worrying again. Although I am more bullish than many I’m not entirely sure this optimism is well founded. As we’ll shortly discover there are some worrying signs from the CDS and bond markets which suggest that we’re a long way from being clear of trouble.

But for arguments sake let’s suggest that the recent turnaround in sentiment is completely justified. How much further on the upside have we got to run? The chart below is from online financial software provider Sharescope and looks at the FTSE 100 benchmark index since early October.

I’ve shown the increasing amplitude of slumps and rallies. What’s worrying is that the amplitude of market turbulence has been increasing steadily over time. We’re now into an environment where falls and increases of not far off 10% are looking ordinary, although the trend lines suggest that we’re still in a firm bear market. My guess is that if the recent past is any guide at all in these volatile times, the current bounce back probably won’t go much over 10 to 11% from a low of 5537 for the FTSE 100. Obviously if we see the intervention of a new external driver such as determined central bank action or a proper, definitive end to oil’s swoon, this trend could easily be broken and we could see a push back to 6500 territory. But overall I sense that we’ll be lucky to see the FTSE much above 6150 in the short term.

One interesting conclusion emerges from this very simple analysis. If there is another big slump in share prices – perhaps taking us closer to 5400 – investor’s might be amply compensated for taking a leveraged view of the upside (assuming there is one!) afterwards, as markets bounce back. A rally of 8 to 10% looks entirely possible!

What might cause this renewed outbreak in hostilities between the bulls and the bears? One hint of future trouble comes in the shape of the banking system. Investors have marked down banking sector shares as worries about an impending recession gathers momentum.

This has led to real concerns about the pricing of risk within the sector. Just a few weeks back I highlighted the fact that bank CDS options – in effect insurance policies against banks defaulting on their bonds – seemed utterly becalmed. Investors didn’t seem to think there were any risks at all. Well, in the last few weeks we’ve witnessed a remarkable turnaround. CDS rates have shot up across the board as investors start to fret about bank losses in the event of a new global recession. Over the last month rates have increased for every bank in the list below, implying higher funding rates. The smallest increases over the last month have been for JPMorgan, Australian bank Macquarie and Japanese outfit Nomura. The biggest monthly jumps (increases of more than 90% in pricing) have been for a long list of British banks including Lloyds and Royal Bank of Scotland Deutsche Bank.  These numbers are reflected on annualised changes where CDS rates have doubled for nearly all the British banks.

12th February 2016

Bank

OneYear

FiveYear

MonthlyChange

AnnualChange

Santander UK

27

77

38

20

Barclays

61

107

91

110

Citigroup

40

110

26

36

Commerzbank

78

138

50

82

Credit Suisse

63

113

29

102

Deutsche Bank

103

175

80

160

Goldman Sachs

42

110

25

24

HSBC

65

124

71

157

JP Morgan

41

85.5

13

26

Lloyds

35

88

81

81

Morgan Stanley

39

108

22

36

Nomura

24

84

21

-9

Rabobank

24

74

43

49

RBS

62

106

81

105

Soc Gen

39

103

49

20

UBS

31

70

44

52

My own personal view is that there isn’t – for the moment at least – much systemic risk of a banking sector meltdown. Arguably these CDS option rates were mispriced before the current market turbulence and all that we’ve seen recently is pricing going back to sensible levels. But I also concede that investors are seriously starting to price in the risk of an imminent recession – which will in turn increase lending defaults and hurt bank capital levels. One widely used indicator of this concern is the average spread for US corporate debts rated BBB over US 'safe' Treasury bonds. This is currently running a bit under 300 basis points, a recent high. A widening spread indicates a very real fear of recession as the chart to the right makes clear.

Maybe it’s not just CDS option markets that were complacent about the financial risks following a slowdown – arguably equity investor’s need another burst of volatility to properly price in the risk of declining earnings?

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The content of Asset Allocator is provided by David Stevenson, an independent financial journalist. The views expressed in this page are those of David Stevenson only, and Societe Generale takes no responsibility for his views. The views expressed are David Stevenson's views as of the date of publication only. Neither David Stevenson nor Societe Generale accepts any liability arising from investment decisions you may make for your own account. This material is intended to give general information only and is not to be construed as investment advice. The investments mentioned may not be suitable for everybody and you should ensure that you fully understand the investment you intend to make before making an investment. Links to external websites are not operated by or affiliated with Societe Generale. While we aim to point you to useful external websites, we cannot be responsible for their content or accuracy. Societe Generale takes responsibility for the views expressed on any external websites or any liability arising from investment decisions you may make. You should seek professional advice if any of the content of this page is unclear.

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