A stormy summer


September 25, 2011

Two weeks in the world of finance seems to be an eternity these days, with more incidents packed in than one normally encounters in a year of normal living. Two weeks ago, in this column, I wrote about the turmoil in Europe, led by the Greek financial crisis, but rapidly spreading to other eurozone countries.

My lament was that the European leader who had exacerbated the problem, the German Chancellor Angel Merkel, simply did not fathom that the issue went far beyond saving Greece: this is about saving post-Second World War Europe and ensuring that this wealthy continent remains a bastion of peace and stability.

A few days ago, Angela Merkel said this: "This challenge is existential and we have to rise to it. The euro is in danger. If we don’t deal with this danger, then the consequences for us in Europe are incalculable. If the euro fails, then Europe fails."  Bravo, Frau Merkel has risen to the occasion and started to speak the same language as the eminent architects of modern Europe, Jean Monnet, Francois Mitterrand and Helmut Kohl.

At the same time, as part of the strategy to defend the euro, she announced controversial measures as part of a battle against speculators. Germany instituted a ban until March next year on the naked short sale of shares in the country’s top financial institutions and the bonds of eurozone countries. It has also banned the purchase of credit default swaps (CDS) on eurozone government bonds, other than for hedging purposes. 

 Naked shorts - when the person selling the asset does not own it and has not borrowed it from a third-party broker - had been blamed for exacerbating falls in the stock market. Finally, and most importantly, Merkel sounded the rallying cry of cooperative behavior, stating that Europe now more than ever needed to work together to overcome this 'existential' crisis.

The financial markets, however, had their own dramatic reaction to Merkel’s initial indecision, the hastily patched together European emergency fund of US$1tn, and then to Merkel’s above announcement. In these past two long tumultuous weeks, global financial markets have been raging like a serious summer storm, something more akin to a cyclone or hurricane:

  • The euro plunged from US$1.28 to a low of US$1.214, a five per cent drop and a four-year low. It has rallied in the past couple of days.
  • The British pound also dropped five per cent from US$1.50 to a low of US$1.42, though it has now rallied very slightly to US$1.44.
  • The South African rand has dropped eight per cent from US$7.34 to US$8.00.  At this rate, there will be substantial savings for anyone visiting for the football World Cup.
  • The Australian dollar, a good indicator of market risk appetite, went off a cliff, losing ten per cent against the US dollar in five trading sessions.
  • The Japanese yen moved up sharply against the Aussie dollar by nine per cent and the euro by eight per cent, whilst it was three per cent higher against the US dollar. The euro clawed back some of these losses in the last couple of sessions.
  • The Indian rupee, coming off considerable strength in the past few months, weakened five per cent against the US$ from Rs44.7 to Rs46.9.  This will bring sighs of relief to Indian exporters, but will bring frowns to domestic policy makers already fighting an upsurge in inflation.
  • Stock markets have been in turmoil: the S&P500 in New York has dropped by almost eight per cent, the Dow Jones tumbled four per cent in one day last Thursday, the FTSE 100 index in London dropped below 5,000 for the first time in 8 months.
  • Wall Street’s Vix index, which measures risk-aversion and fear, jumped nearly 50 per cent.
  • US Treasuries yields hit a 12-month low, with the ten-year note at one point down to a one-year low of 3.12 per cent.  German government bunds hit record high prices, as yields came down sharply.

•Commodities slumped across the board: the July crude oil contract on the NYMEX has lost 13 per cent and is now trading at US$70 a barrel, copper prices hit a four-month low.

•Gold shed five per cent, after hitting a record high of US$1,243 per ounce on May 12.

Investors’ appetite for risk plummeted in these two long weeks, and they fled stocks, riskier currencies and commodities to the yen and safe-haven bonds. In times of uncertainty, the flight of global capital to perceived safety is magnified.

What does all of this mean for businesses and individuals? Businesses across the world, already starved of bank finance, will now find it even more difficult to raise capital from the equity and bond markets. Many will have to put any expansion plans on hold.

Banks are looking for excuses to pull the plug on loans, and any breaches of covenants will probably lead to businesses having to either pay higher interest rates or, in the worst case, find alternative sources of capital in a very short period of time. Companies that are involved in trading in multiple currencies have to juggle a number of balls at one go in order to avoid severe currency losses.

One of my businesses, which purchases raw materials from India and China in US dollars and sells finished goods in the UK and Europe in pounds and euro, has now started to purchase from Asian suppliers only in pounds and euro in order to avoid the currency risk. Another of my companies uses a gamut of hedging tools across five different currency trades.

The absolute focus of my businesses is now on working capital and cash flow management, in order to avoid any reliance on bank financing.  Individuals, with pension funds invested in stocks, will have taken blows to their retirement wealth. Wealthy individual investors, who tend to place bets on riskier emerging market stocks, will have had double hits as both share values and local currencies fell.

Thursday and Friday last week saw some respite, as some appetitive for risk returned. But the volatility is here to stay.  Weekly swings in stock markets of five-ten per cent are now the norm, and even currencies can easily move four-five per cent. 

In the medium term, governments across Europe and in the USA still have much work to do to solve their fiscal and trade deficits, burgeoning unemployment and financial sector weaknesses. Governments and regulators will throw out ad hoc policies, such as the German ban on naked short selling, as they try to limit damage. The new UK Treasury Chief Secretary warned on Saturday that the UK is "Moving from an age of plenty to an age of austerity," as he plans to announce the biggest public sector spending squeeze since the Second World War. 

The Obama administration is in the final throes of putting together sweeping financial regulatory reform legislation that will reshape the banking sector. In the meanwhile, the ultra-conservative Tea Party is gaining ground in local elections, taking advantage of the economic distress of stunned middle Americans to rail against Washington and press for the abolition of the Federal Reserve. In other countries, other types of disorder threaten economic growth. Unions in Athens and Madrid and Lisbon are preparing ground for renewed battle.

The Red Shirts might have been forced out of their barricades in Central Bangkok, but their discontent and agitation will continue until a political settlement is found. The Thai finance minister fears that continued political problems will knock at least a third off this year’s growth projections. In China, there are fears that an over stoked economy, led by a housing bubble, will have to cool down. All of this uncertainty does not bode well for the summer. Global financial markets will endure a hot, stormy summer.

Perhaps the best advice to an investor is to switch off for the summer and to repose in the cool climes of a high-altitude mountain, high above the dark clouds, thunder, lightening and lashing rain of the financial storms in the plains below.