Post Lehman, markets have showed themselves particularly prone to panics, which is why good ‘panic indicators’ may be the cheapest way to monitor when it is necessary to purchase protection against fat-tail risks. There are of course many such tools, but one of the most reliable panic indicators is the EUR/CHF exchange rate and the daily volatility of this cross rate, especially as compared to Spain 10-year government spread over German Bunds, and the volatility of US long bonds. As the charts on p. 2 show, there are a signs that the European sovereign debt crisis is still worrying investors, while the pile-up in cash confirms a point we made in Friday’s Daily—namely, that today’s only crowded trade is on the sidelines. So what are the odds that either of these two concerns—another sovereign crisis or a US double dip—reach a tipping point and become a “panic”?
- EU Sovereign: CDS on weaker sovereign countries remain elevated, and the recent jump in the Swiss Franc points to possible further widening of Euro sovereign spreads (see top chart, p. 2). One could argue that, ever since the EMU rescue package on May 9th, the risk of an outright default in Europe has dropped significantly and that the recent drop in the Euro and the widening of sovereign spreads is not entirely justified. On the other hand, a lot of investors are still not convinced that the political situation in Greece will allow the country to take the pain necessary to reform (and we have seen more signs of discontent over the past few weeks)—and instead citizens will clamor for a default scenario. Overall, EMU equities have been outperforming on the reform theme, and our view is that they will continue to do so (especially if the Euro keeps weakening). In this sense, it makes sense to position for further equity gains, but hedge with some default insurance.
- US economy: The risk is that double-dip concerns will soon be upgraded to the dreaded “secondary depression”, a classic during the Gold Standard years. Indeed, Charles has long argued that such a panic is necessary in order to force the US to cut spending/interference. This is precisely what we saw in Europe, with the panic in weaker sovereigns forcing the start of a new era of fiscal restraint on the continent. This is why we have recommended that investors hedge their global equity positions with zero coupons, with the VIX index, with cash in a ‘good currency’, or with Asian long-dated bonds.
At this stage, most investors are well-informed of the above risks and presumably portfolios have been adjusted appropriately. But what if the panic comes from the other direction? Readers will know we are not in the double dip camp (see Markets Are Pricing in the ‘New Normal’ and A Misunderstood Quarter). Besides anything else, we think the US political system is unlikely to tolerate a prolonged period of spend and tax government. One of these days, the markets will start focusing on the possibility of a political change in the US, putting the US on the path of much-needed decline in US government spending as a percentage of GDP. Then, who knows, we may have a “panic” buying on equities? In which case the best strategy at the moment would be to gradually sell the asset going through a buying panic (e.g., long-dated bonds, Swiss Franc, etc… ) and buying the neglected assets (e.g., equities). After all, 50% of the return in a bull market is made in the first 10% of the uptrend (time-wise)…which is what most people sitting on the fences will rediscover eventually.
Copyright (c) 2010 GaveKal
