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February 11, 2013 7:20 pm
Politician walks out of door. Journalist puts microphone to his mouth. Politician mouths something. Markets move.” Life became rudimentary for European financial markets when the eurozone debt crisis erupted, says John Phizackerley, chief executive of Nomura’s European operations.
Gripped by uncertainty and fixated by eurozone leaders’ moves and missteps, share trading volumes have fallen sharply. Such political and economic news has increasingly driven stock and bond markets, deterring traders who would otherwise have sought profitable opportunities from big trends unrelated to the eurozone.
Volumes in the Eurofirst 300 index leading stocks have fallen more than 45 per cent from their peak in the second half of 2007. And it is not just European markets that have fallen into a funk. Although early 2013 saw share prices surging as the crisis mood ebbed, US trading volumes remain low, with daily trades down 40 per cent since the first half of 2009.
Turnover in foreign exchange and credit markets has also tumbled over recent years. Measures of market volatility – how much share prices chop and change – have fallen, while “correlation indices”, showing how different asset classes are rising and falling together, have increased. “A degree of jadedness has entered markets,” says Stacy Williams, strategist at HSBC.
After a global economic slump caused by seemingly reckless financial market activity, a period of calm might appear welcome. But moribund markets spell bad news for bank employees, and schadenfreude by others would be misplaced if they were being lulled into a false sense of security. “Individual investors are in for a roller-coaster ride in terms of volatility that they are not prepared to deal with,” warns Andrew Lo, professor of finance at the MIT Sloan school of management in Boston.
Historically low interest rates orchestrated by central banks have made it difficult for investors to earn decent returns. Thinner, static markets make it harder still to eke out gains. The risk is that financial markets fail in their role of promoting job creation and prosperity by allocating capital efficiently to the real economy. Whether such trends are reversed will also determine the shape of the post-crisis financial world.
“The problem will arrive when we see a loss of risk appetite and we get a ‘discontinuous adjustment’ as they say – in other words, it could be vicious,” says Mark Cliffe, chief economist at ING, the Dutch bank.
The crises of recent years – in the eurozone and elsewhere – have not been the only factors depressing global financial market activity. Actions by central banks, such as “quantitative easing” by the US Federal Reserve or large-scale liquidity injections by the European Central Bank, have stabilised economies – but failed to create much growth. Not only are markets less exciting, sluggish activity means less need for transactions.
“Foreign exchange volumes are highly correlated to global trade,” explains Gil Mandelzis, chief executive of EBS, the trading platform. “Last year trading was centred around some very meaningful events – usually news of something to do with the crisis.” According to EBS data, electronic foreign exchange trading volumes were almost 30 per cent lower in the second half of last year than in the same period in 2006 – before the financial crisis erupted.
Poor economic growth has meant fewer companies listing their shares. The value of European initial public offerings fell by almost two-thirds last year compared with 2011, to just $14bn, according to Dealogic data. With fewer fresh supplies of equities, and companies buying back shares, trading in markets has inevitably fallen.
Also depressing activity has been a regulatory onslaught aimed at making markets safer. Banks are having to hold more capital to trade; in corporate bond markets, investors fret that banks have scaled back their market making so much that it would be hard to sell if sentiment turned suddenly. Europe has seen intermittent bans on “short selling” – selling assets you do not own in the hope of buying them back at cheaper prices.
Regulators are demanding that trades in derivatives such as credit default swaps (CDS), which protect against default, are backed by adequate collateral or security. Global trading in CDS has fallen by about 18 per cent compared with mid-2010, according to data from the Depository Trust & Clearing Corporation.
Similar factors explain rising cross-market correlation indices. Markets have all focused on the same big issues: currently, whether the world’s advanced economies can return to solid growth. Recent years have been characterised by switches between “risk on” and “risk off” – or between buying riskier assets and heading for havens – depending on the prevailing sentiment. “Correlations are high for good reasons. Equities, bonds and currencies are all going up and down together because they all depend on the global recovery,” says Mr Williams. HSBC’s “risk-on, risk-off” index, which measures the extent of cross-asset correlations globally, remains elevated even after this year’s share rally.
A more controversial issue is whether correlations have risen because of computerised, “high frequency” trading executed in fractions of a second. Technology has encouraged high-volume, low-margin business models based on exploiting short-term trends, and broken down distinctions between different financial products by encouraging complex products that bridge traditional distinctions.
High-frequency traders, however, deny that their computer algorithms have the effect of pushing markets all in the same direction. “If we were truly able to both cause correlations and profit from it, we would be making infinite amounts of money, which we are not,” says Remco Lenterman, managing director of IMC, a high-frequency trading company, who speaks on behalf of the sector.
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Whatever the precise causes, lacklustre markets have hit jobs in finance. Employment in London’s wholesale financial sector will drop to 237,000 this year, down a third from a peak in 2007, says the UK’s Centre for Economics and Business Research. Yet a lesson from the crisis is that banker happiness levels are not necessarily positively correlated with future economic growth prospects. “Things that worry banks are on the whole good for us. It is the things that don’t worry banks that we should watch out for,” says Andrew Smithers, founder of Smithers & Co, the economic advisers.
If low volumes mean more stable trading conditions, this should logically be good news for “end users” of capital markets, such as companies thinking of raising equity. A “risk-on, risk-off” herd mentality could create opportunities for active investors who take the time to scrutinise fundamental factors that should determine bond or share prices over the long term. “It suggests things are being mispriced. If your valuation model is good and seriously applied, then rising correlations are a wonderful opportunity,” says Paul Woolley, senior fellow at the London School of Economics.
Nevertheless, bankers and financiers are certain that their woes matter for the rest of the economy. “Economies benefit from viable, liquid and transparent capital markets,” says Mr Phizackerley of Nomura. “We want Europe to go head-to-head with the US and Asia. We don’t want it to be shrunk to some kind of backwater.”
Even if higher correlations create opportunities for active, long-term investors, it is harder to justify the immediate cost of extensive research in this environment. “How can you charge a fee if you are selling different shades of grey?” asks Ramin Nakisa, strategist at UBS. Investors have been attracted increasingly to low cost, index-tracking “exchange traded funds” as a cheaper way of riding market trends. Higher correlations across asset classes make it more difficult to diversify portfolios, a traditional strategy for improving the balance between risks and rewards. If that makes investors more hesitant, flows of capital to the real economy would be further constrained.
A bigger concern is that markets are simply enjoying a calm period before the next storm. The rise in correlations is not a problem in itself, “it is the reason why correlations have gone up that we should worry about”, argues Mr Smithers. “The really dangerous thing that is going on at the moment is that central bank policy is increasing the risk of another crisis.”
Arguing that fresh turmoil looms ahead seems odd when global stock markets are enjoying a rally and measures of market volatility have fallen. The CBOE Vix index, the flagship Wall Street yardstick of expected US share market turbulence – dubbed the US “fear index” – remained surprisingly subdued last year even as the eurozone crisis intensified and the US faced its fiscal crisis. This year, it has fallen to levels not seen since before the financial crisis erupted.
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But the headline Vix index, and Vstoxx, its European equivalent, which has behaved similarly, measure implied volatility levels expected only over the month ahead. Measures of expected market volatility over longer periods are noticeably higher. “The market tells you that at the moment we’re on an even keel, but in nine months’ time there could be an upset,” says Mr Nakisa.
Robert Brown, chairman of the global investment committee at Towers Watson consultancy, which advises sovereign wealth funds, says: “The actual level of true volatility in the sense of global political and economic risk is higher than what is reflected in short-term market volatility. The danger is that people get lulled into a false sense of security.”
There are plenty of possible events that could trigger fresh turmoil, from unexpected shocks to the global economy or setbacks in the eurozone, US or elsewhere. Another worry is that, despite all their efforts, regulators have failed to make the financial system safer.
“Systemic stability remains work in progress,” warns Mr Cliffe of ING. “The kinds of structural changes that we have seen in financial markets suggest that asset market volatility, which triggered the crisis, could actually get worse.”
There have been signs of improvement. Warnings about future turmoil might be too gloomy, creating opportunities for those who place trades on volatility indicators. Foreign exchange markets sprang back to life in January thanks to talk of a “currency war” fought by the world’s central banks, led by Japan’s. Foreign exchange volumes on EBS, the trading platform, were 22 per cent higher in January than a year earlier, although that might reflect EBS’s strength in yen transactions. Equity trading volumes have edged higher, encouraging optimists to believe gradual improvements in the economic outlook will soon feed through into healthier financial markets.
But not everyone is convinced. The lesson of history is that after financial crises, market edginess is long lasting, says Prof Lo.
“The same happened after the 1929 crash. It eventually calms, but I expect that we have at least three to five years until we see the financial and regulatory landscape settling down.”
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