When someone is in pain, they are sometimes administered a dose of morphine. Morphine is obtained from the opium plant. The financial markets also have their own drug that is used to relieve pain. It is called hopium and someone is under the influence of the fictitious drug hopium when their trade is losing money, but they hold onto the position in the hope it will bounce back. In the current market environment, many investors are either watching from the sidelines, waiting for the opportunity to step back in or taking strong doses of hopium as they will the market to go higher against all odds. The hopium was evident last week as the global stock markets were in yo-yo mode. Up one day, down the next, then back up again. The downdrafts were due to the ongoing Euro crisis while the hopium fuelled uptick was based on the rumour/expectation/hope that global central banks will intervene in the crisis in a co-ordinated manner similar to 2008. Yet while stock market investors cling to every ray of light in search for the end of the tunnel, the bond market keeps suggesting the ray of light is that of an oncoming train. The story from the bond market is a tale of global disinflation even deflation and recession even depression.
Price to earnings
Appreciate the way the cycle works. In times of exuberance, stocks rise beyond their true or intrinsic value based on their level of earnings as investors pile in. Since earnings are a point of fact, the stock bubble manifests itself through an expansion of the price an investor is prepared to pay for those earnings (the P/E ratio). In a time of exuberance and growth, the argument is that future earnings should be valued higher because the environment of growth makes it more certain and there is a greater potential to increase those earnings further as demand increases. Apply the same metric to a bond, eg, the ten-year US treasury bond. A ten-year was recently issued at a yield of around 1.60 per cent, the lowest ever. If $100 of bond gives a yield (earnings) of $1.60, then the price to earnings (P/E) of that bond is 62.5X. For reference, the average P/E of the US stock market is around 13 times ($100 of earnings at 13X = S&P 500 of 1,300). Why would an investor pay 62.5 times for each $1 of earnings for one asset class (bonds) when stocks can be had for just 13 times for each $1 of earnings? Logically, one would expect the cheaper asset (stocks) would find favour with investors.
Stocks vs bonds
The cash flows of a stock and a bond differ in that bonds represent a contractual obligation to make payments (interest) and return principal at a defined period. Stocks, on the other hand, pay dividends at the discretion of management and your return of principal is dependant on the point in time at which you choose to sell. There are no contractual cash flows when dealing with stocks. In the current environment, investors are so uncertain about the economic and financial outlook that they are prepared to pay a significant premium for the certain cash flows of bonds and heavily discount the uncertain cash flows of stocks. Since bonds represent a contractual obligation there is no upside in a stable interest rate environment. Investors would want to ensure that the return on the bond is higher than the rate of inflation. The ten-year US treasury at 1.6 per cent is providing a return below the current rate of US inflation, which is on a 2.0 per cent handle. One of the ways this investment can make sense is if inflation were to fall in the ensuing period of the bond. Falling inflation would suggest a shrinking economy and we experienced this in T&T when our inflation rate fell from 15 per cent to 2.0 per cent as our economy slipped into recession. If interest rates were to rise, the price of the bond will fall, so another reason for there to be demand for a ten-year bond at 1.6 per cent is an expectation that interest rates will either remain flat or fall further during the period. For rates to fall further there will have to be a deleveraging scenario where on the margin credit is being repaid faster than new credit is issued. The lack of supply of new bonds increases the demand for existing paper pushing yields down. The conventional view is that deflation, deleveraging and recession should be feared by investors. Bonds are therefore the asset class of choice in these challenging times. However there is another dimension to investing in bonds that are fairly unique to the current environment.
Sovereign risk
When one invests in the debt of a highly rated sovereign nation that investment is generally considered to be free of credit risk. This would be the case for a US dollar bond issued by the US government, a sterling bond issued by the United Kingdom, a yen bond issued by Japan or a euro bond issued by any of the European countries. This gave these sovereign bonds a unique risk profile. If you were paying attention to the news flow you will note that the credit ratings of many countries are being downgraded to the point where countries are moving from investment grade to junk status in short order with only bailouts preventing an outright default. Sovereign debt especially in what used to be the AAA segment of the debt market is not what it used to be. Recall the sub-prime debacle was, in part, due to assets which were rated as AAA, but which turned out to be less credit worthy. One rating agency that tends to be ahead of the curve is Egan Jones and over the past year they have downgraded the US two notches. Italy is now rated a BB credit, France a BBB credit, Germany and the UK are AA- and Spain to junk (CCC). Based on their track record, it is only a matter of time before the "Big 3" rating agencies catch up. Technically, countries that issue bonds in their home currency can print money to satisfy the debt. However, that can cause inflation and the value of the currency to fall and is considered an implied default in that the value returned to investors is less than the purchasing power of the amount invested.
Many investors would be tempted to trade the deteriorating credit conditions across the globe. This is exactly what the US bank JP Morgan attempted to do. However, the fear trade into bonds described above caused the markets to move against them with interest rates falling whereas the credit downgrades would suggest rates rising. This resulted in the US$2 billion trading loss. The fact that one of the largest banks in the US and the world was prepared to put capital at risk on the assumption that a global credit crisis was imminent is one matter, the fact that the trade failed is also reason for pause.
The loss on this trade was $2 billion and some sources have suggested that it would take a loss of $50 billion to push JP Morgan into bankruptcy. While US$50 billion is a large number, it represents under 2.5 per cent of the bank's total assets.
In other words, a relatively small loss relative to the size of the JP Morgan balance sheet can push the operation over the edge. Such an event will cause markets to freeze up in a manner not too different from the days of 2007/8 and shows how little things have changed.
There are many scenarios in the global financial markets that can give rise to extreme even unknown reactions. Greece exiting the Euro, a default by Spain or Italy, bond yields rising in Japan or the US and a hard landing in China are just a few examples.
As was the case with JP Morgan, even if none of these events were to occur taking on too big a trading position in anticipation of a major market event and being wrong, either in terms of the direction or timing or both, can have major consequences. In order words, things can go wrong just by attempting to profit from what can go wrong. We live in a world where no amount of capital is sufficient if you do not understand the risks involved. This is a time for consolidation, not exuberance.
Ian Narine is a broker registered with the Securities and Exchange Commission.
