Markets across the world are depressed, following a gloomy European tune. Every passing day, it more and more resembles a funeral dirge. France’s CAC 40 Index plumbed a low of 2,769 points this month, a bare 12% above its nadir in the months after the Lehman crisis. The Madrid General Index’s low this month was just 7.5% higher than the lows to which it plummeted after Lehman’s collapse. These numbers show the depth of pessimism in the European markets.
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The Bank of America-Merrill Lynch survey of global fund managers for September confirms that view. It shows that a net 38% of fund managers are underweight Europe, a level so extreme that it has been seen only twice during the last 10 years—October 2008 and in March 2009. Over 60% say they are underweight on European banks. European Union (EU) sovereign debt funding risk is seen as the biggest tail risk by almost 70% of the fund managers surveyed. European markets are close to pricing in a Lehman-like event, probably something even worse than a Greek default.
Risk appetite is low and this is reflected not just in European markets. BofA-ML’s risk and liquidity indicator is currently at its lowest since March 2009, which was the month in which stock markets sunk to their lows as a result of the banking crisis and the Lehman collapse. Hedge funds have slashed their exposure to equities and lowered leverage. Average cash balances with global fund managers are slightly lower than in August, but remains at a high 4.9%. Portfolio managers are now a net 36% overweight cash. They are also underweight equities for the first time since May 2009.
Unsurprisingly, given the much higher growth rates in emerging markets (EMs), fund managers were a net 30% of investors overweight, compared with 27% in August. Recall that in March, before the fresh round of tremors from Greece and when optimism about the US economy reigned, fund managers were neutral on emerging markets. Among global emerging market investors, India’s underweight fell in September compared with the previous month, but it is still one of the most underweight markets. The BofA-Merrill Lynch survey is often seen as a contrarian indicator. Does this mean that it’s time to start dipping your toes in the markets? BofA-ML says that for contrarians, the trades are: long equities, global banks, Europe, Japan utilities, EM resources; short cash, EU energy and staples, US technology, EM consumer.
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The problem, however, is that in its July survey, BofA-ML had said, “Contrarians should note that extreme sector underweights have been established in EU and US banks and utilities.” A contrarian going for the EU banks trade in July would have been burnt to a cinder by now. The problem with Europe is while the markets wait with bated breath for Merkel or Sarkozy to reassure them, the fact of the matter is that no one seems to be in charge.
It is also very doubtful if a policy of austerity will actually improve the fiscal deficit. Austerity will mean lower growth, which will depress tax revenues. So far, policymakers in Europe haven’t been able to convince the markets that they are able to talk with one voice and have the will to tackle the issues. Many fund managers believe a Greek default is just a matter of time. Nevertheless, the markets are so depressed at the moment that any piece of good news could trigger a rally. The cash to fuel that rally is also available.
There is, though, one chilling fact: as Andrew Haldane, executive director for financial stability at the Bank of England, points out, the macroeconomic situation today is far better than during the Great Depression, with one exception: government finances. The International Monetary Fund (IMF) expects debt-to-GDP ratios in the G-7 economies this year to breach 100% of GDP for the first time since the World War II. A paper by Reinhart and Rogoff said in 2010 that with public debt levels above 90%, median growth falls by around 1 percentage point and average growth falls considerably more. That is why a majority of fund managers now believe that Europe will slip into a recession in the next 12 months, according to the BofA-ML survey.
There could be worse to come. Citibank says they “expect a series of sovereign ratings downgrades among euro area countries in the next three-six months, including Italy, Spain, Greece, Portugal and Cyprus. We also expect Italy, Spain, Portugal and Ireland to be downgraded further over the longer term (next two-three years). Over the next two-three years, we also expect that France and Austria are likely to be put on negative outlook, with Belgium at risk of a single notch downgrade.”
So while action by policymakers to defuse the crisis in Europe could lead to a rally, the uncertainty is unlikely to go away in a hurry.
Manas Chakravarty looks at trends and issues in the financial markets. Comment at email@example.com