Category: Financial Markets

Are Financial Markets About To Change?

By Viktor Shvets of Macquarie via Zero Hedge.

Investors are currently residing in a surreal world of low volatilities and spreads, ignoring potentially radical shifts in monetary and fiscal policies and unwinding of extraordinary measures of the last decade. Even as Central Banks (CBs) are worried about lack of volatility and excessive risk-taking, investors seem convinced that either strength of economic recovery, or return to liquidity and cost of capital supports, will ensure that volatilities are kept under control. Thus, either way, investors seem to expect that spreads would stay low and elevated valuations of various asset classes remain a permanent feature of an investment landscape.

Do we agree? In our view, financial markets have been for years drifting away from real economies. Not only is the value of financial assets at least five-to-ten times larger than the underlying economies, but also this ‘financial cloud’ is now managed by computer trading, algorithms, AI and passive investments.

This is potentially a highly destabilizing mix.

CBs are aware of dangers; hence the warnings by IMF and BIS to be ‘mindful’ of gaps between economic growth  and asset bubbles. In our view, CBs and financial supervisory bodies have essentially morphed from masters of the universe into slaves of grotesquely swollen financial markets.

The key to monetary policy is no longer to guide real economies, but to avoid a collapse of the financial cloud, out of fear of what a return to traditional price discovery and volatilities might imply for wealth creation and asset prices. Over the last three decades, real economies (everything from personal savings to fixed-asset investment) have become far more tightly intertwined with asset values than with wages or productivity.

In this surreal world of complete dominance of financial assets, conventional economic rules break down and financialization and avoidance of sharp asset price contractions becomes the paramount policy objective. In our view, this implies that liquidity supports cannot be withdrawn and cost of capital (holistically defined) can never rise.

Only a return to private sector dominance and accelerating productivity (rather than recoveries driven by liquidity and/or stimulus) can ensure ‘beautiful deleveraging’. We maintain that this remains a low-probability event.

Far more likely is that the latest two-year-old recovery was due to a mix of unique and to some extent unsustainable factors, such as massive liquidity injections by key CBs (US$3.5 trillion – Mar’16 and Dec’17), coordinated monetary policies (since Feb’16) and as always, China’s stimulus.

The question therefore is what would happen to values and volatilities, if these three supports are gradually  withdrawn. For example, CBs’ liquidity injection in ’18 is likely to be only ~US$0.7 trillion (turning negative in ’19) or growth of ~5%, barely enough to cover global nominal GDP (~6%).

Similarly, CBs are likely to make repeated attempts to raise cost of capital, despite likely inability to do so while China is tightening, and if history is any guide, it would more than likely over-tighten. This should raise volatilities. Even if assume that recovery is indeed more sustainable, CBs (uncomfortable as they are with current excessive valuations and low volatilities) would be happy to see volatilities rise and return to some form of price discovery. The 64-dollar dollar question is whether ‘patient is  sufficiently healthy to withstand pressure’.

Thus, one way or another, it seems volatilities are likely to rise at some point in ’18, and as always ‘canary’ in the coalmine would be high yield, FX and EM markets.

 

On Cryptocurrencies And Investor Protection

The U.S. Securities and Exchange Commission Chairman Jay Clayton spoke at Stanford University’s Stanford Rock Center for Corporate Governance and discussed his first eight months at the SEC and his enforcement, examination, market, and capital formation priorities. His comments on cryptocurriences were revealing.

SEC is clearly monitoring Initial Coin Offers (ICO) , and is concerned about the lack of protection for investors. There is significant risk of price manipulation, yet the underlying blockchain technologies offer significant opportunity.

“What I see happening in the ICO market today is ‘let me have all of the disclosure freedom of a private placement and all of the secondary activity and ability to market this of a public offering. We decided in 1934: that [having both of these at once] led to a lot of problems.”

“I think we can say that wherever the date is, it’s passed,” he said when asked whether his commission has made ICO rules clear enough yet.

“There are a lot of protections in the way stock trades on exchanges… these platforms that you’re seeing where people are trading cryptocurrencies — there are none of these rules… The opportunity for price manipulation is at orders of magnitude.”

“Blockchain, distributed ledger tech — I don’t think any of us think it’s a fad… it clearly has a applications that are gonna add efficiencies.”

“If this market continues as it is, this will not be the last enforcement actions that we take,” he said of the three ICOs the S.E.C. has moved against so far.

“Some of the offerings that we’re seeing, if the lawyers are telling them it’s OK, they’re just plain wrong,” he said, adding that taking action against lawyers knowing giving advice to ICO issuers that is against current laws is a possibility.

Source: Axios

U.S. Mortgage Rates Can’t Catch a Break

From Mortgage News Daily.

After taking just one day off from the prevailing move higher, mortgage rates were back at it today, heading back to the worst levels in more than 9 months.  The average lender is now back in line with the highs seen 2 days ago on Monday afternoon.  Over slightly longer time-frames, rates have risen an eighth of a percentage point since last week, a quarter of a point from 2 weeks ago, and 3/8ths of a point since mid December.  That makes this the worst run since the abrupt spike following 2016’s presidential election.

Unfortunately, this trend won’t necessarily stop simply because things have “gotten bad.”  While it’s true that the economic effects of higher and higher rates will eventually have a self-righting effect, that could take months–even years to play out.  While this doesn’t necessarily mean that rates will continue a linear trend higher in the coming months, it does mean the current trend is not our friend, and that it would take some huge changes in bond market trading levels before it made sense to lower our defenses.

Softer property could weaken Aussie equities

From InvestorDaily.

Although global equity markets are looking strong for 2018, local equities may be hurt by troughs in the domestic property market, says Tribeca Investment Partners.

According to Tribeca Investment Partners portfolio manager Sean Fenton, there is mounting evidence that the Australian housing cycle has already reached its peak, further reinforced by APRA’s efforts in curbing mortgage lending.

“A heavily indebted household sector that is experiencing flat to negative real income growth, as well as dealing with higher energy and healthcare costs, and which has drawn down its savings rate, is unlikely to fill the gap in growth,” Mr Fenton said.

“Further downside risk to the economy may emerge if the current tightening in mortgage lending standards pushes house prices lower and generates negative equity effects.”

With global markets encouraged by “easy monetary conditions”, central banks would be unwilling to make any sudden moves and lower the interest rate too quickly, “particularly as inflation has remained quiescent”.

“This provides fertile ground for equity markets to rally, but also creates an environment of heightened risk as areas of stretched valuation become more apparent,” Mr Fenton said.

Tribeca would continue to underweight sectors sensitive to the interest rate as well as increase its underweight to the building materials, retail and property development sectors.

“Domestically, we are positioned more defensively in gaming, select industrials and a small overweight to banks,” Mr Fenton added.

So You Want To Be An International Financial Centre?

From The Bank Underground.

The UK has a comparative advantage in financial services. But specialisation in this activity brings with it the challenge of the large gross capital flows that are linked to financial services exports.

The modern financial services industry allocates global capital flows through its balance sheets. Crudely speaking, profits correspond to a percentage over the value of flows, especially (volatile) banking flows, as banks arbitrage between assets and liabilities in different countries.

The chart captures this relationship by comparing the assets generated by banking flows (relative to GDP) – a measure of financial openness – with financial services exports (also relative to GDP). Countries which host international financial centres (the green dots in the chart), such as London for the UK (the red dot), are amongst the most open in the world.

Crucially, the chart is not capturing a mechanical effect. In the UK, for example, only one sixth of the statistical estimate for financial services exports is derived indirectly from international investment position statistics. The bulk of it is obtained from surveys conducted with banks. The estimate is also not affected by recent revisions to the UK national accounts.

International financial centres are compensated for providing essential financial services to the rest of the world. But the flipside is the need to absorb and manage the potential risks from volatile capital flows.

Note: Bank Underground is a blog for Bank of England staff to share views that challenge – or support – prevailing policy orthodoxies. The views expressed here are those of the authors, and are not necessarily those of the Bank of England, or its policy committees.

ASIC Licenses First Crowd-sourced Funding Intermediaries

The Australian Securities and Investments Commission (ASIC) has licensed the first crowd-sourced funding (CSF) intermediaries under the new CSF regime.

Seven companies have been issued with Australian Financial Services (AFS) licence authorisations to act as intermediaries able to provide a crowd-sourced funding service. With the grant of these new authorisations eligible public companies will now be able to use the CSF regime to raise capital by making offers of ordinary shares to investors via the on-line platform of one of these intermediaries.

ASIC Commissioner John Price said that this marked a significant milestone for crowd-sourced funding in Australia.

‘ASIC has been assessing applications as a matter of priority, as suitable intermediaries needed to be licensed before fundraising under the new regime could commence. Intermediaries have an important gatekeeper role which will be key to building and maintaining investor trust in crowd-sourced fundraising, so we are pleased to have now issued the first tranche of authorisations,’ he said.

The CSF regime is designed to provide start-ups and small to medium sized companies with a new means to access capital to develop and grow. CSF offers are subject to fewer regulatory requirements than other forms of public fundraising.

The newly licensed intermediaries have now been added to ASIC’s register of AFS licensees. ASIC’s free online search can be used by investors, potential crowd-sourced funders and others to confirm the authorisations held by individual licensees. ASIC encourages both CSF investors and companies to check whether their intermediary holds an AFS licence with appropriate authorisation to provide CSF services.

ASIC has previously highlighted the importance of investors understanding both the benefits and risks of investing via crowd-sourced funding. Further information regarding crowd-funding can be found on ASIC’s MoneySmart website.

Background

On 29 September 2017 the Corporations Amendment (Crowd-sourced Funding) Act 2017 and associated regulations came into effect – establishing a regulatory framework to facilitate crowd-sourced equity funding in Australia.

One of the key objectives of the regime is to reduce the regulatory burden on smaller companies associated with raising funds from the public via the issue of ordinary shares.

Global Rating Outlooks Most Positive Since Crisis, But…

The prospect of rating upgrades outnumbering downgrades this year and next is higher than at any time since the financial crisis, Fitch Ratings says in its latest global Credit Outlook report. But credit quality may start to weaken beyond this as ultra-supportive monetary policy is phased out and rising interest rates start to affect funding costs and asset quality.

“The rating outlook trend is the most upbeat in a decade, with positive outlooks outnumbering negatives. But the net bias is only just over 1% and occurs as the world is about to hit peak growth in the current cycle. The continued tightening of monetary policy, together with significant policy and political uncertainty, is likely to pose increasing challenges to ratings,” said Monica Insoll, Managing Director, in Fitch’s Credit Market Research team.

Global rating outlooks continue to improve. The average net outlook balance across all sectors globally turned positive for the first time since the financial crisis, at 1.1% as at 30 November 2017, up from -7.9% at the start of the year.

The trend is evident across sovereigns, corporates and financial institutions, with prospects brightening for developed and emerging markets alike. The outlook for structured finance has the most pronounced positive bias, at net 9%. Other sectors are largely experiencing rating stability, although there are pockets of rating pressure in some regions and certain subsectors.

The key drivers of the expected widespread improvement in credit quality are economic growth, still largely supportive monetary and fiscal policies, and more stable commodity prices. Fitch expects global growth to edge up to 3.3% in 2018, boosted by increased investment. However, beyond 2018 growth is likely to moderate, while monetary policy conditions will tighten.

The two main macro risks to ratings are the unwinding of quantitative easing and policy and political uncertainty, including from a heavy election cycle in emerging markets this year.

The QE unwind is likely to put pressure on sovereigns as government debt is high in many countries. Banks could be exposed to asset-quality problems following the long period of cheap credit, with high property prices in some countries at risk of deflating as the interest rate cycle turns. In the eurozone, banks will also need to rely more on market funding rather than the ECB.

In the corporate sector, emerging-markets issuer could be challenged by the reversal of capital flows but those in developed markets are likely to cope quite well. However, certain sub-sectors face rating pressure for idiosyncratic reasons, including traditional retail in the US and Europe, and utilities in the UK.

Geographic areas with negative rating outlook bias include the Middle East, Africa, China and Latin America, where several countries will hold elections this year and outcomes are uncertain.

The more positive outlook for rating activity in the short term should be seen against the backdrop of downward rating migration in several sectors in recent years. This trend has been most pronounced for sovereigns and financial institutions, with the share of ‘AAA’ to ‘A’ ratings in the latter hitting a low of 37% on 30 November 2017, having fallen steadily from 54% at end-2007.

Our six-monthly credit outlook report provides an overview of Fitch’s outlooks across all rated sectors and regions, identifying the main macro factors that will drive credit trends over the next 12-24 months. It focuses on outlook outliers – negative and positive – as the vast majority of ratings are typically stable. The data in today’s report is as of 30 November 2017.

ASIC Highlights Sell-Side Research Conflicts

Sell-side” research is general financial advice prepared and distributed by an AFS licensee to investors to help them make decisions about financial products. ASIC says  such firms must manage the conflicting interests of their issuing and investing clients when preparing investor education research. They have given the industry six months (to 1 July 2018) to make sure their compliance measures conform to the ASIC’s expectations as expressed in the released regulatory guidance.

ASIC has released regulatory guidance on managing conflicts of interest and handling inside information by Australian financial services (AFS) licensees that provide sell-side research.

Research helps investors to make investment decisions. The quality of research can affect the advice received and investment decisions. A licensee who provides research must comply with a number of regulatory obligations. They must:

  • control and manage inside information
  • manage conflicts during the capital raising process, including avoiding,
  • controlling and disclosing these conflictsmanage research teams, including budgeting, research analyst remuneration and coverage decisions

Regulatory Guide 264 Sell-side research (RG 264) looks at the key stages of a capital raising transaction and provides specific guidelines on how an AFS licensee should appropriately manage conflicts of interest during each of these stages , including the preparation and production of investor education reports. RG 264 also provides general guidance for AFS licensees on the identification and handling of inside information by research analysts, and about the structure and funding of sell-side research teams.

The guidance addresses uneven market practice that has developed since the publication of Regulatory Guide 79 Research report providers: Improving the quality of investment research (RG 79) in 2004. It also responds to industry requests for more detailed guidance on sell-side research and supplements guidance in RG 79.

RG 264 takes into account feedback from stakeholders following public consultation earlier this year, see Report 560 Response to Submissions on CP 290 Sell-side research (REP 560).

Commissioner Cathie Armour said, ‘The timely flow of information and objective research analysis is vital to fair and efficient markets. Investors consider sell-side research when making investment decisions. It is critical that sell-side research represents the genuine, professional opinion of analysts.

‘Wholesale investors want early information and analyst insights on companies undertaking capital raising. Firms that manage this process must manage the conflicting interests of their issuing and investing clients when preparing investor education research. It is important thatthis deal-related research does not undermine the prospectus disclosure or continuous disclosure requirements. RG 264 will help industry strike the right balance between these competing considerations’.

While RG 264 does not extend the regulatory framework in RG 79, ASIC will give industry six months to 1 July 2018 to make sure their compliance measures conform to the expectations set out in the this guide.

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Background

In June 2017, ASIC released Consultation Paper 290 Sell-side research (CP 290) which proposed to provide further guidance on managing conflicts of interest and inside information involving sell-side research.

The consultation followed the release of Report 486 Sell-side research and corporate advisory: Confidential information and conflicts (REP 486) in August 2016. REP 486 set out observations from our review of how material non-public information and conflicts of interest are handled in the context of sell-side research and corporate advisory activities.

ASIC’s review showed that AFS licensees involved in providing research would benefit from detailed guidance on managing material, non-public information and conflicts of interest.

Sell-side research is general financial advice prepared and distributed by an AFS licensee to investors to help them make decisions about financial products.

Bitcoin Takes A Dive

Further evidence of the volatility of Bitcoin, the virtual distributed ledger currency, which operates without supervision, or central bank support.

Bitcoin touched an all-time high of $19,896 on December 17 having passed the $15,000 mark on December 7. It’s slumped over the past few days, to a low of $12,504 before recovering somewhat. It is still up over 1,100 percent this year. Bitcoin is not alone, the other 20 or so crypto-currencies also retraced.

Many say serious numbers of unsophisticated investors have been piling in (even buying Bitcoins on their credit cards!).  This volatility is likely to continue, and prospective investors need to be aware they may loose their investment, they may not – there can be no certainties.

Opinion is split as to whether this is simply a speculative bubble similar to “Tulip Mania” or whether there is more here about a potential digital replacement for the US$. We suspect the former is closer to the truth.

The classic bubble shape of the South Sea Bubble is often cited and is an interesting case study.

South Sea Bubble

A bubble? We don’t even know how to value Bitcoin

From The Conversation.

Bitcoin is a “speculative mania” according to the governor of the Reserve Bank of Australia. But it’s not so easy to say that Bitcoin is a bubble – we don’t know how to value it.

Recent price rises (close to A$18,000 in the past three months) may be too great and can’t continue. But the Bitcoin market is only just maturing as an investment and as a currency, and so it may still have room to grow.

A bubble is when the price of an asset diverges from its “fundamentals” – the aspects of an asset that investors use to value it. These could be the income that can be earned from a stock over time, a company’s cash flow, the state of a country’s economy, or even the rent from property.

But Bitcoin does not pay out profits (like shares) or rent (like property), and is not attached a national economy (like fiat currencies). This is part of the reason why it is hard to tell what the underlying value of Bitcoin is or should be.

In the search for fundamentals some have suggested we should look at the supply of Bitcoins in the market (which is regulated by the technology itself), the number of Bitcoin transactions through the market, or even the energy consumed by Bitcoin miners (the computers that validate transactions and are rewarded with Bitcoins).

Diverging from fundamentals

If we take a close look, we can see how the price of Bitcoin may be diverging from these fundamentals. For instance, it is becoming less profitable to be a miner, especially as the energy required increases. At some stage the cost may exceed the price of Bitcoin, making the network less worthwhile to both mine and invest.

Bitcoin may be the best known cryptocurrency but it is also losing marketshare to other cryptocurrencies, such as Ethereum and Litecoin. Bitcoin currently accounts for 59.4% of the total global cryptocurrency market, but at the beginning of 2016 it was 91.3%. Many of these other cryptocurrencies have more functionality than Bitcoin (such as Ethereum’s ability to execute smart contracts), or are more efficient and use less energy (such as Litecoin).

Government policy, such as taxation or the establishment of national digital currencies, may also make it riskier or less worthwhile to mine, transact or hold the cryptocurrency. China’s ban on Initial Coin Offerings earlier this year reduced the value of Bitcoin by 20% in 24 hours.

Without these fundamentals the price of Bitcoin largely reflects speculation. And there is some evidence that people are simply buying and holding Bitcoin in the hope it will keep rising in value (also known as Greater Fool investing). Certainly, the cap on the total number (21 million) of Bitcoins that can exist, makes the currency inherently deflationary – the value of the currency relative to goods and services will keep increasing even without speculation and so there is a disincentive to spend it.

Bitcoin still has room to grow

Many big investors – including banks and hedge funds – have not yet entered into the market. The volatility and lack of regulation around Bitcoin are two reasons stopping these investors from jumping in.

There are new financial products being developed, such as futures contracts, that may reduce the risk of holding Bitcoin and allow these institutional investors to get in.

But Bitcoin futures contracts – where people can place bets on the future price of stocks or markets – may also work against the price of Bitcoin. Just like gamblers place bets on horse races rather than buying a horse, investors may simply buy and sell the futures contracts rather than Bitcoin itself (some contracts are even settled in cash, rather than Bitcoin). All of this could lead to less actual Bitcoin changing hands, leading to less demand.

Although the rush to invest is apparently encouraging some people to take out mortgages to buy Bitcoin, traditional banks won’t lend specifically for that purpose as the market is too volatile.

But it’s not just on the finance side that the Bitcoin market is set to expand. More infrastructure to support Bitcoin in the broader economy is rolling out, which should spur demand.

Bitcoin ATMs are being installed in many countries, including Australia. Bitcoin lending is emerging on peer-to-peer platforms, and new and more regulated marketplaces are being created.

Many companies are accepting Bitcoin as payment. That means that even if the speculation dies down, Bitcoin can still be traded for some goods and services.

And finally, although the fundamentals of Bitcoin are still up for debate, when it comes to transaction volume through the network there appears to be a lot of room for growth.

It’s good to remember that people have been calling Bitcoin a bubble for a long time, even when the price was just US$35 in 2013.

In the end, this is uncharted territory. We don’t know how to value Bitcoin, or what will happen. Historical examples may or may not apply.

What we do know is that the technology behind most cryptocurrencies is enabling new models of value transfer through secure global consensus networks, and that is causing excitement and nervousness. Investors should beware.

Authors: Alicia (Lucy) Cameron, Senior Research Consultant, CSIRO;
Kelly Trinh, Data Scientist, CSIRO