Capital Markets

2011 was the year when politics trumped markets


Traders work on the floor of the New York Stock Exchange on December 20, 2011. USA credit rating slash is among political factors that hit the capital markets. File

For anyone who makes money by making sense of financial markets, 2011 was a confounding year. Whether it was Europe’s seemingly intractable debt crisis, uprisings in the Middle East or the political bickering and growing debt burden that cost the United States its AAA credit rating, investors had to be more nimble than ever to stay ahead of swiftly changing sentiment.

When the history books are written, 2011 may go down as the year when political risk trumped economics, earnings and interest rates as the main force driving capital markets.

“I can’t remember a year when politics had such a big impact on capital markets,” said Ron Florance, head of investment strategy at Wells Fargo Private Bank, which oversees $157 billion in assets. “Maybe during the crash of 1987, but that lasted for a day. This has lasted for 365.”

Just ask Tony Crescenzi, a portfolio manager at PIMCO, operator of the world’s largest bond fund. For most of his 28-year career, a successful strategy boiled down to making the right call on the US economy. Not anymore.

“Now you’ve got all these other things in the mix. I’ve had to use a lot more of my time to learn about a lot more things,” he said, noting that German, Greek, Chinese and other foreign newspapers are now part of his daily reading regimen.
Few expect things to be different in 2012. Russell Napier, strategist at CLSA Asia Pacific Markets, a Hong Kong-based brokerage, said he fears a European banking crisis next year that could lead to the nationalisation of some banks and push both Europe and the United States into recession.

“The bigger the politics quotient, the more volatile the markets,” Mr Napier said. “And it isn’t going to get any better next year.”

What the intersection of politics, economics and finance has meant for investors this year is not immediately apparent. The benchmark S&P 500 index looks set to finish the year roughly where it began. The euro, meanwhile, has shed just 2.5 per cent against the dollar — hardly what one would expect from a currency some investors fear may not be around much longer.

“But that doesn’t begin to describe what investors went through,” Florance said. Jeff Rubin, an analyst at Birinyi Associates says the average daily spread between the S&P’s high and low in August was 3.39 per cent.

That’s below the vertigo-inducing swings seen after Lehman Brothers collapsed in 2008, but certainly volatile enough to make for very uncomfortable trading.

After political bickering over raising the US debt ceiling brought the United States to the brink of default in August and Standard & Poor’s stripped the country of its gold-plated AAA rating, stocks went into free-fall, shedding some 12 per cent by the end of September.

Then in October, they abruptly reversed course, rising more than 10 per cent. “It was mind-numbing volatility,” Florance said. “Every single headline created a stunning response.”

To be sure, 2011 generated a lot of market-moving headlines. A devastating earthquake in Japan, regime change in Egypt and Libya, and Europe’s constant attempts to get ahead of a worsening debt crisis sparked wild fluctuations in stocks, commodities, bonds and currencies.

On top of that, activist central bank policies in developed economies and government intervention in foreign exchange markets have kept investors on their toes. Even now, with barely a week left in 2011, investors can only guess at whether US lawmakers will agree to extend a payroll tax cut for 160 million workers. Economists and businesses fear expiration will hurt an already-fragile economy. There’s even less clarity when it comes to Europe, where multiple attempts to prevent a debt crisis from spreading and to reassure markets have failed.

As the year winds down, borrowing costs for Italy and Spain are close to their euro-era highs and worries about the European banking system remain elevated. “It’s a microcosm of the entire year,” Crescenzi said. “Most sensible people would have expected policymakers in the US and Europe to have taken a different approach, because the approach they chose was a big negative for risk assets.”

More worrisome, Chinese growth appears to be slowing, which would be arguably worse for big exporters dependent on demand from what is now the world’s second-largest economy.

Furthermore, that may prompt Beijing to put the brakes on recent yuan appreciation, said Karl Schamotta, currency strategist at Western Union Business Solutions. That would make it harder for struggling Western economies to boost growth through increased exports.

Defying logic

Some of the industry’s surest shooters lost their focus this year. Bill Gross, co-chief investment officer of PIMCO, bet heavily against Treasuries, which turned out to be a top performer in 2011. Investors responded by yanking $10.3 billion from PIMCO’s Total Return Fund in the year to November, according to fund tracker Morningstar.

FX Concepts, one of the largest currency hedge funds with $4.3 billion in assets, was down 17.8 per cent through October.

“Wise old head or not, these are very difficult market conditions to trade,” said Alan Wilde, head of fixed income and currency at Baring Asset Management in London, which oversees $50 billion in assets.

Of course, a 10-year Treasury yield around two per cent despite a US credit downgrade and a budget deficit running at nearly 10 percent of output would seem to defy logic, but that’s the kind of year it has been.

“I have sympathy for Gross and others who believed bond yields had dropped too far and bet on making money from rising yields,” Wilde said. “Longer term this is absolutely the right trade to have on. If it is not, then financial markets are doomed, as low short and long yields will be a precursor to a global depression.”

The trick, as always, is getting the timing right.

Colin Lundgren, who helps oversee $171 billion as head of fixed income strategy at Columbia Management in Minneapolis, said manageable inflation, slow economic growth and Europe’s ongoing crisis will probably limit how far Treasury yields will rise in 2012.

If Europe does get its act together and US growth and inflation rise more than expected, “that could spell a pretty ugly scenario” for bond bulls, he said.

“With the absolute level of rates so low and consensus leaning so strongly the other way, you just have to worry that we will eventually have a year of reckoning,” he said. “Maybe 2013 is the unlucky number.”