Starting Over
Everybody knows the saying someone has backed the wrong horse. While initially, the term assumingly directly referred to bets on horse racing, where the bettors lost all their bets, nowadays, the saying is used more broadly for losses or disappointments in general. Those who chose wisely backed the right horse.
It was usually exposed throughout history if you have backed the right or wrong horse. For example, in 2008, when problems in the US housing market spreaded into the real economy, it turned out that all those issued Mortgage Backed Securities (MBS) were much riskier than the AAA ratings of the rating agencies would have let one assume.
In the years prior, the housing loan business of the banks experienced a real boom, and rising demand for real estate pushed housing prices up. The fact that the value of the loan security of the borrower continued to grow, and the assumption that this would go on indefinitely, led banks to ramp up loan issuance. The more loans the banks handed out, the looser the lending standards became. Some banks specialized in subprime loans and so-called NINJA loans (No Income, No Job or Asset) and handed out credit to customers with bad credit ratings.
The assumption that real estate prices increase indefinitely would be proven wrong in the end, though. At the end of 2006, US real estate prices started to fall. Combined with a rise in interest rates, borrowers now not only struggled to repay their debt but were also unable to repay the loan when they sold the loan security, mostly their own home. More and more borrowers were forced to default.
A time lag caused troubles in the banking sector, as many banks have issued MBS, which bundled housing loans with various credit ratings and sold them. The rating agencies gave those securities the best credit rating, as it was assumed to be improbable that too many of the bundled loans would turn sour. However, over time the issued securities were stuffed with more and more subprime loans.
Additionally, because of their credit rating, banks started to use their mortgage-backed securities as collateral when they borrowed money from other banks in the interbank market. As the price of those securities began to fall due to the slump in the US housing market, regulatory equity rules forced banks to sell other assets to keep their equity stable, leading to falling prices in those markets.
Due to the developments, banks started to restrict lending to each other, and the interbank market froze. Several credit institutions faced payment difficulties because of no longer sufficient liquidity. The traditional bank Lehman Brothers was hit the hardest. During the housing boom years, when Lehman was highly engaged in real estate lending, the bank booked record profits each year, but now, profits collapsed. On September 10, 2008, Lehman announced that it expected a 3.9 billion dollar loss for the third quarter. At that point, its equity share price was already down 90 % year-to-date. Lehman’s CEO, Richard Dick Fuld Jr., had his back up against the wall.
He still did not expect Lehman to go bankrupt, though, as he speculated that the government would come to the rescue at some point. Further, Field thought that Lehman Brothers was already near closing a deal for a merger with Merrill Lynch. Looking backward, it turns out that Fuld backed the wrong horse. After a secret meeting in the halls of the New York Fed, where all big Wall Street bank CEOs except Fuld participated, Merrill Lynch blew up the deal and decided to merge with another big Wall Street bank instead, Bank of America.
Fuld then desperately tried to organize a merger with Barclays, but the deal also blew up because the Bank of England vetoed the merger. As a result, after more than 150 years in business, Lehman filed for bankruptcy on September 15, 2008. The era of Dick Fuld, one of the most successful bank CEOs of the years prior, ended, partly because Fuld was so sure that the deal with Merrill Lynch would be closed if the government did not come to the rescue.
I do not want to discuss the Great Financial Crisis of 2008 today, but ask the question of market participants probably also backing the wrong horse currently. Year-to-date, European equity price gains exceeded those in Japan and the US by far.
While the Eurostoxx 50 and the Dax rose by 8 and 9 %, US equity gains remained meager. The Dow Jones is wobbling around its year-end price, and the S&P 500 is only slightly up, about 2 %.
Respectively, the European economy got through the winter much better than most had expected a couple of months prior. Due to warmer temperatures, Europeans consumed much less gas than in previous winters, and energy prices continued to fall substantially from their latest highs from last summer. At the moment, energy prices are about as high as in the first months of last year, shortly before the war in Ukraine started.
Economic conditions also continue to improve in the euro area. The German ZEW index, which shows current and expected economic condition judgments from analysts and institutional investors, is continuously picking up. The ZEW expectations index was much better than expected (16.9 vs. -15).
Due to falling electricity and natural gas prices, consumer price inflation is also cooling. In December, consumer prices fell by 0.4% in the euro area, and measured year-over-year, they are clearly off from their peak (10.6%) in October of last year.
Is this a sign that inflation in the euro area peaked in October? While some people offer some good arguments to support their thesis, some facts still oppose this view, so another rise in inflation should not be ruled out totally.
At first sight, one could assume that the European economies have the worst behind them and, more importantly, far better shape than most market observers would have expected. Slowing economic activity in the west and weak demand from China because of its zero-covid policies led to falling commodity prices in the second half of last year, fueling the latest fall in consumer prices. Additionally, the euro has appreciated substantially against the dollar. While at the end of September, EUR/USD was at 0.96, one euro is currently worth 1.08 US dollars.
Moreover, one should not forget the influence of government interventions, which were implemented to dampen the effects of rising consumer prices. Gas price caps, fuel price caps, lower value-added sales taxes on fuels; the variety of measures taken by European governments to lower prices was huge.
So, one can conclude that those government interventions and the fall in energy and commodity prices mainly explain the latest slowing of consumer price increases. However, core inflation still rose in the euro area in December, from 5 % in November to 5.2 % in December, measured year-over-year. Hence, it is likely that consumer price inflation will remain sticky, although headline inflation probably continues to edge lower in the coming months. Still, inflation numbers are a lagging indicator.
Another reason economic data was better than feared in recent months is that governments ramped up expenses to support consumers. That probably is a factor why core inflation continued to rise in December. However, warmer-than-usual weather and falling energy prices were also helpful for European governments. This week in Davos, Christian Lindner announced that it is probable that Germany would not need to spend all of what it has budgeted to combat the energy crisis.
Another reason economic sentiment in the euro area is improving is that China finally started to end its zero-covid policies and is planning to open up its economy in the coming months. For most European countries, China is the most important trading partner; thus, a reopening of China will push up demand for European export goods.
The Chinese reopening assumingly is the main driver behind the current outperformance of European equities compared to their US peers. It should be supportive of the European economy in the months ahead. Recently, Goldman Sachs sacked its recessionary outlook on Europe and expected the European economy not to shrink this year. In their newest GDP outlook, Goldman predicts 0.6 % GDP growth, while expected -0.1 % in a prior outlook.
Indeed, one is inclined to assume that the worst is behind for Europe and that the reopening of Europe’s most important trading partner will support the economy. However, a Chinese reopening also means that commodity demand will pick up again. Like European equities, commodity prices have risen year-to-date, especially industrial metals such as aluminum and copper, as the Chinese ramp up their industrial production.
Suppose commodity and energy prices have bottomed already, and the recent rise in prices will continue due to growing Chinese demand. In that case, the current signs of diminishing inflation could evaporate in the coming months, and inflation could become more entrenched.
Moreover, the ban on seaborne deliveries of diesel from Russia to Europe will kick in in three weeks. Russia is still Europe’s biggest diesel supplier by a margin. In 2022, the EU imported 220 million barrels of Russian diesel. As Europe stops buying diesel from Russia, it needs to get the supply from other sources, for example, Arab countries, India, the US, or China.
Currently, analysts expect that Europe can cope with the loss of Russian diesel and will be able to buy the supply elsewhere. China plays a crucial role in that analysis, as it has highly elevated its diesel exports from 81,600 barrels in January to 722,000 in December. Although only a tiny portion of those exports end up in Europe, it frees up supply from other sources that could theoretically be shipped to Europe. However, the scenario only holds if Russian diesel does not disappear entirely from the market and Russia can sell its diesel to someone else. Yet, the induced price cap could cause exactly that or significantly reduce the amount of Russian diesel available on world markets.
Assuming that this would lead to a shrinking supply of diesel to Europe and that buying diesel from other sources is more expensive and leads to higher transport costs might support ongoing consumer price inflation if businesses pass those price increases on to consumers.
Further, European industries still have to cope with much higher than usual energy prices, despite the latest sharp price drop. Compared to the US, gas prices are still seven times higher in Europe, as the US is an energy net exporter, while Europe is an energy net importer.
Due to the EU turning away from Russia and its energy, energy prices will remain high over the coming years. Thus businesses will continue to think about reallocating production from Europe to other parts of the world.
As consumer price inflation is still at 9.2 % in the euro area, European bond markets show no sign of worry. 10y Bund yield fell 50bps year-to-date, Italian 10y yields fell by 100bps. Over the last weeks, the German yield curve continued to invert further. However, weaker-than-expected inflation numbers have fueled a rally in European sovereign bonds.
This week, European bond prices profited from better-than-expected economic data in the eurozone. While market participants already expect Fed rate cuts in the second half of the year, more and more are seeing a similar, shortly delayed scenario for the eurozone.
Market participants seem to forget that eurozone CPI is still at 9.2%, much higher than in the US, and core inflation is still on the rise. Rumors about a potential 25bps rate hike in March (below what the ECB has communicated so far) also supported bond prices.
Although ECB officials countered the rumors by saying that the ECB is still planning for a 50bps rate hike in March, bonds are still slightly up. Further, it seems market participants do not have in mind that effective net supply in European sovereigns will exceed 500 billion euros this year, while the ECB will become a net seller. Thus, I assume the latest rally in European bonds will end soon, and yields will start to rise again.
Consequently, one can conclude that the Chinese reopening will support demand for European export goods and that it is not unlikely that Europe will not fall into recession this year from a current viewpoint. The other side of the coin is that it is probable that, due to worsening production conditions, supply will not be able to grow in line with demand or even, in the worst case, falls. If companies consider reallocating production, the very least we can expect is higher goods prices during the transition phase.
Thus, the expectation that the ECB will cut rates this year is not very plausible, at least if the ECB continues to fight inflation (or at least pretends to). It has to be seen if rates are kept up at the currently expected rates for longer or even need to be raised further.
Therefore I expect that the latest bond rally will end soon and that the bond bull market is not (yet) back, and we will experience rising yields in the coming months. If the ECB comes to the (in my view obvious) conclusion that rates need to stay higher for longer, European equities might also pare the latest gains of the China reopens trade. Probably, investors will have backed the wrong horse.
And this is the hope for tommorow, that today you will return
Can we start again? Go back in time to where we startedKillswitch Engage - Starting Over
I wish you a splendid weekend!
Fabian Wintersberger
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(All posts are my personal opinion only and do not represent those of people, institutions, or organizations that the owner may or may not be associated with in a professional or personal capacity and are no investment advice)
Highly appreciate forward looking "what's not fully priced/preferred development" alternative scenario reasoning.