Lies, damned lies and valuations
The Barclays UK Government Inflation-Linked Bond index experienced a 13 standard-deviation event on 10 January. This asteroid strike followed the UK’s Office for National Statistics (ONS) announcement about plans for its problematic retail price index (RPI), to which UK ‘linkers’ are linked. Its calculation is substandard and probably overstates inflation, so the market concluded that it would be dropped and that linker coupons would shrink; 10-year yields had been creeping up for a month. Then the ONS announced its decision to retain RPI for linkers – and within minutes the Barclays index was up an incredible 4.5%.
Three days earlier, the Basel Committee extended the range of assets that banks can use to calculate their liquidity coverage ratios under Basel III, and pushed the
compliance date out to 2019 – boosting financials and the general mood of euphoria, itself the result of the US Congress’s last-minute ‘resolution’ of the fiscal cliff, the unedifying brinkmanship of which we are sure to re-visit during February’s double-whammy debt-ceiling and sequester debates. As with RPI, almost everyone who went on-record about the cliff was (wrongly) confident about the outcome.
Few were wrong-footed by Japan’s elections, but corporate performance over recent months suggests that the ecstatic market response is based more on Shinzo Abe’s yen-trashing than on anything more fundamental. Similarly, the scramble for European risk assets is predicated on Mario Draghi’s “anything it takes” promise – itself predicated on Spain applying for bail-out funds (which asset managers expected imminently, several weeks ago).
Those arguing for a comeback by fundamentals have evidence: implied equity volatility is extremely low and implied correlations declined through 2012. When the FOMC’s latest minutes revealed some surprising hawkishness, traders bought the dollar – a ‘traditional’ FX play – rather than selling it as a safe haven. Since mid-November, European equities have outperformed US equities – perhaps reflecting a fundamental relative-value opportunity being realised – and they were much less sensitive to the fiscal-cliff shenanigans.
But then again, the dollar quickly resumed its ‘risk-on’ weakness, and while European and US stocks are now more equally valued, is 17 times earnings the right value? Does low implied volatility suggest that investors think 17 times is cheap, or that they’ve persuaded themselves that the Bernanke and Draghi ‘puts’ will keep stocks expensive? Lower correlations signal more focus on company fundamentals, but what do relative values tell us about absolute value? How many times during the run-up in corporate credit have you been told to stop worrying about yields and focus on spreads?
Sometimes, when asset managers herald a ‘return to fundamentals’, they appear to mean ‘panic over, markets are up’. But a real return to fundamentals could easily send markets the other way. Investors should take great care when trillions ride on the decisions of politicians, regulators, central bankers and – heaven help us – statisticians.