A nervous summer for the Badger of Broad Street

High-summer is seldom a good time for markets. Nervous trading and thin volumes never make for a positive upside story. Stocks have corrected. But this year it feels even worse as market participants worry more about the widespread threats of disorderly corrections and routs.

There are a number of reasons why.

It’s not just the geopolitical mess that now overlays all activity. It’s also the fact that markets are evolving to reflect lessened liquidity from banks. Investors are nervous and are looking to innovate the use of new products to take market views. And, then, of course, there is the big question… when will interest rates rise?

On the geo-political front, the multiple points of concern are obvious – Ukraine dominates the picture, with everyone unsure how a stand-off with Russia may develop. It looks likely to deepen, and that’s clearly bad news for Europe. The Germans, the last place in Europe where the lights are still on, will suffer most due to the scale of its exports to Russia. The UK, in contrast, will suffer little – although Europe will no doubt accuse Cameron of hypocrisy over oligarchs while simultaneously selling Russia helicopter assault ships.

Add the problems in Gaza, Syria, Iraq, and North Africa, and the global picture is not pretty. Overlay that with global growth problems and you can see concerns on multiple points – Argentina, property worries in China and an increasing number of folk worrying about Europe’s problems reigniting in Portugal, Italy or Greece.

There hasn’t been much contagion from the collapse of Banco Espirito Santo, but many players believe it’s the tip of an iceberg of corruption that will be exposed in Portugal. If it happens in Portugal, when will the penny drop in Italy and elsewhere. Another full-scale European crisis later this year perhaps?

The fact that Obama is being characterized as a lame-duck, disinterested and ineffectual US President – a self-fulfilling charge – also impinges markets. There is a global feel things are badly wrong, but not much can actually be done about it.

Markets hate uncertainty, but that’s what they’ve got for the present. Very uncertain outcomes from hotspots around the globe. Of course, the obvious trade in times of tension is to buy gold – but that’s been a dull market recently. It’s now trading in the $1,300 area, compared to the top of $1,900 in 2011. Recently we’ve seen a very gentle trend towards higher prices, but nothing like we’d expect ahead of a major global crisis – 100 years ago there were stories of the entire German high command dumping stocks and shares as war approached. Not today – global demand from the yellow stuff has slumped.

So where is the safe haven money going?

Much to the surprise of many, US Treasuries have rallied through 2014, a counter-intuitive move if you believe the Fed will shortly raise US interest rates. They’ve rallied because folk are in love with the dollar again, and are buying the asset they perceive to be the safest and most liquid – US Government Bonds.

It’s a different story in less safe parts of the bond market where Emerging Markets have been slapped, and Hi-yield junk bond markets have been spanked into the long-grass. That uncertainty will spread and deepen holders of these assets start to ponder who they get out – chronically illiquid markets quickly become traps.

And the bond markets have never been as illiquid as they are today – caused by capital rules and regulations stopping banks from taking risk. Bank no longer provide liquidity by making markets in most bond sectors. As a result liquidity has crashed and markets have become less efficient.

That leaves investors looking for other ways to invest.

Hence the rise in exchange traded products like ETFs – funds which replicate the big bond indices and are often more liquid than the underlying markets. At the moment ETFs account for a tiny portion of markets, but they will rise as investors find ways to use them to manage money, smooth cashflows and take sectoral investment views.

Changes such as the move away from single asset risks to the risks of wider index are changing the way markets work. As are developments like the number of real money funds replacing banks as direct lenders. Much of it is very positive.

Which leads us to the last point for today – do we think global interest rates are set to rise?

A lot of people believe the Bank of England could act later this year, followed by the US Fed next year. Personally, I reckon central bankers will keep reminding markets that rates must raise, but they won’t do anything sudden or early, lest it rock sentiment. Sentiment is rickety enough due to the ongoing geo-politics.

So what’s the trade for the week? Buy dollars and the Treasury run isn’t over yet. I’m also thinking about a speculative play in gold… just in case, just in case…

Badger