“Prolonged Period of Risk to Institutional and Retail Investors of Further – Possibly Significant – Market Corrections”

European Market Regulator flags big issues, including the “decoupling of financial market performance and underlying economic activity.”

By Nick Corbishley, for WOLF STREET:

The European Securities and Markets Authority (ESMA) warned of a “prolonged period of risk to institutional and retail investors of further – possibly significant – market corrections and very high risks” across its jurisdiction.

“Of particular concern” is the sustainability of the recent market rebound and the potential impact of another broad market sell-off on EU corporates and their credit quality, as well as on credit institutions.

The “decoupling of financial market performance and underlying economic activity” — the worst economic crisis in a lifetime — is raising serious questions about “the sustainability of the market rebound,” ESMA says in its Trends, Risks and Vulnerabilities Report of 2020.

Beyond the immediate risks posed by a second wave of infections, other external events, such as Brexit or trade tensions between the US and China, could further destabilize fragile market conditions in the near term.

From a long-term perspective, the crisis is likely to affect economic activity permanently, “owing to lasting unemployment or structural changes, which might have an impact on future earnings.” The increase in private and public sector debt could also give rise to solvency and sustainability issues.

In corporate bond markets, spreads have narrowed but they remain well above pre-crisis levels, owing to heightened credit risk and underlying vulnerabilities related to high corporate leverage. There was also a wide divergence across sectors and asset classes in April and May. Across non-financials, the automotive sector suffered the largest decline, followed by the energy sector.

In one of the report’s rare positive notes, central counterparties (CCPs) proved resilient throughout the period, despite the surge in clearing activity coupled with the sharp rise in initial and variation margins. That said, there’s still a high risk of a further deterioration in credit quality, which is likely to spark a fresh round of credit downgrades.

The risks of “fallen angels” remain high, and securitized products (e.g. Collateralized Loan Obligations (CLOs)) could also be affected. “The COVID-19 crisis is disrupting markets in ways that were impossible to predict when CLO ratings were assigned before the epidemic”, ESMA notes.

This raises the likelihood of further credit downgrades as the crisis evolves. Recent developments in the leveraged loan market attest to (emphasis added) “a deterioration in loan documentation, a widespread decline of financial covenants and increased use of accounting techniques by borrowers to reduce their apparent financial leverage.” Taken together, these “magnify the risk” that when defaults occur, they are more likely to occur together – clustered across firms and sectors.

“The COVID-19 turmoil has also highlighted the risks of market-wide stress” for investment funds due to the “interconnectedness and spillovers in the EU fund industry,” the report said.

In the midst of the turmoil, some asset managers decided to suspend redemptions, including most property funds, because of “valuation uncertainty” and the intensity of outflows (run on the fund) that couldn’t be met through sales of these illiquid assets, indicating, as ESMA says, “that funds exposed to less liquid asset classes are more likely to be affected by shocks originating in other markets than funds invested in more liquid assets.”

In its report, which analyzes the period from late February to the end of June, ESMA saw the financial market go through three different stages:

  1. A liquidity and volatility period (mid-February – end-March) during which markets, investment funds and infrastructures faced inordinate levels of stress. Huge volumes of money poured out of management funds and high-risk assets. Redemptions from bond funds reached record highs in March, resulting in outflows of 4% of their net asset value (NAV) in 1Q20.
  2. A rebound period (early to end-April) in which markets rebounded swiftly on the back of hugely accommodative monetary and fiscal policy actions, which continue to this days. Outflows from funds slowed and eventually gave way to net inflows, as investors flooded back into the market. By the end of April around half of the fund outflows had been reversed.
  3. A differentiation stage (starting early May) during which credit and solvency risk came to the fore, as investors began differentiating between issuers and asset classes amid ongoing deterioration of economic fundamentals.

In the second quarter as a whole, as volatility receded and liquidity improved, European equity markets enjoyed their best quarterly performance since 2015, with a rise of 20%. They are now up around 40% since the trough reached in mid-March, and are almost back to pre-crisis levels. But the performance of European stock markets has been wildly uneven:

  • By far the best performer, Germany’s DAXK index, which strips out the effects of dividends that are included in the DAX, has rebounded 48% and has come close to recapturing its pre-Covid highs.
  • France’s CAC has bounced back 32% and Italy’s FTSE Mbe, 30%
  • The continent’s two major laggards, Spain’s IBEX 35 and the UK’s FTSE 100, have respectively risen by just 14% and 13% off their March lows.

Italy and Spain were both locked down longer and more severely than Germany and are also hugely dependent on tourism, so it makes sense that their markets haven’t rebounded as much. More striking is the divergence between Spain’s index and its French and Italian counterparts, suggesting that investors are particularly worried about the Spanish economy. As for the UK, investors are skittish about what additional turmoil could occur if it were to leave the EU without a deal at the end of this year. By Nick Corbishley, for WOLF STREET.

“Valuation uncertainties” were citied once again. And the trail of the Windhorst bonds. Read… €22Bn Hedge Fund H2O, Majority-Owned by Natixis, Ordered to Freeze Funds. Fishy Smells Emanate

Enjoy reading WOLF STREET and want to support it? Using ad blockers – I totally get why – but want to support the site? You can donate. I appreciate it immensely. Click on the beer and iced-tea mug to find out how:

Would you like to be notified via email when WOLF STREET publishes a new article? Sign up here.

  36 comments for ““Prolonged Period of Risk to Institutional and Retail Investors of Further – Possibly Significant – Market Corrections”

  1. 2banana says:

    Why would this not be true….especially in a non growth economy.

    “The increase in private and public sector debt could also give rise to solvency and sustainability issues.”

  2. MonkeyBusiness says:

    If Italy’s banks can withstand everything that has happened, perhaps their “obituaries” were written too soon.

    • Wolf Richter says:

      They were bailed out BEFORE the pandemic, and they’re now getting massive support from the ECB.

      • MonkeyBusiness says:

        Sure, but the ECB will only withdraw their support once these guys can stand on their own.

        Looks to me like we are in for a long period of muddling through.

        • nick kelly says:

          ‘only withdraw their support once these guys can stand on their own’.

          Or when the ‘frugal five’ decide they’ve had enough,with the already reluctant, much smaller four only agreeing so far after being ‘coaxed’ by Germany.

          I don’t follow German politics closely but think it unlikely that Merkel will be followed by a leader with such an almost religious belief in the EU project. This does not mean he or she will be anti-EU but the days of ‘whatever it takes’ could be numbered.

          We had a preview of this with the tightening of conditions on Greece. Re: the theme of big bad Germany picking on poor little Greece, see Micheal Lewis’s: ‘Boomerang’ (2012 about the post GFC in Europe. In Greece, he discovers a society perhaps un-bailable. No one has ever been jailed for tax evasion. As Lewis interviews in a swank hotel, the local expert says: ‘we won’t get a receipt when we pay’

          If Germany enters a long recession, Spain may be next to encounter tightened loan conditions.

        • char says:

          Germany makes its money with selling cars. Electric cars have a different cost structure and labour demand than ICE cars. Towns like Stuttgart will likely be hit very hard by the transition so the assumption that Germany will stay in the frugal group is IMHO not a certainty and the “frugal” four who in reality they spend more than Italy have a combined population smaller than Spain.

        • MonkeyBusiness says:

          Frugal five is a joke. It’s just another kabuki in the end.

  3. nick kelly says:

    Tells us something about Brexit that the UK is lagging all, even Spain.

    Picky trivia: I am a Brit ( dual cit) although not practicing, and thought we still distinguished between the UK and the ‘continent’ meaning the geography not the legal EU.

    • John Taylor says:

      I wonder if part of the reason that the U.K. is lagging is because of the sector mix in the UK FTSE 100.
      London has an enormous financial sector, and that sector has been lagging in general.

  4. Jdog says:

    Euphoria, is often followed by misery…

  5. char says:

    Spanish index is also a Latin American index. Latin America is not doing well and Mexico is doing the wrong type of TINA according to the Neo’s

    • polecat says:

      The Neo who, and the TINAS therein ??

      could you possibly clarify for this lowly moke ?

      • MarMar says:

        Neoliberals
        TINA = “There is No Alternative”; look it up on Wikipedia

      • char says:

        Normally a country in Mexico position will make labour bleed and protect capital but with current president is more the kind to bleed capitol, which is partly controlled by Spanish Stocks.

  6. gorbachev says:

    I dont think there much faith in currencies

    holding their value right now.It explains to

    me the panic to buy almost anything that might

    hold its value.Give savers 5% on their saving and

    watch this bubble go away pronto.

    • Old School says:

      Are people in Germany or the other wealthy countries nervous about having savings in Euros? It’s such a young currency with a shaky political foundation.

    • Thomas Roberts says:

      Almost all assets classes are currently overvalued. With currencies though you have to store them in the bank (if you have a significant amount) and so the risk is that if the bank collapses you could lose some or all of your money. Only some countries have Deposit insurance on money in the bank and not of all these will necessarily be upheld in more dire circumstances, plus there are limits and there is some amount of time it would take to get that money if the bank goes under. Right now people are chasing the idea that if you “invest” money you are entitled to get a positive return on investment. People will of course try to spread their money around. That promised return on investment is what I would say turns people away from cash, especially, as they see the stock market climb ever higher. Cash right now is one of the best and safest assets to own (depending on currency). Potentially, the best asset class right now is precious metals, but, most with enough savings will need a bank or vault of some sort to store them and that has it’s own issues. The idea that the euro-zone could implode and the Chinese interference in HK will also suppress those typically strong currencies. Currencies are the only asset class everyone participates in.

      • Frederick says:

        Silver is an exception at half it’s 2011 peak. Manipulation anyone?

      • Engin-ear says:

        I like your reasoning.

        Currencies is the most liquid asset in the world. It exists mostly in digital form, thus the digital money you “have” is not exactly in your possession: the bank has it and you have a debt claim on your money parked at bank. A subtle legal point.

        All asset protection strategies we speak about here are great in stable environment.

        If my understanding is correct, the places on Titanic life-boats were not exactly distributed according to the size of your wealth back home.

      • Thomas Rudwall says:

        You don’t need a bank or vault to buy gold miners:
        GDX (ETF Basket of Senior producing miners) is up
        39 % year-to-date – S & P is up just 3 %. Or if you were fortunate enough on January 1 to hold world’s biggest gold miner and only miner component of S & P – Newmont (NEM) – you’re up 54 % through today, 9/8.

        • Thomas Roberts says:

          Your talking about stocks though, not, physical metals. The stocks of miners aren’t guaranteed to make large sums of money even if gold does well. Also, the main purpose of physical metals is to hold value, not necessarily to grow it. I haven’t looked into it, but, the miners might be really good stocks, but, the growth of stocks so far this year has been erratic to say the least across the entirety of stock markets. The miners might be worth looking into for stock buyers, but, one would has to consider where they (each individual company) mine and their existing and typical agreements (where they have acquired the right to mine and how much of the value they get to keep), so as to figure out if the value of gold rises, if each particular company would profit off of that and to what extent.

      • Thomas Rudwall says:

        You might look into AEM & PAAS in addition to NEM & GDX. Nothing’s guaranteed with any stock.

        Disclosure: I’m long these stocks (+ others).

  7. Bobby Dents says:

    Well at least the PPP/PUA is gone. Nice bump to unemployment coming in the 4th quarter(with census layoffs giving it a bit more of a nudge). No wonder the Administration didn’t want that to end August 1st like Congress.

  8. Bobber says:

    If one European authority is saying markets are overvalued and risky, why is another European authority using monetary policy to further increase asset prices? Is this what people should expect from government? Double speak?

    • MonkeyBusiness says:

      Pretty much. And the Germans might be the ultimate experts when it comes to double speaking. They criticize the ECB all the time for printing money, but they don’t do anything else to stop it.

      • Frederick says:

        Do you actually believe that German politicians have any power to do anything about it? Because I don’t

        • Thomas Roberts says:

          The issue in the EU/eurozone is that too many countries didn’t behave financially responsibility for too long and so countries like Germany often have to look out for themselves in certain issues. Everyone does that, but, the Germans as the largest economy in the EU (and in many ways the center) always get the criticism. Unless, enough less responsible countries like Spain and Greece either leave the EU or turns things around. What choice does Germany really have? The EU will have to become either more or less integrated or it will implode. If it does implode, a new smaller stronger EU could arise, most not in it, could be screwed though.

          As for the ECB, if individual countries don’t act responsibly, the ECB cannot either. Realistically though, the ECB probably just protects the rich. While very similar to the US Federal Reserve, there are many important differences.

  9. Fat Chewer. says:

    If the Euro regulator is anything like Oz, all the investors have been screwed long before the warning was issued.

  10. CRV says:

    We can’t say we haven’t been warned.

    • buda atum says:

      No, we can’t say we haven’t been warned. And I bet the Fed heard this and were like, “what the heck do you think you are doing, European Market Regulator, telling everyone what’s about to happen”!? Fed shouldn’t worry of course. Americans don’t listen to Europeans!

      By the way, another reason the FTSE hasn’t done so well might be the conservativeness of the Brits. We are not so pilled into the stock market like Americans are, I don’t think.

  11. Dave says:

    Who else is hearing people talk about investing in stocks in their work place with increased frequency? It seems the hot trend and I wonder if it is an indicator?

    • buda atum says:

      Not in my work place, but when folks in Lagos Nigeria are giving share tips, it feels like shoeshine on Wall Street times.

    • Lisa_Hooker says:

      “When even shoeshine boys are giving you stock tips, it’s time to sell”

  12. CRstophr says:

    S&P 500 NASDAQ DOW 30 is doomed if some of the “dividend aristocrats” are ever evaluated on Tangible Book Value Per Share (TBVPS) principles. Have a look at MMM or SWK or T

    https://www.bloomberg.com/opinion/articles/2019-12-23/worthless-companies-are-decade-s-big-market-winners

    Certainly not a dividend aristocrat but AZO is nuts even when compared to TSLA

    Perpetual suspension of disbelief and continued hopium application is all that is required…

Comments are closed.