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Friday, July 31st, 2015

Financial markets see sectoral risks becoming more similar over time
posted by Vasileios Douzenis

Figure 1: Rolling Asset Betas (2-years of daily data)

EE calculations based on Bloomberg data.

In the last two months’ entries we explained how during periods of market turbulence a “flight to safety” effect is often present among market participants.  Last month, in particular, we noticed how despite what was perceived as an increased probability of “Grexit”, the core identifiers of a “flight to safety” effect were not observed.  UK utilities maintained their positive momentum while, on the other hand, the asset betas of companies in the UK financial sector maintained their somewhat negative trajectory.

July has been an eventful month for financial markets with major developments for the European Union and the Eurozone.  The stalling negotiations between Greece and its creditors, delayed, among other reasons, because of a referendum, appeared to be progressing when preliminary steps for a third bailout package were agreed.  While this can be seen as a positive step, it raised concern regarding decision making at the Eurozone level and highlighted some of the system’s structural weaknesses. At the same time, things are taking a negative turn in China with the stock market experiencing significant volatility and some rather significant day-to-day drops and triggering concerns among investors.

Data presented in the above graph highlights the persistent reversal in the “flight to safety” effect, with utilities’ beta increasing and financials’ falling, while other sectors appear to be more or less stable.  The visually striking convergence in the figure can also be confirmed statistically.  The coefficient of variation across these ten sectors (into which Bloomberg subdivides the FTSE as a whole) has fallen from 35 per cent in January 2014 to 17 per cent in July 2015.

04:15 PM | Permalink

Wednesday, July 1st, 2015

The deterioration of the Greek crisis has no material impact on the risk of UK equity, yet.
posted by Dr Andrew Lilico & Dr Stefano Ficco

Figure 1:  Rolling Asset Betas (2-years of daily data)

EE calculations based on Bloomberg data.


The “beta” of an asset tells us how the riskiness of that asset changes relative to the sum of all assets in the economy. The beta of all assets is by definition equal to 1. Periods of market turbulence are often characterised by “flight to safety” effects which are associated with a decrease of asset betas in sectors perceived to be safer (e.g. utilities), and an increase in the betas of relatively riskier assets (e.g. financials). The reverse (i.e. utility betas rising and financial betas decreasing) is often observed when investors’ risk appetite increases.

Despite the increase in market volatility over the last month and the higher perceived chance of a “Grexit”, recent movements in two-year rolling sectoral betas do not suggest any material “flight to safety” effect yet. Indeed quite the reverse. The betas of UK utilities and UK financials assets maintain, respectively, the positive and negative trajectories they have had for some time, implying if anything a continued reversal of the flights-to-safety of 2008-2012. It is possible, however, that if there had been some very recent flight to safety it would not yet be showing up in these data.

11:50 AM | Permalink

Monday, June 1st, 2015

Political risk plus reversal of flight to safety effects sees utility betas rise
posted by Dr Andrew Lilico & Dr Stefano Ficco

 Figure 1: Rolling Asset Betas (2-years of daily data)

EE calculations based on Bloomberg data.


The “beta” of an asset tells us how the riskiness of that asset changes relative to the sum of all assets in the economy.  The beta of all assets is by definition equal to 1.  Periods of crisis don’t usually affect all sectors equally.  For example, in the Great Recession financial and construction (“Materials”) stocks came to be seen as more risky than before.  If their relative riskiness and hence betas go up, the relative riskiness of other stocks such as utilities must (mathematically) go down.  This is part of what is sometimes called a “flight to safety”.

By contrast, over the past eighteen months, as the UK economic recovery has become more secure, the riskiness of financials and materials stocks has fallen back again.  So that part of the flight to safety effect has reversed, with utilities betas rising.

Another factor, however, may have been political risk in the run-up to the 2015 General Election, with the main political parties competing to propose various means (e.g. price freezes) to be “tougher” on utilities.  It remains to be seen whether, with the unexpectedly decisive General Election result, this shift is reversed or exacerbated.

04:25 PM | Permalink

Friday, June 7th, 2013

Turkey’s protests threaten to unnerve the economic electorate too
posted by Brian Biggs

After days of protests, ballooning from a niche sit-in over green space in Istanbul to country-wide demonstrations calling for a change in government, Turkey’s Deputy Prime Minister Bulent Arnic conceded “we do not have the right and cannot afford to ignore people. Democracies cannot exist without opposition.”  This insight is better late than never, but recent market movements have focussed attention on the relationship between socio-political stability, image and economic prospects in Turkey.

Emerging markets are often dependent on capital from abroad to finance expenditure.  This can be due to underdeveloped domestic capital markets or the desire of foreign investors to buy into good growth potential where domestic creditors simply can’t meet the demand for funds.  Alternatively, emerging markets — like developed markets — sometimes take in foreign capital to finance current account deficits.  The former usually comes in the form of foreign direct investment or long-term portfolio investment, whereas the latter is typically made up of short-term portfolio investment.

Since Erdogan took office in 2003, Turkey’s current account deficit measured on a moving average basis has grown a staggering 14 fold.

Table 1. Turkish current account deficit (12 month moving average), 2003-2013

Source: Central Bank of the Republic of Turkey; Bloomberg

Short-term investment is, by definition, far more mobile than long-term investment.  Leaning heavily on short-term investment is precarious position to be in for any country, but this is especially true for countries exposed to strong reputation risk.  If alarmed, investors can pull out of a country in a moment’s notice and leave the country starved of capital. 

Since 2010, Turkey has become increasingly reliant on short-term foreign investment.  Were investors to stage a mass exodus, Turkey would find itself lacking the resources to fuel its historically strong growth, keep inflation subdued, and service its debts — all trumpeted achievements of the last decade.  This could explain, in part, the recent tumult in Turkish equity, credit, and currency markets.

Figure 2. Short-term and long-term foreign investment in Turkey, 2007-2013


Source: Turkey Data Monitor; BBC

Another key source of growth for many emerging markets is tourism.  As in economic performance, Turkey as a tourism destination has shot up the league tables since 2003.  Turkey is now the sixth most popular tourism destination in the world.  The country’s tourism industry is valued around $30 billion.  Services comprise around 63 per cent of the Turkish economy, and tourism comprises a significant chunk of Turkish services.  Any hit to the country’s image as a safe holiday destination could seriously bruise economic growth.

Although talk of a “Turkish Spring” has been played down by many commentators — indeed, I would also caution against such comparisons — patterns in post-Arab Spring tourism in Egypt, Tunisia, and other such countries act as a warning to Turkish politicians.  Tourist arrivals in Egypt fell by 4.5 million following its episode of political upheaval.  This was a key drag on the Egyptian economy. 

In terms of tourism, Turkey actually benefitted from the Arab Spring, as the country was seen as a substitutable product but without the risks.  This time, that relationship could be reversed. 

Admittedly, tourism as a per cent of total employment is somewhat lower in Egypt than in Turkey (14 per cent in the former and 8 per cent in the latter).  Nevertheless, a significant drop in foreign footfall could pose a real threat to the country’s economic prospects.

The direct impacts of the demonstrations on the Turkish economy, such as strikes and damages to property, are likely to be minimal.  The real threat comes from falling out of favour with those bringing cash into the country.  Investors and holiday-goers, like the Turkish electorate, have been voting for Erdogan over the last decade by bringing their money to Turkey.  And also like political votes, those economic votes are likely to disappear unless the current situation is managed delicately.

03:20 PM | Permalink

Tuesday, May 28th, 2013

Three Monetary Policy Insights from Last Week
posted by Brian Biggs

Ben Bernanke spoke, and the world shuddered.  Testifying before Congress, the chairman of the Federal Reserve indicated that the FOMC could start to scale back the pace of its asset purchases “in the next few meetings.”  In suggesting that the Fed might start buying less than the current $85 billion of bonds per month as early as September, he pulled the trigger on what Warren Buffet called the shot heard around the world.

Markets around the world went into a tailspin.  All of the main G10 equity markets suffered declines on Bernanke’s words.  Most notably, the Nikkei 225 tumbled 7%, its largest single day drop since the Tokohu earthquake and tsunami in 2011.

This is remarkable.  Bernanke was clear that change to QE would involve buying fewer securities, not ending the programme entirely.  In his prepared statement, Bernanke struck a dovish tone, praising extraordinary monetary operations for their role in supporting the real economy and making it clear that the Fed did not want to pull back on stimulus measures prematurely.  Continuing Buffet’s analogy, Bernanke might have fired the shot, but the gun was full of blanks.

We did, however, get a preview of how the market might react when monetary conditions do begin to normalise.  Three insights are apparent after seeing how financial markets could react if the Fed were to begin to change the direction of monetary policy.

1. There’s no such thing as strictly domestic monetary policy.  Formally, the Fed will keep with accommodative monetary policy until the FOMC is sufficiently confident that the unemployment rate will fall below 6.5 per cent.  All central banks are bound by their domestic mandates, such as price stability or promoting full employment within their respective borders.  Recently the Fed has been focusing on the employment side of its mandate.

The sell-off that met Bernanke’s suggestion of slowing QE underscores the truly global nature of domestic monetary policy decisions.  Discussions of monetary policy coming out of central banks around the world often begin with the domestic picture of, say, the labour market and price levels and then turn to international headwinds later.  To the extent that international reverberations of domestic monetary policy can have an impact on a central bank’s domestic policy goals, it is indeed within a central bank’s mandate to consider the global implications of monetary policy.  In other contexts, such as recent fears over currency wars, the international community can exert significant influence on domestic policy.

So in spite of the Fed’s domestic mandate, the international picture is important as well.  If Bernanke just hinting at winding down QE can have such a strong impact on asset prices globally, it’s likely that the Fed doesn’t just look at domestic labour market and price level indicators when deciding on US monetary policy.

2. Asset prices are highly sensitive to stimulus withdrawal.  This seems obvious on the face of it, but no one really knew (or knows) how tightening monetary policy will impact asset prices.  We have no modern precedent.  The last time the Fed raised its benchmark interest rate was in June of 2006, when the target rate was increased from 5 per cent to 5.25 per cent.  Interest rates at that level aren’t even conceivable in the current policy environment.  We’re in uncharted territory, both with regard to the level and duration of interest rates and the size of the Fed’s balance sheet.

The frenzied downside reaction to Bernanke’s testimony highlights how sensitive global asset prices are to central bank largesse.  This is especially true considering the Fed didn’t actually do anything.  He hinted at the possibility that the Fed might consider scaling back the pace of QE.  Even so, scaling back asset purchases probably wouldn’t alter the path of the Fed’s balance sheet materially.  Also, interest rates would still remain pressed up against the zero bound.

The fall in pro-cyclical asset prices probably wasn’t entirely due to Bernanke.  China is slowing, and many investors were likely taking some profits off of the recent bull run, particularly in equities.  Nonetheless, it’s clear that Bernanke’s comments pushed prices down to some degree.  If asset prices were indeed justified by fundamentals, then Bernanke’s comments would have had a more muted effect.  The sharp fall in risk assets suggests that central banks are blowing bubbles in the financial markets.  The extent to which asset prices are due to bubbles versus fundamentals might be proxied by how steep the drop in prices were in response to Bernanke’s comments.  However measured, last week offered some clues about just how dependent on stimulus some assets really are.

3. When monetary normalisation does occur, it will be slow and announced far in advanceEventually, monetary policy conditions will have to return to normal.  Some might argue that future monetary policy will be radically different to pre-2008 trends due to the “new normal” situation in the real economy.  I think monetary policy indicators will eventually revert to the long-run averages.  Regardless of which camp you might be in, virtually no-one agrees that monetary policy can remain as it has been for the last five years.

This raises the question of how central banks will unwind highly accommodative monetary operations.  Like all central bank operations, monetary normalisation will be as much about communication strategy as it will be about the technical details of the policy change.

John Williams of the San Francisco Fed opined that policy movements could be up or down, but that would be out of step with the Fed’s policy since the crisis.  The Fed, along with its peers around the world, have tried to blunt the uncertainty associated with being off the monetary map by communicating its policy decisions in advance and even tying policy to some concrete dates or indicator values.

Last week, the Fed saw the effects of announcing the potential of tapering QE months in advance, and they were nasty.  Barring a substantial spike in inflation, the Fed might eschew the Volcker approach to monetary tightening and instead slowly communicate to the market that QE will be slowly winding down and, eventually, interest rates will slowly rise.  That is, not only will policy be announced far in advance, but policy changes will be gradual.  This could allow asset bubbles to deflate prior to the tightening itself, which would hopefully minimise volatility in the markets.  It may also allow firms and individuals that hold deflating assets to realise losses more gradually and remain solvent.

This blog has focused on the Fed, but the same arguments apply to the Bank of England or the European Central Bank.  In short, the episode surrounding Bernanke’s testimony before Congress gives us a glimpse into what to expect when central banks globally start cooling down the printing presses.


12:19 PM | Permalink