Research Dept. News
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Monthly Report, num 358 - June 2012
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Financial markets
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Monetary and capital markets
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Uncertainty takes hold of the financial scene
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Doubts regarding Greece and Spain dominate investor sentiment.
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The world's financial markets have gone through a complicated period in May. Two factors have had a combined effect: a more agitated political and economic climate in the euro area and poor economic activity figures in the emerging countries, in particular China. After the elections on 6 May, Greece's political crisis, a reflection of the country's hesitant support for the conditions imposed by Brussels, is jeopardizing the whole of the euro area. Speculation that Greece might leave the euro, together with the mistrust caused by the state of health of Spain's banks, have sent risk premia soaring in peripheral Europe. The debate on the design, orientation and functioning of the Economic and Monetary Union is entering a decisive phase, just at a time of elections to provide the approaching big decisions with democratic legitimacy. France's change in government entails a notable alteration in the correlation of forces within Europe, initially adding to the uncertainty. In addition, within the international macroeconomic context, the publication of weaker activity figures than expected in key countries such as China has harmed global growth prospects. Given this situation, the financial markets, reflecting investors' hopes and fears, are still enduring a period marked by uncertainty and the search for safe options.
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Expectation regarding the actions of the monetary authorities
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Investors examine the statements made by central banks.
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Because of the upswing in credit tensions within the euro area and the worsening expectations of world economic growth over the last few weeks, investors are following the movements and statements given by the main central banks very closely. Although it's true that the Federal Reserve and the European Central Bank have always stated they are prepared to use additional monetary stimuli if necessary, neither of the two authorities has officially announced any future actions as yet.
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The Fed identifies risks that threaten economic growth.
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In the case of the United States, debate centres on the possible approval of a third round of public bond purchases (quantitative easing or QE) by the Federal Reserve (Fed). As explained in the minutes of the last Federal Open Market Committee meeting, the authority estimates that the US economy's near future will be characterized by a moderate but sustainable rate of growth that will provide the right conditions to create jobs. This suggests that those in charge at the Fed largely believe it won't be necessary to employ additional quantitative measures to those already in place but they have left the door open. The authority has expressed its satisfaction with the current monetary policy strategy and with the effectiveness of the instruments being used. The core elements are the commitment to keep interest rates as low as possible, at the level of 0%-0.25%, until the end of 2014, and the proposal to maintain, in its portfolio, the more than two billion dollars in US Treasury bonds and mortgages it has gradually acquired over the last four years. However, the Fed has also stated that it is prepared to introduce new extraordinary measures (without giving any clues as to which) if, contrary to its main forecast, the economy relapses. In fact, at the committee's last meeting, there were more members acknowledging an increase in risks that could compromise the recovery process. The two most notable risks are the threat posed by the upswing in credit tensions in the euro area and the possibility of an abrupt fiscal contraction in the United States. Related to this very issue, the Federal Reserve Chairman, Ben Bernanke, has encouraged policymakers to adopt fiscal consolidation measures while taking into account their effects on the private sector's capacity for spending and investment. In his opinion, excessive austerity might hit hard the potential expansion of households and firms and therefore the economy as a whole.
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The ECB does not announce whether it will buy up more peripheral sovereign debt.
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In the euro area, the actions and statements given by representatives of the European Central Bank (ECB) are also being exhaustively studied by the financial markets. In this case, these measures have a dual function: to encourage growth in the euro area and relieve tension in the sovereign credit markets. At the ECB's last regular meeting, its Governing Council decided to keep the official interest rate at 1%. The stabilization of business indicators, albeit at low levels, and the equilibrium of long-term inflationary expectations are the main arguments justifying this decision, according to its accompanying analysis. Similarly, Mario Draghi, the ECB President, referred to the good performance of the financial markets after the implementation of the extraordinary measures agreed to date (principally the two three-year LTROs), this circumstance being the reason why further monetary stimuli had been ruled out. Investors' reaction to this message of continuation reveals some disappointment, in particular due to the lack of clues regarding the ECB's actions as a buyer of public debt from peripheral Europe (specifically Spain), given the recent rises in risk premia.
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The Bundesbank takes a more flexible approach to inflation.
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However, possibly the most relevant element of the last few weeks in terms of the euro area's monetary policy has concerned the Bundesbank. The President of the Bundesbank, Jens Weidmann, stated that it would consider it appropriate for inflation to be above the euro area's average for the German economy, as a measure to help correct the imbalances of competitiveness between Germany and the countries in the south of Europe. Similarly, the German Finance Minister, Wolfgang Schäuble, supported this position, specifying that an inflation range of between 2% and 3% for Germany would be desirable and confirming that there was enough margin for wage rises in the country. Should this come about, Germany's more flexible stance on inflation represents a very powerful ingredient in the formula that should lead to the region's economic and financial stabilization.
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The central banks of the emerging countries continue to relax their monetary policy.
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With regard to the emerging countries, the expectation generated by the actions of its central banks is less intense than that seen in the developed countries. Their monetary policies have been easing for months now and May was no exception. The response of the monetary authorities to the slowdown in activity in their economies is being carried out in an orderly, prescient manner. This is their approach to achieve the objective of a soft landing for growth rates, as well as greater control over inflation. The means employed rely simultaneously on interest rate cuts and quantitative measures, which vary depending on the country. The latest sign of this kind of action was the third consecutive lowering of the reserve ratio required for banks, carried out by the Chinese monetary authority. The Asian giant's economic trend has caused some concern over the last few weeks with figures being surprisingly low and some fear an abrupt slowdown. These fears seem exaggerated, given that this weakness is more temporary in nature and related to the change in the pattern of development, from exports to domestic demand.
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Interbank interest rates look very stable.
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In this scenario, interbank markets in the United States and in the euro area have been dominated by stability. In Europe's case, in spite of the political turmoil in Greece and the increase of fears regarding Spain's banking system, the huge liquidity provided by the ECB with its three-year auctions has continued to facilitate a reduction of the Euribor interest rates. In any case, this circumstance is not, in itself, a sign of a normalized market. On the other hand, there are still signs of dysfunction, such as banks' intensive use of the ECB deposit facility and the very high risk premia demanded in operations with peripheral institutions. These obstacles will probably diminish as the different solvency tests and valuations are satisfactorily resolved that are being carried out on the financial institutions of beleaguered countries.
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Same tension, new record lows for German and US debt
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Spain's sovereign debt is severely punished.
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Throughout the month of May, in addition to the doubts regarding Spain's ability to meet its deficit reduction targets, which had already emerged in April, were two events that intensified financial tensions even further. On the one hand, the holding of new elections in Greece (for the 17 June), given the inability of political leaders to form a coalition government after May's general election. Polls show a complex electoral map where we cannot rule out extreme scenarios. On the other hand, investors had to interpret the financial reform announced by the Spanish government. Although important issues are covered related to the degree of solvency of the institutions, what is true is that some uncertainty has been created associated with the findings to be published by the two external evaluators and, if necessary, how the government would tackle the requirement to recapitalize the banking system. Within this context, investors once again hit lower credit quality debt hard, taking refuge in bonds issued by Germany and the United States, prioritizing safety over yields.
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Investors differentiate France from the peripheral countries.
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The increase in political and financial tension had a very negative effect on yields for peripheral Europe's sovereign debt. The yield on Spain's ten-year bonds broke the barrier of 6% and its differential with Germany reached 490 basis points, the highest since 1995. Italy's debt also performed badly, albeit still far from the peaks reached a few months ago.
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Debt interest rates for Germany and the United States are at a record low.
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In spite of the difficult situation, the ECB has still not intervened in the secondary market, nor has it shown any signs of doing so, by buying up Spain and Italy's debt in order to contain this upswing in yields. In any case, debt issuances in the primary market have offered a less dramatic view as the respective Treasuries have managed to place securities with different maturities, registering good demand at higher interest rates that they've had to accept.
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It's interesting to note the favourable performance of France's sovereign debt, whose yield at 10 years fell from a level of almost 3.0% down to 2.75%. Unlike what happened in November, this time investors are positively differentiating French debt. In other words, the investor community believes that the risk taken on with French debt is closer to that of Germany's than the peripheral countries. In any case, Germany's sovereign bonds benefitted, once again, from a lot of investors opting for safety, resulting in yields at ten years falling to the level of 1.41%, a record low.
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On the other side of the Atlantic, US sovereign bonds have performed similarly to their German peers. In addition to being supported by relatively better economic expectations than those of the euro area, US debt is also helped by a very lax monetary policy. This, together with the security provided by a country with a very high rating and the expectation that the Federal Reserve might implement, if necessary, another round of quantitative easing, has meant that investors have pushed down yields on ten-year US debt from 1.95% to levels of around 1.70%.
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The euro loses ground
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The euro suffers from an economic, institutional and sovereign debt crisis.
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The threat to the euro area as a whole caused by the uncertain political future of Greece, greater risks in the euro area's debt markets and poor growth prospects for the region are pushing down the euro. In May its exchange rate fell by 5% against the dollar, leaving the exchange rate between both currencies at 1.25 dollars per euro. Downward pressures on the single currency have also been notable in relation to currencies such as the pound sterling, the Japanese yen, the Danish krone and the Swiss franc. Some of these countries have reacted with measures aimed at slowing up the appreciation of their currencies, revealing the destabilizing effects and distortion created by the euro area crisis. The fear of extreme scenarios of a break-up or prolonged recession is pushing many international investors to reduce their positions in euros, in a process that appears somewhat hasty and would not be reasonable much beyond what has already been observed, at least in the medium term.
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The emerging currencies also look weak.
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The currencies of the emerging countries have also been affected by the repercussions of the European crisis, as risk aversion has intensified and financing flows have been hindered. Moreover, the unpleasant surprises given by recent figures for several emerging economies have also had a similar effect. In fact, the currencies of these countries have looked particularly weak, recording a sharp depreciation against the dollar and a moderate one against the euro. The decision of the Chinese authorities to no longer put a stop to its currency's appreciation against the dollar but even to partially reverse this has contributed to this process, recalling the «currency war» but with different characters.
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Issuances slow up in the corporate bond markets
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Global uncertainty affects corporate bonds.
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The worsening climate in peripheral Europe has affected the corporate bond markets. Whereas, during the previous months, this market stood out for its remarkable ability to resist the adversities of the euro area crisis (from the point of view of issuances and the extent of capital flows), in May investor mood and the issuance of corporate bonds had been fully infected. In addition, over the last few weeks this sentiment has been furthered by the widespread deterioration in macroeconomic expectations at a global level.
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The volume of corporate bond issuances slows up.
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Logically, these factors have different repercussions on bonds depending on the geographical area and sector. Specifically, the sector most severely affected by the current situation is banking. The outcome of the credit problems resulting from the European crisis, the tougher regulations for the sector and consequent deleveraging of institutions is being reflected in a slowdown in issuances of these bonds at a global level. In the first four months of the year, the total volume of these issuances was the lowest since 2005. In the case of the euro area, this process intensified after the two three-year liquidity auctions by the ECB. Many European institutions have managed to cover a large proportion of their funding requirements for this year, thereby reducing their dependence on covered bonds. Part of these effects has also been passed on to the US market. The recent downgrade in credit quality for banks on the periphery of the euro area (Spain and Italy) has led to more expensive risk premia in the negotiation with European banks.
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US investment degree bonds stand firm.
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The bonds of non-financial firms in Europe have also deteriorated significantly, affected by the worsening macroeconomic conditions in the region and greater risk aversion. Performance has not been so negative in the United States, at least in the investment degree segment. This is partly due to the boost from US sovereign debt which, as has already been mentioned, has acted as a safe haven, a role that is also being played, to some extent, by large US companies with healthy balance sheets.
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Uncertainty hits the stock markets
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The fall in the Ibex 35 is due to many different factors of a financial and real nature.
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Once again, the main international stock market indices were in the red last month. The financial instability dominating the euro area, with its epicentre in Greece and aftershocks in Spain, and the moderate figures for activity worldwide have provided powerful reasons to ruin investors' appetite for risk. Over the last two months, most indices have seen a large part of the gains disappear that they had accumulated since the start of the year, with notable exceptions such as the S&P 500. In the euro area, the largest stock markets have fallen by more than 5% since January, although it is the Spanish index that heads the list. The value of Spanish stocks and shares is in the firing line of investors, both institutional and private. In addition to Greece's uncertain future, there is also a loss of confidence regarding the Spanish economy's ability to meet the fiscal targets set by Brussels and the degree of solvency of its banking sector. Regarding this issue, the government approved a new royal decree that requires banks to increase provisions for their exposure to the real estate sector, as well as a valuation of the sector's total assets by two independent experts. Although these measures meet the requirements being made by the financial markets regarding the transparency of bank balance sheets, there are fears that this might have a big impact on the profit and capital of many institutions in the sector. These events coincided with the government's intervention in the BFA-Bankia group, pushing the Ibex down even further, which has returned to its 1997 level.
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Improved corporate earnings in the United States boost the stock markets.
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On the international stock market scene, in addition to believing that the risks of euro area contagion have increased, investors are also taking other elements into account. In the case of the United States, the relative strength of corporate earnings during the first quarter of 2012 and the continually favourable profit projections by analysts have had a positive effect that has offset the negative to some extent. Another notable fact providing a certain degree of support for these indices is active involvement in investment funds, guided by strategies based on the return by dividend of shares. In the area of the emerging countries, although the last month has seen some downward movement in the main indices, the fact that most of these economies are implementing more flexible monetary measures is encouraging expectations of a medium-term recovery.
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Insurance for a slightly irrational world
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Insurance business is important. And so it should be, as it allows us to protect ourselves against large losses associated with events that, although infrequent, cannot be ruled out from our lives. Logically, this importance is translated into monetary terms: in 2010, insurance premiums represented the equivalent of 7% of the world's GDP, being most important in regions such as Europe, North America and Japan. Given its social and economic relevance, it's no surprise that insurance has been accompanied by a huge regulatory effort. Because of this situation, we might expect everything related to the insurance sector to be supported by the best economic theory available. But is this actually the case? Unfortunately the answer is probably in the negative.
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To bring some order to such a broad field, we propose two fundamental questions that any theory must be able to answer: why does insurance exist and why does insurance regulation exist? Traditional economic theory provides us with an answer to both questions that serves as a starting point. Insurance exists because it has value for individuals. This value comes from the fact that it helps to transfer money from times when it is not very necessary to others when it might be much more so. The alternative, individual savings, is less efficient as it reserves money for needs that might not occur in the future.(1) Thus far, the issue appears simple but it starts to get more complicated if we take into account the fact that there are information problems.
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In any contractual relationship between the insured and the insurer, the information available to both parties is clearly asymmetrical. It's difficult for the insurance company to have information on the insured and to monitor the insured's behaviour after the insurance contract has been signed. Those who want to insure themselves are likely to take more risks than the average for the population and, once insured, tend to be less careful than those not covered by insurance. These are, known as problems of adverse selection and moral hazard, respectively.
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Of course information problems are not limited to the area of insurance companies. Policyholders must also face a notable lack of information regarding aspects such as the solvency of insurers and the specific terms of their contracts. In short, the great risk for policyholders is whether, when they need it, they will actually get the promised payment (either because the company has gone bankrupt or because clauses which they were unaware of mean they are not entitled to any payout).
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These problems of information are the customary justification for regulation. Regulation attempts to reduce the information problems that cannot be eliminated by the market itself. While the information problems faced by companies tend to be resolved reasonably efficiently in the private area (for example, by means of corporate policies for exemptions or overpricing certain groups that are more likely to take excessive risks), those affecting consumers usually require public regulation. In short, it is a question of helping the «private» information of companies to become public (or of reducing the effort required by consumers to have this information).(2) The regulation governing most countries aims to ensure the solvency of insurers and a certain quality of contracts and their fulfillment. Some of the most usual instruments are the requirement to use standardized contracts, conditions for joining the sector, limitations to price fixing and solvency rules (usually in the form of capital requirements and other financial conditions).
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(1) In academic terms, consumers take out insurance because they are adverse to risk and because insurance is a more efficient instrument against potential losses than savings, as a means to equalize the marginal utility of consumption over time.
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All these practices would be enough if consumers, the cornerstone which the regulator is attempting to protect, behaved with the rationality expected by the theory. But we know this is not the case. In the insurance business, as in other markets, anomalies are frequent. When a high demand for insurance would be expected due to catastrophic accidents (precisely the kind of large but infrequent loss that would best warrant an insurance policy), the reality is that there is an excessively low demand for this kind of product. For example, in New Orleans only 40% of households had some kind of insurance against floods, a situation that proved to be disastrous after hurricane Katrina. However, other types of less rational situations are usually more in demand than their theoretical optimum. Frequently mentioned are insurance policies with deductibles that are too low or the extension of cover for certain consumer durables.
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These anomalies are essentially due to two categories of limitations suffered by consumers. Firstly, consumers are influenced by a series of biases that affect how the value of insurance is perceived, either by underestimating it (producing a demand below the optimum level) or by overvaluing it (thereby leading to excessive demand for insurance). The first of these cases occurs due to two biases detected in the literature: what is called hyperbolic discounting (or an irrationally high preference for money in the present rather than the future) and what is known as the over-optimism bias (the ill-founded belief that negative events won't happen to us). Other biases have also been detected that can lead to consumers overvaluing insurance, such as those based on superstition (the belief that, if you take out insurance against an accident, it won't happen to you), on copying the decisions of others («herd behaviour») and an excessive emotional tie to the object or person (which is consequently over-insured).
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Together with these difficulties in perceiving the right value of insurance, a second group of limitations results from the cognitive difficulty in taking decisions based on situations of risk and uncertainty. In addition to the classic behavioural regularities often mentioned in various transactions,(3) in insurance an aversion to taking certain events into account has been noted as particularly relevant (including death and other stigmatized taboos), as well as an aversion to complexity. In general terms, the outcome of these limitations to being able to process information is that people too often decide not to take out an insurance policy.
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In short, in the slightly irrational (or, more accurately, imperfectly rational) world we alluded to in the title, regulation tends to defend society from the excessive presence of private information surrounding insurance transactions. However, protecting consumers from all these biases we have just mentioned is far from commonplace. One of the problems is that, as we are reminded by Baker and Siegelman, two key authors in this debate, although consumer «errors» can be detected, adequate regulation is far from easy.(4) This is because, in behavioural economics, the link is weak between behaviour and welfare (in the usual economic sense). For example, and remembering one of the biases mentioned above, how could regulation protect me from the fact that I get satisfaction (or reduce my anxiety) from being superstitious?
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(2) Nonetheless, it should be noted that, on certain occasions, these private practices end up blocking some groups out of the market. In order to avoid this situation of some people not being able to take out insurance, under certain circumstances regulation forces insurers to insure these groups.
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(3) The classic reference is Kahneman, D. and A. Tversky (1979), «Prospect theory: An analysis of decision under risk», Econometrica, vol. 47, pp. 263-291.
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(4) See Baker, T. and P. Siegelman (2011), «Law and Economics after the Behavioral Turn: Learning from Insurance», Flom Petrie Health Policy Workshop.
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Although this issue has started to be explored academically for certain types of insurance, in general for those policies that suffer from too low or too high a demand, and which are easier to handle, the findings are a long way from being conclusive. To give an example, in 2003 in the United Kingdom, the case was studied of additional cover for electronic products. It was concluded that, in effect, this was requested to a greater extent than was rationally desirable and a proposal was made to increase competition in the sector (the report was by the Competition Reform Commission). The «behavioural» proposal which was put forward in some academic circles was to protect consumers from themselves, since they were too emotional regarding the insured object, by making it impossible to offer such extensions to cover. Clearly not a very satisfactory solution. However, as behavioural economics advances, it should be better equipped to help this world made up of the imperfectly rational consumers we are.
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This box was prepared by Àlex Ruiz
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International Unit, Research Department, "la Caixa"
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