City blues

It has been a source of huge frustration to the financial services industry that it was side-lined during the Brexit negotiations with ministers apparently fixated on securing a deal for the fishing industry. It is a sign of the madness which has infected policymaking over recent years that an industry which – to one decimal place – accounts for 0% of GDP and which employs around 12,000 people, was prioritised over one which accounts for almost 7% of GDP; employs almost 1.4 million people and generates an external surplus which offsets a large chunk of the deficit in merchandise trade. Since the start of 2021 the British financial services industry no longer has unfettered access to its client base in the EU. Whilst there are many who would wish to see the City taken down a peg or two, the industry is of such a scale that a threat to the business model does have potentially major economic implications.

Recent events raise three obvious questions: (i) why did the British government fail to protect an industry in which it enjoys a significant comparative advantage; (ii) how has the nature of trade in financial services changed and (iii) what is likely to happen in future?

Why were financial services excluded from the Brexit negotiations?

The government apparently believed the City was big enough to look after itself, being as it is one of the largest financial hubs in the world. It was believed that the breadth and depth of services on offer could not be replicated elsewhere in the EU and that it made sense for the UK to defend its interests in other areas. I have long thought that this view was criminally complacent. Immediately after the 2016 referendum banks started to make provisions to continue conducting business on the assumption that they would no longer have access to the single market. I did point out in 2017 that financial institutions were not waiting around for government to make a decision. If ministers had been listening to what bankers told them, they would have realised just how much contingency planning was going on and how prepared they were to move business out of London.

How has the nature of financial services trade changed?

Access to the EU single market for financial services is governed by passporting rights. This means that once a firm is authorised in one EU state it can trade freely in any other with minimal additional authorisation. Passporting is based on the single EU rulebook for financial services and is not available for firms based in countries outside of the EU and the EEA, which face significant regulatory barriers to EU market access. As it is now treated as a third country for EU trading purposes, UK-based firms must now rely on regulatory equivalence in order to access the wider market. This works on the principle that the EU considers UK laws as having the same intent and produce broadly the same outcomes as those of the EU. But whilst it does give the UK market access, the degree of coverage is more limited than passporting and it can be unilaterally withdrawn with just 30 days’ notice which is no basis for long-term planning.

Where do we go from here?

For all that the Brexit trade treaty was signed last December, negotiations on financial services are far from done. Both sides intend to agree a Memorandum of Understanding by March 2021 to establish a framework which preserves financial stability, market integrity and the protection of investors and consumers. The issue of how to deal with equivalence determination is also likely to come up.

None of this disguises the fact that in the early weeks of 2021, the UK finds itself skating on very thin ice. It has seen its access to the EU market significantly reduced. Worse still, the EU appears engaged in a form of “land grab” to onshore as much financial services business as possible in a bid to reduce dependence on London as it ultimately attempts to form its own capital market union. To the extent that Brexit was sold as a project to enhance the UK’s global interests, British politicians can hardly complain when the EU responds by looking out for its own interests. It is hard to avoid the view that the City has been hung out to dry, but the fault for this lies squarely with politicians who either did not understand or (worse) ignored the industry and did not look out for British interests during negotiations.

 

There has been a lot of chatter about the erosion of the City’s position since the start of the year. One of the more well-publicised items was the news that Amsterdam’s trading volume in stocks exceeded that of London in January (chart 1). On the one hand the direct impact of this is marginal. It will not cost many jobs because trading is largely done electronically. Nor will there be a significant loss of tax revenue due to the fact that this is a low margin business. But it is symbolic. London does not have an inalienable right to remain the EU’s financial market place and we do have to wonder whether companies planning to list in Europe will necessarily see London as the go-to place in future. According to research by the think-tank New Financial at the end of 2019, 75% of all non-EU bank assets in the EU were held in the UK. By end-2020 it estimates that this share fell to 65% and it is likely to fall further in future. In addition, other parts of the industry are loosening their ties to London with trading of European carbon futures also set to move to Amsterdam.

In a speech last week, BoE Governor Andrew Bailey bemoaned the current state of affairs. He noted that “the UK has granted equivalence to the EU in some areas, but the EU has not done likewise to the UK.” Bailey also noted that the EU is attempting to hold the UK to “a standard that the EU holds no other country to and would, I suspect, not agree to be held to itself.” He concluded that the UK cannot allow itself to be a rule taker in financial services given that the assets of the sector are ten times that of UK GDP. Bailey is no tub-thumping Brexiteer and the BoE has consistently warned of the risks to London’s financial position resulting from Brexit. It will give him no pleasure to point out that its worst fears have been realised.

There is no doubt that the current arrangement on financial services trade is detrimental to the City’s interests. New Financial notes that there are 39 different types of equivalence arrangement but reckons that the UK has so far been granted two compared to 23 in force between the US and EU (chart 2). Matters do not appear likely to improve anytime soon since the EU has no incentive to offer the UK a better deal without a compromise in other areas which would undermine the regulatory independence that many politicians were seeking. Chancellor Rishi Sunak recently suggested that the City could use this opportunity to generate a 1986-style Big Bang 2.0 but this is not a view shared by Andrew Bailey, who noted last week that the UK should not “create a low regulation, high risk, anything goes financial centre and system. We have an overwhelming body of evidence that such an approach is not in our own interests, let alone anyone else’s.”

Quite what happens next is unclear. London still has advantages in terms of its network of related services and is still home to the global insurance industry. It also has a head start in fintech and has made great strides in green finance which put it ahead of many continental financial centres. But although the UK possesses large and deep financial markets only half the City’s wholesale business is derived from UK customers, with 25% coming from the EU. I have been making the point for many years that since financial services are a global industry, the threats to London also emanate from New York and Asia. Although the City is not about to collapse, it is difficult to see how a business that depends on barrier-free trade will enjoy the same pre-eminence as before. There were many in the City who voted for Brexit in 2016. I warned them at the time to be careful what they wished for. Now they may be about to reap what they sowed.

When is financial democratisation simply speculation?

Financial democratisation refers to the process of removing control of the finance industry away from a small number of financial institutions and distributing the power among the general public. Over the years this has taken a number of forms. Back in the 1980s in the UK, the Thatcher government pursued a policy of liberalising the financial services industry and attempted to widen the distribution of share ownership throughout the economy. More recently, advances in fintech have allowed individuals easier access to the financial markets which has in turn allowed them to more easily manage their own portfolios and give them a bigger slice of the action.

Every so often this debate breaks out of the narrow confines of management consultancies and academia and impacts on public consciousness in a big way. The most recent manifestation was the massive rally in GameStop shares driven by a wave of online activism on the Reddit platform. To give the backstory, a group of online investors had been making the case for investing in GameStop, a video game and gaming merchandise retailer. Institutional investors believed there was no future in the business and a number of hedge funds had big short positions on the stock. However, a number of day traders realised that if they could force the price higher they would inflict heavy losses on the short sellers. In this way the GameStop case quickly became a cause celebre for activists looking to deal a bloody nose to the financial professionals. If one of the features of democracy is the right to protest, this event can be viewed as the investment equivalent of taking to the barricades.

One of the notable features of the GameStop saga is that it was exacerbated by the use of options. Day traders who were organising their activities over Reddit bought short-dated call options in GameStop with the result that the market makers who sold the options were essentially taking short positions in the stock. As a result the sellers of options were forced to buy it in order to hedge their positions, driving the price ever higher. This is a so-called gamma squeeze – a measure of the change in the value of the option with respect to the change in the price of the underlying security – and is an inevitable consequence of the structure of the options market (this article on Yahoo Finance gives a great overview of how the options market worked in this case). The whole affair resulted in two of the hedge funds betting on a fall in the price of GameStop being forced to cut their positions as the price climbed ever higher. In the case of one of these funds, Melvin Capital, its backers were forced to inject almost $3 billion in order to keep it afloat. One-nil to the activists.

Comes a day of reckoning

Whilst it is true that markets should not just serve the interests of the wealthy, and it is a great spectator sport to watch David winning out over Goliath, the episode does raise a number of worrying questions to which there are as yet no answers. Most obviously, do the small investors really understand the risks inherent in options trading? At the end of January there were 9860 open contracts, each one requiring the holder to buy 100 GameStop shares at prices between $300 and $320 per share. Investors were no longer merely the holder of a financial instrument – they were potential shareholders who had to find $312 million in order to exercise their option. Since the small investors did not have that kind of money (they have merely bought an option to purchase the stock, they do not have to buy it), the market makers issued a margin call. Since the investors struggled to find the funds to even meet this call, the issuers of the options closed out the position by selling GameStop stock. Surprise, surprise, the price of GameStop then collapsed thus demonstrating the dangers of an options-fuelled surge in prices and highlighting the old adage that if something is too good to be true it probably is.

Those who bought call options will lose a few hundred dollars which they may justify as a small price to pay for poking the hedge fund community in the eye. But anyone who rode on the coattails of the surge by simply buying the stock in the expectation of further gains could have suffered an unexpectedly nasty shock as the price collapsed. It was not for nothing that Warren Buffett once called derivatives “financial weapons of mass destruction.”

Another point worth noting is that the band of investors who got together on Reddit’s rWallStreetbets page engaged in the kind of collusive activity which if institutional investors did it would see them prosecuted by the financial authorities. It seems evident that some form of regulatory response is necessary. But what exactly? After all, it would merely inflame those activists who believe the system is rigged against them if actions were taken to inhibit their access to markets. 

A team of journalists at the New York Times came up with a series of reform suggestions which, as they readily admit, are “conversation starters, not endorsements.” Their approach is to raise the barriers faced by institutions rather than keeping out the hoi-polloi. Amongst the measures put forward are the introduction of a transaction tax which could “reduce the attractiveness of the high-speed trading that gives sophisticated Wall Street firms a huge advantage.” In addition, there is a case for a debate about forcing hedge funds to disclose their short selling positions and forcing an end to private meetings between companies and investors which gives “the biggest financial players information that the general investing public lacks.” One of the more controversial proposals is the resurrection of the Buffett Rule that “effectively imposed a 30 percent income tax on anyone who earns more than $1 million. This wouldn’t address the markets, necessarily, but would boost perceptions of fairness in the system as a whole, which is partly what the GameStop trade is about.”

Following the events of 2008, the financial sector came to be blamed for the crash – all the more so as governments appeared willing to provide support to banks but less so to the wider economy. It is perhaps little wonder that activists have since had the financial community in their sights. Financial democratisation is a worthy goal and raising barriers to entry to the smaller investor may not be the right way to go about remedying the issues that the GameStop episode throws up. Speculation has taken place for as long as markets have existed. But failure to address the problems raised in recent weeks will simply add another layer of uncertainty to an already volatile market environment.

Markets keen on the vaccine

2020 has proven to be the year from hell, yet two pieces of good news have today given markets a rocket-propelled surge. Markets were overjoyed enough with the news that the uncertainty surrounding the US election is effectively over but the news that a promising vaccine has been developed against Covid-19 sent them into ecstasy. The vaccine has been developed by Pfizer Inc. and BioNTech and is 90% effective, according to the manufacturers. It is obviously very early days to be talking about a solution to the pandemic which has produced the biggest collapse in global activity in 90 years. The vaccine may yet prove to be a damp squib, and it will not prevent the next few months being exceptionally difficult for the European and US economies. But it does represent a potential game changer. 

Market implications 

In terms of the market reaction the FTSE100 today recorded its 17^th largest daily increase on data back to 1984 (9437 observations); the rise in the CAC40 was the 10^th largest on data back to 1969 (13528 data points) whilst the IBEX recorded its 6^th biggest increase since 1987 (8829 observations). That said, all three markets remain heavily underwater for the year (chart). Interestingly, sectors which have been particularly badly ravaged over the past six months have been amongst the strongest performers. The stock price of International Airlines Group rose by 25% in the course of today, although it is still 70% below the 2020 peak recorded in January. By contrast, companies whose business model has thrived during the lockdown have underperformed. Ocado Group Plc, which provides grocery home delivery services, was down 12%. On the other side of the Atlantic, Zoom’s price was down 14% at the time of writing and even Amazon was down 2%. All this strikes me as a little premature. A lot of international business meetings will likely continue to be conducted via Zoom rather than people jetting off for a one hour face-to-face as companies continue to bear down on costs.

Whilst it may be a little early to swap your Zoom stocks for IAG, there is some method in the market madness even though it is questionable whether it should be factoring in all the good news immediately. A combination of extremely low interest rates and the prospect of an economic recovery ought to support equities in the medium-term. Accordingly investors may reduce some of their exposure to safe haven assets such as fixed income and gold and position into equities, although a prudent investor who missed today’s rally may be advised to buy on the dips since some of today’s gains will undoubtedly be given back before long. 

Economic implications 

The prospect of a vaccine has major economic implications. After all there is a lot of pent-up demand which has been postponed since the spring. But the vaccine is nowhere near ready for widespread use and even if it does get approval before year-end, as has been suggested, it is unlikely to be widely available until the second half of next year at the earliest. Accordingly the impact on the wider economy is unlikely to be felt before 2022. Over the coming months governments will thus have to continue providing support to those who have lost their jobs or whose jobs are at risk. But the prospect of a vaccine changes the calculus by resolving the duration mismatch problem which governments have faced in the course of this year.

Whilst governments want to provide as much support to the economy as possible, they are also acutely aware of the costs The UK government has in recent months been particularly hesitant to open the taps further. Only last month Chancellor Rishi Sunak suggested that “we have a sacred responsibility to future generations to leave the public finances strong and … this Conservative government will always balance the books.” But if a vaccine is in the offing governments will not face an open-ended commitment to provide fiscal support: They can act in the near-term with a high degree of confidence that an economic recovery lies ahead.

This does not change my long-held view that there will be a considerable degree of economic scarring. It is highly likely that the pandemic will prove to be a watershed for the economy. Part of the change in economic behaviour observed over the last eight months will prove to be permanent with the result that there will be a period of resource reallocation as the economy transitions to a new structure. Such an outcome could be driven by a change in tastes (e.g. a preference for online shopping rather than physical shopping, which will have major implications for the retail sector). This in turn will almost certainly result in frictional unemployment which will take some time to be eliminated. It could also mean that the sectoral distribution of capital which prevailed prior to the pandemic will have to be significantly changed, implying a faster rate of capital scrapping in those areas where it is no longer required which turn will depress the economy’s potential growth rate (at least temporarily).

The UK will find itself in a worse position than other European economies. It is becoming increasingly evident that the form of Brexit the government is intent on delivering will be a much harder variant than imagined even a year ago (I will come back to this in a future post). Accordingly it is likely that even in the absence of the restrictions imposed by Covid-19 the UK will take longer to get back to pre-recession levels of output than elsewhere.

For all today’s optimism there is still the potential for the path out of the pandemic to prove torturous and uneven. However it represents the first piece of genuinely good news in the fight against Covid-19. As The Queen put it in her April broadcast “while we may have more still to endure, better days will return: we will be with our friends again; we will be with our families again; we will meet again.” But as the old song has it, “Don’t know where, don’t know when.”

A second wave comes crashing down

Markets have been unsettled for some time about the prospect of a second Covid wave and they finally capitulated this week. The market collapse on Wednesday, which saw the S&P500 fall more than 3.5% and the DAX fall more than 4%, came on the day that Germany introduced a stringent set of national lockdown restrictions involving a one-month shutdown of bars and restaurants which is due to come into effect on Monday. France also announced a national lockdown which came into effect today. It may not be quite as stringent as that enforced earlier in the year but it is still pretty drastic. As President Macron said in his TV address, “the virus is circulating in France at a speed that even the most pessimistic forecast didn’t foresee … The measures we’ve taken have turned out to be insufficient to counter a wave that’s affecting all Europe.” Given the renewed spread of the disease, it seems only a matter of time before the UK is forced to follow suit.

What does a second wave mean for the global economy? Throughout this year, most reputable forecast institutions have presented a range of alternative scenarios around the baseline and it is worth digging into some of the details of the IMF’s forecast released last week. The IMF baseline looks for a 4.4% contraction in global GDP this year followed by a rebound of 5.2% in 2021 (in my humble opinion this sounds like a stretch since it implies that all the damage done to output in 2020 will be recouped next year). However, whilst the downside scenario garnered rather fewer headlines it was nonetheless illustrative. It is based on the assumption that Covid proves difficult to contain, with a significant drag on activity in the second half of 2020 extending into 2021. In addition, the IMF assumes that progress on finding effective treatment is rather slower than currently assumed, with a delay in the process of finding a vaccine and the requirement that social distancing measures have to remain in place for a long time to come.

Under these circumstances the global growth rate next year could come in as low as 0.9% versus the baseline projection of 5.2% and it takes until 2025 before output is back on the path implied by the baseline (chart 1). It is also notable that in this scenario emerging markets take a larger than proportional hit. This accords with my long held view that since EMs are acutely dependent on a recovery in their main export markets, the IMF is too optimistic on how quickly output in Asia will rebound in the baseline projection.

As far as markets are concerned , we have been here before. The equity declines registered on Wednesday may not be the biggest daily falls this year but they are not far away from some of the dramatic swings recorded in March. On the one hand there is some scope for cautious optimism in that we have a rather better idea of what we are letting ourselves in for. Accordingly, equity indices may not fall as sharply since we are operating in less unfamiliar territory. Against that, markets may be on the verge of capitulation as the pandemic proves not to be the short, sharp shock that was expected in the spring. As is usual at times of equity market stress the tech sector comes in for the closest scrutiny (chart 2). In addition to concerns that the pandemic may take the edge off demand, the fact that Apple’s iPhone sales and Twitter’s user growth both missed estimates added to the sense of market uncertainty. Next week’s US Presidential election may have longer-lasting consequences for the tech sector if Joe Biden is elected to the White House and embarks on a programme of cutting the tech companies down to size.

However, for the time being I tend to take a more optimistic line. For one thing we should not read too much into equity volatility just a few days ahead of the most important US election for years. Part of the recent wobbles may reflect some position squaring ahead of the main event. Moreover,  central banks are pumping in liquidity on an unprecedented scale. The Fed has increased its balance sheet by two trillion dollars this year, primarily due to purchases of Treasury securities which will suffice to keep bond yields at ultra-low levels. Here in Europe, current estimates suggest that EMU governments will issue €1.2 trillion of gross debt next year but maturing bonds and interest payments could reduce the net figure to €405bn. Even without the promised monetary expansion the ECB is expected to buy €460bn of debt in the secondary market – more than planned issuance. This downward pressure on global yields when plugged into a simple discounted cash flow model ought to be enough to put a floor under equity markets.

But even if markets do hold up, the economy will take a long time to recover from the scarring effects of Covid. In the US, for example, the unemployment rate currently stands at 7.9%, twice as high as in February prior to the pandemic whilst employment is around 11 million below pre-recession levels. What makes me somewhat uneasy is that we have entered a period where there is a mounting disparity between what is happening to markets and conditions in the real economy which underpin them.

This will be manifest in elevated P/E ratios. I have frequently referred to the Shiller trailing 10-year P/E ratio for the S&P500 as a measure which smooths out cyclical variations and have noted that over recent years it has remained very high in a historical context (chart 3). In just the last few months it has rebounded back to pre-recession highs following a dip in the wake of market panic in March. This is a clear illustration of the extent to which traditional valuation metrics no longer apply and for the foreseeable future the equity market will be running on the back of the support given by central banks. Given the lack of clarity from the normal pricing metrics it could be a very bumpy few months for markets.

A highly technical rally

As the summer draws to a close the S&P500 continues to power to new highs, contrary to expectations earlier in the year when it looked like the corona effect would change the business model, if not forever then for a very long time. The benchmark US index looks set to post its best August performance since 1986. But trends in aggregate indices are not necessarily a good guide to what is happening in corporate America.

The focus of attention of late is the contribution of tech stocks to the surge in US markets. This was brought into sharp focus last week when Apple became the first company ever to post a market cap of USD 2 trillion. The company’s market cap has increased by almost 118% since the March trough, followed not far behind by Amazon whose market cap is up by 104%. At the start of the year, the FAANG sector accounted for 14.1% of the S&P500 market cap; today it stands at 19.8% and since March these five companies have contributed 25% of the increase in the index.

That is a very powerful motive force behind the surge in the aggregate index but the S&P average increase is a much lower, although still-healthy, 65% from the trough. The recovery since March has been described in some quarters as a K-shaped recovery with an increasing divergence between the top performing stocks and the worst performers. It is thus becoming increasingly obvious that this is an unbalanced US rally which is dependent on a small number of stocks. In that sense it is reminiscent of the surge in the late-1990s which proved unsustainable when the tech bubble burst.

One key difference, however, is that the FAANG stocks today have a deliverable product and a proven business model. Investors are not buying companies that offer the promise of a product at some point in the future. Amazon acts as the world’s global market place with a delivery system that can ensure that nearly anything you want can be brought to your door. That said, investors are prepared to pay a very high price to hold the stock of these digital disruptors and price metrics paint a more nuanced picture of the sector. The S&P500 as a whole is trading on a P/E multiple of 27.2x expected 2020 earnings, well above the 21x at the start of the year, but this is distorted upwards by the tech sector. Whilst Google and Facebook are trading at current year multiples of 32x, Apple is at 39x and Amazon and Netflix are running at 71x and 74x respectively (chart). Clearly the surge in FAANG is being driven by a strong earnings performance in recent months, but a lot is priced in for the future and some parts of the tech universe look more expensive than others. I can see why investors are keen to pay a premium for Amazon given the way it is shaping the face of retail, even though it looks very expensive, but Netflix?

From an investor perspective, current trends do not suggest buying an aggregate index tracker since a FAANG index contains all the stocks which are driving the market. Against that, a portfolio diversification argument would caution against putting too many eggs in one basket. Nonetheless it puts the European performance into perspective and perhaps the apparent underperformance of the FTSE100 is a better reflection of average corporate performance than the red hot S&P500.  In that light, it is notable that a recent report from Bank of America pointed out that the market cap of the US tech sector alone stands at $9.1 trillion, which is bigger than the market cap of all Europe ($8.9 trillion).

As one who has watched markets boom and bust a few times over, the surge in tech stocks should remind us of Stein’s Law, articulated by the economist Herbert Stein, that “if something cannot go on forever, it will stop." Or to paraphrase, if a trend can’t continue, it won’t. What this ignores, however, is the timing problem. You bet against a bull market like this at your peril because, as the old adage has it, “the markets can remain irrational longer than you can remain solvent.” With yesterday’s news that the Fed is effectively committing to low interest rates for a very long time to come (I will come back to this another time), debt is simply not going to act as a major constraint on company actions.

At some point, there surely has to be some form of reckoning even if monetary policy is not going to be the catalyst for a market sell-off in the coming years. But what might be the trigger? It is possible that investors will simply rotate out of tech at some point, especially if Covid becomes less of an economic threat (perhaps because a vaccine is developed). This might lead the tech sector to underperform vis-à-vis the “old economy” rather than collapse outright. Geopolitics could play a role if the US-China spat were to heat up. But perhaps the most likely catalyst is that governments start to make good on their promises to introduce a digital tax, particularly in Europe. The US also has a history of breaking up monopolies and history buffs will recall the breakup of Standard Oil which fell foul of anti-trust legislation in the early twentieth century whilst as recently as the 1980s, the Reagan administration took the axe to AT&T.

That certainly will not happen if Donald Trump is re-elected and it is even doubtful that a President Biden would want to go down that path, especially since his running mate Kamala Harris is perceived as very tech friendly. But in this crazy world, we have learned never to say never.