Friday 13 April 2018 FINANCIAL TIMES COMPANIES & MARKETS @ FINANCIAL TIMES LIMITED Stocks gain ground as Middle East jitters ebb Oil prices retreat in choppy trading, gold slides STEPHEN SMITH AND KATE ALLEN What you need to know • Wall Street opens positively and European markets also moving higher • Oil prices choppy amid Middle East tension • Dollar firmer as investors digest Fed minutes, euro slides • Rouble strengthens after sanctions-driven slide • Bourses down in Asia after weak lead overnight from US “Markets are moving from the relief that the trade war rhetoric has stepped back for now to a realisation that the Middle East rhetoric is stepping up,” said Jim Reid of Deutsche Bank. “The short-term geopolitical fear has been the dominant theme over the last 24 hours, overshadowing an in-line US CPI [inflation] print and a slightly hawkish set of Fed minutes.” Hot topic Wall Street stocks are higher and European markets are folding on to early gains after Asian bourses followed Wednesday’s dip lower amid continued rumblings of geopolitical tension in the Middle East. The benchmark S&P 500 is up 1 per cent at 2,669 while the Dow Jones Industrial Average is 1.3 per cent higher. The Europe-wide Stoxx 600 is 0.7 per cent stronger while Germany’s Xetra Dax is up 1.1 per cent and London’s FTSE 100 is 0.1 per cent firmer. Russian equities are rallying after a tumultuous start to the week. But the dollar-denominated RTS stock gauge is off 10.4 per cent over the course of the week against a 4 per cent fall for the rouble-denominated Moex. Overnight on Wall Street, the S&P 500 shed 0.6 per cent amid the heightened geopolitical tension and after the minutes from US policymakers’ latest meeting indi- ANDREW EDGECLIFFE-JOHNSON Hearst has agreed to pay $2.8bn to buy out its French partner in Fitch Group, the privately owned US media group said on Thursday, increasing its focus on credit ratings and other financial information services. The all-cash purchase, for which Hearst has not had to raise new financing, makes Fitch Hearst’s largest wholly-owned business. “Fitch CEO Paul Taylor has built a great team that has delivered impressive growth in the ratings and information services businesses,” Steven Swartz, chief executive officer of the New York group, said in a statement. The deal brings to an end what Mr Swartz called “an excellent partnership” with Fimalac, the holding cated that Federal Reserve officials were considering the possibility of steeper interest rate rises. Asian equities staged an early climb that later crumbled, leaving the Hang Seng benchmark 0.2 per cent lower on the day. Shares in Chinese state-owned oil firms rose but that was more than offset by a fall in tech stocks. The Shanghai Composite closed 0.9 per cent lower. In Tokyo, the Topix index finished off 0.4 per cent. New Zealand stocks on the NZX 50 closed 0.6 per cent lower after the country’s prime minister announced it would ban future offshore oil and gas exploration. Commodities Oil benchmarks are lower again after bouncing off earlier dips. International benchmark Brent crude briefly rose above $73 a barrel on Wednesday to its highest level for nearly four years after US president Donald Trump warned Russia to “get ready” for US missiles to be fired at Syria and reports that Saudi Arabia’s air defences had intercepted a “rocket” above Riyadh. Brent then pulled back later in the Wednesday session from a peak of $73 a barrel to dip below $72. Trading on Thursday has seen the global benchmark move between gains and losses, currently down 1 per cent on the session at $71.36 a barrel. US marker West Texas Intermediate is 0.9 per cent lower on the day at $66.20. Gold is down 1.1 per cent, or $14, at $1,338 an ounce after touching $1,365 on Wednesday. Forex and fixed income The dollar index, which measures the greenback against a basket of other currencies, is up 0.4 per cent. Sterling is 0.1 per cent higher against the dollar at $1.4193 while the euro is down 0.5 per cent at $1.2302 — unsettled by some disappointing eurozone industrial production data. Hearst pays $2.8bn to take full control of Fitch Group company for French billionaire Marc Ladreit de Lacharrière. Hearst bought its first 20 per cent stake in Fitch from Fimalac in 2006 for $592m, and spent another $2.6bn increasing its holding to 80 per cent between 2009 and 2014. The company noted that Fitch had diversified in recent years, and now derived more than 20 per cent of its revenues from data products unrelated to its core ratings business, where it competes with the larger Moody’s and Standard & Poor’s. Hearst is still best known for newspapers such as the Houston Chronicle and magazines such as Cosmopolitan but has stakes in television networks from A&E to ESPN, television stations from Boston to Sacramento, and investments in digital media companies including BuzzFeed and Vice. C002D5556 BUSINESS DAY S&P warns of risks in leveraged loan market as deals surge A3 Limited investor security in debt agreements seen ending badly as credit cycle peaks ERIC PLATT and Europe, and that companies and rower friendly terms, setting the private equity firms were willing to stage for lower recovery values if pay more to clinch deals than at any companies subsequently default. S&P Global has warned investors in the $1tn leveraged loan Paul Draffin, analyst at S&P said: tections in a bond or loan document time since at least 2003 in the US. The quality of covenants — the pro- market that weak lending terms “History shows us that the worst debt that can limit the amount of debt a pose a risk as the credit cycle approaches a peak and deal making has times . . . Now is the perfect time to it can pay its equity investors in transactions are done at the best of borrower can take on or how much surged in recent months. be cautious.” dividends — has steadily weakened While a number of high-profile Scott Roberts, the head of high in recent years. investors have warned of the risks yield at Invesco, said the recent “We’ve already seen weaker of leverage in the $8.8tn US corporate bond market, money continues could spark additional M&A activ- [over] the last couple of years,” Beth declines in the US stock market terms continuously deteriorating pouring into the US loan market, ity, coaxing private equity buyers MacLean, a bank loan portfolio where interest rates are floating and who had been sidelined by the high manager with Pimco, said of covenant packages. “I’m not sure the adjust higher as the Federal Reserve equity valuations back to the market. tightens policy. Bank loan funds have PE firms are sitting on record “drypowder” of $1.7tn, money they have However, Rob Cignarella, who market can tolerate much worse.” attracted more than $3bn of money this year, following 2017’s $15bn raised to fund takeovers, according heads global leveraged finance in haul, according to EPFR. to data provider Preqin. asset manager PGIM’s fixed-income That has bolstered confidence “Despite the equity volatility, business, noted that the market had among dealmakers that they can the high yield and leveraged loan yet to see the kind of leveraged buyout activity that occurred between finance mergers and acquisitions. markets are still open to finance Takeovers worth more than $1.2tn these deals,” said Mr Roberts. “There 2006 and 2007, when a string of have been announced so far this is a ton of [private equity] capital $10bn-plus private-equity backed year, up more than 45 per cent from chomping at the bit and a leveraged takeovers were struck. Even with a a year prior, Dealogic data shows. loan market still looking for paper.” recent uptick in volatility, he said it The New York-based rating agency warned that leverage was ap- raised the risk that a flurry of deals to risk assets. One warning sign he That kind of backdrop S&P said was “hard” to reduce his exposure proaching or exceeding levels seen could be financed with limited would look for though: over-leveraged, PE-backed before the financial crisis in the US investor security packages and bor- LBOs. UK consumer credit drops ‘significantly’ Changing appetite to risk and a lending squeeze cools market in first quarter GAVIN JACKSON The availability of consumer credit dropped “significantly” in the first quarter of 2018, according to a survey of credit conditions published on Thursday by the Bank of England. A net 38.7 per cent of lenders reported that the availability of unsecured consumer credit — such as credit card lending and overdrafts — fell during the three months to the end of March, compared with the previous quarter. “The availability of unsecured credit to households was reported to have decreased significantly in Q1,” the BoE wrote in its report. “This was largely driven by a changing appetite to risk, with lenders also reporting that the credit scoring criteria for granting both credit card and other unsecured loan applications tightened significantly in Q1.” Consumer borrowing has helped to keep the UK economy growing following the June 2016 EU referendum, as households have borrowed or dipped into savings in order to maintain their living standards as prices have risen faster than incomes. However, the increase in borrowing has also worried economists and regulators. “The credit conditions survey for the first quarter of 2018 should go down pretty well at the Bank of England given its view that recent rapid growth in consumer credit has created a ‘pocket of risk’,” said Howard Archer, chief economic adviser to the EY ITEM Club. “The Bank of England has also warned that banks risk becoming complacent in their lending behaviour so it should take some comfort from banks reportedly tightening their lending standards for granting unsecured consumer credit,” he added. Previous studies by the BoE and others have found that much of the rise in borrowing over the past year has been by those on higher incomes using credit cards or buying new cars on credit. The BoE interviewed banks and building societies between February 19 and March 9 to compile the report. The central bank weighted their responses to reflect their market share. Recommended Analysis High yield bonds UK’s high-yield high street struggles under hefty debt load The lenders said they expected the availability of consumer credit to remain virtually unchanged over the second quarter of the year. It was the first time respondents to the survey had not expected unsecured credit to become less available over the next three months since late 2016. Lenders also reported defaults on unsecured credit had increased during the first quarter of the year, and said they were expected to increase again during the second quarter. Defaults were increasing slower on credit cards than on other kinds of loans. Separate figures published on Thursday by the Office for National Statistics said that the proportion of cash saved by households had fallen to 0.9 per cent in 2017, the lowest cash savings ratio since 2009.
A4 BUSINESS DAY C002D5556 Friday 13 April 2018 FT ANALYSIS How a volatility virus infected Wall Street The collapse of a few small funds in February helped fuel a terrifying stock-market slide. Why? ROBIN WIGGLESWORTH Music teacher Chris Pomrink was driving between two lessons outside Philadelphia, when a friend called with some distressing news: “Hey Chris, XIV is in trouble.” Pomrink, 30, checked his trading account. It was February 2 and XIV — an arcane, fiendishly complex financial security that he had sunk $2,500 into earlier that week — had indeed taken a beating. The “exchange-traded note”, or ETN, which allowed traders to bet on the US stock market remaining tranquil, had made Pomrink a bundle of money after he stumbled across it on a site for traders back in 2015, so he decided to keep the faith. But worse was to come after the weekend. On February 5, the mounting bout of market volatility suddenly shredded XIV, in a day so torrid that traders have since dubbed it “vol-mageddon”. This can’t be real, Pomrink recalls thinking. By the time he woke up the next morning, the ETN had lost 94 per cent of its value and its manager announced plans to shutter the fund entirely. “I just couldn’t decipher it,” Pomrink says. “It was pretty brutal.” Ruing the mishap, he enlisted his friend Zubair Latib — a fellow daytrading musician who had cashed out his $6,000 from XIV just four days before its implosion — and wrote a lament, set to the melody of Tom Petty’s “Free Fallin’”. “It’s a long day, watching a correction, the S&P crashing through the floor. I bought the XIV, ’cause I’ll make my money back. I’m a bad boy, ’cause I bought even more. Now XIV is free falling. Yeah, XIV is free falling,” they sang mournfully on a video they quickly uploaded to YouTube. For Pomrink, the blow was surviv- able, merely wiping out the gains he had made trading XIV in 2017. But for markets, it was more serious. The collapse of XIV and two other similar funds exacerbated the turmoil, turning what could have been a normal, even healthy reversal into a terrifying slide. The US stock market suffered one of the swiftest 10 per cent slumps in history, and global equities lost $4.2tn that week. In terms of dollars, that is more than the total losses suffered by the Nasdaq index when the dotcom bubble burst. Volatility is an inevitable part of financial markets. But XIV and a handful of similar funds held only $3bn ahead of that fateful Monday. Why did the collapse of such small, little-known funds help to fuel the wider carnage? At its heart, this is an eerily familiar tale of Wall Street innovation, greed and hubris. It is a story of a good idea overdone, of financial engineers creating something new, lucrative and potentially dangerous for hedge funds, insurers, banks and ordinary investors to trade — arguably making the global financial system more fragile in the process. Over the past six decades, volatility has come to dominate risk-management models across the finance industry. At the same time, a motley crew of academics and investment bankers have turned volatility itself into something that can be sliced and diced, bought and sold, just like any bond, stock or barrel of oil. This has arguably created a potentially dangerous feedback loop, one that makes markets even more prone to booms and busts. Eric Lonergan, a fund manager at M&G Investments, compares the use of volatility as a proxy for risk to a “virus” that has infected the entire finance industry and gradually “corrupted” its behaviour. “It is absolutely everywhere now,” he says. “It makes intelligent people make clearly stupid decisions.” The tale of how volatility conquered Wall Street features multiple Nobel laureates, a plethora of investment bankers and Mark Cuban, the billionaire owner of the Dallas Mavericks basketball team. But the genesis was arguably the intellectual ferment of the University of Chicago’s famed economics department six decades ago. Growing up in Chicago in the 1930s and 1940s, Harry Markowitz enjoyed baseball and football, playing the violin and reading philosophy, especially David Hume and René Descartes. The bookish son of two grocers had little interest in the world of money. Yet after his undergraduate degree at the University of Chicago, Markowitz decided to stay on and pursue a graduate degree in economics, studying under legends such as Milton Friedman. “Descartes was a big inspiration, so when I went into economics I naturally gradually gravitated towards the economics of uncertainty,” he recalls. “It was a wonderful time.” In 1950, a chance meeting set Markowitz on the path towards revolutionising how the investment industry functioned. For a long time, fund managers had been judged largely by their performance. People intuitively understood that riskier investments should generate higher returns to compensate for the dangers of losing their money, but there was little rigour to it. Then, while waiting for his university supervisor, Markowitz struck up a conversation with a visiting stockbroker, and realised he could apply some of his economic thinking to markets. The 25-year-old wrote a groundbreaking paper entitled “Portfolio Selection”. Published in the Journal of Finance in 1952, it argued that returns should be judged against, and optimised for, the amount of risk taken. Since risk can be a vague concept, Markowitz used “variance”, or volatility, as a handy proxy. For example, stocks are more volatile than bonds, so investors should expect better returns to justify the increased risk. While Markowitz was not the first to use volatility as a shorthand for risk, he was the first to put it in a rigorous framework, according to Richard Bookstaber, a former risk manager and adviser to the US Treasury who now works for the University of California. “What Markowitz did was to put it in the context of optimising for risk,” he says. “When I went to school in the 1970s, [his work] was ingrained into everything we did. It became self-evident that this was the way to look at the world.” Together with other insights — such as the importance of diversification, famously the only “free lunch” in markets — this became known as “modern portfolio theory”. Today it underpins much of the modern investing world. It also won Harry Markowitz, father of modern portfolio theory © Alamy Markowitz a Nobel prize in economics in 1990. “It happened in the twinkle of an eye,” he says. “People ask me if I knew I’d get a Nobel prize. I always say no, but I knew I’d get a PhD.” It was another Nobel prize-winning economist — and a disciple of Markowitz — who would ultimately inject volatility as a proxy for risk into the bloodstream of the investment industry. William Sharpe dropped out of Berkeley, where he was planning to study medicine, and pursued a degree in business administration at the University of California Los Angeles. Finding accounting a bore, he decided to major in economics, and was fascinated by Markowitz’s work, eventually pursuing a doctorate in which the older economist served as an informal adviser. Sharpe later taught at the University of Washington, and it was there, in 1966, that he published a seminal paper entitled “Mutual Fund Performance”. This introduced a rule that is still measured and cited by virtually every money manager as a yardstick for their skill. What became known as the “Sharpe ratio” was just a simple mathematical measure of what Sharpe called “reward to variability”. In other words, directly comparing the returns of a fund manager to the volatility of his performance, and subtracting the returns of a risk-free asset such as cash. Its simplicity means that almost every fund manager in the world still includes the Sharpe ratio in their investor prospectus. Despite the acclaim surrounding this academic work, it took some time before volatility-as-risk started to infect markets. Back in the 1960s and 1970s, accurate financial data were hard to get, and the rudimentary computers that were popping up on Wall Street were inadequate to the task of calculating the volatility of various markets or stocks. But all that began to change in the 1980s. Today, Till Guldimann runs a small, picturesque vineyard in Saratoga, California, where he grows a mix of Cabernet Sauvignon and Bordeaux grapes. Born in Switzerland, Guldimann dreamt of becoming a neurologist but decided he wouldn’t be very good at it and switched to electrical engineering. When he then thought he wouldn’t make a very good electrical engineer either, he took an MBA at Harvard and started working at JPMorgan. There he constructed a computer system to monitor major currency exchange rates minute by minute. This may seem humdrum in a world where a Google search can reveal instantaneous information for most currencies across the world, but at the time it was a huge leap. JPMorgan summoned him to New York and put him in charge of monitoring the bank’s exposure to the whims of markets. Fittingly for a vintner, he describes the job in agrarian terms. “Risk management relied on limits. So you told traders how many pigs or horses they could buy [to control their risk],” he says. “But it was hard to gauge the overall exposure . . . because we had to measure the relationship between pigs and horses. If you had $100 worth of horses on our books, and $50 of pigs, then the overall exposure might not be $150.” In other words, a bank had to know the “correlation” between bonds and stocks — or pigs and horses. Because bonds typically rally when stocks sell off, $150 worth of bond and equity exposure in practice tends to add up to less actual market exposure than the sums might imply.