Snapshots recalls some of the credit pricing models that were used prior to the last crisis. They were built by quants who were clever PhDs and engineers and came from precision industries such as aeronautics. They knew how to build 400,000 kilo metal airframes that could fly through thin air but their financial models crashed the economy in a matter of years.
It is clear that there was nothing wrong with their models. It was the underlying financial data that was feeding the models. Financial statistics and especially credit data are patchy and full of behavioural biases. They are not like the smooth continuous data such as air flow found in the physical environment that the quants were used to. Coders call this phenomenon GIGO: garbage in, garbage out.
The good news is that a lot of the complexity and leverage in those pricing models and structures has gone. However, critical thinking is still required when looking at the same underlying data sets when making investments today.
Regular readers of Snapshots will know we have been cautious on Italy since late last year (Snapshots 1-Sep-17). We were too early and our reasoning was in the right area but the wrong zip code. We initially thought that talk of parallel currencies (Euro Lira) by populist parties could cause the market to worry about Italian sovereign risk. We did not foresee a new government asking for a debt haircut of €250bn from the European Central Bank. Note that the ECB holds €341bn of Italian government bonds with an average maturity of eight years.
Opponents of the ECB’s QE programme always talked about moral hazard inherent in these cross-country asset purchases. The new government has denied they will ask for debt forgiveness but it seems to have been conveniently leaked. We view this as posturing but it is coming close to the tapering of the ECB’s asset purchases in September and fits squarely into our theme of normalisation this year. We expect more dispersion and volatility between core and peripheral European yields in line with the respective creditworthiness of the countries in the Eurozone.
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