Lessons from Asia
European equity investors should take note that since 1998, East Asian markets have surged tenfold in dollar terms. In theAsian crisis in 1997-98, Asian stock markets were valued at less than US companies; the Thai stock market, for example, bottomed out at just $30 billion, less than Chrysler’s market capitalization at the time. Insolvency fears in Bangkok spread across Asia, resulting in international investors shunning the markets and leading to violent domestic protests. Sound familiar? Roll forward to 2012: the Greek stock market is valued at $42 billion, less than Costco in the US, and Italy’s stock market now has a total value equivalent to Apple’s. The results in Europe are similar to the effects on foreign investment and domestic unrest that the Asian crisis had on that region.
Asia recovered by abandoning the dollar peg during a period of strong global growth, enabling GDP to return to a current account surplus. Of course, there are challenging differences between the European and Asian models: Abandoning the euro is not a viable option for most European states, nor is the current global climate so favorable. Therefore, European governments are starting to realize the inevitable – austerity alone is just not enough. Western profligacy is generating too much thrift in economies that require immediate consumer spending and company investment.Government-initiated growth strategies are gaining ground alongside readjustment to wages and employment to regain competitiveness, although the process remains painfully slow.
The first hope for emergence from recession in Europe lies with the Irish. Their labor costs have fallen roughly 18 percent, versus 7 percent in Spain, Portugal and Greece, providing the first current account surplus in peripheral Europe, at 9 percent of GDP. Yet success remains tentative; Dublin’s fiscal situation is still dire. Debt levels in 2013 will reach 121 percent of economic output, with a budget deficit pushing 8 percent of GDP -- both among the worst in the Eurozone. As inefficient businesses and employees realign, however, economic recovery will lead to a rise in labor productivity and wages, and boost company growth.
There is also growing optimism around Spain. As well as a host of unprofitable banks, Spain also is home to Inditex, the world’s No. 1 retail outfit. The company’s chairman, Amancio Ortega Gaona, is the world's third-richest man (behind Carlos Sim and Bill Gates), with assets of 43.5 billion euros. A rising entrepreneurial streak in Spain may yet prove that radical surgery can enable a dying patient to return to health.
Bond Yields: The Race to Zero
Increasing certainty in the future of the Eurozone has conversely led to erosion in fixed income returns. Although bond issuance has been at an all-time high in 2012, the inventory models and liquidity in the secondary market are slowly being stifled. Investors are becoming impatient with dwindling returns versus improving corporate balance sheets and company valuations together with attractive dividend yields. Recent research by TABB indicates that 22 percent of market participants now see the switch into fixed income as static or reversing (see Exhibit 1).
[Related Video: “The Ticking Bond Bomb”]
A guaranteed European equity revival, however, is too simplistic given the politics and regulation surrounding equity trading today. The fundamentals may be appealing, but the surrounding market structure has shifted. New questions are emerging as to whether the new challenges in executing equity order flow will benefit equity derivative trading rather than the underlying company share; and what the impact of this will be on the broader economy. With asset managers harnessed to blue chip investments and startups frozen out of the traditional market structure, new rules of engagement will have to be found.
Who Will Trade What, and Where, in 2013?
Overall equity volumes were in sharp decline in 2012, with European participants in TABB research showing a fall of 27% in European equities traded. However, market participants claimed this was due not only to the fall in underlying order volumes, but also due to the impact on order execution in anincreasingly fragmented marketplace. The current liquidity challenge is creating a Catch 22 dilemma for the buy side: Increased automation means that the sales trader no longer sees the flow, encouraging the requirement for small-clip-sized automated trading and creating a self-fulfilling prophecy. Algorithms and smart order routers have become the most viable opportunity to find the other side of the order flow in a highly fragmented market. Despite some initial reservations, the interaction with automated flow also now includes long-only investors choosing to engage with HFT.
Although supporter for and opposition against HFT remain polarized, the balance is shifting due to the challenging market conditions. 2013 heralds a continued regulatory focus, with the outcome of the MiFID II amendments still under discussion regarding a minimum resting time of 500 milliseconds and establishing acceptable order-to-trade ratios, as well as order cancellation or modification fees.
[Related: “What Europe Really Thinks of HFT”]
In addition, the introduction in Germany last year of the “Act for the Prevention of Risks and the Abuse of High Frequency Trading” proposes new definitions of algorithmic trading and HFT. Given the increasing regulatory rhetoric against HFT participants, their purported benefits and impact on the marketplace need to be better understood not only in relation to price discovery but also the impact on long-term investor confidence; increased data and data management costs; and greater risk controls. There is growing support within the industry for the provision of greater analysis similar to the HOT study recently completed in Canada rather than arbitrarily regulating an industry participant out of the game.
The Industry Fights Back
This analysis of market interaction is extending to all participants and venues. The changing face of European equity trading means that the status quo is unsustainable. Buy-side traders are becoming more like sell-side desks, the sell side looks more like exchanges, hedge funds are incorporating long-only strategies, and vice versa. All participants are heavily focused on interacting with the changing market structure to respond quickly and efficiently to current trading conditions.
Declining volumes leave market participants trapped between the desire for greater transparency and the requirement to deliver best execution for clients. As a result, dark trading remains on the increase, with 58 percent of market participants trading more than 10 percent of their flow in the dark to counteract diminished liquidity and increased market impact, according to TABB research. As participants become more discerning as they gain experience, one-third now see the value of trading in the dark as sporadic and venue-dependent; as a result, they look to their brokers to help them trade smarter in the dark.
Others are looking to artificially recreate the order flow they seek, with brokers focusing trading activity on artificial block trades and buy-side traders collating order flow internally. Even vendors are getting in on the act; Fidessa and Thomson Reuters recently announced a joint initiative enabling buy-side traders to cut through large volumes to access actionable and relevant IOIs (indications of interest) quickly.
TABB Group believes the trends in European equities have never been more important than they are now, as they illustrate the important choices that the financial services industry will have to face -- both in the underlying asset class and the developing market structure as a result.
In the coming weeks, TABB Group will explore the ongoing and emerging questions facing European equities, including:
If the European bond bubble does finally burst, will European equity volumes return, and where?
How will the European equity market participant structure developas a result?
What will be the impact of further regulation on dark order flows and HFT market share?
How will this impact European Commissions for 2013?
If you’re interested in participating in the TABB study, or if you want to highlight topics that you would like to see included in the study, please email me at email@example.com. In the meantime, here’s to a happy and prosperous New Year in 2013 for all market participants across the globe.