Tuesday, 23 December 2008

Revision momentum still points downwards

It has for many years been a tradition in the stock market to monitor the analysts following a given company. If the company is going through a rough patch, it is taken as a positive indicator once analysts begin to turn their own forecasts more positive. Thus, following the pattern – the momentum in earnings upgrades - in what supposedly more informed folk say about the company, the less informed investor can gauge when it would be time to turn more positive. Admittedly, this observation is rarely taken to be a sufficiently strong indicator about when to buy.

This "methodology" could equally well be applied to the overall economy. Over the past weeks a number of studies and forecasts have been released by various economic research institutions. Approaching the various reports in the way described above does not exactly provide for a lot of optimism leading into the new year.

So far, particularly in the stock markets, one economic statement has gained almost mantra-like status: The economy will improve in Q3 of 2009. Recently it has been updated to: the economy will improve in second half of 2009. When examining the various forecasts, it appears that there is successively less evidence to support this optimism.

In November, IMF reduced the 2009 growth forecasts from 3 percent growth to 2.2 per cent. The industrialised countries are expected to see a negative growth of 0.9 per cent, so the positive economic growth is coming from the developing countries.

In December, the World Bank published a revised estimate of a global economic growth of only 0.9 per cent, but remains optimistic about the outlook for 2009.

In the US, a host of institutions make forecasts and in general they are still revising their forecasts downward. The Energy Information Administration wrote on December 9 that "The current global economic slowdown is now projected to be more severe and longer than in last month's Outlook".

Members of the Securities Industry and Financial Markets Association's Economic Advisory Roundtable – sort of consensus for the financial industry - in December expected the current U.S. recession to continue into mid-2009, with subdued growth thereafter through the end of the year. -1.0% growth in 2009.

In Germany, the Kiel-based institute IfW released a very negative forecast of a negative growth of no less than -2.7 per cent in 2009 and a near-zero growth in 2010. This forecast easily beat the otherwise negative forecasts published by Bundesbank (-0.9%), Institut fur Wirtschaftsforschung (-1.9%), RWI (-2.0%) and ifo (-2.2%).

France's INSEE reported last week that there will be negative growth in the first two quarters of 2009 and that after that, only a very small recovery is likely. Economic periodical The Economist expects France's GDP to contract by 1.3 per cent in 2009.

Italy is the same story: all institutions, Banca d'Italia, OECD, IMF, and a host of private forecasts have since November been moved down from somewhat positive to an expected minus of -1.5%.

Reading through the accompanying notes reveals an interesting fact, namely that the recent downward revisions mainly affect the first half of 2009. Compared to the situation a couple of months ago, it is now expected that the downturn is faster and deeper in the first half of the year and then suddenly things get better in the second half. Personally, I believe it will prove an illusion. I do not understand how it is possible to predict a sharper downturn in the first two quarters of the year without it spilling into the last two quarters.

My guess is therefore that as the next round of revisions comes in February/March of 2009 they will likely postpone the recovery.

All of this looks pretty grim, to say the least. Economic forecasts are always by nature, made under a set of assumptions regarding the future. One typical assumption is the economic policy. Policy makers have the possibility of adding more fiscal stimulus if the economic forecasts look to bad, thereby invalidating the forecasts.

It is typical to use assume that the economic policy (public spending, investment, taxes and the like) will in fact be implemented as they are planned at the moment the forecast is made. At this moment, this is probably the largest source of uncertainty to this very negative outlook.

Across the world, various policy packages have been implemented in order to get the economy going (different from the ongoing initiatives of getting the credit markets going again). Apart from what the Chinese government is doing, so far nothing impressive has been put in place. EU has presented a package of 1.75-2.0 per cent of GDP but a lot of it was already existing policy plans. UK has cut TVA temporarily, which is likely to miss the target as people will not spend the extra cash, but use it to draw down debt. Rumours from the Obama transition team is revised almost weekly in regard to the magnitude of the fiscal stimulus package.

My guess is that as the downwards momentum accelerates in the coming months, more fiscal stimulus may be added as well as a further easing of monetary policy worldwide. If that happens in time, there is still a possibility that the global downturn will bottom out towards the end of 2009. There are, however, far too many ifs and buts behind the various forecasts.

Wednesday, 17 December 2008

Fed pulls out all the stops and stock markets get it right

Federal Reserve's statement yesterday was no less than historic. For the first time, Fed commits to use "all available tools" to fight the downturn. It looks like a Japanese-style Zero rate policy, but it is a good deal more. In fact, Fed allows itself to inflate its balance sheets through unlimited asset swap transactions and no questions will be asked about the quality of the collateral for an extended period of time. By making funds available to the banks at an interest rate of zero, the banks can make money on lending even at a couple of per cent. Nonetheless, this move is largely symbolical compared the continued expansion of the asset swap program.

Given that the banks have so far reduced credits instead of granting new ones, the asset swap program partially bypasses the banking sector by offering the possibility for Fed to grant collateralised loans directly to non-financial institutions or at least to non-bank organisations. All well and good, and there is now no doubt that Fed is applying plan C in targeted and consistent way. I has already had the desired effect on the longer term yields with 10-year treasury yields heading towards 2 per cent and mortgage rates falling in parallel.

What may not be so positive is the background for this move. The US economy is still deteriorating. Not one single economic indicator is pointing even to a stabilisation. One element of a recession, namely an increase in the corporate default rate is only at the beginning. Even if the savings rate has jumped sharply – sober estimates say to 2.5% of disposable income – in a matter of months, it is still anybody's guess when the US households will finally feel that they have reduced their debts enough in order to resume normal spending. Car sales are still dead in the water and credit card companies are reining in debt instead of expanding it. The only shimmer of light comes from the weekly refinancing activity, where an increase is an indication that US home owners are in fact restructuring their debt by taking longer term loans at the currently attractive rates. All of these factors are unknowns that make it very difficult to time when the US economy may hit rock bottom and begin to rebound.

We have seen some powerful rallies in the stock markets recently. They are built on the assumption that with all the good work by Fed and Obama signalling ever-growing economic stimulus once he has moved into the oval office. It makes sense that with so much power and determination being poured into the project of getting the economy going, it will eventually happen. The only question is when this will happen.

I earlier subscribed to a point of view that 3rd quarter of 2009 would be the time when the US economy could have seen the bulk of the contraction and it would be possible to imagine a rebound. I am not so sure it will happen that fast. The mainline scenarios for growth now appears to have settled on a contraction of about 2 per cent for the US economy in 2009 after an almost flat/slightly negative growth in 2008.

At the same time estimates for the "necessary contraction" required in order to re-establish the savings rate to healthy levels have ranged between four and seven per cent accumulated over the duration of the downturn. Even if we stay at the comfortable end of this range, the current mainline growth estimations for 2008 and 2009 only sums up to half of that. So either the negative growth will continue into 2010 or the downturn in the economy will be a good deal more severe than the current consensus estimates.

Which brings us back to the stock markets. While the stock market perennially prides itself of being able to predict events that will happen 6-9 months time, this ability appears somewhat impaired recently. And the stock market needs an economic rebound to see an earnings rebound. What if the rebound only comes well into 2010 because the debt overhang is still too heavy? Obviously it would lead to another downturn in the market. I simply refuse to believe that the average of the stock market operate without being able to take into account this possibility. Yet we have seen a healthy recovery in the stock markets recently.

If looking for an alternative explanation, it might be useful simply to think as follows: the market suffers from a total "lack of visibility". This is analyst-speech for "we don't know what will happen" – which appears a rather sensible thing to admit. So we all act on the basis of perceived probabilities instead. With each of the initiatives coming from the US and even from Europe over the past weeks, the perceived probability of a rebound in 3rd quarter of 2009 has clearly increased. That makes the case for maintaining short positions less attractive. So it could indeed be that the main driver of the recent rallies have been short covering, punctuated by selling from those who still have to liquidate positions (read: hedge funds being hit by redemptions). Judging by the relatively low volume of turnover in the stock markets, this could indeed be the case. While this is not exactly a strong basis for a sustained rally, it at least gives some legs to a continued rebound, which will last as long as the market perceives that the probability of a rebound within 6-9 months is increasing.

Wednesday, 10 December 2008

Happy days waiting around the corner?

Over the past week or so, it appears that the level of confidence in the financial markets has improved several notches. Trying to summarise why, one arrives at a situation more or less as follows:

  • Led by the Federal Reserve, the world's central banks are doing what is necessary in order to improve the situation in the financial sector, and even to bypass it if necessary. Fed has even begun to monetise the public sector deficit – known as printing money – and bypass the financial sector in creating credit
  • Across the world, with China as the leaders, political leaders are putting in place fiscal stimulus in order to get the economies going
  • Long term interest rates are plunging
  • Commodities and in particular crude oil have fallen so much in price that it will stimulate the economies
  • Stock prices are almost at a giveaway level
  • By third quarter of 2009 we will have seen the worst of the downturn and we will be on our way back to better times.

I would like to be able to join in that happy chorus. I am also slightly more positive about the future economic developments than I was six weeks ago, mainly because it appears that politicians across the world are ready to scrap the traditional way of thinking. By this I mean the conventional wisdom of economic policy as it has been understood more or less since the Reagan-Thatcher era.

However, I have quite some difficulty in joining the optimists. Let us try and take each of the arguments above and look at it.

Central banks are certainly doing a lot. Two weeks ago Federal Reserve began monetising the debt and introducing several instruments allowing for a closer control of the conditions in the money market. It was announced that Fed would be interventionist regarding the yield curve and that financial assets of a highly troubled nature could serve as collateral for facilities with the Fed. The effect has been a predictable fall in US yields along the curve, and direct intervention in the mortgage market has led to a narrowing spread for MBS over government bond yields. The effects of this have spread to Europe, where the central banks have cut interest rates to unprecedented levels. European central banks have not yet, however, begun a process of quantitative easing. I consider this to be all positive, as the Fed has reacted quickly and fully in line with what is necessary. Fears of this leading to inflation are overdone, as the Fed can easily mop up the excess liquidity once the situation is better.

In Europe, the banks are in general in a much better state (with the UK as the possible exception). The current "credit freeze" may be more severe than what is completely normal in a period of economic downturn, but there are good reasons to believe that the governments will let their voices be heard clearly in their capacity of part-owners of many banks, pushing for less strict credit conditions. If that should not work, there are several more instruments left, most notably in the repo-area, where the central banks can accept progressively worse assets as collateral for liquidity.

Governments are working overtime in order to stimulate the economies. Or are they, really? So far US lawmakers have done nothing, understandable given the limbo period before the swearing in of the Obama administration. He has, on the other hand promised rapid action after 20 January. So far he has been talking of packages to the tune of 2.5 percent of the GDP. Not half enough to stave off a deep recession, as it lurks behind the horizon. Given the need of US households to consolidate their balance sheets, the recession will be deep or it will be a medium recession followed by a long period of sluggish recovery.

China presented an impressive package, supposed to be worth more than $500bn of government stimulus. Upon closer inspection, a significant part of this happened to be infrastructure spending which was already planned in advance. So the overall short term impact will be much smaller than announced.

Across Europe, the governments are presenting each a package of their own. According to the estimations of the EU commission, the overall effect will be some 1.5 per cent of EU GDP. Some of the initiatives were in place before the crisis hit and some are brought forward. Net new initiatives are likely to be somewhat less than 1 per cent of GDP. Some will work very well (announced infrastructure projects in Denmark, France and Germany) but will be slow in the coming. Some will not work as desired (temporary tax reductions or VAT cuts). Summarising it all, the effective stimulus in Europe will be significantly smaller and slower than most people are meant to believe.

Long term interest rates have been plunging. Bond markets have been reacting absolutely rationally to the change in the US monetary policy and the world is profiting from it. In particular it will be positive for troubled home owners, who will be helped to refinance with long term loans at low rates. And companies in need of long term finance should find it easier to issue bonds. Whether anybody will buy them is still anybody's guess. Some – including myself – are worried about the long-term effect on inflation and hence, on the long bond yields. It is not a relevant issue right now, and will be addressed when the governments or central banks find it appropriate to tighten monetary policy.

Commodities and oil have fallen considerably, offering an impetus to the markets. Quite correct, but the prices have fallen from speculative levels and are likely to have undershot meaningfully on the way down. After all, commodities and oil have to be priced at least at levels where they can finance the search for new sources as the existing mines/oil fields dry up. That may not be the case for several items right now and they will begin to move back. And nobody could take the 84% fall in Baltic Dry rates seriously. Anyway, the world did not enter a recession because of high commodities and energy prices. So yes, the current low level of commodities prices are a plus, but unlikely in itself to pull us out of the recession.

Stocks are cheap. Oh, really? Yes, if you compare to the peak of valuation in the summer of 2007. And of course if you assume that companies will return to the same level of profitability seen in the first half of 2007. And provided that valuations improve.

What will happen if they do not get back to the same profitability levels? My guess is that they will not anytime soon revert to those happy days. The banking sector will be hobbled for decades to come, as regulators de facto will tighten reserve requirements visibly and for an extended period of time, introduce limitations to the bank's activities.

It will reverberate into other sectors because credit will be less readily available and in particular, financing M&A activities will be hurt. Venture funds and private equity funds, who have been important players in the "grey" credit creation, are likely to be regulated in a rather more strict way.

In order to return to profitability, companies in all sectors will depend critically on a return to sustainable economic growth. Eventually, economic growth will return. But for a span of years, it is likely to be slower than seen in the past 10 or 15 years. There are two reasons for that. A good deal of the growth was credit financed, a driver which will be off the table for an extended period of time. Secondly, we are not only looking at a situation where new credits will be limited, we are looking at one where existing credits will have to be reduced. The size of this debt overhang in the US is significant enough that it will take years to work it down. In that period US consumption will grow slower than before and be a drag on the world economy.

With growth below par, and finance for M&A drying up, the case for a rapid return to profitability is weak. Unless the Asian consumers suddenly turn themselves from being excess savers into excess consumers.

Even if stock markets return to profitability, there is no guarantee that valuations will begin to pick up either – exactly for the reasons mentioned above.

By Q3 2009 we have seen the worst. Stock markets still celebrate themselves for being able to predict turns in the economy 6-9 months ahead. Yet they did not see the current recession coming, so the predictive ability of the stock market appears rather jaded.

But still, things will turn in late 2009? I hope so, but am not too optimistic. The fiscal stimulus packages appear too small and too late in the coming. There is a new wave of resets on 'Alt-A' loans coming in the first months of 2009. We have still not seen the full impact of the Credit Default Swaps. The economic downturn has become sharper in recent months, but we have not yet seen the traditional surge in corporate defaults. Once that happens, we will find out how bad the situation is in the CDS market. I am afraid that it may not be a pretty sight.

So all in all, while too much pessimism is not good for the markets, I still have some difficulties in letting myself be swept away by any wave of optimism..

Friday, 5 December 2008

Strong increase in US jobless claims

US Labor Department announced today that nonfarm payroll employment fell sharply in November, as 533,000 jobs were lost. The official unemployment rate increased by 0.2% to 6.7% From October to November. At the same time the Nonfarm Payroll number for October was revised for the worse, from an initial reading of 240,000 to 320,000. Not exactly a trivial revision either. Consensus estimates for the November number stood at 350,000 lost jobs.

Since the start of the recession, the economy has lost 1.9 million jobs, the number of unemployed people increased by 2.7 million and the jobless rate rose by 1.7 percentage points.

Not entirely surprising, the stock markets reacted negatively to the publication of such bad numbers. In the tug-of-war between the forces claiming that now it cannot get much worse and those stating that this is only the beginning, the latter scored a hands down victory.

No doubt, the US economic situation is bad enough, and there we will continue to be showered in nasty-looking economic indicators for quite a while to come.

But before panicking over the Nonfarm Payroll statistics as they were released Friday, one has to remember that employment numbers are not an indicator of things to come. They are what in economist-speak is called a lagging indicator. Employment statistics are an indication of how employers were thinking about the future some months ago – before they set in motion the actions that led to the laying off of their employees.

Similarly, do not expect to find the employment statistics to give an early indication of the turn for the better – whenever that may be. When unemployment begins to fall, it will be several months, maybe more than a year after the bottom of the recession.

Hiring or firing on a large scale is in the vast majority of cases expensive business and is usually not undertaken until it really is necessary. There may be various obstacles depending on the jurisdiction, Europe being a case in point. What makes it expensive is, however, not the compensation paid to the leavers. Instead, it is the loss of human capital from the company. An overwhelming majority of jobs require particular skills paired with good dose of experience. Firing on a large scale means that a company waves goodbye to a lot of knowledge, and the laid off employees may not be available next time an upturn comes around.

Similarly, once the economy gets better, many companies will have similar reservations hiring on a large scale. New employees have to be trained for the jobs, and that is often a huge expense, so the companies will prefer to run at capacity or above for as long as possible. Germany is a case in point, where employment still continued to increase in October – as if German companies had not realised what was going on in the rest of the world.

The German unemployment has been steadily falling over the past three years or so. But well before that, in 2004 and 2005 many German companies began to improve their profitability in a meaningful way after a serious wave of restructurings. That in turn led to new hirings from late 2005 and onwards, and it is only now that this trend is likely to be broken.

So why would the market react so strongly to the US nonfarm payrolls. Probably because it is not readily known that it is a lagging indicator. On top of that it appears that the depth of the recession is only now beginning to dawn on a large segment of market participants.

Wednesday, 3 December 2008

Some good news for investors in mortgage bonds – and for the rest of us

Under some hype, the US Federal Reserve announced an extra $800bn facility, which was allegedly being "pumped" into the markets. This new initiative as not passed by congress for the rather simple reason that this was a conceptually simple extension of Fed's normal lending facilities. Yet another letter combination joined the fray, the TALF , short for Term Asset-Backed Securities Loan Facility, which will lend up to $200 billion to holders of AAA-rated ABS backed by newly and recently originated consumer and small business loans. The Fed also will purchase up to $100 billion in debt from the Fannie Mae and Freddie Mac, and up to $500 billion in GSE-backed mortgage-backed bonds.

At the same time it has been visible in the market that Federal Reserve is buying Treasury bonds all along the yield curve. Fed Chairman Ben Bernanke has even stated that Fed has "obviously limited" room for lowering short term interest rates further and that other, less used policies, may be used. Such as buying Treasury bonds.

There are several implications of these moves. Most importantly, the conjunction of the two indicates that Fed is acting very actively in order to make sure that the T-bond yield curve keeps flattening, and secondly, that the huge risk premium in the mortgage segment will be forced down. The reason is that the US government is under heavy pressure to "do something" about the slowly unfolding disaster going on in the US mortgage market. One of the elements of "doing something" is to create conditions under which some homeowners now under pressure from high refinancing rates in the short end of the market can be offered a debt restructuring to a less volatile segment of the market and thereby lower their financing rates significantly. Federal Reserve is working to create the background for a "bail-out" of home-owners. Of course the concrete form of that will be determined by the new Administration in the US.

Overall that $500bn in the TALF would be enough to purchase more than half of all new issues in the GSE backed mortgage segment, and hence enough to take a lot of the troubled assets out of the market. It appears that finally the cornerstone is being laid for switching into mortgage bonds instead of treasuries: falling T-bond yields along the curve PLUS a narrowing spread. This is likely to spread all over the world, were mortgage spreads have remained stubbornly high, despite lack of convincing signs that conditions are just half as bad as in the US.

But the more important message is that by buying bonds along the T-bond yield curve, Fed is simply monetising (part of) the government deficit. Printing money and pouring it directly into the economy instead of putting money into the banking system which remains frozen, anyway. For more than 30 years it has been the credo of all responsible economists that central banks should not monetise the debt of the public sector, but doing so right now is a definite step in the right direction. It means that the dysfunctional banking system is partly bypassed and fresh money is handed down where it is needed, primarily to the mortgage lenders.

In the good old days – some months ago – this would have been considered sacrilege and likened to putting out the inflationary fire with kerosene. Now, with inflation plummeting and the d-word back in fashion again, printing money is not any longer one of the seven deadly sins of a central banker. Deflation is still far away, but dis-inflation is certainly back. So now there is leeway to increase the monetary stimulus. Fed Chief Ben Bernanke was ridiculed in 2002 for suggesting that printing money in a recession might help if everything else failed. He was even nicknamed Helicopter Ben because the economists' standard parable is to throw money down from a helicopter.

Pretty much everything else has failed, and with increasing paralysis of policymakers in the dying days of the Bush Administration, the Fed has made a very significant move in the right direction.

Whether it is enough, is still an open question. Remember that the next segment in the US mortgage market to have massive resets of the introductory "teaser rates" is the "Alt-A", one notch up from the "Sub-Prime". They will have massive resets in March and April 2009. Maybe a plan will be in place to help them avoid a wave of foreclosures. Maybe not. The stock market appears convinced that the latter is the case.

Oh yes, and if you have exposure to dollar assets, here is a small teaser - of a different nature. If US short term interest rates are on their way towards zero, and if Fed is printing money - what will happen to the dollar?

NBER drives home the message: This is BAD

Forgive me for being a little bit confused. For years, friends and colleagues working in the financial sector have told me that what happened yesterday is of no importance to the stock markets. What counts is what happens NOW and what is expected to happen in the (near) future.

Monday, nevertheless, the stock markets sold off on news that a group of economists had decided that the US economic recession began in December 2007. Why, one could ask, is it suddenly so important now. Particularly since everybody has understood that we are in a recession.

National Bureau of Economic research, NBER, is a privately funded group of economists, but its board has won the privilege of officially stating when recessions begin (and end). Being professional economists, they use a wider set of economic indicators than the rest of us (you have probably heard of the definition: two consecutive quarters of negative GDP growth), employment, manufacturing, industrial production, retail sales, and income.

Their role has never been that of "playing politics", meaning that their definitions were meant for use when designing economic policy. Instead it is a rather academic exercise, aimed at academic economists and analysts looking at the really long trends. NBER established that the previous recession ended in October 2001 and the US had 73 months of growth. But then employment peaked in December 2007, Personal Income in the same month, while manufacturing and retail sales had peaked in June 2008. Industrial production peaked in January 2008.

Maybe it has to do with perceptions of the recession. Some pundits were already getting into the futile game of guessing the "shape" of the recession. Would it be V-shaped (short and sharp) or U-shaped (taking a little bit longer to recover from)?

Then this bunch of economists tell us that the recession has already lasted for 11 months. The longest recessions of the post war era were both 16 months long (73-74 and 81-82). Worse, there are absolutely no signs of this recession abating. If anything, the downturn is still accelerating. Car sales continue to collapse, employment is falling, retail sales are still falling. Repossessions of residential property is accelerating, so are defaults on home loans. And we have still not seen the commercial property sector give in despite rumours, and there have still not been any marked increase in corporate defaults.

NBER's statements made it clear to even the most starry-eyed optimist that this recession is at least going to be longer than anything we have seen this side of WW2. It has also the hallmarks of being deeper than anything seen since the '30s.

There you have it. The combination of NBERs statements and the continued flow of really bad news drove home the message to everybody: the point of reference for this downturn is not any longer any recent recession, but the depression. Understandably, the stock market took cover and the oil prices resumed their fall.

Then in a twist of brilliant irony, the markets began to rally again. Now the arguments were turned on their heads again: now we know it is so much worse than what we believed last Friday. So now we cannot be surprised badly any more. So let us go and buy some stocks.

Suddenly, yesterday began to look so – yesterday. I have argued earlier that this recession is going to become deep because of the debt overhand, compounded by the banks' various follies in the derivatives markets. I am afraid I have still seen nothing that will make it likely that the stock markets could not become negatively surprised again.

Friday, 28 November 2008

EU stimulus package – for real?

According to many American pundits, the EU countries are late out of the starting blocks in terms of economic stimulus to counteract the economic downturn. Europe is – so the story goes – unable to agree and to act because of the decision structure of the EU itself.

The EU commission this week released the news that EU will introduce a package worth some €200bn aimed at stimulating the economic activity and that at least made it seem as if something is moving in Europe. Unfortunately, the design of the package will confirm the worst prejudices held by the Americans.

Presented as a major new initative, the EU stimulus package amounts to some 1.5% of the area's total GDP. In terms of stimulus to a world facing a rapidly contracting demand, it is underwhelming. But at least it comes on top of what the individual member states have already put into place or agreed to? Here's the catch: EU's stimulus package contains no new initiatives. It is simply a listing of the initiatives by the member states, nicely presented. It was even made clear that the package could be smaller if some of the member states decided that they could not afford to live up their own spending targets. In other words, a total hoax, proving that the US is always faster, nimbler, smarter, when it comes to economic decisions.

Think again. We have heard of the TARP of $700bn, then some extra $150bn was introduced for other purposes and last week another rescue program of $800bn was presented. Now those are real numbers instead of the scrawny €200bn ($230bn) the Europeans can come up with. And the money is already being spent.

However plausible this may sound, there are a number of misconceptions to clear away. The US rescue packets are not stimulus programs. They are asset swaps. Uncle Sam doles out some money and receives something in return. Money is given to the banks, and equity stakes are received in return. Or packages of mortgage debt. Or anything really that looks slightly iffy. It may well be that the assets received may end up worthless, but the point is that it is all an exercise in balance sheet manipulation. Various US government institutions, lead by the Fed, are simply boosting their balance sheets, swapping one type of assets for another. Given the quality of the assets received, some losses may be taken, but others (bank shareholdings) may indeed turn profitable with time. There is some symmetry to that. The US banking sector is reducing the balance sheets, so the government is boosting the public sector balance sheets. But for now, these programs do not require immediate financing.

Europeans have not been stingy on this front. The total of European asset swap programs exceeds €1800bn, or at least that is what the governments have committed themselves to as a provisional upper limit. In this respect, it is perfectly sane to say that the Europeans have in fact acted with more punch than the friends stateside. It also appears that the Europeans programmes are more thoroughly thought out. So far, the US rescue effort has been an exercise in changing priorities every two weeks or so. It is the result of the US administration constantly being behind the curve in realising where a fire will break out next. The most recent €800bn package is aimed to help credit card debt, student loans, and car loans. Exactly as many observers had pointed out would be necessary. Those loan types were not considered when the TARP was introduced little more than a month ago. Less friendly observers might be less merciful and claim that the rescue action has been run in a totally headless manner.

Of course the various asset swap programs may at the end prove costly to the taxpayers and could entail tax increases in the medium term. However, that is not our concerns here. The important thing to understand is that these programmes were designed specifically to keep the financial systems afloat. Trying to get the economies going is a different issue, and it will have to be resolved by increasing demand. And that is what the economic stimulus packages will be about.

Even if stimulus packages always take some time to put in place, and even if the EU package is nothing but a collection of already decided initiatives, put through a word processor and given a nice layout, it is still a sign that the European countries are doing something. As an example, Spain released details of its programme earlier today.

President-elect Obama has already indicated that he wants a stimulus package of $250bn ready for when he takes office on 20 January. His newly appointed economic team is supposedly already working on it. Given the depth of the problems in the US economy, $250bn will not be anywhere enough and there will be more programmes coming on stream. But the fact is that market talk about the Europeans falling behind the curve is simply not true.

Wednesday, 26 November 2008

Some lessons from Economic Theory 101

As the details begin to come in about the various programs worldwide to help the economies going again after the hitting the concrete wall in September and October, it may be worth taking a look at some of the fundamentals.

For beginners, this crisis does not have its root in exotic financial products, difficult to understand and totally intransparent. Those products only allowed an underlying problem to continue for way too long, namely a "debt inflation". By this I mean that too many economic players in several countries had indebted themselves beyond reason. In times of old – two decades ago – the banking system would have stopped them from doing so somewhat earlier. But this time the banking system had invented products that allowed them to believe that the risks were so effectively diversified that the lending could go on forever. We now know it was not true. And we are up that creek, seemingly without a paddle.

We are now facing a debt overhang of alarming proportions. There are a number of ways out. One is known by everybody who has ever owed a little too much money away – you cut back and live within your means until the situation is mended. For entire economies there is another way out, namely inflating until the real value of the debt has been reduced to manageable proportions. And then there is the tough one, defaulting on the debt. Which is a good deal more difficult for a country to handle than for individuals. We will look at the first one here, as that is the one currently being discussed in the market.

The first solution, to cut back on one's standard of living is exactly what we are looking at now. The traditional recipes – usually dished out to Third World Countries by the IMF – consists in a combination of policies that aim to reduce the standard of living of the households and to boost the exports. This will invariably entail a period of slow or negative growth in private consumption while the savings balances are re-established. This time it is not the IMF who to the tune of a chorus of assorted leftist protests imposes strict conditions. It is the developed economies themselves that are reacting against years of excess.

Whereas the US and the UK undoubtedly are leading the pack in terms of household sector indebtedness, there are many other countries who to some degree are suffering under the same problems. And the world is heading into a rapid and deep recession because consumers are beginning to get very scared and are cutting back on the consumption. This situation is then amplified by a seriously handicapped banking system which has stopped lending despite hefty dollops of state subsidies.

Lesson Number One is thus that we have a recession coming on because it is necessary in order to correct a huge debt overhang.

Now everybody is looking to the governments for help to "kickstart" the economies. UK's Chancellor Alistair Darling presented a package yesterday. US Treasury Secretary Paulson began talking about an additional $800bn of public money on top of the $700bn or $950bn already being doled out to the banking sector. In Europe it appears to be more difficult to arrive at some kind of agreement. France's president Sarkozy has been leaning on Germany's Chancellor Merkel for Germany to take the lead in pulling Europe out of the quagmire. The EU Commission has had to limit itself to call on the Member States to do something and has suggested fiddling with the VAT rates. But so far we are months away from really detailed programs (UK being the exception, probably because PM Brown himself is a former Chancellor of the Exchequer and hence as a grasp of the details. Plus an absolute majority in parliament).

Currently, the game is about guessing "how much" will be needed by way of stimulus. The counterquestion could be "in order to obtain what?" Globally , we are in totally uncharted waters. A severe recession is on its way. So do we want to avoid the recession entirely as some of the players in the stock markets appear to believe with their continued optimistic earnings estimates for 2009 and 2010?

I am afraid that it is not possible. The scale of the debt overhang in the US alone is astronomical enough that it will be a while for them to sort out the mess stateside. And given the weight of the US economy worldwide, this alone will work as a drag on the world economy. Then add the other countries where a property boom has helped to undermine savings. Some of the more thoughtful commentators and analysts appear to agree that the US economy alone could shrink by 5-7 percent in order to impose a sufficiently deep reduction in living standards. While this being a piece of back-of-the-envelope calculation, it goes well with other studies over the past five years addressing the possibilities of redressing the international imbalances.

It appears that what we can hope for is to cushion the blow of the recession, keep the banking system afloat and try to learn from past mistakes. But Lesson Number Two is that nothing can be done now to avoid a recession. We can only hope for its effects to be dampened.

Which leads us to the third issue, namely how to spend the gazillions of dollars/euros/yen now about to be handed out. I am afraid that we have to go back to Macroeconomics 101. Again. Even to those who had hoped that Keynes was well and truly dead, one only needs to mention the word liquidity trap in order to explain the situation. It has been popping up more and more frequently in the past three weeks: for all the help granted to the banking sector, nothing has managed to stimulate lending. We are in a situation where further easing of monetary policy will not work. The details are different from what Keynes explained, but the result is the same. Billions will yet be spent on underpinning the financial system, but will have no effect on getting the economy moving again. In order to obtain that, one has to look to the same elements as in the '30s: Demand.

There is no shortage in Europe of suggestions of temporary VAT reductions. In the US the talk is about temporary income tax reductions. But hey, have a look at the consumer, now understanding that he has bought a family home too expensive for his salary, and his job becoming more and more likely to go out the window as the recession progresses. He is unlikely to spend any windfalls from tax relief of one sort or another on consumption. He will use every penny to reduce his debts. This behaviour is fully in line with one of the more deep-seated theories of consumer behaviour, namely the permanent-income hypothesis, developed by one Milton Friedman in the '50s. It briefly states that consumers will base their consumption on what they believe to be their long-term income and save any windfall gains. Such as temporary tax reliefs...

Over the past three decades, it has become more and more Conventional Wisdom that state-run expenditure programmes should be avoided. No more New Deals to mess with the profit incentive structure in a well-functioning capitalist economy. But we do not have a well-functioning economy at this moment in time. A long, ideologically based foray into deregulation caused us to fall off that road. So the Third Lesson we can derive from basic economic theory is that public sector demand probably will be necessary in order to stimulate the economy.

Monday, 24 November 2008

New US economic team sets off global bear market rally

In the afternoon Friday, NY time, rumours began to circulate that President-Elect Barack Obama had reached agreement with the two people who are supposed to take the central economics positions in his new administration. The rumours were almost confirmed by the Obama camp, so not it is considered as a given that the present President of the New York Fed, Timothy Geithner, will be appointed Secretary of the Treasury and former Treasury Secretary Lawrence Summers will be appointed Head of the National Economic Council.

If these appointments are made – and it appears there is no reason really to doubt the veracity of the rumours – it is a very, very different cup of tea from what we have seen over the past 8 years. For a while I pulled the joke on colleagues of asking them the name of the incumbent Secretary of the Treasury under Bush. Most had a tendency to hesitate a moment. Which was of course nothing but an indication of how far down the list of priorities the economy was to be found during the Bush Administration. This had of course been exactly the opposite of what was the case under Clinton, where Robert Rubin and Larry Summers held star status.

But now the economy is back with a vengeance, and Obama has chosen people respected as highly competent in the area. Geithner has made a quiet but very quick career. His first job was with one very influential lobbying organisation, Kissinger and Associates. He then moved on to the US Treasury Department in 1998 and in 1998 he was appointed Undersecretary, despite being a card-carrying republican. He left to join IMF in 2001 and in 2003 he was appointed president of the New York Fed.

Holding the most influential position in the US Federal Reserve system after Chairman Ben Bernanke, he has been deeply involved in virtually every major turn of the present crisis, and has gained respect as a hands on manager with a very strong understanding of the workings of the financial markets.

Geithner represents a very different approach to the markets from that professed by the current Administration (and the current Treasury Secretary). He is known as a strong advocate of an approach that definitely gives a role to government in controlling and setting the rules for the markets, and for creating a well-defined framework for the economy.

Some pundits have doubted his competence in the field of macroeconomics. One could say that for the coming two years or so, there will be enough day-to-day issues to keep Geithner focused. If not, he will have Larry Summers, his former mentor, available as a long-term planner.

Nobody doubts Summers' academic and economic competences, least of all himself. Earning his PhD in Economics at Harvard, he went on to become one of the youngest tenured professors at the same institution. He has a reputation for being a bruiser and a power player, who has alienated many former friends. After leaving the Clinton Administration He was appointed President of Harvard University and forced to leave in 2005 after a string of internal controversies that culminated in a fight over the relative merits of men and women in academics. He was, however, invited to return to Harvard in 2007 as an economics professor.

While being a strong proponent of international trade – and thus not necessarily in line with many Democrat party members, he is nonetheless a strong believer in coherent economic policies and medium term economic strategies (this term was entirely missing from the Republican vocabulary in the past 8 years). In the position of head of the National Economic Council, his role will exactly be to device such policies.

The markets cheered this new team with a strong rally, also helped by the fact that Obama went on the record to state that he will favour an economic stimulus package in order to get the economy kick-started. Summers has been on the record suggesting exactly the same. And with Citigroup on the ropes, the car industry on the verge of bankruptcy and very sign that the economy is going in reverse, there is no doubt that this was exactly what the markets wanted to hear. Friday afternoon saw a strong rally, undoubtedly helped by the squaring of significant short positions.

Nice words alone will not revive the economy. Indeed, given the need for the US household sector to redress its savings balance, a significant stimulus is needed in order to avoid a deep recession. While Obama may be ready to offer such support, it will be months away and the economy could be a good deal worse before help finally arrives.

Friday, 21 November 2008

Another letter combination to memorise: CMBX

The last two sessions in US market have been scary, and maybe even scarier than anything seen over the last month. Dow is now down 20%+ in November, a good deal more than the 16.6% it fell in the horror month of October. It has been financials and most notably Citicorp which has been at the centre of this new meltdown.

So far, each turn in this crisis has been narrowly related to one or the other segment of asset-backed securities. First it was the CDOs containing Sub-Prime loans. Then it became clear that the market for CDSs is totally intransparent and rather dangerous to dabble in for the likes of – yes, AIG. We have the segment of CDOs based on the Alt-A segment of US mortgage loans waiting for us in March and April when large number of loans will have their teaser introductory rates reset to rates two to three times higher. Right now it is yet another letter combination that proves explosive, namely CMBS, or Commercial mortgage-backed securities.

So far it appears that a game plan for the remainder of this banking crisis is that each of the various segments of securitised loans will blow up. Each time the banks will be hit a little bit harder than expected because despite the idea of securitisation – that the banks did not want to carry the credit risk, but only to receive the fees for arranging – the banks have been greedy enough to still hold quite some risk on the books.

CMBS – to any follower of the story of the Sub-Prime CDO's there should not be any big surprises. Mortgage loans issued to commercial property owners or developers with collateral in the underlying property is now coming heavily under strain because the borrowers are beginning to default on loans. The spread of such repackaged loans had maintained a very respectable and almost constant spread over AAA rated issues of around 200 bp throughout the months of September and October. But in the beginning of this week it went badly wrong here as well. According to www.markit.com the spread, known as the CMBX spread, widened from 250bp on Monday to a rather impressive 850bp on Thursday. The trigger was apparently that two of the largest commercial mortgage loans granted to the Westin chain of hotels are nearing defaults.

Looking at it from a distance it does not appear that we should be anywhere near a crisis yet. The market is of about $700bn and is considered one where everyone involved is a professional – no ignorant Sub-prime borrowers around here. The rate of loans transferred to a Special server – the last step before default – doubled from mid-2007 to mid-2008. All the way from 0.5 per cent to 1 per cent. When compared to the expected default rate on certain mortgage loans of 20% it looks like small fry.

However, now the cat is out of the bag and speculators are taking aggressive bets on a collapse in this market segment. Bad news for Citi, who has reported to have an 11% exposure to this market segment. Big C closed 2007 at 29.44 . It ended at $4.71 on Thursday, down 26% from the day before, having lost some 84% of its value in 2008.

Is this the end of C? Probably not given the bailout package, but it may now be the next bank to be nationalised. Even if it does not happen the last two days prove beyond any reasonable doubt that despite the siren calls to buy stocks at the current very "cheap" levels, the uncertainty continues to grow in the real economy.

Tuesday, 18 November 2008

Cheap shares? Don’t hold your breath

Turn on the business TV and you will find out that according to the experts there, shares worldwide are now cheap. One of the things I have noted, is that the enthusiasm for saying that stocks are attractive appears to be inversely proportional to the age of the expert (OK, Warren Buffett is the exception). I suspect the reason more seasoned observers have some problems digging out the enthusiasm is that "this time it is different".

Remember that catchphrase? It was very popular during the internet boom and summarised the pie-in-the-sky arguments why stocks should continue to increase even if valuations were already off the scale. It of course appeared that things were not different. The stock market proved not to be able to walk on air forever.

This time around I believe the use of the TTID is far more justified. We are not just talking about a normal downturn here. We are talking about what increasingly look like deepest and widest economic setback since the '30s. But we are not only looking at a situation where company earnings are falling as the result of a normal economic recession. We are looking at a situation where a lot of the rules are being rewritten and at this moment in time nobody really knows what the outcome will be.

One thing is certain; the financial sector will come out of this crisis with a dramatically reduced scope for actions and with a significantly reduced profitability. Everybody with some insight into the matters has understood that one of the drivers of the folly in the banking sector has been securitisation. Banks have been able to arrange for credits without having to take the risk on their own balance for very long. This disintermediation will in all likelihood be reversed.

Issuance of lowly rated corporate bonds will be significantly reduced because the borrowers will be critical and the rating agencies will be forced to clean up their act, much like the audit companies after the Enron scandal. The banks will thus have to carry more risk, the risk will be controlled far more precisely and the banks' earnings will come down because the underwriting fees will shrink. Add that the banks will be forced to come clear about derivative products created on the basis of the corporate loans (CDS's and CLO's). If the junk bond debacle in the late '80 is anything to go by, it will be at least 10 years before the CDO's and CDS's will again become mainstream. For a while such products will be vilified and regulators will come down hard on financial institutions if they try to get too massively back into that business.

This will in its turn make life much harder for private equity companies, venture capitalists and leveraged buy-out artists as the effect will be to make credit more scarce and more expensive. Over the past 3-4 years many bankers have privately shaken their head at the fact that risk was priced so aggressively. No more so, and we are likely to go to the other extreme for quite a while.

At the end of the day, the changes in the financial sector will end up making it more difficult to continue with the restructuring trend that has been at the root of the increased profitability of many companies. A combination of increased risk aversion, more expensive credit and tighter regulation is a bad cocktail for a return to the quite intensive M&A activities of the past years. This will in itself act as a brake on the future development of profitability.

But it is getting worse. According to a report titled " Preparing for a Slump in Earnings " from McKinsey, between 2004 and 2007, the earnings of S&P 500 companies as a proportion of GDP expanded to around 6 percent, compared with a long-run average of around 3 percent, with the highest increase in the financial and energy sectors.

This growth in earnings was primarily driven by increased sales. According to McKinsey, expansion of margins was not a significant contributor to overall earnings growth. These revenues were fuelled by the expansion of consumer credit. Now take a look at the collapsing property prices, the trouble in the US credit card companies, the fact that despite massive government subsidies, banks are tightening credit standards. Worldwide – and most so in the US – households will be led into a deleveraging of their own balance sheets. That will – as I have repeated before – lead to a period of sub-par growth in demand.

Then there is the banking sector itself. Using US data, we get the extremes of a story that can be told in every western country: from being 7.5% of the S%P 500 in 1990 it rose to a whopping 22.3 per cent in 2006 and currently it is still the biggest sector, standing at 16.0 per cent. This development is of course the immediate result of the strong increase in profitability of the banking sector. Not bad for a sector that in fact creates no value in the form of GDP except for the salaries to the employed. With the changes under way that will lead to lower profitability, it is difficult to see how finance stocks can lead the stock markets upwards.

There are probably those who are significantly better than I when it comes to crystal ball reading. I just observe that a host of parameters influencing the stock market valuation are in a state of flux. Calling a bottom in the stock market under these conditions appear rather ambitious.


Monday, 17 November 2008

G20 marks the end of American dominance

It is very easy to be disappointed at the statement released at the conclusion of the G20 Meeting in Washington in the weekend. Its carefully crafted words made it clear that there is no agreement on a coordinated effort to stave off the global recession. No joint effort even if the most recent data points to the fact that economic growth is falling off a cliff in many countries, and not only in the USA. However, it is also clear that even if there is no coordinated effort, the various countries will do whatever they can in terms of fiscal stimulus.

There was also a pledge not to use protectionist measures in order to protect the respective economies. But that apart the meeting appeared to have focused a lot on the massive regulatory failure that lies behind the current quagmire. In this respect the meeting was very important.
For starters, it was a G20 meeting and not the typical G7/8 meeting. This in itself is an important recognition that the G7, while not irrelevant, is not the right forum for this kind of meetings. While G7 represents about 55% of the world economy, the rest of the world now represents 45% and it is growing much faster than the G7. Some of the countries outside the G7 hold the world’s largest currency reserves, courtesy the US current account deficit.
When the participants of the meeting now begin to talk about a reform of the global financial system, it is simply a recognition that the monopolar world system created after WW2 is now about to be replaced by a multipolar system.

The global economic system of the post-war era, known as the Bretton Woods, had one anchor, namely the USA, whose economic and military might was considered unassailable. This situation has changed dramatically under the Bush Administration. Or at least it has become clear how much it has changed.

USA is now the world’s largest debtor. Its banking system is in ruins. Its manufacturing sector has largely been dismantled and moved to China. The car industry is about to go belly up. So even if the US economy still is a powerhouse of invention, it finds itself in a dramatically reduced position as an international player.

The US military might is still frightening. But the inability to win a resounding victory over insurgents in a smallish Arab country has not been lost on many.
In other words, the rest of the world does not any longer see the USA being able to dictate the conditions for economic and political cooperation. The content of the statement concluding the G20 meeting reflects this fact.

The bulk of the text is about a reform of the international economic system. If all the elements of the text are in fact implemented, the US will have to accept that its financial watchdogs are essentially a part of an international system and must adhere to international standards. US regulators will have to adhere to rules for transparency. Its accounting laws will have to be harmonised. Risk models and risk accounting will be harmonised with the rest of the world.
Its banks will be forced to operate under conditions that will look much like how the rest of the world operates (and become dramatically less profitable).

The sacred right of US CEOs to receive silly amounts of money as remuneration will be subject to a review securing that CEOs cannot enrich themselves by increasing risk for the banking sector.

Credit rating agencies (where the US has had a virtual monopoly) will see their influence and business reduced and controlled). An international clearing institution for certain financial derivatives(CDS’s) will effectively remove them from being controlled by US banks. All banks – including US banks - operating cross border will be subject will be under international supervisory committees.

On top of that, tax havens that contribute to the financial instability will be targeted (read Cayman Islands, the home of most hedge funds of this world).

Most of this is sufficiently technical not to attract the interest of the average audience. And it is absolutely certain that the USA will try by hook or by crook not to let herself be tied into such an international structure as it influences something as important as the US banking sector. There will be rearguard action by the truckload.

Yet, the G20 meeting marked something very important: The end of US financial dominance.

Thursday, 6 November 2008

Good luck to Mr Obama. He will need it

Rarely has a US presidential candidate been as popular abroad as Barack Obama. Probably it has to do with his eminent use of classical rhetoric, and on his repeated use of the word “Change” without being overly specific about what will have to change. It has played into a world, tired of the Bush administration’s arrogance and disdain for other nations’ interests or points of view.
Obama may very well be the person to change American politics. Bush and in particular his vice president Cheney chose to take partisan politics to an extreme, and it has left USA with a dysfunctional political systems, unable to even begin handling he enormous problems facing the country: an “endowment” (pension) system that will be insolvent in a few years, the most expensive health system in world that still offers no coverage to 40m Americans, a crumbling transport and energy infrastructure, an education system in dire need of an overhaul. For the sake of his voters – and all other Americans – let us hope that Obama will have the good luck to make progress in increasing the ability of the political systems to make long-term decisions. Even if they are unpopular in the short term.

But for the rest of us, the changes that Obama will bring is likely to be more a question of form rather than substance.

Once sworn in as US President, Obama will still approach the world with the idea to promote american interests worldwide. At the very basic level, there are a number of parameters that have not changed significantly in the past 50 years. First, USA must prevent strategical alliances on the Eurasian continent from developing into a military threat to US security. Secondly, USA will maintain a strong position towards Middle East oil producers. Oil will not be allowed to fall under the control of hostile regimes, no matter their religious background. Third, America must protect its ability to project force to any location in the world. Fourth, USA must try to gain control over strategic elements of the global food supply. And, yes, even if USA has no significant strategic interests there, any USA administration will continue to prop up Israel.

These elements have been underlying the Bush administration forays into Iraq and Afghanistan. Bush and Cheney chose to stop playing by the rules of an international system of agreements, best symbolised by the UN, once they felt it was in America’s interest to do so.

Barack Obama may lead the US back towards participation in the international system of law, agreements and institutions created in the postwar period by the USA herself. If he chooses that route, there is no doubt that the international reaction will be strong ly positive. But do not be mistaken. America’s main national interests have not changed and will be pursued as vigourously by an Obama administration as by the Bush Administration. Only the form will be different.

On the subjects closer to voters and public opinion, terrorism, climate change, and poverty, Obama will probably be far more flexible towards international cooperation. Provided this does not entail a threat to vital American interests

There is a considerable hope out there that Obama will attack the economic problems besetting USA in a more aggressive way than his predecessor. This amounts to simplifying matters seriously, the situation is so complex that caution is required while at the same time speed is of quite some importance.

The immediate economic challenges for Obama contain: declining wage and asset (home and stock market) values, modifying mortgage debt and preventing foreclosures, fiscal impact of bailouts, introducing financial sector regulation, providing fiscal stimulus and cushioning the middle-class amid recession, high foreign debt burden, lay-offs, and continued tight credit conditions.

Later, when all of these items have been brought under control or resolved, US federal government finances will look disastrous, and he will then have to address that.

Obama is facing a cocktail of economic problems in bad need of being addressed quickly. Unfortunately, many of the problems have no easy solution but will entail sacrifice from many of the people who have just voted Obama into office. So the big question is whether he will be ready to use his newly-won political capital and act decisively now or move cautiously and risk being bogged down by competing demands from within his own party. Doing so could be costly for the US economy for years to come.

I have stated it before, but it bears repeating. USA is in the throes of a rapidly unfolding recession, entirely of her own making. American consumers, hooked on credit, have acted together with an underregulated financial system in creating a real estate bubble now collapsing faster and broader than most believed it possible. The very first priority is to stop the rot (or necrosis) in the financial system –including the credit card companies and the auto financing institutions. Next is to cushion the blow of the imploding property prices. Once this has happened the precipitous fall in economic activity will likely stabilise. But that will not be a sign that the consumer can go back to spending like yesterday. Many American household simply have to reduce debt by whatever means they have. Banks will be restricted in their business activities by new regulation. As a consequence there will be no quick return to the carefree spending of the good old days 15 months ago.

The most likely scenario is still no or negative growth in 2009 followed by an extended period of below-par growth. Given the weight of the US consumer in the global economy, the effects will be visible everywhere.

That the financial markets are particularly optimistic about the short term prospects seem rather misplaced. There are no quick fixes to the current situation. Obama will from 21 January 2009 be faced with an economic situation that may cost him the reelection 4 years later if American consumers do not see a marked improvement in their standards of living. So whoever has been afraid that this is the time for Obama and a Democratic congress to begin “redistributing wealth” can rest assured. It will not be any time soon that Obama will have the luxury of that kind of choices.

To those who find this too negative, there are always the historical facts to resort to: Democratic presidents have in the past 40 years been better for the stock markets than Republican ones. Budget discipline has been better under Democrats than under Republicans. Interest rates have been lower. So for the financial markets things will look up. It will just take some time. While we are waiting, things may deteriorate further.

Monday, 3 November 2008

The Banks Won't Lend

Banks do not lend! At least not enough. Instead they appear to be doing what everybody hoped they would not do after receiving generous government help. They appear to be tightening credit conditions and to be hoarding the cash they have been handed. Over the past week we have seen two administrations, about as difficult as they come, the US and the French, both being very frank. The banks better start lending now, or else!

As if it were not enough that the monumental incompetence of US banks in handling the risks related to mortgage lending has thrown the financial sector worldwide into a crisis, it now appears that banks do not readily use the government grants to lend. Instead they appear to be hoarding the cash.

While it is easy to be populist on this one and condemn the banks for their apparently continuing greed when facing the consequences of their past actions, maybe the situation is indeed indicative of a simple fact: the banks are nowhere near to be out of the woods.

Banks are –despite any number of government subsidies and handouts – enterprises that work to maximise their profits under impression of the risks taken. When free cash is not taken and immediately used to boost profits, there are two possible explanations. One is that the banks still judge it too risky to increase lending significantly. The other is that a long-term view tells that there are better opportunities waiting around the corner.

Let us consider the first option, the perceived risk. Here it should be made clear that the crisis hitting the two opposing sides of the Atlantic are in fact very different in nature. US banks are primarily hit by a deluge of bad debts, and have to cope with enormous write-offs. European banks were to a much smaller extent hit by bad debts, even if some illustrious examples had in fact bought some nicely repackaged toxic debts. In Europe, the banks began to suffer in earnest when the interbank market froze up. In this respect the European banks are less severely hit than their US counterparts. Unfortunately, as the weeks pass, this difference is losing importance as banks worldwide are now setting their sights on the accelerating global downturn. Starting in the US, the world was already moving towards a slowdown when the Subprime loans began to go off like time bombs. It is a completely normal reaction from banks to rein in lending during downturns, and has been seen at the onset of every recession.

Looking at the most recent events on the economics front somehow leaves a clear impression of why banks are in no hurry to increase lending. They are simply afraid of throwing good money after bad money.

Last week saw the harrowing sight of a US Federal Reserve Chairman strongly recommending a senate panel to introduce a strong set of fiscal initiatives in order to boost the economy. In plain words: Even if the US government debt is at a post war high, Congress and President should simply increase government spending and care less about the long term effect of the financing. Bernanke effectively told US lawmakers to do something. This is a radical break with the caution usually characterising central bankers. It could easily be considered a sign that Bernanke is afraid of seeing the credit crunch seriously affect credit card debt, auto loans, commercial property finance (and from our own world, leveraged buyout artists and hedge funds). This message is fully understood by the banks, which on their daily business can follow exactly these sectors of the secondary credit creation. It simply indicates that there are still many, many losses out there to be dealt with and it makes sense not to throw the new money around too quickly. While the European economies are less severely hit than the US economy, today’s EU forecast for economic growth was dramatically lower than the forecast published just a few months ago, and the “risk scenario” was even more negative. European banks are likely to be more cautious going forward.

Of course politicians will posture and threaten. The question is just whether increasing loans now makes financial sense in the medium term.

Which leads us to the next reason for sitting on the cash. There has been absolutely no beating around the bush from politicians on both sides of the pond: the name of the game is consolidation of the banking sector. Hank Paulson has said it, Treasury spokespeople have said it. EU’s finance commissioner Almunia has said it. Governments across the European continent have said it. So the governments are very much ready to support further mergers and take-overs. It is all in line with my stated view that we are working towards a situation where each country are trying to anoint certain banks to come out the winners of this debacle. Participating in this game and coming out on top requires some free cash. It may be as simple as that.

I am not trying to excuse the banks. The recent history has shown the sector from its absolutely worst side. But it does not mean that the banks do not have very good and logical reasons not to spend the government handouts immediately. It is just my impression that the current political logic may tend to overlook such niceties entirely.

Friday, 31 October 2008

Just a feeling? Don't bank on it

We have sensed it for a while but signs are multiplying that there is indeed a recession on the way, and it appears that the slowing of the economic growth rate is rapid. When I use such careful terms it is the consequence of the simple fact that reliable economic data releases often arrive only three months after the events, so in fact we still have only very little facts to judge the situation on.

We have received a slew of economic indicators from the US since the banking crisis broke in early September. Which is in fact quite remarkable since we are now only at the end of October. This is because US economic indicators to a higher degree than elsewhere in the world are based on what could best be characterised as opinion polls. Where many other countries have national statistical offices, tasked with collecting and treating economic data right from the sources, this is not the case in the US. Many US economic indicators are indeed based on interviews, aiming to recreate a sentiment. This is not entirely unreliable to the extent that sentiment often precedes decision making.

In the current situation, however, it makes judging the actual situation a good deal more difficult. We have been presented with 24/7 coverage of the banking crisis, in some instances it has even made its way into the sports pages (sic!). Obviously, that has made a great impression on many. When we then have that our own uncertainty a few weeks later is repackaged and presented as an economic fact, we become even more nervous.

So while there is no doubt that the banking crisis was severe, it has largely been averted, but now things are beginning to look bad in other sectors as well.

So how much is there about the economic situation as it unfolds right now – is the downturn created by TV coverage of the banking crisis?

I believe it is important to start with the fact that over the past years – since 2001 to be precise – the world has experienced a growth of credit without historical parallel. The impact has been visible everywhere, as cheap credit has been available globally, and nowhere more so than in the USA. However, the impact on people’s lives has critically depended on the way consumers and industries would have access to the credit. Probably, the consumers in USA and UK are the most “addicted” to credit, whereas a country like Germany has a tradition of financial prudence at an individual level. Not many years ago, buying a car for borrowed money in Germany would have led to a few lifted eyebrows. And in China, consumer credit is still only in its infancy.

One effect of years of easy credit is that people get used to it. It therefore begins to affect real economic allocation of money. Various investment projects get less scrutiny. For a family, often the most important investment in their lives is their home. In the good old days clearing one’s mortgage debt before retirement was considered a prudent way of approaching the investment.

But from the US evidence has appeared that many families began to consider their home as a short term investment rather than a place to live. Many began systematically to practice “equity extraction”, i.e. borrowing against the increasing price of the property, using the proceeds for spending.

With steadily increasing prices, with falling standards of verification from the lenders, with an unregulated process of selling new mortgages loans, it developed into a dangerous leveraging of the personal balance sheets of many American families. Through the increasingly integrated global economy, this spread to other countries as well.

One can shake one’s head and ask how this could continue, even as more and more indicators pointed to the simple fact that the price of residential property had long time exceeded the level where a normal family could afford to buy.

But the logic from the creditors was simple: the buyers (or borrowers) will profit from ever-increasing prices, so if they cannot afford the mortgage, they can always sell – and even make a profit out of it.

In most countries, buying a too expensive home quickly will put a squeeze on other kinds of consumption, not least because the banks and mortgage companies scrutinise the borrowers. There will simply be a stop for further credit. This also goes for the “equity extraction” loans.

In the US – and increasingly in the UK as well – the separation of credit card companies from the banks have led to a huge increase in credit financed consumption. It is not unusual for US families to have 5-6 credit cards and to roll the balance from one credit card over to a new credit card. As long as no delays are tracked in the monthly payments to each company, no red lights are set off. But at some point in time, of course this Ponzi scheme will come crashing down. We could very well be at that point in time, and the effect on US consumption more profound than understood by the market.

Irrespective of the poor quality of economic indicators from the US, there is no doubt that we are now well into a massive cleaning out of consumer’s balance sheets in that country. Finally, American consumers are coming to terms with the drying up of credit. The effect could be deeper than we currently think.

What makes the situation serious for the rest of the world is not only the fact that the US is a very large player in the world economy. It is also the fact that private consumption accounts for almost 70% of the US economy. Contrast this with Europe, where it is not unusual that public spending makes up some 50% of the economy and about 10% comes from corporate investment, leaving about 40% to private consumption. Hence, in a downturn (as well as an upturn), the US economy is very likely to see wider and faster swings than the European economies.

Add to this that the US consumer has had a zero or negative savings rate over the past years, fuelled by the easy credit.

The main problem about all this is that it often takes years to repair consumer balance sheets. My home country, Denmark, had an experience of the same kind in late 1986. It took the biblical 7 years before the economic situation had improved sufficiently for the economy to take off, and that even required some clever fiddling with the tax system to “help” consumers make the right savings decisions.

If this experience is anything to go by, there is no chance that the US recession will be a short-lived experience. Rules have changed for mortgage credits, property prices are dropping, pension plans are reduced in value, credit cards will be harder to come by. Car finance will not be as readily available.

My guess is that sorting out this situation will take all of Obama’s first election period. It may even cost him reelection. As a consequence rest of the world will experience a period of slower growth. I am afraid we are only at the beginning. The economic indicators will come in and show that this is more than just a feeling.

Tuesday, 28 October 2008

On request: What do I think about the markets?

Some readers have mailed me asking for my no holds barred statement regarding the direction of the markets, probably because they hope it will help them in taking positions. Here it is, but I emphatically reserve the right to change my mind as things develop. And if you do take positions on the basis of this post, it is entirely at your own risk.

Interest rates: Worldwide interest rates are heading downwards and will end up in negative territory globally, when corrected for inflation. ECB will likely be a tad slower than Fed. Some countries have gotten themselves in trouble with their currencies and will need to keep interest rates high, or choose the obvious solution of abandoning whatever pegging arrangements they have. Speculators are already picking out some of the weaker links and they will have to defend themselves with determination.

Bond yields: Government bond yields will fall as the global recession scenario unfolds. Any remaining inflation fears will quickly evaporate. Corporate bonds are more of a problem. The recent widening of lower-grade spreads over sovereign issues indicate a much steeper downturn and much higher default rates than the stock market appears to believe in. At least for the coming 24 hours. All things mortgage related will be in deep trouble and no prisoners will be taken.

Currencies: Unwinding short yen positions may still have some legs. Strengthening of dollar will eventually peter out, as the design of the US banking rescue package is as designed to weaken the currency with a dramatic easing of monetary policy. Add that there are still no signs of an improvement in one of the fundamental imbalances in the US, the current account deficit. Unfortunately some individual currencies may still be picked out for speculation. So if you are long a small currency where the central bank has been running some kind of shadow peg against one or two major currencies but still have no real swap arrangements with a big central bank, head for the exit.

Stocks: All bets are off and it is not really the time to be discerning. If you believe (as I do) that there is still a lot of off-loading to be done by hedge funds, sell into rallies, and those rallies can be strong, 15-20 per cent. If you believe that the recession scenario is now priced in, go buying. It is time to bring out your copy of Graham and Dodd’s Security Analysis. If you do not have time or patience to read that, try and find stocks trading at a market value lower than their net current assets. Dividend yield and other indicators are off, for who knows where dividends will be a year from now.

Oil: I am getting hesitant on this one after the huge fall. I do believe, however, that there is one more downside attempt left, and the geopolitical implications of an oil price lower than $50 per barrel are visible with the naked eye. It must be very difficult to sit in the US Treasury, with a newly minted shareholding in the world’s largest commodity traders, and NOT calling them to tell that a further fall would be, ahem, highly convenient. Of course not a good idea if you are still long in companies producing alternative energy technologies.

Commodities: It is the ultimate recession play and I believe that there is still a considerable downside across the board. Gold will suffer as inflation expectations wither away, base metals will suffer with the unfolding recession scenario. Reason is still not available in these markets. They overshot on the way up, and it could well be that they overshoot on the way down as well.

Emerging markets assets: have been pummelled as it became clear that the much-vaunted status of being self-contained has not yet been achieved. Next shoe to drop: these markets do not have any significant built-in automatic stabilisers as demand slows, due to the recession in the export markets. It can turn uglier, still.

Hedge funds of the long-short or equity derivative variety: I would like to believe that the worst is over. In my post yesterday I gave the arguments that there is a certain probability that it will instead get much worse. The combination of margin calls, bank deleveraging, and investors wanting to leave look deadly to me. And Paulson has made it clear that the cavalry will not be charging to help bailing hedge funds out.

Monday, 27 October 2008

Hedge Fund Tumble?

In the current stock market sell-off, a new phase appears to have been reached. Market participants have apparently given up hoping that stocks will come back up any time soon. The rather dramatic downtrend will apparently continue, and now the game is all about finding a reasonable explanation why it is so.

This being said, I tend to agree that there is a lot of companies out there trading at prices that are compatible with a deep and long recession. If this economic downturn does not materialise or if its severity falls short of what market participants currently think, the streets are littered with bargains, and some even represent that wet dream of value investors, companies selling at a market value below their cash holdings.

Unfortunately, this does not preclude a further price fall, and I am afraid I lean towards believing that they there is indeed further downwards potential, and this is for reasons linked to hedge funds.

We all know that the word “hedge” in hedge funds is but a historical remnant from a long gone period where such funds would in fact hedge parts of their portfolio. Later such funds got the more appropriate mention “long-short funds”. Among all the various categories of hedge funds, the long-short funds have always been the dominant, dwarfing all other categories. Originally this category of funds did in fact hedge some or most market risk, relying on long stock picks to provide the return.

As the number of hedge funds grew rapidly, not least because of the handsome remuneration and the near-complete obscurity about their actual positions, their returns began to look more and more like that of simple index investment, leveraged a couple of times. That was not very surprising, simply reflecting the law of large numbers.

And something else: stories began to abound that a large number of long-short funds were actually more leveraged directional bets than anything else. Apparently many funds gave up pretending to do the long-short thing, with markets powering ahead it was more attractive just to run with the market – leveraged.

It is also well known that hedge funds on top of being unregulated and deploying remuneration schemes out of line with performance, have used a quite insidious lock-up method. Their positions have apparently been so complex and difficult to liquidate that investors had to accept only to have quarterly liquidity, and often with at least a month long notice period.

Now fast-forward to the current situation. At the beginning of the year, hedge fund assets likely stood in excess of $2.75tn, and it appears safe to assume with the lion’s share in equities or equity-linked products. The goings-on around Bear, Sterns led to some withdrawals, but the brunt of the financial crisis set in just after 1 September, leaving a lot of investors with having to wait until December before they can announce the withdrawals for year end. These withdrawals are likely to be massive, given the collapsing risk appetite in the markets. Rumours and talk in the market points to the possibility of a 10-25% withdrawal. Even if the average hedge fund has lost more than 20% in value since the beginning of the year, even if not all of the hedge fund assets are invested in equity related products and even if some withdrawals have already taken place, the amounts are likely to be significant.

On the other hand, there are the banks who have extended credits to the hedge funds, often in highly incestuous “prime broker” arrangements. The banks are now under a heavy pressure to reduce risks, and obvious the hedge funds are in their sights, meeting margin calls from the lenders.

So it is obvious that we are looking at a huge squeeze here, and if my timeline is correct, we have only seen the beginning. Discerning hedge fund managers (an oxymoron?) have of course begun to unwind positions some time ago. But I have trouble believing that there is not much more to come as we come closer to crunch time around the turn of the year.

There may some who believe that some of the Bailout Money from the US government could be used to help hedge funds in distress. No such luck, as US Treasury Secretary Paulson has been adamant that those funds will go exclusively to "federally regulated financial institutions that lend money".

Already now, pundits believe it likely that up to a 1000 hedge funds may fold over the coming months, some in an orderly fashion, some will come crashing down. Some of them will have been invested in products related to credit derivatives and so on. In no circumstances it will look nice.

In order to end on a different note, try to think over what will happen to the pension funds if massive withdrawals from the hedge funds leads to a continued negative stock market. Let us assume that the market can fall another 30 per cent on hedge fund liquidations alone. The question is then: how many defined benefits pension schemes around the world will have to hit the panic button and reduce stock market exposure in order to avoid being unable to mathematically meet future liabilities?

Anybody for more bad news? I hope somebody out there will correct my line of argument here. Otherwise, stock markets will risk going from very bad to rather worse, I am afraid.

The End of Bretton Woods

At a time when pundits repeatedly invoke Bretton Woods as an inspiration for a solution to the financial crisis, the Europe-Asia summit that took place in the past days are a significant step in the direction of dismantling Bretton Woods.

To make sure, Bretton Woods is the name of a winter resort in New Hampshire where the US and the allies agreed on a new financial world order to re-establish the world economy after Second World War. It was a system based on the simple fact that the US had emerged from the war as the unchallenged economic superpower of the world. The US was the ultimate backer of a system that built on an idea of free trade, fixed exchange rates, abolishing tariffs and capital controls, the World Bank, and the IMF.

With USA as the main economic backer (and main military power) there were no objections to the fact that Washington called the shots. At least in the beginning. As time passed the system has been shocked several times, and most profoundly as the USA abolished the gold standard in 1971. Nevertheless, the US has held on to its position as the main force behind the global financial order.

Over the past decade, the USA has done much in order to undermine her own position. Prudence in the banking system was replaced by ideologically inspired deregulation leading to the current banking crisis (as admitted by Alan Greenspan). USA squandered its position as the world’s largest creditor and handed that position over to emerging China. Instead, US became the world’s largest debtor, thus depending on the world’s savers to finance the ever-escalating current account deficit. In Iraq, the limits to the military might of the world’s only superpower was clearly demonstrated.

All of this has led to Europe and China together calling for an overhaul of the world’s financial system – at a summit where the US was not invited. Russia was not a formal participant, but there is no doubt that Russia will sign on to the idea, particularly as Russia and China through the Shanghai Cooperation Organisation have been diligent in clearing away strategic differences. Obviously there are not details on the table yet. It is, however, possible to guess what will be proposed, and it will all amount to serious curbs on the American way of doing banking. That is less important than the fact that the summit has taken place and concluded in a very clear demonstration of agreement. It is an outright challenge to the USA’s position as the world’s economic superpower.

We are thus moving closer to what my friend William Engdahl doubtlessly would call “Halford Mackinders Nightmare” – a situation where all significant powers on the Eurasian continent agree on their common strategic interests. For more on this, consult William Engdahl’s website http://www.oilgeopolitics.net/ .

It is ironic that this happens a few weeks before Zbigniew Brzezinsky via a probable democratic election victory will semi-officially be elevated to the “Eminence Grise” of American foreign policy. Brzezinsky has on several occasions written about how the US has as an overriding foreign policy priority to make sure that no alliance is established between the major powers on the Eurasian continent. This representative of Realpolitik will certainly bring an acute understanding of the new global agenda to the new administration.

If the unlikely should happen, and a Republican president be elected, the message will not be wasted on the new administration. It is my guess that the rather enigmatic reports that US Treasury Secretary Paulson forced all of the nine largest US banks to accept government stakeholding even if they swore not to need this “help”, has a lot to do with preparing for this coming fight for global financial dominance.

Friday, 24 October 2008

Capitulation trades? – not yet

Quite a number of commentators have (particularly on Fridays during the last trading hours) used the term “capitulation”, intended to mean that sellers in the stock markets are now exhausted of selling and need a well-deserved rest after having “capitulated”. Thus tired of some day’s hard work, there are no more left to sell and presumably it should lead to a stabilisation of the markets.

I am afraid that this may be too early. Obviously I hope to be wrong on this one, but there are some market elements missing from this all too human explanation.

Over the past years, hedge funds have represented some 60% of the turnover in the stock market. Despite the allure of the name, hedge funds are not necessarily hedged, and the best indicator for hedge fund performance remains a simple stock market index, leveraged between two and three times. The truly market neutral or even market contrary funds are thin on the ground among the estimated 11,000 hedge funds worldwide.

Obviously, the best hedge fund managers have already long time ago unwound positions. But it is my guess that they are still only a minority. With the credit markets drying up, banks have increasingly put pressure on all leveraged investors to unwind positions or to put in more collateral. Given that most hedge funds are so-called long-short funds, but for the past two years for all practical purposes long funds, it is highly likely that there are still many hedge funds out there who are caught in exactly the same situation as a lot of amateur investors. They have seen huge losses, they did not get out in time, and now they feel it is “too late”. But they will increasingly be squeezed into action by banks tightening up on the credit.

I agree that there are many, many companies out there who are already trading at very attractive prices. We are rapidly approaching a classical value situation where companies are selling below their asset value or even below the value of their cash holdings. It may indeed be the buying opportunity of the decade.

Unfortunately that is no guarantee that the ongoing credit freeze compounded with galloping recession fears cannot force further falls in the stock markets. Beware before you step out to catch the falling piano.

The morning after

After weeks of what seemed like useless political bickering over a rescue plan that was wrongly conceived right from the start, the US bank rescue plan finally received an overhaul that made it look like what the Europeans are doing. Not that the Europeans were too quick off the mark, the attempts at agreeing a rescue package being delayed by the necessity to balance broad agreement with national political interests.

In the end reason prevailed – at least in terms of the technicalities of the rescue. The Swedish model – itself strongly inspired by the US bank rescue in the ‘30s - is by and large being implemented world-wide: Governments will take ownership stakes in return for money to the banks, guarantees for depositors are introduced or expanded, dud assets will be taken off the balances and the taxpayers will be able to recover some money once the sector recovers. Incompetent bank management will be pushed out. What is now waiting in the wings is a monumental restructuring of the banking sector where the anointed winners will be allowed to take over the weakest competitors.

This slow and grinding process will quickly be relegated to the finance pages of the newspapers. Sadly, since it is in this process the future of the global financial sector will be shaped, and the balance of financial power between US, Europe, and the rest of the world will be determined.

Meanwhile, signs are multiplying that a global economic slowdown is on its way. Financial journalists and bank analysts have managed to convince themselves that the financial crisis is now leading to an economic downturn.

Quite the contrary: financial institutions began to crack up because an economic downturn was already progressing and that created the financial sector crisis. Excessive use of instruments allegedly devised to spread the risk assured that the crisis hit everywhere. However, tightening credit conditions have obviously accelerated the downturn. Globally, the recent coordinated rate cuts had less to do with the financial crisis than with averting a global recession.

Let us establish a couple of facts: Irrespective of the goings-on in the financial sector, the US economy was heading for a slowdown. Former Fed Chairman Alan Greenspan’s policy of keeping the interest rates as low as possible paired with “innovation” in mortgage finance created an unprecedented boom in house prices and loan-financed consumption. Add that the US federal government has been running a huge deficit in the past years. Even if US corporations have been accumulating capital, the US economy has been a rollercoaster, fuelled by overconsumption. Lest anybody does not believe this, let then have a brief glance at the US trade deficit.

It is a particular feature of the US economic and political system that the enduring problem of loan driven overconsumption has not been addressed for decades. It has undermined the standing of the US in the world, turning the world’s most powerful economy into the world’s biggest debtor. Not even the US of A can on a long term escape the plight of the debtor: Reduce your consumption below your income and begin to pay back.

Anybody who has tried to be in this position knows how painful it is to tighten the belt, reduce consumption and postpone consumption one would otherwise have preferred to enjoy now. Usually one has to be careful comparing economics at an aggregate level with household economics. However, this is one case where the parallel is entirely justified. US consumers as well as the federal government will have to endure a period of bringing the books back in good order.

Rescuing the banks will make this impossible to obtain for the federal government, putting even more onus on the consumers. Households will have to save more and consume less. House prices will fall further; employment will have to increase in the short to medium term. Given the weight of the US private consumption in the global economy, slower growth will influence global growth negatively, even if the savings balance is much healthier elsewhere.

We are not talking disasters, at least not yet. If one is to believe international institutions, global economic growth will slow from 4%+ p.a. to somewhere between 1% and 2%. It will still be uncomfortable, as unemployment will increase and property prices will be heading downwards for some time. But it should be over by the end of 2009 or beginning of 2010. Chances are still that the economic effect of the global bank rescue package also counts as a quite significant stimulus package, and provided that the global financial market resume lending operations, growth will probably resume relatively quickly.

USA is in a situation different from most of the rest of the world. Its savings ratio is sufficiently low that it badly needs repair. It is possible that the next administration will aim at restoring the basic equilibrium in the economy, keeping growth below par for all of the next presidential election period. A ‘30s-like depression is unlikely. But a slow, painful period where mainly the households change their savings patterns, forced by the economic reality. It will probably bear similarity to the downturn in the 1970’s where another behavioural pattern, namely inflationary expectations had to change.

The addiction to debt financed consumption is not as pronounced elsewhere in the world (UK being a possible exception, but with much better public finances). US consumers led the party when finance was plentiful. They will now have to take the lead in the headaches and the cleaning up the morning after the party.