Sunday, 28 August 2011

Ben did not deliver, but Wolfgang did

 US Fed Chief Ben Bernanke’s speech at the annual meeting of central bankers in Jackson Hole ended up by being an anticlimax. Before the speech we were told that the markets would collapse if he did not announce a large-scale bond purchase program. He did not, but he did repeat that in case the (US) economic situation did deteriorate, Federal Reserve will do something. So at the end of the day, the stock markets chose to interpret the lack of announcement as a positive statement that the economy is not that bad, after all. Confused? You are not alone. But you have just witnessed one of those episodes that demonstrate why central bankers rarely speak plainly.

At a much lower-profile economic conference at the St Gallen university in Switzerland, Germany’s Finance Minister Schäuble made some statements that were far clearer. He bluntly stated that the global programs of fiscal consolidation create a risk that the global economy faces a period of seven lean years in terms of economic growth. He also said that structural economic reform is necessary in four EU member countries and that governments should take a greater responsibility in fighting the global economic crisis.

Note that Schäuble is a politician who is not facing an election anytime soon, he is not trying to become Germany’s next Chancellor, and he has a reputation for speaking his mind – he did after all state that the previous US Quantitative Easing Programme was “clueless” and that it was a proof of how the US did not know how to solve its crisis.

Readers of this blog will not be surprised that I share Schäuble’s point of view. It is just rare to hear it stated so clearly from a senior politician in one of the large global economies. I believe that there is a risk of a period of slow growth because of the ongoing unwinding of the debt global debt bubble.

Quietly, consumers in many OECD countries have increased their savings rate significantly. It means that traditional measures to stimulate demand – lower taxes – will not work as it will only increase the savings. In itself it is enough to warrant a period of slow growth. Now this is being compounded by fiscal austerity measures that will only extend the period of slow growth further.

At the beginning of 2009, I used the same biblical metaphor of the seven lean years. That is soon three years ago. With another four years to go, I still may be right. That economic growth will be back on track by 2016 instead 2018 as implied by Schäuble.

However, there are still some structural problems where I do not see any signs of improvement. They may still derail any well-meant attempt at letting short-term pain be a mean to achieve long-term gains.

I am talking about the fact that there are countries, where the access to consumer loan finance is easy and considered almost a human right, and the biggest of them is the US. In Europe, UK is the main representative of this attitude. It could happen that there is a political backlash waiting from consumers (voters), who get fed up with having to save. 

There is no political gain to be had for anybody to try and fix this by introducing legislation or regulation that puts a limit on the access to loans. No, I do not mean quantitative restrictions, but something as simple as requesting that consumers are able to make a reasonable down payment on house or car before financing the rest. Banks should be forced to make a minimum verification of borrower’s credit worthiness before extending a loan. And so on.

I know, it is not very likely. Politicians have a tendency to think in terms of elections, and that is bad news for structural reform. But then we can hope for something else – the continuation of the current trend towards forcing the banks to have a far more significant capital base. It will cut the banking sector down to size, it will reduce the profitability of the sector, it will reduce its political influence. And at the end of the day, this deleveraging will contribute to extending the period of below-trend growth. Meaning that Schäuble may end up being right that 2018 is a likely time for return to trend growth.

There are many aspects of the cleaning up after a debt bubble that burst. Schäuble did not touch upon them all. But at least he has the political courage to speak up.

Monday, 22 August 2011

Look out for more surprises

In March I argued in a blog post that the stock markets were setting themselves up for a fall. I used the opportunity to explain how to use the Economic Surprise Indicators as some kind of composite indicator that has at least some value in predicting the future market mood.

An Economic Surprise Indicator measures if data releases are on average better than, in line with, or worse than consensus estimates. The indicator reached a peak in March this year and has been falling in a straight line ever since. This is pretty much in line with my explanations of 5 months ago, and certainly, the markets have heeded the call:

“Markets do not really react to good or bad news. Markets react to surprisingly good or bad news. Markets react to change rather than predictability.

Despite decades of economic research on the formation of economic expectations, most economists and stock market analysts display “adaptive expectations”: if they are surprised positively, they revise forecast upwards. If they are surprised negatively, they revise downwards.

So now that we have all been surprised positively for some months, you can be absolutely sure that forecasts are now being adjusted upwards. At some point in time they will have caught up with reality. From that point on, we will begin to have negative surprises. A new revision cycle will begin and the market mood will again turn.”

The question is where we are now, 5-6 months later? The Economic Surprise Indicator nosedived as the economy began to slow. Somewhat belated, stock markets found out on 1 August and we have had quite some market mayhem since then.

Economists and Analysts are beavering away on their forecasts of economic growth and company earnings. We are seeing a wave of downgrades. The term “Recession” is back in fashion. At the same time the Economic Surprise Indicator has stabilised at a very low level, indicating that economic surprises are still negative.

The indicator is not the answer to everything. But once the wave of forecast downgrades are over – and believe me, the downgrades will be aggressive – the market will suddenly begin to receive positive surprises. The most likely result is that the current negative sentiment will change. Market participants will convince themselves that it is not quite as bad as they thought. The “hidden factor” in the equation is to understand that the underlying consensus estimates are moving as a result of positive or negative surprises.

The important thing here is that in order to stabilise the market sentiment, it does not matter that we are looking at 5 years of below trend growth. It matters that the market somehow adopts it as a consensus. At that point in time, risk willingness will increase again.

When it will happen? I don’t know for sure. But it is typical that a cycle from exuberance to despair and stabilisation takes some six months. So sometime in September, maybe. Or it could be that downgrades are dramatic enough to stabilise sentiment earlier. 

Tuesday, 16 August 2011

It is tough to be a stock market dealer

Among bond dealers, it is a well-known fact that the stock markets cannot concentrate on more than one thing at a time. So it must be tough to be a stock dealer or advisor these days. There are so many things to worry about.

Maybe one should not be too tough on the market participants when they are being interviewed for TV or press. With a significant slowdown looming, downgrades falling hard and fast and something wrong in the Euro-zone, it really is possible to be quite confused.

Stock markets tell us that the S&P downgrade of the US Treasuries ushered in a period of grave turmoil in the stock markets and that further debt trouble in Europe makes it worse. One more downgrade would bring more chaos. So how come that those incompetent politicians are just sitting on their hands instead of doing something??

Please! Let us try and go as far back as to 1 August. Europe had just announced a clever Greek restructuring plan that avoided what everybody feared, a default event. Italy had approved a significant program to cut its government deficit. In the US, the debt ceiling had just been lifted after weeks of undignified brinkmanship. That should be what every stock market would need to create a solid rally.

In the event, the opposite happened. The bond markets had already given clear indications months in advance: Economic growth had shifted down a gear or two. Suddenly the stock markets began to fall on fears of a recession that would for sure hit company earnings. Pure logic, except one could speculate why the stock markets’ Wile E Coyote moment had lasted that long.

And then S&P announced its downgrade. Since that moment stock markets have traded sideways under high volatility. Bond yields have fallen as more evidence of the economic slowdown came in. In other words, there has been NO effect of the S&P downgrade.

But since the economic slowdown was now sort of old news, the stock markets had to find something to rationalise the palpable fear. Maybe France will lose her AAA-rating (quickly denied in unison by the tree big ratings agencies)? Maybe Italy will collapse (with a government debt at the same level as 8 years ago)? Maybe Spain may not be able to cut it (with a budget deficit and a government debt lower than that of the USA)? The Euro, then? Will it collapse (it has traded in a narrow range over the past weeks)?

Everywhere we look, things look pretty much the same as they did 4 months ago. Some uncertainties have been removed (the Greek restructuring) and some new uncertainties have appeared (the slower growth worldwide). For investors with a longer memory than 2 market days, it is obvious that the moment where the stock market discovered the slower growth, something was bound to happen.

It is particularly interesting to hear market participants now quickly turning into experts on German domestic politics. They are now looking for shards of evidence that Chancellor Merkel may throw overboard well-established (and healthy) policy principles in order to calm the nerves of stock market participants who have already forgotten everything that has happened over the past month.

I am not trying to say that everything is OK. Even if I disagree with the sometimes brutal austerity programmes and believe they will cost economic growth in the future, a lot of things are being done in Europe to fix the situation.

Unfortunately, structural problems in the Eurozone cannot be fixed within a 24-hour news cycle. Germany will eventually cave in to Eurozone bonds. But only after a revision of the EU Treaty that gives real teeth to a European fiscal authority and only after several countries have had the time to amend their constitutions in order to implement the new treaty in local legislation. That will not happen anytime soon.

We will hear more nonsense from the stock markets. The best antidote is to try and keep the focus on what is the real driver of events: it’s the economy, stupid.

Monday, 15 August 2011

Why Germany will not accept Eurozone bonds

There is a lot of guesswork going on in the financial press about Germany’s apparent refusal to condone the issue of Eurozone bonds. Such bonds are bonds, issued by a relevant institution of the EU, underwritten by every member state, and the proceeds of the sale of such bonds could then go to member countries that have problems borrowing money in the financial markets.

Financial journalists have a tendency to dismiss politicians as bumbling idiots because they do not do everything the markets demand. In this case, we hear that the market wants bonds issued with complete, gold-plated German guarantees.  Germany is not likely to accept that.

It is not because European politicians are incompetent. It is because the “battle to save the Euro” is played out on many levels. The upper level is where the panic has been: Something was needed to “rescue” Greece.

At a deeper level, it is about sovereignty. And about moral hazard – again. A look at history gives some important clues

Since Germany accepted the principle of a monetary union in connection with the German reunification, nothing has been more constant than the German unwillingness to underwrite moral hazard. Early on, Germany had spotted that the Monetary Union would give countries such as Italy the possibility of profiting from lower interest rates while maintaining the right to flood the market with government bonds denominated in EUR. As a result, Germany pressed hard to have a “stability pact” that would put at least some limitations on the more irresponsible governments in the Euro-zone.

As we all know now, nobody took the Stability Pact seriously, and it was never enforced. Germany’s nightmare came true.

The Stability Pact was only a second best. Germany, already familiar with a federal structure, would have preferred a Euro-zone fiscal authority. In the ‘90s this was unthinkable, as the governments jealously guarded their prerogative to collect taxes and decide government spending. It is after all one of the key elements in politicking.

Now, almost two decades later, Germany’s attitude is fundamentally the same. Germany will not underwrite Eurozone government bonds unless moral hazard is taken off the table. Germany will not bail out government after government because they have behave recklessly with their own public finances.

Under the impression of the market turmoil several countries are increasingly understanding that it is impossible to have a monetary union without adequate institutions. As a result, ECB has been permitted to expand its activities way beyond what its charted allows it to do. Some governments are ready to consider some kind of federalism in fiscal matters.

France resists any such idea. President Sarkozy has repeated what every president before him has stated. The prerogative to decide on taxes and spending lies with the French government.

In my view, France is playing with high stakes here. The French economy has not been “liberated” from the government influence and is increasingly lagging behind the German export locomotive. Nevertheless, France insists on being treated on a par with Germany. In Berlin this is accepted because membership of the Eurozone is a geopolitical imperative, and a Eurozone without France AND Germany is irrelevant. So France is playing on Germany being willing to go further in saving the Eurozone than has already been the case.

I would not bet on that happening. After all, the basic tenet of German policy towards the economic policy in the Eurozone has remained unchanged for a very long time. It makes complete sense that one country should not write blank cheques to everybody else. The financial markets may rail against German inflexibility as much as they like.

But there is no reason to expect that Germany should listen. Money talks. It is Germany holding the purse strings, and that gives a guarantee that Europe will listen.

In case anybody wants to have a short summary of Germany’s position, Finance Minister Schäuble laid it out clearly last year in Financial Times. It is worthwhile reading again.

Thursday, 11 August 2011

Thrift's Paradox or how economics can be made simple

We are all slaves to dead economists, the (late) British economist JM Keynes famously stated. A lot of politicians on both sides of the Atlantic have committed mistakes that indicate that they could need a hefty dose of pre-Keynes thinking. I am talking of the Thrift’s Paradox, first formulated by Mandeville in 1714. Put briefly, it states that if we all save to become richer, we all end up poorer.

It is a brief statement, and to most people without understanding of economics, it seems like simple nonsense. If something works for me (saving to improve my financial situation) it must also work for the government.

It sounds obvious. But it does not make it any more correct. If I save, it means that somebody else’s business will suffer a lack of demand. And if a lot of consumers decide to hold back on consumption, it will mean that a lot of demand disappears. In the end it is felt all the way down to the producers and they will respond by reducing output and laying off staff.

This simple mechanism is one of the most misunderstood issues in economics. It is also one of the most misused. It is easy to make political soundbites by comparing the public sector to a household. It is difficult to catch voters’ attention while trying to explain why it is wrong.

In the current situation, households on both sides of the Atlantic are saving in order to improve their balance sheets. That leads to lower demand. It would only be normal if the government sectors would do the opposite, spend in excess of the revenue, in order to keep the economy going during the transition. The public sectors can then – later – concentrate on improving its balance sheet. Usually, the governments are then also helped by a sprinkling of inflation reducing the real value of the debt.

Because of the suddenness and the depth of the economic setback in 2008/2009, many governments are running sizeable deficits – induced by lower tax revenue and increased spending related to unemployment. Since late 2010 significant efforts have been made to reduce government deficits. That austerity hits us now.

In the US, a weak president has left the field open to voodoo economics espoused by an uncompromising Tea Party. In Europe, the strongest economy, Germany, is also the one least inclined to add stimulus. And Germany will not “save Europe” until Europe’s institutions have been reformed – which is being blocked by France.

Central banks are the only ones left holding the rope. They do not have an awful lot of rope to give. Economic growth estimates will be adjusted downwards in the near future. A period of slow growth seemingly lies ahead. A lot of it caused by a wrong policy reaction, caused by the wrong political philosophy at the wrong time.

For once I will quote from the Economist's Free Exchange Blog. (Article from 28 July 2011). It reads:

“The challenges facing Europe and America are big, but they're not mysterious. In Europe, the issues are sovereign debt, vulnerable banks, and a poorly designed currency area. It's not tricky to see what must be done. Peripheral debts should be addressed through austerity, sure. But unsustainable debt loads need to be written down. Banks should be recapitalised to prevent trouble in financial markets. Emergency funds should be bolstered to fight sovereign and banking contagion. And substantial fiscal integration must take place, including fiscal transfers to support peripheral economies while they get their budgets in order. The central bank should also stop fighting the phantom of accelerating inflation.(...) 
“Again, it's not like the correct policy path is incredibly complicated. Here, I'll sum it up in three quick steps:

Don't cause a major crisis.
Do spend more and tax less for the next year or so.
Do spend less and tax more after that.”

Wonder how far stock markets will have to fall and unemployment will have to increase before politicians get it. If they don’t, well...

Tuesday, 9 August 2011

It's the debt, stupid

Stock markets are plunging on an unappealing cocktail of worries about economic growth, the handling of sovereign debt problems, the apparent inability of politicians to bail out the markets when the markets really want it, and a handful of other assorted ailments. 

Given that analysts now realise that growth in 2H of 2011 is going to be slower, they are working overtime to adjust earnings estimates. Those estimates will invariably be lower than the pie-in-the-sky estimates of just two weeks ago, and the assumed valuations of the stock markets may take a serious blow.

How come that the adjustment to slower growth has come so quickly? At my company, Origo, we have warned about the “soft patch” ahead since late March, when early indicators showed that the US economy was in for a slowdown. European indicators have been unequivocal since April. That was also the month when commodities took notice.

On the other hand, bond markets have been right on the ball this time. Bond yields of high quality sovereign debt have fallen in the past months, giving another clear indication that something was afoot.

However, indicators of (stock) market euphoria have shown the increasing divergence between the optimism in the stock markets and the increasingly gloomy economic background. The speed of adjustment indicates what has been obvious for some time: stock markets have been living in their own little bubble for a while, and that bubble has now burst.

Summing up all these indicators, we arrive at a picture of the best announced stock market correction for a decade. The stock markets have yet again failed to predict important economic trends. Now they are rapidly adjusting and “Double-dip Recession” is now a favourite buzzword.

Which brings me to my point. For those who believe that the decline in the stock market reliably predicts a new recession, remember the famous dictum of the late economist Paul Samuelson: “The stock market has predicted nine of the last five recessions.”

I do not think we are heading into a global recession, i.e. a new period of negative growth. But I do believe that we are heading into a period of growth below trend. Remember that this economic crisis is not your standard run-of-the-mill recession. We are cleaning up after a major debt-fuelled party. It means that households, particularly in the US and the UK have to redress their balance sheets. It takes time to bring down debt, and in that period consumption has to be lower. Obviously it also hurts the banks that have financed the party.

It would not have taken more than a few years if the public sectors were in a position to let their balance sheets deteriorate for a period. That has historically been the role of the public sector in smoothing out economic cycles. But many countries were not in that position when the downturn started in 2008. Public sector finances in USA, UK, and some smaller European countries were hit full force.

At the same time the countries that could have afforded to expand their balance sheets were gripped by fiscal conservatism. The results have not been encouraging. We now have a situation where both private and public sectors are working to consolidate their balance sheets. That leaves the monetary policy to do the job of getting the economy moving.

It can’t. Monetary policy can only create the conditions for growth, and central banks have certainly done so. But when the consumers and business leaders are more focused on reducing debt than increasing loans, adaptive monetary policy won’t work. In such a liquidity trap, the money created by central banks in all likelihood fuels speculation in financial assets instead.

Oh, and in the longer term, it may be inflationary. Some voices are already afraid of an impending hyperinflation. In the big picture, however, such fears are pushed aside as asset reflation is supposed to make consumers feel better and hence more prone to consumption.

Central banks can reliably be counted upon to support the stock market this time around, too. It does not change the fact that we probably are heading into that period of below-par growth that may last for quite a while. It may not be a recession, but growth will be slow enough that it feels like one. I don’t know who came up with the expression “the new normal”.  But I do think that it is what we are looking at now. 

Monday, 8 August 2011

Will China speed up a floating of the CNY?

It is interesting to observe China’s government join the chorus in demanding that the US government clean house and get back to a situation where economic policy is based on facts rather than woodoo and political blackmailing.

I could not agree more, but it is fascinating to hear China indicate that unless something happens, the country will have to reconsider its position as the world’s largest holder of US treasury bonds. Either it is complete nonsense, or else the Chinese authorities are telling us something. The timing is impeccable.

With everybody being busy panicking it is a good time to make important political statements that will not be seized upon by protectionist US politicians.

To repeat the obvious: as long as the Chinese current account is in surplus AND as long as the Chinese government opts for a (very) slow appreciation of the CNY against USD, China has no choice. The Central Bank is forced to purchase USD denominated assets in order to avoid an appreciation of the CNY. As long as the currency peg is maintained, Chinese worries about the value of the dollar are just theatrics.

China has no effective mechanism for absorbing the boost to domestic liquidity that comes when Chinese exporters exchange their dollars for CNY. This huge boost to the domestic liquidity is easily the most difficult issue for Chinese policy makers to control as it drives domestic inflation upwards. It forces the central bank to increase interest rates, when in fact the correct thing to do would be to sell CNY-denominated government bonds to the public.

As long as China does not change her currency policy, the harsh words about the US government and the need to replace to dollar with another reserve currency are simply noise, aimed at positioning China favourably towards their own constituency, a large number of developing countries. But the words will not be followed by actions.

However, something else may be brewing. In a series of articles, Yu Yongding, currently President of the China Society of World Economics, and a former member of the monetary policy committee of the Peoples' Bank of China as well as Director of the Chinese Academy of Sciences Institute of World Economics and Politics has indicated that the Chinese government is ready to move a bit faster towards letting the CNY free itself from the peg to the USD.

There is no doubt that the Chinese leadership finds itself in a dilemma. The USD peg has been instrumental in building up Chinese exports and has created a huge flow of investments into China. But now that policy creates other, insidious domestic problems. Yu Yongding’s articles indicate that a serious discussion is going on inside the corridors of power in China.

Yu Yongding is adamant that a currency reform must happen on “market terms”. Translated to plain talk it means: We will not do it if it can be seen as a result of American pressure.

While this kind of exegesis may seem irrelevant as the stock markets are taking a pounding, it is worth noticing that the symbiosis between US deficits, Chinese surplus and a CNY-USD peg has allowed us all to have lower interest rates than we have really needed. It has been one of the important elements in creating the debt-fuelled boom that burst in 2008 (of course, bad regulation and plain greed were other important drivers).

So if China is now signalling a further, more significant step away from the need to buy USD treasury bonds, the world better sit up and listen. The impact would be far bigger than further downgrades of US debt. The ensuing increase in bond yields would be sufficient to actually force the savings balance of the USA towards an improvement. Not a bad idea. But it would help to keep US growth below trend growth for a decade or so. And the rest of us certainly would not like that.

Sunday, 7 August 2011

S&P downgrades the US and their own importance

So Standard and Poor’s has stripped the USA of the AAA rating for its federal debt. A lot of media attention is paid to this fact and legions of experts are being asked by serious-looking news presenters: Is this really the end of the world?
Fortunately it is not.

My initial reaction was that if Standard and Poor’s put the same good analysis into the US government debt as they put into the analysis of Sub-Prime Mortgages, we are probably fine. Readers are reminded that Standard and Poor’s together with Moody’s and Fitch were caught pants down having essentially eschewed even a minimal research effort in order to maximise revenue when CDO’s were all the rage at 5 years ago.

Since then, the three US government chartered ratings institutions have done quite some work to re-establish their tarnished image and - one presumes – their revenue. They have not really succeeded.

It is a fact that the ratings institutions are home to a series of conflicts of interest that would have clients run away screaming. Their business model is that they are paid by the issuers of the bonds to be rated. They cannot be sued for damages in case they are mistaken, since they simply get away with invoking the First Amendment to the US Constitution: Their expensive analyses are simply expressions of the right to free speech. They have a government-approved monopoly on the rating of nearly anything. Like auditing companies it is considered suspicious if an issuer terminates the contract with them. They do not shy away from rating a whole “production chain” of derivative products, including the insurance companies.

Despite an appalling track record, these institutions still hold considerable power. It is because pension funds and other institutional investors across the globe have given themselves internal guidelines that essentially dictate the portfolio composition on the basis of the ratings of the bonds.

Doing so of course frees the institutions of the responsibility for having an informed opinion about the assets they hold. That reduces the cost of running an investment department considerably.

It is not because of the quality of their analysis that ratings matter. They matter because they have become a convenient replacement for independent thinking. And because of the way huge amounts of money may move as a result.

The US government and congress of course now protest: S&P are wrong. So did the Greek government and parliament as the ratings downgrades fell thick and fast over Greece the past 15 months. They know very well that money may move out of their assets as a result, pushing up interest rates in the process.

Fortunately there are signs that the financial markets have learnt to take the ratings with a pinch of salt. After some noise, investors probably will conclude that there are no compelling reasons to reshape portfolios on the basis of the downgrade alone.

The only alternative is of course to modernise the ratings institutions. They should be made liable for their own mistakes (well, not exactly in fashion in the financial sector these days). More ratings agencies should be established. Government licensing should be withdrawn and new entrants should be given easier access. Government or supranational institutions should get involved. That would be the only way of putting an end to the political meddling and abuse of monopoly powers so blatantly displayed by the ratings institutions.