Fed Almighty? Erh, no...

Interestingly enough, at yesterday’s meeting, US Federal Reserve at the same time declared that significant risks threaten the economic situation AND decided not to introduce a new programme for monetising the Federal deficit. If things are bad, then why not try to do something about it?

The only logical explanation is that Fed does not find that there is a lot that a further QE-programme could really do about the economic situation in the short term. We are still in a Keynesian liquidity trap, where zero interest rates have no effect on the demand for credit, and hence does not contribute to increase the economic activity. Fed Chairman Bernanke was clear about such issues at the Jackson Hole conference in late August: “economic policies that support robust economic growth in the long run are outside the province of the central bank”.

Instead he, and with him a number of other high profiled officials have lately been very clear that cleaning up the mess is a responsibility of the elected governments. IMF Chief Lagarde, World Bank Chief Zoellick, and several other central bankers from across the globe have issued statements that closely match Bernanke’s explanation at the same meeting:

“To allow the economy to grow at its full potential, policymakers must work to promote macroeconomic and financial stability; adopt effective tax, trade, and regulatory policies; foster the development of a skilled workforce; encourage productive investment, both private and public; and provide appropriate support for research and development and for the adoption of new technologies (...)  Although the issue of fiscal sustainability must urgently be addressed, fiscal policymakers should not, as a consequence, disregard the fragility of the current economic recovery. Fortunately, the two goals of achieving fiscal sustainability--which is the result of responsible policies set in place for the longer term--and avoiding the creation of fiscal headwinds for the current recovery are not incompatible. Acting now to put in place a credible plan for reducing future deficits over the longer term, while being attentive to the implications of fiscal choices for the recovery in the near term, can help serve both objectives”.

And there is more: “Finally, and perhaps most challenging, the country would be well served by a better process for making fiscal decisions”.

There you have it: Fed does not feel that it can do an awful lot more. It is up to US lawmakers to pull up their socks and act in order to bring the economy back on an even keel.

However, the European sovereign crisis, the increase in the price of credit risk and the fear of having government debt downgraded have led to a resurgence in fiscal conservatism at the wrong moment. Simple recklessness on the part of US Republican lawmakers does not make it better. Just a few months ago, governments in the entire OECD area seemed bent on making things worse by introducing austerity programs. Since then, the sharp deceleration in economic growth and renewed market turmoil has led policy makers to ease the foot away from the brake, sort of.

It is perhaps symptomatic that the markets have lost confidence in politicians to a degree that central bankers’ statements are studied more closely than anything else. But Fed’s lack of action clearly indicates that there is not an awful lot more central bankers can do.

What next, then? With politicians constantly on the verge of committing major policy errors and central banks with only little dry powder left, what will create the growth the world so badly needs? It has been said before and I repeat: A period of sub-par growth while fiscal balances are redressed. 

A word of reason

Beginning in 2008, I have several times pointed out that banks would come out of this recession downsized and with dramatically lower profitability than has been the case in the past two decades.

For a while it appeared that panic-stricken politicians had given banks yet another opportunity to consolidate and get even bigger – and even more unlikely to be allowed to fail.

Now, it appears that the UK is leading the way in how to get out of the mess. The Independent Banking Commission delivered its proposal for a bank reform yesterday, and it makes a lot of sense.

Instead of breaking up the banks, the Commission suggests to consider banks as two different businesses. 

One, the sexy one, is investment banking, securities trading, and all that. The other is the boring part of banking: savings, lending, payments services. We could call it a utility.

The utility part of banking is the services that are absolutely indispensable to a society, and the banking commission suggests that this part of the banking sector is “ring fenced” by higher capital requirements and in essence kept separate from the investment banking activities.

That would turn the utility banking into a dull, but safe economic activity. It would prevent the banks from using the capital base from utility banking for funding of investment banking activities. It makes a lot of sense – and it harks back to the US Glass-Steagall act from the ‘30s, which even legally separated the two kinds of activities. The introduction of that act marked the beginning of the longest period of the US without banking failures.

The recommendations from the UK banking commission make an awful lot of sense. It recognises that the society needs banks, but not all activities currently categorised as banking. It makes it clear that the profitability of the utility banking will be (much) lower – just like that of water supplies, telephone services, electricity etc. It makes it clear that the banking industry finally will have to pay the price for two decades of foolish greed.

For a second – in 2009 – I had started to have my doubts as bonuses in the banking sector again took off into the stratosphere.

Predictably, the UK banking sector is already lobbying heavily to avoid the “disaster”. But I am afraid that the lobbying will not work any longer. One of the members of the Commission, Martin Wolf, Economics editor of Financial Times is quoted for saying:  If you live in a world in which the real rate of interest on safe government bonds, bonds that the world regards as safe, is about half a percent or less, you might wonder whether you can reasonably expect a reasonably safe return of 15 percent on equity in a bank.

An equally simple word of reason from a man who cannot in any way be accused of left-leaning tendencies, UK Chancellor George Osborne: We should not confuse the interest of bank shareholders with those of British taxpayers.

So right. In America, Jamie Dimon, CEO of JP Morgan Chase, made a rant against the proposed Basel III capital requirements, qualifying them as “anti-American”. His concern is that the Basel rules will force the banks towards deleveraging and lower profitability. Obviously, US banking lobbyists are not as successful in Basel as they are in Washington DC, so Dimon suggests that the USA withdraws from Basel-based BIS altogether to avoid such disasters.

In Europe, the banks are in no position to tell the politicians what to do. With an impending bankruptcy in Greece and still carrying huge losses forward, many European banks are or will be de facto insolvent. They will depend on government support going forward. It might be that the Eurozone governments let themselves be inspired by the UK thinking.

Utility banking may be the right solution, as well as a healthy way of thinking. Contrary to what the banks have tried to make us believe, it will not be the end of the world as we see it if the banks are forced to downsize. Unfortunately, the banking lobby is still strong enough that it can persuade politicians to wait and postpone, which only delays the necessary.

Will it ever get better?

So the economic slowdown is upon us. Everybody is busy revising estimates for economic growth and company earnings downwards. And the talk of the town is: will we end in a recession? That question is probably misleading. There is not a huge difference between a growth rate of 0.1% and one of -0.1%. Neither will feel good and neither will generate jobs or an investment boom.

The financial markets have (finally) adjusted. As far back as in mid-July, the stock markets were still humming along, convinced that company earnings could only continue to grow linearly. Bond markets were as usual negative and yields had reached new low levels that were only compatible with – recession. Corporate bonds were firmly in the camp of the stock markets.

Now, six weeks later, the bond market again proved right. Stocks and corporate bonds have fallen off a cliff, and nobody can apparently find any good news that will turn the market mood around. It will probably take some weeks before this can happen, and weeks are an eternity in market time.

It is my conviction that markets react stronger to surprises than to anything else. Most market participants feel good about being part of the great big market consensus, and it is only when this consensus is disturbed that something has to change.

Forecasts are coming down, and in all experience it will mean that we will soon have a situation where market consensus undershoots the economic development. My guess is that by mid-September this process will have run its course. The markets will by then be ready to be taken by positive surprises.

In the current gloomy mood, nobody can see what would create growth. However, there are several elements that could turn positive. First, we have negative real interest rates. Former chairman of the US Council of Economic Advisors, Christina Romer, in academic works showed how low interest rates eventually end up by supporting the housing market. Negative real interest rates also push capital out of cash and short-term bonds, lowering the price of capital for companies. Consumers who have postponed purchases of cars and other durable goods will have a pent-up demand. Similarly, companies will have a greater need for investment after a long period of no investments. Inventories will have been brought down or written off.

And finally, austerity measures will be if not postponed, then at least delayed. Reality is finally about to win over ideological arguments that deficits will have to be cut dramatically here and now. It is slowly becoming clear that austerity will hamper growth.

So if – and that is still a BIG if – nothing goes wrong in the European banking sector, we are setting the scene for the stock markets to be positively surprised, even if economic growth will remain weak for a while.

At Origo, our work with market risk indicators has led us to precisely track the gap between economic downturn and unfounded optimism in the stock markets. We will report back here when the opposite scenario begins to unfold.

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.

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. 

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.

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.