Contagion defined

While we wait for the all-encompassing, gold-plated solution to EU's institutional problems, one could reflect on the term "contagion”. The concept has been used so often in recent months that we have almost become immune to its possible meaning.

Progressive distrust
I suppose it means that distrust of one kind of assets (Greek government bonds, for example) leads the financial markets to lose confidence in other assets - such as Italian government bonds. In the financial markets it means that the price of the suspected asset drops to reflect the new perceived risk of owning the asset. Completely logical, this.

So "contagion" means that investors reassess risk on assets one by one, and it implies that prices adjust - mostly downward. Contagion is therefore a sign that the markets have begun to think. This should create some concern, since the markets not exactly known for composure when they find out that they have been wrong.

Risk reassessed
Since 1998 it has been Standard Operating Procedure that when something went wrong in the world economy, interest rates were lowered and ample liquidity was supplied to the market. Since Asia during the same period took over the production of industrial goods, this policy did not stoke inflation.

Yields on government bonds fell, and in an attempt to achieve higher returns, institutional investors around the world dramatically increased holdings of low-quality bonds and equities. As a result risk premiums fell dramatically.

A clear example is that the Italian government bond yield was less than 20bp higher than German government bonds back in 2005. A clear sign that the risk was severely underestimated and the risk premiums had fallen too far.

We think and we re-think
The banking crisis in 2008 meant that market participants again are thinking about the correct price of risk. With usual decorum and restraint, the financial markets have entered into a permanent state of catatonic shock.

In other words, the "contagion" translates into a progressive understanding that risk should be reassessed. It seems that politicians everywhere find that such knowledge must be stopped by all means before it goes too far.

A potential victim of risk re-pricing : U.S. overconsumption
Now think what could happen if the markets began to ask critical questions about the World’s largest debtor by far, the US of A.

It would mean sharply higher U.S. bond yields. The burden of debt service would force a reform of public spending and taxation. Consumers would be forced to save instead of borrowing. Businesses would have to rely more on labour instead of cheap capital.

The road to get us there would certainly not be smooth and without obstacles. But "contagion" might ultimately not be the worst outcome. 

Risk willingness increases

Despite the continued uncertainty over what will actually be done in order to stabilise Greece and the European banks, G20 meeting in the weekend 15/16 October delivered enough details and pointers that the financial markets will begin taking the risk premium out of the market. Later on, it could develop into some kind of euphoria that will turn upside down everything that has happened in the past few months. It started two weeks ago as the first rumours of a comprehensive solution began to circulate and it can continue for a while, at least.

Bank crisis solution

Our often repeated take on the situation is that at least two crises overlay each other: Greece, and a general debt crisis, which in turn reflects itself in a very unhealthy banking sector. As I have stated earlier, Greece must have a debt restructuring in order to get out of the mess, and that will lead to some serious cash injections to the banks. The US banks already got their no-strings-attached social help three years ago, and the European banks will probably receive their gift vouchers over the coming six months. 

A classic “risk-on” reaction

In concrete talk, “taking the risk premium out” means: 

• Stocks will gain, possibly lead by the bank stocks, and primarily in Europe. 
• Bond yields on higher-rated sovereigns will increase, the yield curve will steepen.
• Yield spreads of lower rated sovereigns over higher-rated sovereigns will narrow, in some cases sharply. 
• High yield bonds will see the their yield spreads over government bonds narrow but at a slower pace than what happens in the spread between high and low rated sovereigns.
• Dollar will weaken against the Euro and so will other “safe” currencies.
• Commodity currencies will increase against the USD.
• Commodities (primarily industrial commodities) will rise moderately, and oil will receive a boost.
• Gold may fall further, as the “safe haven effect” vanishes.

It may look like an asset rotation, but we not yet seen market volumes corresponding to a major move of capital between asset classes.

A new divergence is building

A bit further out another theme is building. The markets had not seen the sharp slowing of the global economy as late as one week before the stock markets fell out of bed in early August. “The End of the World” is still very much on everybody’s mind.

At some point the markets will realise that apocalypse is not now! Nor indeed anytime soon. The risk-on scenario will then be followed by a proper risk-rally. It will probably last for some months before the underlying longer-term problems again are taken seriously. The debt crisis has not gone away, and it will continue to subdue growth for the coming years. It will be uncomfortable (particularly if you work in a bank), but not disastrous. 

Inching closer?

It could very well be that we are in the last weeks before the Greek debt restructuring. At least we hear more and more noise from the Euro-group about the terms of the haircut private sector bond holders will have to take.

On 21 July the Euro-group members presented an agreement whereby the Greek debt would be written down by 21 per cent. It did not take long time to calculate that even with the economic reforms agreed by Greek government at that time, it would not be enough. Greece needs a combination of spending reductions and debt reduction in order to get back from the dead.

With the 21% debt write-off, it would take very optimistic assumptions about future Greek economic growth in order believe that the “primary” surplus (government revenue minus expenditure ex debt service) could be sufficient to cover the servicing of debts to the tune of 170 per cent of GDP.

Several sober estimates have consistently pointed to a haircut between 50% and 70% in order for Greece to get a fresh start. That matches exactly what we now hear from the Euro-zone, namely that “more than 50%” of the debt will have to be written off. It is a great step forward that the truth is finally being tabled.

But, it is not over yet. ECB apparently is against the idea of a Greek haircut of 66%. Instead ECB insists that the 21% “voluntary” haircut must be implemented. One could wonder why, given that a haircut of 50-70% is the only thing that makes sense. Probably it has a lot to do with politics (I will not be so mean as to suggest it could have something to do with the Greek bonds held by ECB itself!).

Let us assume that the banks take the 21% haircut. In that case they would probably need only a minor capital increase, and it would possibly be possible to find that money in the market. Shareholders would be happy and the interbank market would unfreeze rapidly. No wonder the banks endorse this strongly. It would be a carbon copy of the US “money-for-nothing” program, called TARP.

The problem is that in order to arrive at a debt reduction of 66%, EFSF and the Euro-zone countries somehow would have to finance the difference between the bank’s losses and the necessary debt reduction. One could imagine that EFSF simply would underwrite difference or take over the Greek government bonds at artificially inflated prices. This would amount to a de facto gift to Greece and/or the banks.

That would be just about the worst thing that could happen for Chancellor Merkel and the other European leaders. Their electorates could rightly claim that their governments had just rewarded Greece and the banks for their recklessness.

Let us instead assume that the haircut is fixed at 66%. The banks for sure would need capital injections from their governments. In that case the governments will be able to present the expenses as a help to domestic banks and not as a rescue of the reckless Greek. The governments would for an extended period of time take control of the banks. That would be far more palatable for the electorate.

Either way, Europe’s governments will end up having to foot the bill. The difference is in the resulting relationship to the banks and the electorate. It is easy to see why politicians prefer the larger haircut. It is equally easy to see why the banks prefer the 21% haircut. 

Could the markets have got it wrong?

It is a dangerous game to say that the markets are wrong. As JM Keynes noted: The market can stay irrational longer than you can stay solvent.

Nevertheless, there are some elements of the developments in the last week that are worth a comment.

We have heard US Secretary of the Treasury Geithner tell us that Europe is acting too slowly and that we have to act in order to avoid a disaster. We have read tons of analyses of the Eurozone debt problem, built on dubious assumptions. And we have seen economists who 3 short months ago trumpeted a return to strong growth re-brand themselves as doomsday prophets. 

The underlying economic situation is serious, but not because of the issues that are now driving the crescendo. The Western World has over the past years built a mountain of debt which is clearly unsustainable. The main culprits are the private households who in line with falling interest rates have leveraged themselves harder and harder, mainly in the property market.

Public sectors have “taken over” some of the debt during the first phase of the Great Contraction in 2009 and 2010. Countries with a weak budget discipline have been pushed in the direction of something quite unsustainable. This affects primarily the US and in second line, the UK.

The historically high Debt/GDP ratio will slowly be reduced in the coming decade. As the banks are the pivot in the debt explosion – no banks, no loans – a deleveraging will automatic lead to a shrinking of the banks’ balances. This process is progressing, but is slipping under the radar of the financial markets.

Instead, the markets are busy with something as relatively unimportant as Greece. Government after government has been lying about the real economic situation, and Greece now faces a default. It appears that the Eurozone is about to arrive at a solution that will allow an orderly default, assuming a 50-66% haircut.

This would imply a loss for (European) banks up to €130bn. A large amount, but not impossible to handle. The data released in relation to the European “stress” test showed that a default of this magnitude is possible to control.

Then we have Portugal and Ireland, which at this moment in time do not finance themselves in the open markets. They work to reduce their government deficits. Ireland has progressed nicely and is ready to try a fresh bond issue some time in 2012. There are no reason to expect that these two countries should default on their loans.

Spain is frequently mentioned, even if the country has a relatively low government debt, and a government deficit lower than those of the USA and the UK.

Italy has a government debt of some 120% of GDP, the same as 10 years ago. Reforms have been introduced that will reduce the government deficit to acceptable levels over the coming two years. There will be a significant surplus on the primary budget balance, ie. before interest payments on the existing debt.

There is hardly any reason to believe that Spain or Italy should default on their debt. However, the panic in the financial markets has reached levels that probably requires that EU provides sufficient credit facilities that both countries for a while could cover their financing needs without tapping the markets. This is not a situation based on facts, but on panic.

Then there is the interbank market. The diffuse fears of losses in the European banks have led to a freeze in the interbank market. Central banks have reacted correctly and provide liquidity in order to avoid a replay of the Lehman collapse. A further deterioration of the situation  will not come from this source.

All in all it is a complicated situation where several stories are playing out on different levels. Stock and commodities markets have reacted with a huge increase in risk averseness. A quite understandable reaction, but not particularly logical, given the facts.

But what will happen once Greece has defaulted and the European credit facilities have been increased X-fold?

Then we can return to the really ugly story, namely that OECD needs to bring the debt situation under control. As I have written before, this will imply an extended period of sub-par growth and shrinking bank balances. This problem is not isolated to Europe.

The good news is that even in such a situation, it will be possible to have well functioning markets. The bank sector, however, will see no solution to its problems with the capital base as well as with bad loans.

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.