Monsieur De Mallestroit

10/02/2012: Joining the hands of the US economy

2012-02-10T01:25:00.000-08:00

US President Harry Truman once famously demanded a one-handed economist – exasperated by economists’ tendency to qualify all of their statements with “on the one hand” and “on the other hand.” The mixed signals emanating from the US economy right now also make it difficult to arrive at unequivocal conclusions: Recent statistics show a steadily improving economy, but the Federal Reserve continued to paint a sobering picture despite this new information.
First, let’s look at the statistics. While not outstanding, fourth-quarter GDP growth came in at a solid annualized rate of 2.8 percent. Moreover, the US labor market improved significantly in January, with unemployment dropping to 8.3 percent, the best figure since February 2009.
But compare this with Fed Chairman Ben Bernanke’s latest congressional testimony. After acknowledging improved economic conditions, he went on to stress that “the sluggish expansion has left the economy vulnerable to shocks,” and economic developments must be monitored closely because the outlook for the US “remains uncertain.” This is not exactly upbeat.
Reconciling these pictures presents us with another dilemma. We can claim that one is right and the other is wrong. Or we can consider the possibility that the Federal Reserve is motivated by more than the state of the US economy – and hence these perspectives are not so contradictory after all.
Many economists are taking the former approach, pointing out what they see as serious flaws in the data. The latest US growth figure may have been 2.8 percent, they say, but 2 percentage points came from involuntary inventory buildup. Real demand thus only grew by 0.8 percent, which is nothing exciting. Moreover, the GDP price index measured inflation at just 0.4 percent in the fourth quarter, taking nominal GDP growth to 3.2 percent. Correcting this growth for 3 percent headline consumer price inflation suddenly makes it look flat.
However, if we take the positive data at face value, I tend to think the Fed’s rather bleak comments have another goal. After all, if the economy really is improving, delaying the first interest rate increase until late 2014 simply doesn’t make sense – unless the Fed wants to see something more than a recovery before it hikes rates.
In my view, the Fed is waiting for a significant improvement of US public debt, which exceeds US GDP at over 15 trillion US dollars. The annual cost of servicing this debt will go up by 100 billion dollars with every rate hike of 0.65 percentage points .The US only enjoys even a AA+ credit rating is because its central bank can lower interest rates by printing money. If it were part of the Eurozone, where individual countries have no such recourse, its credit rating would likely fall somewhere between Belgium’s AA and Italy’s BBB+. Despite improving economic data, the Federal Reserve looks poised to keep rates lower until public debt comes down. By accentuating the negative at this potentially transitional moment – as the economic environment finally seems to be improving – the Fed can justify its decision without bringing US national debt into the discussion.

03/02/2012: Japan: one statistic, three possibilities of trouble ahead

2012-02-03T01:23:00.000-08:00

Things have calmed in Japan since the catastrophe of last March. Investors also have worries elsewhere: the European debt crisis, the US Fed’s efforts to mime control, China’s slowdown or tensions in the Persian Gulf. But the current calm surrounding Japan could hide some nasty issues.
Since Japan’s housing and stock market bubbles burst in the early 1990s, Japan has hovered in a deflationary stagnation, exacerbated by its demographics. Interest rates are stuck at zero and the public debt-to-GDP ratio, at 240%, is twice that of Italy. For many observers, Japan is prototypical of what developed economies such as the Eurozone, US or UK are poised to become.
So, nothing new in the Land of the Rising Sun? Think again. The Japanese trade balance for November recently showed its ninth consecutive negative monthly reading. The last bad streak of such length came between August 2008 and March 2009, during the global recession, and before that in 1980. What can we say about this? Optimists would argue that a global rebalancing is occurring; Japan, like China, Germany and the oil-exporting countries, usually shows a structural surplus and is now correcting that. Others say Japan has not yet recovered from Fukushima, roughly 90% of its nuclear plants are currently not working and it needs to compensate that by importing more oil. Hence, the pattern will reverse once the Japanese energy supply problems are solved.
Pessimists seek other explanations for this unusual data. We see three, which if true, point to a bleak future for Japan and also for the rest of the world economy: the strength of the Japanese yen, the weakness of Chinese demand, and diminishing Japanese savings.
The strength of a currency usually helps to explain trade patterns. In our case, the Japanese yen has risen dramatically in recent months. It is now at an all-time high against both the US dollar and the euro. Expressed in trade-weighted real terms, it is 10% above the 1995 peak, when, however, the trade balance was strongly positive. In our view, this high exchange rate and the persisting trade deficit give credence to those who press the Bank of Japan to adopt an exchange rate floor for the yen. Hence, we would not be surprised to see much more Japanese currency intervention in the future.
Lack of demand for exports from abroad also causes trade deficits. Growth appears to be faltering in China, the prime importer from Japan; the Japanese trade deficit may reflect this. We might be seeing a replay of what happened in 2008–2009.
Our last explanation for Japan’s negative trade figures is the most bearish. We can view a trade deficit from two angles, the first being international: exports minus imports. The second, inter-temporal view, looks at domestic production minus domestic demand. A negative trade balance thus expresses the fact that a country consumes more than it produces, or that it is indebting itself abroad. If this were the main cause of Japan’s deficit, then running a public debt at 240% of GDP with interest rates at almost zero would be quite dubious.
The aging of the Japanese population has been accompanied by a falling rate of private household savings. If the government can no longer rely on Japanese private savings to absorb its deficits, then it will need to find international investors. But these are not likely to lend willingly to such a heavily indebted country at zero interest rates. Hence, the only alternative Japan might have is to monetize its own public debt. Since Japan is prototypical of what is now happening to many developed economies including the US, its trade deficit could also herald what we can expect as the endgame of the financial crisis of 2007: debt monetization followed by massive inflation.

27/01/2012: Optimism, pessimism and the contrarian paradox

2012-01-27T01:23:00.000-08:00

My colleagues know me to be quite pessimistic about the future, grumbling remarks like, “It’s always darkest just before it goes pitch black.” But I am not alone. Pessimism regarding the future is a quirk of our trade.
Being pessimistic provides the advantage of compensating the well known “optimism bias” in behavioral finance, the systematic tendency for individuals to overestimate positive future outcomes and underestimate negative ones. It can also be seen as an effective strategy in forecasting. You are forgiven much more easily for being wrong about a negative forecast than about a positive one. In the first case, the public will happily forget the bearish forecast, while in the second case it will blame the rosy forecaster for not having seen the darkness coming.
So I’m a joyful pessimist. Nevertheless, two weeks ago I met my match when debating with the chief investment officer of a successful London hedge fund. A smart and eloquent gentleman, his view of the future was even bleaker than mine: “The US hasn’t even started its deleveraging process. So far, the enormous debt has only been shifted from one entity to the next. It will take at least 15 years of quasi-stagnation to bring the US back on track. The euro will implode. China is facing the mother of all housing bubbles,” and so on…
When asked what made him the most skeptical about his own forecasts, he had this answer: “I am a contrarian, taking more often than not the opposite view of the market consensus. It has been one of the foundations of my investment success. However, currently – quite unusually, I must say – the consensus is also very pessimistic, which makes me uncomfortable.”
In fact, being pessimistic and being a contrarian come in tandem. Since the crowd normally falls for the optimism bias, pessimism is a corollary of being contrarian. Logically, this means that a pessimistic herd would produce a sense of cognitive dissonance for a contrarian – someone who takes the opposite view of the consensus. How can this be solved?
Psychology will tell you that when confronted with cognitive dissonance, you need to reduce one of the sources of it. So in our case, either you follow the pessimistic herd, or you become an optimistic contrarian.Or, you can always seek another strategy to mitigate the paradoxical information. This is what my interlocutor actually did: “In fact, while the consensus of analysts is pessimistic, the crowd of investors is not, just look at the market since the beginning of the year.” We’ll see how this plays out…

20/12/2012: The French dramAAA

2012-01-20T01:21:00.000-08:00

Markets expected it, Standard & Poor’s signaled it two months ago. Even French government officials showed resignation recently. Nevertheless, the news of the downgrade of France’s credit rating from AAA to AA+ fell just short of a national tragedy.
Just after the decision last weekend, French media suggested that the nation had not been so humiliated since “Les Bleus” were ousted in the first round of the 2010 World Cup.
It occurred only 100 days before the presidential elections. All candidates (with the notable exception of the French President himself), have commented on the downgrade, and are blaming the government and its fiscal policy of the last five years for the loss of the AAA.
Even worse, mere months ago, after the downgrade of the US, Mr. Sarkozy insisted that France would not lose this “national treasure” under his watch. In retrospect, this was a tactical mistake for the prospects of his reelection. The vast majority of the French population didn’t know what a AAA rating meant before it was so prominently put forth by their president. Now, though, the downgrade has hurt the national pride.
Unfortunately for Mr. Sarkozy and his government, this downgrade came while Germany not only stays at AAA, but has an outlook that remains stable. So the downgrade cannot be framed as a European problem, but must be considered French-specific.
None of this bodes well for Mr. Sarkozy, who currently lags in the polls. Unclear, though, is whether his main competitor, the Socialist François Hollande, will really profit from this. Initial reactions in the media indicated that both the centrist François Bayrou as well as Marine Le Pen from the far right could be the main beneficiaries among candidates.
This could seriously jeopardize Mr. Sarkozy’s chances to reach the second round of the election. The latest polls published before the downgrade showed Mrs Le Pen just behind Mr. Sarkozy in terms of vote intentions in the first round.
Therefore, a worst-case scenario, like that of 2002, when the far right candidate Jean-Marie Le Pen, the father of Mrs Le Pen, entered the second round, cannot be excluded anymore. This may prompt Mr. Sarkozy to adopt a far more populist tone in his Presidential campaign. Initiatives like the unilateral introduction of a tax on financial transactions already point this way.
Unfortunately, the French downgrade is not only a French bane. It also affects the European debt crisis. The downgrade of France resulted a couple of days later in the downgrade of the European Financial Stability Facility. This will impact its funding costs, making rescue plans more expensive and more complex.
It also puts a wedge between the German-French leadership of the crisis. So far, despite the spread widening observed between German and French interest rates since the beginning of the European debt crisis, their leaders discussed on the same eye level. The downgrade demoted France clearly to junior partner, or even lower, in the tandem.In the French Le Parisien a couple of weeks ago, Mr. Sarkozy expressed the wish not to become “the leader of the Club Med.” Criticized across the political spectrum and held personally responsible for the downgrade by many French, the undeclared candidate might well change his tactics in the coming weeks, opting for a more confrontational course rather than shadowing Germany. In this respect, the next European summit on 30 January will be very important.

14/01/2012: Nowhere to hide from governments in need

2012-01-14T01:20:00.000-08:00

When governments need money, they shake down the citizenry. The cudgel of legality may justify measures that are borderline ethical and can amount to slow, torturous bleeding of cash or asset value into state coffers. Present poor finances in many nations signal we may be in for repeated summons to pay.
During a presentation in Hamburg two years ago, I insisted that ultimately the enormous creation of money and the monetization of government debt, we’d been seeing in the US, the UK and also – although indirectly – in Europe, would lead to massive inflation. From this I segued to hyperinflation. Asked in the plenum how to protect against such a scenario, I gave the obvious answers: gold, real estate and everything related to “physical” assets.
Afterwards an older gentleman approached me: “I disagree with you on your last statement regarding good investments in circumstances of hyperinflation. My grandparents mastered the German hyperinflation of the early 1920s well, because they had prime real estate here in Hamburg and also in Berlin. However, once the hyperinflation was over, the German government was still in need of money. So it put prohibitive, even confiscatory, taxes on real estate, and my grandparents lost half their wealth.”
This made me ponder the issue more deeply. The difficulties of developed economies currently are not due to ultra-expansive monetary policies, which could lead to inflation. Governments have a much more profound problem (to which inflation is one solution): the lack of funding of their expenditures going forward. In simple terms: Governments need money and will do whatever they can to find it.
No asset is safe when a government needs money. When President Franklin Roosevelt decided to debase the gold value of the US dollar from one twentieth of an ounce to one thirty-fifth of an ounce (a devaluation of 43%) in 1933, he issued Executive Order 6102 and forbade the hoarding of gold in the US. During the Argentinean crisis in 2001, when the government started to devalue the peso, it introduced the so called “corralito,” freezing all domestic bank accounts (both in pesos and US dollars), and then the “corralón,” forcibly exchanging the deposits (including the US dollar ones) in peso-denominated bonds.
Last year Hungary – in financial need – decided that private pension funds would be de facto nationalized and would help to finance the government debt. France is presently considering introducing a so-called Tobin tax on financial transactions, if needed. This tax, labeled an “absurdity” in 1999 by French President Sarkozy, is in my view more than just a gimmick to woo French voters, punish mean financial markets and to annoy the British. With a debt-to-GDP ratio which will hit 90% this year, a deficit that refuses to decline, and very bleak growth perspectives, France is in desperate need of fresh sources of financing.I think that in the next couple of months and years, with growth remaining subdued due to demographic constraints and with unfunded public liabilities becoming more perceptible, the risk that governments will adopt Procrustean measures to cut their funding needs to size will dramatically increase. Hence we could see more financial repression, capital controls, tariffs and trade barriers and ultimately the decline of globalization.

06/01/2012: The sun is setting on the dollar's empire

2012-01-06T01:14:00.000-08:00

The foreign exchange world just got more complicated. Two small pieces of news over the holidays suggest that the preeminence of western currencies – especially the US dollar – is on the wane, even if they continue to grab most of the media limelight.
If these first few days have been anything to go by, the US and Europe will once again dominate the news in 2012. French President Sarkozy and German Chancellor Merkel will soon meet to prepare for the European summit later this month – which at least has not been defined as another “last-chance summit” (not yet, anyway). In the US, the Republican Iowa caucuses officially launched the presidential campaign that will be with us for the next several months. We think investors will still see the US dollar as a safe haven despite the election uncertainty, which should keep it strong against the euro.
So, same old, same old? Not so fast. Two stories indicate that the US dollar is nevertheless losing more ground as the world’s reserve currency. Chinese Premier Wen Jiabao and Japanese Prime Minister Yoshihiko Noda announced over Christmas that they will promote the use of their own currencies in bilateral trade, rather than passing these transactions through the US dollar.
This in itself is nothing new: China already has similar agreements with several trading partners, most notably Brazil. But the volume of bilateral trade between China and Japan – the world’s second and third largest economies – is five times bigger than that between China and Brazil. China is Japan’s main export destination, and Japan is number three for China, behind the European Union and the US.
At the same summit, Japan announced that it would buy around 500 million US dollars initially in Chinese government bonds – but these bonds will be denominated in yuan. The amount itself may be small, but this deal will clearly help to weaken one of the main objections against the yuan becoming a world-leading currency: the Chinese financial market’s lack of depth. In fact, this could mark the beginning of a virtuous circle. The more assets are issued in the Chinese currency, the deeper the financial market will become, and hence the more attractive it will be to issue more assets in yuan.
Certain Federal Reserve statistics released at the end of December also suggest the dollar might be headed for trouble: Holdings of US Treasuries by foreign central banks had fallen by a record amount of 69 billion US dollars over the last four weeks on record. And if the Bank of Japan hadn’t bought Treasuries as a way of weakening the yen against the dollar, the picture would have looked even worse. The sobering fact is that if Japan and China keep working together on their bilateral exchange rate, this sort of dollar-supporting intervention can no longer be taken for granted.
China and Japan hold so much US public debt that this trend could even impact US interest rates at some stage. Taken together, Asia’s two economic powers – the top two foreign holders of US Treasuries – own a whopping 2.1 trillion dollars of US debt. This constitutes roughly 15 percent of the total US debt, and twice as much as the Federal Reserve’s holdings.If economically powerful countries like China and Japan intensify their efforts to eliminate the US dollar as middleman, it could seriously undermine the dominance of the dollar as the world’s reserve currency. If other countries were to follow suit and reduce their dependence on the US currency, we could see the shine come off of it – and its tarnished self-proclaimed challenger, the euro – once and for all.

21/12/2011: Still unfinished business

2011-12-21T01:09:00.000-08:00

Looking at 2011 through the rear-view mirror, we need to acknowledge that it has been quite a formidable year. It started with the “Arab Spring” and ended – there is still another week to go – with the passing of Kim Jong Il, the North Korean leader.
In between, there were many extreme events of both the “Black Swan” type, such as the Fukushima disaster, and the politically self-inflicted type, such as the US debt ceiling debate and the five last chance summits to resolve the euro crisis.
All this made 2011 a challenging year for the markets. Many equity indices, especially in Europe, are significantly down from 2010, and volatility is almost back at levels last seen during the financial crisis of 2008. There doesn’t seem to be any end in sight.
It can be quite revealing to take a glimpse at what we wrote a year ago, so I pulled up the text, I wrote in 2010, “Unfinished business,” and was rather surprised that its first paragraph is still a perfect fit a year later, adjusting the outlook horizon accordingly: “With a week to go until New Year’s Eve, 2010 ends with many unresolved problems that will continue to affect the first part of 2011… The most obvious is the European sovereign debt crisis, or, as we prefer to call it, the crisis of the euro.
So far, European leaders have failed to address the underlying problem of the crisis: To really function as a currency area, the Eurozone simply needs much more economic, fiscal and social integration.
Instead, they have focused on reshuffling and guaranteeing governments’ debts with ever more complex schemes. Despite these band-aids, the debts refuse to disappear… Hence, we expect the crisis of the euro to continue making headlines in the first months of 2011.”
I continued by acknowledging the US debt problems, which are also still unsolved and are likely to remain unsolved in 2012, a presidential election year. I concluded with China’s struggle with its inflation issues. At least this last point has been dealt with in 2011, to the extent that now it is the Chinese growth outlook that worries many market participants.
Despite all the challenges that prevailed in late 2010, I thought 2011 would be a transition year, with at least a decent performance in the equity markets, since stocks had been fairly valued and in some cases even cheap.
I was proven wrong. Indeed, even technical analysts indicated that 2011 should be an outstanding year for equity markets, being the third year of a US presidential term. Since World War II, this period has delivered a 16% performance on average on the S&P 500, compared with 5% in the first year, 4% in the second, and 7% in the fourth. So much for inferring patterns without enough data points.
This is why we enter 2012 in a very cautious and conservative mood. Although equities are now even more attractively valued than in late 2010, we learned from 2011 that a state of unfinished business is not a healthy environment for aggressive investing.

16/12/2011: France’s latent power over the future of a common currency

2011-12-16T01:05:00.000-08:00

The concept of any euro only makes sense if France participates. Thus, even in the unlikely scenario of a euro split and adapted to the economic strength of user countries, France plays a crucial role.
Every new European summit failing its chance to save the euro and finally resolve the European sovereign debt crisis raises the prospects of a possible breakup of the common currency. Don’t get me wrong: This is not our base case. We still assign only negligible probability to such a scenario. Nevertheless, we do consider that the consequences of such an event would be disastrous, so the risk, defined as likelihood times expected loss, is quite significant.
Numerous scenarios are currently discussed in the press about how such a breakup could proceed. They range from one or several countries exiting the euro to a full disentanglement of the common currency into seventeen new national ones. Often discussed is the split of the euro in two parts: a northern euro or “neuro,” and a southern euro or “seuro.” The neuro would take in all the strong countries of the Eurozone, and the seuro all the weak ones.
We see this among the least likely of scenarios. Why? Because the concept of any euro only makes sense with the participation of France. A neuro without France, including only Germany, the Netherlands, Austria and maybe Finland, would not differ at all from the good old Deutschmark. Before 1999, both the Netherlands and Austria were de facto pegged to the Deutschmark. Implicitly Switzerland also had such a peg, and Yugoslavia quite explicitly before it dissolved in the early 1990s. Therefore, the participation of France is crucial to make it something truly different.
A seuro with Spain, Italy, maybe Portugal and Greece, but without France, doesn’t make any sense either. Why would Spain and Italy want to share a common currency? The exports of Italy to Spain represent 6% of all Italian exports; Italy exports twice as much to both Germany and France. In comparison, Spain’s exports to Italy represent 9% of all Spanish exports, while those to Germany are 11% and to France a whopping 19%. Hence, again, only a participation of France in a seuro would grant lasting credibility to this new common currency.France is on the verge of losing its AAA rating. Top French politicians including President Nicolas Sarkozy, alluded to this recently. Once this has occurred, as we’ve discussed here previously, Mr. Sarkozy’s strategy to follow Germany on its gloomy austerity path may seriously jeopardize his chances for reelection next year. He will need to exert pressure on his German partners to ease their rigid stance, either by allowing Eurobonds or a greater involvement of the European Central Bank to mitigate the current contagion. In this respect, France has far more negotiation leverage than it realizes or has recently exercised. Because wherever France shall go, the euro will also follow.

09/12/2011: On European diets and Euro defibrillators

2011-12-09T01:04:00.000-08:00

The difficult task for someone, who writes editorials for a weekly publication edited on Fridays, is that politicians have the unfortunate habit to come up with big decisions on weekends. Hence many outcomes speculated upon at the end of one week might be completely out of question at the beginning of the next one. We are currently once again at such a juncture. I am writing my editorial on this Friday 9 December, while European politicians are meeting for a summit, which might be again labeled summit of last chance.
Since Greece ignited the fuse of the European crisis eighteen months ago we had already numerous summits of last chances and plans to once and for all solve the crisis. Carole Sirou, the head of France research at Standard & Poor’s, mentioned on Monday in the aftermath of the rating agency’s announcement to put under review 15 of the 17 Eurozone countries, the eighteen European summits over the last two years, each of them disappointing investors, as one major reason for this decisions.
Churchill once said about Americans that they will always do the right thing, but only after exhausting all other options. Under pressure from rating agencies, with interest rates increasing, social tension mounting, impatient markets ready to sell all European sovereign debt, including the German one, we hope this time Europeans act like Churchill’s Americans and come with a credible solution. But what would a credible solution be?
I like to compare the Eurozone with a very heavy man, who is in the middle of a heart attack, surrounded by doctors, who are telling him that he should go on a diet and lose some weight. While this is a very sound advice in the longer run, which everyone would agree with, it is not tackling the fact that just in this moment the patient has a heart attack and that a shock from a defibrillator would be an appropriate mean to make sure he’s not dying.
It is clear that a long term solution of the Euro crisis is needed in the form of more fiscal discipline, which implies both more austerity and loss of sovereignty from the Eurozone countries. But such a plan, which President Sarkozy and Chancellor Merkel alluded to last Monday is incomplete without tackling the short term issue of stopping the Eurozone contagion; more concretely of ensuring that interest rates on the sovereign debt of Eurozone members, which haven’t bee rescued so far are not reaching unsustainable levels. Here only one institution could do the trick, the European Central Bank, either directly or indirectly through the International Monetary Fund, the European Financial Stability Facility or a yet to be created new institution.
If we get those two elements in the plan than it could give a relief, which would last longer than the ones the last plans achieved but we would just be at the beginning of solving the whole crisis. If we don’t get those elements or something close to it in one form or another, than we should brace for markets, which might again run havoc.A diet without defibrillator will be not credible to stop the crisis in the short run. A defibrillator without a diet will be not credible to solve the crisis in the long run.

02/12/2011: Europe’s French swan

2011-12-02T01:02:00.000-08:00

The race against time to save the euro has now seriously started. The dismal bund auction last week, the Italian interest rates now stuck above 7% and the Spanish ones close to those levels, despite new elected and non-elected “technocratic” governments, the spread between German and French bonds widening to levels last seen in the early 1990s and Moody’s announcing that even Germany is not safe from downgrade: all this point to the endgame.
Famous British editorialists are becoming almost hysterical. Wolfgang Münchau writes in the Financial Times of Monday 28 November: “The Eurozone has 10 days at most.” Ambrose Evans-Pritchard tops it the same day in the Daily Telegraph: “What we know for certain is that Europe’s current policy settings must lead ineluctably to ruin and perhaps to fascism. Nothing can be worse.” The German newsmagazine Spiegel runs its cover with a broken one euro coin in front of a gloomy dark sky asking: “What now?”
New solutions leaked during last week-end and likely on the table at the next European summit on 9 December, like the introduction of Eurobonds for a “core Eurozone” or the involvement of the International Monetary Fund to channel European Central Bank funding are too complex and too cumbersome in an environment, where market participants are asking for quick fixes involving the ECB.
… and then there is the huge Damocles sword over the Eurozone: the possibility of a rating downgrade of France, losing its AAA. This event would precipitate the euro crisis in a completely new dimension.
Not that this downgrade is unexpected. It is not a black swan. Currently we are forecasting that France will lose its top rating within the next two years. With French interest rates rising quickly, it could happen sooner rather than later. However, if it would happen before May 2012, i.e. before the Presidential elections in France, then France’s reaction is likely to become a 180 turnaround from the policy followed so far. This is for me the French swan.
Nicolas Sarkozy the incumbent President will run again and despite current rather weak poll numbers he has a fair chance to get reelected given that he is an excellent campaigner. His campaign will run on two axes: 1) law and order and 2) economic and fiscal responsibility. France losing the AAA rating would seriously tarnish the fiscal responsibility narrative and would certainly be used by Mr. Sarkozy’s rivals. They are already now pointing to the fact that under his Presidency France’s debt increased by 500 billion euros.
In my view after a first outraged reaction bashing markets and rating agencies in the same vein US President Obama reacted after the US lost its AAA, the French government might well take the stance of becoming the defender of the Mediterranean countries instead of shadowing Germany, as it does now.
A rift between Germany and France is very likely to become the beginning of the end of the euro crisis. Either with France’s weight the supposedly “weak” countries get then at least some relief from the European Central Bank or under French leadership they might consider other options leaving Germany alone with his strong euro, its psycho rigid European Central Bank and a deep recession. The French swan could well be the one singing the demise of the euro.

25/11/2011: Dear China, give me your money! Signed: the euro

2011-11-25T05:12:00.000-08:00

In trying circumstances, European leaders can lose their aplomb, and naively expect counterparties to behave outside of economic etiquette. We can learn a lesson from China.

A couple of weeks ago in Brussels, to save the euro once and for all, leaders agreed to create an off-balance-sheet, special-purpose investment vehicle to the European Financial Stability Facility. This SPIV to the EFSF would be fed with capital from China, Japan, Brazil, Norway and anyone else with a vested interest in the euro's survival. That was the idea.

Hence, after negotiating through the night of 26-27 October, tired European leaders told bleary-eyed journalists that French President Sarkozy, still perky, was on the phone with Chinese Prime Minister Hu Jintao, begging him to back the plan with funds. So far, none of the potential donors has agreed to fund the EFSF, even after detailed explanation by European leaders at the G20 in Cannes. Distrust not only of the EFSF but also the ability of Europe to resolve its own crisis is profound.

Shameful, in my view, is that such a rich continent as Europe now needs external help from emerging markets to save its own currency. This walk to Canossa answers the question of whether the euro could ever rival the US dollar once and for all with a resounding “no!” There are more fundamental flaws imbedded in the plea for foreign aid, however. They come from international bookkeeping.

If China gave 500 billion euros to the EFSF, this would be an import of capital to the Eurozone from China. So what would stand opposite this import of capital in the ledger? Very likely it would be found in the current account balance as a deficit, implying an increase of the Eurozone trade deficit with China.

The US is getting much more money from China than Europe and the Eurozone ever will. In fact, the vast US current account and trade deficits mirror the massive growth of China's dollar reserves through buying of US treasury and agency bonds. The US never explicitly asked for this money, but did not refuse it, either. Current grandstanding by US politicians about Chinese currency manipulation aims to reduce those deficits and ultimately – by extension – at not accepting Chinese money as capital anymore.

By asking China to contribute to the EFSF SPIV, Eurozone leaders are taking a path opposite to that the US pretends to cancel. But I am not sure that European politicians really grasp the full implications of the EFSF SPIV. Begging China for money invites the fox into the henhouse, even if China does not seize the chance to leverage its own agenda.

In international macroeconomic quid pro quo, a benefit (funding) requires eventual payment. Here the Chinese are more thoughtful economists (and bookkeepers) than Europeans. Europe's petition to China will be answered: “Dear Europe, open your markets to our exports wider first, then we might consider investing into your funny currency.” China is right in this.

European politicians might consider this response a form of blackmail, but it is merely normal economic behavior. Especially in international markets and capital flows, no one gets a free lunch.

18/11/2011: Navigating drunken sailor markets

2011-11-18T05:11:00.000-08:00

The gales of politics and economics have markets sailing in circles, pitching and rolling on nervous seas. Anchors and safe havens seem wishful, steering a long-term course is harrowing. The volatility of it all might actually deliver some return. Just don’t try to predict what tomorrow may bring.

I arrived in the office just past seven in the morning on Monday, 14 November. Silvio Berlusconi had resigned as Italian Prime Minister, replaced by Mario Monti, a move seen by many as the one needed to calm markets.

To prepare for an interview about the Italian political change and its implications for the euro, I head to the coffee machine and punch it twice for a double espresso, then switch on the TV for the latest news from Asian markets to start the week. On CNBC, the news anchor asks a clever trader from an Australian investment boutique, “Well John, what is your feeling for today? Will the market be in a risk-on or risk-off mood?” The double espresso is to no avail; this line of inquiry depresses me.

Is this what things boil down to now? Worldwide, thousands of dedicated analysts, economists, strategists and theorists, technicians and rocket scientists, scrutinize every asset class, dissect economic statistics, examine historical patterns, weigh every word and central banker antic, plumb the Byzantium of Greek politics and the Florentine of present-day Italy. For what? Is all we need to know now “risk-on or risk-off?” Even a dart-throwing chimpanzee seems a worthier benchmark.

What to do in such a market? Wait until European politicians finally make up their minds? For sure, if “risk-on, risk-off” sounds like coin flipping, then trying to time the market is no better strategy. Neither is thinking that a magic, unshakable asset exists somewhere. In my view, capital protection, over a longer time horizon, can already be achieved with a well-diversified portfolio. While equities might induce tachycardia on occasion, at least those paying high dividends consistently grant some income for the doctor bills. Many “safe” government bonds don’t even do this anymore.

Bolder investors seeking opportunities in this challenging environment should focus on market volatility. It is currently very high and hence expensive to buy. History has shown that it tends to revert to its mean. Looking ahead six months from now, we think the euro crisis will have been resolved, either through forceful ECB intervention to end speculation against sovereign European debt (best case scenario), or by a break-up of the Eurozone (worst case scenario). In both cases, the uncertainty will be gone and market participants should again return to fundamentals. This means that market volatility and its price will have dropped. So why not sell some volatility today?

A final piece of advice to those who are flummoxed by market mood changes: don’t try to explain those swings – and therefore stop watching CNBC, or whatever other TV channel. They only focus on high-frequency jitters. While we can explain why the sailor drank and why markets are currently in a “risk-on, risk-off” mood, we will never be able to forecast whether the drunken sailor’s next step will be to the left or the right.

11/11/2011: The politics of scapegoating

2011-11-11T05:10:00.000-08:00

The Greek prime minister has resigned, the Italian one will. These are the desired results of the “friendly” pressure from France and Germany and the less amiable sort from financial markets. But now what? Beyond these symbolic outcomes, everything is more or less the same, or even worse.

Greece is still bankrupt and Italy has entered an explosive debt spiral with interest rates shooting above 7%. Even a “technocratic government of experts” in both Athens and Rome wouldn’t change these facts. Next year, Greece will clock negative growth for the fifth year in a row. Its GDP, as I see it, will be somewhere between 20% and 25% lower than it was in 2007. This evolution recalls the US experience during the Great Depression from 1929 to 1934. Even had the Greek debt stayed constant in the last five years, Greece’s debt-to-GDP ratio would still have increased by more than 25 percentage points. This means the drastic austerity measures adopted so far have only succeeded in pushing Greece further into poverty.

We can continue to joke about the number of untaxed swimming pools in Athens and the supposed 400 blind people living on an Aegean island with 800 inhabitants. But at some point, we need to question whether the brutal and collective punishment of the Greek population for the misdeeds of their government – falsifying statistics to gain acceptance into the euro – is justified. After all, it was the foreign creditors who eagerly lent money to a country they had perceived as being as solid as Germany. And by the way, did we ever hear the Germans voicing doubts and concerns about Greece before 2010?

Italy is even more of a sad story. I remember the first time I was confronted with economic statistics. It must have been in the early 1980s, when I was still a youngster. My father and I were watching news on TV announcing that Belgium would be the first developed country since World War II to post a government debt higher than its GDP. The journalist went on to say that Italy was just behind. And what did it mean? Nothing.

Italy has had a high debt-to-GDP ratio for the last thirty years, yet no one seemed to care until a couple of weeks ago. The ratio occults the fact that Italy has been among the most virtuous European nations in the last decade. It entered the Eurozone with a debt-to-GDP ratio above 115% and reduced it to about 104% by 2007 despite having almost no growth at all. For comparison, take the supposedly more serious countries of France and Germany. From 1999 to 2007, their debt-to-GDP ratios went from roughly 60% to almost 70%. The soon-to-be-former Prime Minister Berlusconi might be considered a buffoon by many, but fiscal profligacy was not one of his flaws.

You might object that Italy has a growth problem, and you would be right. Since entering the Eurozone, its competitiveness as measured by unit labor cost has declined relative to Germany’s by more than 30%. But austerity will not solve the lack of growth. It will only exacerbate it.

After Greece, Ireland, Portugal, Spain and now Italy, who will be the next in line? Belgium, or even France? The politics of scapegoating the weak European countries has so far worked for the Grande Nation. It kept a government that has increased its debt by half a trillion euros in the last five years from becoming the center of the market’s attention. This could change rapidly. Moody’s has put France’s AAA credit rating under review. In case of a downgrade, President Sarkozy, who faces elections in May, could be the next casualty of the euro crisis. If such a scenario came true, the weak politicians would obviously blame the markets.

But remember: The euro was conceived as a political project, not an economic one. Thus, if the euro fails, it will be a failure of politics, not economics. Finding scapegoats and blame-gaming wouldn’t help then.

04/11/2011: Wishful sinking

2011-11-04T05:09:00.000-07:00

In a funny commercial run by Berlitz Languages a few years ago, a young German coast guard is left alone in a control room to monitor the radars. Suddenly, a voice comes out of the radio: “Mayday, mayday! Can you hear us? We are sinking, we are sinking!” In a rather thick German accent, the novice officer nervously answers the distress call: “Hello? Zis is ze Cherman Coast Guard. What are you sinking about?”

In my view, there is no better metaphor to illustrate the latest compromise to solve – once again and once for all – the crisis of the euro. Yet again, it is too little, too late, and continues to rely on a fundamental disagreement between Germany alongside other northern Eurozone members, and the European periphery alongside France, despite the fact that President Sarkozy would deny any rift between France and Germany.

Two trilemmas, one concerning Europe as a whole and the other specific to Germany, are leading to the current crisis. A trilemma—unlike the either/or situation of a dilemma—demands a choice of two out of three options since, logically, only two are possible at any given time. The one that pertains to Europe is the Rodrik trilemma of globalization, named after the Harvard economist Dani Rodrik who was among the first to identify it.

In the current context, it states: you cannot have at the same time a supranational entity (the EU) using a common currency (the euro) with sovereign nation-states that practice democracy. Between the Eurozone, the sovereign nation-states and democracy, at least one will have to give.

You can have a Eurozone and nation-states at the expense of democracy. This is what the populations of Greece, Portugal and all other peripheral European nations are currently experiencing: not having any say in the austerity measures imposed upon them. In this respect, the recent decision of Greek Prime Minister Papandreou to submit the Brussels accord to a referendum can only be applauded, despite having caused markets to scream bloody murder. You can have a democratic Eurozone, but this would imply a hefty loss of sovereignty among the nation-states, and this is what the ultimate goal of a fiscal union is. And you can have democratic nation-states without the Eurozone. This would be the euro-breakup scenario.

But the Rodrik trilemma unfortunately does not encompass the full complexity of the crisis. On top of it, you have a Germany-specific trilemma: We want to keep the euro, but we want neither to pay more nor any solution that would increase inflation. Here again one of the three wishes is incompatible with the other two. If you want to keep the euro, then the path to fiscal union will imply much more in terms of transfers from the European core to the periphery.

An alternative to keeping the euro without having to pay for it would be to monetize the toxic debt of the European periphery. This is a strategy practiced on their own sovereign debt by such “serious” central banks as the Federal Reserve and the Bank of England under their quantitative easing programs. But for historical reasons, this is a no-go for Germany.

So if both paying more and building inflation potential are out of the equation, the whole concept of the euro needs to be questioned. Neither of the two trilemmas has been seriously answered and tackled by the seventh definitive plan. Hence I foresee more definitive plans and meetings of last chance down the road, unless a solution imposes itself. Such a solution would not necessarily be the best outcome. Hence, without serious thinking, the euro will be sinking.

21/10/2011: The Grand Plan

2011-10-21T05:08:00.000-07:00

At the European summit on 23 October, the seventh definitive plan, also named the “Grand Plan,” to solve the crisis of the euro is supposed to be unveiled. Perhaps we’ll have to wait until Wednesday or another week for the G20 summit in Cannes on 3 – 4 November.

The last Merkel-Sarkozy summit ended without clear direction, and since then leaks of dubious veracity, hints and second-guessing have put market participants on alert. We will not add to the noise; instead we point to some critical factors that need to be addressed: the size of the Greek default, the avoidance of geographical contagion and the recapitalization of European financial intermediaries.

Consensus view now even among European leaders is that Greece will have to default. What this means in terms of haircuts is still unclear. While the sixth definitive plan (how long ago was that?) aimed at a 21% haircut on a voluntary basis, 50% is heard most often now.

Eurogroup President Jean-Claude Juncker even alluded to a 60% figure. He later apologized for having misspoken, but this latest number actually comes closer to the haircut we believe will be necessary to put Greece back in a sustainable situation: 70% (see our latest UBS research focus for more details).

Since the start of the Greek crisis the question of who is next in line has always been present. Ireland and Portugal are usually seen as the riskiest candidates. However, their finances are secured by rescue plans until end of 2013. The critical countries are Italy and Spain. Both have currently stable debt dynamics, which could, however, become explosive if interest rates exceed 6.5–7%. This is why the European Central Bank has recently bought Italian and Spanish debt on a large scale, de facto applying the same policy as the Federal Reserve or the Bank of England with their respective quantitative easing programs. An alternative to this bond-buying program currently discussed by analysts would be to let the EFSF work as a sovereign debt insurance company, like the monoline firms in the US do for the municipal bond market. The advantage of such a solution would be to increase the “firepower” of the EFSF, but there is a residual risk that such a solution is not credible in the long run.

The dismantling of Dexia made clear to European leaders that the two stress tests carried out on European financial intermediaries were indeed too soft. A recapitalization of the European banking sector is now very likely. IMF head Christine Lagarde has put the price tag of such intervention at EUR 200 billion. We think it could even go beyond EUR 300 billion.

Who will pay for this? In our view, here lies the largest rift between France and Germany. France is striving for a European solution, aware that in the case of a national solution it might lose its AAA rating, already now under scrutiny by Moody’s. Germany aims at a national solution because there is great risk that a renewed increase of the EFSF will not pass the German parliament. The risk of France losing its AAA rating does need serious consideration by Germany, because that loss would almost surely mean that the EFSF would not have a AAA rating either, increasing its cost of capital.

All this leads to the conclusion that while we might finally get a Grand Plan to solve the crisis of the euro, it is not yet the silver bullet which will end it.

19/10/2011: Growth now! If only it were so easy…

2011-10-19T05:06:00.000-07:00

There is a new fad idea espoused by many economists, analysts, pundits and other editorial scribblers today: that debt is not the problem, at least not the most urgent one; the lack of growth is. If growth would return, the thinking goes, all our problems would be solved. Unfortunately, bringing growth back in the current environment is a rather daunting task.

Austerity measures are counterproductive because they weigh on growth. They could even lead to a self-reinforcing deadly spiral such as in the Greek case, where the government is shrinking the economy and thus the tax base, ultimately increasing or at least not reducing the public deficit as it is supposed to be doing. To the faddists, it would be better for governments to boost growth by even more deficit spending and only at a later stage care about the debt.

While at first glance it might bear some logic, this analysis occludes the simple truth that what led us to our current dismal situation in the first place – excessive debt from private households and governments – will certainly not be the solution that would pull us out of our misery. Asking financial intermediaries to lend with abandon conflicts with forcing the same financial intermediaries to repair their still shaky balance sheets. Creating incentives for private households to borrow more through low interest rates can only work if those households are not already overly indebted and trying to reduce their burden.

In the 1930s the great economist John Maynard Keynes advocated large public infrastructure projects to boost demand, but he did so in an environment in which governments were not facing massive debts and the risk of being downgraded by rating agencies.

Keynesianism, according to Keynes – though many self-proclaimed Keynesian economists would oppose this statement – should only be used in times of crisis. This is where we are now, so it seems to make perfect sense to use it. But this is a threadbare policy. Having been used so often, even in good times when Keynes did not mean for them to be used, fiscal stimuli have lost their traction.

So since the demand push cannot come from private households and is currently rather inefficient when coming from the public sector, it leaves only one possible growth booster: demand from abroad. Blaming the Chinese, the Germans, the Swiss and all other countries that were exporting instead of incurring debt over the last ten years for acting stingy now has become one of the most popular acts of political posturing in the deleveraging countries. But leaving aside possible cultural differences, is it any wonder why a country would choose not to follow the same debt-ridden path taken by the US, the UK and many countries in the European periphery?

Starting a trade war now in the hope that the winner would be able to boost growth might worsen the current slump. Even without retaliation from the trading partner, protectionist measures usually increase consumer prices, which further depresses real incomes. Patience coupled with ongoing efforts to slowly but surely bring down debt and repair balance sheets – in other words, to keep calm and carry on in the face of austerity – is the only sound advice an economist can give. Unfortunately, this is not what politicians facing elections want to hear and, even more importantly, want to tell their constituents.

14/10/2011: Europe's Black Swan

2011-10-14T05:05:00.000-07:00

Greece is poised to default within the next six months. This view, which we also hold, has now become market consensus. The question now is more: what will happen after a Greek default? Many analysts are pointing to the fact that this would fatally lead to an exit of Greece from the euro with the possible scenario, if this becomes nasty, that other countries might also leave it. De facto, the euro experience would end.

One needs, however, to ask whether a Greek exit would really be in the best interest of Greece. Greek exports could obviously profit from it, but Greece does not have much to export anyway, save tourism. But who would visit a country which just defaulted and contains risk of social unrest? Turning the other way round and knowing that Greece is importing many goods including energy, who would accept the new drachma as a means of exchange to pay the oil bill? Hence, I personally remain very skeptical, when confronted with a Greek euro exit scenario.

I also do not believe in a scenario in which Germany leaves the euro. A certain number of German politicians are pleading for such a move, arguing that Germany is currently loading unbearable costs upon its shoulders to ensure the future of the common currency. However, this view forgets that an exit of Germany from the Eurozone would also cause massive costs to the country.

A recent, thorough report from UBS Investment Bank states: “If Germany were to leave, we believe the cost to be around EUR 6,000 to EUR 8,000 for every German adult and child in the first year, and a range of EUR 3,500 to EUR 4,500 per person, per year thereafter. That is the equivalent of 20% to 25% of GDP in the first year. In comparison, the cost of bailing out Greece, Ireland and Portugal entirely in the wake of the default of those countries would be a little over EUR 1,000 per person, in a single hit.” (See: Stéphane Déo, Paul Donovan and Larry Hatheway: Euro break-up – the consequences, UBS Investment Research, 6 September 2011).

The German costs of leaving the euro come mainly from exporters facing a massive appreciation of a new Deutschmark and of financial intermediaries facing a massive depreciation of their assets remaining in euros. In my view, the euro will not be unraveled at the top or at the bottom.

But there is a risk that this could happen from somewhere no one is really looking: Slovakia.

Slovakia entered the Eurozone in 2009 as the second-to-last member (before Estonia, which joined the euro in 2011). It is also the second-poorest country in the Eurozone (again before Estonia). Its GDP per capita is only 60% of that of Greece and 40% of that of Ireland. To be accepted into the Eurozone, Slovakia made enormous efforts. Its debt-to-GDP ratio went down from 50% in 2000 to 27% in 2008, while the Greek debt-to-GDP ratio increased from 103% to 111% during the same period. And this country is now asked to contribute EUR 7.7 billion to the European Financial Stability Facility (EFSF); this contribution would represent almost 10% of its GDP.

So it shouldn’t surprise anyone that the Slovak parliament might vote against the EFSF and by that, since it requires the unanimity of all 17 Eurozone members, it might jeopardize the whole project. Europe is likely to put heavy pressure on Slovakia both with carrots and sticks. But Europe is walking on thin ice here, since a euro exit by Slovakia could be the best strategy for the country. Given its current fiscal soundness as well as the fact that the old Slovak koruna appreciated against the euro before the country joined the Eurozone, a new Slovak currency would certainly be credible and internationally accepted.

Moreover, given the rather high unemployment rate as well as rather low inflation, Slovakia could in fact benefit from an autonomous monetary policy. Finally, one should not forget that Slovakia has some expertise in leaving currency unions; less then twenty years ago it exited the common currency with the Czech Republic.

All those arguments could make Slovakia the proverbial Black Swan of the Eurozone, which if a euro exit would be perceived as successful, might give other unhappy Eurozone members ideas. While an exit by Slovakia is not our main scenario, the tail risk of such an event needs at least to be flagged.

07/10/2011: Ricardo equalizes Keynes

2011-10-07T05:03:00.000-07:00

The dismal science has seen a practitioner lauded with a Nobel Prize since 1969, to be awarded this year on 10 October. Dismal as the present economic situation appears, the reigning confusion on what should be done to get us out of it hardly seems like science.

In the US, for example, the monetary base has tripled since fall 2008 on two sprees of quantitative easing (QE), Fed fund rates are at zero, where they will stay until 2013, and Operation Twist as well as angst about the overall economic outlook have lowered 10-year Treasury yields to some 1.7%, a low for the last 60 years. Lending is stalled, the housing market still ails and unemployment hovers over 9% for three years running.

Monetary policy seems useless. This is a typical liquidity trap, in my view. John Maynard Keynes studied this, a situation in which monetary policy becomes ineffective. Households and firms are not spurred by low interest rates to consume or invest, but hoard cash due to a grim economic outlook and/or because they are deleveraging. Hence, in this environment neither Operation Twist nor still more QE would boost the faltering US economy.

So should we do nothing? Keynes and prominent successors, most notably 2008 Nobel Prize winner Paul Krugman, argue loudly instead: no, to the contrary. Fiscal policy provides greatest traction to an economy stuck in a liquidity bog.

Moreover, low interest rates ease government deficit financing and can stimulate the business cycle through infrastructure investments. This is the theory, and is how one would have reacted in the 1930s, when Keynes wrote his General Theory.

Today, though, a major caveat undermines such fiscal policy. The Ricardo equivalence theorem, after the classical English economist David Ricardo and rediscovered in 1973 by “neoclassical” economist Robert Barro, states that rational subjects are indifferent to the financing origins of government expenditures, i.e., to whether these are taxes or deficits. Why? Because deficits can be seen as future taxes, and one can show that discounted future taxes correspond to the current tax one would pay if government expenditure were financed through tax receipts instead of deficits.

The Ricardo equivalence has been downplayed in economics articles as a nice theory removed from reality, criticized among other reasons because it assumes that individuals have perfect foresight about the future of taxes. However, the present context in the US could make it more relevant. In the recent debt ceiling debate the US government agreed to reduce the debt later, though it is still making deficits now. So future tax increases should not surprise anyone.

In anticipation thereof, citizens might start to adapt and reduce their consumption and investment patterns now. But what of those, who despite the US government’s commitment, do not expect future tax increases to reduce debt? They fall under another “neoclassical” theory developed by 2004 Nobel Prize winners Edward Prescott and Finn Kydland about the “time inconsistency” of political decisions. In its simplest form this theory grants that a government commitment to reduce debt at a later stage is worth only as much as the paper on which it is written.

30/09/2011: Leaving the portfolio comfort zone

2011-09-30T05:02:00.000-07:00

In the last 10 years, world growth did not start in the West, nor did equity market performance; these have been more or less flat for a decade. Instead, emerging markets yielded 70% to 100% of world growth, depending on the year. Average portfolios of Western clients, however, have not reflected this fact.

Europe is now in its worst crisis since the inception of the euro. The outcome could yet be very nasty. The US has struggled with poor growth since the 2007–2008 financial crisis; this may go on indefinitely. Japan has never recovered from the burst of its stock and housing bubbles some 25 years ago. There are not many places to hide in the developed economies. They also face high public debt as well as the challenge of over-aging societies.

While emerging markets now generate 50% of world GDP when measured in purchasing power, this amounts to merely 30% when measured with market exchange rates – showing that their currencies are still massively undervalued. Data from Capgemini, however, show that portfolios in developed economies have between 85% and 95% of their assets invested in developed economies, with a significant portion in home markets. US investors invest in the US, Germans in Germany, the Swiss in Switzerland. This “home bias” can be seen as one cause for poor portfolio performance over the last 10 years.

People tend to buy what they know; they consider what is farther away more risky. This attitude has some merits. Currency risk, costlier information gathering, tax and legal concerns can arise. But even accounting for those factors, there remains a systematic underweight of emerging markets in portfolios of developed market investors. Two misconceptions might explain this: hindsight bias and a traditional apprehension toward very volatile assets.

Past performance is no guarantee for future performance, so one cannot argue that emerging markets have performed absolutely, well ahead of developed markets over the last decade, and so project future returns. Nevertheless, the future appears favorable for emerging markets. Many are converging towards the developed economies, so their growth rates will go on outperforming in the long run. Encompassing setbacks and conservative growth assumptions, one still arrives at forecasts that emerging markets will account for 65% of the world economy by 2025 and 75% by 2050.

As for volatility, politics, the rule of law and corruption still mark many emerging markets. But in the US and in Europe of late we have also wanted for political leadership, visibility and accountability. In fact, considering the financial crisis which hit the US in 2007–2008, and the sovereign debt crisis which is currently unfolding in Europe, emerging market investors are far less dazzled and confused than developed economy investors, since those crises appear familiar to them.

Don’t get me wrong, I am not pleading for a large-scale shift of assets from developed to emerging markets, but leaving the usual comfort zone and seeing emerging markets with new lenses is in my view likely to be rewarding from a risk-return perspective.

23/09/2011: Spicy goulash… soon available in Austria?

2011-09-23T05:00:00.000-07:00

The land of the Magyar is far from the European periphery, but potential for high temperament can be both engaging and infectious.

The acronym formerly used for Portugal, Ireland, Greece and Spain has been updated to include market focus on Italy and to improve political correctness, so we reorder the letters and call this new coterie GIIPS; the muddle that markets see there is the same. Greece will eventually default, goes the narrative, and Portugal and Ireland are next, but in fact these latter two countries are under the umbrella of the European Financial Stability Facility (EFSF) at least until end of 2013.

Spain and Italy are more critical; the latter’s sovereign debt was just downgraded by Standard and Poor’s from A+ to single A with a negative outlook. The European Central Bank (ECB) is buying these nations’ government bonds to lower the interest rates. Beyond the GIIPS, market participants consider Belgium, with a government debt-to-GDP ratio above 100%, and France, also with negative debt dynamics, as potentially critical.

Germany, the Netherlands, Finland and Austria are presently the only countries not disturbed by the euro crisis. But actually, the next bout of indigestion could come from a source which has previously simmered very calmly: Hungary.

There, between 2004 and 2008, some HUF 4 trillion worth of mortgages and consumer loans were ladled out in Swiss francs because households wanted to profit from the comparatively much lower CHF interest rates. Today this debt composes 60% of all Hungarian mortgages and 16% of Hungarian GDP. Similar situations exist in Poland and Croatia but are not as extreme.

The problem with these Hungarian mortgages is that back in 2008 the CHFHUF exchange rate was at 160, while today it is at 240. Thus the franc and the value of CHF-denominated mortgages and consumer loans have increased by 50%. Indebted Hungarian households are under stress; someone put way too much paprika in the goulash.

To ease households’ debt burden temporarily, Hungary recently introduced an exchange rate fixing scheme. Interest payments are thereby made at a fixed exchange rate of 180, i.e., 25% lower than the current market rate. To fill the gap between this fixed exchange rate and the spot rate, banks issue bridging loans, to be repaid after 2014. Now Austria enters the fray, and to a lesser extent Germany.

Eurozone banks expanded heavily into Eastern Europe in the last decade. The Bank for International Settlements reports that today some 80% of Hungary’s banking sector is foreign-owned, with Austria accounting for 27% and Germany 21%. A large part of Hungary’s CHF-denominated debt was served by Austrian banks; German banks accounted for a lesser amount. Assuming that a large portion of the currency exposure was not hedged – which one must, since otherwise the interest rates on the Swiss franc loans wouldn’t have been so tasty – foreign and particularly Austrian banks are now at risk of a surge in non-performing loans. To spice the dish even more, the Hungarian government just announced the option for borrowers, if they can come up with the cash, to repay their mortgage at the favorable rate of 180 and let banks assume the loss in the gap.

Austria can well support its banks should the current situation cause discomfort. Nevertheless, if the story gets too hot, market participants may take such contagion as further evidence of the deepening debt crisis, inducing a reassessment of Eurozone safety as a whole.

16/09/2011: Eurozone politicians just can’t win

2011-09-16T08:24:00.000-07:00

The Eurozone’s debt crisis certainly looks quite intractable, but in fact several options could stabilize or even mitigate the situation. The problem? They are all hard sells for elected politicians.

Let’s call them the three Es: Eurobonds, the EFSF and the ECB. Each could play a role in tackling the ongoing Eurozone crisis, but each would also entail costs that electorates are unlikely to accept. As Euro Group President and Luxembourg Prime Minister Jean-Claude Juncker once said of other unpopular economic reforms: “We all know what to do, we just don’t know how to get reelected after we’ve done it.”

Eurobonds – so goes the theory – would replace country-specific bonds with a common bond that pools Eurozone governments’ sovereign debt. The conditions governing issuance would presumably ensure that no single country puts itself into excessive debt. This solution seems to have a lot going for it at first glance, as the Eurozone ratio of sovereign debt to gross domestic product is better than that of the UK, the US or Japan. But this doesn’t guarantee that rating agencies will play ball: Standard & Poor’s has already warned that it won’t rate Eurobonds any higher than their lowest-rated participants.

During the subprime crisis, we learned the hard way that you can’t mix AAA- and CCC-rated debt and expect to get untainted AAA debt as a result. I don’t think you can call it CCC, either – but nevertheless, presenting Germany, France and the Netherlands with the prospect of losing their AAA ratings makes this solution rather difficult from a purely political perspective.

The European Financial Stability Facility (EFSF) could also mitigate the current crisis. But many analysts and market participants think it would need far greater means at its disposal, especially if Italy keeps looking vulnerable. We often hear two trillion euro as a target figure. This would certainly exceed Germany’s financing capability, and with so much depending on German taxpayers, politicians there won’t be able to win elections even with a lower number.

Finally, the European Central Bank (ECB) could play a part in taming the crisis by buying more government bonds from troubled countries. It used this tactic at the beginning of the crisis, and revived it again in the last few weeks as Spain and Italy came under increasing attack. Nevertheless, detractors claim that a policy like this raises the long-term risk of inflation. In fact, ECB chief economist Jürgen Stark recently resigned over this very issue, showing that the bond-buying option won’t win many friends in inflation-phobic Germany.

Creating the euro was a political project, not an economic one, and rescuing it will therefore require a political decision. Economics can only help to identify the costs associated with the possible solutions, and these costs will of course make it difficult for decision makers to get reelected. Forced to choose among various costly and unpopular options, European politicians just can’t win.

09/09/2011: SNB decides enough is enough

2011-09-09T08:21:00.000-07:00

Perhaps, it was one of the boldest moves by any central bank or economic decision-maker since the beginning of the financial crisis in 2007/08. Certainly, it was one the most unexpected, and it must have caught many investors on the wrong foot.

At 10 a.m. local time on 6 September, the Swiss National Bank pounded a fist on the table and said, “Enough!” The communiqué was unambiguous and left no room for interpretation or second-guessing: “With immediate effect, (the SNB) will no longer tolerate a EURCHF exchange rate below the minimum rate of CHF 1.20. The SNB will enforce this minimum rate with the utmost determination and is prepared to buy foreign currency in unlimited quantities.”

The markets received the message loud and clear. Within seconds, the Swiss franc lost 10 big centimes against the euro and seven against the US dollar. To all those who had argued that the central bank of a tiny country like Switzerland cannot withstand the power of the markets, the SNB’s bold move was a strong counterattack. Indeed, a central bank can always fight the appreciation of its own currency. It has the means: “unlimited” quantities of money created through the printing press. All it needs is the will to do it and the ability to bear the long-term consequences.

The first critique that came after the move was an obvious one: What would happen with inflation? At the moment, this debate is futile. With the largest Swiss retailers Migros and Coop slashing their prices, and with export firms extending workers’ hours to the limit without increasing their salaries – thus effectively decreasing hourly wages – Switzerland is on a deflationary path. No doubt about it, inflation pressures will come in the long run; but even at a rate of 1.20 against the euro, the Swiss franc is currently having a deflationary effect. It means the long run can be rather long.

Markets will test the will of the SNB over the next couple of weeks. However, in my view, given the very strong language of the communiqué – and unless the SNB wants to completely lose its credibility – it will defend the 1.20 limit tooth and nail.

What does this mean for investors? As long as the SNB is defending the 1.20 limit, the Swiss franc in principle no longer bears any appreciation risk against the euro. This fact could be the basis for building up carry trades by using the franc as a funding currency to invest in bonds in euros, with higher yields than the ones in Switzerland.

Should this strategy catch on and become fashionable, the SNB will have won the battle, because carry trades usually undermine the value of a currency. As a funding currency, the Swiss franc could quickly retreat against the euro to 1.25, 1.30 and even beyond without the need for further SNB intervention.
Of course, it is still too early to say that the SNB has won the war against the brutal appreciation of the Swiss franc. But it has at least won a battle by spreading doubt among the markets that the franc is as good as gold and a safe haven. In my view, with a strong will and thanks to the oddity of carry trades, it might be able to extend its advantage sooner rather than later without putting too much money on the table.

05/09/2011: Will Mad Men take over the Fed?

2011-09-05T08:14:00.000-07:00

Ever since the HBO series Mad Men conquered the TV screens, the 1960s are back in fashion. Mixing fancy cocktails, wearing hats, listening to the Beatles and the Beach Boys and even chain-smoking are back in vogue. Can the Federal Reserve resist this fad? According to more and more investors and analysts, the answer is no. Meet Operation Twist.

What sounds at first like the name of a martini or a James Bond movie is a monetary policy option explored in February 1961.

After two rounds of quantitative easing, which while stabilizing the US economy didn’t really help to re-boost it, something else must be attempted. Quantitative easing was about increasing the monetary base, providing liquidity to the market and (in QE2) lowering yields on the long end of the interest curve by purchasing government bonds on the secondary market.

In a Washington Post op-ed on 4 November 2010, Federal Reserve Chairman Bernanke explained QE2 as follows: “Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.”

Two months after the end of QE2, the bottom line is rather sobering to say the least. US unemployment has stalled above 9% with the US economy not creating any jobs in August, the housing market continues to be deeply depressed, credit activity is slim and the gains on the stock market after the introduction of QE2 have already been halved. The main problem with plain vanilla quantitative easing remains the fact that the cheap central bank money is not transmitted to the economy through the credit channel.

Money multipliers, which would show this transmission, remain stuck at their low post-financial crisis levels. Financial intermediaries seem to prefer using the cheap money they can get at the Fed to invest in government bonds instead of lending it to the private sector.

Operation Twist would remedy this. At least this is what many analysts seem to think and why it has become the most hotly debated “new” option of the Fed. In a nutshell, the central bank would issue short-dated bills and use the proceeds to buy long-dated government bonds. By doing so, it would lift the short end of the yield curve and lower the long end, thus entering in direct competition with the financial intermediaries on the government bond markets while at the same time pushing their refinancing costs higher.

Flattening the yield curve is commonly considered to be a more restrictive policy. Spreads, the difference between long and short interest rates, are therefore usually a rather good business cycle indicator because the lower they are the lower growth will be. Why then this counterintuitive measure in an environment of low growth? The reasoning behind such a policy is that with lower government bond yields and higher refinancing costs financial intermediaries will have an incentive to increase their lending activity again instead of investing in government bonds, thus boosting the housing market and firms’ investments.

In theory, such a policy makes sense, but we believe there are several caveats. First and foremost, a policy aimed at getting financial intermediaries to lend more is in blatant opposition to the aim to make those financial intermediaries financially more solid in the aftermath of the financial crisis. It is not a done deal that the balance sheets of many banks have been repaired and cleaned enough to allow them to increase their risks yet again. But even if this would be the case and this is the second caveat, it is not a done deal either, that households and firms will be willing to take more credit again.

Japanese economist Richard Koo, who wrote the seminal “Holy Grail of Macroeconomics” explaining the financial and banking crisis of the early 1990s and the subsequent deflationary stagnation of Japan, is making this argument: “The economics profession has never considered a recession that could be caused by the private sector minimizing debt in order to repair balance sheets after a debt-financed bubble in asset prices. As a result, the profession has no clue as to what is the right thing to do. In this rare type of recession, monetary policy is useless because people with negative equity will not borrow, no matter what the interest rate. Nor will there be many lenders when banks have such huge problems with their balance sheets.”

While we don’t know now whether an Operation Twist will be implemented as the next move of the Fed, we can already assess now that its success is less than certain. Nevertheless, an Operation Twist would at least in the short run challenge our call for short duration since it aims to lift short-term interest rates and reduce long-term interest rates. Hence, it will be an important event to follow closely.

02/09/2011: Recession… again! Do we know and can we respond?

2011-09-02T08:19:00.000-07:00

The likelihood of a US recession was one of two main fears, the other being the European sovereign debt crisis, which drove equities much lower during August. The dive abated somewhat last week on the news that at least Federal Reserve Bank Chairman Ben Bernanke doesn’t see recession as a prime scenario so far. Nevertheless, the question whether the US and other regions are heading back to a recession will haunt us for the next couple of months.

The common definition for a recession is two quarters in a row of negative gross domestic product (GDP) growth. While this definition is also used in the US, identifying “official” recessions is actually the responsibility of the National Bureau of Economic Research (NBER). To do so, it uses a battery of statistics reflecting not only real GDP but also employment and real income. Since identification is a cumbersome procedure, it usually takes between 12 and 18 months for the NBER to declare the beginning or the end of a recession.

Assuming that the US entered a recession in July or August 2011 would mean that the NBER would declare that condition by fall 2012 at the earliest. Hence, the NBER approach is not very useful for investors, who want to know whether we are in a recession now or are heading into one within the next couple of months. Fortunately there are several techniques to estimate at least the likelihood that we are in a recession. These compile a bunch of current business cycle statistics and deliver a probability that we are in a recession. Such models are now giving probabilities between 0% and 40%, depending on the statistics included or excluded. On average the result is roughly 30%, not enough to make it our central scenario but still enough to be considered rather plausible.

With recession risks rising to uncomfortable levels, elevated corporate earnings expectations could bring equity markets down further. During recessionary periods, earnings expectations are massively reduced, creating negative pressure for share prices. Given present historically high corporate margins, this downside is considerable in a potential recessionary outcome. The good news is that current valuation levels are long-term attractive, meaning the downside is not as severe as usual – but we think investors should rather search for safety while uncertainty remains so high.

Specifically, we recommend investors who see the recession case as central to reduce their cyclical equity exposure further and move it to cash, corporate bonds or defensive and high dividend yielding equities, depending on their risk profile. We would not regard government bonds as the best safe haven alternative at the current stage of low yields and rising government debt levels. Exposure to broad-based commodity indices should also be reduced.

We don’t know for sure, whether we are in or will head into a recession, but we know that the risks are not negligible. Hence it is paramount to at least stress-test your portfolio for such a scenario. Markets will remain volatile until the answer becomes clearer.

26/08/2011: The money supply mystery

2011-08-26T08:12:00.000-07:00

A common metaphor compares the economy with a plane. Central bankers and government officials pilot the cockpit and economic statistics blink as warning lights. At present, the US Boeing’s cockpit has many lights flashing red to indicate an imminent nosedive, while in the European Airbus the compass is broken, so the plane circles aimlessly.

Over the pilot's shoulder in the US aircraft, we see that a new warning light has begun to flash over the last two weeks, but its color is hard to distinguish. Is it green or red? The monetary aggregate M2, published on a weekly base by the Federal Reserve, is spiking.

In the US, M2 is broadly defined as the physical currency held by the public, including all checking and savings accounts, time deposits and money market mutual funds held by individual investors. It is the broadest of all official monetary statistics since March 2006, when survey of the even broader monetary aggregate M3 (M2 + institutional money market mutual funds, eurodollar deposits and repurchase agreements) was discontinued.

The M2 surge started in the last week of June and has gained momentum. The money supply went from USD 9 trillion to 9.5 trillion in less than two months (roughly a 5.5% increase, annualized over 40%). The last such surge in M2 occurred in 2008 just after the Lehman bankruptcy. But only by going back to 1983 does one find a proportional surge as large as we currently see. So is this information positive or negative?

We could argue on the positive side that the so-called “money multiplier,” which expresses the transmission of highly powered central bank money into the broader public is finally moving in the right direction. An important criticism by those who saw the growth of the monetary base since 2008 (more than a tripling) as ineffective has been its absence from broader money aggregates. The money printed by the Fed in the quantitative easing programs to purchase US Treasuries ended up in the vaults of financial intermediaries and did not reach firms or consumers. Recent weeks saw only a minimal uptick of the money multiplier from its depressed level, so it is too early to assess whether that is actually the cause of the surge in M2 and therefore a positive evolution.

On the negative side, one could argue that we are seeing something similar, but on a larger scale, to what we experienced in 2008. When the commercial paper market in the US froze after the Lehman bankruptcy, some money market funds “broke the buck;” their share value dropped below one US dollar. This led to a run on them, and the outflow of funds was put in supposedly safe checking and saving accounts, which are part of M2, while the funds are not. Similarly now, due to the European sovereign debt crisis and tensions on the European interbank market, there has been a run on European banks, with money being transferred to US banks.

These two negative developments are however not backed by other statistics. The extended M2 which includes the institutional money market funds shows a similar surge, though not as important, as that in the more restricted M2. As for the story about a run on the European banks, if it were true, then a massive shift of funds from European to American banks should have been reflected in the EURUSD exchange rate. However, the last couple of weeks have not shown this; instead EURUSD moved more or less sideways between 1.40 and 1.45.

So what could be driving this surge? A theoretical explanation which will need empirical grunt work to be confirmed, is that during recent market turmoil investors have capitulated, sold equity positions and placed the money in checking and saving accounts. If this were the case, then short-term this is negative, because it points towards more capitulation in the near future and more depressed equity markets. However, if this explanation is true and circumstances are really similar to what happened in 1983, at that time a local bottom of the equity market expressed in real terms, then this situation could be one of the most positive signals for equities over the longer run. Why? Because the 1983 capitulation marked the starting point for almost two decades of bullish equity markets.

With all the doom and gloom out there, and most of the warning lights flashing red, a true contrarian signal should at least be explored further.