What’s best for Germany?

German politicians, especially Ms. Merkel have come in for a lot of flak over the past two or three years, not least from me. However, as politicians, they are faced with the extremely difficult task of reconciling domestic and European political considerations, a task that would tax even Solomon.

Domestically, fiscal conservatism and the unwillingness to be the milch cow for the eurozone have been powerful forces. The economic narrative has been one of a prudent Germany and a profligate periphery. As usual, this is only half the story. The fact that Germany through deficient domestic demand and the concomitant capital flows to the periphery were an important factor in the credit booms (and busts) is barely acknowledged.

German politicians, to their credit, have sought to be “good” Europeans. Within the constraints of domestic political considerations, they have done their best to shore up the eurozone, often going way beyond the cautious rhetoric aimed at reassuring domestic voters. Bail out funds have been agreed and the LTRO are both examples where the actions of the eurozone (with the tacit agreement of Germany) have gone much further than expected.

Even so, eurozone policy has tended to be quite slow with Germany acting as a brake on more extensive and unorthodox policies. If M. Hollande is elected, then the balance of the eurozone may start to tip in a different direction with less emphasis on fiscal discipline and structural reform.

What will Germany do if its narrative of the crisis is challenged? If the best interests of Germany are no longer served by the euro and the broader European Union, what will Germany do?

The next elections to the Bundestag are in autumn 2013, so I think we will see an increasingly domestic bent to the political rhetoric in the latter part of this year and into next. Unfortunately, I suspect, we will see little quality debate on what really benefits Germany and Europe. Rather we will see the politics of recrimination and populism.

There’s no doubt that Germany has benefited enormously from the euro. The boom in the periphery up until 2007 enabled Germany to restructure its economy providing strong external demand to offset weak domestic demand. Higher inflation allowed Germany to reduce relative costs without deflation.

In the aftermath of the crisis, the deflationary policies of the periphery have helped to hold down German inflation despite a strong labour market. The travails of the euro have also ensured that the euro exchange rate is competitive for Germany (although not for many of its euro partners).

While the exchange rate of the euro is still a major positive, it seems to me that many other factors are becoming less attractive for Germany’s continued participation in the eurozone. The most obvious is the continuing demands of other members that Germany back stops the system and indulges in a covert financial transfer.

Germany is also accruing a potential problem in Target2 balances. No-one seems quite sure how this might work out. Thirdly, like China, Germany might face increasing inflationary pressures in one form or another. Rather than CPI price rises, this might be in the form of wages rises. Indeed, industrial relations might deteriorate as unions demand a reward for previous wage restraint.

Unions and workers may also face pressure from immigrant workers competing for jobs. While this might offset inflationary wage pressures, it could cause social unrest. Apparently there’s a huge demand in Spain for German (and English) language lessons.

On the political front, there is increasing resentment of German imposed austerity measures. With unemployment rising, this is likely to get worse. In the same way that the German narrative of the crisis is focused on the lazy and profligate Club Med, the members of Club Med are increasingly using Germany as a scape goat for their problems, some of which are self inflicted.

As the German elections approach, I expect to see the rhetoric to get increasingly rancourous. It will be interesting to see if there is any real debate over leaving the euro. The powerful German business lobby is likely to favour the status quo. However, the general public may become more euro sceptic, perceived that Germany is damned if they stay in and damned if they leave.

It is possible that the Bundesbank will view an exit as increasingly desirable. It is clear that the establishment is unhappy with the ECB’s latest actions. The BB is hamstrung in its inflation aversion and desire to protect the German financial system by its inability to operate monetary policy. Regaining its old powers must seem increasingly attractive.

A return to the DM would give a one off, potentially significant, increase in German living standards and tame the perceived inflation threat. It would be negative for corporate German profit margins, but companies have coped with this in the past and the high value added nature of German production should cushion the impact somewhat.

An interesting question that I can’t answer is whether the German political establishment feel they have sufficiently atoned for the Second World War and are willing to strike out for German interests at the risk of breaking with the post-war order.

My feeling is that if Germany is subjected to more and more vociferous hectoring, they will be inclined to break the Franco-German axis which dominated Europe for sixty-odd years. There would be a huge opportunity for the UK to forge a new relationship with Germany and re-cast the EU into more of a free trade zone than a political union.

Viewed from the outside, it seems that Germany’s best interests would be best served by an exit from the eurozone. The next eighteen months may provide the political impetus to facilitate this.

I am off to walk across Scotland next week and won’t be back until near the end of May. It’s tough being retired!

A final song for Europe?

Holland and Holland together with their friend Lamont Dozier wrote a string of hits for Motown artists in the 1960s, including ten number ones for The Supremes. One of their last songs for Motown was for Martha and the Vandellas, titled “One Way Out”.

Now we have an altogether less melodic pairing of Hollande and Holland that could be penning a final song for the eurozone and possibly the EU project itself. The collapse of the Dutch government is a particularly bitter blow for the austerity autocrats.

Hitherto, the Netherlands has been at the forefront of the drive for austerity and discipline. Strange how it’s so much easier to call for austerity when it cost you little or nothing. When it causes real sacrifice at home, it becomes a different matter for politicians.

Arguably, the Dutch are even bigger culprits than Germany in the game of imbalances in the eurozone. Its trade surplus is even larger as a percentage of GDP than Germany’s. If a country with as strong a mercantilist bent as the Netherlands can’t hack fiscal consolidation, what incentive is there for the Club Med countries?

The Germans must be seriously thinking whether this whole euro project is worthwhile. Despite the soothing noises from the ECB, the Bundesbank looks horribly exposed to credit risk through the Target2 system. Delay has only caused an ever increasing exposure.

Meanwhile, back on planet France, it seems we have regressed to the 1960s. M. Hollande’s policies seem to be stuck in a pre-globalisation and pre-single market time warp. Lowering the retirement age, employing 60,000 new teachers and soaking the rich with a 75% tax rate ignore the realities of France’s financial situation, you have to wonder whether Hollande has been imbibing some 1960s psychotropic drugs. Perhaps underneath his crisp white shirt he has a tie dye t-shirt.

If M. Hollande wins, then all hell could break loose in the eurozone. All pretence of an austerity solution will disappear in the eyes of the market and it will be every man for himself. It is not fanciful to suggest that it will shake the European Union to the core.

The reassertion of national sovereignty is likely to lead to the rolling back of a number of important integrationist policies. Namely, the free movement of goods and capital. Capital controls may well be imposed in the financial turmoil of a eurozone disintegration. The single market would also be called into question.

Left wing political ideology tends to be inward looking and defensive. Trade protectionism is a common policy of both far left and far right political persuasions. When things get tough, the natural inclination is to hunker down and look after your own narrow interests.

Absolutely central to the eurozone’s survival is the willingness of Germany to act as a provider of capital to the stressed periphery through the Target2 system, including to France. If France goes socialist, will the Germans say enough is enough? Perhaps Germany will be singing “One Way Out” and rush for the exit.

It’s the imbalances, stupid

To understand the world, policy responses and consequences, you really need to look at the macroeconomic imbalances. I’ve banged on enough about the eurozone and the reluctance of policy makers to accept that imbalances in the eurozone require a set of policy responses from Germany that seem politically unfeasible (i.e. domestic demand expansion, higher inflation, accumulation of debt and a trade deficit). No matter how much wriggling and squirming there is, it is impossible to get away from these verities.

However, it’s not just the eurozone that faces difficult and painful choices. China is another region of extreme economic imbalances that require policy makers to make hard choices. Michael Pettis outlines the choices that need to be made and the reasons and consequences in this thoughtful blog post. In some ways, I have more confidence that China will make sensible choices.

At least leadership understands the issues. The political system has the capability to take tough decisions and to see them through, unlike the eurozone. Whether those options will be taken is open to doubt given the influence of various interest groups within the Chinese political system.

All for one and none for all

Reciprocity is vital for harmonious relations between countries, yet it rarely happens. One glaring recent example of a lack of reciprocity is India’s retrospective imposition of capital gains tax on foreign companies overturning 50 years of practise and several supreme court judgements. Contrast this xenophobia and capriciousness with the UK’s willingness to allow Indian companies to buy significant parts of the UK’s industrial sector without penalties.

This sort of behaviour happens all the time in the area of trade and is part of the rough and tumble of global commerce. More serious, is a lack of reciprocity in legally binding supranational entities. The inability to achieve remedies through unilateral actions becomes a cancer to harmonious relationships.

When the history of the eurozone comes to be written in a few years time, one of the key roots of its failure will be the lack of reciprocity between Germany and the periphery. I cannot see how this won’t lead to a huge political rupture at some juncture.

At the beginning of the eurozone, Germany entered with an overvalued exchange rate. As we all know, Germany undertook a significant restructuring of its industrial base, improving labour competitiveness in the first 6–7 years of the euro’s life. This restructuring was not achieved in isolation. It was helped considerably by two interlinked factors.

Firstly, for many countries, especially the periphery, interest rates fell to levels not seen for at least a generation. Not surprisingly, this set off an economic boom which produced high levels of capital expenditure, property investment and surging trade deficits. The weakness of German domestic demand was offset for German corporates by the strength of demand in most of the rest of the eurozone.

The second interlinked factor was that inflation in the periphery was significantly higher than in Germany, enabling Germany to regain labour price competitiveness simply by allowing competitor wages rages to rise more quickly than its own. Unfortunately for the periphery, productivity did not rise rapidly enough to compensated for wage inflation, so competitiveness, both in a European and a global context was eroded. If countries had retained their own currencies, then exchange rates would have moved to accommodate these changes in relative prices, as they have for the UK, which shared many of the same features as the eurozone periphery.

Not only was the lack of currency flexibility an issue, but the “one size fits all” interest rate policy of the ECB turned out to be a “one size fits none” policy. Rates were too low for the booming periphery. While they might have been somewhat high for Germany, differential inflation and strong export demand eased the burden.

So we can characterise the history of the first 7–8 years of the eurozone as one where the imbalance of starting exchange rates were worked out by excessive demand growth and high inflation in the periphery helping Germany in its adjustment of lowering its relative wage costs. This process had largely run its course by 2007/8. Indeed, the global financial crisis revealed that Germany had become very competitive in both a European and global context.

Marching forward to 2010/12, we now see that the role of Germany should be reversed. For the periphery to regain competitiveness, it needs Germany to have strong domestic demand, a property boom, higher inflation and to run a trade deficit with the rest of the eurozone. This would reciprocate the boom conditions that prevailed in the periphery that allowed Germany to restructure relatively painlessly. Instead we see a growing reluctance to accept the flip side of the benefits that Germany has enjoyed in the euro system.

It seems that Germany was very happy to allow the “profligacy” of the periphery to benefit the German economy as it was going through its transition, but now that the boot is on the other foot, it will not allow stronger domestic demand, higher inflation or higher imports to help the periphery trade its way out of its problems. “All for one but none for all” when it comes to  Germany’s turn to reciprocate.

In fact, it gets even worse. Instead of leaving things as they are, German policy is now gearing up to prevent any boom in Germany from developing. We already have the debt brake in the constitution, but now other measures are being enacted specifically to dampen any rise in property prices and growth in consumer credit. With a friend like this, who needs enemies?

In one sense, I don’t blame the Germans for looking at the shambles that the credit boom produced in Spain an Ireland and wanting to prevent a recurrence in Germany. However, Germany accepted the benefits, now it should take some responsibility. Unfortunately, the domestic narrative in Germany appears to be one of German virtuosity and periphery profligacy. The unwillingness to acknowledge the role played by the boom in the periphery in helping Germany in the early difficult years of the eurozone is a significant block to a rational policy mix to enable the eurozone to survive.

Not only are German politicians in denial over economic history, they are also in denial over basic economic reality. Unsurprisingly, Germans want the debts run up by the periphery to be repaid. What they don’t seem to grasp is that the only way that this can be achieved is through Germany running a trade deficit with those countries. It’s not an economic theory, it’s a simple accounting fact.

In the end, the Achilles heel of the eurozone and the broader European project is the denial that sovereign states, when push comes to shove, will act in their own interests. Altruism is in short supply in international relations.

The eurozone is not dead yet, but the fundamental inconsistencies and paradoxes have yet to be solved. Germany’s actions suggest they are insoluble. For the eurozone to work, Germany needs to act in an altruistic manner which appears impossible given the domestic political background. LTRO has bought time for the politicians to come up with a solution, but it has also produced a deadline and a mechanism for the breakup of the euro.

The deadline will come in two years time when markets start to factor in a refinancing of the LTRO largesse. The mechanism for breakup is that the LTRO is producing the re-domestication of sovereign debt. Spanish and Italian banks are loading up on domestic sovereign debt, playing the carry trade. As current debt matures and is refinanced through the domestic banking system, there will be a natural unscrambling of assets within the eurozone. The asset side of bank balance sheets will become increasingly domestic. If this process continues, then the eventual splitting of the eurozone will be much easier.

Like Mark Twain’s death, the demise of the eurozone has been prematurely reported on a number of occasions. Because commentators have cried “wolf” on many occasions doesn’t mean that one day the wolf will not appear.

Animal spirits

Source: Zero Hedge

There are definitely signs that animal spirits are returning. Earlier in the week, the VIX made a five-year low. When you think about the levels of fear in markets back in October, it’s a remarkable recovery. A lot of people, myself included, underestimated the impact of  the ECB’s LTRO. By backstopping the funding requirements of the Eurozone’s banks for a couple of years, the ECB has removed the immediate threat of more Dexia type liquidity/solvency crises for a while. It’s open to question as to how long this palliative will last, especially as Germany is getting more vociferous in its opposition to further tranches of central banks funding.

Source: Zero Hedge

This has all been a pleasant surprise to investors, but an excessively low VIX is also a warning. The chart above illustrates that it can be a precursor to a sharp rise in volatility and a fall in the equity market. Equally, however, there can be extended periods of quiescent volatility. It seems to me that economic indicators may supply support to markets for a while longer. In the US recovery does seem to be gaining some traction and the resumption of borrowing by the economy overall is a sign of returning confidence. I think it’s also likely that eurozone indicators could surprise on the upside, now that the immediate crisis has been dampened down.

Source: Global Economic Trend Analysis

Bond yields in the US have started to rise. If banks really are cashing out on their profits from Operation Twist, then the money will flow back into the real economy, unless the Fed decide to start unwinding its balance sheet. I would be really surprised if the Fed started selling assets back into the market to extinguish bank reserves, so it seems likely that any rise in bond yields, as long as it is modest, will bring a stimulus to economic activity and should be welcomed.

The gazillion dollar question for the Fed is whether the money multiplier comes back into play. If banks start to multiply aggressively reserves held at the Fed, it will be presented with a huge policy dilemma. However, I think it unlikely that this will happen. The recent stress tests show that a number of banks are somewhat borderline, despite only four failing. The announcement that JPM is raising its dividend and buying back stock, suggests that banks are not about to apply aggressively capital or reserves to lending.

One little aside is that Mr Dimon must have mightily upset the Fed with his arrogant pre-empting of the results of the stress test. To me it seems like a pretty foolish move to antagonise your regulator needlessly. Dimon has put JPM in a potentially perilous position if it ever needs favours from the Fed. One reason why Bear Stearns was allowed to go under was long memories from its intransigence on the LTCM rescue. Remember hubris, Mr Dimon.

US deleveraging over?

This chart from Zero Hedge caught me completely by surprise. According to the Federal Reserve Flow of Funds report, the US economy is beginning to borrow again across all sectors. Wow, that’s big news and if it follows through, changes the game. The US can become an engine of world growth again and it should help ease the eurozone crisis.

However, I’m suspicious that this trend can last for any length of time. Firstly, it suggests that the US current account will start deteriorating again. This makes any growth phase self-limiting, although deregulation of the capital account in China could change that somewhat gloomy prognostication.

The second issue is that the US has to grasp the fiscal consolidation nettle. Obviously, if the private sector is borrowing again, fiscal consolidation is easier without destroying growth. However, aggressive consolidation might tip the private sector back into a more balance sheet strengthening mode, so there’s a delicate balancing act to achieve.

The third observation is that if the private sector is borrowing again, then monetary policy will need to change. The Fed will not need to indulge in QE3, indeed it will have to wind down its balance sheet. Also, if the money multiplier kicks in, the Fed will have to be aggressive in withdrawing monetary support if it wishes to avoid an inflationary pulse. This might become a huge dilemma for the Fed as it may have to reverse its recent pledge of keeping interest rates low to late 2014.

Potentially this is very concerning for bond investors as interest rates may have to rise, potentially wrong footing investors who are playing the yield curve. If the inflationary psyche changes from one of benign inflation or deflation to one of rising inflation, there will be carnage in bond markets, given the current low level of yields.

Rising bond yields would be negative for equities, but even more so would be a rising liquidity requirement from the non-financial economy implied by rising borrowing. All asset markets, but especially risk asset markets, have benefited from abundant central bank liquidity creation which has been soaked up by asset markets, driving prices higher. The lack of demand from the non-financial economy has meant that one way or another this liquidity has found its way to asset markets.

If the non-financial sector begins to borrow again, then asset markets could find themselves squeezed by the liquidity demand from the non-financial sector on the one hand and the removal of central bank (i.e. the Federal Reserve) accommodation on the other. Given that bonds are richly valued and that equities are at or near the top of the profit margin cycle, any market sell off could be very painful indeed.

I’m not sure that even gold could sit out the next downturn. As a zero income asset, if funding becomes tighter, then, presumably marginal holders will get shaken out. Who knows what leveraged structures there are in the gold market with derivatives and ETFs. The one thing you can be sure of is that long bull markets produce complacency and over leverage.

In the short-term,especially the run up to the US presidential elections, markets may be benign as growth pleasantly surprises on the upside in the US. Perhaps there will also be a calmer period in the eurozone as banks and governments get drunk on the LTRO. My feeling is that as we get to autumn time, the prospect of fiscal retrenchment in the US, together with inflationary and monetary strains, and a possible further round of problems in the eurozone, investors will get a cold shower.

All this assumes that there is no blow up in Iran or a re-run of the Greek farce in Portugal. Hey-ho, every silver lining seems to have a cloud.

National income and savings explained

I can’t imagine that any eurocrats or  German politicians read this blog, but just in case, I want to explain some really simple economics regarding national income, savings, investment and the trade balance.

In a closed economy, national income (GDP) is defined as:

Y=C+I+G

where Y=GDP, C=consumption, I=investment and G=government spending.

If we rearrange this formula to give us investment:

I=Y-C-G

In a closed economy, any money left over from consumption is deemed savings (S), hence,

S=Y-C-G

From these two equations, we can see that investment and savings must equal each other, i.e.

I=S

However, this model leaves out the trade account. In an open economy, we must add the trade balance or net exports (NX).

Y=C+I+G+NX

Rearranging this formula, Y-C-G=I+NX. We also know that S=Y-C-G. From this we can deduce that S=I+NX.

Again rearranging this formula we get  S-I=NX (or X-M, where X is exports and M is imports). Even more simplistically, net national savings equals the trade balance.

If we define the repayment of debt as the excess of savings over investment, then by definition the economy must run a trade surplus to pay down debt. If a creditor economy wants its loans to be repayed, then it has to run a trade deficit.

Will someone please explain this to Ms Merkel, Mr Schäuble and the buffoons in Brussels?

The eurozone is at war with double-entry bookkeeping

Sometimes you come across a brilliant description of a situation in the press. Martin Wolf sums up the eurocrats perfectly in today’s FT by writing that “The eurozone is at war with double-entry bookkeeping”. How many times must it be said: “for every surplus, there must be a deficit and for every creditor, there must be a debtor”? As I have said before, it’s not an economic theory, it’s an economic fact. I’m backing the double entry bookkeeping system to beat the eurocrats.

At the next ECOFIN meeting, someone needs to have the temerity to ask Ms Merkel how the periphery can reduce its government indebtedness without Germany running a trade deficit. Perhaps the Spanish will, having found the courage to face down the EU on its budget deficit. Someone has to.

Exactly

Barry Ritholtz on the great Credit Default Swap swindle.

The 2012 Chocolate Fireguard Award?

The financial industry has a long an inglorious history of selling products that are about as useful as a chocolate fireguard. The financial and economic system was brought to its knees by Collateralised Debt Obligations where triple A promises turned out to be worth little more than those attached to Zimbabwean government bonds. We’ve also seen the scam of Payment Protection Insurance which was not only sold to people who couldn’t claim payments but even if they did qualify, the conditions were so onerous and arcane, that many couldn’t receive benefits. At least in the last case, massive fines and compensation has been levied on the banks that sold the product.

Are Credit Default Swaps going to win the Chocolate Fireguard Award of 2012? The decision by the ISDA that the Greek “voluntary” restructuring is not a credit event beggars belief. Firstly, private sector debt holders have been unilaterally (probably illegally) subordinated by the ECB. To rub salt into the wound, they’ve had collective action clauses retroactively imposed on them.

I see the lawyers have been crawling all over the wording of Greek CDS contracts to see if the writers can wriggle out of their obligations. The ISDA determinations committee is riddled with conflicts of interest. It’s ironic that Bill Gross has criticised the decision but PIMCO are on the committee that agreed that a credit event hasn’t been triggered. These guys have no shame. Common sense says that bond holders have been forced to take a substantial write-down on the value of their bonds through the actions of the Greek government and the EU. Surely their insurance cover should be triggered on the orignal principal, not the value of the exchanged bond.

I have a nasty feeling that the CDS market is being manipulated and gerrymandered by the all-powerful investment banks. While they can well afford the payouts on Greek debt, they must be scared witless about the potential payouts on Italian and Spanish debt. Why not set a precedent through the Greek restructuring that reduces if not eliminates their liabilities? It’s a scandal that the precedents for payouts can be set by a committee of mainly banks that would benefit enormously from establishing a precedent from the Greek “restructuring”. Yet again we see the financial industry selling customers a product that claims to be one thing and when it comes to crystallising value, turns out to worth substantially less or virtually worthless.

Potentially, this is going to have huge implications. Faith in the Credit Default Swap market will be severely damaged, possibly irreparably. Clients are going to be much more reticent about buying CDS. In the short-term writers of CDS will benefit as the value of protection falls. Could this be part of the strategy of the large banks? Will they buy back and cancel the protection that they’ve written? It could be the biggest bear closing trade of all time.

Secondly, hedging is going to be a lot more difficult, so punters are going to be a lot more cautious about buying less than pristine debt. In the below A grade debt markets this is going to mean higher yields and less demand. You also have to wonder whether investors will want to buy certain classes of sovereign debt, given that the rules of the game can be retrospectively changed.

Thirdly, there has to be some significant valuation issues. Hitherto, CDS hedges have been “perfect”, i.e. models have assumed that CDS contracts will fully offset defaults. If this is no longer the case and a risk discount of non or partial payment has to be built-in, then there’s going to have to be some significant write-downs in the value of CDS holdings. My bet is that this will be a negative for most investment funds, insurers and small banks. Large banks may be a net beneficiary.

If I were a holder of a Greek CDS, I’d be spitting blood now. I suspect there will be some kind of partial payout in the end, but trust in the CDS market and the sanctity of contracts may have been fatally wounded. As I pointed out yesterday, financial markets and economies cannot operate efficiently without trust. Perhaps my Chocolate Fireguard of the Decade award should go to the all-powerful investment banks who have utterly corrupted the financial system.

Where are we now?

It’s been just over two weeks from my last post. At lunch, I was asked why I hadn’t posted much recently. Quite frankly, it’s difficult to add much to what I have already written. The fundamentals of the eurozone are little changed. As I mentioned last time, the LTRO has injected a huge amount of liquidity and taken away the near term liquidity risk in Eurozone banks. The chances of another Dexia type incident in the short-term are remote. The longer term solvency issues remain in place and the Eurozone banks are wading deeper into the sovereign bond risk mire. The ECB might say that banks need to wean themselves off central bank funding but the LTRO does the exact opposite. In 18 months time the market will start to get twitchy again. However, the bankers are handing over the problem to the politicians. The problem is now so large, to allow defaults will cause a catastrophic implosion.

Unlike ZeroHedge, I’m not whingeing. Governments and central banks do whatever they do. It may not be fair or necessarily the correct policy, but they are the house in the capital markets casino. Asset markets are enjoying being goosed by the liquidity rush. The real economy is not going to use it, so asset prices rise. Lie back and enjoy it while it lasts. How long will it last? It could go on for some while.

Something that increasingly concerns me is the way that trust is being abused. The latest example is the ISDA’s declaration today that the Greece restructuring is not a credit event. How can this be? The ECB (possibly illegally) ensures that the Greek debt it holds has seniority. Collective action clauses are inserted retroactively. Private sector bond holders will have to take substantial write downs on the values of the bonds they hold. HOW CAN THIS NOT BE A CREDIT EVENT? The only answer can be the committee of the ISDA who decide. It is rammed full of conflicted parties, mainly large banks who have written CDS contracts. Unless they change their decision, the conclusion has to be that CDS contracts are worthless.

Quite frankly, this is only the latest example of how trust is being destroyed in financial markets:

• The disappearance of client funds at MF Global despite the requirement to segregate them, coupled with the conflict of interest that JPM had in the affair.
• The US mortgage settlement, which looks like a stitch up by the banks at the expense of the US taxpayer, mortgage bond holders and mortgagees.
• The transfer of a huge derivative portfolio by Bank of America into a corporate entity insured by the FDIC.
• The back door funding of Eurozone governments through he LTRO.
• High frequency traders placing their computers next to exchanges to get in first on orders and their tactic of order stuffing.
• ETF Funds stuffed full of derivatives not underlying securities, claiming to be index trackers.
• Bank managements awarding themselves huge bonuses at the expense of shareholders and the tax paying public.

Those are just a handful of examples. I could go on but you get the picture. The word credit is derived from the Latin word to believe or trust. Capital markets, indeed economies need participants to trust each other, otherwise transaction costs rise, liquidity falls and markets become less efficient. I’m old enough to remember the old Stock Exchange motto “my word is my bond”. Those days are long gone. Who can be trusted these days? Where are we now? I actually think markets and investors are completely lost. It’s not just the policies, it’s the ethics.

Voting or weighing?

Benjamin Graham said that in the short term the market is a voting machine, but in the longer term it is a weighing machine. It seems to me that the markets are in a voting mood at the moment. The liquidity provided by central banks has driven up asset prices over the past couple of months, so that equity markets are at six months highs.

If you have read Gordon Pepper’s book, The Liquidity Theory of Asset Prices, this shouldn’t be a huge surprise. When the ECB joined the Fed and BoE at the liquidity party through its LTRO, it was the signal investors had been waiting for. The threat of a Dexia style funding crisis was largely removed, so the excess liquidity sloshing around in the system could seek out risk assets with a degree of confidence.

The ECB has taken off the Trichet hair shirt and Draghi has donned his party shirt. While solvency concerns remain and structural problems in the eurozone persist, in the short term, who cares? The crisis can has been given another boot down the road.

With European economies either in recession or close to recession, there is little or no demand for credit from the real economy, so the liquidity creation of central banks flows into asset markets. The initial beneficiary was fixed interest markets, but with near term tail risk removed, equity markets have taken up the baton.

Investors are voting with their money, regardless of the cyclical negatives. Fund managers cannot be left behind. Those with high cash positions are risking their careers, so capitulation is the name of the game. Without a shock event, this process has further to run, although the “easy” money has already been made.

Equity markets look cheap relative to bonds (except bonds might be expensive). However, that is predicated on top of the cycle earnings making PEs look cheaper than the underlying reality. We’ve already seen some flickers of disappointment and distress in the corporate world.  These are just the first pebbles but the avalanche of downgrades may not come for a while. The process of corporate profit margins peaking typically takes longer than the bears anticipate, lulling the bulls into a false sense of security.

The weighing machine will not be operational until the cycle turns. The excess liquidity will have to be destroyed somehow. This will either be through inflation, where the value of each monetary unit depreciates relative to physical assets. Alternatively, a portion of the money created gets incinerated by defaults and bad debts, which tends to be deflationary.

The eurozone appears to be set up for a deflationary outcome. The collapsing domestic demand outside the core is profoundly deflationary and the ECB’s liquidity operations are unlikely to turn the tide. In the US and UK, an inflationary denouement is possible, but the weakening eurozone economy and early signs of stuttering growth in China may see a period of disinflation or even mild deflation first.

If the Fed and BoE decide deflation is the dominant force they will push monetary policy to the limits to fend it off. Ultimately they could set off an inflationary surge, wrong footing investors. Markets extract the maximum pain from the maximum number of people. What would cause the maximum pain would be deflation, where investors sell real assets and load up on bonds, followed by an episode of inflation, destroying the real value of said bonds.

Ultimately the value of assets will need to be weighed. The cash flows attaching to both bonds and equities will have to be measured by a proper yard stick. There is no doubt that discount rates are too low and that low discount rates have boosted asset prices.

Sovereign bond yields in “safe” countries (i.e. US, Germany, UK), where there is little default risk, have been pushed to levels unthinkable just a few years ago. Risk free rates are exceptionally low. These will rise at some stage either because growth returns or inflations rears its ugly head. When this happens, asset markets will get caned.

However, I feel this is still some way off. I can’t see the deleveraging phase of the global economy lasting much less than another five years, so it may not be until near the end of this decade that the scales are recalibrated.

In the mean time, some wealth will be destroyed through recession, deflation and default. We could even see falling equity markets again when recession cuts into corporate profit margins. Fiscal consolidation and government spending cuts are also negative for corporate profit margins.

Central banks are scared witless that a further collapse in asset prices will set in motion another debt liquidation spiral. They are right to fear this, but the aggregate level of corporate profits and tax revenues are inadequate to support the current level of all asset prices (equities, corporate and government bonds) at a sensible discount rate. Something will have to give. Either defaults will reduce the principal and interest costs or inflation will have to erode the real value of the principal and interest payable.

One way or another the scales will show that the current level of asset prices is too high in real terms. They have to fall either in nominal terms or the real value has to be eroded by inflation. As for the day of judgement, who knows, but sooner or later it will come.

Why would you trust a politician?

I wouldn’t blame Stephen Hester if he decided to resign. For Ed Miliband and Ed Balls to attack Hester over his remuneration is the height of hypocrisy. They were both members of the government that employed Hester and set the terms of his contract. Not only that, he was persuaded by Gordon Brown to take the job for the public good and take a remuneration package that was lower than the current market rate.

While I do think that executive pay if far too high, I’m not sure I would put Hester in that class. Let’s not forget that RBS was a basket case when he took over with a balance sheet 1.7 times the size of the UK economy. At least he has now trimmed that so it is the same size as the UK economy!

The share price of RBS is well below the government’s cost price, but bank share prices in general are well down. To make this the basis for a rewards for failure argument is at best disingenuous and at worst downright deceitful. It seems to me that Hester is doing a good job of rescuing RBS. This requires a lot of skill and fortitude. Not any Tom, Dick or Harry can do it.

Not only does the Labour faux indignation disgust me, but the lack of support from the current government is particularly spineless. They have avoided any responsibility by claiming (rightly) that Hester’s remuneration is a matter for the board, him and the terms of his contract. However, they have expressed a wish that he doesn’t take his bonus. Power without responsibility.

Quite frankly, why would anyone take a job like this again? The politicians who appoint you, don’t have the decency to stand up and defend you, even though they set your contract and beg you to take the job. Not only that, any succeeding administration doesn’t have the guts to abide by a legal contract. No wonder we’re in a mess.

Events, dear boy

When Harold Macmillan was when asked what was most likely to blow governments off course, he replied “events, dear boy, events”. Both politics and economics, by their very nature are unpredictable. Unlike the physical sciences, cause and effect can be both mean reverting and reflexive. The cross over point is not always obvious and events are unpredictable.

I’ve not written anything over the past two weeks, not because nothing has happened, but because there has been little insight to pass on. At the end of last year, it looked like we were seeing the demise of the eurozone, but the ECB’s LTRO seems to have postponed the denouement.

While the LTRO does not solve the solvency crisis of banks and sovereigns, it has bought some time. How much is still open to question. A Greek default in March could open the floodgates. Equally, there has been ample time to arranged contingencies.

Containing any spill over into Portugal will be a severe test to eurozone policy makers, but they can’t say they haven’t been warned. The LTRO should contain the short-term liquidity strains in the eurozone bank sector. With so much liquidity being placed at the ECB, despite a negative spread, most banks will have secured themselves against all but a severe run. For those brave enough, the carry trade on sovereign bonds provides an opportunity to rebuild some capital.

We seem to have returned to a “wait and see” period in markets. Asset prices have yet again been buoyed by monetary pump priming by central banks, but the real economy can’t use (or doesn’t want to) use the credit provided, so it goes into asset markets. While there is the latent threat of inflation, it does appear that the global economy, especially the West, is in a true liquidity trap.

At these times, it is best to return to what we do know rather than speculate about events, that by their very nature, are unpredictable in timing and magnitude. What we do know is that there are two fixed points in the global economy that are causing severe distortions.

The first is the renminbi peg. This has caused the problems for both the Chinese and US economies. Put simply, it has caused over consumption, low savings, and investment in the US and the opposite in China. The trade and capital imbalances are an out-working of this. Arguably, it has also caused higher unemployment in the US.

There are some positive signs that other economic mechanisms, mainly high inflation in China, are bringing about a rebalancing. The real effective exchange rate of the renminbi is appreciating through the substantially higher rate of inflation in China. This seems to be having the effect of rebalancing trade. The trade surplus, although volatile, is declining.

China would be more sensible to allow the exchange rate to appreciate to offset these inflationary pressures rather than allow high inflation. By maintaining its crawling peg, monetary conditions are red hot and are producing severe distortions within the economy. My guess is that the Chinese are afraid to allow too much appreciation because the corporate sector operates on thin profit margins. A bust in the corporate sector allied to the over extended position of the banks to the real estate sector would wreak havoc in the banks.

However, it is impossible to know when the chickens will come home to roost in China. The problems of an overheated real estate market, hidden debts in the municipalities, over investment, financial repression, low share of GDP taken by wages and corruption are well known and rehearsed. National statistics are so unreliable that a bust could be occurring long before it’s recognised by outsiders. Nevertheless, the rebalancing that appears to be happening between the US and China makes me a bit more relaxed, although still wary.

The other fixed point is the eurozone. The competitive divergence and the accompanying trade and capital imbalances are now a frequent topic for debate in the quality press. Anyone and everyone by now should know the underlying cause of the crisis. What is lacking is recognition by the political elite. Germany is trotting out the same austerity prescription, seemingly not understanding that the only way the the south can repay its debts to the north is for the trade surplus of the north to become a trade deficit.

In a fixed currency regime, this can only be achieved by the north (i.e. Germany) indulging in a massive domestic demand stimulus, a credit boom and tolerating significantly higher rate of inflation than the overall eurozone. It will also have to come to terms with a trade deficit. The matching offsetting capital flows can then be used to pay down the debts owed by the south.

For every trade surplus, there must be a trade deficit. For every creditor, there must be a debtor. This is not economic theory, it is economic fact. German politicians either don’t understand or don’t want to understand. Until the disease is correctly diagnosed, there can be no cure. Sadly, that is where we are in the euro crisis.

How will it play out? No-one knows for sure. It could easily drag on for another two years, but I suspect the crunch will come sooner. Should a Greek default cause a unstoppable cascade to Portugal spreading to Ireland, Spain and Italy, then the game will be over. However, this seems too obvious.

The French elections could be another catalyst. Hollande will be very different to Sarkozy. Germany will be less likely to tolerate a Hollande view of Europe. The fiscal pact has already run into some legal sand traps. It will be dead if the Socialists win in France. The next German federal elections in 2013 will start to enter the political calculus as this year develops.

In my view, Italy is the elephant in the room. It has a completely technocratic government with no democratic mandate. As the unpopularity of the previous regime fades over time and the austerity measures bite, Italians are likely to question the legitimacy of the government. Civil unrest is a distinct possibility. Berlusconi is biding his time and waiting for a chance of revenge. Because Italy runs a primary budget surplus, it could exit it the euro and function in a way that Greece cannot.

I do wonder whether, when push comes to shove, Germany will really go for full fiscal union. Regaining the Deutschemark will look an increasingly attractive option. The banking system will need to be recapitalised, but it will anyway whatever happens. Better to do that with a strong currency. German exports will suffer, but perhaps not as badly as anticipated as German industry tends to be high value added and somewhat price insensitive. German consumers would get a huge boost in relative purchasing power, which would be politically popular. Personally, I believe a German exit is the least disruptive option.

If the eurozone breaks up, many pundits have forecast the end of the world. I take the opposite view. Dislocation will be severe but the changes in currency and competitive parities would unleash a strong rebalancing mechanism which could be the foundation for a decade of growth. At the moment the eurozone is a depression and deflation monster. Get rid of it and we could be surprised at the strength of a recovery in Europe.

The tragicomedy continues part 2

So the proposed EU treaty to impose greater fiscal discipline will allow countries to temporarily deviate from the rules “in case of an unusual event” or in “periods of severe economic downturn.” It will also restrict the powers of the European Court of Justice. This is becoming more and more of a farce. Will Sarkozy’s trousers fall down at the next press conference or Merkel do a Judy Finnigan? After all the fuss, it seems that Cameron has largely got his way and the single market is untouched. I suppose we are getting to a stage where the EU leaders no longer have any credibility to lose.

While the odd couple agree on the Financial Transactions Tax, before Merkel reveals that she may not be able to persuade the Bundestag to pass the legislation, markets are screaming “crisis”. Investors are paying Germany to look after their money with a negative yield on the latest bill auction, ditrusting the banks to keep it safe. Unicredit is on the verge on imploding. The Greek banks are bleeding deposits. The latest German GDP figures look great year-on-year but dire quarter-on-quarter. Quite frankly I wouldn’t trust this lot to run a sweet shop.