Stocks, bonds and quantitative easing

Stock and bond investors cannot agree on where the economy is going. Their disagreement is driving both markets and only one of them is going to be right.

Congenial stock investors are seizing on any positive data point, strong earnings report and now the prospect of more quantitative easing as proof that slowly the economy is recovering, thereby justifying a rally. Meanwhile more cynical bond investors have likewise seized on any weak data, sovereign debt jitters in Europe and now quantitative easing as proof the economy still faces more bouts of painful deleveraging and possibly deflation, thereby justifying a rally.

Through until March or so, stocks seemed to have the upper hand in the argument until the European sovereign debt crisis put an end to the post-crisis rally, triggering a bond rally as investors sought refuge in the arms of the most solvent governments. Since weak economic data spooked the Federal Reserve into plotting its return to the Treasury market with a second round of quantitative easing, both stocks and bonds have decided to rally. Unfortunately, both risk and risk-free assets cannot long rally together.

Stock investors have the plausible argument on their side that shares are cheap by historic standards and can also claim that there is a dangerous bubble brewing in bonds. Meanwhile, bond investors have historically been much better forecasters of where the economy is headed. The inversion of the yield curve has an uncanny knack for signalling choppy waters ahead while stocks tend to start falling after the economy has weakened or entered into recession. But ultimately, the argument for stocks or bonds comes down to whether you believe that the downturn was cyclical or a structural shift.

If you believe that the financial and economic crisis was cyclical then there is no reason not to think that the economy can return to levels of activity it enjoyed shortly before things went pear shaped. However, if you believe that the crisis has ushered in a fundamental shift in the structure of the economy then you should definitely have big doubts about things returning to the way they were.

We side with the bond investors’ take on the world. Debt issued in unprecedented proportions has created a vast overcapacity in the economy to produce and consume. We can not afford what we are able to produce or consume unless either we take on more leverage again or unless prices come down to levels that would not require more debt. With its plans to start buying Treasuries again, the Federal Reserve clearly does not want deflation to be the mechanism of adjustment and would much rather that the economy take on more, but cheaper debt, especially to refinance existing debt at easier rates.

Unfortunately, the economy so far has shown little interest in more debt. As bonds have rallied and market interest rates have plunged, mortgage lending has not rallied as would be hoped. Rather it keeps falling.

Lower interest rates have so far not created more demand for credit. This does not bode well for a fresh wave of quantitative easing from the Fed. If lower rates are already not reviving credit demand why should even lower rates caused by the Fed’s planned Treasury purchases fuel demand? And yet, while the possible fruit quantitative easing might bear are uncertain, it carries huge risks. It could undermine faith in the dollar if suddenly the mass of dollars explodes as Fed creates bank reserves to pay for the Treasuries it buys from banks. But a perhaps more real danger is that if quantitative easing fails to revive credit demand and boost the broader economy, it could undermine faith in the Fed at a time when it is about the only institution with much credibility in Washington. That would be truly scary.

Ultimately, quantitative easing is better for bonds in the short term than stocks. Bonds can be certain to rally if the Fed buys Treasuries whereas any stock rally is likely to peter out quickly once stock investors realize how weak the economy is if it needs more liquidity pumped into it. But once stocks do stop rallying, a time will come when they will truly be a bargain and bonds will be overbought.

 

 

Of angry voters and bond pussy-cats

Governments have thrown more cash at keeping voters happy in the last few years than ever before. One would expect voters to repay the favor with some show of gratitude. One would also expect those who lent the governments the money to be getting seriously jittery.

But that is not  the case. All the G7 governments, expect for perhaps ever-congenial Canada, are battling to preserve their political authority as confidence in them quickly wanes. In France Sarkozy’s ratings keep testing new lows as he faces what seems like weekly mass protests against pension reform. Italy’s Berlusconi faces also what seems like weekly no  confidence votes in parliament, and manages to barely scrape by. Even mighty Merkel is slogging through the political wilderness in Germany. Britain’s new government is struggling to prove itself. In Japan, the prime minister Kan barely survived a challenge to his authority from a rival “shadow sho’gun”. And finally, in the US, Obama’s democrats are widely expected to suffer painful losses in the mid-term elections. How’s that for gratitude after throwing billions at voters to keep their livelihoods from going up in smoke during the financial/economic crisis?

While governments get no respect from the people who elected them, bond markets are giving a huge vote of confidence in them. Governments spent far more than they had coming in over  the last few years and yet the so-called bond vigilantes are far from getting geared up to teach them a thing or two. Indeed, the bond vigilantes, who so memorably struck fear into the hearts of the Clinton administration, have become bond pussy cats.

So why are voters and bond investors not playing the roles one would expect them to play at this point in the economic cycle? We would suggest that it is quite simply because the recovery has proven to be so disappointing despite all of the cash governments pumped into their economies over the last few years. Economies may have emerged from recession, but people are feeling neither more prosperous and nor secure about the prosperity that they have managed to hang on to. Likewise, bond investors are equally unconvinced that recovery has firmly taken hold and are pricing for a real possibility of deflation. In that light, it’s hardly surprising that voters are angry and bond investors compliant.

 

Devil wears Prada — and so do speculators

On a lighter note…

The financial media are rife with unnamed sources (presumably spokespeople, executives and assorted PR people) confiding in any journalist who will listen that Prada — once again — is considering going public with an IPO. Does one need any other pretext to liquidate a stock portfolio…

We raise the question because Prada has uncanny knack for calling the top of a stock cycle with its IPO ambitions. Most notably, at the peak of the tech bubble Prada first got the IPO itch and then again got it again in 2008. While they probably enriched their already none-to-poor investment bankers in the process, on both occasions the luxury goods company got cold feet and probably saved itself the ignominy of seeing its newly minted shares crash to the ground like a clumsy model on a catwalk.

While Prada strives to be in the avant-garde on the catwalks, it is ultimately a conservative, family controlled and run business that has a lot to lose from a botched IPO and a lot to gain from a successful offering. Therefore, the timing of its IPO is essential, especially in light of the fact that as a luxury goods company like Prada by nature has a cyclical business tied in no small part to the fortunes of financial markets. To be worthwhile, a Prada IPO must fetch a high price. But for a cyclical company like Prada to fetch high price, it’s got to be at the peak of the cycle. And everyone knows what happens at the peak of a cycle…

Fed Treasury purchases won’t get banks lending

So the US economy is starting to look shaky. What’s the Fed to do? With short-term interest rates already at rock bottom, over the summer the Fed started wading into the Treasury market to keep longer-term interest rates down. The more gloomy the outlook gets for the economy, the more likely it becomes that the Fed will make a big plunge into the Treasury market to really get longer term rates down. But that could easily backfire, having the unintended consequence of discouraging banks from lending more to households and businesses.

Although most banks are on the mend, they still don’t have a lot going for them. Sure, some business lines are doing alright, but their main act of lending to consumers and companies is lousy. Luckily for them, they can borrow at rock bottom short-term interest rates and turn around and lend it longer-term and risk-free to the government and its cohorts, earning a juicy spread in the process. It’s good business if you can get.

But if the Fed really starts buying Treasuries again big time and longer term interest rates come down, then there goes the banks nice little earner. If the banks lose a main source of juicy, low-risk income are they going to want to take the risk of rushing out and start lending to everybody or are they going to buckle up and sit tight? There’s a real chance the banks will sit tight.

The sad fact is that the Fed has precious few options left — if any — to help revive the economy.

Budget austerity does not necessarily mean political suicide

Finally, some good news for embattled European governments. Taking the axe to the civil service and cutting generous and popular social benefits does not necessarily lead to electoral suicide. So says a group of three academics led by Harvard’s Alberto Alesina.

With a growing number of European governments resigned to slashing spending and hiking taxes to avoid following Greece towards the abyss, Alesina and graduate students from Berkley and NYU looked at data for western European countries going back to 1975 to see if politicians really need to be spending as many sleepless night as they surely are. They conclude:

The bottom line is that it is possible for fiscally responsible governments to engage in large fiscal adjustments and survive politically. Moreover, acting on the spending side is no more costly that doing on the tax side. A sense of urgency because of impending crisis, a bit of time between the adjustment and the next election, good communication with the public, are ingredients that help.

That turns the conventional wisdom on its head. In perhaps the most recent example that the researchers are right that fiscal austerity is not political suicide, Czech voters voted in a coalition last weekend whose top priority is to restore the health of the public finances. Voters also punished the Social Democrats, whose promises to keep up high levels spending on costly social programs inspired not only mistrust but even voter anger, we are told by sources on the ground.

In those halcyon days before the financial crisis, Luxembourg premier and finance minister Jean-Claude Juncker once famously remarked about structural reforms that European governments knew what they needed to do but if ever they did then they would never hold office again after the next election. It’s a shame that the conventional wisdom did not get turned on its head before the crisis because they would be in a lot less pain now that they have no choice.

Greeks resigned to accepting austerity drive

Greeks are up in arms about the latest wave of austerity cuts. Communists unfurled banners urging revolt from the Acropolis, thousands marched on the parliament, demonstrations degenerated into pitched battles between riot police and Molotov cocktail hurtling youths. No way will Greeks accept the sacrifices that their Socialist government is asking of them. Right?

Well, that is the picture one gets from the international press over the last week. But having just returned from Athens where I was covering the crisis for an international news organization, that picture seems at best highly distorted. When you speak to Greeks, even many of those who were protesting in the streets, most seem resigned to accepting that the whole country has no choice but to make painful sacrifices to avoid a financial meltdown. Whether talking to people in the public sector or the private sector, that was repeatedly the message that I and my colleagues got.

Of course, the unions are up in arms and managed to mobilise more people than they would usually for the recent demonstrations. But isn’t that what one would expect anyway? Probably about 50,000 people marched in the biggest demonstration on Wednesday, which is not that many in a city of about a million people. As for the violence, Greek demonstrations frequently turn violent and is widely expected and accepted. On the ground, the clashes between police and protesting youths had an almost ritualistic feel to them as though each side had done it so many times before that they knew their roles perfectly like ballet dancers. The youths would taunt the police, who would put up with it to a point, then would push them back with tear gas.

On Wednesday, the violence definitely got out of hand when the Marfin bank caught fire, killing three people by inhalation. But that was because some hot-headed hooligan had the idiotic idea to smash a window and toss a Molotov cocktail. But the sad truth is that Greek protests often involve hooligans using the opportunity of a demonstration to come downtown, smash things up a bit and toss a few Molotov cocktails. With youth unemployment running stubbornly above 30 percent, the youth have a lot of frustration and anger to vent when they don’t happen to be part of the connected classes that know the right people for getting a job. Greece is not alone in this either. Disillusioned youths with few opportunities are the main raw ingredient for pretty much any riots whether they be in Greece, Paris suburbs, LA or Brixton. All they need is a pretext to riot and Greek youths definitely had one last week.

The protests did not stop the Greek parliament from approving the austerity plan with a comfortable majority. It would have been overwhelmingly approved if the conservative New Democracy party that is largely responsible for much of Greece’s current problems had risen above petty politics and backed the plan. Ironically, it was therefore Prime Minister George Papandreou’s Socialists that passed legislation imposing budgetary rigor and economic liberalisation — things their conservative predecessors didn’t dare to do when they were in power.

While Papandreou’s ratings have taken a hit from pushing through an unpopular austerity drive, remarkably he remains more popular than his conservative rival Antoni Samaras. That goes to show that the much of the population has indeed understood that there is no other choice than painful spending cuts and tax hikes, just as Papandreou has repeatedly argued.

Of course, this picture contrasts sharply with what one has seen in the international media lately where one could get the opposite impression that the population is in open revolt against the government. But remember, these days media are battling with each other for your attention and the best way to do that is to focus exclusively on drama at the expense of the broader context. Of course, there was violence in Greece last week, of course there are people who are up in arms against the austerity plan. But that does not reflect the attitude of the broader population. At least not for now. The situation could change and change quickly. But for now Greeks are largely resigned to the fact that their way of life over the last 10 years will have to change.

The return of risk

Financial markets are rediscovering that it’s a dangerous world out there.

With Greece’s debt agony getting worse by the day, investors are rushing to the perceived safe havens of the dollar, treasury bonds and even the yen as they wake up to the fact that it’s still a very risky world out there.

For months, investors have been content to bid stocks ever higher, pushing equity valuations well beyond their long-term averages despite the manifest political, economic, fiscal, tax and regulatory risks begotten by the policy responses to the financial crisis. Such complacency drove the premium investors demand to own risky stocks instead of risk-free bonds to a mere 4.16 percent at the start of the month — ominously lower than the 4.22 percent registered just before Lehman brothers blew up, according to calculations by NYU Stern School Professor Aswath Damodaran.

With markets once again flirting with meltdown mode following the downgrade of Greek debt to junk, the so-called equity risk premium has shot up to 4.7 percent, according to our calculation using Damodaran’s method. That’s certainly still a far cry from the 7.87 percent booked at the trough of the market slump in March 2009, but it’s a big jump from the start of the month. Clearly, after settling into smug complacency, investors are once again trembling as risk rears its ugly head.

Eurozone agrees to subsidize Greek profligacy

It was many months in the making, but finally the eurozone has produced a convincing bailout to keep debt-plagued Greece from keeling over into the abyss of default.
However, it comes at a high price and the 30 billion euros that eurozone finance ministers have agreed to scrape together for Greece in below market loans is only the beginning of what the bailout will cost the eurozone

Since the loans are being offered at below market rates (after Germany apparently lifted its objections), the rescue ultimately will subsidize the cost of Athens’ past profligacy. While German taxpayers — who go to the polls next month — will not be happy to be underwriting Greek overspending, such is the cost of maintaining stability in the eurozone and avoiding the slide down a slippery slope of contagious debt crises.

However, the rescue could still unravel. Some creditor countries could still get cold feet about lending large sums to Greeks, especially since some have their own dire financial woes and are desperate to hold on to cash. Officials still have to hammer out the so-called conditionality, the tough budgetary sacrifices that Athens will have to make to get the loans if it asks for them. Who knows how much more belt-tightening the Greek government can impose on population not exactly used to the rigors of tough budgetary discipline.

Ultimately, the whole Greek drama episode has dealt a painful blow to the eurozone’s image because of the breathtakingly amateurish handling of the crisis, which exposed all of the bloc’s weaknesses at precisely the moment when it should have been showing its strengths. There is no reason that what eurozone ministers agreed on Sunday couldn’t have been put on the table six weeks ago. Perhaps Germany just wanted to make the Greeks sweat before offering a lifeline — if so they have severely damage the euro project in the process.

Market calls eurozone’s Greek rescue bluff

When eurozone leaders agreed to a rescue plan for Greece last week in Brussels, they were hoping the bond market would respond to their show of support for Athens by easing up interest rates and snapping up any new Greek issues. Although the yield on 10-year Greek government bonds initially fell after the show of support, it has since climbed back up to over 6.5 percent, indicating that market has called the eurozone leaders’ bluff. Ultimately, the Greek bailout agreement was a stunt aimed at restoring just enough confidence in Greece and their support of Greece for Athens to be able to issue enough debt to make it through the coming weeks, when its financing needs peak.

When one looks at the communique eurozone leaders agreed to on March 25, it is apparent that they were in fact utterly unable to overcome their divisions about whether and how to bail out Greece and could thus only agree on a face-saving text of extreme ambiguity. They promise to extend loans to Greece if “market financing becomes insufficient”. They say they will extend loans to Greece without any “subsidy element”, presumably meaning at market rates. But by the time “market financing becomes insufficient” for Greece and the country is teetering on the abyss of default, then the market rates on its debt are going to be sky-high. Can eurozone countries realistically demand Greece to pay crippling interest rates on emergency loans? Politically, it’s highly unlikely. So in other words, the agreement can’t be taken at its word.

Therefore, given the inherent ambiguity in the eurozone’s bailout agreement, if Greece ever does really need the help, the details will have to be worked out on the fly, which means that the IMF will probably have to take the lead unless the eurozone ever gets its act together. Luckily, for Greece Monday’s 7-year bond issue should tide Athens over through April, leaving 11.6 billion euros to be found for May, according to bank Unicredit. While Greece is getting close to getting over the hump of its peak financing needs, things could still get messy.

Will France join the PIGS?

French presidential elections are not until 2012 but Nicolas Sarkozy’s drubbing in regional elections last weekend means that everything he does between now and then will be aimed at re-election.

Already before the financial crisis Sarkozy’s reform drive had lost some serious steam. Now, after getting thrashed by the Socialists, you can forget about any reforms in France that might upset the electorate. More importantly, you can expect the French government to do everything it can to put off reining in spending until after the presidential elections.

After running a deficit of 7.9 percent of GDP last year, Sarkozy’s government expects the shortfall to peak this year at 8.2 percent — not Greek levels but getting up there nonetheless. After this year, the government then expects the deficit to fall to 3.0 percent of GDP by 2013. In other words, the government is counting on more than halving its deficit in the midst of what is likely to be very tough presidential campaign. With typical understatement, the European Commission said last week that “the assumptions underlying the programme scenario are assessed as rather optimistic.” No kidding. It goes on to remark that “some expenditure-side measures are not specified” and that the government’s deficit-busting plans are based on rosy economic forecasts.

Sarkozy will probably not ease up so much on budgetary discipline that France joins the PIGS group of dangerously high deficit countries on the eurozone’s periphery, because that would ultimately undermine his ambitions for a second mandate just as much driving a hard line on the deficit would. So the most likely scenario is that the government simply tries to put off as much necessary belt-tightening until after the elections.

While France won’t join the PIGS, it will certainly do no favours for the eurozone’s international and market credibility if efforts to cut the deficit flag in the bloc’s second biggest economy. It will also make already fraught tensions with Germany worse and it means that restoring health to public finances will be the last of priorities when France holds the G20 and G8 presidencies next year.