So it Begins - Bernanke begins the taper hoping for less of a battle than Helms Deep

                "So it begins!" - The words of the fictional Theodan, King of Rohan at the start of the Battle of Helm's Deep in the epic The Two Towers. One wonders if potential Theodan doppleganger Ben Bernanke was having these same thoughts as he prepared to give the Fed's announcement on Wednesday that the time had come to taper. You can almost imagine him standing there looking out over Wall Street with tens of thousands of orcs (a.k.a traders) preparing an all out assault on bonds and stocks and Bernanke wondering if what he was about to unleash would be the right weapons to save the day. Turning to his fellow FOMC board members - "So it begins".

"So it begins" - Bernanke will be hoping to have an easier ride than Theodan at the Battle of Helms Deep

              And so it does begin. Slowly, a little bit at a time. After the markets original bet of a September start to tapering, Bernanke and the Fed finally began the reduction in the amount of stimulus being pumped into the market by $10bn. Starting in January the Fed announced that the size of the monthly QE stimulus would be $75bn a month ($35bn on Mortgage Bonds and $40bn on Treasuries). Initial market reaction to this was actually positive, a sharp contrast to the original response back in May on the suggestion of tapering. The S&P 500 and Dow Jones raced to fresh record highs up over 1.5%, whilst 5 year Treasury yields closed at 1.63% and 10 year at 2.94% yesterday. Whilst the yield increase represent an upword movement in future rate expectations, it is perhaps smaller than one would have expected given the fear the market previously showed at the mere mention of tapering.

          The positive stock market response and relatively mild increase in yields is a definite positive and reflects potentially a skilled handling of the situation from the Fed's perspective. Markets potentially had been expecting the first taper to be of a more dramatic nature, with some estimates of a $30-40bn reduction being used in the first round. By testing the market with only a slight $10bn reduction in monthly QE, the Fed effectively said we're not going to make you go completely cold turkey. Going back to my previous analogy comparing it to the kid trying to ride a bike, it's as if the child who was so afraid of his parent letting go of the handle bars suddenly realised that even though the parent has taken their hands off the handle bars, they've left the stabilisers still on. The market is now starting to realise that the Fed isn't just going to let go of the handlebars completely without support. Recent predictions since Wednesday's announcement seem to be suggesting that the Fed, under the new leadership of Janet Yellon from January, could withdraw $10bn each month over the next 7 meetings, a gradual, predictable weaning, which would allow the market to digest in an organised manner the consequences and begin to focus properly on the real economy.

        Even with this gradual withdrawal of monthly QE the Fed has also acted to control the further rise of interest rates through increasingly less rigid forward guidance. Whilst previous guidance had the market believing that inflation around and below 2% and an unemployment rate below 6.5% were set in stone levels that would see the base rate start to rise, Bernanke has now sought to further dispel this fact. The latest guidance suggests that rates will remain in the current 0-0.25% band potentially well past the point where unemployment is below 6.5%. This is especially the case should inflation continue to remain roughly half the target of 2%. Analysts now predict that we may not see any rate rises until mid 2015 or even 2016, a far cry from the end of 2014 most were predicting just a few months ago.

                  The beginning of the taper though is good news and the ultimate complete removal of the ongoing stimulus is likely to be beneficial for the economy. There is potential that inflation would not actually begin to rise again until the point that QE is no longer being pumped into the market. Some analysts suggest that far from being inflationary, QE actually is causing there to be less inflation. The inflationary impact of QE has of course been seen in asset prices, but there is potential that this is at the expense of other prices. This is not that I believe that by stopping monthly QE we will see a dramatic fall in asset prices. The approach the Fed appear to have taken by a staggered reduction in the stimulus will allow the market to focus on the fundamentals of the economy and individual company performance again. So long as these continue to grow then there is no reason the stock market cannot continue to sustain the current levels. We are by no means out of the woods yet. The US economy is still only predicted to grow between 2.5-3% over the next couple of years compared to an average of 3.2% coming out of the previous 2 recessions. But this must be put in context of the scale of this recession compared to 1991 and 2001 and the efforts required to ensure it didn't become like the 1930s. If the Fed can maintain what it has now begun, to the point where no additional stimulus is required towards the end of 2014 whilst still convincing the market that interest rates will remain low until that escape velocity is in full force, then it will have done it's job. Right now it seems it may just be succeeding.

       And so it begins. For now the ferocity of the orcs seems quite mild for Bernanke compared to what Theodan faced. Bernanke, and now Yellen (the future Gandalf?), will just be hoping their own Battle for Helms Deep in restoring the forces of order in the market continues along this smoother course than the King of Rohan. They may even be getting the orcs on their side!

Just because you don't understand it, it doesn't mean it's not useful to meet financial goals

                     Last week I found myself getting into two interesting and contrasting conversations over dinner about particular investments. A friend of mine was discussing with me his taste for trading stocks and ETFs on a weekly basis, effectively trying to time the market and get in and out of stocks from what he says was based entirely on analysts commentary and predictions. Now I've been pretty vocal on my thoughts of the folly of trying to trade on a short term basis by timing the ups and downs of the markets and individual stocks and I relayed this to him. He was very insistent so I suggested to him that if he wanted to predict on short term movements he should consider investing in an ETF on the VIX (An index often used as a proxy for future short term volatility of the S&P 500) in the lead up to the next US budget and debt ceiling issues and then sell just before deadline (after all we're likely to have another deja vu budget debacle!). I said to him this was probably more predictable and likely to give a higher short term return than any of his stock equivalents. (As way of example, investing in VIXY:US over the last budget crisis period could have netted a 20% return in 3 weeks). He however wasn't to be moved, telling me that whilst he didn't quite understand the product, investing in this type of index was pure gambling as opposed to his stock bets.

               It did get me thinking though that often we look at financial products we don't understand and think of them as purely speculative (or gambling) tools. It is understandable that after the effects of the last financial crisis many look at derivatives as just another invented way to make money. Warren Buffet has famously called them "financial weapons of mass destruction". But as with most of what we now perceive as being an investment class, the majority of derivatives were not created for the pure purpose of speculation. 

Derivatives weren't always purely speculative

               The first traded derivative contracts were futures on a variety of commodities. The idea was that farmers growing corn, for example, would be able to know exactly what price they would get for the corn they were delivering in March, as oppose to being faced with a lower price than expected if they were just to sell it on delivery. It provided a contract with a predetermined price which gave more financial certainty to both the buyer and the seller of the corn. Options also evolved as a form of insurance contract. Like a house insurance contract where you might be worried about losing value because of a fire in your home, a person who holds a stock, might purchase a put option to protect themselves should the stock price fall below a certain level over a certain timeframe. 

             I think it's fair to say that most derivatives began life this way, offering it's purchasers some form of security against an asset which they held. The aforementioned VIX futures were seen as a way for traders in US markets to protect themselves against market volatility, the idea being that when markets fall extensively is usually when they are at their most volatile. By holding a contract which makes money when markets become more volatile, you are giving yourself some protection when your stock holdings might be in freefall in a downturn. The Credit Default Swap (CDS), which is now a several hundred trillion dollar market, came about as a way for bondholders or loan issuers to insure themselves against the risk of default by those they had lent to. Even the more structured products often came about as a means of offering protection to holders of the underlyings, albeit by ever more complicated methods. Of course where one person seeks a means of protection for unwanted risks, there are many others who see this as an opportunity for speculation and financial gain. Hence why these markets, once started, often get out of hand and end up as another method for investors, individual and institutional, to ever increase their wealth (or decrease when the going gets tough!). The notional value of CDSs out there often outweighs the notional value of the bonds and loans upon which they provide insurance as speculators use it as a means to both receive premiums or hope for payoff through the survival or downfall of any number of corporates or countries. 

Are Derivatives really any different from other Asset Classes?

               If we're honest though, is this really any different from what we'd consider investing or speculating on other asset classes which we consider normal? After all, a house or a flat, for most of us, is a place for us to live, something which we all need. Somewhere at some point, someone realised that they could purchase many properties and charge other people to live in them because everyone needs a place to live so is willing to pay for that privilege. Yes bricks and mortar leaves you with something physical, but the reason for investing is just the same and carries risks of its own. I don't think there are many people who still believe in the belief that property always rises after the collapse in most developed countries from 2007. If your investment horizon ended then and you were left holding your property portfolio in Dublin with an over 50% decrease in value you definitely wouldn't think that way any more.

               People are always looking for new and innovative ways to invest their money and increase their wealth, with derivatives now being no different from property in that respect. All of which brings me to that second interesting dinner conversation from last week. Whilst pondering whether speculating using derivatives or property was really that much different, I remarked on Friday night that I didn't much see how art existed as a true investment type and wondered where the value was. To my surprise I was given a very interesting rundown on the workings of the art market and how there are specialists out there with a sharp eye looking for the next up and coming artists for investors wanting to diversify their portfolio (and prepared to wait for that patient 20-30 year return). Unless you already have that Monet or Manet in a family collection (or a celler in Munich) then investors now need to find what they hope will be the next big thing. Knowing now whether a Laura Sykes or Zachary Walsh artwork will eventually sell like an Andy Warhol or even a Master seemed to me like an impossibility to predict but, like any investment, there are specialist analysts out there who feel able to give an expert opinion on where the growth prospects are and the right pieces to buy and hold. There's now even funds set up with the sole purpose of investing in art, although the minimum entry is most certainly far beyond that of all but the more wealthy investors. As the number of wealthy investors from the Middle East and Asia look for increasingly diverse ways to preserve and grow their capital, it seems likely that investment in this area is certain to continue to grow, pushing further the value of some pieces. As with any up and coming investment, my dinner colleague maintained that the great thing about art was that "it never loses it's value". As interest in this area as an investment too grows, that interest will begin to spike and values will increase further, because when there's money to be made, everyone wants a piece. However as with all speculative investments be it property, stocks or derivatives there is always dips when money becomes tight and people need to get out and art will be no different, even if we can't see it now. 

Will a Laura Sykes piece be worth the same as an Andy Warhol in 40 years?

  Know what you're investing in

                  My being corrected on the value of art only served further to demonstrate that where one person may see a house as a dwelling or an option as protection, there are others who see the speculative investment prospects in such tools. Whilst I might like a nice painting to decorate my flat, I won't be out there buying art in the hope it'll be worth 200 fold in 20 years time. However that's because I don't claim to understand it. I accept that there are others that do and have the potential resources to take advantage. The truth is derivatives as an investment type isn't much different from any other asset. They all started out as a use for a more practical reasons and are now further tools to make money for those willing to risk it. Just because we don't understand something, doesn't mean there can't be financial benefits to it, but just make sure what you're sticking your money into you do understand. That's the mistake that people make.

               

Are we living life in a bubble?

                       Debate is currently raging amongst the many market commentators and economists as to whether or not we currently sit in the middle of an asset bubble driven by the Quantitative Easing being pumped into the market by the Fed. The US has seen the S&P 500 hit new all time highs in recent weeks over 1,800 as the exuberance shows no sign of abating, whilst the FTSE 100 is up 14% for the past year, up over 60% from the depths of 2008. Meanwhile you have companies like Twitter doing an IPO and seeing a price rise over 55% from the IPO level a month ago, despite not having ever made a profit. In fact it lost $80m last year and has already lost $133.9m for the first months of this year. At the time of it’s IPO it was valued at roughly 43 times its revenue. Of course the purpose of investing in a loss making company like this at IPO is that you are there to take advantage of the fact that you believe the company is the future and will really profit in the coming medium term.

             However, there are many who believe that it is a dangerous sign of a repeat of the perils of ‘99 where tech companies where sold off for increasingly nonsensical levels which ultimately resulted in the crash, the levels of which most market indices have struggled to get back to. Meanwhile, they argue that the prices of other companies are vastly overpriced already as investors pile their money into equities as a result of the belief that with QE that this is the only viable place to get a good yield and that the money will keep on coming so prices will keep on rising. There are those that think if you’re looking for a quick buck, then stick it into the current market and you’ll be alright because all you have to get out before it crashes. It’s all beginning to sound very much like the mentality of a bubble.

Performance of FTSE100 vs S&P500 since Nov 2008

                  So is it going to burst? With all the talk of tapering some markets have already started to see a retraction in prices, mainly in emerging markets, as investors begin to pull back funds from there which they may have borrowed to invest as the cost of investing increases. It would appear to many that for all the money pumped into the economy from QE, it has mainly acted to increase asset prices without having any real effect on the economy. However this is to ignore some fundamental truths. In his most recent letter to his investors, Niels Jensonfrom Absolute Return Partners makes the point that but for the use of QE, GDP would most likely be between 5 and 15% below its current levels in the US. The UK I’d imagine would be in a similar boat. That is quite a substantial figure to recover from and we would most likely have been in a depression the likes of which we would struggle to recover from for many, many more years. Just look at Greece and the struggles it is having with its economy roughly 25% below its peak before the crash. However, as Niels Jenson also argues, the positive effects of QE have reduced steadily in each phase, including its impact on asset prices. I’ve mentioned before that the Fed needs to begin its taper as soon as possible in order to help investors wean themselves off the easy money, but also to continue to try and keep real interest rates close to their current levels. For this to work it of course requires the market to truly believe that the Fed will not adjust their base rate too soon. A lot of commentary on the incumbent Fed Chief, Janet Yellen, is that she will work to use forward guidance and reduce the threshold unemployment level required before rates will rise to 5.5% and then even 5%. This should hopefully indicate to markets that rates are likely to stay low for a further required period while the economy continues to recover and reduce any panic which may occur should tapering begin soon.

                    Where does this all leave investors as to whether they should or shouldn't put money into equities? In one of my earlier articles I spoke about the thin line between speculation and gambling and how, in the current market, trading on a daily, weekly or monthly basis is, per the textbook definition, a gamble. The risk is just too hard to really assess versus the potential return. Investors need to have a proper plan as to what they are looking to achieve. Just under 9 years ago I wrote my Masters dissertation examining whether investing in value strategies in the UK really outperforms investing in pricier stocks once you account for the extra risk involved. A value investment strategy involves buying companies who have lower fundamentals compared to other stocks. For example, low price-earnings ratio, low price-cash flow ratio or low market value to book value. The research did find it was possible to invest in a portfolio of value stocks and make superior returns over 1, 3 and 5 years without any extra risk being involved, however in order to make it work you needed to invest in a portfolio of the 200 value stocks, a pretty large financial commitment for any individual investor.  But it does show it is possible to find opportunities without having a greater level of risk, so long as you are prepared to invest for the medium to long term. But to select just a handful of these “value” stocks and gamble that they would be the winners is to misunderstand the realities of investing.

                Of course, quite possibly the greatest investor of our time began life as a value investor.  The difference is that Warren Buffett doesn’t just look at the basic fundamentals but has always spent time understanding the company itself and most everything about it in order to determine whether a potential investment was underpriced in the long run as opposed to a company being in a permanent downturn (or worse).  Buffett’s company Berkshire Hathaway only holds stakes in about 50 listed companies globally but the likelihood is all these decisions have involved careful focus on the business as well as looking at market fundamentals indicating undervaluing. Buffett’s record over the last 60 years has proved that it is possible to pick substantially more winners than losers over a sustained period of time. The most remarkable thing about Warren Buffett is that he is very open about how he decides what to invest in, seemingly making it easy for the rest of us to just follow his mantra. Such a method should give us the reassurance in the current market to continue to invest in undervalued stocks even if a bubble is in existence. The reality is that the vast majority of investors have neither the patience nor discipline to follow in the Sage of Omaha’s footsteps. He however makes sure he invests for the medium to long term in most cases.   

               Therein lies the lesson to us all. Investing in equities must be done with a realistic long term view in mind, in terms of both the businesses we’re investing in and the timeframe we’re prepared to wait for our returns. Looking for a quick buck plunging capital into the latest fad may all sound great to everyone, but who really has the foresight (or is paying enough attention) to know when that fad is at an end before it’s too late. We all want to be the one who makes the superior investment call, but often it’s better to just make the average investment call. Investing in a market index fund or ETF in the knowledge that it may soon go down, but should go further up in the long term. It may not be exciting, but at least you know you’ll be average.

So are we in a bubble which is about to pop? Quite possibly.

               Is it going to pop because of tapering of QE? Not unless the real economic fundamentals which asset values should be based on drop back at the same time. We may see an initial pullback from the current highs we’re seeing in the initial phases following a taper, but the likelihood is that we will continue to see the current levels sustained (if not increased further) so long as the economy continues to progress. We’re a long way off seeing a full recovery just yet, but so long as things don’t get worse again there is no need to panic.

And what if the bubble does burst before it’s fully formed? Then make sure now you’ve made the right choices for your time-horizon so you can weather a couple year storm. Otherwise now is the time to remove that gamble before it’s too late.

Divergence in global monetary policy could see the Eurozone left behind

                   There's not much that takes the majority of the market too much by surprise these days. The complacency that the US politicians would reach an interim deal saw markets keep their calm in the lead up this time before rising steadily since. The lead up to most interest rate (or tapering decisions) on a monthly basis is already met with economist and analyst expectations predicting in the majority what the likelihood of the decision would be, generally days before the announcement, with the various markets pricing it all in. So last Thursday, with both the BoE and ECB predicted to keep the status quo in their respective announcements, there was no reason to think any different. After all, only 3 out of 70 economists that Bloomberg surveyed felt the ECB would reduce the base rate on the Euro this month. But they hadn't accounted for Super Mario Draghi and his mates.

     To the shock of many, the ECB decided to act sooner than predicted and promptly lowered the base rate on the euro from 0.5% to 0.25%. The ECB felt forced to act as inflation has plummeted from 2.2% in January to just 0.7% this month (it was as much as 1.6% in August). With such a sudden decline in just a short period of time, the spectre looms of potential deflation and Super Mario felt the need to act now before it was too late. The euro instantly dropped over 1.5 cents against both the dollar and pound.

       Whilst for most people the idea of no inflation sounds like a good thing (after all doesn't it mean things start to cost less?) on the whole broad deflation, if sustained, can be worse in many ways than a higher inflation rate. Robert Peston goes into the consequences of deflation (as well as the impact of ECBs cut on the UK) quite well in his blog on Thursday and it is worthwhile read. As he describes "If businesses and consumers began to believe that deflation was a serious prospect, they would defer purchases and investments to take advantage of falling prices.........there would be an even greater incentive for businesses, households and banks to reduce their debts - to save as if there's no tomorrow - because of the threat of deflation increasing the real burden of those debts"

               If you believe the price of something is going to reduce, then you will wait for it to cost less before you buy it. Of course if you delay too long on your purchases then the economy itself will suffer as companies begin to stutter again as they struggle to cover their costs. They will then seek to reduce costs, which itself could be a reduction in staff or reduction in wages paid to staff, again reducing the income the population has to spend on items further depressing the situation. Meanwhile, in a similar vein that the value of money becomes less over time due to inflation, the opposite is true during a deflationary period. Any debts will begin to increase in value, unless they are paid off, and people will be tempted to put all their money under the mattress to save for when things become even more affordable (and avoid suffering deflation on investing it). The more money stored and saved up by people and companies, means less money spent on investment of any kind which ultimately becomes detrimental economic growth. Once deflation hits, the downward spiral it causes can be difficult to find a way out of, as Japan has found over the last 2 decades.

                 Given how depressed the Eurozone economy has been over the last few years, especially in the periphery, it might come as a surprise to many that the ECB has waited so long to drop it's base rate. The policy direction of the ECB now however points to significant divergence between the 3 main western monetary policy makers. In the US, talk continues apace about the possibility of the Fed beginning their taper of QE as early as December as GDP looks like growing over 2.5% for the year. Meanwhile the UK's economy continues to speed up with some analysts predicting it will have shown an increase of over 3% for the whole of 2013. Meanwhile the UK has not introduced any additional QE stimulus from its targeted £375bn total it has had for many months and the most recent forward guidance from Mark Carney had indicated the status quo would remain for at least another couple of years. Should the UK continue on it's current trajectory there is every possibility that the Bank of England may feel the need to tighten sooner, especially should inflation also continue to remain close to 3%.

                   The recovery in both the UK and US is however still tentative. In the US, the continuous threat of no real resolution on the US budget deficit and debt ceiling overhangs any recovery. Whilst here in the UK further failing retail companies (with Blockbuster and Barretts amongst the latest to go back into administration) show signs that we're still not out of the woods. However at least compared with the Eurozone there appears to be some form of recovery which can be used as a platform to move forward. The lack of real performance across the eurozone makes it a realistic prospect that rates in Europe will not only remain even lower for the foreseeable future but the ECB may need to rewrite the rulebook as a last ditch action to prevent deflation if the latest rate cut fails to work.

                 This may be easier said than done, if the Germans decide to put their foot down. Germany is especially fearful of the consequences that inflation, and specifically hyperinflation could result in, which is understandable given it's own fight with it in the 1920s and the devastating ultimate consequences of that. Whilst a focus on history can be useful in helping to make wiser decisions, too much obsession in attempting to relate history to the present can be to the detriment of the present and future. The ECB has already shown itself to be sluggish to react at times to it's recent troubles acting with caution where it's fellow central bankers abroad have been more decisive. Germany will need to accept that being part of a union requires accepting what is best for that union as a whole. The ECB has tried to act quicker this time to ensure it will stop deflation before it is too late and hopefully help stimulate the eurozone recovery as an additional consequence. Any further dithering resulting from internal national differences may not only see the eurozone left behind in any recovery but worse still could drag the US and especially UK economies back down with it.

It is not the fall, but the landing that counts

"This is the story of a man falling from a 50 story building. As he falls, for reassurance he repeats:
'So Far, so good. So far, so good. So far, so good'. 
How you fall doesn't matter, it's how you land." (Hubert, La Haine (1995))

            The opening lines from the excellent French film La Haine are said by another character, Vince, to describe society in free fall. Whatever metaphor the director was trying to demonstrate, for me the man falling resembles market reaction and some political attitude to the impending hitting of the US debt ceiling.

                  October 17th is the date given by the US Treasury that the US will hit the limit of it's borrowing unless Congress approves an increase in the debt ceiling. But with no compromise forthcoming that scary possibility is beginning to increase in likelihood. Yet despite this impending potential default on US debt, market reaction has been relatively muted compared to what you might expect with the risks attached to such a scenario for the worlds largest economy and so called safest asset.

                   The S&P 500 is only down 1.8% since September 27th and sits just 3.7% below the record high of 1,725 reached on September 18th. 10 and 5 Year Treasury yields have actually fallen over the last couple of weeks by 4 and 6% respectively to 2.65% and 1.41%. The 3 month t-bills have seen their yields spike by 400%, but this is to a yield of just 0.05%, hardly the sort of yield you'd expect to see charged to a country potentially 9 days away from default. This is the same market which back in June pushed the S&P down 4.8% in a week, and pushed 5yr and 10yr yields up 41bps and 35bps respectively just on the hint of QE being reduced. Meanwhile the current 5-year US Sovereign CDS spread (effectively the cost for an investor to insure against US default on the 5-year bond) sits only at a cost of 35.5bps, slightly above that of the UK. We're falling down the building, but 'so far, so good'. Perhaps the first sign of real panic was seen yesterday in the 1 month t-bill yield which doubled to 0.27% from the previous day, having been only 0.01% on 20th September, perhaps investors seeing the impending floor below, but again not the sort of premium one would demand on an asset potentially close to default.

                   The truth is the attitude of 'so far so good' from the markets, and from certain Republicans who view that hitting the debt ceiling is no big deal itself, could be seen from the point of view that they think they're looking at the boy who cried wolf. After all, we've been here before. In July/August 2011 a similar crisis ensued only to be averted at the last minute through negotiations between Obama and Republicans, while at the end 2012 hitting the debt ceiling was avoided through the budget sequestration enforcing fiscal cuts. Back in 2011 the market only fell through the floor in the last week with S&P 500 dropping 9.9% in the last 8 days of the crisis, but even then, the 1 month bill peaked at a yield of only 0.16% and investors actually bought more long-term treasury bonds as "safe assets". It is perhaps this failure of the markets to panic which is encouraging Republicans from not backing down from their stance, even while the President and Treasury Secretary correctly indicate that a default on US debts would be catastrophic for both the US and world economies. After all, if the market "professionals" aren't really panicking then surely it's no big deal?

                      Part of the issue is no one is quite sure what will happen if the debt ceiling is reached. The US is unique among sovereigns in that there is apparently no joint default clause in their bond issuances. This would mean should the US fail to pay investors on bonds maturing at the end of October, they would not be declared in technical default of their other bonds. Meanwhile having been close to this point before in 2011, the Treasury could have methods up it's sleeve to ensure any sovereign default is delayed for as long as possible by prioritising payments (as Republicans seem to think). After all, in most organisations, when you come close to disaster, and that disaster could occur again, you then should ensure you have a plan in place to mitigate that event in future, as best you can. Payments could, for example, be made to the bond holders first with delays on social welfare payments, so at least in the eyes of investors and the ratings agencies then the US is still good for it's borrowings. An interesting article from FT Alphaville however indicates that the Treasury may not necessarily find it so easy with their infrastructure to do this prioritisation. The Treasury of course isn't going to reveal it's plan in public, especially from a political perspective, to give the Republicans any more reason to believe it is not a big deal so they can continue to hold out. There are also suggestions the Fed could intervene, as it was specifically designed to prevent financial crises and has powers under an 'exigent circumstances clause' to do whatever is in it's power monetarily to prevent disaster. This could include buying existing bonds from the treasury for funding purposes. All of this however is pure speculation and it should really make us worry that we're here, again.

                        The reality is, that even if any of the above measures delayed the US from default for the few days extra needed to reach agreement the damage caused would be hard to reverse, if it could be reversed at all. Goldman Sachs estimate that a failure to raise the debt ceiling and the resulting fiscal pullback could reduce annual GDP in the US by 4.2%. To put that in perspective the US is currently only growing at a year on year growth of 1.6% in the last quarter. Even if the US prioritised making payments to bondholders as opposed to other expenses as suggested, whilst it would not put it in sovereign default, it's inability to make payments to those it owes would severely damage it's credibility. As with any business that fails to make payments on time, it would make all it's creditors less trusting to lend to it in future for fear that they would be next. The interest rate demanded of the US treasury, already on an upward trend over fears of tapering, would be pushed up even further as investors would demand a higher risk premium for holding an asset seemingly constantly on the brink of default. The credit rating agencies of Fitch and Moody's who have yet to downgrade the US, would also most likely reassess and could follow their peers at S&P in imposing a ratings downgrade. Further downgrades could force many organisations such as money market funds to dispose of their treasury holdings as they are obliged to hold higher quality assets, whilst the use of these assets for collateral on derivative contracts may also have to be reduced. This forced sale of treasuries would push the price down and yields up, further increasing not only the cost for the US to borrow, but also having a knock on affect on borrowing costs for everyone wishing to borrow in US dollars. The view of the US dollar as the reserve currency and US Treasury Bonds as the risk free asset could ultimately be called into question. To paraphrase Hubert, it's not the fall that matters, it's the landing that counts.

            All of this says, that putting such an important economic matter as the ability to increase a country's debt, into the hands of those who seemingly have no real grasp of basic economics and it's consequences, is, as Warren Buffet suggested, akin to threatening to set off a nuclear bomb on themselves. We wouldn't do that, so we shouldn't use the debt ceiling the same way. Not that Obama can claim the moral high ground here. There is no better example of the pure politicising of this tool than from the words of Obama himself as a senator back in January 2006 opposing the debt ceiling increase then:

“The fact that we are here today to debate raising America’s debt limit is a sign of leadership failure. It is a sign that the U.S. government can’t pay its own bills. ... I therefore intend to oppose the effort to increase America’s debt limit.”

Obama now obviously says he regrets that action as a naive new Senator, but it is an example of why many naive Congressman shouldn't have such a power. We shouldn't have to wait for them to get into the Oval Office or their party into power to realise that this is not something which should be used and abused for political gain. Compromise needs to be reached and fast and then this pointless tool should be taken away from the irresponsible. 

            But instead both sides wait, neither wanting to flinch. It reminds me of that superb advert for Guinness back in the 1990's of the surfer waiting for the perfect wave and the words quoted out of Moby Dick. The tagline for Guinness of course is 'Good Things Come To Those Who Wait'. Not however when you're falling from a 50 story building. Markets are very soon going to realise that we're about to hit that floor as they look down. If we do hit the floor it's going to impact us all, possibly in a way far worse than the recession we're just crawling out of. Waiting is not an option, its time to pull the parachute chords. How you fall doesn't matter, it's how you land.

Sometimes an open roof is a good idea

 

    Denmark and the United States may not be comparable in terms of the sizes of their economies, but they do have one unique bond - they are the only 2 developed countries to have a debt ceiling. As I write this, the United States is caught up in political wrangling in Congress over the annual budget which, if not resolved imminently, could result in the non payment of interest on government debt, effectively putting the largest economy (and the world's "least risky" asset) in technical default. 

                 Most governments simply issue debt when the cash coming in from tax collections is insufficient to cover the bills coming due from government spending. Both the United States and Denmark however have put a dollar limit on how much debt the government can issue. This legislative limit is decided by Congress on an annual basis and the national government debt cannot exceed this level. Should this ceiling come close to being breached without being raised, as it is now, then the federal government will have to act to immediately cut expenditure to prevent such a scenario until agreement is reached on raising the limit. Such "extraordinary measures" may include the temporary shutdown of certain government run institutions. The internal revenue service (IRS), for example, could stop responding to taxpayer questions by phone while the services and activities of some other bureaus could be halted completely. 

              The idea of an absolute debt ceiling in the US came into being in 1917. Prior to that, Congress was required to approve the issuance of every additional US Treasury Bond. By passing the debt ceiling law in 1917 it enabled the federal government to issue bonds without the approval of congress so long as the total issuance remained below the preset amount. Upon approval of the budget each year, Congress would then also pass legislation increasing the size of the debt limit to allow for the additional borrowings required. This of course was never meant to be used as a political tool to hold a government to ransom and would have been seen at the time as an adequate way for Congress to keep tabs on the federal government's debt, without the need to approve every additional issuance required. This in effect is where the Danish and US models diverge. 

                 In 2010, after the financial crisis caused a large increase in government debt, the Danes reacted by doubling their existing debt ceiling, which was already far above the existing debt, to a level 3 times the debt required at the time. By doing this they ensured that there was no scope for the ceiling to limit the ability of government to function, as is currently at risk of happening in the US. 

               This is not the first time political stalemate has pushed things to the brink with no fewer than 17 funding gaps required to avoid the ceiling being breached between 1977 and 1996 alone. As recently as 2011 the US was on the brink of having to default as party politics pushed things to the wire, before a last minute temporary agreement increased the limit to a level sufficient for another couple of years. At that time the risk was deemed so great that S&P became the first credit rating agency to downgrade the US from the top ranking of AAA to AA+. Ironically, despite the downgrade, treasury yields fell as investors still flocked to the US as the safe haven (Although even S&P have questioned whether investors should pay attention to their ratings!).  

               The US debt ceiling currently stands at $16.7 trillion and most estimates believe this figure will be hit by mid-October. As a percentage of GDP, US debt is around 101%. Both of these figures could be taken as a reason to worry and indicate that potentially a ceiling and getting things in shape might not be a bad idea. However as mentioned in the article on austerity there is no substantial evidence to suggest that a debt ratio of this size is a restriction on the US economy. An increasing size of US debt, for now, is likely to be sustainable for the US due to it's ability to control and issue debt in it's own currency, nor is it having an inflationary impact at present with inflation continuing to remain well below the target 2% level. The US economy is also moving forward with it currently expected to grow at an annualized rate of 2.5% in the 4th quarter according to some estimates. 

             However Moody's Analytics chief economist predicts that a US government shutdown lasting just 2 weeks could reduce growth a 2.3% annualized rate, while a shutdown for 3-4 weeks could result in a 1.4 percentage point reduction to a rate of 1.1%. The common perception is that a last minute deal will take place before the US comes to a situation of default, but these figures indicate that the government shutdown required just to get to mid-October would in itself cause bad damage to an economy which is only just getting going. It seems very clear that for the sake of pushing, or not pushing, through the US healthcare bill, that politicians on both sides are willing to "play chicken" with the US and in effect the global economy. This in itself shows an irresponsibility of all the politicians involved. I'm not going to make a political statement on whether the Republicans or Democrats are right in their views on the Affordable Care Act, but differences on these issues should not be used to put a whole economy and economic recovery at risk. One can only hope that the politicians involved come to their senses. 

              Of crucial importance once any decision is reached is to remove the possibility of such a scenario happening again. This should be done by either removing the debt ceiling completely or, following Denmark's lead, acting in a bipartisan manner to set it at a level far beyond that which could effect the day to day running of government. There is still plenty of scope then for party politics in the US to disrupt the Affordable Care Act or any other piece of legislation should they so wish, but at least with an open ceiling, or with a high ceiling, such divergent issues won't impact the essential requirement of the Treasury to pay the bills which already exist. 

"There is something rotten in the state of Denmark" remarked Marcellus to Horatio in the first Act of William Shakespeare's Hamlet. Perhaps if the bard was around today he would be tempted to look to Capitol Hill for inspiration, as modern era Denmark on this occasion has shown the way. Let us hope the US has the sense to follow.   

Another day in September to remember, but how long to forget?

 

What is it about September and October?

Maybe it's the thought that it's straight after the end of the holiday season. The realisation sets in that the next real break from it all is still over 3 months away. Maybe this then leads to an early onset of the "winter blues" and a fear of armageddon as the days draw ever shorter and the weather ever colder. Then every now and again this end of days fear results in an end of days moment. Whatever the reason may be, September and October have proved to be the dark days through history for the economy and the markets, the time when everything seems to just come to a head.

• September 18th 1873 - Black Thursday - triggering the panic of 1873
• The Panic of 1907 reached a climax in October.
• October 24th 1927 - Black Thursday - and October 29th 1927 - Black Tuesday - saw the great Wall Street crash and the onset of the depression.
• October 19th 1987 - Black Monday - when global markets collapsed and the Dow Jones fell over 22% in one day.
• 16th September 1992 - Black Wednesday - when an attack on sterling by speculators forced it to withdraw from the ERM.
• 15th September 2008 - Lehman Brothers declares bankruptcy causing global market panic and the onset of the Great Recession.

                The most recent of those days is approaching it's 5th anniversary on Sunday and we are still scrabbling around hoping we are moving beyond the green shoots of recovery to a more stable global economy. As many commentators have written, that fateful day in September was not the cause of the current financial crisis, but it pushed it over the edge as the fear that gripped threatened to collapse the whole financial system and with it the world as we knew it.

                Even in hindsight that moment was not inevitable for those on the outside or the inside of the firm. The moral hazard had been set by the Fed assisted bailout of Bear Sterns by JP Morgan and the government bailout of Fannie Mae and Freddie Mac as well as others. The market anticipated the same result for Lehman even as it sent its share price plummeting ever faster towards zero. Even on the Friday before there was seemingly a knowledge for those of us inside the firm that we would still be walking through the same doors on Monday morning, it was just very likely we'd be working for new masters. Barclays and Bank of America we were told were the suitors and one of those was likely to take over by the end of the weekend. The Fed was calling all the heads of the major banks together to work through a solution which would save the company from bankruptcy in a way which would prevent an outright collapse in the markets. This had happened before when the behemoths of the financial world had got together and worked to ensure the world kept turning. In 1907 the eponymous banker JP Morgan had locked all the chief financiers of the time in a room until they came to a solution to bailout the Trust Company of America. In 1998, as the hedge fund Long Term Capital Management tinkered on the brink of collapse, threatening to drag others with it, a similar plan was drawn up for all the major banks at the time to cough up the money to stave off the $3.625bn collapse (intriguingly also in September!).

             This time however it was not to be. No agreement could be reached in a weekend as to how to save the firm or how to unwind it in an orderly fashion. Bank of America went to Merrill Lynch's rescue, stepping in before they could become the obvious next victims, whilst Barclays (whether stopped or not by the FSA at the time) decided against buying the firm and instead picked up the New York side of the franchise post bankruptcy, the piece they most desired. Lehman Brothers was thus left to file for the largest bankruptcy in history ($681bn if you're interested, 5 times that of Worldcom the previous largest) sending the financial world into chaos as the house of cards began to collapse across the globe. Governments were forced to act to stop the rot immediately and ended up acting to save the majority of financial institutions through the very bailouts they sought to avoid giving to Lehman Brothers. The markets plunged all around and the supply of credit ground to a halt as every institution was afraid to lend fearing their counterparty was next to fall. (As for me and the rest of the Lehman employees on that Monday morning, we were left to scratch our heads (or mostly hold head in hands) walking out the building with boxes of belongings (whose belongings in some cases is questionable!) wondering where we would go to next. Some of us got lucky while others didn't. But I'll save you the personal stories and recollections for a later age when I feel fit to write my memoirs.).

           Now that we're 5 years on from that headline event of the financial crisis, the question on everyone's lips is could it happen again or are we doing enough to stop it. 

           For the majority of the populations of the countries affected there is a feeling of animosity towards the banking industry as governments from the UK, Iceland, Ireland, the US and many many others were forced to pump trillions of dollars (that's thousands of billions) into the banking industry preventing it's collapse. There's no doubt in my mind that the actions of both governments and central banks were necessary to avoid the world hurtling towards another great depression. That these actions themselves may have created a moral hazard for the future remains a fear. 

         The banks themselves still remain leveraged to a degree which, in the result of a similar withdrawal of funds from the bank due to some panic, whether by retail depositors or the withdrawal of short term funding (as was the case for Lehman and Bear Sterns), would still leave them needing rescue either by peers or the government. Lehman was leveraged at it's peak by 44 to 1 (Goldman and Morgan Stanley at the time had ratios in the 20s or 30s). Whilst now Morgan Stanley is estimated to be leveraged 14-1, a drastic reduction, a similar sudden shock for them would leave them desperately scrabbling around for further capital. They are not alone in this respect. Under banking regulations known as Basel III, proposals have been drawn up for banks to increase the amount of assets they hold and the strengthen the quality of those assets, but it will take several years for many banks to get to those levels and it's effects, at least in the short to medium term, may serve to curtail bank lending at a time when the economy would benefit from increased lending. Barclays, for example, recently announced rights and convertible bond issuances to help raise £8bn of the £13.8bn pounds they require to get to the required levels, as well as talking about reducing its balance sheet.  

                 What about one of the other major causes - the use of certain derivatives and their inter-connectivity in the market? Even here global regulators are struggling to come up with robust rules to try and ensure there is enough regulation and tracking of these products that it is easier to ascertain who holds what, where they hold it and, if the music again stops, which firms are going to be left with the toxic time bomb this time. Each region has been working hard to draw up their own rules and try and make them as coherent as possible. The Dodd-Frank Act passed in the US has tried to ensure all derivative transactions are centrally reported on the day of transaction, whilst also seeking to settle more and more OTC derivatives, such as Credit Default Swaps, through centralised clearing houses. The idea with these requirements is to increase the transparency of trading in these products and to reduce counterparty risks by having them settled through a central area where netting can be carried out if needs be in the case of disaster. The European Market Infrastructure Regulation (EMIR) seeks to implement a similar exercise in Europe. Both these pieces of legislature go some ways to improving the risks imposed by certain forms of derivatives, but there still remains doubt as to whether this will prevent issues caused by the more complex financial products similar to those which played a part in the crisis. Financial innovation has and will continue to play a part, and in most cases an important part, in providing new ways of financing and hedging for companies and banks alike. Some of these will seek to find a legal way around tax, accounting or other regulations. The relevant authorities, be it the PRA in the UK, CFTC or SEC in the US or the EU bodies, will need to ensure that they keep apace with developments in the market to seek to understand the products as and when they evolve. They will need to act to amend legislation at the time the products are in their infancy to ensure future risks are mitigated long before they happen.  

              The banks themselves of course having been bitten so badly and left with so many bad debts are also ensuring, for now, that those they lend to will on, the whole, have the ability to pay it back. The idea of lending money to someone with no income, no job or Assets (NINJA) is at this time a thing of the past and one which banks are unlikely to want to take up again in a hurry. Meanwhile discussions continue apace globally about what further measures to put in place to ensure banks don't end up in a similar situation again. 

                 It is a slow process, but gradually the pieces are coming together to help reduce the likelihood of the same mistakes being made again. Therein however in the solution and the potential solutions lie the answer about whether this could happen again. The authorities can look back at the last crisis and its causes and devise many ways in which to mitigate it happening in the future, but it is very hard to put in place laws which will restrict the next crisis from happening when, as Donald Rumsfeld might put it, it is likely to be an unknown unknown which triggers it. One of the main factors in the cause of the crisis which is very difficult to mitigate against in the future is the one which links many of those affected and involved in the crisis, that of greed. Greed is a human trait which has become more and more prevalent in human society in the 20th and 21st centuries, the need to want more. Whether it was in the banks seeking to sell more and more products to inflate profits and bonuses, or the man in the street seeking to borrow money they couldn't afford to buy a bigger house or car, the wish for more of the good things in life even when it should be beyond our reach is ultimately what pushes things over the edge. The truth is if the roles of the 2 examples before were reversed both would still act in a similar vein, it's unfortunately part of most of our natures. 

            This crisis and the housing bubble in it's lead up were no different in that respect to any of the previous bubbles. Whether it was the dotcom bubble, the tulip bubble of the 17th century or the recent property bubbles, bubbles form because people see an asset rising steadily in value and they want a piece of the action and get "their share" of the profit. The issue with a bubble is that most can't see it ending before it bursts and as a result plenty get burnt. This time the fire was hotter and more people got burnt as a result. The consequences of the 1929 crash and the depression remained etched in the memory for decades precisely because the repercussions were so immensely bad. The solutions put in place at that time eventually did the best to ensure the same wouldn't happen again, although it took a long time to find the right solutions. After a long lapse though inevitably more bubbles came and went, even if not to the same extent, as the memories faded and the exuberance returned. 

                The response and speed of response to the current crisis have meant, so far, we've not been faced with another great depression. As markets already look to have bounced back, and house prices rise again, the fear becomes that it won't take long to forget the excesses of 5 years ago and the bubbles will return, spurred on by the greed of those that have already forgotten. It won't be the same as before, it rarely is, and we can hope that the remedies put in place this time can stave off a similar size of crisis for the foreseeable future. Eventually though, memories will fade of the consequences of the past and there will be further boom followed by just as great bust. That is capitalism I'm afraid and all that can be done is to try to soften the blows that arrive, preferably before they arrive. But even when it does happen again, we still may never know for certain why the darkest financial days seem to occur as the sun itself begins to fade. 

Should the markets fear conflict in Syria?

            

                 As the US and other nations size up whether they are going to bomb Syria, potentially risking a wider regional war, equity markets took fright last Tuesday and recorded a 1-2% drop across Europe and the US as this prospect looked an inevitability. Oil began rising quickly over the fear any conflict could affect supplies whilst some investors began going long on Gold, the traditional safe haven, pushing the price up. Whilst the immediacy of any action has reduced slightly over the last couple of days, leaving markets to concentrate on the economic recovery and Fed tapering, the likelihood is still there that some form of action will soon be upon us. The market slide on Tuesday got me thinking as to whether investors really weigh up the implications or they just automatically sell at the fear of war.

                          As with all events, investors want to make sure they are betting on the right side. In 1815 Nathan Rothschild posted his own messengers on the battlefield of Waterloo in order that he could know as soon as possible who the victors were. In fact his messengers arrived back to London a full day before the official British messengers enabling him to take advantage in the markets (although the extent to which he profited from this event versus the losses he occurred on other long term bets is disputed). Nowadays traders get real time information (and misinformation) direct from their Bloomberg terminals and 24 hour news channels with the likelihood for any competitive advantage significantly reduced. But is there really the need for investors to fear action in Syria or is any sell off in advance of military action a pointless gesture when measured in it's real impact on the fundamentals in the market?

                                   In the more recent past, evidence seems to suggest the economic impact on the main western economies of military conflict is relatively minor. The economy appears to plug along regardless of what the military forces of the UK, US or France might be involved in and the initial market fear is usually quickly erased. It is of course difficult to completely isolate the impact made by conflict, and the other consequences of those actions, on the market itself, but it is useful to look at how the market performed during similar military confrontations over the last 25 years. The market reaction to military intervention in general tends to show a similar pattern of showing fear (even if limited) in the lead-up, but by the time the bombing or conflict begins the impact has been weighed up as ineffective on the wider economy and so investors carry on as normal and return to focus on everything else. In the days leading up to NATO bombing in Kosovo, for example, the S&P 500 fell 3.4% but this level was recovered within days. With the Iraq War in 2003 the S&P 500 saw a fall of 9% between the day in October 2002 that the Senate passed a resolution authorising force in Iraq until 11th March 2003, a few days before the start of the conflict. This was entirely reversed however just over a week later by the time the conflict actually started on March 20th. Meanwhile the impact of the start of bombing on Libya in 2011 on the market was virtually no reaction whatsoever. Whilst the S&P 500 was seen to be down as much as 13% during the course of the Libya campaign this was due to the ongoing economic issues from the recession and bore no impact from the consequences of military action.

                    So if the recent past seems to indicate limited impact from the involvement of the US and UK in the end, why then are we seeing market jitters at the hint of action (from the US even if the UK opts out)?

                      As always with the market, it's the fear of the worst from some, and the fear of missing out (FOMO - more technically known as herd behaviour) of others not wanting to get left holding the the wrong assets should things deteriorate, which is causing the additional drag. There is no doubt that there are substantial risks associated by any Western attack on Syria, the main one from an economic point of view being the potential for regional destabalisation, in particular the involvement of Iran. Syria itself has limited impact on oil supplies, but should Iran feel the need to get directly involved (as opposed to using proxies such as Hezbollah) it could potentially disrupt oil supplies in the Straights of Hormuz which in itself would force the price of oil up further. This increase in oil price, especially for a sustained period of time, would put pressure on the economic recovery across the globe and would also directly hurt households with increased petrol and heating costs potentially right as winter approaches. The First Gulf War back in 1991 had a similar impact in it's lead up following Iraq's invasion of Kuwait on 2nd August 1990. Back then spiraling oil prices actually pushed the US back into recession with equity markets also falling up to 16%. The downturn was however shortlived with markets recovering within 8 months of the initial invasion by Iraq once the conflict had started, while the oil fears were reduced by Saudi Arabia providing additional supply within a couple of months of Iraq's initial invasion.

                        The lead-up to the 1991 Gulf War can be seen as an example of where the fear of the worst can itself have drastic consequences, even when the end result from the conflict shows those fears as being overblown. With the markets returning to their levels before the invasion within a relatively short space of time for such a steep decline (16%), investors who would have panicked and sold equities in fear on the downward spiral and only gone back in once the war was over, as I'm sure several did, would have suffered financial losses as a result (in addition to their costs of having to execute the transactions) as opposed to those who held on in anticipation of a swift recovery.

                    The benefit of hindsight is always wonderful in these situations. The world at that time was only just out of the cold war, and had recent memories of the effects of the oil crises of 1973 and 1979 to drive it's fear that the effects of conflict with Iraq may not be as short and successful as it turned out. Saudi Arabia itself after all was seen as a next potential target as well. More recently however interventions in these conflicts have become more regular, with western intervention to various extents in Bosnia, Kosovo, Afghanistan, Iraq and Libya all coming within the last 20 years, and as we've seen with only relatively brief, if any impact on equity markets. The likelihood is here too that any intervention in Syria will remain brief and localised. There are prospects of Iranian involvement, but again this matters only to the markets in as much that it will disrupt factors which effect the economy. For any medium or long term investors in equity it would seem good enough to sit and watch any market volatility in the lead up to conflict, in the knowledge that markets will revert once it becomes apparent there is no real economic impact in the West. The real focus from an investors perspective, should be whether the current levels of growth will gain speed, that too will become more apparent in the coming weeks.

Method in the Madness

"Though this be madness, yet there is method in it" - Polonius in William Shakespeare's Hamlet, referring to the eponymous hero.

         Global markets have been on a slow (or in the case of emerging Asian markets quite fast) downward trajectory over the last week or so as the world gets itself into a panic that the Fed might be beginning to taper. I've discussed before the seeming irrationality to most of us of this flight from risk at the precise moment when the Fed is indicating to us that the life support will only be reduced on signs that things are recovering. And as more good news from the US seems to indicate that the tapering might start as soon as September, global equity and bond markets have seen a flight out of these assets with the fear of what might happen next seemingly reducing investors appetite for risk.

        In my first post a couple of months ago, I raised the possibility of whether central banks had created an inescapable cycle. I questioned whether the low interest rates and QE stimulus had driven the equity market rise, and the possibility that any removal of this stimulus could lead to a fall in these global markets with a potential impact on the real economy as a result, thus forcing a return to further stimulus measures. This seemed to show some elements of truth based on the market reactions to Bernanke's various comments on tapering and following positive economic news in the US, with global market sell offs at each point. 

             The popular theory at the moment is that the tapering by the Fed is going to begin in September, especially with the encouraging GDP and job figures over the last few weeks. The market, anticipating this, has seen 10 year US treasury yields up at 2.88% and a fall in the S&P 500 and other stock markets around the globe. However whilst the fall in equity markets in emerging economies such as Philippines, Thailand and Indonesia has been quite significant, the S&P 500 currently only sits 3.8% below the high of 1,708 at 1,645 (as of last night's close). To put this in perspective, this is still 4.5% higher than the level when the market fell shortly after Bernanke gave his speech clarifying his forward guidance policy. So despite the market knowing that tapering was coming, and the feeling that it was likely to begin in September for some time, equity markets in the developed western economies are above the level they were at immediately post the initial announcement. 

            If we work on the assumption that equity markets have already priced in what they know or believe, then the effect of the reduction in QE being used in September should already be reflected in the prices. This is not to say that the market won't react negatively when it happens, but the last few months seem to have demonstrated that once the market digests the news, it will then continue to climb based on the underlying economic fundamentals. These economic fundamentals are, improving GDP growth figures in the US, UK and Eurozone and improving, albeit slowly, unemployment figures in all 3 regions as well. Perhaps the use of forward guidance has already enabled the market to adjust to what is going to happen in the near future, and after the initial panic, the correction appears to reflect the real economic improvement in the economy. If this is the case, then forward guidance is doing it's job. The market is preparing itself already for a reduction in the stimulus, therefore the shock effect when it does actually occur is likely to be less. Assuming the real economy continue to improve as they are at the moment, then the equity market will continue to move forward. 

             Many market commentators are wary of forward guidance, stating it is madness to give firm figures in advance to the market. But if the market has already priced in slowly the effect of a reduction in QE, then from Bernanke's perspective if this be madness, there is indeed a method in it. That method may well be working, but I guess we'll only really find out soon.

A new dawn for the UK, let's hope it's not loonie!

As Nina Simone famously sung

"Birds flying high you know how I feel, Sun in the sky you know how I feel, breeze driftin' on by you know how I feel, It's a new dawn, It's a new day, It's a new life and I'm feeling.......... mildly optimistic"

Well, she didn't quite finish like that, but if she was writing that song in the UK at the moment she might prefer my altered version.

Wednesday marked a new dawn for monetary policy in the UK with the formal introduction of forward guidance as part of the monthly inflation report. I've covered my thoughts on forward guidance being a positive progression before so now it's in place I thought it would be useful to have a quick look at what the policy is.

         In brief the BoE has now indicated it is going to tie it's monetary policy to the level of unemployment in the UK in addition to targeting inflation, but with the emphasis being that inflation must remain under control first and foremost.

In the words of the Bank of England (MPC by the way stands for Monetary Policy Committee of the BoE - those that decide these things!)

"In particular, the MPC intends not to raise Bank Rate from its current level of 0.5% at least until the Labour Force Survey headline measure of the unemployment rate has fallen to a threshold of 7%, subject to the conditions below. 

The MPC stands ready to undertake further asset purchases while the unemployment rate remains above 7% if it judges that additional monetary stimulus is warranted. But until the unemployment threshold is reached, and subject to the conditions below, the MPC intends not to reduce the stock of asset purchases financed by the issuance of central bank reserves and, consistent with that, intends to reinvest the cash flows associated with all maturing gilts held in the Asset Purchase Facility."

The caveat for all of this is inflation and the markets. 

                   Inflation in the UK is currently around the 2.9% mark. The target level for inflation is required to be around 2%, although it's rarely been at that level for quite some time. The BoE has predicted that inflation will likely remain roughly at about 2.5% for the next 18-24 months, however their reputation in accurately predicting this has been relatively unsuccessful. They are likely to accept a level of inflation which stays roughly at the current level. If however inflation starts to increase even more, then they could look to reduce their asset holdings, or increase rates, to control inflation before unemployment is near breaking below that 7% level. 

               With the financial stability indicator it is a lot more vague as to what might cause the BoE to adjust it's forward guidance stance. The only indication is a point when "the Financial Policy Committee (FPC) judges that the stance of monetary policy poses a significant threat to financial stability that cannot be contained by the substantial range of mitigating policy actions available to the FPC". What these financial stability indicators are could include a large list of issues - over spiraling house prices, a devaluation in the pound to a non-beneficial level - the list could be endless, but the BoE doesn't specify.

In addition to all of this, the BoE signed off their statement indicating that even if these "knockouts" (consistent high inflation breaches or financial instability) were reached this doesn't necessarily mean they'll reverse course. 

So far so hazy! If compared to the Fed's attempts at forward guidance a couple of months ago it seems a lot less clear cut. But then maybe, wary of the way the market reacted to the Fed trying to give a clear positive picture, the BoE felt the need to reassure markets that nothing was set in stone. The timelines given by Mark Carney for UK improvement were also on the more pessimistic side compared to the US, which potentially emphasises the need for more caution in their guidance. UK unemployment currently sits at 7.8%. The medium term equilibrium rate for unemployment in the UK is estimated at being around 6.5%. But the BoE suggests that unemployment won't get towards the 7% threshold until 2016, indicating interest rates to remain low, and QE to remain in place, for a further 2.5 to 3 years - a full year and a half beyond the Fed's estimates for the US. 

         These timelines don't particularly inspire reason for optimism. But these are perhaps the safest estimates for them to give based on their projections and will of course be subject to change if things improve more rapidly. I think it is better to give a more leveled outlook on this rather than promote over exuberance and over optimism by making people think the rate will be increased earlier, if they don't believe it to be so. If that 7% threshold is met within the next year, then the BoE will act earlier in order to reduce QE and begin raising rates. There has already been positive signs for the UK Economy over the last few months with growth (although small) over the last 2 quarters and other key indicators showing things are gradually improving (despite the negative spin the BBC might always try and use!). So I think there is reason for optimism, we just have to be realistic that this is just the start and things will hopefully slowly take shape, even if it isn't as quick as the US, it's almost certainly going to be quicker than Europe.

         As for Mark Carney's first foray into forward guidance in the UK. We now have further clarity over what the Bank of England is going to be looking to when it is deciding monetary policy. We have a clearer unemployment rate, which is published each month for all to see, as well as the previously known target level of inflation. All in all it helps both the market and the individual to better plan for the future, which is a good thing. Everything is always subject to change in life, but at least the parts of the puzzle which help determine where interest rates are going to go is more visible. The first level of forward guidance whilst providing clarity in terms of observable levels has though left some uncertainty as to when the Bank might have to sway away from their current projections, so maybe in time more clarity around this aspect would be helpful. 

            I found out last week that the nickname for the Canadian dollar is "the Loonie". The Canadian at the head of the BoE will be striving to ensure the English press don't christen him similarly. He's made a good start, so for now he'll be alright, but if there's too much increase in the haziness they might just be tempted! 

Have a good weekend!

The Loonie, not to be confused with.......

......the Loony

The Age of Austerity - a necessity for all?

            This weeks posting seeks to look at the issue of Austerity and whether it is a necessity as a way out of the current crisis. Whilst Austerity has been the favoured solution for many countries to reduce deficits now to help stimulate growth, serious questions have been raised as to whether it is actually undermining growth. Countries such as the UK with control over its own currency and monetary policy should perhaps not be too concerned at this point with a rising debt level so long as spending is targeted at the right areas. Unfortunately for other countries, such as those struggling in the Eurozone, a lack of economic tools leaves them with no choice but to follow austerity potentially for years to come.           

                    Austerity. The word has become one of the most used and looked up since the crisis began in 2008. In 2010 it was named word of the year by Merriam-Webster's Dictionary. We are, according to the prime-minister David Cameron in a speech given in 2009, living in the "Age of Austerity". From an economic perspective, it is defined on Wikipedia as describing "policies used by governments to reduce budget deficits during adverse economic conditions. These policies may include spending cuts, tax increases, or a mixture of the two. Austerity policies may be attempts to demonstrate governments' liquidity to their creditors and credit rating agencies by bringing fiscal incomes closer to expenditures."

                As we know we are currently in the worst recession since the 1930s. Many governments (including the UK) have been running large deficits for many years and have been forced to increase the amount of borrowing required to fund those deficits drastically due to the (whisper it quietly) “banking crisis”. Countries such as Ireland, Greece and Portugal have required bailouts from the EU and IMF because their fiscal deficits grew so large that the fear of default drove up their borrowing costs to a level leaving them unable to borrow sufficiently in the market. The conditions required for them to accept these bailouts was to pursue austerity to attempt to reduce their national debt as a % of GDP and that, as a result of this, growth would flow back to these countries. The UK under the existing government has also attempted to follow an austerity path looking to reduce the size of the UK deficit and in turn keep the size of the borrowing to a containable level.

                The idea of resorting to large fiscal deficit reduction in the midst of a recession as a means to attempt to control the national debt level gained popularity in the early years of the current crisis due to a paper by renowned economists Carmen Reinhart and Kenneth Rogoff. In their paper “Growth in a Debt in Time” they attempted to demonstrate that once a developed country’s debt gets to a level of 90% of GDP or above then this will cause economic growth to slow substantially. As a result, countries need to work to reduce their debt levels to keep them below the 90% bound. If they fail to do so, the crisis in confidence can provoke “very sudden and “unexpected” financial crises. At the very minimum, this would suggest that traditional debt management issues should be at the forefront of public policy concerns.” As a result of this paper many countries, especially those in the Eurozone and the UK saw austerity as a core tool to maintain market confidence. The hope being that a narrower deficit or better a surplus (and as a result smaller Debt/GDP ratio) will then lead to increased private sector and foreign investment and ultimately to a return to sustainable growth.

             This method is significantly different from previous traditional measures used in order to return economies to growth. As mentioned in this blog previously one such method is monetary stimulus. Through the reduction in interest rates (and other such recent efforts like QE) it should encourage the private sector to save less and invest their money in infrastructure (and hopefully not just the stock market!) which in turn will multiply through and lead to a growth in the economy. As we know this has already been enacted by the central banks in the UK, US and Eurozone.

                      The other method conventionally used by governments in the midst of a recession is for them to spend their way out of it. A method which has been in use since Keynes at the height of the Depression.  Fiscal stimulus involves increased government spending and/or a reduction in taxes. The theory is by the government spending more, through investment in construction for example, it will multiply through to other parts of the economy leading to increased spending elsewhere and ultimately to growth. Meanwhile a reduction in taxes should lead to an increase in the number of pounds in firms’ and individuals’ pockets with the hope that they spend it on investment or goods and services which itself will lead to improved overall economic performance.

Fiscal stimulus however is obviously at odds with the idea of austerity. So is austerity really the right method or should we be trying to spend our way out of this recession despite the rising debt levels?

           

                       One of the problems with trying to ascertain whether any policy or method is the correct way forward is the partisanship of those who promote and criticise each method. At the economists level those that are pro-austerity such as Reinhart and Rogoff are prepared to defend their paper and stance despite increasing evidence there may be flaws in their argument. Meanwhile on the other side are economists such as Paul Krugman who believes that austerity should not be undertaken. It is hard to find any middle ground or potentially constructive conversation as neither side seems to want to meet in the middle instead of vehemently sticking to their guns (and indeed criticising the other). On the political side, one only needs to try and read the Wikipedia entry on the UK Government Austerity Programme to get a glimpse of the polarity of the issue. The site has a warning at the top stating the neutrality of the article has been called into question given its perceived strong anti-government stance.

            

                         The use of Reinhart-Rogoff’s theory itself has in the past 6 months been heavily called into question. It follows the discovery that they were missing some data which proved crucial to their findings. The 90% debt-GDP ratio, used by them as the critical point for governments, is now seen as quite arbitrary and not a level which can be used by every country as the perilous point which must not be passed. Meanwhile there is evidence to the contrary which shows that it is slow growth which leads to higher debt levels and not the other way round. This make more sense because as the economy slows down governments will spend more in order to try to stimulate it, leading to an increase in the deficit and, if there is not equivalent increase in GDP at that time, an increase in the debt-GDP ratio. So where does this leave us?

                        

               The reality is it depends on the country’s individual situation, their access to all the tools necessary and the markets perception of their ability to recover and cover their debts.

                    

                        This week I was introduced to the writings of an economist called Cullen Roche. Roche has written an excellent paper around about how money works in modern society under a theory known as monetary realism. According to Roche, Monetary Realism “seeks to describe the operational realities of the monetary system through understanding the specific institutional design and relationships that exist in a particular monetary system”. The paper itself is well worth a read for its insights into how the money system works in the modern world. Even if it is more specific to the US, it gave me a good insight as to some of the issues faced by other economies around the globe. One of the more interesting aspects which I gauged from this was that the US, or a similar economy with full control over its currency and issuing debt in its own currency, should in theory not need to go bankrupt (i.e. default on paying its debts) if its debt were to increase too much. Should there not be demand in the market for US Treasuries being issued (i.e. they cannot borrow enough to cover their deficit or repay existing debt) then the Fed could simply print more money to cover whatever shortfall there has been. This, of course, is only up to a point, but with the US that point would be relatively high due to the diverseness of the US economy.  The big risk is that excessive money printing will result in a high inflationary environment and potentially a weakening of the dollar (and resulting increase in cost of imports) which in turn could have a real impact on the cost of living of the inhabitants. However it is only once it reaches near to this point that there is the real risk, and the hope would be that the economy has been corrected before that point and as a result tightening and a reduction of the debt can then be achieved during a period of growth.

                         

                           As Roche mentions, “government cannot just spend and spend or the extra flow of funds and net financial assets in the system could cause inflation, drive up prices and reduce living standards. It’s important to understand that government cannot just spend recklessly.” It’s thus vitally important government spending is done in an efficient manner because as he points out, “if spending is misdirected or misguided there is a very real possibility this will simply result in higher inflation that is not offset by increased production.” Governments need to invest in projects which will lead to both short, medium and long term growth by having an impact through private sector investment. Needless spending on infrastructure projects such as new bridges, new roads or the like where they have no real long term benefit, whilst providing an injection in the short term, will only be detrimental in the long run. This is where the government needs to get the right balance, which admittedly can be quite difficult.

                              

                         If we look at the UK, we can see it operates economically in a similar format to the US. It issues debt in its own currency, has a relatively diverse economy and has the power to control its own money supply and currency. The UK government has officially been following a plan of national austerity. However if you were to actually look at what has been happening with the current account deficit and national debt it is visible that the government expenditure is actually growing. The last year saw the deficit increased to 3.7% of GDP after being only 1.5% of GDP in Jan 2012. Meanwhile the national debt has expanded from being 73.9% of GDP in 2010 to currently being 90.7% of GDP. Inflation however is now currently at 2.8% but had previously consistently been above this since the crisis started. So despite the increased borrowing, inflation has not spiked. The cost of borrowing for the UK government in the meantime is still only 2.4% yield on 10-year Gilts, down from 3.4% in 2010 when the base interest rate was already 0.5% at that time. As the evidence we saw earlier seems to suggest, there is no reason to fear such an increase in the debt level for the UK above the previously thought 90% danger level. A quick look at Japan sees a country with a Debt to GDP level of over 200% but still with very low borrowing costs and extremely low inflation if not at times deflation. Whilst I am not trying to use Japan as a beacon of economic health, it is a useful comparison to show that having a higher Debt-GDP ratio will not necessarily cause the sort of high (or hyper) inflation and borrowing costs used as fear by those who wish to curb spending completely.

                          

                          From the evidence, I would suggest that the Government in the UK, whilst talking about austerity now, should take the long term view of boosting spending now, in the hope that the real austerity and cut backs can be carried out at a point when the economy is already growing sufficiently on its own. Such examples are with the help to buy scheme and HS2 projects. Whether these will ultimately be “roads to nowhere” or will actually drive things forward in years to come can only wait to be seen and highlights the problems governments have in identifying areas which will assist real long term growth as well as just short term boost. The past 2 quarters have seen slow, slow signs of growth returning to the UK with 0.3% and 0.6% in Q1 and Q2 respectively, but whether this will gather momentum in itself in the coming years will depend on continued government assistance now. The key is that once the UK does start on a path of sustainable growth that this period is then used to begin to reduce down the debt through increased tightening in unnecessary areas of expenditure. This depends very much on the political will of all sides to ignore partisanship and do what is best for the country.

                       

                   Europe on the other hand, especially the peripheral Europe of Portugal, Ireland, Greece and Spain do not have a similar amount of flexibility. Due to the constraints of being unable to issue debts in a currency under their own control, as well as having no control over monetary policy, has left these struggling economies at the mercy of the demands of the markets. True, the excesses during the boom years have pushed these economies to the state they are currently in. However their lack of ability to use monetary policy in order to assist in stimulating the economy and easing the downward spiral have seen these countries fall further into depression than they might otherwise have done. Any attempts by them to try to use fiscal expansion as a method to drive their way out would have been met with a market pushing borrowing costs up to unacceptable levels that the countries would have no option but to default. In the cases of Ireland, Greece and Portugal this has already led to each country requiring bailouts from the EU and IMF. The ECB, needing to play the role a central bank is required to in these situations, has its hands tied in trying to meet the requirements of stronger economies such as Germany versus those in trouble. As such they can only really deal with items on a macro level. This is visible when you hear the ECB often talk about Eurozone growth as a whole which is held up by the strongest economies. In the same way talk last week that the worst is over is premature in my mind. Whilst the Eurozone as a whole may slowly begin to make its way towards growth, the troubled economies are a long way off recovery, as Greece’s continued need for assistance is evidence of.

                        

                 While Paul Krugman beats a drum against austerity, the unfortunate reality for Ireland, Greece and Portugal is that there is no alternative choice due to the pressures of the market. Should any of these economies attempt to move away from austerity then the borrowing costs reflected in the market would only serve to push all these economies back towards default. Such results were seen by the spike in both the Portuguese Bond Yields and CDS spread (the market measure of risk of Portuguese default) at the hint that the coalition may split over a lack of willpower for further deficit reduction. Whilst I agree with Krugman that austerity will not assist these countries in regaining growth the simple truth of the matter is that due to market forces and the lack of tools available there is no other option available. The result will be that these countries, especially Greece, will continue to suffer for many years to come until ineffective spending is reigned in.

             

                        A big difference I believe in the responses of the different economies to austerity measures however can be seen in the response of the people and the opposition political parties. It is no surprise that Ireland is seen as the poster boy of austerity. As Mohammed El-Erian recently wrote “Right or wrong, Ireland will stick with austerity. Efforts to regain national control of the country’s destiny, the Irish seem to believe, must take time.” This is reflected in the relative lack of mass protest compared to Spain, Portugal and Greece as well as in the fact that the main opposition party Fianna Fail publicly backs the austerity measures. With the 3 most recent quarters of GDP showing a further contraction in the Irish economy, the indicators are that it will take time for Ireland to recover but they are in comparatively better shape than the other troubled Eurozone nations. The acceptance that current hardships are necessary after the excesses enjoyed by the majority of the population is perhaps an indicator to the other countries to desist from political brinkmanship and complaint and to pitch in and attempt to stop the slide together.

                     

                    In conclusion, the evidence to me seems to indicate that austerity, in the true sense of the word, is not going to help bring growth back to troubled economies. For countries such as the UK and US, a pull back from unnecessary spending in certain areas should be carried out, but there is no risk at the moment from an increase in debt levels so long as the additional spending is targeted effectively. Once the economies are growing sufficiently, that is the time to reign in further avoidable government spending and seek to reduce the debt. Unfortunately due to the constraints on peripheral Eurozone of both market forces and a lack of monetary control there is no choice for them but to concentrate on dramatically reducing their debt levels and spending now. The political debate about who was to blame in the first place will wrangle on for years, but the truth is that everyone in one way or another gained from the financial excess. The key for now is not to concentrate on the blame but to implement the solution. Unfortunately, depending on the country will depend how much control over the solution your government has.