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.

Structured Products – They’re not for everyone, but you shouldn’t just dismiss them!

Before you start, this one might not be for the fainthearted. I’m writing this in response to an article I read entirely dismissing structured products. In my response I’ve tried my best to simplify as much as possible what are, by their very nature, complex products in the hope of persuading you that there are 2 sides to this conversation. While a lot of these products should not be touched by individual investors, sometimes and in some circumstances they could be of use for the individual, so long as they properly understand what it is they are buying. As a result I hope to make the point that making a blanket stay away message on any financial product should at least show the whole picture to let investors make their own minds up. Now with any luck I haven’t scared you off too much before you start! On the contrary, I hope I’ve encouraged you to expand your knowledge, so please read on!

                         Earlier this week I stumbled upon an article written for MoneyWeek telling people to steer completely clear of structured products (“Don’t fall for structured products”). That no one should invest in them ever because they are all rubbish and the investor would always lose out. The author based her complete dismissal of all of these products on a couple of new products she’d been sent which she deemed to be too risky to even think about, because mostly there was too much downside potential for the investor with a very limited upside. Whilst I believe she had a point in reference to the two products she mentioned, it struck me very much as being a severe case of using two bad examples for the purpose of dismissing everything in that field. It’s a bit like telling me I should keep my money under a mattress because the 2 savings accounts I looked at give 0% interest and are both at nearly bankrupt banks, so as a result there’s no point saving in any savings accounts (although some might argue at the moment it’s just as effective!). In reality what you’d do would be to look out for the best account for you which offers the best return. All financial products are essentially the same from that respect.

               

                         Now I’m aware that a large number of the people reading the blog will be wondering what on earth I’m talking about when I speak of structured products. Sure, I well know my family and most of my friends used to look at me confused when I mentioned I worked with structured derivatives. They still came out wondering what it was I did when I tried to explain. But, for the hope of not boring those already in the industry, I think it’s worthwhile to give those not in the know a brief overview. 

                     In relatively simple terms, a structured product uses derivatives on a mixture of different assets to create a tailored payoff for the investor. This mix of assets could include anything (bonds, equity indices, individual stocks, fx etc.). Most of you will probably have heard of some of the more infamous structured products which assisted in bringing about the financial crises – Mortgage Backed Securities (MBS), Collateral Debt Obligations (CDOs) for example - and in it you can already see some of the dangers of certain of these products. The specific types of structured product discussed in the money week article however are what are known as equity structured notes.

                  Equity structured notes themselves can take many forms, but it effectively will give you a payoff linked to the performance of a single equity or index or a group of equities/indices over a period of time. The main benefit of these products is that they will sometimes offer to protect your capital somewhat (in a process known as capital protection) through selling you a bond as part of the structure. (It’s important to know at this point, that this capital protection is provided by the institution that is issuing the product, so there is a risk there.) These products can range massively in complexity from the simple ones, offering you only the upside on the performance of an index, or they can be extremely complex, involving all sorts of caveats as to what your return will be based on. There are whole books written and still to be written on these, but hopefully you have the very basic gist. As you can see, even from the off they’re not for everyone!

                  The moneyweek article focused on 2 particular products both of whose payoff was on the slightly more complex side for a basic investor. In them, the investor only got a small coupon each quarter from their investment and even this was dependent on all 3 stocks used in the product performing positively over the 2 year timeframe. If all 3 shares fell by more than 20% in that time, then you stood at risk of losing some if not all of the capital you put in (although to lose all your capital HSBC, BP and Vodafone’s share price would all have to fall to 0, an apocalyptic thought for any pension fund holder!). As you can see, a product of this kind has inherent risks and this is one where the upside certainly doesn’t seem to necessarily compensate for the downside. So if you were now interested in either of these products as a private investor I’d suggest you read what I wrote a few weeks ago on the difference between speculation and gambling so you can decide which it is you are doing and whether blackjack is more suitable.

               But they’re not all this complex. What if you could buy a structured note which pretty much guaranteed your capital 100% and also gave you a 55% coupon after 5 years? All that you’d need would be for the FTSE 100 to be above what it was now in 5 years time, just by 1 point. If it is you get your money back as well as 55%, if it isn’t then you get the capital you invested back. Or alternatively what if you similarly were offered a coupon of 4 times the performance of the S&P 500 over the next 5 years up to a maximum of 80% with your capital similarly protected should the S&P 500 finish below the current rate? There’s certainly reasons not to take these products. After all, the FTSE 100 may perform better than 55% in that time frame and you’ve then lost out so in theory you would have been better off buying directly into a FTSE 100 tracker and holding it for the 5 years. If the S&P 500 finishes below today’s level then you only get your money back with no return effectively eroding the value of the money you had when you could have just put it in a savings account and at least earned some interest. But therein as always lies the benefit of hindsight. As an investor, we could always have made more money if we had a time machine.

                  If I had offered you these products 4 years ago in 2008, with all the uncertainty that was around then, there’s a fair chance that some of you would have found these quite appealing. Barclays offered these exact products back then and they wouldn’t have been the only ones. Markets were trading near lows not seen since 2003 with the FTSE around the 3600 mark and S&P around 700. There was uncertainty as to how much they were likely to rise in the next few years and meanwhile with interest rates approaching or already at their all-time lows there was not much to be returned by keeping your money in a savings account. Given all that uncertainty, some investors may have assessed that markets were going to go up, but it was difficult to see how much, and there was the possibility that in 5 years time they could be near to where they currently were. You’re afraid of losing your capital if you invest directly in the market, so the capital protection element gives you comfort around that, (assuming you have faith the institution issuing will still be around then). In addition the prospect of a 55% return should the FTSE have been even 1% above its level at the time is a better prospect than only 1% by just sticking your money in a FTSE tracker. So for an investor who had a mildly positive view on the FTSE 100 over that 5 year period, but wasn’t so convinced on the size of the upside and also wanted to protect his investment, this may have suited him. It offered some kind of security and the potential for a decent return of 55% so long as the FTSE was in even a small element of positivity after the 5 years. There are plenty of this type of product available today from various institutions.

But of course there are risks, after all there’s no such thing as a free lunch!

• Loss of upside: On the simplest level you may feel you’ve protected yourself against any falls, but you’ve also limited yourself on the upside. However as a cost of giving yourself protection, you have to accept that you won’t be able to take advantage should markets really take off. It’s the choice you make. In the end, you want to make sure you get the return you are aiming for. So long as you’ve done that then there should be no regrets.                                                                                            
• The Capital Protection Risk (Counterparty Risk): As I alluded to before, the capital protection is only as good as the company which issues the note. There’s no sure thing in this world, and you need to know who is telling you they’re protecting your money because if they go under then your money goes under. It is estimated that investors held in the region of $18bn worth of Lehman Brothers issued structured products when they declared bankruptcy! Those investors now need to queue up with all the other creditors to see what they’ll get back. It’s important to assess who is guaranteeing your capital but, as Lehman proved, nothing is assured.                                                                               
• Liquidity Risk (The ability to sell): In theory the structured products that individual investors can buy are tradeable on the market, so the investor can sell the product as and when they want. In reality however there are only a limited number of each note issued each time, and the ability to sell is, as with any security, based on the willingness of someone to buy. As a result whilst there is a market on offer, if things don’t turn out as you’d hoped and you want to get out before the note reaches the end of its life, you may not get back as much as you’d hoped.                                                                    
• Complexity: As I mentioned much earlier, structured notes can be very complex. Even notes which appear to offer a very simple payoff at the end may contain several features whereby your capital may be affected should the index or underlying share hit certain levels. Like an antibiotic, always read the label. You want to make sure you’ve read the entire termsheet and all the caveats so you know what will happen to your money! Don’t just be taken by the high potential return offered if you can’t figure out how you get there. Even if you can understand it, it doesn’t necessarily make it a good investment compared to a simpler solution. 

                   As you can see from all of this, these products are certainly not for everyone and in some cases it’s debateable whether the risks make them suitable for any individual investor. They can b complex, but it doesn’t mean you shouldn’t try to educate yourself to understand them. There are times and in certain situations where there is the potential for an individual investor to make a true risk assessment on an equity structured note and deem it to be a better fit to his/her risk profile at that moment in time than a straight investment into an equity or equity index. That is the decision for the individual investor to make. I’m not a financial advisor, nor do I claim to be offering financial advice. I’ve previously spent 8 years working with structured equity traders so I probably have more knowledge on this than most of the general public but I stand to make no money by explaining them. Are they suitable for everyone? Certainly not. Are they suitable for most people? No way. But that doesn’t mean you should just reject them out of hand. Everyone deserves to understand a bit more of what they’re being told to steer clear from so they can make their own decisions. Hopefully I’ve gone a little further in doing that!