Alternative Investment Management Association Representing the global hedge fund industry
Markets have been suffering a lack of confidence in the future and the resulting drag on world growth has been severe. Since the financial panic of September 2008, marked by the very messy handling of the bankruptcy of Lehman Brothers and the next-day bailout of AIG, the world has witnessed continuing erosion in the confidence accorded to policy-makers, technocrats, and political leaders to restore a long-term belief that the financial system can once again function smoothly. The most severe confidence problems are currently centered in Europe, but the problem is global and epidemic.
When confidence is lacking, risk-taking in the pursuit of even modest expected returns is curbed. Capital flows only slowly, and exchange rates are impacted by bouts of global deleveraging. The unfortunate reality is that once confidence has been lost, there are no quick fixes to restore it. The “Whew!” moments, when one thinks the crisis may have been averted, do not necessarily last. The medicines that can work are a combination of time with the absence of further debacles coupled with a return to more disciplined long-term policy-making by governments, regulators, and central bankers who confront reality rather than make empty promises. While we can be assured that time will continue passing, it is much less certain that there will be no new debacles and it is way too much to hope for realism from political leaders facing divided electorates.
In assessing the current state of markets, we need to take a global approach to understanding the challenge of a lack of confidence that markets face, and then we should realistically take a hard look at the progress that has been made since the financial panic of 2008. In the midst of an erosion of confidence, it is easy to lose sight of many of the positive things that have been accomplished by governments and economies around the world. So, while we start this analysis from the perspective that the glass is half empty, we will close with a more optimistic assessment that the glass is half full, suggesting the next bubble to burst may occur in the flight-to-quality assets.
THE GLASS IS HALF EMPTY
Currently, the largest obstacle to rebuilding market confidence is in Europe with the seemingly never-ending saga of the sovereign debt crisis. It is now obvious to everyone that the Euro was born with the birth defect of lacking a unified fiscal structure to go with the central monetary policy implied by the single currency. We have learned more recently, however, that sovereign debt problems and the banking system problems are intertwined in complex ways. Hence, the pressure on the latest EU summit to unify banking system supervision to complement the monetary policy powers of the European Central Bank (ECB).
One critical observation that has emerged over the last two years of wrangling with the Greek debt crisis and the contagion to Portugal, Spain, and Italy is that the European Union (EU) may have an unwieldy governance structure, but there is a very strong commitment to maintain the Euro as the single currency. While extreme political posturing before arriving at the negotiating table is typical, with each passing European summit (and there will be many more), one can perceive a deep underlying commitment to avoid a breakup of the Euro and to take even politically unpalatable action to sufficiently mutualize enough sovereign debt to get through the crisis.
Unfortunately, one also senses that the common commitment to the Euro and solving the sovereign debt crisis is largely born out of fear: Fear of the economic disruption that would be caused by a break-up of the single currency; Fear of the ramifications of a failed bail-out on the careers of the political leaders and technocrats that have engineered the expensive package of debt relief and banking system support. It is not confidence inspiring.
What the European debt crisis has highlighted for Japan is its vulnerability due to its massive debt. Japan has the highest government debt to GDP ratio of any major country. Japan has an aging and shrinking population. This means that Japan cannot grow its way out of debt (and by the way, neither can Europe or the US).
Japan has postponed its debt crisis by mostly owing the debt to itself (not to foreigners) and by the Bank of Japan maintaining a zero rate policy since 1995. The role of the zero-rate policy cannot be understated. There is a virtual commitment from the Bank of Japan to keep short-term rates near zero for a very extended period of time, and this means pension funds, the Post Office, and banks know they can fund their massive holdings of Japanese Government Bonds (JGBs) at a positive carry. Even this approach probably has its limits as the debt piles higher and higher, and this is why the consumption tax, with its near certainty of serving as a serious drag on economic growth was passed by the lower chamber and will likely soon become the law of the land.
Of course, austerity is rarely popular, and the political leadership in Japan is not particularly stable. Japan is on its sixth Prime Minister in as many years, and ”seven in seven” seems highly probable with the passage of legislation to sharply increase the consumption tax. There is nothing here to build confidence, but disaster is not around the corner either. The economy will probably see its 20-year average real GDP growth rate of 1.7% cut in half for the next few years as the consumption tax rises. And further austerity will likely be needed to control government expenditures. All the while, the Bank of Japan will keep rates at zero, and domestic long-term holders of Japanese Government Bonds will earn the carry, small as it is. When this bubble bursts, the epicenter in the markets may well be the Japanese yen, but one should not underestimate how long a zero-rate policy can sustain the status quo.
In China, the generational transition to new leadership comes at a time that the domestic economy is decelerating much more than many market participants anticipated. The growth slowdown in China is a direct consequence of the intense building during the 20-year infrastructure boom. Now that there are fewer new projects, Chinese growth will need to come from domestic consumption and that is not the natural state of a society that is aging rapidly and depends on the extended family unit for long-term financial security and health care.
Moreover, there is the looming elephant in the room of demographics, with two themes set to interact in the next decade in a disruptive fashion. For now, China gets some 4% real GDP growth each year from the direct and indirect consequences of the migration of 12-15 million people from rural to urban areas. The higher productivity of urban industrial workers and the infrastructure spending required to effectively build a new New York City every year helps sustain the economy. Without the rural-to-urban migration, China’s real GDP growth might shrink to 3% - 4%, instead of the 7.5% we expect for 2012. Once the rural-to-urban migration slows markedly in the next decade, the real demographic time bomb of a rapidly aging population comes into play in full force. Due to decades of the one-child policy, China slowed its population growth, but it also put in play a much faster aging of the population than any major country has ever experienced. Aging populations do not sustain rapid economic growth, and they place intense pressures on the health care systems and social safety nets, both of which are lacking in China.
The bottom line is that the new leadership in China that will take over toward the end of 2012 is inheriting a country that has modernized at a magnificent pace, and yet will now face mounting economic challenges. In the “what have you done for me lately” psychology of financial markets, uncertainty and lack of confidence is the order of the day until the new leadership can prove itself – and that, of course, takes time.
In the US, there is a total absence of long-term fiscal policy, with automatic spending cuts and tax hikes coming at year end, if Congress fails to act. Depending on the US Congress to take effective and long-term action – well, that is not confidence inspiring. Usually, economists are happy to project sustained economic growth when Congress does little and leaves well enough alone. What has happened this time around, however, is that previously legislated tax and spending policies had time stamps that are coming due at the end of 2012. So, if Congress fails to act, there will be severe consequences for the economy from the abrupt shift to austerity.
One also needs to appreciate the local nature of all politics. While as a whole, the US Congress according to opinion polls is held in extremely low esteem, the same polls show considerably higher approval ratings for each and every Congress person in his or her own district. That is, the country does not approve of the Congress it elected, but each district likes its own Congress person just fine.
Congress is not the only culprit in assessing confidence in the US. The Federal Reserve is a growing part of the confidence problem in the US. The Federal Reserve remains in emergency policy mode and regularly promises more action without delivering any results in terms of encouraging full employment. What has been missing from the Federal Reserve is a convincing cost-benefit analysis of what expanded quantitative easing policies really accomplish, and whether their long-term costs may not be outweighing any benefits.
Let’s be clear. When the economy was collapsing following the freeze-up of the banking system with the very messy bankruptcy of Lehman Brothers and bail-out of AIG back in September 2008, the Federal Reserve stepped up to the challenge with a trillion dollar asset buying program, known as QE1 (for quantitative easing program #1). We credit that initial round of quantitative easing with preventing a major depression that could have been worse than the one in the 1930s.
Subsequent rounds of quantitative easing by the Federal Reserve as well as operation twist program to extend the maturities of its asset holdings, however, were not conducted to save an obviously failing banking system. These subsequent rounds of quantitative easing were aimed at trying to get an already growing economy to create jobs at a more rapid pace.
Our understanding and interpretation of economic theory suggests that there was little likelihood of QE2 and Operation Twist having any measurable impact on unemployment. With the benefit of hindsight, we still argue that QE2 and Operation Twist were not helpful. Indeed, they are actually damaging in several ways, which is why a thorough cost-benefit analysis would be useful.
The first issue relates to the fact that QE2 and Operation Twist were designed to distort the Treasury yield curve – albeit for good intentions. We believe that market distortions, however, have costs, and in this case we are seeing a wholesale transfer of wealth away from long-term savers and pensioners, due to lower bond yields, with the objective of making capital cheaper for companies to expand production and increase hiring. Business investment and expansion decisions, however, are much more dependent on corporate views of the future demand and risks than on the cost of capital. That is, even if capital is cheap, businesses will be reluctant to expand if they perceive elevated risks in future demand. And, with the economy aging and savings and pensions under stress, well, the Federal Reserve has effectively engineered a drag on demand as an unintended and unappreciated consequence of QE2 and Operation Twist.
The second issue relates to the long-term management of monetary policy. The Federal Reserve needs about $1 trillion in its balance sheet for the normal conduct of monetary policy. It has about $3 trillion after its quantitative easing programs.
This additional $2 trillion is funded by paying interest on excess reserves, currently set at 0.25% or 25 basis points. [The first $1 trillion is funded by the cash or currency circulating in the economy, and has no interest cost.] If and when the Federal Reserve returns to a more normal federal funds rate policy, then we expect the rate paid on excess reserves to rise as well.
That is, the Federal Reserve will have to pay the higher rate to make sure that the excess reserves from the QE programs do not turn into rampant credit expansion and produce inflationary pressures. Alternatively, the Federal Reserve could sell the excess securities, but our guess is that the Federal Reserve will be reluctant to dump its holdings of Treasuries and mortgage-backed securities on the market and unwind quantitative easing with its implications for disturbing markets at the same time as the federal funds rate is being pushed a little higher and back toward a more normal relationship with inflation.
In short, QE2 and Operation Twist have not helped to lower the unemployment rate any faster than already was occurring, but these operations may have immensely complicated the long-term conduct of monetary policy and the ability of the Federal Reserve to exit its emergency policy mode.
And the final issue is, of course, about confidence – or the damage to confidence being caused by the Federal Reserve remaining in emergency policy mode when the financial crisis has eased. The US economy has been growing in real GDP terms for three years. The unemployment rate has fallen from its peak of 10.0% to the low 8% range. Banking profits recovered back in 2010, as did the profits of non-financial corporations. The US economy may not be producing jobs as fast as the Federal Reserve and policy makers would hope or like, but given all the turmoil in Europe and the slowdown in China and other emerging market countries, the US economy is actually a bright light on the world scene. Thus, our argument is simply that the policy of the Federal Reserve, to stay in emergency mode, and not to take even a few baby steps back toward a more normal monetary policy and one that involves a little less distortion of the yield curve is sending a strong message to the market participants that the Federal Reserve does not have any faith in the current state of the economy and perceives a relapse as imminent.
This perpetuates the cycle of confidence erosion. If the Federal Reserve really does perceive a relapse as imminent, then by all means keep rates at zero. If the Federal Reserve, however, is buying insurance against an economic relapse, then it needs to recognize the very high and potentially damaging costs of its actions. Insurance is often appropriate, but it is never free, and the Federal Reserve needs to carefully weigh the costs of buying expensive insurance that may not work for a problem that may not exist.
THE GLASS IS HALF FULL
Fortunately, a lack of confidence is curable with time. The key is whether there are new and serious financial debacles to upset the healing process. So, we need to realistically take stock of the probabilities of future man-made financial disasters. Our assessment is that the probability of further system-damaging financial shocks has been greatly diminished over the past year.
The progress on a number of fronts has been obscured in part by market volatility stemming from bouts of uncertainty and a lack of confidence. We need to remember that US banks are well-capitalized and profitable. Many European banks still need more capital, but their problems are better understood now, the ECB is providing massive liquidity, and commitment to EU-wide banking supervision is on the way. A problem bank is much less able to rock the system today than a few years back.
Economic growth is less than robust around the world, but most emerging market countries are still growing, just more slowly than at their peaks. The US is on a 2% to 2.5% real growth path. Japan has recovered from the earthquake and tsunami. Europe, though, is moving into recession, but for the continent as a hold the damage is manageable. We are in the middle of a world growth slowdown, but not a world recession.
Global corporations are profitable and have been hoarding cash. They are in much better financial condition compared to 2008-2009 to either withstand a shock or to expand when they perceive conditions and risks will allow it. Indeed, corporations have made great strides in maintaining profitability while managing ambiguity and an uncertain future.
Our conclusions are that market participants’ lack of confidence in political leadership has meant more volatile markets, has contributed to the risk-on/risk-off trading mentality, and has convinced corporations to hoard cash rather to expand. All of these manifestations of a lack of confidence in leadership have been self-reinforcing. Moreover, the erosion of confidence has obscured the progress that has been made on the economic front. The practical implication for investors is that risks are probably both lower and much more balanced than market perceptions may appear. If and when confidence slowly returns as time passes and no further system-threatening debacles occur, the one hypothetical possibility is that the next big bubble to burst may well be in the flight-to-quality sectors. That is, the best investments of the past few years during the erosion of confidence may be the worst investments if confidence starts to slowly improve. This suggest much more volatility and risk for the currencies of the funding countries, such as the US and Japan, as well the US Treasury market which is offering negative real returns even in long maturities. The compliance maxim – “past performance is not necessarily a guide to future performance – may be the watch word for the coming few years.
All examples in this presentation are hypothetical interpretations of situations and are used for explanation purposes only. This report and the information herein should not be considered investment advice or the results of actual market experience.
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