Archives for September 2012

Time for Mitt to take the gloves off

The US Presidential election is between two candidates, one of whom believes that it is not worth worrying about the 47% of voters who do not earn enough to pay income tax, and the other who tells small businessmen that it was the government that enabled their business to be successful. Such a clear ideological difference should mean that the result matters greatly to Wall Street and financial markets.

Yet, 2012 has seen little impact on markets from US politics – the headlines this year have been about the Eurozone debt crisis, the Federal Reserve’s policy and the Chinese economy. The election should be close given the poor performance of the US economy (though not its stock market) under Obama, but the lack of strong Republican candidates has left them with the rather uncharismatic Romney as their best choice. His gaffes in recent weeks leave him currently trailing Obama in most of the key swing states as the contest enters the final straight.

There are three election debates to come, which could turn things around, but it seems unlikely that the experienced and eloquent Obama would lose out so badly to the more formal Romney in head-to-head debate.  A Romney win from here would be a big surprise but would in all likelihood also come with Republican majorities in both Congress and the Senate This is typically a combination that Wall Street would cheer. However an Obama win would be combined with a continued Republican majority in Congress and the only question for markets would be what happens to the Senate. Currently the Democrats have a 51-47 majority with 2 Independents – with 33 Senate seats being contested in November. Of those 7 (6 of which are currently held by Democrats) are believed to be races that are too close to call.

This all matters because of the “fiscal cliff”. This is (i) a number of previously agreed tax cut measures which expire on December 31, and (ii) the penalty clause US politicians set for themselves if they were unable to agree on long term measures to reduce the budget deficit, which make roughly equal cuts in defence and welfare spending. The idea of the penalty clause was that each side would be forced to make compromises on a longer term deal in an attempt to avoid large cuts in the area that most concerned them (defence for the Republicans and welfare for the Democrats) – sadly it didn’t work. The combination of all these measures would be to tighten fiscal policy by about 4% of GDP in 2013 and would send the US economy into recession.

No one seriously believes that such a massive tightening of policy would be allowed to happen, but to avoid it , the “lame-duck” sessions that occur from the election until Christmas with the old membership of both Congress and Senate, will have to agree to some compromises. It is perhaps understandable that, before the elections, neither side were prepared to make any compromises, but the hostility shown by many in the Republican Party towards Obama since he became President has taken the working relationship in Washington between the two parties to a very low ebb. It is not clear that this would change if Obama were to be re-elected and still faced a hostile Republican party in the two Houses. It is possible that an angry and upset Republican Party would not make any compromises and let the US economy fall into recession.

Markets are currently pricing in an Obama victory, and then some sort of compromise over the fiscal cliff that doesn’t drive the US economy into recession. A Republican victory would lead to a rally on Wall Street, but a bad-tempered defeat for them where emotions ran high would be a very negative development for America and the world.

Changes to the UK Retail Prices Index – implications for index-linked gilts

The UK’s Office for National Statistics (“ONS”) has announced a consultation on a proposal to change the way it calculates the Retail Prices Index (“RPI”). For the last few decades, in the minds of the British public this is believed to be the best measure of inflation in the economy. This has been reinforced by the introduction in the 1980s of index-linked bonds, which are government bonds offering inflation protection by indexing both capital and income payments by the change in the RPI. In addition, many private sector pension schemes have pensions which rise in line with the RPI, and many regulated industries have their pricing models set by regulators which are linked to the RPI. The RPI is a key part of the fabric of British life.

Sadly, the ONS believe that it is, statistically, a rather poor measure of inflation (as described later). In 1996, all EU members were required to calculate their inflation measures on a consistent basis – this index is the Consumer Prices Index (“CPI”), and being of a much more modern construction, this is the measure now preferred by the government for setting its inflation objective to the Bank of England (“BoE”), and state pensions and benefits are now linked to the CPI.

The RPI and CPI use the same price inputs each month, but a different statistical formula – this formula effect meant that historically the RPI tended to be 0.5% a year higher than the CPI. Thus, when Gordon Brown switched the BoE inflation mandate from an objective of 2.5% on the RPI, it became 2.0% on the CPI.

To illustrate this formula effect, consider a prices index, calculated monthly, with just two components, say strawberries and batteries over just two months. In both months the price of batteries is unchanged but the price of strawberries doubles in the first month and then halves in the second month. Over the two months combined, the geometric-weighted CPI will show that the rate of price inflation is zero, since all prices are the same as when the index began. However the arithmetic-weighting methodology of the RPI means that it will have risen and the rate of inflation will be deemed to be positive. Thus the RPI has an inherent upward bias compared to the CPI.

Since 2010 when changes to the RPI’s measures of clothing and footwear prices were made, the size of this formula effect has grown to almost 1.0% per year, and is in danger of creating mistrust in the statistics, which is why the ONS is seeking to change the methodology. Doing so would, however, have important effects on all those areas of British life which are referenced to the RPI.

In particular the expected returns of index-linked bonds (currently worth £280bn) would be 0.5-1.0% lower each year. At a time of very low government bond yields, this is significant. Should the BoE determine that the proposal amounted to a “fundamental change” that would be “materially detrimental” to the bondholders, then investors could, under the issuing terms of index-linked bonds,  demand their money back from the government. However, they would only be entitled to the par value of their bonds uplifted by inflation, which in general is well below their current market value.

The implications for markets are that by making this proposal the ONS has introduced a new risk factor for index-linked bonds that did not exist before – the measure of the rate of inflation used for returns may be lower than before. Ordinarily that should lead to lower prices. However, this news has come out at the same time as the Federal Reserve’s decision to engage in open-ended Quantitative Easing, which represents a clear shift in policy target away from controlling inflation and towards lower unemployment. This has boosted longer term inflation expectations in markets, and pushed up prices of index-linked bonds.

Index-linked bonds still provide investment portfolios with the most direct insurance against future inflation, but the effective payout on that insurance may be about to be cut. As with any insurance policy the balance between insurance premium, insurance payout and probability of payout has to be kept under review – recent events are tilting that balance away from having too much of this insurance in a portfolio. Globally, those investors who are not in countries with index-linked bonds have historically opted for gold as their inflation insurance.


Bernanke sets the printing presses to “GO” and walks away

The recent decision of the Federal Reserve to go ahead with a policy of QE3 by which they buy $40bn of mortgage and agency securities every month until further notice was dramatic and shocking in many regards:

  • Timing – Historically the Fed has sought to avoid making major policy moves in their last meeting before an election for fear of being seen to be acting politically. In 2008, there was a global crisis which required action – this is not the case in 2012.
  • Politics – Romney and many in the Republican Party have already made clear their opposition to Bernanke personally and to the policies of Quantitative Easing already adopted. Were Romney to be elected, he might choose to ignore the fact that Bernanke has been appointed until 2014 and seek to get him replaced. The Fed’s action can be interpreted as a major political snub at a critical juncture.
  • Economic justification – Both QE1 and QE2 were introduced at a time of clear weakness in the US  economy and significant financial market concerns about the possibility of deflation. So far this year, the US economy has been growing at about a 2% rate, unemployment has been declining gently and inflation expectations have been rising.
  • Size – At $40bn per month, the policy amounts to an annualised rate of QE of  half a trillion dollars. However, the reinvestment of principals and coupons and the continued working of Operation Twist (which followed QE2) mean that for the rest of this year the Federal Reserve will in fact be purchasing securities at an annualised rate of over a trillion dollars. These are astonishing amounts of money.
  • Transmission mechanism – In the press conference following the decision, Bernanke was asked about how he expected this policy to have real world effects. He repeated his  belief that by raising equity prices, companies would find it cheaper to invest. In addition, he said that because this time the Fed was buying mortgage securities, this would reduce mortgage costs in the economy, thus boosting house prices, so helping consumers to feel wealthier, which would encourage them to spend more. This trickle-down effect of previous QE policies from injecting money into financial markets moving into the real economy is widely believed not to have worked. It appears to benefit those in financial institutions whilst having little real economic impact.
  • Duration – By making QE3 open-ended and further insisting that the Federal Reserve would not begin to tighten policy until recovery was very firmly established, even at the risk of some higher inflation in the short term, Bernanke has made it very clear that continuous easing is now the default policy setting, probably for several years. Previous QE announcements were for set amounts of money over set periods of time – this is very different – money will continue to be printed until the economy recovers.

So the unlimited money printing of the Federal Reserve now sits alongside the unlimited buying of peripheral bonds by the ECB announced the week before  and the unlimited selling of its currency by the Swiss National Bank that has been in operation for a year. Central Banks – so long famed for their moderation and control in all things relating to money have set the printing presses to “GO” and walked away.

One conclusion that could be taken from this is that the Central Banks, who we hope are a little better informed about these things than the rest of us, are terrified, and that the state of the global economy and financial system is in fact far worse than anyone is prepared to admit.

The clearest market implications of this shocking move are to expect a weaker dollar (with so many more dollars now being printed) and a higher gold price. QE1 and QE2 were positive for equity prices, but the biggest beneficiaries were precious metals (gold and silver), oil and agricultural commodities. It is by no means clear that QE3 will do anything to boost real growth in the economy, and so the boost to equities may be more short-lived and less significant than previous rounds. Most interesting has been the recent moves in government bond markets where yields have risen as long-term expected inflation worries have begun to return.

The single currency – making Germany more European or Europe more German?

Following the fall of the Berlin Wall when Kohl wanted to press ahead with the reunification of Germany, the price of Mitterand’s acceptance of this was to demand that Germany share the power of its currency with the rest of Europe (or more particularly France) in a monetary union. Germany agreed provided that the guardian of the currency, the ECB, was made in the image of the Bundesbank, with its rigorous implementation of policies to control inflation. Both were happy because Mitterand believed he was making Germany more European, Kohl believed he was making Europe more German and the Bundesbank believed that it had the right to criticise and have a special influence over the policies of the ECB.

Until last year, the ECB did indeed operate in much the same way as the Bundesbank would have done, tending to be quick to raise interest rates and rather slow to cut them. After a Dutchman and a Frenchman, it was to have been a German, Axel Weber, who was expected to take over the ECB Presidency. However, he resigned following the introduction of the ECB policy of limited buying of the bonds of troubled peripheral governments, which in retrospect was a fairly minor breach of Bundesbank monetary orthodoxy. The man selected to take over the Presidency was Mario Draghi, an Italian and a former investment banker.

By the time Draghi took over as President in November, Europe was in deep crisis, and the ability of the politicians to respond with bailout money funded by the other governments was almost nil. If the Euro were to survive it would require extraordinary monetary policy measures. Draghi understood this and introduced two Long Term Repurchase Operations, lending unlimited money to any Eurozone bank at 1% for 3 years. Much of this was used by the Spanish and Italian banks to buy their own government bonds trading at much higher yields. For the Bundesbank this was pretty close to the direct funding of government deficits, which is illegal – they were unhappy but did not oppose it.

The crisis has worsened during this year and Spain has become close to joining the ranks of those on the bailout list. Doing so would use up most the capacity of the bailout funds (which were designed to be so big that they would never need to be used). Over the summer, Draghi has come out with a new bond-buying plan for which he has garnered substantial support. Under the plan, if the politicians agree to a sovereign bail-out with conditions, and use some of the bail-out funds set up for the purpose, then the ECB will buy bonds of those countries to maintain their deficit financing costs at a reasonable level, in potentially unlimited amounts.

Rather neatly, everyone, except the Bundesbank is happy with this. The German politicians can claim that any bail-out requires German approval and will be subject to strict conditions, thus making Europeans more German, whilst the rest of Europe sees the ECB being publicly prepared to print large quantities of money to support the weaker European economies even though this creates the risk of inflation in Germany, making Germany more European! The Bundesbank reject it because the ECB is now no longer operating in the Bundesbank’s image.

The history of the crisis in Europe is that at each step Germany talks tough and finally gives in and pays up to keep the Euro alive. It has reached the end of contributing to bail-out funds with taxpayer funds and future bail-outs need the money to be printed by the ECB. Draghi’s plan allows this to happen, once the politicians agree to a bail-out. Despite their talk, German politicians always do seem to agree to them, and so, ineluctably, the Germans are giving up on the sound money orthodoxy, which has served them so well over the last 50 years. It is the Germans who are becoming more European rather than the Europeans becoming more German.

The implication for markets is that the pattern of markets is set to continue on a loop: creating crises in the bond markets of weaker countries, followed by those counties requesting assistance from Germany and Germany demanding more austerity from them before acquiescing, leading to a rally in markets before the cycle starts again. Draghi’s plan is a good solution for today but doesn’t solve the fundamental problems. However, if German politicians continue to become more European, the clearest market implication is to sell German government bonds, because Germany will either take on the debts of the rest of Europe in some way or the money printed by the ECB will create inflation in Germany.