Archives for November 2012

Hello Governor

In choosing Mark Carney as the next Governor of the Bank of England, George Osborne appears to have adopted the strategy employed by Roman Abramovitch, the owner of Chelsea Football Club, when selecting managers.

Mr Osborne scoured the world for someone who (i) was respected as a monetary policy expert in order to be effective as Chairman of the Monetary Policy Committee, (ii) understood the global banking industry to maintain and develop the role of London as a major force in the world’s financial structure and (iii) was a very effective executive to deal with what has been identified as a very inflexible culture and hierarchical structure in the Bank of England.

In Mr Carney, he appears to have found the man that best meets those criteria.  However, he is not British, though he does have a British wife and he says he will take on British nationality, and he is expensive.  These concerns, which would have counted against him very strongly in previous times, are outweighed by his reputation in the global markets and the application of more money.  Mr Carney’s basic salary will be almost 60% higher than Lord King’s and with other elements could end up being more than double what the current incumbent earns.

Mr Carney’s time at the Bank of Canada is lauded.  He was at the helm when the Canadian economy went through the financial crisis and under him it returned to a reasonable level of growth, without a banking sector meltdown, and without resorting to zero per cent interest rates or Quantitative Easing.

However, it is also true to say that much of Mr Carney’s success at the Bank of Canada is down to the work of his predecessors.  The Canadian banking system was much more tightly controlled in the lead up to the global crisis (having gone through its own meltdown in the early 1990s), with the result that neither the banks nor the Canadian consumers became over-leveraged as was the case throughout most of the rest of the G7.  Mr Carney took over at the Bank of Canada a few months before the crisis occurred, so no blame could be attached to him, and the problems he faced were far less severe than those found in the UK or the US.  He did not need to take the aggressive easing measures required elsewhere, and when Obama embarked on the huge fiscal stimulus in the US in 2009 and 2010, the Canadian economy was a natural beneficiary of the extra demand this generated.

Napoleon famously remarked that he preferred lucky Generals over clever Generals, and Mr Osborne would doubtless agree with Napoleon. Mr Carney has, it could be argued, been a little lucky.  The Governor of the Bank of England’s newly expanded role is a huge job, requiring economic policy dexterity to deal with a weak economy dependent upon an over-sized banking system that is undergoing major structural change in an institution with an out-of-date culture.  He is the best man for the job, but it will be a hugely difficult one – perhaps like managing Chelsea?


Buy Asia

It has been well understood for some years now that the driving force of global growth over the next decade is most likely to be the rise of the middle class consumer in the larger emerging economies, mostly in Asia.  This argues for heavy exposure, on a long term or secular view, to Asian stock markets and those Western companies that are successful in selling to the Asian consumer.

This secular view does however, from time to time, encompass cyclical periods of weakness, and the Asian stock markets have endured such a period over the last year and a half.  Current price levels in Asia provide an excellent opportunity for investors to buy into the key secular trend at a cyclically opportune moment.

The recently announced change in Chinese leadership has, arguably, inhibited the Chinese leaders from taking stronger policy action to support its economy, as attention within Beijing in the last year has focussed on internal Party matters, rather than the state of the economy.  The economy has been surprisingly weak for several quarters, and the official data was even permitted to show the last quarter as delivering 7.4% growth, which is slightly below the government’s 7.5% target. Other data from non-government bodies have appeared to show a much weaker economy this year.

The two major issues holding back a more supportive economic policy have been sharply rising food and house prices, both of which hurt the poorer sections of Chinese society.  In recent months however, both of these areas have shown distinct slowing in their inflation rates, and this has given policymakers more scope to ease policy. The economic data published over the last two months have also indicated signs that the tide of the economy is clearly stabilising and may be turning up.  The reason for this upturn seems to be an improvement in Asian consumer demand, rather than export demand from the West.  China’s new leadership team will thus be taking over at a good moment.

The Shanghai stock market has been a very poor performer since its peak in 2007, and has only been lower than current levels in late 2008.  Turnover in the Shanghai market is currently very low and is dominated by private Chinese investors seeking to make short-term trading profits.   Interest could easily be revived by some good news from the Chinese economy as valuations are historically low.  The other Asian markets, with their greater base of institutional shareholders (particularly foreign) and more-established, better-governed companies, have outperformed the Shanghai market, but valuations are still well below historic averages at a time of above-average profitability.

The secular thesis of much stronger growth in Asia than in the West is still very much intact; the recent cyclical weakness caused by a tightening of Chinese policy in 2011 and the slowdown  in Europe, China’s largest regional trading partner, has led to underperformance of the Asian equity markets over the last eighteen months. Recent data give grounds for believing this cyclical weakness is ending and that now provides an excellent opportunity to increase investment exposure to Asian equities.

“Zombie” companies: – Why corporate bankruptcies have to increase to spur recovery

Corporate bankruptcy plays a very important role within a competitive, free-market economy. Enterprises that fail were either providing a good or service that was not in sufficient demand from the rest of the economy or were providing a good or service that was not competitive with other providers in the marketplace.  Bankruptcy provides a means for the resources that were being used by the unsuccessful company to be taken from inefficient use to a more efficient use.  If this is continually occurring throughout the economy, then the use or resources will be efficient and the level of economic activity will be greater.

The US economy has generally been very good at this.  As the fortunes of industries wax and wane, both capital and workers can be seen moving from the struggling parts of the economy to the newly growing and profitable parts.  Private sector capital will always be highly mobile, but with relatively poor welfare benefits and the advantages of a common language and laws, the US workforce is also very mobile and ready to change geography and sector of work.

The above is fine in theory.   However, for politicians, elected by voters who want secure jobs, the concept of long term resource efficiency will often play second fiddle to protecting companies from going bankrupt and making their workforce unemployed.  If too many bankruptcies (that should have occurred) are avoided, then there will be adverse economic consequences.

Japan’s long period of very slow growth since 1990 can be at least partially attributed to the reluctance of their banks to foreclose on companies and force them into bankruptcy.  The alternative was to reduce the interest rates due on the loans to very low levels, even though there was little prospect of ever repaying the principal amount – in Japan they are known as “zombie” companies.  This reluctance was for two reasons. Firstly, the banks themselves were critically short of capital, and forcing companies into bankruptcy would mean that they would have to acknowledge losses, which would reduce their capital base and weaken the perception of their capital strength in the market.  Secondly the culture of Japanese society, which like many Asian cultures, places a large emphasis of maintaining “face” and avoiding “shame”.   Going bankrupt and formally not making good on your responsibilities to creditors is seen as very shameful, and many will go to great lengths to avoid it.  In the US by contrast, having a company go bankrupt is seen as part of the learning process to becoming a successful entrepreneur.

Recent data on European bankruptcies by Creditreform Research , is very illuminating.  When ranking European countries by the number of corporate insolvencies per 10,000 businesses in 2011, the four countries with the lowest rates of insolvency are Greece (5), Spain(18), Italy (26) and Portugal (57).  These are the Eurozone peripheral countries with the poorest economic performance.  The countries with the highest rates of insolvency are Austria (152), Denmark (182) and Luxembourg (316), which have all been relatively successful European economies.   The differences in this data between countries strongly supports the idea that an insolvency process that allows bankruptcies to occur easily, works to the benefit if the economy as a whole.

After the 2008 Crash, one of the surprises in the UK economic data in the face of weak economic performance, has been the rate of corporate insolvencies.  In the 1990s, business liquidations averaged about 160 per 10,000 companies, but during and since this crisis the number has not even reached 100.  There is a general sense that, as in Japan in the 1990s, banks are not foreclosing on companies.  This is (i) to avoid even more bad publicity than they have been receiving already, (ii) to avoid selling off whatever assets there are at knock-down prices and so realise larger losses than might be warranted, and (iii) to avoid write-offs from their capital bases at a time when their regulatory capital requirements are rising sharply.  Thus, as in Japan, they are content to roll over existing debt at low interest rates, even though they know that their collateral is worth far less than the loans against it.

The UK therefore probably now has a fair share of “zombie” companies. In the longer term, this will tend to inhibit recovery and growth in the UK economy, but in the shorter term it may well explain why the UK unemployment data has been consistently better than expected.  The other conclusion is that considerable, unrecognised bad debts still exist within the UK and European banking systems.  This underpins our concern that there will not be a return to stronger growth in the UK and Europe for several years ahead, which will limit returns from financial markets.

Mario’s Magic

Mario Draghi, the ECB President, can look back over his first twelve months in office with a great deal of satisfaction with what he has managed to achieve.  What he has done has been necessary, but it is not sufficient to maintain the integrity, and indeed the existence of the Euro.

Mr Draghi took over from Jean-Claude Trichet with the peripheral Eurozone bond markets in crisis.  At his first meeting of the ECB last November, he reversed the ill-timed interest rate increase made by his predecessor in July.  At his second meeting, he cut interest rates again and announced a Long Term Repurchase Operation (LTRO), which allowed any Eurozone bank to borrow as much money as it wished (subject to collateral rules) at a rate of 1% for 3 years.  In February, he announced a second LTRO.  For banks in Italy and Spain in particular, this was a lifeline as the money enabled them to buy into bonds issued by their governments which were then yielding much more than 1%, and so locking in a profit stream.  These two LTROs injected over one trillion euros of new liquidity into the banking system and eased the escalating liquidity crisis in the Spanish and Italian banking systems.  Though providing liquidity to markets in times of great stress is part of the job description of any Central Banker, Draghi, was seen to be very bold by opting for 3 year LTROs, much longer than anything else that had been previously done by the ECB and in unlimited size, which restored confidence to the system.

Unfortunately, the Eurozone’s problems were much worse than a banking liquidity crisis.  As 2012 progressed, it became clear that the Spanish banking system had a major issue of solvency.  In July, the Eurozone countries appeared to agree that the new bail-out mechanism, the ESM, would be able to lend directly to the Spanish banks, without the funds becoming a liability of the Spanish government and thus increasing the sovereign debt.  This was conditional on obtaining agreement to the setting up of a European Banking Union.  Within a few weeks however, Germany, Finland and Holland reneged on this agreement and Spanish bond yields rose as fears of a Spanish bailout and debt restructuring returned.

At a speech in London, just before the Olympics, Mr. Draghi made a dramatic comment: – “Within our mandate, the ECB is ready to do whatever it takes to preserve the Euro.  And believe me, it will be enough”.  In placing the preservation of the Euro as its highest priority, it effectively downgraded the importance of its previous prime priority, the control of inflation – the only acceptable target for German Central Bankers.  He quickly gained the support of all the political leaders and all the other ECB members apart from the Head of the Bundesbank, Jens Weidmann.

Draghi’s plan was that once a country had requested a bailout from its Eurozone partners, which had been approved by the other member states (unanimously, but with conditions), then the ECB would be prepared to purchase unlimited amounts of that country’s bonds to ensure that the interest rates in that economy would be aligned with what the ECB regarded as reasonable.  To Draghi, this would ensure that the ECB’s policy on interest rates was not sabotaged by the markets pricing in a Euro-exit risk premium that should not exist.  For Mrs Merkel and other Northern European leaders, the power to decide on a bailout still remained with them, but the ECB was doing the hard work of putting up the money.  Draghi’s manoeuvrings had isolated the Bundesbank, which was the only dissenting voice within the ECB.

Over the last twelve months, Draghi’s boldness and creativity have kept the Eurozone with a functioning monetary system.  The financial markets have understood and applauded his moves, sharply bringing down the cost of borrowing for the peripheral governments.  For his actions to continue to be successful in keeping the Euro together, however, he needs the politicians to make some difficult decisions.  The Northern European creditors must be prepared to (i) take losses on their Greek bailout loans, (ii) lend Greece more money to get it back on its feet, and (iii) when Spain and possibly other countries come to request bailouts, then the conditionality they impose needs to be politically bearable within the debtor countries.  In turn, the Southern European debtors must be prepared to adopt structural reforms and spending cuts that are painful but necessary for their countries to live within their means.  German and Italian elections next year will bring confusing political rhetoric, but it will be their politicians’ actions rather than their words that will determine whether Mr Draghi will go down in history as the man who saved the Euro.