On the QT

2009 saw the world embark on a giant economic experiment – that of Quantitative Easing (QE) in which Central Banks injected large amounts of money into their financial systems. Next month, the Federal Reserve announced this week, will see a new first for monetary policy – a policy of Quantitative Tightening (QT) in which money will be withdrawn from the financial system.
They have announced that this new policy will be phased in, starting at a rate of $10bn per month from October, rising each quarter to $50bn per month by October 2018. At the same time, they expect to raise interest rate four more times to 2% by the end of 2018.
The timing of this policy shift appears less related to current economic conditions and much more to two other factors. First is that Western Central Banks appear, as a group, to have decided that the very easy monetary policies need to be pulled back. In addition to the Federal Reserve, the Bank of England has also recently indicated its desire to increase interest rates and the ECB is has laid out plans to bring to an end its QE programme. This tightening seems to be globally co-ordinated. Secondly, the Federal Reserve appears to be publicly setting out its policy for the next year, in such a way that it would be embarrassing not to carry it through. This comes at exactly the time that there are many places on the Federal Reserve Board to be filled over the next twelve months by nominees of President Trump, including the key role of Chairman currently filled by Janet Yellen.
Over the period of QE, from October 2008 to October 2014, the Federal Reserve increased its balance sheet from about $750bn to $4.5 trillion through 3 separate programmes of purchases. Its peak purchase rate was $85bn per month.
The widely accepted effects of the QE policy were:
1. It helped to offset the effects of the Global Financial Crisis in 2008/9, and prevented a 1930s style Depression from setting in.
2. It has done little to foster a rapid economic recovery, instead US GDP growth has stabilised at a muted 2% pa rate, only a little higher than the increase in population, and inflation has struggled to exceed 2%. There is little evidence that the increased money supply has found its way into the real economy through physical investment.
3. The prices of financial have moved much higher, principally through higher valuations relative to the income streams they produce. This is evident in house prices, stock prices, bond prices and the prices of prestige assets such as artwork and vintage cars. The increased money supply has thus remained within the financial economy rather than the real economy.
4. The combination of lacklustre real economic growth, rapid growth in financial asset prices, and the skewed distribution of wealth in the US economy has meant that the very wealthiest in 2008 have become even more wealthy and inequality has risen very substantially with the richest 0.1% gaining much more than the richest 1%, who gained much more than the richest 10% who gained much more than the rest of the population.
The implications of QT are thus that what has been to be a key support for financial market prices will be reversed by falling valuations as money is withdrawn from the financial system. It may also be that in fact this has a limited impact on the real economy as the decline in wealth will affect only the very wealthiest in society who demonstrate a low correlation between changes in their wealth and changes in their spending patterns.
A deeper concern is that QT will affect valuations in both equity and bond markets at the same time. Most investors have not seen an environment in which both markets fall simultaneously and this has the potential for aggressive selling of leveraged positions in markets, which could take markets down to surprisingly low levels.

Peter Pan, Central Banks and markets

J M Barrie’s Peter Pan had a very strong grasp of the necessity of faith – “Whenever a child says “I don’t believe in fairies”, there’s a fairy somewhere that falls down dead” was written in 1911, and his own ability to fly was critically dependent on his lack of doubt that he could fly.

Ever since the introduction of QE in 2009, markets have had faith that the unconventional actions of the Central Banks would lead to economic recovery. The markets’ expectation of better times ahead itself played a key role in boosting confidence in the real economy, so helping to generate that recovery.

In the last three months however, that faith has been eroding as markets have come to believe that central banks are no longer in control of events. In Japan, the failure to boost QE further at the end of 2014, when the Bank of Japan were expected to do so, closely followed by the adoption of negative interest rates a week after denying they would do so looks like panic. In Europe, Draghi encouraged markets to believe that further ECB easing would be forthcoming in December, only to be unable to deliver it, and then repeated the encouragement that action would be taken in March after market weakness in January. The ECB appears to be a very divided Central Bank. In the US, the Federal Reserve clearly indicated in December when it raised interest rates for the first time in seven years that it expected four further such increases in 2016. Yet markets now assign an equal probability to their next move being a rate cut as a rate hike – the Fed is losing credibility.

Behind all this is the continued deterioration in growth expectations – a year ago there was a general sense that 2015 would see economic recovery around the world as the enormous global monetary easing over the previous six years finally bore fruit. The reality was that once again growth disappointed expectations even with the tailwind of a much lower oil price. Market sentiment is giving up on monetary policy producing economic recovery, and their lack of belief will make it even harder for Central Banks to deliver it.

In particular the move to negative interest rates in Europe and Japan, and the admission by Janet Yellen that the Federal Reserve would also do so if they believed it was necessary has alarmed investors in bank securities, both equities and bonds. Coming as it does with further downgrades to global growth expectations, markets have drawn the implication that central banks themselves are losing confidence that further QE will stimulate economies and thus they are moving towards the idea of negative interest rates. If the Central Banks no longer believe in QE, why should anyone else?

Widespread negative interest rates have not been adopted before – perhaps they will incentivise people to spend rather than save, but that is unclear. What is clear is that negative interest rates are bad news for banks – they have been very reluctant to extend negative interest rates to most depositors, with the result that their net interest margins are falling, at a time when loan growth is slow or non-existent. Banks are the worst performing equity sector so far in 2016.

Markets have now lost faith in the ability of Central Banks to create economic growth – falling bond yields and falling equity prices demonstrate this. To recapture that faith, Central Banks will have to take even more aggressive, unusual and unexpected action.

Greece – one month on

It is now one month since Syriza came to power in the Greek general election. Much has been said across Europe, many meetings held but little has changed.

Syriza said, both ahead of and immediately after the election, that they would immediately and unilaterally throw out the Troika (the term for the EC, ECB and IMF group that oversaw Greece’s adherence to the bailout conditions imposed) to regain sovereignty over economic policy and end austerity. They said that they would demand a haircut on the amount of debt owed and that the rest of Europe would agree to this because it was (a) fair and just and (b) Europe would be scared that Greece might pull out of the euro and set off a chain reaction amongst other members that would call into question the very existence of the single currency.

Over the last few days Syriza has backed down from all of these demands, with apparently very little gained in return. Europe has stated very clearly that any write-down in the value of the outstanding debt is unacceptable to them, and Europe has continued to demand that the same trio of institutions (though now called the institutions rather than the Troika) determine whether Greece is complying with its obligations under the original bailout agreement. Also rather than anything happening immediately as Syriza demanded further discussions will take place over the next four months and conclude just before Greece is required to repay the next tranche of its debt.

It seems difficult to argue anything but that Syriza has failed miserably to deliver what it had promised the Greek voters – and indeed the risk now is that Syriza is unable to get its own MPs to give parliamentary approval to what it has agreed with Europe – which would lead to a new crisis.

With a finance minister who was formerly a professor of game theory, everyone was interested to see the negotiating techniques that Syriza adopted. At the time, and even more so with hindsight, they do not seem to have been very smart. The first acts of Tsipras and Varoufakis (the prime minister and finance minister) seemed designed to upset and offend the Germans, which may have good for domestic politics, but not ideal for bringing on board the key decision-maker in reaching agreement with Europe. They also made significant concessions very early – within a few days of coming to power, Tsipras was saying that Greece intended to repay every euro of its debts. Syriza’s maximum leverage was always likely to be immediately after the election, when “democracy” was on their side – by allowing discussion to go on for another four months they will lose that benefit. Finally it became clear as time went on that the “disaster” scenario of Greece pulling out of the euro, was something that Germany was quite prepared to live with (indeed many Germans are actively campaigning for it) whereas Syriza did not have a mandate to allow that , given that 70% of Greeks want to remain in the euro.

By contrast, Europe, led by Germany but strongly encouraged by both other Northern countries such as Finland who share the German approach to economic discipline, and by Southern countries such as Spain and Portugal, who have been through similar austerity programmes to Greece without (much) complaint and did not see why Greece should get any special treatment, played their hand in a very robust style. Schauble, the German finance minister seemed to revel in the role of “euro-enforcer”, and has insisted on Greece backing down on almost every substantive element of their demands.

The lessons from the last month seem to be (i) when going into a negotiation you need a credible fall-back position if you can’t get what you want – Syriza rather put a gun to their own head and threatened to shoot, (ii) Syriza, by conceding externally in Europe, may well have lost credibility internally, disappointing both many of their own party members and many Greeks who voted for them and (iii) Europe does not recognise democracy as an appropriate reason to go against past agreements and the rule of law (Juncker has made this point explicitly) – it should now be abundantly clear that being a part of the euro means a substantial loss of sovereignty for a nation, especially if they have a weak financial system.

Not much has changed in the last month. Greece is still stuck with debt it will never be able to repay, the Greek government has almost no say in how its economy is to be run, and the European political class have asserted their right to ignore the results of democracy in their quest to maintain the structurally-flawed single currency. This is not a long-term equilibrium – there are more crises to come.

“Alptraum” – German for nightmare

Recent events in Europe have seen many of Germany’s worst fears come true.

  • January 22 saw the ECB finally agree to initiate a policy of Quantitative Easing despite the objections of the German members on the Council. The ECB, supposedly created in the image of the Bundesbank, is now committed to a policy of money creation whose deliberate target is to increase in the inflation rate. Both the policy and its objective are in violent opposition to all that German monetary policy has sought to achieve over the last 70 years.
  • January 25 saw the Greek election result in Syriza polling far higher and thus gaining many more seats than had been expected. Instead of choosing to go into coalition with a more moderate centre-left party, Syriza formed a coalition with the far-right Independent Greeks, with whom they disagree completely on most issues but are agreed on one key policy – the tearing-up of the bailout agreements. The Independent Greeks are strongly anti-Germany and wish to reclaim war reparations they claim Germany owes to Greece. Today Greece now has what is arguably the most anti-German and authentically communist government in the European Union. The coalition are committed to tearing up the bail-out agreements signed by previous Greek governments and are demanding that much of the debt they owe be written off. Germany was a necessary, but very reluctant, party to these agreements as they appeared to compromise the key “no bailout” clause of the Maastricht Treaty.
  • January 26 witnessed Tsipras’ – the newly sworn-in Greek prime minister – first act paying a visit to the Kesariani rifle range, the site of a memorial to 600 Greek resistance fighters who were executed in a single day in 1944 by German occupying troops. The symbolism of Greek resistance to German subjugation today through opposition to the hated bailout agreements was clear and very deliberate.
  • Following this visit, the first ambassador that he decided to meet with was the Russian ambassador, who re-affirmed Russia’s readiness to provide financial support to Greece should they require it. The EU’s policy of sanctions on Russia, of which Merkel was a key influence and driver last year, has to be extended in the summer and requires unanimity from EU members.
  • The first domestic policies that the new government intends to enact are an end to planned privatisations, a large increase in the minimum wage, the re-establishment of thousands of public sector jobs that have been cut in recent years and increases in pensions. All of these will make meeting the targets for the Greek budget deficit impossible to achieve in the short term – they will also hit the competitiveness of the Greek economy and threaten to undo the gains that have been made in this area in recent years.

Though both the German and Greek governments are saying they do not want Greece to leave the euro, the possibility of this occurring is now very real as the halving of the prices in Greek bank shares since Syriza’s victory is indicating (Greek banks would be immediately bankrupt should they lose the liquidity support of the ECB). Many Germans are now quite prepared to take the risk of another eurozone crisis should Greece leave the single currency, and in domestic political terms, Merkel has little in the way of compromises that she can offer. Until quite recently Syriza was calling for Greece to leave the single currency, but in recent months softened their rhetoric as polls show that three-quarters of Greeks wish to remain in the euro. Being effectively thrown out of the euro by the EU for standing up for Greek interests may well be seen by many in Syriza as a good outcome.

The last week has seen each side harden their positions. Whilst the history of the EU tends to be one of finding the minimum necessary compromise at the last possible minute, the philosophical differences between the German and Greek governments are ultimately not reconcilable and one or both of them will have to give way on key points of principle for Greece to remain in the single currency.

The German dilemma

Within the Eurozone, Germany is coming under increasing pressure to approve and adopt policies designed to stimulate the Eurozone economy. This is because (i) Germany is the largest economy in the Eurozone, (ii) since the global financial crisis, Germany has enjoyed the strongest performance within the Eurozone based mainly on exports, which has led to a very substantial trade surplus, (iii) German public finances are in a very healthy state compared with most in the Eurozone and (iv) they are rich and have the policy flexibility to act.

Many in the rest of Europe are calling on the German government to launch a large debt-financed fiscal boost through public investment spending, creating, it is hoped, jobs and demand throughout the Eurozone. The Germans are resisting this strongly because they have worked very hard in recent years to get their government finances back onto a solid footing, and are expected to get close to a balanced budget in 2014. German politicians are stoutly resisting European calls for them to spend more and move back into deficit.

It is though in monetary policy where the greater controversy is being generated. Through his public utterances over the last six months, Mario Draghi has sought, to maintain market confidence by positioning the ECB as about to introduce a US- or UK-style QE programme in its efforts to boost demand and inflation. However the actual policy steps agreed at ECB meetings have not lived up his words – QE is always just a few months away. It is clear that, behind the scenes, the Bundesbank and several ECB members are fiercely opposed to such a policy, with many in Germany believing it to be illegal. They are angry at the way that Draghi has sought to bounce them into such a policy by his public statements.

To many in Europe (and indeed the world), the Germans are the bad guys, doggedly blocking any moves to boost the moribund Eurozone economy due to their particular economic ideological fixations around sound government finances, conservative monetary policy and a strong currency. Being so out of step with their Western allies is not a position in which post-war German governments have wished to find themselves, and in any other field than economic policy, they would have made adjustments to their position and found a compromise.

It should however be recalled that Germany never asked for the single currency, and when it became inevitable, did their best to restrict membership only to those economies that were happy to embrace German economic orthodoxies, for precisely the reasons that are now being played out within the Eurozone.

In 1990, Mitterand’s price for accepting the re-unification of Germany was monetary union. In permitting Germany to become a much larger, and thus more powerful nation, he sought to maintain France’s significance by sharing the all-powerful Deutschemark. Kohl accepted this provided that all those involved in monetary union were prepared to manage their economies according to German orthodoxy. Thus the ECB’s mandate was constructed along very similar lines to that of the Bundesbank – very independent of politicians, with a mandate of low inflation delivered through conservative monetary policy. Similarly, the Maastricht Treaty constrained the size of government deficits and public debt that individual countries would be permitted. With these in place, the only economic solution for countries finding themselves in economic difficulties is for export-led growth, with the private sector becoming more competitive in global markets through cost control, innovation and structural reform. There would be no room for short-tem fixes generated by lower interest rates, weaker currencies and debt-financed government spending.

The criteria for membership of the euro were deliberately designed to exclude what are now known as the peripheral economies. Only the “core” European economies were expected to qualify, who understood and were prepared to accept German economic thinking. However everyone wanted to qualify and through a combination of the long economic boom of the 1990s and some very creative accounting, the euro began life both with many more members than Germany had ever intended, and with much weaker (though disguised) public finances than Germany would have countenanced.

Since 2008, the Germans have continued to espouse the policies that they believe were written into the monetary union. Thus they expect countries to embrace public sector austerity to reduce budget deficits and bring their giddy debt levels back under control, they expect their Central Bank to adhere to policies of sound money by control of money supply growth and they have a particular fear of Central Banks who buy government debt with newly-printed money. This is the economic and monetary union Germany insisted on, signed up to and has always believed that others had agreed to.

To date they have not relented on these principles, but it is leading to great pain and bad will across Europe, where the peripheral economies which previously resorted to policies of devaluation and government spending to boost their economies in times of trouble, cannot understand why these should not be adopted now. Germany now faces its greatest dilemma – whether to abandon the economic principles which have been the foundation of its economic success since 1945 and remain on good terms with the rest of Europe, or, remain true to its economic ideals and be the cause of the break-up of the monetary union as weaker economies are forced to leave.

In 2012, Angela Merkel opted to bail out Greece rather than risk the break-up of the euro, though by all accounts the decision was close and arrived at only after months of consideration. When the ECB finally votes to adopt QE (almost certainly sometime in early 2015), there will be vigorous opposition within Germany including legal challenges. Once again Mrs Merkel’s leadership will be key in determining the future for Germany and for Europe.

Nippon Europe?

Angela Merkel’s favourite set of facts about Europe are that it represents 7% of the world’s population, 25% of the world’s GDP and 50% of the world’s social spending. It is this that informs Germany’s insistence that the rest of the Eurozone meet their budget deficit targets.  In recent years, through harsh austerity, the peripheral economies have made good progress in reducing their budget deficits.  Progress has been very disappointing at the core of Europe and in particular France and Italy, which together represent almost 37% of the Eurozone economy.  These countries still have much painful restructuring to come, which will continue to depress demand in the Eurozone as a whole: Europe’s economy is likely to continue to stagnate and it increasingly resembles the Japanese economy of 10 – 15 years ago in terms of high levels of public debt, poor demographics and weak policy action.  We believe Europe offers few opportunities for profitable investment in the next few years, and therefore remain VERY LIGHT in Europe in our model portfolios.

The second quarter data for Eurozone growth was disappointing, showing zero growth for the Eurozone as a whole, and of great concern for the health of the core, all of the three largest economies (Germany, France and Italy) reported negative growth:

  • Growth in Germany has been hurt by the switch and slowdown in spending in China, away from investment and infrastructure spending towards consumer spending, and also by the sanctions imposed on Russia – two trends that seem likely to persist for some time;
  • The French Government has been forced to admit that their economy will not grow this year, and they expect only 1% GDP growth in 2015, with the result that France will not be able to meet the EU targets for budget deficit reduction, which have already been extended by two years from the original target dates. Though Francois Hollande accepts the need for French austerity and reform, many of his Socialist Party colleagues are opposed to the necessary measures and are unlikely to vote for them in parliament. The recent dissolution of the cabinet highlights the growing division within the Socialist Party;
  • In Italy the economy has already endured a lost decade. The size of the economy in real terms has not grown since Q1 2000, and in nominal terms has not grown since Q3 2007. The budget deficit remains large, but Prime Minister Matteo Renzi has effectively warned his Eurozone partners that he will seek to ignore the EU budget and fiscal rules designed to reduce Italy’s debt/GDP ratio. Italy’s finances would be in far healthier shape but for the interest that has to be paid on Italy’s €2 trillion government debt.

The stage is now set for a major argument within the Eurozone between Germany and the Northern economies (mainly Finland, the Netherlands and Austria) who are currently demanding that France and Italy reduce their deficits and the countries themselves, which appear very reluctant to take the necessary measures. This is likely to lead to a long period of drift amongst the leaders of the Eurozone, and create uncertainty about the future direction of European economic policy.

Meanwhile, clear evidence of progress in the periphery can be seen in the record of both Ireland and Spain’s private sectors, which have been at the forefront of efforts to make their industries more competitive with Germany since 2008.  From 1998 to 2008, Irish and Spanish Unit Labour Costs (“ULCs”), which represent the average cost of labour per unit of output, rose steadily while German ULCs were unchanged, and so the former became increasingly uncompetitive. Since 2008, German ULCs have risen but Irish and Spanish ULCs have fallen back, bringing their economies back to the competitiveness relative to Germany last seen in in 2005.

In France and Italy, in contrast to Ireland and Spain, ULCs have continued to rise since 2008 – there has been no improvement in competitiveness relative to Germany. The core of the Eurozone economy is steadily becoming less able to compete in global markets, which has negative implications for the potential for these economies to grow.  Both France and Italy need the austerity in both public and private sectors that the peripheral economies have been undergoing in the last few years.

Europe’s economic problems – (i) excessive public sector debt, (ii) poor demographics and (iii) a banking system suspected to be hiding considerable bad debts, leaving banks unwilling to lend – are eerily similar to those of Japan over the last two decades, an economy which has seen zero nominal GDP growth over that period, and is now embarking on one of the most extraordinary policies of money-printing ever seen in a developed economy. There is also a fourth problem, which is the existence of the Euro with its flawed construction that seeks to deliver a monetary union without a political union.  For many countries, remaining in the Euro requires strong deflationary policies, while coming out of the Euro would be seen as a hugely negative political loss of face.

The peripheral economies have taken their medicine, with frightening results in terms of youth unemployment and living standards in recent years. The same, however, cannot be said of France and Italy, and when the dose is taken, given the size of their economies it will lead to far greater repercussions on the European economy, than was seen with the peripheral economies.  With a strong currency, high unemployment and weak wage growth, the medium term outlook for the Eurozone economy is bleak, and returns to investors will be challenging to find.  The ECB is the one institution that could break the logjam, but to do so would require a QE programme on such an enormous scale that Germany could never accept it.  If the ECB does resort to a policy of QE, it will likely be too small to be effective, and will merely lead to disappointed financial markets.   We therefore remain VERY LIGHT in Europe in our model portfolios.

 

 

 

Banking Matters

Healthy banks are a critical ingredient in the economic infrastructure that underpins growth and equity market performance.  Today the healthiest banks are found in Japan and Asia and the weakest in the Eurozone.  Thus banks in Japan and Asia look best placed to support growth in their economies, whilst Eurozone banks appear worst-placed.  This analysis contributes to and supports our current positioning within equity markets, where we favour the Japanese and Asian markets and are cautious on the Eurozone markets.

Five years ago, Hank Paulson, the then US Treasury Secretary, decided that financial markets would be able to deal with the bankruptcy of Lehman Bros, and refused public money to rescue it.  His judgement was that Lehmans was not “Too Big to Fail” and it proved to be wrong, since the following six months led to an almost total shutdown in interbank lending and a collapse in economic activity all over the world.  Governments around the world were forced to provide capital for the weaker banks in their economies and central banks provided the liquidity for banks that the banking system had previously provided by itself.  In hindsight, Lehmans was “Too Big to Fail”, and by implication, so were many more banks all over the world.

Over the five years since then, policymakers have focussed much more on dealing with the macro-economic consequences of the crisis than on dealing with this key weakness that caused the crisis.  Some small steps have been made. Firstly, there is now an official list of systemically important financial institutions produced by the Financial Stability Board, a new global body that monitors the global financial system and makes recommendations for change.  These institutions have slightly higher capital requirements than other banks to reflect the fact that since they are agreed to be systemically important, they will be bailed out in the event of a future crisis.  Secondly, many countries have now brought in the concept of “living wills” for their largest banks, setting out how their activities can be wound down in a rapid and orderly fashion in the event of them falling into a financial crisis.  These steps effectively acknowledge that many banks remain “Too Big to Fail”, and merely attempt to make it easier to deal with any problems that may arise from that reality.

The crisis actually made the larger banks even bigger, since weaker institutions were pushed into mergers with what were thought to be stronger institutions – in the US, Merrill Lynch was absorbed by Bank of America and Bear Stearns was absorbed by J P Morgan, and in the UK, HBOS was forced into a merger with Lloyds.  The financial crisis in Japan over the last 20 years has seen the number of major banks there decline from ten to just three as the banks merged to maintain profitability.  Earlier this year the US Attorney General, Eric Holder, admitted publicly that as well as being “Too Big to Fail”, he believed that the largest banks had become “Too Big to Jail”, since prosecuting these banks for fraud or money-laundering offences might be so damaging to their reputations and their businesses that it might have significant economic consequences.

Within the more troubled Eurozone economies, where governments found it difficult to find buyers for the bonds issued to finance their burgeoning deficits, the local banks were “encouraged” to buy the bond issues, using the extra liquidity supplied by the ECB.  This has created a potential downward spiral, in which a government struggling to service its debts creates problems for its own banking system, which then requires bail-outs from the same government to keep it afloat.  Italy and Spain are most at risk of falling into this spiral.

Almost by definition, banks deemed “Too Big to Fail” have significant political influence, and will use it to fight attempts to make them smaller.  Tougher capital requirements are being imposed, but only to levels that would have been seen as hugely risky by the bank managements of thirty years ago.  Policymakers have a clear conflict here – they are desperate for banks to resume lending to stimulate and support economic growth, but demanding higher capital ratios of the banks only acts to restrain lending.  There has been little in the way of forcing the banks to become smaller entities, apart from the ending of proprietary trading within investment banks and, in the UK, the Lloyds spin-off of a number of its branches under the TSB brand name.

The health of a country’s banking system is generally seen as critical to its ability to support economic growth – though this is less true in America where the corporate bond market is extremely deep and wide, enabling smaller and riskier companies to raise bond finance as well as loan finance.  Some may be surprised that the major economy with the healthiest banking system is Japan – this follows two decades of the banks writing off bad debts and making little in the way of new loans over this period.  Loan-to-deposit ratios are now very low and the capacity to lend to the private sector of the Japanese economy is great, should the demand for those loans improve (which finally appears to be happening).  Asian banks underwent an existential crisis in the late 1990s, and continue to maintain prudent capital and loan-to-deposit ratios – they remain very well-placed to support the expected rapid growth in Asia.  The UK banks are still working their way through a large amount of bad debt related to UK commercial property, but are believed to have made provisions for the bulk, if not all, of their expected losses – they are now in a position to consider lending again, though are still scarred from the experience of the last few years.

It is the Eurozone that is the home of the greatest banking problems today.  Each country has a number of banks that are nationally systemically important, and so do not wish to see fail, but where there are substantial unrecognised bad debts.  These debts cannot be written off without imperilling the capital position of the banks, and so they remain on the banks’ balance sheets. The amount of new capital  that Eurozone banks would be required to find in order to be able to write off these debts and remain in business is believed to be very large, beyond the capacity of the financial markets to provide, and will thus require capital to be provided by governments, which are themselves short of funds.  Until this is resolved, Eurozone banks are in a very weak position to support growth through new lending.

Thus banks in Japan and Asia look best placed to support growth in their economies, whilst Eurozone banks appear worst-placed.  This analysis contributes to and supports our current positioning within equity markets, where we favour the Japanese and Asian markets and are cautious on the Eurozone markets.

The Global Monetary Policy Kaleidoscope

In 2009, in the face of a global economic crisis, the major economies of the world came together and acted in concert to ease monetary policy aggressively.  Together with fiscal stimulus in the US and China, these policies helped to prevent the world from slipping into depression.  Four years on, the economic conditions around the world vary enormously, and the appropriate monetary policies are now very different (though for all countries fiscal restraint is deemed necessary).  These differing monetary policies are producing clear differences in how the local financial markets are performing, and in 2013 there has been a much greater dispersion of performance between equity markets around the world than in 2012.

The economy with the most aggressively easy monetary policy (relative to the size of its economy)  is currently Japan, where in response to the lead of the new Prime Minister, the new Bank of Japan Governor has begun a programme of doubling the country’s monetary base in just two years.  This is being done deliberately to raise the rate of inflation in Japan from the negative rates seen in recent years to the new target of 2%.  To bring Japan out of its 20 year deflation, policymakers have articulated that inflation, and inflation expectations, need to rise to boost the nominal growth rate of the economy.  Should the current policy settings not be sufficient to do this, it is expected that policymakers will move monetary policy to an even easier stance.  The weaker yen that is likely from this policy should be instrumental in helping to boost inflation.

Next is the US, where currently the QE programme is about $4bn of new money creation every day that the financial markets are open.  Before the latest Japanese policy move, this constituted the most aggressive monetary easing.  However, the recent furore following Bernanke’s comments about the tapering of the QE policy indicate the sensitivity of markets to changes in the direction of US monetary policy.  Bernanke tried to argue that tapering a policy of printing $4bn every day to one of printing $2bn or $3bn was still a very accommodative policy; the markets however appeared to interpret it as a tightening of policy.  The rise in US bond yields since May shows that a policy that is easy, but less easy than it was, creates different expectations in the minds of investors, and the Federal Reserve’s words have thus changed the thinking of investors.

Both the ECB and the Bank of England are at a similar phase in their monetary policy.  Both have pursued unconventional policies in the past, the ECB with their three year LTROs and the Bank of England with their own QE programme, but have done little recently to move policy easier.  However, the new Bank of England Governor has clearly been tasked with boosting economic growth in the lead-up to the next election, and the ECB is concerned about the continued poor performance of the Eurozone economy.   The recent rise in bond yields that began in the US and spread across the Atlantic has been unwelcome as it raises the cost of borrowing for business and so offsets the otherwise easy policy in both the UK and the Eurozone.  A further easing of monetary policy can therefore be expected from both Central Banks, and crucially, for markets, the direction of monetary policy is still moving easier, in contrast to the US.

In China, markets have been surprised by the actions of the People’s Bank of China in not providing sufficient liquidity for the interbank market to operate smoothly in the face of liquidity pressures.  This caused overnight interest rates briefly to move above 10%, and has been interpreted as a lesson to the banking system that they have been too carefree with their lending and need to cut back.  This is effectively an act of policy tightening, though it is unlikely that the Chinese will take such tightening too far and seriously damage the economy’s growth prospects.

Finally, there are a number of significant emerging markets such as Brazil, Turkey, Indonesia and India where Central Banks have actually raised interest rates or have indicated an intention to do.  For the most part, this has been due to currency weakness, which boosts inflationary pressures in these economies, and so a tightening of monetary policy is believed to be required, in contrast to most of the rest of the world.

The league table of the stance of monetary policy, which runs from Japan, the US, the UK, Europe, China and Asia and then other emerging markets correlates precisely with the league table of year-to-date equity market performance.  Those countries with the easiest stance of monetary policy are those whose stock markets have performed best, and those with the tightest policy stance have performed worst.  This highlights the increasing dependence of financial markets on the liquidity provided by Central Banks, rather than fundamental economic and earnings trends.

Looking forward, we would expect Japan to remain at the top of the easy monetary league, with the UK moving up and the US moving down in the next few months, and the Eurozone having little room to make any changes.  China’s slowing growth will eventually produce an easier monetary policy, but may not be imminent, while the other emerging markets appear to be the furthest away from easier policy.  Japan and Asia remain the most favoured markets in our portfolios with Europe and Emerging Markets the least favoured.

Eur-out

For the last quarter of a century, Germany has been open to monetary union with the rest of Europe, provided that three conditions were satisfied.  These are (i) no bailouts of other countries who were also in such a monetary union, (ii) the Central Bank that sat at the centre of this union was heavily modelled on the Bundesbank and its operation of monetary policy and (iii) all participating were subject to clear rules with regard to budget deficits and total government debt.  With all three conditions in place, then Germany felt that all other countries in the monetary union would be forced to manage their economies in the same way that the German economy was managed.

Since the crisis, all three of these conditions are being severely tested, causing increasing angst to many in Germany.  With regard to the first condition, it is currently true that no country has been bailed out by transfers from the other countries. However, Greece has stretched this interpretation to the very limit.  Huge amounts of money have been lent to Greece by the IMF, the EU and the ECB (and so not directly by other countries), which are officially repayable.  All non-official holders of Greek debt have had their arms twisted to agree to their holdings being substantially written off.  Most investors expect the official holders also to agree to write-offs (at which point the money is no longer lent but in reality given), but this will not occur until 2014, after this year’s German elections.  Germany’s first condition (no bail outs) will be breached next year.

Under its first two Presidents, Duisenberg and Trichet, the ECB did, in fact, model itself heavily on the Bundesbank in its operation of monetary policy. Draghi, however, took over at the height of the crisis.  His first act was to provide a trillion euros of extra liquidity for weak banks from the peripheral countries, in exchange for collateral of very dubious quality, a tactic which drew criticism from the Bundesbank, but great acclaim from most other quarters.  Then last summer, as Spain appeared to have lost the confidence of markets to issue its debt, Draghi invented the concept of Outright Monetary Transactions, which permitted the ECB to intervene in government bond markets to an unlimited extent. The Bundesbank, saw this (rightly) as tantamount to the printing of money, as was being practised in the US, Japan and the UK, but was the lone vote against within the ECB Council.  Crucially for Draghi, Merkel decided to over-rule the Bundesbank and gave Germany’s blessing to this very un-Bundesbank action.  Germany’s second condition has already been breached.

The third condition is the one which matters most, and which Germany will least be prepared to see breached.  To emphasise the point, Germany has brought forward its draft of the 2014 budget, demonstrating that it continues to cut government spending to meet its target of a balanced budget in 2015.  The message to the rest of the eurozone is unambiguous – they too must meet their promises of cutting government spending to achieve balanced budgets in the medium term.

The forthcoming EU summit will contain no Italian government, following the post-election stalemate in which over half of the voters voted for parties which explicitly rejected the EU-led austerity programme initiated by Monti.  The French government has just announced that it now expects a deficit of 3.8% of GDP this year, compared with its EU target of 3.0% – it seems unlikely that President Hollande will make any great attempt at further government spending cuts.  In Greece, the latest tranche of official loans is dependent upon clear plans for Greece to cut 150,000 civil servants from its headcount in the next eighteen months. Greek politicians are very reluctant to agree and even more reluctant to implement such plans.  Both the Spanish and Portugese have promised their people that they have had the last round of cuts, but their budget deficits remain too high due to the continuing recession in these countries.

Austerity in the Mediterranean countries is reaching its political limits.  If Germany continues to insist on its third condition (the control of budget deficits) as Merkel will want to be seen to be doing ahead of her election in October, then the possibility of a country falling out of the euro in the short term is once more very real.  In the longer term, even if Germany gives a little ground now, it will continue to insist on governments reducing their budget deficits at a rapid pace that will mean little or negative growth in many eurozone countries for years to come.  This price will prove too high for some economies.

The investment implications of this are to maintain low exposure to euro-denominated assets until more reflationary policies are being actively pursued in the euro area – if Germany continues to stand on its principles, this may be never.

Weak Yen weakens Germany

Germany, the powerhouse economy of the Eurozone, recently announced 2012 GDP growth of only 0.5%, and that it expected 2013 to deliver only 0.4% growth.  At a time when most of rest of the Eurozone is undergoing policies of austerity and reductions in private sector wage costs, they are looking to Germany to be the source of demand for their goods and services, which their own economies are currently unable to provide.

With a balanced budget, near full employment, and a trade surplus of 7% of GDP, Germany is ideally placed to pursue policies designed to boost German consumer incomes and spending, which the rest of the Eurozone could supply.  Yet, aside from some very modest pre-election tax cuts, which have already been announced, there is no indication that German politicians wish to go down such a road.

This is for two reasons.  Firstly, they take the view that the reason for their economic success is precisely because they have not, historically, pursued such short-term stimulatory policies, but have instead concentrated on ensuring they have globally competitive private-sector industries and a structurally balanced public-sector budget.  Secondly, the German Finance Ministry has realised that in the next few years they will need to provide funds to meet their obligations to the EFSF and the ESM, which have been set up to provide the bail-out monies for the weaker countries. They are thus already planning for offsetting public sector spending cuts in 2014 and beyond – in sharp contrast to all other countries, who are hoping further bail-outs won’t be needed, or will seek to borrow the funds from the markets if they are.

So, domestic spending is unlikely to be driving the German economy in the near future.  As usual, Germany will be hoping to benefit from global demand for its exports. Here though, the actions of the ECB and Japan may thwart those hopes.

Despite the Eurozone sliding back into recession, at its last two monthly meetings, the ECB has not cut interest rates when many commentators thought that it could and should have done.  Indeed after the last meeting, Mr Draghi made clear that the ECB had done as much as it could to promote growth, and it was now the role of governments to produce pro-growth policies.  The markets interpreted this as saying that no more rate cuts or easing of monetary policy would be forthcoming, in contrast to the $85bn each month of QE from the Federal Reserve.  Since then the euro has been the strongest of the major currencies, making German exports less competitive.

In Japan, the focus of the new government to stimulate the economy by all possible means including weakening the currency has seen the yen fall sharply in recent weeks.  Against the euro the yen is 20% weaker over two months and 26% weaker over six months.  These are dramatic moves for any major exchange rate, but the euro-yen exchange rate is particularly important for Japan and Germany.  This is because their strengths are in very similar industries, and competition is hard-fought in sectors such as automobiles, power plants and high-technology capital goods.

In early 2009, the exchange rate was 140 yen to the euro, and over the next 3 years the yen strengthened to 95 yen to the euro, making Japanese companies very uncompetitive against European (but most importantly, German) companies. German exports performed very well in 2010 and 2011, particularly to China.  This was also helped by a diplomatic row between Japan and China about sovereignty rights over some small islands lying between their two countries, sparking popular anti-Japanese sentiments inside China, and consumer boycotts of Japanese goods.

Japan is now deliberately weakening the yen further to stimulate their economy – the recent 20+% fall in the exchange rate will be a particular problem for German competitiveness, and will hold back export demand this year.

The investment implications of this are to remain wary of the European economy and light in European shares, to expect the euro to strengthen , and to be heavy in Japanese shares, but to avoid the yen exposure by, for example, owning currency-hedged share classes of Japanese funds.