Archive for July 30th, 2012

The ‘Upside-Down World’ of Wall Street

Monday, July 30th, 2012

Tags: Nbsp, Upside Down World, Wall Street
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The Death of Equities Redux

Monday, July 30th, 2012

A famous Business Week article, “The Death of Equities,” concluded, “Today, the old attitude of buying solid stocks as a cornerstone for one’s life savings and retirement has simply disappeared.” Sound familiar? The article was published in August 1979.

The Business Week article discusses how, with “stocks averaging a return of less than 3% throughout the decade,” investors were fleeing equities in favor of cash and real assets such as property, gold and silver. “Further,” it states, “this ‘death of equity’ can no longer be seen as something a stock market rally—however strong—will check. It has persisted for more than 10 years through market rallies, business cycles, recession, recoveries and booms….For better or worse, then, the US economy probably has to regard the death of equities as near-permanent condition.”

The primary economic problem back then was high inflation, which had devastated returns for stocks and bonds but had greatly buoyed the value of real assets such as gold. Of course, Paul Volcker, then Chairman of the Federal Reserve, was soon to unleash his war on inflation, which set the stage for a prolonged period of strong equity and bond market returns.

But the article says other factors contributed to the death of equities: “The institutionalization of inflation—along with structural changes in communications and psychology—has killed the U.S. equity market for millions of investors. We are all thinking shorter term than our fathers and our grandfathers.”

Inflation (at least of the consumer-price variety) has not been the problem it was in the 1970s, but I would argue that structural changes in communications and psychology have been, if anything, more severe. We are all subject sooner and sooner to more and more information. And, as a consequence, we are thinking shorter term than our fathers and grandfathers and, I should add, mothers and grandmothers.

Equities are no more likely to be dead now than they were in August 1979. Indeed, the expected return advantage of stocks versus government bonds is unusually high at present, in our opinion. However, shorter-time horizons may require us to revisit our investment portfolios. In addition to longer-horizon strategies like value and growth, investors may need to consider shorter-horizon strategies, such as equity income or low-volatility stocks.

Finally, for those investors worried about the return of the inflation bogeyman, holding some exposure to real assets is a good insurance policy.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.

Patrick Rudden is Head of Blend Strategies at AllianceBernstein.

Tags: Bond Market, Booms, Business Cycles, Business Week Article, Chairman Of The Federal Reserve, Economic Problem, Federal Reserve, Gold And Silver, Grandfathers, Grandmothers, inflation, Institutionalization, Market Rally, Paul Volcker, Prolonged Period, Real Assets, Recession, Rudden, Stock Market, Stocks And Bonds
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Are Investors Worried About the Right Risk?

Monday, July 30th, 2012

by Seth Masters, Chief Investment Strategist, AllianceBernstein

Individual and institutional investors alike have been shifting their capital from stocks to cash and bonds at a rapid rate in recent years, despite extraordinarily low interest rates. But if investors stop to weigh the importance of two different types of risk, they’ll see they still need stocks.

It’s tempting to give up on stocks after more than a decade of high volatility and low returns from stocks—and lower volatility with higher returns from bonds. But we think that 10 years from now, investors who do so will wish they had stayed in stocks—or added to them.

That’s not to say we think investors don’t need bonds. Despite extremely low current yields, we think bonds should still play their usual roles in the portfolios of most long-term investors: providing income, preserving capital and providing protection in times of stock-market distress (because bond prices tend to rise at such times). Bonds will be especially important if the market outcomes are at the extreme low end of our forecast range of potential outcomes.

But most investors are likely to need stocks to feel confident that they will have enough to live on, despite the high volatility of recent years. Remember that volatility isn’t the only type of risk. There’s also shortfall risk: not having enough money to meet your spending requirements. Investors must weigh both types of risk when making strategic asset-allocation decisions.

If you’re just thinking about market volatility, bond-oriented portfolios may look very appealing, especially today. We estimate there is less than a 2% chance that a portfolio with a 20% allocation to stocks and an 80% allocation to bonds will suffer a 20% peak-to-trough loss at some point over the next 10 years, compared with the 15% chance of such a loss for a portfolio with 60% in stocks (Display, left), as the left side of the display below shows. But if you’re just thinking about shortfall risk, a portfolio with 60% in stocks looks more attractive (Display, right).

We estimate that a 65-year-old retired couple planning to withdraw only 3% of their portfolio, grown with inflation, has a 12% chance of running out of money if they invest in the portfolio with 60% in stocks. That may not sound great, but it is materially better than the 24% odds of running out of money if they invest in a portfolio with 20% in stocks.

Today, uncertain macroeconomic conditions make large stock-market drops more likely than usual, and very low bond yields provide a thinner cushion. As a result, market risk can’t easily be avoided. And trying to avoid market risk is not a good strategy if it increases shortfall risk too much. A 20% loss is certainly painful, but it doesn’t hurt as much as running out of all of your money. Many investors who are currently focused on market volatility should be paying at least as much attention to shortfall risk.

The views expressed herein do not constitute research, investment advice, or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.

Seth J. Masters is Chief Investment Officer for Asset Allocation at AllianceBernstein and Chief Investment Officer of Bernstein Global Wealth Management, a unit of AllianceBernstein.

The Bernstein Wealth Forecasting System,^SM driven by the Capital Markets Engine, uses a Monte Carlo model that simulates 10,000 plausible paths of return for each asset class and inflation and produces a probability distribution of outcomes. The model does not draw randomly from a set of historical returns to produce estimates for the future. Instead, the forecasts (1) are based on the building blocks of asset returns, such as inflation, yields, yield spreads, stock earnings and price multiples; (2) incorporate the linkages that exist among the returns of various asset classes; (3) take into account current market conditions at the beginning of the analysis; and (4) factor in a reasonable degree of randomness and unpredictability.

Tags: Asset Allocation Decisions, Bond Prices, Bonds, Chief Investment Strategist, Current Yields, Enough Money, Institutional Investors, Low Interest Rates, Market Outcomes, Market Volatility, Portfolios, Rapid Rate, Seth, Shortfall, Stock Market, Stocks, Strategic Asset Allocation, Term Investors, Trough
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Dow 30 Trading Range Screen (Bespoke)

Monday, July 30th, 2012

by Bespoke Investment Group

This screen allows users to quickly identify which stocks in their portfolio have upside or downside momentum, and which ones may be getting overheated or deeply oversold. For the Dow, 16 of the 30 members are now in overbought territory, although just two (KO and WMT) are in extreme overbought territory. Just three Dow stocks are oversold — AA, CSCO and HPQ. Of these three, CSCO still has downside momentum, while AA has seen a pickup lately and may have more upside. Of the stocks in Neutral territory, American Express (AXP), Caterpillar (CAT) and IBM currently have the most upside momentum, while McDonald’s (MCD), Pfizer (PFE) and United Tech (UTX) have downside momentum.

Bespoke Premium Plus members have the ability to run their portfolios through a number of screens that we provide. One of these screens is our trading range screen, which allows clients to view where a large number of stocks are trading from an overbought/oversold perspective on one simple page. Below we have run the screen on the 30 stocks that make up the Dow Jones Industrial Average. For each stock, the light and dark green shading represents oversold territory, while the light and dark red shading represents overbought territory. The Neutral line represents the 50-day moving average. The dot for each stock shows where it is currently trading, while the tail shows where it was one week ago.

Become a Premium Plus member today to have Bespoke run your portfolio through our trading range screen!

Tags: American Express, Axp, Bespoke Investment Group, Caterpillar Cat, Csco, Dow 30, Dow Jones, Dow Jones Industrial Average, Dow Stocks, Hpq, Investment Group, Mcd, Momentum, Moving Average, Neutral Line, Neutral Territory, Pfe, Pfizer, Shading, United Tech, Wmt
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Can it Really Be That Easy?

Monday, July 30th, 2012

by Bespoke Investment Group

Throughout the year in reports to our Bespoke Premium clients, we have highlighted the similarities between this year and prior Presidential Election years numerous times. Most recently, in early July we noted the fact that based on the historical pattern the S&P 500 could see a modest pullback in mid-July coinciding with the kick-off of earnings season. Sure enough, the market saw some choppiness about a week and a half ago and subsequently rebounded in the middle of last week. Holding to the historical pattern, that rebound came right at the same time that the market historically sees its summer low.

If the pattern continues, the S&P 500 could be set up for a nice rally to end the Summer. Will it hold? Only time will tell, but if the historical pattern has worked so far, what’s to stop it from continuing?

Tags: Amp, Choppiness, Earnings Season, Investment Group, Nbsp, Presidential Election, Pullback, Rally, Rebound
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Equity Implications for a Modest-Return World

Monday, July 30th, 2012

by Andrew Pyne, PIMCO

Equity valuations appear reasonable, but volatility is likely to remain elevated amid slowing global economic growth and macroeconomic risks.
As macro events drive markets, the probability of fundamental mispricing increases, providing opportunity for active managers to add value.
Investors should consider increasing exposure to emerging markets, deploying downside-risk and volatility-mitigation, emphasizing dividends and focusing on active share.

PIMCO’s secular outlook calls for slowing global economic growth, a world that is still multi-speed, and unresolved macroeconomic risks that are likely to result in continued heightened volatility. While our view on the economy is a cautious one, overall equity valuations appear reasonable, and corporate fundamentals, as measured by earnings, margins and balance sheets, are relatively attractive. The outlook for equities, then, can be expressed as a tug of war between these macro headwinds and micro fundamentals.

What does this mean for equities, which are still the dominant risk in investor portfolios? Overall, we believe that continued policy confusion and economic fundamentals that are trending in a negative direction will create headwinds. As the developed world continues to delever, we expect global equities to experience a modest-return environment.

Challenges and solutions

The clear implication is that this creates a challenge for investors. Most investors historically have relied on equities to help achieve their target portfolio returns. In this environment, though, beta is unlikely to deliver the returns required. We believe that investors should consider the following:

Increase exposure to faster-growing economies. Many portfolios should be more global with higher allocations to emerging markets.
Incorporate downside-risk and volatility-mitigation to address the higher probabilities of negative macro events.
Emphasize dividends, which will likely be a more important component of equity total returns.
Take greater active risk and focus on active share. In a modest-return world, if beta doesn’t get the job done, then alpha may be a significant percentage of an investor’s equity returns.

Multi-speed world

The key risk to the global economy is Europe, which given significant structural challenges and policy uncertainty is facing prolonged subdued growth and the risk of recession. Why then do we suggest equity portfolios be more global? The answer lies partly in the way equities have traditionally been categorized. Companies are often classified by their country of domicile, but we think they are better defined by their end-markets. Despite significant risks at home, many European multinationals have meaningful exposure to emerging markets. If we find businesses with stable cash flows, high dividend yields, strong end-market growth – and with valuations that discount home-market risks – these can be attractive investment opportunities.

In addition, we believe most investors, particularly those with a home-market bias, would benefit from increased direct exposure to emerging markets. While emerging markets are certainly not immune to the struggles of the developed world, emerging markets and developed markets face very different economic scenarios. We expect emerging markets to continue to gain share of global GDP, but most investors are still underweight the asset class. We expect emerging markets to account for more than 50% of global GDP in purchasing power parity terms over the next three to five years. They already are about a third of global equity market caps. Yet emerging market equities represent only about 7% of the average investor’s portfolio.

Managing macro risks

Our second suggestion is to prioritize downside- and volatility-mitigation in equity portfolios. Correlations among stocks have increased meaningfully over the past few years; they’ve tended to spike around negative macro events and decrease as uncertainty subsides (see Figure 1). This suggests that the “risk-on/risk-off” sentiment that drives stock prices is often governed by macro news flows, not company fundamentals.

There are two takeaways for investors. The first is that macro does impact stock prices, and so while equity investing has traditionally been thought of as a bottom-up endeavor, we believe managers need to consider both bottom-up and top-down views as part of their research process.

The second takeaway is that because there are unresolved macro risks, investors must recognize that, given the way returns compound over time, protecting on the downside could be a critical contributor to long-term returns. Part of the solution may be increasing allocations to active mandates from passive. Although investors could lose more with an active approach, by definition traditional indexes will capture 100% of down-market performance.

We believe protecting on the downside requires a very active approach. Strategies including low-volatility and dividend-focused investing, tail-risk hedging, and flexibility to short stocks or raise cash, may result in improved risk mitigation compared with a passive strategy.

Dividend income

Dividend income, a significant portion of historical equity returns, is likely to be even more important in an environment of slower growth. Of course, if we were expecting broad multiple expansion and strong global growth – as we saw in the ‘80s and ‘90s – then the message simply would be “buy equities and enjoy the ride.” As Figure 2 shows, however, dividends often have been a substantial portion of total equity performance during periods of modest returns. While many investors’ assumptions and expectations for equities were formed by the 20-year bull market of the ‘80s and ‘90s, the ‘40s, ‘60s and ‘70s may be more instructive for the period ahead.

We also believe the opportunity for dividend-paying stocks is more of a global story than a U.S. one. Given demand from U.S. investors for income, traditional dividend-paying sectors in the U.S. – telecom, utilities, Real Estate Investment Trusts (REITs), and Master Limited Partnerships (MLPs) – are generally quite expensive, whereas select non-U.S. equities, including emerging markets, remain attractive sources of yield.

Essential alpha

Two points outlined above – the notion that macroeconomic news flow influences stock prices and the expectation for modest returns – each reinforce the importance of alpha in helping investors achieve their goals. As macro events drive markets, the probability of fundamental mispricing increases, providing opportunity for active managers to add value. The key is to be highly selective, identifying the long-term winners even as the markets are indiscriminate in the short term.

For many investors, the importance of alpha should prompt a reconsideration of the mix of passive and active equity allocations. At the very least, we believe investors should ensure that their active managers are truly active, with high active share a prerequisite for inclusion in their portfolio (please see Equity Investing: From Style Box to Global Unconstrained, May 2012).

Revisiting equity portfolios

In an environment of fatter tails, there is always the possibility of a right-tail event. Enactment of comprehensive and bipartisan policies to address structural problems in developed markets, for example, would be welcome news and would likely lead to broad multiple expansion and higher returns in the equity markets. However, absent such developments, economic fundamentals suggest more modest returns.

Many investor portfolios may not be positioned for a lower-return world, particularly those that were structured during a higher-return equity environment. We believe investors would be well served to take a fresh look at their equity allocations. If beta will not suffice, then investors should work to ensure their portfolios have the characteristics needed to succeed.

Past performance is not a guarantee or a reliable indicator of future results. Equities may decline in value due to both real and perceived general market, economic, and industry conditions. Dividends are not guaranteed and are subject to change and/or elimination. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. REITs are subject to risk, such as poor performance by the manager, adverse changes to tax laws or failure to qualify for tax-free pass-through of income. Entering into short sales includes the potential for loss of more money than the actual cost of the investment, and the risk that the third party to the short sale may fail to honor its contract terms, causing a loss to the portfolio. Tail risk hedging may involve entering into financial derivatives that are expected to increase in value during the occurrence of tail events. Investing in a tail event instrument could lose all or a portion of its value even in a period of severe market stress. A tail event is unpredictable; therefore, investments in instruments tied to the occurrence of a tail event are speculative. Derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested.

The correlation of various indices or securities against one another or against inflation is based upon data over a certain time period. These correlations may vary substantially in the future or over different time periods that can result in greater volatility.

Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest for the long-term, especially during periods of downturn in the market. Outlook and strategies are subject to change without notice.

The S&P 500 Index is an unmanaged market index generally considered representative of the stock market as a whole. The index focuses on the Large-Cap segment of the U.S. equities market. The S&P 90 (prior to 1957) was a value-weighted index based on 90 stocks. It is not possible to invest directly in an unmanaged index.

This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission.

Tags: Active Share, Balance Sheets, Downside Risk, Economic Fundamentals, Emerging Markets, Global Economic Growth, Global Equities, Headwinds, Impo, Mitigation, Negative Direction, PIMCO, Policy Confusion, Portfolio Returns, Pyne, Target, Tug Of War, Valuations, Value Investors, Volatility
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Secular Outlook: Implications for Investors

Monday, July 30th, 2012

by William R. Benz, PIMCO

For investors, the biggest challenge now is moving from a world of normal distributions, with expected occurrences around the mean, to one of bi-modal distributions where more extreme scenarios prevail.
Key institutions, including governments and central banks, were previously stabilising forces but are now helping to accelerate underlying, destabilising trends in the global economy and financial markets.
In this environment, investors need to invest for outcomes rather than simply for beta and diversification.

Perhaps the most important tradition at PIMCO is our annual Secular Forum in May. Since I joined 26 years ago and participated in my first forum with 16 other investment professionals, our forums have become much bigger and much more global. More than 300 of us descended on Newport Beach or tuned in via video in our most recent round. But the tradition continues, as does the intensity and excitement, with the output of our forum – our three- to five-year secular outlook – forming the cornerstone of both our longer-term investment strategy and our business positioning.

Mohamed El-Erian, our CEO and co-CIO, in his Secular Outlook commentary “Policy Confusions & Inflection Points,” summarized three themes that we expect to play out over the next few years: continued policy and political confusion, overly incremental public and private sector responses and, therefore, greater potential for inflection points. Mohamed also discussed the key investment implications of our outlook, noting that the strategies and guidelines that may have served investors in the past will likely be challenged in the context of inflection dynamics.

That point is worth revisiting and expanding upon because, in our view, investing is fundamentally changing. Previously, most investors simply aimed to beat their benchmarks and diversify among assets to mitigate risk. But today, as we face unusual uncertainty in the global economy and the financial markets, extreme events are not only possible but increasingly likely, and in this environment, we believe investors need to define their objectives and choose strategies that target specific outcomes.

Investors’ biggest challenge

The world is facing a number of very significant challenges for which there are no easy solutions. The eurozone faces high debt levels, a lack of structural growth and pressure to get the policy mix right to avoid contagion. The U.S. is suffering slow growth, high debt, a looming fiscal cliff and political polarisation. While enjoying higher relative growth, China and the developing world are also slowing and making difficult transitions from export-led to consumer-driven ‘emerged’ economies. And globally, a lack of policy coordination, increased income inequality and the growing use of social networks as communication tools also present long-term challenges.

Uncertainty is one common theme, and another is the potential for more extreme outcomes, good or bad. The eurozone, for instance, has to either find a path toward fiscal union or create a mechanism for orderly exit, with very little room to manoeuvre in between. Likewise, the U.S. needs to find a way to resolve its fiscal issues or face the consequences of a further downgrade and eventual loss of reserve currency status.

For investors, then, the biggest challenge is not continued volatility; that’s almost a given. The challenge is moving from a world of normal distributions, with expected occurrences around the mean, to one of bi-modal distributions where more extreme scenarios prevail.

Key institutions: once stabilisers, now accelerants

In the old normal, key institutions acted as stabilisers: They generally behaved in a counter-cyclical fashion to help enforce reversion to the mean. For example, governments and central banks enacted policies to stimulate growth and prevent deflation during economic downturns and did the opposite in upturns. Regulators tended to de-regulate during tough times and tighten the rules during times of excess, while financial institutions decreased and increased lending as interest rates rose and fell.

Their actions, individually and collectively, helped bring economic growth and the markets back to normal, back to long-term averages, back to the mean. They weren’t necessarily coordinated, but they were generally effective and helped create the Great Moderation of steady growth, strong returns and relatively low volatility that we witnessed from the mid-to-late 1980s until the global financial crisis in 2008.

But today, these institutions are acting as accelerants. Governments in Europe, the U.S. and Japan are under pressure to pursue fiscal austerity rather than stimulate growth, exacerbating the downturn. Central banks are largely going their own way, after a well-coordinated response to the financial crisis, and in some cases, are resisting stimulative measures, which is slowing, if not preventing, the healing process. Regulators, adopting a ‘never again’ mentality, are creating blunt instruments to solve complex problems, leading to unintended consequences, particularly in the banking sector, at a time when more rather than less lending should be the recommended medicine. And banks, especially in the eurozone, have been severely impacted by their holdings of sovereign debt, which, in turn, has led to a vicious cycle of falling share prices, credit rating downgrades, asset sales, reduced lending, slowing local economies, worsening government balance sheets and ultimately, an acceleration of, rather than a counterbalance to, the crisis.

Finally, investors are also acting as accelerants. Individual investors have always been more momentum-driven but had little aggregate impact on markets in the past due to their small size, lack of timely and direct access to information and lack of coordinated activity. But as they’ve grown in size and sophistication, accessing real-time information through their defined contribution plans, global platforms, multi-national distributors, private banks and independent financial advisors, their impact has become much more pronounced. When risk sectors outperform, flows into those sectors tend to increase; when they underperform, flows tend to diminish. In both cases, underlying trends are reinforced.

What’s even more interesting is how the behaviour of institutional investors has changed. This began in 2000-01, after the technology bubble burst. The perfect storm of plunging equity markets and falling interest rates turned corporate and public pension plan surpluses into deficits and created big challenges for foundations, endowments and others seeking income and targeting specific absolute returns. The movement toward solution-based investing was born as investors began to shift toward liability-driven investing (LDI), absolute return, income seeking and other, more specific strategies. The momentum increased following Lehman’s bankruptcy and again in response to recent events in Europe. But with this shift has come a more activist (or re-activist) approach, as investors make larger and more frequent changes to overall strategy, tactical weightings, benchmarks and guidelines. Some still prefer to rebalance around their longer-term, normal policy targets, but as a group – and we see this globally across our client base – institutional investors have indeed become more active.

Governments, central banks, regulators, financial institutions and investors – each group is responding to the challenges they are facing in a logical and well-intentioned fashion. Yet in the current secular environment, we believe their actions are adding to, rather than smoothing, volatility. And instead of acting as stabilising forces, we believe they are actually helping to accelerate the underlying destabilising trends. (See figure below.)

Significant implications for investors

Global challenges combined with these market accelerants have created an environment of unusual uncertainty in which ‘muddle-through’ is a temporary state. We believe this has significant implications for investors, particularly those who are still investing simply for beta and diversification rather than for specific outcomes.

First and foremost, the new normal is here, and investors need to embrace it. We coined the phrase a few years ago to describe a multi-speed world on a bumpy journey of deleveraging, reregulation and eventual reflation. We can argue whether we’re still on the journey or we’ve arrived at the final (though still very bumpy) destination. But what’s clear is that what felt like a ‘new’ normal back then now just feels normal. Gone are the days of the Great Moderation, reversion to the mean and normal-shaped distributions, in our view; instead, continued (high) volatility, acceleration in trends and bi-modal outcomes have become the new norm. In an era when muddle-through is no longer a viable option – for Europe, the U.S. and potentially others – investors need to rethink their overall approach and brace for more extreme economic and market events.

Second, there is no free lunch. There never really was, but investors are facing even more difficult trade-offs today. If the objective is to enhance yield or upside potential through credit, high yield, emerging markets, equities or other risk sectors, the likely trade-offs in a bi-modal world are higher volatility and greater downside. If the goal instead is to own ‘safe haven’ assets for downside risk mitigation, such as U.S. Treasuries, U.K. gilts or German bunds, the trade-off is currently negative real yields. And if the need is to maximise liquidity through cash instruments, the payoff is truly negative real yields (with negative nominal yields on occasion). Even when seeking inflation protection, whether through inflation-linked bonds or hard assets – like gold, real estate and commodities – we believe the trade-offs in terms of real yields, volatility and downside risk are much less attractive in this environment.

Third, investors need to think differently with respect to allocations, benchmarks and guidelines. We’ve highlighted this in the past, but it’s even more important today. In our view, asset allocation should be risk-factor-based as bi-modal distributions and accelerants are not friendly toward traditional mean-variance methodologies, which aim to maximize returns for given levels of risk. Benchmarks should be GDP- rather than market value-weighted, particularly in fixed income space, to reduce exposure to those countries, sectors and issuers with the highest or fastest growing debt. And guidelines should be flexible, with more rather than less discretion, so as to allow managers to play both offence and defence in a bi-modal world.

Fourth, investors should be confident in their managers’ ability to understand and measure risk. Global challenges, market accelerants and unusual uncertainty put a premium on risk management. This includes understanding how the credit sensitivity of fixed income investments can affect their duration – i.e., ‘hard’ versus ‘soft’ duration – and help determine what is considered a ‘safe haven’ and what isn’t. It means performing credit analysis of sovereigns knowing they have more than just interest rate risk. It necessitates analysing the entire spectrum of the capital structure to pinpoint exact needs in terms of collateral, covenants and other forms of defence. Derivatives continue to be useful tools, but being able to identify and control counterparty risk is increasingly important. And leverage, while appropriate in certain circumstances, needs to be well understood. Bottom line: we believe in developing multiple risk measures and stress testing often.

Finally, investors need to develop specific objectives and invest for outcomes rather than simply for beta and diversification. Many investors traditionally started with risk/return targets and used historical mean-variance analysis as a framework to determine asset allocations across multiple asset classes, with benchmarks for each asset class and sub-category, and then found managers that aimed to provide returns above their benchmarks. In the days of normal-shaped distributions and reversion to the mean, this was a widely accepted strategy: Long-term realised returns and volatility came in largely as expected, and further diversification – across asset classes, within asset classes and across different managers and styles – helped to smooth short-term swings. It was a beta-driven strategy, aided by diversification. But the world has changed, and we believe investors need to deepen their understanding of their objectives and invest for outcomes.

Setting objectives and investing for outcomes

Every investor has a unique set of needs and circumstances that should form the basis for setting investment objectives. Yet it’s important to consider the secular context as well, particularly given the challenges and trade-offs we’re likely to face:

Prolonged period of low real yields on high-quality assets, with negative real yields on traditional ‘safe havens’
Increased potential for low and even negative real returns
Continued high volatility with increased likelihood of bi-modal outcomes
Eventual, though uneven, inflation pressures

Income-oriented investors should consider emphasizing high-quality fixed income spread sectors, such as covered bonds, mortgage- and asset-backed securities, investment grade credit and, depending on risk tolerance, upper-tier emerging market and high yield issues and higher dividend-paying equities.

Investors with specific return objectives should consider focusing more on absolute return strategies, ranging from unlevered LIBOR-plus approaches – essentially seeking to outperform cash – to alternative strategies, depending on their risk/return targets and liquidity needs. Credit, emerging markets, equities and other asset classes can also play roles, individually or grouped into a multi-asset approach, as long as risk factors and exposures are well understood and investors consider ways to potentially limit downside risk under more extreme ‘left tail’ scenarios.

Investors concerned with volatility and ‘fat tail’ events should consider risk-mitigating strategies. If investors want to defend against downside, potential strategies would include positions in hard-duration, ‘safe-haven’ assets, explicit tail-risk hedges or a combination. Investors focused on liabilities may want a liability-matching or LDI program. Alternatively, if the goal is to maximise liquidity, cash and short-term strategies would likely play a significant role.

Lastly, for investors worried about reflation, the suggested focus is on potential inflation hedges, such as inflation-linked bonds, commodities and real estate.

In truth, many investors will likely want to employ more than one approach – income with an inflation-hedging component, absolute return with tail-risk hedges, LDI programs that include a combination of derivative-based overlays with LIBOR-plus strategies on the underlying collateral, or any of these with a cash buffer that can be used for liquidity or to invest tactically if the opportunity arises. And this makes sense. In our view, as long as investors focus on their objectives and their targeted outcomes, rather than fall into the old ‘invest for beta and diversification’ trap, they can navigate a world of secular challenges, accelerants and unusual uncertainty.

Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk. Covered bonds are generally affected by changing interest rates and credit spread; there is no guarantee that covered bonds will be free from counterparty default. High-yield, lower-rated, securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Mortgage and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and their value may fluctuate in response to the market’s perception of issuer creditworthiness; while generally supported by some form of government or private guarantee there is no assurance that private guarantors will meet their obligations. Absolute return portfolios may not necessarily fully participate in strong (positive) market rallies. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Inflation-linked bonds (ILBs) issued by a government are fixed-income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs decline in value when real interest rates rise. Certain U.S. Government securities are backed by the full faith of the government, obligations of U.S. Government agencies and authorities are supported by varying degrees but are generally not backed by the full faith of the U.S. Government; portfolios that invest in such securities are not guaranteed and will fluctuate in value. Equities may decline in value due to both real and perceived general market, economic, and industry conditions. Dividends are not guaranteed and are subject to change and/or elimination. The value of real estate and portfolios that invest in real estate may fluctuate due to: losses from casualty or condemnation, changes in local and general economic conditions, supply and demand, interest rates, property tax rates, regulatory limitations on rents, zoning laws, and operating expenses. Commodities contain heightened risk including market, political, regulatory, and natural conditions, and may not be suitable for all investors. Tail risk hedging may involve entering into financial derivatives that are expected to increase in value during the occurrence of tail events. Investing in a tail event instrument could lose all or a portion of its value even in a period of severe market stress. A tail event is unpredictable; therefore, investments in instruments tied to the occurrence of a tail event are speculative. Derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. Diversification does not ensure against loss. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market.
LIBOR (London Interbank Offered Rate) is the rate banks charge each other for short-term Eurodollar loans. It is not possible to invest directly in an unmanaged index.

Tags: Benchmarks, Central Banks, Confusions, Cornerstone, Diversification, Financial Markets, First Forum, Global Economy, Inflection Points, Investment Implications, Investment Professionals, Investment Strategy, Mohamed, Newport Beach, Normal Distributions, Occurrences, PIMCO, Political Confusion, Private Sector, Term Investment
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Treading Water (Sonders)

Monday, July 30th, 2012

July 27, 2012

by Liz Ann Sonders, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.
and Brad Sorensen, CFA, Director of Market and Sector Analysis, Schwab Center for Financial Research,
and Michelle Gibley, CFA, Director of International Research, Schwab Center for Financial Research

Key Points

Volume has been low and stocks have managed to drift higher, despite some volatile days; but conviction appears to be lacking. We seem to be biding time until the action heats back up as summer winds down, but market-moving events can happen at any time.
The US economy continues to slow and Fed Chairman Bernanke had a relatively dour outlook before Congress. But it appears things would have to get worse before another round of easing is initiated; the effectiveness of which we continue to question.
Yields in Spain and Italy indicate action may be needed sooner rather than later, but we did get positive remarks by the ECB, which led to market rallies and a big drop in yields, providing a measure of hope. Meanwhile, Chinese growth has been hit by the global economic slowdown but their lack of transparency means getting a good read is difficult.

In contrast to the athletes in the Olympics that are laser-focused on moving forward and achieving their objectives, markets seem to be caught in a sort of summer malaise. Volume has been depressed and sentiment surveys show retail investor skepticism at high levels-despite stock market performance being relatively decent this year, with the S&P 500′s 8.5% gain through July 20 the best showing to this point in the year since 2000 (thanks to Wolfe Trahan & Co. Portfolio Strategy). But with policymakers lacking the discipline and focus of Olympic athletes (the understatement of the year), and continuing publicity hits to the financial sector, we can’t blame investors for their doubts; and determining what direction the next major move will likely be more difficult than usual. Whenever you get politicians and the courts involved in the financial picture, predictions become even more difficult than usual, and that’s saying something!

In this frustrating, unpredictable environment, we find it helpful to take a step back. Asset allocation continues to be important and investors need to pay attention to their distribution of money relative to their time horizon and risk tolerance. In this environment, investors ignore their portfolios at their peril as things can and likely will change quickly. We are unlikely to see any resolution to the fiscal cliff before the election and the eurozone crisis remains on tenuous footing; notwithstanding Mario Draghi’s encouraging comments (discussed below). But if you look out the five years that we suggest is an appropriate time horizon for equities, it’s difficult to imagine that we’ll still be dealing with these same issues. And US equities remain quite cheap based on historical measures and recently hit a cyclical high in terms of relative performance to most other global equity markets. Our view that the US market will be the best relative performer through at least the balance of 2012 has not changed.

Economy keeping its head above water—barely

The US economic picture continues pointing toward still (barely) positive but slowing growth. Somewhat concerning, however, was the third-consecutive negative reading on retail sales, the Philly Fed Index remaining in negative territory, and the Index of Leading Economic Indicators declining by 0.3% last month.

LEI paints a disappointing portrait

LEI paints a disappointing portrait

Source: FactSet, U.S. Conference Board. As of July 24, 2012.

However, there continue to be positive offsets that did not exist in either of the past two years when we also dealt with growth scares—dominant among them is the recovery in housing. We’ve seen steady improvement over the course of the year; but housing is now less than 3% of US gross domestic product (GDP) after hitting a high of over 6% at the peak in the bubble. The National Association of Home Builders (NAHB) Index rose 6 points to 35, still below the 50 mark that would denote a growing housing market, but the best reading since March 2007. Additionally, housing starts rose 6.9% to the highest level since October 2008.

Housing now contributing positively?

Housing now contributing positively?

Source: FactSet, U.S. Census Bureau. As of July 24, 2012.

And although existing home sales posted a decline of 5.4%, the National Association of Realtors noted that the fall was attributable to inventory tightness, something that we haven’t heard in a while. In fact, there is now just a 6.6 month supply of existing homes for sale, versus 9.1 months a year ago. We’re not trumpeting the all-clear signal yet, but it appears to us that housing is now a help and not a hindrance to economic growth.

Additional support for our “muddle through” view comes from various other areas such as the Empire Manufacturing Index getting a modest bump to 7.4, industrial production expanding by 0.4%, and jobless claims remaining comfortably below 400,000. We are also through the bulk of earnings season and bottom-line results, while not spectacular, were largely better than reduced expectations. However, top-line growth was somewhat disappointing but consistent with the low level of nominal GDP growth.

Policy frustration grows

Unfortunately, much of the frustration expressed during earnings season was directed toward Washington. Politics has thrust itself into the middle of both the markets and the economy and cannot be ignored. Corporate executives are increasingly pointing toward the uncertainty surrounding regulation and tax policy as reasons that they were unwilling to take the risk of expanding their business or hiring new workers. And while companies often take shots at Washington, the difference this time around is the unanimity in the desires of executives. While each would likely have their own view on what the ultimate outcome would look like, the bottom line for the vast majority of them is that they need a bottom line. Businesses can adjust to a variety of circumstances—that’s one thing that has made America what it is—but they need to know the rules of the game. Unfortunately, Washington’s dysfunction and the typical antics in an election year suggest limited resolutions to what presently ails confidence and hiring.

Last week’s outrage was to hear a sitting Senator tell the Chairman of the Federal Reserve—after hearing again that the best thing for economic growth would be responsibly addressing the fiscal cliff—that the Fed better “get to work” because Congress was hopelessly deadlocked. And while Bernanke said the Fed is prepared to act again if necessary, our belief is that there is little they can do at this point to have a real impact on the economy.

Europe’s cliff draws nearer

Europe has leaned more toward collectivist fiscal policies than the US, which has helped to contribute to the ongoing debt crisis as governments have spent and promised beyond their means. At some point, bills have to be paid, and without strong incentives to take risks and expand business, payers start to dwindle while payees increase.

Currently, policymakers are again treading water but summer doldrums are noticeable in the peripheral sovereign bond auctions in Europe, where the few buyers that are showing up are demanding higher rates, particularly for Spanish and Italian government debt.

The risks for Spain remain high, with regional government debt and deficits the new concern du jour. Despite the 17 regional governments being major contributors to the 2011 deficit slip, the Spanish central government has been unable to control their spending due to strong cultural and historical adherence to regional autonomy. Regional government spending is significant, as they control education, health and social services, accounting for 50% of total government spending. The buyers’ strike for Spanish debt is intensified for regional governments, where the 10-year debt yield for the region of Catalonia exceeded 14% in June and the region of Valencia had to pay a punitive 6.8% six-month yield to roll over 500 million euros of debt in May.

As a result, yet another bailout fund has been created; this time for Spain’s regional governments, which Spain insists will not increase its borrowing burden. When adding to bank capital needs that were revised higher and deficit targets which were adjusted larger, investors are skeptical. This lack of confidence has resulted in Spanish government short-term yields spiking nearly as high as long-term rates, a sign of market stress, although we did see a marked pullback following the Draghi comments.

Spain’s stress gauge volatile

Spain's stress gauge volatile

Source: FactSet, Tullett Prebon. As of July 26, 2012.

With Spain’s average maturity of 6.4 years resulting in a 4.1% average interest rate, rates may need to stay elevated longer before a bailout is necessary, but more forceful action is needed to contain the situation. The reason is that the size of Spain’s economy and government bond market is around double the combined size of those of Greece, Portugal and Ireland, and Spain’s problems have increasingly ensnared Italy.

Meanwhile, eurozone bailout funds are still impotent, with the temporary European Financial Stability Facility (EFSF) lacking sufficient funds, the permanent European Stability Mechanism (ESM) on hold for a ruling by the German Constitutional Court in September, and the European Central Bank (ECB) is not yet using monetary measures to solve what they view a fiscal problem. Despite recent comments by ECB President Mario Draghi indicating they would do “whatever it takes to preserve the euro,” actions are still lacking and their ability to implement substantial plans is likely severely constrained by their mandate and the continuing disagreements among member nations. While the market rallied on the comments and reminds us that sharp rallies are possible on potential positive movement, words have become less meaningful and more decisive action is needed.

We’ve said in the past that the situation is rife for outbreaks of market volatility, as we continue to see. Moody’s Investor Service apparently concurs, downgrading the outlooks for the AAA-rated nations of Germany, the Netherlands and Luxembourg. It was due in part to the rising risk of future liabilities, because policymaker’s “continued reactive and gradualist” response will “very likely be associated with a series of shocks, which are likely to rise in magnitude the longer the crisis persists.”

We’ve believed it would take severe market instability, nearing the edge of the precipice, before more forceful actions would be taken. The flattening of the Spanish yield curve indicates more forceful actions are drawing closer, with the ECB the institution able to respond most quickly. Granting the ESM a banking license could create large firepower, but Draghi said in July that this could risk the ECB’s credibility by behaving outside its mandate—seemingly conflicting with the above statement of unconditional support. Other “non-standard” measures such as restarting the Securities Market Program (SMP) for sovereign bond purchases were not discussed at the ECB’s July policy meeting, but traders are on the lookout for a change in the ECB’s stance.

Germany remains resistant to endlessly fund peripheral country problems, as it is responsible for the largest share of potential future liabilities. With Greece’s problems remaining, a Greek exit from the euro is not out of question. Conversely, there have been increasingly vocal suggestions that Germany leave the euro. While this is easier said than done and any action would have attendant costs, the ultimate decision is political, and therefore difficult to forecast.

All of the wrangling does have an outcome we can foresee—likely continued economic suppression in the eurozone; as uncertainty halts investment and spending, and a hobbled banking sector hampers lending. Additionally, the rollercoaster of investor sentiment is likely to remain, and we continue to believe European stocks will underperform most other global markets.

Chinese economic data manipulated?

China’s lack of transparency breeds speculation about where the economy is headed. Attention has focused on a significant slowdown in electricity production and consumption, which have fallen to single-digit rates in recent months, while gross domestic product (GDP) has slowed more modestly.

China’s electricity deviation historically “normal”

China's electricity deviation historically normal

Source: FactSet, National Bureau of Statistics of China. As of July 24, 2012.

Electricity production has deviated from GDP in the past, not only in China, but also in other major economies, including the United States. This statistic is volatile and it is important to note that one of China’s major long-term initiatives has been to lower its energy usage per unit of GDP, and that energy-intensive industrial sectors have slowed more than the overall economy.

Positively, HBSC’s initial manufacturing purchasing manager index (PMI) for July rose to a five-month high of 49.5, driven by gains in production and export order components. We are skeptical China’s economy has yet to significantly accelerate, believing growth in China will slow further in the third quarter, but remain above a hard landing. Conversely, the Street is still grappling with the slowdown, forecasting a turn higher in third quarter growth 8.2% from 7.6% in the second quarter. A pick-up in fiscal and monetary stimulus is likely needed for China’s economy to reaccelerate, and the government thus far has been disappointingly slow and measured on this front.

With the desire to keep social unrest at bay, employment trends are likely closely monitored by Chinese officials. While not yet at a crisis level, the faster rate of contraction in employment indicated in the HSBC report, and comments from consumer-goods maker Jarden about a “halt” in wage inflation momentum, may indicate stepped up stimulus measures could be on the immediate horizon.

Spiking corn prices have ignited concern about food prices, in particular for emerging markets where the food component in consumer price inflation (CPI) indexes is two-to-five times larger than in developed markets, which could limit growth and continued easing by emerging market central banks. We are monitoring the situation, but aren’t yet ready to declare a lasting and broad increase in overall food prices, with prices of the important staple of rice still subdued. Read more international research at www.schwab.com/oninternational.

So what?

With such a conglomeration of concerns, investors can be tempted to throw up their hands in frustration and seek the perceived safety of a nice, comfortable mattress. However, as we saw with the Draghi comments, sharp equity rallies are possible and we believe at some time in the not-too-distant future resolutions to the two major issues—the eurozone crisis and the fiscal cliff—will emerge, setting the stage for a renewed sustainable move. Waiting until it occurs carries risks just as staying invested does, so we urge investors to maintain a diversified portfolio with a bit more exposure to the US side of the ledger at the expense of some European exposure. Valuations are attractive and sentiment is very pessimistic—a contrarian indicator. For tactical investors we would suggest adding to equities during pullbacks and trimming outsized positions during any fierce rallies.

This commentary originally appeared at Schwab.com

Important Disclosures

The MSCI EAFE® Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization index that is designed to measure developed market equity performance, excluding the United States and Canada. As of May 27, 2010, the MSCI EAFE Index consisted of the following 22 developed market country indexes: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland and the United Kingdom.

The MSCI Emerging Markets Index^SM is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets. As of May 27, 2010, the MSCI Emerging Markets Index consisted of the following 21 emerging-market country indexes: Brazil, Chile, China, Colombia, the Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand and Turkey.

The S&P 500® index is an index of widely traded stocks.

Indexes are unmanaged, do not incur fees or expenses and cannot be invested in directly.

Past performance is no guarantee of future results.

Investing in sectors may involve a greater degree of risk than investments with broader diversification.

International investments are subject to additional risks such as currency fluctuations, political instability and the potential for illiquid markets. Investing in emerging markets can accentuate these risks.

The information contained herein is obtained from sources believed to be reliable, but its accuracy or completeness is not guaranteed. This report is for informational purposes only and is not a solicitation or a recommendation that any particular investor should purchase or sell any particular security. Schwab does not assess the suitability or the potential value of any particular investment. All expressions of opinions are subject to change without notice.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

Tags: BRICs, Charles Schwab, Chief Investment Strategist, Chinese Growth, ECB, Fed Chairman Bernanke, Financial Sector, Getting A Good Read, Global Economic Slowdown, Liz Ann, Olympic Athletes, Portfolio Strategy, Research Key, Retail Investor, Sector Analysis, Senior Vice President, Stock Market Performance, Summer Winds, Trahan, Treading Water, Understatement Of The Year
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No Such Thing As Risk? (Hussman)

Monday, July 30th, 2012

by John Hussman, Hussman Funds

The enthusiasm of investors about central-bank interventions has reached a pitch that is already well-reflected in market prices, and a level of confidence that with little doubt, investors will ultimately regret. In the face of this enthusiasm, one almost wonders why nations across the world and throughout recorded history have ever had to deal with economic recessions or fluctuations in the financial markets. The current, widely-embraced message is that there is no such thing as an economic problem, and no such thing as risk. Bernanke, Draghi and other central bankers have finally figured it out, and now, as a result, economic recessions and market downturns never have to happen again. They just won’t allow it, printing more money will solve everything, and that’s all that any of us need to understand. And if it doesn’t solve everything, they can just keep doing more until it works, because there is no consequence to doing so, and all historical evidence to the contrary can finally, thankfully, be ignored. How could anyone ever have believed, at any point in history, that economics was any more complicated than that?

Unfortunately, the full force of economic history suggests a different narrative. Up to a certain point, which seems to be about 100-120% debt-to-GDP, countries can pull themselves from the brink of sovereign crisis through a combination of austerity (spending reductions), restructuring (putting insolvent financial institutions into receivership and altering the terms of unworkable private and public debt), and monetization (relief of government debt through the permanent creation of currency). Austerity generally reduces economic growth (and corporate profits) in a way that delivers less debt reduction benefit than expected, restructuring is often stimulative to growth because good new capital no longer has to subsidize old misallocations, but is politically contentious, and monetization of bad debt produces clear but often quite delayed inflationary pressures. None of these choices is simple.

Moreover, once countries have created massive deficits and debt burdens beyond about 120% of GDP – typically not to accumulate of productive assets and investments that service that debt, but instead to fund consumption, bail out insolvency, and compensate labor without output – austerity produces further economic depression, restructuring becomes disorderly and produces further economic depression, and attempts at monetization tend to be hyperinflationary.

Europe is fast approaching the point at which every solution will be disruptive, and remains urgently in need of debt restructuring, particularly across its banking system. It is a pleasant but time-consuming fantasy to believe that governments that are already approaching their own insolvency thresholds can effectively bail out a banking system that has already surpassed them. To expect the ECB to simply print money to solve the sovereign debt problems of Spain, Italy and other members is also dangerous. This hope prevents these nations from taking receivership of insolvent institutions now, and allows them to continue to operate in a way that threatens much more disorderly outcomes later. The reality is that Europe is not a unified economic and political entity with a single national character and obligations that are mutualized among its members. It is instead a geographic region where the economic, political and cultural differences remain very distinct. While each country is willing to cooperate in setting common rules and practices that are to their own benefit, they are unlikely to cooperate when it comes to decisions that require the stronger economies to interminably subsidize the insolvent ones through direct fiscal transfers or permanent money creation that has the same effect.

With regard to last week’s ebullience over the possibility of ECB buying of sovereign debt, my concern continues to be the danger of assuming that a solvency problem can simply be addressed as a liquidity problem. If the European Central Bank buys Spanish or Italian debt in volume, there is very little likelihood that it will ever be able to disgorge this debt. This is because: any eventual ECB sales of debt holdings – or failure to roll those holdings over – will have to be offset by private demand in the same amount, when Spanish and Italian debt/GDP ratios are unlikely to be smaller; the European banking system is already largely insolvent, and; the European continent is already in recession, which means that the volume of distressed sovereign debt is likely to expand even beyond the reasonable capacity of the ECB to absorb it. So major ECB purchases would effectively amount to money-printing, and Germany, Finland and other countries in opposition are fully aware of that. Reversible liquidity operations may be monetary policy, but non-reversible money-printing is quite simply fiscal policy.

For a review of some of the issues the ECB faces, see Why the ECB Won’t (and Shouldn’t) Just Print. In evaluating the repeated assurances that emerge out of Europe, keep in mind that details matter. For example, the phrase “Germany is prepared to do everything that is necessary to defend the Euro” has repeatedly meant “everything that is politically necessary” and “everything that is legally required.” It has also been demonstrated again and again that Germany (among other stronger European countries) has no intention of allowing a blank check for direct EFSF or ECB bailouts without a change in the EU law that imposes a surrender of fiscal sovereignty and centralized fiscal control of Euro member countries. Following Thursday’s assurances by ECB head Mario Draghi to protect the Euro (just after Germany’s Angela Merkel left on a hiking trip), it took until Saturday for the German finance minister to step into the void with the predictable, “No, these speculations are unfounded.” It was widely reported that Germany again tossed out the “everything that is necessary” bone on Sunday, but one had to read the French dispatch to find that this accord referred to nothing but an agreement between Germany and Italy to do everything necessary to quickly implement June’s plan for a plan to establish a centralized banking regulator: l’Allemagne et l’Italie sont d’accord pour “que les conclusions du conseil européen des 28 et 29 juin soient mises en oeuvre aussi rapidement que possible.”

In the U.S., quantitative easing has had the effect of helping oversold financial markets recover or slightly surpass the peak that the S&P 500 Index achieved over the preceding 6-month period, but there is much less evidence that it will do much for the financial markets when prices are already elevated and risk-premiums already deeply depressed (see What if the Fed Throws a QE3 and Nobody Comes?). The upper Bollinger band of the S&P 500 on both weekly and monthly resolutions is at about 1430. That level represents our best estimate for the market’s upside potential in the event that the Federal Reserve initiates a third program of quantitative easing. Given that our economic measures continue to indicate that the U.S. has entered a new recession, it is not clear that another round of QE will even achieve that effect.

In the event that another round of QE has a greater or more durable effect, we’ve introduced enough additional constraints on our staggered-strike hedges that we wouldn’t expect the decay in option premium that we experienced during QE2. The market reestablished an “overvalued, overbought, overbullish” syndrome last week, so another round of QE is unlikely to move us to a significantly constructive investment stance as long as that syndrome is in place. Still, we don’t expect to move our strike prices higher in the event of further improvement in market internals, so the “tight” character of our present hedge will moderate in the event the market advances from here. Suffice it to say that I’m not worried that another round of QE will create difficulties for our approach, though it should also be clear that such an event wouldn’t automatically prompt us to shift to a bullish investment stance.

What worries me most

Investors sometimes ask what I worry about most from the perspective of our investment strategy. Do I worry that the Fed will initiate another round of QE and distort the markets to such an extent and duration that our approach will not capture new realities? Do I worry that government interventions have created a world where old economic rules and relationships no longer apply? Do I worry about the quality of government statistics or the potential for misreporting or seasonal adjustment distortions in the data we use? The answer is that all of these issues can exert a short-run influence on the course of our investment approach, but none of them alter the relationship between valuations and long-term returns, and I don’t expect any of them to significantly reduce the effectiveness of our strategy over the complete market cycle.

As I noted as the market approached its highs a few months ago, what I worry about most is that conservative investors will become impatient with maintaining a defensive position in a dangerous and elevated market – not because investment prospects have materially improved, but simply because short-lived runs of speculative relief seem too enticing to miss. Volatile but ultimately directionless periods of elevated valuations, as we saw in 2000-early 2001, 2007-early 2008, and which we’ve observed since April 2010, tend to exhaust defensive investors and encourage complacency toward market risk at the worst possible time.

Certainly, for our shareholders in Strategic Growth Fund, I’ve compounded this impatience, because our “miss” in 2009-early 2010 – which I would not expect to be repeated in future cycles even under identical conditions – blends in with our defensiveness since early-2010, which aside from a few differences related to option positions, I would expect to be repeated in future cycles under identical conditions. The result is one long period of defensiveness, which understandably leaves those unfamiliar with that 2009-early 2010 period with the assumption that our approach will never be constructive.

I view these weekly comments as something of a conversation with shareholders, so I do my best to address questions that come up more than once or twice in a short period of time. In Strategic Growth Fund, understanding performance in recent years is one of those questions, so I ask the indulgence of shareholders who have walked through this discussion before, and I hope that the comments are useful even for those that have. Thanks.

Let’s first address the period since early 2010. Given the policy of central banks in recent years to provide what amount to free put options to investors, there are certainly ways we could have saved a few percent in actual put option premium (incorporated in our present methods as added criteria related to trend-following measures). But the fact is that the S&P 500 Index was within 5% of its April 2010 peak only a few weeks ago, and there remains a strong risk that the market will move significantly below that level in the months ahead. From a historical standpoint, the conditions we’ve seen since early-2010 have warranted a generally defensive position, and the negatives have accelerated significantly in recent months. We would expect to adopt a similarly defensive position again in future cycles under the same conditions. The only way to get around that would to be to take actions that would have produced significant losses if they were taken regularly on a historical basis.

Unfortunately, the warranted and repeatable defensiveness we’ve adopted since 2010 blends in with a non-recurring intervention during 2009-early 2010 (which I discussed regularly during that period) to ensure that our hedging approach was robust to Depression-era data.

Recall that this intervention was not driven by any problem with the performance of our investment approach. Indeed, by the beginning of 2009, a dollar invested in Strategic Growth Fund at its inception in 2000 had grown to about four times the value of the same investment in the S&P 500 Index. The Fund was ahead of the S&P 500 at every standard and non-standard investment horizon, with dramatically smaller losses. For example, from the 2007 stock market peak, the S&P 500 Index had suffered a peak-to-trough loss of 55.25%, while the deepest loss experienced by Strategic Growth Fund was 21.45%. To put that difference in perspective, note that simply moving from a 55.25% loss to a 21.45% loss requires an offsetting recovery of 75.53%. It takes extraordinary good fortune to recover from deep drawdowns, which is why we make such an effort to avoid them.

Still, as the credit crisis worsened in 2009, it became clear that both the economy and the financial markets were behaving in ways that were “out of sample” from the standpoint of the post-war data on which our existing return/risk estimates were based. That kind of situation demands stress-testing; a concept that too few investors take seriously until it’s too late. I took our existing approach to Depression-era data and found that though it performed reasonably well over the full period from a return perspective, it also allowed a number of very deep interim losses before recovering. Even though our approach had performed well, a Depression-like outcome could not be ruled out (and to some degree still can’t), so I insisted that our methods should be robust to “holdout” data from both the Depression era and the post-war period. I discussed that challenge repeatedly in the weekly comments and annual reports as our “two data sets” problem. We reached a satisfactory solution in 2010 through the introduction of ensemble methods in our hedging approach. But by that point, we had also missed a significant market rebound.

The result has been my elevation to the title of Permabear, Doomsayer, and other lovely aliases. It’s kind of tragic that I both lessened my reputation and missed returns for shareholders – though I expect only temporarily – because of what I viewed (and continue to view) as fiduciary duty. At least shareholders can be sure that I’ll never knowingly lead them down a rabbit hole. While we have – apart from the most recent cycle – been successful in strongly outperforming the market over complete cycles (bull-peak to bull-peak, bear-trough to bear-trough) with substantially smaller drawdowns, it’s important to recognize that we do have a much greater tolerance for tracking differences versus the S&P 500 over the course of the market cycle than some investors can accept. Our investment approach is simply not appropriate for those investors. Significant tracking differences will occur again and again over time, because they are inherent in our approach, particularly in the richly-valued portion of a given market cycle.

Meanwhile, I’m confident that that our stress-testing miss during the most recent cycle (which works out to a cumulative lag of just under 13% over the peak-to-peak market cycle from 2007-2012) is something we can more than offset in future cycles. Also, given our willingness to remove the majority of our hedges in early 2003 at valuations that were in no way compelling from a historical standpoint, it should be clear that we don’t require Armageddon to adopt a constructive or even aggressive investment stance.

So what do I worry about? I worry that investors forget how devastating a deep investment loss can be on a portfolio. I worry that the constant hope for central bank action has given investors a false sense of security that recessions and deep market downturns can be made obsolete. I worry that the depth of the recessions and downturns – when they occur – will be much deeper precisely because of the speculation, moral hazard, and misallocation of resources that monetary authorities have encouraged. I worry that both a global recession and severe market downturn are closer at hand than investors assume, partly despite, and partly because, they have so fully embraced the illusory salvation of monetary intervention.

Market Climate

Our measures of prospective stock market return/risk deteriorated slightly last week, from the most negative 0.8% of market history, to the most negative 0.6%. These are minor distinctions, of course, but it is important to emphasize how rare and negative present conditions are from a historical standpoint. I recognize that many analysts consider stocks to be cheap on the basis of “forward operating earnings,” but I continue to believe that the 50-70% elevation in profit margins relative to historical norms is an artifact of extreme deficit spending and depressed savings rates, and that as a U.S. recession unfolds, profit margins and forward earnings estimates will collapse. This is currently seen as heresy (as was my assertion just before the tech-collapse that technology earnings would turn out to be cyclical), but that’s how earnings and profit margins work.

Looking out anywhere from 2 weeks to 18 months, our measures remain very defensive, with the worst horizon being about 7 months out. Additional firming in market action from here would modestly improve our near-term measures of prospective return (which are more dependent on trend-following factors), but would generate little improvement beyond a horizon of several weeks. Meanwhile, our estimate of prospective 10-year S&P 500 total returns (nominal) is now only 4.7%. This figure may seem appealing relative to a 1.5% yield on 10-year Treasury bonds, but as I’ve noted before, you don’t “lock in” a long-term return on an investment; you ride it out over time. My expectation is that this ride will be extremely uncomfortable for passive buy-and-hold investors over the coming decade, and that there will be numerous opportunities to accept both stock and bond market risk at substantially higher prospective returns.

Strategic Growth and Strategic International remain tightly hedged, Strategic Dividend Value remains hedged at about half of the value of its holdings – its most defensive stance, and Strategic Total Return continues to carry a duration of about one year, with about 10% of assets in precious metals shares and a few percent of assets in utility shares and foreign currencies.

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Tags: Austerity, Bad Debt, Brink, Corporate Profits, Debt Reduction, Draghi, Economic Growth, Economic History, Economic Problem, Economic Recessions, Evidence To The Contrary, Financial Institutions, Financial Markets, Fluctuations, Full Force, Government Debt, Hussman, Hussman Funds, John Hussman, Public Debt, Receivership
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Europe Is Japan? Goldman Expects ECB To Become The BOJ, Purchase Private Assets

Monday, July 30th, 2012

Goldman’s ex-employee Mario Draghi is in a box: he knows he has to do something, but he also knows his options are very limited politically and financially. Yet he has no choice but to escalate and must surprise markets with a forceful intervention as per his words last week or else. What does that leave him? Well, according to Goldman’s Huw Pill, nothing short of pulling a BOJ and announcing on Thursday that he will proceed with monetization of private assets, an event which so far only the Bank of Japan has publicly engaged in, and one which will confirm the world’s relentless Japanization. From Pill: “Given the (to us) surprisingly bold tone of Mr. Draghi’s comments last week, we nevertheless think a new initiative may well be in the offing. We have argued in the past that the next step in the escalation of the ECB response would be outright purchases of private assets. Acting in this direction on Thursday would represent a significant event. We forecast the announcement of measures to permit NCBs to purchase private-sector assets under their own risk to implement ‘credit easing’, within a general framework approved by the Governing Council. This would allow purchases of unsecured bank debt and corporate debt, enabling NCBs to ease private-sector financial conditions where such support is most needed.” Why would the ECB do this: “A natural objection to outright purchases of assets issued by the private sector is that they involve the assumption of too much credit risk by the ECB. But substantial risk is already assumed via credit operations.” In other words, the only thing better than a little global central banker put is a whole lot global central banker put, and when every central planner is now all in, there is no longer any downside to putting in even more taxpayer risk on the table. Or so the thinking goes.

Of course, a rational person may wonder: why would the ECB, which a week ago was arguing for impairing senior debt, suddenly go ahead and monetize not only senior but subordinated debt. And one step further, one may also wonder if this is merely the latest iteration of a Goldman call that should be faded. Because if so, the market is in for a rude awakening. Alternatively, if Draghi does go the full Shirakawa, expect merely a brief LTRO-type response higher, to be followed by yet another major swoon lower as the drug addict demands more, more, more, only that more no longer exists with each succeesive asset dilution iteration.

From Goldman:

We forecast that the ECB will permit NCB purchases of private sector assets

ECB President Draghi’s comments in London last week have raised market expectations that important new measures will be announced by the Governing Council on Thursday (August 2).

Were the Spanish government to request support from the EFSF ahead of Thursday’s meeting and accept the implied conditionality, we would expect the ECB to offer significant support to sovereigns, including through outright ECB purchases of government debt via the SMP. This would mark a significant acceleration and intensification of what we have previously forecast. However, our base case is that events will not move so quickly: the Spanish government is pre-funded through October and, according to the latest reports, an immediate Spanish request to the EFSF is unlikely. We do not expect the ECB to move unilaterally: we view explicit and concrete political support for its actions via EFSF conditionality as a prerequisite for an extension of support to the sovereign markets.

The ECB therefore risks disappointing heightened expectations. Bringing forward measures to ease private-sector financing conditions in the periphery is a likely response. Well-flagged possibilities in this regard include a further easing of collateral eligibility standards and new longer-tenor refinancing operations. But precisely because these measures have been anticipated, they are unlikely to satisfy the market expectations raised by Mr. Draghi’s comments. And we would in any case view the effectiveness of such measures as questionable, given the segmentation of financial markets and dysfunctionality of financial systems in the periphery.

Given the (to us) surprisingly bold tone of Mr. Draghi’s comments last week, we nevertheless think a new initiative may well be in the offing. We have argued in the past that the next step in the escalation of the ECB response would be outright purchases of private assets. Acting in this direction on Thursday would represent a significant event. We forecast the announcement of measures to permit NCBs to purchase private-sector assets under their own risk to implement ‘credit easing’, within a general framework approved by the Governing Council. This would allow purchases of unsecured bank debt and corporate debt, enabling NCBs to ease private-sector financial conditions where such support is most needed. Progress in centralising banking supervision at the ECB would facilitate such support for the banking sector.

1.Market tensions continue to mount in the Euro area, in an environment of ongoing macroeconomic weakness.

2.Thursday’s comments by ECB President Draghi in London have raised expectations that the ECB will resume purchases of peripheral sovereign debt via its Securities Markets Programme (SMP). Peripheral markets have rallied as a result.

3.Anything short of an announcement of such a resumption at next week’s ECB Governing Council meeting risks disappointing markets. Indeed, expectations have been raised further on reports that a package of additional measures (interest rate cuts, new liquidity operations) is being prepared in parallel for the August 2 ECB monetary policy meeting.

4.Thus far, we have assumed that the European Financial Stability Facility (EFSF) would be the authorities’ first line of defence in addressing sovereign market tensions. We continue to hold this view. Moreover, we anticipated that the ECB would act in a supportive manner towards sovereign markets should the EFSF take up its responsibility in this regard, for example by offering another longer tenor LTRO operation on a fixed rate / full allotment basis (thereby supporting Euro area banks’ purchase of peripheral sovereign debt). We also continue to hold this view. And recognising the limited capacity of the EFSF / ESM, we have assumed that ultimately the ECB’s balance sheet will need to be mobilised to fund financial support for vulnerable Euro area sovereigns. Our view here is also unchanged.

5.How then to interpret the (to us) surprising boldness of Mr. Draghi’s remarks in London last week? We see them as reflective of an accelerated pace of events, rather than a fundamental change of character. We organise our further analysis around two possible explanations for this acceleration: (a) that Mr. Draghi expects an imminent Spanish request for EFSF support, and therefore foreshadows ECB action as part of a more comprehensive policy response; and (b) that Mr. Draghi’s concerns about contagion and spillovers from sovereign funding tensions in Spain have become more acute.

The Spanish are coming

6.We had been working on the assumption that – with the Spanish sovereign pre-funded for several months yet – we would not see Spanish recourse to the EFSF until the early autumn, as the usual political prevarication prevailed.

7.Mr. Draghi was clearly aware of the market expectations he was creating last week; hence, his comments might suggest he is confident that the Spanish government will turn to the EFSF sooner than that, opening the way for new ECB actions in the coming weeks. Comments from the German and French governments in the aftermath of Mr. Draghi’s remarks, which point to the EFSF as the vehicle for addressing market tensions, would support this view.

8.We continue to doubt the ECB will act ahead of a Spanish request for EFSF support. A unilateral reactivation of SMP purchases of sovereign debt by the ECB in the form seen on past occasions risks being not only ineffective, but even counterproductive – for all the usual reasons:

As Friday’s statement from the Bundesbank demonstrates, its resistance to central bank purchases of peripheral sovereign debt remains strong. The Bundesbank is not alone. Reigniting discord within the ECB’s decision-making bodies by restarting the SMP threatens to disrupt once again the ECB’s capacity to act on this and other dimensions of policy. And such discord inevitably implies commitment to such interventions is somewhat ambiguous, thereby undermining their effectiveness;
Given how ECB holdings were treated in the Greek debt restructuring, subordination concerns understandably persist among market participants. Declarations of a willingness to take losses on SMP holdings ring hollow: actions speak louder than words in this context. While the ECB may have the opportunity to demonstrate such willingness sooner rather than later in the Greek context, the effectiveness of unilateral SMP purchases is questionable: they need to encourage rather than deter the natural longer-term holders of peripheral sovereign debt from re-entering this market;
Above all, were the ECB to restart SMP purchases unilaterally, the incentive for the Spanish government to seek EFSF support – and accept the implied conditionality – would be reduced. An opportunity to hardwire the necessary consolidation, reform and adjustment into the institutional system would be lost. Broadly speaking, we take a positive view of the Spanish government’s policy programme. While we see scope for accelerating and deepening structural reform, if anything we view their envisaged fiscal adjustment as possibly too aggressive. But these measures have not arisen spontaneously: they have come in response to market pressure. For market pressure to be relieved by external financial support, we view the introduction of greater conditionality as crucial to maintain the momentum of adjustment.
More generally, it has been a long-held ambition of the ECB to ensure governments have explicit financial involvement with regard to peripheral sovereign debt purchases via the EFSF, rather than leaving the ECB to take sole responsibility. And involving the EFSF introduces the necessary formal conditionality and political accountability to the process, which – as last year’s experience in Italy demonstrates – the ECB acting alone lacks.

9.As we have argued in the past, such concerns make us even more sceptical of proposals to cap peripheral sovereign yields or target spreads through an ECB commitment to potentially unlimited SMP purchases of peripheral government debt. Market participants seek the certainty offered by such an unconditional commitment to stabilise yields. Given the multiplicity of uncertainties they face at present, that desire is understandable. But such an unconditional commitment by the ECB renders public budget constraints very soft. Irrespective of their behaviour, governments are able to borrow at the rates pegged by the ECB, serving to create moral hazard and scope for ‘free-riding’ on others’ disciplined behaviour.

10.For the ECB in the current environment, this tension between satisfying markets and constraining government is inescapable. It lies at the heart of the difficult course the ECB has charted throughout the financial crisis. Managing the trade-off entails offering external financial support to governments in return for their acceptance of conditionality. Hence, involvement of the EFSF to provide political legitimacy to that conditionality appears crucial.

11.All this leaves the initiative for triggering the next steps in the hands of the Spanish government. Should a request for EFSF support be forthcoming ahead of or in parallel with the ECB Governing Council meeting next Thursday, it would open the door for the ECB to announce supportive measures on that occasion.

12.As we have said in the past, in parallel with EFSF purchases of Spanish sovereign debt subject to adherence to the conditionality expressed in the required Memorandum of Understanding (MoU), we would expect the ECB to support sovereign markets through a repeat of the longer-tenor LTROs that served this purpose earlier in the year. These fund banks to buy domestic sovereign debt in the primary market (where the ECB is prohibited by the Treaty from operating directly). The latest data reveal greater reluctance on the part of Spanish banks to increase their holdings of sovereign debt, while Italian banks continue to show a willingness to do so. In the former case, some ‘arm twisting’ may be required to ensure demand at sovereign auctions, but with public ownership of the Spanish banking sector on the increase, this should be possible.

13.Moreover, recognising the inadequate capacity of the EFSF in the face of sovereign tensions in Spain and / or Italy, we have argued that ultimately – and probably sooner rather than later –the ECB will be drawn into funding that vehicle. With considerations in the German Constitutional Court delaying the introduction of the EFSF’s permanent (and slightly larger) successor (the European Stability Mechanism, ESM) until at least mid-September, this concern will be particularly acute in the coming weeks.

14.We have always argued that the typical characterisation of how this funding would be provided – giving the EFSF / ESM a banking licence – was an unnecessarily clumsy and provocative route in the face of the well-known institutional and political sensitivities. Admittedly, having the ECB make outright government debt purchases via the SMP in parallel with EFSF / ESM interventions (as envisaged above) is not much (if any) better in this regard, but nevertheless has returned to the discussion. A less controversial scheme, perhaps involving the publicly-owned development banks of the larger Euro area countries, could be found. But these institutional and legal niceties should not detract from the underlying economic reality: one way or another, the ECB’s balance sheet has been and will be mobilised to support sovereign funding. As reflected in the preceding discussion, the crucial question concerns the terms on which this funding is provided.

Addressing contagion (1): Cross-country sovereign spillovers

15.All this assumes that Spain will request EFSF support. Yet German Finance Minister Schaeuble is reported on Saturday as saying a Spanish request for EFSF support is not imminent, as Spain does not face immediate funding problems. And in this Mr. Schaeuble is correct. Having taking advantage of the post-LTRO euphoria in the first quarter, the Spanish government has pre-funded itself, probably through early October. On Spain’s part, there is no urgency to seek external financial support.

16.But Spanish tensions have implications elsewhere. One rationale for immediate ECB action is to contain potential contagion across countries. After all, the introduction of the SMP back in May 2010 stemmed from the concerns that disorder in Greek sovereign markets was dragging down ‘innocent bystanders’ with more modest fundamental problems, simply because of adverse market dynamics. In his London remarks, Mr. Draghi appeared to endorse this line by reviving discussion of the need to re-establish an effective transmission of monetary policy throughout the Euro area.

17.Italy is the most pressing case in this regard. With a primary fiscal surplus, even from its initial high level of sovereign debt the Italian fiscal situation is sustainable – provided that outstanding debt can be rolled over at reasonable rates. But this crucial condition is not met in the current challenging environment. Political pressure is therefore building in Italy: despite accepting the pain of fiscal austerity (and suffering a deep and prolonged recession as a result), Italy has not been rewarded by the markets or by their European partners.

18.In his London comments, Mr. Draghi referred to the impact of ‘convertibility risk’ on interest rates, yields and financial conditions. These remarks are consistent with our own interpretation of recent developments: as the risk of Euro exit has mounted through the crisis, a redenomination risk has become embedded in some asset prices. Uncertain as to what a paper Euro-denominated asset originating from the periphery really represents, foreign investors have been unwilling to hold, still less buy, such assets – and peripheral financial conditions have tightened significantly as a result. Viewing the emergence of this redenomination risk as a systemic problem of which Spanish funding tensions are simply a symptom, one can argue that a systemic solution is required. However well Spain and Italy behave, they are victims of a systemic problem over which they have limited influence.

19.The impact of such systemic considerations could justify ECB actions to contain sovereign spreads. But unfortunately for ECB policy makers, spreads do not come with labels. As we have argued in the past with respect to the distinction between liquidity and solvency risks, a grey area exists between spreads arising from systemic risks and those coming from country-specific economic fundamentals. Attempts to cap sovereign spreads run foul of the dangers expressed above: while they can offset the impact of systemic risks beyond the country’s control, they can also induce free-riding and moral hazard.

20.Conditionality is therefore required. And that leads us back to the role of the EFSF/ ESM in providing the political legitimacy for such conditionality. In the end, the elimination of redenomination risk requires fundamental changes that prompt long-term private holders of sovereign debt back into peripheral markets. Introducing incentive problems makes achievement of that goal harder rather than easier.

Addressing contagion (2): Spillovers from public- to private-sector financing

21.Concerns about spillovers from Spanish sovereign funding tensions not only extend to other countries, but also to the Spanish private sector. Mr. Draghi’s remarks about the impairment of the monetary policy transmission mechanism reflect the extremely difficult financing conditions facing Spanish companies and households, and weak pass-through of official ECB rate cuts to the Spanish real economy. Our own recent analysis of the relationships among official interest rates, bank lending rates and sovereign yields support these concerns. And we have demonstrated that these concerns are not unique to Spain: similar issues arise in Italy and the rest of the periphery.

22.One approach to addressing this problem is to reduce the sovereign spreads that are associated with higher bank funding costs and financial market dislocations. SMP purchases of sovereign debt are a natural vehicle for the ECB to use in that context. But such an approach immediately runs into the problems identified above: the effectiveness of such interventions will be greater the less conditional they are, but the risk of free-riding by the fiscal authorities will be greater.

23.An alternative approach would be to bypass the sovereign spreads and support private-sector financing directly. With its broad and widening definition of collateral eligibility, purchases of bank covered bonds and 3-year LTROs, the ECB has already engaged in variants of this approach, a path now being mimicked by some other central banks. But scope exists to go further.

24.Collateral eligibility could be relaxed again and the haircuts imposed on collateral values reduced. Indeed, the ECB is already engaged in a review of its collateral framework: we anticipate that this will look to remove sovereign credit ratings from the system, in an attempt to eliminate the ‘cliff risk’ inherent in the current system. While the rationale for such a measure may be systemic, it is undoubtedly convenient in the specific circumstances faced by Spain now. And a review of the collateral system offers scope to make more aggressive easing measures elsewhere. Further longer-tenor LTRO operations could be envisaged, out to 5 or 10 years.

25.But, particularly in Spain, the efficacy of such measures is open to question. With the replacement of private unsecured financing with funding from the ECB’s 3-year LTROs against eligible collateral, assets on Spanish bank balance sheets have become encumbered. While bank funding at ECB operations is now cheap and readily available, insufficient free collateral is available to exploit this. Buying covered bonds – as the ECB has done in the past – does not help in this respect (as it also, by nature, involves encumbering bank assets), while changes in collateral eligibility and haircuts have a marginal impact.

26.Outright central bank purchases of unsecured bank debt – something that we have discussed previously – would address this issue. They would support banks’ balance sheet flexibility and facilitate the flow of credit to bank-dependent (and thus credit-starved) small and medium-sized enterprises (SMEs), particularly if marginal incentives were introduced to expand new credit and direct it towards SMEs. Of course, despite the recapitalisation scheme being put in place in Spain, other constraints (notably capital problems) weigh on banks’ ability to lend. And credit demand is weak. So such measures are not a panacea. But in a bank-dependent economy where the traditional interest rate channel of monetary policy transmission is impaired by market segmentation, they may be the most effective tools available. And the prospect of assuming responsibility for banking supervision across the Euro area may make the ECB more willing to act aggressively through the banks.

27.Extending the chain of logic developed above, this would point to the desirability of bypassing not only the sovereign space, but also the banking system by buying corporate debt. Admittedly corporate debt markets in the periphery are underdeveloped. But were the ECB to initiate purchases, issuance would no doubt quickly follow. And financing the larger corporates that are able to issue would improve their working capital position and thereby indirectly ease financing pressures on their SME suppliers as payment periods normalise.

28.A natural objection to outright purchases of assets issued by the private sector is that they involve the assumption of too much credit risk by the ECB. But substantial risk is already assumed via credit operations. And, by their nature, credit easing measures involve the assumption of credit risk. The more aggressive the measure, the greater risk assumed. If – as the macro data suggest – Spain and Italy need substantial stimulus, then imparting that via credit easing means that a lot of risk will need to be taken. And given the present segmented state of Euro area financial markets, for a given willingness to accept risk, it may be preferable to make targeted interventions in the countries and sectors where tensions are most acute – even if this means the risks inherent in any single position is greater.

29.The risk assumed can also be distributed across countries in a politically acceptable manner. As with the risk associated with the national schemes for bringing unrated corporate loans as collateral introduced last December, one could envisage the ECB approving a set of voluntary national private asset programmes proposed by NCBs to reflect their particular circumstances, where the credit risk in those operations remained on the NCB balance sheet. Of course, this would not eliminate the risk faced by Germany and the Bundesbank: to the extent that such purchases create TARGET 2 balances (which is likely to be significant), the Bundesbank would still suffer losses in the event of Euro break-up or a peripheral country exit. But the idiosyncratic risks associated with an individual purchase (or indeed any cyclical or sectoral risk that does not lead to exit) would fall on the peripheral country alone, and not on Germany or other Euro area countries. (Of course, in some respects this is a disadvantage: only the ‘catastrophe risk’ is mutualised, but other forms of risk are concentrated at the national level. Thus the risk sharing benefits of a more integrated financial sector are forgone.)

30.Such a scheme allows NCBs to undertake quasi-fiscal action (since credit easing is a form of public subsidy) and monetise the fiscal consequences (by expanding their balance sheets). NCB purchases of private-sector assets (within a framework overseen by the ECB that leaves the credit risk inherent in such operations lying on the NCB balance sheet) offer scope for surgical interventions targeted to address the most impaired elements of monetary policy transmission, while limiting the potential adverse consequences for incentives (especially of governments). Cosmetically, such measures will add to the impression of a renewed Balkanisation of monetary policy in the Euro area. But, with Euro financial markets deeply segmented, such targeted measures offer a way of managing the consequences of that segmentation for the private sector and real economy while maintaining the pressure for governments to act on fundamentals in a manner that reduces and ultimately eliminates the segmentation over time.

Tags: Bank Debt, Bank Of Japan, Central Planner, Corporate Debt, Credit Operations, Credit Risk, Downside, ECB, Escalation, Goldman, Governing Council, Huw, Japanization, Mario Draghi, Monetization, Private Assets, Rational Person, Substantial Risk, Taxpayer Risk, Whole Lot
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