Archive for August 29th, 2012
Wednesday, August 29th, 2012
Tomatoes and the Low Vol Effect
by Ryan Larson, Research Affiliates
Growing up, my sister and I spent summers at our grandparents’ house where one of our favorite treats was fresh sliced tomatoes with sugar on top. Snack time always brought out the fun debate about whether tomatoes are a fruit or vegetable. Without the Internet to render a definitive verdict, we settled on enjoy- ing the tomato regardless of its categorization.
Today we can find out quickly whether toma- toes are a vegetable or fruit. The answer is both! Botanically, tomatoes are a fruit. Cultur- ally and legally, they are a vegetable. In 1894, the U.S. Supreme Court ruled that tomatoes were a vegetable, allowing the U.S. Govern- ment to impose a tariff on imported tomatoes, protecting domestic farmers.1
Like tomatoes to farmers and botanists, inves- tors classify risk in equity portfolios differently depending on their point of reference. In its simplest form, there are two types of equity risk: absolute risk and relative risk. Research shows that in an ideal world, investors should prefer to invest 100% in low volatility strate- gies that minimize absolute risk. However, the overwhelming trend to delegate authority to institutional money managers—who generally focus on relative performance—makes this outcome unrealistic. This issue of Fundamentals explores ways to improve the outcome for both absolute and relative risk investors.
Absolute to Relative Risk
For the first three-quarters of the 20th century, the majority of outstanding equity shares were held by individual investors who focused on total return and absolute risk.2 Individuals tended to purchase blue-chip stocks in a buy-and-hold strategy, banking the dividends on a regular basis. There were few specialized institutional money managers acting on behalf of other investors.3
Investment success was measured by a stock’s total return (dividends paid plus stock price gain) relative to its absolute risk (standard deviation). William Sharpe (1966) formalized the concept of return relative to absolute risk when he introduced the “reward-to-variability ratio”; the formula was later renamed the “Sharpe ratio.” Two changes in the 1970s and 1980s contributed to a shift from absolute risk to relative risk as the frame of reference. The first was the growth of assets in pension funds that led to financial intermediation, and the second was the emergence of passive capitalization-weighted indexing.
Assets invested in plans that outsource investment management (the most notable being public and corporate defined benefit plans and 401(k) plans) exploded from $369 billion in 1974 to $19 trillion today.4 This dele- gation of investment authority to institutional money managers meant a need to measure the success of these hired guns. The anchor for performance success became the market portfolio—the S&P 500 Index, or broader indices, such as the Russell 3000 Index. Conveniently, in 1973, cap- weighted index funds were developed to offer investors an easy, cheap way to access stocks, emphasizing relative risk investing even more.
Today, the clear majority of equity strate- gies operate either explicitly or implicitly with an eye toward minimizing relative risk. Indeed, the standard deviation and beta of most managers is very similar.5 Thus, the differentiating factors in man- ager selection should be excess return, tracking error, and the ratio between the two—the information ratio. If a manager experiences a lot of tracking error and seri- ously underperforms the index, the man- ager faces the risk of termination. With the average manager running a tracking error of over 6%, randomness alone puts him at risk of getting fired.6 Three years is typically the longest boards allow a man- ager to underperform the market before pulling the plug. Portfolio managers are a self-preservation-oriented bunch, so they began to manage their portfolios with an eye on the index and toward minimiz- ing relative risk (tracking error), with less concern for absolute risk (standard deviation).
With the advent of the Fundamental Index® approach in early 2005, investors suddenly had a second implementation option for a relative risk pursuit that sought alpha from a different angle. The Fundamental Index method eliminates “negative alpha”; that is, the inefficiency caused by a cap-weighted index portfolio overweighting overvalued stocks and underweighting undervalued stocks and not rebalancing.
Back to the Future?
Today we are witnessing a renaissance of sorts as investors, battered by the bear markets of the 2000s, are more open to the idea of equity strategies focused on minimizing absolute risk. In fact, the strong shift into hedge funds during the past decade reflects a desire to reduce absolute risk. However, we believe there is a superior way to achieve this goal: low volatility strategies, which offer nearly the same statistical properties of hedge funds, but do so in a liquid, transparent, low cost manner—and with better Sharpe ratios.7
Low volatility strategies contradict what finance students learned in business school that the security market line (SML) slopes upward linearly. In other words, theory says that higher volatility or higher beta stocks should produce higher rates of return to compensate for the greater market risk. Evidence exists since the 1970s that the SML is much flatter than CAPM predicts.8 Perversely, low volatility stocks earn higher returns than high volatility stocks!
Most managers who have launched low volatility strategies over the past five to seven years to capitalize on “de-risking demand” build their portfolios through a quantitative optimization process that estimates the covariance matrix in a complicated, black-box solution. We observe these optimized low volatility strategies tend to emphasize small-cap stocks and have high turnover (90%). However, our research finds that there is no ex ante long-term performance differ- ence between any of these low volatility methodologies! All “true” low volatility portfolios should earn a premium return of about 2% in the United States and do so with 25% less absolute risk than the benchmark.9 Even something as simple as screening out high volatility stocks and weighting by the inverse of volatility (i.e., allocating more to low volatility stocks) will produce a comparable result. (Our low volatility approach employs a similar investor-friendly process.)
The explanations for the seemingly counterintuitive result of the low volatil- ity anomaly are nearly as widespread as the amount of products entering the marketplace. Our view is far simpler. First, the excess return of the strategies comes from the fact that, like the Fundamental Index method or even equal-weighting, low volatility methodologies don’t use price to weight the portfolio. Therefore, before transaction costs, they should produce a similar excess return to any other non-price-weighted strategy. And indeed they do. The risk reduction is a simple byproduct of focusing on the lower volatility portion of the equity market. Therefore, what investors need to focus on is finding the low volatility strategy that is simple and intuitive with the lowest cost and easiest implementation.
Low volatility strategies can lead to a high amount of investor regret because of their very large tracking error of 8–10%, leading to a high probability of buying and sell-ing those strategies at the wrong time because of relative risk benchmarking. For example, during 2011 low volatility stocks outperformed the broad stock market by 10%, then lagged by 5% in first quarter 2012, and outperformed again in the second quarter 2012 by 5%.10 What a seesaw! Because of high tracking error, successful low volatility investing must throw out any comparison to relative risk measures such as the information ratio and re-frame performance relative to a different anchor: the Sharpe ratio.
Choose Your Risk Wisely
Investors now have two very distinct paths for gaining equity exposure. Figure 1 outlines the trade-offs between the two risk focuses. The vertical axis measures the information ratio, or the excess return per unit of tracking error. The relative risk investor, concerned with tracking error, seeks to maximize the information ratio often at the expense of higher absolute volatility. The horizontal axis displays the Sharpe ratio, or the excess return of the portfolio over cash relative to the port- folio standard deviation. The absolute risk investor, by focusing on reducing standard deviation, defines success by the Sharpe ratio, but incurs sizable tracking error (relative risk) in doing so. To illustrate the trade-offs, we plot four reference portfolios:
- S&P 500—This benchmark portfolio has an information ratio of 0 as it has no excess return or tracking error against itself and a Sharpe ratio of less than 0.4. The market portfolio is an inefficient long-term portfolio solution.
- Active Managers—This portfolio rep- resents the typical way relative risk investors have sought to increase the information ratio; over the 1991–2011 time period, the average manager earns a slight premium over the market.
- Fundamental Index Method—This portfolio illustrates the improved information ratio (at a reasonable tracking error level) achievable by applying a non-price methodology in an economically representative manner. Because the Fundamental Index method owns a very similar roster of companies to capitaliza- tion weighting, it tends to have a similar volatility level and so the Sharpe ratio improves only margin- ally. Thus, the Fundamental Index method is an ideal solution for those that live predominantly in the rela- tive risk camp.
- Low Volatility—This portfolio illus- trates the improved Sharpe ratio achievable by shifting from relative risk to absolute risk-focused equity investing. Low volatility strategies earn a near one-to-one ratio of return to risk, while cap-weighted S&P 500 investors take on double the amount of risk to earn the same return!
It should be readily apparent that it is very difficult for a single portfolio approach to be both a relative risk and an absolute risk winner. The more one wants to shift from a relative approach to an absolute one, the more one will have to screen out large portions of the market and, accord- ingly, accept more tracking error. On the flipside, a shift from absolute risk to relative risk will mean purchasing higher beta stocks that comprise a large portion of the market. Predictably, this increases absolute volatility. Only the lucky tomato gets to be both a fruit and a vegetable.
We assert that a critical takeaway from Figure 1 is that the first step of an equity structure review ought to be a discussion of the client’s primary risk measure. A client with substantial oversight and reg- ular peer group comparisons is likely to prefer a continued reliance upon relative risk and information ratio maximization. Investors willing to take more “maverick” risk12 can make a conscious choice to devote all, or some portion, of their equity portfolio to Sharpe ratio maximization that presumably enjoys a closer link with their liabilities.
Clients who are willing to take some tracking error risk, but are not willing to go all in, can split their allocation among the various portfolios. A simple strategy of equally weighting allocations to the traditional cap-weighted index, the Fun- damental Index method and low volatility increases returns by 2% and decreases risk 2% relative to the conventional portfolio! This equity portfolio earns 11% returns with 13% risk, all with manage- able tracking error under 5%.13 Of course, these results are achieved with no stock picking, no manager due diligence, and no forecasting. Further, a thoughtfully designed Fundamental Index portfolio and low volatility approach can capture nearly all of these “paper portfolio” results by emphasizing low turnover, sizable capacity, and economic representation.
Fruit or vegetable, a tomato with sugar on it tastes great. But the difference between relative risk and absolute risk is more than just semantics—it relates to investor preferences. For the investor more concerned about tracking error and measurement against a benchmark and his peers, a relative risk approach is more relevant. For the investor who desires avoiding sharp downdrafts but does not mind tracking error deviation, an absolute risk approach based on improved Sharpe ratios may be more appropriate. In either case, both relative and absolute risk investors can improve the structure of their equity portfolios by migrating away from the conventional equity allocation.
1. Nix v. Hedden. Vegetables were subject to the Tariff Act of 1883, while fruits were exempt. The U.S. Commerce Department still clas- sifies tomatoes as vegetables, although the tariff was removed in 1994 with the passage of NAFTA.
2. In 1968, institutional investors owned just 15% of U.S. stock market shares. Today, that figure is approximately 75%. See Baker, Bradley and Wurgler (2011).
3. Most “institutional” investors were bank trust departments invest- ing on behalf of wealthy families. Hedge funds didn’t exist, with the exception of a couple of pioneers like the Graham–Newman partner- ship and Alfred Winslow Jones.
4. According to the Employee Benefit Research Institute, there was $162 billion in U.S. state and local retirement pension plans in 1979 and $2.7 trillion in 2010, and $64 billion in federal government retirement plans in 1979 and $1.3 trillion in 2009. According to the Investment Company Institute, there is $3.4 trillion invested in 401(k) plans in 1Q2012, up from zero in 1980, and $2.5 trillion in corporate pension plans in 1Q2012, up from $130 billion in 1974. The balance is in other DC plans, IRAs, and annuities.
5. As an example of how active managers are not that different from the market, the eVestment Alliance U.S. Large Cap manager universe (758 managers) over the past 10 years (6/2002–6/2012) reveals an average beta of 0.99 with the bulk of managers’ betas between 0.93 and 1.04. The results are nearly identical for the past 20 years (6/1992–6/2012), but with a smaller subset of 194 managers. The majority of managers have standard deviations between 15–17% for both of these time periods, right around the market’s 15.5%.
6. There is a one-in-three chance during a “normal” one-standard deviation event any given year a manager would underperform by 6%. Suppose the manager underperforms by 6% in the first year and earns no excess returns the next two years. This would mean finishing the all-important three-year judgment period with about a –2% relative underperformance before fees. Quite often, that type of underperformance results in termination for active managers.
7. Over the past 10 years, the HFRI Equity Hedge Index returned 4.5% annualized with 9% volatility, while low volatility stocks earned 7% with 11% volatility. The Sharpe ratio of low volatility is better than hedge funds! Correlation to the S&P 500 Index was 0.85 for both hedge funds and low volatility, and tracking error to the S&P was approximately 10% for both. To us, investors are much better off using low volatility equities to maximize Sharpe ratio than high cost hedge funds.
8. See Fischer Black (1972) and Robert Haugen (1972 and 1975). 9. Kuo and Li (2012).
10. Comparing the S&P 500 Low Volatility Index to the S&P 500 Index.
11. We use the S&P 500 Low Volatility Index to represent the returns of low volatility portfolios. The S&P 500 Low Volatility Index builds a portfolio of the 100 stocks within the broad S&P 500 that had the lowest standard deviation of returns over the past 252 trading days. It is rebalanced quarterly. Its inception was January 1, 1991, so we use that as a beginning point for the study. Also, going back in time earlier than 1991 becomes difficult to find a broad set of active managers that are truly representative of an investor’s opportunity set. Starting in 1991 there are just 162 managers in the eVestment Large Cap Equity universe for the study period. This dataset suffers from survivorship bias, and is gross of fees. Thus, we are giving active management an edge here, as their positive 1% excess return over this time period has been shown by many researchers to be well above what an actual investor earns through active management,
which is typically negative alpha after costs.
12. Maverick risk describes the willingness to adopt an asset allocation
that looks very different from that of the typical plan. Most U.S. pen- sion portfolios are aligned around a 60% equity / 40% bond anchor with some allocation to alternatives. Within the equity structure, the conventional portfolios are heavy in domestic equities, and active management and cap-weighted indexing.
13. Of course, a 50/50 split between the Fundamental Index and low volatility strategies would deliver a more optimal portfolio!
Baker, Malcolm, Brendan Bradley, and Jeffrey Wurgler. 2011. “Benchmarks as Limits to Arbitrage: Understanding the Low-Volatility Anomaly.” Finan- cial Analysts Journal, vol. 67, no. 1 (January/February):40–54.
Black, Fischer. 1972. “Capital Market Equilibrium with Restricted Borrow- ing.” Journal of Business, vol. 4, no. 3 (July):444–455.
Black, Fischer, Michael C. Jensen, and Myron Scholes. 1972. “The Capital Asset Pricing Model: Some Empirical Tests.” In Studies in the Theory of Capital Markets. Edited by Michael C. Jensen. New York: Praeger.
Haugen, Robert A., and A. James Heins. 1972. “On the Evidence Support- ing the Existence of Risk Premiums in the Capital Markets.” Wisconsin Working Paper (December).
_______. 1975. “Risk and the Rate of Return on Financial Assets: Some Old Wine in New Bottles.” Journal of Financial and Quantitative Analysis, vol. 10, no. 5 (December):775–784.
Kuo, Li-Lan and Feifei Li. 2012. “An Investor’s Low Volatility Strategy.” Research Affiliates White Paper (June).
Sharpe, William F. 1966. “Mutual Fund Performance.” Journal of Business, vol. 39, no. 1 (January):119–138.
_______. 1994. “The Sharpe Ratio.” Journal of Portfolio Management, vol. 21, no. 1 (Fall):49–58.
Wednesday, August 29th, 2012
Waiting for Bernanke
Equity markets continue to stall prior to Bernanke’s speech at Jackson Hole on Friday morning. Short term momentum indicators continue to roll over from overbought levels.
The Dow Jones Transportation Average is leading U.S. equity markets on the downside.
Percent of stocks trading above their 50 day moving average continued to drift lower from intermediate overbought levels.
The Semiconductor sector is starting to show signs of rolling over as it enters its steepest period of seasonal weakness. Yesterday, the sector fell below its 20 day moving average. Short term momentum indicators have rolled over from overbought levels. Strength relative to the S&P 500 Index also has rolled over. Meanwhile, revenues in the industry have stalled. See chart provided by the Semiconductor Industry Association through this link:
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Horizons Seasonal Rotation ETF HAC August 28th 2012
Wednesday, August 29th, 2012
Seasonality, Odds for ‘Easing Disappointment’ Warrant Caution in Broader Markets
by Don Vialoux, EquityClock.com
Upcoming US Events for Today:
- Q2 GDP Estimate will be released at 8:30am. The market expects an increase of 1.7% versus an increase of 1.5% previous.
- Pending Home Sales for July will be released at 10:00am. The market expects an increase of 1.0% versus a decline of 1.4% previous.
- Weekly Crude Inventories will be released at 10:30am.
- The Fed’s Beige Book for August will be released at 2:00pm.
Upcoming International Events for Today:
- German Consumer Price Index for August will be released at 8:00am EST. The market expects a year-over-year increase of 1.9% versus 1.7% previous.
- Japanese Retail Sales fro July will be released at 7:50pm EST. The market expects a year-over-year decline of 0.3% versus an increase of 0.2% previous.
Markets traded flat on Tuesday as investors held the tape steady ahead of Ben Bernanke’s speech in Jackson Hole at the end of this week. Economic news was mixed with the Case Shiller Home Price Index and the Richmond Fed Manufacturing Index both beating expectations, while Consumer Confidence showed a significant miss. The Case Shiller report showed a year-over-year gain of 0.5% for the month of June, beating estimates of 0.0%, in a sign that the housing market continues to improve. The Richmond Fed received a boost from last months low of –17 to report a –9, still in contractionary mode but better than the analyst estimate of –10. And perhaps the most important indicator given the time of year is Consumer Confidence, which reported a 9-month low of 60.6, well below estimates of 65.8. Consumer confidence has been trending lower since last Christmas and it is not a very optimistic sign that the lows of the year are becoming realized as we enter the period of seasonal strength for retail, with back-to-school, Thanksgiving, and Christmas spending expected to give the economy a boost. Retail is a key driver of the economy in the last few months of the year and if consumers are not confident, they may not spend. Here is what Econoday.com had to say regarding this report:
Weakness in today’s report is centered in the assessment of future conditions where components make up 60 percent of the composite index. The three components all show deterioration especially in the degree of pessimism on future business conditions, employment, and income. Pessimism for these readings, particularly income, poses an early warning for retailers as they prepare for the holiday shopping season.
So analysts for the past week have been providing their guess as to what Ben Bernanke will reveal in this week’s speech and more importantly, what will the Fed and the ECB will offer at their upcoming meetings: Will additional monetary stimulus be offered as is widely anticipated? Additional stimulus seems to be a foregone conclusion by the market and many analysts expect that something will be offered, perhaps in the coming days. Unfortunately, the chances of further monetary stimulus at this point in time are very low for one reason: rates. It is commonly known that the Fed follows the 5-year breakeven rate, which gauges the level of inflation in the economy. Back at the last FOMC meeting at the end of July, the rate of inflation was essentially within a downward trend channel, suggesting disinflation. In order to correct the trend, further accommodation appeared appropriate, which is what the Fed’s notes indicated. However, since the meeting, the rate of inflation has broken out of this 5-month declining trend and has now moved closer to 2% (1.98% as of Tuesday’s close). Back in January the Fed set an inflation target of 2%, noting that an inflation rate of 2 percent is best aligned with its congressionally mandated goals of price stability and full employment. Looking at the 5-year chart and the points where previous quantitative easing programs were initiated, you can clearly see that the additional easing was offered when inflation was significantly low (or negative as in the case of the end of 2008). With Inflation seemingly stabilizing over the past year around the informal target range of roughly 1.7 percent to 2 percent under the current Operation Twist program, it is probably unreasonable for the Fed to act further at this time in order to push the limit.
But let’s not forget that the ECB is also expected to act. Back at their last meeting, yields on Spanish an Italian debt were in a firm uptrend, posing a significant threat to destabilization in the Euro zone and prompting the ECB President to stand behind the struggling currency. Since those comments, yields have broken a 5-month rising trend, bringing calm to the area. And lets not forget that the next ECB meeting (September 6) happens before the German court ruling on the constitutionality of the ESM (September 12), potentially constraining European Central Bank officials until the judgment is received. With markets at resistance and expectations of further easing likely to prove unrealistic, the chance of a market selloff based upon disappointment is greater than the chance of a market surge higher based on additional stimulus. Keep in mind that anything is still possible as central banks can be known to surprise, but the probability favours a disappointment, which puts the market at risk of a shock event given the complacency that is prevalent within equities. Caution is prudent.
Now, on to today’s warning signal. In each of the reports this week we have indentified reasons to be cautious due technical indicators diverging from the recent market strength. Today we focus on copper. Commodities have no doubt been strong recently, helped by a weaker US dollar. This has allowed breakouts to be realized in Gold, Platinum, and Silver. Energy commodities remain on a positive trend, holding near the highs of the summer. And agricultural commodities certainly have a bid to them with drought conditions fueling speculation of supply disruptions. However, as all of these commodities hover around the highs of the summer/quarter, copper has failed to participate. The commodity has been unable to break through the highs set at the beginning of July as it holds within an underperforming trend that began in February. Copper is often referred to as Dr. Copper due to its ability to predict market strength as a result of the cyclical nature of the commodity. Copper has also underperformed gold since April, just as equity markets were peaking. In fact, the relative performance of Copper (the risk-on trade) and Gold (the risk-off trade) has been very indicative of equity market strength. Copper bottomed relative to Gold in October of 2011, moving higher through to April 2012, just as the equity market peaked. Similarly, copper bottomed relative to gold in the summer of 2010, just before the Fed induced stimulus rally that lasted through to early 2011. The relative performance then declined through Q2 and Q3 of 2011, almost forecasting the negative move to come for equities from July through October. Results are similar in past occurrences as well. The recent divergence between Copper relative to Gold and equities suggests that risk aversion continues to persist, a bearish setup that could lead to market declines. The period of seasonal strength for copper runs from December all the way through to July as manufacturing activity picks up in the first half of the year.
Sentiment on Tuesday, as gauged by the put-call ratio, ended bullish at 0.83.
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Wednesday, August 29th, 2012
The weak consumer sentiment number today was a surprise. After all, the S&P500 index is up 13.7% year to date (including dividend). The recent equity market rally should have boosted the consumer net worth and improved consumer confidence.
A quick empirical analysis (below) shows that a large portion (r^2 =84%, beta = .33) of the change in consumer net worth is explained by the moves in the stock market. This is a recent relationship, as the US consumer exposure to equities has been larger over the past 20 years than previously (the relationship was weaker during the previous 30 years: r^2 = 68%, beta = .18).
In fact the US consumer wealth has increased considerably since the financial crisis, to a large extent driven by the stock market (particularly given that housing has been stagnant until very recently).
Source: ISI Group
But increased wealth does not seem to be improving how consumers feel. Actually over the past few months the divergence between consumer sentiment and the equity market (which reflects improved net worth) is quite striking.
Something is spooking the consumer enough to cancel out the effects of the market rally. And the divergence is not just with the market. The recent uptick in the Citi Economic Surprise Index – indicating better overall economic data – is also not reflected in the sentiment trend.
WSJ: – Perhaps more worrisome, though, is the divergence between some of the hard economic data – such as jobs, manufacturing and housing reports – compared to soft data such as sentiment surveys. Much of the hard data have gotten better this summer, as measured by Citigroup’s Economic Surprise Index, which has risen in each of the last four straight weeks. But sentiment surveys are still lagging.
Part of the explanation is that the consumer is not as worried about the current situation (including a strong stock market) as she is about the future. The “present situation” portion of the Conference Board index was basically flat, while the “expectations” component was down 7.9. The consumer is not confident in her ability to retain this improved net worth.
LA Times: There was little change in how consumers viewed their current situation. For example, 34.4% of people surveyed said business conditions right now were bad, the same percentage as in July. And 40.7% of those surveyed in August described jobs as “hard to get,” down slightly from 41% a month earlier.
But consumers’ long-term view headed south. The percentage of respondents who expected business conditions to improve over the next six months dropped to 16.5%, from 19% in July. And 23.4% of those surveyed in August said they expected the economy to produce fewer jobs in the same upcoming period, up from 20.6%.
Not surprisingly the poor “forward looking” sentiment is also visible in the increased steepness of the VIX curve (discussed earlier).
The US fiscal cliff (see discussion), the Eurozone uncertainty (particularly with the scary looking September calendar), the upcoming election, and weak labor markets are some of the more common explanations for poor consumer expectations.
WSJ: – “Households continue to worry about a difficult job market, the European debt crisis, the upcoming ‘fiscal cliff,’ and the political wrangling in Washington and in the presidential campaign,” says Steven Wood, chief economist at Insight Economics.
But the spike in gasoline prices and the expectation of rising food prices due to the drought could be even more damaging to confidence, because consumers face these cost increases on a daily basis. Related to this, the US consumers are also concerned about the possibility of QE3, which may exacerbate the “headline inflation” (fresh in consumers’ memory from 2011). As discussed before (see this post), even the anticipation of asset purchases by the Fed could have negative ramifications on the US consumer (in spite of driving equity prices higher).
Whatever the case, the divergence between economic indicators that have trended up recently (particularly the equity markets) and consumer confidence can not continue indefinitely. Something’s got to give. The concern of course is that consumer sentiment in the long run could end up being more accurate than other forward looking indicators.
WSJ: – At some point, both sets of data points will start moving closer in tandem. “By its very nature this divergence is unlikely to persist,” … “Our expectation is that the convergence will be toward the sentiment indicators, suggesting that the current upturn in economic momentum could prove fleeting.”
Copyright © SoberLook.com
Wednesday, August 29th, 2012
Originally posted at Project-Syndicate,
Hans-Werner Sinn – Judgment Day For The Euro
Hans-Werner Sinn is Professor of Economics at the University of Munich and President of the Ifo Institute for Economic Research. He also serves on the German economy ministry’s Advisory Council. Hi… Full profile
Europe and the world are eagerly awaiting the decision of Germany’s Constitutional Court on September 12 regarding the European Stability Mechanism (ESM), the proposed permanent successor to the eurozone’s current emergency lender, the European Financial Stability Mechanism. The Court must rule on German plaintiffs’ claim that legislation to establish the ESM would violate Germany’s Grundgesetz (Basic Law). If the Court rules in the plaintiffs’ favor, it will ask Germany’s president not to sign the ESM treaty, which has already been ratified by Germany’s Bundestag (parliament).
There are serious concerns on all sides about the pending decision. Investors are worried that the Court could oppose the ESM such that they would have to bear the losses from their bad investments. Taxpayers and pensioners in European countries that still have solid economies are worried that the Court could pave the way for socialization of eurozone debt, saddling them with the burden of these same investors’ losses.
The plaintiffs represent the entire political spectrum, including the Left Party, the Christian Social Union MP Peter Gauweiler, and the justice minister in former Chancellor Gerhard Schröder’s Social Democratic government, Herta Däubler-Gmelin, who has collected tens of thousands of signatures supporting her case. There is also a group of retired professors of economics and law, and another of “ordinary” citizens, whose individual complaints have been selected as examples by the Court.
The plaintiffs have raised several objections to the ESM.
First, they claim that it breaches the Maastricht Treaty’s “no bail-out” clause (Article 125). Germany agreed to relinquish the Deutsche Mark on the condition that the new currency area would not lead to direct or indirect socialization of its members’ debt, thus precluding any financial assistance from EU funds for states facing bankruptcy. Indeed, the new currency was conceived as a unit of account for economic exchange that would not have any wealth implications at all.
The plaintiffs argue that, in the case of Greece, breaching Article 125 required proof that its insolvency would pose a greater danger than anticipated when the Maastricht Treaty was drafted. However, no such proof was provided.
Second, Germany’s law on the introduction of the ESM obliges Germany’s representative on the ESM Council to vote only after having asked the Bundestag for a decision. According to the plaintiffs, this is not permissible under international law. If Germany had wished to constrain its governor’s authority in this way, it should have informed the other signatory states prior to doing so. On the other hand, Germany’s representative on the Governing Council is sworn to secrecy, which, the plaintiffs argue, precludes any accountability to the Bundestag.
Moreover, the plaintiffs claim that, while the ESM treaty is restrictive in granting resources to individual states, requiring a qualified majority vote, it does not specify the conditions under which losses are acceptable. Losses can result from excessive wages paid by the ESM Governing Council members to themselves, a dearth of energy in efforts to collect debts from countries that have received credit, or other forms of mismanagement. And, because Governing Council and Executive Board members enjoy immunity from criminal prosecution, misbehavior cannot be punished.
If losses arise, they must be covered by the initial cash contribution of €80 billion ($100 billion), which then would be topped up automatically by all participating countries according to their capital shares. If individual countries are no longer able to make the necessary contributions, others must do so on their behalf. In principle, a single country might have to assume the entire burden of losses. Such joint and several liability, the plaintiffs assert, contradicts the Court’s previous statements that Germany should not accept any financial commitments stemming from other states’ behavior.
Worse, according to the plaintiffs, although the liability of any country vis-à-vis external partners is limited to that country’s share of capital, this limitation does not apply to other signatory states. It is theoretically possible that a single country could be held liable for the ESM’s total exposure of €700 billion.
Finally, the ESM cannot be considered on its own, but must be seen in the context of the total exposure amount, which includes the €1.4 trillion in bailout funds that have already been granted. In particular, the Target2 credit drawn by the crisis-afflicted countries’ central banks, which already totals almost €1 trillion, should also be taken into consideration.
Nobody knows how the Constitutional Court will rule on these objections. Most observers believe that the Court is unlikely to oppose the ESM treaty, though many expect the judges to demand certain amendments, or to ask Germany’s president to make his signature subject to certain qualifications.
It is good that the Court’s decisions cannot be forecast, and even better that the Court cannot be lobbied or petitioned. The European Union can be based only on the rule of law. If those in power can break its rules on a case-by-case basis, the EU will never develop into the stable construct that is a prerequisite for peace and prosperity.
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Wednesday, August 29th, 2012
When jawboning is stuck on max, and mere talking and exortations to just “believe” lead to no incremental benefit for PIIGS bonds and the leve of the Dax, what is a central planner to do? Why start, er, fingerboning, and write extended missive on the future of one doomed utopian vision or another. Sure enough, the former Goldmanite has just released the following Op-ed in German Zeit, titled, “The future of the euro: stability through change“, which contains this piece of sheer brilliance: “The ECB is not a political institution. But it is committed to its responsibilities as an institution of the European Union.” The European Union which is first and foremost a… political institution.
Full Op-Ed below:
The future of the euro: stability through change
Contribution from Mario Draghi, President of the ECB, Published in “Die Zeit”, 29 August 2012
Across Europe, a fundamental debate is taking place about the future of the euro. Many citizens are concerned about where Europe is heading. Yet the solutions presented appear to them unsatisfactory. This is because these solutions offer binary choices: either we must go back to the past, or we must move to a United States of Europe. My answer to the question is: to have a stable euro we do not need to choose between extremes.
The reason this debate is taking place is not the euro as a currency. The objectives of the single currency remain as relevant today as they were when the single currency was agreed. To spread price stability and sustainable growth to all European citizens. To reap the gains of the world’s largest single market and make the historic process of European unification irreversible. To raise Europe’s standing – not only economically but also politically – in a globalised world.
The debate is taking place because the euro area has not yet fully succeeded as a polity. Currencies ultimately depend on the institutions that stand behind them. When the euro was first proposed, there were those who said it would have to be preceded by a long process of political integration. This was because sharing a currency would imply a high degree of joint decision-making. Member countries would be a “Schicksalsgemeinschaft” and would need strong common democratic underpinnings.
But a deliberate choice was made in the 1990s not to give the euro such features. The euro was launched as a “currency without a state” to preserve the sovereignty and diversity of member countries. This informed the so-called “Maastricht setup”, which laid the euro’s institutional foundations. But as recent events have shown, this institutional framework left the euro area insufficiently equipped to ensure sound economic policies and effectively manage crises.
For this reason, the way ahead cannot be a return to the status quo ante. The challenges of having a single monetary policy but loosely coordinated fiscal, economic and financial policies have been clearly revealed by the crisis. As Jean Monnet said, coordination “ is a method which promotes discussion, but it does not lead to a decision.” And strong decisions have to be made to manage the world’s second most important currency.
A new architecture for the euro area is desirable to create sustained prosperity for all euro area countries, and especially for Germany. The root of Germany’s success is its deep integration into the European and world economies. To continue to prosper, Germany needs to remain an anchor of a strong currency, at the centre of a zone of monetary stability and in a dynamic and competitive euro area economy. Only a stronger economic and monetary union can provide this.
Yet this new architecture does not require a political union first. It is clear that monetary union does entail a higher degree of joint decision-making. But economic integration and political integration can develop in parallel. Where necessary, sovereignty in selected economic policy fields can and should be pooled and democratic legitimation deepened.
How far should this go? We do not need a centralisation of all economic policies. Instead, we can answer this question pragmatically: by calmly asking ourselves which are the minimum requirements to complete economic and monetary union. And in doing so, we will find that all the necessary measures are firmly within our reach.
For fiscal policies, we need true oversight over national budgets. The consequences of misguided fiscal policies in a monetary union are too severe to remain self-policed. For broader economic policies, we need to guarantee competitiveness. Countries must be able to generate sustainable growth and high employment without excessive imbalances. The euro area is not a nation-state where persistent cross-regional subsidies have sufficient popular support. Therefore, we cannot afford a situation where some regions run permanently large deficits vis-à-vis others.
For financial policies, there need to be powers at the centre to limit excessive risk-taking by banks and regulatory capture by supervisors. This is the best way to protect euro area taxpayers. There also needs to be a framework for bank resolution that safeguards public finances, as we see in other federations. In the U.S., for example, on average about 90, mostly smaller, banks per year have been resolved since 2008 and this had no impact on the solvency of the sovereign.
Political union can, and shall, develop hand-in-hand with fiscal, economic and financial union. The sharing of powers and of accountability can move in parallel. We should not forget that 60 years of European integration have already created a significant degree of political union. Decisions are made by an EU Council filled by national ministers and by a directly elected European Parliament. The challenge is to further increase the legitimacy of these bodies commensurate with increasing their responsibilities and to seek ways to better anchor European processes at the national level.
A more solid political foundation should allow for agreement on a basic principle: that it is neither sustainable nor legitimate for countries to pursue national policies that can cause economic harm for others. This constraint has to be built into how countries design their economic and social models. The only sustainable model is one that is consistent with the terms of a common currency. Countries have to live within their means. Competition and labour markets have to be reinvigorated. Banks have to conform to the highest regulatory standards and focus on serving the real economy. This is not the end, but the renewal of the European social model.
From the ECB’s perspective, a strong economic union is an essential complement to the single monetary policy. Building this will require a structured process with correct sequencing. Yet citizens can be certain that three elements will remain constant. The ECB will do what is necessary to ensure price stability. It will remain independent. And it will always act within the limits of its mandate.
Yet it should be understood that fulfilling our mandate sometimes requires us to go beyond standard monetary policy tools. When markets are fragmented or influenced by irrational fears, our monetary policy signals do not reach citizens evenly across the euro area. We have to fix such blockages to ensure a single monetary policy and therefore price stability for all euro area citizens. This may at times require exceptional measures. But this is our responsibility as the central bank of the euro area as a whole.
The ECB is not a political institution. But it is committed to its responsibilities as an institution of the European Union. As such, we never lose sight of our mission to guarantee a strong and stable currency. The banknotes that we issue bear the European flag and are a powerful symbol of European identity.
Those who want to go back to the past misunderstand the significance of the euro. Those who claim only a full federation can be sustainable set the bar too high. What we need is a gradual and structured effort to complete EMU. This would finally give the euro the stable foundations it deserves. It would fully achieve the ultimate goals for which the Union and the euro were founded: stability, prosperity and peace. We know this is what the people in Europe, and in Germany, aspire to.
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