The Financial Crisis of 2008 represented a turning point for the capital markets, financial regulation and global central bank policies. For the twenty years leading up to the Financial Crisis, accommodative monetary policies of the developed countries resulted in prosperity, higher wages, increased asset prices and an overall higher standard of living. However, this false sense of perpetual prosperity resulted in unbalanced social service and pension benefits that are now more difficult to rationalize in the economic environment following the Financial Crisis. Developed countries, including Spain, Italy, Japan and the United States, simply amassed too much debt. The capital markets are now in a period of deleveraging which is marked by austerity, tight credit, transfer of wealth, debt restructuring, and central bank intervention in the capital markets. And, because of the structural problems with the European Union, Europe is having more difficulty dealing with its deleveraging.
This Investment Perspective discusses the growing debt problems in Europe and our expectations for the U.S. government to get more involved in developing solutions.
European countries moved to a common currency twenty years ago as a way to promote economic growth and trade. The euro is a cooperative currency that requires member countries to maintain certain fiscal disciplines in order to be a member in good standing. Unfortunately, most of the member countries are not within their required covenants (including the 3% budget deficit to GDP ratio) for membership in the European Union. In contrast, the United States has a complete federal union. Europe lacks a central government that can tax, borrow funds and disperse money through a common Treasury; it really only has a cooperative currency. Unlike the Federal Reserve, Europe does not have a centralized banking system that can be the “lender of last resort” or a Federal Deposit Insurance Commission (FDIC) which can safe guard depositors and wind-down troubled banks.
As a result of the differences in structure, we see distinct differences in the deleveraging of the United States and European capital markets. In the United States, the Federal Reserve has provided adequate liquidity through its quantitative easing programs allowing interest rates to remain low. However, domestic private credit expansion has been relatively tight given the constrained capital position and uncertain regulatory environment. Europe is facing more difficulty managing its deleveraging in large part due to the structural problems of the euro, the role of the European Central Bank, and the cumbersome decision making process of the European Union.
What We Know About Europe
Europe is a mess.
Last month, Greece failed to install a new government when the party opposed to austerity won a majority of seats in parliament, and it has set an election for June 17th to vote on whether the country should remain in the euro. Go figure. Greeks say they are in favor of taking the rescue money provided by the European Union and the IMF, but fail to elect politicians prepared to implement the austerity measures that were agreed to as part of taking the money. At the same time, Spain’s government has been bumbling through the process of propping up its banking system after the country nationalized the third largest bank causing a spike in Spanish government bond yields. The result has been increased volatility in global financial markets over concerns of Greece exiting the European Union and the contagion effects of the deterioration of the Spanish banking system.
Unfortunately, European leaders are no further along in dealing with their banking and debt problems than they were at this time last year. As investors, we need to recognize the following:
Every deleveraging is characterized by slow economic growth, and results in debt restructurings, bankruptcies, and some transfer of wealth. In Europe, we expect that the richer countries which include Germany, the Netherlands and Finland, will ultimately have to subsidize those countries that have incurred larger debt loads including Italy and Spain. While we are not clear how that transfer of wealth will look, it is inevitable for the euro to be a viable currency going forward.
Gregory J. Hahn, CFA
A major part of our investment thesis is that the developed countries in the world have too much debt relative to the size and historical growth rates of their economy. Essentially, these governments, which include the United States, much of Europe, the United Kingdom and Japan, have borrowed excessively over the past ten years in order to sustain the quality of life for its citizens. However, the costs of continued borrowing have risen as the amount of debt has increased. Furthermore, the economies of these developed countries are growing too slowly for revenues to offset the burden of increased expenditures. We expect that these countries will have significant difficulty reducing their debt burdens through continued stimulus initiatives as they attempt to inflate their economies. Unlike other post-recession periods where stimulative central bank policies allowed for economic growth, the economies of developed countries are showing weak growth.
We still believe that austerity measures of Europe which are designed to curb spending will help to shrink the debt burden over the next three to five years. However it comes at a great price – slow economic growth. And, the strategies the European banks are pursing to shore up capital levels, which include selling off non-core businesses and shrinking loan portfolios, will restrict private credit expansion. Combined with austerity measures, the contraction in credit will hurt business and consumer confidence. We believe that ultimately Europe will be split into two regions: countries that are healthy and those where economies are impaired and unemployment rates are high as a result of austerity measures to shrink budgets. We expect the Eurozone will move into a deep recession and will be a drag on global economic growth, particularly emerging market economies, over the near term.
Progress in Europe – the Bleeding has Stopped…for Now
Well, the Eurozone Crisis has calmed down – sort of. After almost two years in the making, Greece finally defaulted on its debt in February. Italy is back from the brink, and Ireland is living with new austerity limits. After the European Central Bank flooded the market with over €1 trillion in low interest loans, interest rates throughout the Eurozone have retreated sharply reflecting the improvement in investor sentiment. However, all we’ve really done is stabilize the patient on the operating table by infusing more debt (in the form of liquidity) into the financial system. The bleeding has stopped temporarily; but, the Eurozone still faces major challenges. Now, we need to see a coordinated plan to reduce the debt levels and instill sustained economic growth over time. This requires both austerity and prosperity and will only happen when there is fiscal unity in Europe.
We believe there are two fundamental problems that will make resolving Europe’s debt crisis difficult. First, because most countries in Europe are rooted in socialism, austerity will prove culturally impossible. Generations of citizens in Spain, Greece and Italy have been raised to rely on the state for social programs and retirement. This learned behavior will not change overnight. We expect the standard of living will decline for its citizens, and, as a result there will be an increase in civil unrest. Right now, we are in a period of uncertainty as citizens are now coming aware of what new austerity measures mean to their standard of living and quality of life. Second, countries in Europe have showed a consistent lack of ability to follow through on expense cuts. Spain is already trying to increase their allowed budget deficit from -4.4% to -5.3% for next year. We expect this pattern of missing target budget deficits will continue over the next several years as austerity measures prove too draconian for citizens and European leaders prove ineffective at enforcing fiscal discipline.
We believe the fiscal problems of Greece are not over. As the country digests and then challenges the austerity measures that have been thrust upon them, the battle to leave the Euro will likely heat up. At the same time, Portugal’s fiscal imbalances need to be addressed. Portugal’s budget deficit to GDP ratio for 2011 landed at -5.9%, but only after some financial accounting related to pension assets according to the European Central Bank. At the same time, Portugal is faced with refinancing sovereign debt next year which may prove difficult with yields in excess of 11% on its current debt outstanding. Buyers of Portugal’s debt are worried that the same haircut Greece’s debt holders faced in a restructuring will fall upon them. Portugal’s “funding gap” will need to be addressed by June according to the IMF. However, the battle for the Euro will be fought in Italy and Spain which loom as bigger in scope and complexity.
One of the likely outcomes will be a reduction in the population of many European countries including Greece, Spain and Italy as people migrate out of the more distressed European countries to find better employment opportunities. History shows that three things occur as a result of severe recession and decline in the standard of living: an increase in poverty levels, a migration of the population out of the distressed areas, and an increase in civil unrest, crime and corruption.
The developed countries in the world, which include the United States, United Kingdom and Japan, generally have two problems: they have too much debt and the growth they are experiencing is too slow. The result is that developed countries will have significant difficulty reducing their debt burdens through continued stimulus initiatives as they attempt to inflate their economies. Unlike other post-recession periods where stimulative central bank policies allowed for expansion, the economies of developed countries are not responding. We still believe that the austerity measures of Europe, which are designed to curb spending, will help to shrink the debt burden over the next three to five years. However, it comes at a great price – slow economic growth. Furthermore, until the European banking system is recapitalized, which includes shrinking the balance sheets relative to the existing capital levels, Europe will not experience sustained economic growth. Ultimately, we expect Europe will be a drag on the global economy over the near term. This Investment Perspective – The Global Finanical Crisis discusses the progress toward stability in Europe and what it means for your investment portfolio.
The Coming Recession in Europe
We have written extensively about our conviction that Europe will experience a deep recession as a result of forced austerity measures from the European Commission. Last fall, our analysis of the economic projections from both the International Monetary Fund and the Eurostat databases showed only Greece was projected to contract. At that time we believed the projections were overly optimistic given the size of the austerity measures required and the negative impact on private credit expansion as the European banks strengthen their capital positions.
Last week, the European Commission, the executive body of the European Union, revised economic forecasts for 10 European countries sharply lower. Last fall, the European Commission had forecast that the Eurozone economic activity would expand by 0.5% in 2012; that has been revised to a -0.3% contraction in economic growth.
We believe the length of the expected contraction in the Eurozone, as well as the severity, will be a function of three things: expected global demand, the ability of the European banks to support private credit expansion, and the stability of the global financial system.
Greece Defaults on its Debt – Finally
Standard and Poor’s rating service downgraded the debt of Greece from CC to selective default this week, making Greece the first Eurozone member to be officially rated in default. The downgrade was a result of the Greek Parliament’s initiative to retroactively add collective action clauses to its sovereign debt which essentially force minority bondholders to accept the proposed bond swap. This paves the way for Greece to receive €130 billion in rescue aid along with the write down in outstanding debt. Greece was forced to take its cod liver oil.
The bailout of Greece has taken the better part of two years and has been a huge focus for European leaders. The default sets a new precedent in financial engineering of a sovereign issuer including the initiative to force holdout investors to accept the terms of the majority. Unbelievably, it is still not clear if this action classifies as a default which will trigger payouts on the Credit Default Swaps of Greece. The cumbersome process and financial jiggering required to bailout Greece will now be applied to Portugal. In addition, we expect other countries, lead by Ireland and Spain, to begin a prolonged process of re-negotiating their individual deals for austerity measures with the European Commission. Spain’s ratio of budget deficit to GDP for 2011 was targeted at 6%. However, Spain reported this week that its budget deficit for 2012 came in at 6.51% of GDP, missing its target by a significant margin. Given the expected 1% contraction in Spain’s GDP growth for 2102, we expect that the 4.4% target for the budget deficit will be nearly impossible to reach. There will be a pattern of European governments requesting more lenient austerity targets over the next several years which will be necessary to sustain economic growth, but result in a slower mending of the debt problem.
The European Banking Crisis has been Abated
Prior to Mario Draghi taking the helm of the European Central Bank, the leadership did not view the role of the ECB as the “lender of last resort”. Rather, the ECB’s role was limited to executing monetary policy throughout the Eurozone in order to maintain price stability. During the Financial Crisis of 2008, the ECB was slow to act and never provided liquidity measures designed to prop up the banking system in the manner that other countries, including the United States and United Kingdom, did. In 2010, the member states of the European Union agreed to form the European Financial Stability Facility (ESFS) which was funded by the member states and the IMF. By leveraging the ESFS (another form of elegant financial engineering that got us all into this mess), the ECB created a balance sheet that is in excess of €2 trillion that it can now use to provide much needed liquidity to the European banking system in order to normalize operations and interbank lending.
The ECB completed its second round of direct lending to European banks, and we believe it has been tremendously successful in providing stability to their shattered banking system. After lending nearly €469 billion in December of last year, the ECB yesterday completed another round of low interest rate loans to European banks totaling €529 billion. Again, these loans were priced at a rate of 1% for a three year term. The European banks rely more heavily on wholesale funding (which includes institutional Certificates of Deposit and bonds) instead of more stable retail deposits like the banks in the United States and Canada. As a result, their funding base is less secure. These loans from the ECB allow the banks to shore up their funding needs for the next several years removing any doubt of their ability to roll over their maturing liabilities. Total Reserves of European banks excluding gold are at their highest levels in over ten years.
To be clear, this adds additional debt to the European system but allows the necessary liquidity to work through the system in the hopes that private credit expansion will be sustained and grow. We view this as an interim step that is necessary to maintain confidence in the European banking system. The next step is to execute the plans to reduce the debt burden over the next several years. The European members have shown a consistent inability to hold to a fiscal discipline that embraces austerity and controls spending.
In our opinion, the global economy still faces major downside risks as the tepid recovery continues to be threatened by stresses coming from the Eurozone. We are surprised to see stocks, bonds and gold rally so far this year, and at the same time volatility is trending back down to its 52 week lows. We believe in being compensated for the risks we’re taking investing in financial assets and in harvesting the winners in the portfolio. We are actively hedging the equity exposure of the portfolio and continue to shorten the duration of bond portfolios where appropriate. As volatility has declined, so have credit spreads. As a result we are looking for opportunities to move up in quality since the cost to do so has become a lot less.
Courage is doing what you’re afraid to do. There can be no courage unless you’re scared. –Edward Rickenbacker
We expect the challenges investors will face in 2012 will be as formidable as last year. As we look at our economy, the capital markets, and our political environment since the Financial Crisis of 2008, it seems we still haven’t addressed the big issues; and, it appears we don’t have much of a plan to address these issues in the near future. So, with a pragmatic sense of the current environment, we offer three general themes for 2012:
- Our economy is deleveraging which raises unique challenges for investors;
- Traditional monetary and fiscal policies are running out of ammunition;
- The structural problems imbedded in the economy and capital markets, which include the political environment inWashingtonDC, will hinder economic progress.
The single biggest risk to the rate of economic growth in this country is the debt burden of the federal government. It took 228 years for our country to achieve $7 trillion in federal debt. It only took us the last seven years to double it to $14 trillion. Like Europe andJapan, we have reached the limit to how much debt we can assume and we lack the courage to address the problem effectively.
There is a difference between an economy that is in a recession and one that is deleveraging. An economy that is deleveraging is plagued with benign growth, dismal credit expansion, and low demand. In a recession, banks loosen lending standards to extend credit which stimulates growth. In a deleveraging, credit remains tight as banks focus on increasing capital levels. Domestically, we have not experienced the pain of a sustained deleveraging since the 1930’s. The process will likely last the better part of a decade and will be complicated by the lack of consistent financial regulation. We expect the backdrop of deleveraging will be a constant theme for developing investment strategies and assessing relative value in the capital markets.
Since the Financial Crisis, we have recognized there are structural problems that exist in both the economy and the financial system. We believe that these structural problems are so powerful and deterministic to the performance of financial assets that we need to break them out separately to better assess risk and return. By reference, in last year’s Economic and Capital Market Outlook | 2011, we wrote:
…we believe that the inherent risks to investors are deceptively high in today’s markets given the extended government intervention in our capital markets, the huge budget deficit, the muted outlook for job growth and the lack of business formation that currently exists. The Fed is hopeful that the economy can grow its way out of these excesses and generate enough demand to drive tax revenues and consumption to absorb the slack resources in the system. Our concern is that a massive global debt crisis has already formed and, left unaddressed, will ultimately threaten the fragile economic recovery that is taking place. Thus, our investment theme for 2011 is again focused on conservatism and principal preservation and less on extended risk strategies.
As we look at 2012, our view remains consistent with last year’s. We are cautious on the fragile state of theU.S.economy and believe that some markets are not pricing risk efficiently due to the Federal Reserve’s intervention. We are in the throes of a global debt crisis and world leaders have not been effective in addressing the problems. And, we believe volatility will remain at last year’s escalated levels.
Gregory J. Hahn, CFA
President & CIO
October 11, 2011
As we move into earnings season, we believe the two key drivers to financial market direction today are the problems in Europe and their inability to deal with Greece’s debt burden and the outlook for the U.S. economy. Soon, investor attention will turn to next year’s election campaign and what that means for entitlement programs, debt reduction, spending, and tax policy. However, a quiet cancer creeping through the capital markets is the disconnected process of financial regulatory reform. The combined effects of inadequate regulation of the financial industry will likely perpetuate many of the inadequacies that lead to the Financial Crisis, and ultimately may lead to further severe capital market turmoil.
Financial Regulatory Reform
One of our main tenants for analyzing the capital markets and developing investment strategies after the financial crisis is that we need to see financial regulatory reform. More specifically, we need financial regulatory reform that has teeth and provides a set of rules that everyone in the financial services industry follows, and can deal with the complex securities and transactions that are prevalent in the markets. As capital markets and securities have become more complex over the past 15 years, the regulatory framework has remained largely untouched since the securities laws that were implemented following the market crash of 1929. After the Financial Crisis, Congress passed the Dodd-Frank Act, which provides a framework for regulatory reform; however, it requires that roughly 100 rules be written which will address some of the gaps in the financial regulatory framework. We are growing more discouraged by the slow progress toward financial regulatory reform.
The incremental changes in the capital markets that have occurred over the past decade which include the repeal of Glass-Steagall, the unchecked growth in the use of derivatives, the rapid electronic trading systems that now account for over 60% of the volume on the exchanges, and the pervasive misrepresentation within the industry of structured securities (which are not registered with SEC) to individual investors, in the aggregate have shifted the stability of our capital markets and financial system resulting in a “buyer beware” oriented market. Last month Reebok settled with the Justice Department for $25 million over false claims advertising its athletic shoes that tone your legs better. While the company has no proof of the claim, the company paid the fine, yet continues to stand by their assertions. Unfortunately, that illustrates the American business culture today – see if you can get away with it and deny it if you get caught. We believe that investors need the Consumer Protection Agency which was formed as a result of the Dodd-Frank Act to better protect us from the predatory practices that are still pervasive in the investment industry. Also, we believe that investors would benefit from all securities, regardless of their offering status, being registered with the Securities & Exchange Commission.
Yesterday, the Federal Reserve announced its newest initiative to spur economic growth by investing a portion of its massive portfolio in US Treasury securities with maturities between six and thirty years. Up until this point the Federal Reserve has initiated two asset purchase programs since 2009 totaling $2.4 trillion. Each program was designed to lower short term interest rates in order to stimulate economic growth in an environment clouded by health care reform, financial regulatory reform and partisan infighting in Congress. On the heels of the downgrade of the credit rating of the US Treasury debt to AA+, interest rates are at the lowest levels in history. Now, the Fed is stepping in to further manipulate the capital markets in an effort to lower long term interest rates even further, and flatten the yield curve to further stimulate economic growth.
We believe that it is important to recognize that we have entered another chapter in a huge central bank experiment that has never been tested before. The fundamentals that apply to security valuation matter less as central bank manipulation overshadows unconstrained free market forces. The Federal Reserve has taken its balance sheet from $914 billion to $2.4 trillion in the past three years in an effort to provide capital market stability and stimulate economic growth in the absence of private credit expansion. Clearly, the Fed sees trouble in the economy and Fed Chairman Bernanke is not inclined to let market forces work independently. First, we’ll explain the Fed’s latest initiative. Then we’ll attempt to provide some context for the actions of the Federal Reserve and why current monetary policy is ineffective.
The Federal Reserve – “Operation Twist”
By our estimates, the Federal Reserve currently owns $2.1 trillion in US Treasury and mortgage-backed securities. Through the Fed’s two asset purchase programs, known as quantitative easing, banks were able to sell securities which met certain maturity requirements to the Fed and free up capital to redeploy in other investments. In turn, the Federal Reserve accumulated a securities portfolio with the ultimate goal to lower short term interest rates. The result is an orchestrated transfer of debt from the private sector to the government sector.
The Fed has pushed the Federal Funds Rate, generally described as the rate in which banks lend to one another, from 5% in 2008 down to 0.25% today. Given the structural problems in the capital markets and the economy, traditional monetary policy initiatives which include adjusting the money supply and short term interest rates have proven ineffective in spurring economic activity. As a result, our central bank initiated the quantitative easing programs to step in where traditional monetary policy was ineffective. However, the Fed has determined that it should do more to adjust the term structure of interest rates. In addition to lowering short term interest rates, the Fed is now attempting to lower long term interest rates including yields on ten year and thirty year US Treasury securities, by selling short dated securities as well as reinvesting the coupon payments, prepayments, and maturities in longer dated US Treasury securities.
The result of the Fed’s newest initiative will be to reduce the slope of the yield curve – the difference between yields on short US Treasury notes and long dated US Treasury bonds. As students of the capital markets, we believe the yield curve is still the best predictor of economic activity. However, in the absence of meaningful policy initiatives to create jobs and real incentives for the banks to expand credit, the Fed is attempting to push long term interest rates lower to allow cheaper financing for those who can take advantage of it.
We believe that we have entered into a new monetary regime where our central bank directly manipulates interest rates through open market purchases. These are not temporary programs; we believe that the Federal Reserve’s asset purchase programs will exist for a prolonged period of time and that any thought of a Fed exit plan is naïve. We are concerned that the unintended consequences of the Fed’s initiatives will result in more harm on the economy and financial system. These concerns include insurance companies’ inability to profitably fund certain insurance products, retiree’s inability to earn enough interest income on their savings to maintain their life style and fixed income mutual funds inability to earn a total return that exceeds their investment expenses. And, while we acknowledge that that the Fed’s initial response to the financial crisis was necessary and largely successful, moving further down the path of manipulated lower interest rates without fixing the structural problems in the economy which are prohibiting capital formation, credit expansion and business investment will only make it harder to wean ourselves back to free market policies.