As of the writing of this post the major markets are all in 2%-plus territory for no particularly solid reason – in other words, business as usual for the tea leaves readers who are back in the saddle as the world of risk on / risk off solidifies its return to front and center of daily market forces. The rumor of the day has it that something of a plan may be forming around a bailout for the Spanish financial system that would forego some of the bitter-pill austerity the Continent’s policymakers have tried to feed down the throats of other ailing economies in the Eurozone crisis. As usual the details, such as they exist, are foggy and nothing is fundamentally different in terms of solving the root problems plaguing the troubled sovereigns. But no matter – we are back in the world of risk on / risk off that dominated for most of the second half of last year, and it is reasonable to take the view that this paradigm may continue to play itself out. Meanwhile noises have been wafting out of top US Fed members to the effect that a new round of quantitative easing is by no means off the table for ongoing central bank policy formation.
The willingness of investors to trade solely on the basis of speculative rumors that may or may not become actual news headlines, let alone clear and constructive policy decisions, may have something to do with a measure that has become more a talisman than a barometer. The S&P 500 is hovering a bit above its 200-day moving average, having briefly dipped below that average during the sell-off last week. Now there is nothing particularly special about the 200-day average – it is a simple rolling average calculation, nothing more. In normal times it can serve a role as one more useful data point for market observers who hold stock in momentum theories. But looking at the performance charts over the past twelve months it is kind of easy to see what may be driving investors to play a careful 200-day average game. During this time there have only been two decisive moves through the average. One was at the end of July last year when the markets plunged in the wake of the debt ceiling debacle. The other was right at the end of the year when the ECB began the first phase of its €1 trillion restructuring program to relieve banks of short term obligations coming due by deferring maturity for three years. That action confirmed the (response to policy-driven) uptrend that had started at the beginning of October.
When the S&P 500 dipped below the 200-day average last week you could almost hear the brakes squealing as investors paused to take stock of what might or might not precipitate another sustained fall through that support level. Much of the buying we have seen since then, particularly today’s strong moves, are probably attributable to short covering in fear of “announcement risk”. This would take the form of the latest incarnation of platitudes and paeans to unity and solidarity along with some broad-brush outlines of a plan – just enough to kick the can down the road one more time. You don’t want to be doubling down on your bet against the market if the policymakers successfully pull that one off one more time.
The big question we continue to monitor is when the specter of announcement risk ceases to cause fear and trembling. Remember, this has been going on for two solid years now. Everything starts to go pear-shaped, investors panic, the central banks come to the rescue with a mix of soothing platitudes and occasional policy actions – just enough to provide the reassurances that they will always be there as a buyer of last resort. The Greenspan Put of old is the Universal Central Bank Put of new. The problem is that apart from goosing up risk asset markets for awhile until the next bad thing comes along, these policy tools appear to have had a very minimal effect on the actual economy. With 10-year US Treasury notes yielding 1.5% and German Bunds at historical lows, exactly what kind of central bank stimulus can provide the incentive for companies to aggressively move to extend more credit? With Europe enduring what seems more and more like a repeat of its painful withdrawal from the gold standard in the first half of the 20th century, how much can piecemeal platitudes accomplish if not supported by realistic plans that get at the fundamental core of the region’s problems?
Investors are crowded around the S&P’s 200-day moving average wondering the same things, hesitant to be on the wrong side but ready to place their bets when they have enough directional confirmation. We can’t imagine this play can pull off too many more acts without something substantial changing that confirms whether today’s valuation levels are screaming “buy” or screaming “run for the hills”.
As of this writing it is too early to tell how the most recent curve ball thrown in the ongoing Eurozone debacle will turn out. The referendum proposed earlier this week by Greek premier George Papandreou caught the world by surprise. Actually, to employ the terminology now in vogue and quite relevant to the idea behind this referendum, the 1% were caught unawares and displayed much consternation, while the 99% looked on and said “hmmm, okay then”. The referendum itself looks like it won’t see the light of day, and despite surviving a vote of confidence today neither may Papandreou himself in the not too distant future. At this point we do not know. But here is a prediction: this is likely not to be the last time in this saga that the messiness of democracy clashes with the efficiency of a financial bailout. Occupy Eurozone has arrived. Whether one supports the “Occupy” mindset or not, there is another voice at the table in the Eurozone as on Wall Street, in Oakland and many points elsewhere. It will have to be reckoned with regardless of the imminent fate of the Greek government.
At the end of last week Eurozone leaders finally reached the end of a physically and emotionally taxing round of negotiations on the terms of a deal that would, at least for the time being, mitigate the prospect of a chaotic Greek default that could take other sovereigns down with it. Markets responded to the deal with unconcealed jubilation while expert commentators tended to accord it the “two cheers” treatment – good for what it accomplishes for now, but far from being any kind of deep solution to the long-term problems that the Eurozone faces. The elite consensus was that this was good enough, now let’s move on. Negotiators no doubt looked forward to the prospect of seeing their families again after weeks upon weeks of brutal round-the-clock haranguing and consensus-building.
Then came Papandreou’s bombshell, just in time to roil asset markets on Tuesday. From the birthplace of democracy came a fairly straightforward notion: since the terms of the deal will involve deep, painful austerity measures that will have far-reaching effects on Greece’s citenzry, should not the citizenry have the opportunity to make their voice heard? After all they are going to have to live with the outcome – one way or another – for quite some time to come. No, no! cried the exhausted policy leaders. They pointed to irrationality revealed in the polls – a majority of Greeks appear to want all the benefits that the stability of the Eurozone confers without any of the spending cuts, tax increases and other measures that will be required to get their economy back on track. They’ll just cut of their nose to spite their face, went the conventional wisdom, and the outcome will be lose-lose all around.
The polls do reveal a lack of logical thinking, to be true. Popular-voice polls often do. But that is not really the point. What Papandreou – wittingly or not – stumbled onto was the idea that the voice of real people who are not policymakers or financial executives at large European banks should be a part of whatever decisions are made about the economic future of the countries in which they live. In short that is what the whole Occupy phenomenon is about – a voice, not a specific set of demands or policy prescriptions (few of which are in evidence). Vox clamantis in deserto – a voice crying in the wilderness. Referendum or not, that voice is not going to disappear wispily into the ether.
There are no easy answers to any of the problems the world is facing now – anemic growth, crushing debt, dysfunctional politics and discredited institutions. If you will, neither the 1% nor the 99% can supply the answers. What seems clear, though, is that the days where the single answer to each successive financial crisis is to throw enough money at the institutions caught up in the mess to bail them out of their woes (and create successive asset bubbles in the process) are numbered. This will very likely make for an even bumpier ride in the near to intermediate term (if such a thing is even possible given the daily market gyrations that have already become the norm). In the long term, however, it may turn out to be the less disruptive road to take. Major pillars of the social contract that Europeans have come to expect from their governments will in just about all likelihood have to change dramatically. This will probably be more stable if the 99% feel some ownership in the process and its ultimate results.
We humans are generally in the habit of marking off the annual calendar by milestone events that help give some structure to the otherwise random passage of time. At this time of year back-to-school vibes are in the air. But before we get to Labor Day there is another Big Important Date fast approaching. That’s “Ben Week”, and it’s this week, when Fed chairman Bernanke heads out west to give a speech at a central bank conference organized by the Kansas City Fed. Against a backdrop of soaring peaks and skies of deep azure Ben Bernanke will say something about the present state of things – we don’t know what that something will be, but it will likely move markets in one fashion or another, perhaps decisively, perhaps locking in a sustainable directional trend that so far has been largely absent in 2011, or then again perhaps not. The actual “event” of Ben Week will last for maybe 30 minutes or so, this Friday, August 26. Between now and then, in marketland it’s all Ben Week prognostications and divinations. Quid facies o Bernanke magne?
It was just a year ago that the Fed chair used the same picturesque opportunity to announce the launch of QE2. Right on cue risk asset markets embarked on a fall rally that powered through the tricks or treats of October and the cheery festoonery of Christmastime portfolio window dressing right into 2011. And then…something right out of the movie “Groundhog Day” as a burgeoning spring rally ran into the headwinds of a European debt crisis and weaker-than-expected macroeconomic indicators. Markets turned south, volatility spiked and now, one year to the day later, all eyes are again on the Fed. Listen carefully and you may hear that same refrain of “I Got You Babe” that dragged Bill Murray out of his sleep over and over again on that never-ending February morning.
But that may be where the déjà vu ends. Markets are already trading up strongly ahead of Friday, but given the extent to which they have been beaten down over the past several weeks it is not altogether surprising to see a swell of bargain-hunting taking a position ahead of the announcement. The thinking is fairly sound: if Bernanke does take bold action in the form of some kind of QE3 that expands the Fed’s balance sheet again or something of equal import, then shares are likely to rise dramatically from today’s low levels. On the other hand, if he merely makes mildly encouraging utterances about how the “Fed stands ready” then one may see a bit of selling but the downside would be limited. Along this line of thinking it would be not unusual to see solid buying continue over the remainder of the week.
The larger question is whether even a bold QE3 program would produce the kind of sustained market effect it did last year. After all, one could argue that QE2 did little other than to prop up asset prices for awhile. Unemployment hasn’t budged, consumer confidence remains low, the housing market is stuck and manufacturing indicators have turned down. Corporate profits are strong but the effects of that strength have yet to be felt much in the US economy. Sure, a Fed asset buying program could juice up prices for a few days, but eventually there has to be some connection between asset price growth and real economics. Right? Anyone? Bueller?
A great deal has been said over the last three days about the S&P downgrade of US government debt. Much of this chatter has been wearily familiar as the usual actors who reside in Versailles-on-the-Potomac recite from the predictable scripts of blame and false sanctimony. Let’s get straight to the point: how is the world different today, and how is it not different?
How it’s not different: The US has not ceased to be a safe haven. Look at the evidence – stock markets are plunging while, true to form, yields on US Treasuries are lower than they were last week. Remember – yields fall when prices rise. In fact the 10-year Treasury is right now flirting with a yield of 2.3%, which is a low of historical magnitude. The plain fact is that there is a global glut of savings that has to park itself somewhere. US corporate balance sheets are swelled with over $1 trillion in cash, and at any given time a good chunk of that cash will be invested in some mix of US government debt, downgrade or not.
How it’s partially different: There are other assets performing the safe haven role along with Treasuries: gold is up $40 today, and both the Swiss franc and the Japanese yen have resisted concerted policymakers’ efforts to keep the exchange rate down. As we noted in a recent column (Safe Haven Economics 3.0) the notion of safe haven asset itself is changing with the times. Relatively speaking there is no natural successor to US government debt as the go-to risk free asset. Rather than the idea of one “risk free asset” we should start thinking along the lines of “low risk basket” as a valuation benchmark.
Which brings us to how it is different: The absolute level of risk is higher now. Whether one agrees or disagrees with S&P’s decision (and fans of the rating agency appear to be few and far between) it is meaningful in a long-term sense that the bellwether asset of the last sixty years of global economic history is no longer triple-A. Not because the US can’t pay its bills – it can, simply by printing more money as Alan Greenspan himself blurted out on one of the Sunday talk shows – but because the pillars of the global economy – the US, Western Europe and Japan – are not as solid as they once were.
With the downgrade behind us attention will once again shift back to Europe. “Italy and Spain are the new Bear and Lehman” goes one pessimistic point of view. Actually they are not, for a number of reasons. Italy is not bankrupt – in fact it has a very high rate of domestic savings and its national fiscal budget is in primary surplus (i.e. before including interest obligations). Spain’s debt-to-GDP ratio is just over 60%, a far cry from the 140% ratio of Greece. In 2008 we were looking at the very real possibility that the banking system itself would simply stop working – payroll systems would stop direct depositing wages into checking accounts and ATMs would run out of cash. We are not looking at that specter – not today at any rate. There is a crisis of confidence in European bond markets, and that has long-term implications for the EU and the viability of the Euro. But what we expect to be more likely in the short term is ongoing volatility with a number of variables that could send markets higher or lower on any given day. Trying to guess which variables will show up on which day would be a fool’s errand indeed.
As these words come to page we are six days away from August 2, the supposed drop-dead date for the US government’s running out of money and, for the first time since 1790, being unable to meet all its financial obligations. Right now it is hard to see the entrenched pig-headedness of vested interests giving way to compromise for the common good – but stranger things have happened I suppose. Perhaps there will be an eleventh-hour-and-fifty-ninth-minute solution. Another distinct possibility is that August 2 comes and goes, no deal is on the table but markets and the economy keep hobbling along anyway. If nothing else, we have become remarkably skilled at kicking the can down the road, putting Band-Aids on the ailing patient and foregoing tough choices. I would still be more willing to bet on some patchwork fix that holds the wolves at bay rather than immediate financial Armageddon.
Regardless of how the next six days turn out, however, one thing seems to be fairly evident – we are at the dawn of a new age of Safe Haven Economics. The concept of a “safe haven” investment is probably as old as finance itself – a place to park your hard-earned capital and sleep a bit easier when the storms rage. So why have we chosen to call this version 3.0? We could go back further, but for the purposes of this post it is sufficient to think of the age of the gold standard and the pound sterling – from the late 18th to the early 20th century – as version 1.0. That era hung on life support for a brief time after the First World War and then fell apart as the clouds of the Great Depression gathered. After the dust had settled from the turbulent ‘30s and the Second World War the United States held the undisputed mantle to version 2.0. The US dollar and Treasury bonds would be the dominant safe haven investments for the next sixty years. Even the financial crisis of 2008 – a meltdown largely caused by US financial institutions – failed to dislodge the dollar and the T-bond from their caché as the go-to port in a raging storm.
This time around things are different. I think the writing was on the wall in 2008 that dollar-denominated hegemony was in its waning days, but investors as much as any human genus are creatures of habit, slow to change. Make no mistake – the transition from version 2.0 to 3.0 looks different from the last go-around. There is nothing on the financial stage today to compare to the clear leadership role the US dollar played when the world went off the gold standard. Rather, what we are seeing is the emergence of something like a safe haven basket – a collection of assets that can play the role of “risk off” trades when capital goes a-scurrying. The Swiss franc, the Japanese yen and gold (some things never change) clearly appear to be part of that basket. Arguably certain other currencies such as the Aussie dollar may be included as well. How about other AAA-rated debt? One of the many possible curiosities of the fallout from a downgrade of US government debt is that the safest domestic corporate bonds remain AAA-rated. Why not? After all, the companies that issue those bonds are citizens of the world much more than they are distinctly American.
In finance we have long been used to thinking in terms of the “risk-free asset”. Perhaps it is time to start recasting this as the “risk-free basket”, the defining characteristic of Safe Haven Economics, v3.0.