One way to visualize what is happening in this latest round of Euromarket jitters is to look at the present disparity in returns among European stock markets. Sweden and Denmark, both non-Eurozone countries (i.e. they continue to use the Swedish krona and Danish krone respectively), are at the top of the tables with year to date returns in the neighborhood of 25% as of November 12. Germany, the Eurozone’s putative anchor of stability, is up 8.2% YTD (also as of November 12) while other relatively stable markets like Belgium, Austria and the Netherlands are in low-single digit territory.
Then the bottom drops out with the Not-So-Fabulous-Five: Portugal, Italy, Spain, Ireland and Greece cover a spectrum of returns from -6.5% (Portugal) to -37.0% (Greece) as of 11/12 year to date. The EU, the world’s second-largest economy when aggregated, is bookended by countries whose national currencies are not directly affected by the fate of the Euro on one side, and the countries that actually could determine the currency’s fate on the other side.
This is the background context for the latest slings and arrows to rail at the ramparts of Fortress Europe: these being of a decidedly Emerald Isle flavor. As we write this the consensus appears to be forming around the conclusion that Ireland will require a financial bailout to the tune of $100 billion give or take. A “technical team” is in Dublin now to review the details, even as the Irish government continues to dissemble about not actually-really-totally needing the bailout just yet. As yields on Irish government debt rise to record levels this appears to be Act III of the Greek Tragicomedy of 2010, with Acts IV and V (Spain? Portugal? La bella Italia, cosi fan tutti?) plausibly waiting in the wings. You will recall that Greece’s woes catalyzed EU policymakers and central bank authorities to mobilize €750 billion earlier this year, and the Irish bailout, should it proceed, would be drawn from those funds.
This time around there is less genuine fretting among observers that the Eurozone is teetering on the edge of the abyss – the stability of the currency does not appear to be in doubt. Actually, the fiscal house of Europe is in better order than those of either the US or Japan, and from our standpoint there appears to be a greater level of seriousness among EU policymakers in addressing the crisis than could be said of their colleagues in Tokyo or Washington. Having said that, there are sharply defined tensions among Eurozone countries, with most of the ill will being directed at Germany. The Germans have been constant critics of the bailout from its early days, and recent days this criticism has sharpened around the notion that public funds from the bailout should ensure the return of 100 cents on every euro held by private bondholders. The sharp rise in Irish bond yields reflects in part a concern by would-be investors that a bailout might fully compensate them in the event of a default. From their side the Germans argue that private investors need to wean themselves from those warm and fuzzy guarantees of full compensation they have become so used to hearing. Sound familiar? Debates over the Greenspan/Bernanke put are an ongoing feature of discourse on this side of the jet stream.
All of this matters greatly from an asset allocation perspective. We have been used to a world defined by two flavors of non-domestic investments: “developed international” and “emerging markets”. The topography of the real world is considerably more complex than that. You can’t really look at the EU as one “asset”, for example, when you have such fundamental disparity between the economic strengths and weaknesses of its member countries. EAFE – Europe, Australasia and Far East – is hardly an adequate benchmark for international equities when it includes nearly-insolvent European states alongside the high-growth markets of Pacific ex-Japan. The job of making intelligent portfolio allocation decisions becomes ever more challenging – and we believe there are opportunities amidst the chaos.
Two events of considerable and related importance took place last week. The 2010 US midterm elections produced a seismic shift in the balance of power of the legislative branch, from Democrats to Republicans. And the Federal Reserve announced its long-anticipated plan to embark on a new program of quantitative easing. These two events give us considerable insight into how US economic policy is to be approached for at least the next twelve months and possibly longer.
The markets took a day to digest all the news as it unfolded over Tuesday and Wednesday, and then erupted for major across-the-board gains on Thursday. In fact, as it stands now 2010 is shaping up with potential to be another strong year in US equities following the performance in 2009. Years like 2009 and 2003 are rebound years – they come off the trough of a major bear market and often register calendar year gains over 30%. But sustaining that kind of strength into a follow-on year of double-digit growth is somewhat rarer (2004, for example, produced rather anemic returns for US equities in the mid-single digits). As of the Friday 11/5 close the Russell 3000 was up 12.9% year-to-date, and the market’s firm undertone suggests that a year-end “window dressing” momentum rally could conceivably take the indexes higher still.
Is it all justified? Let’s take a closer look at last week’s news events. We start with the Fed’s action because, quite simply, the Fed is where it’s at for just about any economic policy is likely to be enacted for the next year or more.
QE2, the new round of quantitative easing announced last Wednesday, will pump $600 billion of new money into the markets to purchase long-dated Treasury bonds. The Fed will do this to the tune of about $75 billion per month up through the end of the 2nd quarter in 2011. In addition the Fed will reinvest proceeds from existing securities (from the 2009 QE program) as they come due, meaning that in total its national balance sheet goes up by that $600 billion. Now, bear in mind that the Fed’s charter has a double mandate: promote policies that maintain healthy levels of employment in the economy and stable prices. The desired outcome, in this regard, would be for QE2 to stimulate new credit creation, spurring businesses to expand and hire new workers, while at the same time not triggering inflation beyond where it currently sits – about 1-2% per year.
That second goal – 1-2% inflation, is probably more likely than the first. Inflation may be a problem again one day, but for now the conditions needed for it to happen – either organic growth in household incomes leading to increased spending; or some kind of indexation between wages and prices like the catalyst that sparked the inflation of the early 1970s – is unlikely. On the other hand, for QE2 to make a meaningful dent in that sticky unemployment number will require a bit more heavy lifting. Not only will the eased credit conditions have to really induce companies to expand – but they will actually have to make proactive decisions to hire more US workers rather than, say, some combination of outsourcing and investing in more business automation to achieve productivity gains. It’s possible – but the case is awfully shaky.
As for that other event of last week – it is hard to say much else other than that we are likely to be in for a long period of legislative gridlock. Depending on your political point of view you may find that dismaying or comforting – but to the extent that any bold policymaking actions are going to have an impact on the economy next year those actions are much more likely to be originating from Ben Bernanke and his team than from Capitol Hill or the White House.
Things to Watch
Existing home sales on Mon 10/25 (update: up 10%; higher than expected)
Case-Shiller home prices on Tues 10/26 (update: down 0.2%; lower than expected)
Consumer confidence index on Tues 10/26 (update: increase to 50.2%; close to expectations)
Durable goods orders on Wed 10/27
New home sales on Wed 10/27
3Q GDP initial estimate on Fri 10/29
Earnings: du Pont, Ford, Kimberly-Clark, Comcast, P&G, Exxon Mobil, Met Life, Microsoft, Merck
On the Menu: This Week in the Public Discourse
US government issues $10 billion of TIPS at a negative interest rate (-0.55%). TIPS provide natural hedge against inflation (i.e. hedge against QE run wild) but also benefits from deflation because the principal amount is only adjusted upwards against inflation (value not eroded if prices decline).
Dollar continues downward trend against most currencies (UK pound is one notable exception). Dollar and equities continue to move in near-perfect negative correlation (bear in mind that for foreign investors in US stocks, with non-dollar base currencies, a 5% increase in US stock prices and a 5% decrease in the value of the US dollar nets out to a 0% return).
UK budget direction announced on October 20 – moves to make significant cuts to government spending generally applauded as bold (as opposed to certain other Anglo-Saxon economies…) but market responses (in UK debt, pound sterling & equities) reflect an ambivalence about prospects for success.
Overall the earnings season is a bit more muted than 2Q: bright spots this week include strong rebound numbers from Ford, but Kimberly-Clark highlights weakness in staple consumer goods.
Housing remains stuck in the mud: higher sales of existing homes reflects availability and high volume of foreclosure sales, but prices remain mired around 2003 levels. No immediate recovery seen.
Market tenure remains generally upbeat – strong week in US last week with gains largely holding this week in somewhat more muted trading. October can be the cruelest month but this year it looks like we may escape the fright nights and head into window-dressing season with plenty of momentum.
Things to Watch
Report on international trade balance due out Thurs 10/14
Producer Price Index report due out Thurs 10/14
Consumer Price index report due out Fri 10/15
Earnings announcements this week: Intel, JPMorganChase, Google, GE
On the Menu: This Week in the Public Discourse
“Bad but not so bad” is the new “good”: Most of the positive undertone in equities markets is coming from QE2 expectations, which requires the economy to be in relatively bad shape, but not bad enough to fall back into recession. Watch the CPI numbers at the end of the week.
3Q earnings are underway. Alcoa topped estimates. Of the firms reporting this week GE and Intel are probably most significant as directional bellwethers.
Policymakers ended the weekend’s G20 session with no resolution on the ongoing currency market issues. Meanwhile Thailand joined the party with measures aimed at controlling the recent strength of the baht (Thailand’s currency). Over $7.7 billion of foreign investment has come into Thai bonds this year (a pattern playing out in other emerging markets as well).
All eyes on November: the Fed will determine its stance on QE at the November Open Market Committee meeting. Our most likely scenario has more money coming into equities positions in the meantime as consensus builds towards a new round of easing. However any signals to the contrary – either from Fed policymakers or from unexpected economic signals – could catalyze a trend reversal.
Treasury yields continue to set records: the 2-year note is yielding 0.35% now and the 10-year is down at 2.26%. The US dollar is at 9-month lows although the decline has stabilized so far this week.
Capital flows into emerging markets: “hot money” or structural shift? Probably both – portfolios are re-allocating increased weights to EM (including ours), but the pace has been particularly intense in the past several weeks. Interesting fact: An average increase of 2.5% by developed- market portfolios into EM (e.g. you increase an EM exposure from 5% to 7.5%) implies $500 billion in aggregate. Hence the concerns playing out by policymakers in Thailand, Korea, Brazil and other “hot” markets.
The latest entrée offering itself up to the financial chattering classes for tasting and appraising is Basel III, the new incarnation of the capital adequacy guidelines financial institutions are supposed to follow to protect against losses in their risk assets portfolios. The heart of Basel III consists of stricter reserve requirements – essentially more capital that banks have to reserve against the possibility of loss. There is a grace period – a long grace period extending to 2019 – for banks to come into full compliance with the new requirements. Bank stocks reacted very well to the Basel III announcement earlier this week, causing one to wonder whether this is just another regulatory lamb ambulating among the wolves. The community of wise observers holds divergent views: Reuters columnist Felix Salmon has a rather rosy take on the new regime, while the FT’s Martin Wolf likens it to a “mouse that did not roar”.
The three-sticks appellation, of course, means that there was a Basel I and a Basel II. So anyone with a more or less intact memory extending back to, say, 2008 may want to know: what exactly were those prequels were doing to save humanity when the entire global financial system was teetering on the event horizon of eternal oblivion? Good question. Let’s do a quick crash course in the evolution of the Basel capital accords and then take stock of what Basel III may or may not do to make the financial ecosystem a bit more pleasant and stable for its bedraggled denizens.
Basel is a lovely little Swiss town near a point where France, Germany and Switzerland converge, just a stone’s throw as the cuckoo flies from the Black Forest, Lake Lucerne and plenty of other lures that draw legions of central bankers from around the world into project gigs with the Bank for International Settlements (BIS). BIS is a supranational agency which functions as a bank for central banks. Career central bankers populate the so-called Basel Committees that analyze and provide recommendations and guidelines intended to make the world financial system function efficiently, safely and transparently (here would be the appropriate place for stand-up comedians to riff about bankers in Basel overindulging in the regional favorite Schwarzwälderkirschtorte while New York and London burned…).
The Basel Committee on Banking Supervision (BCBS) is the entity entrusted with the promulgation of capital adequacy guidelines. Basel I, the first set of capital accords, appeared in the late 1980s and caused a kerfuffle among financial institutions that now had to ensure they had sufficient levels of capital to meet these new international guidelines (Japan’s banks were particularly flummoxed as the new rules came into effect just as bursting of the country’s legendary asset bubble was dramatically eroding their fragile capital base). Under Basel I banks had to maintain capital levels of 8% against their risk-adjusted assets (such assets being assigned a risk weighting based on their deemed credit quality). This was divided into two tiers. Tier I was considered to be common equity and other things plausibly similar to common equity, i.e. the most reliable risk protection. Tier 2 consisted of somewhat dicier forms of capital like deeply subordinated debt. No less than 4% of that 8% capital requirement had to be Tier 1, and at least half of that 4% Tier 1 had to be “core Tier 1”, i.e. straightforward common equity.
It would be tempting at this point in the story to skip right over Basel II and compare how the Basel III changes just announced compare with that original Basel I formula – because Basel III represents a very meaningful change in the core capital requirements. But skipping over Basel II would leave out the part of the story explaining why the Basel accords did so little to prevent the financial system’s meltdown.
The Basel II effort began in the late 1990s with an attempt to expand the 1988 accord’s purview beyond capital adequacy to more nuanced definitions of and mitigation strategies for risk. That attempt meandered over the years, buffeted by a lack of ability to achieve broad enough consensus on many issues to close the deal and implement new guidelines. Finally Basel II came into effect in 2006 in the form of three “pillars”: one for minimum capital adequacy guidelines (the same 8% ratio as Basel I), a second for “bank supervisory practices” and a third labeled “market discipline”. No, you are not alone – many observers at the time had no clear idea what that third pillar was all about. While much of the thinking behind Basel II was worthy in theory – for example extending the definition of risk beyond traditional financial metrics to include the systemic risk of critically important operational systems like payment and settlement systems – in practice Basel II deferred too much to the ability of financial institutions themselves to promulgate effective risk management and supervisory practices. We know better now – but in the middle of the 2000s it was still the conventional wisdom to believe that large systemically critical financial institutions could regulate themselves and make disciplined, grown-up decisions when tempted by Mammon’s lavishly abundant dessert tray.
So that brings us to Basel III, which sensibly goes back to the core importance of capital adequacy. Recall that the Tier 1 component from Basel I was 4% of risk-adjusted assets, with at least 2% comprised of pure, straightforward common equity. Basel III more than doubles that core equity component from 2% to 4.5%, and in addition mandates that total Tier 1 (i.e. common equity plus equity-like qualifying instruments) be a minimum 6% rather than 4%. So, just to be clear: 4.5% minimum core common equity, 6% minimum core common equity plus other Tier 1-qualifying instruments. The base minimum capital requirement for Tier 1 + Tier 2 remains at 8%.
But then the guidelines mandate an additional “conservation buffer” of core common equity of 2.5%. So in fact the “core common equity” component goes from 2% under Basel I to 7% under Basel II. Effectively, then, total Tier 1 is 8.5% (of which 7% is core common equity) and total Tier 1 + Tier 2 is 10.5% (8% plus the 2.5% equity buffer).
And finally, there is another new category of risk provision called a “countercyclical buffer”. This is expressed as a range from 0 – 2.5% that is to be applied in environments deemed to be at high risk (i.e. in the heady good times when frothy loan expansion threatens asset quality). It is not entirely clear when and how this countercyclical buffer would be applied, so for now it is probably best to leave it out of the calculations.
Here’s the catch: financial institutions have until 2019 to bring themselves into full compliance along a gradated implementation plan (I should note in parallel that over this time period the banks will also have to phase out some of the dodgier instruments that up to now have qualified as Tier 1 – so the Tier 1 capital base should be “cleaner” as a result). So Basel III really isn’t going to be a lifeline if we have another systemic implosion in the next several years, which is always a distinct possibility. And there is no inherent reason why having a Tier 1 capital base of 7% rather than 2% would be the decisive factor in preventing another collapse.
Having said that, though, I am on the side of the debate that sees the glass half full here. 2% was a ridiculously low ratio for common equity against all of an institution’s on-balance sheet risk assets. Having the new guidelines issued instills some clarity and would hopefully facilitate a climate where institutions seeking to demonstrate a newfound respect for prudence will take the jump and start to build their new provisions well ahead of 2019. The Basel committees serve an important function in global financial markets, and I for one will welcome more forward-looking leadership from them in these very tricky times.