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Katrina Lamb, CFA
Head of Investment Strategy & Research
Katrina Lamb’s international investment industry career spans more than 25 years and includes both buy and sell side experience. She specializes in the research, analysis, and evaluation of the capital markets opportunities that... Full Bio
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.
Here is a perfect little encapsulation of the schizophrenic market environment we currently inhabit: with the earnings season in full swing 86% of S&P 500 companies reporting to date have beaten expectations, including a bevy of consumer heavyweights like Apple (as my colleague Masood Vojdani pointed out in his blog post earlier this week). At the same time the Conference Board’s consumer confidence index declined for a second straight month to 50.4, its lowest showing since February. Corporations are looking good, households are feeling glum. No wonder the market has been on this lurching path to nowhere for the past several months.
It would seem rather intuitive that corporate profits and confidence go hand in hand, or at least have a reasonably robust coefficient of correlation. It was Calvin Coolidge back in the 1920s who proclaimed that “what’s good for American business is good for America,” and that theme has become something akin to canonical law in this land since then. The post-World War II boom that lasted through to the early 1970s saw a massive expansion of household income, industrial output, exports, dynamic consumer markets and every other meaningful indicator of economic progress. The Great Growth Market of 1982-2000 likewise produced both record earnings for S&P 500 companies and increased household income (though also increased household debt, an ominous presage of things to come).
The relationship between confidence and earnings started to become less tenuous in the middle of the last decade. Corporate earnings seasons during the latter half of the 2003-2007 growth market were a continual-motion case of “can you top this?” Wall Street handily rewarded the record-busting earners, but meanwhile household incomes were flatlining, job creation was not keeping pace with natural population growth, and consumer confidence was tremulous – neither robust nor morose, but uncertain. Of course, the confidence and earnings trajectories reunited in 2008 in the other direction as both plummeted with the Great Recession.
The current disparity of low confidence and high profits may be only temporary, of course. But there is a plausible argument as to why that may not be the case, and here it is. American households are, by definition, American. They are made up of people who by and large live, work, raise children, shop, dine out, volunteer and pursue happiness in America. The corporations that make up the S&P 500, on the other hand, are AINOs: Americans In Name Only. Scour the income statements of the companies with the largest market caps and you will understand that these are truly citizens of the world. Their fortunes are only partly tied to the country where their home offices are legally registered, and less so with each passing quarter. When you travel overseas you see iPhone-toting teenagers in Moscow, GM-driving families pulling into KFC drive-in windows in Beijing, GE appliances adorning the bright modern kitchens of young urban couples in Kuala Lumpur.
But it is not just that our largest companies are selling to the world’s fastest-growing consumer markets. They are also employing the citizens of these countries in droves. Cisco recently invested over $1 billion to open a second headquarters in Bangalore, India. This high-tech town in the Indian state of Karnataka is also home to GE’s largest R&D center anywhere in the world. When you think of Indian citizens who work for US companies the image of the sari-clad woman in a small cubicle with headphone in ears, helping a caller from Cincinnati with questions about a mortgage payment, is woefully out of date. At these gleaming corporate centers smartly-dressed members of the burgeoning middle class – a global force reckoned at around 6 billion strong – are pursuing their professional aspirations the way that upwardly-mobile Americans have for many generations.
And there is still one more piece of the puzzle. In addition to consumer markets and production markets, the capital markets that fund US businesses are also relocating. For the 12 months ended in June 2010 the percentage (by volume) of global initial public offerings (IPOs) that took place in the US was a mere 10%. That means that the overwhelming flow of money into the “hot new things” that populate IPO markets flowed in other markets, facilitated by bankers, syndication experts and investors dispersed around the world.
What does this all mean? The principal conclusion I draw is that the economy’s long-term recovery, such that it may be, could bear very little resemblance in its impact on American households to the two previous macro growth environments of the 1950s-70s and 1980s-00s. Consumer, production and capital markets are global, increasingly frictionless and beginning to cluster in defined global regions like Southeast Asia. The one means of production component that remains rooted to domestic turf is the actual supply of labor – the people who get up and go to work somewhere less than 60 miles from home (usually, though certainly not without exception!). These people cannot simply pack up one night and reappear in Bangalore or Doha (Qatar) or Shanghai the next day.
So if the fortunes of American households and AINO corporations are indeed diverging, what does this mean for the economy, for the markets, for business-government relations, for the cohesiveness of our society? These are questions to be taken seriously. Expect to hear a great deal more from me and my colleagues in the weeks and months ahead.
The dog days of summer are upon us. We all have different ways of marking our seasonal calendars: my own “dog days” typically kick in after the July 4th holiday and the Wimbledon tennis finals, knowing that the next combination of a long weekend and Grand Slam tennis tournament will come in early September with Labor Day, the US Open and the new energy that anticipates autumn. Between now and then it’s all about the heat and humidity that define summers along the languid byways of the Chesapeake Watershed Region.
Investment markets seem to be feeling the heat as well – heading upwards for several days and then listlessly falling back like a Metro passenger dealing with a broken escalator in the midday sun. Even the renowned 3:30 Club has been somewhat muted of late – while we have had our fair share of 1%-plus days, we’ve seen fewer of those extreme lurches at the end of the trading day when the computer algorithms kick in with their hairtrigger buys and sells. Maybe the algorithms, too, are kicking back at Bethany Beach or casting their flies in the Savage River…
The major variable heading into the next couple weeks is the onset of corporate earnings season, kicking off as usual with Alcoa’s announcement after today’s market close. Investors will be interested to get more data points to help them sort out all the conflicting signals in the economy. Earnings surprises on the upside will add more weight to the default hypothesis that we are not headed towards the precipice of an imminent double-dip recession, and the consensus sentiment seems to anticipate this being the case. Of course, “surprises” in the earnings world are a double-edged sword, and early signs of stress by redoubtable market heavyweights like GE or Intel could set a negative tone for the season.
Over the course of this year to date we have characterized the global economic recovery as a series of “fits and starts”. Earlier in the second quarter there seemed to be more starts than fits and the US appeared to be gaining traction in shoring up global growth. The intensifying problems in second-tier European nations back in May raised the specter of more “fits” given the implications of solvency problems in the Eurozone for the US as well as the global growth engines of China, Brazil and India. Observers of macroeconomic policy are stuck between the rock of unsustainable deficits and the hard place of unbudging unemployment, underemployment and falling incomes. And thus the listlessness and indecision that bedevil the markets as moist droplets of hot air shimmer above the Potomac River.
Robust earnings could indeed stir the market out of its torpor and provide some direction, but we think there is an equally plausible case to make that the fits and starts may continue to contain any bull or bear tendencies from breaking out too decisively in either direction. Maybe it’s just the effect the dog days have on us, but we see the opportunity for sluggishness to continue being the market’s defining characteristic.
For the last month or so the market has exhibited two qualities: volatility and aimlessness. After another drop of more than 2.5% today the Dow and the S&P 500 were back to roughly their lows of May, when they first entered technical correction territory from the cyclical highs reached in April. Based on the trading patterns we’ve seen during this period it is clear that anything could happen tomorrow - daily gains or losses of more than 2% seem to be a fixed piece of the firmament. We always tell our clients to put little stock in the vagaries of the short-term and all the more so when the wild ways of the 3:30 Club hold sway. But there is also, we think, something of a deeper nature going on here - something, dare we sound so French? - philosophical. A philosophical dilemma, actually, with two diametrically opposed schools of thought about how we get out of our economic predicament.
Call these opposed schools of thought Team Krugman and Team Merkel. Reader’s of Princeton economist Paul Krugman’s New York Times columns know what he thinks needs to be done: increase spending via stimulus programs to ward off the dreaded Return of 1937. 1937 was the year when - in Krugman’s telling - a four year run of growth from the depths of the Depression was choked off by a premature return to austerity measures targeting deficit reduction. Because the austerity measures directly hit the incomes and jobs of working Americans they killed off the incipient seeds of organic growth and sent the country back into a deflationary spiral that only ended with the onset of wartime spending. Krugman’s point - and it is a compelling one supported by history - is that choking off a recovery is ultimately not going to help lower deficits - it will not only increase deficits but also increase the misery of unemployed, barely employed or hanging-on-by-a-thread employed Americans (or, for that matter, the good citizens of the battered Eurozone).
Despite the intellectual rigor of Team Krugman’s arguments it is the other side, Team Merkel, that is winning the war of words in the estuaries of public discourse. German Chancellor Angela Merkel has fast become the global face of the deficit hawks, whose main argument is that, figuratively, you don’t cure the drunkard by pumping more booze into his system. In this metaphor the bond market plays the role of the drunkard’s wife: for awhile she goes with the flow and supports him because there seems to be no better alternative (read: 10-year Treasury yields below 3% and the 2-year at historic lows below 0.6%). But eventually she’s going to reach her limit of tolerance, get up and slam the door on her way out - Treasury yields soar through the roof because nobody thinks of Uncle Sam as a risk-free investment any more. Catastrophically high interest rates in turn make a deficit crisis a deficit Armageddon, and so it goes.
The problem - and thus the “exquisite philosophical dilemma” of our title to this posting - is that there is a reasonable case to make that the road to meltdown could lead through either of these scenarios - the premature hijacking of a recovery or the toxic effects of adding flames to the fires of insolvency. Very few people in the world share the absolute certainty of conviction that both Paul Krugman and Angela Merkel display in the correctness of their respective positions. That makes all of us nervous and uncertain, which is the time-honored recipe for extreme market volatility.
Here at MVCM we generally think of ourselves as unbeholden to rigid ideology. After all the essence of our investment philosophy is the “chaos of wisdoms” - no one answer is right and we try to distill clarity from the complex ecosystem that is the global investment world. Much more is at stake here than who wins the battle of words and arguments - and we hope that prudent discourse will lead to prudent policy actions and calmer markets. But that calm is hard to discern today.
The week began on a sour note, adding to last Friday’s 324-point selloff on the Dow as the 3:30 Club knocked another 115 points off the index today. The return of volatility has been a generally negative story for global risk assets, most of which are considerably down from where they were at the beginning of spring. The world’s safe havens are playing their time-honored roles in the investor pantomime, with gold prices at 12-month highs and U.S. Treasury yields at 12-month lows. Both the dollar and the yen are sharply higher versus the euro - in roughly equivalent amounts, in fact, as the current dollar/yen rate of 91 is roughly what it was at the beginning of the year.
The yen’s relative strength is not helping Japan’s fragile economic recovery to gain traction: capital expenditures are coming in lower than expected as businesses contemplate the effects of lower exports to Europe (currency and demand weakness) and China (where financial tightening is having a broader effect on spending activity). As the annual rainy season gets underway in Tokyo investor moods were likewise gray and dour with the Nikkei 225 registering a 3.8% drop to close at 9520.
The overarching narrative in financial markets has not really been focused on Japan, as other stories of more immediacy have crowded out precious front-page media real estate. Subprime mortgages in 2007, Wall Street’s fallen masters of the universe in ‘08, the recovery of ‘09 and now the EU debt crisis have been the successive stories of the day. THat may change, and in my own opinion there is a better-than-average probability that the $5 trillion economy with a debt/GDP ratio of 197%, chronic deflation and the worst demographic outlook of the developed world is going to have its day on center stage.
If nothing else Japan offers a sobering case study for equities market analysis. On December 31 1989 the Nikkei index reached its all-time high of just under 40,000. That was 21 years ago. Today the same Nikkei is valued at less than 25% of that high-water mark. That is an astounding data point. In the wake of the Great Depression and Second World War it took the U.S. stock market about 25 years to recover its high-point value of 1929, but by 1937 it had recovered about 50% of that value and survived the most turbulent crises of the 20th century before resuming its long-term upward climb. There is simply no precedent in modern securities markets for an economically mature country’s stock market to sustain as bleak a long-term picture as Japan’s does. “Stocks for the long term” is the investor’s mantra, but that mantra has one large glaring elephant in the room that cannot be ignored.
The curious case of Japan’s stock market is going to be the subject of an upcoming in-depth research piece. As for the remainder of this week, keep an eye on the bond market data points in Europe. Belgium had a rather flaccid auction of 10-year bonds that generated some market chatter about the “Greece of the north” - an unwelcome moniker to be sure. We’ve been talking about Hungary for some time now in our commentaries, and this week has Budapest back in the news. No rest for the weary indeed.