Sentinel News

Market Insights: July 2012

How Hoover Caused the Euro Crisis

Europe: Separate and Unequal
There is a Burkean principle that many sorts of change must be regarded with skepticism. In the last few months in Europe we have seen new maxims, new ideas, new commitments, new resolves, lots of new acronyms, yet very little has changed from two years ago when Greece surfaced as the first casualty of the banking/sovereign crisis. Some of the language has impressed. Who could not thrill at remarks like, "We have a clear commitment to a single banking supervisor...and direct recapitalization of banks...a compact for growth...Convincing vision for economic union"? But implementation remains inadequate and we remain in the crisis waiting room, waiting for the next crash cart to come flying by. Usually on a Friday.

This is not to minimize problems or demonize politicians. Europe is tied with a Gordian knot of laudable idealism. Unions should allow freer movement, economic dynamism, rule harmonization and collective solutions, all of which are embedded in the original spirit of the EEC[1], which has morphed into the current EU. But there is a straight line that runs from Hoover to Monnet to the eurocrats struggling with the problems today which helps explain today's intractability. Hoover's corporatism was the received wisdom of the day. It centered on the notion that the state, businesses, employees and other forces could make life better. As an engineer, he had no problem using whatever tools came to hand with one directive after another accompanied by incessant activist rhetoric. When Monnet, and others, set up the EEC, they were much impressed with this "indicative planning" and the notion of perfect competition. It infused the spirit of the original institutions.

And that's the line held today. The trouble is that it has been very good at establishing plans on the small stuff and, true to form, on July 1st of this year new cell phone roaming tariffs were issued that capped prices to, yes, "improve competition." But very bad on the big stuff. And that's what counts right now. The big issues are:

  1. bank recapitalization
  2. sovereign/bank debt linkage
  3. fiscal austerity plans
  4. internal devaluations
  5. regional bank reform
  6. internal capital flight
  7. debt mutualization, and above all
  8. declining GDP per capita

The current background is rapidly declining economic measures, slowdowns in lending and unemployment that will result in social costs for years. The ECB[2] is constitutionally prevented from doing much about it. Further easing policies, such as buying troubled assets, are not in their remit and 2% inflation is their only known target. Banks are not only undercapitalized but actively shrinking assets to meet new standards. How undercapitalized? Well around €250bn is a reasonable guess and given a fractional reserve ratio of around 10:1 that could take out as much as 15% of available credit from the European economy. That means real demand begins to dry up which means demand for money follows.

So that's why today we have negative rates in four major European economies. The last time we had these for any extended period was with Switzerland in the 1970s. It was the only world currency not afflicted by inflation and was much sought after as a safety status. But this time is different. Negative rates only work for investors if either prices are falling rapidly or the preference for cash overrides every investment. Cash, in this case, becomes a zero coupon perpetual. This is a very good thing to have if you want to maintain your purchasing power and you fear for your savings institution. In turn, this weakens banks which have to shrink the asset (loans) side of the balance sheet if the cash (liabilities) side is moving out. That's already shown up in the dismal performance of European bank stocks this year. How to break this cycle? Some sort of government borrowing and spending program accompanied by a securities buying program to arrest credit contraction. We're not optimistic.

Changes in Europe but not so in US
The US, by contrast, has made very few changes. Any crises in the US, the most formidable being the so-called fiscal cliff and contagion from Europe, are one step removed. The economy is softening, employment barely able to contain population growth, household deleveraging ongoing, wages stagnant and fiscal drag from the government. The result is, as a wise Bernanke put in 1999, "self-induced paralysis." The diagnosis he made then for Japan rings very similar to today. If we had structural problems on the supply side, the evidence would be inflation not the very muted price changes we have seen for the last few years. Here's the TIPS rate, which allows the government to borrow at negative rates, along with inflation which is barely breaking a sweat and, cumulatively, way below the 2% target set some years ago as the "feels about right" rate.

A recent dive into the CPI[3] showed that not only was CPI at 0% but that many of its 260 or so components have substitution (butter at -1.4% and margarine at +0.8%, for example). The CPI remains a controversial measure but the expanse of its components suggests that consumers can defer, if not avoid, many of its changes. But the most important component by far is OER[4] which is growing around 1.2%. This shows the 5-units or more housing starts, which we think are a good proxy for future rental demand, and annual OER. There's very little here to suggest any inflation risk.

Back to Bernanke in 1999, where he insisted that low nominal rates did not mean accommodative monetary policy and he warned that low inflation in a credit driven economy was highly dangerous. To get out of the liquidity trap, he recommended that a CB[5] drive i) more information on policy ii) a 4% inflation target iii) devaluation iv) financing a tax cut through bond purchases and v) a wider use of open market operations. So what have we had? Successive downgrades of economic performance but no further policies to address growth and employment. Yet. So things may have to get a bit worse to get a little better. Which is why we have had...

A very timid move by the Fed.
Recent testimony and communication from the Fed showed the entire board revising down expectations on the economy: i) GDP down by $500bn ii) unemployment up 500,000 and iii) lower core and PCE[6] inflation. Not just for 2012 but next year as well. That's complacent. In April they said that the economy still had plenty of slack and that inflationary pressures were minimal. And so they were. So why only a modest extension of Twist?

  1. Partly because of pressure...there's a hawkish camp that systematically overstates inflation and finds dealing with the whole unemployment thing very tiresome.
  2. They want to set the bar high for any further moves. A liquidity crisis, fiscal tightening or a confidence blow would all fit the bill.
  3. Credit flow is on a slow repair with bank C&I [7] loans up 15% in the last six months so pushing rates lower will probably not help much.

  4. The market is already at low rates; further purchases may distort more than help.
  5. It allows the Fed to keep talking more aggressively which helps keep the markets primed for some no sell-off in bonds expected.

The one thing we like about it is the $270bn of Treasury purchases from now until year-end. That runs down the Fed's holdings of 3-year paper to zero as they focus buying in the 6-10 year space, which is typically the benchmark for corporate bond issuance and 30-year mortgages.

So why the fear over inflation and deficits?
There's a perennial concern over both (which resurfaced in the Humphrey-Hawkins testimony) when both have improved recently and were not that high to begin with. It's more than just agitprop so here are some thoughts:

  1. Medicare and Medicaid appear on every pay stub twice a month. People see it high and rising, ergo everything else must be bad.
  2. Ditto for 401(k)/403(b)/457 statements...down and weak and we're reminded of that four times a year.
  3. Outstanding debt at $13tr is bandied around, not the net number which excludes the trust funds. Ditto the net interest on debt which is at its lowest in years. Blame Rogoff.
  4. Inequality and unfairness: there's a general feeling that the profligate (read sub-prime) and the 1% got a bailout. Look around for a target and, see, the Fed helped them a general plague on them.
  5. People underestimate how much the government gives them. Buy a house (at any price), go to college, have a pension, buy healthcare coverage, use an FSA[8], put ethanol in your car, buy flood insurance, have a fire, lose money on a stock, buy from Amazon, pay your financial adviser, etc. and, congratulations, you are the proud owner of a tax subsidy from the government. But how many people know or feel that? And how many would change it?

Just some ideas on why we get the Pavlovian polemics on deficits and inflation. And why we're in a policy vacuum.

Just to keep us on our toes
The data on housing continued to show a trend that has taken us from starts at 630,000 a year ago to 760,000 this month and industrial production rose 0.7%. It's not yet enough to move DPI[9] which remains woefully stuck at around $32,500 per capita.

And on the "not so good" list we have the payrolls, fiscal drag, slowdown in the agricultural sector, and a big slowing of retail sales. Here they are, in real terms, barely at 2005 levels.

Which in turn is probably driven by this...deleveraging on a major scale.

And For Capital Markets
Bonds: The Defensive Trade
We're at the top of recent trading ranges. This year we have probably turned over core bond funds close to 900%. That's highly unusual for us but reflects that the value we're seeing in bonds is fleeting. There are price advantages to be gained and market distortions that arise, which we try to exploit. But there's no long-term value in bonds and it pays to be very nimble. We're fading treasuries because the trade has been so volatile. The duration on treasuries are 9.2 for GT10 and 21.2 for GT30. They trade with fast moves on thin news. Last week we saw the benchmark GT30 move on the back of a $5bn trade. In a market with $500bn of daily turnover, that's a nervous market.

We like MBS[10]. They have a high carry in a low yield world with very low new issuance. The possibility of the Fed buying more should support prices. Elsewhere, new issues remain very well bid as does CMBS[11] mostly because of resolutions on multi-family and large properties (there's that property market theme again). The appetite in new IG [12] names is very healthy especially as the treasury market remains well bid and a defensive trade. But don't get sucked in by the yield only story.

US Equities: Long-term Only Please
The S&P [13] is doing better than it did in 2010 and 2011 when we also saw 2Q weakness. The market has recently honed in to defensive sectors like telecom services and utilities. In a flight to yield market, they worked. We've seen much more stability in large cap than in mid and small this year. The US remains one of the strongest equity markets YTD. Part of that is explained by US companies' balance sheet strength and part by earnings power. The S&P should earn around $100 this year, which gives us a P/E of around 13x and an earnings yield of 7.6%. That compares to a Moody's Baa[14] yield of around 5%.

But one is nominal (the bonds) and the other real (stocks) which suggest the equity risk premium is very high right now. The differential of the current 2.3% yield on the S&P and the bonds is also at its lowest since 1976 and highlights the fact that investors are willing to pay higher prices for the bonds of a company than the stock. Which is another way of saying that they're ready to overpay for protection. This can persist for a while but allows some nice valuations and buying entry points. We'll continue to pick up good names we want to own on weak days and stay with quality.

So put all this together:

  1. US looks the best bet for macro management...
  2. and capital market prices.
  3. Europe will have a summer lull but there are no policies in place that make a difference.
  4. Some monetary policy change will come from the Fed, probably not later than Jackson Hole.
  5. There's no inflation that matters but...
  6. there is a distrust of the economic policies and so confidence brittle.
  7. Demand remains uneven; the ongoing recovery in housing will be critical.

This article contains the current opinions of the author but not necessarily those of Sentinel Investments. The author's opinions are subject to change without notice. This article is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

Sources: Paul Johnson, A History of the Modern World: From 1917 to the 1980s; Ben S. Bernanke, Japanese Monetary Policy: A Case of Self-Induced Paralysis?, 1999; Federal Reserve Board; Federal Reserve Bank of St. Louis; High Frequency Economics; FT Alphaville; J.P. Morgan Market Intelligence; US Census Bureau; US Bureau or Economic Analysis; US Bureau of Labor Statistics, Sentinel Asset Management, Inc.

[1] European Economic Community
[2] European Central Bank
[3] Consumer Price Index
[4] Owners' Equivalent Rent
[5] central bank
[6] Personal Consumption Expenditures
[7] Commercial & Industrial
[8] Flexible Spending Account
[9] Disposable Personal Income
[10] mortgage-backed securities
[11] commercial mortgage-backed securities
[12] investment grade
[13] Standard & Poor's 500 Index is an unmanaged index of 500 widely held US equity securities chosen for market size, liquidity, and industry group representation.
[14] Moody's Seasoned Baa Corporate Bond Yield, source: Board of Governors of the Federal Reserve System, Federal Reserve Bank of St. Louis, Economic Research




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