Taper Tantrums

For days after death hair and fingernails continue to grow, but phone calls taper off. – Johnny Carson

A new term has entered the vocabulary of investors – tapering.

Ben Bernanke, the president of the Federal Reserve Board of the United States otherwise known as the US Central Bank, suggested in a speech on 19 June 2013 that the time was coming when the United States would reduce the amount of bonds it was buying under the most recent Quantitative Easing scheme (QE 3), before finally ceasing these purchases perhaps at the end of 2014.

The investment markets, like jittery 16 year olds assisted by their computers, panicked and initiated a major sell off of fixed Income debt instruments without understanding the caveats attached to Dr. Bernanke’s statement. This was indeed expected, though the exact timing was unclear. This has been called a ‘Taper Tantrum’ by Michael Hasenstab from Franklin Templeton. Why spoil a good story with facts?

At the same time Chinese economic data announced a relative slowing of growth in the Chinese economy coupled with a tightening of the rules regarding the non-regulated lending sector. All of this was expected, but caused ructions anyway, even though the gradual changes in the Chinese economy from investment-led to consumer demand-led have been clear for a while.

Having started the panic (in truth Dr. Bernanke’s speech came after the Asian markets had begun their decline), Dr. Bernanke’s team made some effort to explain that what he had actually meant was that if unemployment figures in the US allow it, the bond purchase by the Fed would slowly begin to decline. Not only that, but clearly it is too soon for the similar schemes in Europe and indeed in the United Kingdom to be wound down. This is despite the fact that the most recent economic data from Germany and the United Kingdom is broadly positive, even if Southern Europe is still fragile at best.

Economists describe the panic as the markets pricing in the change in US monetary policy well before it actually happens. There is an expectation of higher interest rates in the USA which will reverse the capital outflows to the Emerging Markets and indeed to the high yield end of the debt markets.

Let’s get our retaliation in first.

The economies most likely to suffer are those that have large current account deficits and are therefore most dependent on offshore investment from sources of ‘hot money’. For instance, the Ukraine, Turkey, South Africa and India have been badly hit. In addition companies are more likely than governments to suffer from a tightening of liquidity. Corporate borrowers (according to the Economist intelligence Unit) are likely to roll over their debt more frequently than governments.

A shortage of liquidity will cause much higher costs and companies which have become used to spending and borrowing will have to return to the old days of abstinence. Not only that, but the available money will only be available for much shorter maturities than in the past. Governments that are facing social unrest will also find that sources of new debt are drying up. All this is due to happen in the future, but that is not (in the eyes of a panicky market ) an excuse for not pressing the panic button now.

The emerging markets, both governments and companies, are potentially very valuable areas in which to invest and should form part of all but the most conservative portfolios. It is however essential to select the best managers with professional research teams in order to make best use of the risks.

In China (so reports Professor Xiaozu Wang in the South China Morning Post) the fears of a curb on bank lending should in fact be seen as a shortage of equity financing to meet the demand for capital.

Chinese banks ran out of money last week. They had to scramble to find funds to meet their regulatory liquidity requirements and borrowing rates for overnight money briefly exceeded 30%. This also sent shock waves around the world, focusing attention on the health of Chinese banks and bringing calls for controls on Chinese bank credit.

The reality of life is that Chinese Banks had mismanaged their liquidity and their lack of belief in the central bank’s determination to control lending. Just as in the West, banks’ dynamic lending came about because it was tolerated. Chinese corporate growth has been faster than the ability of those companies to expand their capital base, leaving them with the easy option of increasing their debt. This works well as long as the banks can lend and then continually refinance the funding for their loans. While there is no loan crisis in China, the banks have growing non-performing loan positions on their balance sheets. This is acceptable at present, but a sudden forced reduction in lending would immediately affect investment in productive enterprises and be detrimental to future growth.

The Chinese government has not yet made equity financing a priority. This will have to come eventually as corporate growth continues and debt becomes more expensive.

In the meantime the US and European markets, seeing that the Chinese economic growth data had shown a slight decline to some 7.5% a year, decided that the boom times in China were over. It is easy to make such assumptions from the financial dealing desks of London and New York, but the reality is that the Chinese economy is moving away from being principally driven by large scale investment projects to a domestic consumer demand driven (and therefore more stable) system.

There is a lot of growth still to be seen in China and a lot of investment too; it will come from increasingly different sources than in the past, something that dealing room traders who are not even sure where China is will have to follow after it has happened.

Finally, we are seeing a new era of volatility, which is causing uncertainty, something that investors hate. The investment markets have over-reacted to this uncertainty by heading for the hills. Like a pendulum, the trend will return to where it started.

Company debt, especially that of the foremost profitable companies operating in the international markets, still makes a sound investment. Much the same thing can be said about the equity of these companies; the correlation between the two is very close whereas the yield on equity is normally higher.

Those who are not afraid of the present markets and believe in the future, will profit from the present uncertainty.

League of Nations Mark 2.0

The League of Nations is very well when the sparrows shout, but no good at all when eagles fall out. – Benito Mussolini, Italian Dictator

The first League of Nations was set up after the First World War with the aim of ensuring world peace through collective security and the settling of international disputes through negotiation and arbitration. At its peak it had 58 members but it utterly failed in its task, was unable to do more than hold conferences and refused to impose sanctions which didn’t suit its senior member states. Ultimately it was unable to prevent the Second World War.

The European Union is still growing in size, but is also incapable of take any binding decisions. The needs and interests of its member states are too diverse; what suits Germany and its beliefs, whether economic, financial or diplomatic, all too often does not suit members of the southern bloc. No decisions are taken, no economic growth can occur, no direction can be decided upon or followed.
Europe, when judged by Europe-wide economic and social statistics, shows a poor picture. In fact the northern bloc is not doing badly, for that the southern bloc is doing far worse than even the most pessimistic reports suggest. Unemployment in Spain and Greece is catastrophic and getting worse, the Italian economy is a mess.

What does all this prove?

Probably nothing. But there is a long held habit of becoming infatuated with short term data and over-reacting to it as if it were marking the onset of the next phase in a double, triple, or quadruple dip. If any panic measures are ever decided upon, they are generally meaningless.
European governments, now infamous for their absolute inability to take any decisions worth talking about, are calling for greater regulation of the capital markets, forgetting all the while that these markets are already highly regulated. The politicians, mainly so that they can play to their own galleries, are demanding that banks and financial institutions should be even more regulated than they are now.

The reality is that the shadow financial sector is almost completely unregulated. To be clear, this sector includes investment banks, hedge funds, money market funds and Structured Investment Vehicles, which borrow money in large size from the international money markets in order to invest it in longer term securities which may suddenly become anything other than secure. It was the problems these vehicles faced in 2008 and the losses the banking sector faced from their loans to them that largely caused the economic disaster of 2008.
In Europe, we do not need Special Investment Vehicles to cause us nightmares; these come all by themselves through political lethargy, inaction and incompetence.

Dr. John Hulsman, a former CIA adviser, suggests there are four factors which are leading to what he calls a ‘terminal decline’ in European fortunes.

1. Donor fatigue on the part of the German public. The German Chancellor Angela Merkel, with an eye firmly on the general election in September is not being open regarding the choices facing the country. Either Germany, which already owns a huge proportion of debt issued by the poorer countries, continues to pay for the deficits of other countries without limit and accept a higher level of inflation or it should end the European project.
2. Italian political fatigue. The present coalition government of left and right is facing ever declining national economic strength. It reflects the belief on the part of the Italian public that all established politicians are part of the same self-serving elite and yet rule by grey technocrats who have little personality has little or no public support.
3. The United Kingdom has European Union fatigue. David Cameron the prime minister has little support from his own party when it comes to Europe and equally little support in Europe when it comes to renegotiating Britain’s place in the EU. The British public has lost faith in the incompetence of the European politicians and the British opposition are, if anything, even more opposed to European membership than the government
4. France has reality fatigue. President Hollande is now utterly unpopular because his election promises misled a public that desperately wanted to be misled and the French political elite fear the slightest hint of structural reform. Nothing will change in France because there is still a widespread belief that austerity and indeed any form of economics are subjects for other people and not for the French. The French people do not want to hear the truth and their politicians are too afraid to tell them.
It is certain that investing in the bonds issued by European governments is potentially disastrous. There are investors who believe that the small additional margin they receive on investments in Spanish or Italian Debt is worth having. Greek debt is already completely owned by the ECB. In reality, these yields are being held artificially low and should in reality be very much higher. Given a change of policy when the northern bloc is no longer willing to subsidize the olive oil states and the ECB can no longer rely on German political and financial support, the prices on debt not already owned by the ECB will collapse.

Against that there are still excellent export driven companies in Europe and elsewhere which make the stock markets very attractive indeed.
I cannot emphasize strongly enough that high quality equities selected by experienced fund managers with a track record of success over several years are the new safe haven for careful investors.