Margins of error

In response to Macro Maestro's earlier post, several people gave the same response - equities' resilience makes sense because of corporate cost-cutting. (This also seems to be the argument being touted around by strategists at Citi.) They point out that during the recent recession, the US profit share increased sharply as companies slashed wages and employment. A double dip - consistent with current bond yields - would allow this process to continue, justifying current equity valuations.

This argument seems ludicrous to Macro Maestro. Yes, profit margins can rise during a recession but it's hard to see this continuing indefinitely when nominal GDP (the main determinant of profits - look at the historical correlation) is extremely weak for a prolonged time. (Profits growth roughly equals nominal GDP growth plus the change in margins.) So Macro Maestro thinks recent US profits performance is a short-term 'levels effect' as companies eliminated the inefficiencies that built up during the boom years. The US profit share is already close to its cyclical peaks and Macro Maestro finds it hard to believe this will rise further, especially if top-line earnings (nominal GDP) collapses.

Plus Macro Maestro doesn't recall Japanese corporate profits or equities performing too well during its 'lost decade'.

Dislocated

During the summer, bond and equity markets started to diverge:

10-year yields in many advanced economies (including the UK, US and Germany) fell to their lowest levels since the depths of the financial crisis (and in some cases their lowest levels on record), while equity prices have generally held up. Of course, there are a few exceptions to this, notably within EMU (Greek, Irish and Portuguese yields have risen back towards their May 2010 peaks).

Such sharp divergences between bonds and equities are unusual. Early 2008 was the last time this occurred, when the yield curve inverted (signalling recession) and stocks tried to shrug this off. Macro Maestro remembers talking to investors at the time and there were stark differences in opinion, even within the same financial institution. In general, ‘bond types’ were talking about deep recession, liquidity traps and even depression while equity investors believed the sub-prime crisis would be relatively contained. (We know how that worked out..)

This time there seem to be several possible explanations:

1.       Perhaps the most benign possibility is that central banks are depressing bond yield by talking about further monetary stimulus. Another round of global QE should depress bond yields and, if successful, support future growth (and hence equity valuations). As evidence, we should note Ben Bernanke set out the Fed’s remaining policy options in an August speech. Goldman Sachs are now forecasting another round of US asset purchased by the end of the year.

2.       Some claim the bond market is a better leading indicator that equities. In this scenario, the global economy is about to experience a ‘double dip’ recession and the equity market is simply mispriced. This was the case in 2007-08. Still, bond investors seems to be taking a significant gamble. Recent US data have been soft, but certainly not at recessionary levels. (Euro-area indicators are still consistent with above-trend GDP growth.) Current levels of yields seem more consistent with a Japanese-style deflationary environment – this is certainly not something Macro Maestro would be comfortable forecasting with such conviction, particularly as it relies on the complete breakdown in private sector confidence. (Is such a thing forecastable?) Still, the recent decline in 10-year spot yields (at least in the UK) does seem to have been driven by the inflation expectations component (see chart below – based on BoE data):

3.       There is a bubble in bond markets. After a two-decade rally in bond prices, investors are getting carried away and buying bonds purely as a momentum trade. A minor example of this occurred in late 2002, when the original Ben Bernanke ‘plan B’ speech triggered a sharp, temporary drop in bond yields. As it turned out, deflation concerns were largely a hoax.

Macro Maestro isn't convinced by 1. With the exception of Goldman's Jan Hatzius, most investors/economists reacted to Bernanke's speech with a 'is that it?'. So that leaves 2 or 3. Macro Maestro belives 3 is a more compelling explanation than 2 - the bond market's utter conviction in deflation is difficult to justify. But that doesn't mean Macro Maestro isn't worried about the global growth outlook..

Basel Faulty?

(Macro Maestro couldn't resist this rather obvious title, even though he is generally in agreement with yesterday's regulatory announcements.)

On Sunday, the Basel Committee on Banking Supervision said it had finally agreed new capital requirements, which would be phased in over a number of years. (Largely to keep the Germans happy - what does this say about the state of their banking sector?). The headline was a rise in the minimum Tier 1 capital ratio from 4% to 6%, plus a new 'conservation buffer' of 2.5%. (Tier 1 capital is broadly shareholders' equity - the original purchase price of stock - plus retained profits minus cumulative losses.)

The 'conservation buffer' forces bank to hold additional capital as protection against unexpected shocks. If banks fall within this buffer they will face restrictions on dividends and bonuses. Officials don't want markets to regard this additional buffer as part of the new minimum, but it's hard to see how this can be avoided. So the minimum requirement effectively jumps from 4% to 8.5%.

Then, there is a new 'countercyclical' capital buffer. This means when credit is growing strongly, the conservation buffer widens further. At the height of the credit cycle, this would push the effective minimum capital requirement up by a further 2.5% to 11%.

These are big changes, so what do they mean? Macro Maestro will leave market strategists to work out the impact on the banking sector overall. But the reaction from the market so far is positive, with bank stocks jumping sharply. Presumably, this means either these regulations were less onerous than some had feared, or investors are celebrating the removal of one important source of uncertainty. (Pity about all the others..)

Still, Macro Maestro is more interested in the impact on financial stability. Here, he is reminded of two important pieces of research:

First, in its Q4 December 2009 Financial Stability Report, the Bank of England analyzed past financial crises to discover what they implied about the needs of future capital requirements. [Sweden, (1990-93), Finland (1990-94), Norway (1988-92) and Japan (1992-2004). Their work suggested Tier 1 capital ratios of around 8.5% would have been required to prevent government capital injections during those crises - bang in line with the new Basel minimum. This suggests to Macro Maestro that the new minimum is broadly right and certainly a vast improvement on what we had before.

Second, a UK FSA paper found a countercyclical capital buffer could have powerful macro-prudential advantages by damping the lending cycle. They found a 3% point increase in capital requirements (broadly the buffer agreed by Basel) would reduce private-sector lending by around 5% after 3 years.  This isn't a huge effect, but it might well be stronger if matched by tighter regulations in other countries (a global multiplier?). At the margin, this would have helped in the period 2005-07. But Macro Maestro believes policymakers should also introduce other policies to properly damp the credit cycle (eg higher interest rates even if inflation is low, stricter loan-to-value controls on mortgages).

Of course, we still need to know more on the detail (particularly when it comes to the countercyclical buffer) but to Macro Maestro these reforms seem to be moving in the right direction..

Fed up

Ben Bernanke is having a tough time. In July, when he presented his semi-annual testimony to Congress, he was heavily criticized for not outlining a plan B. Investors wanted to know what he would do to get the economy moving again if it fell back into recession. So, in August (at Jackson Hole), he duly obliged and explained in some detail the Fed’s policy options. These included: (i) further asset purchases, (ii) committing to keep policy rates low (conditional on economic developments or for a set period of time); and (iii) reducing the interest rate the Fed pays on bank reserves.

This did little to sooth market nervousness. Commentators noted, not only did these options seem a little underwhelming, but Bernanke himself was keen to outline their limitations. Macro Maestro shares this scepticism, but he understands Bernanke’s cautious approach. The Fed Chairman is still clinging to a view of the economy that does not require further stimulus. Perhaps he was hoping data over the next few months would make such a policy discussion redundant, reducing the risk that by outlining these options he further undermines confidence.

Unfortunately, activity data seems likely to remain weak and underlying inflation readings will probably subside further. So it’s important to start to debate about Plan B. There are some, notably in Europe, who are opposed to these policies because they involve taking risks with central bank credibility. There is even a hint of this in Bernanke’s discussion, when he points out that these policies might complicate the Fed’s exit strategy. Macro Maestro doesn’t really share these moral concerns and certainly doesn’t believe they will be a constraint on US policy. (It’s a different story in the euro area.) If the Fed genuinely starts to fear deflation, it will be willing to try anything to avoid it. (Note Bernanke explicitly didn’t rule out raising its inflation target – equivalent to central bank suicide – if the situation deteriorated far enough.)

Macro Maestro’s concern is whether the existing policy options will prove effective. Certainly, there seems little scope to employ Bernanke’s proposals (ii) and (iii). Markets already believe the Fed will keep interest rates on hold for a long time into the future, so there seems little benefit to explicitly saying so. (Especially as they’d probably make this commitment conditional on the economic outlook – the bond market has formed its own view on the economic outlook). And with the interest rate on reserves already at 0.25%, there seems little scope to reduce it further. As Alan Blinder points out, they could make it negative and charge banks for holding reserves but this seems unlikely to provide a powerful impetus for private-sector lending.

That leaves asset purchases. Macro Maestro’s is sceptical about asset purchases because he notes the UK experience. While admittedly we don’t know what would have happened in the absence of Quantitative Easing (QE), even a relatively large asset purchase scheme (purchasing over 20% of the outstanding gilt stock) seems to have done little to boost money supply or private-sector lending in the UK. Asset prices did recover, but only in line with other major economies. That is not to say QE had no effect. Macro Maestro believe the first wave of QE (globally) played an important role in supporting private-sector confidence in early 2009, when many feared monetary policy had already run out of options. But this was largely a confidence trick. If policymakers must resort to another round of asset purchases, Macro Maestro isn’t convinced it will trigger a similar shift in sentiment. And the reaction to Bernanke speech, certainly compared to the reaction this same speech had in 2002, suggests markets have alrady become more sceptical.

Big dipper

Returning from a two week vacation, Macro Maestro notes little has changed during his time off. The ECB and the BoE remain firmly on hold, the Fed is still talking about a new round of quantitative easing (while desperately hoping they wont need it) and the main issue for investors remains the strength and sustainability of the US economy. Friday's US payrolls report helped stiffen equity investors resolve, but other data have been decidedly weak.

Still, the debate about 'double dip' in the US, to Macro Maestro at least, seems to be missing the point. In particular, some economists last week argued a US double dip isn't likely because the parts of the economy that usually push GDP growth negative - notably housing and inventories - are currently so weak, it's hard to see them creating a drag large enough to pull the rest of the economy down. Macro Maestro doesn't take comfort from this kind of analysis. The debate is not whether the US will contract at some point in the remainder in 2010, rather it's about the underlying strength of the economy in 2011. If economic activity remains lacklustre, as Macro Maestro fears, then the US is still risking a Japanese style fate (and recent impressive data in Europe wont last). Worse, policymakers seem to be running out of ideas to get the recovery started again. And that means equity markets - which are still hoping for sustained economic expansion - would be woefully mispriced. Sharp falls in stock price could put us back to where we were in early 2009 (but without the hope of a V shaped recovery that lingered back then..)

(Macro Maestro's vacation didn't do anything to cheer his mood about the global outlook.)

Vacation

Macro Maestro is now on holiday until early September.

American sucker

American Sucker tells the true story of David Denby, the New York film critic, who got a little too caught up in the late 1990s tech bubble. After splitting up with his wife in early 2000, Mr Denby liquidated most of his family’s assets and invested them in tech stocks. With prices rising rapidly, he became completely obsessed with the ‘new economy’ boom – religiously watching CNBC, attending conferences, and striking up personal acquaintances with Henry Blodget (the former Merrill Lynch tech analyst) and the biotech entrepreneur Sam Waksal (who was eventually jailed for corruption). Like the Titantic movie, the ending is entirely predictable – he loses a fortune – but the book still provides a valuable insight into asset bubble psychology.

As the market began to fall, Denby was convinced it would bounce back. Occasionally it did, but not for long. So he hung onto his tech stocks until the very end of the downturn, by which time many of them were worthless. Unfortunately, he couldn’t accept the market was largely a bubble because he could see evidence of the ‘new economy’ all around him – computers were everywhere and communications were changing rapidly. In some ways of course, he was right. The data show the US economy genuinely changed in the late 1990s – unemployment fell dramatically without triggering rampant wage inflation, productivity accelerated significantly and, once companies focused on exploiting all the efficiency gains (ironically, after the bubble had burst), profits eventually reached a record share of national income. But, as in many bubbles, the market took an idea with some fundamental basis and simply got carried away.

While such excesses are no longer obvious in equity markets, Macro Maestro thinks you can see signs of this bubble mentality in other markets – notably the bond market. Right now, it is certainly hard to get too worried about inflation. Most major economies are running large negative output gaps and Asian exporters, concerned about maintaining market share at a time of low growth and a weak dollar, are still cutting their prices in the West. But the absence of high inflation does not imply – as the bond market seems to be assuming – that deflation is inevitable. Yet, a US ten-year yield of 2.5% seems to be pricing exactly that. And more subtlety, the momentum (and commentary) in the market seems to suggest investors are buying bonds purely because they think yields will continue to fall. This is the same basic psychology behind all bubbles and it was certainly apparent in the late 1990s stock bubble. Bond investors should also remember, of course, the state of public finances in the US and UK. Surely these warrant some kind of risk premium on the paper they are buying?

Macro Maestro doesn’t expect global deflation, but he does see another 12-18 months of weak growth and low inflation. This alone will generate significant volatility in financial markets. Most investors currently seem to have a bimodal view of the world - they are asking only whether we face deflation or inflation. As always, somewhere in-between these two extremes lies the most likely outcome. So, as the news fluctuates and investors' expectations flicker between these two scenario, asset prices will be volatile and there will be plenty of opportunities for the savvy punter to make money. (As long as they don't get drawn into dangerous momentum trades.)