While there have been some notable disappointments in earnings in the last fortnight, it has been the pick-up in GDP figures around the World (apart from Britain) that seems to have sustained the rally in equities. Yesterday the US announced a surprisingly strong 3.5% rate of growth in the third quarter of this year and markets rose accordingly.
I am still very cautious about accepting these figures as proof of the worst being behind us, but the market seems more than happy to seize on them as a reason to maintain buying. Volume is still light on the up days and heavier on the down days, so there are definite warning signals of indices being near tops, but these signals have been around for several months. The October correction I thought would happen didn’t and it is clear that the affects of fiscal stimulus are being felt throughout the financial system (not least manifested in the obscene quarterly profits again reported by investment banks earlier in the month).
Are current stock valuations indicative of yet another bubble?
Based on earnings the answer to this is almost certainly yes, but what I am more interested in at the moment is the debate surrounding exit strategies for fiscal stimulus. Remember my view that any talk of recovery is premature until the process of removing fiscal stimulus measures has started. Until that point, such is the magnitude of the measures that were introduced they continue to have a hugely distorting affect on fundamental economic data and financial market participation.
One problem we have faced in determining how our prospects are likely to fair in 2010 has been the lack of information surrounding global Government and Central Bank exit strategies. While comprehensive plans are still lacking we have finally seen some significant developments in the US and Europe.
Earlier in the week there was a substantial sell off of European financial stocks as the European Central Bank (ECB) issued a warning to banks who had received state aid from Governments that if they did not present plans for unwinding support by mid-November then the ECB would step in directly to resolve this. Given the strength of the warning the sell-off was not at all surprising and this issue is bound to have an impact in the coming month.
However this announcement was then overshadowed by US Treasury Secretary Tim Geithner’s testimony in Congress yesterday. I was able to watch this live and the atmosphere was tense to say the least. There is serious disquiet about the viability of the Obama Administration’s plans, specifically there are fears of too complicated a regulatory structure being created and the threat of the moral hazard of formalising a process for future bailouts.
After all the previous regulatory system failed to curb the excessive behaviour behind the Credit Crisis so what hope is there that a more arcane incarnation will prevent future crises? Not much. This fear is then amplified with the prospect that the US Government will underwrite the financial system, no matter what it does. I have written about this before, but if you are interested in reading more this Wall Street Journal blog provides some excellent analysis.
One particularly interesting exchange during Geithner’s testimony occurred over the idea of setting up an equivalent of the Federal Deposit Insurance Corporation to prepay for any future bailouts. I have to admit on this issue I agree with Geithner completely, the idea is ridiculous. Such a fund would be to institutionalise failure within the financial system. The sole purpose of the fund would be to bail out those banks “too big to fail”. The last thing the Global Economy needs is such a backstop for banking executives. This would almost certainly guarantee a return to (if not a surpassing of) some of the worst behaviours, which caused the Credit Crisis.
However watching this exchange got me thinking about a creative method of ensuring appropriate banking behaviour in the future. The financial system is too complex to regulate and there isn’t the serious appetite for substantially simplifying it. At the same time prepaying to compensate for excessive risk taking is nonsense. We need a system that does not encourage or, more importantly, reward wild gambling but rather discourages and penalises it.
This brings me back to retrospective taxation. You may remember that I was deeply in favour of retrospective taxation on individual bankers’ bonuses, earned from failed or mis sold financial instruments. As it turned out this did not happen back in the spring, apparently because Governments did not have the legal right to do this.
Now though, I feel retrospective taxation should be revisited as an idea for encouraging future banking stability. New rules, regulations and laws are being crafted at the moment so the time is right to put in place such a structure. I am convinced that the threat of retrospective personal and corporate taxation would be the perfect antedote to greed-driven banking.
If we have learnt nothing else from the Credit Crisis and its after-tremors it is the total commitment bankers have to acting in their own interests. I am fully in favour of people being rewarded for creative, hard work, but the manner in which the financial system operates means we cannot trust it to self-regulate. At the same time we cannot trust our Governments or Central Banks to perform effective oversight. However we will always be able to rely on politicians to react to public outrage.
In creating a system that relies on bankers’ instincts for self-preservation and which provides politicians with the tools to respond to public outrage at financial mismanagement this strikes me as having the potential to be a finely balanced, but powerful deterrent. I am not suggesting this would be a complete solution, but it could form an intrinsic part.
We will find out more over the course of the next month, but I really hope we will start to get a much clearer picture of how the Fed, the US Treasury and the ECB plan to remove fiscal stimulus measures.
And while all this is happening what have we heard about the Bank of England’s plans? If yesterday’s Times is to be believed then the BoE is going to extend Quantative Easing by another £25billion. Wonderful, juts what the Nation’s balance sheet needs — more debt! We need to wait and see if this happens at next week’s Monetary Policy Committee meeting, but if it does our prospects for a decent recovery in the next few years continue to wane.