Monthly Archives: October 2009

30th October Exit Strategies and coming back to retrospective taxation

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.

15th October Deficits, deflation and delusion

I wrote a week ago that various data sets from around the World were fascinating. I have spent quite a bit of time since then trying to understand their implications.

On Tuesday the Reserve Bank of Australia raised interest rates. On Wednesday the Consumer Price Index in the UK fell to 1.1%. Then on Friday the US trade deficit fell to $30.7bn.

Taken together these three announcements have reinforced my view that the Global Economy is still woefully imbalanced and any talk of serious recovery is premature at best, deluded at worst.

If we were truly witnessing the beginning of a global upturn then the Reserve Bank of Australia would be acting as the vanguard for the other central banks of the G20. The removal of fiscal stimulus measures and rising interest rates would be the clearest indicators that policy makers have faith that their endeavours have worked.

There is an argument that the bias of Australia’s economy towards its rich base of natural resources make it likely that it will be one of the first developed nations to emerge from the recession. However this does not mean that the US and UK will necessarily be hot on its heels. Australia’s major trading partner is China. While there are still serious question marks over the true state of Chinese markets, the country will still maintain a voracious appetite for metals and minerals. It is for this reason that the Australians can start to talk seriously about reducing central bank intervention and start focusing on building again.

Sadly the same cannot be said for us in this country. Wednesday’s inflation data scotched any speculation that the Bank of England sees rates rising in the foreseeable future. By extension it is not a great leap of analysis to expect that Quantitative Easing will also persist and might even be extended.

The longer this strategy is pursued then the more difficult it is going to be to unwind. The current inflation data is giving us a stark warning. People and companies are spending a lot less money. There is less demand, which means there must be less economic activity. When we consider this is against the backdrop of unprecedented fiscal stimulus then this picture is deeply troubling.

Historically excessive money supply has caused inflationary pressure. Admittedly this can take some time to have a noticeable affect, but what are we supposed to believe when we hear that “interest rates are to remain low for years” as the Centre for Economic Business Research predicted?

Faced with poor economic prospects and a worrying inflation outlook it is no wonder that Sterling has taken the pounding it has in the last week. And it was not alone. The Dollar has also taken a substantial hit, prompting the latest upwards burst in commodity prices.

While the narrowing of the US trade deficit could be viewed as a positive consequence of Fed fiscal policy, it also belays underlying problems. As the Dollar has continued to tank it is natural that US purchasers are buying more American goods and importing fewer foreign ones. However the pace of decline of the deficit clearly points to falling demand. After all do we seriously believe that a 20% decline in the Dollar in the last two years (a rough estimate against a basket of currencies) has suddenly made the American labour force that much more competitive than the Chinese? Certainly European goods and services are a lot more expensive, but the substantial bulk of US imports are from the Far East.

If Sterling and the Dollar continue to extend their declines in the coming months then we all need to pay a lot more attention to our prospects, in the event of the failure of the last two year’s fiscal policy.

And yet in spite of this stocks have continued to rise……

8th October One fascinating article in a fascinating week

OK today’s entry isn’t really a blog, but I am trying to make sense of events that have been happening. I am going to write today or tomorrow, but in the meantime have a read of this article in the Times.

A friend sent it to me and it gives a fascinating insight into events surrounding the British bailout of Lloyds and RBS. If accurate (and I don’t see any reason why it isn’t) this article clearly shows how rushed this was. Given the scale and complexity of it, the fact it was put together so hastily doesn’t fill me with that much confidence and only heightens my sense that we are living through the greatest economic experiment ever attempted.

Talk of recovery is premature.

3rd October Who remembers the banking stress tests?

Back in the spring all attention was focused on the Obama Administration’s banking “stress tests”. At the time markets were still in free-fall, huge fiscal stimulus measures were still being devised and the future looked exceptionally bleak. All of this had been caused by the Lehman meltdown the previous autumn and the consensus was that recovery could not begin until the banking crisis has been resolved.

The stress tests were meant to restore our faith in the American banking system.

While the official measures used in these tests were never released, the consistency of reports about some of the key ones was such that it gave the impression details had been leaked. Given the importance of this information to markets and the number of organisations and people involved this was hardly surprising. Apart from anything else it gave beleaguered banking CEOs the opportunity to “prove” that their institutions were now safe.

Of course the official purpose of the stress tests was to provide the Administration with justification for the huge level of fiscal stimulus they proposed, by painting a worst case scenario of economic decline.

The hope was that so long as the economy did not decline beyond the worst predictions then taxpayer exposure to the Credit Crisis would be kept to a minimum as further collapse in the banking sector would be avoided. Economic growth could resume and the nation state would avoid bankruptcy. We could all then breathe a huge collective sigh of relief and get back to living our happy lives of blissful consumption.

Or at least so long as the fiscal stimulus works….

Yesterday’s US Payrolls report should have sounded a serious warning to markets, not that you would have guessed it by the reaction of equities or the majority of coverage on this event. In case you missed it the US labour market shed an additional 263,000 jobs in September, well beyond the 175,000 expected. While this figure can be subject to large revisions, the unemployment rate tends to be a more stable data set. This now stands at 9.8% in the US.

It is this figure that has caused me most concern.

In April one of the most reported measures used in the stress tests was the unemployment rate. There were two main reasons for this. First unemployment is an economic figure which all people have an intuitive feel for. The more unemployed there are the worse shape an economy is in. The second reason is slightly more subtle. Higher unemployment affects all areas of what should be a bank’s core activities, namely commercial and consumer lending. The fewer jobs there are then the worse companies are performing and the less able individuals are to honour existing loans. In short this equates to larger losses for the bank.

If what was written was true then the Administration projected a maximum rise in unemployment to 10%. That was a maximum rise. In other words the worst case scenario.

Assuming that the official figures do not get revised lower, which might happen, then we are fast approaching the point at which the banking sector was expected to start to come under serious recessionary pressure, on top of the self-inflicted balance sheet pain of the Credit Crisis.

If we consider the last set of results from the banking sector we will remember that their activities in the real economy were already showing substantial losses. The profits were generated from their ephemeral trading activities pushing digital paper around the World and raking commission off transactional volume.

I wrote at the time how this was both morally and economically problematic.

Well if we use the increasing unemployment rate as a proxy for determining further strain on banking balance sheets, then it would not be a great stretch of the imagination to expect the “need” for more fiscal stimulus in 2010. If this happens then the only question will be who will trust this policy?