"In a deleveraging/deflationary world, the cornerstone of asset management is not "capital appreciation" but "capital preservation." We often take what Paul Krugman says with a grain of salt, but we do believe he is on the right track in telling Bloomberg that he doesn't buy the "flight-to-quality" explanation for the continued fall in the bond yields of "haven" sovereign bond yields. In a deleveraging world, the excess liquidity provided by central banks to offset fiscal tightening (austerity) and balance sheet shrinkage primarily goes into least risk government-sponsored fixed income, and having experienced first hand Japan's lost two decades, we suspect the Anglo Saxon developed economies are also headed for a lost decade, where monetary policy interest rates stay close to zero-bound for a really long time, meaning Anglo Saxon long bond yields could also stay low for an equally long time.
Yields on government bonds in Germany, the U.K., the U.S. and Japan are at almost the lowest ever recorded because policy makers in these countries have been unable to restart sustainable economic growth. In other words, any country that has a reasonably stable government, its own currency and borrows in its own currency, have very low for a very good reason, they are essentially trapped in a disinflationary or deflationary spiral.
ECB is Worse Off than Japan in the 1990s
As pointed out in a Bloomberg Brief, the performance of the Japanese economy 20 years ago was better than that of the current Euro area excluding Germany. Japan's GDP was 7% higher four and a half years after the Nikkei 225 peaked in December 1989, according to the IMF's measure in constant prices. The superior performance of the Japanese economy then relative to the Euro area now because of less fiscal deterioration. Gross debt-to-GDP in Japan increased by 10 percentage points from 1990 to 1993, or from 67.3% to 77.3%. The deterioration this time in Euroland has been much worse, from 66.4% end 2007 to 88.1% end 2011. ECB analysts see similar fiscal problems as well as demographics. In addition, the Eurozone, like Japan in the 1990s, has responded slowly to the crisis and has not anticipated a protracted slowdown in Eurozone economies even though credit is contracting, which disrupts the monetary transmission mechanism (money multiplier) of the banks and renders conventional monetary policy ineffective, which is exactly what happened in Japan.
The Demise of Shadow Banking Money Multipliers
The Demise of Shadow Banking Money Multipliers
Vox.eu.org analysts see an era of negative money multipliers, and those who expect that simply expanding bank reserves (through QE, etc.) will create money in the "real economy" seriously under-appreciate how complex the modern financial system is. Primarily, ”shadow banks” and “non-banks” were until 2007 responsible for significantly more lending/liquidity in the system than was appreciated. Before the 2008 financial crisis, the shadow banking system threatened to surpass the conventional banking system subject to conventional central bank monetary policy. Thus unless the Fed, ECB, Bank of England and Japan's BOJ can completely replace the credit/liquidity previously provided by the shadow banking system, total credit availability continues to shrink as the banks money multiplier continues to shrink.
When participants in the shadow banking system get spooked and raise collateral requirements, there is a massive rush for "safe" securities, creating a large funding shortfall at banks because big chunks of assets become "unfundable" at the same time. After the financial crisis, the total size of the shadow banking system itself shrunk appreciably. Basically, what the U.S. Fed has been doing is providing enough liquidity to cover imminent banking liabilities previously easily funded by the shadow banks based on illiquid collateral, plus alpha, but they haven't been able to completely replace the decline in total credit provided by the shadow banking system.
Thus actual market liquidity conditions remain tight despite massive central bank balance sheet utilization, because quantitative easing merely swaps bank reserves for US treasuries, which is a wash in terms of easing liquidity pressures. More effective for Eurozone banks has been the Fed's USD swaps that addressed a chronic shortage of USD needed to delever Eurozone bank balance sheets. Central bank purchases only enhance liquidity if it swaps monetary assets for "impaired" assets no longer collateralized at full value by the shadow banking system, which would be considered blasphemy by dyed-in-the-wool central banker traditionalists, and central banks simply cannot provide the kind of risk-based credit that came from the shadow banking system. Ironically, a new QE3 program, which some like Marc Faber believe would have to be "huge", could actually make the problem worse.
The CRB Commodity Index as a Bellwether for Global Growth Expectations
The CRB commodity index continues to function as a better indicator of global economic growth expectations than inflation. Since the bottom in global equity markets in Q1 2009, investors have gone through periodic "growth scares" triggered by renewed crisis in the Eurozone and/or the expiration of extraordinary Fed policy measures, i.e., QE1, QE2 and now Operation Twist this June.
The CRB peaked in the first half of 2011 driven by QE2. In the past 9 months the index has found a support level at about 293. As this is the third time during the period that we’ve approached this level, we could again see a bounce on a) indications the Euro crisis is easing, and/or b) additional measures announced by the Fed.
The CRB peaked in the first half of 2011 driven by QE2. In the past 9 months the index has found a support level at about 293. As this is the third time during the period that we’ve approached this level, we could again see a bounce on a) indications the Euro crisis is easing, and/or b) additional measures announced by the Fed.
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| Hat Tip: Pragmatic Capitalism |
Bank Stocks as the Bellwether of Financial Sector Stress
While some also point to the CRB as an indicator of financial stress conditions, we believe the CRB, as it reflects global economic expectation, is a secondary indicator in that financial sector stress increasing implies lower economic growth. For a more direct indication of financial sector stress, we would instead look at the bank stock indices in general, and at those individual bank stocks generally believed to be the most exposed to increased financial sector stress. By the same token, bank stocks should be underweighted globally as long as the Eurozone debt crisis continues to worsen. As can be seen by the MSCI world indices, the underperformance gap of the financials (banks) has been widening since March 2011, despite the brief period of outperformance by US financials in the first few months of 2012.
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| Source: MSCI |
If Krugman's description of a lost decade for the Anglo Saxon economies where policy rates (and bond yields) stay at or near historical lows for a very long time as they have done in Japan, the underperformance of bank stocks will continue to widen for an equally long time, as was also seen in Japan since 1990. In the early stages of Japan's decades long malaise, the bank stocks actually kept up with rallies in the aggregate indices. But as monetary policy hit zero bound and the temporary boost from successive fiscal stimulus packages wore of, the relative performance of Japanese banks got worse, not better, as bond yields continued their march downward below 1.0% to an eventualy low of a mere 0.50%. Notice also that the banks failed to participate in a noticeable way in the subsequent IT (circa 2000) and Koizumi reform mini-bubbles, even though Japan's banking crisis ostensibly ended in Q2 2003.
In the 2002~2007 Koizumi reform bubble, the bank stocks surged from the Q2 2003 low as they were re-priced as going concern instead of bankruptcy candidates for about a year, then entered a new steady downtrend as corporates continued to delever their balance sheets and became cash rich with the larger, financially sound companies seeing decreasing need for bank financing and thus "main bank" entangling alliances.
In the 2002~2007 Koizumi reform bubble, the bank stocks surged from the Q2 2003 low as they were re-priced as going concern instead of bankruptcy candidates for about a year, then entered a new steady downtrend as corporates continued to delever their balance sheets and became cash rich with the larger, financially sound companies seeing decreasing need for bank financing and thus "main bank" entangling alliances.
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| Source: Nikkei Astra |
The World Has Changed: Wall Street Banks in Secular Decline?
While instigating the US housing bubble crisis, US banks were bailed out by the US treasury and Federal Reserve in a big way, which allowed them to delverage fairly aggressively, even though they continued many of their shadow banking practices, as evidenced by the recent $2 billion loss by "the best-of-the-best" JP Morgan (JPM).
Almost four years after the financial crisis, the stocks of US banks such as Citigroup (C) and other majors continue to trade below liquidation values because investors don't know how much balance sheet risk (like JP Morgan's loss) there is, and analysts are forecasting no rebound in revenue or profitability soon. Instead of anticipating a revival of trading and investment-banking profits, shareholders expect firms to reduce headcount and pay across the board, even for CEOs, because the banking boom before the crisis is unlikely to return in this decade amid stricter regulation and deleveraging efforts. Further, new capital requirements in addition to stricter regulation mean bank stocks will begin looking more like utilities, ostensibly with lower but more stable returns.
The future of the Euro could be determined in the next six months--with US bank stocks falling 50% or rising 25%, according to some analysts. With a Euro-breakup, US banks could lose 20% of their tangible book value. Like what was seen among Japan's banks and financial firms over the past 10 years, the bloated US and Eurozone workforces in financial services could enter a long-term decline, with bloated compensation packages also seeing a significant shrinkage, if the decline is secular, which the Japanese experience suggests it will be.