Morgan Stanley: Paradise Lost

Another nice post from Morgan Stanley analyst Joachim Fels

Morgan Stanley - Global Economic Forum:

Once upon a time: In comparison to the challenges facing central bankers today, the one-and-a-half decades in the run-up to the credit crisis must have felt like paradise for monetary policymakers, where they could do (almost) no wrong. They were standing on the shoulders of giants like Paul Volcker and others, who had successfully fought the Great Inflation with restrictive monetary policies during the 1980s and had thus restored central bank credibility. Importantly, they were also helped in their pursuit of price stability by a combination of favourable external factors beyond their control - globalisation, deregulation and a productivity ‘miracle' - that kept inflation in check even when monetary policy was expansionary. Hence, central bankers could have their cake and eat it: they were able to slash interest rates aggressively whenever a financial crisis or recession came along, and to only raise rates very slowly thereafter, without creating inflating pressures or sacrificing credibility. If anything, these firefighting missions coupled with ongoing low inflation added to the image of central bankers as the ‘maestros' of their economies and financial markets.

Maestro myth revealed: Alas, as is now widely recognised (also by many central bankers), these actions sowed the seeds for an asset price and credit bubble of gigantic proportions. Since the bubble burst, we have been moving from crisis to crisis - a credit and banking crisis, the Great Recession, an emerging market crisis and now a European sovereign debt crisis. With central banks having long been forced (by circumstances rather than government decree) to open the floodgates and apply an unprecedented series of unconventional measures, it looks more and more likely to us that the confidence crisis in banks and sovereigns will ultimately morph into a crisis of confidence in the central banks who act as lenders of last resort to both banks and governments. Yes, central banks can extend unlimited amounts of credit to banks and governments. But they do so by issuing ever more of their own liabilities - money. And just as the trust in banks' and governments' liabilities eroded when they issued ever more, we believe that the trust in money will erode if central banks issue ever more of it.

Gold and exchange rates illustrate confidence loss: A loss of confidence in the value of fiat money usually shows up first in the price of gold and in exchange rates. By these standards, the process has long started. The price of gold has more than doubled from its pre-crisis levels at the start of 2007, no matter whether it is measured in US dollars, euros or sterling. And exchange rates - the relative price of fiat currencies - have also reflected (relative) confidence losses. Last year, when the Fed embarked on active quantitative easing with massive asset purchases, while the ECB was less aggressive and engaged in the less risky versions of ‘passive' quantitative easing, the dollar weakened significantly against the euro. This year, when the Fed ended its asset purchase programme and the ECB was recently forced to become more aggressive by extending liquidity support to the banks again and starting to buy government bonds (though at a much smaller scale than the Fed) outright, the euro was punished relative to the dollar.

Inflation still low... Meanwhile, the internal value of money, as measured by its purchasing power in terms of goods and services, has been reasonably stable as inflation has remained low, especially in the US and Europe. But this is hardly surprising, given that the global economy only started to emerge from its deepest post-war recession at around this time last year. Moreover, it provides little comfort for the future as global monetary policies remain extremely accommodative despite the economic recovery and as we believe that the sovereign debt crisis will keep both the ECB and the Fed on hold for longer and will thus make it more difficult for many emerging market central banks to tighten monetary policy (see "XXL Liquidity",The Global Monetary Analyst, May 12, 2010).

...but the UK may be a leading indicator: Interestingly, the country with the highest current inflation rate in the G10 is the UK, with CPI inflation at 3.7% by far exceeding the 2% target. Even excluding the VAT hike (but only assuming partial pass-through), our UK economists think that CPI inflation would be running at slightly above 3% currently. Judged by the expansion of the Bank of England's balance sheet since the start of the crisis, the UK has also had the most aggressive monetary policy response, and sterling has weakened significantly versus both the dollar and the euro over the past couple of years. And, as an aside, the UK experience flies in the face of the popular theory that, in order to create inflation, you must have solid credit creation and broad money growth - both M4 and M4 lending (on the BoE's preferred measure that excludes intermediate OFCs) have only barely picked up fairly recently. Recall that similar arguments about preconditions for an economic recovery were put to rest last year when a surge in excess liquidity provided enough traction for the start of the economic recovery. Credit creation and broad money growth or the absence of economic slack would certainly aid and abet inflation, but their absence does not necessarily rule out inflation and inflationary risks when such expansionary monetary policy regimes are in place.

ECB the latest victim: More recently, the focus has shifted to the ECB, which has traditionally been viewed as the most independent and credible among the major central banks by many market participants. To a large extent, the ECB's credibility has been built on its very nature of a supranational central bank mandated with the primary goal of price stability, issuing a denationalised currency remote from government influence. However, the credit crisis that has morphed into a sovereign crisis has forced the ECB into actions that threaten to undermine its credibility over time.

Credibility undermined: First, the ECB had to make a climb-down on its collateral rules by accepting Greek government bonds irrespective of their credit rating. While justified as an exceptional step, it seems clear that the ECB will not be able to deny similar treatment to any other member state getting into trouble. Second, the decision to buy government bonds in the ‘dysfunctional' secondary market was a big step, as can be seen by the open controversy it created in the ECB Council. While these purchases do not violate the Maastricht Treaty, which only rules out direct lending to governments or bond purchases at auction, they clearly help governments finance their deficits at lower rates than otherwise. Third, by continuing to provide banks with unlimited liquidity at various maturities, the ECB keeps even the weakest players afloat and thus slows down the necessary consolidation and recapitalisation in the banking sector.

Hostage to financial and fiscal stability concerns: Of course, all these measures can be justified with concerns about domino effects and thus a potential meltdown of the system, and it is difficult to see how the ECB could have acted differently in these situations. Yet, these actions also delay the necessary adjustment as banks and governments have learned to rely on the ECB as a lender of last resort. And without the necessary adjustment in the form of banking sector consolidation or the threat of regulatory intervention (breakups, orderly wind-downs, etc.), recapitalisation of banks (especially those in public ownership) and major fiscal reforms, the ECB will likely remain hostage to financial stability concerns and find it difficult to respond to inflationary pressures when they appear.

Vigilantes asleep: In short, over the next several years, central banks will face an uphill battle to defend their credibility, and many of them will have their hands tied by financial and fiscal stability concerns. Amazingly, though, while the gold price and currency markets have been sensitive to these concerns, bond markets appear to be lulled in by liquidity, carry and roll-down that seems to springs eternal. But this is not new: bond markets also took years to take on board the Great Inflation of the 1970s and the big disinflation of the 1980s and 1990s. The famed bond vigilantes are fast asleep, again.

Did we miss a trick?

Deus Ex Macchiato:

Larry Elliott has a thought provoking article in today’s Guardian. He quotes Roubini, who says

… that it is precisely because the downturn has been handled more deftly this time that the impetus for deep, structural reform has faltered. “Had policymakers failed to arrest the crisis, as they failed during the Depression, the calls for reform today would be deafening: there’s nothing like ubiquitous breadlines and 25% unemployment to focus the minds of legislators.”

But, thankfully, policymakers did avoid most of the mistakes of the 1930s and we are where we are. In the circumstances, what the future holds is either full-blown recovery courtesy of the breathing space provided by central banks and finance ministries; another crash preceded by what the late socialist thinker Chris Harman described as “zombie capitalism”; or reform and renewal.

Full recovery would mean that the global economy could continue to prosper even when governments withdraw the support provided by low interest rates, tax cuts and higher public spending. That looks improbable, particularly since there is likely to be a simultaneous tightening of fiscal policy in many countries.

Zombie capitalism is where governments continue to buy up worthless paper from banks, where fundamentally insolvent institutions are kept alive for fear that their failure would cause systemic risk, where every country tries to export its way out of trouble, where the shrinkage of the financial sector depresses growth rates, and where the global imbalances between surplus and deficit countries remain worryingly large. That looks a more likely option.

What, then, are the prospects for reform and renewal? At the very least, this route is likely to be long, hard and strewn with setbacks. It may not be chosen … until there is system failure.

This is an interesting thesis. I don’t wholly buy it, but the idea that precisely by doing enough to fix the immediate problem, but not enough to address its causes, we have left ourselves exposed to a Japanese style slow, shallow but long lasting recession is interesting. Certainly by missing the chance to nationalise the worst affected parties, such as RBS, we also lost the opportunity to restructure banking broadly. It might well turn out that that ideologically-motivated decision was a bad one. That won’t be clear for some years, and it may well be that the summer 2010 panic is minor. But if it isn’t, we will be criticising 2008’s crisis management for some time.

James Montier: “I want to break free”

James Montier, former Societe Generale analyst now forking for GMO, put out couple days ago a nice report about risk, benchmarking and asset allocation. Whole report is worth reading, but let me high,light two things:

Problems with Policy Portfolios

Problem 1:  Risk isn’t volatility. To begin, we should ask ourselves why we are concerned with volatility as a measure of risk. Modern portfolio theory is so entrenched in the innermost workings of the world of finance that risk is typically defined as standard deviation or variance. 

However, risk isn’t a number. It is a concept. Ben Graham argued that we should focus on the danger of permanent loss of capital as a sensible measure of risk: What is the chance that I will see my capital permanently impaired by this investment? This strikes me as a much more sensible viewpoint than the mathematically elegant but ultimately distracting practice of assuming that risk is equivalent to standard deviation. 

Volatility creates opportunity, not risk. As John Maynard Keynes long ago opined, “It is largely the  uctuations which throw up the bargains and the uncertainty due to fluctuations which prevents other people from taking advantage of them.”  

For instance, let’s look at equity volatility. Exhibit 3 shows a measure of the volatility of the S&P 500. Were equities more risky in late 2007 or early 2009? If you follow the edicts of standard nance, then 2007 was a much less risky year than 2009. Now, tell me again that risk and volatility are the same thing! 

Problem 3:  Benchmarking alters behavior. The third problem is that benchmarking tends to alter investment Managers’ behavior along three important dimensions. First, managers motivated to compete against an index may lose sight of whether an investment is attractive or even sound in an absolute sense. They focus upon relative, not absolute, valuation.

Second, as soon as you give a manager an index, the measure of “risk” changes to tracking error: how far away from the benchmark are we? Sadly, in a benchmark-tracking-error, career–risk-dominated world, Keynes’ edict that “It is better for reputation to fail conventionally than to succeed unconventionally” governs the day. For benchmarked investors, the risk-free asset is no longer cash, but the index that they are compared against. 

This is evidenced by the drive to be fully invested at all points in time. After all, if the goal is to beat the market without falling significantly behind, it makes sense to remain 100% invested. (Witness Exhibit 6, which shows the relentless decline in cash levels in U.S. equity mutual funds.) Remaining fully invested at all times means that the investor simply chooses the best available investment. Relative attractiveness becomes the only investment yardstick. 

Finally, benchmarked managers start to think about return in a relative sense as well. I’ve always hated the idea of sitting in front of a client having lost money, but claiming good performance because I’d just lost less than an index. That very concept sticks in my craw as an investor.

The bottom line is that, effectively, everything becomes relative (risk, return, and valuation) in a benchmarked world. 

JM-I Want to Break Free