Monday, September 3, 2012

Labor Day Idylls and Europhoria

Think back to the dreaded global financial meltdown of 2008.  Monetary policy spigots wide open.  U.S. and then global real estate prices escalating. The 'originate and distibute' model in full swing at specialty finance companies.  Underwriting standards out the window.  Real estate price increases self-fulfilling.  Investors move to riskier and riskier trades to amp up their returns. 

Charles Prince makes the penetrating observation,
"When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing."
According to Deloitte's Shadow Banking Index research, assets in the shadow system peaked in the first quarter of 2008 at $21 trillion, compared to $15 trillion in the regulated banking sector.  The Reserve Primary Fund breaks the buck in 2008, beginning a run on more than $300 billion in assets in prime money market funds.  You know the rest of the story.

Here we are in the summer of 2012.  Monetary policy no longer operates through spigots but through a fire hose.  The Fed Chairman says he has a study showing easy money has produced 2 million more jobs than would otherwise have been possible, and nobody laughs or asks him to explain who created these jobs and why.  It is utter nonsense, but markets turn upward. 

Looking at a beautiful day on the Midwestern prairie, Walt Whitman's lines seem to summarize the views of our manic/depressive markets,
"O CAPTAIN! my Captain! our fearful trip is done;
The ship has weather’d every rack, the prize we sought is won;
The port is near, the bells I hear, the people all exulting.."
 Let's think about our more sophisticated neighbors in the European Union.  Global stock and bond markets have been buoyed by a Eurobanking bureaucrat stamping his feet and saying something like, "Dadgummit, I guarantee that the euro will survive.  You can bet the Sardinian villa on it."  The people exulted.  One thing he didn't say: what will that currency look like, and which nations will be in the currency union?  I don't think that Greece will be on the list.

Spain has had Valencia, Catalonia and Andalusia ask for central government help.  The Spanish government cannot cope with their requests, plain and simple.  Now, the Spanish PM talks about a EU-wide banking resolution system that will take care of Spanish banks and some 6,000 EU-wide institutions in total. Note to file: the EU does not have and is unlikely to create a workable mechanism for achieving these ends before the Spanish situation worsens with 20 billion in euro debt coming due in October. 

Yet, "currency markets are calm," and "European stocks finish higher."  The prospect for a Thursday EU meeting will keep the music box cranking and the weasel will stay contained until then. 

Recent earnings announcements from technology bellwethers like HP, Cisco and Dell have all been characterized by anemic top line revenue growth, and cuts in 2013 revenue estimates.  Asian manufacturing is slowing down dramatically, and some of its tech leaders like Acer are on life support. Cost cutting, staff reductions and restructuring are already factored into valuations. This isn't a great scenario for multiple expansion or for earnings growth looking forward.

The recent failure of SEC Chair Mary Schapiro to bring about reform of money market funds is important when looking back to the 2008 crisis.  The SEC has been "engaging for two and a half years on structural reform of money market funds."  Commissioner Luis Aguilar's two page, volte-face on reform seemed hollow and out of character.  Even with the 2010 reforms to the repo market, this market, particularly the roles of the two clearing banks, JP Morgan Chase and Bank of New York Mellon, still poses significant risks to the global system in 2012.  We haven't dealt with these issues either.

Again, U.S. equity market are near their highs, and U.S. fixed income managers now talk about looking at selected European credits as very attractive.  Aside from assurances of central bank backstopping, how can these notes issued by deadbeats be a compelling, risk-adjusted value?   World financial markets see the world as the poet Whitman did in his verse.

Going back to the 2006-2008 analogy, the music today is being played by central bankers.  Bernanke, Draghi and others have promised unlimited, interminable liquidity support to asset markets. 

Chicago Booth Professor John Cochrane puts it best in describing how the Fed has gone off the rails with respect to its fundamental mission as a central bank,

"Since the 2008 financial crisis, however, the Federal Reserve has intervened in a wide variety of markets, including commercial paper, mortgages and long-term Treasury debt. At the height of the crisis, the Fed lent directly to teetering nonbank institutions, such as insurance giant AIG, and participated in several shotgun marriages, most notably between Bank of America and Merrill Lynch.

These "nontraditional" interventions are not going away anytime soon. Many Fed officials, including Fed Chairman Ben Bernanke, see "credit constraints" and "segmented markets" throughout the economy, which the Fed's standard tools don't address. Moreover, interest rates near zero have rendered those tools nearly powerless, so the Fed will naturally search for bigger guns. In his speech Friday in Jackson Hole, Wyo., Mr. Bernanke made it clear that "we should not rule out the further use of such [nontraditional] policies if economic conditions warrant."
When the markets no longer listen to the central bankers' music, the current, long running game of musical chairs will also be over.

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