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Wegelin & Co - Investment commentary 272 - Too Big Not To Fail

Wegelin & Co - Investment commentary 272 - Too Big Not To Fail

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Published by thecynicaleconomist
Wegelin & Co - Investment commentary 272 - Too Big Not To Fail
Wegelin & Co - Investment commentary 272 - Too Big Not To Fail

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09/11/2010

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Investment Commentary No. 272 August 23, 2010
 
Too big not to fail
1.
 
Zero returns
Those who possess assets, or indeed live fromthem, assume that they will generate a return.Not every day, admittedly, or even every year.But at least in the long term, on average, and oncondition that everything has not been bet, un-wisely, on a single asset or category of assets.Investors – our clients – live from and with thisquasi-axiom of positive returns, and so do we,who advise them and act with them in thesematters. And all the complex portfolio optimisa-tions of the insurance companies and the pen-sion funds are based on this single quasi-axiom:on the “expected average return” – five, six ormore percent for stocks, three or four percentfor fixed-interest investments, one or two per-cent for short-term money – rest all the strategicand tactical decisions and guidelines regarded bythe responsible bodies and the supervisory au-thorities as a more or less sacred mantra. Theyare sanctified under the rubric of “economicfundamentals”. The assumptions for averagereturns are thus not a quasi-axiom, but a real one,not subject to challenge.Far be it from us to call this “economic funda-mental” into question. Basically, we believe in itourselves (what else should we believe in?). It’s just that real-time events currently – and, sadly,“currently” here means “for a considerable timenow” – tell a different story. There’s little ornothing to be made from assets. Returns havepractically reached zero, and, regrettably, thisapplies to a good many of the relevant assetcategories.Let’s start with money-market investments; withcall and fixed deposits, money-market funds, andthe like. In Swiss francs, there’s no return undersix months, unless the selected investment con-tains some sort of additional risk (LehmanBrothers …). Things are not really any betterwith the investment currencies, the euro and theUS dollar, and certainly not for the yen.Anyone wanting to achieve a return of at leastone percent from a fixed-interest investment inSwiss francs must opt for a maturity of almostfive years, if he wishes to entrust his funds to areasonably reliable debtor. The yield on a ten-year investment in US T-bills is currently 2.6percent; the yield on eurobonds is at a similarlevel, and, once again, there’s not much to behad from the yen. Long-term bond investmentsare, however, exposed to a significant interest-rate risk. Roughly speaking, the potential fall inprice if the interest rate rises by one percent isabout equivalent to the weighted maturity of thebond. So far, it has been worthwhile acceptingthis risk, as interest rates have fallen furtherfrom an already low level. The rises in the priceof bonds this produced have also been responsi-ble for some of the returns generated on mixedportfolios. This agreeable state of affairs is now,however, gradually coming to an end, as long-and even longer-term (30-year T-bills) invest-ments approach zero yields. The consequencesof interest-rate risk are becoming increasinglyasymmetrical.And what about stocks, of which it is said thatthey should reward investors with a hefty “eq-uity risk premium”? The picture could hardly bemore sombre. Those who with their unbelievablyingenious tactical over- and underweighting haveearned nothing, but at least made no mistakes –that is, those who have simply held stocks intheir portfolio on a diversified basis – will haveto go back ten or even, depending on the region,up to eleven (USA) or twenty (Japan) years tosee a positive return. And this, nota bene, in-cluding reinvested dividends. The figure belowshows clearly how stocks have been markingtime. Given that very many deliberate invest-ment decisions are made pro-cyclically, it ismore than likely to be the case that a very largenumber of investors have been waiting a verylong time for an appropriate return on theircapital.
 
W
EGELIN
& C
O
.
Investment Commentary No. 272 Page 2
Stocks: the long wait
020406080100120140160Jan 99Jan 00Jan 01Jan 02Jan 03Jan 04Jan 05Jan 06Jan 07Jan 08Jan 09Jan 10USAGermanyIndexed (July 2010)JapanSwitzerland
 
Source: Bloomberg; Wegelin analysisNote: Regional total-return indices (i.e. with reinvesteddividends) in local currencies; S&P 500 for the USA, SPI forSwitzerland, DAX for Germany
With returns like these, it is little wonder thatpeople are increasingly wondering what thepoint of it all is. A realistic perspective on re-turns offers cold comfort. It is the case that infla-tion has also been low in recent years, so thatholding on to the assets has at least not involvedany significant loss of purchasing power. But nopension fund is kept going by zero returns, andnor is any satisfactory cash-flow generated froman individual pensioner’s capital. Look at it howyou like: those dependent on returns from theirassets have been holding a bad hand for somewhile.
2.
 
Perplexity as a phenomenon
At times when axioms and quasi-axioms comeunder discussion, when fundamental questionsare being posed and when so many situationshave “never been like this before”, it’s smallwonder that those most easily observable indica-tors of the public mood, the stock exchanges, arewallowing around like a ship that has lost bothkeel and rudder, and whose sails are in shreds.The lack of direction on the stock markets overrecent months has been almost unbearable formany market players, and the commentatorshave excelled themselves with overinterpreta-tions of events of little or no significance.The most recent example of this is provided bythe apparently so disappointing economic statis-tics from the USA. There is undoubtedly a re-markable amount about the country that invitesnegative reporting: the continuing high rate of unemployment for instance, the failure to re-structure the real estate market, or the exorbi-tant rise in the national debt. We shall comeback to these matters in this Investment Com-mentary, but they have all been known about fora good while now. But if the rate of accelerationof a couple of indicators, such as the quarterlychange in GDP, slackens off a bit after the rapidupswing out of the recession of 2008/2009 (whichwas entirely predictable to any level-headedobserver), then the suggestion that this presagesdescent into another recession can only be re-garded as evidence of a thoroughly over-excitedstate of nerves. “Double dip” has been the newbuzzword in recent weeks. Over-excitement is apoor counsellor: those who believe they can seea change of trend here will all too often to bedeceived by natural fluctuations and the oscilla-tion of data.No, there are no key economic question marks,either in the USA or in Europe. Those whobased their economic forecasts on an indiscrimi-nate extrapolation of the rapid increase in indus-trial inventory (in the wake of the abruptreduction in inventory caused by the extensivecollapse of global trade as a consequence of thefinancial crisis in the previous year) were quitesimply wrong. Those who based their profit fore-casts directly on company figures fuelled by therebound were simply too euphoric. The “lazy L”,the wearisome economic recovery that we fearedlay ahead for the next couple of years, seemsincreasingly likely to be the outlook for the west-ern industrial nations – including, incidentally,Germany, and its apparently miraculous exports;here too, there is no call for the over-interpretation of a specific situation. The overallEuropean situation is characterised by a muchmore sluggish track. With regard to economicissues, there is no real justification either forperplexity or for the enormous mood swings onthe stock exchanges.The problem arises with structural issues. Here,perplexity is more than justified. Let’s begin withthe banking system, as it presents itself in thewake of the financial crisis. How healthy is itreally? Nominally, it doesn’t look too bad –earnings, and particularly those of the institu-tions hard-hit by the crisis, have improvedsharply. Balance sheets, for example those of UBS or Citigroup, have been seriously reduced.And the equity situation has improved corre-spondingly. So far, so good. But is the bankingsystem in the western industrial nations actuallyfulfilling its economic function? Strangely, at atime of record availability of cheap liquidityfrom the central banks (hence the low moneymarket rates in all the relevant currencies) thereis almost no credit business going on. This meansthat the banks have remained almost inactive intheir function as conveyor belts between thecentral banks and the real economy. Or, to put itmore plainly, since the financial crisis the bankshave remained in a dysfunctional state.
 
W
EGELIN
& C
O
.
Investment Commentary No. 272 Page 3The figure below makes the situation abundantlyplain. The money supply M3 in the USA, whichis no longer calculated by the Fed (why not?) butis still tracked by intelligent people, continues toplummet, while the Fed’s excess reserves remainat the highest level.
Misallocated money
02004006008001,0001,2001,400Jan 08Apr 08Jul 08Oct 08Jan 09Apr 09Jul 09Oct 09Jan 10Apr 10Jul 1011,70012,30012,90013,50014,10014,70015,30015,900
Commercial bank reserves with the Fed(left-hand scale)Money supply M3(right-hand scale)
 
Source: Federal Reserve, shadowstats.comNote: Figures in USD billion; M3 = Cash + savings + timedeposits
Of course, blame can be laid at the door of thereal economy, which is obviously generating toolittle demand for credit: “You can lead the horseto water, but you can’t make it drink”. The lackof enthusiasm for investment is probably themirror-image of the lack of risk appetite on thebanking side. With interest rates very low nomi-nally, and possibly negative in real terms, suchbehaviour on both sides is extremely strange, if not indeed off-putting. Something must be radi-cally wrong somewhere: otherwise an investmentand credit boom would be in full swing!Low interest rates, record liquidity supplies,“quantitative easing” (which can be equatedwith the direct supply of capital to the system bythe central banks), a farewell to the concept of an “exit strategy” (i.e. to an end to “quantitativeeasing”): according to current economic theorywe should long have been feeling inflationarypressure. Hence the perplexity of the monetaristCassandras: inflation has fallen to an all-timelow on both sides of the Atlantic; there is no signof any constraint on the supply of goods, onaccount of the productivity gains both in theemerging markets and in the domestic econo-mies. It almost looks as if J. K. Galbraith, thatveteran Keynesian, was right after all. He re-cently utterly dismissed any warnings about thenegative impact of the extremely stimulatingmonetary and fiscal policy (
The Economist 
,12.8.2010, p. 60). By way of reminder: TARP,the American government’s stimulation pro-gramme, amounted to USD 700 billion. Further,for fiscal 2009, the ARRA (American Recoveryand Reinvestment Act of 2009) was created withUSD 800 billion. The Fed’s balance sheet wasexpanded from USD 943 billion (2008) to USD2,368 billion (2010) for the purpose of buying updomestic debt. The European and Japanesetotals look little different.However, and here’s another source of perplex-ity, Keynesian economics throws up more ques-tion marks than anything else – never mindabout success stories. For even if it really is thecase that an extremely stimulatory monetary andfiscal policy does no damage with regard to infla-tion, it has sadly also become clear in the mean-while that it doesn’t actually do much goodeither. Unemployment in the USA seems stuckat the high level of 9.5 percent (including thoseworking part-time who would be happy to workfull-time, it’s almost 20 percent), the US realestate market has been at best stabilised, and therallying cry of “Yes, we can!” now generates atbest a weary shrug of the shoulders. Despiterecord low interest rates, average Americans aresaving, while the state piles deficit on deficit.Having been close to zero for many years, thesavings rate for American households is now 6.2percent. The US government’s debt has risen by28.4 percent since the end of 2008. Put differ-ently: one side provides stimulation as neverbefore, but on the other side, this stimulationobviously achieves little or nothing.Perplexity over monetary policy too. By now,the extreme stimulation of the system by practi-cally all the relevant central banks has comeunder criticism not only from academic circles,but also from insiders, so to speak. The annualreport of the Bank for International Settlements(BIS) devotes a whole chapter to the potentialnegative impact of the low-interest-rate policy(BIS 80th Annual Report, Basle, June 2010, p.36ff). It discusses microeconomic misallocationsby companies, as well as global distortions; thefear is expressed that the increasingly desperatesearch for returns will result in dangerous risk-taking by investors, and there’s more in a similarvein. However, not one of the critics has everindicated where the right – or at least an appro-priate – interest rate might lie when there ispractically no inflation, and the fear is rather of deflation. Criticism is cheap when there’s noneed to comment on the alternatives and theirrelative advantages and disadvantages.
3.
 
A lonely student in a sea of flames
Perplexity in the markets, in all the institutionsand at all levels: this cries out for some effort atexplanation. Pictures are sometimes worth athousand words – if they are the right ones. Let’stry. With the burning steppes and smoulderingtundra, with the Kremlin swathed in acrid

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