Eurogeddon? (Report/Blog)

By Alan Fisher 

Euros PHOTO CREDIT: Fernando D. Ramirez/flickrFor the last 18 months, the euro has been in trouble. There have been a series of emergency meetings, crisis summits and rescue attempts but still the stench of death hangs around the currency. Its future should become clearer in the next month or so.

Just two weeks ago, eurozone leaders were patting themselves on the back for creating the European Financial Stability Facility, a mechanism to help countries who found borrowing on the open markets much too expensive. The problem is that Italy is now in trouble and the EFSF simply is not big enough to bail out the world’s eighth largest economy.

Italy has been in trouble for a while – but things started to get substantially worse in June when its credit rating was put on watch by global credit agencies. Slowly the cost of borrowing ticked up. Italy refused to do much about it. Panic spread. The cost of bonds hit a 14-year high of 6.189 per cent, which essentially means Italy was shut out of the international financial markets.

At that point Italian Prime Minister Silvio Berlusconi finally took action.  He announced a round of austerity measures – spending cuts and tax rises – and brought forward the date when Italy’s budget would be balanced to 2013.  

That was enough to secure support from the European Central Bank. It announced it would step into the market on Monday and buy up some of the debts of countries that were struggling, steadying the markets in the short term at least. It did, however, leave the impression that the ECB was dictating policy in exchange for financial support.

Four of the 23 ECB governing council members – including the key vote of the German Central Bank chief – are against bond purchases.  

And it’s divisions like that which have been exploited by the markets.  

The options for the euro are now becoming clearer.

First the countries backing the EFSF can pour more money into it.  It is expected to have a fund of around $630bn but it needs around $2.8 trillion if it’s to cover the debts of Italy and Spain, which is also considered at risk.  That is thought to be unpopular and unlikely.

Or there can be full fiscal integration across the eurozone. The euro was always a political project rather than a financial one. Full integration would mean a centralised financial policy implemented across the continent, a loss of sovereignty over financial matters for many capitals and in the current climate, severe austerity measures which would be deeply unpopular.

This would create a new European finance ministry and as the strongest economy, Germany would have to pour huge financial resources into it and give it enough clout to guarantee the debts of eurozone countries. Getting all 17 members of the eurozone to sign up to that seems highly problematical.

Another alternative is scrapping the Euro altogether.  That would be extremely expensive and have huge implications for the banking sector which has massive exposure to eurozone debts. A huge injection of funds would be needed to stop a run on the banks. Some analysts believe the Germans regard this as the less expensive long-term option.

For 18 months, every decision taken to safeguard the euro has been largely a political one as leaders and finance ministers try to decide how far they can go without losing massive support at home. And that had led to fears about Europe’s ability to get ahead of the crisis and deal with it rather than react to events. It’s become known as "kicking the can down the road".

The austerity cuts, so beloved by central bankers and financial institutions, almost always mean higher taxes, a more expensive cost of living, poorer public services and job losses; millions of job losses. That hits the prospect of growth in economies, which in turn generates fears of recession or depression. Macro economics is about large numbers and large concepts – and it’s easy to forget it affects real people and real lives.

Originally published by Al Jazeera on August 8, 2011 under Creative Commons Licensing 

HUMMONEY - The Crisis of our Confidence (Perspective)

--By Greg Lewin

 “Nothing is more dangerous than an idea, when it is the only one you have.”   Emile August Chartier

As the financial crisis unfolded and policy actions were chosen the mission was clear: increase economic activity, repair the housing market and get people back to work. Step One involved the transfer of many of the troubled assets (bad decisions) from the balance sheets of the banks to the balance sheets of the federal government. Step Two was to institute a series of stimulus measures which included numerous tax incentives and some make work projects. Step Three, called QE2, involves a two part process ultimately leading to the injection of money into the stock and commodity markets to create what is called the wealth effect in the hope of stimulating spending and therefore growth. We have written about these subjects in the past and encourage your review should you wish more detail. Although this story has been broadly reviewed, we suggest one important subtlety has often been overlooked - the use of leverage as a deliberate policy choice.

In Step One assets flowed from the banks to the government, thereby deleveraging the banks. Now as assets are flowing back to the banks in Step Three, in the form of cash, the banks are once again free to employ the leverage they were unable to use when burdened with troubled assets. Federal Reserve policies have essentially lowered interest rates to zero, forcing investors, including banks, to seek returns in more speculative assets, such as stocks and commodities, rather than fixed return instruments like bonds.  The basic business model of all banks is the liberal use of leverage, which has generally ranged from 10 to 30 times their capital bases.  So now after capital was recycled from the banks (who were burdened with troubled loans that could not sustain more leverage) to the government and back again to the banks essentially in the form of cash, the banks are able to back the deployment of this cash into the stock and commodity markets with their customary leverage.  As if by magic, leveraged capital is thrust back into the markets without repairing any of the problematic assets that were the genesis of our problems.  It should become a little clearer why the markets have exhibited such consistent strength since the inception of QE2. We have once again employed our traditional weapons of leverage and speculation to address our financial problems.

But the magic does not stop there.  The market operatives can apply a special sauce to effectively increase their leverage on market behavior to create the results they desire. One of the fascinating features of financial markets is the power of the marginal dollar. What does this mean? Let’s use the stock of IBM as an example. IBM has a market capitalization of over $200 billion and trades approximately 4 million shares per day. At a price of $160 per share that suggests 4x160 or $640 million of stock trades on an average day, or 0.032% of the total value of the company.  Yet consider how often you see IBM change well over 1% and on occasion as much as 5%.  This impact on the overall value of this gigantic fixture of American business is as much as 30 to 150 times greater than the proportional value of the shares traded. How can this happen? It is beyond rare that any single piece of information that could possibly arise on a given day could alter the destiny of such a large and great company to this degree. Because the vast majority of shares do not trade on any given day or for that matter series of days, the point being made is that marginally traded shares have incredible power over the fundamental value ascribed to businesses of any scale. Let me assure you our 30 to 150 times example gives us ample room to support our assertion should we be referencing days of unusually large volume. And this is by no means fictional value. The price of one’s shares can impact the cost of raising capital, the ease of recruiting and retaining employees and the ease of gathering new business as a strong stock price influences the perceptions of customers regarding the health and vitality of an institution. To further add to this brew I can also share that the way the Fed advertises when it injects cash in the system allows sophisticated traders to create the vast portion of the stock price move for the day in very small windows of activity. So often this marginal dollar impact is not a matter of the daily shares but a few minutes of the day’s volume and shares making this marginal dollar effect that much more powerful. As a final point let’s add one last twist. What if instead of just buying stocks and commodities our new speculative dollars go into futures contracts, each of which represent hundreds of shares of the underlying assets being traded?

Well you get the point.  Our government has once again figured out a clever way of using financial markets to try to repair fundamental problems. You might argue that no one seems to get hurt and maybe it will help us get out of this mess. If we are lucky that may be the case, but a lot of us were taught that you usually don’t get something for nothing, and this is where the laws of unintended consequences sometimes raise their head, otherwise known as Black Swans. In this case, one could argue that is exactly what we are beginning to see, because along with QE2 we have seen the enormous spike in commodities prices across the board from agriculture to energy. And it is these very spikes in costs which have pressured the costs of living around the world that may have been a catalyst to the activities we are now seeing spread across the Middle East. So my caution remains, beware when you have one idea, especially one which has such a dubious record of success. 

 ---The views expressed here are of the author, HUMMoney contributor Greg Lewin; currently a General Partner at TLF Capital, an investment management firm. During the past 26 years he has been a senior money manager or partner in Wall Street firms including Neuberger Berman, Charter Oak Partners and Sailfish Capital.

HUMMONEY - Disappointing Realities (Perspective)

I want to bring to your attention some important findings from a recently updated report released by McKinsey & Co. regarding the accuracy of Wall Street analysts’ earnings forecasts. The following remarks should prove instructive:

• “Only in years such as 2003 and 2006 where strong economic growth generated actual earnings that caught up with earlier predictions, do forecasts actually hit the mark.”
• “When economic growth accelerates the size of the forecast error declines; when economic growth slows, it increases.”
• “Moreover, analysts have been persistently overoptimistic for the past 25 years, with estimates ranging from 10 to 12 percent a year, compared with actual earnings growth of 6 percent.”
• “… long-term earnings growth for the market as a whole is unlikely to differ significantly from growth in GDP, as prior McKinsey research has shown.”

So what should we learn from these points?

• Analysts’ forecasts are highly inaccurate. An additional caution that can be deduced is the questionable accuracy of company forecasts, which are the primary source of analysts’ information.
• The accuracy of forecasts declines as GDP slows. It’s a lot easier to be right when things are not so tough. 
• Corporate earnings highly correlate with GDP.

To incorporate this information for today’s world, we know that in the recent economic cycle GDP peaked in 4Q09 at 5.6% then declined to an estimated 2.5% in Q3 2010. Economic statistics thus far reported for the fourth quarter point to another quarter of deceleration. If this is the case, investors should be wary of earnings forecasts which paint a cheery picture. Realities may prove to be quite disappointing.   

---The views expressed here are of the author, HUMMoney contributor Greg Lewin; currently a General Partner at TLF Capital, an investment management firm. During the past 26 years he has been a senior money manager or partner in Wall Street firms including Neuberger Berman, Charter Oak Partners and Sailfish Capital.  

HUMMONEY - Preaching to the Choir (Perspective)

- by Greg Lewin

I have been told by some pretty fancy preachers that if you want somebody to get the message make sure you tell it to them 3 times. Now think how often you have heard, “If we hadn’t taken action our economy, financial system and our nation would have been in deep trouble”, or possibly, “Our swift action helped us avoid the next Great Depression.”  Well if the preachers are right your antennae should be way up because someone wants you to buy what they are selling.

Let’s look a little closer on how and why this speech making device was and continues to be used so regularly. If you were a strategic thinker, let alone a political strategic thinker, you would want to construct a game you couldn’t lose.  Now how might you swing such a slick maneuver? Let’s say there is a choice to be made between A or B. This would mathematically calculate that you have a 50:50 chance of success. To improve your odds you might engage in some sort of study to aid in making the best choice, but maybe you are insecure enough that research alone does not give you the edge you desire. Maybe, if you are a little crafty, you decide against more research and turn your attention toward actively depreciating the choice not taken. Now if you can accomplish this, think how the odds of success might change. If you actively kill the choice not taken, then if your choice is correct you win but if your choice fails it is no worse than the choice not taken, or at worst your failure is neutral. Now that is a much better game. So investing your energy in the non-choice can be a far better strategy, in certain fields of endeavor, than investing time and energy in the research driven choice. Sound familiar? So our government and assorted luminaries took action and selected massive financial warfare to combat this recession, as they simultaneously invested considerable time and effort in explaining the risks of inaction.

Even though you may now know the game they are playing, it still may be reasonable to ask, should you buy what they are selling? After a brief review of the outcomes I believe the answer is clear. Did they think that 1 ½ years following their initial important policy decisions we would still be burdened with record high unemployment, home foreclosures, personal bankruptcies, federal debt and Wall Street  profit, to name just a few unintended consequences?  With this tremendous record, do you think it deserving that we concede 20:20 vision to these policy makers regarding the consequences of the road not taken?

Whenever you engage in a game where someone else can’t lose that probably means you can’t win. As an investor it serves you well to repeatedly analyze your assumptions and carefully separate facts and opinion. Because in the investment game you only get credit for the decisions made and the only insurance against loss is to align yourself with an economic reality that validates your decision. Simply stated, we play in a world of win and lose and we use research to improve the ratio of risk to reward. All else is just preaching to the choir.

 ---The views expressed here are of the author, HUMMoney contributor Greg Lewin; currently a General Partner at TLF Capital, an investment management firm. During the past 26 years he has been a senior money manager or partner in Wall Street firms including Neuberger Berman, Charter Oak Partners and Sailfish Capital.