Monthly Archives: June 2012

Macro Focus: Europe’s Version of Let’s Make a Deal?

Fri, JUN 29th, 2012

Today’s EU news is big, especially in that it signals leaders understand the problems and are willing to coordinate a response to keep it from spiraling out of control. Likewise, it also suggests that Ms. No-Eurobonds-While-I’m-Alive doesn’t hold all of the cards in this game. Spain and Italy matter. And they have something Greece never had: Weight.

Here’s the quick rundown of the “deal.” Wait. Perhaps we shouldn’t call it that. At this point, they’re more like guidelines.

ESM bailout funds will not subordinate private bondholders, this is good because being put into second and third creditor status has to, some degree, kept private investors out of the capital markets and this decision changes that

ESM bailout funds will not add to sovereign debt loads because they will go straight to recapitalizing troubled European banks as opposed to channeled through the sovereigns

ESM bailout funds may come with little-to-no strings attached, which is good because past Trokia conditions [via govt bailouts] meant austerity [a self-defeating cycle in a recession]

ECB will act as an agent and purchase bonds on behalf of the ESM basically giving the ESM direct access to the ECB printing press

It goes back to what we’ve been saying for many months, for all of their bickering, silliness and divisiveness, EU leaders know/believe that more Europe with a common currency [even with its challenges] is more economically beneficial to the region [and the world] than allowing it to break apart. The challenges are great. No, they’re huge. But the core doesn’t want to give lifelines away for free — a noble pursuit. That said, the costs of dissolving the monetary union are bigger. They’re incalculable. Germany gets that. Thus, markets [most pointedly when in risk-off mode] have consistently underestimated EU leaders’ willingness and resourcefulness to act.

That said, I do think there are a number of hurdles left to leap: German parliamentary ratification and unanimous EU approval, which includes Finland; exact ESM structure and available funding resources; ECB offering support; clarity on the funding assistance chiefly whether there are truly no Troika conditions; the possibility of a required legal makeover to implement these changes. And these hurdles are just top of mind. It’s likely many others will follow.

Oh, FYI – the ECB has a policy meeting on July 5th. Perhaps we get more clarity on their role here, and perhaps we get a rate cut as a sign of their willingness to play ball [1% —> 0.75%]?

What’s more, the ESM itself still must be ratified [although I do expect this to happen] before it can officially begin operations [expected July 9th]. So in other words, at present, this deal is all built upon a bailout facility that doesn’t legally exist yet.

OK. Assuming everything goes to plan: Deal terms receive full EU approval; ESM is officially given the green light; little-to-no Troika conditionality; ESM truly doesn’t subordinate private bondholders with some backdoor clause; and ECB affirms support making its printing press available, the earliest we could see an actual EU single bank regulator [to oversee ESM, mutual banking, etc.] would likely be Jan 1st, 2013. Therefore, the ESM won’t be able to actually start this new plan until then.

Six months is a life time in today’s market climate. Even if we do in fact achieve most of these things [which is my baseline scenario] that doesn’t mean all is now saved today. No. The market will continue to be whipped around over the short-term by headlines out of Europe calling into question details of the guidelines deal.

In addition, still-soft US macroeconomic data will probably continue to do its naughty little part as a stock market destabilzer. For now. Second quarter earnings seasons officially kicks of on — guess what! — July 9th. We will get a better picture of the health of the business cycle then. This is every bit as important, perhaps more so, than any short-on-details “deal” EU leaders can conjure up.

Jason L. Ware, MBA
Market Strategist, Chief Analyst
Albion Financial Group
(801) 487-3700; (877) 487-6200

Macro Focus: To QE or not to QE, That is the Question.

Tues, JUN 26th, 2012

Whether ’tis Nobler in the mind to suffer, The Slings and Arrows of outrageous Fortune, Or to take Arms against a Sea of troubles …” Bill Shakespeare once opined.

Often discussed, debated, and over-analyzed is what arguably is the quintessential and most pressing economic question relevant today: Is QE [quantitative easing] working to assuage our Sea of economic troubles?

To some extent.

Unmistakably, these monetary programs had more punch to both stocks and the real economy in the first two iterations. It certainly seems that the more numbers you add to QE the less thrust it has. Many ask if Fed intervention is the right step. Regardless of whether it’s right or wrong, it’s necessary medicine. To be sure, you cannot cure a debt crisis with more debt, but you can buy time [cliche alert: kicking that can down the road] while policymakers [hopefully] implement pro-growth structural reforms. To wit, the only way to cure a debt crisis is with economic growth. Fed policy makers are doing the best they can given a bad situation.

The real problem is the transmission mechanism. The Fed is pushing against a string here. U.S. banks have tons of liquidity, it’s the transfer of that cash into the real economy via lending [credit creation] that is the problem. Banks aren’t eager to lend, and to be completely frank there isn’t much new loan demand for revolving lines anyway — the kind of credit that provides a boost to continuous purchasing power. We are in the throes of a deleveraging cycle and you cannot force more food down the throat of the stuffed buffet patron. They have to want it.

So we’re left to wonder: What’s the Fed’s strategy here? It’s not a pleasant answer, but it’s all they’ve got — the wealth effect. Bernanke believes that as more money is pumped into the system [even with a broken transmission] market participants must follow suit and sell safe havens to buy stocks [old Wall Street adage: You can’t fight the Fed]. This nudging of investors along the risk curve causes stock prices to rise and thus households “feel” more wealthy. This feeling, the thinking goes, results in increasing consumption patterns [demand], which helps keep the economy humming. Many do not believe this wealth effect actually happens. I, too, am skeptical based on the premise that most economic studies — including our own research — demonstrate that people make the bulk of their purchasing decisions on their “permanent” income streams [e.g. salaries and wages] not on transitory fluctuations [like stock prices]. Rising stock prices do very little to change the underlying stream of cash flows.

So what’s the point?

While I believe the wealth effect offers very little long-run benefit, it does seem to ever-so-slightly alter consumption over the short-run. Studies have consistently shown that a 1% rise in stock values can add an ephemeral 0.04% to GDP growth. I argue, however, that this is not because people actually feel wealthier, but rather it’s because so many use the stock market as a quick gauge of the overall health of the economy. Consumers don’t spend money on a good or service because the value of their 401k is up. But, if the market is rising the conclusion drawn is that the economy must be doing OK and this psychological reprieve can influence small short-run decisions. Therefore, while the bulk of purchases are tied to salaries and wages, there can be a marginal effect to goosing stock prices. Therein lies the benefit for QE. But how given this anemic and short-run response?


The long-run is but a string of short-runs and broad stock market reaction to the last three Fed programs resulted in bold run-ups [mean increase of 47%]. Undeniably, QE1 offered an outsized portion of this. When stripping out QE1 the resulting mean is still a spirited 30% [median, 33%]. Under the assumption that the relationship has held-up post-2008, nearly 1.2% of additional GDP growth was forged with each program. The Fed likely believes [or clearly hopes] this correlation remains given its current approach to policy. Under the assumption that another QE program bestows upon stocks the unbroken trend of positive but diminishing returns, say something like 15-20%, this could theoretically produce 0.6-0.8% of GDP bump. While it isn’t much, it’s something. It’s not contraction. It’s not complete loss of economic momentum. It’s not falling sentiment. It’s not deflation.

These alternative outcomes would likely be the result if they simply did nothing [as many advocate]. But, they won’t. They cannot sit on their hands while their dual-mandate of price stability and employment implodes. They can print, and without imminent fear of run-away inflation due to above-trend resource slack in the economy — especially in labor, but also in fixed-asset utilization rates. This notion has been validated by a nearly $2T [yes, trillion!] expansion in the Fed’s balance sheet since 2008 yet inflation has persisted, for the most part, under the 2% target set by the Fed. Until this resource slack tightens the Fed has bullets and they will fire them as they see fit.

The Fed surely cannot leave our economic fate with Congress in hopes of a fiscal solution. That’s about as reliable as allowing kids to grade their own homework. Nope. What Bernanke & Co. must do is something, and this infinite-QE something is the strategy they choose to target given the available resources.

How long must we ride this wave?

Could be many years, but nobody really knows for sure. To paraphrase Bill Gross: We are in quicksand and the Fed is on dry land extending a hand. This is a long workout and high economic growth [>4% real GDP growth] and dependable double-digit stock returns are likely a thing of the past. At least for the foreseeable future, anyway.

Jason L. Ware, MBA
Market Strategist, Chief Analyst
Albion Financial Group
(801) 487-3700; (877) 487-6200