We thought it would be fun to put together a virtual round table discussion featuring three hypothetical investors spanning the globe-- one Asian based (Asia), one European based (Euro), and one US based (USA). Each jurisdiction has its own particular set of local issues, and we thought it would be fun to try to compare and contrast how a hypothetical sophisticated institutional investor from each of these jurisdictions might look at the world, in terms of both similarities and differences. Here is our attempt to do so, we hope you enjoy!!
Charles E. Johnson (CEJ), Managing Director of Tano Capital LLC, a global alternative investment management firm, is the host of this fictional round table discussion.
(The characters Asia, Euro, and USA are entirely fictional; any resemblance to real or living persons is unintentional and purely coincidental.)
CEJ: Welcome gentlemen!! I am delighted to convene on behalf of Tano Capital the first “virtual” annual global outlook round table discussion, spanning the globe from Asia to Europe to the US! Mr. Asia, why don’t you lead us off…..what if anything, is causing you to lose sleep in the global markets these days?
Asia: One of the biggest challenges for us is to try to figure out how the US Europe and Japan are going to meet their future entitlements commitments, e.g. how are they going to deal with them going forward? I am very worried about what the developing governments are going to do in the face of all the developed world’s liabilities.
USA: I don’t think it will be very easy. I have a theory, it’s all going to be resolved by inflation, significant inflation. I think the only reason the US hasn’t already had significant inflation is that the economy is not that good so there’s no demand, and as soon as we get some demand and the economy starts to pick up, we are going to have massive inflation. That’s the only way out.
Euro: For that scenario you have to make two assumptions, one is that the central banks get disenfranchised, one way or another, either by changing their legal mandates or putting in puppet chairman, or by simply putting so much political pressure on them that they somehow acquiesce, and allow rates to rise far above the inflation rate. The second assumption, which I find is even more difficult to maintain, is you then have to assume that you have enough financial repression power so that interest rates don’t run away from you. I don’t see how you could engineer a solution without having interest rates just run away from you, so at the end of the day, whatever you gain by this tactic, you end up paying more than you would save due to higher interest rates. As soon as the market anticipates this, I don’t see how you can win that battle. Of course the combination of financial repression, so the market doesn’t operate efficiently anymore, and high inflation would be the worst case scenario. How do you see that Asia, do you think, assuming we could get the central banks out of the way, do you think you could successfully run the inflation policy without disturbing interest rates?
Asia: I think you must not underestimate the ability of the central banks to repress interest rates, in the US and the UK. I think USA has a very interesting point, once the economies start to pick up, rates will begin to rise. Right now inflation is running about 2.6%, according to the CPI, and US treasury bonds are less than 2%, so the thing is if inflation in China picks up, what is the Fed going to do? My sense is that the Fed will continue to repress interest rates, but how long can the Fed do that successfully? I’m very concerned, as over the last ten years, a very unusual phenomenon has arisen, in that the correlation between bonds and equities is -0.8%. In the previous ten years, the correlation varied between +0.4% and - 0.4%, so a lot of portfolios are constructed based on this newer -0.8% correlation. So a lot of sovereign wealth funds and pension funds are loading up on fixed income even as interest rates are going down, and even as real rates become more negative. Let’s say suddenly the bond markets tank, (which I don’t think will happen any time soon because of the current repression policies) if they lose control, and there is panic in the bond markets; with all the portfolios that are over exposed to bonds, you could see a very serious bear market developing in fixed income. That is my concern, that a lot of portfolios are constructed around this more recent aberrant negative correlation number of -0.8%.
Euro: If the market were to smell an inflationary policy, governments would witness such a spike in interest rates that the funding costs would rise faster than they could run down your debt through inflationary policies, unless you are able to engineer tremendous repression, far beyond what we are seeing at the moment. It’s also not just the correlations that are a problem; we also need to consider the regulatory regime. If you look at insurance companies, they have been pushed increasingly into fixed income from a regulatory perspective, and the low current rates are making their lives that much more difficult, with longevity going the other way on top of that. They are being required to hold large bond positions by the regulators and have no choice.
Asia: This is the same kind of situation we experienced with portfolio insurance before the market crash of ‘87. As the price goes up, you buy more and more, and then when the party stops, you have to get out all at once.
CEJ: So let me ask this. How far or how large theoretically, could a central bank expand its balance sheet? What is the limit? We’ve seen a doubling and a tripling in the US in the last five years, is there a theoretical limit?
Euro: Well, the US and the ECB and the Bank of England now are running at about 10% of GDP in terms of balance sheet, roughly. In some cases, we have seen numbers much larger than that. So, there’s still a long way to go in theory. You could however imagine a scenario where the political system says enough is enough. Arguably, we are seeing some of that in the US.
CEJ: How do you see Japan, what is the end game in Japan, they are probably the most levered, and they apparently have the worst demographic problem?
Asia: Japan will probably be the first test of this, the amount of debt outstanding is so huge, that I don’t see how the government or the policy makers can allow a sharp rise in interest rates. You are going to see a very major quantitative easing (QE) by the Japanese. So, what it means if they were to embark on that, it would have an effect on their exchange rate. I think therefore that the Yen is very vulnerable, I think the Japanese would rather intervene very massively, and suppress the long end of the curve going up, and in the process the Yen would weaken and they wouldn’t mind. The first 20 movement, from 80 to 100 would make them very happy. I’m watching that situation very closely.
Euro: Don’t forget that all their debt is held domestically, so in an extreme situation, you could use other means of repression internally.
Asia: If that happens, then the Japanese banks are really in trouble, since they own so much Japanese government debt.
CEJ: Is there any scenario where you could see the Japanese repatriating some of their huge FX surplus, which is approaching 2 trillion Dollars? Wouldn’t that then cause the Yen to strengthen, and isn’t that a big risk to shorting it?
Asia: No, no, I think the first priority for them is to keep long term interest rates from going up, since if you move from 1% to 2% it’s a very big deal in terms of debt servicing; the second priority is to get the economy to grow again, because they are in deflation, so I think the policy of intervening massively, to repress long term interest rates makes a lot of sense for them. So far they have resisted doing that, but I think they will become very aggressive if the bond market comes under pressure, and then the currency will weaken.
Euro: When the Swiss began talking about putting a floor under the Swiss Franc last year, the big concern was what is this going to do to as a signaling effect to the Japanese? The concern within the G7 was not so much the Swiss, it was understood, they had a particular problem and didn’t have a bond market so they couldn’t do QE and they needed to do something; but the big concern was if this works, could it encourage the Japanese to try to do the same.
Asia: Certainly, that probably explains why the US Treasury recently publicly criticized the Japanese for intervening to prevent the Yen from strengthening beyond 76. It seemed to me unusual at the time because in the past, the US and Japan have worked things out in private. My guess is that the US felt if it appeared to condone the Japanese intervention to weaken the Yen, it would be difficult for them to continue to maintain pressure on China to strengthen the Renminbi.
Euro: There is a big difference, if you look at a long term chart of the real effective exchange rates, you will find remarkably, besides the very high nominal level of the Yen, the Yen’s real effective exchange rate is currently pretty much at its long term average. The Swiss case is clearly different. Last year, the Swiss Franc was literally off the charts, around 30% above the long term average going back to the 1970s.
CEJ: I have another question. How come the Euro remains stubbornly pegged around $1.32? Why hasn’t all the turmoil in Europe caused it to weaken more, which would seem to be the intuitive way things would work?
Euro: I see that as a big problem. It seems to me to optimize the chance of Europe muddling through with the current course of action by way of a substantially weaker Euro, say around 20%. The question is how do you do that?
USA: So, who’s supporting the Euro?
Euro: Well, I guess the market is telling us that there is also a lack of appetite for the current alternatives. If you take that same chart of real effective exchange rates, the Dollar is very close to its all-time historic low on a real effective basis. I think the way you take some of the pressure off in Europe is to see a substantially weaker Euro against the Dollar. It would serve the US in getting it away from that very weak level of the exchange rate, so you buy some insurance against the inflation scenario kicking up too quickly, and you get some stimulus in Europe with a much weaker exchange rate. I think that would actually suit everyone. With the US economy doing what it is doing now, I don’t think the US economy would suffer all that badly if the Dollar strengthened significantly. It would also put some dampening effects on inflation. I think that’s the trade, although in the last few days it’s been going in the other direction.
CEJ: Still, who is buying the Euro now? Why is it strengthening? If I’m a central bank, and I hold different currencies, and watching what’s developing in Europe, Spain, Portugal , Greece etc., possibly heading for a train wreck, why would I hold Euro instead of Dollars?
Asia: The Eurozone is broadly in balance in terms of its current account, while the US is running massive deficits.
Euro: German bund yields are at 1.6%. That tells you where the money is going. I think there is a massive rush into German fixed income. Germany is growing at 4%; the yield is at an all-time record low, so you have the big portfolios shifting from the periphery into the core.
USA: I think the fiscal situation overall in the US and Japan is pretty bad, and that’s certainly got to be weighing on those currencies versus the Euro. The countries who don’t have such problems and whose currencies are more commodity based have been doing very well, such as the Canadian Dollar, the Australian Dollar and the Norwegian Krone, and they will likely continue to appreciate versus the fiscally sick countries over the longer term. There certainly have been funding problems within the Eurozone, forcing probable repatriation of overseas funds back into Euro as well.
Asia: I recently looked at a large global bond hedge fund manager’s portfolio. His 10 year track record is on average up 11% per year, which I consider phenomenal for the current macro environment. If you look at his portfolio, he is cumulatively short the US, developed Europe and Japan, and long the Asian currencies, Malaysia, Taiwan, China, Singapore, some Eastern Europeans and some of the South American currencies. Over the last 40 years, the currencies that had it tough were Sterling and the US Dollar. First people shifted from Sterling to the Dollar, but quickly came to the conclusion that even the Dollar was also going to go down, so at that point the trade became buying the Deutschmark, the Swiss Franc the Japanese Yen and gold. I really think going forward over the next ten years all these currencies must go down against this basket of emerging markets currencies, much as the Dollar and Sterling did against them in previous decades.
CEJ: The emerging markets don’t have the bad debt problem either.
Asia: Until the global imbalances get resolved in some way over time, part of the solution has got to be that this group of currencies appreciates over time versus the developed world.
USA: That’s why I think the only solution for the Dollar and the Euro longer term is inflation.
Euro: Again, I remain skeptical about this. I think there is another route, which could be much more unpleasant and very dangerous. And that’s simply that we will end up seeing debt restructuring in a number of major economies. Of course, this would have very far reaching implications for markets, as it basically means we lose the anchor of the risk free rate, at least partly. If you assume the high inflation route will not be available or not possible either because it’s not politically feasible or that central banks will act to defend price stability as they are mandated to do; then you are left with either very significantly augmenting growth, which is going to be pretty rough, or fundamentally altering the existing social contract in most western economies. Of course, we know how incredibly difficult this will be from a political standpoint. Failing that, you will have to begin to consider debt restructurings for which, incidentally, we currently have no orderly international mechanism.
USA: Well, if we continue to run trillion Dollar deficits, it’s only a matter of time before we either inflate or default, and I think they would inflate before they would default. I don’t think the government can control it at that point, that’s all I’m saying.
CEJ: What do you think about the Renminbi, and it becoming convertible sooner than people think?
USA: I think it’s pretty obvious that the Renminbi has to be a strong currency, and that it’s only a matter of time before it becomes convertible.
Asia: But why would they want to do that? You’ve got to figure out, how is it in the Chinese’s self-interest to open the capital account, to have the financial system more vulnerable, to international flows… I think they will postpone it for as long as possible.
Euro: That’s the reason they have such remarkable stability in the FX markets, right? The obvious trade at some point, is what Asia said (short developed markets currencies, long emerging markets currencies) but at the moment that can’t happen because there is no alternative to the Euro and the Dollar, on a large scale, and because both the Dollar and Euro are more or less in the same camp, ……. So you have this frozen stasis in the FX market, which I guess will stay that way until there’s enough convertibility to offer liquid alternatives in the emerging world.
CEJ: In 2009, Premier Wen came out and made some noise about setting up a global central bank to issue global currency; I guess along the lines that Keynes had proposed in the 1930’s with the “Bancos”. The US initially seemed OK with this, but shortly thereafter backed off very rapidly, as it would obviously not be in the interest of the US to do that. Do you think this is a feasible long term solution, or is this just a pie in the sky proposal with no chance?
Euro: I think realistically we are a very long way away from that.
USA: Aren’t there some advantages to the country that issues the global reserve currency?
Euro: Yes, many.
USA: Then why wouldn’t the Chinese want to take over that role? Wouldn’t China benefit economically from being the issuer of a global reserve currency?
Asia: When you need to finance an external deficit, then it makes a lot of sense. You are the reserve currency, so it makes it much cheaper to finance a deficit. Sterling was a reserve currency…
USA: Is that the only reason to be a reserve currency, to finance a deficit cheaply?
Asia: You have a deficit, so having people hold your currency makes it cheaper to finance your standard of living. The Chinese are not in that situation, and I don’t think they will be for quite some time.
Euro: You basically have cheaper funding. Safer and cheaper funding.… They also know that if they go convertible they will immediately face sudden and significant appreciation. It wouldn’t be a great place to be for them.
Asia: As long as they have a current account surplus, they won’t want to be the reserve currency.
Euro: That’s by the way, the reason why the Germans behind all the rhetoric don’t want the Euro to fail. If this was to happen, they would have immediate and significant appreciation, and they are still very much an export driven economy, albeit by way of high value-added goods.
CEJ: So if that’s the case then why has China recently made some fairly visible liberalizations in Renminbi convertibility?
Asia: They really haven’t done that much. I know of some groups that have been trying to increase their QFII quotas for some time, and they have been very, very slow to respond.
CEJ: Yes, those A shares look pretty cheap right now. Another question, why do you think P/E ratios are contracting globally?
Asia: In China?
CEJ: Seemingly everywhere. Have you looked at a long term chart of global PE ratios lately? They all seem to be contracting. Any ideas why?
Asia: There are some worrying things, for example this transition that China is going through, from 10% growth and 2% inflation, to 8% growth and 4% inflation. You are seeing the effects of debt in earnings, earnings growth of Chinese companies is negative and it means there is a lot of operating leverage in the system, which is why the stock market is coming down in China.
USA: I didn’t realize earnings were coming down.
Asia: Well, in China they are. Earnings growth is negative. You are seeing the effects of that. The Chinese companies have very high operating leverage, and many of them are increasingly financially levered. So when you have both, any slowdown or decline in top line revenue, has a very strong influence on the bottom line.
CEJ: In the US, earnings are pretty robust, certainly margins are very robust, yet PE’s are falling.
USA: US companies have a lot of cash, and aren’t earning anything on that cash in the current rate environment.
Euro: That may be one of the reasons why PE’s are lower.
Asia: Profit margins in the US are at an all-time high, as is the profits share of the national income. People may expect, that going forward, labor will want a bigger share of the profits, and may also be anticipating that the government will increase taxation. I’m frankly puzzled why so many American companies are holding so much cash? They are not investing, is it a lack of confidence?
USA: There’s very low growth, and there’s great uncertainty about the future. If you look at what’s happened in the last few years, the US federal government has bought lawsuits against almost every industry. The government acts like it has a vast distrust of the private sector, and so they are looking for opportunities to sue for alleged illegal practices, so it’s just not a good climate for companies, and companies just pull in their horns and don’t invest any more than they absolutely have to.
Euro: At some point, you would think as the cash keeps building the ‘animal spirits’ would kick in and they would start re-investing…
USA: Well, it hasn’t kicked in yet. The federal agencies are just churning out new regulations which increase companies expenses…. the banks… in fact, both JP Morgan and Wells Fargo’s last earnings reports were disappointing because their regulatory costs have increased so much. And that’s just the start of it. I think there’s great uncertainty as to what’s going to happen, and I think that’s why people are cautious and not willing to expand.
Euro: So how does the US fix the problem?
USA: We have to back off on regulations. For example, there is a completely new agency that comes in in 2013 which is to be funded by the Federal Reserve, has no congressional oversight and has no limit on its budget. It doesn’t go through congress; it can hire and expand as much as it wants, or as much as the Federal Reserve wants it to.
Euro: Is this the systemic risk board or the systemic risk council?
USA: The Financial Oversight Board, they just have a license to regulate, and people have no idea what they are going to do. They can come in and regulate fees; they told the banks how much they can charge on overdrafts, as well as other various services. In effect, it’s almost a de facto nationalization of the US Banks.
Asia: There’s no doubt it’s a very challenging world for investments right now, when you have government bonds where they are, and you have inflation sort of rearing its head going into the future, I think the only thing you can settle for is probably with companies having strong balance sheets and good yields, which will give you the best way of navigating through all of this.
USA: I think that’s right. One of the reasons the stock market has been pretty good lately is because you can’t make any money in government bonds.
Euro: To buy bonds or gold at this stage, you have to be a pretty brave soul.
USA: I’m not so sure that gold has seen its top yet.
Euro: Still, if you haven’t been in it, would you buy it at these levels?
USA: It’s chancy, I admit. It also seemed hard to buy it at $1,000 not too long ago though.
Asia: I read a very interesting street research piece recently. It makes a very interesting case that the oil price is the new interest rate. What it means is that because government bond yields are being repressed artificially, we have lost a signal of where real interest rates are. And so it says the more repression we have, the more liquidity that comes into the system, and that liquidity is not going to go into the real economy, but a lot of it goes into oil. And it says what then happens, as the oil price hits certain levels, say $140 per bbl., it cools down the economy, as oil accounts for about 8% of total expenditures for a lot of the big developed economies. So what it was proposing is that there is a lot of new money flowing into the oil market, Brent crude is now the new benchmark, and once it reaches $140 or so it will act in the same way on the economy as raising interest rates used to.
USA: Yes, I think that’s true. That’s a very interesting way to look at it. I also wonder as a corollary to that, when is natural gas going to replace oil? There are a lot of vehicles, buses etc. being changed over to natural gas…
Asia: Do you think that natural gas and shale oil and shale gas has the potential to allow the US to become energy self-sufficient?
USA: It does, if the environmentalists would get out of the way and let things develop. The environmental lobby is so powerful it’s basically blocked a lot of new potential development. The senator from Alaska was being interviewed today on TV, and she said the US actually has 26% (she’s including shale and some other stuff) of world supply of oil and yet we are still not self-sufficient, and it’s because the environmentalists have tied up drilling and exploration. In the arctic, the naval reserve is supposed to be bigger than the North Slope, yet we have never even drilled one well. It’s out of bounds for any drilling at this point. Then you’ve got shale, heavy oil, and heavy oil sands. North Dakota is now one of the major producers of oil in the US.
Asia: If the US could become energy self-sufficient, it would have huge implications for policy.
USA: True, but it’s never going to happen in the near future.
Euro: Asia, how do you see the end play in Europe?
Asia: Who in their right mind, would want to buy French Government bonds at 3%?
Euro: Even if things were going well, that would be a good question…….. That’s the problem, it is just not clear from here where any incremental large scale buyers will emerge from.
Asia: I think the reason why the markets are relatively benign, (although of course Spanish yields are going up), is that I think they will progressively move to the Germans and do some form of a Eurobond type of financing. I think that’s the assumption people are coming to. Don’t you think so?
Euro: Well, I would put it this way. Germany might ultimately be prepared to take this European Union project to its political conclusion with some form of common finance ministry and some form of common financing. The problem is that there is deep sense in Germany that the only way to do that is to essentially force the peripheral countries to become more like Holland, Germany and the Nordics. You can think of it as a kind of arm twisting strategy where you don’t reward anyone that doesn’t become fiscally and structurally virtuous. Therefore, the periphery countries need to change, they need to become more like the center countries. So the question is, whether you can bring them along, or whether at some point you have to leave some behind and just complete the project with like-minded countries. The way I see it is that at the moment, you have a sort of policy incrementalism towards that strategic view.
CEJ: Is it politically feasible? Will the German people sit still for that?
Euro: I think with the proper leadership they probably would, but they are going to extract a pretty heavy price out of the periphery. I think the question is more whether the periphery politics will allow that price to be extracted. Obviously, the risk is that from a political perspective, they reach a point, where they say: we’ve had enough, it’s not worth it. That’s the point of maximum risk.
CEJ: To your point, Greece, which appears to be in a total political meltdown, could potentially in the near future elect an extreme right wing or left wing government which probably would then repudiate much of the austerity measures already agreed to… what happens then?
Euro: I think in a case like that, there will probably be no other choice left but to let them to their own fate, something which, of course, was simply not meant to happen in the original design which was conceived as a solidarity union and a union of destiny.
CEJ: They just cut them out?
Euro: Well, they will essentially be left behind. The real and big question then, is what happens in Spain and ultimately in France. Ultimately, France is the real lynchpin.
USA: Will France go along with Germany; I can’t see that happening unless their back was to the wall?
Asia: After May 6th, the upcoming second round of the French elections, market prices are long Ms. Merkel. I think, at least over the last two years, during the Eurozone crisis, although Merkel and Sarkozy didn’t always see eye to eye, they have always been able to patch up their differences. And come out with a more or less a unified position. After the new elections in France, I think it’s going to be a stormy period, and filled with more uncertainty. I think the only realistic way to contain the market crisis from here, is if they can raise a trillion Euros, and take Spain and Italy entirely out of the market for 2-3 years.
USA: Unless they change their policies.
Asia: No no, for at least for 2-3 years, financing can be provided directly to Spain and Italy because the private market is not going to fund them. If funding can be provided to them by the ‘government repressed rate’ as opposed to the market rate for 2-3 years to demonstrate progress in bringing down the deficits etc., and they can reach the position of debt sustainability, then at that point, they can come back to the market themselves.
USA: How are you going to get them to reform so they don’t just have the same problem again?
Asia: They have a reform program now, in both Spain and Italy.
Euro: But they’ve already started to backtrack on it.
Asia: Yes, they have backtracked on it, so what are you going to do to them? You punish them?
USA: That’s why you wonder what the future of Europe is going to be.
Euro: It’s a very sad story and it could have been so different. This trillion Dollars could have been a lot lower. I think if they had acted decisively in 2009 it would have cost them more like $200 billion. The trouble is this incrementalism is terrible because it has exhausted the political will in Germany to do this. If you have to come back every three months with a higher number, eventually they are going to say we don’t want to do this anymore.
USA: I think even bailing them out with a trillion Euros at this point is not going to give them the spine to do what needs to be done, all you accomplish is taking the current pressure off.
Euro: My gut feeling is, and it’s not a pleasant thought to contemplate, is that the issue of debt restructuring in major economies will come to the forefront within the next five years. I just don’t think inflating will work, and I don’t see how they can do it. So yes, you could give them the trillion, they should have done it six months ago, but as you said, do you think Italy is really going to do what they need to do at that point? Most German citizens are very skeptical about this.
Asia: Also, I think to complicate the problem is the European banking system. The Spanish Banks, the French Banks, the Italian Banks. We have a global banking system where the American Banks as a whole are not dependent on the wholesale market for funding, whereas the European banking system is highly dependent on the wholesale market. Those guys are broke, their loan to deposit ratios are at unsustainable levels. So for a very long time, the European banking system has had a disproportionate share of global banking activity, disproportionate relative to their capital base. Where did they get the money from? They have been borrowing in the US money markets, the commercial paper markets, the interbank markets and elsewhere, and now they are in big trouble. No one is willing to lend them money now, and the interbank market has dried up. So if they cannot finance themselves, the ECB has got to fund them, so they take their money from the ECB and go buy government bonds which they use for collateral. Now a lot of their longer term financing is coming due. So even the ECB’s one trillion infusion has not quite covered the maturing financing needs over the next two years, so they have become yet another source of tension in the market.
USA: The only remedy is economic growth. How do you get that from where we are today?
Euro: It’s very tough. As I said earlier, I think what would help at the margin is if you had a very significant weakening of the Euro. That’s may provide enough oxygen for the muddling through scenario to work, in the best case scenario.
CEJ: How could they engineer that?
Euro: That is indeed a big question. One possibility is that the ECB eventually puts in place a zero rate policy. They could even introduce their own version of quantitative easing with reference to a much lower inflation forecast. At the moment, the problem with that is with oil prices where they are, head line inflation (which is what the ECB mainly focuses on) is actually above their inflation targets. So for the ECB to cut rates right now would be a hard sell in Germany. The reaction there would be, wait a minute, we already have 2.4% inflation. Of course, the other problem Europe has is that the countries that would most benefit would be the core, so Germany would boom even more, and you might have an inflation rate in Germany significantly higher than the overall Eurozone 2% inflation target. Again, that would be a tough sell in Germany, even if the overall Eurozone inflation rate were to settle around the 2% mark. At the end of the day, Germans want to see price stability in Germany. What is needed would be a much weaker Euro, a booming Germany and a hall pass for inflation to rise to 4-5% in Germany. That would give enough of a lift to the periphery to dig their way out of the hole, but of course the second inflation rises to 3-4% in Germany, the political atmosphere in Germany will become a very difficult one.
Asia: Do you think the Germans could be outvoted on the ECB?
Euro: They can, but if that happens the whole system is at risk. Statutorily, it’s no problem, but the reality is very different. If you had another Bundesbank president, or another German resign, then it becomes very hard to see even a muddling through scenario working.
Asia: Do you think it’s conceivable that Germany and the Benelux countries could leave the Euro?
Euro: Perhaps, but I think they’re rightly scared because of what the consequences would be. They are very concerned because what they saw happen elsewhere when exchange rates go through the roof, and that’s exactly what would happen in Germany if they left the Euro.
Asia: That is a big risk for the Euro. If the Germans and the Benelux leave, how could it continue?
Euro: I cannot see Germany splitting with France. If France were left behind, that would change 60 years of European history. That would be a paradigm shift away from everything we know about European integration.
Asia: Initially, we drew the line at Spain, and then we drew the line at Italy, now you are talking about France.
Euro: My sense is for the Germans to disengage from France is virtually inconceivable. That’s the founding principal of European integration.
USA: Speaking economically, France is not strong like Germany, so I don’t think they would bring them along. They could only pay for them so long unless they perform.
Euro: If you embrace that scenario, you have to accept that everything we know about European history since the end of World War II is wrong. Then you are in a very different world.
Asia: Also, I don’t think Germany would want to be accused of abandoning Europe.
Euro: I think that’s why their strategy is to be as tough as possible, but never be in the position where you are the “bad guy”. If the others choose to die, that’s a different matter.
USA: It’s a fine line between letting them die and letting them choose to die.
Asia: So, what do you think the next move of the ECB will be, assuming the market crisis escalates?
Euro: I think they’ll eventually cut rates, and they’ll go to a form of zero rate policy, some form of QE, justified on the basis of the inflation outlook, and not on the basis of some sort of gimmick. Effectively, they’ll say we need looser policy, and we can’t do it any other way, so this is how we are going to do it. The curve ball in that scenario is oil. Six months ago, it would have been nice if inflation fell, so on a forecast basis they could justify they needed looser monetary policy, and so they could slowly go the way of cutting rates to zero and maybe doing some QE; but now that would be quite difficult because inflation is actually already exceeding their target. Of course, if they have an accident, they could just say well yes, inflation is currently high, but on a forecast basis we expect inflation to be dramatically lower.
CEJ: What do you make of Wen Jiabao coming out and saying that the five big SOE banks in China are too big? Why would he go to the press with that? Is it because he is now a lame duck, and trying to continue to move forward his agenda even into the new leadership?
Asia: I think perhaps it’s a signal that he feels that the new political leadership may not be strong enough to undergo the kind of reform that China needs to do to continue moving forward. Basically the economic system favors the state and not market interests. They are all staffed by party officials, so there is a huge vested interest in sticking to the current party system, so there is a huge misallocation of resources, and most of the loans in the banking system go to the big State Owned Enterprises (SOE’s); whereas the small and medium sized businesses are starved of capital. Wen must believe that when the new leadership takes over, they will not be strong enough to start this reform without a kick start, and he steps down in March next year.
CEJ: But then why didn’t he start the reform earlier?
Asia: I think he was trying to do that, until the global financial crisis hit. When the global financial crisis hit, they had to switch on the ATM. They went to the big banks and said we have to pump almost a trillion Dollars into the economy, can you imagine, one trillion for the Chinese? So he knew that had to be done to save the Chinese economy from going into recession. Already before the crisis was commencing, they knew the crisis was not sustainable. You cannot have subsidies like they have without massive misallocation of assets.
CEJ: It looks to me like at the top level, they may disagree, they may argue and fight, but eventually, they decide, and when they do, they close ranks in a unified stance. So it’s a much more efficient and effective form of government than many others.
Asia: China has a problem; they can only maintain 8% growth with more and more leverage.
CEJ: Compared with the developed world, how leveraged are they? Don’t they have plenty of more room to continue?
Asia: The US debt to GDP is about 350%; China currently is about 200%.
CEJ: That’s on balance sheet debt. If you include the off balance sheet entitlement obligations it’s more like 600% debt to GDP in the US. China doesn’t have the off balance sheet debt problem.
Asia: What I am concerned about is that unless they reform the economy…. their growth rates could continue to slow, perhaps quite dramatically, because in some sectors, the leverage is already too high.
USA: What about the leverage in the US? You now have all kinds of new regulatory agencies to regulate the healthcare system; I think as a result you are going to end up with another trillion Dollar deficit related just to healthcare.
CEJ: I recently went down to Stanford, and listened to a PHD outline what needs to be done to fix the US healthcare system. He had a plan, very carefully thought through, which outlined step by step the way to fix the current mess. It sounded quite logical, and doable, so after his presentation was concluded; someone from the audience got up and asked him if he had shared this plan with anyone in the US government. He said, why yes, in fact I took it to the Clinton administration, the Bush Administration and the Obama administration. He said they all really like the idea, but they couldn’t get any traction going to get it through congress---it’s like the tax code, they’ll never reform it, because at the end of the day the congress would end up relinquishing too much power. Maintaining control over the tax code enables them to raise funds for election campaigns.
Asia: USA, what do you see as the biggest risk to the asset management business?
USA: The cumulative increase in global regulation is a big issue for us. I think also a collapse of the US Dollar could give us some major problems, but there’s not much we can do about that, and the probability of that at this point in time is low. I think inflation is not good for us, and inflation is never good for investments, neither bonds nor stocks.
Euro: So, to conclude this fabulous discussion this evening, if you had 2 billion Dollars to invest today, how would you invest it?
Asia: I would hold 50% in cash. Even though it pays next to nothing, because I think there is going to be a lot of opportunities.
USA: That’s why the corporations are doing the same thing.
Euro: How much would you have in fixed income? How much would you have in bonds?
Asia: Nothing. Why do big institutions buy government bonds? Partly for liquidity, and secondly, you think that those bonds are risk free, from the viewpoint of credit risk, you just have to accept interest rate risk, but you assume there is no credit risk. But today, you have the situation where they are still liquid, there’s no doubt about that, but there is credit risk, and there’s a serious risk of capital impairment.
Euro: And the yield is so low that you are better off just holding cash….
USA: So you buy gold…..
Asia: No, I think gold is quite dangerous also…
Euro: So essentially what you do is you are in cash…..
Asia: When the equity markets begin to stabilize and move up, gold will come off. Gold is for those who are risk averse, but if you think the equity markets will do relatively ok, I don’t think gold is going to be a good investment.
Euro: So your other 50% would be in high quality, high yield stocks?
Asia: Stocks with strong balance sheets, as long as they give me a dividend yield 50 basis points higher than government bonds I’m quite happy.
Euro: And the equity markets are very liquid by the way…
CEJ: What jurisdiction would you buy equities in? Would you buy European equities, or emerging markets equities or US equities?
Asia: It’s a bit difficult to generalize, but basically some of the European stocks are very interesting, some of the European stocks which have been caught, the non-financials, have been sold down very very badly, and some of these are international companies, with good exposures, with top line exposures to emerging markets, for example, the luxury automobiles, BMW etc.
CEJ: Thank you Asia, Euro and USA, for a most stimulating and thought provoking ‘virtual’ round table discussion. I very much look forward to future installments!!