08 May April Market Commentary
Monthly Economic & Investment Market Commentary
On one side of the current debate we have those that say governments can and should seek to smooth the economic cycle by running surpluses when times are good. By taxing more than they spend, governments can pay down debt, and / or invest in vehicles such as sovereign wealth funds. Then when hard economic times hit, as the business cycle says they will, there is a greater capacity to support a struggling economy, including by running budget deficits to fund stimulatory programs.
Opposing that view are those that see only a much more limited role for government, influenced by their belief that governments have a poor track record at best of intervening at the right time and in the right manner; a view for which there is much support, particular given recent experiences.
The United Kingdom is again in recession, as are the PIIGS – Portugal, Italy, Ireland, Greece and Spain, along with a couple of others including Holland and Belgium. Unemployment rates are high across Europe; the 17 countries in the euro area have an average unemployment rate of 10.9%, up 1% from a year earlier. Problem countries are not surprisingly much worse, Greece is double that rate and Spain is even worse at 24.4% as at March 2012.
With hindsight we see clearly that troubled European economies were able to borrow too much money too cheaply, and certainly far in excess of what could be supported by their individual economies. This debt burden came to rest on the public balance sheet when private banks that were considered too big to fail, needed to be bailed out. As Bank of England Governor Mervyn King recently said:
For the banks, it was a case of heads I win, tails you – the taxpayer – lose.(1)
The Europeans have therefore to deal with their current problems of huge debts, economic recession, high unemployment and low tax revenues, but also to seek to address the deficiencies that contributed to their current dire situation. Mario Draghi, President of the European Central Bank, has taken to talking of the need for not only a “fiscal compact”, but also a “growth compact.”
The former is the cause for the protests in much of Europe, requiring drastic cuts in government spending including social welfare programs, and leading to several changes of government, including French President Nicolas Sarkozy last weekend. His successor Francois Hollande is from the Socialist Party, and has called for the renegotiation of the recent pact calling for constitutional amendments requiring balanced budgets in each euro zone country.
A top tax rate of 75% also attracted headlines, though a more sanguine view of the potential impacts was given in a recent interview:
His camp recognizes that for budgetary reasons they have to keep most of the reforms in place. He‟s facing a possible further downgrade in France and a rise on borrowing costs. He knows that, and he‟ll take steps to reassure the markets.(2)
As for addressing the deficiencies that contributed to the current situation, Mervyn King has the three Rs for the UK banking system. Regulation, a resolution mechanism that means depositors are protected if a bank fails, and a restructure that that separates commercial banking from risky investment banking. Mario Draghi wants to finish the euro project, pointing to the success in creating a monetary union as a template for the proposed fiscal union. However, the widely read magazine The Economist is skeptical, noting
it has worked in the past, but the politics had soured before the euro crisis and have turned sourer since, with many voters now hostile to the European project as well as austerity.(3)
Mervyn King has a very difficult job, but Mario Draghi’s is much harder. We will watch from the sidelines and source our International Equities exposure in Asia and Emerging Markets.
The US has its own proposed reforms to deal with the excesses in the banking sector, though the political environment does not provide much confidence that the policies will be enacted. Much of the reform package has become known as the Volcker Rule, after the former Chairman of the Federal Reserve, though the man himself has distanced himself from the original proposal. The thrust of the reform was also to prevent commercial banks from undertaking risky investment banking activities, like operating private equity and hedge funds, and to limit the trading that banks did on their own accounts, so called proprietary trading.
Volcker was appointed to Chair President Obama’s Economic Recovery Advisory Board shortly after the President came to office in early 2009. The initial reform proposal was outlined in a three page proposal to the President. When it was included in the Wall Street Reform and Consumer Protection Act that was submitted to Congress the Volcker Rule took up 10 pages. When it came out of Congress, after the financial sector lobbyists had had their say, it was just shy of 300 pages, and being decried by the financial sector as too complex and costly to implement!(4)
Without being overly cynical, and to borrow a line from the Watergate scandal of the 1970s, you need only “follow the money”. Presidential elections are very expensive, estimates are that the battle between incumbent President Obama and likely Republican nominee Mitt Romney will cost in excess of US$6 billion, up from US$5 billion for the 2008 election. Fortunately the US Supreme Court has recently allowed unlimited spending from corporations on “electioneering communications”, and so the influence of lobbyists and industry associations, at the expense of individuals is a trend that will continue, meaning reforms such as those proposed by Paul Volcker stand little chance of success.
What chance then of the United States addressing their current imbalances, if not the long term structural reforms? Unfortunately, later this year we will likely see more evidence of the hyper partisanship that is paralysing any reform initiatives. We hear a lot these days about the “fiscal cliff” that awaits the United States towards the end of this year, which is the result of last year’s failure of the Joint Select Committee on Deficit Reduction to agree on a combination of spending cuts and tax increases.
The earlier Budget Control Act of 2011, the last minute agreement reached in the midst of the debt ceiling crisis, specifies mandatory spending cuts, which combined with the expiration of what were intended to be temporary lower tax rates implemented under President Bush, and a reduction in payroll tax, amounts to a “fiscal cliff.” The CEO of the world‟s largest bond investor summed up the situation:
A fiscal contraction of this magnitude and composition would stop dead in its tracks the economy’s nascent healing and job creation. Consumption and investment would be harmed. Foreigners would become more cautious about buying our ever increasing debt issuance. And with our internal growth momentum weakened, the headwinds from the European debt crisis could prove overwhelming.(5)
Much will depend on the outcome of the November elections, and not just who sits in the Oval Office, but which party controls the House and Senate.
APRIL TIPPING POINTS
1. Mervyn King, Governor. The 2012 BBC Today Programme Lecture, London. 2-May-12.
2. Brad Plumer. “Why you should care about the French election” Interview with Arthur Goldhammer, Centre for European Studies, Harvard University. Washington Post. 21-Apr-12.
3. Free Exchange. “What Mario means when he talks about growth.” The Economist. 3-May-12.
4. James B. Stewart. “Volcker Rule, Once Simple, Now Boggles.” The New York Times. 21-Oct-11.
5. Mohamed El-Erian. “The fiscal cliff cometh”. New York Times. 4-May-12.
About Reuben Zelwer
Reuben Zelwer established Adapt Wealth Management in 2011 to help time poor clients achieve financial freedom. For over 15 years, Reuben has helped professionals, executives, business owner and those approaching retirement make the most of their circumstances by making good financial decisions. Reuben’s professional practice is complemented by substantial voluntary work, which has included setting up financial literacy and savings programs in the local community.