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Market Insights: Markets Lack Confidence


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Markets have been suffering a lack confidence in the future and the resulting drag on world growth has been severe. Since the financial panic of September 2008, marked by the very messy handling of the bankruptcy of Lehman Brothers and the next-day bailout of AIG, the world has witnessed continuing erosion in the confidence accorded to policy-makers, technocrats, and political leaders to restore a long-term belief that the financial system can once again function smoothly. The most severe confidence problems are currently centered in Europe, but the problem is global and epidemic.

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Market Insights: Markets Lack Confidence

  1. 1. Market nsights By Blu Putnam, Chief Economist, CME Group 5 July 2012Markets Lack Confidence – Yet Glassmay be Half FullAll examples in this presentation are hypothetical passing, it is much less certain that there will be no new debaclesinterpretations of situations and are used for explanation and it is way too much to hope for realism from political leaderspurposes only. This report and the information herein facing divided electorates.should not be considered investment advice or the results In assessing the current state of markets, we need to take aof actual market experience. global approach to understanding the challenge of a lack ofMarkets have been suffering a lack of confidence in the future confidence that markets face, and then we should realisticallyand the resulting drag on world growth has been severe. take a hard look at the progress that has been made since theSince the financial panic of September 2008, marked by the financial panic of 2008. In the midst of an erosion of confidence,very messy handling of the bankruptcy of Lehman Brothers it is easy to lose sight of many of the positive things that haveand the next-day bailout of AIG, the world has witnessed been accomplished by governments and economies aroundcontinuing erosion in the confidence accorded to policy-makers, the world. So, while we start this analysis from the perspectivetechnocrats, and political leaders to restore a long-term belief that the glass is half empty, we will close with a more optimisticthat the financial system can once again function smoothly. assessment that the glass is half full, suggesting the next bubbleThe most severe confidence problems are currently centered in to burst may occur in the flight-to-quality assets.Europe, but the problem is global and epidemic. The Glass is Half EmptyWhen confidence is lacking, risk-taking in the pursuit of even Europe. Currently, the largest obstacle to rebuilding marketmodest expected returns is curbed. Capital flows only slowly, and confidence is in Europe with the seemingly never-ending sagaexchange rates are impacted by bouts of global deleveraging. The of the sovereign debt crisis. It is now obvious to everyone thatunfortunate reality is that once confidence has been lost, there the Euro was born with the birth defect of lacking a unified fiscalare no quick fixes to restore it. The “Whew!” moments, when structure to go with the central monetary policy implied by theone thinks the crisis may have been averted, do not necessarily single currency. We have learned more recently, however, thatlast. The medicines that can work are a combination of time with sovereign debt problems and the banking system problems arethe absence of further debacles coupled with a return to more intertwined in complex ways. Hence, the pressure on the latestdisciplined long-term policy-making by governments, regulators, EU summit to unify banking system supervision to complementand central bankers who confront reality rather than make the monetary policy powers of the European Central Bank (ECB).empty promises. While we can be assured that time will continue 1 market insights
  2. 2. 5 July 2012One critical observation that has emerged over the last two passed by the lower chamber and will likely soon become theyears of wrangling with the Greek debt crisis and the contagion law of the Portugal, Spain, and Italy is that the European Union (EU) Of course, austerity is rarely popular, and the politicalmay have an unwieldy governance structure, but there is a leadership in Japan is not particularly stable. Japan is on itsvery strong commitment to maintain the Euro as the single 6th Prime Minister in as many years, and ”seven in seven”currency. While extreme political posturing before arriving seems highly probable with the passage of legislation toat the negotiating table is typical, with each passing sharply increase the consumption tax. There is nothing hereEuropean summit (and there will be many more), one can to build confidence, but disaster is not around the cornerperceive a deep underlying commitment to avoid a break- either. The economy will probably see its 20-year average realup of the Euro and to take even politically unpalatable action GDP growth rate of 1.7% cut in half for the next few years asto sufficiently mutualize enough sovereign debt to get through the consumption tax rises. And further austerity will likely bethe crisis. needed to control government expenditures. All the while, theUnfortunately, one also senses that the common commitment Bank of Japan will keep rates at zero, and domestic long-termto the Euro and solving the sovereign debt crisis is largely holders of Japanese Government Bonds will earn the carry,born out of fear: Fear of the economic disruption that would small as it is. When this bubble bursts, the epicenter in thebe caused by a break-up of the single currency; Fear of the markets may well be the Japanese yen, but one should notramifications of a failed bail-out on the careers of the political underestimate how long a zero-rate policy can sustain theleaders and technocrats that have engineered the expensive status quo.package of debt relief and banking system support. [See our China. In China, the generational transition to new leadershipearlier report, “Market Insights: The Political Splintering of comes at a time that the domestic economy is deceleratingEurope” from May 7, 2012, that discusses the politics of the much more than many market participants anticipated. [Seebail-out in more detail.] It is not confidence inspiring. our report from December 12, 2011, “China: Slower ExportJapan. What the European debt crisis has highlighted for Growth, End of the Infrastructure Boom Years” which argued ,Japan is its vulnerability due to its massive debt. Japan has the in detail that the slowdown would be more severe than markethighest government debt to GDP ratio of any major country. participants were projecting.] The growth slowdown in ChinaJapan has an aging and shrinking population. This means that is a direct consequence of the intense building during theJapan cannot grow its way out of debt (and by the way, neither 20-year infrastructure boom. Now that there are fewer newcan Europe or the US). projects, Chinese growth will need to come from domestic consumption and that is not the natural state of a societyJapan has postponed its debt crisis by mostly owing the that is aging rapidly and depends on the extended familydebt to itself (not to foreigners) and by the Bank of Japan unit for long-term financial security and health care.maintaining a zero rate policy since 1995. The role of thezero-rate policy cannot be understated. There is a virtual Moreover, there is the looming elephant in the room ofcommitment from the Bank of Japan to keep short-term demographics, with two themes set to interact in the nextrates near zero for a very extended period of time, and decade in a disruptive fashion. For now, China gets somethis means pension funds, the Post Office, and banks 4% real GDP growth each year from the direct and indirectknow they can fund their massive holdings of Japanese consequences of the migration of 12-15 million people fromGovernment Bonds (JGB’s) at a positive carry. Even this rural to urban areas. The higher productivity of urban industrialapproach probably has its limits as the debt piles higher and workers and the infrastructure spending required to effectivelyhigher, and this is why the consumption tax, with its near build a new New York City every year helps sustain the economy.certainty of serving as a serious drag on economic growth was Without the rural-to-urban migration, China’s real GDP growth2 market insights
  3. 3. 5 July 2012might shrink to 3% - 4%, instead of the 7.5% we expect for full employment. What has been missing from the Federal2012. Once the rural-to-urban migration slows markedly in the Reserve is a convincing cost-benefit analysis of what expandednext decade, the real demographic time bomb of a rapidly aging quantitative easing policies really accomplish, and whetherpopulation comes into play in full force. Due to decades of the their long-term costs may not be outweighing any policy, China slowed its population growth, but it Let’s be clear. When the economy was collapsing followingalso put in play a much faster aging of the population than the freeze-up of the banking system with the very messyany major country has ever experienced. Aging populations bankruptcy of Lehman Brothers and bail-out of AIG backdo not sustain rapid economic growth, and they place intense in September 2008, the Federal Reserve stepped up to thepressures on the health care systems and social safety nets, both challenge with a trillion dollar asset buying program, known asof which are lacking in China. QE1 (for quantitative easing program #1). We credit that initialThe bottom line is that the new leadership in China that will round of quantitative easing with preventing a major depressiontake over toward the end of 2012 is inheriting a country that that could have been worse than the one in the 1930s.has modernized at a magnificent pace, and yet will now face Subsequent rounds of quantitative easing by the Federalmounting economic challenges. In the “what have you done for Reserve as well as operation twist program to extend theme lately” psychology of financial markets, uncertainty and lack maturities of its asset holdings, however, were not conductedof confidence is the order of the day until the new leadership to save an obviously failing banking system. These subsequentcan prove itself – and that, of course, takes time. rounds of quantitative easing were aimed at trying to get anUnited States. In the US, there is a total absence of long-term already growing economy to create jobs at a more rapid pace.fiscal policy, with automatic spending cuts and tax hikes coming Our understanding and interpretation of economic theoryat year end, if Congress fails to act. Depending on the US suggests that there was little likelihood of QE2 and OperationCongress to take effective and long-term action – well, that is not Twist having any measurable impact on unemployment. Withconfidence inspiring. Usually, economists are happy to project the benefit of hindsight, we still argue that QE2 and Operationsustained economic growth when Congress does little and Twist were not helpful. Indeed, they are actually damaging inleaves well enough alone. What has happened this time around, several ways, which is why a thorough cost-benefit analysishowever, is that previously legislated tax and spending policies would be useful.had time stamps that are coming due at the end of 2012. So, if The first issue relates to the fact that QE2 and Operation TwistCongress fails to act, there will be severe consequences for the were designed to distort the Treasury yield curve – albeit foreconomy from the abrupt shift to austerity. good intentions. We believe that market distortions, however,One also needs to appreciate the local nature of all politics. have costs, and in this case we are seeing a wholesale transferWhile as a whole, the US Congress according to opinion of wealth away from long-term savers and pensioners, duepolls is held in extremely low esteem, the same polls show to lower bond yields, with the objective of making capitalconsiderably higher approval ratings for each and every cheaper for companies to expand production and increaseCongress person in his or her own district. That is, the country hiring. Business investment and expansion decisions, however,does not approve of the Congress it elected, but each are much more dependent on corporate views of the futuredistrict likes its own Congress person just fine. demand and risks than on the cost of capital. That is, even if capital is cheap, businesses will be reluctant to expand ifCongress is not the only culprit in assessing confidence they perceive elevated risks in future demand. And, with thein the US. The Federal Reserve is a growing part of the economy aging and savings and pensions under stress, well,confidence problem in the US. The Federal Reserve remains the Federal Reserve has effectively engineered a drag onin emergency policy mode and regularly promises more demand as an unintended and unappreciated consequence ofaction without delivering any results in terms of encouraging QE2 and Operation Twist.3 market insights
  4. 4. 5 July 2012The second issue relates to the long-term management of that the Federal Reserve does not have any faith in the currentmonetary policy. The Federal Reserve needs about $1 trillion in state of the economy and perceives a relapse as imminent. Thisits balance sheet for the normal conduct of monetary policy. perpetuates the cycle of confidence erosion.It has about $3 trillion after its quantitative easing programs. If the Federal Reserve really does perceive a relapse asThis additional $2 trillion is funded by paying interest on excess imminent, then by all means keep rates at zero. If the Federalreserves, currently set at 0.25% or 25 basis points. [The first Reserve, however, is buying insurance against an economic$1 trillion is funded by the cash or currency circulating in the relapse, then it needs to recognize the very high and potentiallyeconomy, and has no interest cost.] If and when the Federal damaging costs of its actions. Insurance is often appropriate,Reserve returns to a more normal federal funds rate policy, but it is never free, and the Federal Reserve needs tothen we expect the rate paid on excess reserves to rise as well. carefully weigh the costs of buying expensive insuranceThat is, the Federal Reserve will have to pay the higher rate to that may not work for a problem that may not exist.make sure that the excess reserves from the QE programs donot turn into rampant credit expansion and produce inflationary The Glass is Half Fullpressures. Alternatively, the Federal Reserve could sell the Fortunately, a lack of confidence is curable with time. The key isexcess securities, but our guess is that the Federal Reserve will whether there are new and serious financial debacles to upsetbe reluctant to dump its holdings of Treasuries and mortgage- the healing process. So, we need to realistically take stock ofbacked securities on the market and unwind quantitative the probabilities of future man-made financial disasters. Oureasing with its implications for disturbing markets at the same assessment is that the probability of further system-damagingtime as the federal funds rate is being pushed a little higher and financial shocks has been greatly diminished over the past year.back toward a more normal relationship with inflation. In short,QE2 and Operation Twist have not helped to lower the The progress on a number of fronts has been obscured in partunemployment rate any faster than already was occurring, by market volatility stemming from bouts of uncertainty andbut these operations may have immensely complicated a lack of confidence. We need to remember that US banks arethe long-term conduct of monetary policy and the ability well-capitalized and profitable. Many European banks still needof the Federal Reserve to exit its emergency policy mode. more capital, but their problems are better understood now, the ECB is providing massive liquidity, and commitment to EU-wideAnd the final issue is, of course, about confidence – or the banking supervision is on the way. A problem bank is much lessdamage to confidence being caused by the Federal Reserve able to rock the system today than a few years back.remaining in emergency policy mode when the financial crisishas eased. The US economy has been growing in real GDP terms Economic growth is less than robust around the world, butfor three years. The unemployment rate has fallen from its peak most emerging market countries are still growing, just moreof 10.0% to the low 8% range. Banking profits recovered back slowly than at their peaks. The US is on a 2% to 2.5% realin 2010, as did the profits of non-financial corporations. The growth path. Japan has recovered from the earthquake andUS economy may not be producing jobs as fast as the Federal tsunami. Europe, though, is moving into recession, but for theReserve and policy makers would hope or like, but given all the continent as a hold the damage is manageable. We are in theturmoil in Europe and the slowdown in China and other emerging middle of a world growth slowdown, but not a world countries, the US economy is actually a bright light on Global corporations are profitable and have been hoardingthe world scene. Thus, our argument is simply that the policy of cash. They are in much better financial condition compared tothe Federal Reserve, to stay in emergency mode, and not to take 2008-2009 to either withstand a shock or to expand when theyeven a few baby steps back toward a more normal monetary perceive conditions and risks will allow it. Indeed, corporationspolicy and one that involves a little less distortion of the yield have made great strides in maintaining profitability whilecurve is sending a strong message to the market participants managing ambiguity and an uncertain future.4 market insights
  5. 5. 5 July 2012Our conclusions are that market participants’ lack of possibility is that the next big bubble to burst may well be inconfidence in political leadership has meant more volatile the flight-to-quality sectors. That is, the best investmentsmarkets, has contributed to the risk-on/risk-off trading of the past few years during the erosion of confidencementality, and has convinced corporations to hoard cash may be the worst investments if confidence starts torather to expand. All of these manifestations of a lack of slowly improve. This suggest much more volatility and riskconfidence in leadership have been self-reinforcing. Moreover, for the currencies of the funding countries, such as the USthe erosion of confidence has obscured the progress that has and Japan, as well the US Treasury market which is offeringbeen made on the economic front. The practical implication negative real returns even in long maturities. The compliancefor investors is that risks are probably both lower and much maxim – “past performance is not necessarily a guide tomore balanced than market perceptions may appear. If and future performance – may be the watch word for the comingwhen confidence slowly returns as time passes and no further few years.system-threatening debacles occur, the one hypotheticalAdditional ResourcesFor more market insights, visit Group is a trademark of CME Group Inc. The Globe Logo, CME, Chicago Mercantile Exchange and Globex are trademarks of Chicago Mercantile.Exchange Inc. CBOT and the Chicago Board of Trade are trademarks of the Board of Trade of the City of Chicago, Inc. New York Mercantile Exchange and NYMEX areregistered trademarks of the New York Mercantile Exchange, Inc. COMEX is a trademark of Commodity Exchange, Inc.The information within this brochure has been compiled by CME Group for general purposes only. CME Group assumes no responsibility for any errors or omissions.Although every attempt has been made to ensure the accuracy of the information within this brochure. Additionally, all examples in this brochure are hypotheticalsituations, used for explanation purposes only, and should not be considered investment advice or the results of actual market experience.Copyright © 2012 CME Group. All rights reserved.5 market insights