Aamer Ghaffar's Blog

The EU has been struggling with a slow-moving but uncontainable crisis related to the colossal debts faced by its peripheral economies. The debt crisis that plagues the EU  (with terrible ramifications for the rest of the world) first surfaced in Greece back in October 2009.

The issue first came to light when the newly elected Prime Minister George A. Papandreou announced that his predecessor had covered up the size of the country’s growing deficit. Its been a rocky few years since that speech back in the fall of 2009, this  comprehensive timeline of how Europe entered the mess that she is in today  is a must read for anyone who wants to understand (and continue to follow) the crisis in a clear and very well written manner.

Politics, The Economy

Last week global equities were at a seven week low. It does not take a rocket scientist to realize the strong correlation between the price drop and the fact that Angela Merkel has continued to oppose Euro Bonds as a solution to the European debt crisis. However, this should not come as a surprise to anyone. For the past 18 months, Germany has tried every trick in the book, from forcing countries to take drastic austerity measures to asking the IMF to step in, and my favorite, to somehow pass the buck to China, all in an attempt to ensure that she has to pay the least amount possible for the European bailouts.

Be as it may, it is time to call out Germany and point out the fact that she has benefited a great deal with the adoption of the Euro and is partly responsible for the mess  the EU is in right now.

If it were not for the Euro, the German Deutsche Mark would have fared the same fate as the Swiss Frank and Brazilian Real. The later two countries have been dealing with huge amounts of upward pressure (which results in making exports less attractive) due to the copious amounts of hot capital that is flowing into them. However, the huge surge in German exports (most noticeably from August 2009 to May 2011) would have otherwise been significantly curtailed had Germany not been tethered to the Euro. Conversely, had the European periphery kept their local currencies, they would still have suffered a similar fate with regard to the financial shock. However, they would not have had to deal with the loss of competitiveness that they face in market right now — a factor that is making the recovery all the more difficult.

Before the introduction of the Euro, the Greek and Portuguese public used to save in their local currencies, creating a semi competitive customer base for T-bonds. This  resulted in a somewhat consistent way for governments to fund themselves. The introduction of the Euro led investors to prefer the purchasing of Euro assets over bonds denominated in local currencies. After the current crisis in Greece and Portugal,investors who want European assets can buy them in Germany, and since there is no lender of last resort, the local governments have to pay cautious investors a significant premium. In short, borrowing costs for these governments have increased significantly and the large capital outflow from these countries have resulted in a strong inflow into Germany. Thus Germany has been able to capitalize on the weaker periphery nations

Contagion is not just the name of a Matt Damon  movie. It is a serious problem that is plaguing the EU. Belgium’s 10 year yields shot up 25 basis points to 5.74. To put this in context, this is the equivalent of the Spanish yields before the most recent Euro Zone Summit (which took place during the last week of October.)

The speed of the crisis has far exceeded the speed of the political response, and time is running out. If member states continue to deal with unstable funding, I would not be surprised if these countries start to flirt with the idea of exiting the European Union, as the financial cost of staying in the Eurozone will far outweigh the benefit. It is important to note that this not an experiment that I endorse, as the risk of playing out this option will have a catastrophic outcome.

I am generally not the type of person who paints doomsday scenarios, but if substantial measures are not taken during the European Council meetings to be held in December, the future of the unified (economic) continent that has taken over a decade to build will come into serious question.

Politics, The Economy

Finance

This past week, equity markets around the world experienced their worst week since the depths of the financial crisis. To make matters worse S&P decided to downgrade the US’s credit rating (Fitch and Moody’s have reiterated the AAA rating, though put the US on watch).

S&P, the same company that could not see a problem with companies such as AIG, Bear Stearns, Lehman (or any of the other companies that led the financial crisis) had a sudden bout of consciousness in which it decided that the US debt was not worthy of the AAA rating.  Aside from the dodgy track record mentioned above, Analysts at the treasury were able to find a two trillion dollar error in S&P’s calculation backing the downgrade (a number I believe to be a little bigger than a rounding error). However, I am not surprised by S&P’s decision to power through with the downgrade. At the end of the day the rating agency had made up its mind that if cuts worth at least 4 trillion dollars were not made in attempts to reduce the deficit, that it  would downgrade the US’s credit rating. In short, the boisterous announcements made earlier in the year coupled with the rounding error lead S&P no choice but to move ahead with the downgrade.

Ramifications of the downgrade:

Not much in the bond market, everything else…Catastrophic! I expect a massive sell-off in equities and a  negative impact on  the rest of the economy as well. Some of the major players that will be hurt are entities such as Freddie Mac, Fannie Mae, the Federal Reserve as well as the New York Fed, as these entities will face some problems with lending money due to the downgrade in government securities.

The reason why treasuries will not feel the pinch is because Treasury’s are not like private or public companies. They can’t go bankrupt, and creditors can’t seize America’s assets. There are very few investors who will feel the need to sell T-bonds because it’s rated AA+ instead of AAA. The funny thing is that yields may grow lower rather than higher when people move from equities to Treasuries. The reason is simple, at the end of the day T-Bonds are still the safest assets.

John Boehner and the Tea Party:
One does not have to look further than a few posts to know that I tend to lean to the right when it comes to economics. However, I would be lying if I did not say that the reaction of  John Boehner has been a cross between comical, infuriating and sad. His office did not skip a beat and were quick to make an announcement that the downgrade was the  “latest consequence of the out-of-control spending that has taken place in Washington for decades.” What is funny is that S&P announcement pointed the finger to Bohmer and his colleagues more than anyone else. The announcement from S&P read as follows,

“The political brinkmanship of recent months highlights what we see as America’s governance and policy making becoming less stable, less effective, and less predictable than what we previously believed. The statutory debt ceiling and the threat of default have become political bargaining chips in the debate over fiscal policy … [This] weakens the government’s ability to manage public finances …”.

What is scary is that Republican Minority leader Mitch McConnell has vowed to fight to raise the ceiling next time around as well.  Let’s just be clear, you cannot continue to ask for taxes to be cut when keeping in mind that today the US has the lowest tax rate that it has had in last 60 years, 14% of GDP where the historical average has been 19%. It is not possible to try and cut the deficit by cutting spending and at the same time not add any revenue.

It is imperative for politicians (on both sides) to  note that  at this time the US needs a stimulus, not consolidation and a cut in spending. The result of continuing to curb spending and ignoring the fact that we are in a recession will be catastrophic and possibly lead to a double dip recession. Yes, spending needs to be curtailed in the long run, no one in their right mind can disagree. However, we also cannot lose sight of the fact that the US is in desperate need to jump start short term growth with a short term fiscal stimulus (which of course needs to be accompanied with a robust long term plan)

Some questions for S&P to answer:
1) If the US is not AAA, who is and why?

2) What will the ramifications be to the peripheral European economies? Are Greece, Spain and Italy all going to downgraded further as well?

3) And this is the most important…Why now? I cannot think of a single fundamental reason as to why the rating should have been dropped now compared to a few months ago?

Note:
In all this gloomy mess there is some good news, Timmy G has decided to stay till the 2012 elections.

Politics, The Economy

The proposed 2012 US budget outlines $3.7 trillion of spend with an anticipated $1.1 trillion in savings to be achieved over the next 10 years.  The lion’s share of spending is on Social Security, Healthcare and other entitlements. Rather than trying to reform the programs, cuts to defense and discretionary spending were proposed as a means of funding.

However, I am not as surprised by the fact that social security and healthcare were not tackled, these issues seem to always generate more emotion and debate than actual solutions. I am not saying that this is right thing to do, its just a sad fact. What surprises me is the assumption that the US economy is going to grow by 6.5% (before accounting for inflation) over the next 10 years. The current US growth rate (for 2011)  is projected to be a little over 3% (according to projections made by Analysts at JP Morgan).   

Sticking with the theme of growth and raising money, an interesting aspect that is not receiving much attention is the amount the US government spends on servicing its debt (amount paid to its lenders). The current proposal has sanctioned 6.31% of government revenues to be paid to lenders. It is important to note that the rate at which debt is paid is tightly aligned with the movement of intrest rates of the bond markets. At the time of  borrowing the goverment was able to make the most of low interest rates (that are still below the historic average of 2%) and borrow large amounts of money required for various bail outs. Unfortunatly, nothing in life is free and what may seem like a good deal at the time may have ramifications in the future, printing and borrowing money is no exception. Analysts at Barcllays Capital show just how bad things can get when looking at three diffrent scenarios of intrest rates and the resulting ramifications on servicing debt.

Borowing costs at 2% would result in 8.5% of government revenues being used to service debt in 2020.
Borriwong costs at 4%  would cause the number to rise to 15.1% of revenues in 2020
Borrowing costs at 6% means that a whopping 21% of revenues will be spent on servicng debt in 2020

What I cannot comprehend is how irresponsible the politicians are being while trying to tackle the budget. The Republicans want $60 billion in cuts to the proposed budget. However, rather than pushing for reform to social security and taking a closer look at the defense budget or find ways to tackle the growing debt problem, they want to cut Planned Parenthood, National Public Radio and Americore. The Economist   has a powerful and well thought out article discussing the cruel joke that is being played at the expense of the American public. The article sheds light on the following points,

• Non-defense discretionary spending was equal to 3.6% of GDP in 1963. It was also equal to 3.6% of GDP in 2008. (Hence it is hard to prove that disscretionary income  is the cause of an increase in government spending or that cutting it will help balance the budget)
• The school reform program has been decimated by a reallocation of a whopping $336 million
• The National Endowment of the Arts narrowly lost an additional $22.5 million.

The three points mentioned above bear testament to the lack of understanding and long term vision by the US congress today. Another perplexing thought is the eagerness of the Republicans to cut $131 million allocated to the Securities and Exchange Commission (or from another angle the the Democrats failing to restore the funding.) Whether it was the Madoff scandal, Bear Sterns, Credit Default Swaps or the financial meltdown in its entirety, the SEC has always been considered a responsible party for its lack of oversight (and rightfully so).Riddle me this, if the SEC is being given new responsibilities under Wall Street reforms, why is congress cutting  funding and in turn hindering them from doing their job? 

I am not claiming that the solution is easy; my plea to congress (both Democrats and Republicans) is to set aside party lines and focus on the betterment of the American people. Cutting programs like Americore, focusing on discretionary spending while ignoring the debt problem or threatening to lock out and shut down the goverment  is not the way to solve the current economic mess that we are in.

Politics, The Economy

Current state of the economy:
Unemployment is at 9.6%, inflation is at 1.17%, GDP real growth is at 2.5% per year.

Stroll through memory lane…

• Circa 2004, the SEC announced that it was going to waive its leverage rules, allowing some of the biggest firms on Wall Street to increase their leverage ratio from 12 to 1 to up to 30 or even 40 to 1. This was a major reason why firms like Bear Sterns were allowed to lever themselves up to such asinine levels and eventually crash.

• How can one forget the beginning of the century when the US was on course for a 6 trillion dollar surplus. It was in early 2000 when Mr. Alan Greenspan decided to drop the federal fund rates to 1%, resulting in an inflationary downturn in both housing and commodities.

• What manages to blow my mind the most was the decision to repeal Glass-Stegall and replace it with the Financial Service Modernization Act. (I could not have thought of a more inaccurate name myself). How could the government ignore  one of the more important lessons that we received from the crash of 1987 – By keeping Main Street banking separate from Wall Street, credit availability will not be  hampered (on Main Street) to the degree it would be (and was) after the act was repealed.

Reading the points above, the last thing one would think about doing is commending the government on a job well done.

However,Warren Buffet thanks Uncle Sam.  The letter  is an interesting perspective, and helps us look at how bad things could have been had the government not taken the steps that it did. One can continue to blame the government for the past but must also give it the recognition it deserves for handing the crisis.  As Mr. Buffet points out, though the actions of the government were not (and are still far from) flawless, it should be given recognition for the swift handling of the situation (even if it was a major player in the lead up to it).

Personally, I would say Kudos but stop short of Thank you.

Politics, The Economy

Although the famous quote may have worked for Frank Costanza from the popular sit com Seinfeld, the EU banking sector is going to have to say a lot more to instill confidence in its ailing economy.

The top ninety-one banks that account for roughly two-thirds of the banking assets in Europe passed the stress tests that were conducted later last week. I would have had absolutely no reservations in betting my mortgage on the results of the European stress test being positive. This is not because I have undying faith in the economy, but  because a positive result was expected. Stress tests would not have been announced if a bunch of banks were in the position to fail. The purpose of conducting the stress tests was to instill confidence, not ruin it.

I am not entirely sure if that goal was achieved. The Wall Street Journal has a well thought out article discussing the stress tests conducted by European regulators . The article asserts that the scenarios were not tough enough to give a true picture of whether or not the banks could survive a double dip recession. If you do not like to read (which would be  ironic as you are reading a blog at the moment) the graph at the end of the article says it all – it shows a huge cluster of banks barely making the 6% tier one ratio requirement. Therefore, though only seven banks failed, there are a boat load of banks teetering at the brink of failure. The article covers some good points for both sides of the argument but does not really touch upon the issue that I have with the tests.

All this talk about ‘transparency’ and getting  ‘insight into Europe’s banking’ is fine and dandy, but it seems like a classic case of not looking at the real issue. My beef with the test, aside from the fact that the rules were not stringent enough, is quite simple: the tier one ratio itself can be massaged to a great degree (much like a discounted cash flow valuation). Since the essence of tier one is to measure a variation of a shareholder’s equity to risk adjusted measure of assets, trying to ascertain what the “correct” risk weighting of the assets is open to subjective judgment.

Second, the Sovereign debt issue which is a huge threat to the EU was out of scope of the stress test. Spain is currently plagued with a huge number of over levered banks due to its property crisis. Not taking sovereign debt into account is like focusing on losing 15lbs but ignoring your soaring cholesterol level. Yes it’s a good goal, but it’s not going to lower the risk of a heart attack. I am not advocating that the stress tests should be scrapped, but they should not be considered a harbinger of things being OK at the moment. I do not expect anything drastic to happen in the next year or two since the crisis is still fresh. However, once the IMF and EU tighten their pockets and local governments funds start to dry up, sovereign debt will be a big issue for European banks as well as the Global economy.

P.S. Food for thought: here is an article on Bloomberg discussing how the European debt market, specifically German bonds may take a hit as a result of the the stress tests in Europe. Lets see how the next week pans out.

Finance

What in the name of all that is pure and holy was the ECB thinking? This was a golden opportunity to buy back debt and increase investor confidence. It seems like the ECB has a plan that does not include loading up their balance sheet (like their UK and US counterparts did). As expected the ECB did not alter rates (and maintained the record low 1%). However, the surprise came with the decision to refrain from buying back debt. Though I do not have enough knowledge to deem the move a mistake, a lot more clarity is needed to understand what the ECB plans to do in order to control the crisis. Seeing the behavior of Europe collectively as well as the ECB begs the question: is Europe really a union or just separate countries?

Germany will get to answer this question first hand today when it votes on the aid package for Greece. Unfortunately it is not as simple as giving money and all will be fine and dandy. Even if Greece gets the aid package it seems like it is a small band-aid on a gash that needs multiple stitches. On the other hand, if Greece does not get the package things can get even worse. This would not be good for anyone, especially Germany whose rates are already being affected. Keeping this point in mind I feel Germany will give the package. The question is how much and with what conditions?

Greece has other problems aside from the aid package.  A decline in aggregate demand due to a cut in spending resulting in exports becoming more expensive, 10% unemployment, a stimulus based on borrowed money and the uncertainty related to whether or not the protests are going to continue or if they are going to get worse is making the matter a lot more complicated.

The US had its own drama with the Dow  losing 700 points in 15 minutes and the turning around and gaining 600 points in the next 20 minutes supposedly due to human error. The story right now is that a trader typed B for billion instead of M for million – sounds ludicrous and frankly speaking, I don’t buy it. There has to be more to this story.

The error did not help consumer confidence as the Vix jumped 60% punting it above the 40%  mark for the first time in a year. Even though these trades (e.g.) Accenture for a penny or P & G for thirty five dollars will not stand, its negative impact is going to linger. In the short run traders who made money legitimately will now have their trades scratched, which in turn hurts confidence. In the long term it is going to make price discovery (a process where one determines the price of an asset through supply and demand in the market place for said asset) a heck of a lot harder.

Note: The UK has a lot more to look forward to since its Debt which is 13% of GDP is going to force rating agencies to revisit it’s credit rating – even though the conservatives have promised to raise taxes and aggressively fight the deficit.

The Economy

After a short break I have decided to start writing again. Thanks for the notes of encouragement.

Europe has finally decided to join the ‘economic meltdown party’ the US threw almost 3 years ago. Wow, did she make an entrance. The Euro is at a fourteen month low against the dollar primarily due to the uncertainty regarding sovereign debt in Europe. (Sovereign debt is a debt instrument guaranteed by the government). What started with Greece being unable to honour its sovereign debt soon morphed into, Italy, Spain and now Portugal being, or in the process of being downgraded by the rating agencies. Though the analysts seem to be spilt on the problem of  financial contagion (as defined by Investopedia to be the likelihood of significant economic changes in one country spreading to other countries, in this case referring to economic crises). It is still an issue to be very worried about. The last time we saw severe financial contagion was in 1997 when the Asian economic crisis, started in Thailand and eventually spread to South East Asia and Latin America. In the case of the EU what is even more worrying is that the Euro-Zone is connected not only through geography and low trade barriers but a common currency as well.

Affect on the EU economies:
If the suffering of Greece and Portugal was not bad enough, the Wall Street Journal Blog has an interesting post discussing how Spanish spreads are widening as we speak. This is a serious issue considering that Spain is the 4th largest economy in the EU. Though Spain’s debt problem is not as bad as the one in Greece, it does have problems of its own regarding unemployment. Affected European countries are cutting spending to tackle the crisis which in turn is going to have a negative impact on future growth rates of these countries. The current rioting opposing the austerity measures taken by the governments is not making the situation any better.

Though the UK is not having problems with its sovereign debt, it is still in the news with the looming elections. It will be interesting to see how the UK election will pan out. I am curious to see what kind of government the people want — one that is big on bailouts and intervention or one that takes a more conservative, survival of the fittest approach. Needless to say the election will have a significant impact on how the crisis unfolds.

Affect on the Euro:
The current crisis can have an effect on the future of the Euro as well. Stuart Burns makes a great case for how Greece, (along with most of the Mediterranean countries) have enjoyed the fixed borrowing rates by being a member of the European Union. Greece with little or no organic growth and double digit unemployment and inflation was allowed to borrow money at the same rate as France or Germany. As a result the Greek economy grew rapidly (mostly through financing by the public sector) but did not have the means to support herself. With the current bailout and fear of contagion, responsible countries like Germany or France are being tested, and are not taking kindly to the increase in the  borrowing costs and taxes in order to bail out other EU member countries.

Affect on US Markets
The dow lost around 200 points yesterday and 95% of S&P stocks were down while the Vix was moving up. Though these movements could be attributed to the Oil spill on the Gulf of Mexico and the foiled terrorist plot in NYC, it would be naive to think that the state of Europe is not causing a significant burden on the US or even global markets. The unemployment numbers to be released in the next few days will have a significant impact on how the US economy will react to the current declines.

If the US should learn any lesson from this European crisis, it should be that the inability to repay sovereign debt is a real concern, especially after accumulating a large deficit. Is it time for the US to start taking care of its own debt? Jim Owens, CEO of Caterpillar Inc. writes a phenomenal article in which he goes over major areas of the economy that the government should be focusing on in order to tackle the current deficit problem in order to heal the ailing economy.

Note- The ECB (European Central Bank) general meeting tomorrow morning is going to have a significant impact on the direction of the Euro. Hopefully, the ECB will restructure the debt of the struggling countries and cut interest rates. Such cuts will devalue the Euro, but it is a necessary step at this point.

Finance, The Economy

Unfortunately Hollywood was wrong about 2010, we are no where near to having flying cars, jet packs or robots as butlers. However, here’s what we can expect:

1) Policy:
The past year it was easy to make policy to counter the global economic meltdown because of coordination amongst the leading economies.  There was no special reason for the coordination and cooperation except that it was painfully obvious that it was the only move that could be made. The real test is going to come now when the countries will have to start planning exit strategies from the current stimulus driven global economy (since governments can’t fund their recovery efforts for ever). Developed economies like the US and Britain have to be careful not to make the mistake of withdrawing the stimulus too quickly like in the case of the US in 1937 and Japan in 1997, where the ill timed change in policy (in this case a tax increase) sent these already fragile economies back into recession. In short, withdrawing the stimulus too soon= recession and deflation!

With the large US current account deficit I feel fiscal policy should remain the same  for most of 2010 (with modest tightening)  since a tightening of fiscal policy will happen when the tax cuts susnset in 2011. This could prove to be tricky, as this is right around the time the stimulus programs will begin to start tapering down. As mentioned earlier, if not handled with care the US can fall back into the deep dark gallows of the recension. Therefore, after a very busy crisis management 2009, 2010 should be quiet for policy makers as governments will be focusing on taking charge of their over inflated budget deficits.

2) Shape of the recovery: will it be in the shape of a  V, U  or a reverse square root?
The recovery of the US economy should be interesting. The recovery after a recession is traditionally strong whereas after a financial crisis it is obviously weak. Since the US was caught in the perfect storm between both, it is difficult to determine which route the recovery will take. A a lot will depend on how fiscal and monetary policy pan out.

I think it is safe to assume that the a V or U shape recovery of out of the question. The excess spending and borrowing of the past few years will take a lot more to recover than a few months of good economic news and data. I have to agree with the economists that believe that that the  recovery will be in the shape of a reverse square root. This basically means that the economy will expand briskly and then taper down to an extended period of weak growth.

3) Interest rates:
In the past high interest rates were caused by inflation and their lowering ended recessions (well it was not that simple but it was pretty darn close). This time is an exception (we’ve all heard that before). At the time of entering the recession the US had a modest interest rate of 5.25%. The Fed effectively cut it to zero and aggressively bought bonds, mortgage backed securities and anything else it could to get the economy going again. However, bank loans to both businesses and individuals still continue to decline with only government backed Fannie and Ginnie Mae along with Freddie Mac are the only one to really give out credit.

Interest rates, as mentioned earlier, will have to be treated with great care. If growth is good the Fed will resist the temptation to increase rates.  However, as of right now I feel that a very modest increase will be witnessed by mid 2010 and go through 2011. Depending on how interest rates will move, stocks will be impacted as well. When interest rates move up people move from ‘offensive stocks’, semi conductors, tech etc. to ‘defensive’ ones like pharma and food.

4) Housing market:
This is going to be a tough one to call. Some analysts are seeing a bottom while others are expecting it to go down further. The facts are quite depressing: new home construction is at its lowest point of GDP since the 1960′s and inventory of  unsold new homes is the lowest its been in nearly 2 decades.  Ive already mentioned (in a previous post) that commercial real-estate is a ticking time bomb, ready to wreak havoc. I feel that with unemployment still in double digits, housing stats will not be improving any time soon.

5) Unemployment:
Though double digit unemployment is concerning, in terms of employment numbers improving your guess is as good as mine. I expect it to peak at around 10.4% and then be in check after Q2 in 2010.

6) Inflation:
Inflation is something to be worried about in the long term. Currently there is not a high probability of any run away inflation. Basic economics states that inflation is caused when there is excess aggregate demand. However, currently the economy is dealing with excess capacity (firms are not producing to their optimal capacity) rather than excess aggregate demand.

7) Company earnings:
Pundits have been quite happy with earnings from companies and with the economy in general. Without sounding like a pessimist, though the end of 2009 did seem encouraging it is important to note that the numbers may be a little skewed as the economy went through a serious tightening followed by a widening of credit spreads. Furthermore, a lot of companies feeling the pinch were able to strip out a lot of the bad results while conveniently leaving in the non-recurring (one time) positive results.

2010 will not see the economy soar. It will consist more of policy makers trying to tackle weak demand for borrowing, fixing their balance sheets and developing strategies to ween the economy off the stimulus. It is going to be a year that needs to be handled with intense care, finesse and economic prowess.

It has been a tough year for a lot of people. Lets work hard not only to improve our lives but the lives of those around us. I hope people realize that they have a lot to be grateful for and that though things may be tough, we have it better than a lot of those less fortunate around us… On that note, I would like to both wish all my readers a very happy and prosperous new year and thank you for reading and supporting my blog.

Finance, The Economy