Month: April 2015

No, central banks don’t believe in the “wealth effect” either!

It is generally believed that the unconventional monetary policy of the Fed (and by extension the ECB and BOJ) is due to the so-called „wealth effect“. According to this theory, a rise in asset values will lead to higher average wealth, which in turn will boost confidence and spending. As for those households who have no assets to show for, don’t worry, the wealth is supposed to „trickle down“, from top to bottom. Step by step, all boats will be lifted by the tide.

Now, as an Austrian, I have always been sceptical of this theory. After all, the economic system is too complex to be planned in this way and unintended consequences are the rule, rather than the exception, as any real world decision maker will testify. Further, the typical Keynesian analysis of the root cause of the problem, namely that all ills are due to a lack of „confidence,“ strikes me as rather simplistic. What about incentives? The legal framework? Labour market flexibility? There is much, much more to a growing economy than confidence. And how do you define (or measure) confidence anyway?

But my view has changed. I do no longer believe the Fed believes in the wealth effect either. They are not that naive!

They must have noticed that buying financial assets merely increases inequality (and the systemic risks). A billionaire who gets another billion doesn’t spend much more than before. He usually also doesn’t start a new business. He still remembers how hard he had to work in the beginning to be successful: the sacrifice, the tension, the nagging doubts. Now he wants to enjoy the money – conspicuous consumption (check out Jim Chanos’s Sotheby’s short thesis here). Yes, he might give it to charity. But charitable spending, doesn’t lead to sustainable growth. Only risk taking and hard work can to that.

Likewise in Europe, Mario Draghi is not that stupid to believe that driving down the funding costs of his native Italy from 1.5 percent to negative will suddenly kick-start lending, or a healthy venture capital scene in that country. Obviously, the Mafia problem in the south is not a function of interest rates. He also must already have noticed that buying time for reforms doesn’t automatically lead to politicians delivering them. There simply is no empirical evidence whatsoever of governments reforming without a crisis. The much-cited Swedish banking crisis is a case in point: interest rates back than were not negative – they were in the triple digits…

But what, then, is this experiment about?

I think it has to do with the precarious state of the banking system. As I have hinted at on this blog (here) a few weeks back, I do not think the US banking system has been really fixed. In other words, I disagree with the common view that it is only Europe’s banks that are plagued by high NPLs. They might not appear as NPLs on the balance sheet, but surely a lot of debtors in the US are quite levered and would be in serious trouble with slightly higher rates.

Or, just ask yourself what would happen to the profitability of the banking system, if the Fed funds rate were 2 percent, i.e. if there were a cost to liquidity again. (2 percent is close to the 1.75 percent Stan Druckenmiller believes the fed funds rate should be if the Fed still followed the Taylor rule). Does anybody think they could reprice their assets accordingly? I can tell you what would happen: Banks would have an incentive to stop the extend and pretend game they like to play with debtors that are underwater. This would lead to accounting losses and falling asset values, as banks try to liquidate collateral.

Not convinced?

David Einhorn’s latest quaterly letter contains an interesting observation which seems to confirm my thoughts. He points out that the sale of large chunks of GE capital, the banking arm of General Electric, led to a huge „after tax charge“ of USD 16 billion thereby casting doubt on GE’s reporting. Now, David thinks this is a GE specific problem, whereas I believe it is a bank-specific thing. I do not think GE could have cooked its books for such a long time if it were a mere industrial play.

Conclusion

I think central banks unorthodox policies are due to the fact that they recognize the banking system still suffers from legacy problems. Of course, it would be difficult to sell a back-door bailout of the banks to the public, hence the „wealth effect“. Now, there is no need to resort to conspiracy theories to get this result. It is a natural result of bureaucratic risk aversion and incentives. Neither does it imply that central bankers are omniscient. Whereas they are not that stupid to truly believe in the „wealth effect,“ they nevertheless can be considered naive to think that inflating asset prices can solve the bad debt problem, but more on that in another post.

Excellent Article on Turkey

Wanted to share this excellent post on Turkey by Dani Rodrik. I agree with all he says.

I have been trading the Turkish market since 2003, but have sold all my positions in 2011. Ever since I have waited for this house of cards to crash. Given that many European banks are engaged there, this could be a much bigger catalyst than anything Greece related. I have never understood the hype around Turkey’s economy over the past five years and always enjoy to compare the articles in the financial press on Turkey with those on Russia. The latter is always treated as a basket case, although fundamentals (and potential) are much, much better there. Further, Turkey’s president easily matches Putin when it comes to silencing critical opponents.

Interesting how political issues colour the reporting of the free press. More attention should be paid to these things…

The Russian Ruble is rising

As regular readers know, I have been heavily long Russian assets since December. I have outlined my thesis several times on this blog. Although I am up double digits for the quarter (despite a 35 percent cash position), I am not satisfied with my performance. Given that the consensus was so wrong, I should have made more of it. Back in December I wanted to put up to 30 percent of my net worth in Russian assets, which I could not do as the market improved rather quickly. Lesson: cost averaging is a dumb idea when assets are deeply undervalued (and I was a bit lazy as well)….

Costly mistake!

Now I read about Elvira Nabullina, the head of Russia’s Central Bank, saying:

There’s no reason to expect QE from us — our main instrument is the key rate,” Nabiullina said Tuesday. “I understand the sincere wish both to make loans more accessible and to spur economic growth. I understand these goals but believe that the recipes used by many countries won’t work and will have the opposite effect in the conditions of our Russian economy.

That’s correct Elvira: debt fuelled growth only distorts the economy and anyway mainly helps the crony capitalists, not the average Russian voter…

Although I think a technical correction could be in the cards for the RUB, with Central bank heads like this the Ruble could become the new DMark 🙂

PS. For the record: I DO think Elvira Nabullina handled the Rosneft refinancing badly, thereby causing the completely unnecessary RUB spike in December. I wanted to write a post on this, but lacked the time. Nonetheless, as CB-governor she is far better than Yellen or Draghi.

 

Fresh insight into Greek banks

A reader has sent me his analysis of another Greek bank, Eurobank. He does a sum-of-the parts valuation, backs out the market’s expectation of future business and concludes that unrealistic operative improvements would have to be undertaken in order to justify the current value. In other words: Future business value explains a large part of the valuation. Great analysis. Read the whole piece!

In my discussion of Piraeus bank with David Einhorn back in November, it turned out that David is expecting the market to award Piraeus with a premium to BV three years down the road (BV of 1.5) as a result of healthy growth and profitability prospects. In other words, an investment at the prices back then only made sense if you were willing to assign a substantial value to future business – as is the case with Eurobank now. I was highly sceptical then, I remain sceptical now, although prices have come down quite a bit.

How is such a discrepancy in evaluation possible?

Of course, different opinions make a market, so there is nothing strange about that per se (although mainstream academia still operates under the “common knowledge” assumption resulting no-trade theorems, but that’s another topic). But, I think it is still helpful to understand the source of the discrepancy as thereby you understand your own thesis better. For instance, whereas it turned out that David Einhorn was more bullish on the Greek economy than me, I do not think that was the major source for our different assessment of the situation. Instead, I think David (and the market) underestimate(d) the impact of “legacy” assets, i.e. loans made in the past which are performing poorly and still on the balance sheet. The more the book value of legacy assets overestimates the market value of these assets, the higher your estimation of future business value has to be ceteris paribus.

And no amount of liquidity can solve the NPL problem for the Greek banks. After all, there is a reason why one distinguishes between a solvency and a liquidity crisis…

As goes Iron Ore, so goes Australia…

The AUD has been weakening consistently this year . This is logical given the drop in iron ore, Australia’s main export product, in Q1 2015. From the FT,

(…) Iron ore, which slumped almost 50 per cent in 2014 because of growing supply glut, have fallen a further 30 per cent in the year to date and has sunk 10 per cent in the past three trading sessions (…)

It seems that the decline is gathering speed. I think the AUD has to fall much further for the reasons outlined in my orignal post. For convenience, I am reproducing the main chart that shows how important iron ore is for the Australian economy…Aussie-exports-by-type-590x560

In a nutshell, Australia’s economy has little to show for apart from commodities.  This is also reflected in the economic complexity index (ECI) where Australia ranks 52 – lower than Greece (47) or Costa Rica (51) and far behind Russia (31), a country which is commonly associated with commodity dependency (and which I have been long since December)…

I find the case that Australia’s economy is a developed one hard to make. Nevertheless, its gdp/capita, measured in USD, is higher than in the US or Europe. The currency has a lot more to fall….

(Disclosure: Long RUB, short AUD)