James Saft

James Saft is a Reuters columnist. The opinions expressed are his own.

HUNTSVILLE, Ala., Aug 30 – In an unintended irony for a continent with a great public transport infrastructure Europe’s debt rescue plans are turning into a train wreck. Consider that as Greek two-year interest rates stood at 45 percent on Monday, officials and interests in the euro zone descended into an unseemly mix of squabbling over assets, denying the undeniable and disagreeing about first principles. Even as weak as recent U.S. economic data has been, these fractures, which imply heightened risk of a bank-centered market crisis, are surely the main source of the recent extreme financial volatility.

Most interesting was the intervention by newly minted International Monetary Fund Managing Director Christine Lagarde on Saturday who warned “developments this summer have indicated we are in a dangerous new phase.”

Lagarde went on to say that Europe’s banks need “urgent recapitalization,” using public funds if necessary, and advised that one option would be to use the European Financial Stability Fund (EFSF), or some other vehicle, to inject capital into banks directly.

Here we have the head of the IMF, a woman who was until recently the finance minister of France, more or less asserting that the bank stress tests are best disregarded and that people should have real doubts about the banks they do business with, invest in and lend to.

This is nothing that cannot be seen in market prices, of course, but it’s a bit as if U.S. Treasury Secretary Tim Geithner were to leave government service, set up as an equity analyst and come out with a “sell” rating on Bank of America.

Not helpful, even if perhaps true.

Lagarde said that Europe risks a liquidity crisis, though surely any crisis that comes as a result of people withdrawing credit from banks because they have not got enough capital has to be classed as a crisis of solvency.

Euro zone officials were quick to stamp on the idea, pointing out there were well known remedial steps being taken as a result of the stress tests, and that new banking regulations offered further protection. It is good that euro zone officials can agree that they’ve solved the bank capital problem, because very few others seem to agree.

On other issues, European officialdom is showing comical, if destructive, disagreement. Take Finland’s demand for collateral as part of its participation in the rescue of Greece. This demand immediately sparked a round of “me too” demands from other smaller euro zone players, states whose share of the package is about 10 percent. To an outsider, this looks suspiciously like a lack of faith in Greece and in their European partners. It has the feel not of a rescue of a sovereign state and euro zone partner, but of in-fighting among the creditors in a bankruptcy.

While Finland appears to have backed off from some of its demands, the situation hardly inspires confidence.

A LITTLE LOCAL DIFFICULTY

And of course even within countries there are deep political divisions over the right path. Germany is an excellent case in point; Chancellor Angela Merkel last week came out against Finland’s bilateral deal and euro zone common bonds, while maintaining that she would be able to push through approval by parliament of the expansion of the EFSF. Reports in German media indicate substantial opposition within Merkel’s somewhat shaky coalition, meaning she may be forced to seek votes from the opposition. Merkel has canceled a long-planned visit to Russia on Sept. 7, the day of the vote.

The ECB’s decision to buy Spanish and Italian debt on the open market, a thus far successful effort to cap interest rates for the two vulnerable states, has left it subject to strong criticism that it has overstepped its bounds and compromised its independence.

German President Christian Wulff last week inveighed against the ECB’s action and against the last-minute nature of recent policy-making.

“I regard the massive acquisition of the bonds of individual states via the European Central Bank as legally questionable,” he said, speaking at an economics conference in Lindau, Germany.

Wulff cited an article in the European Union’s fundamental treaty, which he said prohibits the ECB from buying bonds directly from governments.

“Decisions have to be made in parliament in a liberal democracy. That is where legitimacy lies,” he said. This is an interesting echo of the less well tempered criticism of Ben Bernanke by presidential hopeful Rick Perry, who said that further radical easing by the central bank would be “treacherous, almost treasonous.”

The truth, perhaps, is that Europe is a group in an impossible situation, just as the Fed is an institution in an untenable position. Groups of people in impossible situations tend only to act when forced, and only rarely are able to act in concert.

Expect an active and unsettling September.

At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.

James Saft is a Reuters columnist. The opinions expressed are his own.

HUNTSVILLE — The best reason to sell risk assets is perhaps that the best reason to buy them in are hopes for what one man will say on Friday in a mountain resort.

Federal Reserve Chairman Ben Bernanke’s much anticipated speech at the Jackson Hole economics conference is the subject of fervent wish-casting by investors hoping for another dose of central bank adrenaline, either in the form of more asset purchases, a move to entice banks to lend, or possibly a change in the composition of the bonds the central bank already owns.

Relief measures may be offered, and a rally of risky assets will ensue, but even if they do, Bernanke faces one really powerful opposing force: a wall of money coming the other direction in the aftermath of the credit downgrade of the U.S.

Since the U.S. lost its AAA rating on Aug. 6, 10-year bond yields have tumbled, falling below 2 percent for the first time in history at one point, and even now at an extremely low 2.25 percent. The fall actually began in the weeks before the downgrade, and was in part driven by anticipation of it.

To be clear, falling bond yields also reflect deteriorating economic fundamentals, but much of the momentum has been and will be driven by the profound shock that the loss of the U.S. AAA rating, or risk-free status, has dealt the global financial system.

“This is precisely the reason why U.S. government bond yields have dropped so much in recent months,” Jochen Felsenheimer of Munich-based asset management company Assenagon wrote to clients.

“And not, as officials would have us believe, because most investors see U.S. government bonds as a safe haven. The exact opposite is actually the case.”

This is the great risk-off trade, a huge flow of funds out of riskier instruments like shares back into government bonds, as investors newly alive to the possibility of sovereign default seek to recalibrate the overall risk/reward balance of their portfolios.

While lower Treasury yields make it easier for the U.S. to finance itself, and theoretically should make riskier investments more attractive, the fact that the money is coming out of stocks means that confidence and balance sheets makes this particular drop in interest rates far from stimulative.

MUCH DEPENDS ON A RISK-FREE RATE

To understand why this may be so powerful, it is important to know just how central the concept of the U.S. as a risk free borrower was to the global financial system. This idea, that there exists a risk-free rate against which investors can measure every kind of risk, underpins how central banks work, how the banking system functions and how a huge number of portfolios are constructed.

The widely-used Capital Asset Pricing Model (CAPM), pioneered by Nobel economics laureate William Sharpe, uses the existence of the risk-free rate as a key input to allow the measurement of how much return investors should demand from a given instrument given their objectives.

Risk taking, such as buying a share or making a loan to a company, is, under CAPM, predicated on the existence of risk-free Treasuries, which can serve as a kind of ballast to portfolios. If investors think Treasuries may actually carry a small but real chance of defaulting they will react, at least at first, by selling riskier investments and buying more Treasuries as a means of bringing their overall investment closer to their risk tolerance.

Similarly asset liability management as practiced by insurance companies depends on there being risk-free investments that can help them manage their risks. Since the very purpose of an insurance company is to maintain enough capital to meet obligations, suddenly introducing the idea that Treasuries actually represent credit risk is earth shaking. Rather than simply worrying about the risk that interest rates might rise or fall, insurance companies will be worrying about getting their money back. Again, the knee-jerk reaction should be to sell risk assets and buy the safest ones around, ironically Treasuries.

The other implication of all of this is that as the world’s investors take on less risk in their investments they accept less return, raising problems for pension saving and also very probably acting as a brake on overall economic growth.
It must be very tempting to Bernanke and the Federal Reserve to look at this great risk-off trade and think they hold the solution, to take some new radical step to flush money out of comparative safety and back into the risk markets.

Unfortunately, confidence in the sovereign credit of the U.S. and confidence in the Fed must be closely intertwined. Each succeeding intervention by the Fed has had seemingly less effect, and for a shorter period of time.

If there is a risk rally on Friday, let’s see how long it lasts.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

James Saft is a Reuters columnist. The opinions expressed are his own.

For Libyans the fall of Muammar Gaddafi comes about 40 years too late, but from the point of view of the global economy it is not a moment too soon.

The apparent end of the reign of Gaddafi, whose whereabouts were unknown on Monday after rebels took Tripoli, will take pressure off of the price of energy, especially in hard-hit parts of southern Europe, and thus ultimately may remove roadblocks to further easing by either the European Central Bank or Federal Reserve.

Brent crude futures, the key European measure, fell by as much as 3 percent on Monday following the taking of Tripoli by Libyan rebels before settling about 1 percent down, while the U.S. measure rose about a third of a percent.

Libya accounts for about 2 percent of global oil production and in particular has supplied much of the oil consumed in Italy. While experts caution that it may take some time to restore production and exports, the nightmare option of mass sabotage by the falling regime now seems unlikely. Regime change also opens up the possibility that production and exploration in Libya are more competently and aggressively pursued than they had been. Corruption and kickbacks are rife in Libya, and while that may or may not improve, if it does, look for production figures to improve over the longer term.

Lower energy prices are an unalloyed good at this point for the global economy. High gasoline and heating costs act as a brake on consumer demand, something the hard-hit southern euro zone nations can ill afford as they descend into a vicious cycle of austerity and economic contraction.

To be sure, the impact of Libya, even at best, will be small, especially considering the fundamental challenges facing the global economy. Lower gas prices will help consumers in Milan and Little Rock, but it does nothing to improve the equity positions of banks in Italy, and precious little to underpin house prices in the U.S.

That said, it is about time the global economy caught a break, and if this is the one it is going to get, well, things could be worse.

MONETARY POLICY LEEWAY?

With any luck, falling energy prices will give the European Central Bank reason, or at least plausible cover, to reverse their disastrous recent hikes in interest rates. The ECB has hiked key rates twice since April, by a total of a half a percentage point to 1.5 percent. That, simply, is exactly the last thing the euro zone needs as half of it slides into recession and the other half considers if it wants to pick up the check or run for the exit.

At its last interest-rate-setting meeting two weeks ago, the ECB said risks to inflation were still to the upside and that the risks to the economy were balanced, indicating that it was at that time considering yet another increase. Rising oil, gas and electricity prices have contributed strongly to inflation in key measures considered by the ECB, so a reversal would allow the hawks to side with the few doves.

Even if the ECB does nothing, and given their track record that is perhaps the most likely outcome, lower energy prices will help consumption, especially in Italy, and will, at the margins, help to make uncompetitive southern European industries a bit better able to win business internationally.

Again, energy will do nothing to help the banking industry, nor to smooth the path towards fiscal union.

In the U.S., the effects of a new Libya will be less, but even there it will perhaps make the Fed’s position slightly easier.While the Fed concentrates on core inflation, which does not include energy prices, energy costs obviously have a strong impact on inflation over time, and on inflation expectations, which often look through the core figures to focus on the actual out-of-pocket pain at the pumps.

If energy prices fall and the fall is sustained, that will remove one argument against making some new attempt at easing monetary conditions, perhaps even by a third round of quantitative easing.

That said, it is unclear if QE3 will come to pass even if oil drops dramatically, and even less clear if it would be a good idea under any circumstances.

There is still strong internal and political opposition to QE, and for that to be resolved the Fed may need to see a continuing weakening in the economy and employment. At any rate, QE has a poor record of helping anything other than risk assets, and those temporarily.

And of course, the ultimate irony is that should the Fed get radical again by buying up bonds, that in itself will likely fuel a rally in oil which may undermine much of the benefit. That’s what happened last time, after all.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

James Saft is a Reuters columnist. The opinions expressed are his own.

HUNTSVILLE, Ala. – It’s not just that the U.S. economy is ebbing; the stock market has finally woken up to the harsh impact that government austerity will have on corporate profits.

Shares fell again on Wednesday, with the S&P 500 now nearly 15 percent below its late-July peaks. There are plenty of triggers for the fall — the downgrade of the U.S. by Standard & Poor’s and a worsening debt crisis in the euro zone

• but the truth is that the slow-motion small crash is best understood as a reading on what diminishing demand, caused by falling government spending, will do for profits.

Shares rose on Tuesday after the Federal Reserve nailed short-term interest rates to the floor for a promised two years, but that brief bout of euphoria quickly ebbed. It’s not surprising that the Pavlovian response to Fed stimulus is a rally, after all for the past 20 years every market crisis has been met by easier money. What is striking is that the half-life effectiveness of Fed action has diminished so greatly. Perhaps QE3, when it comes, will only buy the market four hours.

“Most investors think that dipping to fair value for a minute and bouncing is normal,” famed value investor Jeremy Grantham of GMO wrote in a note to clients.

“It is, in fact, highly aberrant historically. Markets staying down and washing away a whole generation’s false expectations, high animal spirits, and excessive risk-taking — that would be normal.”

Those resisting that “old normal” point to low share prices when compared to earnings. Sure, valuations are already low historically, but the screaming anomaly in the system is between the health and robustness of the economic system and the level of corporate profits.

Corporate profits before interest, depreciation and tax now account for about 35 percent of GDP, the highest such figure in at least 60 years. Those profits come courtesy, at least in the last couple of years, of deficit spending that helped take up the slack left when consumers realized they couldn’t get rich by borrowing against their houses. Profits have also benefited  from efficiencies, of course, but that too ultimately has its limits.

STAGNANT WAGES

The U.S. has offshored millions of jobs, raising margins, but in so doing has kept wages horribly stagnant. As Grantham points out, wages per hour in real terms in the U.S. are actually down over the past 40 years. Who will buy things, other than the top one percent? Can U.S. stocks prosper in a Versailles-style service economy aimed at only the wealthiest? Not likely.

Remember too that because wage growth has been suppressed in China by official policy aimed at maximizing exports, the consuming classes there are nowhere near large enough to take up the slack. Don’t believe those stories about Chinese driving Buicks and talking on iPhones. There are nowhere near enough of them to keep corporate profits in the U.S. where they are today.

If you accept that government spending in the U.S. will fall over time, you have to conclude that corporate profits will fall as well, at least for the time being. There could conceivably be some private market miracle of innovation and growth that eventually justifies higher stock market valuations, but that is neither guaranteed nor likely to arrive in the next couple of years.

In fact the only way, mathematically, that profits could be maintained at current levels or rise in the face of declining government spending would be for households to save less or borrow more. That isn’t happening; households are saving more than they did a few years ago, but less than they ought to given the poor performance of their assets and wages and the lousy state of their personal balance sheets.

Americans hold too much debt, have poor income growth and are in the process of losing faith in those two Easter bunnies of investment: housing and the stock market.

And remember, cuts in government spending are almost certainly what we will get. The Republicans on Wednesday announced their delegates to the Congressional “super committee” on debt reduction and all six are signatories to a “no new taxes pledge.”

So, the fall in the stock market is rational. There will be some mixture of falling corporate profits and slow to negative growth in the medium term, conditions that are good for safer bonds and bad for equities.

The main risk to this forecast is actually on the downside

• that a crisis in Europe or in the banking system prompts faster, more volatile falls.

The good news, but not for current equity investors, is that falling profits and rising wages will eventually be a harbinger of a recovering economy.

At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.

James Saft is a Reuters columnist. The opinions expressed are his own.

HUNTSVILLE, Ala. — With a U.S. debt deal hopefully past, we can look forward to the ritual trotting out of explanations for why investors should be bullish despite a broken political system and a AAA rating on the edge.

We got a hint of this Monday morning, as shares in the U.S. rallied on news of an expected compromise deal to raise the debt ceiling, but sadly the fun lasted all of 30 minutes before data showing manufacturing was sputtering towards contraction sent shares lower.

Never fear, though, there is no situation bleak enough to make the sellers of hope take flight, so, for the perplexed, here is a handy guide to the four bullish arguments that you should simply ignore in the coming days.

1 — “Corporations are in great shape”

This one, a perennial favorite, posits that even if the U.S. faces a little local difficulty with its debt, don’t worry, its corporations are global now, able to exploit opportunities in a borderless world. After all, look at earnings — they are at lifetime highs despite faltering growth. What’s more, corporate balance sheets are lean, not weighed down by all of that nasty debt that is plaguing the countries and consumers they serve.

First, this argument assumes that corporations can somehow continue to make profits despite faltering spending among their clients. This simply isn’t true, and contraction in government and among households will bring earnings down with a bump, though with a lag.

Secondly, globalization is a powerful force, but corporations will not be able to slip the coming round of taxation. Athens’ woes may not be Apple’s woes, but Washington’s woes definitely will be.

2 — “Money is easy”

Look how low interest rates are, this tale goes, this is highly stimulative. And, if you are lucky enough to still be credit-worthy, there is tons of money out there for the asking. This is going to be very sweet for people with good ideas for investment, and when the economy accelerates it will do it in a burst. Furthermore, all of those fears of inflation are proving wrong; that means rates can stay low longer.

This argument again tries to lift the individual company or investor from the macro backdrop, and won’t work. Rates are low in absolute terms, but relative to growth and capacity utilization they should be substantially lower. They can’t drop below zero, of course, and the Federal Reserve’s willingness to engage in another round of quantitative easing will be very low, given the mixed success of the first two and the political capital such a move would consume.

Falling bond yields can’t be read as a green light to growth, but rather as a reflection of the risks of a double dip, and quite possibly more Japan-style deflation fears to come.

3 — “Emerging markets will save us”

Sure, the U.S. is stumbling and Europe is in crisis, this particular bullish take goes, but emerging markets are still growing strongly and will drive demand for raw materials, food and consumer goods. Just invest in companies which make, mine or grow the things emerging markets want and you will clean up.

Well, Chinese manufacturing is actually contracting, according to the latest HSBC purchasing managers index survey, while India’s manufacturing sector is showing the weakest growth in 20 months.

Emerging markets can no more escape the gravity of global growth than can corporations, and the big picture is very weak. Look at Britain, where manufacturing is also going into recession, hurt by lousy domestic demand courtesy of the policy of austerity the U.S. apparently wants to now follow. Look at Italy, which is looking fragile and may soon add its considerable weight to the deflationary force flowing out of Europe.

4 — “Someone is always making money somewhere”

This one, beloved of brokers everywhere, is the original sin of the investment industry. It posits that there are no bad markets, only bad investors unable to capitalize on the opportunities that the twists and turns of the market provides. It is a deeply seductive idea, as it plays on our narcissism, our false feelings that we are uncommonly provided with common sense and, of course, our desire to becoming satisfyingly rich.

The implication here is that no matter how bad the backdrop, you as an investor should be able to game it, to aggressively time the market. The truth is you can’t time the market; very likely neither can your broker, your mutual fund manager or your pension fund manager. Someone out there probably can, but we will either never find them or won’t realize it if we do.

Here is the bottom line: global growth is slowing alarmingly, austerity is in fashion and the U.S. looks politically and economically weak. The stage looks set for years of subpar growth.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)