James Saft

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

While it may well be a case of cut the U.S. budget or suffer a bond crisis, the current debate begs a question: who will pick up the slack in the economy and who exactly will finance them?

Democrats and Republicans raced, in a plodding sort of way, on Wednesday to reach a compromise budget deal that would keep the government operating past a Friday deadline.

Regardless of what may be wise, the likelihood is that there are going to be further substantial cuts in government expenditure, though this won’t begin in earnest until after the 2012 elections.

That is when the fun is going to start.

It is a simple fact that every dollar less in government expenditure is a dollar less received by the private sector.

Households in the U.S., being already in a sort of adrenal failure, are in no shape to expand spending and borrowing when the government contracts. Even the most extreme monetary policy over the past three years has only managed to bring on a tepid resumption in consumer spending, and, given the state of the housing market and the depressing path of wages, families beneath the top 10 percent are simply not going to go on a spree.

That leaves the corporate sector, and that is where we come to the role of the banks; their fantastic profits and their doubtful ability to finance a substantial recovery.

“The current balance sheet ratios of U.S. banks remain a serious impediment to the economy’s sustained recovery,” according to Andrew Smithers, economist at Smithers & Co in London.

If government is cutting and households are moribund, corporations are going to feel the strain in the form of reduced cash flow. This may mean increased investment, which implies taking on additional debt, or it may mean a fall in profits from their current historically high levels.

The state of corporate profits, as outlined in the national accounts released at the end of March, are really astounding. Overall corporate profits margins are at a record above 35 percent, their highest level ever in records stretching back before the crash of 1929.

The lion’s share of these profit margins are being generated by financials, which are at about 54 percent, well above their previous 1929 peak and more than 40 percent above mean. While that mean argues for a reversion, it is interesting to consider exactly why profits in finance recovered so quickly and with such an extreme trajectory.

ECONOMY TAILORED FOR BANKS

All of this is because the economy has been engineered by the authorities to allow for a bank recovery via profits, almost certainly at the expense of the rest of the economy. It is especially striking that while financial firms are far smaller than the rest of the corporate world in terms of the value they generate, they are twice as profitable per dollar of output. We also can’t expect banks to lead an investment recovery; they make fixed investments of only about a tenth of what nonfinancial corporations do.

Of course Geithner, Bernanke and Co were frantic to save the banks because they play a vital role in the economy; they must finance the assets that lead to expansion.

The problem though is that retained profits of the banks are only barely sufficient to support the growth in assets that would come with a healthy recovery, according to Smithers. If financial profits revert to mean, as is likely, especially in a rising interest rate environment, the banking sector may not have the muscle to fulfill its role. Bank equity ratios too, though high compared to recent standards, are not when looked at in the longer term.

Asset growth is crucial; looking at FDIC figures, asset growth in the banking system is running at about 6.75 percent, below the 7 and 8 percent growth of most of the last decade. Considering that securitization remains largely shut down, with the exception of the government-backed housing markets, this implies really quite tepid asset growth.

So, we have a government that is going to embark on painful cuts, a household sector that will suffer rather than compensate and a corporate sector dominated by finance, which leaks huge amounts of its profits in excess compensation and can’t even be relied upon to play its role in financing the economy.

It would have all been very different if the U.S. had forced proper writedowns and banking recapitalizations. The economy would not have had to be engineered for bank health and Main Street malaise, as it is today, and the healthy financial sector would be better able to support growth.

Budget cuts are coming, they will be painful and they will expose the weaknesses remaining in the banking system.

(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.)

It looks just about possible that creditors are going to be paying something like their share of the euro zone debt disaster after all.

This could be a little patch of justice in an unfair world, but like most justice it promises long term benefits but short term pain, both for those dispensing and receiving it.

Firstly, people with money and a choice are going to – indeed already are – voting with their feet, choosing not to lend to the ailing governments on Europe’s periphery.

Secondly some of these creditors to Ireland, Greece and Portugal and their banks will very likely find that their share of the damage exceeds their capital, an inconvenient reality for both the banks involved and the sovereign hosts who will have to pick up the pieces.

The EU summit last week ended with a set of policies that told creditors directly that their heads will be on the block when the European Stability Mechanism (ESM), a bailout conduit, kicks in.

All European government bonds issued from July 2013 will include a provision that makes buyers vulnerable to forced extensions of the bonds, reductions in interest rates and ultimately write downs of principle in the event of a crisis.

On top of that, once the ESM takes effect, garden variety lenders like banks and pension funds will be subordinated, meaning the government bailout fund gets its money back first.

Accessing the fund may require a debt restructuring, a polite term for a partial default.

While this may be just and is definitely politically expedient for the politicians trying to sell the bailout back in Berlin and Paris, it is also the equivalent of ringing a great big fire alarm in a crowded theater – everyone is going to head for the exits.

And they duly have. Ratings agency Standard & Poor’s has downgraded Portugal and Greece, citing the new rules this week. There is every reason to expect that Ireland will not be far behind.

Credit spreads have widened in a self-reinforcing spiral that makes accessing emergency help more likely, which in itself is cause for yet more selling of government bonds.

Don’t get me wrong. People who have lent money in a cynical attempt to cash in on the moral hazard trade deserve their losses, as do earlier lenders who merely failed to do their due diligence.

That said, I can’t help but feel this is going to spin out of the orbit of burden sharing and into something a bit more chaotic. For me, as for many German taxpayers, this is looking like a “be careful what you wish for” moment.

IRISH BANK CREDITORS FACE SHEARS

Shortly after this column is published, Ireland will release the results of its new stress tests on its cratering banking sector. At the same time, if news reports are correct, an indefinite term bailout vehicle for them with ECB and EU support will also be announced.

The stress tests will likely show that Irish banks need an additional 30 billion euros or so of capital, taking Irish state investment to 75 billion or so, a whopping 45 percent of annual gross national product.

This is a staggering amount and given that the policies of austerity will only erode the value of the assets Irish banks have lent against further, there is no guarantee that this is where it ends.

Ireland’s new government appears to be taking a harder line about forcing lenders to Irish banks to take a portion of the losses. Subordinated creditors are sure to have their loans restructured and senior creditors may well face losses too.

To be clear, it is right that the banks that fed the Irish banking beast with easy loans take losses as a means of easing the hardships that are falling on the Irish people.  Ireland’s banking system, like Iceland’s and arguably Britain’s, was way out of proportion to the size of its economy.

This may well be simply a negotiating ploy by the Irish government, as a substantial write down of Irish bank debts will spread losses, and more importantly fear, widely across Europe’s banking system.

A rescheduling by Ireland, Greece or Portugal will be highly disruptive for global markets and you can bet that the ECB and EU are under tremendous pressure to make sure it does not happen.

There is, though, a sense that there is not political will or capacity to bring about a solution that keeps Greece, Ireland and Portugal all on board but can also be sold to the German electorate.

It has been a long first three months of the year. Egypt, Japan and Libya have distracted attention, while the long-running and procedural nature of the euro zone’s problems make them a pleasure to ignore.

Things could, in the next week, move rapidly and perhaps upend widespread expectations of an ECB hike on April 7.

(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. Email: jamessaft@jamessaft.com)

Will bond investors keep faith with U.S. government debt amid signs of growing global inflation?

In the end, as with all banks, even central banks, it boils down to trust.

Asked on Wednesday at an appearance before the U.S. House of Representatives Budget Committee if the Fed’s $600 billion programme of quantitative easing amounted to monetization — that Peter to Paul transfer when a government prints money to pay for a shortfall — Ben Bernanke said an interesting thing:

“Monetization involves a permanent increase in money supply though money creation. (QE) is a temporary measure that will be reversed. Money will be normalized and there will be no permanent increase in outstanding balance sheet or inflation.”

So, because he intends to undo it later, he’s not doing it now.

This is both demonstrably false and deeply, at least for now, true.

False because, of course, money is being created to fund the purchase of debt issued by the Treasury. True because Bernanke can avoid the disaster often associated with monetization so long as he retains the faith of the world’s investors that he not only intends to unwind QE but will be able to do so at the right time in the future.

Monetization is an inflammatory term because so often in the past the practice of funding a revenue shortfall by buying debt with newly printed money has worked out poorly, resulting in an inflationary spiral that beggars creditors and kills the real economy.

You can bet your last Confederate dollar that all the previous central bankers who bought their own bonds with their own printed money promised that they too would withdraw before it was too late. And some of them actually did withdraw the extra money, including some of Bernanke’s predecessors at the Fed during and for a time after World War II.

Daniel Thornton, a vice president at the St Louis Fed,  suggests a slightly broader but still self-referential definition of monetization, in essence saying that it can only be judged not by action but by comparing a central bank’s performance against its targets. <http://research.stlouisfed.org/publications/es/10/ES1014.pdf> That is well and good, but really leaves investors with nothing to rely upon but faith.

NO SIGN OF PANIC
So far, at least, the signs are that the world’s bond buyers believe Bernanke; so-called 5yr5yr forwards, a measure of inflationary expectations in five years’ time, show an uptick of about a percentage point since QE2 came on to the agenda last August, but only up to a pretty tame 2.8 percent or so. It is likely that some of that move represents rising risk of runaway inflation, but it also reflects rising confidence in growth.

Despite medium- and long-term concerns about the budget and the economy, Bernanke is in a reasonably strong position; he represents the world’s largest economy and its principle reserve currency.

That said, the loss of confidence, if it came, would be swift and devastating, more all of a sudden than little by little.

While Bernanke’s recent comments give little indication that a rethink of QE is coming soon, his colleagues are now sounding a lot less enthusiastic.

“Barring some unexpected shock to the economy or financial system, I think we are pushing the envelope with the current round of Treasury purchases,” Dallas Fed President Richard Fisher, a noted hawk, said in a speech on Tuesday.

“I would be very wary of expanding our balance sheet further; indeed, given current economic and financial conditions, it is hard for me to envision a scenario where I would not use my voting position this year to formally dissent should the FOMC recommend another tranche of monetary accommodation.”

Fisher goes on to blame Congress for creating the debt, but the message and fear are clear: monetization should be rolled back.

In speeches the same day, Jeffrey Lacker of the Richmond Fed recommended that the Fed consider adjusting QE in light of improving data while the Atlanta Fed’s Dennis Lockhart said he thought no more bond buying would be needed after the expiry of the current $600 billion plan at the end of June.

Those are still minority views, and will be until Bernanke changes his tone. Given the very mixed signals coming out of the U.S. jobs market, don’t expect that to happen any time in the next month. Remember too what happened last year, when the Fed stepped back from QE1 only to see the economy weaken undesirably as the year wore on. Markets only revived once Bernanke all but promised another round of bond buying at the end of August.

For now, the controls are still in Bernanke’s hands, but keep watching the bond market.

(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. email: jamessaft@jamessaft.com)

Looking to hedge against a spike in inflation? Equities may not be much help.

Neither, for that matter, will you do all that well over the longer haul with bonds, cash or even commodities, at least on the historical evidence. In short, when it comes to investing, inflation is a real drag.

It’s impossible to know if, much less when, the current very stimulative monetary policy in the developed world will spur inflation, but increasingly indicators are raising concerns. Emerging market economies show signs of overheating, while prices of food and many other commodities are surging.

The traditional view has been that equities are an effective hedge against inflation, in least over the long term, because companies will, all things being equal, eventually pass on inflation to their clients as higher prices.

That’s the theory, but the practice may prove to be much different, according to a study by IMF economists Alexander Attie and Shaun Roache, who examined the performance of a range of traditional asset classes in the aftermath of inflation shocks.

“Among traditional asset classes, inflation hedges are imperfect at best and unlikely to work at worst,” according to Attie and Roache.

First, the authors looked at returns in the 12 months after inflation shocks in the period after the 1973 end of the Bretton Woods system of fixed currencies. The results were not surprising; bonds got killed, equities did badly, as did cash, while commodities were an effective hedge. Real estate investment trusts (REITs) did about as badly as equities, somewhat undermining the argument for real estate during inflationary periods.

All well and good, but really only of use for the small number of daredevils who are willing to make big asset allocation shifts over a short period of time.

For most savers, not to mention pension funds and endowments, the more useful question is how do you hedge against inflation for the longer term?

The results for equities were not encouraging.

“Equity returns decline in the months following an inflation shock and do not experience a meaningful recovery thereafter, leaving them as the worst performing asset class in our sample,” according to the study.

“Our findings are consistent with evidence from a range of earlier studies and add further weight to the evidence against the theoretical arguments for equities as a real asset class providing inflation protection when inflation is rising.”

Over the 18 months after the shock, real returns were negative, though less negative than bonds, which get hammered by inflation. Equities improve a bit over the next couple of years, but even when looked at in the long run of more than five years an inflation shock makes for losses in real terms.

IN THE LONG RUN WE’RE ALL …
As for the other asset prices, inflation proves very difficult to hedge against even over the longer term. Take commodities, the star performer in the first 18 months after inflation bites; spot prices decline in the medium term and when you get above five years after the inflationary event you are looking at actual losses in spot prices. This might be because inflation hits demand, but also might be because high prices spur greater investment in efficiency, which over the long term also moderates demand.

While bonds get killed in the first couple of years after an inflation shock, after about three years returns improve, presumably partly because investors demand higher yields to make up for nasty recent experiences.

Cash returns do a bit better, but even cash, which can go where it likes in search of better returns as inflation increases, fails to serve as a perfect hedge over the longer term.

So, how to hedge against inflation? Inflation-protected bonds such as TIPS would work, but to be a hedge you have to buy and hold to maturity, as outside forces can easily distort returns through the life of a given bond.

Given that inflation is a portfolio killer, why then are equity markets booming? Well, in emerging markets where inflation is kicking in first they are not. In developed markets, investors seem to be placing a touching amount of faith in central bankers. After all, if the Federal Reserve and ECB don’t pull the plug on stimulus in time, inflation can easily get out of control.

Or perhaps equity markets are betting the central banks will fail to stoke growth and be forced to blow a larger asset market bubble as a consequence.

Or maybe everybody thinks they will be the genius who gets out in time.

(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. email: jamessaft@jamessaft.com)