James Saft

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

HUNTSVILLE, Ala. – Right about now, even the most committed capitalist investor ought to be hoping for one thing: that labor soon has the upper hand.

That’s because the whole edifice: the global economy, the consumption-based developed economies and the share prices they power are crumbling because average workers simply haven’t got enough earning and buying power to play their central role.

Wages in the U.S., for example, have been stagnant for the best part of 40 years, during which time the consumption merry-go-round has only been kept spinning through a combination of artificially high asset prices and spending borrowed money.

Consumer incomes actually fell in August for the first time in almost two years, according to new data, and consumer spending only eked out a modest gain due to a sharp fall in the savings rate. Given that people are living longer and have stressed balance sheets, dis-saving is a tactic that will only work for so long.

This state of affairs has allowed corporate profits, as a share of the economy, to hit their highest point in the second quarter since records began in 1947, and on track to hit an annual high since at least 1929. Even the stock market no longer sees that as evidence of rude health, as shown by the steady, grinding decline in prices relative to earnings.

To be sure, this long-term stagnation in wages is in substantial part because of globalization. Some of what labor in the developed world lost has been converted to gains for labor in emerging markets, where income has surged over the past decade. Nonetheless, the system is predicated on consumption in the west and that consumption is crimped by stagnant incomes and high debt loads.

Up to a point this will be self-correcting. Wages in China, for example, have grown strongly, which will eventually lead to domestic consumption there and to a balancing out in the relative costs of production. Sadly, that long-term solution is not going to arrive in time to save this morning’s equity investors, which is perhaps why so many of them are deciding to become this afternoon’s debt investors.

This is the catch for equities; a vibrant economy depends on a rebalancing of negotiating power between labor and capital, but that very process is going to undermine corporate profits, and with them stock prices. The best strategy may well be to remain structurally underweight equities until that rebalancing has happened or until the stock market moves ahead to price it in.

UNSUPPORTIVE POLICY

There has, rightly, been a great focus on debt in the current malaise, with much head-scratching over how to deal with Greek sovereign debt and individual mortgage debt. That’s natural because debts come due and when defaulted upon have a nasty habit of causing a chain of defaults through the economy. Even so, the focus then has been on how to protect debt holders from the consequences of their foolishness and the foolishness of the parties they loaned money to.

“Almost all remedies proposed by global authorities to date have approached the problem from the standpoint of favoring capital as opposed to labor,” bond giant Bill Gross of Pimco wrote in a note to clients.

“If the banks could just be stabilized, if the ‘markets’ could just be elevated back in the direction of peak 401(k) levels, if interest rates could just be lower so that borrowers would inevitably take the bait, then labor — job creation — would inevitably follow. It has not.”

In the case of Greece, that is because austerity only makes it weaker and less able to bear the debt’s burden. In the case of over-indebted mortgage holders it is because most loan modifications leave the borrower with more than they can afford.

All of what we are describing is deflationary, which makes the epic rally in government bonds seem not so much a bubble as a down payment on future gains.

Investors hoping, as they will and as they should, to make profits need to get some things straight in their own minds: who, exactly, is going to buy all of these goods and services and where are they going to get the money?

It is not clear that monetary policy can address this. Its success rate so far is not great. It is far less clear that fiscal policy will even be given a chance.

It is reasonable to expect that eventually western labor will make gains, and that emerging market labor’s new buying power will slowly build and provide a buttress to global demand. That’s not happening any time soon, to judge by the run of events, which is a good reason to remain shy of equities.

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.

You can lie to taxpayers or you can lie to creditors, European authorities are learning, but doing both at the same time is very hard.

The proposed policy that current senior creditors to troubled states will not face losses on their loans but future private lenders will be forced to share in losses with taxpayers is so irrational, so bound to fail that it falls out of the realm of economics and into the ambit of brain injury.

European Union member states will this week hold a summit at which they will create a permanent fund to lend to troubled members under co-called strict conditions of fiscal responsibility.

At the very same time, leaders of the 27-country European Union will sign on to a pronouncement by euro zone finance ministers saying that private lenders will have to share the pain, on a case-by-case basis, of any sovereign debt restructuring after 2013.

So let’s recap, because this is truly bizarre: Lenders to Ireland or the other troubled states won’t take a hit now but if they stick around until 2013 then they will take losses along with the taxpayers. Oh yeah, and the current round of bailouts are aimed at seeing Ireland and Greece through the next couple of years, at which point it will become extremely dangerous to lend to them, as their economies will have shrunk, their debt burdens bloomed and private lenders will be on the hook.

To add to this, the European Stability Mechanism, the name of the new fund, will be senior to all creditors except the International Monetary Fund, meaning that in the event of a bankruptcy it would be paid first. Ratings agency Fitch looked at this provision and quite rightly said that it might lead to lower ratings on shaky euro zone sovereigns.

The only way you could make this policy mix work was if you could find a very rich lender with no ability to conceptualize the future. Hmm, let’s see  a rich entity with limited ability to fully imagine a future state – it must be the European Union!

Few private lenders will stick around, they will sell their bonds and the only buyers will be the EU or ECB, which itself as it understands this predicament is hugely unwilling to play along.

Germany and France are both so unwilling to both have principles and pay for them that they are refusing to act on proposals for common European bonds and are expected to resist moves to increase the size of the European Financial Stability Fund, the vehicle now being used for bailouts.

LIMITED OPTIONS

Germany and France in October began to insist that private creditors would share the pain, thus touching off the current euro zone mini-crisis and bringing forward the ” rescue” of Ireland. I say bring forward because most rational observers realized that Ireland could not pay the debts of its banks, despite having pledged to do so.

Private creditors knew that Ireland is insolvent, as is Greece and very likely Spain, but also knew that since there is no escape hatch from the euro and no apparent will to end the union or bring down insolvent banks that their loans were reasonably safe.

German and French taxpayers know this too and are not happy, as it means their tax money will be flowing to the periphery for years to come. Hence, German and French tough talk and insistence that private creditors will pay in future, which in turn forces investors to act on their analysis of insolvency and sell.

Private money is quite happy to keep funding a bankrupt entity but only so long as the moral hazard play, the implied guarantee from on high, is still in force.

Why then haven’t spreads on weak euro zone bonds risen even higher? Well, besides the fact that the European Central Bank is actively buying, it is the fact that investors can’t quite believe that the European Union is serious.

They know that getting out will be a disaster and a humiliation but that forcing private creditors to take haircuts could cause a banking crisis. So, no haircuts and no reckoning.

Investors are betting, at least for now, that the EU is lying to taxpayers, or to itself, rather than to them.
My guess is that we go on like this for a while; periodic crises that force the EU to pledge ever more money to member states without ever acknowledging that they are insolvent or forcing their private creditors to swallow losses.

That ends only if one of three things happens; the market decides that it won’t lend to Germany and France anymore, the weak nations revolt from austerity or the taxpayers of Germany and France decide that euro-geddon is better than picking up every check.

(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.)

The good news is that the European Central Bank will probably start a massive additional round of quantitative easing to fight the break-up of the euro zone.

The bad news is that they will, as ever, only choose the right policy, as Winston Churchill said of the Americans, after exhausting all of the alternatives.

Global share markets rallied furiously on Wednesday, fed by hopes that the ECB would increase its bond-buying efforts, a possibility raised by its chief Jean-Claude Trichet in an appearance before the European Parliament. Trichet faces stern opposition inside the ECB from fellow central bankers, notably German Axel Weber, who believe that policy should be normalized rather than loosened.

This opposition, in combination with an unsure political climate, means that euro zone authorities will probably continue to try to buttress, enlarge and formalize the bailout mechanism while trying to maintain the fiction that something approaching normality reigns in European money and bank funding markets.

Why would QE be used to fight the break-up of the euro zone, now being widely discussed as the crisis spreads to ever larger member states?

Because QE, or really we should simply call it the monetization of government borrowing, offers some hope of easing the austerity now being imposed on Ireland and soon to come in Portugal and Spain.

Europe has made a choice to not allow member states to default or to allow their weakened banks to default, as default would threaten banks elsewhere. That leaves weakened economies carrying a crushing amount of debt, debt they will attempt to repay by budget cuts. This is a recipe for an economic death spiral, as a smaller and smaller economy becomes less and less able to shoulder its debt service.

Without their own currencies to devalue, the weak of Europe have no other safety valves.

While QE is genuinely dangerous, it will ease conditions and can be directed at peripheral bond markets.Default is a better option, but Europe is unwilling to go there, at least not yet.

So, QE it will be, but the issue becomes when and how large.

“If the political masters in Europe wish to maintain the status quo then the answer lies in the monetization of debt. The ECB, with the ability to print money, can support the market by buying government bonds,” Stefan Isaacs, of fund manager M&G Investments, wrote in a note to investors.

“However what is needed is ‘shock and awe’ rather than tentative, reactionary responses, if indeed the ultimate goal is to support the euro in its current guise. That said, I’m not convinced that an about-turn is likely any time soon. The hawks in the ECB remain, for now, firmly attached to their mandate of price stability.”

EUROPE LOOKS FOR A BAZOOKA
For now, the ECB is likely to do what it can by way of bond purchases and liquidity support while temporizing over the pace and scale of returning the system to normality.

The focus of action, then, will be on increasing the size and prestige of the European Financial Stability Facility,  created in May and so far employed to help both Greece and Ireland. ECB council member Weber suggested in November this could be increased and there have been some indications that both the euro zone and IMF are discussing this.

This strategy is appealing to Weber and to others in Europe because it emphasizes euro zone strength and resolve, taking real money and lending it to allow member states time to pay back their debts, rather than printing up a mess of inflation and euro weakness to ease the pain.

A muscular strategy, but also a failing one. The 750 billion euros was meant to be big and intimidating back in May, but now looks paltry. If Spain needs help would 1.5 trillion euros look much better? Not if the debts of the weak Spanish regional banks are not partly extinguished. The same math of austerity and growth that applies now to Ireland will apply to Portugal and Spain in time.

So, QE, preferably large, from the ECB, but likely not until they are pushed early next year.

If this happens, or rather as its likelihood rises, it will drive a massive rally in risk assets and drive even more liquidity to Asia. Many investors will be giddy that the ECB and Federal Reserve are both driving asset prices higher, while a substantial minority, fearing inflation, will flee government debt and buy energy, commodities and gold.

The big loser, in the near term, will be China, which will have to eat European- and U.S.-exported inflation and will fret over its trillions in euro and dollar reserves.

(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 Saft at: jamessaft@jamessaft.com)

From Dublin to Paris to Budapest to inside those brown UPS trucks delivering holiday packages, it has been a tough few weeks for savers and retirees.

Moves by the Irish, French and Hungarian governments, and by the famous delivery company, showed that in the post-crisis world retirees, present and future, will be paying much of the price and taking on more of the risk.

This goes beyond merely cutting back on pension benefits, rising to actual appropriation of supposedly long-term retirement assets to help fund short term emergencies.

Let’s start with Ireland, which is kicking in 10 billion euros from its National Pensions Reserve Fund into an 85 billion euro package of support for its banks.

Trust me, this does not reduce the risk profile of the NPRF, which was set up as a sovereign wealth fund to help pay for state retirement benefits.

Putting aside jokes about sovereignty and wealth, of which there is appreciably less in Ireland than formerly, this is effectively a transfer of wealth from the Irish people to its banks. Or rather, to the institutions, mostly European banks, which hold Irish bank debt, none of whom as senior creditors will share in the pain.

In many jurisdictions if Ireland were a corporation and the NPRF part of the corporation’s pension fund, then making such a move would be illegal, and quite rightly so.

Of course this is not the first time that the NPRF has been used in this way. It has already “invested” 7 billion euros into Irish banks and has pledged another 3.7 billion to struggling Allied Irish Banks.

Also under consideration is a regulatory move that would effectively compel some private Irish pension funds to hold more Irish government debt, thereby providing the state with a captive investor base but hugely raising the risks for savers.

On to Hungary, which is seeking to cut its very high level of public debt as it prepares for entry to a euro single currency which may well self-destruct before it ever gets the chance to join. Hungary’s government last week finalized new rules designed to force members of private pension plans to opt back into a state controlled pay-as-you go option.

The idea, such as it is, is that participants in the private plans will fork over their $14 billion or so in savings, equal to about 10 percent of Hungary’s GDP, to the government in exchange for a pledge of a pension from the state. Hungary plans to use the funds to make pension payments to current retirees this year and next as well as to pay down government debt.

It is, in short, an outrage.

PACKAGES SOMETIMES GET LOST
Earlier this month France launched a move similar to Ireland’s as part of legislation that raised the age of retirement.

France is transferring more than 20 billion euros of assets belonging to its Fonds de Reserve pour les Retraites (FRR), a funded portion of its retirement system, to Cades, a fund designed to be run down to pay for social benefits.

The transfer will take place over a number of years and the mix of assets held by the FRR in the meantime will shift radically, implying a large shift to government debt. Very convenient for the French Treasury but perhaps not so good for future retirees.

Finally, let’s turn to UPS, which earlier this month became one of the most notable of a string of U.S. companies to sell bonds in order to fund its obligations to its underfunded pension fund. UPS sold $2 billion of bonds due in 2021 and 2040, with the longer dated portion yielding about 5.0 percent.

A decade of paltry equity market returns and current low bond yields, which are used to calculate future liabilities to retirees, have left many firms, including UPS, with funding deficits.

Debt financing pension obligations is in essence a plan to try and make a spread between the cost of financing and the returns the company is able to make on its pension assets.

Borrowing to speculate in financial markets to make up for a lack of previous saving; what could possibly go wrong?

To be fair, UPS, which is one of many large U.S. corporations making similar moves, can’t be equated with Ireland or Hungary. UPS has the same legal obligation to its pension fund no matter how it chooses to fund it, so the bond issue from that perspective does not raise the risk for retirees.

That said, a participant in a company pension plan is dependent on the ability of the company to meet its obligations. The more debt the company takes on, the higher that risk is.

Savers of all types are being asked to shoulder risks they did not sign on for, the costs of which they will inevitably bear.

(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 James Saft at jamessaft@jamessaft.com)