29/01/2010: What if the Fed ran China's monetary policy?

In 1997, after hiking interest rates several times and watching the US equity market reach new high after new high in what he famously termed a bout of “irrational exuberance,” former Fed Chairman Alan Greenspan finally threw in the towel. As he explained in his memoirs, published ten years later: “In effect, investors were teaching the Fed a lesson. You can’t tell when a market is overvalued, and you can’t fight market forces.” This was a reversal from the old Wall Street adage, “Don’t fight the Fed.” Greenspan’s admission of defeat was revealing: It underlined how firmly the belief in the righteousness of market forces was anchored among central bankers.

Or was it actually the threat of repeating Japan's experience in the early 1990s that made the Fed reluctant to curb financial excesses? Trying to deflate the immense equity and housing bubble that it helped inflate in the late 1980s, the Bank of Japan overdid its restrictive measures and did not act quickly enough to reverse monetary policy once the air was out of the bubble. This led to decades of deflationary stagnation in Japan, proving in hindsight that dealing with asset bubbles is not an easy task.

Whether it was denial, like current Fed Chairman Ben Bernanke’s now famous quote from 2005 (“US house prices largely reflect strong economic fundamentals.”) or an admission of powerlessness like the one given by Greenspan in a 2002 speech (“[…] it was far from obvious that bubbles, even if identified early, could be preempted short of the central bank inducing a substantial contraction in economic activity – the very outcome we would be seeking to avoid."), the Fed’s recent track record of dealing with bubbles has been rather dismal.

Moreover, it now seems that even the Fed, or at least Chairman Bernanke, refuses to accept any responsibility for having fueled the US housing bubble with excessively low interest rates. In a recent speech reviewing the housing bubble in the making, Bernanke concluded: “[…] monetary policy during that period – though certainly accommodative – does not appear to have been inappropriate, given the state of the economy and policymakers’ medium-term objectives.”

In this context, the latest action out of China is encouraging. On 12 January, the People’s Bank of China decided to hike bank reserve requirements. This was seen as a first step toward a more restrictive monetary policy. Obviously, you can argue that it was first and foremost an attempt to cool the economy, which is now running at a growth rate of almost 11%, and tamp down on inflation, which has accelerated from half a percent to almost two percent within the past month.

In reality, however, the first objective of this measure, which was accompanied by a clear warning to different Chinese banks to control their lending activity and to watch for risks associated with the property sector, was to calm down the current real estate frenzy.

Is there a real estate bubble in China? The case is not yet very clear. Some prime real estate markets like Shanghai, Beijing and Shenzhen have seen a doubling of their prices over the last year. Despite this, prices have not surged in second-tier cities, and overall Chinese real estate prices have increased by only slightly more than 8% per year. Also, in terms of housing affordability, the valuation of Chinese real estate does not look extreme.

What prompted the People’s Bank of China to embark on a more restrictive policy was the tremendous lending growth observed in the first three weeks of 2010, which equaled what was seen in all of January 2009. Instead of guessing whether or not their housing market is in an actual bubble, the Chinese have decided to clamp down on the sort of activity that could potentially inflate a bubble in the first place.

There is definitively a lesson here for the Fed. In 2003-2006, the Fed was also confronted with a large increase in debt held by US households of roughly 10% a year. However, instead of worrying, the Fed saw this as an opportunity. To quote Greenspan in a 2005 speech: “Improvements in lending practices driven by information technology have enabled lenders to reach out to households with previously unrecognized borrowing capacities.” Where such an analysis ultimately led is now well known.

21/01/2010: How central banks focus on the core and miss the point

Only a couple of years ago, in those distant days when former US Fed President Alan Greenspan still enjoyed the nickname "Maestro," being a central banker was a relatively easy job. Academics had it all figured out. The mission of central banks, explicitly or implicitly, was "inflation targeting."

In 1998, current Fed President Ben Bernanke coauthored a 400-page compendium that examined the mission of central banks in various countries. Back then, the banks' track record was excellent. After all, they vanquished the hefty inflation of the late 1970s and early 1980s.

But there were some discordant voices heard amid all the applause. One line of argument asserted that the line of causality was blurry between the low inflation environment of the 1990s and the actions of central banks. Globalization and the IT revolution could also take some credit for the taming of inflation, ran the argument.

Another critique, one that has been heard often since the financial crisis erupted, stressed the state of denial that central bankers adopted when confronted with obvious speculative bubbles.

In a similar vein runs still another argument. When targeting inflation, central bankers will not focus on the overall inflation figure but on so-called "core" inflation, which conveniently strips out some of the most volatile and painful components for the public, namely food and oil prices.

Why do central banks employ the selective blinders of core inflation? Because, they say, there is nothing an individual central bank, especially a small one, can do about oil prices, which are set on international markets and often influenced by politics and cartels, not merely supply and demand. This tunnel-vision view of inflation leads to the paradox that despite running inflation rates of 2.7% in the US and 2.9% in the UK, both the US Fed and the Bank of England are (rightly) concerned looming about deflationary pressures.

Granting that central banks cannot individually move oil prices, they could have an impact through collective action, couldn't they? But central banks do not play well with others, it seems. There was some cooperation at the peak of the financial crisis, but now central banks have returned to their individual, often uncoordinated ways.

We see some very clear consequences from this go-it-alone mentality. For one, it will lead to high volatility on the currency markets and it also assures a persistent overhang of liquidity internationally, with the concomitant risk of creating new speculative bubbles. We think oil be a candidate here.

Ultimately, headline inflation – the cost for a fixed basket of goods – may also trend significantly higher. But most central bankers will certainly dismiss such a bounce, citing "special factors" and continuing to focus on the core rate. Whether this really helps the public remains an open question.

15/01/2010: The mission accomplished fallacy

One of more iconic images of the decade just ended was recorded on May 1, 2003, on the deck of the aircraft carrier USS Abraham Lincoln. Wearing a fighter pilot's flight suit, President George W. Bush strode purposefully across the vast deck where he had just landed to address the assembled servicemen and -women. Behind him, a large banner proclaimed, "Mission accomplished." A month earlier Bagdad, and with it Saddam Hussein’s regime, had fallen.

Almost seven years later, US troops are still in Iraq and over 95% of their casualties to date followed this carefully staged event. As an emblem of misplaced optimism, the photo and the moment it captured should serve as a sobering reminder that serenity does not automatically follow a cataclysm.

In the economic arena, a similar appreciation error looms as we attempt to interpret the financial crisis of 2008 and its aftermath. Over a year after Lehman Brothers' bankruptcy, all the big economies around the globe have clawed their way out of recession. Financial markets bottomed out last March, and then staged a rather impressive rally. The media, at least, has declared the mission accomplished. Federal Reserve President Ben Bernanke, considered by many the architect of this recovery, was Time magazine's Person of the Year in 2009. So, why are we keeping our celebratory Champagne firmly corked?

Despite upturns in both the business cycle and the markets, we still cannot rule out two grim scenarios: for one, economic weakness could return with a vengeance, and for another, corrosive inflationary pressure could gather steam.

Regarding the business cycle, we should recall how things developed 1937. After it successfully pulled the US economy out of the Great Depression, Roosevelt’s government shut down its fiscal and monetary programs much too rapidly, as virtually all economic historians today would agree. The result was a renewed and very severe recession, from which the US economy only managed to emerge in the wake of World War II.

Today, most developed economies are heavily burdened by fiscal and monetary policies that, on a relative scale, dwarf those undertaken to combat the Great Depression. Hence, a 1937-style relapse, or even something worse, could well unfold if these stimulative measures are withdrawn too rashly.

On the other hand, the sheer size of the policy interventions that saved the global economy from systemic collapse is mindboggling. And clearly if this life support were continued for too long, the risk of an economic breakdown is very real indeed. Printing money is simply not a sustainable economic remedy.

In the US, the monetary base has more than doubled from a year ago. Moreover, the public debt-to-GDP ratio is poised to cross the 100% threshold, as it already has in many other countries. In Japan, the 200% debt-to-GDP threshold is in sight. These hyperspace levels of liquidity and debt growth are, of course, very conducive to driving up inflation pressures or inflating new speculative bubbles. These conditions are also ripe for sovereign default threats, and Greece could be the canary in the coalmine here.

Governments and central bankers murmur reassuringly in the nightly news that everything is under control. But how can they be so sure? We have never before experienced a comparable global monetary and fiscal expansion, unless we take times of war into account. Wherever we stand today, the mission is certainly not accomplished and photo-ops will not suffice.

14/01/2010: Taking the fun out of fundamentals

The bursting of two bubbles in less than a decade has effectively gutted the case for the efficient market hypothesis. Once a proud cornerstone of modern financial market theory, EMH posits that asset prices ultimately deviate little from their fair values, and taking on more risk is the only way for investors to “beat the market.”

The core article of faith for EMH is the conviction that market participants are rational, a view difficult to maintain after the dizzying cycle of wealth creation and destruction we have witnessed over the past ten years. Small compensation it may be, but the latest financial crisis also allows us to reconcile a couple of other paradoxes of received economic theory.

Twenty-five years ago, US economists Rajnish Mehra and Edward C. Prescott wrote one of the most influential academic articles in finance and economics, “The Equity Premium: A puzzle.” Reviewing the years 1889–1978, they observed that the yield on US equities as measured by the S&P 500 index outperformed that of US short-term debt by more than six percentage points per year. If investors were really rational agents, then this premium could only be reconciled by assuming an implausibly high level of risk aversion.

The equity premium puzzle initiated hundreds of research papers. Even today it resists a broadly-accepted answer. But the latest financial crisis suggests two explanations. First, given two major stock market corrections in a decade, the case for an equity premium has simply vanished. The second explanation can be derived from the massive losses of the latest market corrections. If, as behavioral economists assert, investors experience the pain of a loss much more than the joy of a similar gain, it is little wonder that they will demand a much bigger premium for a volatile investment than a rational approach would suggest.

Similarly, another paradox that found favor between 2002 and 2008, namely the carry trade, has recently regained some traction. As explained below by Tom Flury, our FX strategist, standard economic theory would have interest rate differences between two currencies match the appreciation of the low- versus the high-yielding currency. But the carry trade demonstrates the exact opposite: over longer periods, low-yielding currencies tend to decline against high-yielders, delivering a nice, supposedly risk-free, return for investors.

Again, the financial crisis offers an insight into this paradox. The size of the losses suffered by carry-traders during last autumn’s abrupt realignment of currencies dwarfed the gains they had enjoyed over the previous several years. A fitting verdict here can be found in a remark attributed to John Maynard Keynes: “The market can stay irrational longer than you can stay solvent.” But, as Milton Friedman noted: “There is no such thing as a free lunch.”

07/01/2010: The myth of the lost decade

January always kicks off with a burst of optimism: attendance soars at gyms and fitness centers and cigarette sales plummet. We really do make noble New Year’s resolutions but come February this seasonal effect sadly vanishes.

Another favorite pastime in early January is reviewing the previous 365 days. The media fills with thoughtful appraisals of the year that was and we also cannot resist this tradition. You will find in the accompanying a review of clients’ questions, and our answers, published in UBS investor’s guide in 2009. We assess our answers now, remembering that hindsight is always 20-20.

This New Year adds a twist because we also can take stock of an entire decade. It’s still unclear how this period will be labeled in the future—the 2000s, the Noughties, the Aughts or even the Naughty Aughties have all been proposed. But there is emerging consensus on one point, at least among the punditocracy: the past ten years have already been judged a lost decade.

For example, in a recent column in The New York Times entitled "The Big Zero," Nobel Prize-winning economist Paul Krugman was quite unconditional, writing, "It was a decade in which nothing good happened." The facts appear persuasive: by the end of 2009, US private-sector employment was at the same level as in 1999 and, adjusted for inflation, median US household income was significantly lower, as were US house prices.

Looking at financial markets, equities in developed countries declined over the past decade. In local currency terms, the MSCI World free total return index, which aggregates all developed stock markets, declined from 518 to 514. In US dollars, it increased slightly, by 0.2% per year, but this more reflects the dollar’s weakness than market strength, we would argue.

The decade clearly had its losers, but can we really say it was lost? We don’t dispute that some economic trends and financial markets had a rather dismal time. But there are at least two caveats to apply before delivering a verdict on the decade past: Let’s not be too Western- or even US-centric, and also not too equity-centric.

While the US and many other developed countries did indeed languish, it was the Roaring Noughties for most of the emerging markets. From an economic perspective, China is poised to become the world’s second-largest economy in 2010. And from an equity perspective, the average yearly stock market returns from Brazil (+14.1%), Russia (+15.6%), India (+14.1%) and even China (+11%) simply dwarf those of any developed stock market for the decade.

This robust activity obviously had consequences for other asset classes, like commodities. Both gold and oil had their best ten-year runs since the 1970s. But even bond investors had a rather decent decade. At the beginning of 2010, the emerging market theme shows no sign of running out of steam, as these economies lead the current recovery.

But in the spirit of New Year’s cheer, we can also share some optimism for developed equities. Although we don’t have many precedents for study, so far no lost decade was followed by another.