28/07/2011: The euro cannot liberate itself from economic laws

The sixth “definitive” plan in less than eighteen months for saving the Eurozone and helping the peripheral countries beset by the debt crisis – in particular Greece – was approved two weeks ago. Unlike their American colleagues who have only just managed to reach an agreement about their debt problem, European politicians were able to set off on their summer holidays satisfied.

In this new final solution, a partial (or “selective” as rating agencies would say) payment default by Greece is now clearly set out for the first time. We are far from the bragging of a year ago when any form of default was ruled out and scoffed at as pure fabrication by analysts lacking a sensational story.

Economics is the science of choices, nicknamed the “dismal science” because every choice has a price. This price is often not explicit, but rather implicit, resulting from lost opportunities. Most of the time, once a choice has been made, it cannot be reversed.

The fact that the European sovereign debt crisis has reached such a magnitude is the result of the lack of willingness to make choices. As a result, events have imposed themselves.

Like economists, the general public is now discovering that the European single currency was never an economic project in the first place, but rather a political one. Economists warned before the introduction of the euro that this project would fail unless fiscal institutions were built or, at the very least, more in-depth fiscal coordination was created. They got it right.

Despite the new rescue package for Greece, the Eurozone, as it currently stands, will probably not last much longer. Politicians in Europe have postponed the day of reckoning, but the current strategy of imposing drastic austerity measures on the European periphery has run its course.

On the one hand, less than a month ago the first signs appeared of cracks in a big country that is “too big to be saved,” namely Italy. On the other hand, barely a week later Portugal’s new prime minister, Pedro Passos Coelho, was quite explicit when he stated: “We want to take part in an ambitious European project and make our contribution so Europe can confront its problems in the most ambitious way, but as prime minister I will not stand by and wait for Europe to govern Portugal.” Further austerity measures might push some European peripheral nations to reconsider their participation in the common currency.

In my view, to avoid a breakup there are only three different possible paths out of the current crisis: 1) letting the problematic countries default, at least partially; 2) bailing them out; 3) monetizing their debt.

Letting the countries default could induce contagion effects both in still solid countries in the Eurozone and among European financial intermediaries. It is for this reason that this solution has often been held up to public obloquy by European politicians as having “even worse consequences than the default of Lehman Brothers.” With the partial default of Greece explicitly acknowledged in the latest plan, this alternative is nevertheless becoming the most likely of the three.

Bailing out the peripheral countries by having the “core” countries, principally Germany, fully or partially backing their debt would certainly provoke a moral wrong. The bailed-out countries might see their past fiscal profligacy actually honored. Should this not be the case, core-country politicians still face an extremely hard task selling such a bailout to their populations. In Germany, the controversy following the latest rescue plan for Greece is only just beginning.

Finally, monetizing some of the debt of peripheral countries is currently not allowed by the statutes of the European Central Bank (ECB). The ECB cannot make such purchases, in contrast to what the Federal Reserve did for US debt during quantitative easing, because this action would lead to inflation. However, the fact that bonds of peripheral countries which are already now rated as junk or worse are still accepted as collateral by the ECB shows that its rules and regulations are subject to interpretation.

For Germany and other “strong” Eurozone countries the choice for maintaining the single currency can thus be summarized as putting their financial intermediaries at risk, bearing the burden of a bailout, or provoking an inflationary shift through the monetization of debt. As I see it, the most likely outcome will be a combination of all three. This is the price for keeping the euro.

22/07/2011: Valuing valuation

Like practitioners of other trades, finance professionals are sometimes so entrenched in their own jargon that they can be unaware that no one else understands them. I was reminded of this fact by a non analyst colleague a couple of days ago: “This is likely one of the most recurring of your phrases when you talk about stocks: “Equities are fairly valued” or “equities are cheap.” Can you please explain to me what you mean by that? What kind of metrics or models do you use to come to such a conclusion? And how reliable is such a statement?”

Answering these questions would require a much larger space than a short note. For an in-depth treatment of this question, I refer to a small, easy-to-understand, but very substantive book, The Little Book of Valuation, by Aswath Damodaran, published recently by John Wiley & Sons.

Valuing an asset basically means estimating its intrinsic value and then comparing it with its actual price. If there is a significant difference between the two numbers, then the asset is said to be under- or overvalued. For exchange rates, for example, you can use the so-called purchasing power parity. Comparing the prices of goods (such as the Big Mac) or baskets of goods in two different countries and finding the exchange rate that would equalize the value of those goods expressed in a common currency is a valuation exercise.

For equities, more sophisticated models are often used such as discounted cash flow, profit or dividend models. Here, you assume that the equity of a company is a claim on all future cash flows, profits or dividends. By discounting them with an interest rate – as future cash flows have less value than present cash flows – you find the value of a specific equity. Obviously, to get to this number, you need to make assumptions regarding future cash flows, profits or dividends as well as interest rates. This is the job of equity analysts. Aside from this absolute valuation approach, you can also use relative valuation, where you would compare the value of a specific equity with its sector or regional peers.

The main problem with valuation is that it relies on future assumptions and forecasts, and could therefore be misleading if those assumptions and forecasts prove to be wrong. As investment legend Howard Marks once said: “An accurate opinion on valuation, loosely held, will be of limited help. An incorrect opinion on valuation, strongly held, is far worse.”

This is why investment experts who use valuation as the main or even the single reason for an investment decision usually focus on valuation extremes, i.e., when an asset is highly over- or undervalued. This means such investors are usually seen as contrarians because, against market consensus, they will sell a highly overvalued asset and buy a highly undervalued one. It also means that they need patience. It can sometimes take years for assets to find their way back to their fundamental or fair value – remember the dot-com and US real estate bubbles – but, ultimately, they do.

15/07/2011: Risk hopping and blame gaming

Market participants’ nose for conflict, figuratively for blood, has kept them well occupied this year with the constant scrapping in Europe and the US on debt issues. Long-term, however, investors carry a sober lesson away from the skirmishing: government debt has lost its reliability.

To quote an esteemed American colleague, the US labor market report for June of last Friday contained “no silver lining at all.” Only 18,000 new jobs added, an unemployment rate creeping upward for the third month in a row and downward revisions of previous employment data. Even starry-eyed forecasters have begun trimming their growth forecasts for the US economy. Whether the “soft patch” is becoming “softer” or “patchier” is left for economists to debate. It took not even a day, however, and market participants were again tooth and claw into the European sovereign debt crisis, with Italy the newest prey.

The whole first part of 2011 has been like this: hopping back and forth from one potential risk to the next, from Europe and its sovereign debts issues to the US and its growth and debt issues. From the outside it appears a competition is taking place between Europe and the US. The sides point fingers across the Atlantic, taunting “You’re uglier!” Many US market participants are aghast at the amount of debt in some European peripheral countries; they mock European politicians as lacking the will to decide, the courage to attack problems at the heart.

Europeans counter these charges by arguing that the US shrouds its own problems with statistics which obscure the true size of the government debt. Moreover, US politicians play with fire, when – as in the present debate about the debt ceiling – some even consider a technical, temporary default by the US as a means to achieve certain goals.

Finally, European politicians get incensed at “Anglo-American” rating agencies and accuse them of exacerbating the European peripheral debt issue. As a Swiss, hence neutral and unbiased, one first notices that the piles of public debt on both sides of the Atlantic are of the same order of magnitude. The approaches to mitigate the debt problems, however, are quite different. Basically there are four possible ways to reduce a debt-to-GDP ratio: austerity (more government revenues, less government spending), inflation, higher economic growth, and default. So far Europe has played the austerity card and – in the case of Greece – is likely to play the default card down the road. The US, on the other hand, has bet on a yet-to-come recovery, and by monetizing some of the debt is also playing the inflation card.

For investors, these different approaches to ease public debt problems ultimately boil down to a choice between a long erosion of the real value of the investment through inflation, in the case of the US, or to a quick loss through default in the case of the European periphery. Thus in both cases the attractiveness of sovereign debt as a safe investment vanishes. We can only repeat our mantra (all together now): avoid long-term government bonds.

08/07/2011: An old trick

“There are three kinds of lies: lies, damned lies, and statistics.” This well known pun, which US author Mark Twain attributed to the British Prime Minister Benjamin Disraeli, has again been illustrated by the recent debate regarding US inflation and how to measure it.

In May the headline inflation rate in the US posted a whopping 3.6%, its highest reading since October 2008. More worrisome still is the fact that this rate has almost tripled in the last six months, despite which the Federal Reserve kept its cool, continuing to argue that headline inflation doesn’t matter. Focus should remain on the core rate, which excludes volatile components like oil and food prices.

A new polemic now enters the debate. The Dow Jones news agency reported that changes to inflation measurement are part of the ongoing negotiations between Republicans and Democrats regarding the US debt: “Lawmakers are considering changing how the Consumer Price Index is calculated, a move that could save perhaps USD 220 billion and represent significant progress in the ongoing federal debt ceiling and deficit reduction talks.”

Interestingly enough, this might be a proposal the two entrenched camps could agree on. Both want to do something about the deficit. But while the Republicans insist on reducing government expenditures and not increasing taxes, the Democrats want to increase taxes and keep government expenditures where they are.

Since “inflation” is generally thought “bad” by the broader public, governments traditionally try to show inflation to be as low as possible. Each revision of the official definition of inflation measured with the consumer price index (CPI) in the US over the last half century – not only there but also elsewhere – has resulted in lower official inflation rates – and as a mirror image, higher real growth rates in the economy.

The concept of a “core rate” was introduced in the early 1970s under US President Richard Nixon, when energy and food prices started to surge. Then in the early 1990s several debates led to an in-depth revision of the US CPI.

The main adjustment was to replace the fixed weights of goods and services in the representative consumer basket used to measure inflation with variable weights. This took into account changes in tastes and habits, e.g., CD players replacing tape recorders. Technological progress was another reason. A notable example is the iPad 2, which is twice as fast and half as thin as the iPad 1, but costs the same price – a clear technical “deflation” of this particular product. Now, the US CPI undergoes a revision of the weights every two years along these lines.

Also discussed was whether price-induced substitutions shouldn’t be part of the weighting scheme. If the price of potatoes increases, people tend to eat more rice, hence the weight of rice in the consumer basket should increase while that for potatoes should decrease. So far this factor hasn’t been made explicit in the calculation of the US CPI. However, it has been implicitly taken into account by using geometrical instead of arithmetical means in the CPI computation. This technicality will understate large price increases and overstate price drops.

The revision now under discussion makes these substitution effects more explicit. If agreed upon, official inflation will be once again lowered. This helps both to reduce government expenditures while increasing revenues.

Expenditures are reduced because many incomes derived from social security programs are indexed to the official inflation rate. Revenues are increased because inflation is nothing else than a wealth redistribution from creditors to debtors, or put differently, a taxation on savings. Understating real inflation by fumbling with its measurement allows the creation of more of it while mitigating some of the debt problems facing the US government.

In this context, the old German saying that “you shouldn’t trust any statistic you haven’t falsified yourself,” may be the best advice one can offer.