European Commission President Jean-Claude Juncker State of the Union Address 14 September 2016

An existential crisis is engulfing Europe

“Our European Union is, at least in part, in an existential crisis… I have witnessed several decades of EU integration. There were many strong moments. Of course, there were many difficult times too, and times of crisis.But never before have I seen such little common ground between our Member States. So few areas where they agree to work together.”

The challenges are many

“…we should admit that we have many unresolved problems in Europe. There can be no doubt about this. From high unemployment and social inequality, to mountains of public debt, to the huge challenge of integrating refugees, to the very real threats to our security at home and abroad – every one of Europe’s Member States has been affected by the continuing crises of our times. We are even faced with the unhappy prospect of a member leaving our ranks”

Action is needed more than mere words

“…we should be aware that the world is watching us. I just came back from the G20 meeting in China. Europe occupies 7 chairs at the table of this important global gathering. Despite our big presence, there were more questions than we had common answers to…I know that you here in this House would be only too willing to give clear answers to these questions. But we need our words to be followed by joint action. Otherwise, they will be just that: words. And with words alone, you cannot shape international affairs.”

European banks are doing better

“European banks are in much better shape than two years ago, thanks to our joint European efforts. Europe needs its banks. But an economy almost entirely dependent on bank credit is bad for financial stability. It is also bad for business, as we saw during the financial crisis. That is why it is now urgent we accelerate our work on the Capital Markets Union.”

European Central Bank (ECB) Press conference July 2016

Mario Draghi, ECB President

Financial markets were resilient post-Brexit with help from central banks

“Following the UK referendum on EU membership, our assessment is that euro area financial markets have weathered the spike in uncertainty and volatility with encouraging resilience. The announced readiness of central banks to provide liquidity, if needed, and our accommodative monetary policy measures, as well as a robust regulatory and supervisory framework, have all helped to keep market stress contained.

The intention is to meet policy objectives by all instruments necessary

“Governing Council continues to monitor economic and financial conditions very closely and safeguard pass-through of monetary policy…If warranted to achieve its objective, the Governing Council will act by using all the instruments available within its mandate.”

Sluggish growth in the Euro area in Q2 2016 expected to persist in the near term

“Euro area real GDP increased by 0.6%, quarter on quarter, in the first quarter of 2016, after 0.4% in the last quarter of 2015. Growth continues to be supported by domestic demand, while export growth has remained modest. Incoming data point to ongoing growth in the second quarter of 2016, though at a lower rate than in the first quarter. Looking ahead, we continue to expect the economic recovery to proceed at a moderate pace.”

Significant headwinds inform a negative growth outlook

“headwinds to the economic recovery in the euro area include the outcome of the UK referendum and other geopolitical uncertainties, subdued growth prospects in emerging markets, the necessary balance sheet adjustments in a number of sectors and a sluggish pace of implementation of structural reforms. Against this background, the risks to the euro area growth outlook remain tilted to the downside.”

To generate optimal results, monetary policy needs to be augmented by structural reforms and fiscal policy

“in order to reap the full benefits from our monetary policy measures, other policy areas must contribute much more decisively, both at the national and at the European level. The implementation of structural reforms needs to be substantially stepped up to reduce structural unemployment and boost potential output growth in the euro area. Structural reforms are necessary in all euro area countries….Fiscal policies should also support the economic recovery, while remaining in compliance with the fiscal rules of the European Union.”

The Swiss National Bank’s Currency Peg

Between the Yen and the Euro, the foreign exchange markets have seen some excitement in recent months.  One currency cross that has been anything but exciting though has been that of the Euro against the Swiss Franc (EUR/CHF).  After a rapid depreciation of the Euro during the heart of the European Financial Crisis, the Swiss National Bank decided to explicitly peg the Swiss Franc at 1.20 EUR/CHF.  The SNB had maintained a “soft peg” up until that point by purchasing EUR in the open market, but the explicit peg was needed to stop the appreciation.

Below is a chart of the evolution of the SNB balance sheet as it has tried to stop the CHF from appreciating.  The balance sheet has expanded by nearly 5x and foreign currency now represents almost 90% of the bank’s assets.  As a result, the CHF has effectively become backed by the Euro.

Debate Word Count

Below is a frequency analysis of the number of times that nations were mentioned in last night’s foreign policy debate.  Almost the entire discussion focused on the Middle East, with some references to China.  In all, the 10 largest countries in the world plus our 4 largest trading partners not in that category were mentioned 42 times.  Without China they would’ve been mentioned 10.  Meanwhile six Middle Eastern countries were mentioned 141 times.
While one might argue that there isn’t any reason to talk about regions that aren’t top of mind, “Europe” was mentioned once during the debate and last I checked there are some pretty big things going on in that part of the world today that the next POTUS may want to opine on.
Countries Mentioned in Presidential Debate

Will there be more QE?

Given that Mario Draghi announced unlimited asset purchases last week, equity markets have been rallying along side the Euro; however, if Draghi ends up exercising his buying power and Bernanke doesn’t announce more QE tomorrow, the Euro rally may be short lived.  Since 2009 (as theory would predict) the value of EUR/USD has been closely linked with the relative size of each central bank’s balance sheet.  The more that the Fed prints, the more the EUR gains against the dollar.  The more the ECB prints, the more the EUR falls against the dollar.

Euro value ECB Fed Balance SheetRecently following two sizeable LTROs the ECB balance sheet has grown significantly to eclipse the Fed balance sheet (in nominal fiat/local currency terms).  The balance sheet would likely expand even further on new outright purchases.  This implies that there could be further downside for the Euro, unless Bernanke acts to counteract.

The ECB’s newfound willingness to expand its balance sheet introduces an interesting game theory aspect to US monetary policy that wasn’t as prominent in 2009/10.  If Bernanke wants a weak dollar relative to other global currencies, he may be forced to act further.  Otherwise we could be looking at a much stronger dollar along with the anti-correlated equity prices that come with that.

Of course, who cares if the numerical value of the S&P falls if the dollars that measure its value are worth more?  Depending on his actions, Bernanke might.

Thoughts on Today’s ECB Action

Equity markets are rallying today on news out of Europe that the ECB stands ready to conduct Outright Monetary Transactions (OMT) of sovereign debt.  This is the second major monetary weapon that the ECB has used to try to combat the European situation.  The other, performed earlier this year, were Long term refinancing operations (LTROs).

Below is a comprehensive list of ECB monetary tools for a framework of where OMT fits vs LTRO (note LTROs were extended to 3 year maturity in 2012).  The table is from a monetary policy primer that the ECB put out in 2011.  It can be found: here.

ECB Monetary Policy Tools
Even though the tools are listed separately, in the current framework, there isn’t much difference between LTRO and OMT.  In both operations, the ECB is effectively taking unwanted sovereign paper of maturity 1-3 years out of the banking system and onto its balance sheet.  The major difference is that the ECB committed to a range of size for LTROs (the two combined ended up being over 1T Euro).  For the OMT, the ECB is keeping the promise open ended.
The other main difference is that it’s unclear to what extent the LTROs were fully sterilized.  Deposits ended up back at the ECB, but the ECB didn’t exactly lock up the new liquidity by issuing ECB debt securities.  The “sterilization”mechanism of the LTRO is that eventually after three years the money comes back to the ECB when the repo is settled.  But until then the money supply is effectively raised.  With OMT reports are suggesting that the ECB will sell current securities holdings and thereby not increase its balance sheet.  This would make OMTs much less effective than LTRO as a QE mechanism.  It would also limit the size of OMTs to roughly 270B Euro of securities that are already on the ECB balance sheet.  However, an important undiscussed tool that the ECB has is the issuance of debt securities to absorb liquidity.  If the ECB issued debt to absorb OMT purchases, this could make even sterilized OMT a program of unlimited size.  This option would effectively be a debt swap, sovereign debt for ECB debt across the entire Eurozone.  With central banks every program has the possibility of being of unlimited size, OMT could formalize it.  That’s the important point.  
Central banks have unlimited authority to print money if they choose to do so.  The reason that the US isn’t in a European-style situation is the unwavering belief that Ben Bernanke stands ready to do everything possible including buying US government debt with printed money to ensure that the US would never default.  Up until now the markets seemed to not believe that the ECB would act similarly, even though the ECB has repeatedly intimated that it would.  Perhaps today the market is finally getting Draghi’s message.  
Ultimately it comes down to whether or not the market believes that Draghi is willing and able to buy sovereign debt in unlimited quantities.  If the market does, then we could have a “long lasting” solution to the European problem–at least as “long lasting” as the US or Japanese debt solution is.  Of course you cant solve an insolvency problem with liquidity and so in the case of all three regions, monetary policy can only be so effective.  If debt and deficits aren’t reduced in real terms then policy has only shoved the burden onto the monetary system with inflation as the result.

Eurozone Olympic Medal Count

With just three days left in the London games, the US olympic team has finally taken the lead in the medal count from China, and hopefully wont relinquish it between now and Sunday.

However, with some calling for fiscal union in Europe, would an athletic union be so far fetched?  If the Europeans banded their athletes together like they have banded their currency, they would be much better off on the medal tally.  In fact, the combined Eurozone has a commanding lead at the London olympics, having won 138 medals compared to 90 by the US and a measly 81 by the Chinese.

Just like they do economically, Germany and France lead the way athletically.  Italy, the Netherlands and Spain all are big contributors, while Greece and Portugal are just riding their larger peers’ coat-tails.

S&P 500 Priced in Euros

Today the S&P 500 was up 1.65%, but considering that the dollar was down 1.26% vs. the Euro, if you were a European investor in the US market, you hardly realized any gains–such is the power of currency.  Much like how perception of physical motion is defined by one’s frame of reference, motion in financial markets only meaningful relative to the value of the currency of reference.  Gains and losses in markets, measured in currency, can be completely illusory based on the change in value of the currency itself.  To illustrate the point, the chart below is a chart of the S&P 500 as viewed by a European investor, measured in Euros.  It’s a completely different picture than the one that we’re used to seeing, primarily because 2007 never reached the peak of 2000.  Bull and Bear markets happen over different time frames.  Technical levels become completely different.  Simply rebasing the unit of measurement can alter the interpretation completely.  YTD the S&P 500 is up 15% in Euro terms compared to 8% in USD.

Tupperware Commentary 2Q12

An interesting take on the world economy from Rick Goings, CEO of Tupperware, an extremely global company:

I spent a lot of time this last month doing not only big group but one on one meetings with the investment community, not only in the United States but more and more focusing on Europe where people tend to hold longer. And but one of the key questions I’m asked almost everywhere I’m, is people want to tap into what are we seeing out there and what do we hear out there?
They understand that the bulk of our sales and profits are outside the U.S., which by the way is only 5% of the world’s population and this is an important question because the perspective one has, if they are getting their news from Wall Street Journal, Financial Times, CNBC or even many U.S.-based analyst reports, one would think that the world is in chaos and it’s bleak out there.
And yet, we just did a review and quite frankly, our perspective is there’s more firm places, more (inaudible) firm out there in the world and things look pretty good and look better than we’ve seen in years. Here’s a brief scan.
In Europe, contrary to what you may read, Europe is not going to fall into the Mediterranean, although it sells newspapers. Politicians there are showing a never before level of commitment and flexibility as they work to hold euro land together. And they are driven by two major things, the desire for peace and economic necessity.
But I do the review and I say well, CIS under Putin, Medvedev, Russian style but it works and we feel good. Nordics look good, Germany looks good. We get down into Turkey, looks good. Greece, who cares, it’s too small, Italy, 66 governments since the Second World War, its stability Italian style.
And then we turn it up, Benelux looks good and it is interesting in France, even under Holland, an interesting perspective. Most of the dramatic changes in governments with regard to repositioning government spending to be less happened under mid land who was an extreme left wing. So we, because he had the ability to bring the assembly within, so I feel, okay, about Europe.
Turning to Latin America, a few topline points in major markets, I already mentioned about the PRI in Mexico. So I feel good about that. In Venezuela, it appears Chavez’s grip is slipping, plus he’s sick, Brazil, fifth largest population in the world, sixth largest economy in the world and a real bright future.
In Asia, finally, 40% of the population, China, India, Indonesia and the driving force is going to be the explosive growth of their middle class, which is going to move from $500 million to $1.7 billion by 2020. In each of these markets, importantly, we have been awarded the status Superbrand. This is interesting, because we’ve never advertised.
Now, I know when somebody reads the recent talk of China’s economy slowing, two things are important to remember. Number one, it’s still growing at 7.5% and number two, the government which is very directive has been proactive with the stimulus and matter of fact, they cut the borrowing rates to stimulate the economy twice in one month.
So, net-net, before I turn it over to Mike, a final thought. When you put it all together, we’re confident in our portfolio and our future. We’re not going to hit on all cylinders in every quarter.

Comparison of Japan, US and European Consumer Balance Sheet

When comparing the economies of Japan, Europe and the United States, it’s important to remember that the structure of the financial systems of each area are very different.  Below is a great chart put together by the BOJ which compares what the asset side of households’ balance sheets looks like.

US consumers hold a much larger share of their financial assets in equity markets compared to Japanese or Euro area residents.  This is why when the equity markets sell off in the US there is a much greater effect on the real economy than there is in Japan or Europe.  In Japan and Europe, the consumer doesn’t get the signal of a weak economy until unemployment rises, or the banking system hurts to the point that deposits are impaired.