A Long Bridge to Where?

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A Long Bridge to Where?

“The best the ECB can do is to buy time in the hope that other policy-making entities with better instruments will step in, both at the national and regional levels”

-Mohammed El-Erian, Former CEO of PIMCO

There was certainly no shortage of action in the markets this week. Following a week when the Swiss France made a 30 per cent move in a matter of seconds, it would have been hard to believe we could match the week prior in terms of volatility and excitement. We are currently witnessing an undeniable shift in monetary policy. Six years since a financial crisis, and just recently the consensus was for an improving economy and a rising rate environment, but instead we are now seeing round two of central bank stimulus with a number of G20 central banks participating.

The surprise for the markets this week was provided by the European Central Bank. Somehow the ECB was able to deliver investors an open ended stimulus program that exceeded expectations. The oft-quoted Mario Draghi line from the summer of 2012 pledging to do whatever it takes to preserve the Euro finally came to fruition. The ECB President, Mr. Draghi and his team of central bankers delivered a US Fed style open ended stimulus aimed to buoy risk assets and support the sovereign debt markets of member nations. The question is, will it work?

The shortfall with Quantitative Easing in the United States was very simply the fact that there were no complimentary fiscal policies. Too many analysts and commentators concentrate on the actions of central bankers and whether or not there policies are justified. This is the wrong question to be asking.

A prime example of this was the Swiss National Bank’s decision last week to abandon the peg. Their balance sheet had grown so exponentially, and would have been under even more pressure to support the Franc given the action seen in the Euro this week. Abandonment was more an inevitability than a decision. And in the United States, 2008 and 2009 saw credit markets freeze and a slow response in terms of fiscal policies. The Fed bought time for the economy by keeping rates near zero, keeping downward pressure on long term debt markets, and an imperfect response, but created a wealth effect in the equity markets to hope for increased consumption and spending in the economy.

Similarly, the Europe Union will see similar outcomes, but faces similar challenges. Moreover, the situation there is posed as even more challenging given already politically unpopular and unfavourable policies and social unrest. One common example of this, and has been evident through the Euro Crisis is small businesses through Europe cannot get affordable credit and loans because the financial institutions don’t want the risk. The transmission of the process undertaken by the ECB to the financial institutions to the lenders is broken, and that’s just one task to fix.

Mohammed El-Erian’s quote above addresses the shortfall in the ECB’s policies. Many have referred to these coordinated actions by central banks as building a bridge to nowhere. I don’t like to be that pessimistic. But the point is that monetary policy will not be a sufficient solution to spurring economic activity should they not be accompanied by policies from fiscal and regional levels of government. Time will tell if my views will have to shift.

Cutting Their Losses, Early

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The Swiss National Bank (SNB) shocked currency markets Thursday of this week with a policy decision that crippled the Euro-Franc cross. Their announcement sent the franc soaring 30 per cent against the euro before settling lower, (still 16 per cent stronger) into the end of the week. This was as the SNB abandoned their 1.20 franc peg they’ve been defending since September of 2011, coincidently when the gold market peaked at over 1,900 USD per ounce. The decision by the SNB has far reaching implications for not only financial markets, but also for when policy becomes exhausted and policy makers themselves are rendered helpless.

The move in the Swiss franc really demands the attention of investors as it is one of the biggest, if not the biggest, single day move from a liquid western economy’s currency in modern time. Beyond the questions of the stability of financial markets and the overleveraged and crowded trades that amounted to millions of dollars in losses for investors, there are the direct losses to Swiss businesses and the Swiss economy as their exporters are heavily linked to and trade with a European market. As well, the price adjustment in the franc reminded all investors of a bid for haven assets as even gold ended the week 4.5 per cent higher.

The SNB’s decision to abandon the peg to the euro ultimately came down to necessity. The commonly watched EURUSD is down over 15 per cent over the last year, and pressure on the euro continues for multiple reasons. The first is simply the threat of deflation to the Eurozone. Stagnant growth and the trap of weak business investment and broken fiscal and monetary policy have the region looking hapless. Then if we include the probability of the European Central Bank embarking on an episode of quantitative easing and factor the likelihood of a Greek exit from the currency union, there are many downward pressures on the euro.

The Swiss franc faces the same appreciation pressures as almost all other currencies that trade directly against the euro. In order to defend their peg they’ve been maintaining for over the last three years, they had to expand their balance sheet (print francs) and buy euro denominated assets. The balance sheet of the SNB relative to the GDP of the Swiss Economy has expanded so drastically they are now the largest of any western central bank at around 80 per cent. By comparison, when the US Federal Reserve saw balance expansion to 4 trillion USD during the process of Quantitative Easing, their balance sheet to GDP ratio was around 26 per cent.

The threat for the SNB was that the size of their assets on their balance sheet would soon dwarf their economy, and their large proportion of assets denominated in euros would too heavily impact their economy from fluctuations and volatility in the euro exchange rate. As is the case with most exchange rates pegs, the market forces will eventually takeover and the outcome that the policy makers had been trying to avoid (like an overly strong franc) becomes reality.

As we see central banks like the ECB and Bank of Japan make moves that increase their influence on financial markets via balance sheet expansion, questions center on the idea of stability. Furthermore, was the market action Thursday a “one-off’, or are we amidst an environment that is setting itself up for snap price adjustments that leave investors too slow and unable to react?

A Longer Term View

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Following a year where US equity markets found the ability to overcome a Russian invasion of Ukraine, a tremendous decline in oil and commodity prices, and policy uncertainty in the major economies of the European Union and Japan, investors have to question whether the same resilience can hold through 2015. Renowned bond fund manager Bill Gross asked a similar question this week in his monthly investment outlook, taking a look at the year ahead and then suggesting we are now at an inflection point where the western world’s troubles of slowing economic growth can no longer be solved with debt creation and money printing. Consequently, 2015 will be a year for losses in most asset classes as capital looks for a new harbour that can produce positive returns.

The first full trading week of 2015 certainly complemented this story quite well. Violent selloffs in North American equity markets recorded the worst start for North American stocks since 2008. But it begs the question whether markets are destined for a year of negative returns as Mr. Gross suggests, or can they overcome the crippling factors of deflation in Europe and a weakening emerging market picture along with declining commodity prices.

It’s difficult to imagine in such an interconnected global economy how the US is able to decouple itself, and avoid the perils of economic headwinds originating from outside North America. It is a much different scenario than a few years ago when North American markets were much more vulnerable to fragility of the European economies and the systematic risk of a sovereign debt crisis. Turmoil in peripheral European countries seemed to reap much more havoc than the effect we’ve seen recently. Perhaps that was because of the interconnectedness of the debt crisis. Whereas today, Greek snap election called for later in January do not raise as much fear because bailout loans to the IMF are close to being paid back and Greece’s problems too many extents have been contained to Greece.

But as the European deflation fears once again present themselves (as was reported midweek for the first time in 5 years), the idea of a system wide issue now comes forward again. Mario Draghi and European Central Banks ultimate challenge will be preventing a deflation scenario in Europe, and time does seem of the essence. There has been no change to the fact that unemployment rates remain elevated across the peripheral Eurozone and particularly for the younger demographics. Investment suffers not only from the prospects of subpar returns, but also from the perspective of currency risk as the euro lost approximately 13 per cent in 2014. The paramount example is that German 10 year bunds are yielding less than half a per cent as the trend continues lower. Growth prospects continue to diminish.

Whether or not the North American markets perform in the short term will be determined by investors comfort with their volatility. At this point, six years into a bull market, it’s about the longer term view. Above all else, the number one consensus call a year ago as 2014 began was that interest rates in the US were going to begin to creep higher. And perhaps to the surprise of many, longer term bonds were one of the best performing asset classes of the last year. The consensus was wrong. Interest rates were supposed to move higher because of improving prospects for long term economic growth. Instead, they moved in the other direction.

With all the caution and some pessimism from respected analysts such as the aforementioned Mr. Gross, gold is catching a bid and is moving somewhat in tandem with a stronger US dollar. This could very well be that the US dollar is in for a rest and a bit of a pullback from recent levels which would add to gold’s punch. The biggest worry going into the second half of 2015 could very be the rekindling of the sovereign debt crisis and this time it will be much more difficult to paper over.