Month: September 2011

‘Operation Twist’ – What is it? How could it help? But why will it not?

As the US launches $400bn ‘Operation Twist’ in a desperate attempt to kick-start the economy, concerns arise over how effective this will be. It’s true that something needs to be done and inflation restricts the options open to the Fed but the strategy has a poor track record in terms of effectiveness. We will be in a lower growth environment for longer and should prepare accordingly.

 

The Economy Struggles: Something needs to be done

The US remains driven by consumer spending (~70% of GDP), but weak consumer confidence and limited access to financing are severe headwinds. Unemployment is stuck at 9% and even more worrying are the ‘under-employment’ figures which include those that have been forced to cut their working week rise as far as 18.5% of the population. In addition to discouraging spending, the longer this continues, the more skills are being eroded. Therefore the US government is under an immense pressure to act.

But inflation restricts options

So what can they do? When conventional monetary policy has become ineffective, since short term interest rates are already low, that’s where quantitative easing steps in.  With the aim of stimulating the economy, the Fed will buy financial assets in order to inject money into the markets. Bernanke has made it clear that one of the pre-requisites is a re-emergence of deflationary risks. However, inflation remains stubbornly above 2%. Pumping more money into the markets increases its supply and therefore reduces its value. With the currency less valuable, it doesn’t go as far as it used to and you get less ‘bang for you buck’. Things seem more expensive and inflation has been boosted.

Operation Twist to the rescue?

There is hope. One form of quantitative easing avoids the problem of inflation – Operation Twist. The strategy still involves the Fed buying long term government bonds, but in this case, it’s offset with selling short term bonds. This avoids flooding the market with cash which would exacerbate inflation. Another way this method is also described, by selling short term bonds and buying longer term bonds, is an extending of the maturity of Fed’s bond portfolio. Buying these long dated bonds increases demand and therefore reduces the amount of interest the bond issuer has to offer to entice buyers. A reduced longer term rate makes for example mortgages (long term borrowing) more affordable which would hopefully encourage spending.

A Poor Track Record

History teaches that Operation Twist may be of limited use.  When it was applied back in 1961, it only reduced rates by 15bps! This would not be enough to encourage spending, hiring and boost the economy sufficiently.

What can you do?

Prepare for a lower growth environment for longer. Pay attention to the type of customer a company in which you’re interested in investing services. A strong balance sheet, pricing power and protected demand will serve firms well.

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Banks Slash Jobs but Severe Headwinds Remain

As banks all over the world slash jobs, we ask ourselves – will this produce more streamline firms ready to generate significant profits, or a sign of the poor outlook for the sector? Unfortunately, stifling regulation repressive and a false bubble has driven this move and severe headwinds remain through exposure to struggling economies and substantial funding needs.

The 50 largest banks around the world have announced almost 60,000 job cuts. UBS are laying off 5.3% of their workforce, blaming stricter capital requirements and slowdown in client trading activity; Credit Suisse cutting jobs by 4% to save SFr1bn and Lloyds a whopping 14%.

Restrictive regulation make banks more stable but less profitable

Stricter capital requirements were just the type of new regulatory measures the Chief Executive of Standard Chartered feared at Davos back in January, would “stifle growth”. At this time we saw banks such as Credit Suisse missing earnings targets and downgrade their expectations severely going forward (from above 18% return on equity to 15%, which turned out to still be too high).

UBS has seen costs in their investment banking division soar to 77% of income and net profit fall almost 50% from a year earlier. Stricter capital requirements mean banks have to hold a higher amount of capital in order to honour withdrawals if hit with operating losses. Furthermore, restrictions on bonuses led to increases in fixed salaries and an inflexible cost base.

Backtracking on a false bubble

Job cuts should also be set within the context of occurring after a ‘false bubble’. Post the 2008 financial crisis and bank bankruptcies and proprietary trading layoffs, the fixed income, currency and commodity business of the remaining players boomed as competition dropped. Banks began expanding. UBS’s proposed cuts of 3,500 jobs comes after an expansion of 1,700 to the workforce and incomparable to the 18,500 job losses experienced during the crisis.

Exposure to struggling economies is a key threat

Crucially, these cuts do nothing to solve the biggest problem these banks are struggling with. They have substantial exposure to struggling EU economies. In Germany, bank exposure to the PIIGS (Portugal, Italy, Ireland and Spain) amounts to more than 18% of the countries GDP. Just last month Commerzbank suffered a €760m write-down from holding debt that is unlikely to be repaid, which all but wiped out their entire earnings for the second quarter of the year. Further fuelling fear of the spread of the crisis from periphery to core is that French banks are among the largest holders of Greek debt.

Here in the UK we’re by no means immune. Our banks have £100bn connected to the fate of these periphery economies. RBS, 83% owned by the British taxpayer is so heavily exposed to Greek debt that it has written off £733m so far this year.

Severe funding needs and fear of lending exacerbate the problem

90 EU banks need to roll €5.4tn over the next 24 months. This will be funded at higher rates and with disappearing demand as investors become more wary, exacerbating the problem. In addition these banks need to raise an extra $100bn by the end of the year. An inability to borrow to satisfy current obligations, not withstanding any expansive moves, is a serious obstacle to profit generation. 

Moreover, job cuts do nothing to boost confidence to encourage banks to lend. Just two weeks ago, EU banks deposited €107bn with the European Central Bank overnight than lend to each other. If banks are not even lending to each other, losing out on a valuable opportunity to make money, then how encouraged are we as investors to get involved?