Central banks are only part of the solution.

Disruptive influences are here to stay, investors should “look to the evidence”, says global investment manager

“Gone are the days when central banks could pull the levers and set global economies on the right course. Their actions still have an effect, but they have clearly failed to resolve many of the fundamental problems facing world economies post GFC.”

This is the view of John Birkhold, Partner at global investment manager, Origin Asset Management, who yesterday warned investors to take new technologies seriously in their search for investment performance.

Following the GFC, central banks adopted policies which, in Origin’s view, failed to address the real issues facing many developed economies. Aggressively accommodative monetary policy, like quantitative easing in the US, may have staved off disaster in the short term, but is likely to have far-reaching, longer term negative consequences in many cases.

“Together, low interest rates and ample liquidity have allowed many struggling economies to put off addressing the difficult re-structuring decisions that need to be made. And more than that, I would argue that the actions of central banks are in fact creating some of the same economic conditions which led to the GFC in the first place,” Mr Birkhold said.

Nonetheless, investors understand that they must make their calls based on the world they are faced with and not the world they would like to have. And if innovation and disruptive technology are here to stay, the challenge lies in identifying the companies most likely to create wealth for their shareholders going forward.

According to Mr Birkhold, by its very nature, disruptive technology is deflationary and, as with all major change, there will be both winners and losers as a result.

“The consumer often wins as technology becomes better and cheaper, whereas previously profitable companies see barriers to entry diminish and previously profitable markets dissipate. This is particularly true for organisations stuck in the middle of flattening business environment and find themselves disintermediated,” he explained.

Mr Birkhold went on to say that relying on actual evidence and analysing individual companies using a bottom-up approach is the best way to trying to identify long term winners. Origin is invested in a number of areas where current trends appear supportive, including:

• Home builders in the UK, which continue to be relatively cheap while exhibiting strong underlying fundamentals.
• Parts of the global auto industry also appear attractive thanks in part to increasing demand for cars in some markets, as well as technological innovation.
• Information technology firms in industries such as smart phone supply chain, the “internet of things” and cloud-based software providers.
• Bio-technology, which is being helped by aging demographics globally and also from significant advances made in the treatment of chronic disease such as Hepatitis C and prostate cancer.

Mr Birkhold concluded by saying that investors should not fixate on central bank manoeuvrings and instead should try and identify firms that will be able to survive and even prosper in the intrinsically deflationary environment that the developed world is likely to face for the foreseeable future.

“And for my money, firms that are able to adapt and innovate will be the ones that will most likely create significant wealth for their shareholders going forward,” Mr Birkhold said.

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Blueprint needed for financial system overhaul: Erskinomics Consulting

The Financial System Inquiry (FSI) should seize the moment and recommend an overhaul of the regulation of Australia’s financial system, says Alex Erskine, managing director and founder of Erskinomics Consulting.

He says the “efficient markets” regulatory philosophy that was the centrepiece of the Wallis/Costello approach to regulation failed in the GFC – and now is the time to recalibrate the regulatory architecture.

In a paper titled “Regulating the Australian financial system”, one of four papers that form part of the Australian Centre for Financial Studies’ Funding Australia’s Future initiative, Erskine argues that the Council of Financial Regulators (CFR) – a legacy of the Wallis Inquiry – should have a far greater role in regulating the system.

“This Wallis inspiration relies on clubby cooperation is not necessarily proactive and is unaccountable. It has worked well so far, but the future is likely to be more testing.

“But by recreating it as a statutory body with an independent non-executive chair, publishing an agenda and minutes for regular meetings and accountable half-yearly to parliament, the CFR should have two roles: to oversee the effectiveness of regulation and to be perpetually paranoid about systemic financial instability and make decisions on the conduct of macro-prudential policy.

“The Council could contract the RBA and other regulatory agencies as appropriate to implement its macro-prudential policy decisions, resolving the confusion between the RBA and APRA over macro-prudential policy.”

The Erskine prescription for a new regulatory framework also envisages revised roles for the major players in the system.

“The Reserve Bank’s responsibility for financial stability should be transferred to the CFR. This will let the council determine macro-prudential policy actions on a pre-emptive basis while allowing the bank to implement monetary policy with a sole focus on inflation.

“The Australian Prudential Regulation Authority (APRA) needs to have a mandate to protect taxpayers from the risk of bail-outs made explicitly part of its objectives.

“It should also be required to prepare a risk appetite statement, agreed with the government, and set capital and liquidity standards for prudentially-regulated institutions to protect taxpayers from all except a periodic ‘unavoidable’ financial crisis. To clarify its role and responsibilities, APRA’s competition mandate, which it has largely overlooked, should be transferred to the Australian Competition and Consumer Commission (ACCC).

“The Australian Securities and Investments Commission (ASIC), in a post GFC world, should have one objective: market integrity. It should be equipped with effective data, analysis, policy and regulatory tools to perform this task, with funding remaining with taxpayers to limit risk of regulatory capture. Its competition and consumer responsibilities should be stripped out and assigned to the ACCC.

“Finally, the role of the Australian Competition and Consumer Commission (ACCC) should be reinvigorated and made a member of the CFR.

“A vigorous competition regulator will be more important for Australia’s future: key competition questions will arise from the increasing vertical integration of the dominant banks into all aspects of finance and the implications of the emerging international trend to ring-fence core banking from riskier trading businesses. The ACCC should receive the competition mandates currently held (and generally ignored) by APRA and other regulators.”

Erskine says the “efficient markets” philosophy depended on banks and their investors fearing they can go bust and consumers fearing they will lose their deposits, creating sufficient incentives to manage their risks and, in doing so, and aided by prudential regulation, perpetually nudging the financial system towards equilibrium even while permitting individual failures.

“This unreality was made obvious in the systemic financial shock of the GFC. In Australia, every prudentially regulated entity became too-big-to-fail, key borrowings were guaranteed by government, and deposits are now largely insured through the Financial Claims Scheme (FCS), all in contradiction to the Wallis Inquiry intellectual underpinnings.

“The GFC showed beyond doubt a determination from governments, including the Australian Government, to limit through policies and regulations the risk and damage of systemic crises. In doing so, taxpayers were put at great risk, though fortunately in Australia the cost of support measures remained contingent and were not drawn on.

“It is time now to recognise the reality of this support and to devise a regulatory system that limits the risk to taxpayers in future crises. Financial system regulation, especially prudential and macro-prudential, needs to be reassessed in this ‘systemic stability’ light, and the risk to taxpayers appropriately managed.”

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The new Dodd-Frank Act, which will once again split savings and investment banking in the US, aims to usher in as successful a regulatory regime as the one provided by the Glass-Steagall Act of 1933 until its final, fatal repeal 13 years ago.

But the Wall Street Reform and Consumer Protection Act of 2010, known as Dodd-Frank after its authors Senator Chris Dodd and Congressman Barney Frank, is onerous and flawed lawmaking. It has since been nibbled at by bank lobbyists and is not yet complete – 11 bodies are fleshing out the law’s intent in regulations.

While the biggest overhaul of US finances since the 1930s will provide an employment boost for lawyers and regulators, the law may be too feeble to prevent a systemic collapse. Yet don’t lose heart. The world’s financial system has some things helping keep it in check including a powerful invisible force.

The main aims of Dodd-Frank are to prevent a systemic financial crisis, to control derivatives and to provide a coping mechanism for when a too-big-to-fail financial institution fails. And it does make worthwhile attempts at these goals. Oversight has been consolidated to some extent and many derivatives will now trade on public exchanges, so they will be less opaque and less debt-laced.

The biggest test of the act will be how it copes with the failure of a non-bank whose collapse threatens the financial system such as the demise of Lehman Brothers did. (US policymakers have long been able to handle a failing bank and protect depositors – they have closed more than 445 banks in the past four years with little fuss.) In 2008, authorities only had the bankruptcy process (Lehman’s option) or bailouts for creditors (the solution for AIG) as options when non-bank giants struck trouble. Under Dodd-Frank, authorities can put a non-bank posing a systemic risk in receivership and either sell it or split it into a bad bank and a viable bank, which still operates. In this insolvency process, depositors are supposed to get their money back, shareholders are ruined and creditors accept an appropriate loss. The aim, as always, is to stop a wider run on banks.

One problem is that the new law was written by those who think the US government overstepped its power after Lehman failed in 2008 when Washington provided taxpayer-funded bailouts to save institutions that floundered due to speculation.

The act forbids many of the rescue measures that were adopted four years ago. Banned are company-specific support as was done for companies such as AIG and Citigroup, government help for money-market funds and guarantees on bonds issued by financial firms unless approved by Congress.

One problem is that it’s harder for the Federal Reserve to help sound banks facing a liquidity crisis – a key plank of central banking. Other flaws of the insolvency process under Dodd-Frank are that it makes no allowance for how to treat a US institution’s international assets, it assumes authorities will act pre-emptively and it presupposes that policymakers can formulate an acceptable formula of losses for creditors without sparking wider repercussions. Ultimately, we will only know if Dodd-Frank can cope with a systemic threat when it’s tested.

The Volcker rule

The most renowned part of Dodd-Frank is the contentious Volcker rule, named after former Fed chairman Paul Volcker who pushed for its inclusion. This tenet from next year resurrects the part of Glass-Steagall that bans banks that accept deposits from trading (speculating) with shareholder funds. In other words, it separates commercial and investment banking. The rule aims to stop speculators from gaining access to the taxpayer support that deposit-taking commercial banks enjoy. Authorities want to protect deposit-taking or savings banks (and their lending) from gambles that go awry. The US Government Accountability Office calculates that the six largest US bank holding companies lost nearly US$16 billion on proprietary trading in the 18 months ending December 2008, Bloomberg reports.

The Volcker rule allows savings banks to conduct short-term trades for hedging or market-making, while limiting bank investments in private-equity and hedge funds to 3% of tier-one capital. (Glass-Steagall, in practice, was tougher because it banned speculation and market making and most underwriting.) The new restrictions may limit banks’ trading profits – the pre-2008 source of much bank revenue and large banker bonuses. In response, many big US banks have shut or sold proprietary trading desks or started hedge funds run by their former prop traders.
Bankers are lobbying to weaken a rule that they have two years to comply with because they say it will increase risk, limit liquidity, boost costs for investors, spur gaming and create litigation. JPMorgan Chase’s antics will make their job harder as its CEO Jamie Dimon was one of the strongest advocates of watering down the Volcker rule – he helped create a loophole for “portfolio hedging”, the frolics that cost his bank so much. They won’t stop trying though.

The power of memory

Dodd-Frank has its flaws. Big banks were not broken up, so they still threaten the system if they collapse. Much of the so-called shadow banking system is untouched and the law barely covers Fannie Mae and Freddie Mac, the government-sponsored home-lending agencies that received the largest bailouts in 2008. There is no international insolvency formula in place. Lobbyists are trying to thwart the transparent trading of derivatives. The law imposes costs on banks that will reduce earnings and lending and thereby economic growth. On top of all this, presumptive Republican presidential candidate Mitt Romney wants to repeal the law.

Should we worry about the safety of the US, hence global, financial system? Probably not – for two reasons.

Firstly, the finance industry is offering up enough scandals to shatter its political support, even with all the money thrown at US lawmakers. The billions of dollars lost by JPMorgan Chase’s London-based trading unit is undermining the credibility of those trying to stave off a wider divide between savings and investment banks. The US Senate finding in July that the UK-based HSBC exposed the US to “a wide array of money laundering, drug trafficking and terrorist-financing risks” and similar accusations against Standard Chartered by New York regulators reinforce the lack of ethics among bankers. They perhaps even overshadow for amorality the fraud involving the world’s biggest banks centred around the rigging of the London and Euribor interbank offered rates, which are the benchmarks for about US$10 trillion in personal and commercial loans and about US$350 trillion in derivatives.

These scandals are shaping up as ones that will have devastating political (as well as financial) costs for banks. If they fail to usher in harsher regulatory regimes, it will only take a few more displays of such rottenness to leave banks defenceless against populist calls for rabid regulation. In one of the most telling U-turns among bankers to date, Sandy Weill, the man who championed the repeal of Glass-Steagall so he could forge Citigroup through acquisition, called for big banks to be broken up so that we have a system “that’s not going to risk the taxpayer dollar, that’s not too big to fail”.

Secondly, there is an invisible power policing finance that is more effective than the most draconian and watertight of laws – memory. The greatest force in favour of the smooth running of the world’s financial system is that people remember what recently went wrong and why. While the world is still dealing with the aftermaths of the US sub-prime crisis and financial booby traps planted before 2008 may still explode, it’s likely that bankers will find it harder to misbehave for a while.

Investors, regulators, voters and even bankers acknowledge the malpractices that led to the global financial crisis. So they are mending their ways – if anything, they have overcompensated for their risk taking or laxness.

Within banking, while rogue traders will always exist, compliance departments are more powerful, stricter lending standards are in force and senior management and boards are more suspicious of financial wizardry and trading units somehow earning a fortune, even if not at JPMorgan Chase until it lost billions. Most bankers realise that if there is another financial catastrophe soon their industry will be overregulated for a long time. Regulators are more vigilant and empowered, so much so they risk stifling innovation with their thousands of pages of laws and tougher capital controls. Rating agencies are more conservative with their approvals. Investors are so risk averse they prefer cash and government bonds to higher-yielding equities, let alone something like mortgage-backed derivatives banged together by US investment banks. Most people now understand that home prices can fall. Voters want finance regulated and are wary of free-market ideologies, even if they are electing conservative governments. Free-market zealots will find it harder to be appointed as heads of central banks and, if any are, they would never carry the aura of Alan Greenspan at his most untouchable.

The memory of the economic woes triggered by the US sub-prime lending crisis will linger in the worst-hit countries for generations. The time when proper regulations will be needed will be when people now in their twenties are well retired and their grandchildren are shaping society. After all, it was not until six decades after the Great Depression that bankers were able to convince US lawmakers to ditch Glass-Steagall to allow the marriage of investment and commercial banks, thereby giving utilities – for that’s what savings banks more or less are – the ability to gamble away billions and help trigger a global financial crisis.

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The slump in markets over the last month naturally raises a lot of questions: what’s driving it? Are we seeing a re-run of the global financial crisis (GFC)? What’s the risk of a return to recession? Can China save the world again? Have shares bottomed? How vulnerable is Australia?
Why the sharp fall in shares (& other growth trades)?

Put simply, shares have taken a tumble on fears of a return to recession in the US and Europe, and worries this will drag down the rest of the world. A few months ago we thought that global growth was just going through a temporary soft patch (on the back of Japanese supply chain disruptions and the earlier surge in oil prices) and that even though shares might remain volatile and see further weakness through the September quarter, the trend would remain up as profits continued to rise and global monetary conditions remained easy.

But the events of the last few weeks have called this view into question. Economic data has remained weak and debt crises in the US and Europe are increasing the pressure for more fiscal austerity at a time when growth is fragile. Political bumbling on both sides of the Atlantic, Standard & Poors’ downgrade of America and fears of more downgrades to come have only compounded these fears. Furthermore, memories of the 2008-09 GFC are still fresh in the minds of investors so the attitude seems to be shoot first and ask questions later.

Are we seeing a re-run of the GFC?
It’s still early days yet, but our view is this is very different to the GFC. Public debt problems have been brewing for some time so exposures should be well known and more transparent. The leverage and complex financial engineering that caused so much trouble in the GFC is not a factor now. Interbank lending markets are much better supported by central banks. Consequently, while interbank lending spreads (the difference between what banks charge to lend to each other and expected official short term interest rates) and credit spreads (the difference between corporate and government borrowing rates) are picking up, they remain relatively low.

While it’s early days yet, the risk of a complete seizing up in lending markets – including in areas like trade finance that helped spread the GFC to emerging countries – as occurred in late 2008, seems low. However, the recent speculative attacks on French banks and moves by US money market funds to stop lending them $US funds are worth watching.

What’s the risk of a return to global recession?
The risk of recession has increased significantly in Europe and the US. Fiscal austerity is occurring much earlier than is desirable, and recent political wrangling has put public debt problems front and centre in investors’ minds and dealt a huge blow to business and consumer confidence. Europe is probably the biggest risk. It seems to be stuck in an ever worsening cycle of periodic investor panic over debt blow outs, causing more fiscal austerity causing weaker growth causing further budget deterioration causing more market panic causing more austerity and so on. This process started in the peripheral countries but now appears to be spreading into Italy and France. A fiscal union is a long way off and won’t solve current problems anyway, and the European Central Bank seems unwilling (or unable) to provide monetary relief.

And the US is now starting down the same path with fiscal austerity set to knock up to 2% from growth next year. However, there are several reasons to believe that while the risk of recession in the major industrial countries has increased substantially, it will probably just be avoided:

• The fall in oil and commodity prices generally will take pressure off household budgets and business costs. 
• Cyclical sectors that can push the US economy into recession are already at recession levels – eg housing. 
• Longer term borrowing costs in the US have fallen to extraordinarily low levels and the Fed is effectively committing to keep them there for two years. This is enabling homeowners to refinance to lower rates.
• Near zero returns on cash are making it very difficult for US companies to continue adding to their already record cash stockpiles. The incentive to get out and invest, or at least buy back shares or other companies, is huge. 

It’s looking increasingly likely the US will head down the path of another round of quantitative easing (ie QE3 – which involves pumping more cash into the US economy). While one can debate the seeming failure of QE1 and QE2 to spark a strong recovery, the US probably would have been a lot weaker were it not for these actions and at least it seems to have prevented the US from sliding into price deflation.  

We put the risk of a return to recession in industrialised countries at 40% – slightly higher in Europe, but slightly lower in the US – with fragile sub-par growth of around 1 to 1.5% being the most likely outcome at around 60% chance.

Can China save the world again?
This brings us to the emerging world and China. Providing there is no drying up in trade finance, it is likely China and the emerging world will be able to hold up. Inflationary pressures in China and the rest of the emerging world are already fading on the back of lower oil and food prices, and with growth coming off the boil this should clear the way for easier monetary policies. With short term interest rates having increased over the last two years there is plenty of scope to cut, unlike in advanced countries. Second, public debt levels in the emerging world remain low so there is still plenty of room for stimulus if need be. Overall China is likely to see growth of around 8 to 9% and emerging countries around 5.5% which implies global growth of 3 to 3.5%. This is well below IMF expectations but not disastrous. 

How vulnerable is Australia to a new global downturn?
Australia is vulnerable to any renewed global downturn, given impacts on confidence, financial flows, and potentially trade. However, Australia is far better placed to withstand a global downturn and we see the risk of recession here as low at around 20%. Interest rates have a long way to fall.

The $A would likely fall if the global economy returns to recession boosting competitiveness. Public debt is a fraction of that in other countries and so more stimulus can be applied if need be. Corporate gearing levels are low and companies are cashed up. Banks are less dependent on global markets for funding than in 2007. Australian households have also built up a large savings buffer. Finally, our key export markets in Asia are more secure than those in Europe and the US.

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