This article was originally published in MoneyWeek magazine issue number 562 on 4 November 2011, and was available exclusively to magazine subscribers. To read all our subscriber-only articles right away, sign up for a three-week free trial now .
Having finally agreed a deal on a second Greek bail-out last week, European politicians were rewarded with a short but sharp stockmarket rally. This week, the Greek prime minister, George Papandreou, brought everyone back down to earth by calling for a referendum on the terms of the deal. Greeks are already rioting over the austerity measures imposed under the terms of the first bail-out, so any referendum would be likely to come out against the deal, which amounts to €130bn for Greece, including a 50% haircut' on Greek national debt.
Greece has a history of holding out for more money from Europe. The latest move is already angering Germany, already balking at the spiralling future costs of holding the euro together. After all, if Greece gets a new deal, Ireland and Portugal will ask for better bail-out terms too. Yet German leader Angela Merkel and France's president Nicolas Sarkozy know that core' European nations (like their own) must somehow come up with enough money to reduce the peripheral' nations' debt-to-GDP ratios to the point where those countries can start the productivity reforms that would put their economies back on a growth track. Otherwise, their high debt burdens, with a high deficit adding to their woes every year, can only end in disaster.
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The threat to the banks
Why can't the core' just abandon Greece and other peripherals' (such as Ireland, Portugal, Spain and Italy) to failure? There are several reasons, but the main economic problem is Europe's banking sector. Central bankers in the US and UK realised by late 2008 that there was a lot more to the financial crisis than just US subprime securities. So Anglo-Saxon banks have spent the past three years retrenching. They have been shrinking loans and making some attempt to get their balance sheets back to health.
But Europe has spent the last three years prevaricating and viewing the financial crisis as primarily an American problem. As a result, euro-area banks haven't even started deleveraging. To make things worse, the European banking system has always been much more highly leveraged than that of the US. In the US, average leverage ratios (equity to assets) were around 5.6% at the start of the crisis. Many major European banks today have leverage ratios nearer to half that. This leaves them with very little scope to absorb unexpected losses in the peripheral sovereign debt bonds they once viewed as risk-free, let alone the private-sector loans they've written. As a result, if countries default, or worse leave the euro and devalue to save themselves, they'll kill the banks. And not just those in their own country, but the ones in core Europe that lent to the periphery as well. That's why the core' has to stump up to save the rest of Europe. But how?
This is where the big bail-out fund, the European Financial Stability Facility (EFSF), is meant to step in. The latest plan is to allow the EFSF, financed by €440bn of commitments', to leverage itself up, perhaps by guaranteeing the first 20% loss on any debt it insures. However, the losses implied in a default, let alone a devaluation, would come to much more than 20% (even Greece's 50% haircut is some way short of what analysts expect the final loss to be). As a result, debt markets are charging peripherals' more and more to compensate for the risks for example, Italian bonds now yield more than 6% again.
In short, there's not enough money in the pot. But Merkel and Sarkozy don't feel they can return to their increasingly irate, nervous voters with a demand for cash that would be big enough to quell the bond markets' worries. Meanwhile, Greece has already revealed that this is no picnic for the recipient countries either, hence the hardball negotiating tactics over the conditions attached to any bail-out. On top of that, Greece's debts today are only the tip of the iceberg. There are also the excessive debts of other peripherals' to consider, as well as any future growth in debts as countries struggle to grow their economies in the face of necessary, but contractionary, structural and fiscal adjustments.
The next big risk bank runs
So what happens next? Given that sovereign default, let alone a euro exit and devaluation by any country, implies massive losses for banks, runs on the most vulnerable-looking institutions are the next big risk. That's why politicians have brought forward (from 2019 to early 2012) the deadline for Europe's banks to prove they are well capitalised. They have also bumped up the required core tier 1 capital ratio from 7% to 9%. In other words, banks have been told to hold a bigger buffer against losses. After all, the last thing anyone wants is a run on banks seen as too weak to take the devaluation hit, if bail-out talks look like they will fail to keep the Greeks inside the euro.
Taking into account the 50% Greek haircut, Europe's banks face an apparent €106bn capital shortfall. This is supposed to be raised from the capital markets, but it will be underwritten by the authorities, who are standing by with taxpayer funds if required. But what the European authorities don't seem to realise is this: telling a bank that it's undercapitalised is exactly the same as telling it to shrink assets (in other words, stop lending and start reining in existing loans, so that your outstanding loans fall relative to your capital). If you then also recapitalise an undercapitalised bank, that gives it the wherewithal to start this process.
For example, in Japan, banks were stuck for five years. They were unable to grow their loan books because they were undercapitalised in the first place. But they couldn't afford to write-off bad debts either, because this would have made them even more undercapitalised. It was only when the state injected capital into the banks in late 1998 ironically, the aim was to promote easier lending that banks were able to start shedding loans. That process went on for seven years. It was a similar story in the US and Britain in the aftermath of Lehman's collapse.
The €106bn of new bank capital being demanded by the European Banking Authority will have to come from private-sector bank deposits. I suspect that no one in Europe has realised that this will shrink broad money supply. This is the technical bit, but bank deposit liabilities are money supply while bank non-deposit liabilities (which consist of retained earnings and paid-in capital) are not. To put it simply, anyone who uses savings to invest in new banking shares is removing money from the broad money supply. The Bank of England's first quarterly bulletin this year included a study that calculated UK bank capital-raising from late 2008 drained a gross £240bn, or a net £160bn after adjusting for banks' gilt purchases, from UK broad money supply. In other words, if you recapitalise the banks, you also need to do quantitative easing (QE new money printing).
Besides this, the banks' capital to asset ratio (K/A) is also negatively related to bank lending in a very mechanistic way. If banks are told to hold more capital, then the amount they lend must fall. This is a straightforward reversal of the credit bubble period, where Basel II regulations meant that, after June 2004, capital requirements were effectively lowered, resulting in bank assets (the loans they write) leaping up. As the chart onbelow shows, if there hadn't been £200bn of QE in the British crisis so far (and there will be a further £75bn to tide us over for the next 12 months), then the shrinking of bank lending we've seen so far would have reduced UK money supply by £200bn; and a fall in broad money supply is the textbook definition of deflation.
Europe will have to do QE
The real reason that there has been no QE in Europe so far is because there has been no need to neutralise a bank-led credit crunch, because they haven't forced their banks to recapitalise yet. It's also the reason why, while many household names have vanished from the global banking system over the past few years, only one Dexia has been European (and that one was hardly a household name).
But the Europeans have ended up in a situation where, some four years after the crisis first manifest, they're only now finally demanding that their banks recognise losses, raise new capital and hold more capital in future. These are the three demands that precipitated the credit crunch in Japan in 1999, as well as in the US and UK in 2008. To force European banks to shed assets at exactly the same time as governments are being forced to cut back too can have only one outcome a deflationary crunch. Recession is likely, depression all too possible.
Once these forces have been unleashed, bank loan contraction typically lasts about six years. The only humane, rational policy response will be for the European Central Bank (ECB) to drop outgoing president Jean-Claude Trichet's slavish adherence to (German) Consumer Price Index (CPI) targets. That means slashing Europe's key interest rate as hard and as fast as new ECB president Mario Draghi thinks is possible. But cutting rates won't be enough. Even as Britain has started QE2 and the US considers extra QE3, the eurozone will be forced to embark on the biggest money-printing programme of all.
QE's key function is to neutralise the contraction in broad money supply caused by banks shedding loan assets, so as to head off outright deflation. Yes, it's inflationary. It dilutes the currency, leading to some headline inflation of imported staples. But despite 15% of GDP worth of QE, neither US nor UK core inflation rates are much above their post-World War II lows; real estate prices, especially commercial, continue to fall; the money supply has barely risen; and real wage growth has been negative. If you want to know how much more pronounced these deflationary forces would have been without QE, just look across the Irish Sea.
Indeed, a European credit crunch, before it triggers QE, is likely to have a big impact on financial markets and the economy. When US banks first shed assets in late 2008 and early 2009, they focused on the loans they could most easily dispose of, not necessarily the tricky ones they would need to address ultimately such as underwater real-estate loans. As a result, short-term loans, and those with liquid collateral backing, took the brunt of the first wave of contraction. Interbank lending dried up, squeezing bank funding. Trade finance ceased, which saw global trade collapse more rapidly than in the 1930s. Loans backed by securities were pulled, forcing hedge funds into fire-sales.
European banks are more important to the business sector than those in the US are, implying the impact will be felt here. French banks are central to trade finance, especially in funding the Swiss-based commodity trading houses. So commodities especially may be natural casualties of a European credit crunch.
So what will QE mean for Europe when it launches? It might prevent deflation. But it's no miracle cure. Indeed, it's very regressive (it punishes the poor and rewards the wealthy). First, weakening the currency pushes up the cost of imported staples like food and energy, which hits the poor hardest. Secondly, if interest rates are held at ultra-low levels for a long time, banks start to worry about what will happen when they go up. Realising that asset prices are bound to fall in the future, banks keep lending to the rich (who have other collateral), but the poor become credit-starved, and have to pay more for what credit they can get. Thirdly, the way that QE is injected into the economy, via the financial markets, allows financial-sector staff, whose jobs have already been saved by funds from taxpayers, to charge commissions and trading spreads on the flows. In Europe, the divisions between winners and losers are more likely to be visible at a national level, fanning discord.
As far as investors go, QE has important implications, especially for the currency. The US Federal Reserve reckons that, at $600bn, QE2's impact on the economy was equivalent to three 0.25% rate cuts. The value of the combined US QE programme to date comes to $2.35trn. If you include actual interest-rate cuts earlier in the crisis, it means that over the last five years, US interest rates have fallen by 6.7 percentage points relative to the eurozone. This is what has driven the euro higher against the dollar. But now this relative interest differential is about to reverse, perhaps significantly. That is likely to drive the dollar higher against the euro over the coming months and years.
A strong dollar determines almost all other investment strategies, promoting the opposite risk-off' scenario to the risk-on' one that has dominated markets for most of the last month. As funds flow into dollars, they need a safe haven to sit in. So this scenario looks very good for US Treasuries, especially if the hawks at the Federal Reserve continue to delay and dilute QE3. However, by the same token, a strong dollar is not good for commodities. A contraction in bank-funded trade credit would be bad news too. That makes commodities a doubly dangerous place to be. Growth-orientated stocks would also suffer from a European deflation, especially those that earn in euros. Far better will be defensive, high-yield plays, especially if they have strong dollar earnings. Fortunately, the FTSE 100 is full of such stocks. But best of all will be high-yielding, defensive, domestic US stocks, where UK-based investors will be able to pick up both the yield and the currency appreciation. We look at the best options below.
The best stocks to tuck away now
The problem US stocks pose for income-seekers is the yield or rather the lack of it, writes David Stevenson. The average payout ratio on the S&P 500 index is just 2.1%. But don't despair. Sticking with defensives' shares in companies that don't need economic growth to make their money still looks like a good bet. There are pockets of value here that also pay decent dividends. In September, we highlighted two big pharma candidates. Since then, both Merck (US: MRK) and Eli Lilly (US: LLY) have nudged up a few cents on third-quarter results that beat analysts' forecasts. But both still look great value on 2011 p/e ratios of nine and 8.6 respectively, with prospective yields of 4.6% and 5.7%.
Indeed, the healthcare sector is one of the best areas for US income-seekers. Johnson & Johnson (US: JNJ) gets more than three-quarters of revenues from healthcare products. It has a portfolio of household names and a great track record: earnings per share have grown for 48 years running, and the dividend has been hiked for 26 years in a row. On top of that, there's net cash on the balance sheet, and net profits are set to rise by at least 6% a year until 2013. Yet the group, on a forecast 2011 p/e of just 12.7, has a prospective yield of 3.6%, which is set to rise to 3.8% in 2012. Meanwhile, global health and hygiene company Kimberley-Clark (US: KMB) is a touch pricier it's on a forecast p/e for next year of 13. But the prospective yield is over 4%.
Other options are consumer staple firms, such as food and drink makers. Pick of the better yielders here is soup and sauce maker Campbell Soup (US: CPB) on a forecast multiple of 13 for 2012 and a 3.7% prospective yield. Cigarette manufacturer Altria (US: MO) also falls into this sector. It may not be to everyone's taste, but the current year yield of 5.9% is attractive.
James Ferguson qualified with an MA (Hons) in economics from Edinburgh University in 1985. For the last 21 years he has had a high-powered career in institutional stock broking, specialising in equities, working for Nomura, Robert Fleming, SBC Warburg, Dresdner Kleinwort Wasserstein and Mitsubishi Securities.
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