We blame oil, the biggest mover of the bunch. If oil is falling dramatically, that must be bad for the economy and equities, right? No, not right. Equity traders don’t know which comes first, the chicken or the egg. When it comes to oil, we say supply-and-demand are the chicken and the price is the egg.
It was one thing for oil to crater during the financial crisis (from the $146.73 high on July 15, 2008 to the close at $33.87 on Dec 23, 2008—Reuters continuous futures contract basis). Then we had the finan-cial sector frozen and economies tanking—of course oil followed. This time we have less global de-mand, although nothing too awful, plus higher supply, mostly in the US. Oil prices are falling on per-fectly understandable supply and demand factors. It’s not certain that economies and the financial sector have to follow oil. In fact, it’s not even logical. Many, many enterprises will have improved profit margins from lower energy costs, and households will have more disposable income, especially in the US. Lower oil prices should be good for both the stock market (unless you are ExxonMobil) and the economy.
The FT’s clever Mr. Authers has a great sentence: “Americans may have found the best and safest way to retaliate against Vladimir Putin: produce more oil, and use less of it. Miles driven per capita has now fallen for nine years in a row.” Moreover, as Bloomberg puts it, the US has an 800-pound gorilla--the consumer, who is 70% of the $16.8 trillion economy or $11 trillion. Consumer spending is averaging 2% pa and will accelerate to 2.3% this year and 2.7% in 2015. “The combination of more jobs, falling gaso-line prices and low borrowing costs will help lift household purchases. Such tailwinds probably matter more than Europe’s struggles or the slackening in emerging markets that caused the Dow Jones Industri-al Average last week to erase its gains for the year.”
So, to say the US stock market is heading into a bear market phase for this or that reason is to forget that earnings are probably okay and we are only at the start of earnings season, anyway. The Fed has just said the process of getting to the First Rate Hike will probably be more prolonged—oh, good, the highly leveraged can stay that way.
There are only three big negatives out there today—the rising dollar, falling oil and equity prices and how Mr. Draghi can make QE work, both institutionally and politically.
Europe has the greatest collection of uncertainties. The FX market may not pay much attention (now or later), but the ECB review of European banks due Oct 26 is a Big Deal. Yesterday the ECB released a kind of interim report on the banking sector, according to the NYT. It says banks have not fully recov-ered from the crisis. The sector is using deposits more than interbank borrowed funds but still beset by bad loans and low profitability. This is called “subdued financial performance.” The ECB may be pre-paring the ground for the October 26 report to name some banks that should be closed or recapitalized. As for nonperforming loans, “the turning point does not yet appear to have been reached.” Not to get too preachy, but the banks are the medium through which central bank policy flows to the real economy—businesses and households.
Coming from another direction, today Bloomberg reports that the Financial Stability Board is pre-paring its report on capital adequacy of the world’s 27 largest banks. This won’t be released until after the ECB review, but already analysts are trying to quantify how much more capital the too-big-to-fail banks will need. One outfit (Barclays) has $237 billion while another (AllianceBernstein) has $870 billion. “The range is so wide because proposals from the Basel-based Financial Stability Board outline various possibilities for the amount lenders need to have available as a portion of risk-weighted assets [from 16% to 205]. With those holdings in excess of $21 trillion at the lenders most directly affected, small changes to assumptions translate into big numbers.” The Basel Committee may add another 5% for a max of 25%.
Here’s the kicker: European banks will need relatively more than others. A London ratings agency says the worst-case 25% would mean the shortfall in Europe is €482 billion. A Citigroup analyst says “European banks, including some second-tier lenders, will probably have to issue about 500 billion eu-ros of senior debt through holding companies, if they have them.”
The ECB, in preparing its capital adequacy and stress test review for Oct 26, is certainly keeping an eye on what the FSB report is likely to call for. How embarrassing if the ECB calls for additional capital of x and the FSB calls for a multiple of x. The silver lining is that lots of collateralized paper may get gener-ated out of it, exactly what the doctor ordered for QE.
And that brings us to the final entry--today European Court of Justice in Brussel starts considering whether Outright Monetary Transactions (OMT) is legal. Draghi pulled the rabbit out of the hat with this one—“whatever it takes”—but OMT was rejected by the country it was designed for, Spain, and never actually used. The German Constitutional Court chickened out and declined to make a determination, passing the case upstream to the European Court. What if the European Court says OMT is not legal under the ECB’s mandate? That would, presumably, put the kybosh on QE. The eurozone members could go back and amend the treaties to allow the ECB to buy sovereign paper, but that would take a long time and it’s not clear Germany would not prevail, since the prudent and solvent always hate bail-ing out the reckless and insolvent.
There are a lot of moving parts here and it’s always possible the European banking sector cures itself without drama. Many banks have already recapitalized and restructured. But we have come to expect bad behavior from banks, so let’s not count on it. Meanwhile, the Germans are putting their eggs in the infrastructure basket. Today at the FinMin meeting in Luzembourg, German FinMin Schaeuble said “The EU won’t repeat ‘old mistakes’ that didn’t work in the past to counter a worsening of the economic environment.” He is waiting for the EC and European Investment Bank to draw up a project list by year-end. To pay for it, ESM will not be needed. “We won’t do this by using the capital stock of the ESM but, where appropriate, by a necessary increase in the capital of the EIB. We have plenty of options.” This might be called the fiscal alternative.
Well, in enough size, infrastructure spending can indeed be a powerful force. Think Hoover Dam, TVA and WPA. But to the extent the members have to repay European Investment Bank borrowings, in-creased spending can’t be hidden from the Maastricht and Stability Pact limits of each member. This is almost a back-door way to give exceptions to deficit limits. The French are sure to notice. It may be mean to say so, but it’s sort of nice to see somebody else have institutional problems and not just the US, although our idiots are demonstrably worse (default would be okay, let’s not fund Veterans Affairs or ebola outbreak stations).
Europe is in a soup of its own making. Those who remember the pre-EMU days should be breathing a sigh of relief—in the old days, by now we would have had competitive devaluations and probably a na-tionalization or two. But realistically, the best new methods are just the bad old methods dressed up in better clothes. The top solution is still devaluation and a good contributor to recession is still deficit spending on infrastructure. We are back to seeing the euro well under 1.2500.
This morning FX briefing is an information service, not a trading system. All trade recommendations are included in the afternoon report.
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