Be Afraid of Fear Itself

Includes: CNY, ERO, EU
by: Shane Lofgren

In a past article, I wrote that stock prices were falling on nothing more than fear. The fundamentals of the global economy were sound, the EU was taking the least bad steps to resolve their sovereign debt issues and soon fear would turn into greed and stock prices would come roaring back. The analysis was roughly sound; however, there was one fundamental underestimation that made my conclusions all wrong and that is the power of fear.

Fear, uncertainty and falling confidence, which began as a result of the Greek sovereign debt crisis, are spreading through the minds of economic actors over the entire globe. They are triggering a tightening of monetary conditions, a decline in investment, consumption, demand and income. As markets observe these declines, the emotions are confirmed, becoming more deeply entrenched and causing further declines. Every day they are not resolved they gain momentum. This downward trend will feed and be fed by other weaknesses in the economy including geopolitical instability, new government regulations and a worsening of the quality of fragile-- but currently manageable-- debts. Most policy options to stop this downward trend will be ineffective, very politically difficult, and/or have severe side effects. There is some hope that certain moves by governments could couple with news that surprises to the upside to build a countervailing optimistic trend, but this seems unlikely. Rather, my best assessment is that fear will drive the global economy and stock prices back down into a recession.

This fear and uncertainty first took hold as a reaction to the EU response to its sovereign debt crisis. In my previous article I argued that the EU was pursuing the least bad options to resolve their crisis and thus stocks ought to recover. I still feel I was partly right. The ECB's decision to monetize debt restored short term functionality to debt markets. It helped trigger a fall in the Euro, which will help boost EU exports and reduce real debt burdens. It will also, hopefully, bring about moderate inflation which will also reduce real debt burdens. Austerity measures will hopefully help make debt more sustainable and, given the political capital spent to pass them, are unlikely to be abandoned for at least a couple of years.

I still believe this is correct analysis; however, stock prices depend on the world economy, not just the EU. While these measures might be the least bad for the EU, and perhaps the world economy as well, they are certainly not good for the world economy. A falling Euro hurts non-EU economies at least as much as it helps the EU. Austerity measures, though necessary, decrease demand in the midst of a fragile recovery. Worst of all, the time it took for these measures to be decided upon, the lack of political unity surrounding their implementation, and the serious political unpopularity of many measures combine with these adverse side effects to create a strong feeling of fear and uncertainty in economic actors around the world.

Now, many, including myself as recently as two weeks ago, naively assume a sharp distinction between emotion and “the real economy.” Emotion is fluffy, it's intangible, it's inconsequential; what really matters are more tangible measures such as income, job creation, investment etc. Yet all of those tangible measures are driven by the decisions of human economic actors and their emotion-influenced expectations for the future. On the credit demand side, when firms are uncertain about whether there will be increased demand for their products, they invest less, they hire fewer workers, they give fewer raises etc. There is evidence that this mood is taking hold.

According to The Economist, “Companies have issued just $47 billion of bonds so far in May. They are on course for the lowest monthly total since December 1999, according to Bloomberg.”1 While conditions may be worst in the EU, a diminishing appetite for expansion appears to be occurring globally. An article by the Financial Times shows Japan is also experiencing a squeeze, stating that, “cash on company balance sheets has been swelling and demand for corporate loans remains weak as capital expenditure has yet to recover, leaving banks with excess cash to invest and few places to put it."2 On the credit supply side, when banks are uncertain about firms' future prospects, they demand higher rates to compensate for their risk. This also appears to be happening: the LIBOR has risen from .25 in March to 0.55.3

Furthermore, according to The Economist, conditions are expected to worsen: “the health of the banking system is once more being called into question... much bigger rate moves are priced into the forward market... the Eurodollar future that shows the cost of borrowing for the average bank in the three months between September and December is already 1.1%. European banks... have to pay a further half a percentage point, making their total cost 1.6%.”4 If they cannot find takers at the rates they want, they park their excess liquidity in the best investments they can find, usually T-bills or overnight deposit facilities at central banks (roughly the equivalent of taking money back out of the system), actions which generate little or no increased demand or income. There is evidence that this too is starting to occur. Rates on T-bills are dropping.

According to the Financial Times, “use of the ECB’s “deposit facility” rose to €316.4bn on Tuesday [June 1st 2010] – exceeding even levels seen after the collapse of Lehman Brothers in September 2008.”5 Thus, as uncertainty grows, fewer firms want to take the risk of expanding payrolls or investing in new capital and for those that do, their costs of doing so are increasing. The lesson here: falling confidence creates downward pressure on the “real economy”--investment, demand, profits, income, jobs.

Falling confidence, uncertainty and fear all have an even more insidious characteristic: they create the conditions which create more of themselves. As confidence begins to fall, so does the real economy. When the real economy begins to fall, people find their fears confirmed and those who were originally optimistic begin to find themselves increasingly worried. More firms delay hiring and investment, further driving the real economy down and building up fears. I believe we are starting to see the effects of the past month and a half of fear now playing out. In April, the U.S. Jobs data of 290,000 new non-census jobs beat consensus estimates of 200,000 new jobs.6 Jobs are a lagging indicator of previous conditions, however (the April report comes out in May etc.). Thus, while confidence began to be shaken in April, fear hadn't quite taken hold as strongly. Now, come May, we are starting to see the effects.

According to Bloomberg: “private nonfarm employment increased only 41,000, following a 218,000 boost in April.”7 This is not the only negative development in May which will contribute to eroding confidence. According to the Financial Times, “Yields of Spain, Portugal, Greece, Italy and Ireland are on average 75 basis points higher than just after the €750bn rescue plan was announced,”8 the Dow is down below 10,000, oil is below 75, the BDI is starting to turn downward. All of these downward indicators confirm the fears of those who first began to fear last month, entrenching the emotion and making the trend harder to break.

If we are beginning to slide back into recession, it won't just be fear that drives us downward. For all the talk of the strength of the real economy, there are areas of serious weakness that exist regardless of the current emotional environment. Geopolitical instability, unresolved bad debts from the crisis in 2008, new regulations and an anti-financial political climate all threaten to fuel and be fueled by fear-driven trends. In terms of geopolitical instability, consider 9/11: the capital destruction was very small in the grand scheme, but its psychological toll greatly fueled the recessionary pressure already building in 2001. Not that I expect anything so extreme, but clearly events only slightly related to the economy can have a major impact. In addition to the usual hot spots in the Middle East, markets are currently eying North Korea warily and images of further austerity-driven riots from Europe will take their toll.

More tangibly, fragile debts threaten to become toxic once more. According to the Financial Times, “the European Central Bank... forecast another €195bn in bank writedowns this year and next.”9 Recessionary pressure will make banks less able to withstand further writedowns on their unresolved debts from the previous financial crisis at the same time as it is likely to increase the amount of total writedowns. This will happen not just in the EU but around the world. Anticipating this shock, the risk tolerance of financial institutions will fall further, driving up premiums demanded for increasingly risky investments. This will also drive up the risk of another banking crisis. All of these effects will further shake confidence.

Most worrisome is the potential tightening that could come from regulatory reform. This is almost certain to increase banks' lending costs by requiring them to hold more capital. According to The Economist, “In America, analysts at Barclays Capital calculate that the hit from domestic legislation alone could amount to 16% of banks' profits in 2013. Analysts at Credit Suisse reckon European banks' profits in 2012 could fall by 37% because of proposed regulation.”10 There is further uncertainty about the broader implications of reform. Much of the regulation seems to be fueled by popular outrage against bailouts. Thus, the question arises in the minds of economic actors of how exactly governments would act if monetary conditions became extremely tight like they were in 2008. Would governments be willing to extend extraordinary monetary support once more? Would they throw their angry constituents a bone, allowing some banks to default like they did with Bear Stearns and Lehman Brothers and then bail out the rest? Or would they allow the whole financial system to implode?

How much do will governments mean it when they say they won't bail out banks? The Economist writes of this uncertainty that “recent political discussions about financial reform have centered around the desire to avoid future bank bailouts; Barack Obama has said as much. Markets may be taking politicians at their word.”11 This fear looms larger the tighter credit conditions become and the more possible such a scenario becomes—thus the uncertainty fuels itself. This uncertainty will likely have an immediate impact on credit conditions. Referring to the conference to reconcile the House and Senate versions of the American financial reform bill, The Economist writes, “The impact of some parts of the package will remain unclear even after the conference finishes its work. Ratings agencies will downgrade banks' debt, raising their funding costs, if they see the bill as a reduction of government support. This is “the thing most likely to trouble my sleep”, says the head of one Wall Street firm.”12

I see little that policy can do to buck this trend. Loosening monetary policy seems very difficult and unlikely to be effective. Interest rates at major central banks around the world are near zero right now, so there's little that can be done there. Increasing regulation and the unpopularity of bailouts means that central bankers are going to find it politically difficult to expand balance sheets or loosen reserve requirements. Observe the uproar over the ECB's decision to buy sovereign debt—even now they're trying to stop such measures rather than expand them13. Even if central banks are able to expand balance sheets significantly, they risk damaging confidence further as has happened with the ECB decision to buy government debt. Finally, in a risk averse investment climate, it's likely that little of the new liquidity would end up being used in activities that boost demand, jobs, income or investment as consumers and firms would be reluctant to borrow—instead it'd likely end up going straight back to the central banks in their deposit facilities.

Fiscal stimulus would likely be more effective, but is likely to be even more difficult than monetary loosening. Unlike monetary policy, fiscal stimulus could be guaranteed to generate investment, jobs, income and demand. However, developed countries have been applying heavy stimulus for the last few years, driving up their deficits and debt stocks in the process. As a result, most EU countries are now starting to cut government spending and end previous stimulus programs, rather than expand them. It would be very difficult politically for them to reverse course and resume stimulus once more. It would also likely be difficult for EU countries to issue the debt needed to engage in this stimulus (the one country that could expand stimulus, Germany, has a populace that seems opposed to it and the government has already gone the other way in cutting spending).

The situation in the U.S. is better, but not good. The U.S. hasn't cut government spending and is enjoying very low rates on its debt because of its relative safety. However, stimulus measures are starting to draw to a close, the government just added a huge liability with the health care bill and the political backlash against government spending is currently quite intense. Expanding stimulus to the extent needed would likely prove very difficult politically. Furthermore, even if stimulus in the U.S. or EU could be expanded significantly, it's uncertain whether it would cause more harm than good, given the worry it could provoke from investors.

More effective policy would be for countries with relatively low deficits and debt stocks, such as Germany, China, and other strong emerging economies to engage in further domestic stimulus and take steps to boost domestic demand. This is happening to an extent currently—China and many other emerging economies engaged in massive stimulus in 2008 that continues today. However, these countries seem intent on reversing course. Germany especially seems to be using its influence to push in the opposite direction. Referring to the need for countries in Northern Europe to take measures to boost demand, The Economist writes, “unfortunately, Germany's government seems to be drawing exactly the opposite conclusions, promising to set an example with tough cuts when it should be helping to stimulate growth. The worry is that, under German pressure, the ECB will have the same misguided tendency to toughness, condemning the Euro area to years of stagnation.”14

Allowing the Yuan to appreciate against the dollar would help boost demand and allow rich countries to achieve growth and debt sustainability through exporting to China. However, given the pain that China is already feeling from the fall of the Euro, it seems unlikely that they will want to inflict further damage to their exporters by allowing the dollar to fall as well. If worsening credit conditions push the Euro yet lower, then the possibility of a revaluation of the Yuan will sink in kind. Finally, there is also the worry that the emerging economies on whose demand this scenario depends, including China, are growing too fast already and further stimulus would create dangerous inflation and bubbles. The Economist writes of this that “many [emerging economies] are already overheating, with prices rising and asset bubbles inflating. Most have inappropriately loose monetary policy... This suggests a need for tighter monetary policy. Central banks in Brazil, Malaysia and elsewhere have begun.”15 These seem to be the best policy options, but they either seem highly unlikely or else have dangerous side effects.

The one policy event that seems both possible and clearly beneficial that could buck this trend is serious market reforms in the EU. This would aid in job creation, income growth and productivity growth, especially in Portugal and Spain, the most fear-inducing economies. Perhaps even more importantly and regardless of real impacts, such reforms have been touted for so long as a good thing that the positive buzz it would generate would likely have an immediate, self reinforcing effect. Spreads would drop on bonds immediately, the LIBOR would drop and confidence would return. Such reforms seem more likely than at any time in recent history given the intense reform pressure the markets are putting on EU countries. If this good news were followed by further news with upside surprise, it could generate some serious positive momentum and stave off recession.

Ultimately, I don't know enough about European politics to even venture the guess of the chance of this happening. However, I do know that it would need to happen soon. Every day without good news allows the downward momentum to feed on itself and grow. Before, fears were mostly groundless and easily ignored given the constant stream of good news generated by the positive momentum that developed by the end of '09. Already things are different. That news is rapidly getting worse, entrenching the fear and ensuring that more bad news awaits in the coming months. The fragility of the recovery, the large number of unresolved bad debts promise to provide ample fuel for the fire. What few other policy responses remain that could break the downward momentum are of doubtful effectiveness, extreme political unpopularity, or carry serious side effects. Thus, unless I see that good news soon (and, given the political responses I've seen lately, I'm doubtful that I will), I'm a firm bear convert—proof of the infectious nature of negative sentiment—and am very short on most all stocks. While it may be true that, as Franklin Delano Roosevelt said “the only thing we have to fear is fear itself,” remember when he said it: 1933, at the worst part of the Great Depression. Disregard the power of fear at your own risk.

P.S.: Given that not so very long ago I was arguing a very different case, I would view this article as my current best attempt to understand a very strange global situation. Every day I study and read more and every day my analysis changes. Read it thus with a grain of salt and criticize liberally.

4 Ibid.