Thoughts on the Big Picture: The Ugly Contest Just got Uglier

Summers are supposed to be fun and relaxing. Not this one. A combination of events in late July and early August caused market strains that have not been seen since those dark days in the fall of 2008 and winter of 2009. Policy makers responded, though options are more limited. The risk is that the investment waters remain treacherous into next year.

Keynes once compared investing to a beauty contest where the challenge is not to pick who you think is the most beautiful but who everyone else thinks is the most beautiful. Yet in the post-Keynesian world, where fiscal excess are being corrected, perhaps rather than a beauty contest, investing has becoming more of an ugly contest. In this light,the race has been between the European debt crisis on one hand and the US poor growth and debt ceiling and rating concerns on the other.

Massive monetary and fiscal easing earlier in the crisis helped end the deep economic contractions and stabilize the markets. The situation was far from the normal that investors were familiar with, but the fragile stability was punctured by three forces: The economic shock from Japan’s earthquake/tsunami/nuclear disaster, the inability of European officials to contain the debt crisis to the relatively small countries on the peripheral of Europe, and by the protracted debt ceiling debate in the US Congress and the unexpectedly poor economic performance in the first half, despite the fiscal stimulus and QEII.

The situation came to a head in late July and early August. The policy response came from the European officials. They made plans to increase the flexibility, but not the size of the European Financial Stabilization Facility. The European Central Bank re-introduced emergency lending facilities, resumed their bond purchases to include Spanish and Italian bonds.

The Federal Reserve responded by opening the door a bit further to renewed asset purchases (QEIII?) and putting numbers around its signal that rates will remain low of an extended period to mean until at least mid 2013.

The Japanese yen and the Swiss franc saw dramatic appreciation as safe haven flows flooded in. The Bank of Japan responded by what appears to massive one day intervention (estimates suggest around $50 bln) and increasing the size of their asset purchases plan (QE). Within four days the intervention-inspired yen weakness was completely recouped.

The Swiss National Bank responded with its own version of quantitative easing by signaling a substantial rise in money supply (sight deposits) in two steps from CHF30 bln to CHF120 bln (~$165 bln), a near-zero interest rate policy and other measures aimed at boosting liquidity, such as foreign exchange swaps.

To appreciate the magnitude of the challenge facing the Swiss economy, especially exporters and the tourist industry consider in the 12-months through August 10th the Swiss franc had appreciated 44% against the US dollar and 36% against the euro. In comparison, over the same period, the yen had appreciated 11.3% against the dollar and 3.3% against the euro.

For asset managers, the impact of the appreciation of the safe havens varied. In the three-months through August 10th, the Swiss equity market was among the worst performers, losing more than a quarter of its value. In contrast the Japanese stock market loss less than 9% of its value and was the best performing G7 stock market in local currency and dollar terms. However, Japanese 10-year bonds saw a minor 9 bp decline in yield over the same period, while Swiss government bonds have seen a 84 bp decline in yield. As of August 10th Swiss 10-year bond yields were below Japanese yields and EuroSwiss futures (similar to Eurodollar futures) implied a negative interest rate through March 2013.

There are four major takeaways from these developments:

First, the de-leveraging in the US leaves the economy in a fragile condition and vulnerable to exogenous and endogenous shocks. This is further exacerbated by the constraints on fiscal and monetary policy. While a renewed economic contraction is not the most likely scenario, it remains a risk.

Second, the European debt crisis is much larger than just Greece, Ireland and Portugal. Although the ECB’s buying of Italian and Spanish bonds generated instantaneous positive results, many investors seem unimpressed as prices for credit default swaps have moved in the opposite direction. Adequate funds to address the situation have not yet been agreed upon from either the public or private sectors. In that context, the linkages between the sovereign and the banks, poses substantial risks to both.

Third, the political processes in the United States and Europe, as currently configured, seem woefully inadequate to address the economic and financial challenges. This political weakness can only exacerbate and prolong the crisis and create more collateral damage.

Fourth, taken individually and collectively, these takeaways warn that the investment climate may remain volatile and risk-adjusted returns lower than pre-crisis. The economic and political conditions leaved little margin of error. Small shocks and dislocations can have outsized impacts.

Perhaps this is one of the times that Will Rogers warning is particularly relevant that sometimes the return of your money is more important than the return on your money.