James Saft

By James Saft

(Reuters) – Portfolio rebalancing is one of those things which sounds sensible until you actually have to do it.

At which point, it usually just seems terrifying.

Portfolio rebalancing — the art of selling what has gone up and buying what has gone down — has a good track record along with lots of research backing up the assertion that it, in aggregate, will improve investors’ portfolio returns.

But the most crucial and high-value opportunities to rebalance usually come at exactly the kinds of times when even rational investors feel like hiding under their desks. Imagine a market crash, where you lose 8 or 10 percent of your portfolio and then, being a sensible investor, realize that right now is the time to sell the bonds that have held their value and load up on equities.

Not easy.

Jason Hsu, chief investment officer at investment advisory firm Research Affiliates, argues that this explains why so many otherwise rational investors, including large institutions, pass on rebalancing at critical junctures.

“When you buy risk assets during economic distress, there is a significant probability that, in the interim, your portfolio may suffer a greater decline than if you didn’t rebalance,” Hsu writes in a note to investors.

“In the short run, your probability of being fired as a fiduciary, of being blamed by clients you advise, and, most importantly, of marital strife, becomes moderately higher when you rebalance.”

So, there you have it: you can rebalance but you have to weigh the benefit against the potential career and personal costs of doing something that can often look like running back into a burning building.

The benefits of rebalancing can only really be judged many quarters, if not years, after the act, and have to be viewed as part of an overall strategy. Buying into a falling market, on the other hand, especially in periods of acute distress, has the very real chance of looking extremely stupid right away.

This is an important point to remember as we sail into an August and autumn which may bring real distress in Europe and upsets in global capital markets.

GOOD EVIDENCE, GOOD ENTRY POINTS

The literature on rebalancing is vast and pretty one-sided. If an asset falls in price and is cheap based on historical experience it has, on average, a better chance of providing superior returns going forward.

John Campbell of Harvard and Robert Shiller of Yale wrote an early paper arguing of the use of dividend ratios to predict future returns in 1998, and presciently, were quite bearish on equities based on how they read the evidence.

Picking entry points can be hard but a disciplined rebalancing strategy does this for you, allowing the market to guide you as to when to buy and when to sell.

TWO-WAY PHENOMENON

This may help to explain both the phenomenon of momentum investors, who pile in when markets are good, and why they can sometimes, at least for a time, outperform. Just as an investor is more likely, psychologically, to go into his shell when suffering losses, so they become more fearless and aggressive when markets are strong.

When portfolio returns are strong, you are perhaps more likely to feel as if you are playing with the “house’s money” and will take on more risk. At the same time, these periods are usually ones in which macro and political news is supportive, making it easier still to allow one’s overweight position in what has already gone up to ride. The wave of money this generates can drive prices and returns, though not forever.

At the same time, beaten-down investors who’ve suffered losses may come to fear that, if they are individuals, they will face difficult lifestyle choices, or if they are professionals, that they may get fired.

To be sure, sometime there is no reversion to mean, and doubtless there are many Lehman Brothers and Bear, Stearns shareholders who are still waiting for the bounce.

So, what to do if we know something is good for us but expect that we will find it difficult to make ourselves eat our vegetables anyway?

Andrew Ang, of Columbia Business School, has argued for what he calls “countercyclical investing,” which he says needs to be institutionalized rather than left to the discretion of managers. This kind of behavioral strategy is promising but deeply unsettling.

It is easy to read the papers and accept that rebalancing works. It will be a lot harder if the euro falls to tatters later this year to hold your breath and buy into risk assets.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com and find more columns atblogs.reuters.com/james-saft)

(James Saft is a Reuters columnist. The opinions expressed are his own.)

(Editing by Lauren Young)

By James Saft

Aug 2(Reuters) – Switzerland is rapidly turning into a large
hedge fund with a small country attached.

Switzerland on Tuesday revealed its foreign exchange
reserves now total 365 billion francs ($374 billion), a rise of
50 percent in just three months and taking it to a dizzying 62
percent of Swiss annual output. A small Alpine country with a
big banking industry is now the world’s sixth-largest reserves
holder, behind only much larger or resource-rich countries like
China, Japan, Russia and Saudi Arabia.

The reason: the Swiss National Bank’s strategy of imposing a
cap on the value of the franc against the euro, a
policy which obliges it to buy euros in unlimited amounts when
the exchange rate hits its line in the sand of 1.20 francs to
the euro.

That’s right: if anyone, anywhere, wants to exit their
position in the troubled euro, no matter how large, the SNB will
buy at a guaranteed price and hand over in exchange francs.

Little wonder Switzerland is experiencing a property price
boom. That’s essentially a global macro hedge fund strategy,
though no hedge fund manage would be foolish enough to publish
and commit to it.

The SNB believes that this policy defends the ability of
Swiss companies to compete internationally and also helps to
limit the deflationary impact of a strongly rising currency.

So it does, but Switzerland has done this only at the price
of taking on an enormous amount of risk, and in essence painting
a big bull’s-eye on itself.

To be sure, the SNB made a bit more than $8 billion on its
holdings in the second quarter, due in part to movements in the
price of gold and capital market holdings. Not quite hedge fund
hurdle territory, but better than losing.

And of course the SNB has something no hedge fund has – a
printing press which allows it to satisfy any obligations with
freshly created money. That means no redemption calls from pesky
investors, though they may well get howls of outrage at some
point from taxpayers and the politicians who represent them.

DIVERSIFICATION, THERE’S THE RUB

At issue is not the SNB’s ability to fund – it can – or the
near-term benefits, but rather what happens if things go
terribly badly in the euro zone. The worse things get the
heavier the flows of euros in Swiss coffers will be, and the
more disastrous, and pointless, the losses if ever the currency
union comes asunder. At that point, or sometime in the run-up,
the SNB will blink, as everyone understands they will, and
choose to crystallize their losses rather than add to them.

Why on earth allow everyone in Spain, and all of the dubious
euros in offshore havens to simply sell their dross for Swiss
francs? The peg, being static, won’t loosen, it will break like
a dam if it breaks at all, but not before saddling the Swiss
with a disproportionate share of the euro pain.

The SNB was relatively inactive in diversifying its
reserves, somewhat to the market’s surprise. The euro share of
reserves went up to 60 percent from 51 percent three months
before, implying that the central bank had only been doing a
small amount of selling euros for other currencies.

“This outcome could lead investors to question the
sustainability of the peg,” Todd Elmer, currency strategist at
Citigroup wrote in a note to clients.

“The SNB has been unable to diversify a large portion of its
EUR holdings, so investors may see greater risk of severe
capital losses (and potential desperation selling) down the
road. Thus investors may be less inclined to believe that the
SNB can maintain its present course in the face of mounting
pressure”

To be sure, the euro does not have to fall apart and the peg
may never be seriously challenged. If so it will have gained a
meaningful benefit to its economy, and may even bag a reasonable
return on its money.

But by taking euro risk on, Switzerland is making itself
hostage to euro zone policy, and subjecting itself to a huge and
destabilizing loss. Switzerland has no control over the German
electorate, or Italian bank depositors, but has chosen to make
itself even more at their mercy. This is exactly the bad trade
that banks and economies were making for years before the onset
of the crisis — a small gain now against an unlikely but
catastrophic loss sometime in the future.

Policy makers err in thinking they can control markets, when
what they are really trying to do is control events, a task
beyond the ability of mortals.

By James Saft

(Reuters) – Beware central bankers selling euros employing false analogies.

European Central Bank President Mario Draghi invited us last week to believe a string of unlikely things when he compared the euro’s travails to the supposedly impossible flight of the bumblebee.

The news that drove markets upward last week, however, was Draghi’s pledge to “do whatever it takes” to preserve the euro, wording that investors interpreted as flagging another round of bond purchases of weak euro zone nations in the secondary market.

Perhaps more striking was the following flight of entomology: “The euro is like a bumblebee. This is a mystery of nature because it shouldn’t fly but instead it does,” Draghi told a conference in London on Friday.

“So the euro was a bumblebee that flew very well for several years. And now – and I think people ask “how come?” – probably there was something in the atmosphere, in the air, that made the bumblebee fly. Now something must have changed in the air, and we know what after the financial crisis. The bumblebee would have to graduate to a real bee. And that’s what it’s doing.”

It’s hard to think of a single line of argument that better exemplifies the disorganized magical thinking of euro zone policy makers, and ironically given that markets jumped on the speech, one that gives you better reason to be short the euro and the euro zone.

This reasoning is wrong and confused in a number of ways. First, scientists now do understand how bumblebees fly. They are notably inefficient, which might also be said of the ECB, but the idea that bumblebee flight is scientifically impossible appears to be a myth. blogs.reuters.com/james-saft

By James Saft

(Reuters) – With risks of a U.S. recession mounting, it is shaping up to be a hairy summer for investors.

The recent run of U.S. economic data has been disappointing, with weak employment and manufacturing numbers. The Economic Cycle Research Institute’s four-week moving average of its key gauge has now been negative for eight straight weeks, and consumer spending is down for the third month in a row. Moreover, and more crucially, government spending reductions pose a threat, both this year and next.

Secondly, the United States, at the very least, will have to contend with deflationary waves from Europe for the foreseeable future.

Even if the ECB steps in to rescue Spain — or whoever ails next — it seems very likely that Europe will act as a drag as well as a source of risk and uncertainty.

Finally, we might be in the first earnings season since 2009 in which earnings at S&P 500 companies actually sink. The run has been disappointing thus far, with Apple showing that perhaps not enough people need new phones every six to nine months, and Zynga Inc demonstrating the limits of a business strategy based on virtual soil and make-believe manure.

“The disappointing slew of revenue results in the ongoing Q2 U.S. reporting round is entirely consistent with the economy having dipped into recession,” Societe Generale strategist Albert Edward wrote in a note to clients.

Third-quarter earnings of Standard & Poor’s 500 companies are now expected to dip 0.1 percent from a year ago, a sharp downward revision from the July 1 forecast of 3.1 percent growth, Thomson Reuters data showed on Thursday.

“Analysts are now hammering downward their full-year revenue projections. But even before the earnings reporting season got started, it was already clear that something was amiss on the U.S. corporate top-line as nominal business sales growth totally stalled in the three months to May on an economy-wide basis.”

While margins on some readings appear to be holding up, in a disparity between margins and the top line it is usually wise to trust in revenues as the more reliable guide. Margins, after all, can be hoisted higher by many means but cash flows never lie.

Balanced against these risks is, in essence, one institution: the Federal Reserve.

Investors’ prime hope is that the Fed will swoop in with quantitative easing or some other form of relief should the economy, and markets, show real signs of stress. A story by The Wall Street Journal’s Jon Hilsenrath, seen to have a line into Fed thinking, raised the possibility that some action may come out of the Fed’s meeting next week.

LONG WAY TO JACKSON HOLE

But there are several fundamental problems with an investment strategy predicated on help from the Fed.

First off, there is every chance that nothing, or very little, comes out of next week’s meeting. While there is some hope that there might be tinkering with the rate of interest banks are paid on reserves or perhaps a small bond buying program targeted at the housing market, the outlook for a really big piece of stimulus at this point is not good.

If so, that means we have to wait until the Jackson Hole economic conference, hosted by the Kansas City Fed at the end of August, for hope of delivery.

That is quite possible – the Fed in recent years has used this forum as a place at which to deliver new programs. Still, it is a long way to Jackson Hole, and in the meantime, there are plenty of possible sources of shocks and volatility.

There is also, of course, the possibility that the Fed duly delivers and after an inevitable rally, stocks fade rapidly once again.

We have had four years of extraordinary monetary policy and the big winners so far have been bondholders. Neither the economy or the stock market has been able to maintain traction in that time.

Like the repeated rescues by the European Central Bank, the shelf life of Fed-induced euphoria seems to get shorter every time. A market that believes that 1) the U.S. is heading into recession and 2) the Fed will not be very effective is one on the way down.

“The first rule of summer is not to trade; the second is if you have to trade, not to do much; the third is if you have to do a lot, then only buy safe stuff,” Bob Savage, a long-time market veteran and CEO of research clearinghouse Track.com wrote to clients.

Summer 2012 might prove to be a good time to do very little other than keep your head down and enjoy the Olympics.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com and find more columns at blogs.reuters.com/james-saft)

(James Saft is a Reuters columnist. The opinions expressed are his own.)

(Editing by Walden Siew, Desking by Gary Crosse)

By James Saft

(Reuters) – It doesn’t get much worse than a state like, say, Spain, borrowing money through a lottery.

Well, maybe actually it does, as Spain’s state-owned lottery is seeking a 6 billion euro ($7.3 billion) loan from a syndicate of international lenders to fund its contribution to a bailout pot for cash-strapped regional governments.

That’s right, Spain’s solution to its debt problem is leveraging up its lottery. The only thing that would make this scheme more emblematic of Spain’s desperation is if the plan was to plow the 6 billion euros back into tickets for the annual Christmas draw — El Gordo — and live happily ever after on the winnings.

Instead, Spain’s Sociedad Estatal Loterias y Apuestas del Estado, SA (SELAE) is contributing to an 18-billion-euro fund which will be available to provide emergency funding to hard-hit regional governments. The Spanish treasury is supplying the remaining 12 billion euros. The fund, announced two weeks ago, already has one supplicant, the region of Valencia which on Friday asked for aid of 3.5 billion euros. Catalonia is mulling making an application, as assuredly are many other regions, which have struggled as the economy slumped and development flat-lined.

Spanish regional governments face re-financing needs between now and the end of the year which are almost the size of the entire fund, calling into question whether even lottery money will be enough.

This is the same country which brought you the ban on short selling, announced on Monday and likely to be as ineffective as bans in years past.

Spanish regional debt has more than doubled since 2008, and now is equal to about 13 percent of GDP.

Already in receipt of a proposed banking bailout, speculation has been rising that Spain will need a full-blow rescue from its European and international partners. This has driven Spanish borrowing rates to unsustainable levels, with 10-year yields on Wednesday at 7.38 percent, slightly below all-time highs set early in the week.

In March Spain was able to sell six-month Treasury paper at a yield of under 1 percent. Tuesday it had to pay 3.69 percent.

LEVERAGED AUSTERITY

Spain considered and then shelved last September a public stock offering of SELAE, after market conditions deteriorated. While it is hard to predict how well subscribed the loan will be, it must be said to carry some very particular risks. Lotteries are essentially state-licensed money printing machines, and while we don’t know the exact pledges Spain has or may make about SELAE’s exclusive rights to hold lotteries, we do know that Spain is desperate for money and may well be more so in a year or two. And, of course, there is always the risk that a loan made in euros becomes redenominated into new pesetas should the worst happen and Spain leave the euro.

And, of course, any region which taps the fund must make cuts in spending to allow it to repay it, a measure which will only deepen the savage contraction. On top of that they must give up future tax receipts.

This is the real madness of Spain’s policy — it is looking for any leverage it can obtain, but at the same time following a totally counterproductive policy of austerity. Spain, like Greece, needs either hugely subsidized loans from Germany and the EU or, better yet, needs to see some of its debts simply vaporized. Europe and the ECB’s current policy will only bring on deflation and shrinking GDP, both of which will make the un-payable debts all the more a lost cause.

That’s really what financial markets are telling you when they hike Spain’s borrowing costs.

Spain itself is predicting a half-percent contraction in 2013, a probably overly optimistic assessment. Government spending excluding interest payments will be 6.6 percent below the ceiling for this year, the government said last week. Included in those cuts is a 12 percent cut in funds for central government which suffered similar cuts just three months ago.

To be fair, the lottery is an asset and Spain, as the grantor of its license, has a right to the lion’s share of the proceeds. And indeed lotteries are supposed to be counter-cyclical, enjoying heightened popularity during tough times.

The whole approach, though, is wrong. Spain doesn’t need more debt, even if it is off-balance sheet. It needs less. It doesn’t need more spending cuts, it needs spending restored, at least until the death spiral can be arrested.

Unless we see a very generous rescue backed by Germany, or an out of character bout of targeted quantitative easing by the ECB, Spain will continue to be under pressure, and will itself pressure the euro project.

(James Saft is a Reuters columnist. The opinions expressed are his own)

(Editing by James Dalgleish)

(At the time of publication, Reuters columnist James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. For previous columns by James Saft, click on)

By James Saft

(Reuters) – After four years of failure, Italy and Spain have opened yet another pointless front in Europe’s war against reality.

Spain and Italy both introduced short-selling bans on Monday, reacting to steep falls in their stock markets and as confidence slipped in their ability to repay their debts, prop up their banking systems and tend to their economies while remaining within the euro currency.

While only a fool could look on recent history and say that markets must always remain untrammeled, the instinctual urge to suppress reality by stopping investors from acting in their own perceived best interests is usually counterproductive.

It is also always a screaming sell signal, one that investors will put into action regardless of regulation.

Italy re-introduced a ban on short selling – bets that securities will fall in price – of financial stocks, this time for one week. Spain went further: banning for three months short selling for all Spanish shares, as well as index short bets, or any similar trade in derivatives on or off of established exchanges.

While the ban helped Spanish and Italian shares to reverse earlier sharp losses, selling of government bonds continued as investors demanded a record rate of interest of 7.4 percent to hold Spanish 10-year debt. Italian 10-year bonds also fell, taking their yield to 6.38 percent.

Little wonder: both countries are in difficult straits, short-selling bans do nothing to change that, and, plainly, have a terrible track record for success.

Both countries are facing growing financing needs, made more complicated by a disturbingly incomplete picture of the borrowing needs of their regional governments and the stresses this will place on the European Financial Stability Facility.

“It’s called contagion,” economist David Rosenberg, of Gluskin, Sheff in Toronto wrote in a note to clients.

“The problem is that there isn’t enough in the EFSF kitty to bail out the Spanish sovereign, its banks and its regions, and then have to deal with Italy. The breakup of the euro zone is no longer a taboo topic, even at the highest level at the EU and IMF.”

A LITTLE HISTORY

Anyone with a memory or access to Google can easily find out exactly how successful these bans will be. A year ago in August, Italy, Spain as well as France and Belgium enacted short-selling restrictions as shares in their banking industries plunged. Patently Europe’s economy is now worse and its banking system remains intact only due to the grace and favor of liquidity from the ECB and pledges of official support and capital. Those shorting European shares a year ago were correct, both in analysis and in outcome.

Matters descended into farce in November when Carlo Giovanardi, at the time undersecretary in Silvio Berlusconi’s government in charge of family policy and drug prevention, laid the blame for volatility in Milan’s bourse on stimulant abuse by traders, a matter he thought might merit mandatory drug testing. The question of what drugs the traders were taking when bidding Italian banks up during the boom was not asked.

Or recall the $1 trillion bailout the EU launched in May of 2011 claiming it would effectively curb “wolfpack behavior” in financial markets. … The problem isn’t with the wolves, it is with the caribou.

And remember too that much of Europe, along with most of the rest of the developed world, slapped short-selling bans on their exchanges during the darkest days of the financial crisis in the last three months of 2008. Patently this did nothing to address the euro zone’s structural flaws, which weren’t even the focus of concern at that point.

A study by economists Alessandro Beber and Marco Pagano of short selling bans around the world during the 07-09 period was damning. www.csef.it/WP/wp241.pdf

They found that the bans hurt market liquidity, retarded price discovery and, with the possible exception of U.S. financial shares, failed to support prices.

Short-selling bans are, and are perhaps intended to be, a side-show, an effort by officials with little else to offer to seem as if they are taking matters in hand. If Italy and Spain had genuine solutions to their banking and debt woes they clearly would not need to suppress price discovery.

A government which will ban short selling is one step closer to being one which may eventually think it has good reason to impose capital controls. That will be well understood and is a potent message for Italy and Spain to be sending.

(James Saft is a Reuters columnist. The opinions expressed are his own)

(Editing by James Dalgleish)

(At the time of publication, Reuters columnist James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. For previous columns by James Saft, click on)

By James Saft

(Reuters) – It just might be time to rethink that global diversification strategy.

New research shows that the chances of a global stock market crash have increased 15-fold in the past two decades, implying a crash about every two years.

That’s something to think about, given that international diversification has long been sold to investors as the next best thing to a free lunch.

The finding, in a paper published in June by Thijs Markwat, a Dutch quantitative researcher at Robeco Asset Management, should send many scrambling to re-think their asset allocations. (here)

Markwat defines a global crash as a week in which the four major equity markets – Europe, the United States, Asia and Latin America – all turn in losses that would be in the bottom 5 percent in terms of performance. At minimum, that would be the equivalent of a 5.9 percent fall in global stocks over a week.

While the chances of that happening in 1992 were only 0.1 percent per week, by February 2010 it had risen to 1.5 percent, theoretically implying a global crash on average about every two years.

“The main conclusion for risk-managers reads that geographical diversification opportunities are almost monotonically decreasing, as the global crash probabilities keep rising. To keep the risk of portfolios at acceptable levels, risk-managers should think of other ways, besides geographical diversification, to diversify their exposures,” Markwat wrote.

While it is obvious to anyone paying attention that equities are riskier than many assumed 20 years ago, this is a stark illustration of exactly how volatile — and highly correlated — international equities have become.

My guess is that as the reality of this volatility and correlation becomes widely understood, investors will demand higher risk premia for shares. In other words, global stocks as an asset class may well have further to fall.

The idea that global diversification could act as a hedge gained in popularity in the 1970s and ’80s as investors observed that major markets often tracked one another only loosely, offering in essence cheap insurance for a portfolio.

While correlations between the U.S. and European markets were only 0.51 in 1992, by 2010 that had risen to 0.83. The link between U.S. and Asian shares rose during the period from just 0.41 to 0.64. That implies there was still significant diversification value, though that value is shrinking over time.

GLOBALIZATION

The Asian crisis of 1997-98 seems to have driven a permanent increase in correlations. Having reported on financial markets at the time, that makes sense to me.

When Thailand started to fall apart, the prevailing wisdom was that this was totally irrelevant to U.S. investors, a misconception many continued to hold right up until the point of the Long-Term Capital Management failure.

That event ushered in the boom, bust and bailout pattern we are still following today.

Investors began to understand, slowly, that global equity markets are reasonably tightly linked. This drove appetite for financial news, and also led, inevitably, to more attempts by investors to get out in front of a rout in one place by selling up in another, even if they themselves had no exposure in the original market to begin selling off.

So, what came first, the chicken or the egg? While surely this is a fundamental-driven phenomenon, a reflection of the globalization of the economy, it is also in part driven by the behavior of investors in reaction to that globalization.

The bigger question for investors is: What should they do now?

Clearly, there is still value in diversification, even taking into account currency risk, as lots of diversification can be gained across asset classes. Just take a look at returns on U.S. 10-year Treasuries against the S&P 500 for proof.

There is also, plainly, only very imperfect correlation within fixed income classes and regions, implying real value to an internationally diversified fixed-income portfolio.

The same forces that are driving interest rates up in Spain — and fixed income returns down — are helping to drive bond prices in Denmark and Germany strongly higher, leading to negative interest rates in many cases.

While neither end of that trade may seem appetizing, imagine for a minute you are an Italian saver: you will be heartily glad to be getting a tiny coupon on your German or U.S. bonds when compared with the losses, real and potential, on your domestic bond holdings.

Correlations in equity markets are also, very probably, going to continue rising. The major shocks, like the Asian crisis, tend to have a big and lasting impact on correlations. A euro crisis that turns truly horrible would surely be big enough to prompt a global sell-off in shares, and to drive correlations significantly higher.

A pessimist will see this as driving equities lower. An optimist will realize that markets usually overshoot and, eventually, equities will be a fantastic buy.

Keep your powder dry.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com and find more columns atblogs.reuters.com/james-saft)

(James Saft is a Reuters columnist. The opinions expressed are his own.)

(Editing by Walden Siew and Dan Grebler)

July 19 (Reuters) – If there is one thing more worrying than
leaders avoiding the truth it is when they start to speak it.

Unusually frank comments from German Chancellor Angela
Merkel on Wednesday came, within this context, as quite a
surprise:

“We have not yet shaped the European project in a way that
we can be sure that everything will turn out well, we still have
work to do,” Merkel said in an interview posted on her Christian
Democratic Union party’s website.

Gee, Angela, now that you mention it, we’re not so sure
either.

Merkel quickly added she was “optimistic that we will
succeed,” though she has been saying roughly that for seemingly
ever and progress has been, well, mixed. The question then is
why she chose this particular moment to state the blindingly
obvious.

As ever, a look at how markets reacted can be illuminating.
In this case, the euro fell, sharply, and government bonds
rallied, sending yields lower. Clearly such statements don’t
inspire much confidence – if you were a corporate manager would
this make you more or less likely to invest and hire? The rally
in German bonds, for example, may also denote a conviction that
Merkel’s honesty denotes a smaller chance that the German
treasury will be picking up ever larger bills.

As for the euro, a currency whose principal backer thinks it
might not make it is one with risks skewed to the downside. I’d
also like to point out that for the foreseeable future whenever
we see a high official say or do something surprising, that
surprise can be expected to usually have the effect of driving
their home currency lower. We are, after all, in a currency war.

Probably internal politics, both within Germany and between
it and its European partners, has as much a role in Merkel’s
new-found realism as did any concerns about the price at which
Germany can sell to China and the U.S.

A shock can tend to galvanize one’s negotiating partners.
And she faces a revolt within her own party – one unlikely to
succeed – ahead of a vote Thursday in the lower house of
parliament over Germany’s contribution to the Spanish bailout.

That being said, the risks officially ignored have a nasty
habit of moving straight to reality once officialdom actually
acknowledges their existence. The risks of euro break-up are
probably higher than many who heard Merkel realize and
definitely higher once she uttered the words.

WELCOME WORDS FROM THE IMF

Another unusual, and welcome, source of plain talk on
Wednesday was the International Monetary Fund, which positively
lit into the European Central Bank, calling on it to be far more
active in supporting the euro zone economy. The IMF said there
was about a 25 percent chance of falling prices, and outright
deflation by early 2014, with risks concentrated in the hard-hit
southern parts of the euro zone.

Besides calling for the ECB to be given full lender of last
resort responsibility, the IMF was emphatic in calling for much
easier monetary policy and more active work to support the
transition to a more highly integrated zone.

The IMF is essentially calling for a kitchen-sink policy
from the ECB in which it would cut interest rates, do “sizable”
quantitative easing, make more targeted purchases of weak
sovereign bonds and do further rounds of offering banks cheap
liquidity. They also called on the ECB to accept equal status
with other creditors.

This was a blunt message and disconcerting in its vehemence,
made all the more so when you realize that the ECB is highly
unlikely to follow anything close to this course of action
unless it finds itself in truly dire circumstances.

Apparently, a one-in-four chance of deflation may not be
enough to rouse the bank from its narrow view of its remit and
obligations.

While it is difficult to forecast events in Europe, it is
becoming easier and easier to understand Europe’s likely
economic and market impact over the next couple of years. While
the negative impact started out about a year ago as mostly due
to uncertainty, the impact will be becoming more and more real
as the months go on, the southern economies slump and the euro
zone sends out wave upon wave of deflationary power to the rest
of the global economy.

While a disruptive change in the euro is the biggest risk,
the longer the crisis goes on without resolution, the higher the
baseline cost in dropping demand will be.

(James Saft is a Reuters columnist. The opinions expressed are his own)

By James Saft

(Reuters) – Never mind that our largest banks are too big to be allowed to fail, they show every sign of being too big for investors.

By now anyone committing capital to the largest banks must do so with the understanding that they aren’t just risky and volatile, but often badly managed and highly likely to produce further scandals in which insiders gain at the expense of everyone else in the capital structure.

For bondholders, the largest banks at least come with an implied backstop from governments, but shareholders have no-one else to blame for their woes but themselves.

Exhibit A is JP Morgan, which on Friday revealed that losing trades in its chief investment office had ballooned in size and would now cost it at least $5.8 billion. Even worse, JP Morgan suggested that traders had been trying to hide losses. That’s not surprising, but the fact that they were able to get away with it for a time raises grave questions about the bank’s controls.

Combine this with the LIBOR scandal – thus far confined mostly to Barclays but likely to spread – and you have ample evidence that you cannot expect our largest banks to be managed effectively in shareholders’ interests.

“I’m wondering if the firm as a whole has reached some sort of tipping point in terms of size or complexity that makes it more difficult to manage,” CLSA analyst Mike Mayo asked JP Morgan chief Jamie Dimon on a Friday conference call.

Dimon’s flat denial and the list of profitable accomplishments he backed it up with has to be measured against a litany of risk management and compliance failures which the bank has revealed in recent months.

“We saw how the sausage is made today in the slides, but I wonder if I’ll get food poisoning sometime in the future,” Mayo said.

Just one trading day later and JP Morgan is slapped with a lawsuit in New York alleging that the bank wrongly pushed poor-performing in-house funds and investments on its brokerage clients. A spokeswoman for New York-based JPMorgan Chase did not immediately return a call from Reuters seeking comment

Complexity, as any trader trying to sneak an aggressive accounting past his manager will tell you, is the enemy of control, and the biggest banks are fearsomely large and complex. The more complex an organization is and the more complex its products, the more opportunities there are for various forces within it to try to game that complexity to their own advantage.

None of the existing checks against this appear to work satisfactorily: not regulation as it stands; not internal controls and surely not the activities of boards, which too often are studded with the kind of worthy but unsophisticated types who are wholly incapable of preventing what government itself seems unable to.

RETURNS ARE PROOF

A mis-selling scandal in Britain, under which banks sold small businesses toxic and difficult-to-fathom interest rate swaps, is a great example of the asymmetric risks in the industry, illustrating as it does the way in which clients are abused, employees profit and shareholders ultimately suffer.

Barclays, HSBC, Lloyds Banking Group and the Royal Bank of Scotland are all subject to a settlement which should cost them hundreds of millions of dollars to compensate businesses for products they often did not need and the risks of which they were not informed.

This payout may seem minor when the Libor debacle has run its course. The potential number of claimants is mind-boggling, given the amount of derivatives and loans which incorporate the interest rate, and any further banks implicated will only increase shareholders’ potential liabilities.

While Mayo’s comments, which evinced nervous laughter on the call, seem daring, you could argue that he is only plainly stating the case as illustrated by the numbers.

JP Morgan trades on about just 8 times earnings, and at only about 80 percent of its book value. Citigroup and Barclay’s figures are yet worse. Citigroup as of the first quarter was creating a risk-adjusted return on capital of about one half of one percent, according to risk management firm Institutional Risk Analytics.

These figures show tremendous wariness by investors towards the industry.

All risk is attractive at the right price, even banking risk, and at some point investors may decide that the future will be brighter. The traditional argument for jam tomorrow is that banking is cyclical, that the economy and activity will eventually recover, bringing higher profits and ultimately even perhaps higher earnings multiples.

A better alternative for shareholders may be to demand the break-up of the largest banks. The safe parts will be worth more and the risky parts may be whittled away by regulation anyway.

Employees are the only clear beneficiaries of the status quo.

(Editing by James Dalgleish)

(At the time of publication, Reuters columnist James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. For previous columns by James Saft, click on)

By James Saft

(Reuters) – Since 1994, according to the New York Federal Reserve, 80 percent of U.S. stocks’ excess returns occurred in the 24 hours before scheduled announcements by the Federal Open Market Committee.

There can be no single data point that better explains the madness of official monetary policy in its interaction with financial markets.

As explained in a recently updated paper by New York Fed economists David Lucca and Emanuel Moench, an enormous proportion of the equity risk premium – the extra return investors get for holding stocks – occurs in the window directly around Fed policy announcements. James Dalgleish)

(At the time of publication, Reuters columnist James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. For previous columns by James Saft, click on)