Global Market Insights | A Fisher Investments Blog

Thank Goodness

It seems European leaders are finally coming to their senses about the Financial Transactions Tax: 

Europe Rows Back on FTT Plans

Philip Aldrick, The Telegraph

Details on how the tax will change are still fuzzy, as national leaders are still negotiating with the European Commission. But it does seem likely the tax won’t take full effect on January 1, 2014 as originally planned, and it appears derivatives—and potentially sovereign debt—won’t be taxed, and the tax rates will fall. What’s left, it seems, will be a 0.01% stamp duty on equity trades.

What’s not clear, however, is how officials will address the most problematic piece of the tax: its extraterritorial reach. In their attempts to prevent tax avoidance, commissioners decided to apply the tax to every security issued in 1 of the 11 nations adopting the FTT. So, for example, if someone in the UK or US bought or sold shares of a German firm, they’d have to pay. If the EU’s airline carbon tax is any guide, this is unenforceable—governments could just make it illegal for their citizens to comply, just as China did with the airlines tax, which is one big reason it was abandoned late last year. US and UK officials have questioned the FTT’s legality, and the UK even filed suit at the European Court of Justice.

Ideally, officials would just agree to kill the FTT entirely—many have admitted it will likely hurt Europe’s economy, financial sector and public finances, and they don’t expect it to raise much revenue (initial forecasts of €35 billion were recently slashed to €3.5 billion). If they do keep part of it, however, the small stamp duty on shares is probably the least harmful—the UK has had a share stamp duty for a while, without much ill effect. However, I believe they’ll be better off if they drop the extraterritorial provisions—if they don’t, firms have incentive to move away from those 11 countries, which could hollow out their private sectors over time. That’s the opposite of what nations like France, Spain, Portugal, Greece and Slovenia need—these countries need to get more competitive, not less.

Currency Wars—A Losing Battle

Competitive devaluations have been a hot topic lately—countries deliberately weakening their currencies in order to make their exports cheaper and, theoretically, boost output. In recent months, as Japan’s yen has weakened and supposedly given Japanese exporters an advantage over competitors in South Korea and Taiwan, investors have grown fearful of tit-for-tat competitive devaluations throughout Asia—better known as a currency war—potentially disrupting trade and economic activity. 

Good news: That’s a pretty unlikely outcome.

Here’s why. Competitive devaluation is based on a faulty premise—that a weak currency is a net benefit. A weaker currency does help somewhat by making exports cheaper, but that doesn’t always translate into higher export volumes. For example, the value of Japan’s exports has increased as the yen has weakened, but export volumes have fallen. So it’s tough to argue a weaker yen has boosted overall output. Plus, the weak yen has a nasty side effect—more expensive imports. This is a big headwind for Japan, which imports most of its fuel—pricier energy raises production costs. Manufacturers are also squeezed by more expensive imports of component parts. And as energy costs rise, they likely have less cash to spend on these imported components. That can potentially lead to supply shortages, pushing export costs higher and offsetting much of the weak currency’s positive effects.

You can see this in Taiwan’s recent trade data—that may seem like a surprising source, but Taiwan exports several high-tech components (e.g., semiconductors and flat screen panels) to Japanese firms, so it’s a key indicator. In March, Taiwan’s exports to Japan fell 15.6% y/y by value—and given the currency moves over the past year, that means exports by volume fell significantly, too. So Japanese firms imported fewer and more expensive components from Taiwan, which likely pushes their manufacturing costs up and diminishes their output—and makes whatever goods they do produce more expensive than they otherwise would have been.

So policymakers who deliberately weaken a currency aren’t automatically giving their economy a boost. Rather, they’re picking winners and losers between the few firms that produce goods domestically start-to-finish and the many manufacturers that import raw materials and intermediate components—not to mention the consumers who benefit from cheaper imports. Japanese policymakers may not understand this at the moment, but other countries likely do and don’t see much reason to strive for a weaker currency.

 

 

Downgrade Redux

Fitch jumped on the downgrade bandwagon on Friday, cutting the UK’s credit rating one notch to AA+—just like Moody’s did in February. And like Moody’s downgrade, Fitch’s move shouldn’t be much of a game changer for UK debt markets. 

In its statement, Fitch cited the “weaker economic and fiscal outlook” and claimed the UK has “no fiscal space to absorb further adverse economic and financial shocks.”

I polled a few of my colleagues, and none of us have any idea what “fiscal space” means—leave it to a ratings agency to use indecipherable lingo instead of plain English. But if Fitch is referring to the UK’s ability to continue servicing debt if the economy worsens, I disagree—some simple data from gilt markets show the Treasury has plenty of breathing room.

The chart below shows the average maturity and yields of all outstanding gilts, excluding those the government owns itself (which effectively cancel). The longer the maturity, the longer the UK has to repay its debt—and the less near-term economic troubles impact repayment risk. The lower the yield, the cheaper that debt is. As you’ll see, the maturity’s lengthened by nearly three years since June 2005, and the average yield has fallen by more than half. That means UK debt is arguably more sustainable today than it was eight years ago—that hardly merits a downgrade. 

Exhibit: Average Maturity and Yield of Outstanding Gilts (Net)

 

Source: UK Debt Management Office, 6/1/2005 – 12/31/2012.

 

Another piece of Fitch’s rationale seems similarly flawed: The agency doesn’t believe UK debt will get under 90% of GDP in a reasonable amount of time. 

What’s so magic about 90%? Well, that’s the level two well-respected US economists claimed is the tipping point for a country’s public debt—in a study they conducted three years ago, they found that once debt hits 90% of GDP, average economic growth falls from 3% to -0.1% (based on historical data since WWII). Those findings have underpinned many nations’ and organizations’ policies and recommendations since 2010. But last week, a few researchers from the University of Massachusetts debunked those findings. After they examined the dataset and methodology used in the initial study, they found the results were skewed by an Excel coding error, omitted data and a strangely high weighting of one datapoint (New Zealand in 1951). After accounting for those errors, they reran the analysis and found that growth averages over 2% once debt hits 90% of GDP. The 90% mark simply isn’t a dividing line between sustainable and unsustainable debt (as history would tell us, considering the UK’s grown tremendously over time despite having debt levels far higher than 90% at times).

So once again, it seems a rater has based its decision on an arbitrary benchmark, not the UK’s creditworthiness. 

Lessons From Japan

On April 11, the Post Office made a big announcement: In the near future, it will begin offering personal bank accounts, making it a full one-stop financial services provider. 

On the one hand, this may seem like a good idea on the surface. The Big Four high street banks hold almost 75% of the personal account market, so clearly competition is needed. And the Post Office, with its strong network of 11,500 branches, might have the clout to give them a run for their money.

Pick this apart further though, and it’s fraught with problems.

The Post Office is state-owned. Technically, it’s a subsidiary of Royal Mail, which should eventually be privatized under the Postal Services Act of 2011, but for now it’s 100% government-owned. Plus, the Act doesn’t include plans to privatize the Post Office—instead, there are provisions to spin it off into a separate state-owned company.

So the Post Office is and likely remains a state-owned banking/insurance/postal services firm. That sounds a lot like Japan Post, Japan’s state-owned banking/insurance/postal services firm. Or, as The Wall Street Journal once dubbed it, the bank that ate Japan.

In terms of deposits, Japan Post is the biggest bank in the world, with about £1.39 trillion. Savers love it because it offers a small but guaranteed return, which it can do because it has state backing. And it uses most of those deposits to buy Japanese government debt—essentially, it provides the government backdoor financing, which has helped the government run its debt load up to more than 220% of GDP. If it weren’t state-owned, it wouldn’t have this luxury. Like all banks, it would have to compete and fend for itself without a government guarantee, so it would probably have to diversify away from Japanese sovereign bonds, and the government would have to get its finances in order.

I’m not saying the UK’s setting itself up for this exact same scenario once the Post Office begins taking retail deposits (in addition to the ISAs it already offers), but there’s clearly potential to distort competition and public finances. With state backing and control, the UK Post Office could easily follow Japan Post’s lead and over-concentrate in gilts. It could also offer artificially high deposit rates since it wouldn’t have to worry about maximizing shareholder value. That may help increase competition in UK banking, but it wouldn’t be free and fair competition—which is how all proper competition should be.

If policymakers want to challenge the Big Four’s dominance, offering personal accounts through the Post Office isn’t the answer. Instead, they should make it as easy as possible for challenger banks (small, upstart high street banks) to launch and grow. For example, they could make it easier and cheaper to get a banking license, reduce the business tax, further reduce corporation taxes, lighten regulations and make capital requirements more flexible (as I recently wrote on MarketMinder, current plans to temporarily reduce challenger banks’ capital requirements miss the mark badly). That will allow a healthy competition—without distorting markets.

Thank Goodness for Gridlock

Ever been frustrated with the gridlock in Parliament? Do you wish the coalition had an easier time passing legislation?

If so, try thinking about what could happen if the opposite were true—if one party (any of them—whichever you like least) had a huge majority and could pass whatever they wanted. Chances are we’d see some pretty squirrely measures.

Case in point: In Hungary, where the proto-fascist Fidesz party has a two-thirds majority, Parliament has passed yet another onerous, nonsensical tax.

 Hungary to Jolt Media Service Providers With “Weather Tax”

Moving forward, all media providers will have to pay a “meteorological service fee” of 0.5% of annual advertising revenue—whether or not they report the weather. Why? Because the state has decided to control the weather—or, at least, the reporting of it. The bill decrees only the state can pursue “meteorological activities,” because only it can operate the required “network of sensors, data processing and local forecasting systems” and provide “accurate and credible information.” Hence, the new service charge, which is apparently “necessary to protect the population and guarantee the safety of their properties.”

(No, I’m not sure how many Hungarians have been injured by rogue weather forecasts.)

This is a blatant tax grab on media firms—Portfolio.hu estimates it amounts to a 2.5% or higher surtax on media profits—and the latest salvo in Prime Minister Viktor Orban’s assault on press freedom. He’s already made it impossible for radio stations affiliated with the opposition to get long-term broadcasting licenses—instead, they’re forced to submit bids to continue using their frequency every 60 days. And they very often lose, but the courts overrule the decision at the last minute when they inevitably discover the winning bid didn’t meet eligibility criteria. So the opposition stays on the air, but only by jumping through hoops every two months. The weather service fee is likely another veiled attempt to get opposition broadcasters off the air: Tax them into oblivion so they can’t afford to stay in business.

Fortunately, there’s likely a way around this. Media providers could reorganize as holding companies and establish separate subsidiaries—one for advertising sales, one for broadcasting. Then the broadcaster would technically have no ad revenue and no weather tax obligations. Reorganization would be a hassle and costly in the near term, but it beats paying extra taxes over time—especially for broadcasters that don’t give weather reports.

Now, aren’t you glad you live in a country whose parliament doesn’t have enough unity to pass something like this? I sure am!

The Inefficiencies of Public Investment

 As Europe continues muddling through a recession, the calls for more public investment in research and development are getting louder—high-tech fiscal stimulus, if you will. 

I can see why this sounds attractive. Typically, fiscal stimulus is associated with infrastructure spending, which only brings a temporary jobs boost. Improved infrastructure does facilitate economic activity—think how bigger high-speed broadband networks would improve commerce, or how more efficient rail systems would improve shipping times—but those improvements don’t immediately register in GDP. By contrast, spending on high-tech innovation—at least in theory—would provide longer-term job support as well as boost output.

But, there’s a catch—governments typically aren’t so great at picking which research initiatives to invest in. The money often goes to waste, as it did when the US invested $150 million in an LG Chem lithium ion battery production facility—where auditors discovered employees spent most of their time playing videogames because production never went online. Or, it’s used to create products for which there’s not much economic need. This is what’s happened in Taiwan, where the state-funded Industrial Technology Research Institute is about to release hotly anticipated … diapers.

Taiwan-Made ‘Smart’ Disposable Diapers to Hit Market This Year

By “smart” diapers, they mean diapers fitted with computer sensors registering when adult diapers are soiled and WiFi transmitters to let hospital workers know they need changing. It’s certainly one of the most innovative products I’ve ever seen, and I have to applaud the supply-side approach—there likely wasn’t huge pre-existing demand for something like this—but I question how productive these will be. The market seems limited—they’re designed for hospital, not household use. And whether hospitals will spend on the new technology or simply rely on patients to summon nurses when diapers need changing seems uncertain.

If a private investor were deciding whether to fund this project, they’d likely do a cost-benefit analysis weighing these and other factors to determine whether the initiative’s profitable. That last word is key—because private investors have more skin in the game, and because their main goal is return on investment, they’ll only invest in projects they expect to earn a competitive profit. And those projects likely end up being the most economically useful. Governments typically don’t have that profit motive, so there’s less incentive for them to be discerning about the pros and cons.

Don’t get me wrong, computerized diapers may very well improve quality of care for some Taiwanese patients. I just think money might be better spent on things that could have a greater impact—maybe improved X-ray technology, cutting-edge treatments, or new pharmaceuticals. Thankfully though, those industries have ample private funds behind them.

Hear, Hear for Free Trade!

 The US and EU’s plans to negotiate a massive free trade agreement were big news on both sides of the Atlantic—and, somewhat surprisingly, I didn’t see one article suggest it’s a bad idea for either side. Contrast that with the reactions to the US and EU’s recent free trade deals with South Korea, when people on all sides worried the agreements would hurt their domestic agriculture and auto sectors. 

I’d like to think this represents a shift in the popular mentality toward free trade, but I hesitate. To me, it seems like folks are most optimistic because economic growth is slower, and they’ll take anything that could give it a boost. Most analysts agree free trade would significantly boost output and jobs on both sides, making it quite attractive right now.

As negotiations heat up though, we could very well see some popular and political resistance. Not over lowering tariffs—transatlantic trade is already mostly cheap or tariff-free—but in doing away with subsidies, restrictions and regulations that prevent the free flow of goods and services. Truly free trade could require both sides to reduce or abandon agricultural subsidies, limit auto and airline industry bailouts (widely seen as competition-distorting subsidies), and open air travel and financial services markets—all politically sensitive issues. Equally sensitive will be efforts to lower the EU’s resistance to imports of genetically modified crops and open the US to raw milk products (like delicious French cheese) from the EU. And efforts to harmonize food, drug and other safety standards could set consumers on edge. I expect we’ll see plenty of lobbying and protesting against these compromises over the next several months.

If we all can overcome these differences though, the rewards will be great—particularly for entrepreneurs and small businesses lacking the resources to fight the tangle of red tape limiting trade today. With less regulation and bureaucracy in their way, exporting will be cheaper and easier, making it a far less costly undertaking—businesses won’t need teams or consultants dedicated to navigating regulatory mazes. This is especially true for service-oriented firms, given how closed services markets are right now. With small businesses struggling to grow on both sides of the Atlantic, free trade couldn’t come at a better time.

So here’s hoping the strong political will to complete this stays steadfast on both sides!

And, on a somewhat related note, here’s hoping the European Commission sees successful negotiations and realizes it is possible to have a fully functional multi-national marketplace without a morass of institutional bureaucracy. (Read Jeremy Warner’s excellent piece in Friday’s Telegraph, “Yes to Free Trade With the US—No to All the Other EU Guff,” for more.)

Japan’s Political Morass in One Handy Chart

There’s a new word in Japan these days: Abenomics. 

That’s code for the economic policies of new Prime Minister Shinzo Abe, who believes his plans for massive fiscal and monetary stimulus will finally break Japan out of its long-running economic funk (and judging from his recent poll numbers, many Japanese citizens have bought in).

My colleagues and I have written at length about Abe’s plans and whether they’ll work—suffice it to say fiscal stimulus may give the economy a near-term boost, but the monetary stimulus appears rather feckless, and neither addresses Japan’s underlying economic issues.

Shinzo Abe’s Unstimulating Stimulus

(MarketMinder Editorial Staff)

Unlimited Easing, Limited Impact

(Yours Truly, Equities.com)

What Japan needs more than stimulus, in my view, is deep economic reform to address these issues, which include weak demographics, waning productivity, narrow labor markets, outdated immigration policy and too much trade protectionism, just to name a few. Japan’s also hampered by a weak corporate environment, where mega-conglomerates’ bank holding companies have a vested interest in keeping unprofitable subsidiaries afloat. The preservation of unprofitable firms has contributed to business investment’s steady decline over the past 15 years (in real and nominal terms) and makes it difficult for new businesses to penetrate domestic markets.

Many Japanese officials seem to understand this, yet reforms have been few and far between in recent years. One big reason: Japan’s premiership has a revolving door, which tends to turn about once a year, limiting each government’s ability to effect meaningful change. You can see this in Exhibit 1, which is the handiwork of Fisher Investments Research Analyst extraordinaire Tim Schluter.

Exhibit 1: Recent Prime Ministers’ Days in Office

Source: Fisher Investments Research.

Yes, Abe really is on his second turn at the helm.

Junichiro Koizumi is the last Prime Minister who stayed in office for any real length of time—and, not coincidentally, the last real reformer. Since then, however, not only has reform stalled, but the succeeding administrations have slowly unwound one of his crowning achievements: The privatization of Japan Post, the state-run banking behemoth. Some of these gentleman have had good ideas—the most recent Prime Minister, Yoshihiko Noda, pushed heavily for trade liberalization—but falling poll numbers, political turnover and (to be fair) the Great Tohoku Earthquake/Fukushima Daiichi nuclear disaster have kept meaningful change at bay.

Interestingly, Abe was Koizumi’s hand-chosen successor, and he pledged to see Koizumi’s reforms through during his first term. That didn’t happen, as Abe instead focused on more nationalistic issues, like making Japanese school curriculum more “patriotic.” Meanwhile, the economy stalled, his poll numbers sank, and his Liberal Democratic Party lost control of the Japanese Parliament’s upper house. Shortly after that election, he stepped down as party leader, citing health issues.

This time around, Abe seems more focused on the economy, though his plans are focusing on the symptoms of Japan’s economic issues more than the issues themselves. Plus, his nationalist agenda, which includes removing pacifist language from the constitution and increasing Japan’s military presence in light of escalating tensions with China over the Senkaku/Diaoyu islands, could again distract him from economic issues. If that happens, and Japan’s economy doesn’t improve, the revolving door could turn again. Will he change course and go back to his mentor’s reform roots before that happens?

Showdown in Portugal

 Last year, I theorized that the EU/IMF/ECB troika’s mandated deficit targets were contributing to Portugal’s economic troubles by forcing the government to raise taxes when it should have cut them to stimulate growth. 

Now, it seems Portuguese President Anibal Cavaco Silva has the same idea:

 

Portugal Warns EU-IMF Troika to Back Off on Austerity Demands

Ambrose Evans-Pritchard, The Telegraph

One day after asking Portugal’s constitutional court to investigate the legality of the tax increases in 2013’s budget, President Silva gave a rousing speech on his “arguments” with the troika’s requirements. “Fiscal austerity is leading to declining output and lower tax revenue. We must stop this vicious circle,” he said.

He’s quite right. Below is an updated snapshot of how Portugal’s fared under the past year of austerity:

 

 

Source: October and December Statistical Bulletins, Bank of Portugal.

 

The more these numbers fall, the more Portuguese citizens hurt, and the less tax revenue the government collects—and the longer it takes to narrow the deficit. This aspect of the troika’s policy is counterproductive.

Now, some analysts say President Silva’s speech was a rebuke to Prime Minister Pedro Passos Coelho, but I don’t see it this way. Coelho had to pass another round of austerity measures last October in order for Portugal to continue receiving aid under its 2011 bailout agreement, and spending cuts alone wouldn’t have satisfied the troika. Without the threat of discontinued aid looming over him, it’s difficult to imagine Coelho—historically a champion of freer markets—pushing for Portugal’s largest tax hike in recent memory. President Silva may be using the tax hikes’ “fairness” as grounds to question their constitutionality, but in my view, this is likely just legal cover for an international political gambit. It seems pretty clear the troika, not the prime minister—and tax hikes in principle, rather than their fairness—is in his crosshairs.

Whether the troika takes heed and softens a bit, however, is another matter entirely.

 

More Trouble in Hungary

Storm clouds are gathering once again in Hungary. 

Over the summer, things appeared to be improving there. Prime Minister Viktor Orban’s government had amended prior legislative changes that would have limited the central bank’s independence and eroded some personal freedom. The need to comply with EU treaties, it seemed, would trump Orban’s ultra-nationalist aims.

Now, however, it appears optimism was premature. Orban may have adjusted the central bank legislation to comply with the EU’s requirements, but in practice, he’s still managed to strip the bank’s independence. In 2011, Orban appointed four “non-executive members” to the bank’s board, and these individuals have steamrolled monetary policy in Orban’s preferred direction, overruling bank President Andras Simor and his deputies.

Orban has been dissatisfied with Simor’s monetary policy since he took office in 2010. Simor has focused on preventing runaway inflation—a real risk in Hungary, where the currency is near all-time lows. Orban, however, wants monetary policy to be much more accommodative in order to offset the contractionary effects of his economic policy. Because he’s slapped banks, telecom and energy firms with extraordinary taxes, banks aren’t lending, businesses aren’t investing, and Hungary’s economy continues stagnating. Hence, Orban wants to slash interest rates to get capital moving again so he can keep these harmful taxes in place.

Simor would rather not play along—he understands loosening monetary policy will increase the risk of inflation and won’t fix Hungary’s underlying economic and policy issues. But rather than listen to reason, Orban seems content to continue forcing his agenda. Simor’s term expires next March, and Orban’s deputies are already eyeing a “new strategic alliance” with a central bank chief much more aligned with their interests—interests that likely include doing whatever it takes to artificially boost growth before the 2014 general election. A policy turnaround—something Hungary needs desperately—appears sadly unlikely.