ECB Cuts Rates when Stock Markets are at Record Highs

The ECB took Financial markets by surprise when it announced a 0.25% cut in its core interest rate on Thursday. Most analysts, including yours truly, expected rates to remain as they were and indeed few expected rates to ever dip below the 0.50% rate announced earlier this year. It is obvious the ECB is less than impressed with the limp growth being experienced in the Eurozone, and with inflation running at a meagre 0.7%, the European economy is in danger of slipping into a Japan-like decade of economic stagnancy and deflation. Indeed we can say we are already half way along that road.

But is the ultra accommodative policy of the ECB enough to help Europe reverse course? Experience elsewhere would suggest not. Japan's lost decade occurred at a time when the Bank of Japan kept interest rates close to zero, printed money at will and facilitated a carry trade that saw the Yen kicked around in currency markets. Despite the exhaustive efforts of the Bank, apart from exporters, there was very little economic uplift in Japan's domestic economy and the country has spent the best part of twenty years in a deflationary rut.

So can Mario Draghi & Co. avoid the economic chasm that so engulfed Japan for much of the past twenty years? We are five years in and thus far the omens are not good. The ECB and the Eurozone are running out of options and unless European consumers begin to find work and find the propensity to spend, then stagnation will become denigration and to déja vu we are doomed.

Given the German influence within the ECB and its strong resistance to quantitative easing as a method of economic stimulation, the Eurozone is highly unlikely to follow the same path as Japan, the US and the UK in rolling out the printing presses, simply to appease the flawed political lines of economic argument. One thing we have learned over the past five years is that quantitative easing has had minimal positive impact on real economies across the world and it has merely acted as a tool by those at the top end of the financial tree to stoke the fire in financial markets.

Since the economic collapse five years ago, virtually the only place where we have seen inflation, and indeed heightened inflation, has been in stock markets, commodity markets and in a range of other financial instruments. Indeed many of the increases in these markets are hyper inflationary and are totally out of synch with consumer experience and with the normal rules of economic supply and demand. To be fair there are two very real contributory factors leading to the growth in major stock indices, one being that the lack of credit on the ground has squeezed out a huge chunk of the SME market in favour of cash-rich conglomerates, and the other being that sustained growth in the developing world has hugely benefited multinational PLCs.

However there remains a huge disconnect between the growth in stock markets as against GDP growth in the real economy which suggests financial markets are due a very significant correction downwards. Investors in stocks should not take the ECB move on Thursday as a positive sign for the medium-term outlook for stocks. The ECB is not the line of either first or last defence for financial markets in the same way the Fed acts as the great protector of Wall Street. And with ECB rates at a level under which there is no scope, when the trap door opens under the weight of inflated stock markets, there will be little to nothing the ECB can do, even were it as inclined as the Fed to intervene.

Apple, Google and the Tax Holidays on Offer in Ireland

Much has been written in the past two weeks about apparent anomalies in the tax regime in Ireland and the ability of two of the biggest corporations in the world – namely Apple and Google, to exploit these anomalies to their advantage, i.e. to avoid paying taxes to the tune of Billions of dollars, to any tax authority, anywhere, for many years. Neither company has broken any law, rather, both have jumped on the incredibly generous tax laws which operate in Ireland, a country that enables large multinationals to register their entities in Ireland while not having to be tax resident there, nor indeed tax resident anywhere.

There have been many vocal objections within Europe in recent years to Ireland’s lowly corporation tax rate of 12.5% which is significantly lower than the EU norm. However, despite the protestations, Ireland managed to convince the Troika during the bailout talks 2.5 years ago that Ireland had to retain this tax rate to ensure the sustainability of existing business operations from multinationals in the country, a sector that currently provides upwards of 150,000 jobs in a county with a population of around 4 million people. The fear was that if this tax rate was increased significantly, it would trigger an exit of multinational firms from the economy, and further depress an already stuttering economy, thus exacerbating the country’s already dire debt problems.

However, the Apple and Google story really has nothing to do with Ireland’s corporation tax rate. Even if the corporation tax rate were 35% (as in the US), this would not have made much difference to the actual tax take Ireland would have netted from either company, as Apple and Google only pay nominal tax in Ireland, reported as being just 0.05% and 0.14% respectively of total income channeled through their Irish entities. The tax anomalies that exist in Ireland permit a company to register there, but if the entity is managed from outside the Irish jurisdiction, it can be deemed to not be tax resident in Ireland, thus the corporation does not have to pay tax to the Irish State for the operations of these companies. In the case of Apple, three of the Group’s main revenue generating companies are registered in Ireland, but are tax resident in Bermuda, where there is no tax. Using this arrangement, Apple managed to restrict its overall tax liability across the globe in 2011, to just 1.9% of the Group’s income. Apple is a US conglomerate with its Headquarters in Silicon Valley, and given the corporation tax rate for American registered companies is 35%, it is easy to see why certain people in charge of the legislature in the US might get quite exercised on this issue.

Similarly, in the UK, the House of Commons were informed two weeks ago, that Google Ireland paid tax of just €70 Million on sales of €47 Billion between 2005 and 2011. Google’s sales in the UK were channelled through its Irish company and Google essentially paid no tax in the UK on UK sales. Google availed of the same tax loophole as Apple, whereby it funneled revenues from non-Irish operations through Irish subsidiaries which although registered in Ireland, were not deemed tax resident in Ireland. The funds then made their way to a Bermuda registered Google company, to avail of the 0% tax rate on offer there. The House of Commons committee subsequently branded Google ‘devious’.

So who is to blame for the tens of Billions of dollars in lost tax revenue? It is hard to blame the companies themselves directly, as ultimately the function of corporate companies is to maximise the wealth of their shareholders. There is an argument that both Apple and Google come up short in terms of displaying corporate moral responsibility, whereby they have deliberately avoided paying their fair share in tax contributions back to the economies that contributed most to their success. However most corporations will generally operate within the legal parameters set for them, and if the legal parameters come up short, and this provides an opportunity, then most companies will take such an opportunity if it helps it to preserve and grow its wealth for shareholders.

The Irish Government has been at pains over the past week to state Ireland is not a tax haven and that the government does not do deals with companies on the tax liability a company must pay. However the fact is that Ireland deliberately operates an accommodative policy surrounding legal registration and tax residency and this accommodation is used by scores of multinationals to avoid paying tax in other jurisdictions. This has nothing to do with the low corporation tax regime already operating in Ireland. Apple and Google between them provide about 6.000 jobs in Ireland and these jobs are obviously deemed more important to the country than the very significant tax revenue the country could earn from both companies, and indeed from other multinationals, were these companies forced to pay corporation tax on all earnings channeled through all their Irish registered entities.

The European Union could introduce a rule that all companies registered in the European Union are automatically liable for tax at the tax rate applicable in the jurisdiction in which the company is registered, closing off the Irish loophole that permits a company to be registered as a legal entity in one country, while being resident for tax purposes in a separate jurisdiction. Of course the EU, US and other major governments could also determine that, for tax purposes, IP has to be registered in the country of origin of the IP, as opposed to being registered in some remote island and thereby by proxy, this would force large multinational companies like Apple and Google to radically rethink their policy in relation to corporate responsibility and tax and their overall economic contribution to all society.

Bob - May 27th 2013

Jamie Dimon's Two Fingers to Governance

What is going on at JP Morgan Chase?

Despite the multiple scandals that has plagued the broader Banking sector in recent years and the more recent 'London Whale' trading scandal, where JP Morgan blew billions of dollars of investors money, JP Morgan Bank has spectacularly demonstrated its inability and reluctance to embrace strong leadership and transparency by voting down a proposal to separate the key corporate roles of Chairman and CEO. As to why this proposal needed to go to a vote by shareholders in the first place, says a lot about Jamie Dimon's own personal agenda within the Bank and his rather alarming indifference to best practices in governance. What is he afraid of? What has he got to hide? Why does he not want to be accountable to anyone within the Organisation?

Even undergraduate students that study business studies and corporate governance will know the critical importance for the separation of the CEO and Chairman roles in an organisation. The Board's job is to oversee the performance of management and to hold management to account. How can the Board carry out this function if the Chairman of the Board happens to also be the Head of Management (CEO). Given the Chairman sets the agenda for Board meetings and is the most powerful and influential person on the Board, how can the Board function in any meaningful or effective manner, if the Chairman also happens to be Management's chief representative and defender on the Board.

The fact a publicly listed Bank the size of JP Morgan Chase is even allowed to retain a CEO and Chairman as the same person does not say much for the regulatory authorities in the US. In many countries this would be a breach of governance practice and the Bank would be expected to provide an explanation in its Annual Report for the breach, and to provide details on what it is doing to rectify the transgression. Many of the failings of international banks during the financial crisis had to do with core governance failures and the failure of Boards to rein in management, when risks in the sector began to escalate.

JP Morgan Chase may well argue that it outperformed and outlasted most of its competitors during the Banking crisis, but that does not give Mr Dimon a license to be answerable to nobody and to both manage and govern the bank as he sees fit. If he is truly proud of the job he has done, he would be open to transparency and accountability, and welcome a non-executive Chairperson to evaluate his performance and to report back independently to the Bank's shareholders. Ultimately one has to ask what is the role of the non-executive Directors on the Board of the Bank and if these Directors believe it enhances their corporate reputations to sit on such a dysfunctional Board structure. How effective can the Remuneration Committee be if a member wishes to question the remuneration package afforded to Jamie Dimon? Dare they strike it down? They can hardly revert to the Chair for guidance, or support.

The number one requirement in good corporate governance practice is the separation of the CEO and Chair roles. Any organisation that fails this simple test is a long-term recipe for disaster and should be seen as a significant risk for would-be investors. JP Morgan Chase is an Institution where strong ego wins out over strong governance. Step clear!

Bob - May 22 2013

Market Watch: Canadian Dollar

Is it time for the Canadian Dollar to make a significant correction against its Australian counterpart?

The Canadian dollar is traditionally one of the more difficult currencies to predict in terms of medium to longer term movement, given direction is principally dictated by a number of factors outside the confines of the Canadian economy and the monetary policy moves of the Bank of Canada, namely 1) the general trend in global commodity prices and 2) close affiliation and thus link to the performance of the US economy and the US dollar.

It is thus a risky currency to trade, although over the past 12 months it has generally traded within a fairly confined range against the US dollar, while trading a little stronger against the Euro for all of 2013. The Canadian dollar has not had anything like the same inflated gains achieved by the Aussie and New Zealand dollars since the turnaround in global financial markets, but this is thanks to the much more accommodative interest policy adopted by the Bank of Canada, as against that adopted by the Central Banks in Australia and New Zealand. Interest rates in Canada have remained at 1.00% while the higher rates on offer in the Aussie dollar (3% + up until recently) meant that any speculative holding trade involving commodity currencies has generally gone on the Aussie dollar. The recent sharp fall in metal prices and the reduction in overnight rates (to 2.75%) announced by the Reserve Bank of Australia last week has triggered some dilution in this holding trade, and the loonie is now up 5% against the Aussie in the past month. However, the pair are due a further correction given the Aussie is still trading almost 30% higher against the loonie than when the pair last traded at a fully corrected price back in early 2009. Of course the problem with being bearish on the AUD/CAD pair is the punitive overnight cost of the interest rate differential (2.75% Vs 1.00%), but the signs do indicate this pair should make a significant move downwards, certainly down to 95 and possibly down to 90, through the course of this year.

But, and this is an important but, the Canadian dollar will only make significant gains against the Aussie on the back of a move downwards in AUD/USD, and thus a good hedge to take on in tandem with a sell of AUD/CAD, is to sell USD/CAD. While not the perfect hedge, it will significantly reduce the risk of holding AUD/CAD in the medium term, while the interest rate differential in selling USD/CAD is in the traders favour (0.25% Vs 1.00%). This strategy is for an initial 3 months.

Ted - May 15 2013

Austerity and ECB Policy

Last Thursday the ECB announced a 25 basis points reduction in its overnight rate bringing interest rates to 0.50%, the lowest level they have reached in the Euro era. An accommodative policy has been adopted by the Federal Reserve, ECB, Bank of England since the Financial crisis in 2007-2008, but all the evidence suggests this policy has failed miserably to stimulate many of the major economies in the developed world, with contraction again the dominant force in Europe and Japan, while the US experiences a moderate recovery. The Euro area economy contracted at an annualised rate of 0.6% in the final quarter of 2012, while Japan contracted at a rate of 0.4%. The UK economy grew by a slight 0.6% annualised rate in the first quarter of 2013, while the US economy expanded by a more impressive 2.5% in the same quarter.

Little to none of the cheap money being fed into the bank chain from the top of the hierarchy by the Central Banks is making its way into the real economy - i.e. by way of retail bank support and lending to small businesses and end consumers. If the people that are the lifeblood of the economy are starved of cash and disposable income, then the real economy is missing the basic stimulus it needs to grow and the Central Banks need to reassess its policy, or, more importantly, reassess how the institutional banks are interpreting their policy. Owing to flagrant indifference of the banking sector to the Central Bank's policy intentions, any trickle of funding that does currently make its way from the banks to the real economy usually brings with it a vastly inflated interest rate tag, just to reinforce the fact that accommodative monetary policy is not accommodative where it is needed. None of this money is available at an affordable price where it is needed most.

But if the cheap money being ushered out by the Central Banks is not going into the real economy, where is it going?

Answer: Into risk assets such as commodities, bonds, even equities. How? The institutional banks are borrowing cheap money from the Central Banks, such as the Fed, ECB and Bank of Japan, and rather than making this money available for end borrowers (the original intention of the Central Banks), the Institutional banks are diverting the cheap funds from the Central Banks into their own investment channels, to speculate on higher risk investments in the hope of a more profitable and quick return. For the most part this tactic has worked over the last 3 years with largely exaggerated price increases achieved in commodities and equities, while sovereign bonds in many defunct European countries are now achieving close to record yields for investors. The added political lobbying by bank interests of influential governments within the European Union has helped to safeguard bond investments, as the EU currently prohibits sovereign debt write-downs and the burning of major bondholders exposed to Europe's burgeoning sovereign and banking debt. Any country that might consider straying from this policy is threatened with expulsion from the Euro.

For the institutional banks it is a no-brainer. Why lend money to the man on the street or to someone starting up in business, with the risk that entails, when the option exists to direct this money into a 6% yielding bond, a speculative fund investing in oil futures (up 50% since 2009), or gold (still up 113% in the past 4.5 years despite a recent sell-off) or equities (The Dow is up a massive 130% in the same period). A 5-year term loan given to a small business might yield 18% over 5 years and is not without risk, while a mortgage given to an end consumer might yield 40% after 20 years. The differential gap in terms of potential yield between investment risk and lending risk is something of a moral dilemma for institutional banks, but not one they lose any sleep about, and when push comes to shove it is lending to the real economy that is losing out to speculative investment. Of course what this means is that with cheap and free money barging its way into riskier assets, these assets have grown at a rate which is completely out of synch with growth in the underlying economies and thus the aforementioned assets are completely overpriced in real economic price terms and the run-up in prices is unsustainable, and many of these assets are soon headed for a serious downward correction, if not crash landing, in the not too distant future. Oddly enough, given the impact of political bullying and potential ECB intervention, sovereign bonds within the Euro area may be at the lower end of this risk investment scale.

So what does this mean? Central Banks are accelerating a policy of providing cheap money to banks so these banks may use this money to invest in risk instruments rather than lend this money to the real economy. The net result for many of the underlying economies is economic contraction as government austerity measures intensify and fuel costs continue to inflate, thanks largely to the speculative investment which the Central Banks are inadvertently helping to fuel. Cash-starved businesses in developed economies are being run aground and unemployment in Europe is now at a Euro era high at 12.1%. Japan's Central Bank is currently undertaking desperate measures to try to discredit it own currency with the result that the currency has fallen 28% against the dollar in the past 8 months, while the Nikkei has soared 63% since the middle of November. The price moves in Japan are totally at odds with the economy's lack of economic growth and its underlying fundamentals and the price moves appear more fictional than real. It just does not seem plausible that such moves can occur and be representative of the economic facts. But of course they are not representative of the real economy, rather they are representative of the repatriation of cheap funds originating from the speculative children (banks) of accommodative Central Bank policy, as their fund managers race trigger-happy across the globe, in an avaricious chase for big profits from risky assets.

Why are institutional banks allowed to borrow money for half nothing from the ECB, Bank of England, Bank of Japan and the Fed, when this cheap money is not finding its way into the real economy and is not being used to help the economies of the Euro, UK, Japan and United States? The reason is simply because, despite the near-collapse of the banking sector in Europe just a frighteningly short time ago, the ECB and other major Central Banks have failed miserably to impose the proper regulatory procedures required to keep the money distribution policies of banks under control. It is incredulous that the ECB itself has not imposed stricter rules and monitoring procedures, for tracking cheap funds being poured into the banking sector, given the strict rules it has imposed on the Governments of the Euro area, forcing an era of severe and heretofore unseen levels of austerity, for most of the citizens of the Euro area. Is it that the ECB, and Central Banks generally, are run by bankers whose modus operandi is for the benefit and growth of banks, moreover the real economy and its citizens?

Bob - 7th May 2013