Markets Insight

February 3, 2015 9:03 am

Reach for returns takes funds into the shadows

Tracy Alloway

Asset managers delve deeper into shadow bank territory for returns 

The sun set behind buildings in Shanghai, China, on Sunday, June 30, 2013. China's expansion probably slowed for a second straight quarter, based on the median estimate in a Bloomberg News analyst survey, after export growth collapsed and Premier Li Keqiang reined in record credit expansion to contain shadow-banking risks. Photographer: Tomohiro Ohsumi/Bloomberg©Bloomberg
“Holy Cow Batman, these bonds can outperform stocks!” Bill Gross wrote back in 2003.
Then chief investment officer at Pimco, he was describing a strategy of effectively borrowing money and using financial instruments to boost returns on fixed income securities, a process better known as deploying leverage.

Using leverage, he argued, could allow investors to achieve the seemingly impossible; generate the kind of profits typical of stocks while enjoying the stability typical of bonds. Super hero-like indeed. But the strategy came with a significant catch: in order to juice up returns, fund managers needed to engage with the so-called shadow banking system.

The extent to which low interest rates have driven mutual funds and other asset managers to become entwined with shadow banking is laid bare in a new research paper by Zoltan Pozsar, former senior adviser at the US Treasury.
This shadow banking system has long been described as a network of non-bank financial intermediaries, but it is perhaps better characterised as a reference to a particular set of financial activities.

Classic examples of such activities include financial institutions borrowing money by pawning their assets through ‘repo’ agreements or securities lending transactions, as well as using derivatives.

Traditional notions of shadow banking usually centre on the idea of repo being used to fund the balance sheets of broker-dealers and banks. When entities like Lehman Brothers and Bear Stearns became locked out of the repo market in 2008 they suddenly found themselves starved of financing, triggering an avalanche of stress across the financial system.
Regulators have spent the years since the financial crisis trying to clamp down on shadow banking as they attempt to improve the overall safety of the financial system. Since such activities are rarely associated with traditional mutual funds that invest in bonds and other assets on behalf of large investors such as pension funds and insurers, such funds have rarely been mentioned in conjunction with shadow banking.

Mr Pozsar’s research suggests that is a mistake. For example, a cursory look at the balance sheet of Pimco’s flagship Total Return Fund shows a bevy of derivatives including futures, forwards and swaps. Moreover, its repo borrowings at the end of the first quarter of 2014 stood at $1.12bn. The fund’s subsequent annual report shows repo borrowings for the period averaged $5.73bn — more than five times the amount reported at quarter-end.
Such window dressing is usually associated with big investment banks that cut back on their leverage ahead of quarter ends as they seek to flatter their funding profiles and impress their investors.

Its presence on Pimco’s balance sheet is symptomatic of a long-term trend that has seen mutual funds evolve from staid, largely “long-only” managers into very different beasts. In addition to accumulating billions of dollars’ worth of fixed income securities in recent years, the funds have reached for an alternative financial toolkit of derivatives, securities lending and other forms of leverage, to help boost returns.
How did we arrive at this somewhat unexpected situation? Mr Pozsar’s paper posits two main causes.

First, mutual funds have spent much of the 21st century fending off a two-pronged attack from hedge funds and exchange traded funds that have made hefty inroads into the asset management market.

As Mr Pozsar puts it: “These industry trends were the sources of a competitive push that drove the creep of leverage into the industry’s traditional, long-only, relative-return bond funds.”

Second, that competition has occurred at the same time as big investors have had to grapple with low interest rates and low growth. While the yield on the benchmark US Treasury has dropped from an average of 6 per cent in 2000 to 1.66 per cent currently, the return expectations of public pension funds have barely budged at roughly 8 per cent, according to the paper.
Says Mr Pozsar: “Reach for yield is omnipresent in a financial system where investors are hard-wired to beat their benchmarks, but reach for yield intensifies as actual yields drift farther and farther away from the return targets of investors with fixed liabilities.”

In other words, as pension funds grapple with a classic case of asset-liability mismatch caused by high return expectations coupled with very low yields and growth, mutual funds have attempted to fill the gap by levering up their fixed income securities through traditional shadow banking methods.

The obvious solution — lowering the return expectations of investors such as pension funds — is far easier said than done. A much more palatable policy recommendation one could take away from the paper is that if regulators want to clamp down on shadow banking activities, they might do well to take a more holistic look at the environment that is fuelling them.

By seeking to leverage fixed income assets to offset the problems of relentlessly low yields, mutual funds are striving to become the super heroes that investors need at this particular moment in time — but they are having to lurk in the shadows to do so.

02/03/2015 05:10 PM

European Parliament President Schulz

'Greek Voters Should Be Realistic'

Interview by Nikolaus Blome and Christoph Schult

European Parliament President Martin Schulz visited newly elected Greek Prime Minister Alexis Tsipras late last week in Athens.

European Parliament President Martin Schulz visited newly elected Greek Prime Minister Alexis Tsipras late last week in Athens.

Newly elected Greek Prime Minister Alexis Tsipras has promised to free his country from the strict demands of its European creditors. In a SPIEGEL interview, European Parliament President Martin Schulz says there is room for compromise, but warns Athens must tread carefully.

SPIEGEL: Mr. Schulz, if you look at the campaign promises that helped new Greek Prime Minister Alexis Tsipras win last week's vote, one has the feeling that the Greeks are hoping for a pink elephant that can play drums.

Schulz: Greek voters should be realistic. It is rare that all election hopes are fulfilled. And there is no such thing as pink elephants that can play drums.

SPIEGEL: What can Tsipras do to avoid looking like a liar when it becomes apparent that he won't be able to fulfil all of his promises?

Schulz: Tsipras promised the Greeks he would improve the situation in which they find themselves by negotiating changes with the European Union. He would be well advised to tell the Greeks: "I can try, but I can't guarantee you anything." That would be the truth.

SPIEGEL: He has said that he refuses to accept the conditions agreed to with his country's European creditors. He said he wants to "tear them up."

Schulz: The decisive question is: How do we approach Alexis Tsipras? As the devil personified? Or as a head of government like any other? When I spoke to him for the first time three years ago, he had little idea how the EU worked. He told me: If the Greeks elect us, then it is their sovereign choice and our EU partners have to accept it. In response, I asked: And if the Germans elect a government that refuses all support to Greece, then that is their sovereign decision, right? He said: No, you have to show solidarity, you have obligated yourselves to do so. Now, he has to accept that Greece has to live up to the treaties that have been signed. Greece has received an enormous amount of help from the other euro-zone member states. Were he to terminate the conditions imposed, it would put his country in danger.

SPIEGEL: Is that what Chancellor Angela Merkel means when she says "market-conform democracy"?

Schulz: There is no such thing.

SPIEGEL: In Greece there is, because the newly elected government is unable to do what it has promised, not least because financial markets and investors wouldn't provide the funding to do so.

Schulz: The point is a different one. In a currency union like the one we have, member states have transferred sovereignty in a core area -- currency -- to a trans-national entity. Unfortunately, we failed to create the political instruments necessary to deal with such a situation at the same time.

SPIEGEL: How free can an election be when a country cannot choose certain alternatives because they cannot be financed?

Schulz: It's not like that. Of course there are other steps Greece can take in complete sovereignty. Hardly one of them hasn't already been mentioned: exiting the euro zone, for example, or leaving the entire EU. But politicians also have the responsibility to tell their people what would then happen.

SPIEGEL: Is that not a paradox of democracy? Greek voters have provided Tsipras with a strong mandate, but when he arrives in Brussels, he'll find that it is of little use?

Schulz: Syriza received 36.3 percent of the vote, meaning that two-thirds of Greeks don't share Mr. Tsipras' approach.

SPIEGEL: You are a Social Democrat. The SPD in Germany would be ecstatic where it to receive 36 percent. Or would you also say in such a situation that two-thirds didn't vote for your party?

Schulz: Were you to write in SPIEGEL that 36 percent for the SPD was a powerful governing mandate, I wouldn't contradict you.

SPIEGEL: Thank you.

Schulz: But that doesn't mean that you can throw international agreements over board at will. EU members have a limited sovereignty. The EU isn't a federation, but we are a union of state with a common currency. In such a system, it is essential that compromises be made -- by Alexis Tsipras but also with Alexis Tsipras.

SPIEGEL: What kind of compromises do you envision?

Schulz: I told Tsipras that it wouldn't help Greece were he to call the Greek reform program or loan paybacks into question. But we can certainly talk about how we can divert investments to Greece from the new €315 billion European Commission program.

SPIEGEL: Thus far, Greece has drastically cut spending, but has hardly made significant structural reforms.

Schulz: That is why we can't limit the debate with Tsipras to a debt cut. A debt cut would not solve the country's current problems, because interest and principal payments have largely been suspended.
Greece has huge potential, but it is crippled by nepotism, bureaucracy and tax flight. Were Tsipras to focus on those problems, he would have all of Europe behind him.

SPIEGEL: Tsipras has promised Greek voters a debt haircut.

Schulz: Again: There is currently no majority for a debt cut.

SPIEGEL: What about a so-called "soft restructuring," wherein the interest rates are reduced further and the period is lengthened?

Schulz: The Greek state is currently bringing more money in than it spends, not including interest payments and debt pay-down. We should focus our energies on how to use this so-called "primary surplus" for investments or, where necessary, for social improvements.

SPIEGEL: So are you in favor of extending the loan periods?

Schulz: Currently, the last payment is scheduled for 2057. Moving that back by 10 years really doesn't make much of a difference anymore. The main thing is that Greece puts itself into a position where it can pay down its debt at all.

SPIEGEL: Tsipras wants to get rid of the troika, the body made up of the European Commission, the European Central Bank and the International Monetary Fund that monitors Greece's austerity and reform programs.

Schulz: I interpreted such demands as campaign rhetoric. The mandate of the Troika in its current form expires at the end of February anyway, along with the current aid package. It would be better had Greece thrown its support behind reforms early on. If we can achieve that with Tsipras more easily than with previous governments, I would wholeheartedly welcome it.

SPIEGEL: The idea behind the troika, though, was to create a kind of technocratic buffer between Brussels and the effects of its policies. Were the troika to disappear, the European Union will be made directly responsible for the effects.

Schulz: That is how it should be. If we want to create an EU that is also a political union, then those who make decisions must take responsibility. I am not one of those who wants IMF participation at all costs.

SPIEGEL: The German government wanted IMF participation at all costs because it didn't trust the European Commission to be strict enough with Greece and other countries needing aid.

Schulz: As far as I know, it was the other way around. It wasn't the IMF demanding a tough line, but the EU Commission under then President José Manuel Barroso. I don't think you can accuse the Barroso Commission of being too lenient with countries in deficit.

SPIEGEL: Do you think Tsipras' victory will call into question the entire euro rescue strategy followed in recent years?

Schulz: It's not like Alexis Tsipras' victory has suddenly enlightened us all. The fact is that the new European Commission has begun changing direction with the goal of combining budget consolidation and structural reforms with sustainable investments in growth and employment.

SPIEGEL: Commission President Jean-Claude Juncker has presented a new interpretation of the Stability and Growth Pact. Accordingly, those who violate EU deficit rules can buy more time to pay down new borrowings merely by announcing their intention to undertake structural reforms.

Schulz: The flexibility presented by Juncker represents the solidifying of the change in direction, and it is supported by Angela Merkel. She has accepted, after some hesitancy, that investments in infrastructure are necessary if we finally want more growth and jobs in the EU.

SPIEGEL: Tsipras' election victory in Greece, the European Commission's newfound understanding for Italy and France: Has the German model for Europe, a vision calling for rules to be more strictly followed than in the past, failed?

Schulz: The huge pressure exerted by net payers at the apex of the euro crisis had its effect, and it was largely a positive one. Without this pressure, countries would not have accepted that they had to get their budgets under control. It's just that limiting European policy to budget consolidation isn't enough.

SPIEGEL: The pressure was only exerted so long as Germany, along with other net payers, maintained it. Now, the European Central Bank, under President Mario Draghi, is following the path of cheap money. That reduces pressure and clears the way for a weakening of the Stability Pact.

Schulz: It was the one-dimensional focus on budgetary consolidation that forced Mario Draghi to take action. I believe that the measures taken by the ECB could create growth. But that isn't a call for budgetary laxness. The most energetic objections currently facing the new Greek prime minister are coming from those countries that pulled themselves out of crisis by way of draconian austerity and reform. Countries like Spain, Portugal and Ireland have no interest in granting Greece a rebate on its obligations.

SPIEGEL: But larger countries are also at issue. France has already twice received more time to get its deficit under control and Paris now needs more time yet again. Does it send the right message for the European Commission to weaken the Stability Pact?

Schulz: The reins have not been slackened: A vigorous discussion is currently underway between Brussels and Paris. Of course one can try to bring the Paris government to its knees and say: You have to do more, another cut in retirement benefits here, another tax hike there, so that the deficit slides below the 3 percent limit in 2015. But if France only manages it in 2017, it's not a huge deal.
The point in time isn't so important as the question as to whether France takes its pledges seriously.

SPIEGEL: According to the new rules, certain investments can be deducted from the budget deficit calculation.

Schulz: That is overdue and should go much further in my opinion. France is a G-7 member state which cannot, for example, deduct the billions it makes available for European security from its deficit. The French operation Serval, which supported the Malian army in its fight against Islamists, served the security of all of us. The Stability Pact should consider such expenditures.

SPIEGEL: Still, the Stability Pact would appear to be the only instrument available to bring European countries in line when it comes to economic and financial policy. And it is necessary to prevent the euro from falling apart.

Schulz: That is the crux of our currency union: the fact that most decisions are made by the nation-states themselves, meaning that each individual country is granted an exception. Instead, we need a European economic government that is responsible for all forms of economic and currency policy.

SPIEGEL: Are you not afraid that Europeans would be opposed to such a plan because Brussels seems to them to be so far away and because they don't trust the European Parliament to exert sufficient control?

Schulz: It would no longer represent a significant surrender of sovereignty on the part of the nation states. We would merely provide a political framework to that which has already become reality. But of course it will be difficult. I am not under the illusion that we will be able to make treaty amendments on the short term.

SPIEGEL: The new Commission has almost been in office for 100 days. How do you see Jean-Claude Juncker's first three months?

Schulz: Jean-Claude Juncker is my political partner. It wasn't easy for him at the beginning ...

SPIEGEL: … because of the revelations pertaining to the lenient tax policies in Luxembourg, of which he was the prime minister for more than a decade.

Schulz: We are working together to bring Europe forward. He has undertaken important and correct preparations for the future. That is true of economic policy just as it is of the fight against tax dodging. Juncker recently said a very important sentence: "The country of profit must also be the country of taxation." That was the guiding light of my election campaign. If Juncker has now adopted it, then I am satisfied.

SPIEGEL: Mr. Schulz, we thank you for this interview.


The Unreality of Obama’s Realpolitik

With the president unwilling to project U.S. might, Iran and other bad actors rush to exploit the power vacuum.

By Josef Joffe
Feb. 2, 2015 7:36 p.m. ET

When historians look back on President Obama’s foreign policy, it likely will be defined by two shibboleths: “leading from behind” and “we don’t have a strategy yet.” Great powers lead from the front, and they don’t formulate strategy on the fly. They must have a strategy beforehand, one based on power and purpose that tells challengers what to expect. Nowhere is this truer than with the Islamic Republic of Iran, a rival power playing for the highest stakes: nuclear weapons and regional hegemony.

The retort from Mr. Obama , if he ever laid out a Middle East strategy, might go like this:

 “Iran is No. 1 in the region, and we need its help against Islamic State and sundry Sunni terror groups. Save for a massive assault with all its incalculable consequences, we cannot denuclearize Iran; we can only slow its march toward the bomb and guard against a rapid breakout. Rising powers must be accommodated for the sake of peace and cooperation. So let’s be good realpolitikers, especially since it’s time for a little nation-building at home.”

Realism in foreign policy is the first rule, but what’s missing in Mr. Obama’s vocabulary?

Words such as “balance,” “order,” “containment” and “alliance-cohesion”—the bread and butter of realism.

The dearth of such ideas in this administration is striking. But the problem goes deeper. Iran is not a “normal” would-be great power, amenable to a grand bargain where I give and you give and we both cooperate as we compete.

Realists should understand the difference between a “revisionist” and a “revolutionary” power.

Revisionists (“I want more”) can be accommodated; revolutionaries (“I want it all”) cannot.

Revisionists want to rearrange the pieces on the chessboard, revolutionaries want to overturn the table in the name of the true faith, be it secular or divine.

Napoleon was a revolutionary. He went all the way to Moscow and Cairo to bring down princes and potentates under the banner of “democracy.” The early Soviet Union changed the banner to “communism” but behaved similarly. Hitler wanted to crush Europe’s nation-states in favor of the German “master race.” All of them had to be defeated—or, in the nuclear age, contained for decades on end.

Iran is a two-headed creature, combining both R’s. As revisionist, it seeks to unseat the U.S. in the region, targeting Lebanon and Syria with proxies like Hezbollah, or directly with its expeditionary Guard forces. It reaches for nuclear weapons to cow the U.S., Israel and the rest.

As revolutionary, the regime in Tehran subverts its neighbors in the name of the one and only true God, seeking to impose Shiite supremacy from Beirut to Baghdad. Shiite Houthi forces just grabbed power in Yemen.

The Shiites shall reign where Shiites live.

The point is that revolutionary powers, driven by the consuming faith of being on the right side of history, cannot be appeased. How do you compromise with Allah or, earlier, with the worldly God of communism? How, indeed, could Protestants and Catholics strike a deal in the religious mayhem of the 16th and 17th centuries? They fought each other to exhaustion.           

Faith warriors have to be vanquished or contained, as in George Kennan’s immortal words at the dawn of the Cold War: “unceasing pressure” until “the breakup or the gradual mellowing of Soviet power.” It worked without war, but it took 40 years. The first sinner against Kennan’s realism was George W. Bush when he went to war against Saddam, removing the single most important bulwark against Iran and liberating Shiite power throughout Iraq.

Mr. Obama, what irony, is going one worse. He has been counting on diplomacy to stop the Iranian bomb, but he has reaped stalemate. Unwilling to commit serious force against Islamic State, he is allowing the Iranians to brag that they are doing America’s work in Syria and Iraq.

Riyadh, Amman and Jerusalem are neither amused nor assured. The Russians, who have their “advisers” helping Syrian dictator Bashar Assad, are eagerly watching for signs of American weakness, not just in the Middle East but also in Eastern Europe.

OK, life is horrifyingly complicated in the Middle East, and sometimes the “good guys” must sup with the devil, as the West did when it linked up with Stalin against Hitler in 1941. But this dusty analogy holds a lesson: Keep your powder dry, and your troops ready, as the U.S. failed to do after V-E Day in the spring of 1945. Soviet armies stayed in Germany while Stalin subjugated Eastern Europe and proceeded to subvert Greece, Turkey, France and Italy.

The point is that Mr. Obama is confusing revolutionary Iran with a reasonable revisionist power. President Hasan Rouhani may be reasonable; his boss, Supreme Leader Ayatollah Ali Khamenei, is not. For him, the “Great Satan” is indispensable as a cosmic enemy who legitimizes Islamic rule. As the U.S. tacitly collaborates with Iran on Islamic State and al-Nusra, Tehran keeps pushing its pawns forward while egging on Shiite revolutionaries all over the Middle East—damn Western sanctions, no matter how hard they bite.

To borrow from Forrest Gump : Power is as power does. Iran knows this. Aside from a few exceptions like the killing of bin Laden and the timid reinsertion of American might in Iraq, the supposed realist Mr. Obama does not.

Mr. Joffe is a fellow at the Institute of International Studies and the Hoover Institution, both at Stanford University, where he also teaches U.S. foreign policy. His latest book is “The Myth of America’s Decline” (Liveright, 2013).

February 3, 2015 8:52 am

Rising dollar hits US corporate earnings

Eric Platt in New York

Even Apple, the world’s most valuable company that set a record with its $18bn quarterly profit, has a currency problem.
In the fourth quarter, as the company sold nine iPhones a second, the dollar strengthened against virtually all of its trading partners. The cost to Apple: more than $2bn in lost sales and the brief closure of its Russian website as the rouble plummeted. That problem is only going to deepen, executives caution.
Dozens of US companies have warned that a sharply stronger dollar has eaten into revenues and crimped profits over the final three months of the year, forcing businesses to cut costs as hedging strategies fail to offset currency fluctuations.
Pfizer, United Technologies, Procter & Gamble, Microsoft and Google have been among the long list of multinationals that have blamed the US greenback for lost sales. Currency consultancy FiREapps says the losses could reach $12bn in the fourth quarter, three times the impact seen in the third quarter.
The currency swings have had a similar effect to monetary tightening, analysts say, and the difficulty is likely to be exacerbated as the European Central Bank unleashes a new round of bond buying. Bank of America expects full-year earnings forecasts to be clipped as strategists update 2015 foreign exchange and energy prices.
“The recent strength in the dollar has put American multinational companies on the back foot when it comes to revenue and earnings guidance for 2015,” says Nicholas Colas, chief market strategist at Convergex. “Moreover, the trend seems to be towards an even stronger dollar.

There’s plenty of talk about the dollar going to par against the euro.”

A stronger dollar has several effects on corporate earnings. For most, sales and profit earned abroad are suddenly worth less as companies translate results in euros, yen and so forth back into the US currency. Further, the cost to manufacture goods within the US has remained steady, forcing executives to either raise prices to protect margins at the loss of some orders, or maintain prices to avoid alienating customers.

At Apple, chief financial officer Luca Maestri says the Japanese yen and Russian rouble proved most costly, although profits were also hit by movements in the euro, and Australian and Canadian dollars. Mr Maestri says year-on-year growth in the company’s fiscal first quarter, which includes the festive shopping season, would have been 4 percentage points, or roughly $2.3bn, higher if currencies were constant.

In the current quarter currency shifts are likely to shave 5 percentage points off Apple’s growth, or $2.3bn. That is more than S&P 500 constituents Mattel, Royal Caribbean, SanDisk and Charles Schwab each generated in revenues in the final three months of 2014.

As “our existing hedges expire, they get replaced by new contracts at current levels, and therefore the protection that is provided to us by our hedging programme diminishes over time”, Mr Maestri said on a call with analysts. “It goes without saying a strong US dollar has a negative impact on our international business.”

Consumer staples behemoth Procter & Gamble, which owns Tide detergent, Crest toothpaste and Bounty paper towels, called the currency swings “unprecedented”, warning it would trim 5 per cent from sales and 12 per cent, or at least $1.4bn, from net earnings this year.
Howard Silverblatt, senior index analyst with S&P Dow Jones Indices, says the dollar has been “the excuse of the quarter”, with executives pointing to the currency for lacklustre results. More than two-fifths of S&P 500 sales are generated abroad, with the technology, energy and industrials sectors realising more than half of revenues outside of the US.

For the fourth quarter, earnings per share for the blue-chip index are expected to climb 6.4 per cent from a year earlier, marginally below forecasts at the start of December, according to S&P Dow Jones Indices. However, full-year 2015 forecasts have been trimmed drastically as the dollar soared and oil prices cratered. Analysts now predict S&P 500 earnings will rise 2.7 per cent in the current year, including a contraction in the first quarter, down from forecasts for as much as 12.3 per cent in October.

Each 10 per cent increase in the dollar against its trade-weighted peers will reduce S&P 500 earnings by about $3, Goldman Sachs notes. While bottom-up earnings estimates have been cut to roughly $120 per share for the index, most strategists on Wall Street still have a rosier view, indicating downgrades could be on the horizon.

“The impact of currency is all investors want to talk about following disappointing guidance by companies,” Amanda Sneider, a strategist with Goldman Sachs, says. “Investors appear willing to largely move past the translational impact of currency but remain concerned by the transactional impact.”