Black Hole Investing

By John Mauldin

Scientists say the rules change in a cosmic “black hole” at what astrophysicists call the event horizon. How do they know that? Not by observation, since what happens in there is, by definition, un-seeable. They infer it from the surroundings, which say that the mathematics of the universe as we understand them change at the event horizon.

Or maybe not. One theory says we are all inside a black hole right now. That could possibly explain a few things about central bank policy.

Last week I showed you Ray Dalio’s latest Three Big Issues article. To recap, Ray says we are now in a world where…

  • Central banks have limited ability to stimulate growth as we approach the end of a long-term debt cycle.

  • Wealth and political polarity are producing internal conflict between the rich and poor as well as between capitalists and socialist.

  • There is also external conflict between a rising power (China) and the existing world leader (the USA).

The world last saw this combination in the 1930s, which is not comforting, to say the least. But as I said, we can get through this together if we approach it wisely. That’s a big “if,” given the ways some investors behave at cyclical peaks, but people will do what they do. We can only control our own actions, and today I want to talk about some we can take.

We are approaching the black hole, which means we can’t rely on previously reliable strategies. Let’s start with a jolt of reality.

Realistic Forecasts

As investors we have to make assumptions about the future. We know they will likely prove wrong, but something has to guide our asset allocation decisions.

Many long-term investors assume stocks will give them 6–8% real annual returns if they simply buy and hold long enough. Pension fund trustees hire consultants to reassure them of this “fact,” along with similar interest rate and bond forecasts, and then make investment and benefit decisions.

Those reassurances are increasingly hollow, thanks to both low rates and inflated stock valuations, yet people running massive piles of money behave as if they are unquestionably correct.

You can, however, find more realistic forecasts from reliable, conflict-free sources. One of my favorites is Grantham Mayo Van Otterloo, or GMO. Here are their latest 7-year asset class forecasts, as of July 31, 2019.

Source: GMO

These are bleak numbers if you hope to earn any positive return at all, much less 6% or more. If GMO is right, the only answer is a large allocation to emerging markets which, because they are emerging, are also riskier. The more typical 60/40 domestic stock/bond portfolio is a certain loss, according to GMO. (Note these are all “real” returns, which means the amount by which they exceed the inflation rate).

Others like my friends at Research Affiliates (Rob Arnott), Crestmont Research (Ed Easterling), or John Hussman (Hussman Funds) have similar forecasts. They differ in their methodologies but the basic direction is the same. The point is that returns in the next 7 or 10 years will not look anything like the past.

If you think these are reasonable forecasts (I do), then one reaction is to keep most of your assets in cash for at least a fractionally positive, low-risk return. That’s simple to do. But it probably won’t get you to your financial goals.

Remember, though, this forecast is what GMO expects if you buy and hold those asset classes for the next seven years. Nothing requires most of us to do that. We are free to move between them and use other asset classes, too… which is exactly what I think we should do.

Profound Technological Change

I mentioned last week that technology will bring profound changes. I’m expounding on that in my book. It has major investment implications. Companies small and large, all over the world, are right now inventing new technologies that are going to change our lives.

I’ve used this example before, but think of the now-ubiquitous smartphone. Apple launched that category with the iPhone in 2007. Many who saw them as expensive toys at first now can’t live without them. That shows you how fast, and how deeply, a technology we didn’t even know we needed can change everyday life. Not always for the better, but the change is real.

The iPhone ecosystem around it spawned other successful companies. The productivity gains it gave users led to growth in seemingly unrelated fields.

We have a radically different (and, on balance, better) economy now than we would have without it.

Note also, the iPhone launched just months before the Great Recession began, and proved indispensable anyway. So our macro challenges, serious though they may be, won’t necessarily stop progress. They may even accelerate it.

I expect to see fortunes made in biotechnology, and particularly life extension and age reversal drugs, but that will only be the beginning.

Autonomous vehicle technology is going to restructure our cities and enhance our productivity as we put those traffic jam hours to better use. AI and Big Data will enable quantum leaps in many fields.

I could go on with more examples, but here’s the point: Innovation will continue in almost any economic scenario you can imagine. Recession will, at most, delay it a bit. Not every innovative company will succeed but some will, and the rewards will be huge. If you want capital gains, the opportunities will be there… but not in a passive index strategy. You will need active management and expert managers.

Owning index funds won’t help much because by definition most of these companies will start out small and not have meaningful presence in the indexes. By the time they are big enough to be meaningful, the really massive gains will have already been made. That means you will want to find active managers who focus on particular fields and allocate them some of your risk (not core!) capital. These will not be sure things.

Income Challenges

Now, capital gains aren’t (and shouldn’t be) everyone’s goal. Many of my Baby Boomer peers have assets but need current income, which is scarce and getting scarcer in this low-yield world. The way central banks are going, conventional debt instruments probably won’t do it.

This week the ECB lowered its base rate to -0.50% and announced it will stay there for a long time. I think it is increasingly obvious we are headed back to the zero bound on short-term US government debt. That will drag down interest rates on most fixed income instruments.

Here again, I think the market will provide solutions but they won’t be what once was thought of as “normal.” Our parents and grandparents could count on 5% or better yields in safe, predictable CDs and Treasury bills. That’s fantasy now. So, what do you do?

The first thing, if you’re not already fully retired, is to maximize your job income and increase your savings. Watch your spending, too. Now is not the time for frivolity. Be the ant, not the grasshopper.

That still won’t be enough for most income-seeking investors. We will need higher yields from our portfolios. Right now, this is more than a minor challenge unless you want to take significant principal risk. Government bonds yield nothing (or less) and corporate bonds are headed that way. High-yield bonds indeed have higher yields but also higher risk. What to do?

I think interest rates are going lower and will stay lower for a very long time, just as I and my fellow Boomers are hitting retirement age. (I’ll start getting Social Security when I turn 70 next month. I remember reading somewhere that I’ll earn something like 1 to 2% compound returns on my Social Security “investment.” Ouch.)

The good news is that markets eventually respond to demand. More and more companies will concentrate on returning investor capital. As businesses stabilize into steady cash flow, they will be able to pay increasingly higher dividends, and may find it is a good way to maintain their share prices. In addition, I think many old-fashioned value companies are getting ready to come back into favor as their steady dividends become attractive to a retiring generation.

Remember, there are different ways to slice this pie. It doesn’t have to be standard dividends. I expect innovative structures will emerge to offer yield with controlled risk—new kinds of preferred shares, convertible securities, etc. Some exist right now, but legal barriers restrict them only to the wealthiest investors. Here again, if the demand exists, elected officials will respond by relaxing those barriers.

Higher yields come with higher risk, of course. That’s why you should spread your capital across more than one and not risk too much on any one strategy. A strategy I have seen used with great success is simple high-yield bond timing. While those trading algorithms can be complex, even simple ones can sometimes yield above-market returns over a full cycle.

As my dad would tell me when I was growing up, “Son, betteth not thy whole wad on one horse.” That was as close to biblical language as he could get.

Central banks and politicians are the problem, not the solution. Last week President Trump openly told the Federal Reserve to reduce interest rates to zero or lower.

Seriously? What business activity will that encourage? The latest National Federation of Independent Business survey (by my good friend Bill “Dunk” Dunkelberg) clearly shows that small businesses aren’t worried about interest rates. What they need is more customers and predictable government policies. In a world of trade wars and potential currency wars brought on by central bank manipulation, predictable is not a word that comes to mind.

Further, do the president and his economic advisors understand the realities facing the average retiree? In this zero-interest-rate world, exactly how are retirees supposed to survive without taking much more risk than they should?

The financial repression emanating from central banks all over the world borders on criminal, and that they think they are “helping” us is risible.

They are on the verge of destroying a generation come the next recession.

They have encouraged retirees to seek yield and riskier investments precisely when they should not be.

They are robbing savers and asking us to say thank you because they are so wise.

Crazy Numbers

Many financial advisors, apparently unaware the event horizon is near, continue to recommend old solutions like the “60/40” portfolio. That strategy does have a compelling history. Those who adopted and actually stuck with it (which is very hard) had several good decades. That doesn’t guarantee them several more, though. I believe times have changed.

But those decades basically started in the late 40s and went up until 2000. After 2000, the stock market (the S&P 500) has basically doubled, mostly in the last few years, which is less than a 4% return. When (not if) we have a recession and the stock market drops 40% or more, index investors will have spent 20 years with a less than 1% compound annual return. A 50% drop, which could certainly happen in a recession, would wipe out all their gains, even without inflation.

And yes, there have been historical periods where stock market returns have been negative for 20 years. 1930s anyone? Yes, it is an uncomfortable parallel.

The “logic” of 60/40 is that it gives you diversification. The bonds should perform well when the stocks run into difficulty, and vice versa. You might even get lucky and have both components rise together. But you can also be unlucky and see them both fall, an outcome I think increasingly likely. Louis Gave wrote about this last week.

Historically, the optimized portfolio of choice, and the one beloved of quant analysts everywhere, has been a balanced portfolio comprising 60% growth stocks and 40% long-dated bonds. Yet recently, this has come to look less and less like an optimized portfolio, and more and more like a “dumbbell portfolio,” in which investors hedge overvalued growth stocks with overvalued bonds.

At current valuations, such a portfolio no longer offers diversification. Instead, it is a portfolio betting outright on continued central bank intervention and ever-lower interest rates. Given some of the rhetoric coming from central bankers recently, this is a bet which could now be getting increasingly dangerous.

(Over My Shoulder members can read Louis Gave’s full “Dumbbell Portfolio” article with a summary and key points. Not a member? Click here to join us.)

We are rapidly approaching the event horizon where central bank intervention and ever-lower interest rates will not help your bond portfolio. That is already the case in Europe and Japan. Stocks are at historically high valuations and subject to a severe bear market brought on by a recession.

“Diversification” is not simply owning different asset classes. They have to be uncorrelated to each other and, more important, stay uncorrelated. That was a problem in 2008 when lots of previously disconnected categories suddenly started moving in lockstep.

For the moment, I still think long-term yields will keep falling, helping the bond side of a 60/40 portfolio. Meanwhile, negative or nearly negative yields will push more money into stocks, driving up that side of the ledger. So 60/40 could keep firing on all cylinders for a while. But it won’t do so forever, and the ending will probably be sudden and spectacular.

Which brings us to my final point. The primary investment goal as we approach the black hole should be “Hold on to what you have.” Or, in other words, capital preservation. But you may not realize that capital preservation can be better than growth, if the growth comes with too much risk. Here’s the math.

  • Recovering from a 20% loss requires a 25% gain

  • Recovering from a 30% loss requires a 43% gain

  • Recovering from a 40% loss requires a 67% gain

  • Recovering from a 50% loss requires a 100% gain

  • Recovering from a 60% loss requires a 150% gain

If you fall in one of these deep holes you will spend valuable time just getting out of it before you can even start booking any gains. Once you start to fall, the black hole won’t let go. Far better not to get too close.

Friends don’t let friends buy and hold. I can’t say that strongly enough. You must have a well thought out hedging strategy if you’re going to be long the stock market. If your investment advisor simply has you in a 60/40 portfolio and tells you that “we are invested for the long term and the market will come back,” pick up your capital and walk away. I can’t be any more blunt than that.

Every investment advisor, including me, uses these words in their disclosure documents: Past Performance Is Not Indicative of Future Results. I think that has never been more true than for the coming decade. The 2020s will be more volatile and difficult for the typical buy-and-hold index fund investor than anything we have seen in my lifetime.

Active investment management is not particularly popular right now since passive strategies have outperformed. But I think that is getting ready to change. You should start, if you’re not already, investigating active management and more proactive investment styles. You will be much happier if you do.

Personally, I am still happily invested in a number of hedge funds but the strategies I select are limited, as many hedge fund styles have seen great challenges in producing acceptable risk/reward returns.

That is getting ready to change. I believe some hedge fund styles like the distressed debt, fixed income and event driven spaces are going to be very attractive. Who knows? Maybe even long/short funds will eventually find their former mojo.

At the economic event horizon, we all need to become black hole investors. Relying on past performance as the tectonic plates shift underneath us, as the central bank black holes begin to suck historical performance into their maws, we must look forward rather than backwards to design our portfolios.

At the event horizon, as the Jefferson Airplane song of my youth says, logic and proportion are fallen sloppy dead. You better feed your head with much more forward-looking strategies.

Sunday I will fly to New York, meeting with old friends and new, and researching some management styles and managers, along with a few new biotech investments. Yes, my own personal focus is on biotech, and I do have a larger position of my personal portfolio in biotech stocks than I do in other areas. I should probably take a more holistic approach, but I actually give money to other managers who focus on different parts of the market, and spend more of my personal portfolio time on biotech. Ask me in 10 years if that was a good decision.

Tuesday night I get to be with Danielle DiMartino Booth on her birthday in New York, celebrating it with a number of our mutual friends. Danielle was Richard Fisher’s personal researcher at the Dallas Fed and now writes the must-read Daily Feather newsletter.

In one of the early Batman movies, the Joker says, “Where does he get all those wonderful toys?” I read The Daily Feather and I ask myself, “Where does she get all those wonderful stories and analogies?” And the data is truly a marvel.

I’ll be back in Puerto Rico on Wednesday afternoon, with meetings in San Juan before returning home to Dorado. Then the next Monday I will fly to Houston in the early evening. I will spend the next day with my partners at SMH (Sanders, Morris, Harris) going over strategies for clients and meeting with companies (yes, one might be biotech) and hopefully Texas barbecue for dinner. Then up early the next morning to go back to Puerto Rico.

Theoretically, I have no travel scheduled for the next month after that. But past performance suggests that something will happen to keep me from staying home for 30 days straight. We’ll see…

And with that, I will hit the send button. You have a great week and I hope you get to spend it with good friends and great conversation. It’s hard to get any better than that combination.

Your trying to figure out how I got old enough to get Social Security analyst,

John Mauldin
Co-Founder, Mauldin Economics


How rock-bottom bond yields spread from Japan to the rest of the world

Japan’s impact is felt keenly in American and European corporate-credit markets

IT WOULD BE hard to think of a business that is on the face of it quite as dull as Norinchukin Bank. A co-operative, it was founded almost a century ago to take deposits from and lend to Japanese farmers. Yet Norinchukin came blinking into the spotlight earlier this year when it emerged that it had been a voracious buyer of collateralised loan obligations (CLOs)—pools of risky business loans used to finance buy-outs by private-equity firms. At the last count, in June, Norinchukin owned $75bn-worth.

The escapades of Norinchukin offer a parable. One part of its lesson is that when interest rates are stuck near zero for a long time, as they have been in Japan, banks’ normal source of profits comes under pressure. The other part is the lengths to which they must go to boost those profits, in this case by buying exotic foreign securities with attractive yields.

Norinchukin is not alone. Japanese banks and insurance companies have been big buyers of the triple-A-rated tranches of CLOs, as well as other sorts of investment-grade corporate debt.

For this, blame negative bond yields. When the Bank of Japan’s board meets on September 19th, it is not expected to reduce its main interest rate, currently -0.1%. But any increase in interest rates seems a long way off. And as long as rates are at rock-bottom in Japan, it is hard for them to rise in other places. Bond-buying by desperate Japanese banks and insurance companies is a big part of what keeps a lid on yields elsewhere.

Japan’s sway on global asset markets has been felt ever since it liberalised its capital account in 1980. Later that decade Japanese investors snapped up trophy properties in America, such as the Rockefeller Centre in New York and Pebble Beach golf course in California. In the 1990s they piled into American tech firms. Both forays ended badly, but Japan’s stock of foreign securities has kept growing as its surplus savings have piled up.

Japan is already the world’s biggest creditor. Its net foreign assets—what its residents (government, householders and firms) own minus what they owe to foreigners—are worth around $3trn, or 60% of its annual GDP. And that understates Japan’s influence on global asset markets. Since 2012 both sides of its national balance-sheet have grown rapidly (see chart), as Japanese investors borrowed abroad to buy yet more assets.

Japan’s impact is felt most keenly in corporate-credit markets in America and Europe. Its pension and insurance firms, which need to make regular payments to retirees, are at least as hungry for bonds with a decent yield as are their peers elsewhere. But the grasping for yield is made all the more desperate by the struggles of Japan’s banks.

It is hard to make money from lending to the government when bond yields are negative. In ageing, high-saving Japan, private-sector borrowers are scarce. So bank profits have suffered.

A report last year by a financial regulator found that half of Japan’s regional banks lost money on their lending businesses.

Though yields in Europe are lower than in America, they are nevertheless attractive to Japanese buyers who hedge their currency risk. Most currency hedges are for less than a year and many are for three months. The cost of such hedges is linked to the cost of short-term borrowing in the foreign currency.

A rising yield curve thus gives the best currency-hedged returns: the yield is high at the long end but short rates are low. For that reason, currency-hedged Japanese investors have preferred to buy corporate bonds or other credit securities in Europe rather than in America, where short-term interest rates are relatively high.

Locals lament that high-quality European and American corporate bonds are treated as safe assets, akin to sovereign bonds. Analysts’ efforts to work out which companies are more or less likely to default, and so which bonds are more or less valuable, seem almost quaint. “The Japan bid is not driven by credit risk,” complains one analyst. “It is all about headline yield.”

Some see Japan as a template: its path of ever-lower interest rates one that other rich, debt-ridden economies have been destined to follow and will now struggle to escape. But Japan’s troubles also have a direct influence on other countries. This makes itself felt through the country’s considerable sway over global capital markets.

The outworkings are strange and unpredictable. Who would have thought that the rainy-day deposits of Japan’s farmers and fishermen would be used to fuel leveraged buy-outs in America and Europe?

ECB Launches Major Stimulus Package, Cuts Key Rate

Central bank’s rate cut triggered an immediate response from President Trump

By Tom Fairless

FRANKFURT—The European Central Bank cut its key interest rate and launched a sweeping package of bond purchases Thursday that lays the ground work for what is likely to be a long period of ultraloose monetary policy, jolting European financial markets and triggering an immediate response from President Trump.

The ECB’s pre-emptive move was aimed at insulating the eurozone’s wobbling economy from a global slowdown and trade tensions.

It is the ECB’s largest dose of monetary stimulus in 3½ years and a bold finale for departing PresidentMario Draghi,who looks to be committing his successor to negative interest rates and an open-ended bond-buying program, possibly for years.

The move triggered immediate criticism from German banks, while leaving key practical questions unanswered. Primarily: How long can the ECB keep buying bonds without enlarging the pool of assets it can buy? Some analysts estimated it might be less than a year.

The euro fell against the dollar after the decision was announced, down 0.4% at $1.10, before recovering. Eurozone government bonds rallied as investors anticipated a longer period of low interest rates and the return to bond markets of a giant buyer.

In a tweet, Mr. Trump said the ECB was “trying, and succeeding, in depreciating the Euro against the VERY strong Dollar, hurting U.S. exports.” 

The ECB joins central banks around the world, including the Federal Reserve, that have been cutting interest rates in recent weeks amid a bitter trade dispute between the U.S. and China, a fall in trade volumes and a slowdown in global growth. Second-quarter figures released Thursday by the Organization for Economic Cooperation and Development showed year-to-year economic growth in the Group of 20 leading economies was at its weakest since the start of 2013.

The Fed is expected to cut its key interest rate by a quarter percentage point next week, following a similar cut in July, its first since 2008.

In a statement, the ECB said it would cut its key interest rate by 0.1 percentage point, to minus 0.5%, and start buying €20 billion ($22 billion) a month of eurozone debt, restarting a so-called quantitative easing program that it only phased out last December.

The new QE program is expected to “run for as long as necessary,” and only to end shortly before the bank starts raising interest rates, the ECB said.

The ECB also promised not to raise interest rates “until it has seen the inflation outlook robustly converge” with its target of just below 2%. Thursday’s cut was the ECB’s first since March 2016.

“The final showdown has started with a big bang,” saidCarsten Brzeski,an economist with ING in Frankfurt.

Government bond yields fell across Europe as investors welcomed the package. Benchmark German 10-year bund yields traded at minus 0.66%, down from minus 0.56% earlier in the day. Italian 10-year bond yields dropped sharply, to 0.80% from above 1% earlier in the day. Yields on U.S. Treasurys also fell across the maturity spectrum.

Mr. Draghi said at a news conference that the ECB had acted in response to persistently weak inflation, and a drop in investors’ expectations for future inflation. Recent economic data have shown “a more protracted weakness of the euro area economy, the persistence of prominent downside risks and muted inflationary pressures,” he said.

The ECB’s policies are politically sensitive on both sides of the Atlantic. Mr. Trump criticized Mr. Draghi on Twitter in June for signaling that fresh ECB stimulus was coming. The president has repeatedly criticized the Fed for being less aggressive.

“The Fed sits, and sits, and sits,” Mr. Trump tweeted on Thursday, responding to the ECB’s move. “They get paid to borrow money, while we are paying interest!”

Asked about Mr. Trump’s tweet, Mr. Draghi said the ECB doesn’t target the euro exchange rate. “We have a mandate, we pursue price stability and we don’t target exchange rates. Period,” he said.

Some have questioned whether the fresh shot of stimulus will succeed in protecting the eurozone economy from an international trade war that shows little sign of abating. With borrowing rates in the eurozone already exceedingly low, the economy won’t benefit much from the stimulus, say Mr. Draghi’s critics.

By launching such a bold stimulus package, Mr. Draghi has left the central bank with very little ammunition to fight any new downturn. Unlike the Fed, the ECB never raised interest rates or trimmed its bondholdings during the economic recovery.

Crucially, ECB officials didn’t decide to enlarge the pool of assets the bank can buy, probably reflecting divisions within the committee over how to expand the program further. ECB officials from northern Europe are wary about dipping further into government debt markets or buying new types of assets such as equities, as the Bank of Japanhas done.

Frederik Ducrozet,an economist with Pictet Wealth Management in Geneva, estimated that the ECB can only continue its bond purchases for 9-12 months under the current rules of its QE program. Those rules prohibit the bank from buying more than a third of any government’s debt.

Mario Draghi, President of the European Central Bank at his penultimate meeting, Sept. 12. Photo: ronald wittek/Shutterstock

Mr. Draghi said, “There was no appetite to discuss limits, because we have the headroom to go on for quite some time without raising the discussion about limits.”

“Despite all the market excitement now, the question remains whether this will be enough to get growth and inflation back on track as the real elephant in the room is fiscal policy,” said Mr. Brzeski.

The eurozone economy’s growth has slowed to less than 1%, half the pace of the U.S. Europe has been hit hard by international tensions around trade because of its reliance on exports, with Germany—the region’s economic powerhouse—particularly vulnerable. The bloc also faces the possibility of a disorderly exit from the European Union by the U.K., a prospect that could seriously disrupt business and finance.

The package also binds the hands of Mr. Draghi’s successor, former International Monetary Fund Managing DirectorChristine Lagarde,who will take office on Nov. 1.

Eurozone inflation has been running far beneath the ECB’s target rate of just below 2%, and it isn’t expected to return to target for years.

With interest rates falling further below zero, the ECB also moved Thursday to provide relief for the region’s embattled banks, whose profits have been hurt by negative interest rates. The ECB will create a mechanism to shield banks from the full force of negative rates, and sweeten the terms of a fresh batch of long-term loans.

How U.S. Banks Took Over the World

A decade ago, they almost brought down the global financial system. Now they rule it.

By Liz Hoffman and Telis Demos

America's banks have rarely been so dominant in global finance. A decade after fueling the financial crisis, they are the top choice for companies looking to move or raise money and merge. Photo: Photo Illustration by Emil Lendof/The Wall Street Journal; Photos: iStock

When two of Europe’s corporate titans sat down to negotiate a merger this year, they called American banks.

Fiat Chrysler Automobiles hired Goldman Sachs Group Inc. GS -2.42%▲ as its lead adviser. France’s Renault SAhired a boutique bank stacked with Goldman alumni. In a deal that would reshape Europe’s auto industry, the continental banks that had sustained Fiat and Renault for more than a century were muscled aside by a pair of Wall Street deal makers.

A decade after fueling a crisis that nearly brought down the global financial system, America’s banks are ruling it. They earned 62% of global investment-banking fees last year, up from 53% in 2011, according to Coalition, an industry data provider. Last year, U.S. banks took home $7 of every $10 in merger fees, $6 of every $10 in stock commissions, and $6 of every $10 paid to hold and move corporate cash.

Europe’s banks are smaller, less profitable and beating a hasty retreat from Wall Street. Germany’s Deutsche Bank AG DB 0.69%▲ is firing thousands of investment bankers. Switzerland’s UBS Group AG abandoned its huge trading floor in Stamford, Conn., to refocus on its roots as a private bank.

Barclays BCS -0.30%▲ is the lone holdout with an ambition to be a universal global bank. Under Chief ExecutiveJes Staley,an American who rose to prominence at JPMorgan Chase JPM -1.18%▲ & Co., the bank has resisted shareholder calls to go back to its roots serving British consumers and companies.

From their central perch in London and with close ties to developing countries, Europe’s banks were primed to benefit as financial services went global. They charged onto Wall Street in the 1990s and pressed their advantage as U.S. banks limped out of the 2008 crisis.

Then, “they handed the whole system on a platter to the Americans,” saidColm Kelleher,the Irish-born former Morgan Stanley executive.

Coming out of the crisis, U.S. banks quickly raised capital and shed risk, unpleasant tasks that Europeans put off. American businesses recovered quickly, and its consumers are eager to borrow and spend. A tax cut in 2018 boosted profits. Interest rates have risen.

Meanwhile in Europe, regional economies are sputtering and borrowing has slowed. 

Central bankers have cut interest rates below zero, which leaves banks struggling to eke out a profit on loans. Banking policy in Europe remains fractured, with national and continental regulators pursuing often conflicting agendas.

“It is not our remit to promote national, or even European, champions,” saidAndrea Enria,the European Central Bank’s top banking regulator.

Twenty-five years ago, European banks charged into the U.S. They bought storied firms like Donaldson, Lufkin & Jenrette and Wasserstein Perella and dangled big paydays for rainmakers. When Deutsche Bank announced a $10 billion takeover of Bankers Trust in 1998, it promised at least $400 million in bonuses to retain top bankers.

The challenges of merging a conservative European commercial lender and a U.S. derivatives shop gave competitors pause. Goldman’s CEO,Hank Paulson,shared his doubts with a hotel ballroom of his bankers: Deutsche Bank “just signed up for 10 years of pain,” attendees remember him saying.

Henry Paulson is sworn in as Treasury secretary by Supreme Court Chief Justice John Roberts in 2006. Before he headed the Treasury, he ran Goldman Sachs. Photo: Jim Young/REUTERS

But in an era of cheap debt and light regulation, the land grab seemed to pay off. Deutsche Bank had a $3 trillion balance sheet in 2007 and that year earned twice as much as Bank of America securities-trading. Royal Bank of Scotlandwas briefly the largest bank in the world, wielding a balance sheet bigger than Britain’s entire economy.

Even the financial crisis looked at first like an opportunity. When Barclays PLC bought Lehman Brothers in a fire sale, it got 10,000 of the firm’s U.S. bankers and few of its bad debts. On Lehman’s Times Square trading floor, the loudspeakers played “God Save The Queen.” Deutsche Bank pounced on Wall Street’s clients.

The high-water mark was in 2011, when global investment-banking fees were roughly split between European and U.S. firms.

The good times didn’t last. A 2012 sovereign-debt crisis across the continent put new pressure on the region’s biggest banks. Economic growth slowed across the continent. Central bankers turned interest rates negative in 2014. German media calls them “Strafzinsen,” translating roughly to “penalty rates.”

UBS slashed 10,000 jobs and cut big parts of its trading operation. Royal Bank of Scotland fired thousands of investment bankers and sold its U.S. retail arm to focus on the U.K. Three-quarters of the Lehman bankers Barclays picked up in 2008 were gone within five years, according to Financial Industry Regulatory Authority records.

Meanwhile, U.S. banks were quietly encroaching on European rivals’ territory. In 2009, JPMorgan completed an acquisition of Cazenove, the U.K. investment bank. Every year since 2014, JPMorgan has generated more investment-banking revenue across Europe than anyone else, according to Dealogic. (The London-listed owner of Peppa Pig, a British cartoon character, hired JPMorgan Cazenove to advise on its sale in August to U.S. toy giant Hasbro Inc.)

As U.S. banks got stronger and their European rivals weakened, client loyalties began to change.

Today’s companies are increasingly global. They make more of their money in the U.S. and have swapped a shareholder register stacked with old-line European families and trusts for the likes of BlackRock Inc.and other U.S. investment giants, where Wall Street banks are better connected. The percentage of U.K. companies’ stock owned by foreigners rose from 16% in 1994 to 53% in 2016, according to government statistics.

Fiat, the Italian car maker that pursued a tie-up with France’s Renault this year, makes two-thirds of its money in the U.S., where it owns Chrysler. Its shots are called byJohn Elkann,the New York-born scion of the family that founded Fiat in 1899.

One of Mr. Elkann’s closest advisers is a Goldman Sachs banker who for the past 15 years has organized a yearly gathering of European billionaire business owners, according to people who have attended. They swap stories, share advice and, more often than not, hire Goldman for deals. 

Globalization has cost the Europeans not just on headline-grabbing mergers, but in the everyday business of managing money for clients. Deliveroo, a food-delivery startup based in the U.K., sought to ramp up in Europe and the Middle East. Instead of hiring local banks in each market, it consolidated its money flows with Citigroup , C -1.45%▲ which has local licenses in 98 countries and a global digital platform.

JPMorgan has made a big push to expand transaction banking for European clients. In 2010 it established a new unit of global bankers to pitch day-to-day transaction services to big companies, and later took over dozens of European transaction relationships from RBS.

UBS’s Stamford, Conn., trading floor in 2005. It was able to accommodate 1,400 traders and staff. Photo: Rick Friedman/Corbis/Getty Images

Most recently JPMorgan said it is extending its commercial banking business globally, targeting hundreds of midsize businesses across Europe. It has sought to take on a more local flavoring, doing things like sponsoring math-and-science programs for students in France, Germany and Italy.

Last year, Citigroup and JPMorgan were two of the three biggest providers of day-to-day transaction banking globally, along with Britain’s HSBC HoldingsPLC, according to Coalition. U.S. banks accounted for 57% of the global transaction-banking revenue pool among the biggest banks in that business, versus 22% for Europeans, Coalition said.

The German Economy Is Running Out of Options

Germany can no longer rely on the European Central Bank to prop up its exporters.

By Ryan Bridges


It’s crunch time for Germany and the European Central Bank. For close to a decade, the ECB has been cutting interest rates while urging member states that have funds for fiscal stimulus (read: Germany) to use them. The ECB grew increasingly desperate to stimulate the eurozone economy and raise inflation, and in 2015, it finally introduced its asset purchases program. It continued to urge the German government to act in order to support growth throughout the bloc, and Germany continued to refuse. From Berlin, things didn’t look so bad. The ECB’s easy money kept the value of the euro down, which gave a boost to German exports and the German budget, practically without Berlin having to lift a finger. Until the second half of 2018, the German economy was riding high, even as German politicians and bankers lamented the effect that the ECB’s low interest rates were having on German savers and bank profits.

But now, Germany’s economy is slowing. China isn’t growing as quickly as before, while Brexit and the U.S.-China trade war (not to mention the threat of U.S. tariffs on European goods) have hurt business and consumer confidence.

The Bundesbank, Germany’s central bank, wrote in its August monthly report that the economy was likely to slip into a technical recession in the third quarter.

After all this time, the ECB’s dovish policies, intended to prop up struggling Southern European economies, are finally starting to make sense for the eurozone’s largest economy, too.

There are just two problems: First, Germany’s monetary hawks, of which there are many, don’t yet see things that way. Second and more important, the ECB’s options for stimulus are almost entirely depleted. There’s a bit more that can be done, but not without stretching the limits of European Union law and agitating the already testy Germans. If the German economy is going to get a boost, it’ll need to come from within.


To Ease, or Not to Ease
At its last meeting in late July, the ECB Governing Council expressed its determination to act if inflation in the eurozone did not move closer to its 2 percent target. Investors came away expecting a further lowering of the rate charged on banks’ deposits with the ECB and a resumption of asset purchases, which were wrapped up only at the end of 2018.

The Governing Council meets again on Sept. 12, but Germany’s hawks are already fearing the worst and pushing back. Bundesbank President Jens Weidmann, in an interview last week with the Frankfurter Allgemeine Sonntagszeitung, criticized the tendency to look to monetary policymakers for major responses to every blip in the data. Sabine Lautenschlaeger, a German member of the ECB’s executive board, said it was too soon for a huge stimulus package. (The Dutch and Austrian central bank chiefs have voiced similar concerns.) The chief German economist at Deutsche Bank, Stefan Schneider, explained the German conservative perspective nicely, writing that “Anglo-Saxon” policymakers and economists were wrong to believe that smart policies could sustain economic expansions indefinitely. The last time a German government tried to outsmart market forces, he wrote, it ended up triggering the stagflation period of the 1970s and 1980s.

The German monetary hawks’ assessment is that the current slowdown is not yet a crisis and doesn’t have to become one if policymakers just keep their wits about them. The causes of the downturn are idiosyncratic and external: the U.S.-China trade war, China’s slowdown and uncertainty surrounding the United Kingdom’s departure from the EU. Those factors will work themselves out, confidence will rebound and growth will resume. And if the problems are all external, the solutions can’t be found internally – neither by monetary easing nor by a decision by Berlin to issue new debt. Only if the recession lingers or deepens should authorities jump into action.

The ECB, which was modeled after the Bundesbank but philosophically has resembled it less and less since the eurozone crisis began, doesn’t see things the same way.

But its toolkit is nearly empty. The central bank’s main refinancing rate is already at zero percent. The deposit rate has been at minus 0.4 percent since March 2016, and there’s little expectation that deeper cuts would have much effect on growth. More attention has focused on the central bank’s asset purchases program, particularly the 2.1 trillion-euro ($2.3 trillion) Public Sector Purchase Program, which involves buying government bonds. The ECB’s self-imposed issuer limit caps its holdings of each country’s debt at 33 percent to prevent the central bank from gaining a blocking minority (which would enable it to vote down future restructuring proposals) and to defend it against charges that the program amounts to monetary financing, which is banned under EU law. Reuters estimates that the ECB already holds 30 percent of German, Dutch and Finnish government debt. With this in mind, the ECB is reportedly considering raising the limit to 50 percent, which would surely spark legal challenges in Germany. Indeed, one such challenge is still working its way through the German Federal Constitutional Court. A ruling against the ECB would be unexpected, but if it were to happen, it might force the Bundesbank to cease participation in the Public Sector Purchase Program, potentially endangering the whole program.
The Fiscal Option
If monetary policy options are almost tapped out, Berlin may have no choice but to open the fiscal spigot – if, fiscally conservative policymakers caution, the recession deepens or lingers. Outside of Germany, calls for the government to do something – invest more in physical and digital infrastructure and climate protection, cut taxes, reduce barriers to investment, etc. – have reached a fever pitch. In recent months those calls have even spread inside Germany itself.

The German government started hinting at greater flexibility on spending early last month. An unnamed senior government official told Reuters in early August that Berlin may scrap its commitment to balanced budgets in order to finance a climate protection program. A high-ranking member of the Social Democratic Party, the junior partner in Germany’s governing coalition, reportedly said the balanced-budget policy was untenable. The following week, officials in the chancellery and Finance Ministry told German weekly magazine Der Spiegel that Chancellor Angela Merkel and her finance minister were prepared to set principle aside and take on new debt to stabilize the economy in a crisis. Days later, Finance Minister Olaf Scholz attached a number to the rumors: 50 billion euros, the same size, he said, as the stimulus plan Berlin put together in 2009. (In fact, it is the size of Germany’s second stimulus package. Two other packages in 2008 and 2009 totaled 11 billion euros and 8.5 billion euros, respectively.)

The days when the ECB’s easy money policies can prop up German exports – or the eurozone economy – seem to be coming to a close. Gradually, the German political establishment is recognizing that the country’s economy needs a boost and that no salvation is likely to come from outside sources (quite the opposite – U.S. car tariffs could hit later this year), or indeed from that central bank that it loves to hate. In the short term, tax cuts, which are already in the works, and stimulus measures like the 2009 “cash-for-clunkers” car scrappage scheme can help. But decades of underinvestment have taken their toll. The good news for Germany is that its years of scrimping have given it significant fiscal room to maneuver. Higher levels of spending in Germany would be a relief for other European economies and would take some of the pressure off the ECB. The bad news is that not everyone agrees that action is warranted, and even among those who do, there’s no consensus that German policies contributed to the slowdown in the first place.

Two Systems, One World

Like the twentieth-century Cold War between the United States and the Soviet Union, the new rivalry between China and the West is a contest between fundamentally incompatible political systems. And the idea that freedom and democracy will prevail can no longer be taken for granted.

Joschka Fischer

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BERLIN – With the 30th anniversary of the fall of the Berlin Wall approaching, the issue of freedom has returned to the fore in Moscow and Hong Kong, albeit under very different historical and political circumstances. We are reminded that the modern era was built on freedom, and on the recognition that all people are born equal.

This radical Enlightenment idea, when it took hold, constituted a break from all previous history. But times have changed. In the twenty-first century, we are confronted with a fundamental question: Could a modernized form of authoritarianism represent an alternative to liberal democracy and the rule of law?

In 1989, the obvious answer to that question would have been no, not just in the West but around the world. Since then, however, we have witnessed the revival of nationalism in Europe, the failure of the Arab Spring, the election of US President Donald Trump, Russia’s relapse into revanchism, and the emergence of a global China. Now, all bets on liberal democracy are off.

China’s emergence as a second military, economic, and technological superpower suggests that there is now an alternative development model. In modern China, the rule of law and democracy are regarded as a threat to one-party rule. Hence, the ongoing protests for freedom and democratic accountability in Hong Kong expose a division not just between two normative frameworks, but between two systems of political power.

For a while, China appeared to have found a formula for bridging this divide. The principle of “one country, two systems” was supposed to allow for the orderly reintegration of Hong Kong and (more aspirationally) Taiwan. Should this formula now fail in Hong Kong, there will be an immediate escalation of military tensions across the Taiwan Strait, because the island’s continued special status will become impossible for the Chinese government to accept or ignore.

Still, the formula has indeed worked so far. Hong Kong has become extraordinarily important to the Chinese economy, because it provides access to global capital markets and serves as a financial gateway for inward foreign direct investment. And the relationship with Taiwan has, for the most part, remained relatively quiet.

The arrangement with Hong Kong worked because the government in Beijing showed ample consideration for the city’s semiautonomous status. But as China has grown stronger, its perception of itself as a new global superpower has produced a change in behavior. The Chinese authorities are exerting ever more influence in Hong Kong, suggesting that they want to move in the direction of “one country, one system.”

The proposed law (since suspended) to enable the extradition of people arrested in Hong Kong to mainland China was widely seen as a threat to democracy and the rule of law in the former British colony. The authorities in Beijing know perfectly well that this attempt to weaken Hong Kong’s autonomy – not covert operations by foreign intelligence services – is why millions of people have taken to the city’s streets.

Given the current power structures in China (and Russia), the mass protests this summer in Hong Kong (and Moscow) have little to no chance of success in the short term. Yet they are significant nonetheless, because they provide a foil for the democratic malaise that has spread throughout the West.

More broadly, the division of the world into two systems immediately brings back memories of the Cold War. But in that conflict, the main issue was military strength – hence the centrality of the nuclear-arms race. When it came to living standards, the Soviet Bloc never really had a chance (as was obvious in the so-called Kitchen Debate between then-US Vice President Richard Nixon and the Soviet leader, Nikita Khrushchev, in 1959).

The competition with China, however, will be precisely about the question of which system delivers more in terms of technological and material progress. China’s ascent from a poverty-stricken developing country to an economic powerhouse is one of the greatest achievements of the modern era. Millions of people have been lifted out of poverty and into a growing consumption-oriented middle class, and millions more could soon follow them.

At the same time, although China has been building up its military, it has not exerted force beyond its immediate neighborhood, unlike the Soviet Union. When China pursues its strategic interests in Africa and Eastern Europe, it does so through economic and financial means. It owes its growing global influence not to its military, but to its economy and its growing capacity for rapid technological innovation. For the West, the “Chinese Challenge,” then, is to show that its model of democracy is still better suited than Eastern-style authoritarianism for the majority of humankind.

In this larger contest, US President Donald Trump is something of a Chinese Trojan Horse. Although he is waging an aggressive trade and technology war against China, he is also doing everything he can to undermine the credibility of the Western model. In historical terms, his attacks on democracy will prove far more consequential than his tariffs. Making matters worse, Europe, with its obvious economic weaknesses and geopolitical naiveté, is also failing to marshal a defense of the Western model.

At this stage, China’s ascent cannot be prevented. The country is simply too large and too strong to be boycotted or contained; at any rate, the Chinese people’s desire to share in global prosperity is entirely legitimate. The West has little choice but to maintain good relations with the new superpower, while at the same time defending its values.

The rise of China – and of the Chinese system – will inevitably create more competition, and these new rivalries must be handled peacefully at all costs. A world with eight billion people cannot afford a global conflict.

Whether China’s model of authoritarian modernization can succeed in the long term is a question for future generations of Chinese. Those with no memories of past horrors such as the Cultural Revolution may simply regard the Chinese model as a matter of course.

But the modern age was built on liberty. As we have seen in this summer in Hong Kong and Moscow, that lesson will not be forgotten anytime soon.

Joschka Fischer was German Foreign Minister and Vice Chancellor from 1998-2005, a term marked by Germany's strong support for NATO's intervention in Kosovo in 1999, followed by its opposition to the war in Iraq. Fischer entered electoral politics after participating in the anti-establishment protests of the 1960s and 1970s, and played a key role in founding Germany's Green Party, which he led for almost two decades.