In an article posted on the Liberty Street Economics blog of the Federal Reserve Bank of New York (“NY Fed”), authors James Vickery and April Meehl concluded that the latest NY Fed Report Quarterly Trends for Consolidated U.S. Banking Organizations demonstrates significant improvement in the performance of bank loan portfolios over the past few years.
- Emmanuel Macron’s election as President of France has buoyed European markets, as it is the third election this year in which populist candidates have been defeated. Moreover, with Angela Merkel’s party scoring key wins in regional elections, her chances of being re-elected in the fall are high.
- In addition to lessened political risks, investors have been attracted by better-than-expected economic performance in the European Union (EU) this year. Germany’s economy has been the locomotive, and Macron’s election has raised hopes that France will finally embark on much-needed structural reforms and that a renewed Franco-German partnership will revive the EU, as well.
- Weighing these considerations, this may be a good time to add exposure to European equity markets: Profit growth has surged recently and political risk has lessened, while the discount on European stocks relative to the U.S. is in line with long-term norms. The main risks are that Macron may not be able to deliver reforms and a populist leader could become Italy’s next President.
Background: EU Political Risks Lessen, while European Economies Improve
At the start of this year, a key issue relating to Europe was the prospect that elections in several countries – notably, Austria, Holland, France, Germany and Italy – could result in populist victories that would threaten the EU’s viability in the wake of last year’s vote in the UK in favor of Brexit. France’s election was perceived to be the most important, because Marine Le Pen, the far right candidate, advocated that France should leave the EU and the euro. While the odds of this happening were low, investor concerns heightened leading up to the first round elections, when there was a possibility Le Pen and far-left candidate, Jean-Luc Mélenchon, could be the two finalists. In the event, Emmanuel Macron, a centrist politician who campaigned as a reformer, emerged as the front runner and went on to defeat Le Pen handily in the run-off.
In the wake of these developments, European equity markets rallied at one point by 5%, led by an 8% advance for the CAC. The rally not only reflects investor relief that France will remain a core member of the EU, but also that the tide of populism on the continent has been contained: The French election is the third in a row in which populist candidates were defeated, and recent state elections in Germany indicate that Angela Merkel’s prospects for being re-elected Chancellor appear very good.
At the same time, the EU has experienced better-than-expected economic performance, led by Germany: The 2.5% annualized rise in German GDP in the first quarter was the biggest in four quarters, and was well above potential (1.8% according to European Commission estimates.) Investment in machinery and equipment also picked up in the quarter, suggesting a broadening of the expansion, which had been led by personal consumption. German GDP in real terms is now 8.5% above its pre-crisis peak in 1Q 2008, well above other EU members. Meanwhile, unemployment in Germany has fallen below 4% from a peak of more than 10% during the crisis.
For the EU as a whole, real GDP growth was 2% annualized, the best showing in the past two years. The improvement in growth is linked to the European Central Bank’s policies to keep interest rates near zero while expanding its balance sheet via asset purchases. In addition, the 10% depreciation of the euro against the dollar in the past three years helped boost exports.
As in the United States, so-called “soft data” such as purchasing managers’ indexes and sentiment readings show a marked pick-up since the latter part of 2016. Indeed, according to Credit Suisse, the latest PMI readings are consistent with EU growth accelerating to 3% (see Figure 1). We would note, however, that hard economic data does not yet indicate the improvement in business sentiment. Nonetheless, the latest EC forecast calls for the EU to grow by 1.7% this year, which is a considerable improvement from the past few years.
Figure 1: European PMI Surveys Point to Stronger Growth
Source: Thomson Reuters, Markit, Credit Suisse.
Another positive development is headline CPI has accelerated this year and is approaching the ECB’s 2% target, after running close to zero in 2015-2016. This suggests the threat of deflation is waning, and the ECB can consider normalizing interest rates if this pattern continues. That said, we believe the ECB will be very cautious about tightening monetary policy.
Will Macron Transform France and the EU?
To some extent, the boost in European equities since the first round of the French elections can be attributed to a relief rally that Marine Le Pen was not elected. Beyond this, in the wake of Macron’s very decisive victory, some observers have asked whether the election could represent a turning point for France and the EU: Macron is a reformer who also seeks closer ties between France and Germany, which constitute the core of the euro-zone.
Soon after his election, Macron visited German Chancellor Angela Merkel, and both pledged to work closely to draw up a “road map” of reforms for the EU, including the possibility of implementing treaty changes, if necessary. Merkel noted that work first needed to be conducted on reforms that are needed before changes in the EU treaty would be implemented. One of the most important is the need for greater fiscal sharing if the EU is to evolve from a monetary union to a fiscal union. To go down that route, however, Germany wants to be confident France is committed to structural reforms that will make its economy more dynamic. The reason: Germany undertook a comprehensive set of labor market reforms in the previous decade that are credited for reviving its economy.
For his part, Macron has called for a “revolution” to simplify France’s Labor Code, which is a 3,600 page document that regulates nearly every aspect of employer-employee relations. This will not be easy to pull off, however, as he will encounter strikers and protesters, as previous French Presidents have. For example, Francois Hollande, Macron’s processor, backed away from embarking on labor reforms in the face of stiff opposition. Other reforms being considered include cutting the corporate tax rate from 33% to 25%, and reducing the size of France’s bloated government. The latter goal, however, is modest, as Macron seeks to slow the expansion of government rather than to reduce its size, which is the largest among the leading industrial countries.
Having formed a new political party, Macron must first build a coalition with existing parties, so that he can gain a legislative majority in the parliamentary elections in June. Those he has recruited so far lean strongly to the left, with many coming from the reform faction of the Socialist Party. To appeal to the right, Macron is credited with making a wise choice of Édouard Philippe as Prime Minister. Still, it appears unlikely Macron will win an outright majority, and he therefore may have to rule with a coalition. Consequently, it remains unclear how successful he will be in achieving reforms that France desperately needs.
The Case for European Equities
The principal reasons for considering European equities are that (i) earnings prospects have improved with the economic upturn, while (ii) Macron’s election and the rejection of populism in several key European countries have lessened political risk.
The improvement in European corporate profits is shown in Figure 2. It illustrates how far they lagged the U.S. market when economic growth trailed that in the U.S., and how they have improved recently. Among developed countries, European stock markets traditionally have been the most levered to economic performance, and this continues to be the case, as earnings growth in Europe has exceeded that in the U.S. recently. Moreover, the percentage of European companies beating expectations is the highest in a decade. An additional factor supporting corporate profitability has been the weak euro. Although it has firmed against the dollar recently, it is still relatively cheap on a purchasing-power basis.
Figure 2: European Corporate Profits Lag the U.S. Until Recently
12-month trailing EPS, Index, Jan 2006 = 100
Source: Datastream, JPMAM. April 28, 2017.
On the surface, it appears European equities may offer good relative value, as the discount of European multiples to the U.S. is about 15%. The latter, however, is close to the average of the past decade or so, when one takes into account differences in the sector compositions. Therefore, we consider European equities to be reasonably valued relative to the U.S.
The other major consideration is that political risk in Europe has diminished considerably with Macron’s election and the likelihood that Angela Merkel will be re-elected Chancellor of Germany. This has contributed to inflows of funds into European markets recently. The principal risk for investors is disappointment that Macron may not be able to deliver on his reform agenda. Another risk is that populism could resurface in the Italian presidential elections that must be held no later than a year from now.
Weighing these considerations, I believe now may be a good time to add to European equities, after years of being cautious about European markets.
Balance sheet data on two episodes of U.S. central banking are now available in spreadsheet form for the first time. Adil Javat has written a paper that digitizes data on the First Bank of the United States. The bank, established in 1791, was federally chartered and partly owned by the federal government. It was the only bank to have a nationwide branch network because states did not allow banks they chartered to branch across state lines, or in many cases even within them. The bank’s unusual attributes made in in effect a quasi central bank. The Democratic Party objected to it for that reason, and denied the bank an extension when its federal charter expired in 1811. The following year the United States became embroiled in the War of 1812 and missed the services that the Bank of the United States had provided. The U.S. Congress chartered a second Bank of the United States that began operations in 1817. It in turn was denied an extension of its charter by the Democratic Party in 1836. A fire at the U.S. Department of the Treasury in 1833 destroyed many records of the First Bank of the United States, so what remains is fragmentary, and is the fruit of searches of various archives by the 20th century historian James Wettereau. Perhaps more records are still out there, gathering dust somewhere?
Justin Chen and Andrew Gibson have written a paper that digitizes the weekly balance sheet of the Federal Reserve System (now called the H.4.1 release) from the Fed’s opening in 1914 to 1941. Their data will be of interest to anyone interested in the Fed’s behavior during the tumultuous period that included World War I, the sharp but short postwar depression of 1920-21, and the Great Depression. Previously — and surprisingly, given how much has been written about the early years of the Fed — digitized data were only available at monthly frequency. Weekly data should offer finer insights into the Fed’s behavior during episodes in which events were moving fast.
Javat, Chen, and Gibson are all students of CFS Senior Counselor Steve Hanke, and wrote their papers in a research course Hanke teaches for undergraduates at Johns Hopkins University. I read and commented on drafts of the papers.
(For the spreadsheets, see this page. There is a link underneath each paper to its accompanying workbook.)
Board of Governors of the Federal Reserve System (“Board”) Governor Daniel K. Tarullo submitted his resignation letter to President Trump. The resignation is effective April 5, 2017. Governor Tarullo’s departure will leave the Board with three vacancies.
Governor Tarullo served as Chair of the Board’s Committee on Supervision and Regulation and Chair of the Financial Stability Board’s Standing Committee on Supervisory and Regulatory Cooperation. He also served as the informal “Vice Chairman of Supervision,” a Dodd-Frank created position that was never filled by President Obama. In that capacity, Governor Tarullo has been recognized as the architect of much of the Board’s post-crisis policy and regulatory decision-making.
The four current Governors are: Stanley Fischer (term expires January 31, 2020); Janet Yellen (term expires January 31, 2024); Lael Brainard (term expires January 31, 2026); and Jerome H. Powell (term expires January 31, 2028). The term of current Chair Janet Yellen expires February 3, 2018. President Trump will have the opportunity to influence the direction of the Board by filling the three vacant seats, naming a new Chair, and filling key leadership positions.
Lofchie Comment: Governor Tarullo pursued an expansionary regulatory philosophy. He believed that financial market participants fell into two categories: banks that were at least indirectly regulated by the Federal Reserve Board, and shadow banks that were improperly avoiding regulation by the Board. (See Fed Governor Examines Post-Crisis Financial Regulation; Governor Tarullo Delivers Speech Regarding Shadow Banking and Systemic Risk Regulation.) Throughout his tenure, Governor Tarullo seemed to be oddly hostile to the securities financing markets and largely indifferent to declines in liquidity in the financial markets. (See Federal Reserve Board Governor Tarullo Calls for Regulatory Approach to “Runnable Funding”.)
Governor Tarullo could have remained to complete his full term set to expire on January 31, 2022. It is clear, however that the Governor’s expansionary regulatory philosophy would have come into direct conflict with the views of the new administration. Governor Tarullo’s resignation is significant given the influence that he held over the regulatory direction at the Board.
Mickey D. Levy (Chief Economist of Berenberg Capital Markets for the Americas and Asia) testified before the House Financial Services Committee on monetary policy.
He focused on how non-monetary factors including a growing web of government taxes, regulations and mandated expenses were harming the economy.
His line of thinking is of special note as these themes have been revealed over the years by CFS Divisia monetary aggregates and components.
His Testimony Resetting Monetary Policy is available online – http://financialservices.house.gov/uploadedfiles/hhrg-114-ba19-wstate-mlevy-20161207.pdf
President-elect Donald Trump noted that “we have a very false economy,” due to the Fed “keeping the rates down.” He is right.
Yet, the question remains how to exit from this policy while avoiding catastrophe in the bond market and building a safer monetary policy framework for the future.
The Fed needs to integrate state and bank money into the policy discourse, including its own reports to Congress and the public.
Here, Congress can help.
For full remarks:
The Federal Reserve Bank of New York issued a comprehensive overview of its counterparty framework, which includes a new policy on counterparties for all domestic and foreign market operations. The new counterparty policy is the result of a multi-year review of the framework for counterparty relationships across the full range of the trading desk operations in domestic and foreign financial markets.
Highlights from the new policy include:
- reducing the minimum net regulatory capital (“NRC”) threshold for broker-dealer counterparties from $150 million to $50 million, in order to broaden the pool of eligible firms;
- raising the minimum Tier 1 capital threshold for the banks, branches, and agencies of foreign banking organizations from $150 million to $1 billion, to better align the Tier 1 threshold with the new NRC threshold (which is measured with respect to Tier 1 capital of the bank holding company); and
- introducing a 0.25% minimum U.S. government market share threshold as a means to more directly quantify the business capabilities of firms that express interest in becoming a primary dealer.
Under the new policy, counterparties will be expected to:
- operate in accordance with the Best Practices for Treasury, Agency Debt and Agency Mortgage-Backed Securities Markets (published by the New York Fed-sponsored Treasury Market Practices Group) and FX market best practices guidance (such as the Global Preamble, promulgated by the New York Fed-sponsored Foreign Exchange Committee);
- provide insight to regulators on an ongoing basis into developments in the markets in which they transact;
- meet any minimum capital thresholds or other standards that are set forth by their primary regulator;
- provide information (as needed) for counterparty risk management and monitoring; and
- establish a compliance program that is consistent with the sound practices observed in the industry, and support adherence to the terms of its counterparty relationship with the Federal Reserve Bank of New York.
The Federal Reserve Bank of New York also provided the following materials for firms interested in becoming a counterparty:
- reverse repo counterparties;
- primary dealer counterparties;
- foreign exchange counterparties; and
- foreign reserves management counterparties.
The new policy and eligibility criteria are immediately effective.
Lofchie Comment: It is notable that the New York Fed reduced the capital requirements for primary dealers, while at the same time increasing those requirements for counterparties to foreign exchange transactions. Further, one could question whether reduced capital requirements for primary dealers reflect diminished market interest in operating as a primary dealer.
Former Chief of the SDR Division at the IMF Warren Coats unpacks a statement by Senator Jeff Merkley that
“The Fed should be using its economic expertise to highlight the long-term devastating impacts of failing to provide the opportunity for the skills needed for the economy of the future.” 
Warren’s paper examines monetary management in the United States – since the Nixon shock of closing the gold window and launching wage and price controls – to research the statement above. He finds:
- No tradeoff exists between employment and inflation in the long run.
- Radical innovations in New Zealand sparked rules that ultimately fell short of expectations.
- NGDP targeting ignores the benefits of stable money.
- The return to a hard anchor for monetary policy – such as the SDR – is attractive.
Although CFS is not promoting the idea of a newfound use for the SDR, monetary policy is in need of a rethink. Warren’s ideas are thoughtful and informative.
To view the full paper:
As always, CFS welcomes opinion.
 Ylan Q. Mui, https://www.washingtonpost.com/news/wonk/wp/2016/08/26/liberals-fought-for-janet-yellen-to-lead-the-fed-now-they-hope-shes-more-more-ally-than-adversary/ The Washington Post Aug. 27, 2016
When considering financial regulation (and regulation generally) and their expressed attitudes towards the financial system, the two platforms are positioned almost diametrically in opposition. It is necessary, therefore, to say something about the parties’ views of the role that government should play both in providing employment and in the role of private enterprise. The Republican platform is based on the standard position that private enterprise is to be strongly encouraged and is generally preferable to governmental enterprise. By contrast, the Democratic platform is largely about governmental spending and enterprise; including, for example, government spending on infrastructure: drinking water and waste systems, climate change initiatives, education, industrial energy efficiency, broadband networks, health care, child care, care for the aged, housing, supporting groundbreaking research and so on. The Democratic platform supports such spending not only at the federal level, but also at the state and municipal level. While the summary above does not fully include these spending initiatives, it would not be possible to assess the Democratic position on financial regulation and the direct conduct of financial activities by the government without that context.
The focus of this discussion is on financial regulation. The Republican platform, provides little in the way of ambitious new plans. It is, at its core, completely skeptical of regulation, describing all of it as a “tax.” This is obviously not true: good regulations are necessary for growth because they keep market participants honest. Advocating for the abolition of the Internal Revenue Service, as the platform does at one point, seems to be a wholly unserious proposition. That being said, it is all a matter of perspective. If one believes that our current system of financial regulation is more in need of pruning than of fertilization, then such unseriousness is a bit of welcome relief from the unseriousness of our current debates.
The Democratic platform, by contrast, is breathtaking in its ambition. It is not possible to ignore the extent to which the Democratic platform envisions a substantial replacement of the private financial system by government-owned financial enterprises. A notable example: the platform advocates the idea that the Postal Service should provide “basic” banking services. While the only such service that is expressly mentioned is check cashing, the platform strongly suggests that such services would also include deposits and lending. In addition, the platform would establish an “independent, national infrastructure bank” to, among other things, “provide loans and other financial assistance for . . . multi-modal infrastructure projects.” (What in the world does that mean?) Then there are also the half dozen or more other loan and investment services for which the platform makes provision. The platform seems to intend that the Postal Service would enter into direct competition with community banks. It would seem to be the strong, albeit implicit, belief of the drafters of the Democratic platform that the government would be successful in not only community banking but in a whole range of investment banking-type activities.
The Democratic platform spends a fair amount of time demonizing all those who work in financial services as part of a hostile and criminal operation. Perhaps those who are in government should be a bit more modest given that the number of senior government officials who have been convicted of financial crimes is fairly substantial. That said, the supposedly corrupt “revolving door” between financial regulators and the financial industry seems to be overstated if not completely fictional. Where is the evidence that anyone at the SEC has been negatively influenced by their previous job? Whether or not the authors of the draft platform have any genuine goal in that regard, the effect of the assumption will be the same: preventing knowledgeable individuals from working for financial regulators. If being ignorant of how markets work should be considered to be such an asset, then perhaps financial regulators should be selected randomly from the phone book (though a lottery drawn from a list of academics might yield even more candidates with this particular asset).
Much of the detail of the Democratic platform is either unserious or intellectually incoherent. What does it mean to protect the independence of the Federal Reserve Board, but to make it more representative? If the Board is to be more “representative”; i.e., reflecting the popular will, what is the purpose of its independence? Likewise, is it absolutely necessary that “every Republican effort to weaken” Dodd-Frank must be stopped – i.e., that it is wrong to reassess the 2,000-page statute after six years of operation in order to gauge its failures and successes? Does anyone really believe that Dodd-Frank is such a perfect work of art that any attempt to revisit its contents is a form of desecration? The politicization of every issue makes it impossible to have a rational discussion about financial regulation.
Interestingly, there are some areas of agreement between the Democrats and the Republicans in their political platforms. Both express skepticism of international trade (both single out China) and both are opposed to “too big to fail” (which seems to be the regulatory equivalent of supporting the baking of apple pie).
It is perhaps unfair to critique political platforms given the general understanding that they are for the most part meaningless monologues that will be ignored by the soon-to-be elected officials. Nonetheless, even if they are not directly actionable documents, they do influence the parameters of the debate that is to come, and thus it seems appropriate to treat the documents as significant.
The Republican platform position is highly critical of Dodd-Frank for “establish[ing] unprecedented government control over the nation’s financial markets,” forcing “central planning of the financial sector” and creating “unaccountable bureaucracies” that have “killed jobs.” In general, the Republican platform describes financial regulations as “just another tax” and states that Americans should “consider a regulatory budget that would cap the costs federal agencies could impose on the economy in any given year.” In particular, Republicans would:
- abolish the Consumer Financial Protection Bureau or subject it to congressional appropriation;
- “advance legislation that brings transparency and accountability to the Federal Reserve, the Federal Open Market Committee, and the Federal Reserve’s dealing with foreign banks”;
- (regarding “too-big-to fail”) “ensure that the problems of any financial institution can be resolved through the Bankruptcy Code”; and
- endorse prudent regulation of the banking system to ensure that FDIC-regulated banks are properly capitalized and taxpayers are protected against bailouts.
The Republican Platform criticized the Dodd-Frank Act:
Rather than address the cause of the crisis — the government’s own housing policies — the [Dodd-Frank Act] extended government control over the economy by creating new unaccountable bureaucracies. Predictably, central planning of our financial sector has not created jobs, it has killed them. It has not limited risks, it has created more. It has not encouraged economic growth, it has shackled it.