Dysfunction Drives the ECB by Scott Perry

LP L FINANCIAL R E S E AR C H

Weekly Economic Commentary September 4, 2012

Dysfunction Drives the ECB John Canally, CFA Economist LPL Financial

Highlights Dysfunction in the European financial markets may lead the European Central Bank (ECB) to purchase sovereign debt in the open market. The ECB may look to lower rates for consumers and businesses through another round of debt purchases. Unlike the U.S., Europe has been greatly impacted by a lack of business spending. Please see the LPL Financial Research Weekly Calendar on page 3

The European Central Bank (ECB) holds its monthly policy meeting this Thursday, September 6, 2012, and is poised to support the European economy through the purchase of sovereign debt of Eurozone member nations. The ECB has used this approach before (in early 2010 and mid2011), but markets viewed those forays by the ECB into quantitative easing, or QE, (purchasing sovereign debt in the open market) as scattershot (at best). In recent weeks, ECB President Mario Draghi has been floating the idea of more ECB purchases, oftentimes battling the German Bundesbank (the German central bank and main predecessor of the ECB in Europe) over the ability to do so. But Draghi has been careful to say that any purchases would only come after countries have demonstrated a commitment to push ahead with budget cuts and structural reform, couched in the phrase “conditionality.” We will leave this quite pertinent debate over the ability of the ECB to purchase bonds and under what conditions they would do so for another commentary. This week we will explore what the ECB might be trying to achieve by purchasing sovereign debt in the open market.

To QE or Not to QE in Europe

The ECB may authorize a “QE” in Europe as soon as this week.

Today, despite the two earlier rounds of quantitative easing and several rounds of measures aimed at promoting liquidity in the European banking and financial systems, consumers and businesses still face very high borrowing rates and even difficulty obtaining financing. As a result, loans by the financial sector to households and consumers in Europe have been shrinking for more than three years. In short, the ECB (and many financial market participants) remain concerned that the dysfunction in the European financial system, a symptom of the high levels of sovereign debt clogging up European banks’ balance sheets, may not get better anytime soon without more help from policymakers. That help may come this week in the form of another round of QE in Europe.

ECB vs. Fed: Different Approaches to QE It is interesting to note however, that what the ECB is trying to accomplish with another round of QE is slightly different from what the Federal Reserve (Fed) is looking to achieve as it prepares to do a third round of quantitative easing as soon as next week. The Fed

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is contemplating purchases of — and therefore reducing the supply of — nearly riskless assets (U.S. Treasuries and high-quality mortgage backed securities) in an effort to push large pools of private investors (pension funds, hedge funds, etc.) into somewhat more risky assets like municipal bonds, corporate bonds, and high-yield bonds. If the ECB wanted to achieve this goal, they might simply purchase German bunds on the open market. Instead, the ECB is targeting the “severe malfunctioning in the price formation process in the bond markets of euro area countries,” as stated by the ECB after its last policy meeting in early August 2012. By purchasing bonds of peripheral European nations (Portugal, Ireland, Spain etc.) — where bond markets are currently pricing in a relatively high probably that these countries will eventually leave the Eurozone — the ECB hopes to help reset prices in a dysfunctional market, reassure market participants of the “irreversibility of the euro,” and in the process, lower the cost of borrowing for businesses and consumers in those countries.

1 Mortgage Rates Are Rising in Italy

U.S. Commitment Rate: Conventional 30-Yr Fixed Rate Mortgages, FHLMC, % Italy: New Bank Loans for Home Purchases, %

European Consumers Are Not Seeing Lower Rates

7 6 5 4 3 2

Source: FRB, Bdlt, Haver Analytics 09/04/12 (Shaded Areas Indicate Recession)

2 Uncertainty Surrounding the Sovereign Debt Crisis in the Eurozone Is Severely Impacting the Flow of Credit to European Corporations

22.5

Loans by European Banks to European Businesses, Year-Over-Year, % Change, Seasonally Adjusted, Bil Euros Loans by U.S. Banks to U.S. Businesses, Year-Over-Year, % Change, Seasonally Adjusted, Bil $

15.0 7.5 0.0 -7.5 -15.0 -22.5

Source: ECB, FRB, Haver Analytics 09/04/12 (Shaded Areas Indicate Recession)

The nearby charts help to illustrate the problem. Figure 1 is Italian mortgage rates versus mortgage rates in the United States. While not strictly an apples-to-apples comparison (mortgage loans in Europe tend to be set from five- and seven-year government debt rates, while fixed rate loans in the United States are tied to 10- and 30-year Treasury rates), it is clear that the low official rates in Europe (the ECB’s overnight lending rate is 0.75%), and plenty of liquidity in the banking system, are not translating into lower rates for consumers. While mortgage rates in the United States have moved sharply lower in the past five years, from well over 7.0% to well under 3.0%, mortgage rates in Italy have moved substantially higher. Interest rates on other types of consumer loans in Europe are rising as well, dampening businesses’ ability to expand, and consumers’ ability to make purchases. Thus, a key goal of another round of debt purchases by the ECB would be to lower borrowing rates for consumers and businesses.

European Business Unable to Invest or Hire Another Eurozone woe that may be ameliorated by a sustained round of sovereign debt purchases by the ECB would be the availability of credit. Figure 2 compares the year-over-year percentage change in commercial and industrial (C&I) loans by U.S. banks to the business sector in the United States to the similar metric in the Eurozone. The level of C&I loans outstanding, which is a component of the LPL Financial Research Current Conditions Index (CCI), is nearly 15% higher than a year ago. In the Eurozone, it is a completely different story. Loans by monetary financial institutions (MFIs) in Europe — mainly banks — to European businesses have contracted over the past year, after rebounding modestly in the first year of the recovery (2009 – 2010) from the Great Recession. Without capital from banks and other financial institutions, European businesses cannot invest in or expand existing operations, or hire new workers. The persistent lack of

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W E E KLY E CONOMIC CO MME N TAR Y LPL Financial Research Weekly Calendar

U.S. Data

Fed

Global Notables

2012

Holiday

EU Meets on banking union

4 Sep

ISM Manufacturing (Aug) Construction Spending (Jul) Vehicle Sales (Aug) Democratic National Convention begins

Australia: Central Bank Meeting EU President van Rompuy meets German Chancellor Merkel Italy’s Prime Minister Monti meets French President Hollande Canada: Quebec Provincial election Brazil: Industrial Production (Aug)

5 Sep

6 Sep

7 Sep

QUIET PERIOD

3 Sep

Productivity (Q2)

Challenger Layoff Announcements (Aug) ADP Employment (Aug) Initial Claims (9/1) ISM Non-Manufacturing (Aug)

Employment Report (Aug)

3 U.S. Banks’ Lending Standards for Business Loans Have Eased While Lending Standards Set by European Banks Have Tightened Recently 100 80

Business Lending Standards: European Banks, %* Business Lending Standards: U.S. Banks, %

Above Zero = Tight

20 0

Below Zero = Easy

-20 -40

Descending = Getting Easier

Ascending = Getting Tighter

ECB Meeting BOE Meeting Spain: Bond Auction Spanish Prime Minister Rajoy meets German Chancellor Merkel France: Bond Auction Sweden: Central Bank Meeting Malaysia: Central Bank Meeting Peru: Central Bank Meeting Germany: Exports and Imports (Jul) Mexico: Central Bank Meeting APEC Summit in Russia

business investment in Europe has led to persistently high unemployment, and most likely underemployment as well, slower economic growth, and, ultimately, higher budget deficits, which are at the root of the overall dysfunction in the European financial system. In addition, the absence of business spending in Europe has had a major impact on imports of capital goods into Europe, which, in turn, has dampened export growth in China, Japan, and the United States.

European Banks Overly Cautious With Lending

The Lending Standards Line:

Germany: Bond Auction Eurozone: PMI- Services (Aug) Thailand: Central Bank Meeting Canada: Central Bank Meeting EU President Van Rompuy meets French President Hollande Brazil: Inflation (Aug)

Source: FRB, ECB 09/04/12 * Diffusion Index: % of respondents reporting tighter lending conditions less % of respondents reporting easier lending conditions.

Higher rates and reduced availability of credit for European businesses and consumers are only part of the story. Saddled with billions of dollars of heretofore “safe” sovereign European debt on their balance sheets, European banks remain overly cautious about who they lend to. Tighter lending standards — on top of higher rates and reduced availability — exacerbate the economic and financial situation in Europe. By purchasing the debt of certain countries in the open market, the ECB hopes to break this logjam and make credit more readily available to the private sector. Figure 3 compares the lending standards for business loans made by U.S. banks and banks in the Eurozone. Over the past three years, as the Fed embarked on several rounds of quantitative easing and U.S. banks

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In Europe, banks’ lending standards for businesses remain relatively tight and have actually tightened significantly over the past year or so, as the sovereign debt crisis in Europe has intensified.

shed bad assets built up during the housing bubble, bank lending standards for business loans eased dramatically. In Europe, however, after becoming less restrictive in the immediate aftermath of the Great Recession, banks’ lending standards for businesses remain relatively tight and have actually tightened significantly over the past year or so, as the sovereign debt crisis in Europe has intensified. In recent weeks and months, the ECB has sounded especially strident about the need to address the “severe malfunctioning in the price formation process in the bond markets of euro area countries” as well as the “financial fragmentation” that hinders the functioning of monetary policy in Europe. By taking steps toward more aggressive and systematic bond buying, the ECB hopes to begin to address the dysfunction, and help to get badly needed credit flowing again to struggling European businesses and consumers. n

LPL Financial Research 2012 Forecasts

GDP 2%*

Federal Funds Rate 0%^

Private Payrolls +200K/mo.†

Please see our 2012 Outlook for more details on LPL Financial Research forecasts.

IMPORTANT DISCLOSURES The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly. * Gross Domestic Product (GDP) is the monetary value of all the finished goods and services produced within a country's borders in a specific time period, though GDP is usually calculated on an annual basis. It includes all of private and public consumption, government outlays, investments and exports less imports that occur within a defined territory. ^ Federal Funds Rate is the interest rate at which depository institutions actively trade balances held at the Federal Reserve, called federal funds, with each other, usually overnight, on an uncollateralized basis. † Private Sector – the total nonfarm payroll accounts for approximately 80% of the workers who produce the entire gross domestic product of the United States. The nonfarm payroll statistic is reported monthly, on the first Friday of the month, and is used to assist government policy makers and economists determine the current state of the economy and predict future levels of economic activity. It doesn’t include: - general government employees - private household employees - employees of nonprofit organizations that provide assistance to individuals - farm employees

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Stock investing involves risk including loss of principal. International investing involves special risks, such as currency fluctuation and political instability, and may not be suitable for all investors. Quantitative Easing is a government monetary policy occasionally used to increase the money supply by buying government securities or other securities from the market. Quantitative easing increases the money supply by flooding financial institutions with capital in an effort to promote increased lending and liquidity.Â The Institute for Supply Management (ISM) index is based on surveys of more than 300 manufacturing firms by the Institute of Supply Management. The ISM Manufacturing Index monitors employment, production inventories, new orders, and supplier deliveries. A composite diffusion index is created that monitors conditions in national manufacturing based on the data from these surveys. Challenger, Gray & Christmas is the oldest executive outplacement firm in the United States. The firm conducts regular surveys and issues reports on the state of the economy, employment, job-seeking, layoffs, and executive compensation.

This research material has been prepared by LPL Financial. To the extent you are receiving investment advice from a separately registered independent investment advisor, please note that LPL Financial is not an affiliate of and makes no representation with respect to such entity. Not FDIC/NCUA Insured | Not Bank/Credit Union Guaranteed | May Lose Value | Not Guaranteed by any Government Agency | Not a Bank/Credit Union Deposit

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Weekly Market Commentary September 4, 2012

What Wall Street Is Saying About the Election May Surprise You While there are many election polls, what matters most to investors is what is priced in on Wall Street rather than what people are saying on Main Street. A stock market-based “election poll” is useful, in that it highlights what the market is pricing in about the outcome of the November elections.

Jeffrey Kleintop, CFA Chief Market Strategist LPL Financial

Highlights A stock market-based “election poll” is useful, in that it highlights what the market is pricing in about the outcome of the November elections. Our “Wall Street” Election Poll suggests Republicans have yet to erode the gains in the odds that Democrats retain their control in Washington. Investors may have become too complacent that the Senate Democrats will retain their seats and quickly find a grand compromise with House Republicans to avoid going over the socalled fiscal cliff into a recession in 2013.

What Wall Street is saying about the election may surprise you. Our “Wall Street” Election Poll suggests Republicans have yet to erode the gains in the odds that Democrats retain their control. These odds improved early this summer as the Supreme Court upheld the Affordable Care Act, more commonly known as Obamacare. Our poll reflects the path taken by other market-based assessments of the election such the Intrade.com futures contracts on President Obama’s re-election and on the party control of the Senate, which have moved from about a 75% chance the Republicans prevail in the Senate to a toss-up now.

1 Democrats Chances of Retaining Power Have Improved “Wall Street” Election Poll (Dem. vs. Rep.), Left Scale Intrade.com Odds Republicans Win Senate , Right 120

Scale, Inverted

35%

115

45%

110

55%

105

65%

100

75%

85%

95% Jan

Feb

Mar

Apr

May

Jun

Jul

Based upon the most legislation-sensitive industries, earlier this year we created two indexes to help us track the market’s implied forecast of the election outcome reflected in the performance of these industries. Each index is composed of an equal weighting among eight industries that when combined total well over 100 stocks in the S&P 500 index. To track what the market has priced in for the Democrats’ odds of retaining the White House and Senate, we took our Democrats index and divided it by our Republicans index. This is what we track as the “Wall Street” Election Poll, published by LPL Financial Research on Thursdays. An upward sloping line suggests the market may be pricing in a rising likelihood of the Democrats retaining the White House and their majority in the Senate, while a downward sloping line suggests improving prospects for the Republicans.

Aug

Source: LPL Financial, Intrade.com, FactSet Research Systems 09/04/12

With the S&P 500 having risen back to around four-year highs, investors may have become too complacent that the Senate Democrats will retain their seats and quickly find a grand compromise with House Republicans on extending the Bush tax cuts and other actions to avoid going over the socalled fiscal cliff into a recession in 2013. The Congressional Budget Office recently confirmed our long-held view that a recession is a given in 2013, if no action is taken to moderate the combination of tax hikes and spending cuts totaling over $500 billion already written into current law. We think a compromise may be harder to reach than the market seems to think if the Democrats prevail in the Senate and the House remains, as is likely, in the hands of the Republicans. Recall that the status quo in Washington was no help to markets last year, as the unwillingness to compromise on both sides

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2 S&P 500 Industries Likely to React More Favorably to One Party

of the aisle led to the debt ceiling debacle last August, sending the S&P 500 down over 10% in three trading days.

Democrats

Republicans

S&P 500 Health Care Facilities

S&P 500 Coal & Consumable Fuels

S&P 500 Food & Staples Retailing

S&P 500 Diversified Financial Services

S&P 500 Gas Utilities

S&P 500 Oil & Gas Exploration & Production

Governor Romney’s Vice President pick of Congressman Ryan may raise the stakes further for investors in 2013. If President Obama wins by focusing his re-election campaign on attacking the controversial and potentially unpopular elements of the Ryan plan (which is supported by the House Republicans and, notably, Ryan is chairman of the House Budget committee), it may make a grand compromise even more difficult between the White House and Congress in 2013 to avoid going over the fiscal cliff into a recession and bear market.

S&P 500 Health Care Services

S&P 500 Oil & Gas Drilling

S&P 500 Life Sciences Tools & Services

S&P 500 Managed Care

S&P 500 Construction Materials

S&P 500 Electric Utilities

S&P 500 Homebuilding

S&P 500 Specialty Retail

S&P 500 Construction & Farm Machinery

S&P 500 Telecommunications Services

It is possible that stocks may be overstating Democrats’ momentum ahead of what are likely to be close elections. If so, look for a potential surge in the Republican-favored industries. If not, stocks may begin to stumble until a clear path to a compromise on the fiscal cliff can be reached.

Source: LPL Financial 09/04/12 For detailed information about this index’s construction, please see our Weekly Market Commentary: The “Wall Street” Election Poll (05/07/12).

It is not just this year that markets may begin to fear a divided Congress. Since 1901, the Dow Jones Industrial Average has fallen an annualized -3% during the 12% of the time that featured a split-party Congress, according to Ned Davis Research. Returns were much better when the control of Congress was in the hands of one party or the other. Gridlock is unlikely to be good for investors in 2013. We will continue to publish the LPL Financial “Wall Street” Election Poll each Thursday as part of our investor election analysis as politics become a bigger driver of the market in the coming weeks. n

3 Dow Jones Industrial Average and Congressional Control Since 1901 Party

Annualized Return %

% of Time

Democrats

5.5%

55.4%

Republicans

7.8%

32.3%

Split

-3.0%

12.2%

Source: Ned Davis Research 08/31/12

IMPORTANT DISCLOSURES The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly. The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful. The Standard & Poor’s 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. Dow Jones Industrial Average (DJIA): The Dow Jones Industrial Average Index is comprised of U.S.-listed stocks of companies that produce other (non-transportation and non-utility) goods and services. The Dow Jones Industrial Averages are maintained by editors of The Wall Street Journal. While the stock selection process is somewhat subjective, a stock typically is added only if the company has an excellent reputation, demonstrates sustained growth, is of interest to a large number of investors and accurately represents the market sectors covered by the average. The Dow Jones averages are unique in that they are price weighted; therefore their component weightings are affected only by changes in the stocks’ prices. This research material has been prepared by LPL Financial.

To the extent you are receiving investment advice from a separately registered independent investment advisor, please note that LPL Financial is not an affiliate of and makes no representation with respect to such entity. Not FDIC or NCUA/NCUSIF Insured | No Bank or Credit Union Guarantee | May Lose Value | Not Guaranteed by any Government Agency | Not a Bank/Credit Union Deposit

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