People Respond to Incentives: The Rest is Commentary

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1 We prefer not to delve into arcane matters of macroeconomics, but the current environment compels a level of detail that elicits understanding of the most important global macro issue influencing asset prices. To this end, we discuss the European Monetary Union (EMU) TARGET2 payment settlement system and its influence on the outcome of eurozone deliberations. Subsequently, this commentary evaluates potential US election outcomes and future dividend tax rates. The potential influence on high dividend paying stocks is the focus of attention. In both cases, investors must be aware that people, politicians and populace, respond to their incentives. Super Mario is on Target In early August 2011, a financial system funding crisis in Europe resulted in a collapse of risky asset prices. On November 1, Mario Draghi succeeded Jean Claude Trichet as President of the European Central Bank (ECB) and the situation began to change. Draghi earned his PhD at MIT, Fed Chairman Ben Bernanke s alma mater, and was considered less likely than Trichet to follow staunchly price stability tenants endemic to the then failing transmission mechanisms of European monetary policy in Europe. Draghi lived up to our expectations and in December 2011 introduced the first Long Term Refinancing Operation (LTRO), providing 1% loans with a three year term. Combined with the second LTRO in February 2012, these operations introduced new loans of 1 trillion. From November 2011 through the end of the first quarter of 2012, the span of these developments, risky assets recovered a significant portion of the funding crisis depreciation. The second quarter of 2012 brought a second European crisis, the compounding crises of sovereign solvency and bank capital adequacy, resulting in another risky asset price collapse. This crisis was more complicated than the funding crisis, but we believe it will be resolved satisfactorily, inducing a strong risky asset price rally. The euro will very likely not exist with its current composition in a few years. However, it is likely to retain its structure in the near term. If European leadership feels that contagion can be contained, Spain and Italy spared, then Greece may exit (Grexit); otherwise, the eurozone will continue for now. There are three reasons for this prognostication, each spawned with the creation of the euro in January 1999: Currencies of the 17 member nations were integrated into the euro at exchange rates that vastly favored Germany, the deutschemark entered at avery cheap (low) rate and the other countries currencies entered at relatively expensive (high) rates. When the euro was introduced in January 1999, the 17 national central banks (NCBs) that comprise the EMU combined their transaction settlement systems into a single system creating an integrated settlement system referred by the acronym TARGET. The second version, TARGET2, is the financial plumbing of the EMU. Increasingly, credit is being siphoned from the German private sector through the ECB TARGET2 system to peripheral enterprises. Since the deutschemark entered the euro at a cheap exchange rate, Germany started with and retained a competitive advantage relative to the other 16 EMU nations. Absent significant wage and price adjustment in each of the nations, this situation results in a real growth and export advantage for Germany. If the euro breaks into its constituent currencies, the deutschemark that emerges will strengthen to eliminate this economic disequilibrium. Further, the deutschemark will be considered perhaps the only truly hard currency in the world and would likely evidence further strength to reflect this hard currency premium. Such a currency appreciation (revaluation) would eliminate, perhaps more than eliminate, Germany s competitive advantage and lead to slower future real growth. Clearly, this is an unpalatable development for German business and for Angela Merkel as she seeks reelection in the fall of The creation of TARGET2 has resulted in steadily ratcheting pressure on Germany to hold things together. With each additional day of fear and capital flight, this pressure increases for Angela Merkel.

2 In order to understand TARGET2, consider the U.S. Federal Reserve created in 1913 with 12 regional Fed banks. I live outside Chicago and have a checking account with my local bank. I like to fish and frequently spend money in Texas on electronics and fishing paraphernalia. At the end of one of these trips, the Dallas regional Fed has accounting balances representing these expenditures and deposits by businessintolocaltexasbanks. Moreover,the Chicago Fed observes offsetting accounting balances. This would not be a big deal, unless of course Texas decides to secede from the U.S. The accounting balances on the Dallas and Chicago Feds balance sheets would become claims and liabilities that would need settlement. To prevent such a situation, in April of every year the regional Fed banks reconcile these imbalances. Returning to Europe, the EMU was created with a fundamental flaw, similar imbalances between the 17 NCBs are never reconciled. All EMU banks maintain reserve accounts at their NCBs. When a Spanish bank makes a payment to a German bank via TARGET2, the Spanish bank's reserve account at its NCB is debited and that of the German bank at the Bundesbank is credited by thesameamount. These credits and debits result in intra EMU imbalances. These imbalances result in a net bilateral position of each bank with the ECB. Across the EMU, these balances sum to zero and were not considered important by European leadership and financial officials, until they exploded in size over the last few years. Even so, an eerie form of denial permeated Eurozone leadership until this year. Critically, these claims and liabilities have no maturity and are not collateralized. Moreover, the growth of these claims and liabilities cannot be stopped without dissolving the euro. If Spain were to exit the Eurozone, over 350 billion in liabilities would be owed by the Spanish NCB to the ECB system. Much more critically, the German NCB (the Bundesbank), would have claims of 700 billion if the euro were to dissolve. These claims and liabilities would be settled in drachma, lira, peseta, deutschemarks and other national currencies through a legal process that is neither clear nor tested.

3 TARGET2 transfers are also recorded in the Balance of Payment statistics. Analyzing this data indicates that growing imbalances have resulted in the effective transfer of loans from the peripheral NCBs to the ECB and on to the Bundesbank. The Bundesbank's assets have risen from about 600 billion in 2009 to over 1 trillion today. While its TARGET2 claims have grown, loans to German banks have declined from over 200 billion to around 50 billion. In other words, the TARGET2 system is draining credit from the Germany economy and funneling it to the Spanish, Italian, Greek, Portuguese, and Irish economies. The longer the process continues, the more potential damage to the core eurozone economies. Since losses on these loans are shared by the EMU members according to their ECB capital, any departure from the eurozone by a peripheral country would shift TARGET2 liabilities and loans to the remaining eurozone countries. As these three reasons clearly indicate, Germany may be recalcitrant, but ithastremendousincentivestoholdthe eurozone together until TARGET2 imbalances are reduced and a regular process of reconciliation is implemented. Some contend that a euro breakup would cost Germany about three times what it would cost to keep it together. The ironic perversity, Germany wants and needs the euro to survive and neither Italy nor Spain can afford not to be the first country to exit the euro. Germany will fight as hard as Spain and Italy to maintain the eurozone status quo. Thus, in our opinion, the situation is volatile and asset prices will suffer from unanticipatable "risk on" and "risk off" behavior, but the euro will survive to settle payments for the foreseeable future. Joint solvency and bank capital issues will be resolved and risky assets will reward patient investors. In the interim, TARGET2 results in free flowing liquidity, the effective bailout of financial institutions in peripheral Europe, the mutualization of liabilities across the eurozone, and a transfer of risk from the private sector to the public sector. TARGET2 is already doing what European leadership is fighting to accomplish through endless summits, media posturing, and local politicking. Sooner or later, the inevitable will occur by leadership design rather than monetary system fiat. Some Germans now claim that TARGET2 is unconstitutional under German constitutional law. Popular and official pressure will grow to exit this train hurtling down the track; Germany has every incentive to slow the train and mind the gap before exiting. Draghi is showing leadership and is maneuvering to bring eurozone leaders together with a focus on problem resolution, ostensibly forcing Germany further into a corner of its ownmaking. Coming into August, Draghi indicated d the ECB's willingness to buy Spanish and Italian debt, despite the sole objections of Germany's ECB policy council member Jens Weidmann. The strategic balance in Europe has shifted away from austere Teutonic demands emanating from Germany to more reasonable and viable overtures from the rest of Europe. Thankfully, it appears that some of Germany's leadership is beginning to understand the magnitude of Germany's problems and risks and the direction of its incentives. Intersection of US High Dividend Yielding Stocks and Fiscal Cliff While the application of incentives pertaining to the situation in Europe is currently front and center, we see a similar build up coming soon in the US and are also anticipating similar incentive driven responses in advance. Political gridlock in the US is often viewed favorably by markets, but no legislative action by the end of the year means the US goes off a fiscal cliff. The fiscal cliff refers to the potential combined set of tax increases and spending cuts amounting to over $500 billion coming into effect as a result of inaction. More specifically, while there are three main pieces of legislation in play at once, we are focused especially on the possible outcome of changes to tax rates on dividend income. The top tax rate on dividends is currently 15.0% and with the healthcare reform tax law change this rate is set to increase to anywhere between 18.8% 8% to 43.4% 4% in 2013 a wide range making the stakes high for investors and politicians alike.

4 From a logistical perspective, we know that Congress is largely on recess and unlikely to agree on any legislation before the Presidential election in November. This ultimately leaves only a handful of weeks to come to agreement during the lame duck session at the end of the year. From an incentives standpoint, we look at the probability of election outcomes around the set of President and Congress combinations and the potential likelihood of agreement around various levels of dividend tax rates and the aggregation of these levels and probabilities. This examination of logistics and incentives, suggests a relatively high likelihood of increased dividend tax rates at the end of the year. The possibility that rates increase from a lack of agreed action in 2012 and then are changed (perhaps retroactively) in 2013 is also pretty high, and so we also examine a similar series of outcomes for Obama: Probability [59%] Romney: Probability [41%] Conditional Probabilities [13.2%] [54.4%] [30.1%] [2.3%] [1.2%] [23.1%] [1.5%] [74.3%] Congress Combinations 1 DS/DH DS/RH RS/DH RS/RH DS/DH DS/RH RS/DH RS/RH Joint Probabilities [7.8%] [32.1%] [17.7%] [1.4%] [0.5%] [9.5%] [0.6%] [30.4%] Tax Rate on Dividends Aggregate End of 2012 (Lame Duck) 39.0% 30.6% 28.7% 37.0% 31.4% 31.4% 28.9% 28.9% 30.6% % 26.4% 24.4% 23.7% 26.9% 23.5% 25.2% 20.0% 24.8% 1 DS = Democratic Senate, DH = Democratic House, RS = Republican Senate, RH = Republican House Source: Intrade and William Blair For example, if Romney has a 41% chance of winning i the Presidential election, conditional on his winning, i the chance of the Senate and House also having a Republican majority is around 74% for a joint probability of a Republican President, Senate and House at just over 30%. In this outcome, it is likely that Obama would either extend the expiring tax legislation for one year as a goodwill gesture or that there would be some agreement for less than the highest possible rates by the end of the year. This aggregated probability leads to an expected dividend rate of just under 29% at the end of the year. In this outcome, it is likely that any agreement in 2013, after the lame duck session, would tend even more toward the lower end of the range for an expected dividend rate of about 20%. In outcomes where Obama wins the election, we believe the baseline incentive is to go off the cliff and then introduce some peeling back of taxes in This progression, rather than the reverse, allows for framing the endgame as tax cuts in 2013 rather than tax increases in When we aggregate across the eight potential presidential & congressional outcomes we get expected dividend tax rates of 30% at the end of 2012 and 25% at the end of These are increases as high as double the current rate and are likely to make high dividend yielding stocks less attractive all else equal in an environment where we re seeing a relatively sustained coincident reach for yield that continues to bid up high yielding names. Companies that offer high dividend yields due to a predisposition to a high payout ratio look especially vulnerable and can be found in the utilities and telecom sectors.

5 Conclusion Understanding incentives and using it as a systematic tool to forecast behaviorofthedriversofmacromarketsisa relatively recent science that investors now need to adopt to remain current in a macro thematic world. Game theory based analysis in an environment where the opportunity for miscalculation among existing players is significant creates opportunity for investment tinsighti as it is sometimes possible to understand d incentives better than the actors onthestage. Wehopethatourattempttodelveintotheserelativelyarcanematters of macroeconomics better informs our understanding of the incentive driven responses affecting global macro themes.

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