Chris Kuflik - ScotiaMcLeod Montreal

 Politicians in Germany and the U.S. are rushing to change capital market regulations this week. They are pandering to populist outcries against the bailouts of their financial institutions. Elected officials are looking for a quick and simple solution to quiet their people down; unfortunately most politicians do not understand how capital markets work. Their ignorance has been a disaster for global markets this past last week. Their political moves could lead to lower returns and higher costs for Canadians, even when markets improve.

Germany’s chancellor Angela Merkel expressed a desire to gain control over what she calls “destructive” financial markets. On Tuesday, her government announced a ban on naked short selling of shares of financial institutions, government bonds, and credit default swaps on government debt. European stocks traded down the day after the German announcement. CS Strategist Andrew Garthwaite notes that the last time a ban on short-selling of financial stocks was announced, on 19 September 2008, after the Leaman collapse, the stock prices of global banks surged 13% that very day, but then fell 24% in the next four weeks and 41% over the next three months.

Merkel’s hastily prepared proposals have a tinge of desperation to them. She did not co-ordinate the move with other European countries, and it is not clear that they will follow her lead. Even if they do, the French bank BNP Paribas thinks that would be unless the U.S. did the same. There are fears that the German plan could backfire, doing the markets more harm than good.

Moreover, the German ban did not cover trading in the euro. Investors bearish on the outcome of the European crisis over sovereign debt have been putting heavy pressure on the currency. The euro fell to a four-year low against the U.S.dollar under US$1.22 after the German announcement on Tuesday. The IMF tried to calm the waters on Wednesday, stating that the euro’s decline would help European exports. The IMF also expressed the view that the euro was close to an “equilibrium” value against the dollar. On Wednesday, the euro recovered to almost US$1.24.

German politicians remain traumatized by the national historical memory of hyperinflation in the 1920s, even if they are not old enough to remember it. Berlin has therefore been extremely strict with Athens about Greece’s fiscal irresponsibility; and German politicians want rules for everyone, not just ad-hoc fixes. The economic newspaper Handelsblatt reports a draft government proposal on how to deal with budget transgressors. The measures in the German draft would include four steps. First, the debtor country would temporarily lose access to EU structural funds. Second, it would lose such access permanently. Third, its voting rights in the European Council, the EU’s highest political body, would be forfeited. Then fourth, the now officially bankrupt country would be subject to managed insolvency proceedings. According to the Royal Bank of Scotland, this proposal would be a roadmap for defaults. By making rules for how defaults could happen, it could end up facilitating them. This prospect is more frightening than the new ban on short selling, and it could take the crisis to another level.

On Wednesday, the U.S. Senate decided to delay voting on its own financial reform bill. Still, key issues relating to derivatives and proprietary trading remain unresolved. Shares of U.S.financial institutions will remain subject to choppy trading.

I have little confidence in the politicians’ ability to create the legislation required to solve the economic problems facing Europe and the United States.The proposed regulations would raise the cost of capital, slow economic growth and decrease liquidity, hurting investment. The proposals do not address the root of the problems: too much debt and too much leverage.

The countries having problems, The US and Europe, want to regulate the exchanges and tax the banking system. Worse, they want to offload part of the burden to countries that kept their houses in order and did not have problems such as Canada.The G-20 meeting next month in Toronto will consider a proposal for such a global bank tax that would feed a fund tobe used to backstop future financial crises. However, the taxes collected would remain in the same country, and the funds could be diverted to that country’s general coffers. This seems ill considered.

Canadian cabinet ministers have been travelling to G-20 countries to garner support against the bank tax. Such a tax would only lead to higher bank fees for every Canadian. We did not need to bailout our banks and we do not need that tax.

As for the present sell-off, it is too early to tell whether this will be a minor or major correction. Its one redeeming feature is that it may provide the opportunity later to enter income investments at more reasonable prices. We will continue to monitor the situation closely and adhere to our disciplined approach.

Please call us at 514-287-2931 to discuss possible investments whilst mitigating potential future risks.

Wishing you a great long weekend!

Chris Kuflik

Associate Director, Wealth Management

Wealth Advisor

514-287-2931

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www.chriskwealth.com

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