Economic chaos? The dollar crumbling? Central banks printing money like crazy? Probably the only real surprise about the surge in gold prices over the last few months is that it took so long to arrive.
Last week, gold touched an all-time high of $1,277.50. Back in September it was still less than $1000. Chalk that up as a victory for the gold bugs.
This week, the price is heading down, dropping below $1,200. Chalk that up as a victory for the gold skeptics, who regularly point out that the metal's value is just a sentimental memory from a long-buried era.
In reality, while investors are right to be nervous about inflation, maybe they are catching on that it's wrong to see gold as the best hedge against a general rise in prices. There are plenty of alternatives: equities, property, oil, luxuries or private-equity funds should prove just as effective a way of shielding yourself.
It isn't hard to figure out why investors had been getting interested in gold again. Central banks are pumping freshly minted money into the system. A few hundred years of economic history syas that eventualy this will lead to inflation. It might be next year, or the year after. It doesn't make much difference--it will arrive sooner or later, and you'll need to get your portfolio in shape before it does.
Alloyed Record
But gold? Whether it's a hedge against inflation depends on where you want to start drawing the graph. Back in 2002, gold was less than $300. If you bought it then, you'd certainly have protected yourself against rising prices-- and mad a fat profit as well. The 1990's were a different story. Gold started that decade at around $400, and ended it below $300. Not so great. As for the 1980s, forget it: gold lost almost half it's value during that decade.
In reality, gold has a mixed record. Nor should you be surprised about that. A few industrial uses, and jewelry, aside, gold is valuable only insofar as other investors think it is valuable. By itself it isn't necessarily worth anything. Nor does it generate interest or dividends. If the price doesn't rise, you don't get anything.
There isn't much chance, either, of the world's central banks making their currencies convertible into gold once again. They would bankrupt their governments in the process. It may secure itself a greater role as a reserve asset. But the gold standard isn't about to be re-imposed.
In truth, while gold may have a role in protecting against inflation, there are plenty of alternatives. Here are five you should be thinking about--particularly when you bear in mind that gold is already close to an all-time high.
Real-Estate Rebound
One, property. The price of real estate won't always move exactly in line with inflation. And you might want to steer clear of the markets where there has yet to be much of a retreat from the exuberant prices of 2006 and 2007. Even so, if there is more money chasing a static amount of land and buildings, prices are going to rise.
Oil
Two, oil. They used to call it black gold and maybe they should again. It has already stopped being just stuff we put in our cars, and use to heat houses, and has become an investment asset in itself. How else can we explain the fact that oil has ticked up past $70 a barrel even while we're living through the worst global recession since World War II? Oil is already, in effect, an alternative to gold. The one difference is that you can put it in your car and drive somewhere--making it far more useful than stuff good for little more than dental fillings and trinkets to wear around your neck. (Did I just say that?...Oh, that's right....diamonds are a girl's best friend.)
Stock Picking
Three, equities. Moderate, persistent inflation in the 3 percent range is good for the kind of big, blue-chip companies that dominate the major global stock markets. They can edge up rices along with everyone else. And they can usually get away with increasing wages just a bit less than inflation, so cutting labor costs as well--particularly as unions are far less powerful than they used to be. In those circumstances, the shareholders should do fine--and their equities will more than keep up with rising prices.
Luxury Goods
Four, luxury goods and collectibles. Once inflation takes off, it is only real assets that will hold their value--everything else is just paper, and that will be of dwindling use. Assets don't get much more real than historic art, valuable antiques, vintage automobiles or fine wines. They should start to soar in price as the mega-rich realize they are among the few ways to protect wealth. And, if you get it wrong, you can always hang them on the wall, or drink them.
Private Equity Funds
Five, private-equity funds. This one might not be obvious. But a leveraged buyout firm buys well-established companies, in basic industries, and then loads them up with lots of debt, while hanging on to a little bit of equity. Inflation will effectively wipe out all that debt. The result? The equity that is left over will be worth far more. What do you think the Chinese have been doing these last few years?
Rate Squeeze
Of course, none of these will necessarily work in the long-term. The only real way to control inflation once it gets started is to raise interest rates high enough to create a deep recession, and so choke off rising prices. That's what central bankers did in the late 1970s and early 1980s, and may do again sometime around 2015 or 2020. Once that happens, you'll need to think again--you might not want to be in property or equities.
That, however, is some way off. As we move into the early stages of an inflationary era, those five assets should do at least as well as gold, if not better.
Tuesday, December 8, 2009
Monday, October 12, 2009
A New Leading Indicator
Economists are wrong to dismiss unemployment as merely a lagging indicator, a sign of where the economy has been.
In fact, I believe that the 26-year high jobless rate is also an omen of things to come.
The climb in the September rate to 9.8 percent, double the level at the start of last year, leaves the U.S. saddled with about 15 million people out of work and with limited prospects. That will further hurt the housing market and weigh on the wages of those still employed, threatening to undercut the economic recovery.
Today’s unemployment rate is much more than a lagging indicator. It is also a signal of future pressures on consumption, housing and the country’s social safety net.
The job market tends to trail the economy in a recovery because companies hesitate to take on more workers until they are convinced the expansion will last. What’s different this time is the large and protracted rise in joblessness and the likelihood that it will stay high for years. That means unemployment will affect the economy going forward, not merely reflect where it has been.
Less Credit, Fewer Jobs
The U.S. is entering a "new normal" -- a sustained period of annual growth of about 2 percent -- as Americans adjust to a world where credit and jobs are less plentiful. In the five years before the recession began at the end of 2007, gross domestic product expanded at an average annual rate of 2.8 percent. The struggle to generate jobs means the Federal Reserve will keep its benchmark interest rate near zero through next year.
Joblessness will be the number one public policy problem for 2010. The Democrats could get hurt by that in the November Congressional elections.
The September numbers were “wall-to-wall ugly,” as payroll cuts accelerated to 263,000 from 201,000 in August.
Dropping Out
Unemployment would have topped 10 percent if not for the more than half million Americans who left the workforce. Long- term joblessness -- the percentage of the unemployed out of work for 27 weeks or more -- rose to a record 35.6 percent, or 5.4 million Americans.
The 62-year-old executive added in an interview that the economy will probably recover more slowly than in past rebounds.
Even before the job figures, Fed Chairman Ben S. Bernanke told lawmakers on Oct. 1 that economic growth next year probably won’t be strong enough to “substantially” bring down the jobless rate, which may remain above 9 percent at the end of 2010.
Economic Experience
Employment and unemployment, economic experience suggests, is a lagging indicator.
The last recovery started in December 2001; unemployment didn’t fall until five months later. In 1991, the expansion began in April and the jobless rate fell briefly in July, only to resume rising into the next year.
While the unemployment rate this time will again lag behind the recovery, which probably started in the third quarter, the distress in the job market was also saying something about the future.
We have an army of unemployed. That’s telling us a lot, in a leading way, about the picture for the consumer.
Wages And Bankruptcies
U.S. consumer bankruptcies rose past 1 million through the first nine months of the year, the highest since 2005 changes to bankruptcy laws.
Employment expenses in the U.S. -- both wages and benefits -- increased at a record low year-on-year rate of 1.8 percent in the second quarter after a 2.1 percent increase in the first, as the high jobless rate held down worker compensation, according to an index compiled by the Labor Department.
Retailers are pulling back before the holiday sales season.
U.S. retail job losses jumped to 38,500 in September from 8,800 in August as car dealers and other stores cut payrolls.
Mattel Inc. and Hasbro Inc., the world’s two biggest toymakers, are shifting toward lower prices this holiday season as budget-conscious parents seek bargains. Eighty percent of El Segundo, California-based Mattel’s toys will cost less than $30 this year, compared with 75 percent last year.
More Foreclosures
Housing, which has traditionally led the economy out of recession, may also be hurt as the continued rise in unemployment boosts foreclosures. It is possible for home prices to resume their downward slide, after jumping by the most in almost four years in 20 U.S. cities in July, as the jobless rate rises to 10.5 percent in the middle of next year.
Mortgages 60 days or more past due climbed to 5.3 percent of loans through June 30, up from 4.8 percent on March 31 and 3 percent a year earlier, the Office of the Comptroller of the Currency and the Office of Thrift Supervision said on Sept. 30.
First-time foreclosure filings fell 0.4 percent from the first quarter, helped by Obama’s loan-modification program, according to the two government bank regulators in Washington.
U.S. homebuilders will have operating losses of more than $500 million in 2010 as mounting foreclosures and unemployment further erode home prices, Moody’s Investors Service said in a Sept. 30 report. The New York-based bond rating company extended its negative credit outlook for the industry for the next 12 to 18 months, meaning Moody’s may lower the builders’ debt ratings.
Housing Woes
Banks will also be hurt as housing’s woes lead to more loan losses.
The depressed job market may take its toll on politicians. Democratic lawmakers in the House of Representatives are particularly vulnerable if voters blame Obama for a sour economy.
Since 1945, the party that controls the White House has lost an average of 16 House seats in a president’s first midterm election, according to the Cook Political Report. Obama’s Democratic Party currently has 256 seats in the chamber, compared with 178 for the Republicans.
The House approved legislation last month that would extend unemployment benefits by 13 weeks for people in 27 states with jobless rates of at least 8.5 percent in August. The Senate is considering the measure.
It’s very important for policy makers to remain very aggressive. The severe stress in the job market is the most significant threat to the nascent recovery.
In fact, I believe that the 26-year high jobless rate is also an omen of things to come.
The climb in the September rate to 9.8 percent, double the level at the start of last year, leaves the U.S. saddled with about 15 million people out of work and with limited prospects. That will further hurt the housing market and weigh on the wages of those still employed, threatening to undercut the economic recovery.
Today’s unemployment rate is much more than a lagging indicator. It is also a signal of future pressures on consumption, housing and the country’s social safety net.
The job market tends to trail the economy in a recovery because companies hesitate to take on more workers until they are convinced the expansion will last. What’s different this time is the large and protracted rise in joblessness and the likelihood that it will stay high for years. That means unemployment will affect the economy going forward, not merely reflect where it has been.
Less Credit, Fewer Jobs
The U.S. is entering a "new normal" -- a sustained period of annual growth of about 2 percent -- as Americans adjust to a world where credit and jobs are less plentiful. In the five years before the recession began at the end of 2007, gross domestic product expanded at an average annual rate of 2.8 percent. The struggle to generate jobs means the Federal Reserve will keep its benchmark interest rate near zero through next year.
Joblessness will be the number one public policy problem for 2010. The Democrats could get hurt by that in the November Congressional elections.
The September numbers were “wall-to-wall ugly,” as payroll cuts accelerated to 263,000 from 201,000 in August.
Dropping Out
Unemployment would have topped 10 percent if not for the more than half million Americans who left the workforce. Long- term joblessness -- the percentage of the unemployed out of work for 27 weeks or more -- rose to a record 35.6 percent, or 5.4 million Americans.
The 62-year-old executive added in an interview that the economy will probably recover more slowly than in past rebounds.
Even before the job figures, Fed Chairman Ben S. Bernanke told lawmakers on Oct. 1 that economic growth next year probably won’t be strong enough to “substantially” bring down the jobless rate, which may remain above 9 percent at the end of 2010.
Economic Experience
Employment and unemployment, economic experience suggests, is a lagging indicator.
The last recovery started in December 2001; unemployment didn’t fall until five months later. In 1991, the expansion began in April and the jobless rate fell briefly in July, only to resume rising into the next year.
While the unemployment rate this time will again lag behind the recovery, which probably started in the third quarter, the distress in the job market was also saying something about the future.
We have an army of unemployed. That’s telling us a lot, in a leading way, about the picture for the consumer.
Wages And Bankruptcies
U.S. consumer bankruptcies rose past 1 million through the first nine months of the year, the highest since 2005 changes to bankruptcy laws.
Employment expenses in the U.S. -- both wages and benefits -- increased at a record low year-on-year rate of 1.8 percent in the second quarter after a 2.1 percent increase in the first, as the high jobless rate held down worker compensation, according to an index compiled by the Labor Department.
Retailers are pulling back before the holiday sales season.
U.S. retail job losses jumped to 38,500 in September from 8,800 in August as car dealers and other stores cut payrolls.
Mattel Inc. and Hasbro Inc., the world’s two biggest toymakers, are shifting toward lower prices this holiday season as budget-conscious parents seek bargains. Eighty percent of El Segundo, California-based Mattel’s toys will cost less than $30 this year, compared with 75 percent last year.
More Foreclosures
Housing, which has traditionally led the economy out of recession, may also be hurt as the continued rise in unemployment boosts foreclosures. It is possible for home prices to resume their downward slide, after jumping by the most in almost four years in 20 U.S. cities in July, as the jobless rate rises to 10.5 percent in the middle of next year.
Mortgages 60 days or more past due climbed to 5.3 percent of loans through June 30, up from 4.8 percent on March 31 and 3 percent a year earlier, the Office of the Comptroller of the Currency and the Office of Thrift Supervision said on Sept. 30.
First-time foreclosure filings fell 0.4 percent from the first quarter, helped by Obama’s loan-modification program, according to the two government bank regulators in Washington.
U.S. homebuilders will have operating losses of more than $500 million in 2010 as mounting foreclosures and unemployment further erode home prices, Moody’s Investors Service said in a Sept. 30 report. The New York-based bond rating company extended its negative credit outlook for the industry for the next 12 to 18 months, meaning Moody’s may lower the builders’ debt ratings.
Housing Woes
Banks will also be hurt as housing’s woes lead to more loan losses.
The depressed job market may take its toll on politicians. Democratic lawmakers in the House of Representatives are particularly vulnerable if voters blame Obama for a sour economy.
Since 1945, the party that controls the White House has lost an average of 16 House seats in a president’s first midterm election, according to the Cook Political Report. Obama’s Democratic Party currently has 256 seats in the chamber, compared with 178 for the Republicans.
The House approved legislation last month that would extend unemployment benefits by 13 weeks for people in 27 states with jobless rates of at least 8.5 percent in August. The Senate is considering the measure.
It’s very important for policy makers to remain very aggressive. The severe stress in the job market is the most significant threat to the nascent recovery.
Thursday, September 17, 2009
The Global Financial Crises' Is Over, If You Believe It Is!
No, Not Really!
Mixed Metaphors
Botanical commentators are finding "green shoots." The astronomically minded have seen "glimmers." The meteorologically minded have spoken about the storms "abating." Strong rallies in equity and debt markets have confirmed the recovery for the "true believers."
The Global Financial Crisis (GFC) crisis is over!
It is useful to remember Winston Churchill's observation after the British expeditionary force's escape from Dunkirk: "[Britain] must be very careful not to assign to this deliverance the attributes of a victory.'' There may be confusion between "stabilization'' and "recovery.''
The green-shoots theory is based on a slowdown in the rate of decline in key economic indicators, improvements in the financial system, unprecedented government support for the banking system, near-zero interest rates and large fiscal stimulus packages. The recovery of emerging markets, especially China, also underpins hopes of a swift return to growth.
Receiving the Messengers
The puzzling thing is that real economy indicators continue to be poor.
GDP forecasts for 2009 have steadily deteriorated, with world growth expected to be negative 2% to 3%, with especially poor prospects for Japan and the euro zone. Industrial output, employment, consumption, investment and global trade continue to be weak. Even China, which expected to grow between 6% and 8% in 2009, experienced a fall in exports of over 20% over the last year.
The wealth effects of the GFC on economic activity are unclear.
In the United States alone, $30 trillion of value has been destroyed. Pension funds have lost anywhere between 20% and 50% of their value. Combined with declines in housing prices and reduced dividends and investment income, the sharp decline in wealth may not be yet to fully flow through into consumption.
The financial system has stabilized but not returned to the "rude good health" that current executive compensation demands within banks would suggest.
Good results for Goldman Sachs and J.P.Morgan are offset by less impressive performances by Bank of America, CitiGroup and Morgan Stanley. Profitability is patchy and reliant on risky trading income and large underwriting revenues from capital raisings by financial institutions and companies who are de-leveraging aggressively. Asset quality remains vulnerable to more bad debts from the normal recessionary credit cycle that is working through the economy.
Bank risk levels have increased to and in some cases beyond pre-crisis levels.
Goldman Sachs second-quarter earnings showed an increase in risk levels as measured by Value-at-Risk (VAR). The increase in risk is probably understated as it takes into account diversification benefits that may be overstated under conditions of market stress. It is probably also understated because of assumption of trading liquidity that may be optimistic given recent experience. The higher levels of risk-taking reflect increasing comfort in central bank support of financial institutions' liquidity and their ability and willingness to intervene to limit price risks. Leverage and lending against risky assets has resumed at a rate not seen since 2007.
Capital remains scarce and bank balance sheets are at best not growing and at worst shrinking. Some estimates suggest that the bank capital shortfall could be in range of $1 trillion to $2 trillion, equivalent to a credit contraction of around 20% to 30% from previous levels. Proposed bank regulations, primarily the increased levels of capital and lower permitted leverage, will also affect the ability of the financial system to extend credit.
The link between debt and economic growth is well established. The global economy probably needs around $4 to $5 of debt to create $1 of GDP growth
.
International Monetary Fund researchers Tamin Bayoumi and Ola Melander, in a study of the economic impacts of an adverse shock to bank capital ("Credit Matters: Empirical Evidence on U.S. Macro-Financial Linkages," IMF Working Paper 08/169) found that in the United States, a one percentage point fall in Tier 1 risk-weighted capital ratios reduces real GDP by 1.5%.
This means that global bank capital shortage may restrain credit creation thereby reducing economic activity and sustainable growth levels.
The impact of fiscal stimulus packages has been variable. In some jurisdictions, the payments have been saved or applied towards debt reduction rather than consumption. Targeted measures, such as the cash-for-clunkers' deals (cleverly packaged as ‘green' environmental initiatives) have boosted immediate demand for cars, but the long-term demand effects are unclear.
The multiplier effect of the fiscal initiatives is likely to be low. Major infrastructure initiatives will take time to implement. Few projects are "shovel ready." The rate of return on government spending programs, some of which are politically motivated, is unclear. Government spending increasing capacity is likely to create problems in a world where many industries are operating with surplus capacity. Government bailout packages for various industries, such as the auto and housing industries, however well intentioned, are delaying much needed capacity adjustments and risk prolonging the problems.
The phoenix-like recovery in emerging markets is primarily driven by panicked government spending and loose monetary policies increasing available credit. Estimates suggest that around 6% of China's growth of around 8% is attributable to government spending and increased bank lending.
The extraordinary increase in lending in China is fueling unsustainable growth. In the first half of 2009, new loans totaled more than $1 trillion. This compares to total loans for all of 2008 of around $600 billion. Current lending is running at around three times 2008 levels and at a staggering 25% of China's GDP. The combination of government spending and bank loans has resulted in sharp increases in fixed asset investments (up 30% from 2008). Government incentives, in the form of rebates for purchases of high value durables such as cars and white goods, have also increased consumption (up 15% from 2008). Even Chinese government officials have admitted that the recovery is "unbalanced."
The increase in industrial production in the absence of real end demand for products could result in a rapid inventory buildup. The availability of credit is also fueling rampant speculation in stocks, property and commodities. Estimates suggest that around 20% to 30% of new bank lending is finding it way into the stock market, in part driving up values.
The price rise in emerging market shares, debt and currencies also reflects a blind belief that anywhere must be safer and more promising than the U.S., Japan or Europe. This misses the point that these markets have a strong trading and export orientation or are external capital dependent. While some have bright long-term futures, they will need to make difficult and slow adjustments to their growth models to return to trend growth.
The recovery in emerging markets has, in turn, underpinned the recovery in commodity prices and economies dependent on natural resources. A significant part of this is inventory restocking but there is a speculative element. Availability of abundant and low-cost bank financing, combined with a deep-seated fear of the long-term prospects of U.S. Treasury bonds and the dollar, has encouraged speculative stockpiling of certain commodities, artificially boosting demand.
In reality, the global economy has, in all probability, entered a period of stability after a fairly big decline. Market sentiment seems to be shaped less by facts than the Doors' song: "I've been down for so long, it feels like up to me."
Government Largesse
A key risk remains the ability of governments to finance their burgeoning government deficits. A wretched combination of declining tax revenues, increased government spending to cushion the economy from recession and bailout packages for banks and other "worthies" means that many countries face large and continuing budget deficits.
In August, the U.S. Congressional Budget Office released forecast that project the 10-year deficit to reach over $9 trillion, some $2 trillion more than it had estimated as recently as March 2009. Even countries with relatively healthy balance sheets such as Australia do not anticipate balancing their books for many years. If the problems of an aging population and unfunded liabilities such as public sector pensions, health-care and social security arrangements are included, then the budgetary position looks considerably worse.
In 2009, total sovereign debt issues are expected to total more than $5 trillion, of which the United States alone will need to finance around $3 trillion. The increases in sovereign debt issuance are astonishing – U.S. around 300%, U.K. over 400%, euro zone around 50%. Government debt-to-GDP ratios for many developed countries are projected to reach and remain at levels in excess of 100%.
Overall government deficits in major economies through the recession are estimated to total around $10 trillion (around 27% of GDP of these economies). The work of economists Kenneth Rogoff and Carmen Reinhart on previous recessions suggests that the deficit estimates are conservative and the amount that will need to be financed will be between $15 trillion (40% of GDP) and $33 trillion (86% of GDP).
As a comparison, the total amount of global investment assets under management, according to one estimate, is around $120 trillion. This provides some idea of the funding task ahead.
Long-term interest rates have risen sharply, reflecting supply pressures. The 30-year U.S. Treasury yield has increased by around 1.50 percentage points since the start of 2009. Maturities also have shortened, increasing the refinancing challenges ahead. Participation of central banks in the U.S. and U.K. bond markets, under their quantitative-easing mandates, has hold down interest-rate increases, creating a somewhat artificial market.
A key issue over the coming months is the continued demand for increased sovereign debt issues.
China, Japan and Europe historically have been major buyers of U.S. Treasury bonds. As their own fiscal position changes and their current account surplus shrinks, the ability of these investors to absorb the increased supply is unclear. China's foreign exchange reserves are growing more slowly than before. China has continued to purchase U.S. Treasury bonds, but some purchases represent a switch from U.S. agency paper. As the United States has increased its issuance program, China's purchases are now a smaller portion of the total.
In the best case, the government debt issuance is accommodated but squeezes out other borrowers. In the worst case, governments find themselves unable to finance their deficits setting off a new stage of the GFC.
Withdrawal Method
Given the size of the intervention, a key question is the timing of withdrawal of government support for the economy.
The current apparent health of the financial system owes everything to wide-ranging government support. The ability of the banks to raise equity and debt is substantially underwritten by the "too-big-to-fail" doctrine. Profitability is supported by low and, in some cases, zero cost of deposits and a sharply upward sloping yield curve that creates significant earnings from borrowing short and lending long. Withdrawal of support may expose deep-seated and unresolved problems in the financial system.
Substantial quantities of structured securities are now held by central banks either as collateral for funding arrangements or through other innovative market support mechanisms. This has substantially increased the size of central bank balance sheets in the U.S., U.K and Europe.
It is not clear how and when these "temporary" positions will be unwound. Attempts to create structures for repackaging these securities, such as the frequently touted but still to be implemented Public Private Investment Partnership (PPIP) program, have enjoyed limited success. Untimely attempts by governments to liquidate these portfolios may be disruptive to fragile markets.
These securities may have to be held to maturity (sometimes over 10 years in the case of some Asset Backed Securities (ABS) and allowed to self liquidate from the underlying cash flows. The bloated central bank balance sheets may restrict policy flexibility significantly.
Government spending has been substituted for private consumption and investment. The deficits will ultimately necessitate a combination of increased taxation and reduced spending to correct this position.
Assume a country has government debt equal to 100% of its GDP. Assuming an annual interest rate of 5% and a GDP growth rate of 4%, a 1% budget surplus is required to maintain debt at current levels. If the gap between interest rates and growth is greater, then the size of the required surplus is commensurately larger. In effect, it is unlikely that the present expansionary fiscal position can be sustained over a long period. The fiscal position of major economies may restrain growth.
Fundamental Truths
Belief in the recovery story and sharp financial market rallies fail to recognize that little has actually changed since the GFC began. Fundamental failures have not been fully addressed.
The required reduction in debt levels has not been completed. Increases in government debt have substantially offset reductions in private sector debt.
Instead of dealing with the problem of leverage, the debt has also merely been rolled forward through a variety of clever warehousing structures and the manipulation of accounting rules.
In a system that has excessive leverage, there are only two adjustment mechanisms:
The value of assets supporting the debt and income available to service the borrowing can be increased, usually by inflation.
The value of the debt can be reduced through writing it down to the real value of the assets.
Governments and central banks have gambled on inflation despite its social and economic costs. In reality, inflationary pressures in the global economy are not apparent. The rebound in energy and food costs has prevented deflation. The absence of demand, excess capacity, reduced credit creation and low velocity of money circulation may mean that it is disinflation or deflation that is the problem going forward.
There is now faith-based reliance on governments' ability to rescue the economy. Intervention has helped stabilize economic activity and the financial system but it improbable that government actions alone can prevent the necessary adjustment in debt levels and growth rates.
Government's share of most developed economies is around 25% to 40% of GDP. Its role in liberal democracies is limited by the fact that is fundamentally an intermediary, not dissimilar to a bank. It derives its resources through taxation from certain sectors of the economy and redirects it to other sectors. This means that its ability to control an economy has limits in the absence of nationalization of all productive activity.
In the short run, governments can borrow or print money to augment its resources. Like all debt, it borrows from tomorrow to pay for today. Quantitative easing (the now respectable name for printing money) also has limits, unless governments are willing to risk hyper-inflation and the social dissolution of the Weimar Republic or Zimbabwe. While governments can influence an economy, they cannot completely reverse inevitable adjustments dictated by market forces.
Governments may also be impeding necessary adjustments. Rising government investment is increasing capacity in a world with stagnant demand and over-capacity in many sectors.
China's current growth is being driven by government investment that is increasing capacity, which in the absence of sufficient domestic demand may be directed to exports increasing the global supply glut. Politically and socially motivated bailouts of national champions and strategic industries mean the necessary reductions in capacity through bankruptcy and corporate failure have not been allowed to happen.
There are even signs that the financial sector is rediscovering old habits. The government and taxpayer paid for return to profitability of major financial institutions, and the return of remuneration levels to pre-crisis levels raises fundamental questions about whether any change has occurred. After the strong second-quarter earnings report for Goldman Sachs, Chief Financial Officer David Viniar told Bloomberg News that, "Our model really never changed, we've said very consistently that our business model remained the same." Despite the egregious excesses, governments seem collectively to lack the will to reform the financial system to avoid the problems of the past.
In 2007, when the U.S. housing bubble collapsed, the satirical magazine The Onion demanded that the American people be given another bubble to speculate in. Their wish now appears to have granted.
Actions to stabilize the global economy seem only to have created new bubbles – in government debt and emerging markets.
Government actions seem to be primarily designed to ensuring continuation of the Ponzi scheme. The only lesson learned is that no Ponzi scheme can ever be allowed to stop.
As states one familiar but anonymous saying: "Never in the history of the world has there been a situation so bad that the government can't make it worse."
Global Questions
There is broad agreement that a key component of the GFC was the problem of global capital imbalances.
A central feature was debt-funded consumption in the United States that allowed 5% of the global population to constitute 25% of its GDP, 15% of consumption and 48% of global current account deficit.
Japan, China, Germany and the other savers funded the consumption.
At its peak, the United States was absorbing about 85% of total global capital flows to fund its government and private debt.
Any lasting solution to the GFC requires this imbalance to be dealt with.
The glib solution requires the United States to save more and consume less, and the savers to save less and consume more. The problems in implementing the solution are considerable.
Timothy Geithner's recent discussion with Chinese officials, to assure his hosts of the safety of their investments in dollars and U.S. Treasury bonds, reveals the dilemma.
On the one hand, America needs the Chinese to continue and increase their purchase of U.S. government debt to finance its fiscal stimulus and bailouts.
On the other hand, America needs China to cut the size of its current account surplus, boost government spending, encourage personal consumption and reduce savings.
All this should also occur ideally without any major decline in the value of the dollar or U.S. Treasury bonds or the need for China to liberalize it currency and open its capital account, allowing internationalization of the Renminbi!
A cursory look at the respective economies highlights the magnitude of the task.
Consumption's contribution to U.S. GDP is 71%, while in China, it is 37%. Given that the GDP of China is around $4 trillion to $5 trillion, vs. $15 trillion for the United States, and average income in China is around 10% to 15% of U.S. earnings, the difficulty of using Chinese consumption to drive the global economy becomes apparent.
Additionally, over the last 25 years, Chinese consumption has declined from around 50% to current levels of 37%. During that same period, Chinese savings have risen and exports have been the engine for growth. Given that a significant portion of exports is driven ultimately by American buyer, lower U.S. growth and declining consumption creates significant challenges for China.
Dealing with these global imbalances has not been a high priority in the various summits, symposiums and talk-fests that global leaders have shuttled to and from. The focus has been ‘NATO' – no action talk only. Half-hearted and unworkable proposals, such as the use of the synthetic Special Drawing Rights as reserve currency, have emerged.
Globally Unbalanced
Reliance on Chinese foreign currency reserves is probably misplaced.
Chinese reserves, a large proportion denominated in dollars, may have limited value. They cannot be effectively liquidated or mobilized without massive losses. Increasingly strident Chinese rhetoric about the safety of their dollar assets reflects increasing panic.
In reality, China is trying desperately to switch its reserves into real assets – commodity or resource producers where foreign countries will allow. In the meantime, China continues to purchase more dollars and U.S. Treasury bond to preserve the value of existing holdings in a surreal logic.
On the other side, the U.S. continues to seek to preserve the status of the dollar as the sole reserve currency in order to enable itself to finance itself. The intractable nature of this problem is evident in the frequently contradictory statements from various Chinese spokesmen regarding the official position on the dollar.
No sustainable global recovery is likely without addressing the fundamental global imbalances that lie at the heart of the GFC.
Placebo Effects
Wolfgang Münchau, writing in the Financial Times on June 14, 2009, eloquently summed up developments. "Instead of solving the problems to generate a recovery, the political strategies have consisted of waiting for a recovery to solve the problem. The Europeans are relying on the Americans to generate growth. The Americans are relying on the Chinese, who in turn are waiting for the rest of the world."
The placebo effect is a pervasive phenomenon in medicine. A sham medical intervention may cause the patient to believe that the treatment will change his or her condition sometime causing the actual condition to improve. Conditioning, expectations and motivation all can play a role in placebo effect.
In recent times, investors, markets and governments have all come to believe in the recovery, sometimes by selective interpretation of facts to support the conclusion that they need. As T.S. Eliot observed: "Mankind cannot take too much reality."
Given reluctance or inability to deal with the real problems, it is not entirely clear whether the GFC cures are real or inert treatments.
It is also not clear whether current improvements in market and economic conditions are sustainable or merely a short-term placebo effect.
Mixed Metaphors
Botanical commentators are finding "green shoots." The astronomically minded have seen "glimmers." The meteorologically minded have spoken about the storms "abating." Strong rallies in equity and debt markets have confirmed the recovery for the "true believers."
The Global Financial Crisis (GFC) crisis is over!
It is useful to remember Winston Churchill's observation after the British expeditionary force's escape from Dunkirk: "[Britain] must be very careful not to assign to this deliverance the attributes of a victory.'' There may be confusion between "stabilization'' and "recovery.''
The green-shoots theory is based on a slowdown in the rate of decline in key economic indicators, improvements in the financial system, unprecedented government support for the banking system, near-zero interest rates and large fiscal stimulus packages. The recovery of emerging markets, especially China, also underpins hopes of a swift return to growth.
Receiving the Messengers
The puzzling thing is that real economy indicators continue to be poor.
GDP forecasts for 2009 have steadily deteriorated, with world growth expected to be negative 2% to 3%, with especially poor prospects for Japan and the euro zone. Industrial output, employment, consumption, investment and global trade continue to be weak. Even China, which expected to grow between 6% and 8% in 2009, experienced a fall in exports of over 20% over the last year.
The wealth effects of the GFC on economic activity are unclear.
In the United States alone, $30 trillion of value has been destroyed. Pension funds have lost anywhere between 20% and 50% of their value. Combined with declines in housing prices and reduced dividends and investment income, the sharp decline in wealth may not be yet to fully flow through into consumption.
The financial system has stabilized but not returned to the "rude good health" that current executive compensation demands within banks would suggest.
Good results for Goldman Sachs and J.P.Morgan are offset by less impressive performances by Bank of America, CitiGroup and Morgan Stanley. Profitability is patchy and reliant on risky trading income and large underwriting revenues from capital raisings by financial institutions and companies who are de-leveraging aggressively. Asset quality remains vulnerable to more bad debts from the normal recessionary credit cycle that is working through the economy.
Bank risk levels have increased to and in some cases beyond pre-crisis levels.
Goldman Sachs second-quarter earnings showed an increase in risk levels as measured by Value-at-Risk (VAR). The increase in risk is probably understated as it takes into account diversification benefits that may be overstated under conditions of market stress. It is probably also understated because of assumption of trading liquidity that may be optimistic given recent experience. The higher levels of risk-taking reflect increasing comfort in central bank support of financial institutions' liquidity and their ability and willingness to intervene to limit price risks. Leverage and lending against risky assets has resumed at a rate not seen since 2007.
Capital remains scarce and bank balance sheets are at best not growing and at worst shrinking. Some estimates suggest that the bank capital shortfall could be in range of $1 trillion to $2 trillion, equivalent to a credit contraction of around 20% to 30% from previous levels. Proposed bank regulations, primarily the increased levels of capital and lower permitted leverage, will also affect the ability of the financial system to extend credit.
The link between debt and economic growth is well established. The global economy probably needs around $4 to $5 of debt to create $1 of GDP growth
.
International Monetary Fund researchers Tamin Bayoumi and Ola Melander, in a study of the economic impacts of an adverse shock to bank capital ("Credit Matters: Empirical Evidence on U.S. Macro-Financial Linkages," IMF Working Paper 08/169) found that in the United States, a one percentage point fall in Tier 1 risk-weighted capital ratios reduces real GDP by 1.5%.
This means that global bank capital shortage may restrain credit creation thereby reducing economic activity and sustainable growth levels.
The impact of fiscal stimulus packages has been variable. In some jurisdictions, the payments have been saved or applied towards debt reduction rather than consumption. Targeted measures, such as the cash-for-clunkers' deals (cleverly packaged as ‘green' environmental initiatives) have boosted immediate demand for cars, but the long-term demand effects are unclear.
The multiplier effect of the fiscal initiatives is likely to be low. Major infrastructure initiatives will take time to implement. Few projects are "shovel ready." The rate of return on government spending programs, some of which are politically motivated, is unclear. Government spending increasing capacity is likely to create problems in a world where many industries are operating with surplus capacity. Government bailout packages for various industries, such as the auto and housing industries, however well intentioned, are delaying much needed capacity adjustments and risk prolonging the problems.
The phoenix-like recovery in emerging markets is primarily driven by panicked government spending and loose monetary policies increasing available credit. Estimates suggest that around 6% of China's growth of around 8% is attributable to government spending and increased bank lending.
The extraordinary increase in lending in China is fueling unsustainable growth. In the first half of 2009, new loans totaled more than $1 trillion. This compares to total loans for all of 2008 of around $600 billion. Current lending is running at around three times 2008 levels and at a staggering 25% of China's GDP. The combination of government spending and bank loans has resulted in sharp increases in fixed asset investments (up 30% from 2008). Government incentives, in the form of rebates for purchases of high value durables such as cars and white goods, have also increased consumption (up 15% from 2008). Even Chinese government officials have admitted that the recovery is "unbalanced."
The increase in industrial production in the absence of real end demand for products could result in a rapid inventory buildup. The availability of credit is also fueling rampant speculation in stocks, property and commodities. Estimates suggest that around 20% to 30% of new bank lending is finding it way into the stock market, in part driving up values.
The price rise in emerging market shares, debt and currencies also reflects a blind belief that anywhere must be safer and more promising than the U.S., Japan or Europe. This misses the point that these markets have a strong trading and export orientation or are external capital dependent. While some have bright long-term futures, they will need to make difficult and slow adjustments to their growth models to return to trend growth.
The recovery in emerging markets has, in turn, underpinned the recovery in commodity prices and economies dependent on natural resources. A significant part of this is inventory restocking but there is a speculative element. Availability of abundant and low-cost bank financing, combined with a deep-seated fear of the long-term prospects of U.S. Treasury bonds and the dollar, has encouraged speculative stockpiling of certain commodities, artificially boosting demand.
In reality, the global economy has, in all probability, entered a period of stability after a fairly big decline. Market sentiment seems to be shaped less by facts than the Doors' song: "I've been down for so long, it feels like up to me."
Government Largesse
A key risk remains the ability of governments to finance their burgeoning government deficits. A wretched combination of declining tax revenues, increased government spending to cushion the economy from recession and bailout packages for banks and other "worthies" means that many countries face large and continuing budget deficits.
In August, the U.S. Congressional Budget Office released forecast that project the 10-year deficit to reach over $9 trillion, some $2 trillion more than it had estimated as recently as March 2009. Even countries with relatively healthy balance sheets such as Australia do not anticipate balancing their books for many years. If the problems of an aging population and unfunded liabilities such as public sector pensions, health-care and social security arrangements are included, then the budgetary position looks considerably worse.
In 2009, total sovereign debt issues are expected to total more than $5 trillion, of which the United States alone will need to finance around $3 trillion. The increases in sovereign debt issuance are astonishing – U.S. around 300%, U.K. over 400%, euro zone around 50%. Government debt-to-GDP ratios for many developed countries are projected to reach and remain at levels in excess of 100%.
Overall government deficits in major economies through the recession are estimated to total around $10 trillion (around 27% of GDP of these economies). The work of economists Kenneth Rogoff and Carmen Reinhart on previous recessions suggests that the deficit estimates are conservative and the amount that will need to be financed will be between $15 trillion (40% of GDP) and $33 trillion (86% of GDP).
As a comparison, the total amount of global investment assets under management, according to one estimate, is around $120 trillion. This provides some idea of the funding task ahead.
Long-term interest rates have risen sharply, reflecting supply pressures. The 30-year U.S. Treasury yield has increased by around 1.50 percentage points since the start of 2009. Maturities also have shortened, increasing the refinancing challenges ahead. Participation of central banks in the U.S. and U.K. bond markets, under their quantitative-easing mandates, has hold down interest-rate increases, creating a somewhat artificial market.
A key issue over the coming months is the continued demand for increased sovereign debt issues.
China, Japan and Europe historically have been major buyers of U.S. Treasury bonds. As their own fiscal position changes and their current account surplus shrinks, the ability of these investors to absorb the increased supply is unclear. China's foreign exchange reserves are growing more slowly than before. China has continued to purchase U.S. Treasury bonds, but some purchases represent a switch from U.S. agency paper. As the United States has increased its issuance program, China's purchases are now a smaller portion of the total.
In the best case, the government debt issuance is accommodated but squeezes out other borrowers. In the worst case, governments find themselves unable to finance their deficits setting off a new stage of the GFC.
Withdrawal Method
Given the size of the intervention, a key question is the timing of withdrawal of government support for the economy.
The current apparent health of the financial system owes everything to wide-ranging government support. The ability of the banks to raise equity and debt is substantially underwritten by the "too-big-to-fail" doctrine. Profitability is supported by low and, in some cases, zero cost of deposits and a sharply upward sloping yield curve that creates significant earnings from borrowing short and lending long. Withdrawal of support may expose deep-seated and unresolved problems in the financial system.
Substantial quantities of structured securities are now held by central banks either as collateral for funding arrangements or through other innovative market support mechanisms. This has substantially increased the size of central bank balance sheets in the U.S., U.K and Europe.
It is not clear how and when these "temporary" positions will be unwound. Attempts to create structures for repackaging these securities, such as the frequently touted but still to be implemented Public Private Investment Partnership (PPIP) program, have enjoyed limited success. Untimely attempts by governments to liquidate these portfolios may be disruptive to fragile markets.
These securities may have to be held to maturity (sometimes over 10 years in the case of some Asset Backed Securities (ABS) and allowed to self liquidate from the underlying cash flows. The bloated central bank balance sheets may restrict policy flexibility significantly.
Government spending has been substituted for private consumption and investment. The deficits will ultimately necessitate a combination of increased taxation and reduced spending to correct this position.
Assume a country has government debt equal to 100% of its GDP. Assuming an annual interest rate of 5% and a GDP growth rate of 4%, a 1% budget surplus is required to maintain debt at current levels. If the gap between interest rates and growth is greater, then the size of the required surplus is commensurately larger. In effect, it is unlikely that the present expansionary fiscal position can be sustained over a long period. The fiscal position of major economies may restrain growth.
Fundamental Truths
Belief in the recovery story and sharp financial market rallies fail to recognize that little has actually changed since the GFC began. Fundamental failures have not been fully addressed.
The required reduction in debt levels has not been completed. Increases in government debt have substantially offset reductions in private sector debt.
Instead of dealing with the problem of leverage, the debt has also merely been rolled forward through a variety of clever warehousing structures and the manipulation of accounting rules.
In a system that has excessive leverage, there are only two adjustment mechanisms:
The value of assets supporting the debt and income available to service the borrowing can be increased, usually by inflation.
The value of the debt can be reduced through writing it down to the real value of the assets.
Governments and central banks have gambled on inflation despite its social and economic costs. In reality, inflationary pressures in the global economy are not apparent. The rebound in energy and food costs has prevented deflation. The absence of demand, excess capacity, reduced credit creation and low velocity of money circulation may mean that it is disinflation or deflation that is the problem going forward.
There is now faith-based reliance on governments' ability to rescue the economy. Intervention has helped stabilize economic activity and the financial system but it improbable that government actions alone can prevent the necessary adjustment in debt levels and growth rates.
Government's share of most developed economies is around 25% to 40% of GDP. Its role in liberal democracies is limited by the fact that is fundamentally an intermediary, not dissimilar to a bank. It derives its resources through taxation from certain sectors of the economy and redirects it to other sectors. This means that its ability to control an economy has limits in the absence of nationalization of all productive activity.
In the short run, governments can borrow or print money to augment its resources. Like all debt, it borrows from tomorrow to pay for today. Quantitative easing (the now respectable name for printing money) also has limits, unless governments are willing to risk hyper-inflation and the social dissolution of the Weimar Republic or Zimbabwe. While governments can influence an economy, they cannot completely reverse inevitable adjustments dictated by market forces.
Governments may also be impeding necessary adjustments. Rising government investment is increasing capacity in a world with stagnant demand and over-capacity in many sectors.
China's current growth is being driven by government investment that is increasing capacity, which in the absence of sufficient domestic demand may be directed to exports increasing the global supply glut. Politically and socially motivated bailouts of national champions and strategic industries mean the necessary reductions in capacity through bankruptcy and corporate failure have not been allowed to happen.
There are even signs that the financial sector is rediscovering old habits. The government and taxpayer paid for return to profitability of major financial institutions, and the return of remuneration levels to pre-crisis levels raises fundamental questions about whether any change has occurred. After the strong second-quarter earnings report for Goldman Sachs, Chief Financial Officer David Viniar told Bloomberg News that, "Our model really never changed, we've said very consistently that our business model remained the same." Despite the egregious excesses, governments seem collectively to lack the will to reform the financial system to avoid the problems of the past.
In 2007, when the U.S. housing bubble collapsed, the satirical magazine The Onion demanded that the American people be given another bubble to speculate in. Their wish now appears to have granted.
Actions to stabilize the global economy seem only to have created new bubbles – in government debt and emerging markets.
Government actions seem to be primarily designed to ensuring continuation of the Ponzi scheme. The only lesson learned is that no Ponzi scheme can ever be allowed to stop.
As states one familiar but anonymous saying: "Never in the history of the world has there been a situation so bad that the government can't make it worse."
Global Questions
There is broad agreement that a key component of the GFC was the problem of global capital imbalances.
A central feature was debt-funded consumption in the United States that allowed 5% of the global population to constitute 25% of its GDP, 15% of consumption and 48% of global current account deficit.
Japan, China, Germany and the other savers funded the consumption.
At its peak, the United States was absorbing about 85% of total global capital flows to fund its government and private debt.
Any lasting solution to the GFC requires this imbalance to be dealt with.
The glib solution requires the United States to save more and consume less, and the savers to save less and consume more. The problems in implementing the solution are considerable.
Timothy Geithner's recent discussion with Chinese officials, to assure his hosts of the safety of their investments in dollars and U.S. Treasury bonds, reveals the dilemma.
On the one hand, America needs the Chinese to continue and increase their purchase of U.S. government debt to finance its fiscal stimulus and bailouts.
On the other hand, America needs China to cut the size of its current account surplus, boost government spending, encourage personal consumption and reduce savings.
All this should also occur ideally without any major decline in the value of the dollar or U.S. Treasury bonds or the need for China to liberalize it currency and open its capital account, allowing internationalization of the Renminbi!
A cursory look at the respective economies highlights the magnitude of the task.
Consumption's contribution to U.S. GDP is 71%, while in China, it is 37%. Given that the GDP of China is around $4 trillion to $5 trillion, vs. $15 trillion for the United States, and average income in China is around 10% to 15% of U.S. earnings, the difficulty of using Chinese consumption to drive the global economy becomes apparent.
Additionally, over the last 25 years, Chinese consumption has declined from around 50% to current levels of 37%. During that same period, Chinese savings have risen and exports have been the engine for growth. Given that a significant portion of exports is driven ultimately by American buyer, lower U.S. growth and declining consumption creates significant challenges for China.
Dealing with these global imbalances has not been a high priority in the various summits, symposiums and talk-fests that global leaders have shuttled to and from. The focus has been ‘NATO' – no action talk only. Half-hearted and unworkable proposals, such as the use of the synthetic Special Drawing Rights as reserve currency, have emerged.
Globally Unbalanced
Reliance on Chinese foreign currency reserves is probably misplaced.
Chinese reserves, a large proportion denominated in dollars, may have limited value. They cannot be effectively liquidated or mobilized without massive losses. Increasingly strident Chinese rhetoric about the safety of their dollar assets reflects increasing panic.
In reality, China is trying desperately to switch its reserves into real assets – commodity or resource producers where foreign countries will allow. In the meantime, China continues to purchase more dollars and U.S. Treasury bond to preserve the value of existing holdings in a surreal logic.
On the other side, the U.S. continues to seek to preserve the status of the dollar as the sole reserve currency in order to enable itself to finance itself. The intractable nature of this problem is evident in the frequently contradictory statements from various Chinese spokesmen regarding the official position on the dollar.
No sustainable global recovery is likely without addressing the fundamental global imbalances that lie at the heart of the GFC.
Placebo Effects
Wolfgang Münchau, writing in the Financial Times on June 14, 2009, eloquently summed up developments. "Instead of solving the problems to generate a recovery, the political strategies have consisted of waiting for a recovery to solve the problem. The Europeans are relying on the Americans to generate growth. The Americans are relying on the Chinese, who in turn are waiting for the rest of the world."
The placebo effect is a pervasive phenomenon in medicine. A sham medical intervention may cause the patient to believe that the treatment will change his or her condition sometime causing the actual condition to improve. Conditioning, expectations and motivation all can play a role in placebo effect.
In recent times, investors, markets and governments have all come to believe in the recovery, sometimes by selective interpretation of facts to support the conclusion that they need. As T.S. Eliot observed: "Mankind cannot take too much reality."
Given reluctance or inability to deal with the real problems, it is not entirely clear whether the GFC cures are real or inert treatments.
It is also not clear whether current improvements in market and economic conditions are sustainable or merely a short-term placebo effect.
Tuesday, July 21, 2009
Watch These Indexes This Summer
You might think your summer vacation is nothing more than a week of lazing around, working out how some of those applications on your iPhone actually work, and getting reacquainted with your family.
Not so.
If you are smart, you can tell a lot about how the markets are going to evolve just by keeping a close eye on what is happening around the pool of a luxury five-star resort in Sardinia, Crete or the Algarve.
By the time you get back to your desk after a few weeks off, you will have a pretty good grasp of the world economy and know what to do with your investment portfolio.
Here’s a list of the main indexes you need to be tracking as you lie back on that sun lounger:
The Blackberry Index:
The mergers-and-acquisitions market doesn’t take a rest for the holidays. Blockbuster bids for the European fall are being plotted right now. M&A bankers working on a deal can’t afford to stay out of the loop for more than a few hours. If there are lots of people scrolling furiously on their BlackBerrys and wearing out their fingers composing memos on a tiny keypad, expect plenty of big deals in September. If the BlackBerrys remain silent, assume the markets are dead.
The Private-Jet Index:
After a couple of days, you will have a fair idea of when the scheduled planes land at the closest airport. But private jets operate on their own timetable, and the families traveling on them might show up anytime. The more people flying in privately, the better the markets are looking. This index can mainly be used as a measure of the private-equity industry. Those guys never fly public if they can help it.
The Towel Index:
Take a look at how many towels are left by the time you finally saunter down to the pool in the morning. If there are none to be had, that can only mean one thing: The Germans are back, and talk of the demise of Europe’s export machine will have been exaggerated. Conversely, if there are plenty of towels available, that means the heart of the European economy is still in terrible shape, and there is zero chance of a sustained recovery this year.
The Nanny Index:
Why exactly having a husband who works for a hedge fund means a woman can’t look after her own children is something even the most distinguished biologists have never been able to explain. It is, though, an indisputable fact. If you see a lot of stressed-looking women struggling to figure out how to get sun cream on a 2-year-old, assume redemptions at the hedge funds are still running high. If they are flanked by nannies taking care of everything while the woman of the house works on her tan, you can assume those long-short currency-commodity arbitrage strategies are raking in the cash again.
The Paperback Index:
Take a good look at what your fellow guests are reading around the pool. If they are gripped by some frightening-looking tome explaining why the world is heading for a new Stone Age, you can be sure their company/bank/fund is teetering on the edge of bankruptcy and they are trying to understand why. If they are just relaxing with the latest bestseller, you can deduce that things aren’t so bad.
The Crane Index:
In the last decade, much of southern Europe, and Spain in particular, has been turned into a forest of cranes. New apartment blocks, preferably with views over the sea, were being thrown up every minute and sold just as quickly. From your pool, you may be able to count a dozen or more cranes. But is anyone working on them? If they are, credit must still be flowing through the system. If there are lots of abandoned cranes on building sites, there is only one conclusion: There is still a lot of pain ahead in the property market, more trouble for banks, and you need to scurry back into cash fast.
The Natasha Index:
Anyone visiting a swank Mediterranean resort in the last few years will have noticed the way they have been taken over by Russian oil moguls, usually with a team of gorgeous, if slightly icy-looking, blond women in tow. With the commodity markets in freefall, many oligarchs have been canceling their holidays, or at least cutting back on the number of women they take with them. So take a close look (not too close -- these guys get jealous) at the throng of bikinis. The more Natashas you see, and the more stunning they look, the better the outlook for the oil and commodity markets.
Armed with all that information, you should be able to figure out precisely where the markets are going. You could even Blackberry the data back to the office, along with a few fancy graphs, then reclassify the trip as research, and claim the whole thing back on expenses.
Not so.
If you are smart, you can tell a lot about how the markets are going to evolve just by keeping a close eye on what is happening around the pool of a luxury five-star resort in Sardinia, Crete or the Algarve.
By the time you get back to your desk after a few weeks off, you will have a pretty good grasp of the world economy and know what to do with your investment portfolio.
Here’s a list of the main indexes you need to be tracking as you lie back on that sun lounger:
The Blackberry Index:
The mergers-and-acquisitions market doesn’t take a rest for the holidays. Blockbuster bids for the European fall are being plotted right now. M&A bankers working on a deal can’t afford to stay out of the loop for more than a few hours. If there are lots of people scrolling furiously on their BlackBerrys and wearing out their fingers composing memos on a tiny keypad, expect plenty of big deals in September. If the BlackBerrys remain silent, assume the markets are dead.
The Private-Jet Index:
After a couple of days, you will have a fair idea of when the scheduled planes land at the closest airport. But private jets operate on their own timetable, and the families traveling on them might show up anytime. The more people flying in privately, the better the markets are looking. This index can mainly be used as a measure of the private-equity industry. Those guys never fly public if they can help it.
The Towel Index:
Take a look at how many towels are left by the time you finally saunter down to the pool in the morning. If there are none to be had, that can only mean one thing: The Germans are back, and talk of the demise of Europe’s export machine will have been exaggerated. Conversely, if there are plenty of towels available, that means the heart of the European economy is still in terrible shape, and there is zero chance of a sustained recovery this year.
The Nanny Index:
Why exactly having a husband who works for a hedge fund means a woman can’t look after her own children is something even the most distinguished biologists have never been able to explain. It is, though, an indisputable fact. If you see a lot of stressed-looking women struggling to figure out how to get sun cream on a 2-year-old, assume redemptions at the hedge funds are still running high. If they are flanked by nannies taking care of everything while the woman of the house works on her tan, you can assume those long-short currency-commodity arbitrage strategies are raking in the cash again.
The Paperback Index:
Take a good look at what your fellow guests are reading around the pool. If they are gripped by some frightening-looking tome explaining why the world is heading for a new Stone Age, you can be sure their company/bank/fund is teetering on the edge of bankruptcy and they are trying to understand why. If they are just relaxing with the latest bestseller, you can deduce that things aren’t so bad.
The Crane Index:
In the last decade, much of southern Europe, and Spain in particular, has been turned into a forest of cranes. New apartment blocks, preferably with views over the sea, were being thrown up every minute and sold just as quickly. From your pool, you may be able to count a dozen or more cranes. But is anyone working on them? If they are, credit must still be flowing through the system. If there are lots of abandoned cranes on building sites, there is only one conclusion: There is still a lot of pain ahead in the property market, more trouble for banks, and you need to scurry back into cash fast.
The Natasha Index:
Anyone visiting a swank Mediterranean resort in the last few years will have noticed the way they have been taken over by Russian oil moguls, usually with a team of gorgeous, if slightly icy-looking, blond women in tow. With the commodity markets in freefall, many oligarchs have been canceling their holidays, or at least cutting back on the number of women they take with them. So take a close look (not too close -- these guys get jealous) at the throng of bikinis. The more Natashas you see, and the more stunning they look, the better the outlook for the oil and commodity markets.
Armed with all that information, you should be able to figure out precisely where the markets are going. You could even Blackberry the data back to the office, along with a few fancy graphs, then reclassify the trip as research, and claim the whole thing back on expenses.
Wednesday, May 13, 2009
For Whom The Bell Rings
They say a bell never rings in the market. This is not strictly true. Every now and then one does ring - usually two or three times, as in theatre intermissions - to announce a bull or a bear run is nearing its end. Well, U.S. President Barack Obama's recent speech regarding Chrysler was just such a bell.
Before I go any further, I feel that I must make it clear that I am a supporter of Mr. Obama on most issues, but every once in a while, we seem to have irreconcilable differences.
What did Mr. Obama say? He said he stands with the unions against Wall Street, and vehemently faulted hedge fund bond investors for insisting on their legal rights in a bankruptcy.
I am not sure if you grasp how momentous this is. A U.S. president effectively said the law be damned, the sanctity of commercial contracts be damned, if such constructs cause pain to unions.
Would you buy a U.S. industrial bond in such an environment? No, and neither would I, nor would most other rational bond buyers. Thus in this one act the U.S. President nearly guaranteed that the U.S. stock and bond markets, before year-end, would plunge until the administration realizes that capital cannot be coerced, Soviet-style, into keeping unproductive enterprises going.
It is not yet Hugo Chavez nationalizing foreign oil companies, or Fidel Castro nationalizing United Fruit, or Vladimir Putin robbing BP of its assets, but it is close. From now on, bond investors who up to now could rely on the courts to stand behind their bond indentures could be forced to fight the President of the United States.
To their credit, the bondholders insisted they'd fight for their property rights - but of course they don't have much chance against the President.
When the president of the largest mercantile power on earth effectively says the sanctity of contracts is not for the courts to uphold, and the mesmerized populace (and media) meekly assent, all commercial contracts thereby become devalued, and the market for such contracts - for what are stocks and bonds but that? - must eventually tank.
Are we seeing this happen right before our very eyes? Is this the beginning of a long and painful decline? I sure hope not.
Since early March, the market, just like in 1938, would likely stage a 40- to 50-per-cent rebound from the then-6,600 Dow's fair-value level, before likely going into a two-year funk. The rebound is two-thirds there, and you can forget the "likely": Mr. Obama just ensured the funk would be upon us before year-end.
From here on, the Dow could rise another 1,000 to 1,200 points - say about 15 per cent more. Enjoy it, but don't get taken by Mr. Obama's hypnotizing rhetoric. I'd use the last few hundred Dow points to lighten up. And if you own non-government bonds, be equally wary, because Mr. Obama will have no compunction taking your money and handing it to the unions that helped elect him, forgetting temporarily, if conveniently, that the rest of us, also had something constructive to do with his election.
Can you hear the bell ringing?
Before I go any further, I feel that I must make it clear that I am a supporter of Mr. Obama on most issues, but every once in a while, we seem to have irreconcilable differences.
What did Mr. Obama say? He said he stands with the unions against Wall Street, and vehemently faulted hedge fund bond investors for insisting on their legal rights in a bankruptcy.
I am not sure if you grasp how momentous this is. A U.S. president effectively said the law be damned, the sanctity of commercial contracts be damned, if such constructs cause pain to unions.
Would you buy a U.S. industrial bond in such an environment? No, and neither would I, nor would most other rational bond buyers. Thus in this one act the U.S. President nearly guaranteed that the U.S. stock and bond markets, before year-end, would plunge until the administration realizes that capital cannot be coerced, Soviet-style, into keeping unproductive enterprises going.
It is not yet Hugo Chavez nationalizing foreign oil companies, or Fidel Castro nationalizing United Fruit, or Vladimir Putin robbing BP of its assets, but it is close. From now on, bond investors who up to now could rely on the courts to stand behind their bond indentures could be forced to fight the President of the United States.
To their credit, the bondholders insisted they'd fight for their property rights - but of course they don't have much chance against the President.
When the president of the largest mercantile power on earth effectively says the sanctity of contracts is not for the courts to uphold, and the mesmerized populace (and media) meekly assent, all commercial contracts thereby become devalued, and the market for such contracts - for what are stocks and bonds but that? - must eventually tank.
Are we seeing this happen right before our very eyes? Is this the beginning of a long and painful decline? I sure hope not.
Since early March, the market, just like in 1938, would likely stage a 40- to 50-per-cent rebound from the then-6,600 Dow's fair-value level, before likely going into a two-year funk. The rebound is two-thirds there, and you can forget the "likely": Mr. Obama just ensured the funk would be upon us before year-end.
From here on, the Dow could rise another 1,000 to 1,200 points - say about 15 per cent more. Enjoy it, but don't get taken by Mr. Obama's hypnotizing rhetoric. I'd use the last few hundred Dow points to lighten up. And if you own non-government bonds, be equally wary, because Mr. Obama will have no compunction taking your money and handing it to the unions that helped elect him, forgetting temporarily, if conveniently, that the rest of us, also had something constructive to do with his election.
Can you hear the bell ringing?
Thursday, February 19, 2009
Why Hedge Funds Might Shine In 2009
High-Quality Funds Will Emerge Stronger From The War Of Attrition.
Hedge fund managers, once the swashbuckling frontiersmen of international finance and subject of fawning cocktail party banter, have quickly gone from hero to goat. As the global credit bubble burst with a vengeance in 2008, so too did the oft-touted myth that these alternative strategies could deliver positive results in any market.
But those claims painted the universe with too broad a brush. There has always been a difference between arbitrage funds that isolated structural inefficiencies, and speculators that either didn't hedge or used the ability to short stock as a means of leveraging directional bets. Clearly it should never have been expected that a fund that was short financials and long commodities, as many hedge funds were last year, would have a market neutral, "absolute return" profile. The majority of North American offerings fall into that camp, so it's no surprise we've seen stark declines among many of our homegrown funds.
To be sure, even many arbitrage funds have been badly stung, and many, many hedge funds will disappear in the next six months as a war of attrition rages. But the ones that survive may just find that the next two years are very good to them.
The Return Of Mispriced Assets
Arbitrage opportunities are the low hanging fruit of modern investing. In their purest form they represent the chance to make risk-free profits because some inefficiency has caused two identical securities to temporarily diverge in price. These opportunities are the bread and butter of most traditional hedge fund strategies.
In the years preceding the current mess, with the size of the hedge fund world expanding apace, as soon as the price of anything broke out of its normal range there was a wave of capital pushing it back in line. The increased competition had killed, or at least badly maimed, the golden goose. That's one of the reasons equity volatility was so muted between 2002 and 2007, despite major events like the Iraq War, Hurricane Katrina, and the $6 billion implosion of hedge fund Amaranth Advisors. It also explains why hedge funds were strapping on more and more leverage: the size of the mispricings had become so small they needed to magnify them artificially, and credit was abundantly available.
Now some of that low hanging fruit is back. With volatility at record levels and desperate hedge funds reversing their trades to get out of them quickly, mispricings are everywhere and those with the means can take their pick of compelling opportunities.
Indiscriminate Selling
With redemption requests flooding the inboxes of hedge funds and mutual funds alike, good names are being dragged down alongside the bad as investors rush for the nearest exits in equities and corporate bonds. While the direction of markets is unpredictable in the near term, it seems reasonable to assume that quality companies will once again be separated from their weaker counterparts. Hedge funds that can buy an industry's leaders and short its likely casualties are poised to benefit from that differentiation, even if a broad-based rally is slow to materialize.
Food For Vultures
The current crisis had its roots in esoteric derivatives that repackaged subprime mortgages. In fact, anything with an acronym -- CLO, CDS, ABCP -- seemed to draw some blame for the ensuing rout. Complex instruments were uniformly scorned and experienced sell-offs of massive proportion.
Invariably the pendulum swings too far in both directions, and as time passes there will likely be tremendous buying opportunities in areas like convertible bonds and asset-backed securities. This is a realm of the market that most pension and mutual funds don't venture into, either because it's not in their mandate or they don't have the analytical resources. Look for a few well-capitalized hedge funds to swoop in for major bargains in some of these complex securities.
There will also be the potential for strategic acquisitions. In financial markets, disaster breeds opportunism, and as large companies and trading operations teeter on the brink of failure there will be self-interested parties ready to scoop them up on very favourable terms. The winners in this game will be those with flexible mandates and access to cash. When Amaranth collapsed in the fall of 2006, J.P. Morgan Chase and hedge fund Citadel Investment Group bought up the fund's entire trading book at distressed prices. More recently, manager John Paulson, whose hedge funds are among a small group that experienced significant gains in 2008, was one of the acquirers of failed Californian bank IndyMac, along with fellow hedgie George Soros.
As many observers have noted, the global hedge fund industry has begun, and will continue, to go through a well-needed shakeout. Lured by hefty paycheques, traders and rocket scientists began opening hedge funds to the point of saturation, with fewer and fewer market opportunities to justify their existence. From the perspective of unitholders, certain structural aspects of the archetypal hedge fund are undesirable, such as high fees and poor disclosure, and these will need to improve as the asset class matures.
Many funds will soon close their doors forever, but those that survive will emerge with increased market share and a renewed chance to make big profits across the spectrum of tradable securities. As high-volume, fast-acting trading entities, hedge funds are still very important prime brokerage clients for the major banks. Having that VIP status, large hedge funds will be among the first to regain the ability to apply leverage and borrow stock.
As the division sets in between the quick and the dead, monitoring the group's results will be harder than ever. Hedge fund index statistics will be unreliable as survivorship bias takes on more and more significance. Even numbers that incorporate fund failures, such as the returns on funds of funds, will, by averaging out the winners and losers, mask the extremes at either end.
Hedge fund managers, once the swashbuckling frontiersmen of international finance and subject of fawning cocktail party banter, have quickly gone from hero to goat. As the global credit bubble burst with a vengeance in 2008, so too did the oft-touted myth that these alternative strategies could deliver positive results in any market.
But those claims painted the universe with too broad a brush. There has always been a difference between arbitrage funds that isolated structural inefficiencies, and speculators that either didn't hedge or used the ability to short stock as a means of leveraging directional bets. Clearly it should never have been expected that a fund that was short financials and long commodities, as many hedge funds were last year, would have a market neutral, "absolute return" profile. The majority of North American offerings fall into that camp, so it's no surprise we've seen stark declines among many of our homegrown funds.
To be sure, even many arbitrage funds have been badly stung, and many, many hedge funds will disappear in the next six months as a war of attrition rages. But the ones that survive may just find that the next two years are very good to them.
The Return Of Mispriced Assets
Arbitrage opportunities are the low hanging fruit of modern investing. In their purest form they represent the chance to make risk-free profits because some inefficiency has caused two identical securities to temporarily diverge in price. These opportunities are the bread and butter of most traditional hedge fund strategies.
In the years preceding the current mess, with the size of the hedge fund world expanding apace, as soon as the price of anything broke out of its normal range there was a wave of capital pushing it back in line. The increased competition had killed, or at least badly maimed, the golden goose. That's one of the reasons equity volatility was so muted between 2002 and 2007, despite major events like the Iraq War, Hurricane Katrina, and the $6 billion implosion of hedge fund Amaranth Advisors. It also explains why hedge funds were strapping on more and more leverage: the size of the mispricings had become so small they needed to magnify them artificially, and credit was abundantly available.
Now some of that low hanging fruit is back. With volatility at record levels and desperate hedge funds reversing their trades to get out of them quickly, mispricings are everywhere and those with the means can take their pick of compelling opportunities.
Indiscriminate Selling
With redemption requests flooding the inboxes of hedge funds and mutual funds alike, good names are being dragged down alongside the bad as investors rush for the nearest exits in equities and corporate bonds. While the direction of markets is unpredictable in the near term, it seems reasonable to assume that quality companies will once again be separated from their weaker counterparts. Hedge funds that can buy an industry's leaders and short its likely casualties are poised to benefit from that differentiation, even if a broad-based rally is slow to materialize.
Food For Vultures
The current crisis had its roots in esoteric derivatives that repackaged subprime mortgages. In fact, anything with an acronym -- CLO, CDS, ABCP -- seemed to draw some blame for the ensuing rout. Complex instruments were uniformly scorned and experienced sell-offs of massive proportion.
Invariably the pendulum swings too far in both directions, and as time passes there will likely be tremendous buying opportunities in areas like convertible bonds and asset-backed securities. This is a realm of the market that most pension and mutual funds don't venture into, either because it's not in their mandate or they don't have the analytical resources. Look for a few well-capitalized hedge funds to swoop in for major bargains in some of these complex securities.
There will also be the potential for strategic acquisitions. In financial markets, disaster breeds opportunism, and as large companies and trading operations teeter on the brink of failure there will be self-interested parties ready to scoop them up on very favourable terms. The winners in this game will be those with flexible mandates and access to cash. When Amaranth collapsed in the fall of 2006, J.P. Morgan Chase and hedge fund Citadel Investment Group bought up the fund's entire trading book at distressed prices. More recently, manager John Paulson, whose hedge funds are among a small group that experienced significant gains in 2008, was one of the acquirers of failed Californian bank IndyMac, along with fellow hedgie George Soros.
As many observers have noted, the global hedge fund industry has begun, and will continue, to go through a well-needed shakeout. Lured by hefty paycheques, traders and rocket scientists began opening hedge funds to the point of saturation, with fewer and fewer market opportunities to justify their existence. From the perspective of unitholders, certain structural aspects of the archetypal hedge fund are undesirable, such as high fees and poor disclosure, and these will need to improve as the asset class matures.
Many funds will soon close their doors forever, but those that survive will emerge with increased market share and a renewed chance to make big profits across the spectrum of tradable securities. As high-volume, fast-acting trading entities, hedge funds are still very important prime brokerage clients for the major banks. Having that VIP status, large hedge funds will be among the first to regain the ability to apply leverage and borrow stock.
As the division sets in between the quick and the dead, monitoring the group's results will be harder than ever. Hedge fund index statistics will be unreliable as survivorship bias takes on more and more significance. Even numbers that incorporate fund failures, such as the returns on funds of funds, will, by averaging out the winners and losers, mask the extremes at either end.
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