By Simon Grey, on January 17th, 2012
Time and again, Americans are told to look to Japan as a warning of what the country might become if the right path is not followed, although there is intense disagreement about what that path might be. Here, for instance, is how the CNN analyst David Gergen has described Japan: “It’s now a very demoralized country and it has really been set back.”
But that presentation of Japan is a myth. By many measures, the Japanese economy has done very well during the so-called lost decades, which started with a stock market crash in January 1990. By some of the most important measures, it has done a lot better than the United States.
Japan has succeeded in delivering an increasingly affluent lifestyle to its people despite the financial crash. In the fullness of time, it is likely that this era will be viewed as an outstanding success story.
How can the reality and the image be so different? And can the United States learn from Japan’s experience?
It is true that Japanese housing prices have never returned to the ludicrous highs they briefly touched in the wild final stage of the boom. Neither has the Tokyo stock market.
When the talking heads speak of a decline, what they really mean is a loss of stock portfolio value. Or, more accurately, a decline in the prices of stocks, bonds, real estate, and other forms of capital. The wealthy abhor this potentiality because it would effectively destroy their wealth. While this concern isn’t altogether problematic (why shouldn’t they be self-interested, just like everyone else in the world?), the proposed solutions are.
Preventing “decline” is largely contingent on keeping capital prices afloat, which is itself contingent on leverage (which, it should be noticed, will be subsidized by taxpayers in some way), debt, and/or inflation. This is the only way. Capital asset prices are already significantly overvalued; the only way to keep it this way is to continue the policies that enabled this in the first place.
The only alternative is to let capital asset prices crash and then recover. This is the optimal strategy, in the sense of doing what’s best for the most people, for this strategy only requires non-intervention in the economy, which is unsurprisingly cheaper than intervention and bailouts. The reason why the talking heads never propose this is because the timeline for recovery is fuzzy at best.
Quite simply, once the market crashes and capital prices return to their pre-malinvestment valuations, it will be some time before those prices go back up again. This poses a problem to the wealthy employers of the talking heads, for said employers have spent their lifetime accumulating this imaginary wealth and, now that they are beginning to look at retiring, they do not want to see it simply vanish.
Therefore, the mainstream argument against decline—which is prevented only by bailouts and leverage—is entirely founded on the assumption that maintaining capital asset prices is desirable. Given the costs of doing so, and given that the result only benefit wealthy crooks, it seems clear that the best course of action is to welcome decline with open arms. This way, as is seen in Japan, living well will not simply be the privilege of the wealthy.
By The Gold Report, on January 11th, 2012
  What do investors need to be watching out for in 2012? More Eurozone drama? Record gold highs? A hard landing in China? The U.S. Global Investors team addressed these questions with Endgame: The End of the Debt Supercycle author John Mauldin in a Jan. 5 Outlook 2012 webinar. The Streetwise Reports editors highlight some of the expert insights.
John Mauldin: Instead of doing an annual forecast, I’m going to look out about five years, which may be five times more foolish. What I want to do rather than try and figure out where the stock market is going to be at the end of 2012 or what gold is going to do, is look at the choices we have around the world.
In most cases, political events don’t change the economic world all that much. It’ll probably annoy partisans on both sides, but if Clinton had lost to George Bush senior the first time, we would have still had a bull market. We were already in recovery. Yes, we would have had different Supreme Court Justices, but that’s not the economic world. We were set on a path. If Gore had beaten Bush 2, economically I don’t think much would have changed. We still would have had the end of a bull market and a recession in 2001. We would have had a housing bubble. Greenspan would have probably been reappointed either way. We would have had a credit crisis because we were in the process of building up debt that started in the ’50s. Europe was building its debt up. Japan was building its debt up. That is the reality.
Now the private sector is deleveraging, but sovereign debt is in a bubble. The air is coming out. My view is that the wheels are going to fall off Europe this year. I have been researching the Mayan codes and I have determined that the ancient Mayans were not astrologers; they were economists. They weren’t predicting the end of the world; they were simply predicting the end of Europe. That is a humorous way of saying this is the year Europe is going to have to make some very difficult choices. Greece gets to choose what kind of depression it wants, hard and fast or slow and long. It can’t avoid depression completely. It has borrowed too much money. The government is too big. It has come to the end of the ability to raise money at low rates. Italy and Spain are well on that path along with the rest of Europe. So, they have to make a decision, a political decision that is going to have major economic consequences.
Does Europe want to be a political union that looks more like the United States, where the individual entities have to run balanced budgets and can’t print their own money and have some kind of fiscal controls or they go back to a two-tiered Europe with multiple currencies. One way or another, this is the year that Europe is running out of road to kick the can.
Fortunately, in the U.S. we are not there yet. We have some room to make a decision. That decision is going to be made in 2012 because by 2013 we are going to have to decide how we deal with the deficits and debt. After 2014, the bond markets will start to raise rates. Total U.S. debt is continuing to grow because governments are growing debt faster than private citizens are decreasing debt. The bond markets are starting to rebel long before you would think they would for a country that’s the world reserve currency. The key is whether debt is excessive relative to income. If you can make your debt service, people will still lend you money. When they don’t think you can, they will stop. That’s when you have a crisis. It’s a debt super cycle. And, when you reach the end, you have to deal with the debt. You can pay it down. You can default on it. You can print the money, extend it out with lower rates or financial repression, which are all other ways to look at default. But, nonetheless, that debt is there.
The problem we are facing in the U.S. is that gross domestic product (GDP) is consumption plus investment plus government spending plus net exports. If we decrease government spending over time, we decrease GDP. That’s the problem that Greece is going through right now. It has to decrease government spending by 4.5%, thus shrinking the economy. But it can’t increase government spending without increasing debt or taking taxes away, which decreases consumption. Nothing the government does will make things better. The U.S. is on the same path. We can become Greece by continuing to borrow or be proactive and say we are going to get our deficits under control over a period of five or six years. The economy is still going to be slower than we would like and unemployment higher than we would like. That’s just the rules. We’re at the end game. We are at the end of the debt super cycle and that’s what happens.
Printing money doesn’t increase the GDP in actual real terms, but it makes everyone holding gold happy because the value of natural resources goes up. That is why I buy gold every month. I take those coins, I put them in a vault and I hope I never need them. I quite frankly hope gold goes back to $300/ounce (oz) because that means the economy is in wonderful shape. I’m actually afraid that gold is going to go up in value, which means we are not getting our act together.
That leads to questions about fault. Did the banks do things they shouldn’t have? Yes. Were they the cause of it? No. Was Greenspan the cause of the bubble? No. He was part of the cause. I mean, we did a lot of things as a country that weren’t good choices. Should we have allowed our banks to go to 30 and 40 to 1 leverage? No. Should we have repealed Glass-Steagall? No. The problem is that real median household income hasn’t moved for 15 years because real private GDP hasn’t changed. The only thing that has grown is government spending.
John Derrick: In 2011, the European financial crisis moved from the periphery to the core. Central bank policies were big drivers of the decline. The European Central Bank and China raised rates early in the year and again in July as fears of a China slowdown grew. That early tightening to fend off inflation had a big impact on the course of events throughout the year. The other big events were the U.S. credit downgrade in August and currency intervention, particularly in the Japanese yen.
Frank Holmes: There is a huge amount of borrowing around the world in Japanese yen because it is so inexpensive. That includes investing in commodities, resources and emerging markets. And, every time we see this huge signal move by the yen, you get this rippling effect that takes about six weeks to resolve itself with commodities being sold down. Therefore, a lot of fund managers borrowing in Japanese yen are long energy stocks, resource stocks and emerging markets, which leads to a lot of selling.
JD: The second half of last year was very volatile, but the market ended essentially flat. In fact, much of the volatility was concentrated in the last month, which made for a very difficult psychological environment, as the market has been somewhat schizophrenic with weekly rallies and selloffs.
Spikes in the yen caused market selloffs. This hit commodities especially hard. So the secret for 2012 is to use the volatility. Buy on the volatility spikes. Unfortunately, what most people do is just the opposite. Another thing to look for in 2012 is a positive fourth year of the presidential election cycle as the government tries to implement policies that will get them reelected.
Brian Hicks: There has been a lot of concern about money supply growth in the emerging markets, particularly in China, which reduced bank reserve requirements last year. A reacceleration of global money supply can be particularly constructive for commodities going forward as there has been a high correlation between money supply growth and commodities.
If you were to take all the global money and back that by gold, the price of gold could go to $10,000/oz. If you just use half of the global money supply, gold would trade at about $5,000/oz, up from approximately $1,600/oz right now. The more U.S. dollars in circulation, the higher the price of gold. This has been the main factor increasing the price of gold since 1998 and will continue to be the case in the years to come. Gold has a lot of running room to go.
Another driver for the price of gold has been federal deficits. Government spending is way above revenues. We hit a point in 2000 where spending as a percentage of GDP greatly exceeded taxes as a percentage of GDP. This could be a point of no return and could potentially drive the price of gold even higher. There has been a large bifurcation between the price of gold and gold equities, particularly in the last couple of years as risk aversion has prompted many investors to buy the bullion as opposed to gold equities. This is creating opportunity. We feel like there’s going to be a catch up in gold equities, many of which are trading at very low multiples to cash flows and earnings. Stocks such as Newmont Mining Corp. (NEM:NYSE) look like value stocks now paying high dividend yields and trading at sub 10-times price to earnings ratios. This could really present an attractive opportunity in 2012.
JD: Just a comment on all the takeovers. We were seeing 6% premiums on takeovers in ‘06. Now we are talking 60+ premiums. That’s another reflection of how undervalued the stocks are relative to commodities.
BH: That’s a great point. We have seen tremendous value creation based on mergers and acquisitions.
Shifting gears a little bit, crude oil and refined product inventories ended the year at the lowest level on record (about 685 million barrels). That’s 6% below the prior year. It’s particularly interesting when you consider some of the geopolitical factors that have arisen with Iran talking about blocking off the Strait of Hormuz. This is a primary factor behind oil price supports despite the tenuous economic environment. Many investors don’t realize that Russia is very important for non-OPEC (Organization of Petroleum Exporting Countries) supply, a key factor in containing oil price spikes. Russia is increasing production while other non-OPEC production in Mexico or in the North Sea have been declining significantly, which has helped to bolster OPEC’s market share. It has also limited the ability of oil markets to increase production out of the Middle East due to the inability to invest in those troubled areas. In fact, Russian production has been quite steady since 2006, increasing anywhere from 100 to 400,000 barrels per day (bpd), mid-single digit growth. But, forecasters predict in 2012 we will see flat production growth, which is troubling given the fact that we continue to see demand increase in other areas of the world, mainly out of China. This will be a driving factor going forward for crude oil prices.
Evan Smith: Oil supply threats include geopolitical problems at a time when oil supply and spare capacity at OPEC is rather low—a little over 2 million bpd. Nearly 40% of global supply is under autocratic rule. Iran has threatened to disrupt the supply of crude oil and products through the Strait of Hormuz where about a third of global oil supply passes. So, any disruption, even temporarily, would cause a severe spike in oil prices. We think oil prices could support $100/barrel. One of the things we like in 2012 is higher exposure to master limited partnerships partly because of their steady cash flows. They are becoming a growth business now. The capital expenditures here in the United States have grown from $3.5 billion (B) in 2005 to nearly $16B this year. This is partly because of the growth in many of the shale plays, which require increased infrastructure. We think this is an excellent investment opportunity. We also see a big opportunity for the global oil services. We can see that capital expenditures have been rising. We expect them to rise from about $500B to nearly $.5 trillion this year, an increase of 15%. So, we see tremendous opportunity for some of the oil services contractors and equipment providers. Another key driver is the impressive amount of money that has been invested in North America. Just over the last three years nearly $129B in mergers, acquisitions and joint ventures has occurred. Global companies are coming to North America to invest in these shale plays because the economics are so attractive due to improved technology. They want to learn that technology and take it home. So, we think there is continued opportunity for investors in the resource play here in North America.
Shifting gears, one of the base metals we will target is copper. It is our favorite base metal. The demand side is holding up relatively well compared to some of the other base metals. Even in China, which is the largest market for copper growth, the build out of the grid is really a key driver. That is holding up quite well. On the other side of the supply/demand equation, supply has been a problem. Through most of the boom in copper prices, mine output has lagged forecasts. Causes included weather, labor strikes and just poor grade. The bottom line is that supply has not kept up with demand. We have not solved that problem so we think 2012 should be a relatively good year for copper prices.
Another theme we like is the agricultural space. Global population continues to grow. The emerging middle class continues to consume more grains, principally through the production of more meat as people consume more protein in their diets. There has been a huge surge in the need for the production of grains, yet no more land is being created. One of the key ways we’re seeing increased yields out of croplands is through higher applications of fertilizers. That has created a fairly tight situation for potash, specifically. But, other fertilizers such as nitrogen and phosphate are also benefiting from this trend.
FH: I would just add that the world’s population has doubled from the ’70s when we had rising commodities. There’s a very different factor and China and India have a global footprint that they didn’t have.
Xian Liang: China remains the biggest driver of world demand for energy due to a rising middle class, but it is in a very early stage when it comes to discretionary spending. Take for example passenger cars. Despite a tremendous growth in auto consumption in the last decade, only 18% of Chinese households own a car. Car ownership in China is just one-tenth of U.S. levels or the same level it was in the U.S. in 1914. Air travel remains at the U.S. equivalent of the 1950s. This illustrates a great growth potential going forward. Urbanization is one of the most significant trends driving consumption. In 2011, the number of urban residents in China exceeded rural residents for the first time in Chinese history. But, China won’t stop at this 50% urbanization rate if the historical trajectory of its richer neighbor, South Korea, is any guide. We could have another 30% of growth by the year 2013. South Korea outgrew its urbanization rates in a 40-year time span. And, if China continues to urbanize, there will be about 200 million new urban households in China, which creates enormous demand for consumer staples, durable goods and housing.
China’s government policies signal the trend will continue. China raised reserve requirement ratios 12 times since January 2010. We view that as an early signal for the next easing cycle. The last time China eased reserve ratios in October 2008, that triggered a big market rally in Chinese stocks. This should bode well for stocks. We don’t think the Chinese auto boom is over. Actually, in the last couple of days, officials in China hinted that new measures may be introduced to support auto and home appliance sales.
Outside of China, we see government policies remaining very positive in southeast Asia, especially in Indonesia and Thailand. The money supply in the past two years has not deteriorated in these two countries, in fact, it is growing at a healthy 16% year over year. This is part of the reason why we remain positive on southeast Asia. Indonesia is rich in natural resources, but it doesn’t depend as much on exports. In fact two-thirds of its GDP is driven by domestic consumption, which is how it managed to escape a recession in 2008 and 2009. Favorable demographics is a factor. It is a very young country. More than 45% of the population is under 24 years old and 2 million people a year are joining the work force. Second, urbanization is creating new consumer demand. Just like China, Indonesia’s household debt is low. Total mortgage loans outstanding account for only 3% of GDP. Consumer credit is still at a very early state. I see tremendous growth potential going forward.
FH: The money supply is growing very rapidly in the entire region. I think it’s not just a China story. It’s a whole emerging market. And, I like to characterize it as the American dream trade as all these countries want the American dream. They all want a house. They want a car. They want all the lifestyle that we have.
John Derrick joined U.S. Global Investors Inc. in January 1999 as an investment analyst for the U.S. Global Investors money market and tax free funds. In March 2004, he was promoted from portfolio manager to director of research and now manages the day-to-day operations of the investment team. Prior to joining U.S. Global Investors, Derrick worked at Fidelity Investments. He has appeared on CNBC and Bloomberg TV and has also been a guest on Marketwatch Radio and NPR. Derrick has been featured in stories for BusinessWeek, The New York Times, the Associated Press and USA Today. A graduate of The University of Texas at Arlington, Derrick earned a Bachelor of Arts in finance. He sits on the board of directors for the CFA Society of San Antonio.
Brian Hicks joined U.S. Global Investors Inc. in 2004 as a co-manager of the company’s Global Resources Fund (PSPFX). He is responsible for portfolio allocation, stock selection and research coverage for the energy and basic materials sectors. Prior to joining U.S. Global Investors, Hicks was an associate oil and gas analyst for A.G. Edwards Inc. He also worked previously as an institutional equity/options trader and liaison to the foreign equity desk at Charles Schwab & Co., and at Invesco Funds Group, Inc. as an industry research and product development analyst. Hicks holds a Master of Science degree in finance, and a bachelor’s in business administration from the University of Colorado.
Frank Holmes is CEO and chief investment officer at U.S. Global Investors Inc., which manages a diversified family of mutual funds and hedge funds specializing in natural resources, emerging markets and infrastructure. In 2006 Mining Journal, a leading publication for the global resources industry, chose him as mining fund manager of the year. Holmes coauthored The Goldwatcher: Demystifying Gold Investing (2008). A regular contributor to investor-education websites and speaker at investment conferences, he writes articles for investment-focused publications and appears on television as a business commentator.
Xian Liang is an Asia research analyst at U.S. Global Investors Inc. and a Shanghai native.
John Mauldin is the author of New York Times Best Sellers list four times. They include Bull’s Eye Investing: Targeting Real Returns in a Smoke and Mirrors Market, Just One Thing: Twelve of the World’s Best Investors Reveal the One Strategy You Can’t Overlook and Endgame: The End of the Debt Supercycle and How it Changes Everything. He also edits the free weekly e-letter Outside the Box. Mauldin also offers The Mauldin Circle, a free service that connects accredited investors to an exclusive network of money managers and alternative investment opportunities. He is a frequent contributor to publications including The Financial Times and The Daily Reckoning, as well as a regular guest on CNBC, Yahoo Tech Ticker and Bloomberg TV. Mauldin is the President of Millennium Wave Advisors, an investment advisory firm registered with multiple states. He is also a registered representative of Millennium Wave Securities, a FINRA-registered broker-dealer.
Evan Smith joined U.S. Global Investors Inc. in 2004 as co-portfolio manager of the Global Resources Fund (PSPFX). Previously, he was a trader with Koch Capital Markets in Houston where he executed quantitative long-short equities strategies. He was also an equities research analyst with Sanders Morris Harris in Houston where he followed energy companies in the oil and gas, coal mining and pipeline sectors. In addition, he was with the Valuation Services Group of Arthur Andersen LLP. Smith holds a Bachelor of Science degree in mechanical engineering from the University of Texas in Austin.
By Claus Vistesen, on October 17th, 2011
It was telling that just as the ECRI and other notable research outfits decided to push recession button on the US economy the data flow became notably more positive. This could be a sign of the times that the cycle is just too volatile for even capable analysts to call or it could simply be a blip to the otherwise fundamental issue that economic weakness is here to stay for now.
Risk asset markets however made no mince of the recent stabilisation of the euro land crisis as well as the better news flow from the US economy. Just take the following headlines from Bloomberg and you know exactly what kind of sentiment I am talking about.
Quote Bloomberg
U.S. stocks advanced, giving the Standard & Poor’s 500 Index its biggest weekly gain since July 2009, as retail sales beat economists’ estimates and the Group of 20 nations began discussions on Europe’s debt crisis.
(…)
U.S. 30-year bonds capped the longest weekly losing streak since January as concern eased that Europe is unable to curb its debt crisis and U.S. retail sales climbed, damping bets the country will fall into a recession.
The question is then whether it signals a decisive and lasting breakout or whether it was simply a rally to the top of a choppy range before we start another descend to test the lows. Recent weeks’ market movement will suggest that you sell the current levels as top of a post crash range and I, for one do not think we are out of the woods yet. It is important to emphasize two issues on the US economy when it comes to the likelihood of a recession.
Firstly, the US housing market has never recovered and inventories remain low. This means that there is not much room for the economy to slump even if it does enter a recession. Any recession is then likely to be relatively short. Secondly, all liquidity gauges we are watching are pointing strongly upwards which is likely to provide strong tailwinds for risky assets 9-12 months out. Excess global liquidity, US broad and narrow measures of money are all shooting up.
In addition, we should consider the slow but sure movements by all four major central banks to increase either the short term liquidity or simply re-starting QE.
The BOE put itself at the front of the pack with the recent addition of another bn 75 GBP worth of QE, but likewise at the ECB it was interesting to see that long term liquidity operations was re-instated together with an expansion of the covered bond purchasing programme. Additionally, the ECB has been and will continue to be more or less forced to support bonds in the periphery, particularly in Spain and Italy, in order to ring fence the periphery from the coming Greek default. In comparison, the Fed’s latest much debated Operation Twist looks almost modest since it is, by the letter of the theory, not quantitative easing but rather qualitative easing [1]. Of course, the market is fully expecting the Fed to act aggressively should the economy falter further with a joint financing programme with the Treasury for long duration mortgage products as the most likely initiative alongside the more technical move in the form of reducing interest rates on excess bank reserves to negative.
I think it is important to realise that the Fed, with its latest actions, have its gaze firmly fixed on stimulating a recovery in the US housing market which is seen as the most important missing leg in an already faltering US recovery.
In Japan, the BOJ’s situation is different in the sense that economic has been distorted by first the devastation of the earthquake and then obviously the technical recovery as supply side disruptions have eased off. I take note of the fact that the BOJ has verbally put a lot of promises on the table in terms of stimulating the economy not least, one would imagine, in relation to the ongoing strength of the JPY. Finally, it is worth pointing out that the BOJ’s balance sheet has actually expanded briskly in the past two months.
The main conclusion to draw here I think is that while it is certainly not over yet, developed market policy makers are starting to open the floodgates. The euro zone crisis will remain a severe drag and like an almost chronic illness will continue to flare up. A disorderly Greek default can still not be ruled out and as the euro zone policy makers seem to take comfort on even a second of calm it seems to me that the market will have to push harder before we get a realistic proposal for a Greek default.
The recovery in the periphery (or obvious lack thereof) is still not working. The internal devaluation in the European periphery is alive and well when it comes to nominal wage increases which is getting a beating but in the context of lingering inflation in core and headline it leads to a squeeze in real wages and further depresses the recovery. The problem is that a sharp reduction in living standards through a decline in real wages to restore competitiveness is needed but if it occurs without any form of nominal currency depreciation not to mention in the context of very sticky core inflation, it just becomes counterproductive. Absent a fiscal union to socialise the risks it is difficult to see how the euro zone policy makers will be able to come with a fudge that will satisfy markets. In that regard I agree with Chris Wood here.
Ultimately, GREED & fear’s view on all of the above remain the same. This is that the only coherent end game for Euroland remains a formal move towards collective fiscal responsibility, which would ultimately address the fundamental cause of the present crisis. This is the financial fault line represented by monetary union without fiscal union. Euroland either has to go down this path or it has to confront all the problems associated with a break up since in GREED & fear’s view there is no “middle way”
One positive development on Greece is that the private sector involvement (PSI) proposal originally envisioned seems to have been abandoned for a much more realistic haircut.
But more challenging issues remain.
It was hardly surprising that the S&P downgraded Spain last week which only serves to underline the issue that while Greece may be the imminent worry the real problem lies in Spain and quite possibly Italy. There is a limit to the amount of Italian and Spanish bonds that the ECB can buy as long as it is evidently clear that growth prospects continue to remain difficult.
In emerging markets and touching on the theme I dealt with in my last installment the recent inflation data from India indicate why I continue to think that investors may hold too high expectations for easing in big emerging markets.
Quote Bloomberg
India’s inflation exceeded 9 percent for a 10th straight month in September, maintaining pressure on the central bank to extend its record interest-rate increases.The benchmark wholesale-price index rose 9.72 percent from a year earlier after a 9.78 percent jump in August, the commerce ministry said in New Delhi today. The median of 21 estimates in a Bloomberg News survey was for a 9.75 percent increase.
Elevated inflation in India and China are crimping room for policy makers to ease monetary policy and support global growth amid Europe’s debt crisis and a faltering U.S. recovery. India’s central bank Governor Duvvuri Subbarao said yesterday that a more than 9 percent inflation is above “comfort level.”
Of course, the picture is not uniform here with notable economies such as Brazil and Indonesia already lowering interest rates but all eyes are currently on China (and secondarily India) and here I think that we will have to see stronger signs of a hard landing or a relapse into a more severe global slowdown we can expect policy makers to actively stimulate.
In summary, I think that we are indeed nearing an inflection point at which money printing in the developed world will once again provide relief to risky asset markets but the problem is that the underlying economic backdrop has not improved much. In particular, the ongoing lack of resolution in the euro zone represents an issue but Eastern Europe as well as a housing bubble in Australia (and perhaps even in Denmark) are also potential sources of uncertainty not to mention the unravelling of credit excess in China. As such, “it” is far from over but a tradable bounce in risky assets which goes beyond the current choppy range may soon represent itself.
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[1] – The distinction between quantitative and qualitative easing is simple. The former refers to an expansion of the balance sheet through the central bank increasing its liabilities and adding a corresponding amount of assets. The latter refers to changing the composition of the asset side of the central bank’s balance sheet and as I am reading the gist of OT the Fed has committed to keep its balance sheet unchanged by selling short term bonds and buying long term bonds. Try this one for a good recap of what QE is and isn’t.
By Claus Vistesen, on August 5th, 2011
In case you did not notice it, the much discussed “range” on the SP500 broke in spectacular fashion yesterday as the short rollers bypassed the 1250 mark in the same style as the Germany pantzer passed the Maginot line back in the early stages of WWII.
Basically, two many people tried to catch the knife of the falling market (everywhere) in anticipation of just one good data point or perhaps CB intervention but nothing came. As such the pain trade is still down I think. Of course, we DID walk into the office to some JPY selling by the BOJ and the ECB finally looked outside the ivory tower to see the badlands that its stfu policy has so far engineered even if the continuing mention of inflation risks somehow strikes me as beyond crazy.
With most market participants probably now sitting shivering in a corner wishing that yesterday was Friday, there is indeed a day today and one has to assume that a bad jobs report will bring the whole world down on the back of stock investors. Blood is currently flowing but it can get worse, much worse than this.
Given the feedback loop between our recession indicators and the SP500 with the former taking the latter as an input there is clearly now a real risk of a recession in the US and on my casual calculation it is well above 50%.
Now, if the pain trade is still down the decision by BNY Mellon today to charge customers for holding large piles of cash indicates to me that the pendulum has swung extremely fast into uber fear mode. My feeling is that the market has much further downside from here in the short term, but nothing goes down in a straight line forever. In this sense a US recession market level is likely to be very close to this level, it may still squeeze the longs yet awhile.
More generally, I am constructive on how this might impact emerging markets in the sense that inflation is now likely to be even more a non issue. This is especially the case in economies who have mainly been combatting headline inflation (e.g. Chile with India as a rather more sinister case of demand pull inflation too). There will be no recession in EM and therfore a re-rotation into EM from here on as DM slumps into a recession is one way to stay constructive even in the midst of the bloodbath taking place.
By Claus Vistesen, on June 24th, 2011
Not too long ago, I compared the Japanese economy to a bumblebee because of the economy’s ability to keep on chucking along even as the government debt/GDP ratio stormed above the 200% mark. I am starting to think that the same comparison might be warranted too in the case of my home country.
One striking aspect of the Danish economy that any economist following the discourse on Denmark must be pondering is that despite the widespread idea that Denmark has a serious productivity problem relative to its peers, it has not yet shown up in the data. Denmark is still running a sizeable trade as well as income surplus which together adds up to a tasty current account surplus.
So what gives and can this situation be maintained?
The reason that I have been forced to think about this was today’s report by Bloomie that the Danish bank and mortgate originator Nykredit announced that it would actively seek to widen its international investor base for covered bonds backed by mortgages of which the bank is Europe’s largest holder and which contributes to making the Danish market for mortgages one of the world’s biggest.
Basically, the problem for Danish financial institutions is that under the new Basel rules, covered bonds backed by mortgages will be treated as less liquid than government bonds (and thus less liquid than is currently the case) and thus Nykredit et al will be left holding way too many of these securities. The problem in a nutshell is this;
Denmark is leading efforts to persuade the European Union to ease liquidity rules set by the Basel Committee on Banking Supervision that the Nordic country says penalize the world’s third-largest mortgage-bond market. While the EU has signaled it may accommodate some of the demands, standards scheduled to take effect by 2015 are still likely to treat covered bonds as less liquid assets than government debt, Engberg Jensen said.
“I don’t think we can totally avoid a haircut” on how banks treat covered bonds in their liquid assets, he said. “I don’t think that we’ll end up with rules where covered bonds and government bonds are equal.” This means “we need to find a broader investor base. We want to be stronger in Europe and we have also started in the Middle East and the Far East. We’ve had investors for many years in the U.S. and Europe.”
Under the new rules, banks must abide to a limit of 40% in terms of how much of the securities portfolio that can be made up by (mortgage) covered bonds which leads to the obvious result that …
“If we get the new rules, most Danish banks will have to restructure to sell mortgage bonds and buy government bonds,” Engberg Jensen said. While Danish banks have relied on the country’s covered bonds to generate liquid assets, lenders in Germany and Asia have room to purchase the securities without breaching Basel’s 40 percent limit, Nykredit estimates. The company wants to sell its bonds to banks in those regions to make up for the selloff it expects to see in Denmark, Nykredit Group Managing Director Karsten Knudsen said in the same interview.
Denmark has a problem here, a big one in my opinion and the only chart you need to look at is the following.
(click on picture for better viewing)
Despite the crisis, Denmark has not delevered substantially and mortgage debt remains a sizeable portion of GDP; 134% by my calculations in 2010. And this is mortgage debt alone and thus leaves out a large private debt burden, all corporate debt as well as a growing government debt.
It is important to understand where Denmark is here. Denmark is like Spain, Ireland and Australia with large a large private debt burden which will only really make itself felt once the government has to assume the final bill (think Ireland here). Now, at this point my compatriots would know doubt file this post under the “one flew over the (…)’s nest” folder as comparing Denmark with the countries made above seem more than outrageous. But try to get the main point here. Denmark’s main debt problem is in the private sector and given the Irish experience, once the sovereign has to plug a hole in the domestic financial system, it is the total debt that matters and not merely the government debt.
Recently, the EU commission issued a report with a stark warning to Danish policy makers that both the size and structure of the housing market with the majority of loans made up by variable interest rate and no-amortisation/down payment (often both in the same loan!) represented a current and future source of instability. The Danish central bank has even suggested to phase out these loans entirely even if it seems that such a proposal has not got political backing in the Danish parliament regardless of the result of this year’s election.
According to Bloomberg, Nykredit and others have noted that they will try to separate the way they funds their adjustable rate mortgage portfolio from their fixed rate portfolio. This is almost hilarious in its uselessness in my opinion since the main problem here is not a flow issue but a stock issue as evidenced by the chart above.
When all is said, I think you should take away the following point from this.
Essentially, if Danish mortgage originators start selling bonds to foreign investors for the obvious rational reason that they need to abide to new capital requirement rules it will mean a defacto deterioration of the current account (not necessarily a problem, just a fact when you sell securities abroad). So, the question is; how willing will foreigners be to finance one of the most overlevered housing markets in the world and at what yields?
When I run the scenario in my head, I end up in a situation where it might be quite difficult to push Danish covered bonds to foreigners at acceptable prices, liquidity will dry up and re-financing will get more difficult. In addition, if yields go up prices (i.e. house prices) will fall and exacerbate the difficulty in pushing the securities since the prices on the underlying collateral (i.e. property will go down).
Now, far be it from me to attempt to put Denmark in a club to which it does not belong but think about it for a minute. The road map for how a Danish government might be forced to issue government bonds and swap them for unsellable covered bonds in order to allow its financial institutions to abide to the Basel rules is an almost sinister way in which the Danish sovereign ultimately may end up being on the hook for the total stock of debt in the society, just as we have seen elsewhere.
Am I seeing ghosts? Perhaps, but consider yourself warned.
 Join the forum discussion on this post - (1) Posts
By Ajay Shah, on May 20th, 2011
Thomas E. Ricks (in Foreign Policy) and Lawrence Wright (in New Yorker) on Pakistan.
C. Rangarajan on the debate about the debt management office and about inflation targeting (the latter is an interview with Tamal Bandyopadhyay).
Saurabh Mishra, Susanna Lundstrom and Rahul Anand have a fascinating piece on the sophistication of India’s service exports. Many people suffer from what I call `the widget illusion’, where somehow it is good to make tangible things, and making intangible things is considered wrong. It is high time we get away from such notions.
Kenya’s experience with mobile phones and payments is important for us in India. Read William Jack and Tavneet Suri on this, on voxEU.
I found there are interesting links between this article in The Economist, and the ideas on system-driven credit in a UID world in
this committee report.
Do you use up the power of monetary policy to stabilise inflation, or do you use up this power to manipulate the exchange rate? Some
people think that manipulating exchange rates, and thus fueling export growth, is a shortcut to high GDP growth. Nicolas Magud and
Sebastian Sosa (on voxEU) say that the potential payoff from exchange rate misalignment is small.
A working paper: Liquidity considerations in estimating implied volatility by Rohini Grover and Susan Thomas.
A working paper: Improving the legal process in enforcement at SEBI by Dharmishta Raval.
A working paper: Has India emerged? Business cycle facts from a transitioning economy by Chetan Ghate, Radhika Pandey, and Ila Patnaik.
Mobile trucks that sell food, and link up to customers using twitter: is India is ready for this? See Caroline McCarthy on CNet News.
A first response on the killing of UBL by Steve Coll.
Robert S. Boynton has an article in the Atlantic about how modern communication technology is actually making a small difference to breaking down the North Korean government.
Henry Shukman has a great story in Outside magazine about the 3000 square kilometres of `Chernobyl Exclusion Zone’ which has turned into a miracle for biodiversity. I often wonder what would happen if 3000 square kilometres of prime Gangetic land became true forest.
Perhaps 10% of blind men can teach themselves how to see.
Michael Lewis has a persuasive sounding article, about how a Richter 7.9 earthquake that hits Tokyo will devastate the world
economy. This was written in 1989. By and large, these things did not happen in the recent Richter 9.0 earthquake. Yes, the
recent quake did not frontally hit Tokyo, but then Richter 9.0 is way bigger than 7.9 (this is log scale). It is a useful exercise,
for everyone interested in finance, to read this article and understand how such journalistic thinking goes wrong.
Is research funding going into randomised trials yielding a good bang for the buck? My personal view is that a better use of money is to build datasets like this which are then placed into the public domain, and used by hundreds of researchers.
By Claus Vistesen, on April 18th, 2011
In a seminal paper [1] from 1958 Franco Modigliani and Merton H Miller showed why investors should not care about whether firms were financed with debt or equity. This led to the idea of the the debt irrelevance proposition and although the DIP is a theoretical benchmark rather than a real world rule the 1958 paper by Modigliani and Miller remains a key contribution to the finance literature. We should not however extend the same role to the recent attempt by researchers [2] to re-invent the DIP in a new guise replacing “debt” by “demographics”. Allow me to explain why.
Demographics, Just Forget About It …
My point of departure is Edward Chancellor’s recent GMO letter in which he tackles what he considers to be the non-issue of Japan’s dire demographics. He emphasizes two things; firstly, that economists are notoriously poor at predicting demographic variables and secondly he notes that whatever relevance demographics might have for macroeconomic analysis at large (of which Mr Chancellor appears skeptical) it is irrelevant for the investor;
Besides, long-term demographic forecasts aren’t particularly relevant for equity investors. It’s true that changes in the population have a sizable impact on GDP growth. But stock market returns are not positively correlated with economic growth. Returns from equities are a function of valuation and future returns on capital – a subject to which I will return later – rather than changes in GDP. Nor is there a positive correlation between population growth and stock market returns. In short, investors should not get too hung up on inherently unreliable long-term demographic projections for Japan.
It is important to underline, in fairness to Chancellor, that the points are made with specific focus on Japan but the the argument seems to have a more general hue. This is even more obvious in relation to one of Chancellor’s main references in the form of Morgan Stanley analyst Alexander Kinmont’s note entitled The Irrelevance of “Demographics”? Kinmont puts up the following four points which I will use as my points of reference;
1. It is not clear that demographic estimates are accurate over long time frames. In fact, while spurious specificity is one of the attractions of demographics as a talking point, the fact that neither death rates nor birth rates have proven predictable should caution one against accepting any assertion about demographics.
2. It is not clear that demographics are the critical variable in determining the level of economic growth. That role falls to the growth rate of TFP.
3. It is not clear that equity returns are related to absolute levels of growth. Equity returns are an issue of valuation. Nominal returns are greatly affected by inflation too.
4. It is not clear that demographic change, even if it is allowed as a negative for economic growth, is necessarily negative for stocks, as certain forms of demographic change may be associated with a rising equity market multiple. Demographic change could in fact represent a benign environment for stocks.
On the first point Kinmont makes points to the irony in that the worry about Japanese demographics seems to be peaking just as Japanese fertility is on the mend. This is a cheap shot though and not one which stands up to scrutiny. First of all on the fertility trend itself I get the same chart as Kinmont’s below using data from the World Bank showing a rebound in Japan from a low point of 1.29 in 2003 and 2004 to 1.37 in 2009. However, Indexmundi which takes its data from the CIA World Factbook has fertility much lower and actually declining in Japan. The latest data point from the CIA World Factbook reports an estimate of TFR in 2011 is 1.21. This is a pretty steep difference and I invite comments as to suggest the right number or at least the right trend.
(click on picture for better viewing)
All this is of course underlines Kinmont’s point that we don’t know the future and that economists have a proven track record for abysmal forecast performance. Still, we should get our concepts right at the offset. Long term projections in age structures are likely to be robust as they are a function of people already being born and while migration may change the course of ageing in any given country the fact that we are all ageing at one at the same time means that there are fewer migrants to go around. I would then claim that ageing does matter and that understanding how an economy such as Japan adapts to the ageing of its population remains one of the most vexing and important issues for social scientists and investors alike.
So when Kinmont implies that low fertility in Japan is a non-issue I have to strongly oppose. Just take a look at the chart above Kinmont himself uses. Fertility has been below replacement levels in Japan since 1970 and on current growth rates (assuming a constant growth rate of fertility which in itself is dubious to the extreme) fertility levels would reach replacement levels some time in 2030-40. So, that would be 60 years with below replacement fertility. Even if fertility in Japan (and again in most of the OECD) took a discrete jump to replacement levels it would do very little to change the outlook for ageing in the immediate future.
In claiming that demographics do not matter Chancellor are Kinmont are taking a very wide brush over the general recognition in the academic literature that our economic systems tend to hit a snag once fertility falls below a certain level (a TFR of 1.5). This is also called a fertility trap and what it means is that it becomes very difficult to escape negative population dynamics once they set in. I emphasize this since it highlights that we are not, as a friend of mine likes to point, simply shooting arrows into the void when we point to the importance of these issues. I recommend the following presentation by Wolfgang Lutz et al and the paper that goes with it or this old post at AFOE by Edward if you are still not convinced.
In terms of the postulated increase in Japanese fertility since the mid 2000 it is a positive development, but as is evident from the data this rebound is extremely uncertain. In addition, we need to know whether this is just an echo of the tempo effect (and thus how large the rebound is likely to be) or whether it reflects a real change in attitudes on quantity. I am open to contributions here but the only thing we can for certain is that ageing, in Japan and the rest of the OECD, will continue its march onwards. Here I also feel that Kinmont puts up a straw man when he invokes the idea of Japan’s population going to zero;
The unrevealed assumption, then, behind the mathematics used to arrive at widely-used population estimates is that the Japanese population will drop to zero. One cannot help but suggest that the logic of demographic pessimism is circular.
I want to re-emphasize that the issue here is not predicting fertility and death rates but recognizing the effect that the current and past trends have on ageing today and tomorrow. Try the recent work by Wolfgang Lutz, Warren C. Sanderson, and Sergei Scherbov if you want to see the cutting edge here and while uncertainty is still a key variable ageing remains a tangible reality. The main question issue I would like to get across is then that the demographic transition manifests itself in a transition of ageing and that this essentially becomes our main unit of analysis.
Growth and Demographics, No Connection?
Kinmont and Chancellor argue that demographics are likely to be less important for growth over time as total factor productivity (TFP) growth tends to be the main driver of growth.
Japan could quite easily grow at a good rate, especially in per capita terms, for a high-income developed country even in the face of a falling population (or more precisely a falling working age population). All that is required is for TFP growth to accelerate back to the level of growth enjoyed by Japan prior to the bursting of the Bubble in 1989. TFP slowdown preceded the population peak. Variation in TFP performance not in labour input growth is likely to be larger than the negative effects of population change.
This is an important point and more importantly, Kinmont offers an argument to explain the declining labour input in Japan’s economy which links in with the fact that Japan has been stuck in deflation and at the zero lower bound for the best part of two decades (my emphasis).
Labour input has in fact fallen at an accelerating pace over the past 20 years. It is clear that the fall is principally a decline in man-hours. This cannot be simply a function of a decline in the working age population because that decline only began in 2000. Instead, its origins must lie in rising unemployment and under-employment. A persuasive new paper, The Paradox of Toil, by a researcher at the NY Fed [3] argues that a decline in labour input is a natural consequence of a deflationary economy with zero (or effectively zero) interest rates.
In short, the declining labor input in Japan is a function of deflation and being stuck at the zero lower bound. In addition, this Fed Researcher Kinmont refers to is Gauti Eggertson who studied under Krugman at Princeton and did most of his initial work on the liquidity trap and the zero lower bound. So, I would be careful getting in his way without a strong look at the argument.
I think however that we might be dealing with the problem of a missing link in the sense that demographics may be one of the primary sources of deflation and the liquidity trap in the first place. This is an argument that has been pushed in Japan’s case in the sense that it was a lack of pent up demand that held Japan back in the 1990s as well as deleveraging. Indeed, Japan may hold a cautionary tale on the effects of a balance sheet recession in an economy where fertility has been below the replacement level for an extended period. The Eurozone periphery (ex Ireland) who have even ceded monetary policy to Frankfurt are case studies to this theory I think.
I would also emphasize that as labour input declines so does, obviously, consumption (aggregate demand) input which again feeds into the the paradox of thrift in the closed economy (or perhaps even a realisation crisis?). In an open economy it leads to export dependency as domestic investment actvity responds to foreign demand as well as the excess income you earn from a positive net foreign asset position (if you are so lucky as to have one) becomes a crucial source of growth.
Another more fundamental point is that if the total factor productivity growth (TFP) is a residual what is actually hidden in this residual? Well, I had a wack at the whole argument a while ago from the perspective of the academic armchair.
Technology and productivity are famously assumed exogenous in the Neo-Classical tradition while New Growth theory as it was developed in the 1980s and 1990s emphasised the need to specifically account for the evolution of technology. Today, I would venture the claim that there is a consensus that productivity and technology is a function of what we could call, broadly, institutional quality which encompass almost anything imaginable from basic property rights to the level of entrepreneurship. Indeed, a large part of research is still devoted to pinning down exactly which determinants that are most important here both across countries and through time. Now, I would argue that, in the context of standard growth theory, this is where the scope for the study of the effect of population dynamics is largest. Thus I don’t think it is unreasonable to expect the level and evolution of productivity growth and technological development to be a function of the current population structure but also its velocity which is a function of e.g. migration (new inputs?), future working age size etc. Also, this is also where human capital and the evolution of technology is joined at the hip through the idea of innovative capacity and readiness.
Once we venture into the notion of endogenous growth theory and thus the attempt to directly explain the sources and components of total factor productivity growth there is growing evidence that age structure/demographics alongside a host of other variables are important. Try this one for a recent literature review, and for the general link between growth and demographics the list of contributions is long. You just need to read around a bit.
I would argue then that growth and prosperity of the modern capitalist welfare state is highly conditional on some form of demographic balance and Japan has long since moved beyond into unbalanced territory. Basically, Japan is stuck in a liquidity trap as well as a fertility trap. The latter works along the lines of depressing consumption demand and making it very difficult to maintain key economic structures such as e.g pension systems. In addition, ageing affect the growth path of an economy and leads to export dependency, this last point however which I concede is not yet an established fact in the literature.
What about stocks then?
We seem to have two intertwined arguments here. Firstly, the extent to which demographics may have an influence on growth it is irrelevant for the investor since you can’t buy GDP growth anyway. Secondly, the evidence of a correlation between demographics and equity prices is weak and indeed, if anything, should be bullish for Japan (this last point is made by Kinmont).
Thus the FT summarized the latest findings of the London Business School team of Dimson, Marsh and Staunton, as published in the Credit Suisse Global Investment Returns Yearbook, 2010. The LBS academics examined all the available data (83 markets), and concluded that “99 per cent of the changes in equity returns could be attributed to factors other than changes in GDP”. (…) Growth is not all that it is cracked up to be. This analysis underscores previous academic findings showing that growth
per se to be of only small importance to stocks.
It would be unwise to disagree with the gist of this point. Even if I can make a connection between demographics, growth and investor performance it is very likely that buying into such a story at too high a valuation will lead to poor returns. Buying at the right value is the most important aspect of any investment decision.
This however is not the same thing as saying that just as you make sure to “buy cheap” poor demographics, low growth etc are completely irrelevant. Rather, I think that the extent to which the modern investor needs to understand a decidedly more complex macro picture with lingering deflation, heightened risk of sovereign defaults and zero lower bounds the understanding of demographic dynamics is key. We are then again discussing the question of deflation and low interest rates in Japan;
The origin of Japan’s problems is falling valuation when compared with the rest of the world. When we note in addition that it is excesses of inflation or the arrival of deflation (that is, monetary phenomena reflecting policy errors) which tend to reduce market average valuations, we feel it safe to conclude that demography will have next to nothing to do with the longer-term return profile of the Japanese market either in nominal or real terms.
I feel this is a very dangerous claim to make because it assumes that the deflation dynamics of Japan and indeed the problems facing the Bank of Japan in reviving credit growth are unrelated to demographics. In addition there is the unintended consequence of BOJ having to monetize an ever greater amount of JGB issuance in the future which in itself becomes more paramount as Japan ages.
On the second point regarding a direct relationship between demographics and stock prices (asset prices in general if you will) I think Kinmont does better especially because he does not fall into the asset meltdown hypothesis trap. In short the asset meltdown hypothesis states, in a US context, that as the baby boomers retire they will dissave and thus need to sell off their financial assets to a market which cannot support the flow, because the generation in the working age years is smaller, and that this will lead to an “asset meltdown”. Generalized, this is then the classic (and naive) nexus between life cycle economics and financial markets which postulate that dissaving into old age is rapid and imminent.
There are two problems here. Firstly, the empirical (and indeed theoretical literature) has found it very difficult to verify that dissaving occur among elderly cohorts to the extent postulated by the standard life cycle theory. Secondly, the relationship between asset prices and broad demographic aggregates appear weak. Results differ from country to country and most studies take place in a US and Anglo-Saxon setting which tend to bias the results further.
Kinmont does however point to a study by Geanakoplos, Magill and Quinzili [4] which show how the ratio of the 45-54 age group to the 25-34 age group is closely related to P/E ratios. As this ratio is set to increase in Japan, Kinmont ventures the idea that, if anything, perhaps you would want to buy Japan on the basis of demographics.
I have read the research by Geanakoplos et al and I find it intriguing, but my problem is that it does not control for the old age dependency ratio which suggests that the key ratio will be correlated with ageing in general. But I should be hesitant disregarding it on the basis of this hunch. I am preparing a large panel data set at the moment on demographics and stock prices with the aim to essentially rejuvenate a literature which seems too focused on the asset meltdown hypothesis noted above.
On a more general level, demographics and investment has been a core theme in the post crisis flow into emerging markets which, by and large, share the characteristics of being in the middle or at the end of their demographic dividend. Again, this does not nullify the importance of valuation and certainly, the recent soft patch notwithstanding, many emerging markets are still looking expensive.
Where goes the DIP then?
If you build your story up around the notion that investors buy value and not GDP growth you can easily come to the conclusion that demographics are irrelevant for the investor at large. This however would be a mistake.
I would be the first to wish for a return to a state of affairs in which investors needed only to look at valuation and firm fundamentals to make their decisions. Today however, you need to understand the macro backdrop and in order to do that you need a firm grip on how demographics affect macroeconomics. Pointing out that we are poor at predicting birth and death rates as well as pointing to weak evidence between growth and demographics do not cut it. We need not predict fertility and mortality but instead we need to understand the effects of ageing already present and there is plenty of evidence that demographics affect the growth rate and growth path of the economy.
I am more sympathetic to the strict relationship between stocks and demographics which is fickle and not well understood. Clearly, there is not presently any convincing model or framework which suggests how and why you might be able to buy sound demographics on a beta level. My main bet is that demographics should, at least, be used to qualify the notion of the global market portfolio and especially that demographics be used to re-balance such a portfolio over time.
In conclusion, Kinmont and Chancellor bring up some valid and good points in their attempt to brush away demographics as an important input variable to investment and macroeconomic analysis but you shouldn’t be fooled. Just as was the case with the original DIP you accept this new version at your peril.
—
[1] – Franco Modigliani and Merton H Miller (1958) – The Cost of Capital, Corporation Finance and the Theory of Investment, American Economic Review 48 (June 1958) pp. 261-297.
[2] – GMO White Paper – After Tohoku: Do Investors Face Another Lost Decade from Japan?, Edward Chancellor and Morgan Stanley Japan Strategy – The Irrelevance of “Demographics”?, Alexander Kinmont. I realise that I have lately been referring to sources and pieces of research which by nature of their origin (banks, research firms etc) are behind subscription walls. I am sorry, but I will make sure to produce relevant quotes so that my readers can follow the issues and arguments. I cannot upload full PDF versions of the reports for obvious reasons and I hope my readers will understand.
[3] – The Paradox of Toil, Gauti Eggertsson, Federal Reserve Bank of New York Staff Reports, no. 433, February 2010
[4] – Demography and the Long-run Predictability of the Stock Market. John Geanakoplos, Michael Magill, and Martine Quinzili; August 2002, Revised: April 2004. Cowles Foundation Discussion Paper No. 1380
By The Energy Report, on March 25th, 2011
 John Pugsley, author of the highly successful newsletter, The Stealth Investor, is struggling with some sudden health issues. But in this exclusive interview with The Gold Report, he shared his insight on how the global economic situation, including the catastrophe in Japan, is affecting the prospects for precious metals-related investments.
Editor’s Note: Shortly after this interview was recorded, Mr. Pugsley suffered a major heart attack. Our thoughts are with him and his family as we share his insights. New subscriptions to The Stealth Investor have been temporarily suspended.
The Gold Report: Good morning, John. Please start by commenting on how the tragedy in Japan and conflicts in the Middle East might affect precious metals and mining stocks in the near future.
John Pugsley: We are in a particularly exciting period for speculating in the natural resource area and specifically the mining stocks. What’s going on right now in the world is we’ve gotten totally into paper money. Governments have had a big backlash from all the money that was printed over the last 20 years in all of the major countries of the world. When the 2008 economic bubble swept across the globe, governments tried to solve it by printing more paper money. Every time they get into a problem, they think they can bail out their past credit excesses by creating more credit. This is absolutely going to lead to inflation. Whether we want to call it hyperinflation or not, it’s going to come and it’s going to come with a vengeance. That’s the opportunity for all of us because this pile of government debt is building in all the banks and pensions funds around the world.
TGR: So how does the situation in Japan fit into this picture?
JP: It is absolutely insane to think that rebuilding after the devastating earthquake and tsunami in Japan could act as stimulus for GDP growth. That would be like saying that building bombs and blowing things up during a war stimulates the economy. That doesn’t create a better world for anybody. If wiping out entire cities really does create a rising GDP and standard of living, why not just go ahead and do that periodically and have a wonderful economy. That’s just insane. Instead, they’re going to print enormous quantities of paper yen, which will result in passing the loss on to lower-income individuals just as the federal deficits in the United States are passing losses down to the lower classes.
When prices rise, the retired and those on limited incomes will be the victims. I feel sorry for them. But, by the same token, those of us who have some assets can take advantage of this by positioning ourselves outside of the paper-money bubble by investing in natural resource commodities like gold and silver. The real assets are the things we use everyday—copper, steel, zinc, lead and aluminum. These natural resources are the opposite end of money—they are what the price level is priced against. The opportunities are going to be enormous in the next five years. That’s why every time we see a dip in any of these areas, we’re going in and buying. If they fall more, we buy more. So, we’re positioning ourselves.
TGR: When you point out copper, steel, zinc and lead, those are commodities that are used in an expanding economy. Are you so bullish on them because you’re expecting that, worldwide, we’re going to have an expanding economy over the next several years?
JP: Well, I’m very hesitant to ever try to judge the short-term direction of anything. I’m looking at the longer term. I don’t think we’re going to see a lot of expansion in one year, but that doesn’t mean we’re not going to be using these commodities. Clearly, when the world or one country goes into a recession there’s a lot less copper, zinc, lead, aluminum and so on used. But, those are only temporary setbacks.
The fact is that I have a very, very long-term positive view on the progress of man. There’s a wonderful book out now called The Rational Optimist: How Prosperity Evolves (Matt Ridley, Harper, 2010). It really helps you realize how, decade after decade, century after century, people are getting richer and richer. They’re demanding more and more in the way of standard of living. With India and China—and not too long ago, the Soviet Union—opening up to free market and free enterprise and breaking down some of the governmental barriers to individual initiatives, we’re going to see rising demand for goods and services. Look at the automobiles, refrigerators, air conditioners and cell phones that we have. This has happened very rapidly over the last decade and it’s going to continue. So, whether we have a brief setback here with this recessionary period of maybe two, three, five years doesn’t really break the long-term trend. It’s just one of those dips that provides buying opportunities.
TGR: How are you taking advantage of this situation?
JP: This is one of the reasons that we happen to be in the prospect-generation area. We’re at the very beginning. Most of our companies are not producing companies. Most of the things we look for are very tiny, what are known as “prospect generators.” They’re at the hot end of the whole business. History proves that discovery, and then selling off to property developers is the more aggressive, explosive, profit-making area. This is where the real money’s been made in the last decade and where we’ve made our money. You have to take a long view, however.
Between the time someone discovers a copper, gold or zinc deposit and the time it’s actually put into production is three, four, five, six years or longer. So, we’re not looking for instantaneous turnaround despite the fact that we’ve had some of those. The gap between picking up a few streambed samples, trenching and finally punching a hole and turning it into a mine is very involved. So, I don’t really look at the short term. I’m very optimistic about the 5- to 10-year run going forward.
TGR: It sounds like your position really hasn’t changed over the last year. So, despite the fact that most of these prices have risen substantially, you still believe that they present excellent prospects for investors out there?
JP: Yes, and they’re coming all the time. You just have to find the young companies, the new companies with bright young geologists behind them to go out and look. Because commodity prices have gone up, it has created a tremendous interest in this area. That’s one of the reasons that some of our juniors and some of our majors have improved so quickly. Rick Rule, who just returned from the Prospectors and Developers Conference (PDAC) in Toronto, said attendance at that event has exploded from 1,500 to 33,000 attendees in the 10 years he has been attending. That just tells you that people are flooding into a sector that’s doing well.
TGR: Isn’t that a dangerous sign?
JP: In 1928, every bellhop and elevator operator was touting stocks to anyone who would listen. Clearly, it was a bubble market. Whether this is a bubble market right now for these commodities depends upon the value of money. If I’m correct and the trillions and trillions of dollars, yen, deutsche marks and euros pouring into the banking systems continues, everything is going to go up in price.
One of the things that has to go up in price is the raw commodities that will be needed to continue civilization as we know it. So, I don’t think we have to look at this last period as a bubble that must be corrected. Sure it could correct somewhat, but I think the offsetting event here is the printing of this paper money. At some point, this has got to start coming back into the market. When prices start going up, that means the prices of commodities have to go up proportionately.
TGR: So, when you last interviewed with The Gold Report in April 2010, you told us about some of the resource-based stocks you were invested in at that point. You had some nice gains in those. I was wondering if you could give us an update on what’s happened with them.
JP: We’ve had some excellent experiences with many of our prospect generators. Esperanza Resources (TSX.V:EPZ) was one that we bought and really liked. The company was a prospect generator and it had a property in Peru that looked very, very exciting called the San Luis Project. Esperanza sold that off to Silver Standard Resources Inc. (TSX:SSO; NASDAQ:SSRI). It hasn’t participated greatly in the current rally, but the company will be coming out with a feasibility study. I think it’ll probably come out this fall and at that point, it’ll get taken over.
People haven’t noticed that Esperanza has almost a 40% position, which gives it control of another company, called Global Minerals, Ltd. (TSX.V:CTG; Fkft:DPF), and CTG’s got a very, very attractive silver project. It’s called Strieborna. It’s a silver/copper deposit in Slovakia that’s gotten some attention. It includes 14.3 million ounces (14.3 Moz.) of silver and 48 million pounds (48 Mlb.) of copper in the measured and indicated (M&I) categories and another 8–9 Moz. silver and 28 or 30 Mlb. copper. So, its stake is going to become very valuable. Already, I think the company is up about fivefold over what it paid when it originally made the investment. It also has the Cerro Jumil property in Mexico, which is a bulk tonnage gold deposit. It appears to contain almost 1 Moz. gold equivalent (Au Eq.) in the M&I category. In terms of its inferred resources, it has another 250,000 oz (Koz.). We bought Esperanza at $1.75. We sold when it more than doubled at $4.10, and then we bought it back again at $1. We sold half of that when it doubled, and now it’s $1.86.
So, I think that Esperanza is a good buy at this point. We’re holding it. I don’t have it in as a re-buy for our portfolio, but I think it’s an excellent company. It reminds me of another prospect generator that’s done very well for us. We went into a little company called Canplats that we bought back about four years ago at $0.22. It was a typical prospect generator with a project in Mexico, and its market cap was about $7 million at the time. Well, the company hit and we sold part along the way; but we sold our final piece when it was bought out at $4.60. So, it was a twentybagger along the way.
TGR: Any other companies you’re looking at that you really like?
JP: We’ve got a couple more prospect generators in there that I’m very hot on. Riverside Resources Inc. (TSX:RRI) is one and Miranda Gold Corp. (TSX.V:MAD) is another. They’re getting some press up there because specialists like Rick Rule, Paul van Eeden and Fred Cook are talking about these companies. I think they’re great. They give you the kind of high leverage and high return that you like. But the risk is relatively low because the property is good and the geologists behind them are top notch. These guys really know what they’re doing.
TGR: One of the companies you talked about last time was Altius Minerals Corporation (TSX.V:ALS). Are you still holding it and what does the company look like to you at this time?
JP: Altius Minerals is just a fantastic company. It hasn’t made any mistakes and has about $200 million in the kitty right now. Now, a lot of companies get cash in the kitty by selling shares. Altius hasn’t gotten the cash by diluting the stock. President and CEO Brian Dalton has gotten that cash by making some really wise deals selling uranium and copper properties that the company has discovered. This is a fantastic company and the best is yet to come. So, I’m a strong advocate of Altius Minerals. I think that anybody who gets in there and hangs with ALT is going to be a very happy investor.
TGR: So, if an investor doesn’t have a position in Altius, is this a good time to buy? Or should we wait for a pullback?
JP: I think it’s probably a good buy at this point. It’s been bobbing around the $10–$13 area. It could easily be a $20 or $30 stock. The Stealth Investor originally bought it back in April 2006 at $6 and it rose quickly. We sold about one-third of it and bought it again when it dropped to $7. Then we bought a tranche at $5. So, all of our tranches have done extremely well. I’m not a buyer at this point because we’re looking for little $10- to $50-million market cap companies, but I’m certainly going to hold on to it.
TGR: Earlier, you gave the examples of copper, steel, zinc and lead. Do you have any of these everyday commodity-oriented juniors in your portfolio that are really intriguing to you at this point?
JP: We’ve got a couple of others, Mansfield Minerals Inc. (TSX.V:MDR) is one. But I hate to give it away before I actually add the company. My subscribers come first.
TGR: That’s understandable. How about some final thoughts on strategic changes readers might consider in their investment philosophies?
JP: Watch what the banking system and the government are doing. I published an article a couple of months ago called Rethinking Gold, a long-term historical look at money and commodities. A better understanding of the big picture should influence what you do in the short term heavily.
TGR: Thanks again for taking the time to share your insights on the investment implications of current world economic events and how this impacts our readers’ relative to gold and metals investments.
John Pugsley entered the investment business in the late 1960s and started sharing some of what he’d learned through his first book, Common Sense Economics. The book sold more than 150,000 hardcover copies. The second book he penned—The Alpha Strategy: The Ultimate Plan of Financial Self-Defense for the Small Investor—spent nine weeks on the New York Times’ bestseller list and is considered a standard reference for stocking up on food and household goods as a hedge against inflation. He started Common Sense Viewpoint, an investment-economic newsletter covering political, economic and investment topics, in 1975 and published it for 10 years. At its peak, it had more than 30,000 subscribers. He then wrote and published John Pugsley’s Journal, for another decade. A popular speaker and talk show guest, as well as a prolific author and successful investor, he is currently pouring his experience and energy into Stealth Investor, a weekly stock advisory that alerts subscribers to potential investments beneath the radar of the big funds and brokerage houses. (Please note that new subscriptions to Stealth Investor have been temporarily suspended.)
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By Claus Vistesen, on March 21st, 2011
The past week has showed the dark side of media coverage and analysis of current events and a test on just how much information you stuff down the public’s throat. In the narrowness of my own world the financial industry has a tendency to produce an extra amount of hyperbole in situations of geo-political tensions and/or natural disasters with unknown consequences. In some sense this is a reflection of one of the oldest theories of finance and economics in the form of the efficient market hypothesis and how it tends to break down in the context of extreme uncertainty. Still, I swear that if I open one more report whose authors are turning self-made nuclear scientists overnight I will bin it!
Yet, the long term consequences of the ongoing upheaval in North Africa and the Middle East as well as how Japan manages to rebound from the worst crisis for the country since the Second World War are important for investors. In the following and with a promise of no mention whatsoever of nuclear fuel, rods, or Chernobyl I will evaluate some of the potential effects on Japan’s economy (and indeed, Edward has beat me to it over at JEW, so do have a look there too).
Saving for a Crisis?
In some sense it is too early start putting a numerical figure for the costs of reconstructing in Japan, but it also almost certain that the economy retains the capability to rebuild itself and thus to stage a strong “technical” growth rebound.
Yet, the crisis may also lead to a number of structural changes.
As a first point I would note that the earthquake is likely to speed up the path towards the inflection point at which the BOJ starts monetizing the marginal flow of Japanese government bonds (JGBs) or Japan starts to borrow externally. In principle, I would hold these two scenarios to be one or the other, but in reality we could see a combination.
Two points are important.
1) Japan owes much of its growth rate and indeed its ”survival” to a very strong net international investment position. This is crucial to understand. Japan owns much more assets abroad than foreigners own in Japan and this adds a positive income flow which adds to gross national income (GNI).
2) A strong net investment position essentially translates into positive external savings and leads to a positive income balance which, alongside the trade surplus (or deficit), makes up the current account . This means that when we speak about Japan as export dependent it is a misnomer. Japan is much more dependent on positive net foreign asset income (the income balance) than the exports of excess widgets. If the CA/GDP is about 3% in Japan 2% is the income balance and 1% is the trade surplus (as a rule of thumb). Obviously, on the margin export flows matter a lot but added together over time the ”national wealth effect” from the income balance is higher.
In relation to the reconstructuring efforts, the standard story goes that Japan would have to repatriate these foreign assets effectively selling foreign assets and getting USD, EUR, AUD etc and converting them back into JPY. This would then lead to JPY appreciation which would further crimp the Japanese economy.
Now evidently, this week’s snappy moves in the JPY has nothing to do with this as this is likely to be a slow process but structurally this may become important and a real challenge for Japan. According the initial judgement of the situation by Fitch, the Japanese insurance industry (and indeed the global re-insurance) existing capital buffers should be plentiful.This suggests that this is a non-issue, but given the evolution of savings in Japan relative to the demand for JGB financing there is alreadt a very large future claim on these foreign assets. More specifically, Fitch is arguing in the context of potentially downgrading Japanese insurers on the capital loss of paying for the rebuilding efforts and thus the analysis can not be directly related to Japan’s foreign assets.
Megan McArdle is less sanguine;
(…) while the global reinsurance industry will bear some substantial losses, in many cases, the losses will be borne by the government–or by people and companies whose insurance does not cover the damage that was done. The nuclear industry was required to buy insurance through a special industry insurer with liability limits that now seem laughably small–about $2 billion. And many of the damages simply aren’t insured at all.
In a cynical way, this squares off well with Fitch’ concrete assessment of the insurance industry in that they are likely to dodge the main costs. On the other hand, as Megan also points out, this is certain to put an even stronger strain on Japan’s already overstrained government finances.
Indeed, even if the reconstructing would not drain anywhere close to all of Japan’s foreign assets it would constitute a de-facto claim on these assets either directly or because it would lead to a higher flow of JGBs in the primary market in need for buyers.
There is an alternative of course. As I have argued before, it would be infinitely more attractive for Japan that the BOJ printed money to fund the reconstructing so that the export machine did not falter, but this again would bring the point closer at which the BOJ would effectively be the only bid for the marginal flow of JGBs. You might call this the obviously irresponsive reply, but remember that Japan is still stuck in deflation and thus the cost of such policies is effectively zero at this point.
The big macro picture here is then that Japan may now be forced to run down its only source of savings and essentially its main source of economic growth.
The metaphor here is very simple. Let us say I am unemployed and only earn very little income from the bits and bobs of small jobs I can find (i.e I have a low ”trend growth in income” as Japan does). However, my uncle left me a pool of money and these are all parked in tasty dividend stocks which gives me some income each year so that I can live well.
Now, my house burns down and I have no insurance. What do I do?
Well, I do the only thing I can. I would need to sell those stocks in order to build a new house with the proceeds, but then once my house is rebuilt, my portfolio of dividend stocks will be much smaller and I will earn less dividend income (and I will still unemployed!). This, in a nutshell is the issue for Japan. When I have no more dividend stocks, I go to the bank and they either charge me an interest rate I can’t pay or tell me to bugger off altogether.
And I would re-emphasize that Japan is in a really tight spot since domestic growth and savings are in a structural downtrend and deflation is now a reality in Japan. So it will become very difficult to rebuilt those external savings.
Now for the good news. On even the worst estimates, it is very unlikely that the rebuilding efforts will eat away all Japan’s external savings and let us remember that Japan won’t sink into the Pacific. But with the power grid in need of major structural overhaul, the ensuing and looming disaster with the nuclear reactors at Fukushima, the general knock to economic growth, the already already public debt overhang etc one would be complacent if one did not think a little about straws and camel backs. Indeed, this is also the conclusion made by Edward;
Serious as the short term impacts may well be, in the longer run the shadow which will be cast by what is currently happening in Japan could well be very long indeed, in a way which few today can even contemplate (although see this for a good first pass). The justification for this assertion is not only our increased awareness of our collective vulnerability to the impact of natural disasters, there is also Japan’s pioneer status in one very new and very global phenomenon – population ageing – to think about. As we will see below, the optimistic (I would say denial) prognosis is that Japan will soon valiantly overcome this latest bout of adversity in a similar way to which they overcame the post WWII devastation. The Japanese will surely be valiant in their efforts (one only has to think of the spirit of sacrifice of those poor workers who have been asked to handle directly the reactor problem), but their ability to overcome adversity will not be comparable to that registered in an earlier epoch when they had the wind behind them rather than gusting straight into their faces.
Shock and Awe by the BOJ?
Even before the earthquake roiled Japan, comments were beginning to emerge that the BOJ was going to be forced into a shock and awe jolt of QE that would trump even that of the Fed. The reasons here though would be the same as they would be now. Essentially, the BOJ is fighting a war on three fronts.
- General freeze in money markets and general cash/liquidity levels in the economy
- Backstopping the JGB market which could take a severe knock here. I think Ben is very right to point to the risk that the CDS on Japan is very sticky, once it goes up it does not go down. I mean, why should it really?
- The JPY.
On the first, I think time is working for the BOJ and after last week’s extreme bout of uncertainty due to the unravelling of the nuclear reactors, pressures should already be easing. I would then hold this to be ”managable”.
On the second, it could get very serious, very quickly and I would be looking closely at the BOJ balance sheet. In this week’s G&F Chris Wood points towards how the earthquake has given the BOJ room for movement;
From a valuation perspective, the Topix is now trading below book value again at 0.96x price-to-book . Global investors should use this opportunity to overweight Japan if they have not already done so. GREED & fear’s bull case rests on two foundations, as discussed here recently (see GREED & fear – An ode to the BoJ, 3 March 2011). The first point is the extent to which Japanese corporates have proven they can live with a stronger yen. This is why it is not necessary any more to believe in a weakening yen to assume an outperforming Japanese market. Second, there are clear indications that Japan has commenced a new property upturn which increases the collateral value of the banking system. On this point the earthquake has “helped” in the sense that it has prompted the Bank of Japan to increase its assets purchase programme of private sector assets, and not just JGBs. Thus, the BoJ doubled its asset purchase programme to Y10tn on Monday, with the maximum amount of purchases in index-linked ETFs and J-REITs both doubled to Y900bn and Y100bn respectively.
Two effects need to be noticed here. One is the effect from the BOJ expanding its balance sheet on equity markets and secondly, there is the need to support the structural deficit spending. On the latter, it is noteworthy that CDS on Japanese long term government debt has been creeping up especially as it may prove quite sticky. This means that the BOJ may need to massage the curve on the long end it stands to reason that mounting concern over long term debt sutainability in Japan could lead to a strong steepening of the curve. This is to say that the long term default risk of Japan could rise very quickly since in the end, they will default at some point so in theory it could simply go parabolic. I am not saying that this will happen, but think about the Eurozone. The ECB is effectively the only buyer of peripheral bonds … it could be the same for Japan and long dated bonds.
Naturally, they could move the financing down the yield curve which could mask some of the default risk as duration changes, but in the end it would be the same. But here I am shooting blanks since I don’t know the maturity schedule of Japan’s government debt portfolio.
Structurally, the BOJ faces two main challenges with the JGBs. One is to soak up the annual excess issuance of JGBs relative to domestic demand and secondly there is the flow in the secondary market as pension funds run down their balance sheets to fund pension payouts.
On the third, nilly willy intervention in the spot market will work for about five minutes and then it will get bid down again. In this context, it was interesting to see that the violent move in the JPY prompted the G7 to intervene. Whether they have the clout to lean against the market here is debatable, but ironically they may soon have to back off if the BOJ starts monetizing debt as the rest of the world tightens.
Japan will Move On
In the end, we should all already be vindicated by the strong resilience shown by the Japanese people in the face of their current tragedy. I am certain that Japan will move on as a people and as a society. However, as a macroeconomy things are looking increasingly grim. We don’t yet know what will really come of the attempts the by G7 to keep a lid on JPY appreciation and failing that, we don’t really know what the world will look like with a BOJ engaged in QE far and beyond what the Fed is currently administering.
The point here is not to kick a country which is already down but simply to face up to the realities that the costs of this truly exogenous shock will weigh down on an already unsustainable economic system. So although Japan may now see the opportunity to push the reset button in a number of corners of society, there is no economic equivalent.
By Ajay Shah, on March 14th, 2011
If you are in India, and hear news about the earthquake, tsunami and nuclear reactors in Japan, you might want to trade on this. Either because you are hedging Japan exposure that’s embedded in your Indian equity holdings, or because you think you are an informed speculator who has a better and faster judgment about what these events mean for Japan.
Sadly, the Indian capital controls don’t let you trade on the Nikkei 225, which is the Nifty of Japan. But there is something you can do: Trade on the JPY/INR futures trading on NSE.
Quite a few people seem to have thought like this. Here’s a graph of the turnover:
Now let’s pause to think about the story playing out on this market. On one hand, it’s the purely domestic speculators or hedgers, who are buying and selling from each other. This is fine, but where are the linkages to the global financial system?
The most important arbitrage which should be at work is in the currency triplet INR/USD, USD/JPY and JPY/INR. But unfortunately, currency futures trading in India does not include the USD/JPY contract, so one crucial leg of the arbitrage is not readily available. With turnover like $100 million in a day, I’m sure some people are doing such arbitrage in some painful ways.  
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