The results from Japan’s general election Sunday may be a bellwether event for nuclear power. In a landslide win, Japan’s Liberal Democratic Party (LDP) claimed 294 out of the 480 seats in the lower house of the Diet Sunday, defeating anti-nuclear opponents with a platform focused on economic issues and foreign policy. The Energy Report reached out to leading North American analysts for their take on Japan’s changing of the guard and its effect on uranium stocks.
Energy played an important role in this election, and as the National Journal reports, LDP Leader Shinzo Abe has criticized Democratic Party of Japan Leader Yoshihiko Noda’s goals to eliminate nuclear power from Japan’s energy mix as both “unrealistic” and “irresponsible.”
Federation of Electric Power Companies of Japan (FEPC) Chairman Makoto Yagi echoed this stance in his Dec. 17 statement, which declared the election a “breakthrough event in regenerating the nation” and called for a diverse energy portfolio that would allow Japan to “attain the three Es of energy security, environmental conservation and economy.”
Nuclear Restart Timing Remains Uncertain
Abe’s LDP plans to decide on a general nuclear reactor restart within three years, with a longer-term goal to determine the best overall energy mix for the country in the next ten years. As UPI reports, the LDP is expected to “approve the restarts one at a time, when the Nuclear Regulation Authority certifies them to be safe.” So far, just two of Japan’s 50 nuclear reactors have come back on-line following the Fukushima nuclear power plant disaster. Critics emphasize that the LDP will have to tread carefully on the still-controversial issue and contend with Japan’s regulatory and bureaucratic bodies in accomplishing a wider restart.
But the markets themselves were very quick to respond. World Nuclear News reported a 33% jump in Tokyo Electric Power Co. (9501:OSE; TKECF:OTCPK) shares and an 18% boost in share prices for Kansai Electric Power Co. (KEP:NYSE; 9503:OSE). Australian uranium producers Paladin Energy Ltd. (PDN:TSX; PDN:ASX) and Energy Resources of Australia Ltd. (ERA:ASX) rose 8.4% and 5%, respectively.
Although national polls have shown that 80% of Japanese favored a nuclear phaseout, the country’s election results told a different story and many commentators are expressing support of the LDP’s economy-focused agenda. Kazuhisa Kawakami, a political science professor at Meiji Gakuin University, argued that “we need to prioritize the economy, especially because we are an island nation,” he told the Associated Press. “We’re not like Germany. We can’t just get energy from other countries in a pinch.”
Across the Pacific, some North America-based analysts are decidedly bullish on a bright future for uranium producers.
Rob Chang of Cantor Fitzgerald Canada commented, “We view the Japanese election results as a catalyst for the uranium market because it is the strongest indication to date that Japan will return to meaningful nuclear electricity use. With the Russia-U.S. highly enriched uranium agreement drawing to a close at the end of 2013 and removing about 24 million pounds (Mlb) of uranium from the market, Cantor Research forecasts a continuous uranium supply deficit for many years.” [See chart.]
Source: Cantor Fitzgerald Research
Dundee Securities Analyst David Talbot agrees, commenting that “the LDP win may be a turning point for the nuclear sector and the catalyst many investors have waited for. Although we believe the uranium price may be the only catalyst some investors will consider, we expect that this news could accelerate the likelihood that at least part of the Japanese nuclear fleet gets back on-line, perhaps even earlier than mid-2013.”
Talbot went a step further, sharing his uranium producer picks on the back of Japan’s election results: “Energy Fuels Inc. (EFR:TSX) is a potential turnaround story—it has been punished the most of the uranium producers this year. But it is now focused on lower-cost, higher-grade production from its Arizona Strip breccia pipe mines, with its new Pinenut mine scheduled for startup shortly and its Canyon project in the pipeline. The company announced in September that it would close three higher-cost operations.
“This is a story has: 1) huge leverage to risking uranium prices; 2) a significant regional resource base; 3) the only conventional mill in operation in the U.S.; 4) no need to spend $150 million to construct a new mill despite receiving its Nuclear Regulatory Commission permits; and 5) vast potential to expand production. . .as uranium prices are expected to rise, given the company’s high leverage to prices, we would expect to see Energy Fuels shares to rise in tandem.”
Talbot has a relatively large coverage universe on uranium producers and explorers, and he shared a few more names on his short list in his ecstatic report published Monday:
“Ur-Energy Inc. (URE:TSX; URG:NYSE.MKT) is a top pick in the developer space; this is likely the first U.S. in-situ recovery producer to come on-line next year. Construction is on track and it plans to add recent acquisitions to its pipeline.
“Laramide Resources Ltd. (LAM:TSX) has also outperformed its peers this year as the Queensland uranium mining ban appears set to be overturned. Exploration at its 52-Mlb flagship project continues to deliver.
“Kivalliq Energy Corp. (KIV:TSX.V) is our top pick of the explorers. It has made six discoveries this year alone in Nunavut, and it moves closer to expanding resources toward that 40-Mlb milestone.
“Uranium Participation Corp. (U:TSX) is already on a hot streak, up 11% from last month. . .this is the smallest discount that Uranium Participation has traded since Fukushima, and given its hard assets, we don’t feel that it should be at a discount at all.”
Back on the Table
In a country that has just elected its seventh prime minister in six and a half years, winning a two-thirds majority is not a final victory; it’s an entrance into an ongoing political battle. Opinions are mixed as to how effectively the LDP can carry out its goals, but one thing is clear: Nuclear power is back on the table.
The market action of last week repeated a lesson that many a punter appeared to have forgotten. Never run a bearish book into a European summit and especially not one where expectations for a result are as lows as they were going into Friday’s meeting. Risk assets went up like a rocket with especially oil releasing heavily oversold momentum and you really could not do much wrong if you were running even moderately net long.
Above Expectations in Europe
Obviously, the market is buying the rumour and not the fact. In traditional summit fashion we got a lot of road maps and promises but very little concrete effort. Details were exceedingly sketchy and to talk about game changers is premature. We usually do not get game changers from the EU, but merely fudge cakes. Alpha.Sources would however like to remind investors that such fudge cakes may be enough to quell the market’s sugar addiction for several weeks.
Three points are worth making.
Firstly, the ESM appears to get the ability recapitalise banks directly and the door has also been opened up for the ESM/EFSF to buy peripheral debt without implied seniority. This is a big step in breaking the link between banks and the sovereign. Ireland and Spain in particular will be the beneficiaries of this. Alpha.Sources remain skeptical that the broadcasted notion of no conditionality will hold, but at least in principle there is a now a negotiated result which seems to allow countries to get help for their banks with little or no conditionality on the sovereign and no addition to sovereign debt to GDP. This is a significant step towards risk mutualisation through a banking union and ultimately a fiscal union. Alpha.Sources would note however that without applying haircuts to bondholders of both sovereign and private debt, One link is broken but another one is created between core Europe and the entire European banking system. While such a link may be stronger through the effective backing of the whole eurozone balance the key question is how far Germany and the EU will go. This question is particularly relevant (and binding) as it will inevitably become clear that whatever initial amount of euros ceded to the ESM/EFSF to sprinkle over Europe’s barren financial markets, it will almost surely be too low.
Secondly, the electorate and political establishment in Greece have every right to be perplexed. Greece has thus spent the past 3 months under an effective threat of being kicked out of the eurozone only to watch Spain and Italy get away with what is essentially preferential treatment. The fact that systemically important entities, sovereign as well as private, are given special treatment in this crisis is nothing new, but it remains a democratic problem in the EU. Like Portugal who remains the only country ever to get fined under the Stability and Growth Pact even as virtually every country violated the rules, Greece may rightfully feel a sense of injustice.
Alpha.Sources would then venture the claim that a Greek exit is now out of the question in the short run (i.e. in 2012). Even as Germany may still move to extract its pound of flesh from Italy and Spain, there is now little chance that Germany and the EU can play hard ball against Greece in the coming negotiations with the Troika. Greece could obviously still become the whipping boy, but the continuing argument that Greece is special is now so worn that even European politicians must be able to see that they can’t use it anymore. On this background, Alpha.Sources can’t see the ECB shutting off Greece from the ELA while the ESM/EFSF is loading up on Spanish bank equity as well as non-senior Italian and Spanish sovereign debt.
Thirdly, the modest but clear movement towards official creditors not being considered senior could potentially go a long way to break the doomsday loop by which once a country enters bailout proceedings it will never access the market again. Alpha.Sources emphasizes potentially here however and for now, Alpha.Sources will stick to the main rule that whatever we might constitute normal market access the eurozone periphery is far from it, but there is another silver lining to this. Consequently, in Greece it will alleviate the pressure on the ECB, EU and the IMF as it is clear that the country will need a second write down of its debt which will inevitably involve its official sector creditors.
As a general conclusion, the summit results implies a very large degree of risk mutualisation which it is unclear that Germany will ultimately go for, but multiple conclusions are not possible at the same time and so far the market and punditry seem to view this, rightly or wrongly, as victory for Hollande, Monti and Rajoy. This also means that the decoupling of Bunds from US treasuries and Gilts as well as the recent steady increase in German CDS is set to continue. This is also why Alpha.Sources believes that unlike the German national team who might have to wait two years and the World Cup to redeem itself, Merkel will get her shot much sooner.
One thing Germany will push for is the fiscal compact rules to be put in motion at a fast track pace and also, if the ESM is to take direct and equal ownership of European banks Alpha.Sources feels certain that this will come with extended EU supervision of the involved banks.
Unimpressed in Japan
Another seemingly important political result this week was the approval of the increase in Japan’s consumption tax, an increase which has been debated consistently for 5 years in Japan. If the final tax bill is passed, the tax rate will increase from the current 5% to 10% in two steps from to 8% in 2014 and 10% in 2015.
While the consumption tax has long been touted as the first step to put an end to the fiscal train wreck of Japan’s public finances Alpha.Sources believes that the measure will ultimately be counter productive. Japan’s fiscal problems consequently do not stem from a lack of revenue, but rather from too much spending. Trying to extract more revenues from a domestic economy where aggregate demand is already chronically weak due to an ageing population will only steal consumption from a future which is, in an almost literal sense, not there.
In this piece written on a similar VAT hike in Germany, yours truly presented a relatively simple economic framework for what it means to increase indirect taxes in the context of a rapidly ageing economy. In a nutshell, the argument is that while there will be a pure statistical effect on inflation readings as a result of the tax hike as well as positive effect on consumption as the purchase of durables is pushed forward, the end result is likely going to be deflationary.
The following quote, while requiring a little bit of basic microeconomic intuition, presents the argument,
(…) students of applied microeconomics learn to distinguish between the point of impact and point of incidence of a tax. The former constitues the party who actually levies the tax towards the government whereas the latter denotes the party who actually supports the tax. In the case of a value-added tax (an indirect tax) the point of impact would then be the consumer who (through an intermediary; e.g. a retailer) levies the tax towards the government. However, it is much more interesting in this case to discuss the point of incidence of the tax that is who actually supports the tax. In order for us to do so we need to introduce yet another economic concept, namely supply and demand elasticities of the tax hike. Consequently, the party with the highest relative elasticity (i.e. flexibility) towards the tax will also avoid supporting the lion’s share of the tax increase. What this means in the concrete case of the German tax is of course very difficult to asses. Yet, since for example consumers’ demand elasticity in this case can be operationalized as the relative fraction of disposable income which is consumed and saved (i.e. the MPC and MPS) we might actually be able to sketch a framework which suggests why the VAT hike in fact should not have been expected to rapidly push up inflation in the first place. The point would then be that the consumers’ demand elasticity towards consumption and thus flexibility towards avoiding the tax relative to businesses would be positively correlated with the marginal propensity to save.
In a rapidly ageing society, the attempt to extract tax revenue through consumption taxes fundamentally misunderstands the consumption and saving dynamics in the context of population ageing.
Still, we should expect higher consumption in Japan and also, ironically, that inflation may nudge its way up close to the 1% mark set as the target for the BOJ. It would be tragic if this prompted the central bank to lay down its guard because the end result would almost surely be more deflation and contraction.
With that dear reader it seems that just as Italy spearheaded by the enigma that is Balotelli managed to exceed expectations against Germany (only to come crashing down in the final!), so did we also get a number of political results which, at a first glance at least, were above expectations. In Europe, Alpha.Sources harbours a scant hope that the seeds layn may provide a little calm in the coming months however fleeting this might be while in Japan, the sentiment here at this blog is decidedly unimpressed.
First off obviously; Spain and the country’s bailout which was announced yesterday. Alpha.Sources is amazed that it has not happened before really. As we have seen so often before when Europe is on the brink of disaster this time with a Greek exit looming and Spanish banks in tatters, a response has been cooked up in the fudge factory.
Spain asked euro region governments for a bailout worth as much as 100 billion euros ($125 billion) to rescue its banking system as the country became the biggest euro economy so far to seek international aid.“The Spanish government declares its intention of seeking European financing for the recapitalization of the Spanish banks that need it,” Spanish Economy Minister Luis de Guindos told reporters in Madrid today. A statement by euro region finance ministers said the loan amount will “cover estimated capital requirements with an additional safety margin.”
With Greece the immediate danger only a couple of weeks ago, the failure by Bankia seems to suddenly have alerted the eurostriches to the vortex of capital destruction in the Spanish banking system and the inevitable bailout got the fast track rubber stamp.
Two points are interesting to focus on initially here.
Firstly, the headline number of €125 billion is big, really big. Only a couple of weeks ago we were hearing numbers of a €20 to €30 billion euros for Spanish banks and this underscores just how expensive this may turn out to be. Consequently, we don’t really believe that this is going to be the final number now do we?
Looking at mortgages alone, the accumulation of negative equity by households may rack up a total tally of more than €250 billion euros and this does not include property developer loans. Spain decided early on to attempt to let time be a healer and assumed that losses could be taken over time without the market catching on. This weekend’s events show us that this is not possible and I think that the final number will have German and IMF accountants working over time to figure out just exactly where the money is going to come from. A corollary to this point is the also that the EU badly needs to sort out the firepower for the EFSF and the ESM since the original structure simply won’t have to capital to sort out Spain and cannot, in its current form, simply access the market for more.
Secondly, the battle of numbers mentioned above seem initially to have taken the backseat to the discussion of whether in fact Spain has gotten a bailout or simply a very cheap loan by a willing lender. Finance minister Luis de Guindos plays the part well.
“The financial support will be directed to the FROB [Spain's Fund for Orderly Bank Restructuring] which will inject it in the financial entities that need it,” said finance minister Luís de Guindos in a press conference this afternoon. “It is a loan with very favorable terms, much more favorable than the market’s. In no way is this a bailout.
Obviously, this is nonsense but we must understand that this is a critical discourse to push for Spain. Every single country that has so far received an EU/IMF bailout is dead in the water either now effectively under permanent stewardship of a troika or simply in some form of default. In this light, Spain has a distinct interest in pushing the story that this is not a bailout, but my feeling is that this weekend may have marked the last time for a long while that the Spanish sovereign has accessed the market on normal market conditions.
In this sense, yours truly certainly agrees with Edward. If it walks like one and quacks like one and all that.
“Of course it’s a bailout. What else would you call it? If you can’t finance your debt, and you have to ask someone else to finance it, it’s a bailout. But everybody who’s taken a bailout is dead, and Rajoy doesn’t want to be dead.”
Still, while Edward may have the right point here there is a finer point to be made. The higher the EU/IMF bailout efforts reaches up through the pecking order in the peripheral economies the weaker Germany’s and the EU’s hand becomes. You can just imagine the discussion about conditionality with Spain withRajoy et al simply pointing out the obvious in terms of a complete meltdown of the euro zone economy in the even of an un-managed unravelling of the Spanish banking system.
The smoke screens will be blown thick and fast from Madrid, but the initial spin is very easy to predict. Spain’s problems, we will be told, reside in its banks and therefore the government needs less supervision relative to Greece where the government is the culprit. As Lisa Abend puts it (article linked above),
Any European and IMF oversight–the latter will not be contributing funds but will be involved in monitoring their use–will be restricted to the financial sector, not the Spanish macroeconomic system as a whole.
This is absolute tripe of course. One of the main lessons of this crisis is that in the case of a highly risky stock of private debt in the private (banking) sector it is only a matter of time before this liability must be assumed by the sovereign (Ireland is an example here, but Australia and Denmark exhibit similar characteristics). One would expect Spain to continue playing this implicit card of systemic importance in order to starve off the stigma of bailout. Naturally, this is grossly unfair for Greece which is being submitted to chemotherapy even as there is a 50/50 chance that the treatment itself will kill the patient. This is is especially the case if the ECB/EU end up chucking the country out through a stop of the ECB liquidity life line.
Reality Creeping up on Japan
Of the deluge of news the past couple of weeks, what caught Alpha.Sources’ attention was how the Bank of Japan pushed back against increasing government cries for more monetisation.
BOJ Deputy Governor Hirohide Yamaguchi said the central bank will not rule out further easing if risks in Europe materialize and exert strong downward pressure on Japan’s economy. But he signaled that Japan will likely achieve the BOJ’s 1 percent inflation target without further monetary easing steps, saying the bank’s stimulus measures in February and April have heightened the chance the economy will resume a recovery.
A sign of the times perhaps that central banks are starting to feel the pressure from the very guardians of their assumed independence to do more, and to do it more aggressively. As always it will be difficult for central banks to do much since ultimately that would involve biting the very hand that feeds them.
Still, it was refreshing to hear the governor Shirakawa rise above the relationship with the ministry of finance to link Japan’s chronic deflation problem to the country’s ageing population. If only leaders and economists in Europe would listen to this rather than the consensus that has now emerged that a euro breakup and exit is now the inevitable outcome.
Another interesting structural force which seems to be at play in Japan is the fact that the trade balance may never swing back into surplus due to the dependence on energy imports. Primarily LNG imports tied to the oil price on long term contracts. Alliance Bernstein estimates in a recent note that of the Y1 trillion increase in imports since April 2010, about Y700 billion has come from LNG imports which has replaced the country’s idle nuclear capacity. As such idleness is likely to be structural so will the persistent trade deficit likely become structural.
We should remember however that Japan still runs a substantial current account surplus as a result of a positive income balance derived from the world’s largest positive net foreign asset position. Still, the current account surplus is shrinking fast coming in at only 2% of GDP in 2011 which is the lowest in 12 years. As suhc, despite Mr Shirakawa believing that the BOJ has done enough, the onus on the central bank rises to start monitising government debt less Japan wants to peddle bonds to foreigners in which case reality would instantly catch up the Japan’s government finances.
Deflation Risks Re-Emerge with a Venegance, but Central Banks Prefer Stagflation
Moving on to the market, my dear reader we are at it again. Europe is once again on the brink of disaster with a Greek exit looming and Spain all but certain to seek the inevitable bailout. As so often before, starting up the fudge factory seems to be the most likely outcome , but could this time be different?
A number of heavy weight columnists have recently (yet again) proclaimed that the end of the world is nigh. Most devastatingly was of course Raoul Pal’s End Game presentation which gives investors a mere 6 month to protect themselves before heading for the bunker.
In addition, Soc Gen’s Albert Edwards also recently touched on the growing and most disconcerting disconnect between global stock markets and all time low (and even zero or negative) bond yields in the developed world.
As 30y German Bund yields slide below 2% and rapidly converge towards Japanese rates, we have a taster of what is to come in the US and UK in the months ahead. We still see US 10y yields even now making new all-time lows falling below 1% as hard landings occur in China and the US. The secular equity valuation bear market began in 2000 and renewed global recession will be the trigger to catalyse the third and hopefully final, gut-wrenching phase of valuation de-rating. Expect the S&P500 to decline decisively below its March 2009, 666 intra-day low. All hope will be crushed.
And in his latest flash comment, Greed and Fear (Chris Wood) also alerts investors to the threat of deflation.
The consensus monkeys have been proved wrong yet again. A mere three months after talkingheads on the sell side were doing their usual annual first quarter ritual of proclaiming the endof the “secular” bull market in US treasury bonds, the ten-year bond yield made a new all-timelow of 1.45% on Friday.
It continues to amaze GREED & fear how most analysts in the West continue to underestimate the deflationary structural forces at play and are always trying to pick the peak of the bond bull market (in price terms) and the commencement of inflation. Still the main reason GREED & fear has so far avoided succumbing to this temptation is that GREED & fear has been observing Japan for more than 20 years. And for GREED & fear, and for anyone else who has been watching Japan for a similar period, the market action in the West since the global financial crisis hit in the summer of 2008 does not surprise. Rather it remains eerily familiar.
Alpha Sources is concerned, as ever, that a wash-out is coming and certainly remains in the structural deflation camp in so far as goes global debt and growth dynamics writ large. It is also the contention here that it remains a widowmaking trade to call the end of the bull market in bonds, that would require much a much more sinster involvement of bond vigilantes from whatever hole they might appear.
However two points are worth noting.
Firstly, G&F’s comparison with Japan may only be as good as it goes. While the blueprint is the same and there central banks have woved no to repeat the Japanese experience. The stated intention of central banks remain to print when it doubt.
Nowhere is this clearer than with Bernanke. The Fed chairman has demonstrably stated his intention not to travel down Japan’s road to deflation. Could it be that this commitment in itself will lead us to an alternative outcome? As always, the proof will be in the actual effect of additional monetary and fiscal stimulus where I would note that in past periods of QE in the US, bond yields have increased! Then there is of course the BOE where Mervyn King and his council have been extremely aggressive in their efforts to combat perceived deflation risks.
Secondly, on the scenario laid out by Albert Edwards, one has to note that the stock market is essentially just a nominal price and nominal prices can be manipulated by authorities. While Edwards clearly believe that we are heading towards a situation where this is impossible, Alpha.Sources would be weary betting on a fallout in the S&P 500 to the 500s before the Fed’s toolbox has been completely exhausted. Negtive interest rate on excess reserves as well as outright unsterilized purchases of financial assets are the likely next steps if things go south from here.
But, as always, Edwards is on to something. As stock markets ran up in the aftermath of the ECB’s LTRO yields stayed pinned to the floor. When and how aggressively would yields catch up to the stock market? Well, it seems now that we know the answer to this question; the market may just be about to catch up with falling bond yields even if the latter remains severly oversold in the short run.
We are now in a situation where developed government bond markets still considered safe are pricing in a calamity, but it is important for investors to understand that such apparent grave “expectations” are amplified by the very nature of post crisis financial markets where government bond markets across the European periphery are considered nothing but a very risky equity investment (due to the implied subordination to an ever growing size of the institutional (ECB and IMF) sector involvement in this market).
In this sense, there is a considerable fundamental mispricing mechanism being operated at the current juncture where normal discounted cash flow valuation analysis cannot be used to explain why anyone would want to pile into government bonds. Or put differently, there are many reasons to hold government bonds and the discounted return from holding to maturity is not necessarily one of them. Liquidity and preservation of the face value of capital are much more important in the current climate even to such an extent that investors are willing to pay a premium for the return of their capital at a later date (negative interest rates).
In the US for example, it is not clear to Alpha.Sources for example that inflation expectations in the US are pricing in stagflation rather than deflation. This makes sense if we believe in Bernanke’s commitment. Of two evils, the Fed appears to prefer stagflation over deflation and it will make sure that faced with such a binary menu, the former is what materialises.
In the short run, the stark drop in US payrolls may give direction with equities likely to correct downwards towards what the bond market has been telling us for a while rather than the other way around. But ultimately and while Alpha.Sources is weary of the threat of deflation, it is important to show significant respect the playbooks of central banks. Evidence has taught us not to underestimate the ruthlessness by which central bankers are ready to provide inflationary stimulus and as such Alpha.Sources will be hesitant to claim, unlike in the case of Spanish politicians, that they are blowing smoke screens.
Are developed nations across the globe at the precipice of oblivion? Yep, says pundit John Mauldin. Fresh after the announcement of a new joint venture with Casey Research and the conclusion of his own Strategic Investment Conference in Carlsbad, Mauldin spoke to The Gold Report. He believes that investors have a small window to save their investments from the end of the debt supercycle, but they’ll have to move fast.
The Gold Report: What does your new partnership with Casey Research mean for investors going forward?
John Mauldin: We’re creating a joint venture, Mauldin Economics, which will have its own brand and publications. We’ll be starting out with a fixed-income letter. Casey Research and Mauldin Economics will be sister companies. It’s not so much a partnership with Casey as it’s a partnership with the team that runs Casey.
There will be a number of other letters, too. Editors and writers whom I like and have worked with will be writing rather than me. My personal letter will still always go out Friday. I’ll still be doing Outside the Box and some other services.
David Galland and Olivier Garrett will become the publishing managers. Galland is one of the greatest marketers in the country. This gives me an opportunity to let him run everything while I spend more time on reading, writing and research, which are what I do best and enjoy the most.
TGR: You have spoken about the end of the developed-world debt supercycle and the end of the ability for governments to borrow cheap money. You said this development is bullish because that debt was invested in inefficient ways and now it will be invested in smart ways. How will countries like Germany, France, Spain and Ireland be affected differently from a country like China or Argentina by this endgame?
JM: Those are all radically different countries. The developed European countries—Ireland, Spain, Italy, even France—are going to see their governments forced to shrink. Germany will have to limit its growth in government.
China is different. It didn’t get into a government debt bubble. It has its own particular crisis to deal with. It has a housing and banking debt bubble.
Argentina is just a bad case. President Cristina Kirchner is displaying signs of massive economic psychosis. The actions that she’s been taking are the opposite of what you would do if you want to be able to stand up and say, “We’re a civilized country that respects the rule of law.” It is demonstrably bad for equity investors. People who loan money or do business in Argentina in such a way that the government can access their capital deserve what they get.
Ireland has rule of law. I think Ireland is a great place to put a foreign company. It has English-speaking people, hard workers, an educated labor force and low taxes. It set itself up to be the source for international business.
TGR: Ireland was booming for a short period of time.
JM: It boomed too well. It didn’t continue because, just like Spain and the U.S., it believed its own housing bubble. Too much of its economy was invested in housing, which is what China is going to have a problem with. It just built too much stuff with too much money, and it’s going to have to rationalize.
Australia has a housing bubble. There’s a book that came out last week that talks about the Australian miracle and why it’s different this time. I think, “Oh, could they ring a bell at the top any louder?”
TGR: The housing bubble is a private-sector bubble, though.
JM: But it affects everything. The government says, “We have to do something to help the poor housing people who are idiots to put the money in to begin with.”
TGR: When you were talking about the end of the debt supercycle, you meant government debt as opposed to private-sector debt. You came up with two scenarios. One is somewhat controlled with austerity, reduced costs and increased taxes. One is, I assume, uncontrolled with bankruptcies and defaults.
JM: We won’t have uncontrolled default. It will be intelligently initiated, or it will be crisis-induced with less thought and more pain.
TGR: Which is more likely?
JM: I’d put a 60% chance on the U.S. actually doing it right now and doing it best. Most politicians know that if we don’t do something, we’re, the technical term is, screwed. It will shock us in the extreme, but we have to do it.
Do you think what Greece and Spain are facing now is something they contemplated five years ago? Hell, no. They’re in a crisis and they’re being forced to do things that they should have done 15 years ago, but they keep putting it off. Bubbles are going to burst. The only way to deal with a real bubble is to prevent it from happening to begin with. Otherwise, you have to deal with the aftermath. The Federal Reserve thinks lower interest rates will help us deal with the aftermath of the next bubble and the crisis. No, they won’t. They were one partial cause of it.
TGR: There is some economic dependency between Europe and the U.S. Is there a contagion that will force the U.S. to act more swiftly?
JM: The contagion is that the bond market will watch Europe go through a crisis country by country, then watch Japan go through its own crisis.
Japan is a bug in a search of a windshield. Its savings have gone from 16% down to 1%. And they are going lower and will turn negative because it’s just dying. It’s very sad. We’ve never seen anything like this in the history of the world. Japan will have to start printing money in a manner that will shock everyone.
Then the bond market will look at the U.S. and say, “Wait a minute. We’ve seen this movie twice now. We know how it ends, and it ends in tears. It’s a horror show. If you don’t mind, U.S. market, we’d like to leave at intermission.”
Rather than having the three, four or five years that we should have from today, being completely profligate and running crazy deficits, we don’t have that much time. The bond market will jerk our chain, which is actually fortunate, because the deeper in debt we go, the harder it is and the more pain we have to go through to get out. That’s why Greece is down. Greece should have been trying to figure this out four years ago. The numbers are on the ball. It’s arithmetic. It’s not rocket science.
TGR: In January, you predicted that the wheels would fall off of Europe this year, but you also said that you think the European Union will stay together. What will be the precursors of a final collapse after years of handwringing?
JM: When the cost of staying together is more than the cost of breaking up.
TGR: How is that calculated?
JM: Europe is going to have to send €1 trillion to bail out Italy in addition to the trillions it has already spent. Then it’s going to have to come up with some way to fund the Spanish banks; Spain can’t do it. Spain is going to have to go through massive austerity. At some point, the population will get fed up and want out. The Germans are already fed up because they’re getting handed the tab constantly.
There are three things Europe has to do if it wants to stay together. It has to solve its sovereign debt problem, the banking crisis and its trade imbalances.
The southern European nations have watched the cost of producing goods rise by an average of 30% against Germany and the cohort nations because their labor has been more productive. The only way to rationalize those trade imbalances is for either German labor prices to rise or for peripheral labor prices to fall. The latter is more likely, but it takes a very long time for wages to fall 30%.
It’s not likely that everybody in Spain will agree to cut everything by 30% either. No. You think they were rioting in the streets before? Staying in the euro is a disaster for Spain. Getting out of the euro is just a different form of disaster. Either way, it’s a disaster. Spain is in deep, deep chili. There’s nothing it can do.
TGR: So, who decides if the cost of staying together is worth it?
JM: It’s the pain experienced by the voters. What are we seeing in Greece today? Two factions have had a massive majority in Greece, the center left and the center right. They go back and forth. The same two families control them and have since the early 1970s. It looks like the two of them together may not get 40% in the elections coming up.
Forty percent is required to be able to form a government. The bar is set that low. It’s not even 50% as it is in most countries because surely one party can get at least 40%, right? No. The rest of the country is so angry, it’s split among 10 different, little itty-bitty parties: hard Communists, hard right nationalists and so on, all of whom hate austerity.
The Irish threw out a government that had been in charge for 80 years because it took on the new debt. The new government claimed it would deal with it. It hasn’t, but it will deal with it before the next election. It is going to repudiate that bank debt. Either Sinn Fein will be elected, which means a crazy bunch of people will be put in charge, or the Irish people will vote for somebody who will tell the Central European Bank and the German, French and British banks to go piss off.
TGR: But doesn’t that then start the ball rolling on a banking crisis?
JM: Ireland’s debt is only €60 billion (B). In the grand scheme of things, it’s starting to look like pretty small potatoes.
TGR: But it opens the door for every other sovereign country if Ireland goes back.
JM: Greece just did it. It defaulted on its debt.
TGR: I think it officially wrote it down to pennies under, so technically it did not default.
JM: There will be some euphemism for the Irish debt, too.
TGR: There are winners and losers in each of these crises. How can investors, seeing this collapse coming, either preserve assets and buying power or even profit from it?
JM: There is just no one-size-fits-all answer. I know that’s not what investors want to hear. They want to hear, “Buy this, sell this, do this.”
Typically, a crisis like this is not good to the equity market. There are certainly specific stocks and areas that will do well. Shorter term bonds with some high yields look pretty good. There are dividend plays from international stocks and maybe in their currencies. A very aggressive move is to go long the Japanese Nikkei and short the yen, because if Japan does print money as I expect it to do, the Nikkei will go up quite high in percentage terms. In dollar terms, it will look as if it’s been flat. But if you short the yen, that’s a way to play a crisis.
Should investors buy some gold? Yes. I buy coins. My fondest dream is that my gold, like my health and my life insurance, will never be used. I hope I give my gold to my great-great-grandkids and Papa John will say, “I don’t know why I bought these silly yellow trinkets. Do you want to play with them? We can use them for checkers or something.”
TGR: There never is a one-size-fits-all solution, is there?
JM: No. You need to hedge everything. You need to be aware that there is black-swan risk out there during this. This is not a typical market. We can’t use models that we’ve used in the past and expect markets to behave as they have in the past. Don’t throw the models away. They will be useful in four or five years. We can come back after we’ve hit the reset button. It’s like the blue screen of death that some of us remember from the 1980s. You’d be typing along and you’d get the blue screen. It was a “feature” that Microsoft built into its software. You just had to hit the reset and start again. If you hadn’t prepared for the blue screen of death, if you hadn’t been saving every 30 seconds, you were out of luck.
TGR: That’s a great analogy.
JM: We’re in the process of hitting the reset button. Investors need to be prepared for when the blue screen of death comes along. They better make sure to hit the save button. When they restart the computer, their assets will come back up and they can start working on them again. It’s key for investors to act because we have a limited period of time before we get another blue screen of death.
TGR: You’re predicting this will happen within five years—not another decade.
JM: We don’t have a decade, maybe three years. Spain doesn’t even have three years. Europe has to deal with Spain now. It thought €1 trillion bought it a year; it bought it a month. It has to do something.
TGR: But “has to do something” and “doing something” don’t always go together.
JM: For the Europeans they do. They’ll have meetings. They’ll call together the finance ministers. They’ll talk frankly with each other. They’ll come up with some type of joint statement and solidarity. They’ll kick the can down the road. That’s what the Europeans want to do. They have this massive desire to be European. They may be able to do it. I hope they do. I’m thinking a united Europe is better for the world than a bunch of countries, but that might not be my view if I were Italian or Spanish.
TGR: There is a lot of talk about savings. In an environment where there is potential to have more quantitative easing by Europe, China and the U.S., doesn’t that in essence wound the saver?
JM: Savers are getting wounded now if they’re buying Treasuries. They don’t have to buy Treasuries. There are opportunities, especially for smaller savers, to find pockets of real yield. It’s pretty tough if you’re trying to run a $1B portfolio, but if you’re trying to run a $100–500K portfolio, you could buy pockets of orphan bonds in the market that can pay a nice level of interest, well above inflation. They’re shorter in duration. They’re good credits. You can find solid foreign companies that pay very nice dividend yields of around 8%, too.
TGR: Why not dividend yields in U.S. companies?
JM: There are some companies in the U.S. that have dividend yields that are attractive, but not many. Most of them have dividend yields that are lower than what I can find in a more stable municipal bond that’s shorter term and tax-free. Do I want a 2% dividend yield from a single-A company? It’s a nice thing, but I’d rather have 5% tax-free money from a municipal. Investors ask where to find tax-free. You go find orphan bonds. You do your homework. There are no funds out there that do this stuff. You have to pay attention. If it were easy, everybody could do it. There are no hot stock tips. It’s work.
TGR: You moderated a panel on inflation versus deflation at the Casey Conference at the end of April. Do you think that government will reverse the natural deflation tendencies and push us into hyperinflation, as some people here have said?
JM: No, that’s total rubbish. Hyperinflation in the U.S.—really? What world are they living in? Could we have inflation? Could it get to 10%? Yes. The Fed would have to crank it down and it would be very embarrassed. We are not Argentina. That’s just not a realistic scenario. That’s black-helicopter-type talk.
TGR: Amid all this doom and gloom, I feel that you are quite optimistic about U.S. citizens. You talked about the dysfunctional U.S. gross domestic product, but you said you were bullish on the innovative power of the U.S. Can Americans turn the country’s economics around by inventing things?
JM: Yes. Once we get to the other side of the blue screen of death, there will be more new technology, new business and innovation in the next 10 years than we saw in all of the last century. It’s going to be a fantastic set of opportunities for investors and entrepreneurs. It will be the most exciting period in history. I just hope that someone can figure out how to make me young again—and they’re working on it.
For more information on the strategic Investment Conference go to https://hedge-fund-conference.com/2012/invitation.aspx.
John Mauldin has been the author of New York Times best sellers 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 writes the free weekly Thoughts from the Frontline e-letter and edits the free weekly 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 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.
Mauldin gave more details about the demise of the debt supercycle at the Casey Research Recovery Reality Check Summit. You can hear his entire presentation—entitled End Game Scenarios—as well as every other recorded summit session with the Summit Audio Collection. It features over 20 hours of sobering economic analysis, round-table discussions, updates of stocks from the natural resource sector, actionable investment advice and much more from 31 of the world’s foremost financial experts (including famous contrarian investor Doug Casey and Porter Stansberry of End of America fame. More information is available here: http://www.caseyresearch.com/cm/cd-summit-spring2012?ppref=AUR449IN0512D.
The ECB and BOE have shown their intent with their recent aggressive balance sheet expansions and the Fed is trying hard to keep the door open for more QE even as the data in the US continues to defy the general global slowdown.
In Asia however sticky inflation in India, a desire to nail property developers to the wall in China and a belief in a post earthquake recovery in Japan have kept the big Asian central banks from providing additional easing. Even in Australia where the economy has been teetering on the brink of a recession for 6 months, the central bank has refrained from any decisive moves.
In three out of the four cases above however things may slowly be about to change.
In India, the central bank recently opened the door for considerable easing in 2012 as headline inflation comes in. The market has already heavily discounted such a move with Indian equities up about 25% since mid December 2011 and some big ticket single names such as Tata Motors up more than 50%.
Reserve Bank of India Deputy Governor Subir Gokarn said the monetary authority will cut interest rates once it’s confident inflation will keep slowing.“The stance now is that we have reached the peak and any further action will be toward easing,” Gokarn, 52, said in an interview at his office while discussing the rupee, the government’s budget deficit and bond repurchases. The central bank isn’t concerned about the currency’s record monthly advance in January “because in a sense it’s a correction,” following last year’s 16 percent decline, he said. Emerging-markets have stepped up efforts to shield growth from the impact of Europe’s debt crisis, with Brazil, Russia and the Philippines cutting rates in recent months.
The road is not entirely clear for easing by the RBI where two issues may still derail the central bank’s intention to start an easing cycle.
Firstly, the government’s budget deficit continues to increase and while borrowing to invest in infrastructure etc in India is certainly worthwhile, monetary policy may still have to lean against excessively and essentially structural deficit spending by the government. This is particularly the case as supply side constraints may mean that such deficit spending adds substantially to inflation.
Secondly, the INR may be subject to substantial weakening on a resurgence in global volatility. The Fed’s USD swap lines as well as the the ECB’s efforts to backstop the European banking system have so far calmed things down. Nevertheless, should another period of strong and sudden INR weakness ensue, it means the RBI would not be able to reduce the yield difference to the rest of the world in any meaningful way.
In China, the economy is now visibly slowing. Foreign exchange reserve accumulation have ground to a halt and M1 growth is negative on the year. Even if the desire to cool down excessive credit growth and nailing property developers to the wall might still constitute top priorties, the balance is shifting towards easing.
China is seen making more cuts to banks’ reserve requirements to fuel lending and sustain economic growth as the housing market cools and Europe’s sovereign-debt crisis weighs on exports.The proportion of cash that lenders must set aside will fall half a percentage point from Feb. 24, the central bank said Feb. 18 on its website. Standard Chartered Plc forecasts at least three more reductions this year, while HSBC Holdings Plc (HSBA) sees a minimum of two.
So far, Chinese authorities seem content to use the reserve requirement ratio (RRR) as the main tool to provide easing. This makes sense in a command market economy where the government can be fairly sure to control the supply side of credit through loan quotas. I think however that the calls for no interest rate cuts until mid 2012 may turn out to be wrong if China is about to slow to the extent that our leading indicators show. Property prices have fallen (or failed to rise) for some time now in China and as growth slows further, the authorities may rightfully begin to argue that their near term objectives have been achieved.
Perhaps the most interesting development this week however came in Japan where the BOJ apparently got my memo as they restarted QE.
Japan’s central bank unexpectedly added 10 trillion yen ($128 billion) to an asset-purchase program and set an inflation goal after an economic slide fueled criticism it has been slower to act than counterparts.An asset fund increased to 30 trillion yen, with a credit lending program staying at 35 trillion yen, the Bank of Japan said in Tokyo today. The BOJ also said that it will target 1 percent inflation “for the time being.”
This decision appears to have gone completely under the radar, but I think it is very significant. Two points are particularly important to emphasize. Firstly, the entire 10 trillion yen added to the asset purchase program has been earmarked to JGBs which signals the BOJ’s willingness (or the MOF’s orders) that budget deficits in Japan are now to be directly monetised to a much higher degree than has earlier been the case. Secondly, the BOJ has now committed itself to an inflation target (1%) and will use balance sheet expansion to reach this goal.
This is textbook QE and should be bearish for the Yen and bullish for the Nikkei, but things may not be so simple of course. Chris Wood adds to the discussion in the latest version of Greed and Fear .
The second point is whether the latest news is a signal to short the yen. On the face of it, it should be. But the issue is whether the BoJ Governor Masaaki Shirakawa is going to follow the previous examples of his conduct of unorthodox monetary policy; whereby he raises thequantity of the so-called asset purchase programme but does not exactly accelerate the pace ofthe buying to fulfil the programme. Thus, the Bank of Japan has so far purchased ¥10.3tn of assets since the latest programme was first announced on 28 October 2010, amounting to only 52% of the previous target of ¥20tn set in October 2011.
In other words, how serious is this inflation target and over what horizon does the BOJ intend to reach it? Only time will tell, but given the persistence of deflation in Japan I would argue that any semi-serious adherence to this inflation target would require substantial balance sheet expansion by the BOJ.
As Chris Wood aptly puts it, the move by the BOJ is merely the latest evidence of the bull market in central bank balance sheet expansion and more importantly, relative central bank balance sheet. In a world where export driven growth is seen as everyone as the way out of debt purgatory you need expand and print more than your peers. On this, I also slightly disagree with Chris that Japan does not need a weaker JPY. My own analysis suggest that corporate margins in Japan are very sensitive to changes in the Yen. But that is a discussion for another time. For now, I will agree with Chris that we have seen the beginning of a sea change in Japan, but we need to see the BOJ backing up intentions.
Ultimately though, the most significant piece of news from Asia last week was the indication from both Japan and China that they would stand ready to offer their full support for the euro zone. The idea is simple; China and Japan would use the IMF as conduit to create the only real bazooka (apart from ECB monitisation).
Quote Bloomberg (my emphasis)
Japanese Finance Minister Jun Azumi said his nation and China will work together to help Europe solve its debt crisis through the International Monetary Fund.Europe needs a bigger so-called firewall of added funding to contain the crisis, even as Greece shows some improvement in solving its financial woes, Azumi told reporters in Beijing yesterday after meeting Chinese Vice Premier Wang Qishan. Azumi, who met Chinese Finance Minister Xiu Xuren during his visit, also said he asked China to make its currency more flexible.“We shared the view that Europe needs to make more efforts to create a bigger firewall,” Azumi said. “We also agreed to act together as the IMF will probably ask the U.S., Japan and China” to help boost its lending capacity.
This would indeed be global monetary relief from Asia.
I have been enjoying myself in the Austrian Alps last week and hence the lower output. Here is my look though, of a number of notable news stories and contributions.
Benoît Cœuré, Member of the Executive Board of the ECB has penned a speech (and argument) on global (excess) liquidity. Izabella likes it and I agree with her that it is a good piece. I am not sure though that it is that much different than the Savings Glut argument put forward by Bernanke, but I may be missing the fine print (i.e. need to read it more carefully). The biggest problem I have is that he assumes that the lack of safe government (i.e. AAA rated assets) is cyclical and due to market failure or other “temporary” factors. Izabella interprets it as follows,
What’s the solution to this vicious liquidity circle? Simple, says Cœuré. The euro area needs to regain its role as a global supplier of safe assets. Something which could be achieved by a) ensuring that Eurozone countries have become fiscally sound and b) diverting excess liquidity from other zones back into “programme countries” by way of the IMF.
I disagree. The failure of euro zone economies and indeed large parts of the OECD edifice in general to provide “safe haven” assets is deeply structural and tied to population ageing. Unfortunately, there is little prospect that the euro zone economies will be able to supply AAA rated securities for a long time and herin lies the rub. Of course, if we are talking euro bonds, but then again. I will believe it when I see it.
Japan and the currency wars
A recent Bloomberg article suggested that Japan has been “secretly” selling JPY to try to stem the tide and force through depreciation of the Yen.
Japan used so-called stealth intervention in November as the government sought to stem yen gains that hammered earnings at makers of exports ranging from cars to electronics.Finance Ministry data released today showed Japan conducted 1.02 trillion yen ($13.3 billion) worth of unannounced intervention during the first four days of November, after selling a record 8.07 trillion yen on Oct. 31, when the yen climbed to a post World War II high of 75.35 against the dollar. The currency’s strength has eroded profits at exporters such as Sharp Corp. and Honda Motor Co., just as faltering global growth undermines demand.
Open market operations to sell domestic currency are so old school. Didn’t they get the memo in Japan? In a world where all major central banks are either at or very close to the zero bound, it is central bank balance sheet expansion (quantitative easing) that matters. On this note, both Japan and the Fed are being left decisively behind by the ECB and BOE (at least in the past six months). Of course, even the usage of “standard” measures in Japan is being contested and as long as this is the case, the Yen will continue to strengthen.
Don’t bet on deflation with the current team of global central bankers
Elsewhere, I am wondering where all the deflation, let alone disinflation, is. I am a sworn deflationist and I believe in the main thesis of the deleveraging/depression/deflation crowd. However, I have the utmost respect for the inflationist bias of global central banks and with the current batch of policy makers at the helm, deflation is a very remote risk.
The latest data show that inflation in China recently quickened as well as producer prices in the UK increased in the week that the BOE announced another round of QE. Of course, this is not all clear cut. Chinese real M1 (YoY) recently moved into negative territory for the first time since 1996 and in the UK, it is noteworthy that core inflation (ex food, beverages, tobacco and petroleum) came in noticeably lower in January.
I will change my views on the basis of changing data, but I am beginning to think that the bout of global headline disinflation we are expecting as a result of the global slowdown will reverse itself much, much quicker than many (including me) have expected. Arguably, we still need decisive easing in emerging markets and QE3 from the Fed, but it is more a matter of when and not if this happens and as such, global central bankers remain fully committed to creating inflation.
The main problem so far for those arguing for strong central bank action (including me) is the absence of nominal growth in output in excess of consistently rising headline inflation. Could this be a result of doing too little, perhaps, but at the moment stagflation remains the best way to describe our current economic situation and thus inflation in all forms is a drag on growth. Should the genie finally come out of the bottle in the form of consistent wage increases central bankers may find that they got more than they bargained for even if the alternative is equally painful.
The Greek experiment is about to end
Greece remains the main talking point and also the only thing that appears to prevent equity markets ripping to new highs. Greece is bankrupt and while I understand that the patience of the rescue committee will run out at some point, I am astounded that anyone expects this hideous experiment to end well. Greece will see its fifth year of contraction this year and for what? A membership of a currency union that does not work anyway?
We are told by the Troika, the EU and the IMF that failure to reach a deal would be catastrophic and thus that Greece has no way out but to take the medicine. However, Greece has a real choice and the stronger she is pushed the more obvious the end result is. Internal devaluation and decades of austerity don’t work; not in Greece and not elsewhere. This remains the KEY issue that the euro area politicians and the ECB have not understood. The social fabrics of society won’t stand the pressure and strain. Textbooks tell us that the cure is simple when you can’t devalue, but practical experience have now shown otherwise.
I am neither on the Greeks’ nor the IMF/Troika’s side, but I simply point out the obvious destiny of current events; failure! Even if Greece manages to appease its creditors with austerity, the end result in terms of Greek macroeconomic balances is still unsustainable and thus the underlying problems will not have been solved.
The ECB and the IMF will likely face significant drawdowns on their Greek bondholdings regardless of whether they use such drawdowns as ”carrot” for Greece to push through austerity measures. This is what the establishment has not yet understood.
MF Global investigation fails to uncover illegal activity?
Megan McArdle has an amazing article suggesting that the investigation on the failure of MF Global is finding it difficult to uncover anything illegal.
Megan quotes a piece from Reuters (no link available)
Lawyers and people familiar with the MF Global investigation of the firm that was run by former Goldman Sachs head Jon Corzine say that even though the hunt is still on to find out whether or not officials at MF Global intended to pilfer customer money in a desperate bid to keep the brokerage from failing, the trail at this point is growing cold.
This seems very odd to me even if I have not followed the aftermath in detail. I completely agree with the sentiment expressed by Megan.
I don’t understand how this could be true. To be clear, I am not saying that it couldn’t be true-only that I don’t understand how such a thing could have happened. There is more than a billion dollars missing from supposedly segregated client accounts. I understand that it was chaotic, but what kind of chaos causes you to accidentally move money out of money that any moderately sophisticated compliance system should have automatically flagged for approval?
While my professional responsibilities are confined to the smooth running of a macro research product I sit in an office, and work, with asset managers and ever since the failure of MF global I would imagine that their general level of concern has increased. This is understandable. If your main counterparty as an asset manager (i.e. your prime broker) essentially decides to steal your deposits and/or allocate them to losing trades against the principle of segregated accounts, it really does not matter what you do. No matter the tightness of the shop run on the asset managers’ end, he will face significant and perhaps even fatal losses.
Obviously counterparty risk is as old as finance itself and any decent asset manager today will deal with more than one broker and even have a strategy on how to manage counterparty risk. Ultimately though, mutual trust between asset managers and their prime brokers is a commodity which has been severely impaired by the MF Global failure and this is an issue for all players in financial markets.
Dealing with vintage data in economic forecasts using instrument variables (wonkish!)
A recent note from the George Washington University points to an interesting study from Warwick University on the forecasting of data vintages in the context of US output and inflation forecasts. The problem is as follows;
Consider a simple benchmark autoregressive model that a forecaster might use to forecast an economic variable yt. In order to estimate the parameters to be used for the forecast, typically the forecaster will obtain the most recently updated data on yt (i.e. the vintage of yt available at that time) and estimate the model using those data. However, the data in this single time series may in fact be coming from different data generating processes. The data some time back in the series have gone through monthly revisions, annual revisions, and perhaps several benchmark revisions. The most recent data, however, have been only “lightly revised,” as Clements and Galvão term it. Therefore, Clements and Galvão argue that the data in a single vintage are of“different maturities.” Forecasters may want to forecast future revisions to data as well as exploit any forecast ability of data revisions to improve forecasts of future observations. In their article, Clements and Galvão suggest that a multiple-vintage vector autoregressive model (VAR) is a useful approach for forecasters working with data subject torevisions. This comment discusses the importance of taking revisions into consideration and compares the multiple-vintage VAR approach of Clements and Galvão to a state-space approach.
This is a significant issue but remember; if the following holds, we need not worry too much about it.
If the revisions are unpredictable and the early data are efficient estimates of future data, then we may not need to be concerned about the different vintages.
Most economists assume that the statement above is true and simply force through their model. Being a great believer in practical usability when it comes to empirical economics, I would argue that in most cases this will not cause too many problems in most cases. However, a growing body of evidence suggest two important issues to consider. Firstly, revisions are predictable and thus provide important ex-ante information which should be incorporated into the the forecast. Secondly, even if revisions are unpredictable, the manner in which data is revised may itself provide important information on future data readings.
I agree, but the problem is potentially much more severe. Another issue then concerns that situation where you try to forecast Y(t) as a function of X(t) where both variables may be subject to revisions. Normally, we would solve this issue by restricting X(t) to variables where revisions are minimal (or absent alltogether). One way to do this is to use market based data (market prices, closing values of securities etc) which are, by definition, not revised. However, in the context of the e.g the classical leading indicators framework pioneered by Geoffrey H Moore, this issue re-emerges X(t) is cast in the form of real economic variables (themselves potentially subject to revision).
We have replicated and refined many of the LEIs described by Moore et al and applied it to various economic data series with specific fitting of a time series regression in each case. However, such an approach may still suffer from vintage data issues (as described above. One solution that I been thinking about is to imagine two forms of right hand variables. X(t, economic) and X(t, market based); if the latter is unrevised it might be possible to find an instrument for X(t, economic) (final revision!) using a variation of X(t, market based). This would, in my opinion, constitute an elegant way to solve the issue of data revisions in your explanatory variables.
In practice, you could also try to replace Y(t, economic) with Y(t, market based), but this is probably too a-theoretical and ad-hoc.
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.
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.
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.
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 . 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.
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.
 – 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.
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.