Hugh Hendry On Europe: “You Can’t Make Up How Bad It Is”

Thursday, May 3rd, 2012

At The Milken Institute conference yesterday, Hugh Hendry delivered his usual eloquent and critical insights on the state of Europe. Beginning with the statement that “All of Europe has defaulted”, the canny-wee-fella (translation: shrewd and cautious young chap) explained that “The political economy in Europe is such that the politicians chose to default on their spending obligations to their citizens in order to honor the pact with their financial creditors and so as time goes on, the politicians are being rejected.” Between France’s election of Mr. Hollande and Luxembourg’s ‘when times get tough you have to lie’ Juncker, Hendry says the only inspiration for Europe is fiction as “you just can’t make up how bad it is” as he goes on to discuss the precedent for a way forward, the grotesque distortions of fixed exchange rate regimes, why Weimar happened, why the transfer union will never happen, Ayn Rand’s reality, and fear politicians are feeling.

The entire discussion is well worth watching for a sense of the underlying reality in Europe.

The underlying reality that what the European monetary union is about is not about preventing a third so-called European civil war, it is essentially about making someone (France, Germany or both) a Great Power, a European Hegemon, and a global player.

Starting at around 12:00, Hugh begins his must-watch discussion…

And begins again at around 30:00, Hendry discusses the British perspective on the impeccable logic of the German mind and why the transfer union will never happen in Europe…and why Wiemar happened…

At around 46:00, Hendry addresses Germany’s emerging housing bubble (and why it won’t occur) and the two forms of leverage in the world.

From 52:40, Hendry takes on the view of (disagreeing with) a weak USD and the US being supplanted as a global leader

Hendry confesses to not being able to finish reading Ayn Rand’s Atlas Shrugged at around 1:02:00 and explains why (apart from its length and lack of pictures)…noting that is too depressingly real in its description of the world we live in today…

We have reached a profound point in economic history where the truth is unpalatable to the political class – and that truth is that the scale and magnitude of the problem is larger than their ability to respond – and it terrifies them.

Concluding at 1:10:10 – “we are single-digit years away from the most profound market clearing moment”

(h/t Stock Bitch)

Tags: Ayn Rand, British Perspective, Creditors, Critical Insights, Distortions, European Monetary Union, Exchange Rate Regimes, Fella, Global Leader, Global Player, Hegemon, Hollande, Housing Bubble, Hugh Hendry, Impeccable Logic, Juncker, Milken Institute Conference, Pact, Political Economy, Politicians
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Bill Gross: Investment Outlook (May 2012)

Wednesday, May 2nd, 2012

Tuesday Never Comes

May 2012

by William H. Gross, Co-Chief, PIMCO

- The current acceleration of credit via central bank policies will likely produce a positive rate of real economic growth this year for most developed countries, but the structural distortions brought about by zero bound interest rates will limit that growth and induce serious risks in future years.

- Not suddenly, but over time, gradually higher rates of inflation should be the result of QE policies and zero bound yields that will likely continue for years to come.

- Focus on securities with shorter durations – bonds with maturities in the five-year range and stocks paying dividends that offer 3%–4% yields. In addition, real assets/commodities should occupy an increasing percentage of portfolios.

The global economy is floating on an ocean of credit, and a good thing too as our cartoon friend Wimpy reminds us. Without it, he would be a hungry puppy by next Tuesday and nearly seven billion world citizens would be worse off if barter, and not credit, was the oil that lubricated trade. Unlike Wimpy, early societies functioned without an exchange of (money) or the promise to pay it back in the future (credit). Growth was limited, however, because savings or investment could not be incented properly. Those that wanted to save for a rainy day had no means to express that caution; better to consume a banana or a hamburger today than to watch it rot and become worthless on Tuesday. But money changed all of that and the ability to borrow and exchange it for repayment at some future date was the economic elixir of the ages. Shakespeare, with his admonition to “neither a borrower nor a lender be,” might have won a 17th century Pulitzer, but definitely not a Nobel Prize for economics.

Still, the use of credit never really kicked into high gear until the discovery of fractional reserve banking and the ultimate formation of central banks to facilitate and protect its disbursement. Picture a Wild, Wild West Bank in Yuma, Arizona back in 1901. It had a big safe where miners left their gold nuggets for safe keeping, but in order to become more than a depository, the bank needed to issue notes and letters of credit in an amount greater than the gold in its vault. Theoretically there was some of the owner’s gold dust in there too, but who was counting as long as gold came in and gold went out and Yuma’s citizens thought that the bank’s notes were backed by tangible evidence of wealth. Fractional reserve banking was aborning in the 20th century, sharpshooters and all.

Problem was that many of those local banks with their individual currencies and drafts went out of business, leading to panics and mild depressions throughout the growing states, and so in 1913 the dollar became our single currency, and the Federal Reserve our official central bank. The Fed, with a certain amount of gold certificates, would then extend credit to its member banks, which would then extend credit to businesses, which would magically promote savings, investment and economic growth. No leftover hamburgers on Tuesday for Wimpy – his tummy was grumbling and by god, or by Fed, he was gonna get it NOW.

This process of credit and its creation powered global economies for the next century. It benefited not only consumers who wanted their burgers now, but lenders and investors who were willing to go hungry on Friday for the benefit of getting their money back with interest on Tuesday. Both sides experienced a win/win exchange as the real economy charged ahead, creating jobs, technological advances and the eradication of disease. What was not to like about credit? Nothing really, except much as the absence of it hindered ancient societies, the excess of it now hobbles modern economies. Credit is the foundation of the wealth creation process, but it can also be the cause of financial instability and potential wealth destruction. Like nuclear energy, “atomic” credit or debt must be controlled if it is to benefit, as opposed to destroy.

And so the job of modern-day central bankers – Bernanke, King, Draghi and their global counterparts – is to decide how to control a beneficial chain reaction without it getting out of hand. In many ways they are like their Wild, Wild West counterparts, trying to convince skeptical depositors that the gold will always be there. Yet, since 1971, when Nixon cratered Bretton Woods, there has been no explicit or even implicit gold backing. The U.S. and therefore the world’s finance-based economies have been backed by an increasing amount of IOUs, which are simply paper promises to create more paper when there is an old-fashioned 20th century run on the banks, or incredibly enough – even when there is not. Lacking a disciplined parental example, the banks, investment banks, money managers and hedge funds piled paper on top of paper as well, creating derivatives and seemingly endless chains of repos and rehypothecation of repos to amass a total amount of credit that literally cannot be counted. Estimates suggest global credit in the financial sector exceeds $200 trillion, with developed economies’ central banks holding only $15 trillion in reserves or figurative “gold dust.” If so, then the global banking system is levered at least thirteen times. These numbers don’t even count the amount of side bets or credit default swaps, which can’t be used as burger payments, but which total $700–$800 trillion alone. Wimpy has financed so many Whoppers that Tuesday can never come. Judgment day must always be around the corner or after the next weekend. Wimpy cannot pay the tab, except with more and more credit creation, as Euroland countries are discovering first hand.

Yet how much credit is too much credit and how is a dedicated central banker to know? Part of the problem is in clearly defining what does or doesn’t fit the definition. There are the families of M’s – M1, M2 and the disbanded M3 in the U.S. – the former two of which the Fed now loosely uses to monitor a growth rate so as not to bring credit creation to a boil. 21st century privateers, however, proved there can be no accurate gauge of credit growth as long as banks and the shadow banks can create their own money at will. CDOs, CLOs and securitized lending that managed to skirt regulatory standards for bank loans by applying 1%, 2% and 5% “haircuts” to securitized assets made a mockery of sound banking and ultimately created great risk for central bankers and their ability to temper the excess of credit creation. In 2008, central bankers never really knew how much debt was out there, and to be honest, they don’t know now.

Austrian school economists might say “no matter, forget the counting – all a central banker has to do is observe the interest rate, the price of credit, to know whether things have gotten out of hand.” And they may have had a point – even after 1971 and up to the mid-1990s, but then economies and the credit that was driving them morphed into a universe that the conservative Austrians would not have recognized. With the dotcoms, the subprimes and now the reflexive delevering of our financial system, it is practically impossible to know what interest rate is applicable. With the QEs and LTROs reducing real yields far below absolute zero, a central banker must wander aimlessly in policy space, wondering how much credit to create, how many Treasuries to buy, and how firm a twist to give the yield curve in order to allow Wimpy the chance for another burger and a side order of fries.

What they should know – and what the following chart, provided by the always observant Jim Bianco, shows – is that when QEI and QEII lapsed in recent years, stock prices declined by 10%–15% until magically they came back to live another day. The same stunting effect can be observed in the bond market when measured by real as opposed to nominal interest rates. They go down with QEs and up in their absence.

Admittedly, Chart 1 shows only two real data points, which are difficult for a Fed Chairman or his staff to rely on, but common sense underlies the historical observation as well. With the Fed buying nearly 70% of all five- to 30-year Treasuries during Operation Twist, and similarly large percentage amounts of Treasury and Agency mortgage-backed issuance since the beginning of QEI in December 2008, who will buy them now, if the Fed doesn’t?

The Fed appears to have a theory that is somewhat incomprehensible to me, stressing the “stock” of Treasuries as opposed to the “flow.” Future flows and annual supplies of $1 trillion and more, the theory argues, will be gobbled up by the market even without the Fed’s help, at current artificially suppressed yields because the private market’s “stock” of Treasuries has been depleted. Much like a wine cellar, I suppose, that is now nearly empty because policymakers have been drinking the rare vintages, wine lovers will now be forced to restock their cellars to get a historically comfortable inventory. Hmmm, being a beer drinker myself, I might otherwise assume that appetites might switch due to higher prices (and lower yields). And if wine or bonds were mandated to fill the cellar, then why not a foreign wine or a foreign bond? And too, I’m sure the Chinese in addition to PIMCO clients would be willing at the margin to change their preferences to real as opposed to financial assets. More conservative investors might migrate to cash as the preferred alternative, because the price of bonds or burgers was too high. Wimpy, in other words, might just go vegan if burgers aren’t cooked to taste.Because of QEs, the associated Twist, and similar check writing by the BOE, BOJ and ECB, several trillion dollars of what is academically referred to as “base money,” and what Main Street citizens would recognize as “gold dust,” has been added to global central bank vaults. Rather than dug out of the ground, this credit has been created at the stroke of a pen or a touch of the keyboard in today’s electronic monetary system. How that is done is a topic for another day, but since the early 1900s, and especially since 1971, it has been done so often that prices of goods and services are 400% of what they were when President Nixon decided to propel central banking to another orbit. “We are all Keynesians now,” he said back then, but he should have replaced Mr. Keynes with Mr. Burns, Miller, Volcker, Greenspan and Bernanke. We are all central bankers now, at least from the standpoint of endorsing stimulative policies that permit Wimpy and his seven billion counterparts to keep on eating burgers, and their lenders, by the way, to keep on coining profits.

Part productive, but increasingly destructive, the current acceleration of credit via central bank policies will likely produce a positive rate of real economic growth this year for most developed countries, but the structural distortions brought about by zero bound interest rates will limit that growth as argued in previous Outlooks, and induce serious risks in future years. In addition, inflation should creep higher. Do not be mellowed by the affirmation of a 2% target rate of inflation here in the U.S. or as targeted in six of the G-7 nations. Not suddenly, but over time, gradually higher rates of inflation should be the result of QE policies and zero bound yields that were initiated in late 2008 and which will likely continue for years to come. We are hooked on cheap credit just as Wimpy was hooked on Friday’s burgers. As I highlighted last month in “The Great Escape,” bond and equity investors should focus on securities with shorter durations – bonds with maturities in the five-year range and stocks paying dividends that offer 3%–4% yields. In addition, real assets/commodities should occupy an increasing percentage of portfolios. Wimpy would not be pleased by this change of diet nor by the cost and risk of burgers for delivery next Tuesday. But for him, and for central bankers, the hope is that Tuesday never comes.

William H. Gross
Managing Director ​

Tags: Admonition, Bank Policies, Bill Gross, Central Banks, Disbursement, Distortions, Fractional Reserve Banking, Future Years, Global Economy, Gross Co, Gross Investment, Hungry Puppy, Investment Outlook, Maturities, Nobel Prize For Economics, Qe, Real Assets, William H Gross, Wimpy, World Citizens
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A False Sense of Security (Hussman)

Sunday, March 25th, 2012

“The world economy has stepped back from the brink and we have causes to be a little bit more optimistic. But optimism should not give us a sense of comfort and certainly should not lull us into a false sense of security.”

IMF Managing Director Christine Lagarde, March 17, 2012

As we examine the present evidence relating to both the financial markets and the global economy, the aspect that strikes us most is the extent to which Wall Street continues to emphasize superficially positive data in preference for deeper analysis, to extrapolate short-term distortions as if they were long-term trends, and to misconstrue freshly printed wallpaper and thin supporting ice as if they were solid walls and floors.

Two propositions we heard last week were characteristic of this false sense of security. One was a remark by an analyst that stocks were in a “secular bull market” here. The other was a Wall Street “factoid” being passed around, suggesting that the “equity risk premium” on stocks has never been higher.

Let’s address these in turn. When people talk about bull and bear markets, they often use the terms “cyclical” and “secular.” One cyclical bull and one cyclical bear market comprise the normal garden-variety market cycle of about 5 years in duration (though with quite a bit of variation around that norm, see “notes on secular and cyclical markets” in Hanging Around, Hoping to Get Lucky ). Taking very broad averages, a cyclical bull market lasts about 3.75 years, averaging a trough-to-peak gain of about 150%, and a cyclical bear market lasts about 1.25 years, averaging a decline of just over 30% from peak-to-trough. If you do the compounding, you’ll observe that the typical bear market wipes out more than half of the preceding bull market gain.

However, those averages mask an additional source of variation, which depends on “secular” conditions. If you examine market history as far back as the late-1800′s, you’ll find that market valuations have moved in broad advancing and declining phases, with each phase lasting about 17-18 years in duration (that still should be treated only as a tendency, and there’s no reason I know for treating it as a magic number). As an example, stocks moved from extremely low valuations in 1947 to quite rich valuations by 1965, producing a long “secular” bull market where each successive cyclical bull market topped out at higher and higher valuation multiples. In contrast, from 1965 to 1982, valuation multiples went through a long contraction, where each successive cyclical bear market bottomed out at lower and lower valuation multiples.

The effect of these longer valuation “waves” is this: during long secular bull phases, the cyclical bull markets tend to be longer and more rewarding, and the cyclical bear markets tend to be shorter and less damaging. In secular bulls, the market is running with the wind at its back. The secular bull market period from 1982 through 2000 was a good example of this tendency.

In contrast, during long secular bear phases, the cyclical bull markets tend to be shorter and less rewarding, while the cyclical bear markets tend to be longer and more violent. In secular bears, the market is swimming against the tide. The secular bear period that began in 2000 has been a good example of this tendency.

As Nautilus Capital observes, the average cyclical bull market in a secular bear market period has produced an average gain of only about 85%, lasting less than 3 years on average. In contrast, the average cyclical bear in a secular bear has been unusually violent, averaging a 39% loss over a span of about a year and a half. Compound the two, and that’s enough damage to drag the cumulative full-cycle return down to just 13%, on average.

Needless to say, the assertion that stocks are in a “secular” bull market is really an assertion that investors can let down their guard, in the sense that downturns are likely to be muted and advances will be extended. But from our standpoint, if you’re going to pick a secular team, it would be best to have reliable data to back up the choice.

So what distinguishes a secular bull from a secular bear? Valuations. Not just any valuation measure however – it’s important to demonstrate that the valuation measure you choose actually has a strong and demonstrable long-term relationship with subsequent market returns (which is where Wall Street’s disingenuous use of toy models like simple price-to-forward earnings multiples and the “Fed Model” makes us nearly apoplectic).

Below, I’ve annotated our usual valuation chart to provide a better sense of what drives the long “secular” movements in the stock market. The chart uses our standard valuation methodology to estimate prospective market returns.

It should be quickly evident that secular bull markets don’t simply come out of the blue. They emerge precisely because stocks become priced to achieve extraordinarily high long-term returns. Both the 1947-1965 secular bull and the 1982-2000 secular bull began at points where stocks were priced to achieve 10-year returns of close to 20% annually. In contrast, the 1965-1982 secular bear began with prospective 10-year returns of just 5.9% (though slightly higher than the 4.4% yield on Treasury bonds at the time), and of course, the secular bear that began in 2000 emerged from bubble valuations, where we projected negative 10-year total returns at the time.

It seems to be an article of faith among some analysts that the 2009 low represented the start of a new secular bull market, but two features are noteworthy. The first is that the valuation achieved in 2009 was nowhere near the valuation that typically ushers in a new secular bull market. The second is that the brief undervaluation we observed in 2009 was quickly eliminated. At present, we project total returns for the S&P 500 of just over 4% annually over the coming decade. This is even worse than the valuation where the 1965-1982 secular bear started (though certainly less extreme than the 2000 peak). Though interest rates are lower today than in the 1965-1982 period, satisfactory returns from present levels will require investors to sustain rich valuations indefinitely.

Again, it’s worth emphasizing that our standard valuation methods are (and have remained) well-correlated with subsequent market returns – a very basic criterion that is painfully lacking among many popular valuation measures such as the Fed Model. It strikes me as absolutely bizarre that so many Wall Street “professionals” offer up the Fed Model and the “forward operating earnings times arbitrary multiple” approach so freely, when it takes nothing but some data and a few hours of effort to demonstrate that those approaches are nearly worthless (see for example the August 20, 2007 comment Long Term Evidence on the Fed Model and Forward Operating P/E Ratios – not that many analysts agreed with our valuation concerns at that point either).

A related assertion we’ve heard a lot lately is that “the equity risk premium on stocks has never been higher.” In the finance literature, the “equity risk premium” is essentially the return that stocks are priced to achieve, in excess of the risk-free interest rate. Of course, these estimates vary wildly depending on the method you use (many common ones which, again, have virtually no correlation with actual subsequent returns). A few popular methods include 1) the Fed Model (forward operating earnings yield minus the 10-year Treasury yield); 2) dividend yield plus projected earnings growth, minus the 10-year Treasury yield; 3) historical stock returns minus the 10-year Treasury yield, which is a particularly misleading measure of the returns stocks are priced to achieve in the future, or; 4) any of the above using the prevailing T-bill yield instead of 10-year yields.

Among the problems with these typical approaches is that stocks are not 3-month or 10-year instruments, but have a duration that is essentially the inverse of the dividend yield (so at present, the duration of stocks is roughly 50 years, compared with a 10-year Treasury, which has a duration closer to 7 years). So the appropriate “risk free” return in these estimates should really be either a Treasury yield of equivalent maturity – none which are available, or at least an estimate of the average expected short-term risk free rate expected over the same horizon. Needless to say, estimates of the equity risk premium get a false benefit if you use today’s unusually suppressed, short-duration risk-free rates.

The larger difficulty is the estimate of the prospective return on stocks. If you want to use a 10-year Treasury yield as a benchmark, you would also want to use a 10-year projected return for the S&P 500. On that note, and using reliable valuation methods (see above), the difference between the expected 10-year total return on stocks and the 10-year Treasury yield is presently less than 2% (nominal).

How does this compare historically? It’s notable that the estimated equity risk premium was severely negative during the late-1990′s market bubble. Not surprisingly, stocks have performed terribly versus risk-free Treasuries as a result. Excluding bubble-era data, we estimate that the normal historical equity risk premium (on a 10-year horizon) has been just over 6%, reaching 17% in the late-1940′s as a secular bull market was beginning, and holding in the 5-9% range even during the high-inflation 1970′s. Including the late-1990′s bubble period in the calculation brings the average down to just over 4.5%.

When has the equity risk premium been as low as it is today? Prior to the late-1990′s bubble period, the estimated equity risk premium has been below 2% only during the two-year period leading up to the 1929 peak, between 1968-1972 (when the equity risk premium finally normalized as a result of the 1973-1974 market plunge), and briefly in 1987, before the market crash of that year. We know how each of these periods ended. The only real variation is in how long the preceding overvaluation was sustained.

Profit margins and a false sense of security

One of the aspects of the market that is most likely to confuse investors here is the wide range of opinions about valuation, with some analysts arguing that stocks are cheap or fairly valued, and others – including Jeremy Grantham, Albert Edwards, and of course us – arguing that valuations are very rich.

The following chart may help to bridge that gulf. Essentially, analysts who view stocks as “cheap” here are invariably basing that conclusion on current and year-ahead forecasts for earnings. In contrast, analysts who view stocks as richly valued are typically those who view stocks as a claim not on this years’ or next years’ earnings, but instead are a claim on a long-term stream of deliverable cash flows. Simply put, there is presently a massive difference between short-horizon earnings measures and longer-term, normalized earnings measures.

What’s going on here is that profit margins have never been wider in history. But profit margins are also highly cyclical over time. The wide margins at present are partly the result of deficit spending amounting to more than 8% of GDP – where government transfer payments are still holding up nearly 20% of total consumer spending, and partly the result of foreign labor outsourcing (directly, and also indirectly through imported intermediate goods) which has held down wage and salary payouts. Indeed, the ratio of corporate profits to GDP is now close to 70% above its long-term norm.

Now, if you look at the red line (right scale, inverted), you’ll notice that unusually high profit shares are invariably correlated with unusually low growth in corporate profits over the following 5-year period. Thanks to continuing deficits and extraordinary monetary interventions, this effect has been largely postponed in recent years, allowing profits to expand to present extremes. We are not arguing that profit margins necessarily have to decline over the near-term, and our concerns don’t rest on the assumption that they will. It is sufficient to recognize that the bulk of the value of any stock is not in the early years of earnings, but in the long tail of future cash flows – especially if payouts are low. Stocks are essentially 50-year instruments here in terms of the cash flows that are relevant to their valuation. There are a lot of factors and quiet math that affect the P/E multiple that can be appropriately applied to earnings. Slapping an arbitrary multiple onto elevated earnings reflecting extraordinarily inflated profit margins ignores all of it.

The upshot is that if investors are willing to believe (without the use of off-label hallucinogens) that current profit margins are the new normal, and will be sustained indefinitely, then Wall Street’s valuations based on current and forward earnings estimates can be taken at face value. This assumption of a permanently high plateau in profit margins is quietly embedded into every discussion of “forward earnings” here.

As a side note, analysts continue bemoan the “inexplicable” gap between the economic malaise of “Main Street” and the optimism of Wall Street. Compare the previous graph to the one below, which shows how the “Muppets” are doing (and people wonder why I’m cynical about corporate culture). An economy that is this far out of balance is one that is unlikely to avoid toppling over to some extent. Capitalism and free markets work, and America remains the most creative and innovative nation on the planet, but until policy makers and regulators wake up, it will be impossible to escape the long-term consequences of distorted markets, reckless bubble-seeking Fed Chairmen, repressively low interest rates that penalize saving and lower the bar for productive investment, a self-serving financial system, and bailouts that remove all consequences for misallocating capital that could otherwise create jobs and raise living standards.

The iron law of equilibrium

A final observation. We continue to hear endless variations of this comment – “The Fed is creating huge amounts of money, and all of that money has to go somewhere.”

Actually no, it does not. The iron law of equilibrium is that once a security is issued – whether that piece of paper is a share of stock, a bond certificate, or a dollar bill – that security has to be held by someone in exactly that form, and in no other form, until it is retired. If IBM issues one share of stock, that share of stock can change hands between any number of people, but someone has to hold that share until it is retired. If the Fed creates a dollar of base money, that base money can change hands between any number of people, but someone has to hold that dollar until it is retired. There is no “getting out” of cash and into stocks in aggregate. There is only an exchange of ownership between existing pieces of paper that will each continue to exist until each is retired.

So the proper question isn’t where all of these pieces of paper will go – they still have to be held by someone exactly as they are. They may change hands, but in equilibrium, they don’t go anywhere. They can’t go anywhere in aggregate. The only real question is this: how low do you have to drive the returns on all other competing assets until the “someone” holding that dollar bill has no incentive to try to trade it for some other piece of paper? This, precisely this, and only this, is what the Fed is manipulating with its massive interventions. By creating enormous amounts of paper, and hoarding higher duration securities like Treasury securities, the Fed is trying to force investors into risky assets until the prospective returns on all competing assets are driven so low that investors and banks holding cash are willing to just sit on it. In short, the Fed has focused its efforts on creating a bubble in risky assets, on the misguided, semi-psychotic, and empirically disprovable notion that this will make people feel wealthier and get them to spend and borrow – despite the fact that their incomes can’t support it without massive government transfer payments.

Aside from periodic jolts of enthusiasm that release some amount of pent-up demand for a few months at a time, what this policy has actually produced is near-zero prospective returns on nearly every class of assets. These assets will now go on to actually achieve tepid returns for an extended period of time, provided that things work out well, and a collapse in the prices of risky assets if investors ever get the inclination to demand a normal return as compensation for the risk they are taking.

Market Climate

The Market Climate for stocks remains characterized by an unusually hostile set of indicator syndromes, most notably, an “overvalued, overbought, overbullish, rising-yields” syndrome that has historically been unfavorable for stocks regardless of prevailing Fed policy or trend-following indicators. Even in recent years, the effect of Fed policy and other interventions has been evident after significant market weakness (essentially limiting the follow through and helping to re-establish rich valuations), but those interventions have not prevented the weakness itself – not in 2007-2009, not in 2010, and not in 2011. Our primary risk estimates are now in the worst 0.5% of what we observe in historical data. We have increasingly used the word “warning” in our weekly comments for that reason. Strategic Growth and Strategic International remain fully hedged. Strategic Dividend Value is hedged at 50% of the value of stocks held by the Fund, which is its most tightly hedged stance. Strategic Total Return maintains a generally conservative stance as well, with a duration of just under 3 years in Treasuries, and about 5% of assets allocated between precious metals shares, utility shares, and foreign currencies. I strongly expect that we will have significantly better opportunities to accept financial risk in expectation of return than the near-zero prospects the Federal Reserve has forced upon investors at present.

Meanwhile, our economic concerns persist, as detailed last week and in prior comments. Despite a low-level rebound in various coincident measures, we continue to observe general weakness in the most informative leading measures (as we saw again in data from Europe and China last week as well). Based on the typical lead-time of these measures, we are now in a window where we would expect deteriorating coincident data over the coming 2-3 months. As I’ve noted in prior comments, to the extent that we observe economic data coming in better than expected during this window, the inferred state of the economy is likely to improve, and we would then be able to suspend our recession concerns. Regardless, it’s important to recognize that our defensiveness about the stock market here is distinct from those economic concerns, and our risk estimates would remain quite high (based on factors including the prevailing overvalued, overbought, overbullish, rising-yields syndrome), even if we were to zero out our recession concerns.

Tags: Bear Market, Bear Markets, Bull And Bear, Christine Lagarde, Distortions, Equity Risk Premium, False Sense Of Security, Financial Markets, Garden Variety, Global Economy, Hussman, Imf, Market History, Market Valuations, Secular Bull Market, Sense Of Security, Source Of Variation, Term Trends, Trough, World Economy
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Goldman’s Jan Hatzius: 3 Reasons to Expect Fed to Still Ease in April or June

Friday, March 16th, 2012

Based on some of the “action” and commentary in the past few days, it appears many believe the Fed is potentially stepping away from the monetary easing parade based on comments from the last FOMC meeting.  I don’t believe that, nor does Goldman’s top economist honcho, Jan Hatzius.

“It has definitely become a closer call, but we still expect another asset purchase program that involves purchases of both mortgage-backed securities and Treasurys,” he said.

Below he outlines the 3 reasons he expects the Fed to announce an easing in April or June, I particular want to highlight the last one  i.e. no continued easing = tightening! since the market has priced in further easing.

Also note Hatzius highlights the potential impact of warmer weather (which many have noted) and seasonal adjustment distortions.  If you have not read the piece from December on this, it is important to note - it gets very little play in the financial media but we’ve seen spikes up in economic activity in Q4′s and Q1′s and down in Q2′s and Q3′s (which lead to more monetary easing!).  Hence the government economic data, if it follows the pattern of the past few years should begin to weaken in April-June if for nothing else than the distortions 2008-2009 have had on traditional seasonal adjustments.

On to Hatzius:

1. The improvement might not last.

With real GDP growth tracking just 2% in the first quarter and signs that at least some of the recent strength is probably due to the unusual warm weather and perhaps some seasonal adjustment distortions, question marks still surround the true pace of activity growth. In addition, there are still several actual or potential “headwinds” for growth, including a reduced boost from inventory accumulation, the recent increase in oil and gasoline prices, continued risks from the crisis in Europe, and the specter of fiscal retrenchment after the presidential election.

2. Even if the improvement does last, faster growth would be desirable to push down the unemployment rate more quickly.

Fed officials believe that the level of economic activity and employment is still far below potential. This means a large number of individuals are involuntarily unemployed, which not only causes hardship in the near term but may also translate into higher structural unemployment in the long term…This creates an incentive to find policies that speed up the return to full employment.

3. Not easing might be equivalent to tightening.

At a minimum, the bond market currently discounts some probability of QE3. This has kept financial conditions easier than they otherwise would have been, which has presumably supported economic activity. A decision not to ratify expectations of QE3 could therefore result in a tightening of financial conditions.

Tags: Asset Purchase, Distortions, Economic Activity, Economic Data, Fiscal Retrenchment, Fomc, Gasoline Prices, GDP Growth, Goldman, Headwinds, Presidential Election, Q4, Question Marks, Real Gdp, Seasonal Adjustment, Seasonal Adjustments, Specter, Spikes, Treasurys, Warm Weather
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Charting Today’s Second Worst Ever Initial Claims Miss To Expectations

Thursday, May 5th, 2011

Today’s horrendous Initial Claims number was so bad that not even CNBC tried to spin it. In fact, as John Lohman points out, it was the second biggest miss to consensus in history! Of course, seeing how this is consensus and the BLS does not reveal any unknown information, we wonder just how difficult is it to factor in any special factors in determining project numbers, and if the answer is “very” then why do we need economists in the first place (that’s rhetorical). And while Liesman is in Europe on some assignment, here is Goldman explaining why the historic miss was based entirely on special factors.

Charting historical misses to consensus

And heeeeeere’s Goldman:

MAIN POINTS:1. Initial jobless claims rose to 474k in the last week of April, from 431k in the previous week. The Department of Labor (DOL) cited three main factors behind the increase. First, plant shutdowns in the auto sector caused temporary layoffs. Second, Oregon reformatted its extended benefits program which “also pulled in some new claimants” (according to Bloomberg). Third, initial claims in New York rose due to seasonal adjustment problems. According to the DOL, the change in Oregon accounted for only 1,000 or so of the increase, and the impact of auto shutdowns was “very small”. The major factor behind the increase was “administrative”, reflecting seasonal claims in New York that were all filed in a single week. This accounted for about 25,000 of the increase last week, according to the DOL.2. Even with these distortions accounted for, the result was still poor, and suggests some slowing of employment growth. This is more likely to have implications for the May employment report than for tomorrow’s report, which is based on a survey conducted in the week of April 10-16, well before the numbers reported today.3. Nonfarm productivity grew at a 1.6% annual rate in Q1, better than we or the consensus expected. Nonfarm output significantly outpaced economy-wide GDP growth (3.1% versus 1.8%) while employee hours grew at a similar rate to the past two quarters (1.4%). Unit labor costs were up slightly more than expected, and 1.2% on a year-over-year basis, although in historical terms these remain extremely muted.

Initial Claims: 474K – Bring Out QE3

And scene: jobless claims explode to 474K, beyond the worst economist expectation, far above consensus of 410K, and well above the previous (upward revised of course) number of 431K. This is the worst claims number since Aigist 2010. Game over for the US “recovery.”

Welcome to the US Recovery:

Those collecting EUC and Extended Claims continue dropping of the 99-week roster, with 48K no longer collecting weekly government paychecks.

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Tags: Auto Sector, Bls, Claimants, Cnbc, Consensus, Department Of Labor, Distortions, Dol, Economists, Employment Growth, Employment Report, Gold, Goldman, Initial Claims, Initial Jobless Claims, Layoffs, Lohman, Misses, Plant Shutdowns, Project Numbers, Seasonal Adjustment
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Brazil: Let’s Try Some Old-Fashioned “Capital Control” First

Tuesday, October 26th, 2010

Brazil: Let’s Try Some Old-Fashioned “Capital Control” First

With the second round of the Brazilian presidential election set for October 31st, we thought it would be a good time to focus on the country and steps the next administration can take to limit growing imbalances in the economy as well as the strength of the real. The election has gone mostly unnoticed by markets, in sharp contrast to the 2002 contest, but one need only look to the last few weeks to understand the importance of the vote.

The government has been one of the more vocal in the current ‘currency-war’ debate, viewing appreciation of the real as a detriment to exporters and the economy at large. Thus, in addition to using the traditional intervention method of selling reais in exchange for dollars (at a considerable loss on the yield differential), Brasilia has been experimenting with some less traditional methods. On October 4th, the IOF tax was increased from 2% to 4% on foreign investment in fixed-income securities only. The policy acts as a de facto tax on corporate issuers and simply funnels more of the foreign capital into equity markets. This had little effect on the value of the real and the impact it will have is distortionary. Just over two weeks later, that tax was increased from 4% to 6%. (Chart 1) This time, the real did see some depreciation, probably due more to concerns over policy uncertainty than actual fundamentals. The other stated goal of the IOF tax when it was first initiated was to increase the percentage of foreign direct investment relative to the potentially flighty portfolio investment. By this measure, the tax has had no visible impact. (Chart 2)

So how does this all relate to next week’s election, you ask? It is our belief that Brazil has a tool at its disposal to counteract some real strength that would not need come with unnecessary distortions – fiscal restraint. The likelihood of this tool being used depends largely on the winner of next week’s poll. Though the policy stances of the two candidates have not been well-flushed out, it is our view that Lula’s handpicked successor, Dilma Rousseff  is much less likely to reduce spending than her opponent, José Serra. In fact, we view a Rousseff victory to mean increased future government spending. Despite recent polls showing a narrowing between the two candidates, we continue to find it very unlikely that Serra will pull off an upset on the 31st.

Government consumption accounts for a large portion of nominal GDP in Brazil and the level has been steadily rising in recent years. On a real basis, we expect government spending to increase 4% this year. While it is hard to attack a government for fiscal profligacy when we only project a general government shortfall of 2.3% this year, the deficit only tells half the story. When it is taken into consideration that government revenues increased 14.77% y-o-y at the most recent reading, the government’s fiscal stance becomes decidedly expansionary, as well as pro-cyclical.

To understand the pro-cyclical nature of the spending, consider that Q2 GDP figures showed an 8.7% y-o-y expansion. (Chart 3) Unemployment has fallen dramatically, from 7.7% last September to 6.2% in September 2010. As could be inferred from the robust employment growth, private consumption is also up strongly this year. This is all a way of saying that government stimulus is no longer necessary. We acknowledge that the country is still in need of considerable social welfare programs to address rampant poverty; however, we believe in the long-term that achieving lasting poverty reduction will be best achieved through macroeconomic stability.

With all else equal, including no changes from the central bank, a reduction in government expenditure should reduce the value of real by slowing down aggregate demand. Admittedly, it is difficult to quantify what the actual nominal impact on the exchange rate of a spending cut would be. However, why not cut unnecessary spending when it will help in the ‘currency war,’ improve confidence in a historically spendthrift government, and reduce the likelihood of an overheated economy? Seems like a win-win, and then some, but a win-win that becomes less likely with a Rousseff win.

Tags: Brazil, Corporate Issuers, Currency War, De Facto Tax, Depreciation, Detriment, Distortions, Fiscal Restraint, Fixed Income, Foreign Direct Investment, Foreign Investment, Funnels, Income Securities, Northern Trust, October 31st, Policy Uncertainty, Portfolio Investment, Presidential Election, Reais, Thies, Visible Impact
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