David Rosenberg: Where to Go For Positive Returns

Monday, July 23rd, 2012

 

 
David Rosenberg discusses how the 3 D’s (Deleveraging, Deflation, and Demographics) are hurting markets, and where investors can go for positive returns, with Wealthtrack’s Consuelo Mack.

Here is the full transcript:

CONSUELO MACK: This week on WealthTrack, the influential economist whose projections have been right on target. Financial Thought Leader David Rosenberg shows how the 3 D’s of deleveraging, deflation and demographics are hurting economies and markets and where investors can go for positive returns, next on Consuelo Mack WealthTrack.

Hello and welcome to this edition of WealthTrack. I’m Consuelo Mack. This week, we are sitting down for an in-depth interview with one of the handful of prognosticators who has gotten it right going into and through the rolling global financial crisis we are experiencing to this day. He is Financial Thought Leader David Rosenberg, chief economist and strategist at Toronto-based wealth management firm Gluskin Sheff. Dave returned to his native Canada in 2009 after spending many years as Chief North American Economist at Merrill Lynch, where Institutional Investor magazine placed him on their coveted “All American All Star Team” from 2005-2008.

Rosenberg took on the bullish Wall Street herd as early as 2004, when he started warning about the developing housing and credit bubble which, as he predicted throughout, would wreak havoc on the financial system and many world economies. Well he hit the nail on the head again last year, forecasting the global economy would slow and that treasury bond yields would fall- another homerun. In his influential and widely read daily “Breakfast With Dave” reports, he ranges across the globe covering everything from Europe and how “it is rather incredible that this rolling crisis is now going on 2-1/2 years and policy makers have yet to find a viable solution”; to emerging markets and “why the once mighty BRIC currencies are depreciating of late at their fastest pace since the 1998 Asian crisis”; to the financial markets and “how the “pattern of the past three years is unmistakable as each spring, the equity market corrected as stimulus measures wore off, to only then prompt more incursions by the fall.”

What other patterns are unmistakable to Dave Rosenberg and why did he write in a recent report that “the future is brighter than you think”? I asked him all of the above and more, starting with what he thinks the most important patterns for the economy and markets.

DAVID ROSENBERG: I think the primary trend is still one of deleveraging. It hasn’t really changed much from the last time that the two of us spoke; it’s become much more global in nature. So it started off in the U.S. four or five years ago, in the American mortgage market, the housing market, consumer loans in general, but now we’re seeing how it’s morphed into the survival of the welfare state and all the debt finance to prop up these peripheral countries in Europe, and even now there’s questions about whether China is going to have a hard or soft landing because of a perceived property bubble there.

So we’re still in this deleveraging cycle, still dealing with the impact of too much debt relative to the size of the global economy, and this is what’s creating all this market angst and instability that we’re still living with; notwithstanding the fact that the economy, the U.S. economy is three years in a recovery, we’re still stuck in a very slow growth mode, but recurring financial market instability at the same time.

CONSUELO MACK: So is there any way of knowing whether the second half is going to be worse, better, or the same as the first half? Because, I mean, I’m thinking of my audience out there, and myself included, and saying, “I don’t want to live through another three or four years like this.” So what’s it going to look like, do you think the second half?

DAVID ROSENBERG: Well, I’m going to sound like a classic economist here and say it’s going to be somewhere in between, and this is what I mean. Are we going to get another gut wrenching, you know, 7% decline in GDP, and lose another 8 million jobs? I don’t think we’re going to go through anything close to what we endured in ’08 and ’09.

CONSUELO MACK: And to back-to-back kind of 50% decline in the stock market?

DAVID ROSENBERG: It’s not going to be that bad. But then again, you have to take a look at the contours of the recovery. I actually think the recovery tells you a lot more than the actual gut-wrenching recession did, because normally when you do this with the economy, you do that.

CONSUELO MACK: You get to a V, right?

DAVID ROSENBERG: Well, even in that 1933-’36 period, you got a huge recovery, much bigger than we had this time around, and this time around we had basically a checkmark of left-hand person, that’s what we had. It was not a V-shaped recovery; it was a very meager recovery, especially when you consider everything that the government threw at this thing. Consider the Fed took rates to 0 in December of ’08, they’ve tripled the size of their balance sheet $3 trillion. We’ve had, what, $4 trillion, four years of trillion-dollar deficits, and…

CONSUELO MACK: The fiscal stimulus…

DAVID ROSENBERG: …and more foreclosure moratoria. We’ve tried everything. So we’ve had modest economic growth, but very unacceptable. And now what’s happening is the Fed is left now with all these uncreative tools. Like Ben Bernanke certainly believes that he can do more but, you know, in Economics 101 you learn about the law of diminishing returns, and it’s basically that you end up getting less and less and less incremental impact from the same policies over time. And so that was the same with QE1, QE2, with the LTRO that we had out of Europe. We were getting just a smaller incremental impact on the economy with each individual policy proposal.

CONSUELO MACK: So therefore three years into a quote, unquote “recovery”, so are we on the cusp of another recession?

DAVID ROSENBERG: Cusp or precipice, I don’t know if I’m quite there yet. The economy is extremely fragile. The underlying trend in the economy is barely 2%, it’s barely 2%. So when you have a trade shock that can wipe out 2 percentage points of growth, you’re left with 0. Now, maybe that’s not a recession in the classical sense because we’re not actually going in reverse, but the unemployment rate is going up in a no-growth environment. And then you talk about this so-called fiscal drag, this fiscal cliff that we’re going to see next year- it’s because, you know, we’re probably not in as bad as shape as the Europeans, but here in America, we’ve kicked the can down the road a lot in terms of the Bush tax cuts getting extended, in terms of payroll tax relief, extended unemployment insurance benefits, all these provisions expire December 31st. So just by the government taking back the parking permit from everybody, we have a drag on the economy next year from fiscal restraint, 4 percentage points of GDP, percentage points.

CONSUELO MACK: Which we don’t have. So listening to you, Dave, quite honestly, I do want to kind of bury my head in the sand and I’m thinking to myself, you know, that I want to be in incredibly safe assets, that this is no time to put risk on. And yet, you know, one of the things that you follow, as well, is investor sentiment and the fact that there is a growing despair out there that people are very frightened and worried. And as we know traditionally, that’s in fact, the time when it’s actually best to buy risk.

DAVID ROSENBERG: I mean, there are always opportunities. In a fat-tail world, you’ve got to be very cognizant of the risks. So it’s as much not just focusing on the gross returns, but we have to – and this is what we’re doing every day at my shop at Gluskin Sheff- is we are assessing the risk, identifying it, managing it, and pricing it. And frankly it’s not about, you know, being risk averse. You know, people think that somehow, you know, when you talk about risk all the time you’re risk averse. It’s always important to make sure as an investor that you’re getting paid to take on the risk, that you’re not paying…

CONSUELO MACK: Right, so it’s price is really…

DAVID ROSENBERG: Right. Like, for example, I would say, you know, the high-yield bond market right now is actually, I would argue, priced for a bad economic outcome. You want to buy the assets that you think have already discounted. What’s embedded, what’s the story in this particular asset class, what’s it telling you? So I’m taking a look at the high-yield market right now. I think it’s actually very attractive. We have a core portfolio of high-yield bonds, and the reason I say that is because ultimately when you’re buying corporate bonds, you’re staking a claim in the corporate balance sheet. And the one thing that’s not changed, despite the fact that we’ve got all this angst overseas, the fact that the U.S. economy has hit stall speed, corporate default rates are barely more than 2%, you’ve got corporate balance sheets in great shape whether you look at debt equity ratios, or interest coverage ratios- the fact that treasurers companies both Canada in the U.S. have locked in their maturity schedules, 80% of corporate debt is locked in. In some sense, the corporate sector is in better financial shape than the government sector is. So I like corporate bonds.

CONSUELO MACK: One of the things that you’ve told clients is that reliance and deriving a stable income stream while preserving capital is paramount right now. So in these uncertain times, stability of income stream is one of your major investment focuses.

DAVID ROSENBERG: Right. And it comes down to what my overall theme is called: the macro and market outlook in 3D. So I’m talking about the 3Ds. What are the 3Ds? Well, they’re deflation, there’s demographics, and there is deleveraging and we talked about the deleveraging. There’s also this demographic overlay because the first of the Boomers are 55 going on 56, that’s the median age. The first of the Boomers are in their mid-60s, and so they control the wealth. They’re in a different part of their investment life cycle right now, and so accumulating cash flows as opposed to relying on strictly capital appreciation for the Boomer class, the life cycles as far as investments are concerned, that’s altered. And we’re seeing it in our own business in terms of what our clients are telling us, how they would like their money managed.

So you’ve got the demographics talking about the deleveraging, but the deflation. And so people will say to me, “Well, I thought in a deflation, cash is king in a deflation.” And the answer is well, you know, historically that’s true. That’s the ultimate capital preservation- cash is king in deflationary environment except when interest rates are 0. And so then it’s not cash is king, cash flow is king. So it’s imperative. It’s not just about preservation of capital, which of course in the fat-tail world, which is the deleveraging world, capital preservation is key; but you have to overlay that with preservation of cash flows. That’s why MLPs have been so popular.

CONSUELO MACK: Right, Master Limited Partnerships.

DAVID ROSENBERG: That’s why muni funds. That’s right, and that’s why REITs, and that’s why dividend growth, dividend yield have been so popular now. People come back and say to me, “But these things look so expensive.” Well, they look expensive because that’s what’s in demand, you know? And it doesn’t mean because it’s expensive you don’t want to buy it. You know, the perfume I bought is expensive, yeah, but is it good? Yes. Well, okay, that’s why it’s expensive because it’s a good thing to buy. These are good strategies right now, and that’s why their prices have been up as much as they have.

CONSUELO MACK: So as far as this pattern that we’ve seen for the past three years in the stock market, and where it rallies until the spring and then it basically sells off. That has been very disheartening for investors. Are we locked into that for the foreseeable future?

DAVID ROSENBERG: I think what we have is this battle going on, got this battle. We have the secular forces of deflation coming from all this deleveraging and the deleveraging, of course, takes demand out of the global economy, you’ve got the deflation, and then you’ve got these governments fighting it hard. So the secular forces of deflation in the market place, and then the tug-of-war as governments come in and reflate- whether it’s China, or whether it’s the U.S. government, or whether it’s the ECB. And so what this does is creates tremendous volatility, tremendous volatility.

But once again, the question is for an investor, what do I do with this volatility? How can I sleep at night? And that’s why in conjunction with say income equity over here, and corporate bonds over there, there should be a slice in the portfolio in hedge funds that really hedge long-short strategies that can actually be…

CONSUELO MACK: And they exist? There really are hedge funds that really hedge?

DAVID ROSENBERG: Well, you know, hedge funds have been around for 50 years. They got a bad name in the last cycle because they weren’t hedge funds, they were leverage long-only funds. But there are firms out there that are either hedge funds. You know, Gluskin Sheff is not a hedge fund, but 20% of our business is managing these long-short strategies, and it’s actually a very effective way to be nimble in the market place when you get these dislocations.

It’s really just taking sectors and companies that you think are bad businesses, are going to cut their dividends, and you put a short position on them, and you couple that with long position of the companies that you think are going to grow the dividends over time.

CONSUELO MACK: So let’s talk about earnings, because I know that you’ve said that the E in the price earnings ratio, the earnings, they are problematical. So what is your outlook for corporate earnings? And again, what does that mean for the stock market?

DAVID ROSENBERG: Well, corporate earnings right now have hit an inflection point, and it’s not just that they’re slowing, they’re actually starting to contract. Earnings are actually, after a three-year period of steady increases off those lows in 2009, corporate profits are actually now starting to decline outright.

CONSUELO MACK: And you’re talking about the S&P 500?

DAVID ROSENBERG: S&P 500 and even bigger picture. When we got the GDP numbers a couple of weeks ago- the GDP numbers give you corporate earnings for all of America, not just for the large-cap companies- and corporate earnings are coming down. And my sense is that the earnings estimates by the analysts on Wall Street is still far too high. Earnings estimates are important. I’m noticing that fewer companies are giving guidance. Fewer companies are giving guidance. What’s that telling you? That corporate CEOs, very similarly, they have a very clouded crystal ball right now. Fewer companies are giving guidance, and then the ones that are giving guidance, for every one that’s saying something positive about their business, two to three are saying something negative about what the outlook is. And on top of that, the estimates are starting to come down. I don’t think they’ve come down enough.

What does it mean for the stock market? You know, I think that if we were to go into a recession, normally the market corrects 20%. I’m not going to say that we’re going into a recession, but my sense is that the stock market is going to remain at best in the range that it’s been in for the past several months. We have to respect the range, but we’re going to be still in for a lot of volatility, which is why I was saying before that hedge funds, they really hedged, totally appropriate. On top of that, you have to be nimble and as tactical as you possibly can be, but if you’re going to ask me do I think that there’s more downside pressure given the risks out there, and especially to corporate earnings, the answer is yes. I think at this stage, without getting into, you know, what’s your call on where we can get to, I think the balance of risks is at that the market goes down over the near term and then goes up. And if it does, I think it will be a great buying opportunity down the road.

CONSUELO MACK: Let me ask you just about another macro issue, which is what about Europe? And you’ve said, you wrote recently that, you know, you’re two and a half years in, you know, these rolling problems keep coming up in Europe, and there are no viable solutions.

DAVID ROSENBERG: Well, I mean, there are solutions. I don’t know how viable they are. I think it’s a matter of just looking at it realistically. The European Union was working just fine. You know, the whole notion that we were going to try and avoid another World War, another European war at all costs. I don’t think that we needed to have a currency union to achieve that. You can’t have a monetary union and not have the fiscal union, and an integrated banking union. You can’t have it.

CONSUELO MACK: So realistically, I mean, are the 17 countries going to sacrifice their sovereignty?

DAVID ROSENBERG: Hardly likely. I had breakfast recently with a CEO of a major Canadian bank, and he told me that they have a Eurozone breakup committee. And he said this is happening around the world. Any major multinational corporation, any business that is doing business in Europe has one of these Eurozone breakup committees, not unlike the pre-Y2K committees that you had in the late 1990s. So you can bet your bottom Euro that if that’s what they’re doing, the Eurocrats in Brussels are trying to come up with some sort of… you talk about viable, what’s a viable exit strategy? Unless the ECB steps up en masse and rapidly expands its balance sheet, and starts buying the bonds of Italy and Spain en masse at auction, you know, that’s pretty radical. I don’t know what the quick fix is. So I think that the end game will ultimately be that the Eurozone breaks up.

CONSUELO MACK: One of your investment themes that we’ve talked about basically has been capital preservation and income orientation, as well, and one of the themes that you and I have talked about in the past is what you call “SIRP”, which is Safety and Income at a Reasonable Price. Are you looking for SIRP investments? Is that still a major strategy theme?

DAVID ROSENBERG: I would say that SIRP has its thumbprints across all the portfolios we’re running at Gluskin Sheff. In fact, what’s interesting is that we, for years, since 2001 we’re running this one particular strategy that’s called “premium income”, which it’s a hybrid, it’s got dividends, and it could have REITs, it could have preferred, convertible bonds; it’s really a portfolio aimed at distribution, a portfolio aimed at generating monthly cash flows for our clients.

CONSUELO MACK: And that’s Safety and Income at a Reasonable Price.

DAVID ROSENBERG: Right. Well, when we say… for example, when I talked about corporate bonds, and we’re talking about “safety” in quotes; I mean, safety, it’s relative. When talking about corporate bonds, it’s because of the quality of the balance sheets are very strong. Because that’s inherently when you’re buying corporate bonds, it’s mostly about default risk. You want to minimize that strong balance sheets. When I talk about on the equity side, we’re talking about running portfolios that have a low beta, which means low correlations with the overall market direction.

CONSUELO MACK: Right. The overall stock market direction.

DAVID ROSENBERG: The overall stock market direction, so we’re talking about, so it’s not just about, you know, does this company have a consistent history of paying off dividends, and we like the business. It’s also how does it move relative to the overall market? So in a period like this where it’s very tumultuous, and where the market is more prone to go down than up, you want to run your portfolios with very low betas. And so that’s the safety part, that’s the “S” part of the SIRP.

CONSUELO MACK: And the low correlations of the markets, in a highly correlated market, which is what we’ve been in for the last several years, so what are the areas that aren’t correlated that have low betas?

DAVID ROSENBERG: Well, for example, one of the themes that we liked has been the consumer frugality theme. So it means consignment stores, it means private label, it means do-it-yourselfers. I mean, for example, you could actually say, wow, because a Home Depot, does it fall under that category as an example. I’m not going to go sell my home, I’m not going to move, I’m underwater in my mortgage, but you know what? I still want to have a fun life, so instead of buying a new home, I’ll spruce up my existing home. And so home repair, a do-it-yourselfer, and so you can find…

CONSUELO MACK: So can you match a name or two to, you know, the frugality theme? So, for instance, frugality, what’s a–

DAVID ROSENBERG: Well, I’ll tell you one area where we have been long, and it’s worked out well has been the dollar stores. And they’ve been phenomenal investments, and by the way, it’s not just because low income households shop there, you’d find… and what the studies are showing is that a greater share of middle income households are actually going to dollar stores. And that’s an area where we have focused on in terms of our consumer exposure.

CONSUELO MACK: Let me run down a couple of the other investment themes, noncyclical. So give me, you know, what’s the theory behind the noncyclical emphasis? And give me an idea.

DAVID ROSENBERG: Well, it’s all about generating stable cash flows. In an uncertain environment, what do you want in an uncertain environment? You want stability. What about utilities, regulated utilities? Regulated utilities. They have regulated pricing power. What about telecom? And it might not just be the stock, you might want to buy the bonds of these companies. Once again, if you have a single A telecom company that’s giving you a triple B yield, you know, I will be happy to take that all day long in terms of looking at the risk and reward. So telecom, utilities, consumer staples, these are the areas that will tend to outperform in the environment that I’m describing right now.

CONSUELO MACK: And one other category that you had was hard assets. So what are we talking about when you’re emphasizing hard assets?

DAVID ROSENBERG: Resources are not a bad place to be. They’re already corrected quite a bit, so resources, whether it’s raw food, or whether it’s, I would say energy, which is corrected quite a bit. ]If you’re a long-term investor, these are complements. They’re not going to generate a yield for you, but they are what you want to own, things you can see, touch and feel in a very uncertain world, and these things have cheapened up quite a bit, as a hedge against the income part of the portfolio.

CONSUELO MACK: So one question is One Investment for long-term to diversify portfolio, what is it that you would recommend that we all own some of?

DAVID ROSENBERG: Well, I’m still a big advocate of corporate bonds. As I said, I think balance sheets are in great shape, default rates are low, there is too much default risk priced in, and so I would say I would focus on, let’s try and generate equity-like returns without taking on the equity risk. And there is a part of the capital structure that can accomplish that, and it’s called “corporate credit”. That is still to me a happy medium between 0 percent treasury bills and going out in the riskiest part of the equity structure. So corporate bonds to me are a solid investment.

CONSUELO MACK: And Dave Rosenberg, you know, you have a reputation of being a permabear, which is not fair, because you were also known as a permabull in the ‘80s and the ‘90s, and in a recent report you said” the future is brighter than you think.” Why when others are despairing are you getting enthusiastic about the future?

DAVID ROSENBERG: Well, I’m not going to say I’m getting enthusiastic about the future. What I am willing to do is put out some checkmarks as to what can cause me to turn more optimistic. And so I see a flicker of light, and it’s realization that politics will lead the financial markets, which will lead the economy, and what leads the politics is the grassroots level, and so what happened last month, for example, I think in Wisconsin with the recall in San Jose, San Diego, and there seems to be this growing realization at the grassroots level that we have to get our public sector balance sheets in better shape; that these underfunded liabilities have to come under control. So we’re starting to see more of a groundswell of support.

What I’m thinking about is how things will change politically on November the 6th, understanding, coming from Canada; Canada went through what Europe is going through right now. Canada is going through what the U.S. was going through back in the early 1990s. You could never have predicted that Canada ten years later would be the poster child for fiscal integrity globally. But it took tremendous political courage.

CONSUELO MACK: We’ll see what happens, and that’s what you’re going to be watching, Dave Rosenberg.

DAVID ROSENBERG: I’m more than willing to reclaim my status of a permabull that I had in the ‘80s and ‘90s if I see those clouds part come November.

CONSUELO MACK: All right, Dave Rosenberg, so great to have you here from Canada, Gluskin Sheff. It always a pleasure to have you on WealthTrack.

DAVID ROSENBERG: Thank you.

CONSUELO MACK: At the conclusion of every WealthTrack, we try to leave you with one suggestion to help you build and protect your wealth over the long term. This week’s reiterates one we just talked about- Dave Rosenberg’s long-time income generating strategies which is S.I.R.P.: safety and income at a reasonable price. So this week’s Action Point is: seek safety and income at a reasonable price, or S.I.R.P.!

Everything we know about the financial markets right now points to ongoing volatility and headwinds for stock price appreciation. Among the areas Rosenberg recommends where you can find reliable dividend growth and dividend yields are: Canadian and U.S. preferred stock shares, which are senior to common stocks; energy infrastructure investments, such as natural gas pipelines; and utilities. All S.I.R.P. vehicles.

And that concludes this edition of WealthTrack. I hope you can join us next week. We are going to sit down with an investment professional who combines two disciplines: overall investment strategy and actual fund management. BlackRock consultant Bob Doll will join us to discuss macro trends and micro strategies. Until then, to see this program again, or others and read my Action Points and our guests’ One Investment recommendations, please visit our website, wealthtrack.com Have a great weekend and make the week ahead a productive one.

Tags: American Economist, Chief Economist, Consuelo Mack, Credit Bubble, David Rosenberg, Deflation, Demographics, Depth Interview, Global Economy, Global Financial Crisis, Institutional Investor Magazine, Investors, Merrill Lynch, Native Canada, Prognosticators, Sheff, Target, Treasury Bond Yields, Viable Solution, Wealth Management Firm, Wealthtrack, World Economies
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Energy and Natural Resources Market Radar (July 16, 2012)

Saturday, July 14th, 2012

Energy and Natural Resources Market Radar (July 16, 2012)

Strengths

• The yield on 10-year U.S. Treasury Notes closed at 1.488 percent on Friday, below the May Consumer Price Index of 1.7 percent, giving investors a negative real return. Comparatively, the Global Resources Fund’s portfolio currently has an average dividend yield of 3.75 percent.
• China’s GDP grew 7.6 percent for the second quarter year-over-year, slightly lower than expected, leading to a gain in copper and crude oil futures toward the end of the week. It seems that the market is expecting a stimulus to come about from China to offset all the pressures of slowing growth. The global financial crisis was the last time China’s demand slowed this much, having a GDP increase of only 6.2 percent during the first quarter of 2009 year-over-year.
• Corn prices hit 52-week highs this week after the U.S. Department of Agriculture estimated a drop in crop yields of 12 percent, the largest month-over-month drop in nearly a decade. Jerry Norton, chair of the Interagency Commodity Estimates Committee, stated that “It’s a very unusual situation.” Only 40 percent of the nation’s corn crop is in good to excellent condition, significantly lower from last year’s 69 percent rating.
• Oil prices (Brent) gained over 4 percent this week to close at a six-week high of $102.76 per barrel as hopes for additional stimulus from the Chinese government boosted sentiment.

Weaknesses

• Statoil was set to shut down operations until the government of Norway intervened on the 16-day oil strike, putting an end to the restriction of supply that was driving up oil prices. The workers were forced back to work and the National Wages Board will attempt to resolve the conflict.
• Although China imports were up year-over-year in June, they increased by only 6.3 percent, less than half of forecasts, contributing further to an already stressed demand with regard to commodities. One factor of the increase in China’s trade surplus can be attributed to the excess stockpiling measures China took before Indonesia’s export tax on metals went into effect in May.
• China’s main coal mining provinces have plans to cut back on output in an effort to alleviate market conditions. According to Platts, a number of Shanxi-based miners have already cut output by 20 to 30 percent since May.
• U.S. net new aluminum orders fell sharply in June, according to data released from the Aluminum Association. Aluminum orders (less can stock) fell 4.4 percent year-over-year in June.

Opportunities

• China Copper Mines has applied to exploit five mineral waste dumps in Zambia which may have a yield of 600 metric tons of copper cathode per year. This project will increase China’s presence in Zambia, Africa’s largest producer of copper.

• Julio Velarde Flores, President of the Central Reserve Bank of Peru, commented this week on the growth prospects of the country. He is optimistic and believes they can exceed the economic growth targets for the year. Peru, the world’s second largest producer of copper, is in the process of seeking investment from wealth funds in Singapore.
• Anglo American has reached a deal with the government of Moquegua to build a $3 billion Quellaveco copper mine, according to Oscar Valdes, Prime Minister of Peru. 220,000 tons of copper per year is estimated to come out of Quellaveco, which is close to one-fifth of Peru’s 2011 total output.

Threats

• By 2016, the Democratic Republic of Congo hopes to triple its current output of copper to 1.5 million, according to Mines Minister Martin Kabwelulu. The Congo has about half of the world’s cobalt reserves, and is aiming to boost output by 65 percent. The government, however, plans on increasing the state’s stake in mining operations which will be used to promote the growth of industry, the country, and its people.
• According to Reuters, Baoshan Iron & Steel, China’s biggest listed steelmaker, will cut August prices of its main products by 4.6 percent as seasonal demand slows. Global Times recently reported that China’s domestic steel prices hit two-year lows during the first week of July. Until we see more quantitative easing in China, we will be unlikely to see any large gains in steel prices in the near future.
• The U.S. Energy Information Administration lowered its 2013 forecast of global oil demand to 730,000 barrels per day. The International Energy Agency however took a contrarian viewpoint with their forecast, estimating that oil demand would rise by one million barrels per day, 1.1 percent higher than in 2012, but still lower than levels seen prior to the financial crisis.

Tags: 52 Week Highs, China Imports, Consumer Price Index, Copper Futures, Corn Crop, Corn Prices, Crop Yields, Crude Oil Futures, Department Of Agriculture, Dividend Yield, Gdp Increase, Global Financial Crisis, Global Resources, Government Of Norway, Market Radar, Oil Strike, Resources Fund, Time China, Treasury Notes, U S Treasury
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U.S. Exports: A Lower Gear, but Still Cruising

Tuesday, July 10th, 2012

by Milton Ezrati, Lord Abbett

July 2, 2012

Exports have remained one of the few consistent bright spots in this otherwise subpar economic recovery. The growth of exports at times has added as much as two percentage points to the overall pace of the economy’s expansion and is a major reason why American manufacturing has staged a comeback in recent years—a “renaissance” some have called it. But of late, with the dollar rising against both the euro and the yen, and with growth overseas slowing or, in Europe’s case, falling, questions have arisen about the sustainability of U.S. export strength. Doubtless, the pace of gain will slow, but probabilities suggest that the growth will continue.

The American export boom actually took off in 2007, stood up remarkably well during the 2008–09 recession, and has generally picked up momentum since. As Table 1 shows, exports of goods and services jumped 13.3% in 2007 and continued to grow almost apace in 2008, even as the global financial crisis rocked world economies. Unsurprisingly, exports fell during the global recession year of 2009, but they rebounded into 2010 and 2011, despite the disappointing pace of the global expansion. Even more recently, as China has reduced its overall growth expectations and Europe has fallen into recession, export growth so far this year has actually accelerated. Because exports amount to barely 15% of all U.S. economic output, this performance, impressive as it is, could not turn a sluggish recovery into a rapid one, but it has been fast enough at times to add considerably to the pace of growth. In late 2007, net exports accounted for more than half the economy’s overall expansion. In 2010 and early 2011, they accounted for one-third of the economy’s overall growth.

The expansion of the global economy, especially the emerging world, explains some of these gains. The 2007 export jump, especially, reflected the booms in China, India, and other emerging economies that were proceeding at the time and that consumed industrial supplies and raw materials for which the U.S. economy, among others, was in a good position to provide. Of course, the global downturn in the late 2008/early 2009 helps explain the export drop averaged in 2009, but that picture quickly changed as the emerging economies resumed their rapid growth trajectories in 2010 and in the early part of 2011.

Also explaining the American export picture are the declines in the dollar’s foreign exchange rate, which cumulatively enhanced American producers’ price competitiveness. Between 2002 and 2007, for example, the euro rose about 40% against the dollar, while the yen rose more than 15%. These favorable (for exports) currency patterns continued through much of this more recent period too, further enhancing America’s competitive position. In 2007 alone, the dollar cheapened almost 10% against the euro and then rose only slightly since, at least until much more recently. The move against the yen was even more dramatic. Between mid-2007 and late 2011, the yen rose almost 40% against the dollar. Not only did the currency moves give U.S. producers inroads into the European and Japanese markets but, more significantly, they also gave a significant edge against the European and Japanese competition in faster-growing third markets, such as China, India, and Brazil.

There can be no denying, however, that the dollar’s recent gains, if they persist, will strip away some of this competitive edge. In recent weeks, for instance, the euro and the yen have each cheapened almost 5.5% against the dollar. But because previous dollar declines had given American producers such huge pricing advantages, even recent dramatic currency moves leave much of this country’s former global pricing advantage intact. According to calculations by the OECD (Organization for Economic Cooperation and Development), underlying measures of comparable pricing (what econometricians refer to as purchasing power parity), put today’s euro, at about $1.25, only just on a competitive par with dollar-based production. Comparable calculations for Japan show the yen still giving American producers a huge 35% pricing advantage against the Japan-based competition.

Though combined with slowing global growth, recent dollar strength will retard the future rates of export gain, but it should be clear that relative pricing advantages have hardly proceeded far enough to erase it. For one, trading arrangements are based on ongoing pricing and supply relationships built over long periods of time. Those that have developed in favor of American products during these past years of great American pricing advantages will take a long while to unwind. Given the American advantage implicit in the still pricey yen, it is doubtful that such a process has even begun or will begin for some time yet. If the euro is closer to competitive parity, it still offers no special pricing advantage that would prompt buyers to switch away from established American suppliers. On this basis, exports should continue to contribute to aggregate growth in the U.S. economy, albeit at a reduced rate, say, growing 8–10% rather than within the 14–17% range of the past three years.

Table 1. U.S. Exports of Goods and Services

Source: Bureau of the Census, Department of Commerce.
*Through April annualized.
+ Calculated from December through April and expressed at an annual rate.

The opinions in the preceding commentary are as of the date of publication and subject to change based on subsequent developments and may not reflect the views of the firm as a whole. This material is not intended to be legal or tax advice and is not to be relied upon as a forecast, or research or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. Investors should not assume that investments in the securities and/or sectors described were or will be profitable. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy or completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.

Investors should carefully consider the investment objectives, risks, charges, and expenses of the Lord Abbett funds. This and other important information is contained in each fund’s summary prospectus and/or prospectus. To obtain a prospectus or summary prospectus on any Lord Abbett mutual fund, contact your investment professional or Lord Abbett Distributor LLC at 888-522-2388 or visit us at www.lordabbett.com. Read the prospectus carefully before you invest.

Tags: American Export, Booms, Economi, Economic Output, Economic Recovery, Export Boom, Global Economy, Global Expansion, Global Financial Crisis, Global Recession, Growth Expectations, Lord Abbett, Milton Ezrati, Momentum, Pace, Percentage Points, Probabilities, Renaissance, Sustainability, World Economies, Yen
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Inside Job, Narrated by Matt Damon (Full Length HD)

Monday, July 9th, 2012

‘Inside Job’ provides a comprehensive analysis of the global financial crisis of 2008, which at a cost over $20 trillion, caused millions of people to lose their jobs and homes in the worst recession since the Great Depression, and nearly resulted in a global financial collapse. Through exhaustive research and extensive interviews with key financial insiders, politicians, journalists, and academics, the film traces the rise of a rogue industry which has corrupted politics, regulation, and academia. It was made on location in the United States, Iceland, England, France, Singapore, and China.

Inside Job, Narrated by Matt Damon (Full Length HD) from jwrock on Vimeo.

For up to date information for preparing for a financial collapse go to preppernews.net/

Tags: Academia, Academics, China Job, England, Financial Collapse, Full Length, Global Financial Crisis, Great Depression, Hd, Insiders, Jobs, Journalists, Matt Damon, Nbsp, Politicians, Recession, Singapore Job, Trillion, United States, Vimeo
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Last Month a Disaster for Commodities

Tuesday, May 15th, 2012

I went to circle back today to look at what has been among the weakest areas of the market, and chart after chart came up in the commodity space.   Here is a chart of the performance of the futures in various markets (mostly commodities) over the past month (via Finviz) and it’s a mess.  Ironically, natural gas – the most hated commodity of most of the first quarter, was the standout.  Reversion to mean trade.   Coal is not listed, but that group looks as bad as solar stocks… ironic since the latter was supposed to supplant the former at some point.

There is an in depth story on the sector in the WSJ today as well.

• Commodities fell to nearly two-year lows last week, measured by a widely used benchmark, prompting investors to ponder whether the massive rally that began in 1999 may be faltering.
• China is cooling down at the same time the U.S. is struggling to heat up, clouding the outlook for the world’s two biggest consumers. And producers of some raw materials have ramped up supplies enough to create at least temporary gluts, particularly if appetites falter.
• For more than a decade, investing in commodities was practically a sure thing. Prices rose in nine of the 12 years starting in 1999. Even down years had explanations, such as the Sept. 11 attacks in 2001 and the global financial crisis in 2008.
• On Friday, the Dow Jones-UBS Commodity Index, which tracks futures contracts for 20 basic goods, fell 1% to the lowest level since September 2010. U.S. crude oil, gold and cotton—all components of the index—helped lead the way down, as each hit fresh lows for 2012. The index is down 4% this year after a 13% drop last year, putting it on track for the first consecutive declines since 1997 and 1998.

Tags: Appetites, Commodities Prices, Commodity Index, Commodity Space, Crude Oil, Declines, Dow Jones, energy, Futures Contracts, Global Financial Crisis, Gluts, Investing In Commodities, Lows, Massive Rally, Natural Gas, Raw Materials, Sept 11 Attacks, Standout, Sure Thing, Ubs, Wsj
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The Flaws of Finance (James Montier)

Tuesday, May 15th, 2012

by James Montier, GMO

This paper is based on a speech delivered at the 65th Annual CFA Institute Conference in Chicago on May 6, 2012.

As a child, watching my parents write postcards whilst we were all on holiday was an instructive experience. My mother would meticulously write out the card, scattering a few interesting holiday tidbits within the text. My father, whose sum total of postcards sent was invariably just one (to his office), opted for a considerably more efficient approach. His method is shown at the left in Exhibit 1.

I think we can construct a similar diagram to explain the Global Financial Crisis (GFC), represented at the right in Exhibit 1. In essence, the GFC seems to have sprung from the interaction of the following four “bads”: bad models, bad behaviour, bad policies (which is really just bad behaviour on the part of central banks and regulators), and bad incentives.

In an effort to rethink finance, I want to examine each of these factors in turn, beginning with bad models. Bad Models, or, Why We Need a Hippocratic Oath in Finance

The National Rifle Association is well-known for its slogan “Guns don’t kill people; people kill people.” This sentiment has a long history and echoes the words of Seneca the Younger that “A sword never kills anybody; it is a tool in the killer’s hand.” I have often heard fans of financial modelling use a similar line of defence.

However, one of my favourite comedians, Eddie Izzard, has a rebuttal that I find most compelling. He points out that “Guns don’t kill people; people kill people, but so do monkeys if you give them guns.” This is akin to my view of financial models. Give a monkey a value at risk (VaR) model or the capital asset pricing model (CAPM) and you’ve got a potential financial disaster on your hands.

The intelligent supporters of models are always quick to point out that financial models are, of course, an abstraction from reality. Just as physicists can study worlds without frictions, financial modelers should not be attacked for trying to reduce the complexity of the “real world” into tractable forms.

Finance is often said to suffer from Physics Envy. This is generally held to mean that we in finance would love to write out complex equations and models as do those working in the field of Physics. There are certainly a large number of market participants who would love this outcome.

I believe, though, that there is much we could learn from Physics. For instance, you don’t find physicists betting that a feather and a brick will hit the ground at the same time in the real world. In other words, they are acutely aware of the limitations imposed by their assumptions. In contrast, all too often people seem ready to bet the ranch on the flimsiest of financial models.

Read the whole letter in the slidedeck below (Fullscreen for the easier read, or download)

JM_FlawsofFinance_512

Tags: Asset Pricing, Bad Behaviour, Bads, Capital Asset Pricing Model, Capital Asset Pricing Model Capm, Central Banks, Cfa Institute, Eddie Izzard, Financial Disaster, Financial Modelling, Financial Models, Global Financial Crisis, Hippocratic Oath, James Montier, Line Of Defence, National Rifle Association, Rebuttal, Sum Total, Value At Risk, Value At Risk Var
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Energy and Natural Resources Market Radar (April 30, 2012)

Sunday, April 29th, 2012

Energy and Natural Resources Market Radar (April 30, 2012)

The S&P 500 Energy Index has decreased about 8 percent over the past 12 months. This decline represents a one-sigma event in standard deviation terms. Historically, this has occurred only 18.5 percent of the time in the past 10 years. As shown in the chart below, there were only two episodes when performance was worse on a one-year rolling basis: During the 2002-2003 period and during the global financial crisis in 2008-2009 when the U.S. was in a recession. To us, the S&P 500 Energy stocks represent a buying opportunity, as adding to core positions after a correction is a prudent way to invest.

Strengths

• According to the World Steel Association, global steel production rose 1.8 percent year-over-year to 132 million tonnes in March and China produced 46.6 percent of the world’s crude steel.
• Emerging market oil fundamentals continue to improve with Indian oil demand in March higher year-over-year by 5.4 percent (175 thousand b/d) to a record high of 3.403 mb/d. Diesel demand was higher year-over-year by a strong 10.8 percent (143 thousand b/d) to 1.464 mb/d, buoyed by higher diesel penetration in automobiles and strong growth in the power sector too.
• Central bank gold buying in March was confirmed by a data release from the International Monetary Fund on Tuesday. Mexico’s central bank purchased 541,000 ounces during the month, Russia added 532,000 ounces, Turkey bought 369,000 ounces and Kazakhstan’s reserves rose by 138,000 ounces. Although the buying is not large relative to central bank purchases over the same period in 2011 (for Mexico in particular), confirmation that central banks are still net buyers should be overall positive for the market.
• According to the China Electricity Council (CEC), electricity consumption in the country grew by 6.8 percent year-over-year in first quarter 2012 to 1,166 billion kWh. Meanwhile, March’s growth rate was 7 percent year-over-year, with a decent pickup from manufacturing industry consumption at 7.6 percent year-over-year compared with 2.1 percent year-over-year for the quarter as a whole. Copper hit a three-week high on Friday as tight supplies of the metal outside China kept prices supported, although there are worries about the escalating debt crisis in Europe following a Spanish credit downgrade.
• In a sign of tightening supplies, copper inventories in LME-registered warehouses fell to their lowest levels since November 2008 at 251,825 tonnes, with cancelled warrants – the metal earmarked for delivery – at 39.5 percent of total stock. In Shanghai, copper stockpiles fell to the lowest since February to 204,762 tonnes.

Weaknesses

• World Steel (WSA) published its updated Short Range Outlook for apparent steel use. The 2012 forecast was revised down by 3.5 percent to 1,422 million tonnes. Tonnage wise, this is mainly driven by China where the 2012 forecast was revised down by 33 million tonnes, or 4.8 percent. The global revision was 51 million tonnes. The forecast for the EU-27 was revised down by 5 percent and the NAFTA estimate is up slightly by 0.6 percent. 2012 growth is expected to be 3.6 percent, down from 5.6 percent in 2011. Steel use in 2013 is expected to grow 4.5 percent. Growth in China is expected to be 4 percent both in 2012 and 2013. These forecasts from WSA regarding Chinese steel use growth are the lowest ones yet. Chinese steel usage is expected to be 45.6 percent of global usage in 2012. The EU-27 is the only region where steel use is expected to fall in 2012, by 1.2 percent.
• According to the National Development and Reform Commission, China’s crude oil output fell 1.4 percent year-over-year to 50.03 million tonnes in the first three months of 2012.

Opportunities

• Credit Suisse estimates that Chinese total oil demand will rise to 12.2 million barrels per day by 2015, up from approximately 10 million barrels per day currently and will reach 15 million barrels per day by 2020 as China’s car fleet grows to record levels.
• Japan will continue using U.S. coking coal as an alternative to major suppliers such as Australia, but for the longer term, countries such as Mozambique and Russia will play a larger role in the Asia-Pacific coking coal market, the head of Japan’s steel association said this week. Coking coal imports by Japan from its top supplier in Australia will fall sharply in April and May due to force majeure declared on April 2 by BHP Billiton Ltd. and Mitsubishi Corp. at mines they jointly own, Hayashida said. This was due to strikes and heavy rain. Japan’s imports of U.S. coking coal surged in March, rising 57 percent on the year, while its imports from Australia dropped 17 percent, government data showed.

Threat

• Peru’s miners plan to start a national strike on May 14 to protest worker layoffs at mines and refineries, said Luis Castillo, General Secretary of Peru’s Mining Federation. Miners are protesting the dismissal of workers at Gerdau unit Empresa Siderurgica del Peru SAA and Shougang Corp.’s Hierro Peru iron mine, as well as a decision by creditors to liquidate Renco Group Inc.’s zinc smelter, Castillo said. Union officials will meet for talks with President Ollanta Humala, he said.

Tags: Bank Gold, Bank Purchases, Central Banks, Core Positions, Crude Steel, Diesel Penetration, Electricity Consumption, Energy Index, energy stocks, Global Financial Crisis, Global Steel, Indian Oil, International Monetary Fund, Market Radar, Oil Demand, Power Sector, S Central, Steel Association, Steel Production, World Steel
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Keep Your Eye on Institutional Cash

Monday, April 2nd, 2012

I find the assets of institutional money-market fund, published by the Fed on a weekly basis, an extremely useful tool in determining the direction of the U.S. stock market. Institutional money-market funds comprise approximately 65% of all money-market funds but to focus on liquidity in terms of value per se may be misleading, though, as the asset allocation including liquidity of retirement funds is highly regulated. The actual liquidity of regulated funds in terms of value is therefore likely to grow in line with the overall value of retirement funds in rising stock markets.

Although not scientifically correct, I express the institutional money-market funds as a percentage of the total U.S. stock market capitalization as represented by the Wilshire 5000 Price Index as a proxy of total institutional funds to get a better picture of institutional fund liquidity, and named it the institutional liquidity ratio. In the graph below it is evident that the liquidity ratio remained virtually unchanged from 1991 to end 2000, meaning that liquidity moved in line with the broad stock market. Since the end of 2000 the face of fund management changed as five major events rocked investors: 1) the ICT bubble finally burst; 2) 9/11; 3) U.S. corporate scandals; 4) the housing bubble; 5) Lehman/great financial crisis. The events in 1, 2 and 3 took the liquidity ratio to 15% while the Lehman Saga and the subsequent global financial crisis saw the liquidity ratio peak at 35%.

Sources: FRED; I-Net Bridge; Plexus Holdings.

The value of the liquidity ratio lies in its smoothed annualized growth rate that is calculated by using linear smoothing �’ similar to how I estimate ECRI in calculating the smoothed annualized growth rate of the WLI.  When the growth rate surged in the third quarter of 2000 it indicated a change of heart by fund managers as they upped their liquidity at the cost of stocks, resulting in the ensuing bear market in stocks. When they slashed their liquidity levels in favor or stocks in the second quarter of 2003 it happened to be the bottom of the market. In 2006 the first warning signals appeared as the growth rate of the liquidity ratio turned positive. In the fourth quarter of 2007 the growth rate of the liquidity ratio jumped as institutions again favored liquidity ahead of stocks. When the growth rate of the liquidity ratio turned negative again, indicating that institutions were again favoring stocks, the downtrend in the S&P 500 since the start of 2008 was finally broken. It is also clear that the institutions have favored equities ahead of cash since then, except for a slightly positive move in the liquidity ratio’s smoothed growth in October last year.

Sources: FRED; I-Net Bridge; Plexus Holdings.

At this stage it is evident that despite calls from some of my fellow commentators that another bear market is in the offing, the institutions continue to favor stocks ahead of cash.

What I find most interesting as well is that the smoothed annualized growth rate of the liquidity ratio is more reliable than the WLI smoothed annualized growth rate. The liquidity ratio did not give the same false calls in 2010 and 2011 as the WLI did. To my mind the liquidity ratio is a comprehensive indication of institutions’ feeling towards all risk markets, while the WLI is probably a fixed weighted index of the risk markets and does not necessarily reflect institutions’ attitude towards risk assets.

Sources: FRED; I-Net Bridge; Dismal Scientist; Plexus Holdings.

I always wondered what following Robert Shiller had with his PE10 that is based on 10-year trailing earnings. Well, the following graph says it all.

Sources: FRED; Robert Shiller; I-Net Bridge; Plexus Holdings.

It is noteworthy that the liquidity ratio started to increase many weeks before the stock market’s rating was slashed at the start of 2008. That is because the institutions watch the Conference Board’s Consumer Confidence Index very closely and adjust their liquidity ratios according to the main indicator of the underlying economy! (Please note the reverse order of the liquidity ratio in the graph.)

Sources: FRED; I-Net Bridge; Plexus Holdings.

My conclusion is not to call a bear market at this stage. It does seem that the market is overextended, especially if one looks at the gap between consumer confidence and the liquidity ratio. In a recent article I also warned about the PE10 getting ahead of itself, but we could be in for a prolonged period of an overbought stock market.

Tags: Asset Allocation, Bear Market, Change Of Heart, Corporate Scandals, Fund Managers, Global Financial Crisis, Housing Bubble, Institutional Fund, Institutional Funds, Institutional Money, Liquidity Ratio, Mining, Money Market Fund, Money Market Funds, Price Index, Retirement Funds, Stock Market Capitalization, Stock Markets, U S Stock Market, Wilshire 5000, Wli
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The American Recovery, by Mohamed El Erian

Friday, March 23rd, 2012

NEWPORT BEACH – The United States has gone through an arduous period of intervention and rehabilitation since the global financial crisis in 2008 sent it to the economic equivalent of the emergency room. It moved from the intensive-care unit to the recovery room and, just recently, was discharged from the hospital. The question now is whether the US economy is ready not just to walk, but also to run and sprint. The answer will powerfully influence global economic prospects.

It is easy to forget how critical things were back in the fourth quarter of 2008 and the first quarter of 2009. Having suffered what economists call a “sudden stop,” many parts of the US economy were imploding or had ceased to function – to extend the medical metaphor, even the most vital organs were threatened.

Economic activity collapsed and unemployment surged. Credit stopped flowing. Banks were on the verge of bankruptcy and nationalization. International trade was disrupted. Income and wealth inequalities worsened. And a general sense of fear and uncertainty inhibited the few healthy parts of the economy from engaging in meaningful hiring, investment, and expansion.

Parlous conditions required dramatic measures. And that is what the economy got in the form of unprecedented fiscal stimulus and unthinkable policy activism on the part of the US Federal Reserve.

As they intervened, American policymakers consulted closely with their counterparts around the world, urging them to take supportive steps. And they did, culminating in one of the most successful periods of global policy coordination in history, involving both advanced and emerging economies.

For many, the global economic summit held in London in April 2009 marks the point when the US economy turned the corner. The change was so notable that many policymakers fell into the trap of projecting a quick rebound, especially given America’s prior history of economic dynamism and resilience, only to be humbled by what has proven to be a protracted and complex process of recovery. Even today, that process highlights the scale and scope of the economy’s structural weaknesses.

Complete Article

Copyright © Project Syndicate

Tags: American Policymakers, Dramatic Measures, Economic Activity, Economic Dynamism, Economic Summit, Emergency Room, Emerging Economies, Fiscal Stimulus, Global Economic Prospects, Global Financial Crisis, Global Policy, Income And Wealth, Intensive Care Unit, Mohamed El Erian, Nationalization, Newport Beach, Policy Coordination, Resilience, Sense Of Fear, Vital Organs
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The Three R’s of Investing

Thursday, December 22nd, 2011

The Three R’s of Investing

by Mark Seidner, Managing Director, PIMCO

• ​The inability to achieve sustainable levels of economic growth raises the risk of recession in many developed world economies.
• Under financial repression, market interest rates are kept very low for a very long time period with the hope of stimulating investment, but repression also starves savers to the benefit of borrowers.
• Increasing risk with an uncertain distribution of possible outcomes should lead to caution regarding traditional models and asset allocation practices.

Volatile and manic movements are becoming commonplace in the financial markets. The pendulum that perpetually swings between optimism and pessimism is changing direction more frequently, driven by extrapolation of the latest economic data point, political rumblings and rumors.

We are aware of the traditional three R’s that constitute the foundation of elementary education: Reading, wRiting and aRithmetic. Investors, however, should increasingly be wary of the three R’s that impact investment outcomes today and in the period ahead: Recession, Repression and Risk.

Recession
In the aftermath of the global financial crisis, PIMCO identified the forces of deleveraging, reregulation and deglobalization that act as restraints on potential economic growth for developed world economies. These are increasingly compounded by strained public sector balance sheets and political forces that tend to polarize rather than unite. The result in many countries is a lack of automatic stabilizers that are so necessary in an increasingly volatile economic environment. Normally, political forces respond to economic and financial market outcomes. In the current environment, political actions (or inactions) drive economic and financial market results. Look no further than the debt ceiling debacle and subsequent complete failure of the super committee in the United States and the inability of European leaders to make necessary progress in resolving the sovereign debt crisis.

Stubbornly high unemployment and underemployment rates, stagnant income levels and growing unrest are the consequence.

In capitalist, or market-based economies, the inability to achieve sustainable levels of economic growth that fuel virtuous cycles of spending, investment and employment growth raises the risk that vicious cycles ensue, resulting in an ever-present risk of recession.

As a result, one hears concerns for an upcoming lost decade in many developed world economies growing louder and louder.

Repression
Financial repression is a simple concept with profound implications. Under financial repression, market interest rates are kept very low for a very long time period, starving savers to the benefit of borrowers. The hope goes beyond creditors subsidizing debtors. It is also to stimulate risk-taking, investment activity and economic growth.

The best means of managing mounting public sector debt levels is to generate real economic growth. If real growth is elusive, nominal growth rates fueled by inflation above average borrowing costs will reduce debt-to-GDP ratios. Two simultaneous conditions are necessary: Growth, either real or nominal, and low government borrowing costs.

In August 2011, the Standard & Poor’s rating agency decided to downgrade the rating of United States Treasury debt from the top tier AAA to AA+. What seemed like critically important news was quickly overshadowed the following week when the Federal Reserve announced a shift in communication strategy. In every statement since March 2009, the Fed had stated that “economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.” Then on August 9, 2011, the language changed to “economic conditions…are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.”

The message to savers and investors was clear. For savers, there will be no income in bank accounts or money market funds for at least two years and likely longer. For investors, there is no means of achieving a positive real (or nominal for that fact) real rate of return on the presumed risk-free interest rate.

The market impact was immediate. The two-year U.S. Treasury note, which offered an average yield of 0.75% from March 2009 through July 2011, fell to about 0.25%.

The new commitment language is repressive to savers and low duration investors. Operation Twist, the Fed’s subsequent plan to adjust its balance sheet by selling Treasury notes with maturities less than three years and buying T-notes and T-bonds longer than six years, is repressive to all Treasury investors.

The 30-year U.S. Treasury currently yields little more than 3%. That is a fixed, nominal return with no growth potential and is eroded by any prospect of inflation. The reward does not seem compelling, and with price volatility over 20%, neither does the risk.

Risk and Implications
The continuous concern about recession and the increasing role of policymakers and other non-commercial participants in financial markets increases risks dramatically.

PIMCO frames this increasing element of risk in financial market and economic outcomes in the probabilistic context of a normal distribution, one that now has a flatter distribution of potential outcomes with fatter tails.

At PIMCO, we constantly ask questions in order to anticipate the full range of potential developments. Key questions include: What if the concept of a change in the distribution of expected outcomes does not go far enough? What are the implications of an environment characterized by a more pronounced set of outcomes exhibiting markedly distinct and contrasting forms? How should investors respond in an environment where what is considered an average outcome or expectation becomes the least probable event and the rare becomes commonplace?

Uncertainty and volatility can be paralyzing, and understandably so. But rather than become frozen with fear, now is the time to recognize regime change and consider making structural modifications.

The heightened risk of recession increases the importance of a strong balance sheet as volatile economic outcomes will likely have a magnified impact on the success and failure of countries, companies and individuals. In the near term, investment success will largely be defined as avoiding the risk of permanent principal loss by stress testing across meaningful possible tail events. Differentiated outcomes and failure are a near certainty. Capitalizing on distressed situations – most likely first in Europe and then elsewhere – will differentiate investment results over a longer time horizon.

Repression requires a keen focus on income, particularly in a world where aging demographics increase the need for known cash flow when traditional sources such as government bonds do not suffice.

Increasing risk with an uncertain distribution of possible outcomes should lead to caution regarding traditional models and asset allocation practices. A significant element in the investment management industry is built on the notion of a normal distribution. If the shape or characteristics of the distribution are questioned, then many related concepts – such as mean reversion and rebalancing – must also be questioned. Price change is not nearly sufficient as a signal for portfolio action. Price analysis accompanied by fundamental outlook is necessary.

Portfolios constructed with a carefully selected and diverse set of return drivers, a focus on income and a forward-looking approach to risk management may be able to avoid the pitfalls of the three R’s and increase the probability of navigating an increasingly uncertain economic and financial market environment.

Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. The credit quality of a particular security or group of securities does not ensure the stability or safety of the overall portfolio. Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions, and each investor should evaluate their ability to invest for the long-term, especially during periods of downturn in the market.
This material contains the current opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. ©2011, PIMCO.

Tags: Asset Allocation, Automatic Stabilizers, Debt Ceiling, Education Reading, Elementary Education, European Leaders, Extrapolation, Financial Repression, Global Financial Crisis, Impact Investment, Manic Movements, Market Interest Rates, Market Outcomes, Optimism And Pessimism, Political Actions, Rumblings, Sustainable Levels, Traditional Models, Volatile Economic Environment, World Economies
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