Posts Tagged ‘Investment Outlook’
Saturday, August 11th, 2012
The Solution…is the Problem, Part II
When we wrote Part I of this paper in June 2009, the total U.S. public debt was just north of $10 trillion. Since then, that figure has increased by more than 50% to almost $16 trillion, thanks largely to unprecedented levels of government intervention.
Once the exclusive domain of central bankers and policy makers, acronyms such as QE, LTRO, SMP, TWIST, TARP, TALF have found their way into the mainstream. With the aim of providing stimulus to the economy, central planners of all stripes have both increased spending and reduced taxes in most rich countries. But do these fiscal and monetary measures really increase economic activity or do they have other perverse effects?
In today’s overleveraged world, greater deficits and government spending, financed by an expansion of public debt and the monetary base (“the printing press”), are not the answer to our economic woes. In fact, these policies have been proven to have a negative impact on growth.
While it hasn’t received much attention in recent years, a wide body of economic theory suggests that government policies and their size relative to the total economy can have a significant detrimental impact on economic growth. A recent paper from the Stockholm Research Institute of Industrial Economics compiles evidence from numerous empirical studies and finds that, for rich countries, there is overwhelming evidence of a negative relationship between a large government (either through taxes and/or spending as a share of GDP) and economic growth.1 All else being equal, countries where government plays a large role in the economy tend to experience lower GDP growth.
Of course, correlation does not imply causation. While the literature is not definitive on causation, it still provides strong evidence that more taxes and government spending as a share of GDP (except for productive investments such as education) is associated with lower growth.
One exception to these findings is the experience of Scandinavian countries. They have both high taxes and high government spending as a share of GDP but have experienced relatively rapid growth over the past 20 years. However, a significant share of their spending goes to education, which has been found to foster growth. They also counterbalance the large role of the state with very liberal, pro-market reforms and low levels of public debt.2
Debt overhang and economic growth
Even if one believes that temporary Keynesian-type fiscal stimulus, in the form of tax breaks and increased government spending, can spur growth in the short-term, these actions inevitably lead to larger deficits and higher government debt (see July 2010 Markets at a Glance, “Fooled By Stimulus”). As Figures 1 and 2 below show, the U.S. Federal Government deficit and debt levels are already at their highest levels since the end of World War II and the scope of future stimulus appears to be rather limited. According to our projections (which assume there will be no fiscal cliff), the U.S. federal debt will increase significantly as the deficit remains sustained and elevated. For many European countries the situation is even worse.
FIGURE 1: U.S. DEFICIT AS A SHARE OF GDP
FIGURE 2: U.S. DEBT-TO-GDP*
Source: The White House: Office of Management and Budget (OMB) and Sprott Calculations
*For reasons discussed in May 2009 Markets at a Glance The Solution … is the Problem, Part 1, we show total federal debt subject to the debt ceiling.
High levels of debt, or debt overhangs, cause more problems. Recent work by Carmen Reinhart and Kenneth Rogoff (Harvard University) demonstrates that banking crises are strongly associated with large increases in government indebtedness, long periods of unemployment and, ultimately, some form of default. They identify a threshold of 90% debt-to-GDP as the trigger to a debt crisis.3 As shown in Figure 2, the U.S. has already passed that threshold.
The historical evidence shows that countries with large governments and high levels of debt have on average, achieved lower economic growth. Given the already high level of debt and deficits in most developed countries, it is doubtful that increased fiscal stimulus will really help the recovery. It’s clear that debt is the problem and the solution does not lie in piling on even more of it. The current debt situation, coupled with the increasing lack of transparency of politically motivated regulations and interventions, leaves little room for a healthy deleveraging of our economies. Here is what central planners have in mind.
Debt overhang resolution and implications for the future
Througout history, high debt-to-GDP ratios have been resolved through five channels:4
- Economic growth
- Sudden bursts of inflation
- Steady financial repression and inflation
Clearly, number one and two are not working right now and, in some European countries, are actually negatively reinforcing each other. The U.S. is facing its homegrown fiscal cliff and political polarization makes its resolution doubtful. Number three seems politically unacceptable for rich, developed nations, which see default as the realm of developing countries. Sudden bursts of inflation are hard to contain and work only so many times as investors, assuming a normal bond market, demand higher interest rates to compensate for inflation risk. Moreover, with interest rates already, at zero it seems that we are left with number five: steady financial repression and inflation. This terminology was first introduced in the early 1970s by Edward Shaw and Ronald McKinnon, both from Stanford University.5
They define financial repression as:
- Explicit or indirect caps or ceilings on interest rates
- The creation and maintenance of a captive domestic audience (i.e.: forced holdings of government debt by financial institutions and pension funds)
- Direct ownership of financial institutions and/or entry restriction in the financial industry (i.e.: China, India)
We are clearly living through a period of financial repression. The symptoms include:
- Artificially low interest rates in most of the G20 countries and commitments to keep them low for long periods of time combined with inflation, which results in negative real interest rates
- Large expansion of central banks’ balance sheets through the purchase of government bonds
- Basel III liquidity rules which force banks to hold more government debt on their balance sheets6,
- Newly nationalized banks in many countries (UK, Ireland, Spain, etc.), which have drastically increased their holdings of government debt
- and it will bet worse…
Figure 3 below shows that financial repression can be observed within the holdings of U.S. financial institutions and pension funds, which have steadily increased their holdings of U.S. Treasuries since 2009.
FIGURE 3: HOLDINGS OF U.S. TREASURY SECURITIES BY DOMESTIC FINANCIAL INSTITUTIONS
Source: Federal Reserve Flow of Funds
It’s clear that governments are preparing for more. A key component to erasing government debt through inflation is extending the duration (maturity) of one’s outstanding bonds. In a normal bond market, negative real interest rates make it difficult to roll over short-term debt at low borrowing rates (although financial repression and captive financial institutions certainly help to keep rates lower than they normally would be). Due to this tendency for short-term rates to rise with inflation, however, it is in the best interests of highly-indebted countries to issue the majority of their bonds at the long end of the yield curve. As Figure 4 shows, the US Treasury is proactively planning to increase the maturity of its outstanding debt (green line) in order to maximize its benefit from inflation erosion. In other words, they are capitalizing on the current flight to safety to set the stage for further financial repression down the road. The same is true for the U.K., which benefits from one of the longest weighted-average maturity of debt in the developed world. For Eurozone countries to do away with their current debt overhang they will either have to default (the least preferred option for political reasons) or use the good old combination of steady inflation and financial repression (feared by the Germans and the ECB central planners).
FIGURE 4: U.S. TREASURY WEIGHTED AVERAGE MATURITY OF MARKETABLE DEBT
Source: U.S. Treasury Office of Debt Management, Fiscal Year 2012 Q1 Report
On both sides of the Atlantic, the largest contributors to the current crisis are excessive debt and spending. We are now at a point where additional government stimulus measures will have negligible, if not detrimental effects on the economy and long-term growth. Debt has to be reduced, not increased by more deficits. Central planners have demonstrated that they don’t have the discipline to implement the Keynesian model of surplus in good times in order to finance deficits in bad times. We have now reached the limit of indebtedness and need to muddle through a painful but necessary deleveraging.
The politically favoured option of financial repression and negative real interest rates has important implications. Negative real interest rates are basically a thinly disguised tax on savers and a subsidy to profligate borrowers. By definition, taxes distort incentives and, as discussed earlier, discourage savings. Also, financial institutions, which are traditionally supposed to funnel savings towards productive investments, are restrained from doing so because a large share of their balance sheets is encumbered by government securities. The same is true for pension funds, which instead of holding corporate paper or shares, now hold an ever growing share of public debt. Pensioners, who are also savers, get hurt in the process.
The current misconception that our economic salvation lies with more stimulus is both treacherous and self-defeating. As long as we continue down this path, the “solution” will continue to be the problem. There is no miracle cure to our current woes and recent proposals by central planners risk worsening the economic outlook for decades to come.
1 Bergh, A., Henrekson, M. (2011): “Government Size and Growth: A Survey and Interpretation of the Evidence”, Research Institute of Industrial Economics, IFN Working Paper No. 858, April 2011.
2 Bergh, A., Karlsson, M., (2010): “Government Size and Growth: Accounting for Economic Freedom and Globalization”, Public Choice 142 (1–2): 195–213.
3 Reinhart, C., Rogoff, K. (2010): “From Financial Crash to Debt Crisis”, National Bureau of Economic Research, NBER Working Paper #15795, March 2010. Reinhart, C., Rogoff, K. (2011): “A Decade of Debt”, National Bureau of Economic Research, NBER Working Paper #16827, February 2011. Reinhart, C., (2012): “A Series of Unfortunate Events: Common Sequencing Patterns in Financial Crises”, National Bureau of Economic Research ,NBER Working Paper #17941, March 2012.
4 Reinhart, C., Sbrancia, B. (2011): “The Liquidation of Government Debt”, Bank of International Settlements – Monetary and Economic Department, BIS Working Paper #363, November 2011. Reinhart, C., Reinhart, V., Rogoff, K. (2012): “Debt Overhangs: Past and Present”, National Bureau of Economic Research ,NBER Working Paper #18015, April 2012.
5 McKinnon, R., (1973): “Money and Capital in Economic Development”, Washington DC: Brookings Institute. Shaw, E., (1973): “Financial Deepening in Economic Development”, New York: Oxford University Press.
6 Bordeleau, E., Graham, C., (2010): “The Impact of Liquidity on Bank Profitability”, Bank of Canada Working Paper, WP#2010-38, December 2010.
Tags: Central Planners, Detrimental Impact, Economic Theory, Economic Woes, Empirical Studies, Eric Sprott, GDP Growth, Government Intervention, government spending, India, Industrial Economics, Investment Outlook, Monetary Base, Monetary Measures, Negative Relationship, Overwhelming Evidence, Perverse Effects, Productive Investments, Public Debt, Rich Countries, Sprott, Unprecedented Levels
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Tuesday, August 7th, 2012
August 6, 2012
The Wall Street Journal published an article on August 1 headlined: “Bill Gross: Equities are Dead.” In fairness to Gross, what he actually wrote in his August “Investment Outlook” was, “the cult of equities is dying.” We agree with most of Gross’s argument—but not with his unsupported forecast of extremely low stock returns.
Let’s take a look at Gross’s claims:
1) Gross notes that bonds have outperformed stocks for the last 10, 20 and 30 years. With long US Treasuries currently yielding 2.7%, it is unlikely that bonds will replicate the performance of decades past.
We agree. That is why stocks are attractive today relative to bonds. Bonds—having outperformed—are now unusually expensive and have low expected returns going forward. By contrast, stocks—having performed poorly—are cheaper than normal and are likely to significantly outperform bonds over the next 10 years.
2) Gross argues that US stocks can’t maintain their 6.6% average annualized real return over the last 100 years. The 6.6% real equity return was 3% higher than real GDP growth, with shareholders gaining at the expense of labor and government. Labor and government must demand some recompense for wealth creation, and GDP growth itself must slow due to deleveraging.
We agree. We are now in a lower return environment. The question is, how low? Let’s concede that stocks will grow in line with real GDP. Over the long haul, real GDP growth primarily reflects population (growing a little over 1%) and productivity (growing just above 2%). That would give us a projected real equity return of maybe 3%—less than half the historical 6.6% rate.
3) Gross asserts that stocks will have a nominal return of 4%.
This is where Gross’s math gets fuzzy. Why this sudden switch to nominal instead of real returns? Does Gross expect that US population will shrink, productivity gains will disappear, and inflation will remain quiescent forever? That is what needs to happen for long-term nominal GDP growth to be as low as 4%. The scenario is possible, but hardly likely. Just assuming that inflation runs at a relatively tame 3% with below-normal real GDP growth of another 3%, we’d have nominal equity returns of 6% or so. That looks quite attractive when you get just 2.7% for holding long bonds to maturity.
In our recently published paper “The Case for the 20,000 Dow,” we show that with reasonable assumptions we can get returns in the 6% to 7% range and that the Dow hits that target in five to 10 years. We will also lay out our argument in an upcoming blog post.
Most investors today are very concerned about equity volatility, and for good reason. But there is another risk that should concern investors: the risk that their investments will not keep up with inflation and meet their goals. As investors balance short-term market risk against the long-run risk of falling short of their objectives, we think an appropriate allocation to equities continues to improve the likelihood for success.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.
Seth J. Masters is Chief Investment Officer of Asset Allocation and Defined Contribution Investments at AllianceBernstein and Chief Investment Officer of Bernstein Global Wealth Management, a unit of AllianceBernstein.
Tags: Alliancebernstein, August 1, Bill Gross, Bonds, Equity Return, Fairness, GDP, GDP Growth, Government Labor, inflation, Investment Outlook, Productivity Gains, Real Gdp, Recompense, Seth, Stock Returns, Treasuries, Wall Street Journal, Wealth Creation
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Thursday, July 5th, 2012
Investment Outlook, July 2012
What’s In A Name?
by William H. Gross, PIMCO
- Not only banks and insurance companies but sovereign nations as well cannot all be counted on to guarantee a return of principal, let alone a return on investment.
- An authentic debt crisis – which the world is now experiencing – can only be ultimately cured in two ways: 1) default on it, or 2) print more money in order to inflate it away.
- There are very few clean dirty shirts in this world. Timing in investment markets is critical and at the moment the U.S. is considered to be the cleanest.
What’s in a name? I wish I’d asked my parents how they came up with mine, because I’ve never really been a good “Bill.” That is not to say that I’m uncomfortable in my own skin – I usually am – but I’ve never really been at ease with the name. Perhaps it’s genetic because the discomfort seems to run in the family. Who could blame my father I suppose for insisting on “Dutch” as opposed to Sewell Gross the IV! Imagine: a nameological tyranny of four successive Sewells! It ended with him, but then there was my brother Craig who insisted on Chip and my sister Lynn who in her fifties changed her name to Lyn. At least I didn’t have to worry about calling her by the wrong name, although I have boo-booed on birthday cards. In any case, we Grosses seem to dislike our names.
Having kids, however, allowed me to set the record straight or at least mutate those genes which kept rejecting given names that seemed appropriate to parents, but not to Gross progeny. My first attempt at cracking the code came with my first son, Jeff. I liked “Jeff.” It was short, masculine and was the first name of a Duke basketball star in the 1960s. I’d be a better Jeff than a Bill. Next up was Jennifer, whose name came from a Donovan number one hit song and then there was Nick. Nick was actually Sue’s favorite name, but I easily conceded. Who couldn’t like Nick? Saint Nick, just in the Nick of time, Nick, Nick, Nick. I would’ve been a good Nick.
Now at 68, however, I’ve run out of naming opportunities which has caused me to begin to nitpick my last name. I mean there are Smith(s) because their occupational heritage was presumably a craftsman, and Johnson(s) who were the sons of John, but Gross? What’s a Gross? A Gross, as it turns out, is twelve dozen or 144. Numerology is not my bag, but the frequency of this number’s occurrence is more than eerie. My first home was on 14401 La Mancha and my home for the last 25 years has been 144 Seabring Way. I was born in 1944, the 144 in this case being necessarily interrupted by a centurion digit. In addition, while my birthdate was 4/13 instead of 4/14, my mother always informed me as mothers do, that I was born at 9:36 p.m. which I only recently calculated to be 144 minutes short of the 4/14/44 date. Very strange.
Gross also means “big” in German and was adopted by the English with an E on the end as in Grosse Point, Michigan. Neither of those connections disturbs me, nor does the expression “how gross.” I always sort of shrugged and told myself to get over it. What bothers me most about it though is that I keep getting advertising pamphlets in the mail from Jewish mausoleums. Seems like half the Grosses in the world are Christian and half are Jewish. The Christians don’t seem to be concerned about my hereafter, but the followers of the Jewish faith do. For that I’m thankful, but I’d prefer not to be reminded of my impending doom, so at 68 I wish I wasn’t a Gross. Not a Bill, not a Gross – go figure. What’s in a name?
7% returns out of reach
Mayor Michael Bloomberg in a February trip to his state capital to discuss pension funding told a legislator that “if I can give you one piece of financial advice, it’s: If somebody offers you a guaranteed 7% on your money for the rest of your life, you take it and just make sure the guy’s name isn’t Madoff.” So names, it seems are important to others outside the Gross family and I probably should hold off changing the “Bill” and even the “Gross” if only because it’s not Madoff. That 7% return though – I’m not sure it’s possible in this era of the New Normal where negative real rates on Treasuries and its incumbent financial repression dominate bond and asset markets alike. Aside from the 7% return expectation however – which many pension funds and liability structures assume at a bare minimum – what struck me about the Mayor’s comment was the assumption that there were legitimate guarantors of investment returns throughout the world. Even assuming that Madoff and his Ponzi lookalikes are now under lock and key, recent events have shown that not only banks and insurance companies with their presumed “money good” guarantees, but sovereign nations as well cannot all be counted on to guarantee a return of principal, let alone a return on investment that comes anywhere close to matching 7% in nominal terms. What does Greece tell us if not that money, credit and financial investments dependent on ever expanding growth of credit are sometimes subject to buzz cut defaults with scalp level clippers, as opposed to a trimming of the bangs with haute couture scissors. 7%? Greek, Spanish and almost all non-Germanic Euroland bond investors would be happy for much less – they’d request a modern day Will Rogers haircut, which was defined in the 1930s when he said, “I’m more concerned about the return of my money than the return on my money.” Trillions of global investment dollars, Euros and Yen would settle for just that if they could only reclaim their prior investments at par, and then silently deposit them in a mattress for safekeeping.
Debt crisis can’t be cured with more debt
What global investors, fixated on historical cyclical trends as opposed to secular delevering dynamics fail to appreciate is that economies and their financial markets historically have taken several decades as opposed to several years to renormalize once the fatal grip of too much debt wreaks havoc on the assumed perpetuity of capitalism’s prosperity machine. Can a debt crisis be cured with more debt? Yes, if initial debt levels are reasonable and central banks are able to rejuvenate the delicate dance between debtor and creditor – each believing that they are getting a good deal in terms of risk, reward and the deployment of funds between now and some future maturity. But when debt as a percentage of GDP, or debt service as a percentage of household income, or the appropriateness of the term structure (short vs. long) on both borrower and lender balance sheets becomes imbalanced, then the well-oiled capitalistic engine may sputter and in some cases – as in Greece – freeze up. That’s when a debt crisis can’t be cured with more debt, be it in the form of QEs or LTROs, or implicit firewalls created or to be created by Eurobonds, ESMs, the IMF or any other agency that presumably is money good. The fact is that the current burden of global debt is only being lightly alleviated via zero-bound interest rates. None of it, other than Greek PSI or minor amounts of private U.S. mortgage debt has been extinguished over the post-Lehman era; it has only been transferred from one pocket to another. Banks, insurance companies and mutual funds have passed the peripheral Old Maid from their hands to that of the ECB, or to Spanish and Italian banks, and ultimately on to the German core. Does it matter that Greece decides to stay with the Euro or that the Southern peripherals move towards austerity, or that the U.S. in November decides to go Red or Blue? Not much. Solutions for real growth matter only at the margin. An authentic debt crisis – which the world is now experiencing – can only be ultimately cured in two ways: 1) default on it, or 2) print more money in order to inflate it away. Both 1 and 2 are poison for bond and stock holders, which is why 7% returns – guaranteed or not – are so comical.
In search of those mythical returns, investors have shifted both bond and equity funds into what we at PIMCO call the “cleanest dirty shirt” countries. Not content to wallow in the mud of the southern Euroland PIGS despite their (coincidentally) 7% yields, investors have preferred 0% 2-year German Schatz or almost as ridiculous 0% 30-year U.K. linkers under the assumption that their principal at least will be “guaranteed.” For 30 years though, U.K. investors will guarantee themselves a return at or below their future purchasing power. Mayor Bloomberg it seems has a Sophie’s Choice – 7% with debt–laden, mud-caked Spanish polo shirts or 0% with bleached but still stained knock-offs. His Honor – and all other investors – must decide if as Shakespeare posed “a rose is a rose by any other name.” Is a clean dirty shirt a dirty shirt by another name? And if not, in the midst of a global debt crisis can there actually be such a thing as a clean dirty shirt that justifies near 0% yields? The fit, it seems, may be a tad tight the closer bonds get to zero.
Is the U.S. shirt really clean?
This observer must obviously admit – as do rating services – that some countries are better than others. Those with initial debt conditions that don’t exceed historical norms, those that can print and issue debt in their own currencies, those that have reasonable trade balances, those that emphasize the sanctity of property rights, those that dominate the global military stage, those with innovation and education, those…. I could go on. Many of the above conditions point investors to the ultimate “safe haven,” the cleanest of the dirty shirts, the champion of champions, rose of all roses – the United States. I will not dispute it, market movements have confirmed it and my own experience in 2011 is a testament to it. Don’t underweight Uncle Sam in a debt crisis. Money seeking a safe haven will find it in America’s deep and liquid (almost Aaa rated) bond and equity markets.
Yet there may come a time when the king adorned in his clean dirty shirt may be redressed or perhaps undressed to reveal he has no clothes – just like Greece – just like many or most of the rest of them. The chart below shows America’s debt/GDP which at close to 100% is not near-term threatening, but if continued upward on trend could be absolutely debilitating. 7-8% annual deficits while alleviated and tempered by the financing of them with negative real interest rates, promise to raise that 100% number to 125% within five years if nothing is done. Yet as stunning and as Greek-like as that percentage is, it comes nowhere close to the actual liabilities of the U.S. government that represent promises nearly as sacrosanct as the interest and principal on a 30-year Treasury. Social Security, Medicare and Medicaid liabilities when measured on the same present value basis as our current $15 trillion of outstanding debt, total four times as much: $66 trillion according to unbiased, non-political, Office of Management and Budget (OMB) estimates of future liabilities. In addition, studies estimated the unfunded liabilities of state and local governments at an additional $38 trillion. All together they would accelerate the line in chart 1 to 800% of GDP. And we look down on the Greeks?
Mayor Bloomberg was on to something when he told Albany legislators to look for anyone or any firm with a name other than Madoff to seek out their vaunted 7%. What he didn’t say is that our U.S. President – past, present and future – heads a financing scheme that has similar characteristics. Think of the U.S. balance sheet with its $66 trillion dollars of liabilities as one giant PIK bond – Payment In Kind. The corporate bond market has PIKs although they tend to be junk market rated. Instead of paying actual current interest they promise to pay future bills with more and more bonds – payment in kind. That’s what Social Security ($8 trillion) is; that’s what Medicare is ($23 trillion); and that’s essentially what Medicaid is ($35 trillion) although the latter is appropriated annually and therefore disguised as an actual debt. U.S. Treasuries are one giant PIK bond that can only partially be paid off under assumptions of Old Normal 3% real growth rates, or check writing by the Federal Reserve that inflates away the debt and a bondholder’s real principal at the same time.
So Mr. Mayor, I would tell investors this: There are very few clean dirty shirts in this world. Timing in investment markets is critical and at the moment the U.S. is considered to be the cleanest. That’s why PIMCO owns them. But things change. A blossoming rose wilts over time. A good name can be slandered, a great opportunity to change fiscal direction squandered within a few short years. This debt crisis should be considered global as opposed to regional, and investors should recognize that clean dirty shirts are not forever thus. Over time, they may have to change their name, their rating, or at least their reputation as a clothes horse.
William H. Gross
All investments contain risk and may lose value. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk; investments may be worth more or less than the original cost when redeemed. Equities may decline in value due to both real and perceived general market, economic, and industry conditions. Sovereign securities are generally backed by the issuing government, obligations of U.S. Government agencies and authorities are supported by varying degrees but are generally not backed by the full faith of the U.S. Government; portfolios that invest in such securities are not guaranteed and will fluctuate in value. The credit quality of a particular security or group of securities does not ensure the stability or safety of an overall portfolio. The Quality ratings of individual issues/issuers are provided to indicate the credit worthiness of such issues/issuer and generally range from AAA, Aaa, or AAA (highest) to D, C, or D (lowest) for S&P, Moody’s, and Fitch respectively.
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. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Pacific Investment Management Company LLC.
Copyright © 2012, PIMCO
Tags: Basketball Star, Bill Gross, Birthday Cards, Brother Craig, Cracking The Code, Debt Crisis, Dirty Shirts, Duke Basketball, Gross Investment, Investment Markets, Investment Outlook, Nick Nick, Nick Of Time, Own Skin, Return On Investment, Saint Nick, Sewell, Sewells, Sister Lynn, Sovereign Nations, Time Nick, William H Gross
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Sunday, June 10th, 2012
The Absolute Return Letter
First Mover Advantage
“The problem with socialism is that you eventually run out of other people’s money.”
- Margaret Thatcher
Bubble? What bubble?
Sometimes I wish I could have a second go at my writing. Last month, and not for the first time, I realised that what had seemed pretty clear and unequivocal to me was misunderstood by many readers. More specifically, I am referring to the concluding remarks in last month’s Absolute Return Letter where I stated that Asia has the potential to become a re-run of Europe. My argument was based on the simple but undeniable fact that policy rates are well below where they ought to be when taking into consideration the overall level of economic activity and inflation (the so-called Taylor rule).
Those comments were interpreted by many readers as if I expect an imminent crisis in Asia of the sort we currently suffer from in Europe. Nothing could be further from the truth. Allow me to explain:
Following the introduction of the euro, Spain and Ireland, and to a lesser degree Portugal, experienced an enormous construction-led economic boom which was the direct consequence of easy access to cheap capital. The ECB was certainly aware of the potential problems this might create down the road; however, it had no choice but to set the policy rate at a ‘one size fits all’ level, and the German economy badly needed some stimulus back in the early stages of the euro era. By choosing to support the weakest link in the chain, the ECB had effectively sown the seeds of a bubble which would blow up almost a decade later.
There are at least two lessons to be learned from that experience, the first one being that bubbles take a long time (as in many years) to build up and, in the meantime, there is usually a great deal of money to be made. Secondly, when the ECB responded to the bursting of the dot.com bubble, as most central banks did in 2001-02, the law of unintended consequences kicked in. By their very nature, bubbles create echo bubbles. What is currently happening in Asia – and I throw in Australia for convenience – could very well turn out to be an early to mid stage echo bubble.
I had been planning on writing on the topic of Asia in much more detail this month, partly to clarify my views expressed in last month’s conclusion (which I hope I have accomplished now) but also to address some of the nearer term issues Asia is facing. Then things in Europe got out of hand again, following the Greek elections, so Asia will have to wait until next month.
As a primer to next month’s letter, I couldn’t resist the urge to throw in just one chart, produced by the great economist and blogger Steve Keen from Down Under. Steve has produced a long term chart of Australian versus US property prices (see chart 1 below and the whole paper here). Steve finds it outright comical that Australians are in complete denial as to where they are in the property cycle. Bubble? What bubble? Much more on this topic next month.
It is a banking crisis idiot!
Now back to Europe. The eurozone crisis has always been a banking crisis. It only morphed into a sovereign crisis because of political incompetence. Solve the banking crisis and you have solved the euro crisis. That is my prediction. On the other hand, as long as the Germans continue to say Nein to pretty much anything that anyone puts on the table, we are still a long way away from solving the crisis. Only a few days ago Angela Merkel reiterated her rejection of the idea of mutualising eurozone sovereign debt. The proposal came from SPD, the major opposition party in Germany, with the idea being that all eurozone debt within 60% debt-to-GDP should be mutually guaranteed. However, Merkel said Nein. Again.
Tags: Absolute Return, Central Banks, China, ECB, Economic Activity, Economic Boom, Enormous Construction, First Mover Advantage, German Economy, Imminent Crisis, Introduction Of The Euro, Investment Outlook, Margaret Thatcher, Niels Jensen, Stimulus, Taking Into Consideration, Taylor Rule, Undeniable Fact, Unintended Consequence, Weakest Link, Weakest Link In The Chain
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Friday, June 1st, 2012
by Rob Arnott, Research Affiliates (RAFI)
Imagine a boss who is generally supportive of your efforts, but has some odd tendencies around rewarding initiative. Let’s call him Mr. Market.1 Every time you go in for your annual review, Mr. Market gives you a raise which is usually 1% or 2% above inflation, and asks, “Whaddya think?” If you’re “passive” and take whatever Mr. Market offers, you wind up with a steady but modest increase in your income, year after year, assuming the company is still doing well. Mr. Market, however, does not view all projects equally. If you offer to take over some project that he hates, he boosts your raise by an average of 3–6%. With a little initiative, you can triple the average real raise—over and above inflation—that everyone else is getting.
Unfortunately, Mr. Market is also bipolar, with wide mood swings. If you’re willing to take on a project that he really hates, he may give you a 15% raise, just to get it off his desk. On the other hand, if you’re taking a project that he doesn’t much mind doing, he may actually take away some of the normal raise. Because you run this risk every time you propose to take on a new project, it takes a modicum of courage to make these offers to the boss.
With a boss like Mr. Market, what is the right strategy for success? The answer is obvious: You need the courage to stick with the profitable strategy through the good times and the tough times. We’ll come back to Mr. Market shortly. First, we need to understand the true nature of wealth, income, and spending. Sustainable Spending as a Strategy Although people tend to measure wealth in terms of the dollar value of a portfolio, we believe it is better to measure wealth in terms of the real spending that the portfolio can sustain over the entire life of the obligations served by the portfolio. In 2004, we coined the expression “sustainable spending,” to gauge this true value of a portfolio.2 Jim Garland used the term “portfolio fecundity,” to describe much the same concept.3
Consider a simple thought experiment. It’s a bull market. Prices double on everything we own, while the dividend yield drops in half. Are we better off? The long-term spending that the portfolio can sustain hasn’t changed a bit. In 1997, Peter Bernstein and I4 pointed out that bull markets are actually very bad news for those who are net savers, building a portfolio to fund future needs, because it costs more to buy the same real income stream (a very crude measure of sustainable real spending5) after the bull market than before. We’re better off only if we’re spending from the portfolio immediately, not saving more for the future!
Many people felt jubilation at the peak of the tech bubble, because they felt so wealthy. And they were—as long as they were inclined to liquidate their holdings and spend before the market lost its euphoria. If they were still investing (e.g., for some future retirement), those new purchases bought precious little yield! Reciprocally, people felt panic and dismay at the 2009 trough of the financial crisis, because they felt as if their assets had been wiped out. And they were—if they intended to liquidate and spend their assets immediately. But, for the buyand- hold investor, their real income was higher than at the 2007 peak!
None of this is unfamiliar to the serious student of capital markets. So, what lessons can the thoughtful observer learn from “sustainable spending”? In the following discussion, we find bear market drawdowns have little impact on sustainable spending. Indeed, these sell-offs provide opportunities to increase our sustainable spending through disciplined rebalancing between asset classes or within asset classes, especially volatile ones like equities.
This requires courage: “no guts, no glory.”6
What is Wealth?
Ben Graham liked to distinguish between a temporary loss of value and a permanent loss of capital. The former is a rebalancing opportunity; the latter is a disaster. In a highly diversified portfolio where all the idiosyncratic risk has been diversified away, the latter is extremely rare. At some time during the 20th century, the stock markets of Argentina, Russia, Germany, Japan, China, and Egypt each went essentially to zero. Suffice it to say those investors had much bigger things to worry about than their stocks! Temporary losses of value are frequent; at times they can become so frightening that they become permanent—for those that sell. Through the lens of sustainable spending, these losses are far less severe. Table 1 illustrates the 10 bear markets larger than 30%, in real total return, in the past century. These aren’t as rare as most people think! The average loss is a horrific 46% real return loss (including dividends, but before taxes). Our nest egg is chopped in half, usually in less than two years. That’s awful… for anyone who wants to spend all of their money at the trough.
For those focused on the spending power of the portfolio, most of these monster bear markets were surprisingly boring. The peak to trough decline in real dividend distributions was a scant 3% drop, on average. Even in the Great Depression, real dividend distributions fell by “only” 25%. Of course, the drop was worse in simple nominal terms, because we had deflation. A 25% cut in real spending power on our portfolio, while very unpleasant, was small relative to the 80% real loss of portfolio value… and it was temporary. This 25% drop in our real spending power was the single worst outlier in a century.
On average, real sustainable spending sagged slightly during these 10 worst bear markets, then recovered massively, on average by 35%, off of their lows just five years after the market trough. In almost every case, our real distributions also achieved new highs, relative to our pre-crisis spending, besting the dividends of the previous market peak by an average of 29%! Keep in mind that this is the increase in real dividends, not just nominal payouts.
For those focused on the level of real spending, rather than the level of prices, the worst market downturns in U.S. history were mostly brief bouts of minor disappointment. The results in the recent Global Financial Crisis bear a special mention. While U.S. stocks tumbled by 51%, the real dividends distributed by the S&P 500 Index grew by 4%. To be sure, the real dividends have given up that 4% gain in the subsequent three years. But, from the perspective of spending power, these past 4½ years have been utterly boring and benign! For the buy-and-hold investor, bear markets aren’t nearly as bad as they seem. Massive market corrections disproportionately impact market prices versus spending power. But our proposed shift in our focus—drawing attention away from the value of our portfolio toward the spending power it can sustain— requires real courage: courage to ignore headlines, our brokerage statements, and our natural human instincts to sell.
Return on Courage
Now suppose we have the nerve, not only to focus on our real sustainable spending, but also to seek to increase our real sustainable spending in market downturns! If we rebalance into higher yielding assets after they’ve cratered, presumably funded from assets that have performed much better, we can systematically ratchet our sustainable spending ever higher. This ground is amply explored in asset allocation literature. Indeed, the essence of Tactical Asset Allocation (TAA) is an effort to rebalance into investments when they become most uncomfortable, and are therefore priced with a superior risk premium, to reward those who are courageous enough to invest at such times.
Even a mechanistic rebalancing policy would have compelled a trade from stocks into bonds at the peak in 2000. The trend-chasers who bought stocks at the peak, let alone buyers of high-flying growth or tech stocks, may not live long enough to be wealthier than their contrarian friends who bought ordinary Treasury bonds at that same time. They funded the success of TAA managers and strategies. Conversely, in 2009, a disciplined rebalancing strategy compelled us to buy “Anything but Treasuries.” Treasuries had dipped to the lowest yields seen in three generations. At the same time, almost anything else offered generous future spending, with many markets priced at near-record yields. Still, this was a very frightening trade.
Tags: Bipolar, Boss, Courage, Dollar Value, Expression, Good Times, inflation, Initiative, Investment Outlook, Market 1, Modicum, Mood Swings, Profitable Strategy, Rafi, Research Affiliates, Rob Arnott, Tendencies, Tough Times, True Nature, Wealth Income
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Thursday, May 31st, 2012
Jeff Rubin, author of The End of Growth (his second best-selling instalment), discusses the effect and ramifications of expensive-to-produce oil, in the context of the developed world’s over-indebtness, with Pierre Daillie. He says our growth expectations, including those of Canada need to be adjusted downward, as low interest rates will not be sufficient to re-ignite growth, and the catch-22 of (high) oil prices will snooker (global economic) growth in the foreseeable future.
Rubin, former Chief Economist, CIBC World Markets, shares his current investment outlook as well.
At the heart of Rubin’s thesis is his well-informed premise that we’ve burned all the ‘cheap’ oil, and unless we learn to use less oil, growing global consumption of the black stuff can only come at growth’s expense.
Bottom line: We are destined to relinquish economic growth in return for the increasing global appetite for energy.
The End of Growth, by Jeff Rubin, is an eye-opener, an interesting and controversial perspective on the future of trending issues affecting global economic progress.
The End of Growth – Do You agree or disagree?
Tags: Appetite, Bottom Line, Canadian Market, Catch 22, Cheap Oil, Chief Economist, Economic Progress, Eye Opener, Foreseeable Future, Global Consumption, Global Economic Growth, Growth Expectations, Indebtness, Instalment, Investment Outlook, Jeff Rubin, Low Interest Rates, Nbsp, Oil Prices, Perspective, Premise, Ramifications, Snooker, Thesis, World Markets
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Thursday, May 31st, 2012
Wall Street Food Chain
by William H. Gross, PIMCO
- Soaring debt/GDP ratios in previously sacrosanct AAA countries have made low cost funding increasingly a function of central banks as opposed to private market investors.
- Both the lower quality and lower yields of such previously sacrosanct debt represent a potential breaking point in our now 40-year-old global monetary system.
- Bond investors should favor quality and “clean dirty shirt” sovereigns (U.S., Mexico and Brazil), for example, as well as emphasize intermediate maturities that gradually shorten over the next few years. Equity investors should likewise favor stable cash flow global companies and ones exposed to high growth markets.
The whales of our current economic society swim mainly in financial market oceans. Innovators such as Jobs and Gates are as rare within the privileged 1% as giant squid are to sharks, because the 1% feed primarily off of money, not invention. They would have you believe that stocks, bonds and real estate move higher because of their wisdom, when in fact, prices float on an ocean of credit, a sea in which all fish and mammals are now increasingly at risk because of high debt and its delevering consequences. Still, as the system delevers, there are winners and losers, a Wall Street food chain in effect.
These economic and/or financial food chains depend on lots of little fishes in the sea for their longevity. Decades ago, one of my first Investment Outlooks introduced “The Plankton Theory” which hypothesized that the mighty whale depends on the lowly plankton for its survival. The same applies in my view to Wall, or even Main Street. When examining the well-known wealth distribution triangle of land/labor/capital, the Wall Street food chain segregates capital between the haves and have-nots: The Fed and its member banks are the metaphorical whales, the small investors earning .01% on their money market funds are the plankton. Yet similar comparisons can be drawn between capital and labor. We are at a point in time where profits and compensation of the fortunate 1% – both financial and non-financial – dominate wages of the 99% and the imbalances between the two are as distorted as those within the capital food chain itself. “Ninety-nine for the one” and “one for the ninety-nine” characterizes our global economy and its financial markets in 2012, with the obvious understanding that it is better to be a whale than a plankton. Not only do Wall Street and Newport Beach whales like myself have blowholes where they can express their omnipotence as they occasionally surface for public comment, but they don’t have to worry as yet about being someone else’s lunch.
Delevering Threatens Global Monetary System
Yet while the whales have no immediate worries about extinction, their environment is changing – and changing for the worse. The global monetary system which has evolved and morphed over the past century but always in the direction of easier, cheaper and more abundant credit, may have reached a point at which it can no longer operate efficiently and equitably to promote economic growth and the fair distribution of its benefits. Future changes, which lie on a visible horizon, may not be so beneficial for our ocean’s oversized creatures.
The balance between financial whales and plankton – powerful creditors and much smaller debtors – is significantly dependent on the successful functioning of our global monetary system. What is a global monetary system? It is basically how the world conducts and pays for commerce. Historically, several different systems have been employed but basically they have either been commodity-based systems – gold and silver primarily – or a fiat system – paper money. After rejecting the gold standard at Bretton Woods in 1945, developed nations accepted a hybrid based on dollar convertibility and the fixing of the greenback at $35.00 per ounce. When that was overwhelmed by U.S. fiscal deficits and dollar printing in the late 1960s, President Nixon ushered in a new, rather loosely defined system that was still dollar dependent for trade and monetary transactions but relied on the consolidated “good behavior” of G-7 central banks to print money parsimoniously and to target inflation close to 2%. Heartened by Paul Volcker in 1979, markets and economies gradually accepted this implicit promise and global credit markets and their economies grew like baby whales, swallowing up tons of debt-related plankton as they matured. The global monetary system seemed to be working smoothly, and instead of Shamu, it was labeled the “great moderation.” The laws of natural selection and modern day finance seemed to be functioning as anticipated, and the whales were ascendant.
Too Much Risk, Too Little Return
Functioning yes, but perhaps not so moderately or smoothly – especially since 2008. Policy responses by fiscal and monetary authorities have managed to prevent substantial haircutting of the $200 trillion or so of financial assets that comprise our global monetary system, yet in the process have increased the risk and lowered the return of sovereign securities which represent its core. Soaring debt/GDP ratios in previously sacrosanct AAA countries have made low cost funding increasingly a function of central banks as opposed to private market investors. QEs and LTROs totaling trillions have been publically spawned in recent years. In the process, however, yields and future returns have plunged, presenting not a warm Pacific Ocean of positive real interest rates, but a frigid, Arctic ice-ladened sea when compared to 2–3% inflation now commonplace in developed economies.
Both the lower quality and lower yields of previously sacrosanct debt therefore represent a potential breaking point in our now 40-year-old global monetary system. Neither condition was considered feasible as recently as five years ago. Now, however, with even the United States suffering a credit downgrade to AA+ and offering negative 200 basis point real policy rates for the privilege of investing in Treasury bills, the willingness of creditor whales – as opposed to debtors – to support the existing system may soon descend. Such a transition occurs because lenders either perceive too much risk or refuse to accept near zero-based returns on their investments. As they question the value of much of the $200 trillion which comprises our current system, they move marginally elsewhere – to real assets such as land, gold and tangible things, or to cash and a figurative mattress where at least their money is readily accessible. “There she blows,” screamed Captain Ahab and similarly intentioned debt holders may soon follow suit, presenting the possibility of a new global monetary system in future years, or if not, one which is stagnant, dysfunctional and ill-equipped to facilitate the process of productive investment.
Tags: Bill Gross, Bond Investors, Brazil, Central Banks, Equity Investors, Estate Move, Fishes In The Sea, Food Chains, Giant Squid, Global Monetary System, Gross Investment, Haves And Have Nots, Investment Outlook, Little Fishes, Market Investors, Member Banks, Money Market Funds, Stocks Bonds, Street Food, Wealth Distribution, William H Gross, Winners And Losers
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Monday, May 7th, 2012
by Jeffrey Saut, Chief Investment Strategist, Raymond James
May 7, 2012
“Toto, I have a feeling we’re not in Kansas anymore.”
… Dorothy; The Wizard of Oz
While most people know “The Wizard of Oz” as one of the most popular films ever made, what is little known is that the book was based on an economic and political commentary surrounding the debate over “sound money” that occurred in the late 1800s. Indeed, L. Frank Baum’s book was penned in 1900 following unrest in the agriculture arena due to the debate between gold, silver, and the dollar standard. The book, therefore, is supposedly an allegory of these historical events, making the events easier to understand. In said book, Dorothy represents traditional American values. The Scarecrow portrays the American farmer, the Tin Man represents the workers, and the Cowardly Lion depicts William Jennings Bryan. Recall that at the time Mr. Bryan was the official standard bearer for the “silver movement,” as well as the unsuccessful Democratic presidential candidate of 1896. Interestingly, in the original story Dorothy’s slippers were made of silver, not ruby, implying that silver was the Populists’ solution to the nation’s economic woes. Meanwhile, the Yellow Brick Road was the gold standard, and Toto (Dorothy’s faithful dog) represented the Prohibitionists, who were an important part of the silverite coalition. The Wicked Witch of the West symbolizes President William McKinley; and the Wizard is Mark Hanna, who was the chairman of the Republican Party and made promises that he could not keep. Obviously, “Oz” is the abbreviation for “ounce.”
It should be noted that before 1873 the U.S. dollar was defined as consisting of either 22.5 grains of gold or 371 grains of silver. This set the legal price of silver in terms of gold at a ratio of roughly 16:1 and put the country on a gold/silver bimetallic standard. Since both metals had other uses than just coinage, whenever the ratio got out of whack rational people would buy the cheaper metal and take it to the mint for coinage. That provided a natural stabilizing arbitrage. With the 1873 Coinage Act, however, the silver dollar was omitted, effectively shifting the country from a bimetallic to purely a gold standard. Other countries soon followed, and as tons of silver was unloaded, the market price of silver to gold rose from 16:1 to a ratio of 40:1. The result was that the dollar was now linked to a metal that was getting scarcer. Particularly hurt by these events were the net debtors, among them the farmers because they had to face a rising real value of their dollar/gold denominated debts combined with declining agricultural prices. Now, while there was a bunch of “noise” in between (The Sherman Silver Purchase Act of 1890, the panic and depression of 1893, etc.), the situation hit its zenith in 1896 culminating with William Jennings Bryan’s “Cross of Gold” speech at the Democratic National Convention.
Plainly, the turmoil following the “1873 Coinage Act,” the “Sherman Silver Purchase Act of 1890,” and the subsequent panic, and depression, of 1893 left the phrase “time for a change” swirling across the country as citizens struggled to correct the numerous wrong-footed schemes that were so hastily conceived by the country’s elected leaders. While I have digressed, I find monetary history truly fascinating and would note that the value of our current dollar, measured in 1900 dollars, is worth roughly $0.03. And that, ladies and gentlemen, is why you want to have your dollars in productive assets that have healthy cash flows, hopefully pay dividends, and will keep up with the inflation that is most certainly coming our way.
I revisit the dollar/gold topic this morning because I think the most important chart in the world may be in the process of breaking down. The chart in question is that of the U.S. Dollar. Since January of this year the Dollar Index ($DXY/79.59) has reversed its pattern of making higher highs and higher lows, as can be seen in the chart on page 3. Interestingly, the last short-term dollar “top out” occurred on last month’s bad employment report, so given Friday’s poor employment report the dollar’s path this week should be watched closely. Moreover, despite the official line from the powers that be, I think Ben Bernanke actually wants a lower dollar. Not only would it bring about the whiff of inflation that is needed, it also would increase our exports and allow us to pay back our debts with cheaper dollars. A breakdown below February’s intraday reaction low of 78.12, which would also break the index below its 200-day moving average (DMA) at 78.36, would likely confirm the dollar’s downside. The quid pro quo is I think a weaker dollar would be bullish for the equity markets.
Speaking to gold, I have been bullish on gold, and stuff stocks in general (energy, cement, timber, agriculture, water, electricity, precious metals, etc.), ever since China joined the World Trade Organization (WTO) in 2001 on the assumption that when per capita incomes rise people consume more “stuff.” We rode that theme to large profits until the Dow Theory “sell signal” of November 2007 where said investments had grown into such large “bets” that we recommended selling 30% – 40% of our stuff stocks to rebalance portfolios. The strategy was to allow long-term capital gains to accrue to portfolios, and raise some cash, going into what we thought was going to be a difficult 2008. Since the stock market’s bottoming process began in October 2008 (actually on 10/10/08 when 92.6% of all stocks traded made new annual lows, a statistic I have not seen in more than 40 years in this business) gold has been on a tear, having rallied from $681 into last summer’s closing reaction high of $1891.90. At that time I warned investors I was putting “in” gold’s short/intermediate high, and recommended adjusting precious metals positions accordingly, when I bought six of our son’s gold coins to help fund his summer excursion to Europe. The result was I paid slightly over $1900 per coin; and, so far that has proven to be the peak price. While I think gold is in a consolidation pattern that will eventually be resolved with higher prices, I don’t think that will happen for a while.
Turning to the stock market, the S&P 500 (SPX/1369.10) and the NASDAQ Composite (COMP/2956.34) suffered their worst week of the year, falling 2.44% and 3.68%, respectively. The weekly wilt left both indices near their lows for the week, as well as below their 50-DMAs. Such action brings into view the intraday April reaction lows of 1357.38 for the SPX and 2946.04 for the COMP. A confirmed close below those levels would represent a break below what a technical analyst would term a “spread triple bottom” with short-term negative implications. That caused one old Wall Street wag to exclaim, “Triple bottoms rarely hold!” This week should hold the key for that statement. Last week’s consternations centered around economic and earnings reports. As we have been warning since the beginning of April, the economic reports have taken a decided turn towards the softer side. Last week that skein worsened since of the 21 reports released only seven came in better than expected. Likewise, the 1Q12 earning report “beat rate” has been softening over the past three weeks, having fallen from a 73% reading to last week’s 61% level for the S&P 1500. Even worse is the decline in companies giving positive forward earnings guidance. Of course, that is causing analysts to reduce their expectations. Accordingly, of the 10 S&P macro sectors the best upward earnings revision ratios are in Consumer Discretionary (+19.1%), Financials (+18.6%), and Industrial (+17.7%). Meanwhile, Energy has the worst ratio (-36.3%), likely driven by falling energy prices and bulging inventories.
The call for this week: If the spread triple bottom around SPX 1358 holds this week there should be another rally attempt, albeit still within the range-bound environment we have seen for the past eight weeks. If the 1358 level fails to hold, then we might just get what I have been looking since the beginning of February, a quick dip into the 1320 – 1340 support zone. If that occurs, it would most certainly leave the NYSE McClellan Oscillator very oversold, as well as finally raise my daily and weekly stock market internal energy indicators back to levels that would register a full load of energy, something I have been waiting for the past eight weeks. And this morning, given the “throw the bums out” election results in the EU, it looks like the SPX’s 1358 is at least going to be tested if not violated. Personally, I would like to see a plunge into the 1320 – 1340 zone, but they don’t run Wall Street for my benefit. As for vehicles under consideration for your “buy list,” in addition to the index exchange-traded product of your choice, in last week’s verbal strategy comment we listed three companies that are favorably rated by our fundamental analysts and are “triple plays.” Triple plays are companies that have beaten earnings/revenue estimates and have raised forward earnings guidance. Those names were: Abbott Labs (ABT/$62.41/Outperform); Equinix (EQIX/$158.94/Strong Buy); and Intuitive Surgical (ISRG/$565.16/Outperform).
Tags: American Farmer, Chief Investment Strategist, Cowardly Lion, Democratic Presidential Candidate, Dollar Standard, Economic Woes, Investment Outlook, jeffrey saut, L Frank Baum, Mark Hanna, President William Mckinley, Price Of Silver, Prohibitionists, Saut, Tin Man, Traditional American Values, Wicked Witch Of The West, William Jennings Bryan, William Mckinley, Wizard Of Oz, Yellow Brick Road
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Wednesday, May 2nd, 2012
Is it Déjà Vu all Over Again?
April 30, 2012
by James Paulsen, Chief Investment Strategist, Wells Capital Management (Wells Fargo)
After nearly six months of persistently better-than-expected economic reports and a regularly rising stock market, metrics on the economy have turned a bit more mixed lately while stock market prices have struggled in recent weeks. This has caused many to wonder whether the economy and the stock market are headed again toward another “spring swoon” like those experienced during 2010 and 2011.
Spookily, conditions do seem remarkably similar today to those which preceded the last two spring thaws. In 2010, the stock market peaked on April 23 and in 2011 it peaked on April 29. Well, it’s April again and stocks are struggling? Moreover, in each of the last two years, just like this year, the spring stalls were preceded by improved economic reports and by a surge which carried stock prices to new recovery highs. Finally, rising gas prices have again played a dominant role in recent months as they did leading up to both of the last two spring swoons.
So, is everyone best advised to simply “Sell in May and Go Away”—something which worked well in each of the last two years? Although similarities to past swoons are troubling and while the recovery will inevitably “ebb and flow,” there are several critical differences evident this year which should help keep the economy and the stock market out of “swoon’s way” during the balance of 2012.
Economic Policies are More Accommodative
Economic policies are notably more accommodative today compared to either 2010 or 2011. In 2010, the pace of the M2 money supply had slowed to a restrictive 1 percent annual pace, and in early 2011 it was only rising at a very modest 4 to 5 percent pace. By contrast, today, the annual growth in the M2 money supply has persisted about a robust 10 percent clip since last fall!
In both early 2010 and early 2011, the 30-year national average mortgage rate (Chart 1) rose above 5 percent prior to the spring swoons. Today, the mortgage rate is near an all-time record low below 4 percent! Significant accelerations in consumer inflation ravished household real incomes prior to both the 2010 and 2011 economic stalls. As illustrated in Chart 2, the annual rate of consumer price inflation jumped from -2 percent (deflation) in mid 2009 to about +2.5 percent by early 2010. Similarly, the annual inflation rate rose from about 1 percent at the end of 2010 to about 3.5 percent by 2011 springtime. These spikes in consumer prices significantly reduced real household income gains. Today, by contrast, real incomes are being boosted by a decline in the consumer price inflation rate from about 4 percent last fall to 2.7 percent currently!
While the Japanese tsunami had ravished U.S. manufacturing supply chains last year, today the “Japan bounce” is helping revive U.S. industrial activity. Finally, global economic policy officials are almost universally accommodative today. Until last fall, euro-zone officials refused to ease interest rates or expand the ECB balance sheet. Recently, however, both policies have been eased significantly! Similarly, until late last year, most emerging world economic policy officials were attempting to moderate recoveries by tightening policies. Now, nearly all of the emerging world is easing conditions to reaccelerate recoveries.
In both 2010 and 2011, economic policies were decidedly more restrictive and probably played a significant role in the resulting economic and stock market swoons. Today, however, much more accommodative global economic policies should bring a more favorable outcome.
U.S. Economic Recovery More Mature
The spring swoon in 2010 hit before the economic recovery had even reached its first anniversary. Today, the recovery is much more mature and therefore less vulnerable to swoons than it was in either 2010 or 2011.
Several recent economic reports portray a maturing economy. In the first quarter, average monthly job gains were in excess of 200 thousand for the first time in this recovery. Initial weekly unemployment insurance claims have finally fallen below 400 thousand and the unemployment rate is enjoying its most persistent decline of the recovery. Additionally, the present situation consumer confidence index (Chart 3) has risen to a new recovery high, the economy has enjoyed the most robust retail spending of the recovery, auto sales have again recovered to about a 15 million annual pace, and an array of recent housing reports suggest the greatest level of housing activity since the industry collapsed. Finally, bank loans (Chart 4), absent during much of the first two years of this recovery, have risen steadily during the last year!
While the economic recovery has not yet surged ahead with strong momentum, many of the traditional engines of growth which often suggest a sustainable recovery (e.g., job creation, consumer and business confidence, improvement in big ticket spending propensities on cars and homes, and better bank lending) are now increasingly evident. With the economy simultaneously firing on so many more cylinders than it was in early 2010 or early last year, it appears much better equipped to weather adversities.
Household Fundamentals Much Improved
The U.S. household is also much less vulnerable to shocks compared to earlier in this recovery. Consumer fundamentals have improved markedly in the last year. The job market has finally come to life, consumer confidence has risen to its highest level of the recovery, and real wages and salaries are rising by about 2 percent in the last year compared to a negative growth rate in early 2010. The U.S. personal savings rate has averaged 5.1 percent in the last four years which represents the highest persistent savings rate in more than a decade, and the U.S. household liquidity ratio (cash holdings as a percent of net worth) has been hovering about a 20-year high since the start of the recovery. Moreover, despite virtually no recovery yet in housing prices, households have already regained almost two-thirds of the loss in net worth experienced during the crisis.
Tags: April 29, Chief Investment Strategist, Critical Differences, Dominant Role, Economic Policies, Economic Reports, Investment Outlook, M2, Market Metrics, Money Supply, Pace, Rising Gas Prices, Six Months, Spring Thaws, Stock Market Prices, Stock Prices, Swoon, Swoons, Wells Capital Management, Wells Fargo
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Wednesday, May 2nd, 2012
Tuesday Never Comes
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
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