Friday, 27 August 2010

Fantasyland and the imaginary world of spending multipliers.

"The president still seems to believe in the imaginary world of spending multipliers — whereby each dollar of additional spending results in something in the order of $1.40 in additional output."

"Bury Keynesian Voodoo Before It Can Bury Us All"
by Kevin Hassett

"Aug. 23 (Bloomberg) -- Initial claims for unemployment benefits surged to 500,000 in mid-August, a level more typical of a recession than a recovery. The bad news confirmed what conservative economists have been saying for some time: The biggest Keynesian stimulus in U.S. history was a bust."

"A 2002 study by economists Richard Hemming, Selma Mahfouz and Axel Schimmelpfennig of recessions in 27 developed economies from 1971 to 1998 found that increased spending by government had, in almost all cases, a barely noticeable impact, and sometimes a negative one. Heavily indebted countries that spent more in recessions grew about 0.5 percent less, relative to trend, than countries that didn’t, the study found."

It is impossible to calculate the effect of deficit-financed government spending on demand without specifying how people expect the deficit to be paid off in the future, this is the very reason why the Keynesian inspired stimulus did not work. The theory of rational expectations can be used to support this:

"If the Federal Reserve attempts to lower unemployment through expansionary monetary policy economic agents will anticipate the effects of the change of policy and raise their expectations of future inflation accordingly. This in turn will counteract the expansionary effect of the increased money supply. All that the government can do is raise the inflation rate, not employment. This is a distinctly New Classical outcome."

The Policy Ineffectiveness Proposition (PIP) is a new classical theory proposed in 1976 by Thomas J. Sargent and Neil Wallace based upon the theory of rational expectations:

"If the government employed monetary expansion in order to increase output, agents would foresee the effects, and wage and price expectations would be revised upwards accordingly. Real wages and prices remain constant and therefore so does output, no money illusion occurs."

Marc Faber the author of the famous Gloom Boom & Doom Report also thinks QE will be interpreted as inflationay. Marc Faber sits in the Austrian camp and his latest comment is based on the theory of rational expectation. A self-fullfilling prophecy?

We have witnessed the impacts of a herd mentality and the effects on numerous occasions, such as bank runs. Also, people believing another recession is coming, and will be hoarding cash, which will trigger a deeper slump in consumption and another downturn.

The Macro picture is still very bleak and inflating air in a pierced balloon just doesn't work.

David Goldman on his excellent blog, accurately describe the terrible state of the US economy:

"Pension funds will have umpty-zillion-dollar deficits once they recalculate their liabilities at a 3% rate of return rather than the fictional 8.5% return assumed by most of the defined-benefit plans during the 2000s. The equity risk premium will remain depressed for a generation. The banks can’t make money after the short-lived boom in distressed assets because demand for yield has flattened the curve to the point that their old trades are less economical. Hedge funds can’t make money because they are behind the banks in the queue for assets."

It is going extremely difficult going forward for pension funds to cover their liabilities. In conjunction with very severe headwinds with high unemployment and damaged balance sheets, you also have demographic issues in the coming years which will be painful to address.

Although Wall Street has been bailed out, Main Street is still ongoing the pain of unemployment and deleveraging. It is still very tough out there and balance sheets haven't been repaired.

Wednesday, 18 August 2010

Dead Cat Bounce

From a market perspective, it still feels like a dead cat bounce:

Foreclosures are still rising and so far this year 110 banks faild in the US compared to around 140 for the whole of 2009.

In relation to Greece, I posted on the 16th of June that Greece was in a worse shape that Argentina (another I told you This is now reflected in the CDS market:

"The cost of protecting Argentine debt against non-payment for five years with credit-default swaps fell 15 basis points, or 0.15 percentage point, to 817 this week, 27 less than similar contracts for Greece, according to CMA DataVision. Greek swaps rose 24 basis points in the same period.

Five-year credit default swaps tied to Argentine debt tumbled 175 basis points the past three months, the biggest decline among governments in the world after Ukraine and Pakistan, according to CMA. Contracts for Greece surged 230 to 844 during the same period, the world’s biggest surge behind Venezuela.

Argentine credit risk will remain below Greece as surging commodity exports boost tax revenue in South America’s second- biggest economy, according to Wells Fargo & Co. While Argentina’s economy is forecast to grow 9.7 percent this year by Morgan Stanley, the fastest in the region, Greece’s gross domestic product may shrink 4 percent, according to the government and European Union estimates.

“It is definitely a longer-term trend,” said Aryam Vazquez, an emerging-markets economist at Wells Fargo in New York. “The economy is growing, and the growth outlook is very robust. But more importantly, the fiscal situation is very strong. Their financing needs aren’t even a concern now, and that clearly is not the case with Greece.”

The yield of Government debt also reflects the trend:

"The average yield on Argentine bonds sank 93 basis points to 9.92 this year, according to JPMorgan Chase & Co. indexes. The yield on the 5.83 percent peso-denominated bond due in 2033 is 10.15 percent. The yield on Greece’s bonds due in 2020 surged 438 basis points to 10.61 percent since trading began in March, according to data compiled by Bloomberg."

In Argentina, you continue to have a lower debt-to-GDP rate, less rollover risk and relatively high growth,” Craige said in a phone interview. “These are much more likely to attract capital than countries that have high debt-to-GDP, structural fiscal deficits and high rollover risk, such as Greece.”

But in relation to Argentina being a safe place to invest, it is definitely not the case until a government change, the election will be held in December 2011:

“Argentina’s macro management is still very poor,” said Bertrand Delgado, an economist at Roubini Global Economics LLC in New York. Argentina’s credit-default swaps will only “see a significant move downward with a regime change, to one that’s somewhat more market friendly and has the political capital to implement the necessary changes in macro policy. That’s still a long bet,” he said.

If you use import cover as an indicator of a country's cash reserve to protect itself from external crises, the common rule is three months worth of import is adequate.

China and Russia stand at more than two years (Russia is around 30 months, China around 26 months, source The Economist).

Emerging markets economies stand out as well in terms of Import Cover: Thailand, Brazil and Argentina.

Greece is still in worse shape than Argentina, its import cover stands less than two months
whereas Argentina is around 12 months.

At the same time while households in the US, the government is adding debt at a faster pace, this is not going to end well. Please find below Michael Pento's view:

"According to the Flow of Funds Report, households reduced debt at a 2.4% annualized rate (US$330 billion) during the first quarter of 2010. Meanwhile, the federal government was piling on debt at an 18.5% annual rate ($1.44 trillion). Since every dollar of government debt is a promise to tax the private sector in the future with interest, this public spending spree effectively negated the Herculean efforts of the private sector to return to a sustainable path.

That's where the arrogance of Washington is really apparent. Scores of millions of American consumers have made the decision that reducing their debt burden is in their best interests right now. But a few hundred individuals in government believe they know better than the collective wisdom of the entire free market.

By leveraging up the public sector, they have used their power to confiscate our savings. In short, they are forbidding us from following the common sense path to fiscal health. "

Until you start to see meaningful job creation in the US, we cannot really talk about a recovery. What we have so far is the worse jobless recovery since 2001:

Severe recessions normally generates strong-labour market recoveries. This is not the case this time around. What we have witnessed in many industries, is creative destruction à la Schumpeter. Given the current deflationary environment in this ongoing deleveraging process, companies have learnt how to cope with a smaller workforce. Some jobs will simply not return, no matter how much money you throw at it.

The Endgame - Fin de partie

The current attitude of Central Banks and in particular the Fed is reminiscent of Samuel Beckett's Theatre of the Absurd play called Endgame, hence the title of this post.

Beckett's play, is also a reference to Chess Endgame. Beckett was an avid Chess player.

Endgames can be divided into three categories:

Theoretical endgames – positions where the correct line of play is generally known and well-analyzed, so the solution is a matter of technique.

Practical endgames – positions arising in actual games, where skillful play should transform it into a theoretical endgame position.

Artistic endgames (studies) – contrived positions which contain a theoretical endgame hidden by problematic complications

Martin Sibileau on the 12th of August published a very interesting post which I highly recommend reading. He goes through on how the game has changed dramatically recently and why the Fed has got it dangerously so wrong again. Martin Sibileau is currently a Director for the Loan Portfolio Management Team of a major Toronto headquartered financial institution.

"Simply, the Fed decided that instead of allowing its balance sheet to shrink, as the mortgage backed securities and agency debt it holds are repaid, it will reinvest those amounts (which are not minor, estimated at $200BNover the next 12 months) back into the Treasuries market. We understand it will target purchases in the 2-7yrs range, which caused the 10-30yr to steepen sharply in the last two sessions. The spread between costs of liquidity in the Euro and USD currency zones, discussed a week ago, continued to widen also for this same reason, but the sensitivity of risk assets to it reversed. Another thing to keep in mind: If the Fed purchases Treasuries directly from the Treasury, it will not only be keeping the size of liquidity available in the system steady but also, it will be monetizing fiscal deficits. The street is watching…"

"One of the first rules any student of Economics learns is that if a monopoly controls quantities, it cannot control prices and vice versa, if it controls prices, it cannot control quantities. Until Tuesday, the Fed was targeting the price of its liabilities. It was concerned with the so called general price level. Since Tuesday, it is concerned with their quantity."

Like a broken record, I kept saying that the only results that will be generated from an extension of QE is inflation down the line. We are still in a deflationary environment but the EndGame will be Stagflation.
It is becoming more and more obvious we are heading towards stagflation. Martin Sibileau also comes to the same conclusion on his blog.

I also recommend you read the following post from David Goldman:

"Bloomberg today reports that the first rise in CPI in four months has reduced fears of deflation. This is silly. Between 2000 and 2008, the Federal Reserve ignored the bubble in home prices because rents failed to rise, and CPI measures rent (or home rental equivalent) rather than home prices. Now that home prices have collapsed, and homeowners are being turned out of their dwellings, rents have stabilized, because fewer people can buy houses and must rent instead. This is the consequence of a 22% all in unemployment rate. The only thing that has reflated during the dead-cat bounce that earlier masqueraded as recovery was the corporate profit picture, achieved largely through cost-cutting (more unemployment) or financial manipulation by the Fed, which handed banks the steepest yield curve in history.

Asset markets, though, reflect considerable deflation risk. A preference for cash and fixed-income assets over brick and mortar is a statement that physical assets are more likely to be cheaper in the future. There is a huge demographic tailwind behind fixed income markets, as I mentioned on the Kudlow Report Wednesday evening. The population is aging rapidly: between 2005 and 2020, the proportion of Americans aged 60 and over will rise from 16.7% to 22.8%, according to UN data. For “more developed regions,” the increase will be from 20% to 28%. That generates a huge demand for savings instruments. And that is inherently deflationary: aging savers buy future goods (securities) rather than present goods."

David concludes his post from the 13th of August with the following comments:

"Absent a fiscal reform that provides incentives to entrepreneurs to shift into physical assets, the Japan scenario is likely. There’s no more striking sign of deflation than private equity and real estate funds turning money back to investors. If the fund managers can’t find projects worth buying (which pay them handsome fees), it’s likely that corporate managers can’t either."

Although David sits tightly in the deflationary camp, while like Martin Sibileau, I still believe in a Stagflation scenario due to the inefficiency of QE to generate growth(please see previous posts), David is also playing defence:

"I own plenty of inflation-hedge equities (against the possibility that my core expectation of deflation turns out wrong), but I’m happy with the bulletproof tax exempts I bought at higher yields than are presently available"

"In short, the economy is going nowhere, and the stock market doesn’t have a second act after the heroic cost-cutting of last year."

From my point of view, we are still in a deflationary environment. This is due to the massive amount of deleveraging that still needs to go through. Banks are still busy using the steepest yield curve in history to repair their balance sheets, and many banks are effectively not lending due to risk aversion and lack of risk appetite due to heavier regulations as well as to very stringent credit standards.

But, given the propensity with which the Fed is likely to be using QE to tentatively boost the US economy, it will be inflationary down the line.

To conclude Andy Xie has very well written on the inflation coming in the near future, please see below link (Andy Xie is an independent economist based in Shanghai and was formerly Morgan Stanley’s chief economist for the Asia- Pacific region):

Inflation, Not Deflation, Mr. Bernanke
By Andy Xie 08.16.2010 18:12

"The globalization reality is that developed economies like Europe, Japan, and the U.S. will suffer slow growth and high unemployment. Stimulus is the wrong medicine for solving problems. Believing this will lead to excessive stimulus, which causes inflation and bubbles in emerging economies first and inflation in developed economies later. The wrong policy prescription pushes the global economy through unnecessary gyrations, stagflation and possibly another major financial crisis in the emerging economies. It's high time for Mr. Bernanke to wake up from his stimulus obsession."

Thursday, 5 August 2010

Solid...Solid as a Rock...

Northern Rock Asset Management the "Bad Bank" has posted better results than Northern Rock Plc the "Good Bank". How interesting...

Net profit of GBP 359 millions versus net loss of GBP 142.6 millions.

The good bank has increased its mortgage lending by 50 % to 2 billions GBP up until June, yet it still producing a loss.

This is partly due to the withdrawal of GBP 2 billions GBP of savings due to the end of the guarantee of 100 percent of deposits by the government.

Still GBP 22.5 Billions to be repaid to the UK taxpayer though...

Northern Rock has GBP 47.2billion of residential mortgages still sitting on its books.

Yet David Jones, its former CFO was only fined by the FSA 320,000 GBP and barred from working in finance. This is ridiculous given the CFO had clearly misled investors on the level of bad loans leading to the spectacular collapse of the bank.

In November 2007, Alistair Darling declared the following in the Commons: he insisted that the Government “fully expected” to get back the GBP 24 billion that the Bank of England had lent to the troubled bank because the money was secured against its assets.

On the 17th of February this was the statement made by Alistair Darling in respect of the nationalisation of Northern Rock:

"The Financial Services Authority continue to assure me the bank is solvent. It believes that Northern Rock's mortgage book is of good quality. And the FSA will also continue to regulate the Northern Rock."

And on the 6th of August 2008 the Government injected an additional GBP 3 billion into Northern Rock because at that time the bank indicated repossessions had soared 180 per cent and losses had jumped to GBP 585million in the first six months of 2008 only.

So much for the FSA good understanding of Northern Rock's quality of its mortgage book...

Under the existing business plan for Northern Rock, the bank must repay all the money its owns by the end of 2010.

Northern Rock used to have a "fantastic" mortgage product called Together mortgage which let some borrowers borrow up to 125 per cent of a property's value! Nice one...

In August 2008, the arrears on this product was 2.14 percent, double the industry average and was rising super fast at the time.

One year later Northern Rock was borrowing GBP 11 millions a day from taxpayers.

"Its outstanding net debt to the Bank of England reached GBP 10.9billion in the first half of the year, up from GBP 8.9billion at the end of 2008."

Read more:

"Some 39 per cent of its 560,000 customers are in negative equity, the figures showed - an extraordinary 218,000 people."

A year later arrears on the fantastic Together Mortgage had soared:

"Arrears on these loans spiked to 6.5 per cent of Northern Rock's loan book, up from 2.14 per cent in the first half of 2008. The industry average stands at just 2.39 per cent."

Up to 6 months after Northern Rock had been bailed out, it was still providing Together Mortgages at the tune of GBP 800 Millions from September 2007 to February 2008.

The reason why the good bank is losing money is that we are still in a deleveraging process, which means that people, are borrowing less and saving more, which makes it difficult for Northern Rock Plc to make a profit.

The government would like banks to increase lending, which is very difficult in this deleveraging environment. While small business are struggling to get access to loans, Banks have gone back to tightening their credit standards which mean their are much more cautious in relation to the lending their are willing to make, while they are also still busy repairing their balances sheets.

Given banks are a leverage play on the economy, it is an encouraging sign that profits are on the increase (but not sufficient). Yet there are still many issues in relation to the solidity of the recovery, due to the urgent need of structural reforms in government spending and the high level of unemployment.

There is a risk of a double dip, not only because of the seriousness of the damages caused by the crisis but as well due to the increasing risks from a geopolitical point view.
To name a few, the increasing tensions between Venezuela and Colombia, as well as Iran still busy building up its nuclear program.
Also the risk of an increase in interest rates, could as well dent seriously the fragile recovery taking place. The Bank of England for instance is facing increase inflationary pressure due to the failing of QE. Commodities are also rising fast given drought and other issues. For instance price of wheat are increasing very fast, which will have an impact in the level of consumer prices: today Wheat futures rose 7.9 percent to USD 8.155 a bushel in Chicago, the highest price since August 2008...

The Bank of England will try to delay the inevitable as long as possible but it will have to raise rates in the short term.
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