Opinions and observations expressed on this blog reflect the authors' individual experiences and should not be construed to be financial advice. None of the members of this blog are licensed financial advisors. Please consult your own licensed financial advisor if you wish to act on any recommendations here.

Monday, November 29, 2010

Illiquidity vs. Insolvency and The European Crisis

There's a big distinction that needs to be made between illiquidity and insolvency when it comes to debt crises and it is useful for thinking about when looking at Ireland.

A crisis of liquidity arises when some kind of short term shock prevents an entity from making a regularly scheduled payment or a huge one-time crisis causes a huge blip in the flow of funds. For instance, let's say I normally can roll over a $10,000 loan every 12 months without issue, but suddenly the bank says no, leaving me with a $10,000 hole in my balance sheet. I can liquidate financial assets, but I don't have enough time to arrange everything. My friends can look at me and say, "Sure, here's 10 grand. Pay us back soon." and this is no big problem for me. A few weeks later, I am done liquidating assets and I have paid them back. This is actually kind of similar to what happened to AIG, incidentally.

Let us look at a case where I would be insolvent. Let's say I had a $500,000 mortgage and I could service it with a $120,000 income fairly easily. However, my income was based on a bunch of one-time incentive pay that I won't get again and my more regular pay is about $50,000. Combined with the mortgage, I have a large car payment, high property taxes and so on. What's more, because the economy is bad, I can't reasonably expect to increase my income any time soon. Over the next year, I am obligated to pay more than my entire gross income in these various payments. Even worse, I am $200,000 underwater on my mortgage because of the real estate slump. If you came along and said, "I'll give you a credit line of $20,000 that you have to pay back in three years." I would tell you it just doesn't matter. To use a technical term.... I'm screwed.

Europe's approach is very much like the latter, but with an added twist. They give you the credit line, but force you to take a pay cut in the form of austerity policies that reduce your tax base through deflationary forces. In the case of Greece, they deserve to suffer from austerity policies as they were profligate. Ireland, on the other hand, was not and everyone is paying for the sins of overly leveraged, irresponsible banks that took advantage of their size to maximize risk and doing so while knowing the state would inevitably bail them out. Ireland will never be able to pay it back, not with an economy relegated to depression. Ireland should default, or just come close to it, so that Europe gives more favorable terms to a country that doesn't deserve what is happening to it.

Saturday, November 27, 2010

Quantitative Easing Explained.... By Sane People

This isn't as silly as the much more popular version that was made by Austrian (school) economists/Tea Party/etc idiots, but it is fundamentally much more correct.

A peculiar resiliency of markets to geopolitical crises

One of the interesting sub-plots of the ongoing crisis between North and South Korea is that it's had a comparatively small effect on South Korean stock markets. 

Sure, markets have sold off a little bit, but considering the prospect of a potentially ruinous war, markets have been taking it all in stride. Then again, if you look back to the Cuban Missile Crisis in 1962, our markets did not sell off much. The Dow fell from about 586 to about 569 during the crisis. That's a fairly puny decline of around 3%. As a point of fact, it's hard to make the argument that a decline that small was even caused by the crisis. 

When you compare it to the vast overreaction to 9/11 or the sell-off preceding the Iraq War, which had very little economic effect, such reactions are puzzling, but it seems that markets don't sell off much on the low probability of disastrous events and sell off drastically on the high probability or the occurrence of relatively minor events. 

Some people should not talk about public finance

Ugh. W. Kurt Hauser wrote a piece in the Wall Street Journal that nearly gave me an aneurysm.

He asserts that no matter what you do with taxes, tax revenue comes in at 19% of GDP because tax increases hurt economic growth and tax cuts increase it. Oh really?

If you average the Bush years versus the Clinton years, the federal government average taxes as a percentage of GDP nearly 2 full percentage points below the Clinton years. This was despite a huge run up in corporate tax receipts as corporate profits hit an all-time high that had just about nothing to do with tax policy since corporate tax rates were left at 35%. Comparing peaks in the business cycle we also have about a 2 percentage point gap. 

Not all of this is the static effect of taxes being at lower levels. It is also a function of the fact that the economy did not grow nearly as quickly in the 2000s as in the 1990s. However, that in of itself would seem to indicate that tax cuts don't generate additional revenue as there was nothing particularly remarkable about economic growth following two significant tax cuts in 2001 and 2003. 

Ah, but Mr. Hauser says that we can see that economic growth was revived by the tax cuts. He says the six quarters following the tax cuts averaged a GDP growth rate of 3.8% compared to an average of 1.8% prior to the 2003 tax cuts. First of all, he is ignoring that the larger of the two tax cuts was passed in May of 2001. Secondly, he is ignoring the fact that the Federal Reserve was substantially aiding the recovery from the recession with massive monetary stimulus. Thirdly, the recovery in the economy was led by residential fixed investment, which had little to nothing to do with tax policy changes. Fourthly, at comparable portions of the business cycle, tax revenues as a percentage of GDP were lower in a systematic way. So, not only did GDP not grow as fast, we collected less of it in taxes. 

Looking at the same comparison he attempted to make for just the 2003 tax cuts, we have 1.3% average growth in the six quarters following the 2001 tax cuts compared to the six quarters preceding them at 2.2%. Also, for the recent stimulus (which I am sure Mr. Hauser does not approve of), we have averaged 2.3% since its passage compared to -2.1% in the six quarters before it. Is this disingenuous? Oh heck yeah, but what he did also was. This sort of analysis does not constitute any form of economic analysis. It is selectively applied correlation analysis, but there is no systematic approach applied to compare the period he selected with other similar periods and other tax policy decisions, or to control for what other economic trends were at work (Federal Reserve interest rate decisions, reductions in oil prices, housing market trends, etc.), or... well... any kind of analysis at all. 

Incidentally, under a similar form of analysis I could point out that the six quarters following the Reagan tax cuts averaged -0.9% GDP growth, but that isn't fair since the Fed killed economic growth to subdue inflation. Similarly, you cannot credit the growth that started in Q4 1982 to the tax cuts entirely because the Fed was the primary agent stimulating economic growth at that point. 

If you make decisions on whether or not to invest on political pundits such as Mr. Hauser, who also apparently has an incredibly inflated ego, I urge you to reconsider. I would remind everyone that many Glenn Beck followers completely missed the largest stock market rally in recent history from the March 2009 lows because they were convinced that some Communist takeover had just occurred. 

Monday, November 22, 2010

The Irish Financial Crisis Becomes a Political Crisis


This has been an ongoing concern of mine for most of the European debt crisis. First, universal austerity simply does not work as a strategy for dealing with massive debt levels as its deflationary influence essentially digs the hole deeper as you are trying to get out. Secondly, it's politically damaging considering that it will coincide with a severe economic crisis. Ireland is in the midst of what can only be described as a depression and that will not correct anytime soon. In fact, it will get much much worse considering the magnitude of their fiscal contraction. The incumbent government will lose the next national election considering that the prime minister has a whopping 11% approval rating from the last poll I saw. Frankly, they should lose given that they have been in power for the boom and now the collapse.

This really is an issue where many Irish sense that their nationally sovereignty is at risk in these bailout agreements. At the same time, they really don't have a choice, but then again neither does Europe. The EU cannot allow Ireland and its banks to fail due to the collateral damage. It will be interesting if Ireland decides to take the approach that they will limit what austerity measures they put in place because they realize their importance to European financial stability. In the long run, Ireland's economic situation will get so bad that it risks severe political instability of the sort that we haven't seen in a while in most developed countries. They already have a 14.1% unemployment rate and that will not get better with the austerity measures being proposed.

As far as the EU's approach on all of this, I am doubtful of its long term viability. Basically, Germany and France are on the verge of backstopping Greece, Ireland, and then Portugal and Spain. If and when Spain becomes part of the mix, I really don't know that they are good for the money. At the same time, they are pursuing deeply deflationary policies which pose a particular problem in the context of a deflating asset bubble. The deflating real estate prices in Ireland, the UK and Spain are one of the major causes of the ongoing banking problems and austerity will only contribute to further deflation of those prices. As this pain continues, it will be difficult for governments to maintain policies of retrenchment.

Frankly, there is a serious risk that Europe is entering a deflationary spiral of a fairly severe magnitude, which will invariably lead to continued political instability.

Wednesday, November 17, 2010

Ireland and Financial Contagion

So, I believe it is time to bring out this table again of U.S. banking exposure:

As you can see, our banks have a fair amount of exposure to Ireland, but more worrying is this article from the Daily Telegraph. The exposure that British banks have to Ireland may be sufficient to sink them in their already battered state. What's more is that the current government in the UK is already somewhat hobbled by flagging approval ratings in the face of budget cuts. I am not certain how much stomach there is for potentially another big round of bailouts. International coordination might take some of the sting out of it, but we are looking at another round of substantial bailouts that are quite unpopular. Apparently, the IMF stands ready to save the day. The indications are that Ireland is actually the reluctant party and that the EU and and the IMF have been attempting to push for a bailout for some time.

Fundamentally, a bailout is needed to prevent a severe near term financial crisis in Ireland. While many have tried to point out that Ireland's government is funded through mid-2011, that is only relative to current spending. Ireland has guaranteed basically all deposits at domestic banks, meaning that widespread failures would trigger significant immediate government spending. In short, if the banking crisis gets bad enough, there is a solvency issue.

Frankly, I'm amazed that the Irish banks are still standing after a run amounting to 11% of deposits has already taken place. We'll see if an international backstop stops the bleeding. If you want to speculate on worthless Irish bank stocks, have at Anglo Irish (AIB), but what little is left of the value there is probably at risk even at these levels. At best we are probably talking serious dilution.

Monday, November 15, 2010

The Municipal Bond Rout

One thing I've always marveled at is just how quickly a bond market panic can materialize. Case in point, the municipal bond market rout over the past several trading days.

My favorite proxy for munis, MUB, has sold off in spectacular fashion, but this rout has not been entirely confined to munis. Treasuries have sold off too, as shown in this comparison with TLT.

Still, when you consider the generally narrower bounds in which MUB trades due to not only being long term securities, it is clear that this sell-off is more than just a turn away from government bonds generally. Now, as to the proximate cause of this panic, it is hard to say. There isn't a general financial panic like there was when muni bonds did this back in 2008.
That sell-off was caused by hedge funds desperately raising cash from whatever they could and they liquidated municipal bonds without mercy. This sell-off has been partially blamed on a large issue by California  coming to the market. I'm not so sure about that. I have a hard time buying that a $12 billion issue by California is enough to cause this mayhem. It is true that with Republicans now controlling one house of Congress that federal aid to state and local governments is unlikely to aid them as they attempt to bridge their budget gaps. Still, the election outcome was not a surprise and usually bond markets price things like that in.

The PIMCO California Municipal Income Fund (PCQ) might be making a bit of a fool of me, though. It has shown a sharper rout than munis in general and because California is such a large segment of the muni market this may make sense. However, with California now having the ability to pass budgets more easily, I'm not sure that questions about California's solvency are quite as pertinent as they used to be. Regardless, California munis have been obliterated.

Very oddly, this has been accompanied by a sell-off, not a rally, in gold. If there's one asset I would expect would do well in a rout of safe assets, it would be gold.

This bears watching and there's easy money to be made in munis if the sell-off gets out of control. Don't be so foolish as to pick up individual issues since if you happen to buy a special district's issues without understanding what revenue stream backs its payments, you can end up in a world of hurt. Those can and do default.

Sunday, November 14, 2010

A Brief Editorial on What Is Needed to Balance the Federal Budget

Because I was asked to give my thoughts on the long term federal budget deficit picture, I will. Nothing I am about to express is any official position tied to my post with the State Budget Office in the Wisconsin Department of Administration and neither reflects the views of the outgoing administration nor the incoming administration. Now that those preliminaries are out of the way, on to the real business at hand.

It is important that the deficit is first framed correctly and to get past all of the politics of it. What it boils down to is that this is an issue that primarily relates to revenue, rather than expenditures. Yes, one could argue that if we reduced our expenditures to a more "reasonable" level (whatever that means), we could make current revenues adequate. However, in terms of actually determining how we got from moderate, though still large deficits, to extraordinarily huge ones, we need to look at the revenue side of the ledger. What we find here is that, despite these assertions by some that taxes are far too high, taxes as a percentage of GDP are the lowest the have been in recent memory.

What we have seen since the recession began is a large one time spike in expenditures due to higher automatic stabilizers (unemployment benefits, food stamps, Medicaid, etc) and of course the bailouts, which were necessary to prevent a complete meltdown. Unfortunately, the aspect of this that isn't one-time is the large addition of debt, which will increase debt service payments dramatically. Most of the other increased expenditures enacted over the past few years are nothing out of the ordinary and don't amount to a dramatic increase in permanent spending much beyond what would have occurred otherwise.

The combination of the 2001 and 2003 tax cuts along with the cut punch of this recession has driven tax revenues as a percentage of GDP to right around 15%. With an economic recovery and the reversal of the Bush tax cuts, the CBO projects that revenues would return to over 20% of GDP by fiscal year 2014. Of course, the difficulty is that there is not a chance we will be able to reverse all of the tax cuts, even though we really should do so. As a consequence, instead of a 3.0% of GDP deficit by the middle of the decade, we are probably looking at more along the lines of 4-4.5% of GDP, depending on how much of the tax cuts we retain.

We do need to recognize that we need more than just tax increases on upper income earners in order to solve the revenue side of the equation. There needs to be a broad based tax increase, possibly led by what the deficit commission has laid out with the elimination of a variety of tax expenditures including the mortgage interest deduction. I am particularly in favor of that since I've believed for years that the mortgage interest deduction is one of the many things that drastically distorts the housing market. I would be in favor of keeping it in a compromise, but with a low maximum deduction. The tax code, generally, needs to be simplified so that the rates are more meaningful both to taxpayers and to policymakers, but this needs to be done in a decidedly revenue additive way.

Additionally, while a progressive tax code is desirable, we do need to increase taxes in a broad way since relying on only the highest tier of income produces a great deal of revenue volatility as bonus and interest income that is subject to the highest marginal tax rate is immensely variable in economic booms and recessions. One way of achieving a broad based tax increase that would be gradual would be to suspend indexing of the brackets for several years while also raising rates on the top three brackets. In an ideal world, income between $100,000 and $200,000 would be taxed at 35%, between $200,000 and $350,000 at 40% and $350,000 and above at 45%. There should be no offsetting tax cuts whatsoever. The only shift I think would be desirable would be the elimination of the corporate income tax and a commensurate shift of burden onto personal income taxes. Of course, good luck getting that done politically.

Though I've generally been in favor of preferential tax rates for investment income, when you look at the national income accounts, it is clear that we can't just wall off dividend income from paying its fair share of taxes. We're talking around $800 billion to $1 trillion a year in dividend income and, additionally, several hundred billion a year in capital gains realizations. Further, due to various tax schemes that we can get into another time, a lot of income gets sheltered into the more favorable investment tax rates (see carried interest). In more flush times, I might be in favor of maintaining the preferential treatment of investment income, but as it stands now this is a sacrifice that might have to be made. A consequence would be a contraction in valuations since expected after-tax earnings on investments would be reduced.

I haven't done all of the math, but instead of what the deficit commission has suggested with taxes as a percentage of GDP never topping 21%, we should approach it with a mind to increase taxes as a % of GDP to 23% or even 24%. It's an inevitable payback for having taxes far too low in relation to spending for too long. It's not that spending has been out of control, but rather that we haven't been paying for our existing commitments. As a consequence, the deficits accumulated have rolled up into a large future debt service burden that will crowd out other necessary areas of federal spending that are realistically too painful to cut back on.

On the expenditure side, in the short run defense spending has to bear the brunt of the reductions. Outside of one-time economic stimulus spending, non-defense discretionary spending has not increased a great deal in a fairly long time. That's not to say that it shouldn't be reduced, but that quite frankly there isn't enough there to cut. In defense spending, there is a good deal of froth that doesn't do us very much good. I know some have tried to argue that defense spending is more stimulative than other forms of government spending, but that is utterly preposterous. If someone can tell me how this:
is more stimulative than this:
I'm all ears. The truth is that defense spending delivers very poor bang for the buck in terms of the domestic economy. Spending money on capital equipment that is not used for the provision of future goods or services does not deliver the same multiplier as spending that is used for future production. The appropriate lesson drawn from the World War II spending is that when you are in a massive economic slump, a heroic deficit can bridge the gap in private consumption. To say that building thousands of Sherman tanks to be destroyed on the fields of France is more stimulative than building new schools, highways and power grids is fairly astonishing. In any case, the end result of this is that spending cuts should be concentrated in what is a truly bloated defense budget to the tune of $100 billion, concentrated in procurement, the navy and the more extraneous portions of the air force.

I'm all in favor of a non-defense discretionary spending freeze starting in FY13 and possibly even reducing spending then by 5%. In truth, most of the effects here are marginal at best, but there is some effect there to be sure. I'm not willing to cut NIH and some of the other major chunks of the non-defense discretionary budget that are vital to long term research and development in this country, which is where we need to be focusing investment. This economy will only continue to be competitive with massive investments in human and physical capital and those have to be well targeted. Spending cuts must be prioritized based on economic impact. Those with less economic disruption must bear more of the burden than those that have high returns in the sectors that are our growth engines in science and technology.

As far as the timing of all of this, it is not vital nor prudent that any of this be done right away. It is not vital because the deficit will narrow considerably as some of the one-time revenue hits and spending hikes wear off. It is not prudent because a sudden and drastic fiscal contraction of 3-4% of GDP would invariably cause a recession and once again depress tax revenues into the 15-16% of GDP region. In the next fiscal year we face a steep contraction in state and local government budgets that, combined with severe federal budget reductions, could drastically damage domestic consumption. We need to get over the hump and be well on the way to sustained economic growth before taking on a sharp fiscal contraction. If we repeat the mistakes of 1937-38, we will regret it. In general, I would prefer to wait at least one year before bringing on the pain. Some of the defense cuts can be done sooner than that since their effect on the macro economy is likely to be quite muted. The mix of the fiscal contraction should be initially weighted toward high income tax increases and defense spending cuts since those have the smallest short term contractionary effects on the economy.

While Social Security and Medicare changes are not that important in the short run to righting the deficit, in the long term the deficit will become truly massive nearly entirely on account of Medicare. Social Security is easy to fix where you eliminate the cap on taxable earnings and also go to lower inflation factors for benefits. This would actually throw off a lot of excess cash that would inevitably go to the general fund. What's better is that neither change would undermine the basic functions of the program. These changes can be implemented years from now and we will still avoid disaster.

Medicare is tricky as the policy levers available are either brutally simple (strictly capping benefits, raising eligibility age, etc) or nearly impossible to assess (increasing competition in the health care industry, capping medical malpractice awards, better enforcement actions). I generally subscribe to the view that at some point health care inflation will slow down considerably, which is not baked into most of the long term budget forecasts. Regardless, CBO has modeled what happens under such slowdowns and you still come nowhere near closing the gap. I have to admit I don't have good answers here beyond draconian ones. I am willing to wager that health care inflation won't always be such a high multiple of inflation in general solely because at the rates the "experts" are speaking of it would crowd out the rest of the economy. At some point before then, employers would scream and drop coverage if costs didn't come down and state and local governments might do the same. Even so, the aging of the population, which is a somewhat (though not entirely) separate issue from high rates of health care inflation, will drive up expenditures significantly as is. This simply cannot be bridged with tax increases because the sorts of tax increases we would need would be utterly ruinous. Unless a strong regimen of cost control is implemented in one form or another, this will destroy us. To repeat, I don't have good answers here.

Now, let me briefly address those who think that you can cut taxes and the deficit at the same time. This is baloney. The reason why tax cuts generally are followed with higher nominal dollars of revenue is that the tax cuts that have been implemented are smaller than the underlying growth in revenue. There is basic simple math that makes it nearly impossible for tax cuts to pay for themselves. If you are at 20% of GDP in taxes and you implement 1% of GDP in tax cuts, GDP has to grow 5% above where it would have in absence of the tax cuts in order to make up the gap you have created in revenue. That's a multiplier of 5x. I've never seen a single study that suggests anything like that is even remotely possible and most suggest multipliers of less than 1x. It's a little more complicated than that because the distribution of income might change more heavily toward upper income groups with lower rates as upper income earners might be comparatively more incentivized to work, pushing more income into higher marginal rates. Even so, the numbers are nearly impossible. It's true that the stimulative effects of tax cuts do replace some of the lost revenue, but they will not improve your fiscal position nor will they even break even.

Those are my thoughts for now. I regret not having more specific dollar amounts available since I didn't have the time necessary to model all of this even in a rough fashion. Luckily there is a New York Times tool that has some estimates for various proposals: https://www.nytimes.com/interactive/2010/11/13/weekinreview/deficits-graphic.html

Friday, November 12, 2010

Strength of Treasury Auctions

This table is from Haver Analytics. When you look at the bid to cover ratios (value of bids/value of accepted bids), yes the recent auction was disappointing relative to auctions this year. However, when compared to actions in normal times, such as 2006, it's still stronger than at that point. I don't remember anyone in 2006 saying that the U.S. government was on the brink of default. 

The same certainly goes for shorter term bills and notes, where we have actually seen record high bid to cover ratios for some issues. Some of these levels are about 2x what they were in 2006. Generally, the shorter term you go right now, the higher the bid to cover ratios are. Bid to cover ratios have generally been a little bit stronger (and I do mean a little bit) on the short end of the curve than on the long end, probably due to there being a greater preference for more liquid assets. 

Now, what we are seeing in recent action is that bid to cover ratios for short term instruments are running around 4-5x compared to long term running around 2.3x to 2.7x. The reason for this disparity is that long term treasuries are simply a very risky proposition at these interest rates. The odds of significant principal loss are high whereas you don't run that risk with the short term bills. You don't earn any interest on them either, but it's still reflective of individuals and institutions being more concerned about capital preservation than appreciation. 
There was a bit of concern on Wednesday about a "disastrous" 30-year treasury bond auction. In truth, by the metrics that are typically used, it really wasn't that bad.

Thursday, November 11, 2010

Deficit Reduction

So to my surprise, Obama's deficit reduction committee announced some ideas recently. http://www.foxnews.com/politics/2010/11/10/deficit-commission-recommends-changes-social-security/ . The reason it surprised me is that usually these types of committees don't amount to anything. But, since they are led by some former politicians, they are savvy and know that the first person to propose something sets the discussion for the future debate.

As for the actual merits of their proposals? I would love to hear from the expert on government spending, Mr BQ Budget Master.

Dirty Sexy Money

Money and politics go hand in hand, but luckily, there is still some hope for democracy. This site lists candidates by how much of their own money they spent on their election. As one can see, the self funders don't have the greatest record. http://www.washingtonpost.com/wp-srv/politics/dollars-per-vote/index.html
However, there is still plenty of money in politics with so much political fundraising as well as outside spending. I guess we need to make some smart investment choices so we can buy votes in the future.

Tuesday, November 9, 2010

Something interesting from MMC's earnings report

Marsh and McClennan (MMC) has been a perpetually disappointing stock and the single worst of my DRIP plans since I bought it in 2005. That was one of those cases where I tried to venture into something I didn't understand after they had a bid rigging scandal that crushed the performance of their primary insurance brokerage unit and then had a scandal in their Putnam Funds unit as well. The result was that until recently every single earnings report they had was an incredible disappointment. Now they are just mildly disappointing.

In any case, when I was going through their press release, I couldn't help but notice that Mercer Consulting is seeing strong revenue growth in the area of health benefits (8% growth on an underlying basis). Earlier this year they were only experiencing about 2% growth. It could be that comparisons are easier now, though I don't quite think that's the case. More likely, this is an interesting side effect of the health care reform law. An entirely different storyline is visible in their "Rewards, Talent & Communications" line which often has to do with HR consulting for executive compensation packages. The growth there was quite strong at 12% on an underlying basis. It's possible that this signals more white collar employment and compensation growth in the near future, though it is good to avoid reading too much into any one number.

Milton Friedman on the Gold Standard

Since Robert Zoellick, a man of a profoundly meager intellect, decided to open his trap on the Gold Standard, I think it might be worth having a man of a far greater intellect speak on the subject. While I certainly do not endorse everything Milton Friedman stood for, he was a brilliant man who was a generous enough man to recognize the brilliance of Keynes even though he disagreed with him vehemently.

Robert Zoellick is an Idiot


Basically, Robert Zoellick, head of the World Bank, is saying that we should entertain the return of gold-backed currency largely because markets, at the moment, are treating gold as an alternative to paper currency. Somehow, he believes, currencies backed by gold would provide more stable economies. Never mind that while global economies were on the gold standard in the 19th and early 20th centuries we had routine severe financial crises about every seven years and a very nasty tendency toward deflation.

James Hamilton over at Econbrowser has a fairly succinct post on this matter about how the gold standard actually contributed to the Great Depression (and probably made previous depressions worse as well). http://www.econbrowser.com/archives/2005/12/the_gold_standa.html

Sunday, November 7, 2010

QE and the Macro Climate for Stocks, Bonds, and Commodities

Since the Fed has decided to further monetize the debt in bid to try even more monetary stimulus, a few things are clear. One is that the Federal Reserve is absolutely nowhere near tightening and won't be for many months to come. That should be no surprise considering the size of the present shortfall in employment. The other is that the dollar looks like an extremely unfavorable investment right now, meaning that foreign stocks are comparatively more attractive in the interim as the supply of dollars will increase greatly as well as the fact that US interest rates will do a poor job of attracting fixed income investments. Foreign investors holding dollar denominated investments better watch out.

One thing that is abundantly clear is that financial markets have interpreted this Fed action as an all clear signal and everything from gold to Goldman Sachs (GS) has joined in. We are not in bubble territory in the stock market, though we are almost there in some, though not all, commodities markets. Those who are using commodities as a substitute for investing in financial assets in times of loose monetary policy continue to push those assets further and further from their fundamental values. There is no need to be worried about a bubble being fueled in the real estate markets. Those are so far deflated that no amount of monetary or fiscal stimulus could re-inflate them because investor expectations of returns have been so brutally throttled.

In the short run, meaning the next few weeks, I would not be stunned to see some retracement of recent gains on the order of as much as 5% in domestic stock markets. However, the next 12 months or so should be quite good. Earnings growth for the time being is strong and interest rates will not be a headwind. Commodities markets are probably a better than even shot to outperform in this environment as this global distrust of "paper" currencies seems to really be hitting a frenzy. However, once this current period of extremely loose policy relents those investments will crack much worse than the equity markets in the aggregate because there is much less of a link to fundamental value.

Stocks are supported by extraordinary levels of corporate profitability that make overall valuations quite reasonable. This is due in no small part to the current levels of slack in the labor markets that allow corporations to enjoy a larger share of productivity gains without passing them along as wage increases. However, lack of investment in both human and physical capital means, to a large extent, that corporations are cannibalizing future earnings for current earnings. Invariably this means that future earnings growth will be relatively muted as corporations need to hire and expand plant and equipment to grow sales as conditions normalize. That will prove to have a dampening effect on the later stages of the present rally.

Bonds, on the other hand, are currently being supported by Fed purchases, but this obviously will wear off, particularly as investors in long term bonds become frustrated by their low rates of return compared to high rates of return elsewhere. As such, prices will fall and yields will rise, possibly considerably. Long term treasuries are thus not a particularly good place to be.

Now, all of this is just my own opinion, which in no way constitutes professional advice, and I could certainly be wrong as I have been in the past. Still, it seems to me that this represents a fair summary of where we are right now.

Sometimes the interplay between politics and economics doesn't make sense:


When you think about it, Democrats did quite well in California (12%+ unemployment) and quite badly in my home state of Wisconsin (7.8% unemployment). Does that make much sense? Not really. Of course, I have argued that we are simply in an era of dramatic political volatility rather than any particular ideological movement one way or the other. If you look at Europe, center-right governments in Germany, France, and Italy are all on the verge of collapse or are at the very least deeply unpopular. The newly elected center-right government in the UK already has fallen behind Labour in recent polling.

At the same time, Japan has recently lurched right after electing its first clear center-left government in several decades. Some of the Latin American governments seem to be shifting right, though that certainly didn't hold in Brazil where the Worker's Party (which is effectively Socialist) won quite easily. Spain's socialist government is probably quite likely to lose when the next election happens there due to truly crippling unemployment rates and an economy very unlikely to right itself anytime soon.

We are simply at a time where it is advantageous not to be in power and this was even true in 2008 as well. There were parts of the Democrats' success, or alternatively the Republicans' weakness, that under most elections would have been quite stunning, but in an environment of extreme economic strife such things can happen. The same applied this year as well in reverse.

I suspect that 2012 will see a fairly large number of seats change hands again in the House. If we enter a protracted period of stagnation, or something that at least feels like it, don't be surprised if party control changes routinely. The interesting consequence of that is that we might see truly paralyzed decision making at a time when fairly decisive action is required.

Saturday, November 6, 2010

How Big is the Employment Gap?

When trolling around blogs, I've seen some discussion about the size of the employment "gap". Put simply this is the difference between where we would be in total employment in a healthy labor market relative to our labor force compared to where we are now. The old rule of thumb that is used is that we have to create about 150,000 jobs a month just to break even on this proposition. Given that we were seeing employment contracting virtually non-stop from the beginning of 2008 until the end of 2009 by a total of nearly 8 million and have grown by less than 100,000 a month on average since then, this gap is huge.

However, there are some complications in arriving at it. One is that the proportion of the adult population involved in the labor force is not a constant even beyond the swings related to economic activity.

Excluding cyclical activity, the employment to population ratio clearly was in an up trend from the early 1970s to the late 1990s as more women entered the labor force. However, it is possible that this has started to slide into reverse, but it is hard to tell at the moment given the enormous magnitude of this recession. If the employment to population ratio is actually in decline, this somewhat lowers the threshold of necessary job creation. Let's say for the sake of argument that the average of the employment to population ratio from March of 2001 (the start of the last recession) to December 2007 (the start of this recession) is a decent proxy for a healthy participation rate. That works out to be 62.79% or so. If we take that percentage and multiply it by the adult non-institutional population, we get something like this:
This is household survey data rather than the headline establishment survey data we generally see in the press. It's harder to turn establishment survey data into these sorts of numbers, but that doesn't mean that I won't try. In any case, by this measure, the employment gap is approximately 10,712,000. This gap gets worse by about 122k a month with no job creation. 

Just for the sake of comparison, let's do something one should never do and compare establishment survey data to this and mix some data sets. This is a big no-no, but it's to try to put the headline number of +151k in context. 
By the way, the reason that the trend has kinks in it is that the non-institutional civilian population number tends to be adjusted periodically and that leads to these one-time adjustments like that. In any case, by this measure we are 11.4 million below where we need to be. What's interesting is that we barely got where we needed to be in the last expansion because it was quite weak. One could argue that outside of the housing bubble and its associated positive effects including booms in the construction and financial services industries, we didn't have much of an expansion at all between 2002 and 2007. Growth was sub-par as it was and Lord knows where we would have been in absence of the housing bubble. Going forward, it appears that the number of new jobs we need in the establishment survey to break even is around 116,000 a month.

The employment gap isn't necessary to close in order to restore growth, but until it starts narrowing a great deal you are going to have substantial downward pressures on wages. The prospects for generalized inflation with this much slack in the labor market are quite low.

Friday, November 5, 2010

October Employment Report

The overall change in non-farm payrolls was +151,000. The interesting piece was what happened to hours worked in that the aggregate hours worked increased a smidge over 0.4%, which is actually a very strong number. Government continues to be a drag, but not in the way that some who say that government is out of control would imagine as employment dropped 8,000. Interestingly, with revisions, the private sector has gained more than 100,000 jobs each of the last three months while government has averaged nearly 100,000 in losses.

Overall, this was actually a flat-out solid report and it does seem to echo what we saw in the ISM indices earlier this week. We still aren't going to make any meaningful dent in unemployment for several months even if we keep this rate up.

Wednesday, November 3, 2010

October Auto Sales Fairly Strong

In case you missed it, October was a, by recent standards, a banner month for auto sales. We are still at levels that during normal times would indicate serious problems or would otherwise be dismissed a freakishly low, but the fact that the automakers are profitable at these sales levels speaks well to the performance of their stock prices.

Ford (F), has had quite a nice run as well all know, but it still is not that richly valued. According to Marketwatch data, it's trading at a little over 7x forward earnings estimates, which are probably too low. Even after rising so much so fast, it's still not exactly that rich. Now, will you make 10-fold on your money again? Certainly not. However, a decent 40% from here is certainly conceivable.

Looking elsewhere in the automotive sector to automotive parts suppliers, I don't see so many good buys, however. Borg Warner (BWA) is looking a little pricey, at least relative to the market. Johnson Controls (JCI), a personal favorite of mine, looks good from here, but not better than Ford. I kind of like Dana (DAN), but it still doesn't exactly scream "buy".

All of them have had impressive one year runs, however.

Notice the S&P 500 down there, having a respectable 15% gain that looks positively puny. Normally, after a sector has had such a break-out performance one would expect that it might be about to go through a phase of dramatic underperformance. However, before that happens I think there is still room to run for the sector as a whole, though Ford seems to be the best positioned. As for the looming GM IPO, I would need to take a good look at their financials. They've been somewhat opaque while in their quasi-public-private status.