Monday, January 25, 2010

Debt and Debtors: Why Greece Matters for Governments and Investors, Part II

Say not unto thy neighbour, Go, and come again, and to morrow I will give; when thou hast it by thee.
Proverbs, 3:29

Into 2009, governments around the world went into serious deficit mode as taxes fell but spending rose. They also bailed out many banks and took on their debt load. The US's bailout of AIG has cost $180bn so far, and the total bailout cost in Britain is a stunning $1,380bn. In late 2009 and continuing to today, sovereign (government) bond markets are showing some strange signs.

Some facts doesn't make sense. Japan’s public debt has already risen above 200% of GDP, but the government can borrow for 10 years at 1.4%. In contrast, Australia’s government debt is much lower at about 25% of GDP, but it pays over 5.5%. Other rich countries with varying debt ratios all pay roughly 3.5-4%. Everyone is watching the sickest governments, which include Japan ("a bug in search of a windshield") and the PIIGS (Portugal, Ireland, Italy, Greece, and Spain). Greece is especially important.

To avoid scaring bond buyers (who buy the government bonds to finance deficits), governments need credible 5-year plans to bring deficits down.
They must convince markets of their discipline to get their fiscal houses in order. Germany has done this with a Constitutional amendment forcing a balanced budget by 2015; the US and UK have done nothing. Read about the German's prudent Constitutional Deficit Rule here: IMF on German CD Rule.

Members of the EU normally must abide by a clause of the Maastricht treaty where deficits remain under 3% of GDP. All the EU governments have collectively ignored this, but some have put measures into place to get back there (Germany, the Netherlands), whereas others have 6-8% deficits that may go on for a long time. This is bad for bonds. Across the eurozone, where countries lack control over their money supply, the risk of default is more real. That is one of the reasons why the Markit SovX index, a basket of sovereign CDS on Europe’s top 15 nations, at 71.5 basis points (bps), is now 14% more expensive than the the index for the region’s top 125 investment-grade companies. To wit: an index of government bonds costs more to insure than an index of corporate bonds - bond investors prefer the full faith and credit of companies over countries! This is shocking - Western governments are supposed to be safer and more stable than companies headquartered inside them, because theoretically they can tax the companies and the populace to pay their debts.

Greece seems to be the worst offender of the PIIGS. Its total debt is estimated as high as 875% of GDP, compared to rich world normal of 500-600% (this includes all on and off balance sheet debt and an estimate of social spending commitments, according to McKinsey). Greece's outstanding government debt alone is between 120-130% of GDP. The Greek deficits were worse than what the previous Conservative government published of 6%. The Conservatives under Kostas Karamanlis basically lied through the national statistics department. The new, Socialist government under George Papandreou came in on October 2009 and published the correct number of 12% (recently revised up to 13%).

To put Greece into perspective: The cost to insure bonds from Greece defaulting has risen 140bp since September, to 263bp. This is six times more than leading companies such as Unilever, BP and Deutsche Post. Before the financial crisis, the cost to insure sovereigns was lower than corporates. In August 2007, Greek CDS traded at 11bp, while Unilever, BP and Deutsche Post all traded around 20bp. I state the point again: markets trust some large multinationals more than they trust the sovereign government and people of Greece!

To get deficits down, the Greek Socialist government that campaigned on and promised more social spending and "cohesion" will have to cut public sector pay, reduce union wages, and generally force people's incomes down so labor costs in Greece come down. As the table title "Unit labour costs" below shows, Greek citizens got too many raises from 2000 to 2008 compared to Germany, so now their pay is bloated - just as the entire EU got bloated because the euro appreciated and made exporting tougher. Good luck to Mr. Papendreou, as any action he takes will lead to a recession and protests (it seems only a matter of degree - his choice is between a depression or a severe recession).

Labor is Expensive and Inflexible while Monetary Policy is Tight: A Deadly Combination

Greece has a few, difficult options (and traditional inflation isn't one of them):

1) Belt-tightening: The current government estimates it can bring deficits down from 13% to 3% by 2012. Even Germany, with its more modest 6-7% deficit, isn't that foolishly optimistic in projections. More importantly, no cuts have been enacted yet. As the Americans say, "Big hat, no cattle."

2) Default on debt:
This is what the Eurozone bond spreads are trying to settle on so far, with investors comparing the ultra-safe German bunds (equivalent to US Treasuries for Europe) to the PIIGs spreads over Bunds. While no one has a clue about the right price, to me a 2-3% spread on an irresponsible country doesn't seem attractive - rather, it seems pathetic. Also, default doesn't have to be outright debt repudiation. It can mean some type of moratorium on interest payments, and the restructuring of loan terms. (Even the US did it in 1934, when FDR abrogated the gold clause in government and private contracts and in 1971, when Richard Nixon abandoned the gold standard altogether). Default can also occur via inflation, currency debasement ("I loved the smell of a debased currency in the morning"), the imposition of capital controls, and special taxes that hinder or disrupt private contracts. Seen this way, a few countries in eastern and western Europe may already be technically at risk of default.

Spreads on Greece Bonds are Higher than Other PIIGS

3) Leave the Euro, return to the drachma, and force debtholders to accept a weaker currency when their bonds mature: Greece's Prime Minister and Finance Minister say it's committed to belt-tightening and keeping the euro, and won't leave. Which brings me to my "Financial Market Denial Rule": Anytime a CEO or government-head formally denies something in a press conference, the odds of it being true are higher than what the consensus previously expected.

As Greece denies it will leave the EU, its odds of doing so rise. Previously, I put the odds of that event at 5%, but now I bump it up to 25%.

As examples of this in the sovereign case, consider Russia denying it would default on bonds in 1998, Thailand claiming it wouldn't run out of foreign exchange reserves and devalue in 1997, or the UK denying it would take the pound of the ERM in 1992.

The consequences would likely be high. A Greek central banker, George Provopoulos, recently wrote an FT op-ed to his own country counseling against it, and he listed these consequences of Greece leaving the EU:
●Any devaluation of the new currency would increase the cost of imports, raising inflation.
●Monetary policy would lack the credibility established by the European Central Bank. As a result, inflation expectations would rise.
●Expectations of further devaluations would arise, increasing both currency-risk and country-risk premiums.
●The above factors would push up nominal interest rates, leading to higher costs of servicing the public debt and undermining fiscal adjustment, thereby taking resources away from other, productive areas.
●The costs of converting currencies with the remaining members of the eurozone would be re-introduced, inhibiting trade and investment.
●The exchange-rate uncertainty with the euro area would increase the costs of conducting business, further deterring trade and investment.
●Existing euro-denominated debt would become foreign-currency debt. Any devaluation of the new domestic currency against the euro would increase the debt burden.
●Greece would no longer benefit from the economies of scale, including the enlargement of the foreign exchange market, which decreases the volatility of prices in that market, derived from sharing the euro.

So it's clearly the last and worst option for Greece is to leave the EMU - it's akin to Iceland telling the UK goverment and banks to "go f- themselves" in not bailing out British depositors who put money with Icelandic banks.

Even more interesting, the European Central Bank (ECB) recently released a paper about the legality of Greece leaving the EU. See the abstract below.

by Phoebus Athanassiou, ECB

This paper examines the issues of secession and expulsion from the European Union (EU) and Economic and Monetary Union (EMU). It concludes that negotiated
withdrawal from the EU would not be legally impossible even prior to the ratification of the Lisbon Treaty, and that unilateral withdrawal would undoubtedly be legally controversial; that, while permissible, a recently enacted exit clause is, prima facie, not in harmony with the rationale of the European unification project and is otherwise problematic, mainly from a legal perspective; that a Member State’s exit from EMU, without a parallel withdrawal from the EU, would be legally inconceivable; and that, while perhaps feasible through indirect means, a Member State’s expulsion from the EU or EMU, would be legally next to impossible. This paper concludes with a reminder that while, institutionally, a Member State’s membership of the euro area would not survive the discontinuation of its membership of the EU, the same need not be true of the former Member State’s use of the euro.

The carefully worded (and confusing) abstract suggests that a country can't pull out of the EU and EMU. Yet the guts of the paper says that the new Lisbon treaty (enacted in late 2009) actually makes it quite easy for Greece to leave the EU. The newspapers have misread this paper as meaning that pulling out is legally tough or impossible.

One can interpret the paper as the Germans, through the ECB in Frankfurt, telling the Greeks that they're OK with the Greeks leaving. The paper also points out that it's nearly impossible to expel a member nation (would take a unanimous vote from all, including the expelled country). So the Germans can't force the Greeks to leave, but they can strongly hint: "Get your house in order, or else get out (no bailout)." And that's just what the German Finance minister did lats monh when he told the Boersenzeitung newspaper that governments allowing their budgets to slide deep into deficit, like Greece, face “severe consequences" and that Greece mustn’t serve as an example that “one can somehow muddle through."

Government (and societal) deleveraging will be difficult over the next few years. Many governments will be tempted to default, and George Magnus of UBS gives five reasons why:
First, sovereign debt service costs are set to soar, overshadowing those for programmes, such as environmental protection and some social services, and, unlike past successful fiscal adjustments, no country can lower interest rates as a palliative. Perversely, the contrary may be the case.
Second, OECD governments have experienced a threefold increase in their structural deficits, about a quarter of which is attributable to the drop in tax revenues, some of which may be permanent, for example, where they are related to financial services and housing.
Third, a weak economic growth environment augurs poorly for effective fiscal adjustment, as will be evident as the bungee jump nature of economic recovery becomes clearer.
Fourth, the financial crisis and the recession are the immediate cyclical reasons for the disarray in public finance, but these pale next to the structural costs of age-related public spending, which are starting to rise relentlessly.
Fifth, high levels of capital mobility complicate debt management. Credit rating agencies have been quick to downgrade and opine about several sovereigns. The significance of their actions lies in the fact that most central banks, and some sovereign wealth funds, cannot hold securities rated below AA. Most ‘long-only’ asset managers have such restrictions too.

So what can governments have to do to get out of the mess? Mr. Magnus states the hard choices eloquently:

Governments have to commit to credible details for fiscal stabilisation, and to structural reforms that address demographic issues, and the need for new growth drivers. The war on waste, raid on the rich, and other slogans will no longer do. They should raise the pensionable age, tackle public sector pension arrangements, and blaze a trail towards higher labour force participation and phased retirement patterns. They should end post-1945 middle class, homeowner, and corporate tax privileges, to finance jobs- and growth-oriented programmes that support the green economy, infrastructure, innovation, and education. Effective political leadership and imagination are essential if default risks are to remain at arm’s length. Otherwise, a spike in bond yields somewhere is all but assured and it may be impossible to prevent both contagion, and in the end, recourse to capital controls.

Saturday, January 23, 2010

Senators: Reject Chairman Bernanke - Alpha

In this post, I will argue that the US Senate, in its capacity to “advise and consent” to the President’s appointments, should reject Benjamin Shalom Bernanke’s nomination for a second term as Fed Chairman.

I must begin by saying I bear no personal animus to Mr. Bernanke. I believe he is an honest and capable civil servant, a first-rate economist (having read much of his work), and a person who truly cares about what’s best for the people of the United States. I believe Bernanke is quite disgusted that he was forced to bail out the banks.

Mr. Bernanke Prays for the Senate to Reconfirm Him

Time magazine recently named Mr. Bernanke its “Person of the Year.” This is misguided. Many economists and the media are not holding Mr. Bernanke accountable for his numerous mistakes. The deeper problem is that the American people are not holding their public officials accountable for mistakes (one hopes the recent MA election is a sign of change). Now it’s time for the US Senate, representing the American people, to reject Mr. Bernanke. The three reasons I propose are:

1) Rates and Regulations Fumbled: Mr. Bernanke as Fed Chairman failed the American financial system in setting too easy a monetary policy – he kept interest rates too low for too long and did not regulate banks properly. He helped create the housing bubble.

2) Reserve Requirements Too Low: Mr. Bernanke as Fed Chairman failed the financial system as an overseer in letting bank reserves fall too low – he let weak and poorly capitalized banks threaten the entire system.

3) Strict Liability Rejection: A Fed Chairman should be held “strictly accountable” for his mistakes – despite doing the right thing in the eye of the crisis, Mr. Bernanke helped get us there and shouldn’t be the Chairman leading us out. He also seems to lack original ideas to put the mess behind the country.

So let me begin:

1) Rates and Regulations Fumbled: The Fed under Mr. Bernanke had too loose a monetary policy from 2004 to 2008. This kept interest rates low and fuelled the housing bubble. In addition, the Fed didn’t regulate lending terms, allowing deviations from standard mortgage terms. A standard mortgage is a fixed-rate, 30 year mortgage, with 20-30% down – and the owner occupies the property. Without regulation and oversight from the Fed, many subprime lenders allowed “NINJA” loans of “no income, no job, no assets” along with “adjustable rate mortgages” (ARMs) with low teaser rates that would reset at much higher, unaffordable levels. This created a speculative bubble in housing.

The Fed Kept Rates Too Low, Contrary to the Respected Taylor Model

Mr. Bernanke and former Fed Chairman Greenspan saw some “isolated froth” but denied the housing bubble as it occurred. They were regulators sleeping on the job (and Mr. Greenspan has admitted and apologized for this). While the buildup of the subprime crisis was complex (see the papers below), the one thing that is clear is that Mr. Benanke was the main regulator responsible (the SEC and OFHEO also take much blame).

“The Subprime Crisis: Cause, Effect and Consequences” (Whalen)

Understanding the Subprime Mortgage Crisis (Demyanyk & Van Hemert)

For a broader and more cutting analysis of the meltdown and Bernanke's responsibility (along with other regulators), see the recent book by Judge Richard Posner:
A Failure of Capitalism

A few weeks ago, Mr. Bernanke gave a self-serving speech to a convention of economists (the annual AEA meeting) where he failed to take responsibility for Fed failures since 2004. Read the speech here, and the rebuttal of the respected economist John Taylor (of Stanford) here.
Bernanke's speech to the AEA - Jan. 2010
John Taylor of Stanford's response

Even Mr. Bernanke's supporters admit the Fed Chairman has made many mistakes, while Bernanke hunkers down and won't admit to them: see Econbrowser here arguing Bernanke be kept.

The point of this: Mr. Bernanke is still not taking responsibility for his mistake on rate-setting and the housing bubble. He claims that in only hindsight people can see a bubble. Yet economists and business magazines were saying from 2002 to 2005 that they saw a housing bubble. See the quotes below and the magazine covers.

Dean Baker, economist and co-director of the Center for Economic & Policy Research:
We've never seen this sort of run-up in home prices in U.S. history. In the past, home prices have always moved pretty much at the same rate with inflation's overall rate. But in the last seven years, they've outpaced the rate of inflation by 60 percentage points. This kind of run-up becomes unsustainable. Right now, the market is caught up in the psychology of a bubble. You see the fastest increases just before the collapse. (Businessweek, June 2005)

John Templeton, Investor:
Every previous major bear market has been accompanied by a bear market in home prices. . . . This time, home prices have gone up 20%, and this represents a very dangerous situation. When home prices do start down, they will fall remarkably far. In Japan, home prices are down to less than half what they were at the stock market peak. . . A home price decline of as little as 20% would put a lot of people in bankruptcy. (Interview with Robert Flaherty in Equities magazine, 2003)

Cover Stories of Fortune magazine in 2002 and Businessweek in 2005:

Mr. Bernanke, unlike Mr. Greenspan, cannot admit that he was and is wrong. He should be rejected by the Senate.

2) Reserve Requirements Too Low:
Mr. Bernanke as Fed Chairman failed the financial system as an overseer in letting bank reserves fall too low – he let weak and poorly capitalized banks threaten the entire system. Few economists and journalists are pressing this error. At the core, reserves are cash that a bank must keep with a central bank to protect depositors and show the bank is stable and well-capitalized. Banks don't like to keep this money lying around and not earning interest, so regulators force them by law to do it. Reserves are a much more powerful tool than rates to prick a bubble before it starts. See this background for why reserve requirements are important, from the Fed, from the lax NY Fed, and from a hard-headed Chinese government central banker.

One reason that the crisis occurred in 2008 was that many financial institutions were massively overleveraged and had too little tangible book equity capital to sustain their debts. Along with their tangible book equity, their reserves with the Fed were also too low. While the broker-dealers (which the Fed didn’t directly regulate, until they last few converted to bank holding companies) were the worst offenders, numerous banks like Wachovia, Washington Mutual, Corus Bank, Indymac, and others were making bad loans with little equity to back it up. Their reserve levels were too low. It’s arguable that Citigroup and Bank of America had far too low levels. So when the crisis hit, the banks' cushions to absorb losses were too thin, and this created the domino effect of failing banks, fire sales in bad assets, falling asset prices, and so on in a vicious cycle.

In general, the leverage of the financial system was far too high (reserves and tangible equity were too low). More problematically, as bad US policies let the real income levels of middle classes stagnate, the Fed’s hands-off approach allowed banks to increase the crushing debt load on middle class Americans. The Fed should take direct responsibility for this.

To highlight the intentional tragedy of this, I remember a personal conversation with an analyst at a large financial institution (whose name you will know), one of the largest issuers of credit cards in the US. He told me the financial models his division created were made to maximize debt loads on the holders of credit cards, and earn money through fees and interest. Their models assumed that a majority of borrowers would never pay the bank back and go bankrupt, but that the bank would still make money off of fees and interest to overcome that. Why isn't the Fed regulating this sort of predatory lending? Credit card regulation falls under the Fed's powers; yet the Fed has fought a turf battle to keep the President from forming a new Consumer Protection Agency even as it has failed to protect consumers.

See the charts below for middle class debts and high bank leverage.

Middle Class Debt Gets Higher as Banks Take on More Leverage

3) Strict Liability Rejection: A Fed Chairman should be held “strictly accountable” for his mistakes – despite doing the right thing in the eye of the crisis, Mr. Bernanke helped get us there and shouldn’t be the Chairman leading us out. Strict liability means the person in charge should be held accountable for failure whether or not we can prove he is at fault. So if you buy a new car and the brakes fail the next day, the auto company should be held at fault without you having to prove it made a car with bad brakes. The US Navy has a long-standing policy for ship captains. If a captain gets a ship into a major accident, he/she is relieved of duty, no matter who is at fault. Whether the captain is not competent or merely unlucky doesn’t matter. It’s not a harsh rule for an institution, but only a common sense one in a world where proving fault in difficult.

While I believe the facts below show Mr. Bernanke to be at fault, I don’t believe the US Senate needs to find fault. It should just apply “no fault” strict liability and not confirm Mr. Bernanke for the failure under his watch. "Bernanke kept a recession from becoming another Depression" just isn't a good enough reason to keep him because he was one of the regulators helping to cause the current recession.

Captains of Crashed Ships are Held Strictly Accountable

As a final point to the strict liability argument, Mr. Bernanke seems tired and without fresh ideas. His prevention of a financial system meltdown in October 2008 was creative and well-done (many smart investors, from Warren Buffett to Bill Gross and George Soros were expecting Armageddon at one point, and Mr. Buffett went on to make his Pearl Harbor speeches). Yet Mr. Bernanke doesn’t have any original ideas for the Fed to help the US get out of the mess and reduce the massive amounts of debt. Ken Rogoff of Harvard has suggested targeting 5-7% inflation, far against the central bank orthodoxy of 1-3% inflation. The Bank of Japan, for better or worse, has allowed deflation to hit. Mr. Bernanke has started the US on the right steps with quantitative and qualitative easing (though he rejects calling a spade a spade for the latter), but he has no new ideas.

As a side note, Mr. Bernanke will still be around as a Fed Governor and member of the FOMC even if he doesn’t get reappointed (his term there lasts till 2020). That will give him a chance to redeem himself from a place where he can do less harm.

In sum, the US Senate should use its good sense and judgment to reject Mr. Bernanke’s nomination as Fed Chairman. Recent news suggests some Democratic senators are leaning this way. I hope their constituents (you – the American people, to whom your representatives listen) bombard the Senate with calls and letters to reject Mr. Bernanke.

Some other competent candidates for the Fed Chairman position that President Obama should consider are (from all sides of the political spectrum):
-Janet Yellen (SF Fed President)
-Sheila Bair (Head of the FDIC)
-Paul Krugman (Professor at Princeton)
-Kenneth Rogoff (Professor at Harvard)
-Martin Feldstein (Professor at Harvard, former Chair of President Reagan’s CEA).

One candidate I reject is current CEA Chair Larry Summers, who has already shown himself to be an advocate for the banks and not policies to strengthen the American middle classes. Witness his opposition to Paul Volcker’s suggested and necessary bank reforms. Despite his brilliance at arguing, Mr. Summers has failed as a steward of financial and economic policies, as his speculative betting at Harvard shows.

Thursday, January 21, 2010

Political Tremors in DC over Obamacare, Bank Reform, and More - Alpha

What a difference a week makes, as some major events have been taking place in Washington DC this week:

1) The likely failure of the Obama health care reform (the largest economic measure from DC since the 1930s)
2) New bank reform momentum behind the "Volcker Rule"
3) Positioning for a "Debt Reduction" panel
4) The most major and radical "conservative" Supreme Court decision in a decade
5) What Americans want - Attention Mr. President

I point mostly to articles from the Washington Post, which still has the best coverage on DC and the federal government (putting the NY Times and WSJ to shame). For information junkies, other niche publications on American politics that insiders read and that I recommend are Cook's Political Report, the Congressional Quarterly, the National Journal, and ABC's The Note (which I hear Bill Clinton still reads daily).

1) Obamacare Fails:
No way around it, the voters of Massachusetts just killed Obamacare. With only 59 "Democratic" votes in the Senate, it's highly unlikely a revised plan will pass both the House and the Senate (odds went from a close 50/50 with 60 votes to 90/10 against the plan with 59 votes). It's Obama's first big failure. The only way to get around this is to eliminate the anachronistic "cloture" rule (since 1917) of the Senate that forces 60 vote supermajorities. This is an idiotic rule that must eventually go, but I doubt the pusillanimous Democrats have the guts to kill it (maybe a braver, future Republican administration will kill it to "get an up or down vote" on a judge). One a sidenote, kudos to the voters of MA for rejecting the arrogant dominance of the Dems in holding that particular Senate seat - it has basically been a Kennedy throne since JFK took it in 1953. This a 57-year old family seat finally being opened! Pharma and health insurance stocks rallied in delight when the Dems lost this seat.

2) New bank reform momentum behind the "Volcker Rule"
Previously, Larry Summers and Tim Geithner were stalling on any meaningful bank reform. Only Paul Volcker and British regulators were pushing for something substantive. It looks like Obama just pushed back his own bank-friendly economics team for some real reform. As Vega says, we'll wait to see what they actually do, but policy-wise, the President is much closer to real reform now. Now we have to ask for Mr. Geithner to be sacked for a more neutral hand, less beholden to the big banks (note the little banks have gotten nothing from Geithner). For more interesting reform ideas, see what NYU professors and the witty Prof. Buiter wrote.

3) Positioning for a "Debt Reduction" panel

Congress will never enact meaningful reform to lower the deficit by raising taxes and cutting spending. The nature of getting re-elected means you kick the bucket down the road - it's a commitment problem. Germany has solved this with a Constitutional amendment that kicks in at 2016 forcing balanced budgets. The US needs the same amendment. But failing that, the next best policy is an independent panel that comes up with a solution and forces Congress to vote, to be held accountable. The details matter here. President Obama wants a voluntary proposal from a panel created by executive order; Congress could modify this voluntary proposal with pork or not even vote on it. Serious Republicans and Sen. Evan Bayh (D-Ind.) want a law enacting the panel, with a single final recommendation and a forced up-or-down vote in Congress, so it's very clear to voters which representative is against balanced budgets. If the US is to stay fiscally solvent and not go bust through defaults or inflation, the technical details of the panel are crucial. Bond investors should watch this closely.

4) Citizens United: The most major and radical "conservative" Supreme Court decision in a decade

In a display of stunning narrow-mindedness and lack of common sense, the Supreme Court upheld a strong right of free speech for legal entities that are not human beings. While I strongly support free speech for citizens/humans, this specious reasoning continues the "corporation as person" doctrine from the 1886 Santa Clara County case where a corrupt Supreme Court held for the all-powerful Southern Pacific railroad (affectionately known as "the Octopus")that corporations were persons and had rights like human beings. This is the logical end of many years of such silliness - now, your next neighbor, a corporate entity, can't actually vote in an election, but it can outspend you by hundreds of millions of dollars in mass media ads. This is the largest win for corporate interests and the corrupting influence of money on politics since Bellotti in the 1970s. It is also a radical break from legal precedent and an example of "conservative" law-making on the bench from Chief Justice Roberts. Finally, I doubt this decision is good for shareholders as it's entrenched management that is most likely to wield corporate dollars to bribe politicians (though any highly regulated company will win, as it's easier to buy a committee chairman than to follow regulations). I end with something any flesh-and-blood American can agree on: A corporation isn't a person, and money isn't speech.

5) What Americans want - Attention Mr. President

So the irony is that just as Obama bites the biggest hand feeding him (the banking lobby, who were his largest group donor via Goldman, Citi, JPM, UBS), the Supreme Court hands a major legal victory to the corporations. But Obama is a shrewd politician. He knows that the priorities of ordinary Americans are:
i) JOBS! It's unemployment, stupid.
ii) THE DEFICIT. Americans, esp. centrists and independents, are getting angry about government spending where they can't see results but they know they will get a big tax bill down the road. As Vega posted, tax rates are definitely going to go up across the board (the question is who bears the costs).
iii) HEALTH CARE COSTS. Obama's noble attempt to enact universal health care has failed. Now he needs to get to the tougher problem of rationing health care and bringing down costs for something that may be impossible to do (Baumol's cost disease)

In a future post, I will present my modest "sketchy plan" for deficit elimination and an efficient tax system. Stay tuned.

Shrinking Banks - Ari Paul

Today, Obama announced two new initiatives to dramatically reduce the size of large banks and the risk they take. Depending on how these are implemented, it could be revolutionary, cataclysmic, or business as usual.

The long delayed political populism is gaining momentum. Obama asserts that he will “recover every last dime” that was paid to large financial institutions. He says he will “no longer allow banks to stray too far from their central mission of serving their customers.” To accomplish this he is proposing the new “Volcker Rule”, which will ban hedge fund and private equity operations by large banks. Secondly, Obama is planning to extend the deposit cap to include other forms of bank funding, effectively limiting the size of big banks and preventing further consolidation.

The first thing to note is that the 50 largest banks provide about 85% of all market liquidity. If they completely stopped trading tomorrow, equity and bond trading would basically cease. The fear of this scenario could drive violent liquidations as asset managers rush to avoid a repeat of October 2008, when they couldn’t find a bid to sell their bonds and derivatives.

Realistically, I think these new initiatives are unlikely to have a huge impact. Obama has said that banks will still be allowed to execute customer orders. In doing so, banks frequently take the other side of the trade. This is conceptually prop trading since the bank is exposed to loss and may use skill to produce gains. However, it is considered market making within the financial community. The CEO of Goldman Sachs, Lloyd Blankfein, recently told the Senate that Goldman Sachs did not engage in prop trading, but rather in market making. To explain this distinction: market making is viewed as a benign provision of liquidity; the idea is that the market maker serves humanity by making it less expensive for market participants to buy and sell securities. In exchange for this service, the market maker collects the bid/ask spread. Market making is sometimes viewed as a relatively conservative endeavor. In contrast, the term “prop trading” more often refers to making strategic bets. Whereas the market maker might get short a small amount of stock for a couple days because a customer wanted to buy it, the prop trader will heavily short the stock believing the company will soon go bankrupt. These distinctions are entirely arbitrary; market making is prop trading and I believe it is impossible to distinguish the two with regulation.

Since banks are allowed to continue market making and it is almost impossible to distinguish market making from other prop trading, I’m deeply skeptical that Obama will be able to prevent banks from engaging in risky prop trading. This is all conjecture though, since we have no idea what form the initiatives will take. My best guess is that Obama will enact legislation that will look very menacing but most of the big banks will find loopholes to continue business as usual. To the extent that the legislation succeeds in reducing prop trading at banks, the winners are the largest hedge funds that will step in to fill the void.

Tuesday, January 19, 2010

Debt and Debtors: A Global Picture of Deleveraging (Part 1) - Alpha

“And forgive us our debts, as we forgive our debtors.”
-The Lord’s Prayer in the English Bible

Debt is the poisoned root for the global economy and financial markets. It is the big substructure that all investors must weigh, the deflationary gravity that will push down equity, commodity, and all risk-asset prices (despite the current sugar rush from unsustainable monetary policies). Deleveraging means paying off debts; and mind you, risk-taking and economic growth cannot occur if debts are too high. We go into the visual details in this post.

The McKinsey Global Institute (MGI) has come out with a superb report on global debt and deleveraging, available here (very long and detailed):

McKinsey Debt and Deleveraging Report (2010)

See shorter text summaries from Gillian Tett of the FT and the Economist.

See also the masterful Rogoff/Reinhart study (which we also refer to), presenting centuries of history on debt and defaults:
This Time is Different: A Panoramic View of Eight Centuries of
Financial Crises (2008/2009)

MGI looked at the facts on the ground and analyzed 45 historic episodes of deleveraging, in which an economy significantly reduced its total debt-to-GDP ratio, that have occurred since 1930. Below is our analysis of their conclusions, heavy on visuals and light on text.

1) US total debt at highest levels since 1929 (before the Great Depression):
This reached its highest level in 2008 in the last 110 years, only once before seen in 1929/1930. In that instance, deleveraging took 20 years. (Note: This is a Morgan Stanley slide)

2) All “rich” countries are in deep debt: The US wasn’t alone in the cancerous debt growth. All rich Western countries, along with Japan and S. Korea, were part of this foolish debt binge. Empirically, after a credit-based expansion and major financial crisis, every country nearly always has a long period of deleveraging.

3) Emerging market stars are light on debt: Countries like the BRICS, took on much less debt in comparison. Russia, of all countries, was a responsible Hetty.

4) Debt varies greatly by sector - households and CRE are the sickest: A heat map shows that the two areas most needing deleveraging are households and commercial real estate. Households are getting a massive savings penalty in low rates, whereas commercial real estate (CRE) lenders are pushing back doomsday with a “pretend and extend” approach to maturing debt. Surprisingly, many governments and corporate borrowers are much healthier than investors realize.

These are McKinsey’s metrics in coming up with the heat map:

5) The UK and Japan were hogs, Russia was a minnow: Interestingly, government debt is the biggest problem for Japan, but it’s the least problematic for the UK (where everything else, household, corporate, and financial hurts equally). The US and Germany are close in the level and near-equal composition of their debts. Russian financial institutions and corporations were relative hogs; its government and household were the most frugal in the world.

6) Sovereign debt crises (a hardy perennial): For a sovereign crisis to occur, total debt must be high, deficits must be trending higher, debt service must come close to unbearable bounds, and the bond buyers must be twitchy. Japan has high total debt and bad deficits, but its debt is mostly owned by Japanese savers who are forced to own government debt through institutions like Japan Post. But as Japanese savers eventually need to fund their retirements, this could get nasty for Japanese rates. For a deep, fascinating analysis of Japan, see some SG research here: SG on Japan's Sovereign Crisis

By this measure, the US is in a pretty safe place in the short run, but the trend is not sustainable. The million-dollar question is who implodes first: Japan, the UK, Greece, and some of the PIIGs (Portugal, Ireland, Italy, Greece, Spain) seem to be top contenders.

Sovereign crises seem to happen in waves, with defaults occurring every 20 to 40 years. (Rogoff/Reinhart)

Also, the hotter or more mobile that capital is, the greater is the incidence of a banking crisis. (Rogoff/Reinhart)

7) Only 4 ways to get out of the debt mess:

i) belt-tightening,
ii) high inflation,
iii) massive default,
iv) high GDP growth/productivity.

The rich world will have to decide between options 1 and 2, as option 3 has a very high long-term cost and option 4 is illusory (even though I’m a “tech optimist”, even I’m not that optimistic given the debt loads – Silicon Valley, seen from the ground, seems to be in a nasty, secular contraction for innovation/startups despite the health of the big companies like Intel, Oracle, Google, etc.).

Inflation will certainly be part of the solution – in the long-run, no paper currency is worth the pulp it’s printed on. That’s why investors turn to the “hard” currencies of gold and silver – they can’t be printed/duplicated but must be slowly mined over decades. (Rogoff/Reinhart)

8) GDP growth depends on the policy path taken: Depending on the road taken, GDP growth could recover faster or slower. In the short-run, belt tightening is the best strategy, but strangely, in the long-run default seems to lead to the best outcome! (I would question that with the examples of Argentina and Thailand, but Russia survived 1998 quite well). As McKinsey puts it: “Deleveraging episodes are painful, lasting six to seven years on average and reducing the ratio of debt to GDP by 25 percent. GDP typically contracts during the first several years and then recovers.”

9) CRE, GSEs, and Big Banks are the worst offenders: Digging down into micro details, commercial real estate and the US broker-dealers (the Big Banks, the “Banksters”) went completely bonkers. But craziest of all were the government-sponsored entities (GSEs) of Fannie and Freddie, where it was “tails shareholders win, and heads the government/taxpayers lose” on their massively levered bets. Two problems from the GSEs and Banksters: i) insanely high debt/equity ratios, ii) liquidity mismatches, meaning borrowing money short and lending it long. Congress, the Fed, and the feckless GSE regulators take much of the blame here.

10) Governments have dealt with hard times before: The two fascinating charts below show how the US and UK governments borrowed too much after previous wars and then had to pay back the debt. For the US, recent high borrowings came with Reagan to finish the Cold War (1980-1988) and then with George W. Bush for the Middle Eastern Wars (Iraq 2, Afghanistan). George H.W. Bush and Bill Clinton should get credit for being the responsible, “fiscal clean-up” Presidents. In the end, debt must come down and debtors must be forgiven. But many paths lead to that eventual conclusion.

11) Historic deleveraging episodes: Below is the dataset that McKinsey used in their study.

Monday, January 18, 2010

Tax Hikes and Legislation - Ari Paul

You can view a PDF version of this post here:

In this issue:
1. The Massive Deficit
2. Looming Personal and Corporate Tax Hikes
3. Other Taxes and Legislation
4. The New Tax Math
5. Implications of a Debt Spiral

The US deficit is projected to grow by about $10 trillion dollars over the next decade. I’ll examine the massive federal deficit and the new taxes coming that will help reduce it. I’ll also look at the biggest financial legislation currently being discussed and how it will impact the federal budget.

1. The Massive Debt
The Congressional Budget Office (CBO) estimates that the federal deficit will average $1.1 trillion per year for the next decade without tax hikes. This $1.1 trillion represents about 8% of GDP and assumes that the government’s borrowing rates remain low and that economic growth returns to historical trend. The CBO warns that this deficit may result in a death spiral of growing debt that would eventually require the US to effectively default. To make things worse, states had budgetary shortfalls of about $110 billion in 2009 and will likely face shortfalls of $150 billion each in 2010 and 2011. There’s also a roughly $1.5 trillion pension shortfall that may require a federal bailout.

2. Looming Personal and Corporate Tax Hikes
The Bush tax cuts expire at the end of 2010. This will cause marginal personal income tax rates to rise 3-5%. Obama’s budget also limits itemized deductions and includes other provisions that raise about $63 billion in new tax revenue per year.

Healthcare taxes: A “Cadillac Tax” on premium healthcare plans would bring in $15 billion a year and would affect about 25% of Americans, including 25% of union workers; it is opposed by many large unions and many not make it into the final healthcare bill.

New taxes on businesses starting in 2011 total about $35 billion a year and include excise taxes, repeal of subsidies to the energy industry, and a repeal of LIFO accounting.

3. Other Taxes and Legislation
The “Jobs Bill”: a new stimulus bill aimed at producing jobs may include a $250 payment to seniors, subsidies for transportation and green energy projects, and tax breaks for small businesses. Early estimates of the cost are $75 - $150 billion. The Senate will begin discussion on January 19th.

One-time bonus tax: Britain and France have imposed a 50% one-time tax on Bankers’ bonuses. Germany is pondering the idea but looks unlikely to follow. US Congressman Welch just introduced a similar bill in the US, but it looks unlikely to become law.

Financial Transactions tax: two versions are floating around, one in the Senate and one in the House. Bill 2927 was introduced late December by Senator Harkin and would impose a roughly $150 billion a year tax on securities transactions. Earlier in December, a bill titled “Let Wall Street Pay for the Restoration of Main Street Act of 2009” was introduced by Rep DeFazio. Both bills impose a tax on stock transactions of 0.25% and on futures and derivatives of 0.02%. Currently this seems unlikely to pass. I examined the effects of this kind of tax here:

Climate Legislation: We have no idea what this bill will look like if and when it eventually passes, nor how much it will cost. The burden is on the Senate and climate is currently low on their priority list. After “Angliagate” and the failure of the Copenhagen climate talks, the democrats may lack the political will to get involved in another messy legislative fight. Opponents believe any bill is likely to impose large costs on businesses.

Big Bank Tax: The Obama Administration is pushing for a $90 billion tax on the largest 50 banks. We don't know exactly what form this will take, but it will probably be spread out over a decade.

4. The New Tax Math
These new taxes total about $120 billion in revenue per year. Additionally, the CBO estimates that current healthcare legislation will reduce the deficit by $10 billion per year. There are many questionable assumptions built into these numbers; the Obama administration has discussed extending certain provisions of the 2001 and 2003 tax cuts and we don’t know what will happen with the Alternative Minimum Tax or what new fees will be imposed on banks; also, the estimates of health care costs have a giant margin of error. Under these assumptions, the new taxes (and healthcare deficit reduction) only reduce the annual deficit by about 8%. Also built into these numbers is an assumption of 3% annual real GDP growth over the next decade and 1% inflation. Weaker growth or higher borrowing costs would cause the deficit to rise even faster.

5. Implications of a Debt Spiral
Eventually, growing fiscal deficits become unsustainable and it appears the US may have already entered a debt spiral. Japan successfully maintained a debt to GDP ratio of 150% for over a decade, so it’s not obvious when a high sovereign debt level will lead to crisis. Japan was able to maintain such a high debt level for so long at least in part because the Yen was an international reserve currency and Japanese citizens maintained an extremely high savings rate (financing Japan’s debt at low interest rates). The US has an even stronger reserve currency, and if we enter recession again the savings rate may skyrocket. In other words, we may be able to survive in the debt spiral for quite a long time. However, eventually we will have to either sharply devalue our currency or find some other way to default on the unsustainable debt. The other option, raising taxes and decreasing expenditures, would require sacrifices so great they seem politically impossible.

The Yap live on a small collection of islands in the south pacific. As money, they use giant stone wheels called Rai (pictured above). Maybe after the US devalues the dollar into worthlessness we’ll all be using stone wheels as money. I can picture the commercials – giant stone wheels 4 gold!

Friday, January 8, 2010

How to Invest in the Chinese Miracle, where Locals Prosper and Foreign Devils Don’t - Alpha

The biggest economic and financial development of the 21st century is the rise of China. My hypothesis is that well-connected Chinese entrepreneurs and bureaucrats will financially prosper in China over the next few decades, as will the growing middle classes. But foreign investors (ethic non-Chinese) will not make money, as they plunge billions every year buying Brooklyn Bridges (Yangtze Bridges) that will never return them a cent. To wit: foreign direct investment (real investment, not financial instruments) in China between 2001 and 2008 ranged between $26bn to $44bn - not much of that will ever come out to investors. I end the post with ideas on how to get investment exposure to the Chinese miracle by not investing in China (the Gold Rush thesis).

Here are the facts for China's economic growth:
-Population: The largest in the world, with 1.34 billion people, it is mostly a young population (92% below the age of 65) with a low dependency ratio (few dependents for every worker – but this well get worse fast).

-GDP growth: Between 9-13% from 2006 to 2008, and a stunning 8% in 2009 when most of the world went negative. While these stats are probably fudged (esp. at the local level), the high level is generally in the ballpark.

Make no mistake: economic growth rates matter. The US, with an expected 2% GPD growth rate over the next 10 years, will increase its GDP from $13.5trn to $16.5trn. China, with an expected 9% rate, will increase its GDP from $8trn to $18.9trn. While Americans will enjoy fat, sleek, and contented lives with higher GDP per capita (fewer people to share the pie), China will be the world’s largest economy.

The Chinese are the world’s greatest entrepreneurs. Whether you’re in Nairobi, Rome, New York, Sydney, or Buenos Aires, you may notice the small retail shops, restaurants, dry cleaners, and other business run by Chinese small businessmen and women. Southeast Asia is dominated by Chinese entrepreneurs. Some stats:

-60 million Chinese entrepreneurs worldwide.
-Chinese entrepreneurs control 70% of the Southeast Asian economy.
-517 out of 1000 top-ranking companies in Asia are owned by ethnic Chinese.
-50% of foreign direct investment (FDI) inflows to mainland China stem from their own expats worldwide.

-Sound Government (for Economic Policy): More controversially, China has one of the best-run central governments in the world, by economic measures. Kudos to the current Politburo Standing Committee of the Communist Party of China; they’ve done much more for the Chinese middle classes, and to reduce poverty, than either the Bush or Obama administrations have done in the US. Besides the amazing growth rates mentioned above (which put India to shame), China had the largest fiscal stimulus package in the world in 2008 in response to the global crisis, at 14% of its expected 2008 GDP. It led the world in recovery. So much so, that the Carnegie Endowment thought the US should copy China. Chinese tax rates are low, and China is also the world’s largest exporter and saver, making and shipping goods to the rest of the world and saving its surpluses (over $2 trillion in foreign exchange).

More broadly, China has had the greatest reduction of poverty the world has ever seen, from 1980 to 2005.

By political, social, and environmental measures, China does a much worse job. But more on that later.

Today, the hosannas and optimistic melodies on the China story are played aloud. The world has much to be happy for, as a billion richer Chinese people is a good event for human development. Assuming that the Chinese government is smart enough to avoid starting wars or developing an imperial global military presence (ahem), it will do well.

Now for reality. Foreign investors (ethic non-Chinese) are basically gifting their money to Chinese entrepreneurs and bureaucrats when they invest there. Some economists have pointed out that economic growth doesn’t necessarily translate into equity returns (valuations still matter, and China is off the deep end in a bubble today, according to America’s best short seller and a glance at public market P/E ratios). I offer three more conceptual reasons for my hypothesis. First come incentives (agency costs). Second is the lack of basic property, speech, and politico-legal rights. Third is a reading of developing market history, especially 19th century American history.

1) One-sided incentives for China’s entrepreneurs and managers (high agency costs):
China’s entrepreneurs and managers have a strong incentive to take foreign capital and technology (including know-how), build a strong company, and then to sever the foreign partner.

Put yourself in an entrepreneur’s shoes. You speak Mandarin, have all the necessary government and family connections (guanxi) to operate, have sweated for years on the ground (after breaking out of poverty), and there is no restriction against you appropriating a business after you build it. Why share it with the pesky foreign investors, who were born with TVs, cars, and free health care? How many entrepreneurs in Silicon Valley would kick their VCs to the curb, after success, if there were no legal consequences? (Hint: A lot). The economic term for this is agency costs – they are much higher in China than most other countries, but investors aren’t paying attention. To counter agency costs, an investor has to be able to monitor entrepreneurs/managers, and then discipline or remove them if needed. In China? Fuggadaboutit.

For a real life example, consider the French company Groupe Danone’s foray into making yogurt in China. They picked a stellar local entrepreneur, Zong Qinghou, who took Danone’s capital, technology, and know-how to start a joint venture. While managing it, he then set up parallel company to compete with it. Eventually, as Danone realized it would lose everything, it settled with Qinghou for a small sum, and basically lost out any long-term future in the Chinese yogurt markets.

Previous China fads have provided books of material for this. See Beijing Jeep or Mr. China for earlier pipe dreams brought to reality. Sure, there are honest entrepreneurs like BYD’s Wang Chuanfu, but this is a matter of personal character in a system that is both amoral and stacked against foreigners (Note, this guy is so bold that he drinks battery fluid to make a business point).

Sure, this incentive system isn’t fair to foreign investors. But neither was the Western occupation of China for a hundred years, the forced sale of drugs like opium to the Chinese masses, and the crushing of local resistance against the “Foreign Devils” (the Boxer Rebellion). Don’t forget the recent bombing of a Chinese embassy in Kosovo by US planes in 1999 (can you imagine Chinese planes bombing a US embassy anywhere, and what the outcry would be over that – what American wouldn’t want war?). Culturally, most Chinese just don’t care about giving a fair shake to wealthy and imperialistic foreign investors. Have doubts about this? Consider how the Chinese system respects no Western intellectual property (estimated $23bn stolen in 2005), but forces the West to respect Chinese patents. Forget fairness, this is amoral sharp dealing.

2) A lack of lack of basic property, speech, and politico-legal rights in China:
This was the detail I brought up earlier on, when discussing the miracle of Chinese growth. Basically, the question for a foreign investor is, what do you do when a bond issuer fails to pay you, or your equity partner reneges on you like Mr. Qinghou? Answer: nothing. You take it on the muzzle, tuck your tail between your legs, and whimper away. Chinese courts are a mess, the rule of law and corruption are worse than the world average, and the “voice and accountability” of people is one of the lowest in the world (see the World Bank’s Governance matters chart below, which suggests China has become less politically stable and more corrupt in the last decade).

The World Bank on Chinese Governance, Corruption, and Rule of Law

You can go to court to sue your equity partner, but you will lose your case (he likely has a political relationship with the judge). A bondholder can try forcing a Chinese company into bankruptcy, but the odds of success are very low (my banker friends in restructuring departments of global banks tell me the two places in the world they can’t collect from are former Soviet republics, run by ex-Mafia/KGB types, and China). Buying bonds without a clear law of bankruptcy/defaults and an honest system backing it up is just insane.

OK, so the legal system is worthless. What about pressure in the press? Well, that’s tough to do when the press won’t even publicize your problems, because it’s controlled by a government who doesn’t want to scare away other potential foreign investors. It’s not just Chinese dissidents protesting gross human abuses that are muzzled; foreign investors don’t have a chance. No free speech means no chance of protesting to get a fair shake or get your money back. I would go further and argue that for property rights to exist, one must have a fair degree of free speech rights (your right to own property depends on your right to publically argue for why you should keep it).

Put bluntly, the game in China is rigged. Economic Freedom for the average citizen is low, and it’s almost nothing for the foreign investor. The Heritage Foundation, a think tank, puts China at 132 in the world, below Yemen, Rwanda, Columbia, and Niger. This is a game for the House, its croupiers, and other insiders.

3) A reading of developing market history, especially 19th century American history, suggests foreign investors boost economic development but lose much of their money to locals. Throughout the 19th century, the US flourished with an influx of European capital. Foreign bondholders financed railroads, cities, and industrial mining operations. The caveat is that they got wiped out in their railroads investments from 1870-1892 (the single largest use of capital in US for that period), as unscrupulous local entrepreneurs transferred wealth to themselves. Dust out the history books and read about Leland Stanford (yes, the Stanford who was a California Governor and with an eponymous University), Jay Gould, and E.H. Harriman (Maury Klein’s books are a great starting point). Likewise, the foreign bondholders didn’t get much back from US states and municipalities.

Unfortunately, we don’t have any investors from the 1880s alive to tell us their stories today, but consider the "Memoirs of Henry Villard." Mr. Villard fought honestly and bravely for European bondholders to receive something, anything, on their rotten American investments. In one European bond investment in the US, only half of the nominal investment was ever received by the railroad company in Oregon, the rest having dissipated along the way. Generally, much of the management and directors of American railroads (the largest corporations of their time, by far the biggest part of the capital markets) transferred foreign wealth to themselves.

Henry Villard (1835-1900), Protector of European Bondholders Against Crooked American Railroads

In sum, direct investing in China is such a bad idea that your common sense should stop you (but wait, very few institutional investors seem to have common sense). Of course, traders and hedge funds who speculate daily in Chinese stocks (in and out like mosquitoes around buffalo) will survive. But investors, that is, people with locked in capital or holding periods greater than a week or month, enter at their peril. The one counterexample I can think of is Warren Buffett's large Petrochina investment in China for a year, which was a naked bet on cheap oil assets and paid off handsomely. But I doubt even the Standing Committee would want to screw the world's most famous investor (imagine the publicity), and time will tell whether smaller investors get this treatment (odds are they won't).

So what’s a foreign investor to do, to get China exposure?

The Gold Rush Thesis - Buy China through Australia, Canada, and other Exporters: The thesis comes from the California gold rush in the 1840s and 1850s. Very few of the prospectors and miners made money in the mountains and plains, but the ones who did quite well were the merchants who sold to them. For example, the magnates Collis Huntington and Mark Hopkins made their first fortune selling dry goods, mining supplies, and other hardware to miners; they later partnered with Leland Stanford to create a railroad/transportation monopoly.

A Dry Goods Store and Hotel in a Mining Town in Sutter Creek, Circa 1850

For the 21st century, investors should look to prospering Australian and Canadian companies who export into China. Examples include Penn West, Talisman Energy, Suncor Energy, Barrick Gold, Alcan, and Potash Corp. Similarly Australia has some great resource companies like BHP Billiton, Bluescope Steel, and Ashton Mining. For the US and Germany, tech companies with dominant positions, like Cisco, Oracle, Siemens, and Twintec will do well. Generally, China’s largest imports are electrical machinery, oil, metals, scientific instruments, and office machines and equipment. Of course, younger companies who export heavily into China will do even better than the multinationals, but I’m not revealing my list of whom I’m betting on.

Monday, January 4, 2010

Pimco is Bearish and Disgusted with both Risk-Assets and US Treasuries - Alpha

The gentlemen at Pimco are some of the savviest bond investors in the world. They also are great at making actionable macroeconomic predictions and actually positioning portfolios on their outlooks (something I see too little of in the investment world - acting and holding on to your convictions!). Quite simply, Pimco's returns for 2008, 2009, and the two decades before have been stellar.

Gross and El-Erian: The Best Team Since Buffett and Munger

Well, three top thinkers have Pimco have come out with rather bearish views, and trigger-happy fund managers, euphoric little guy investors, and regulators should take note when the smart money publicly puts out its views:

1) Bill Gross, Pimco's co-founder and PM of its largest fund (the Total Return Fund is the world's largest bond fund), has these thoughts:

-"The U.S. and most other G-7 economies have been significantly and artificially influenced by asset price appreciation for decades. Stock and home prices went up – then consumers liquefied and spent the capital gains either by borrowing against them or selling outright. Growth, in other words, was influenced on the upside by leverage, securitization, and the belief that wealth creation was a function of asset appreciation as opposed to the production of goods and services."

-"Financial leverage, in other words, drove the prices of stocks, bonds, homes, and shopping malls to extraordinary valuation levels – at least compared to 1956 – and there could be payback ahead as the leveraging turns into delevering and nominal GDP growth regains the winner’s platform..."

-"This 100% overvaluation from recent price peaks of course is crude, simplistic, and unrealistically pessimistic. It implies that stocks should be at – gasp – Dow 7,000 – and that home prices – gasp – should be cut in half from 2007 levels, and that commercial real estate (Las Vegas hotels, big city office buildings that are 20% empty) should likewise face the delevering guillotine."

-"[P]olicymakers, (The Fed, the Treasury, the FDIC) recognize the predicament, maybe not with the same model or in the same magnitude, but they recognize that asset prices must be supported in order to generate positive future nominal GDP growth somewhere close to historical norms. The virus has infected far too many parts of the economy’s body, for far too long, to go cold turkey. . .
That support, of course, comes in numerous ways. Financial system guarantees, TARP recapitalization of banks, TAFs, TALFs, PPIFs – and in Europe and the UK, low interest rate term financing, semi-bank nationalizations, and asset purchase programs similar to the United States. In the case of the U.S., the amount of the implicit and explicit financial support given by policymakers totals perhaps as much as $5 trillion, which goes part way to support the $15 trillion overvaluation of assets theoretically calculated in the PIMCO model (100% of nominal GDP)."

-"The Fed is trying to reflate the U.S. economy. The process of reflation involves lowering short-term rates to such a painful level that investors are forced or enticed to term out their short-term cash into higher-risk bonds or stocks. Once your cash has recapitalized and revitalized corporate America and homeowners, well, then the Fed will start to be concerned about inflation – not until. To date that transition is incomplete, mainly because mortgage refinancing and the purchase of new homes is being thwarted by significant changes in down payment requirements. The Treasury as well, has a significant average life extension of its own debt to foist on investors before the Fed can raise short-term Fed Funds."

-What to buy: "Where does that leave you, the individual investor, the small saver who is paying the price of the .01%? Damned if you do, damned if you don’t. Do you buy the investment grade bond market with its average yield of 3.75% (less than 3% after upfront fees and annual expenses at most run-of-the-mill bond funds)? Do you buy high yield bonds at 8% and assume the risk of default bullets whizzing at you? Or 2% yielding stocks that have already appreciated 65% from the recent bottom, which according to some estimates are now well above their long-term PE average on a cyclically adjusted basis? . . . If companies are going to move toward a utility model, why suffer the transformational revaluation risk of equities with such a low 2% dividend return? . . . Let me tell you what I’m doing. . .I figure, why not just buy utilities if that’s what the future American capitalistic model is likely to resemble. Pricewise, they’re only halfway between their 2007 peaks and 2008 lows – 25% off the top, 25% from the bottom. Their growth in earnings should mimic the U.S. economy as they always have, and most importantly they yield 5-6% not .01%! In a low growth environment, it seems to me that a company’s stock should yield more than its less risky debt, and many utilities provide just that opportunity. Utilities and even quasi-utility telecommunication companies now yield between 5 and 6%, whereas their 10- and 30-year bonds yield less and at a higher tax rate to you the investor."

2) Mohammed El-Erian, CEO and PM, expects a second financial dip (with some odds of a second economic dip), and a long "new normal" of "below model/trend" GDP growth and stagnation:
-"We're on a sugar high... It feels good for a while but is unsustainable." [This burst of economic activity fed by government spending and near-zero interest rates will soon peter out.]

—Stocks will drop 10 percent in the space of three or four weeks, bringing the Standard & Poor's 500 index below 1,000 — though El-Erian is not predicting when.

—The unemployment rate will be hovering above 8 percent in late 2010.

—U.S. gross domestic product will grow at an average 2% or so for years to come — a third slower than we're used to.

-Many of the bulls don't appreciate just how much the government props still under the economy are masking its weakness. Instead of focusing on the fundamentals today, they're looking to the past, expecting a quick economic rebound because that's what's happened before. We're trained to think the "farther you fall, the higher you'll bounce back... We're hostage to the V."

-We've probably seen the worst of the crisis but consumers, and not just Washington, need to start spending again for the recovery to really take hold. This won't happen soon. Like in the Great Depression, Americans are saving more and borrowing less — a shift in attitudes toward family finances that Pimco thinks will last a generation. More regulation and higher taxes will crimp growth for years to come.

3) Fed Watcher Paul McCulley, a PM, presents the firm's 2010 Investment Outlook (their shared internal consensus):
-The world is uncertain, and risk assets are not looking good. Multiple outcomes are likely as "there is still uncertainty over three major issues, which in turn creates a range of possible outcomes in our forecast. Depending on how these issues progress, we’re looking at multiple potential resolutions of the inherent tension in the overall system."

-"The first issue is the peg between the Chinese yuan and the U.S. dollar, which essentially gives us a one-size-fits-all monetary policy in a very differentiated world. Progress, or lack of progress, on this issue could lead to several outcomes. If China were to let its currency appreciate, it could regain a degree of monetary policy autonomy and a better ability to manage the risk of overheating and asset price inflation. Another outcome, however, is that China refuses to let the yuan appreciate, essentially maintaining too easy of a monetary policy for itself and the developing countries that shadow Chinese policies. This would create bubble risk, particularly for assets such as emerging market (EM) equities and commodities.

The second major uncertainty is what will happen when the Fed completes its mortgage-backed securities (MBS) buying programs. We know that it will have an unfriendly effect on the interest rate markets, but we don’t know the magnitude, because it’s too hard to isolate the supply and demand dynamics between fundamentals and the stimulus programs. The key variables are the “stock” effect, or the lingering price impact of the amount of duration taken out of the marketplace, and the “flow” effect, which is the price impact when the Fed stops buying. They’ll keep the stock, but they’re just not going to be part of the flow any more.

The third uncertainty is any change in the Fed’s pre-commitment language, which is currently committed to keeping the fed funds rate exceptionally low for an “extended period.” We don’t think the Fed is going to tighten any time in 2010, but long before the FOMC (Federal Open Market Committee) actually does the deed, it will have to change its language. That could very well happen in 2010, and there is genuine uncertainty over how quickly and strongly the market will anticipate a tightening process. Our gut feeling is that the moment the Fed changes any one of its words, it’s going to be a very unpleasant experience, because the marketplace has very little patience and a very big imagination. The most important book at the Fed right now is a thesaurus, and it’s probably sitting on top of Paul Samuelson’s Foundations of Economic Analysis."

-"Sturdy growth in the emerging markets space, even if less than the Old Normal, and slower growth in the developed countries. Inflation, meanwhile, will probably be too low in the developed world because of still-huge output gaps. What the forecasts can’t tell, however, is that asset price inflation – including commodities – is becoming a more important dimension in our forecast because it’s becoming a more influential component of central banks’ reactions around the world." Note that Pimco has deep lines into many of the world central banks, and has former Fed Chairman Alan Greenspan as a special adviser.

-For Pimco's all important thoughts on portfolio positioning for 2010, read the whole piece here to the end: (summary, hug the benchmarks and go light on US and UK bonds of all sorts in relation to the EU and strong, commodity-driven EM countries, and up your cash allocation - but no word on gold or other metals)
[I don't get paid or anything from Pimco for this referral, but kudos to them for communicating strong research and convictions different than the market consensus).