Thursday, January 31, 2008

Why? What? When?

The Fed cut rates by another 50 bp (0.50%) yesterday for an unprecedented total 125 bp in just 8 days. This brings the target rate to 3.00%, already one of the lowest levels since Bretton Woods and the inception of the Dollar Hegemony era. And there is more to come: immediately after the FOMC announcement a major Wall Street firm predicted (begged?) that the next cut will be a full 100 bp to 2.00%.

Data: St. Louis Fed

By comparison, Fed funds were already at a low 3.00% on Sept. 1, 2001 towards the end of the previous recession, and Mr. Greenspan only took them lower because of the tragic events that transpired on 9/11. We may fault the Maestro for thus starting the largest real estate bubble in US history, but I am certain that every one of us would have reacted to the emergency in the same way and slashed rates, at the time.

Are we faced with an emergency today? Clearly, the unprecedented actions by the Fed and the administration show they are worried - panicked, even - that the developing economic slowdown portends much worse than a garden-variety recession. Their "sweat" is clearly showing, in sharp contrast to sensible advice ("Never let them see you sweat") and Shakespearean observation ("The lady doth protest too much, methinks").

I will try to briefly answer the three questions from the post title.

Why are they worried? Because the global economy has become so highly financialized that everyone looks to "markets" for their decisions - even their emotional well-being. Mainstream media run live tickers on their stations and sites, and economic news that were once relegated to the back sections are now at the front page. This is a very dangerous dynamic, nestled as it is within a highly complex system.

What are they worried about? That negative market action will be instantly transmitted via the above dynamic to the "real" economy, resulting in a seizure: slashed consumer spending and mass layoffs. And this holds for the entire world, not just the US, because global markets have become highly correlated.

How fast could this happen? We already saw last week how quickly global markets can accelerate to the downside. In the era of "just-in-time" everything, the domino effects to the "real" global economy can't be cushioned by inventory builds or delayed production and delivery schedules. Every businessman is now trigger-happy - look at the chart below.

Chart: FRB

Perhaps the Fed's rapid-fire cuts will prevent the slowdown from turning into what Mr. Bernanke and the administration fear most. But their fear has me spooked, I'll tell you... To paraphrase FDR: The only thing I have to fear, is their fear itself.


P.S. The Monster Employment Index for January was just released, showing a sharp drop from previous months and also falling to the lowest level since February 2006. The index tracks online employment advertising.

Wednesday, January 30, 2008

"A Bank Is Not A Casino"

Verbatim quote from Jean Veil, one of SocGen's attorneys: "Kevriel did not have the right to gamble 50 billion euro. A bank is not a casino."

Oh, really?? Tell that to the tens of thousands of traders who work in dealing rooms as market makers and customer reps (i.e. croupiers), or betting the bank's own money outright (i.e. in-house gamblers). Even theoretically low-risk arbitrage can quickly turn into scary gambling, when the correlations change (just ask the LTCM folks). The lawyer's own statement makes it clear: Kevriel had the right to gamble - it's just that he wasn't authorized to gamble so much.

"Modern" banking has today edged much closer to outright gambling, particularly after the repeal of the Glass-Steagall Act. Sarkozy is 100% correct in saying "the financial system has lost sight of its purpose". It used to be that finance served the real economy, but in the last 10-ish years the world has come upside down and finance has taken center stage, expecting the rest of the economy to service it - or provide a bail out whenever it needs one.

I don't have to go very far to prove it: In 1984, after two years working as an engineer, I was the only member of my graduating class to go into finance (0.28%). A couple of months ago I was amazed to find out that 33% of my alma mater's 2007 graduates went into finance - and we're talking about a traditional "monoline" Joe Engineer school, not some lib arts/finance university.

Banks are not casinos... Who are we kidding here? I, for one, am immune to regular casinos; I find them boring, and so do most of the bank traders I know. The reason? The amounts wagered are incredibly small, by comparison to what goes on in "our" casinos, and the type of bets available are simplistic and unexciting. Wager on "come seven", or "black/red"? C'mon... we need at least a few hundred million to get us excited and much more complex ideas to stimulate our minds. Some, like Monsieur Kevriel, go overboard and cause the house to bust - but this is only a matter of scale, not of function.

Oh yes, M. Jean Veil, today most banks are casinos. Why do you think they need all those sophisticated risk control and oversight systems?


For more information on the subject of financial risk management please see Bookstaber's "A Demon of Our Own Design", in the Amazon sidebar on the right of the screen. The writer is a real pro.

Tuesday, January 29, 2008

Money Does Not Grow On Trees

The market is expecting Mr. Bernanke to provide another 50 bp rate cut tomorrow, bringing Fed funds to 3.00%, well below inflation. What is the Chairman trying to do? Simply this:

(a) Prevent adjustable rate mortgages from re-setting higher and so ease the immediate pain in housing and,

(b) Create inflationary pressures to counter - as much as possible - the deflationary spiral that has already started in credit and asset markets.

Point (a) is self-explanatory, but point (b) requires further elaboration.

First, let's look at asset markets and consumer spending.

Economists, and the Fed's own econometric model, estimate that asset wealth has a direct 5% effect on consumer spending, i.e. for every $1 increase or decrease in asset wealth, people adjust their spending by 5 cents. This link derives from two sources: the psychological "wealth effect" (I feel richer, so I can spend more of my income and save less) and using assets as collateral to borrow and spend (I can "unlock" my wealth and spend it now).

As of the third quarter of 2007, American households owned $21 trillion in real estate and $11 trillion in equities. A 10% drop in housing prices and a 15% drop in equities would thus result in a reduction of approximately $187 billion in consumer spending, or 2% of personal consumption expenditures. This may not sound like much, but in fact, there has never been a year (or even a quarter) when US consumers did not increase spending in absolute terms, the Great Depression excepted (see chart below, click to enlarge).

Personal Consumption Expenditure, Percent Change From Prior Period

During other slowdowns growth in earned income and less saving carried people through, allowing them to keep spending until things turned around. Not now: the saving rate is already zero or negative, and wage growth has been very meagre, averaging 3% nominal for 25 years (currently 3.7%).

In other words, people were already spending more than they made and their wages were stuck. Only way out was to borrow in order to increase spending, but the credit crunch has now made this more difficult. The credit crunch begat the asset crunch, which is quickly turning into a spending crunch. Spiral down..

So, Mr. Bernanke, who cannot control wages, can only do one thing: drop interest rates so fast that people will be tempted to borrow again, hopefully assuming more debt than what is being destroyed right now (write-offs, abandoned houses, etc.). Because - and make no mistake about this - the destruction of debt is the destruction of money, and the destruction of money leads to deflation, by definition. Money does not grow on trees, after all - it can only be created via borrowing.. Here's my own version of the Money Tree:

$ Now $
$ Hear This: $
$ Money is debt. $
$ No debt, no money. $
$ Less debt, less money. $
$ Less money, less inflation. $
$ Even less money, is deflation. $
$ Because $
$ "Inflation is always and everywhere $
$ A monetary phenomenon." $

If people and businesses won't or can't borrow, Keynes said the government should, and thus keep the flow of money going, i.e. create a fiscal stimulus. I find it amusing, and highly instructive, to observe how quickly the supposedly most laissez faire US administration in 75 years dumped classical economics and embraced Keynes. Oh yeah, in calm seas everyone is a salty mariner, but let the boat rock a little and watch as they scream and scramble for the life preservers...

OK, bottom line...

Here's a simple assignment: You are Ben Bernanke. Now, create inflation.

Note: it is a lot harder than you think, and please don't just say "run the printing presses".

Feel free to use the comment section.

Monday, January 28, 2008

Stock Market: Now A Lagging Indicator

The behavior of the stock market has always been considered a leading economic indicator. In fact, the performance of the S&P 500 index is used by the Conference Board in calculating the official US Leading Indicators. Nevertheless, could it be that share prices are now lagging indicators? Let's look at the data.

The chart below (click to enlarge) plots the annual percent change in S&P 500 (blue line) vs. the performance of the "real" economy: annual changes in retail and restaurant sales (red), new orders for manufactured goods (pink), housing starts (green) and private employment (olive).

Notice how the broad economy started weakening in 2006 but stocks kept moving higher, even accelerating their ascent, until recently. Clearly, stocks were lagging the real economy.

In my opinion, the following are the main reasons for this unusual behavior:
  1. Stock valuations remained high because financial engineering spread out credit risk via derivatives (CDOs, CLOs, CDSs, SIVs, etc.). This theoretically lowered the overall business cycle risk and ultimately resulted in low equity risk premia (i.e. higher P/Es). As we found out, this was a fundamental mistake: Cutting the risk salami into thinner slices didn't make the salami itself any smaller and lots of it eventually found its way into places where it didn't belong (e.g. money market and pension funds). Food poisoning ensued and the market has now gone into purgative mode.
  2. After two decades of the Greenspan put, people believed that the Fed and other central banks could always bail out investors by cutting rates to the bone. However, under credit crunch and zero saving conditions it is near impossible to adequately stimulate the economy - and business profits - by just cutting interest rates. The result has been a panicky government rushing to provide fiscal stimulus.
  3. Strength in BRIC economies was supposed to counterbalance a possible Western slowdown and keep raising profits for global corporations, i.e. decoupling. I maintain that the BRIC surge is largely derivative and highly fragile, a product of supplying and vendor-financing over-indebted consumers in the US and the EU. This remains to be proven, but I note with interest that Chinese officials emphasize that their growth is heavily dependent on exports and that Arab oil producers refuse to raise production, even when publicly scolded by President Bush, fearing a collapse in prices from lower demand (assuming they can raise production, of course).
  4. Almost the entire world has accepted the capitalist laissez-faire model, theoretically allowing the invisible hand to guide profits ever higher, without meddlesome government interference. My personal view is that this is tantamount to unchecked reliance on religious dogma and that is will end badly, but, once again, it remains to be seen.
  5. All of the above are combined into the Great Moderation Theory (GMT), which holds that recessions will be infrequent and shallow, resulting in small peak-to-trough profit declines. In other words, the theory proclaims the effective abolishment of the business cycle.
But was GMT the result of structural economic transformation, as so many hope, or was it just a mirage, a process of temporarily prolonging and increasing economic activity by incurring higher debt? The chart below (click to enlarge) shows growth in real GDP (blue line) and household debt (red). Notice the unusually prolonged period of accelerating household debt after 1993 and compare it to the extended period without a serious recession.

GDP and Household Debt Expansion

Back to the stock market: from previous posts we know that corporations and investors "bought" into the GMT concept and kept replacing equity with debt in their balance sheets, removing unprecedented amounts of equity from the market via buy-backs and LBOs (see chart below). In other words, they have bet the farm on the economy not going into a serious recession (this explains the panicky rate cuts from the Fed).

All of the above, taken together, had up to now kept share prices higher than otherwise - i.e. stocks lagged the economy. Therefore, we may soon discover if the Great Moderation holds, or if it turns into the Great Unravelling.

Sunday, January 27, 2008

One Sentence, Again

"We have to put a stop to this financial system which is out of its mind and which has lost sight of its purpose", Sarkozy said on Saturday during a visit to India. He was reacting to the SocGen "rogue trader" loss. Bravo, Monsieur le President.

Or, as Obelix himself might have said, Ils sont fous ces Romains (they are crazy, those Romans).

Friday, January 25, 2008

What's So Scary About A Recession?

In 25 years looking at the US economy and global markets, I have never seen such swift action from the Fed and the government, theoretically designed to avert or ease a looming recession. For example, the Fed's 75 bp one-day cut was the largest in its history and the fiscal stimulus bill was approved by Congress in record time. Everything is being done in a great big hurry. Why? And what further conclusions may be drawn from such action?

Part of the reason lies in the people: Mr. Bernanke is an academic who made a career out of blaming the Great Depression on the Fed, and Mr. Bush has never met a tax cut he didn't like. In addition, most of Congress is up for re-election this year and sending cash to voters is as close to hog heaven as a politician will ever get in his/her career.

But from a statistical standpoint, at least, the overall economy hasn't yet weakened appreciably. The medicine being administered seems way out of proportion to the illness. At 3.50% Fed funds are already at the level of late 2001, when the economy was 3/4 of the way out of the recession and much below current inflation, which is running at 5.7% annualized for the three months ended in December.

Fed Funds Target Rate

Because of the Great Depression, American financial and political institutions are terrified of the spectre of deflation. Until perhaps a decade ago, a replay of such a catastrophe was deemed impossible because of the Keynesian social state erected in the intervening decades. But two developments since the 1990's have apparently changed this view:

a) Japan became a glaring example of a modern welfare state suffering from two decades of deflation and zero growth due to the bursting of share and real estate bubbles.

b) Beginning with the Reagan Revolution, the US radically transformed its economy and is now focused on free markets, laissez-faire and individualism, instead of government intervention and social cohesion. Its structure is currently closer to that of the 1920's than at any other time since the end of WWII.

In other words, I think Washington and Wall Street now recognize the danger of a deflationary implosion, even if they don't come out and say it openly, and even if they caused it themselves by unchecked reliance on Adam Smith's invisible hand. This would certainly explain the swiftness and the size of the "insurance policy" currently being taken out by the Fed and the government (i.e. watch what they do, not what they say).

It looks like Bush, Bernanke, Paulson and Co. are scared to death and the recent plunge in global stock markets is giving them the willies. After all, those that live by the sword (the market) are in constant fear of being killed by it.

Thursday, January 24, 2008

And Who Will Bail Out The Other Guys?

The NY State insurance regulators are trying to put together a bank scheme to recapitalize the monoline credit insurers, so that AAA ratings can be salvaged. Banks are obviously concerned because of the higher capital adequacy ratios and haircuts required for non-AAA holdings.

  1. Where are they going to get the equity money ($15-30 billion, depending on who you ask) considering they are still raising money for themselves from abroad?
  2. How will the banks' new foreign investors (Kuwaitis, Koreans, Singaporeans, Chinese..) react to having their money even partially siphoned from "their" banks to the insurers?
  3. Why throw good money away, when the new kid on the block is ready to steal the business with a sparkling new AAA rating? I'm referring to Mr. Buffett's new credit insurance company, which has stated it will only insure muni bonds. In other words, it will skim the cream and leave the sludge - structured finance - to the old monolines.
The scheme is being considered to "protect" the AAA ratings on the existing sludge, something that banks and many others who bought it (pension funds, bond mutual funds, trusts) are very concerned about. The usual smoke and mirrors is not going to work in this case, because the rating agencies are unlikely to play ball. Their reputation has already been badly tarnished, and as the recession sets in every pol inside the Beltway will be looking for scapegoats. And it's an election year...

But the more serious question is this: The monolines have underwritten insurance on $2.4 trillion worth of bonds and are regulated... what about all the CDS sellers who are not tightly regulated? Hedge funds, for example...

Who will bail them out, if need be? The CDX investment grade index is shown below.


P.S. SocGen announced a huge $7.1 billion loss from a single rogue trader. They are calling it "fraud", but of course it is plain old failure to supervise. The scheme was apparently the regular "hide and roll", common in all such trader hanky-panky. But the loss size is astonishing, particularly coming from a low-level 100k/yr equity trader. Something smells fishy here - for example, how could a lowly employee put on such big positions? His book must have been in the high tens of billions and that's not easy to do, or hide, no matter how well he knew "the system". Sophisticated risk and compliance systems have multiple layers and cannot be "gamed" by a single person. Hmmmm...

But if the loss was the responsibility of just one tiny trader, then SocGen's risk management system is worse than swiss cheese: high in fat and full of holes. Incroyable!

Wednesday, January 23, 2008

You Can Take A Bipolar Cow To Water...

Why are lower interest rates and tax rebates mostly useless in averting a coming deep recession? For the same reason that you may drive a cow to water, but you can't force her to drink.

American households are in deep structural trouble, so they aren't going to borrow more and they won't spend their rebated pennies from heaven. They are finally waking up to the reality that in the past two decades they have borrowed and consumed too much, while saving very little. Call it Aesop's "The Ant and The Grasshopper" or the hangover after a binge, the effect is the same: people will go into a prolonged period of abstinence in order to repair their financial damage.

Personal Saving Rate (Income Minus Spending)

This is not a morality tale, however. It's not about castigating people who, as I said in previous posts, had to borrow in order to maintain a decent lifestyle. Look at all the data you want: in the end you will find that while corporate earnings rose as much as 40% per year, wage increases for working Americans came to a pittance (see chart below, click to enlarge). Businesses "did not share" and this is a monumental mistake that corporate America is going to regret for decades to come.

Annual Change in Corporate Profits (blue) and Hourly Earnings (red)

This is not a morality issue, either. It's not about ethically "bad" corporations vs. "good" workers - though I bet that's how it will ultimately play out when the political pendulum swings to populism. Instead, it's all about competence: if top managers don't have the common sense to pay workers enough to comfortably afford their own goods and services a la Henry Ford, then they are immensely incompetent businessmen, plain and simple. If they face dumping from abroad, then they should be screaming bloody murder to Washington, instead of sending campaign contributions.

Furthermore, making up lost earned income in the form of increased asset wealth is a fool's errand: financial asset ownership is highly concentrated to the top 5-10% of the population and real estate, though more evenly distributed, is not liquid enough to substitute for income. In fact, borrowing against housing "wealth" while incomes stagnated was the proximate cause for the current mess.

Washington needs to wake up. This is not their daddy's ho-hum recession but a virulent grand-daddy come to visit from the late-19th century. The trifecta of high debt-low income, zero saving and asset deflation cannot be overcome with low interest rates and pocket change. The credit crunch shows us that borrowing is part of the problem, not the solution, and panicky tax rebate proposals are proof that it is income that is lacking, not lower taxes.

Finally, Dr. Bernanke should understand that financial markets are in practice composed of manic-depressives that always demand more meds, not reasonable ivory tower academics who realize when to stop. It is his job to know when to give in and when to just say no, otherwise the inmates will take over and tear the whole place apart. Look at what just happened: the Fed did the biggest one-day cut in its history, down to 3.50%, but the inmates are already back demanding more, with 3m T-bills at 2.30%, 2-year notes at 1.95% and 5-year at 2.50%. I hope the Chairman can recognize market blackmail when he sees it.

Watch out Mr. Chairman. If you pay too much attention to us bipolar misfits we're going to take you down to the ZIRP hole faster than you can spell Sikorsky. And I mean it - right now, anyway. In 30 seconds I may change my mind. Or not.

Tuesday, January 22, 2008

It's All About Fundamentals, Again

I had written this for posting tomorrow, but with today's developments (Fed cut by an emergency 75 bp) it is more timely to post it today.

List of relevant rates, as of today:

Fed Funds: 3.50%
3m T-bills: 2.50%
2y T-note: 2.05%
5y T-bond: 2.65%

What is the fixed income market saying? Don't bet on a fast recovery.


As global financial markets gyrate, it is a challenge to keep our eyes dispassionately fixed on the economic fundamentals. Yet, we must.

Here are the key points:
  • The global recovery after 2001 was based on: (a) debt-financed household consumption, (b) debt-financed asset appreciation, and (c) the sharp rise in energy and resource prices, which created huge wealth effects in producer countries.
  • The economic growth of BRICs was derivative, i.e. it was a result of (a) and (b) above, and served to further enhance (c).
  • Ultimately, therefore, the whole structure is anchored on the excess consumption of a few hundred million westerners (US and EU), who could spend far above their earned income because they borrowed so easily and cheaply.
Let's examine the last point further, i.e. borrowing by western households:
  • Household borrowing in the US and EU was ramped up when dollar and euro interest rates collapsed to multi-decade lows following the 2000-01 recession and the 9/11 events.
  • Lenders came from: (a) savings-rich Japan looking for higher rates than available in ZIRP-yen, a.k.a. the carry trade and (b) BRICs and resource exporters that could not, or would not, spend their earnings within their own economies. This created what Secretary Paulson has previously described as a "savings glut".
  • A series of financial "innovations" spread credit risk and exposure wider than ever and greatly weakened lending standards.
Let's now examine and interpret present conditions:
  • The US sub-prime crisis is merely the first step of wider credit troubles in the West. The weakest borrowers went under the fastest; next come highly leveraged corporates, speculative commercial real estate and companies with excess capacity, built in anticipation of continuous good times.
  • Vendor financing of western consumers by China and resource exporters was a blind misallocation of capital that resulted in bubbles. Instead of buying western securities, they should have invested their money in domestic social services to raise living standards widely (this is particularly true for China and Russia*). They acted as providers of concentrated, speculative "margin" money to western consumers and they thus share in the blame for the bubbles.
How are things going to proceed from here? What follows is my personal opinion which, as all views of the future, should be taken with properly-sized doses of scepticism (jumbo-pack recommended).
  • Western consumers will revert to spending within their means. It is possible that they will cut even further, in order to repair their overstretched household balance sheets. Saving rates will rise in the US and EU.
  • Fiscal policy "boost" initiatives that are based solely on tax cuts/rebates will be proven ineffective, as the bulk of the money will be saved instead of spent.
  • The BRIC economies will suffer from slowdowns induced by overcapacity and bad business loans.
  • Credit crunch and risk aversion will spread to more sectors and more economies - it will become a wider global phenomenon.
  • Interest rate cuts will bring western economies closer to ZIRP and liquidity holes, instead of inducing credit expansion and consumer-lead growth.
  • We will see significant further deflation in asset prices, and may even see bouts of deflation for consumer goods, brought upon by excess capacity.
  • Commodity prices may decline, particularly where marginal demand is directly tied to robust economic growth conditions (energy, metals, etc.).
In the days, weeks and months to come it may become very tempting to misinterpret the temporary gyrations of share indices, thinking them guides to future economic activity. I believe times are changing, back to when real economic fundamentals determine asset and commodity prices instead of the other way around. The cart is going back behind the horse, where it properly belongs.

We should keep our eyes fixed on the real economy "horse", instead of the market "cart". Some economists and policy setters had become very lazy of late, thinking the Dow told all. It doesn't, and it's high time they started earning their keep honestly, once again...


(*) In the case of the Gulf emirates this was admittedly difficult because of their small domestic economies. How many indoor ski centers can one build in the desert?

Another Shoe

Despite the well-documented plunge in residential real estate, private non-residential construction was still robust in November, as the chart below shows (click to enlarge). Spending came in at a record $375.8 billion annualized; by comparison, private residential construction in the same month was $484.9 billion annualized. Therefore, non-residential construction is a very important sector for the economy, almost as important as housing.

The breakdown by type of construction is shown below (click to enlarge).

With 50% of the activity concentrated in commercial space, offices and hotels, a recession will result in further woes for the real estate sector and the banks that finance it.

Monday, January 21, 2008

A Quick Question

On the back of some pretty nasty behavior by global markets while the US is closed in observance of MLK's birthday, I have a single question to ask those that believe in "decoupling":

If the global economy has become highly integrated, as so many say ("globalization"), isn't it illogical that parts of it will decouple by a wide margin and just keep going strong, despite weakness in the US, EU and Japan (70% of global nominal GDP)?


Maybe decoupling enthusiasts are just "having a dream"?

Friday, January 18, 2008

Bad Medicine

The government has finally admitted that the Fed can't by itself prevent a recession and is now working to come up with a fiscal stimulus package.

(Open Parenthesis: The NY times yesterday ran an 8,000-word Ben Bernanke hagiography by Roger Lowenstein (
"The Education of Ben Bernanke"), accelerating its publication from this coming Sunday, to coincide with yesterday's testimony to Congress. It's a must read, as far as Beltway whitewashes go: it includes a lengthy explication of the Fed's history and limited power to shape the economy and blames Alan Greenspan for everything. What is poor, poor Professor Ben to do? Not subtle, but, then again, it wasn't meant to be. Close Parenthesis).

President and Congress are looking for a "quickie" economic stimulus package that will consist of personal tax cuts or rebates, plus some form of corporate investment incentive (e.g. faster depreciation). The whole thing is expected to come in at around $100 billion, or 0.70% of GDP.

Judging from the remedy being considered, it is clear that the diagnosis is grossly wrong. The doctors are prescribing aspirin to a patient whose splitting headache is caused by a brain tumor and not the hangover from last night's overindulgence. Let's look at the "medical" evidence - I won't provide charts because they have been posted here numerous times already.
  • Record high ratios of debt-to-GDP and debt-to-income.
  • Record high debt service ratio (debt payments-to-income).
  • Zero/negative saving rate; a hand-to-mouth existence.
  • Stagnant earned income growth.
  • Smallest job growth for a recovery ever (since at least 1940)
  • Low quality of new jobs, loss of high value-added manufacturing.
  • Rising disparities in wealth and income.
  • A generational time-bomb ticking away - baby boomer retirement.
Say you are a doctor, and this 350-lb smoking, drinking patient with asthma, high blood cholesterol, diabetes and heart disease walks into your office complaining of a headache. Obviously, you can't cure him overnight - but to just ask him if he had too much to drink last night is really, really bad medicine. The fellow needs a lifestyle overhaul, or he will be pushing up daisies soon enough.

"Take two and call me in the morning" is inadequate, irresponsible and dangerous for America's economic health.

Thursday, January 17, 2008

Philly Fed Ugly

Short post today. The Philadelphia Fed just released its monthly survey of business conditions for manufacturing in its area (see chart below). The current activity diffusion index was expected at -1.5 and instead came in at -20.9. Ugly.

Philadelphia Fed Business Outlook Survey Indices

New orders and shipments swung sharply from positive to negative and so did employment prospects. Details are in the table below (click to enlarge).

Then again, prospects for the US manufacturing sector can best be described as follows: Boeing. If you don't believe me, look at the next chart, also from the Fed, that shows new orders and backlogs for capital goods. Excluding aircraft, new and unfilled orders are at 1999-2000 levels..

Wednesday, January 16, 2008

The Press Meets The Wrench

Sometimes, two sentences are enough.

The NY Times today has an excellent article that starts: "Ben Bernanke, meet Gary Crittenden. While you're easing credit, he is tightening it." In two brief sentences the writer (Floyd Norris) speaks volumes: Gary Crittenden is Citigroup's CFO, who just told analysts the largest bank in the US is reducing consumer lending and raising interest rates. Asked whether credit card lending was an area where Citi might want to “pull back or increase pricing,” he responded, “All of the above.” Mortgage lending is also being cut.

That's what a credit crunch looks like, in the ground: lenders working to repair damaged balance sheets end up throwing monkey wrenches into the Fed's "printing press". And that's also how economies slide to the bottom of a liquidity trap, staring in frustration at a useless ZIRP .

These developments are not unique to Citi, caused as they are by well-publicized write-offs and "beggars-can't-be-choosers" entreaties for Asian moneybags. The entire US banking industry is tightening, as the following charts show (click to enlarge). They come from the Fed's October 2007 senior loan officer opinion survey. The January 2008 survey will be released in February and will likely show further credit tightening.
  • Residential mortgage standards tightened sharply, particularly for prime mortgages.
Net Percentage Tightening Standards for Residential Mortgages
Net Percentage Tightening Standards for Commercial RE Loans
  • Credit cards were not impacted as much, back in October, but matters are changing fast now. With Citi tightening, other lenders won't be far behind. Notice that "other" consumer loans were already tightening.
Net Percentage Tightening Standards for Consumer Loans
  • Spreads over banks' own cost of funds are rising sharply.
Net Percentage Increasing Spreads of Loan Rates

Money, in other words, is getting dearer and more difficult to get. Printing press, meet the mon(k)ey wrench...

Oh, and China just raised bank reserve requirements again, by 0.50% to 15%. That's the highest in at least 20 years. Hank Paulson, meet your lenders. They just got tighter, too.

Tuesday, January 15, 2008

Stocks, Bonds, LBO's and PPT's

Why was the stock market -until recently- so apathetic to the various negative signals coming out of the economy and credit markets? Many point fingers to the so-called Plunge Protection Team (PPT), which has supposedly moved from rare interventions during crisis events to full-blown daily manipulation.

It is a matter of definition as to what or who exactly is the PPT but, as I have said before, the market is now easier than ever to "steer", strictly from a means and methods standpoint. These are the reasons:
  1. Individual investors and speculators have mostly departed the scene, leaving the game to the professionals (pls. refer to post from May 18, 2007). This is important because it is impossible to consistently predict and control the actions of millions of individuals holding thousands of different shares. The best example is what happened during the 2000-01 day-trader craze.
  2. The market has become derivativized to an unprecedented extent. On any given day the top most active issues are the various trackers (QQQ, Russell, super-shorts, etc.). This is a market where the derivative tail wags the cash-market dog, at least for the index-heavy issues.
  3. The emergence of highly capitalized hedge, private and sovereign funds has concentrated the market into the hands of fewer players, in combination with the few global prime brokers, who also actively trade for their own account.
It follows that the market's facade (i.e. the popular indices) has become theoretically easier to manipulate on a daily basis. Nevertheless, effective manipulation requires more than the ability and the means to do so; there must also exist an underlying current, a fundamental backstop upon which daily operations can be based. In other words, there must be ultimate buyers or sellers of cash stocks, depending on what kind of manipulation is being undertaken (bullish or bearish).

Since we are currently talking - theoretically, always - about bullish manipulation by the "PPT", we must look for ultimate buyers.

In this regard, one of the most revealing charts I have seen in months is the net amount of equity withdrawn from US markets through buy-backs, buy-outs and LBO's (black bars, chart below - click to enlarge). The amount reached a record $210 billion in the 3Q2007, from near zero in early 2004.

Chart: FRB

The US has never before experienced such a sustained equity withdrawal in the history of its public markets. In just four years between 2004-07 total net equity withdrawn came to over $1.6 trillion, an enormous sum when compared to US market capitalization (end-2003: $14.3 trillion, end-2007: $19.9 trillion). The effect was to provide a constantly growing underlying "bid" for cash shares, one that leveraged the performance of indices: while total capitalization rose only 39% in the above period, the S&P 500 index gained 67%, i.e. 70% faster. (Does this make it a Potemkin village market?)

Where did the money for the buy-backs and LBO's come from?
Some came from corporate earnings, which reached a record ratio of GDP; but most of it came from debt. Record low credit spreads and volatilities encouraged CFOs and private equity funds to buy shares with borrowed money. Investment bankers, always fee-hungry, piped in with their advice: "There is too little debt and too much equity on corporate balance sheets". (The same bankers are today eating their words as they go hat-in-hand to raise emergency capital for themselves, but that's a story for another day.)

The chart below shows net issuance of bonds (i.e. new debt) by US corporations. The total amount during 2004-07 came to $3.2 trillion, another record. Given the furious M&A and LBO activity in 2005-07, obviously a big chunk of that money went to finance share purchases.

Chart: FRB

To sum it up: the market was riding a sea of buy-backs, M&A's and LBO's that were financed by cheap and easy credit. The "PPT" helped things along, taking advantage of the means, methods and conditions mentioned above, to support their own books. By my definition, therefore, the "real" PPT is a loose association of major market players that trade their own book taking advantage of dominant position and back-stopped with customer orders from LBO's, etc. It's the oldest game in Appletown: taking advantage of customer flows, with some new bells and whistles added.

As to the future: the credit crunch slashes LBO and M&A activity, while lower corporate profits reduce share buy-backs. The sovereign wealth funds will be more prominent, but they don't have the same equity and risk appetite as the other players. In addition, they are subject to significant internal political and power-play pressures. If their investments show mark-to-market losses, their managers will quickly go into CYA (cover your ass) mode. Add all these together and the conclusion is that customer flow is ebbing quickly.

The consequences for ongoing "PPT" operations are, in my view, quite obvious.

Monday, January 14, 2008

The "Virtual Reality" Recovery - And Beyond

We are told that lost manufacturing jobs are made up in the service sector. OK then, let's look at how many service jobs were created during the last expansion versus the past. Surprise, surprise: such job creation peaked at the lowest level since at least 1940, when BLS started keeping data (chart below, click to enlarge).

Service-Providing Jobs - 12 month percent change (BLS)

The service job situation is not isolated, but part of an overall decline in job-creation trends. Total non-farm job creation has been weak in the last expansion, too - again, the lowest peak since 1940 (chart below).

Total Non-Farm Jobs - 12 month percent change (BLS)

The recovery following the 1990-91 recession was called the "jobless recovery" because of the low rate at which it created new jobs (peaked at +3.5% y-o-y) . What, then, should we call the recovery from the 2001-02 recession, which created jobs at a peak rate of only +2.1% (currently at +1.0%) ? And this was only made possible through the rapid expansion of household debt vs. income and the pumping of asset bubbles.

I think, therefore, that for the US the 2003-07 period should be called the "virtual reality recovery". Unfortunately, the looming recession is already shaping up to be very real.

The US is not alone in this condition: several European countries followed the same path, made possible by record-low Euro interest rates. ECB slashed rates as low as 2% in 2003 and a building boom created jobs and consumer demand that kept Europe growing, albeit very slowly. Club Med and the UK are particularly pointed examples, but so are some of the newer EU members and peripheral economies (e.g. Turkey). Households there borrowed heavily in foreign exchange (e.g. euro, yen and swiss francs) to "take advantage" of low interest rates vs. their own currencies.

In the US, the Fed is bending over backwards to accommodate Bush fils by sharply cutting rates, even in the face of rising inflation (Nov.2007 was 4.3% annualized). Perhaps Bernanke does not want to be accused of damaging the economy - as Greenspan was by Bush pere for keeping rates too high prior to the 1990-91 recession, which cost George Bush a second term ("It's the economy, stupid"... "I've fallen and I can't get up").

But the ECB is not playing along, seeing that average consumer inflation in the eurozone is at 3.1% vs. 2% target. Indeed, several eurozone countries are already experiencing higher rates: Spain 4.1%, Greece 3.9%, Ireland 3.5%. Many non-eurozone EU countries have much higher inflation (e.g. Latvia 13.7%, Bulgaria 11.4%, Estonia 9.3%, Romania 6.8%), but the key point is that every single EU country (except Holland at 1.8%) is now above the 2% ceiling and even inflation-phobic Germany is at 3.3% (all figures annualized November 2007 rates). Unless inflation somehow drops sharply in the next few months, do not expect the ECB to cut rates significantly.

In Asia, China is raising interest rates and bank reserve ratios quickly, imposing price controls for food and fuel and allowing the yuan to appreciate somewhat faster. With 37% of its GDP made up of exports, a concurrent slowdown in the US and EU won't leave its economy unscathed, despite hopes of decoupling. A slowdown from 11% growth to even as much as 5% won't be a "recession" per se, but I think it will definitely feel like one in China. And if the US-EU slowdowns happen faster and last longer than current projections, the Chinese economy itself will enter a bona-fide recession, as unthinkable as this may seem right now.

In conclusion, I believe the "virtual reality" recovery that sustained the Western economies and boosted Asia into an export boom is coming to an end.

Saturday, January 12, 2008

Fifty Cents On The Dollar: The Empire State Building Story

Vulture investors are putting together syndicates to purchase US real estate, crowing that they are getting it for fifty cents on the dollar, focusing particularly in "carrion-infested" states like Florida. And Bank of America is buying the whole of Countrywide Financial at a deep discount after its initial $2 billion investment went very sour, very quickly.

A little history may serve as a warning to overzealous buzzards.

The Empire State Building was completed in record time (one year!) in 1931, costing a total of $41 million ($25 million for the building plus $17 million for the land). Construction costs were half the original estimates because the Great Depression quickly and dramatically cut prices and wages. The owners were John Raskob and a group of wealthy investors from the du Pont, Kaufman and Earl families - hardly unwashed hoi polloi. I imagine they, too, thought they were getting a bargain at fifty cents on the dollar.

Things did not work out as expected. The building could not find tenants and was called the Empty State Building for years; it was eventually sold by the Raskob estate in 1951 for a total of $34 million. Not only did the original investors suffer a loss in absolute terms, but in the meantime inflation had cut the value of the dollar down to 67 cents. In real terms their loss was 45% and they had to wait twenty years to get even that.

But... this time is different - right?


P.S. Yesterday's post created a not-unexpected storm of comments, both pro and con, particularly about the "targeted jobs program". Let me clarify a few points:

1. I'm not calling for the government itself to go out and employ millions of people, but to create the conditions where private industry will do so. Just look at what Germany is doing with mandatory renewable energy legislation.

2. Building a new energy infrastructure is completely different from building a "bridges to nowhere", as happened in Japan. We are actually in dire need of such infrastructure, for economic, environmental and national security reasons.

3. Funding/incentives will necessarily have to come from a variety of sources: carbon taxes, cutting defence spending (less needed to guard oil), a more graduated income tax scale, etc. The amount needed is proportional to the energy balance between fossil fuels and cleaner sources, i.e. the ratio of EROEI's will provide a rough idea of the money needed.

4. Government action is absolutely essential because entrenched fossil fuel interests are not going to do it by themselves. Their combined profits are in the trillions annually.

5. The most serious challenge is not technological choice but geopolitical economic balance. If, as I expect, the new energy regime is distributed vs. central (think Internet vs. mainframe) the thorniest question is how we transit from Dollar Hegemony to Sustainable Growth. The current global socio-economic model is Perma-Growth fueled by oil and gas. The US is center stage because the dollars it issues at will contain oil-purchase value (i.e. oil producers accept them in exchange for oil). The mind boggles at the challenge of changing this structure, but it MUST be done.

For those not quite sure how oil, money, growth and the environment are connected please look at the following books at the Amazon sidebar:
  • The Prize
  • Resource Wars
  • Blood and Oil
  • Something New Under The Sun

Friday, January 11, 2008

The Bernanke Paradox And How To Overcome It

Following on the heels of the Greenspan Conundrum, we may get a Bernanke Paradox. Rapid cuts of US interest rates may not revive the debt-ridden and asset-dependent US economy, but instead drive it closer to what Mr. Bernanke fears most: the hole of a liquidity trap. Given the nature of the developing recession (deflationary asset and credit contraction), the odds of this happening are increasing.

Central to this line of thought is the observation that the current slowdown is not the common variety, caused by excess inventory accumulation. Rather, it is most similar to the popping of the Japanese bubble: a stubborn contraction preceded and caused by excessive credit expansion and unsustainable asset appreciation.

The term "excessive credit expansion" is best explained by the following chart, showing the annual growth in household debt (red line) and hourly earnings (blue line). Borrowing rose much faster than earned income for too long (1998-2006) and is now imploding because households cannot properly service their existing debt out of current income. It follows that Americans won't jump into more debt and won't rush out to buy new assets until their balance sheets are lighter and debt service can be more comfortably met by earned income - a process that will take many years (The Slow Recession).

Annual Growth Rates for Household Debt and Hourly Earnings

The characteristics of this potential liquidity trap is different from the classical definition (lenders unwilling to lend). This trap may be aggravated by borrowers unwilling or unable to borrow, even if benchmark interest rates near 0%. Thus, the Bernanke Paradox.

I am aware that American consumers (72% of GDP) have historically pulled the economy out of previous slumps and that betting against their propensity to "shop till they drop" has been a losing proposition. But, in my opinion, right now they are "dropped, so they can't shop". It's not for lack of want, but lack of means that the mighty US consumer is pulling back.

Under such a scenario, cutting interest rates in a panicky mode can only exacerbate matters. It officially signals that the Fed and the government expect worse to come for the economy and causes consumers to respond by shutting down spending even faster. Let's not forget that the "wealth effect" caused by the prior real estate run-up is now rapidly becoming a "poverty effect", further depressing their propensity to consume.

In the last few days several economists are finally saying that monetary policy alone won't do the job, a position that I have long held and expressed in this blog. They want fiscal policy to help out but I fear they are looking in the wrong direction, since they focus exclusively on tax cuts. It is quite obvious that Bush's favorites (permanent tax cuts for the rich) won't do a thing, but even cuts and one-time rebates targeted to the poor and middle classes won't achieve more than a temporary boost. And this, assuming most of the money isn't saved instead, a possibility that can't be ignored.

To be effective, economic policy must rapidly raise real earned incomes for the "bottom" 95% of Americans that have not substantially benefited from the 2003-07 expansion and who are feeling unsure of their future. In other words, what we need is a targeted jobs program. This is a difficult proposition that does not lend itself to quick fixes, announced as TV sound-bites by politicians ("$1,000 for every family"). Instead, serious problems demand serious fixes, not one-liners.

My proposal may smack of "state planning" - and you know what? That's exactly what it is. The US needs official policies that will create high value-added jobs in energy and environmental mitigation, to name my two favorite fields that are also the most pressing problems facing our world. Hoping that the invisible hand of the free market will cause solutions to miraculously materialize is tantamount to believing in the tooth fairy.

We need government-sponsored action on a scale several times bigger than the Manhattan or Apollo projects. Expecting private enterprise to undertake them is unrealistic: such projects are simply not profitable enough in the short time horizon that business operates in. Every infrastructure development that radically altered the American economy was undertaken and financed by the government: going as far back as the Erie Canal (1817-1825), the Panama Canal, TVA, the great dams, the interstate highways, ports and airports.. even the Internet was originally a government scheme.

This is the kind and scale of economic - fiscal policy we urgently need. If anyone has a better idea, please let me know because I, for one, do not believe in tooth fairies.

Thursday, January 10, 2008

More Kettles and Such

Yesterday I visited the same electrical/electronics store as last October, when I posted the original China Kettle, Dryer and Scale, Inc. piece. This time I did a little more research on small appliances, casually strolling down the aisles...

The same conclusions apply as in the first post, with the added observation that MP3s are in a bubble all of their own. I noticed that the two most expensive models were iPods, whatever that means for competitive conditions in a sector so crucial for Apple.

The price spread from low-to-high in each appliance category is roughly 1-to-10, excluding a few very top-end models that are not really comparable with the rest. Corollary: tapped-out consumers can trade down in their selections as never before; for example, why pay ten times more for the simple task of boiling water? Again, whatever this means for retail sales and profits...

Speaking of appliances, stainless steel demand is dropping, even in Asia. The region's largest steelmaker (by market value) announced lower sales and a 20% drop in profit, blaming less demand from appliance makers and builders. Other steelmakers in Asia are reporting similar trends. Decoupling, where art thou?

Wednesday, January 9, 2008

A Gross CDS Warning

PIMCO's Bill Gross is easily the most influential fixed income money manager so what he says counts, even when talks his book (as he should). His latest monthly Investment Outlook focuses on the shadow pyramid banking system that has arisen during the last few years and on the effect of potential Credit Default Swaps (CDS) losses, which he calculates at $250 billion net of recoveries. He lays out his case in a clear and straightforward manner that is both easy and enjoyable to read. Highly recommended.

Confirming his view, the current action of the CDX indices for investment grade and junk corporate CDS is very poor: spreads have jumped to 96 and 564 basis points, respectively. These are record highs for the indices and mirror the weakening stock market environment - a correlation that I have constantly emphasized in this blog.

Furthermore, I believe that Mr.Gross's underestimates the potential losses. It does not account for the possibility that thinly capitalized speculative CDS sellers (e.g. hedge funds) may be unable to fulfil their insurance obligations, thus rendering opposing hedges worthless. The troubles at credit insurance monolines (and Mr. Buffet's decision to start his own) make this quite clear.
P.S. Three totally unrelated stories which I found interesting:

Monday, January 7, 2008

About Decoupling

In the previous post I argued that the BRIC "wings" of the global economy cannot make up for the looming consumer driven recession in the US and possibly Europe. Others argue that China, and perhaps India, will simply substitute domestic consumption for exports and keep chugging along, i.e. decoupling. Is this supported by the data? No.

GDP per capita at purchasing power parity is as follows (2006 data, CIA Factbook).

The figures speak for themselves, but some further elaboration is perhaps needed:
  • People in poor countries like China and India spend a greater portion of their income for basic necessities like food and fuel, leaving less for discretionary spending. For example, food in China accounts for 30-35% of the CPI index, indicating that the average family spends an equivalent portion of their income for food. By contrast, expense for food at home is only 8% of US CPI.
  • A large part of GDP in China and India comes from FDI (i.e. capital spending by foreigners), geared towards creating manufacturing capacity for exports. This ties in to the previous point: most of the value added to export goods does not come from cheap labor, but from foreign capital in the form of new plant and equipment. Simply put, Chinese cannot afford to purchase the value they add to their export goods.

Saturday, January 5, 2008

The Phoney Recession

World War II officially started when the Nazis invaded Poland in September 1939, forcing France and Britain to declare war on Germany. French and British troops manned the Maginot Line, Germans faced them from their own Siegfried Line and ... nothing much happened - until the cataclysmic attack on France in May 1940. This intervening period was dubbed the Phoney War.

The unfolding global economic crisis started back in early 2007 with a warning shot from US sub-prime mortgages. Viewed as an isolated event, this first crisis quickly quieted down - only to flare up again in the fall, engulfing the financial sector and sending money markets reeling. Still, the global economy was deemed healthy because BRICs were at full speed, US consumers kept spending and jobs were plentiful. In addition, rate cuts and liquidity injections provided by the Fed and ECB worked to reassure equity markets, soothing otherwise frayed nerves. The majority of economists and market analysts were sceptical, but not unduly alarmed. The truth is, however, that they have been lulled into complacency by a "phoney economy".

In the past two weeks the armies of the Global Recession have finally attacked the main front, the US economy. Holiday shopping was flat, housing and manufacturing weakened further, private employment dropped - Americans are reeling from high debt, rising fuel and food prices, low incomes, negative saving and dropping house prices. The blitzkrieg is in full blast now and the center of the defensive line is rapidly caving. In this election cycle no fiscal policy reinforcements can be expected, either (e.g. tax cuts). The Bush administration is politically bankrupt and may only manage a retreat. Given its past record of incompetency, from the Iraq war to New Orleans, chances are it will botch even this badly.

With the center gone, the wings made up of European and Asian auxiliaries are not going to be able to withstand by themselves the full force of the global recession. Decoupling is an illusion, another myth of the phoney economy that will prove as effective as the static Maginot Line was against Guderian's tanks and the Luftwaffe. The main reason is that at the core of decoupling stands, once again, the US consumer - a force that has now crumbled from within.

Oh, decoupling happened, all right: production moved abroad, but consumption - fuelled by easy vendor credit - stayed home. A simple statistic: minimum wage is $5.85 in the US and 55 cents in China. Even ignoring the fact that more Chinese make minimum wage and save more of it than Americans, it is obvious that China simply cannot consume more than a fraction of what it produces.

Let's look at those "wings" more closely. Europe is as much dependent on artificial growth boosts as the US: Club Med (Spain and Greece) fed on the familiar recipe of zooming household debt and real estate bubbles, newer EU members also borrowed with abandon (in yen and Swiss francs, no less), Russia is a hollowed-out economy entirely reliant on oil and gas and Britain, anchored as it is on the City's financial industry, is already reeling from the American disease. Germany, France and Italy are stalling at 1.6%-1.8% GDP growth; the strong euro is killing their exports. Inflation at 3.1% is far above the ECB's 2% target, and this only because the euro is somewhat cushioning the damage from imported oil and Chinese goods.

In Asia, Japan is similarly dependent on exports for whatever growth it can eke out. Its goods are almost entirely focused on affluent consumers (i.e. the US and Europe) and cannot be marketed to China and India; likewise for South Korea and Taiwan. The second (or third, depending on counting methodology) largest economy in the world is thus a basket case, growth-wise. China is growing on capital spending/investment steroids (around 50% of GDP), mostly because it is building factories and infrastructure to support exports going to America and Europe (readers may remember an older post titled China Kettle, Dryer and Scale, Inc.). The confluence of lower export demand and PBoC's tighter monetary policy are going to reduce growth much faster than people think, in my opinion.

India doesn't really "belong" to the BRIC bloc, except for a small percentage of its otherwise agrarian and backward economy, located in a couple of big cities and tech service enclaves. Australia, Canada, Brazil and the Gulf Arab economies are in a class by themselves. They are essentially pure commodity plays, one or two dominoes further removed from faltering US and EU consumers.

This is not to say that every country is solely dependent on the state of the American and European consumerist economies. But unlike recent decades, when the capitalist and free market system affected directly only a minority of the global population, globalization has today exposed the entire world to the vagaries of the business cycle. Dominoes falling in New York and London are once again affecting Moscow, Shanghai and Mumbai even more than they did during the glory days of laissez faire in the 19th century. Communism and interventionist statism certainly created a lot of dead weight, but it also provided inertia that attenuated the ups and downs of the global cycle.

I fear the phoney recession period is ending and the main attack of the Global Recession is about to commence.

Thursday, January 3, 2008

Monster Jobs

I have been following the Monster Employment Index for several months now because it tracks online employment adverts, unlike the more traditional newspaper want-ad index which has been losing importance, with job postings moving increasingly to the Internet. Its latest reading for December 2007 was just released and it shows a very sizeable drop from 183 to to 169, only part of which can be attributed to seasonal factors (the index is not seasonally adjusted). Growth in job postings has been dropping steadily and is now down to 1.2% versus last December.

Add the rising number of claims for initial and continuing unemployment benefits, and the employment picture is darkening fast. With the "shopping-madness that wasn't" holiday period now behind us, I expect significant job reductions in the retail segment as stores adjust to lower growth. Retail jobs at 15.4 million account for 16.4% of all private service jobs, one of the largest groups in the employment universe.