The Axis of Weeble is Definitely Wobbling

Monday, May 14th, 2012

Wee­bles wob­bling, spin­ning tops run­ning out of energy, run­ning out of room to kick the can, what­ever anal­ogy you want to use, the world seems like an incred­i­bly dan­ger­ous place.

Greece is going to leave the Euro. That is now pretty much everyone’s expec­ta­tion. I con­tinue to believe that although they are highly likely to leave, it isn’t for a few more months, and that there will be some real effort from the Troika, led by the ECB to resolve this sit­u­a­tion. This isn’t about help­ing Greece. This is about sav­ing what is left of Europe. What does a new cur­rency really do for Greece? It sounds excit­ing and the con­ven­tional wis­dom is that it lets them inflate their way out of their prob­lem. I think all it will do is inflate them into a “Mad Max” world. How is Greece going to be able to afford gas and food if they revert to the Drachma on short notice? Greece doesn’t export enough to get a huge imme­di­ate ben­e­fit. Yes, it will be cheaper to pro­duce in Greece, but very lit­tle is set up to take advan­tage of that right now.

But it is the ECB and the rest of Europe that need to worry. Greece needs fur­ther debt cuts even more than it needs a new cur­rency. Not only would the ECB’s and IMF’s exist­ing hold­ings be con­verted to the new cur­rency, Greece may decide to default out­right. The ECB and IMF are both star­ing at mas­sive losses. If Greece goes to the Drachma and doesn’t change the debt to Drachma, then they will have killed them­selves. That just isn’t pos­si­ble. So switch­ing to drachma, and then pos­si­bly even default­ing is what is nec­es­sary. How will the ECB and IMF deal with it? The ECB might have to make a cap­i­tal call. That would send tremors through the sys­tem. The IMF will deal with it, but expect talk about coun­tries pulling out of the fire­wall. There is talk about hav­ing the EFSF make the ECB whole. That’s not even tak­ing money from one pocket and shift­ing it to another, it’s the same damn pocket. The mar­ket will not like that.

Short­ing Ger­many, prefer­ably bunds, is my favorite way to play this (with French bonds a close sec­ond). I think the next leg if it occurs wipes out the myth of Ger­many as “safe haven”. If Greece goes, losses to the Troika will be real and any attempt to paint over them will be too obvi­ous. The stag­ger­ing size of the com­mit­ments that will ulti­mately flow onto the shoul­ders of Ger­many and France will end the idea that some­how their credit is some­how bet­ter. The guar­an­tees mat­ter, and these bonds will be affected.

I still expect some “sur­prise” head­lines bring­ing all the peo­ple involved to some form of res­o­lu­tion, that won’t obvi­ously fix every­thing, but will buy time. Notice Draghi has not once said any­thing about this, and really he seems far and away the most com­pe­tent per­son at the ECB.

Then back here, we can focus more on JP Mor­gan. Since 2007, JPM had a loss in one quar­ter only. They lost 9 cents in Q4 2008. The just made 1.70 in Q1 of this year. Citi had 9 quar­ters of losses in that period. Their worst quar­ter was –23.80 per share com­pared to a tiny 1.11 per share in Q1. MS had 6 quar­ters of losses, with the biggest being 3.61 AND they lost money in 2 quar­ters last year. Yes, $2 bil­lion is a big num­ber. It may have grown, it may turn out smaller. In any case, it is unlikely JPM will have a loss this quar­ter. This group and the over­all risk man­age­ment of the firm is part of why they have done so well rel­a­tive to their peers. If you want to focus on the fact that $2 bil­lion is a huge num­ber to a nor­mal per­son, that is fine, but you may be get­ting more angry than you should. The real­ity is that JPM, with $2.3 tril­lion in assets is huge, and every busi­ness they are in is big, and P&L swings will be large in $ terms, but seem com­pletely rea­son­able in per­cent­age terms.

Yes, reg­u­la­tory scrutiny will inten­sify, but this is a prob­lem at all big banks. The spe­cific risk of this trade has been over­done. Unfor­tu­nately it is hard to tell how much of the price move is spe­cific to one aspect or the other, so I can’t quite get com­fort­able with the sit­u­a­tion in terms of get­ting long JPM, but will be look­ing at out­per­for­mance trades.

Futures have already had a wild ride, and I would expect that to con­tinue through­out the day. MAIN is out to 169 +12 bps on the day. XOVER is at 718 +36 bps on the day. It is ugly, with min­i­mal liq­uid­ity – even the best mar­ket mak­ers are back to mak­ing 1 bp mar­kets in MAIN. IG18 is open­ing at 112, which is 3.5 bps wider, and HY18 is at 94 3/8, so down about 5/8. The moves in XOVER and HY rel­a­tive to MAIN and IG seem more nor­mal than Fri­day, when we saw almost amaz­ing out­per­for­mance in the HY space (where JPM is allegedly short).

Spain and Italy are under attack again. Ten year yields have hit 6.26% and 5.70% respec­tively while CDS is at 640 and 480 respec­tively. Scary num­bers, though Span­ish 10 year may be get­ting to the point where we see some ECB inter­ven­tion in the sec­ondary markets.

So with prob­lems across the globe and the mood so dim, I can’t help but think we are set up for a rally on the back of any scrap of good news. I don’t see Greece hit­ting the break­ing point just yet, and the mar­ket will digest the JPM loss as it thinks more ratio­nally, and Spain and Italy are not so heinous that they should respond well to any ECB intervention.

Tags: Analogy, Axis, Conventional Wisdom, Currency, Dangerous Place, Drachma, ECB, Efsf, Expectation, Firewall, Gas And Food, Greece, Imf Deal, Mad Max, Massive Losses, Max World, Spinning Tops, Tremors, Troika, Weeble, Weebles
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60 Minutes Reviews the European Debt Crisis

Monday, April 9th, 2012

60 Min­utes did a piece on the sit­u­a­tion in Europe, and for a not finan­cial ori­ented TV show, it did a pretty fine job of describ­ing the sit­u­a­tion for a mass audi­ence.   They key line I wish they had expanded upon was along the lines of "in the past, if Greece found its accounts over­drawn the coun­try sim­ply printed more money, or deval­ued its cur­rency…" – which are paths the U.S., U.K. and Japan now fol­low.   Fur­ther they should have explained how these finan­cial injec­tions are back­door bailouts for the finan­cial élite, namely Ger­man and French banks, among others.

How­ever, it was inter­est­ing to see the dynamic between Greece and Ger­many in far greater detail than the num­bers we are numb to – the long and vio­lent his­tory of this con­ti­nent makes for inter­est­ing relationships.

14 minute video, email read­ers will need to come to site to view

Tags: 60 Minutes, Backdoor, Continent, Currency, Debt Crisis, Europe, Financial Elite, French Banks, Germany, Greece, Japan, Job, Key Line, Mass Audience, Money, Relationships, Tv Show, Video Email, Violent History
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10 Things You Should Know About The Federal Reserve

Friday, March 2nd, 2012

By Michael Sny­der

What would hap­pen if the Fed­eral Reserve was shut down per­ma­nently? That is a ques­tion that CNBC asked recently, but unfor­tu­nately most Amer­i­cans don't really think about the Fed much. Most Amer­i­cans are con­tent with believ­ing that the Fed­eral Reserve is just another stuffy gov­ern­ment agency that sets our inter­est rates and that is watch­ing out for the best inter­ests of the Amer­i­can people.

But that is not the case at all. The truth is that the Fed­eral Reserve is a pri­vate bank­ing car­tel that has been designed to sys­tem­at­i­cally destroy the value of our cur­rency, drain the wealth of the Amer­i­can pub­lic and enslave the fed­eral gov­ern­ment to per­pet­u­ally expand­ing debt. Dur­ing this elec­tion year, the econ­omy is the num­ber one issue that vot­ers are con­cerned about. But instead of end­lessly blam­ing both polit­i­cal par­ties, the truth is that most of the blame should be placed at the feet of the Fed­eral Reserve. The Fed­eral Reserve has more power over the per­for­mance of the U.S. econ­omy than any­one else does.

The Fed­eral Reserve con­trols the money sup­ply, the Fed­eral Reserve sets the inter­est rates and the Fed­eral Reserve hands out bailouts to the big banks that absolutely dwarf any­thing that Con­gress ever did. If the Amer­i­can peo­ple are ever going to learn what is really going on with our econ­omy, then it is absolutely imper­a­tive that they get edu­cated about the Fed­eral Reserve. 

The fol­low­ing are 10 things that every Amer­i­can should know about the Fed­eral Reserve....
 
#1 The Fed­eral Reserve Sys­tem Is A Pri­vately Owned Bank­ing Car­tel


The Fed­eral Reserve is not a gov­ern­ment agency.
The truth is that it is a pri­vately owned cen­tral bank. It is owned by the banks that are mem­bers of the Fed­eral Reserve system.

We do not know how much of the sys­tem each bank owns, because that has never been dis­closed to the Amer­i­can people.

The Fed­eral Reserve openly admits that it is pri­vately owned. When it was defend­ing itself against a Bloomberg request for infor­ma­tion under the Free­dom of Infor­ma­tion Act, the Fed­eral Reserve stated unequiv­o­cally in court that it was "not an agency" of the fed­eral gov­ern­ment and there­fore not sub­ject to the Free­dom of Infor­ma­tion Act.

In fact, if you want to find out that the Fed­eral Reserve sys­tem is owned by the mem­ber banks, all you have to do is go to the Fed­eral Reserve web­site....

The twelve regional Fed­eral Reserve Banks, which were estab­lished by Con­gress as the oper­at­ing arms of the nation's cen­tral bank­ing sys­tem, are orga­nized much like pri­vate corporations–possibly lead­ing to some con­fu­sion about "own­er­ship." For exam­ple, the Reserve Banks issue shares of stock to mem­ber banks. How­ever, own­ing Reserve Bank stock is quite dif­fer­ent from own­ing stock in a pri­vate com­pany. The Reserve Banks are not oper­ated for profit, and own­er­ship of a cer­tain amount of stock is, by law, a con­di­tion of mem­ber­ship in the Sys­tem. The stock may not be sold, traded, or pledged as secu­rity for a loan; div­i­dends are, by law, 6 per­cent per year.

For­eign gov­ern­ments and for­eign banks do own sig­nif­i­cant own­er­ship inter­ests in the mem­ber banks that own the Fed­eral Reserve sys­tem. So it would be accu­rate to say that the Fed­eral Reserve is par­tially foreign-owned.
But until the exact own­er­ship shares of the Fed­eral Reserve are revealed, we will never know to what extent the Fed is foreign-owned.
 
#2 The Fed­eral Reserve Sys­tem Is A Per­pet­ual Debt Machine


As long as the Fed­eral Reserve Sys­tem exists, U.S. gov­ern­ment debt will con­tinue to go up and up and up.
This runs con­trary to the con­ven­tional wis­dom that Democ­rats and Repub­li­cans would have us believe, but unfor­tu­nately it is true.
The way our sys­tem works, when­ever more money is cre­ated more debt is cre­ated as well.

For exam­ple, when­ever the U.S. gov­ern­ment wants to spend more money than it takes in (which hap­pens con­stantly), it has to go ask the Fed­eral Reserve for it. The fed­eral gov­ern­ment gives U.S. Trea­sury bonds to the Fed­eral Reserve, and the Fed­eral Reserve gives the U.S. gov­ern­ment "Fed­eral Reserve Notes" in return. Usu­ally this is just done electronically.

So where does the Fed­eral Reserve get the Fed­eral Reserve Notes?
It just cre­ates them out of thin air.

Wouldn't you like to be able to cre­ate money out of thin air?

Instead of issu­ing money directly, the U.S. gov­ern­ment lets the Fed­eral Reserve cre­ate it out of thin air and then the U.S. gov­ern­ment bor­rows it.

Talk about stupid.

When this new debt is cre­ated, the amount of inter­est that the U.S. gov­ern­ment will even­tu­ally pay on that debt is not also cre­ated.
So where will that money come from?

Well, even­tu­ally the U.S. gov­ern­ment will have to go back to the Fed­eral Reserve to get even more money to finance the ever expand­ing debt that it has got­ten itself trapped into.

It is a debt spi­ral that is designed to go on perpetually.

You see, the real­ity is that the money sup­ply is designed to con­stantly expand under the Fed­eral Reserve sys­tem. That is why we have all become accus­tomed to think­ing of infla­tion as "normal".

So what does the Fed­eral Reserve do with the U.S. Trea­sury bonds that it gets from the U.S. gov­ern­ment?
Well, it sells them off to oth­ers. There are lots of peo­ple out there that have made a ton of money by hold­ing U.S. gov­ern­ment debt.

In fis­cal 2011, the U.S. gov­ern­ment paid out 454 bil­lion dol­lars just in inter­est on the national debt.

That is 454 bil­lion dol­lars that was taken out of our pock­ets and put into the pock­ets of wealthy indi­vid­u­als and for­eign gov­ern­ments around the globe.

The truth is that our cur­rent debt-based mon­e­tary sys­tem was designed by greedy bankers that wanted to make enor­mous prof­its by using the Fed­eral Reserve as a tool to cre­ate money out of thin air and lend it to the U.S. gov­ern­ment at interest.

And that plan is work­ing quite well.

Most Amer­i­cans today don't under­stand how any of this works, but many promi­nent Amer­i­cans in the past did under­stand it.

For exam­ple, Thomas Edi­son was once quoted in the New York Times as say­ing the following....

That is to say, under the old way any time we wish to add to the national wealth we are com­pelled to add to the national debt.

Now, that is what Henry Ford wants to pre­vent. He thinks it is stu­pid, and so do I, that for the loan of $30,000,000 of their own money the peo­ple of the United States should be com­pelled to pay $66,000,000 — that is what it amounts to, with interest.

Peo­ple who will not turn a shov­el­ful of dirt nor con­tribute a pound of mate­r­ial will col­lect more money from the United States than will the peo­ple who sup­ply the mate­r­ial and do the work. That is the ter­ri­ble thing about inter­est. In all our great bond issues the inter­est is always greater than the prin­ci­pal. All of the great pub­lic works cost more than twice the actual cost, on that account.

Under the present sys­tem of doing busi­ness we sim­ply add 120 to 150 per cent, to the stated cost.

But here is the point: If our nation can issue a dol­lar bond, it can issue a dol­lar bill. The ele­ment that makes the bond good makes the bill good.

We should have lis­tened to men like Edi­son and Ford.

But we didn't.

And so we pay the price.

On July 1, 1914 (a few months after the Fed was cre­ated) the U.S. national debt was 2.9 bil­lion dollars.

Today, it is more than more than 5000 times larger.

Yes, the per­pet­ual debt machine is work­ing quite well, and most Amer­i­cans do not even real­ize what is hap­pen­ing.
 
#3 The Fed­eral Reserve Has Destroyed More Than 96% Of The Value Of The U.S. Dol­lar

Did you know that the U.S. dol­lar has lost 96.2 per­cent of its value since 1900? Of course almost all of that decline has hap­pened since the Fed­eral Reserve was cre­ated in 1913.

Because the money sup­ply is designed to expand con­stantly, it is guar­an­teed that all of our dol­lars will con­stantly lose value.
Infla­tion is a "hid­den tax" that con­tin­u­ally robs us all of our wealth. The Fed­eral Reserve always says that it is "com­mit­ted" to con­trol­ling infla­tion, but that never seems to work out so well.

And cur­rent Fed­eral Reserve Chair­man Ben Bernanke says that it is actu­ally a good thing to have a lit­tle bit of infla­tion. He plans to try to keep the infla­tion rate at about 2 per­cent in the com­ing years.

So what is so bad about 2 per­cent? That doesn't sound so bad, does it?

Well, just con­sider the fol­low­ing excerpt from a recent Forbes arti­cle....

The Fed­eral Reserve Open Mar­ket Com­mit­tee (FOMC) has made it offi­cial: After its lat­est two day meet­ing, it announced its goal to devalue the dol­lar by 33% over the next 20 years. The debauch of the dol­lar will be even greater if the Fed exceeds its goal of a 2 per­cent per year increase in the price level.

 
#4 The Fed­eral Reserve Can Bail Out Who­ever It Wants To With No Account­abil­ity


The Amer­i­can peo­ple got so upset about the bailouts that Con­gress gave to the Wall Street banks and to the big automak­ers, but did you know that the biggest bailouts of all were given out by the Fed­eral Reserve?

Thanks to a very lim­ited audit of the Fed­eral Reserve that Con­gress approved a while back, we learned that the Fed made tril­lions of dol­lars in secret bailout loans to the big Wall Street banks dur­ing the last finan­cial cri­sis. They even secretly loaned out hun­dreds of bil­lions of dol­lars to for­eign banks.
 

Accord­ing to the results of the lim­ited Fed audit men­tioned above, a total of $16.1 tril­lion in secret loans were made by the Fed­eral Reserve between Decem­ber 1, 2007 and July 21, 2010.
 
The fol­low­ing is a list of loan recip­i­ents that was taken directly from page 131 of the audit report....
 
Cit­i­group — $2.513 tril­lion
Mor­gan Stan­ley — $2.041 tril­lion
Mer­rill Lynch — $1.949 tril­lion
Bank of Amer­ica — $1.344 tril­lion
Bar­clays PLC — $868 bil­lion
Bear Sterns — $853 bil­lion
Gold­man Sachs — $814 bil­lion
Royal Bank of Scot­land — $541 bil­lion
JP Mor­gan Chase — $391 bil­lion
Deutsche Bank — $354 bil­lion
UBS — $287 bil­lion
Credit Suisse — $262 bil­lion
Lehman Broth­ers — $183 bil­lion
Bank of Scot­land — $181 bil­lion
BNP Paribas — $175 bil­lion
Wells Fargo — $159 bil­lion
Dexia — $159 bil­lion
Wachovia — $142 bil­lion
Dres­d­ner Bank — $135 bil­lion
Soci­ete Gen­erale — $124 bil­lion
"All Other Bor­row­ers" — $2.639 tril­lion
 
So why haven't we heard more about this?
 
This is scan­dalous.
In addi­tion, it turns out that the Fed paid enor­mous sums of money to the big Wall Street banks to help "admin­is­ter" these nearly interest-free loans....

Not only did the Fed­eral Reserve give 16.1 tril­lion dol­lars in nearly interest-free loans to the "too big to fail" banks, the Fed also paid them over 600 mil­lion dol­lars to help run the emer­gency lend­ing pro­gram. Accord­ing to the GAO, the Fed­eral Reserve shelled out an astound­ing $659.4 mil­lion in "fees" to the very finan­cial insti­tu­tions which caused the finan­cial cri­sis in the first place.

 
Does read­ing that make you angry?
 
It should.
 
#5 The Fed­eral Reserve Is Pay­ing Banks Not To Lend Money


Did you know that the Fed­eral Reserve is actu­ally pay­ing banks not to make loans?
It is true.
 
Sec­tion 128 of the Emer­gency Eco­nomic Sta­bi­liza­tion Act of 2008 allows the Fed­eral Reserve to pay inter­est on "excess reserves" that U.S. banks park at the Fed.
 
So the banks can just send their cash to the Fed and watch the money come rolling in risk-free.
 
So are many banks tak­ing advan­tage of this?
 
You tell me. Just check out the chart below. The amount of "excess reserves" parked at the Fed has gone from nearly noth­ing to about 1.5 tril­lion dol­lars since 2008....

 
But shouldn't the banks be lend­ing the money to us so that we can start busi­nesses and buy homes?
 
You would think that is how it is sup­posed to work.
 
Unfor­tu­nately, the Fed­eral Reserve is not work­ing for us.
 
The Fed­eral Reserve is work­ing for the big banks.
 
Sadly, most Amer­i­cans have no idea what is going on.
 
Another exam­ple of this is the gov­ern­ment debt carry trade.
 
Here is how it works. The Fed­eral Reserve lends gigan­tic piles of nearly interest-free cash to the big Wall Street banks, and in turn those banks use the money to buy up huge amounts of gov­ern­ment debt. Since the return on gov­ern­ment debt is higher, the banks are able to make large prof­its very eas­ily and with very lit­tle risk.
 
This scam was also explained in a recent arti­cle in the Guardian....

Con­sider this: we pre­tend that banks are pri­vate busi­nesses that should be allowed to run their own affairs. But they are the biggest scroungers of pub­lic money of our time. Banks are lent vast sums of money by cen­tral banks at near-zero inter­est. They lend that money to us or back to the gov­ern­ment at higher rates and rake in the dif­fer­ence by the bil­lion. They don't even have to make clever invest­ments to make huge profits.

That is a pretty good lit­tle scam they have got going, wouldn't you say?
 
#6 The Fed­eral Reserve Cre­ates Arti­fi­cial Eco­nomic Bub­bles That Are Extremely Dam­ag­ing
 
By allow­ing a cen­tral­ized author­ity such as the Fed­eral Reserve to dic­tate inter­est rates, it cre­ates an envi­ron­ment where finan­cial bub­bles can be cre­ated very eas­ily.
Over the past sev­eral decades, we have seen bub­ble after bub­ble. Most of these have been the result of the Fed­eral Reserve keep­ing inter­est rates arti­fi­cially low. If the free mar­ket had been set­ting inter­est rates all this time, things would have never got­ten so far out of hand.
 
For exam­ple, the hous­ing crash would have never been so hor­rific if the Fed­eral Reserve had not cre­ated such ideal con­di­tions for a hous­ing bub­ble in the first place. But we allow the Fed to con­tinue to make the same mis­takes.
 
Right now, the Fed­eral Reserve con­tin­ues to set inter­est rates much, much lower than they should be. This is caus­ing a tremen­dous mis­al­lo­ca­tion of eco­nomic resources, and there will be mas­sive con­se­quences for that down the line.
#7 The Fed­eral Reserve Sys­tem Is Dom­i­nated By The Big Wall Street Banks
 Even since it was cre­ated, the Fed­eral Reserve sys­tem has been dom­i­nated by the big Wall Street banks.
The fol­low­ing is from a pre­vi­ous arti­cle that I did about the Fed....

The New York rep­re­sen­ta­tive is the only per­ma­nent mem­ber of the Fed­eral Open Mar­ket Com­mit­tee, while other regional banks rotate in 2 and 3 year inter­vals. The for­mer head of the New York Fed, Tim­o­thy Gei­th­ner, is now U.S. Trea­sury Sec­re­tary. The truth is that the Fed­eral Reserve Bank of New York has always been the most impor­tant of the regional Fed banks by far, and in turn the Fed­eral Reserve Bank of New York has always been dom­i­nated by Wall Street and the major New York banks.

 
#8 It Is Not An Acci­dent That We Saw The Per­sonal Income Tax And The Fed­eral Reserve Sys­tem Both Come Into Exis­tence In 1913
 On Feb­ru­ary 3rd, 1913 the 16th Amend­ment to the U.S. Con­sti­tu­tion was rat­i­fied. Later that year, the United States Rev­enue Act of 1913 imposed a per­sonal income tax on the Amer­i­can peo­ple and we have had one ever since.
 
With­out a per­sonal income tax, it is hard to have a cen­tral bank. It takes a lot of money to finance all of the gov­ern­ment debt that a cen­tral bank­ing sys­tem cre­ates.
 
It is no acci­dent that the 16th Amend­ment was rat­i­fied in 1913 and the Fed­eral Reserve sys­tem was also cre­ated in 1913.
They have a sym­bi­otic rela­tion­ship and they are designed to work together.
We could fill Con­gress with peo­ple that are com­mit­ted to end­ing this oppres­sive sys­tem, but so far we have cho­sen not to do that.
So our chil­dren and our grand­chil­dren will face a life­time of debt slav­ery because of us.
I am sure they will be thank­ful for that.
 
#9 The Cur­rent Fed­eral Reserve Chair­man, Ben Bernanke, Has A Night­mar­ish Track Record Of Incom­pe­tence
 
The main­stream media por­trays Fed­eral Reserve Chair­man Ben Bernanke as a bril­liant econ­o­mist, but is that really the case?
Let's go to the video­tape.
The fol­low­ing is an extended excerpt from an arti­cle that I pub­lished pre­vi­ously....
———-
In 2005, Bernanke said that we shouldn't worry because hous­ing prices had never declined on a nation­wide basis before and he said that he believed that the U.S. would con­tinue to expe­ri­ence close to "full employment"....

"We’ve never had a decline in house prices on a nation­wide basis. So, what I think what is more likely is that house prices will slow, maybe sta­bi­lize, might slow con­sump­tion spend­ing a bit. I don’t think it’s gonna drive the econ­omy too far from its full employ­ment path, though."

In 2005, Bernanke also said that he believed that deriv­a­tives were per­fectly safe and posed no dan­ger to finan­cial markets....

"With respect to their safety, deriv­a­tives, for the most part, are traded among very sophis­ti­cated finan­cial insti­tu­tions and indi­vid­u­als who have con­sid­er­able incen­tive to under­stand them and to use them properly."

In 2006, Bernanke said that hous­ing prices would prob­a­bly keep rising....

"Hous­ing mar­kets are cool­ing a bit. Our expec­ta­tion is that the decline in activ­ity or the slow­ing in activ­ity will be mod­er­ate, that house prices will prob­a­bly con­tinue to rise."

In 2007, Bernanke insisted that there was not a prob­lem with sub­prime mortgages....

"At this junc­ture, how­ever, the impact on the broader econ­omy and finan­cial mar­kets of the prob­lems in the sub­prime mar­ket seems likely to be con­tained. In par­tic­u­lar, mort­gages to prime bor­row­ers and fixed-rate mort­gages to all classes of bor­row­ers con­tinue to per­form well, with low rates of delinquency."

In 2008, Bernanke said that a reces­sion was not coming....

"The Fed­eral Reserve is not cur­rently fore­cast­ing a recession."

A few months before Fan­nie Mae and Fred­die Mac col­lapsed, Bernanke insisted that they were totally secure....

"The GSEs are ade­quately cap­i­tal­ized. They are in no dan­ger of failing."

For many more exam­ples that demon­strate the absolutely night­mar­ish track record of Fed­eral Reserve Chair­man Ben Bernanke, please see the fol­low­ing arti­cles....
*"Say What? 30 Ben Bernanke Quotes That Are So Stu­pid That You Won’t Know Whether To Laugh Or Cry"
*"Is Ben Bernanke A Liar, A Lunatic Or Is He Just Com­pletely And Totally Incom­pe­tent?"
But after being wrong over and over and over, Barack Obama still nom­i­nated Ben Bernanke for another term as Chair­man of the Fed.
———-
 
#10 The Fed­eral Reserve Has Become Way Too Pow­er­ful
 
The Fed­eral Reserve is the most unde­mo­c­ra­tic insti­tu­tion in America.

The Fed­eral Reserve has become so pow­er­ful that it is now known as "the fourth branch of gov­ern­ment", but there are less checks and bal­ances on the Fed than there are on the other three branches.

The Fed­eral Reserve runs the U.S. econ­omy but it is not account­able to the Amer­i­can peo­ple. We can't vote those that run the Fed out of office if we do not like what they do.

Yes, the pres­i­dent appoints those that run the Fed, but he also knows that if he does not tread lightly he won't get the money from the big Wall Street banks that he needs for his next election.

Thank­fully, there are a few mem­bers of Con­gress that are com­plain­ing about how much power the Fed has. For exam­ple, Ron

Paul once told MSNBC that he believes that the Fed­eral Reserve is now actu­ally more pow­er­ful than Con­gress.....

"The reg­u­la­tions should be on the Fed­eral Reserve. We should have trans­parency of the Fed­eral Reserve. They can cre­ate tril­lions of dol­lars to bail out their friends, and we don’t even have any trans­parency of this. They’re more pow­er­ful than the Congress."

As mem­bers of Con­gress such as Ron Paul have started to shed some light on the activ­i­ties of the Fed­eral Reserve, that has caused many in the main­stream media to come to the defense of the Fed.

For exam­ple, a recent CNBC arti­cle enti­tled "If The Fed­eral Reserve Is Abol­ished, What Then?" makes it sound like there is absolutely no other ratio­nal alter­na­tive to hav­ing the Fed­eral Reserve run our economy.

But this is not what our founders intended.

The founders did not intend for a pri­vate bank­ing car­tel to issue our money and set our inter­est rates for us.

Accord­ing to Arti­cle I, Sec­tion 8 of the U.S. Con­sti­tu­tion, the U.S. Con­gress has been given the respon­si­bil­ity to "coin Money, reg­u­late the Value thereof, and of for­eign Coin, and fix the Stan­dard of Weights and Measures".

So why is the Fed­eral Reserve doing it?

But the CNBC arti­cle men­tioned above makes it sound like the sky would fall if con­trol of the cur­rency was handed back over to the Amer­i­can people.

At one point, the arti­cle asks the fol­low­ing question....

"How would the U.S. econ­omy then func­tion? Some­thing has to take its place, right?"

No, the truth is that we don't need any­one to "man­age" our econ­omy.
The U.S. Trea­sury could be in charge of issu­ing our cur­rency and the free mar­ket could set our inter­est rates.

We don't need to have a centrally-planned economy.

We aren't China.

And it goes against every­thing that our founders believed to be run­ning up so much gov­ern­ment debt.

For exam­ple, Thomas Jef­fer­son once declared that if he could add just one more amend­ment to the U.S. Con­sti­tu­tion it would be a ban on all gov­ern­ment bor­row­ing....

I wish it were pos­si­ble to obtain a sin­gle amend­ment to our Con­sti­tu­tion. I would be will­ing to depend on that alone for the reduc­tion of the admin­is­tra­tion of our gov­ern­ment to the gen­uine prin­ci­ples of its Con­sti­tu­tion; I mean an addi­tional arti­cle, tak­ing from the fed­eral gov­ern­ment the power of borrowing.

Oh, how things would have been dif­fer­ent if we had only lis­tened to Thomas Jef­fer­son.
Please share this arti­cle with as many peo­ple as you can. These are things that every Amer­i­can should know about the Fed­eral Reserve, and we need to edu­cate the Amer­i­can peo­ple about the Fed while there is still time.

About The Author — Michael Sny­der is the founder and edi­tor of The Eco­nomic Collapse

The views and opin­ions expressed herein are the author's own, and do not nec­es­sar­ily reflect those of Econ­Mat­ters.

Tags: American People, Banks, Bloomberg, Cartel, Cnbc, Congress, Currency, Economy, Election Year, Federal Government, Federal Money, Federal Reserve, Federal Reserve System, Feet, Government Agency, interest rates, Michael Snyder, Money Supply, Political Parties, Private Banking, Truth
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$10 Trillion In 2 years — 'Over' Abundant Liquidity And Expectations

Friday, February 24th, 2012

A funny thing hap­pened while we all waited for the Fed to announce QE3. The rest of the world did it for them. Cour­tesy of Bloomberg's excel­lent Eco­nom­ics Brief, and the n'th time, here is what a multi-trillion dol­lar liq­uid­ity expan­sion looks like even with the Fed run­ning silent. And this is also what $10 tril­lion in 2 years pumped into the mar­kets looks like. Won­der where the mar­ket gets its "spring step" from? Now you know. Thank you Econ­o­mist PhD's!

We do note that EUR strength recently (as the ECB appears done for now) and the accel­er­a­tion of asset prices in Europe (bank stocks, credit etc.) appear to have done a good job of dis­count­ing the next LTRO already — and in fact are start­ing to retrace as LTRO 2 expec­ta­tions are ratch­eted back from the cajil­lion EUR level as the stigma con­tin­ues to rise, ECB mem­bers raise con­cerns over depen­dency (banks are not forced to delever and also will not re-engage in the inter-bank lend­ing mar­ket), and just like last year per­haps the ECB will hike rates to stall infla­tion fears (think­ing of all-time record local cur­rency gas prices as tran­si­tory is hard after a per­sis­tent 3 year trend higher).

Charts: Bloomberg

Tags: Acceleration, Asset Prices, Bank stocks, Banks, Bloomberg, Currency, ECB, Economist, Funny Thing, Gas Prices, Good Job, Inflation Fears, liquidity, Nbsp, Rest Of The World, Spring Step, Stigma, Th Time, Time Record, Trillion
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R.I.P. Fed Dollar Swap Intervention: Central Bank Liquidity Injection Half Life Two Weeks

Wednesday, December 14th, 2011

As noted two weeks ago when pre­dict­ing the effi­ciency and dura­tion of the lat­est global coör­di­nated USD liq­uid­ity injec­tion, we had a sink­ing feel­ing the Fed action would have a very brief time span. Sure enough, judg­ing by the action in two crit­i­cal FX liq­uid­ity indi­ca­tors — the 3M and 1 Y basis swap indi­ca­tors, the dol­lar short­age is baaaaack... only this time, very para­dox­i­cally, with implied infi­nite back­stop­ping from the Fed: if even that fac­tor no longer has an influ­ence on the market's per­cep­tion of liq­uid­ity risk we are in very deep trou­ble. Which of course is to be expected: the gross syn­thetic dol­lar short back in 2007 was $6.5 tril­lion. Add a few years of ZIRP to this, where the USD is also the fund­ing cur­rency of the world, and one can see why the global USD short posi­tion cur­rently is in the dou­ble digit tril­lions. So just how will the Fed back­stop $10+ tril­lion in explicit USD shorts? We can't wait to find out.

3 Month Euro Basis Swap now almost back to pre Novem­ber 30 global bailout levels:

... but the real action now is in the 1 Year Basis Swap which is back down to Decem­ber 2008 levels.

Tags: 3m, Backstop, Bailout, Bank Liquidity, Basis Swap, Currency, Deep Trouble, Dollar Bank, Duration, Efficiency, Euro, Gross, Half Life, Liquidity Risk, Perception, Short Position, Time Span, Trillion, Trillions, Zirp
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What’s Really Driving Gold?

Friday, November 18th, 2011

Nov. 14, 2011 — I was in New York to par­tic­i­pate on a panel at Terrapin’s Com­modi­ties Week 2011 Con­fer­ence. This is one of the most impor­tant gath­er­ings of com­modi­ties investors and traders in the world.

I had the oppor­tu­nity to stop by the Invest­ment­News offices to speak with Mark Bruno regard­ing higher gold prices. One of sev­eral key fac­tors influ­enc­ing gold’s recent price action is neg­a­tive real inter­est rates.

When­ever a coun­try has neg­a­tive real rates, mean­ing the infla­tion­ary rate (CPI) is greater than the cur­rent inter­est rate, gold tends to rise in that country’s cur­rency. Right now, investors are los­ing money on Trea­sury bills and money mar­ket accounts because inter­est rates are near zero and infla­tion sits just under 4 percent.

I also dis­cuss what I think could derail higher bul­lion prices and dis­cuss how emerg­ing economies are enjoy­ing a ris­ing GDP per capita and how this could influ­ence gold.

Also, read about how gold is cur­rently in sea­son.

Tags: Bullion Prices, Commodities, CPI, Currency, Current Interest Rate, Emerging Economies, Gatherings, GDP, Gdp Per Capita, Gold Price, Gold Prices, inflation, interest rates, Investors, Mark Bruno, Money Market Accounts, Rate Gold, Terrapin, Treasury Bills
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Not Over by a Longshot (Hussman)

Monday, September 26th, 2011

Not Over by a Long­shot

by John P. Huss­man, Ph.D., Huss­man Funds

On Fri­day, the yield on 1-year Greek gov­ern­ment bonds closed above 135%. As I've noted in recent weeks, the bond mar­kets con­tinue to reflect expec­ta­tions of cer­tain default on Greek debt. All they are work­ing out now is the recov­ery rate. As of last week, the expected recov­ery rate implied by bond prices stands at about 43% of face value. Since Greece is still run­ning a pri­mary deficit (it can't pay its bills even if debt ser­vic­ing costs drop to zero), my impres­sion is that the even­tual default may be even worse. Still, if I were to ven­ture a guess, it would also be that Greece will be given a small amount of new fund­ing in the com­ing weeks in order for the gov­ern­ment to con­tinue run­ning and delay the inevitable. The rea­son is that Europe needs time to bet­ter pre­pare for a default, and Euro­pean lead­ers appear to be scram­bling to get banks to bol­ster their cap­i­tal as quickly as pos­si­ble (some­how investors responded to that news with a short-lived rally last week, as if the need to accel­er­ate the time­line for banks to acquire addi­tional cap­i­tal is a good thing).

If you're atten­tive to how Euro­pean lead­ers are phras­ing things these days, you'll notice that (except for offi­cials in Greece) they've stopped say­ing that Greece itself will not be allowed to default, and instead insist that the Euro­pean finan­cial sys­tem and the Euro­pean mon­e­tary union will be defended. While it's pos­si­ble that the equity mar­kets will mount a relief rally in the event of new fund­ing to Greece, it will be impor­tant to rec­og­nize that hand­ing out a bit more relief would be prepara­tory to a default, and that would prob­a­bly be reflected in a fail­ure of Greek yields to retreat sig­nif­i­cantly on that news.

As for the euro itself, we presently esti­mate the value around $1.42, which wouldn't change much unless Europe inflates to avoid periph­eral defaults. Ulti­mately, the value of a cur­rency is deter­mined by rel­a­tive price lev­els and inter­est rates (see Valu­ing For­eign Cur­ren­cies ). While the euro may come under pres­sure as default con­cerns develop, we actu­ally expect the euro to sur­vive among its strongest mem­bers, with some fis­cally unsta­ble periph­eral mem­bers exit­ing and peg­ging instead. So we're not par­tic­u­larly com­pelled by the notion that the euro will col­lapse if Greece fails, and with Euro­pean equi­ties look­ing increas­ingly rea­son­able on a val­u­a­tion basis, we're inclined to use sig­nif­i­cant fur­ther weak­ness as a longer-term oppor­tu­nity. Mas­sive buy­ing of periph­eral debt by the Euro­pean Cen­tral Bank would dra­mat­i­cally weaken the prospects for a sta­ble euro, but there seem to be more respon­si­ble pol­icy mak­ers over­see­ing the ECB than we have at the Fed­eral Reserve.

On the bright side, our esti­mate of the return/risk pro­file for stocks moved from hard-negative to more mod­er­ately neg­a­tive last week. It's a start. Undoubt­edly, the best chance for a sus­tained advance (aside from short-term spikes on short cov­er­ing or bailout hopes) would be for that advance to begin from sig­nif­i­cantly lower lev­els. Unless we observe a robust improve­ment in mar­ket inter­nals from cur­rent lev­els, which appears doubt­ful given fur­ther con­fir­ma­tion of oncom­ing reces­sion, the broad ensem­ble of data we observe doesn't offer much lat­i­tude to estab­lish a con­struc­tive posi­tion based on, say, weak tech­ni­cal rever­sals or other scraps that the mar­kets might toss out in the near term. The first 13 weeks of a reces­sion are among the most pre­dictably hos­tile peri­ods for equi­ties in the data. We'll take our evi­dence as it comes, but the pri­mary risks — reces­sion, default and global credit strains — con­tinue to increase

As for val­u­a­tions, our esti­mate of 10-year total returns for the S&P 500 has now climbed to 5.7% annu­ally, albeit with the sig­nif­i­cant risk of los­ing per­haps 4 to 6 times that amount in the next year or so — most likely fol­lowed by much higher aver­age returns in the back years, suf­fi­cient to bring the 10-year aver­age back up to 5.7% over­all. Need­less to say, we're inclined to wait on a shift in evi­dence — at least enough to push the expected return/risk pro­file pos­i­tive — before tak­ing on sig­nif­i­cant mar­ket exposure.

Gold and gold stocks were whacked last week, which despite the dis­com­fort is actu­ally a good sign from a "Sornette-type bub­ble" stand­point. Par­a­bolic ascent, if not reg­u­larly and mate­ri­ally cor­rected, is a sign of extreme, almost arro­gant over­con­fi­dence that typ­i­cally pre­cedes true crashes. Though we're con­vinced that the econ­omy is mov­ing into reces­sion, there is actu­ally lit­tle evi­dence of poor per­for­mance for gold shares dur­ing reces­sions (cer­tainly noth­ing like what we see in the broad equity mar­ket). Gold shares are gen­er­ally more sen­si­tive to the trend of Trea­sury yields, and real inflation-adjusted yields in par­tic­u­lar (ris­ing real yields are gen­er­ally unfa­vor­able). More­over, the ratio of spot gold to the XAU is now at a record high, so even in the event of a more pro­tracted decline in the metal, it is not clear that the equi­ties will fol­low. The sell­off appeared to be a reflex pro­voked by the need for some mar­ket par­tic­i­pants to raise cash, with a rel­a­tive desir­abil­ity of sell­ing the biggest gain­ers. We con­tinue to esti­mate a strong expected return/risk trade­off in pre­cious met­als shares, but given the volatil­ity, even a 20% allo­ca­tion in Strate­gic Total Return is suf­fi­ciently con­struc­tive in my view, and lim­its the poten­tial for major dis­com­fort even in the unex­pected event that gold retreats sig­nif­i­cantly more.

Learn­ing from History

I con­tinue to expect that the com­ing years will con­tain far more dis­rup­tive behav­ior in the econ­omy and the finan­cial mar­kets than investors may be con­di­tioned to believe is "nor­mal" from a post-war stand­point, and espe­cially from the mis­lead­ing expe­ri­ence of the recent bub­ble period. As Jeremy Grantham said last week, "This is no mar­ket for young men," mean­ing that unless you are a crusty vet­eran of mar­ket tur­bu­lence, it is dan­ger­ous to base invest­ment deci­sions on beliefs about what ought to be "nor­mal" (the bubble-based bench­marks that Wall Street ana­lysts are apply­ing price-to-forward-operating earn­ings, and their will­ing­ness to bake in the assump­tion of record profit mar­gins for the indef­i­nite future, is a good exam­ple of this danger).

I've always believed that the best sup­ple­ment for age is data, which is why data is our largest expense next to pay­roll (as a side note, though we often get requests, our licenses pre­vent redis­trib­ut­ing raw data). Once the credit cri­sis forced us to con­tem­plate Depression-era out­comes, I admit­tedly took share­hold­ers through some frus­tra­tion dur­ing 2009 and 2010 as we recon­fig­ured our meth­ods to reflect data well beyond the post-war period, but as we are likely to expe­ri­ence con­di­tions that are "out of sam­ple" rel­a­tive to recent decades, it was crit­i­cal to have meth­ods that per­formed strongly in data from as many peri­ods as we could get our hands on. I believe that investors will invite dif­fi­culty if they sim­ply assume that we live in a world of short reces­sions and auto­matic expan­sions, or base their val­u­a­tion esti­mates on for­ward oper­at­ing earn­ings using bench­marks reflec­tive of the recent bub­ble period, or assume an econ­omy that is obe­di­ent to Wall Street's peren­nial expec­ta­tion for every down­turn to be res­cued by "a rebound in the sec­ond half." The ensem­bles are effec­tive in reduc­ing our reliance on any spe­cific model or period of time.

I should note again that our ensem­ble meth­ods, had they been in hand at the time, would not have sup­ported an invest­ment posi­tion that was nearly as defen­sive as we were in prac­tice dur­ing much of 2009 and early 2010. They would, how­ever, have been strongly defen­sive since about April 2010 (as we were in prac­tice), and of course, have been defen­sive since we put them into use late last year. Still, we've had sev­eral peri­ods of mod­estly con­struc­tive expo­sure since then, and are con­tin­u­ally open to oppor­tu­ni­ties to estab­lish mar­ket expo­sure at points where the expected return/risk pro­file of stocks becomes pos­i­tive. So while more than a decade of dis­mal mar­ket returns has largely val­i­dated our gen­er­ally defen­sive invest­ment stance (and con­versely, our defen­sive stances have gen­er­ally antic­i­pated dis­mal mar­ket returns), I expect that we are well equipped to iden­tify con­struc­tive oppor­tu­ni­ties even if the mar­ket con­tin­ues to have chal­lenges in pro­duc­ing durable returns for a while. On the brighter side, we also expect to even­tu­ally have a mar­ket that is priced to achieve both strong and durable long-term returns, as we've had for much of mar­ket his­tory out­side the past 15 years or so, and in those envi­ron­ments we'll typ­i­cally be able to get along with­out any hedge at all.

From an eco­nomic stand­point, it is also essen­tial to approach the oncom­ing down­turn with an under­stand­ing of his­tory. On that note, the McK­in­sey Global Insti­tute put out a report last year (Debt and Delever­ag­ing: The global credit bub­ble and its eco­nomic con­se­quences ) that pro­vides a use­ful con­text for what we are now observing:

"While we can­not say for cer­tain that delever­ag­ing will occur today, we do know empir­i­cally that delever­ag­ing has fol­lowed nearly every major finan­cial cri­sis in the past half-century. We find 45 episodes of delever­ag­ing since the Great Depres­sion in which the ratio of total debt rel­a­tive to GDP declined, and 32 of them fol­lowed a finan­cial cri­sis. These include some instances in which delever­ag­ing occurred only in the pub­lic sec­tor; oth­ers in which the pri­vate sec­tor delever­aged; and some in which both the pub­lic and pri­vate sec­tors delever­aged simul­ta­ne­ously. The his­toric episodes of delever­ag­ing fit into one of four arche­types: 1) aus­ter­ity (or 'belt-tightening'), in which credit growth lags behind GDP growth for many years; 2) mas­sive defaults; 3) high infla­tion; or 4) grow­ing out of debt through very rapid real GDP growth caused by a war effort, a 'peace div­i­dend' fol­low­ing war, or an oil boom [for oil-producing countries].

"The his­toric episodes show that delever­ag­ing can occur through dif­fer­ent macro­eco­nomic chan­nels. These either reduce the growth of credit, increase nom­i­nal GDP growth, or both. The 'mas­sive default' arche­type results in delever­ag­ing by reduc­ing the out­stand­ing stock of credit as loans are writ­ten down. The 'high infla­tion' arche­type works by increas­ing nom­i­nal GDP growth. The 'grow­ing out of debt' arche­type works through a marked accel­er­a­tion of real GDP growth, which his­tor­i­cally has been the case only in war time or dur­ing com­mod­ity booms.

"The 'belt-tightening' arche­type was by far the most com­mon of the four, account­ing for roughly half of the delever­ag­ing episodes. If today's economies were to fol­low this path, they would expe­ri­ence six to seven years of delever­ag­ing, in which the debt-to-GDP ratio declines by about 25 per­cent. Delever­ag­ing would begin two years after the start of the cri­sis, and GDP would con­tract for the first two to three years of delever­ag­ing, and then start grow­ing again. [This] arche­type works by slow­ing credit growth and increas­ing net sav­ing while main­tain­ing nom­i­nal GDP growth. Other chan­nels, such as defaults and infla­tion, can also play a role in belt-tightening episodes. The dif­fi­culty is how to sup­port nom­i­nal GDP growth as pri­vate sav­ing increases, since that implies a reduc­tion in con­sump­tion growth. If house­holds save more and busi­nesses invest less, GDP will be reduced unless it is sup­ported by another factor.

"It is doubt­ful today that one sin­gle macro­eco­nomic fac­tor will enable delever­ag­ing, given the large sizes of the economies involved. It is more likely that delever­ag­ing will occur through mar­ginal improve­ments in many fac­tors: some improve­ment in net exports, per­haps some increase in labor force par­tic­i­pa­tion, fur­ther defaults, maybe some infla­tion, and hope­fully sus­tained pro­duc­tiv­ity growth. Poli­cies to enable and sup­port these changes will be critical.

"Sev­eral fea­tures of the cri­sis today, includ­ing its global nature and the large pro­jected increases in gov­ern­ment debt, could delay the start of delever­ag­ing and result in a longer period of debt reduc­tion than in the past. In past episodes, a sig­nif­i­cant increase in net exports often helped sup­port GDP growth dur­ing delever­ag­ing. But it is unlikely today that the most highly lever­aged major economies could all simul­ta­ne­ously increase their net exports. More­over, cur­rent pro­jec­tions of gov­ern­ment debt in some coun­tries, such as the United King­dom, the United States, and Spain, may off­set reduc­tions in debt by house­holds and com­mer­cial real estate sec­tors. We there­fore see a risk that the mature economies may remain highly lever­aged for a pro­longed period, which would cre­ate a frag­ile and poten­tially unsta­ble eco­nomic out­look over the next five to ten years. They may then go through many years in which, all else being equal, GDP growth is slower than it would have been oth­er­wise as debt is paid down. These highly lever­aged economies may there­fore remain vul­ner­a­ble to eco­nomic shocks for some time.

"At this writ­ing [2010], the delever­ag­ing process has barely begun. Each week brings news of another coun­try strain­ing under the bur­den of too much debt or impend­ing bank losses from over-indebted com­pa­nies. The burst­ing of the great global credit bub­ble is not over yet."

How to Restruc­ture a Major Bank

And finally, since by all appear­ances we are likely to observe fur­ther strains in the bank­ing sec­tor, both on account of Greek con­cerns and as a follow-on to likely eco­nomic weak­ness, it is a good time to review some com­ments on bank restruc­tur­ing by Robert Hall (the Chair­man of the NBER's Reces­sion Dat­ing Com­mit­tee and one of my for­mer dis­ser­ta­tion advi­sors at Stan­ford), and econ­o­mist Susan Wood­ward. This from 2009, but equally applic­a­ble today. Hall and Wood­ward include some tech­ni­cal details, but the upshot is that there is no rea­son to believe that banks need to be bailed out at every turn, or that bank bond­hold­ers have to con­stantly be made whole, in order to pro­tect depos­i­tors or main­tain an intact finan­cial system:

"Econ­o­mists are increas­ingly puz­zled by the government's treat­ment of banks and other finan­cial insti­tu­tions that are tee­ter­ing near insol­vency. The doc­trine is widely accepted that insti­tu­tions in this state are a dan­ger to the econ­omy (because their incen­tive is to take some big risks to try to get out of the hole, as the S&Ls did in the 1980s) and that reg­u­la­tors should take prompt, aggres­sive action to return them to sound finan­cial con­di­tion. This doc­trine calls for insti­tu­tions to be reor­ga­nized or recap­i­tal­ized so that they are unam­bigu­ously sol­vent and the con­se­quences of risk-taking are mainly their own. The government's actions for Chrysler and Gen­eral Motors fol­low the doc­trine. In Chrysler's case, bank­ruptcy con­verts the claims of debthold­ers into equity, mak­ing its new rela­tion­ship with Fiat finan­cially attrac­tive to Fiat. Gen­eral Motors may be able to con­tinue as a stand-alone automaker if the claims of its debthold­ers, includ­ing the debt-like claims of retirees, become equity.

"By con­trast, the government's cur­rent pol­icy for all large finan­cial insti­tu­tions is to drib­ble tax­pay­ers' funds into the insti­tu­tions so that they can meet their stated oblig­a­tions to all par­ties, includ­ing debthold­ers, but just barely. The gov­ern­ment injects funds into AIG, Cit­i­group, the Bank of Amer­ica, and many other insti­tu­tions to keep them just above water. The gov­ern­ment has for­got­ten the doc­trine of imme­di­ate full recap­i­tal­iza­tion in the case of finan­cial insti­tu­tions, despite the clear lessons of inter­na­tional expe­ri­ence. The Scan­di­na­vian coun­tries aggres­sively reor­ga­nized and recap­i­tal­ized banks after the cri­sis of the early 1990s and quickly restored full employ­ment and growth; the Japan­ese fol­lowed the pol­icy of sup­port­ing mar­ginal banks for what became the 'lost decade.'

"The cel­e­brated stress tests illus­trate the cur­rent pol­icy per­fectly. The stress test takes the cur­rent con­di­tion of the bank as the goal for the future. The test has noth­ing to do with ensur­ing that banks are heav­ily cap­i­tal­ized, ready to resume their nor­mal roles in the econ­omy. The stress test is the right way to fig­ure out the min­i­mum amount needed to inject in weak banks to keep them barely afloat, but that is the wrong pol­icy. The gov­ern­ment turned to stress tests, it appears, out of dis­com­fort with the answers the stan­dard cap­i­tal tests gave, based on see­ing that prop­erly mea­sured cap­i­tal was ade­quate in rela­tion to obligations.

"The effect of the government's cur­rent pol­icy is to pay off all claimants on finan­cial insti­tu­tions at face value, includ­ing those which, when they were first issued, had no expec­ta­tion of fed­eral bailout and received sub­stan­tial inter­est pre­mi­ums on account of their will­ing­ness to accept the risk of default. There are much bet­ter uses for fed­eral money than hand­ing cap­i­tal gains to debtholders.

"If an insti­tu­tion has sub­stan­tial amounts of debt out­stand­ing that is sub­or­di­nated to all other claims, reor­ga­ni­za­tion is fairly sim­ple. The dan­ger to the insti­tu­tion is that the sub­or­di­nated claimants will put the insti­tu­tion into bank­ruptcy at some future time when the insti­tu­tion fails to make required pay­ments to those debthold­ers and that the bank­ruptcy will plunge the entire orga­ni­za­tion into Lehman-like chaos. To side­step this dan­ger, the reor­ga­ni­za­tion alters the claims of the sub­or­di­nated debthold­ers so that they can­not trig­ger a bank­ruptcy or so that the bank­ruptcy that they can trig­ger does not inter­fere with the activ­i­ties of the institution.

"The first approach is easy. It is the one that the gov­ern­ment pushed on the debthold­ers of the automakers–convert debt to equity. With new pow­ers granted by Con­gress, the gov­ern­ment could fig­ure out a con­ver­sion value for a large amount of debt that gave the debthold­ers the same mar­ket value as equity as they cur­rently enjoy. The debthold­ers would suf­fer no cap­i­tal gain or loss. As the expe­ri­ence with automak­ers' debt showed, it is vir­tu­ally impos­si­ble to achieve such an exchange vol­un­tar­ily, because both sides will play “chicken” until adult super­vi­sion inter­venes. The com­pul­sion of new law is necessary.

"If a bor­der­line insti­tu­tion lacks enough fully-subordinated debt to achieve an ade­quate level of cap­i­tal by con­vert­ing debt to equity, longer-term debt could be treated as if it were fully sub­or­di­nated. Again, the debthold­ers could be given equity equal in value to the mar­ket value of the debt they gave up. In this case, the claimants sub­or­di­nate to the con­verted debthold­ers would enjoy a cap­tial gain, at the cost of the shareholders.

"Actual exchanges of debt for equity are not needed to recap­i­tal­ize shaky insti­tu­tions. Recall that the goal is to pre­vent bank­ruptcy from inter­fer­ing with sub­stan­tive busi­ness, not to pre­vent bank­ruptcy entirely. Reor­ga­niz­ing an insti­tu­tion so that the debthold­ers retain a debt claim is prac­ti­cal. If the insti­tu­tion suf­fers fur­ther losses in value which cause it to default on the debt, a bank­ruptcy will occur. Our ear­lier post (The Right Way to Cre­ate a Good Bank and a Bad Bank) described how to do this. In brief, the debthold­ers' and exist­ing share­hold­ers' claims are moved to a hold­ing com­pany (if they are not already in a hold­ing com­pany) which owns all of the equity in the oper­at­ing insti­tu­tion. Some peo­ple, includ­ing us in our ear­lier post, called the hold­ing com­pany the “bad bank” and the oper­at­ing entity the “good bank.” If the earn­ings of the oper­at­ing insti­tu­tion are insuf­fi­cient to meet the oblig­a­tions to the debthold­ers at some future time, the hold­ing com­pany does a sim­ple Chap­ter 7 bank­ruptcy in which the debthold­ers become the share­hold­ers in the hold­ing com­pany, with no impli­ca­tions for the oper­at­ing insti­tu­tion. This type of reoga­ni­za­tion involves quite a few alter­ations in the con­tracts between the oper­at­ing insti­tu­tion and its cus­tomers and coun­ter­par­ties, so it def­i­nitely requires the kinds of new pow­ers that the Trea­sury has sought recently from Congress.

"The bot­tom line is that Con­gress and the tax­pay­ers are intol­er­ant of con­tin­ued expen­di­tures for bailouts that gen­er­ate large cap­i­tal gains for debthold­ers, that the bailout pol­icy main­tains shaky finan­cial insti­tu­tions while a bet­ter pol­icy would deliver fully cap­i­tal­ized, reli­able ones.

"Among econ­o­mists, a con­sen­sus is form­ing that reg­u­la­tion of the finan­cial instu­ti­tons that enjoy the government's pro­tec­tion should com­pel those insti­tu­tions to have a struc­ture that eases the type of reor­ga­ni­za­tion dis­cussed above (see the State­ment of the Squam Lake Work­ing Group , an alliance of lead­ing finan­cial econ­o­mists). The sim­plest ver­sion is to require that banks hold fully sub­or­di­nated debt and equity of, say, 40 per­cent of assets, in a hold­ing com­pany, in such a way that the bank­ruptcy of the hold­ing com­pany would not inter­fere even briefly with the imme­di­ate oper­a­tions of the bank. As we dis­cussed above, if the oper­a­tions of the bank, paid as div­i­dends to the hold­ing com­pany, could not meet the oblig­a­tions to the debthold­ers, the hold­ing com­pany would go through a Chap­ter 7 bank­ruptcy and the bond­hold­ers would take over as share­hold­ers. The Squam Lake pro­posal would side­step the bank­ruptcy by design­ing the debt to con­vert to equity on its own terms under adverse conditions.

"Under a require­ment of sub­stan­tial amounts of sub­or­di­nated debt, bank deposits would become almost com­pletely safe. Banks would be lim­ited to financ­ing their activ­i­ties through deposits to the remain­ing frac­tion, 60 per­cent in our exam­ple above. For larger banks, this would not be a bind­ing limitation."

Mar­ket Climate

As of last week, the Mar­ket Cli­mate for stocks remained neg­a­tive, but less so than in recent weeks. Strate­gic Growth and Strate­gic Inter­na­tional Equity remain well-hedged, but we are open to shift­ing to a con­struc­tive expo­sure if the evi­dence changes. The best like­li­hood for a sus­tained mar­ket advance is for that advance to begin from sig­nif­i­cantly lower lev­els, but we'll respond to the data as it evolves. In Strate­gic Total Return, we con­tinue to have a dura­tion of about 1.5 years, with about 20% in pre­cious met­als shares, about 4% in util­ity shares, and a cou­ple of per­cent of assets in non-euro for­eign currencies.

Tags: Banks, Bond Markets, Bond Prices, Bonds, Currency, European Leaders, European Monetary Union, Face Value, Failure, Gold, Government Bonds, Greece, Greek Government, Guess, Hussman Funds, Investors, Longshot, Outlook, Phrasing, Rally, Relative Price Levels, Running, Timeline
Posted in Bonds, Brazil, Gold, Markets, Outlook | Comments Off

Jim Rogers Talks to CNBC About the Current Dire Straits

Saturday, September 24th, 2011

by Trader Mark, Fund My Mutual Fund

Some­times Jim Rogers gets repeta­tive since he usu­ally pounds the same the­o­ries — which is not bad from the view­point he has a long term out­look, but in this inter­view with CNBC yes­ter­day there are some inter­est­ing items regard­ing his cur­rent posi­tions (cur­rently long dol­lar even though he does not believe it to be a safe haven), and some trade / cur­rency ten­sions devel­op­ing.  I must have missed the news about Brazil­ian import tar­iff on Chi­nese goods.

For those newer to trad­ing I think his view on the dol­lar is impor­tant to under­stand from a les­son stand­point.  Even if you the dol­lar is 'cooked' long term, time frame is impor­tant.  For the near term, the U.S. dol­lar still is con­sid­ered a safe haven (best house on a street full of crack homes) and in panic peo­ple flee to U.S. Trea­suries and the dol­lar.  So while Jim believes U.S. lead­er­ship (I use that word loosely) is con­stantly doing dam­age to its cur­rency, he under­stands the way the other peo­ple in the mar­ket will react and will take advan­tage of it.  (Rogers is a huge long term bear on the currency)

8 minute video

• The U.S. dol­lar is going higher “against major cur­ren­cies,” well-known investor Jim Rogers told CNBC Thurs­day. The dol­lar "is going up against every­thing right now” for a num­ber of rea­sons, said Rogers. Oné may be that every­body is pan­ick­ing "and for some rea­son they’re rush­ing into the U.S. dol­lar.” “The U.S. dol­lar is not a safe haven, if you ask me, but I do own it,” he added.
• Also, Rogers noted he would own the U.S. dol­lar, or the Swiss Franc, or agri­cul­ture. “Agri­cul­ture prices [are] get­ting banged right now. I am kind of plan­ning on buy­ing Swiss francs, more dol­lars and agriculture.”
• In addi­tion, he weighed in on China’s econ­omy, say­ing, “They’re doing their best to cool things off … I expect them to con­tinue to do it, and that is caus­ing more slow­down around the world.”
• But “the major prob­lems are com­ing from the west," Roger stressed. “They are com­ing from Europe and the [United States]. We are much worse off than we were in 2008 because the debt has gone through the roof.”  “At least in 2008 there was the pos­si­bil­ity that the gov­ern­ments could bail us out. Now, of course, the gov­ern­ments have got­ten deep, deep, deep into debt them­selves,” he added. “Every­body is in much worse shape.”
• Plus, there are all sorts of trade ten­sions and cur­rency ten­sion devel­op­ing, Rogers went on to say. “Brazil  is sort of ignited a trade war [by putting a 30 per­cent import tar­iff on China and Korea ]. And right now China is try­ing to get the Euro­peans to let them open up the trade with China more. The Euro­peans are say­ing no, so China is say­ing, 'No, we won’t bail you out.'"
• “I hope the trade war doesn’t break out" because through­out his­tory when it does it has "caused depres­sions,” Rogers added. “You saw what hap­pened in the 1930s. It led to depres­sion and it also led to war. So I hope it can be contained.”
• Ben Bernanke's idea that low-interest rates are good, "is killing the peo­ple who save and invest, and that's really hurt­ing a very, very large part of the pop­u­la­tion," con­cluded Rogers. (some­thing we've said count­less times)  [Mar 31, 2010: Ben Bernanke Con­tent to Sac­ri­fice Savers to Recap­i­tal­ize Banks and Ben­e­fit Debtors]

Tags: Agriculture Agriculture, Agriculture Prices, Brazil, Chinese Goods, Cnbc, Currency, Dire Straits, Import Tariff, Jim Rogers, Mutual Fund, Outlook, Safe Haven, Slowdown, Standpoint, Swiss Franc, Swiss Francs, Tensions, Term Outlook, Term Time, Time Frame, Treasuries, Viewpoint
Posted in Brazil, ETFs, Markets, Outlook | Comments Off

Preparing for a Greek Default (Hussman)

Sunday, September 18th, 2011

Prepar­ing for a Greek Default

by John P. Huss­man, Ph.D., Huss­man Funds

The yield on 1-year Greek gov­ern­ment debt ended last week at 110%, down slightly from a mid-week peak of 130%. Even with the pull­back, the Greek yield struc­ture con­tin­ues to imply default with cer­tainty. All the mar­kets are really quib­bling about here is the recov­ery rate — what per­cent­age of face value investors can expect to obtain post-default. That fig­ure was still hov­er­ing near 50% as of Fri­day, but was a bit higher than we saw a few days earlier.

Despite a Greek 1-year yield that is already over 100%, it is still pos­si­ble to kick the can down the road for another few months with another bailout, but the costs of that would now be extra­or­di­nar­ily high because of the low expected recov­ery rate. Much bet­ter to pro­vide the funds to a post-default Greece, or to use them to recap­i­tal­ize the bank­ing sys­tem after losses that now appear inevitable.

Doureios Hip­pos: Greek 1-year yields — Quidquid id est, timeo Danaos et dona ferentes.

As a refresher on how all of this works, the fol­low­ing chart appeared years ago in the Econ­o­mist, a chron­i­cle of the fran­tic bail-outs in the months pre­ced­ing the default of Argen­tine debt (which amounted to about $81 bil­lion. Need­less to say, the num­bers involved in a poten­tial Greek default are much larger, but the pat­tern we are see­ing in Greece is iden­ti­cal to the sig­na­ture of other his­tor­i­cal sov­er­eign defaults (see Uruguay, Rus­sia and other coun­tries as well ) — a sus­tained rise in yields, cou­pled with offi­cial state­ments about the "impos­si­bil­ity" of default, mul­ti­ple bailout efforts that quickly fail, cul­mi­nat­ing in a ver­ti­cal spike in yields (toward the inverse of the expected recov­ery rate, minus 1).

The case of Argentina is instruc­tive because it was in a sit­u­a­tion much like that of Greece. Argentina's cur­rency was both pegged and offi­cially con­vert­ible into the U.S. dol­lar, and most of Argentina's debt was denom­i­nated in U.S. dol­lars, cre­at­ing a sit­u­a­tion where its debt bur­den was in the form of a cur­rency that it effec­tively could not print. The sub­se­quent default was accom­pa­nied first by an abrupt deval­u­a­tion of the peso to a new peg, and even­tu­ally to com­plete aban­don­ment of the pegged exchange rate.

From the his­tory of sov­er­eign defaults, we can already cre­ate some­thing of a roadmap of the finan­cial cri­sis that appears about to unfold, and the asso­ci­ated choices involved.

Sup­pose first that Greece agrees to imple­ment new aus­ter­ity mea­sures and receives another tranche of bailout fund­ing. We already know that apply­ing severe bud­get aus­ter­ity in an econ­omy that is in depres­sion (as Greece essen­tially is) does not mate­ri­ally close the bud­get deficit, but instead pro­duces fur­ther eco­nomic weak­ness and rev­enue short­falls. The past year has been a clear exam­ple of that. By the end of the year, even with new bailout fund­ing, Greece will have a debt-to-GDP ratio approach­ing 180%. This is an impos­si­ble debt bur­den to ser­vice, and would be even if inter­est rates in Greece were only a few per­cent. New bailout fund­ing here means that we'll observe more riot­ing in Greece as new aus­ter­ity mea­sures are imple­mented, the Greek econ­omy will largely shut down, and within a few months, we'll be fac­ing the default issue again but at an even higher debt-to-GDP level and even lower antic­i­pated recov­ery rates.

Thus, a bailout today does not avert default, but at best defers it to a later date, and squan­ders funds that could oth­er­wise be used to sta­bi­lize the Euro­pean bank­ing sys­tem once that inevitable default occurs.

Of course, there is the implau­si­ble option for stronger coun­tries such as France and Ger­many to lit­er­ally pay off half of the gov­ern­ment debt of Greece, tak­ing those debt bur­dens upon them­selves. But this clearly would not be tol­er­a­ble polit­i­cally, and would invite sim­i­lar expec­ta­tions from other tee­ter­ing Euro-zone coun­tries such as Por­tu­gal, undoubt­edly also encour­ag­ing them to com­pletely aban­don any remain­ing fis­cal discipline.

So Greece will default, either now or within sev­eral months. In response, three actions will be crit­i­cal: pre­vent­ing con­ta­gion, pre­serv­ing the euro, and sta­bi­liz­ing the bank­ing system.

Tags: Argentina, Bailout, Banking System, Bonds, Currency, Economist, Face Value, Few Days, Government Debt, Greece, Greek Government, Hippos, Hussman Funds, Impossibility, Losses, Official Statements, Pullback, Signature, Spike, Timeo Danaos Et Dona Ferentes, Value Investors
Posted in Bonds, Brazil, Markets | Comments Off

More on How Inflation Turns Us Into Con Artists

Thursday, March 31st, 2011

via ZeroHedge.com

Here's a Phil's Stock World favorite for today.  John Rubino is the co-author of the book "The Col­lapse of the Dol­lar" and writes fre­quent arti­cles about the econ­omy at his blog, "Dol­lar Col­lapse." — Ilene

More on How Infla­tion Turns Us Into Con Artists

Cour­tesy of JOHN RUBINO of Dol­lar Collapse

John May­nard Keynes once said of inflation:

There is no sub­tler, no surer means of over­turn­ing the exist­ing basis of soci­ety than to debauch the cur­rency. The process engages all the hid­den forces of eco­nomic law on the side of destruc­tion, and does it in a man­ner which not one man in a mil­lion is able to diagnose.

Here’s one of the “hid­den forces of eco­nomic law” to which Keynes referred, cour­tesy of yesterday’s New York Times:

Food Infla­tion Kept Hid­den in Smaller Bags

Chips are dis­ap­pear­ing from bags, candy from boxes and veg­eta­bles from cans.

As an expected increase in the cost of raw mate­ri­als looms for late sum­mer, con­sumers are begin­ning to encounter shrink­ing food packages.

With unem­ploy­ment still high, com­pa­nies in recent months have tried to cam­ou­flage price increases by sell­ing their prod­ucts in tiny and tinier pack­ages. So far, the changes are most vis­i­ble at the gro­cery store, where shop­pers are pay­ing the same amount, but get­ting less.

For Lisa Stauber, stretch­ing her bud­get to feed her nine chil­dren in Hous­ton often requires care­ful mon­i­tor­ing at the store. Recently, when she cooked her usual three boxes of pasta for a big fam­ily din­ner, she was sur­prised by a smaller yield, and she began to sus­pect some­thing was up.

“Whole wheat pasta had gone from 16 ounces to 13.25 ounces,” she said. “I bought three boxes and it wasn’t enough — that was a lit­tle embar­rass­ing. I bought the same amount I always buy, I just didn’t real­ize it, because who reads the sizes all the time?”

Ms. Stauber, 33, said she began inspect­ing her other pur­chases, aisle by aisle. Many canned veg­eta­bles dropped to 13 or 14 ounces from 16; boxes of baby wipes went to 72 from 80; and sugar was stacked in 4-pound, not 5-pound, bags, she said.

Five or so years ago, Ms. Stauber bought 16-ounce cans of corn. Then they were 15.5 ounces, then 14.5 ounces, and the size is still drop­ping. “The first time I’ve ever seen an 11-ounce can of corn at the store was about three weeks ago, and I was just floored,” she said. “It’s sneaky, because they fig­ure peo­ple won’t know.”

In every eco­nomic down­turn in the last few decades, com­pa­nies have reduced the size of some prod­ucts, dis­guis­ing price increases and avoid­ing com­par­isons on same-size pack­ages, before and after an increase. Each time, the mar­ket­ing cam­paigns are coy; this time, the smaller ver­sions are “greener” (pack­ages good for the envi­ron­ment) or more “portable” (lit­tle carry bags for the take­out lifestyle) or “health­ier” (fewer calories).

Where com­pa­nies can­not change sizes — as in cloth­ing or appli­ances — they have warned that prices will be going up, as the costs of cot­ton, energy, grain and other raw mate­ri­als are rising.

“Con­sumers are gen­er­ally more sen­si­tive to changes in prices than to changes in quan­tity,” John T. Gourville, a mar­ket­ing pro­fes­sor at Har­vard Busi­ness School, said. “And com­pa­nies try to do it in such a way that you don’t notice, maybe keep­ing the height and width the same, but chang­ing the depth so the sil­hou­ette of the pack­age on the shelf looks the same. Or some­times they add more air to the chips bag or a scoop in the bot­tom of the peanut but­ter jar so it looks the same size.”Thomas J. Alexan­der, a finance pro­fes­sor at North­wood Uni­ver­sity, said that busi­nesses had lit­tle choice these days when faced with increases in the costs of their raw goods. “Com­pa­nies only have pric­ing power when wages are also increas­ing, and we’re not see­ing that right now because of the high unem­ploy­ment,” he said.

Most com­pa­nies reduce prod­ucts qui­etly, hop­ing con­sumers are not read­ing labels too closely.

But the down­siz­ing keeps occur­ring. A can of Chicken of the Sea alba­core tuna is now packed at 5 ounces, instead of the 6-ounce ver­sion still on some shelves, and in some cases, the 5-ounce can costs more than the larger one. Bags of Dori­tos, Tos­ti­tos and Fritos now hold 20 per­cent fewer chips than in 2009, though a spokesman said those extra chips were just a “lim­ited time” offer.

Try­ing to keep cus­tomers from feel­ing cheated, some com­pa­nies are intro­duc­ing new con­tain­ers that, they say, have ter­rific advan­tages — and just hap­pen to con­tain less product.

Kraft is intro­duc­ing “Fresh Stacks” pack­ages for its Nabisco Pre­mium saltines and Honey Maid gra­ham crack­ers. Each has about 15 per­cent fewer crack­ers than the stan­dard boxes, but the price has not changed. Kraft says that because the Fresh Stacks include more sleeves of crack­ers, they are more portable and “the pack­ag­ing for­mat offers the ben­e­fit of added fresh­ness,” said Basil T. Maglaris, a Kraft spokesman, in an e-mail.

And Proc­ter & Gam­ble is expand­ing its “Future Friendly” prod­ucts, which it pro­motes as using at least 15 per­cent less energy, water or pack­ag­ing than the stan­dard ones.“They are more envi­ron­men­tally friendly, that’s true — but they’re also smaller,” said Paula Rosen­blum, man­ag­ing part­ner for retail sys­tems research at Focus.com, an online spe­cial­ist net­work. “They announce it as great new pack­ag­ing, and in fact what it is is smaller pack­ag­ing, smaller amounts of the prod­uct,” she said.

Or mar­keters design a new shape and size alto­gether, com­pli­cat­ing any effort to com­par­i­son shop. The unwrapped Reese’s Minis, which were intro­duced in Feb­ru­ary, are smaller than the foil-wrapped Minia­tures. They are also more expen­sive — $0.57 an ounce at FreshDi­rect, ver­sus $0.37 an ounce for the indi­vid­u­ally wrapped.

At H. J. Heinz, prices on ketchup, condi­ments, sauces and Ore-Ida prod­ucts have already gone up, and the com­pany is sell­ing smaller-than-usual ver­sions of condi­ments, like 5-ounce bot­tles of items like Heinz 57 Sauce sold at places like Dol­lar General.

Some thoughts:

• When Fed offi­cials claim that infla­tion is “well con­tained” are they mea­sur­ing per ounce or per pack­age? It wouldn’t be a sur­prise, given how dis­con­nected from real­ity they fre­quently sound, if they’re being fooled by man­u­fac­tur­ers’ pack­ag­ing scams. [The Fed offi­cials may mea­sure pack­age to pack­age with­out being "fooled."  I remem­ber read­ing that that was per­mis­si­ble and will look for the ref­er­ence.  See also Michael Panzner's "More than a lit­tle doubt." — Ilene]

• If man­u­fac­tur­ers are play­ing games with pack­age sizes you can bet they’re also using cheaper ingre­di­ents, so not only are we get­ting less of our favorite things, they’re prob­a­bly not as good as they were when we first devel­oped an attach­ment to them.

• It’s an arti­cle of faith among mod­ern econ­o­mists that a lit­tle infla­tion is a good thing because it lets com­pa­nies raise prices and work­ers get raises, so every­one feels richer. But that ignores the other side of the equa­tion, which is, as we’re now see­ing, a decline in prod­uct qual­ity and pro­ducer cred­i­bil­ity. In the end we don’t feel richer because we got a raise; we feel ripped off by com­pa­nies we used to respect.

• Those same econ­o­mists see defla­tion as a bad thing because it makes debt harder to carry. But this also over­looks the impact of incen­tives on behav­ior and char­ac­ter. Con­sider: if you make, say, candy bars and the prices of sugar and choco­late are going down, you want to avoid hav­ing to cut your sell­ing price because hold­ing the line on price pro­duces a wider profit mar­gin. So you start using higher-grade choco­late or increas­ing your candy bars’ size — and you let your cus­tomers know that you’re improv­ing your prod­ucts. Your cred­i­bil­ity goes up because you’re offer­ing a bet­ter deal, and doing so very pub­licly. As this prac­tice spreads through the larger econ­omy, the result is a cul­ture of qual­ity and integrity and cus­tomer ser­vice. Where infla­tion turns mer­chants into secre­tive con artists, defla­tion pro­duces trans­par­ent pur­vey­ors of ever-better deals. In a defla­tion­ary world, our pay­checks don’t rise as much, but every­one seems to be work­ing for us rather than try­ing to rip us off.

• Viewed this way, only an idiot (or a Key­ne­sian econ­o­mist) would choose infla­tion over deflation.

Pic­ture credit: Jesse's Café Americain

Tags: Canned Vegetables, Co Author, Collapse, Con Artists, Currency, Economic Law, energy, Family Dinner, Food Packages, Frequent Articles, Grocery Store, John Maynard Keynes, John Rubino, Man In A Million, New York Times, oil, Price Increases, Stauber, Stock World, Surer, Three Boxes, Time Ms, Whole Wheat Pasta
Posted in Credit Markets, Energy & Natural Resources, Markets, Oil and Gas | Comments Off

Bill Gross: Investment Outlook (April 2011)

Wednesday, March 30th, 2011

Invest­ment Outlook

by William H. Gross, April 2011

Skunked

• Medicare, Med­ic­aid and Social Secu­rity now account for 44% of total fed­eral spend­ing and are steadily rising.
• Pre­vi­ous Con­gresses (and Admin­is­tra­tions) have relied on the assump­tion that we can grow our way out of this oner­ous debt burden.
• Unless enti­tle­ments are sub­stan­tially reformed, the U.S. will likely default on its debt; not in con­ven­tional ways, but via infla­tion, cur­rency deval­u­a­tion and low to neg­a­tive real inter­est rates.

That adorable skunk, Pepé Le Pew, is one of my wife Sue’s favorite car­toon char­ac­ters. There’s some­thing affa­ble, even roman­tic about him as he seeks to woo his female com­pan­ions with a French accent and promises of a skunk bun­ga­low and bed­rooms full of lit­tle Pepés in future years. It’s easy to love a skunk – but only on the sil­ver screen, and if in real life – at a con­sid­er­able dis­tance. I think of Con­gress that way. Every two or six years, they dress up in full makeup, pre­tend­ing to be the change, vow­ing to cor­rect what hasn’t been cor­rected, promis­ing dis­ci­pline as opposed to prof­li­gate over­spend­ing and under­tax­a­tion, and striv­ing to bal­ance the bud­get when all oth­ers have failed. Oooh Pepé – Mon Chéri! But don’t believe them – hold your nose instead! Oh, I kid the Con­gress. Per­haps they don’t have black and white stripes with bushy tails. Per­haps there’s just a stink bomb that the Con­gres­sional sergeant-at-arms sets off every time they con­vene and the gavel falls to sig­nify the begin­ning of the “people’s busi­ness.” Per­haps. But, in all cases, cit­i­zens of Amer­ica – hold your noses. You ain’t smelled nothin’ yet.

I speak, of course, to the bud­get deficit and Washington’s inabil­ity to rec­og­nize the intractable: 75% of the bud­get is non-discretionary and enti­tle­ment based. With­out attack­ing enti­tle­ments – Medicare, Med­ic­aid and Social Secu­rity – we are smelling $1 tril­lion deficits as far as the nose can sniff. Once dom­i­nated by defense spend­ing, these three cat­e­gories now account for 44% of total Fed­eral spend­ing and are steadily ris­ing. As Chart 1 points out, after defense and inter­est pay­ments on the national debt are excluded, remain­ing dis­cre­tionary expenses for edu­ca­tion, infra­struc­ture, agri­cul­ture and hous­ing con­sti­tute at most 25% of the 2011 fis­cal year fed­eral spend­ing bud­get of $4 tril­lion. You could elim­i­nate it all and still wind up with a deficit of nearly $700 bil­lion! So come on you stinkers; enough of the Pepé Le Pew romance and promises. Enti­tle­ment spend­ing is where the money is and you need to reform it.

Even then, the sit­u­a­tion is almost beyond repair. Check out the Treasury’s and Health and Human Ser­vices’ own data for the net present value of enti­tle­ment lia­bil­i­ties shown in Chart 2.

Tags: Bill Gross, Budget Deficit, Bushy Tails, Cartoon Characters, Currency, Currency Devaluation, Debt Burden, Federal Spending, Female Companions, French Accent, Future Years, Gross Investment, Infrastructure, Investment Outlook, Medicare Medicaid, Overspending, Promising Discipline, Sergeant At Arms, Silver, Stink Bomb, Trillion Deficits, White Stripes, William H Gross
Posted in Infrastructure, Markets, Outlook, Silver | Comments Off

The Biggest Urban Legend in Finance (Arnott)

Wednesday, March 30th, 2011

by Robert Arnott, Research Affil­i­ates

Stocks ought to pro­duce higher returns than bonds in order for the cap­i­tal mar­kets to “work.” Oth­er­wise, stock­hold­ers would not be paid for the addi­tional risk they take for being lower down the cap­i­tal struc­ture. It comes as no sur­prise, there­fore, that stock­hold­ers have enjoyed out­sized returns for their efforts for most—but not all—long time periods.

Ibbot­son Asso­ciates, whose annual data com­pendium¹ cov­ers U.S. stocks and U.S. bonds since Jan­u­ary 1926, shows the S&P 500 Index com­pound­ing through Decem­ber 2010 at an annual rate of 9.9% vs. 5.5% for long-term gov­ern­ment bonds, an excess return of 4.4%. This return com­pounds expo­nen­tially with time. A $1,000 U.S. stock invest­ment in 1926 would have bal­looned to $3 mil­lion by Decem­ber 2010 vs. $92,000 for an invest­ment in long-term bonds, a 32-fold difference.

Embold­ened by the 1980s and 1990s (when stocks com­pounded at 17.6% and 18.2% per annum, respec­tively), “Stocks for the Long Run” became the mantra for long-term invest­ing, as well as a best-selling book. This view is now embed­ded into the psy­che of an entire gen­er­a­tion of pro­fes­sional and casual investors who ignore the fact that much of those out­sized returns were a con­se­quence of soar­ing val­u­a­tion mul­ti­ples and tum­bling yields. In this issue we exam­ine his­tor­i­cal U.S. equity per­for­mance from a larger per­spec­tive and find that today’s over­whelm­ing equity bias is built on a shaky foun­da­tion, reliant on a short and unrep­re­sen­ta­tive time period.

Let’s Talk Really Long-Term

For those will­ing to do the home­work, longer-term stock and bond data exist for the United States. But that pic­ture isn’t quite as rosy as from 1926–2010; there­fore, it doesn’t receive as much atten­tion from Wall Street opti­mists. From 1802–2010, U.S. stocks gen­er­ated a 7.9% annual return vs. 5.1% for long-term gov­ern­ment bonds.² Our real­ized excess return was cut to 2.8%—a one-third reduction—by adding 125 years of cap­i­tal mar­kets history!

Of course, many observers will declare 19th cen­tury data irrel­e­vant. A lot has changed! The sur­vival of the United States was in doubt dur­ing the early part of the cen­tury (War of 1812) and dur­ing the debil­i­tat­ing Civil War of the 1860s. The United States was an “emerg­ing mar­ket”! The econ­omy was notably short on global trade and long sub­sis­tence agri­cul­ture. Fur­ther­more, there were three major wars and four depressions—two were deeper than the Great Depression—between 1800 and 1870, a span when data on mar­ket returns were notably thin.

By the fol­low­ing cen­tury, the United States and its equity mar­kets enjoyed good for­tune. It was not invaded and occu­pied by a for­eign power. It did not suf­fer a gov­ern­ment over­throw… just ask Russ­ian investors their return on cap­i­tal after the Bol­she­vik Rev­o­lu­tion! As Ben Gra­ham might cau­tion, beware the dif­fer­ence between the loss on cap­i­tal (a drop in price, from which we can recover) and a loss of cap­i­tal (100% loss, from which we can­not). Russia’s stock mar­ket wasn’t alone in the 20th cen­tury as three addi­tional top 15 mar­kets in 1900—Egypt, Argentina, and China—suffered a 100% loss of cap­i­tal while Ger­many (twice) and Japan (once) came very close.³

Whether we use 200+ years or 80+ years, how many peo­ple are pur­su­ing an invest­ment pro­gram of that dura­tion? No one, of course. Even “per­pet­ual” insti­tu­tions such as uni­ver­sity endow­ments aren’t exempt. As the late eco­nomic his­to­rian Peter Bern­stein com­mented, “…this kind of long run will exceed the life expectan­cies of most peo­ple mature enough to be invited to join such boards of trustees.”⁴ Rel­e­vant hori­zons for all “long term” invest­ment pro­grams are sig­nif­i­cantly shorter—10 years or 20 years, maybe 30.

Shouldn’t a span of one, two, or three decades be suf­fi­cient for investors to be rewarded for bear­ing the risk of hold­ing stocks? As dis­played in Table 1, trail­ing returns for stocks haven’t come close to earn­ing the excess returns that we’ve all come to expect, even after stocks world­wide dou­bled from the early March 2009 lows dur­ing the Global Finan­cial Cri­sis! We’ll save an explo­ration for how the Fun­da­men­tal Index® con­cept rad­i­cally reshapes this pic­ture for another time.

Where is the wealth cre­ation implied by the Ibbot­son data? Stock mar­ket investors took the risk—riding out every bub­ble, every crash, every spec­tac­u­lar bank­ruptcy and bear mar­ket, over a 30-year stretch. How much were they com­pen­sated for the blood, sweat, and tears spilled with all this volatil­ity? A measly 53 basis points per annum! Indeed, investors who have incurred the ups and downs over the past decade have lost money com­pared to what they could have earned from long-term gov­ern­ment bonds. They’ve paid for the priv­i­lege of incur­ring stomach-churning risk. Not only did Trea­sury bond investors sleep bet­ter, they ate bet­ter too!

A 30-year stock mar­ket excess return of approx­i­mately zero is a huge dis­ap­point­ment to the legions of “stocks at any price” long-term investors. But it’s not the first extended drought. From 1803 to 1857,5 U.S. equi­ties strug­gled; the stock investor would have received a third of the end­ing wealth of the bond investor. Stocks man­aged to break even only in 1871. Most observers would be shocked to learn there was ever a 68-year stretch of stock mar­ket under­per­for­mance. After a 72-year bull mar­ket from 1857 through 1929, another dry spell ensued. From 1929 through 1949, stocks failed to match bonds, the only long-term short­fall in the Ibbot­son time sam­ple. Per­haps it was the extra­or­di­nary period of history—The Great Depres­sion and World War II—and the spec­tac­u­lar after­math from 1950–1999, that lulled recent investors into a false sense of secu­rity regard­ing long-term equity per­for­mance.⁶

The Odds

For­tu­nately for the cap­i­tal mar­kets and equity investors, an exam­i­na­tion of his­tory shows that, yes, stocks have a high ten­dency to out­per­form gov­ern­ment bonds over 10-year and 20-year peri­ods. Fig­ure 1 illus­trates rolling 10– and 20-year “win rates” for equi­ties ver­sus gov­ern­ment bonds. We break the data into Ibbot­son (1926–2010) and Total (1802–2010). The Ibbot­son time­frame con­firms investor behav­ior in the 30 years since Ibbot­son and Sin­que­field pub­lished their ground­break­ing study.⁷ For the vast major­ity of periods—86% for 10 years and 96% for 20 years—equities out­per­form bonds. But the longer term data are less con­vinc­ing. For 10-year peri­ods, equi­ties out­per­form in 71% of the obser­va­tions, ris­ing to 83% for 20 years.

A 70% or 80% win rate still offers pretty good odds. In pro­fes­sional bas­ket­ball, those are aver­age to above-average free throw per­cent­ages. But the rel­a­tively small prob­a­bil­ity of fail­ure masks the mag­ni­tude of a miss. Just as a sin­gle missed free throw can cost a bas­ket­ball cham­pi­onship, so too can an equity “miss” lead to dras­tic con­se­quences, as the past 10 years have shown. There is no guar­an­tee of supe­rior equity returns, which begs the ques­tion: Why does our indus­try act like there’s one? More impor­tant, why take all that risk for a skinny equity premium?

Con­clu­sion

We aren’t say­ing that we should expect bonds to beat stocks over the next 10 or 20 years. Rather, this brief his­tory les­son illu­mi­nates that the much-vaunted 4–5% risk pre­mium for stocks is unre­li­able and a dan­ger­ous assump­tion on which to make our future plans. In our view, a more nor­mal eco­nomic envi­ron­ment would sug­gest 2–3%, which is the his­toric risk pre­mium absent the rise in val­u­a­tion mul­ti­ples in the past 30 years. But these are not nor­mal times. Today’s low start­ing yields, com­bined with the prospec­tive chal­lenges from our addic­tion to debt-financed con­sump­tion and aging pop­u­la­tion, would put us closer to 1%.

It would be fool­ish to act as if the past 200 years is fully rep­re­sen­ta­tive of the future. For one thing, the United States was an emerg­ing mar­ket for much of that period, with only a hand­ful of indus­tries and an unsta­ble cur­rency. In the past cen­tury, we dodged chal­lenges and dif­fi­cul­ties that laid waste to the plans of investors in many coun­tries. Nas­sim Taleb points out that “Black Swans”—unwelcome out­liers that exceed the bounds of normalcy—are a recur­ring phe­nom­e­non; the abnor­mal is, indeed, nor­mal. Our own stock mar­ket his­tory is but a sin­gle sam­ple of a large and unknow­able pop­u­la­tion of poten­tial outcomes.

Peter Bern­stein relent­lessly reminded us there are things we can never know, that pros­per­ity and invest­ing suc­cess are inher­ently “risky”; they can dis­ap­pear in a flash. Uncer­tainty is always with us. The old adage puts it suc­cinctly: “If you want God to laugh, tell him your plans.” Con­cen­trat­ing the major­ity of one’s invest­ment port­fo­lio in one invest­ment cat­e­gory, based on an unknow­able and fickle long-term equity pre­mium, is a dan­ger­ous game of “prob­a­bil­ity chicken.”

End­notes

1. Ibbot­son® SBBI® 2011 Clas­sic Year­book: Mar­ket Results for Stocks, Bonds, Bills, and Infla­tion 1926–2010, Morningstar.

2. For much of this sec­tion, we rely on the data that Peter Bern­stein and I assem­bled for “What Risk Pre­mium is ‘Nor­mal’?” Finan­cial Ana­lysts Jour­nal, March/April 2002. We are indebted to many sources for this data, ranging

from Ibbot­son Asso­ciates, the Cowles Com­mis­sion, Bill Schw­ert of Rochester Uni­ver­sity, and Bob Shiller of Yale. For the full ros­ter of sources, see the FAJ paper.

3. See Arnott and Bern­stein (2002).

4. See Peter Bern­stein, “What Rate of Return Can You Rea­son­ably Expect… or What Can the Long Run Tell Us about the Short Run?” Finan­cial Ana­lysts Jour­nal, March/April 1997.

5. 20-year bonds were used when­ever pos­si­ble but the longest matu­ri­ties tended to be 10 years for much of the nine­teenth cen­tury. Also, in the 1840s, there was a brief span with no gov­ern­ment debt (we should be so lucky!),

hence no gov­ern­ment bonds. Under these cir­cum­stances, the equiv­a­lent to today’s Gov­ern­ment Spon­sored Enter­prises, rail­way and canal bonds, were used as these projects typ­i­cally had the tacit sup­port of the government.

6. For more on this, see Robert Arnott, “Bonds: Why Bother?” Jour­nal of Indexes, May/June 2009.

7. Roger G. Ibbot­son and Rex A. Sin­que­field, “Stocks, Bonds, Bills and Infla­tion: Year-by-Year His­tor­i­cal Returns (1926–1974),” Jour­nal of Busi­ness, Jan­u­ary 1976.

©2011 Research Affil­i­ates, LLC. The mate­r­ial con­tained in this doc­u­ment is for gen­eral infor­ma­tion pur­poses only. It relates only to a hypo­thet­i­cal model of past per­for­mance of the Fun­da­men­tal Index® strat­egy itself, and not to any asset man­age­ment prod­ucts based on this index. No allowance has been made for trad­ing costs or man­age­ment fees which would reduce invest­ment per­for­mance. Actual results may dif­fer. This mate­r­ial is not intended as an offer or a solic­i­ta­tion for the pur­chase and/or sale of any secu­rity or finan­cial instru­ment, nor is it advice or a rec­om­men­da­tion to enter into any trans­ac­tion. This mate­r­ial is based on infor­ma­tion that is con­sid­ered to be reli­able, but Research Affil­i­ates® and its related enti­ties (col­lec­tively “RA”) make this infor­ma­tion avail­able on an “as is” basis and make no war­ranties, express or implied regard­ing the accu­racy of the infor­ma­tion con­tained herein, for any par­tic­u­lar pur­pose. RA is not respon­si­ble for any errors or omis­sions or for results obtained from the use of this infor­ma­tion. Noth­ing con­tained in this mate­r­ial is intended to con­sti­tute legal, tax, secu­ri­ties, finan­cial or invest­ment advice, nor an opin­ion regard­ing the appro­pri­ate­ness of any invest­ment. The gen­eral infor­ma­tion con­tained in this mate­r­ial should not be acted upon with­out obtain­ing spe­cific legal, tax or invest­ment advice from a licensed pro­fes­sional. Indexes are not man­aged invest­ment prod­ucts, and, as such can­not be invested in directly. Returns rep­re­sent back-tested per­for­mance based on rules used in the cre­ation of the index, are not a guar­an­tee of future per­for­mance and are not indica­tive of any spe­cific invest­ment. Research Affil­i­ates, LLC, is an invest­ment adviser reg­is­tered under the Invest­ment Advi­sors Act of 1940 with the U.S. Secu­ri­ties and Exchange Com­mis­sion (SEC).

Rus­sell Invest­ment Group is the source and owner of the Rus­sell Index data con­tained or reflected in this mate­r­ial and all trade­marks and copy­rights related thereto. The pre­sen­ta­tion may con­tain con­fi­den­tial infor­ma­tion and unau­tho­rized use, dis­clo­sure, copy­ing, dis­sem­i­na­tion, or redis­tri­b­u­tion is strictly pro­hib­ited. This is a pre­sen­ta­tion of RA. Rus­sell Invest­ment Group is not respon­si­ble for the for­mat­ting or con­fig­u­ra­tion of this mate­r­ial or for any inac­cu­racy in RA’s pre­sen­ta­tion thereof.

The trade names Fun­da­men­tal Index®, RAFI®, the RAFI logo, and the Research Affil­i­ates® cor­po­rate name and logo are reg­is­tered trade­marks and are the exclu­sive intel­lec­tual prop­erty of RA. Any use of these trade names and logos with­out the prior writ­ten per­mis­sion of RA is expressly pro­hib­ited. RA reserves the right to take any and all nec­es­sary action to pre­serve all of its rights, title and inter­est in and to these marks. Fun­da­men­tal Index® con­cept, the non-capitalization method for cre­at­ing and weight­ing of an index of secu­ri­ties, is patented and patent-pending pro­pri­etary intel­lec­tual prop­erty of RA. (US Patent No. 7,620,577; 7,747,502; and 7,792,719; Patent Pend­ing Publ. Nos. US-2007–0055598-A1, US-2008–0288416-A1, US-2010–0191628, US-2010–0262563, WO 2005/076812, WO 2007/078399 A2, WO 2008/118372,EPN 1733352, and HK1099110).

The views and opin­ions expressed are those of the author and not nec­es­sar­ily those of Research Affil­i­ates, LLC. The opin­ions are sub­ject to change with­out notice.

Copy­right © Research Affil­i­ates

Tags: Annum, Best Selling Book, Bond Data, Capital Markets, Capital Structure, China, Currency, Emerging Markets, Excess Return, Government Bonds, Ibbotson Associates, Investment Bonds, Optimists, Research Affiliates, Robert Arnott, Russia, Shaky Foundation, Stock Investment, Stockholders, Term Bonds, Term Investing, Term Stock, Time Periods, Urban Legend
Posted in Markets | Comments Off

Commodities in Portfolio Construction (Lee)

Tuesday, March 29th, 2011

Com­modi­ties in Port­fo­lio Con­struc­tion

by Alfred Lee, CFA, DMS
Vice Pres­i­dent & Invest­ment Strate­gist
BMO ETFs & Global Struc­tured Invest­ments
BMO Asset Man­age­ment Inc.
alfred.lee[at]bmo.com

Monthly Strat­egy Report March 2011

Over the last decade, com­mod­ity and commodity-related invest­ments have gained sig­nif­i­cant pop­u­lar­ity with both insti­tu­tional and retail investors. Given their siz­able returns over the last ten years, his­tor­i­cal low cor­re­la­tion to tra­di­tional asset classes and emerg­ing mar­kets soak­ing up much of the sup­ply, it should not come as much of a sur­prise. Com­ing out of the credit cri­sis, major cen­tral banks around the globe, most notably the U.S. Fed­eral Reserve (Fed), were focused on reflat­ing the global economy.

The co-ordinated easy mon­e­tary poli­cies, gov­ern­ment stim­u­lus mea­sures along with quan­ti­ta­tive eas­ing were largely a pos­i­tive for broad com­modi­ties which tend to be used as a hedge against declin­ing cur­rency val­ues and par­tic­u­larly a falling U.S. dol­lar. Essen­tially, investors ben­e­fited from merely hav­ing expo­sure to a broad bas­ket of com­mod­ity and com­mod­ity related investments.

With global stim­u­lus and the sec­ond instal­ment of quan­ti­ta­tive easing1 (QE2) mov­ing fur­ther into the rear-view, the refla­tion trade should be less of a dri­ver in global com­mod­ity prices going for­ward, espe­cially con­sid­er­ing the Fed is antic­i­pated by some to remove QE2 stim­u­lus this sum­mer. Inde­pen­dent sup­ply and demand fun­da­men­tals as a result should play a more impor­tant role in dri­ving com­mod­ity prices going for­ward. In addi­tion, with polit­i­cal tur­moil in the Mid­dle East and now the unfor­tu­nate tsunami in Japan, these issues will have dif­fer­ent macro fac­tors on the vary­ing com­mod­ity sub-groups.

Com­mod­ity Differentiation

With that in mind, investors may want to con­sider com­mod­ity dif­fer­en­ti­a­tion at this point in their port­fo­lio con­struc­tion process. As global eco­nomic fun­da­men­tals slowly improve, cor­re­la­tion between assets and within assets such as com­modi­ties should nat­u­rally decrease (as detailed in the cor­re­la­tion matri­ces on the fol­low­ing page) in an eco­nomic thaw­ing process. More­over, as pre­vi­ously men­tioned, the neg­a­tive head­lines will have vary­ing impacts and ram­i­fi­ca­tions on each of the com­mod­ity groups. Investors should there­fore focus on com­modi­ties that have the best risk-adjusted returns and those which will fur­ther opti­mize their over­all portfolio.

As many investors are aware, the pro­lif­er­a­tion of exchange traded funds (ETFs) and exchange traded prod­ucts (ETPs)2 have allowed investors to effi­ciently imple­ment com­mod­ity expo­sure to their port­fo­lios in a num­ber of dif­fer­ent ways. Through ETFs and ETPs, investors can access com­mod­ity futures, com­mod­ity related com­pa­nies and in some cases, spot prices. Investors should how­ever first be cog­nisant that dif­fer­ent com­mod­ity sub-groups react dif­fer­ently to macro-economic events and each also has its own fun­da­men­tal and tech­ni­cal trad­ing pat­terns. Sec­ondly, how each ETF or ETP struc­ture reacts to these same macro-events can also be dif­fer­ent based on how it is access­ing the spe­cific under­ly­ing com­mod­ity (ie through spot, futures or equities).

For fur­ther infor­ma­tion on the advan­tages and dis­ad­van­tages of each com­mod­ity ETF/ETP struc­ture, please see the “Gain­ing Com­mod­ity Expo­sure Through ETFs” on our web­site. In the fol­low­ing pages, we will out­line our fun­da­men­tal and tech­ni­cal out­look on four major com­mod­ity sub­groups: agri­cul­ture, base met­als, energy and pre­cious metals.

• Agri­cul­ture. As we men­tioned at the begin­ning of the year in our BMO ETF 2011 Out­look Report, food price infla­tion will be a topic du jour this year, with global pop­u­la­tion antic­i­pated to hit seven bil­lion and the ris­ing wealth in the emerg­ing nations con­tin­u­ing to place upward pres­sure on soft com­mod­ity prices. Fur­ther­more, extreme weather pat­terns over the last year in Aus­tralia and Latin Amer­ica will lead to tighter sup­plies. Already this year, we have seen the
future con­tracts of a num­ber of soft com­modi­ties such as wheat hit its limit up3 in trading.

Now with a num­ber of agri­cul­ture com­mod­ity con­tracts such as wheat, corn and soy­beans cur­rently trad­ing in backwardation4 or in mild contango5, we pre­fer attain­ing soft-commodity expo­sure through futures based ETFs/ETPs. Some agri­cul­ture related com­pa­nies may expe­ri­ence expan­sion at the mid­dle por­tion of their income state­ments should they not be able to pass full grain cost appre­ci­a­tion to con­sumers. As a result, futures may pro­vide a more pure expo­sure to higher agri­cul­ture prices con­sid­er­ing the cur­rent char­ac­ter­is­tics of the com­mod­ity curve. We would cau­tion how­ever, that with the strong run up in many of the agri­cul­ture con­tracts, we would look at tech­ni­cal indi­ca­tors such as RSI6 and MACD7 for entry points.

Poten­tial Invest­ment Opportunities:

• BMO Agri­cul­ture Com­mod­ity Index ETF (ZCA)
– on pullbacks.

• Base met­als. Base met­als as a group saw very siz­able returns in 2009 with the S&P/GSCI Indus­trial Met­als Spot Index gain­ing 91.2%. As cop­per, zinc and nickel are largely tied to indus­trial pro­duc­tion, prices in these met­als are rather sen­si­tive to eco­nomic expan­sion. In addi­tion base metal prices are highly cor­re­lated to stock mar­ket sen­ti­ment, given equity val­ues on a whole are also a lead­ing macro-economic indi­ca­tor. In 2010, volatil­ity in equity mar­ket sen­ti­ment with
investors switch­ing fre­quently between the “risk-on” and “risk-off” trade, led base met­als as a group to lag other com­mod­ity groups. We are the least favourable on base met­als when look­ing for assets to best opti­mize a portfolio’s risk/return char­ac­ter­is­tics because of the high cor­re­la­tion between cop­per, zinc and other indus­trial met­als to equity prices.

More­over, as we see equity mar­ket volatil­ity shocks to be a com­mon theme this year, base metal future trades should be uti­lized more for higher-beta momen­tum trades based on tim­ing than port­fo­lio con­struc­tion build­ing blocks. For investors look­ing for base metal expo­sure, we do how­ever cur­rently favour futures based ETPs over equity-based ETFs as base-metal related com­pa­nies have run sig­nif­i­cantly against the S&P/GSCI Indus­trial Met­als Spot Index. The futures curve char­ac­ter­is­tics for base met­als are mixed with a num­ber of con­tracts recently mov­ing to a steeper back­war­da­tion. Nev­er­the­less, prod­ucts incor­po­rat­ing a “smart-roll” fea­ture that look to reduce roll effects should be con­sid­ered by those desir­ing expo­sure in this area.

Poten­tial Invest­ment Opportunities:

• BMO Base-Metals Com­mod­ity Index ETF (ZCA)
– for momen­tum based trades.

• Energy. Energy prices remain one of the wild­cards in the revival of the global econ­omy. Should Brent crude prices and, to a lesser extent, West Texas Inter­me­di­ate (WTI) defy grav­ity for a sus­tained period of time, it could poten­tially put the brakes on the global recov­ery as higher oil prices would increase every­thing from costs of pro­duc­tion inputs to trans­porta­tion. How­ever, much of the recent rise in crude prices is also a result of the mar­kets pric­ing in a risk pre­mium and an emo­tional ele­ment, seen through a widen­ing gap between implied and real­ized volatil­ity on crude.

Investors with an extremely short-term hori­zon may want to con­sider futures-based energy ETPs. Though we wouldn’t be sur­prised to see the price of Brent crude and WTI rise fur­ther, it comes at a higher risk/reward trade-off given the siz­able amount of emo­tion that is cur­rently priced into oil. Last month, when rumours that Libyan leader Muam­mar Gaddafi was shot broke out, the emo­tional pre­mium in oil prices quickly dis­si­pated before rapidly recov­er­ing after the news was declared
false. This demon­strated the exces­sive level of polit­i­cal pre­mium cur­rently built into crude prices. An invest­ment in crude through futures is there­fore an indi­rect bet that tur­moil in the Mid­dle East will con­tinue. Addi­tion­ally as we had fore­casted back in Jan­u­ary, higher crude prices would come at higher volatil­ity lev­els this year. As such, we believe oil related com­pa­nies have a bet­ter risk/reward trade-off at this point, even if they have lagged crude prices as they show a more sta­ble trend and have exhib­ited lower volatil­ity levels.

Poten­tial Invest­ment Opportunities:

• BMO Energy Com­mod­ity Index ETF (ZCE)
– Shorter-term investors

• BMO Junior Oil Index ETF (ZJO)
– Longer-term investors

• Pre­cious Met­als. Of the four com­mod­ity groups men­tioned, pre­cious met­als have shown to be the least cor­re­lated to broad based equi­ties. The non-correlation to both the S&P 500 Com­pos­ite Index and the S&P/TSX Com­pos­ite Index is largely the affect of the market’s uti­liza­tion of pre­cious met­als, such as gold, as a multi-purpose hedge. Last year, the sov­er­eign debt cri­sis and con­cerns of a global cur­rency war led to the use of pre­cious met­als as a hedge against fiat cur­ren­cies. This year, with food and com­mod­ity prices ris­ing, money is slowly tran­si­tion­ing out of the for­mer trade as an alter­na­tive cur­rency and into a hedge against infla­tion concerns.

On a tech­ni­cal level, gold prices have recently shown strength par­tic­u­larly against the equity mar­ket and base met­als. Within the pre­cious met­als sec­tor, small-cap gold com­pa­nies, which we were extremely bull­ish on through­out 2010, have recently been gain­ing rel­a­tive strength against large-cap gold com­pa­nies. Investors look­ing for port­fo­lio diver­si­fi­ca­tion may want to con­sider bul­lion or ETPs that track gold through bul­lion or futures, whereas investors look­ing for ways to gen­er­ate port­fo­lio alpha should con­sider junior gold companies.

Poten­tial Invest­ment Opportunities:

• BMO Pre­cious Met­als Com­mod­ity Index ETF (ZCP)
– Investors look­ing for port­fo­lio diversification

• BMO Junior Gold Index ETF (ZJO) – Investors look­ing
to gen­er­ate port­fo­lio alpha

In con­clu­sion, we believe com­mod­ity expo­sure will remain an instru­men­tal build­ing block for both insti­tu­tional and retail port­fo­lios. How­ever, with cor­re­la­tions between com­mod­ity sub-groups on the decline, investors should first con­sider the sub-group of com­modi­ties that will best opti­mize their invest­ment strat­egy and then deter­mine the invest­ment struc­ture that is best suited to exe­cute their objec­tives. With the pos­si­bil­ity of the removal of QE2 stim­u­lus by the Fed quickly approach­ing, investors will also need to con­sider indi­vid­ual sup­ply and demand fun­da­men­tals of each com­mod­ity since the refla­tion trade will be less preva­lent in keep­ing all com­modi­ties afloat.

Foot­notes

1 Quan­ti­ta­tive eas­ing: An uncon­ven­tional mon­e­tary pol­icy used by some cen­tral banks when tra­di­tional mea­sures have not pro­duced the desired effect. Money sup­ply is typ­i­cally increased in an effort to pro­mote increased lend­ing and liquidity.

2 Exchange-traded prod­ucts (ETPs): A broader cat­e­go­riza­tion of exchange-traded funds that also include prod­ucts that hold com­modi­ties, futures and other asset types.

3 Limit up: The max­i­mum amount by which the price of a com­mod­ity futures con­tract may advance in one trad­ing day. Some mar­kets close trad­ing of these con­tracts when the limit up is reached; whereas oth­ers allow trad­ing to resume if the price moves away from the day’s limit. If there is a major event affect­ing the market’s sen­ti­ment toward a par­tic­u­lar com­mod­ity, it may take sev­eral trad­ing days before the con­tract price fully reflects this change. On each trad­ing day, the trad­ing limit will be reached before the market’s equi­lib­rium con­tract price is met.

4 Back­war­da­tion: When the futures price is below the expected future spot price. Con­se­quently, the price will rise to the spot price before the deliv­ery date.

5 Con­tango: When the futures price is above the expected future spot price. Con­se­quently, the price will decline to the spot price before the deliv­ery date.

6 RSI: Rel­a­tive Strength Index is a tech­ni­cal momen­tum indi­ca­tor that com­pares the mag­ni­tude of recent gains to recent losses in an attempt to deter­mine over­bought and over­sold con­di­tions of an asset. A read­ing of 30 or less is gen­er­ally con­sid­ered over­sold, whereas a read­ing of 70 or more will be con­sid­ered overbought.

7 MACD: Mov­ing Aver­age Con­ver­gence Diver­gence: A trend-following momen­tum indi­ca­tor that shows the rela­tion­ship between two mov­ing aver­ages of prices. The MACD is cal­cu­lated by sub­tract­ing the 26-day expo­nen­tial mov­ing aver­age (EMA) from the 12-day EMA. A nine-day EMA of the MACD, called the “sig­nal line”, is then plot­ted on top of the MACD, func­tion­ing as a trig­ger for buy and sell signals.

For more infor­ma­tion on BMO ETFs, please visit our web­site bmo.com/etfs or con­tact your finan­cial advisor.

To be added to the dis­tri­b­u­tion list for our Monthly Strat­egy Report and Trade Oppor­tu­ni­ties Report, please visit our home­page at bmo.com/etfs to sub­scribe or email alfred.lee@bmo.com with title: “Add to dis­tri­b­u­tion list.”

Stan­dard & Poor’s®, S&P® and S&P GSCI® are reg­is­tered trade­marks of Stan­dard & Poor’s Finan­cial Ser­vices LLC (“S&P”) and have been licensed for use by BMO Asset Man­age­ment Inc. BMO Agri­cul­ture Com­mod­ity Index ETF, BMO Base Met­als Com­mod­ity Index ETF, BMO Energy Com­mod­ity Index ETF, BMO Pre­cious Met­als Com­mod­ity Index ETF are not spon­sored, endorsed, sold or pro­moted by S&P or its Affil­i­ates and S&P and its Affil­i­ates make no rep­re­sen­ta­tion, war­ranty or con­di­tion regard­ing the advis­abil­ity of buy­ing, sell­ing or hold­ing units of the ETFs.

Com­mis­sions, man­age­ment fees and expenses all may be asso­ci­ated with invest­ments in exchange traded funds. Please read the prospec­tus before invest­ing. The funds are not guar­an­teed, their val­ues change fre­quently and past per­for­mance may not be repeated.

This com­mu­ni­ca­tion is intended for infor­ma­tional pur­poses only and is not, and should not be con­strued as, invest­ment and/or tax advice to any indi­vid­ual. Par­tic­u­lar invest­ments and/or trad­ing strate­gies should be eval­u­ated rel­a­tive to each individual’s cir­cum­stances. Indi­vid­u­als should seek the advice of pro­fes­sion­als, as appro­pri­ate, regard­ing any par­tic­u­lar investment.

BMO ETFs are admin­is­tered and man­aged by BMO Asset Man­age­ment Inc., a port­fo­lio man­ager and a sep­a­rate legal entity from the Bank of Montréal.

® Reg­is­tered trade-marks of Bank of Montréal.

Tags: Alfred Lee, Asset Classes, Asset Management Inc, BMO, BMO ETFs, Central Banks, Commodities, Commodity Prices, Correlation Matrices, Credit Crisis, Currency, Currency Values, Economic Fundamentals, Emerging Markets, energy, ETF, ETFs, Global Commodity, Global Economy, Gold, Instalment, Investment Strategist, Last Decade, Last Ten Years, Macro Factors, Monetary Policies, oil, Political Turmoil, Portfolio Construction, Rear View, Retail Investors, Strategy Report, Structured Investments, Tsunami In Japan
Posted in Commodities, Credit Markets, Energy & Natural Resources, ETFs, Gold, Markets, Oil and Gas, Outlook | Comments Off

Equities on the Rise Despite Geopolitical Risks

Tuesday, March 29th, 2011

by Bob Doll, Chief Equity Strate­gist, Fun­da­men­tal Equi­ties, Black­Rock

Risk assets (and equi­ties in par­tic­u­lar) pow­ered to a strong week of gains, with the Dow Jones Indus­trial Aver­age climb­ing 3.1% to 12,221, the S&P 500 Index advanc­ing 2.7% to 1,314 and the Nas­daq Com­pos­ite ris­ing 3.8% to 2,743. Although a num­ber of near-term risks remain (par­tic­u­larly related to the unpre­dictabil­ity of esca­lat­ing unrest in the Mid­dle East), we main­tain our view that equity mar­kets are likely to con­tinue their long-term trend of outperformance.

Before the earth­quake in Japan and the widen­ing tur­moil in the Mid­dle East and North Africa that occurred sev­eral weeks ago, eco­nomic growth in both the United States and the world was accel­er­at­ing. We were see­ing improve­ments in unem­ploy­ment claims, man­u­fac­tur­ing data, cap­i­tal expen­di­tures as well as in other lead­ing indi­ca­tors. It seemed as if the United States was in the process of tran­si­tion­ing to a self-sustaining expan­sion (although the hous­ing mar­ket has remained stub­bornly weak). The labor mar­ket as a whole still required some heal­ing, but even that area of the econ­omy was show­ing signs of improve­ment. Now the ques­tion many investors are ask­ing is whether the events of the last few weeks will inter­rupt this transition.

The sit­u­a­tion in Japan appears to be mod­er­at­ing, although the long-term impacts of the earth­quake and result­ing nuclear risks remain unknown. From our per­spec­tive, the esca­lat­ing tur­moil in the Mid­dle East rep­re­sents a more seri­ous risk. The grow­ing rebel­lion in Libya and the imple­men­ta­tion of the no-fly zone have been gen­er­at­ing the most head­lines, but as we have been say­ing in recent com­men­taries, we are focus­ing our atten­tion on Saudi Ara­bia. The move­ment of Saudi mil­i­tary forces into Bahrain cer­tainly rep­re­sents a new dynamic and widen­ing of the geopo­lit­i­cal risks in the broader region, but as of now, unrest in Saudi Ara­bia itself remains contained.

Given Saudi Arabia’s promi­nence in the global oil trade, polit­i­cal unrest in the coun­try would have the poten­tial to trig­ger an addi­tional major spike in oil prices. Oil prices have already jumped higher over the past sev­eral weeks and appear to have a risk pre­mium of some­where around $20 a bar­rel already built into the cur­rent price. A major dis­rup­tion in actual sup­plies in Saudi Ara­bia (or else­where) could push oil prices back to their record lev­els of around $150 a bar­rel. If oil prices reached that level and remained there for some time, it would cer­tainly rep­re­sent a seri­ous threat to global eco­nomic growth, but this is a hypo­thet­i­cal sit­u­a­tion that we believe is unlikely to play out. Given this back­drop, our answer to the ques­tion raised above is no, the short-term risks are unlikely to derail the eco­nomic recov­ery. Mon­e­tary and fis­cal sup­port remains con­ducive to stronger growth lev­els, and despite con­cerns to the con­trary, we are not expect­ing infla­tion risks to rise at any point soon.

With last week’s rally, and the ben­e­fit of hind­sight, it looks to us like the recent sell­off was more a mat­ter of risk aver­sion, hedg­ing and posi­tion cov­er­ing than it was an actual shift in broader investor sen­ti­ment from bull­ish to bear­ish. From the intra­day peak to trough, stocks fell around 7% (with the S&P 500 hit­ting a low of 1,250) and have since recov­ered 5% of their value. We would cau­tion that this rebound may be tem­po­rary, that the cor­rec­tive period may not yet be over and that future gains may be more uneven than they were toward the end of last year and early in 2011. Nev­er­the­less, we con­tinue to believe that stocks (and US stocks in par­tic­u­lar) should remain a pre­ferred asset class.

Bob Doll is Chief Equity Strate­gist for Fun­da­men­tal Equi­ties at Black­Rock^® a pre­mier provider of global invest­ment man­age­ment, risk man­age­ment and advi­sory ser­vices. Mr. Doll is also Lead Port­fo­lio Man­ager of BlackRock's Large Cap Series Funds. Prior to join­ing the firm, Mr. Doll was Pres­i­dent and Chief Invest­ment Offi­cer at Mer­rill Lynch Invest­ment Managers.

Sources: Black­Rock; Bank Credit Ana­lyst. This mate­r­ial is not intended to be relied upon as a fore­cast, research or invest­ment advice, and is not a rec­om­men­da­tion, offer or solic­i­ta­tion to buy or sell any secu­ri­ties or to adopt any invest­ment strat­egy. The opin­ions expressed are as of March 28, 2011, and may change as sub­se­quent con­di­tions vary. The infor­ma­tion and opin­ions con­tained in this mate­r­ial are derived from pro­pri­etary and non­pro­pri­etary sources deemed by Black­Rock to be reli­able, are not nec­es­sar­ily all-inclusive and are not guar­an­teed as to accu­racy. Past per­for­mance is no guar­an­tee of future results. There is no guar­an­tee that any fore­casts made will come to pass. Reliance upon infor­ma­tion in this mate­r­ial is at the sole dis­cre­tion of the reader. Invest­ment involves risks. Inter­na­tional invest­ing involves addi­tional risks, includ­ing risks related to for­eign cur­rency, lim­ited liq­uid­ity, less gov­ern­ment reg­u­la­tion and the pos­si­bil­ity of sub­stan­tial volatil­ity due to adverse polit­i­cal, eco­nomic or other devel­op­ments. The two main risks related to fixed income invest­ing are inter­est rate risk and credit risk. Typ­i­cally, when inter­est rates rise, there is a cor­re­spond­ing decline in the mar­ket value of bonds. Credit risk refers to the pos­si­bil­ity that the issuer of the bond will not be able to make prin­ci­pal and inter­est pay­ments. Index per­for­mance is shown for illus­tra­tive pur­poses only. You can­not invest directly in an index.

Copy­right © Black­Rock

Tags: Bob Doll, Capital Expenditures, Currency, Dow Jones, Dow Jones Industrial, Dow Jones Industrial Average, Earthquake In Japan, Fly Zone, Housing Market, Leading Indicators, Military Forces, Nasdaq Composite, North Africa, Nuclear Risks, oil, Outperformance, Saudi Arabia, Strategist, Term Trend, Transitioning, Unemployment Claims, Unpredictability
Posted in Credit Markets, Energy & Natural Resources, Markets, Oil and Gas | Comments Off

Teflon Market (Andrews)

Monday, March 28th, 2011

Teflon Mar­ket

by David Andrews, CFA, Direc­tor, Invest­ment Man­age­ment and Research, Richard­son GMP

Many the­o­ries are mak­ing the rounds about why the stock mar­ket con­tin­ues to march higher in the face of nat­ural dis­as­ters, a nuclear cri­sis and gov­ern­ment col­lapses. The relent­less advance by stocks con­tin­ues as global stocks gained for a sev­enth day, the longest rally for the MSCI World Index since September.

In Canada, the big news was that the oppo­si­tion top­pled Prime Min­is­ter Stephen Harper’s gov­ern­ment, trig­ger­ing an elec­tion that may result in an alliance to reverse his cor­po­rate tax cuts and over­turn plans for more mil­i­tary spend­ing. Oppo­si­tion mem­bers from the Lib­er­als, New Democ­rats and Bloc Québé­cois passed a motion of no con­fi­dence in the house, which under Cana­dian par­lia­men­tary tra­di­tion leads to the legislature’s dis­so­lu­tion. The motion was passed by a vote of 156–145. Our dol­lar fell 0.6 per­cent to 98.12 cents per U.S. dol­lar, the biggest intra­day drop since March 16.

Sov­er­eign debt con­cerns returned to the fold this week with Portugal’s par­lia­ment reject­ing pro­posed bud­get cuts that ulti­mately led to Prime Min­is­ter Jose Socrates’ res­ig­na­tion. Fitch rat­ings announced a cut in Portugal’s long-term for­eign and local credit rat­ings to ‘A-’ from ‘A+ The extra yield investors demand to hold 10-year Por­tuguese bonds over bench­mark Ger­man bunds rose the most in four months. Bonds pared declines after two Euro­pean offi­cials with direct knowl­edge of the mat­ter said a bailout for Por­tu­gal may total as much as 70 bil­lion euros ($99 bil­lion). Gold ini­tially surged to a high of $1447 before set­tling back to the $1430 level as both the Euro and the U.S. dol­lar slipped this week.

Protests in the Mid­dle East & North Africa both inten­si­fied and widened as Libya’s Muam­mar Qaddafi remains defi­ant despite NATO-led air strikes enforc­ing the no-fly zone. In addi­tion, protests spread into Syria and were met with stiff police and mil­i­tary inter­ven­tion. Oil prices swung between gains and losses this week, end­ing lower as crude failed to breach tech­ni­cal resis­tance at its 30-month high and on con­cern that the Euro­pean debt sit­u­a­tion and the cri­sis in Japan will curb future fuel demand.

The Road Back to Surplus?

Cana­di­ans will be return­ing to the polls with Tuesday’s Bud­get defeated in a non-confidence vote. In that Bud­get, pro­jec­tions were made for our national bud­get to return to a sur­plus posi­tion
by fis­cal 2015. Prior to our sur­pluses of the past decade and in the 1990s, do you remem­ber when Canada posted its last sur­plus? If you guessed 1969 you’d be cor­rect when our total fed­eral debt stood at $19.2 bil­lion. The debt reached its peak in 1996 when it totaled $562.8 bil­lion and then fell to $457.6 bil­lion in 2007. At the end of fis­cal 2009-10, the fed­eral debt was esti­mated to be $519.1 bil­lion. The grow­ing debt is a result of the stim­u­lus spend­ing and bor­row­ing that was required after the finan­cial cri­sis of 2008.

The Trad­ing Week Ahead

U.S. eco­nomic data will likely steal investors’ atten­tion away from the ongo­ing geopo­lit­i­cal and nat­ural dis­as­ter sto­ries of the past sev­eral weeks. The first day of April falls this Fri­day,
which means the U.S. non­farm pay­rolls and employ­ment data for March will be released. The antic­i­pa­tion will begin to build on Wednes­day with the ADP Employ­ment report. ADP is expected to show a healthy num­ber north of 200,000 in March. Despite a mod­est decline from the Feb­ru­ary, the U.S. labour mar­ket is indeed recov­er­ing. ISM man­u­fac­tur­ing data should con­firm that U.S. fac­tory
pro­duc­tion is boom­ing and give sup­port to equity mar­kets. Stock mar­ket investors should not fear the eco­nomic fall­out from the Japan­ese dis­as­ter or the Mid­dle East con­flict. In Feb­ru­ary, the ISM reached its high­est read­ing (61.4) since 1984. Read­ings north of 50 point to expansion.

First quar­ter Earn­ings Sea­son begins April 11th and with no dis­re­spect to the hand­ful report­ing this week, none of them will be mar­ket mov­ing.

QUESTION OF THE WEEK
Q: Tues­day was bud­get day in Canada where the Con­ser­v­a­tives pro­jected a return to fed­eral fis­cal sur­plus by 2015. By that time, Canada will have its largest national debt ever in absolute terms. How do our pub­lic debt lev­els look rel­a­tive to our econ­omy (GDP) and how do we stack up against other coun­tries in the world?

A: Accord­ing to the World Fact book, based on 2010 fig­ures, Canada’s debt to GDP is 34%, which is much smaller than it was dur­ing the deficits of the early 1990s. While we posted our high­est deficit in his­tory last year, our debt lev­els are smaller today (when com­pared to the size of the entire econ­omy) than they were 20 years ago. Below are the debt to GDP ratios of Canada and other coun­tries you may find inter­est­ing. Believe it or not the low­est debt to GDP fig­ure amongst the 128 coun­tries is Libya at 3.3%. Canada ranks bet­ter than aver­age giv­ing it much more finan­cial flex­i­bil­ity than other more heav­ily indebted nations. The debt fig­ures used in the cal­cu­la­tion reflect the cumu­la­tive total of all gov­ern­ment bor­row­ings less repay­ments that are denom­i­nated in a country's home cur­rency. Pub­lic debt should not be con­fused with exter­nal debt, which reflects the for­eign cur­rency lia­bil­i­ties of both the pri­vate and pub­lic sector.

The opin­ions expressed in this report are the opin­ions of the author and read­ers should not assume they reflect the opin­ions or rec­om­men­da­tions of Richard­son GMP Lim­ited or its affil­i­ates. Assump­tions, opin­ions and esti­mates con­sti­tute the author’s judg­ment as of the date of this mate­r­ial and are sub­ject to change with­out notice. We do not war­rant the com­plete­ness or accu­racy of this mate­r­ial, and it should not be relied upon as such. Before act­ing on any rec­om­men­da­tion, you should con­sider whether it is suit­able for your par­tic­u­lar cir­cum­stances and, if nec­es­sary, seek pro­fes­sional advice. Past per­for­mance is not indica­tive of future results.

Richard­son GMP Lim­ited is a mem­ber of Cana­dian Investor Pro­tec­tion Fund. Richard­son is a trade-mark of James Richard­son & Sons, Lim­ited. GMP is a reg­is­tered trade-mark of GMP Secu­ri­ties L.P. Both used under license by Richard­son GMP Limited.

Copy­right © Richard­son GMP

Tags: Air Strikes, Bloc Quebecois, Bunds, Canadian, Canadian Market, Currency, European Officials, Fitch Ratings, Fly Zone, Global Stocks, Gold, Military Spending, Motion Of No Confidence, Msci World Index, Muammar Qaddafi, Natural Disasters, New Democrats, Nuclear Crisis, oil, Opposition Members, Parliamentary Tradition, Prime Minister Stephen Harper, Relentless Advance, Sovereign Debt, Stephen Harper
Posted in Canadian Market, Credit Markets, Energy & Natural Resources, Gold, Markets, Oil and Gas | Comments Off

Gold Market Cheat Sheet (March 28, 2011)

Sunday, March 27th, 2011

Gold Mar­ket Cheat Sheet (March 28, 2011)

For the week, spot gold closed at $1,429.75, up $10.84 per ounce, or 0.76 per­cent for the week. Gold equi­ties, as mea­sured by the Philadel­phia Gold & Sil­ver Index, rose 5.07 per­cent. The U.S. Trade-Weighted Dol­lar Index moved slightly higher, up 0.62 per­cent for the week.

Strengths

• The gold price rose to a record $1,447 per ounce, as unrest in Libya and the Mid­dle East and Portugal’s pos­si­ble $100 bil­lion bailout spurred demand for the pre­cious metal.
• Last week, the Utah leg­is­la­ture passed a bill allow­ing gold and sil­ver coins to be used as legal ten­der in the state, accord­ing to the true value of the metal in the coins and not by the face value stated on the coin. Sim­i­lar pro­pos­als have been devel­oped in Col­orado, Geor­gia, Indi­ana, Iowa, Mis­souri, Mon­tana, New Hamp­shire, Okla­homa, South Car­olina, Ten­nessee, Ver­mont, and Washington.
• In India, stan­dard 24-carat gold coins have been sell­ing extremely well at more than 466 post offices through­out the coun­try. Despite the high price, Indian con­sumers have been buy­ing small quan­ti­ties of coins to give dur­ing the fes­ti­val season.

Weak­nesses

• The Asso­ci­a­tion of Min­ing & Explo­ration Com­pa­nies (AMEC) reit­er­ated its oppo­si­tion of Australia’s Min­er­als Resource Rent Tax. AMEC’s chief exec­u­tive said it was extremely dis­ap­point­ing that con­cerns of mem­ber com­pa­nies have not been con­sid­ered by the fed­eral gov­ern­ment. “Sug­ges­tions by Trea­surer Swan that the indus­try has agreed with the Min­er­als Resource Rent Tax are incor­rect, as agree­ment was only reached with three large multi-national multi-commodity con­glom­er­ates and not other junior-tiered min­ing com­pa­nies that will be affected by this addi­tional tax.”
• The Las Vegas Review-Journal reported that Assem­bly­woman Peggy Pierce will intro­duce a bill that will cap the value of legally deductible expenses at 40 per­cent, which could cost the state’s min­ing indus­try more than $2 bil­lion in tax deductions.
• Nevada State Sen­ate Major­ity Leader Steve Hors­ford asked the Nevada Tax Com­mis­sion to embark on an emer­gency rule-making pro­ceed­ing that he hopes will fix the “incon­sis­ten­cies” and “loop­holes” that exist in Nevada’s net pro­ceeds of mines tax law. Rather than chang­ing Nevada’s Con­sti­tu­tion or remov­ing the cap on net pro­ceeds tax lim­its, Hors­ford seeks amend­ments to cur­rent allow­able deduc­tions for oper­at­ing costs, salaries, employee recruit­ment costs, mar­ket­ing, and con­vert­ing min­er­als into money. The Nevada law­maker would also elim­i­nate deduc­tions for con­sult­ing ser­vices, and, iron­i­cally, mine recla­ma­tion costs, which Hors­ford says should not be deducted because Nevada tax law did not pro­vide for mine recla­ma­tion deductions.

Oppor­tu­ni­ties

• Texas Rep­re­sen­ta­tive Ron Paul has sched­uled an April 1 hear­ing of the U.S. House Sub­com­mit­tee on Domes­tic Mon­e­tary Pol­icy to exam­ine the bul­lion pro­grams at the U.S. Mint. Last week Paul intro­duced H.R. 1098, the Free Com­pe­ti­tion in Cur­rency Act of 2011 that would repeal legal ten­der laws in order to pro­hibit tax­a­tion on gold, sil­ver, plat­inum, pal­la­dium and rhodium bul­lion. The Coin Mod­ern­iza­tion, Over­sight and Con­ti­nu­ity Act of 2010 gives the U.S. Mint greater flex­i­bil­ity in meet­ing the demand for bul­lion coins as well as meet­ing the demand for gold and sil­ver which Paul’s bill would change.
• Gold­man Sachs said it fore­cast gold prices ral­ly­ing to a record $1,480 an ounce in three months on declin­ing U.S. real inter­est rates. The bank said it still expects gold prices to reach a peak in 2012 as U.S. inter­est rates are set to rise as the econ­omy con­tin­ues to recover. Gold­man has a six-month gold view at $1,565 an ounce, and a 12-month fore­cast of $1,690 an ounce.
• In a bub­ble, mar­ket play­ers seek to sup­ply the mar­ket with as much as they can pos­si­bly sell at inflated prices. The price of gold has quadru­pled in the past ten years and the gold indus­try strug­gles to sus­tain new mine pro­duc­tion of bul­lion at the same level it was in 2001.

Threats

• Even as gold min­ers report stronger cash flows and good prof­its, costs are increas­ingly becom­ing an area of con­cern and some worry about the impact costs will have on cap­i­tal expen­di­ture. Min­ers are wor­ried that cap­i­tal spend­ing on new projects will become unman­age­able as labor, steel and energy costs keep push­ing higher.
• On top of that, gold min­ers have suf­fered as the Cana­dian dol­lar, Aus­tralian dol­lar, Chilean peso and Mex­i­can peso strength­ened against the U.S. dol­lar (sales of most min­ers are typ­i­cally denom­i­nated in U.S. dol­lars, while costs are often based in local “com­mod­ity” currencies).
• Min­ing exec­u­tives at the Reuters Global Min­ing and Steel Sum­mit noted that coun­tries threat­en­ing to seize a big­ger share of min­ing returns risk alien­at­ing investors and adding another layer of expense to an already increas­ing cost line.

Tags: 24 Carat Gold, Canadian, Canadian Market, Currency, Deductible Expenses, Dollar Index, energy, Exploration Companies, Georgia Indiana, Gold, Gold And Silver, Gold Coins, Gold Equities, Gold Market, Gold Price, India, Indian Consumers, Las Vegas Review Journal, Legal Tender, Philadelphia Gold, Silver, Silver Coins, Silver Index, Small Quantities, Spot Gold, Utah Legislature, Vegas Review Journal
Posted in Canadian Market, Gold, India, Markets, Silver | Comments Off

As The World Turns (Brown)

Wednesday, March 23rd, 2011

As The World Turns

by Scott Brown, Ph.D., Chief Econ­o­mist, Ray­mond James

March 21 – March 25, 2011

Japan’s earthquake/tsunami/nuclear tragedy and height­ened ten­sions in the Mid­dle East and North Africa have led to some con­cerns about the global econ­omy, and in turn, the strength of the U.S. recov­ery. A weaker Japan­ese econ­omy and supply-chain dis­rup­tions are detri­men­tal to U.S. growth, but mod­er­ately and only short-term in nature. Devel­op­ments in the Mid­dle East and North Africa are more uncer­tain, but are likely to keep oil prices rel­a­tively ele­vated. None of this is expected to jeop­ar­dize the U.S. recov­ery, but it could keep growth from being as strong as was hoped for just a month ago.

Assess­ments of the dam­age from Japan’s earth­quake and tsunami will become clearer over time, although the sit­u­a­tion at dam­aged nuclear reac­tors is more uncer­tain. The dis­as­ter is a major set­back for Japan’s econ­omy, but nat­ural dis­as­ters are typ­i­cally fol­lowed by a period of rebuild­ing, which is pos­i­tive for growth. More imme­di­ately, trade and supply-chain dis­rup­tion will rip­ple around the world, although the impact on aggre­gate global growth is likely to be small. Before the quake, Japan was viewed to have a rel­a­tively high degree of excess capac­ity. In the weeks ahead, we can expect to see other parts of Japan mak­ing up a large part of the out­put lost in the dam­aged region.

Prob­lems with the nuclear reac­tors may com­pound Japan’s recov­ery. Rolling black­outs, for exam­ple, could lead to supply-chain prob­lems more broadly. It may also shift sen­ti­ment about nuclear power in other coun­tries, adding some­what to the price of oil over the long term (due to a rel­a­tive increase in demand).

Is there a dan­ger that Japan will dump its hold­ings of U.S. Trea­suries to fund recon­struc­tion? Not likely. Japan has a huge ratio of pub­lic debt to GDP, but also a very high pri­vate sav­ings rate. The coun­try should have no prob­lem fund­ing its rebuild­ing efforts. In the short-term, repa­tri­a­tion fears are a sig­nif­i­cant issue for the cur­rency and fixed income mar­kets. We nor­mally see some cap­i­tal com­ing back to Japan at the end of every quar­ter, and espe­cially at the fis­cal year-end (which is March), as a kind of “window-dressing” for cor­po­rate prof­its. Japan­ese firms will typ­i­cally sell Trea­sury bills, repa­tri­ate the cap­i­tal, then buy Trea­sury bills again at the start of the next quar­ter. The recent dis­as­ter means that this repa­tri­a­tion will likely be both larger and ear­lier than usual. The result is a short-term boost in the yen. A rally in the yen would not be help­ful for Japan­ese exports. On Fri­day, G7 finance min­is­ters and cen­tral bankers agreed to a coör­di­nated inter­ven­tion to halt the yen’s rise. Still, while any large-scale sell­ing of U.S. notes and bonds is unlikely, there may be less Japan­ese demand at future U.S. Trea­sury auc­tions. The first big test will come next week, with the monthly auc­tion of 2-, 5-, and 7-year Trea­sury notes.

Mean­while, back in the Mid­dle East and North Africa, ten­sions con­tin­ued to sim­mer last week. As Col. Muam­mar el-Qaddafi appeared to gain the upper hand, the U.N. Secu­rity Coun­cil approved the cre­ation of a no-fly zone in Libya. The Wall Street Jour­nal reported that Egypt’s mil­i­tary was ship­ping arms to the oppo­si­tion in Libya. With a pend­ing threat of airstrikes by the west­ern coun­tries, Qaddafi report­edly called for a cease-fire. Protests con­tin­ued in Yemen and Bahrain, as both coun­tries declared states of emer­gency. Oil prices fell fol­low­ing Japan’s earth­quake and tsunami, largely on expec­ta­tions of weaker demand in the short-term (although longer-term oil con­tracts also declined). How­ever, oil prices rebounded as atten­tion turned back to the Mid­dle East (up on the UN Secu­rity Coun­cil deci­sion and down a bit on news of a pos­si­ble cease-fire).

The U.S. eco­nomic out­look depends crit­i­cally on the price of oil. If the recent surge in oil prices sticks, esti­mates of real GDP growth for this year would be shaved lower by 0.5% or more. A lit­tle over a month ago, the con­sen­sus view was that real GDP would grow 3.5% to 4.0% this year (4Q11-over-4Q10) – good, but not enough to gen­er­ate sub­stan­tial improve­ment in the job mar­ket. Now we’re talk­ing about GDP growth in the 2.5% to 3.5% range – per­fectly accept­able if the econ­omy were at full employ­ment, but it’s not. If oil prices con­tinue to rise, the out­look for U.S. growth would be damp­ened fur­ther, but it would likely take a much larger increase in the price of oil ($135 or more) to cause a reces­sion. If oil prices were to fall back to the $80-$90 range, the growth out­look would improve dramatically.

Last week, the Fed acknowl­edged that high prices of oil and other com­modi­ties will put upward pres­sure on con­sumer price infla­tion in the near term. How­ever, the Fed expects the impact to be tran­si­tory. The key will be what hap­pens to the under­ly­ing trends in infla­tion and infla­tion expec­ta­tions. Some increase in core infla­tion (rel­a­tive to last year) is wel­come, but it doesn’t look like the trend will get out of hand.

Copy­right © Ray­mond James

Tags: Chief Economist, Commodities, Currency, Disruptions, Excess Capacity, Global Economy, Global Growth, Japanese Economy, Natural Disasters, North Africa, Nuclear Reactors, Nuclear Tragedy, oil, Oil Prices, Price Of Oil, Private Savings, Public Debt, Raymond James, Relative Increase, Repatriation, Ripple, Rolling Blackouts, Treasuries
Posted in Commodities, Energy & Natural Resources, Markets, Oil and Gas, Outlook | Comments Off

The Risk in Carry Trades

Wednesday, March 23rd, 2011

by Lukas Menkhoff , Lucio Sarno , Maik Schmel­ing , and Andreas Schrimpf, via VoxEU.org

The carry trade – bor­row­ing in cur­ren­cies with low inter­est rates and invest­ing in cur­ren­cies with high inter­est rates – has been a sur­pris­ing hit for decades. This col­umn pro­vides empir­i­cal evi­dence sug­gest­ing that the mys­te­ri­ously high returns this gen­er­ates can actu­ally be explained as com­pen­sa­tion for the volatil­ity risk undertaken.

The “carry trade” is the most pop­u­lar trad­ing strat­egy in cur­rency mar­kets. Traders bor­row in cur­ren­cies with low inter­est rates (neg­a­tive for­ward pre­mium) and invest in cur­ren­cies with high inter­est rates (pos­i­tive for­ward pre­mium), prof­it­ing from the mar­gin. Yet accord­ing to the uncov­ered inter­est par­ity this strat­egy should not work. If investors are both ratio­nal and risk-neutral, then exchange-rate changes will elim­i­nate any gain aris­ing from the dif­fer­en­tial in inter­est rates across coun­tries. It is well doc­u­mented, how­ever, that exchange-rate changes do not com­pen­sate for the interest-rate dif­fer­en­tial. If any­thing, the oppo­site holds true empir­i­cally – high-interest-rate cur­ren­cies tend to appre­ci­ate while low-interest-rate cur­ren­cies tend to depre­ci­ate. As a con­se­quence, carry trades form a prof­itable invest­ment strat­egy, vio­late the uncov­ered inter­est par­ity and give rise to the “for­ward pre­mium puz­zle” (Fama 1984).

Con­sid­er­ing the very liq­uid foreign-exchange mar­kets, the dis­man­tling of bar­ri­ers to cap­i­tal flows between coun­tries, and the exis­tence of inter­na­tional cur­rency spec­u­la­tion dur­ing this period, it is dif­fi­cult to under­stand why carry trades have been prof­itable for such a long time. A sim­ple and the­o­ret­i­cally con­vinc­ing solu­tion for this puz­zle is the con­sid­er­a­tion of time-varying risk pre­mia. If invest­ments in cur­ren­cies with high inter­est rates deliver low returns dur­ing “bad times”, then carry trade prof­its are merely a com­pen­sa­tion for higher risk-exposure by investors. How­ever, the empir­i­cal lit­er­a­ture has seri­ous prob­lems to con­vinc­ingly iden­tify risk fac­tors that drive these pre­mia until today.

What is the risk in carry trades?

In a recent paper we sug­gest a res­o­lu­tion (Menkhoff et al. 2011). We start by sort­ing cur­ren­cies into port­fo­lios accord­ing to their for­ward pre­mium (or, equiv­a­lently, their rel­a­tive interest-rate dif­fer­en­tial ver­sus US money mar­ket inter­est rates) at the end of each month, as first pro­posed in aca­d­e­mic research by Lustig and Verdel­han (2007). We form five such port­fo­lios. Invest­ing in the high­est rel­a­tive interest-rate quin­tile, i.e. port­fo­lio 5, and short­ing the low­est rel­a­tive interest-rate quin­tile, i.e. port­fo­lio 1, there­fore results in a carry-trade port­fo­lio. This carry trade leads to large and sig­nif­i­cant aver­age excess returns of more than 5% even after account­ing for trans­ac­tion costs and the recent mar­ket tur­moil. These returns can­not be explained by stan­dard mea­sures of risk (e.g. Burn­side et al. 2011) and seem to offer a free lunch to investors.

We argue that these high returns to cur­rency carry trades can indeed be under­stood as a com­pen­sa­tion for risk. Finance the­ory pre­dicts that investors are con­cerned about vari­ables affect­ing the evo­lu­tion of the invest­ment oppor­tu­ni­ties and wish to hedge against unex­pected changes (inno­va­tions) in mar­ket volatil­ity, lead­ing risk-averse agents to demand cur­ren­cies that can hedge against this risk. We test whether the sen­si­tiv­ity of excess returns to global foreign-exchange volatil­ity risk can ratio­nalise the returns to cur­rency port­fo­lios in a stan­dard asset-pricing frame­work. We find that high-interest-rate cur­ren­cies are neg­a­tively related to inno­va­tions in global foreign-exchange volatil­ity and thus deliver low returns in times of unex­pect­edly high volatil­ity, when low inter­est rate cur­ren­cies pro­vide a hedge by yield­ing pos­i­tive returns.

To prove this point, we carry out the empir­i­cal analy­sis using data for spot exchange rates and 1-month for­ward exchange rates ver­sus the dol­lar over the sam­ple period from Novem­ber 1983 to August 2009, obtained from BBI and Reuters (via Datas­tream). The total sam­ple con­sists of 48 coun­tries, but we also study a smaller sub-sample con­sist­ing of only 15 devel­oped coun­tries with a longer data history.

From these data, we con­struct carry-trade port­fo­lios and exam­ine their excess returns. We also con­struct a proxy for global foreign-exchange volatil­ity, which is sim­ply the cross-sectional stan­dard devi­a­tion of volatil­ity across all cur­ren­cies in the port­fo­lio, cal­cu­lated month by month from daily data. Fig­ure 1 shows cumu­la­tive returns for the carry-trade port­fo­lio for all coun­tries and for the smaller sam­ple of devel­oped coun­tries. Shaded areas cor­re­spond to NBER-defined reces­sions. Inter­est­ingly, carry trades among devel­oped coun­tries were more prof­itable in the 80s and 90s; only in the last part of the sam­ple did the inclu­sion of emerg­ing mar­kets' cur­ren­cies improve returns to the carry trade. Also, the two reces­sions in the early 90s and 2000s did not have any sig­nif­i­cant influ­ence on returns. It is only in the last reces­sion — that also saw a mas­sive finan­cial cri­sis — that carry-trade returns show some sen­si­tiv­ity to macro­eco­nomic con­di­tions. By and large, most of the major spikes in carry-trade returns (e.g. in 1986, 1992, 1997/1998, 2006) seem rather unre­lated to the US busi­ness cycle. The graph also shows our proxy for global foreign-exchange volatil­ity and its inno­va­tions, which appears to pick up obvi­ous times of tur­moil, includ­ing the recent finan­cial crisis.

Fig­ure 1. Cumu­la­tive carry trade returns

Fig­ure 2 pro­vides a graph­i­cal analy­sis to illus­trate our point (we carry out exten­sive tests to estab­lish our results in our paper). We visu­alise the rela­tion­ship between global foreign-exchange volatil­ity risk and cur­rency excess returns. To do so, we divide the sam­ple into four sub-samples depend­ing on the value of global foreign-exchange volatil­ity inno­va­tions. The first sub-sample con­tains the 25% months with the low­est real­i­sa­tions of foreign-exchange volatil­ity risk and the fourth sub-sample con­tains the 25% months with the high­est real­i­sa­tions. We then cal­cu­late aver­age excess returns for these sub-samples for the return dif­fer­ence between port­fo­lio 5 and 1. Results are shown in Fig­ure 2 for the sam­ple of all coun­tries and for the smaller sam­ple of 15 devel­oped countries.

Fig­ure 2. Dis­tri­b­u­tion of global foreign-exchange volatility

All Coun­tries

Devel­oped countries

Bars show the annu­alised mean returns of the carry-trade port­fo­lio. As can be seen from the fig­ure, high-interest-rate cur­ren­cies clearly yield higher excess returns when volatil­ity risk is low and vice versa. Aver­age excess returns for the long-short port­fo­lios decrease monot­o­n­i­cally when mov­ing from the low to the high-volatility states for the sam­ple of devel­oped coun­tries, and almost monot­o­n­i­cally for the full sam­ple of coun­tries. While this analy­sis is inten­tion­ally sim­ple, it intu­itively demon­strates a clear rela­tion­ship between global foreign-exchange volatil­ity inno­va­tions and returns to carry-trade portfolios.

How well does this risk explain the returns to carry trades?

The answer is: sur­pris­ingly well. In fact, we can explain over 95% of the vari­a­tion in the cross-section of our sorted port­fo­lios. This point can be seen visu­ally in Fig­ure 3, which shows the mean excess returns from the five port­fo­lios (the actual data) and the cor­re­spond­ing mean excess returns pre­dicted by the asset pric­ing model based on our global volatil­ity risk vari­able. Essen­tially, we obtain almost a 45 degree line, indi­cat­ing that the volatility-risk proxy cap­tures almost fully the vari­a­tion in port­fo­lio returns.

Fig­ure 3. Realised mean excess returns

All coun­tries

Devel­oped countries

Con­clu­sion

We pro­pose a mea­sure of global foreign-exchange volatil­ity inno­va­tions as a sys­tem­atic risk fac­tor that explains the returns from carry trades. There is a sig­nif­i­cantly neg­a­tive co-movement of high-interest-rate cur­ren­cies (carry-trade-investment cur­ren­cies) with global foreign-exchange volatil­ity inno­va­tions, whereas low-interest-rate cur­ren­cies (carry-trade-funding cur­ren­cies) pro­vide a hedge against unex­pected volatil­ity changes. Fur­ther analy­sis shows that liq­uid­ity risk also mat­ters for the cross-section of cur­rency returns, albeit to a lesser degree. These results also extend to other cross-sections of asset returns such as indi­vid­ual cur­rency returns, equity momen­tum, and cor­po­rate bonds.

Ref­er­ences

Burn­side, C, M Eichen­baum, I Kleshchel­ski, and S Rebelo (2011), “Do Peso Prob­lems Explain the Returns to the Carry Trade?”, Review of Finan­cial Stud­ies, forth­com­ing.

Fama, EF (1984), “For­ward and Spot Exchange Rates” , Jour­nal of Mon­e­tary Eco­nom­ics, 14:319–338.

Lustig, H and A Verdel­han (2007), “The Cross Sec­tion of For­eign Cur­rency Risk Pre­mia and Con­sump­tion Growth Risk” , Amer­i­can Eco­nomic Review, 97:89–117.

Men­hoff, L, L Sarno, M Schmel­ing, and A Schrimpf (2011), “Carry Trades and Global For­eign Exchange Volatil­ity”, Jour­nal of Finance, forth­com­ing. CEPR Dis­cus­sion Paper 8291.

Tags: Carry Trade, Currency, Currency Markets, Currency Speculation, Emerging Markets, Empirical Literature, Exchange Rate Changes, Foreign Exchange Markets, High Interest Rate, High Interest Rates, Interest Parity, International Currency, Low Interest Rates, Lucio Sarno, Lukas Menkhoff, Maik Schmeling, oil, Profitable Investment, Risk Exposure, Risk Premia, Schrimpf, Trade Profits, Volatility Risk
Posted in Energy & Natural Resources, Markets, Oil and Gas | Comments Off

Risks to the Global Economy Should Remain Contained (Doll)

Monday, March 21st, 2011

by Bob Doll, Chief Equity Strate­gist, Fun­da­men­tal Equi­ties, Black­Rock

Esca­lat­ing anx­i­ety over the dam­age from the earth­quake in Japan and result­ing nuclear reac­tor prob­lems as well as ris­ing ten­sions in Libya and the Mid­dle East resulted in an aggres­sive sell­off in equity prices early last week. Despite an end-of-week rally, stocks were down for the week as a whole, with the Dow Jones Indus­trial Aver­age falling 1.5% to 11,859, the S&P 500 Index declin­ing 1.9% to 1,279 and the Nas­daq Com­pos­ite los­ing 2.7% to 2,644.

The events of the last sev­eral weeks serve as a reminder about how quickly poten­tial risks can turn into down­side real­ity. The régime changes in Tunisia and Egypt, other upris­ings in the region, the esca­la­tion of the civil war in Libya and the poten­tial for nuclear cat­a­stro­phe in Japan have all worked together to drive investor unease higher and have caused sig­nif­i­cantly higher lev­els of mar­ket volatil­ity. Pre­dict­ing the exact out­come of any, let alone all, of these events is, of course, impos­si­ble, but based on the infor­ma­tion we have today, our assess­ment is that none of these risks have yet derailed, or will derail, the global eco­nomic recov­ery or the longer-term bull mar­ket in equities.

Tak­ing a look at the Mid­dle East, the biggest wild­card in our opin­ion is what might hap­pen in Saudi Ara­bia. Given its promi­nence in the oil trade, any polit­i­cal dis­rup­tion in Saudi Ara­bia would have a sig­nif­i­cantly higher impact than what we have seen already, but as we have dis­cussed in pre­vi­ous weeks, Saudi Arabia’s eco­nomic and polit­i­cal sys­tems are more sta­ble than those of its neigh­bors and the risks are cor­re­spond­ingly lower.

Regard­ing Japan, the cur­rent prob­lems will no doubt act as a short-term drag on Japan­ese eco­nomic growth lev­els, but over the longer term we expect recon­struc­tion efforts will help to make lower growth a tem­po­rary prob­lem. As a result of all of these, we do not believe that the cur­rent risks dom­i­nat­ing the head­lines will have an overly sig­nif­i­cant impact. Should con­di­tions worsen (par­tic­u­larly in terms of the nuclear cri­sis get­ting worse and/or a sig­nif­i­cant run up in oil prices) that may change, but for now we remain cau­tiously optimistic.

At present, we believe that the global eco­nomic recov­ery will stay on track, and we do not expect to see infla­tion rise notice­ably in the devel­oped world. Before the cur­rent risks devel­oped a few weeks ago, the global econ­omy had pretty solid momen­tum, and fun­da­men­tals remain strong. At the Fed­eral Reserve’s pol­icy meet­ing last week, cen­tral bankers acknowl­edged the risks of higher oil prices, but also indi­cated that the Fed had a more upbeat assess­ment of the over­all econ­omy. Cor­po­rate prof­its have remained strong and pre­lim­i­nary indi­ca­tions are that cor­po­ra­tions are not being neg­a­tively affected by the increase in energy costs. Indeed, cor­po­rate hir­ing plans have been accel­er­at­ing, and we believe that jobs growth should continue.

In any case, how­ever, short-term risks are clearly dom­i­nat­ing mar­ket sen­ti­ment and con­fi­dence lev­els have receded. Mar­kets have been in a cor­rec­tive mode for the last cou­ple of weeks and that trad­ing envi­ron­ment is likely to per­sist. Last week, the S&P 500 Index reached a low of around 1,250. We think that level may be a low from which mar­kets will expe­ri­ence a bounce (although that low may be tested again). We believe it will take some time, and addi­tional clar­ity, to move past all of this.

Sources: Black­Rock; Bank Credit Ana­lyst. This mate­r­ial is not intended to be relied upon as a fore­cast, research or invest­ment advice, and is not a rec­om­men­da­tion, offer or solic­i­ta­tion to buy or sell any secu­ri­ties or to adopt any invest­ment strat­egy. The opin­ions expressed are as of March 21, 2011, and may change as sub­se­quent con­di­tions vary. The infor­ma­tion and opin­ions con­tained in this mate­r­ial are derived from pro­pri­etary and non­pro­pri­etary sources deemed by Black­Rock to be reli­able, are not nec­es­sar­ily all-inclusive and are not guar­an­teed as to accu­racy. Past per­for­mance is no guar­an­tee of future results. There is no guar­an­tee that any fore­casts made will come to pass. Reliance upon infor­ma­tion in this mate­r­ial is at the sole dis­cre­tion of the reader. Invest­ment involves risks. Inter­na­tional invest­ing involves addi­tional risks, includ­ing risks related to for­eign cur­rency, lim­ited liq­uid­ity, less gov­ern­ment reg­u­la­tion and the pos­si­bil­ity of sub­stan­tial volatil­ity due to adverse polit­i­cal, eco­nomic or other devel­op­ments. The two main risks related to fixed income invest­ing are inter­est rate risk and credit risk. Typ­i­cally, when inter­est rates rise, there is a cor­re­spond­ing decline in the mar­ket value of bonds. Credit risk refers to the pos­si­bil­ity that the issuer of the bond will not be able to make prin­ci­pal and inter­est pay­ments. Index per­for­mance is shown for illus­tra­tive pur­poses only. You can­not invest directly in an index.

Copy­right © Black­Rock

Tags: Bob Doll, Currency, Dow Jones, Dow Jones Industrial, Dow Jones Industrial Average, Drag On, Earthquake In Japan, Economic Recovery, energy, Exact Outcome, Global Economy, Investor Unease, Market Volatility, Nasdaq Composite, Nuclear Catastrophe, Nuclear Reactor, oil, Oil Trade, Reconstruction Efforts, Regime Changes, Saudi Arabia, Selloff, Uprisings
Posted in Credit Markets, Energy & Natural Resources, Markets, Oil and Gas | Comments Off

The Influence of Fear (Watson)

Monday, March 21st, 2011

The Influ­ence of Fear

Gareth Wat­son, CFA – Vice Pres­i­dent, Invest­ment Man­age­ment and Research, Richard­son GMP

For some time now, mar­ket fore­cast­ers had been call­ing for some form of mar­ket con­sol­i­da­tion con­sid­er­ing that many global indices had been ral­ly­ing since Sep­tem­ber. The unfor­tu­nate dis­as­ter in Japan last week cre­ated the oppor­tu­nity for that con­sol­i­da­tion and investors acted accord­ingly. As we approached mar­ket close last Fri­day, lit­tle did we know how exten­sive the  dam­age was in Japan, nor  did we under­stand the nuclear prob­lems that would send global mar­kets lower on Tues­day in par­tic­u­lar. The lack of con­crete infor­ma­tion com­ing from the Fukushima Dai­ichi nuclear facil­ity forced many investors to hit the panic but­ton. Trad­ing off of fear causes us to sell first and think later. How­ever, once the ini­tial panic sell­ing tran­spired, there was a recog­ni­tion in a num­ber of mar­kets that such a broad based sell off had cre­ated some buy­ing oppor­tu­ni­ties. While many mar­kets fin­ished the week lower, they did man­age to regain lost ground as the week pro­gressed. The TSX Index was for­tu­nate enough to post a weekly gain.

With­out a doubt Japan dom­i­nated mar­ket activ­ity this week and will likely top head­lines again next week. How­ever, we did see other events develop across the globe includ­ing an esca­la­tion of ten­sions in Bahrain while the U.N. Secu­rity Coun­cil cre­ated a no-fly zone in Libya. Europe was still top­i­cal as Por­tu­gal was down­graded after last week’s down­grade for Spain, the United States bought itself more time to pass a bud­get, and Par­lia­ment returned to Ottawa before next week’s budget/confidence vote which could send our coun­try into an election.

Com­modi­ties were on quite a roller coaster ride as the events in Japan caused some investors to sell and hold cash while other investors feared that global demand for resources could decline as Japan is the third largest national econ­omy in the world. Yet, some com­mod­ity prices rebounded mid-week as the emerg­ing mar­ket growth story is still largely intact and geopo­lit­i­cal events in the Mid­dle East and Libya helped boost spec­u­la­tive pre­mi­ums in the energy space.

With the volatil­ity of com­mod­ity prices increas­ing, we also saw sim­i­lar trad­ing pat­terns for the Cana­dian dol­lar which lost just over a cent on the week, but was down almost 2.5 cents at one point on Tuesday.

What's Going On With the Japan­ese Yen?

Con­sid­er­ing what’s hap­pened to Japan over the past week, it would be nor­mal to assume that its cur­rency, the Yen, would weaken since so many aspects of the Japan­ese econ­omy have been
impaired. How­ever, the com­plete oppo­site hap­pened as the Yen appre­ci­ated against the U.S. dol­lar after the earth­quake and tsunami struck. The Yen strength­ened even after the Cen­tral Bank of Japan poured bil­lions of dol­lars into Japan’s finan­cial sys­tem to weaken the Yen and help exporters by mak­ing Japan­ese prod­ucts cheaper. The strength is likely a result of the expec­ta­tion that Japan may have to repa­tri­ate a lot of for­eign hold­ings in order to have the money required to rebuild the coun­try. Friday’s mate­r­ial weak­en­ing of the Yen was a result of G7 Cen­tral Banks com­ing together to sell Yen hold­ings while buy­ing bas­kets of other currencies.

The Trad­ing Week Ahead

There is no doubt that Japan will be a dri­ving fac­tor for investor sen­ti­ment next week as offi­cials try and get the upper hand on the nuclear sit­u­a­tion. How­ever, the intro­duc­tion of a no-fly zone in Libya and other stir­ring ten­sions in the Mid­dle East could cer­tainly see this region return to the front pages and have a mate­r­ial influ­ence on crude prices. Next week will be quiet   with respect to eco­nomic releases in Canada. How­ever, we will see some mean­ing­ful data in the U.S. per­tain­ing to GDP growth, con­sumer con­fi­dence and the hous­ing market.

As the vast major­ity of earn­ings sea­son has come and gone for the quar­ter, we won’t see many earn­ings releases amongst large cap com­pa­nies in North Amer­ica in the com­ing days. One excep­tion is Research in Motion which will report its fis­cal Q4/11 earn­ings on Thurs­day after mar­ket close. Investors will be anx­ious to see results from Christ­mas sales but will also be look­ing for more details con­cern­ing the launch of the long awaited Play­book tablet device which has been rumoured for release on April 10.

While cer­tainly less sig­nif­i­cant from a global per­spec­tive, the Con­ser­v­a­tive Gov­ern­ment in Canada will table a bud­get on Tues­day and as usual there is all kinds of spec­u­la­tion that we could be headed for an elec­tion. Regard­less of the out­come, we would not be sur­prised to see the Cana­dian dol­lar weaken slightly if an elec­tion is called, unless investors don’t expect Canada’s polit­i­cal land­scape to change. In this case, the loonie may not be affected at all by domes­tic politics.

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