GDP Revisions

I’ll admit it, I just don’t understand: first, we had a reported 3.5%, revised down to 2.8% (about 20% off the mark), revised down again to 2.2% (about 37% off the original mark). So what we have is a reported estimate, give or take 40%? That doesn’t sound like it has much value to begin with. Now I’m not a conspiracy theorist, but I do believe people in power like to stay in power, and they’re often willing to massage numbers to achieve that goal. Hence we see periodic “updates” to how certain statistics are calculated, as an example. Here, what is interesting is that we have a massive downward revision, driven mainly by inventory drawdowns and cash-for-clunkers spending. Now, what will happen next quarter? Well, some new government stimulus will have to be announced to replace cash-for-clunkers and the new home tax credit that’s holding up purchases, and inventories will be built up from depressed levels. Add to that some massaging of 40% to the upside estimate, and I assume that next quarter’s initial estimates will somehow make Obama and Co. geniuses. See some economists reactions here from the wsj.com.

Unfortunately for them, I don’t think the bond market is buying it, and for that matter, neither is the stock market. As of this writing the Dow is up 30+ points and heading down. Treasuries continue to be weak, and the year isn’t over, so look for the upcoming issues’ performance for more signs of strength or weakness in the appetite to lend to Obama & Co

Institutional impact on comparative economic development

This being the 4th of July weekend, I decided that the week would be dedicated to a “Don’t Count America Out Yet” series. In that light, I went back to examine the NY Times articles from the late 1980’s admonishing American managers, praising Japanese manufacturing and long-termism thinking, and worrying over the purchase of American assets by the Japanese. In hindsight, it turns out that American business sold to the Japanese at the top and were able to buy back the assets on the cheap only a few short years later. It wasn’t, however, without pain. The US went through a severe recession in the early 1990’s, with high seemingly structural unemployment, banking crises in the form of S&L’s, a mideast war, and currency fluctuations (many would point in hindsight to the currency markets providing a key signal prior to the 1987 crash – although their predictive value a priori is questionable, at best). Yet the US, contrary to popular fears, was able to withstand the structural and economic challenges.

The natural question arises of “why?”. Was the US recovery predictable? Which factors led to our recovery? Are those factors in place today? Etc.

To answer the questions, I looked to the academic literature examining the comparative development of colonies, countries, and, more importantly, divergent economic structures. What I found was simultaneously encouraging and worrying. . .

One of the best articles I found was by Acemoglu, Johnson, and Robinson, titled Institutions and Economic Development.

In this paper, we discuss how and why institutions— broadly, the economic and political organization of societies— affect economic incentives and outcomes. After briefly surveying a number of theories of institutional differences across countries, we focus on two questions: why societies may choose institutions that are not good for economic development, and why institutions, even bad institutions, persist.

So what made me hopeful after my surveys? The papers I read mentioned two factors which, when applied to the US, should give us hope. First is the establishment of certain institutions. The most important of these are institutions which foster and protect property rights. Luckily, the US still retains its vast institution framework dedicated to property rights, the foundation for the efficient allocation of capital. Under the rent-seeking theory, protecting property rights is the main driver of political power struggles, and only through the establishment of clear procedures for transferring and maintaining property rights can business people make investments and can society encourage production. The second factor is the inertia associated with institutions. Once institutions are established, they are dificult and costly to change. Namely, once a country is on an inefficient path, the strucutural changes become increasingly difficult to shift. Again, since the US started on a path of property rights, representative democracy, etc. in the modified neoclassical tradition, the main foundations for the allocation of capital and resources have not changed.

In light of these surveys, our institutional foundation should provide a certain predictive value to the US weathering the current recession. However, a few notable should already come to mind. Said property rights are under ever-increasing threats. The GM bondholder saga is a manifestation of the expropriation of property by the government. Other examples abound; for example, the forced renegotiation of mortgages, forced mergers, and politically motivated infusion of equity capital. In this vein, the devaluation of currencies is a stealth tax, or a stealth expropriation of wealth by the government. The tide seems to continue. Everything from government-rationed healthcare, to ever larger ineffective regulatory bureaucracies (think Office of Homeland Security and a revamped financial regulator). The obvious second concern, is that once these institutions will be in place, they will be increasingly difficult to reverse. A quick example is Medicare, the US government mandated health care system. In this system, everyone over the age of 65 is covered, yet the bureaucracy is crippling and the system is bankrupt by all normal (read, non-governmental) measures. However, there is little political ability to reform the system, let alone start from scratch. The fear is that the new institutions and precedents will take us further down the wrong path.

Again, this being the 4th of July, I’ll focus on the positives. The preceding paragraph was pointing to some worrying signs, but should not be in and of itself discouraging. The US citizenry has not consented and might not allow the expropriation by the political elite. Certainly, it does not appear that everyone is on board to change the healthcare system so quickly. Second, our main focus here is on the investment front. In that light, investments are always relative to other alternatives. From that perspective, the US still remains a better long term protector of property rights than, say, China or Russia. Might these countries surpass the US in the near future on certain metrics? Of course. Yet, as an investor, I still contend that the risk premium offered by emerging markets debt, for example, is not adequately compensating me at this stage for the risk of expropriation of my capital (either directly or through the respective country’s own currency debasement). 4-10% risk premium over Treasuries? Hmmmm. Maybe at the high end it’s enough of an incentive for some shorter term investments (i.e. bonds, currencies) but I’m not taking that risk for the next decade of two for only a few percents. So the US, in my mind, still retains at least one competitive advantage: institutions. Flawed, but still the world leader.

Connect The Dots: Week Ending 06.12.2009

Last week was full of charts. This week, let’s discuss some of the main themes we’re witnessing.

The equity markets were relatively tame this week. Gold, oil, and agribusiness industries showed big moves, but not in the same direction. All eyes were on interest rates and more specifically the steepening yield curve. As I mentioned throughout the week, the US’s ability to garner the worlds savings a plow them into our ever increasing supply of Treasuries will end at some point. For a long time, my focus was on maintaining a short Treasuries position through TBT and futures positions. I am no longer comfortable with that trade. The long term position still makes sense, but the implementation has become more difficult. There are now endless pundits talking of inflation risks, hedge funds piling into TBT, and short US dollar positioning. I just don’t like it when so many people agree in such a short period of time. Just a few months ago, we were in the minority as survey after survey showed most money managers believing deflation was the main problem. I can’t help but believe that most of them will end up being squeezed. Look at the 2-10 spread below. The steepener trade has been all the rage of late hitting ALL TIME highs early last week. Things settled down a bit toward the end of last week and the steepener has continued its correction this week closing at 2.50. Thatsabet and I disagree on how long the correction could last. He is looking at around 2.30-ish as the limit; however, I believe that it depends on who is going to get caught on the wrong side of this move. We might see some big names being squeezed and have to push yields on the 10 year back down significantly.

(source: Bloomberg)

It will be interesting to see this unfold in the next few weeks. What we are witnessing is a two-faced market. On the one hand, there are clear signs of inflation. Oil has doubled off its $35 lows and is now above $70. The steepening yield curve can signal inflation expectations rising (as investors don’t want to hold long term fixed income instruments). And, since inflation is always and everywhere a monetary phenomenon, dollars continue to be pumped into the system through the ballooning of the Fed balance sheet (quantitative easing) and the USD is facing significant strain.

On the flip side, we have deflationary pressures continuing. Job losses and recessionary pressures are continuing. Real estate deflation continues in virtually every segment as rental yields continue to decline. Companies face continuing pricing pressures with no ability to raise prices. The best business to start these days appears to be a bank, with government subsidies and a steep yield curve, a regional player with no legacy portfolios is a no brainer.

Can the Fed increase interest rates here? I don’t think so. Can they stop buying 20-30% of every auction? I doubt it. So the inflationary pressures will continue. Yet simultaneously, I don’t see margin expansion and earnings power returning to companies. So I’m wary of the pure inflation story.

Some other notes we made from conversations this week. Some advisors out there are encouraging clients to move into credit and high yield, even as they are warning against investing in equities. This seems somewhat incongruous. For high yield bonds (junk bonds) to provide adequate return, these advisors must believe that the yield and capital appreciation available will make up for the higher default rates we have been witnessing. If they believe that these companies will be able to pay back the 15-20% interest rates on some of these bonds, they must believe that the companies are going into an earnings environment that will support those payments. Additionally, these same advisors are now mentioning gold and inflation protection in the same presentations. Hmmmmm. If inflation is indeed coming, I wouldn’t want to be in a fixed income instrument. If earnings and margins will improve, I’d also rather be in stocks than bonds. Separately, if earnings won’t be improving, then the junk bonds won’t provide me with the returns I seek. High yield spreads need to get wider in this kind of environment for me to find them attractive enough.

Paulson is buying CBRE. I don’t like being on the other side of the trade from Paulson. The Ultrashort Real Estate ETF, SRS, a favorite of day traders and amateur traders, has gone from $60 to $18. For those still holding on, just know that the numbers from daily compounding are working against you. Say thank you for the $18 and walk away. There are other ways to short real estate if you want to take the other side of Paulson.

Lastly, I just want to note a couple of important points we can’t take our eyes off of.

In the currency markets the USD has continued its correction but the possible basing pattern continues. Should DXY hold 79 and proceed to take out 81.5 we could have a target toward 84. Thatsabet believes this would be a negative for equities, but I think it would be a positive as money flows back into the equity market from abroad. Overall, higher yields will be USD positive.

 (source: Bloomberg)

On another note, any recovery will probably need financials to stabilize and lead the way. Below is the XLF relative to the SPX. This continues to be an important and leading indicator for the direction of the markets. For the past several weeks the banks have been going nowhere RELATIVE to the markets. They have issued 85B in securities and that is currently being digested by the markets. Underperformance by the banks is usually a precursor to overall market weakness. We’ll keep following it with you to look for signs of a real recovery.

(source: Bloomberg)

And for those of you keeping track of our weekly standards:

Our market monitor…looking at various indices for the week, month, quarter, and YTD…

(source: Bloomberg)

And our relative monitor – Looking at the changes of various sectors relative to the S&P 500…

(source: Bloomberg)

Libertarians under attack…

Henry Kaufman writes an op-ed piece in today FT (http://www.ft.com/cms/s/0/705574f2-3356-11de-8f1b-00144feabdc0,s01=1.html) that I just can’t ignore.

He writes:

My second major concern about the conduct of monetary policy is the Fed’s prevailing economic libertarianism. At the heart of this economic dogma is the belief that markets know best and that those who compete well will prosper, while those who do not will fail.

He goes on to lists 6 points of failure on the part of the Fed that were the results of the Fed’s “dogma”. I don’t even know where to start with this one, so let’s start with his six points.

First, it explains to a large extent why the Fed did not strongly oppose the removal of Glass-Steagall restrictions.

You cannot take Glass-Steagall out of context. The act, also known as the Banking Act of 1933, placed a separation between commercial banking activity and investment banking activity. Kaufman’s contention that a libertarian mindset led to repealing the act implies a few things: first, it implies that the act wouldn’t be repealed without the mindset. Second, it implies that it is specifically this mindset that prompted the repeal of the act. Third, Kaufman wants to blame someone for the current situation, so the Fed and Libertarians with it are a good association. There were banking crises before the act, there were banking crises after the act, there will be banking crises in the future. The act didn’t stop the S&L crisis, not the lending crises that came before. Kaufman’s association of the act being repealed and then his implication that it’s libertarianism that cause it are naive at best.

Second, it also helps explain why the Fed failed to recognise that abandoning Glass-Steagall created more institutions that were “too big to fail”.

Libertarianism would have prompted the Fed to let companies fail. Thinking that market forces have corrective mechanisms is economics. Thinking that government is not the right arbiter of who should fail and who should survive is capitalism, libertarianism, democratic, and liberal (in the positive sense of the word).

Third, it diminished the supervisory role of the Fed, especially its direct responsibility to regulate bank holding companies. To be sure, the Fed’s supervisory responsibilities have never been very visible in the monetary policy decision-making process. But its tilt toward an economic libertarian approach pushed supervision a notch down just at a time when financial market complexity was on the rise.

I don’t think this is a result of libertarianism. It’s a result of an entire culture built on lack of responsibility and a whole host of factors which history will judge. Is he really saying that a Fed (which many libertarians would criticize for even existing) didn’t regulate enough due to libertarianism? He sees no other causes?

Fourth, as hands-on supervision slackened, quantitative risk modelling became increasingly acceptable. This approach, especially quantitative modelling to assess the safety of a financial institution, was far from adequate. But it worked hand in glove with a philosophy that markets knew best.

Again, is he blaming libertarianism for the use of quantitative modeling? The next time he’s performing a transaction maybe he should think twice before using Excel. Using mdoels is not libertarianism or any other “ism”. The problem is not using models, it’s relying on models, and that’s not an “ism”, it’s just common sense. 

Fifth, adherence to economic libertarianism inhibited the Fed from using the bully pulpit or moral suasion to constrain market excesses. It is difficult to believe that recourse to moral suasion by a Fed chairman would be ineffective. Such public pronouncements about financial excesses are hard to ignore, reaching the broad public as well as market participants.

The Fed led the way to excess through manipulating interest rates. That’s not libertarian – it’s exactly the opposite! He’s criticizing the Fed for not being involved enough, when in reality, they were a main source of the problem. I’d like to take Kaufman out for a cup of coffee (my treat) and explain to him how his anger is misdirected. He recognize that the Fed couldn’t do a good job even if it wanted to (debatable) and that this is a reason to give the government less authority, not more.

Sixth, the Fed’s increasingly libertarian philosophy underpinned its view that it could not know how to recognise a credit bubble but knew what to do once a bubble burst. This is a philosophy plagued with fallacies. Credit bubbles can be detected in a number of ways, such as rapid growth of credit, very high price/earnings ratios and very narrow yield spreads between high- and low-quality debt.

Indeed, Kaufman and I would once again look at the evidence and come to different conclusions. I think the Fed didn’t and couldn’t know that there was a market bubble, which is why they should have stayed away from manipulating and trying to predict. He thinks they should know and then should control.

Dr. Henry Kaufman is probably a brilliant man. I, sadly, am not, so take my criticism for what it is. Kaufman seems to be angry and not know who to blame, so he lashed out at the Fed (partially rightly) and “Libertarianism”, a catch-all “ism” for him, which he misdefined, misanalyzed, and mmitakenly blames for our current woes. Disappointing that his argument is both oversimplistic and completely mistaken in the entire cause and effect relationship.

WSJ: Overheard

Don’t expect to see Paul Krugman waltzing at Vienna’s Opera Ball any time soon. Official Austria is still seething two weeks after the Nobel laureate suggested that the nation could go bankrupt. At a meeting with foreign journalists, The economist put Austria in the same boat as Iceland and Ireland, characterizing the exposure of the country’s banks to Eastern Europe as “scary.” Austria’s central-bank president quickly put out a statement asserting that Austria’s creditworthiness was “beyond question.” Austrian Chancellor Werner Faymann called the comments “absurd,” while Finance Minister Josef Proell accused Krugman of waging an “economic war” against the country. In an op-ed in Austria’s Die Presse this week, former Chancellor Wolfgang Schuessel called the economist a “prophet of doom.” Krugman seemed taken aback. “It seems that I have reached the stage where I create a stir by saying the obvious,” he wrote on his blog.

Ludwig von Mises

“However conditions may be, it is certain that no manipulations of banks can provide the economic system with capital goods. What is needed for a sound expansion of production is additional capital goods, not money or fiduciary media. The credit expansion boom is built on the sands of banknotes and deposits. It
must collapse.