Disclaimer. After nearly 40 years managing money for some of the largest life offices and investment managers in the world, I think I have something to offer. These days I'm retired, and I can't by law give you advice. While I do make mistakes, I try hard to do my analysis thoroughly, and to make sure my data are correct (old habits die hard!) Also, don't ask me why I called it "Volewica". It's too late, now.

BTW, clicking on most charts will produce the original-sized, i.e., bigger version.

Thursday, June 30, 2011

Debt, debt and yet more debt.

Two interesting articles (1, 2) about the ballooning debt problem in the west.

The problem everywhere is simple: governments can't tax special interest groups.  Taxes have to be raised on everybody.  But government can and does benefit special interest groups.  So increasing taxes (which are general or potentially so) engenders huge opposition from everybody; increasing benefits has diluted costs for everybody but concentrated benefits for a few.  Hence lobby groups and PACs.  Nobody rises up in arms about a special benefit generously awarded by the government to a few.  By all means increase the pension/build a new airport/privide a nice subsidy to a small group!  But I don't want to pay for it.  Especially if it can be funded by borrowing.

Look at the chart below.  This shows Federal government taxes and expenditure as a percent of GDP.  The gap is long standing.  Ironically, the only surplus was under a Democratic President, Bill Clinton.  The ballooning in expenditure and the fall in revenue in 2008, 09 and 10 is typical of recession.  Normally as the recovery progresses, the tax percentage rises, expenditures fall.  But this cycle has been different, because it's been so sluggish, so far.  Hideously expensive wars don't help (the Afghan war costs $2 billion a week).

This photo of a tea party protester sums it up.

It's enough to make you weep.

Yet a too rapid rise now in taxes and cut in expenditures will plunge the US back into recession.  The Greek experience, where fiscal tightening resulted in a worse budget outcome after the economy collapsed is instructive.  If you maintain that the US is unique ("American exceptionalism") and nothing can be learnt from a bunch of dodgy cheese-paring monkey-wrench foreigners, look what happened in 1937, when a new Republican House and Senate tightened fiscal policy on the argument that a balanced budget would "restore confidence".    There was a very deep recession.

At the moment, the US consumer is being supported by massive subventions from government at all levels. Net net, US individuals are receiving more from the government than they are paying to it.  It would be a mistake to savagely reverse that position too quickly.

Yes, something needs to be done about the deficits -- but not quite yet. Perhaps the best option is to temporarily suspend indexation of benefits such as old age pensions and unemployment benefits. And do something about health costs: the US spends twice as much as Oz does as a percentage of GDP on health with inferior outcomes.

Ross Gittins' words are worth repeating:

To boil it down, the reason Greece is in so much trouble is that every Greek wanted a government that did all the expensive things governments do, but none wanted to pay tax.
Greece's politicians did not have the courage to tell their people that, in the end, you cannot have one without the other.

The Greek government ran budget deficits for year after year, racking up more and more government debt, eventually doing dodgy deals to disguise the amount of that debt until - surprise, surprise - the day of reckoning arrived.

The major advanced economies ... have not had the courage to tell their voters that government benefits have to be paid with higher taxes.

Greece is now in the hands of its bank manager and - another surprise - he is not inclined to be gentle or reasonable.

Replace "Greece" with "most western countries" and you get the picture.   He goes on to say:

The ideal way to get on top of your debts is to trade your way out. Keep the income coming in, hold down your expenses and use the difference to pay down the principal. What makes it hard is the continuing big interest payments you have to meet before you can reduce the principal. Once your bankers lose faith in you, they may well increase the interest rate you are paying to cover their heightened risk.

For governments it is even harder. If they start from a position of annual deficit, they have to slash spending and raise taxes just to return the budget to balance and so stop adding to the principal. To get the budget into surplus - and so have money to reduce the principal - they have to cut spending and raise taxes even further.

But the more governments cut their spending and raise taxes, the more they slow the growth of their economies. And the more slowly their economies grow, the more slowly their tax revenue grows and the higher is their spending on dole payments, making it that much harder to get back to surplus.

The trouble with bank managers is that when finally they lose patience with you, they become quite unreasonable, imposing requirements and restrictions that actually make it harder for you to repay your debt. And when the ''bank manager'' takes the form of a herd of anonymous traders in global financial markets, their actions can be destructive and even self-defeating.

Something needs to be done about the deficits over the long term.  Markets (if they believe you, and they don't believe the Greeks) will accept a long-term soultion.  It's a depressing solution: restrained spending and rising taxes (as a percentage of GDP) for a decade.  What's more, the old panacea which hid increasing middle class impoverishment over the last 30 years -- borrow on the back of rising asset prices -- is kaputt. 

However, America is exceptional in at least one way.  Its debt is in the global currency, US dollars.  Its bond market is the widest and deepst in the world.  So it, perhaps alone in the world's developed economies, can probably afford one more year of pump-priming.  After that, the deluge.

Monday, June 27, 2011

The GOP's Abstract Professors

This illuminating article by Fareed Zakaria of Time Magazine is well worth reading. 

It's odd how the theoretical belief system of Communism and socialism has been so comprehensively replaced by a new belief system on the right.

As just one example:  does anybody (except the hyper-rich and extreme conservatives) really believe that cutting taxes on the rich and raising taxes/reducing benefits for the poor will expand demand at a time like this?  It's batty: the savings rates of the poor are very low, and of the rich high.  To stimulate demand now, you need to cut taxes for the poor and the middle class and fund this with tax increases on the rich -- unless your national debt is low enough to fund it with borrowing.  Which the US's isn't -- because of previous tax cuts for the rich, among other things.

Friday, June 24, 2011

Japan IP starts to recover

A lot of the weakness in US economic activity has been due to natural disasters.  The earthquake and tsunami in Japan  and the resulting loss of electric power caused a loss of production in tightly-linked production processes.  Just-in-time manufacturing comes to a juddering halt if any part can't be produced -- and disruption from the earthquake itself followed by a collapse in electricity production meant that even unaffected plants couldn't continue manufacturing.  This affected the US car plants of the Japanese car manufacturers too.  There was also a major flood in the mid-west of the US, which also impacted production and sales.

Japanese production has started to recover.  The US will too.  How much of the US and Japanese weakness is due to natural factors and how much is just a classic mid-cycle dip remains to be seen.  My guess remains that growth in the US will re-accelerate in coming months.  Monetary stimulus has been too great for it not to.  And fiscal tightening -- which would have a big negative impact if post-bubble Japan is any guide -- is still a year away.  Unless of course, the pollies can't get their act together and the debt ceiling isn't raised.  Bizarre.

Thursday, June 23, 2011

Get Rich Slowly

Most ppl would like to get rich quickly: win the lotto, marry well, discover some fantastic thing which will make you enormously rich.  I wish you well.  Alas, most of us have to save up our capital over time.

Let's make some simple assumptions.  Let's assume that the total return (i.e., capital plus dividends/interest) is 8%.  Let's assume the inflation rate is 3% so the real return is 5%.  Assume the average wage is $60000 per annum (it's a bit higher than that in Australia) and that you can only save 10% of your pay.  That's quite a low percentage: in China, the average worker saves 40%, in Victorian Britain the savings rate was 25%.  Assume that you go on saving 10% of your pay, and that pay rises by the inflation rate but no faster (so no rise in real terms)

The chart shows how your capital grows.  By 20 years you'd have $330,000, by 24 years $500,000 and by 30 years nearly $900,000.  Just from 10% a year -- of course, that's assuming that all income and capital gains are reinvested.

As it happens, the very long term total return from both residential property and shares in Australia is around 12% per annum, and that includes the 1987 crash, the GFC, etc.  At 12%, 30 years would give you $1.8 million, and 25 years $1 million.  All from saving.

The Asian cultures know this, just as ours once did.  We now borrow heavily to fund our lifestyle.  They have high savings ratios.  Who do you think will be the richer over time?

And yes, I've ignored taxes.  But you can find low-tax and tax-free environments to park your savings as well as other tax minimisation strategies.  And anyway, even at 8% the cumulative effect of savings plus time is substantial, and the actual return (in Oz) has been 50% higher.

Wednesday, June 22, 2011

AMP sees shares as "very cheap"

Chinese IP, yoy % change

My mate Shane Oliver at AMP, who has a good record and is I think one of the better analysts around, reckons that Ozzie shares are "very cheap" right now.  I agree.  In fact, setting aside the GFC (which was exceptional), they haven't been this cheap for two decades.  Of course that doesn't mean that they'll go up in the next few weeks, but it does mean that on a longer-term, say 1 year perspective, the risks are all on the upside.

The US isn't that cheap, though, not unless you believe analysts' EPS projections.  Which I don't.

China PMI (net % positive)

The China outlook is key to the whole global recovery.  If China falls into recession, we are in very serious trouble.  Here's what Shane has to say about China:

First, thanks to slowing economic and money supply growth and a topping in food prices, inflation is likely to slow over the next six months allowing the authorities to take their foot off the monetary brake. Second, while excess housing is apparent in some cities and in some categories, overall China has not been building enough houses so fears of a property crash are way overdone. Third, China will likely support its banks should the investment loans associated with the 2008-09 stimulus go wrong. Finally, given the risk of social unrest Chinese authorities will do all they can to avoid a hard landing. And in a semi-command economy with very low public debt and huge foreign exchange reserves, they have plenty of fire power to do just that. So far while growth indicators have cooled, there is no sign of a hard landing.
 In another piece in The Age, another analyst suggests the commodity (and therefore our own Ozzie) boom will continue for at least a decade.  Well, maybe.  I've heard these sorts of long-term predictions before.  They've usually been wrong.

Breaking Point

Those who believe that Greece will pay its debts are dreaming.  Read this.

That's what the Greek government bond yield is telling you.  At 17% vs 3% on German bonds, either Greece will pay its bonds in deflated drachmas after it's left the euro zone, or it will repay them in long-dated euro "restuctured" low-interest bonds after lenders have taken a "haircut", or it won't repay them at all.  The odds (for now) are still on the second option.  The Greek parliament is meeting as I write this. 

Monday, June 20, 2011

Bank Exposure to Greece

This chart comes from an article by the BBC.

It's misleading in that a big chunk of the French exposure is through Credit Agricole's subsidiary Emporiki.

A Greek default is unlikely to much affect bank capital according to this WSJ article.  But ... a public sector default (unless it's a massaged default, otherwise known as a restructuring) will lead to big private sector problems, so the problem is prolly worse than they say.

All the same, whereas the Lehman's failure was a case of it being OK on Friday and gone on Monday, its real problems being known to only a few in the market, this whole Greek default has given everybody time to factor in the worst case scenarios.  Everybody knows that Greece is in trouble, and how much each bank could lose.  It's unexpected shocks like the Lehman failure which cause big falls in markets, not those problems which have been common knowledge for many months,

As I pointed out a couple of days ago, Greece is in a much worse position than Ireland and Portugal.   To some extent Greec is sui generis.  So there will most probably not be contagion.  And, should Greece have a disorderly default instead of a managed one (i.e., a restructuring) the ECB will lend enough money to the German and French banks to stop them folding.  This is definitely not a Lehman moment, despite the chatter.   What it does mean though is that bank lending growth in Europe will be constrained, and so, therefore, will economic growth.  But we knew that already.

Friday, June 17, 2011

The Greek Tragedy

Though there is obviously a clear risk that the Greek disease will spread to the Ireland, Portugal and Spain, there is a key difference between Greece and the other PIGS.

Michael Pascoe -- one of the more thoughtful journos writing about finance -- in an interesting article in Melbourne's The Age discusses why:

Greece itself remains an insignificant, hopelessly corrupt and inefficient economy that shows no sign of changing any time soon. Michael Lewis, author of Liar's Poker, The Big Short and Moneyball, among others, has written an enjoyable feature on the mess for Vanity Fair. A small example of his examples:
The average government job pays almost three times the average private-sector job. The national railroad has annual revenues of 100 million euros ($134 million) against an annual wage bill of 400 million, plus 300 million euros in other expenses. The average state railroad employee earns 65,000 euros a year. Twenty years ago a successful businessman turned minister of finance named Stefanos Manos pointed out that it would be cheaper to put all Greece's rail passengers into taxicabs: it's still true. “We have a railroad company which is bankrupt beyond comprehension,” Manos put it to me. “And yet there isn't a single private company in Greece with that kind of average pay.” The Greek public-school system is the site of breathtaking inefficiency: one of the lowest-ranked systems in Europe, it nonetheless employs four times as many teachers per pupil as the highest-ranked, Finland's. Greeks who send their children to public schools simply assume that they will need to hire private tutors to make sure they actually learn something.
And there's more:
The retirement age for Greek jobs classified as “arduous” is as early as 55 for men and 50 for women. As this is also the moment when the state begins to shovel out generous pensions, more than 600 Greek professions somehow managed to get themselves classified as arduous: hairdressers, radio announcers, waiters, musicians, and on and on and on.

None of this is true of the other countries in trouble.  Ireland foolishly guaranteed not just bank deposits but also bank bonds and even bank loans which produced an eye-watering deficit of 32% of GDP.    Eric Reguly of Toronto's Globe and Mail points this out in this excellent article:

In each of the three, but mostly in Greece and Ireland, there is no sense of shared sacrifice. Everyone – politicians, tax evaders, teachers, executives, bankers – is responsible for their countries’ financial and economic calamities. Yet it is the European Union banks and their senior creditors who are suffering the least. Their gain comes from everyone else’s pain.
European Central Bank president Jean-Claude Trichet will not hear suggestions of a Greek debt restructuring as Athens tries to negotiate a second bailout package.
His fear is that forcing private bondholders to take losses would destroy the Greek banks and severely damage the rest of the European banks with heavy exposure to Greece, potentially triggering a second European financial crisis (Royal Bank of Canada’s investment arm estimates that European commercial banks hold about €90-billion [$125-billion] of Greek sovereign debt). Mr. Trichet’s probable ECB successor, Bank of Italy boss Mario Draghi, has endorsed the ECB party line.
If the European banks and their bondholders are to be protected, the costs of the bailout, by definition, have to be borne by the taxpayer. Based on the latest economic and employment figures, the taxpayer is getting hammered as the austerity programs demanded by the EU, the ECB and the International Monetary Fund kick in with a vengeance.
The latest Greek labour and economic data are grim. The unemployment rate has climbed to 16.2 per cent. Among the young (15 to 24 years old) it is 42.5 per cent, up from just under 30 per cent in 2010. For workers between 25 and 34, the rate is 22.6 per cent. First-quarter year-over-year gross domestic product contracted 5.5 per cent, against the forecast 4.8 per cent.
As GDP sinks, the unemployment figures will almost certainly get worse, dooming an entire generation of young, educated workers to the dole. No surprise that the protests and strikes are getting bigger and angrier. On Wednesday, Athens was paralyzed by a 24-hour strike that turned violent. Austerity programs and employment growth almost never go hand in hand.
 As for Ireland:
The shakedown of the Irish taxpayer is even less fair, to the point of cruelty. That’s because Ireland did not have an economic crisis so much as a bank crisis, one aided and abetted by the government. Dublin not only guaranteed bank deposits (which it had to do); it guaranteed most of the banks bonds, made a €40-billion commitment to buy dud bank loans and committed a similar amount to recapitalize the banks.
The result was catastrophic. The cost of the bank rescues more than doubled Ireland’s 2010 budget deficit to an astounding 32 per cent of GDP and pushed up its total public debt to GDP to almost 100 per cent from 65 per cent a year earlier. “The government got into debt by taking over its banks’ debts. In an unfathomable act of charity, this was done only to save the French and German banks,” said Marshall Auerback, global portfolio strategist at Madison Street Partners, a Denver hedge fund.
Who is paying for the reckless behaviour of the Irish banks? The Irish taxpayer, of course. Ireland is still in recession. The unemployment rate is 14.7 per cent and the jobless are leaving the country in droves to find work. “Writing assets down to fair value and then recapitalizing the banks should be the first priority in restoring economic growth after a banking crisis,” Lombard Street Research economic consultant Leigh Skene told The Guardian. “Sadly, Europe went in the opposite direction and tried to ensure that no bank, regardless of how insolvent [it was], defaulted on its liabilities.”

The banks shouldn't have lent to Greece; the Greeks shouldn't have borrowed; the banks should have been forced to wear the cost of bad loans in Ireland, and the truth is, they probably will.  Pretending that it isn't happening is just the sort of stunt bureaucrats and pollies pull.  It won't wash.

Meanwhile, the forced austerity has made things worse by plunging both Ireland and Greece deeper into recession, so increasing their budget deficits despite tax rises and spending cuts.  Proof, if you needed it (a) that Keynesianism works and (b) that creditors are often cretins.

Expect a Greek default, probably dolled up as a "restructuring" and a shift in attention to Ireland.   But I suspect Ireland will not be allowed to fail.  The ECB and the banks will have learnt their lesson after Greece walks away from its debts.  Funny how we keep on having to do this.  You'd think all these highly paid bankers and executives would learn the lessons of history.  They haven't, so far, but they will soon.

Thursday, June 16, 2011

The Greek Debt Crisis (again)

Once again, markets are being roiled by concerns that Greece will default on its debts.  For some time now it's been obvious that a restructuring of Greek debt is inevitable, but bureaucrats and politicians have continued to pretend that austerity will be enough to guarantee payment.

The Greek government’s debt to GDP ratio exceeds 100%.  This means that the interest paid on this debt will be a significant percentage of GDP.  If interest rates are low, say 1 or 2%, as they are in Japan, the interest cost of the debt will also be low.  But if doubts arise about the ability or willingness of the government to repay the debt, then interest rates start rising, and the interest burden starts to rise as markets increase the risk premium applied to that country’s debt, thus increasing the risk that the debts won’t be paid.  This doom loop has hit Greece.  10-year bond yields are now above 17%. 

The burden on the Greek population is insupportable.  It is likely that the government will fall today or in the next few days and Greece will default.

Does this crisis mean you should switch into defensive investments such as cash?  No (though it's close) for 6 reasons:

  1. Chinese growth will continue. China is the world’s second largest economy (and is the world’s largest consumer of raw materials).   Chinese growth is now driven by internal forces rather than exports.
  2. Though US growth is slowing this has much to do with natural disasters – the tsunami in Japan stopped car part production which affected US car production and sales; and floods in the mid-west also impacted output and sales.  Outside the PIGS (Portugal, Ireland, Greece, Spain) growth in Europe is strong.
  3. Share markets are a lot cheaper than they were--though they're still not screaming buys.
  4. The markets have seen this crisis developing over the last year, and most of the bad news is now “in the price.”  Nobody now believes Greece will avoid default except bureaucrats and politicians.
  5. Policy makers are extremely aware of the dangers and will move aggressively to ease liquidity on any sign that the crisis is spreading.  If necessary, central banks can buy bank bonds or lend banks unlimited cash on the security of government paper or even lend them money directly.
  6. Unlike the situation at the beginning of the GFC, when economies were ripe for a cyclical downturn, now we are still in the middle of the upswing from the trough of the recession.

But it's hard to see share markets booming on this, isn't it?