Volewica

US recovery strengthening

2012-01-30T17:24:00.000-08:00

I mentioned a couple of posts ago that the US data were surprising on the upside and that revisions were to the upside too. These are usually signs of a strengthening economy. Over the next few days we'll get a slew of new data: the labour market indicators and the ISM indices.

While the unemployment rate lags the cycle, the change in the unemployment rate coincides with the cycle. You have to invert it, because unemployment falls as the economy recovers. You can see from the chart below how strong this indicator now is, after the mid-cycle correction associated with the aftermath of the Japanese earthquake and tsunami.

Similarly, the change in payrolls is also improving, as the chart below shows. Nowhere near fast enough, given the slump during the GFC, but still -- improving.

Meanwhile, housing appears to have finally turned the corner. But more of that tomorrow.

Draghi not a drag

2012-01-24T18:14:00.000-08:00

The new head of the ECB, Mario Draghi, has moved decisively to short-circuit the debt-refinancing crisis in the euro area. Unlike Trichet, the previous head, Draghi is an economist, and he clearly understands feedback loops. The ECB last month lent banks an unprecedented E489 billion (US$ 606 billion) at a low interest rate for three years, and the banks promptly used the funds to buy the national government's government stock. Yields on 2 year Spanish government paper have fallen 180 basis points (1.8%) to 3.14%; yields on Italian 2 year bonds fell 2.7% to 3.54%. The impact on 10 year bonds has been smaller, but still material (see chart)

Source: Bloomberg

Since it was high interest rates on the government bonds which were causing government deficits to blow out, this was a decisive circuit breaker, and was seen as such by the markets, with big name borrowers (RaboBank Nederland and Nordea Bank, for example) able to raise E19.5 billion in new senior unsecured debt, which had been impossible before.

There is to be a second bidding for loans at the end of next month, and the ECB will ease the rules on what constitutes acceptable collateral. This will give another fillip to confidence. Meanwhile, the negotiations on a sensible debt restructure for Greece are close to completion, with only an argument about precisely what rates the new 30-year paper is to pay.

The good news lies more in the clear signal the ECB has given: it's prepared to use very unconventional means to prevent the euro and the European economy melting down. Yes, the pollies are still squabbling like cockies looking for an evening roost. Yes, longer-term austerity will still be needed as budgets move towards balance. And yes, the level of debt is still high. But if the ECB has at last started behaving like a real Central Bank we can realistically hope that a 1930s-type collapse has been averted.

Copper

2012-01-23T19:40:00.000-08:00

The copper price looks as if it's started a new run (see chart) as has my base metals index (not shown). The close is above the 50 day moving average, which is rising, though the 50 day isn't yet above the 150 day. But it looks a lot like early '09 doesn't it?

The US is accelerating, the ECB has decided to act like a real central bank and provide the unlimited support to the European banks it's supposed to, and China is at its low point.

It's been a while ...

2012-01-21T20:22:00.000-08:00

I've been wrestling with the usual demons. Not to mention time-short.

So just a quickie.

Some thoughts:

US data have been consistently better than expected and also consistently revised upwards, always a reliable sign of growth strengthening
European data have done the opposite -- no surprise, given Europe's problems and the staggeringly inept response of the pollies and the ECB
Chinese data have been weak and anecdotal reports suggest that monetary tightening has bitten deep. Since inflation has decisively peaked, I expect the Chinese pooh-bahs to aggressively stimulate this year. They've already started with one cut to liquid asset requirements. They're going to do a lot more.
The S&P 500 has broken upwards, but the Ozzie market hasn't yet. The S&P has broken out on the top side of a bullish wedge, the 50 day moving average has turned up, the original has crossed the moving average on the upside, the 150 day moving average has turned up and the 50 day has crossed the 150 day on the upside. Actually all this happened a coupla weeks ago, and I meant to alert y'all, but I didn't get round to it. :-(

Method in her madness

2011-11-26T16:02:00.001-08:00

Polonius:
What is the matter, my lord?

Hamlet:
Between who?

Polonius:
I mean, the matter that you read, my lord.

Hamlet:
Slanders, sir; for the satirical rogue says here that old men
have grey beards, that their faces are wrinkled, their eyes purging
thick amber and plum-tree gum, and that they have a plentiful
lack of wit, together with most weak hams; all which, sir, though
I most powerfully and potently believe, yet I hold it not honesty
to have it thus set down, for yourself, sir, shall grow old as I am, if
like a crab you could go backward.

Polonius:
[Aside] Though this be madness, yet there is method in't.

Hamlet Act 2, scene 2, 193–206

[Quote via this site]

All along I (and most commentators) have been assuming that Angela Merkel's and the ECB's intransigence is because of a purblind stupidity. But what if, as The Age/Sydney Morning Herald journo Michael Pascoe plausibly argues, it's part of a plan.

As Niccolo Machiavelli once more-or-less advised, you don’t want to waste a good crisis. Angela Merkel isn’t. And if that means a highly dangerous game of brinkmanship for months to come, sobeit if Germany achieves control of Europe.

There is nothing necessarily sinister about that. If Merkel’s plan to force European fiscal union – the necessary missing ingredient to sustain Europe’s half-baked monetary union – happens to result in Germany effectively dominating proceedings, well, who better? Or perhaps: who else?

Germany already dominates the thinking and actions of the European Central Bank. When it’s suited German needs in the past, the ECB has been compliant in easing money supply. Right now it suits Germany for the ECB to hang very tough indeed, threatening economic Armageddon, and that’s what the ECB is doing. There’s no point in being virtuous if it results in having no economy left to be virtuous about.

Perhaps, after all, there is method in their madness.

The European Crisis

2011-11-17T12:15:00.001-08:00

Everybody except the Germans can see that to stop the European and Euro crisis, the European Central Bank must stand behind the government bond markets in Europe. A Central Bank has unlimited capacity to create money. In the old old days it was printing presses, these days it's electronic funds transfer. The CB buys government stock in the open market and settles by drawing funds on itself. Only the Central Bank can do this. Everybody else in the system has to have the money first. The CB creates the funds it uses to buy the government stock. It can add to its assets (in this case, government stock) and its liabilities (bank at-sight deposits with it) to an unlimited extent. This is what Central Banks have been doing for well over 200 years. In a financial crisis they intervene in the bond and money markets to prevent a temporary panic becoming a major economic disaster.

But Germany refuses to allow the ECB to do this. The Germans are still fighting the last war, so to speak. After the first World War and the second, Germany suffered hyperinflation because of excessive use of the printing presses to finance government spending. The problem now, though, is the risk of deflation. You do not want to have falling prices in heavily indebted economies. You do not.

And Germany (rightly) maintains that the Greeks and Italians got themselves into this mess and must now do the hard yards to get themselves out of it. Well, yes. But if you live in the top storey of a a block of flats and a flat on the first floor starts burning, you don't refuse to help because its their own stupid fault. You provide unlimited water, because if the fire spreads your flat will burn too. Already fiscal tightening (raising taxes and cutting government spending) will cut 1 to 2% off Euro GDP next year. And the banks are contracting their balance sheets, to try and get their equity up to a "safe" percentage -- i.e., they're contracting lending.

The chart says it all. It shows Euro IP (Industrial production) and the PMI (Purchasing managers survey). The PMI leads by a couple of months. It's heading south fast.

The ECB should cut the discount rate, now, to 0%. It should announce that it will buy Italian government bonds to whatever extent necessary to keep yields at 6% or below. Of course, the ECB will eventually act. But will it move before Europe's "Lehman moment" or after?

Crunch time.

Will the ECB save the Eurozone?

2011-11-15T16:32:00.001-08:00

Laurence Knight, BBC finance blogger, says:

100,000 Mark note: hyperinflation

From the beginning, the obvious solution to the crisis - as many economist have been loudly shouting - is for the ECB to weigh in.

As the central bank, it is the gatekeeper of the eurozone's money supply. So it can simply create out of thin air the cash that is needed to rescue Italy.

If the ECB stood unambiguously behind Italy, by making an unlimited commitment to buy up the country's debts, then investors' worries about whether those debts can be repaid should evaporate.

Of course, printing money does not solve the longer-term problems that got Italy (and other southern Europeans) into their current pickle in the first place.

It does not cut Italian wages to more competitive levels. It does not make Italy's debts or overspending disappear. And it does not break the albatross-like stranglehold of vested business interests on much of the Italian economy.

But it will help. Because the longer the crisis goes on, the more that business confidence, consumer confidence and confidence in Europe's banks collapses, and therefore the more collateral damage is done to Europe's economy.

And a recession right now will make Italy's economic problems even harder to solve.

Exactly. Precisely. When are they going to get it?

Read the whole article here. It's good.

The Domino Effect

2011-11-04T01:32:00.000-07:00

An excellent summary of the way the interconnections in Europe make it far more than just a Greek problem.

But finally the ECB starts behaving like a real central bank, and cuts rates. Not be enough, and too slow, but better late than never.

The Greek end-game

2011-11-02T19:05:00.000-07:00

An insightful article by Ambrose Evans-Pritchard.

He's right.

So why should we buy shares?

The only argument I can think of is that this will force the ECB to behave like a proper central bank and force it to act as a lender of last resort and supply unlimited funds to European banks. But what if they don't?

Looks to me like the technicals suggest the market's going higher. For now I'd be reasonably fully invested. But if the 30 day moving average turns down and the 150 day moving average at that point is still falling, I'll sell.

World IP

2011-10-15T19:21:00.000-07:00

World IP (Industrial Production) continues to show divergent trends in developed and emerging markets. The decline in growth in the BRIC countries looks as if it has stopped, but the OECD countries (most of which, with the key exceptions of Mexico and Turkey, are developed countries) are still dragging along at around 1 percent. That includes Germany which is still strong. Not exactly boom conditions for the rest.

However, the world IP diffusion index suggests growth is accelerating again. A diffusion index will tend to lead changes in the underlying data. Notice how the diffusion index suggested a renewed acceleration in world growth early this year but turned down after the Japanese earthquake and US mid-west floods. If -- a big if -- Europe manages to avoid recession, my guess is that the world recovery will accelerate. In my view, to avoid a European relapse into recession, the ECB will have to cut rates. Which they prolly won't. Still, they might. So we keep watching.

First data points for September

2011-10-14T18:20:00.000-07:00

In the US, we've got the two ISM surveys and the employment data. I've updated my coinciding index for September. Employment data for previous months were revised up, often an indication that the economy is strengthening. Previous months' retail sales data were also revised higher. The chart below suggests that though growth has slowed somewhat, the economy is not entering a "double dip".

The picture for Europe is much less rosy, and a European credit crisis will see the US turn down again. I'm waiting for an effective European policy response before I recommit to the market.

Thumbs Down for Bank Plan

2011-10-14T00:57:00.000-07:00

European PMI

An intriguing article from the London Telegraph via The Age.

The message from bankers at the Association for Financial Markets in Europe (AFME) annual dinner in London this week was a concerning one. This was not because of the reference by the guest speaker, Jean-Claude Trichet, to just how close the world has come to a repeat of the Great Depression. Even the European Central Bank president would no doubt admit that’s still very much a real and present danger.

Rather, it was because there seemed to be scarcely a person in the room who thought the grand plan to recapitalise the European banking system would do the trick. Indeed, many took the same view as Josef Ackermann, chief executive of Deutsche Bank, that it’s likely to be outright counter-productive.

The overwhelming message was: We don’t need this new capital. And if regulators really are going to force us to mark sovereign debt to market and backstop capital to 9 per cent, then we’ll be doing it by shrinking the balance sheet, not by raising new equity at today’s penalty rates. Thanks very much, but no thanks.

What is needed is unlimited lending by the ECB to the banks at an interest rate way below the inflation rate until the crisis has passed. And until we really are in crisis, that isn't going to happen. Meanwhile, the European economy is sinking back into recession.

Huddle and muddle

2011-10-10T02:05:00.000-07:00

(Apologies for the long gap in posting. I've been too busy restructuring portfolios to write much.)

Recent massive market instability has reflected substantialuncertainty about policy (and therefore outcomes) in major countries.

In the United States,the political paralysis in Washingtonhas prevented sensible policy initiatives which would have helped supportgrowth. Despite President Obama's "Jobs Package", this hasn’t changed, since Congress won't do anything. At least, though, the Federal Reserve Bank retains the freedom ofaction to increase monetary stimulus if fiscal policy (taxes and governmentspending) is tightened too much.

In Europe, the situation ismuch more serious. If Europewere a true single entity for fiscal and monetary purposes, then we’d be muchmore confident of a solution to her pressing problems. Ostensibly, it is such an entity. But in fact it is not, because only a verysmall percentage of EU-wide revenue is raised by the EU itself. It’s as if, in Australia, the Federal governmentreceived handouts from the states instead of the other way round. And although there is again supposedly asingle monetary area because of the single currency, the Euro, in fact the ECB(European Central Bank) is dominated by Germany (its head office is inFrankfurt where the German Bundesbank’s offices are), and its councils aredivided against themselves.

In a genuine single currency/single fiscal entity, bank andsovereign debt problems can ultimately be resolved by printing money. In the US, if necessary, this is what theFed will do (which is why the gold price is so strong). In a true European Federation, banks wouldhold government bonds from all the constituent parts of the Federation withoutworrying about individual national fiscal imbalances, and if question roseabout the countries’ ability to repay these debts, the ECB would, as Central Banksdo, simply buy up the government paper, as well as extend unlimited support tothe banks it oversees, regardless of their domicile.

But in Europe, both theGerman politicians and the ECB have dragged their feet at each stage of thecrisis. At each stage, too little wasdone to resolve the issue. At one pointthe ECB even refused to buy Greek debt or accept it as collateral for loans tobanks. Understandable perhaps, but notwhat a Greek central bank would have done (which is why, of course, Greekinflation was always much higher than the European average before it joined theEuro), and not what was required by the situation. To drawan analogy, it’s as if the Sydney-based RBA were to refuse to support a bank inPerth or Brisbane.

The political compromises inherent in the creation of theEuro have started to unravel. Theessential role of “lender of last resort” undertaken by any central bank worthits salt, has been performed with reluctance and self-defeating caveats by theECB. This raises the risks enormously.

What we don’t know is whether this untenablesituation will be resolved cleanly or with a great deal of messy “collateraldamage”. Given the ineptitude andparalysis of both the ECB and the EU itself, the chances are high that theywill only act after the fact. By whichtime, European markets will be substantially lower, and our market withit. On the other hand, good policy maystill happen, and if it does, we will have seen the low point of world sharemarkets. This wide range of possibleoutcomes is reflected in the very large day-to-day volatility in financialmarkets globally.

What this implies for investment decision-making is that neither“value” nor “growth” can be easily determined right now. With a wide range of possible outcomes,choosing the one in the middle will most definitely not lead to superiorinvestment performance—the gap is too wide. Until we know what will happen, we must be watchful and prepared to movequickly, reducing or increasing exposures to shares as required. There istill the possibility of a substantial rally. But risks are increasing.

It’s worth repeating that China andalso the other BRIC countries (Russia, India, Brazil) will continue to grow,particularly China, where the authorities are redirecting demand internally,and whose finances are sound. Consumershave high savings rates, houses are bought with 60% or less loan finance, andinternal demand is robust.

As an aside, Chinahas enough gold and foreign exchange reserves ($3 trillion) to buy up theentire Republic of Italy’s outstandinggovernment debt ($2.4 trillion). Or, toput it another way, China has almost enough money—just in its gold and forexreserves, and without having to borrow any funds—to buy the top 20 US companies(total market cap $3.5 trillion). This includes Exxon Mobil, Wal-Mart, Google,IBM, Apple, Johnson & Johnson, Proctor and Gamble, Merck, Pfizer, Chevronand so on and so on. This is the sort offinancial firepower that the USonce was able to marshal.

Very difficult times, as hard and as confusing as any I've encountered in my 40 years managing money.

Class war

2011-09-21T20:20:00.000-07:00

Billionaire Warren Buffett pointed out that he has a 17% tax rate, lower than all the other 20 ppl in his office who have tax rates between 33 and 40% but who have much lower incomes than he does. He thinks it should change. It should.

Time to split banks

2011-09-18T14:04:00.000-07:00

UBS has just shown again why banks are not to be trusted.

Historically, banks which lent money (for example to buy houses or fund trade) were separate from banks which traded in securities. But economists argued that this separation was unnecessary. Banks, they said, could be trusted to be sensible.

The GFC has I would have thought decisively destroyed that rosy view of banks and bankers. The greed and folly of the banks plunged the world into a financial crisis which has still not been resolved.

When banks are "too big to fail" controls and regulations need to be tightened. Banks involved in trading shares/currencies/derivatives should have much higher ratios of capital to assets than banks lending money to buy houses on conservative loan to valuation ratios. The Lebanese banking system had no crisis during the GFC because Lebanese banks only lend you 60% of the value of the property. With bank assets bigger than GDP, it's quite clear that lending banks should be tightly regulated, even as "merchant/investment banks" are not.

No one minds banks losing their own capital. But when profits are privatised and losses socialised it's time to act.

US now = Japan in the 90s?

2011-09-18T13:48:00.000-07:00

Another thoughtful article from Stephanie Flanders of the BBC.

Some quotes from the article:

In terms of economic growth, the US's performance over the last five years now looks no better than Japan's in the five years after its asset bubbles burst in the late 1980s. Indeed, in employment terms it has been considerably worse.

The jobs picture was already bleak at the start of the year - but, if anything it now looks even worse, with unemployment still hovering around the 9% mark, and a record 40% of the jobless now unemployed for more than six months.

In the past, economists have tended to laud the flexibility of the US labour market: unemployment might rise more quickly in a recession, but it would then fall more quickly as the economy recovered, and long-term unemployment was always much lower. Now US labour flexibility seems only to be operating in one direction, while the "over-regulated" German labour market has performed surprisingly well.

A few startling statistics highlight the failure of the US economy to deliver jobs for its rising population: in 1958, 85% of working age American men were in work. Today, less than 64% have jobs, and - in case you think that is simply due to women entering the workforce - the share of all Americans, men and women, in work is now lower than it has been since the early 1980s.

It's not only jobs. In its latest assessment of the US economy, the IMF looked in detail at the past ten US recessions. On nearly all the key measures - loss of output, employment, investment or growth in personal disposable income, the two downturns of the 21st century (2000-1 and 2008-9) have been the worst.

That is what gives rise to the suggestion that the US has already suffered a "lost decade" - at least on Main Street. Real average household income fell by 3.6% between 2001 and 2009, and real incomes have fallen again in 2011, as inflation has picked up but wages have remained flat. The weakness in earnings is also uncannily similar to Japan (see Capital Economics chart 8).

All the evidence suggests that the US model of aggressive (some might say vicious) capitalism has failed.

US Coinciding Index for August

2011-09-16T16:11:00.000-07:00

I have all the data for my US coinciding index for August except one, which I've estimated. In contrast to the weak employment data, the index is surprisingly robust. I've plotted the 3 month rate of change in the index against a weighted average of the ISM industry and ISM services surveys. Both series have been extreme-adjusted to remove statistical aberrations. On the face of it, these data do not yet point towards a double dip.

The correlation between these two indicators is very close. Of course, the 3 month rate of change would tend to lead the underlying series, which account for the absence of any leading relationship in the ISM surveys.

As always, clicking on the chart will give it you in the original size.

Finally

2011-09-15T19:40:00.000-07:00

The European pollies continue to dither, but the key central banks are taking action. Finally.

Stephanie Flanders has a thoughtful blog post about the whole mess here.

I still think Greece will effectively default. Its burdens are too great now. But .... it's just possible that the default will be orderly.

Interesting times. I took some money off the table a few days ago, despairing that the Europeans would get their actions together. The outlook today is brighter. Somewhat.

World Growth

2011-08-26T21:18:00.000-07:00

Here's my chart of year-on-year growth in OECD and BRIC industrial production (2007 GDP weights) OECD growth appears to be still decelerating, though more slowly. Growth in Europe has basically stopped (chart not shown). Once again, the ECB (European Central Bank) has demonstrated its rank incompetence. It needs to cut rates now, before it's too late. Certainly it ought to be doing some fairly serious quantitative easing. The US is OK, Eastern Europe is growing slowly but still positive (chart not shown), and the BRIC countries continue to grow solidly (on average) though a biggish chunk of that is now coming from China.

The US Budget Problem

2011-08-25T20:52:00.000-07:00

The people want more spending, but they won't vote for higher taxes. In fact, they want tax cuts as well. The budget deficit took years to get here, and what's needed is not a massive spending cut/tax hike now (because that will plunge the US back into deep recession) but a plan over 5 or 10 years to achieve balance.

Fix the Fiscal Roof only when it's sunny

2011-08-20T16:33:00.000-07:00

An insightful article showing why household finances are not the same as the finances of a country.

Fairies at the Bottom of the Garden

2011-08-19T23:19:00.000-07:00

By KAL from The Economist

My Coinciding Index for the US for July

2011-08-16T22:46:00.000-07:00

We have most of the components now. Extreme-adjusted (a process which removes statistical aberrations), it rose 0.36%, unadjusted 0.40%. Quite respectable, really. It looks more and more plausible that at least part of the weakness in previous months was due to aftereffects of the Japanese earthquake and tsunami, and floods in the US Midwest. You can see the effects very clearly in the "level" chart (the lower one)

The Global Public Debt Problem

2011-08-16T19:58:00.000-07:00

This chart sums it up.

So should all the big deficit/big debt countries be slashing spending and upping taxes? No. Because that will just worsen the downturn and in turn increase the deficits and the debt. So how do you square this circle? You freeze spending, not cut it, and you increase taxes (modestly) in future years. You can freeze spending by freezing defence spending, and removing or reducing indexation of pensions and public sector salaries. While you're at it, you might also do some fundamental reforms, for example by introducing a gradual increase in the old age pension qualifying age. Then you make sure monetary policy is very accomodative, and if inflation drifts up a little you pretend you haven't noticed.

Don't hold your breath.

Deep recession, but very sluggish recovery

2011-08-16T19:28:00.000-07:00

Total employment is shown as a percent decline from the peak for each cycle. The GFC crisis caused the biggest decline since the war. In the past, sharp declines have been followed by sharp increases. But not this time.

Frankly, despite the rebound in the markets I'm beginning to wonder whether the required yield on shares isn't going to start rising. Which will mean that share markets will struggle. Perhaps (and it's only perhaps, so far) this is a dead cat bounce. I'll be watching the technicals very closely for the next couple of months.

[Source: Morgan Stanley]

America is rotting at the core

2011-08-15T13:51:00.000-07:00

An excellent guest article in Melbourne's The Age newspaper, by Hugh White from the Lowy Institute.

[...] until now it has been easy to assume that America itself is not in decline: that the global power shift is driven by China's growing strength, not by American weakness. China might grow stronger, but America would remain a uniquely vibrant, resilient and innovative country, and a beacon to the world.

Now one has to wonder. It is possible that we are witnessing not one but two remarkable national transformations, as America stumbles while China ascends. If so, that will make the shifting power balance between them much faster, more destabilising and more risky than we thought.

[...]

As manufacturing has declined, its place has been taken by new ''knowledge'' industries such as finance and IT. But these industries do not create the vast numbers of well-paid jobs that once provided the bedrock of American society. Instead they provide very high paying jobs for relatively few people. This produces the second big long-term change in America's economy - the stagnation in average incomes.

While the relatively few people who work at the top end of America's growth industries have done very well, average incomes have hardly risen for the past 30 years. That's a very sharp contrast to what's happened in Australia, for example, where average incomes have been rising steadily.

[...]

Which brings us to politics. Clearly America's political system has always been untidy, but it has mostly produced good government. Governing America has, however, become harder over the past few decades. Politics everywhere is first and foremost about choosing how to distribute wealth. Until recently the choices have always been relatively easy in America, because there has been a lot of wealth to go around. Now there is, relatively speaking, less to go round, the choices become harder, and the struggles over them intensify.

Several things then happen. First, the debt grows, as both government and people try to avoid choices by borrowing money. Second, politics becomes polarised, as voters scrabble harder for the choices that suit them best. Third, people become susceptible to any politician who can convince them that somehow the hard choices do not have to be made.

Americans believed George W. Bush when he said they could invade Iraq and cut taxes. And they believed Barack Obama's beguiling mantra. ''Yes, we can'' was a promise to Americans that they did not have to make hard choices - a promise he could never keep. Now many Americans seem to believe the Tea Party that cutting taxes will fix everything. As if.

A tale of two worlds

2011-08-11T15:00:00.000-07:00

This chart is fascinating. At least I think it is. It shows the level of industrial production, indexed to January 2008, the beginning of the GFC.

Note how OECD IP (industrial production) is still below the peak in January 2008. But BRIC (Brazil, Russia, India, China) IP is now nearly 40% above the January level. Note also how the recession in the BRIC countries was mild and short, while in the OECD as a whole (there are exceptions: Turkey for example) the recession was very deep and the recovery, contrary to the usual pattern, where a sharp downturn is followed by an equally sharp upturn, output is rising only slowly and tediously. And this is despite massive monetary and (initially) fiscal stimulus.

Debt is an obvious reason, and the tea party numpties' desire to eliminate the deficit is superficially laudable but actually beyond-belief cretinous. Cutting government spending now will push the US back into recession. In 1937, after a long and painful recovery from the Great Depression, the last downturn caused by excessive debt, the Republicans who had gained control of both houses in the previous election (though the President remained the Democrat Roosevelt) , cut the deficit ("it will restore confidence") and plunged the US back into the deepest recession since the Great Depression. Does mankind ever learn?

Meanwhile, thank your lucky stars that despite the brainless ningies in Washington, China is still growing fast. For without it we really would be in the dwang.

Red Means Recalcitrant

2011-08-10T18:46:00.000-07:00

This Economist blog post had this incredibly revealing chart:

That about sums it up, neh?

Forget the US -- we're dependent on China now

2011-08-06T17:10:00.000-07:00

In an article in Melbourne's The Age newspaper, Michael Pascoe pours scorn on those Ozzies who tremble when the US struggles.

It's worth reading, not just for fellow Ozzies but also for those Americans who care about where the American economy, and with it America's power, are headed.

Nearly 40 per cent of China's exports went to the US in 2001. Now that figure is down about 20 per cent and falling as a matter of policy. The China Daily runs stories about exporters diversifying, targeting markets in Brazil, India, Egypt, anywhere other than the US. It's an entirely obvious strategy as two-thirds of the world's growth already comes from outside the G-7, the ''old world'' major industrialised nations.

What's more, Beijing knows it has to flick the switch from exports to domestic consumption to maintain the strong economic growth it needs for social stability. That's officially spelt out in the latest five-year plan. And, unlike the US, China is actively pursuing the required economic reform instead of just talking about it.

Good news for Australia. Depressing for the US. The US's inability to come to terms with the facts reminds me of another great power, Great Britain, taking 30 years after the second world war to sort out its economic mess. Will American pollies be that blind and stupid? I'm very afraid they will.

Not yet a recession

2011-08-04T21:43:00.000-07:00

So we have the two ISMs for July and the components for my coinciding index for June. Weakening but not yet indicating recession -- more of classic mid-cycle slowdown. Tonight we get payrolls, unemployment and overtime, all reliable indicators.

Meanwhile there's blood on the streets. I recommend against panicking.

The Long Term

2011-08-01T22:42:00.000-07:00

We're inclined to worry a lot about short-term fluctuations in markets. The media love drama: they sell more newspapers/get more hits in bad times than on ordinary. "Stock Market Losses Top $5 billion" is a catchier headline than "Stock Markets Gains Top $5 billion" Actually, though, in the fullness of time, the short term wobbles translate into huge long term growth.

Source:AMP Capital Investors, figures within brackets denote peak to trough % declines

This chart from AMP Capital Investors (and alas, it's the biggest I can make it), shows the long-term movement of the Ozzie stock market. This is the total return, i.e., represents capital plus dividends and has been plotted with a log scale so that percentage movements are the same anywhere along the y-axis. A chart for the US would have a different slope but the same aspect.

The long term return since 1900 has been 11.8% per annum (or 7.7% after inflation). The calculation assumes that dividends are reinvested. This period includes the great depression, the 1960s stock market stagnation (remember the nifty 50 share bubble?), the 1987 crash and the GFC. The return since 1950 has been roughly the same. You often hear people say, Oh, I doubled my money on my house since I bought it 20 years ago. That sounds like a lot, doesn't it? Yet it is a measly 3.5% per annum! 11.8% will increase your money by over 9 times over 20 years. (I had to check that calculation to be sure I was right)

The markets may well go lower in the short term. But there's every reason to believe that in 20 years time, assuming your reinvest your divvies, you'll have a lot more than you do now. And on that time horizon, at least here in Oz, it's a good time to buy.

The Debt Deal

2011-08-01T13:38:00.000-07:00

Paul Krugman is right. Obama has given in to the right wing extremists in the Republican party. Once again America has shown its uniqueness. In the worst possible way.

Start with the economics. We currently have a deeply depressed economy. We will almost certainly continue to have a depressed economy all through next year. And we will probably have a depressed economy through 2013 as well, if not beyond.

The worst thing you can do in these circumstances is slash government spending, since that will depress the economy even further. Pay no attention to those who invoke the confidence fairy, claiming that tough action on the budget will reassure businesses and consumers, leading them to spend more. It doesn't work that way, a fact confirmed by many studies of the historical record.

Paul Krugman's overstating the case a little here, since its seems to me that most of the cuts are later rather than earlier, and "entitlements" had to be reined in because they were growing too fast. But there will be big cuts shorter term as well. And that's batty. Yes, the deficit does need to be cut, but not savagely, and not yet:

Indeed, slashing spending while the economy is depressed won't even help the budget situation much, and might well make it worse. On one side, interest rates on federal borrowing are currently very low, so spending cuts now will do little to reduce future interest costs. On the other side, making the economy weaker now will also hurt its long-run prospects, which will in turn reduce future revenue. So those demanding spending cuts now are like mediaeval doctors who treated the sick by bleeding them, and thereby made them even sicker.

And here, he is again exactly right:

And then there are the reported terms of the deal, which amount to an abject surrender on the part of the President. First, there will be big spending cuts, with no increase in revenue. Then a panel will make recommendations for further deficit reduction - and if these recommendations aren't accepted, there will be more spending cuts.

Republicans will supposedly have an incentive to make concessions the next time around, because defence spending will be among the areas cut. But the GOP has just demonstrated its willingness to risk financial collapse unless it gets everything its most extreme members want. Why expect it to be more reasonable in the next round?

In fact, Republicans will surely be emboldened by the way Obama keeps folding in the face of their threats. He surrendered in December, extending all the Bush tax cuts; he surrendered earlier this year when they threatened to shut down the government; and he has now surrendered on a grand scale to raw extortion over the debt ceiling. Maybe it's just me, but I see a pattern here.

This is The Economist's take:

If Republicans are the clear winner from this deal, the economy is the loser. An ideal deficit-reduction package would have coupled near-term stimulus with long-term consolidation that stabilised then reduced the debt as a share of GDP. This deal certainly doesn’t do the first and it’s unclear that it will do the second. True, it does not add significant new fiscal tightening: total discretionary spending would be a mere $7 billion lower in fiscal 2012 and $3 billion in fiscal 2013 than current levels, according to a Democratic Senate fact sheet. On the other hand fiscal policy is already set to tighten automatically; the International Monetary Fund estimates by the equivalent of 1.4% of GDP. Mr Obama had hoped to extend the payroll tax cut as part of the deal. He may yet do so during the Congressional negotiations, but that seems a fading prospect. It is striking that last Friday’s appallingly weak GDP data did nothing to shape the deal any further in the direction of near-term stimulus.

As for long-term fiscal consolidation, the deal also falls short. Total deficit reduction of $2.5 trillion is less than the $4 trillion that bipartisan groups and political leaders had more or less agreed was necessary to put the debt on a meaningful downward path relative to GDP. It’s also the number Standard & Poor’s, a credit rating agency, had suggested was necessary for America to avoid a downgrade to its AAA credit rating. And it’s worth noting that now that GDP has been revised to be smaller than we’d realised, debt is larger as a share of GDP.

In the end, hopes for a grand bargain that addressed entitlements, taxes and near-term economic support ran aground on the harsh reality that all these things would require bridging profound philosophical differences that have developed over decades. The odds that the next few months will yield a different outcome seem low: further brinkmanship (albeit of a less terrifying sort than seen in the past weeks) is more likely. That has become the routine way that fiscal policy gets made in America. True, stockmarkets rallied with relief that the most reckless path has been avoided. Meeting such a low standard should hardly be considered a vote of confidence in America’s fundamental fiscal and political maturity.

Meanwhile, while US pollies focus entirely (and ineptly) on domestic issues, China continues to grow at 9% a year and the US at 2%. In 10 years time, the US economy will be 25% larger, the Chinese 240%. China will be the world's largest economy. Those of us who admire the US have cause for much concern.

What keeps me awake at night

2011-07-28T14:08:00.000-07:00

Something goes seriously wrong in China. Without Chinese growth, there would be virtually no world growth. The countries in Europe which are doing well (Sweden, Germany, Switzerland, Czech Rep) are doing it on the back of exports to China, and surrounding the success stories is a fringe of over-indebted potential defaulters. I'm not saying it's likely, but it's what I'm keeping a close watch on. After all, Czarist Russia was the fastest growing economy in the world in the decade up to 1914. It didn't get back to that level of output again until the mid-1950s.
Fringe Europe defaults messily. An organised default (labelled a "restructuring") would be OK. But if Greece walks away from its debts, and then Ireland, and the Portugal, things would be grim, because after that we'd be wondering about Spain and Italy. Of course, the crisis would force the pollies to act. But while they dithered, share markets would decline. This is a reasonably high risk. And what really worries me about this is that an already sluggish Europe would be pushed back into recession, taking the rest of the world with it. My judgement: a Greek default/"restructuring" is a certainty sooner rather than later. The others should struggle on. But I worry that I'm wrong.
The US has its own excessive debt/too low savings rate problems. Plus ... the US might inadvertently default on its debt. This is the world's largest, deepest and most liquid bond market; the dollar is the world's reserve currency;, the US has (still) the world's largest economy. I don't think the Tea Partiers will push the US into default, but if they do, all bets are off. Default would paralyse the banking system and crush loans. A second GFC. That's just what we need right now. If that happens, I'll be selling everything and going into cash.

Bull markets climb a "wall of worry". However ....

Oops

2011-07-28T04:10:00.000-07:00

Big falls overnight on Wall Street and in Europe. The brinkmanship continues. Are US pollies really going to push the world into another GFC? Can they really be that partisan and demented to drive their economy and the rest of the world into another serious recession? Whatever happened to noblesse oblige?

I'm starting to worry, now, that they will. O tempora! O mores!

The US Debt Ceiling

2011-07-25T14:28:00.000-07:00

Common sense suggests that that spending be cut and taxes be increased. But so mired in their dislike for the other party are they that Congress cannot come to an agreement. From here, it looks as if it's the Republicans who are being more recalcitrant, refusing point blank to raise taxes.

If the debt ceiling isn't raised, the Federal Government won't default on the debt. What it will do is stop paying salaries of government departments. Maybe, to concentrate their minds, they could start with salaries and expenses for Congressmen and Senators.

Tea Party Numpties

2011-07-21T19:50:00.000-07:00

Looks as if some sort of compromise is happening. As some political commentator once said about the British Cabinet: Nothing concentrates the mind of the Cabinet quite so much as a fall in the Pound. Do any of the pollies playing chicken with the US debt cap know just how dangerous a default by the US would be? I suspect the intelligent ones (if that's not an oxymoron) do. Which is why I'm not selling and running screaming for the hills. (Why the hills?)

The Debt Doom-Loop

2011-07-17T17:41:00.000-07:00

Let's suppose a country (Greece, for example) owes 150% of GDP. Now let's suppose that it has been paying, say, 4% on 10 year money. That means that the interest on government debt as a percentage of GDP is 6% (4%*150%). If tax revenue is, say, 30% of GDP, interest alone will use up 20% of tax revenue.   Put it another way: if the government wishes to run a balanced budget, taxes as a percentage of GDP have to be 25% higher than they would have to be if there was no debt.

A moderately parlous situation, but the markets could live with this if they believed the government was going to "trade its way" out of the mess, by for example, running a balanced budget.   Over ten years, real growth of 2.5% and inflation of 2.5% will increase nominal GDP by two thirds. This will reduce the ratio of debt to GDP to below 100% and the ratio of debt interest to revenue to below 4%. You don't even need to run a surplus for this improvement to happen.

However, suppose the government goes on running deficits. Let's suppose its deficit is a modest 5% of GDP. Let's also assume that its outstanding debt has an average life of 10 years, so that one tenth comes up for refinancing each year. In fact (bizarrely) most governments have debts with much shorter average lives, often as low as 6 or 7 years, with maturities skewed towards 3 or 4 year paper. On our assumptions, the government would have to borrow 15% of GDP each year, 10% refinancing and 5% new money. In practice the numbers would be much higher, because more of the debt would mature each year.

All well and good, as long as the markets trust the government.

What happened in Greece was that the previous (Conservative!) government lied about the level of debt and the size of the deficit (O tempora! O mores!) The new government trumpeted the sins of its predecessors to the market shortly after it came to office (instead of keeping quiet and moving as fast as it could to rectify the situation behind the scenes). The market panicked and the yield on Greek debt started to soar.

At an 8% yield, say, the debt cost doubles as a percentage of GDP. Not overnight, because only some of the debt is maturing.   On our very conservative assumptions, the Greek government would have to borrow/refinance 15% of GDP each year -- though in practice it could easily be as high as 30% of GDP because of the short profile of total oustanding debt.   That means that the deficit widens by at least 1.2% of GDP more each year that interest rates remain at 8% instead of 4%. Remember that debt maturities were much shorter in Greece and the deficit much larger. And that current yields are now 17%. Suddenly the situation slips out of control. The markets sell more Greek bonds which pushes up bond yields even more, the deficit gets worse, the markets get more frightened ... and wham! A massive doom loop emerges.

It becomes impossible for the government to "trade its way" out of the crisis. Tax increases and spending cuts become inevitable. But this reduces GDP growth, which makes the deficit worse and also makes the market more convinced that the government will in the end be unable or unwilling to honour its debts. Yields rise again, the deficit gets bigger, another "package" is introduced, things get still worse, etc, etc. That's where Greece is now.

And that's why most analysts reckon that a government shouldn't let its debt get above 100% of GDP. At that point the risks of a self-feeding meltdown rise alarmingly.

Chart from http://www.usgovernmentspending.com/index.php

US government debt is perilously close to 100% of GDP. The Tea Party crackpots want to cut expenditure (while not cutting Medicare, despite it being "socialized medicine"). The Democrats want to raise taxes (while not cutting entitlements). Either remedy would slow growth, making the deficit worse. Draconian tax increases and spending cuts now will push the US back into recession. But reforms in the out years, cutting both spending and increasing taxes would convince the markets that the problem is only temporary. Right now, it looks as if the US is going down the Greek path of pollies taking no action at all. Greece is just 0.5% of the world economy. The US is over 20%. The risks are obvious.

[As usual, clicking on the chart will produce a bigger image]

Getting out from under

2011-07-14T17:08:00.000-07:00

An interesting interview with Jim O'Neill of Goldman Sachs London about the Greek debt crisis, made before the Greek Parliamentary vote. Longish but worth listening to. (For those who don't know, his accent is midland English, though the 'f' instead of 'th' is an individual quirk, one my dad had too. Of course, maybe he's just lived in London a long time: the f/th alternation is something the Cockneys do too.)

Greek 10 year bond yield

The problem is that raising taxes and reducing expenditure merely deepen the economic downturn which in turn reduces tax revenue and increases government expenditure all over again. This dynamic has already happened in Greece which is why we're having this second package, and in a smaller way is happening in the US, where employment growth is puny because state, local and federal government employment has fallen by nearly a million since the GFC as states and municipalities try to balance their budgets. At the same time, the doubts about creditworthiness lead to interest rates on government debt rising (as shown in the chart on the left, from Bloomberg.) Refinancing old debt at higher interest rates causes the deficit to balloon even further, thus increasing doubts, which causes even higher rates and further tax increases .... The doom loop continues until there is a circuit breaker. So far the pollies on either side of the Atlantic haven't produced any suggestion of a circuit breaker, as O'Neill points out. A circuit breaker would be O'Neill's suggestion of a central Euro lending authority, for the portion of government debt below 60% of GDP. Or it might be a refinancing of short-dated debt liabilities with longer-dated instruments at lower yields, a la Brady bonds plan from the late 1980s, with the banks "taking a haircut". The ECB (European Central Bank) is against this, but frankly, the ECB hasn't covered itself with glory over the last few years, and it may be time to tell them to go take a jump.

If the crisis spreads to the other PIIGS (Portugal, Ireland, Italy, Greece, Spain) it could be both bad and good. Bad initially, because markets will not like it at all, but good later because it might be enough to get the pollies to engineer a solution. We shall see. Getting out from under will take more than pious protestations.

China leads the charge

2011-07-13T20:19:00.000-07:00

China continues to grow at astonishingly rapid growth rates. Malcom Maiden of The Age comments here.

If you smooth the data, IP continues to grow at around 14%, which means, if it goes on (and it prolly will), that industrial production will rise over three and a half times over the next ten years.

Sounds ridiculous? Remember, Japanese IP grew at between 15 and 20 % from the early 1950s until the first oil shock (1973). No reason why China shouldn't do the same. Except pollution. (Which is why, BTW, China is going to become a very keen member of the control-carbon-emissions mob)

The most recent piece of data which jogged the share markets higher was Q2 GDP. Now Chinese data are a bit dodgy, everybody knows that. All the same, if you cross-check IP with say electricity usage, freight volumes, etc. etc., whatever the exact growth rate is, the number is large. So the Q2 yoy GDP increase of 9.5% may well in fact be somewhat lower. Or higher. Whatever. It's still much much higher than in other countries. And if true, and continued, Chinese GDP would rise 2.5 times over the next ten years. And that would make it the world's biggest economy.

A while ago, I noticed that Wall Street had started to respond to Chinese data. And I found that most intriguing. The rise of China changes everything:politics, economics, the global power balance, the environment. Whereas Europe and the US are constrained by low savings rates and high debt, China is not. Not that any of the US pollies would notice that their petty childish deliberations are irrelevant in the face of this major shift in the world's centre of gravity. They might just let off the bomb by not raising the debt ceiling. Sigh. Tell me, do democracies deliberately select cretins to run themselves?

Mid-cycle blip ... or something worse?

2011-07-11T04:02:00.000-07:00

Friday's employment data weren't exactly scintillating. Everything was worse than expected: payrolls, the unemployment rate and overtime hours. I've mentioned before that the payrolls data underestimate employment growth initially in the first year of the recovery, with the underestimation only being corrected years later with the census. So the employment numbers are prolly a bit better than the headlines. But this underestimation doesn't affect the unemployment data (which come from a different survey). And unemployment and the unemployment rate went up.

This is the first time in 50 years that the unemployment rate has risen so soon after the cyclical turning point. OK, the Japanese earthquake and tsunami had some impact, as did the mid-west floods. All the same ...

So far I'm sticking to the view that this is a classic mid-cycle blip. But I'm now watching the data very closely. And I suspect the Fed is too. Japan had 20 years of stagnation after its property bubble burst back in 1990. What if America is going to go through a similar experience?

More on that dismal prospect in the next post.

Debt, debt and yet more debt.

2011-06-29T20:31:00.000-07:00

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.

The GOP's Abstract Professors

2011-06-26T19:30:00.000-07:00

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.

Japan IP starts to recover

2011-06-24T02:29:00.000-07:00

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.

Get Rich Slowly

2011-06-22T18:58:00.000-07:00

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.

AMP sees shares as "very cheap"

2011-06-22T03:10:00.000-07:00

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

2011-06-21T14:52:00.000-07:00

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.

Bank Exposure to Greece

2011-06-19T20:19:00.000-07:00

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.

The Greek Tragedy

2011-06-17T02:36:00.000-07:00

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.

The Greek Debt Crisis (again)

2011-06-15T23:46:00.000-07:00

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:

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.
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.
Share markets are a lot cheaper than they were--though they're still not screaming buys.
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.
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.
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?

The Fundamental Problem

2011-04-12T03:51:00.000-07:00

Too much debt (oh, and let's not forget the impending shortage of oil)

Look how the debt ratio collapsed in the aftermath of the Great Depression. The resulting low debt levels enabled the boom of the 50s, 60s, 80s and 90s. But each upswing needed more debt.

Debt ratios have to decline like they did in the 30s and 40s. And that is a huge structural headwind to longer-term growth.

[Source: Morgan Stanley]

Parasitical Plutocrats

2011-04-07T18:34:00.000-07:00

March Labour Stats Strong

2011-04-01T15:21:00.000-07:00

I've mentioned before how in an upturn, the estimates for employment growth from the payroll employment survey understate the rise in employment because the survey doesn't pick up new establishments at first. It's only after the census surveys, sometimes a couple of years later, that the statisticians adjust the establishment survey for start-ups. They then "panel-beat" the series backwards to make it fit in with the new census data. So the growth in payrolls of 216,000, in itself not a poor figure, likely understates real employment growth.

Both the change in the unemployment rate (inverted because it falls as the economy recovers) and overtime hours in manufacturing were very strong. The recovery is on track, and better than everyone thinks.

As usual, if you click on the chart you can see it in all its original-sized glory.

Correction over?

2011-03-21T18:30:00.000-07:00

The US market was down just 7% at the lowest point in this recent correction. Momentum (right hand chart) is now fairly oversold, not as oversold as it was during the European debt crisis of June/July last year, so it (and the market could go lower). But I suspect not: the economic recovery is just too strong. Earnings are up over 40% year on year, and much of that is coming from top-line growth, i.e., sales, not margin expansion. I'd be a buyer. For now. For the next six months, but perhaps not after, the risk of being out of the market is still higher than of being in it.

World Growth on Track

2011-03-17T17:00:00.000-07:00

I've just updated my data for world industrial production (IP).

Normally, in the kind of downturn which occurred during the GFC (Global Financial Crisis) the year-on-year change plunges as output collapses, but then zooms as output recovers, simply because the year-ago data were so low: with a low base big positives are generated even if in absolute terms you're not yet back at previous highs. It's what happens after that that is interesting. Do the year-on-year changes continue to track back towards zero, implying underlying growth is weak? Or, after the inevitable mathematically induced "slowdown" (because the base data are so low a big year-on-year change is inevitable) does the rate of change stop falling at a reasonably high level?

It's a mixed picture. Core Europe (Germany/France), in particular, Germany is sizzling. IP growth in Germany is 12 percent-ish and has been for several months. Ditto in Denmark and Sweden (not core but tied into Germany's manufacturing boom.) France is sharing (at a lower rate) Germany's boom. Spain, Italy and the UK aren't quite so hot, but they're still growing faster than they were before the crisis. Singapore, HK, Taiwan, Korea are simply racing along, and whereas growth in China slowed abruptly as the authorities tightened (don't look at interest rates for evidence -- these guys tighten the old-fashioned way, with liquid asset requirements), it now appears to have bottomed. And as I said a coupla days ago, US stats are strong.

World growth is fine. The current correction in the markets is just that: a correction. At some point, though, as spare capacity is used up outside the BRIC countries, the powerful policy stimuli introduced to combat the GFC will have to be withdrawn. It'll get interesting, then.

All data seasonally and extreme adjusted using NBER methodology

US Indicators Surprisingly Strong

2011-03-16T04:19:00.000-07:00

In particular, the ISM indices. These are now the highest they've been for two decades and are still in an uptrend.

The change in the unemployment rate (inverted, naturally, since unemployment goes up in recessions and down in recoveries) is also the highest for decades.

Employment growth is sluggish, if you believe the official data. Which I don't -- the payrolls survey always underestimates employment growth in the first year of recovery, because new firms are not picked up by the Dept of Labor. It's only later that the undercounting is corrected by the statisticians. Right now the change in unemployment is in my opinion the better indicator. And it says the strongest growth in over 2 decades -- scarcely surprising when you consider QE2.

Housing starts remain very very sluggish, however. A sign of major structural problems (too much debt, a too low savings ratio) but those haven't been enough to counteract the influence of massive liquidity injections. These underlying problems will reemerge when the stimulus starts being withdrawn -- in my judgement that's still many months away. And though share markets do look ahead, I don't think their present travails reflect a sober assessment of 2012 tightening. Which means this is most probably just a correction not the beginning of a new big one.

Watch this space.

[As usual, if you click on the charts, you'll be able to see bigger, crisper, more readable versions]

QE2 revisited

2011-01-11T16:42:00.000-08:00

When I talked about QE2 before, I said the stimulus of $2 billion in 1933 was less than the $800 billion the Fed is undertaking now. What I didn't realise is how much less. The 1933 $2 billion is about $35 billion in today's money, since price levels have risen 17.5 times since then. But the real economy has also increased 17 times since 1933. Now money/debt/bank deposits/loans etc are nominal amounts. So any monetary stimulus (whether tax cuts, spending increases or "open market operations"/"quantitative easing") have to compared to nominal levels of economic activity, not real (inflation-adjusted) levels. In nominal terms, economic activity in the US has increased around 300 times since 1933. Thus to achieve the same effect of the $2 billion then, relative to economic activity, the QE stimulus would have to have been $600 billion, and it fact it's one third higher. This stimulus is massive.

A brief aside on the quantity theory of money. Nineteenth century economists postulated a relationship between money supply and economic activity, in a formula like this: MV=PT. To de-mystify: M = the money supply; V= the velocity of money (the number of times it "turns over" -- if everybody is paid weekly you'll need a smaller money supply than if everybody is paid monthly); P=the price level, and T= the level (in volume terms) of "trade", i.e., GDP or national income. The experts will elaborate all the complexities raised by the precise definitions involved, but for the time being, forget those. It's the principle which matters.

What the Fed is doing is massively expanding the money supply/easing credit availablity. This implies either that velocity will collapse (because low confidence will stop ppl spending more); or that the price level will rise with no increase in T; or that T will rise. Now a price level rise is very unlikely. If this were Zimbabwe, with a kleptocratic hierarchy, where hyper-inflation expectations are embedded, this is exactly what would happen. In fact V would rise, as everybody tried to dump their worthless currency even faster. But in the US, price expectations are for very low inflation over the next few years (look at the yield on index-linked US treasuries). In fact, a modest rise in prices in the US would be a good thing. Only rising commodity prices are keeping inflation positive in the US, and those rising prices are due to the Chinese boom not the US one. Underlying inflation is close to zero.

That leaves V and T. If confidence is so catastrophically low that massive increases in liquidity (M) do not translate into increases in T (real economic output and demand), then V will fall, and the stimulus will fail. But confidence isn't that dire. True, it's not marvellous. But it's enough for new hiring to take place, for some new investment in plant and equipment to occur, for retail sales to hold up. So even if some of the new M is absorbed by lower V, some will feed through into T, alias real growth. And as that picks-up, so some of the stored M will be spent, and V will start to rise. In turn this will expand T which will again improve confidence leading to further rises in V and so on. The virtuous cycle.

Of course, at some point M will have to be restrained if P isn't to start accelerating. That's the trick. And it's a hard one. But it's next year's problem. I am no longer perplexed. I think economic growth will accelerate this year, dragging the market with it. Next year, though, is murkier. Withdrawal of the additional M and deficit cutting round the globe will slow growth. But that's 2012's problem, which I'll talk about later. And of course, the structural problem of too much debt (private and public) remains.

It's bad

2010-12-13T17:16:00.000-08:00

From Grog's Gamut, an Ozzie political blog, I got these two interesting charts. He in turn got them here.

The chart shows the percentage change in employment (so comparisons over long periods are possible, even though the US population has tripled over sixty years) with the deepest point of the downturn shown as month zero. This is the worst post WWII downturn, without any question. But we already knew that. What is scary is that the gap between the experience this cycle and most previous cycles is widening. Yes, employment is rising, but at the rate typical of a moderate downturn not the severe one we had. And of course, that's because the US has far, far too much debt, which in turn means that housing, which typically rebounds sharply during the recovery, hasn't this time.

The comparison with Australia is interesting though probably not instructive. For a long time we had a higher unemployment rate than the US. Now our rate is lower than the US's. The lucky country, indeed. Thanks for all our raw materials. And thank you China.

Lies, Damn lies, and Statistics

2010-12-11T23:26:00.000-08:00

The release of Australia's latest labour force survey was greeted by everybody with euphoria. The headlines trumpeted a fall in the unemployment rate, and a huge surge in employment. The digger dollar strengthened and the market rose.

But all these reactions showed how little people -- including the oh-so-wise shakers and movers -- really understand about statistical processes. The Ozzie population is around 22 million. The sample from which these data are estimated is not much over 1200 people interviewed. So from a small number the statistician has to estimate a much much larger number. This would suggest fairly wide absolute errors in the data, even if in percentage terms they would be quite small. And so it is. Look at the table below:

Movements in seasonally adjusted series between
October 2010 and November 2010

Monthly change

95% Confidence interval

Total Employment

54 600

109 200

Total Unemployment

-19 500

-50 500

11 500

Unemployment rate

-0.2 pts

-0.4 pts

0.0 pts

Participation rate

0.1 pts

-0.3 pts

0.5 pts

- nil or rounded to zero (including null cells)

Note that total employment is estimated to have risen by 54,600. In the context of the US, the equivalent jump in employment would be close to 900,000. That would indeed be a boom. But the 95% confidence interval gives a range of between zero and 109,200. We are 95% sure that employment didn't fall, nor that it rose more than 109,200. That's a big gap, folks. The markets assumed that the statistics were exact. They're not. They a blur, a smudge, a vision seen by a short-sighted person who isn't wearing his glasses.

Unemployment Rate

Now the statistical boffins in Canberra know this. They would like to have a larger sample so that they could narrow the 95% confidence limits. But the government is saving money, by keeping down the sample size. Cretins. Because the pollies don't understand stats either. All the statisticians can do is to warn us to use the smoothed trend as the guide, not the seasonally adjusted data. And note how the trend in unemployment has stopped falling and has started rising. Gently, but nevertheless it's headed higher. The RBA has been raising the cash rate. Mortgage rates have risen even faster. Loan demand has slumped. Housing clearance rates (the number of houses offered for auction which are actually sold) have fallen sharply in the two main metropolises. This indicator is an excellent guide to house prices. The Reject Shop's recent profit warning says that demand is weak. The savings ratio has gone from below zero to 10%.

Total Employment

Now let's have a look at the level of employment. Notice that it's above trend. What normally happens when a time series deviates from its trend is that it snaps back to trend. You can see how that happened in January 2010. Employment rose very sharply, only to fall a little in the next month. Remember: these are the putative centres of a blur. They are not divinely inspired numbers accurate to the last decimal place. But the trend is your best estimate to what's going on.

My conclusion is that the economy is pausing, slowing. Not to recession, not with China booming and our exports with it, but growth is definitely weakening. And the economy outside the mining sector is very weak indeed.

Even if your interest in the Ozzie economy and its markets is minimal, the lessons about statistical variance and unreliability are the same in all economies. And I wonder, when inevitably next month's data are weak, even if the trends are unchanged, will the digger dollar fall and the share market with it?

QE2

2010-12-07T23:46:00.000-08:00

QE2. No, not the ship, though it's as big as she is. Quantitative easing. It used to be called "open market operations".

How does it work? The central bank -- the Federal Reserve Board ("Fed"), or in Australia, the Reserve bank of Australia (RBA -- difficult, huh?) buys government stock or quality private sector paper such as securitised mortgages (oh, wait, those aren't quality any more) or good corporate bonds. It pays whoever it buys them from with a cheque drawn on itself (or, in truth, these days an EFT from its account) to the seller of the paper. The seller (in fact, his bank) then has additional cash (defining cash to include at-sight deposits at the Fed) He will have too much cash. If the yield curve is positive, which it is in most countries now, cash will earn very little (zero in the US, for example) while longer-dated paper (say one or two year governments) will earn a couple of percent, with loans earning even more. Of course, that's assuming you're willing to make loans and can find sound and willing borrowers, which is a problem right now. The sound ones aren't especially willing. But there will be some who are willing to borrow and likely to repay, and the amount of money available to them will have risen while its price will have have gone down. And that's what the Fed is aiming for. Because if loans increase, investment in plant and equipment will rise, asset prices will increase as valuation rates fall, and a virtuous cycle of rising demand, employment and output will have begun.

There will be an additional effect. The supply of US dollars will increase sharply. This will reduce the value of the US$ relative to other currencies, i.e., the dollar will depreciate. This will make imports into America more expensive and exports cheaper. This will add to US demand and US employment. It will also put upward pressure under prices, and that would be a good thing. Measured by underlying inflation rates, we are close to deflation. Deflation in an economy with too much debt is devastating -- it was a key factor in the collapse after the 1929 great stock market crash. The value of the debt rises in real terms when there is deflation, making repayment harder. Interest rates can only fall to zero, in nominal terms. If prices are falling, then in real terms, interest rates are above zero. Stimulus becomes harder, then as the crisis extends, impossible.

Will it work? Well, it did before. In 1933, after nearly four years of a steady downward grind in price levels, wages, employment, industrial production, sales, incomes and GDP, the Fed conducted open market operations. It bought $2 billion of federal bonds. In today's money that's less than what's proposed now, though the economy is far bigger. Within 3 months IP bottomed, within 6 employment started to rise, and the great depression was over. Prior to that the Fed had tightened monetary policy because it was afraid of inflation(sound familiar?) In 1937, the Fed tightened policy again, and the government, under pressure from earlier tea-partiers, cut spending and raised taxes, and there was a very sharp downturn. Neither Palin nor Huckabee or their ilk are intellectual giants. There's a serious risk that mistake will be repeated, with swingeing cuts to spending. But, if the Fed has anything to do with it, QE will happen, and my guess is it'll work. It won't stop the savage structural problem of an economy which saves too little, has borrowed too much, and has far too much debt (and I'm not talking about the government) , but it will resuscitate the patient for a while. The real risk will come, when as in 1937, they start to withdraw the stimulus. 2013, anyone?

Mid-Cycle Slowdown Ending

2010-11-14T17:54:00.000-08:00

US labour market stats suggest that the fairly typical mid-cycle correction will be over soon. Employment rose, though the unemployment rate was unchanged as was the very sensitive (and reliable) overtime hours series. More recent weekly data confirm this improvement.

But don't expect a runaway boom. Unless QE works flawlessly, which it won't. More of that in another post.

BTW, notice how there was a small double-dip in 2003. They happen. What's different this time is not the minor cycles but the huge drag imposed by excessive debt and falling house prices.

Soggy

2010-11-03T18:28:00.000-07:00

We're having a double dip in the US. But it looks very much as if we'll avoid a new recession. The two ISM surveys for October confirm that the economy isn't going into meltdown. Both the services and the manufacturing ISMs were up on the month. Just in case, the Fed announced QE2 last night, which will prevent a new recession, despite the problems caused by far too much debt. But getting a "normal" recovery will be much harder.

For the world as a whole, things look a lot better. World GDP growth is 4% plus, because strong growth in the BRIC countries and in Asia outside Japan is compensating for the soggy US economy.

(As ever, click on the chart itself to see it full size)

Perplexed

2010-11-03T03:02:00.000-07:00

(If you click on the charts, you can see them in their original size)

I'm not sure how to read the rally since 5th July in both the S&P500 (up 16.7%) and the All Ords( up 12.3%). The Ozzie rally is easier to understand. Most of our exports go to booming Asian economies, our terms of trade have improved dramatically, and our economy is doing very well, so well in fact that the RBA has upped the cash rate again.

But the US economy is growing at half its trend growth, instead of the 2 or 3 times trend typical of a recovery. So why the US rally? OK, profits are doing well, but that's because firms are controlling costs by only slowly increasing payrolls. You'd think that consumer spending would also have been held back because of this, but the big GFC handouts have helped sustain PCE even despite a rising savings rate. The Tea Party crowd will ensure fiscal tightening intensifies, a good reason to be cautious about both profits and the US recovery. Yet without government support, consumer spending can't hold up, and already the first signs of weakness are emerging (see the latest monthly PCE data). So for companies, the top line will cease growing, implying that collective cost cutting will no longer benefit the bottom line, as it has done so far in the recovery. But it's hard to see it continuing to work.

OK, what else will keep profits rising? A falling dollar will do wonders, both via a direct effect on profits from overseas subsidiaries but also as a result of higher sales. But a falling dollar will intensify the headwinds facing Europe and Japan -- unless they also embrace the drug of quantitative easing. So really, what the market is saying is that it's going up because of QE. All the same, debt hasn't gone away (more of that in another post) and monetary easing works better when you can get negative real rates, which is very hard when inflation is close to zero. There's a lot riding on Bernanke's helicopter.

Markets are close to previous highs and are fairly fully valued on trailing PEs (which I use because prospective PEs are doubtful, in all honesty). They're also fairly overbought. It may be a typical mid-term correction (though it was sharper than normal) and QE may save the world. I'm worried, all the same.

Debt and the Recovery

2010-10-26T19:39:00.000-07:00

Historically, US recoveries have always been fuelled by debt. Savings rates declined, car loans soared, and housing starts rebounded. In fact we have never had a US recovery without a previous recovery in housing starts.This time round, because there is already too much debt, savings rates have risen instead of fallen, car sales are OK at best, and housing is in the doldrums.

Starts are off their lows, but the contrast with previous cycles is abundantly clear. Vigorous it ain't -- and that's despite the steepest decline since data were first collected back in the 50s. Yet what did you expect? House prices are barely rising, credit remains tight, and consumers aren't exactly optimistic.

Still, with QE2, housing should at least hold steady. But don't hold your breath for a runaway boom.

(BTW, if you click on the image you'll be able to see it in its original size.)

Double Dip Blues.

2010-10-20T16:49:00.000-07:00

Commentators argue about the meaning of double dip. Let's not get pedantic: growth slipping from 3 or 4% to zero, with a couple of quarters of zero or near-zero growth, is pretty much a double dip in my book. And that is what's happening in the US. My COI (US coinciding index) has been updated for the latest industrial production (IP) data. Not good. And the sogginess is confirmed by the ISM indices, consumer sentiment and above all housing. Fact is: there's too much debt, individual and government. So the stimulus applied is ineffective. Pushing on a string.

Ironically, the unwillingness of China to allow the yuan to rise means that US monetary policy is accelerating Chinese growth. Chinese gold and forex reserves now exceed 2.5 trillion US$. And every time the Bank of China buys US dollars to stop the yuan rising, it adds to domestic money supply.

Moral of the story: there is a new bubble just starting in emerging markets. It'll run for a while before it comes to a sticky end. And US investors in emerging markets will get the benefit of a falling dollar as well as rising share markets.

That assumes the US double dip doesn't trigger another debt meltdown. We're perilously close to deflation. Watch this space.

Of course, we've seen this all before. As this song reminds us.

Tortoise -- and Hare

2010-09-27T20:07:00.000-07:00

It's clear who the tortoises are: hugely indebted Western economies. Too much government and private debt have slowed --and will continue to slow -- recovery.

My own coinciding index for the US shows how after the inventory rebound, growth has slowed. The trend is still up, but oh what a slow grind it will be. At this pace, the index will not pass its previous peak for at least another three years. Meanwhile in the BRIC countries (Brazil, Russia, India, China) IP passed its previous peak months ago. It's true that growth rates there have dipped a little too, but that's because the authorities have had to tighten because things were growing too fast. We should be so lucky.

What a disaster the theories of rational expectations and rational markets have proved to be! It's no accident that the countries which are now booming have sound finances: high savings ratios, government deficits used to fund infrastructure not current expenditure, huge forex reserves and tightly regulated banking systems.

In the short term the West's share markets will continue to rise. But 'boom' is definitely not the word you'd apply to their progress -- their advance will be slow and erratic. I don't expect the S&P 500 high of 1524 in March 2000, or 1562 in October 2007 to be much exceeded in the next 10 or 15 years. Just as US markets were unable to beat previous peaks between 1966 and 1982, so the unwinding of the credit excesses of the last two decades will make investment performance once again matters of timing and economic fundamentals. And cycles are likely to be shorter than we've got used to. "Buy on dips" will remain the expensive mistake it's been for the last 10 years.

Not so for the hare economies, especially since massive monetary stimulus in the West will provide very favourable conditions for the developing markets. Buy resources, and buy Australia. Our market continues to outperform the US, even in same-currency terms.

New Highs

2010-09-20T15:48:00.000-07:00

The S&P 500 closed at a new high (relative to the last few months) yesterday. As you can see from the chart this is a decisive breakout on the upside. Note also that the 150 day moving average has turned up, though the 45 day moving average has yet to cross above the longer-term moving average.

My judgment is that the uptrend has resumed, though because of huge individual and government debt throughout the developed world, the economic recovery will be sluggish, and the market will mirror that. On top of which, valuations simply aren't compelling. All the same, it is clearly better to be in than out. The weakness since mid-April is looking increasingly like a classic mid-cycle correction.

Off to the races

2010-09-16T19:06:00.000-07:00

No, prolly not. But the US share market is drifting higher, and I suspect will continue to do so. It's about to break out of the top of the range it's been in since May (Ozzie markets have already decisively broken out on the upside)

Nothing too dramatic, because the US recovery continues to be a bit sickly. But China is the key, and as long as China continues to race along at 14% IP growth, big US companies (who earn a lot from exports and their overseas subsidiaries) are likely to have rising profits. But if China falters . . . we are in serious trouble.

I'll keep you posted.

The Lucky Country

2010-09-01T04:11:00.001-07:00

Take a look at the relative growth rates of Australia, New Zealand, the US, UK and Europe in the chart. Starting in Q1/2004 at 100, Australia is nearly at 155 (and that was before today's scorching 1.2 % Q-on-Q growth estimate for Q2/2010) much higher than any of the other countries or regions shown.

Why?

Partly luck. China continues to boom, and we're selling them raw materials. China is now the world's largest consumer of commodities. And despite a Chinese "slowdown" (we should be so lucky), prices and volumes just keep going up.

Partly good management. Unlike the Fed, the RBA took away the liquor before the party got too wild. They started raising interest rates early on before the 2002-2007 boom got out of hand, whereas the Fed kept rates too low allowing an unsustainable housing bubble to swell. When it duly burst everybody was covered with gunk.

Partly immigration. Massive immigration, some of it allegedly temporary (students here to study in a cheap but definitely not nasty English-speaking country) helped push up demand for housing, demand for everything. Our unemployment rate is just 5%.

There's talk of an Ozzie housing bubble. Meself, I doubt it. Unless... they slash immigration and remove negative gearing.

BTW, did you observe the good performance of New Zealand in all this? And they don't produce any commodities. Beaut country though. Maybe it's all the tourism.

So.....

2010-05-04T16:58:00.000-07:00

I haven't posted here for a year. Why not? A couple of reasons, but the main one is that I couldn't work out how to paste charts into a blog. All the suggested solutions were inefficient. Well, that's changed. If you're interested, here's what I do. I copy the chart from Excel or my APL program suite into Paint.net, a reaaaaaally good free graphics program, save it as a jpeg or png,and there you go!

Anyway, it turns out that I was right in my last blog post (a) that it was the bottom of the market and (b) that the world economy would recover. See for yourself.

The chart shows the change in world IP, divided into the OECD (developed world) and BRIC (Brazil, Russia, India, China). Happy days are here again? Not quite. As a result of the big debt swap, excessive private debt was replaced with excessive government debt, and markets have been spattered with a bit of melting Greece. Growth was always going to be lethargic coming out of the GFC lows, because of all the debt, and actually I've been pleasantly surprised by just how strong the recovery in Asia, and North and South America has been. Just Europe is sluggish.

Longer term, something will have to be done about debts. But I suspect we'll muddle through for now. Which doesn't mean markets won't correct. But it doesn't imply a new major bear market. Not yet, anyway.

Daily Obsession

2009-03-22T17:24:00.000-07:00

Curious how the market commentators focus on day-to-day movements and try to draw insight and understanding from them. The market is down/up today by x%.

What matters is the longer-term sweeps, and since these are made up of shorter shallower sine waves intertwined with longer deeper sine waves, what matters is the waves. Or, if you like, is the tide coming in or going out, never mind the ripples on the sea. So Wall St was down 2% Friday. Big deal. What do you expect, after a 10-14% rally? All advances consist of up days and down days, just all all retreats are interspersed with days when the market goes up.

China is 30% off its lows, Chinese eco and financial data show a recovery has begun, and it will prolly take the rest of Asia up with it, just as it took Japan, South Korea, Taiwan etc down when it spiked downwards in the second half of last year. China doesn't have a banking crisis (this time anyway) It has the financial wherewithal to stimulate. And guess what? Its balance of payments might well go into deficit as it assumes the locomotive role in the recovery. Will that be a worry? No. And it will be perfectly consistent with the US moving into surplus as savings rates rebound.

So... the short-term waves are probably down or sideways, the longer-term up. Except perhaps in the US which is in such deep trouble that the best it can expect is an L-shaped recovery. We will prolly test the previous lows here in Oz. But I'm confident they'll hold.

Interesting times.

Happy Days Are Here Again

2009-03-19T03:29:00.000-07:00

The song -- full of joy -- first came out in 1929. Of course, we all know what happened after that, don't we? The greatest depression in a hundred years. US real GDP declining 26%. The Nazis rising to power as a result in Germany. And so on and so on.

Wall St up 14.1% since the low. The All Ords up 9.8%. And the rally has happened because of the best possible reason -- the banks are profitable. Or so they say.

Well, it's time. Recent eco data have been better than expected, especially in China. And maybe the big slump after Lehman's failure is over. The technicals don't yet confirm that a new bull market has begun. I certainly hope it has, but... it has to exceed previous highs. It's close in Oz, but not in the US. All the same, emerging markets -- the canary in the coal mine -- have bottomed, technically. China is 30% off its lows. Latin America is holding up.

We shall see. In the meantime, why not party? And not to the tunes of the noughties but the happier music of the 20s and 30s. Like this one.

V-Shaped recessions (and such stuff)

2009-03-12T01:56:00.000-07:00

There are at least three different kinds of recessions -- though no recession is 100% purely of one kind. One happens because of the bursting of an asset price bubble. That is the kind that has happened in the US. House prices rose too far, too fast. People borrowed heavily – and banks were happy to lend to them – in the expectation that this would continue indefinitely. The stupidity and greed of those involved is exactly comparable to the follies shown by speculators in previous asset price bubbles, starting with the Tulip mania in Holland in the early 17th century, and frequently repeated since. Recovery from this kind of recession is slow and difficult – though it always occurs! Bank balance sheets have to be restructured. Individuals have to repay debt (or go bankrupt, which worsens the banks’ difficulties). This takes time -- years, usually

Another happens because inflation starts to rise as free capacity in labour and equipment is reduced by a strong economic expansion. Central banks tighten policy in response to the rising inflation and often overdo it, producing recessions rather than growth slowdowns. The recessions of the 70s and 80s were of this kind.

The third kind of recession occurs when, for whatever reason, inventories are seen as being too high. Often the reason can be because of one of the other kind of recessions, but the "trade cycles" of the 19th century were usually inventory recessions, often triggered by a banking panic (does that sound familiar?) Imagine, for example, a company producing and selling 100 units a month of some item, while keeping one month’s worth of production/sales to hand. Now suppose its sales fall 10%, and it decides to cut production to keep it in line with sales. Production must fall 10%, right, to 90 units a month? Wrong. Because now the company must keep just 90 units in its inventories (the new level of sales per month), but actually has 100, production must fall by 20 units, temporarily, i.e., twice as fast as the fall in sales. Once the adjustment period is over, production goes back up from 80 to 90, because desired inventories now equal actual inventories. Of course, it’s not as simple as that, because one company’s orders are another company’s sales. As each company responds to the downturn, the decline is sales and production is exacerbated by feedback. But – and this is crucial – inventory recessions inevitably end, because inventories reach desired levels, production and orders start to rise, and the whole process reverses. The inventory cycle produces “V”-shaped recessions – a sharp drop off in sales, output and employment is followed by an almost as sharp recovery.

The Chinese economy and its suppliers and markets (Japan, Taiwan, Hong Kong, Thailand, Malaysia, South Korea) are suffering a savage inventory recession right now. Industrial production, imports and exports are declining by dramatic amounts. But these countries have not got failing banks or overgeared consumers. The Asian countries learned the hard lessons of their 1997 crisis, a result of overborrowing and overinvestment leading to credit and exchange rate crises. They have been more prudent since. In China the personal savings rate is 40% (in the US about 3%, up from zero), forex reserves are two trillion dollars (equal by some estimates to the amount needed to recapitalise US banks), and consumers have no consumer debt and only very moderate mortgage debt all based on loans made at very conservative ratios to valuation. Asian countries which are not networked into the Chinese industrial machine (India, Indonesia and Pakistan) have to date had to endure merely a moderate slowing in their industrial output, because they have not had the inventory recession taking place in China and its trading partners.

At some point quite soon, the steep industrial declines in China and the economies linked closely to it will end. The Chinese PMI index suggests that this has begun, though IP and exports still look soggy. Car sales have rebounded, fixed investment is up sharply. Even without massive stimulus in China (and the government has already announced a trillion-dollar support program and cut interest rates sharply), inventories will reach desired ratios to sales, production will stop falling and then start rising, and the world economy will bottom. Remember that these countries, at 23% of the world economy, are together larger than the US which is only 21% of the world economy. Asia as a whole is now 30% of the world economy.

Even in the US there are tentative signs of hope. Retail sales in February were flat after a big rise in January. The ISM indices for January and February have lifted off their low points, contrary to the expectations of the gurus. These indices, by the way, are very reliable pointers to the state of the economy.

This is not to say that trends aren’t still down. They are. The US economy will continue to slide for many months more. But the slide has slowed. In mathematical terms we are at a flexion point, where the rate of descent is diminishing, though the descent itself continues. Yet the probability of a rapid recovery is low. The problem at the core of the crisis, the housing market, remains unresolved, and is likely to remain so until the administration nationalises the major banks. Similar problems face other economies where the Anglo-Saxon model of a housing boom fuelled by indulgent government policies was followed, economies such as the UK, Ireland and Spain. In all these countries, the recovery will be slow. But for once the gurus are probably right: the low point for this cycle will be in Q2 or Q3. Which means the low for stock markets may well be happening right now.

Falling more slowly

2009-03-09T20:12:00.000-07:00

There are some tentative signs that we are approaching a flexion point in the economy in the US. The descent in the economy has by no means ended, but the rate of decline appears to have slowed.

A good sign of how bad things are at any stage in the cycle is the extent to which new data releases are worse than the consensus of gurus' forecasts. From September onwards, this pattern held -- horrible numbers, consistently worse than expected. But in January and February, data have been a bit better than expected. In particular, the ISM averages have drifted up (they cannot be said to have bounced) from the late 2008 lows. The monthly personal consumption and income data surprised on the upside in January. Payrolls were no worse than expected, and seem to have levelled off at a loss of around 650 K jobs per month.

Alas, without some sort of stability in housing, you simply aren't going to see a sustained recovery. And until the US govt nationalizes the banks, I don't see that happening. Yet even here, there are some scintillas of light. The AR mortgage rate is finally starting to fall. Since cash is effectively zero, and the mortgage rate is just where it was when cash was 5.25, it's easy to see why monetary policy isn't working. But the spread between the both fixed rate and adjustable rate mortgages is pulling in. The global yield curve has steepened sharply.

Based on the Chinese manufacturing ISM, I suspect the Chinese IP numbers will surprise on the upside when they are released next week. We'll see.

There will be a recovery, and just as the gurus missed the steepest recession since 1937, so they will probably miss the quiet signals of the recovery.

Onwards and Upwards?

2009-02-07T14:57:00.000-08:00

Maybe this is the market low -- at least for our market (not so sure about the US). I've noticed a few numbers, around the world, have been a bit better than expected, notably the two ISM surveys for January. Our market is just about as cheap as it's ever been, and the authorities are blasting away on their Big Berthas -- rate cuts, tax cuts, bank refinancing initiatives. If this were property, we'd all agree it was a screaming buy. Surely the same applies to shares. And it does look as if our market doesn't want to fall any further, if you look at day to day movements.

Still, I thought it looked like it had bottomed a few months ago, and then we have the Lehman's debacle. So...

I'll keep you posted.