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Archive for August 2013

Archive for August, 2013

Outside the Box: Exit Schmexit

 

In last week’s Outside the Box, which included a paper from the San Francisco Federal Reserve on the effectiveness of quantitative easing, I wrote, “What [authors] Cúrdia and Ferrero are really saying is that the latest round of QE, massive as it has been, has not had all that much effect on the economy, and that other factors should be taken into account. I’m sure this thesis is somewhat controversial, and I look forward to seeing what QE proponents like David Zervos over at Jefferies have to say about it.”

And David thundered back with an answer the next day, more or less along the lines that I expected but with an interesting twist. He thinks the San Francisco paper is basically a fig leaf, intellectual covering for a policy the Fed must pursue no matter what. Quoting from his work, which is the lead story for this week’s Outside the Box:

There is no doubt these folks are trying to delicately pop a fixed-income leverage bubble. They are deathly afraid of a souped-up version of the 1994 rout! They know that balance sheet expansion comes with the parasitic side effect of excessive private sector leverage. And as of now they feel the potential costs of further expansion are beginning to outweigh the benefits. The economy is recovering; QE has been working like a charm; but it’s time to nip the side effects in the bud. That’s the current Committee view!

As a consequence, there is a campaign underway by the FOMC to somehow convince us all that “soothing language” will be better than QE injections. That, of course, is like trying to tell Charlie Sheen that a warm cozy snuggle by the fireplace with a good book will be better than an eight ball. The market is not stupid, and neither is Charlie — both will freak out when u try to take their drugs away! And to be sure, we are 130bps into this freak-out session on 10yr rates. The bubble has been popped. And the question we should all be asking ourselves is, will the Fed lose control of the situation? My answer to that (for now) is NO! But I must say, there is quite a bit more room for a policy mistake than at any other time in the past few years.”

We follow David’s brief but pointed analysis with two related pieces, the first from Stephen Roach, who talks about the potential consequences for emerging markets when central banks have to reduce their easing. As we have all seen, even the run-up to tapering has not been pretty, and emerging-market central banks everywhere are complaining; but as James Bullard, president of the St. Louis Fed, noted in an interview with Bloomberg Radio, the domestic economy is the primary objective of Fed policy. “We’re not going to make policy based on emerging-market volatility alone,” he said. “They were complaining about us easing too much. Now when we start to talk about taper they’re complaining about too tight of a policy. They have an independent monetary policy, and they have to use that to manage their own economies.”

And so it goes without saying that, since we have an independent policy, too, what happens in foreign economic climates can’t have much of an effect on us, can it? Au contraire, says the ever-colorful Joan McCullough. In our final piece, she rewinds the historical videotape to show that the US Treasury and Federal Reserve have ganged up more than once to bail out foreign countries before they could create big problems here.

But let’s hear Joan say it:

So what’s the difference if we send money to foreign shores to stop the hemorrhaging so that it doesn’t reach us?  Or if we acknowledge that having printed money and caused those foreign countries to be at the whim of fast, free do-re-mi … we now put them in jeopardy by our withdrawing same?  We did it in Mexico.  We did it in Asia.  We saw them nearly implode once the hot money started to leave big time and saw that this would cause us problems.  So we took action to defend ourselves.

Why now, are they denying this reality?  Just plain stupid?  Or is there a method to the madness?  Such as they see that they have created such a horrific, no exit mess as the result of QE Infinity and ZIRP, that they must now pretend that US policy has always been “every man for himself”?  When we know that this is blatantly false?

As you read these three pieces, recognize that the problems described are all part of the same set of unintended consequences of massive central bank monetary easing and related unorthodox policies, and that the time is rapidly approaching when the world is simply going to have to live within its means.

“AND what is so rare as a day in June?
Then, if ever, come perfect days;
Then Heaven tries earth if it be in tune,
And over it softly her warm ear lays;
Whether we look, or whether we listen,
We hear life murmur, or see it glisten…”

― James Russell Lowell

With apologies to Mr. Lowell, far more rare is a pleasant day in Texas in August. But this year, while temperatures are still in the 90s during the day, the evenings cool down enough to allow one to comfortably sit outdoors at a restaurant or on the deck. I remember one span of two weeks in the 1980s when temperatures soared into the 110s every day. Generally, Texas is miserably hot in August, but this has been the best weather in August I can remember in my entire 63 years. I am sure that global warming is responsible somehow. This paean to the weather is occasioned by the wonderful evening I spent last night with my friend from the first grade Randy Scroggins, over chili rellenos and salsa at Gloria’s, sharing life memories and updates on our kids. It is a special relationship that can survive youth, business successes and failures, and 13 kids between us. We’ve lived each other’s ups and downs but have always been there for each other.

In two weeks I fly to Bismarck, where I will spend the day with Loren Kopseng, flying first to South Dakota and Mount Rushmore to play tourist (and to finally be able to say I have visited all 50 states) and then north to the Bakken for an update and tour of that fabulous oil play. Last year I flew around the block in a helicopter with Loren as he introduced me to the region. He asked me if I knew anything about oil, and I said I grew up in the oil patch but that my best friend (which would’ve been Randy) wouldn’t let me invest in his oil company in 1981, when he was on one of his really big rolls.

“Wow!” said Loren. “He was a really good friend to you. 1981 was the first time I went bankrupt in the oil business.” There’s something special about oil wildcatters in general and Texas wildcatters in particular. I recognize that passion when I talk to Loren. Slightly mad, just about a half bubble off dead center, as my dad would say. But damn, you’ve got to love ‘em.

Your wishing I had a few oil wells now analyst,

John Mauldin, Editor
Outside the Box
subscribers@mauldineconomics.com


 

Guidance Schmidance … Show Me the Money

By David Zervos, Jefferies & Co.

“Actions speak louder than words.”

“Talk is cheap.”

“Speak softly and carry a big stick.”

These are common aphorisms which have been used historically to admonish those with loquacious tendencies to pipe down. They are words of wisdom — and something our central bankers should think about long and hard. The release of the minutes yesterday confirms that there is a campaign within the core of the Committee to wean our economy off of an ever-increasing central bank balance sheet and to rely instead on “words” for the necessary accommodation. The recent work from the SF Fed, along with some tortured paragraphs on forward guidance in the minutes, indicates that “the power of mental persuasion” is fast becoming the central monetary policy tool for the FOMC. To make the concept simple, they are replacing the big stick of money printing with the cheap talk of forward guidance.

Why are they doing this? Well, reading between the lines, it appears that many on the Committee are nervous about the size of the USD 4 trillion balance sheet. It is a BIG stick — and frankly it has worked pretty darn well at creating a reflationary recovery. But as we in the market and those on the Committee know all too well, there are some nasty long term negative side effects from excessive QE usage — the difficulty in draining excess reserves effectively down the road, the potential for creating politically sensitive mark-to-market losses, and of course the big kahuna: the systemic risks arising from excessive leveraged risk taking in fixed-income markets. On this last point I found this passage in the minutes quite revealing:

Some participants also stated that financial developments during the intermeeting period might have helped put the financial system on a more sustainable footing, insofar as those developments were associated with an unwinding of unsustainable speculative positions or an increase in term premiums from extraordinarily low levels.

There is no doubt these folks are trying to delicately pop a fixed-income leverage bubble. They are deathly afraid of a souped-up version of the 1994 rout! They know that balance sheet expansion comes with the parasitic side effect of excessive private sector leverage. And as of now they feel the potential costs of further expansion are beginning to outweigh the benefits. The economy is recovering; QE has been working like a charm; but it’s time to nip the side effects in the bud. That’s the current Committee view!

As a consequence, there is a campaign underway by the FOMC to somehow convince us all that “soothing language” will be better than QE injections. That, of course, is like trying to tell Charlie Sheen that a warm cozy snuggle by the fireplace with a good book will be better than an eight ball. The market is not stupid, and neither is Charlie — both will freak out when u try to take their drugs away! And to be sure, we are 130bps into this freak-out session on 10yr rates. The bubble has been popped. And the question we should all be asking ourselves is, will the Fed lose control of the situation? My answer to that (for now) is NO! But I must say, there is quite a bit more room for a policy mistake than at any other time in the past few years.

Why? Because the idea that forward guidance is somehow going to ease the pain of exiting from QE is a pipe dream. In fact, it takes enormous hubris on the part of our central bankers to believe their words are so powerful. I thought we had rid the central banking community of such ridiculous delusions of grandeur in 2008/09 — but no such luck, they are back to their old ways. The really sad part about all of this is that the Fed is trying to convince us forward guidance will work precisely when the Board of Governors is going to lose between three and five of its voting members. Ben, Betsy, and Susan are all gone next year. And Jerome and Janet could easily leave as well. Oh yeah, and the Cleveland Fed will get a new president in 2014. Honestly, it’s hard to remember a time in the past when the POTUS had so much potential control of the FOMC. So the idea that time-consistent forward guidance has any value at this stage is basically insane.

But that will not stop the Fed propaganda machine from trying. Remember, we have that excellent bit of research from some leading SF Fed economists to fall back upon. They have a “model” — yes, one of those wondrous Fed concoctions that were so effective at forecasting economic activity for the past few decades (insert more sarcasm). Let’s take an excerpt on “model assumptions” from the Economic Letter authored by those SF Fed economists:

We consider an economy with two types of investors. The first can invest in both short- and long-term assets. For them, a lower risk premium prompts them to reallocate their portfolios, but doesn’t change their spending behavior. If all investors behaved this way, a change in the risk premium would not affect the economy. The second type of investor buys only long-term bonds, for example to match asset duration with life events, such as retirement date. If long-term yields fall, these investors have less incentive to save and may allocate more money to consumption or investment in nonfinancial assets. This boosts aggregate demand and puts upward pressure on inflation.

Really? A model with 2 types of investors in some highly stylized metaphor of an economic system is going detect that markets reacted more to guidance on rates than large scale purchases? Where are the mortgage REITS, where are the hedge funds, where are the dealers, where are the sovereign wealth funds??? PUUULLLEASE!! This might be an interesting exercise for some PhD students, but in the real world it has NO use! This reminds me of the joke about the three econometricians applying for a job on Wall Street — one from Harvard, one from Princeton, and one from Faber College. The joke goes something like this:

Three econometricians head in for an interview with a large investment bank on Wall Street. The first one is from Harvard — Dr Smith. He steps in to meet the head of trading and on the white board in the room are two jagged lines pointing upwards that look awfully similar. The head of trading says to Dr Smith — what do you think the correlation is between those two time series on the white board? Dr Smith answers — at least .95 maybe .99. The head of trading says thanks and sends him out. Dr Jones from Princeton then steps in and the same thing happens. Finally, Dr Blutarsky from Faber College (and a Delta house alum) strolls in looking hung over and a bit dazed. The head of trading asks the same question, and Dr Blutarsky responds — what would you like it to be? Instantly, the head of trading says — YOUR HIRED!

Seriously though, after seeing this paper and reading the minutes, I had an instant memory of being at a St Louis Fed conference in 2009. It was the 30th-anniversary celebration of the great money-targeting experiment of ’79-’82. Oddly enough, Volcker wouldn’t come. But in the audience was Steve Axilrod, who basically ran the entire staff at the Fed during that time. He told a story about Volcker calling him and a few of the other senior economists into a room in early 1979 to discuss raising rates aggressively. He needed “an academic rationale” for driving rates much higher and thereby squashing inflation. But he couldn’t just say “I’m raising rates,” as that would be too politically controversial. Et voila, the staff came up with a new study suggesting that targeting the money supply rather than interest rates was a more appropriate and effective way to stop inflation. In short order the funds rate target was abandoned, and the era of money supply  targeting began. Oh yeah, and after the changeover, the first print on short rates in October 1979 was 300bps higher!

That would not be the first time the Fed  manufactured research to support a policy stance, and it clearly was not the last. The reality is, they are trying to cleanly get out of a VERY tricky situation. The good times from QE are in the here and now (i.e. housing up, spoos up, u-rate down etc etc). The bad times are lurking on the horizon (i.e. difficult balance sheet unwinding, higher inflation, emerging market stress, systemic financial asset deleveraging, etc., etc.). That said, so far they have done a fabulous job of extinguishing a bunch of the excessive fixed-income leverage from the system. But they need to be careful. The markets and the economy are still fragile. They have made the mistake many times before of declaring victory too early. We needed the QE, and we may need it a lot longer. The last thing we need now is a bunch of sanctimonious central bankers telling us their words matter more than their actions. Their actions are what saved us, their words have been an annoyance! The only way words would really matter is if Ben (or Larry/Janet) followed Mario and said: “Our policy is to do whatever it takes to generate asset price reflation and an economic recovery.” Now that’s the kind of speaking softly and carrying a big stick that Teddy Roosevelt would be proud of!

I suspect, when all is said and done, the FOMC will actually follow that simple rule (as it largely has done up until now). But for the moment, they are trying to be cute and rid us of some nasty leverage based side effects of QE. So far so good, but if their strategy backfires and side effect management contaminates the seeds of recovery, the stick will come out VERY quickly just like it has in the past. And once again actions will speak louder than words! Good luck trading.

The Global QE Exit Crisis

By Stephen Roach, Yale University Jackson Institute of Global Affairs

The global economy could be in the early stages of another crisis. Once again, the US Federal Reserve is in the eye of the storm.

As the Fed attempts to exit from so-called quantitative easing (QE) — its unprecedented policy of massive purchases of long-term assets — many high-flying emerging economies suddenly find themselves in a vise. Currency and stock markets in India and Indonesia are plunging, with collateral damage evident in Brazil, South Africa, and Turkey.

The Fed insists that it is blameless — the same absurd position that it took in the aftermath of the Great Crisis of 2008-2009, when it maintained that its excessive monetary accommodation had nothing to do with the property and credit bubbles that nearly pushed the world into the abyss. It remains steeped in denial: Were it not for the interest-rate suppression that QE has imposed on developed countries since 2009, the search for yield would not have flooded emerging economies with short-term “hot” money.

As in the mid-2000′s, there is plenty of blame to go around this time as well. The Fed is hardly alone in embracing unconventional monetary easing. Moreover, the aforementioned developing economies all have one thing in common: large current-account deficits.

According to the International Monetary Fund, India’s external deficit, for example, is likely to average 5% of GDP in 2012-2013, compared to 2.8% in 2008-2011. Similarly, Indonesia’s current-account deficit, at 3% of GDP in 2012-2013, represents an even sharper deterioration from surpluses that averaged 0.7% of GDP in 2008-2011. Comparable patterns are evident in Brazil, South Africa, and Turkey.

A large current-account deficit is a classic symptom of a pre-crisis economy living beyond its means — in effect, investing more than it is saving. The only way to sustain economic growth in the face of such an imbalance is to borrow surplus savings from abroad.

That is where QE came into play. It provided a surplus of yield-seeking capital from investors in developed countries, thereby allowing emerging economies to remain on high-growth trajectories. IMF research puts emerging markets’ cumulative capital inflows at close to $4 trillion since the onset of QE in 2009. Enticed by the siren song of a shortcut to rapid economic growth, these inflows lulled emerging-market countries into believing that their imbalances were sustainable, enabling them to avoid the discipline needed to put their economies on more stable and viable paths.

This is an endemic feature of the modern global economy. Rather than owning up to the economic slowdown that current-account deficits signal — accepting a little less growth today for more sustainable growth in the future — politicians and policymakers opt for risky growth gambits that ultimately backfire.

That has been the case in developing Asia, not just in India and Indonesia today, but also in the 1990′s, when sharply widening current-account deficits were a harbinger of the wrenching financial crisis of 1997-1998. But it has been equally true of the developed world.

America’s gaping current-account deficit of the mid-2000′s was, in fact, a glaring warning of the distortions created by a shift to asset-dependent saving at a time when dangerous bubbles were forming in asset and credit markets. Europe’s sovereign-debt crisis is an outgrowth of sharp disparities between the peripheral economies with outsize current-account deficits — especially Greece, Portugal, and Spain — and core countries like Germany, with large surpluses.

Central bankers have done everything in their power to finesse these problems. Under the leadership of Ben Bernanke and his predecessor, Alan Greenspan, the Fed condoned asset and credit bubbles, treating them as new sources of economic growth. Bernanke has gone even further, arguing that the growth windfall from QE would be more than sufficient to compensate for any destabilizing hot-money flows in and out of emerging economies. Yet the absence of any such growth windfall in a still-sluggish US economy has unmasked QE as little more than a yield-seeking liquidity foil.

The QE exit strategy, if the Fed ever summons the courage to pull it off, would do little more than redirect surplus liquidity from higher-yielding developing markets back to home markets. At present, with the Fed hinting at the first phase of the exit — the so-called QE taper — financial markets are already responding to expectations of reduced money creation and eventual increases in interest rates in the developed world.

Never mind the Fed’s promises that any such moves will be glacial — that it is unlikely to trigger any meaningful increases in policy rates until 2014 or 2015. As the more than 1.1 percentage-point increase in 10-year Treasury yields over the past year indicates, markets have an uncanny knack for discounting glacial events in a short period of time.

Courtesy of that discounting mechanism, the risk-adjusted yield arbitrage has now started to move against emerging-market securities. Not surprisingly, those economies with current-account deficits are feeling the heat first. Suddenly, their saving-investment imbalances are harder to fund in a post-QE regime, an outcome that has taken a wrenching toll on currencies in India, Indonesia, Brazil, and Turkey.

As a result, these countries have been left ensnared in policy traps: Orthodox defense strategies for plunging currencies usually entail higher interest rates — an unpalatable option for emerging economies that are also experiencing downward pressure on economic growth.

Where this stops, nobody knows. That was the case in Asia in the late 1990′s, as well as in the US in 2009. But, with more than a dozen major crises hitting the world economy since the early 1980′s, there is no mistaking the message: imbalances are not sustainable, regardless of how hard central banks try to duck the consequences.

Developing economies are now feeling the full force of the Fed’s moment of reckoning. They are guilty of failing to face up to their own rebalancing during the heady days of the QE sugar high. And the Fed is just as guilty, if not more so, for orchestrating this failed policy experiment in the first place.

They So Stink

By Joan McCullough, East Shore Partners

Let’s just cut to the chase.  They so stink, it’s beyond the pale. 

It was the middle of last night.  I’m diggin’ around, readin’ here and there.  When I come across this B’berg article:  “FED Officials Rebuff Coordination Calls As QE Taper Looms”.  By Simon Kennedy, Joshua Zumbrun and Jeff Kearns.

http://www.businessweek.com/news/2013-08-25/fed-officials-rebuff-coordination-calls-as-stimulus-taper-looms

This is a must read.  Meanwhile, here’s the gist:  At Jackson Hole, more than one emerging market honcho expressed concern regarding the possibility of his respective country’s demise as the FED hints about cuttin’ off the loose juice.  All the reasons we have cited previously in this space, i.e., the spectrum of nasty fall-out to these emerging economies (formerly known as “Third World” was expressed; I said “formerly” … for the time being anyhow) … not the least of which is the aptly-named “fast money’ doin’ what it always does:  exit in a hurry.  Leaving these poor slobs in the lurch on many levels, big time. 

The response from the FED geeks cited in the piece:  Tough noogies.  Every man for himself.  Our mandate is only applicable to maintain the health of the US.  Go fish.

Best response to that baloney cited  in the piece:  From Christine Lagarde, head of the IMF.  “Watch out that your arrogant response doesn’t go full circle … and come back to ite you on the bass.” 

Like I said, that’s the nutshell.  It is definitely a must read.

By the time I got done with the article, I was jumpin’ furious. 

So now it’s time to Go to the Video, for those who either weren’t here yet (whippersnappers) or those who may need a reminder (aging dinosaurs).  As to show how this infernal game has rolled and keeps rollin’.  Much to my enragement. 

The bottomline is that these sunzabees are ruthless.  Bullschmitt rolls off their tongues way too effortlessly.  And I for one, have had enough enzyme free donkey fazoo shoveled my way to last two lifetimes.  Their arrogance is unexampled.  And it is clear that they labor under the delusion that we all have amnesia.  And are way too stupid to see thru their crap.

Tough noogies indeed.  Every man for himself, eh?

Do you get the picture?  Great.  Now let’s take these bums apart, inch by inch.  I’m writin’ most of this off the top of my head.  My memory gets real sharp when I get berserk. 

Here it is:

It is the Mexican peso crisis of 1994. 

What really happened is that the Mexicans lied about how much they had left in dollar reserves; they had been defending the peso.  As it was under siege.

And although they swore up that they would not devalue, bang, they did it.

Their Treasury market (Tesobonos and Cetes) as I recall, seized up.  Who was trapped, holdin’ Herman and a lot of Mexican paper?  Some of the biggest US institutional accounts.

What did we do?

Trader Bob Rubin, then Secretary of the Treasury, conspired with the head of the FED, Alan Greenspan, to raid the Exchange Stabilization Fund.  Which had been established under Roosevelt to stabilize the buck.  Under so many guises, not the least preposterous one being Rubin’s claim that stabilizing the Peso would stop illegal border crossings, we sent taxpayer do-re-mi into Mexico.  Which provided a much-needed exit for those US institutional investors who needed it.

Greenspan testified before Congress, the day I threw my shoe at the TV screen in the trading room, that he had “no record of the route the US funds took once delivered locally”.  This was the truth.  It was what this bamboozler didn’t say, that was critical.  And since Congress was too ignorant to ask the next logical question once he said “I have no record”, a good leather pump went flyin’.

What was that next, logical question?  “If you don’t have the records, who does?”  And the answer, natch, would have been, of course “THE FREAKIN’ MEXICAN CENTRAL BANK.”

Of course, we never got to that point.  The dopes in Congress were satisfied that Magoo didn’t have the records. And gave this fibber a pass.

And  so went the taxpayer money, down south.  Then back up north.  And the illegals kept swarmin’ the borders.  But Rubin was nowhere to be questioned about his baloney.  SOS.

Nevertheless, we knew what the excuse was for raiding the ESF right off the get-go because Rubin had repeated it so often: In stabilizing the Peso, we stabilize the buck.  Due to the cross-border investing, this is a given, i.e., it is in our best interests to prevent a crack-up over there … in order to prevent reverberations being felt over here.

What you probably don’t recall as vividly is that back then, there were in effect some regs regarding the amounts that could be released from the ESF before Congress had to give its approval.  I believe the magic line in the sand was a cool billion $.  And that’s part of the reason why we had all the hearings at the time.  Because Congress, as you know, is supposed to control our purse strings.  As part of the system of checks and balances.  I know.  That became a joke under Obama.  Nevertheless, it’s still on the books.  So plod on we must with this tale.

We are January of 1995 now.  Clinton is in the WH.  Monica is still under the desk, so Bubba  still has clout.  Greenspan/Rubin told him to ask Congress for $40 bil in loan guarantees for the Mexican government.  Get it?  They issued the cetes that these big US institutions were trapped with. So why not give them loan guarantees, eh?  Smart.

Congress said no. 

Which should have put an end to the whole thing.  But Clinton defied them and gave Mexico $20 bil.  Now remember, $20 bil was a lotta’ do-re-mi back then.  And for the record, was the largest slug the ESF had ever even thought about dolin’ out. 

So tempers were flaring in Congress.  Not only because Clinton et al had flipped them the bird, but because of the size of the guarantee.  As I recall, $20 bil was roughly half of the whole stash in the ESF. 

To shut Congress up, Clinton cited Roosevelt or some baloney.  Because apparently under the Gold Act of 1934 … yeah, that abomination  … Clinton claimed he had discretion.  (So why didn’t he just use it instead of going thru the motions?  Right. )

Okay, where’s this goin’?  To make the point that back during the Mexican crisis, we made it plain to all, that taking steps necessary to stabilize other countries where US investors are heavily exposed … is in the best interest of the US.

So, okay, that is the job of Treasury, right?  What has it got to do with the FED?  Greenspan and Rubin sat shoulder to shoulder at those hearings.  The sight was much written about at the time.  I clearly remember it and was taken aback myself.  As they did nothing to dispel rumors that they had put their heads together on the Mexican bailout.  And why would Treasury act without the FED’s counsel anyhow, right?  It is the FED which does the transfers and oversees the financial system.  So the FED gets no pass on this one.  Ever.  Cahoots 24:7?  You bet.  Keep readin’.

What was happening before our very eyes was the resurrection of the ESF.  Where many that day in the trading room where I sat, had never even heard of it.  Some guys sittin’ upstairs, too, were equally givin’ it the “ES… what?”.  So you get the picture.

Thus, the ESF was resurrected and then stood on its ear. 

As follows:  We morphed from promoting, starting in the 1930s, occasional, quiet, clandestine efforts to maintain the stability of the buck.  Period.   To a new, broader mandate which required us to keep orderly exchange agreements with our counterparties by stabilizing any and all foreign exchange rates.  See the difference?  The original intent was to keep the buck on an even keel.    The New Age of Rubin expanded that to mean that we had an obligation to keep other country’s money balanced.  So that ours would not be rocked and thus go haywire.  Which would upset the US economic applecart.

And that’s how they got away with all that carry-on almost 20 years ago.  By disguising a bail-out of some big institutions as “Mexico’s interest is our interest.”  And we never objected.

So Rubin took it further.  

We are now in late 1997.  Around Christmas.   

S. Korea was blowin’ up.  So Rubin had dinner with Greenspan.  Again.  And the various aides.  In order to figure out a way to solve this latest crisis. 

What had been happening in the lead up to this dinner?  Asia was goin’ down the rathole.  But Rubin, still chafing from criticism over the use of the ESF in the Mexican caper, kept a distance from these countries, opting to deem them as local annoyances and not critical to the US economic miracle.   

Unfortunately, it just kept gettin’ worse until it threatened to [de]stabilize the whole area.

Let’s be more specific about that.  Thailand and Malaysia aside, S. Korea had paper all over the globe.  And they were on the brink.  And Japan … was one of their biggest investors, holdin’ huge S Korean debt.  For the record, at the time, they were high on our list of trading partners, too, about #5 or 6.  And as you know, we have thousands of US troops stationed there as well.

So he could no longer ignore this stuff.

Because by now, the world of derivatives was starting to unfold to where it was a word heard on the 6 o’clock news by most of America. 

What was the deal, then? 

It would have been hard to find a country, large or small, who didn’t hold S Korean investments.  So the US would have gotten banged by a S Korean implosion … either directly or indirectly. 

And since Japan … a major world economy …  had the biggest exposure, it didn’t take too much of a stretch of the imagination to see how once the derivatives and interest rate and currency swaps and forex contracts and other sundry hedges got dragged  into the vortex, that it would only be a NY minute before their crap landed on our sunny shores.

The US was not quick to figure this out.  I remind you who was Deputy Treasury Secretary at the time:  Larry Summers.  Yes.  One and the same.

He was dispatched to find out how much reserves S Korea had left.  The old story, right?  How many bucks do you have in the vault, eh?

Apparently, it wasn’t much.  So behind the scenes … and using the IMF as the beard, the US cobbled together a $75 bil bailout package in the form of loans to S. Korea.  Attached to these loans was a message from Trader Bob delivered by the IMF to S Korea:  drop your trade barriers and rebuild your financial system.  Which was a joke.  Because a handful of families/titans controlled the whole magilla, employing a huge chunk of the population to boot.

That was in early December when the IMF cut the package for S. Korea with us pushing behind the scenes.  Early December of 1997.

But it didn’t work, no sir. As much as Clinton tried to downplay it, it didn’t work.  And S Korea kept hemorrhaging reserves as the foreign money couldn’t get out fast enough.

And that, ladies and germs, is what precipitated that Christmas-time dinner between Rubin and Greenspan.

It is noteworthy that by this point, the Japanese stock market was gettin’ drubbed mercilessly.  And fingers were being pointed.  And the DJIA then started to lose ground.  The rumors were ceaseless and went something like this: If the US doesn’t stop the mess unfolding in S Korea, then directly and indirectly, they are gonna’ take the US economy to its knees.  As Asia in general was a total mess; US earnings in the area were in jeopardy.  Got that?  US earnings in the area were in jeopardy.  And S Korea’s reserves by then were estimated to be under $10 bil; Mexico had about $6 bil left when they pulled the trigger.  So it was a matter of days before S Korea did the same.

The IMF kicked into gear and demanded more funds from the US.  Which we kicked in.  Disguised by further commitments at the time from Germany, Japan and the UK and probably others who had exposure, too.

How did this work out?

McDonough was Chairman of the NY FED at the time.  He got on the blower and asked all the big banks to roll over their loans to S Korea.

And very importantly, asked them not to execute margin calls on any derivatives and such with S Korean entities that had gone south. 

Having no choice in the matter, apparently they complied.

That’s the gist of what happened.  After that stuff, there was a load of political carry-on as the S Korean unions got involved and there was a power struggle at the top of their country’s leadership.

But you get the point.  You see the extremes that we went to … and the taxpayer money that was put at risk to becalm a financial crisis … away from these shores.  In the process, we ended up financing the government/ large business entities of a foreign country which the US said was strategic to the continued success of the US economic miracle.

So what’s the difference if we send money to foreign shores to stop the hemorrhaging so that it doesn’t reach us?  Or if we acknowledge that having printed money and caused those foreign countries to be at the whim of fast, free do-re-mi … we now put them in jeopardy by our withdrawing same?  

We did it in Mexico.  We did it in Asia.  We saw them nearly implode once the hot money started to leave big time and saw that this would cause us problems.  So we took action to defend ourselves. 

Why now, are they denying this reality? 

Just plain stupid?  Or is there a method to the madness?  Such as they see that they have created such a horrific, no exit mess as the result of QE Infinity and ZIRP, that they must now pretend that US policy has always been “every man for himself”?  When we know that this is blatantly false? 

I’ll be giving this poser some more thought including how the Nikkei and then the DJIA followed suit and why.  Way back then.  Suggest you do the same.

Like I said, they so stink. 

Geez.

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Outside the Box and MauldinEconomics.com is not an offering for any investment. It represents only the opinions of John Mauldin and those that he interviews. Any views expressed are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest and is not in any way a testimony of, or associated with, Mauldin’s other firms. John Mauldin is the Chairman of Mauldin Economics, LLC. He also is the President of Millennium Wave Advisors, LLC (MWA) which is an investment advisory firm registered with multiple states, President and registered representative of Millennium Wave Securities, LLC, (MWS) member FINRA, SIPC, through which securities may be offered . MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB) and NFA Member. Millennium Wave Investments is a dba of MWA LLC and MWS LLC. This message may contain information that is confidential or privileged and is intended only for the individual or entity named above and does not constitute an offer for or advice about any alternative investment product. Such advice can only be made when accompanied by a prospectus or similar offering document. Past performance is not indicative of future performance. Please make sure to review important disclosures at the end of each article. Mauldin companies may have a marketing relationship with products and services mentioned in this letter for a fee.

Note: Joining The Mauldin Circle is not an offering for any investment. It represents only the opinions of John Mauldin and Millennium Wave Investments. It is intended solely for investors who have registered with Millennium Wave Investments and its partners at http://www.MauldinCircle.com (formerly AccreditedInvestor.ws) or directly related websites. The Mauldin Circle may send out material that is provided on a confidential basis, and subscribers to the Mauldin Circle are not to send this letter to anyone other than their professional investment counselors. Investors should discuss any investment with their personal investment counsel. You are advised to discuss with your financial advisers your investment options and whether any investment is suitable for your specific needs prior to making any investments. John Mauldin is the President of Millennium Wave Advisors, LLC (MWA), which is an investment advisory firm registered with multiple states. John Mauldin is a registered representative of Millennium Wave Securities, LLC, (MWS), an FINRA registered broker-dealer. MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB). Millennium Wave Investments is a dba of MWA LLC and MWS LLC. Millennium Wave Investments cooperates in the consulting on and marketing of private and non-private investment offerings with other independent firms such as Altegris Investments; Capital Management Group; Absolute Return Partners, LLP; Fynn Capital; Nicola Wealth Management; and Plexus Asset Management. Investment offerings recommended by Mauldin may pay a portion of their fees to these independent firms, who will share 1/3 of those fees with MWS and thus with Mauldin. Any views expressed herein are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest with any CTA, fund, or program mentioned here or elsewhere. Before seeking any advisor’s services or making an investment in a fund, investors must read and examine thoroughly the respective disclosure document or offering memorandum. Since these firms and Mauldin receive fees from the funds they recommend/market, they only recommend/market products with which they have been able to negotiate fee arrangements.

PAST RESULTS ARE NOT INDICATIVE OF FUTURE RESULTS. THERE IS RISK OF LOSS AS WELL AS THE OPPORTUNITY FOR GAIN WHEN INVESTING IN MANAGED FUNDS. WHEN CONSIDERING ALTERNATIVE INVESTMENTS, INCLUDING HEDGE FUNDS, YOU SHOULD CONSIDER VARIOUS RISKS INCLUDING THE FACT THAT SOME PRODUCTS: OFTEN ENGAGE IN LEVERAGING AND OTHER SPECULATIVE INVESTMENT PRACTICES THAT MAY INCREASE THE RISK OF INVESTMENT LOSS, CAN BE ILLIQUID, ARE NOT REQUIRED TO PROVIDE PERIODIC PRICING OR VALUATION INFORMATION TO INVESTORS, MAY INVOLVE COMPLEX TAX STRUCTURES AND DELAYS IN DISTRIBUTING IMPORTANT TAX INFORMATION, ARE NOT SUBJECT TO THE SAME REGULATORY REQUIREMENTS AS MUTUAL FUNDS, OFTEN CHARGE HIGH FEES, AND IN MANY CASES THE UNDERLYING INVESTMENTS ARE NOT TRANSPARENT AND ARE KNOWN ONLY TO THE INVESTMENT MANAGER. Alternative investment performance can be volatile. An investor could lose all or a substantial amount of his or her investment. Often, alternative investment fund and account managers have total trading authority over their funds or accounts; the use of a single advisor applying generally similar trading programs could mean lack of diversification and, consequently, higher risk. There is often no secondary market for an investor’s interest in alternative investments, and none is expected to develop.

Thoughts from the Frontline: France: On the Edge of the Periphery

 

“The emotional side of me tends to imagine France, like the princess in the fairy stories or the Madonna in the frescoes, as dedicated to an exalted and exceptional destiny. Instinctively I have the feeling that Providence has created her either for complete successes or for exemplary misfortunes. Our country, as it is, surrounded by the others as they are, must aim high and hold itself straight, on pain of mortal danger. In short, to my mind, France cannot be France without greatness.

– Charles de Gaulle, from his memoirs

Recently there have been a spate of horrific train wrecks in the news. Almost inevitably we find out there was human error involved. Almost four years ago I began writing about the coming train wreck that was Europe and specifically Greece. It was clear from the numbers that Greece would have to default, and I thought at the time that Portugal would not be too far behind. Spain and Italy clearly needed massive restructuring. Part of the problem I highlighted was the significant imbalance between exports and imports in all of the above countries.

In the Eurozone there was no mechanism by which exchange rates could be used to balance the labor-cost differentials between the peripheral countries and those of the northern tier. And then there’s France. I’ve been writing in this space for some time that France has the potential to become the next Greece. I’ve spent a good deal of time this past month reviewing the European situation, and I’m more convinced than ever that France is on its way to becoming the most significant economic train wreck in Europe within the next few years.

We shifted focus at the beginning of the year to Japan because of the real crisis that is brewing there. Over the next few months I will begin to refocus on Europe as that train threatens to go off the track again. And true to form, this wreck will be entirely due to human error, coupled with a large dollop of hubris. This week we will take a brief look at the problems developing in Europe and then do a series of in-depth dives between now and the beginning of winter. The coming European crisis will not show up next week but will start playing in a movie theater near you sometime next year. Today’s letter will close with a little speculation on how the developing conflict between France and Germany and the rest of its euro neighbors will play out.

France: On the Edge of the Periphery

I think I need first to acknowledge that the market clearly doesn’t agree with me. The market for French OATS (Obligations Assimilables du Trésor), their longer-term bonds, sees no risk. The following chart is a comparison of interest rates for much of the developed world, which I reproduce for those who are interested in comparative details. Notice that French rates are lower than those of the US, Canada, and the UK. Now I understand that interest rates are a function of monetary policy, inflation expectations, and the demand for money, which are all related to economic growth, but still….

France’s neighbors, Italy and Spain, have rates that are roughly double France’s. But as we will see, the underlying economics are not that much different for the three countries, and you can make a good case that France’s trajectory may be the worst.

“No: France Is Not Bankrupt” – Really?

We will start with a remarkable example of both hubris and economic ignorance published earlier this year in Le Monde. Under the headlineNo: France Is Not Bankrupt,” Bruno Moschetto, a professor of economics at the University of Paris I and HEC, made the following case. He apparently wrote this with a straight face. If you are not alone, please try not to giggle out loud and annoy people around you. (Hat tip to my good friend Mike Shedlock.)

No, France is not bankrupt …. The claim is untrue economically and financially. France is not and will not bankrupt because it would then be in a state of insolvency.

A state cannot be bankrupt, in its own currency, to foreigners and residents, since the latter would be invited to meet its debt by an immediate increase in taxation.

In abstract, the state is its citizens, and the citizens are the guarantors of obligations of the state. In the final analysis, “The state is us.” To be in a state of suspension of payments, a state would have to be indebted in a foreign currency, unable to deal with foreign currency liabilities in that currency….

Ultimately our leaders have all the financial and political means, through the levying of taxes, to be facing our deadlines in euros. And besides, our lenders regularly renew their confidence, and rates have never been lower.

Four things leap to mind as I read this. First, Professor, saying a country is not bankrupt because it would then be insolvent is kind of like saying your daughter cannot be pregnant because she would then have a baby. Just because something is unthinkable doesn’t mean it can’t happen.

To continue reading this article from Thoughts from the Frontline – a free weekly publication by John Mauldin, renowned financial expert, best-selling author, and Chairman of Mauldin Economics – please click here.

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Thoughts From the Frontline and MauldinEconomics.com is not an offering for any investment. It represents only the opinions of John Mauldin and those that he interviews. Any views expressed are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest and is not in any way a testimony of, or associated with, Mauldin’s other firms. John Mauldin is the Chairman of Mauldin Economics, LLC. He also is the President and registered representative of Millennium Wave Advisors, LLC (MWA) which is an investment advisory firm registered with multiple states, President and registered representative of Millennium Wave Securities, LLC, (MWS) member FINRA and SIPC, through which securities may be offered. MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB) and NFA Member. Millennium Wave Investments is a dba of MWA LLC and MWS LLC. This message may contain information that is confidential or privileged and is intended only for the individual or entity named above and does not constitute an offer for or advice about any alternative investment product. Such advice can only be made when accompanied by a prospectus or similar offering document. Past performance is not indicative of future performance. Please make sure to review important disclosures at the end of each article. Mauldin companies may have a marketing relationship with products and services mentioned in this letter for a fee.

Note: Joining The Mauldin Circle is not an offering for any investment. It represents only the opinions of John Mauldin and Millennium Wave Investments. It is intended solely for investors who have registered with Millennium Wave Investments and its partners at http://www.MauldinCircle.com (formerly AccreditedInvestor.ws) or directly related websites. The Mauldin Circle may send out material that is provided on a confidential basis, and subscribers to the Mauldin Circle are not to send this letter to anyone other than their professional investment counselors. Investors should discuss any investment with their personal investment counsel. John Mauldin is the President of Millennium Wave Advisors, LLC (MWA), which is an investment advisory firm registered with multiple states. John Mauldin is a registered representative of Millennium Wave Securities, LLC, (MWS), an FINRA registered broker-dealer. MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB). Millennium Wave Investments is a dba of MWA LLC and MWS LLC. Millennium Wave Investments cooperates in the consulting on and marketing of private and non-private investment offerings with other independent firms such as Altegris Investments; Capital Management Group; Absolute Return Partners, LLP; Fynn Capital; Nicola Wealth Management; and Plexus Asset Management. Investment offerings recommended by Mauldin may pay a portion of their fees to these independent firms, who will share 1/3 of those fees with MWS and thus with Mauldin. Any views expressed herein are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest with any CTA, fund, or program mentioned here or elsewhere. Before seeking any advisor’s services or making an investment in a fund, investors must read and examine thoroughly the respective disclosure document or offering memorandum. Since these firms and Mauldin receive fees from the funds they recommend/market, they only recommend/market products with which they have been able to negotiate fee arrangements.

PAST RESULTS ARE NOT INDICATIVE OF FUTURE RESULTS. THERE IS RISK OF LOSS AS WELL AS THE OPPORTUNITY FOR GAIN WHEN INVESTING IN MANAGED FUNDS. WHEN CONSIDERING ALTERNATIVE INVESTMENTS, INCLUDING HEDGE FUNDS, YOU SHOULD CONSIDER VARIOUS RISKS INCLUDING THE FACT THAT SOME PRODUCTS: OFTEN ENGAGE IN LEVERAGING AND OTHER SPECULATIVE INVESTMENT PRACTICES THAT MAY INCREASE THE RISK OF INVESTMENT LOSS, CAN BE ILLIQUID, ARE NOT REQUIRED TO PROVIDE PERIODIC PRICING OR VALUATION INFORMATION TO INVESTORS, MAY INVOLVE COMPLEX TAX STRUCTURES AND DELAYS IN DISTRIBUTING IMPORTANT TAX INFORMATION, ARE NOT SUBJECT TO THE SAME REGULATORY REQUIREMENTS AS MUTUAL FUNDS, OFTEN CHARGE HIGH FEES, AND IN MANY CASES THE UNDERLYING INVESTMENTS ARE NOT TRANSPARENT AND ARE KNOWN ONLY TO THE INVESTMENT MANAGER. Alternative investment performance can be volatile. An investor could lose all or a substantial amount of his or her investment. Often, alternative investment fund and account managers have total trading authority over their funds or accounts; the use of a single advisor applying generally similar trading programs could mean lack of diversification and, consequently, higher risk. There is often no secondary market for an investor’s interest in alternative investments, and none is expected to develop. You are advised to discuss with your financial advisers your investment options and whether any investment is suitable for your specific needs prior to making any investments.

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Things That Make You Go Hmmm: The Hypocritic Oath

 

By Grant Williams  |  August 19, 2013

 

 (Wikipedia): The Hippocratic Oath is an oath historically taken by physicians and other healthcare professionals swearing to practice medicine honestly. It is widely believed to have been written either by Hippocrates, often regarded as the father of western medicine, or by one of his students. The oath is written in Ionic Greek (late 5th century BC), and is usually included in the Hippocratic Corpus. Classical scholar Ludwig Edelstein proposed that the oath was written by Pythagoreans, a theory that has been questioned due to the lack of evidence for a school of Pythagorean medicine. Of historic and traditional value, the oath is considered a rite of passage for practitioners of medicine in many countries, although nowadays the modernized version of the text varies among them.

The Hippocratic Oath (orkos) is one of the most widely known Greek medical texts. It requires a new physician to swear upon a number of healing gods that he will uphold a set of professional ethical standards.

There is absolutely no legal obligation whatsoever for any medical graduate to swear an oath to any healing god; and yet some 98% of American students make such a pledge upon graduation. In Britain, the number is only 50%, but I am presuming that’s because dentists are exempted.

The situation in Europe is slightly different. In 1948, the Declaration of Geneva was adopted by the General Assembly of the World Medical Association in, you’ve guessed it, Geneva in order to standardize the Hippocratic Oath. As is the way of large, global organizations, the General Assembly amended the oath in 1968 … and 1983 … and 1994, before it was “editorially revised” in 2005 … and again in 2006. That’s Europe for you, folks.

In accordance with the International Code of Medical Ethics, the Declaration of Geneva was intended to create a formulation of the Hippocratic Oath that would allow “the oath’s moral truths [to] be comprehended and acknowledged in a modern way”.

Which is nice.

The current version of the Declaration of Geneva (subject, obviously, to further amendment, since I am writing this on Saturday and it probably won’t reach you before Tuesday) reads as follows:

At the time of being admitted as a member of the medical profession:

•I solemnly pledge to consecrate my life to the service of humanity;


•I will give to my teachers the respect and gratitude that is their due;


•I will practice my profession with conscience and dignity;


•The health of my patient will be my first consideration;


•I will respect the secrets that are confided in me, even after the patient has died;


•I will maintain by all the means in my power, the honour and the noble traditions of the medical profession;


•My colleagues will be my sisters and brothers;


•I will not permit considerations of age, disease or disability, creed, ethnic origin, gender, nationality, political affiliation, race, sexual orientation, social standing or any other factor to intervene between my duty and my patient;


•I will maintain the utmost respect for human life;


•I will not use my medical knowledge to violate human rights and civil liberties, even under threat;


•I make these promises solemnly, freely and upon my honour.

Personally, if I were about to start practicing medicine, I think I would prefer to take the original Oath, which supposedly started out like this (though it has been argued that these exact words do not appear in the text as written by Hippocrates):

First, do no harm.

Simple, pithy, easy to remember. That’s how you start an oath, Pope Pius X. “I profess that God, the origin and end of all things, can be known with certainty by the natural light of reason from the created world” (the Oath Against Modernism, 1910) just doesn’t have the same kind of zip.

And I don’t know what you radical Republicans over there in the corner are snickering about. “I do solemnly swear that I have never voluntarily borne arms against the United States since I have been a citizen thereof” is hardly going to sell a whole bunch of T-shirts at rallies, now, is it? No. It’s not.

I must say, though, that the Omerta is a little more like it. Legend has it that it originated when a wounded man said to his assailant, “If I live, I’ll kill you. If I die, I forgive you”. Now THAT is a bumper sticker I could get behind — but unfortunately I promised not to talk about it.

Unfortunately for Hippocrates and all his successors in the medical arena, however, the Greek word for “jealous”, “play-acting”, “acting out”, “cowardly”, or “dissembling” is hypokrisis; and this is the etymological root of the word hypocrisy, which is defined as:

The state of falsely claiming to possess characteristics, such as religiosity or virtues, that one lacks. Hypocrisy involves the deception of others and is thus a kind of lie.

Over the last several years, a new oath has appeared in the world of finance as global investment banks have been hauled in front of Senate committees, Congressional panels, various regulatory bodies, and (what always used to be the harshest of judges) the public: the Hypocritic Oath.

It begins thus:

First, admit no wrong.

To continue reading this article from Things That Make You Go Hmmm… – a free weekly newsletter by Grant Williams, a highly respected financial expert and current portfolio and strategy advisor at Vulpes Investment Management in Singapore – please click here.

130820_OTB_sm

Outside the Box: What Has QE Actually Accomplished?

 

The market is obsessed with “tapering.” The assumption is that all the “juice” in the economy is somehow the product of the Federal Reserve’s actions. The headline on the front page of the Wall Street Journal today reads “Fear of Fed Retreat Roils India.” I suppose one has to come up with some kind of reason to explain the convergence of emerging equity markets and those of the US. My friend Dan Greenhaus over at BTIG sent out this ugly graph (if you are an emerging-market investor) this morning:

As I’ve highlighted over the last few months, I’m pretty well convinced that there is something more fundamental going on. And that even bigger changes may be coming in the near future. This week we look at two pithy analyses of the likely effectiveness of Fed tapering and what it might portend.

The first article is from (of all places) the San Francisco Federal Reserve, where Janet Yellen used to be the president, prior to her appointment to the Federal Reserve Board of Governors. Authored by Vasco Cúrdia and Andrea Ferrero, the paper is calledHow Stimulatory Are Large-Scale Asset Purchases? When you read this, remember, you have here Federal Reserve system economists writing publicly about the policy of the Federal Reserve. There is a certain diplomatic politeness required in such papers. What Cúrdia and Ferrero are really saying is that the latest round of QE, massive as it has been, has not had all that much effect on the economy, and that other factors should be taken into account. I’m sure this thesis is somewhat controversial, and I look forward to seeing what QE proponents like David Zervos over at Jefferies have to say about it.

Cúrdia and Ferrero write:

The Federal Reserve’s large-scale purchases of long-term Treasury securities most likely provided a moderate boost to economic growth and inflation. Importantly, the effects appear to depend greatly on the Fed’s guidance that short-term interest rates would remain low for an extended period. Indeed, estimates from a macroeconomic model suggest that such interest rate forward guidance probably has greater effects than signals about the amount of assets purchased.

This piece makes a great set-up to an essay published just yesterday by my friend and “Camp Kotok” fishing buddy Bob Eisenbeis, vice chairman & chief monetary economist at Cumberland Advisors. Bob points out that there is going to be a great deal of turnover in the Federal Reserve Board of Governors in the coming year, leading to a lot of discussion and a probable walking back of the QE asset-purchase process. Bob continues:

So what does this mean for investors? There clearly is a disconnect between theory and evidence, and it is currently impacting the FOMC’s intended policy. This, together with the personal/political considerations surrounding the composition of the Board of Governors, its leadership, and the makeup of the voting presidents, makes divining what is likely to happen even more difficult.  One thing seems rather clear at this point, and that is that other factors besides “incoming data” will be in play, which will only serve to increase volatility and place a premium on hedging by investors.

In reading the speeches of the various FOMC participants, it seems to me there is growing concern over the size and continuation of the current asset-purchase model. Now, with the analysis from Cúrdia and Ferrero and the follow-on commentary from Eisenbeis, there is even data questioning its efficacy. Given the volatility that has clearly been introduced into the market, I think you’re going to see a real effort to begin to reduce the size of QE. The interesting thing is that if the San Francisco Fed paper is right, the effects of tapering shouldn’t be all that large, and the far more important question concerns the level of interest rates. And on that topic the consensus seems to be clear: we are going to have low rates for a very long period of time. Indeed, it is that low-rate regime that we should be paying far more attention to than to tapering. I think you will find this week’s Outside the Box interesting and provocative summer reading.

I am back in Dallas, where we are having what is the mildest August that I can remember in my almost 64 years in Texas. Sitting outside at a restaurant or by the pool in the evening is quite pleasant. This follows one of the mildest winters that I can remember. If this becomes typical Dallas weather in the new, global warming era, our biggest problem will be dealing with tax refugees from San Diego seeking more favorable tax and weatherclimates.

Last week I finished a major project while I was in Montana. I feel as if I have got a 900-pound gorilla off my back. Now I can now focus on the 50 20-pound monkeys that have lined up in the last few months, waiting their turn. But small monkeys are easy—I can dispatch a few of those every day. As long as I can get rid of more of them than get in line, I can end the day with a sense of accomplishment. Meanwhile the apartment construction is now entering the fun phase where we can see things really happening, and I get to play amateur designer while being supervised by professionals. Yesterday we met with the young gentleman who will be handling media and connectivity for the apartment. Everything is now tied together—TVs, computers, lighting, air conditioning and heating, security cameras, door locks, sound and music—into one server/controller, organized by iPad minis and accessible anywhere in the world from my iPad. If it has an electronic connection, it is going into the home network.

There is a young gentleman in our family who has now gone to work for Sony. He sat in on the initial meeting about the home network and talked to us about where Sony (and their competitors) will be in five years. He emphasized that our wiring needs will be very different then and that we need to plan for the changes today. He and the media guy walk through the place like two kids in a candy store, talking about what can be done. So we are wiring the place for products that don’t even exist yet. Somehow that appeals to the amateur futurist in me. And we will be installing more than a few Sony products, without even benefiting from the yen depreciation that I think we will see in the next several years.

You’re watching the world change rapidly around him analyst,

John Mauldin, Editor
Outside the Box
subscribers@mauldineconomics.com


 

How Stimulatory Are Large-Scale Asset Purchases?

By Vasco Cúrdia and Andrea Ferrero

The Federal Reserve’s large-scale purchases of long-term Treasury securities most likely provided a moderate boost to economic growth and inflation. Importantly, the effects appear to depend greatly on the Fed’s guidance that short-term interest rates would remain low for an extended period. Indeed, estimates from a macroeconomic model suggest that such interest rate forward guidance probably has greater effects than signals about the amount of assets purchased.

With the Federal Reserve’s benchmark federal funds rate near zero since late 2008, the central bank has used alternative tools to stimulate the economy. In particular, the Fed has purchased large quantities of long-term Treasury and mortgage-backed securities, a policy often referred to as quantitative easing. It has also provided more information about the probable future path of the short-term interest rate, a policy known as forward guidance. This Economic Letter uses a macroeconomic model to examine the effects of quantitative easing and forward guidance on growth and inflation.

In November 2010, the Fed’s policy committee, the Federal Open Market Committee (FOMC), announced a program to purchase $600 billion of long-term Treasury securities, the second of a series of large-scale asset purchases (LSAPs). The program’s goal was to boost economic growth and put inflation at levels more consistent with the Fed’s maximum employment and price stability mandate. In Chen, Cúrdia, and Ferrero (2012), we estimate that the second LSAP program, known as QE2, added about 0.13 percentage point to real GDP growth in late 2010 and 0.03 percentage point to inflation.

Our analysis suggests that forward guidance is essential for quantitative easing to be effective. Without forward guidance, QE2 would have added only 0.04 percentage point to GDP growth and 0.02 to inflation. Under conventional monetary policy, higher economic growth and inflation would usually lead the Fed to raise interest rates, offsetting the effects of LSAPs. Forward guidance during QE2 mitigated that factor by making it clear that the federal funds rate was not likely to increase.

Our estimates suggest that the effects of a program like QE2 on GDP growth are smaller and more uncertain than a conventional policy move of temporarily reducing the federal funds rate by 0.25 percentage point. In addition, our analysis suggests that communication about when the Fed will begin to raise the federal funds rate from its near-zero level will be more important than signals about the precise timing of the end of QE3, the current round of LSAPs.

Macroeconomic models and asset purchases

Evaluation of LSAP programs requires a model to examine what would have happened without these initiatives. Chen et al. (2012) propose a standard macroeconomic model with two additional features: first, allowing LSAPs to affect the spread between short- and long-term yields, and, second, allowing changes in that spread to affect economic activity and inflation.

The first feature involves LSAP effects on financial markets. An investor can buy either a short-term bond and reinvest proceeds until the desired maturity or buy a long-term bond of the desired maturity. If these alternatives are identical, then their expected returns should also be identical. Hence, the long-term yield should be an average of expected future short-term yields. In reality though, these alternatives present different risks and costs, which imply that the long-term yield equals the expected average future short-term yield plus a risk premium.

LSAPs can affect economic growth and inflation through the risk premium. (For an analysis of the impact of LSAPs through signaling effects about future short-term yields, see Bauer and Rudebusch 2012). In our model, the risk premium results from transaction costs paid to buy long-term bonds. We assume that transaction costs increase with the amount of long-term bonds held by private investors, suggesting that LSAPs reduce the long-term bond risk premium by reducing the absolute amount of privately held long-term bonds.

The second feature in our model concerns the transmission from the risk premium to the economy. We consider an economy with two types of investors. The first can invest in both short- and long-term assets. For them, a lower risk premium prompts them to reallocate their portfolios, but doesn’t change their spending behavior. If all investors behaved this way, a change in the risk premium would not affect the economy.

The second type of investor buys only long-term bonds, for example to match asset duration with life events, such as retirement date. If long-term yields fall, these investors have less incentive to save and may allocate more money to consumption or investment in nonfinancial assets. This boosts aggregate demand and puts upward pressure on inflation.

These two types of investors represent a form of financial market segmentation, allowing for the risk premium to affect economic activity. The degree of segmentation is determined by what fraction of investors buy only long-term bonds. The higher the proportion of such investors, the more LSAPs affect the real economy.

Simulating the effects of QE2 on GDP and inflation

To examine the economic effects of an LSAP program similar to QE2, we run simulations based on U.S. macroeconomic data from the third quarter of 1987 to the third quarter of 2009. We assume that the Fed’s purchase program lasts five years, gradually accumulating $600 billion of long-term Treasury securities in the first year, holding them for two years, and gradually reducing them over the last two years. We further assume that forward guidance states that the central bank will keep the policy interest rate at zero for the program’s first four quarters.

Our model estimates that such a program lowers the risk premium by a median of 0.12 percentage point. Figure 1 shows the program’s effects on real GDP growth and inflation. The red line is the median effect in annualized percentage points. The shaded areas represent probability bands from 50% to 90% around the median. The estimates reflect uncertainty arising from three factors: the sensitivity of the risk premium to the asset purchases, the degree of investor segmentation, and other model parameters influencing the economy’s response to interest rate changes.

The 0.13 percentage point median impact on real GDP growth fades after two years. The median effect on inflation is a mere 0.03 percentage point. To put these numbers in perspective, QE2 was announced in the fourth quarter of 2010. Real GDP growth in that quarter was 1.1% and personal consumption expenditure price index (PCEPI) inflation excluding food and energy was 0.8%. Our estimates suggest that, without LSAPs, real GDP growth would have been about 0.97% and core PCEPI inflation about 0.77%.

Chung et al. (2011) find effects about twice as big. Baumeister and Benati (2010) find marginal effects on GDP and inflation of about 3 percentage points and 1 percentage point respectively. Both studies use different methods and assumptions regarding the risk premium. The results of Chung and co-authors fall inside our 50% probability band. But our analysis assigns a negligible chance of LSAP effects as strong as those reported in Baumeister and Benati. Our effects are more limited because the data do not support much bond market segmentation. Thus, we find only modest economic impact.

It’s possible that our data sample excludes periods of high financial turbulence that could encourage stronger financial segmentation. That could cause us to underestimate LSAP effects, particularly during the first few asset purchase rounds. To evaluate this, we run our simulation with at least a 5% degree of segmentation. In our first simulation, the probability of at least that level of segmentation is only 50%. With at least 5% segmentation, the impact on real GDP growth nearly doubles to 0.22 percentage point. The effect on inflation remains only about 0.04 percentage point.

Asset purchases and interest rate policy

Fed interest rate policy plays an important role in determining the effects of LSAPs on economic growth. The Fed normally sets a higher federal funds rate target in response to higher inflation or economic growth. Thus, if LSAPs boost the economy, they should lead to a higher federal funds rate, offsetting the stimulus. In our simulation, we assume that the FOMC keeps the rate at zero for four quarters and then follows conventional monetary policy.

To explore this interaction, we consider two alternative scenarios. First, if the FOMC had no commitment to keep the interest rate near zero, the median effect of QE2 would have dropped to only 0.04 percentage point on economic growth and 0.02 percentage point on inflation. Second, if the commitment to keep the federal funds rate near zero lasts five quarters instead of four, then the effect would be 0.22 percentage point on GDP growth and 0.05 percentage point on inflation. Taken together, these alternative simulations suggest that LSAP economic effects greatly depend on expectations about interest rate policy.

Comparing LSAP effects with conventional policy rate cuts

How do LSAP effects compare with those of a conventional federal funds rate cut? Figure 2 shows the effects of a standard 0.25 percentage point temporary federal funds rate cut. GDP growth increases about 0.26 percentage point and inflation rises about 0.04 percentage point. This suggests that a program like QE2 stimulates GDP growth only about half as much as a 0.25 percentage point interest rate cut. Both policy tools have similar effects on inflation. However, if we pair the LSAP program with a commitment to keep the federal funds rate near zero for five quarters instead of four quarters, then the median effects on real GDP growth and inflation are similar to those of the 0.25 percentage point interest rate cut.

Importantly, uncertainty about the effects of LSAPs on economic growth is much higher than uncertainty about the impact of a federal funds rate cut, as can be seen by comparing the shaded bands in Figures 1 and 2. Our simulations suggest that the main reason for this difference is substantial uncertainty about the degree of financial segmentation. Segmentation is crucial for the effects of asset purchases, but is irrelevant for the impact of a federal funds rate cut on the economy.

Conclusion

Asset purchase programs like QE2 appear to have, at best, moderate effects on economic growth and inflation. Research suggests that the key reason these effects are limited is that bond market segmentation is small. Moreover, the magnitude of LSAP effects depends greatly on expectations for interest rate policy, but those effects are weaker and more uncertain than conventional interest rate policy. This suggests that communication about the beginning of federal funds rate increases will have stronger effects than guidance about the end of asset purchases.

Vasco Cúrdia is a senior economist in the Economic Research Department of the Federal Reserve Bank of San Francisco.

Andrea Ferrero is a senior economist at the Federal Reserve Bank of New York.

When Will the Fed Begin Tapering Its Asset Purchase Program?

By Bob Eisenbeis, Vice Chairman & Chief Monetary Economist, Cumberland Advisors

This question is on all market participants’ minds.  Attention is now centered on whether the process will begin, as some FOMC participants have suggested, as early as the September FOMC meeting. Indeed, it seems highly unusual that, in the first week of August and in the wake of the controversial press conference held after the FOMC’s June meeting, four Federal Reserve Bank presidents, widely considered representative of the full spectrum of views among FOMC participants, have gone on record suggesting that tapering of the Fed’s $85 billion/month asset purchase program could begin as soon as the September. The four are President Fisher (hawk), Presidents Pianalto and Lockhart (centrists), and President Evans (dove).  To be sure, we have heard ad nauseum from FOMC participants that their actions will be conditioned upon “incoming data.” Putting all that aside, there are both personal and political considerations as well as theoretical economic issues that complicate the tapering formulation process.

First, there are some interesting internal FOMC political considerations that might give current FOMC members pause as they consider starting the tapering process this year. To do so with only three FOMC meetings left before a new Fed chairman might be seated would effectively pre-commit both that new chairman and the reconstituted FOMC to a policy path that virtually no members would have had a say in formulating.

Consider first the situation on the Federal Reserve Board itself. President Obama has indicated that he will nominate a new chairman of the Fed sometime this fall, so Chairman Bernanke is already a lame duck. Additionally, Governor Duke has left the Board, and Governor Raskin has been nominated for the number-two position at the Treasury. Governor Powell’s term is up on January 31, 2014. These transitions mean that there are soon to be four vacancies on the Board of Governors.  Finally, should Governor Yellen not be named to replace Chairman Bernanke, there would be little reason for her to stay on. That would leave only two current Board members – Governor Tarullo, a lawyer, and Governor Stein (the only economist), neither of whom experienced the events of the 2007-2008 financial crisis firsthand at the Fed. 

Add to this unprecedented turnover at the Board the fact that the only Federal Reserve Bank president who will vote both this year and next is the New York Fed’s President Dudley, a permanent FOMC member. Finally, Cleveland President Pianalto, who is scheduled to have a vote next year, has announced her retirement; and President Fisher, who is also scheduled to vote next year, reaches the mandatory retirement age of 65 in 2014. This means that there potentially could be as many seven new voting members on the FOMC next year, none of whom are currently in place. The present FOMC has no idea what those people’s views are or what their policy preferences may be. To initiate a tapering policy this year under such circumstances could be highly disruptive should the new FOMC desire to pursue a different policy program next year. All of this argues for caution on the part of the current FOMC, especially given the turmoil that has roiled markets recently over policy concerns and the lack of evidence that the economy has suddenly picked up sufficient steam, such that policy actions would be required at this time.

Another key issue concerns the theory behind the Fed’s asset purchase programs and the growing evidence regarding their efficacy or lack thereof. Fed officials have been dogged in their attempts to distinguish among the FOMC’s zero interest rate policy (holding the Federal Funds rate between 0 and .25 percent), the interest rate paid on reserves, its asset purchase programs, and its communications and forward-guidance tools. Because nominal interest rates cannot fall below zero, there is a limit to how far accommodative policy can be extended by lowering interest rates.

One way to think about this is that in fixing the price of Federal Funds, which constitute tradable excess reserves at the Fed, the FOMC is controlling the quantity of reserves in the banking system and ultimately the money supply. Low rates are accommodative because the opportunity cost to banks of holding low-yielding assets in the form of deposits at the Fed is high relative to the returns that can be made by making loans (and in doing so, also increasing the money supply through the deposit expansion multiplier). The opposite applies when rates are high and policy is restrictive. But at the zero bound it is no long possible to lower rates and encourage expansion of bank reserves and the money supply indirectly, so the Fed provides extra accommodation by operating directly on the supply of bank reserves through its asset purchases. The Fed pays for the Treasuries and MBS by writing up banks’ deposits held at the Fed, and in that way it provides further accommodation by increasing the quantity of excess reserves, and hence Federal Funds, directly.

Asset purchases also do another thing. When Treasuries and MBS are taken out of the private sector market, their prices increase and their yields decline.  This makes them less attractive to hold relative to other higher-yielding assets such as equities, corporate debt, and loans. This is termed the portfolio balance effect.   Indeed, many have argued that because of the portfolio balance effect, yield-seeking funds have found their way into equities and are behind the increase in the stock market. Of course, this was one of the intents of the asset purchase program: the hope was that an increase in perceived wealth would stimulate consumer spending, encourage investment and promote economic growth. 

There is another component of this policy, however, that is rooted in the theory of the term structure. That theory in its simplest form, assuming no inflation, holds that real longer-term interest rates can also be represented by a series of real short-term rates.  That is, if real long-term rates are higher than real short-term rates, this implies that investors expect short-term rates to rise in the future. The logic is simply that an investor could, for example, invest in either a two-year obligation or two one-year obligations – a one-year spot rate and a one-year forward contract on the same instrument. Aside from a small fee for giving up liquidity by holding the two-year instrument, an investor who does not expect short-term rates to rise would be indifferent as to the choice of holding two one-year instruments versus the two-year instrument. However, if the investor expects short-term interest rates to rise, then he or she would always opt to hold the sequence of two one-year investments unless the rate on the two-year instrument was sufficiently high to make the investor indifferent as to which option was chosen. So by comparing the rate on a two-year investment with the rates on a sequence of two one-year investments, it is possible to determine, for example, whether short-term rates are expected to rise in the future, because the rate on the one-year forward instrument will be higher than the spot rate if short-term rates are expected to increase.  The opposite would hold if short term rates are expected to fall.

In the case of the Fed’s $85 billion/month asset purchase program, which involves the purchase of long-term Treasuries and MBS, the Fed is taking these assets out of the private market, bidding up their prices, lowering their yields, and interfering with both the normal term structure and market expectations about future rates. By doing so, the FOMC is over riding market expectations and is de facto signaling that it intends to keep short-term interest rates lower than the might otherwise expected. In fact, this is exactly what the FOMC has said in the statements released after its meetings. This is the so-called signaling channel that has been investigated recently by economists at the San Francisco Fed. (See Bauer and Rudebusch, “The Signaling Channel for Federal Reserve Bond Purchases,” FRB San Francisco Working Paper Series, August 2012.)  Another FRB San Francisco paper (see Cúrdia and Ferrero, “How Stimulatory Are Large-Scale Asset Purchases?” FRBSF Economic Letter, August 12, 2013) supports the importance of the signaling interpretation. The authors estimate that without the signaling effect, the second asset purchase program, known as QE 2 (when the Fed purchased an additional $600 billion in securities), would have added only 4 basis points to real GDP growth and 2 basis points to inflation.  But when they also estimated forward guidance effect, they conclude that it dwarfed QE2 alone by adding another 9 basis points to GDP growth (but only another 1 basis point to inflation).

Now, what about the $85 billion asset purchase program? Using data from the Treasury on its net issuance of debt in 2013 to date, we find that the Federal Reserve has purchased 75% of those securities.  So, if the Fed were to begin to scale back its purchases, more Treasury supply would be available to the private sector, putting downward pressure on prices and raising rates.  According to the expectations theory the rise in rates, because of the FOMC’s tapering would logically be interpreted by the market as a signal by the Fed that short-term rates will rise sooner than previously expected. Thus, notwithstanding the FOMC’s view that it was not (according to the theories it was following) tightening policy, markets would be led to conclude the opposite. Indeed, the abrupt reaction to even the hint by FOMC participants that the FOMC might consider tapering its program, demonstrates that the market interpreted the talk as a signal that rates would rise sooner than expected.

So what does this mean for investors? There clearly is a disconnect between theory and evidence and it is currently impacting the FOMC’s intended policy.  This, together with the personal/political considerations surrounding the composition of the Board of Governors, its leadership, and the makeup of the voting presidents, makes divining what is likely to happen even more difficult.  One thing seems rather clear at this point, and that is that other factors besides “incoming data” will be in play, which will only serve to increase volatility and place a premium on hedging by investors.

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Outside the Box and MauldinEconomics.com is not an offering for any investment. It represents only the opinions of John Mauldin and those that he interviews. Any views expressed are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest and is not in any way a testimony of, or associated with, Mauldin’s other firms. John Mauldin is the Chairman of Mauldin Economics, LLC. He also is the President of Millennium Wave Advisors, LLC (MWA) which is an investment advisory firm registered with multiple states, President and registered representative of Millennium Wave Securities, LLC, (MWS) member FINRA, SIPC, through which securities may be offered . MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB) and NFA Member. Millennium Wave Investments is a dba of MWA LLC and MWS LLC. This message may contain information that is confidential or privileged and is intended only for the individual or entity named above and does not constitute an offer for or advice about any alternative investment product. Such advice can only be made when accompanied by a prospectus or similar offering document. Past performance is not indicative of future performance. Please make sure to review important disclosures at the end of each article. Mauldin companies may have a marketing relationship with products and services mentioned in this letter for a fee.

Note: Joining The Mauldin Circle is not an offering for any investment. It represents only the opinions of John Mauldin and Millennium Wave Investments. It is intended solely for investors who have registered with Millennium Wave Investments and its partners at http://www.MauldinCircle.com (formerly AccreditedInvestor.ws) or directly related websites. The Mauldin Circle may send out material that is provided on a confidential basis, and subscribers to the Mauldin Circle are not to send this letter to anyone other than their professional investment counselors. Investors should discuss any investment with their personal investment counsel. You are advised to discuss with your financial advisers your investment options and whether any investment is suitable for your specific needs prior to making any investments. John Mauldin is the President of Millennium Wave Advisors, LLC (MWA), which is an investment advisory firm registered with multiple states. John Mauldin is a registered representative of Millennium Wave Securities, LLC, (MWS), an FINRA registered broker-dealer. MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB). Millennium Wave Investments is a dba of MWA LLC and MWS LLC. Millennium Wave Investments cooperates in the consulting on and marketing of private and non-private investment offerings with other independent firms such as Altegris Investments; Capital Management Group; Absolute Return Partners, LLP; Fynn Capital; Nicola Wealth Management; and Plexus Asset Management. Investment offerings recommended by Mauldin may pay a portion of their fees to these independent firms, who will share 1/3 of those fees with MWS and thus with Mauldin. Any views expressed herein are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest with any CTA, fund, or program mentioned here or elsewhere. Before seeking any advisor’s services or making an investment in a fund, investors must read and examine thoroughly the respective disclosure document or offering memorandum. Since these firms and Mauldin receive fees from the funds they recommend/market, they only recommend/market products with which they have been able to negotiate fee arrangements.

PAST RESULTS ARE NOT INDICATIVE OF FUTURE RESULTS. THERE IS RISK OF LOSS AS WELL AS THE OPPORTUNITY FOR GAIN WHEN INVESTING IN MANAGED FUNDS. WHEN CONSIDERING ALTERNATIVE INVESTMENTS, INCLUDING HEDGE FUNDS, YOU SHOULD CONSIDER VARIOUS RISKS INCLUDING THE FACT THAT SOME PRODUCTS: OFTEN ENGAGE IN LEVERAGING AND OTHER SPECULATIVE INVESTMENT PRACTICES THAT MAY INCREASE THE RISK OF INVESTMENT LOSS, CAN BE ILLIQUID, ARE NOT REQUIRED TO PROVIDE PERIODIC PRICING OR VALUATION INFORMATION TO INVESTORS, MAY INVOLVE COMPLEX TAX STRUCTURES AND DELAYS IN DISTRIBUTING IMPORTANT TAX INFORMATION, ARE NOT SUBJECT TO THE SAME REGULATORY REQUIREMENTS AS MUTUAL FUNDS, OFTEN CHARGE HIGH FEES, AND IN MANY CASES THE UNDERLYING INVESTMENTS ARE NOT TRANSPARENT AND ARE KNOWN ONLY TO THE INVESTMENT MANAGER. Alternative investment performance can be volatile. An investor could lose all or a substantial amount of his or her investment. Often, alternative investment fund and account managers have total trading authority over their funds or accounts; the use of a single advisor applying generally similar trading programs could mean lack of diversification and, consequently, higher risk. There is often no secondary market for an investor’s interest in alternative investments, and none is expected to develop.

130817_TFTF_sm

Thoughts from the Frontline: Signs of the Top

 

We are told they don’t ring a bell when bull or bear markets start. That may be true, but it does seem that there are similar signs as we approach turning points. This week in my reading I have been struck by a number of signs that suggest that, if we haven’t reached a top in the latest bull market cycle, at least a pause may be in order. Let’s review a few of them. The first comes from Charles Gave, who notes that margin debt is now back to extremes.

I started in the fascinating business of trying to understand why markets go up and down in February 1971. The old money manager in the French bank which had hired me straightaway said: “Charles, you will never get rich in this business using other people’s money. Do NOT leverage your positions. Leverage might be all right for fellows who deal in real estate, but for those in stock markets, it only brings misery.”

Being young and smart (or so I thought), I assumed this advice could not conceivably apply to me. A few margin calls later, accompanied by quite a string of sleepless nights, and I came to realize that the old gentleman had a point.

Now that I am quite old myself and certainly not as smart as I thought I was in 1971, I find myself tracking the moves of the poor souls who believe they can leverage profitably. Then I do the opposite. This is why Charles the 70-year-old is watching what Charles the 30-year-old is doing—to do the reverse. Have a look at the graph.

The red line at the top is New York Stock Exchange margin debt as a multiple of US GDP per capita, the black line on the bottom pane is a ratio between US stocks and (government) bonds. It seems that the fellows using other people’s money to get rich have an uncanny ability to leverage up when shares become overvalued vs. bonds. They also seem to get most enthusiastic just before a recession, usually after a prolonged outperformance of equities against bonds.

They leverage in order to participate as much as possible in what looks like a free ride, with no downside risk. There are always a number of good reasons why the stock market cannot change direction. Take your pick: “technology has created a new type of economy,” or “house prices never go down,” or “we have recently discovered an infinite source of wealth called QE.” These reasons can be added to a long roster of other excuses such as, “I can get insurance against the next market decline” (1987) or “the Fed will never, ever allow for positive real rates to appear” (1979) or “oil prices cannot quadruple” (1974).

The rise in the stock market this past year has not been because of fundamentals. Earnings in the nonfinancial sector have been flat. Mark Gongloff writes on the HuffPost site:

Bloomberg figures that bank earnings rose 27% in the second quarter, which was the only thing keeping the S&P 500 from reporting a net drop in profits for the quarter. With the banks, S&P 500 profits were up 3.3% in the quarter, Bloomberg estimates. Without them, S&P 500 profits would have been down 1.2%.

Lousy profits have not kept the S&P 500 from gaining nearly 19 percent so far this year. But even that performance trails the financial sector, which is up 26 percent this year. The banks topped the broader market last year, too, doubling the broader market’s gain. And banks have managed all this despite never-ending scandals, onerous regulations and the scorn of an angry nation.

The Wall Street Journal suggests that non-financial companies might have finally reached the limit of how much profit they can squeeze out of a dour economy by laying off workers and cutting costs. Banks, on the other hand, have the useful ability to skim rent from even the lamest economy. They’re proving it now and finding profits in innovative ways, like moving aluminum around in warehouses to create a sense of scarcity and drive up prices.” (Huffington Post)

This lack of profits is showing up in the economy. Nominal GDP growth over the past year was the slowest ever recorded outside of a recession, as the following chart from the London Telegraph demonstrates.

And because the rise in the stock market has not been accompanied by an increase in earnings, price-to-earnings ratios have risen back to levels that suggest the market is getting closer to stalling out. I post the following tables from the Wall Street Journal. While the Dow and the S&P 500 are not at nosebleed levels, they are certainly pricey. The Russell 2000 and the NASDAQ, on the other hand, are seriously overpriced in terms of earnings.

To continue reading this article from Thoughts from the Frontline – a free weekly publication by John Mauldin, renowned financial expert, best-selling author, and Chairman of Mauldin Economics – please click here.

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Thoughts From the Frontline and MauldinEconomics.com is not an offering for any investment. It represents only the opinions of John Mauldin and those that he interviews. Any views expressed are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest and is not in any way a testimony of, or associated with, Mauldin’s other firms. John Mauldin is the Chairman of Mauldin Economics, LLC. He also is the President and registered representative of Millennium Wave Advisors, LLC (MWA) which is an investment advisory firm registered with multiple states, President and registered representative of Millennium Wave Securities, LLC, (MWS) member FINRA and SIPC, through which securities may be offered. MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB) and NFA Member. Millennium Wave Investments is a dba of MWA LLC and MWS LLC. This message may contain information that is confidential or privileged and is intended only for the individual or entity named above and does not constitute an offer for or advice about any alternative investment product. Such advice can only be made when accompanied by a prospectus or similar offering document. Past performance is not indicative of future performance. Please make sure to review important disclosures at the end of each article. Mauldin companies may have a marketing relationship with products and services mentioned in this letter for a fee.

Note: Joining The Mauldin Circle is not an offering for any investment. It represents only the opinions of John Mauldin and Millennium Wave Investments. It is intended solely for investors who have registered with Millennium Wave Investments and its partners at http://www.MauldinCircle.com (formerly AccreditedInvestor.ws) or directly related websites. The Mauldin Circle may send out material that is provided on a confidential basis, and subscribers to the Mauldin Circle are not to send this letter to anyone other than their professional investment counselors. Investors should discuss any investment with their personal investment counsel. John Mauldin is the President of Millennium Wave Advisors, LLC (MWA), which is an investment advisory firm registered with multiple states. John Mauldin is a registered representative of Millennium Wave Securities, LLC, (MWS), an FINRA registered broker-dealer. MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB). Millennium Wave Investments is a dba of MWA LLC and MWS LLC. Millennium Wave Investments cooperates in the consulting on and marketing of private and non-private investment offerings with other independent firms such as Altegris Investments; Capital Management Group; Absolute Return Partners, LLP; Fynn Capital; Nicola Wealth Management; and Plexus Asset Management. Investment offerings recommended by Mauldin may pay a portion of their fees to these independent firms, who will share 1/3 of those fees with MWS and thus with Mauldin. Any views expressed herein are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest with any CTA, fund, or program mentioned here or elsewhere. Before seeking any advisor’s services or making an investment in a fund, investors must read and examine thoroughly the respective disclosure document or offering memorandum. Since these firms and Mauldin receive fees from the funds they recommend/market, they only recommend/market products with which they have been able to negotiate fee arrangements.

PAST RESULTS ARE NOT INDICATIVE OF FUTURE RESULTS. THERE IS RISK OF LOSS AS WELL AS THE OPPORTUNITY FOR GAIN WHEN INVESTING IN MANAGED FUNDS. WHEN CONSIDERING ALTERNATIVE INVESTMENTS, INCLUDING HEDGE FUNDS, YOU SHOULD CONSIDER VARIOUS RISKS INCLUDING THE FACT THAT SOME PRODUCTS: OFTEN ENGAGE IN LEVERAGING AND OTHER SPECULATIVE INVESTMENT PRACTICES THAT MAY INCREASE THE RISK OF INVESTMENT LOSS, CAN BE ILLIQUID, ARE NOT REQUIRED TO PROVIDE PERIODIC PRICING OR VALUATION INFORMATION TO INVESTORS, MAY INVOLVE COMPLEX TAX STRUCTURES AND DELAYS IN DISTRIBUTING IMPORTANT TAX INFORMATION, ARE NOT SUBJECT TO THE SAME REGULATORY REQUIREMENTS AS MUTUAL FUNDS, OFTEN CHARGE HIGH FEES, AND IN MANY CASES THE UNDERLYING INVESTMENTS ARE NOT TRANSPARENT AND ARE KNOWN ONLY TO THE INVESTMENT MANAGER. Alternative investment performance can be volatile. An investor could lose all or a substantial amount of his or her investment. Often, alternative investment fund and account managers have total trading authority over their funds or accounts; the use of a single advisor applying generally similar trading programs could mean lack of diversification and, consequently, higher risk. There is often no secondary market for an investor’s interest in alternative investments, and none is expected to develop. You are advised to discuss with your financial advisers your investment options and whether any investment is suitable for your specific needs prior to making any investments.

All material presented herein is believed to be reliable but we cannot attest to its accuracy. Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staffs may or may not have investments in any funds cited above as well as economic interest. John Mauldin can be reached at 800-829-7273.

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Outside the Box: The New Normal-Some Expensive Consequences

 

Everybody talks about the weather, but there’s not much we can do about it except make plans that take into account what mother nature may throw at us. For most of us that means planning for the next few days, but we should all be aware of climate patterns that are going to affect us for the next 20 to 30 years. And those patterns are changing not just because of global climate change but also due to long-term periodic changes in the Atlantic and Pacific oceans.

Look at what my friend and one of the world’s preeminent climatologists Evelyn Browning Gariss writes:

The “New Normal” [climate pattern], with a warm Atlantic and a Pacific that tends to be cool (interrupted by El Niños) is changing US temperature and precipitation patterns. This in turn has had a major impact on sectors of the US economy. Remember, companies doing long-term planning often use records that are only 25 to 30 years in duration. The PDO tipped only 7 years ago. Most of the records that are used by policy-makers are biased towards times when the PDO was wetter than it is today. This has resulted in mistaken ideas of how rare a weather event may be. We saw what a potential disaster this 25-30 year approach could be when NOAA tropical storm concerns were brushed aside by New York and New Jersey because there had been no landfalls since the 1950s.

We are dealing with the same Atlantic and Pacific configurations that shaped the 1950s. Our economy and society will have to learn to cope with this New Normal.

Evelyn is the daughter of Ibn Browning, who for decades was one of the leading climatologists in America, and she has carried on that proud tradition. I regularly read her work and factor it into my thinking. If you like what you find in the special excerpt from The Browning Newsletter that Evelyn and colleagues have prepared for this week’s Outside the Box, you can learn more and subscribe here.

Note that if you invest in companies or run your own business, where long-term and seasonal climate and weather movements can make a difference and you are not consulting with serious climatologists you are (as I used to tell my kids when they were growing up) just “cruising for a bruising.”

As this note on the climate is brief, I want to commend to you something that will let you take action on another important, long-term problem, that of growing unfunded federal government liabilities. My friend Lawrence Kotlikoff has been doing yeoman work drafting legislation for which he has now lined up significant bipartisan support in Congress. This bill would require congressional budgeting offices to actually state the long-term fiscal impact of current legislation on future generations. He also has support of 12 Nobel laureates and over 500 economists, who represent as broad a spectrum of economic thinking as you will find today.

This generation of Americans is very likely to be the first generation in our history as a nation to leave a worse economy and a worse fiscal position than the one they inherited. The INFORM ACT is a step in the right direction toward informing Americans of the magnitude of this problem.” – James Heckman, Nobel Laureate in Economics

I offer Kotlikoff’s summary of the Inform Act at the conclusion of this Outside the Box and urge you to go to http://www.theinformact.org/ and sign up yourself and pass the word to your friends and associates. If you have contacts in Congress, then get them to add their names to the bill. No Congressman will be able to publicly oppose this bill, although privately many of them will be horrified that their constituents and especially young people may begin to learn the truth.

I find myself happily ensconced on Flathead Lake in Montana. I’m with my friend Darrell Cain, and we’re looking out over the lake at the magnificent Rockies. The weather is about as perfect as it can get. They don’t call this region the Big Sky Country for nothing. The night sky is unbelievable, and from the deck you’re looking directly up into the Pleiades in the middle of the annual meteor shower. It is spectacular up here. And for the first time in my life I saw the International Space Station fly past. It was clearly the brightest object in the sky, and due to its motion opposite the Earth’s rotation, it appeared to be screamingly fast. And it is fast! 17,500 mph and an orbit of the Earth every 92 minutes. It went from horizon to horizon in just a few minutes.

I will be here another four days, and I can see why Darrell has come here every summer for the last 10 years and is now here with his extended family. This is a slice of heaven. But today is the last day with the family, and then it’s just me, Darrell, and ETF trading maven Steve Cucchiaro, founder of Windhaven. It will be interesting to see what I write this week, after I’ve had a little time to relax and think.

Finally, let me commend a couple short articles written by my friend Barry Ritholtz: “On the Value of Not Knowing” and “10 reasons why economics is an art, not a science.”

And with that it’s time to go ahead and hit the send button.

You’re trying to introduce myself to the concept of relaxing analyst,

John Mauldin, Editor
Outside the Box
subscribers@mauldineconomics.com


 

The New Normal — Some Expensive Consequences

Excerpted from The Browning Newsletter, August 2013, Vol. 38, No. 8

SUMMARY

From the Western wildfires to the Great Lakes, from insurance to transportation, real estate values, and fuel, the “New Normal” is having a major negative impact on certain sectors of the North American economy.

Long-term planning, using 20+ years of data, is biased towards climate conditions that no longer exist. If long-term planners look at 60-80 years of climate data, they should make different and better decisions.

Climate change is affecting the bottom line. The changes in two long-term trends are raising costs and cutting profits for a number of industries. As long as each bad year is accepted as a one-off, rather than the New Normal, these “unexpected” losses will continue.

•      THE ATLANTIC – The waters in the Gulf Stream are flowing faster, carrying more hot tropical waters along US shores.

•      THE PACIFIC – The Pacific has a 50-60 year cycle, called the Pacific Decadal Oscillation (PDO), that shifts warmer waters through the Northern Pacific. Starting in 1999 and tipping in 2006, the PDO has shifted cooler waters to US shores. Although occasionally interrupted by a warm El Niño, this creates drier Western weather. [Figure 1]

History shows that both trends will last another 15 to 20 years. We are starting to see the impact of these changes.

figure1

Most models include weather patterns from the era when the Pacific Decadal Oscillation was positive. Now it is negative, creating drier conditions in Western North America.
©Evelyn Garriss Browning

Wildfires: “Not Every House Should Be Saved”

When the PDO changed to its negative phase, the West became drier. Forest densities that were appropriate during the wet positive phase are too dense in drier times. The trees in the tightly packed forests became stressed, leaving them more susceptible to disease, insect infestations, and wildfires. Policies that were adequate for managing the wilderness in the wet phase of the PDO do not work now. This has led to disastrous megafires in the Western states. As noted by Bill Gabbart of Wildfire Today, “Six of the last 9 years had more burned acres than in any year between 1960 and 2003.”

This is not just a Western problem. [Figure 2] The cold PDO magnifies the impact of cool La Niñas. This, combined with the warm Atlantic, has made drought more common in the South and Midwest. Wildfires, if not megafires, have become more common in these areas as well.

figure 2

Since the Atlantic warmed in 1995, North America has faced a greater risk of drought. With a negative PDO (cool Pacific), the Southwest, Rocky Mountains, Southern Plains, and Midwest face greater risk of drought.
US data: USGS ©Evelyn Garriss Browning

Policies and Insurance

When the PDO turned warm and wet in the 1970s, there was a national surge in home building in what is known as the Wildland/Urban Interface (WUI). According to a 2005 report cited by the Forest Service, some 32 percent of US housing units and 10 percent of all land with housing are situated in the WUI fire-prone ecosystems.

The cost of fighting these fires is soaring – since 2000 the national price tag has tripled to $3 billion. In 1991, firefighting took up 13% of the Forest Service budget. Last year it consumed 40%. Meanwhile, firefighters are changing their strategies toward the WUI communities. Firefighters now focus on protecting the community rather than putting out the fire. The wildfire thins out the underbrush in the surrounding wilderness. Less mentioned is the strategy of declaring extremely fire-vulnerable houses indefensible and refusing to commit crews to some high-risk firescapes with limited values.

As forest fire fighting has increasingly focused on protecting communities and private property and costs have increased, there have been growing demands that property owners pay for the services and/or be discouraged from developing in WUI areas.

With federal policy increasingly defining forest fire damage to property as a natural disaster, similar to hurricanes and floods, property owners in Woodland/Urban Interface zones, 32% of all US housing units, can expect to see mounting insurance rates. This is happening in an already struggling housing market.

Western Water Levels: Electricity and Irrigation

At the beginning of August, only Montana’s reservoirs were at or above capacity [Figure 3], while those of four Western states (Colorado, Nevada, New Mexico, and Oregon) were running at less than 50% capacity. The official measurements are not yet out, but reservoir levels have continued to decline.


figure3
Western Reservoirs have been lower since the PDO began changing in 1999.

When water levels are low, the division of stored water reserves is determined by politics. Remember, obscure endangered fish and wealthy country clubs have more political clout than farms. In the current drought, California’s Central Valley Project is allotting only 20% of its water to farmers, and unless there’s a wet winter coming up, they might get 0% next year.

Studies show that Western droughts and lower reservoir levels affect coal and nuclear electrical facilities as well as hydroelectricity. (Coal and nuclear generators need water for cooling.) Previous Western droughts reduced hydroelectricity production by 13.2%, raising energy costs by 9.5%.

Great Lakes Water Levels

The Western US is not the only region with low lake levels. Lakes Michigan and Huron set new record-low water levels last December, while the other Great Lakes dropped as well. Although some of this is due to the low snowfall levels of the winter of 2011/2012, the real problem is that the lakes have endured 14 years of below-average levels. [Figure 4]


figure 4
Selected Great Lakes water levels: 1916-2013. For the last 14 years, Great Lakes water levels have been severely reduced since 1999. This historically correlates to the negative PDO.
http://www.glerl.noaa.gov/data/now/wlevels/levels.html

There is no scientific literature that ties the lower Great Lakes levels to the negative PDO, but the two correlate historically. If the negative PDO is a large factor in reducing water levels, then these lower levels will continue another 20 years.

The economic impact of these falling levels is hard to overstate. The lower levels pose economic threats to numerous industries that rely on the lakes’ water supply, including, shipping, electric, (especially hydroelectric) power generation, tourism, and recreational boating.

Both US and Canadian industries that rely on bulk materials such as iron ore, coal, limestone, and salt are hugely dependent on lake travel. Lakers move products at prices that beat rail or road by as much as $20 per ton of cargo. Lower lake levels, however, force ships to lighten their loads, making hauling less efficient. It is estimated, for example, that a large laker, 1,000 feet long, would ship 324,000 fewer tons per season for each inch lost from Great Lake levels.

The lower Great Lakes levels, combined with hotter summer temperatures, have had serious impacts on energy production. The cost of shipping coal has increased, and a recent Department of Energy study reports that multiple Midwestern electrical plants have been affected. Oil, coal, gas, and nuclear generators that depend on the lakes’ waters for cooling have seen lower water levels and higher temperatures affect their efficiency, which in turn has raised the cost of electricity to consumers.

Conclusion

The “New Normal,” with a warm Atlantic and a Pacific that tends to be cool (interrupted by El Niños) is changing US temperature and precipitation patterns. This in turn has had a major impact on sectors of the US economy.

Remember, companies doing long-term planning often use records that are only 25 to 30 years in duration. The PDO tipped only 7 years ago. Most of the records that are used by policy-makers are biased towards times when the PDO was wetter than it is today. This has resulted in mistaken ideas of how rare a particular weather event may be. We saw what a disaster this 25-30 year approach could be when NOAA tropical storm concerns were brushed aside by New York and New Jersey because there had been no landfalls since the 1950s.

We are dealing with the same Atlantic and Pacific configurations that shaped the 1950s. Our economy and society will have to learn to cope with this New Normal.

This generation of Americans is very likely to be the first generation in our history as a nation to leave a worse economy and a worse fiscal position than the one they inherited. THE INFORM ACT is a step in the right direction toward informing Americans of the magnitude of this problem.”
– James Heckman, Nobel Laureate in Economics

Dear Fellow Economists and Other Fellow Citizens,

Please join the 12 Nobel Laureates in Economics, prominent former government officials, and others listed here in endorsing the INFORM ACT.

The INFORM ACT requires the Congressional Budget Office (CBO), the General Accountability Office (GAO), and the Office of Management and Budget (OMB) to do fiscal gap accounting and generational accounting on an annual basis and, upon request by Congress, to use these accounting methods to evaluate major proposed changes in fiscal legislation.

The INFORM ACT is a bi-partisan initiative. The bill was introduced Senators Kaine (Democrat from Virginia) and Senator Thune (Republican from South Dakota) and is being co-sponsored by Senator Coons (Democrat from Delaware) and Senator Portman (Republican from Ohio). The Bill will shortly be introduced on a bi-partisan basis in the House of Representatives.

Background

The fiscal gap is a comprehensive measure of our government’s indebtedness. It is defined as the present value of all projected future expenditures, including servicing outstanding official federal debt, less the present value of all projected future tax and other receipts, including income accruing from the government’s current ownership of financial assets.

Generational accounting measures the burden on today’s and tomorrow’s children of closing the fiscal gap assuming that current adults are neither asked to pay more in taxes nor receive less in transfer payments than current policy suggests and that successive younger generations’ lifetime tax payments net of transfer payments received rise in proportion to their labor earnings.

Neither fiscal gap nor generational accounting are perfect measures of fiscal sustainability or generation-specific fiscal burdens. But they offer significant advantages relative to conventional measures of official debt. First, they are comprehensive and forward-looking. Second, they are based on the government’s intertemporal or long-term budget constraint, which is a mainstay of economic models of fiscal policy. Third, neither generational accounting nor fiscal gap accounting leave anything off the books.

Fiscal gap accounting and generational accounting have been done for roughly 40 developed and developing countries either by their treasury departments, finance ministries, or central banks, or by the IMF, the World Bank, or other international agencies, or by academics and think tanks. Fiscal gap accounting is not new to our own government. The Social Security Trustees and Medicare Trustees have been presenting such calculations for their own systems for years in their annual reports. And generational accounting has been included in the President’s Budget on three occasions.

According to recent IMF and CBO projections, the U.S. fiscal gap is far larger than the official debt and compounding very rapidly. The longer we wait to close the fiscal gap, the more difficult will be the adjustment for ourselves and for our children. This said, acknowledging the government’s fiscal gap and deciding how to deal with it does not rule out productive government investments in infrastructure, education, research, or the environment, or in pro-growth tax reforms.

Your endorsement, together with those of the Nobel Laureates and former high-level government officials, will be included in an open letter to Congress, which will be printed in the New York Times in a full page ad in the Fall. A copy of the letter is provided on this site.

Please Endorse the INFORM ACT by clicking on the ENDORSE tab on [our] site. Please also forward the url to this site, tweet it, like it, share it and do anything else you can to encourage other economists and concerned citizens to endorse the INFORM ACT.

With deep appreciation for your consideration of this request,

Larry Kotlikoff
Professor of Economics, Boston University

http://www.theinformact.org/

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Outside the Box and MauldinEconomics.com is not an offering for any investment. It represents only the opinions of John Mauldin and those that he interviews. Any views expressed are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest and is not in any way a testimony of, or associated with, Mauldin’s other firms. John Mauldin is the Chairman of Mauldin Economics, LLC. He also is the President of Millennium Wave Advisors, LLC (MWA) which is an investment advisory firm registered with multiple states, President and registered representative of Millennium Wave Securities, LLC, (MWS) member FINRA, SIPC, through which securities may be offered . MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB) and NFA Member. Millennium Wave Investments is a dba of MWA LLC and MWS LLC. This message may contain information that is confidential or privileged and is intended only for the individual or entity named above and does not constitute an offer for or advice about any alternative investment product. Such advice can only be made when accompanied by a prospectus or similar offering document. Past performance is not indicative of future performance. Please make sure to review important disclosures at the end of each article. Mauldin companies may have a marketing relationship with products and services mentioned in this letter for a fee.

Note: Joining The Mauldin Circle is not an offering for any investment. It represents only the opinions of John Mauldin and Millennium Wave Investments. It is intended solely for investors who have registered with Millennium Wave Investments and its partners at http://www.MauldinCircle.com (formerly AccreditedInvestor.ws) or directly related websites. The Mauldin Circle may send out material that is provided on a confidential basis, and subscribers to the Mauldin Circle are not to send this letter to anyone other than their professional investment counselors. Investors should discuss any investment with their personal investment counsel. You are advised to discuss with your financial advisers your investment options and whether any investment is suitable for your specific needs prior to making any investments. John Mauldin is the President of Millennium Wave Advisors, LLC (MWA), which is an investment advisory firm registered with multiple states. John Mauldin is a registered representative of Millennium Wave Securities, LLC, (MWS), an FINRA registered broker-dealer. MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB). Millennium Wave Investments is a dba of MWA LLC and MWS LLC. Millennium Wave Investments cooperates in the consulting on and marketing of private and non-private investment offerings with other independent firms such as Altegris Investments; Capital Management Group; Absolute Return Partners, LLP; Fynn Capital; Nicola Wealth Management; and Plexus Asset Management. Investment offerings recommended by Mauldin may pay a portion of their fees to these independent firms, who will share 1/3 of those fees with MWS and thus with Mauldin. Any views expressed herein are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest with any CTA, fund, or program mentioned here or elsewhere. Before seeking any advisor’s services or making an investment in a fund, investors must read and examine thoroughly the respective disclosure document or offering memorandum. Since these firms and Mauldin receive fees from the funds they recommend/market, they only recommend/market products with which they have been able to negotiate fee arrangements.

PAST RESULTS ARE NOT INDICATIVE OF FUTURE RESULTS. THERE IS RISK OF LOSS AS WELL AS THE OPPORTUNITY FOR GAIN WHEN INVESTING IN MANAGED FUNDS. WHEN CONSIDERING ALTERNATIVE INVESTMENTS, INCLUDING HEDGE FUNDS, YOU SHOULD CONSIDER VARIOUS RISKS INCLUDING THE FACT THAT SOME PRODUCTS: OFTEN ENGAGE IN LEVERAGING AND OTHER SPECULATIVE INVESTMENT PRACTICES THAT MAY INCREASE THE RISK OF INVESTMENT LOSS, CAN BE ILLIQUID, ARE NOT REQUIRED TO PROVIDE PERIODIC PRICING OR VALUATION INFORMATION TO INVESTORS, MAY INVOLVE COMPLEX TAX STRUCTURES AND DELAYS IN DISTRIBUTING IMPORTANT TAX INFORMATION, ARE NOT SUBJECT TO THE SAME REGULATORY REQUIREMENTS AS MUTUAL FUNDS, OFTEN CHARGE HIGH FEES, AND IN MANY CASES THE UNDERLYING INVESTMENTS ARE NOT TRANSPARENT AND ARE KNOWN ONLY TO THE INVESTMENT MANAGER. Alternative investment performance can be volatile. An investor could lose all or a substantial amount of his or her investment. Often, alternative investment fund and account managers have total trading authority over their funds or accounts; the use of a single advisor applying generally similar trading programs could mean lack of diversification and, consequently, higher risk. There is often no secondary market for an investor’s interest in alternative investments, and none is expected to develop.

All material presented herein is believed to be reliable but we cannot attest to its accuracy. Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staffs may or may not have investments in any funds cited above as well as economic interest. John Mauldin can be reached at 800-829-7273.

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Thoughts from the Frontline: We Can’t Take the Chance

 

What would it have been like to be in the decision-maker’s seat at a central bank in the midst of the crisis in 2008-09? You’d know that you won’t have the luxury of going back and making better decisions five years later. Instead, you have to act on the torrent of information that’s coming at you from every quarter, and none of it is good. Major banks are literally collapsing, the interbank market is almost nonexistent, and there is panic in the air. Perhaps you feel that panic in the pit of your stomach. This week we’ll perform a little thought experiment to see if we can extrapolate what is likely to happen in when the next crisis kicks in.

This week’s letter was triggered by a semiformal debate in Maine last week. David Kotok assembled about 50 economists, financial analysts, money managers, and media personalities to share a few days of fabulous food, what turned out to be great fishing, and awesome conversation. There were more Federal Reserve economists this year than in the past, as well as more attendees with the title “Chief Economist” on their business cards, many from large institutional names you would recognize. This was my seventh year to attend “Camp Kotok.” David really did a marvelous job of bringing a diverse group of thinkers together, and I think everyone agreed this was the best conference ever. I learned a lot.

Before we get into the letter, a little side note. Luciana Lopez from Reuters attended for the first time this year and wanted to do interviews. David asked me if I would take her out on the lake in our boat, since most of the other attendees went out in small canoes. Trey and I were glad to share our space. While we were out fishing, she asked if she could interview me. I said “Sure” and waited for her to bring out her recorder. She pulled out an iPhone 5 and started asking questions. Not the usual studio setting I am used to. I had serious trepidations about how this was going to look on-screen.

She sent a link to her edited interviews last Monday, and I have to admit I was impressed at what she could do with a simple iPhone 5. I am supposed to be on top of a changing world, but sometimes these things still take me by surprise. I make no representations about the quality of the content of the interviews, at least my portion of them, but the phone is another matter. And in a few years this will be a $100 consumer item.

In her interviews, Luciana asked two questions: “When will the Fed start to taper?” and “Who will be the next Fed chair?” You can see some of our answers at reut.rs/13if7Er and reut.rs/13gegE8.

We Can’t Take the Chance

On Saturday night David scheduled a formal debate between bond maven Jim Bianco and former Bank of England Monetary Policy Committee member David Blanchflower  (everyone at the camp called him Danny). Jim Bianco needs little introduction to longtime readers, but for newbies, he is one of the top bond and interest-rate gurus in the world. His research is some of the best you can get – if you can get your hands on it.

Blanchflower needs a little setup. He is currently a professor at Dartmouth and has one of the more impressive resumés you will find. He is not afraid to be a contrarian and voted in the minority in 18 out of 36 meetings in which he participated as an external member of the Bank of England‘s interest rate-setting Monetary Policy Committee (MPC) from June 2006 to June 2009. (The MPC is the British equivalent of the US Federal Open Market Committee.) Blanchflower’s The Wage Curve, drawing on 8 years of data from 4 million people in 16 countries, argued that the wage curve, which plots wages against unemployment, is negatively sloping, reversing the conclusion from generations of macroeconomic theory. “The Phillips Curve is wrong, it’s as fundamental as that,” Blanchflower has stated. Blanchflower is also known as the “happiness guru” for his work on the economics of happiness. He quantified the relationship between age and happiness and between marriage, sex, and happiness. Who knew that people who have more sex are happier? Well, we all did, but now we have economic proof.

I got to spend a good deal of time with Danny on this trip and enjoyed hearing him talk about what it was like to be responsible for setting monetary policy in the midst of a crisis. We also argued late into the night on a variety of subjects. He is an altogether fun guy as well as a professional who takes his economics seriously. He is far more mainstream than your humble analyst, as were many of the denizens of Camp Kotok. On the other hand, I can’t think of a major stream of economic thought that wasn’t represented aggressively at one point or another. If you have thin skin or weak data, this outing is one you might not enjoy. You need to bring your A game with this crowd.

The format for the debate between Bianco and Blanchflower was simple. The question revolved around Federal Reserve policy and what the Fed should do today. To taper or not to taper? In fact, should they even entertain further quantitative easing? Bianco made the case that quantitative easing has become the problem rather than the solution. Blanchflower argued that quantitative easing is the correct policy. Fairly standard arguments from both sides but well-reasoned and well-presented.

It was during the question-and-answer period that my interest was piqued. Bianco had made a forceful argument that big banks should have been allowed to fail rather than being bailed out. The question from the floor to Danny was, in essence, “What if the Bianco is right? Wouldn’t it have been better to let banks fail and then restructure them in bankruptcy? Wouldn’t we have recovered faster, rather than suffering in the slow-growth, high-unemployment world where we find ourselves now?”

Blanchflower pointed his finger right at Jim and spoke forcefully. “It wasn’t the possibility that he was right that preoccupied us. We couldn’t take the chance that he was wrong. If he was wrong and we did nothing, the world would’ve ended and it would’ve been our fault. We had to act.”

That sentence has stayed with me for the past week: “We couldn’t take the chance that he was wrong.” Whether or not you like the implications of what he said, the simple fact is that he was expressing the reigning paradigm of economic thought in the world of central bankers.

Now, let’s hold that train of thought for a few minutes as we introduce an essay by French geophysicist and complex systems analyst Didier Sornette  and his colleague Peter Cauwels. Sornette is Professor on the Chair of Entrepreneurial Risks at the Department of Management Technology and Economics of the Swiss Federal Institute of Technology Zurich. (This introduction comes from work I have been doing in collaboration with Jonathan Tepper, my co-author for Endgame.)

By far the biggest advances in understanding the dynamics of bubbles in recent years have come from Sornette. He has developed mathematical models to explain earthquake activity, Amazon book sales, herding behavior in social networks like Facebook, and even stock market bubbles and crashes. He wrote a book titled Why Stockmarkets Crash. He found that most theories do a very poor job of explaining bubbles.

Sornette found that log-periodic power laws do a good job of describing speculative bubbles, with very few exceptions. Classic bubbles tend to have a parabolic advances with shallow and increasingly frequent corrections. Eventually, you begin to see price spikes at one-day, one-hour, and even ten-minute intervals before crashes. 

After a crash, journalists go looking for the cause. They’ll blame something like portfolio insurance for the crash of 1987 or the bankruptcy of Lehman Brothers for the Great Recession, rather than blaming a fundamentally unstable market. Sornette disagrees:

Most approaches to explain crashes search for possible mechanisms or effects that operate at very short time scales (hours, days or weeks at most). We propose here a radically different view: the underlying cause of the crash must be searched months and years before it, in the progressive increasing build-up of market cooperativity or effective interactions between investors, often translated into accelerating ascent of the market price (the bubble). According to this “critical” point of view, the specific manner by which prices collapsed is not the most important problem: a crash occurs because the market has entered an unstable phase and any small disturbance or process may have triggered the instability. Think of a ruler held up vertically on your finger: this very unstable position will lead eventually to its collapse, as a result of a small (or absence of adequate) motion of your hand…. The collapse is fundamentally due to the unstable position; the instantaneous cause of the collapse is secondary. In the same vein, the growth of the sensitivity and the growing instability of the market close to such a critical point might explain why attempts to unravel the local origin of the crash have been so diverse. Essentially, anything would work once the system is ripe.

To continue reading this article from Thoughts from the Frontline – a free weekly publication by John Mauldin, renowned financial expert, best-selling author, and Chairman of Mauldin Economics – please click here.

© 2013 Mauldin Economics. All Rights Reserved.
Thoughts from the Frontline is a free weekly economic e-letter by best-selling author and renowned financial expert, John Mauldin. You can learn more and get your free subscription by visiting www.MauldinEconomics.com.

Please write to subscribers@mauldineconomics.com to inform us of any reproductions, including when and where copy will be reproduced. You must keep the letter intact, from introduction to disclaimers. If you would like to quote brief portions only, please reference www.MauldinEconomics.com.

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Thoughts From the Frontline and MauldinEconomics.com is not an offering for any investment. It represents only the opinions of John Mauldin and those that he interviews. Any views expressed are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest and is not in any way a testimony of, or associated with, Mauldin’s other firms. John Mauldin is the Chairman of Mauldin Economics, LLC. He also is the President and registered representative of Millennium Wave Advisors, LLC (MWA) which is an investment advisory firm registered with multiple states, President and registered representative of Millennium Wave Securities, LLC, (MWS) member FINRA and SIPC, through which securities may be offered. MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB) and NFA Member. Millennium Wave Investments is a dba of MWA LLC and MWS LLC. This message may contain information that is confidential or privileged and is intended only for the individual or entity named above and does not constitute an offer for or advice about any alternative investment product. Such advice can only be made when accompanied by a prospectus or similar offering document. Past performance is not indicative of future performance. Please make sure to review important disclosures at the end of each article. Mauldin companies may have a marketing relationship with products and services mentioned in this letter for a fee.

Note: Joining The Mauldin Circle is not an offering for any investment. It represents only the opinions of John Mauldin and Millennium Wave Investments. It is intended solely for investors who have registered with Millennium Wave Investments and its partners at http://www.MauldinCircle.com (formerly AccreditedInvestor.ws) or directly related websites. The Mauldin Circle may send out material that is provided on a confidential basis, and subscribers to the Mauldin Circle are not to send this letter to anyone other than their professional investment counselors. Investors should discuss any investment with their personal investment counsel. John Mauldin is the President of Millennium Wave Advisors, LLC (MWA), which is an investment advisory firm registered with multiple states. John Mauldin is a registered representative of Millennium Wave Securities, LLC, (MWS), an FINRA registered broker-dealer. MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB). Millennium Wave Investments is a dba of MWA LLC and MWS LLC. Millennium Wave Investments cooperates in the consulting on and marketing of private and non-private investment offerings with other independent firms such as Altegris Investments; Capital Management Group; Absolute Return Partners, LLP; Fynn Capital; Nicola Wealth Management; and Plexus Asset Management. Investment offerings recommended by Mauldin may pay a portion of their fees to these independent firms, who will share 1/3 of those fees with MWS and thus with Mauldin. Any views expressed herein are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest with any CTA, fund, or program mentioned here or elsewhere. Before seeking any advisor’s services or making an investment in a fund, investors must read and examine thoroughly the respective disclosure document or offering memorandum. Since these firms and Mauldin receive fees from the funds they recommend/market, they only recommend/market products with which they have been able to negotiate fee arrangements.

PAST RESULTS ARE NOT INDICATIVE OF FUTURE RESULTS. THERE IS RISK OF LOSS AS WELL AS THE OPPORTUNITY FOR GAIN WHEN INVESTING IN MANAGED FUNDS. WHEN CONSIDERING ALTERNATIVE INVESTMENTS, INCLUDING HEDGE FUNDS, YOU SHOULD CONSIDER VARIOUS RISKS INCLUDING THE FACT THAT SOME PRODUCTS: OFTEN ENGAGE IN LEVERAGING AND OTHER SPECULATIVE INVESTMENT PRACTICES THAT MAY INCREASE THE RISK OF INVESTMENT LOSS, CAN BE ILLIQUID, ARE NOT REQUIRED TO PROVIDE PERIODIC PRICING OR VALUATION INFORMATION TO INVESTORS, MAY INVOLVE COMPLEX TAX STRUCTURES AND DELAYS IN DISTRIBUTING IMPORTANT TAX INFORMATION, ARE NOT SUBJECT TO THE SAME REGULATORY REQUIREMENTS AS MUTUAL FUNDS, OFTEN CHARGE HIGH FEES, AND IN MANY CASES THE UNDERLYING INVESTMENTS ARE NOT TRANSPARENT AND ARE KNOWN ONLY TO THE INVESTMENT MANAGER. Alternative investment performance can be volatile. An investor could lose all or a substantial amount of his or her investment. Often, alternative investment fund and account managers have total trading authority over their funds or accounts; the use of a single advisor applying generally similar trading programs could mean lack of diversification and, consequently, higher risk. There is often no secondary market for an investor’s interest in alternative investments, and none is expected to develop. You are advised to discuss with your financial advisers your investment options and whether any investment is suitable for your specific needs prior to making any investments.

All material presented herein is believed to be reliable but we cannot attest to its accuracy. Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staffs may or may not have investments in any funds cited above as well as economic interest. John Mauldin can be reached at 800-829-7273.

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Outside the Box: Bad Omens

By John Mauldin

 

We have clearly been in a recent run of higher interest rates, with a looming “threat” that there might be less quantitative easing before the end of the year. It would appear now that Bernanke wants to leave his successor to implement what everyone knows must be coming at some point: a return to a normal interest-rate environment. While rising interest rates are bad for me personally (for another four months), a return to normalcy would be good for our future – though the transition is likely to be bumpy.

With this in mind, I offer this week’s Outside the Box from Louis and Charles Gave. In a brief essay entitled “Bad Omens,” they note:

 … if the recent global equity market sell-off can be laid at the feet of the 100bp move higher in US bond yields, it is hard to know how another 50bp increase in real rates will be digested.

US investors might not have noticed, but there is carnage scattered here and there on the world’s markets, and not just the equity markets. The central banks of the world, in their furious attempts to promote stability through easy-money policies, have cooked up a witches’ brew of instability of unknown quantity and contents. There is no set formula for this concoction; they are making it up as they go along. Anything that seems to calm the storm momentarily becomes the order of the day. Bernanke hints at the mere possibility of less easing (not tightening, God forbid!), something that we all know must happen at some point, and the market throws up and half a dozen Fed governors go on the air to say “Not really … maybe … we are going to be cautious … we’ll go slow … no one wants to do anything rash” – etc. It was almost comical.

Thus we can expect a volatile summer (as the interns man the trading desks), and I think you will find the Gaves’ insights useful.

I am somewhat better, though still weak, but I’m glad to be home where I can pause and rest as necessary. I have not been down this long since I was a kid. For all those years of good health I am grateful, and I hope to go another 50 years without problems like the ones I’ve had this week. In the grand scheme of things, there are so many who are having to deal with so much more. I am a lucky man.

I feel I should have warned my readers about the rise in interest rates. Rates have risen since just about the day that I irrevocably committed to a large mortgage which I cannot lock in until construction is done. The interim loan rate is quite cheap, but I am made acutely aware of what rising interest rates can do to a home payment, since I must go to more conventional financing within a year. And hedge in yen.

The weather here in Texas is abnormally nice for July. Instead of the typical 100s, highs are in the low 80s, at least in the shade. If it was this way all the time, our problem would be dealing with the tax refugees from California and New England. Have a great week.

Your watching his new place begin to take shape analyst,

John Mauldin, Editor
Outside the Box
subscribers@mauldineconomics.com

Bad Omens

By Louis Gave & Charles Gave

In late May we published a debate piece on the near-term outlook for equity markets. Since then, emerging markets have once again lived up to their name by proving themselves hard to emerge from during an emergency (in USD terms, Brazil is down –35% year to date while Chinese valuations are back to 2008-crisis levels); for their part, European and US equity markets have pulled back, while the only salvation has come from Japan (the one market where it’s possible to find attractive valuations, accelerating economic activity and liquidity growth feeding off a Tour de France vitamin cocktail). But is this a case of Japan being the best looking horse in the glue factory? In the following paper, we aim to review a number of signs from equity markets that look somewhat ominous. Needless to say, we welcome any feedback on the below.

The question at hand: is this a break-out?

The chart over-leaf traces the relative performance of the S&P 500 against long-dated bonds since the Asian Crisis in 1997. Since then, the world has experienced a series of deflationary shocks, each of which has been met by more activism from the Fed and other central banks: i.e.: lower rates and higher monetary base growth. And each time, the excess money allowed for the rise in a few asset classes (TMT in the late 1990s, housing and financial intermediaries in the mid 2000s, commodities, fixed income instruments and emerging markets in the late 2000s…). But each time, the asset price rise was followed by an equity market bust; begging the question of whether the bust that seems to be unfolding in emerging markets is now the third iteration of a movie every investor has seen before (and which few have enjoyed)? Or whether the recent correlation between bonds and equities indicates that the repeated deflationary shocks are a thing of the past and nominal GDP growth will accelerate from now on? Could we be at a structural turning point?

1– A first bad omen: fewer markets rising

In the chart below, we take the top twenty equity markets in the world and compile a diffusion index that shows how many rose in the previous six months, against how many fell. So when the grey bar is at +20, global equity investors have made money in every major market; when the index reads –20 they found nowhere to hide. And when the number is in negative territory, it simply means that more markets have fallen then risen in the previous six months. The red line is the performance of the S&P 500. Since 1992, we have had 14 occurrences in which more stock markets were falling than rising. In 10 of these 14 occurrences, the S&P500 fell by at least –10%. In the other 4, the S&P 500’s performance hovered between 0% and –10%. As things stand, the S&P 500 has recorded a double digit rise in the past six months, a major divergence.

2– Another bad omen: collapsing silver prices

Unfortunately, it’s not as if, lately, equity markets have been the only place to lose money. Indeed, as every gold bug has rediscovered in recent months, precious metals have again proven that they are anything but a safe-haven. Still, drops of 30% or more in silver prices do not happen that often: looking back at the past 100 years, such drops have only occurred 11 times. And interestingly, each one of these massive declines marked a significant change in the world financial system.

To cut a long story short, the investment rules after large declines in precious metals were almost always totally different from the rules which prevailed before the fall. More worryingly, each such decline was accompanied by a massive recession/depression somewhere in the world and almost every time by a recession in the US (grey shaded areas), the only exception being 1983-1984 when the Latin American depression did not trigger a US recession but instead a collapse in oil prices.

3– Beyond stocks and precious metals

Let us imagine a pension fund whose assets are invested conservatively with 40% in global fixed income, 40% in global equities, 10% in the world’s largest hedge funds (Bridgewater, Man-AHL, AQR…), 5% in gold and 5% in private equity. Leaving aside the private equity illiquid pocket, our pension fund will have basically lost between 5% and 15% of its assets across the board in just a few weeks.

Following these widespread losses, will our pension fund look to a) increase its risk and average down on the more beaten-up asset classes (i.e.: emerging market equities) or b) reduce its risk and use the recent rise in yield to immunize liabilities (or reduce its portfolio’s volatility)? In a world directed by VaR measures, CAPM models, and CYA boards, is that even a question?

4– Falling inflation expectations

Not that the imagined pension fund in question would automatically be wrong in increasing its fixed income allocation. After all, inflation expectations in the US (and almost everywhere) are falling like a stone, implying that fixed income instruments now offer a much higher real yield than the recent rise in nominal interest rates might imply:

And these collapsing inflation expectations bring us to the chart above for, since the Asian Crisis, each time US inflation expectations fell below 1.5% (i.e.: a deflationary shock), US equities took a beating. That [doted] line in the sand is approaching fast. Just as worryingly, the collapse in inflation expectations, combined with the rise in nominal rates, means that the recent rise in US Baa real bond yields is the biggest one witnessed since the start of 2009—when bond markets were massively overbought.

Of course, one could argue that the recent rise in yields is nothing to worry about; that it is just the side effect of the air coming out of the bond market bubble (see our Quarterly Strategy Chart Book 2Q12—The Global Bond Yield Conundrum). Unfortunately, recent weeks have shown that such an attitude may be too carefree as most assets have reacted badly to falling bond prices. Indeed, if the recent global equity market sell-off can be laid at the feet of the 100bp move higher in US bond yields, it is hard to know how another 50bp increase in real rates will be digested? Looking at the bond vs equity trade-off today, it is easy to imagine Woody Allen saying “we have reached a cross-road. One way (rising yields?) leads us to despair and annihilation, the other (falling yields?) to certain death. I hope we choose wisely.”

Conclusion

So here we are, with:

  • China, the single biggest contributor to global growth over the past decade, slowing markedly.
  • World trade now flirting with recession.
  • OECD industrial production in negative territory YoY.
  • Southern Europe showing renewed signs of political tensions (i.e.: Portugal, Greece, Italy…) as unemployment continues its relentless march higher and tax receipts continue to collapse.
  • Short-term interest rates almost everywhere around the world that are unable to go any lower, even as real rates start to creep higher.
  • Valuations on most equity markets that are nowhere near distressed (except perhaps for the BRICS?).
  • A World MSCI that has now just dipped below its six month moving average.
  • A diffusion index of global equity markets that is flashing dark amber.
  • Margins in the US at record highs and likely to come under pressure, if only because of the rising dollar (most of the US margin expansion of the past decade has occurred thanks to foreign earnings—earnings that may now be challenging to sustain in the face of a weaker global trade growth and a stronger dollar).

Lackluster growth? Falling margins (outside of Japan)? Rising real rates? Unappealing valuations (outside of the BRICS)?… Perhaps these make up the wall of worry that global equities will climb successfully. After all, if the British and Irish Lions can win a rugby series in the Southern hemisphere, while a Scotsman wins Wimbledon, then nothing is impossible. Though perhaps the simpler explanation to the above growing list of bad omens was formulated by Claudius who said that “when sorrows come, they come not as single spies, but in battalions”.

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Outside the Box is a free weekly economic e-letter by best-selling author and renowned financial expert, John Mauldin. You can learn more and get your free subscription by visiting www.MauldinEconomics.com.
Please write to subscribers@mauldineconomics.com to inform us of any reproductions, including when and where copy will be reproduced. You must keep the letter intact, from introduction to disclaimers. If you would like to quote brief portions only, please reference www.MauldinEconomics.com.
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Outside the Box and MauldinEconomics.com is not an offering for any investment. It represents only the opinions of John Mauldin and those that he interviews. Any views expressed are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest and is not in any way a testimony of, or associated with, Mauldin’s other firms. John Mauldin is the Chairman of Mauldin Economics, LLC. He also is the President of Millennium Wave Advisors, LLC (MWA) which is an investment advisory firm registered with multiple states, President and registered representative of Millennium Wave Securities, LLC, (MWS) member FINRA, SIPC, through which securities may be offered . MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB) and NFA Member. Millennium Wave Investments is a dba of MWA LLC and MWS LLC. This message may contain information that is confidential or privileged and is intended only for the individual or entity named above and does not constitute an offer for or advice about any alternative investment product. Such advice can only be made when accompanied by a prospectus or similar offering document. Past performance is not indicative of future performance. Please make sure to review important disclosures at the end of each article. Mauldin companies may have a marketing relationship with products and services mentioned in this letter for a fee.

Note: Joining The Mauldin Circle is not an offering for any investment. It represents only the opinions of John Mauldin and Millennium Wave Investments. It is intended solely for investors who have registered with Millennium Wave Investments and its partners at http://www.MauldinCircle.com (formerly AccreditedInvestor.ws) or directly related websites. The Mauldin Circle may send out material that is provided on a confidential basis, and subscribers to the Mauldin Circle are not to send this letter to anyone other than their professional investment counselors. Investors should discuss any investment with their personal investment counsel. You are advised to discuss with your financial advisers your investment options and whether any investment is suitable for your specific needs prior to making any investments. John Mauldin is the President of Millennium Wave Advisors, LLC (MWA), which is an investment advisory firm registered with multiple states. John Mauldin is a registered representative of Millennium Wave Securities, LLC, (MWS), an FINRA registered broker-dealer. MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB). Millennium Wave Investments is a dba of MWA LLC and MWS LLC. Millennium Wave Investments cooperates in the consulting on and marketing of private and non-private investment offerings with other independent firms such as Altegris Investments; Capital Management Group; Absolute Return Partners, LLP; Fynn Capital; Nicola Wealth Management; and Plexus Asset Management. Investment offerings recommended by Mauldin may pay a portion of their fees to these independent firms, who will share 1/3 of those fees with MWS and thus with Mauldin. Any views expressed herein are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest with any CTA, fund, or program mentioned here or elsewhere. Before seeking any advisor’s services or making an investment in a fund, investors must read and examine thoroughly the respective disclosure document or offering memorandum. Since these firms and Mauldin receive fees from the funds they recommend/market, they only recommend/market products with which they have been able to negotiate fee arrangements.

PAST RESULTS ARE NOT INDICATIVE OF FUTURE RESULTS. THERE IS RISK OF LOSS AS WELL AS THE OPPORTUNITY FOR GAIN WHEN INVESTING IN MANAGED FUNDS. WHEN CONSIDERING ALTERNATIVE INVESTMENTS, INCLUDING HEDGE FUNDS, YOU SHOULD CONSIDER VARIOUS RISKS INCLUDING THE FACT THAT SOME PRODUCTS: OFTEN ENGAGE IN LEVERAGING AND OTHER SPECULATIVE INVESTMENT PRACTICES THAT MAY INCREASE THE RISK OF INVESTMENT LOSS, CAN BE ILLIQUID, ARE NOT REQUIRED TO PROVIDE PERIODIC PRICING OR VALUATION INFORMATION TO INVESTORS, MAY INVOLVE COMPLEX TAX STRUCTURES AND DELAYS IN DISTRIBUTING IMPORTANT TAX INFORMATION, ARE NOT SUBJECT TO THE SAME REGULATORY REQUIREMENTS AS MUTUAL FUNDS, OFTEN CHARGE HIGH FEES, AND IN MANY CASES THE UNDERLYING INVESTMENTS ARE NOT TRANSPARENT AND ARE KNOWN ONLY TO THE INVESTMENT MANAGER. Alternative investment performance can be volatile. An investor could lose all or a substantial amount of his or her investment. Often, alternative investment fund and account managers have total trading authority over their funds or accounts; the use of a single advisor applying generally similar trading programs could mean lack of diversification and, consequently, higher risk. There is often no secondary market for an investor’s interest in alternative investments, and none is expected to develop.

All material presented herein is believed to be reliable but we cannot attest to its accuracy. Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staffs may or may not have investments in any funds cited above as well as economic interest. John Mauldin can be reached at 800-829-7273.

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Outside the Box: Mind the (Expectations) Gap: Demographic Trends and GDP

 

For today’s Outside the Box we have a very special research piece by Rob Arnott of Research Associates and his colleague Denis Chaves. Rob was with us at Leen’s Lodge last week, and in the final evening discussion session he asked an interesting question having to do with demography and GDP growth. I was intrigued by it, but the group soon moved on without fully exploring Rob’s idea; so I mentioned it to him again later, and he was good enough to send along the following paper.

Rob’s description of their work, in an email to me this afternoon, gives us a pretty good synopsis:

[W]e show that the past 60 years—which we think of as “normal”— enjoyed a demographic tailwind which we can quantify.  It was worth about 1% per year, meaning that, if we think of 3% growth as normal, it’s really 2% growth plus a demographic tailwind of 1%. 

The coming decades—due to the rising support ratios from the aging boomers—will experience a demographic headwind of (very roughly—these will be wildly out-of-sample conditions) roughly the same 1%.  So, if 3% growth was normal, 1% growth (again, very roughly) becomes normal.  This is the reason behind my concerns regarding the legacy of monetary and fiscal experiments, and debt and deficits we leave our children.

One can see the potential for higher growth from new sources of ingenuity and the ongoing human experiment with technology, but the headwinds Rob talks about are very real and need to be factored into our analysis of the future structure of our portfolios.

Rob is one of my great friends, and we have spent a lot of time together over the years. We first met at the home of the late Peter Bernstein and soon found that we shared a great deal in terms of how we view the markets. Rob was then the editor of the Financial Analysts Journal. He has won no fewer than five Graham and Dodd Scrolls, awarded by the CFA Institute for best article of the year, plus lots of other honors. He is the largest outside manager at PIMCO, and he is the intellectual light behind the Fundamental Indexes I have written about so many times. He is simply one of the smartest guys on the planet and one of the most fun as well. What many people don’t know is that he has one of the top three or so motorcycle collections in the world. His bikes don’t just sit around looking pretty, either—they can all still go on the road. I don’t do motorcycles, not having a death wish, but Rob thinks riding them at 140 MPH (on a legal track) is entertaining. Quite the contrast to the conservative investor image he projects at meetings.

I am back in Dallas and catching up on a few things, but I’m still remembering the weekend. The fishing in our boat was the best Trey and I have had in seven years. We caught more fish the last morning than we had in an entire week in some previous years. We stayed busy pulling in one fairly large bass (catch and release!) after another. At one point we had three lines hit at the same time. Nothing fancy in terms of bait, just funny-colored plastic worms. Technically, I won on the most fish caught, after losing that contest for six years running, but Trey had me on the size of fish. He caught some monsters. And we enjoyed ourselves more than on any previous outing to Camp Kotok. The annual Maine fishing trip has become my gauge on Trey’s growing up.

I stopped off to see my mother after I landed Monday evening. She will be 96 next week, and though she is now bedridden, she is mentally as sharp as ever. She is not sick or suffering, thank God, but her body is just slowly rebelling. None of her ten brothers and sisters ever got to 96 (although a number made it to 95), so every time I leave home there is a certain emotion in me that I don’t really want to confront.

That old Jimmy Durante song from my youth kept playing in my head as I sat next to her:

Don’t you know that it’s worth
Every treasure on earth
To be young at heart?
For, as rich as you are,
It’s much better by far
To be young at heart
And, if you should survive
To a hundred and five,

Look at all you’ll derive
Just by being alive!
Now, here is the best part:
You have a head start
If you are amongst the very young …
At heart.

Your never gonna grow up analyst,

John Mauldin, Editor
Outside the Box
subscribers@mauldineconomics.com


Mind the (Expectations) Gap: Demographic Trends and GDP

By Rob Arnott and Denis Chaves

A large body of research in psychology and economics shows that human beings tend to form their expectations by relying on past experiences—especially recent ones. Malmendier and Nagel (2011), for instance, talk about investors who live through long periods of poor stock market performance and how this experience affects their risk-taking propensities… for life. The most famous example comes from the “Depression Babies,” an entire generation that was scarred for life by the financial and macroeconomic shocks of the Great Depression. Of course the opposite effect also exists: periods of economic ebullience give rise to more intrepid investors, entrepreneurs, and so on.

Those times might feel like a distant past now, but until recently 3–4% growth in real GDP was considered “normal.” So it should come as no surprise that the economic performance of the past few decades has strongly influenced expectations about economic growth. However, when optimistic expectations get detached from reality we risk creating a significant expectations gap—a disconnect between what we take for granted given our recent experiences and what we should anticipate given simple arithmetic.

We explore the role of demography—one of the three Ds of the 3-D hurricane of debt, deficits, and demographics—on economic growth in this issue of Fundamentals.2 The following synopsis of our forthcoming paper on the topic (Arnott and Chaves, 2013) demonstrates that favorable trends in the size and composition of populations have helped to fuel the rapid economic growth experienced in the developed world over the past 60 years, and their reversal plays a crucial part in the current rapid deceleration in developed world growth.

Demographic Evolution

Tracing very long term trends will certainly help situate existing and emerging demographic states of affairs in their historical context. It may also indicate what used to be “normal,” if, indeed, there ever was such a condition. We examine four distinct phases that represent past, current, and future population profiles across different countries:3

Phase I. The first phase, covering most of human history, was ostensibly a high-mortality steady state, with births roughly matching deaths, short lifespans, and elevated support ratios (the number of non-workers, young and old, supported by the labor force). Life in the first phase can probably be described best by Hobbes’ famous quote as “solitary, poor, nasty, brutish, and short.”4

Phase II. This phase, beginning around the time of the industrial revolution and climbing to a pinnacle in the decades after the Second World War, was characterized by a steady rise in life expectancy and a decline in birthrates. The working-age population soared and support ratios improved enormously.

Phase III. This phase, beginning in the present century, is almost an inverted image of the second phase: the fraction of seniors skyrockets and the fraction of workers tumbles. Until fertility rates get back to replacement levels (roughly 2.1 children per woman of child-bearing age), the population crests and begins to subside, with very high support ratios associated with senior citizens. However, this should not come as a surprise, because both phases II and III are impelled by the same forces: rising life expectancies and falling fertility rates.

Phase IV. This phase is the “future state,” which is by definition somewhat speculative. For convenience, we model it as a new steady state with births equaling deaths, and with long lifespans, perhaps much longer than today’s. We include it for the purpose of comparison; since phases II and III are unquestionably temporary, it must differ from them.

The demographic profiles for each phase are illustrated in Figure 1. The solid blue line shows the profile of one of the first reasonably accurate demographic tables, produced by Edmond Halley for the city of Breslau (currently Wroclaw in Poland) in 1693.5 Not surprisingly, mortality rates were much higher than they are today. In particular, infant mortality was so high that there is an inflection in the curve right after age group 0–4: many newborns didn’t last a single year, let alone five. Median life expectancy was only 24 years at birth, but 34 for those fortunate or hardy enough to survive that first lethal year.6 From our perspective, phase I is a “steady state”; through the lens of our telescope, population structures were relatively stable for centuries. Obviously, for someone living through famine, wars, or decimating diseases, life was anything but stable.

The second phase is represented by the green lines, which depict two distinct points in U.S. history—1950 and 2010— and the average for the intervening period. It is possible to see the peak of the baby boomers in 1950 (dashed line) and the subsequent increase in the relative size of the working force in 2010 (dotted line). In these six decades, tumbling support ratios provided a strong tailwind to economic growth, as children fell relentlessly to historical lows as a share of the population, the working-age population soared, and support ratios for senior citizens remained low. Interestingly, the dotted line for 2010 becomes almost flat up to approximately age 50, reflecting the combined effects of lower mortality rates and the transition to a new steady state (phase IV).

As an extreme example of the strong demographic imbalances which are developing in some countries, the red line presents the forecasted demographic profile for Japan in 2050. The slope of the curve is completely reversed, revealing a discouragingly small number of children and an astonishingly large number of senior citizens.

Finally, the gold line shows an example of a demographic profile of a hypothetical country with a life expectancy of 80 years (approximately the life expectancy for the developed economies of the world at the present time). This phase will be characterized by support ratios that are both higher than the demographic tailwind of recent decades and lower than what we expect in the coming phase III decades.

Economic Growth

As interesting as studying historical and prospective demography might be, such an analysis would be incomplete if we did not consider the future prosperity of different countries in view of their past, current, and future demographic profiles. For this reason, we combine the rich trove of past and forecasted future data from the United Nations with our previous work establishing a link between demographic profiles and economic growth. Figure 2, drawn from Arnott and Chaves (2012), shows the relationship between the size of each age group and growth in Real Per Capita GDP.

Our results show that children have a slightly negative effect on economic growth, but young adults start to positively contribute as they join the workforce. Skeptics might argue that wages and productivity peak later in life, typically in one’s 40s and 50s. This is generally true, and helps to explain why the most prosperous nations often have a larger proportion of mature adults than the less prosperous nations. However, the definition of a peak, whether for productivity or anything else, is that we stop rising and start falling! When we reach peak productivity, by definition our productivity growth is zero.

The average contribution to GDP growth becomes negative between 55 and 60. This does not mean that people begin to consume more GDP than they produce after age 55, only that—on average—workers above age 55 have passed their peak in productivity. Intuitively, the average 60-year-old is more productive than the average 40-year-old, but not so relative to the average 55-year-old. At ages 60 and above, the coefficients decline much more sharply: the mature worker exhibits falling productivity, and in retiring, a worker’s productivity simply falls off a cliff.

The influence of demography on economic growth should not be underestimated. Our research shows that demography contributed to a tailwind in Phase II and will likely contribute to a headwind in Phase III. Figure 3 presents the results for the countries of the G-8 and the BRICs. We forecast growth in Real Per Capita GDP (holding everything else constant) for every five-year interval between 1950 and 2050, based on the demographic linkages observed in the 1950–2010 data spanning 22 countries. These are not “normal” GDP growth rates, they are abnormal GDP growth rates, reflecting the impact of a demographic tailwind or headwind.

Japan displays the most manifest effects. The Japanese “economic miracle” of the 1960s to the 1980s got a terrific lift from demography. The birthrate plunged, so that support ratios associated with legions of children disappeared, and the support ratios associated with legions of senior citizens did not really outstrip the decline in the roster of children until the 1990s. Their demographic “dividend” may have peaked at approximately 3% per year, relative to the average demographic profile of the century from 1950 to 2050.

Now, the youngsters of the late 1940s and early 1950s are approaching retirement, and the baby bust from about 1980 onward is delivering a continually shrinking roster of new entrants to the labor force. With relatively few young workers to take the place of retiring boomers, Japan’s prospective demographic headwind may be greater than 2% per year. A transition from a 3% tailwind to a 2% headwind is shocking: it suggests a 5 percentage point drop in normal real per capita GDP growth rates from the heady growth of the 1960s to the 1980s. Even if changes in policies and entitlements can halve these figures, it’s a formidable headwind.

All 12 countries will confront varying speeds of demographic headwinds in the coming decades, first in the developed economies, then in the older emerging economies (China and Russia), and finally in the younger emerging economies (Brazil and India). These headwinds get stronger over time and appear to stabilize in the developed world and the older emerging economies only after about 2040. For the younger emerging economies, the demographic headwinds do not become acute for perhaps another 20–30 years.

All 12 countries enjoyed demographic tailwinds during the past 60 years, so these headwinds will feel more obstructive than they are. It is human nature to consider our personal experience to have been “normal,” so we evaluate subsequent events in comparison with this self-referential “norm.” If the people of Japan consider the former tailwind of 2–3% to be “normal,” then a future 2% headwind will feel like a ponderous 4–5% drag, relative to expectations. On average, the countries in this analysis enjoyed benign demographic profiles that boosted GDP growth by around 1% per year during much of the past six decades.

The first few decades of the sample were particularly beneficial to developed countries. China and Brazil seem to have experienced their peak demographic dividend recently. That said, a 2% erosion in high-single-digit growth is hardly a pessimistic forecast. Absent egregious policy missteps, these economies have ample room to catch up to the developed world, albeit at a gently decelerating pace. The young emerging economies, like India (where the median age today is still only 25), will continue to enjoy a demography-fueled tailwind over the next decade or two.

Conclusion

Our main goal in presenting these results is to correct the common misconception that developed countries went through a “normal” period of high growth, as if we are all entitled to fast-growing prosperity. In reality, the developed world is entering a new phase in which the low fertility rates of past decades lead to slow growth (in many countries, no growth) in the young adult population; young adults are the dominant engine for GDP growth. Mature adults, many of whom are at or near their peak productivity, are poised to retire, creating an impressive surge in the rolls of senior citizens. These newlyminted senior citizens, transitioning from near-peak productivity to retirement in a single step, will be drawing on the economy while no longer producing goods and services. The unequivocal good news of a steady rise in life expectancy means that these retirees will create a very substantial drag on GDP growth, as these seniors move from peak productivity to negligible productivity in just a few years.

The danger is not in the slower growth.

Slow growth is not a bad thing. It’s still growth. The danger is in an expectations gap, in which we consider slower growth unacceptable. If we expect our policy elite to deliver implausible growth, in an environment in which a demographic tailwind has become a demographic headwind, they will deliver temporary outsized “growth” with debt-financed consumption (deficit spending). If we resist the necessary policy changes that can moderate these headwinds, we risk magnifying their impact.

Endnotes

1. The title is borrowed from Russel Kinnel’s wonderful Morningstar research, repurposed to our demography topic.
2. See past issues of Fundamentals for more on the 3-D Hurricane.
3. This choice of four phases might not come from traditional demographic theory, but it serves our purposes of illustrating the transitions most countries are recently experiencing.
4. Hobbes, Thomas. 1651. Leviathan, or the Matter, Form, and Power of a Commonwealth, Ecclesiastical and Civil. London: Andrew Crooke.
5. According to Bacaër (2011), before the 18th century it was common to publish bulletins with baptisms and burials that contained the cause of death—mainly to inform citizens about plague epidemics—but not the age of death. For this reason, most tables produced involved a significant amount of guesswork to estimate the age of death from the cause of death.
6. Halley himself won the actuarial lottery of the 17th century, reaching age 85. His own tables gave him a 1.4% chance of living so long.

References

Arnott, Robert D., and Denis B. Chaves. 2012. “Demographic Changes, Financial Markets, and the Economy.” Financial Analysts Journal, vol. 68, no. 1 (January/February):23–46.
———. 2013. “A New ‘New Normal’ in Demography and Economic Growth.” Journal of Indexes (forthcoming).
Bacaër, Nicolas. 2011. A Short History of Mathematical Population Dynamics. London: Springer Verlag.
Malmendier, Ulrike, and Stefan Nagel. 2011. “Depression Babies: Do Macroeconomic Experiences Affect Risk Taking?” Quarterly Journal of Economics, vol. 126, no. 1 (February):373–416.

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