Get On The Right Train

As we enter into the fall season, it’s a good time to stop and reflect on the summer. The summer has been a relatively quiet one where speculation was afoul without much concrete action. Speculations of further US Federal Reserve quantitative easing or another round of Chinese economic stimulus were abound in the rallying market.

In Asia, China reported July inflation of 1.8% year over year, a level which can better accommodate both expansionary monetary and fiscal policy. 2012 is a political transition year for the Chinese Communist Party, and the last thing the government wants is social unrest from a rapid slowdown. At current levels of inflation Beijing can act quickly to reverse some of the fiscal policies used to slow down the housing market and expand the monetary base through its control of the banking system. As an example and seen in the chart below, the stimulus package announced in the midst of the 2008 financial crisis came after a significant decline in China’s CPI.

Source: Bloomberg

The Chinese government will need to initiate stimulus to maintain social and economic stability in addition to meeting the 7.5% growth target announced by premier Wen Jia Bao earlier this year. Will it be as strong and outright of a package as last time? Definitely not, but it’s a pretty good bet they will do something that will move the markets. If I knew when I’d be a millionaire.

We enter the fall months alongside warnings by media pundits of a volatile market driven by disruptive quotes from the European leaders. It isn’t hard to see why this sentiment persists with such a range-bound market in the last year. As I see it, people are worn from a bear market and the easiest way is to go up. I’ve been seeing a lot more articles about how people are becoming disinterested in the markets – nothing gets their attention like a rally. 

Sentiment can shift at a moment’s notice and just hope that you are riding on the right train! Good luck.

WWGD - What Will Germany Do?

I read a Reuters article that had a quote from a German official that made a really simple point that sounded a bit arrogant, but has some truth to it:

The fundamental question is relatively simple. Do our partners really want more Europe, or do they just want more German money?
link to article

At the end of the day, with all the media flip-flopping in Europe from Greece to Spain to Italy to Ireland and back to Greece, the power is with the largest and strongest creditor, Germany. Whatever they decide will be the ultimate market mover.

French Elections, Greece (Again?!), and JPMorgan

Just when things seemed like they were settling down, in the span of a week macro events took hold of the markets once again.

First came the French elections. The socialist party leader François Hollande beat out Sarkozy, and brought back memories of another left French president, François Mitterand. Mitterand was the socialist president who nationalized crucial industries, including banks and energy-related companies, set up the 39 hour work week, gave 5 weeks of holidays, and increased a whole lot of social benefits. Good lord. You can see why many people are worried.

Then came some 37 year old Greek socialist, Alexi Tsipras who somehow came in 2nd in the latest elections. I don’t think he even expected to garner so many votes. Nonetheless he’s speaking up like a confident politician as if he were the chosen one or something. He sure enough spits out a lot of nonsense like how Greece can renegade on the deals they’ve made with the European Union to get monetary support and somehow still stay in the EU. Alexi Tsipras, you’d be surprised how angry those Germans and French can become.

Lastly, the $2,3,4,5….BILLION loss on ‘hedging’ by JPMorgan. It’s obvious most of these banks, in an effort to tip-toe their way around the Volker rule, have just moved some of their proprietary trading into their Treasury departments and just changed the name of the activity to ‘hedging’ their balance sheet. When you’re playing with the gigantic balance sheet of Jamie Dimon, one misstep and you’re screwed.

Markets took all of this in in stride, selling on each of the news.

Should you be worried? Short view is, yeah, why not, all this isn’t spectacular for the markets. However, a long term view is that this will all come to pass with no severe long term effects. Hollande will be constrained by the rules of the European Union. Go ahead, try to break the rules while Germany, France, Italy, etc are all looking. Can Greece break their agreements and stay in the EU? Probably not. One article I read on Reuters had a little snippet at the end of it which pretty much summarizes the big picture:

Greece could run out of money as soon as the end of June. The prospect that Greece might declare bankruptcy and leave the euro caused panic across the euro zone last year. Since then, European banks have written off the value of most of their Greek debt, making them less prone to shock if Greece defaults.
link to article

Basically since Greek debt is worthless, it really shouldn’t cause anymore long term effects. Markets would react negatively in the short term if they do in fact renegade and leave the EU, but because all the debt is written off already, who cares? (other than of course the Greeks who will be further thrown into a deep depression, unfortunately)

Lastly, the case of JPMorgan is quite an unfortunate one and will probably help with passing more financial regulation. But they (the governments) were going to do that anyways!

David Einhorn's World of Jelly Donuts and the Simpsons

I read an article by David Einhorn today that hilariously and seamlessly intertwined the Simpsons (the 20+season show with Homer, Marge, etc), jelly donuts, and...the Federal Reserve. I'm a big fan of David Einhorn, notorious for being an outspoken investor (most recently for his call on Green Mountain Coffee, which recently fell off a cliff) as well as his comedic encounter with Punch Tavern which resulted in him being fined $11mm for insider trading. You may not agree with what he says, but he's very thoughtful when it comes to investing. Did I mention that he won the World Series of Poker, which he just did for fun?

Don't underestimate his youthful looks! 

The article, posted on the Huffington Post, talks about how the Fed is essentially feeding the market and economy jelly donuts, ie Quantitative Easing, 'QE'. The first jelly donut tastes pretty good, but after 12 or so you start feeling sick. Einhorn doesn't understand why the market wants QE3, which is equivalent of the 12th jelly donut, which no longer tastes good nor does it give us energy. Another thing the Fed is doing with its super low interest rates is distorting the behavior of the people in what on the surface seems like a good thing (spend more!) but instead messes with the economy in the longer term:

Consider my neighbors, Homer, Marge, and their three adult children, Bart, Lisa and Maggie. Homer has retired from the nuclear plant, and he and Marge live off savings and Homer's pension. Bart is in a bit of trouble with too much credit card debt and an underwater mortgage. Lisa has been putting away her salary and has enough for a downpayment on her first home. Maggie owns her own business and is ready to expand.

When interest rates are high, Homer and Marge park their savings in CDs or Money Market accounts and get a decent return. There is no incentive for them to take much risk with their money. Bart gets into trouble very quickly and defaults on his loans. Lisa decides she can't afford a mortgage until rates fall. And Maggie, who's been helping out Bart with some of his expenses, believes that she'd make money if she grew the business, but possibly not enough to service the debt she'd be undertaking.

When interest rates are low, everything changes. Homer and Marge are getting only a little interest on their savings, and are struggling to live off Homer's pension. They need to rethink their finances. Bart can manage to keep up the minimum payments on his credit cards and stay in his house. Lisa can get a cheap mortgage, and Maggie doesn't need to make such optimistic assumptions in order to expand her business.

Everyone agrees that low interest rates are a good way to stimulate a stalled economy. The Fed takes this logic a step further. It believes that if low interest rates are good, then zero-interest rates must be even better. As a brief emergency measure, such drastic behavior is reasonable and can even be necessary. In 2008, Chairman Bernanke had near unanimous support for his decision to drop rates to near zero. At the peak of the crisis, it made sense. But that was four long years and many jelly donuts ago. In the 2012 economy, a zero rate policy not only adds no benefit, it's actually harmful. Just ask the Simpsons.

Source: The Huffington Post, link to the article 

By the way, isn't that such a funny picture?

Most of the things Einhorn writes about has been talked about a lot and is in fact quite well known, but the way he writes about it, I think even a 6th grader could understand it which is an achievement in itself. If you read on, he goes on to argue that it's time to adjust the interest rates so that the Baby Boomers can retire (Homer and Marge), the people who are teetering on the edge of defaulting on their mortgage/loan will actually default or become delinquent (Bart), people who want to invest/grow a business can do so with proper incentives (Lisa/Maggie), and the economy won't be flooded with easy money that the wealthy can speculate with (Mr. Burns):

It's time for Chairman Bernanke to begin restoring the markets to their natural balance. Provide the proper incentives for Lisa and Maggie to start investing in the economy again. Let Bart possibly default on his unsustainable debts so that the banks can start getting those loans off the books. Stop giving Mr. Burns access to free money that he can use to speculate in bonds and commodities at the expense of the middle class. As for Homer and Marge, quit trying to fool them into thinking they're wealthy and instead give them the opportunity to retire with some financial security. With a little extra money in their pocket, Marge can go back to the beauty parlor, and Homer can support the beer and bowling economy.

In many ways he's right, it may hurt more in the short run, but it's time to fix up economic incentives for people before the economy becomes so distorted that another bubble becomes "too big to fail". The most obvious one is the asset that Einhorn doesn't want to invest in, but has no choice with what he believes the Fed is doing, gold:

As a result, I will keep a substantial long exposure to gold -- which serves as a Jelly Donut antidote for my portfolio. While I'd love for our leaders to adopt sensible policies that would reduce the tail risks so that I could sell our gold, one nice thing about gold is that it doesn't even have quarterly conference calls.

Is Europe in a Depression?!

The other day I read in the Business Times an interview with 4 quite notable investment managers. Kenneth Courtis, a former vice-chairman of Goldman Sachs and co-founder of Themes Investment Management, gave a quite striking remark on the situation in Europe:

“Large swathes of the eurozone are already in recession now, and its southern tier – Greece, Spain, Portugal, as well as Ireland – are in outright depressions”
Link to the article

My instant reaction was: holy cow! I’ve been following the situation in Europe as you can see in my previous posts, but never even thought about it as drastic as a depression. I’ve always thought about depressions as a thing of the past, like a pre-WW II kind of event that would never happen in my lifetime (I don’t expect to live that long). At first, I thought he was just being airy and bold, after all, this was an interview and these guys will use the interview as a marketing tool.

But as I thought about it more and more, I realized that there was no way that Europe would NOT enter a depression.

When a country goes into a recession, it usually has two ways to dig itself out of the hole: fiscal tightening or monetary easing/devaluation of their currency. The former is in fact the more responsible way to do it, but is also both politically and socially tough. So most countries will choose the latter since it’s just easier to explain to the people that they’ll get to keep their jobs rather than cutting the budget. Even though monetary easing will end up hurting people’s pockets all the same through inflation, it’s a delayed process that’s easier on people – biggest example is what’s going on in the USA right now.

In the case of Europe, the countries can’t exercise independent monetary policy, so they have no choice but to go the route of fiscal tightening. Thus you see the high unemployment rates, budget cuts, etc in Europe (eg >20% unemployment in Spain), whereas in the USA you see unemployment rates easing downwards and a much more optimistic view of the economy.

If the Europeans choose to keep the Euro and the European Union intact which they seem quite intent on doing, many of the problematic countries will undoubtedly slip into not just recession, but depression. The EU may get saved, but the people will suffer for it. 

After Greece, What Now?

It’s been a tumultuous last few months in the markets. Investor emotions have run high, low, and everywhere in between from the European crisis. Watching with intrigue from the sidelines, I wondered every week when the crisis would end, and when it ended how I would know that it had ended. The trend seemed scripted: the European leaders would put out a plan that would “save” the EU, the stock markets would rally, only for the indexes to be lower within a week.

After an up and down last few months, it seems like the critical stage of the Greek crisis has passed with a steady and ‘successful’ debt restructuring/default, reducing total government debt of €206 billion by about half. In tango with the debt swap, the EU has agreed to release another bailout worth about €130, neatly covering Greece’s debt payments for a long while. Great deal for Greece, horrible for the investors (i.e., European banks, asset management firms). This has also triggered a credit event, meaning that we all get to witness how a credit default swap works (CDS), which are supposed to insure against a default. Exciting stuff.

Is it the end of Greece? In my mind, ‘yes’ both figuratively and literally. Greek debts have been covered temporarily, but it also means there will be tough times ahead for the Greek economy. Previous countries that had defaulted/restructured their debt, like Mexico and Argentina, have taken a long time to crawl back up after getting hit pretty hard.

On a side note, for a long term investor these events have been a learning experience. I for one, had never even heard of terms like Long Term Refinancing Operations (LTRO) or TARGET2, nor had I ever witnessed a country defaulting on their debt and how a credit default swap (CDS) actually worked.
So what’s next? Media has focused on the high crude oil prices ($125), nagging elevated high European government bond yields and the slow-down in China (7.5% GDP growth). All are legitimate concerns which I will talk about:

• Oil - Having read the news scouring for reasons of the return of the high oil prices, it seems like people largely blame Iran and supply and demand. To me that does sound very plausible, but I’m starting to become inclined to think that it’s the low interest rates that’s inflating the commodity prices. Do I have any facts to back this up? Haven’t looked to be honest, but this rationale of low interest rates inflating assets remains the most logical to me. I mean, why else is gold, a useless commodity as a friend always likes to remind me, priced more than the laptop I’m using to write this blog?
  • More importantly, how significant are high oil prices to the global economy? I believe that the world, having seen oil prices above $140 as recently as 2008, won’t be impacted as much as before. The relative rise in oil prices from $80 to $125 just isn’t as much as from $20 to $140. People aren’t really as shocked as 2008 and the ‘wow’ factor just isn’t there. Not to say that it won’t have an effect in slowing down the economy, but I wouldn’t highlight it as the insurmountable concern in the world.
• Spanish/Portuguese/Italian bond yields – Yes, yields are elevated, but is the EU prepared to take action in case something drastic happens? Seems like it, yes, so I’m crossing it off my list as something I should worry in my sleep about. Wouldn’t it be cool if I could pick what I dreamt about in my sleep?
• Slowdown in China – Wait, so the world had to wait until Wen Jiabao to say that the Chinese economy was slowing down to know that the Chinese economy was slowing down? Hope you insinuated my incredulous tone of voice.

So no, I still haven’t answered the title of my post. I haven’t because as opposed to all the complexity of the concerns in the market, my view is relatively simple and one that readers of my previous posts will know. As long as monetary policy is accommodative to growth in the world, which it is as seen by the multitude of central banks that have stopped hiking interest rates or have kept low interest rates, the economy will slowly crawl back up. Maybe not at the rapid speeds seen in the mid 2000’s, but it will chug along. Even with high oil prices, which I have seen many-an-article talk about how they are usually followed by a recession, I don’t see the world economy receding much more. Certainly not unless oil prices rise to above $160, which could certainly spell trouble as that means inflation concerns might trump growth concerns for central banks across the world in the form of rapidly increasing high interest rates.*

* In my mind, the speed of interest rate hikes matters significantly. Shocks are usually not good for the system.