Friday, October 30, 2009

Paranormal Activity to Another Black Monday?


Simon Maierhofer of ETFguide.com writes Whats Next - Minor Correction or Major Collapse?:
Over the past few months, every attempt by the bears to depress prices has been met with renewed buying pressure, resulting in even higher prices. What goes up, however, has to come down and some subtle signs are indicating that this decline might be more than a simple correction, much more.

It was after midnight on April 15th, 1912 when the unsinkable did the unthinkable. Built and labeled as unsinkable, the Titanic was the most advanced and largest passenger steamship of its time.

Even though the Titanic's crew was aware of the fact that the waters were iceberg-infested, the ship was heading full-steam for a destination it would never reach.

Being aware of danger is one thing; acting prudently for protection is another.

Today, investors find themselves in an environment that is infested with symbolic icebergs. For savvy investors willing to pay attention and heed warnings, this doesn’t necessarily translate into a financial shipwreck, while others might soon be reminded of the Titanic when they look at their account balance.

Iceberg cluster #1: Lack of leadership

Throughout the financial meltdown financials, real estate, and homebuilders fell harder and faster than broad market indexes a la S&P 500 (SNP: ^GSPC) and Dow Jones (DJI: ^DJI). Beginning with the miraculous March revival (more about that in a moment), the broad market rose while financials, real estate, and homebuilders soared.

Those three sectors led the decline and led the subsequent (mock) recovery. Since it is reasonable to assume that those sectors will continue to lead the market throughout this economic cycle, it behooves investors to watch such leading sectors closely.

The S&P 500 (NYSEArca: SPY) recorded a closing high on October 19th at 1,097. The Financial Select Sector SPDRs (NYSEArca: XLF) reached their closing high a few days earlier on October 15th. Since their respective closing highs, the S&P 500 has dropped 2.82%, while XLF has already shed 5.64%.

A more pronounced performance slump is visible in the home builders sector. The SPDR S&P Homebuilders ETF (NYSEArca: XHB) peaked on September 16th and has fallen 9.97% since. Keep in mind that XHB’s lackluster performance comes on the heels of the biggest monthly increase in total home sales in ten years.

Even though the inventory of existing homes fell 7.5% month-over month in September (to 3.6 million units), the shadow inventory of 3.5 million foreclosed homes is probably weighing heavily on home builders. Shadow inventory represents foreclosed homes that are vacant, still included on bank’s balance sheets, but have not hit the market yet. 3.5 million homes equal about 1 – 2 years worth of supply.

Iceberg cluster #2: Non-confirmation in the technology sector

Apple, Wall Street’s new darling, reported block buster earnings and rallied over 10% to new all-time highs. Microsoft reported better than expected numbers and spiked 7.4%. Investors loved Amazon’s outlook so much that they bid up the stock by over 33%. Combined, the three companies account for nearly 24% of the Nasdaq (Nasdaq: ^IXIC), yet the Nasdaq is traded lower today than before earnings season on October 14th. The same is true for the Technology Select Sector SPDRs (NYSEArca: XLK).

If 24% of the Nasdaq’s components rallied between 7 and 33%, without lifting the index, a lot of tech companies must be hurting. In fact, the Nasdaq’s (Nasdaq: QQQQ) performance is masking the decline IBM, Intel, and many other once high-flying tech companies have seen over the past 1-2 weeks.

Iceberg cluster #3: Earnings are a lagging – not leading – indicator

Even though expectations were low to begin with (beating earnings forecasts was likened to an A student asked to achieve only a C), there is no arguing that this quarter’s reports were much better than last quarters.

Many view this as a sign that the economy had hit rock-bottom back in March. In fact, 80% of economists now believe that the recession is over (probably the same 80% that didn’t see the recession coming in 2007). However, as the chart below shows, earnings per share (EPS) are directly linked to the stock market’s performance at best and a lagging indicator at worst.

Alcoa, one of the biggest components of the hottest sector – materials (NYSEArca: XLB), surprised investors with a positive third quarter. Year-to-date, however, Alcoa lost $0.75 per share. This compares to a profit of $2.95 per share in 2007. At this point, Alcoa does not even have a P/E ratio, since Alcoa has no “E” – earnings.

Considering the relationship between stocks and earnings, it would be interesting to know what caused the March bottom.

Throughout February and March, Wall Street was covered by a veil of uncertainty and worry that the country would slip into another depression. Ever since the Great Depression, there’ve never been as many articles referring to the Great Depression as in March.

It is exactly that kind of pessimism that foreshadows market bottoms of some significance. Such pessimism rids the market of weak stock holders and opens the door for buyers to bid up prices. That’s exactly what the ETF Profit Strategy Newsletter predicted via the March 2nd Trend Change Alert.

Below is a brief excerpt taken from the Trend Change Alert: “A multi-month rally, the biggest rally since the October 2007 all-time highs, should lift the indexes by some 30-40%. Tuesday's (2-23-09) 4% spike may be an indication of the initial intensity of the rally. Beaten down sectors like financials (NYSEArca: VFH), industrials (NYSEArca: XLI), materials (NYSEArca: IYM) and consumer discretionaries (NYSEArca: XLY) are likely to see the biggest percentage gains over the next few months.” Many of the recommended ETFs gained triple digits in the upcoming months.

This rise in stock prices and consumer sentiment, along with serious cost-cutting by publicly held corporations, shrank corporate losses and even created profits for some corporations. But once again, it was rising stock prices that resulted in better than expected profits, not vice verse.

Iceberg cluster #4: No demand for products

It seems like companies have boosted their production. The key question is whether this uptick is merely due to an effort to restock inventories, or actual demand by the consumer. Fortunately for investors, there’s an easy way to find out.

If there is real demand by consumers, it will be reflected by shipping and transport companies. Products in demand need to be shipped from the manufacturer to the consumer or wholesaler. A look at the transportation/shipping sector providers, therefore, an easy and logical answer.

UPS shipments fell for the sevenths consecutive quarter. UPS’ profits fell 43% year over year due to lower demand for packaged deliveries. Burlington Northern, the biggest component of the Dow Jones Transportation Average (NYSEArca: IYT), reported that its freight revenue dropped 27% year over year.

This is exactly the opposite of what you’d expect to happen in a new, sound bull market.

Iceberg cluster #5: (Over) valuation

Would you buy the Dow Jones at 10,000? It probably depends on where you see the Dow trade a week, a month, or a year from today. Many investors and Wall Street gurus are advocating to buy the Dow at current levels.

Let me ask you this: Did you buy the Dow at 7,000? If you didn’t buy the Dow a few months ago at 7,000, why would you buy it today at 10,000? Today’s Dow is 50% more expensive than it was seven months ago, yet more people are willing to buy now than in March. Aside from the stock market, there is no other “salesman” able to sell a product for a 50% premium.

Bait-and switch at its finest

How can the stock market get away with this? The only difference between March 2009 and today is perception. Even though it defies logic, stocks are perceived to be a better deal today than in March.

Imagine what will happen when the perception changes. Once investors start believing that they can buy stocks later at a lower price they will wait, buyers will dry up, and stocks will plummet.

It’s no stretch to expect lower prices. Even though prices have come off multi-decade lows, earnings are lower than any other time since the Great Depression. The S&P 500’s P/E ratio (stock price divided by annual earnings), based on actual reported earnings have sky-rocketed to all-time highs.

Anybody buying the S&P 500 at current prices is paying 138 times as much as reported earnings. In other words, based on this year’s earnings, it would take 138 years of profits to repay your investment.

Would you buy a Subway franchise at 138 times its annual profit if you knew that 15 – 20 is the historical average? 15 – 20 is the average P/E ratio over the past 100 years. Anybody buying now will have to be prepared for significantly lower prices.

Some things never change

History teaches us that overvalued markets can’t last forever. History also teaches us how far the market will have to drop to reach fair values. The bear markets of the 1930s, 1940s, 1950s, 1970s and 1980s have provided us with a valuation reset template.

Every bear market bottom has seen P/E ratios drop to historically low levels. Investors, however, don’t have to rely on P/E ratios alone. Dividend yields, mutual fund cash levels, and the Dow measured in the only true currency – gold (NYSEArca: GLD) provide another window into the future – a nearly fail-proof composite indictor.

The October issue of the ETF Profit Strategy Newsletter plots the historic performance of the stock market against P/E ratios, dividend yields, mutual fund cash reserves, and the Dow measured in gold, along with target levels for the ultimate market bottom. A picture paints a thousand words and those charts speak volumes about the market’s future.

Did you know that the Titanic received an iceberg warning less than two hours before an iceberg brushed the ship's starboard side, buckling the hull in several places? An angry communications officer responded: “Shut up, shut up, I am busy; I am working.” There are plenty of indicators warning investors today. Will you heed the warning and avoid financial shipwreck?

Given Friday's action in the stock market, you might be worried about that another Black Monday is right around the corner. Financial journalist Jon Talton writes Echoes of another great crash -- and the lessons we refuse to learn:

This is the anniversary of Black Monday, the day in October 1929 when the stock market crashed. The Dow saw a record drop and things only got worse as the week progressed (there was a Black Tuesday, too).

It's clear now that the crash of that day was not the beginning of the Great Depression but its loudest symptom. Other areas of the economy had been faltering for years and income inequality was near record highs, but this was cloaked by the mania on Wall Street, back in the day when banks could engage in highly speculative trading.

Of course, that toxic environment was rekindled in our time by the repeal of the Depression-era Glass-Steagall Act in 1999, and we got just what the reformers of the 1930s would have feared.

Milton Friedman made his mark as a great economist (as opposed to a great polemicist) by work with Anna Schwartz showing how the Federal Reserve botched its response to the crash, turning what might have been a short-term panic into a deep depression. This was a lesson current Fed Chairman Ben Bernanke was determined to implement -- and indeed, Fed action pulled us back from the brink.

Where, exactly, "back from the brink is" nobody can say with precision. Average Americans are still hurting and the job market is a disaster, although nowhere along the lines of the Great Depression. We have yet to see the unintended consequences of Bernanke's "anything it takes" strategy, which was not followed by meaningful regulatory reform.

Time will tell. But the severity of the Depression forced major changes, such as the prohibition of commercial banks from engaging in high-risk ventures. This time, no such overhaul is happening. None of the swindlers who created the bubble have been called to account -- Bernie Madoff is penny-ante -- and the systemic risks that existed before our crash continue.

In other words, this time things didn't get bad enough. But the risk of new crashes is if anything higher than ever. And our current predicament seems to have no quick solution or the will to push one through. So we rattle along on a bottom -- better, to be sure, than in 1929, but more perilous in its own ways.

I don't get too excited when I see one day sell-offs. I was talking to a trader who told me he thinks hedge funds are unwinding risk trades going into year-end. Maybe they are or maybe this is another classic shakedown of nervous investors before they bring this market much higher.

[Note: Bears and bulls should listen to Tim Knight's Halloween video commentary. He might be right but I think he's underestimating the force of the global liquidity rally.]

Either way, enjoy your Halloween weekend and try not to think about the markets. I hear 'Paranormal Activity' is sweeping America (see trailer below). A good horror flick should help keep your mind off the nightmare on Wall Street.

Thursday, October 29, 2009

Canada's New Public Option?


Frank Swedlove, President of the Canadian Life and Health Insurance Association, wrote an editorial for the National Post stating that a new government pension plan is not necessary:

The financial crisis has elicited much hand-wringing and introspection about the need for a drastic overhaul of Canada's pension system. Canadians are increasingly concerned about their retirement income security. In addition to declining membership in defined benefit (DB) pension plans, these concerns have been dramatically heightened by market downturns that began last year -- with the result that we now hear calls from some quarters for government-sponsored defined contribution (DC) pension plans. To answer those calls with such plans would be a mistake.

Governments are quite rightly asking how to ensure that the retirement savings of Canadians grow, are secure and will generate adequate income when needed. Canada's life and health insurers welcome this interest.

This emphasis on retirement planning is a positive development and the life and health insurance industry has supported recent government reviews of the pension system and continues to work with governments to find solutions. Proposals from governments, think tanks and the private sector should all be considered.

What, then, will encourage more Canadians to save for their retirement and encourage their employers to assist them and offer pension security?

First, we need to recognize that both the public and private sectors have already done a great deal to contribute substantially to supporting Canadians in retirement.

The publicly-funded Old Age Security (OAS) program and the CPP offer important forms of basic assistance. Given recent funding reforms, the CPP is recognized around the world as a successful universal DB plan. But OAS and CPP are not intended to be the only sources of retirement income for Canadians.

Privately-run RRSPs, including group plans, supplement public plans through a wide range of offerings tailored to meet the needs of individuals and their employers. Such plans are a reasonable and cost-effective alternative for some employers who wish to help their employees save for the future.

And then there are DC and DB pension plans that are an integral part of the retirement income for many Canadians.

As service providers to over 70% of the pension plans in Canada, and an even larger share of employer-sponsored group RRSPs, Canada's life and health insurance companies expertly manage the retirement plans of many Canadians. We see some simple ways to encourage pension participation, provide more predictable retirement incomes and reduce costs to consumers.

Governments can encourage much greater participation in pension plans by streamlining and simplifying pension rules. Rather than building something brand new, legislative changes could use existing private-sector infrastructure to expand options.

For example, multi-employer pension plans are currently available to some Canadians, typically those in construction trades, where individual tradespeople may work for many employers over the course of a year. Pension contributions are made by each employer to a single plan, based on the number of hours worked.

Building on this model, multi-employer plans could be offered to all Canadians by eliminating current legislative requirements for an employment relationship between the sponsor and the members. In effect, any employer, and even the self-employed, could participate in a large-scale plan that would provide professional management and increase economies of scale.

Permitting default enrolment into a plan, perhaps at reduced contribution levels for new employees, would increase levels of earlier participation in a cost-effective way. And allowing automatic increases in contribution rates based on age, tenure or seniority would gradually move employees to more robust savings levels.

Similarly, since pensions are currently regulated at both federal and provincial levels, harmonization of pension laws could significantly reduce compliance costs that erode investment returns.

Secondly, Canada's life insurers already offer guaranteed retirement income products that allow individuals to securely shift from asset accumulation into the retirement payout phase. Newer insurance products build on this secure foundation, providing potential market growth while guaranteeing a base level of income. In effect, they combine the income security of traditional DB pensions with the predictable costs of DC plans.

While some of the proposed government-sponsored DC plans have similar characteristics to the expanded multi-employer plans, establishing new government-run pension plans introduces a number of potential disadvantages. One is that it creates a monopoly with the consequential lack of flexibility and innovation.

Second is an expectation by taxpayers that such plans would guarantee retirement income levels, rather than simply invest funds, which could have dire fiscal consequences in the future. Finally, such an arrangement duplicates the infrastructure that the private sector already has in place.

Canada's pension system can work even better with some minor but key adjustments to existing legislation. A massive redesign involving government sponsorship that could introduce new risks to the public purse is simply not required.

It was only a matter of time before the insurance industry got out to peddle its "private sector solution" to fixing the pension problem. But as I have written before, the insurance industry's pension fix is really no solution at all because it leaves far too many Canadians without an adequate retirement income.

When it comes to the pension pie, the insurance industry wants a big piece of the action. Notice how the editorial sounds a lot like those fear-mongering campaigns from U.S. health insurance companies, warning us of the "dire fiscal consequences in the future". The only thing missing was "we don't want a public option for pensions".

The Canadian insurance industry is out to protect its profits. They charge huge fees for those multi-employer plans they manage. They know that they can't compete with a well-governed public pension plan, just like U.S. health insurance companies can't compete with a well-run government healthcare plan.

Of course, the key in all this is good governance, something which wasn't even mentioned in the latest pension reforms. Kathryn May of the Ottawa Citizen reports that more than 500 on federal payroll top $200K:

The Harper government shelled out salaries and bonuses exceeding $200,000 to more than 500 federal employees last year, according to newly released documents.

The largest number of federal workers in a single department who topped the $200,000 mark are at National Defence, where about 160 military personnel earned salaries in that range or higher. That includes the military’s top brass, but 37 are of the top wage-earners are dentists and 108 are doctors.

Defence officials say the forces have to pay such salaries to attract medical specialists from the private sector. In recent years, it also offered signing bonuses to new medical recruits. The military doesn’t pay bonuses.

The list of the country’s top-paid bureaucrats and political appointees was tabled in the House of Commons this week in response to an order paper question by the NDP.

They include about 160 deputy ministers, associate deputy ministers, agents of Parliament, and heads of agencies commissions and tribunals. The appointments to these top jobs are political or governor-in-council appointments overseen by the Privy Council Office.

There are four levels of deputy ministers and all make more than $200,000. Last year, they ranged from about $208,000 to a $300,400 for most senior deputies — who can also earn up to 39 per cent of their salaries in performance pay and bonuses.

The size of the executive cadre in the government has grown steadily over the past decade and so have the number of assistant deputy ministers whose salaries have cracked $200,000. Treasury Board reported that among the government’s 5,400 executives about 69 EX-5s made an average of $214,000 last year — compared to 14 three years earlier. Salaries are in the $186,000 range, plus up to 25 per cent in bonuses.

The RCMP and Canadian Security Intelligence Agency reported that only RCMP Commissioner William Elliott and former CSIS director Jim Judd made salaries over $200,000, but noted that didn’t include staff who made overtime.

After Defence, the next largest single cluster of $200,000-plus wage earners were at the Public Sector Pension Investment Board, the arms-length corporation that lost $9.5 billion last year managing the pensions of Canada’s bureaucrats, military and RCMP. Its president and CEO, Gordon Fyfe, earned the biggest payout of $1.2 million in salary and bonuses.

Its executives can earn bonuses between 95 per cent and 180 per cent of their salaries. The top six executives, whose bonuses were reported, collected about $3.8 million in annual and deferred bonuses.

The PSPIB was warned by some MPs on a finance committee in April against paying bonuses in a recession and with such lagging performance. The board of directors determines executive pay.

However, PSPIB officials said executives received no bonuses for last year’s fund performance. They did, however, receive bonuses for the “personal objectives” they met in 2009, as well as for the fund’s performance between 2004-2007 which had been deferred as a “retention” tool to ensure executives stayed on.

The CBC reported 22 of its executives — whose salaries ranged from $125,000 to $375,000 — to the $200,000-plus list. The Business Development Bank reported eight of its executives topped $200,000. There were also seven at Canada Housing and Mortgage Corporation; seven at the Export Development Corporation; five at the Bank of Canada; three at the Royal Canadian Mint and five at VIA Rail.

The salaries for Crown corporation executives vary from $134,700 to a range of $410,000 to $482,40 for Canada Post president Moya Greene.

The government’s executive pay is determined by a special advisory committee, led by Carol Stephenson, dean of the Richard Ivey School of Business at University of Western Ontario. The committee studies the market and recommends salary, performance pay and bonus packages for all executives, deputy ministers, other governor-in-council appointees and CEOs of Crown corporations.

With the recession, the advisory committee recommended executives face the same wage controls as other public servants this year and performance pay remain at least year’s levels.

The Harper government’s Expenditure Restraint Act forced wage controls on most federal workers in departments and agencies to try and rein in spending. It gave executives the same wage package it imposed on unionized employees: 2.3 per cent in 2008 and 1.5 per cent in each of the next three years.

The restraint act, however, doesn’t apply to some Crown corporations, including larger ones like VIA Rail, the Mint and Canada Post.

PSP Investments lost 23% in FY2009, underperforming its policy portfolio by a staggering 5.1% and they still managed to dole out $3.8 million in annual and deferred bonuses to "retain" their top executives. Doesn't Wall Street come up with the same silly arguments?

And it's not just PSP Investments. With the sole exception of the Caisse, all the major public pension plans doled out big bonuses last year despite disastrous results. CPPIB's senior managers were smiling all the way to the bank after they lost 19% in FY2009.

I can just hear them now: "Stop being so coy, Leo, you know the rules of the game". More like I know all the games most large public pension funds play with their private market benchmarks so they can get away with big (bogus) bonuses at the end of the year.

The Ontario Municipal Employees Retirement System (OMERS) recently announced it's reducing its reliance on external GPs:
The CAN$43bn (€27.4bn) pension fund has decided to move away from externally managed funds and into direct private equity investing, with the goal of shifting its private equity portfolio from 80 per cent direct investments from the current 35 per cent, according to reports.

The pension’s goal is to reduce externally managed investments to 20 per cent of its portfolio. Currently, OMERS’ private equity portfolio is 65 per cent invested through fund managers and 35 per cent through direct investments. The fund reportedly has a target of ten per cent allocation to private equity.

The fund has expanded its global reach over the past year by opening offices in London and New York. At the time of opening the London office, OMERS president and CEO Michael Nobrega said that the fund’s “long-term goal is to invest 42.5 per cent of our net investment assets in private markets on a global basis.” OMERS has $5bn of capital interests in real estate and infrastructure assets in the UK.

OMERS provides retirement benefits to 380,000 members on behalf of over 900 different employers in the province of Ontario, Canada.
So OMERS has a long-term goal of investing 42.5% of its net investments in private markets and it want to shift its private equity portfolio to 80% direct investments from the current 35%.

I have already written on why OMERS is betting big on private markets. Sounds like Mr. Nobrega wants to pull off another Borealis Infrastructure, spining off the private equity group to make a killing in the process. You got to wonder why is he placing so much of the focus on private markets?

Also, if infrastructure investments are so hot, why did Ontario Teachers', the second-largest investor in Macquarie Infrastructure Group, sell its stake ahead of the global toll road operator's expected move to sever its relationship with investment banking parent Macquarie Group:

According to a number of traders who did not want to be named, the 244.7 million securities in MIG representing 10.8 per cent of its issued capital -- crossed on the Australian stock exchange before trading began yesterday -- were sold by Canada's Ontario Teachers Pension Plan Board.

Canada's largest private pension fund, with over $C87 billion ($90bn) in assets at December 2008, OTPP held an 11.7 per cent stake in MIG at June 30, behind only Macquarie's 17.3 per cent stake on the register.

The stake was being offered to institutional investors at a floor price of $1.40 a security through an institutional bookbuild handled by JPMorgan, the traders said.

Securities in MIG were down 11c to $1.43 yesterday. The planned sale by OTPP comes as MIG mulls a split of its toll roads into two separate listed entities with different leverage and growth profiles and also considers severing its management agreement with Macquarie in an effort to make the group more palatable to investors and boost security-holder value.

The proposed split, which many market watchers expect to be revealed at MIG's annual meeting on October 30, follows a review that has stretched over a number of months as the group has grappled with debt of around $30 billion across a portfolio including some highly leveraged and poorly performing road assets that are concentrated in Europe and North America.

A move to internalise management at MIG would follow a similar move completed last week by global airport fund MAp and would be the latest step by Macquarie to distance itself from a listed funds model as it instead focuses on growing its global investment banking operations.

However, MAp endured much shareholder criticism and even legal challenges from investors concerned over the generosity of the $345m its independent directors agreed to pay to Macquarie in lieu of the bank receiving ongoing management and performance fees from the fund, and traders said this could have contributed to the decision by OTPP.

"I don't think that Ontario Teachers were particularly enthusiastic about the fee that is going to have to be paid to Macquarie if they do go down the path to internalise management, so I believe that may be a sticking point," said Justin Gallagher, head of Sydney sales trading at RBS.

OTPP has been a major investor in listed Australian infrastructure companies. It is also the third-largest shareholder in MIG's rival toll road group, Transurban, in which it has a 12.2 per cent stake valued at $700m, and last month sought to increase its stake in Bristol airport to 50 per cent after agreeing to buy 35.5 per cent of the British gateway from MAp for pound stg. 128m ($230m).

Mr Gallagher said the strength of the Australian dollar was probably also a factor in OTPP's decision

The strength of the Australian dollar was a factor behind the unwinding of a major "long-term" asset? It sounds to me like Ontario Teachers' lost lots of money on that deal, providing more evidence that when it comes to private markets, they too are flying off course.

So given all these spurious investments in private markets by public pension funds, why am I still arguing for a public option for pensions? Because, it's the only viable long-term solution to the pension crisis. But to make this work, we need to address the serious governance gaps that still plague our public pension plans. Ignoring them will only lead to more abuse in the compensation that is being doled out to senior pension executives who by and large are delivering mediocre results.

Wednesday, October 28, 2009

To the Moon Or to the Sun?


In his November investment outlook, Midnight Candles, PIMCO's Bill Gross tells us that assets are way overvalued:
Let me start out by summarizing a long-standing PIMCO thesis: The U.S. and most other G-7 economies have been significantly and artificially influenced by asset price appreciation for decades. Stock and home prices went up – then consumers liquefied and spent the capital gains either by borrowing against them or selling outright. Growth, in other words, was influenced on the upside by leverage, securitization, and the belief that wealth creation was a function of asset appreciation as opposed to the production of goods and services. American and other similarly addicted global citizens long ago learned to focus on markets as opposed to the economic foundation behind them.
So far I am with you, Bill. We basically forgot that real wealth comes from real production not from trading stocks, bonds, and commodities on-line. Forget the clowns on CNBC where you regularly appear talking up your book, and focus on real work.

Bill goes on to write:

PIMCO long-term (half-century) chart comparing the annual percentage growth rate of a much broader category of assets than stocks alone relative to nominal GDP. Let’s not just make this a stock market roast, let’s extend it to bonds, commercial real estate, and anything that has a price tag on it to see if those price stickers are justified by historical growth in the economy.

This comparison uses a different format with a smoothing five-year trailing valuation growth rate for all U.S. assets since 1956 vs. corresponding economic growth. Several interesting points. First of all, assets didn’t always appreciate faster than GDP. For the first several decades of this history, economic growth, not paper wealth, was king. We were getting richer by making things, not paper. Beginning in the 1980s, however, the cult of the markets, which included the development of financial derivatives and the increasing use of leverage, began to dominate. A long history marred only by negative givebacks during recessions in the early 1990s, 2001–2002, and 2008–2009, produced a persistent increase in asset prices vs. nominal GDP that led to an average overall 50-year appreciation advantage of 1.3% annually.

That’s another way of saying you would have been far better off investing in paper than factories or machinery or the requisite components of an educated workforce. We, in effect, were hollowing out our productive future at the expense of worthless paper such as subprimes, dotcoms, or in part, blue chip stocks and investment grade/government bonds.

Putting a compounding computer to this 1.3% annual outperformance for 50 years, produces a double, and leads to the conclusion that the return from all assets was 100% (or 15 trillion – one year’s GDP) higher than what it theoretically should have been. Financial leverage, in other words, drove the prices of stocks, bonds, homes, and shopping malls to extraordinary valuation levels – at least compared to 1956 – and there could be payback ahead as the leveraging turns into delevering and nominal GDP growth regains the winner’s platform.

WHOA! Did you all get that? Bill says assets are $15 trillion overvalued! The game is over and now we face a protracted period of deleveraging and asset deflation.

He goes on to write:

At the center of U.S. policy support, however, rests the “extraordinarily low” or 0% policy rate. How long the Fed remains there is dependent on the pace of the recovery of nominal GDP as well as the mix of that nominal rate between real growth and inflation.

My sense is that nominal GDP must show realistic signs of stabilizing near 4% before the Fed would be willing to risk raising rates. The current embedded cost of U.S. debt markets is close to 6% and nominal GDP must grow within reach of that level if policymakers are to avoid continuing debt deflation in corporate and household balance sheets.

While the U.S. economy will likely approach 4% nominal growth in 2009’s second half, the ability to sustain those levels once inventory rebalancing and fiscal pump-priming effects wear off is debatable. The Fed will likely require 12–18 months of 4%+ nominal growth before abandoning the 0% benchmark.

I am with you on this, Bill, but I look at it from a jobs perspective. The Fed won't dare raise interest rates until U.S. unemployment falls well below 10% and even then, they'll think twice about it. But what you don't get Bill is that the Fed is convinced they can create another asset bubble and they're betting this will lead to real economic inflation down the road.

Importantly, when confronted between two evils, the Fed will always choose inflation over deflation. And therein lies the kink, we need asset bubbles to keep the fantasy alive.

But not everyone is as pessimistic as Bill Gross. On Monday, James Altucher was interviewed on Tech Ticker, telling us that the economy and the stock market were going to blast off from here:

Ever since the market bottomed in March, a parade of bears have warned about all manner of coming calamities:

  • An end to the "sucker's rally"
  • A collapse of the financial system
  • A double-dip recession
  • A commercial real-estate collapse
  • A decade of "deleveraging" as consumers recover from a drunken debt binge

Ridiculous, says James Altucher, managing director at Formula Capital.

The economy is recovering nicely, says Altucher, and 2010 is going to be a huge year. Companies that stopped making things and fired thousands of employees last winter out of fear of a second Great Depression will restock their shelves and start hiring like mad. The federal stimulus, which has barely kicked in yet, will really get cranking. Consumers will find jobs much easier to get, and the resulting optimism (and income) will prompt them to start spending again.

And the market?

It's going to the moon, says Altucher.

In fact, the biggest thing Altucher is worried about is another monster bubble, which the Fed will have to stomp out by raising interest rates too quickly. But that's a year away. In the meantime, he's confident the recovery will knock your socks off.

I think Mr. Altucher is getting ahead of himself. However, as I stated before, there is an unprecedented amount of liquidity in the global financial system that can easily lead to another bubble sooner than you think. Is the market "going to the moon"? You can call me crazy, but my bet is still that the market is going to the sun and it will melt up faster than it takes Bill Gross to blow out his midnight candles.

So while Mr. Gross worries about a cold wind from the future blowing into his bedroom, I worry about the next bubble in stocks and how many people are going to get burned chasing it higher.

Tuesday, October 27, 2009

More Overselling of Pensions?


The Honourable Jim Flaherty, Canada's Minister of Finance, released a reform plan for the federal private pension legislative and regulatory framework on Tuesday:

"Our Government has listened carefully to Canadians," said Minister Flaherty. "We understand the value of secure and sustainable pension plans. We are proposing a balanced package of measures for the benefit of pension plan sponsors, plan members and retirees."

Today’s announcement comes out of extensive consultations with Canadians, beginning with the January release of a discussion paper, Strengthening the Legislative and Regulatory Framework for Private Pension Plans Subject to the Pension Benefits Standards Act, 1985, and including online consultations.

In March and April, Ted Menzies, Parliamentary Secretary to the Minister of Finance, chaired a series of national public and private consultation meetings across Canada to hear the views of Canadians on strengthening the framework.

The package includes measures to:

  • Enhance protections for plan members.
  • Reduce funding volatility for defined benefit plans.
  • Make it easier for participants to negotiate changes to their pension arrangements.
  • Improve the framework for defined contribution plans and for negotiated contribution plans.
  • Modernize the rules for investments made by pension funds.

"These reforms will provide enhanced benefit security for workers and retirees while allowing pension plan sponsors to better manage their funding obligations as part of their overall business operations," said Minister Flaherty.

In particular, the Government plans to restrict an employer’s ability to take a contribution holiday unless a 5-per-cent funding cushion remains, change the solvency funding methodology to make it less volatile and less pro-cyclical by basing the funding requirements on a three-year average, and require employers to fully fund pension benefits on plan termination.

In addition, the Government intends to increase the pension surplus threshold under the Income Tax Act, which applies to both federally and provincially regulated defined benefit plans, to 25 per cent from 10 per cent.

The proposed changes are aimed at federally regulated private pension plans, which represent about 7 per cent of pension plans in Canada.

While some of the proposed changes can be introduced by changes to regulation, others will be implemented by legislation, which is expected to be introduced in Parliament.

Protecting seniors is a priority for the Government. In addition to these pension framework modernizations, the Government has taken action by:

  • Introducing legislation to implement the results of the Canada Pension Plan (CPP) Triennial Review, concluded at the May 2009 Federal/Provincial/Territorial Finance Ministers’ Meeting, which includes a number of measures that will improve the effectiveness and resilience of the CPP while ensuring it remains affordable and fair for future generations.
  • Leading a Federal/Provincial/Territorial Research Working Group on Retirement Income Adequacy, which will report to Ministers of Finance and Ministers Responsible for Pensions in December to ensure that all Canadian governments have a common understanding of the strengths and challenges facing the retirement income system in Canada.

This builds on our Government’s four-year record on seniors’ issues, which provides $1.9 billion annually in tax relief to seniors and pensioners, including:

  • Increasing the Age Credit amount by $1,000 as of 2009, on top of the $1,000 increase introduced as of 2006.
  • Increasing the age limit for maturing pensions and Registered Retirement Savings Plans to 71 from 69 as of 2007.
  • Introducing pension income splitting as of 2007.
  • Doubling the amount of income eligible for the Pension Income Credit (to $2,000 from $1,000) as of 2006.

In addition, the new Tax-Free Savings Account will provide additional tax-efficient savings opportunities for all Canadians, including seniors.

Soon after the press release, the media started commenting on the proposed reforms. Jonathan Chevreau of the National Post reports that Ottawa's pension reform has five main objectives:

1.) ENHANCED PROTECTIONS FOR PLAN MEMBERS

i. Plan sponsors will be required to fully fund pension benefits on plan termination. Any solvency deficit that exists at the time of termination will be required to be amortized in equal payments over no more than five years. The obligations of the employer determined following the termination will be considered unsecured debt of the company. This would eliminate the possibility that a pension plan could be voluntarily terminated when assets are not sufficient to pay full promised benefits.

ii. Employer contribution holidays will only be permitted if the pension plan is more than fully funded by a solvency margin, which will be set at a level of 5% of solvency liabilities. The practice of taking contribution holidays was widespread in the past and has been a contributing factor towards the underfunding of pension plans during the past several years.

iii. Sponsor declared partial terminations will be eliminated from the Act.

iv. There will be immediate vesting of benefits. Under the current framework, there is a two-year maximum period before accrued benefits are vested. It is proposed that vesting be made immediate upon membership in a plan.

2. REDUCE FUNDING VOLATILITY FOR DEFINED BENEFIT PLAN SPONSORS

i. Introduce a new standard for establishing minimum funding requirements on a solvency basis that will use average - rather than current - solvency ratios to determine minimum funding requirements. The average solvency position of the plan for funding purposes will be defined as the average of solvency ratios over the current and previous two years. This will be based on the market value of plan assets. The amortization period for solvency deficiencies will remain at five years. The going concern methodology and its 15 year amortization period will remain unchanged. Annual valuations will be required to support the new solvency funding standard.

ii. Sponsors will be permitted to use properly structured letters of credit to satisfy solvency payments up to a limit of 15% of plan assets.

iii. The 10% pension surplus threshold in the Income Tax Act will be increased to 25%. The Income Tax Act allows employers to make whatever contributions are necessary to ensure that pension benefits promised under a defined benefit Registered Pension Plan are fully funded on an actuarially determined basis. However, if plans have surplus funds over a specified threshold, employer contributions must be suspended. The new threshold will apply for 2010 and subsequent years.

3. RESOLUTION OF PLAN-SPECIFIC PROBLEMS

A workout scheme for distressed pension plans will be established to help facilitate the resolution of plan-specific problems that arise in some circumstances when a particular plan sponsor cannot meet near term funding requirements. The scheme will permit sponsors, plan members and retirees of a distressed pension plan to negotiate funding arrangements that are not in conformity with the regulations to facilitate a plan restructuring. It will respond to situations where the existing framework imposes funding requirements that cannot be reasonably met, and as such, may actually be detrimental to benefit security.

4. FRAMEWORK FOR DEFINED CONTRIBUTION AND NEGOTIATED CONTRIBUTION DEFINED BENEFIT PLANS

i. Provisions of the Act and the Regulations will be revised to provide clarity on the responsibilities and accountabilities of the parties involved with defined contribution plans. Plan sponsors and members will benefit from a framework for defined contribution plans that will:

• Provide explicit guidance on the responsibilities and accountabilities applicable to employers, members, administrators and investment providers with respect to defined contribution plans. The framework will consider the Capital Asset Plan (CAP) Guidelines released by the Canadian Association of Pension Supervisory Authorities to provide best practices on these roles.

• Eliminate the requirement for a Statement of Investment Policy and Procedures for a CAP defined contribution plan.

•Measures specifically pertaining to defined contribution arrangements will be clearly articulated in the Act and Regulations.

ii. Pension plans will have the option to permit members to receive Life Income Fund (LIF) payments directly from a defined contribution pension fund. Permitting the payment of LIF-style retirement benefits directly from the defined contribution plan account balance allows members to continue to have their pension savings managed by the plan, instead of having to assume greater personal responsibility for the management of the funds by transferring them to a LIF account at a financial institution.

5) MODERNIZATION OF PENSION FUND INVESTMENT RULES

The present pension fund investment framework, which imposes a prudent person standard supplemented with quantitative investment limits, will be modernized as follows:


• Remove the quantitative limits in respect of resource and real property investments.
• Amend the 10% concentration limit to limit pension funds to investing a maximum of 10% of the market value of assets of the pension fund (rather than the book value) in any one entity. An exception to this rule will exist for pooled investments over which the employer does not exercise direct control, such as mutual fund investments.
• Prohibit direct self investment (e.g., an employer would no longer be permitted to invest any amount of its pension fund in its own debt or shares).
OTHER MEASURES

i. To reduce administrative burden for plan sponsors and permit the orderly windup of plans upon termination, the benefits of members who cannot be located will be permitted to be transferred to a central repository.

ii. The Office of the Superintendent of Financial Institutions will be given additional powers to intervene when there are concerns about the work of a plan's actuary.

iii. A number of other technical improvements to the Act and the Regulations will be made to align the framework more explicitly with the way that it is commonly interpreted and administered. These technical amendments are as follows:

• Restrict annuity purchases for an ongoing plan if the plan is underfunded to be consistent with the treatment of transfers of lump sum benefits.
• Amend the definition of termination to avoid catching situations where the plan is not necessarily terminated, and clarify the timing and content of information to plan beneficiaries following a termination.
• Eliminate pre-1987 references in the Act, which are largely out of date.
• Remove the requirement that pension plans report to the Superintendent on inflation adjustments made to the pension benefits.
• Amend the definition of former member to ensure that plan members who have transferred to a new plan do not have a say in future surplus distributions in the older, original plan.
• Clarify that in situations where the accrued benefits constitute small amounts, they can be paid out as a lump sum at retirement.
• Require that payments owed to pension plans be remitted monthly rather than quarterly.

Monday, October 26, 2009

Partial Recovery in Global Pensions?


Reuters reports that Pensions funds recouping some of 2008 losses:
Pension funds tracked by the OECD recovered $1.5 trillion (918 billion pounds) in the first half of 2009 of the $5.4 trillion they lost in market value last year, the Organisation for Economic Co-operation and Development said on Monday.

"The recovery in pension fund performance has continued through September 30, 2009, on the back of strong equity returns, but it will be some time before the 2008 losses are fully recouped," the Paris-based agency said.

Pension funds staged a partial recovery in the first half, generating investment returns of 3.5 percent in nominal terms, said the OECD, whose 30 members are mostly rich industrialised economies (click on image above to enlarge).

Best performing funds in the OECD area were, on average, in Norway and Turkey, with nominal returns of more than 10 percent, compared with nominal returns of 4 percent for funds in the United States, the report said.

Total pension funds assets still remained 14 percent below their December 2007 levels as of June 30, 2009, it said in a report called OECD Pensions Markets in Focus.

"Thanks to the stock market rally in emerging markets, some non-OECD countries have already largely made up their 2008 investment losses," the report said.

By the middle of the year, Chilean pension funds had largely made up their 2008 losses, while assets of Israeli pension funds were above their December 2007 level, the report said.

The market value of pension funds tracked by the OECD fell to $22.4 trillion by the end of 2008 from $27.8 trillion at the end of 2007.

Global share prices as measured by the MSCI All-Country World Index have risen close to 70 percent from a trough in early March.

Click here to read the OECD report on pensions. The rally in global stock markets has helped fuel the partial recovery in OECD pension assets but it will take years before these assets fully recover. Why? Because given the low bond yields throughout the developed world, it is unrealistic to expect stocks to continue rising at this blistering pace.

However, I have argued that a liquidity driven rally means that stock prices can disconnect from fundamentals for a while but not indefinitely. Global stock markets are pricing in a global V-shaped recovery but the recovery may be more modest than what is being priced in.

Paul Hannon and John W. Miller of the WSJ report that Trade Data Underscore Weakness of Recovery:

Global trade flows slipped in August after rising for the two previous months, an indication that the economic recovery is more fragile and anemic than previous data have hinted.

The Netherlands Bureau for Economic Policy Analysis said trade volumes fell 2% from July, according to an algorithm based on customs data from 23 developed countries and 60 emerging markets, accounting for 95% of global trade.

The report is closely watched because it comes out before those compiled by the World Trade Organization and other institutions.

Global trade flows plummeted in the final months of last year as demand slowed and banks financed fewer cross-border transactions. Volumes were down 13% in August compared with the previous year.

The trade crisis has hit exporting powerhouses such as Japan and Germany particularly hard, sparked minor waves of protectionism almost everywhere, and inspired world leaders to make more funds available for trade finance.

The International Monetary Fund says world trade will fall 11.9% overall in 2009, the biggest drop since the Great Depression. The IMF sees a modest 2.5% increase in 2010.

Flows steadied during the second quarter of 2009, inspiring hopes of a recovery. The Organization for Economic Cooperation and Development said Friday that exports from the Group of Seven leading industrial nations rose 0.8% from the first quarter, although imports continued to fall, by 2.5%.

The Netherlands Bureau for Economic Policy Analysis, also known by its Dutch acronym CPB, calculated that trade was up 3.7% in July over June, prompting many observers to conclude that a true recovery was under way.

Many analysts, however, say the trend has bottomed out but that it is too early to predict where it will end in the next few months.

In a report released with the numbers, the CPB warned against placing too much emphasis on one month's trade figures, saying they are "volatile." It noted that in the three months to August, trade flows were up 1.8% on the three months to May.

One point of concern is that exporters are increasingly dependent on Asia to fuel export growth. Imports by emerging markets in Asia, including China were up 6.6% in the three months leading up to August, the CPB said.

"Chinese demand is sucking up a lot of that Middle Eastern petrochemical product that's not flowing into Europe or the U.S.," says Richard Longden, a spokesman for Ineos Group Ltd., a U.K.-based petrochemical group. "The challenge that remains particularly for European producers is the slow return of domestic demand."

Global trade is a key barometer for global growth. And the challenges plaguing European producers have been exacerbated by the appreciation of the euro relative to the U.S. dollar. This is one reason why I believe it's silly to claim the death-defying dollar is doomed. Moreover, the Chinese disconnect will jeopardize the global recovery by harming global trade.

So while OECD pension assets have recovered from 2008, mostly because global equity markets have soared from their March lows, the future looks very uncertain. Liquidity rallies can only last for while, but ultimately the fundamentals have to justify the valuations or else gravity takes over.

[Note: Read Jeremy Grantham's latest comment posted on ZH.]

Perhaps this is why Canadian federal Finance Minister Jim Flaherty says "comprehensive reform" to federally regulated pension plans is on its way:

In question period Monday, Flaherty said his department has completed a "vast consultation" with various stakeholders across the country, led by his parliamentary secretary Ted Menzies. The consultation began last January.

Flaherty said this consultation will result in reforms which will be announced soon.

He added that the federal government has also created a working group with the provinces and territories to find a collaborative solution to pension problems in Canada, as fewer than 10 per cent of pension plans in Canada are federally regulated.

"This is a serious issue. It is not to be dealt with on the back of an envelope or by a knee-jerk reaction. It's to be dealt with collaboratively, intelligently and thoroughly by governments working together in Canada," Flaherty said.

Reports say these reforms could include allowing funds to carry a greater surplus than they can currently. Existing legislation prevents federally regulated employers from over-funding their pension plans by more than 10 per cent. The goal of this is to protect federal tax revenue, as contributions to pension plans are exempt from taxes.

The government is also considering requiring pension plans to report more often. Currently, if a federally regulated plan does not have a deficit, it only has to report every three years.

However, the Conservative government won't consider creating a federal program to protect pensioners in case a company goes bankrupt, something NDP Leader Jack Layton has proposed in the past.

Ontario is the only province that has a pension benefits guarantee fund, which provides the province's pensioners with up to $1,000 a month in the event a plan fails to provide its full benefit, or any benefit at all. It is funded by corporate contributions, and the government has no legal obligation to top it up.

However, the Ontario government has admitted that with only about $100 million in funds, the pension guarantee fund is dramatically underfunded.

Public and private pension plans across the country have taken a beating from the financial crisis as well as historically low interest rates, with many suffering serious solvency deficits as a result. In addition, the recession has pushed many companies into bankruptcy, leaving some pensioners in the lurch.

Many interest groups have called for a vast overhaul of Canada's pension system to protect pensioners as Canada's population ages.

A recent survey by the Office of the Superintendent of Financial Institutions put the average solvency ratio for the 400 or so private plans it regulates at 0.88 or 88 per cent as of June 30.

That means that, on average, the total value of assets in all federally regulated private plans were 12 per cent lower than liabilities. That was a three per cent improvement from December 2008 when the assets of such plans were 15 per cent short of liabilities.

But while the average solvency deficit was 12 per cent, it is much greater for some plans and in some cases has reached 50 per cent of more.

The time for comprehensive pension reforms can't come soon enough. I will reserve judgment until I see the final proposals. But I warn the Government of Canada, any proposals that do not address the serious governance gaps at our public pension plans are doomed to fail.

Finally, the Globe and Mail reports that in a speech given in Montreal today, Bank of Canada Governor Mark Carney warned banks against 'hubris:

Bank of Canada Governor Mark Carney, a former international investment banker, is taking aim at his former counterparts on Wall Street and in the City of London.

In remarkably forceful comments Monday, Mr. Carney suggested bankers in the United States and Europe are suffering from hubris, have lost sight of their proper role in the economy, and can't be trusted to operate in the best interests of the financial system.

“The financial system must transition from its self-appointed role as the apex of economic activity to once again be the servant of the real economy,” Mr. Carney said in a speech in Montreal. “Stronger institutions and a system that can withstand failure are necessary conditions. But full realization of this objective also requires a change of attitude.”

The comments were directed mostly at banks in the U.S. and Europe, based in New York and London, cities Mr. Carney worked in during a 12-year career with Goldman Sachs. They're also test grounds for the complex financial products and runaway risk-taking behind the financial crisis.

I went over Mr. Carney's entire speech and thought it was excellent and well articulated. In fact, I think the Bank of Canada can work with OSFI to play a key supervisory role of Canada's large public pension plans as well as federally regulated private pension plans.

The time for a new governance framework is long overdue and if the Government of Canada is going to get serious on pension reforms, it has to get serious about revamping the governance at Canadian public pension funds.

Sunday, October 25, 2009

Soros on Alignment of Interests


The FT reports that Soros calls Wall St profits ‘gifts’ from state:

The big profits made by some of Wall Street’s leading banks are “hidden gifts” from the state, and taxpayer resentment of such companies is “justified”, George Soros, the fund manager, said in an interview with the Financial Times.

“Those earnings are not the achievement of risk-takers,” Mr Soros said. “These are gifts, hidden gifts, from the government, so I don’t think that those monies should be used to pay bonuses. There’s a resentment which I think is justified.”

Mr Soros, who joins a transatlantic chorus calling for limits on risk, leverage and compensation at big banks, said proprietary traders belong at hedge funds, not at banks, and that the compensation at Wall Street companies should be limited to prevent excessive risk.

“With the too-big-to-fail concept comes a need to regulate the payments that employees receive,” said Mr Soros, who will elaborate on his views in lectures in Budapest next week.

Some bankers have argued that limits on pay would make it difficult for them to retain their most talented risk-takers. Mr Soros agreed and said this would be a good thing.

“That would push the risk-takers who are good at taking risks out of Goldman Sachs into hedge funds, where they actually belong, because hedge funds take risks with their own capital, not with deposits and not with government guarantees,” he said.

Asked if his opinions were influenced by his personal investments, Mr Soros said no and pointed out that he has long advocated more regulation of hedge funds.

Mr. Soros is absolutely right, if they want to take risks, let them do it managing a hedge fund on their own, not within a bank. This way, they have skin in the game (I would never invest with any hedge fund manager who does not have the bulk of their liquid net worth in their fund). If their bets go wrong, they feel the pain.

But the banks want risk-takers and they pay big bucks to attract and retain them. It's all about showing profits, even if those profits come from people who have no skin in the game and couldn't care less about the risks they're taking to maximize their bonuses.

The same goes for pension funds with internal hedge fund operations. In good years, portfolio managers can make a lot of money, but in bad years, they can fall back on their four-year rolling return. Total nonsense. I use to shake my head watching some "star" managers at the large pension funds I worked for be treated like royalty because they made $50 million, $100 million or $200 million taking stupid risks with other people's money.

[Note: People forget that to make a lot of money you got to take a lot of risk. They look at the bottom line and never ask how were those returns generated and were the risks acceptable or irresponsibly high.]

I'll never forget a lunch I had with one senior pension fund manager and a couple of sharp fund of hedge funds principals. Basically, this pension fund manager was engaging in complicated, illiquid, twenty year swap trades using the balance sheet of the pension fund he was working for. Nobody really understood the risks he was taking but he was treated like an 'investment god' inside this pension fund.

At the lunch, he was exploring the idea of setting up his own hedge fund. He explained the strategy to both fund of funds principals, and asked them what they thought. One of them looked at him and told him straight out "stay where you are at the large Canadian pension fund. Nobody in their right mind would ever fund this strategy. You can do what you're doing because of where you are but one day, you'll run into problems".

Sure enough, in 2008, he did run into problems. He was exceptionally bright, but he failed to appreciate the macro and liquidity risks he was taking and it ended up costing him his job. I wonder if he would have taken the same risks if all his net worth was tied up in the pension funds he was managing.

Saturday, October 24, 2009

The Chinese Disconnect?


A follow-up to my last comment on the death-defying dollar. In his NYT op-ed column, Paul Krugman writes about The Chinese Disconnect and notes the following:

Many economists, myself included, believe that China’s asset-buying spree helped inflate the housing bubble, setting the stage for the global financial crisis. But China’s insistence on keeping the yuan/dollar rate fixed, even when the dollar declines, may be doing even more harm now.

Although there has been a lot of doomsaying about the falling dollar, that decline is actually both natural and desirable. America needs a weaker dollar to help reduce its trade deficit, and it’s getting that weaker dollar as nervous investors, who flocked into the presumed safety of U.S. debt at the peak of the crisis, have started putting their money to work elsewhere.

But China has been keeping its currency pegged to the dollar — which means that a country with a huge trade surplus and a rapidly recovering economy, a country whose currency should be rising in value, is in effect engineering a large devaluation instead.

And that’s a particularly bad thing to do at a time when the world economy remains deeply depressed due to inadequate overall demand. By pursuing a weak-currency policy, China is siphoning some of that inadequate demand away from other nations, which is hurting growth almost everywhere. The biggest victims, by the way, are probably workers in other poor countries. In normal times, I’d be among the first to reject claims that China is stealing other peoples’ jobs, but right now it’s the simple truth.

So what are we going to do?

U.S. officials have been extremely cautious about confronting the China problem, to such an extent that last week the Treasury Department, while expressing “concerns,” certified in a required report to Congress that China is not — repeat not — manipulating its currency. They’re kidding, right?

The thing is, right now this caution makes little sense. Suppose the Chinese were to do what Wall Street and Washington seem to fear and start selling some of their dollar hoard. Under current conditions, this would actually help the U.S. economy by making our exports more competitive.

In fact, some countries, most notably Switzerland, have been trying to support their economies by selling their own currencies on the foreign exchange market. The United States, mainly for diplomatic reasons, can’t do this; but if the Chinese decide to do it on our behalf, we should send them a thank-you note.

The point is that with the world economy still in a precarious state, beggar-thy-neighbor policies by major players can’t be tolerated. Something must be done about China’s currency.
Krugman's article prompted this response by Zachary Karabell on the Huffington Post:

But what exactly must be done? And more to the point, what can be? Declaiming that something must be done assumes that the United States or some other world power can coerce or force the Chinese government to change their approach to currency in particular and economic policy in general. Before the crisis of the past year, Chinese authorities had actually begun a slow, quiet revaluation of the currency, but only after American politicians and officials stopped using the currency question as a cudgel against China. The recent decision of Timothy Geithner and the Obama Administration not to label China a currency manipulator marked a welcome change in tactics. Compare that choice to the much-publicized Schumer-Graham tariff of 27.5%. It never went into effect, but it hovered as a threat that if China didn't immediately revalue its currency, dire things would follow.

But with China now accounting for nearly $1 trillion of American debt, and with the two economies in a symbiotic relationship that neither loves but that neither can escape, the U.S. can't simply insist that China do something about its currency and expect action. These economies are now fused (see my new book Superfusion). Much like the United States for last half of the 20th century, China is becoming a global economic behemoth. It isn't supplanting the United States anytime soon, but it is rapidly joining the U.S. as the other most important engine of the global system. It remains much poorer and less developed, but it is generating a substantial share of global activity and its cascade can be felt from Rio to Melbourne.

Given that, why would China decide to disrupt the system simply because it causes consternation in America or Europe? Its economy is booming and its policies, however unorthodox, are working. China will again allow its currency to appreciate when it feels that doing so won't cause a crisis of disrupt growth. Its massive accumulation of reserves is an issue. As the crisis eases, it's likely that Beijing will return to its pre-2008 policy of gradual appreciation, especially now that it is focusing on generating domestic demand and wants greater purchasing power for Chinese citizens. But Secretary Geithner - contrary to the criticisms of Krugman and others - has been exactly right in not publicly calling out China. Such an act would be both arrogant and foolish. In the world today, the United States can afford to be neither. Let's hope we remember that.

Writing for the WSJ's China Real Time Report, Jason Dean reports that the yuan may rise later rather than sooner:

Predicting the government’s handling of the exchange rate has generally proven a fool’s errand: Analysts were saying a de-pegging was imminent for years before it finally happened in 2005, and few foresaw the re-pegging last year.

The yuan bulls may well be right - there are many strong arguments for appreciation.

But the difficulties involved for Beijing haven’t disappeared, either. Does it go fast or slow? The gradual-but-seemingly-inexorable rise from July 2005 to July 2008 drew a flood of speculative hot money into the economy – which China’s leaders hated. A rapid, one-time jump could catch speculators off guard – but also shock domestic companies and disrupt the economy, which Beijing would hate even more.

It’s also worth remembering the circumstances last year when the re-pegging occurred. True, China’s export growth had slowed a bit in some months, but exports rose a blistering 27% in July 2008, and continued to grow by around 20% for three more months. GDP grew 10.1% in the second quarter. It wasn’t till September that the People’s Bank of China started cutting interest rates, and Beijing didn’t truly go into crisis mode till November – the month exports started falling for the first time in years, and China unveiled its monster 4 trillion yuan stimulus package.

If China put the brakes on the yuan’s rise well before the real crisis hit, it could be a while after the crisis disappears before it taps the gas again.

Stephen Green, China economist for Standard Chartered, said in a note last month that exports will need to be growing at a double-digit rate before the yuan is allowed to resume its rise. He doesn’t think the exchange rate will start to budge until the second half of next year – and projects a move of less than 1% between now and the end of 2010.

Finally, Chrystia Freeland, US managing editor of the Financial Times interviewed George Soros about the state of the world economy. It is an excellent interview, worth reading in its entirety (you can also watch it by clicking here). Here is what Mr. Soros had to say about the U.S. dollar and China's peg:

FT: Given this continued weakness in the US economy, are people right to start to be concerned about the dollar?

GS: Well, they are of course and the dollar is a very weak currency except for all the others. So there is a general lack of confidence in currencies and a move away from currencies into real assets. The Chinese are continuing to run a big trade surplus and they're still accumulating assets and basically the renminbi is permanently undervalued because it's tied to the dollar. There is a diversification from assets that are normally held by central banks into other assets, especially in the area of commodities. So there is a push in gold, there's a strength in oil, and that is in a way a flight from currencies.

FT: Is there going to be a tipping point, a moment at which the dollar is fatally weakened? Or does it just sort of carry on?

GS: As long as the renminbi is tied to the dollar, I don't see how the decline in the dollar can go too far. Now, of course, to some extent it's very helpful because with the US consumers saving more and spending less, exports can be way for the US economy to be balanced. So, an orderly decline of the dollar is actually desirable.

An orderly decline of the dollar? We've already seen a steep decline in the U.S. dollar. The big question is how will other nations respond to the symbiotic relationship between the U.S. and China? This week we saw Asian currencies declining on intervention speculation. Will we see intervention in the currency markets? I am not sure, but the current path is unsustainable and will require some sort of intervention as it poses serious risks to the global recovery.