Friday, December 10, 2010

Unstable Equilibrium

Woodblock print by Utagawa Hiroshige

Freeze and Thaw

An increasing number of analysts are forecasting better time ahead for the economy and the stock market. Elaine Garzarelli daid on CNBC that there will be better economic growth and stock market performance next year as a result of the money put into action by QE II.  PIMCO's Mohammed El-Erian also raised his US growth forecast for 2011, to between 3.0 and 3.5 percent from an earlier estimate of 2.0 to 2.5 percent, based on the prospect that Bush-era tax cuts will be extended for another two years. However, he added that further stimulus would be needed to sustain growth.

To be sure, not all of the optimism is US-centered or long-term. Byron Wien just came out with a warning that investors need to be invested in emerging markets, and he recommended a portfolio allocation that emphasizes emerging markets, high yield bonds, and hedge funds.  Bill Gross just advised fixed-income investors to look to emerging markets like Brazil where they can earn an attractive real interest rate, rather than the pittance offered in the US.

Also, many structural factors are against the US in the longer term. Gross added: “The U.S. is being out-trained, out-educated and out- maneuvered in the global competition for employment.”  About his forecast of higher US economic growth, El-Erian wrote: "Maintaining such a growth rate beyond 2011 requires additional measures to enhance competitiveness and achieve medium-term fiscal consolidation."

Risk Probabilities Remain Tilted Toward Recession and Deflation

Despite recent talk in the press about signs of an improving economy, a look at a broader range of evidence shows persistent and underlying economic weakness. Combined with underlying conditions, including high levels of debt in both the private and public sectors, the economic and financial evidence suggests that the way out of this country's troubles will be a long slog and fraught with risks.

Fed Chairman Bernanke said last Sunday that the economy is barely expanding at a sustainable pace and that it’s possible the Fed may expand bond purchases beyond the $600 billion announced last month to spur growth. “We’re not very far from the level where the economy is not self-sustaining,” Bernanke said in an interview broadcast yesterday by CBS Corp.’s “60 Minutes” program. “It’s very close to the border. It takes about 2.5 percent growth just to keep unemployment stable and that’s about what we’re getting.”

Indeed, this country is not alone in its troubles. Around the developed world, financial systems burdened by high levels of debt and stagnant economies are highly dependent on government policies for their maintenance. Certainly, the economies and financial systems of the US, EU, and Japan are supported only by extraordinary monetary policy, and errors in these countries' policies could have negative repercussions that would reverberate around the world. As Hugh Hendry says in his December 2010 Eclectica Fund commentary, "This is an environment rich in policy error contingencies."

Hendry also made the very practical point that serious dislocations can also present serious investment opportunities. In the spirit that our wealth is only as safe as our ability to prepare for an uncertain future, I'd like to review recent commentaries about these risks and uncertainties.

Is Santa Coming to Your House?

In case anyone thinks that the economy and financial system actually are making progress, he or she need look no farther than recent news headlines. As an example, consider the headlines from the news stories reprinted in The Automatic Earth blog, last Saturday, December 4, 2010:

Senate Republicans Defeat Reauthorization Of Jobless Aid, Tax Cuts

4 Million Americans Set To Lose Unemployment Benefits Even If Congress Passes Extension

Here Are The The AWFUL Details Behind Today's Big Jobs Report Miss

Value Sinking Fastest on Homes Priced Low to Start

Homes Prices are Plunging: Let's Talk About the Deficit

Distressed Homes in U.S. Sell at Biggest Discount in Five Years

The con of the century – Federal Reserve made $9 trillion in short-term loans to only 18 financial institutions. Since 2000 the US dollar has fallen by 33 percent. The hidden cost of the bailouts.

ECB bows to German veto on mass bond purchases

Angela Merkel warned that Germany could abandon the euro

The details within these stories are no better than the headlines. For example, consider the imbalance between good and bad news in this list of employment facts from the above-mentioned jobs report article:

1. First, the headline: Nonfarm payrolls barely move upward.
2. And the unemployment rate is now creeping up again.
3. Those unemployed for more than 15 weeks is now near 2010 highs.

4. And those unemployed for more than 27 weeks is moving higher.

5. The civilian employment ratio is back at the post recession low.

6. Civilian employment numbers have given up the past few months' gains.

7. The civilian participation rate is now at a new low.

8. Weekly hours have slipped as well.

9. Now, a look at the industries hardest hit: Manufacturing employment in non durable goods now below 2010 lows.

10. And durable goods manufacturing jobs don't look too much better.

11. Government jobs have dipped again, although only slightly.

12. Construction jobs remain low, and flat.

13. BRIGHT SIGN: Total private industry jobs are still moving higher.

He's Making a List

Maybe we can muddle through with a weak economy, or maybe not. For my part, I'm worried about all the risks we fact before (if ever) we get out of the woods. Pragmatic Capitalism made this point forcefully: "I still believe we are mired in a balance sheet recession that will result in below trend growth, deflationary risks and leaves us extremely vulnerable to exogenous risks that could exacerbate the current malaise."

If the current stagnant situation is being propped up only with extraordinary monetary policy, then surely the situation is actually quite fragile. A world delicately balanced between debt disaster and policy overreach must surely be fraught with numerous, serious risks. Niels Jensen, Managing Partner of Absolute Return Partners LLP listed 12 risk factors for the attention of readers of his latest Absolute Return Letter.  Here are the risk factors, each accompanied by my own short exegesis:

High yield priced for perfection? Are spreads getting so tight that one could even talk of a bubble, and could that bubble burst, should the US (and/or European) economy fall back into recession?

The risk of double dipping. Just consider the economic news that I listed earlier.

The sinking ship of Japan. This refers to the high and growing level of government debt, the funding of which is endangered by an old and aging population.

Beggar thy neighbor mentality. Just consider administration talk of devaluing the dollar to increase exports (as if anyone needed our products), complaints from various emerging countries about manipulated interest rates in the US, and China's policy with the Renminbi.

Capital flows too hot to handle. We read every day about the risks of overheating in China and other emerging economies. Capital controls would damage both overseas investors and internal growth. Not imposing controls would risk high inflation and runaway bubbles in commodities and other assets.

Chinese inflation out of control? Although the leadership has said that it is considering price controls on food, lax monetary policy is pushing up prices of a variety of goods and assets.

Food inflation induced civil unrest. Based on the last food price peak in 2008, it may not be too much to expect civil unrest across Asia if food prices continue to climb.

Is India an accident waiting to happen? Although India is financing its external deficit with ease at present, due to the positive capital flows into emerging markets, tighter overseas monetary policies or a change in investor risk perceptions could endanger those flows.

European contagion and solvency risk. Current efforts to avert a crisis are just kicking the can down the road. Banks are in trouble, and the underlying solvency problems are not being solved by adjustments in liquidity.

Massive refinancing program. "This programme poses the biggest risk to my benign outlook for bond yields ...", because of the huge financing needs that are approaching, according to Jensen. Zero Hedge ventured that the problem is even bigger: "Simply put, it's not just fiscally-challenged nations in the eurozone that are suddenly being forced to address the threat posed by too much borrowing. Over the next 12 months, countries across the world, including the United States, will be looking to roll over approximately $10 trillion worth of debt."

Premature withdrawal of monetary support. Not only are the indebted peripheral nations of Europe dependent on continuous support, but the US economy is in danger if Congress follows through on Republican promises to rein in the Federal budget, seemingly without any consideration of the consequences.

Israel launching a pre-emptive strike on Iran’s nuclear facilities. The world is full of political-military risks, and this is just one risk that happens to be a current focus of attention.

I don't know if these are exactly the risks that I would focus on, but they serve to convey the general notion that the present unstable equilibrium could easily be disturbed and send the system sliding off into a new trough of worse conditions.

He's Checking It Twice

Naturally, David Rosenberg has taken his turn listing risks to economic recovery, and out of his list, I think that these two pose particular domestic threats next year:

Massive tightening in U.S. fiscal policy coming via spending cuts and tax hikes. This is the part of the macro forecast that is not given enough attention.

Many goodies will expire at the end of the year and question marks linger over whether they will be extended. These range from the Build America Bond program that subsidized municipal issuance, the Bush-era tax cuts, the extended/emergency jobless benefits, and the little-known Obama tax benefit called the Making Work Pay Credit.

Pragmatic Capitalism reviewed Rosenberg's list and added another domestic risk : "The one major risk that Rosenberg and the market is largely overlooking at this juncture is the housing double dip. This has the potential to be THE most important story of 2011. As I've previously explained, declining asset values are highly destructive during a balance sheet recession."

Tighter fiscal policy will do no good for the economy, and it also brings into question how much money the states might receive from the Federal government should states continue down their present road to budgetary crisis. In "Mounting Debts by States Stoke Fears of Crisis" The New York Times noted just a few examples of how bad the situation has become:

"The State of Illinois is still paying off billions in bills that it got from schools and social service providers last year. Arizona recently stopped paying for certain organ transplants for people in its Medicaid program. States are releasing prisoners early, more to cut expenses than to reward good behavior. And in Newark, the city laid off 13 percent of its police officers last week."

Given continued problems with the national economy, many states could be overwhelmed by debt in a few years, if they are not already at the brink of the precipice. Worries about Federal willingness to aid the states may not be mere fear mongering. The Times added: "Analysts fear that at some point — no one knows when — investors could balk at lending to the weakest states, setting off a crisis that could spread to the stronger ones, much as the turmoil in Europe has spread from country to country."

Felix Rohatyn, the financier who helped save New York City from budget problems in the 1980s warned that while municipal bankruptcies were rare, they appeared increasingly possible. Mr. Rohatyn added that the imbalances are so large in some places that the federal government will probably have to step in at some point, even if that seems unlikely in the current political climate.

In noting the likelihood of legislative deadlock in 2011, David Rosenberg wrote:

Folks, we are on life support. We have been since 2008. Nothing will change in 2011. QE has been extended, the tax cuts will be extended, BABs and the Agency loan limits are being extended. The IV is full and inserted into the arm. The juice that is keeping us alive is still flowing. But make no mistake about this. Without the IV the lights will go out very quickly. 2011 is the last year for these extensions. When we wake up to the fact that we are alive only as a result of medicine we take on a daily basis there is going to be another “event”.

In the current political climate, we have to wonder what kind of price the Republicans might try to exact in exchange for eventual bailouts of the states. Breaking public employee unions would surely please the Republicans, but they might have to provoke a state bankruptcy crisis in order to get their way. Financial systems don't like crises, unfortunately.

In Wednesday’s NYT, David Leonhardt commented: “Mr. Obama effectively traded tax cuts for the affluent, which Republicans were demanding, for a second stimulus bill that seemed improbable a few weeks ago.” It seems likely that any resulting stimulus will be too little to make a difference.

It is to be hoped that the recent extension of tax breaks for the wealthy will prompt those who are often referred to as the "job creators" to get with it and start hiring. Given that the demand for goods from the masses is lacking, there is little reason for more hiring, but we can all hope. At least there are some modest increases in prospective hiring surveys for the first quarter of next year.

The Neighbors Have Been Naughty Too

David Rosenberg has a good way with words, so I'll let him express the nature of the risks with Europe: 

"All these “rescue” packages in euroland really do is provide bridge financing — they do not resolve the underlying structural problems in these countries or the deflating asset values in bank balance sheets."

"The massive selloff in government bond markets, even in countries like Belgium and Italy (let alone Portugal and Spain), is a clear sign that the bond vigilantes are now targeting the supposedly stronger governments in the eurozone. These bond vigilantes are also speculating that the national purse will be needed to keep their banks afloat and the relentless widening in CDS spreads is an added suggestion from the markets that these governments may not have the resources to fully repay their creditors once they have moved to support their banking systems."

The Washington Post commented last Tuesday that bond markets are not the only worry with Europe:  "A greater danger is that a full-blown debt crisis in Europe could put new pressure on the region's banks, tightening credit and potentially slowing growth in one of the world's largest economic engines. It could also send the euro plunging against the dollar, making the greenback stronger on world markets and undermining the efforts of the Obama administration to boost U.S. exports overseas."

In a guest editorial in Naked Capitalism, the author of Washington's Blog wrote: "...... by assuming huge portions of the risk from banks trading in toxic derivatives, and by spending trillions that they don’t have, central banks have put their countries at risk from default."

Nouriel Roubini put it this way, “So at some point you need restructuring. At some point you need the creditors of the banks to take a hit —otherwise you put all this debt on the balance sheet of government. And then you break the back of government—and then government is insolvent.” There remains the question of what kind of restructurings will take place, but Europe seems to be kicking the can down the road at present. The transfer of risks onto government balance sheets is already being reflected in the widening of sovereign credit default swaps.

Should there be a systemic breakdown in Europe, it could bring a banking crisis of the same kind that we saw in 2008. Banks in the US, Europe, and elsewhere could face sudden lack of liquidity if European banks take a hit.  Investors on the whole are probably not prepared for such an event.

The Bond Vigilantes May Beat Santa to Town

CNBC reported Wednesday that Nouriel Roubini voiced concern over the compromise on extending tax cuts between President Obama and Republican Congressional leaders. Roubini said that the agreement could expose the US to bond vigilantes who will drive up bond yields. The Fed has kept short-term rates as rock-bottom levels to support the fragile economy, and an increase in bond yields could damage any chance of a recovery

Roubini said on Twitter: “Obama-GOP tax deal costs $900 billion over two years. US kicking the can further down the road. Are bond vigilantes starting to wake up?”  Bond prices have fallen from the highs of a few weeks ago when speculators were anticipating the Fed's purchases under QE II, and renewed worries about US government debt levels could send Treasury prices even lower.

Worries about the debt positions of other advanced economies, which seem to be in even worse condition, might be a mitigating condition preventing any abrupt break in US bond prices. Nevertheless, given the seeming intractability of the debt problem, it would not be surprising to see recurring periods of worry about US debt levels over the next few years, accompanied by occasional declines in bond prices.

Progress on reducing the national debt will require both steady tax revenues and reduced budget expenditures. The weak economy will make progress on both fronts very difficult, since it will increase demands for fiscal and monetary intervention. As Jesse's Crossroads Cafe put it, "For a nation that is a net debtor, deflation is tantamount to suicide."

Despite criticisms of its monetary policies, the Fed seems unlikely to allow deflationary suicide anytime soon.  In his CBS interview, Federal Reserve Chairman Ben Bernanke did not rule out buying more than $600 billion of bonds in further quantitative easing. Once the idea of an imminent QE III gets into the consciousness of Wall Street, we should not be surprised to see even more money piling into commodities, emerging markets, and other "risk" assets. Perhaps this time the weakness of Europe will help to support the dollar ... perhaps.  A weaker dollar would help exporting industries in the US, if the Fed could engineer it.

According to the New York Times, financial markets have interpreted the tax cut deal, which was announced this week between the administration and Congress, as contributing to economic growth over the next couple of years but also increasing the federal deficit and raising borrowing costs. Higher borrowing costs would not help in funding extant debts, and the elephantine issue of reducing the federal debt is being pushed off to the future.  Whatever happens on the fiscal side, the monetary side of policy seems likely to keep levitating financial asset prices. When that levitation will end it hard to tell, but at some point the bond vigilantes will likely have their say.

An increasing number of analysts is saying that it makes no sense for the Fed to keep monetary conditions so loose when the economy is enjoying growth in excess of 2 percent.  They may have a point, because the bond market has responded to better growth prospects, and bond prices have declined recently.  Given all of the risks that we have enumerated in this article, we have to wonder if that growth spurt will be short-lived.


Pundits who make point predictions about the economy and the markets are absolutely foolish, because any alert observer will admit that the future is a swirling sea of variables.  No one knows what is going to happen.  On the other hand, we all need to protect our assets and prepare for the future.  To do that, we need to consider a range of alternative futures and form judgments about their relative plausibilities.   You can tell in which direction I think the probabilities are pointing.