Friday, 29 May 2009

Back to normal again? ...Yes and no

Bill Gross is probably one of the most widely respected investment voices out there. Recently, at the 2009 Morningstar Investment Conference he shared his views about the future for financial markets and investment expectations. In his address he warned investors not to think that everything will simply return to the way it was before the crisis. We will have to get used to a different environment with perhaps lower return expectations.

Arijit Dutta of Morningstar reports:

Bill Gross of PIMCO gave a sobering assessment of market prospects during his luncheon keynote address at the 2009 Morningstar Investment Conference on Thursday. Gross effectively discredited the idea that this brutal bear market will give way to a new decade of prosperity for risky assets, a notion that some notable speakers this year have cautiously entertained. Instead, Gross foresees a new investing landscape in which we will have to get used to a permanently downgraded economy and much lower returns on all manner of risk-taking.

Gross is a founder and co-chief investment officer of PIMCO, and his stellar, multi-decade record at the $150 billion PIMCO Total Return
fund makes him one of the biggest rainmakers among all money managers in history. His ideas carry a lot of weight indeed, which doesn't make it any easier for most people wedded to the notion of a secular bull market interrupted by periodic setbacks (whom Gross called "children of the bull market") to digest this sketch of a new, lesser-return normal.

In a conversational speech, Gross outlined how we got here and what makes this bear market different. He pointed out the rise of active central banking since the end of the gold standard (as administered within the Bretton Woods system) as the key impetus behind the golden age of financial capitalism and the "great moderation" of macroeconomic risk that we enjoyed for more than two decades.
We got used to the comforts of that era to our own peril, and it directly or indirectly led to massive global imbalances such as the indebtedness of the U.S. consumer and the Western financial system on one side and the bulging foreign exchange coffers of China on the other.
Now, as we go on a long, hard journey to repair our collective balance sheets, Gross sees no quick return to the days of low unemployment, low inflation, and solid economic growth.

Gross suggested that investors would need to question many long-held beliefs as they adjust to this new normal. Among them is the idea that risky assets such as stocks are always better for the long run. In the subdued economic climate ahead, risk-taking is simply not going to be as rewarding, so investors may want to switch down to a more sedate asset allocation mix with more bonds and stable blue chip stocks.

Another key piece of advice from Gross is to raise investments outside the U.S because the dollar is likely to lose its status as the world's reserve currency amid massive levels of government debt.

Finally, Gross predicts a saner, more stewardship-minded money management industry characterized by greater aversion to loss and lower fees.

Thursday, 28 May 2009

Net inflows to mutual funds are back

InvestmentNews reported that investors last month (April) poured new money once again into mutual funds and ETFs after a period of heavy selling.

Investors poured money into equity mutual funds, including exchange traded funds, in April in a reversal from the previous month, when those funds experienced net outflows, according to a report released yesterday by Financial Research Corp. of Boston.
Domestic and global equity funds, and ETFs, posted net inflows of $8.5 billion and $6.9 billion, respectively. In March, domestic equity funds had net outflows of $18.8 billion, and international/global stock funds had outflows of $13.7 billion, FRC reported.
Corporate-bond funds led the objective category, with the largest net inflow at $16.6 billion in April. At the same time, international fixed-income funds had the largest net outflows at $447 million.
The Pimco Total Return Fund was the best-selling fund for the month of April, posting $3.8 billion in net inflows, the report found. Year-to-date through April 30, the $150 billion fund had $14.5 billion in net inflows.
Year-to-date through April 30, the $18.7 billion Vanguard Total Bond Market II fund was the best-selling fund, with net inflows of $18.6 billion, the report said. The fund posted $2.3 billion in net inflows for the month of April.

Wednesday, 27 May 2009

The "Too big to fail" mantra

In recent months as the global financial crisis unfolded it became clear western, democratic governments do not fully subscribe to market economic principles when it really mattered. Perhaps the political costs at the time were too high, or market participants expected government intervention to stabilise chaotic market conditions, but do not be surprised if the eventual economic costs are going to be much higher!
John Kay, columnist for the Financial Times, wrote the following thought provoking piece:
Neither a democratic society nor a market economy can accept the notion that a private business is “too big to fail”. Liberal democracies of the modern world based on lightly regulated capitalism acknowledge two mechanisms of accountability – the marketplace and the ballot box. In the marketplace, organisations that do not meet, or respond to, the needs of society are ground between the twin pressures of their customers and their investors. At the ballot box, politicians that do not meet, or respond to, the needs of society suffer popular rejection.
Commercial success and democratic election are the only sources of legitimate authority in a society that no longer relies on spiritual leadership nor respects hereditary titles. An organisation exempt from either of these disciplines represents an unaccountable concentration of power.
If “too big to fail” is incompatible with democracy, it also destroys the dynamism that is the central achievement of the market economy. In principle, there is no reason why disruptive innovations and radically new business models should not come from large, established, dominant companies. In practice, the bureaucratic culture of these organisations is such that this rarely happens. Revolutions in business generally come from new entrants. That is why so many of today’s market leaders – Microsoft, Google, Vodafone and Easyjet – are companies that did not exist a generation ago. These companies could not have succeeded if governments had been committed to the continued leadership of IBM and AOL, AT&T and British Airways.
Any form of selective government support distorts competition. To win such subsidy today, the companies concerned must, like General Motors and Citigroup, be both large and unsuccessful. It is difficult to imagine a policy more damaging to innovation and progress.
The assertion that in future we will supervise the activities of large banks so that their businesses do not fail represents a refusal to address the issue. Even if that assertion were credible – and it is not – the outcome would not deal with either the political problem or the economic problem. Such regulation fails to call managers effectively to account, while supervision that ruled out even the possibility of organisational failure would kill all enterprise.
“Too big to fail” – whether the claimant is a bank or an auto company – is not a status we can live with. It is both better politics and better economics to deal with the problem by facilitating failure than by subsidising it.

Consumer confidence returns...somewhat

Ruth Mantell of MarketWatch, reported the following story:

Consumers have brighter expectations for jobs in coming months, but their overall confidence remains relatively low, the Conference Board reported Tuesday.

A reading on U.S. consumer confidence jumped to 54.9 in May from an upwardly revised 40.8 in April as expectations for jobs improved, according to the Conference Board. The gain is the fourth-largest in the 32-year history of the survey, and the index is at its highest level in eight months. Economists were expecting the index to hit 43.

"Expectations are that business conditions, the labor market and incomes will improve in the coming months," said Lynn Franco, director of the Conference Board's Consumer Research Center. "While confidence is still weak by historical standards, as far as consumers are concerned, the worst is now behind us."

Still, confidence has "a long way to go" before hitting "normal" levels, wrote Ellen Beeson Zentner, senior U.S. macroeconomist with the Bank of Tokyo-Mitsubishi UFJ, in a research note. During recessions, confidence has averaged 76.3, rising to 85.9 during recoveries, and 99.8 during expansions, according to the research note.

The surge in May followed a substantial increase in April. An improved economy is almost a "default" occurrence, given how tough times have been, wrote Dan Greenhaus with the equity strategy group at Miller Tabak, in a research note.

"Of course, whether better days materialize or not remains to be seen," Greenhaus wrote.

The increase in confidence could lead to more spending, wrote economist Stephen Gallagher of Societe Generale in a research note.

"Consumer spending has been mixed. After a strong January, retail spending by consumers has been flat to down," Gallagher wrote. "The confidence gains offset some of the mixed news and suggest we should anticipate some healthier spending increases later this spring and summer."

Thursday, 21 May 2009

Commodity Prices: Recovering too fast?

RGE Monitor, one of the most renowned economic research groups in the world and chaired by the now famous Nouriel Roubini, believes commodity prices are getting ahead of fundamentals again. The following piece is quoted from one of their latest newsletters:

As of May 13, 2009, the Rogers International Commodity Index rose 7.6% since the start of 2009 on the belief that 'green shoots' around the world validated a V-shaped economic recovery in 2009. However, these 'green shoots' might still be a signal of the stabilization of economic activity at low levels, rather than a return to trend growth. Even if GDP growth around the world has bottomed, growth may continue to be negative or sluggish until 2011.
As such, commodity price gains might reveal a false sign of economic recovery – and so might the recent spate of bear market rallies in stock markets and inflows into emerging markets. The strong uptrend in commodity prices since February has been propelled more by technicals (investment demand, opportunistic stockpiling at low prices) than fundamentals (real growth in physical demand and production). Commodity prices could snap back to reality before resuming a more moderate uptrend in line with a U-shaped global growth path.
Base metals posted the strongest rebound among the commodity groups. The S&P GSCI Industrial Metals sub-index rose 21.1% ytd as of May 13, 2009. Copper led the rebound as it had the smallest surplus (as a percent of supply) and China's copper imports reached an all-time high in March. China's import rebound was driven by strategic reserve buying and the re-stocking of depleted inventories to take advantage of low prices - not to reflect (as yet nonexistent) strong growth in global manufacturing or consumption. China’s infrastructure-heavy fiscal stimulus will provide some support to commodities as will the nascent stabilization of the property market, but other private demand may continue to be weak, suggesting that China’s commodity demands may level off at somewhat lower levels than recent trends. Although China's PMIs are the first and only ones globally to indicate expansion in the manufacturing sector with external demand weak, they have a long way to go just to return to mid-2008 levels. Elsewhere, bankruptcy in the U.S. auto sector, dismal auto sales among Europe and Japan's carmakers and weak housing markets have obviated metal stockpiling. Metal demand has been flat globally, leaving the metal price uptrend without any real economic backing. But technicals aside, metals will be hard pressed for a fundamentally sustainable rally until consumer demand growth revives. Moreover, higher average commodity prices might lead some of these green shoots to wither.
Gold is a special commodity in that the fundamentals of physical supply and demand are minor influences on its price. Gold’s price is most often driven by speculative demand for a hedge against inflation or economic uncertainty. Many investors see gold as a substitute for fiat currencies. Consequently, gold prices sometimes track changes in central bank holdings of gold. Gold markets largely ignored China’s surprise revelation that it had increased its gold reserves as much of this had already been priced in by speculators. Moreover, China produces its own gold. The increase in China's gold holdings is just a mere drop in the bucket of its total $1.9 trillion in foreign exchange reserves. Gold's share in China's foreign exchange reserves remains much lower than the global average and well below the U.S. share. But China's interest in gold is consistent with its taste for real assets to gradually diversify from its U.S. bond-heavy portfolio. If other central banks followed suit, gold demand could increase sharply.
The commodity group trading closest to fundamentals has been agriculturals. S&P GSCI Agriculturals registered a small 1.77% ytd increase as of May 15, 2009 – a reasonable price gain in line with the subtle inflection in global consumer demand. Intra-group price performance has largely reflected differences in supply-demand situations: Sugar and coffee have outperformed grains, meat and dairy. Supply deficits due to cane crop failures in India and weather damage to coffee in Colombia have kept sugar and coffee prices at multi-year highs. Meat prices have fallen with the reduction in meat demand due to falling incomes around the world.
Oil futures have risen sharply since March, touching $60 per barrel May 15 2009, despite the weak demand outlook. Preliminary data and economic forecasts suggest that 2009 will mark the second back-to-back annual oil demand decline since the 1980s as industrial and residential demand slows and commercial inventories are high around the world.
There are several macroeconomic implications of this recent increase in commodity prices. Commodity exporting economies and their currencies are, like commodities, vulnerable to a reversal of risk appetite. The green shoots which prompted the in rush into commodities have likewise prompted inflows to commodity exporters like Russia, South Africa as well as Australia and other commodity exporters. The U.S. dollar’s weakness has contributed to strengthening of both G-10 and EM commodity currencies.
The generalized increase in commodity prices across the board and in transportation fuels in particular poses the risk of choking off any global economic recovery. And although current production cuts and delayed investment may have only limited effect on prices in 2009, they could raise the risk of a significant price shock in 2010 which could send the economy back into weakness. Swift increases in commodity prices as we saw in 2008, tend to exacerbate recessions as well as worsen external balances in the U.S. and key oil importers and adding to the amount of capital needed to finance fiscal and financial support packages.

Wednesday, 20 May 2009

The VIX is easing off

Market volatility is synonymous with market uncertainty and fear. It became a primary characteristic of market behaviour since October last year. Now, there are signs volatility is subsiding, or is it too soon to tell?
Nick Godt, reporter of MarketWatch published the following story:
The Chicago Board Options Exchange's volatility index (VIX), otherwise known as the market's fear gauge, has slumped to levels in the last few weeks unseen since before the collapse of Lehman Brothers last September.

"The rally is losing momentum, which is not terribly surprising," said Ken Tower, chief market strategist at Quantitative Analysis Service. "Is the VIX dangerously low? I would say it's close." On Tuesday, the VIX slumped 4.8% to 28.80, a level last seen in early September 2008, just days before Lehman Brothers shut down. The announcement had sent the VIX sharply higher, a move up that continued through December.

The broad market, as measured by the S&P 500, remains up more than 36% since hitting lows in March. On the face of it, lower fear and volatility sound like a good thing. It means investors are more confident to take on risks.
For contrarian investors, the fear gauge, when it reaches extreme levels, is seen as likely to pull back the other way much like an over-extended elastic. And it is therefore all the more fuel for a rally when it does.
But now that the VIX has fallen back sharply, some analysts believe the pulse of the market is at risk of being too tepid and stocks might be facing another leg down.
"This might mean that we're eventually headed for a setback," Tower said. "I still see this as a stabilizing market in a stabilizing economy, but [the market] has come a long way very quickly."
According to FactSet Research, the VIX spiked to record highs of between 81 and 96 in late October, as panic gripped markets worldwide.
From 2003 to July 2007, readings below 20 were the norm. as the market continued to climb during the housing bubble and before the credit crisis surfaced. But by March 2008, as Bear Stearns nearly collapsed, the VIX had jumped above 30 before falling back.
Some, such as currency strategists at BNP Paribas, now believe that the rally will have ran out steam when the VIX reaches 25.

Tuesday, 19 May 2009

When the wise speak, pay attention...

Recently, I came across the following thought provoking comments made during the Berkshire Hathaway AGM where Warren Buffett and Charlie Munger shared their views with an audience of 35,000 shareholders and interested parties:

“If we ran a degree we would just teach students how to value a business and understanding market behaviour. We wouldn’t waste more than 10 minutes on topics like modern portfolio management, etc.”

“Investment is very simple – you’ve got to find a few stocks that you understand and know what they’re worth and stick to them.”

"You got to have inner peace with your decisions once made and then ignore the minute by minute stimuli that come – Emotional stability is vital, more important than a high IQ.”

“Authority does not go with a position – it goes with a person.”
“Of course you’re looking for a business that will do well if it is not managed well – but of course if you have a business like that, you’d prefer it if it is run by people who run it very well.
The $: “The government is doing things (out of current necessity) that will depreciate the purchasing power of the $ - not in the next 12 months, but definitely over the next few years thereafter. The problem is, the market looks ahead and you don’t know when it will start reacting to the expected future inflation. In terms of the relative purchasing power of the $, governments of most developed market countries in the world are following the same policies. So it’s a question of which currency loses most purchasing power over what period of time.”
Regarding complex calculations used to value purchases: “if you need to use a computer or a
calculator to make the calculation, you shouldn’t buy it.” Munger added: “Some of the worst decisions I’ve ever seen are those with future projections and discounts back. It seems like the higher mathematics with more false precision should help you, but it doesn’t. They teach that in business schools because, well, they’ve got to do something…”
“We don’t want contracts – if you make a misjudgement on someone’s passion, no contract is going to save you afterwards. Our model is a seamless way of trust.”
CEO compensation and non-exec directors: “The definition of non-exec directors as being independent is wrong – only if a director is truly independent and does not need the income from his director’s fees is he truly independent. Many directors need the income. More importantly: You want independent directors to think like owners and have business savvy - most independent directors don’t own shares in the company nor do they have any business savvy.” In the end it becomes a club: The CEO nominates the directors and they ensure that he gets good salary increases each year. If they oppose him, it’s unlikely that he’ll nominate them to more boards – which impacts their earnings capacity.
“Charlie always says when we have a difference. I know you’ll figure it out my way ‘cause you’re smart and I’m right.”

When Warren started his partnership in 1956 he promised investors that he would attempt to
beat the Dow by 10% p.a. The current size of Berkshire Hathaway means they can only strive to beat the S&P by a few % points per annum.
Quoted from SIM Global Market Review, May 2009.

Has Dr Doom changed his mind?

Nouriel Roubini, professor of economics and chairman of RGE Monitor, is probably one of the most quoted experts on the financial crisis. He has been credited with predicting the housing market collapse and financial crisis at a time nobody cared to pay any attention. Also, he became known as Dr Doom since his economic outlook remained consistently bleaker than those of many other economists, only to be proven correct.
Recently, a journalist of Business Week held a meeting with him to test his current views on certain issues:

The economy:

Roubini says he doesn’t see much in the way of “glimmers of hope” other economists have noted. Unemployment, capital investment, and exports are all worsening, and while there are a few signs of stability in housing, it’s not much. Overall, he figures, the odds of a prolonged “L-shaped” depression have fallen to less than 20%, from about 30%, thanks largely to the efforts of this administration and, to some extent, the last. He expects global contraction of 2% this year, and expansion of about 0.5% next year, “so small it’s going to feel like a recession still.”
Still, he adds: “I don’t worry as much as six months ago about a near depression.” From the man who has been called Dr. Doom – or, as he prefers, Dr Realistic
– that’s practically cheery.
On securitization and the TALF:
While lending has improved somewhat, Roubini doesn’t credit the Federal Reserve’s Term Asset-Backed Loan Facility. A “reasonable idea” in principle, he says, the funds it has lent to subsidize the purchase of securitized consumer credit “is too small to make a difference.” Moreover, demand from securitizers has proven lower than some expected, either because of the fear of complications from after-the-fact congressional meddling, or because there’s simply too little demand for new lending.
He does see securitization returning in time, “I don’t think we’ll go back to what it was,” he says. But “now we’ve gone from too much to zero.”
On Ben Bernanke’s Federal Reserve:
After underestimating the depth and impact of the housing slump, mistaking the subprime crisis as a niche problem, and failing to seek legislation to dismantle failing banks after Bear Stearns’ collapse last spring, the Fed “has done a lot right,” Roubini says. “Now that the stuff has hit the fan, they have become much more aggressive about doing the right thing.”

Still, he’s not pleased with the Fed’s role as a back-door financier for the rescue effort. It’s understandable that the government has turned to the Fed, since early missteps led the public to see the effort as a bail-out of Wall Street bankers, which in turn has left Congress unwilling to open the purse strings. Still, using the Fed is “a way of bypassing Congress,” Roubini says. “I don’t think it’s a proper process. In a democracy, if you have a fiscal cost, you should do it the right way.”
On the banks:
Roubini has publicy scoffed at the bank stress tests, arguing that the real world’s grim metrics are on course to surpass the assumptions made under its “stress-case” scenario, and soon.
And he’s not impressed by the argument that some banks have been run so much better than their peers that they can better withstand the storm. In the end, the loan portfolios of the top four banks aren’t different enough to make much of a difference, he says. “I think the macro trumps everything else.”
With a capital hole for the industry that “could be really, really huge,” he expects the administration to have to make some tough choices. “Forbearance and time can heal many wounds,” he says. But “some institutions may be so far beyond the pale, even time is not going to heal their wounds.”
For those, Roubini advocates injecting enough capital to support them, even if it means taking a majority stake, and then dismantling them. Yet the administration has ruled out nationalization as a tool. “Based on my conversations, I think hey haven’t changed their minds,” says Roubini, who talks periodically with White House economic adviser Larry Summers and Treasury Secretary Timothy Geithner, with whom he worked during the Clinton Administration. “Eventually you have to think along these lines.”

For the healthier banks, the Public-Private Investment Program could do the trick. “It’s not the worst way to do it, it’s not perfect,” Roubini says. “I’ve been more sympathetic to it than other people.”

Will America pay the price for its ignorance?

The USA enjoys a triple A credit rating since 1917. But irresponsible and imprudent management and policies have put the US A's credit rating under threat. Recently, Moody's has issued a warning that the USA is risking losing their top credit rating if it does not start to sort out its financial affairs, over which there are plenty concerns at the moment.
David Walker, chief executive for the Peter G Peterson foundation, wrote the following article appearing in the Financial Times:

That warning from Moody's focused on the exploding health care and Social Security costs that threaten to engulf the federal government in debt over coming decades. The facts show we’re in even worse shape now, and there are signs that confidence in America’s ability to control its finances is eroding.

Prices have risen on credit default insurance on US government bonds, meaning it costs investors more to protect their investment in Treasury bonds against default than before the crisis hit. Another warning sign has come from the Chinese premier and the head of the People's Bank of China
who expressed concern about America’s longer-term credit worthiness and the value of the dollar.
The US, despite the downturn, has the resources, expertise and resilience to restore its economy and meet its obligations. Moreover, many of the trillions of dollars recently funnelled into the financial system will hopefully rescue it and stimulate our economy.
First, while comprehensive health care reform is needed, it must not further harm our nation’s financial condition. Doing so would send a signal that fiscal prudence is being ignored in the drive to meet societal wants, further mortgaging the country’s future.

Second, failure by the federal government to create a process that would enable tough spending, tax and budget control choices to be made after we turn the corner on the economy would send a signal that our political system is not up to the task of addressing the large, known and growing structural imbalances confronting us.

For too long, the US has delayed making the tough but necessary choices needed to reverse its deteriorating financial condition. One could even argue that our government does not deserve a triple A credit rating based on our current financial condition, structural fiscal imbalances and political stalemate. The credit rating agencies have been wildly wrong before, not least with mortgage-backed securities.

How can one justify bestowing a triple A rating on an entity with an accumulated negative net worth of more than $11,000bn and additional off-balance sheet obligations of $45,000bn? An entity that is set to run a $1,800bn-plus deficit for the current year and trillion dollar-plus deficits for years to come?

Fiscal irresponsibility comes in two primary forms – acts of commission and of omission. Both are in danger of undermining our future.

First, Washington is about to embark on another major health care reform
debate, this time over the need for comprehensive health care reform. The debate is driven, in large part, by the recognition that health care costs are the single largest contributor to our nation’s fiscal imbalance. It also recognises that the US is the only large industrialised nation without some level of guaranteed health coverage.
Recent research conducted for the Peterson Foundation shows that 90 per cent of Americans want the federal government to put its own financial house in order. It also shows that the public supports the creation of a fiscal commission by a two-to-one margin. Yet Washington still sleeps, and it is clear that we cannot count on politicians to make tough transformational changes on multiple fronts using the regular legislative process. We have to act before we face a much larger economic crisis. Let’s not wait until a credit rating downgrade. The time for Washington to wake up is now.

Monday, 11 May 2009

Inflation Targeting by Central Banks: Is it still appropriate?

Not many have escaped blame for causing the global financial crisis. Some more, some maybe less. Central Banks for one probably fit in the latter category. Martin Wolf of the Financial Times think they deserve more blame:

Just over five years ago, Ben Bernanke, now chairman of the Federal Reserve, gave a speech on the “Great Moderation” – the declining volatility of inflation and output over the previous two decades. In this he emphasised the beneficial role of improved monetary policy. Central bankers felt proud of themselves. Pride went before a fall. Today, they are struggling with the deepest recession since the 1930s, a banking system on government life-support and the danger of deflation. How can it have gone so wrong?

Over almost three decades, policymakers and academics became ever more confident that they had found, in inflation targeting, the holy grail of fiat (or man-made) money. It had been a long journey from the gold standard of the 19th century, via the restored gold-exchange standard of the 1920s, the monetary chaos of the 1930s, the Bretton Woods system of adjustable exchange rates of the 1950s and 1960s, the termination of dollar convertibility into gold in 1971, and the monetary targeting of the 1970s and 1980s.

Frederic Mishkin of Columbia University, a former governor of the Federal Reserve and strong proponent of inflation targeting, argued in a book that inflation targeting allows for all relevant variables – exchange rates, stock prices, housing prices and long-term bond prices – via their impact on activity and prospective inflation. Now that we are living with the implosion of the financial system, this view is no longer plausible.
No less discredited is the related view, that it is better to deal with the aftermath of asset price bubbles than prick them in advance.

Complacency about the Great Moderation led first to a Great Unravelling and then a Great Recession. The private sector was complacent about risk. But so, too, were policymakers.
What role then did monetary policy play? I can identify three related critiques of the central banks.

First, John Taylor of Stanford University, a former official in the Bush administration, argues that the Fed lost its way by keeping interest rates too low in the early 2000s and so ignoring his eponymous Taylor rule, which relates interest rates to inflation and output. This caused the housing boom and the subsequent destructive bust.
Prof Taylor has an additional point: by lowering rates too far, the Fed, he argues, also caused the rates offered by other central banks to be too low, thereby generating bubbles across a large part of the world. This induced a lowering of standards for granting credit and so a credit bubble.
Second, a number of critics argue that central banks ought to target asset prices because of the huge damage subsequent collapses cause. As Andrew Smithers of London-based Smithers & Co notes in a recent report (Inflation: Neither Inevitable Nor Helpful, 30 April 2009), “by allowing asset bubbles, central banks have lost control of their economies, so that the risks of both inflation and deflation have increased”.

Thus, when nominal asset prices and associated credit stocks go out of line with nominal income and prices of goods and services, one of two things is likely to happen: asset prices collapse, which threatens mass bankruptcy, depression and deflation; or prices of goods and services are pushed up to the level consistent with high asset prices, in which case there is inflation. In the short term, central banks also find themselves driven towards unconventional monetary policies that have unpredictable monetary effects.

Finally, economists in the “Austrian” tradition argue that the mistake was to set interest rates below the “natural rate”. This, argued Friedrich Hayek, also happened in the 1920s. The result is misallocation of resources. It also generates explosive growth of unsound credit. Then, in the downturn – as the American economist, Irving Fisher, argued in his Debt-Deflation Theory of Great Depressions, published in 1933 – balance-sheet deflation will set in, greatly aggravated by falling prices and shrinking incomes.

Whichever critique one accepts, it seems clear, in retrospect, that monetary policy was too loose. As a result, we now face two challenges: clearing up the mess and designing a new approach to monetary policy.

On the former, we have three alternatives: liquidation; inflation; or growth. A policy of liquidation would proceed via mass bankruptcy and the collapse of a large part of the existing credit. That is an insane choice. A deliberate policy of inflation would re-awaken inflationary expectations and lead, inevitably, to another recession, in order to re-establish monetary stability. This leaves us only with growth. It is essential to sustain demand and return to growth without stoking up another credit bubble. This is going to be hard. That is why we should not have fallen into the quagmire in the first place.

On the latter, the choice, in the short term, is certainly going to be “inflation targeting plus”. “Out” is likely to be the “risk management” approach of the Fed, which turned out to give an unduly asymmetric response to negative economic shocks. “In” is likely to be “leaning against the wind” whenever asset prices rise rapidly and to exceptionally high levels, along with a counter-cyclical “macro-prudential” approach to capital requirements in systemically significant financial institutions.

This unforeseen crisis is surely a disaster for monetary policy. Most of us – I was one – thought we had at last found the holy grail. Now we know it was a mirage. This may be the last chance for fiat money. If it is not made to work better than it has done, who knows what our children might decide? Perhaps, in despair, they will even embrace what I still consider to be the absurdity of gold.

Quoted from: "Central banks must target more than just inflation" by Martin Wolf, Financial Times, May 5, 2009.

Unemployment hits multi-decade highs

The inevitable outcome of an economic recession is rising unemployment. By how much depends on the severity of the economic downturn. Well, judging by the numbers this recession is pretty severe. Financial Times reported the following story:

US unemployment climbed to 8.9 per cent in April, its highest level in a quarter of a century, as the economy shed more than half a million jobs, official figures revealed on Friday.

The latest non-farm payrolls data showed that 539,000 jobs were lost in April, making it the seventh-worst month for job losses in half a century.
The decline was down from a revised 699,000 loss the previous month and the smallest monthly loss total since last October.
“While it is somewhat encouraging that this number is lower than it has been in each of the past six months, it is a sobering toll,” said Barack Obama, US president. “It underscores the point that we are still in the midst of a recession that was years in the making and will be months or even years in the unmaking.”

Analysts said some slowing in the pace of job losses was consistent with the idea that the rate of decline in the US economy was slowing. However, the jobs report confirmed that the US labour market was still very far from stabilising.

Over the past six months, the US economy has lost 3.94m jobs – the most in any similar period since records began, exceeding even the job losses caused by demobilisation after the second world war.
Analysts said the rate of initial unemployment claims looked to have peaked, suggesting job losses would be lower in the coming months, but that unemployment was likely to rise well into next year.

Thursday, 7 May 2009

A painful, but necessary solution to the financial crisis

Professors Matthew Richardson and Nouriel Roubini are of the opinion that no easy, pain-free solution is possible to solve the financial crisis. They wrote the following article that appeared on

Joseph Schumpeter famously argued that the essence of capitalism was creative destruction, by which new economic structures are born from the rubble of older ones. The government stress tests on the 19 largest US banks could have facilitated this process. The opportunity looks likely to be missed.

The tests, which measure how viable banks are under adverse economic conditions, have no “failed” category, even if as many as 10 are reported to need additional capital. But, given that the economic environment already reflects the tests’ worst-case scenario and that recent estimates by the IMF of financial sector losses have doubled in six months, the stress test results will not be credibly interpreted as a sign of bank health.

Instead, market participants will conclude that banks requiring extra capital have, in fact, failed. As a result, these institutions will not be able to raise outside capital and will immediately require government help.

Once again, the question will be how the near-insolvent banks can be kept afloat, to avoid systemic risk. But the question we really should be asking is: why keep insolvent banks afloat? We believe there is no convincing answer; we should instead find ways to manage the systemic risk of bank failures.

Schumpeter’s biggest fear was that creative destruction would lead capitalism to collapse from within, because society would not be able to handle the chaos. He was right to be afraid. The response of governments worldwide to the financial crisis has been to give the structure of private profit-taking an ever-growing scaffolding of socialised risk. Trillions of dollars have been thrown at the system, just so that we can avoid the natural process of creative destruction that would take down these institutions’ creditors. Why shouldn’t the creditors bear the losses?

One possible reason is the “Lehman factor” – the bank runs that would occur as a result of a big failure. But we have learnt from the Lehman collapse and know not to leave the sector high and dry when a systemic institution fails. Just being transparent about which banks clearly passed the stress tests would alleviate many of the fears.

Another reason is counterparty risk, the fear of being on the other side of a transaction with a failed bank. But unlike with Lehman, the government can stand behind any counterparty transaction. This will become easier if a new insolvency regime for systemically important financial institutions is passed on a fast-track basis by Congress. Problem nearly solved.

That leaves the creditors – depositors, short- and long-term debt-holders and preferred shareholders. For the large complex banks, about half are depositors. To avoid runs on these deposits, the government has to provide a backstop. But it is not clear it needs to cover other creditors of a bank, as the failures of IndyMac
and Washington Mutual attest.

Even if systemic risk were still present, the government should protect the debt (up to some level) only of the solvent banks, not the insolvent ones. That way, the risk of the insolvent institutions would be transferred back from the public to the private sector, from the taxpayer to the creditors.

Suppose the systemic risk problem is solved. The other argument against allowing banks to fail is that after a big loss by creditors, no one would be willing to lend to banks – which would devastate credit markets. However, the creative-destructive, Schumpeterian, nature of capitalism would solve this problem. Once unsecured debtholders of insolvent banks lose, market discipline would return to the whole sector.

This discipline would force the remaining banks to change their behaviour, probably leading to their breaking themselves up. The reform of systemic risk in the financial system would be mostly organic, not requiring the heavy hand of government.

Why did creditors not prevent the banks taking excessive risks before the crisis hit? For the very same reason creditors are getting a free pass now: they expected to be bailed out. For capitalism to move forward, it is time for a little orderly creative destruction.

Stressful times for the banks...

Greg Morcroft of MarketWatch, wrote the following story:

Shares of the country's largest banks rose Wednesday as details emerging about stress test results looked better than expected.
Bank of America confirmed in a published report that a government checkup determined the company needs an additional $34 billion in tangible common equity, and that those needs can be covered by converting existing government investments into common stock. That's less than analysts and investors had been predicting the bank might need.

Bank of America and the others will have various options in raising new capital, including converting current preferred shares held by the government to common stock, as Citigroup has already agreed to do, or by selling assets or securities.

Further aiding bank gains, another report indicated that the tests have determined American Express will not need new capital. The government holds $25 billion of convertible preferred shares of J.P. Morgan Chase, while it has invested about $3.4 billion in American Express.
Wells Fargo & Co will need about $15 billion in capital following a U.S. government-led stress test, Bloomberg reported. Wells currently holds $25 billion of capital from the government, which it got in exchange for preferred shares under the TARP plan.
Bloomberg also reported that Citigroup would need about $5 billion of new capital. The federal government has already invested $45 billion in Bank of America but that investment was in preferred shares and doesn't count toward the type of capital regulators are testing major U.S. institutions for. According to the reports, the bank could convert the preferred into common shares, and the new common stock would count toward the required capital. That would, according to the reports, preclude the need for a new investment from the government.
Bank of America shares, a component of the Dow Jones Industrial Average, traded 10% in the pre-open but recovered and were up about 12% by afternoon at $12.13.
"It is conceivable that Bank of America could convert its existing preferred stock, and put the capital issue behind it assuming the economy does not take another significant leg down," Citigroup analysts said in a research report Wednesday.
However, such a conversion would create its own new problem-- namely, making the U.S. government one of the bank's largest shareholders and diluting the stakes of existing shareholders. "Our analysis shows dilution could range from as low as 20% to as high as 35%," the Citigroup analysts said of Bank of America.
The New York Times report cited J. Steele Alpin, Bank of America's chief administrative officer, as saying, "We're not happy about it because it's still a big number. We think it should be a bit less at the end of the day." Some analysts had expected Bank of America to need up to $70 billion of fresh capital.

On a related note, banks that want to return money received under Washington's Troubled Asset Relief Program will have to show that they can borrow funds without government guarantees, making it less attractive for some to free themselves from the government's clutches, The Wall Street Journal reported late Tuesday.
Some banks are keen to return the TARP funds, partly because of the strict conditions they place on executive compensation, dividend payments and stock buybacks imposed after the investments were made in the wake of the September financial crisis. However, regulators want to make sure that banks are financially strong enough to keep lending before allowing them to return the money.

Monday, 4 May 2009

The recession is gathering momentum...

Jane Croft of the Financial Times reported on the rising figure for personal insolvencies and company failures in the UK; clearly a sign of the times we live in...

It was the worst quarter for personal insolvencies since the 1980s, said Mark Sands, of KPMG professional services. The figure at the height of the early 1990s recession was 38,792 for the whole of 1992. Consumer debt is still at record levels and people are being hit by the recession which is pushing up unemployment and repossessions,” said Mr Sands. He predicts 150,000 personal insolvencies this year.

Pat Boyden, of PwC business recovery services, said he expected the number to increase to between 130,000 and 150,000 this year partly because of the introduction of debt relief orders, a new form of bankruptcy for people with debts of less than £15,000.

“We are now seeing a lot of self-employed people and entrepreneurs and buy-to-let landlords getting into difficulty,” Mr Boyden said. “What may be interesting is that in the 1990s recession, bankruptcies continued to increase for nearly three years after the worst of the recession had passed.
“If that is the case this time, we may be seeing record figures every quarter until 2012,” he added. The rise in bad debts will push up impairment provisions at embattled banks as people default on credit cards, loans and mortgages.

Company failures also rose sharply in the first quarter of the year. Insolvency Service figures show that 4,941 companies went into compulsory liquidation or creditors’ voluntary liquidations.
This is a jump of 56 per cent from the same period in 2008 and a 7.1 per cent rise on the last quarter of 2008.