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Watch out for this week’s minutes from the FOMC meeting

8 Jul

Since Bernanke’s suggestion that QE may be tapered sooner than markets expected, equities have fallen, bond yields have risen and many commodities, particularly metals, have fallen off a cliff.

What can we expect from the minutes?

The statement following the meeting on June 19th said: “Labor market conditions have shown further improvement in recent months, on balance, but the unemployment rate remains elevated. Household spending and business fixed investment advanced, and the housing sector has strengthened further, but fiscal policy is restraining economic growth. Partly reflecting transitory influences, inflation has been running below the Committee’s longer-run objective, but longer-term inflation expectations have remained stable.”

Markets read into this that the Fed was preparing to taper its QE program. The minutes might suggest markets were a little too eager to sell risk assets and that the committee may not be as confident about the recovery as it may have first appeared.

Last week’s statement by the new BOE Governor, Mark Carney, and Mario Draghi, the ECB’s president made clear that Central Bank policy will remain accomodative for a good while longer. The fact that both statements were made within two hours of each other provides clues that Central Banks believe co-ordinated action, with forward guidance, the first in the BoE’s history, is the most effective way to manage the market’s expectations.

If the minutes do indeeed suggest that tapering may not happen for a while longer, we could see another substantial rise in equity prices. Bond yields appear a little more resilient to recent policy statements which could suggest investors are beginning to hesitate to buy bonds on dips.

The outlook for bond returns has very likely now swung towards the bearish camp.

 

 

Can this market rally continue!?

20 May

With US markets up 17% and Japan up 47% year to date, can equity markets rise any higher?

The S&P 500’s Price to EBITDA has risen from 7.2 at the start of the year to 8.2 now, some 20% above its long term average. Technicals are looking very overbought, economic numbers are grim and commodity prices are pointing to lower demand.

Marc Faber, well known economist and investor said last week…” In the 40 years I’ve been working as an economist and investor, I have never seen such a disconnect between the asset market and the economic reality … Asset markets are in the sky and the economy of the ordinary people is in the dumps, where their real incomes adjusted for inflation are going down and asset markets are going up.”

Can equities really rise any higher? As Keynes famously declared ” the market can remain irrational far longer than you and I can remain solvent.” So yes, but perhaps not for much longer.

The bull case is that optimism can be self-fulfilling. The rise in optimism can get people to start spending and hiring. This in turn could lead to GDP recovery and upgrades in response to lower interest rates and credit spreads, optimism in the banking sector encouraging lending and greater levels of disposable income from lower oil and commodity prices.

But nothing goes up in a straight line and for every quarter of disappointing economic news the chances of a sustained rally become ever slimmer. With investor confidence near record highs and volatility at levels last seen in 2007 one must be very optimistic to remain invested in markets such as these.

Brace yourself. Equities are in for a rough ride

3 May

Valuations are stretched, corporate profit margins are at record highs (can they go any higher?) inflation is falling and commodity prices are pointing to a significant fall in demand.

How long before equities fall?

The Fed’s preferred measure of inflation, the personal consumption expenditure (PCE) deflator, has been declining consistently for a year sitting currently at 1.1%. As CPI usually tracks PCE it is likely that the index will fall towards the 1% mark raising questions from markets on whether the US could fall into a deflationary spiral. The QE impact on markets may finally be coming to an end.

Agricultural commodities, oil and metals, have all been trending lower pointing to weak support from the overall economy. Copper, which typically tracks the S&P very closely, has finally broken down, just as it did in 2007.

With corporate profit margins at record highs it is far more likely that they will revert to the longer term mean rather than continue to expand as is predicted by most Wall Street analysts. Once earnings disappoint a mass re-rating could add substantial pressure to equity prices.

When the penny will finally drop is anyone’s guess but given the odds are increasingly stacked against equity markets and valuations no longer offer easy pickings investors might want to reflect on their equity exposures. 

The Fed pushes, the economy pulls. Who wins?

27 Mar

It depends who is asking.

The under-employment rate remains above 14%, the employment ratio is the lowest in decades (today’s younger generation will probably be the first to be poorer than their parents), GDP growth has stalled and income inequality is rising. 

The economy is under serious threat.

The Fed’s solution is clear: do whatever is necessary to cheapen the cost of capital enough to encourage savers to invest and cheapen the cost of loans for highly indebted borrowers.

The effects have been striking. Bond yields and mortgage rates have plummeted to historic lows. It has never been so cheap to borrow and never has cash earned to little (cash in facts yields a negative return if adjusted for inflation). So why is the economy struggling to recover?

The way that the Fed has achieved its goal has been through printing enormous quantities of money and then distributing it to holders of Governments bonds, mostly banks. 

So rates have successfully fallen but what has happened to all that cash? Most banks have parked it back with the Fed resulting in little net increase in the supply of money flowing through most people’s hands. Inflation on the whole has therefore, so far, been contained.

But the little capital that has seeped into the real economy has, in fact, caused considerable inflationary effects on some asset prices.

Equity prices have more than doubled, commodity prices have risen substantially as has the general price of food.

So who has won so far? The rich, mostly at the cost of the poor and those retired.

Those closest to the Fed’s printing press are clearly the first to benefit. Banks have been able to unwind a great deal of their highly toxic and irresponsible balance sheets enriching bankers and their clients in the process. But lower income families, those furthest from the printing press, are the worst hit. Not only does the freshly printed money never reach their pockets, but it’s effect on the price of oil and food causes a meaningful reduction on their disposable income.

For as long as current monetary policy is maintained we are likely to see this disparity worsening as income inequality continues to rise. Such direction is not only unsustainable but very dangerous to society as a whole.

The rich might become wealthier in the short term but unfortunately, in the long run, there are no winners.

Once the backbone of society breaks we are very much all losers.

The current state of inflation

31 Jan

ACCORDING to Milton Friedman, “inflation is always and everywhere a monetary phenomenon.”

If that is true, then you have to wonder where the heck all of the inflation is, writes Martin Hutchinson for Money Morning.

Every central bank in the Western world is holding interest rates down, and almost all of them are printing money like it’s going out of style.

Five years ago, nearly every economist in the world would have told you this would cause inflation to skyrocket, and the big deficits governments were running would make matters even worse.

Taken together, monetary and fiscal policies are far more extreme than they have ever been.

Yet, inflation has remained rather tame at 2%. In Friedman’s world that just wouldn’t be possible.

What does it all mean?….

It means even Nobel Prize-winning economists can get it wrong-at least in the short run.

Here’s why Friedman has been wrong on inflation so far. It starts with his basic theory.

The central equation of Friedman’s monetary theory is M*V=P*Y, where M is the money supply, Y is Gross Domestic Product, P is the price level and V is the “velocity” of money, thought of intuitively as the speed at which money moves around the economy.

In this case, the M2 money supply has been increased by 11.5% in the last two months and 8.2% in the past year, while the St. Louis Fed’s Money of Zero Maturity (the nearest we can get to the old M3) has increased by 13.1% in the last two months and 8.4% in the last year.

Since GDP is increasing at barely 2%, that ought to mean prices should increase by 6%, just based on the last year’s data alone.

Needless to say, that’s not happening, since consumer price inflation is under 2%.

Of course, monetarists will tell you that money supply produces inflation only with a lag.

Fine, but it’s also true that the M2 money supply has been increasing by 7.4% over the last five years.  Admittedly, there was a year in mid-2009-2010 when it stayed flat, but otherwise the monetary base has been increasing at about 8-10% per year.

Again, growth in those five years has been below 2%, and five years is longer than anyone thinks the lag should be.  So why isn’t inflation at least 5% not 2%?

Monetarists would explain that by telling you that monetary velocity has declined over the last five years.

That’s obvious from the equation, but what is monetary velocity and why has it declined?

The velocity of money is simply the average frequency with which a unit of money is spent in a specific period of time.  And in our day-to-day activities, it’s obvious that monetary velocity has in fact increased.

More people are using debit cards, which cause transactions to move instantaneously from the bank account to the merchant, and many people are using Internet banking, which similarly increases the speed of transactions, reducing both the amount of physical cash carried and the time that old-fashioned checks spend sitting in storage at the US Postal Service.

So what is the problem?

Monetarists will tell you that the decline in monetary velocity is due to the massive balances, over $1 trillion, which the banks have on deposit with the Fed, which just sit there and do nothing.

That’s probably correct since while the deposits exist, the ordinary mechanisms of monetary movement simply don’t work, since that money has no velocity.

As a result, Bernanke and his overseas cohorts have succeeded in saving themselves from being hindered by a surge in inflation.

The Japanese experience over the last 20 years suggests that this position, with a huge money supply and no inflation, may continue for 20 years or more.

In short, thanks to the banks, Freidman’s monetary theory has simply stopped working.

It’s not clear to me whether at some point the banks will start lending the trillion-Dollar balances at the Fed, in which case inflation will revive rapidly.

However, there is one other economic theory that is relevant here.

Austrian economists like Ludwig von Mises will tell you that ultra-low interest rates will create an orgy of speculation, in which markets create a huge volume of “malinvestment” – investment that should not economically have been made, and which has less value than its cost.

Eventually, like it did in 1929, the volume of malinvestment becomes so great that a crash occurs, in which all the bad investments have to be written off, huge losses are taken and a wave of bankruptcies sweeps across the economy.

This didn’t happen in Japan.  The banks went on lending to bad companies, creating a collection of zombies which sapped the vitality from the Japanese economy and has produced more than 20 years of economic stagnation.

In Japan, the politicians have even decided to print more money and do still more deficit spending. Since Japan has debt of 230% of GDP this will almost certainly produce a crisis of confidence, in which buyers stop buying Japan Government Bonds. That will cause the government to default and will more or less shut down the Japanese economy – the worst possible outcome.

Since politicians hate periods of liquidation, they could encourage the same behavior here, in which case growth will continue at current sluggish rates until the Federal deficit becomes so great that nobody will buy US Treasuries.

Again, without a Treasury market, there will be an economic collapse.

At that point, you’re likely to get all the inflation you want – it’s basically what happened in the German Weimar Republic in 1923.

The point is, Bernanke has created something of a new monetary ground, increasing the money supply rapidly without getting inflation. But it won’t last.

At some point we’ll get hyperinflation and probably a Treasury default.

Is the JPY now cheap against the USD?

25 Jan

JPY1

Source: Bloomberg

As reported by Bloomberg, the yen’s nominal rate of 90.51 per dollar today is 17 percent lower than the level that takes into account differences in consumer prices in Japan and the U.S., according to the Economist magazine’s Big Mac index. That’s the widest disparity since 2009 and makes the yen the most undervalued of any Group of 10 currency, according to the gauge, which measures worldwide prices of McDonald’s Corp.’s signature burger.

Abe economic adviser Koichi Hamada said 100 per dollar is a “good level” for the yen amid rising criticism globally of the nation’s moves to support exporters. The prime minister isn’t likely to get any sympathy from Group of 20 finance ministers meeting next month in Russia, where a central banker warned of a “currency war” of competitive devaluation.

“Overseas governments will probably voice their objections to Japan relying upon a weaker yen for economic recovery,”
Hiroshi Morikawa, an economist in Tokyo at the Institute for International Monetary Affairs, which conducts research for the government, said Jan. 23. “Developed nations seemingly shared the view that the yen was overvalued when it was at the 70 level, but such a view is likely to recede.”

The yen is on course for an 11th weekly drop, a record in Bloomberg data going back to 1971, and it touched 90.69 per dollar today, the weakest since June 22, 2010.
“Shirakawa has left room for the next BOJ chief to do more aggressive easing,” Daisuke Karakama, a market economist in Tokyo at Mizuho Corporate Bank Ltd., said in a Jan. 23 interview. “The dollar-yen pair has soared at an almost vertical angle since November, and this kind of gain is impossible to continue without a correction. Yen weakness hasn’t changed course.”

Abe is counting on a drop in the currency to bolster an economy that’s estimated to have shrunk for the three consecutive quarters through Dec. 31. Hamada, a retired Yale University economics professor who advises Abe on monetary policy, said Jan. 18 that 100 per dollar is a “good level” and that chipmaker Elpida Memory Inc. went bankrupt because the BOJ didn’t expand its balance sheet fast enough to halt currency appreciation. Deputy Economy Minister Yasutoshi Nishimura yesterday echoed Hamada’s opinion on the 100 yen level.

Japan’s trading partners are starting to grumble that the yen has fallen too far. It tumbled 18 percent against the Korean won last year, the most on record going back to 1986. Bank of Korea Governor Kim Choong Soo said in an interview in Davos, Switzerland with CNBC that “it’s time” global economies discuss currency devaluations.

JPY2

Source: Bloomberg

Alexei Ulyukayev, the first deputy chairman of Russia’s central bank, said on Jan. 16 that leading economies are on the brink of a “currency war” to keep up with Japan. Fed Bank of St. Louis President James Bullard said this month that he was “a little disturbed” by Japan’s exchange-rate strategy.

Officials from Germany and Taiwan have also joined in the chorus of complaints this week about the yen’s drop.

Mr. Abe doesn’t seem to mind and appears focused to ensure the Yen continues on its downward trajectory.

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