This week we turn to Michael Lewitt of HCM Capital for a very insightful letter on the current credit crisis. As I wrote on Friday, it is important for anyone with any involvement in the financial world to pay attention to what is going on in the credit markets. I think it is going to have far more impact than most observers apparently believe.
Michael E. Lewitt is the Managing Member and President of HCM (Hegemony Capital Management). You can read his letter at www.hegcap.com.
I should note that readers will get a second Outside the Box tomorrow morning. We have never done this, but there are just two very good letters in my box demanding to be shared. I think readers will approve the extra material this one time. I am sure you will appreciate Michael's work.
We are in a world far different than the one I learned about in economic text books. As I have written, the shadow banking system of hedge funds and CDOs, CLOs, PIPES, etc. have created a new financing economic reality far different than the traditional banking system was just 20 years ago. Does the Fed have the tools in its toolkit to deal with the new reality?
This week, Bill Gross of Pimco fame looks at the problem in a manner that is truly Outside the Box. Bill Gross has been called "the nation's most prominent bond investor," by the New York times, managing Pimco's Total Return Fund, the world's largest bond fund.
Enjoy your week.
This week in Outside the Box, Louis-Vincent Gave, Charles Gave, Anatole Kaletsky, and company of GaveKal Research delve into the underlying misconceptions that presumes money velocity is and will remain constant, in the equation that says MV = PQ (Money*Velocity = Prices*Quantity) when M is increased. GaveKal Research strive to show that in application this relationship does not hold, and that investors ought to look to velocity to rebound to gauge market recovery or further deterioration. This is an important concept and holds major implications for the inflation debate.
GaveKal venture on to address the Banking crisis in England, how Mervin King & Co. at the BoE responded to the Northern Rock debacle, and why the appropriate response was hindered by political malaise than by BoE incompetence, though mind you there was some to speak of. Furthermore, the Fed 50bps reduction is taken to light on account of the uncertainty of whether such (and potentially further) reductions will prevent the economy from falling into recession.
GaveKal further discusses how the dollar breaching record lows, will affect the inflationary pressures in China, and how the dollar is affecting the oil markets, which happen to be denominated in dollars. I have attached below graphs of the Euro/Dollar conversion rate, and the current (WTI) cost of oil.
Finally, my publisher is running an advertisement for my friends at International Living. I normally don't think abut the ads, but this one is interesting in that it is two years for the normal one year price for a publication that I enjoy. If you travel or think about living somewhere else, this is a good place for information, or to just dream. Enjoy your week.
This week in Outside the Box, good friend Paul McCulley of PIMCO fame addresses the important topic of fed fund easing. Paul addresses the predicament the current Fed finds itself in on account of not wanting to bail out those who took excessive risk in what he dubs the "shadow banking system," - comprising an alphabet soup of levered non-bank investment conduits, vehicles, and structures. The crux of the matter as Paul highlights is that the 50bp discount rate reduction still remains a penalty to the Fed Funds rate, hence simply not an attractive source of funding for real banks, who have access to the Fed funds rate. Bernanke and company are trying to kill the notion of a Fed Put, whereby the Fed "bails out" Wall Street whenever losses increase significantly which further worsens excessive risk taking, or moral hazard. The conclusion is while many would like to think this simply is a Wall Street quant fund predicament, the reality is that Main Street shares the pain in the form of tightening terms, conditions and rates for all but conforming mortgages. Thus, the Fed needs to reduce the Fed funds rate not to bail out Wall Street but rather to save Main Street from recession on account of weaker growth, which to boot would carry serious debt-deflation consequences. I have provided Chart I below in larger print for illustrative purposes.
This week's Outside the Box is from good friend and South African partner Dr. Prieur du Plessis of Plexus Asset Management. Prieur suggests that we should not be surprised at last week's rate cut, as it is consistent with past rate cut cycles when viewed from the fact that banks are tightening up on their lending standards to both consumer and commercial borrowers. There are a number of very original graphs here with some very interesting analysis that is truly Outside the Box.
This week in Outside the Box we take look at the how the Fed acted in the last debt crisis of 1998 and what they are likely to do this time. How will the Fed address the looming liquidity crisis stemming from the subprime debacle primarily, and from the abused Yen carry-trade, lax lending practices, and excess liquidity, generally? Asha Bangalore, Vice President and Economist at the Northern Trust Company, believes that given the actions taken by the European and Japanese banks in response to credit and liquidity concerns in the markets by an infusion of €200 Billion, and ¥600 Billion, respectively, the Fed will also take the customary action of cutting interest rates to assuage the market at the October 30-31 Fed meeting.
Your humble analyst believes that a rate cut will not likely occur on account of inflation concerns, and I thought you should read an opposing and well-reasoned view. As an aside this makes the CPI numbers which will be released this Wednesday very important and any difference from the expectations will have the tendency to move the markets significantly. If inflation comes in high as it did last month, the market will take that as a sign that the Fed will have less room to cut rates. Conversely, if inflation is lower than expected, you could see a real leap. As a reference, the previous CPI (MoM) was .2%, with economists estimating it coming in at .1%, CPI Ex. Food & Energy (MoM) was .2% with no estimated change forecasted.
Today's Outside the Box is a very interesting piece written by Louis-Vincent Gave and the team at GaveKal entitled "Part 2: So What Should We Worry About?" His article is a follow up to an earlier one that he wrote on why he, and the rest of the GaveKal team, had been bullish on the markets a couple of months ago. This letter is to answer the question "what could go wrong" with their previous outlook in light of the recent market climate.
For those of you unfamiliar with GaveKal, the firm was started in the late 1990s in London by Charles Gave, Louis-Vincent Gave and Anatole Kaletsky. GaveKal is a research firm, focusing on macro economics and tactical asset allocation for institutional clients around the world. Louis-Vincent is the CEO of GaveKal where he contributes frequently to the research and was the main author of their books Our Brave New World and The End is Not Nigh.
Let me make a quick remark regarding the latter of his 2 books. The End is Not Nigh has just recently been released and I highly recommend it as a good read. It is a great example of a book that presents a positive view of not just the markets but of the developing world as well. You can purchase the book directly from their website (www.gavekal.com) or through Amazon.
I trust that you will enjoy this week's Outside the Box from the always thought-provoking Louis-Vincent Gave.
Today's Outside the Box will feature one of the better pieces written in the last few years by my good friend Paul McCulley. In his article "The Plankton Theory Meets Minsky," Paul shows the importance of why the problem with sub-prime mortgages will affect the entire housing market rather than just a small sector of it. He goes on to further point out that the excess liquidity in housing and the ability to borrow against home equity over the last couple of years was more than just the doing of the Fed as the loosening of credit lending standards played a significant role. This topic is important because it is at the heart of why I think a housing slowdown will affect the nation's economy.
For a little background on Paul, he is a Managing Director at PIMCO where he writes a monthly commentary titled "Global Central Bank Focus." He is a very intelligent thinker but what I enjoy the most about Paul is his ability to take seemingly complex data and transform it into an easy to understand analysis.
The sub-prime sector has been a hot topic as of late but I trust that you will find this piece to be an "outside the box" take on how it happened and what it will affect in the coming year.
Today's Outside the Box is by my good friend and PIMCO's Managing Director, Paul McCulley. In his article "If Fed Funds Rate 'Fails' to Fall," Paul discusses the mindset behind the decision making of central banks and how they determine policy. From there he goes on to explain that the markets have "priced-in" expectations of the Fed easing rates sometime later this year. But what if the Fed doesn't decide to make a rate cut? Paul takes a quick look at both scenarios.
Paul writes a monthly commentary, the Global Central Bank Focus that, because of its well-researched and unique perspective, is always at the top of my reading list. As a Managing Director at PIMCO, he is an intelligent economist and forward thinker who always provides a valuable perspective.
I trust that you will find this piece interesting and an "Outside the Box" take on the Fed's policy over the coming months.
Last Friday, I wrote about That Stubborn Yield Curve in my Thoughts from the Frontline letter. In it, I quoted a few paragraphs by Pimco's Paul McCulley, but upon reflection, I feel that his whole letter is worthy of taking a look at more in-depth. Paul writes a monthly commentary, the Global Central Bank Focus that, because of its well-researched and unique perspective, is always at the top of my reading list. As a Managing Director at PIMCO, Paul is an intelligent economist and a self-proclaimed "religious Keynesian."
In his article "Time-Varying Variables Vary" (quite the tongue twister), Paul looks back upon his forecast for the Fed Funds rate and evaluates the "Taylor" formula. But one of the things that I like best about Paul is that, despite his lengthy analysis, he is a bottom-line kind of guy who always boils it down to the end result, which in this case, is the future decision making of the Fed.
With Morgan Stanley and Goldman Sachs each weighing in on opposing sides of the interest rate debate, I believe that you will find Paul's piece to be a truly "outside the box" point of view.
This week's letter is once again from two of my favorite economists, Van Hoisington and Dr. Lacy Hunt of Hoisington Investment Management Company in Austin, Texas. They specialize in management of fixed income portfolios for large institutional clients by setting long-term investment strategies based on economic analysis. They have been one of the most successful bond managers in the country. (I have no affiliation with them.) I eagerly read all of their writing and analysis, and find it to be some of the most thought provoking anywhere.
Their second quarter 2006 Quarterly Review and Outlook looks at the current economic situation in the US after a 1st half sell-off, inversion of the yield curve and a recession threatening. With the markets "teeter tottering" between excitement and fear, Hoisington's article proves to be both insightful and timely, which is why I picked it for this week's "Outside the Box."
Bonds will be our subject for today. But this is not your ordinary outlook for bonds. Despite the current consensus amongst the street, HMIC's Van Hoisington and Dr. Lacy Hunt have chosen to take a contrarian's approach to the future of the bond market, because of their concerns for the US economy, which they present in detail.
Hoisington Investment Management Company focuses on long-term investment strategies based on Economic Analysis. The firm is a registered investment advisor specializing in fixed income portfolios with over $3.5 billion under management for large institutional clients. Van R. Hoisington is the President and Chief Investment Officer and has produced an outstanding fifteen-year performance record. Dr. Lacy Hunt, an internationally known economist, joined the firm in 1996 adding depth and expertise with his in-depth research and analysis.
Today's article is from their First Quarter Review and Outlook which I am delighted to present to you with their consent. While constructing their assessment for bonds, Van and Lacy walk through each building block, the Fed's actions, consumer spending and the housing market, along the way to assembling a truly "outside the box" outlook for the economy and fixed income securities.
This week's letter is by good friend Paul McCulley, Managing Director of PIMCO. About once a year he puts together an economic debate between his favorite friend and family pet rabbit, Morgan Le Fay. It always presents a very readable look at global economics and a forecast of what could be ahead.
My Friday letter, Thoughts from the Frontline, included a graph that looked at GDP growth and mortgage equity withdrawals (MEW) and Paul explores what could happen if MEWs come to an end, or at least slow down. McCulley once again takes a look at Bretton Woods II, the housing marketing in the US and what might lead to a slowdown in the economy for 2006.
This is an important piece to help you in your understanding of the issues surrounding the debt, trade and housing bubbles. I am going to touch on a few of his ideas next Saturday in my weekly letter, particularly the quote from around the middle of this essay that has his rabbit asking the following question (MLF throughout are the initials for Morgan Le Fay:
"MLF: So, the housing bubble, or whatever you want to call it, ain't America's fault, but rather the Emerging World's fault?
"PM: No, Morgan, it isn't anybody's fault; it just is. When the Emerging World decided to shift from being a net user to a net provider of savings, those savings had to go somewhere, they had to finance something. Otherwise, the entire world would have fallen into a liquidity trap, triggering a global depression."
Read this when you have some time to think about it. In a few weeks I will be putting together my forecast for next year and I am on the lookout for opinions, like McCulley's, that can help us think Outside the Box.
A reader forwarded the following article to me last week and suggested it might make a good Outside the Box. This week's article comes from Rodney Dickens, Head of Research for ASB Bank, New Zealand and I thank him for letting me share his thoughts with my readers. Rodney has been analyzing the fixed income markets for two decades and has some insights into the current trends in global interest rates.
Rodney refers to the US Fed as the "global custodian of inflation" and finds an interesting relationship between the Fed Funds Rate and G7 capacity utilization. He then goes on to look at China's role in inflation and the current trend in commodity prices. These factors all lead to the conclusion that interest rates will continue to go up globally and that is why it was picked for this week's Outside the Box.
This week we take a look again at my good friend Peter Bernstein, the venerable editor of Economics and Portfolio Strategy. Peter is the dean of economic writers. (Actually, he is more like the Pope of economic writers, except of course, that he is Jewish.) The first and long time editor of the prestigious Journal of Portfolio Management (now serving as a consulting editor), Peter has been observing the investment world for almost 60 years, after serving as a captain in the Air Force in WW2. During his career, he has rubbed shoulders and influenced the movers and shakers in our world. He is the author of nine books in economics and finance plus countless articles in professional journals such as The Harvard Business Review and the Financial Analysts Journal, and in the popular press, including The New York Times, The Wall Street Journal, Worth Magazine, and Bloomberg publications.
His book, Against the Gods - the Remarkable Story of Risk is one of my top five, you gotta read it books. (www.Amazon.com) His latest book, Wedding of the Waters is a powerhouse of historical economic story-telling about the Erie Canal.
Several weeks ago in Outside the Box we looked at Paul McCulley's piece called "Phyrric Victory" and Bernstein offers his views on the subject by critiquing McCulley. Bernstein sees the expectations on inflation being much different than in the past and adverse surprises may be in our future. It is the risk we don't see that always causes the problems and that is why this article became this week's Outside the Box.
You can find out more about my friend Peter by going to http://www.peterlbernsteininc.com/. His newsletter is a must read for serious investors and institutions.
Readers know that Paul McCulley of Pimco, and his cohort Bill Gross, are two of my must read economic analysts. Pimco is in Newport Beach, California, and oversee more than $400 Billion in assets, predominately in fixed income.
This is Paul McCulley's August 2005 Fed Focus letter. Several weeks ago I talked about Greenspan's remarks that the Fed was targeting asset prices. There is nothing more he would like to see than the ten-year bond yield rise, but to this point it has been flat or down. McCulley looks at why the ten-year yield has not gone up, in what he calls the "Greenspan Put" and why an inverted yield curve may be in our future. That is why this was picked for this week's Outside the Box.
This week's letter comes to us from Dr. A. Gary Shilling, president of A. Gary Shilling & Co., Inc. Gary is a long time friend and one of my favorite economic analysts.
Gary takes a look at what he has termed the consumer-dependent economy. The consumer has increasingly become a larger factor in driving our economy with the help of debt and loose monetary policy. Savings, GDP, housing, debt, and bankruptcy trends are pieced together to create a bleak picture of the baby boom retirement years. You will find this very interesting food for thought in this week's Outside the Box.
This week's letter is by Richard Duncan who is based in Hong Kong and is one of the brightest financial analysts I know. Richard is the author of one of my favorite books called The Dollar Crisis: Causes, Consequences, Cures. A new paperback edition that is revised and updated is now available at Amazon for under $14.
Richard said this piece is really an updated version of one of the new chapters in The Dollar Crisis. It looks at the federal deficit, the dollar, Greenspan and offers another explanation for why the longer end of the yield curve has stayed low while the Fed is raising rates on the short end.
Can the current account deficit undermine the Fed's ability to control US interest rates? Let's find out in this week's Outside the Box.
Last weekend I had my second annual Strategic Investment Conference in La Jolla, California. One theme that interested me was that several speakers, including Rob Arnott of Research Associates, Paul McCulley of PIMCO and Richard Russell of Dow Theory Letters, were all negative about Alan Greenspan.
One of my favorite economists, Stephen Roach, of Morgan Stanley gives us a similar opinion. Roach takes a look at the last 6-7 years and the effect that the U.S. Federal Reserve has had on interest rates and bubbles. At some point we must work our way out of the imbalances and hopefully it can be done with a Muddle Through Economy and not a severe depression. That is why I picked Original Sin as this week's Outside The Box.
A few weeks ago, I posted a letter by Dr. Gary shilling on why he thinks there is deflation in our future. For another look at the inflation-deflation debate, this week's letter is by Myles Zyblock, who is Chief Institutional Strategist & Director of Capital Markets Research at the Royal Bank of Canada. Myles takes a look at why we have not seen a big increase in inflation even though the Fed has added vast amounts of monetary liquidity since the late 1990's. Milton Friedman's equation of exchange says that inflation is produced by money supply and the velocity of money. This report looks at a reason the velocity of money may have stayed low and theorizes that it will not last.
Is inflation knocking at the door and if so what are the implications for investments? Let's take a look in this edition of Outside the Box.