This week we review what I learned on my trip to Geneva; we look at a way to invest in the Chinese Renminbi; I offer some thoughts on master strategist Paul McCulley latest essay; I ponder the implications of Bill Bonner's soon to be released best-seller; and, I get more concerned (and vocal) about Greenspan and Fed policy. It should make for a thought-provoking and interesting letter.
Last Tuesday evening I spent one of the more stimulating (and enjoyable) evenings I have had in a long time in the home of one Francis Stobart of SODITIC in Geneva. He had assembled a small, but eclectic, group of Swiss private bankers and asset managers for dinner to discuss whatever small insights into finance and economics I might be able to dispense. I was expected to sing for my exceptional supper and superb wines, but I believe I walked away with far more insight than I was able to impart.
While the size of the firms represented ranged from huge to small and the range of services was quite diverse, we all had one common connection: our clients expect us to come up with investment strategies that make sense in today's world. The problem is the future seems particularly risky as of late, with the world of investment ideas a less and less friendly place. Where does one safely put assets, whether it is billions for institutions or smaller personal accounts for retirees? One very large and rather bearish manager is now suggesting his rather substantial clients allocate 15% to physical gold. While not all participants were quite so bearish, the outlook was more somber than I would have expected.
Reading an advance copy of Bill Bonner's new book, Financial Day of Reckoning (on my computer - it will soon be out in print) on the ten hour return flight did not relieve that note of concern. But it did give me some food for thought as I reflected upon the conversation. A few of those thoughts gleaned from that evening might be of interest:
As might be expected, there were more than a few questions for a Republican from Texas. Not only at this dinner but throughout the week, I was posed some hard, but polite, questions. The night before, I had dined in Paris with a friend of Chirac's, who also had questions. Jean-Michelle noted that it was not the strategy in Iraq that was the concern, but the execution.
I have been a staunch defender, and still am, of the President. But I will tell you that it is disconcerting to talk with sophisticated men of considerable experience in the world who so clearly did not understand the President's view or America's concerns. It was not a case of these men not listening (I did not have an opportunity to discuss events with any ladies). It was not always a case of disagreement. We have clearly not communicated well to the public at large, and that must be corrected or it will come back to haunt us.
But the subject of the evening was primarily economics, so that is where we will return. There was almost universal unease with the US economy. There was a recognition that the US was the economic engine for the world, and a concern the engine was running out of steam. There was an intense discussion on Greenspan's latest policy statements, which none (including me, of course) in the room could understand. It is best summed up in a statement by Alex Bridport, of Bridport and Cie., in a client letter he wrote the next morning. (Bridport is a major firm, consulting with large European institutions on their bond portfolios, which in the aggregate would be well in excess of $100,000,000,000. They have bought over $20,000,000,000 in bonds for their clients just since the beginning of the year. In short, they have their fingers on the pulse of European institutional investors.) This caustic note from Sir Alex:
"When it comes to wealth destruction, the recent fall in bond values must rival any thing that happened to the stock market when the bubble burst. For this contribution to mankind, investors can thank Alan Greenspan for an operation we might call the "Greenscam." It involved him allowing investors to believe that the overwhelming risk was deflation and that all means would be used, including the Fed buying long T-bonds, to keep long-term yields low and support the "carry trade." Then Greenspan pulled the rug and investors all fell down, taking off the carry trade.
"We admit to being as much a victim of the Greenscam as anyone else. At least we all know whom never to trust again. Beyond the half-truths, the inherent contradictions and unproven optimism about the rolling "recovery in six months," our task is to weigh up the likely developments in the US economy as the starting point to what will happen there and elsewhere. Until last week we had "swallowed" the Greenscam line that the economy could only recover or deflate. Since recovery with such a debt load looked impossible, we went along with deflation being the more likely scenario, although, in fairness to ourselves, we saw it as only a short-term phenomenon, as a weakening dollar would offset deflationary pressures in time (we overestimated the amount of time in making a "wild guess" of one year).
"As of last week, because of a little publicized report that producer prices were rising at a 4.8% annual rate, we began to think of the third possibility: stagflation. Given our view that recovery is impossible until the US imbalances have been corrected (a view we hold despite volatile stock market rallies), we see the debate as deflation vs. stagflation. The latter is understood to mean slow growth (only slightly above growth in working population), increasing unemployment, and rising inflation and interest rates.
"A major question for the outlook in this stagflation vs. deflation competition is the future of the dollar. Bridgewater points out that, in past periods of high twin deficits, the dollar fell but bonds did not. They see the Fed producing "whatever liquidity is needed to shift some of the downward pressure on bond and stock markets to the US dollar" - hoping to attract foreign capital because the dollar is cheap (presumably with a view to its appreciating again). Up to that point we agree with Bridgewater's analysis, but we have to part company with them when they continue to see the deflation model and falling yields as the most likely scenario.
"Our view is towards the stagflation model, because of the force of argument from the indices and because the dollar looks likely to fall again. Despite our now leaning towards the stagflation model (yes, we changed our minds over the last few weeks - but the facts changed, too!), it would be inappropriate to recommend maturities other than those close to the bond index. Yields overshot on the way down and may well do on the way up. Besides the Greenscam may not have run its course. New cash should wait on the sidelines or be used to buy instruments to counter a further rise in yields and inflation."
I am attracted to this view, as it is similar to mine, although I think the time-line is somewhat longer and more stretched out. Reviewing quickly, I think we are in a slow growth Muddle Through Economy. The Fed has virtually guaranteed that short-term rates will remain low for some time, until either inflation appears or the economy is soundly growing above trend. Neither, as I explain below, is my most likely scenario. At some point, there will come a recession (there is always another recession), without the Fed having the "ammunition" of being able to lower short term rates. In my opinion, if a significant rise in rates, either long term or short term, were to happen in the current slow growth economy, it would indeed trigger a recession.
Since recessions are by nature deflationary, the Fed will respond with the rest of its arsenal, as they view deflation as the worst of all possible worlds. I believe they will indeed stop deflation dead in its tracks. However, I think that leads not to a comfortable reflation and a return to the Roaring 90's, but to a slow growth inflationary period, similar to the stagflation of the 70's. It will become the Muddle Through Decade.
I use the term Muddle Through to suggest that we are not facing an End of The World As We Know It scenario. For a variety of reasons, I do not think we will see a return of the Great (or even a Lesser) Depression, as do some. However, there are significant imbalances that must be addressed, and until they are, there will not be a return to continued above trend growth. That means the investment opportunities will be different than those of the 80's and 90's.
The Easy Prediction?
And this is where we will momentarily digress and look at Paul McCulley's latest essay. He is the managing director of Pimco, the world's largest bond management company. McCulley makes me think as few other writers do, offering insights and analysis in a flowing writing style. When I disagree with him, as I sometimes do, I am forced to think through the reasons why. Sometimes I change my views, as the facts change, and sometimes I can become ore confident of my own. In either case, it is a valuable exercise. (My real "complaint" with McCulley is that he only writes once a month and I would like to read more of his thought.)
McCulley writes this week at www.pimco.com:
"I believe the Treasury market is in a "rational" bubble, because the intermediate term global economic outlook is a bi-modal one, rather than a "normal" bell curve. Put more bluntly, Keynesian reflationary policies will work and inflation will go up, or they won't work and deflation will unfold. A perpetual muddle-along scenario, the easiest one in the world to predict, is also, I think, the least likely."
(By this, I assume he means suggesting that the current status quo will continue "perpetually" is unlikely. I would agree that "perpetual" is most unlikely. It is difficult to imagine a scenario of low inflation, slow growth lasting for too long a period of time. I will outline the reasons why below. But in the short-run of the next few months and quarters, it seems to me the more likely case.)
So who is right? Bridport or McCulley? Both are sitting on monstrous piles of bonds. Both are extremely smart and have the best and brightest working with them. Let me weigh in, offering a few thoughts on the matter.
As I look around the room at my fellow "predictors," I notice a large gathering at the end of the room labeled "strong recovery." They suggest a powerhouse recovery, as predicted by the Fed for next year (between 3.75% to 4.75%). Fed Governor McTeer suggests that such growth will not even be inflationary. Fed Governor Bernanke's speech this week suggests the same. Powerful growth and no inflation pressures? Ah, for such nirvana to actually arrive. I will be surprised, but delighted.
Or consider the very robust numbers like those from the Blue Chip Economic Survey. They estimated that the gross domestic product gains for the third and fourth quarters would be 3.6% and 3.8%, respectively. (ABC News)
Over on the other end of the room is a smaller crowd of Austrian economists and other assorted bearish predictors, who look at the huge imbalances in trade, debt and government deficits, not to mention large (they think excessive) money growth, and see a very unpleasant ending.
There are not many "stuck in the muddle" of the room with me, though my company is swelling somewhat from the real loneliness of last year. Those who actually have to eat their own cooking are not as optimistic as the Fed. Today we read on Moneyscope: "U.S. businesses are less sanguine. The National Association for Business Economics spoke with 123 corporate planners and financial analysts and came up with a dimmer outlook. According to the NABE survey, the forecasts were 3-to-1 for growth below 3 percent for the remainder of the year."
McCulley make the case for either deflation or a successful reflation. Bridport (as I have) suggests a third alternative: stagflation.
Let's take the case for the deflation scenario. As noted above, this week Fed Governor Ben Bernanke once again weighed into the topic, telling us the deflation threat is real even if the economy enters into a period of robust growth. (For the economically inquisitive, you can read the speech at http://www.federalreserve.gov/boarddocs/speeches/2003/20030723/default.htm)
First, he tells us:
"This distinction between inflation that is positive yet too low and deflation is worth exploring for a moment. Although the Federal Reserve does not have an explicit numerical target range for measured inflation, FOMC behavior and rhetoric have suggested to many observers that the Committee does have an implicit preferred range for inflation. Most relevant here, the bottom of that preferred range clearly seems to be a value greater than zero measured inflation, at least 1 percent per year or so."
He notes that Core CPI was only 1.5% for the year ending June 2003 and trending down in a year over year basis. "Core personal consumption expenditure (PCE) price index, a so-called chain-weight index that has the advantage of allowing for shifting expenditure weights, also fell ...to 1.2 percent." Thus, we are in "shouting distance" of the lower end of the preferred range.
What can happen from here? "..the factor most likely to exert downward pressure on the future course of inflation in the United States is the degree of economic slack that is currently prevailing and will likely continue for some time yet. Although (according to the National Bureau of Economic Research) the U.S. economy is technically in a recovery, job losses have remained significant this year, and capacity utilization in the industrial sector (the only sector for which estimates are available) is still low, suggesting that resource utilization for the economy as a whole is well below normal. By conventional analyses, therefore, even if the pace of real activity picks up considerably this year and next, persistent slack might result in continuing disinflation."
But what if "the pace of real activity" does not pick up considerably? What if the "output gap" or economic slack to which he alludes to does not close? It would seem to follow from Bernanke's thought (and I agree) that deflation becomes an issue. This could come about as the economy continues to slowly shed jobs, raising the level of unemployment, with the accompanying effects of falling consumer confidence and spending. A recession would follow at some point. This might take a long time (up to several years), but without sustained above trend growth, it seems a very possible scenario.
What if instead of a slower pace of growth we have an actual recession? This scenario is real enough in the short term if long term interest rates continue their recent steep rise. (I addressed the concern last week: a substantial rise in mortgage rates, beyond the current levels. Thus mortgage refinancing slows, thus consumer spending on the margin is affected. This also means new housing construction slows as rates rise, and thus the two areas of the economy which are keeping things afloat suffer. The more rates rise, the greater the problem.)
Thus deflation could result from slow growth or a rapid rise in rates. One is faster than the other, but either still gives us deflation.
As McCulley forcefully and logically points out, Greenspan is not likely to raise rates for quite some time, and perhaps not again in his career. (I really do urge readers to read this month's McCulley essay, if only for this point.) As I wrote above, the Fed will act decisively, although as Professor Robert Shiller wrote several weeks ago in the Wall Street Journal, the fear is they will act to late. In either case, whether they are reactive or proactive, they should be able to reinflate the economy. But if we are in a recession, it will not be easy. The Fed will have to use "unconventional means." They will re-ignite inflation.
The point for this phase of the argument is not how much inflation they re-ignite, but to suggest that deflation of more than a short term nature should not be in the future, barring an unforeseen "shock" or serious Fed incompetence.
But Where's the Growth?
But what of the happier scenario: a successful reflation and a solid, growing above trend economy? Let us make no mistake, a Fed forecast 4.75% annual growth rate for several years, even given Bernanke's "output gap," will ease deflation worries, re-ignite employment and set the stage for a healthy rise in interest rates. 4.75% growth will cure a lot of ills and ease a lot of imbalance.
Try as I might, I cannot see such idyllic circumstances in the cards. Where will the growth come from? A large boost in business spending does not seem to be in the cards given the NABE survey of real businesses. As an example, GM reports that 90% of its last quarter profits were from financing activities, and half of that from mortgages. Morgan Stanley predicts GM loses money on its actual car manufacturing in the third quarter. Neither does the ISM survey of manufacturers support the case for a large growth in business spending.
Can consumer spending grow at 4.75%? "In the late 1970s the rate of consumption in the U.S. economy as a percentage of GDP was 62%. By the end of the 1980s, that number rose by 4% to 66%; and it rose another 4% by the end of the 1990s. But by the end of 2001, consumption as a share of current GDP growth exceeded 90%." (Financial Day of Reckoning by Bill Bonner, due out in October - see more below).
If what little growth there is comes from consumer spending, who are already 70% of the economy, how much more of the heavy lifting of growth can they do? Especially given that a large part of that growth comes from debt and mortgage refinancing? If rates are backing up, is it likely that this growth will continue? If lowering rates have been a stimulus, will not rising rates be a drag?
Can the third leg of the economy, housing, be expected to grow from record highs? Admittedly, the recent weeks have set records, but it is highly plausible this was the result of homebuyers pushing their purchase up in time in fear that rates have seen permanent lows and will not come back down. Let's wait and look at what sales will be over the next few months as rates climb back over 6%.
Is a lower dollar going to boost the economy? It will help, but a weakened world economy does not seem ready to buy American with the same vigor with which we buy foreign goods.
Louis Rukeyser suggests that the bond market is confirming what the stock market is saying. They both suggest that a recovery is imminent. The question is: how reliable are such market prophecies? The stock market has given us four separate "predictions" in the past few years only to watch them fail. The bond market could be said to be simply returning to the level prior to the Fed's (evidently) misunderstood "promise" to lower long term rates which Greenspan took off the table.
In short, I fail to see from what quarter the impetus for robust growth comes.
But Where is the Recession?
All that being said, the current data does not suggest a recession. Consumer spending is holding up and even rising slightly. Business spending is positive. Capacity utilization is not falling. Productivity is rising. There was a nice rise in durable goods spending today. Absent an increased rise in mortgage rates, this does not appear to be an economy ready to roll over.
The final scenario of stagflation? I posed the following question to my dinner companions: What is the largest US export? My answer was that it is the US dollar. We are currently exporting 5% of our GDP each year. While it would take too long to go into the total argument, suffice it to say this cannot continue for too long.
The world at some point simply starts to want something besides dollar denominated debt. It will not be too many years at the current rate until foreign central banks would hold all US government debt. It is simply not credible to believe such a situation will occur. Long before that time comes, foreign governments will begin to look for other ways to hold their reserves. The market will simply force them to do so. Too much of a good thing is still too much.
"What investments do you think have potential in the current environment?" they asked as the evening drew to a close. One of my answers was the Chinese renminbi versus the dollar. Given that the room was almost entirely bearish on the dollar, there were nods all around. "How do you do that trade?" they shot back.
I noted that a US bank offered cash equivalent renminbi accounts. How do they do such a thing? Forward swaps on a rolling basis was the answer.
The bank is our old friend Everbank. You can indeed open an account which will be denominated in renminbi. (fyi, renminbi is the official name of the currency. The name the Chinese people call it is the yuan.) The account pays 0.5% annually, but costs you that much to exchange the currency both in and out. When the Chinese government allows the renminbi to revalue, if it goes up against the dollar, you will benefit from that increase. While many observers think it will revalue about 30% over time, the question is how much time is "over time"? Is it 6 weeks or 6 months or 6 years?
The Chinese government shows no indication that it will respond to foreign pressure to allow the currency to rise. They like the competitive edge it gives them as they try to find jobs for their under-employed nation. Then only reason they will do so is the market may force them to allow the currency to slowly rise or they risk over-heating their economy, as articles in both the Financial Times and Business Week point out this week. Since the Chinese government forces their nation's businesses to sell any dollars they receive to the government, the businesses are finding a home for their Chinese currency in real estate, which is rising rapidly in value. To prevent a bubble, the government may be forced to slowly float or widen the bands (the upper and lower limits) under which the currency is allowed to trade. Every time the government widens the bands, I expect the currency will immediately trade to the upper limit of the band.
You can find out more about these accounts by calling Chuck Butler at Everbank at 800-926-4922. In the interest of full disclosure, let me note that my publisher (and through them therefore me) has a sponsorship agreement with Everbank.
When the Chinese begin to find they have too many dollars, the end of what Bonner calls the Dollar Standard Era will be nigh. The dollar will correct. Rates will likely be forced back up. Rising interest rates, rising inflation and slow growth will give us a period that will not be a repeat, but it will be a rhyme, of the 70's and stagflation.
The Fed Must Become Transparent
Let me offer one final thought on a point that hedge fund manager Phillipe Peress of Big Star Capital made at our dinner. He noted that the Swiss central bank made it quite clear last year that the Swiss franc should no longer be considered a "safe haven" currency. Too much money was flowing into the country, causing relative prices to rise. (Indeed, I bought my first $6 Diet Coke [a mere ten ounces] this week. A meal at McDonalds for a family of four costs $30. Switzerland is a wonderful country, but the cost of living is high.) To back up their words, they have drastically cut rates and let it be known they intend to monitor the franc-euro levels. They were quite clear about what they intended to do and then did what they said.
This is in contrast to the recent Fed actions. Paul McCulley noted:
"If there was ever any question about this dynamic dance between the Fed and opportunistic buyers/sellers of duration , market action since last November, when the Fed launched a rhetorical anti-deflation campaign, should end it. Regrettably, Fed Chairman Greenspan started the campaign on November 13 by declaring that the Fed could/might buy longer-duration Treasuries outright:
"There is an implication in the notion (of fighting deflation risks) that we are restricted solely to overnight funds. But our history as an institution indicates that there have been innumerable occasions when we have moved out from short-term assets and invested in long-term Treasuries. We do have the capability, if required to do so, to go well beyond activities related to short-term rates."
"I say that it was "regrettable" that Mr. Greenspan started the anti-deflation campaign this way, because he needlessly changed the nature of how Treasury markets participants must handicap prospective Fed policy. Outright buying of long-term Treasuries was and is a "last resort" for the Fed, and a step that is highly unlikely to ever be taken. The Fed would/will do so if, and only if , market participants fail to appreciate and discount what the Fed was planning to do, and is planning to do: hold the Fed funds rate super low for a long, long time."
The market clearly thought the Fed was planning to move actively on long term rates. They perceived this from Fed speeches and statements. The Fed also clearly understood this was the perception, as more than one commentator, in scores of circles (myself included) noted the apparent change in policy direction. The market, without any real Fed action, drove rates down, thinking they had a green light from the Fed.
Then Greenspan simply discounted the notion in his congressional testimony, and rates have moved violently back up. Recent bond investors have lost money. As Bridport noted, many feel they have been subjected to a Greenscam. Once bitten, twice shy?
It is harder to redeem a reputation than build one. This is why I have been so adamant about transparency at the Fed. Bond investors hate uncertainty. They cannot plan in such an environment, and that is what we have today. Bernanke's speech was made to help quiet such worries.
The last three paragraphs of his speech are the most important (emphasis in bold is mine):
"What I have in mind here is not a formal inflation target but rather a tool for aiding communication. The main purpose of this quantification of price stability would be to provide some guidance to the public and to financial markets as they try to forecast FOMC behavior. In a situation like the current one, with inflation presumably near the bottom of the acceptable range and trending down, and with considerable slack remaining in the real economy, the Fed could make use of this quantitative guidepost to signal its expectation that rates will be kept low for a protracted period, and indeed that they would be reduced further if disinflation were not contained. If private-sector forecasts also called for disinflation, confirming the downward risk to price stability, then medium-term bond yields should accordingly be low, supporting the Fed's reflationary efforts.
"In principle, one could communicate a similar message, though perhaps less precisely, without a quantitative measure of price stability. What is missing from the purely qualitative communication approach, however, is an exit strategy. At some point in the future, if all goes well, inflation will stabilize, and interest rates will begin to rise. The task of communicating the timing of that switch to markets with a minimum of confusion and uncertainty is crucial and difficult. A quantitative measure of price stability provides one objective basis that bond market participants could use to help forecast the change in policy stance. For example, they would know that as disinflation risk recedes and inflation forecasts begin to cluster in the middle to upper portions of the price stability range, the Fed is quite likely to react. And, indeed, the forecasts of bond market participants and the resulting rise in private yields will help to contain inflation, doing some of the Fed's work for it.
"In closing, for me the lesson of the May 6 statement was to underscore the vital importance of central bank communication. In a world in which inflation risks are no longer one-sided and short-term nominal interest rates are at historical lows, the success of monetary policy depends more on how well the central bank communicates its plans and objectives than on any other single factor. "
Such words are refreshing, but are not enough. They must be backed up with actions. It is simply inappropriate that a small group of men operate in such secrecy on matters of vital public interest. Given that their recent actions are clearly promoting instability and putting the entire world economy at risk, it is more than inappropriate.
Home Again, Off Again
It is late and the letter is long enough. I will have to comment on Bill Bonner's book Financial Reckoning Day (Wiley) in a later letter. I have almost finished reading an advance (electronic) copy, and I can tell you I think you should read it as soon as it comes out. Do I agree with every word? No, but like McCulley, Bonner makes me think, and he will make you think, too. If you only read people who think like you, you will soon find you do not do much thinking. It is in the arena of ideas that the blade of the mind gets sharpened. It also helps that he is a writer's writer, one of the best crafter of words I know, and simply a pleasure to read, even if his words are sobering. You can get a copy shipped as soon as it is ready by going to Amazon.com (http://www.amazon.com/exec/obidos/ASIN/0471449733/frontlinethou-20).
I leave on Monday for Nova Scotia. I have promised my bride a week of actual vacation. Just to insure my resolve and from looking at the itinerary, I think she has found a few places where the internet does not conveniently reach. Withdrawal will be hard, but she promises I will survive. At the end of the week, we come back to Halifax and civilization, and there I find if I can work away from the Texas heat and my office for the next two weeks. Clients should note that these latter few weeks will be a working "vacation," and I will be available. I will also contact those who have asked for a meeting in San Francisco from August 14-17.
Your looking forward to cool evenings analyst,
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