China in a bubble???????

I had penned a long piece about the composition of Chinese FX reserves and gone into the Corriente Advisors argument about why China is in a bubble and the RMB is over-valued, when I came across this video:

http://www.pbs.org.pov.utopia/

Nothing I could have written illustrates the argument about over-investing and the "build-it-and-they-will-come" attitude better than this. Enjoy!

PIIGS.....

With all eyes are on Greece and the EU this week and the market taking the ‘support’ being offered with a ‘show-me-the-money’ attitude i.e. general scepticism to an attitude that while not completely similar is reminiscent of the one offered by Bear Stearns CEO Allan Schwarts and Lehman CEO Dick Fuld in the weeks and months before they went out of business: There is no problem, we are fine, it’s the market speculating against us by buying CDS on our debt, it’s unfair and someone should stop them! 

These are not exact quotes, but the kind of attitude offered by ECB governors, various EU top officials etc. Very much like Allan Schwartz and Dick Fuld they refuse to admit (at least in public) that there is a real problem. Leveraged firms as well as most countries with a borrowing requirement need to find investors to buy their debt as and when it needs to be sold, which for many countries is a very regular occurrence.

The PIIGS mnaged to hide quite well in the middle of the financial crisis, as they do not have national currencies, they did not suffer ‘runs’ on their reserves, they did not have to devalue, or defend their currency pegs with extreme interest rate hikes, which would have damaged their economies even further. Now, however, they have to face up to quite hard realities as the easy way out i.e. devaluation is not available, at least not without leaving the Euro. Years of excessive pay rises and erosion of competitiveness has to be paid for. 

A complete lack of fiscal discipline, that could easily be financed in the past, is now required on a level and a scale which is truly breathtaking. 

The only comparable situation in recent memory is Sweden in the mid-nineties. They tried to hold a peg to the Euro, defending it with o/n interest rates of 500% only to in the end give up defending the currency, completely restructure the banking system, and cut interest rates. They managed to do this better than anyone had hoped for at the time. The massive devaluation  did not lead to a lot of inflation, their big industrial manufacturing base became very competitive and it was at the beginning of a new boom in growth across the world.

The currency never recovered, growing up (in Denmark) the SEK was always in the 1.10 - 1.20 DKK range, while it has recently been as low as 0.70 it is now closer to 0.83 still a long way from it’s pre 92 highs, but that has not stopped the Swedes having a full recovery and a well functioning economy. So to all of those saying you cannot devalue yourself out of problems, I say have a look at Sweden (and probably the UK in the same period).

These options are not available to the PIIGS without leaving the Euro - the alternative is an internal ‘devaluation’ which is pay cuts across the board and probably in the 15-25% range depending on how bad the country in question's problems are and how they fare on a competitive basis. Ireland  as the only country in this group has taken steps in this direction, one of the consequences is a drop in inflation of more than 6% in January 2010 on a y//y basis.

How palatable these kind os measures will be in Greece, Spain and Portugal remains to be seen - the alternative is to leave the Euro - or face that the markets may stop funding their deficits and debt roll-over.

Greece is about 2% of EU GDP and it’s debt is a bit more than 2%, so from a strictly ‘how big a cheque do I need to write’ attitude it’s not that big - the problem when you get to Spain is much more significant and not something Germany can easily afford out of petty cash. 

The Spanish troubles are in some ways very deep - the housing market is still in deflating bubble being held from imploding by banks that refuse to take their losses on more than 1 million newly constructed houses and apartments as well as the repossessed properties they are not willing to take losses on, so keep on their books or release in sales at very high prices, but with VERY attractive financing packages, in order not to have to mark down the value of the assets. 

With unemployment north of 20% and the economy having been reliant on construction and tourism to a very high degree, it’s very difficult to see how Spain can work itself out of its current mess without draconian and unpopular measures.

In the mean time the EU leadership should own up to that this is a real problem and not dismiss it as mere market  ‘speculation’ and thinking about how they can do more to stop speculation. In their minds it’s like this: when the market buys member countries debt it’s investment when the market sells the same bonds short, or buy the CDS, then it’s speculation. Somethings never change......maybe they can get Dick Fuld to advise them on how to persuade the market that it is simply wrong......and they are right?

Climate Con?

This is obviously a very hot topic just weeks before the Copenhagen Summit in which the leaders of the world  will agree on a plan of action to save the world from all sorts of disasters......!

The most interesting part of this debate is how one-sided it is and how a few have rail-roaded the entire debate away from whether Climate Change is really caused by (man-made) CO2 emissions and that EVERY politician has jumped on the band wagon.

I’m no scientist but I have read a few of the books on the subject including Tim Flannery’s book, “The Weather Makers” and “The Chilling Stars” by Henrik Svensmark and Nigel Calder to mention a few. I am also not in favour of pollution or the destruction of the planet, making thousand of species extinct, but there is no longer a debate about how to utilize the available resources - it has been decided that this is the greatest threat to the planet AND that we can do something about it. It may well be a serious threat to our planet, but is it really something caused by man and is it really something we can do something about? If one is questioning this ‘fact’ then one is now considered on par with a holocaust denier!

Another interesting fact is that the scientists agreeing with this theory are granted loads of funds and resources and the ones questioning the theory are having their grants and funding taken away - it speaks volumes for ‘independent’ research.

Recently my godfather wrote a presentation on the subject which I found very insightful and interesting (he visited Greenland last year) and has seen first hand what is are called the frontier of Climate Change.

I will not re-write the entire piece but instead try and post it on my blog (unfortunately it’s written in Danish with a few quotes etc in English), but the main points are that the climate has always changed - we have data going back hundreds of thousands of years - but the entire theory is based on the development since 1850 and even in that period the majority of the change occurred between 1910 - 1940.

It has been much warmer in the past than it is currently (in the Bronze Age and in the Middle Ages from 900 - 1300 AD) and there are all sort of potential explanations, the sun and it’s activity being one of them as we should not forget that without the sun the temperature on earth would be -273C.

Since I started penning this piece the most interesting developments have taken place after the University of East Anglia’s servers were hacked and a great deal of email correspondence has been posted on the web. This calls into question whether the lead scientist(s) have abolished science for politics as they seem to have been as ivolved in dis-crediting anyone challenging their ‘beliefs’ as they have been in genuine research. 

What is even more disturbing (and completely new to me) is that the raw data used for establishing historical global temperatures has been deleted. The reason this is important is that the entire theory behind man-made climate change is based on this data which has then been ‘adjusted’ - the adjustment is a scientific one as the way in which the data was collected since 1850 has not been as consistent as it is today. There would have been a number of data points throughout the years for different days and different places around the world. Turning that into an average temperature for the planet is obviously not that straight forward. What we are now left with is the ‘adjusted’ data. Requests for the original data have been rejected and now appear to be impossible to satisfy as the data has been lost or destroyed.

The key reason this analysis is important is that earlier periods’ warming looked a lot like the current warming e.g. the medieval warm period. Research led by Michael Mann of Pennsylvania State University suggested that while the Atlantic (think vineyards in Britain and Vikings sailing everywhere in open long boats) was much warmer the Pacific had been cooler. Without this research there wouldn’t be a climate change movement, because there would be no scientific evidence to suggest that the period since 1850 is extraordinary. That the data on which this whole argument is based may be lost is beyond belief....! Is it just me or does it sound a little bit like the weapons of mass destruction that weren’t really there, but served a purpose in getting a particular course of action through?

The one piece of good news is that Nigel (now Lord) Lawson has announced the creation of the Global Warming Policy Foundation, a think tank, to bring “reason, integrity and balance to a debate that has become seriously unbalanced, irrationally alarmist, and all too often depressingly intolerant”. This is desperately needed and maybe the timing will enable it to have a better chance of getting media coverage, than it otherwise would have!

Strong dollar.....is it really good for the US?

Yesterday I was baffled (yet again) by a republican US politician on CNBC who claimed that the current weak dollar was the cause of manufacturing leaving the US, citing his experience from Michigan in the 80‘ies. So while I am that old and I do remember the 80‘ies, twenty-five years is obviously a long time - in the foreign exchange market it’s more like an eternity - and yes my memory served me correctly, the US dollar was anything but weak, peaking at a $/DM rate of around 3.45, which equates to a €/$ rate of 0.635 and only started to weaken after the Plaza accord in 1985.

If anything a weak US dollar helps investment in the US as it makes exports more competitive and imports less competitive, or reduces the profit margins for the manufacturer, which is why that in the last 20 years (ironically since the 80‘ies) BMW, Mercedes, VW, Toyota, Honda and others have opened production facilities in the US, partially as a hedge against a weak dollar, which could render them un-competitve or substantially less profitable in what still is, the wold’s largest market.

So if anything a strong dollar is not good for the domestic manufacturing industry. 

Obviously it has become one of the hot topics in the markets, with the odd politician jumping on the band-wagon, but as many of them are just jumping on the wagon without having done any analysis themselves it’s really rather embarrassing, but hardly new.

The scare mongers are calling for a collapse in the dollar and while I can clearly see the benefits (for the US) in a relatively weak dollar, it’s not beneficial to the Europeans (Germany’s August trade balance was +8 bill vs +12 bill expectation), nor to the Japanese whose export sectors are hurting because of the strong yen. In fact it’s hard to see who, apart from the Americans, it’s good for and while a true collapse wouldn’t be good for the US, it wouldn’t be good for anyone else either.

Oh, but is is inflationary I hear them say, well yes but some inflation is what is called for if the US (and the rest of the western world) is not to experience serious deflation and by the way, inflation is the cure for an overly indebted economy, as long as the economy’s liabilities are a) fixed rate and b) denominated in the same currency as the assets it holds. The US bond market does not seem to be overly concerned about the prospects of inflation and is taking down record issuance without any problem whatsoever, at least so far.

One of the true idiosyncrasies in this partially post-crisis world is the EVERYONE is looking for an export led recovery and clearly that is not possible.

At the moment the markets are hot on the ‘weak dollar stronger everything else trade’, but while there may be a an argument for holding gold against all (paper) currencies, the same does not necessarily apply to oil, base metals and everything else. What I see coming is a fast and furious correction to the weak dollar trade, as it is too heavily skewed in the direction of the weak dollar strong everything else.

What’s up with some of the grand old titans of the hedge fund industry?

It’s hardly new or a surprise to hear Jim Rogers go on about the virtues of commodities and banging on about inflation - Julian Robertson has now (probably some time ago) joined the bandwagon, but announced it in an interview given to CNBC’s Erin Burnett yesterday.

These gentlemen (and others) are very focused on the public sector debt increase and the potential problems associated herewith. Aren’t they forgetting that public sector debt is just one component of a country’s total debt - and shouldn’t this worry have been expressed years ago as the US carried on with ever rising budget and current account deficits not least as the domestic household savings rate was negative? In effect it was the ‘over-consumption’ of the US consumer that led the country down this path. China supplied the goods (or many of them) and took the dollars from the system as not to re-value the yuan and re-cycled the reserves into treasuries, which in turn kept interest rates lower than they otherwise would have been, which caused mortgage rates to be lower, which pushed up house prices, which made consumers feel richer, which made them spend more......and round and round it went.

Now things have changed......US consumers are now saving at a rate of 6-8% (of disposable income) and while it may increase further it’s not all bad news: this newfound prudent attitude can help the government with its budget deficit as these savings are finding their way into fixed income and money market funds rather than more speculative stock funds. The slack potentially left by the reduced need for ‘re-cycling’ of dollars could be taken up domestically - let’s also not forget that having a steep yield curve is one of the ways of funding a large budget deficit - you get paid to go further out the curve and even if you do not want to have the currency risk the very low short term rates makes it perfectly natural and inexpensive to hedge that risk.

While I don’t disagree completely with Mr Robertson (he mentions that a lot of pain will be necessary, while the imbalances are corrected) and I completely agree that some measures of austerity are necessary to correct primarily the budget deficit e.g. a gas tax, but I completely disagree that interest rates will shoot to 15-20% if the Japanese and the Chinese stop buying (more) treasuries. Their need to buy treasuries (apart from re-investment of coupons payments and redemptions) are predicated on a running trade surpluses with the US. If these surpluses are reduced their will be less buying, but at the same token the savings rate (and the banks) can pick up the slack.

There is a lot of focus on the public sector deficits - and with good reason - but little attention is paid to the total debt issuance, as many securitization markets remain closed and the only real mortgage lender in the US, is the government, total net debt issuance (if the QE measures are factored in) is actually lower now than it was before the crisis hit. Credit spreads have collapsed i.e. other forms of credit have vastly outperformed treasuries to a level where it is probably worth having treasuries over spread product.....!

I am a big believer in looking at the ‘black swan’ scenarios which may have low probability but high impact, but this one I think is much less likely than the world experiencing a true double-dip when the fiscal stimulus is withdrawn and the lows in equity markets are re-tested and perhaps broken. 20% inflation and 20% interest rates would be a breeze compared to that!

Inflation/Deflation.....

I will go out on a limb here and suggest that the current debate is the most divided ever on this topic, albeit with more participants in the inflation camp.

We actually do not have inflation at present - we have deflation as consumer prices (in the US) are -2.1% y/y (July 2009). German producer prices are -7.8% in the same month. These are unprecedented times as this phenomenon has not occurred since the 1940‘s.

Yet, the inflation scare mongers are abundant! Predicting that hyper inflation is just around the corner and comparisons with Zimbabwe are frequent, but where is inflation actually going to come from?

Unemployment is substantial, capacity utilization is low - it’s hard to see the theory of too much money chasing too few goods manifesting itself in the short to medium future. Ah, but I hear the inflation hawks say.........what about all the liquidity measures undertaken by the central banks and their destructive QE programmes - in effect printing money just like in Zimbabwe?

Well, that extra liquidity is in the main ending up with the same central banks that provided it in the first place in the form of extra reserves being placed on deposit with the central banks as there is little appetite for credit from creditworthy consumers and businesses and even less desire on the banks’ behalf to lend, which is why the monetary aggregates are not growing. US M2 growth is running at a seasonally adjusted annual rate of 3.2% in Q2 of this year - it is up 8.1% in july ’09 compared to July’ 08. These are hardly alarming growth rates.

At the same time when the public sectors are expanding their balance sheets the relevant private sectors and in particular households are shrinking their balance sheets - in the US this contraction far outweighs anything done by the Federal Reserve

Even with CPI falling 2.1% in the last year, producer prices are falling faster, which is why many of the large US retailers have been able to increase their margins in the last year as they have only partially passed on the decreases in the prices they pay to suppliers.

So with housing still declining (9.2% of all mortgages are now delinquent in one form or other) the job market is still getting worse as unemployment is expected to pass 10% this year in the US (official survey number - real unemployment is much higher) there will be no demand driven inflation.

So for inflation to come back it has to be caused by supply constraints and with capacity utilization at very low levels it is very difficult to see a scenario where that is going to occur, say for another oil price chock. This also looks less likely in a world that is awash with oil and short of places to store it. Last year’s spike to $147 was in effect driven by the Chinese accumulation so they could still run the Olympics had their traditional electricity sources failed them.

This year the Chinese have been stock piling again buying loads of raw materials and base metals etc, something you can do in a plan economy where no-one will get fired if it turns out to be a mistake and prices fall even further in the future. Now it seems to be over and the Baltic Dry Freight Index is heading back south again to where the freight rates for the finished goods (container shipping rates) are languishing, as these have seen virtually no recovery form the lows. Shipping rates are probably a better indicator of future inflation than so many other things and before they look like getting back to the levels of 2007, which was hardly a high inflation year, there is no need to worry.

Investors in index-linked bonds should pay heed to the fact that deflation can and will take a huge chunk out of the yield they receive. Break-evens can also go negative, as they were in Sweden in ’98.......

Lies, damn lies and statistics

Housing numbers......

Today’s release of New Home Sales brings about the usual euphoria (in the media at least) as they were up a whooping 11% at 384k houses, against the expected 350k.

34,000 houses are a lot of houses????? Well, we’re not actually talking about 34,000 houses, because this is a seasonally adjusted, annualized number - so without knowing what the seasonal adjustment is - the annualized part we can work out and in effect we’re getting excited because of less than 3,000 extra new houses sold in one month!

I read recently that there are 15-18 mill ‘vacant’ homes (as the Americans call them) in the US - these are either, newly constructed, repossessed, for sale, in the shadow inventory (banks hold back repossessed houses as not to flood the market), second homes, vacation homes etc, which all would come to the market should it improve.

Household formation is currently negative in the US according to Sanford Bernstein (that must be a first?) as kids are moving back in with their parents, at a faster rate than net immigration creates demand for houses. Clearly the kids will want to move out again at some stage, but for now the housing situation is getting worse, not better.

3,000 doesn’t really cut it, does it now?