June 20, 2013

Domestic and Foreign Events Are Tying the Fed’s Hands

Posted in Federal Reserve, Finance, Uncategorized tagged , , at 10:29 PM by Robert Barone

NEW YORK (TheStreet) — Despite apparent emerging strength in the U.S. economy, the Fed is faced with serious consequences, if it moves toward a reduction of policy ease. Those consequences include:

           • A potential violent market reaction;
           • the quashing of the nascent private sector animal spirits;
           • the short-term negative consequences of a stronger dollar on imports and exports; and
           • the long-term issues of the size and cost of the debt.

The Wealth Effect

The “wealth effect” has been studied for decades with the universal conclusion that its overall economic impact is marginal; i.e., the wealthy simply have a low marginal propensity to consume. Yet, this appears to be the only benefit of the massive QE programs, which — as documented by two revered market pundits, David Rosenberg and Jeffrey Gundlach — has a nearly 90% correlation with the equity markets.

In recent weeks, we saw the violent reactions in both equity and fixed-income markets to the mere concept of “tapering,” which is not tightening, but simply less easing (a change in the 2nd derivative). Clearly, a move to lessen ease risks the small success that massive QE has had to date.

Deflation

Deflation is a worldwide issue, even among emerging industrial powers like the BRICS. China’s economy, which has been the world’s economic growth engine for the past half decade, appears to be slowing significantly, despite its official purported 7.5% growth rate. The underlying data tell the story, including depressed raw commodity prices, excess high seas shipping capacity, the value of the currencies of commodity-producing countries like Australia, and a falloff in exports from lower-cost producers like South Korea.

Except for Japan, in April, the IMF significantly lowered its growth forecasts for every industrial economy. Thus, any tightening move by the Fed would only exacerbate worldwide deflationary pressures.

Debt Costs

The high and rising cost of U.S. debt, much of which is financed by foreigners, makes abandonment of easy money highly risky for U.S. fiscal policy. The U.S. public is unaware that the true GAAP deficit has exceeded $5 trillion for the past five years. Instead, the $1 trillion cash-flow budget deficit is viewed as the issue. Nevertheless, as time passes, the already built-in additional $4 trillion per year of promises will become current obligations.

I have seen several estimates of the cost of that future debt in rising-interest-rate scenarios. None are pretty. The most recent from Jeffrey Gundlach of Doubleline estimated the cost of the debt and deficit at $2.5 trillion by 2017, if the 10-year rate were to rise gradually from its current 2.1% level to 6.0%. By then, Gundlach says, the debt itself will be $26 trillion. Such deficits and debt levels risk not only inflation, but the dollar’s role as the world’s reserve currency.

Conclusion

The consequences of rising U.S. interest rates are dire. They would exacerbate worldwide deflation, play havoc with the nascent U.S.economic recovery, reverse the limited positive impact of the wealth effect via U.S. equity markets and have dire consequences for the dollar and U.S. fiscal policy. Rising rates will inevitably occur, but don’t count on them anytime soon. 

Robert Barone (Ph.D., Economics, Georgetown University) is a Principal of Universal Value
Advisors (UVA), Reno, NV, a Registered Investment Advisor. Dr. Barone is a former Director of the Federal Home Loan Bank of San Francisco, and is currently a Director of Allied Mineral Products, Columbus, Ohio, AAA Northern California, Nevada, Utah Auto Club, and the associated AAA Insurance Company where he chairs the Investment Committee.

Information cited has been compiled from various sources which UVA believes to be accurate and credible but makes no guarantee as to its accuracy. A more detailed description of the company, its management and practices is contained in its “Firm Brochure” (Form ADV, Part 2A) which may be obtained by contacting UVA at: 9222 Prototype Dr., Reno, NV 89521.

Ph: (775) 284-7778.

Advertisements

June 19, 2013

Taking in those ‘ah-ha’ moments, then and now

Posted in Economy, Uncategorized tagged , , at 9:01 PM by Robert Barone

Everyone has “ah-ha” moments, when something that was murky in one’s mind becomes crystal clear. It could be about a relationship or a career changing event. When such moments occur, things are never the same.
 
Recent ‘ah-ha’ moments
 
In the first few years of this century, when home prices were rapidly rising, few recognized that the trend couldn’t last unless either incomes kept up with prices or interest rates continued to fall. From 2000 to 2006, while incomes rose 2 percent, home prices rose 100 percent. Lesson learned?
 
From July ’82 to August, ’00, the S&P 500 rose 1,400 percent while GDP, a proxy for economic output, rose 305 percent. Of course, the “ah-ha” moment came in 2000, when the stock market began giving back nearly half of its value over the next two years. A similar scenario was repeated from the 2002 lows to the 2007 highs. Lesson relearned?
 
From these experiences, it would be rational to conclude that rapid growth in the nominal value of assets that is not matched by a similar expansion in the economic fundamentals is simply not sustainable. It is called a “bubble.” Given the popping of several such bubbles since the turn of the century, it should be logical to conclude that we have learned to recognize such phenomena.
 
Recognizing current bubbles
 
In the first quarter of 2013, real disposable personal income continued its long-term decline, a trend that began in the ’70s and accelerated around the financial meltdown and housing bubble pop of the Great Recession.
 
According to official government data, real average weekly earnings (using the CPI as the deflator) have fallen 18 percent since their peak in the early ’70s. Yet, despite the fact that the consumer, representing 70 percent of the economy, is still struggling, the S&P 500 rose 10 percent in the first quarter, and through the end of May is up 14 percent for the year. (Ah-ha!)
 
It is clear that the stock market is being driven by the Fed’s quantitative easing (QE) policies. The Fed has injected liquidity by buying huge quantities of treasury and mortgage backed securities, and, so far, that liquidity has simply chased stock prices. Is it any wonder that the stock market falls when there is any indication that QE will be scaled back?
 
QE’s unintended consequences
 
The consequences of QE are much deeper than a correction, even a significant correction, in equity prices. The following is Milton Friedman’s famous tautology (meaning it is always true by definition).
 
MV=PQ
 
This says that the money supply (M) times its velocity (V) (the number of times money changes hands) must equal the number of physical goods bought that year (Q) times the average price paid for those goods (P). It stands to reason that if M*V grows faster than Q, then P must rise.
 
Since the recession and the beginning of QE, the Fed nearly has quadrupled the size of its balance sheet (from $848 billion in August 2008 to $3.0 trillion in April, and growing at $85 billion per month). The Fed’s balance sheet translates directly into bank reserves, and when banks have excess reserves, they can loan those reserves out.
 
Of course, when they do, the money supply grows. There is growing evidence today that consumer deleveraging has ended. Bank loans and commercial paper outstanding are up significantly, as is credit card debt. At the same time, state and local governments spending is once again increasing (just look at the budget recently passed in the Nevada Legislature). During the past year, the monetary base (currency + excess bank reserves) has risen by 18 percent. And, more importantly, M1 (currency + checking account balances) is up 12 percent.
 
Are we approaching another ‘ah-ha’ moment?
 
Bernanke himself knows that inflation appears with long and variable lags. He and co-authors published a paper in 1999 that concluded there are long and variable lags between inflation-causing policies and the inflation itself.
Q is growing at less than 2 percent; M is growing at a double-digit rate. Consumer deleveraging is ending and state and local government spending is rising. This means that velocity (V) has stopped falling. Despite the current consensus among economists and market participants who say inflation is nonexistent, when M*V rises faster than Q, P has to rise! (Ah-ha!)
 
The Fed is targeting inflation and the unemployment rate, both lagging economic indicators. By the time inflation shows up in these laggards, it will be well ingrained.
Worse, Bernanke, Yellen and other Fed governors have embraced the belief that some inflation (2 percent-plus) is desirable even after fighting it for years. I fear the Fed will actually praise the early onset of inflation, which will limit any negative reaction to it by both the Fed and the market.
 
As we learned in the ’70s and ’80s, once inflation becomes ingrained, it is awfully difficult to shake (three years of double-digit interest rates), especially in an economy with growth problems. Inflation destroys the value of your investments. The cost of protection today is cheap.

Robert Barone (Ph.D., economics, Georgetown University) is a principal of Universal Value Advisors, Reno, a registered investment adviser. Barone is a former director of the Federal Home Loan Bank of San Francisco and is currently a director of Allied Mineral Products, Columbus, Ohio, AAA Northern California, Nevada, Utah Auto Club, and the associated AAA Insurance Co., where he chairs the investment committee. Barone or the professionals at UVA (Joshua Barone, Andrea Knapp, Matt Marcewicz and Marvin Grulli) are available to discuss client investment needs.

Call them at 775-284-7778.

Statistics and other information have been compiled from various sources. Universal Value Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.

 

 

 

June 4, 2013

The age-old challenge: Buy low or sell high?

Posted in Economy, Finance, Uncategorized tagged , , at 7:00 PM by Robert Barone

Buy low; sell high. Sounds simple, but easier said than done.
 
Because of “fear,” when assets are “on sale,” few investors buy, thinking that asset prices can still go lower. It is a fact that only a handful of investors actually buy at the low or sell at the high. The odds of you being one of them are quite remote.
 
In the end, one has to have confidence in one’s view of the future to sell when you think the assets are overpriced and to buy when they appear underpriced.
 
Given the rise in equity prices we’ve seen since last November, you might conclude that this column is about selling at the highs. But, it is actually about the other pole — buying at the lows.
 
To set the stage, I need to discuss the two major views of the macroeconomic landscape that exist today among major market players.
 
Two views of the economy
 
View 1: Underlying economic factors are getting stronger, and soon we willsee much-improved economic growth. Pundits here point to a housing market that appears to be healing (prices are once again rising), to a consumer confident enough to continue to consume despite increasing taxes, to record-setting corporate
profits and to a stronger employment market.
 
• View 2: The basic economy is weak and is being propped up by money printing. The
Fed has targeted the equity markets, hoping the “wealth effect,” via rising equity prices, will translate into increased consumption and economic growth.
 
The Fed is committed to the money-printing policy untilsignificant economic growth occurs. Pundits here point to a housing market dependent on historically low interest rates, a consumer not capable of borrowing, record-low capital expenditures on the part of businesses which have and hold a record amounts of cash, and a continuing fall in real income.
 
Europe is in an intense recession, and China’s economy markedly has slowed. In addition, the job creation numbers, they say, are misleading. Of the 293,000 jobs created in April, 278,000 were part time and 309,000 were from self-employment. That means that full-time payroll employment fell by 294,000.
 
Those who hold view 1 believe that the stock market will go higher yet. View 2 holders believe that the equity market is overvalued and, as soon as there is a signalfrom the
Fed that the money printing willslow, that market will correct.
 
The role of monetary policy
 
One thing is for sure:If we don’t get robust economic growth, both in the U.S. and on a globalscale, we are going to see a continuation of the money-printing policies by all of the major central banks CentralBank, Bank of England, Bank ofJapan), at least until “recognized” inflation becomes an issue.
 
The policymakers at those central banks have told us so. Both our Fed and the Bank ofJapan have set inflation targets. And, while the targets appear low (2.0 percent in the U.S. and 2.5 percent in Japan), we all know from common everyday experience (and from private sector studies) that the realrate of inflation is much higher than officially recognized.
 
Monetary policy, by the way, operates with a long and variable lag as we were taught during the inflation experience of the late 1970s and early 1980s. So, by the time an inflation is officially recognized, it is wellestablished and quite hard to quell.
 
We should also acknowledge that we have never had monetary policy conducted with such experimental tools and don’t yet know the unintended consequences.
 
Finally, the independence of the central banks from their respective governments is now questionable, especially since the Abe government in Japan browbeat that central bank into submission to its money-printing views.
 
Is anything low?
 
Remember buy low? Because of the slow growth worldwide, all of the equity prices of naturalresource and commodity stocks and of the commodities themselves are at or near cyclical lows. Copper, coal and agricultural commodities are good examples in the raw commodity space, while in the equity area we have cyclical lows in mining stocks and iron and steelstocks. Oil and natural gas, on the other hand, both are at lows because ofslack demand and because of the large new supplies coming online in the U.S.
 
Under either view 1 or view 2, these look attractive. Can their prices go lower? Of course. In all my years of trading, I think I bought at the printed low only a handful of times.
 
If view 1 turns out to be correct, demand for basic materials and commodities willrise along with their prices.
 
Under view 2, either we will get economic growth or inflation.
If we end up with the latter, commodities and basic materials act as inflation protection hedges.
 
The mention ofsecurities/commodities should not be considered an offer to sell or solicitation to buy investments mentioned. Consult your investment professional to understand the risks and/or how the purchase or sale of these investments may be implemented to meet your investment goals.
 
Robert Barone (Ph.D., economics, Georgetown University) is a principal of Universal Value Advisors, Reno, a registered investment adviser. Barone is a former director of the Federal Home Loan Bank of San Francisco and is currently a director of Allied Mineral Products, Columbus, Ohio, AAA Northern California, Nevada, Utah Auto Club, and the associated AAA Insurance Co., where he chairs the investment committee. Barone or the professionals at UVA (Joshua Barone, Andrea Knapp, Matt Marcewicz and Marvin Grulli) are available to discuss client investment needs.
Call them at 775-284-7778.
Statistics and other information have been compiled from various sources. Universal Value Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.