Investment Postcards from Cape Town

This post is a guest contribution by Rebecca Wilder*, author of the of the News N Economics blog.

The Federal Open Market Committee (FOMC) is making tough decisions right now. Its mandate, “to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates”, is a seriously tall order given current economic conditions.

The unemployment rate sits at 9.7%, while prices bounced back to 2.6% Y/Y in January. On the surface of it, inflation appears to be gaining some traction; but the big numbers are representative of base effects, and that is really all. The drag on prices remains very real.

But there is one little kink in the headline figures of unemployment that complicates an already complicated task: extended unemployment insurance. From the FOMC’s Jan. 26-27 minutes:

Though participants agreed there was considerable slack in resource utilisation, their judgments about the degree of slack varied. The several extensions of emergency unemployment insurance benefits appeared to have raised the measured unemployment rate, relative to levels recorded in past downturns, by encouraging some who have lost their jobs to remain in the labour force. If that effect were large- some estimates suggested it could account for 1 percentage point or more of the increase in the unemployment rate during this recession- then the reported unemployment rate might be overstating the amount of slack in resource utilisation relative to past periods of high unemployment.

Why would extended unemployment benefits increase the unemployment rate? In order to claim unemployment benefits, one must be “in the labour force”; and that means looking for work. Therefore, some workers who would otherwise be classified as “not in the labour force” remain in the work force as “unemployed”. Therefore, the current unemployment rate is elevated above the rate that would occur without the extended benefits. The Fed suggests this differential to be roughly 1% point.

I am in no way proposing that the extended benefits be rescinded, nor am I deluding myself into thinking that the labour market is anything short of awful. But Fed policy is calibrated to the non-inflation-generating level of the unemployment rate. And the current unemployment rate may be closer to the long-run level than the headline number suggests.

I have talked about this before (see this post) from another angle: the long-run level of unemployment may be a moving target right now, i.e., it’s likely rising. Therefore, if it is rising and subsidies are masking the true level of the current unemployment rate, then we may very well get some inflation while the economy is still weak.

Of course, I do not believe we are even near such a threshold level, but it does complicate an already complicated situation. A modified Taylor rule demonstrates the implications for policy:

The chart above illustrates the estimated Taylor Rule using the current unemployment rate (blue line) versus one in which 1% point is shaved off the unemployment rate for every month since January 2008 (green line). The modified rule does suggest the Fed policy rate is currently at (or now below) the prescribed rate.

Source: Rebecca Wilder, News N Economics, February 27, 2010.

* Rebecca Wilder is an economist in the financial industry. She was previously an assistant professor and holds a doctorate in economics.

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The post below is a guest contribution by Marty Weiner of Comstock Partners, the highly regarded investment manager run by Charles Minter.

We have been strong believers in the deflation theme since we have been writing these reports beginning in early 2000 (and even before).  We are attaching a chart depicting the “Cycle of Deflation” which you should print out and refer to as you read this comment.

As you can see by the chart, the typical deflation starts with savings and investment which produces strong sustainable growth in the economy.  However, when “greed” gets added into the equation, things sometimes change into non-sustainable growth.  This is what happened in the late 1900’s when the dot com bubble mania convinced every man woman and adult child to believe that they were all supposed to be multi millionaires.  They became so jealous of their neighbors who boasted about all the money they made in the market, that they also jumped into the market by buying such things as Internet Capital Group, CMGI, Iomega, JDS Uniphase, and many others of the same ilk which are now worthless.

The unraveling started taking place in 2000 and it looked to us like the American public came to their senses.  We expected to have a significant recession where Americans could rebuild their balance sheets as the cycle of deflation took hold.  But,  instead the Fed lowered interest rates to 1% and kept them there for a year causing the public to again become jealous of their neighbors making thousands and millions of dollars on their homes. And also, believe it or not, the housing bubble brought about another bubble in the stock market. We couldn’t believe our eyes!!!

After the housing bubble burst, the stock market also collapsed causing a financial crisis “heard ’round the world”.  Then, we were sure the markets and economy would fall to levels that would repair balance sheets of the household sector and allow the economy to get back to the tried and true savings and productive investment that built this great country.  We still need to repair the household balance sheets that were, and still are, in the worst shape since than the Great Depression.  What will it take to get to the debt repayments and debt defaults (see the last stage of The Cycle of Deflation) that has to take place before a sustained recovery can be accomplished?

We understood that the stock market was extremely oversold in March of 2009 and that there had to be a rally.  But we found the 70% to 80% rally which occurred to be incredulous.  The market is up so far from the lows in March now that they have discounted a V shaped recovery.  We have to wonder if the public and financial institutions will ever learn.

We are now in the “competitive devaluation” part of the cycle of deflation and we should be getting close to repairing the balance sheets that are so out of line with history.  But, there is a stumbling block to the normal competitive devaluations that typically take place. In the past, a country that incurred too much debt just did what they could to devalue their currency in order to export their way out of the dilemma by exporting their goods and services to their trading partners.

Now, however, it is not so simple.  The Chinese have linked their currency to ours, so as we debase our currency, one of our major trading partner’s currency is also declining and China becomes the major beneficiary of the debasement of our dollar. Because of this peg (and the Euro tied to 22 countries) the typical method of debasing the currency of debt laden countries (or countries that just want to get even) have swung down in “The Cycle of Deflation” past competitive devaluations to “beggar thy neighbor” policies.  We explained many times that “beggar-thy-neighbor” policies essentially go much further than just currency debasement, but actually do whatever a country has to do to protect its jobs and its economy.  This means “dumping” goods and services on their trading partners (selling  goods and services below cost and subsidized by the government), increasing tariffs, and anything else in its power to help the economy at their trading partners’ expense.

A perfect example of this lies in the recent accusations from China that the U.S. has been “dumping” chicken products into the Chinese market.  It at first threatened imposing heavy trade duties on U.S. chicken companies, and just recently China did impose the heavy duties.  They imposed duties of 64.5% on Sanderson Farms, 80.5% on Pilgrim’s Pride, and 43% on Tyson Foods which just happens to be an active investor in China.   These types of “beggar-thy-neighbor” policies are an extension of the past policies they have used to support exports. But now they feel that they have to go further since China now accounts for 9% of global exports.  Earlier this month China filed a compliant to the World Trade Organization against the European Union tariffs on imports of Chinese shoes.  “The dollar peg of the rinminbi has put additional pressure on lower end Asian exporters.  This has led to charges of unfair trade from across Asia,” said Jamie Mezl, executive vice president of the Asia Society.  Even nations in Africa and the Middle East are complaining.  “When we look at the reality on the ground we find that there is something akin to a Chinese invasion of the African continent,” Libyan Foreign Minister Musa Kusa said in November.

China’s exports were helped enormously by repegging their renminbi to the dollar in mid 2008.  Their exports got a further boost once the dollar started falling from March of 2009 by about 10%.  Now that the dollar has started up they could be close to reversing that decision.  Despite all the hoopla of China trying to slow down their growth, the above policies don’t support that at all.  The Chinese total debt to GDP is very difficult to quantify, but with the enormous stimulus undertaken last year ($550 billion) and government supported bank lending ($1.3 trillion), we know they are not in great shape.

America has retaliated by imposing punitive tariffs (as much as 99%) on Chinese tires and tubular steel (used in oil and gas wells).  The Chinese government weighed in by condemning the U.S. tariffs as an “abuse of protectionism”.

These examples of Chinese actions illustrate how difficult it is now for debt ridden countries to simply devalue their currency in order to export their way out of the dilemma. And just think about the situation in Europe, where this problem is exacerbated by 22 fold, since they now have 22 countries tied to one currency.

The problem is not confined to America, Asia, and Africa-Look at what is taking place in Greece presently.  In the past, a country like Greece that over indulged and got caught with their “hands in the cookie jar,” would just debase their currency in order to export their way out of the problem.  But, now that their currency is tied to the Euro like 22 other of its trading partners, they don’t have the same option as they did in the past to bail themselves out.

In summary, due to the debt related problems many countries worldwide are struggling to help their own economies at the expense of their trading partners.  In the past this has been accomplished by debasing their currencies in order to export their goods and services.  Because of currency pegs and one currency used by 22 countries (Euro Zone), this means of debt relief is not as easily accomplished.  The next stage of the Cycle of Deflation is the much more onerous “beggar-thy-neighbor” policies in order to support the economies of debt burdened countries.  This is not good news and could have the same effect for the global economies as Smoot Hawley did (a bill in 1929 that became law in 1930 which raised the tariffs on the U.S’s. major trading partners).   Therefore, the main problem of reducing the debt of major economies throughout the world is even more complicated and makes us even more convinced that the secular bear market that started in 2000 is still intact.

Source: Comstock Partners, February 25, 2010.

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This post is a guest contribution by Asha Bangalore* of The Northern Trust  Company.

The most important message from Chairman Bernanke’s testimony is that the federal funds rate will be held at 0%-0.25% for an extended period.  In light of the higher discount rate (0.75% vs. 0.50%) announced on February 18, 2010, market participants obtained confirmation from the Chairman that the change in the discount rate was a removal of emergency accommodation put in place to address the financial crisis and not a sign of tightening of the monetary policy stance.

Overall, Bernanke presented evidence to support the case of an unchanged federal funds rate for an extended period and indicated that inflation will be subdued.  In the Chairman’s opinion, “the job market remains weak” as implied by the high unemployment rate and other related labor market indicators.  Bernanke cited that 40% of the unemployed have been out of work for six months or more in January 2010, which is a sharp increase from a 22.4% reading a year ago (see chart 1).  Conditions of the labor market will play a major role in the likely path of monetary policy in the months ahead.

Contraction of bank lending featured in the testimony, no surprise here.  As chart 2 indicates, the credit machine is not functioning and for self-sustained economic growth, a meaningful rebound of bank loans is necessary.  On the positive side, Bernanke noted that conditions in the short-term markets have returned to the pre-August 2007 levels.

Sales of New Homes Post New Record Low
Sales of new single-family homes fell 11.2% in January to a record low of 309,000. Sales of new single-family homes declined in Northeast (-35.1%), South (-9.5%) and West (-11.9%) but rose in the Midwest (+2.1%).

Inventories of unsold homes rose to a 9.1-month supply (see chart 4), while the median duration to sell a new single-family home rose to 14.2 months (see chart 5).  The median price of a new single-family home fell 2.4% from a year ago to $203,500.  On a year-to-year basis, the median price of a new home has dropped each month from December 2007, with one exception in October 2009.  These are significantly dire numbers which have failed to show an improvement despite the first-time home buyer tax credit of $8000.  The existing homes market has reaped the benefits of the tax credit program.

Source: Asha Bangalore, Northern Trust - Daily Global Commentary, February 24, 2010.

* Asha Bangalore is vice president and economist at The Northern Trust Company, Chicago. Prior to joining the bank in 1994, she was consultant to savings and loan institutions and commercial banks at Financial & Economic Strategies Corporation, Chicago.

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This post is a guest contribution by Rebecca Wilder, author of the of the News N Economics blog.

Forget the Eurozone for just a minute. Japan’s problems are big: Toyota is a major exporter/employer. Last year 48% of all new standard passenger vehicles sold in Japan were Toyotas (or its Lexus brand). The WSJ article describes Toyota’s status in Japan as the following:

In short, Toyota is to Japan what General Motors Corp., in its heyday, was to America. And for a beleaguered country that has suffered a series of institutional blows in recent months - the collapse of the long-ruling political party, the bankruptcy of its champion national airline, a renewed bout of deflation - the global humiliation of Toyota may be the most psychologically damaging blow of all.

Psychological blow, what about an explicit economic blow! Toyota is certain to drag the only Asian G7 economy down, since auto exports are big in aggregate export income.

Japan’s single largest export category in December was, of course, manufacturing: 22% of total exports. And a huge 14% of the total value of exports in December came from motor vehicles (auto sales, that is - separate from parts).

The Japanese economy grew 1.14% in Q4 2009 with a huge 0.67% contribution from exports. The second major contributor was private consumption, which added 0.39%. Going forward, consumption and export contributions are likely to wane from the major Toyota recall campaign that is under way.

First the direct export channel will probably crumble as demand for Toyota cars derails. Second, there will be a lagged labor market effect. Sure, workers will be needed to address the recalls; but the loss in hours stemming from a drop in sales is likely to be much larger, and the net jobs effect negative.

Toyota is a major employer in Japan that currently has 320,808 employees and has already shuttered doors (at least temporarily) in other countries. It’s only a matter of time before the effect hits the home labor market.

This is big. I wouldn’t be surprised if the IMF downgraded its forecast of Japan based solely on Toyota’s misstep.

Source: Rebecca Wilder, News N Economics, February 22, 2010.

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This post is a guest contribution by Dian Chu, market analyst, trader and author of the Economic Forecasts and Opinions blog.

The US dollar rose, commodity prices dropped and stocks fell last Friday after the Federal Reserve unexpectedly lifted an emergency lending rate for the first time since the financial crisis.
The dollar hit an eight-month high against a currency basket, while gold prices rose as investors bought the metal to hedge against paper currencies and debt default risks in Europe. Gold futures ended on Friday with a weekly gain of 3,1% at $1,122.10 an ounce.

Gold’s retreat
Gold rallied to a record $1,218.30 an ounce on Dec. 3, 2009, as near-zero US interest rates and government spending weighed on the dollar, and countries including India and China boosted gold reserves.

However, bullion in the spot market has declined by more than 6% since December, as the US dollar benefited from the unfolding debt crisis in Dubai, Greece and the rest of southern Europe.

New inverse tango with euro
Since gold is primarily a hedge against the dollar and inflation, it typically has the strongest inverse correlation with the US dollar. In the last month, however, the trend has been broken, with gold trending inversely with the euro and positively with the dollar (Fig. 1). The euro has now taken centre stage in dictating the price of gold as it pertains to the fiscal health of Greece and other Eurozone countries.

Fears over the outlook for the euro have been driving investors out of that currency, and lifted both bullion and the dollar as alternative assets. The euro has declined, particularly against the dollar (almost 5%), and gold in euro terms is up 4,2% so far in 2010.

Mariachi - PIIGS & the Fed
The new trend between the euro, dollar and gold is expected to continue amid fiscal challenges in the UK and Eurozone, PIIGS (Portugal, Iceland, Italy, Greece and Spain) in particular. Uncertainty over the details of any financial rescue package for Greece will likely keep the mood in the markets nervous and the currency markets volatile in the near term.

In addition, the Fed’s discount rate hike signals that other central banks will likely follow suit in exiting from stimulus measures, while the Eurozone, UK and Japan will likely lag behind. This view has partly triggered selling of the euro against the dollar and some other currencies to seek a positive yield and perceived safety.

These two factors will likely continue to be the major forces driving the euro’s direction for the rest of Q1, and may spill over into Q2 depending upon solutions to the European Union’s debt problems and dearth of future growth opportunities.

Technicals - short-term mixed
Technically speaking, the short-term indicators of gold are mixed and still trending bearish as gold prices remain in the lower part of its recent trading range.

Technical analysts have widely divergent views as well. For instance, Chartered Market projects gold to reach about $1,400 within 12 months as long as the $1 000 level holds, whereas Barclays Capital considers a “fair value” for gold around the $700 to $800 an ounce level.

Meanwhile, Nouriel Roubini, economics professor at the Stern School of Business, New York University, says that there is a bubble in commodities, and that the price of gold should be no higher than $1 000 an ounce given the current market conditions.

Technical levels of significance would be a breakout above the $1 150 level, which would be bullish, and a breakout below the $1 050 level of support, which would be bearish for the commodity.  (Fig. 2)

Vulnerable to rapid unwind
According to the Commodity Futures Trading Commission (CFTC), NYMEX gold futures open interest increased by 3,2% in January. Commercial traders increased their long positions while holding net short positions. Non-commercial speculators held net long positions but increased their short positions. Overall, about 54% of the participants held net long positions in January. (Fig. 3)

Gold has attractions for those managers of private institutional funds. Many investors from George Soros to John Paulson have been buying gold as lower interest rates and continued money-printing could devalue the US dollar in the long term.

Billionaire fund manager George Soros, for instance, told the financial elite at Davos that gold represented the “ultimate asset bubble“; however, data from SEC filing showed his fund had more than doubled the stake in the SPDR Gold Trust (GLD) three months earlier. In fact, the gold trust is now his fund’s biggest investment, valued at $663 million.

The large number of long speculators playing in the gold market could leave the market vulnerable to a rapid unwinding when sentiment changes - the crowded trade scenario. One can only speculate that Mr Soros could be seeking to exploit this market vulnerability with his seemingly uncharacteristic and contradictory actions.

Other market factors
Furthermore, the gold price direction also hinges on several events about to unfold within the next few months:

1) Greece’s borrowing needs are covered only until mid-March, and the country is set to launch a new bond offering of $7 billion in the coming days - the Eurozone/euro could stand or fall on the success or failure of this bond sale.

2) European finance ministers have given Greece a one-month reprieve to show its deficit reduction plan was being rolled out effectively.

3) Dubai World will present a proposal to creditors in March to restructure about $22 billion of debt.

4) The IMF’s phased open-market sales of the remaining 191,3 tons of gold it planned to sell last year as there are no more official buyers - bearish for gold, unless another central bank steps up.

5) The Federal Reserve will end a $1,25 trillion programme of mortgage-debt purchases in March - gold-bearish as it reduces liquidity.

As ever, gold thrives on financial, economic and monetary uncertainty, of which there is certainly plenty in the world today. Sovereign risk will likely remain the main theme for 2010, and possibly 2011. This all sets the stage for the next five years of monetary and fiscal policy decisions around the globe, which will ultimately define the future for this precious metal from an investment standpoint.

Source: Dian Chu, Economic Forecasts & Opinions, February 21, 2010.

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This post is a guest contribution by Dian Chu, market analyst, trader and author of the Economic Forecasts and Opinions blog.

Amid growing fears of a real-estate bubble, Chinese officials moved to restrain bank lending and rein in inflation by raising China’s bank reserve requirements twice in one month. Global financial markets reacted with risk aversion driving up both the US dollar and Treasuries because of concerns that the leading recovery growth engine of the world could be slowing.

High price & high vacancy In Beijing, the amount of residential floor space sold in 2009 skyrocketed 82% from the year before. Bloomberg reported that Beijing’s office vacancy rate was 22,4% in the third quarter of 2009. Those figures don’t include many new buildings about to open, such as the city’s tallest, the $966 million 74-story China World Tower 3.

In a separate Bloomberg report, an executive from a property advisory firm estimated that roughly 50% of Beijing’s commercial space is vacant today. Meanwhile, according to data from the National Bureau of Statistics, housing prices in China saw a 24% growth spike in 2009. In January, property prices in 70 cities across China rose 9.5% year-on-year, the eighth consecutive year-on-year rise. Standard Chartered also noted in early February that at least seven cities saw land prices triple in 2009.

Dubai x 1,000? What happened is that the liquidity bubble went towards the Chinese property market as developers with access to the $1,4 trillion in new loans last year built skyscrapers and luxury housing.

The surge in lending and strong house prices underscores the concern that the economy is at risk of overheating, and is reminiscent of the US housing bubble. Famous short seller Jim Chanos characterized China as “Dubai times 1,000, or worse,” suggesting that Beijing is cooking its books and manipulating both financial and growth numbers, among other accounting gimmicks.

Bubble call premature Most analysts, however, agree that whatever real estate downturn occurs in China, it won’t equal the crisis experienced in the US.

The issue with bubbles is the lack of an accepted scientific means to properly identify and measure. One way to look at it is to compare the China housing price inflation level with a known housing bubble - the US.

At the height of the US housing boom in mid-2006, prices peaked as much as 90% higher than at the start of their six-year climb. Based on the data from the National Bureau of Statistics, the average home price in China had shot up by roughly the same percentage in the period from 2004 to 2009. Nevertheless, China’s pricing point started at a much lower level than in the US. So, the seemingly equal 90% appreciation does not necessarily translate into the same bubble story.

Koyo Ozeki, head of the Asian credit research group for PIMCO, made a strong case for China’s real-estate market in a recent research report:

“Given China’s potential growth, its real-estate market has plenty of room for enlargement over the long term…”

Ozeki’s view is based on a comparison of the amount of credit extended to the Chinese property sector from 2003 to 2009, equalling 40% of China’s gross domestic product. In the US the figure was 80% from 2000 to 2007.

No US-style bubble Furthermore, the Chinese aren’t exposed to the low-to-no-down-payment loans once popular in the US as down-payments in China average 40% to 60% of the sales price. In other words, the amount of buyer leverage is much lower in China compared with the US, and is less likely to lead to a US-style bubble.

In addition, the US financial crisis was mostly a result of the securitisation of mortgages and the offloading by banks to the markets. This is not part of China’s market structure, which means the impact of a bursting Chinese real-estate bubble would likely be much more muted.

Overblown by short sellers agenda Harvard University financial historian Niall Ferguson points out that:

“Excessively loose monetary policy causes asset bubbles and excessively loose monetary policy is what we have now, it’s a little early to start pointing fingers and calling things ‘bubbles’, however.”

Essentially, the global fear perception of “a sharp new rise of asset prices = bubble” is stoked by the US housing crisis, which ultimately leads to the Great Depression and is used to further Short Sellers Agenda by the likes of James Chanos and others “talking their book” on short positions regarding Chinese investments.

Early intervention is key In the case of any bubble, the sooner the government takes measures, the less damage the bubble can cause to the economy. And Chinese authorities have already taken a series of measures, including a nationwide property sales tax and raising bank reserve requirements, to slow the red-hot market. The message coming out of Beijing right now is that policymakers are becoming more concerned about containing inflation and managing the risk of asset price bubbles. Some analysts also expect more monetary tightening from Beijing in the second quarter.

Long-term challenges abound This is not to say all’s well in China. For instance, high property prices and dim career prospects for the young college graduates (aka ‘ant tribe’) will continue to pose a social economic challenge for Beijing. And economic stagnation would certainly exacerbate this imbalance.

But most of these challenges are long term in nature. If it took almost 20 years for the US subprime mortgage bubble to pop, China conceivably should have plenty of time to still expand while implementing proper policies and measures to prevent a US-style asset bubble collapse.

California & Greece before China So, Jim Chanos’s view of China appears to have some premature conclusions based solely upon flawed analogies with the US real-estate market without taking into consideration the different cultural and market factors.

Meanwhile, in the light of a Bloomberg report (hat tip: Mark Turok) indicating many “money-is-no-object” Chinese investors are travelling halfway across the globe to buy up distressed properties in Los Angeles, California at an average price tag of $3 million, the following should serve as timely advice:

The likelihood of California (and/or Greece) becoming a vassal state of China seems far more imminent than a bubble burst in the East. Place your shorts wisely.

“Reputation is a bubble which man bursts when he tries to blow it for himself.”  ~ Unknown.

Source: Dian Chu, Economic Forecasts & Opinions, February 19, 2010.

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