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Greece in Hotel California

Greece in Hotel California

Greece was all over the headlines again last week as the deadline for debt talks neared. The Maastricht Treaty, which created the European Union, is starting to sound an awful like the Eagles “Hotel California,” with many in Greece left rethinking, “This could be Heaven or this could be Hell.” The treaty provided a lengthy list of requirements to enter the Eurozone “hotel,” but provides no way to exit, making all members, “…just prisoners here, of our own device.” Greece, among quite a few others, didn’t exactly meet the economic fitness requirements to obtain membership in the Eurozone. The current members were well aware that Greece was essentially doping to get the level of performance required and were all too willing to look the other way. After all, “We are programmed to receive. You can check-out any time you like, but you can never leave!”

 

After Greece made it onto the Eurozone team, things went quite well for a while. The global economy appeared to be performing in tip-top shape and “dealers” for Greece’s performance-enhancing creative debt securitizations were ubiquitous. Now before anyone gives into the desire to finger wag, first recall that parts of the US economy also indulged in such performance-enhancing financial supplements, (housing and now the auto sector). Frankly, pre-financial crisis the proliferation of creative debt securitization on the global stage was a lot like an excerpt from a Lance Armstrong post-2012 doping deposition, “Everyone was doing it. You had to if you didn’t want to be left in the dust.” Pssst, a version of this is still going on today, just ask any company that is juicing its EPS by using newly issued debt to fund stock buybacks such as Apple (AAPL), IBM (IBM), Monsanto (MON), CBS (CBS) and many more.

 

Today, global economic conditions are such that the hills have gotten a hell of a lot steeper, the pavement is full of cracks, there are powerful headwinds, rain flurries and Greece’s pre-crisis performance-enhancing suppliers are no where to be seen. Debt-doping allowed the nation to get away with all kinds of economic sins, gorging itself on regulations and labor laws akin to years of multiple-pint nightly threesomes with my two favorite partners-in-crime, Ben and Jerry, followed by many a lazy day-after spent series-binging on “Ex-wives of Rock” while sprawled on the couch munching on peanut butter Cap’n Crunch out of the box. Now with no “supplements” available, an overweight, out-of-shape and endocrine-exhausted Greece is being told to get pedaling faster and faster on a bike with bald tires, a broken gearbox and gyrating handlebars.

 

You would think that Germany, of all countries, would remember that driving a nation into the economic ground is never a good idea. Most economists and politicians refer to Germany’s understandable fear of hyperinflation but that overlooks the much more relevant and painful lesson from the impossible demands placed on the country post WWI, which destroyed not only its relationship with its neighbors, but also its democracy and ultimately led to WWII. How ironic that the Maastricht Treaty, which was conceived in part to prevent another war between European neighbors, is now the cause of so much inter-European strife!

 

Greece simply cannot pay its debt, which is pretty much its standard operating procedure. According to Kenneth Rogoff and Carmen Reinhart, “from 1800 to 2008, Greece was in default 50.6% of the time,” so angry bondholders, how about a reality check? Last week we mentioned that the nation’s economy had contracted by 26% from 2008-2013, yet it is still managing to remain current on its debt payments while running a primary surplus of about 1.5%. That would be a seriously crowd-pleasing performance on NBC’s The Biggest Loser!  The problem is its creditors want Greece to increase that surplus, meaning ride even faster up that blasted hill! Even Jillian Michaels wouldn’t push that hard.

 

Last Thursday Greece formally requested a 6 month extension after four weeks of brinkmanship, which was quickly returned with an “I don’t think so,” from Germany.  On Friday night a four month interim pact was reached that will once again kick the can down the road, albeit a much shorter road than after previous kerfuffles, conditional on Greece submitting a list of reforms by Monday 23rd.  Greece submitted such a list close to midnight on Monday, which the eurozone commission officials claim contains significant changes from “a more vague outline originally discussed at the weekend.”  One official reportedly said, “We are notably encouraged by the strong commitment to combat tax evasion and corruption.”

 

The Eurozone finance ministers will hold a conference call on Tuesday to determine the acceptability of Greece’s proposed reform plans.  Most likely an agreement will be reached.  The bailout money will continue to come and the European Central bank will continue to stand behind the nation’s banking system.  However, all the finger pointing and accusatory language has greatly damaged relationships and backed both parties into difficult corners.  The next round of talks in four months could be even more contentious.

Banks & the Fed – Bail 'em Out then Beat 'em Up

While shoppers were watching their pennies this holiday season, I was grinching over the relationship between the Fed and the big banks as reminiscent of the abusive relationship between Ike and Tina Turner – bail them out then beat them up with an onslaught of massive fines.  According to a global banking study by the Boston Consulting Group, legal claims against the world’s leading banks have reached $178 billion since the financial crisis, with heavy fines now seen as a cost of doing business, a cost ultimately born by shareholders with no banking employees or executives facing charges for wrong-doing.

All these fines do little to deter wrong-doing in the future while taking money out of the hands of those saving for retirement and give it to the government to spend with zero accountability.


 

Unemployment Problems Persist

Unemployment Problems Persist

Perhaps the reason so few are saving is because the job situation isn’t exactly rosy, nor are income levels. According to the most recent report from the Bureau of Labor Statistic, the unemployment rate has dropped to 6.7% which looks on the surface to be good news. However, if you look a bit deeper, the source of that improvement is troubling. The labor force participation rate, meaning the proportion of the population either employed or looking for employment has continued to drop, see chart at right, and is now at mid-1970s levels. Without the drop in the participation rate, the unemployment rate would be around 13%, rather than just under 7%. Additionally, according to data from the Minneapolis Federal Reserve (see chart at right), the American economy is experiencing the worst performance for labor markets since the Great Depression.

 

Some argue that the decline in the labor force participation rate is primarily driven by the inevitable retirement waves of the baby boomers. However, the chart below illustrates that baby boomers are in fact participating in the work force at a higher rate than in decades.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Along with the grim jobs recovery, household income levels continue to struggle, with income levels close to those 20 years ago, see chart above. Bottom Line: The fiscal and monetary stimulus has been unable to get employment or income levels back to anywhere near the levels enjoyed during the start of the 21st century. So far the impact appears to be more visible in rising prices in the stock markets and more recently rising home prices.

100 Years of the Federal Reserve

100 Years of the Federal Reserve

There was a time when no one, outside perhaps the most esoteric economic geek circles, could name the current Chairman of the Federal Reserve. Those days are now long gone as the Fed has taken a much more active role in the economy and the various Fed Presidents and Chairman have evolved into media cult figures, perhaps less riveting than the latest Kardashian marriage collapse, but financially far more provocative.

 

The Fed’s current focus is clearly helping Uncle Sam reflate out of the government’s enormous mountain of debt. The chart on the next page shows the mountain of debt that has been created by impressive levels of spending from both sides of the aisle for a truly bi-partisan mess. The deficit is now almost three times what it was seven years ago, while debt service costs are at about the same level, thanks to Fed sponsored suppression of interest rates. The Fed effectively has complete control of the market for longer-dated Treasuries, with its holdings of bonds with a maturity greater than 10 years increasing by $154 billion through June of this year, (latest data available from the Fed) to a total of over $500 billion. Meanwhile the total outstanding level of such debt, privately held interest-bearing, grew a measly $9.6 billion for a total of $809 billion.


For those of you who enjoy a monetary policy geek-fest, the following summary of comments from the various speakers at the Cato Institute’s Monetary Policy Conference on November 14th, including current Philadelphia Fed President Charles Plosser may be of great interest. I’ll do my best to keep it lively.

 

Charles Plosser opened the conference with a discussion of how many of the both implicit and explicit limits on central banks around the world have been challenged over the past few decades and most dramatically since the financial crisis. He believes the Fed entered into the realm of fiscal policy when it began purchasing non-Treasury securities such as mortgage-backed securities and referenced Milton Friedman’s warning in 1967 that, “We are in danger of assigning to Monetary Policy a greater task than it can accomplish.” Over the past 40 years, it is clear that we have failed to heed Friedman’s warning, with the Fed doing a poor job of aligning expectations with what it is actually capable of accomplishing. Plosser warned that increasing the scope of the Fed’s mandate opens the door for highly discretionary policies, acknowledging that a rules-based approach is unattractive for the majority of policy makers as it ties their hands.,Discretion is the antithesis of commitment, something most politicians loathe. If the Fed gave itself less discretion, it would be held more accountable. He pointed out that the current climate of guess-my-mood communication on the Fed’s part leads investors to make unwise gambles, as they try to read the mysterious tea leaves of Fed speak, such as the recent market tumult over taper talk.

 

Jerry Jordan, the former President of the Cleveland Federal Reserve expanded on Plosser’s comments, pointing out that the existence of a Central Bank with discretionary power essentially guarantees the emergence of moral hazard with the resulting power to grant permission and regulate with discretion, opening the door to crony capitalism. To large banks, their PACs, (Political Action Committees) are often more impactful on their bottom line than their own management. (Shocker, businesses as well as individuals respond to incentives!) He referenced the Fed’s recent report on the impact of quantitative easing on the economy stating that if there is any relationship between economic growth and quantitative easing, it is a remarkably well kept secret, instigating a round of chuckles from the audience. He pointed out that most economists understand that monetary policy cannot correct the mistakes of the rest of government, even though the Fed is currently doing its best to defy that assessment. He argued that central bank independence is a myth, at least during a financial crisis, because once a central bank takes its first steps to support the economy, there is no way out that does not involve collateral damage. That, by definition, prompts pressure from bureaucrats. He believes that exiting the current zero interest rate regime will be exceedingly complex and it will be impossible to escape without considerable financial market volatility. He seconded Plosser’s assessment of the Fed’s move into fiscal policy, asserting that traditional views of monetary policy and its impact are no longer useful as monetary policy has become fiscal policy. This move into fiscal policy has served to increase market volatility as no one can say with certainty, which entities will receive support during a crisis and for how long. Once again, discretion comes at a price.

 

Cato President and CEO John Allison, (former CEO of BB&T Corp, a U.S bank with over $180 billion in assets) discussed the impact he saw of government actions on his former bank. He pointed out that the Patriot Act and the federal privacy policy are in conflict with each other, leading to discretionary enforcement and application by regulators, which opens the door for corruption. He observed one of the great fallacies of current conventional wisdom is that there was financial deregulation under President George W. Bush which led to the crisis. Instead, Allison stated that there was actually a net increase in regulation if you look at the quantity and complexity of the regulations before and after his term. He believes that regulators greatly exacerbated the panic that hit the markets during the financial crisis by effectively suspending the rule of law and greatly increasing their level of discretion. No one had confidence in just what were the rules of the game, nor was there any clarity on who would be bailed out, who wouldn’t, and at what cost and for how long.

 

Kevin Dowd, Professor of Finance and Economics, Durham University, reinforced John Allison’s assertions, pointing out that the original Federal Reserve Act is about 32 pages long. The Glass-Steagall Act is under 40 pages long. The Volker Rule is just under 550 pages. Dodd-Frank, so far, is nearly 850 pages with most expecting it to total around 20,000 pages or more when all the discretionary bits are worked out. Notice a trend in the timeline here? The more complex the regulations, the more costly it is to enforce them, and to comply with them, creating a bias towards ever larger financial institutions, and increasing the opportunity for corruption.

 

For those of you who’d like a bit more, aside from suggesting you look into therapy as my family reiterates every holiday, I recommend going to this site to watch clips of some of the presentations. Despite the gloomy potential, there were frequent rounds of boisterous laughter, albeit the geeky economist style which I enjoy more than I ought to admit.

Interest Rates and National Debt

Interest Rates and National Debt

Interest-Rates-and-National-DebtThe Federal Reserve has been under considerable pressure to provide details for just how it will control all the excess liquidity that it has created through quantitative easing. The Fed’s balance sheet, which can roughly be thought of as a proxy for the potential money supply, is almost 2.4 times the size it was in 2007. Last month I discussed how excess bank reserves have skyrocketed to nearly $1.7 trillion after having historically averaged near zero since the inception of the Federal Reserve. The Fed has argued that it will be able to slowly raise interest rates and carefully reign in those excess funds to prevent rampant inflation. This is something that has never in history been accomplished, so there is no clear roadmap for how to do this successfully, but for argument’s sake, let’s assume that the Fed is indeed capable. The question then becomes, “How will rising interest rates affect the economy and investing?” One of the largest impacts of rising interest rates will be on the financials of the federal government. The chart above shows the U.S. National Debt from 1950 to 2012 (left hand axis) and the annual deficit/surplus (right hand axis). The current national debt is over $16 trillion. Over the past 5 years, the annual deficit has averaged $1.4 trillion. The national debt as a percent of GDP is almost double what it was in 2007. The annual deficit is 9 times the size it was in 2007. The recent sequester cuts sent D.C. into apoplectic fits with dire warnings of impending doom, however those “cuts”, according to the Congressional Budget Office, represented a decrease in the amount of spending increase that is less than the total increase, which means there will still be an increase in net spending after the sequester, (see Congressional Budget Office “Final Sequestration Report for Fiscal Year 2013” published March 2013). Given the emotional hoopla and doomsday rhetoric, it is reasonable to assume that the current level of deficit spending is unlikely to decrease significantly anytime soon.

The current 10 year Treasury interest rate is about 1.8%. It reached its lowest level in July 2012 at 1.53% and the highest rate was 15.32% in September 1981 when Paul Volker put the kibosh on inflation. The historical average rate has been about 4.6%. The current annual interest payment on the debt is just over $220 billion. If interest rates were to rise to only the historical average of 4.6%, that would be an increase of 2.8%, which would be an increase of nearly $110 billion, if we assume for simplicity that all the new issuance is a 10 year terms. (The reality is that some would be shorter term, some would be longer, and this is just meant to give an approximation to illustrate the magnitude of the impact.) That means interest expense on the debt would increase a whopping 50% in the next year. If the deficit spending continued at about the same rate for the next 6 years, annual debt interest payments would become the government’s costliest expense by 2020. For every year that we continue to deficit spend, increasing the national debt, the magnitude of the impact of rising interest rates increases.

That puts the Federal Reserve into quite a pickle if the economy does in fact gets some legs and inflation ignites. Don’t raise rates and face punishing inflation. Raise rates and D.C. is going to be put under even more pressure to reduce spending. No wonder Chairman Ben Bernanke has been giving subtle indications that he isn’t keen on yet another term as Chairman!

GDP and Corporate Growth

GDP and Corporate Growth

GDP and Corporate Growth

None of the four major components of the business cycle, (real income, sales, production and employment) have managed to get back to their 2007 highs, even now as we enter the fifth year of the recovery. This is truly a record, if an unfortunate one.

The chart above shows the continual stop and go pattern that has been GDP growth since the financial crisis. Never before in modern history has the U.S. experienced this many post-recession quarters without having at least one back-to-back 3% plus growth in GDP.  The first quarter of 2013 was reported on Friday April 26th to have grown by 2.5%, while the second quarter of 2013 is currently forecasted to be below 2%.

Corporate Earnings

As we head into the first quarter’s earnings season, 78% of companies have issued negative earnings preannouncements, the highest percentage of companies issuing negative earnings guidance since FactSet began tracking the data in Q1 2006.

The chart above shows in red, the percent of negative preannouncements by quarter and in green the percent of positive preannouncements with the S&P in blue. This is a troublesome trend to say the least and has us watching the market movement carefully. Eventually, stock market growth must be supported by corporate earnings growth and the trend for the past 11 quarters has been fewer and fewer positive corporate earnings surprises, as this chart clearly illustrates. The quantitative easing objective of driving up stock prices in order to create a wealth effect that leads to consumers and businesses spending more is not translating into better than expected corporate earnings.

 

Federal Reserve and National Debt

It took the federal government around 200 years to accumulate a trillion dollars in debt. Within the following decade it tripled that number, then doubled it again in just twelve years, and doubled it again in another 8 years. Overall the national debt has increased sixteen-fold in just 30 years. Incidentally, this period coincides with the complete delinking of the U.S. currency to the gold standard.

So how are we managing all this debt? In 2013 the Federal Reserve will buy approximately 90% of the country’s issuance of Treasuries and mortgage bonds! That’s one way to explain how a nation facing such a growing mountain of debt, a slowing to stalling economy, and a paralyzed political process is able to maintain such incredibly low interest rates. Treasuries have long been used as the standard for the risk-free rate. With only 10%
of the issuance to float freely in the market, the Fed is able to generate considerable demand for this “risk-free” asset class, driving prices up, which means driving interest rates down.

The massive distortions from the various Quantitative Easing programs have damaged the market mechanisms for understanding the true price of risk, which gives markets an understanding of the appropriate cost of capital. A market that no longer can obtain this information has a big problem, because mispricing of risk leads to misallocation of capital.

The proverbial saying goes that markets love to climb a wall of worry. We’ve seen corporate earnings and revenue growth slow sharply through the past year, with corporate guidance for future performance continuing to be rather grim, yet equities have had quite a run. This is due to expanding P/E multiples as we discussed in last month’s newsletter. This expansion is 85% correlated to the Fed’s ongoing balance sheet expansion, as it is now adding about $85 billion of relatively secure fixed income securities to its $3 trillion portfolio on a monthly basis. Such an enormous level of buying in the markets, leaving only 10% of new issuance available for purchase, is forcing investors into other assets, pushing up prices.

How is this level of Fed activity going to end? David Rosenberg of Gluskin Sheff described the situation well by saying,

“I am concerned over the unintended consequences of these experimental policy measures that have no precedence, but perhaps these consequences lie too far ahead in time from a ‘tactical’ sense, but we should be aware of them. The last cycle was built on artificial prosperity propelled by financial creativity on Wall Street and this cycle is being built on an abnormal era of central bank market manipulation.” January 17th, 2013.

Bottom Line: When one looks over the past 12 years of active Federal Reserve monetary policy in which we experienced repeated bubbles followed by painful pops, why does anyone believe this time will be different? Particularly when this time we experienced monetary activism on an unprecedented scale: we are truly in uncharted waters.

The New, New Normal

I’m fairly certain that when the G20 convened, many of the attendees believed that as a result of their high-minded meetings, some brilliant announcement would be given to the markets and once again the world would be deemed safe, at least for a little while.  Instead, the Cannes meeting ended with no solutions and not even a pledge to find solutions. Is this the new normal?  Papandreou is on his way out, which means the odds for passage of the latest rescue plan are improving, but at this point, that means very little for long-term Greek prospects.

Last week the ECB reversed its rate increase from earlier this year, cutting short-term lending rates by 25 basis points to 1.25%.  This should hardly come as a surprise with the Eurozone economy deteriorating at a faster pace than was expected.  Markit, a global financial information services company, reported that Eurozone GDP fell at a quarterly rate of 0.5% in October with little chance for a pick up in the near term.  Output fell and new order inflows contracted at the fastest pace since June 2009.  Eurozone PMI fell to a 28 month low of 46.5 in October, dropping from 49.1 in September.  This is the sharpest drop since November 2008.

In Germany, whose strength has been keeping Europe afloat, industrial production dropped 2.7% in September, on the heels of a 0.4% drop in August.  German factory orders dropped 4.3% in September.

One of the most concerning trends last week was the rise in Italian bond yields, with the 10 year soaring at one point to 6.64% while at the same time German bund yields dropped 2 basis points to 1.79%.  Italy is rapidly approaching the levels that pushed Greece, Ireland and Portugal into bailout mode, but this time the stakes are markedly higher.  Italy’s economy is the 8th largest in the world and its bond market is the third largest!  That’s a bigger problem that all the aforementioned nations combined and it is highly unlikely that Berlusconi’s majority government will survive.  Contagion anyone?  Over the weekend Italy rejected an offer for IMF assistance, but conceded to intensive monitoring with published quarterly fiscal results.  Talk about too little too late!

It is amazing to think that just 11 days ago, on October 27th, the market soared on promises that the EFSF would magically be expanded and levered up by some as yet still unidentified sources and all would be well in the world!  Once again, China was touted as being keen on getting involved.  Is anyone really surprised at this point that they aren’t?  Then in what can only be described as irony on a global scale, the ECB left China after being rejected and headed over to Japan, who debt to GDP is nearing a mind-boggling 228%, with hat in hand looking for support.  That’s like going to the neighborhood crack dealer in search of rehab options!

Italy is now clearly being targeted as the next bailout candidate, but there just isn’t enough firepower to handle the land of linguine.  It needs to refinance $413 billion in the coming year with market rates currently at levels that it simply cannot afford.  How much more can the ECB take on?  They’ve already bought over $100 billion of Italian bonds since August, with very little impact on yields.

Greece’s default appears more likely and more imminent that ever before and there are entirely too many under-capitalized European banks, which means, systemic risk.  This coming at a time when Italy, (remember that this is the 8th largest economy in the world) will need to refinance $413 billion!  Ah fusilli!

For anyone who thinks that Europe’s woes won’t creep across the pond, keep in mind that between 15% and 20% of S&P500 sales and exports are derived from Europe.  Europe is also China’s largest export market, so this has significant global implications outside of the danger to credit markets.

Bottom line – there is no end in sight to the Eurozone debt crisis and the U.S. will not go unscathed.  To make it even more exciting, countries responsible for half of global GDP will be holding elections in the next year, and we all know how candidates love to take advantage of a crisis and stir the pot!  Volatility and fear will be the norm.  Invest accordingly.

How and Why of Greek Debt

How and Why of Greek Debt

When a nation has more debt than it can manage, it has two options (1) inflate its way out by printing more money or (2) restructure the debt.

Typically the most politically feasible solution is to inflate.  Generally wages tend to keep up to some degree with inflation, so the employed feel as if they are getting a raise and don’t gripe too much.  Those in the population who have debts prefer inflation as the relative “cost” of their debt decreases over time, e.g. with 5% inflation, debt declines in real terms by 5% every year.  It is the savers who suffer most as they watch inflation eating away at what they’ve built – in a converse to inflation reducing debt, savings declines in value by 5% every year.  This is why inflation is often referred to as a hidden tax.

The Europeans cannot inflate their way out of too much debt for the PIIGS as the U.S. is way ahead of them in the race to the bottom and they have conflicting needs across countries.  A monetary union without a political, fiscal and cultural union is complicated at best.  So why the continued kick the can?  The largest banks (German Deutsche Bank, the French BNP Paribas, Société Générale and Crédit Agricole SA among many others) have not increased their reserve capital, which would dilute shareholders, and do not want to take losses on their significant holdings of PIIGS bonds.  The euphemistic “restructuring” of these bonds would by definition require some sort of write down in value for the banks.http://www.insidermonkey.com/blog/wp-content/uploads/2011/06/Who-holds-Greek-debt.jpg

Bank’s hold these bonds as assets on their balance sheets.  They are required to maintain a certain level of assets relative to the amount of loans they give.  If the value of their assets were to suddenly drop, they could find themselves in violation of the regulations concerning this ratio.  As you can imagine – that is not good for the banking sector and lending!  We saw the last time this occurred the credit markets effectively shut down, any type of borrowing was nearly impossible, and the engine of the global economy geared way down.

So how did the U.S. get out of the bog in which the Eurozone is currently mired?  In the Spring of 2009, the U.S. banks were eventually forced to raise hard common equity that was then used to absorb losses on loans.  The fixed income market did bottom out in the Fall of 2008, but when banks sought this equity, their stocks did not wither on the vine, albeit life wasn’t exactly rosy.  Rather than taking this approach, the International Monetary Fund (IMF), the European Central Bank (ECB) and the German and French banks are giving Greece just enough liquidity to roll their debt, not the permanent equity investments that were made here in the U.S.  The Euro approach is just a temporary patch on a cracking dam.  Only when the European banks raise equity, as we did here, and the PIIGS debt is restructured will there be a true resolution.

Q1 Dissapointed, Q2 to repeat?

Q1 Dissapointed, Q2 to repeat?

After the disappointing growth in the first quarter of 2011, many economists believed that the economy would pick up in the second quarter.   At Meritas we looked at the trends in housing (still dropping), employment (fewer employed today than in 2000), income (declining real wages) the credit markets (little expansion), and government spending (fiscal stimulus to decline) and just couldn’t see how the math could possibly work to generate a robust second quarter.  Looks like the economists were wrong, as well an many of the big banks.

JPMorgan revised down their estimate to a 2.5% GDP growth rate from 3%, while Bank of America Merrill Lynch cut theirs to 2% from 2.8%.  Deutsche Bank also cut its forecast to 3.2% from 3.7%.

According to the study by Carmen Reinhart and Kennneth Rogoff, “This Time is Different,”  growth rates are typically subdued after a financial crisis versus a recession induced by other factors.  In addition, when countries reach high levels of debt to GDP ratio, near the 1:1 level as exists in the U.S. and most of the developed countries, GDP growth suffers.

Until employment and housing show significant improvements (and the two are clearly related), we don’t expect to see consistently strengthening growth rates.