Sunday, December 29, 2013

Economic happiness in 2014? - Unlikely

I want to be an optimist for 2014 but it is hard to think that way when you look at the facts of the current US economy. There are positive signs in the current economic environment, but how much of this is truth or just the desire to feel better as we start the year. 

To provide context for 2014, we have to start with the major theme that is overhanging the global economy, deleveraging. We were and are still in a balance sheet recession adjustment process. The data that we have on balance sheet recessions is that it may take more than five years to fix the system. A balance sheet recession needs to work through the excesses in the economy. We are doing it at a rate that is consistent with history. We may not like this but it is reality.

We have followed a growth path of around 2.3% since the beginning of the recovery. We are below the long-term growth path and continue to have a large output gap. This is unlikely to be closed in 2014. Global GDP has been revised down by the IMF to 2.9% in 2013 and 3.6% in 2014. This is not a launch pad for a stronger recovery. 

The labor markets are not in good shape and household income is 9.1% below the highs set in 1999 and still over 8% below pre-recession levels. People are not in better income shape, so the driver of consumer spending is not present. Yes, balance sheets have improved, but this is through belt tightening, lower rates, and bankruptcies which wipeout debt. 

Interest rates are being kept low, but there is a fiscal drag in the US economy. The deficit has moved from over $1 trillion to a level that will be closer to just under $700 billion. Fed employment is declining. State and local job growth is still below past highs. It does not seem likely that we will get any fiscal help over the next year. Regulation uncertainty will provide a drag on growth. 

The forward guidance from the Fed is that rates will be kept low even if we move through the 6.5% unemployment rate. We will see low rates even if we go to 6% unemployment, but that does not mean that monetary policy will help with job creation. 

Inflation is below the 2% target for the Fed. The benchmark PCE is at 1.2% and does not show signs of moving higher in the near-term. Labor cost are low, commodity prices are low, and firms have little pricing power in this economy. The Fed wants inflation but has been unable to create it. 

The stock market does not seem to have the environment necessary for significant increases in 2014. Profits for the third quarter are above 9.5% but revenue ha sonly increased by 2.7% YOY. Net income is at the high end of ranges at 14.9% but sales are only increasing 5% YOY. This means that gains are coming from cost containment and lower interest expenses. This cannot continue forever. The gains in stocks are coming form jumps in the P/E ration not earnings. Risk is at low levels as measure by the VIXX index, but given the level of uncertainty in the markets, it is unclear that this also can continue. 

This is gloomy but it is the reality of what we are dealing with. We can have some good news that will create optimism in markets, but we want to be more careful concerning any view of growth opportunities. 


Tett and conventional wisdom

 A very insightful article from Gillian Tett in the FT on unconventional wisdom since the financial crisis. I will not present all of the arguments but will say that it is a good roadmap on what are the key take aways from the Great Recession.

1. Bigger in banking is not better. We do not need institutions that are too big to fail.
2. Finance is self-stabilizing. Yes, and speculators will always drive markets to equilibrium.
3. Taxpayers are on the hook. Always. we cannot take pain in the modern capitalist economy
4. Leverage matters. Leverage kills financial businesses
5. Liquidity matters. You never have it when you need it.
6. Bubbles must be popped early. Yes, bubbles do exist.
7. Structural solutions not taboo. But that does not mean we will get it right.
8. Shadows should not stay shadowy. There are shadows because markets will try and avoid regulation.

So now we have this information, but that does not mean we will know how to use it.

Larry Summers and lower real rates

There is a growing consensus that the US and the world needs more stimulus for longer. Certainly, this should not be surprising given the size of the output gap that has not been closed almost five years since the bottom of the recession. This is also not surprising given the forecasts provided by those who have looked at past balance sheet recessions.

Forget about tapering, the view from the leading monetary economists is that we have to keep real rates even lower for more years to solve the great potential growth gap. The new theme in macroeconomics going back in time to the work of Alvin Hansen is secular stagnation and the Larry Summers is at the vanguard for stating that more has to be done.

The action which is being called for by Summers is a combination of more classic Keynesian economics. Fiscal policy will be more effective at low interest rates, and monetary policy is needed to keep real rates negative. what is startling about the Summers proposal is that it is very clear on the impact for savers - they should be penalized. Rates should be held down in a manner that would be consistent with the Keynesian view of "euthanizing the rentier class". The only way to close the output gap is make money as cheap as possible to push activity forward. Additionally, Summers is willing to accept the risk of a bubbles as simple cost to get the output gap closed. How can we obtain a wealth effect if there will be maker bubbles that will burst.

I am not sure how this is going to help investment and savings if we accept bubble risk and drive down real rates to unacceptable levels. This is truly unchartered territory that could spell disaster for those who are savers but do not have the skill or funds to adapt to this risky environment. 

Morgan Stanley commodity sale to Rosneft

Morgan Stanley will sell its oil merchanting unit to Russia's Rosneft. Rosneft is the largest oil company in Russia, but is not an independent company in the traditional sense, but one that works for the interests of the Russian state. It would be hard pressed to say that it would make corporate decisions that were in conflict with state policy.

This sale is interesting for two reasons. First, it shows the growing commitment of Wall Street firms to get out of the commodity business. Usually a good sign that we are getting close to the commodity bottom when profit maximizing businesses are throwing in the towel. Clearly, the commodity business has not been generating the returns demanded by share-holders. Second, it is interesting that the sale is to a foreign company that is tied closely to the government. This places key logistical assets and information in the hands of a company that may not be profit-maximizing and that may have goals that are conflict with the US. In fact, it could be argued that this sale will reduce the level of competition in the markets and could lead to actions that will place a squeeze on prices at key market choke points. 

Given all of the actions taken by the CFTC to increase market transparency and competition, it is not clear that this sale will be in the bets interests of the market. It is an alarming trend to see more commodity assets in the hands of state owned companies. Is someone watching the competitive store?

Monday, December 23, 2013

SHIBOR problems affect PBOC credibility

What is going on in Chinese financial markets? SHIBOR 1 month rates are at the highest levels since June, 7.65%. It seems odd that we would have huge seasonal swings in interest rates at the end of the quarter and end of the year for a sophisticated financial system, yet here we are with the PBOC pumping money into the banking system to stave off a funding crisis for smaller financial institutions as they search for funds to meet end of year rate requirements.

We have to go back to the real bills doctrine and say clearly that the central bank has to meet the needs of the financial system even if they want to tighten bank standards. It does not matter that there are significant excess reserves. The money is not getting to those who need it. We know that the PBOC  wants to form a more market determined rate environment, but the funding inside China is lopsided toward the large state owned institutions.

Once a crisis begins, it may be hard to stop, and it will have credibility issues across global financial markets. If China wants to show that it can be  major financial player, the central bank has to take care of its house. 

EU downgrade - who will be left at AAA?

S&P has downgraded the EU to AA+ from AAA. The EU does not have much debt outstanding, but it is hard to think of  an organization that is dependent on 28 countries most of who do not have AAA ratings as AAA-rated. You cannot make the EU as a entity issuing debt more creditworthy than the back stop provided by member countries. This should have happened during the sovereign crisis, so no one should argue that S&P made a wrong call. The only argument is that S&P should have done this two years ago. 

We are running out of AAA-rated countries. Of course, the world may not change dramatically if we do not have any AAA-rated. The "safe" assets will be the ones most highly rated. The US has not suffered from downgrade. The same may apply to the EU.  

Central bank design

Ricardo Reis has written a well organized paper on central bank design in the Fall 2013 Journal of Economic Perspectives. I will outline some of the key features because it provides a good framework for any analyst of central bank policy. When thinking about central bank policy, walk through these dimensions.

Central Bank Goals:

The goals of central bank policy should be the driver of any action or policy choice.

Dimension 1: The strictness of the central bank's mandate - Is it just inflation or doe sit include a dual mandate? The Fed seism to be in transition with a growing emphasis on full employment and systemic risks.
Dimension 2: The choice of long-run goals - So what is full employment and potential GDP? What is the inflation goal in the long-run?
Dimension 3: The potential role of additional short-term goals - There is trade-off between controlling inflation in the long-run versus the short-run. Long-term goals may not be achievable in the short-run
Dimension 4: The choice of central bankers - The move at the Fed is to have more academics and viewer true bankers. This will have an impact on goals.

Central Bank resources and policy tools

Dimension 5: The role of the central bank as a source of revenue - This speaks to the relationship with the Treasury department and central bank independence.
Dimension 6: The importance of fiscal backing for the central bank - Again what is the role of the fiscal  government with respect to monetary policy?
Dimension 7: The set of asset held by the central bank - Should it include just Treasury instruments but other types of assets?
Dimension 8: The payment of interest on reserves - This will determine how the central bank is integrated with other banks with respect to reserve lending.

Transparency, commitment, and accountability

Dimension 9:   The importance of announcements and commitments - What is the level of credibility and how are announcements made to the market?
Dimension 10: Choosing the extent of transparency - How much transparency does the central bank want to have?
Dimension 11: Picking the channel(s) of communication - It can be through minutes, speeches, or actions. The choice will have a significant impact on rates.
Dimension 12: The accountability of the central bank - Who holds the central bank accountable?

Call it the twelve questions, but this is very comprehensive review of the key issues of any central bank.


Taper has started - long live forward guidance

The Fed has made its move and has cut the bond purchase plan by $10 billion a month. The program may end by December 2014. So what does this mean? I don't think any one really knows. So we have a cut of $10 billion but the central bank still buys $75 billion. How does this matter relative to what foreign central banks, hedge funds, and dealers may do?

A gradual change in QE is the only reasonable option for the Fed. A step function makes sense in order to have the market adjust to the change in policy; however, we are not sure when the cuts will start to have a bite on investors. Cutting the balance sheet of the Fed should at some point start to have an impact on excess reserves and rates, but whether at $75 or $25 billion is just a guess. Investors will look for other information to answer the question on rates, and the answer is forward guidance.  The forward guidance is that low rates will continue for much longer that the QE.  

So how is this going to work? The quantity side will change, but trust us the rates will stay low for much lower.  What will be the mechanism for policy? This will be a threat to Fed creditability. It is not clear how policy will work.

When policies clash - ZIRP and deposit insurance premium

It is surprising that policies within a single government may clash, or at least that is what you should expect. The left hand should know what the right is doing. Unfortunately, that may not be the case with central banks. Perhaps this is a good reason why central banks should have only one policy directive.

The Fed is following a zero interest rate policy (ZIRP) in an effort to increase aggregate demand. In fact, the policy is actually to force real rates negative. Simple enough. But if investors deposit money in a bank, the bank has to pay for deposit insurance which could be between 5-7 bps. This means that it could actually cost banks money to have new deposits.

Think about this, you offer the depositor a rate and then lend out the money at a slightly higher rate which will allow you to gain the spread. But the spread will have to cover the deposit insurance so that you will have to offer money at a higher positive spread. If you do not have good lending opportunities, you could actually lose money on new deposits.

Deposit insurance is not free, but regulation can impede the ability of banks to lower rates and still make a profit. Regulation on bank capital, which is needed, can also impede lending and hurt aggregate demand. So what are the right policies? It is more than forward guidance. 

Friday, December 20, 2013

Corruption index shows business is difficult to do



The corruption index for 2013 does not tell a very pretty picture especially when you look at emerging market countries. This has important implications for international finance and the movement of money. There is an ongoing issue of why there are capital flows moving from South to North. Capital should be flowing from developed countries; however, if there is ongoing corruption such that many view that funds are not safe, there will still be movement to developed markets even if returns are lower.

If corruption is lowered around the world, capital will flow more freely to countries that actually need it.

Sunday, December 8, 2013

Is trend-following coming back?


The Economist had an article on trend-following managed futures managers which was not very appealing. The thesis is simple, the poor performance one the last three years is a direct result of the markets being controlled by central banks and politicians who want calmness. With markets in hibernation, there are no trends to exploit. Hence, no returns. 

If you look at the volatility of the major asset classes, you will not find any dispute to this fact. Commodity volatility is near 10 year lows. Bond volatility had spike during the "taper talk" but is not down to low levels. Stock volatility is low as measured by the VIXX index. Foreign exchange volatility is also low. If you are a trend-follower, you need market moves. If no market moves or range, it is hard to make a profit and run big portfolios. Traders will have to move to shorter horizons for trading when volatility is lower, but it is much harder to make money consistently with fast reading. That is especially true if the strategy has a lot of money to invest. 

The next question is who or what is causing the low volatility. Well, if central banks are flooding the market with liquidity to keep short rates low and stable, there will not be a lot of volatility in the markets. The discount factor for any market that is driven by a present value calculation will have lower volatility. This is especially true of the most active futures markets.

So, when will trend-following make some money? My guess is that 2014 will be a better year given the  choice of opportunities. If there is more growth, there will be some good opportunities to gain from the short side of bond trading. If there is a failure of growth, we will see another strong bond rally as the talk of taper is cut. A similar bipolar story will apply to foreign exchange and stock indices. It is easy to say that trend-followers can make money in either up or down markets; however, there is more likelihood markets being on a cusp with respect to growth.

Gary Klein - insights on intuition



I like the work of Gary Klein because it tries to understand the simple problem of how individuals in difficult situations make good decisions. There is no time for optimization or decision trees. There is no time for carefully reasoning of all scenarios with what-if analysis. Decisions have to be made and made quickly. This is the life of a trader, a fireman, or a military officer.

The simple graph above is the focus of the work in this book. Everyone wants performance improvement and there are two ways to get it. You can decrease errors or you can increase insights. Most of the work on decision-making is focused on decreasing errors. There is less work and research on how to increase insights which is where Gary has focused his attention.

The emphasis on decision-making is more focused not on mechanistic forms of error reduction but trying to find insights. Klein provides some very good examples, stories, and theories but it is not easy to form better insights. He focuses on some the basics which can provide insights. What are the underlying assumptions used to make the decision. Faulty assumptions will lead to poor conclusions. A variation of the garbage in and garbage out. Just as important is understanding the knowledge needed or used in a decision, the beliefs that reprints the foundation of a decision, priorities of the decision-maker, and constants associated with a decision. We cannot be mind-readers.



We have to make connections. See contradictions that exist in our views and discard flawed beliefs. Klein believes that we can gain insights through practice and experience. There is a framework that can help with this process. We have to work our insight muscles. 

The changing nature of OPEC


OPECis changing. Not because of the direct failure of the cartel but because of changes in the structure of the oil market. Significant changes in both supply and demand will mean that it will more difficult for OPEC to control price. This will lead to the breakdown if there is not an adjustment in behavior.

It is likely we will see a more volatile 2014 in the oil market. There are four reasons for the change in oil market and OPEC:

1. Declining demand from the US. The US will not be energy independent but strong production in oil and natural gas means here is more supply available to the global market from OPEC countries. The oil has to be sold somewhere and likely at a lower price.

2. New supply form Iran and Iraq. If there is some negotiated settlement conceding nuclear power and Iran this will open up production to the global market. There is still IRan supply hitting the markets but a defreezing of the trade restrictions will cause a jump in supply. Iraq will also be a bigger producer in the next few years. It needs huge sums of money to rebuild the country. Hence, there is a willing seller.

3. Asian demand change. The Asian demand is offsetting some of the decline from the US, but there is a wholesale change in OPEC selling from West to East. This has already begun but will continue to be the key logistic issue in the global market.

4. The Saudi's need for funds. There is a significant need for funds to meet budget demands. A cut in production is good for price but may still have a negative impact on revenue.

The world is changing quickly in the global oil market and some players may not be ready for this change.

Bernanke on financial crises


This is short book of four lectures given at George Washington University. There are no real surprises here as we come to the end of the Bernanke period. He provides a good historical context of Fed behavior and what was tried to solve the Financial Crisis. Summed up, the Bernanke doctrine from these lectures is very simple, the US economy was not going to turn into a second Great Depression on his watch. As an economist with a strong study of the Great Depression, he had a clear view that the Depression was worse because the Fed did not prove enough liquidity. 

When in doubt, provide cheap liquidity - as much as possibly needed. 

After the Music Stopped - the best description of the financial crisis


Alan Blinder's After the Music Stopped - The Financial Crisis, the Response, and the Work Ahead is the best work on the Financial Crisis that I have read. If you have to read one single book on the topic, this is the one. I have closely followed the academic and policy work on the Financial Crisis and this book is very well-written, well researched, and pitched at a level that can be ready by most business people. If there is any academic jargon, Blinder covers the issue with side notes. 

He does a good job of not just reporting the fact, but also provides context with economic theory and his personal views. He also provides even-handed recommendations for solving crises and also provides a good review of the policy changes that have been implemented. 

His argument is that this did not have to happen. Policy mistakes years prior as well as mistakes done in real time made for a bad situation. Still, he is not being a Monday morning quarterback. He provides details on why some decisions were very effective and saved the financial system. After reading this boo, you will feel as though we need Alan Blinder to provide more policy advice to the government. 

Friday, December 6, 2013

Forbes - ways to get rich

The latest issue of Forbes provides a number of good quotes on investment advice. Here are some of the best.

The four most dangerous words in investing are "this time is different."

Invest at the point of maximum pessimism.
-Sir John Templeton

Speculation is neither illegal, immoral nor (for most people) fattening to the pocketbook.

Patience is the fund investor's single most powerful ally
-Benjamin Graham

Never invest in any idea you can't illustrate with  crayon.

Know what you own and know why you own it.

Go for  a business that any idiot can run - because sooner or later, any idiot is probably going to run it.
-Peter Lynch

Time is your friend. Impulse is your enemy.
-John Bogle

Diversification is protection against ignorance.

Risk comes form not knowing what you are doing.

Returns decrease as motion increases.

What is smart at one price is dumb at another.

Time is the friend of the wonderful business, the enemy of the mediocre.

No matter how serene today may be, tomorrow is always uncertain.

The risks of being out of the game are huge compared with to the risk of being in it.

Big opportunities come infrequently. When it's raining gold, reach for a bucket, not a thimble.
-Warren Buffet

Buy into forgotten markets.
-Julian Robertson

As a speculator you must embrace disorder and chaos
-Louis Bacon

The market can remain irrational longer than you can remain solvent.
-Gary Shilling


Rule number one: Most things will prove to be cyclical. Rule number two:  some of the greatest opportuntities for gain or loss come when other people forget rule number one.
- Howard Marks

When you feel like bragging, it's probably time to sell.

Buy on the canons and sell on the trumpets.
-John Neff

Never confuse investing with trading.
-Barry Ritholtz

Never buy anything form someone who is out of breath.
- Burton Malkiel

The time to buy is when there's blood on the streets.
-David Dreman







Sunday, December 1, 2013

Listing and sales geography does not match


The Economist will present some dry tables and graphs each week, but this is one that jumped out at me. If you look closely at the three European stock markets you will notice how little sales comes from the local country. If you add developed Europe you will get something closer to the US and Japan but still not the same percentages. 

These stocks are driven by global growth especially emerging markets. The lag of the EU markets relate to the US is twofold. First, growth in the EU has been slower with it just coming out of a recession, but as important, these markets are driven by the growth in EM which has been slowing. The EM markets have been a drag on global stocks markets. If we see more improvement in EM growth next year, we should see more improvement in EU stocks versus the US. 

The link between sales growth, earnings, and stock valuation is not always close but it is still a primary factor for any valuation analysis. 

When living in the Great Plains was dangerous



The Missile Next Door is an interesting book on the development of the MinuteMan missile system that dotted the Great Plains with nuclear tipped missile all pointed at the Soviet Union. The theory behind the missile build-up was simple. The US Air Force would place thousands of cheap ICBM missile in hardened silos around the mostly deserted plains in order to provide enough nuclear firepower to destroy our enemy even if we did not strike first. 

This project developed swiftly in the early '60's and was a massive construction project that changed the face of the country without much discussion. The people of the US knew this was happening but seemed unable to grasp the magnitude of this project beyond the fact that it created local jobs and was supposed to save the country in case of a nuclear attack.

Could this happen in today? Hard to say, but with lowing information voters anything is possible. It sends chills to anyone who reads this book how easily a democracy can follow policies that can have global ramifications without too much discussion. I am not a fan of how the work was presented by the author. It could have been more tightly focused on the key issues of how this got developed and changed the lives of locals, but it is an important part of our Cold War history that needs to be understood. 

The famine and logistics

Jean Ziegler presents a sad book on our inability to feed the world. He is made about all of the talk and no action. It is a sobering book to read around Thanksgiving. 

Over one billion people are either starving or suffering from malnutrition. Some famine may be associated with the randomness of weather and harvests but most can be prevented. Most is a result of man-made decisions, poor government policies, genocide, and exploitation by companies. Free trade unfettered can destroy local food production. Companies try to cut costs and sell more product. All can have the almost unintended consequence of changing the food distribution patterns.   

Policies like ethanol production substitute food in stomach with fuel in tanks. Subsidies for US and EU farmers make for cheap exports. Control by a limited number of agribusinesses can cause high prices. Government restricts food movements. The IMF and World Bank often follow macroeconomic policies that hurt local food distribution. Ziegler also argues that speculators contribute to the climate of famine. His case is not strong, but he presents enough evidence to tell all of us that more can be down to improve the logistics of agricultural production. 

We should be able to do better. 

Commodity investment demand down?


The demand fro commodities as an investment alternative has fallen significantly in 2013. It seems like this will be the worst absolute decline since number shave been tracked and may be the worst in percentage terms as well. Certainly the poor returns have a lot to do with this decline. Money has moved out of the those asset classes which have declined in exchange for increases in equity exposures which have taken on bubble proportions. Global growth and low inflation expectations have also caused a decline in commodity demand; however, this direction can change quickly. Look at the strong gains in 2009 and 2010. 

While global growth prospects have been quite wide, private forecasters are thinking there will be stronger growth in 2014 in the G3 as well as OECD countries. This could be the driver of a change in commodity demand. 

Tuesday, November 26, 2013

The macroeonomic problem - tell me where I am?

As we move closer to the end of the year, the usual process for any money manager is to develop the themes for 2014. It is unlikely that many will be held accountable for these predictions, but they are made every year. Unfortunately, 2014 is going to be very difficult to predict not because there is currently excessive volatility, but the fact that we have so little agreement on what state of the world we are actually in at this time.

I have given up trying to make close predictions on what may happen to the economy. I try to focus on two simple questions. What is the currency state of the world and what direction are we headed? Get me the place and direction and I will be able to form a good portfolio. I do not have to have too much precision.

So what are the key themes that have to be addressed?
  • Is the economy getting better or worse? We do not have agreement.
    • There seems to be two camps concerning the current economy. There is the rosy school which says that labor and hosting are getting better. Consumer balance sheets have improved and we are ready for stronger growth. The gloom schools says that the headline numbers are false. Labor is in bad shape and there is not the basis for strong demand. Asset markets are in a bubble and not to be believed.
  • Do we have set of policies that we think will work? There is no agreement.
    • Monetary policy through quantitative easing is not working. We need to rely on a forward guidance view that seems vacuous. The solution is to keep real rates negative and drive inflation expectations higher. Fiscal policy as a tool is not being effectively used. The austerity school makes some good point but is not going to serve short-term interests. 
  • Do we know what assets are cheap? Not clear
    • More are believing that we have a bubble in financial markets and are willing to accept this as necessary driving growth higher. How can investors buy into this story?
The theme of uncertainty seems to represent 2014. 

Do we understand contagion?



I picked up the book, Contagious - Why Things Catch On by Jonah Berger because it seems very relevant for following financial markets. There has been a movement in financial research on describing markets as going through periods of cascades or that markets are subject to herding. The idea of market cascades suggests that there are periods when investors in markets will all think the same which will tilt the direction of prices to move quickly to a new equilibrium. A similar story can be developed for herding. Market participants will follow the crowd which will cause momentum in prices. Often these models do not describe how the herds or cascades start. Perhaps Jonah Berger's book would have the answer. Unfortunately, I was not given a clear theory for why this behavior will occur. 

Berger tells some interest tales about how contagious behavior has occurred with some products, but it was not clear why some things catch on and others do not. He offers some reasons for why a product or idea will go viral such as social currency, triggers, emotional resonance, observability, usefulness, and storytelling. All of these describe why something may have got contagious, but it seems hard to believe that any of these can be use to predict the next contagious product. Something can have social currency or a trigger but not take off. There is no predictive model and no good explanation. 

I am looking for something simple yet effective. Tell me why some research takes off and is the basis for adjusted demand in a market. Explain why the tech boom became a bubble? Tell me why everyone wanted to speculate on their house in the first decade of this century. These are real problems which need real answers, but Berger's book does not seem to provide the firepower necessary to offer key explanations. 


Strange Rebels - good history




Strange Rebels - 1979 and the birth of the 21st century by Christian Caryl is a very good piece describing recent current events. It falls into the classic historical view that people change and make events not the other way around. Caryl tracks five rebels, four individuals and one group who all rose to power in 1979 and suggests how they may have had the greatest influence on the world today. This is a thoughtful exercise on the power of the individual to change futures events. The individual matters in changing the course of history but we may not know it at the time.

The focus is on John Paul II, Margaret Thatcher, Deng Xiaoping, and Ayatollah Khomeini. Surprisingly, the most powerful rebels are not the usual suspects like the US president. This is an odd group that range from a staunch capitalist, to a communist, and to religious leaders.

To be a great changer, Caryl describes how all of these individuals are outside the normal culture or tradition of the time. All four spent their formative years outside the traditional ways of thinking that dominated the period in which they grew up. Pope John Paul II was an outsider in the communist system of Poland.  John Paul II had a unique view of nationalism, Catholicism, and anti-communism. Margaret Thatcher was influenced by Ayn Rand during the socialist/Labor period of post-WWII Great Britain. Thatcher was even outside the usual Tory view in the UK at the time. Deng Xiaoping was influenced by the power of market-based economics during the the post Cultural Revolution China. He was ousted from power and had to make a unique ascent to power. Ayatollah Khomeini continued his strong devotion to Islam during the period of secular advancement in Iran. He also was an exile for a long period.

What would the 21st century be like without these four individuals? Without John Paul II, there may not have been the overthrown of communism in Eastern Europe. He drove the process forward and gave the Polish people hope for a better life. He also pushed for a more activist church around the world through his unique use of personality and power.

Margaret Thatcher changed the direction of a failing Great Britain and allowed for the ascent of more capitalist leaning governments around the Western world. Without Thatcher, there may not have been a Reagan Revolution. Again, she allowed for a muscular confrontation with the Soviet Union.

Deng Xiapong led the revolution to the current form of state capitalism in China. He was deeply influenced by pragmatic market solution where there was previously ideology. In essence, his directional change saved billions from poverty.

Ayatollah Khomeini set the transition from a secular Islamic world to one focused on religion and nationalism. What would the Middle East be like if there was a secular Iran? There may not have been a war with Iraq in the 1980's. There may not have been a war with the US? There may not have been a 9/11 event. The would not be state sponsored terrorism through their proxies. Peace in the Middle East?

It is worth thinking about what the world would be like without these four individuals. Certainly, it would not be the world we face today.

Lego group has something to teach



The book Brick by Brick: How LEGO rewrote the rules of innovation and conquered the global toy industry is an interesting read of how a company moved from almost failure to an innovative success story.  David Robertson does an effective job of presenting  avery fascinating story although a don't consider this a great management book. It is not much different from others in the field because it does not seem to give a good sense of the tension inside the company and it moved through the process of becoming more innovative. These issues are never easy. There is failure and internal fighting. How is this company able to get beyond its past? Every companies wants to be innovative and creative but so many fail, why?

The story of Lego is still very fascinating. This is an innovative company which follows some simple rules which could be applied to many businesses. There are seven rules that describe Lego, which are what many companies have tried to follow to different degree.

  • Hire diverse and creative people 
  • Head for blue-ocean markets
  • Be customer driven
  • Practice disruptive innovation
  • Foster open innovation - heed the wisdom of the crowd
  • Explore the full spectrum
  • Build an innovative culture

I will not go through all of the key strategy but to say that all of these strategies are not easy to implement. Take the simple idea of hiring creative and diverse employees. Try and find them and include them in your existing culture. This is expensive and prone to failure. Head for blue-ocean markets. This requires a high fixed cost and potential failure. Be customer drive. Who isn't, yet do you listen to everyone? Clearly, you need innovative management. Can that only occur in a private company? 

What makes Lego different is that it executed on all of these key principles and have embodied these key strategies in their thinking. Few have been able to incorporate more than one of the key rules of current business strategy. They did this one brick at a time. 

Thursday, November 21, 2013

OECD forecasts poor growth

OECD forecast for this year and next are now at 2.7 and 3.6 percent versus 3.6 and 5.8 percent. This is a big revision over the last six months. The global economy is not heading in the right direction in spite of the policies that have been chosen by central banks.

Macro research suggests that this is the time for stronger fiscal policy but there does not seem to be a strong appetite for debt financed government spending and the politician have not made a strong case for it. Nevertheless, there is a growing drumbeat from academic macroeconomics that now is the time for more Keynesian economics. We are in a liquidity trap and need to get out through more spending and printing.

Tuesday, November 19, 2013

Bank regulation on the forefront

ECB announced their efforts to hold new stress testing for banks in the EU. This will be an important test for bank regulators and the quality of the financial system in Europe. It will get at one of the chief problems of the EU and central banks in general, the role of bank regulation and lending. I am becoming more of the mind that the bank lending channel is broken and that further monetary policy efforts like QE will ineffective if do not do a better job of having the bank loan transmission policy work.

The ECB will focus on the three pillars of bank regulation, supervisory risk assessment, asset quality review, and stress testing. All of these pillars are difficult to assess but will still have a critical impact on the money transmission process. If there are more restrictions on bank lending or on capital requirements from these stress tests, the bank lending channel will not work effectively. It will not matter what will be the rate set by the ECB, if banks are required to build their capital base.

The ECB is not alone in looking at bank activity. The Fed proposed new liquidity rules for banks last week. The new Fed liquidity rules will be, as stated by one Fed governor, "super equivalent" to the Basel III standard. The new Fed standards are expected to be implemented much sooner than the EU and Basel III standards. The standards will actually be tougher than what we see in Europe.There is a concern that there be will a limited amount of high quality assets available for banks.

There is also a concern that banks should have more liquidity or assets that can be sold within 30 days. The 30-day survival test is modified for institutions that are above $50 billion and not globally focused and will not apply to small institutions. However, the end result is that institutions who can create scale and diversify will be penalized. The net impact is that you cannot extensively lend to anyone accept the very best credits.

Again, the bank regulation will be at cross purposes with the stated goals of monetary policy which is to have more lending through lowering of interest rates. Interest rates are low and the curve is flat so you cannot make money on the spread in rates and the central bank regulator is forcing you to raise more capital. How is this good for getting money in the hands of borrowers at attractive levels? Capital ratios need to improve but micromanaging the banks is not the way to get this done.

Mark Carney also added new views on how the BOE will help banks. He used the specific words, "we are open for business". Forget about moral hazard, the BOE will provide liquidity to banks when needed. He is arguing that the BOE should be helpful to banks in a crisis and make sure they know that funds are available. This is contrary to the BOE approach of the past which was more suspect of providing funds. The BOE wants to make sure that London is still the global center for banking. They are imposing more regulation but they are also making funds more easily available.

Regulation and central bank behavior is diverging in the post-crisis environment. Some of the choices made are not helpful but there will be room for experimentation. we have to allow for regulation experiments.

Monday, November 18, 2013

What is a hedge?

Life used to be so simple. If you said you were hedging an investment, there would be a sense that most financial professionals would know what your talking about, but that has changed. Unfortunately, the idea of defining terms becomes critical when you talk about laws.

The Dodd-Frank law, which has the Volcker Rule, stops banks from trading for a profit that may place shareholders and depositors at risk. Many could argue that this is a sensible provision, but then you get to the heart of all regulation, definitions. A bank cannot trade for a profit but it can hedge. So the simple question is just defining what is a hedge. Hedges are supposed to protect from a loss. Hence if the underlying investment does well, the hedge protection should lose money. It is not insurance, but it offers protection at a cost. If the underlying investment loses money, the hedge will make money. Since there is usually basis risk with any hedge because the hedging instrument and underlying investment are usually not perfectly correlated, the link between profit and loss may be murky.

Put even more simply, if a bank cannot profit from trading do all hedges have to lose money. A bank may make money on some hedges, but how do you define what that means. There has been some argument by SIFMA that would allow for "incidentally" making money from hedge. As if profits from hedges can be accounted for through dumb luck. The organization hedging may be able to make money if the hedging activity promotes the safety and soundness of the organization. Losing money on hedges does not seem to promote safety and soundness.

It seems like we want to have banks restricted in their activities, so that they can only make money on the interest rate spread between borrowing and lending. This simple firm design is workable in a textbook but does not seem to represent what modern banking is all about. Now if you allow the government to provide complete deposit insurance and you have the largest banks too big to fail, this simple model would seem to be a natural result. You do not want a complex firm taking bets with a government guarantee. 

As a regulators, you would want to simplify the business model so it is easier to monitor. perhaps it would be better to start with the underlying assumptions of deposit insurance and too big to fail. If we reduce or eliminate these policies, then it would not be necessary to micromanage banks. The objective of regulators should be to reduce regulator burden not enhance it.

Melt-up versus melt-down - which is a bigger problem

A "melt-up" not "melt-down" is the new key theme in the financial markets. There does not seem to be any fear of a market decline in the current environment. Call it the Bernanke floor. Rather the fear is that we are headed to multiple speculative bubbles around the world. Look at the strong showing  in the US stock market and credit markets. Given current growth rate, are the current equity levels sustainable?  Are credit spreads at levels that will offset default risk? Are housing prices consistent with economic growth? What about Canada housing and other markets where rates are exceptionally low?

It is well-known that equity markets are not closely tried to economic growth in the short-run. Valuation changes can have a significant impact on prices. Similarly, there is not always a close link between earnings and growth. This, of course, changes in the longer run. This is one of the reason why the melt-up occurs. Investors are not willing to trust the economic number. They do trust the momentum.

The policy of central banks has been to inflate where they can. In this case, financial markets have been the easiest. The idea is simple. The inflating of financial assets will increase wealth which will translate into higher consumer spending or greater investment which will boost growth. This story assumes that the link between wealth and spending is tight. It is not. Additionally, if investors do not believe that the increases in wealth are permanent, there will not be a increase in spending. If businesses do not feel that growth is strong, there will not be a corresponding increase in investment regardless of the level of interest rates. 

We continue to melt-up under the hope that optimism takes over and allows for more spending. It does not feel as though this policy is working.

Forward guidance classification

Mike Woodford provided a classification scheme for forward guidance by a central bank last year. He divided communication into two parts, forecasts and commitments. The forecast, or Delphic guidance, would be the predictions that are produced by the Fed to describe where they think the economy is doing. For example, if the Fed argues that the economy is doing better, there is more likelihood that tapering will occur and rates will go up. The Fed would be providing forward guidance through its forecast for growth. The second type of communication is the form of commitment of what the Fed will do as policy. This would be a clear description of current policy and objectives and operating procedures. Forward guidance on QE would describe how the policy would work in order to reduce uncertainty.

If you form a simple rule, the commitment will tell you what is the reaction function, while the forecast will tell you were you are at with respect to the reaction function. Clearly, commitment communication is much  more important than anything that can be conveyed in a forecast. The fed has not shown any better ability at making forecasts than the private sector albeit knowing what the Fed is thinking right or wrong is valuable.

With Vice Chairman Yellen, the most important signs are those that are related to commitment or what is the policy that is to be expected. Here, we are seeing that policy will be the same as Chairman Bernanke. we can say that forward guidance currently is telling us that nothing with change.

Sunday, November 17, 2013

Yellen on banks and commodities

It is becoming increasingly clear that the Fed really does not want banks in the physical commodity business. Vice Chairman Yellen has argued that there is systemic risk to banks form their commodity activity. The Fed is having a "comprehensive review" which usually means that they want to figure how to regulated banks out of the business. If you increase capital charges on these activities, the Fed can make commodities unprofitable for the banks. Profitability on commodity trading has declined this year, so there is all the more reason for banks to think how to exit this business. 
    
This is going to have a major change in the commodity markets because one of the biggest players will not be providing liquidity. This may be a great time to get more involved in commodities.

Treasury collateral may not be good enough

The CFTC may rule that Treasuries are not not sufficient as collateral for swaps and futures. So much for Treasuries being viewed as a risk free asset. The CFTC is arguing that the collateral may not be liquid enough in a crisis. Hence, there is a need for another collateral source. Seems like the CTFC needs to talk with the Treasury Department about this. This will be a very expensive proposition for investors and traders in the swap market. The higher collateral costs will be passed onto traders at the CME. This will destroy liquidity in these markets. if there is actual for more collateral during or right before a crisis, the impact could be devastating. Even in the post-crisis period, a further increase in collared demands could ensure that the markets will not stabilize. There actually could be more stability in a non-exchnage system whereby a bank could flat a loan to a swap trader who is short collateral in the short-run but has real assets to back any loan. The bank can also provide a line of credit in an emergency that can be based on the specifics of the bank client. This may be better than offering a generic exchange back-stop.

Of course, what would you expect given the falling rating on US debt and the problems with the debt ceiling and shutdown. Is the idea of protecting against systemic risk going too far?

Thursday, November 14, 2013

Interest rates back-up continues



In the land of cheap money, Treasury bond rates are at 2011 levels. The Fed buys $85 billion in order to get inflation up and real rates down yet we have been in a march higher for rates all year. We are seeing inflation fall and real rates rise. This does not sound like a policy that is working. Of course, the answer is that you should see what would have happened if we did not follow this policy.

 So if the policy is not working the logical step is to continue doing more of the same. There is a lag between policy action and response. This is well known, but we do not know what the lag or response to QE  will be. The Fed research suggests that the emphasis is on forward guidance not the purchases. So what is the right policy?

CME rates rising

When you control almost all future trading with no competing exchange and you are supposed to be a profit maximizing company, what do you think you will do with your pricing power? You will raise fees. Yes, anyone who has taken managerial economics 101 knows that you will raise your prices if you have new cost needs. You have network economies and a monopoly from the regulator, so the answer is obvious. This is the first increase in four years, but it shows it has pricing muscle. There are costs and needs for new technology, but all of those costs have to be borne by the traders.


FCM's are falling left and right and the CME is doing better. This does not seem like a very good market environment for increasing the cost of trading. .

Wednesday, November 13, 2013

Purpose of business?

I'm not in the business to make money for the other guy. I'm in business to make money for myself.
 - Sheldon Adelson

This is a quote that many people do not like to hear. Isn't this just the invisible hand at work. We need regulation to control these primal urges, but the grasping for profit through innovation and hard work is what drives an economy and growth. Unfortunately, this is often viewed as a negative. 

Stocks overdone?





The S&P 500 is up over 24 percent year to date which is the third largest rally for the first year of a president's second term. The stock index in up  close to 110 percent since Obama has become president and the rally is now five years old. Whether you should much stock in it or not, this is long rally. Nine of the last 12 bull markets have been less than five years. Valuations are not overly high but the market is also not cheap. This rally is all about cheap money and not cheap profits. As long as the cheap money flows, there will be demand for stocks and this could be our number one worry.

Deflation fears?



This is not what is supposed to happen. If you inflate the Fed balance sheet with QE you are supposed to induce inflation in the economy. Where is it? The gold market is saying there are no inflation fears. Commodity markets in general are also saying there are no inflation fears. The tepid growth and output gap says there is no fear of inflation. Asset markets are the only thing inflating.

So what is a central banker to do? Should there be more QE? One school of thought. would argue that QE has not done enough so we need to continue the program. Perhaps the alternative is relevant. The QE program is not working and we have to try something else to get more growth. Perhaps pro-growth strategies on the fiscal side of the equation?

Sunday, November 10, 2013

Thoughts on power from Plato

Access to power must be confined to men who are not in love with it.

-Plato's The Republic

All goes wrong when starved for lack of anything good in their lives, men turn to public affairs hoping to snatch from thence the happiness they hunger for. They set about fighting for power, and this internecine conflict ruins them and their country.

- Plato

The ancients had it right thousands of years ago. You can apply this view to any of your favorite politicians.

Tuesday, October 29, 2013

Debt growth numbers tell a different story from politics


The national debt per capita over time tells an interesting tale especially when looked at through different presidencies. It is not clear that all large debt increases are the result of Democrat presidents. Republican presidents have done a good job of increasing the size of debt burdens. In fact, the growth during the Obama administration has been slower than what has been the case with Reagan and Bush II. The numbers have jumped more on an absolute basis but the debt increases over the last six years by themselves should not be overly alarming. 

So why are some many getting upset about the debt? There is no such thing as looking at data alone without context. We are getting closer to the tipping point discussed by Rogoff and Reinhart with total debt to GDP moving to levels only seen during war time. Still, we have to remember the large deficits post-2008 were not completely structural. Deficits will increase with economy slowdowns. They should reverse on growth. The problems has been slow growth which does not allow the denominator in the debt to GDP number to drive the ratio lower. 

The context of the debt problem has to be associated with structural issues and here we have a significant problem. We cannot keep all our promises.

Rich countries still love commodities


Business Week provided an interesting graphic on the commodity consumption per capita. Well, it  looks like wealthy economies love their commodites as much as the new emerging markets. We use a lot of  raw stuff" to meet our eocnomic lifestyles We may not get more efficient with wealth. Higher per capita income needs more raw material. 

The commodity story has always been about grwoth in China and other EM countries. They have grown substantially, but their per capita demand is still low versus developed countries. Now some of the data is driven by extraction of natural resources, but it still shows the strong dependency of wealthy economies on commodity usage.

Unemployment false signals and monetary policy




What are the drivers of monetary policy?

Forget about forward guidance. The real focus of traders is knowing what the Fed looks at in the economic data. You can then forecast the underlying economic data and anticipate what will happen with the next Fed move. There has been a lot of focus on unemployment, yet that variable seems to have become a false signal. There is not a 7% unemployment signal to suggest that there will be tapering by the Fed. Or, it does not seem like this will be the best signal for the market to follow.

Vice Chairman Yellen suggests that the labor market is more complex and suggest a more nuanced approach looking at a number of variables. For example, unemployment is declining because labor force participation is falling. The unemployment number is a false signal. Unfortunately, it is not clear how much weight the Fed places on these alternative labor signals.

So we listen to the forward guidance because the Fed will not give us the real guidance which are the variables or triggers used to suggest a policy change. It could be that they are not sure of the signals themselves.

Foreign reserves increasing

Foreign exchange reserves have increased another $28 billion last month to $2.93 trillion. The central bank foreign reserves are just under all time highs of  $2.97 trillion.

The purpose of these strong reserves are clear. Be prepared to stop currency appreciation associated with an ongoing weak dollar. Buy dollars to make sure that currencies levels do not get too high. If there is a run on the short-term lending which leads to currency depreciation or that increases volatility, the reserve can be used to buy-back the currency and stop any hot money funding problem.The use of large foreign currency reverse began after the Asian crisis in 1998.

So much for freely floating exchange rates. Central banks do not really like market determined rates. They do not trust market prices. They trust that bubbles and excessive volatility are more likely to occur in these markets. Currencies should not be trusted to market players. There have have been examples of extremes and hot money, but that has been the exception not the norm. close to $3 trillion in insurance funds against large market moves may be excessive. 

Solving the Euro problem and traders

One of the key problems with the Euro is that the countries in the EU are still not fully integrated. The economy of Germany does not move with the those of Italy, Greece or France. There is still a high level of independence which means that some macro fixes would be best be served through a tailored approach. Spain needs macro help that is not necessary for Germany. If each had the their own exchange rate, the weak countries would see an devaluation while the strong growth countries would see appreciation. This would be predicated on growth and independent monetary policy. That cannot happen in the EU today. The internal economic adjustment from an exchange rate change cannot happen if there is a single currency that moves with overall regional behavior. 

Gita Gopinath, a rising Harvard professor in international finance, suggest a novel solution to this problem that could be handled through using the tools of fiscal policy. If you increase VAT taxes on goods and services and also offer decreases in payroll taxes, you will get the same impact as a devaluation of the currency. This approach can be used by each country in the EU to adjust domestic costs. Goods would cost more from the VAT tax but the payroll tax change for domestic goods would make domestic good more profitable and or cheaper. Imported goods prices would increase relative to domestic goods which receive the payroll tax benefit. There would be a switch to cheaper internal goods which would be the same result as a devaluation. The impact of a currency move without a currency move. There are devils in the details but it is an interesting non-market price solution.

Why should a trader care about this idea? One, it does offer a solution to some of the Euro problems, but more importantly, it provides insight on a major theme on what is happening in international finance. There is more focus on trying to adjust economies without seeing the exchange rate change. We are seeing more effort to impose capital controls to stop currency fluctuations. There are more efforts to provide government assistance, but not outright tariffs, to offset the problem of adverse exchange rates. There is a growing focus on using government policy to solve international problems instead of allowing currency prices to adjust. This is a growing issue that is relevant for traders.Governments want to avoid market solutions.

Thursday, October 24, 2013

Naturalistic decision making and modern finance

The root process for decision-making in finance is the use of optimization and the weighing of expected return through alternative scenarios. Quantitative approaches are the hallmark of any business school education as it is related to finance. Probability weight all alternative and find the expected value. There has been a general focus on trying to move away from any process that cannot be quantified. As evidenced by the strong research on the problems of heuristics and biases, there has been a movement away from decisions that are not processed based. 

Behavioral finance is work on what should not be done in decision-making. Better decision-making will be made through minimizing mistakes. The current work on decision-making does not have a focus on what are good or effective practices, yet in the real world, experience tells us that using short-cuts can be helpful and useful. There is a growing alternative to this process driven decision-making to something that is closer to reality.

A close analysis of real world decision-making shows that the focus for doers is not on considering all options but on using experience to find what is perceived to be the best course of action. Call it a form of satisfying, but most decision-makers do not conduct a full analysis of choices. This focus on choice and experience which can be wrongly classified as simple heuristics by some but has been studied and developed as a school of thought referred to as naturalistic decision-making (NDM). The use of repeated decision-making based on past experiences have been referred to as recognition-primed decision-making (RPD). Gary Klein is a an innovative researcher in this area who has studied decision-making by fireman, pilots, and the US Army. In different situations, the focus has to be on sues that have worked in the past.

RPD focuses on defining the situation, matching to what has been learned in the past, followed by specific action. It may not be the best decision, but it can be one that is effective given the evidence available and the time constraint that requires some action. It is a combination of intuition and real time analysis. Deliberate analysis may be too slow in active rapidly changing environment. Action based on experience and mental simulation is a good choice.


This sounds more like how traders may behave when faced with quick market action. Perhaps there should be more teaching of decision-making based on sues developed from analysis specific situations. This is a fruitful area of finance which has not been effectively analyzed. 

Bumper crop in wheat?



The charts may tell you one thing but the stories on the ground say something different. The latest news out of Canada is that there is a huge wheat crop, a 14% increase over last year and a record 80.8 million metric tonnes. The result is infrastructure that is at the breaking point. Domestic storage is full. Farmers have filled their bins, and you cannot sell it to elevators who do not have space. Crops are being left uncovered on the ground because there is a lack of silage bags. There is a shortage of rail cars to move grain to the coast and once  it gets to export centers there also is no storage. 

Nevertheless, wheat has been trading at a premium to corn.  Kansas City high protein wheat is selling at a premium which suggests that supply is down. There has been a nice rally in the CBOT wheat market.  So what should you believe, the evidence in Canada or actual prices?

Wheat is an international market and other growing areas have not fared as well. Simply put, the primary evidence always has to be the price action.  Excess buyers to sellers cause prices to clear at higher levels. Extrapolative evidence from story-telling may be more harmful than helpful for traders. Facts of inconsistency should not be ignored but the Bayesian prior should always be with the evidence with trends. 

Is there a similarity with the Great Depression?


Very interesting chart crossed my desk which caused me to go back once again to history to search for investment answers. Is the current environment like the 1930's? The simple answer is of course not, but there seems to be a close link between the two time series. We have become much more sophisticated in our understanding of economics and policy options, yet the end result on asset prices seems to be the same so far. The key will be whether we repeat what occurred in 1937. The key take-away from the 1930's is that when monetary and fiscal policy were tightened in 1937,  there was a significant decline in financial assets. If we taper in 2014, will we have the same response in asset prices?

There has been a growing revisionist economic history concerning the Great Depression that is being discussed by who I would call the new economic historical structuralists. Their argument is that the Great Depression was not solved by Keynesian policies, pure folklore given the date of when the General Theory was written. It may not even have been solved by the early policies of Roosevelt. The 1933 Banking Holiday and moving off the gold standard may have caused a significant harm, albeit some form of deposit insurance was helpful. Many of the policies of the New Deal were used to curtail demand and thus arrest the deflation in prices.

A close look at stock prices shows that the markets were recovering before 1933 and the New Deal was not able to get equities back to new highs. Clearly, many of the policies of the New Deal created a safety net for citizens, but they did not get us back to full employment or close the output gap. Social policies are not the same as growth policies. We needed to survive a world war to get back to new highs. 


My take-away from the chart is that the Fed should not pull the stimulus too early. I have also said that zero rates is not a good policy. Is this inconsistent? I don't think so. Liquidity has to be made available so money is available of lending but that does not mean that it has to be at zero rates. Zero rates distort the investment process. Monetizing debt distorts capital markets. Regulations that make it more profitable to lend does not have as much a distortion on lending and growth. 

Wednesday, October 23, 2013

Dollar fall-out is real


The debt ceiling crisis is over, for now, but that does not mean that the standing of the US in global markets has been restored. A close look at dollar flows from BNY Mellon shows that dollar flows have continued its slide. We are near lows for the year. The dollar has declined approximately 5% since the beginning of July. The safe haven status of the dollar may be in jeopardy. We saw the spike in Treasury bill rates, albeit only tens of bps,  but you have to ask why a central bank would hold dollar reserves in this environment. The only answer is that there are no alternatives. Find the alternative and demand for dollar will vaporize. Of course, the dollar is a reserve currency and many say that this could not happen. This is true, but that does not mean that foreign investors and central banks are not planning contingencies.

Harvest is slow relative to last year

USDA crop progress by state for the last week shows that the corn and soybean harvest is slower than last year which is consistent with the late planting this year. The question is how this will affect end production given cold weather is coming. This will add variability to the supply equation which will result in more market volatility.

For corn, 39% of the crop has been harvested versus 53%  average for the last five years.  This is the slowest harvest since 2009. Corn shows 60% of the crop being rated good to excellent.  For soybeans, the latest numbers show 11% harvested which is the worst for the data available since 2007. Last year at this time, 41% was harvested. Crop conditions for soybeans show 53% good to excellent which is better than last year but below the 5 year average.

Precious metals performance mix


The three major precious metals, gold, silver, and platinum, have all followed behavior that that is consistent with expectations in a down market. Silver has seen the greatest under performance. Many view silver as the poor man's gold alternative. Hence, there will be stronger reaction when sentiment turns against the precious metals group (PMG). Silver has a 1.3 gold beta while platinum which has industrial usage come in with a .75 beta to gold.

Commodity volatility is falling


It looked as though there was going to be an increase in commodity volatility in 2013 with gains near the end of the  first quarter, yet here we are in the fourth quarter with a continued decline in volatility in commodity markets. This has been an ongoing trend for five years. Each of the major commodity sectors have also seen the same trend in volatility.


Energy markets have followed the same downtrend. We are at five year lows for energy volatility.


Agricultural markets have been subject to greater spikes in volatility yet have also shown a down-trend for five years.We are off the lows seen earlier in the year, but 2013 will have the lowest yearly volatility relative to the last five years.


Industrial metals have been subject to sharp spikes with the same long-term down trend in volatility.2013 will see the lowest levels in five years. There is the potential for spikes in volatility but the markets have matched the tapered volatility in global GDP.

Monday, October 21, 2013

Commodity sector performance differences



What is driving the poor performance in the commodity markets? A first pass is to break down the sector performance of the DJUBS commodity index. We have looked at the top three sectors: energy, agriculture, and industrial markets. Over the last five years, the energy markets have significantly underperformed ags and metals. This decline is related to the great natural gas decline and n oil market which has been rangebound. Every move up in oil prices has been met with greater supply. OPEC and other producers have done a good job of keeping prices with an tolerance that will allow for continued profits. The last three years have seen stronger energy markets relative to other sectors.

Ag markets have been buffeted with strong strong supply shocks. Grain markets have seen drought last year and then strong production this year. Industrial metals have fallen with the slowdown in China growth.

The "Big Divergence" between equities and commodities


There has been a significant divergence between commodity and equity markets. We have looked at the Ten year period for the MSCI world index, the S&P 500, and the DJUBS commodity index. The pre-crisis period showed that the markets moved in tandem with commodities moving ahead of the equity indices late in the cycle. The markets moved together during the decline and moved together through the initial recovery. The fourth quarter of 2011 showed the beginning of the divergence with 2012 and 2013 showing a continued move in opposite directions. The high correlation of the earlier periods have fallen part and commodities decided to march to its own drummer. 


The difference with the S&P 500 becomes very apparent on  a relative basis. These markets are not correlated and have different driving factors.


The real story has been the strong movement in emerging markets over the last ten years. The increase in prices is orders of magnitude higher. On a relative basis commodity prices look tame over the this period. we will not that the strong increase in EM equities is related to the strong demand for raw materials. 



The divergence between emerging markets and commodities relative to the S&P 500 was significant. Commodities matched the US stock market until the end of 2011.


The more recent performance shows that emerging markets and commodities are now more tightly bound together. This binding between emerging markets is not seen in world equity markets which have fallen relative to the S&P 500 but have still outperformed commodity markets.


The end of the financial crisis has caused commodity markets to move more closely with supply and demand for the individual markets within the commodity index. With slower global growth commodity markets are more subject to supply shocks which have been the hallmark for the current commodity environment. 

The impact of QE on asset prices


The FT had a very good graphic on the impact of QE on asset prices. Beautiful graphics should tell us something profound. What I see here is a QE policy that is having less impact on all asset prices. the markets are just not moved by the same way as the earlier QE programs. The only exception to the trend of lower reactions is with Japanese equities. This is a special case because most of the move is related to easing by the BOJ. 

This is not what the Fed was expecting when they started QE3. The talk of tapering has not addressed the simple fact that the current purchase program is not moving asset prices.