ECB Draghi - "whatever it takes to preserve the euro"

ECB president Mario Draghi stated he would do "whatever it takes to preserve the euro". "To the extent that the size of these sovereign premia hamper the functioning of the monetary policy transmission channel, they come within our mandate."

These are strong words and should make the speculation on what actions will be taken even more heightened. These types of comments add to uncertainty although the message is clear. Forget inflation, the job of the central bank will be to save the euro and drop those sovereign risk premium. The only policy will be to buy those risky bonds from Spain, Italy or any other country that cannot get their fiscal house in order. (The bond buying program was halted in March but it is likely it will begin again.) Though there are comments that countries have to get their fiscal house in order, these comments from Draghi seem like the fiscal side has the upper hand.

The flow away from equities - pensions leave stocks

UK pension survey by Mercer states that equity exposure ha declined by 7 percent in one year to 43% of the portfolio, the lowest level since 1974. A similar UBS survey survey shows the same result. That low level was the period of great abandonment of equities. Over 38 percent of managers in the UK expect to lower their equity exposure while only about 1.4 plan to increase their exposure. 24% plan to to decrease their overseas exposure.

A GSAM survey of CIO's in the insurance industry states that there will be more focus on higher yielding credit and a reduction in cash and European financial credits. There is a reach for yield.

A Bank of America survey showed on 14 % of respondents were over-weighted in equities. The majority have stayed away from equities and focused on fixed income yield.

Pensions are looking for wider diversification and more exotic asset classes and have lost confidence in the normal equity bond balance. 

LNG moving around the world

The price differentials for natural gas around the world is creating some major arbitrage opportunities in the cash market and leading to significant distortions in the energy transportation and logistics market. The demand for nat gas is falling in Europe and rising in Asia. Japan has become a extremely large user given it has closed 48 of 50 nuclear power plants. The result is that that LNG tankers are in shortage as cargoes take the long voyage to Japan instead of Europe. Given some of the contracts in place, there are actually voyages to Europe with nat gas cargoes which are then subsequently sent onto Asia.

The differential between US nat gas and the UK and EU is above 2 times and the number for Japan is even higher at close to 4 times. There are only limited cargoes coming to the US. Given time, the US will be a exporter, and the balance of payments deficit will be eliminated. The nat gas bubble any do more to adjust balance of payments than any government policy.

What happened to currency wars?

There was the belief last year that we were headed to currency wars across countries. More important than the global imbalance story which focuses on flows, there has been a view that currencies, prices, will have to adjust to maintain growth.  The currency war view believes that lowering currency values would provide the necessary boost to exports for the growth of many emerging markets and that countries will use their powers to engineer the decline of their currencies. Government forces not market forces will drive currency prices which will impact exports. 

The war is not necessary if there is a flight to quality to the dollar. The DXY dollar index has gained 13.5% in the last year. While there has been actions taken to provide better currency rates by emerging markets, the flight to the dollar has been the main driver of currency movements especially with respect to the Euro. In fact, some countries have reversed policies to cur currencies and have been concerned about greater declines. Currency wars may be on hold; however, further EM slowdown may have governments again playing with rates.

Rational beliefs can be wrong

The fact that I am wrong, Smiley had once replied ... does not make you right.. 

- John Le Carre  The Honorable Schoolboy

There can be rational beliefs which are consistent with the data and with distribution of  a forecasted series but still wrong. Pointing out the error of logic does not make any alternative better. Multiple views may all be wrong. This multiplicity of errors is one of the great subtle issues in an age of uncertainty.

Libor and collusion - what is the alternative

Reports are that regulators are looking into the rate benchmarks around the world for bank collusion.   It  is likely that they will find it.

The LIBOR issue is determining how to price or set benchmarks.  What is the estimated cost of borrowing versus what are the real costs from "trades" or the actually borrowing deals? LIBOR is determined by a daily poll through the BBA, a private institution. The poll asks banks what would be the cost of borrowing for different tenors and currencies. A number of extreme quotes are excluded and the remaining are averaged. Traders have asked the employees providing the poll information to tilt the rates. If there are fewer banks, the chance for collusion increases. Internal surveys increase the chance of collusion within the bank. The benefits of collusion increase with the size and use of these benchmarks.

There is a real problem here, but what happens if we do not have a benchmark? What can be done to eliminate this collusion issue? Should  the government set benchmarks? Asking for quotes creates the chance for gaming and there are few ways to eliminate incentives for collusion without strong enforcement.

Search for yield and emerging market bonds

With lower inflation rates, emerging market bonds are offering a great bond bull market opportunity. The higher yields also offer a place for generating current income. However, this based on the idea that emerging markets all have higher growth and controlled inflation. That may be harder to guarantee in the next few years.

The correlation between emerging market stocks, bonds and currencies has been broken because the credit differential between many emerging markets countries and developed countries has declined. There is not the same flight to quality between developed and merging markets. There is now flight to quality intra-emerging markets. Still these markets may again become correlated if there is a global downturn.

The demand for emerging market debt has been matched by growth in EM bonds. These fixed income makers are becoming deeper and more liquid. EM fixed income debt has moved from $2 trillion to over  $11.5 trillion since the beginning of the century. The search for yield has created willing buyers. Only the search for yield usually ends poorly.

Pension problems rise

There is record pension and OPEB underfunding for S&P 500 companies. Underfunding totals $357 billion in 2011, $100 billion higher than the previous year and $48 billion higher than the record numbers of 2008.  OPEB underfunding rose to $223.4 billion. This problem is coupled with high expected funding rates close to 8 percent that will unlikely be realized. There is a money shortage and there is no way returns can be generated to close the gap. In response, pensions have moved more to fixed income allocations which will exacerbate the shortfall since current long rates are closer to 1.5 percent. Hedge funds and alternative asset classes may help but they cannot be the solution. We will have to see the end of defined benefit pensions. 

Demographics matter for debt and health crisis

 A recent editorial in the WSJ "What's really behind the entitlement crisis?" by Ben Wattenberg focused on demographics as the root cause of the entitlement debt crisis. Entitlements are where the real risks of a debt crisis not core government expenditures.

Whether social security or health care, the US would be better off if there were more young people. A higher birth rate would help offset the growing demographic problem. This is the same problem facing the EU, Japan and China. An aging population that needs services can only be helped with birth rates which are at or above replacement ( a birth rate of 2.1%).

Social security is ponzi scheme that needs workers to support the system. If the number of workers declines, the workers per retiree will increase and funding will not be available except through increasing taxes. Young workers also are needed to pay for health care. More workers are needed to fund pensions. If there are less workers, the aging population will not be able to be supported.  Pro-natal policies are necessary for a the long run. The other alternative is a higher productivity rate which is not always easy to change.

Higher birth rates will not solve the problem anytime soon, but it is necessary to provide an equilibrium and avoid the long-term fiscal cliff. .   

Fiscal cliff fears rise

A BofA/Merrill Lynch fund manager survey states that 1/5 managers fear the fiscal cliff more than the current European crisis.This could be from a US-centric view, but it also could be that investors believe that the US fiscal cliff is real and can have a strong impact on equities. The timing of this event is known, so the high level of anxiety will increase as get closer to the cliff. The weight on equities and all risky assets will increase. Profit forecasts will decrease. No monetary policy will be able to safe the market from this uncertainty. 

CEO confidence starting to turn

The CEO confidence index from the Chief Executive Group looks at expectations of overall business conditions on a scale of 1- 10. The survey provides a good picture of the change in expectations by major businesses outside of their earnings estimates. The story is consistent with what has been seen in the stock market. The gains early in the year have plateaued and we are now seeing a deterioration in confidence as well as the market. This may not be the bets leading indicator, bu ti provide support to the recent weakness in stocks.

"On the border" with QE3

The recent testimony by Fed Chairman Bernanke suggests that more stimulus is on the border. (South of the Border is the place Bernanke worked as a youth.) The criteria for more stimulus has a set of markers: "loss of economic momentum, downside risks to forecast become pronounced, or if inflation seems likely to run below Committee's objectives". We are headed in the direction of hitting all of these markers.

This is what markets are waiting for. The hope is that there will be something new on  the monetary policy front given the addiction to QE needs more to have a significant impact. Once the QE looks to be ending the market sells-off in an effort as if it needs more to meet its addiction.

There are a number of choices for the Fed: more mortgage purchases, more dollar swap lines to shore up the Euro, lower rates on reserves held by the Fed, a relaxing of bank regulation. Unfortunately, many of these choices are more of the same.

Who says corn does not matter?

This is a great chart on how corn has in impact throughout the economy. This will translate into higher prices across many markets. This shock is not inflationary but will show up in the inflation numbers across countries.

The industrial use of corn has been driven by its cheap price. If the price stays high, substitutes will be found. The changing of the demand curve is always a question of time. How fast will elasticities change for a given shock to price. In the real world, there is movement down the demand curve, a shifting of the demand curve, and a changing of the slope of the demand curve. It is never easy to break apart these changes. This is what makes market analysis so difficult.

Crop deterioration is real

The crop conditions report tells all oft the story why corn has rallied against all other commodities. These conditions move into uncharted territory on what will be the price reaction. Many have been comparing this to 1988, but the corn market was very different at that time. There was no ethanol demand. The industrial use of corn was much less. The demand response will be different in 2012. The magnitude of the price rise and the size of deterioration is such that buyers have not made plans for the future based on current prices. Most will agree that price will decline next year, but buying decisions have to be made now. Production adjustments cannot be made. The yield is in the hands of nature, so the price response will have to be on the demand side.

Negative yields start to take hold

What do all of these countries have in common?

Switzerland

Denmark

Germany

Austria

Netherlands

Finland

They all have negative interest rates for 2-year bonds. Longer-term yields are also below the inflation rate, so they have negative real yields. Debt holders are being punished by low yields. Punished may be harsh language because most of low rate environment is associated with a flight to safety, but if the ECB lowers rates to zero and there is a policy uncertainty, the demand for safety leads to extremes. The demand for the high yielding Treasuries seems almost natural. The yield advantage of Treasuries versus EU rates is high. This is not a sustainable environment for fixed income but there is nothing on the horizon to change the dynamics.

Surprise indices suggest poor growth

Citi US surprise index 

Citi EU surprise index 

Citi EM surprise index

The economic surprise indices provide a good measure of whether the markets have made good forecasts on the economy and whether current information is potentially discounted in the markets. Markets will react to surprises and if there is more bad news surprises on the fundamentals, the markets should decline.

If actual data on the economy is coming in higher than expected, then the surprise index will rise. If growth is coming in slower than what was expected, the index will move lower. The data includes all fundamental information that is related to growth. There are many flaws with this type of approach but he produces a good raw estimate on the direction of the economy. The US, which is rich in economic data, will usually be more volatile than other markets. 

The US surprise index from Citi shows growth declines since peaking early in the year. The same pattern albeit more muted also applies to the EU. Emerging market surprise data has taken a nose-dive, but has now stabilized. The general tone is that analysts have not fully discounted the slowness in the global economy.

Growth policies should matter

"So I would say the recipe for the new European economy is to be as competitive as possible"

- Jean-Claude Trichet 

An interesting comment from the former central banker on the European economy. The policies that have been followed by the EU countries have not focused on competition. In fact, in places like France, the policy moves have been to reduce competitiveness through increasing taxes. In Greece, the move top privatization has not occurred. The same can be said about Italy and Spain. The near-sightedness of solving the fiscal problem has led to a focus on taxes and spending cuts and not pro-growth policies. The classic multiplier will be negative when spending is cut and taxes raised. There also is little talk about cutting regulation. When will pro-growth be tried?

Corn and soybean crops burn-up

Corn prices -nearby futures 

Soybean prices - nearby futures

This has been the seventh driest in history since 1895. It could be the warmest July in 117 years. Worst crop conditions for the week of July 8 since the big drought of 1988. Output for corn was cut 12  percent The soybean crop will be the smallest in four years. 

The weather shock has hit the Midwest sharply and there is nothing famers can do. Is this an over-reaction? With the crop size fairly uncertain, commercial buyers have no choice but to gather as much grain and beans as possible to protect against further shortages. There is no new corn coming on the market until Latin America harvest. This talk may seem premature but but the potential crop shortfall is ill-defined. 

From inflation to deflation - here we go again

German inflation moved down to 2% from 2.2% last month. China inflation is falling on lower food costs although luxury goods have still increased. US inflation looks to fall below the 2% mark, so we are moving back to lower inflation and potential fears of deflation on lower growth. This may not happen if there is a continued price shock in agricultural markets, but the switch back to deflation thinking is again rising. With lower growth expectations, deflation fears will rise.

This gives room for another round of QE. Of course, we do not know the link between money growth and inflation. The link between money and inflation broke-down years ago, so it is hard to argue what will be the reaction to inflation expectations. As long as the output gap is negative, it is hard to argue that inflation will rise significantly. 

Price as allocator of resources

Prices in financial markets serve as important signaling mechanisms. Price is an allocator of resources and it does the job very efficiently. That does not mean that the signals are always right, but the market will respond to the prices that are presented it. 

In commodity markets, price serves two important roles: it is a rationer of demand and it is an incentive mechanism for production. Commodity prices will ration demand. As prices increase, users will cut back on demand or it will look at substitutes to lower costs of production. There will be innovation to increase price efficiency and cut costs. Producers will adjust by making more. The incentives for high prices exist when prices rise. 

In the case of corn, the current price increase will cause feed lot operators to cutback demand. Ethanol plants are not profitable and cutting back demand. Creative destruction is occurring. There is no other option.  Ration will start to occur given the size of the move. The cutback and adjustments will increase if users believe the price increase is not temporary. 

Producers will respond to higher prices and generate more supply. This year's North American corn crop is damaged, but the current high prices is already causing Latin American farmers to think about increasing the size of their crop. The high crop prices will cause famers to again plant as much as possible.

These are simple concepts but there is always a need to go back to basics. The trick is learning ho the prices for s specific market will effect the supply and demand of that market uniquely. This means going down to the micro level and understanding the decision process for farmers. It means looking at market demand and determining how it will change for a given move in prices. Markets become more elastic over time. The question is how much time is necessary to get this adjustment. 

Rationalization and decision-making

"There are always a dozen reasons for doing nothing," Ann liked to say..."There is only one reason for doing something. And that's because you want to." Or have to? Ann would furiously deny it: coercion, she would say, is just another word for doing what you want, or for not doing what you are afraid of.

"Reason as logic or reason as motive?"


- John Le Carre Tinker, Tailor, Solder Spy

Two interesting quotes from a great author. We always just do things because we want to. We often use our logic to explain why we do not want to take action. Once we want to do something, reasons are not required. This leads to the second quote. Do we use reasons as logic or just as our motive or justification? We often use reasons as our justification. How can we tell the difference?

Story-telling and forecasting

Learn the facts, Steed-Sprey used to say, then try on the stories like clothing.


-  John Le Carre Tinker Tailor, Soldier Spy

 This is always a good lesson for any analyst. Get comfortable with the facts associated with the market. What are the numbers? Then start to weave a story around the numbers as presented. Do not work from the story and then find the facts. There can be multiple stories that may fit the facts. They should all be tried to determine what makes sense.

Risk management and fallback

" .. You're right, Con. Karla never does anything without a fallback." "He's a professional , darling," Connie Sachs murmured.  - John Le Carre The Honorable Schoolboy

 The true risk manager always has a fallback. There is a "Plan B". There always is an alternative and that is what makes a good investor. He already knows the exit before he enters a trade and he has already thought through the reasons for why he may change a position.

Knowledge is probabilistic

Knowledge itself is probabilistic in nature, a notion emphasized by some currents of philosophical pragmatism.


- "The uselessness of certainty" Carlo Rovelli This will make you smarter 

We are certain of nothing because as our knowledge changes we can reinterpret the facts of the past. History is alive because knowledge is probabilistic. Economics is alive because our views are adapting with new theories. The Great Depression is being reinterpreted because our knowledge of economics is adapting. 

Do we know what we are doing?

"If we knew what we were doing, it wouldn't be called research." - Einstein

This is a great quote. We engage in research to obtain knowledge. We try to find new fact. Tease out new relationships. Find inferences. This is all part of research and the process often leads to more questions. Researchers are not gods but searchers of the truth. 

Uncertainty and power in arguments

This is why uncertainty is so important. Until we can quantify the uncertainty in our statements and our predictions, we have little idea of their power or significance.


- "Uncertainty" Lawrence Krauss This will make you smarter


The  power or significance of statistical test is critical to our thinking when talking about numbers, but it general is not discussed when making forecasts about markets. Why not?

Uncertainty is central

In fact, however, uncertainty is a central component of what makes science successful. Being able to quantify uncertainty and incorporate it into models is what makes science quantitative rather than qualitative. Indeed, no number, no measurement, no observable in science is exact. Quoting numbers without attaching an uncertainty to them implies that they have, in essence, no meaning.


"Uncertainty" - Lawrence Krauss This will make you smarter


We have to always qualify our level of uncertainty. This provides precision in forecasts. It is not enough to say a stock is going higher or going higher by $5, but rather it should be said that it is going higher by $5 with a certain probability.

Certainty is not good

"There is a widely held notion that does plenty of damage: the notion of "scientifically proved." Nearly an oxymoron. The very foundation of science is to keep the door open to doubt. Precisely because we keep questioning everything, especially our own premises, we are always ready to improve our knowledge. Therefore a good scientist is never "certain".

"The uselessness of certainty" Carlo Rovelli

There is no certainty in markets. Forecasts are wrong and we need to accept that there is little that can be proved or that there is value in fixed rules.

Knowledge and emotions are linked

"Wow!"

"Uh oh!"

"Hmm."

Surprise, curiosity, and interest are the three knowledge emotions. Understanding the link between knowledge and emotions is important because this link drives are decision processes and learning. The issues of behavioral finance are associated with modes of thought and emotions. We cannot divorce knowledge and learning from emotions. We are not computers and this is one of the advantages to our thinking. Accepting these differences will help us understand when our knowledge acquisition goes astray.  

This focus on the importance of the knowledge emotions is from New: Understanding of Need for Novelty and Change by  Winifred Gallagher. When we face something new, our first reaction may be surprise. This is the wow moment. A second reaction may be curiosity that this new thing is somehow different from what is normal or should be expected from our usual thought. This will be a moment of either attraction or revulsion. Finally, there is a true interest or a desire to understand what is new. The process of understanding knowledge is emotional and critically linked together.

This patterns is often on display when there is a surprise announcement in the markets. There is the wow effect. This is a surprise. We are then curious about the surprise and then there is an interest to better understand the details. The market reacts with emotions to wow moments.

The movement from data to wisdom

From Big Dog and Little Dog's Performance Juxtaposition, this was developed form work by Antonio Damasio from  Descartes' Error. It provides a  nice way of looking at the development from gathering data to generating information to putting the information in context for knowledge and then acquiring wisdom. 

This second graph extends the linear development. Starting with data in the form of facts, we can gain information by placing this data in context. Knowledge can formed in either an explicit or tacit manner. Tacit knowledge is usually in the  form of experience. Explicit knowledge may be in the form of what we learn in school through processes and concepts. Knowledge conversion comes from internalization. This process leads to wisdom.

Pension reform risks - lipstick on a pig

Interest rates have fallen substantially which means that the aggressively high discounting rates for future liabilities for defined benefit pension will have to be reduced. If discount rates are reduced, companies will have to take more earnings and plow them into the pension plans to meet their obligations. If this happens, company profits decline. This could spell the end of defined benefit pension. Discounting is currently associated with the discount rate average over the last two years. The recent decline n rates is significant and will have a drag on corporate earnings.

However, there is pending legislation that may be signed into law that will allow the discount rate to be the average of the last 25 years. This will increase the discount rate by over two percent. By magic the new legislation will allow for less contributions into the pension plans because the discounted liabilities are less. Everyone wins with this magic! (Except for the workers when they want their pension and find that the money is not there.)

Pensions have moved away from equity and toward bonds. Pension plans have had 72 percent of their portfolio in equities in 2006 and not have about 52 percent last year. They are more dependent on the low interest rates in current bonds. The impact of these asset allocations may make pension more risky especially if the discount rate is higher. This a problem that will be have to be addressed but not now because of the discounting change.