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 where 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.