"Now, stop that whining, Willard!...
Willard, I know this is dangerous, but
if we can save one human life...
Oh, that's the way you feel about,
huh?...
Look Willard, control yourself now...
Listen Willard, according to
this, there's a... Er, how long has that thing been ticking?...
About 5 - 6
minutes, huh?...
Huh?
Oh!... Er... nothing, Willard, nothing... we're
just gonna have to work a little faster than I thought!" - more of Bob Newhart's Defusing A Bomb skit
As I mentioned last week, in this blog I will delve into the United States pension funds as the second in my two part series on Black Swans. As I mentioned before, there are plenty of other problems but these two struck me as the most plausible and threatening of the multitude of issues facing the globe and in particular the United States.
According to a survey conducted by Towers and Watson a consulting firm, the United States pension assets stand at $30 trillion. This is an enormous figure (as are all numbers these days). The problem however is not the size of the number, it is the way that the benefits are calculated.
The first thing we need to do is gain an understanding of how a pension fund works. A pension fund is a legal entity into which tax payers or workers add money and out of which retirees draw payments. Over the years assets accumulate and it is expected that this fund earns returns which offsets inflation expectations and preserves the life of the fund. So there are two things to consider here; first off is how much is being added to or subtracted from the pot in the form of contributions and distributions, and second is what are the expected returns to the asset pile versus the expected payouts and inflation.
The first part to the equation is based on demographic shifts. If you have a large base of young employees and a small base of retirees the incoming payments from the workers more than offset the withdrawals. Once the balance changes withdrawals exceed incoming payments. As the baby boomers are rapidly aging and retiring this shift is happening right before our eyes. Drains are being felt in Social Security and other pension funds that for years have relied on an ever increasing pile of assets to cover the payouts.
In this case the future retirees have to rely on the returns of the assets to cover the expected future payouts. This is similar to a life insurance company which calculates the average life expectancy of the policy holders and then factors in the returns on the policy payments to come up with a cost for the insurance. The problem is that a large number of these pension funds have underestimated the life expectancy of the retirees AND have over estimated the annual returns.
With the rapid improvement in medicine people are living longer and longer. As I mentioned before, the life insurance industry is now running life expectancy tables to age 120. The longer that people live the more that the funds have to pay out. In the past retirees left the workforce around the age of 60 but life expectancy was only 10 years more. Now life expectancy has increased by 50 years but people still expect to retire at 60 and live off their pensions. This is a complete mismatch and spells disaster for these funds as the assets will be exhausted way before the youth of today retire. This problem however is easily solved, just raise the age at which you are able to draw on the fund and voila, instantly fixed. The problem is that this is political suicide so as long as it can be reported that the funds are solvent everyone can brush this under the rug for another year.
So the way to take care of this problem is to produce returns high enough to cover all of the expected withdrawals. At present a lot of these funds have modeled 8% returns. The idea is that you can go out and borrow money around 4% and then earn 8% and the spread will magically cover the future draws on the fund. This is a huge leap of faith and one that is creating an even bigger future problem. Sure this solves the problem of reporting but the gap between actual returns and budgeted returns is large and growing. In the current market environment where the 10-year treasury is yielding only 2%, to think that you can earn a blended rate of return north of 6% is madness. In order to achieve this huge risk has to be taken and that is not a word that should be attached to a retirement account!
The rub is that for the last few years this risk trade has been working admirably. The stock market is up over 100% so achieving these goals has been relatively easy. The problem is that when the market corrects these funds are going to be left high and dry. As Warren Buffet says, "You never know who is swimming naked until the tide goes out." If and when the tide goes out these funds will be left owing not only their retirees but also the investors lending them the money. Essentially these funds in a vein attempt to "protect" the fund have margined the account. Margin increases risk as you are leveraging the asset base to maximize profits. Just like the banks are dong with derivatives. As an interesting side note it came out that when JP Morgan had its "Whale" problem at one point they lost $415 million in one day!
Consensus says that if the government was prepared to bail out GM and Goldman Sachs how could they let the pension fund of say California die? And certainly they cannot, but the burden that this will place on the Federal Reserve would be so extreme that I find it hard to believe that there would not be a market panic far worse than that felt in 2007. Should this ever occur the taxpayer (you and I) would now be footing the bill for government pensioners and this would not be met with open arms, not to mention that the municipal bond market would suddenly be lumped into junk status.
Friday, March 29, 2013
Friday, March 22, 2013
A Ticking Time Bomb
"Now, you're perfectly safe, Willard, there's nothing to worry about as long as
it's ticking...
Er, when it stops ticking, that's something else again, Willard.
Now, listen Willard, get control of yourself...
You and I are going to disarm that thing...
I've got the instruction manual...
Well, no! I'm not coming down there, Willard...
Well, I mean I can't just leave the office anytime I want to!...
NO!!!...
DON'T BRING IT IN HERE, WILLARD, NO!!!" - An exert from Bob Newhart's skit on Diffusing a Bomb
Nassim Taleb, the world famous crisis trader, looks for Black Swans. His theory is that there is only one thing we can be certain of and that is there will be another collapse. He has no idea where or when or how but he knows that the markets will at some point in time take a nose dive. As such, rather than try to time the market he bets all the time on the market dying. Normally he losses but the days when he wins he wins so big that it takes care of the losses and makes him a lot of money.
Now a Black Swan event is an event that is completely unknown and therefore takes the markets by complete surprise however some times there are things that build to a point where it is relatively obvious that this is a problem but for some reason the markets choose to ignore them (think greed or fear). Take as an example the NASDAQ bubble or the housing bubble, these were pretty obvious to see. These bubbles do not derail the markets while they are held together, but when they burst the Black Swan is discovered and this has catastrophic consequences on most portfolios.
To me there are two very obvious problems that unless resolved soon will rear their ugly heads at some point in the future and will make the housing problems look tame. The first is derivatives held off the balance sheets of the major banks of the world and the second is the underfunding of US Pension Funds. I will deal with the first in this blog and will return to the second next week.
Derivatives are contracts written against an underlying asset. For example you can write an option to buy a house at a specified price and at a specified time. The seller of this option pockets the premium that is paid to the buyer giving the buyer the right to buy the house. This option has value all the way up to the exercise date when if the value of the house is less than the price agreed to in the option the contract is worthless. In this example this option really creates no problem or concern.
Now what if we magnify this derivative, create ever more complex derivatives and start to sell them in truck loads? In fact forget about truck loads as that is too small, what if we sold them in trillions? Well that is precisely what has happened. The notional value of the over the counter derivatives market is roughly $650 trillion. Yes that is not a misprint. The vast majority are derivatives related to interest rate swaps but there are derivatives written on essentially everything. I will not go into detail about this market but suffice it to say this is an enormous market which is largely unregulated.
Now I have been watching a show on TV about the planets and the big bang theory and one thing rings true about that as with this market. Big bang theory states that everything came from nothing for the simple reason that for every positive energy there has to be a countering negative energy. The one offsets the other and sums to nothing. Well the same is basically true in the derivatives market. While the notional value is $650 trillion one side offsets the other so the actual value is relatively small. For this reason there is not a lot of press on this subject and banks are able to push the risk off their balance sheets. This is fine while everything is working well, but what happens when the market has its next Black Swan event?
Years ago I worked on the Enron bankruptcy, not at Enron but at Aquila energy. When Enron went down the derivative contracts that were written were taken under the control of the bankruptcy court and the rules in bankruptcy court are very different from those on the exchanges. The bankruptcy code said that any contract where Enron was making a profit they could keep the money and any contract where Enron was losing they could get the money back from the counter party. The chain was broken and it took Aquila down. This is a small example but you can see that should any one of the major banks have a problem it will have the effect of dragging the others down.
This is why when Lehman and AIG went down the Federal Reserve was required to come to their rescue as without their guarantee to protect these contracts the notional value, not the netted value, is what comes into play. Remember that during the housing bubble $30 trillion of global wealth was created and vanished and we are still dealing with the mess. Taking this number to $650 trillion is a number that is far too large even for a unified global effort to repair.
The problem is that unless this market is more strictly regulated banks will continue to add to their portfolio of derivatives creating a larger and larger problem. If history is anything to go on then it will only be after the fact when the regulation will be enacted. By the way the regulatory environment was put in place after Long Term Capital Management went down but the Glass-Steagall Act was repealed in 1999 and since then it has been another Black Swan in the making.
Er, when it stops ticking, that's something else again, Willard.
Now, listen Willard, get control of yourself...
You and I are going to disarm that thing...
I've got the instruction manual...
Well, no! I'm not coming down there, Willard...
Well, I mean I can't just leave the office anytime I want to!...
NO!!!...
DON'T BRING IT IN HERE, WILLARD, NO!!!" - An exert from Bob Newhart's skit on Diffusing a Bomb
Nassim Taleb, the world famous crisis trader, looks for Black Swans. His theory is that there is only one thing we can be certain of and that is there will be another collapse. He has no idea where or when or how but he knows that the markets will at some point in time take a nose dive. As such, rather than try to time the market he bets all the time on the market dying. Normally he losses but the days when he wins he wins so big that it takes care of the losses and makes him a lot of money.
Now a Black Swan event is an event that is completely unknown and therefore takes the markets by complete surprise however some times there are things that build to a point where it is relatively obvious that this is a problem but for some reason the markets choose to ignore them (think greed or fear). Take as an example the NASDAQ bubble or the housing bubble, these were pretty obvious to see. These bubbles do not derail the markets while they are held together, but when they burst the Black Swan is discovered and this has catastrophic consequences on most portfolios.
To me there are two very obvious problems that unless resolved soon will rear their ugly heads at some point in the future and will make the housing problems look tame. The first is derivatives held off the balance sheets of the major banks of the world and the second is the underfunding of US Pension Funds. I will deal with the first in this blog and will return to the second next week.
Derivatives are contracts written against an underlying asset. For example you can write an option to buy a house at a specified price and at a specified time. The seller of this option pockets the premium that is paid to the buyer giving the buyer the right to buy the house. This option has value all the way up to the exercise date when if the value of the house is less than the price agreed to in the option the contract is worthless. In this example this option really creates no problem or concern.
Now what if we magnify this derivative, create ever more complex derivatives and start to sell them in truck loads? In fact forget about truck loads as that is too small, what if we sold them in trillions? Well that is precisely what has happened. The notional value of the over the counter derivatives market is roughly $650 trillion. Yes that is not a misprint. The vast majority are derivatives related to interest rate swaps but there are derivatives written on essentially everything. I will not go into detail about this market but suffice it to say this is an enormous market which is largely unregulated.
Now I have been watching a show on TV about the planets and the big bang theory and one thing rings true about that as with this market. Big bang theory states that everything came from nothing for the simple reason that for every positive energy there has to be a countering negative energy. The one offsets the other and sums to nothing. Well the same is basically true in the derivatives market. While the notional value is $650 trillion one side offsets the other so the actual value is relatively small. For this reason there is not a lot of press on this subject and banks are able to push the risk off their balance sheets. This is fine while everything is working well, but what happens when the market has its next Black Swan event?
Years ago I worked on the Enron bankruptcy, not at Enron but at Aquila energy. When Enron went down the derivative contracts that were written were taken under the control of the bankruptcy court and the rules in bankruptcy court are very different from those on the exchanges. The bankruptcy code said that any contract where Enron was making a profit they could keep the money and any contract where Enron was losing they could get the money back from the counter party. The chain was broken and it took Aquila down. This is a small example but you can see that should any one of the major banks have a problem it will have the effect of dragging the others down.
This is why when Lehman and AIG went down the Federal Reserve was required to come to their rescue as without their guarantee to protect these contracts the notional value, not the netted value, is what comes into play. Remember that during the housing bubble $30 trillion of global wealth was created and vanished and we are still dealing with the mess. Taking this number to $650 trillion is a number that is far too large even for a unified global effort to repair.
The problem is that unless this market is more strictly regulated banks will continue to add to their portfolio of derivatives creating a larger and larger problem. If history is anything to go on then it will only be after the fact when the regulation will be enacted. By the way the regulatory environment was put in place after Long Term Capital Management went down but the Glass-Steagall Act was repealed in 1999 and since then it has been another Black Swan in the making.
Friday, March 15, 2013
A Way Out
"The only thing that's correlated 10% with job creation - and particularly good job creation - is business investment. It is our reduced level of capital investment that has produced our low GDP growth rates and our high unemployment." - Fred Smith CEO of FedEx
By any metric the economy is sputtering. The economy barely grew in the last quarter and unemployment levels are still elevated. All of this comes more than four years after the Great Recession began and after more than $3 trillion of stimulus. This is the largest stimulus ever undertaken and still it is like throwing a bucket of water onto a forest fire, eventually the forest fire will die down but the bucket of water is not making much of an impression. For a better understanding of why this is let's take a look at some basic economics (I know it may seem tedious but I am sure you will learn something so bear with me).
Basic economic accounting will show that the total amount of savings in an economy must equal total real investment in the economy. There is no other possible way for this relationship to exist as remember that real investment is net of any debt. So increasing real investment will result in economic expansion or in other words increasing total savings will result in economic expansion.
Let's first look at Foreign Savings. Foreign Savings is a bit of a misnomer in that this amount is subtracted from savings. The more that is imported the lower the savings rate. For this reason governments try to stimulate exports which is normally done by weakening the exchange rate so that exports become cheaper and imports more expensive. The problem is that countries around the globe are all trying to do the same thing so this is being met with limited success. It is also clear why China, who for decades kept their exchange rate low, ended up with such a huge foreign capital savings balance.
Now we will turn to Government savings. Well if ever there is an oxymoron this is it. Government and Savings are two words that should be the first and last words in the dictionary they are so far apart. The problem is that in this equation there is no way for everyone to be a saver and the Keynesian economists will argue that during weak economic times it is imperative that the government be a net spender in order to absorb the increased level of saving from the private sector. This recession has been particularly bad for the simple reason that the private sector took on too much debt and this debt is being offloaded at a very fast pace. If the government tried to save as well, the corrosion to the economy would be such that an economic implosion would surely have happened. However the Keynesians take it a step further saying that it is this increased savings is what causes the recession.
Their theory is that if you lower interest rates and force consumers to stop saving that this will result in an expansion to the economy and all will be well. For this reason the Federal Reserve is holding interest rates down, taxing savers and throwing huge sums of liquidity into the market. The problem is that all this is doing is promoting speculation rather than investment. The reason for this is that the Keynesians pay little attention to the productivity of the spending but expect that government spending and investment works just as well as private investment and spending. I don’t know about you but I have never seen a government that spends money as efficiently as private business.
The next problem with the way that the Federal Reserve is handling the issues is that during a recession the normal mix of goods and services demanded changes. Goods supplied are suddenly not wanted or not affordable so there is a buildup of unwanted inventory. Until the system changes through innovation this unwanted inventory sits idly on shelves taking up valuable investment dollars. Pumping money into the system without targeting proper investments such as factories, equipment, research and development and capital goods that are demanded by the consumer is just promoting more of the same and is wasted. Furthermore without targeting the benefits employment levels remain low.
In order to stimulate an economy real investments must be stimulated which unfortunately is not being done. Paying people to remain idle or buying toxic debt has not, is not and will not help the general economy. It has the effect of helping a select few at the expense of the majority. While the quote above is fairly accurate the actual level of correlation between domestic investment and unemployment is roughly 80% (not 100% quoted). Stimulating direct investment therefore would have a profound effect on the unemployment rate however it appears that companies are currently reducing domestic investment. The result of this will surely be a higher unemployment rate in the near future the exact opposite of what the Federal Reserve is trying to achieve.
So in order to get this economy in gear government spending should be targeted on increasing direct investment. This can easily be done through things such as investment tax credits, accelerated expensing of investments, R&D incentives and other similar programs that I have mentioned in previous blogs. Until current policies target the issues the only people that will be rewarded are the banks and the few that speculate on the markets. This is not a sustainable solution as trying to stimulate an economy by taxing savers with low interest rates has proven time and time again. So although Mr. Bernanke and his cohorts are patting themselves on the back as the market reaches all time highs it is definitely time to defend your investments or understand that you are now not investing but joining the market of speculation.
By any metric the economy is sputtering. The economy barely grew in the last quarter and unemployment levels are still elevated. All of this comes more than four years after the Great Recession began and after more than $3 trillion of stimulus. This is the largest stimulus ever undertaken and still it is like throwing a bucket of water onto a forest fire, eventually the forest fire will die down but the bucket of water is not making much of an impression. For a better understanding of why this is let's take a look at some basic economics (I know it may seem tedious but I am sure you will learn something so bear with me).
Basic economic accounting will show that the total amount of savings in an economy must equal total real investment in the economy. There is no other possible way for this relationship to exist as remember that real investment is net of any debt. So increasing real investment will result in economic expansion or in other words increasing total savings will result in economic expansion.
|
I
|
=
|
(Y - C - T)
|
+
|
(T - G)
|
-
|
(M - X)
|
|
Gross
|
|
Private
|
|
Government
|
|
Foreign
|
|
Investment
|
|
Savings
|
|
Savings
|
|
Savings
|
Let's first look at Foreign Savings. Foreign Savings is a bit of a misnomer in that this amount is subtracted from savings. The more that is imported the lower the savings rate. For this reason governments try to stimulate exports which is normally done by weakening the exchange rate so that exports become cheaper and imports more expensive. The problem is that countries around the globe are all trying to do the same thing so this is being met with limited success. It is also clear why China, who for decades kept their exchange rate low, ended up with such a huge foreign capital savings balance.
Now we will turn to Government savings. Well if ever there is an oxymoron this is it. Government and Savings are two words that should be the first and last words in the dictionary they are so far apart. The problem is that in this equation there is no way for everyone to be a saver and the Keynesian economists will argue that during weak economic times it is imperative that the government be a net spender in order to absorb the increased level of saving from the private sector. This recession has been particularly bad for the simple reason that the private sector took on too much debt and this debt is being offloaded at a very fast pace. If the government tried to save as well, the corrosion to the economy would be such that an economic implosion would surely have happened. However the Keynesians take it a step further saying that it is this increased savings is what causes the recession.
Their theory is that if you lower interest rates and force consumers to stop saving that this will result in an expansion to the economy and all will be well. For this reason the Federal Reserve is holding interest rates down, taxing savers and throwing huge sums of liquidity into the market. The problem is that all this is doing is promoting speculation rather than investment. The reason for this is that the Keynesians pay little attention to the productivity of the spending but expect that government spending and investment works just as well as private investment and spending. I don’t know about you but I have never seen a government that spends money as efficiently as private business.
The next problem with the way that the Federal Reserve is handling the issues is that during a recession the normal mix of goods and services demanded changes. Goods supplied are suddenly not wanted or not affordable so there is a buildup of unwanted inventory. Until the system changes through innovation this unwanted inventory sits idly on shelves taking up valuable investment dollars. Pumping money into the system without targeting proper investments such as factories, equipment, research and development and capital goods that are demanded by the consumer is just promoting more of the same and is wasted. Furthermore without targeting the benefits employment levels remain low.
In order to stimulate an economy real investments must be stimulated which unfortunately is not being done. Paying people to remain idle or buying toxic debt has not, is not and will not help the general economy. It has the effect of helping a select few at the expense of the majority. While the quote above is fairly accurate the actual level of correlation between domestic investment and unemployment is roughly 80% (not 100% quoted). Stimulating direct investment therefore would have a profound effect on the unemployment rate however it appears that companies are currently reducing domestic investment. The result of this will surely be a higher unemployment rate in the near future the exact opposite of what the Federal Reserve is trying to achieve.
So in order to get this economy in gear government spending should be targeted on increasing direct investment. This can easily be done through things such as investment tax credits, accelerated expensing of investments, R&D incentives and other similar programs that I have mentioned in previous blogs. Until current policies target the issues the only people that will be rewarded are the banks and the few that speculate on the markets. This is not a sustainable solution as trying to stimulate an economy by taxing savers with low interest rates has proven time and time again. So although Mr. Bernanke and his cohorts are patting themselves on the back as the market reaches all time highs it is definitely time to defend your investments or understand that you are now not investing but joining the market of speculation.
Friday, March 8, 2013
The Shell Game
"If you can't define a winning exit strategy for the American people, where we somehow come out ahead, then we're wasting our money, and we're wasting our strategic resources." - Jon Huntsman, Jr
"My main expertise is in the past, but if I have to extrapolate into the future, I would say: no good news any time soon and an obvious exit strategy is not apparent." - Juan Cole
In my view and in the view of many others, the globe's debt problems have spiraled to a level that is near uncontrollable. Worse still is that it appears the globe’s economic recovery is firmly wedded to this stimulus and if it is turned off the so called recovery will fall flat on its face causing untold grief. So unless something is done about the ever growing swell of debt and soon, the world will be hit with a tidal wave that will be more devastating than anything we have ever witnessed before.
The central bankers of the world have decided that printing more money is the solution to all of our problems (personally I think that they are boxed in but I have gone over that in previous blogs so there is no need to go down that road again) and that they will all be able to mop up the excess money supply if and when inflation rears its head. To me this is the biggest Shell Game ever played!
For those of you who do not know, a Shell Game comes from ancient times and is still played today. Essentially the “banker” places a stone under three similar shells. With much dexterity he moves the shells around in an attempt to confuse the gambler. Once he stops moving them around the gambler chooses a shell and lifts it up. If it reveals the stone then he wins and if not the ‘banker” wins. The problem is that the “banker” often uses sleight of hand to remove the stone so that no matter which shell is chosen no stone is present. Worse than that, an adept trickster will suck the unknowing gambler in by “letting” him win a few times and then, as he bets big on a sure thing, removes the stone taking the gambler for a big lose. Not only therefore is the game risky for the gambler but the “banker” also risks his neck if he is caught manipulating the game.
Jump then to the central bankers of the world who are printing money hand over fist in an effort to stimulate the economies of the world. The first problem is that their efforts are not resulting in much upside. In fact as more and more debt comes onto the market there is less and less of a benefit but even as the wall turns into a mountain they keep adding more. History has shown us that in these times it is just a matter of time before inflation kicks in and then it becomes hard to stop. In the past it was almost impossible to control and that was with less than a trillion dollars printed but today globally we are north of $20 trillion and climbing!
Now according to the central bankers they will mop up the excess in no time, staving off uncontrolled inflation, creating an environment that is business and investor friendly – just trust us! One thing I am convinced of is that this will not happen, they are the “banker” in the Shell Game and they have removed the stone. So the real question is why is inflation still so tame?
As the global economy is weak and everyone is trying to debase their currency things have remained relatively well under control. Furthermore there is a perception in the markets that the central governments of the world actually do have things contained and that “this time it will be different”. When consensus changes and the players lift up all the “shells” and discover no stone is when things get ugly. When this change in perception happens is anyone’s guess but it will happen.
Personally I believe that it will be a two step process. My thought is that the first indicator will be a massive sell off in the stock markets and that this sell off will be caused by the realization that the central bankers are eminently going to stop printing money as there is no further perceived benefit. Once this happens, bond yields will remain muted for a relatively long period while stock investors look for safety but once there is a perception that inflation is starting to move out of the control of the authorities yields will start to move and inflation will take control of the globe’s economies.
So what to do in the interim? Well the only thing that is truly working is that the markets of the world are going through the roof. As you know I have advised against playing that game particularly without a solid economic basis for the rally. To me you are playing the Shell Game and you know that there is no stone! Once the market loses faith that the support that is quantitative easing is being removed, then watch out below. This is too big a risk for most to bear so keep out of the way of the train wreck to come. For those that do want an allocation to the market and believe that inflation is just around the corner then gold would be a good place to go, particularly after the recent bloodletting that has occurred in these stocks.
Properties were a good bet a year or two ago but they are looking pretty frothy now particularly when you factor in the affordability numbers. While these were favorable a year ago, with the tax increases taking effect it will take numerous buyers out of the market and this is not a market that can continue to be supported by speculators. While I do not expect property prices to collapse as low interest rates will keep prices buoyant I do not expect property values skyrocket from here.
Your best bet is to stick to short term secure investments that produce a relatively good yield. As an example and not that I am suggesting that these are bullet proof by any means but the Venezuelan Oil Bonds are yielding over 11% and mature in 2014. This appears to be a relatively good investment as a short term option. Looking around there are others that have less risk and provide good rates of return but in all honesty you will be lucky to earn more than 4% on a two year investment. The point is to keep your powder dry so that when things are blitzed that you are able to take advantage of the opportunities and that is where you really will be paid for your patience. Rather give away some upside to protect against a massive capitulation. So whatever you do take my advice and do not get sucked into playing the Shell Game!
"My main expertise is in the past, but if I have to extrapolate into the future, I would say: no good news any time soon and an obvious exit strategy is not apparent." - Juan Cole
In my view and in the view of many others, the globe's debt problems have spiraled to a level that is near uncontrollable. Worse still is that it appears the globe’s economic recovery is firmly wedded to this stimulus and if it is turned off the so called recovery will fall flat on its face causing untold grief. So unless something is done about the ever growing swell of debt and soon, the world will be hit with a tidal wave that will be more devastating than anything we have ever witnessed before.
The central bankers of the world have decided that printing more money is the solution to all of our problems (personally I think that they are boxed in but I have gone over that in previous blogs so there is no need to go down that road again) and that they will all be able to mop up the excess money supply if and when inflation rears its head. To me this is the biggest Shell Game ever played!
For those of you who do not know, a Shell Game comes from ancient times and is still played today. Essentially the “banker” places a stone under three similar shells. With much dexterity he moves the shells around in an attempt to confuse the gambler. Once he stops moving them around the gambler chooses a shell and lifts it up. If it reveals the stone then he wins and if not the ‘banker” wins. The problem is that the “banker” often uses sleight of hand to remove the stone so that no matter which shell is chosen no stone is present. Worse than that, an adept trickster will suck the unknowing gambler in by “letting” him win a few times and then, as he bets big on a sure thing, removes the stone taking the gambler for a big lose. Not only therefore is the game risky for the gambler but the “banker” also risks his neck if he is caught manipulating the game.
Jump then to the central bankers of the world who are printing money hand over fist in an effort to stimulate the economies of the world. The first problem is that their efforts are not resulting in much upside. In fact as more and more debt comes onto the market there is less and less of a benefit but even as the wall turns into a mountain they keep adding more. History has shown us that in these times it is just a matter of time before inflation kicks in and then it becomes hard to stop. In the past it was almost impossible to control and that was with less than a trillion dollars printed but today globally we are north of $20 trillion and climbing!
Now according to the central bankers they will mop up the excess in no time, staving off uncontrolled inflation, creating an environment that is business and investor friendly – just trust us! One thing I am convinced of is that this will not happen, they are the “banker” in the Shell Game and they have removed the stone. So the real question is why is inflation still so tame?
As the global economy is weak and everyone is trying to debase their currency things have remained relatively well under control. Furthermore there is a perception in the markets that the central governments of the world actually do have things contained and that “this time it will be different”. When consensus changes and the players lift up all the “shells” and discover no stone is when things get ugly. When this change in perception happens is anyone’s guess but it will happen.
Personally I believe that it will be a two step process. My thought is that the first indicator will be a massive sell off in the stock markets and that this sell off will be caused by the realization that the central bankers are eminently going to stop printing money as there is no further perceived benefit. Once this happens, bond yields will remain muted for a relatively long period while stock investors look for safety but once there is a perception that inflation is starting to move out of the control of the authorities yields will start to move and inflation will take control of the globe’s economies.
So what to do in the interim? Well the only thing that is truly working is that the markets of the world are going through the roof. As you know I have advised against playing that game particularly without a solid economic basis for the rally. To me you are playing the Shell Game and you know that there is no stone! Once the market loses faith that the support that is quantitative easing is being removed, then watch out below. This is too big a risk for most to bear so keep out of the way of the train wreck to come. For those that do want an allocation to the market and believe that inflation is just around the corner then gold would be a good place to go, particularly after the recent bloodletting that has occurred in these stocks.
Properties were a good bet a year or two ago but they are looking pretty frothy now particularly when you factor in the affordability numbers. While these were favorable a year ago, with the tax increases taking effect it will take numerous buyers out of the market and this is not a market that can continue to be supported by speculators. While I do not expect property prices to collapse as low interest rates will keep prices buoyant I do not expect property values skyrocket from here.
Your best bet is to stick to short term secure investments that produce a relatively good yield. As an example and not that I am suggesting that these are bullet proof by any means but the Venezuelan Oil Bonds are yielding over 11% and mature in 2014. This appears to be a relatively good investment as a short term option. Looking around there are others that have less risk and provide good rates of return but in all honesty you will be lucky to earn more than 4% on a two year investment. The point is to keep your powder dry so that when things are blitzed that you are able to take advantage of the opportunities and that is where you really will be paid for your patience. Rather give away some upside to protect against a massive capitulation. So whatever you do take my advice and do not get sucked into playing the Shell Game!
Friday, March 1, 2013
Tax Your Way Out Of Trouble!
"The upper class keeps all the money, pays none of the taxes. The middle class pays all of the taxes, does all of the work. The poor are there ... just to scare the sh@# out of the middle class. Keep 'em showing up at those jobs." - George Carlin
Recently there has been a lot of interest in an internal devaluation strategy published by a Harvard University professor Gita Gopinath. Her idea is to get the Euro zone out of its current debt crisis by changing the tax structure. As I have explained in previous blogs, the way a country normally gets out of a debt spiral is by devaluing their currency. A weak currency makes local industry more competitive and balances the trade imbalance. It also creates local inflation as global imports become more expensive. This inflation devalues the debt in real terms making it easier to afford the loan payments and hey presto, you are back in business!
The problem in the Euro zone is that there is no way to devalue your currency. So for example if you are Greece, Spain or Italy and you have a mountain of debt your main option used to wiggle your way out of the mess has been taken from you. When Turkey was in a hole they fixed their problem by weakening their currency, but Euro zone countries do not have that option. They are tied together to one currency and that currency is being kept aloft by the strongest players, namely Germany and to a lesser extent France.
So the obvious answer is to leave the currency union but this would be catastrophic for all countries in the Euro zone for reasons too numerous to mention in this blog. That is where Professor Gopinath's paper comes in; instead of devaluing the currency why not create a tax structure that does the same thing? Her idea is to reduce payroll taxes and increase value-added taxes (VAT). By decreasing payroll taxes the local worker automatically gets a raise and will spend the majority of that increase in their local country thereby stimulating the local economy. Furthermore by putting in place a value-added tax the price of imports will be increased while exports would be proportionally cheaper as no VAT is added to exports. A hybrid currency weakening or as it is called an internal devaluation strategy!
French President Francois Hollande proposed a similar plan when he recently presented his budget and other Euro zone countries are considering the idea. So it is all systems go and Europe is fixed! Not so fast. First of all in any VAT scheme there will be the backlash of trade tariffs. Essentially a country that adopts this strategy is placing a tariff on imports which may meet with resistance from trade partners. Furthermore there is no guarantee that the VAT tax will offset the loss of payroll taxes and in countries such as France where social programs abound; cutting payroll taxes may create a bigger hole in the budget than there was before. A bigger hole means more money needed to be borrowed and the spiral continues. Finally if every country in the Euro zone took up this strategy the benefit becomes more and more diluted.
So while the idea has some merit I very much doubt that this is the solution to Europe's problems but it will be interesting to see how it works in France as one thing you can be sure of, everyone is trying to find a solution without cutting benefits and services and that is impossible. Already we are seeing the impact of the automatic budget cuts in the United States and these are having a very real impact on the economy right at the time when weakness abounds. Looks like it is back to the drawing board.
Recently there has been a lot of interest in an internal devaluation strategy published by a Harvard University professor Gita Gopinath. Her idea is to get the Euro zone out of its current debt crisis by changing the tax structure. As I have explained in previous blogs, the way a country normally gets out of a debt spiral is by devaluing their currency. A weak currency makes local industry more competitive and balances the trade imbalance. It also creates local inflation as global imports become more expensive. This inflation devalues the debt in real terms making it easier to afford the loan payments and hey presto, you are back in business!
The problem in the Euro zone is that there is no way to devalue your currency. So for example if you are Greece, Spain or Italy and you have a mountain of debt your main option used to wiggle your way out of the mess has been taken from you. When Turkey was in a hole they fixed their problem by weakening their currency, but Euro zone countries do not have that option. They are tied together to one currency and that currency is being kept aloft by the strongest players, namely Germany and to a lesser extent France.
So the obvious answer is to leave the currency union but this would be catastrophic for all countries in the Euro zone for reasons too numerous to mention in this blog. That is where Professor Gopinath's paper comes in; instead of devaluing the currency why not create a tax structure that does the same thing? Her idea is to reduce payroll taxes and increase value-added taxes (VAT). By decreasing payroll taxes the local worker automatically gets a raise and will spend the majority of that increase in their local country thereby stimulating the local economy. Furthermore by putting in place a value-added tax the price of imports will be increased while exports would be proportionally cheaper as no VAT is added to exports. A hybrid currency weakening or as it is called an internal devaluation strategy!
French President Francois Hollande proposed a similar plan when he recently presented his budget and other Euro zone countries are considering the idea. So it is all systems go and Europe is fixed! Not so fast. First of all in any VAT scheme there will be the backlash of trade tariffs. Essentially a country that adopts this strategy is placing a tariff on imports which may meet with resistance from trade partners. Furthermore there is no guarantee that the VAT tax will offset the loss of payroll taxes and in countries such as France where social programs abound; cutting payroll taxes may create a bigger hole in the budget than there was before. A bigger hole means more money needed to be borrowed and the spiral continues. Finally if every country in the Euro zone took up this strategy the benefit becomes more and more diluted.
So while the idea has some merit I very much doubt that this is the solution to Europe's problems but it will be interesting to see how it works in France as one thing you can be sure of, everyone is trying to find a solution without cutting benefits and services and that is impossible. Already we are seeing the impact of the automatic budget cuts in the United States and these are having a very real impact on the economy right at the time when weakness abounds. Looks like it is back to the drawing board.
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