Consumers are High on Oil Fumes

"To succeed in life you need two things; ignorance and confidence." - Mark Twain

"When you have confidence, you can have a lot of fun.  When you have fun you can do amazing things." - Joe Namath

I have to say that the first quote resonates with me as when I was a college student it seemed that life was easy and that everything just fell into place.  Looking back I was filled with confidence and completely ignorant of the risks that I was surrounded by and yet I managed to succeed where others failed.  Fast forward to today and while a lot (it would be very arrogant for anyone to say all) of my ignorance is gone I am still having fun and that is the true secret to success.

With that in mind it is interesting to see the consumer confidence index at levels not witnessed since 2004, predating the Great Recession.  A few things jump out at me regarding these numbers the first of which is that this number is higher than the numbers achieved in 2005 and 2006 when everyone was making money hand over fist in the property market.  That is amazing to me as the majority of people's incomes are still far from exceeding those income levels.  As you can see in the chart below the all time highs were around the time of the NASDAQ bubble in 2000, another heady time for investors.

The increase in consumer confidence is a direct result of the reduction in the price of energy and gasoline with the added bonus of more jobs available.  It certainly appears that the consumer is ready to open their check books once again and jettison the United States economy into orbit but before we get too excited the index is pretty volatile and when a spike occurs as it did in January it often reverses itself in the following months.  That said the trend is a healthy one and barring any unforeseen global problems it looks like it will be a boost to the economy in 2015.  As I mentioned in last week's blog it looks like it is now the US consumer against the world (can the US consumer spending drag the rest of the world out of its slowdown) and it will be interesting to see who wins out.

As the above quotes show confidence in anything can make the difference between success and failure and with the consumer making up roughly 70% of the United States GDP it is very important to have the confidence numbers high.  As this is one of the most important leading indicators it appears that the US economy is in good stead but as you can see by the chart above, consumers are notoriously bad at timing their confidence as many of the peaks in the confidence number has been met with recessions (the rest of the world wins).

That said after six years it finally seems as if the consumer is being touched by the Federal Reserve's stimulus as while job growth has been trending in the right direction for a while, the wage rate has been stuck.  There is a faint glimmer of hope that wages will finally start to appreciate in 2015 which is good news as this should translate into a revival of spending   Furthermore, as I have eluded to in previous blogs, the growth potential of the United States is far lower than what was previously thought and appears to be around 2.00%.  What this means is that should GDP growth exceed this number that the economy will begin to vacuum up some of the underemployed giving a real boost to consumer sentiment (U.S. consumer wins).

So on the surface it appears that the United States is headed in the right direction and that the footing is becoming more solid.  So who will win, the U.S. consumer or the rest of the world?  I look at it in the same way as trying to getting a footing in deep water, while the U.S. economy is still a little out of its depth, when the wave pulls back it has a chance to gain traction on the sand it just remains to be seen if the footing gained is sustainable (U.S. consumer wins) or whether it will be washed away by another crashing wave (the rest of the world wins) but I have to say I am hopeful that this time that the U.S. will win.

The Great Debase Race

"Although there are countless maladies that are forever causing the decline of kingdoms, princedoms, and republics, the following four (in my judgment) are the most serious: civil discord, a high death rate, sterility of the soil, and the debasement of coinage. The first three are so obvious that everybody recognizes the damage they cause; but the fourth one, which has to do with money, is noticed by only a few very thoughtful people, since it does not operate all at once and at a single blow, but gradually overthrows governments, and in a hidden, insidious way." - Nicolas Copernicus

Yesterday Mario Draghi the president of the European Central Bank announced that starting in March the ECB would buy EU 60 billion a month of corporate and government bonds.  He added that this would continue through September 2016 and could continue longer should there be no proper recovery in the works by that time.  This "stimulus" package amounts to a minimum of EU 1.1 trillion or $1.3 trillion. The immediate impact of the announcement was for stock markets in Europe and the United States to rally and for the Euro to lose 2% against the dollar falling to its lowest level in 11 years.  Margin requirements in the future currency exchange jumped to 100% a sign of impending volatility and risk.

With Europe now firmly in the money printing camp along with Japan and China and with the United States presently sitting on the sideline, the beneficiary is the United States Dollar (USD) which continues its march higher.  While the stock markets of the world rally I continue to hark back to the words of the quote above as this mass global stimulus is going to have a huge impact on generations to come.  As I wrote last week this massive overhead of debt is getting to a level that is unsupportable but that has not deterred the central bankers of the world to print more.  So where can we hide?

The first benefactor is the stock market.  The problem here is that at some point there will be a tipping point where stock valuations become so high that they collapse on themselves.  Whether we are there now or whether they can continue on their surge higher is anyone's guess but as this market is clearly manipulated by the central bankers I choose not to play this game.  Anything that is manipulated will have a poor outcome just ask the Patriots!  The short term benefits (a win) are undermined by a lasting legacy of questions and doubt and in some cases the winner is stripped of their crown like Lance Armstrong.

The debasement of currency leads to a loss of faith in the debased currency so people turn to things that benefit from this loss of faith and the benefactor of this has and always will be gold.  Already gold has risen from just over $1,160 an ounce to $1,300 an ounce in January alone and with the continued debasement of these currencies it should be a huge benefactor in 2015 and beyond.

The bond market should also continue higher as interest rates will continue to remain low but like the stock market this will only last until there is a complete lose of faith in the ability to repay the enormous debt burden at which stage everything falls to pieces (once again another scenario that would be excellent for gold investors).  Can you imagine the 10-year Note yielding 1.00% or lower, as if not you might want to start as in the near term I expect yields to head lower from their already low levels.

So from an investment standpoint you could toy with the stock market but to me the safer bet currently is gold and bonds.  Gold in particular looks interesting as it has been in an all out bear market for the past four years.  Gold mining stocks have been particularly hard hit some losing more than 70% of their value so to me this is the place to be as it just might be that its time has come around again.

How Much is Too Much?

"Perhaps too much of everything is as bad as too little." - Edna Ferber

"I think we consider too much the good luck of the early bird and not enough the bad luck of the early worm." - Franklin D. Roosevelt

When it comes to debt in an economy the question of "too much" is one that is really hard to answer.  According to the Economist global debt has grown steadily since the Second World War.  It was thought that debt on a national level was fine as it netted out to zero (the debtors would receive the collateral from the creditors making it a zero number) but 2007/8 dispelled that theory.  From 2004 to today total global debt has risen from $24.5 trillion to $55.1 trillion, an increase of more than 100% in 10 years.  More interesting is that since 2007 global debt has skyrocketed from $28.1 trillion or almost 100% in just seven years and this includes the massive write-down taken after the financial shock in 2008.  As a percent of global GDP the world debt level now stands at more than 200% of global GDP so it is time to dig into how much is too much as this will have implications for all investments.  It is the largest macroeconomic influence on all of your investments so it needs to be understood.

The initial premise that should the world have to pay off all the debt that it would amount to zero is a fallacy.  This assumption assumes that the collateral will be there with value to support the loan.  As 2008 showed, the world's collateral pool can lose significant value quickly, particularly when there is a loss of faith which is the exact time that the collateral is needed to pay the debt back.  Taking this a step further, if all of the debt outstanding was called in today, there is no way that every asset could be liquidated in such short order so prices would capitulate and the sum total would be zero, that is the debt holders would receive assets worth zero or a total write-off.  Now as we know this is never going to happen but I used it just to illustrate the point that debt at these levels is not a zero sum game.

Debt is manageable as long as there is economic growth or inflation.  These two factors go pretty much hand in hand as one cannot really exist for an extended period without the other showing up.  Growth at some level will result in inflation and inflation is normally driven by growth although it can also come from poor monetary policies and over extension of monetary stimulus (think of Zimbabwe or the Weimar Republic). For this blog and as we are talking global debt I will leave inflation tied to growth.  If you have GDP growth or inflationary growth the percent of debt to the underlying value of the assets falls thereby giving the illusion that the debt level is manageable.  It is an illusion as it only holds as long as asset prices do not fall.  Inflation too makes the debt more palatable as higher wages and tax revenues means that it is easier to service the debt and therefore more controllable.  The worst possible situation for debt is deflation which as I have mentioned in previous blogs makes asset values shrink while the debt remains fixed thereby making the debt level unmanageable and in some cases unserviceable.  With the world edging very close to the deflationary cliff this is a worry as if the world slips into this spiral investment dollars would be non-existent as debtors would be using every available dollar to repay debt rather than investing in business ventures, ideas or infrastructure.

The only way that the debt can remain manageable under this scenario is to keep interest rates low.  Even a small spike in the interest rates would send the world into a debt spiral as once again interest payments would eat up all excess cash crippling investment and cutting government spending.  As an example if interest rates were to rise 2% the annual amount spent on interest payments alone would increase by over $1 trillion a year!  It is not inconceivable that interest rates could jump by 5% knocking $2.5 trillion out of the debtors pockets stunting growth rather severely.  As it is in no-one's interest to let interest rates rise any time soon (at least until global growth shows signs of accelerating in which case as mentioned above debt payments become more manageable) I fully expect interest rates to remain low for a very long period.  Obviously this assumes that governments can keep interest rates down which is also a leap of faith.

As long as consumers, businesses and foreign governments believe that the debt level is manageable then everything is good to go.  If at some point in the future this thought changes, countries and businesses will suddenly see interest rates rise as really it is all based on a simple demand and supply curve.  Right now there is enough demand (faith in repayment is still high) for the debt at low yields but if the demand for the debt falls (lose of confidence in repayment) the only way to encourage buyers to step up is to raise the returns and suddenly you have a situation where the market controls prices rather than the central bankers.  Yields spiral higher and problems expand.  There is an argument that a spike in interest rates would not have an impact as yields are based on long term notes but with $55 trillion of debt with an average maturity of 10 years there is more than $5 trillion maturing each year ($14 billion every day of the year) and that debt would be subject to the higher rates so it would not take long for the increase in rates to be felt.

So while this rising debt level is still not a problem it is important to keep your eyes on it and understand the implications associated with any changes in interest rates and deflation.  Maybe earning 0.0002% interest on your savings forever is better than the alternative!

The Dirty Harry Market

"I know what you're thinking, "Did he fire six shots or only five?"  Well to tell you the truth in all this excitement, I've kinda lost track of it myself.  But being this is a 44 Magnum, the most powerful handgun in the world and would blow your head clean off, you've gotta ask yourself one question, "Do I feel lucky?" Well, do you - punk? - Clint Eastwood as Dirty Harry

I just love this quote. talk about the ultimate tough guy.  The story as some of you may remember continues where he picks up the bad guy's shotgun and walks off.  The robber asks, "Hey, I gotta know", at which point Harry turns around, points the Magnum at the guy's head, pulls the trigger and there is just a click, no bullet remains.  Then with a smile he walks off.  I won't repeat what the bad guy says.

This sort of sums up the opening of the year which I am terming The Dirty Harry Market.  Oil prices continue to crater, stock markets vacillate violently and the mood is generally one of concern and uncertainty (what else is new).  In the first five trading days of the year the market moved more than 1% in four of them and twice more than 1.7%.  Volume on the up days is lower than that of the down days (not a good sign) and this rally is look long in the tooth.  Furthermore there is finally some realization that high yields do equal risk as the spread between investment grade bonds and high yield (or junk) bonds has started to widen considerably in the past few months (see chart below).

As a large amount of money invested in the high yield market was allocated to oil and gas ventures it is clear that the drop in oil prices is having a dramatic effect on the cost of capital.  Undoubtedly a large portion of this debt will become worthless as borrowers will not have the capacity to repay these loans with oil down around $46 a barrel.

So the question that we have to ask ourselves as investors is "Do we feel lucky?"  "Well do you?"  While the United States economy seems to be in relatively good shape (particularly when compared to the rest of the world) there are still major concerns regarding the rest of the world.  Can the United States pull the rest of the world out of their problems or will the rest of the world's problems drag the United States' tepid recovery down with them.  In my blog last week I mentioned that the United States is in a liquidity trap but as a good friend of mine commented it may be more about a leadership trap than a liquidity trap and I have to say that I agree.  Without any clear leadership in the White House and with elections coming up next year it seems that the United States economy is drifting rudderless and the seas are becoming rough.  Pity we don't have Mr. Harry to clean up the rot here but unfortunately life is not at all like the movies.

With this as a backdrop there has to be a proper draw down it is just a matter of when.  Not that I am hoping for one it is just that history always repeats itself and with three years of one way tickets to heaven it just seems like an investment in the stock market is akin to taking a chance that Dirty Harry's gun is out of bullets.  Furthermore make sure that any investment offering a high yield is covered with sufficient collateral as otherwise I would expect that only five bullets were used!

The Liquidity Trap

"A liquidity trap is a situation described in Keynesian economics, in which injections of cash into the private banking system by a central bank fail to decrease interest rates and hence make monetary policy ineffective." - Wikipedia

While central bankers of the world struggle to prevent a deflationary spiral the solution has been to print more money.  In the past money printing worked by forcing interest rates down, attracting consumers and businesses to borrow money thereby stimulating investment, consumption and the economy.  The theory behind why this works is the IS-LM model developed by Sir John Hicks.  The IS-LM model is like a simple demand / supply chart where more demand requires more supply short of which prices rise until the supply catches up.  Too much supply swamps demand pushing prices down driving companies out of business, thereby limiting supply and the equilibrium price returns.

The first line of the IS-LM graph is the downward sloping line IS which stands for investment and savings.  On the vertical axis is the interest rate.  Therefore the independent variable is the interest rate and the dependent variable is income.  As interest rates drop income falls, investment increases and savings fall moving the line to the right and increasing GDP (which is on the horizontal axis).  The upward sloping line is the LM line or liquidity-money line.  The dependent variable is the interest rate while the variable input is income.  This says that the more money that is placed into circulation the lower the interest rate.  Lower interest rates should therefore stimulate the economy as the IS line should move towards more investment.

Based on this theory the Federal Reserve can control the economy and GDP growth by increasing or reducing the supply of money into the economy.  The point at where the two lines intersect should show the level of GDP growth associated with the input of additional funds and the corresponding interest rate.  There is a problem to this theory though.  When there is general pessimism about the economic outlook the IS line shifts to the left and no matter how low interest rates fall or how much money is input there is no growth as the two lines are disconnected - the so called Liquidity Trap.

At this point conventional monetary policy is worthless.  As far as I can see and as I have explained in previous blogs, the  reason that economies get to this level is that governments do not want to do the full Keynesian Monty - that is they are too scared to take all of their clothes off for fear that everyone else leaves their on and they are left to explain why they are naked.  To put it another way if they use all the various aspects of Keynesian stimulus, fiscal and monetary policies (low interest rates, print money, lower tax rates and throw money at shovel ready projects), and they do not work (for whatever reason) they would have no tools with which to try to repair the mess and the mess would be far greater.  Talk about egg on your face!  Additionally, if they use all of these stimulants and they work better than expected then inflation could potentially run out of control once again creating a problem that might be too difficult to control.  More egg, same face!

For these reasons the central bankers of the world seem to feel that it is better to leave a few stimulants on the table for use at a later date.  Make sure the broth is not too hot, cold or worse still too salty before taking a big swallow.  If it is too hot cool it off by removing more stimulants and if too cold add a few more stimulants continually testing it to ensure it is going according to plan.  If you get it too salty then watch out as there is nothing to do but let market forces work it out and that is their worst nightmare.

Now this may seem sensible but economies do not heat up in a few minutes, they can take months if not years to show a sign that the additive is working.  Also once the heat is turned off, the economy can continue to accelerate reaching levels of inflation that become very uncomfortable very quickly.  So in essence it is impossible for a central banker to truly tinker with these levers without creating economic shocks which is what continues to plague all economic theory and which is why barring another global catastrophe my hope for 2015 is that they leave their hands off the switches.