Sunday, November 02, 2008

US Presidential Elections: The Realisms of Proposed “Changes”

``The facts: We have a $10.5 trillion national debt; $53 trillion of unfunded liabilities; a military empire that has US troops in 117 countries and has spent $700 billion on a pre-emptive war that has killed over 4,000 Americans; a $60 billion trade deficit; an annual budget deficit that will exceed $1 trillion in the next year; a crumbling infrastructure with 156,000 structurally deficient bridges; almost total dependence on foreign oil; and an educational system that is failing miserably. We can’t fund guns, butter, banks and now car companies without collapsing our system.” –James Quinn, “Baby Boomers Led Us Into Fiscal, Moral Bankruptcy”, Minyanville

In "The Decline and Fall of the Athenian Republic" 1776.", Alexander Fraser Tytler poignantly wrote, ``A democracy cannot exist as a permanent form of government. It can only exist until the voters discover they can vote themselves largesse from the public treasury. From that moment on, the majority always votes for the candidates promising them the most benefits from the public treasury, with the result that a democracy always collapses over a loss of fiscal responsibility, always followed by a dictatorship. The average of the world's great civilizations before they decline has been 200 years. These nations have progressed in this sequence: From bondage to spiritual faith; from spiritual faith to great courage; from courage to liberty; from liberty to abundance; from abundance to selfishness; from selfishness to complacency; from complacency to apathy; from apathy to dependency; from dependency back again to bondage."

It will be the denouement of the US presidential elections this week. And most likely, the popular, based on polls and prediction markets, will prevail.

The Realisms and Illusions of Change

While “change” has been the key theme for both aspirants to the White House, considering the present economic and financial conditions, the only real change we are going to see seems to be what most of Mr. Tytler’s prediction 3 centuries ago.

And what “changes” would that be?

More debt, more government spending, more government intervention, more future taxes, more running down of present assets and more bondage. In short, the road to bankruptcy.

The popular idea is if people get the government to spend more, this should lift us out of the rut. And if Americans get to redistribute more wealth (see Spreading the Wealth? Market IS Doing It!), this should lead to even more progress.

Yet, if the same idea is correct, then Zimbabwe would have been the most prosperous among the all nations for unabated printing of money for its government to liberally spend and redistribute wealth. Unfortunately, Zimbabwe has been mired in a hyperinflation depression (some reports say 231,000,000% others at 531,000,000% inflation) that is continually felt by its countrymen through the apparent interminable loss of its currency by the millisecond to the point that some its citizenry has resorted to Barter (see The Origin of Money and Today's Mackarel and Animal Farm Currencies).

Or how could one easily forget the redistribution strategies of China’s Mao Tse Tung “great leap forward” or USSR’s Joseph Stalin “egalitarian” regimes whose only achievement is the combined death toll “democide” of 79 million citizens (Hawaii.edu) and a decrepit “everybody-is-poor-except-the-leadership” economy.

Many would argue that the US cannot be compared to Zimbabwe in the sense that America has institutions, markets, and a labor force that is more intelligent, flexible, effective and sophisticated. Maybe the recent Iceland experience should be a wake up reminder of how countries can suddenly go “richest-to-rags” story (see Iceland, the Next Zimbabwe? A “Riches To Rags” Tale?) on major policy blunders. Here, the market idiom also applies, “Past performance does not guarantee future results”.

The fact that markets are meaningfully suppressed and substituted for government intervention effectively transfers resources from the economy’s productive sector to the non-productive sector. When people’s incentives to generate profits are reduced then they are likely to invest less. And reduced investments translate to lower standards of living.

As James Quinn in a recent article at Minyanville wrote, ``In our heyday in the 1950s, manufacturing accounted for 25% of GDP. In 1980, it was still 22% of GDP. Today it’s 12% of GDP. By 2010, it will be under 10%. Our government bureaucracy now commands a larger portion of GDP than manufacturing. Services such as banking, retail sales, transportation and health care now account for two-thirds of the value of the US GDP.

``Past US generations invented the airplane; invented the automobile; discovered penicillin; and built the interstate highway system. The Baby Boom generation has invented credit default swaps; mortgage-backed securities; the fast food drive-through window; discovered the cure for erectile dysfunction; and built bridges to nowhere. No wonder we’re in so much trouble.”

Yet while Americans seem to drool over future welfare spending (a.k.a. free lunch), nobody seems to ask who is going to pay for these or how will it be paid or funded?

The Emerging American Bailout Culture

It is my assumption that most of the Americans are aware of the current crisis, such that the US Congress rapidly passed a fiscal bailout package called the Emergency Economic Act of 2008.

In November of 2006, William Poole, president of the Federal Reserve Bank of St. Louis presciently noted in a panel discussion, “Everyone knows that a policy of bailouts will increase their number.

How true it is today. Proof?

AIG, which had been originally been accorded a loan of $85 billion in exchange for a government guarantee on its liabilities and a management takeover, has now ballooned to $123 billion (New York Times).

Next are the Bond insurers currently seeking shelter under the current TARF program. According to the Wall Street Journal, ``Bond insurers are urging the government to reinsure their battered portfolios, the latest push by the industry to seek relief under the Treasury's $700 billion financial rescue.”

The US government bailout has expanded its reach outside the banking sector to include credit card issuer Capital One Financial (Australian News) which implies that as a precedent, the next step will probably be an industry wide approach.

Then you have a hodgepodge of interest groups vying for the next bailout. Excerpts from the Hill.com

-A diverse collection of interests — from city transit officials to labor unions to “clean tech” advocates — are clamoring to be added to the second stimulus package Congress may consider after the election.

-Labor groups, meanwhile, want the stimulus bill to pay for new road and bridge construction to put people to work.

-The National Governors Association and the National League of Cities among others on Tuesday wrote to House and Senate leadership, asking them to raise the federal matching rate for Medicaid payments and to increase the money spent on infrastructure projects.

-Lobbyists for these groups argue that more federal spending would help minimize the job losses from a recession. In a white paper being circulated on Capitol Hill, the American Shore & Beach Preservation Association, for example, says $5 billion for water resource projects would create 140,000 new jobs.

Then you have the US government indicating more guarantees for troubled mortgages. This from Bloomberg, ``The U.S. Treasury and the Federal Deposit Insurance Corp. are considering a program that may offer about $500 billion in guarantees for troubled mortgages to stem record foreclosures, people familiar with the matter said.

``The plan, which might put as many as 3 million homeowners into affordable loans, would require lenders to restructure mortgages based on a borrower's ability to repay. Under one option, the industry would keep lower monthly payments for five years before raising interest rates, the people said.”

The government gives in a finger, now everybody wants the arm. From one industry to another, from one interest group to another, everybody seems to be clamoring for a bailout. So who’s gonna pay for all these? When will this culture towards accelerated dependency stop?

Throwing Pack Of Meat To The Wolves

This reminds us of self development author Robert Ringer who, in his recent article, cites Nathaniel Branden quoting staunch liberal Bennett Cerf in his book Judgment Day: My Years With Ayn Rand, ``You have to throw welfare programs at people — like throwing meat to a pack of wolves — even if the programs don't accomplish their alleged purpose and even if they're morally wrong… Because otherwise they'll kill you. The masses. They hate intelligence. They're envious of ability. They resent wealth. You've got to throw them something, so they'll let us live."

In a political season, pandering to the masses is the surest route to seize power. But of course, the hoi polloi can’t distinguish between the real thing and the varied interests behind those propping the candidates or even welfare economics behind all the programs being tossed to the people (or its unintended effects).

Some officials in the US government are actually aware of the perils of too much government intervention. This noteworthy excerpt from the testimony of South Carolina Governor Mark Sanford before House Committee on Ways and Means (all highlights mine)…

``Simply throwing money into the marketplace in the hope that something positive will happen ignores the fact that the government has already put over $2 trillion into the system this year using various bailouts and stimulus packages: including $168 million in direct taxpayer rebates this past spring; an $850 billion bailout last month that cost more than we spend on defense or Social Security or Medicaid and Medicare annually; and myriad loans and partial nationalizations of institutions like Freddie Mac and Fannie Mae, JPMorgan Chase, Bear Sterns and AIG. This doesn’t even include the arguably most effective form of stimulus the country has seen over the past year, a market-based infusion of over $125 billion into the economy and taxpayers’ wallets caused by falling oil prices and subsequently lower prices at the pump.

``This year’s $2 trillion plus in bailouts and handouts seems that much more momentous when you consider that federal tax revenues last year were only $2.57 trillion. Simple math demands we ask ourselves if $2 trillion did not ward off the crisis in confidence we’re currently experiencing, then how much can $150 billion more help? Especially since we’re dealing with a $14 trillion economy and a larger $67 trillion world economy, meaning that this shot in the arm represents merely one-fifth of one percent of the world economy…

``Essentially, you’d be transferring taxpayer dollars out of the frying pan – the federal government – and into the fire – the states themselves. I think this stimulus would exacerbate the clearly unsustainable spending trends of states, which has gone up 124 percent over the past 10 years versus federal government spending growth of 83 percent. It would also dangerously encourage even more growth in governmental programs like Medicaid, which in state budgets across the nation already grew 9.5 percent per year over the last decade – certainly unsustainable in our state. Moreover, the United States Department of Health and Human Services just last week projected that spending on Medicaid will grow at an average annual rate of 7.9 percent over the next 10 years – and possibly faster if this stimulus package passes. State debt across the country has also increased by 95 percent over the past decade. In fact, on average every American citizen is on the hook for $1,200 more in state debt than we were 10 years ago. So if government gives in WHO pays for these?”

Soaring US Fiscal Deficits; Can The World Fund It?

Figure 1: Casey Research: US Fiscal Deficit could top $1trillion!

Remember, global trade as a result from today’s crisis seems likely to diminish, as the US, Europe and most OECD economies meaningfully compress from a recession.

This implies that any improvement from the US current account deficit may be offset by a surge in fiscal deficit which is already at a record $455 billion (Bloomberg) to over $1 trillion in 2009, see figure 1.

Yet improving current account deficits for the US translates to almost the same degree of reduction of current account surpluses for Emerging Markets, Asia and other current account surplus nations, which equally means less foreign exchange surplus.

The point is with diminishing accretion of foreign exchange surpluses; such raises the question of funding for US programs, which in the past had been financed by the world, mostly by Asia and EM through acquisition of US financial claims.

Back to basics tells us that governments can only raise revenues in 3 major ways: by borrowing money (issuing debts), by printing money (inflation) or via taxation.

But if global taxpayers can’t fund US programs, and if the world’s capacity to lend and borrow seems limited by the degree of improving current account imbalances, then this leaves one option for the US government; the printing press. And it is a not surprise to see US authorities recognize this option, as it has revved up its monetary printing presses of last resort (see US Federal Reserve: Accelerator to the Floor!).

So while it is true that in the present conditions nation states maybe able to take over the slack or imbue the leverage from the private sector, this isn’t without limits. Unless the world would take upon further risks of the extreme ends of either global depression or hyperinflation as the Austrian School have long warned it to be.

The Coming Super Subprime or Entitlement Crisis

And it doesn’t stop here; today’s crisis has been centered on the credit bubble largely as a function of the US financial sector. What hasn’t been spoken about is the risks of the Baby Boomer or Entitlement Spending Crisis from which David M. Walker, former U.S. Comptroller General, tagged as “super subprime crisis” as even more deadlier than the crisis we face today. (We earlier spoke about this in Tale of The Tape: The Philippine Peso Versus The US Dollar)

This excerpt (Hat tip: Craig McCarty) from David Walker’s article published at CNN/Fortune (all highlights mine),

``The entitlements due from Social Security and Medicare present us with that frightening abyss. The costs of these current programs, along with other health-care costs, could bankrupt our country. The abyss offers no assets, troubled or otherwise, to help us cross it…

``In fact, the deteriorating financial condition of our federal government in the face of skyrocketing health-care costs and the baby-boom retirement could fairly be described as a super-subprime crisis. It would certainly dwarf what we're seeing now.

``The U.S. Government Accountability Office (GAO), noting that the federal balance sheet does not reflect the government's huge unfunded promises in our nation's social-insurance programs, estimated last year that the unfunded obligations for Medicare and Social Security alone totaled almost $41 trillion. That sum, equivalent to $352,000 per U.S. household, is the present-value shortfall between the growing cost of entitlements and the dedicated revenues intended to pay for them over the next 75 years.



Figure 2: GAO: David Walker Fiscal Wake Up Tour in 2006

``Today we are headed toward debt levels that far exceed the all-time record as a percentage of our economy. In fact, by 2040 we are projected to see debt as a percentage of our economy that is double the record set at the end of World War II. Based on GAO data, balancing the budget in 2040 could require us to cut federal spending by 60% or raise overall federal tax burdens to twice today's levels.

``Medicare, Medicaid, and Social Security already account for more than 40% of the total federal budget. And their portion of the budget is expected to grow so fast that their cost, and the cost of servicing our debt, will soon crowd out vital programs, including research and development, critical infrastructure, education, and even national defense.

``The crisis we face is one of numbers and demographics but also of attitudes. Promises were made in an earlier time, when they seemed more affordable. Like homeowners borrowing against the value of their homes in the expectation that the values would go up forever, the American government borrowed against the future and assumed that the economy would grow fast enough to make that debt affordable.

``But our national debt is not limitless, and our foreign lenders are not fools. If we persist on our current "do nothing" path, our future will be jeopardized. Americans need to reconcile the government we want with the taxes we're willing to pay for it.

Mr. Walker’s concern is that unfunded entitlement liabilities will continually mount and take up a significant share of the expenditures relative to the GDP, which can’t be afforded by the US over the coming years. Compound this with the bills from the present programs to bailout the US economy.

Much of the incumbent and aspiring US politicians have had little to say on these matters.

Yet any resolution to this predicament will require vastly unpopular and stringent political decisions. Think of it, rising taxes in general and or cutting retirement benefits or a combination of both will be politically acceptable? Will the next president turn against his supporter to implement the much needed reform?

But like typical politicians the likelihood is that the desire to avoid pain is politically paramount. Because a politician’s political capital or career will be at stake.

Thus, it is likely that the leadership will, once again, adopt a reactionary approach, because it is far more beneficial to game the present rules than to find a solution and enforce them.

Critical Policy Actions Will Draw The Fate Of The World

Steering the US political economy at this very sensitive and fragile stage will be very crucial.

Policies based on populism can set off a very dangerous chain of events. The great depression of the 30s was a result of a series of market stifling government policies that setoff massive waves of unintended consequences.

As analyst John Maudlin aptly points out in his latest outlook on the role of the new US president,

``One is a tax cut for 95% of Americans. The problem is that 47% of Americans do not pay taxes, so what you are really talking about it a massive expansion of welfare. But if you use that tax increase on the "rich" to pay for your "tax cuts" to other Americans, you have no money to pay for other programs, let alone get anywhere close to a balanced budget.

``And of course, as each year passes there is less net Social Security income to the government. If you use your tax increase to fund more expenses today, you will not have that to fund Social Security in 2017 when the program goes into a cash-flow deficit. Or, taxes will really have to rise later in the decade. But then again, that will be another president's problem.

``How do you offer the increased medical programs you propose if you use the tax increase for tax cuts for 95% of Americans (read: welfare for 50%) without really busting the budget? Or any of the $600 billion in programs that you want to see?

``And your serious economic advisors are going to point out (at least in private) that raising taxes on the 5% of wealthiest Americans is eerily similar to what Herbert Hoover did in his administration, along with legislation to restrict free trade and increase tariffs, which you have also advocated. Look where that got him and the country.

``75% of those "rich" you are targeting are actually small businesses that account for 50-75% (depending on how you measure growth) of the net new job growth in the US. When you tax them, you limit their ability to grow their businesses. Further, you reduce their ability to consume at a time when consumer spending is already negative.

``Reduced consumer spending will be reducing corporate profits and thus corporate tax revenues. Just when you need more revenues.

``A tax hike in 2010 of the magnitude you currently propose, in a weak economy, is almost guaranteed to create a double-dip recession. That will not be good for your mid-term elections. Given that the recovery from a second recession is likely to be long and drawn out, it would also make it difficult to get re-elected, as the economy would be the first and foremost issue.”

In short, policy actions will differentiate between the realization of an economic recovery or a fall to the great depression version 2.0.

As we have noted in the past, the 5 cardinal sins in policymaking that may lead to severe bear markets or economic hardships are; protectionism (nationalism, high tariffs, capital controls), regulatory overkill (high cost from added bureaucracy), monetary policy mistakes (bubble forming policies as negative real rates), excess taxation or war (political instability).

Populist policies without the consideration of unintended effects may result to an eventual backlash. Highly burdensome taxes to the productive sectors may lead to lost future revenues which will be inadequate to fund any present redistribution or welfare programs. Inflation will be the next likely path.

In addition, since the US is heavily dependent on the world for both trade (remember little manufacturing) and financing (selling of financial claims), any modern day form of resurrecting the Smoot-Hawley act will equally be disastrous for the US and for the world.

So we hope and pray that the next US President won’t be overwhelmed with hubris enough to send the world into a tailspin by attempting to shape the world in accordance to an unworkable paradigm or ideology or hastily taking upon policy actions without assessing the economic repercussions. After all, financial and economic problems today require financial and economic and hardly political solutions.

US Elections and the Philippines; Final Thoughts

We noted earlier (see Gallup Polls: Filipinos Say US Election Matters, McCain Slightly Favored) that Filipinos and Georgians have acted as the only TWO contrarians nations that has favored the underdog Senator John McCain in a world heavily tilted by 4-1 in favor of the leading candidate Senator Barack Obama.

There is nothing wrong with such contrarianism.

There are many reasons why various nations or even individuals favor certain candidates. Perhaps this could be because the candidate/s and or party aligns with their social-economic-financial political interest, has shared history or culture, agrees with proposed policies, have ties or association with the party or the candidates, shares similar ideology, influenced by the “bandwagon effect” or the desire to be “in” the crowd or captivated to the “charisma” of the candidate or just plain revulsion to the present system or the incumbent.

The latest Philippine senatorial elections (see Philippine Elections Determined by The Contrast Principle!) was an embodiment of the latter’s case from which we even quoted the precept of Franklin Pierce Adams, ``Elections are won by men and women chiefly because most people vote against somebody rather than for somebody.

It looks the same for the US.

The worsening bear market in stocks and real estate which seems reflective of the prevailing economic conditions appears to be a key driving force which appears to have driven the US public into the open arms of the opposition. Also, the rash of the present bailout schemes appears to be feverishly fueling the “bailout culture” from which has boosted the opposition’s welfare based platform.

Whether or not this would seem as a right choice is called opportunity cost. A George Bush Presidency means a lost Sen. John Kerry leadership in the 2004 elections. We will never know what a Kerry Presidency would have been. But from hindsight we know what a Bush presidency is-“the Biggest Spending President since Lyndon Johnson” (McClatchy.com)-unbecoming of an ideal GOP conservative. Put differently, President Bush was more of a Democrat than a Republican in action or a Democrat in Republican robes.

Besides, Vox Populi Vox Dei –“voice of the people is the voice of God” isn’t always true. Just ask Alexander Fraser Tytler “promising them the most benefits from the public treasury” or Bennett Cerf “You have to throw welfare programs at people — like throwing meat to a pack of wolves”. Or assess the Bush administration or any of the previous Philippine administrations.

Reading into the politician’s actions today is like reading tea leaves during the George Bush versus Al Gore elections in 2000 or a George Bush versus John Kerry in 2004.

Yet, projecting present actions from the candidates’ appearances, slogans, sponsorships, endorsements, proposed platforms and speeches as tomorrow’s policies is a mirage! Many of what both candidates had been saying today, in order to get one’s votes, will probably be reversed once they get elected! Like almost all politicians, voters will eventually get duped.

But elections are atmospheres of entertainment. And people love to be amused by demagoguery to the point of fanatically “believing”. Or to quote Bill Bonner of Agora’s Daily Reckoning, ``People come to believe what they must believe when they must believe it.”

Understand that there will be many painful tough calls which will be politically unpalatable. Think super-sub prime crisis, think the deepening bailout culture. All these are unsustainable over the long run. Combined, they are lethal enough to prompt for a global economic and financial nuclear winter from either a US dollar crash (hyperinflation-yes a Zimbabwe model applied on a world scale!) or a global depression. And all these will need some painful reform or adjustments in American lifestyles sometime in the near future. By then, it wouldn’t matter whether one’s vote would count unless it is time for reelections.

Alas, to believe in purported “change” from today’s imagery is nothing but an unfortunate self-delusion.


Watching For A Bottoming Confirmation

``For October 10 to be the bottom it is necessary for the sequence to continue. We believe that it will but to raise confidence we need to witness the proof of more credit spreads tightening and bonds rallying. So the best answer we can give today is, it’s likely October 10 was a bottom but it is also too soon to say decisively yes. We will position accounts as if it is the bottom and we will be vigilant and reverse those positions if we see a reason to do so. The Ned Davis database offers some help. They measure 42 global stock markets; all made new lows in recent days before their rallies. All declines qualify as “bear” markets. 11 of their 12 bottoming indicators have reached extremes that suggest October 10 was the bottom. Retests of those lows have been on declining volume; that is a good sign. Breadth indicators suggest it was a bottom. There are many more pieces of evidence in favor of the October 10 bottom conclusion. I will stop listing here.”-David Kotok, Cumberland Advisors, Tinker to Evers to Chance

The global stock markets have remarkably rallied from the lows of last week. But one curious development is that while the many measures of credit stresses seem to be narrowing (see Credit Spreads: Some Improvements But Not Enough), US mortgages appear to be inching higher. These extrapolate to the still significant economic risks to the US economy.

From market action perspective, the present rally could be construed as merely a bounce off from the latest lows than to imply of a BOTTOM yet.

Besides the rollercoaster market action suggests of a mixed message, while we see some semblance of history possibly repeating itself by a significant recoil from its lows typical of the 1973-1974 bear market bottom, the market volatility of over 4% swings in a day seem reminiscent of the actions of the great depressions (see Global Markets: A Wild, Wild October!).

Markets seem to have already priced in the outcome of the US presidential elections considering the tremendous gaps in survey polls and prediction markets months going into November. And as we have stated earlier, the bear markets and deteriorating economic conditions may have even induced the Americans to embrace the opposition as alternative or as a vote against the present administration than for the opposition (Remember, Republican Senator John McCain grabbed the lead from Senator Barack Obama in August-to suggest that it wasn’t totally dominated by the latter-until the US stock markets melted following the Lehman bankruptcy). It now seems likely that the outcome of the Presidential election will be a lopsided affair infavor of the Democrats.

Unless we are considering a return to a new millennium version of the Great Depression, the main focus will be on how the new US president will deal with the woes of US and global markets and the US banking system.

And our guess is that the US markets should probably be in the process of forming a bottom, as they may already have factored in much of the ongoing but unofficially declared recession in the US and elsewhere.

Figure 3: US Global /Credit Suisse: Market Performance During Recessions

The steep drop to the previous recession levels probably points to a possible bottoming out formation in figure 3, albeit we would like to see lesser intraday volatility swings to accompany the coming sessions as a sign of stabilization.

Frank Holmes of US Global Investors also notes of the large chunk of institutional cash waiting at a sidelines as potential drivers of a recovery in the market. But this would actually depend on the scale of losses that has already been priced in, meaning that if there will be less degree of forcible liquidations, then markets may attempt to gradually regain its confidence levels.


More Compelling Evidence For An Inflection Point in Commodities!

``We have had 8-9 periods of forced liquidation over the past 100-150 years wherein everything was liquidated without regard to fundamentals. This is such a period…Historically the things which have come out best on the other side are things where the fundamental have been unimpaired. Commodities are the only thing I know with unimpaired fundamentals…The cyclical demand for commodities may slow, but the secular supply will be badly affected so the commodity bull market will last longer and go further in the end-Jim Rogers, Commodity Bull Market Will Last Longer

In last week’s A Fear Driven Meltdown, we described how commodities have been pummeled on the account of forcible selling.

As we wrote, ``The meltdown has been focused on the assumption of a dramatic decline of global demand. They seem to forget that with the current credit crisis, many of the planned projects will be put on hold or shelved or cancelled, giving way to constriction of supply. If supply falls far larger than the rate of decline in demand then you end up having lack of supply thus higher prices.”

A report from Danske Bank recently validates our premise (emphasis mine), ``But now another side-effect of the ongoing financial crisis and slide in commodity prices is emerging in the form of an increasingly serious negative impact on the supply of commodities and investment plans. Based on cost estimates from analysts Brook Hunt and the lowest prices we have seen in recent weeks, it would appear that up to 50% of world aluminium production, 30% of world nickel production, 10% of world zinc production and 5% of world copper production are now running at a loss. Since the summer there has been a massive shift in cash flow at metal producers, which have gone from raking in profits to producing at a loss.”

When selling prices of commodities fall below the cost of production, losses will account for reduced supplies and eventually prices will have to readjust higher.

Even farmers are getting squeezed by higher credit cost, declining value of land as collateral, and declining commodity prices, the following excepts from Bloomberg,

``The credit crunch is compounding a profit squeeze for farmers that may curb global harvests and worsen a food crisis for developing countries.

``Global production of wheat, the most-consumed food crop, may drop 4.4 percent next year, said Dan Basse, president of AgResource Co. in Chicago, who has advised farmers, food companies and investors for 29 years. Harvests of corn and soybeans also are likely to fall, Basse said.

``Smaller crops risk reviving prices of farm commodities that sank from records in 2008 after a six-year rally that spurred inflation and sparked riots from Asia to the Caribbean. Futures contracts on the Chicago Board of Trade show wheat will jump 16 percent by the end of 2009, corn will rise 15 percent and soybeans will gain 3 percent…

``The number of hungry around the world is at risk of increasing as the financial crisis cuts investment in agriculture and crops, said Abdolreza Abbassian, secretary of the Intergovernmental Group on Grains at the United Nations Food and Agriculture Organization in Rome. The total increased by 75 million last year to 923 million, the UN estimates.

``In Brazil, the world's third-biggest exporter of corn after the U.S. and Argentina, production may fall more than 20 percent because farmers can't get loans to buy fertilizer, said Enori Barbieri, a National Corn Producers Association vice president. The nation's coffee harvest, the world's largest, may drop 25 percent for the same reason, said Lucio Araujo, commercial director at farmer cooperative Cooxupe, located in Guaxupe….

``Minnetonka, Minnesota-based Cargill and Decatur, Illinois- based Archer Daniels, the world's largest grain processors, are among the crop buyers to halt financing for growers in Brazil, said Eduardo Dahe, who represents the companies as president of the National Association of Fertilizer Distributors…

``In Russia, loan rates for farmers have jumped by half in some cases to more than 20 percent in the past few months, Arkady Zlochevsky, president of the Russian Grain Union, said in an interview earlier this month…

``The value of the collateral farmers use to secure loans -- crops and land -- is diminishing. Lenders are demanding more equity for farm loans used to run operations or acquire land and equipment.”

The contraction in supplies of the base metals and soft or agricultural commodities strongly suggests of an imminent inflection point in the commodity markets.

The high profile market savant Jim Rogers in a recent Bloomberg interview screamed for a buy in Agriculture (see video Jim Rogers: Massive Inflation Ahead, Buy Agriculture!)

And we shouldn’t forget that commodity markets move in secular waves see figure 4.


Figure4: Moneyandmarket.com: Long Term Commodity Moves

To quote Sean Brodrick of Moneyandmarket.com (highlight mine),

``The upswings, or commodities supercycles, can last 20 to 25 years, according to Morgan Stanley’s research. And if the current one follows the pattern, we have many years to go before it plays out. The key drivers are the rapid economic growth in China and infrastructure spending in other large emerging markets.

``The fact is, commodity bull markets can see corrections that will make your head spin.

``Other commodity bull markets in modern history — roughly spanning 1906 to 1923, 1933 to 1955 and 1968 to 1982 — lasted more than twice as long as the current run. They included some sharp corrections before they ran their course, suggesting that the current drop, however sharp, could be temporary.”

So with global central banks collectively running the printing presses on a 24/7 basis into the global financial system plus the severity in the contraction of supply gaining an upper hand vis-à-vis the degree of decline in demand, fundamentals suggest a likely forthcoming inflection point on the commodity markets.

And perhaps a rising commodity markets will reinforce the recovery in global equity markets.


Saturday, November 01, 2008

Credit Spreads: Some Improvements But Not Enough

The global banking credit crunch has triggered many liquidity problems, aside from unmasking some insolvency and balance sheet vulnerabilities across countries and companies or in both the public and private sector around the world.

Notably we see some improvements, although still far from the norm.

All charts from Bloomberg.

Euribor 3 months...

TED Spread...
Hong Kong dollar Hibor...

3 month Libor-OIS Spread...

BBA Libor USD 3 months...


US Federal Reserve: Accelerator to the Floor!

In the battle against debt deflation, TEAM Federal Reserve has gone full blast!

All charts from St. Louis Fed, through October 30

Monetary Aggregates:

Adjusted Monetary Base


MZM (Money with Zero Maturity)

M2

Bank Credit and Federal Reserve Balance sheet holding of US Treasuries
Even as the FOMC brought interest rates down to 1% Fed Fund Futures appear pointing to another 25 basis point cut!

One recent impact: The moribund Commercial Paper and Asset backed markets evincing signs of renewed life!

Kenneth S. Rogoff, a former chief economist at the International Monetary Fund and now a professor at Harvard quoted at the New York Times,

``We’re entering a really fierce global recession. A significant financial crisis has been allowed to morph into a full-fledged global panic. It’s a very dangerous situation. The danger is that instead of having a few bad years, we’ll have another lost decade.”

Mr. Rogoff adds, “If you print enough money, you can create inflation.

That's what the Fed is doing now.

Global Markets: A Wild, Wild October!

Floyd Norris of the New York Times put out some great market statistics backed by impressive charts. (Charts From New York Times, Emphasis on quotes all mine)


Here are Mr. Norris’ observations on October’s rollercoaster period:

-October was the worst month for the Standard & Poor’s index of 500 stocks in 21 years — since the 1987 stock market crash.

-The final week was the best week for the market in 34 years.

-The most volatile in the 80-year history of the S.& P. 500.

-The huge gains of the final week were reminiscent of the sharp recoveries from bear market lows in 1974 and 1982. Both of those moves came while the economy was mired in recession, as it almost certainly is now.


Mr. Norris’ observations on market volatility or number of days in which an index closes up or down at least 4 percent:

-In normal times, the market goes years without having even one such day. There were none, for instance, from 2003 through 2007. There were three such days throughout the 1950s and two in the 1960s.

-In October, there were nine such days.

-The accompanying chart shows the months, from 1928 through the present, when the S.& P. 500 had at least five days with 4 percent moves. Most of them were during the 1929 crash and the Great Depression. (oops!-my comment)

-Until now, September 1932 held the record for the most days with big moves, at eight. (more oops!-my comment)

-Two days during October ended with the index leaping more than 9 percent, something that had happened only nine times in the previous 80 years.

-For the week, the S.& P. 500 was up 10.5 percent, the best weekly gain since a 14.1 percent rise in the week that ended Oct. 11, 1974.

-For the month, the S.& P. 500 was still down 16.9 percent, the worst showing for the index since it fell 21.8 percent in October 1987. The Dow fell 14.1 percent, and the Nasdaq index lost 17.7 percent…

-All of the big days in September and October came after Lehman Brothers was allowed to fail. That Lehman was not deemed important enough to save signaled to investors that there was risk where they thought there was none and caused a sharp tightening of credit for many borrowers, despite efforts by central banks to push interest rates down.

On Global Contagion:

-Many countries, among them Britain, Japan, India and Brazil, also showed more volatility than the United States.

-That volatility was so high everywhere was an indication of how linked markets have become in the age of globalization. It is not just that most industrial countries appear to be in recession, or close to it. Another factor is that investors now own portfolios of shares from around the globe, and in times of stress may sell what they can, instead of just what they want to unload.

On a Possible Bottom:

-If Monday’s stock market lows prove to be the low prices for this cycle, the bear market will have ended with the S.& P. 500 down 46 percent from the peak it reached in October 2007. That would make the bear market almost, but not quite, as bad as the 1973-74 bear market, which ended with the index down 48 percent.

-In the 2000-2 bear market, the fall was 49 percent.

-If the rebound this week indicated that the bear market of 2007-8 had ended, it lasted just over a year and hit bottom on Monday, at 848.92. It recovered to 968.75 by week’s end. There were similar moves in most major indexes. The Dow Jones industrial average ended the week up 11.3 percent, at 9,325.01, and the Nasdaq composite climbed 10.9 percent, to 1,720.95.

My Additional Comments:

It’s a mixed message from the market, although definitely representative of bear market violence.

On the optimistic note, last week’s sharp recovery could be reminiscent of the 1973-1974 “bottom” paradigm.

BUT, from the pessimist side, looking at the market volatility aspect, it could also signify the movements during the Great Depression especially IF we see MORE of the same degree of intense gyrations in the coming sessions.


Thursday, October 30, 2008

How Does Swap Lines Work? Possible Implications to Asia and Emerging Markets

One of the reasons why emerging market governments appear to be “creating” alternative means of conducting exchange is because the credit crunch among banks, mainly centered on the US, has restricted their access to US dollars.

Consequently, this predicament has exposed some of the vulnerabilities of Emerging Markets, which can be identified as having too much foreign currency risk exposure, or too geared domestic balance sheets or excessive dependence on short term debts or too large current account deficits.

While the US has extended an almost unlimited swap arrangement with many G-7 countries, outside the G7 the dearth of access to the US dollar has precipitated a cavalcade of crisis among many Emerging Markets such as Pakistan, South Korea, Argentina, Hungary, Ukraine etc…

Our idea is that the recent swap arrangements with G7 nations have been aimed at mitigating the fallout from the ownership of hazardous junk instruments of G7 institutions by having an open access to US dollars by the provision of liquidity through this swap mechanism from the Federal Reserves with the other global central banks.

Aside from, of course, for political reasons, assistance have been extended to US allies.

This only highlights how the present monetary standard operates with the US as its foundation.

Now that the US has been feeling more of the ramifications from the implosion of the domestically originated credit crisis, it has opted to extend its currency swap arrangement to some emerging markets as Mexico, Brazil and Korea. Also to Singapore.

According to the Federal Reserve, ``Today, the Federal Reserve, the Banco Central do Brasil, the Banco de Mexico, the Bank of Korea, and the Monetary Authority of Singapore are announcing the establishment of temporary reciprocal currency arrangements (swap lines). These facilities, like those already established with other central banks, are designed to help improve liquidity conditions in global financial markets and to mitigate the spread of difficulties in obtaining U.S. dollar funding in fundamentally sound and well managed economies.”

Despite the recent downturn, global trade has significantly supported the US economy, thus the extension of dollar access facility seems to be targeted at cushioning or even inflating emerging market economies for them to sustain economic growth levels enough to continue to buy goods and services from the US.

Aside, there is this hope that once the crisis subside, the EM economies would continue to provide financing to the US by continually buying US financial claims or assets.

But you might wonder how a swap line work?

Mike Hammill of the Atlanta Fed’s research department provides a lucid illustration. His example is based on the September 18th Fed measures.

From Mr. Hammill (all highlights mine),

``A currency swap is a transaction where two parties exchange an agreed amount of two currencies while at the same time agreeing to unwind the currency exchange at a future date.

``Consider this example. Today the Fed initiated a $40 billion swap line with the Bank of England (BOE), meaning that the BOE will receive $40 billion U.S. dollars and the Fed will receive an implied £22 billion (using yesterday’s USD/GBP exchange rate of 1.8173).

Currency Swap:



``An underlying aspect of a currency swap is that banks (and businesses) around the world have assets and liabilities not only in their home currency, but also in dollars. Thus, banks in England need funding in U.S. dollars as well as in pounds.

``However, banks recently have been reluctant to lend to one another. Some observers believe this reluctance relates to uncertainty about the assets that other banks have on their balance sheets or because a bank might be uncertain about its own short-term cash needs. Whatever the cause, this reluctance in the interbank market has pushed up the premium for short-term U.S. dollar funding and has been evident in a sharp escalation in LIBOR rates.

``The currency swap lines were designed to inject liquidity, which can help bring rates down. To take the British pound swap line example a step further, the BOE this morning planned to auction off $40 billion in overnight funds (cash banks can use on a very short-term basis) to private banks in England.



``In effect, this morning’s BOE dollar auction will increase the supply of U.S. dollars in England, which would work to put downward pressure on rates banks charge each other.”

Aside from the IMF, the extension of liquidity of the Federal Reserve to other central banks may temporarily allay the problem of liquidity crunch.

And we could be seeing this knee jerk market response via the rally we are presently seeing in Asian equities aside from improvements in the credit spreads as this Bloomberg report,

``The cost of protecting Asia-Pacific bonds from default tumbled after the Federal Reserve increased cross-border funding and the U.S., China and Taiwan cut interest rates to boost economic growth.

``The benchmark index of credit risk for investment-grade borrowers in Asia outside Japan fell the most since it was created in September 2007. The Markit iTraxx Asia credit-default swap index of 50 borrowers, including Thailand and Hong Kong's Hutchison Whampoa Ltd., fell 90 basis points to 470, according to ICAP Plc data as of 9:50 a.m. in Hong Kong.”

Some Thoughts:

-The domino effect of EM economies had been largely exacerbated by a paucity of liquidity amidst global deleveraging and the high risk aversion landscape which amplified the weaknesses of some EM economies to the point of falling into a crisis. If the US extends more of this swap tools to more EM economies then we should likely see fewer financial pressure and perhaps reduce the risks for the IMF to exhaust their limited $200 billion funds. The important difference is that for many EM it has been a liquidity problem, on the other hand, for US banking and financial institutions it has been a solvency issue.

-The global financial crisis is a systemic risk which emanates from the implosion of US credit related financial claims. Any implication that EM economies are in worst condition than its US mortgage collateralized securitization/derivatives/shadow banking peers is unjustified.

-The recent surge of the US dollar can be seen in the light of its privilege as the world’s currency reserve status. In addition, we must not forget that the present crisis which centers on the shadow banking system, derivatives and structured finance are mostly denominated in US dollars, hence, settlement and payment must be made in US dollars. So the US dollar’s rise is unlikely coming from a safehaven standpoint.

-Swap lines are essentially the US Federal Reserve printing presses outsourced to central banks overseas.

-The US has been strenuously exhausting all means to prevent a deep recession which accentuates higher inflation risks down the road.