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What has caused the big decline in the fortunes of the nation’s newspapers. Figures don’t lie but ...
Alan Abelson has some typically tongue-in-cheek but pointed thoughts on the demise of the newspaper industry, and follows that up with his virtually weekly dose of skepticism with regard to the market rally and to the optimism he sees about an economic recovery.
Newspapers the nation over, it is no secret, have become the quintessentially endangered species. At the typical paper, the only thing falling faster than circulation is advertising lineage. Many a once proud leading daily has folded, while countless others are queuing up to effectively abandon print and take a desperate leap into the vast ethereal expanse of cyberspace.
To be sure, how well they will fare, or even whether they will survive, in their new incarnation as super blogs or 24/7 electronic news spewers knows no man (or woman). After pulling thoughtfully on their chins and squinting wisely, the venerable sages proclaim the source of the papers’ travails is that the press moguls lack a good business plan (as makers of buggy whips early in the last century could have told them, sometimes the only truly good business plan for dying businesses is interment).
The accepted wisdom is that what brought newspapers to their current low estate was a deadly double whammy of deep recession and killer competition from the Internet. We have no quarrel with that, although we suspect that a creeping vogue for illiteracy is playing a role as well. But we also think the news is to blame: It is so darn repetitious that, it pains us to say, readers get awfully bored with it.
Just by way of example, how many times – indeed, how many years, now – have we picked up our favorite paper to be confronted by a boldface headline screaming at us that the incorrigible nukenik, North Korea, is getting ready to blow up the world? Frankly, we are tired of reading about it. OK, if they finally blow up the world, swell, then we will be happy to read about it.
We are the first to admit we do not count foreign policy among our areas of expertise (which are not exactly numerous in any case, once you get past martinis and pro football), but it mystifies us why, what with all those myriad pundits in the State Department, not one in over half a century has ever suggested sending Kim Jong Il, North Korea’s diminutive supreme leader, a nice pair of elevator shoes. Then he would not always be the shortest guy in the room and, we guarantee, his hostility toward the rest of the mankind would inexorably melt away.
And why – while we are on the subject of no-news news – does it warrant front-page coverage that one of our big auto makers is going bankrupt? For gosh sakes, everyone knows that the car makers do not make their money selling cars anymore. They get their dough by filing for Chapter 11, confident that Uncle Sam feeds them a few billion here, a few billion there, to tide them over. Sure beats having to come out with a new model every year.
As an ink-stained wretch from way back, we would hate to give the misimpression that we feel newspapers are dispensable. They are not. And we confess to a lifelong addiction to them. No other medium comes close to the exhaustive (even if sometimes exhausting) coverage they offer. A case very much in point is the nomination of Sonia Sotomayor for the Supreme Court.
Among the many details of Ms. Sotomayor’s life that all those long columns devoted to her background, education and career revealed was this little-noted gem. She entered Princeton in 1972, a couple of months or so after Samuel A. Alito Jr., one of George W. Bush’s appointments to the court, graduated from that ivy-clad institution. Women had been admitted to Princeton a scant few years earlier, and the surge in their presence at the university stirred protest by some of the grumpier male alumni, including, as it emerges, Mr. Alito.
We can hardly wait to see the interaction between the two as they take their respective places on the bench (let us hope they sit side by side). Enjoy the frozen smiles and kindred gestures of collegiality. Keep a careful eye on the body language and the darting glances at each other. It has the promise of a terrific hoot – and whatever our age, circumstances and political persuasion, we would all be the poorer for having missed a memorable spectacle, were it not for our ailing but gallant gazette.
None of the above, we are sorry to say, lets newspapers or their electronic kin off the hook for their contributions, however inadvertent, to the growing investor giddiness that has helped light a big fuse under this roaring stock market. In particular, a heck of a lot of the reporting has put a gloss on even the dreariest economic news.
Obviously, with an economy that has been flirting with catastrophe for going on six months, any semblance of good news is inarguably newsworthy. But, the job of a journalist is not to swallow whole what an interested party tells him, whether said party draws a paycheck from Washington or Wall Street. Rather, it is to act as a filter, separating out the facts from the flotsam. And that means taking a hard look for himself at the figures.
Thus, there were hosannas and chirping galore about the end of the slump in manufacturing when a 1.9% increase was reported for new durable-goods in April. What seemed to have escaped general recognition among the gushing reporters was that the March numbers were sharply reduced from a decline of 0.8% to a drop of 2.1% – which might just have had something to do with April’s unexpected jump.
And as Bill King of the always informative King Report, who has a thing about how much of the official data virtually across the board is quietly revised downward the next month, points out, in the latest tally of jobless claims, the previous week’s data were also shaved from the original number. And that, too, got lost in the jubilation over what was hailed in many quarters as fresh evidence that the labor market was steadying.
While making a big deal over a modest dip in new claims – the total remains dismayingly above the 600,000 mark – both the Street and the media pretty much overlooked the new high in continuing claims, which, Bill notes, extended a parabolic rise. Somehow that doesn't quite square with an uptick in employment.
We still envisage unemployment hitting 10% early next year and the bum job market acting as a big drag on everything from housing (the bubble that ultimately broke the economy) to credit (whose 25-year spree came to an inglorious end) and to consumer spending (which is supposed to be the angel of recovery).
Yes, there are signs that the slump is slowing; but after two horrendously bad quarters back to back, the economy was either going to decline at a somewhat gentler pace or implode. We hope we are wrong, but we do not necessarily believe it is all uphill from here. That the consensus among the seers has swung to a second-half recovery only deepens our doubts
David Rosenberg, ex of Merrill Lynch, is now chief economist and strategist (but a great guy nonetheless) of Gluskin Sheff, a money-management firm based in Toronto. (Dave, as we have mentioned before, hails from Canada.) Anyway, we are pleased to report, he is churning out what he calls his market musings and data deciphering (he is afflicted, poor chap, with a penchant for alliteration).
Crossing the border has not caused Dave to miss a beat. After perusing his latest batch of communiques, we can attest he is as sharp and incisive as ever, if anything maybe a touch more. He is that rare bird in the investment business who is skeptical without being invariably negative; who like Lord Keynes changes his mind when the facts change; who has firm convictions without being dogmatic and is able to convey his reasoning without resorting to gibberish. He also has a neat sense of humor.
We were particularly struck in his latest screed by his apostasy on government bonds. In true contrarian fashion, he takes issue with the increasingly popular notion that we have been witness to a bubble in Treasuries. “The Treasury market was never in a ‘bubble,’” Dave says. “Nothing that is fully guaranteed and pays a coupon semi-annually with no call or prepayment risk goes into a ‘bubble’ just because it was expensive at the yield’s low.”
He elaborates: “Sentiment never got wildly bullish; the public never became enamored of Treasuries; there were no widespread ownership or ‘new paradigm’ thoughts. At the lows in yield, there were legitimate concerns over a depression-like economic backdrop and deflation.” But the Treasury market never met “the classic characteristics of a bubble,” a la dot-com or housing.
Sounds reasonable to us.
Dave, we might add, in his most recent commentary points out that the delinquency data for the first quarter, courtesy of the Mortgage Bankers Association, were decidedly miserable. The overall mortgage-delinquency rate rose to a new high of 9.12%, from 7.88% the previous quarter and 6.35% in the corresponding three months last year. Subprime delinquencies shot up to 24.95%, from 21.88% in the final quarter of ‘08, while prime delinquencies rose to 6.06%, from 5.06% in last year’s fourth quarter (and 3.71% in the like year-earlier stretch).
As Dave comments, “A year ago, the markets and the financials would have taken a big hit on data like this. But, heck, when the government steps in to guarantee the longevity of the large commercial banks,” investors simply shrug off the bad news.
Still, he reflects, such dreary data are eloquent evidence of “the deteriorating level of credit quality, fully 18 months into this crisis.” In short, do not do anything foolish.
WHEN CURRENCIES FALTER
The financiers in Beijing are getting a little leery of dollars and are accumulating gold just in case. You should do likewise.
Steve Hanke suggests you take China’s dissatisfaction with the U.S.’s “management” of the dollar to heart, and get into something else. What instead? Hanke says gold. Nobody manages gold. This is good.
Want to know where the real action will be over the coming months? Forget stocks, think foreign exchange. There are tectonic moves afoot in the currency markets these days. During the past year the Polish zloty has fallen by 23% against the euro and 11% against the Hungarian forint. Now both countries are talking about replacing their currencies with the euro. The International Monetary Fund likes this idea and wants other European countries to “euroize” as fast as possible.
The Chinese are wringing their hands over our Federal Reserve’s ballooning balance sheet. Beijing is threatening to halt its Treasury buying if the dollar slides and has suggested that IMF Special Drawing Rights replace the greenback as the world’s premier reserve currency. A United Nations panel has seconded China’s motion, but just in case it does not happen, China is buying gold.
Currently, dollar-denominated assets account for 64% of the world's official foreign reserves, and the euro accounts for 27% of the total. The British pound and yen account for only 4.1% and 3.3%, respectively. In terms of the international reach of paper money, the dollar dominates, with 60% to 70% of all folding currency held overseas. The comparable figure for the second-place euro is only 10% to 15%. When it comes to foreign exchange trading, the dollar is involved in 88% of all trades.
Will the euro ever challenge the dollar’s supremacy? Not likely. Poland and Hungary want to go euro, but the European Commission and the European Central Bank are dragging their feet. So it is not surprising that the European Union (of which Poland and Hungary are members) is openly hostile toward non-EU countries trying to adopt the euro. It is exactly this pathological insularity that I think will keep the euro from posing a threat to dollar dominance anytime soon.
One caveat relates to the experience of Montenegro, a non-EU country that is currently euro-ized. In late 1999 former president and current Prime Minister Milo Djukanovic (whom I was advising at the time) dumped the Yugoslav dinar and replaced it with the German mark. The mark morphed into the euro, and now Montenegrins use the euro. Indeed, this currency shift was a linchpin in Montenegro’s drive for independence in June 2006, an event followed in April of this year by the approval of Montenegro’s candidacy for EU membership.
It is a lesson for other countries wanting to euroize. The key is to limit the role of indigenous currencies while facilitating euro use. Panama has successfully followed this strategy for a century. Most people doing business and banking in Panama think the U.S. dollar is Panama’s national currency. But it is not. Panama’s currency is the balboa. One balboa is equal to one dollar. And while Panama issues balboa-denominated coins, it does not issue paper money. Thus Panamanians break out balboas only for small transactions requiring coins. The greenback is used for everything else.
Dollar contender, the SDR, consists of 0.6 U.S. dollars, 0.4 euros, 18.4 yen and 0.09 British pounds. Its value fluctuates with exchange rates, and today one SDR is equal to 1.5 U.S. dollars.
The SDR has its backers, and Zhou Xiaochuan, governor of the People’s Bank of China, recently announced that Beijing wanted a new international reserve currency that would be “disconnected from economic conditions and sovereign interests of any single country.” Translation: We want a viable U.S. dollar alternative, possibly the SDR.
But the SDR is not a tangible medium of exchange or a claim on one. It is simply an accounting metric the IMF uses to balance its books. It has no real commercial application. So do not look for it to displace the dollar soon.
I do not blame Beijing for fretting over the state of the international fiat money “system.” It has $2 trillion in official foreign exchange reserves at risk. So stocking up on gold bullion is a smart move.
As currencies fluctuate over the coming months, your advisors may soon be calling you to get into the new slate of exchange-traded currency funds that have hit the market. (See related story, “Buy Junky Currencies”) WisdomTree recently announced ETFs for the yuan, rupee and Brazilian real. Rydex has ETFs tracking the Mexican peso, Russian ruble and Swedish krona. My advice: Stick to the shiny yellow metal, conveniently available via a number of ETFs. Unlike fiat money, it is not controlled by politicians and central bankers.
COUNTER-CYCLICAL OR COUNTERPRODUCTIVE?
The fundamental dilemma today lies not so much in finance but with our deeply impaired economic structure.
Credit Bubble Bulletin editor Doug Noland is back, this time excoriating his “analytical nemesis” Paul McCulley, managing director of PIMCO, the mega-bond fund manager and home base for many a Federal Reserve inflationary policy advocate and apologist. McCulley claims we need enlightened “counter-cyclical regulatory policy to help modulate human nature,” while utterly failing to finger the regulators for their wildly pro-cyclical policies which exacerbated “human nature” and led to the gigantic credit bubble. Give the guys another chance, we guess. This time they mean it when they say they will lay off the sauce.
Or in Noland’s words: “I would strongly counter that it is absolutely imperative to have the good sense not to perpetuate bubbles ... to the point where they risk systemic collapse. Bankrupting the entire country is a completely unacceptable outcome.” Noland is not radical enough, to our knowledge, to advocate getting rid of the Federal Reserve, but its record for countering bubbles is not good. Actually, it is terrible. Let us at least implement this incentive system: Fed governors’ pension is a fixed number of dollars which is based on the price level when they start their tenure.
My old “analytical nemesis”, Paul McCulley, is out with a long piece this week, “The Shadow Banking System and Hyman Minsky’s Economic Journey.” He begins by stating the rather obvious: “creative financing played a massive role in propelling the global financial system to hazy new heights ...” Mr. McCulley then asks a most pertinent question: “How did financing get so creative?” His somewhat insightful article is deeply flawed in that it fails to provide a valid answer.
First and foremost, our credit system ran amok because our “activist” central bank for years pegged and, over time, increasingly manipulated the cost of finance. The Fed essentially guaranteed liquid and continuous markets to an increasingly deregulated and unrestrained marketplace, while repeatedly moving aggressively to bail out the leveraged speculators. The Greenspan Federal Reserve championed “contemporary finance”, in the process creating astounding profit opportunities for those structuring, distributing and leveraging sophisticated Wall Street financial instruments. Dr. Bernanke promised to be there with helicopter money as needed.
The Fed, congress, and various Administrations championed financial deregulation – as financial operators salivated. And it certainly did not hurt that spurring mortgage borrowing and home ownership became a national priority, as the rapidly expanding government-sponsored enterprises transformed the liquidity and marketability of mortgage securities. Unfettered private credit expansion created its own loose financial conditions, leaving Fed rate tinkering ineffectual for tightening credit conditions and Federal Reserve doctrine unwilling to address mounting credit and asset bubbles.
To be sure, the Wall Street finance/mortgage finance bubble propagated out of the massive post-tech bubble inflationary effort. The so-called “shadow banking system” was only one rather conspicuous facet of a historic – and ongoing – experiment in government monetary management.
Mr. McCulley writes: “No, I’m not a socialist.” Ok. Over the years, I have referred to McCulley and his ilk as “inflationists.” An inflationist may not begin his trek as a socialist, but it is the nature of such an endeavor to pretty much end up in that territory by the end of the day. Of course, the inflationists today are calling for more extreme and intrusive reflationary measures than those employed in previous crises and deflationary scares. It is now, apparently, necessary for the “full faith and credit of the sovereign’s balance sheet” to stand behind our entire impaired private sector credit system. At this fragile stage of the inflationary boom, the inflationists have no qualms “betting the ranch.”
Long-time readers know that I, like Mr. McCulley, am a huge admirer of Hyman Minsky. I have over the years deeply embedded Minskian analysis into my analytical framework in an effort to better comprehend the extraordinary financial and economic landscape. Others, including McCulley, have repeatedly invoked Minsky as part of their ideological rationalizations for bailouts and inflationism. And I today find great irony in Mr. McCulley’s piece: After touching upon Minsky’s preeminent analysis with respect to the nature of financial instability and “Ponzi Finance,” McCulley dogmatically prescribes unprecedented government intervention as the elixir to help restore system stability. It is a flawed analytical framework that comes to a perilous recommendation. If Hyman Minsky were with us, he would surely share a similar view that Washington has trapped itself in a most dangerous “Ponzi Finance” dynamic.
We are witnessing the same analytical errors today that were made in the post-tech bubble analysis: The willingness to inflate an even greater bubble for the cause of mitigating the pain from the so-called deflationary risks associated with a bursting of THE bubble. And with each reflation comes a heightened governmental role in both the markets and real economy – to the point where Washington is essentially backstopping the financial and economic systems.
An activist central bank pegging interest rates and manipulating the cost (hence, the flow) of finance creates wonderful opportunities for the savviest traders playing the money game most adeptly.
I used to find it rather perplexing that our nation’s largest bond fund managers were among inflationism’s most vocal proponents. I was naïve; it now seems all so obvious. Of course, market operators prefer to have the Fed and Washington there reliably backstopping the markets. An activist central bank pegging interest rates and manipulating the cost (hence, the flow) of finance creates wonderful opportunities for the savviest traders playing the money game most adeptly. The expansion of bubbles creates great opportunities and then, for the enlightened, the bursting of these bubbles provides only greater profits. Mr. McCulley is fond of blaming the “shadow banking system” for our acute financial and economic fragility. Yet the responsibility lies more generally with a deeply flawed monetary policy regime – a regime hopelessly locked in interest-rate manipulation and inflationism.
To this day I find it perplexing that leading “free market” proponents have been so happy to have the Federal Reserve setting and manipulating the cost of finance throughout the real economy. By now, it should be crystal clear that such a regime cultivates a financial apparatus that systematically misprices risk, over-expands credit, fosters over-leveraging, emboldens speculation, and massively misallocates and misdirects both financial and real resources throughout. After awhile, so much of the financial apparatus is focused primarily on seeking central bank-induced financial profits. Economic profits and real economy price signals become further marginalized. And with each bursting bubble and resulting reflation, the government’s role in the system’s pricing mechanism becomes more ingrained, intrusive and destabilizing. The bubbles change, while the price distortions and imbalances become deeply embedded in the underlying economic structure.
I see no reason to back away from the view that the fundamental dilemma today lies not so much in finance but with our deeply impaired economic structure. This structure is a manifestation of years of mispriced finance, credit and speculative excess, and resource misallocation. From this perspective, it should be obvious that greater Fed-induced market price distortions and Treasury/Fed-induced credit expansion will only exacerbate structural impairment and delay readjustment. If I had to point to a significant weakness in Minsky’s work, it would be the lack of analytical attention paid to the underlying economic structure (and why it is imperative to incorporate Austrian analysis into our analytical frameworks!).
The inflationists today believe that massive (“counter-cyclical”) government market and economic intervention will help the system revive and repair itself. I see current policies as simply a desperate attempt to perpetuate unsustainable financial and economic structures. And system impairment will not have run its course until some semblance of a market-based cost of finance emerges to more effectively allocate financial and real resources throughout the economy. The wholesale socialization of risk may be “counter cyclical” but it is also terribly counterproductive.
After the 9/11 catastrophe, I expressed the view that – if our government was compelled to stimulate – it would be preferable to run temporary fiscal deficits instead of manipulating interest rates and the financial markets. Yet the manipulation of the quantity and cost of credit is much easier for policymakers to implement, and the results (heightened liquidity, risk-taking, and inflating asset prices) can be rather immediate and heartening. Meanwhile, the associated costs are not evident let alone quantifiable. Yet such interventions – and resulting changes in the quantity and flow of finance – seductively take on a life of their own as they breed excesses, future crises and the inevitable call for only greater interventions and inflations.
Mr. McCulley concludes with the insight – and I am paraphrasing here – that deregulated and innovative finance precludes the elimination of “Minsky Moments”: McCulley believes “it’s a matter of having the good sense to have in place a counter-cyclical regulatory policy to help modulate human nature.” I would strongly counter that it is absolutely imperative to have the good sense not to perpetuate bubbles and inflate episodes of “Ponzi Finance” to the point where they risk systemic collapse. Bankrupting the entire country is a completely unacceptable outcome. At some point the inflationists should accept the reality that they are a big part of the problem – and not the solution. Is that what the bond market is beginning to tell us?
Financial services will be a significantly smaller business in the next 20 years, much better capitalized and much less profitable – all of which means lower rewards for its practitioners. That is a development to be welcomed by the rest of us.
Martin Hutchinson, editor of regular PrudentBear.com column The Bear’s Lair, is an interesting writer. His writing is consistent with the title of his book The Great Conservatives. He is skeptical, e.g., of regulation in general, but he is not a capital-B believer in free markets either.
In this Bear’s Lair column he makes some common sense distinctions between regulation which is likely to be effective and that which is not. The Federal Reserve, he points out, is “the least suitable entity on earth to regulate the U.S. banking system.” Why? The Fed “has the power ... to print money every time anything goes wrong; hence being like any bureaucracy eager to hide errors, it prints money to hide any defects that appear in the banking system, hoping to rectify the banks’ asset problems by means of a burst of inflation.” The incentive is cover up system defects rather than fix them, the economic destruction thereby effected be damned.
The Federal Deposit Insurance Corporation (FDIC), on the other hand, is responsible for taking over bad banks when they fail. It charges banks fees for its “insurance.” Since the FDIC does not want to have to go to Congress hat in hand for more money, it has an incentive to kill off risk-seeking behavior in banks and mandate tight leverage and accounting rules to avoid future problems. Unlike the case with the FDA, e.g., stamping out risk-taking behavior in their regulated industry is a good thing.
Whether government policy will be adapted to conform to even this very limited domain of rationality will be seen. The suggested policies are perfectly doable and non-radical. But banks like speculating with the public’s money inside the heads-we-win, tails-you-lose game. And the financial mischief-makers appear to have Obama’s ear.
To keep the public blaming Wall Street for their current miseries, the Obama administration has announced that it is reviewing banking regulation, with a view to appointing a single regulator for the financial services industry. Skeptical as I am of the value of regulation, I am only too well aware that different regulatory systems make a huge difference in practice. I thus thought it worthwhile to review the possibilities.
In order to examine the effectiveness of regulation, you need to look at the motivations of regulators. The Food and Drug Administration, for example, has bolstered its legitimacy for half a century by having moved so slowly in 1957-60 that it never got around to legalizing thalidomide, which caused birth defects when given to pregnant women. Since its “success” in that case, the FDA has generally been motivated by an extreme risk-aversion. This has delayed by years the introduction of new therapies to the U.S. market, and as side-effects has concentrated drug research and development in slow moving behemoths and given the pharmaceutical industry a “cost-plus” culture that has driven U.S. medical inflation to economy-sapping levels.
In general the incentives on regulators represent a tug-of-war between the regulated industry and the natural bureaucratic concern about the consequences of laxity. In bull markets, regulators are captured by the industry concerned, and so regulation becomes too lax. In bad times, as currently in the banking sector, the adverse consequences of laxity become only too clear and so political pressures cause regulators to pile regulation upon regulation, seeking to shut the door after the horse has bolted.
This can be illustrated by considering two misguided regulatory efforts of the last decade. In April 2004, the Securities and Exchange Commission (SEC), under pressure from the brokerages in a period of easy money and a steep yield curve – which makes leverage more profitable if you borrow short and lend long – agreed to exempt brokerages from the net capital rule which had previously restricted them. This now looks incredibly foolish. It led to the 30-to-1 leverage ratios at the major brokerages going into 2008, which in turn led 3 of the 5 to effective bankruptcy within that year. It should have been obvious that without some kind of restriction on leverage, investors with accounts at those brokerages would not be protected unless the taxpayer was called in to fund a bailout. Surprisingly, in the bullish atmosphere of 2004, this was not obvious, even to an SEC led by Bill Donaldson, himself founder of the major brokerage house Donaldson, Lufkin and Jenrette.
In the other direction was the Sarbanes-Oxley legislation, passed in a frenzy in 2002 by a Congress under pressure from its constituents after the dot.com crash and the Enron bankruptcy. This failed to address the major problems of the dot.com era, which were mostly caused by poor shareholder governance and accounting laxity. Instead it imposed legal requirements on even quite small companies that have since proved hugely costly, at close to $5 million annually for small public companies. Section 404, in particular, required companies to get their internal control systems audited and has proved a bonanza for the accounting profession and a huge cost for everyone else. Sarbanes-Oxley has caused a high proportion of major foreign public companies to delist themselves from the New York Stock Exchange, with the unintended consequence of raising an artificial barrier to the globalization of capital markets and effectively barring many large foreign companies to U.S. retail investment.
In an ideal world, financial sector regulation would be unnecessary. Monetary policy would be self-regulating, while banks and investment banks would be constrained by their depositors and securities customers. Since a self-regulating monetary policy (such as the Gold Standard, but not necessarily limited to that possibility) would push up interest rates at moments of speculative excess, such as after 1997, neither financial institutions nor their customers would be able to forget the periods of stringency that followed excess – they would happen too often.
Like most of the classical free-market model, this ideal is of only limited applicability in the real world. When investors and markets in general are not rational, and monetary policy is subject to the political desire to keep the economy forever in expansionary mode, conditions are sufficiently distorted for the free-market unregulated model not to work too well. By regulation, one is always searching for a second-best solution, and recognizing that the solution will itself impose further distortions on the classical system, but this is economics, not theology, and accommodations must be made.
However, consideration of the free market ideal highlights the flaws in some of the proposals. Having the Federal Reserve (Fed) regulate the financial system, for example, is clearly a very bad idea. The Fed has been demonstrating since 1995 that it is prepared to subordinate monetary policy to the political desirability of perpetual expansion. It has even attempted to justify this perpetual expansionism by calling it the “Great Moderation,” when moderation is the one feature of a well-functioning market that the Fed’s expansionism most certainly destroys. A Great Moderation that leads oil prices to double to $147 per barrel within a year, then drop by 3/4, then double again from the bottom in only a few months, meets no definition of moderation that a linguist would recognize.
As a highly political institution and one with a perverse and dangerous built-in tendency towards expansionism, the Fed is thus the least suitable entity on earth to regulate the U.S. banking system (well OK, maybe Vladimir Putin’s Federal Security Service would be worse!). Moreover, it has the power as it has demonstrated over the last two years to print money every time anything goes wrong; hence being like any bureaucracy eager to hide errors, it prints money to hide any defects that appear in the banking system, hoping to rectify the banks’ asset problems by means of a burst of inflation.
This of course precisely what it has done in response to the housing crisis, a tendency for which the reckoning has not yet arrived. However, the recent sharp rise in the 10-year Treasury bond yield is beginning to hint that the bill will be a gigantic one. If it continues, that rise in interest rates will push the housing market back towards further price declines, even though prices are now close to their long-term equilibrium – which will once again destabilize the banking system because of the destruction of mortgage credit quality such further declines would cause.
Instead of a regulator with the power to print money to cover up its mistakes, and the incentive to do so, I would propose a regulator whose incentives are in the opposite direction. The Federal Deposit Insurance Corporation (FDIC) takes over bad banks when they fail, and charges the banking system fees for its insurance activity. Since it does not want to have to go back to Congress for more money, it thus has an incentive to stamp out risk-seeking behavior in banks and mandate tight leverage and accounting rules to avoid problems occurring. Furthermore, since the FDIC charges fees to banks based on its loss experience, there would be an incentive for a naughty bank’s competitors to “snitch” when its risks got out of line, thus both cutting down underpriced competition and risky activity that might lead to higher FDIC fees in the future.
Of all the regulators in this mess, the FDIC’s Sheila Bair is emerging from it best, with her reputation enhanced and her institution’s powers properly used, without excessive power-grabs at the expense of other regulators or the private sector. Naturally, it appears that the FDIC will need quite a lot more money from Congress for its bank bailout efforts, but that is hardly its fault since it does not currently regulate the banking system.
This recommendation tallies with British experience. Before 1998, the Bank of England, which had responsibility for bailouts (as it demonstrated in 1890 and 1973) was also the regulator. The result was a system which experienced no bank failure for 141 years, between Overend, Gurney in 1866 and Northern Rock in 2007. Moreover, before 1997, the Bank did not have full responsibility for monetary policy; that was shared by the Treasury (and before 1931 was set by the gold market). The Bank of England’s money market duty was limited to its role in crisis management, described in 1873 by Walter Bagehot as “to lend on good security, but at a high rate.” Thus the pre-1998 British regulator of banks (though not of the securities market) had roughly the same incentive structure as the FDIC.
The post-1998 British regulatory system, controlled by the Financial Services Agency (FSA), suffered from the twin evils of bureaucracy and regulatory capture. Small institutions were stifled by regulatory costs, in a similar manner to small public companies under Sarbanes-Oxley, while large institutions were allowed to over-leverage themselves and concentrate risk in a way that should have been prevented. However, the FSA, which had no responsibility for bailouts but was a child of the 1986 Financial Services Act disaster, which wiped out the British merchant banks, was consumed by the London market’s attempt to overtake New York as the world’s premier financial market. The RBS takeover of ABN-Amro, in particular, was a case of megalomaniac management overpaying at the top of the market, which a regulator properly concerned with the health of the financial markets would have prevented.
An FDIC regulator, responsible for bailouts, would rein in the banks in a number of ways, notably by imposing tight regulation of derivatives, probably banning credit default swaps altogether as generators of risk out of proportion to their benefits. It would thus be highly unpopular with the banking system, and will no doubt be resisted. The banks’ resistance should be overruled. Financial services will be a significantly smaller business in the next 20 years, much better capitalized and much less profitable – all of which means lower rewards for its practitioners. That is a development to be welcomed by the rest of us.
THE GOVERNMENT BOND GLUT
What happens if the global investment community sours on government bonds as an asset class?
What happens when the government bond bubble pops and people stop treating such bonds as risk-free financial assets, asks Martin Hutchinson. To us this looks inevitable, the only question being when. (Forecast time or price, but not both, goes the old advice for soothsayers.)
Above all, Hutchinson answers, there will be commodities. “Traditionally, central banks held their reserves in gold rather than other countries’ government bonds. For the major central bank pools of money such as Japan, China, Taiwan and the Middle East, we are likely to go back to that.”
“This change in central bank investment policy will have two effects,” he continues. “First, it will cause an enormous bull market in gold ... A gold price of $5,000 per ounce is well within reach. Second, these commodity purchases carried out for investment will increase reported inflation, especially in items such as oil and food ...”
Of course a disfunctional government debt market implies disruption from government defaults and enforced service cutbacks. Ideally there will also be disruption of foreign adventures, Big Brother surveillance, and counterproductive bureaucratic regulation and oversight. One can only hope.
Standing on thinner ice, Hutchinson claims that “sound government debt markets increase economic efficiency by providing a ‘risk-free’ haven for capital balances,” and that therefore “severe bond market indigestion will reduce economic well-being.” We would like to see the theory behind that claim. Among other absurdities, it implies that government deficits, even if incurred for nonproductive uses (i.e., as in the real world), increase economic well-being. No, a world non-functioning government debt markets definitely has its attractions.
Britain last week was put on negative credit watch by Standard & Poor’s for downward re-rating from its current AAA. The United States, Japan and several other countries are running record deficits, yet their bond yields are still close to all-time lows. That brings up an awkward question: What happens if the global investment community, public and private sector, sours on government bonds as an asset class?
If governments were companies, you would not touch their stock with a 10-foot pole.
There is good reason for rational investors to do so. Britain’s debt is forecast by S&P to exceed 100% of Gross Domestic Product (GDP) by 2013, Japan’s debt may exceed a lofty 200% of GDP by 2011 and nobody believes the official forecast that U.S. government debt will remain as low as 80% of GDP by the end of the current budget horizon in 2019. Yet in all three countries, interest rates on government debt are barely above the immediate rate of inflation, let alone the rate of inflation that is likely to arrive in the next 12 to 18 months as monetary “stimulus” works its magic. Face it, if governments were companies, you would not touch their stock with a 10-foot pole.
Monetary authorities like Ben Bernanke who claim loftily that they will withdraw monetary easing well in time before inflation really gets a grip should be disbelieved. So should fiscal panjandrums like Treasury Secretary Tim Geithner or Chancellor of the Exchequer Alistair Darling, when they claim that the current orgy of public spending is only temporary. Cutting spending is far more difficult than increasing it, and will be done only with the greatest reluctance. As for Japanese prime minister Taro Aso, he has an election to face within the next four months, and deeply unscrupulous LDP party barons behind him, who believe that the only way to win the support of the Japanese rural voter is to run a superhighway through his back garden.
As White House Chief of Staff Rahm Emanuel said just after the U.S. election, “You never want a serious crisis to go to waste.” Since the majority of today’s politicians, it appears, have no greater joy in life than spending somebody else’s money, it is not surprising that they have exploited an atmosphere of panic during the onset of the recession to force through gigantic public spending programs that are now coming into effect, almost all of which bear no relationship whatever to economic recovery.
A situation in which governments in several of the world’s largest economies are tapping their bond markets simultaneously at this level has not occurred since World War II.
Most government debt markets (including some but probably not all of those in euros) are thus likely to suffer an oversupply crisis over the next year or so. Funding requirements of the order of 10% of GDP have not been common in the past, except during major wars when the private sector more or less shuts down except for war production and the government takes emergency powers to commandeer resources. A situation in which governments in several of the world’s largest economies are tapping their bond markets simultaneously at this level has not occurred since World War II, and was impossible before that, when the world was on a Gold Standard.
So far, there has been no major crunch, because monetary authorities have funded the deficits – in Britain’s case providing about 65% of their finance, at least for a few months. It is clear however that far from being able to withdraw their excessive monetary accommodation as the economy stabilizes, central banks will have to continue financing budget deficits, because only by that means will the money be raised. That will in turn cause inflation, which will cause the market to re-price nominal interest rates upwards and long-term government bond prices correspondingly downwards.
Even the most hawkish of the Fed governors, the Philadelphia Fed’s Charles Plosser, talked last week only of an inflation problem that might lead to 4% inflation by 2012. He is far too low, and far too late. The recent upsurge in oil and gold prices, back above $60 and close to $1,000 respectively, indicates that inflationary forces have already taken a grip on the global economy.
Government statistical departments have considerable latitude to fudge reported inflation figures for a few months, rounding everything down and giving themselves the benefit of the doubt, and the media and other authority figures will give them all the help they can. But by the end of 2009, it will be obvious to even the doziest Middle Eastern central banker that inflation in the U.S. and Britain, at least, is running at over 5%, and is well on the way to 15% to 20%. Government bond rates of 3% or 4% will at that point become unsustainable, however hard the Fed and the Bank of England buy the bonds.
When we examine the potential government bond market position at that point it is likely to be a grim one. Yields will still be close to zero in real terms, yet inflation will be accelerating while most major governments will still be demanding fantastic amounts of money from the market. In that situation, rational investors will go on a “buyers’ strike.” They will already have more than they want of this supposedly risk-free paper, yet they will be asked to buy still more of it, when they are becoming increasingly sure that it will give them a negligible real yield over the long term, and a money loss through price decline in the short term.
The theory that foreign central banks will buy more of this rubbish in order to protect their existing holdings will at some stage become false, and that refutation will probably happen suddenly. Bonds of OECD governments will have ceased to be a risk-free asset.
The theory that the People’s Bank of China, the Bank of Japan and the various Middle Eastern central banks will buy more of this rubbish in order to protect their existing holdings will at some stage become false, and that refutation will probably happen suddenly. Prices will collapse, and further long-term funding will become impossible. Bonds of OECD governments will have ceased to be a risk-free asset.
Since much of economic history has occurred without government bonds being regarded as the ultimate safety investment, there is no reason why we cannot have an economic system without this postulate. England before 1694 accrued substantial savings without a sound public debt market, the United States had no government debt for substantial portions of the 19th century and a number of Islamic and emerging market economies operate today without government debt markets. However, as these examples will indicate, sound government debt markets increase economic efficiency by providing a “risk-free” haven for capital balances. Thus a collapse in government debt markets will have adverse economic consequences in two ways: There will be direct disruption from government defaults and enforced service cutbacks, and there will be a step backward in economic efficiency, causing a long-term reduction in output potential.
Nevertheless, even without U.S., British or Japanese government debt, risk-averse investors, whether or not central banks, will have second-best alternatives available. There will be a few governments, such as those of Germany, Korea and Brazil, whose economic prospects remain reasonable and which will not have blown through their borrowing capacity. On the other hand, banks will be poor investments, since their now illiquid and risky holdings of government paper will only add to the immense pile of rubbish already on their balance sheets.
It is after all irrational in a capitalist system to assume that wealth-producing businesses are less solid investments than wealth-absorbing governments.
Those stable industrial companies in the United States and Europe which have not over-extended themselves will have shares and maybe bonds (if in non-inflating currencies) outstanding that may appear good value. Shares of Procter & Gamble, Coca-Cola, Nintendo and Cadbury, companies that are not overleveraged and that sell either basic goods or cheap entertainment, will be the true “blue-chip” investments for the safety-conscious investor. It is after all irrational in a capitalist system to assume that wealth-producing businesses are less solid investments than wealth-absorbing governments.
Above all, there will be commodities. Traditionally, central banks held their reserves in gold rather than other countries’ government bonds. For the major central bank pools of money such as Japan, China, Taiwan and the Middle East, we are likely to go back to that. They will diversify a bit from gold, possibly to silver, but also to non-traditional commodity stores of value such as grain, copper, other metals and especially oil.
A gold price of $5,000 per ounce is well within reach.
This change in central bank investment policy will have two effects. First, it will cause an enormous bull market in gold, whose annual production is worth only about $100 billion at current prices, a pittance in relation to the weight of money heading its way. A gold price of $5,000 per ounce is well within reach. Second, these commodity purchases carried out for investment will increase reported inflation, especially in items such as oil and food, which to Ben Bernanke may be “non-core” but to the rest of us are essential for survival.
That is why the argument beloved of central bankers, that inflation is impossible while there are is an “output gap” between actual and potential output, is so erroneous. Anyone who experienced the 1970s, or those under 40 who were paying attention in economic history class, will already know that idea to be bunkum. Twice in 1974 and 1979-82 the United States experienced substantial inflation and recession simultaneously, and Britain in 1975 experienced inflation of 25% in the middle of a deep downturn.
Policymakers WANT to believe that deflation is the main threat, because it justifies zero interest rates, and they WANT to believe that they can borrow 10% of GDP without adverse consequences, because it justifies them in spending public money, which is always fun. However in reality both beliefs are wrong and the global economy is about to demonstrate this the hard way. A rush to commodities will intensify an already problematic surge in inflation, while severe bond market indigestion will reduce economic well-being for much of the next decade.
WHEN IT COMES TO GOLD, IT IS ABOUT CHOOSING THE RIGHT COMPANIES
Lila A. Manassa is responsible for researching and monitoring natural resources companies for the Federated Prudent Bear Fund and Federated Prudent Global Income Fund. She explains what she looks for in a gold mining company. Interesting little explanation, although all the smart analytics in the world will not help you if your company drills a bunch of dry holes.
Historically, our strategy at Federated Prudent Bear has been to maintain an allocation to resources stock investments, predominantly in the precious metals sector, as a hedge against a weakening U.S. dollar and the inflating away of purchasing power due to irresponsible fiscal and monetary policies. As such, we have long maintained a bias toward hard assets in favor of paper ones.
Often we are asked the question, “Do you prefer to own the commodity or the related stocks?” It is a fair question indeed. Many years ago, we decided that building expertise in the resources area would be an important part of our strategy because of the significant value that can be created by a company that can move a nascent resource into an asset that can produce free cash flow. Beyond the largest companies, natural resources – be it energy, precious metals or base metals – are a very inefficient group of stocks. Many of the companies that are finding and building resources are individuals who strike out on their own after years of working for a large organization. Analysis of these smaller, earlier-stage projects requires technical knowledge, i.e., “Can this work?”, with financial expertise, i.e., “At what cost will this work?” It has been my ongoing task to understand what will work and what will not, and to find the highest quality projects at the most reasonable prices.
Reserves and production per share for many senior companies is a metric that seems to be in terminal decline.
All that said, companies present certain challenges, particularly the larger ones. The senior gold producers have historically not paid a great deal of attention to such traditional investment metrics as returns on assets and capital, often instead favoring growth for the sake of getting bigger. Growth in shares outstanding often exceeds the growth in production and reserves. Therefore, reserves and production per share for many senior companies is a metric that seems to be in terminal decline. Mergers often do not create synergies or result in any significant cost savings. The big get bigger, but they do not necessarily get better.
Acquisitions and other management follies aside, mining is an extremely challenging business in its own right. Worldwide grades, or the amount of precious metal per tonne of rock, are in decline, which increases costs per ounce of production – not to mention expropriations by rogue governments, permitting risks, and cost inflation. In addition, many of the projects the majors need to develop in order to show production growth – or in some cases just to keep production flat! – have single-digit internal rates of return.
For example, a recent major piece of news for the precious metals sector was the publication of the feasibility study and related economics for the 50/50 joint venture of Barrick Gold/NovaGold Resources’ Donlin Creek project. The project is one of the world’s largest undeveloped gold deposits, coming in at 29.3 million ounces of gold. A decision to build it out would make the Donlin Creek mine one of the world’s largest producers of gold. However, the project economics seem quite poor. The life-of-mine cash costs per ounce are estimated to be in the order of between $467 and $477 per ounce. At 89.5% gold recovery, the total capital costs per recoverable ounce are over $200 per reserve ounce. In total, this comes to approximately $675 per ounce in costs without even factoring in sunk costs such as exploration, community relations, and other baseline studies – 13 years of work had been done on this project up until this point. The high costs make themselves very clear in an analysis of the returns on the project. With gold at $900 an ounce, the after-tax internal rate of return (IRR) on the project is 7.7%. With gold at $725, the economics seem even more bleak, with an after-tax IRR of only 2.3%. I do not mean to pick on Donlin Creek or on Barrick, I merely attempt to illustrate just how tough a business mining can be.
While we believe the price of gold will rise over the long-term, we acknowledge that there are significant risks in terms of volatility of the gold price over the life of a mine. Therefore, we do not believe it is necessarily prudent for a company to run project-economics for a 15-year mine life at spot gold prices. Additionally, it has been our experience that even when gold prices do rise, costs seem to rise right along with the commodity, rendering the operating leverage argument pretty ineffective.
All of these aforementioned factors have contributed to low and declining average returns for the major gold producers ...
A chart showing returns on assets by year, 2002-2008, for the 7 major gold producers clearly indicates declining returns.
So the question remains, why invest in any of these resources companies? Despite all of the aforementioned industry woes, the fact that world mine supply is in secular decline presents an extraordinary opportunity for those who can find gold and move projects along what we call the “value curve.” The growth of diversified mining companies is achieved predominately through acquisitions, which leaves much of the earlier exploration and development of a project to smaller, independent companies.
The “value curve” is effectively a full-cycle look at how a mine goes from being a mere discovery, through the development, permitting, building and commissioning of an actual producing mine. Effectively, it is an asset creation cycle. At the lowest point in the curve, you have the exploration and appraisal of an ore body. The resource is confirmed, expanded, and estimates as to the tonnage and grade are published in an NI 43-101 compliant resource estimate. Generally, early to advanced exploration companies trade between 0.2 and 0.5 times net asset value (NAV) because many of the risks have not yet been removed. As companies move assets up the value curve and the project is “derisked” – permits are acquired, financing is obtained, resources are further delineated and become reserves, technical and political risks are assessed, and economics are published – they attract higher multiples to net asset value. Although we believe gold prices will be substantially higher in the future than they are today, we look for valuation growth, multiple expansion and the ability to generate free cash flow independent of the gold price. In other words, we want the higher gold price to be the icing on the cake, but not the cake itself. Therefore, my job is to find companies that can execute – that have the right combination of technical expertise, asset quality, and sound economics in order to move assets up the value curve.
This is not to say that there are not attractive opportunities in some of the senior and intermediate names as well. There are several of the larger names with existing production that have either grown organically (i.e., through the drill bit), or used the credit market conditions of late last year and early this year to their advantage in making acquisitions of companies at attractive prices. Many of these acquisition targets had been unable to obtain financing to move their projects up the value curve. However, we believe the most significant alpha generation in our resources portfolio will come from the smaller, independent companies that can create value via the discovery and development of the particular commodity in question.
LET’S HOARD CRUDE OIL
The best solution for getting out of the current mess may not come from conventional thinking.
David Dreman suggests the U.S. would do well to buy depressed oil and other natural resources rather than allegedly depressed bank equity ... and whatever other crap it is buying in an attempt to revive the financial system. Fat chance. But if Uncle Sam will not do that there is nothing to restrain you from doing the same.
We are in the worst financial crisis in modern history, and most of us are sick of reading about the trillions of dollars of taxpayer money being pledged to bail out banks, brokers, insurers and carmakers. The handouts did not stop the crisis from spreading from industry to industry. Even if much of the money is recovered by the U.S. Treasury, we are imposing immense costs on our children and grandchildren.
Have you noticed that the creators of our current game plan are all accredited inside-the-box thinkers? Economist Lawrence Summers and Treasury Secretary Timothy Geithner both won their economic spurs by pushing through extraordinarily poor and timid policies. Summers, who now serves as director of the National Economic Council, was President Clinton’s last Treasury Secretary. In that role he worked successfully in 1999 to repeal the 1933 Glass-Steagall Act. The change allowed commercial banks to go head-to-head with investment banks, so they expanded into riskier lines of business. This contributed to our financial mess. As an encore in 2000, Summers pushed for legislation that allowed unregulated trading in derivatives such as credit default swaps by financial firms. Thanks, Larry.
Secretary Geithner, who headed the Federal Reserve Bank of New York until he landed in his current job, did not miss his chance to make things worse. He was involved in the decision last September to let Lehman Brothers go under. That is what set off the stampede to safety in the money market. Victims of the credit panic include shareholders of AIG, Merrill Lynch, Washington Mutual and Wachovia, not to mention taxpayers and anyone with a 401(k) in stocks.
I am not saying that current economic thinking is completely bankrupt. I am saying that the best solution for getting out of this mess may not come from conventional thinking.
Here is my idea: Instead of spending a trillion propping up insolvent banks, the government should buy oil and other commodities like copper, aluminum and zinc that are now selling at bargain prices. The investment would have strategic value and, more important, it would counteract the deflationary pressures that are contributing to the recession.
These days everyone is worried about deflation. After all, falling prices were one reason that the Great Depression was as bad as it was. Franklin Roosevelt’s gold scheme (raising the price from $20 to $35 an ounce and abrogating gold clauses in private contracts) was an attempt to spur inflation.
My idea is that we accumulate useful resources, such as crude for our strategic oil reserve. This would create new jobs, halt a deflationary spiral and give us some protection against the next international oil crisis. If the government allocated $500 billion at current prices, it would add 10 billion barrels of oil, which amounts to 17 months’ consumption. The government could undertake similar purchase programs for copper, aluminum, lead and other essential industrial commodities now trading at very depressed prices.
An oil-buying binge would be a win for taxpayers as well. Oil bought today below $60 a barrel can be released back into the market at $120 after economic activity has picked up and inflation has resumed.
I am not holding my breath waiting for a call from President Obama or Geithner about my plan. If the government is not going to buy oil, you can do so yourself by purchasing oil producers. One of my favorites is Anadarko Petroleum (45, APC), which has reserves of 2.28 billion barrels, or 4.9 barrels per share. It goes for 9.1 times 2009 earnings.
You should be buying stocks generally, even though the recession is not yet over. Here are three nonresource stocks I like.
Paccar (30, PCAR) makes Peterbilt and Kenworth diesel trucks. This well-managed company is trading at less than half its 2007 high of $63. Paccar goes for 14 times trailing earnings and 45 times likely depressed earnings for 2009. The yield is 2.3%.
Tesoro (16, TSO) is the 3rd-largest petroleum refiner not connected to an exploration company. Margins are down along with the demand for gasoline. But that demand will someday return. Tesoro sells for 5.5 times 2008 earnings and yields 2.5%.
The former Minnesota Mining & Manufacturing, now known as 3M (58, MMM), is another fallen angel that I think will outperform when the economy turns. It is down 40% from its late 2007 high and trades at 13.5 times trailing earnings. While you are waiting for it to recover you collect a 3.5% dividend yield.
BETTING THE FARM
The case for rising food prices.
After selling off viciously along with everything else, some soft commodities have recovered quite vigorously. Soybean futures have risen 48% since their low. Sugar futures are up 40% to 3-year highs. The analysts quoted below expect food inflation to continue.
You are going to have to get used to the fact that you will have to spend a greater proportion of your income on food in the future – after decades of spending less.
That is according to Joakim Helenius, chairman of Trigon Agri, an integrated soft commodities producer in the Ukraine and Russia. He believes that food inflation has only just started – and he is not alone.
Commodities perma-bull Jim Rogers thinks people should not buy shares – he says they should buy commodities instead, especially agricultural commodities. “I can think of very few industries in the world where the fundamentals are getting better. But the fundamentals of commodities are getting better, full stop,” Rogers told CNBC last month.
The price of most commodities has jumped significantly this year, as the global economy slowly stutters toward recovery.
Gains in oil and metals prices may not have much further to go but many believe that the situation with food is different. Soybean futures have risen 48% since their low, with sugar futures rising 40% to 3-year highs.
The Indian government is so concerned by developments that it has outlawed trading in any new sugar futures contracts until the end of this year. The government obviously believes that speculation by investors was the source of recent price rises.
However, many argue that there are fundamental trends driving the increases. The rise in food prices is inevitable, they say. Helenius says there are long-term and short-term factors at play – and these factors have combined to create a bull market in soft commodities.
Over the long-term, the rising global population will be a fundamental driver of the rising price of food.
Last year, Ban Ki Moon, secretary general of the United Nations, predicted that world food production had to increase by half by 2030 to meet rising demand.
Then there is global warming. Dry places are getting dryer and wet places are getting wetter and this is playing havoc with farming.
South America has suffered from a protracted drought this year and many crops have failed. Changing weather patterns are likely to mean this will continue.
Stephen Johnston, partner at Canadian agricultural investment firm Agcapita Partners said: “The fundamentals in the agricultural commodity markets remain unimpaired as they are driven primarily by a large increase in demand coming out of the emerging economies of China and India. We believe that the secular bull market for agricultural commodities is intact.”
Rising wealth leads to rising food consumption but it also leads to more meat consumption. Raising cattle or sheep requires significantly more grain and stimulates demand for soft commodities.
It has been estimated that between 2001 and 2007, emerging economies accounted for a 26 million ton average annual increase in consumption of major food stocks.
Short-term factors are also having an impact and these are responsible for a significant amount of recent gains. One factor is the credit crunch.
“The financial crisis is hitting both sides of the supply and demand equation,” Helenius says. “Poorer countries do not have the finance to import the food that their countries need, but it is hitting the supply side as well. Farmers cannot get the finance they need to buy the inputs that go into growing food.”
Ukraine is a perfect example of this. Because of the financial crisis its agricultural output is set to fall by about a third this year, meaning there will be little food to export after it has met its internal needs.
Helenius believes that the financial crisis is hitting the supply side of the equation harder than the demand side and that is why food prices are likely to continue to rise. There is also the question of the outlook for the dollar. The U.S. Federal Reserve may soon be forced into more quantitative easing, whatever the consequences for the dollar.
One of the major contributors to the last commodities boom was a weakening U.S. currency. Commodities are used as a hedge to protect wealth.
A tumbling dollar is likely to cause food prices to rise as well. Debased currencies stimulate an appetite for investment in real assets.
In a recent note to clients, Eliane Tanner, a commodity analyst at Credit Suisse said: “A shift by central banks across the globe towards quantitative easing will lend support to commodity prices over the longer term.”
Food inflation has been stubborn. Last week, Northern Foods, one of the UK’s largest suppliers of packaged food to supermarkets, said it was here to stay for the foreseeable future. “We anticipate that next year will be equally challenging, with the continuation of food inflation,” it said.
With demand for food continuing to rise significantly as the global population rises and gentrifies, the fundamental arguments for continued rises in soft commodity prices and all that means for inflation are easy to see.
If you are expecting the price of your weekly shopping basket to fall soon, it may be best not to hold your breath.
WHAT “CUBA LIBRE” COULD MEAN FOR INVESTORS
Castro kick-the-bucket-watch plays.
Chances are the U.S. embargo on Cuba in place since 1959 will not be dropped until Fidel Castro dies. Too many special interest groups and politicians oppose it, no matter what logic militates against continuing the embargo. Welcome to politics. But Fidel’s days are numbered. It is just that how numbered is uncertain, as the old dictator continues to hang on.
Those who wish to speculate on companies which may benefit from the lifting of the embargo and consequent greater access to Cuba have several options. They can buy shares in the closed-end Caribbean Basin Fund, managed by closed-end fund specialist Thomas Herzfeld. The fund usually trades at a premium to its net asset value, unlike most closed-end funds. Alternatively, one can buy directly a selection of those companies held in the Caribbean Basin Fund – or any company one discovers for oneself.
Barron’s speculates that cruise operators Carnival and Royal Caribbean Cruises could be “home runs” once the embargo is lifted, as demand would surge for cruises which could now visit the long off-limits island. Cuba has only three deepwater ports, thus one might hedge/augment holdings in the cruise operators with shares of Trailer Bridge, a Florida transport company whose ships have shallow drafts.
It took Commodore Perry a couple of years to open Japan for trade with the U.S. – and he threatened the island nation with bombardment by a naval task force. [Ed: Before the days of the IMF, World Bank, et al, empires required more blatent, but more honest, methods to coerce nations into experiencing the blessings of free trade.] So do not expect the Castro brothers to throw open Cuba to U.S. trade and investment merely because of moves in Washington to relax a 47-year-old trade embargo. A spokesman tells us the Obama administration is not expecting anything momentous soon, and it still is not clear whether the Cuban government is truly interested in better relations.
Even so, the stars favoring freer trade are better aligned than at any time since Castro overthrew the island nation’s pro-American dictator in 1959. First, in a goodwill gesture, President Obama softened the U.S. hard line by allowing more visits by Cuban-Americans and freer flows of cash and electronic goods like cellphones – with more to come if oppressive Cuban laws are relaxed. Second, on a separate track, Congress is proposing a bigger goody bag for Cuba. New York Rep. Charles Rangel, chairman of the House Ways and Means Committee, talks about ending the embargo altogether in 2010, assuming health-care reform is over and done with. Republicans and Democrats on his committee have introduced bills ranging from partial lifting of the embargo to its total elimination, a position endorsed by the influential U.S. Chamber of Commerce.
Says Chamber President Tom Donohue: “Cuba’s poverty is a direct result of half a century of Marxist mismanagement, but the embargo allows the Castros to blame it on Washington. Lifting it would remove their excuse for economic failure, and would help American farmers, businesses and workers – as well as the Cuban people.”
Raul Castro, now running the country, said in reaction to President Obama’s gesture that he is open to discussing anything. But Fidel, father of the revolution, sounded a harder line. Donohue believes the brothers are playing “good cop, bad cop,” and in their hearts would like to see more U.S. trade. Cuba already imports close to $700 million in agricultural products from the U.S. But thus far they have not made any conciliatory gestures of their own.
There is a way to trade on this uncertainty. Tom Herzfeld’s closed-end Caribbean Basin Fund (ticker: CUBA) rises or falls in reaction to the latest news flash concerning Cuba. This is because it invests in companies whose shares would be boosted by the embargo’s elimination. The fund usually trades at a premium to its net asset value.
“When Fidel became ill about three years ago and went into the hospital, the stock spiked up,” says Herzfeld, who operates in Miami, where he also has a money-management firm. But in 1996, when the Cubans shot down a Piper Cub operated by Brothers to the Rescue, killing its three occupants, shares of the closed-end fund dipped. In the past 52 weeks – a period when all stocks were getting hammered – shares traded at a high of $9.18 and a low of $3.11. They recently fetched $6.02.
The closed-end fund’s holdings include Western Union (WU), which operates in Cuba, and home builder Lennar (LEN), which Herzfeld says has a business plan for the island. He avoids two Canadian companies active in Cuba – Sherritt International (SHERF), which runs mines that Castro seized from Freeport McMoRan, and Leisure Canada (LCN.V), which develops properties on the island.
Freeport McMoRan (FCX) is one of his holdings because he believes that any thawing of relations will include recompense for its loss. Plus, the mining company will do well as the world’s economy recovers and the demand for metals and gold increases.
The fund also has shares of Seaboard (SEB), which operates more shipping routes in the Caribbean than any of its competitors, and shares of Trailer Bridge (TRBR), a transport company in Jacksonville, Florida, whose ships have shallow drafts. (Only three of Cuba’s 14 ports are deepwater.)
Herzfeld’s fund also holds shares of Watsco (WSO), a Florida air-conditioning distributor; Norfolk Southern (NSC), which connects to the now privately held Florida East Coast Rail Road at Jacksonville; and MasTec (MTZ), a Florida-based infrastructure company founded by prominent Cuban-American Jorge Mas Canosa.
But the fund’s home runs, if the embargo falls, could be Carnival (CCL) and Royal Caribbean Cruises (RCL), both of which already ply the Caribbean. Not only will they get a tremendous lift from passengers wanting to travel to Cuba, but their entire Caribbean business also should benefit when they add Havana, long shut down, as a port of call.
Rangel says that despite widespread congressional support, lifting the embargo will not be a slam-dunk. Old-line Cuban-Americans with political clout oppose ending it, as do some conservative members of Congress.
This could change overnight if Fidel Castro kicks the bucket. But while he is alive, do not hold your breath waiting for normal relations.
MANPOWER TRIES TO CATCH A WEB WAVE
The world’s second-largest employment agency has a plan to thrive in the postemployee world.
Here is an interesting piece on how Manpower, the large employment agency best known for placing workers in temporary jobs, is adapting to changing times. People have been talking of leaving the “rat race” for decades, usually with the idea of working for themselves. Now increasing unemployment, changing attitudes, and the networking made possible by the internet are actually making/allowing that change to happen.
On the other side, companies often claim they will not rehire the workers they fired during a recession when the recovery comes along ... and proceed to do exactly that. But if they actually walk the talk this time it will leave room for a sizeable industry which acts as a broker between freelancer worker suppliers and company demand for services. Manpower’s idea, along with a host of other companies, is to be such a broker. This will be interesting.
Business has been grim for Manpower, the $22 billion (2008 revenue) Milwaukee employment agency. The one bright spot: Right Management, a high-margin unit that, as the world’s largest provider of outplacement services and workforce retraining, feeds on the current turmoil. Jeffrey Joerres, Manpower’s plain-talking 49-year-old boss, is grateful to have Right, and not just for its profits. The unit has given Manpower an inside look at fast-changing attitudes among displaced middle- and upper-level corporate workers, and now Joerres wants to profit from those changes.
Right has 300 offices, 82 in the U.S., and expects to help 200,000 ex-employees this year, double last year’s number. Companies pay anywhere from $1,500 per head for four weeks of basic middle-management job search guidance to $100,000 for a senior manager outplacement package that includes an office, a secretary and career “advocacy.”
In the past, reports Douglas Matthews, Right’s president, 30% of laid-off U.S. employees counseled by Right initially said they wanted to shift industries or careers – even if they did not all end up doing so. Now 60% say they are yearning for a sea change. The percentage who end up starting their own businesses or working for themselves is rising, too – from 5% to 8% in the last year.
One typical Right client was Michael Masquelier, 47, a 20-year Motorola veteran who managed technical and business development projects before he took a voluntary severance package in December 2007. Now he is a self-employed consultant to startup firms seeking to tap venture capital. He charges $250 an hour, capped at $20,000 a month per client. “I found a niche for myself,” he says.
As his own boss, Masquelier will not be taking a buyout and using Right’s services again. But Joerres sees another way to profit. He has ordered up plans for an Internet service that will act as an intermediary between Manpower’s [symbol: MAN] existing corporate clients and independent contractors like Masquelier.
Will the recession be over by the time this is up and running? Maybe. But big firms, having disgorged millions of workers, will be more reluctant than in past recoveries to feed on full-time staff, Joerres predicts. Nor does he believe top professionals’ desire for more flexibility and independence will disappear when conventional jobs return.
Joerres’s vision of the future: “The call center is everyone’s home, anywhere in the world. I take my card, put it in a laptop, and it says, ‘Jeff Joerres is now ready for work. Here are the benefits I want, here is what I don’t want, and I am only going to work for the next two hours.’ Boom – up comes American Express’s screen.”
Manpower is wrestling with some tough issues. How can the company assure the quality of work sold piecemeal over the Internet? How can it deliver freelancers’ services on time and in great numbers to multinationals? How should it pay this army of informal workers? What laws apply when freelancers from one country perform work for a client in another?
“Social networking is changing the labor market,” says Joerres, who points to Craigslist, where services offered include contract reviews by lawyers, Korean-English translations, editing and wireless setup at home. “There is room for us to enter that space and make it industrial strength, as opposed to a rogue industry,” he adds.
Rogue industry? The for-profit firms already in this business would no doubt take issue with that characterization. Firms that are up and running on the Web include Elance.com, Odesk.com, Sologig.com and VirtualAssistants.com.
Fabio Rosati, the chief executive of Elance, the largest of these four, reports his privately held firm arranged $57 million in consultant and freelance work over the past 12 months, taking an average 8% fee ($4.5 million) on those billings. He says revenues are growing at a 50% annual rate. For its fee, Elance provides skills testing, online interviewing and references from previous employers. When a freelancer takes on a job, Elance holds the payment in escrow until the work is satisfactorily completed.
Rosati, a former Capgemini consultant, saw the potential in this model in 2005. The next year he moved Elance from producing software that allowed companies to internally manage freelancers to matching companies with consultants over the Web. “It will be hard for firms like Manpower to reinvent themselves,” Rosati says. He acknowledges that 80% of the firms using Elance have fewer than 100 employees, but he insists large companies are starting to test the site, too. He says he is not yet allowed to release their names.
Manpower, not so reticent, put us in touch with Laura Kohler, a senior vice president in charge of personnel at her family’s bathroom fixtures firm. Her company does around $5 billion a year in sales and employs 30,000. She says Kohler and similar large firms will not be taking on “full-time and expensive” white-collar staffers anytime soon, and she can see Kohler using Manpower as a broker for freelance finance, marketing and public relations help.
With 55% of Kohler’s employees overseas, she prefers to work with a big service provider like Manpower. “Managing ten different vendor relationships becomes very complex and time-consuming,” Kohler says. “We prefer simplicity of our vendor relationships and a global footprint. Manpower brings research to the table, government relationships, knowledge of different foreign markets. You do not get that in a startup.”
Dragged down by its corporate customers, Manpower’s net income fell 55% to $219 million last year. Revenue fell an additional 21% in the first quarter of 2009, as net income evaporated. The firm’s international portfolio – accounting for 89% of its business – has been no protection this time.
But Right Management, its outplacement business, is expected to break $500 million in sales in 2009, an estimated 12% to 15% increase over last year. In the first quarter its 21.4% profit margin (before interest and taxes) contributed a much needed $29 million to Manpower’s EBIT.
Networking freelancers is for now a small contributor to Manpower’s numbers. But according to the Census Bureau, 20.7 million one-man businesses in the U.S. generated $1 trillion in revenue in 2006. If Joerres does not figure out how to hook them up with its large corporate customers, firms like Elance, coming up fast from the bottom, could someday hand Manpower its own pink slip.
UPDATED MICROSOFT SEARCH SERVICE DRAWS PRE-LAUNCH KUDOS
Singing Bing’s praises. Yahoo! vulnerable?
Microsoft’s new internet search service, Bing, is drawing pre-launch accolades. If it succeeds in increasing its market share of the internet search business from its current mid-digit digits to something more substantial it will come out of the hide of either Google, whose share is over 65%, or Yahoo!, with a 20%-odd share. This would make either of the two stocks vulnerable. Yahoo!, which has been stumbling lately and who fended off an attempted takeover by Microsoft last year, would appear to be more so.
Appearing at The Wall Street Journal’s D: All Things Digital tech conference in Carlsbad, California, last week, Microsoft Chief Executive Steve Ballmer lifted the curtain on a revamped search service called, as you know, Bing.
Ballmer said they chose the name Bing in part because it has potential to be verb-ified. He dreams of people “Binging” places, people and things. (Ten years ago, not many people were using Google as a verb. Or Twitter, for that matter.)
As Ballmer suggested, Live Search sounds like a feature, not a product name – there was never much verb potential in that moniker – and in any case Microsoft (ticker: MSFT) didn not make much of a dent in a market dominated by Google (GOOG) and, to a lesser degree, Yahoo! (YHOO).
But Microsoft has plans to spend major bling to bring some zing to Bing. If nothing else, we can look forward to years of Ballmer – who already had a legendary tendency to pinball around the stage shouting and emoting when giving presentations – yelling “Bing!” at the slightest provocation. The word fits him. He really ought to change his name: Bing Ballmer.
Microsoft is a distant #3 in the U.S. Internet-search market, with market share in the mid-single digits, trailing well behind Yahoo!’s roughly 20% share and Google in the mid-60s or higher, depending on who is counting. The real question: Can Bing boost Microsoft’s market share in search? Judging from the demo at D, plus some noodling around on a pre-release version of the site, I think they very well might succeed.
The Bing search approach focuses on providing people not just with blue links, but also with practical information. Type in a flight number, and get back departure and arrival times and a gate number. Type in Warren Zevon, and you will get back images, links to video, albums, fan sites and related artists. Enter a consumer-products company name, and you get back a link to its Website, as well as – I love this part – a customer-service 800 number to call for help.
People certainly found it appealing. One fund manager I chatted with said that not only does he intend to start using the service when it launches June 3, but also that he is mulling whether to short Google. I was a little startled by that response, but you can see his point: Microsoft might be able to nibble some market share away from Google at the margin, and slow its steady march to complete domination.
The conference also featured an appearance by Yahoo! CEO Carol Bartz, which was one of the more entertaining sessions.
Her blunt, snarky style contrasted refreshingly with Jerry Yang’s dreary performance at last year’s D, and an equally weak reception a few years ago for ex-CEO Terry Semel. People came away with the sense that Bartz was confident and in command, which puts her a step ahead of the previous two occupants of her post.
Yet she did not provide a lot of details on her plans for reviving the business. You could argue she was holding back, but the attendees I talked to, as impressed as they were with Bartz, seemed at a loss about what she should be doing next.
And here is the irony: On the one hand, there is a sense that we have already hit Game Over for the search business, and on the other hand – Bing! – Microsoft appears to doing some real innovation.
Both Ballmer and Bartz gave their usual answers to questions about a potential deal – sure, at the right price, maybe. Bartz said they would willingly sell the search business for “boatloads of money,” which might be more than Microsoft will want to give up.
At a minimum, you would think Steve will want to see how far he can go on Bing power before making another run. And that could make Yahoo! shares vulnerable to at least a short-term slump.
XXX-Rated: JPMorgan, Ambac and an Indecent Insurance Racket
Ten years ago regulators got worried that life insurance companies had too little set aside to cover future liabilities that might follow a rush of death claims. So the regulators, in the form of the National Association of Insurance Commissioners, advanced Regulation XXX, which mandated higher reserves.
Reluctant to set aside a lot of cash for these liabilities, insurers parked them in special-purpose subsidiaries, injecting some of their own cash plus a lot from outside investors willing to buy notes issued by the subs. These notes were akin to subordinated debt of bank holding companies: They provided a capital cushion to help protect policyholders from any future unpleasantness. All told the industry raised $8 billion this way. A selling point for the notes was that they were backed by yet other insurance companies. Financial firms like JPMorgan Chase were contracted to manage the raised capital.
And where did the financial experts invest the subsidiaries’ cash? In subprime securities.
In May Ambac Financial Group, which guaranteed $900 million of the notes in a $2.1 billion deal involving Bermuda reinsurer Scottish Re, sued JPMorgan for $1 billion for gross negligence, claiming JPMorgan’s subprime investments were misbegotten. Scottish Re has already taken a $700 million loss on its equity portion, and for a time the subsidiary, Ballantyne Re, could not make payments on its notes.
Assured Guarantee of Bermuda is also suing JPMorgan in New York state court for negligence in connection with how it managed the $553 million raised in 2006 by an XXX securitization called Orkney Re II. At one point last fall Orkney’s investments had declined by 48%. JPMorgan insists it managed the accounts “appropriately.”
In a 2006 marketing paper Diana Adams, an Ambac managing director, gushed that Ambac’s XXX guarantees were giving life insurance companies regulatory relief. She wrote: “Triple X Meets Triple A: A Perfect Match.”
Like oil and water.
Bargains Among Leveraged Loan Borrowers
Shares of companies tarred by junk loans--but far from default--could be ready to bounce.
Junk-grade companies that owe a lot of money to banks have been hammered in the credit crunch. But not all so-called leveraged loans are created equal. Among those with stringent credit agreements, a hiccup in a borrower’s quarterly results can trigger a default. “Covenant lite” loans, by contrast, offer more breathing room.
In the credit panic investors have scarcely pondered the differences between one leveraged loan borrower and another. With a semblance of normalcy returning to credit markets, however, borrowers solidly in compliance with loan covenants should outperform the broad market in coming months, says Justin M. Smith, senior covenant analyst at the Bank Debt Review. For help finding winners, we asked BDR publisher Xtract Research to look at the two most common covenants for 50 public companies with the biggest leveraged loans tracked by S&P’s LCDX index.
Firms in the table below comfortably meet the bank loans’ mandates for maximum levels of debt/EBITDA and interest expense/EBITDA. Consensus forecasts for Q2 results show improvement (or at least stability) from a year ago. Enterprise multiples (market value plus net debt, divided by EBITDA) do not exceed the market's 8.4.
An additional safety net for investors: Banks are less likely than ever to nudge struggling borrowers into bankruptcy, says S&P credit analyst Christopher Donnelly. That is because distressed financing is scarce and expensive, making reemergence from bankruptcy difficult. Liquidation values are also near their nadir.
Rather than allow MGM Mirage to default in March, its lenders extended the deadline for complying with its leverage limits. Despite disappointing earnings, the casino operator’s shares rallied.
Bandwidth Scarcity in the Cards?
“While Congress and the watchdog groups focus on solving the crisis in energy scarcity,” notes one of our small-cap chaps, Greg Guenthner, “a sleeping problem is creeping up from behind – bandwidth scarcity.
“Already, the information networks that carry your television programs, phone calls and e-mails are nearing capacity ... and without investment today, AT&T expects the Web to reach full capacity by 2010.”
“And that is nothing – we are already projecting bandwidth needs to increase 100-fold by 2015. ... These important deadlines are creeping up on everyone involved in the bandwidth biz. Giants like AT&T and Verizon are prepared to lay down mountains of money to increase Internet capacity across the country. Unlike a decade ago, they will not be doing it by laying traditional metal wires. The future is in fiber optics.
“Fiber optics are superior in nearly every way to the metal wires that likely feed data to your home. Fiber-optic cables carry more data than traditional cables, and they do so farther, at a lower cost and with less interference. Instead of running electrical signals through a metal wire, fiber optics work by carrying pulses of light through flexible glass or plastic fibers.
“Of course, the transition to fiber optics is not cheap. Verizon’s footing a $23 billion installation bill for the cable required to connect 18 million homes to its FiOS service by 2010. Verizon’s money – and that of the other utilities and municipalities who are laying fiber lines – will be gushing into companies ready to take advantage of this trend.”
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