JANUARY 9, 2012

Investing in a 'Fat Tail' World

By pushing interest rates to very low levels, central banks are pushing investors out the risk spectrum.


'The only predictable thing about 2012 is its unpredictability." This insight, which came in a holiday greeting from a professional acquaintance whom I respect highly, is important for any investor looking to generate returns and manage risk over the next 12 months.

Every year has elements of unpredictability, but what's in play in 2012 goes far beyond the usual risk of policy slippages, unexpected election outcomes and geopolitical hotspots. This is also about the global economy losing important anchors.

The very construct of the euro zone, the largest economic area in the world, is uncertain as efforts to keep the 17-member currency union intact continue to falter. Persistent political dysfunction in the United States precludes the world's only superpower from properly controlling its economic destiny. And emerging economies, such as China and India, have gained influence but still lack the institutions to deliver on their new global responsibilities.

Such unpredictability speaks to an uncomfortable possibility of extreme events. "Fat tails"—the technical term for the extremes of an outcome distribution—are risks for any global system that loses its anchors. Economies and markets function differently, companies and households feel unsettled, and policy measures become less effective.

With European economic fragmentation no longer totally unthinkable, expect even more people around the world to opt for "self insurance," thereby sucking growth oxygen from the global economy. We already see this in companies' preference for holding record levels of cash on their balance sheets, not because they like earning virtually no interest income but because they want lots of assurances of safety and freedom of action.

We will also spend quite a bit of 2012 worrying about the stability of European banks and, with that, the smooth functioning of the international monetary system. And all this comes at a time when America, the traditional engine of global growth, is already in an unemployment crisis, has interest rates floored at zero, and faces mounting deficit and debt concerns.

Navigating such unpredictability requires investors to rely less on historical short cuts and, instead, spend more time decomposing asset classes into their constituent risk factors. Moreover, they need to internalize a much broader set of correlations, pursue a more global opportunity set, and mitigate risk not only by diversifying but also by using active tail hedging aimed at protecting against the bad extremes of possible outcomes.

Investors must also stay ahead of a whole range of "unconventional" policy interventions that alter the very functioning and liquidity of markets, including the large-scale use of public printing presses by central banks in Europe and the U.S. By driving interest rates to very low levels, central banks are pushing investors out on the risk spectrum. But there is a reason why being pushed into an activity by the actions of others feels (and is) very different than being pulled in by the inherent attractiveness of the activity. It is a fundamentally less stable situation.

In such a world, prudence is the name of the game, and patience will likely be rewarded. To paraphrase Will Rogers, investors are well-advised to worry first about the return of their capital and second about the return on their capital. In doing so, they should exploit the flexibility that comes with cash and make prudent allocations to instruments that pay positive real returns, including high-quality municipals, bonds issued by countries with solid balance sheets, and the debt and equity of global companies with iron-clad cash flows and debt dynamics.

Unpredictability yields both risks and opportunities, and the answer to it should never be paralysis. More than ever, investors in 2012 will be challenged to understand an unusual set of global dynamics and to position their portfolios accordingly. For many, this will translate into strategies that are generally defensive yet agile enough to also be offensive as opportunities emerge.

Mr. El-Erian, the author of "When Markets Collide: Investment Strategies for the Age of Global Economic Change" (McGraw-Hill, 2008), is CEO of Pimco.
Copyright 2011 Dow Jones & Company, Inc. All Rights Reserved

January 9, 2012 7:21 pm

Why I’m feeling strangely Austrian


The old is dying and the new cannot be born: in the interregnum a great variety of morbid symptoms will appear.” That statement from the Prison Notebooks of the Italian communist Antonio Gramsci was a favourite of student Marxists when I was at university in the 1980s. Back then it struck me as portentous nonsense. But Gramsci’s observation does resonate now – in an age of ideological confusion.

Old certainties about the onward march of the markets are collapsing. But no new theory has established ideologicalhegemony”, to use the concept that Gramsci made famous. Some ideas are, however, gathering new strength. The four strongest emerging trends that I can spot are, in very broad terms: rightwing populist, social democratic-Keynesian, libertarian-Hayekian and anti-capitalist/socialist.

Each of these new trends is a reaction against the dominant ideas of 1978-2008. Back then, for all the nominal differences between communists in China, capitalists in New York and the soft left in Europe, their agreements were more striking than their arguments. Political leaders from all over the world talked the same language about encouraging free trade and globalisation. Increasing inequality was embraced as a price worth paying for faster growth. Deng Xiaoping set the tone when he declared: “To get rich is glorious.” Ronald Reagan or Margaret Thatcher could not have put it better.

In post-crisis Europe, however, rightwing populism is on the rise – from the Freedom party in the Netherlands to the National Front in France and the Northern League in Italy. The populists are anti- globalisation, anti-EU and anti-immigration – the common thread being that all these forces are felt to be hostile to the interests of the nation. Hostility to Islam links Europe’s populist right to parts of the Tea Party movement in the US.

There is some overlap between the populists and the libertarian Hayekians – but the two movements have different obsessions. In the US, Ron Paul, the maverick Republican, carries the banner for libertarianism. He fondly recalls dining with Friedrich Hayek himself and watching an inspiring denunciation of socialism by Ludwig von Mises, another economist of the Austrian school. That explains Mr Paul’s otherwise baffling remark, after last week’s Iowa caucus, in which he said: “I’m waiting for the day when we can say we’re all Austrians now.”

The libertarians are unusual because they argue that the current crisis is caused not by an excess of capitalism, but by too much state intervention. As far as the Austrian school is concerned, the Keynesiancure” for the crisis of capitalism is worse than the disease.

Mr Paul is the purest advocate of a powerful conviction on the American right that the US is afflicted by an over-mighty state. The urge to slash the government back into the 18th century is not a common one in Europe. But Paulite suspicion of central banks that threaten to debase the currency is powerfully echoed in Germany – where the Hayekian right is horrified by the operations of the European Central Bank, and by bail-outs for bankrupt nations. This ideological trend is not confined to the west. In a recent article, Simon Cox of The Economist argued that policy debates in China about the state’s role in reflating the economy also pit Hayekians against Keynesians.

In the west, the fiercest opponents of the Hayekians are the Keynesian-social democrats. Their belief in deficit spending as the key to stimulating the economy often goes hand in hand with a call for a more active and expansive state. In Europe, where there is little scope for more state spending, the social democrats are arguing for much tougher regulation of high finance, a revival of industrial policy – and a renewed stress on tackling inequality. While efforts to label Barack Obama a “socialist” are silly, it is fair to label him a social democrat. The US president does not reject capitalism, but he does seek to soften its edges through a more active state that promises universal healthcare and redistributive taxation. The fact that inequality has become a global concern from China to Chile, and from India to Egypt, suggests that this is another trend that has gone global.

The failure of the hard left to capitalise on the economic crisis testifies to how profoundly communism was discredited by the collapse of the Soviet system. But mass unemployment in Europe might yet produce the conditions for the revival of an anti-capitalist movement. Greece’s two far-left parties are currently at about 18 per cent in the polls. The diverse groups that campaign under the banner of Occupy Wall Street contain some genuine socialists. And China has a powerfulnew left movement that pays lip-service to Maoism.

Events will determine which of these ideological trends sets the tone for the new age. Most people will be buffeted by personal circumstances, and by the news.

Under normal conditions I would probably sign up with the social democratic tendency. The Tea Party is not my cup of tea. But I spent the weekend reading newspaper accounts of the ever more incredible figures that may have to be poured into the bail-outs for banks and countries in Europe. Then I turned the page to read of demands for more protectionism and regulation in the EU. For light relief, I then went to see The Iron Lady – the new film about Margaret Thatcher. The whole experience has left me feeling strangely Austrian.

Copyright The Financial Times Limited 2012.


JANUARY 9, 2012

An Exit Strategy From the Euro

The euro can be phased out the same way Europe's individual currencies were. The bonds of troubled member states would benefit as a result.


Until recently, the euro seemed destined to encompass all of Europe. No longer. None of the remaining outsider European countries seems likely to embrace the common currency. Seven Eastern European countries that recently joined the European Union (Bulgaria, Czech Republic, Hungary, Latvia, Lithuania, Poland and Romania) have announced their intention to revisit their obligations to adopt the euro.

Two non-euro members of the EU, the United Kingdom and Denmark, have explicit opt-out provisions from the common currency, and popular opinion has recently turned strongly against euro membership. In Sweden, which lacks a formal "opt-out" provision (but has cleverly refused to fulfill one of the requirements for membership), a November poll on whether to join the euro was overwhelmingly negative80% no, 11% yes.

In light of the political response to the ongoing fiscal and currency crisis—which is leaning strongly toward a centralized political entity that will likely be even more unpopular than the common currency—I suggest that it would be better to reverse course and eliminate the euro.

When the United Kingdom debated whether to join the path to a single currency in the mid-1990s, my view was that the benefits of euro membershipenhancements for international trade in goods and services and financial transactions—were offset by required participation in its poor social, regulatory and fiscal policies. Still, I thought the U.K. should join if it could get just the common currency.

Now I think that the option of a monetary union without the rest of the baggage is an impossible dream. The single money is inevitably linked to a common central bank with lender-of-last-resort powers. This setup creates important features of fiscal union, showing up recently as bailouts in Greece, Portugal, Ireland, Italy and Spain.

The political reaction at each step of the ongoing crisis has been to strengthen this unionbailout money from the EU and the International Monetary Fund, fiscal involvement by the European Central Bank, and more EU influence on each government's fiscal policies. A common currency loaded on top of a free-trade zone is leading toward a centralized political entity.
Despite some scale benefits from having larger countries, the cost of forcing heterogeneous populations with disparate histories, languages and cultures into a single nation could be prohibitively high.

One legitimate counterexample is to point to the United States. It has prospered with fiscal union, despite the continuing potential for federal bailouts of state governments (such as through explicit rescue programs or the kinds of transfers contained in the stimulus package of 2009-10).

The main saving grace is that, except for Vermont, the states have long histories of balanced-budget requirements. However, with the growing unfunded programs for pensions and health care for state government workers, the balanced-budget requirements have become less meaningful. Structural fiscal problems in the U.S. federal system may eventually become as serious as those in Europe.

The EU specifies with great detail how candidate countries can qualify for euro membership, but it offers no recipe for exit or expulsion. A natural possibility would be to start by throwing out the least qualified members, based on lack of fiscal discipline or other economic criteria. Greece is an obvious candidate—it has been increasingly out of control fiscally since the 1970s. But instead of expulsion, the EU reaction has been to provide a sufficient bailout to deter the country from leaving.

A better plan is to start from the top. Germany could create a parallel currency—a new D-Mark, pegged at 1.0 to the euro. The German government would guarantee that holders of German government bonds could convert euro securities to new-D-mark instruments on a one-to-one basis up to some designated date, perhaps two years in the future. Private German contracts expressed in euros would switch to new-D-mark claims over the same period. The transition would likely feature a period in which the euro and new D-mark circulate as parallel currencies.

Other countries could follow a path toward reintroduction of their own currencies over a two-year period. For example, Italy could have a new lira at 1.0 to the euro. If all the euro-zone countries followed this course, the vanishing of the euro currency in 2014 would come to resemble the disappearance of the 11 separate European moneys in 2001.

A key issue for the transition is to avoid sharp reductions in values of government bonds for Italy and other weak members of the euro zone. After all, the issue that has prompted ever-growing official intervention in recent months has been actual and potential losses of value of government bonds of Greece, Italy and so on. Governments and financial markets worry that these depreciations would lead to bank failures and financial crises in France, Germany and elsewhere.

Worries about values of government bonds are rational because it is unclear whether—even with assistance from the centerItaly and other weak members will be able and willing to meet their long-term euro obligations. A new (or restored) system of national currencies would be more credible, because Italy should be able and willing to meet its obligations denominated in new liras. This credibility underlay the pre-1999 system in which the bonds of Italy and other euro-zone countries were denominated in their own currencies. The old system was imperfectnotably in allowing some countries to have occasionally high inflation—but it's become clear that it was better than the current setup.

My prediction is that an announcement of the new system would raise the value of German bonds, because Germany has strong individual credibility and would no longer have to care for its weak neighbors. Even Italian and other weak-country bonds are likely to rise in value because concerns about individual credibility would be offset by the improved functioning of the overall system.

The euro was a noble experiment, but it has failed. Instead of wasting more money on expanding the system's scope and developing ever larger rescue funds, it would be better for the EU and others to think about how best to revert to a system of individual currencies.

Mr. Barro is an economics professor at Harvard University and a senior fellow of Stanford University's Hoover Institution.
Copyright 2011 Dow Jones & Company, Inc. All Rights Reserved

Markets Insight

January 9, 2012 11:53 am

Emerging markets’ golden age may be over

It wasn’t supposed to happen this way. The biggest surprise for equity investors in 2011 was not the weakness of the crisis-ravaged European markets, but the carnage in the stock markets of the emerging economies. Amazingly Brazil, Russia, India and China did worse than Portugal, Italy, Ireland, Greece and Spain. As a group they were down 26 per cent in US dollar terms, versus a decline of 23 per cent for the bad boys of the eurozone.

While the developed economies have been struggling to generate any growth momentum, the emerging economies have had the opposite problem. Super-easy monetary and fiscal policy has led to real estate bubbles, capacity constraints and labour shortages. In 2011 governments moved to quell the inflationary pressures, even at the cost of stock market sell-offs and weaker growth.


Now that the effects of the tightening are increasingly visible, relaxation of policy cannot be far away. In a conventional cycle, this would mark the end of the bear phase and usher in the next emerging markets boom. However, there are reasons to believe that this is not a conventional cycle. The golden age of emerging market investment may already be over.

The first point is that re-inflating burst bubbles is easier said than done. The Chinese stock market is an example. When the Shanghai Composite Index peaked at 6,000 in 2007, it was valued at a price to book ratio of seven times, richer than the Nikkei Index in 1989 and the Nasdaq in 2000. Despite the unprecedented credit boom subsequently unleashed by Beijing, stock prices managed little more than a dead cat bounce. The Shanghai Index rose to barely half its former high and then tamely relinquished almost all the gains.

The de-bubbling of Chinese equity valuations has run a long way now, but the deflation of major city real estate from nosebleed valuations is at an earlier stage. This has potential to inflict damage on the economy as a whole and perhaps hasten the end of the investment-driven growth model. If China follows the Japanese template of the late 1960s and early 1970s, the downshift from double digit gross domestic product growth will be abrupt, not gradual, and accompanied by a surge in real wages that will crush profit margins.

In the other major emerging economies, the equity market and real estate bubbles have been simultaneous rather than, as with China, consecutive. At first glance forward price to earnings (PE) multiples look reasonable, but Shiller PE ratios – which use ten year averages of earnings – suggest that valuations in, for example, India and Indonesia, are still lofty by historical standards.

A second cause for caution is political and governance risk. The China Reverse Takeover Index, an index of 73 Chinese companies that have backdoor listings on US exchanges, trades on a historical PE ratio of less than 4 times. The low valuation reflects unease triggered by China Forestry and other debacles. A wider loss of confidence could lead to entire markets suffering similar deratings.

The third point is the supply-and-demand balance for equity itself. As a thought-provoking report from McKinsey points out, the world faces a cumulative shortfall in demand for equities relative to supply of some twelve trillion dollars over the current decade. This “equity gap” is almost entirely a phenomenon of the emerging world, which will experience a cascade of equity issuance to finance future growth, but lacks the indigenous equity capital to absorb it.

The notion that investors in the mature economies will automatically gravitate to the high-growth of the emerging world owes more to marketing than empirical research. Credible academic studies (such as by Jay Ritter of the University of Florida and Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School) indicate that the relationship between economic growth and stock market returns is, if anything, mildly negative.

The equity gap helps to explain why this should be so. Rapid growth does not benefit existing shareholders if it requires equally rapid expansion of the capital base. Companies that can capture new opportunities by investing from cashflow are in a different proposition. It may be that the multinationals of the developed world offer the best way to capitalise from emerging economy growth.

After the Asian crisis of the late 1990s, the stock markets of the emerging world were cheap and under-owned and their currencies were super-competitive. The turbo-charged ride of the past decade has left them over-owned and bubbly, while their competitive advantage has been eroded by inflation and currency appreciation. It will take another crisis before they become as compelling again.

Peter Tasker is a Tokyo-based analyst with Arcus Research

Copyright The Financial Times Limited 2012.

Paul Krugman is Dead Wrong: Debt Matters

January 9, 2012

By Shah Gilani, Capital Waves Strategist, Money Morning

Paul Krugman, the Princeton University economics professor, Nobel Prize winner, and regular New York Times op-ed contributor says, "Debt matters, but not that much."
Not only is he off the reservation on this one, but he's completely fallen off his high horse.

In the real world, debt actually matters a lot.
In a Houston Chronicle opinion piece last week, Krugman, riding his horse - whose name might as well be Liberal Conscience - trampled conservatives under the guise of an economics lesson that derided "deficit-worriers" for wrongly seeing "America as being like a family that took out too large a mortgage, and will have a hard time making the monthly payments."

According to Krugman, that's a bad analogy and "the way our politicians think about debt is all wrong, and exaggerates the problem's size."

Decide for yourself. Either debt matters a lot, or not that much...

The World According to Paul Krugman

Professor Krugman calls all the conversation in Washington about debt and deficits a "misplaced focus" and says all of the economic experts "on whom much of Congress relies have been repeatedly wrong about the short-run effects of budget deficits."

He derides the fears that deficits will cause interest rates to soar by pointing out that they haven't moved.

What he doesn't say is that they haven't moved because they're not free to move.

The fact is that the U.S. Federal Reserve has corralled the free market in interest rates by knocking short-term rates to almost zero through successive open market operations and extraordinary quantitative easing measures.

Mr. Krugman mocks those waiting for rates to rise and notes that while they wait "rates have dropped to historical lows."

Maybe what he doesn't realize is that the Fed's actions themselves have been nothing short of historical.

The crux of Mr. Krugman's supposition that debt doesn't matter much is based on his bashing of the popular analogy comparing America's debt problems to those of a mortgaged homeowner.

All of which Krugman claims is "a really bad analogy in at least two ways."

He says, "First, families have to pay back their debt. Governments don't - all they need to do is ensure that debt grows more slowly than their tax base."

"Second," he says, "an over-borrowed family owes the money to someone else; U.S. debt is, to a large extent, money we owe ourselves."

He goes on to say that the debt from World War II was never repaid and didn't make postwar America poorer.

In fact, the Professor points out, "the debt didn't prevent the postwar generation from experiencing the biggest rise in incomes and living standards in our nation's history."

Krugman is Flat Out Wrong

First off, the homeowner analogy is excellent--not irrelevant.

Mr. Krugman is wrong when he says that homeowners have to pay back their debt. The truth is they don't have to.
Just like the government, as long as their creditworthiness is intact and money is available, at whatever cost, homeowners can refinance their mortgages over and over. That's no different than how the government rolls over its own debts.

We saw this phenomenon play out in stark reality during the housing bubble.

Not only were homeowners refinancing their homes to take out money for consumption purposes, they leveraged themselves to buy more homes to multiply the wealth effect they were already experiencing.

In the case of the housing crash, borrowers were counting on rising property values to finance their expanding debts. That's the same as what Krugman says governments should do: make sure debt expansion doesn't outpace revenue growth, in this case taxes.

In the end, though, didn't the bursting of the housing bubble prove that debt eventually matters?

To me, the housing bubble was a pretty darn good analogy as to what happens when mounting debts aren't repaid. When it happens on a systemic basis, the entire economy suffers.

Doesn't our nation's expanding debt and deficit in the face of falling tax revenues and worse, a lower base, portend similar problems on an even larger scale?

Of course, Krugman has it all figured out.

We just have to grow our debt at a slower pace than our tax base grows. Who knew the answer was so simple...

We'll just meet our expanding debt obligations by raising taxes faster. Perfect!

Second, to claim that U.S. debt doesn't matter because we owe it to ourselves, and that homeowners' debts do matter because they owe them to someone else, is absurd.

It is as if we are all going to say to the government, "It's okay you took all of those taxes from us and spent them on stuff we'll mostly never see, wipe the slate clean, we're good. And all the stuff you promised us that you didn't budget for, or worse, those set aside budgets you stole from, it's okay, we're good, we relieve you of what you owe us." It's just stupid.

Also, if you are a homeowner you are paying yourself too, in a sense.

While you are paying the mortgage to your bank you are also paying into a capital asset known as your home. You end up with something of fairly equal value, or more when home prices appreciate.

The Truth about Debt

But we screwed that all up because debts do matter.

Too much debt leads to depreciation and deleveraging, which leads to lower demand, lower production, fewer jobs and a lower tax base.

The last piece of Krugman's argument that our World War II debts were never repaid and that the huge deficits to pay for the war effort led to an extraordinary peacetime expansion is also frighteningly off the mark.

Of course, the savings bonds issued to fund the War have matured and been paid off. And the portion of our national debt brought on by the War was paid off a long time ago.

Just because the U.S. continues to add to its deficit and has to continually rollover debts doesn't mean that we're rolling over debts from 70 years ago.

Mr. Krugman's own argument even addresses that. Rising incomes and our rapidly expanding economy in the postwar period generated a vastly rising tax base and led to prosperity.

But, that had nothing to do with deficits not mattering.

That had everything to do with soldiers returning home and being educated under the G.I. bill, being able to find work in revved-up manufacturing facilities, and the ensuing baby boom that would lead to a substantial increase in the population and tax base.

A Political Axe to Grind

There are a lot of problems with Professor Krugman's argument that deficits don't matter.

But, the biggest problem I have is that instead of addressing deficits in an organic, holistic and objective way, Mr. Krugman addresses these important issues from his political perspective rather than a purely economic perspective.

Bashing conservatives who say deficits matter and spending cuts along with a smaller government are the best way to solve our long-term fiscal problems, and arguing that "responsible governments -- that is governments that are willing to impose modestly higher taxes when the situation warrants it" are the answer to deficits that don't matter much, is polarizing at best and dangerous at worst.

What economists should be advocating is an apolitical approach to both our short-term and long-term problems.

We need smaller deficits over time and a smaller, more responsive government in the long-term.

In the short-term, we need real infrastructure spending, not quantitative easing for banks to increase their bonus pools. We need a massive investment in education and we need an industrial policy that promotes manufacturing and job growth - not the exportation of our capital to less developed countries where labor cost advantages fatten up public corporations that don't pay enough U.S. taxes and hide the money from Uncle Sam in the loopholes Congress digs for them.

Both deficits and politics matter.

And if we don't figure out how to bridle both we are all going to end up in the dirt being trampled by stampeding emerging economies everywhere.