Hoisington Investment Management

Quarterly Review and Outlook

John Mauldin

Oct 30, 2013

In their third-quarter Review and Outlooktoday's Outside the BoxLacy Hunt and Van Hoisington get right down to telling us why the Federal Reserve's Large Scale Asset Purchase (LSAP) program is doomed to failure. (This is a thesis that is dear to my heart, since coauthor Jonathan Tepper and I explore it at length in our just-released book, Code Red.) The Fed scrambled hard and came up with some extraordinary measures to keep the global economy more or less in one piece as the Great Recession unfolded. They had to act fast, and they did; but five years down the road, with sovereign debt balloons swollen near to bursting worldwide, with markets in advanced and emerging nations alike swooning at the mere mention of the word tapering, and with the threat of a major global currency war staring us right in the face, the Fed may have just about reached the end of its rope. But let's let Lacy and Van explain:

Four considerations suggest the Fed will continue to be unsuccessful in engineering stronger growth and higher inflation with their continuation of the current program of Large Scale Asset Purchases (LSAP). First, the Fed’s forecasts have consistently been overly optimistic, indicating that their knowledge of how LSAP operates is flawed. LSAP obviously is not working in the way they had hoped, and they are unable to make needed course corrections. Second, debt levels in the U.S. are so excessive that monetary policy’s traditional transmission mechanism is defunct. Third, recent scholarly studies, all employing different rigorous analytical methods, indicate LSAP is ineffective. Fourth, declining velocity deprives the Fed of the ability to have a measurable influence on aggregate economic activity and is an alternative way of confirming the validity of the aforementioned academic studies.

As the authors explain these four problems with Fed policy and performance, you may find the discussion getting a bit, well, wonkish; but if you want the real lowdown on the limitations of central bank control of the economy (and you do), then you could hardly find a better primer than this.

Hoisington Investment Management Company (www.Hoisingtonmgt.com) is a registered investment advisor specializing in fixed-income portfolios for large institutional clients. Located in Austin, Texas, the firm has over $5 billion under management and is the sub-advisor of the Wasatch-Hoisington US Treasury Fund (WHOSX).

Have a great week!

Your glad for modern dentistry and pain meds analyst,

John Mauldin, Editor
Outside the Box

Hoisington Investment Management

Quarterly Review and Outlook

Third Quarter 2013

Federal Reserve Failures

The Fed's capabilities to engineer changes in economic growth and inflation are asymmetric. It has been historically documented that central bank tools are well suited to fight excess demand and rampant inflation. The Fed showed great resolve in containing the fast price increases in the aftermath of World Wars I and II and the Korean War. Later, in the late 1970s and early 1980s, rampant inflation was brought under control by a determined and persistent Federal Reserve.

However, when an economy is excessively over-indebted and disinflationary factors have forced central banks to make overnight interest rates as close to zero as possible, central bank policy has repeatedly proved powerless to further move inflation or growth metrics. The periods between 1927 and 1939 in the U.S. (and elsewhere) and from 1989 to the present in Japan are clear examples of the impotence of central bank policy actions during periods of over-indebtedness.

Four considerations suggest the Fed will continue to be unsuccessful in engineering stronger growth and higher inflation with their continuation of the current program of Large Scale Asset Purchases (LSAP). First, the Fed's forecasts have consistently been overly optimistic, indicating that their knowledge of how LSAP operates is flawed. LSAP obviously is not working in the way they had hoped, and they are unable to make needed course corrections. Second, debt levels in the U.S. are so excessive that monetary policy's traditional transmission mechanism is defunct. Third, recent scholarly studies, all employing different rigorous analytical methods, indicate LSAP is ineffective.

Fourth, declining velocity deprives the Fed of the ability to have a measurable influence on aggregate economic activity and is an alternative way of confirming the validity of the aforementioned academic studies.

The Fed's Forecasts

First, if the Fed were consistently getting the economy right, then we could conclude that their understanding of current economic conditions is sound. However, if they regularly err, then it is valid to argue that they are misunderstanding the way their actions affect the economy.

During the current expansion the Fed's forecasts for real GDP and inflation have been consistently above the actual outcomes. Late last year, the midpoint of the Fed's central tendency forecast projected an increase in real GDP of 2.7% for 2013. This estimate could miss the mark by nearly 50%.

One possible reason why the Fed has consistently erred on the high side in their growth forecasts is that they assume higher stock prices will lead to higher spending via the so-called wealth effect. The Fed's ad hoc analysis on this subject has been wrong and is in conflict with econometric studies. The studies suggest that when wealth rises or falls consumer spending does not generally respond, or if it does respond it does so feebly. During the run-up of stock and home prices over the past three years, the year-over- year growth in consumer spending has actually decelerated sharply from over 5% in early 2011 to just 2.9% in the four quarters ending Q2 (Chart 1).

Reliance on the wealth effect played a major role in the Fed's poor economic forecasts. LSAP has not been able to spur growth and achieve the Fed's forecasts to date and certainly undermines the Fed's continued assurances that this time will truly be different.

Excessive Debt

Second, another impediment to LSAP's success is the Fed's failure to consider that excessive debt levels block the main channel of monetary influence on economic activity. Scholarly studies published in the past three years document that economic growth slows when public and private debt exceeds 260% to 275% of GDP. In the U.S., from 1870 until the late 1990s, real GDP grew by 3.7% per annum. It was during 2000 that total debt breached the 260% level. Since 2000 growth has averaged a much slower 1.8% per annum.

When total debt moved into this counterproductive zone, other far reaching and unintended consequences became evident. The standard of living, as measured by real median household income, began to stagnate and now stands at the lowest point since 1995.

Additionally, since the start of the current economic expansion, real median household income has fallen 4.3%, a totally unprecedented occurrence. Moreover, both the wealth and income divides have seriously worsened. Over-indebtedness is the primary reason for slower growth, and unfortunately the Fed's activities to date have had only negative, unintended consequences.

Scholarly Studies on Large Scale Asset Purchases

The third item that points toward monetary ineffectiveness is the academic research indicating that LSAP is a losing proposition. The United States now has had five years of experience with which to evaluate the efficacy of LSAP, during which time the Fed's balance sheet has increased a record fourfold. Undeniably, the Fed has conducted an all-out effort to restore normal economic conditions. While monetary policy works with a lag, the LSAP has been in place since 2008 with no measurable benefit. This lapse of time is now far greater than even the longest of the lags measured in the extensive body of scholarly work regarding monetary policy.

Three different studies by respected academicians have independently concluded that indeed these efforts have failed. These studies, employing various approaches, have demonstrated that LSAP cannot shift the Aggregate Demand (AD) Curve (Chart 2). The AD curve intersects the Aggregate Supply Curve to determine the aggregate price level and real GDP and thus nominal GDP. The AD curve is unresponsive to monetary actions. Therefore the price level and real GDP, and thus nominal GDP, are stuck. In this circumstance, the actions of the Fed are irrelevant.

The papers we reference were presented at the Jackson Hole Monetary Conference in August 2013. The first is by Robert E. Hall, one of the world's leading econometricians and a member of the prestigious NBER Cycle Dating Committee. He wrote, "The combination of low investment and low consumption resulted in an extraordinary decline in output demand, which called for a markedly negative real interest rate, one unattainable because the zero lower bound on the nominal interest rate coupled with low inflation put a lower bound on the real rate at only a slightly negative level." Dr. Hall also wrote the following about the large increase in reserves to finance quantitative easing: "An expansion of reserves contracts the economy." In other words, not only has the Fed not improved matters, they have actually made economic conditions worse with their experimentation.

Additionally, he presented evidence that forward guidance and GDP targeting both have serious problems and that central bankers should focus on requiring more capital at banks and more rigorous stress testing.

The next paper is by Hyun Song Shin, another outstanding monetary theorist and econometrician and holder of an endowed chair at Princeton University. He looked at the weighted-average effective one year rate for loans with moderate risk at all commercial banks, the effective Fed Funds rate and the spread between the two in order to evaluate Dr. Hall's study. He also evaluated comparable figures in Europe. In both the U.S. and Europe these spreads increased, supporting Hall's analysis. Dr. Shin also examined quantities such as total credit to U.S. non-financial businesses. He found that lending to non-corporate businesses, which rely on the banks, has been essentially stagnant. Dr. Shin states, "The trouble is that job creation is done most by new businesses, which tend to be small." Thus, he found "disturbing implications for the effectiveness of central bank asset purchases" and supported Hall's conclusions.

Dr. Shin argued that we should not forget how we got into this mess in the first place when he wrote, "Things were not right in the financial system before the crisis, leverage was too high, and the banking sector had become too large." For us, this insight is highly relevant since aggregate debt levels relative to GDP are greater now than in 2007. Dr. Shin, like Dr. Hall, expressed extreme doubts that forward guidance was effective in bringing down longer-term interest rates.

The last paper is by Arvind Krishnamurthy of Northwestern University and Annette Vissing- Jorgensen of the University of California, Berkeley. They uncovered evidence that the Fed's LSAP program had little "portfolio balance" impact on other interest rates and was not macro stimulus. A limited benefit did result from mortgage- backed securities purchases due to announcement effects, but even this small plus may be erased once the still unknown exit costs are included.

Drs. Krishnamurthy and Vissing-Jorgensen also criticized the Fed for not having a clear policy rule or strategy for asset purchases. They argued that the absence of concrete guidance as to the goal of asset purchases, which has been vaguely defined as aimed toward substantial improvement in the outlook for the labor market, neutralizes their impact and complicates an eventual exit. Further, they wrote, "Without such a framework, investors do not know the conditions under which (asset buys) will occur or be unwound." For Krishnamurthy and Vissing-Jorgensen, this "undercuts the efficacy of policy targeted at long- term asset values."

Money Velocity

The fourth problem the Fed faces in their LSAP program is their inability to control the velocity of money. The AD curve is planned expenditures for nominal GDP.

Nominal GDP is equal to the velocity of money (V) multiplied by the stock of money (M), thus GDP = M x V. This is Irving Fisher's equation of Exchange, one of the important pillars of macroeconomics. V peaked in 1997, as private and public debt were quickly approaching the nonproductive zone (Chart 3).

Since then V has plunged. The level of V in the second quarter is at its lowest level in six decades. By allowing high debt levels to accumulate from the 1990s until 2007, the Fed laid the foundation for rendering monetary policy ineffectual. Thus, Fisher was correct when he argued in 1933 that declining velocity would be a symptom of extreme indebtedness just as much as weak aggregate demand. Fisher was able to make this connection because he understood Eugen von Böhm-Bawerk's brilliant insight that debt is future consumption denied. Also, we have the benefit of Hyman Minsky's observation that debt must be able to generate an income stream to repay principal and interest, thereby explaining that there is such a thing as good (productive) debt as opposed to bad (non-productive) debt.

Therefore, the decline in money velocity when there are very high levels of debt to GDP should not be surprising. Moreover, as debt levels increase so does the risk that it will be unable to generate the income stream required to pay principal and interest.

Unintended Consequences

The relentless Fed purchasing of massive amounts of securities has produced no positive economic developments but has had significant negative, unintended consequences. For example, resource allocation in the banking system can be affected. Banks have a limited amount of capital with which to take risks with their portfolio. With this capital, they have two broad options. First, they can confine their portfolio to their historical lower risk role of commercial banking operations – the making of loans and standard investments. However, with interest rates at extremely low levels the profit potential from such endeavors is minimal.

Second, they can allocate resources to their proprietary trading desks to engage in leveraged financial or commodity market speculation. By their very nature these activities are potentially far more profitable, but also much riskier. Therefore, when resources are allocated to the riskier alternative in the face of limited bank capital , fewer resources are available for traditional lending. This deprives the economy of the funds needed for economic growth even though the banks may be able to temporarily improve their earnings by aggressive risk taking.

Perversely, confirming the point made by Dr. Hall, a rise in stock prices generated by excess reserves may deprive, rather than supply, funds needed for economic growth.

Determining with certainty whether funds are being deprived is difficult, but a visible piece of evidence confirms that this is occurring. This factor is the unprecedented downward trend in the money multiplier. The money multiplier is the link between the monetary base (high-powered money) and the money supply (M2). The money multiplier is calculated by dividing the base into M2. Today, the monetary base is $3.5 trillion, and M2 stands at $10.8 trillion. By dividing the monetary base into M2, the money multiplier is 3.1. In 2008, prior to the Fed's massive expansion of the monetary base, the money multiplier stood at 9.3, meaning that $1 of base supported $9.30 of M2.

If reserves created by LSAP were spreading throughout the economy in the traditional manner, then the money multiplier should be more stable. However, if those reserves were essentially funding speculative activity, then reserves would remain with the large banks, and the money multiplier would fall. This is the current condition. The September 2013 level of 3.1 is the lowest in the entire 100-year history of the Federal Reserve (Chart 4). Until the last five years, the money multiplier never dropped below the old historical low of 4.5 reached in late 1940. Thus, LSAP may have produced the unintended consequence of actually reducing economic growth. Stock market investors benefited, but this did not carry through to the broader economy. The net result is that LSAP worsened the gap between high and low income households. When policy makers try untested theories, unknown risks are almost impossible to anticípate.

Interest Rates

Economic growth should be very poor in the final months of 2013. Growth is unlikely to exceed 1%, even less than the already anemic 1.6% rate of growth in the past four quarters. Marked improvement in 2014 is also questionable.

Nominal interest rates have increased this year, and real yields have risen even more sharply because the inflation rate has dropped significantly. Due to the recognition and implementation lags, only half of the $275 billion 2013 tax increase will have been registered by the end of the year, with the remaining impact occurring in 2014 and 2015.

Currently, many of the taxes and other cost burdens of the Affordable Care Act are in the process of being shifted from corporations and profitable small businesses to households, thus serving as a de facto tax increase. In such conditions, the broadest measures of inflation, which are barely exceeding 1%, should weaken further. Sincé LSAP does not constitute macro- stimulus, its continuation is equally meaningless. Therefore, the decision of the Fed not to taper is inconsequential for the outlook for economic growth. We expect the downward trend in long- term Treasury bond yields to resurface as these weaker growth and softer inflationary conditions persist.

Van R. Hoisington
Lacy H. Hunt, Ph.D

Are China’s Banks Next?

Simon Johnson

30 October 2013

 This illustration is by Paul Lachine and comes from <a href="http://www.newsart.com">NewsArt.com</a>, and is the property of the NewsArt organization and of its artist. Reproducing this image is a violation of copyright law.

WASHINGTON, DCAmerica’s recent bout of dysfunctional politics and the eurozone’s on-again, off-again crisis should, on the face of it, present a golden opportunity to China. To be sure, the malaise in the United States and Europe is likely to hurt Chinese exports; but, over the long term, China wants to reorient its economy toward domestic consumption. With the Tea Party wing of America’s Republican Party scaring investors out of the dollar, interest in the Chinese renminbi’s potential as an international reserve currency can only increase.
This will help China to attract more investors seeking to diversify their portfolios. Chinese government debt will become an important global benchmark asset, which should help its private sector to attract funding on reasonable terms, while the predominance of the US Federal Reserve in determining worldwide monetary conditions would presumably diminish. The decades-old shift to a multipolar world for manufacturing could thus lead to a more multipolar currency world, with the renminbi as an important player.
But, despite its unique history and current advantages, China harbors a weakness that is quite similar to what has caused so much trouble in the US and Europe: big banks that have an incentive not to be careful. China’s latest moves suggest that while it may now enjoy some years of greater prominence, its encouragement of its financial institutions to go global is likely to lead to serious trouble.
Ironically, the British government, while no doubt just trying to be hospitable to foreign investors by laying out a red carpet, is helping to set a trap for Chinese financial institutions – and the broader Chinese economy. By encouraging China to build global financial institutions with light regulation, the United Kingdom is not just inviting irresponsible behavior; it could help to pull an entire economy toward ultimately unproductive and even self-destructive activities.
China has long kept tight control over its main banks. Credit policies have helped to juice the economy from time to time, but the authorities have also retained the ability to slow things down when warranted. Banking has become an instrument of economic policy to ensure GDP growth and employment creation, while keeping inflation at an acceptable level.
But the Chinese policy elite are also very taken with the idea that a first-rank country needs a prominent banking system that is active internationally. There is nothing wrong with this ambition, as long as it is handled with great caution. Unfortunately, it is now becoming clear that the hard lessons of recent financial crises have been lost on China.
Bankers never like tight regulation – and they particularly do not appreciate being required to fund their operations with more equity relative to debt. In both good times and bad, their refrain is, “We need lower capital requirements,” meaning they should be allowed to borrow more.
Iceland, Switzerland, and the UK have all learned the hard way that allowing banks to become big relative to their economies brings with it great risks. Bailouts become more expensive and – as in the case of Icelandmay actually be unaffordable. Even when, as in the UK, the cost of losses is not completely ruinous, the direct damage to domestic credit and to broader confidence can be enough to hold back the economy for a half-decade or more.
Mervyn King, the former governor of the Bank of England (BoE), is reported to have said, “Banks live globally and die locally.” In other words, when everything is going well, you may be willing to believe that it does not matter where a particular international bank gets its equity funding and in which jurisdiction its debts are issued. But when bad things happen and there is pressure on financial markets, with fear of insolvency in the air, it matters a great deal if you have a claim on an insured bank in the United States or on an essentially unregulated offshore subsidiary.
China wants to build up its banks’ international operations. And the British are welcoming an expansion of these activities in Londonoffering to treat Chinese banks operating there as branches (subject to Chinese regulation) rather than as subsidiaries (subject to British regulation).
Mark Carney, King’s successor at the BoE, said, “We are open for business,” in terms of providing liquidity loans to backstop big banks. But UK banks’ assets amounted to eight times the country’s GDP before the crisis and will presumably approach that level again with Carney’s encouragement.
Can the BoE – and the UK Treasuryreally provide downside insurance for this full amount, or are the UK authorities set on the path to becoming another Iceland (where the value of bank assets peaked at more than 11 times the country’s GDP)?
The Chinese authorities should take another look at their policies. China is like Cinderellafinally allowed to attend the ball and given a chance to become a prominent player. But midnight could come very quickly, and financial crises do not have fairytale endings.
Simon Johnson, a former chief economist of the IMF, is a professor at MIT Sloan, a senior fellow at the Peterson Institute for International Economics, and co-founder of a leading economics blog, The Baseline Scenario. He is the co-author, with James Kwak, of White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You.

October 30, 2013, 2:06 PM

Parsing the Fed: How the Statement Changed

By Phil Izzo

The Federal Reserve releases a statement at the conclusion of each of its policy-setting meetings, outlining the central bank’s economic outlook and the actions it plans to take. Much of the statement remains the same from meeting to meeting. Fed watchers closely parse changes between statements to see how the Fed’s views are evolving. The following tool compares the latest statement with its immediate predecessor and highlights where policy makers have updated their language. This is the September statement compared with July.

Very little is changed in the statement. The overall assessment of the economy is showing improvement, while there are some additions through subtraction, as worries about financial tightening have been removed. The statement about the housing market was tweaked to note some slowing. Meanwhile, the only other addition was a clarification that Congress’s drag on growth wasn’t limited to the shutdown.

October 30, 2013 3:59 pm

Default by Eike Batista’s OGX to test Latin American debt markets
“It is a sad story,” Arthur Byrnes, a managing director at Deltec Asset Management in New York says of Brazilian industrialist Eike Batista’s spectacular fall from grace.
“In one way, Mr Batista had a lot going for him and was the type of person who could do good things for Brazil in terms of infrastructure and fostering private sector competition. Instead, it all blew up.”

By the numbers: Batista

To enlarge graph click here
After months of restructuring talks, the former billionaire’s flagship oil company OGX said on Tuesday that negotiations with holders of its $3.6bn in bonds had ended with no agreement. On Wednesday, Rio de Janeiro-based OGX filed for protection against its creditors in one of the largest corporate bankruptcies in Latin America.
In Brazil, Mr Batista’s creditors and business partners have been scrambling to protect their interests in the event of bankruptcy. Yet back in the US and Europe, investors in Latin American fixed income assets are left with another question: Will the sinking of Mr Batista’s empire drag with it other corporate bonds in the region?

In the market for Latin American corporate bonds in the past decade, blow-ups like Mr Batista’s OGX have been few and far between. Their arrival has been well telegraphed and their impact so localised that when headlines such as those on Tuesday cause a sell-off, corporate debt in the region has been even more likely to offer rewards for buyers with a long-term investment horizon.

But the past year has been different. Latin American bonds have been under pressure amid a broader sell-off in emerging markets in anticipation of the end of the Federal Reserve’s stimulus programme.
Corporate defaults have spiked throughout the region, with a couple of high-profile cases among Mexican homebuilders. Brazil, in particular, faced a troika of bad news in the form of a slowing economy, higher inflation and a wave of protests. As a result, prices fell and the performance has lagged behind that of emerging market peers.
As of Tuesday, high-grade Latin American corporate debt had accumulated negative returns of 3.3 per cent this year, compared with a negative 1 per cent for broad emerging markets bonds of similar ratings, according to JPMorgan Indices.


Far from putting people off, though, the combination of lower prices and the OGX bankruptcy filing may attract a new wave of buyers, traders and investors said.

“The issue with OGX, as unfortunate as it is, has been dragging for quite some time now,” says the head trader for Latin American bonds at one big US bank. Now we all know how this story ends. It’s almost like a clean slate for Latam bonds. People can finally move on.”

Daniel Shirai, a bond trader at Brasil Plural in New York, agrees. If anything we have seen a rebound in Latin American corporate bonds in the past weeks,” he says. “The situation with OGX was well telegraphed and most dedicated investors know that the troubles with the company were very specific, and not an indication of broad systemic risk.”

OGX missed a $45m payment on its bonds at the beginning of this month and was granted 30 days’ grace to negotiate with creditors, which was set to expire on Thursday.

Latin American corporate bonds have rallied in the past month, helped in part by the Fed’s decision to postpone the tapering of its stimulus programme. Average yields on high-grade bonds fell 57 basis points in that period to stand at 5.44 per cent on Tuesday, according to JPMorgan.

Throughout this process, the top corporations in Brazil, Colombia, Peru were able to borrow money and they always will,” says Mr Byrnes at Deltec.

Indeed, the sell-off in emerging markets earlier this year, the lacklustre returns and even the looming bankruptcy have not deterred Latin American companies from raising record amounts in dollars this year.

New debt offerings from companies such as Brazil’s Petrobras, Mexico’s Pemex and Chile’s state-owned copper producer Codelco, helped push this year’s dollar issuance to a record $82.5bn, according to Dealogic. The amount is 4 per cent higher than the volume sold in the same period to the end of October 2012, and shows little signs of abating in the next couple of months.
Still, investors should not discount the lessons provided by OGX’s demise, says Michael Roche, an emerging-markets strategist at Seaport Group.

“In hindsight, bond investors were premature in extending capital to the company. There was also quite a degree of opaqueness in dealings with investors and not all numbers were clear,” he says.

“The problem is, markets have short term memory. We have to assume mistakes will be made again.”

Batista background


His ex-wife Luma de Oliveira, a former carnival queen and Playboy model, sparked outrage among feminists in 1998 when she appeared in Rio de Janeiro’s famous parade sporting what resembled a dog collar with the name “Eike”.

Mr Batista had two children with Ms Oliveira named after Nordic Gods, Olin and Thor – the latter accidentally ran over and killed a cyclist last year in his father’s Mercedes. He had another son with his long-term girlfriend in June, who he also named after a Scandinavian deityBalder.

Mr Batista on megalomania (from his biography, O X da Questão, The Crux of the Matter): “I’ve been painted as a megalomaniac, as someone who is vain, proud. My response to theseaccusations’ is that none of these things is a defect or anything reproachable.”

His fortune peaked at $34.5bn in March 2012, making him the world’s seventh richest man. By July this year Bloomberg estimated his net worth at only $200m. His previous failed businesses include a jeep company, a courier firm, a beauty salon and ventures in Greece and Russia.

Mr Batista is a sports fanatic in spite of suffering from asthma since the age of 11. He holds a world record for powerboat racing.

As one of seven children of a German mother, Mr Batista worked as an insurance salesman to fund engineering studies in Aachen and speaks five languages. After dropping out of university, he moved to the Amazon to prospect for gold, where he was shot in the back by a worker in a dispute over money.
His entertainment company IMX represents Ultimate Fighting Championships and Cirque du Soleil in Brazil. He also owns Rio’s most upmarket Chinese restaurant, Mr. Lam, with a squid dish named after his son Olin.

Additional reporting by Joseph Leahy in São Paulo

Copyright The Financial Times Limited 2013.