February 19, 2013 7:14 pm
Why the euro crisis is not yet over
If all members of the eurozone would rejoin happily today, they would be extreme masochists
Ingram Pinn©Ingram Pinn

Is the eurozone crisis over? The answer is: “yes and no”. Yes, risks of an immediate crisis are reduced. But no, the currency’s survival is not certain. So long as this is true, the possibility of renewed stress remains.

The best indicator of revived confidence is the decline in interest-rate spreads between sovereign bonds of vulnerable countries and German Bunds. Irish spreads, for example, were just 205 basis points on Monday, down from 1,125 points in July 2011. Portuguese spreads are 465 basis points, while even Greek spreads are 946 basis points, down from 4,680 points in March 2012. Italian and Spanish spreads have been brought to the relatively low levels of 278 and 362 basis points, respectively. (See chart.)
To enlarge graph click here


Behind this improvement lie three realities. The first is Germany’s desire to keep the eurozone intact. The second is the will of vulnerable countries to stick with the policies demanded by creditors. The third was the decision of the European Central Bank to announce bold initiatives – such as an enhanced longer-term refinancing operation for banks and outright monetary transactions for sovereignsdespite Bundesbank opposition. All this has given speculators a glorious run.

Yet that is not the end of the story. The currency union is supposed to be an irrevocable monetary marriage. Even if it is a bad marriage, the union may still survive longer than many thought because the costs of divorce are so high. But a bad romance is still fragile, however large the costs of breaking up. The eurozone is a bad marriage. Can it become a good one?

A good marriage is one spouses would re-enter even if they had the choice to start all over again. Surely, many members would refuse to do so today, for they find themselves inside a nightmare of misery and ill will. In the fourth quarter of last year, eurozone aggregate gross domestic product was still 3 per cent below its pre-crisis peak, while US GDP was 2.4 per cent above it. In the same period, Italian GDP was at levels last seen in 2000 and at 7.6 per cent below its pre-crisis peak. Spain’s GDP was 6.3 per cent below the pre-crisis peak, while its unemployment rate had reached 26 per cent. All the crisis-hit economies, save for Ireland’s, have been in decline for years. See charts.) The Irish economy is essentially stagnant. Even Germany’s GDP was only 1.4 per cent above the pre-crisis peak, its export power weakened by the decline of its main trading partners.

If all members of the eurozone would rejoin happily today, they would be extreme masochists. It is debatable whether even Germany is really better off inside: yes, it has become a champion exporter and runs large external surpluses, but real wages and incomes have been repressed. Meanwhile, the political fabric frays in crisis-hit countries. Anger at home and friction abroad plague both creditors and debtors.

What, then, needs to happen to turn this bad marriage into a good one? The answer has two elements: manage a return to economic health as quickly as possible, and introduce reforms that make a repeat of the disaster improbable. The two are related: the more plausible longer-term health becomes, the quicker should be today’s recovery.

A return to economic health has three related components: write-offs of unpayable debt inherited from the past; rebalancing; and financing of today’s imbalances. In considering how far all this might work, I assume that the risk-sharing and fiscal transfers associated with typical federations are not going to happen in the eurozone. The eurozone will end up more integrated than before, but far less integrated than Australia, Canada or the US.

On debt write-offs, more will be necessary than what has happened for Greece. Moreover, the more the burden of adjustment is forced on to crisis-hit countries via falling prices and wages, the greater the real burden of debt and the bigger the required write-offs. Debt write-offs are likely to be needed both for sovereigns and banks. The resistance to recognising this is immensely strong. But it may be futile.

The journey towards adjustment and renewed growth is even more important. It is going to be hard and long. Suppose the Spanish and Italian economies started to grow at 1.5 per cent a year, which I doubt. It would still take until 2017 or 2018 before they returned to pre-crisis peaks: 10 lost years. Moreover, it is also unclear what would drive such growth. Potential supply does not of itself guarantee actual demand.

Fiscal policy is contractionary. Countries suffering from private sector debt overhangs, such as Spain, are unlikely to see a resurgence in lending, borrowing and spending in the private sector. External demand will be weak, largely because many members are adopting contractionary policies at the same time. Not least because it is far from clear that the competitiveness of crisis-hit countries has improved decisively, except in the case of Ireland, as Capital Economics explains in a recent note. (See chart). Indeed, evidence suggests that Italian external competitiveness is worsening, relative to Germany’s. Yes, the external account deficits have shrunk. But much of this is due to the recessions they have suffered.

Meanwhile, the financing from the ECB, though enough to prevent a sudden collapse into insolvency of weak sovereigns and the banks to which they are tied, required rapid fiscal tightening. The results have been dismal. In a recent letter to ministers, Olli Rehn, the European Commission’s vice-president in charge of economics and monetary affairs, condemned the International Monetary Fund’s recent doubts on fiscal multipliers as nothelpful”. This, I take it, is an indication of heightened sensitivities. Instead of listening to the advice of a wise marriage counsellor, the authorities have rejected it outright.

Those who believe the eurozone’s trials are now behind it must assume either an extraordinary economic turnround or a willingness of those trapped in deep recessions to soldier on, year after grim year. Neither assumption seems at all plausible.

Moreover, prospects for desirable longer-term reforms – a banking union and enhanced risk sharing – look quite remote. Far more likely is a union founded on one-sided, contractionary adjustment. Will the parties live happily ever after or will this union continue to be characterised by irreconcilable differences? The answer seems evident, at least to me. If so, this unhappy story cannot yet be over.

Copyright The Financial Times Limited 2013.

Scrambling for Returns

John Mauldin

Feb 19, 2013

In this special edition of Outside the Box, World Money Analyst contributor Ankur Shah digs in his heels to help us all stay uphill from the slow-motion, jumbled landslide of bond yields and equity returns. Putting some solid analysis under our feet, he leads us onward and upward, dodging dislodged corporate-earnings boulders, relaying warnings shouted back by Head Sherpa Bill Gross, guiding us up the narrow but rock-solid ridge of dividend yields – and what’s that we see glimmering up there, through the swirling mists; can it be this mountain really is capped with gold? To the summit, then!

In all seriousness, Ankur gives us a somewhat technical analysis of the potential for future stock-market returns. This makes a great companion piece to the work Ed Easterling and I did a few weeks back on secular bear markets. In short, the data are not consistent with the beginning of a new secular bull market. Returns are likely to be muted over the next few years.

And how long can total corporate profits continue to stay at all-time highs in terms of GDP? That factor has always been mean-reverting. For a secular bull market to begin from here, we would have to see that percentage go yet higher in what is a low-growth world. Stranger things have happened, but do you want to bet against gravity, and without some way (like a new growth engine) to counteract it?

And now, let’s think nimbly about the stock markets and future returns.

John Mauldin, Editor
Outside the Box

Scrambling for Returns

By Ankur Shah

Success in investing, as with life, sometimes boils down to timing. When I graduated from college in the late ‘90s, I actually had an offer to join PIMCO, which at the time was a relatively small, fixed-income manager tucked away in Newport Beach, California. I remember visiting their headquarters building, with its sweeping view of the Pacific Ocean. I could only imagine Bill Gross at his desk, gazing at the blue expanse and pondering the fate of interest rates across the developed world.

Despite my reverence for Mr. Gross, I chose a different career path, due to my youthful ignorance. I thought to myself, Why would anyone want to be a fixed-income investor when the “realmoney is in equities? As we now know, I inadvertently ended up missing the tail-end of the ongoing bull market in US treasuries and caught the brunt of the secular bear market in equities that began in 2000.

We can see from the chart below that yields on US treasuries are at generational lows. As yield declines, the price of bonds rises. Given the unprecedented level of yields on US treasuries, we are, in my view, close to the end of the secular bull market in government bonds.

As Martin Pring highlighted in his book Investing in the Second Lost Decade:

At the culmination of the 1982-2000 secular bull market in stocks the Fidelity Magellan Fund (a stock fund) was the largest mutual fund in the world. In 2012, the largest mutual fund in the world is the PIMCO Total Return Fund – a bond fund!

It’s no surprise that PIMCO Total Return is the world's largest fund, given that the secular bull market in government debt began in 1981. The question that remains for investors is, with yields so low for US treasuries, what is the upside in terms of prices, from current levels? After all, interest rates are zero-bound at the end of the day. Even Gross himself recently Tweeted, “Gross: Makin’ money with money gettin’ harder every day. When yields approach zero, all financial assets are squeezed.” If the “Bond King” is having trouble finding a decent return, what can we mere mortals hope to achieve?

If fixed-income can’t provide the inflation-adjusted returns that retirement-bound investors so desperately seek, then equities might be the key. Unfortunately, Gross doesn’t see much hope for equities, either. He recently stirred up a bit of controversy in the normally staid world of asset management with his claim that the “cult of equity” was dying, in his August, 2012 Investment Outlook. I actually agree with his original premise that by the end of the current secular bear market in equities, investors will be completely turned off from equities as an asset class. Investors are in for a rough ride, and will earn far less in the current decade than the historical 6.6% annual real return achieved over the past 100 years.

Gross's argument had two main pillars:

1. Since 1912, equities have provided a real return of 6.6%, surpassing real GDP growth of 3.5% over the same timeframe. Essentially, he’s arguing that if stocks continue to appreciate at a faster rate than GDP, then stockholders will eventually own a disproportionate share of total wealth. Thus, expected real returns to shareholders can’t outstrip GDP growth indefinitely.

2. As a percentage of GDP, wages are near an all-time low, concurrent with corporate profits near an all-time high. Corporate profit margins will eventually mean revert.

I agree with Gross that equity investors are facing sub-par returns going forward, but I disagree with the first pillar of his argument. To explain my view, let's start with the basics. Total annual return is calculated as follows:

Total Stock Return = [(P1 – P0) + D] / P0

P0 = Initial price
P1 = Ending price (period 1)
D = Dividends

Essentially, your total return is determined by two components – price appreciation and dividends – in any given year. Using data graciously provided for free and updated on a regular basis by Robert Shiller, I calculated that annualized real returns from equities have been 6.27% since 1871 (the earliest data available). Although I use a longer timeframe than Gross, my calculation of real returns is in the same ballpark.

The key point is that over that timeframe dividends have accounted for 70% of the total annualized real return to investors. Price appreciation added the other 30%.

Price appreciation is ultimately driven by a combination of earnings growth and multiple expansion. Gross is correct when he states that earnings growth is constrained by GDP growth. Additionally, we assume that price multiples will mean revert, which has been the case historically.

Dividends, which are typically spent and not perpetually reinvested, are the main reason that equity investors have achieved real returns well above the rate of GDP growth. If investors had reinvested their dividends, we would expect that over time real returns to equity holders would have diminished as an increasing amount of capital chased after limited profit-making opportunities. Thus, there is nothing inherently illogical about real equity returns outstripping real GDP growth, if we take into consideration that dividends are usually spent and not reinvested.

The second point that Gross raises is correct. We can see in the chart below that corporate profits (after tax) as a percentage of GDP have reached an all-time high.

Conversely, wages as a percentage of GDP have consistently declined since the 1970s. Gross makes the point that the division of GDP between capital, labor, and government can vary over time and greatly advantage one constituency over another. It’s clear that since the end of the 2008 recession, the corporate sector has been the winner.

However, as fund manager John Hussman has consistently stated, corporate profit margins are mean reverting and current profitability levels are unsustainable. If you agree that margins in the corporate sector have peaked, it’s unlikely that the stock market can sustain rising price multiples.

Analysts who view current valuations as cheap on a forward operating earnings basis are making a huge assumption that current profit margins are sustainable. However, analysts who take a normalized earnings approach to valuation will inevitably come to the opposite conclusion. As Hussman observed in a weekly market comment:

Profit margins are also highly cyclical over time. The wide margins at present are partly the result of deficit spending amounting to more than 8% of GDPwhere government transfer payments are still holding up nearly 20% of total consumer spending, and partly the result of foreign labor outsourcing (directly, and also indirectly through imported intermediate goods) which has held down wage and salary payouts. Indeed, the ratio of corporate profits to GDP is now close to 70% above its long-term norm.”

In addition to the potential for declining margins, valuations as measured by the cyclically adjusted P/E ratio (CAPE) are still stretched. Earnings – the denominator in the CAPE ratio – are calculated by taking an average of the past 10 years. By using an average, we normalize for changes in profitability that occur due to the business cycle. Unfortunately, the CAPE ratio doesn’t tell you where the market will head in the next quarter or year, but is an exceptionally useful tool when calculating prospective returns over a long timeframe, such as a decade.

We’re nowhere near the peak levels achieved during the technology boom, but current levels still exceed the historical average of 16.5x, shown in the next chart.

The chart also shows that the market was briefly cheap on a normalized basis in March 2009. Despite the protestations of some analysts, we are not in a new secular bull market for equities. Secular bull markets begin when the CAPE ratio is in the single digits.

What type of return from US equities can we expect going forward, given the current CAPE reading of 21.1x? We can calculate prospective long-term annual total return on the S&P 500 by utilizing the following formula derived by John Hussman:

Long Term Total Return = (1 + g)(Future PE / Current PE)^(1/T) – 1 + dividend yield (Current PE/Future PE + 1) / 2

g = Prospective growth rate of earnings

The equation simply forecasts the two components of total return that, as I noted earlier, are price appreciation and dividend yield. Using the data provided by Shiller, I calculated a long-term historical nominal earnings growth rate of 3.8%. Then, using the current 2.8% S&P dividend yield, I calculated prospective nominal returns for various future CAPE ratios, shown in the next table.

We can see from the table that if the CAPE ratio reverted to slightly below its historical mean of 16.5x, it would result in an annualized prospective return on the S&P 500 of 3.61% over the next ten years. And if the market were to de-rate down to a single-digit CAPE ratio, investors could expect negative returns, based on current valuation levels.

Keep in mind that total return is calculated in nominal terms. So, depending on your inflation expectations, real returns over the next 10 years will be nowhere near historical levels unless earnings can grow well above historical averages or investors are willing to re-rate the market from already-lofty valuations. I have no doubt that prospective returns will eventually improve. Unfortunately, that will entail a significantly lower level on the S&P 500.

Even Bill Gross himself warned about the current valuation levels of stocks and bonds when he tweeted the following back in October: “Gross: Stock and bond managers today must be alchemists: turn lead into gold. NOT likely. Too much lead (bubbled assets).”

With both US treasuries and equities offering poor future returns, where can an investor find adequate inflation-adjusted returns?

With the announcement of QE4, the likelihood of significant inflation surfacing in the back-half of the decade has definitely increased. The best options for investors, in my view, are quality domestic and international equities with decent dividend yields, and precious metals. I may have missed the equity bubble of the late ‘90s and the current bond bubble, but the precious metals bubble is just getting started. I don't plan on missing this one.

Ankur Shah is the founder of the Value Investing India Report, a leading independent, value-oriented journal of the Indian financial markets. Ankur has more than eight years of equity research experience covering emerging markets, with a focus on Southeast Asia. He has worked as both a buy-side investment analyst for a global long/short equity hedge fund and as a sell-side analyst for an emerging-markets investment bank. Ankur is a graduate of Harvard Business School.

jueves, febrero 21, 2013




February 20, 2013, 1:09 p.m. ET

A Fearful Time for Gold


Do you feel lucky, punk? The problem for gold bulls is that too many punks are nodding their heads these days.

 The price of gold, which touched $1,750 an ounce in December, is now around $1,600 - and falling. Polya Lesova joins Markets Hub. Photo: AP.

Gold's latest quantitative easing-fueled rally has now rolled over completely. Trading at less than $1,590 an ounce Wednesday morning in New York, gold futures are back to where they were in early August, just before QE-fever kicked in. Gold has lost 12% since its latest peak in early October.

Such ennui is surprising. QE is continuing, talk of currency war abounds, and Congress's latest self-inflicted crisis, the sequester, looms. This combination of loose money and economic tension is the stuff of gold rallies. That it isn't working should alarm gold bugs.
Bloomberg News

Recent history shows that gold prices have tracked two things pretty closely: the expansion of the Federal Reserve's balance sheet and the decline in real interest rates. Between September 2008 and July 2011, when the Fed's holdings tripled to almost $2.9 trillion, gold roughly doubled to about $1,600. A few months later, as the Fed was on the cusp of announcing Operation Twist, gold hit its all-time peak of just over $1,900. Soon after, the real 10-year rate slipped below zero.

But real rates, even though they remain negative, appear to have bottomed out in December. And while the Fed's assets breached $3 trillion in January, the pace of growth5% year-on-year—is far below the 20%-plus rates that prevailed in 2011.

And fear isn't what it was. The sequestration, even if it happens, is regarded less as a one-way ticket to recession and more as a diversion onto a slower path. Macroeconomic Advisers reckons it would cut economic growth in 2013 from 2.6% to 2%.

It would also likely stay the Fed's hand in ending QE, which should support gold. But just delaying QE's end doesn't provide enough oomph for gold at this point. Instead, this combination of moderate optimism and Fed support is boosting cyclical assets like stocks—which yield dividends—and copper, both of which are up about 8% over the past six months, compared to gold's 4% drop.

True fans of gold will look at all this and see a world lulling itself into a false sense of security—and a buying opportunity ahead of the next deluge. But they also have much to fear from a lack of fear itself.