miércoles, octubre 23, 2013

OPEN LETTER TO THE WORLD GOLD COUNCIL / SPROTT ASSET MANAGEMENT

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Open Letter to the World Gold Council


Dear World Gold Council Executives;

As you very well know, the business environment for gold producers has been extremely challenging over the past few years. While demand for physical gold remains extremely strong, prices on the COMEX have fallen precipitously. This contradictory situation is the single most important obstacle to a healthy gold mining industry.

In my opinion, the massive imbalance between supply and demand is not reflected in prices because available statistics are misleading. It is not the first time that GFMS (and World Gold Council) statistics have come under pressure from the investment community. In his now celebrated “The 1998 Gold Book Annual”, Frank Veneroso demonstrated the inconsistencies in GFMS gold demand data and proceeded to show how they grossly underestimated demand. The tremendous increase in the price of gold over the following years vindicated his conclusions.

For very different reasons, we are now at a similar pivotal point for gold. Over the past few years, we have seen incredible incremental demand from emerging markets. Indeed, so much so that the People’s Bank of China has announced that it is planning to increase the number of firms allowed to import and export gold and ease restrictions on individual buyers.1 In India, the government has been fighting a losing battle against gold imports by imposing import taxes and restrictions.2 Moreover, Non-Western Central Banks from around the world are replacing their U.S. dollar reserves by increasing their holdings of gold.3

But, demand statistics reported by the World Gold Council (WGC) consistently misrepresent reality, mostly with regard to demand from Asia.

To illustrate my point, Table 1 below contrasts mine production with demand from some of the world’s largest gold consumers. According to WGC/GFMS data, the world will mine, on an annualized basis, about 2,800 tonnes of gold for 2013.

But, I adjusted these figures to reflect mine production from China and Russia, which never leaves the country and is used solely to satisfy domestic demand. After adjustments, we have a total world mine supply of about 2,140 tonnes. On the demand side, I make some in-house adjustments to better represent demand from emerging markets. To proxy for gold consumption in China, Hong Kong, India, Thailand and Turkey, I use net imports of gold, as reported by their various governmental agencies. While imports might in general be an imperfect proxy for demand, those countries see very little re-export of what they import and keep most of it for themselves, so it is not unreasonable to assume that what they import they “consume”, on top of their domestic production. To this I add the demand, as estimated by the GFMS, from other countries and that of central banks. I annualized the year-to-date figures and found that for this year, annualized total demand is approximately 5,200 tonnes. On that basis, “core” annualized demand is approximately 3,000 tonnes more than mine supply.

TABLE 1: WORLD GOLD SUPPLY AND DEMAND 2013, IN TONNES
open-letter-table1.gif

Sources: GFMS data comes from the WGC’s “Gold Demand Trends” publications for 2013 Q1 & Q2. Chinese mine supply comes from the China Gold Association and is up to August 2013, the annualized number is a Sprott estimate.5 Russian mine supply comes from the WBMS (Bloomberg ticker WBMGOPRU Index) and is for 2012, 2013 statistics are still unavailable. Chinese data is taken from the Hong Kong Census and Statistics Department and covers the period Jan.-Aug. 2013 and is annualized to account for the 4 missing months to the year. Changes in Central Bank gold reserves are taken from the IMF’s International Financial Statistics, as published on the World Gold Council’s website for 2013 Q1 & Q2 and include all international organizations as well as all central banks. Net imports for Thailand, Turkey and India come from the UN Comtrade database and include gold coins, scrap, powder, jewellery and other items made of gold. The data is for 2013 Q1 & Q2. ETFs data comes from Bloomberg’s ETFGTOTL Index.

However, these figures also exclude what the GFMS dubs “OTC investment and stock flows”, which is a name for a simple plug because no one really knows what is traded in the OTC market. Also, to remain conservative and avoid possible double counting, I exclude the category “technology” from my demand estimate, which the WGC/GFMS estimates to be about 400 tonnes a year.6 Certainly, some of this demand is captured by the demand numbers for China, Turkey, India or Thailand, but it is near impossible to disentangle them. Nonetheless, it should be kept in mind that my demand estimate is conservative and probably understated by a few hundred tonnes.

Of course, another important source of supply is gold recycling, which the GFMS estimates at about 1,300 tonnes for the year. However, this number is questionable at best as gold recycling is hard to estimate. But, most importantly, a large share of it is probably done in India and China, which as mentioned before do not re-export their gold. In the context of my analysis, recycling from those countries should therefore be excluded from the total supply number.

The real incremental source of supply this year has been the flows out of ETFs. According to data compiled by Bloomberg, and as shown at the bottom of Table 1, ETFs have seen outflows of approximately 724 tonnes year-to-date. On an annualized basis, this represents an additional supply of 917 tonnes. But, this incremental supply is only temporary. As shown in Figure 1 below, ETF holdings of gold seem to have stabilized at around 1,900 tonnes after a rapid decline in the first few months of 2013.

The evidence presented here is clear, demand for physical gold is extremely strong and, in reality, without the massive outflows from ETFs (half of world mine supply), it is hard to imagine how this demand would have been met. Since ETFs have a finite size (about 1,900 tonnes left), these outflows cannot continue for much longer (see our article on the topic).7 All these observations point to a considerable imbalance between supply and demand (unless Western Central Banks decide to fill this void with what is left of their reserves). If recycling was reduced by one half (China, India and Russia) and the temporary sales from ETFs were excluded, demand could be as high as 5,185 tonnes versus supply of 2,140 tonnes. The supply-demand imbalance is obvious to all.

FIGURE 1:TONNES OF GOLD IN ETFS
open-letter-chart1.gif
Source: Bloomberg

As was the case when Frank Veneroso first published his book in 1998, the GFMS methodology understates demand and the World Gold Council, by using data from the GFMS, misleads the market place.

To conclude, I urge the leaders of the World Gold Council, for the benefit of their own members, to improve the quality of their data and find alternative sources than the GFMS, which paints a misleading picture of the real demand for gold. This lack of quality information has certainly been one of the driving factors behind the lack of investors’ confidence towards gold as an investment.

Gold has been one of the best performing asset classes since 2000, and the World Gold Council should be promoting it accordingly.

Regards,
eric-sig.png
Eric Sprott

1http://www.reuters.com/article/2013/09/30/china-gold-idUSL4N0HQ15N20130930
2http://www.bloomberg.com/news/2013-10-09/gold-imports-by-india-slump-as-curbs-reduce-demand-for-jewelry.html
3http://business.financialpost.com/2013/10/07/central-banks-to-add-15b-in-gold-this-year/
4This is calculated by taking the total consumer demand for jewellery, coins and bars for 2013 Q1 & Q2 from table 10 of the WGC’s “Gold Demand Trends” and subtracting from it demand from the individual countries we have listed in the table (China/Hong Kong, India, Turkey, Russia and Thailand).
5http://www.cngold.org.cn/newsinfo.aspx?ID=942
6Technology refers to gold used in the fabrication of electronics, dental, medical, other industrial purposes, etc.
7http://www.sprott.com/markets-at-a-glance/redemptions-in-the-gld-are,-oddly-enough,-bullish-for-gold/


America’s debt crisis may drag the eurozone down

Lorenzo Bini Smaghi

October 23, 2013

The temporary agreement to avoid a debt default in the US will produce severe consequences, not only in America but also in the rest of the world, notably in the eurozone.

As long as Barack Obama’s administration and US Congress remain in the hands of different parties, they will muddle through, trying to gain time by postponing the fundamental decisions. The deadline for raising the debt ceiling will be pushed forward, but there is no certainty that the worst scenario can be definitely avoided. In fact, the two main actors have an incentive each time to move ever closer to the precipice and try to obtain some advantage by threatening a default.

This is similar to the game of chicken European policy makers played during the eurozone debt crisis, bringing the single currency very close to collapse. Only at the last minute, when the risk of implosion became apparent, did European politicians ultimately decide to create a European Stability Mechanism and to move towards a banking union. The intervention by the European Central Bank, pledging to do whatever it takes to avoid a collapse of the monetary union, calmed the markets but catastrophic risk has not disappeared. It is reflected in the risk premium of some eurozone sovereign bonds.

If the US political authorities continue to follow the same pattern, market participants will have to start pricing in a non-zero probability of a disaster scenario. The memory of Lehman Brothers has not faded away, after all. Tail risk is likely to increase in the near future.

A repricing of risk for Treasuries can be expected to affect a whole range of asset prices, including in other countries. At the global level, international investors will be induced to further diversify their portfolios, reducing the overweight of dollar-denominated assets in favour of real assets or financial assets denominated in liquid currencies such as the euro.

The incentive to rebalance investors’ portfolios may also be influenced by the US Federal Reserve’s reaction to the recent deal. Interest rates may remain low for longer and capital may be induced to flow outside the US, chasing higher returns.

Overall, the increased tail risk on US government bonds and the likely reaction of US monetary policy should increase demand for non-US assets. The best rated European sovereigns should benefit from such a portfolio shift. It is less clear, however, that the eurozone as a whole will benefit.

Indeed, the supply of euro-denominated assets is not increasing at the same pace as the global demand. As a result, the euro exchange rate can be expected to further appreciate, continuing the trend of the past few weeks. In fact, the European currency is rapidly heading towards the levels prevailing before the start of the euro crisis. The rising current account surplus of the eurozone, resulting from asymmetric internal adjustment, is further contributing to this trend. This restricts monetary conditions in the eurozone.

On balance, the recent US budgetary events will produce direct and indirect restrictive spillover effects in the eurozone, symmetrical with those the eurozone crisis produced in the US at the peak of the crisis between mid-2011 and 2012. However, eurozone authorities seem less well equipped to deal with these spillovers than the US authorities.

While at the peak of the euro crisis the US authorities flew frequently over the Atlantic to convince European policy makers to get their act together and take the steps needed to complete the institutional framework underpinning the single currency, it is more difficult to imagine Herman Van Rompuy, European Council president, meeting back and forth with John Boehner, speaker of the US House of Representatives, and Mr Obama to convince them they need to reach an agreement on the next debt limit in the interests of the world economy.

Furthermore, while the Fed embarked on various waves of quantitative easing to inundate financial markets with liquidity, avoiding an over-appreciation of the dollar, the ECB’s options are more limited. Cutting further the policy interest rate may help divert some of the demand for euro-denominated assets. The acknowledged weakness of the eurozone recovery and the low inflation rate – increasingly distant from the 2 per cent ceiling – provide the necessary justification for such a cut. It would hardly be sufficient, however, to discourage international investors’ demand for euro-denominated assets.

If the strengthening of the euro is a result of increased demand for euro assets by international investors, the only way to counter it – in the absence of capital controls – is to increase the supply of euro assets or to discourage demand. The only institution in a position to do so is the ECB. It could increase overall euro liquidity by operating directly in the markets, which would not be inflationary as long as the liquidity is held by foreign investors for diversification reasons. Alternatively, it could discourage demand for euro liquidity by imposing a negative interest rate on euro deposits held by the central bank.

Either measure would be a significant innovation for the eurozone. However, they may in the end be unavoidable to counteract the unintended consequences of the way the US is managing its debt problems.

The writer is a former member of the executive board of the European Central Bank and currently visiting scholar at Harvard’s Weatherhead Center for International Affairs and at the Istituto Affari Internazionali in Rome


Earnings Growth to Ramp Up? Call Me a Skeptic

John Mauldin

 Oct 22, 2013



 
In today’s Outside the Box, Sheraz Mian, Director of Research for Zacks Investment research, gives us an overview of corporate earnings trends for the past several quarters and consensus expectations going forward, and asks, “How realistic are these expectations?”

Not very, he says, and tells us why. This is the sort of thorough, no-nonsense analysis Zacks is famous for. Zacks Investment Research was founded in 1978 by Len Zacks, PhD. Many innovations have come from this firm over the years, including the creation of the Earningps Consensus that many investors use now to compare versus actual earnings reports. Most notably, Len discovered the predictive power of earnings estimate revisions. He harnessed these benefits into the proprietary Zacks Rank stock rating system that has allowed Zacks Rank to compile an outstanding track record.

I am in New York for the next few days doing a media “tour” for my new book, Code Red, which will be out next week. I saw the book for the first time last night and sat down to read it again, skipping here and there, somewhat like a curious father viewing his new offspring. Co-author Jonathan Tepper and I will be speaking and sitting for a video as well. Tom Keene was very complimentary about the book this morning. It will hopefully be in bookstores this weekend.

The headline on Bloomberg as I send this note is “Europe Breakup Forces Mount as Union Relevance Fades.” You can go to the bank that this will mean the ECB will soon be issuing yet another Code Red version of easy money to try and smooth over a crisis. It’s a familiar pattern. And one that in the end will not yield the results they desire.

I hope this book does as well as Endgame. Tomorrow night (Wednesday) is the book launch party at the Hyatt Union Square from 5:30-7. It will be fun to see old friends and celebrate book #6. Come on by if you like.

Your hoping for more kind reviews analyst,


John Mauldin, Editor
Outside the Box

Earnings Growth to Ramp Up? Call Me a Skeptic

By Sheraz Mian

Stocks have performed impressively this year and have largely been able to hold on to the gains despite monetary and fiscal uncertainties and the less than inspiring economic and earnings pictures. In a price-earnings framework for the market, most of the gains this year have resulted from investors’ willingness to pay a higher multiple for pretty much the same, or even lower, earnings.

Reasonable people can disagree over the extent of the Fed’s role in the market’s upward push, but few would argue that the Bernanke Fed’s easy-money policy has been a key, if not the only, driver of this trend. If nothing else, the Fed policy of deliberately low interest rates pushed investors into riskier assets, including stocks.

But with the Fed getting ready to institute changes to its policy, investors will need to go back to fundamentals to keep pushing stocks higher.

We don’t know when the Fed will start ‘Tapering’ its bond purchases, but we do know that they want to get out of the QE business in the not-too-distant future. What this means for investors is that they will need to pay a lot more attention to corporate earnings fundamentals than has been the case thus far.

The overall level of corporate earnings remains quite high. In fact, aggregate earnings for the S&P 500 reached an all-time record in 2013 Q2 and are expected to be not far from that level in the ongoing Q3 earnings season as well. There hasn’t been much earnings growth lately, but investors are banking on material growth resumption from Q4 onwards. This hope is reflected in current consensus expectations for 2013 Q4 and full-year 2014. 

I remain skeptical of current consensus earnings expectations and would like to share the basis for my skepticism with you. The goal is to convince you that current earnings expectations remain vulnerable to significant downward revisions.

Negative estimate revisions haven't mattered much over the last few quarters as the Fed's generous liquidity supply helped lift all boats. But if the Fed is going to be less of a supporting actor going forward, then it's reasonable to expect investors to start paying more attention to fundamentals. It is in this context that the coming period of negative revisions could potentially result in the market giving back some, if not all, of its recent gains.

This discussion is particularly timely as we are in the midst of the 2013 Q3 earnings season that will help shape consensus estimates for Q4 and beyond. In the following sections, I will give you an update on the Q3 earnings season and critically review consensus expectations for Q4 and beyond.
 
The Q3 Scorecard

As of Monday, October 21st, we have Q3 results from 109 companies in the S&P 500 that combined account for 31.6% of the index’s total market capitalization. Total earnings for these 109 companies are up +7.5% year over and 63.3% of companies beat earnings expectations with a median surprise of +2.1%. Total revenues are up +2.1%, with 45.9% of the companies beating top-line expectations and median revenue surprising by +0.02%.

The table below presents the current scorecard for Q3


Note: One sector, Aerospace, has not reported any Q3 results yet. NRPT means ‘no reports’; NM means ‘not meaningful’.

With results from more than 30% of the S&P 500’s total market capitalization already out, we are seeing the Q3 earnings picture slowly emerge. This is particularly so for the Finance sector, where 51.8% of the sector’s total market cap has already reported. Other sectors with meaningful sample sizes include Transportation (47.3%), Consumer Staples (40.4%), Technology (36.9%) and Medical (25.2%).

Finance has been a steady growth driver for the last many quarters and is diligently playing that role this time around as well despite anemic loan demand, wind-down of the mortgage refi business and weak capital markets activities, particularly on the fixed income side. Outside of Finance, total earnings are up +4.4% for the companies that have reported already.

How do the 2013 Q3 results thus far compare with the last few quarters? 

The short answer is that they are no better than what we have seen from this same group of 109 companies in recent quarters. In fact, on a number of counts the results thus far do not compare favorably to either the preceding quarter (2013 Q2), or the 4-qurater average, or both.

Specifically, the earnings and revenue growth rates and revenue beat ratio are tracking lower, while the earnings beat ratio is about in-line


The charts below compare the beat ratios for these 109 companies with what these same companies reported in Q2 and the 4-quarter average (beat ratio is the % of total companies coming ahead of consensus expectations).


The trends we have seen thus far will shift to some extent as the rest of the reporting season unfolds, but not by much. A composite look at the Q3 earnings season, combining the actual results from the 109 companies with estimates for the 391, is for +2.1% earnings growth on +0.8% higher revenues, as the summary table below shows.

 

Earnings growth rate has averaged a little over +3% over the first two quarters of the year and will likely stay at or below that level in Q3 as well. With respect to beat ratios, roughly two-thirds of the companies come ahead of expectations in a typical quarter and the Q3 ratio will likely be in that same vicinity.

The ‘Expectations Management’ Game


In the run up to the start of the Q3 earnings season, consensus earnings estimates came down sharply. The primary reason for the estimate cuts – guidance from management teams. Companies guided lower for Q3 while reporting Q2 results, a trend that has remained in place for more than a year now.

The chart below does a good job of showing the evolving Q3 earnings expectations over the last few months.


The Q3 estimate cuts weren’t unusual or peculiar to the quarter, as we have been seeing this trend play out repeatedly for more than a year now. The chart below compares the trends in earnings estimate revisions in the run up to the Q3 and Q2 reporting seasons


These expectations mean that Q3 wouldn't be materially different from what we have become accustomed to seeing quarter after quarter, with roughly two-thirds of the companies beating consensus earnings estimates. This game of under-promise and over-deliver by management teams has been around long enough that it has likely lost most of its value in investors’ eyes.

Beat ratios may not carry as much informational value this time around, but what will be particularly important is company guidance for Q4 and beyond. Guidance is always very important, but it has assumed added significance this time around given the elevated hopes that Q4 represents a material earnings growth ramp up after essentially flat growth over the last many quarters.

Evaluating Expectations for Q4 & Beyond


Let's take a look at how consensus earnings expectations for 2013 Q3 compare to what companies earned in the last few quarters and what they are expected to earn in the coming quarters.

The chart below shows the expected Q3 total earnings growth rate for the S&P 500 contrasted with the preceding two and following two quarters. (Please note that the Q3 growth rate is for the composite estimate for the S&P 500, combining the 109 that have reported with the 391 still to come)


The Finance sector has been a big earnings growth driver for some time. Outside of the Finance sector, total earnings growth for the S&P 500 was in the negative in 2013 Q2 and is expected to be no better in Q3. But the high hopes from Q4 and beyond reflect a strong turnaround in growth outside of Finance.

The chart below shows the same data as the one above, but excludes the Finance sector.


What this means is that quarterly earnings growth was +3.4% in the first two quarters of the year, is expected to be 2.1% in Q3, but accelerate to a +9.4% pace in Q4. And not all of the expected Q4 growth is coming from the Finance sector, as the rest of the corporate world is expected to reverse trend and start contributing nicely from Q4 onwards.

The chart below shows the same data, but this time on a trailing 4-quarter basis. The way to read this chart of steadily rising expectations is that total earnings for the S&P 500 are on track to be up +3.8% year over year in the four quarters through Q3, but accelerate to +4.5% in Q4 and +5.6% in 2014 Q1. Consensus expectations are for total earnings growth of +11.8% in calendar year 2014.


The two charts below show earnings for the S&P 500; not EPS, but total earnings. The first chart shows quarterly totals, while the second one presents the same data on a trailing 4-quarter basis. As you can see, the 'level' of total earnings is very high. In fact, quarterly earnings have never been this high - the 2013 Q2 total of $260.3 billion was an all-time quarterly record.



The data in this chart reflects current consensus estimates. This shows that consensus is looking for new all-time record quarterly totals in the coming two quarters. The high expected growth rates in Q4 and beyond are more than just easy comparisons, they represent material gains in total earnings.

The record level of current corporate profits is also borne by the very high level of corporate profits as a share of nominal GDP, which has never been this high ever. The chart below, using data from the BEA, of corporate profits as a share of nominal GDP clearly shows this.


Where Will the Growth Come From?

There is some truth to the claim that the current record level of corporate profits, whether in absolute dollar terms or as a share of the GDP, does not mean that earnings have to necessarily come down. But earnings don’t grow forever either as current consensus expectations of double-digit growth next year and beyond seem to imply. 

After all, earnings in the aggregate can grow only through two avenues - revenue growth and/or margin expansion.

Revenue growth is strongly correlated with 'nominal' GDP growth. If the growth outlook for the global economy is positive or improving, then it’s reasonable to expect corporate revenues to do better as well. But the global economic growth outlook is at best stable, definitely not improving as the recent estimate cuts by the IMF shows.

The U.S. economic outlook has certainly stabilized and GDP growth in Q4 is expected to be modestly better than Q3’s growth pace. The expectation is for growth to materially improve in 2014, with consensus GDP growth estimates north of +3% for 2014 and even higher the following year. Europe isn’t expected to become an engine of global growth any time soon, but the region’s recession has ended and its vitals appear to be stabilizing. The magic of Abenomics is expected to revitalize Japan, but it’s nothing more than a hope at this stage. In the emerging world, sentiment on China has improved, but India, Brazil, Turkey and other former high flyers appear to be struggling.

All in all, this isn’t a picture to get overly excited about. But with almost 60% of the S&P 500 revenues coming from the domestic market, the expected GDP ramp up next year should have a positive effect on corporate revenues, which are expected to increase by +4.2% in 2004. But in order to reach the expected +11.8% total earnings growth in 2014, we need a fair amount of expansion in net margins to compliment the +4.2% revenue growth.

Can Margins Continue to Expand?


The two charts show net margins (total income/total revenues) for the S&P 500, on a quarterly and trailing 4-quarter basis. For both charts, the data through 2013 Q2 represents actual results, while the same for Q3 and beyond represent net margins implied by current consensus estimates for earnings and revenues.


The chart below shows net margins the same data for a longer time span on a calendar year basis – from 2003 through 2014.


As you can see margins have come a long way from the 2009 bottom and by some measures have already peaked out.

Margins follow a cyclical pattern. As the above chart shows, they expand as the economy comes out of a recession and companies use existing resources in labor and capital to drive business. But eventually capacity constraints kick in, forcing companies to spend more for incremental business. Input costs increase and they have hire more employees to produce more products and services. At that stage, margins start to contract again.

We may not be at the contraction stage yet, but given the current record level of margins and how far removed we are from the last cyclical bottom, we probably don’t have lot of room for expansion. The best-case outcome on the margins front will be for stabilization at current levels; meaning that companies are able to hold the line on expenses and keep margins steady. We will need to buy into fairly optimistic assumptions about productivity improvements for current consensus margin expansion expectations to pan out.

So What Gives?


What all of this boils down to is that current consensus earnings estimates are high and they need to come down - and come down quite a bit. I don't subscribe to the view held by some stock market bears that earnings growth will turn negative. But I don't buy into the perennial growth story either.

So what's the big deal if estimates for Q4 come down in the coming days and weeks? After all, estimates have been coming down consistently for more than a year and the stock market has not only ignored the earnings downtrend, but actually scaled new heights.

A big reason for investors' disregard of negative estimate revisions has been that they always looked forward to a growth ramp up down the road. In their drive to push stocks to all-time highs in the recent past, investors have been hoping for substantial growth to eventually resume. The starting point of this expected growth ramp-up kept getting delayed quarter after quarter. The hope currently is that Q4 will be the starting point of such growth.

Guidance has overwhelmingly been negative over the last few quarters. But if current Q4 expectations have to hold, then we will need to see a change on the guidance front; we need to see more companies either guide higher or reaffirm current consensus expectations. Anything short of that will result in a replay of the by-now familiar negative estimate revisions trend that we have been seeing in recent quarters.

Will investors delay the hoped-for earnings growth recovery again this time or finally realize that the period of double-digit earnings growth is perhaps behind us for good? Hard to tell at this stage, but we will find out soon enough.

My sense is that markets can buck trends in aggregate earnings for some time, as they have been doing lately. But expecting the trend to continue indefinitely may not be realistic.

220 Stocks To Sell Now


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These Strong Sells are sinister portfolio killers because many have good fundamentals and seem like good buys.   But something important has happened to each of them that greatly lowers their odds of success. Historically, such stocks perform 6 times worse than the market.

I invite you to examine this list for free and make sure no stock you own or are considering is on it. Today you are welcome to see it and other time-sensitive Zacks information at no charge and with no obligation to purchase anything.


Best,

Sheraz Mian

Sheraz Mian is the Director of Research for Zacks and manages its award-winning Focus List portfolio.

When Blocs Collide

José Luis Machinea

22 October 2013

BUENOS AIRES – Latin America’s two largest economic groupings – the Pacific Alliance and the Southern Common Market (Mercosur) – are pursuing further integration into the global economy in very different ways. Whether they succeed will depend not only on their individual strategies, but on whether these strategies complement each other. Only if they do can the region become a significant global player.
 
The Pacific Alliance – comprising Chile, Colombia, Mexico, and Peru – represents nearly 40% of Latin America’s GDP, having grown at an average annual rate of 2.9% since 2000. Mercosur’s five economies – Argentina, Brazil, Paraguay, Uruguay, and Venezuela – account for roughly 50% of the region’s GDP, and grew by an average of roughly 3.4% per year during the same period, although growth has slowed since 2010.
 
But these economies’ full potential has yet to be unleashed. While Mercosur has been relatively successful in achieving commercial integration, with intra-bloc trade accounting for 15% of member countries’ total trade (and shares larger than 25% for Argentina, Paraguay, and Uruguay), it has failed to deepen the integration of markets for goods and services.
 
Moreover, though trade within the Pacific Alliance stands at only 4%, member countries’ leaders were not particularly ambitious at their summit in May. While they agreed to eliminate in the short run all tariffs for 90% of traded goods, the group has yet to make progress toward creating common rules on “accumulation of origin” (whereby member countries treat the commodities that they import from each other as their own).
 
It is not surprising that the Pacific Alliance, launched in 2012, is lagging behind the two-decade-old Mercosur when it comes to commercial and other forms of integration. But this does not justify its failure to produce more concrete measures, especially given that its member countries are Latin America’s most receptive to trade liberalization. Indeed, Pacific Alliance members have the most free-trade agreements and are among the region’s most competitive economies.
 
Mercosur members, by contrast, remain wary of excessive trade liberalization and, with the exception of Brazil (and to a lesser extent Uruguay), are significantly less competitive. As a result, over the last few years, the grouping has increasingly become a source of frustration, failing to advance integration and, in some areas, even regressing.
 
In fact, despite some political and economic achievements, Mercosur has largely failed to advance the “open regionalism” – economic interdependence and further integration into the world economy through preferential liberalization and deregulation agreements – that the United Nations Economic Commission for Latin America and the Caribbean proposed two decades ago. Mercosur members have established almost no free-trade agreements with other countries, and the agreement that they have been negotiating for several years with the European Union remains out of reach, apparently because of opposition from Argentina.
 
But Mercosur, too, is essential to Latin America’s global economic integration, owing largely to its core country, Brazil, whose international connections and influence are unmatched in the region. If the Pacific Alliance’s creation reflects waning support for Brazil as Latin America’s leading voice in the international community, as seems likely, progress toward regional integration, as well as efforts to negotiate greater economic integration with Asia-Pacific countries (one of the Alliance’s core objectives), could be more difficult.
 
Against this background, competition between the two groupings would be damaging to all. If Mercosur and the Pacific Alliance fail to devise complementary integration strategies, other countries may well decide that it is worth cooperating only with the Alliance, leaving Mercosur to fade into irrelevance. But, without Mercosur’s economic muscle, the Pacific Alliance countries would be unable to power Latin America’s rise to global prominence.
 
Even with a constructive approach, achieving deeper, higher-quality economic integration with Asia’s emerging economies will be difficult. Latin America’s exports to what is now the world’s fastest-growing region are concentrated among primary goods. For example, 70% of Latin America’s exports to China in 2010 were commodities, and 25% were goods manufactured from these materials, often with little added value.
 
This highlights a significant problem for Latin America. Asian countries, like the developed economies, have a tariff-escalation system: the higher the value added to primary goods, the higher the protection. So, if Latin American countries wanted to export higher-value-added goods, they would face significantly higher tariffs, undermining their competitiveness in Asian markets.
 
Given this, comprehensive free-trade agreements are essential. But, while trade deals could provide opportunities for increased participation in global value chains, their impact would be limited without policies aimed at improving competitiveness and diversifying the production structure. Increased regional cooperation would accelerate this process.
 
Together, Latin America’s economic groupings can provide an important platform from which to improve domestic economic stability, increase competitiveness, bolster regional integration, and gain a greater role in the global economy. Indeed, with bold, comprehensive, and harmonious strategies, Mercosur and the Pacific Alliance could finally secure Latin America’s status as one of the world’s major economic players.
 
 
José Luis Machinea, Professor at Torcuato Di Tella University and the University of Buenos Aires, has served as Minister of Economy of Argentina, President of the Central Bank of Argentina, and Executive Secretary of the Economic Commission for Latin America and the Caribbean (ECLAC).


Markets Insight

October 22, 2013 5:12 am

Treasuries have turned anything but risk-free

Those who can diversify out of US debt are likely to do so
 
The US debt ceiling imbroglio may not have resulted in sovereign default, but I suspect that the rise in US Treasury yields from early summer until the temporary resolution of the crisis last week may in due course be seen as reflecting the emergence of a risk premium.
 
An important message of this episode, in other words, is that the world’s main reserve currency is now a very unsafe haven, while US Treasuries are anything but risk free.
 
That, in turn, raises the question of whether the US is inescapably in decline as China rises to challenge its hegemony. Even without default it is clear, in purely financial terms, that anyone who can diversify out of US Treasuries will now feel impelled do so as far as possible.

Nothing could demonstrate more clearly how quickly politics can subvert the thrust of economics.
A mere month ago the US looked the only economy in the developed world close to achieving escape velocity from the crisis, as well as having an underlying dynamism conspicuously absent from Europe or Japan.

Yet the government closure seriously undermined its credibility in economic policy making while imposing a needless drag on growth.

The inability of the US to intervene in Syria has also raised questions about its ability to deploy hard power around the world. At the same time it has shown that its claim to act as a responsible custodian for more than 60 per cent of the world’s official reserves is tarnished.

Rating recklessness
 
The first exhibit on that score is the recklessness displayed by American politicians over the country’s credit rating. They have given the strongest possible hint that the degree of polarisation in Washington guarantees that fiscal punch-ups will be recurring events.
 
Nor is fiscal policy the only problem. Seen from the perspective of central bank managers of official reserves, quantitative easing constitutes dangerously experimental monetary policy for a country entrusted with $6.8tn of such reserves.

For emerging market countries, printing money via QE looks like a policy of competitive devaluation, even if it was embarked on for domestic reasons. And they have an understandable fear that exit from QE, which is the most experimental part of the experiment, will saddle them with even more seriously overvalued currencies along with higher interest rates on their foreign indebtedness.
 
It is also worrying for reserve managers that the Federal Reserve is operating in a fog. This is not just a matter of the impact of government closure on economic statistics, which will delay any retreat from QE. Nor is it purely about the lack of a route map for the exit.

The global financial system is hostage to a big rise in borrowing costs when the retreat from QE puts an end to the current era of extraordinarily low interest rates.

The rise in bond yields will thus inflict big capital losses on bond holders. Neither the Fed nor anybody else can know how those losses will be distributed around an increasingly complex system. How far bonds have been hedged or leveraged is likewise unclear.

Don’t believe central banks

Of course, the central bankers’ response is that the prudential regulators are well aware of the risks and will be on the alert. That is the same message they peddled back in 2008 when they were hopelessly wrong footed after the collapse of Lehman Brothers. Believe it at your peril.

So is there a parallel here with the transfer of hegemonic power from the UK to the US between the wars?

Yes, to a degree, but the differences are important. The UK was far weaker economically after the first world war than the US is today. The current crisis in the US is more political than economic.

And it has to be said that American politicians are doing their utmost to speed up the transfer of power from the US to China. Yet where reserve currency status is concerned, it will take time for China to offer the world a credible reserve currency, not least because its financial markets remain under-developed.

As I argued here two weeks ago, the obvious message for Beijing is to accelerate the pace of financial market development. It will be interesting to see whether the communist party plenum next month unveils plans to do this.

Yet when contemplating blunders on the scale the US has just inflicted on itself, it is easy to underestimate the problems of strategic rivals. The challenge for China in its proposed liberalisation of interest rates and opening up of the capital account is quite as great as the exit from QE will be for the US.

Even so, declinism is now in fashion. It is safe to predict that this will be the global publishing business’s next growth industry.

The writer is an FT columnist

Copyright The Financial Times Limited 2013

Alan Greenspan: ' The system is broken'

The Associated Press
 
 Tuesday, 22 Oct 2013 | 8:28 AM ET

For 18½ years as Federal Reserve chairman, he was celebrated for helping drive a robust U.S. economy. Yet in the years after he stepped down in 2006, he was engulfed by accusations that he helped cause the 2008 financial crisis—the worst since the 1930s.

Now, Alan Greenspan has struck back at any notion that he—or anyone—could have known how or when to defuse the threats that triggered the crisis. He argues in a new book, "The Map and the Territory," that traditional economic forecasting is no match for the irrational risk-taking that can inflate catastrophic price bubbles in assets like homes or tech stocks.
 
In an interview Sunday with The Associated Press, Greenspan reflected on his book, his Fed tenure and the risks that still endanger the financial system. Relaxed and looking fit at 87, he spoke for an hour in the sunroom of his house overlooking a wooded hillside of Northwest Washington. It's a home he shares with his wife, Andrea Mitchell, the NBC News anchor and chief foreign affairs correspondent.

Surrounded by books of presidential and financial history, Greenspan acknowledged some errors of judgment as Fed chair. But he said he saw no reason to downgrade his own assessment of his tenure.
"Our record was fairly good," he said.

He expressed relief at having finally ended an intense 18 months of work on his book. Now, it's on to talk-show chats with the likes of Jon Stewart and Charlie Rose.
 
Greenspan offers high praise for Janet Yellen, President Barack Obama's choice to lead the Fed starting in January. As a member of the Fed's board in Washington, Greenspan recalled, Yellen sometimes helped him better grasp "what this academic is saying."

He says he still plays tennis regularly—singles as well as doubles. And he seems as much a man of the 21st century as he is of the 20th: In search of his iPhone, he twice asked a staffer where it might be.

Reaching back nostalgically to the Republican administration of Gerald Ford, when he led the president's Council of Economic Advisers, Greenspan remembers a different Washington. He recalls it as a time when political leaders dared to trust their opponents and collaborated to reach common goals.

It didn't hurt, Greenspan said, that the Democratic speaker of the House, Thomas P. "Tip" O'Neill, would drop by the West Wing of the White House some nights "and have a bourbon with Jerry."

Here are excerpts of the Greenspan interview, edited for length and clarity:

Q: You write that you were shaken by the 2008 financial crisis because of the failure of one of the pillars of a stable financial market—"rational financial risk management." What did you discover in your research for the book about this issue?

A: Fear and euphoria are dominant forces, and fear is many multiples the size of euphoria. Bubbles go up very slowly as euphoria builds. Then fear hits, and it comes down very sharply. When I started to look at that, I was sort of intellectually shocked. Contagion is the critical phenomenon which causes the thing to fall apart.
 
Q: When you published your last book, "Age of Turbulence," in 2007, you were being hailed as a "maestro" of the global economy. Then the worst financial crisis since the 1930s erupted. Your policies as Fed chair were blamed for sowing the seeds for that crisis. How did the criticism affect you personally?

A: I've been around long enough to know that a good deal of the praise heaped on me I had nothing to do with. The only thing I did object to was the fact that where the criticism was actually wrong. Did it bother me? Of course it bothered me. But I've been around long enough to have ups and down. So you get over it.

Q: With the knowledge you gained from the financial crisis, has it changed your own assessment of how well you performed as Fed chairman?

A: The real question is, should I have done something different? And the answer to that question is no. Did we make mistakes? You bet we made mistakes. But I thought our record was fairly good. Remember, we stepped in, probably at just the right time after Oct. 19, 1987, when the market went down 22 percent. It was pretty rocky for awhile, but I thought we maneuvered that better than I expected we would be able to do. There were a lot of things of that nature where I thought we did well. And there were other things we didn't do well.

(Read more: Why the Fed won't be easing any time soon)

Q: A lot of criticism centers around the failure of the Fed and other regulators to deal with the explosion of subprime mortgages, which were packaged into securities that then turned bad and were at the center of the troubles. Should the Fed have handled subprime mortgage regulation differently?

A: The problem is that we didn't know about it. It was a big surprise to me how big the subprime market had gotten by 2005. I was told very little of the problems were under Fed supervision. But still, if we had seen something big, we would have made a big fuss about it. But we didn't. We were wrong. Could we have caught it? I don't know.
 
Q: You're not a big fan of the Dodd-Frank Act (the 2010 financial regulation law that aims to prevent another crisis). Why not?

A: It was written politically, in a way that the regulators get the responsibility to solve the problem. There is a whole list of things the act wants done, and it specifies how individual regulators are going to solve the problems. Regulators are now required to do vastly more and to square it with other agencies.

Q: You got to know Larry Summers during his eight years at the Treasury Department during the Clinton administration, and you also worked with Janet Yellen when she was a member of the Fed board. Can you talk about both of them? (Summers and Yellen were rivals for the Fed chairmanship.)

A: The one thing about Larry is that we had breakfasts a couple of times a week for years. And never did a word get out. Those were important meetings. You get a certain trust for somebody. I know Larry's shirts stick out the back of his belt. Who cares? The guy is very smart, and he is unquestionably qualified for most any job you can think of. But then so is Janet. There were times when I came to her and I said, `I don't understand what this academic is saying.' And she would explain it to me. That is a valuable resource. She is very sharp.

Q: On a more personal level, what books are you reading that you would recommend?

A: "Lords of Finance" is a very excellent book. He (Liaquat Ahamed, author of the Pulitzer Prize-winning history of central bankers) is going to be my moderator here next Tuesday. That book is an extraordinary book. I read the book on Coolidge (a biography of President Calvin Coolidge by Amity Shlaes) which I found fascinating because so little is known about him.

Q: Do you admire Coolidge?

A: Yes. I always have. He had his problems. It is a very interesting period of American history which I don't fully understand.

Q: Any other books you would recommend?

A: "The Battle of Bretton Woods" (Benn Steil's history of the 1944 international conference in New Hampshire that helped shape modern global finance) is a book I read recently, which is excellent. What those three books have in common is they provide a type of detail which I was never aware of. I know a great deal about history, but I was quite surprised.

Q: You're famous for your love of delving into the minute detail of economic statistics to help track the economy. One of your favorite statistics has been railroad boxcar loadings of autos and other manufactured goods. Are you still following that type of information?

A: Let me put it this way: When (the federal government) stopped publishing data a couple of weeks ago, one thing I had to tell what was going on with the economy was car loadings.

Q: Should the Fed start reducing its $85 billion a month in bond purchases?

A: I've tried to stay away from specific comments on Fed policy, for one good reason. Paul Volcker (his predecessor as Fed chairman) was very thoughtful. He never commented on Fed policy. I don't comment. They have got enough problems. Somebody harking over their shoulders isn't a good idea.

(Read more: Fed's Evans: Shutdown may delay taper)

Q: What advice would you give Yellen, who has served the Fed as a board member, president of the San Francisco regional bank and since 2010 as vice chair?

A: I had a learning curve on a lot of different aspects of how the Fed operates. Janet clearly doesn't need that. Don Kohn (a longtime Fed staffer and vice chairman) mentored me through the early stages.
 
Q: The size of the Federal Reserve's balance sheet stands at a record $3.7 trillion, reflecting all the Treasurys and mortgage-backed securities the Fed has bought to push long-term interest rates down. You have expressed concerns about this size, which is more than four times where the balance sheet stood before the start of the financial crisis. What are your worries?

A: My basic concern is that we have to rein this thing in well before the demand for funds picks up and makes it very difficult to rein in. (Inflation) is not immediate. It is down the road. But historically, there are no cases where central banks blow up their balance sheets or where countries print money which doesn't hit (with higher inflation).

(Read more: How long will crisis drag on the economy?)

Q: You write that our highest priority should be to fix our broken political system. How?

A: Unless you are willing to compromise, society cannot live together. What is happening now is an increasing proportion of positions are getting beyond the point where the system can effectively hold together. I am concerned about it. It's not long ago when a Howard Baker and Bob Dole and Daniel Patrick Moynihan and Lloyd Bentsen spoke to each other. In the Ford administration, Jerry Ford used to be at Tip O'Neill—toe to toe, bang, bang—and then Tip would come over to the West Wing at 6 o'clock and have a bourbon with Jerry. That's what I mean that the system is broken. We have got to find a way back to the comity that we had not that long ago.

—By The Associated Press.

Alan Greenspan will appear on CNBC's "Squawk Box" Wednesday 10/23 at 7:30 a.m. ET.
 
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