Financial Sphere Bubbles

by Doug Noland

November 15, 2014

Not an inopportune time to ponder Financial Sphere vs. Real Economy Sphere analysis.

Alan Greenspan, interviewed by the Financial Times’ Gillian Tett at the Council on Foreign Relations, October 29, 2014:

Greenspan: “One of the things that I used this book (“The Map and the Territory”) to write was to develop a concept of how do you shift from a system where everybody is acting rationally – which is what all our models basically said – to one where reality is where people are acting intuitively, various different types of forms. Irrationality is in many respects systematic – you can model it. And indeed I show in many cases why for example fear is demonstrably a much stronger force than euphoria… This is the type of thing that I think we’ve got to understand. And one of the reasons why I say, as a conclusion in this book, that the non-financial parts of our economy behave very well. They are highly capitalized, and essentially it is a financial system which is totally divorced – a different function than the type of things we do in the non-financial area. One (the financial sector) has to do with the allocation of savings into investment. That is where “animal spirits” really run wild.

I am compelled this week to return to Greenspan’s comments.  They provide a good opportunity to take a deeper dive into my favorite “Financial Sphere vs. Real Economy Sphere” analytical framework.  There’s no more important subject matter – anywhere.

It’s nebulous.  Yet let’s attempt to put some broad parameters around the concept of “Financial Sphere.”  It broadly comprises the “Credit system” and “financial markets.” It encompasses “financial assets” – certainly including all securities (equities and fixed-income) and Credit instruments more generally.  Importantly, “financial markets” includes myriad types of financial obligations and derivatives. 

The “Financial Sphere” includes the financial liabilities of the household, corporate and government sectors.  It includes the assets and liabilities of the financial sector, including the banks, securities broker/dealers, finance companies and insurance companies.  These include liabilities traditionally viewed as the “money supply”, including currency, bank deposits and money fund assets.  It includes the assets and liabilities (debt and MBS) of the GSEs.  The Financial Sphere encompasses the assets and liabilities of the “leveraged speculating community.”  Importantly, especially over recent years, the Financial Sphere also includes Federal Reserve liabilities.

The “Financial Sphere” is tasked with critical functions.  Through lending, it provides the purchasing power necessary to drive both spending in the Real Economy and purchases throughout the assets markets (real and financial).  Financial Sphere includes various forms of risk intermediation, including intermediating interest-rate, Credit, market and, perhaps most importantly, liquidity risks.  This crucial risk intermediation function can be seen prominently in the asset/liability structure of banking system, along with GSE, securities broker/dealer and securitization (“trust”) balance sheets.  Money funds, mutual funds and exchange-traded funds (ETFs) play an important intermediation role.  The expansive global derivatives marketplace has come to provide a profound intermediation role within the Financial Sphere.  The hedge funds and global speculator community, with their prominent use of securities-based leverage and their short-term trading focus, have also come to operate as integral “Financial Sphere” participants - providing the marginal source of securities marketplace liquidity.

Let’s cut to the chase:  it’s my view that Depressions and deflationary collapses are primarily the consequence of a crisis of confidence in the soundness and viability of the Financial Sphere. 
Fortunately, they don’t happen often.  Unfortunately, throughout history they’ve erupted on a recurring basis. 

And I would argue Financial Spheres collapse only after prolonged periods of Bubble excess - protracted excess invariably made possible with active governmental interventions, manipulations and inflations.  Basically, the issue is a general loss of confidence – a loss of faith in the Financial Sphere’s capacity to expand sufficient system Credit and/or to effectively intermediate risk – a lack of confidence in the underlying Credit and financial structure – a loss of confidence in policymaking.  As in the Real Economy Sphere, the degree of dislocation during the Financial Sphere bust is proportional to preceding boom-time excesses.  The scope of cumulative boom-time Financial Sphere expansion, risk intermediation and related financial and economic system distortions chiefly determines the degree of systemic fragility (i.e. the risks of a crisis of confidence and financial collapse).   

The contemporary Financial Sphere is unrecognizable from those of the past.  Traditionally, there would be a supply of money available in the system along with a Credit apparatus largely dominated by bank lending and government debt issuance.  The conventional view holds that a gold standard regime ensured that gold backing limited the issuance of a country’s currency. 

That’s fine.  Yet I tend to think more in terms that a commitment to sustaining a gold standard regime cultivated norms, behaviors and standards that worked to keep the general Financial Sphere in check.  Importantly, there were mechanisms that encouraged self-correction and adjustment. 

Traditionally, the Financial and Real Economy Spheres expanded/inflated in tandem.  After all, the chief function of the financial sector was to provide Credit and finance for economic enterprise.  Even in the event of overheated conditions in finance and the real economy, Financial Sphere ballooning would translate into a synchronized economic boom with generally rising price levels. 

It’s fair to say that things changed heading into and after the U.S. dropped dollar convertibility into gold in the early-‘70s.  Yet the most profound Financial Sphere transformation unfolded during the nineties.  Monetary policy evolved (i.e. rate and yield curve manipulation, market backstopping) that incentivized financial leveraging and asset market speculation.  The GSEs, with their implicit federal backing, became a major factor spurring explosive Financial Sphere inflation, both from a Credit expansion and risk intermediation perspective.  “Activism” on the part of both the Fed and GSEs nurtured unprecedented growth in “Wall Street finance” – including securitizations and derivatives.  Readily available cheap funding; reliable market liquidity backstops; and a general inflationary bias spurred incredible growth in the hedge fund community and global leveraged speculation more generally.

There’s a couple of key points:  First, unique from a historical perspective, the contemporary Financial Sphere operated completely unhinged from gold backing; restraints imposed by currency regimes; and even bank reserve and capital requirements.  Traditional central bank angst for rapid Credit expansion, current account imbalances and speculative excess were tossed out the window.   Instead, central bankers became proponents for Credit expansion, aggressive risk intermediation and inflating securities markets.

The second key point is related to the first and is just as critical:  The unrestrained Financial Sphere became increasingly divorced from the real economy.  In particular, Fed and GSE-related market distortions incentivized asset-based lending, leveraging and speculation.  Not surprisingly, this newfangled Credit system dominated by asset-based lending and speculating became increasingly unstable.  A period of serial asset Bubbles took hold, domestically and internationally. 

A book (or two) could – should – be written documenting and explaining the momentous consequences of Bubble Dynamics overwhelming the Financial Sphere of the world’s reserve currency.   In short, beginning back in the nineties, massive U.S. Current Account Deficits and unfettered speculative finance flooded the world with dollar-based liquidity.  By late in the decade, spectacular bursting EM Bubble contagion coupled with a (Fed-incited) runaway securities boom in the U.S. fueled a destabilizing king dollar dynamic.  Later, post-“Tech” Bubble (“helicopter money”) reflationary measures spurred dollar devaluation, in the process unleashing powerful Credit booms throughout the Eurozone, Asia and more generally around the globe. 

Meanwhile, increasingly unstable global finance and extreme economic imbalances ensured that global central banks adopted Federal Reserve policy activism.  This process took a giant leap with the 2008 crisis.  The Bernanke Fed’s adoption of unprecedented monetary measures unleashed global central bankers to pursue experimental “do whatever it takes” policies completed divorced from traditional central bank doctrine.  Fed policies and resulting dollar devaluation provided EM and China unprecedented capacity to inflate Credit and fuel financial and economic booms:  the “global government finance Bubble.”

Bernanke presided over further momentous Financial Sphere developments.  For one, the Financial Sphere became more of a global phenomenon, spurred on by concerted reflationary monetary policy measures.  Furthermore, a globalized Financial Sphere was the product of closely interlinked securities and derivatives markets; the proliferation of cross-border financial flows; readily accessible cheap securities-based lending on a globalized basis;  and, more generally, by the vast and inflating pool of speculative finance that tied together global financial markets.  

If globalized finance dominated by policy “activism” and distortions wasn’t enough, the Global Financial Sphere Bubble became only further divorced from real economies.  And it is here that I believe future historians will see the catastrophic flaw in Bernanke’s policy doctrine:  the belief that “money” printing and zero rates would inflate a general price level and reflate the economy out of debt problems; that the so-called “wealth effect” from inflating securities prices would spur spending, risk-taking and sustainable economic recovery.

From the perspective of my “Financial Sphere vs. Real Economy Sphere” analytical framework, inflating the contemporary Financial Sphere in hope of spurring sustainable economic recovery is an absolute fool’s errand.  It’s nothing short of reckless.  To inflate Financial Sphere excess based on Real Economy Sphere indicators (i.e. GDP, the unemployment rate or CPI) is lunacy.  After all, we have ample historical evidence of a Financial Sphere dynamics detached from the real economy.  And especially after the past two years, we know the separate Spheres have price dynamics completely divorced from each other (wild securities price inflation vs. disinflationary forces commanding consumer price aggregates). 

As I’ve repeated on numerous occasions, there is no general price level for the Fed or global central bankers to manipulate and control.  The domain of their reflationary policies is within the Financial Sphere and financial asset prices.  And we’ve already witnessed how aggressive Global Financial Sphere inflationary measures can actually fuel disinflationary forces in real economies.  I would argue that Financial Sphere inflation is little more than wealth redistribution.  Moreover, the inequitable distribution of wealth (from most to a fortunate few) is a major force behind underperforming economies (“insufficient demand”) around the globe.  I would further contend that Financial Sphere inflation spurs resource misallocation, certainly including mal- and over-investment around the globe.  The Global Financial Sphere Bubble has certainly been instrumental in stoking a protracted capital investment Bubble in China and throughout Asia.  

I’m sick of hearing the sympathetic “central banks are only game in town.” It’s just hard to believe at this point that flawed central banking is not held accountable for the mess it’s made of things.  Greenspan and Bernanke argue that it’s not the responsibility of central banks to prick Bubbles.  The Bernanke doctrine held that Bubbles could be allowed to run, with enlightened post-Bubble “mopping up” measures waiting to reflate markets, price levels and economies.  But bursting Bubbles and the resulting realization of gross wealth redistribution and economic stagnation leave politicians in a bind.  Massive “mopping up” monetization and deficit spending are dangerously divisive issues.  Central banks become the “only game” because they operate largely outside the political process, have the unique capacity to create rules as they go along, and dictate policies in an area that very few understand.  Today’s sophisticated inflationism is even more seductive than its predecessors.   

When the Financial Sphere runs amuck, things can really run amuck.  Over relatively short periods of time market prices can become precariously detached from real economy fundamentals.  After all, pricing dynamics are quite divergent between the Financial Sphere and the Economic Sphere.  In the real economy, supply and demand interact in determining price. Additional supply leads to lower prices.  Lower prices lead to more demand.  The Financial Sphere is a different animal.  More supply of finance leads to higher prices of financial assets.  Higher financial asset prices spur greater demand.  Central bank intervention to spur Credit growth and asset price inflation will incite speculative Bubbles.  Aggressive post-Bubble “mopping up” will ensure only bigger Bubbles.

The Fed and global central bankers gambled that Financial Sphere intervention, manipulation and inflation would spur real economy reflation.  It’s clear they’re playing a losing hand – it is also apparent that they are not willing to admit their flaws, failings or predicament.  The harsh reality is that central bankers cannot escape Financial Sphere fragility. 

When Global Financial Sphere fragility turned acute back in the summer of 2012 (i.e. Italy, European banks and the euro), Draghi, Bernanke and Kuroda adopted unprecedented measures.  They bought some time but at major costs, including the U.S. securities Bubble, a Bubble in European sovereign debt and unprecedented global leveraged speculation (how big is the “yen carry trade”?).  Several weeks back there were indications that Global Financial Sphere fragility was resurfacing.  And there were indications from Fed officials that more QE could be forthcoming, while Draghi and Kuroda came with more shock and awe monetary stimulus.

The latest Fed, ECB and BOJ show did wonders for U.S. and Japanese stock prices.  Yet yen and euro devaluation bolstered king dollar, much to the expense of commodity-related companies, currencies and countries.  Russia’s ruble was hit again this week, as geopolitics turned only more disconcerting.  There was also further indication of acute fragility unfolding in Brazil.  The Brazilian real dropped 1.65% and 10-year (real) yields jumped another 36bps to 12.92%.  Venezuela 10-year bond yields surged 123 bps to 19.73%.  It’s also worth noting that Mexican stocks were hit for 2.8%.  All in all, evidence mounts of serious EM vulnerability.  I’m sticking with the view that the global Bubble has been pierced and that contagion risks are mounting.  As for U.S. equities, the level of bullishness and complacency is just incredible.

Apparently nothing can get in the way of the mighty year-end rally.

Wall Street's Best Minds

Don’t Fight Powerful Stock-Market Trends

The third year of presidential cycle has been great for stocks. Divided government is also a plus.

By Zachary Karabell

Updated Nov. 14, 2014 1:11 p.m. ET

Unless you have been living under a proverbial rock for the past few weeks (though unlikely if you are reading this), you know that the midterm elections in the United States saw a Republican sweep, with enough senatorial seats gained to take control of the Senate, more seats added to their majority in the House, and a few extra governorships picked up along the way.
Investors, of course, immediately began to ask what the implications might be for markets. That can seem like a variant of “yes, but what does this have to do with me” question. Investors can often be faulted for trying to game out market moves from real world events that should matter on their own right, from wars to disease (hence those tone-deaf television segments about “stocks to own after an oil spill” or “which companies benefit from ISIS?”).
Still, politics matter to markets because they can shape the regulatory and legislative framework that impact businesses, and hence why so many of us are so quick to look at what the potential effects of the midterms on stocks, bonds, interest rates, wages, and earnings.
What goes up may not go down

The short answer is that stocks have done extraordinarily well in the one and two years following midterm elections, and since 1970, with the exception of the two years post-2006 (which encompass the beginning of the financial crisis of 2008-2009), U.S. equities have never gone down. The average gain in equities since 1901 is in the high single digits.
It would be hard to find a stronger trend. Since the 1970s, in the one year following midterm elections, stocks are up an average of 14.5%. For the combined two years, the average is 24.9%. If you take out the declines of 2008, the average is 30%. Going back even farther, the averages are only slightly less gaudy.
You would be hard pressed to find a more powerful pattern. And it holds, as Standard & Poor’s helpfully charted, regardless of whether there is a split Congress, a unified Congress under one party with a president in the White House of a different party, or a unified Congress and a White House controlled by the same party. Stocks went up the one and two years following.
Especially relevant for the next two years: The best scenario for equities has been when there is a unified Congress under the Republican Party and a White House controlled by a Democrat. That is what we will have for the next two years, and since 1945, that has been true for just eight years. But those eight years have averaged 15.1% equity market returns.
The pattern is less clear for bonds. In fact, there isn’t one. The past precedent for equities is strong.
The past precedent for bonds doesn’t exist.
What the next two years might hold

It’s a powerful equity pattern. That doesn’t mean it will hold, of course, and nowhere does the line “past performance is no guarantee of future results” hold more true. Just because something went up in the past in certain conditions in no way means that it will again in the future.
But this unusually strong past pattern does support other arguments for why equities might continue their run of the past five years.
Take third quarter earnings, which the bulk of companies have recently reported. According to FactSet, earnings grew by over 7%, rather more than expected, and revenue grew more than 4% for the companies of the S&P500, and those numbers were higher still if the negative drag of the consumer discretionary sector is taken out. That compares to national GDP growth in the U.S. of less than 2.5% and not substantially more than that globally. Even without central banks in the equation (which they are, but not as much perhaps as many investors appear to believe), it should not be so surprising that stocks are doing well in the U.S. and sovereign bonds are still at very low yields.
But it is still curious why equities have been strong so often after midterm elections through radically different periods economically and historically. One reason could be that investors have a chemical (and at times immature) aversion to uncertainty, and looming elections are a recipe for uncertainty. Who will win? What will they do? Faced with that unknown, many investors hedge their bets, or wait until the election is settled. Then, once the outcome is clear, any outcome, they begin to return to the market and look for opportunities.
It also may be that investors get just as distracted by the noise of elections as the media and the chattering classes. That noise can obscure and distort how other, non-political information gets filtered. Of course, in U.S. midterm elections, not many people actually vote. This time, about 36% of the electorate voted, and of those, 52% voted Republican, which meant that the winning party won with 18% of the eligible vote. That is hardly unusual for the midterms. Even so, political news dominates in the month before, along with the usual hyperventilating hyperbole. Perhaps that weighs on investing decisions in incalculable yet tangible ways.
As for why stocks then do better with a split government characterized by a Democrat in the White House and a Republican Congress—that will have to remain unanswered, especially given that it has only been true for a grand total of eight years.
What might lie ahead

 Given the particular dynamics of this period, it is difficult to see how much might change in Washington itself as a result of the recent election. As many have noted, this group of Republicans and the particular Democrat in the White House do not seem eager to find common ground for needed legislation. The picture in state house and state governments is less grim, but what will happen is more of a state-by-state story than a national narrative that has explicit or clear investing implications.
There are three areas cited as propitious for some action: movement on negotiating stalled trade pacts such as the Trans-Pacific Partnership; movement on U.S. domestic energy regulations including authorization for the much-debated Keystone Pipeline from Canada to the Gulf of Mexico; and a revision of the corporate tax code that would see the overall rate decrease to be more in-line with international averages and a closing of loopholes that would result in more overall corporate tax being collected.
Also mulled, but in our view much less likely, are some movement on immigration reform and meaningful changes to the Affordable Care Act (a.k.a Obamacare). And even in the three areas above where the chances of movement appear decent, the sheer partisan and acrimonious climate of contemporary Washington may just preclude even that.
We are left, then, with a static and locked political scene with a key element of uncertainty removed.

While it is unclear whether the federal government will act incrementally on the issues, it is clear that the federal government is not about to enact sweeping new taxes, expansive new regulations, or innovative new approaches to the continued challenge of wages and jobs. As a result, investor and market attention will and should focus primarily on whether companies are delivering sustainable financial returns, led by skilled management and driven by growing end-markets.
On that score, markets are at the least poised to continue the trends of the past years, with low rates (perhaps not as low as the Fed likely begins raising short-term rates sometime in 2015) and strong earnings. While this bull market has been robust since mid-2009, we should not forget that since 2000, equities have hardly been on a bull run, with the Nasdaq still below its all-time high set in March 2000 and the other indices only a tad above that. Multiples are hardly egregious, and as mentioned, rates are low.
Past performance and past trends are not at all a guarantee of future trends. But for the next two years, it is difficult to make the case that the trend of past midterm elections will be broken. As long as the global financial system does not encounter a crisis, equities seem likely to continue their rise, as they have in all but one case after midterms over many, many decades. 

Karabell is head of global strategy at Envestnet, a leading provider of wealth management technology and services to investment advisors.

Gold Is On Trial And The Verdict Is Just A Few Days Away

  • Two big technical Fridays in a row.
  • Gold tightens.
  • Volatility has increased.
  • Russia adding to reserves.
  • All eyes on the November 30 referendum.

The balance of November puts the gold market on center stage. It starting to feel like Friday is the new buying day for gold. After months and months of bearish price action, the gold market has rallied sharply and given a bullish technical signal on the past two Fridays.

A tale of two Fridays

Last week I posted an article: Gold - A key reversal is that enough to turn a bull into a bear? This past week gold prices came off from the highs made at $1179 on Friday, November 7 until the middle of the trading session on Friday, November 14.

(click to enlarge)

In a repeat of the action on the previous Friday, the gold futures market posted another key reversal day to the upside on Friday, November 14. A key reversal occurs when a market makes a new low from the previous trading session and then closes above those previous sessions' highs. Friday, November 14 marks the second Friday in a row that gold has exhibited this bullish trading pattern.

Validating the moves higher was the volume that traded on these key reversal days, in both cases more than 300,000 contracts traded. From a technical perspective, rising open interest, which has increased from 386,186 contracts on October 10 to 450,363 contracts on November 14 (16.6%), is not only a sign of bullish strength but illustrates renewed interest in gold. While I have been negative on the gold price for some time now due to a rising US dollar and bearish action in many commodity markets, the technical action on the past two Fridays in gold requires reflection. Gold is catching a bid and there are some reasons that it could move higher.

Gold tightens

Recently, the gold market, which tends to trade on a deferred basis at progressively higher prices, has begun to tighten up. Gold offered rates or GOFO rates in London have turned negative out to six months in the future. This means that it costs more to borrow gold. There could be a number of reasons for the tightening - the most obvious would be an increase in demand for physical gold bars.

A pickup in physical buying at lower prices may be to blame. However, Central Banks' pulling back gold deposits from dealers would cause tightness. Another explanation may be a pickup in producer hedging. When a producer sells forward production, the dealer providing the hedge must borrow gold in order to sell and lock in current prices. Another potential explanation for tightness in London is the prospect of repatriation of bullion by a major gold holding government. The bottom line is that there appears to be a shortage of physical gold in London, which is causing the negative rates and market tightness.

Increasing volatility

Daily historical volatility in gold has moved from 8.48% on October 29 to just over 20% on November 14. Higher historical volatility and increased interest in the yellow metal has led to increased action in gold options. Gold last traded on November 14 at $1187.90 and a gold call option, which gives the buyer the right to buy December gold futures at $1200 per ounce, traded up to $12.50 after closing at $2.20 on November 13. These are very short-term options expiring on November 24.

Increasing historical volatility has led to increasing implied volatility as market participants expect wider price ranges. Higher implied volatility has pumped up option premiums.

Russia is adding to gold reserves

Mr. Putin has been having a rough time on the international stage in the second half of 2014. The situation in Ukraine and resulting sanctions have weakened the Russian economy. A bear market in crude oil that has sent prices almost 30% lower has choked cash flow for the Russians.

Traditionally, the Russians sell their domestic gold production to domestic banks, namely Sberbank or VTB. These banks then sell the Russian gold on to foreign banks, however, since the implementation of sanctions, many foreign banks are holding off on buying Russian gold.

This is not to say that the Russians do not have other outlets to sell their gold. Other nations such as China would stand ready to buy Russian gold if necessary. However, rather than sell their gold, Russia has added to gold reserves. The World Gold Council recently reported that Russia has added 115 tons of gold to its reserves so far this year. In fact, the Russian Central Bank has been the biggest official sector buyer of gold over the past ten years. Holdings have tripled to 1,149.8 tons (almost 37 million ounces) since the end of 2004. Russia is now the sixth-largest Central Bank holder of gold. In September, Russia added 37 tons to its coffers. China also continues to be a large official sector buyer of the yellow metal. Owning gold in the current environment decreases Mr. Putin's reliance on other Central Bank foreign exchange reserves and decreases his dependence on the US dollar and euro. One must wonder whether it is Mr. Putin's intention to back his currency, the ruble, with gold to strengthen it during the current period of economic turmoil in the country. The prospect for backing currencies with gold could be yet another reason for recent strength in the metal.

November 30th: Decision Day - The Swiss Referéndum

On November 30, citizens of Switzerland will head to the voting booths to decide on an initiative that would back the Swiss franc with gold. A yes vote on the referendum would force the Swiss National Bank to increase its gold holding to 20% of its official reserves. That percentage now stands at around 8%. The Swiss government currently holds approximately 1040 tons of gold. It would require a purchase of some 1,500 tons over the next five years. A yes on the referendum would prohibit the Central Bank from selling gold holdings and force repatriation of all gold reserves within Swiss borders.

Many Central Banks diversify their gold holdings in order to mitigate geopolitical risk.

Countries tend to hold some of their reserves domestically while storing some in liquid trading centers for gold such as London, New York, Zurich, Asia and Australia. The prospect of a Swiss repatriation could account for some of the current tightness in the London gold market.

Polls in early October showed strong support for the referendum but since then the "no" side has gained momentum, holding a slight edge in the latest survey of voters. Politicians and Central Bankers are strongly opposed to the referendum, saying that if it passes, it will mean a dramatic reduction in their capacity to intervene on currency reserves with disastrous potential consequences for the Swiss economy. If the referendum passes, the ramifications are clear... the Swiss National Bank will more than double their current gold reserves, bringing a new and significant official sector buyer of gold to the market. Additionally, they will bring their bullion back to Switzerland, draining physical metal from the hub of liquidity for the gold market, London.

Gold is on trial and the verdict is coming son

The next two weeks are perhaps the most important weeks for the price and value of gold in years.

Technical indicators are currently bullish with consecutive key-reversal days on the past two Fridays. Russia and China are buying gold and increasing their reserves. The gold market is tightening up due to a shortage of physical metal. Volatility, both historical and implied, is on the upswing as daily price ranges widen. The lead-up to the Swiss referendum has caused gold prices to move higher along with the value of the Swiss franc, which also put in a key reversal to the upside on Friday November 14.

The vote in Switzerland on November 30 could prove to be a watershed event for the price of gold and the metal's role as a reserve asset for years to come. A "yes" vote on the referendum could have contagious results, causing pressure on other governments to consider similar monetary policies. Gold is on trial on November 30 in Switzerland; a "yes" vote means higher prices, while a "no" vote means a return to the kind of trading action we have seen since summer. Keep your eyes on the Swiss election - the fate of the direction of gold lies in this decision.

Heard on the Street

The Not-So-Mighty Chinese Consumer

By Aaron Back

Nov. 13, 2014 10:53 p.m. ET

Judging by Alibaba’s blowout “Singles Day” sale this week, one could be forgiven for thinking all is well with the Chinese consumer. In fact, evidence is stacking up that shopping carts are increasingly bare.

The troubling implication is that China’s resilient spenders are succumbing to an economic downturn, which until recently has been largely confined to property and heavy industrial activity. Declining investment in these areas was bound to eventually feed through, as people working in those industries earn less. Falling home prices add to the sense of anxiety.

Gauging Chinese retail sales is difficult. Official retail sales data have slowed, but are still showing low double digit growth. These figures are flawed, however, because they include certain government and wholesales purchases, while excluding services such as haircuts.

Alternate readings are hardly encouraging. Nielsen estimates that total sales in China of fast-moving consumer goods, including things like food and toiletries, rose just 3% from a year earlier in the three months to September, compared with double digit rates in 2012.

Wal-Mart said Thursday China comparable-store sales fell 2.3% from a year earlier in the three months to October, due to “government austerity, reduction in gift card sales, and deflation in key categories such as dry grocery, liquor and consumables.” One of China’s largest hotel operators, China Lodging, said this week it wouldn’t meet its full-year revenue target because of macro headwinds.

Unilever said last month that China sales fell around 20% in the third quarter, due to a “sharp market slowdown” that led to destocking by merchants. Colgate Palmolive ’s Asia sales rose just 1% in the quarter, with gains in India offsetting declines in the greater China región.

SABMiller , which with a Chinese partner owns best-selling Snow beer, said China lager volumes declined in the six months to September, blaming cool summer weather. Macau casinos reported that declines in VIP gambling spread for the first time to mass market visitors last month. Car sales have slowed too.

Luxury good sales have been feeling the pinch in China for some time due to the government’s anticorruption campaign. But rather than just affecting bribes masked as gift giving, the campaign may be having a broader effect on more prosaic forms of consumption. Employees at state-owned enterprises simply have less cash to spend as they lose perks such as allowances for personal expenditures and gift cards that often came at holiday time.

Moreover, the broad economic downturn is filtering down to consumers by hitting incomes. Official data show inflation-adjusted urban disposable income rose 6.9% from a year earlier in the first nine months of the year, down only slightly from 7% for all last year, but a substantial slowdown compared with 9.6% growth in 2012.

Whether this is the bottom of the consumer cycle or the start of something worse is likely tied to the fate of the property market, in which much of China’s household wealth is stored. Property sales showed tentative signs of finding a bottom in October after restrictions on apartment purchases were relaxed, but prices are still falling. Any real-estate recovery is likely to be weak.

The same goes for consumption.

martes, noviembre 18, 2014



All it needs is love

Capitalism’s reputation has been damaged by the bankers

Nov 15th 2014

WHY don’t more people love capitalism? After more than two centuries, the economic system has brought vast gains in living standards and longevity to the countries that have adopted it. But even in America, capitalism’s spiritual home, a survey conducted in 2013 found that just 54% had a positive view of the term. Another recent poll found that less than half the populations of Greece, Japan and Spain had faith in free markets; support for capitalism, on average, was higher in poor countries like Bangladesh and Ghana than in the advanced world.

The recent financial crisis has intensified criticism of the system, from the Occupy Wall Street movement to the support for parties of the far right and left in Europe.

Perhaps the problem is that the word itself is off-putting (it was invented by 19th century critics). Our image of a capitalist is a 19th century millowner in a top hat or a miserly plutocrat such as Montgomery Burns from “The Simpsons”. The Merriam-Webster dictionary defines a capitalist as “a person who has a lot of money, property, etc, and who uses those things to produce more money”; the Oxford dictionary defines capitalism as “an economic and political system in which a country’s trade and industry are controlled by private owners for profit, rather than by the state”. Neither definition sounds very positive.

Few people would class themselves as a capitalist, or believe they had “a lot” of property or money, and few live directly off profits; most are “wage slaves”. So capitalism sounds like a system that benefits other people, rather than ourselves.

Nor does capitalism relate easily to the Christian ethic which still permeates Western societies. Jesus did not celebrate bankers; he turned the moneychangers out of the temple. His advice to a rich man was “sell all you have and give to the poor”. The role model is the good Samaritan, who selflessly helps others, rather than himself. When we raise our children, we emphasise principles of sharing and fairness; we dole out food and presents equally to each child, regardless of how well they have “performed” during the year. The most reliable complaint of any child is that a decision is “not fair”.

It is hardly surprising then that in adulthood, some people see the great riches accumulated by a few and feel that is not fair either. Inequality is seen as a major problem by 56% of people in rich countries, according to the pollsters.

But there is cognitive dissonance at work. Ask people what they think about a system that gives them the right to own property and the result would be overwhelmingly favourable. Similarly, consumers have no problem appreciating the benefits of competition, eagerly seeking out the best restaurant or the latest gadget. Those options are the product of capitalism. Britons would not enjoy such a choice of mobile phones and services if the industry were still controlled by the old nationalised British Telecom.

So perhaps it is a question of terminology. We need a word that implies a system of private property and competition and makes people think of the local newsagent or market stallholder—businesses they can relate to. These people are capitalists in the sense that they make a living by putting their money at risk. But neither the business-owners concerned nor their customers think of them that way.

Terminology is not the only problem, however. In the past 30 years or so, capitalism has become associated less with businesses operating in a competitive market, and more with the banking sector.

The best and the brightest of society’s graduates have flocked to investment banking. Financial capitalism is inherently less appealing. It produces not iPads, but complex structured products with obscure acronyms. And when governments and central banks are forced to step in to rescue the titans of finance, the idea of a free market also goes out the window. A system that privatises profits and nationalises losses is impossible to justify.

All this matters because voters are in an ugly mood, perhaps because they have not enjoyed real-wage growth in recent years. That marks a change from the 1980s and 1990s when advanced economies enjoyed steady economic growth, encouraging parties of the centre-left to adopt market-friendly policies.

The risk now is that voters back parties that pursue policies which damage trade and investment, and make the developed world’s problems even worse. The reverberations of the financial crisis make it hard for mainstream parties to fight back. Somehow, capitalism, for want of a better word, must be rescued from the bankers.

Last updated: November 14, 2014 5:47 pm

Credit markets play a risky dating game

WASHINGTON, DC - JULY 22: Stacks of twenty dollar bills pass through on machine at the Bureau of Engraving and Printing on July 22, 2011 in Washington, DC. The printing facility of Bureau of Engraving and Printing on 14th Street in Washington was until 1991 the only facility printing Federal Reserve notes until a western facility was opened in Fort Worth, Texas. (Photo by Mark Wilson/Getty Images)©Getty

In the competitive world of online dating, men and women will embellish their profiles to attract the best mates. Salaries are engorged, ages are diminished and heights increased as singles seek promising partners.

In credit markets a similar trend is playing out as companies flatter their bottom lines to attract the best financing deals from investors who are willing to play along in order to get a shot at a debt product with juicy yields.
Analysts, however, are warning that investors’ willingness to overlook such corporate earnings adjustments in their desperation to buy bonds, loans and other securities could come back to haunt them.
“Beauty – or the lack of beauty – is in the eye of the beholder,” says Scott McAdam, portfolio specialist at DDJ Capital Management. “In the late stages of a credit cycle where capital is cheap and there’s a lot of money chasing deals, companies will kind of get away with this.”

In a report published this week Mr McAdam argues that the credibility of a company’s “ebitda” – or earnings before interest, taxes, depreciation and other non-cash items – may be undermined by the appearance of aggressive earnings adjustments known as “add-backs”.
Such add-backs are often used ahead of a transformative deal – such as a merger or acquisition – that is expected to significantly cut a company’s costs or boost its revenue. They are presented in the bond offering marketing documents and loan agreements prepared by issuers and underwriters and can make companies appear more creditworthy than their historical cash generation would indicate.
Inflating earnings can encourage more investors to buy a bond or loan, resulting in lower financing costs for companies but it also means that investors may end up holding assets that do not yield enough to compensate for risk.

Mr McAdam says that in the extreme, debt investors end up taking on equity-like risk because ebitda has been exaggerated and thus total leverage, or borrowing, understated.

In one well-known example, software firm Travelclick secured $560m worth of loans while citing a debt load of 6.6 times ebitda. According to Moody’s, the rating agency, stripping out add-backs resulted in a debt load closer to 10 times ebitda.
Electronic dance music festival organiser, SFX Entertainment, would have negative cash flow without the use of add-backs. Despite the hefty adjustment, investors have lined up to buy SFX debt with the size of a bond deal sold earlier this year increased $20m to $220m thanks to strong demand.

With sophisticated parties on the other side conducting their own analysis of offering documents, it may be difficult to believe investors are being misled.

Credit markets

One experienced investor said that he carefully scrutinised add-backs – giving more weight to cost cuts than to revenue synergies and also evaluating the track records of management teams. But, he added, in a hot market, investors “were more willing to accommodate adjustments”.

Christina Padgett, head of leveraged finance research at Moody’s, says: “It’s not always [companies’] intention but just what the market is offering because there’s so much demand for high-yielding debt right now. It’s an issuer’s market.”

She says the problem of earnings adjustments has been compounded by a wider loan market trend towards deals that come with fewer protections for lenders, known as “covenants.” Such covenants typically require companies to disclose and maintain certain financial metrics – such as a particular debt to earnings ratio.

“One of the things that covenants did in the past was give information to investors and give them an opportunity to force a company to come back to them. Now issuers can make all kinds of financial and strategic decisions without going back to the lenders.”


Op-Ed Columnist

China, Coal, Climate

Paul Krugman

NOV. 13, 2014

It’s easy to be cynical about summit meetings. Often they’re just photo ops, and the photos from the latest Asia-Pacific Economic Cooperation meeting, which had world leaders looking remarkably like the cast of “Star Trek,” were especially cringe-worthy. At best — almost always — they’re just occasions to formally announce agreements already worked out by lower-level officials.

Once in a while, however, something really important emerges. And this is one of those times: The agreement between China and the United States on carbon emissions is, in fact, a big deal.

To understand why, you first have to understand the defense in depth that fossil-fuel interests and their loyal servants — nowadays including the entire Republican Party — have erected against any action to save the planet.

The first line of defense is denial: there is no climate change; it’s a hoax concocted by a cabal including thousands of scientists around the world. Bizarre as it is, this view has powerful adherents, including Senator James Inhofe, who will soon lead the Senate Environment and Public Works Committee. Indeed, some elected officials have done all they can to pursue witch hunts against climate scientists.

Still, as a political matter, attacking scientists has limited effectiveness. It plays well with the Tea Party, but to the broader public — even to non-Tea Party Republicans — it sounds like a crazy conspiracy theory, because it is.

The second line of defense involves economic scare tactics: any attempt to limit emissions will destroy jobs and end growth. This argument sits oddly with the right’s usual faith in markets; we’re supposed to believe that business can transcend any problem, adapt and innovate around any limits, but would shrivel up and die if policy put a price on carbon. Still, what’s bad for the Koch brothers must be bad for America, right?

Like claims of a vast conspiracy of scientists, however, the economic disaster argument has limited traction beyond the right-wing base. Republican leaders may talk of a “war on coal” as if this were self-evidently an attack on American values, but the reality is that the coal industry employs very few people. The real war on coal, or at least on coal miners, was waged by strip-mining and natural gas, and ended a long time ago. And environmental protection is quite popular with the nation at large.

Which brings us to the last line of defense, claims that America can’t do anything about global warming, because other countries, China in particular, will just keep on spewing out greenhouse gases. This is a standard argument at think tanks like the Cato Institute and among conservative pundits. And, to be fair, anyone proposing climate action does have to explain how we can deal with the free-rider problem of countries that refuse to contain emissions.

Now, there is a good answer already available: “carbon tariffs” levied against the exports of countries that refuse to join in the effort to limit emissions. Such tariffs probably wouldn’t even require any change in existing trade law, and they would provide a powerful incentive for holdouts to get with the program. Still, until now, the suggestion that China could be induced to participate in climate protection was informed speculation at best.

But now we have it straight from the source: China has declared its intention to limit carbon emissions.

I know, I know. The language is a little vague, and the target levels of emissions are much higher than environmental experts want. Indeed, even if the deal were to work exactly as stated, the planet would experience a highly damaging rise in temperatures.

But consider the situation. America is not exactly the most reliable negotiating partner on these issues, with climate denialists controlling Congress and the only prospect of action in the near future, and maybe for many years, coming from executive orders. (Not to mention the possibility that the next president could well be an anti-environmentalist who could reverse anything President Obama does.) Meanwhile, China’s leadership has to deal with its own nationalists, who hate any suggestion that the newly risen superpower might be letting the West dictate its policies. So what we’re getting here is more a statement of principle than the shape of policy to come.

But the principle that has just been established is a very important one. Until now, those of us who argued that China could be induced to join an international climate agreement were speculating. Now we have the Chinese saying that they are, indeed, willing to deal — and the opponents of action have to claim that they don’t mean what they say.

Needless to say, I don’t expect the usual suspects to concede that a major part of the anti-environmentalist argument has just collapsed. But it has. This was a good week for the planet.

martes, noviembre 18, 2014



Bank regulation


New rules hemming in banks will make it easier to let them fail—with luck

Nov 15th 2014

WHEN big banks totter, taxpayers usually foot the bill. Given the chaos that would follow an outright failure—bank runs, frozen payment systems and so on—bail-outs have long been the least-bad option for governments. That might end under plans unveiled on November 10th by the Financial Stability Board (FSB), a group of international regulators, that should make it easier for banks to fail without recourse to the public purse.

Under the proposed new rule, the biggest banks will have to hold buffers, or “total loss-absorbing capacity” (TLAC), equivalent to 16-20% of their assets (the loans and investments they make)—vastly more than in the run-up to 2007. The bigger cushion comes in two main forms. First, banks must hold more equity (the money shareholders put into the business) relative to their assets. Second, bondholders, who put up much of the money banks go on to lend, will now be expected to shoulder losses after shareholders are wiped out.

The principle of “bailing in” creditors is welcome. Though in theory many of them should have been hit in 2007-09, in practice imposing losses on them proved legally difficult and so seemed foolhardy to attempt in the midst of a crisis. Now, bonds are counted towards TLAC only if they explicitly bear losses when things go wrong. One such instrument, known as contingent-convertible bonds, or “cocos”, is counted as debt in good times but automatically turns into equity if capital ratios drop below a certain level.

The TLAC rule, which comes into force in 2019, will apply only to 27 “systemically important” global banks such as HSBC and Citigroup. Smaller lenders are exempted, as are bigger ones in emerging markets. But they are widely expected to face similar rules soon.

Mark Carney, the governor of the Bank of England who also chairs the FSB, has made clear TLAC is not designed to prevent individual banks going out of business. The aim is to limit the potential reverberations, making a bank failure more akin to that of an airline or a carmaker, say: painful, complicated, but ultimately not a threat to the wider economy.

That in turn should remove the implicit subsidy big banks have unfairly enjoyed. Because creditors have long assumed the banks were “too big to fail”, they also assumed they would be repaid even if things turned sour. The upshot was that big banks borrowed at rates that were in effect subsidised by taxpayers. Removing that subsidy will dent bank profits—and rightly so.

The TLAC proposals push in the same direction as four previous initiatives designed to make banks sturdier (see table). Bankers complain of a Rubik’s cube of rules: improve one ratio and you may find that another one deteriorates. They also fret that all this new rule-making is scaring away the investors whose money is needed to raise capital to the required level.

In theory, TLAC should be the last big global rule on capital. But regulators are still busy devising a system to ensure banks can be “resolved”, or wound down, should they go bust. Even if banks have lots of capital, they will remain too big to fail if they are too complicated to close. Much work remains to be done there: in August American officials rejected the “living wills” of 11 big banks, which were supposed to show how they could be shut down without causing undue disruption. Some will need to adopt new, simpler structures which in turn may require them to raise yet more equity.

Whether “too big to fail” is indeed over will only become clear during the next crisis. Imposing losses on investors such as pension funds or small-time punters is politically tricky. A recent bank failure in Portugal, Espírito Santo, resulted in a state-backed rescue which spared many bondholders. Hopefully next time will be different.