Wall Street's Best Minds

The Stock Market’s Next Phase

The Wall Street vet argues that the next leg up will be powered by fundamentals, not the Fed.

By Byron Wien           

May 27, 2015 5:46 p.m. ET

Since the axiom “Don’t fight the Fed” came into common parlance, we have all been aware that central bank policy is an important component of market performance. Most of us started out as security or business analysts and believed that fundamental factors like the pace of the economy, earnings growth and interest rates were the drivers of equity values. As we became more experienced, we began to understand the influence of psychology, which can be quantified by technical analysis.

Since the end of the bear market and recession of 2008-9, and the fiscal stimulus and monetary easing that followed those tumultuous years, I have begun to appreciate even more the importance of central bank liquidity in determining the direction of equity markets. This is hardly a conceptual revelation, but I thought I would take a look at it quantitatively.

United States equities have tripled since the March 2009 low. The total capitalization of the Standard & Poor’s 500 has increased from about $6 trillion in March 2009 to $19 trillion today. Obviously this is not the total value of the entire U.S. equity market, because it leaves out much of Nasdaq and other peripheral markets, but most of the capitalization of U.S. public companies is captured by this index.

Earnings have clearly driven a good part of that move; they have more than doubled from $417 billion in 2009 to $1.042 trillion in 2014. Since 2008, the Federal Reserve balance sheet has more than quadrupled from $1 trillion in 2008 to $4.5 trillion.

It took the Fed 95 years to build up a balance sheet of $1 trillion and only six years to go from there to the present level. The Federal Reserve was providing this stimulus to improve the growth of the economy, but it is my view that three quarters of the money injected into the system through the purchase of bonds went into financial assets pushing stock prices up and keeping yields low.

If I am right, the Fed contributed almost $3 trillion (some may have gone into bonds) to the $13 trillion rise in the stock market appreciation from the 2009 low to the current level, earnings increases explained $9 trillion (1.5 x $6 trillion) and other factors accounted for $1 trillion. You could argue that the monetary stimulus financed the multiple expansion in this cycle.

In Europe, a similar condition has taken place. The Euro Stoxx index reached its low in the fall of 2014 with a total market capitalization of €8.1 trillion. The current market capitalization is €10.5 trillion, an increase of about 30%. The balance sheet of the European Central Bank in October 2014 was a little over €2 trillion. It is up about 15% from that level today at about €2.344 trillion. An improvement in the outlook for earnings and the European economy helped here as well as in the U.S., but liquidity played an important role in the rise in the market. Like indices for the United States, the Euro Stoxx doesn’t capture the full market value of all European equities.

In Japan, the balance sheet of the Bank of Japan began to increase sharply after reaching about ¥132 trillion at the beginning of 2012. It is now ¥327 trillion, more than doubling the early 2012 level. The market capitalization of the Tokyo Stock Exchange increased from about ¥254 trillion at the beginning of 2012 to ¥587 trillion currently, again more than doubling. Earnings played a role here as well, but the monetary liquidity could explain much of the market appreciation. The concept of the central bank playing a critical role in market performance has been brought home this year with the relatively strong performance of Europe and Japan because of Mario Draghi’s explicit policy of aggressive easing and the accommodative strategy inherent in Abenomics. In contrast, the Federal Reserve is poised to tighten (interpreted as the withdrawal of liquidity) as soon as it becomes comfortable that the economy can handle higher rates. As a result, the U.S. equity market has made little progress this year, while Europe and Japan are up in double digits in local currencies, and Japan is up in double digits in dollars as well.

At this point, the prospects for both revenue and income growth for United States companies are not robust. Optimistic earnings projections for the S&P 500 show only a small improvement for the year, and even that would require a fair amount of financial engineering, including share buybacks, mergers and acquisitions and leverage. The current level of buybacks and mergers and acquisitions is less than 10% off the pre-crisis high, according to Strategas Research. The strong dollar and the decline in oil prices are negatives for near-term earnings improvement. In the face of these factors, it is something of a wonder that the U.S. market has risen at all this year.

One concept that may be helping the market is earnings yield. The 10-year U.S. Treasury is yielding 2.2%. Even if S&P 500 earnings are flat in 2015, the earnings yield (S&P 500 earnings divided by the price of the index) will be 5.5%, a healthy differential that is similar to the earnings yield in March 2009 when the market bottomed and the current upward move began. Earnings are likely to grow over time while the coupon on the 10-year is fixed. Although there is risk that earnings will fall in a recession, there is no recession currently in sight. The attractiveness of a 5%+ earnings yield compared to a 2% Treasury coupon is compelling to some investors.

There are also fundamental factors on the positive side. I have been counting on housing helping the United States economy move toward a 3% growth rate this year. Mortgage applications for purchase, sales of existing homes and the Case-Shiller home price index are all showing a positive trend. New home sales are, however, presently disappointing. Given that I am convinced that the favorable trends will continue, I expect the unfavorable data will reverse and housing starts will consistently exceed one million before too long. The increase in family formations resulting from improved employment in the 25–34 age bracket also gives me encouragement.

There is other good news on the economic front. The Economic Cycle Research Institute’s Leading Index has turned up sharply. This index correctly forecast the slowdowns in the U.S. economy in 2010, 2011 and 2012. After a worrisome decline earlier this year, the index has turned sharply higher, supporting the view that the economy will improve in the remaining quarters. Investors became concerned recently when real Gross Domestic Product (GDP) growth was reported for the first quarter at .2%. Even this weak number may be revised downward because of the recently announced 43% increase in the trade deficit in the first quarter. The quarter was hurt by severe weather across the eastern part of the country, the strong dollar and the West Coast dock strike. First quarters in the U.S. have been significantly soft since 2009, and if the recovery pattern of the last six years follows, it is reasonable to assume real growth will be in the 2.5% to 3% range for 2015.

We are also seeing some signs of improvement in employee compensation. The Employment Cost Index was up 2.5% in the first quarter. This sharp improvement (it was as low as 1.5% in 2014) should help the housing sector. The recent increase in household formations (back to pre-recession levels) should also help housing. In addition, the willingness of corporate managers to borrow money reflects their optimistic outlook. In April, bank borrowing increased 8.3% on a year-over-year basis, matching the peak in 2009. Other indicators support a positive outlook for the economy: rail car loadings improved and consumer spending was up .3% in March.

Despite the positives, there are also some serious negatives, and assessing their significance is important. Productivity declined 1.9% in the first quarter of 2015 after a smaller drop in the fourth quarter of 2014. Because productivity is a key component of profitability, this is a reason for concern.

Part of this may be attributable to slow revenue growth because of weather and other factors, but productivity improvement is essential to growth. Technology has been a major force in increasing productivity, and we may have reached the point where the incremental benefits of using equipment and processes to increase the output per worker may be taking a rest. Given that revenues going forward are likely to increase slowly, this negative trend in productivity must be reversed.

On the jobs front, the April employment report came in slightly below target at 223,000. The previous month was revised downward to 85,000 from an already disappointing 126,000. Average hourly earnings increased 2.2% year-over-year. The unemployment rate dropped to 5.4% and the participation rate increased to 62.8%. The construction sector was strong, reflecting the improved weather, but manufacturing was disappointing, only adding 1,000 jobs. As expected, most of the jobs were created in the service sector, which tends to have a lower rate of compensation.

While I would have preferred to see a stronger report, nothing in the data would indicate that the economy will not show reasonable growth as we move through the year. Looking at the labor report from a broader perspective, however, there is reason for concern. According to David Malpass of Encima Global, the labor force only grew 166,000 in April, 1.1% year-over-year, which was disappointing. The employment to population ratio is 59.3%, which is 3%-4% below the 2000–2010 level and 5% below the level in the 1990s.

What is troubling about this data on the trade balance, productivity and the employment report is that it suggests that there is unlikely to be a major increase in capital spending. According to the Commerce Department, capital investment was down 3.4% in the first quarter. The U.S. industrial stock is 22 years old, an all-time high, but operating rates are below the 80% where companies begin to plan major capital expenditures. Much of the money that has been spent has bought labor-saving equipment that has enabled companies to deliver goods and services with fewer workers.

An important driver of recent capital spending has been energy, and the sharp drop in oil prices over the past year has had a major negative impact. Now that the price of oil has risen from $43 per barrel (West Texas Intermediate) to over $60, energy capital spending should pick up, assuming current prices will hold. The pending nuclear agreement with Iran, while eliminating a major geopolitical risk, does change the supply / demand balance. If this were signed over the next few months and sanctions are lifted, one million barrels of incremental oil could come into the world market and crude prices could decline again. Right now, the negotiations seem to be running into serious difficulty, so I still expect a pick-up in energy capital expenditures as we move through the year.

I am occasionally questioned about the possibility of a bubble forming in the Nasdaq as a result of the strong performance of technology and biotechnology stocks in the current cycle. Investors clearly have not forgotten the excesses of the 1999-2000 period. Looking at the data, however, there seems to be much less froth this time around. For example, the price-earnings ratio (excluding companies with negative earnings) was 49 in 2000; it is 25 now. The dividend was negligible in 2000; it is 1.13% now. The price to sales ratio was 12 in 2000; it is 3.5 now.

The U.S. market has been long overdue for at least a 10% correction. It has been three years since the last one. Sentiment among investors is optimistic or complacent, not a condition conducive to a sustained upward market move. I still maintain a positive outlook for the S&P 500 for 2015, but perhaps we have to endure a little pain first. By the second half of the year, the market mood may be more subdued and the fundamentals of the economy may be better, providing a more favorable environment for stocks to move higher.

I still expect the S&P 500 to rise 10% or more by the end of the year, but it will have to get there on the basis of fundamentals without the help of liquidity provided by the Federal Reserve.

Wien is vice chairman of Blackstone Advisory Partners LP, where he acts as a senior advisor to both Blackstone and its clients in analyzing economic, social and political trends.

Trans-Pacific Trade Pact Highlights the Political Power of the Affluent

Brendan Nyhan

MAY 27, 2015

The Trans-Pacific Partnership trade deal making its way through Congress is the latest step in a decades-long trend toward liberalizing trade — a somewhat mysterious development given that many Americans are skeptical of freer trade.
But Americans with higher incomes are not so skeptical. They — along with businesses and interest groups that tend to be affiliated with them — are much more likely to support trade liberalization. Trade is thus one of the best examples of how public policy in the United States is often much more responsive to the preferences of the wealthy than to those of the general public.

Skepticism toward free trade among lower-income Americans is often substantial. Data from a 2013 CBS/New York Times poll show that 58 percent of Americans making less than $30,000 per year preferred to limit imports to protect United States industries and jobs, while only 36 percent preferred the wider selection and lower prices of imported goods available under free trade. But the balance of opinion reversed for those making over $100,000. Among that higher-income group, 53 percent favored free trade versus 44 percent who wanted to limit imports.

President Obama spoke about the Trans-Pacific Partnership with Nike employees and other Oregonians this month in Beaverton, Ore. Credit Natalie Behring/Getty Images                    

Similarly, a Pew Research Center survey released on Wednesday found that a plurality of Americans making under $30,000 per year say that their family’s finances have been hurt by free trade agreements (44 percent) rather than helped (38 percent). By contrast, those making more than $100,000 per year overwhelmingly believe free trade has been beneficial — 52 percent said trade agreements have helped their family’s finances versus only 29 percent who said they have hurt.
This economic divide on trade has existed for decades. On average, polls conducted from 1981 to 2002 found that support for free trade policies or agreements was 23 percentage points higher for Americans at the 90th percentile of the income distribution than for those at the 10th percentile, according to research conducted by Martin Gilens, a Princeton professor. In his book “Affluence and Influence: Economic Inequality and Political Power in America,” Mr. Gilens concludes that “U.S. policy on tariffs and trade during the past few decades has clearly been more consistent with the preferences of the affluent and has become more so over time as trade barriers have fallen and bipartisan support for an open trade regime has strengthened.”
One indication of the strength of elite support for free trade is the way that even Democratic presidents who enjoy strong support from labor unions have promoted free trade pacts. Bill Clinton passed the North American Free Trade Agreement against majority opposition from within his party during a time when Democrats controlled both houses of Congress. While President Obama no longer has Democratic majorities in Congress, he similarly chose to advance trade promotion authority through the Senate largely with the support of Republicans — only 14 members of his party backed him Friday.      
None of this is to suggest that politicians are completely ignoring their constituents. Previous studies indicate that elected officials make political calculations in taking positions on trade policy. Most notably, legislators’ votes on trade tend to reflect whether they represent groups who might be especially likely to be helped (for example, educated workers) or hurt (unions) by free trade.
For most members of Congress, however, the political consequences of supporting free trade may be relatively limited even if their constituents are divided on the issue. Because trade issues are often low profile and frequently cut across party boundaries, they tend to play a minor role in election campaigns.
As a result, legislators may feel more freedom to support free trade based on the strength of the consensus among economists that it is generally beneficial for the country. Alternatively, they may be more responsive to wealthy donors and other affluent individuals or groups who may be most vocal on the issue and tend to advocate free trade.
What’s most striking is that trade is only one of many issues for which this pattern exists. As Mr. Gilens notes, middle- and lower-income Americans are also more likely than the affluent to prefer higher taxes on the rich, greater restrictions on legal access to abortions and reduced spending on foreign aid, which suggests public policy might look very different if the political system were more responsive to their preferences.

Wednesday, May 27, 2015

Cash is on its Death Bed ...

by Larry Edelson

Last week, I told you how the smart money, the kind that moves first at the slightest sign of trouble, is on the move again.

Into high-end art, rare coins, diamonds and more.

There are numerous reasons why. Chief among them: The big, savvy and smart money knows what's coming. Western socialist governments, on their death beds, are on a witch hunt to find every penny of wealth you have, track it, and tax it.

Some of you may think the rich deserve to be taxed more. Maybe so, maybe not. I'm not going to get into that debate today.

But what I am going to tell you is that if you think it's only the rich under attack, think again.

Washington and Brussels want your money, too. They want to know how you're earning it. Where it's coming from. Where it's going. Every penny of it.

They also want to control it. They want to get you to spend more to boost the economy. Hence, why negative interest rates, a tax on your money, is spreading through Europe.
Why JP Morgan is the first in the U.S. to impose negative interest rates on customer funds in excess of $250,000. Why more such policies are coming, yes, even here in the U.S.

And perhaps most important of all, why authorities in Europe and the U.S. are moving to abolish cash.

Never mind most of what you already do is electronic. You bank online. You trade online. You conduct business online.

That's not enough for Washington or Brussels. They want all cash gone from the system.

Think I'm kidding, or fear-mongering? Think again. I have long warned that the world was headed to a new, cashless monetary system and to a new reserve currency.

The first such steps have already been taken. The International Monetary Fund (IMF) is now working behind the scenes to make its Special Drawing Rights, or SDRs, the new global reserve currency.

The World Bank is working on its own version.

All over Europe now, cash is under attack. Spain has banned cash transactions over 2,500 euros. Italians have been banned from using cash transactions of more than 1,000 euros, while France is expected to introduce a similar law in September.

France, by the way, is also requiring that all gold in the country and transported through the country must be declared and reported to French customs.

While large cash withdrawals exceeding 10,000 euros per month will also now be monitored and reported.

Throughout Europe now, foreign exchange offices are now required to obtain a copy of someone's ID to exchange more than 1,000 euros.

In the U.K., former Prime Minster Gordon Brown is advocating abolishing all cash and forcing people to use all electronic money via a new nationalized bank.

In effect, Brown wants to usurp the money supply and control it better, he thinks, via a communist-type move to control your savings and spending, allegedly on your behalf.

In Denmark, at least, authorities are being more open about it. They're preparing to introduce a law this fall to make virtually all transactions electronic.

It's not just Europe, though. In many Central and South American countries, finger-printing is required by certain stores and businesses if one pays in cash with US$100 or more. Western Union has certain policies in place that require finger-printing outside the U.S.

Mexico has restrictions on numerous cash transactions.

Here in the U.S., while there are no national cash bans in place, a new trend is indeed emerging.

Louisiana, for instance, recently banned cash transactions for second-hand merchandise — making it tough for flea markets to survive.

In many states, pawn shops are now under very strict scrutiny when it comes to cash transactions, with a good deal of paper work now demanded.

Of course, the propaganda coming out of governments is that cash is how most terrorists and drug dealers work. Outlaw cash, and we put them out of business.

But you and I both know it goes well beyond terrorism and drugs. Just like the NSA spying has.

It's simply another way to spy on you, and to track and tax you — so the government can gain greater control over everything you do.

The problem is that it is going to get worse. Your rights are being trampled on, left and right. The Constitution means nothing these days.

But you have to stop and ask yourself one question: Why do governments want so much power over me these days to control and tax me?

The answer is simple: Western socialist governments are on their death bed, they are fighting for their lives, and if it's a choice between them and you and your rights, they will always choose themselves.

In the end, they will fail. Governments can indeed fool some of the people some of the time, but over time, they can't fool the majority. The people of the world, especially Europe and the U.S., will rise up and throw the bums out ...

In one heck of a giant rebellion and revolution that is coming.

Stay tuned and best wishes, as always ...

domingo, mayo 31, 2015



Peru: 2015 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for Peru

                                                                                                                Publication Date: May 27, 2015
Electronic Access: Free Full text (PDF file size is 2,463KB).
Use the free Adobe Acrobat Reader to view this PDF file

Context: Peru remains one of the best performing economies in Latin America, with solid macroeconomic fundamentals, strong policy frameworks, and visible gains in poverty reduction. Like most of the region, Peru faced a challenging external environment in 2014. External shocks were compounded by domestic supply disruptions and a drop in subnational public investment, and growth decelerated sharply. Headline inflation was slightly above the upper band of the central bank’s (BCRP) target range due to supply shocks, but expectations remained well anchored.

The external current account deficit declined slightly despite weaker external conditions. Outlook and risks: Growth is expected to recover in 2015 and over the medium term, contingent on production at new mines approaching capacity, priority infrastructure projects advancing, and shocks to terms of trade fading. However, downside risks dominate. Externally, these include a surge in global financial volatility, further dollar appreciation, or lower commodity prices and external demand.

Domestic downside risks include weaker investment, uncertainties surrounding 2016 Presidential elections, and persistent social conflicts. A faster unwinding of supply shocks or a more complete pass- through of lower food and fuel global prices constitute upside risks. Near-term policy mix: The policy mix is broadly adequate to support the recovery and maintain macroeconomic stability. The immediate priority is expediting the execution of public investment in line with government plans, while avoiding increases in non-priority current spending. Monetary policy should remain responsive to inflation expectations and external developments. Exchange rate flexibility should be the main line of defense against any additional external pressures.

The timely use of macro-prudential tools and ongoing de-dollarization efforts should further solidify financial stability.

Medium-term prospects: With the end of the commodity boom, a push to deepen structural reforms will be necessary to sustain potential growth and diversify the economy. Revenue losses would need to be offset to finance structural reforms, investment, and inclusion along a gradual fiscal consolidation path. Streamlining legal requirements and red tape is rightly a government reform priority and the ambitious education reform and inclusion polices should stay their course within the framework of fiscal discipline. Persevering with labor market reform remains important. 

May 26, 2015 7:19 pm

Why finance is too much of a good thing

Martin Wolf

It is very costly to police markets riddled with conflicts of interest and asymmetric information

Ingram Pinn illustration©Ingram Pinn
Is it possible to have too much finance? Harmed by the aftermath of financial crises, enraged by bailouts of financial institutions, irritated by the generous remuneration, aghast at repeated malfeasance and infuriated by the impunity of those responsible, most ordinary people would find it all too easy to answer: yes.
They are not alone. Both scholars and staff of influential international institutions, such as the International Monetary Fund and the Bank for International Settlements, agree. It is possible to have too much finance. More importantly, significant economies are in this position, among them Japan and the US.

It is easy to question the role of financial activity. After all, between January 2012 and December 2014, financial institutions paid $139bn in fines to US enforcement agencies. More fundamental is the contrast between the 7 per cent average share of the financial sector in US gross domestic product between 1998 and 2014 and its 29 per cent average share in profits (see chart).
An organised society offers two ways of becoming rich. The normal way has been to exercise monopoly power. Historically, monopoly control over land, usually seized by force, has been the main route to wealth. A competitive market economy offers a socially more desirable alternative: invention and production of goods and services.

Alas, it is also possible to extract rents in markets. The financial sector with its complexity and implicit subsidies is in an excellent position to do so. But such practices do not only shift money from a large number of poorer people to a smaller number of richer ones. It may also gravely damage the economy.

This is the argument of Luigi Zingales of Chicago Booth School, a strong believer in free markets, in his presidential address to the American Finance Association. The harms take two forms. The first is direct damage: an unsustainable credit-fuelled boom, say. Another is indirect damage that results from a breakdown in trust in a financial arrangements, due to crises, pervasive “duping”, or both.

Prof Zingales emphasises the indirect costs. He argues that a vicious circle may emerge between public outrage, rent extraction and back to yet more outrage. When outrage is high, it is difficult to maintain prompt and unbiased settlement of contracts. Without public support, financiers must seek political protection. But only those who enjoy large rents can afford the lobbying. Thus, in the face of public resentment, only rent-extracting finance — above all, the mightiest banks — survive. Inevitably, this further fuels the outrage.

None of this is to deny that finance is essential to any civilised and prosperous society. On the contrary, it is the very importance of finance that makes the abuses so dangerous. Indeed, there is substantial evidence that a rise in credit relative to gross domestic product initially raises economic growth. But this relationship appears to reverse once credit exceeds about 100 per cent of GDP.

Other researchers have shown that rapid credit growth is a significant predictor of a crisis. In a recent note, the IMF uses a more sophisticated indicator of financial development than the credit ratio. This shows that financial development has indeed proceeded apace, notably in advanced countries. It also shows that, after a point, finance damages growth.
Further investigation indicates that this negative effect is concentrated on the growth of “total factor productivity”. This measures the pace of innovation and of improvements in the efficiency with which labour and capital are used. In particular, the IMF suggests, after a point, the allocation of capital and the efficacy of corporate control go awry. Thus, the impact of financial influences on the quality of corporate governance is an important challenge.
Houston, we have a problem. We have a great deal of evidence that too much finance damages economic stability and growth, distorts the distribution of income, undermines confidence in the market economy, corrupts politics and leads to an explosive and, in all probability, ineffective rise in regulation. This ought to worry everybody. But it should be particularly worrying for those who believe most in the moral and economic virtues of competitive markets.

So what is to do be done? Here are a few preliminary answers.

First, morality matters. As Prof Zingales argues, if those who go into finance are encouraged to believe they are entitled to do whatever they can get away with, trust will break down. It is very costly to police markets riddled with conflicts of interest and asymmetric information. We do not, by and large, police doctors in this way because we trust them. We need to be able to trust financiers in much the same way.

Second, reduce incentives for excessive finance. The most important incentive by far is the tax deductibility of interest. This should be ended. In the long run, many debt contracts need to be turned into risk-sharing contracts.

Third, get rid of too big to fail and too big to jail. These two go together. The simplest way to get rid of too big to fail would be to raise the equity capital required of global systemically important financial institutions substantially.

Many would then choose to break themselves up. Once that has happened, fear of the consequences of prosecution should also diminish. Personally, I would go further by separating the monetary from the financial systems, via the introduction of “narrow banking” — that is, backing demand deposits with reserves at the central bank.

Finally, everyone has to understand the incentives at work in all such “markets in promises”. These markets are exposed to corruption by people who do not care whether promises are kept or whether counterparts are even unable to understand what is being promised.

What is needed is not more finance, but better finance. Yes, this might also end up as substantially less finance.

Corruption in football

At last, a challenge to the impunity of FIFA

The arrest of officials should be the first stage in a thorough cleansing of a discredited organisation

May 30th 2015.


FEW arrests can have provoked such Schadenfreude as those of seven senior officials of FIFA, football’s world governing body, early on May 27th at a swish Swiss hotel. The arrests are part of a wide-ranging investigation by America’s FBI into corruption at FIFA, dating back over two decades.

The indictment from the Department of Justice named 14 people on charges including racketeering, wire fraud and paying bribes worth more than $150m. They are likely to face charges in a US federal court. As more people start talking in a bid to sauve qui peut, the investigation will with luck reach into every dark and dank corner of FIFA’s Zurich headquarters.

American extraterritorial jurisdiction is often excessive in its zeal and overbearing in its methods, but in this instance it deserves the gratitude of football fans everywhere. The hope must be that FIFA’s impunity is at last brought to an end and with it the career of the ineffably complacent Sepp Blatter, its 79-year-old president, who was nonetheless expected to be re-elected for a fifth term after The Economist had gone to print.

The evidence of systemic corruption at FIFA has been accumulating for years, but came to a head in 2010 with the bidding for two World Cups. When the right to hold the competition in 2022 was won by tiny, bakingly hot Qatar, against the strong advice of FIFA’s own technical committee, suspicions that votes had been bought were immediately aroused. Thanks to two female whistleblowers and the diligent investigative work of the Sunday Times, a wealth of damning evidence was unearthed involving a Qatari FIFA official, Mohamed bin Hammam, who allegedly wooed football bigwigs in Africa with a $5m slush fund.

Under pressure, Mr Blatter eventually agreed to set up a FIFA “ethics court”. He also appointed Michael Garcia, the American lawyer who helped oust Eliot Spitzer from the position of New York governor, to investigate the allegations of vote-rigging and kickbacks.

Incredibly, Mr Garcia, who spent more than a year looking into the allegations, never interviewed Mr bin Hammam or examined the trove of e-mails acquired by the Sunday Times.

Only a summary version of his report, itself condemned by the investigator as “erroneous representations of the facts and conclusions”, was ever published. Mr Garcia resigned and Mr Blatter sailed serenely on, reneging on a commitment not to stand for election again. The idea that a clearly tainted World Cup bidding process should be reopened was firmly squashed.

The underlying problem at FIFA is that it controls television and marketing rights (worth $4 billion at last year’s World Cup in Brazil), which can be used by those in power to win the loyalty of football federations from poor countries, particularly in Africa. Corruption is tolerated, as long as the money is spread around. Critics of FIFA are dismissed as bad losers and racists.

The language it understands
Even now, there is no certainty that FIFA will embrace reform. The initial test of its willingness to clean house should be the replacement of Mr Blatter with someone who can be trusted with that mission, which must begin with reopening the bidding for the 2018 and 2022 World Cups under conditions of complete transparency. If nothing changes, others must act. UEFA, European football’s umbrella organisation, should leave FIFA and take its teams out of the World Cup. Europe’s broadcasters should decline to bid for rights. And FIFA’s biggest sponsors—the likes of Adidas, Coca-Cola, Visa and Hyundai—should realise that association with it risks damaging their brands.

They must hit the organisation where it hurts most: in its bulging wallet. Until now the stench from FIFA has prompted people to do nothing more than hold their noses. That is no longer an option.

Silver Is Shaping Up To Be The Best Precious Metal Play Of The Decade

  • Despite being caught in a long-term bear market, silver offers considerable long-term potential upside.
  • The gold-to-silver ratio indicates that silver is significantly undervalued in comparison to gold.
  • Supply and demand fundamentals point to an ongoing physical supply deficit that will boost prices.
  • Increasing industrial demand, particularly for solar and hi-tech applications, will exacerbate the supply shortage, driving prices higher.
Silver has been trapped in a severe bear market for the last three years, with it still down by a massive 61% from the ten-year high of $48.70 per ounce hit in April 2011. Recently, silver has rallied, recovering by almost 11% from its 52 week low to now be trading at around $17 per ounce. While this rally increasingly appears to be short-lived, there are a number of catalysts that indicate a favorable long-term outlook for silver.

For these reasons I believe it is significantly undervalued and poised for a massive rally, with its price set to climb higher over the long term, offering investors far better potential returns than gold or other precious metals.

Gold-to-silver ratio

One of the key measures of whether silver is undervalued or overvalued in comparison to gold is the gold-to-silver ratio. This ratio measures the correlation between silver and gold prices, allowing investors to determine when it is the optimal time to invest in silver in preference to gold. The relationship between gold and silver prices, as well as the gold-to-silver ratio for the last two decades, is illustrated below.

(click to enlarge)
Source: Perth Mint.

The gold to silver ratio has widened considerably in recent years. At the height of the gold bull market which peaked in 2011, 38 ounces of silver bought one ounce of gold. This has now more than doubled, with 71 ounces of silver needed to buy an ounce of gold.

The current ratio is also well above the historical average, which over the last century has required somewhere between 50 to 60 ounces of silver to purchase one ounce of gold. Over the last two decades the ratio has averaged 60 ounces of silver to one ounce of gold. While the ratio of silver to gold in the Earth's crust is estimated to be between 17 ounces to 20 ounces of silver to one ounce of gold.

This indicates that silver is heavily undervalued in comparison to gold and that now is the optimal time to invest in silver.

If the ratio were to fall to where it was during the height of the gold bull market, silver based on current prices would need to appreciate by around 86% in value. While if it even returned to the historical average of 50 ounces of silver to one ounce of gold, it would need to appreciate in value by 41%, still offering considerable potential upside to investors.

However, investors should remember that in comparison to gold, silver is far more volatile because of far lower market liquidity coupled with fluctuations in demand for industrial uses, the fabrication of jewelry and as a store of value.

Growing demand

This means there are far more influences on the demand for silver, and hence its price, than with gold, helping to explain the volatility witnessed since the collapse of the bull market in late 2011.

Nonetheless, unlike gold, silver is an industrial metal with a wide range of uses, primarily because of its conductive properties, with it being the most electrically conductive element followed by copper and gold. This sees it in great demand as a component in a range of industrial applications and hi-tech products.

For 2014 alone, industrial demand for silver made up 56% of its total demand and industry has been the primary consumer of silver for some time.

Source: The Silver Institute.

This compares to gold where industrial demand only made up 8% of total gold demand in 2014, with the largest driver of demand being for investment purposes.

In fact, when we look at the next chart it is easy to see that overall industrial demand for silver has been in decline for the last decade and this can be primarily attributed to the virtual extinction of traditional film-based photography.

However, when we take a deeper look at the numbers it can be seen that demand for silver in a range of industrial applications continues to grow.

(click to enlarge)
Source: The Silver Institute.

Silver has become an integral component in a range of hi-tech applications including flexible touch-screens, semi-conductor stackers and light emitting diodes (LEDS). Demand for these components is set to grow exponentially over the coming years as their use in portable consumer electronics, medical and other applications continues to rise.

As we can see, over the last ten years the demand for silver for use in electronic and electrical applications has grown by 15%, and I expect this rate of growth to increase as the demand for hi-tech electronic products soars.

Between now and 2018, annual silver consumption for use in flexible electronics is forecast to grow tenfold, by up to 2 million ounces. Meanwhile, industry insiders expect the demand for silver in the manufacture of LEDs to shoot up to 8 million ounces annually and 10 million ounces for use in semiconductor stackers. This represents a total of an additional 20 million ounces of silver annually being used in the manufacture of these components.

Silver is also a key component in the manufacture of photovoltaic cells (PVs) that are used in solar panels to convert our sun's energy into electricity. The demand for PVs is expected to grow quite strongly between now and 2018.

When manufacturing PVs, around 2.8 million ounces of silver is required to build enough PVs to generate 1 gigawatt (GW) of electricity. For 2014, according to the Silver Institute, this saw 60 million ounces of silver used in their manufacture alone, which equates to 5.6% of the total demand for physical silver during that year.

Furthermore, the demand for silver for use in PVs over the last ten years has grown eightfold, and this trend is expected to continue over the long term. This is because demand for PVs is expected to explode as a number of countries push ahead with instituting green energy targets.

The world's second largest economy, China, has set some aggressive green energy targets because of growing pollution. In 2014 it added 12 GWs of solar power, and in 2015 plans to boost that by 48% to add 17.8 GWs of solar power over the course of the year as it battles to fight pollution.

Based on 2.8 million ounces of silver being required to manufacture sufficient PVs to generate 1 GW, this would see China's demand for silver for use in PVs increase by 16 million ounces or 48% year-over-year.

Even more compelling is that China is targeting to triple its solar power capacity between now and 2020, to 100 GWs. For this to occur, it alone would require 188 million ounces of silver.

But the growing demand for PVs, and thus silver, doesn't end there. A number of other countries are also aggressively targeting to boost the solar power capacity.

Between now and 2018, the European Photovoltaic Industry Association expects Europe to add around 69 GW of additional solar capacity to its energy grid, therefore requiring 193 ounces of silver.

Japan has also established some ambitious solar energy targets in the wake of the Fukushima nuclear disaster, that has already seen it double its solar power capacity since 2011. This trend is expected to continue with plans underway to build more solar power plants. Even Brazil is focused on boosting its solar capacity with plans to build a 350 megawatt (MW) plant on the Amazon's Uatumã River.

This demand for solar energy will see the demand for silver as an integral component in the manufacture of PVs continue to grow exponentially, helping to drive silver prices higher.

Declining silver supplies

The growing demand for silver for use in the manufacture of these hi-tech components will add further pressure to an already constrained supply situation.

According to the Silver Institute, demand for physical silver in 2014 outstripped supply by half a percent, or 4.9 million ounces, and this physical supply deficit can only get worse. For 2015, it has been estimated that supplies of physical silver will decline by around 3.5%, primarily because of falling supplies from mining.

This is because silver miners have sharply decreased investment in exploration and mine development because of markedly weaker silver prices, that have made many ore deposits uneconomical to mine.

If we take a look at a snapshot of the largest primary silver miners, you can see that with the exception of Pan American Silver (NASDAQ:PAAS) and Silver Standard Resources (NASDAQ:SSRI), the other miners have sharply decreased their capital budgets as silver prices have fallen.

(click to enlarge)
Source: Company filings & The Silver Institute.

Such a sharp decline in investment in exploration and mine development will have a long-term impact on silver supply because there is a long lead-in time associated with identifying and exploiting new ore deposits, as well as with ramping up production from existing mines.

As a result I expect the physical supply deficit for silver to continue into 2015 and 2016. A physical supply deficit also suggests a reduction in global silver inventories, further reducing the amount of silver available for investors, the fabrication of jewelry and industrial uses.

I expect this constrained supply situation coupled with growing demand to drive silver prices higher over the long term, while placing a floor under existing prices.

Risks to the investment thesis

Any precious metals investment does not come without risk, particularly with the growing short-term volatility of gold, and in particular silver, prices that we are now witnessing.

These risks include:
  • There is the potential that silver ETFs may make sizable liquidations of their positions as silver rallies, and this would see a considerable amount of bullion entering the physical market over a short time frame, applying considerable downward pressure to silver prices.
  • Declining industrial activity in China, which would see the demand for silver for use in industrial applications decline sharply, with it being among the largest manufacturing markets for the metal.
  • If the U.S. dollar continues to rally strongly, then this will have a sharp impact on silver prices with them being negatively correlated. Nonetheless, the U.S. dollar has already rallied, and strongly, and the consensus view is that it is due for a pullback, thereby mitigating this risk.
  • Any significant rally of silver would see a mad scramble by miners to rapidly boost production in order to take advantage of higher prices, thereby boosting silver supply and forcing down prices. However, this risk is offset by the long lead in times needed to develop silver mining assets and ramp up production.
  • Silver has far lower liquidity than gold and this means it is subject to higher volatility and wider price movements.

Clearly, the fundamentals are in place to support a solid rebound in silver, although it will take time for this rally to occur with short-term volatility set to remain a characteristic of silver prices for the foreseeable future.

Speculative paper trading coupled with higher illiquidity than gold continues to have a negative impact on silver, while significantly increasing the overall volatility of the metal. This means that in the short term it will continue to experience wild price swings and its recent rally will more than likely retrace.

As a result, I certainly wouldn't be "betting the farm" on silver, but it is an investment worthy of consideration, with it offering investors the benefit of solid long-term potential upside coupled with the ability to hedge against further global geopolitical and economic uncertainty because of its status as a safe-haven investment.

The Fed Considers a More Seasoned Approach

By: Peter Schiff

Tuesday, May 26, 2015

Just as the steady torrent of awful economic data, which began in the First Quarter and continued well into April and May, had forced many market analysts to grudgingly concede that 2015 would not see the robust economic growth that most had expected, the statisticians arrived on the scene like a cavalry charge and routed the forces of pessimism with a wave of their spreadsheets.

The campaign began in late April with some seemingly groundbreaking analysis by CNBC's Steve Liesman showing that over a 30 year time frame GDP data had consistently measured first quarter growth at 1.87%, which was far lower than the 2.7% rate averaged in the following three quarters of the year. He pointed out that the trend had gotten even more pronounced since 2010, when first quarter growth averaged just .62% and the remaining three quarters averaged 2.3%. The disparity caused Liesman, and others, to question whether first quarter data should be regarded as reliable.

The problem hinges on the efficacy of the 'seasonal' adjustments that are baked into the GDP methodology. These filters are designed to smooth out the changes in spending, production, and consumption that occur over the course of the year. After all, business and consumers behave differently in December than they do in July.

When Liesman pressed the Bureau of Economic Analysis (the government entity that supplies the data) to explain his findings, the agency responded "BEA is currently examining possible residual seasonality in several series, which may lead to improvements in...the regular annual revision to GDP." We should understand "improvements" to mean changes that make first quarter GDP higher.

A few weeks later the BEA provided some specifics saying methods for counting government defense spending and "certain inventory investment series" could be improved to help address the distortion. It promised to correct these deficiencies by July 30. It promised to correct these deficiencies by July 30. But to make sure that everyone understood that the help was definitely on the way, the BEA issued a blog post on May 22 in which it specified a number of areas in which it will eliminate what it calls "residual seasonality." This term should be accurately defined as "areas that we think should be higher."

As if on cue, the Federal Reserve itself waded into the debate with its own new study (released by the San Francisco Fed - Janet Yellen's former stomping grounds) that seemed to confirm and expand on Liesman's analysis and the BEA's concessions (makes one wonder if these campaigns are coordinated). Fed economists took a hard look at the disappointing .2% annualized first quarter 2015 growth, and determined that the seasonal adjustments that have been in use for years were insufficient to fully reveal the true health of the economy. When the San Francisco Fed added a second level of seasonal adjustments, it determined that Q1 growth should have been measured at 1.8% annualized. While that growth rate would not be considered strong, it is much closer to the 2.7%-3.0% that most forecasters had predicted at the end of 2014. No matter that the Atlanta Fed's "GDP Now," which was designed to be a more objective and contemporaneous measurement tool, was confirming near zero growth in Q1, many economists and media outlets jumped on the Fed study as proof positive that the economy is stronger than the pessimists portray.

In reality, few people actually understand how the complex and opaque seasonal adjustments really work (I know I don't). Fewer still have the patience to wade through the formulas to determine inefficiencies and potential remedies. This provides the statisticians with a good deal of convenient refuge against critics. But it's important to realize that unlike straight GDP measurement, which is ideally a strict accounting of spending, these adjustments can introduce an element of subjective institutional bias.

Government entities (and to a lesser extent media outlets) have many reasons to suggest that the economy is better than it really is. The Fed wants us to believe that its policies are effective; the Federal government wants us to believe that the economy is healthy, and financial media outlets depend on confident investors. I'm not saying that these biases are insidious or conspiratorial, but it does produce an environment where there is more emphasis placed on finding reasons to explain why GDP measurements are low, than there is to find reasons why it is too high. The subjectivity of the seasonal adjustments gives these biases room to run.

People understand that holiday spending juices GDP at the end of the year, and that post-holiday depletion and cold winters cause consumers to retrench. This causes them to try to compensate for the weakness in the first quarter. But there is no pressure for them to find reasons that GDP may be too high in December and May (when Christmas lists and pleasant weather should be encouraging shopping).

Given that, why do we really need seasonal adjustments in the first place? Yes December is different from July, but those differences persist every year. If we are looking at full year GDP, which is the measure that everyone is really after, why not keep a cumulative tally that we compare to prior years rather than prior quarters? Wouldn't this strip out a needless and opaque system of adjustments from a measurement system that is already overly complex to begin with? I believe the truth is the system is getting more complex because we want it that way. We prefer the ability to manipulate figures rather than allowing the figures to tell us things that we don't want to hear.

The real disconnect lies in the failure of the economy to grow, as most people assumed that it would, after the Fed's quantitative easing and zero interest rates had supposedly worked their magic. But as I have said many times before, these policies act more as economic depressants than they do as stimulants. As long as these monetary policies persist, our economy will never return to the growth rates that would be considered healthy.

In any event, many market watchers are grabbing at the San Francisco Fed report to conclude that Janet Yellen will raise rates this year, despite the weakness that the unadjusted GDP reports indicate. Such a conclusion is premature. I believe that the Fed wants us to think that the economy is strong, in the hopes that perception may one day soon become reality. If people think the economy is strong their optimism could influence their spending, hiring, and investing decision. As a result, optimistic Fed pronouncements should be considered just another policy tool; call it "open mouth operations."

But I do not believe the Fed has any actual intention of delivering the rate increases that it may expect will damage our already weak economy.

JPMorgan’s Guilty Plea Puts Wealth Unit in Spot With Regulators

by Neil Weinberg

4:00 AM COT May 26, 2015

JPMorgan Chase & Co. put allegations of currency-fixing largely behind it with a guilty plea, but it’s not out of the woods yet.

With its new felony record, America’s biggest bank needs to seek the Department of Labor’s permission to keep managing money in the $8 trillion private pension market. At the same time, there’s a cloud over the JPMorgan unit where pensions are managed: The Securities and Exchange Commission is well along in an investigation into conflicts of interest in the bank’s wealth-management unit, whose products include individual retirement accounts.

That puts the bank in a sticky position -- arguing that a criminal conviction shouldn’t keep it from managing Americans’ retirement savings, while the SEC is investigating possible wrongdoing in the same división.
“When a bank has enforcement action after enforcement action, it becomes hard to argue that it won’t happen again,” says Urska Velikonja, an assistant law professor at Emory University whose research focuses on securities law.

JPMorgan spokesman Darin Oduyoye declined to comment “on Bloomberg speculation over future events.”

The May 20 guilty pleas by America’s biggest bank and four others -- Citigroup Inc., Barclays Plc, Royal Bank of Scotland Plc and UBS Group AG -- required each to apply for regulatory exemptions from the SEC, as well as from the Labor Department, to carry on business as usual.
The SEC issued the necessary approvals for the banks, but Democrats on Capitol Hill, as well as on the SEC Commission, have criticized rubber-stamping of waiver requests.

Extensive Review

Bank of America Corp. lost its ability late last year to issue certain securities without first seeking SEC permission. Credit Suisse Group AG is operating its $2 billion pension business under a temporary, one-year waiver while the Labor Department conducts an extensive review of whether to grant the Swiss bank’s request for permanent relief.

The stakes are higher for JPMorgan Asset Management, the quickly growing business unit that includes mutual funds, private wealth management and some trusts. Its assets under management included $319 billion in U.S. pension funds at the end of 2014, according to Pensions & Investments.

On the day last week when JPMorgan pleaded guilty to antitrust violations for manipulating currency rates, the bank applied to the Labor Department for an exemption to continue managing pensions as a Qualified Professional Asset Manager.

Banks rely on their QPAM status to carry out key transactions for pension clients, and a plea by any bank affiliate anywhere in the world triggers the need for it to apply for an exemption to maintain that business. JPMorgan needs to secure the waiver before it is sentenced.

SEC Investigation

The Labor Department has taken several months or more, in most cases, to carry out similar reviews. Michael Trupo, a Labor Department spokesman, declined to comment.

The May 20 application came just two weeks after JPMorgan disclosed in a regulatory filing that its wealth-management unit, part of the Asset Management division, is under investigation by the SEC, other government authorities and a self-regulatory organization. The unit was being probed for the sale and use of its own mutual funds and other proprietary product, the bank said.

The investigation is focused on whether JPMorgan employees have been putting customer money into the bank’s own funds and other products, such as structured notes and hedge funds -- not because they are necessarily the best choices for clients, but because those options generate fees for JPMorgan, according to people familiar with the matter.

Executives Deposed

As part of that probe, bank executives have been deposed and thousands of pages of internal documents subpoenaed, Bloomberg reported in March, citing people familiar with the situation. The Office of the Comptroller of the Currency, a primary banking regulator, is assisting the SEC in its investigation, added a person familiar with the matter.

The SEC’s investigation into JPMorgan’s money-management practices has been under way for at least two years, people familiar with the probe have said. Companies often disclose such investigations when they become material for shareholders.

That raises the possibility that the SEC and the other government authorities will reach a conclusion about potential wrongdoing inside the asset-management unit, as the Labor Department continues to review the bank’s waiver for activities by the same group.

JPMorgan faces another potential hurdle at the SEC. Its commissioners last week approved issuing the necessary waivers for JPMorgan and the four other banks, agreeing that their felony records shouldn’t stop them from managing mutual-fund money, among other things.

Enforcement Action

Any civil enforcement action from the SEC that includes injunctions or cease-and-desist orders -- as many do -- would force the bank to appeal for a fresh round of some of the same SEC waivers it has just been granted.

The SEC’s commissioners voted to approve last week’s waivers, with Chairman Mary Jo White, an independent, casting the deciding vote on some of the waivers. Commissioner Kara Stein, one of the two Democrats who voted against several of the waivers, issued a scathing dissent on May 21.

“Allowing these institutions to continue business as usual, after multiple and serious regulatory and criminal violations, poses risks to investors and the American public that are being ignored,” Stein said. “It is not sufficient to look at each waiver request in a vacuum.”

Bankers, lawyers and professors have said it would be hard to imagine that regulators would withhold waivers. Still, said Emory University’s Velikonja, that doesn’t mean these officials couldn’t give banks a few more hoops to jump through.

“I’d be surprised if the SEC didn’t come out with more than the usual compliance programs and independent monitors,” she said. “I’d be very curious to see if instead, it is something new and more invasive than in the past.”

World War D—Deflation

By John Mauldin

May 27, 2015

Everywhere I go I’m asked, “Will there be inflation or deflation? Are we in a bull or bear market? Is the bond bull market over and will interest rates rise?”

The flippant answer to all those questions is “Yes.” And that can be the correct answer as well, but it depends on what your time frame is and what tools you use to measure the markets and inflation. One of the newer members of the Mauldin Economics team is Jawad Mian, who writes a powerful global macro letter from his base in Dubai. He has been making the case for the “end of the deflation trade” (or more properly the return of a reflationary period) and the knock-on effects that would cause. Longtime readers know that I am in the secular deflation camp and ask me why there’s such a seeming difference my views and Jawad’s.

The answer is that Jawad and I are more or less on the same page over the longer term; the difference lies in the time frame of our perspective writings. I tend to think and forecast about longer periods of time, whereas Jawad’s main audience is portfolio managers and traders who are focused on the next 6 to 18 months. I tend to think in secular cycles, while Jawad is focused on the cyclical horizon. When you read the section below that Jawad writes, you will find a fairly upbeat analysis.

And that difference opens up a very important discussion for this week’s letter. I will start off by explaining why I think we are still in a long-term secular bear market in US stocks, even while I can clearly see that we are also in a powerful cyclical bull market. It is important to know both, because there are quite different investment approaches that are appropriate for different combinations of secular and cyclical cycles.

Then we turn to Jawad, who will discuss why we could see a reflationary macro regime emerge in much of the developed world and where the resulting opportunities might lie. I will finish up with why I think that this reflationary period will be temporary, with a potential for a serious round of deflation further out in the future, even though I readily acknowledge that “temporary” could mean a few years. But the looming reality over the longer term is that the coming war over a return of deflation will be fought by central banks everywhere. It will truly be World War D.

Why start with equity markets when we are talking about deflation and inflation? Because we need to see the connections!

Secular Bear Markets

I first wrote about a coming secular bear market in 1999. I was early, of course. The market went up (a lot!) for the next year. Over the next few years I began to do some work looking at secular bear markets not in terms of price but in terms of valuations. My now very good friend Ed Easterling of Crestmont Research was doing similar analysis, and we compared notes. Then we published a series of reports in this letter, which I later adapted in two chapters (co-authored by Ed) of my book Bull’s Eye Investing in 2003.

I believe secular bull and bear markets should be seen in terms of valuation, and cyclical bull and bear markets in terms of price. A secular bull market should be approached with a more aggressive, relative return style of trading, while a secular bear should have an absolute return focus with appropriate risk controls. That difference in trading style is necessary because of how valuations will trend in the two different types of markets.

Let’s look at the updated charts that Ed sent me over the weekend from his fabulous, data-rich website. In general, secular cycles are long-term trends in valuation. These cycles include numerous interim surges and falls in price that reflect shorter-term psychology and economics. The long-term secular cycles can be seen in this first graph, with secular bears represented in red and secular bulls shaded green. The driver of these cycles is the relative valuation of the stock market as reflected in the price/earnings ratio (P/E). When P/E trends higher, it multiplies earnings growth and generates periods of above-average returns. When P/E trends lower, it offsets some or all of earnings growth and delivers periods of below-average returns. P/E is the blue line underlying the secular cycles on the chart.

The P/E segments for all of the red-bar secular bears can be overlaid on a chart with time in years across the bottom and the level of P/E on the side (see chart below). First, secular bears tend to start in the red zone of high P/Es and decline to the green zone of low P/Es. This downshift into a secular bear is caused by a trend in the inflation rate from low, stable inflation to levels of either high inflation or deflation.

Second, this chart includes red and green arrow-lines that highlight the shorter-term cyclical bears and bulls during the current secular bear. The chart demonstrates that longer-term secular periods have cyclical bears and bulls within them, offering very profitable trading opportunities.

Third, the current level of the market P/E indicates that the stock market is fairly high. It is now well above the peaks of past secular bears and nowhere near the levels needed for a secular bull market start.

Even after more than 15 years in a secular bear market, the current secular trend has a ways to go to reach lower valuation levels. How can that be true after such a long period?  In part, it’s because this secular bear started at such high levels. The current secular bear has experienced the same amount of P/E decline that many of the past secular bears experienced over longer and shorter periods, but the current secular bear started at twice the historical highs.

Bears start where bulls end and vice versa. As the secular bull market version of the previous chart shows, the late 1990s bubble took that secular bull market to unprecedented heights. A return from a period of either high inflation or deflation to low, stable levels of inflation will result in a rising trend in P/E during secular bull markets .

The “difference” between Jawad’s and my view on the inflation/deflation question is so important because turns within cycles have a major impact on pricing and valuations.

Yet even though we are in a secular bear that has come a long way with quite a ways to go, this secular bear looks and acts like previous secular bears. For example, here’s the daily graph for the previous secular bear in the 1960s and ’70s.

The cycles are very evident. Note the dramatic magnitude of their swings. Here’s the same format of chart for the current secular bear. Notice there are very similar patterns and magnitude… and new highs in the middle of the secular period.

Right now, many of you are scratching your heads and wondering how we get to lower valuations. Maybe this time is different! Or perhaps we’ll see a longer secular bear market until we return to a “normal” economic environment; and then earnings, prices, and valuations will begin to more closely resemble historical patterns. Remember, rising periods of inflation have historically compressed valuations.

World War D

While deflation fears have persisted since the 2008 meltdown, they intensified last year, with global inflation readings falling to their lowest level since 2009. The collapse in oil prices, combined with generally soft macro data and a rising dollar, is aggravating concerns about the inflation outlook. Inflation expectations have plunged, and sovereign bond markets have rallied sharply, with yields of less than zero in parts of Europe. Negative-yield bonds now account for some €1.5 trillion of debt issued by governments in the euro area, equivalent to almost 30% of the total outstanding. Many expect even more of the global bond market to fall into negative yield territory. Half of all government bonds in the world today yield less than 1%.

Many fear that the current deflation outbreak will turn into a “vicious circle of deflation,” in which consumption is postponed and investment plans are curtailed in anticipation of lower prices. These behaviors contribute to a further drop in demand and additional reductions in prices. The burden of debt increases, since falling incomes make it more difficult to service existing debt as real interest rates rise. Thus, economic growth slows and inflation declines further, hurting consumption and investment even more – hence, the vicious deflationary spiral.

As Christine Lagarde warned in January 2014, “Deflation is the ogre that must be fought decisively.” It is no surprise then that global short-term nominal interest rates are reaching the zero lower bound. Oil-price-induced weak inflation readings have forced aggressive reactions from policymakers, with at least 24 central banks already engaging in some form of monetary easing in 2015. According to my friend David Rosenberg, nearly 90% of the industrialized world economy is presently anchored by zero rates. There is a global focus on fighting deflation.

Why is inflation still nonexistent? And what do we make of all this unprecedented monetary policy? Is debt deflation the biggest risk to the global economy? What are some of the major implications for investors? In the next section Jawad parses the economic data and surveys the macro landscape to offer his cyclical (1 to 2 years) outlook, and then I consider the secular (5 to 10 years) outlook, with a particular emphasis on the threat of deflation.

A Little Less Deflation, A Little More Reflation, Please

By Jawad Mian

Deflation is not always sinister.

I believe the deflation scare of 2014 will give way to a global economic surprise in 2015. The type of deflation likely to be observed this year will benefit the global economy and provide a welcome boost to real household incomes. In my mind, the collapse in oil prices is good deflation; a decline in demand, wages, or forward expectations causes bad deflation. Once the shock of the speed of the recent drop in oil prices is overcome, cheaper oil will undoubtedly be an important net positive for the world economy later in the year.

There is little evidence that expectations of future price declines are suppressing employment, wages, consumer spending intentions, or even global manufacturing activity. Global recruitment difficulties are back at 2006 levels, and there is mounting evidence that wage gains should begin to accelerate where they are needed most: the US, Germany, and Japan.

The US created nearly 3 million jobs in 2014, and real wages have risen more over the past year than at any other point since 2009. Strong momentum in the labor market, ongoing recovery in the US housing market, positive wealth effects from a buoyant stock market, and declines in energy prices should all combine to generate strong consumer-led growth.

It is getting more difficult to attract and retain labor. The tighter labor market has led Walmart, the nation’s largest private employer, to increase wages for 500,000 of its most poorly paid workers. The company plans to spend about $1 billion a year to raise the pay of all employees (1.3 million) to at least $9 an hour, and to at least $10 an hour by next February. I believe Walmart’s bold initiative will lead to higher wages being set for entry-level jobs throughout the retail sector, a trend that may impact over 15 million people.

A look at interest rates, currency values, and reduced energy costs suggests that Europe and Japan will receive a significant reflationary boost. Europe’s economic turnaround is in its early stages and could provide a positive growth surprise over the next two years. The liquidity spigots are wide open, and the largely recapitalized banking system is responding to credit demand, as indicated by the latest ECB bank lending survey. Money supply and bank lending have continued to recover, with loan growth in the euro area about to turn positive for the first time since 2012.

The recent German consumer confidence reading was the highest it has been since 2001. German unemployment is near post-reunification lows, and real wages are growing at the fastest pace in over 20 years. IG Metall, Germany’s largest union, just settled on a 3.4% annual pay rise for its workers in southern Germany. More importantly, the deal is seen as a bellwether for salary negotiations in the rest of the country. Reports suggest that 32 regional contracts (covering seven unions and about 6.5 million workers) expire this year.

This is an essential part of euro-area rebalancing that should support growth in neighboring countries by way of a competitive boost. The Spanish labor market has enjoyed its best year since 2007, and the eurozone’s overall unemployment rate has fallen to a 33-month low.

Deflation is in the process of ending in Japan. The Bank of Japan has successfully cheapened the yen to its most competitive level since 1973 on a real effective exchange-rate basis. Export volumes are rising, and Japan’s balance of payments on tourism has turned positive for the first time in a long time. According to Peter Tasker, in terms of discretionary spending, the tourist boom is equivalent to an increase in the Japanese population of 1.4 million.

With the jobless rate down to 3.4%, Japan should be able to finally achieve some real wage growth this year. Just as Prime Minister Abe has been able to produce a genuine shift in the corporate governance climate in Japan, I firmly believe that Abe will be able to cajole corporate leaders to hike salaries as well, so as to “spread the warm winds of economic recovery to everyone throughout the country.” Last month, Toyota granted its employees their largest wage increase in more than a decade.

The global manufacturing sector has expanded for 28 consecutive months. Based on Markit’s recent Global Purchasing Managers Index (PMI) survey, the rate of output growth accelerated as companies scaled up production to meet rising levels of new work and new export orders. As US economic growth should now be driven more by consumption (which represents two-thirds of the US economy) rather than capital expenditures (capex), this implies stronger global trade, a wider US trade deficit, and a softer US dollar going forward.

The cyclical path of least resistance for commodities may also turn up later this year. A pickup in global PMIs suggests that we may have seen the worst of commodity price deflation. Oil excess supply remains elevated, but prices appear to have bottomed. According to Aurelija Augulyte, a senior analyst at Nordea Markets, even if you hold the dollar and oil prices at current levels, the base effects will effortlessly push the inflation up in the second half of this year.

Global core inflation appears to have already troughed. The number of nations where CPI fell month-over-month has collapsed from 23 in December and 33 in January to just 9 in February. I suspect downside pressure on global inflation readings will soon be exhausted.

In the US, core inflation has surprised positively three months in a row. The core CPI held at 1.8% year on year in April, up from 1.6% in January. Core CPI was at a 2.3% annual rate in the first quarter, up from a 1.6% pace in 2014. The Fed’s preferred measure of inflation (core personal consumption expenditure index) has been roughly stable for two years, around 1.5%.

Forward-looking indicators suggest that core inflation in Europe should also soon turn positive and begin to trend higher. It will become difficult for policymakers to maintain their ultra-dovish tone, with economic momentum improving and inflation rising later in the year. The cyclical upswing will dial back central bank aggression, in my view. Interest rates around the world will remain low, however, to help reduce the budget costs of a large public debt burden.

Source: Ned Davis Research

The clouds of deflation will part.

Even though headline inflation may continue lower in the months ahead, given the extent of the decline in the price of oil, I find reassuring evidence that core inflation in major economic blocs will stabilize as we approach mid-year.

I believe the basic assessment of deflation expectations will completely change, and the market will slowly recognize that there is another economic equilibrium that is very far from the current state.

There are green shoots of economic improvement around the world that augur well for the inflation outlook, but most investors remain too blinded by the oil crash to even notice them. James Paulsen, chief investment strategist at Wells Capital Management, provides an insightful take on our cultural obsession with deflation. I quote (with some edits for brevity):

Today, after more than three decades of disinflation, chronic deflation in the dominant technology sector, and a world which hovers near zero inflation, most are increasingly obsessed with the potential for a deflationary spiral. Despite universal expectations of falling inflation or deflation, however, several forces are emerging which likely ensure serious deflation will not result.

First, emerging world economies were primarily a supply story adding to disinflationary forces in the last decade. However, emerging economies are rapidly transitioning toward a major demand story which will probably prove much larger than the post-war baby boom. Second, balance sheets within the US have been significantly retrofitted since the 2008 crisis. Banks have perhaps never been as strongly capitalized as they are today and have unprecedented lending capacity. Corporate profits are at record highs, business balance sheets are strong, and cash flows are immense. US household net worth is almost 20% higher than its previous record and the debt service burden is at a new low. Household and corporate pent-up demands are considerable (due to the pause in spending during the crises of the 2000s) and the credit creation process is just beginning to revive.… Finally, a cultural obsession with depression and deflation evident since the 2008 crisis has produced unprecedented and massive economic policy stimulus despite a continuous economic recovery in the US for more than five years. When a culture becomes universally obsessed with a problem, it generally solves it!

The reason central bank action has been insufficient to overwhelm the forces of deflation thus far is that government deficits globally have been contracting since 2010.

When central banks have had loose monetary conditions in previous economic cycles, governments have been keen to spend this money to boost growth (and thus inflation); however, in this cycle, we have seen governments retrench their spending.

In other words, fiscal tightening has acted as a counterweight to unprecedented monetary easing.

Emergency measures to reduce government borrowing have actually worsened the debt arithmetic and prolonged the economic malaise felt in major regions of the world. The romantic fixation with balanced budgets is counterproductive when deflationary pressures are building. When the private sector is deleveraging, the public sector must increase its borrowing and spend fortuitously to restore economic balance and boost aggregate demand. The main lesson from our recent travails is that lowering interest rates and engaging in QE is no panacea for growth in a low-inflation world, especially when fiscal policy is pulling in the opposite direction.

The IMF estimates that the effect of the fiscal multiplier at the zero lower bound exceeds the “normal times” multiplier by a large margin. Budget cuts of 0.5%–1% of GDP typically act as an economic drag of around two to four times that amount, so a reversal of fiscal austerity should prove very stimulative. In my view, investors are grossly underestimating the potential for favorable fiscal policies to boost growth in a very easy monetary policy environment.

Budget plans for the world’s major economies in 2015 show that, for the first time since 2009, fiscal policy won’t be a drag, according to Jeffrey Kleintop of Charles Schwab.

He highlights a few recent examples of changes in global fiscal policy:

  • Japan has postponed the planned 2015 consumption tax increase.
  • China has started to announce new spending projects intended to keep the economy from slowing more sharply.
  • In the US, federal spending has increased for five straight months after being flat for five years, rising 5.5% year-over-year in October.
  • France and Italy have been given more time by the European Commission to meet their deficit reduction targets, which means they won’t need to implement substantial spending cuts (tax cuts in France and Italy are more likely this year).
  • Germany should ramp up spending after initially proposing to balance its budget in 2015, while…
  • Europe will likely approve and begin to implement some version of President Juncker’s plan to provide more than €300 billion in spending initiatives.

I view the gradual move toward greater fiscal expenditure as a paradigm shift that will upset deflation expectations and overly subdued growth estimates in the developed world.

The market is a composite personality, and right now investors have developed a “collective consciousness” that is still agonizing over the threat of deflation, even as the inflation environment has been changing substantially. It may not seem like it now, but I believe monetary authorities have overcome the threat of deflation on a cyclical horizon. They have been successful in changing people's perceptions and breaking the deflationary mindset, even if this shift is not yet reflected in the level of global government bond yields.

Government bonds in the major economies remain unattractive from a long-run valuation perspective. Globally, bond yields have fallen to levels not seen for centuries. How long can bond yields remain in their current prostrate position in the face of better economic health in 2015 and possibly into 2016?

I can imagine the world looking very different from the way the market currently expects it to. Since 2008, the global economy has never looked as good as it does today. We are finally entering a growth environment where no region of the world acts as a considerable drag (particularly in the case of Europe and Japan). The expanding strength in numerous international equity markets could be an important signal heralding far more durable global economic growth prospects.

Since 2011, we have seen deflationary trends dominate: the US dollar rising, global growth slowing, commodities crashing, inflation falling, global bond yields declining, and US stocks outperforming the rest of the world. If I am correct in thinking that the market’s deeply entrenched macro concerns regarding deflation will dissipate, all these trends should reverse. A global capital-rotation already appears to be underway that favors markets that have been long-time laggards versus the US stock market. I believe global equity market leadership might be inclined to shift to Europe and Asia.

I also think there is a major revaluation risk to owning government bonds at this stage of the investment cycle. With macro risks waning and inflation expectations slowly rising, I suspect global bond returns have probably crested. As the world emerges from the perceived threat of deflation, bond yields should rise toward equilibrium levels.

To learn more about Jawad and to receive his letter, Stray Reflections, click here.

It’s All About That Debt, ’Bout that Debt, ’Bout that Debt

John again. Now that you have explored Jawad’s thinking on global prospects for a reflationary period, I am going to summarize why I think we have not seen the end of deflation. (I have written about this theme before and will likely delve into it again – it’s important.)

First, normally, financial crises such as we had in 2008–09 bring about a period of deleveraging. This time, there been no debt reduction, and debt levels have skyrocketed throughout the world. Only in a few countries where there were housing bubbles have we even seen consumers retrench. The world is awash in debt! And ironically, the demand for even more debt seems to be insatiable, driving down yields.

In countries all over the world, debt is rising faster than global GDP, which means that at some point the carry cost of that debt is going to have to be reconciled. That is an economic law that was first noticed when the Medes were trading with the Persians. That is true for individuals, corporations, and governments. Of course, governments can monetize that debt if it is in a currency they control, but that course will typically weaken currencies (and thus buying power and value), which is default by another name.

All this was best articulated by Irving Fisher in his writing in the ’30s on the connection between debt and deflation.

The presence of too much debt, as Lacy Hunt and others have demonstrated, will slow the potential growth of GDP, which makes paying off that debt more difficult.

At some point, there will be another recession, with the accompanying bear market; and if there has been no resolution of the debt burden, there will be another debt crisis, and it will be massively deflationary. Central banks will respond with more QE than anyone can possibly imagine today. When will this happen? Two years? Three? Five? No one knows, but this eventuality is baked into the debt cycle.

Given what we have learned about the reaction of central banks and given that the debt problem is global, this next crisis will be unlike anything we have experienced.

I expect US rates to sink to new lows in a period that is also likely to see the final drop in yields of the 30+ year-long bond bull market.

In the meantime, we trade the cyclical cycles and look for yield and safety where we can.

One last point. Inflation, as I have written about in detail, is an artificial construct, and we have changed the way we measure it over the years. The CPI is just one method, and it is not used universally. If the US used the same measuring tools that Europe does, our central bankers would be having heart palpitations right now, as using the Eurozone definition of inflation would show the US in outright deflation.

Look at these charts from my friend Albert Edwards, from a few months ago. The difference in the formula for how you figure inflation in the US and the Eurozone is largely how you deal with the housing component. Today, the same definition shows the US to be in a deflationary zone. By the way, that same measure would have meant that Greenspan should have been a LOT more aggressive in raising rates. It is likely we would have avoided the housing bubble had he done so, or at least it would have been not so big. But that’s a guess.

So, it makes a difference what measures you use, what index methodology you choose, and how you account for value. If you can change the data, you can make it say what you want it to say and support your case, whatever that might be.

Secular versus cyclical matters. We invest mostly in the shorter cyclical term, but the secular patterns tell us where the tail risk lies.

Here and There, New York, New Hampshire, Vermont,
and NYC

I am on the road, making a few one-day business trips. Tomorrow I go to Virginia Beach to see my old friend Mark Finn for the afternoon, before taking a late flight to Dallas. Sunday I go to New York City, where I will be for five days, before going to New Hampshire for a speech and then on to Vermont Sunday afternoon to be with my partners and the management team of Mauldin Economics. Then it’s back to Dallas, where I’m trying to put the rest of my summer together. I know I will be heading up to New England later in August and of course there is the annual fishing trip the first Friday of August in Maine.

For what it’s worth, I will be at the NYSE next Monday to be part of the closing bell ceremony, where Monty Bennett, the chairman of a new public company whose board I am on, Ashford Inc., will ring the bell before we go over to Bobby Van’s and hang with the Friends of Fermentation. I see steaks. Ashford Inc. is involved in the hotel business and managing REITS. I have to admit I am learning a great deal more than I think I am contributing. Getting into the nitty gritty of this company has been a fascinating learning experience about a simple idea – renting a hotel room – that is a very complex business to do right. And, diving deep into Ashford’s numbers, I see all sorts of correlations with other economic data. Intriguing.

By way of a short teaser, I’ve been reading the galleys for my latest book, which should be out in a few weeks. We are going to be offering this book in a slightly different manner than previous books as part of a marketing experiment. I’m quite proud of it and look forward to sharing it with you.

Again, if you’d like to know more about what Jawad writes, you can go here. Jawad has attracted a lot of interest from serious traders and investors around the world, and deservedly so. He left a successful career as a portfolio manager to follow his passion for independent macro research and trading. As he often reminds me, “There is nothing more important to investment success than the freedom to express your own views.” I am really pleased that he wanted to join our team, and I enjoy my frequent interchanges with him. I always learn a lot.

It’s time to hit the send button. I’m in Boston tonight and see Legal Seafood in my near future. Looking over the harbor on this beautiful day, I see sailboats and ferries scurrying everywhere. Back in Texas it is raining and flooding, although Dallas seems to be avoiding the real problems. Houston, however, was built on a swamp, and swamps flood. Not much they can do about it. It was a problem when I lived there in the late ’60s as a student at Rice, and it will still be a problem in another 40 years. Some of us wish we could shift that rain out West, and most wouldn’t even mind if some hit California. Last year at this time there were open worries about many of our lakes drying up. Now the water is over the dams. But that’s Texas for you.

Next week I am going to get a little controversial. I recently had a well-received op-ed in the Investors Business Daily on what policies the US needs to implement to spur economic growth. I am going to develop that theme here. There will be something to please and annoy everyone. Have a great week!

Your never seeming to get to slow down analyst,

John Mauldin