The ‘Divergent’ World of 2015

Veronica Roth’s novel offers a useful way of viewing global politics and economics. Let’s hear it for Dauntless America.

By Niall Ferguson

Jan. 2, 2015 6:31 p.m. ET

Shailene Woodley in the 2014 film version of Veronica Roth’s novel ‘Divergent.’ Associated Press        

In Veronica Roth ’s “Divergent”—a 2011 “young adult” novel set in a dystopian future not a thousand miles removed from “The Hunger Games”—humanity is divided into five factions according to their dominant character traits: Abnegation, Amity, Candor, Dauntless and Erudite. This being a post-apocalyptic Chicago, the last faction turns out to be the bad guys.

People who fail the initiation tests are consigned to poverty as “factionless.” People with multiple traits are classified as “divergent” and persecuted.

If you were to sort the world’s countries into five factions, you would need a slightly modified classification scheme. The U.S., its economic recovery firmly established despite learned talk of secular stagnation, is looking Dauntless. Then there are the Erudite little countries, like Estonia and Singapore, that have the rare distinction of intelligent governance. But the other three factions would need different names.

There are the Abject: from Argentina to Venezuela by way of Russia, corrupt pseudo-democracies reliant on the export of natural resources. There are the Aspirant: from India to Mexico and Peru, countries engaged in a real process of economic reform. And let’s not forget the Catatonic: from Japan to the eurozone, economies either immune to monetary stimulus or reluctant to administer it.

In truth, this is a Divergent world, with many countries—like Ms. Roth’s adolescent heroine, Tris—displaying more than one trait. Mexico would like to be Erudite but retains many traces of its Abject past. Japan is trying its best to be Aspirant, but Prime Minister Shinzo Abe can’t seem to fire his “third arrow” of structural reform. The U.K. would love to be Dauntless, but its economic turnaround lacks the breadth of the U.S. recovery, and political uncertainty around elections in May could prove distinctly daunting.

To understand the world in 2015, it may therefore be preferable to think of four trends that are divergent in the traditional sense. The first, and most obvious, is between the taperers and quantitative-easers in the realm of monetary policy. While the Federal Reserve and the Bank of England have been signaling their intention to “normalize” policy (i.e., to raise interest rates), the Bank of Japan has already launched an open-ended QE program, with the bank’s balance sheet projected to hit 70% of GDP. The European Central Bank, meanwhile, badly needs to reverse two years of balance-sheet contraction.

The second divergence is between exporters and importers of energy in the wake of a steep decline in global oil prices from over $100 a barrel as recently as July to just above $50 at year’s end. Assuming that energy prices do not bounce back in 2015, the outlook is as bleak for exporters as it is rosy for importers.

The third divergence is the political one between democracies and autocracies. The majority of democracies are now characterized by multiple parties, very close results and, consequently, relatively weak governments. In autocracies, by contrast, corrupt hierarchies are tightening their grip on power with old and new forms of coercion, ranging from police brutality in Venezuela to Internet trolling in Russia.

Finally, there is a fourth divergence between soft powers and hard powers. President Obama has shown a growing preference for European-style soft (he might say “smart”) power. Yet hard power is resilient. Having annexed Crimea to Russia, President Putin still has forces camped out in eastern Ukraine. And all over the Muslim world, myriad Islamist organizations, from Islamic State to the Taliban, are using violence to pursue their atavistic goals. In practice, the Obama administration has had little choice but to keep using hard power, from the airstrikes on Islamic State to the economic sanctions on Russia.

What will be the biggest consequences as these four divergences interact in 2015?

Perhaps the most important question relates to the country hardest to categorize: China. In many ways, China fended off the effects of the American financial crisis by turning a little bit American.

After 2009 we saw a proliferation in China of shadow banks, a credit splurge and a real-estate bubble.

Now the bust is here, followed by the inevitable financial distress, with colorfully named casualties like China Credit Equals Gold #1 and Henan Swiftly Soaring Investment.

True, there is unlikely to be a Chinese “Lehman moment.” Rather than let a big bank go bust, the Chinese would rather arrest, try and shoot the CEO. But deflationary pressures are building in an economy characterized by widespread urban and industrial overcapacity. So a key question for 2015 is how much the People’s Bank of China will ease in response. The bank cut rates in November. On Christmas Day it relaxed the restriction on the loan-to-deposit ratio by including interbank deposits from nonbank financial institutions in the denominator without requiring additional reserves on such deposits. More measures like these, and we could see the Shanghai and Shenzhen markets enter bubble territory as small investors flee real-estate for stocks.

The second big question is what the consequences will be of the oil-price slump. At November’s OPEC meeting in Vienna, Saudi oil minister Ali al-Naimi said that although falling oil prices would be painful, losing customers to U.S. shale would be worse. Yet it is not clear that American producers will be the biggest victims of the oil-price slump. Thanks to efficiency gains, the break-even price for the median North American shale development is now $57 compared with $70 in summer 2013.

An Arab official gave the game away in Vienna when he reportedly said: “If in the process, you shave 30% off Iran’s income, fine. If in the process, you shave 30% off Russia’s income, fine.”

Earlier this month the Iranians held a crisis meeting with the Saudis. “We asked the Saudis to help stop the price of oil slipping further,” said an Iranian source quoted in the Times of London. “They replied that Iran should adjust itself to the market and they were happy with the oil price.”

Unlike in the 1980s, when the U.S. clearly pressed the Saudis to cut oil prices to squeeze the Soviet Union, today the Saudis (and Emiratis) seem to be the geopolitical playmakers. Their targets are regimes—in particular Iran’s, but also Russia’s—that have been on the opposing side of the great sectarian war that is raging for control of the post-American Middle East. The essential question is: Can the Saudis hurt the Iranians more than the U.S. has been helping them by easing sanctions in its desperation for a nuclear deal? My bet is that the answer is yes—and that 2015 will see instability in Iran, Russia and Venezuela.

The bad news for authoritarian regimes like Iran’s is simultaneously good news for European democracies, nearly all of which are heavily reliant on imported gas and oil. Yet it is far from clear that EU governments will reap much political reward from cheaper energy.

Eight member states have national elections in 2015: Estonia, Finland, Greece, Poland, Portugal, Slovenia, Spain and the U.K. In most cases, incumbents will struggle to secure re-election. We live in an era when close elections tend to be the rule, as more and more countries are multiparty systems and voters seem to prefer governments with wafer-thin majorities. The rise of populist parties, like Ukip in Britain, is making it harder for mainstream parties to muster majorities.

So this new year may well be one of minority governments—in Europe and in Israel and Canada. The exception to the rule will remain the U.S., where the two-party system looks immovably entrenched and the populists, from Ted Cruz to Elizabeth Warren , remain inside their respective political tents.

What, finally, of the geopolitical consequences of a Divergent world? This looks being a bad year for hard power as Russia wilts under the double punch of sanctions and cheap oil. There is also some reason to expect the Islamic State phenomenon to collapse under the weight of its own violence and incompetence. The trouble is that bad guys can also do soft power, as North Korea has apparently proved with the devastating hack of Sony Pictures. Islamic State, too, may have a bigger future as an online propaganda agency for Islamic extremism than as a wannabe caliphate.

Translating all such trend-following into smart investment decisions is never easy. In retrospect, equity investors last year should have shunned Europe and bought South Asia, the countries of the Middle East and North Africa (MENA), and the U.S. (Five markets were up over 20% in dollar terms: the Philippines, Indonesia, Israel, India and Egypt.) In fixed interest, emerging markets and corporates outperformed Treasurys, but a risk-free return of 4.7% on Treasurys was hard to complain about. Commodities were a no-go zone: not only oil but also gas, base metals and cotton. Who predicted all this? No one I know.

So how best to play the four divergences of 2015? The monetary-policy part seems simple: Stay long on the dollar, short the yen and euro. In energy, shun the high break-even exporters and any assets favored by “petro-crats” (yachts, high-end London homes). In politics, it’s hard to see any country that is going to have an Indian- or Indonesian-style positive transition as a result of elections this year. But I would stick with Mexico, despite elections that are bound to give the ruling PRI a bloody nose.

Finally, keep yourself hedged when it comes to energy prices. There is too much potential instability among too many MENA producers to warrant anything but caution.

In “Divergent,” those who are initiated into the Dauntless faction are forced to cross a “fear landscape” that combines all their innermost fears into a single, terrifying simulation. By comparison with most of the past seven years, the fear landscape of 2015 looks remarkably unterrifying. But that is probably a reason for us all—even the Erudite—to be wary.

Mr. Ferguson is a history professor at Harvard University and managing director of Greenmantle, an advisory firm. His biography of Henry Kissinger will be published by Penguin this year.

Greek expulsion from the euro would demolish EMU’s contagion firewall

Should EMU leaders choose to cut off liquidity support for the Greek banking system they might find that their contagion defences are a fiction

By Ambrose Evans-Pritchard

6:33PM GMT 31 Dec 2014

The ancient Greek Parthenon temple, atop the Acropolis hill overlooking Athens, is framed by a lightning bolt during a thunderstorm that broke out in the Greek capital, late 9 October 2006.

If Syriza rebels win power on January 25 and carry out threats to repudiate the EU-IMF Troika Memorandum, Greece alone will suffer the consequences Photo: AFP

We know from memoirs and a torrent of leaks that Europe’s creditor bloc came frighteningly close to ejecting Greece from the euro in early 2012, and would have done so with relish.

Former US Treasury Secretary Tim Geithner has described the mood at a G7 conclave in Canada in February of that year all too vividly. “The Europeans came into that meeting basically saying: 'We’re going to teach the Greeks a lesson. They are really terrible. They lied to us, and we’re going to crush them,'” he said.
“I just made very clear right then: if you want to be tough on them, that’s fine, but you have to make sure that you’re not going to allow the crisis to spread beyond Greece.”
German chancellor Angela Merkel did later retreat but only once it was clear from stress in the bond markets that Italy and Spain would be swept away in the ensuing panic, setting off an EMU-wide systemic crisis.
The prevailing view in Berlin and even Brussels is that no such risk exists today: Europe has since created a ring of firewalls; debtor states have been knocked into shape by their EMU drill sergeants.

The democratic drama unfolding in Greece this month is therefore a local matter. If Syriza rebels win power on January 25 and carry out threats to repudiate the EU-IMF Troika Memorandum from their “first day in office”, Greece alone will suffer the consequences.
“I believe that monetary union can today handle a Greek exit,” said Michael Hüther, head of Germany’s IW institute. “The knock-on effects would be limited. There has been institutional progress such as the banking union. Europe is far less easily blackmailed than it was three years ago."

This loosely is the “German view”, summed up pithily by Berenberg’s Holger Schmieding: “We’re looking at a Greece problem, the euro crisis is over. I do not expect markets to seriously contest the contagion defences of Europe.”

It sounds plausible. Bond yields in Italy, Spain and Portugal touched a record low this week. Yet it rests on the overarching assumption that the Merkel plan of austerity and “internal devaluation” has succeeded. An army of critics retort that the underlying picture is turning blacker by the day.
Europe’s rescue apparatus is not what it seems. The banking union belies its name. It is merely a supervision union. Each EMU state bears the burden for rescuing its own lenders. Europe’s leaders never delivered on their promise to “break the vicious circle between banks and sovereigns”.
The political facts on the ground are that the anti-euro Front National is leading in France, the neo-Marxist Podemos movement is leading in Spain, and all three opposition parties in Italy are now hostile to monetary union.
The creditor core has destroyed the political unity of EMU by pushing its contractionary agenda too far, and by imposing an “asymmetric adjustment” that forces deficit states alone to close the intra-EMU gap rather than surplus states.
“The conflict over austerity is politically explosive because it is becoming a conflict between Germany and Italy,” says Joschka Fischer, Germany’s former foreign minister.
Such political damage would be unforgivable even if EMU crisis strategy were defensible on economic grounds, but it is not. Mass unemployment – 43pc for youths in Italy and 54pc in Spain – erodes skills. Youth is pure gold for ageing societies. It is being wasted.

Hysteresis effects will reduce the long-term growth rate of these economies, outweighing any of the alleged gains from “reforms”, a euphemism for wage cuts.

Spain’s car factories may be working day and night again after slashing wages by 27pc, and they may be exporting vehicles at a record pace, but this is a displacement effect within EMU at the cost of France and Italy. It pushes the currency bloc as a whole further into a deflationary vortex.
The eurozone recovery that was proclaimed a year ago never happened. Barely out of double-dip recession, it is flirting with a third, even as America roars ahead at a growth rate of 5pc. “I completely underweighted the possibility they would flail around for three years,” said Mr Geithner.

Make that five years.
Not only has EMU strategy managed to trump the Great Depression – leaving output below its prior peak six years on – but it has brought about deflation and therefore proved self-defeating even on its minimalist objective of containing debt.
Italy’s debt ratio has spiked from 116pc to 133pc of GDP in three years despite a primary surplus, simply because nominal GDP has failed to keep pace with interest costs. Alarm in Rome is palpable. 
The Bank of Italy warns that any further drift towards deflation could have “extremely grave consequences”.
The underlying debt dynamics of the eurozone are still deteriorating, a repeat of Britain’s failed efforts to contract its way out of debt in the 1920s.
All that has changed since July 2012 is that the European Central Bank (ECB) has been allowed to act as a lender of last resort; or at least, markets believe so.
Whether this belief would survive an expulsion of Greece from the euro is an open question.

As matters stand, the ECB’s backstop plan for Italian and Spanish debt (OMT) cannot legally be activated. The German constitutional court has ruled that it “manifestly violates” the EU Treaties and is probably ultra vires, implying that the Bundesbank may not take part.

The case was referred to the European Court (ECJ) as a courtesy. Its adjutant-general will issue an opinion on January 14 but this has no legal standing. The judges will not rule for months. When they do, they cannot safely ignore the prior findings of the irascible German court.

Nor can the ECB safely ignore German objections to quantitative easing, unless it is willing to test the limits of German popular consent for the euro. There is talk of a half-baked compromise where each EMU central bank buys only the bonds of its own country, creating a fresh vicious circle. Such is the determination to avoid any pooling of debt or sharing of risk.
The eurozone is not an inch closer to fiscal union. There is a wearying array of “two-packs” and “six-packs” and other such measures to police sinners, capped by a Fiscal Compact of staggering folly, yet nothing has been done to place monetary union on viable foundations.

Should EMU leaders choose to cut off liquidity support for the Greek banking system – forcing a return to the drachma – they might find that their contagion defences are a fiction.
Everybody is tired of Greece’s endless agony. It is precisely when you are most tired that your judgment fails you.


Same old song

Forecasts for 2015 look remarkably like forecasts for 2014

Jan 3rd 2015

IMAGINE that, ten years ago, a group of economists had been made privy to the key American indicators at the start of 2015. They would have been told that GDP grew at an annualised 5% in the latest quarter, that unemployment was 5.8% and falling, and that headline inflation was 1.3%. What would have been their forecast for the level of short-term interest rates today? Perhaps 3%? Or 4%?

It is a fair bet that no economist would have predicted the actual level of interest rates of 0%-0.25%. Those low rates are the key to understanding the outlook for markets in 2015. The Federal Reserve has kept rates so low because it frets that a premature tightening of policy may damage an economy that is still bearing the scars of the financial crisis of 2007-08. Perhaps 2015 will see the first rate increase, but unless there is a surge in inflation (which few expect) the Fed will proceed very cautiously. Elsewhere, it seems highly unlikely that either the European Central Bank or the Bank of Japan will tighten policy in the next 12 months.

This background helps to explain why investors are entering the new year in optimistic mood. A poll of British fund managers by the Association of Investment Companies found that 91% expected equity markets to rise in 2015. A poll of global fund managers by Bank of America Merrill Lynch found that a net 60 percentage points of investors expect the global economy to strengthen in the coming year.

Investors were pretty optimistic at the start of 2014 as well. Although the bulls were eventually right about the American stockmarket—after a few wobbles—the same was not true for emerging markets (see chart). Of the four BRICs, Russia is heading for recession, Brazil is barely growing and Chinese growth has slowed; only in India are prospects perceived to have improved. The fall in commodity prices in 2014, most notably in oil, was linked to the weakness of growth in developing countries.

Commodity-price declines have brought down headline inflation and raise a question about the perennial bearishness of commentators towards the government bond markets. At the start of 2013, there was much talk of a “great rotation” out of bonds and into equities; as 2014 loomed, the sentiment was exactly the same. Despite that, the yield on the 10-year Treasury bond fell during the year while the German 10-year yield even reached a record low.

Once again, yields are expected to rise in 2015, with the median forecast of 74 strategists polled by Bloomberg predicting that the 10-year will hit 3% by the end of the year, compared with 2.21% on December 29th. But it is quite possible that the consensus will be proved wrong again.

Political risk was one factor that supported bond markets in 2014, and it has not disappeared.

The calling of a snap general election in Greece has brought the prospect of further turmoil in the euro zone. If the left-wing Syriza party is elected (and it has a small lead in the latest polls), there would be some awkward negotiations over debt owed to EU institutions and further reforms to the Greek economy. The result could conceivably be that Greece is forced out of the euro. (Ladbrokes, a British bookmaker, has this outcome as an even-money bet.) While most commentators seem to feel that the fallout will be more contained than it would have been in 2011 and 2012, they cannot be certain.

The euro was supposed to be a currency without an exit mechanism. Allowing Greece to leave might set a disastrous precedent. It could even be the euro zone’s Lehman moment—regulators thought that the fallout from the investment bank’s failure in 2008 could be contained, but the bankruptcy triggered a crisis of confidence. Meanwhile, the Greek worries bolster another consensus bet: that the dollar will gain against the euro.

Greece is not the only political problem. Britain has a general election in May which seems likely to result in another hung Parliament; Spain must hold an election by 2015, with Podemos, a Syriza-like party, expected to do well. There is also the possibility that Russia will lash out in the face of Western sanctions, a falling oil price and a shrinking economy.

The most likely outcome is that the equity markets will muddle through for another 12 months, with a few wobbles along the way. A big bull run would probably require economic strength to be more broadly spread around the world, while a crash would require either the loss of American economic momentum or a sudden tightening of monetary policy. If either of those happens, put on the tin hats.

Up and Down Wall Street

Is the Economy Running Too Hot?

The aerodynamic force of surging inflation could soon start popping the rivets of a high-balling U.S. economy.

By Jonathan R. Laing

December 27, 2014

Wow. The Dow 30 Industrials sliced through 18,000 to a record close last Tuesday like a knife through holiday salmon mousse, up some 175% from its 2009 low. And the index continued its rise through the rest of Christmas week. The same day, the Standard & Poor’s 500 index notched its 52nd record close of 2014.
And the bond market, save high-yield securities, shook off fears of a great rotation out of fixed-income instruments after a three-decade plus bull market and gave investors a nice positive, inflation-beating return.
Moreover, few see much to worry about for 2015, despite an economic recovery now long-of-tooth at some 5½ years. Not with last week’s upward revision of third-quarter GDP growth to 5%. And yet inflation seems under control, with much of Wall Street believing that disinflationary winds and slowing economic growth in much of the global economy will keep goods and commodity price increases in check.
Most expect the Fed to raise the short-term federal-funds rate starting at midyear at a measured, decorous pace of 25 basis points (0.25 percentage point) per meeting, not enough to squelch good times ahead.
This conviction is only confirmed by the recent Fed median forecast of the fed-funds rate hitting 1.125% and 2.5% by year-end 2015 and 2016, respectively. Otherwise U.S. 10-year bonds wouldn’t currently be trading at a yield of 2.25%. Clearly, inflation with the current core consumer price index reading of 1.7% is expected to be quiescent for years to come.
Only adding to current investor complacency is the 40-plus percent drop in crude-oil prices for the year. Sure the oil price collapse caused a short-term paroxysm in stock and bond prices. But then cooler heads prevailed. The benefits to U.S. consumers of cheaper prices at the pump and to Corporate America from lower input prices clearly trump any dislocations in the junk bond markets and in oil-producers’ financial results.
Rick Rieder, BlackRock’s chief investment officer, who oversees some $690 billion in fixed-income assets, depicts the slide in energy prices as a fortuitous and powerful instance of “synthetic fiscal stimulus” for both U.S. consumption and employment. The current decline, if sustained, could drop the U.S. unemployment rate of 5.8% to below 5.5% next year all by itself, he opined to Barron’s.
Yet he sees little chance of the economy overheating as a result and a surge of inflation catching the Fed by surprise. Inflation will remain muted due to cheap energy and technological breakthroughs such as Internet retailing, which through improved price discovery keeps prices of goods and services from rising unduly.
Such an environment will be good for stocks next year, he opines. Corporate profit margins figure to remain lush from the improved productivity and efficiency afforded by technology and from continued cheap financing costs. On the latter score, Rieder sees little chance of a surge in longer-term bond yields, the true pivot point of the economy. Long rates will be held down for some time by the flood of baby-boomer retirees increasingly seeking yield instruments, the drag of low bond rates around the world, and the liquidity provided by loosening monetary policies in Japan, the European Union, and elsewhere around the globe.
PERHAPS SUCH OPTIMISM is well founded, particularly during a period of holiday good cheer.

But we feel compelled to offer up a counter-narrative. First, one shouldn’t forget some of the warnings issued in the last year or so by the so-called secular stagnation crowd. Their core insight is that the economy can’t grow as quickly as during much of the post-World War II period when GDP growth averaged over 3% annually. About the best that can be expected is 2% growth.
And that reduced figure is important to keep in mind in light of the blowout third-quarter increase of 5% and the expectation of continued 3% GDP growth over the next two years. Just maybe the economy is currently running too hot, well above its proper air speed, rather than merely playing catchup to recover some lost economic potential. If the former is the case, the aerodynamic force of surging inflation could soon start popping the rivets of a high-balling U.S. economy.
The secular stagnation argument revolves around several common-sensical observations. Most important are U.S. demographics. Growth in the working age population is slowing to under 0.5% annually from a rate that cycled as high as 1.8% in the ’70s when the baby-boom generation and, more specifically, women were streaming into the job market. So these days and over the next two decades there will be fewer new worker bees joining the workforce and, consequently, less honey produced.
Of course a surge in productivity, or hourly output per worker, could compensate for this shortfall in labor force growth. But the news isn’t great on this score either. For the bulk of the post-World-War II period, productivity added an average of 1.5% or more to annual GDP growth, but that number in recent years has shrunk to well under 1%, despite the ballyhooed advances in robotics, cloud computing, big data, digital media, and artificial intelligence.
Nobody is quite sure why this is the case. Maybe workers are wasting more time on social media and entertainment sites. As plausible as any explanation is one offered in a recent report by David Kelly and Hannah Anderson at JPMorgan Asset Management. Among other things, they surmise, “this decline probably reflects the movement of employment from the manufacturing sector (which has always had strong productivity growth) to the service sector (where productivity growth is harder to achieve).”
KEY TO THE FEDERAL RESERVE’S maintenance of its zero-bound, short-term interest-rate regime even after six years, is the conviction that great slack still exists in the U.S. labor market. Invariably cited is the decline in the U.S. Civilian Labor Force Participation rate, which from 2000 to November 2014 descended from around 67% to 62.8% of the U.S. population either gainfully employed or actively job-hunting.
But this attrition seems more secular than the cyclical result of the 2007-09 Great Recession. For one thing, the rate had been dropping well before that downturn.
Likewise most of the 400 basis point drop can be ascribed to baby-boomer retirements, a surge in the number of Americans on federal disability (which has become a blue-collar worker welfare program that has been widely abused) and young people and older workers opting for further education and training instead of work. JPMorgan’s Kelly and Anderson likewise point out that Americans with criminal records of some kind have jumped from 13% of the population in 1991 to 22% in 2012, according to government statistics.
These folks typically can’t find work even if they try, once background checks turn up their past legal troubles. The point of all this analysis of the participation rate is that it’s unlikely that most of the absentees will ever return to the job market.
James Paulsen, chief investment strategist of Wells Capital Management, is concerned that the fast-disappearing slack in the labor markets will give way next year to strong wage growth and its evil cousin, inflation. He sees signs of such a surge in wage growth in the steep fall in the unemployment rate over the past two years and the rise in average hourly earnings of production and non-supervisory employees, which jumped from a 1.28% increase in October 2013 to a 2.48% rate this August before tailing off.
Paulsen examined past instances of the onset of Fed-tightening going back to 1955 and found that in every case stock price/earnings ratios dropped. In many cases, the tightening came early enough in the economic cycle that profit growth more than compensated for the multiple contraction, allowing stock prices to continue to rise.
Yet this time around, he opines that Fed tightening is occurring so late in the recovery cycle, with profit margins at elevated levels, that 2015 will prove a difficult, volatile year for the stock market.
“Stock prices may well be flat for 2015, but I see the likelihood of a nasty, gut-check fall of 15% to 20% in the market sometime next year,” he observes. “The Fed’s current mind-set is likely to fall apart, and the central bank will be forced to tighten faster and far more aggressively than Wall Street currently expects.”
A retired investment manager of our acquaintance sees disquieting parallels between today’s credit cycle and that of 2004. Fed tightening in 2004 began in June and proceeded at a leisurely pace of 17 target price hikes at 25 basis points each over the next two years boosting the fed-fund rate from 1% to 5.25%. In the meantime, excesses in the financial system built up, coming to full efflorescence in the 2007-09 global credit crisis.
This time around, he points out, the unemployment rate is virtually the same as it was six months before the 2004 tightening began while the core consumer price index, at 1.1%, was even lower than the current reading of 1.7%. So there’s considerable danger that the Fed will again find itself woefully behind the curve six months from now, when most expect the current tightening cycle to commence.
Are investment bubbles developing today similar to those begotten during the Naughts due to overly complacent monetary policy and a fixation on disinflation to the exclusion of manifestations of financial market overexuberance? Absolutely, says our friend. He airily ticks off stocks and bonds all across the risk spectrum. Trouble impends, maybe sooner than later, for all manner of U.S. financial markets.
We can only hope such predictions don’t come to pass and positive momentum in the economic cycle and financial prices rule the day. And by the way, Happy New Year.

2015 Will Be All About Iran, China and Russia

Pepe Escobar

17:06 31.12.2014(updated 17:22 31.12.2014)

Upcoming 2015 year will be all about further moves towards the integration of Eurasia as the US is progressively squeezed out of Eurasia, Pepe Escobar believes.

BEIJING, December 31 (Sputnik) — Fasten your seatbelts; 2015 will be a whirlwind pitting China, Russia and Iran against what I have described as the Empire of Chaos.
So yes – it will be all about further moves towards the integration of Eurasia as the US is progressively squeezed out of Eurasia. We will see a complex geostrategic interplay progressively undermining the hegemony of the US dollar as a reserve currency and, most of all, the petrodollar.

For all the immense challenges the Chinese face, all over Beijing it's easy to detect unmistakable signs of a self-assured, self-confident, fully emerged commercial superpower. President Xi Jinping and the current leadership will keep investing heavily in the urbanization drive and the fight against corruption, including at the highest levels of the Chinese Communist Party (CCP).
Internationally, the Chinese will accelerate their overwhelming push for new 'Silk Roads' – both overland and maritime – which will underpin the long-term Chinese master strategy of unifying Eurasia with trade and commerce.
Global oil prices are bound to remain low. All bets are off on whether a nuclear deal will be reached by this summer between Iran and the P5+1. If sanctions (actually economic war) against Iran remain and continue to seriously hurt its economy, Tehran’s reaction will be firm, and will include even more integration with Asia, not the West.
No matter how it was engineered, the fact that stands is that the current financial/strategic oil price collapse is a direct attack against (who else?) Iran and Russia. 
Washington is well-aware that a comprehensive deal with Iran cannot be reached without Russia’s help. That would be the Obama administration’s sole – and I repeat – sole foreign policy success. A return to the “Bomb Iran” hysteria would only suit the proverbial usual (neo-con) suspects. Still, by no accident, both Iran and Russia are now subject to Western sanctions. No matter how it was engineered, the fact that stands is that the current financial/strategic oil price collapse is a direct attack against (who else?) Iran and Russia. 
Now let’s take a look at Russian fundamentals. Russia’s government debt totals only 13.4% of its GDP. Its budget deficit in relation to GDP is only 0.5%.  If we assume a US GDP of $16.8 trillion (the figure for 2013), the US budget deficit totals 4% of GDP, versus 0.5% for Russia.

The Fed is essentially a private corporation owned by regional US private banks, although it passes itself off as a state institution. US publicly held debt is equal to a whopping 74% of GDP in fiscal year 2014. Russia’s is only 13.4%.

The declaration of economic war by the US and EU on Russia – via the run on the ruble and the oil derivative attack – was essentially a derivatives racket. Derivatives – in theory – may be multiplied to infinity. Derivative operators attacked both the ruble and oil prices in order to destroy the Russian economy. The problem is, the Russian economy is more soundly financed than America's.
Considering that this swift move was conceived as a checkmate, Moscow’s defensive strategy was not that bad. On the key energy front, the problem remains the West’s – not Russia’s. If the EU does not buy what Gazprom has to offer, it will collapse.
Moscow’s key mistake was to allow Russia's domestic industry to be financed by external, dollar-denominated debt. Talk about a monster debt trap  which can be easily manipulated by the West. The first step for Moscow should be to closely supervise its banks. Russian companies should borrow domestically and move to sell their assets abroad. Moscow should also consider implementing a system of currency controls so the basic interest rate can be brought down quickly.
And don’t forget that Russia can always deploy a moratorium on debt and interest, affecting over $600 billion. That would shake the entire world's banking system to the core. Talk about an undisguised “message” forcing the US/EU economic warfare to dissolve.
And don’t forget that Russia can always deploy a moratorium on debt and interest, affecting over $600 billion.
Russia does not need to import any raw materials. Russia can easily reverse-engineer virtually any imported technology if it needs to. Most of all, Russia can generate — from the sale of raw materials – enough credit in US dollars or euros. Russia's sale of its energy wealth — or sophisticated military gear — may decline. However, they will bring in the same amount of rubles — as the ruble has also declined. 
Replacing imports with domestic Russian manufacturing makes total sense. There will be an inevitable “adjustment” phase – but that won’t take long. German car manufacturers, for instance, can no longer sell their cars in Russia due to the ruble's decline. This means they will have to relocate their factories to Russia. If they don’t, Asia – from South Korea to China — will blow them out of the market.
Bear and dragon on the prowl
The EU's declaration of economic war against Russia makes no sense whatsoever. Russia controls, directly or indirectly, most of the oil and natural gas between Russia and China: roughly 25% of the world's supply. The Middle East is bound to remain a mess. Africa is unstable. The EU is doing everything it can to cut itself off from its most stable supply of hydrocarbons, prompting Moscow to redirect energy to China and the rest of Asia. What a gift for Beijing – as it minimizes the alarm about the US Navy playing with "containment" across the high seas. 

Still, an unspoken axiom in Beijing is that the Chinese remain extremely worried about an Empire of Chaos losing more and more control, and dictating the stormy terms of the relationship between the EU and Russia. The bottom line is that Beijing would never allow itself to be in a position where the US could interfere with China's energy imports – as was the case with Japan in July 1941 when the US declared war by imposing an oil embargo, cutting off 92% of Japanese oil imports.
Everyone knows a key plank of China’s spectacular surge in industrial power was the requirement for manufacturers to produce in China. If Russia did the same, its economy would be growing at a rate of over 5% per year in no time. It could grow even more if bank credit was tied only to productive investment.
Now imagine Russia and China jointly investing in a new gold, oil and natural resource-backed monetary union as a crucial alternative to the failed debt "democracy" model pushed by the Masters of the Universe on Wall Street, the Western central bank cartel, and neoliberal politicians. They would be showing the Global South that financing prosperity and improved standards of living by saddling future generations with debt was never meant to work in the first place.
Until then, a storm will be threatening our very lives – today and tomorrow. The Masters of the Universe/Washington combo won’t give up their strategy to make Russia a pariah state cut off from trade, the transfer of funds, banking and Western credit markets and thus prone to regime change.
Further on down the road, if all goes according to plan, their target will be (who else) China. And Beijing knows it. Meanwhile, expect a few bombshells to shake the EU to its foundations.

Time may be running out – but for the EU, not Russia. Still, the overall trend won’t be altered; the Empire of Chaos is slowly but surely being squeezed out of Eurasia.
The views expressed in this article are solely those of the author and do not reflect the official position of Sputnik.

This Era of Low-Cost Oil Is Different

Monday, 29 Dec 2014 01:20 PM

By Mohamed El-Erian

Having seen numerous fluctuations in the energy markets over the years, many analysts and policy makers have a natural tendency to “look through” the latest drop in oil prices — that is, to treat the impact as transient rather than as signaling long-term changes.

I suspect that view would be a mistake this time around. The world is experiencing much more than a temporary dip in oil prices. Because of a change in the supply model, this is a fundamental shift that will likely have long-lasting effects.

Through the years, markets have been conditioned to expect OPEC members to cut their production in response to a sharp drop in prices. Saudi Arabia played the role of the “swing producer.” As the biggest producer, it was willing and able to absorb a disproportionately large part of the output cut in order to stabilize prices and provide the basis for a rebound.
It did so directly by adhering to its lowered individual output ceiling, and indirectly by turning a blind eye when other OPEC members cheated by exceeding their ceilings to generate higher earnings.
In the few periods when Saudi Arabia didn't initially play this role, such as in the late 1990s, oil prices collapsed to levels that threatened the commercial viability of even the lower-cost OPEC producers.

Yet in serving as the swing producer through the years, Saudi Arabia learned an important lesson: It isn’t easy to regain market share. This difficulty is greatly amplified now that significant non-traditional energy supplies, including shale, are hitting the market.

That simple calculation is behind Saudi Arabia’s insistence on not reducing production this time. Without such action by the No. 1 producer, and with no one else either able or willing to be the swing producer, OPEC is no longer in a position to lower its production even though oil prices have collapsed by about 50 percent since June.
This change in the production model means it is up to natural market forces to restore pricing power to the oil markets. Low prices will lead to the gradual shutdown of what are now unprofitable oil fields and alternative energy supplies, and they will discourage investment in new capacity. At the same time, they will encourage higher demand for oil.

This will all happen, but it will take a while. In the meantime, as oil prices settle at significantly lower levels, economic behavior will change beyond the “one-off” impact.

As costs fall for manufacturing and a wide range of other activities affected by energy costs, and as consumers spend less on gas and more on other things, many oil-importing nations will see a rise in gross domestic product. And this higher economic activity is likely to boost investment in new plants, equipment and labor, financed by corporate cash sitting on the sidelines.

The likelihood of longer-lasting changes is intensified when we include the geopolitical ripple effects. In addition to creating huge domestic problems for some producers such as Russia and Venezuela, the lower prices reduce these nations’ real and perceived influence on other countries.

Some believe Cuba, for example, agreed to the recent deal with the U.S. because its leaders worried they would be getting less support from Russia and Venezuela. And for countries such as Iraq and Nigeria, low oil prices can fuel more unrest and fragmentation, and increase the domestic and regional disruptive impact of extremist groups.

 Few expected oil prices to fall so far, especially in such a short time. The surprises won’t stop here.

A prolonged period of low oil prices is also likely to result in durable economic, political and geopolitical changes that, not so long ago, would have been considered remote, if not unthinkable.

Credit Markets

U.S. Government Bonds Strengthen to Close Out a Big Year

Investors Have Gained Largest Total Calendar-Year Return Since 2011

By Min Zeng

Updated Dec. 31, 2014 2:47 p.m. ET

U.S. government bonds strengthened Wednesday on the last trading session of 2014, capping the biggest annual rally in three years.
A number of global economic, geopolitical and market scares throughout the year have boosted investors’ demand globally for ultrasafe Treasury bonds.
The yearlong price strength in ultrasafe U.S. government debt has stunned many investors, traders and analysts because the safe-haven bond market rallied along with record-high stock prices. At the start of last January, the consensus was for bond prices to extend their losses of the year before, driven by a U.S. economy gaining steam and the gradual winding down of the Federal Reserve’s monthly bond purchases.
On Wednesday, the yield on the benchmark 10-year Treasury note fell to 2.173% as of 2 p.m., when the bond market was shut ahead of the New Year’s Day holiday. That’s a big tumble from the 3.03% yield at the end of 2013, marking the biggest calendar-year decline since 2011.

Bond prices rise as yields fall.
Treasury bonds overall have handed investors a total return, including price changes and interest payments, of 4.95% this year through Tuesday. That is the biggest calendar-year return since 2011, according to data from Barclays PLC.
“Global investors see Treasury bonds as one of the best liquid and relatively attractive hedges against a plethora of global risks,” said Tony Crescenzi, senior market strategist at Pacific Investment Management Co. in Newport Beach, Calif., which had $1.87 trillion in assets under management as of Sept. 30.
Growth has been stagnant in the eurozone, Japan is in recession and China’s economy has slowed from the torrid pace a decade ago. Falling oil prices since the summer have hurt growth prospects in countries relying heavily on energy exports, generating a currency crisis in Russia this month.
Adding to the list has been this week’s political turmoil in Greece after the nation’s parliament failed to elect a president.
“With uncertainty around the impact of a swift drop in oil and slower global growth, you have an environment where exposure to risk assets may be questioned, therefore Treasury yields and overall interest rates are capped,” said Sean Simko, head of fixed-income management at SEI Investments in Oaks, Pa., which has $146 billion in assets under management.
Another boost for Treasury bonds has been fresh monetary stimulus from the European Central Bank and the Bank of Japan .
Both have stepped up, printing money in recent months to support their flagging economies even as the Fed is prepared to start raising interest rates next year thanks to a stronger U.S. economy.
The liquidity from the ECB and BOJ has encouraged investors to buy national governments’ bonds, sending yields in Japan and many eurozone countries to record lows earlier this month.
The yield on the 10-year government bond in Germany settled at 0.542% Wednesday, down from 1.927% at the end of 2013, according to Tradeweb.
The yield on the 10-year U.K. government bond closed at 1.759% Wednesday, down from 3.039% at the end of 2013.
The sharper decline in yields in Europe has turned U.S. Treasury bonds into an attractive bargain. A rallying dollar this year, driven by the prospect of higher interest rates from the Fed in 2015, has allowed foreign investors to pick up extra gains.

“The U.S. decoupled from the rest of the world when it comes to growth but not when it came to U.S. rates,” said Priya Misra, head of U.S. rates strategy research at Bank of America Merrill Lynch in New York. U.S. yields won’t rise sharply in 2015 “given weak global growth and inflation and easing by other central banks.”

Many big banks have been forced to lower their yield forecasts in 2014 and now they are more modest in their yield predictions for next year. J.P. Morgan Chase & Co. expects the yield on the 10-year Treasury note to rise to 2.7% at the end of 2015. Bank of America expects 2.75%, and Goldman Sachs Group Inc. expects 3%.

Lower Treasury bond yields have sent ripples through other markets, pushing up the value of riskier bonds and stocks. Many U.S. portfolio managers have dabbled into riskier bonds that offer higher yields than Treasury debt to juice returns.

U.S. municipal bonds have been the best-performing U.S. asset class this year, posting a total return of 8.97% as of Tuesday, according to Barclays. U.S. investment-grade corporate bonds also beat Treasurys, with a 7.39% return.

U.S. corporate bonds sold by lower-rated firms are laggards, with a return of 2.45%.

2:50 pm ET Dec 31, 2014


What the Economic Forecasters Got Right—and Wrong—in 2014

By Sudeep Reddy
Many economic forecasters can look back on 2014 as one of their least embarrassing performances of recent years. But they’ll still want to forget many of their projections for the latest year.

It’s not a pretty picture: Most of them in January expected far higher oil prices, firmer inflation, a worse jobless rate and higher interest rates than the year actually delivered. We won’t know until next month how they fared in forecasting economic growth.

We looked back at the projections made in January’s Wall Street Journal survey of economists against what we know today. You won’t judge the forecasters too harshly if you know how they work: Economic projections are a difficult guessing game based on complex computer models, instinct and lots of luck. Here’s to better luck next year.

(See full results from the WSJ Economic Forecasting Survey throughout 2014, including individual economists’ projections.)

GDP Growth

Full-year 2014 consensus projection: 2.8%
Actual: due in early 2015

When the final numbers are in, economic growth probably won’t be as strong as most economists expected. But the economy still appears to have picked up from 2013, with a first-quarter weather-driven contraction offsetting stronger output later in the year.

Unemployment Rate

Consensus projection for December 2014: 6.3%
Actual (November 2014): 5.8%

Almost every economist saw the jobless rate at or above 6% by the end of the year. The consensus for the jobless rate at the end of next year, 2015—5.8%—is right where we were in the latest report. The jobless rate should stay low in 2015 unless the labor market deteriorates or potential workers return to the labor force.

Payroll Growth

Average monthly change in payrolls over next 12 months: 200,000
Actual (11-month average through November 2014): 241,000

Professional economic forecasters tend to go wrong by being too optimistic. Last year, it was the opposite. 

Inflation (consumer price index, annual change)

Projection for December 2014: 1.9%
Actual (November 2014): 1.3%

Credit the sharp drop in energy prices for the miss in forecasting overall inflation. Excluding food and energy, annual inflation clocked in at 1.7% in November.

Interest Rates (10-Year U.S. Treasury yield)

Projection for closing yield in December 2014: 3.52%
Final close: 2.17%

This one is a real doozy for one of the world’s most important interest rates. Every economist in the survey in January was far off the mark in expectations for interest rates in 2014.

Crude Oil

Consensus for the end of December 2014: $94.65/barrel
Final close: $53.27/barrel

The year’s plunge in crude oil prices, from a peak of $107.26 in June, was easily the biggest economic surprise of 2014. Most consumers can celebrate that economists were so wrong.

(This post has been updated to reflect Wednesday’s closing values for crude oil and the 10-year Treasury yield.)