The Global Economy’s Chinese Headwinds
Adair Turner
FEB 12, 2015

China consumers market produce

BEIJING – Last year, the global economy was supposed to start returning to normal. Interest rates would begin rising in the United States and the United Kingdom; quantitative easing would deliver increased inflation in Japan; and restored confidence in banks would enable a credit-led recovery in the eurozone. Twelve months later, normality seems as distant as ever – and economic headwinds from China are a major cause.

To spur economic growth and achieve prosperity, China has sought to follow the path forged by Japan, South Korea, and Taiwan, but with one key difference: size. With populations of 127 million, 50 million, and 23 million, respectively, these model Asian economies could rely on export-led growth to lift them to high-income levels. But the world market is simply not big enough to support high incomes for China's 1.3 billion citizens.
To be sure, the export-led model did work in China for some time, with the trade surplus rising to 10% of GDP in 2007, and manufacturing jobs absorbing surplus rural labor. But the flip side of China's surplus was huge credit-fueled deficits elsewhere, particularly in the US. When the credit bubble collapsed in 2008, China's export markets suffered.
In order to stave off job losses and sustain economic growth, China stimulated domestic demand by unleashing a wave of credit-fueled construction. As commodity imports soared, the current-account surplus fell below 2% of GDP.
China's own economy, however, became more unbalanced. Investment rose from 42% of GDP in 2007 to 48% in 2010, with property and infrastructure projects attracting the most funding. Likewise, credit swelled from 130% of GDP in 2007 to 220% of GDP in 2014, with 45% of credit extended to real estate or related sectors.
This property boom resembled Japan's in the late 1980s, which ended in a bust that led to a protracted period of anemic growth and deflation from which the country is still struggling to escape. With China's per capita income amounting to only a quarter of Japan's during its boom, the risks the country faces should not be underestimated.
The rejoinder is that China is relatively safe, because its per capita capital stock also remains far below Japan's in the 1980s, and much more investment will be needed to support its rapidly expanding urban population (set to increase from 53% of the total in 2013 to 60% by 2020).

But counting on this investment may be excessively optimistic. Though China will indeed need more investment, its capital-allocation mechanism has produced enormous waste.
In fact, by establishing urbanization as an explicit objective – something that Japan, South Korea, and Taiwan never did – China has embedded a structural economic bias toward construction. With hundreds of cities competing with one another through infrastructure development, “ghost towns" will proliferate.
Making matters worse, China's local-government financing model could hardly be more effective at producing overinvestment and excessive leverage. Local governments use land as collateral to take out loans to fund infrastructure investment, then finance repayment by relying on revenues from subsequent land sales. As the property boom wanes, their debts become increasingly unsustainable – a situation that has already reportedly compelled some local governments to borrow money for land purchases to prop up prices. In the economist Hyman Minsky's terminology, simple “speculative" finance has given way to completely circular “Ponzi" activity.
As a result, though total credit in China continues to grow three times faster than nominal GDP, a major downturn is now underway. Property sales have fallen, particularly outside the largest cities, and slower construction growth has left heavy industry facing severe overcapacity. The latest survey data indicate a major slowdown in industrial activity. Last month, producer prices were down 4.3% year on year. The resulting decline in demand has caused commodity prices to fall considerably, undermining the growth prospects of other major emerging economies.
Meanwhile, China's current-account surplus has again soared. Though it seems significantly smaller than pre-crisis levels as a share of GDP – almost 4%, at the latest monthly rates, compared to 10% in 2007 – it has returned to its peak in absolute terms. And it is the absolute size of China's external surplus that determines the impact on global demand. In short, China is back to where it started, with its growth dependent on export demand, which is now severely constrained by debt overhangs in advanced countries.
As a result, China's downturn has intensified the deflationary headwinds holding back global recovery, playing a major role (along with increased supply) in driving down oil prices. Though lower oil prices will be a net boon for the world economy, the decline reflects a serious dearth of demand.
China now must find the solution to a problem that Japan, South Korea, and Taiwan never had to face: how to boost domestic demand rapidly and sustainably. Fortunately, 2014 brought some progress on this front, in the form of a slight uptick (albeit from a very low base) in household consumption as a percentage of GDP.
To accelerate consumption growth, China's leaders must implement a stronger and more comprehensive social safety net, thereby reducing the need for high precautionary savings. Higher dividends from state-owned enterprises could help to finance such an initiative, while removing incentives for overinvestment.
Demographic change – with the number of 15-to-30-year-olds, in particular, falling by 25% over the next decade – could also help. Though population stabilization could exacerbate the dangers of excessive property investment today, it will also tighten labor markets and stimulate wage increases.
China may well be able to meet the challenge ahead. But, as the investment-led phase of its development ends, a significant growth slowdown is certain – and will inevitably intensify deflationary forces in the world economy. Given this, 2015 may well prove to be another year in which hopes of a return to normality are disappointed.

miércoles, febrero 18, 2015


Gold and Fed Rate Hikes

By: Adam Hamilton

Friday, February 13, 2015

Gold's sharp early-year surge has fizzled in recent weeks as investment demand faded. The primary reason is the universal belief that the Fed's upcoming rate hikes are very bearish for gold. Higher rates will make zero-yielding gold relatively less attractive, argues this popular thesis. But history proves just the opposite. Gold actually thrives in rising- and higher-rate environments, so rate hikes are nothing to fear.

This notion definitely seems counterintuitive today. When the Fed finally begins letting interest rates start to normalize after actively suppressing them for years on end, yields on bonds and cash in the form of money-market funds will rise. That will make these asset classes more appealing to investors. So they will migrate out of gold, which yields nothing, into the new higher-yielding bonds and money-market funds.

This logic is simple, which is why the great majority of investors and speculators today believe that gold is going to face relentless selling as rates rise. But rather than accepting this conventional "wisdom" at face value, why not see what's happened in the past? Did the earlier periods of rising and higher rates suck vast amounts of capital out of gold, deflating its price? If not, then this popular thesis is dead wrong.

It's funny how ideas take root and flourish in the financial markets. Traders are highly emotional, with most of their trading decisions based on greed and fear. They also have an overwhelming status-quo bias, expecting current market conditions to persist indefinitely. Thus any rationalization of why stock markets will rally on balance forever while gold fades into oblivion are quickly seized on and trumpeted as truth.

With traders' collective greed and fear constantly overriding their rationality, popular fallacies always exist. They include widespread beliefs today that market history proves are ridiculous.

Such as the ideas that stock markets can rally perpetually without corrections or bears, that stock-market valuations don't matter, and that central banks can successfully manipulate prices forever. History makes a mockery of these!

Yet traders believe what they want to, whatever seems to bolster their views that existing trends have turned permanent in some new era. But the past record is crystal-clear, financial markets are forever cyclical. Asset classes rise as they grow popular, but then inevitably subsequently fall as they drift out of favor again. Gold is no exception. Gold can't drift lower forever any more than stock markets can rally forever.

So instead of just blindly accepting today's belief that the Fed's rate hikes are bearish for gold, why not check the historical record? This first chart includes over 45 years of daily gold-price and interest-rate data. For interest rates I used the yields on benchmark 1-year Treasury bills and 10-year Treasury notes to represent both the short and long ends of the yield curve. Are rising and higher rates really bearish for gold?

Treasuries and Gold 1970 - 2015

The simple answer is absolutely not. Gold's mighty secular bull of the 1970s, which greatly dwarfed the 2000s one, happened during a time of high and rising interest rates! And then gold's subsequent multi-decade secular bear in the 1980s and 1990s unfolded during a long span of interest rates relentlessly falling on balance. Gold rallying with rising rates and slumping with falling rates? That's not in the script.

And over this chart's entire nearly-half-century span, gold and interest rates were actually not highly correlated at all. While gold indeed had the negative correlation with rates that many today expect, it was actually very weak. Gold's correlation r-squares with 1-year and 10-year Treasury yields ran merely 29% and 28% respectively between 1970 and 2015. For all intents and purposes, this is essentially uncorrelated.

Mathematically, only well under a third of gold's daily price action was directly explainable by short- or long-term interest rates. This wouldn't be the case if higher rates made gold far less attractive to investors and vice versa, so today's popular thesis about gold and rates is simply false historically. Actually well over two-thirds of the gold-price action in our lifetimes had nothing to do with the changing interest rates!

Like all other prices, gold's are driven by global supply and demand. And since it takes over a decade to advance a deposit into an operating mine, gold's supply changes very slowly. All the real fundamental action in the yellow metal comes on the demand side. And the big wildcard on that half of the equation comes from investment demand, which can fluctuate massively at the margin. It drives all gold's big moves.

So interest rates could only affect gold through investment demand. Today's traders believe rising and higher rates retard gold investment demand as investors shift capital to higher-yielding bonds.

But they have a monumental historical problem in the form of the biggest secular gold bull of our lifetimes. Back in the 1970s when gold skyrocketed over 24x higher in nominal terms, it actually moved with interest rates!

Treasuries and Gold 1970 - 1980

Way back in March 1971, short rates as represented by 1-year T-Bill yields bottomed at 3.5%. And by October 1979, they would nearly quadruple to 13.6%! Now no one today even thinks the Fed hiking the Federal Funds Rate it directly controls to double-digit ranges is even possible. So there is truly no more extreme example than the 1970s to reveal how rising and higher rates affect gold investment demand.

And obviously gold bucked today's consensus and soared right alongside interest rates! It actually had very high positive correlations with 1-year and 10-year Treasury yields, enough to generate very strong r-squares of 64% and 83% respectively. So from two-thirds to over four-fifths of gold's bullish upside price action between 1970 and 1980 was directly mathematically explainable by the rising interest rates.

Gold was actually strongest when the short-term interest rates utterly dominated by the Fed Funds Rate were rising the fastest. Note gold's giant spikes in 1973 and 1974 as rates soared in direct response to Fed rate hikes. And then gold actually slumped in 1975 and 1976 as interest rates fell, which again flies in the face of what traders expect today. Then it soared again in 1978 and 1979 as rates skyrocketed.

So in the biggest secular gold bull of our lifetimes by far, rising and higher rates were as far from being bearish for gold as they can get. Just the opposite was true, the faster the rate hikes and the higher the rates went, the more investment demand for gold soared! This relationship only seems counterintuitive today because traders' status-quo bias has temporarily blinded them to normal cyclical market behavior.

Rising and higher interest rates are actually bullish for gold for one simple reason. And that is they are actually very bearish for stocks and bonds. Gold is an alternative asset that shines the brightest when the conventional asset classes are suffering. And nothing pummels stock and bond markets like rising interest rates. That is the sole reason the Fed has been so darned slow in normalizing interest rates!

Rising and higher rates hit the stock markets in a variety of ways. They make bond investing relatively more attractive for stock capital. In periods of low interest rates, bond investors are often forced into the stock markets to chase yields. But they never like being there, as stocks paying healthy dividends are always at risk of seeing major price declines. There is essentially zero principal risk in bonds held to maturity.

So as rates rise, the bond investors grudgingly holding stocks exit to migrate back into their favored asset class. Since the pools of bond-market capital are so vast, this selling pushes the stock markets lower. Rising and higher rates also make stock markets look more overvalued in several ways. When bond yields are higher, investors are far less willing to pay high prices in price-to-earnings-ratio terms for stocks.

So the lower demand won't support overvalued stock markets, and they sell off. The higher rates also directly hit corporate profits, which further erode valuations. Companies' debt-servicing expenses rise with rates, reducing earnings. And their customers also face the same higher borrowing costs, so they buy less which dampens corporate sales. And lower sales also naturally lead to lower profits of course.

When stock markets start flagging significantly, which rate hikes usually ensure, investors start flocking to alternative investments led by gold that thrive when general stocks are weak. The reason that gold rocketed 186% higher in 1973 and 1974 despite 1-year Treasury yields climbing from 5.7% to 7.4% with far-higher 9.2% and 10.0% rate spikes within this span was the S&P 500 plummeted by 42% during it!

Rising and higher rates crushed stock markets, so gold investment demand exploded as a safe haven that wouldn't get sucked into the stock markets' downside maelstrom. And conversely when the S&P 500 rebounded out of its 1973-1974 cyclical bear to soar 57% higher in 1975 and 1976, gold plunged 28% despite short rates falling from 7.4% to 4.9%. The stock-market fortunes were the key to gold in the 1970s.

And they still are today. The only reason gold plummeted in 2013 on epic extreme GLD-gold-ETF and gold-futures selling was because the Fed's radically-unprecedented open-ended third quantitative-easing campaign and associated jawboning catapulted the general stock markets far higher. When conventional investments are surging, investment demand for alternatives naturally fades away to nothing.

The Fed's artificial prolonging of this latest cyclical stock bull with extreme money printing is the sole reason gold fell so deeply out of favor in the past couple of years. But these lofty Fed-goosed stock markets are long overdue to roll over into the next cyclical bear, and when that happens gold will shine as investors again seek out alternative investments. The Fed's rate hikes will accelerate this process.

The benchmark S&P 500 has soared an astounding 209% higher in 5.8 years as of late December, far beyond the average ranges of normal cyclical bulls. Its elite component stocks were trading at a nearly-bubble-level average trailing-twelve-month price-to-earnings ratio of 25.1x at the end of last month! And it's been a staggering 3.4 years since the last stock-market correction exceeding 10%. A major selloff is inevitable.

And whenever it happens, gold will catch a huge bid regardless of what interest rates are doing. Again the only reason the Fed has kept its risky and asinine zero-interest-rate policy in place since December 2008 despite the soaring stock markets and improving jobs picture is because it is rightfully terrified of what rate hikes will do to these wildly-overextended stock markets. But it will soon have to act regardless.

Fleeing into bonds isn't a great option for stock-market capital either, as rising and higher rates are even more devastating for bond markets. Bonds are debt contracts with yields fixed at issuance, yet those yields have to trade at current prevailing rates. So as rates rise, bonds are sold until their prices fall low enough for their fixed payments to equal current yields. This means big principal losses for investors.

Long-term investors can hold bonds to maturity to avoid the inevitable mid-term principal losses. But this is a tough bet to make, since new bonds are always coming out in rising-rate periods with higher yields. This makes bond investing an utter minefield when the Fed is hiking rates, an unforgiving realm that makes capital appreciation very difficult for even the best traders. Gold can be much more appealing.

If investment capital is flowing into gold due to rate hikes' serious adverse impact on stocks and bonds, investors in both are attracted to its high returns. When gold is rallying while both stock and bond prices are falling, the gold investment demand grows dramatically and feeds on itself. So contrary to popular "wisdom" today, rising- and higher-rate environments are super-bullish for gold investment demand.

This final chart looks at gold and the benchmark Treasury short and long rates during the last secular gold bull of the 2000s. While neither gold's bull run nor the interest-rate cycles were anywhere near as extreme as in the 1970s, they still prove how wrong today's universal belief is that Fed rate hikes are bad news for gold. Gold actually soared during the Fed's last rate-hike cycle, and thrived in much higher rates.

Treasuries and Gold 2001 - 1980

It is true that interest rates meandered lower on balance during gold's last secular bull. As gold blasted 7.4x higher between April 2001 and August 2011, 1-year and 10-year Treasury yields plummeted by 98% and 58% respectively. But it wasn't the Fed-imposed artificially-low interest rates that drove this latest gold bull. Gold peaked fairly early in the Fed's ZIRP campaign, and well before 10-year yields bottomed.

And that entire massive gold bull happened in a far-higher rate environment than today's. Over its long 10.4-year span, 1-year and 10-year Treasury yields averaged 2.2% and 4.1%. These are way higher than today's prevailing yields, 10.2x and 2.0x respectively. If gold enjoyed such incredible investment demand at these far-higher yields than today's, then why are Fed rate hikes back up to these same levels bearish?

Obviously they're not. But today's emotional investors and speculators want to irrationally believe the Fed's conjured fiction of stock markets rallying forever. So they always look to rationalize their status-quo bias, to latch on to any thesis, no matter how flimsy, if it supports their worldview. And that is today's absurd belief that financial markets are no longer cyclical, that stocks rally forever while gold slumps forever.

Why succumb to this dangerous groupthink instead of simply consulting the historical record? If Fed rate hikes are bearish for gold as everyone assumes these days, then it must have been pounded in the last major rate-hike cycle. That happened between June 2004 and June 2006, a two-year span where the Fed more than quintupled its Federal Funds Rate from 1.00% to 5.25%. Did gold utterly collapse?

Not so you'd notice. Over the exact span of that last major Fed-rate-hike campaign, from FOMC day to FOMC day, gold blasted 49.5% higher! Its young secular bull actually accelerated dramatically while the Fed was aggressively raising rates. Since rising and higher rates make stocks and bonds look a lot less attractive and a lot more overpriced, alternative investments led by gold return to favor.

Don't forget that.

Today's universal belief that the Fed's next rate-hike cycle is bearish for gold is total garbage. It just blows my mind that anyone actually believes it. How can anyone be so foolishly susceptible to herd groupthink that they can't spend a couple hours studying gold's actual reactions during past rising- and higher-rate environments? If rate hikes are bearish for gold, then it would be readily apparent in historical data.

Gold's latest woes were exacerbated by last Friday's big upside surprise on the US monthly jobs report. It ignited heavy gold selling that ultimately pounded the metal down 2.4% that day alone. Why? Because the better-than-expected jobs read led gold-futures traders to think the Fed's rate hikes are going to start sooner rather than later. And these naive speculators chose to believe rationalizations instead of history.

Just like in the past, the inevitable upcoming Fed rate-hike cycle is going to be super-bullish for gold. The rising and higher rates are going to hammer these lofty, overvalued, and overextended stock and bond markets. And that will lead prudent investors to seek alternatives, places to park their capital that move inversely to stocks. There's zero doubt gold investment demand will surge during the coming rate hikes.

And since gold investment demand on the margin determines gold prices, the yellow metal will soar too. You can ride it higher in physical gold coins or the flagship GLD gold ETF. And if you want to leverage gold's coming gains as the Fed pricks its own stock-market bubble, the beaten-down gold stocks will greatly outperform gold to the upside. Only brave contrarians fighting the crowd now will maximize their gains.

Because of all the popular falsehoods plaguing the markets today like this gold-and-rate-hikes one, it's never been more important to cultivate an excellent contrarian source of information.

The bottom line is contrary to the popular belief today, rising- and higher-rate environments are actually very bullish for gold. Rather than making a zero-yielding asset look relatively less attractive, rate hikes serve to hammer conventional stock and bond markets. This leads investors to seek alternatives that rally in times of general-stock weakness. And gold has always been the leading safe-haven investment.

This was certainly true during the epic rate hikes of the 1970s, where gold soared when the Fed was the most aggressive with its extreme rate hikes. And it was also true during the Fed's last major rate-hike cycle of the mid-2000s, when short rates more than quintupled yet gold still surged. And gold is set to defy today's silly universal groupthink delusion and power higher again in the coming Fed rate hikes.

Why it’s time to get off the U.S. dollar bandwagon

Jonathan Ratner

February 6, 2015 | Last Updated: Feb 6 3:16 PM ET
The U.S. dollar is particularly vulnerable if oil prices rebound, global economic growth exceeds expectations, or if the U.S. recovery stalls.
Tomohiro Ohsumi/BloombergThe U.S. dollar is particularly vulnerable if oil prices rebound, global economic growth exceeds expectations, or if the U.S. recovery stalls.

Everyone is betting on the U.S. dollar these days and no wonder.
Whether it’s Canadian equity investors buying domestic manufacturers with costs in loonies and sales in greenbacks, central banks dumping their euro holdings and heading across the Atlantic, or global investors seeking higher yields in U.S. treasuries, America remains the safe haven amid increased volatility in both equity and currency markets.

But seasoned investors know that one-sided trades like this can end up burning those riding the bandwagon. The U.S. dollar is particularly vulnerable if oil prices rebound, global economic growth exceeds expectations, or if the U.S. recovery stalls.

Much of the current optimism for the currency stems from the end of quantitative easing and anticipated rate hikes by the U.S. Federal Reserve, as U.S. economic growth prospects continue to lead the developed world.

Monetary easing by the Bank of Japan and European Central Bank has also served to pummel both the yen and euro, helping the U.S. dollar wrap up its best year since 1997 — appreciating almost 9% in trade-weighted terms.

But a gain of almost 20% by the dollar since mid-2014 also signifies a major tightening in financial conditions. David Rosenberg, chief economist and strategist at Gluskin Sheff + Associates Inc., equates the currency’s rise to a 200-basis-point Fed rate hike, punishing export-dependent sectors the most with a hit that is four times as large on corporate earnings than on GDP.

The negative aspects of the currency on U.S. companies are not widely appreciated yet, as it has a delayed impact. Nonetheless, it comes as little surprise that multinationals such as Apple Inc., Google Inc. and Procter & Gamble Co. all cited the stronger dollar as a hurdle in their recent earnings results.

Data released this week also showed that the U.S. trade deficit in December climbed to its highest level in more than two years, as lower exports and higher imports demonstrate how the greenback’s strength is making U.S. goods and services less competitive versus the global competition.

“As it is, the stronger U.S dollar has already started to punish U.S. companies with a strong export bias, and if we start to see a weakening of the jobs numbers in the coming days as a result of layoffs in the U.S. oil and gas sector, then that could quickly herald a sharp change in thinking as well as a sharp drop in the U.S. dollar, as interest rate rise expectations get pushed out,” said Michael Hewson, chief market analyst at CMC Markets.

The run of recent U.S. economic data shows that the economy is not nearly as robust as the market thinks. For one thing, inflationary pressures remain benign and wage growth continues to be weak. At the same time, even though consumer confidence is at a multi-year high, that has yet to be reflected in retail sales and durable goods data, which are still lacklustre.

Disappointing Q4 GDP numbers further reinforce concerns about the U.S. economy, while Fed officials continue to discuss the prospect of monetary tightening. Talk of policy normalization is understandable, but perhaps policymakers should be a little more cautious given that the ECB prematurely tightened rates in 2011.

A whole host of central banks are cutting rates and shifting to more dovish stances, not to mention those engaging in QE, so there is a distinct possibility that growth in struggling economies will exceed expectations.

“Right now, we have this incredibly stimulative environment with very low oil prices, very low yields globally, and most central banks that are very accommodative,” said Camilla Sutton, chief FX strategist at Scotiabank.

She expects further gains for the U.S. dollar in 2015, but won’t rule out the possibility of a downward surprise if there is better-than-expected data out of places such as Europe, China or even Canada.

Expectations for Europe are very low, but the mood is reminiscent of the beginning of 2014. Almost everybody expected the euro to move lower last year, but it climbed above US$1.39 in May, as some data points were slightly stronger than expected and sentiment followed.

Jonathan Hayward/The Canadian Press
Jonathan Hayward/The Canadian PressThe loonie will hold its own against the greenback if oil prices stabilize, and that will also provide a breath of fresh air to other commodity currencies.

“None of it was strong, but it was just a little bit stronger than expected and I think that was one of the things that supported the euro well above what anyone had anticipated based on the fundamentals,” Ms. Sutton said.

For the Canadian dollar, whether or not you want to call it a “petro currency,” there is no doubt that oil prices are now the most important driver. The Bank of Canada has essentially tied its interest rate policy to oil prices for the near term.

But remember that oil prices can quickly rebound. Back in 1985-1986, global growth was near 3% as it is now, the oil market was riddled with excess supply, and Saudi Arabia was unwilling to cut production.

Mr. Rosenberg noted that WTI crude fell from US$31.80 to US$10.40 between Nov. 21, 1985, and March 31, 1986. But months later, it had rebounded 42%. A year out, oil had surged more than 80%.

“The good news is that these sharp slumps in the oil price do not last for years — they last for months,” he said.

The loonie will hold its own against the greenback if oil prices stabilize, and that will also provide a breath of fresh air to other commodity currencies.

Another factor that will stop the U.S. dollar in its tracks is the eventual convergence of global bond yields. Negative yields in places such as Germany and Finland are becoming more common, making five-year U.S. treasuries at roughly 1.3% look pretty attractive. But it won’t last.

“Make no mistake: bonds are already priced for the world to come to an end, and the world is not coming to an end …,” Mr. Rosenberg said. “And looking at the massive net speculative dollar long positions on the InterContinental Exchange, the bull view on the greenback is arguably the most crowded trade there is across the planet.”

On Wall Street

February 13, 2015 9:30 am

Investors must keep on second guessing the Fed

Henny Sender

The easy money offered by central banks is not without dangers, writes Henny Sender

The February 6 edition of Citigroup’s high yield weekly newsletter posed a question that seemed to summarise the predicament of all fund managers, and not just those navigating the pitfalls of a volatile junk bond market: which is better — to invest in the debt of lower-rated issuers because they offer more attractive absolute yields; or, to invest in the debt of higher-quality companies but do so with leverage in order to generate acceptable returns?

In a world awash with liquidity — but a fragile, unreliable liquidity that ebbs and flows in accordance with the latest utterances from policy makers — one is tempted to ask for a third option.
Many hedge fund managers say fundamental analysis no longer works. Investing is all about second guessing the Federal Reserve instead. Economic data remain uneven, which makes deciding on the timing of any future interest rate rise perilous. JPMorgan expects real growth for the fourth quarter to be revised down to 2 per cent in real terms. Leading indicators like new manufacturing and factory orders also are slowing, while S&P 500 estimates of sales and earnings for 2015 look flattish, notes Michael Cembalest of JPMorgan’s private bank.
Both consumer spending and retail sales were down in December, underscoring the downside risks. In January, retail sales were down 0.8 per cent month on month and much softer than analysts expected.
Meanwhile, inflows into the bond markets have resumed, emerging market debt has bounced back and the spectre of monetary tightening seems to have receded yet again — at least at the time of writing.
If the economy is growing at a mere 2 per cent, surely it is time to conclude that the Fed’s medicine is not healing the real economy. At the same time, the risk taking that the Fed is encouraging by making it difficult for savers to see decent returns without reaching for yield will prove increasingly dangerous. One analyst estimates that yields should be 120 basis points higher than their current levels.

Easy money ultimately is not costless. While few analysts talk about it, low returns for savers may mean an eventual cut in pension benefits and lower demand, especially for retired workers and those contemplating retirement. The Fed’s policies are contributing to income inequality today in the US and they will do so even more tomorrow. It is big borrowers and speculators who are the biggest beneficiaries of Fed policies.

Indeed, if one assumes Fed policy is not working on the economy, suddenly much of the data begin to make sense. For example, the widespread expectation that massive asset purchases and zero rates would lead to inflation assumes that Fed policies would work, that the economy would grow strongly, wages would rise, and excess capacity would disappear. But there is still excess capacity and wages are hardly rising precisely because the real economy remains fragile.

Chief executives have more incentive to buy back their shares (often with money borrowed at low rates) or to buy other companies than to invest in their own businesses.
If deflation really is more of a risk than inflation — precisely because wages and therefore demand remain weak — then the real burden of debt becomes heavier and investors should expect defaults to pick up.

So far, though, recent corporate defaults have been easy to explain away as due either to the heavy leverage private equity firms put on companies that are vulnerable to recession, such as Caesars Entertainment, or companies such as retailer Radio Shack, with thousands of stores that have been marginalised by the same technological changes that have doomed other retailers.
If the oil price comes down because new sources of energy mean Opec can no longer operate as a cartel controlling prices, inflationary pressures subside. But if a big part of the slide is owing to far less demand because of slower, less energy-intensive growth, the information for investors contained in the price slide is very different.

And finally, if the Fed continues to be the biggest reason to take risk, when the Fed finally turns, what happens to all that risk? Central bankers are meant to encourage financial stability not to be cheerleaders for inflated asset prices.

Central Banks and the Bottom Line
Barry Eichengreen, Beatrice Weder di Mauro
FEB 12, 2015

Swiss National Bank Geneva

MUNICH – Around the world, central banks' balance sheets are becoming an increasingly serious concern – most notably for monetary policymakers themselves. When the Swiss National Bank (SNB) abandoned its exchange-rate peg last month, causing the franc to soar by a nosebleed-inducing 20%, it seemed to be acting out of fear that it would suffer balance-sheet losses if it kept purchasing euros and other foreign currencies.
Similarly, critics of the decision to embark on quantitative easing in the eurozone worry that the European Central Bank is dangerously exposed to losses on the southern eurozone members' government bonds. This prompted the ECB Council to leave 80% of those bond purchases on the balance sheets of national central banks, where they will be the responsibility of national governments.
In the United States, meanwhile, the "Audit the Fed" movement is back. Motivated by growth in the Federal Reserve's assets and liabilities, Republicans are introducing bills in both chambers of Congress to require the Fed to reveal more information about its monetary and financial operations.
But should central banks really worry so much about balance-sheet profits and losses? The answer, to put it bluntly, is no.
To be sure, central bankers, like other bankers, do not like losses. But central banks are not like other banks. They are not profit-oriented businesses. Rather, they are agencies for pursuing the public good. Their first responsibility is hitting their inflation target. Their second responsibility is to help close the output gap. Their third responsibility is to ensure financial stability. Balance-sheet considerations rank, at best, a distant fourth on the list of worthy monetary-policy goals.
Equally important, central banks have limited tools with which to pursue these objectives. It follows that a consideration that ranks only fourth in terms of priorities should not be allowed to dictate policy.
Indeed, a clear understanding of their priorities has often led central banks to incur losses when doing so is the price of avoiding deflation or preventing the exchange rate from becoming dangerously overvalued. The Chilean, Czech, and Israeli central banks, for example, have operated with negative net capital for extended periods without damaging their policies.
The reason why adverse consequences need not follow is that the central bank can simply ask the government to replenish its capital, much like when a government covers the losses of its national post office. Everyone is happier when transfers flow the other way. But the role of the central bank is not to be a profit center, especially when those profits come at the cost of other, more important policy objectives.
All of this makes it hard to fathom what the SNB was thinking. The sharp appreciation of the franc threatens to plunge the Swiss economy into deflation and recession. The risk of balance-sheet losses for the SNB, with its euro-heavy portfolio, may be greater now that the ECB has embarked on quantitative easing. But this is no justification for abandoning its mandate to pursue price and financial stability.
The SNB's motive, it appears, was entirely political. Last year, the SNB was dragged into the highly charged debate surrounding a referendum on a “gold initiative" that would have required it to increase its gold reserves to 20%, and limited its ability to conduct monetary policy. One rationale for the initiative was to bullet-proof the SNB's balance sheet against losses. This goal was especially dear to the cantons, the states of the Swiss Confederation, which rely on transfers from the SNB for a significant share of their budgets.
The “gold initiative" was voted down, but the political debate was traumatic. In January, with the accelerating depreciation of the euro, the debate flared up again. The fear was that the SNB's balance-sheet losses might anger cantonal leaders to such a degree that the central bank's independence would be threatened.
Whether true or not, the political salience of the issue underscores the dangers of an arrangement that precludes the SNB from focusing fully on economic and price stability. The obvious solution is not to abandon the franc's euro peg, but to change the cantonal financing mechanism.
And, to those who are concerned for the SNB's independence, one might ask a fundamental question: What is independence for if not to ignore those who complain that the central bank is insufficiently profit-oriented?
The same criticism applies to the loss-sharing arrangements that the ECB attached to its quantitative easing. The ECB's priority should be to avoid deflation, not shield its shareholders from losses. The 80/20 loss-sharing arrangement with the national central banks may have made quantitative easing more palatable in Germany, but it casts doubt on the unity of the eurozone's monetary policy. In a context in which the ECB is seeking to “do whatever it takes" to vanquish deflation, this is an unhelpful complication.
Central bankers are praised softly when they make profits and criticized loudly when they incur losses. They should have the good sense to ignore both the criticism and the praise. Particularly now, the world's monetary policymakers have far more important problems to address.

February 15, 2015 2:09 pm

Oil markets need reform to reflect reality for producers and consumers
The Troll A offshore gas platform, left, operated by Statoil ASA, operates near other platforms in the Troll natural gas and oil field in the North Sea near Bergen, Norway, on Thursday, Oct. 11, 2012. Statoil is holding talks with OAO Gazprom on how to make the Shtokman natural gas project in the Russian Arctic economically viable after the partners delayed the development over costs. Photographer: Chris Ratcliffe/Bloomberg©Bloomberg
The oil crisis of today is often compared with the great oil glut of the 1980s. But demand and supply is no more unbalanced now than it was on average throughout the past decade when the price was much higher. Compared with the flood of oil that hit the markets in 1985, new supplies arriving today are ripples on the water. The world is thirsty for oil. Leading analysts see demand increasing 10 per cent between now and 2020.
Yet across the world, oil executives are watching the price of crude fall — and they are responding by dramatically scaling back their investment plans. Analysts Wood Mackenzie estimate that investment in the sector will fall by more than $100bn in 2015. Oilfield services companies have cut tens of thousands jobs over the past year, pointing to a steep reduction of demand for their services. Supply will contract, restoring balance within a year.

In 1985, investing in a new well was worthwhile if the oil it produced would fetch between $20 and $30 a barrel. Now, more oil comes from wells that are tricky and expensive to build; the break-even price is closer to $60 or $100.

Look at the market fundamentals and it seems prices should soon rebound to the $60 or $80 a barrel levels that would make it worth building the wells that the world needs. But if markets are distorted, and the rebound takes longer than it should, many current production projects will be mothballed — and the price will eventually climb to $90 to $110 a barrel, or higher.

In today’s distorted oil markets, prices do not reflect reality. They are driven instead by financial speculation, which outweighs the real-life factors of supply and demand. Financial markets tend to produce economic bubbles, and those bubbles tend to burst. Remember the dotcom bust and the subprime mortgage crisis? Furthermore, they are prone to manipulation. We have not forgotten the rigging of the Libor interest rate benchmark and the gold price.

The answer might seem to lie in more regulation. In fact, regulation is already excessive and makes things worse. The US has banned the export of oil for more than four decades, giving American oil refineries an unfair advantage over their European peers. The excise regime in the EU, which imposes levies on petroleum-based products, distorts oil consumption markets.

Sanctions against Iran affect oil supplies and trade balances.
In the long term, sanctions against Russia endanger Europe’s security of supply. The fact that oil is taxed differently in different places further distorts the terms of trade and explains why oil markets in Europe and the US have been structured differently.
Financial bubbles, market manipulations, excessive regulation, regional disparities — so grotesque are these distortions that you might question whether there is any such thing as an oil “market” at all.

There is the semblance of a market: buyers and sellers and prices. But they are performing a charade.

What is to be done? First, financial players should no longer be allowed to have such a big influence on the price of oil. In the US, Senators Carl Levin and John McCain have called for steps to prevent price manipulation, though whether they will be implemented, and when, remains an open question.

In any case, the authorities should go further, ensuring that at least 10 or 15 per cent of oil trades involve actually delivering some physical oil. At present almost all “oil trades” are conducted by financial traders, who exchange nothing but electronic tokens or pieces of paper.

We also need international action to make exchanges more transparent and to prevent price manipulation, similar to the measures taken against the Libor manipulators.

Sharing market information, such as production and consumption volumes, prices and contract conditions, would make it harder for price distortions to persist. We should make sure analysts at investment banks do not have hidden conflicts of interest.

A true market for oil, where prices reflect demand and supply, is in the interest of producers and consumers alike. They should work to create one.

The writer is chief executive and chairman of the management board of OJSC Rosneft

Up and Down Wall Street

Currency Wars: Central Banks Play a Dangerous Game

As nations race to reduce the value of their money, the global economy takes a hit. And a look at the earnings of the “S&P 499.”

By Randall W. Forsyth

Feb. 13, 2015 9:55 p.m. ET

It’s the central banks’ world, and we’re just living in it. Never in history have their monetary machinations so dominated financial markets and economies. And as in Star Trek, they have gone boldly where no central banks have gone before—pushing interest rates below zero, once thought to be a practical impossibility.
At the same time, central bankers have resumed their use of a tactic from an earlier, more primitive time that was supposed to be eschewed in this more enlightened age—currency wars.
The signal accomplishment of these policies can be encapsulated in this one result: The U.S. stock market reached a record high last week. That would be unremarkable if central bankers had created true prosperity.
But, according to the estimate of one major bank, the world’s economy will shrink in 2015, in the biggest contraction since 2009, during the aftermath of the financial crisis. That is, if it’s measured in current dollars, not after adjusting for inflation, which the central bankers have been trying desperately to create, and have failed to accomplish thus far.
Not since the 1930s have central banks of countries around the globe so actively, and desperately, tried to stimulate their domestic economies. Confronted by a lack of domestic demand, which has been constrained by a massive debt load taken on during the boom times, they instead have sought to grab a bigger slice of the global economic pie.
Unfortunately, not everybody can gain a larger share of a whole that isn’t growing—or may even be shrinking. That was the lesson of the “beggar thy neighbor” policies of the Great Depression, which mainly served to export deflation and contraction across borders. For that reason, such policies were forsworn in the post–World War II order, which aimed for stable exchange rates to prevent competitive devaluations.
Almost three generations after the Great Depression, that lesson has been unlearned. In the years leading up to the Depression, and even after the contraction began, the Victorian and Edwardian propriety of the gold standard was maintained until the painful steps needed to deflate wages and prices to maintain exchange rates became politically untenable, as the eminent economic historian Barry Eichengreen of the University of California, Berkeley, has written. The countries that were the earliest to throw off what he dubbed “golden fetters” recovered the fastest, starting with Britain, which terminated sterling’s link to gold in 1931.
This, however, is the lesson being relearned. The last vestiges of fixed exchange rates died when the Nixon administration ended the dollar’s convertibility into gold at $35 an ounce in August 1971. Since then, the world has essentially had floating exchange rates. That means they have risen and fallen like a floating dock with the tides. But unlike tides that are determined by nature, the rise and fall of currencies has been driven largely by human policy makers.
Central banks have used flexible exchange rates, rather than more politically problematic structural, supply-side reforms, as the expedient means to stimulate their debt-burdened economies. In an insightful report last week, Morgan Stanley global strategists Manoj Pradhan, Chetan Ahya, and Patryk Drozdzik counted 12 central banks around the globe that recently eased policy, including the European Central Bank and its counterparts in Switzerland, Denmark, Canada, Australia, Russia, India, and Singapore. These were joined by Sweden after the note went to press.
In total, there have been some 514 monetary easing moves by central banks over the past three years, by Evercore ISI’s count. And that easy money has been supporting global stock markets (more of which later).
As for the real economy, the Morgan Stanley analysts write that while currency devaluation is a zero-sum game in a world that isn’t growing, the early movers are the biggest beneficiaries at the expense of the late movers.
The U.S. was the first mover with the Federal Reserve’s quantitative-easing program. Indeed, it was the initiation of QE2 in 2010 that provoked Brazil’s finance minister to make the first accusation that the U.S. was starting a currency war by driving down the value of the dollar—and by necessary extension, driving up exchange rates of other currencies, such as the real, thus hurting the competitiveness of export-dependent economies, such as Brazil.
Since then, the Morgan Stanley team continues, there has been a torrent of easings (as tallied by Evercore ISI) to pass the proverbial hot potato by exporting deflation. That has left just two importers of deflation—the U.S. and China.
The Fed ended QE last year and, according to conventional wisdom, is set to raise its federal-funds target from nearly nil (0% to 0.25%) some time this year. That has sent the dollar sharply higher, resulting in imported deflation. U.S. import prices plunged 2.8% in January, albeit largely because of petroleum. But over the past 12 months, overall import prices slid 8%, with nonpetroleum imports down 1.2%.
China is the other importer of deflation, they continue, owing to the renminbi’s relatively tight peg to the dollar. The RMB’s appreciation has been among the highest since 2005 and since the second quarter of last year. As a result, China has lagged the Bank of Japan, the ECB, and much of the developed and emerging-market economies in using currency depreciation to ease domestic deflation.
The bad news, according to the Morgan Stanley trio, is that not everyone can depreciate their currency at once. “Of particular concern is China, which has done less than others and hence stands to import deflation exactly when it doesn’t need to add to domestic deflationary pressures,” they write.
But they see central bankers around the globe being “fully engaged” in the battle against “lowflation,” generating monetary expansion at home and ultralow or even negative interest rates to generate growth.
The question is: When? Bank of America Merrill Lynch global economists Ethan Harris and Gustavo Reis estimate that global gross domestic product will shrink this year by some $2.3 trillion, which is a result of the dollar’s rise. To put that into perspective, they write, that’s equivalent to an economy somewhere between the size of Brazil’s and the United Kingdom’s having disappeared.
Real growth will actually increase to 3.5% in 2015 from 3.3% in 2014, the BofA ML economists project; but the nominal total will decline in terms of higher-valued dollars. The rub is that we live in a nominal world, with debts and expenses fixed in nominal terms. So, the world needs nominal dollars to meet these nominal obligations.
A drop in global nominal GDP is quite unusual by historical standards, they continue. Only the U.S. and emerging Asia are forecast to see growth in nominal-dollar terms.
The BofA ML economists also don’t expect China to devalue meaningfully, although that poses a major “tail” risk (that is, at the thin ends of the normal, bell-shaped distribution of possible outcomes). But, with China importing deflation, as the Morgan Stanley team notes, the chance remains that the country could join in the currency wars that it has thus far avoided.
WHILE ALL OF THE central bank efforts at lowering currencies and exchange rates won’t likely increase the world economy in dollar terms this year, they have been successful in boosting asset prices. The Standard & Poor’s 500 headed into the three-day Presidents’ Day holiday weekend at a record 2096.99, finally topping the high set just before the turn of the year.
The Wilshire 5000, the broadest measure of the U.S. stock market, surpassed its previous mark on Thursday and also ended at a record on Friday. By Wilshire Associates’ reckoning, the Wilshire 5000 has added some $8 trillion in value since the Fed announced plans for QE3 on Sept. 12, 2012. And since Aug. 26, 2010, when plans for QE2 were revealed, the index has doubled, an increase of $12.8 trillion in the value of U.S. stocks.
Earnings haven’t been giving stocks much lift of late, however. As Jim Bianco of the eponymously named Bianco Research writes, the tepid 4.1% year-over-year earnings growth for the S&P 500 in the fourth quarter projected by Bloomberg is overblown. According to FactSet data, half of that gain came just from Apple (ticker: AAPL.) “The ‘S&P 499’ (S&P 500 less Apple) has a growth rate of less than 2%.”
Stocks’ recent climb has been led by a recovery in oil prices—the U.S. benchmark is back above $50 a barrel—which bounced on the notion that the surfeit of supply will end sooner than bears expect. Whether this is true or not, energy stocks have come off their lows, touched around the turn of the year. But on a technical basis, the sector now is overbought, according to Jeff deGraaf of Renaissance Macro. “When it rolls back under, we’d be sellers,” he writes in a research note.
In addition, markets remain uneasy with the planned cease-fire worked out last week in Ukraine and the continuing talks on Greece’s debts.
Anxiously awaited is Fed Chair Janet Yellen’s trip to Capitol Hill on Feb. 24 and 25, which will be watched for clues about the first rate hike. The real question is whether domestic factors will outweigh global deflation. If the Fed tightens later in the year, it will be on the other side of the currency wars. That is, if the stronger dollar’s drag doesn’t stay the hand of Yellen & Co.

02/13/2015 02:31 PM

Nuclear Specter Returns

'Threat of War Is Higher than in the Cold War'

By Markus Becker in Múnich

B-61 atomic bombs: The Ukraine crisis has increased the risk of a nuclear confrontation between Russia and the West.USAF

B-61 atomic bombs: The Ukraine crisis has increased the risk of a nuclear confrontation between Russia and the West.

The Ukraine crisis has dramatically worsened relations between NATO and Russia. With cooperation on nuclear security now suspended and the lack of a "red telephone," experts at the Munich Security Conference warn any escalation in tensions could grow deadly.

The scientists had no idea that their experiment could spell the end of civilization. On Jan. 25, 1995, Norwegian and American researchers fired a rocket into the skies of northwestern Norway to study the Northern Lights. But the four-stage rocket flew directly through the same corridor that American Minuteman III missiles, equipped with nuclear warheads, would use to travel from the United States to Moscow.

The rocket's speed and flight pattern very closely matched what the Russians expected from a Trident missile that would be fired from a US submarine and detonated at high altitude, with the aim of blinding the Russian early-warning system to prepare for a large-scale nuclear attack by the United States. The Russian military was placed on high alert, and then President Boris Yeltsin activated the keys to launch nuclear weapons. He had less than 10 minutes to decide whether to issue the order to fire.

Yeltsin left the Russian missiles in their silos, probably in part because relations between Russian and the United States were relatively trusting in 1995. But if a similar incident occurred today, as US arms expert Theodore Postol warned recently, it could quite possibly lead to nuclear catastrophe.

Deep Mistrust

"Five or six minutes can be enough time, if you have trust, if you have communication and if you can put this machinery immediately to work," former Russian Foreign Minister Igor Ivanov said on the sidelines of last weekend's Munich Security Conference. Unfortunately, he argued, this machinery works very poorly today, and there is great mistrust.

When asked what would happen today if the 1995 missile incident happened again, Ivanov responded, "I cannot be sure if the right decision would be taken."

Deep mistrust has developed between the West and Russia, and it is having a massive effect on cooperation on security matters.

In November 2014, the Russians announced that they would boycott the 2016 Nuclear Security Summit in the United States. In December, the US Congress voted, for the first time in 25 years, not to approve funding to safeguard nuclear materials in the Russian Federation. A few days later, the Russians terminated cooperation in almost all aspects of nuclear security. The two sides had cooperated successfully for almost two decades. But that is now a thing of the past.

Instead, Russia and the United States are investing giant sums of money to modernize their nuclear arsenals, and NATO recently announced that it was rethinking its nuclear strategy. At the same time, risky encounters between Eastern and Western troops, especially in the air, are becoming more and more common, a report by the European Leadership Network (ELN) recently concluded.

"Civilian pilots don't know how to deal with this," explains ELN Chair Des Browne, a former British defense minister. "One of these incidents could easily escalate. We need to find a mechanism in which we can talk at the highest level."

Brown, together with Ivanov and former US Senator Sam Nunn, the grandfather of international disarmament policy, published an analysis last week. The trio recommends "that reliable communication channels exist in the event of serious incidents." In other words, these channels currently do not exist. Recently Philip Breedlove, the head of NATO Allied Command Operations in Europe, even called for a new "red telephone," alluding to the direct teletype connection established in 1963 between the United States and the Soviet Union after the Cuban missile crisis. A direct line had been set up between NATO and the Russian military's general staff in February 2013, but it was cut as a result of the Ukraine crisis.

'A Very Dangerous Situation'

"Trust has been eroded to the point of almost being destroyed," said Nunn. "You got a war going on right in the middle of Europe. You got a breakdown of the conventional forces treaty, you got the INF (Intermediate-Range Nuclear Forces) treaty under great strain, you got tactical nuclear weapons all over Europe. It's a very dangerous situation."

In late January, the Bulletin of the Atomic Scientists set its "Doomsday Clock" to three minutes to midnight. The last time it was set to that time was in 1983, "when US-Soviet relations were at their iciest point," as the group of scientists explained. The only other time when the situation was even worse was in 1953, when the clock was set to two minutes to midnight. Unchecked climate change and the "nuclear arms race resulting from modernization of huge arsenals" pose "extraordinary and undeniable threats to the continued existence of humanity," the group's statement read.

The current rhetoric coming from the rivals in the East and West seems poorly suited to reducing the threat. "The Russian aggression is a direct threat to NATO," British Defense Secretary Michael Fallon said at the Munich Security Conference.

The situation is made more complicated by the fact that Russia's actions in Ukraine are difficult to define. With camouflage, trickery and deception, the Russians are applying the full arsenal of so-called hybrid warfare, from propaganda to cyber warfare and funding the separatists right up to clandestine military operations.

In Munich, Norwegian Defense Minister Ine Marie Eriksen Søreide demanded that Russia's aggression should be clearly identified as such. "And it goes without saying," she said, "that Article 5 of the NATO Treaty applies to such aggression." This means that if Russia were to attack a NATO member, in the way it is now intervening in Ukraine, all other member states would be required to enter the war to defend that country.

Higher Risks with Hybrid Warfare

"It (hybrid warfare) makes everything more dangerous," said Nunn, "It makes tactical nuclear weapons more dangerous, and it makes weapons material more dangerous." It is common knowledge that some of these weapons are also stationed in Germany. Up to 20 B61 aerial bombs, now being updated at great expense, are stored at the Büchel Air Base in the Eifel region of western Germany.

They are under US command, but German Tornado fighter jets would drop the bombs in the event of a war.

When asked if hybrid warfare could raise the danger of nuclear weapons being used, US diplomat Richard Burt -- who, in his role as chief negotiator, helped put together the Strategic Arms Reduction Treaty, or START, between the United States and the Soviet Union -- answered in the affirmative.

"The simple answer is yes. Both American and Russian nuclear arms are essentially on a kind of hair-trigger alert. Both sides have a nuclear posture where land-based missiles could be authorized for use in less than 15 minutes." In the situation of hybrid warfare, he warns, "that is a dangerous state of play."

"In the Cold War, we created mechanisms of security. A huge number of treaties and documents helped us to avoid a big and serious military crash," says former Foreign Minister Ivanov. "Now the threat of a war is higher than during the Cold War."

Translated from the German by Christopher Sultan

Wealth management in America

Survival of the least fit

Reports of the death of stockbroking in America were exaggerated

Feb 14th 2015
New York

IN THE depths of the financial crisis in 2009, when banks were sacking employees left and right and cutting all costs that were not related to compliance, Morgan Stanley turned heads by buying a big stockbroking unit from Citigroup. Jaundiced observers rolled their eyes.

Stockbroking was seen as a dubious business, devoted less to working with the customer than to working the customer. Worse, the rapid rise of index funds and cheap online share-trading platforms seemed to be rendering the whole industry redundant (see chart).

After a wobbly start, Morgan Stanley’s expanded stockbroking operation has put paid to such sceptical assumptions. The unit’s pre-tax margins have risen steadily and now exceed 20%, without much volatility (unlike other divisions, such as securities trading) and without prompting the kind of concerns about systemic risk that lead to new capital charges and regulations (unlike almost everything else big banks do). Partly as a result, Morgan Stanley’s share price appreciated more than any other big American financial firm in 2014. Almost uniquely among bankers, James Gorman, its chief executive, has emerged from the crisis with an enhanced reputation.

Wealth-management units, as stockbroking arms have been rebranded, are boosting returns at other American banks, too. Merrill Lynch, which collapsed during the crisis thanks to an ill-timed foray into proprietary trading, is now earning pre-tax margins of 25% as a division of Bank of America.

Industry-wide data collected by Aite Group, a consultancy, indicates that by 2013 big American wealth managers had more than recovered from the pronounced shrinkage of assets during the crisis and have since continued to grow. Their profitability has also been bolstered by a shift from charging for individual transactions to levying an annual fee of 1-2% on all the assets they manage.

In theory, wealth-management units are still redundant. There is plenty of academic evidence to suggest that retail investors are better off with index funds. In practice, however, many individuals follow the pack, and so sell when they should buy and buy when they should sell.

Wealth managers, in contrast, draw up an investment plan with clients and then stick to it. So the benefits may come more from avoiding panicked shifts in strategy than from any special skill. At any rate, a study on behalf of Merrill by Dalbar, a research firm, concluded that returns to individuals who invest on their own trail those who hire financial advisers by three percentage points a year—a vast sum, if accurate.

Wealth-management firms provide another benefit that Americans value very highly, in the form of handling the reams of paperwork needed to file taxes or handle inheritance—something online brokers do not do as well. That helps explain a dramatic reversal since 1999, when Merrill was stunned to find its market valuation had been surpassed by that of Charles Schwab, a discount broker.

Now Schwab and others like it, including Vanguard and Fidelity, are trying to become more like Merrill and Morgan Stanley, by offering more than bare-bones service.

Earlier this month, for example, in an effort to broaden its offerings, Fidelity announced the acquisition of eMoney, which provides wealth-planning products to a large number of small advisory firms who use them to bring in and retain clients. The fittest, it seems, are mimicking the unfit.