Up and Down Wall Street

A World of Speculation

A bull-market mindset takes hold in many corners of the globe. Plus, the Fed’s next move.

By Randall W. Forsyth           

June 13, 2015 1:33 a.m. ET

Bull markets may be thought of as a state of mind. The ability, indeed the desire, to believe that taking a risk will not only pay off but pay off well requires a healthy optimism. Or sometimes merely a suspension of doubt.

On the latter score, consider the case of a fledgling broker aiming to go public that, while not based in Lake Wobegon, might as well be. That is the mythical hamlet in Minnesota conjured by Garrison Keillor, “where all the women are strong, all the men are good looking, and all the children are above average.”

Which would be an ideal place for Sidoti & Co., a small brokerage firm that resists the cynicism that is an immutable strand of the DNA of its actual domicile, New York City. For, as our colleagues at The Wall Street Journal reported last week, Sidoti research analysts would indeed be home on the range, where never is heard a discouraging word. That’s because the firm issues only Buy or Neutral recommendations, never one to sell a stock.

The company, citing the so-called quiet period before its planned $35 million initial public offering, declined to comment on the matter, but the offering documents stated, “Because we do not have a ‘sell’ or ‘negative’ rating, there is the potential for investor confusion,” the Journal said. A former employee’s whistle-blower complaint to the Securities and Exchange Commission contends that Sidoti’s incentive structure rewards analysts’ marketing efforts, according to people familiar with the claims cited in the story.

Who’s to say that shares of all of Sidoti’s worthies weren’t deserving to be bought if, as with the kids of Lake Wobegon, they were indeed all above average? Anyhow, a bull market is like grading on a curve where everybody gets bumped up, so everybody wins, right?

But, as those Lotto ads used to say, you’ve got to be in it to win it. And in China, it seems, everybody is in the game. So much so, in fact, that ordinary folks appear to be playing the market more than working.

In a fascinating video package from CNBC, the locals have caught stock market fever, even in rural western China, away from the coastal metropolises. “It’s easier to make money from stocks than farm work,” according to the translation of a farmer being interviewed.

Farmers there don’t tend to their fields while the stock market is open, the report adds. And there they call a local grocer, who the piece says parlayed an $820 investment into $33,000, the “stock market goddess.”All the while, these denizens of the heartland of China monitor their stocks and trade with current-generation smartphones.

None of which comes as a shock, given the well-advertised burgeoning of new retail brokerage accounts in China. But the image of small-size stock punters has been that they were an urban species, from the shoe-shine guys proffering stock tips in the Roaring ’20s to day-trading taxi drivers in the dot.com delirium of the ’90s.

It shouldn’t be too surprising, however, that today’s smartphone technology extends the reach of market mania into northern Shaanxi province. And that has helped lift the Shenzhen exchange to the fifth-largest stock market in the world, surpassing Hong Kong and ahead of Australia, Germany, and Canada. Only the New York Stock Exchange, Nasdaq, Shanghai, and Japan are bigger.

And while there’s no connection to the evident speculative froth in parts of China’s stock market, MSCI’s decision to delay inclusion of Chinese A-shares in its global emerging-market benchmarks seems prudent. By some estimates, including A-shares would eventually have directed some $400 billion into that sector by funds that track MSCI indexes.

The recent episode of Hanergy Thin Film Power Group shows why the choice of what to include in an index is important (“TAN or Burned,” Up & Down Wall Street, May 25). Despite questions about its valuation and business model, the Chinese company soared, then lost $15 billion in value in less than half an hour. In the meantime, Hanergy had become a major holding of a number of U.S. exchange-traded funds, after the stock got picked up by relevant indexes, including Guggenheim Solar (ticker: TAN), simply because of its bloated market capitalization. The experience ought to serve as a cautionary tale of the danger of mindless, mechanical index investing.

Americans’ financial boats also have been among those lifted by the rising stock market tide. According to the latest Federal Reserve Financial Accounts (what used to be called the Flow of Funds), U.S. households’ net worth increased some $1.6 trillion in the first quarter, to a record $84.9 trillion, mainly on gains in the equity market, as well as the recovery in residential real estate.

As Billie Holliday crooned, “Them that’s got shall have.” The equity-market gains accrue mainly to the richest 10% who own about 80% of stocks. As for “them that’s not shall lose,” more than 15% of homeowners were still underwater—that is, owing more than their houses are worth—at the end of the first quarter, according to Zillow, despite the comeback in residential real estate. While that’s an improvement from 16.9% at the end of 2014, it still leaves some four million homeowners still 20% underwater while they wait for the housing recovery to bail them out.

Meanwhile, according to an article in Investment News, brokerage firms are pushing securities-backed loans through independent investment advisors. For years, the big-name wire houses have marketed these loans to their own customers with the pitch that they’re a cheap source of credit to fund big purchases, such as yachts or houses, without disturbing their investment portfolios.

Of course, the firms get to make money on the loans and keep the assets from leaving the building, not a trivial consideration when asset size instead of transactions increasingly drives brokers’ compensation. As for the customers, Josh Brown of Ritholtz Wealth Management was quoted as calling these loans the “rich man’s subprime.”

The economist Hyman Minsky described three phases of borrowing: hedge borrowing, in which cash flow from the investments pay off the loan; speculative borrowing, where earnings cover the debt service but have to be rolled over; and Ponzi borrowing, which depends on selling an asset at a high enough price to repay the debt.

If we’re not at the speculative stage entirely, it would appear we’re headed in that direction, with margin debt at a record and small brokers touting small stocks that are only buys.
(Anybody remember Bob Brennan promoting penny stocks from his helicopter in the 1980s bull market?) Elsewhere, as in China, they’re parlaying their cash like the pimply-faced office guy in the 1990s who exhorted his boss to “light this candle” to day-trade in a memorable online brokerage ad of the time. Or like the house-flippers of the past decade who followed cable-TV gurus’ advice to become real estate moguls with no money down.

So what could go wrong? That question tends not to intrude on a bull-market mind-set.

In that CNBC video on rural Chinese investors, the aforementioned stock market goddess suggested that her followers keep an eye on economic policy. Good advice, given that the 100%-plus rise in the Shanghai market since late last year has come in the wake of officials applying repeated monetary stimulus to counter the slowdown in the real economy.

And Lombard Street Research’s Diana Choyleva writes, Beijing probably wants to keep the rally going for two reasons: to allow rebalancing in the banking system, and for domestic social stability. A property destabilizes because only the rich with assets can play. But even rural residents with a few yuan and a smartphone can get in on the stock market. Be that as it may, U.S. fund investors showed signs of skittishness as they yanked the most money from emerging markets in seven years, withdrawing nearly $8 billion from Asian equities in the past week.

Policy makers around the globe also have taken greater interest in markets recently—mainly currencies—which affects everything else, including interest rates and equities. President Barack Obama early in the week disputed reports that he complained to his fellow Group of Seven heads of state that the dollar was too strong. Similarly, German Chancellor Angela Merkel backed off reported comments that a higher euro is unhelpful to the weaker members of the currency union that have to carry out reforms.

Meanwhile, New Zealand and South Korea cut interest rates last week to bolster growth and curb their currencies.

With politicians focused on monetary matters, the Federal Open Market Committee meets this week amid intense scrutiny about the timing of the liftoff in its federal-funds target. Nothing will happen at this confab, but the key will be revisions in the panel’s economic forecasts and guesses about the funds rate embodied in the “dot plot” charts. The consensus among Fed watchers continues to be a September hike, although the fed-funds futures suggest that December is more likely.

While the Standard & Poor’s 500 eked out a gain barely detectable with the naked eye, all of 0.06%, it did manage to break a two-week losing streak. But it ended the week on a decided downbeat, slumping some 0.7% on Friday amid an array of worries, including the never-ending Greek drama. Markets may not be looking for the Fed to do anything, but they will be waiting on tenterhooks for what Yellen & Co. have to say this week.

The world economy

Watch out

It is only a matter of time before the next recession strikes. The rich world is not ready

Jun 13th 2015 

THE struggle has been long and arduous. But gazing across the battered economies of the rich world it is time to declare that the fight against financial chaos and deflation is won. In 2015, the IMF says, for the first time since 2007 every advanced economy will expand. Rich-world growth should exceed 2% for the first time since 2010 and America’s central bank is likely to raise its rock-bottom interest rates.

However, the global economy still faces all manner of hazards, from the Greek debt saga to China’s shaky markets. Few economies have ever gone as long as a decade without tipping into recession—America’s started growing in 2009. Sod’s law decrees that, sooner or later, policymakers will face another downturn. The danger is that, having used up their arsenal, governments and central banks will not have the ammunition to fight the next recession.

Paradoxically, reducing that risk requires a willingness to keep policy looser for longer today.

The smoke is clearing
The good news comes mainly from America, which leads the rich-world pack. Its unexpected contraction in the first quarter looks like a blip, owing a lot to factors like the weather. The most recent data, including surging vehicle sales and another round of robust employment figures, show that the pace of growth is rebounding. American firms took on 280,000 new workers last month. Bosses are at last having to pay more to find the workers they need.

In other parts of the rich world things are also looking up. In the euro zone unemployment is falling and prices are rising again. Britain’s recovery has lost a bit of puff, but strong employment growth suggests that expansion will continue. Japan roared ahead in the first quarter, growing by 3.9% at an annualised rate. A recovery so broad-based and persistent is no fluke.

Inevitably fragilities remain. Europe is deep in debt and dependent on exports. Japan cannot get inflation to take hold. Wage growth could quickly dent corporate earnings and valuations in America. Emerging economies, which accounted for the bulk of growth in the post-crisis years, have seen better days. The economies of both Brazil and Russia are expected to shrink this year. Poor trade data suggest that Chinese growth may be slowing faster than the government wishes.

If any of these worries causes a downturn the world will be in a rotten position to do much about it. Rarely have so many large economies been so ill-equipped to manage a recession, whatever its provenance, as our “wriggle-r
oom” ranking makes clear. Rich countries’ average debt-to-GDP ratio has risen by about 50% since 2007. In Britain and Spain debt has more than doubled. Nobody knows where the ceiling is, but governments that want to splurge will have to win over jumpy electorates as well as nervous creditors. Countries with only tenuous access to bond markets, as in the euro zone’s periphery, may be unable to launch a big fiscal stimulus.

Monetary policy is yet more cramped. The last time the Federal Reserve raised interest rates was in 2006. The Bank of England’s base rate sits at 0.5%. Records dating back to the 17th century show that, before 2009, it had never fallen below 2%; and futures prices suggest that in early 2018 it will still be only around 1.5%. That is healthy compared with the euro area and Japan, where rates in 2018 are expected to remain stuck near zero. When central banks face their next recession, in other words, they risk having almost no room to boost their economies by cutting interest rates. That would make the next downturn even harder to escape.

The logical answer is to get back to normal as fast as possible. The sooner interest rates rise, the sooner central banks will regain the room to cut rates again when trouble comes along. The faster debts are cut, the easier it will be for governments to borrow to ward off disaster.

Logical, but wrong.
Raising rates while wages are flat and inflation is well below the central bankers’ target risks pushing economies back to the brink of deflation and precipitating the very recession they seek to avoid.

When central banks have raised rates too early—as the European Central Bank did in 2011—they have done such harm that they have felt compelled to reverse course. Better to wait until wage growth is entrenched and inflation is at least back to its target level. Inflation that is a little too high is a lot less dangerous for an economy than premature rate rises are.

Because America’s recovery is strongest, that is where debate about how fast to return monetary policy to normal is fiercest. Hawkish voices at the Fed argue that, with unemployment below 6% and hiring continuing at a torrid pace, it is plainly time to start raising interest rates. In this view, wages and prices are bound to pick up in future. Meanwhile excessively low rates are inflating asset prices and creating long-run financial risks. Those risks are real but manageable. Regulators have the ability to let the air out of asset prices by tightening rules on leverage and liquidity. An economy at full employment and with a healthy level of inflation will be better positioned to withstand a bout of financial instability than one that is flirting with deflation.

The best defence
Governments can also do their bit. There has still been shamefully little growth-boosting investment in infrastructure. The OECD, a club of mostly rich countries, was right to rap George Osborne, Britain’s finance minister, on the knuckles for the scale and pace of his proposed public-spending cuts. Growth is better than austerity as a policy for bringing debts under control. Governments should instead direct their energies towards overdue reforms to product and labour markets. Open product markets encourage enterprise. The freedom to hire workers under flexible contracts is the best way to keep people out of unemployment. Both reforms make an economy better able to cope with the next shock.

Having fought off the effects of the financial crisis, governments and central banks are understandably eager to get back to normal. The way to achieve their goal is to allow the recovery to gather strength first.

Review & Outlook

The Return of Growth Economics

Passing a trade bill would mark the start of a new policy direction.

June 11, 2015 6:50 p.m. ET

Photo: Getty Images

The House vote on trade-promotion authority scheduled for Friday is a key political test for Congress, and as we went to press Thursday Democrats and labor were making a last-ditch effort to kill it. But if a GOP majority puts the bill on President Obama’s desk, the moment could mark the start of a return to the politics of economic growth heading into the 2016 election.

The last major U.S. economic policy turn arrived in 2007 with the Pelosi Congress and the lame-duck Bush Administration. Keynesian “stimulus” spending became the policy default, accompanied by a wave of regulation across the private economy. The financial meltdown accelerated the trend by putting Washington back at the commanding heights of the economy, where it has remained. The result has been the weakest recovery in decades and stagnant real incomes.

Reviving so-called fast-track trade authority is a first step toward a return to the politics of growth over redistribution. The U.S. hasn’t negotiated a new trade pact from start to finish in nearly a decade, though in 2014 nearly half of U.S. goods exports went to our 20 free-trade partners. This has left U.S. companies at a disadvantage as competitors get an advantage in foreign markets.

But freer trade is about far more than increased exports or market share, as David Ricardo and Adam Smith taught. Open trade is more crucial for the imports that force U.S. firms to stay competitive.

Free trade breaks up domestic oligopolies the way Japanese autos did Detroit’s Big Three.

Americans benefit from lower-priced goods and stronger employers that can’t afford to become complacent.

Passing the trade bill will also open the way to a Pacific trade pact involving 12 nations that are some of the world’s fastest-growing markets. This includes Vietnam and the Philippines in Asia but also Chile, Peru and Mexico in this hemisphere.

A Pacific pact is central to Prime Minister Shinzo Abe’s reforms in Japan, which is essential to shake the world’s third largest economy out of 25 years of lethargy. It will also help the U.S. counter China’s growing clout in the Pacific, forcing Beijing to make further reforms if it wants to join a Pacific free-trade zone. More trade means faster growth which means expanding possibilities for political freedom—the opposite of the trend since 2006.

Some Republicans fret that Mr. Obama cannot be trusted with such negotiating power, though Presidents of both parties have had them. This gives his fading Presidency too much credit. The fast-track bill includes numerous provisions to block Mr. Obama from using a trade negotiation to impose an agenda he can’t otherwise get through Congress. If Mr. Obama’s Iran negotiations were subject to the same Congressional scrutiny that applies to trade, his nuclear deal would be dead on arrival.

Mr. Obama’s Presidency will vanish in 19 months, and his successor might be a Republican who will also want trade authority. A GOP White House and Congress will have a long list of priorities and limited political capital, so better to get fast track in the bank now.

Which brings us back to the potential for a return to growth economics. The House Republican majority is the largest since 1928, and key reformers are in place at key committees. Ways and Means Chairman Paul Ryan, who will deserve more credit than Mr. Obama if fast track passes, can then turn to setting the stage for tax and other reforms.

Trade may be the last major bipartisan accomplishment of this Congress given that Mr. Obama retains his veto. Democratic leaders are talking as if they will block spending bills and most other legislation to make the Senate look as dysfunctional as it was when they ran it.

But that shouldn’t deter the GOP from making incremental progress when possible. That could mean some corporate tax reform and income repatriation from overseas that could finance roads and bridges. They may also be able to ease the permitting for natural gas exports or lift the ban on oil exports.

Above all the GOP can set the stage for 2016 by pushing pro-growth initiatives that show voters what could happen if they elect a Republican President. The model here is the late 1970s when Jimmy Carter was President but the winds of reform fanned by William Steiger and Jack Kemp swept through even a Democratic Congress. Eventually House Republicans informed the Reagan agenda that led to the policy revolution that produced the boom of the 1980s.

It’s never easy to predict a major policy turn, and we’ve been too optimistic before. But Republicans have to start somewhere, and Friday’s trade vote is a down payment on their political sincerity and growth agenda. Mr. Obama will soon be yesterday’s man. The Republican Congress has a chance to set tomorrow’s agenda.

America’s economy

Better than it looks

America’s disappointing economy is more robust than it first appears. But higher interest rates are on the horizon, and could bring unexpected risks

Jun 13th 2015

ONE of the ways in which America’s economy leads the world has been, of late, an unrivalled capacity for sending mixed messages. The past six months provide a case in point. The year opened with things looking pretty good: strong growth in late 2014 had led the IMF to project that GDP would rise by 3.1% in 2015; the Congressional Budget Office, America’s fiscal watchdog, expected a 3.4% expansion. In March and April, though, bad news built up, and in May official numbers confirmed that tumbling investment and exports meant that over the first quarter GDP had actually been falling at an annualised rate of 0.7%.

Then the good news came back. In early June data from the Bureau of Labour Statistics (BLS) showed hourly pay rising at an annualised rate of 3.3% in the first quarter and a 280,000 increase in employment in May, both far better numbers than economists had predicted.

This hot and cold pattern is becoming familiar. In 2014 predictions of a more modest 2.6% expansion were also dashed by a weak start to the year. Since growth returned in 2010 it has never beaten 2.5% over a whole year, and often fallen short. This has led some economists to worry that America will never get back to its pre-crisis 3% growth rate and may instead be stuck in a low-growth rut.

If they are right, it would be a huge problem well beyond America’s shores. The world economy is short of momentum: the big emerging markets, previously reliable growth engines, are struggling. Brazil and Russia face deep recessions, and China’s growth is slowing. The IMF predicts that, for the first time since 2007, there could be growth in every advanced economy this year, at an overall rate of 2.4%. But without American impetus the global recovery could come to a halt.

Pessimists cite persistent weakness in consumption and an edging up of the savings rate as signs that this much-needed American growth cannot be relied on. Yet the pessimists, like the optimists, keep having their narrative interrupted by indicators which just don’t fit.

On the basis of the year to date, the optimists have the better case. Poor performance in the first quarter can be ascribed to two particular shocks, a fall in the price of oil and a rise in the value of the dollar. Both now seem over, and the former, at least, unlikely to recur. With household debt much lower than it was and wages rising, the economy looks likely to be stronger than many expect. The worry for the next six months is less that growth will not return, more that concern about financial bubbles will encourage the Federal Reserve to raise rates before wage rises gain enough momentum. Real prospects for further growth could thus be dashed.

Excluding the plunge that started in autumn 2008, from which it mounted a partial recovery fairly quickly, the fall in the oil price from $104 a barrel in July 2014 to $47 in January was the largest six-monthly drop since 1986. Such a fall was reasonably expected to be good news when it comes to consumption—but not so good for the companies that make America the world’s largest oil producer.

Those companies reacted with impressive speed: by November 2014, just four months after oil prices started to slide, the number of active oil rigs had started to fall, too (see chart 1). A year ago the Eagle Ford and Permian basins in Texas boasted 763 active rigs, according to Baker Hughes, a consultancy.

By the end of May they had 342. As well as winding down existing wells, firms have stopped investing in new ones: government figures for investment in mines and oil and gas wells show it falling by $20 billion (more than 15%) in the first quarter of 2015.

So the industry’s contraction was fast and deep. But the countervailing surge in consumer spending never arrived. Petrol prices have fallen by 20% or more across the country; on June 1st they averaged $2.66 a gallon (€0.52 a litre). Produce the price of which depends a lot on transport costs, including fruit, vegetables and dairy products, has become correspondingly cheaper, which is part of the reason why the overall inflation rate has fallen from 1.7% in May 2014 to just 0.1% now. Nevertheless, consumption in the first quarter of 2015 grew by just 1.8%, much more slowly than it had in 2014. Rather than spend their cheap-oil dividends, people saved them. The household-saving rate rose from 4.7% to 5.6% between August 2014 and April 2015. Some analysts blame a bitterly cold February, which kept shoppers indoors.

The second shock was the value of the dollar, which rose in part because people expected further growth to be stimulated by a cheap-oil spurt in spending that never came about. That expectation, on top of a 3.6% annualised growth rate in the second half of 2014, made higher interest rates look imminent. American bonds thus took on a new allure, and as investors piled in the dollar rose by almost 9% in trade-weighted terms.

The rise, exacerbated by labour disputes at California ports, hurt exports even more than might have been expected. Adjusted for inflation they fell at an annualised rate of 7.6% in the first quarter. The drop in net trade (exports less imports) nudged up America’s current-account deficit, which now stands at $410 billion (2.4% of GDP), with the fourth quarter of 2014 showing a 30% deterioration compared with a year earlier. And by making foreign sales worth less back home, the strong dollar also had an effect on corporate profits, which fell by $125.5 billion, or 5.9%, between the last quarter of 2014 and the first quarter of 2015. But the worst of this seems over; the dollar’s appreciation has halted and, indeed, partially reversed—it has depreciated 2% since March,

Shocked, but stirring
The optimistic view is that, having absorbed the oil and dollar hits, there is now nothing between the economy and its deferred growth spurt. Yet there are niggling worries. February may have been cold, but March and April were less so—and yet consumption dropped in those months, too. And industrial production has fallen for five months in a row; between March and April it fell by an annualised 3%.

When numbers like these keep coming it is hard to believe the slowdown is temporary.

Hence the idea of “secular stagnation”. First set out in the 1930s by Alvin Hansen, it is a way of explaining depressions from which economies fail to recover in terms of a persistent mismatch between the supply of savings and the demand for investment. Reviving the idea in 2013, Larry Summers, a former treasury secretary, suggested that demand for investment had fallen because of technological advances that reduce the amount of capital it takes to start a firm.

At the same time, the supply of funds with which to invest has become plentiful, as a combination of ageing and inequality (old and rich people save more), as well as foreign bond-buyers, push savings higher. With a low enough interest rate this could be put right. But if, for an interest rate to be low enough, it needs to drop below zero, sorting things out may well be beyond the powers of the central bank. Thus interest rates can be at the same time both extremely low and too high. The damaging results include low growth, slack credit demand, weak investment and stubbornly high unemployment.

Although this analysis fits some economies—notably the euro zone and Japan—disturbingly well, it is at best only a partial description of America. There are three areas where things don’t look quite as bad as the secular stagnationists would predict. First, if interest rates had been consistently too high, capital expenditure would probably have stalled. But non-residential investment is up by 8% in real terms since its 2008 peak, and by 35% since its 2009 trough. As the government share of GDP shrank following the crash, investment took up the slack. It is true that investment fell in the first quarter of 2015, but that can be put down to the revenue-starved oil sector. Leave the extractive industries out and business investment actually rose by an annualised 1%.

Nor do credit markets suggest that interest rates are too high. American bosses are in a bullish mood. Far from weak demand for funds, borrowing is soaring. Companies are issuing debt at record rates, with $609 billion raised so far in 2015, up by $40 billion on a year ago according to Dealogic, a consultancy. Bank lending to business is strong too, up by 12% in the year to April, according to Federal Reserve data. As some of this money is spent on new offices, machines or software, this surge in credit should end up in some new investment.

A reassuring reduction in Americans’ debts up to the beginning of this year is a second reason for cheer. The latest data show the average household is in robust form, says Aneta Markowska of Société Générale, a bank. The ratio of mortgage debt to GDP has fallen below 80%, back to its 2002 level (see chart 2). Total household debt is around 107% of disposable income, with annual payments taking up less than 10% of disposable income, the lowest amount since at least 1980. (By comparison household debt is 136% of disposable income in Britain.) Household net worth (total assets minus liabilities) is at a record high in real terms, and is close to its pre-crisis peak as a share of GDP.

The third reason is the labour market. The rosy BLS data on pay increases and new jobs are part of a longer trend. Joblessness has fallen consistently since 2010. At 5.4%, unemployment is well below the post-1970 average. The trend shows little sign of slowing. Data on job openings and turnover collected by the BLS show there were on average 5m job openings in each of the first three months of 2015, the highest level since records began in 2000. A faster rise in the number of openings than the number of hires suggests competition for labour might be heating up (see chart 3). The market is fluid too. The number of workers leaving posts has increased, because more workers are quitting: a monthly average of 2.7m workers have left their jobs in 2015. This fact, together with strong data on hiring, suggest that these workers are moving on to better jobs.

Disunited states
There are still reasons to worry. The most recent data show that America’s labour productivity is stalling. The figures released by the BLS in early June showed workers’ output per hour had fallen by 3.1% between the last quarter of 2014 and the first of 2015. The drop was marked in the durables manufacturing sector, which fell by 3.3%; it meant that productivity is up by only 0.3% in the past year. That said, American productivity is still up by 11% since 2007, meaning that it is not yet as worrying as that of its European peers (in Britain output per hour fell over the same period).
If America is not suffering from secular stagnation, the competing explanation is that the country has yet to emerge fully from the financial crisis. James Sweeney of Credit Suisse, a bank, sees the problem in terms of a patchwork of localised depressions. A state-by-state analysis of GDP lends support to this idea. Many regions are growing well: in 14 states real-terms GDP rose by more than 10% between 2009 and 2013. Oregon and Texas expanded by more than 15%—North Dakota’s shale boom pushed output up by an astonishing 55%. At the other end of the scale are ten states, including Maine, Missouri and Nevada, hardly growing at all.

This analysis suggests that the aggregate figures are being held back by states and regions that are yet to recover from the first stage of the crisis: the period of negative equity and tight consumer credit that followed the 2008 housing crash. An analysis of housing data seems to confirm this: growth has been weakest in states which suffered the biggest price drops in 2006-10; strongest where prices tumbled least (see map). But things are turning. Mr Sweeney finds that even in the states that suffered the biggest busts, previously tight credit markets are starting to ease.

Differing views on America’s ailment—a long-term stagnation, or a balance-sheet recession that is easing—influence what economists think should happen to interest rates, which have been unchanged since the end of 2008. The IMF is dovish. In a review published on May 28th its economists recommended that unless there is new evidence of strong wage- or price-inflation, interest rates should not be raised until early 2016. The Bank for International Settlements, a central-banking body based in Basel, takes a different view. Its economists worry that low rates lead to asset-price bubbles, and suggest that it would be wise to start tightening as soon as possible before such bubbles are further inflated by cheap money.

Janet Yellen, who chairs the Fed, and her rate-setting colleagues are likely to take a middle path. Minutes of their meetings show they watch the labour market closely. Each new data point showing rising wages and tightening markets makes a change in September more likely.

At the same time, a further rise in the dollar based on the expectation of such a rise could self-defeatingly delay it by reducing growth prospects again. Knowing the question to be so finely balanced, analysts will pore over week-by-week data to try and divine Ms Yellen’s intentions.

Easy does it
After six years of cheap money, higher interest rates will weigh on borrowers. Prudent investors should keep an eye on America’s firms and equity markets. Despite modest growth over the past five years, companies’ share prices have shot up, with the S&P 500 index rising by 95%. Firms’ earnings have not justified the rise: data collected by Robert Shiller, an economist at Yale University, suggests equities are valued at around 20 times earnings, more than 30% above their long-run average; adjusted for the business cycle things look even worse. Some punters are borrowing to invest, with NYSE data showing margin debt—lending to invest in stocks—rising by 14% since January from $445 billion to $507 billion.

Whether or not this adds up to a bubble, it certainly looks like a market that could stall when interest rates rise and other assets, like bonds and deposits, become more tempting. And it is quite possible that firms’ earnings will soon fall. Staff costs are rising: a combination of higher hourly pay and lower productivity mean unit labour costs rose by 6.7% in the first quarter.

Companies’ bullish borrowing gives them more interest to pay. As earnings growth has slowed, the number of American firms with low credit ratings (BBB- or below) has risen, according to data from Moody’s, a credit-rating agency. If earnings do drop then the mix of high valuation and leveraged investors will sharpen the fall.

The idea that the pain which may be in store for the equity markets can be lessened if rates are raised sooner may seem to add to the case for tightening. History, though, warns against such reasoning. In August 1929, worried about overheating stockmarkets, the Fed raised rates despite signs that the underlying economy was none too strong. The move did not stop the subsequent crash; instead it helped precipitate the worst recession in American history. In the mid-2000s central banks tried the opposite, setting rates for the real economy and leaving markets to correct themselves. The results were equally bad.

This is not 1929. But the lesson is that since markets and the real economy can move at different speeds, central banking must be about more than interest rates. New “macroprudential” tools such as raising capital, liquidity and leverage requirements offer central banks ways to curb excesses in equity markets and sectors with too much borrowing; better that the Fed make use of them than that it tighten interest rates prematurely.

Interest rates should be set with an eye to the real, not financial, economy. Keeping them low will help households in the hardest-hit American regions overcome their lingering balance-sheet recession. It will also ensure that the wage pressure that builds up is not yet another blip.

Better, then, to wait. America seems not to be facing all-out stagnation and its households—if not, necessarily, all of its corporate sector—will be able to absorb higher interest rates when they come. But the time for that is not quite here.

The Fallacies of GDP

 By: Alasdair Macleod
Friday, June 12, 2015

The common error of confusing growth with progress goes largely unnoticed, though it permeates all macroeconomic analysis. There is no better example of this mistake than the fallacies behind the interpretation of Gross Domestic Product. GDP is the market value of all final goods and services in a given year. As such, it is only an accounting identity reflecting the quantity of money in the economy.

Econometricians constructing GDP have devised a sterile statistic that should not be used to set economic policy. It leads to the common error of assuming any increase in GDP is desirable.

Statistics like GDP tell a story of an economy based on historical prices but devoid of any qualitative value; and progress, the improvement in the human condition, is what really matters.

Transactions reflecting both wealth creation and also economically destructive state spending are included in GDP without differentiation. Far from the government component of GDP being singled out from the total, it is often welcomed as contributing to economic growth.

Macroeconomists, with an eye on the statistical impact of cuts in government spending, discourage governments from making them. The lack of distinction between wealth-creation and wealth-destruction is fundamental to their belief that state intervention is beneficial.

More light can be shed on this issue with an example. Imagine an economy with a fixed quantity of money and credit; further assume foreign trade is in balance, and that the population is stable. Products will succeed, stagnate or fail. People will get pay rises, pay cuts or be encouraged by reality to move from the least successful businesses into more successful businesses. The businesses of yesteryear fade and those of tomorrow evolve. Winners will redeploy resources released from the failures. Annual GDP, the sum total of all production paid for by everyone's earnings and profits, will therefore be unaltered from the previous year: it is a zero sum, assuming that as a whole people's money preferences relative to goods do not change. Without the injection of extra money, people are always forced to choose between items: they cannot add to the purchasing power of their income through extra credit created out of thin air, creating demand that otherwise would not exist.

Progress is, therefore, marked by improved products and lower prices, because as the volume and quality of production increases the total money value of them must remain the same. This is true for both final products and for investment in the higher orders of production. But importantly, GDP growth is nil.

Now we must consider what happens in the case of unsound money; that is to say money and credit that can be expanded by the will of the state and the banks it licences. Over a period of time, this new money is absorbed into the economy, reflected in new transactions that otherwise would not have occurred. The value of transactions attributable to the expansion of money and credit is likely to be a multiple of the new money introduced, as it passes from the original beneficiaries to later receivers.

If we assume this is a single expansion of the quantity of money these new transactions will only be a temporary feature. The prices of goods bought with the new money rise to compensate with a time lag. Having initially expanded, real GDP would then contract as the temporal lag between stimulus and price effect is fully unwound. With all transactions fully accounted for real GDP ends up unchanged, always assuming there has been no change in consumer preferences between money and goods.

The dubious benefit of stimulating demand by increasing the quantity of money and credit has been only temporary. Changes in GDP described above reflect not economic progress, but the absorption of the extra quantity of money and credit deployed. If the matter stopped there, the damage to a properly functioning economy would be limited, but monetary inflation also triggers a transfer of wealth from the majority of people to a small rich minority. This happens because price increases spread from where the new money is first deployed (typically through the banks and financial markets), leaving the majority of people to face higher prices with no offsetting monetary benefit.

There is, therefore, a secondary impact: the apparent benefit of increasing the quantity of money is followed by a fall in demand for goods and services because of the wealth-transfer effect, the opposite of the intended result. The economy as a whole ends up worse off than if no monetary stimulus had occurred. This is why extreme monetary inflation is always accompanied by economic collapse.

In the foregoing example, the effect of a single injection of additional money and credit was considered, but once this policy is embarked upon it is almost always continued at a compounding pace. Macroeconomists note only the initial benefits, and when they fade, as described above, they clamour for more. The result over time is that weak-money policies lead to the continual currency debasement with which we are familiar today, together with the build-up of debt, which is the counterpart of expanding bank credit. As the currency buys less, more is required to achieve the same initial effect.

That changes in money and credit do not equate accurately to changes in GDP in practice is partly due to econometricians selecting which activities to include in GDP. They interpose an artificial distinction between categories of spending with the intention of isolating spending on new goods and services deemed to be consumption. This is an error, because these economists are forced into making a subjective judgement that is bound to be at odds with reality. In practice, a consumer can only be described in the broadest terms.

Consumers may spend money on buying assets such as housing, art or stocks and shares: there is no difference between spending on these and on anything else, because they all have a valid purpose in the mind of the consumer. In addition, there are unrecorded transactions on the black market or not recorded from small businesses, as well as transactions in second-hand goods which are specifically excluded on the grounds that the purpose of GDP is to record new production only. Therefore, much economic activity is excluded from the GDP calculation with the complication that money will flow between the econometrician's version of GDP to the wider transaction universe, undermining all the macroeconomists' attempts to link an increase in prices to an increase in the quantities of money and credit.

In conclusion, GDP has nothing to do with economic progress. It is a flawed statistic that imperfectly summarises the money-value of selected transactions over a given period. The fact it is usually positive is a reflection of the temporal difference between monetary inflation and the lagging effect on prices, and has nothing to do with economic progress.

June 10, 2015 5:49 pm

Luxury goods face a global reckoning

John Gapper

The China crackdown shows what can occur suddenly to conspicuous consumption 

Ingram Pinn illustration©Ingram Pinn
As if the luxury goods industry were not already in a fragile mood, Johann Rupert, chairman of Richemont, owner of Cartier and Van Cleef & Arpels, gave it more to worry about this week.
He warned of the damage it faces from growing wealth inequality, and resentment among the have-nots of those who flaunt luxury watches and jewellery.
“What keeps me awake at night is how society will cope with structural unemployment and envy, hatred and class warfare,” he told the FT Business of Luxury Summit in Monaco, discussing his fear that artificial intelligence will kill jobs. “The people with money will not wish to show it. If your child’s best friend’s parents are unemployed, you won’t want to buy anything showy.”

From where I sat, listening to him, a revolution did not appear to be in progress. Ferraris were driving up to the hotel and multi-decked yachts, some with helicopter pads, filled the harbour.

“You are as paranoid as I am,” Ralph Lauren once told Mr Rupert, who concluded: “If you have a healthy dose of paranoia, you survive.”

But just because you are paranoid, it does not mean that people are buying as many of your watches as they used to. Even if Mr Rupert’s dystopia has yet to materialise, some cracks are appearing in the luxury goods industry after a two decade-long boom. During that time, global luxury sales have only fallen twice — in 2003 and 2008-09 — and then rebounded immediately.

One crack is in the market for “affordable luxury” of the kind offered by US companies such as Michael Kors, Coach and Kate Spade, which have grown strongly since 2010. Kors disclosed a 6 per cent fall in quarterly same-store sales last month, with tourist shopping in the US down and consumers shifting from watches to lower-priced jewellery. Coach has suffered similarly.
A second crack, even more worrying for the industry, is the weakness in luxury goods and fashion sales in China. This is a result of the crackdown on Communist party corruption, which has hit the local habit of giving expensive gifts to well-connected officials. Bain & Co expects that luxury goods sales will fall in China in 2015 after years of being the biggest growth market.

A word that designers abhor — “discount” — was mentioned freely in Monaco. “We Chinese demand discounts. We love discounts!” said Sir David Tang, founder of Richemont’s Shanghai Tang and an FT contributor. He recalled talking to one of China’s richest women about shopping in Europe. “How much discount? And I want the [sales tax] back,” she said.

Sluggish sales and high prices in China compared with Europe have made Gucci and others run half-price sales to lure shoppers back into their expensive flagship stores. “The good old time for luxury brands in China is gone. I don’t know when it is coming back — maybe never,” said Jiang Shan of Prowon Consulting, a Shanghai-based adviser to wealthy shoppers.

The luxury industry is hardly falling apart. Global sales of luxury goods rose by 2 per cent to €223bn last year, triple the size of the market 20 years ago, according to Bain. But the industry’s capacity to defy financial gravity is in question. It “badly needs a new growth frontier”, warned Luca Solca, an Exane BNP Paribas analyst.
Much hope is attached to expanding digital sales. Mr Rupert appealed this week for LVMH and Kering, the French luxury groups, to join the online retailer being created by the merger of Yoox of Italy and Richemont’s Net-a-Porter. E-commerce currently contributes only about 6 per cent of luxury sales, compared with 32 per cent through branded stores, so there is room to grow.
But Mr Rupert is right to fret about the bigger picture. The market for fashion and luxury has deepened and broadened during the past two decades. Not only the wealthy but also the middle classes were eager to acquire high-quality, aspirational goods. “Hard luxury” watches and jewellery, and accessories such as Chanel handbags, are widely flourished as style signifiers.
This is being challenged at both ends of the market. Faltering results at Coach and Michael Kors reflect subdued income growth in the US, despite the economic recovery. The broader segment of shoppers on whom the industry now relies find themselves less able to afford affordable luxury.

There are still plenty of millionaires and billionaires in the world — more than ever. But the China crackdown shows what can occur suddenly to conspicuous consumption. Officials there no longer want to be seen wearing expensive watches or driving in flashy cars. A life of luxury will continue as usual in US and European enclaves such as Palm Beach and Monaco, but elsewhere the mood could swing.

Perhaps discretion will be in more demand: minimalist jewellery instead of bling; Audis instead of Ferraris (although Ferrari plans an initial public offering); silver watches rather than gold chronometers. A yacht is hard to disguise, but it can be sailed out of sight of public beaches.

On the bright side, a reckoning would allow designers to offer something new. “They thrive on this grungy, poor, out-of-a-job look,” Mario Testino, the Vogue and Burberry photographer remarked sadly of some fashion photographers’ work, contrasting it with his sunny, optimistic approach. They could be on to something, Mario.

Greece accuses Europe of plotting regime change as creditors draw up ultimatum

The European Commission braces for a “state of emergency” in Greece, fearing social unrest and a break-down of basic supplies

By Ambrose Evans-Pritchard

8:56PM BST 15 Jun 2015

Alexis Tsipras called on the IMF to “adhere to realism”.
Greek premier Alexis Tsipras has accused Europe’s creditor powers of trying to subvert Greece’s elected government after five years of “pillaging”, warning in solemn terms that his country will defend its sovereign dignity whatever the consequences.
The defiant stand came as the European Commission lashed out at the Greeks and warned that the country would collapse into a “state of emergency” unless there is a deal to avert a financial crash.
Germany's EU Commissioner Guenther Oettinger said the creditor powers must draw up urgent plans to cope with social unrest in Greece and a break-down of energy supplies and medicine as soon as July.
In a terse statement, Mr Tsipras called on the EU institutions and the International Monetary Fund to “adhere to realism”.
He accused the creditors of “political motives” for demanding further pension cuts, hinting that their real goal is to destroy the credibility of his radical-Left Syriza government and force regime change.
“We are not only carrying a historical past underlined with struggles. We are carrying our people's dignity as well as the aspirations of all Europeans. We cannot ignore this responsibility. It has to do with democracy,” he said.

Germany’s Suddeutsche Zeitung reported that the creditors are drawing an ultimatum to the Greeks, threatening to cut off Greek access to the European payments system and forcing capital controls on the country as soon as this weekend. The plan would lead to the temporary closure of the banks, followed by a rationing of cash withdrawals.

Syriza sources have told the Telegraph that Greece may seek an injunction from the European Court of Justice to stop the creditors and the EU institutions acting in a way that breaches Greek treaty rights. This would be an unprecedented move, greatly complicating the picture.

Equity markets fell across the Europe and bonds sold off sharply in the high-debt Latin states as investors start to think through the dramatic implications of a Greek default, followed by EMU rupture. “The Greek saga is finally reaching its climax, we think,” said Hans Redeker from Morgan Stanley.

An artist's view of the Greek flag after five months of labyrinthine debt talks

Yields on 10-year Portuguese bonds have jumped almost 170 basis points since their lows in March, reaching an eight-month high of 3.22pc. Spain’s yields have jumped by 120 points to 2.35pc.

While these levels are nothing like the panic spikes in past spasms of the EMU debt crisis, they are approaching levels that could soon tighten borrowing conditions for companies and mortgages. It may become harder for these countries to shake off deflation.

Mario Draghi, the head of the European Central Bank, said the authorities could handle the immediate fall-out from a Greek default but refused to offer any further assurances. “The consequences in medium to long term to the Union is not something we are in a position to foresee," he said.

Mr Draghi was accused of waging “systematic economic warfare” against Greece by a radical Euro-MP from Spain’s Podemos movement, one of a blizzard of virulent attacks in Strasbourg today that show just how dangerously polarised Europe has become after seven years of quasi-depression.

Morgan Stanley said a meeting of EMU finance ministers on Thursday will be “a make-or-break moment”, the last chance to reach a deal that can be scrutinised and passed by the German Bundestag and other national parliaments before June 30 when Greece must pay the IMF €1.6bn.

Mario Draghi said the ECB could not foresee longterm consequences of a Grexit

A Syriza official told the Telegraph that the final denouement may come earlier since depositors will almost certainly try to withdraw their money if there is no accord in sight, setting off a bank run. “We are a little surprised that it has not happened yet. Depositors have been very stoic,” he said.

The Greek side is furious that the creditors are demanding further cuts in pensions – already reduced by 44pc – knowing that this is an emotional red-line for the Syriza movement. They thought they had a deal to opt instead for defence cuts and tax rises.

The suspicion in Athens is that the creditors are deliberately engineering a Greek political crisis in what amounts to an arms-length coup d’etat, an allegation dismissed as absurd in Brussels. The IMF says the Greek pension system gobbles up 16pc of GDP – one of the highest in the world – and must be brought under control before there can be any further money.

The mood is hardening in Berlin where Volker Bouffier, the deputy leader of the ruling Christian Democrats (CDU), said nothing more can be done for a country bent on its own ruin. “It’s awful for the Greek people but we can’t have the rest of European people paying for utterly mad behaviour,” he said.

Slovakia is unhappy about the Greek welfare structure

Feelings are even harsher in Slovakia, where there is near universal indignation at funding a Greek welfare structure that Slovaks can only dream of. “Alexis Tsipras is swindling the whole world and this cannot go on forever,”said Jozef Kollar, vice-chairman of the finance committee.

In a crucial twist, the IMF’s chief economist Olivier Blanchard blamed both sides for the impasse, arguing that there was a limit to what Greece could bear and calling for significant debt relief to restore the country to viability. “A credible deal will require difficult decisions by all sides,” he said.

It is the first time that a senior IMF official has stated that Greece needs a haircut on its public debt – 180pc of GDP – implying direct losses for EMU taxpayers for the first time. The Fund pulled its Greek team out of Europe last week, letting it be known privately that it will not take part until the debt issue is confronted head on.

The withdrawal of the IMF itself has serious implications. Chancellor Angela Merkel is relying on the Fund’s credibility as the ultimate enforcer of reforms to give her political cover in Germany.
Volker Kauder, the CDU’s parliamentary leader, said the departure of the Fund brings matters to a head. “The IMF must remain in the boat, otherwise we cannot give any help,” he said.

Greece's endgame: timeline of upcoming events
June 5
IMF loan repayment: €305m (missed)
June 10
Greece due to sell €1.6bn in Treasury bills to refinance maturing debt
June 12
IMF loan repayment of €312m due
June 16
IMF loan repayment of €573m due
June 18
Eurogroup Meeting in Luxembourg
June 19
IMF loan repayment of €343m due
June 19
Greece owes €85m to the ECB for bonds the central bank bought
June 19
European Union finance ministers meet
June 25 and 26
European Union leaders Summit in Brussels
June 30
Greece due to pay €1.5bn wage and pensions bill by month-end
June 30
Greece’s current bail-out deal expires
Greece must also make all its IMF payments by this date or it will be in arrears to the Fund

The Chimera of Currency Manipulation

Jeffrey Frankel

JUN 10, 2015
Obama Abe TTP

CAMBRIDGE – US President Barack Obama is still pressing to obtain Trade Promotion Authority and use it to conclude negotiations for the Trans-Pacific Partnership (TPP) and the Transatlantic Trade and Investment Partnership (TTIP) with the European Union. But many in the US Congress insist that provisions must be added to the agreements to prevent currency manipulation.
Let’s be clear: If the US were to insist that “strong and enforceable currency disciplines” be part of trade agreements, no deals would be concluded. Other countries would refuse – and they would be right. Linking efforts to prevent currency manipulation to trade agreements has always been a bad idea, and it still is.
True, there are times when particular countries’ currencies can be judged to be undervalued or overvalued, and there are times when their trading partners have a legitimate interest in raising the issue. But even when currency misalignment is relatively clear, trade agreements are not the right way to address it. More suitable venues for resolving exchange-rate issues include the International Monetary Fund, the G-20, the G-7, and bilateral negotiations.
For example the undervalued renminbi was successfully addressed in bilateral China-US discussions from 2004 to 2011. China allowed the currency to appreciate 35% over time. Today it is well within a normal range.
But the fact remains that it is mostly impossible to tell whether a currency is overvalued or undervalued. Manipulation is not like the existence of a tariff or quota that can be verified by independent observers.
A necessary condition for concluding that a country is manipulating its currency is that its authorities are intervening in the foreign-exchange market. The People’s Bank of China, for example, bought a record quantity of dollars from 2004 to 2014, thereby preventing the renminbi’s exchange rate from appreciating as fast as it otherwise would have done. But the Chinese are not doing that anymore. If anything, they have been selling dollars over the last year, keeping the renminbi’s value higher than it would otherwise be.
Moreover, there are often legitimate reasons for intervening in foreign-exchange markets. For example, under the Plaza Accord, the US joined with Japan, Germany, and other G-7 countries in 1985 to intervene cooperatively to weaken the dollar. Indeed, a majority of countries pursue either fixed exchange rates, exchange-rate targets, or managed floating, all of which by definition entail buying and selling foreign exchange to moderate or eliminate exchange-rate fluctuations.
China is not a party to the TPP, but Japan is, and many congressional critics cite it as the target of their insistence that provisions to prevent currency manipulation be included in the deal. The yen has depreciated sharply over the last year, and some US economic interests, particularly the auto industry, accuse Japan of manipulation to keep the currency undervalued. But the last time the Bank of Japan intervened in the foreign exchange market was in 2011. In 2013, Japan joined other G-7 countries in agreeing to a proposal by the US Treasury to refrain from foreign-exchange intervention.
The euro, too, has depreciated significantly against the dollar over the last year, and some US trade critics want provisions to prevent currency manipulation added to the TTIP. But the European Central Bank has not intervened in the foreign-exchange market since 2000 – and that was to support the euro, not weaken it.
Critics who accuse Japan and other countries of currency manipulation presumably know that they have not been intervening in the foreign-exchange market in recent years. They generally point instead to recent monetary loosening. The predictable side effect of quantitative easing (QE) – that is, the purchase of domestic bonds – by the BOJ and the ECB has been the depreciation of the yen and the euro. But central banks can hardly be enjoined from easing monetary policy when domestic economic conditions warrant it, as has obviously been the case in Japan and Europe (and in the US when the Federal Reserve embraced QE).
If monetary expansion does not merit the charge of currency manipulation, still less do other sorts of economic policies. Some have argued that even though the PBOC has stopped buying US and other foreign assets, China’s sovereign wealth funds still do, and that this, too, counts as manipulation.
But it is perfectly sensible and legitimate for China to put some of its savings abroad. (The US would become worried if China and other countries did not want to buy its assets.) Every country makes policy decisions of many sorts every week, many of which can be expected to have an indirect effect on the exchange rate in one direction or the other. The mere fact that a particular policy might weaken the currency does not make that country a manipulator.
Finally, provisions that target other central banks could also be applied against the US. This would not be a case of misusing a tool (a frequent occurrence in trade policy when interest groups lobby for protection against foreign competition); rather, it would be a case of using the tool in precisely the intended way. This is worth bearing in mind, given that the Fed’s adoption of QE in 2008 (which it continued to pursue until last year) had the effect of weakening the dollar from 2009 to 2011, prompting the same accusations of “beggar thy neighbor policies” against the US that congressmen now level against others.
Such charges are always on shaky ground, regardless of their origin. Monetary stimulus in one country may even have a beneficial effect on the rest of the world, as its own restored income growth boosts imports from its trading partners. Whether one considers the accusations of currency manipulation against the US in 2010, its trading partners in 2015, or a future defendant, designating some trade agency to rule on them would merely cause trouble.