Alpha, Beta, and Beyond
JUL 27, 2015
Exchange-traded funds have overtaken hedge funds as an investment vehicle
Aug 1st 2015
IT IS a victory for the humble—for the investment equivalent of a puttering hatchback over a gleaming Porsche. The exchange-traded-fund (ETF) industry is now bigger than the more established business of hedge funds. Assets in the global ETF industry were $2.971 trillion at the end of June, according to ETFGI, a research firm, $2 billion ahead of the hedgies’ $2.969 trillion, as calculated by Hedge Fund Research (see chart 1). In 1999 the ETF industry was less than a tenth the size of its ritzier rival.
ETFs are pooled funds, quoted on stockmarkets, that are designed to replicate the performance of an asset class. They usually do so by tracking a benchmark such as the S&P 500 (for American equities).
Once the fund is set up, portfolio changes are mechanical, responding to changes in the underlying benchmark. Funds can track almost anything from the gold price to commercial property. Some have extremely low expenses: Vanguard’s S&P 500 index tracker charges only a twentieth of a percentage point a year.
Although hedge funds also invest across a wide range of assets, they take a quite different approach. Using far more complicated strategies, they aim to offer investors a superior service: either a higher return than achieved by the benchmark or a better balance of risk and reward.
Because they can sell short (bet on falling prices), they claim to prosper in all kinds of market conditions. In return for this sophistication, they demand higher fees: an annual charge of 2% or so and a performance fee of 15-20%, making their founders very rich indeed. Hedge funds aim to attract “the best and the brightest” managers to their industry; ETFs merely aim to be average.
ETFs target the mass market: the humblest retail investors can participate and could in theory put all their savings in ETFs. The hedge-fund industry has a narrower clientele: it targets the wealthy and big institutions such as pension funds and university endowments. It aims to manage just a small proportion of their portfolios.
Both ETFs and hedge funds have been growing at the expense of a much larger rival—the conventional fund-management industry made up of mutual funds and specialist investors that pursue so-called “active” strategies in an attempt to beat the index. In the late 1990s, when Wall Street was surging thanks to the dotcom boom, conventional managers could generate impressive returns. Since 2000 there have been two bear markets in equities and bond yields have sunk to record lows; conventional managers have struggled.
In a world of reduced returns, the low costs of ETFs are more attractive. For the hedge-fund industry, in contrast, low returns are a problem. Most managers have to invest in the same equity and bond markets as everyone else. In the 1990s hedge funds enjoyed seven years of double-digit average returns. In the first decade of the 2000s, they managed three such years. In this decade, there has been just one.
Even when it comes to avoiding losses, the industry’s record has deteriorated. There were no years of negative returns in the 1990s, but three since 2000. Hedge funds’ reputation took a hit in 2008, when they lost a lot of money. On a rolling five-year basis, their returns have been disappointing (see chart 2).
The deteriorating performance is probably not a coincidence. Hedge funds sold themselves as clever and flexible enough to take advantage of opportunities that conventional fund managers neglected. But there may not be enough such opportunities for an industry with nearly $3 trillion of assets to exploit.
As a result, hedge funds market themselves rather differently from the way they used to. In the 1990s, the heyday of managers like George Soros, the industry sold itself on its ability to generate outsize returns. Nowadays it talks of the ability to generate “risk-adjusted returns”—steadier profits with less volatility. Where once they appealed largely to the rich, hedge funds now target institutions. A recent survey found that a majority of managers expect the bulk of their new money to come from pension funds over the next few years. Some pension funds use a “core-satellite model” in which the bulk of their money is in ETFs (and other low-cost funds that track indices) with the rest in specialist vehicles, including hedge funds and private equity.
Yet the steady return claimed by hedge funds can be replicated, or indeed beaten, with ETFs.
S&P, an index provider, calculated the return over the past five years from a portfolio comprising 50% American bonds and 50% global equities. This portfolio easily outperformed the average return from hedge funds. S&P then deducted hedge-fund-style fees from the model portfolio; the result tracks hedge-fund returns very closely. It looks, in other words, as if hedge funds are a very expensive way of buying widely available assets. Last year CalPERS, California’s public-sector pension fund, announced it was selling off its investments in hedge funds, citing both complexity and costs.
ETFs have also faced criticism. Jack Bogle, the founder of Vanguard, an index-tracking firm, has argued that the ease of dealing in the funds may cause retail investors to trade too much, switching in and out of asset classes in a vain attempt to time the markets. A more widespread concern relates to liquidity. All ETFs allow investors to redeem their holdings instantly, but some of the assets they own, such as corporate bonds, trade infrequently. They thus face a potential problem if prices fall sharply and a lot of investors want to sell at once. That might force them to delay or limit redemptions (imposing “gates”, in the jargon). Some see this as the trigger for the next market crisis.
The industry’s defenders argue that the sector got through the 2008 downturn without a problem. Alan Miller, who used to run a hedge fund but now manages assets for individuals at SCM Direct, which specialises in ETFs, points out that “ETFs have been tested in a lot of market environments and not a single one has failed.”
Short of a calamitous collapse at an individual fund, the ETF industry is likely to keep on growing.
Ten years from now, it may be double or treble the size of the hedge-fund sector. The race is not always to the cheap, but that’s the way to bet.
“Lowflation” forever in the US?
Jul 26 15:38
This judgment about the balance of risks is coming to a head now that the FOMC seems fairly likely to announce lift off for US interest rates in September. The GDP growth rate, and the strengthening in the labour market, seem consistent with an early rate rise. But the inflation rate remains well below the Fed’s 2 per cent target for headline PCE inflation, and the FOMC says it needs to be “reasonably confident” that inflation will return to target over the medium term before they can raise rates.
The FOMC will release its next policy statement on Wednesday. Since its last meeting in June, reported inflation data have barely changed, but there has been a drop of about 19 per cent in the price of oil, and a rise of about 2 per cent in the dollar exchange rate. These two variables were specifically identified when the Fed decided to delay interest rate rises earlier in the year, and the fixed income markets are beginning to think that the same might happen again in the run up to the September meeting.
In the last 12 months, fluctuations in headline inflation have been driven almost entirely by the collapse in oil prices and the uptrend in the dollar. Core inflation has been less affected, but has not been entirely immune from these oil and dollar effects. My colleagues at Fulcrum have estimated a VAR model that tracks the effects of oil and the dollar on reported inflation, and we use this model to predict the future path for inflation, given the recent renewed decline in oil prices (which was not built into the Fed’s June forecast). Here are the results:
This model is not suitable for analysing long-term shifts in underlying inflation because it does not include deep fundamentals like the state of the labour market, and the formation mechanism for inflation expectations. But it should do a reasonable job in making short-term predictions when the oil price and the dollar are moving a great deal, as they are now.
The model suggests that headline PCE inflation will remain around zero until October, 2015 and will then rise to almost 2 per cent by the end of 2016 (mainly because the oil price is expected to stop falling). The core PCE inflation rate, meanwhile, rises gradually from its current level of 1.2 per cent, reaching 1.4 per cent in September and 1.6 per cent at the end of 2015, staying there for much of 2016.
The issue is whether these subdued paths for headline and core inflation are sufficient to enable the FOMC to say that it is “reasonably confident” that inflation is returning to target. On balance, I expect that they will be.
Lately, Janet Yellen has openly accepted that headline inflation will stay close to zero for a while, saying that this is due to temporary oil and dollar effects. So she is unlikely to be surprised by headline inflation prints close to zero during the summer. Meanwhile, she has focused very specifically on the strengthening in the labour market, and not on actual inflation data, as the key for policy:
So I think we need to see additional strength in the labor market and the economy moving somewhat closer to capacity—the output gap shrinking—in order to have confidence that inflation will move back up to 2 percent, but we have made some progress (June FOMC press conference).This indicates that the FOMC will be willing to announce lift off even in the presence of very low inflation prints, provided that the labour market continues to improve.
Elsewhere, other important members of the FOMC like William Dudley have also suggested that they will become more confident about a September rate increase if real GDP continues to grow at about the 2.5 per cent rate that has been in place since the spring. All this suggests that it is reported economic activity and employment releases, rather than the next few months of inflation data, that will critically influence the Fed’s decision in September.
This raises one more question, which is why the Fed considers the labour market to be so important in determining future inflation, given the fact that there has been relatively little connection between them for many years now. A clue to this came in the embarrassing and unintended release of the Fed staff ‘s economic forecasts after the June FOMC meeting.
These forecasts, which are usually kept confidential for five years, showed that the Fed’s economic staff believes that the output gap is now very narrow, at only 1.04 per cent, and that it will disappear almost entirely in 2016. This is based on their estimate that the natural rate of unemployment is 5.2 per cent, only 0.1 per cent below today’s actual unemployment rate.
Furthermore, the staff believes that potential output growth is now only 1.6 per cent, which is well below the current GDP growth rate in the economy. In other words, economic slack is disappearing fast and, on this assessment, the US will not achieve “lowflation forever” unless GDP growth slows down, and unemployment stops falling, in the near future.
It is clear that this unexpectedly pessimistic assessment of the supply side of the economy is the main reason why FOMC members believe that an increase in rates will shortly be necessary. Admittedly, the staff’s economic forecast shows that GDP growth will slow to an average of only 2 per cent after 2016, and they expect that this anaemic growth rate will keep inflation within the 2 per cent target. They also believe that this slowdown will be achieved with only one rate rise this year and with a lower trajectory for rates over the next three years than appears in the FOMC’s famous “dots” plot.
But the “dots” show the view of the official policy makers on the FOMC and they seem to believe that more insurance is needed to maintain a “lowflation” outcome, given the weakness of the supply side in the US economy.
It is the FOMC members more hawkish view, not the staff’s interest rate forecast, that ultimately counts for policy decisions
Are We Seeing a Trend Reversal with Interest Rates?
By: Frank Suess
Mon, Jul 27, 2015
In the second quarter, we saw a jump in yields across the board. The yield of 10-Year US Treasuries jumped from 1.9% to 2.4% over the course of the quarter, representing a yield increase of 50 bps. This led to a decline of almost 2% in the Bloomberg US Treasury Bond Index. In Europe the development was much more dramatic; over the quarter, the Bloomberg German Sovereign Bond Index lost around 4.5% in value. This was due to an increase in the German 10-Year yield from 0.2% to 0.8% (60 bps). It is not completely clear what sparked the massive yield increase in Europe. It might have been a technical correction due to the very high prices bonds were trading at, increased risk aversion towards Europe due to the situation in Greece (Bill Gross even called shorting German bunds "the short of a lifetime"), or possibly aggressive short positions by some investors.
With 30 years of falling interest rates, bonds are today considered to be low risk investments and government bonds are even considered to be an almost riskless asset. However, the developments in the last quarter have shown that this is not the case and losses can occur rapidly when interest rates begin to rise. We therefore need to consider a few important questions in connection with interest rates. Is the development in the last quarter to be perceived as the long awaited turnaround in interest rates? Are Treasuries, other government bonds, and bonds in general as safe as they are perceived by most market participants? How would an increase in interest rates impact a portfolio?
Yields still at historic lows
First of all, it is important to put the development of the last quarter into perspective. Both the US and German 10-Year government yields are still at very low levels (see Figure 1). Although we don't know when the interest rate environment will change, in our view it is still too early to call it the normalization of interest rates after the recent yield development. This is especially the case when we take into consideration that since 2009 we have seen four quarters where the yields increased by more than 20%, but were then followed by new lows.
When we take a long-term look at the development of 10-Year Treasury yields, as depicted in Figure 1, it becomes clear that, excluding some variations, over the past 30 years, yields have been heading in only one direction: down. And this might continue or at least interest rates could stay low for some time.
A look around the globe
As we have mentioned in the beginning of the article, the yield developments in Q2 were not identical across the board. The Eurozone saw a considerably stronger spike in yields than the US did. It is therefore important to differentiate between different countries and regions, when it comes to assumptions related to interest rate developments. In this context, let's have a closer look at the United States, Europe, Japan and China.
With the exception of the US, where the yield increase is possibly related to an anticipated rate hike by the FED, the developments of the previous quarter are not related to a rate hike by a central bank, but rather price changes on the secondary market. It is our understanding that a real turnaround in interest rates will take place when central banks start to hike rates, which is precisely why we will spend some time looking at rate hikes here.
From the countries mentioned earlier, the United States seems closest to a rate hike. However, this does not mean that we expect an imminent and substantial increase in rates any time soon.
The US was the first country to start with its QE program in November 2008, ended it in late 2014 and has in the meantime seen a visible economic recovery. Unemployment figures are currently at 5.3%, close to what the FED considers full employment. Inflation is expected to reach 2.2% next year, which is close to the target inflation rate of 2%. Although downward revisions to GDP expectations have taken place, the economy seems robust and is expected to grow 2.2% this year and 2.8% in 2016. All indications are that a rate hike would be appropriate. Yet, many other countries are still in "QE-mode" and an increase in rates would make the US Dollar more attractive in relation to other currencies, resulting in a burden on the US economy and US companies. We therefore believe that an increase, if any, is likely to come in homeopathic doses and could even be reversed should the economic condition worsen.
Europe just started its asset-purchasing program in March, 2015, and the balance sheet is still around 800 billion below their target of 3.3 trillion Euros. The official aim of the European QE program is to provide liquidity to the banking sector to jump start lending and thus increase economic activity. The inofficial aim, in our view, is to depreciate the Euro in order to increase European competitiveness.
An increase in rates now would be a counterproductive measure for both the official and inofficial aim because rate hikes throttle lending and increase the relative attractiveness of a currency. It is therefore very unlikely that a serious rate hike would be implemented by the ECB anytime before the current program runs out in September, 2016.
The QE program in Japan, dubbed "Abenomics", is starting to show first positive results.
Japan has left the brief recession of last year behind and grew by 3.9% in annualized terms in Q1 of 2015 and is expected to grow well into 2017 (more on Japan in the next article). After having seen decades of deflation and having one of the largest debt-to-GDP ratios, we highly doubt that the Bank of Japan will increase rates at the first sign of a slight economic recovery.
China's economic indicators are being revised downward. GDP growth is expected to decrease from 7.4% in 2014 to 6.5% in 2017 and export numbers are showing weakness. Additionally, we believe that the property downturn is likely to continue. Taking the above-mentioned into consideration, it is understandable why China has started to loosen its monetary policy. Since Q4, 2014, the People's Bank of China (PBoC) has reduced lending rates from 6% to 4.85%.
Furthermore, since the beginning of 2015, reserve requirements for banks have been reduced
twice. Both of these steps are monetary instruments used for loosening monetary policy. Due to the weak economic data, coupled with the fact that bank-lending rates in China are currently between 7-8% in real terms, we believe that the PBoC is likely to further reduce rates and not increase them for the time being.
Where do we think interest rates are headed?
As we have outlined above and summed up in Figure 2, we believe that different countries and regions are at different stages in their monetary policy and a one-size-fits-all answer to the question where interest rates are headed cannot be provided. Nonetheless, we do not believe that an increase on a wide scale would be economically feasible for the time being and there are substantial risks involved due to high debt levels. The German 10 Year yield development (from 0.2% to 0.8%) in the last quarter illustrates that coming from a low base, a triple digit increase in the financing cost can happen very rapidly. Imagine if a government or company that took on debt at a very low cost would suddenly be faced with triple the cost when refinancing or issuing new debt.
How does a rate hike impact my portfolio?
As we are uncertain if and when a rate hike will take place, we will turn to the most burning question for investors: How does a rate hike impact my portfolio? Even if the turnaround doesn't come anytime soon, it will occur eventually. So it is important to understand the impact it can have on one's portfolio.
When interest rates rise, newly issued bonds are issued with a higher coupon than prior to the hike. This means that older bonds issued with a lower yield become relatively less attractive; investors are willing to buy them only at a lower price and thus the price of the bond decreases.
Bond yields are therefore negatively correlated to the bond price.
Figure 3 depicts the value zero-coupon bonds with different maturities would lose if interest rates would rise by 1,2,3 or 4 percentage points. The calculation is based on simplified assumptions (change from a zero interest rate environment and a parallel shift in the yield curve), but is meant to illustrate the impact of a rate hike on bonds. There are two main aspects we would like to concentrate on. Firstly, the higher the rate hike, the more bonds lose. This is intuitive, as the higher the hike, the less attractive a bond, that was issued with a lower yield, becomes. Secondly, the time to maturity is also a critical factor. When interest rates rise, future cash flows from bonds are discounted at the new higher rate. The longer it takes until the capital is repaid, the higher the negative impact on the bond price. There are several other aspects in connection with bond pricing, but going into all the details would go beyond the scope of what we want to cover today.
As a general rule, we can say that an interest rate hike would also be negative for equities.
Future earnings, cash flows, etc. are discounted using a higher rate and this should technically lead to a decrease in prices. Furthermore, when yields rise, bonds become relatively more attractive in comparison to equities and investors tend to increase their allocation to bonds.
However, equities are much less sensitive and react less "mechanically" to interest rate changes than bonds. UBS recently came out with a study where they analyzed the 12 previous cycles of interest rate hikes by the FED. Their conclusion: on average, the S&P 500 increased roughly 10% in value in the 12 months after an initial rate hike. This also holds true when we look at the rate hike prior to the financial crisis, depicted in Figure 4. Although the FED started to hike rates in 2004, stocks continued to perform well, i.e. generating returns of nearly 40% since the start of the hike until the highs in 2007. The substantial increase in the FED fund rate did not negatively impact stocks for several years. This is not to say the general rule of interest rates hurting equities is not true. Our point is rather that even if an imminent rate hike would be at hand, there would be no immediate reason to reduce equity exposure.
And the impact of interest rates on gold? In general there is a negative correlation between gold and real interest rates. When real interest rates rise, gold becomes less sought after, as investors search for investments with higher yields. However, according to the World Gold Council, the negative effect of real interest rates on gold is only triggered when real interest rates rise above 4%.
Conclusion for investors
We don't know where and when an interest rate hike will take place. Nevertheless, monitoring the development of yields should be part of any risk management approach, because as we have shown in this article, yield normalization can have a substantial impact on the portfolio.
Low Gold Prices Seeing Chinese Pile In Again; SGE Withdrawals Exceeding New Mined Supply
by: Lawrence Williams
Jul. 26, 2015 1:23 PM ET
We had already seen the beginnings of a pick up in Chinese demand, as expressed by SGE withdrawals, when they hit well over 60 tonnes for the week ended July 10th (see Huge latest week SGE gold withdrawal figure - 62 tonnes) all at a time when seasonality suggests Chinese demand should actually be at its lowest. But the gold price continued to fall so it would be particularly interesting to see how demand would continue, or whether it would actually increase with more bargain hunters climbing in. In the event, SGE withdrawals for the week ended July 17th have come out at the fifth highest weekly total ever - again, it should be emphasized that this high demand level has been at what is normally a very weak time of the year for Chinese demand - and brings SGE withdrawals for the year to date, according to the chart below from Nick Laird's excellent www.sharelynx.com and www.goldchartsrus.com chart sites, to a huge 1,366 tonnes - probably nearly 80% of global new mined production over the same period. (Global weekly new mined gold supply is around 62 tonnes - so for the past two weeks Chinese SGE withdrawals will have actually exceeded the world's mined supply!)
As can be seen from the above chart, SGE withdrawals are currently running some 59 tonnes higher than at the same stage in China's record 2013 year.
Now we will have to wait for another week to see what the past week's gold price takedown did to Chinese SGE demand - it could well prove to have been even higher and may have helped lead to the end-week price pick up.
But a word of caution here. In China's record 2013 year for gold demand, as expressed by SGE withdrawals, the gold price fell from a beginning of the year level of $1,681.50 at the LBMA morning fix on January 2nd to 1201.50 at the close on December 31st, a decline of 28.5%. The fall was perhaps precipitated by heavy gold sales out of the major gold ETFs in the West and although these were more than counterbalanced by the Chinese figures the latter seem largely to have been ignored by the COMEX dominated market. And this year we are again beginning to see big ETF gold liquidations, albeit not at the same levels as in 2013. This year, gold opened in London on January 2nd at $1,184.25. A similar 28.5% decline would take the year-end gold price down to just below the $850 level! We very much doubt this will actually happen - indeed gold could be well set for a major recovery after the absolutely blatant bear raid which has highlighted how easily the gold price can be manipulated to a previously unenlightened general public and the continuing physical gold flows from West to East have to make such manipulations more difficult as Western physical stocks are depleted.
It is also as well to note that the fall in the price of gold in dollar terms so far this year has actually been exceeded by falls in the price of copper, nickel, aluminium and iron ore in particular - See my article on Mineweb on this: Commodities collapse: It's not just about gold.
Indeed, the overall commodities price crash suggests similarities to 2008 and the so called Global Financial Crisis which brought down, not only commodities, but global stocks of any kind. Are we set for a repeat? Food for thought.
Oil and gas crunch pushes Russia closer to fiscal crisis
'Russia is going to be in a very difficult fiscal situation by 2017. By the end of next year there won’t be any money left in the oil reserve fund,' says Unicredit
By Ambrose Evans-Pritchard
7:42PM BST 23 Jul 2015
Russia is already in dire straits. The economy has contracted by 4.9pc over the past year and the downturn is certain to drag on as oil prices crumble after a tentative rally. Half of Russia’s tax income comes from oil and gas.
Core inflation is running at 16.7pc and real incomes have fallen by 8.4pc over the past year, a far deeper cut to living standards than occurred following the Lehman crisis. This time there is no recovery in sight as Western sanctions remain in place and US shale production limits any rebound in global oil prices.
“We’ve seen the full impact of the crisis in the second quarter. It is now hitting light industry and manufacturing,” said Dmitri Petrov from Nomura.
“Russia is going to be in a very difficult fiscal situation by 2017,” said Lubomir Mitov from Unicredit. “By the end of next year there won’t be any money left in the oil reserve fund and there is a humongous deficit in the pension fund. They are running a budget deficit of 3.7pc of GDP but without developed capital markets Russia can't really afford to run a deficit at all.”
A report by the Higher School of Economics in Moscow warned that a quarter of Russia’s 83 regions are effectively in default as they struggle to cope with salary increases and welfare costs dumped on them by President Vladimir Putin before his election in 2012. “The regions in the far east are basically bankrupt,” said Mr Mitov.
Russian companies have to refinance $86bn in foreign currency debt in the second half of this year.
They cannot easily roll this over since the country is still cut off from global capital markets, so they must rely on swap funding from the central bank.
The authorities can cover part of this from the country’s current account surplus, but a “financing gap” of $10bn to $15bn a quarter remains. This implies a slow depletion of the central bank’s foreign reserves.
The official reserves have dropped from $524bn to $361bn since the Ukraine crisis first erupted in late 2014. Unicredit said the true figure is nearer $340bn once other commitments are stripped out.
Companies and banks have already slashed their hard currency debt by $170bn in a drastic deleveraging over the past 18 months. This whittles away the dollar debt burden, but at a terrible long-term cost for Russia’s productive economy.
“Frankly, I don’t think they can weather this crisis. There has been almost no investment in new oil production except in Western Siberia. They are still relying on old Soviet wells,” said Mr Mitov. The depletion rates in the traditional fields of Western Siberia are running at 8pc-11pc a year.
“They can’t keep up production without access to foreign imports and technology, so we think there could be a fall in output of 5pc to 10pc by 2018,” he said.
Lukoil’s vice-president, Leonid Fedun, said in March that Russia’s oil output could fall 8pc by the end of next year, taking 800,000 barrels a day (b/d) out of global markets, with major implications for the balance of supply and demand.
Any such loss would be corrosive for Russia. It has not happened yet. Russian producers have taken advantage of a new tax regime to raise output this year to 10.7m b/d, close to the post-Soviet peak.
But they are relying on legacy investments and imported machinery that must be replaced sooner or later.
Mr Putin’s long-term strategy depends on opening up the Arctic and the vast shale reserves of the Bazhenov basin and the Volga-Urals. Drilling in these regions is covered by sanctions, forcing Western firms to freeze joint ventures.
Russia lacks the technology to make these projects viable. Average fracking costs in Russia are three times higher than those of cutting-edge drillers in the US.
The oil slump is, in one key sense, worse than in January, when markets thought it was a short-term shock triggered by Saudi policy. This time futures contracts are factoring in no real recovery in prices for two to three years.
The Russian authorities have the crisis under control for now. They have allowed the rouble to fall rather than burning up reserves, providing a cushion for the budget and for oil and gas producers. But this policy is inflationary, and politically toxic.
The underlying strain remains. Russia bet its future on oil, gas and the commodity boom, letting its manufacturing base atrophy in the glory days of the strong rouble.
It has now been left high and dry by the commodity slump, a textbook case of the Resource Curse.
Western sanctions have tightened the vice. “The real problem is that Russia’s economy is going nowhere,” said Mr Mitov.
Requiem for the Macrosaurus
The beginning of the end of the Jurassic Period of economics.
By David Rothkopf
July 27, 2015
This summer’s biggest movie is Jurassic World. Apparently, people have an endless appetite for dinosaurs, which could also explain much about the popularity of Flintstones vitamins or, for that matter, Vladimir Putin. Fortunately for these people, there remain dinosaurs among us who are producing mayhem on a scale unimagined by even Hollywood’s CGI wizards.
We call them economists.
The term may initially evoke visions of kindly bespectacled wonks droning on about arcane theories or perhaps government big shots mumbling unintelligibly before Congress. But we know better: These are powerful women and men. They have made giant policy decisions that have affected the lives of billions, often while working behind closed doors with data and on strategies that few understand and fewer still believe in.
Economics has long been known as the dismal science. Thomas Malthus, a cleric who also wrote about economics, has become the poster child used by many to illustrate the rationale behind this label. (Thomas Carlyle actually first coined the term in reference to the study of the business of slavery.) In the very last years of the 18th century, Malthus posited the argument that population growth would ultimately derail human society’s efforts to perfect itself. “[T]he power of population is,” he wrote, “indefinitely greater than the power in the earth to produce subsistence for man.” It is indeed a grim prognosis. But it highlights another reason economics might be seen as dismal: that is, just how off the mark its predictions can be.
Being wrong has long been a special curse of economists.
Being wrong has long been a special curse of economists. You might not think this would be the case in a so-called “science.” But, of course, all sciences struggle in those early years before scientists have enough data to support theories that can reflect and predict what actually happens in nature. Scientists from Galileo to Einstein have offered great discoveries but, due to the limits of their age, have labored under gross misconceptions. And in economics we are hardly in the era of Galileo quite yet. It is more like we are somewhere in the Middle Ages, where, based on some careful observation of the universe and a really inadequate view of the scope and nature of that universe, we have produced proto-science—also known today as crackpottery. (See long-standing views that the Earth was the center of the solar system or the belief that bleeding patients would cure them by ridding them of their “bad humors.”)
Modern economic approaches, theories, and techniques, the ones that policymakers fret over and to which newspapers devote barrels of ink, will someday be seen as similarly primitive. For example, economic policymakers regularly use gross estimates of national and international economic performances—largely aggregated measures based on data and models that are somewhere between profoundly flawed and crazy wrong—to assess society’s economic health, before determining whether to bleed the economic body politic by reducing the money supply or to warm it up by pumping new money into its system. Between these steps and regulating just how much the government spends and takes in taxes, we have just run through most of the commonly utilized and discussed economic policy tools—the big blunt instruments of macroeconomics.
I remember that when I was in government, those of us who dealt with trade policy or commercial issues were seen as pipsqueaks in the economic scheme of things by all the macrosauruses beneath whose feet the earth trembled, whose pronouncements echoed within the canyons of financial capitals, and who felt everything we and anyone else did was playing at the margins.
But think of the data on which those decisions were based. GDP, as it is calculated today, has roughly the same relationship to the size of the economy as estimates of the number of angels that can dance on the head of a pin do to the size of heaven. It misses vast amounts of economic activity and counts some things as value creation that aren’t at all. Even the guy who pioneered the idea in the 1930s, Simon Kuznets, warned against using it as the prime measure of national economic well-being. Trade data, such as that used in measuring national surpluses and deficits, misses a big chunk of trade in services and much Internet activity, among many other swaths of trade—and is widely reported inaccurately. Labor statistics, such as unemployment rates, are cooked and deceptive. The list goes on. The reality is that only two things are known about most of the data that policymakers use to make decisions: It is late and it is wrong.
But today the world stands at the dawn of a new era thanks to the advent of big data and enhanced computing power. Already there exist data flows that will show economic fluctuations in real time and down to an incredible level of detail: by community, by block, by family, by business, by however you want to slice it. The world will also be able to find correlations never before imagined. Old ideas, like tracking national economic performance based on geography, will give way to new ones, like tracking customizable groups that share much closer correlations than borders. There is a “you-istan” out there full of millions of people who act more like you, who respond to stimuli more like you, and who rise and fall more like you than do your neighbors. Next-generation economists will be able to target their actions more surgically.
Whereas today’s economic models rely on a relative handful of variables, future models will be able to utilize a limitless number, creating opportunities for policymakers to develop new tools.
Many of these new models and tools will require not the insights of microeconomists, but those of nano-economists, superspecialists in the relationship between much smaller economic units and the larger economy as a whole. Economic policymaking will therefore devolve from central governments to state and local governments, which are not only closer to the issues and the solutions that workers, companies, investors, and citizens require, but are better equipped to work with the local private sector in real time to solve those issues.
New economic theories will also emerge based on growing sources of real-time data about every aspect of markets and the factors affecting them—and new, ever more powerful tools will be created for analyzing that data. Some will relate to the fact that soon money as we know it will be replaced by alternative bit-based and mobile-payment systems, knocking old-school monetary policies for a loop. Others will have to do with the new ways we not only create jobs, but define work. There may ultimately be a need to revisit the issue of the redistribution of wealth as big companies harness capital, technology, and data to grow rich—but in so doing, benefit comparatively few investors and employees, while displacing many. Just as the 20th century saw the advent of the weekend, the hyperproductivity of the intelligent-technology-empowered 21st century might see labor demand fall and four- or three-day weeks become the norm. Taxation will transform as methods by which we track activity and levy fees within the economy change; such processes will easily cover more kinds of activity in real time, while algorithms will constantly adjust for the economic circumstances of those being taxed.
Gradually, there will be a recognition that most of the economic value in the global economy is created and exchanged in virtual rather than real space, with important consequences for the metrics and ideas we use for measuring that value.
Indeed, tomorrow’s economics will be so unlike that of today’s that it might just take a Hollywood device—like a mosquito preserved in amber, carrying, for example, the blood of Alan Greenspan, from which viable DNA can re-create this macrosaurus—for future generations to fully grasp the Jurassic Period economic thinking and approaches that have governed and guided our daily lives.
Why the Fed Needs to Get Off the Dime
Waiting until the unemployment rate reaches the natural level before beginning to raise interest rates risks inflation.
By Richard W. Nelson
July 24, 2015 6:52 p.m. ET
Photo: Bloomberg News
There is a lot of discussion about what level of unemployment the Federal Reserve should seek to fulfill its mandate to promote maximum employment and stable prices. This key unemployment rate is called either the “natural” rate, or “Nairu”—the non-accelerating inflation rate of unemployment.
Yet there seems to be an assumption among many policy makers, analysts and market participants that the Fed should wait until the natural rate of unemployment is reached before it begins to raise interest rates. That would be a huge mistake, greatly increasing the chances of significant inflation beginning sometime next year.
The problem is that the Fed has to finish normalizing monetary policy by the time unemployment falls to its natural rate—and that may take more than a year once it begins. If the Fed waits until the natural rate of unemployment is reached, there will be many months when interest rates are too low. These low rates can cause the economy to overheat, putting pressure on prices.
According to economic projections by the Federal Open Market Committee (FOMC) at its June 16-17 meeting, 3.5% to 3.75% is the likely level of the federal-funds rate after monetary-policy normalization is completed. Currently the Fed’s target range for this key interest rate is 0% to 0.25%.
The Fed historically has increased the federal-funds rate by 25 basis points (0.25 percentage points) at each of its monthly meetings. All indications are that the Fed would like to move even more slowly this time around, so it can gauge the impact of its actions on economic activity. That implies it could take 14-15 months or more to complete monetary policy normalization.
The Fed has no time to spare. In the FOMC’s March 2015 economic projections, committee members estimated that over the longer run the unemployment rate would settle in the range of 5% to 5.2%.
However, a recent study by Federal Reserve staff suggests that Nairu may have fallen much lower, perhaps to 4.3%, and the FOMC may well modify its views in this direction. But over the past 15 months, employment growth has been strong and unemployment has fallen by 1.3 percentage points, to 5.3% from 6.6%.
If unemployment continues to fall at this pace, the unemployment rate will fall to around 4%—below the Fed staff’s 4.3% estimate of full employment, and well below the current estimate of the FOMC members, before monetary normalization is complete. This analysis suggests that the Fed is risking inflation beyond its 2% target by waiting to begin raising rates, and will face an increasing risk the longer it waits.
It is true that longer-term interest rates are likely to rise quickly as financial markets anticipate the Fed’s next moves. And so higher short-term and longer-term interest rates could impede employment growth and the achievement of full employment. Still, the FOMC could monitor the movements of interest rates and employment monthly, making appropriate adjustments as needed.
On the other hand, the risks of delay—higher and perhaps rising inflation—are not likely to emerge until we are closer to full employment. By then adjustments would likely be too late.
The best course for the Fed is to begin raising rates very soon, if cautiously.
Mr. Nelson, a former chief economist at the Federal Home Loan Bank of San Francisco and manager of banking research at the New York Federal Reserve, is the founder of RWNelson Economics, a consultancy in Orinda, Calif.
The Disappearing Retirement Fund
by Jeff Thomas
July 27, 2015
As a general principle, I’ve always tended to avoid entrusting others with my money. I’ve avoided funds, as they are often based upon investments that are peaking or close to peaking. I’ve avoided pension funds, as they’re often structured in a similar manner.
And whenever by law I’ve been required to be invested in such funds, they’ve rarely been successful over the long term. In the end, I would invariably have made more money by pursuing those investments that had great promise but at the time were unpopular (and therefore underpriced).
As dubious as I tend to be of conventional investment schemes (and those who broker them), I am doubly dubious of any government-run scheme. Governments, historically, have proved to be poor money managers, and politicians tend to place more value on big promises that garner votes than on delivering on those promises.
And so, I’m predictably biased as to the likelihood of any form of fund that any government may be involved in. Even if it’s structured well, which it may well not be, governments, if they have the power to do so, will tap into the fund, draining it of the intended recipient’s contributions, leaving the fund exposed, should a crisis occur.
And, periodically, crises do occur. Presently, the First World is facing an economic crisis of unprecedented proportions.
As someone who advises on internationalisation (the practice of spreading one’s self both physically and economically over several jurisdictions in order to avoid being victimised by any one jurisdiction), I’m regularly asked what the optimum level of diversification might be for an individual in a given situation.
Whilst many of these individuals can unquestionably benefit from such diversification, there are quite a large number of people who are in the age sixty-and-over category who state that they’re hoping to get by solely on their Social Security and their pension. (If the investor is an American citizen, this often means a 401(k) or similar fund.)
For these individuals, I’m afraid it’s difficult to provide encouraging advice, as their retirement is rooted in what I consider to be dead-end investments that will diminish drastically, or disappear, long before the individual reaches his own demise.
The Social Security fund of virtually every country that has one is woefully underfunded. Typically, these funds have relied on the next generation’s contributions to pay for the benefits to those presently retired or retiring.
Unfortunately, the original premise, back when Social Security was introduced, was that the population would always increase. During the baby-boomer years, benefits were ramped up dramatically, as there were so many younger workers per retiree.
But now, that relationship has reversed. The baby-boom generation lasted for 18 years, so each year, for 18 years, the ratio of working people will diminish against those who have retired.
Ergo, each year, those working will need to be taxed more heavily if the system is to continue.
Unfortunately, at some point, we reach the tipping point and the concept itself is no longer viable.
After that point, benefits will be reduced and, possibly, eliminated altogether.
When retirees first hear this, their reaction is usually, “But that’s not fair. I paid in, all my life. They can’t do this to me.” Unfortunately, it is not a question of “fair”. It’s a question of arithmetic. The promised benefits will decline. As a result, those who are counting on Social Security to sustain them in their retirement will find themselves short.
Similarly, pensions are at risk. Most pensions are invested, to a greater or lesser degree, in the stock market. Most funds pride themselves on being “diversified”, by which they mean that they are invested in a variety of stocks.
Unfortunately, when a stock market crashes, good stocks often head south along with failing stocks, as brokers seek to save their skin by unloading portfolios. (This does not mean that some potentially solid stocks will not experience a recovery in time, but few will ride out a crash unaffected.)
At present, the stock market is being propped up artificially and is overdue for a crash. Although it would be impossible to predict a date, a crash, if it occurs, would have a major and permanent effect on a pension scheme.
But, wait… there’s more.
As if these threats to planned retirement were not enough, there’s a further threat. As previously stated, many governments are financially on the ropes, and historically, when governments find themselves on the verge of insolvency, they invariably react the same way: go back to the cash cow for a final milking. Each of the jurisdictions that is in trouble at present, has, in its playbook, the same collection of milking techniques.
One of those will have a major impact on pensions: the requirement that pension plans must contain a percentage of government Treasuries.
Political leaders have already announced that there’s uncertainty in the economic system and pensioners may be at risk. Therefore, whatever else happens to their plans, it’s essential that a portion of them be guaranteed against failure. Therefore, legislation will be created to ensure that a percentage be in Treasuries, which are “guaranteed”.
Sounds good. And people will be grateful. Unfortunately, the body that is providing the guarantee is the same body that has created the economic crisis. And if the government is insolvent, the “guarantee” will become just one more empty promise.
Recently, the US Supreme Court ruled that employers have a duty to protect workers invested in their 401(k) plans from mutual funds that perform poorly or are too expensive. By passing this ruling, the US government has the power to seize private pension funds “to protect pensioners”. It also has the authority to dictate how funds may be invested.
The way is now paved for the requirement that 401(k)s be invested heavily in US Treasuries. (Some are already voluntarily invested, as much as 80%.)
And so, those who hope to fund their retirements primarily with Social Security and 401(k)s, may well find themselves virtually without retirement income.
The question is whether this means “Game Over” for millions of Americans (and since similar developments are taking place in many other countries in the world, millions more in the EU, Canada, etc.)
And, yes, it does mean “Game Over” for many, unless they choose to exit a system that is set to collapse like an old mine shaft, trapping its occupants.
Still, there remains a brief window of opportunity, and that opportunity is to pay the penalty for exiting the system and internationalising whatever level of wealth can be salvaged.
Ideally, this means physically moving to a jurisdiction where such conditions do not exist, but a more limited escape may be created by removing as much money as possible from the retirement fund, moving it to a less risky jurisdiction and converting it to those forms of wealth storage that are least likely to be targeted by rapacious governments and corrupt banks.
Accepting the realization that the piggy bank will be less full is a painful one but is far less painful than to face the day when the piggy bank is all but empty.
Editor’s Note: If you don’t want to move abroad, you can still benefit from offshoring your retirement savings. It can live abroad instead of you - and outside the immediate reach of bankrupt politicians.
Retirement savings are always a juicy target for governments in need of cash.
In just the past six years, retirement savings have been plundered in some form in Argentina, Poland, Portugal, Hungary, and numerous other countries.
It’s incorrect to assume that it couldn’t happen in the US or your home country. History shows us that it’s standard operating procedure for a government in dire financial straits.
Fortunately by taking your investments offshore, you can make yourself a hard target and make it impossible for your retirement savings to vanish at the drop of a hat.
But it’s not just a defensive measure. Offshoring your retirement savings will unlock a whole world of new international investment opportunities that would otherwise be unavailable.
What Is The Intrinsic Value Of Gold?
by: Andrew Hecht
- Perception rules.
- Gordon Brown and the Brown Bottom.
- 1980 and 2011.
- Intrinsic value for gold in 2015 - rising dollar and divergence.
- Gold's bottom is still a long way below.
In a recent article, about the prospects for the price of gold on Seeking Alpha, a reader by the name of Peter Palms commented, "Gold prices significantly understate the intrinsic value". He went on to compare the price of gold to the sized of global debt. It was certainly an interesting comment; it was Peter's perspective, perhaps Peter's own principle when it comes to the yellow metal. I would argue that when it comes to the price of gold, intrinsic value equals nothing more than a collection of each individual's perspectives. Therefore, as beauty is in the eyes of the beholder, the intrinsic value of gold depends on to whom one is speaking at any given time and the price is merely a matter of mass opinion.
Any asset price has intrinsic and extrinsic value and those values change dramatically over time and even during the trading day on a minute-to-minute basis. A market price for an asset is the price where buyers and sellers come together in an open and transparent market place. The last price where a buyer and seller transacted is best definition of the current price. Market prices result from the perception of those actually buying and selling the asset. If the price drops to a level where one participant thinks it too cheap, they will buy lifting price. If it rises to a level where another participant thinks it too expensive they will sell, thus causing the price to fall.
When it comes to the price of gold, perhaps the asset with the most history as a means of exchange, perception determines its value. The current price for an ounce of gold is a combination of the perceptions of all buyers and sellers of the yellow metal in the world.
Therefore, the gold price is in essence, the result of the wisdom of crowds. Over the course of history, one or more parties can influence the price of this precious metal, at least for short periods. Anyone who has a huge amount of gold to buy or to sell can certainly dictate price for a while. A great example of this is what happened back 1999 and continued until 2002.
Gordon Brown and the Brown Bottom
Central Banks around the world hold gold as part of their foreign currency reserves. Many consider their gold holdings as part of their national treasure. These nations or those who are in charge of their assets assign a great deal of intrinsic value to the yellow metal. However, some do not. In 1999, Gordon Brown the UK Chancellor of the Exchequer must have thought the intrinsic value of gold was very low. So low, that Brown sold approximately half of the United Kingdom's gold reserves, which amounted to some $6.5 billion worth of gold, in a series of auctions at very low prices. The gold sold was approximately half of the UK's $13 billion foreign currency net reserves. The quarterly chart of the COMEX gold futures price highlights the effect of Brown's gold sales.
(click to enlarge)
As the quarterly chart of the COMEX gold futures price illustrates, the price of gold dropped to lows of $252.50 per ounce in 1999 and remained depressed as Gordon Brown auctioned off half of the UK's gold reserves until 2001. That low in gold became the "Brown Bottom".
Gordon Brown sold the lows in gold and perhaps in an effort to get him away from the rest of the UK's national treasure the nation made him Prime Minister subsequent to his sales. Maybe they thought he was safer in another position away from the country's checkbook.
Brown's sale is an example of how the perception of the UK government in 1999 affected the intrinsic value of gold; there have been other examples where mass perception has driven gold in the other direction.
1980 and 2011
Inflation caused the price of gold to skyrocket from $101 per ounce in 1976 to highs of $875 in January of 1980. As the price of gold rose, perception caused the intrinsic value of the yellow metal to increase. What ultimately causes a market to rise is when there are more buyers than sellers. This was the case during that period. After the highs in early 1980, the price of gold continued to fall over two decades reaching its nadir upon the establishment of the Brown Bottom in 1999.
After the U.K. finished selling gold a journey began that took the yellow metal to dizzying heights. Market perception changed once again and the value of gold rose. One decade after the Brown Bottom gold reached $1,920.70 per ounce in July of 2011. Since then the gold price has come back down to earth. Gold has a dual role as a currency and a commodity. Many commodity prices peaked in 2011 and have since moved lower.
Gold has followed suit closing on Friday, July 24, 2015 at $1098 per ounce. The price level is still some $845.50 above the Brown Bottom but is $822.70 below the 2011 highs. For now, the yellow metal is right smack in the middle of the decade long trading range. The intrinsic value for gold is higher than it was in 1999 but lower than in 2011.
Intrinsic value for gold in 2015
Currently the price of gold is under siege and its value has depreciated. Recently gold fell below weekly support at $1130 and the price traded all the way down to lows of $1072.30 last Friday before recovering to $1098. Physical demand for gold has been tepid due to economic weakness in one of the biggest gold buying countries in the world, China. Additionally, the prospects for higher interest rates in the U.S. make gold a less attractive asset.
Gold rose during a period of ever decreasing interest rates. When rates rise, gold becomes less attractive as it pays no interest or dividends to its holders. The U.S. dollar is the international pricing mechanism or benchmark for gold. Historically, there is a strong inverse correlation between the value of the dollar and the price of gold. A stronger dollar has added to weakness in gold thus far in 2015.
Rising dollar and divergence
The U.S. dollar rose from under 80 on the active month dollar index futures contract in May of 2014 to highs of over 100 in March 2015.
(click to enlarge)
The spectacular rise in the greenback made gold rise in other currencies attracting selling into the market. Therefore, gold dropped in U.S. dollar terms. At the same time demand for the precious metal, which has done nothing but move lower since 2011, has been weak which has caused the price to move lower.
Moreover, the price action in other precious metal markets has weighed heavily on the price of gold. Silver and platinum are industrial precious metals. Global economic weakness has caused the price of these metals to fall dramatically along with other metals and commodity prices in general. In fact, these two precious metals have been consistently weaker than gold over the past few years. While many consider the current price of gold weak, as it has declined over 40% from the 2011 highs, the price of gold is today very strong when compared to the price of both silver and platinum on a historical basis.
Over the past forty years, the price of platinum has usually traded at a premium to the price of gold. Platinum is a rarer metal with a higher production cost. Throughout history platinum has been "rich man's gold". The premium for platinum over gold has averaged around $200 per ounce. In 2008, platinum traded at over a $1200 premium and in 2011 and 2012, it traded at a $200 discount. On Friday, July 24, platinum was trading $110 below the price of the yellow metal -- clearly it is not rich man's gold these days. However, the historical price relationship between the two metals tells us that at current prices, either platinum is too cheap or gold is too expensive.
The silver-gold ratio leads us to the same conclusion with respect to the current value for gold. The long-term historical norm for this relationship is 55:1 or 55 ounces of silver value contained in each ounce of gold value. Today this relationship stands at around 75:1. This means that on a historical basis, either silver is too cheap or gold is too expensive at current prices.
The platinum-gold spread and silver-gold ratio are both telling us that gold is too expensive at today's price level for the yellow metal. Add to that the stronger dollar and the prospect for rising U.S. interest rates and gold starts to a lot worse. As a bonus, I have prepared a video on my website Commodix that provides a more in-depth and detailed analysis on gold to illustrate the real value implications and opportunities provided by the current level of this precious metal.
Gold's bottom is still a long way below
Silver closed last Friday at $14.67 per ounce. The long-term average of the silver-gold ratio thus implies a gold price of $806.85 at 55:1. Platinum closed Friday at $988.80 per ounce. The long-term average of the platinum-gold spread thus implies a gold price of $788.80 at a $200 premium for the price of rich man's gold.
Gold broke through long-term support at $1130 earlier this month. It is now trading at more than five-year lows. Technically, the trend is lower in the gold market. The dollar remains strong and interest rates have nowhere to go but higher in the long run. After making yet another new low at $1072.30 last Friday, gold rallied to close at just a shade under $1100 per ounce. While gold recovered nicely from the lows and many will say that a bottom is in for the yellow metal, there are too many factors pointing to a much lower price for the yellow metal.
Today, the intrinsic value for gold is lower than it was last week, last month or last year. The price of gold continues to make lower highs and lower lows since 2011. Therefore, I am a seller of rallies in the yellow metal given all of the factors that signal new lows on the horizon. Gold just simply has very little going for it these days and a lot going against it. Do not forget to check out my podcast on my website on gold.
Meanwhile, the intrinsic value of gold is a matter of perception and beauty is in the eyes of the mass beholders.
Les doy cordialmente la bienvenida a este Blog informativo con artículos, análisis y comentarios de publicaciones especializadas y especialmente seleccionadas, principalmente sobre temas económicos, financieros y políticos de actualidad, que esperamos y deseamos, sean de su máximo interés, utilidad y conveniencia.
Pensamos que solo comprendiendo cabalmente el presente, es que podemos proyectarnos acertadamente hacia el futuro.
Gonzalo Raffo de Lavalle
Las convicciones son mas peligrosos enemigos de la verdad que las mentiras.
Quien conoce su ignorancia revela la mas profunda sabiduría. Quien ignora su ignorancia vive en la mas profunda ilusión.
“There are decades when nothing happens and there are weeks when decades happen.”
Vladimir Ilyich Lenin
You only find out who is swimming naked when the tide goes out.
No soy alguien que sabe, sino alguien que busca.
Only Gold is money. Everything else is debt.
Las grandes almas tienen voluntades; las débiles tan solo deseos.
Quien no lo ha dado todo no ha dado nada.
History repeats itself, first as tragedy, second as farce.
We are travelers on a cosmic journey, stardust, swirling and dancing in the eddies and whirlpools of infinity. Life is eternal. We have stopped for a moment to encounter each other, to meet, to love, to share.This is a precious moment. It is a little parenthesis in eternity.
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