Barron's Cover

What Recession? GDP Set to Grow 3%

The gloomy stock market notwithstanding, economic growth in the U.S. could be the best in years.

By Gene Epstein          


 
Is the U.S. economy going through a growth pause, or is this the pause before the onset of recession?

The answer to that question highlights two quite divergent outcomes for 2016—one good, one terrible.

We subscribe to the former view. But before we make our case, let’s consider the bear argument.

If recession is imminent, then economic output will contract for an extended period, the stock market will continue to head south, and credit spreads will rapidly rise. The near-full-employment economy, signaled by January’s jobless rate of 4.9%, will quickly unravel and vault toward 6% within months.

But what if, as often happens, the indicators signaling recession are false alarms? Then, the generally quite favorable fundamentals at this stage in the expansion should dominate. Indeed, we expect economic growth to run at an annual rate of 2.8% through the first half of this year, then accelerate to 3.2% by the second half.

Growth of real economic output in 2016 would therefore come in at 3%, by the conventional fourth-quarter-over-fourth-quarter measure. This would make 2016 the best-performing calendar year since the expansion began in mid-2009. Under this scenario, the job market will continue to tighten, as the unemployment rate falls toward 4%. Credit spreads will narrow, and the stock market could rebound, probably touching new highs by the end of this year. The wild card: the presidential election.

Our 3% outlook, while upbeat, isn’t off the charts. According to the Feb. 10 release from the monthly Blue Chip Economic Indicators, the consensus of 50 forecasters projects growth in 2016 at 2.4%. Blue Chip’s “optimistic” consensus of top 10 forecasts puts growth at 3% to 3.1%.

Skeptics might wonder if these two divergent routes to famine or feast are too extreme. Might there be a more plausible in-between scenario that splits the difference between recession and accelerating growth?
To begin with, while a 3% increase in gross domestic product might sound unduly ambitious, this reflects only the lowered ambitions of the current era. Every expansion since World War II has gone through intervals of slow growth. However, all have had years in which economic growth ran at 4% or better, including the 2002-07 expansion. If the economy rises by 3% this year, the current expansion will still retain the dubious honor of being the weakest on record (see chart above).

Growth of 4% seems unattainable due to the drag on exports from weak economies abroad, combined with a strong dollar that makes those exports more costly, plus below-par performance of the small-business sector and slowed expansion of the labor force, owing mainly to the retirement of baby boomers. But if the vicious cycle of recession is avoided, a virtuous cycle should ensue, as positive factors reinforce one another.

Employment gains and the tight labor market are already driving up wages and salaries. That is boosting consumer spending, which is encouraging capital investment, which is causing businesses to hire, which, in turn, is driving employment gains. The virtuous cycle has also begun to include the housing sector.

Employment gains make it possible for more people to form households, which spurs demand for apartment buildings and detached homes, which, in turn, leads to greater gains in employment.

With faster top-line growth, corporate profits can also rise. Profit increases typically slow long before an economic expansion runs out of steam. The pace of the bull market of the past few years has probably slowed, but stock prices can still reach new highs.

IF RECESSION IS AROUND the corner, it will turn history on its head. Take the impact of oil since the mid-1970s. As the chart below shows, each of the past six recessions has been preceded by a spike in crude prices, often called an “oil shock.” The logic is straightforward: Businesses and consumers suffer financial shock when this essential commodity suddenly becomes more costly.


The current collapse in petroleum prices has also been called an oil shock, even though plunging tabs for such items as gasoline, heating oil, diesel fuel, and jet fuel have enriched those same businesses and consumers.

Of course, cheaper crude does hurt energy producers. But since most publicly traded companies are consumers of energy, it makes no sense for the broad stock indexes to track oil.

The recent pattern in which the Standard & Poor’s 500 index moves up and down in concert
with crude seems to reflect equity traders’ belief that a low price for crude signals an economic slowdown.

Hopefully, the market will soon break out of this circular-reasoning trap. If Barron’s is right that oil will rise to $55 a barrel by December, this pattern will be broken by events. Our Feb. 6 cover story, “Here Comes $20 Oil,” referred to the likely final leg of the energy bear market, which should end by April, before a rebound to $55 by December.

Defaults by the energy sector on loans are hurting U.S. banks. But according to estimates by economist Carsten Valgreen of Applied Global Macro Research, such loans account for no more than 4% of the banks’ total loan book. So even if losses on these loans run as high as one-half, this should hardly trigger a banking crisis.

As Valgreen also points out, in all three categories of bank lending—commercial and industrial, consumer, and residential real estate—conventionally calculated loss ratios are near historic lows.

“Bank lending has been gathering steam,” observes Rennaissance Macro Research economics head Neil Dutta, noting that over the 13 weeks through Feb. 3, commercial bank lending accelerated across all categories. Valgreen, who helps run a hedge fund that trades on such insights, believes that the recent selloff in U.S. banking stocks offers a unique buying opportunity.

Another channel through which low energy prices supposedly threaten recession: weakness in developing lands that export oil. Making matters worse is slower economic expansion in China, Japan, and the euro zone.

But while U.S. growth will certainly take a hit from lower exports to the global market, Michael Lewis, economics chief at Free Market, observes, “In the modern era, there is not a single recession that can be traced to foreign economic woes.”

For example, the 1998 meltdown in the Asian economies that caused a brief selloff in the U.S. stock market didn’t trigger the recession that many expected at the time. Adds Lewis: “While a U.S. sneeze can give the rest of the world the proverbial flu, the reverse still does not happen.”

To be sure, the ultralow interest rates maintained by the Federal Reserve have created a breeding ground for financial excesses that, when painfully corrected, often bring recession.

But so far, it appears that the Fed and the economy have been lucky. Major excesses are hard to find.

Even if stocks make new highs by the end of the year, standard price/earnings ratios will be noticeably below their peak of 2000, especially if earnings make modest gains. And the home-price bubble that started to burst in 2007 is a long way from forming again. The classic excess cited in the textbooks—the excessive buildup of inventories—is hardly present today, especially in light of the cuts to inventory investment in the second half of last year.

ONE INDICATION that the economy has found renewed strength: the labor force turnaround of prime-age workers 25 to 54. Much of the reason for slowed growth in the labor force has been demographic. The baby boomers are reaching retirement age, and they are merely following a predictable life cycle by leaving the workplace. But as Barron’s has pointed out (“Work’s for Squares,” Aug. 30, 2014), another, far more disconcerting trend was also evident: lower participation by prime-age workers.

This unanticipated trend is a key reason that forecasters have been surprised by how far the unemployment rate has fallen, despite modest growth. Skeptics have therefore dismissed the decline as bogus. Why place any value on a statistic that becomes more favorable as job seekers stop seeking jobs? But that is no longer true of prime-age workers, and the turnaround is due to the full-employment economy signaled by the jobless rate’s decline to 4.9%.

The prime-age labor force fell to a low of 100.6 million in second-quarter 2014 from its fourth-quarter 2007 peak of 104.4 million. Over the past six calendar quarters, however, it has rebounded by 1.3 million, to 101.9 million in January. The unemployment rate’s decline over this period, to 4.9% from 6.2%, has therefore been accompanied by more prime-age job-seekers rejoining the workforce.

THE RECENT TREND in the unemployment rate also tells us something about the diminished chances of recession. Evidence shows that increases in joblessness consistently lead economic turndowns. In the 12 months before all 11 recessions since World War II, the jobless rate rose on a three-month basis at least once, and usually several times, no doubt because it started to feel the tremors from reduced economic activity before the recession hit.

In the 12 months prior to the 2008-09 recession, the unemployment rate rose on a three-month basis no fewer than seven times. Before the previous recession, of 2001, it climbed five times, and before the 1990-91 recession, six times.

But over the past 12 months—in fact, over the past three years—the three-month change in the unemployment rate has generally been negative and occasionally flat; it hasn’t risen even once.

The last three-month increase in joblessness occurred as of January 2013, when it hit 8%.

Further confirming the positive trend in the labor markets: the persistent decline in new claims for unemployment insurance. As Free Market’s Lewis points out, initial claims are “one of the most reliable leading indicators, typically giving ample warning of recessions.” But, he adds, there is “not even an inkling [of a rise] yet.” In the four weeks through Feb. 13, weekly claims averaged 273,000, one of the lowest figures in decades.

For real GDP to grow by 3% this year, real consumer spending must do its part, rising at an annualized 3% or more in each calendar quarter. So far, at least, consumption seems to be off to a good start. Based on the solid retail sales report for January, economist Neil Dutta is tracking 3.2% growth in the current quarter. If that persists, it will be noticeably higher than the lackluster performance of 2015, when real consumption for the full year rose by just 2.6%.

Last year, the money generated by the boost to disposable personal income was mainly saved, rather than spent.

Applied Global Macro Research economist Jason Benderly predicts that consumption will rise by 3.4% this year. His forecast seems plausible if, as he expects, three factors that figured in 2015’s weak performance recede this year.

The first factor, which weighed on consumer spending, was a fall in confidence. Benderly has found the best indicator of consumer confidence isn’t the standard surveys of confidence, but rather credit spreads. The spread between yields on Baa corporate bonds and 10-year Treasuries widened steadily over the course of last year and is now even wider. But as recession fears recede, this spread should start narrowing. That should signal a rise in confidence, he argues, accompanied by a rise in spending.

The second factor is, ironically, faster growth of wages and salaries. Benderly has found that consumer spending responds with a lag when wage-and-salary growth accelerates. That happened last year, with the extra income going into extra saving. This year, however, consumer spending should start to catch up with the increase in income.

THE FINAL FACTOR is also a lagged response, in this case, to lower energy prices. Benderly has found that when prices of necessities decline, consumers initially save much of the windfall, only to spend it later.

So last year’s plunging energy costs went into savings, but much of it will be spent on consumption this year.

Another key component of economic output—investment in plant and equipment— was hurt by the severe cutbacks by the energy sector. But if the oil price rebounds to $55, as Barron’s expects, then key parts of energy investment will make a comeback before the year is out, says Citigroup senior energy analyst Anthony Yuen. And in general, Benderly anticipates a gradual rebound in U.S. manufacturing, as it responds with a normal lag to the pickup in retail sales.

The government portion of output, which began to make small contributions to growth in 2015, should pick up a bit this year, too, given the turnaround in state and local employment. Residential investment, which has been making steady contributions to GDP growth, should also climb a bit faster, as rising incomes spur greater household formation, in turn causing greater production and spurring greater employment and formation of households.

In short, the virtuous cycle should dominate. 



Marc Faber on Cashless Society Insanity and Why Wall Street Hates Gold

by: Mike Gleason


Mike Gleason: It is my privilege now to be joined by a man who needs little introduction, Marc Faber; editor and publisher of The Gloom, Boom & Doom Report. Dr. Faber has frequently appeared on financial shows across the globe and he's a well-known Austrian school economist, and an investment adviser. It's a real honor to have him on with us today. Dr. Faber, thank you so much for joining us.

Marc Faber: It's my pleasure, thank you very much.

Mike Gleason: Well, I want to start out by asking you about the current state of the financial world here in the early part of 2016. We've got the global equities markets continuing to roll over. Meanwhile, the metals are doing quite well and acting as a bit of a safe haven. What do you make of the market action here, so far this year?

Marc Faber: Well, basically, the financial markets have been sick for quite some time.

Emerging markets either never made a new high above the 2006, 2007 highs, or they peaked out in 2011, or some even later in 2014. Basically after about February/March 2015, they started to drift. And in the U.S., the indices were strong, but the average stock was down substantially in 2015. This is called weakness beneath the surface of the indices because an index, theoretically, could have 500 stocks and 499 decline, but one stock goes up a lot and drives up the index. So this happened last year, to some extent, in the U.S... you have the strong stocks, Facebook, Amazon, Netflix, Google, and maybe another 20 stocks that were going up.

And at the same time, you have thousands of stocks that were acting badly and going down, which accounts for actually a horrible performance for most investors. Now in January, reality set in with the strong stocks, they're all down 20, 30, and sometimes even more percentages.

Mike Gleason: Gold has been rallying in dollar terms lately but it has done much better in terms of many other major fiat currencies. The U.S. dollar has been remarkably strong in the past year, although it's finally showing some signs of weakness. What are you expecting over the coming year in the currency markets? Is the dollar going to head higher still or do you see it rolling over?

Marc Faber: The question should be, "Which central bank is the most insane?" Because you understand, the central banks have been manipulating just about everything. They manipulate the currencies, they manipulate interest rates, they manipulate stocks. It's interesting sometimes if you observe in the U.S., when the market is very weak overnight, in other words the S&P futures go down 20, 30 points, suddenly, a buyer emerges and pushes up the market. I believe that the Fed has not just intervened in bonds through Operation Twist, in interest rates through QE programs but occasionally they step into the stock market to stabilize the market and try to push it up. I think other central banks around the world ... in Japan, they announce it, the central bank, the Bank of Japan, is buying shares through ETFs.

So there's a gigantic manipulation and you and I, as an investor, we just don't know how far these insane people will go with the manipulation of markets. Now, already 7 trillion dollars' worth of pounds are trading at less than 0 interest. The talk is that, even in the U.S., they might introduce negative interest rates. Negative interest rates will not help the world; I guarantee you that.

Mike Gleason: Furthering the point there, let's talk about the war on cash for a moment. We have negative interest rates coming into the picture, as you just mentioned, with our own Fed telling U.S. banks to start thinking about how they would handle negative rates. Meanwhile, we're seeing people who want to deal in cash, withdraw their cash, even deposit cash, getting hassled in various ways. Why do you personally think that cash and cash holders are increasingly disfavored by the financial establishment?

Marc Faber: Well, it's clear to me. If you look at the world over the last 100 years, you have a group of people that want to have more and more control over you and me. They want to know where you are, what you do, what you're looking at. Basically, we're moving into an Orwellian society where they can check everything. And cash will still be one of the means where you could go somewhere and buy something and nobody would really know about it. Now they want to abolish it. Of course, if you have negative interest rates, you want to essentially prevent people from hoarding bank notes in their safes at no cost. So you want to deprive them of that privilege, of that freedom, so you introduce a cashless society. In my opinion, it will not work, and let me explain to you why.

Let's say you and I live in a small town of a thousand people and suddenly the government says, "No more cash." Say, I'm the baker and you're the butcher, and a friend of ours is the pharmacist. We can then barter among each other and effect the balances every month or every 3 months and so forth.

Then, some kind of paper money comes back up. These are vouchers. So the war on cash would have the exact opposite effect. You will have a voucher system in every small city, and even in big cities, some smart people will develop the voucher system. So instead of having just one currency, paper currency, you'll have hundreds of paper currencies. Number two; if they want to really launch a cashless society, they would have to take your gold away. That, in some countries, will simply not fly. In other countries, a cashless society is simply not practical because 80% of the population doesn't have a bank account and doesn't have cash to start with.

So in my view, this cashless business is going to fail very badly.

The argument is, of course, "Oh, we want to move into a cashless society because we want to prevent criminality." This is all nonsense. They want to move into cashless society so they can control you.

Mike Gleason: Deutsche Bank has been the subject of major concern. The share price continues to fall and the CDS market indicates default risk at the bank is rising dramatically, but it isn't just Deutsche Bank. The markets suggest risk is spiking for a long list of the largest U.S. and European banks. The potential problem is huge, given that many of these firms are much bigger than Lehman was and they carry even more derivative exposure. How concerned should people be about this? Do you expect problems imminently or is there a good chance this will blow over?

Marc Faber: Well, I have always maintained derivatives will not exist forever. Eventually, there will be no derivatives and we'll start a new system, which is based on, say, gold or another currency that cannot be multiplied by some academics at the central bank. I mean, when you think about it philosophically, now we have 5,000 years of human history from the old days in Babylon up to today that has been recorded. Never, ever before have interest rates been this low. Never, ever before have we had negative interest rates. This has all been created by some mad academics that populate the halls of glass buildings called central banks. This is now really a disgrace to humanity that in democracies in particular, we give so much power to these people that basically rule the world to a large extent.

Mike Gleason: I want to follow up on that. Given all of the mal-investment that has resulted from the low interest rate environment, what are the dangers out there to look out for? I mean, is there another subprime mortgage collapse type of event brewing? Because there do seem to be major stresses developing in the credit markets.

Marc Faber: Well, if you tried to eliminate risks, eventually you have a systemic risk. That was already the view of Karl Popper. But I'd like to make this observation; say, today, the bonds of Deutsche Bank rally strongly and the stock is up something like 12%. Deutsche Bank announced that they will buy back some bonds. Now when you think it through, with whose money? They have a capital shortage, that's why the stock has collapsed by more than 80% since the financial crisis in 2007. The reason they can buy back bonds is that someone is lending the money. But why would anyone lend them the money to buy bonds that essentially that have collapsed this year by something like 20, 30%? Who is lending them the money? The central bank of Europe, the ECB, or the Federal Reserve, or someone innocent. What will eventually happen is a crisis that brings down central banks. But I don't know when, but it's going to happen.

Mike Gleason: It definitely does seem inevitable. They can't keep going on in the current path forever. Switching gears here a moment, any thoughts on the U.S. Presidential election? What do you make of all the success of the anti-establishment candidates on both sides of the spectrum? And do you think that's maybe contributing in any way to the financial market uncertainty and volatility that we're seeing lately? There does seem to be a pretty good chance now of a non-establishment candidate winning in November.

Marc Faber: Well, I think that the American people have figured out that both the Democrats and the Republicans are one in the same mafia family. They protect each other. Both parties know so much dirt on each other that they never speak about it. So there is a status quo, it's no progress at all.

Because they each have something on each other and so the independent candidates who, I'm not sure they will do it, but at least they tell the voters, "Listen, we're going to do something different." And I believe actually that both Sanders and Trump, especially Trump, because he must be very angry at the wealthy Republicans that are so much against him, he's going to go after them. And Sanders, I believe him, that he's going to go after the big banks and Wall Street, because they have really, in good English, screwed the man on the street. What exactly the outcome will be, and whether they will be elected is another question because the establishment both on the Democratic side and the Republican side will fight like mad.

But I think the Democrats realize that the Clintons are over. It's a vicious family and dishonest, and they don't want Hillary Clinton to be the next president. And on the Republican side, they realize that the candidates that the establishment favor, like Rubio, they are not what the people really want. I think the best chance at the present time goes to Cruz. And my view would be that Trump has a very good chance if he can keep rallying people behind him.

Mike Gleason: You've lived in Asia for a number of years now, so there aren't many better to comment on the dynamic of the global shift that's going on from West to East. In terms of China, they have been very active participants in the gold and silver markets and have been big accumulators over the past several years. You even wrote a book about this 14 years ago, about how that region of the world was going to be discovering gold and boy, was that prophetical. So talk about what the Chinese are doing there and what do you think they're trying to position themselves for as we move forward here? Because a lot of gold is moving from what seems to be weak hands in the west and into very strong hands in the east. What effect will this have on the future?

Marc Faber: It's very clear that Asia, with more than 50% of the world's population, has been growing very rapidly in the last 30 to 50 years. China, in particular, over the last 20 years.

China, with 1.3 billion people and India, with 1.2 billion people are very important countries, economically.

And if you look at the standards of living of people in the west, in other words western Europe, the U.S., and I include Japan, are no longer rising but going down for most people. Whereas in the east, I can say that since I arrived in Asia in 1973, just about everybody enjoys a better standard of living.

Just look at, say, Chinese. Until the mid 80s they couldn't travel and then in the early 1990s, there were about 3 to 5 million Chinese travelers overseas. In 2000, there were 10 million Chinese travelers overseas and now there's a little bit less than 120 million Chinese traveling around the world.

So there has been a huge improvement and there has been an increase in their economic power.

The Chinese, for some reason, believe in gold. My sense is that the Chinese would like to eventually have the world's dominant currency, in other words, replace the dollar as the reserve currency of the world.

Whether they manage it this time, I'm not sure, because right now, China has also some of its own problems. But I'd like to tell you, if I have to choose between the problems of western Europe and the U.S. and China, I'd take the problems of China any time.

Mike Gleason: What happens when the West runs out of gold to sell to the East, to China? We talk about currency wars and what may develop there. Would that be one of those potential tipping points if all of a sudden western vaults are completely just wiped out and there's no more gold to send over there? Because you got to think it has an exhaustion point based on how much they're accumulating and how much of the West's gold they're taking.

Marc Faber: Well, I think it will take a very long time until most of the gold has shifted to Asia, but I'd like to clarify one point because there's a misconception about currency wars. In the Fed's statutes, there is a paragraph that says that one of the Fed's mandates is to coordinate - well understood, coordinate - monetary policies with foreign central banks. I'd like to emphasize that the federal reserve talks every day to the Bank of England, to the ECB, and to the Bank of Japan, and that they coordinate monetary policies. Now, I don't believe that they talk every day to the Bank of China and to the Russian Central Bank. That I doubt, but basically among the industrialized block, Japan, Britain, Europe, and the U.S... the so-called allies of the U.S... they coordinate monetary politics.

Now, how long this will work and to what extent there is a currency war, basically what happened is that some big hedge funds, including George Soros, were shorting the Chinese currency. And I don't think that the Chinese want to be held hostage by some speculator.

Thereafter, suddenly the U.S. dollar began to weaken. You understand, the Chinese basically, they have sufficient reserve where they can basically dump U.S. dollars into the market and depress the value of the U.S. dollar. At the same time, they can embarrass, say, the Bank of Japan by pushing up the value of the yen. So I believe it will become very interesting, what happens internationally. We have this colossal liquidity bubble that was created through printing.

Mike Gleason: A few years ago, you had a funny exchange on CNBC with anchor Maria Bartiromo about gold, which really underscores the mainstream's view. For those who haven't heard it, let's have a listen to it and then I'll have you comment.

Maria Bartiromo: You said a moment ago, "Markets go up and down." The dollar goes up and down, stocks go up and down and yet, you also say you will never stop buying gold. So what's behind that strategy? Doesn't gold go up and down too?

Marc Faber: You see, I want to tell you something, Maria, about gold. I buy gold because I'm fearful that we will still have a systemic crisis, that we will have wars and so forth in sum. So I'm buying gold because I'm fearful. I'm sorry to say, Maria, you don't own any gold and you are in great danger because you don't own any gold. So I'm fearful and I own gold, and you are in danger because you don't own any gold.

Maria Bartiromo: You don't know that I don't own any gold... actually, you're right, I don't own any gold. Okay, guilty as charged, I don't own any gold.

Mike Gleason: (laughing) I just loved that. So why is it that most don't understand gold and are so often quick to ridicule those of us who believe in it and view it as real money?

Marc Faber: Basically, gold is an honest currency. You can increase the supply somewhat through the opening of new mines and the exploration and the discovery of new deposit, but you cannot print it and double the supply of gold overnight. That simply doesn't exist. And that quality of gold being a store of value is a disaster for the interventionists that we have at central banks and, by the way, in government. Because if you look at, say, government in 1900 and today, in 1900, U.S. total government expenditure as a percent of the economy were less than 8%. Today, they're over 40%. So do you understand... the government is not representing people anymore - this is what we discussed before about the good showing of Sanders and Trump - but the government is representing itself. It is eating at the economic cake and by eating too much of the economic cake, the remaining economy, the private sector, cannot grow fast enough to boost overall growth rates.

Because the government doesn't do anything to boost growth. It actually is growth-retarding with regulation and laws and all kinds of things. So basically, everybody - the media, the government and in the financial sector - detests and hates gold because it's honest. The whole financial sector, they love money printing, and let me tell you why. Each time the market goes down, whether after March 2000 until 2002/2003, or after 2007... if the markets didn't recover, the financial sector would earn late fees because they are paid according to the asset values and they're paid according to performances. They love money printing and these are the people that are being interviewed on TV, you understand?

The TV, the media, the CNBC, and Bloomberg's office, well, they're not going to interview ordinary people... an electrician, a carpenter, a car mechanic. They interview the people that have a vested interest in money printing because they get performance fees and management fees from money printing. That's why people on CNBC and so on and so forth hate gold.

Mike Gleason: As we begin to close here, what advice do you have for that common man, the electrician and so forth... the people out there who are trying to protect themselves? Both those who may already own gold and silver, and those who don't or those who are on the fence about whether or not they ought to have some. What advice can you share for those folks?

Marc Faber: Well, basically, I think the issue is really, if they introduce a cashless society, I think it's going to be very likely that the government will try to take the gold away from you.

Now, in 1933, this happened and then the government collected the gold and they paid you $20 an ounce.

After they had collected all the gold, they revalued it to $35 an ounce. Nowadays, I'm not sure whether that would fly, but one thing is very clear. In the 1930s, it was easier to hide gold. You could buy it and essentially put it a hole in your car or a safety deposit box at home and so forth. Nowadays, with metal detectors and all kinds of devices, it will be difficult to hide gold.

Equally, if you walk through an airport, probably it's easier to hide some stamps and diamonds than to hide gold, which would respond right away to a metal detector.

So I think it's important for people to think, "If I have a lot of gold, where do I want to store it?" I would say probably gold stored in Asia is in a better, safer place than stored in the U.S. or even in Europe. (Mario) Draghi is basically working with the Fed so if they collect the gold in America, it's likely they will do the same in Europe.

Mike Gleason: As we always advocate, just keep your gold and silver in your own personal possession, don't put it in a bank safety deposit box or anything like that. Have, at least a good portion of it where you can get your hands on it if and when you need it. And beyond that, if you have more than you're able to store yourself seek out a private depository that is outside the banking system - perhaps in a place like Asia for instance like you mentioned. But keep most of what you own within close proximity for sure.

Well, excellent stuff, Dr. Faber. Thank you so much for your time and your wonderful insights.

We really appreciate you staying up late there in Thailand to speak with us today. Now before we let you go, please tell people about how they can subscribe to The Gloom, Boom & Doom Report and get your fantastic commentary on a regular basis.

Marc Faber: Well it's my pleasure. I have a website called GloomBoomDoom.com, or you can just Google my name and then it comes up, GloomBoomDoom.com.

Mike Gleason: It's been a real honor to speak with you, Dr. Faber. I hope we can catch up with you some time again in the future and I wish you a great weekend. Thanks again for joining us.

Marc Faber: Thanks a lot. Bye-bye.

Mike Gleason: Well, that will do it for this week. Thanks again to Marc Faber, editor and publisher of The Gloom, Boom & Doom Report. Again the website is GloomBoomDoom.com.

Be sure to check that out.


Review & Outlook

The Political War on Cash

So long, Ben Franklin. Politicians want to coerce you to spend.

   

Photo: Getty Images
 

These are strange monetary times, with negative interest rates and central bankers deemed to be masters of the universe. So maybe we shouldn’t be surprised that politicians and central bankers are now waging a war on cash. That’s right, policy makers in Europe and the U.S. want to make it harder for the hoi polloi to hold actual currency.

Mario Draghi fired the latest salvo on Monday when he said the European Central Bank would like to ban €500 notes. A day later Harvard economist and Democratic Party favorite Larry Summers declared that it’s time to kill the $100 bill, which would mean goodbye to Ben Franklin. Alexander Hamilton may soon—and shamefully—be replaced on the $10 bill, but at least the 10-spots would exist for a while longer. Ol’ Ben would be banished from the currency the way dead white males like him are banned from the history books.

Limits on cash transactions have been spreading in Europe since the 2008 financial panic, ostensibly to crack down on crime and tax avoidance. Italy has made it illegal to pay cash for anything worth more than €1,000 ($1,116), while France cut its limit to €1,000 from €3,000 last year. British merchants accepting more than €15,000 in cash per transaction must first register with the tax authorities. Fines for violators can run into the thousands of euros. Germany’s Deputy Finance Minister Michael Meister recently proposed a €5,000 cap on cash transactions.

Deutsche Bank CEO John Cryan predicted last month that cash won’t survive another decade.

The enemies of cash claim that only crooks and cranks need large-denomination bills. They want large transactions to be made electronically so government can follow them. Yet these are some of the same European politicians who blew a gasket when they learned that U.S. counterterrorist officials were monitoring money through the Swift global system. Criminals will find a way, large bills or not.

The real reason the war on cash is gearing up now is political: Politicians and central bankers fear that holders of currency could undermine their brave new monetary world of negative interest rates.

Japan and Europe are already deep into negative territory, and U.S. Federal Reserve Chair Janet Yellen said last week the U.S. should be prepared for the possibility. Translation: That’s where the Fed is going in the next recession.

Negative rates are a tax on deposits with banks, with the goal of prodding depositors to remove their cash and spend it to increase economic demand. But that goal will be undermined if citizens hoard cash. And hoarding cash is easier if you can take your deposits out in large-denomination bills you can stick in a safe. It’s harder to keep cash if you can only hold small bills.

So, presto, ban cash. This theme has been pushed by the likes of Bank of England chief economist Andrew Haldane and Harvard’s Kenneth Rogoff, who wrote in the Financial Times that eliminating paper currency would be “by far the simplest” way to “get around” the zero interest-rate bound “that has handcuffed central banks since the financial crisis.” If the benighted peasants won’t spend on their own, well, make it that much harder for them to save money even in their own mattresses.

All of which ignores the virtues of cash for law-abiding citizens. Cash allows legitimate transactions to be executed quickly, without either party paying fees to a bank or credit-card processor. Cash also lets millions of low-income people participate in the economy without maintaining a bank account, the costs of which are mounting as post-2008 regulations drop the ax on fee-free retail banking. While there’s always a risk of being mugged on the way to the store, digital transactions are subject to hacking and computer theft.

Cash is also the currency of gray markets—amounting to 20% or more of gross domestic product in some European countries—that governments would love to tax. But the reason gray markets exist is because high taxes and regulatory costs drive otherwise honest businesses off the books. Politicians may want to think twice about cracking down on the cash economy in a way that might destroy businesses and add millions to the jobless rolls. The Italian economy might shut down without cash.

By all means people should be able to go cashless if they like. But it’s hard to avoid the conclusion that the politicians want to bar cash as one more infringement on economic liberty.

They may go after the big bills now, but does anyone think they’d stop there? Why wouldn’t they eventually ban all cash transactions much as they banned gold and silver as mediums of exchange?

Beware politicians trying to limit the ways you can conduct private economic business. It never turns out well.


Closing Developing Countries’ Capital Drain

Joseph E. Stiglitz, Hamid Rashid
. Drain at construction site


NEW YORK – Developing countries are bracing for a major slowdown this year. According to the UN report World Economic Situation and Prospects 2016, their growth will average only 3.8% this year – the lowest rate since the global financial crisis in 2009 and matched in this century only by the recessionary year of 2001. And what is important to bear in mind is that the slowdown in China and the deep recessions in the Russian Federation and Brazil only explain part of the broad falloff in growth.
 
True, falling demand for natural resources in China (which accounts for nearly half of global demand for base metals) has had a lot to do with the sharp declines in these prices, which have hit many developing and emerging economies in Latin America and Africa hard. Indeed, the UN report lists 29 economies that are likely to be badly affected by China’s slowdown. And the collapse of oil prices by more than 60% since July 2014 has undermined the growth prospects of oil exporters.
 
The real worry, however, is not just falling commodity prices, but also massive capital outflows.
 
During 2009-2014, developing countries collectively received a net capital inflow of $2.2 trillion, partly owing to quantitative easing in advanced economies, which pushed interest rates there to near zero.
 
The search for higher yields drove investors and speculators to developing countries, where the inflows increased leverage, propped up equity prices, and in some cases supported a commodity price boom. Market capitalization in the Mumbai, Johannesburg, São Paulo, and Shanghai stock exchanges, for example, nearly tripled in the years following the financial crisis. Equity markets in other developing countries also witnessed similar dramatic increases during this period.
 
But the capital flows are now reversing, turning negative for the first time since 2006, with net outflows from developing countries in 2015 exceeding $600 billion – more than one-quarter of the inflows they received during the previous six years. The largest outflows have been through banking channels, with international banks reducing their gross credit exposures to developing countries by more than $800 billion in 2015. Capital outflows of this magnitude are likely to have myriad effects: drying up liquidity, increasing the costs of borrowing and debt service, weakening currencies, depleting reserves, and leading to decreases in equity and other asset prices. There will be large knock-on effects on the real economy, including severe damage to developing countries’ growth prospects.
 
This is not the first time that developing countries have faced the challenges of managing pro-cyclical hot capital, but the magnitudes this time are overwhelming. During the Asian financial crisis, net outflows from the East Asian economies were only $12 billion in 1997.
 
Of course, the East Asian economies today are better able to withstand such massive outflows, given their accumulation of international reserves since the financial crisis in 1997. Indeed, the global stock of reserves has more than tripled since the Asian financial crisis. China, for example, used nearly $500 billion of its reserves in 2015 to fight capital outflows and prevent the renminbi’s sharp depreciation; but it still has more than $3 trillion in reserves.
 
The stockpile of reserves may partly explain why huge outflows have not triggered a full-blown financial crisis in developing countries. But not all countries are so fortunate to have a large arsenal.
 
Once again, advocates of free mobility for destabilizing short-term capital flows are being proven wrong. Many emerging markets recognized the dangers and tried to reduce capital inflows. South Korea, for example, has been using a series of macro-prudential measures since 2010, aimed at moderating pro-cyclical cross-border banking-sector liabilities. The measures taken were only partially successful, as the data above show. The question is, what should they do now?
 
Corporate sectors in developing countries, having increased their leverage with capital inflows during the post-2008 period, are particularly vulnerable. Capital outflows will adversely affect their equity prices, push up their debt-to-equity ratios, and increase the likelihood of defaults. The problem is especially severe in commodity-exporting developing economies, where firms borrowed extensively, expecting high commodity prices to persist.
 
Many developing-country governments failed to learn the lesson of earlier crises, which should have prompted regulations and taxes restricting and discouraging foreign-currency exposures.

Now governments need to take quick action to avoid becoming liable for these exposures.

Expedited debtor-friendly bankruptcy procedures could ensure quick restructuring and provide a framework for renegotiating debts.
 
Developing-country governments should also encourage the conversion of such debts to GDP-linked or other types of indexed bonds. Those with high levels of foreign debt but with reserves should also consider buying back their sovereign debt in the international capital market, taking advantage of falling bond prices.
 
While reserves may provide some cushion for minimizing the adverse effects of capital outflows, in most cases they will not be sufficient. Developing countries should resist the temptation of raising interest rates to stem capital outflows. Historically, interest-rate hikes have had little effect. In fact, because they hurt economic growth, further reducing countries’ ability to service external debts, higher interest rates can be counterproductive. Macro-prudential measures can discourage or delay capital outflows, but such measures, too, may be insufficient.
 
In some cases, it may be necessary to introduce selective, targeted, and time-bound capital controls to stem outflows, especially outflows through banking channels. This would entail, for example, restricting capital transfers between parent banks in developed countries and their subsidiaries or branches in developing countries. Following the successful Malaysian example in 1997, developing countries could also temporarily suspend all capital withdrawals to stabilize capital flows and exchange rates. This is perhaps the only recourse for many developing countries to avoid a catastrophic financial crisis. It is important that they act soon.
 
The views expressed here do not represent the views of the United Nations or its member states.
 


When Will Gold and Gold Stocks Correct?

By: Jordan Roy-Byrne





Wednesday evening we raised a question in a subscriber update. We wrote: The current question for Gold and gold stocks is if they will push to higher targets before or a correction or if a correction has already started. We should know the answer in the next day or two. The gold stocks exploded higher on Thursday. GDX gained 6% while GDXJ surged 7.4%. Meanwhile, Gold solidified its support at $1200/oz. Markets that become overbought within strong trends can become extremely overbought before they correct. Recent price action in the precious metals complex argues that the path of least resistance in the short term continues to be higher.

The chart below plots the weekly candle charts of GDXJ and GDX. The first observation is although the miners are very overbought on the daily charts, they aren't that overbought on the weekly charts. They will close this week flat after three strong weeks of gains. Also, the miners figure to face stronger resistance at higher levels. GDXJ is trading pennies below $25.00. If it surpasses its 80-week moving average then its next target is $27-$28. (Note that a measured move from the July 2015 to January 2016 consolidation projects to $28). Meanwhile, GDX is holding above previous resistance at $18. Its next strong resistance targets are $21 and $22. (The measured move from the July 2015 to January 2016 consolidation projects to $21).


GDX and GDXJ Weekly Charts


The monthly chart of Gold continues to give the most clarity on its prognosis. We have written about the importance of Gold holding support at $1180-$1200/oz, which it did this week. A monthly close above that support adds greater confirmation to a change in the primary trend.

Gold has near-term upside potential to $1285/oz which marks monthly resistance and contains the 40-month moving average. Note that weekly resistance is at $1294. In addition, there should be very strong monthly resistance at $1330.

Monthly Gold Chart


The odds favor Gold and gold stocks continuing to move higher before a correction begins. Both GDX and GDXJ could gain more than 10% before reaching stronger resistance while Gold has upside potential to $1285-$1294/oz. The counter-trend moves within very strong trends occur quickly. Gold declined from $1264/oz to $1192/oz in less than three days while the miners (GDX and GDXJ) have corrected 9-10% twice in the past ten days. Unless Gold and gold stocks fall below Thursday's lows then we should anticipate higher prices in the short-term. A bigger correction will come but not yet.


How the Kurds Became Syria’s New Power Brokers

And why Erdogan's war against them threatens to undermine his relationship with the United States and spark a civil war in Turkey.

By Amberin ZamanAmberin Zaman is a Public Policy Scholar at the Wilson Center.

 
How the Kurds Became Syria’s New Power Brokers


Tal Rifaat, Menagh air base, Kefir Naya, Kefir Neris — town after town, village after village is falling to Kurdish-led forces as they blaze their way across northern Syria. The latest push by the U.S.-backed group known as the Syrian Democratic Forces (SDF) marks an explosive new phase in Syria’s five-year war. Turkey, a key, and increasingly unpredictable, NATO ally, is now on the verge of being sucked into the battle, against the group the U.S. favors.

Turkey has long insisted that Syria’s Kurds pose a greater threat to its security than the Islamic State jihadis do, and is furious that the United States is helping them. On Feb. 18, the Turkish government identified a Syrian Kurd, Salih Necar, as the perpetrator of a car bomb attack in the heart of Ankara.

Nacar allegedly drove a car laden with explosives into the midst of shuttle buses carrying military personnel and civilians outside the air force headquarters in the Turkish capital, killing himself and at least 27 other people.

Less than a day later, at least six Turkish soldiers died in the country’s mainly Kurdish province of Diyarbakir following a bomb attack also thought to have been carried out by Kurdish insurgents.

The main Syrian Kurdish militia, the People’s Protection Units (YPG), was set up as a franchise of the Kurdistan Workers’ Party (PKK), which has been fighting the Turkish state on and off since 1984, first for independence and now for Kurdish self-rule inside Turkey. Salih Muslim, the co-chair of the Democratic Union Party, which serves as the political wing of the YPG, swiftly denied any connection to the Ankara blast. The YPG has never attacked Turkey before and would surely desist from any actions that put its alliance with the United States at risk.

However, the Turkish prime minister, Ahmet Davutoglu, an Islamist, insisted that the bomber was “definitely” a member of the YPG who had “infiltrated” Turkey.

Turkey is adamant that the PKK and the YPG are “terrorists.” Washington half agrees. The PKK is on the State Department’s list of terrorist organizations. But the YPG is not, a fact that has paved the way for its deepening partnership in Syria, as Washington has provided the group with air support and weapons.

It remains unclear what sort of retaliatory action Turkey will take. What is certain is that Washington’s delicate balancing act between its Turkish and Kurdish allies is looking more precarious than ever.

Since Feb. 13, Turkish tanks have been shelling SDF positions near the Syrian town of Azaz, which is a vital resupply line for rebel forces in Aleppo who are allied with Ankara and doubles as a rear base against the Kurds. Turkey has vowed to prevent it from falling into their hands. Deputy Prime Minister Yalcin Akdogan made Turkey’s intentions clear, saying that it wants to create a “secure” strip of territory roughly 6 miles deep on the Syrian side of the border, including Azaz. Thousands of Turkish troops have been massing in the area for weeks, prompting Russia to warn that Turkey was planning an invasion of Syria.

These steps have placed Turkey on the brink of a conflict with its regional antagonists. The Kurds say they will fight back against any Turkish aggression. Syrian President Bashar al-Assad, whose own forces are inching their way toward Turkey’s border, says he will do the same. And few doubt that Russia, which is itching to avenge last year’s downing by Turkish pilots of its Sukhoi SU-24 jet, would deliver the biggest whacking of all.

Meanwhile, the SDF is skirting Azaz, punching a corridor further south — well out of Turkey’s range — and recruiting rebel groups along the way. Turkey’s demands that Washington stop aiding Kurdish “terrorists” has so far fallen on deaf ears. Rather, Washington has been calling on Turkey to stop attacking the Syrian Kurds.

Ankara may seem powerless in Syria, but it still has cards to play. It can, and already has begun to, reinforce its rebel proxies against the Kurds. More ominously, it could yet again ease restrictions on the flow of foreign jihadis into Syria.

Turkey’s troubles with its own Kurds explain why it is prepared to go to such extremes. The latest and most promising round of peace talks between the Turkish government and the PKK collapsed last summer when Turkey resumed its battle against the insurgents and began pummeling their strongholds in Kurdish-controlled northern Iraq. The PKK responded by shifting its fight to urban centers in the largely Kurdish southeast of Turkey, where its youth wing is mired in a bloody standoff with Turkish security forces. PKK fighters frequently target army convoys, which is why they cannot be ruled out as a suspect in the Ankara bombing.

The Turkish government claims its fight against the PKK at home is directly connected to the war in Syria. It says it has discovered secret tunnels dug from the Syrian side of the border to the besieged Turkish town of Cizre, scene of some of the grossest rights abuses by the Turkish authorities in recent years. The tunnels are allegedly being used to funnel arms between the Syrian Kurdish insurgents and the PKK. A young Kurdish fighter quoted by Germany’s Der Spiegel confirmed that such tunnels exist.

It didn’t have to be this way — the Kurdish issue didn’t have to threaten to undermine both Turkey’s policy in Syria, and its alliance with the United States. In early 2013, the mood in Ankara was dramatically different: Recep Tayyip Erdogan, the then prime minister who was planning to campaign to become Turkey’s first popularly elected president the following year, was keen to strike a deal with the PKK’s imprisoned leader, Abdullah Ocalan. If the PKK disarmed and withdrew from Turkey, the Kurds would get something substantial — it remains unclear exactly what, but likely greater local autonomy, and some sort of amnesty for those not involved in violence — in return.

That wasn’t all. A deal could have helped Erdogan achieve two of his most cherished goals: The YPG would have had to join the rebel campaign to unseat Assad and refrain from any moves towards self-rule; and Turkey’s largest pro-Kurdish party, the People’s Democracy Party (HDP), would have needed to support Erdogan’s plans not only to become the president but also to expand his powers once in office.

But the PKK refused to play ball, claiming that Turkey’s latter-day “sultan” was stringing them along. Why else had the government not passed a single piece of pro-Kurdish legislation?

And why was it arming jihadis in Syria against the YPG? The government replied that it had provided hundreds of wounded YPG fighters with free medical care and opened its doors to more than a quarter of a million Syrian Kurdish refugees, but the PKK was not swayed.

Hopes of an agreement were rekindled a year ago when the PKK unveiled a 10-point roadmap for peace. But Erdogan swiftly disowned the document, and all communication between Ocalan and the HDP has since ceased.

Yet, Syria’s Kurds have continued to thrive. Today they enjoy the rare distinction of being the sole group that simultaneously enjoys U.S. and Russian support. The YPG’s links with Washington were initially forged when U.S. planes intervened to rescue the Kurdish town of Kobani from the Islamic State in 2014. Since last year, the Kurds have teamed up with a gaggle of opposition Arab, Turkmen, and non-Muslim brigades to form the SDF, mostly as a kind of fig leaf that allows Washington to justify its support for them.

The payoff for both sides has been huge. The SDF has driven the Islamic State out of a broad stretch of territory along the Turkish border, while helping to pressure the jihadis in their self-proclaimed capital of Raqqa. The Kurds boast they now control an area “three times the size of Lebanon.”

The Kurds are now looking to link their two self-administered “cantons” that lie to the east of the Euphrates, named Jazeera and Kobani, with the canton of Afrin, which lies to the west.

This means dislodging the Islamic State from the 60-mile area wedged between them, and also going through an area that rebel groups friendly to Ankara, including more moderate brigades that have received weapons from the CIA, dominate.

Until recently they had to hold back at Washington’s behest. Turkey, which opened the Incirlik air base to anti-Islamic State combat missions in July, claimed it had done so on the condition that the United States would not help the Kurds move west of the Euphrates.

Turkey wanted to organize a non-Kurdish rebel force to uproot the Islamic State from that area west of the Euphrates. But the force never materialized — and Russia’s intervention on behalf of Assad’s crumbling army has also bolstered the Kurds. Helping the SDF boot out anti-Assad rebels from the areas they covet has the added benefit, for Moscow, of poking Turkey in the eye.

But Syria’s Kurds want more. They are angling for diplomatic recognition. Russia has stepped up to the plate, hinting that it will back the Kurds’ plans for autonomy. It also insists that the Kurds must take part in the now-stalled Geneva talks. The United States also backed the Kurds’ participation in peace talks, but backed off when Ankara threatened to stay away from the talks if the Kurds were allowed to join.

The Kurds are skillfully playing the Russians and Americans off of each other to extract as much influence as possible. Kurdish threats to defect squarely to the Russian camp propelled Brett McGurk, President Barack Obama’s special envoy for the anti-Islamic State coalition, to speed up a long-mulled visit to Kobani. On Feb. 1, a beaming McGurk was photographed receiving a plaque from a YPG commander who used to be, as Turkey shrieked, a member of the PKK. Washington appears to be quietly encouraging the Kurds to grab more territory, even at the expense of moderate rebels it has aided and trained, to ensure that Assad’s Russian-backed forces don’t get there first.

All of this is adding to Turkish fury, and Turkey’s Kurds say they are paying the price. The pain that Turkey would like to inflict on their Syrian brethren, their argument runs, is being meted out on them instead.

Washington’s insistence on maintaining the fiction that the PKK and the YPG are completely separate organizations is only making things worse. Indeed, it would not be surprising if the United States were to step up its military and intelligence cooperation with Turkey against the PKK to tamp down anger over its relations with the YPG.

The longer the conflict continues, the more alienated — and radicalized — Turkey’s Kurds will become. For many, the borders separating them from their Syrian cousins have ceased to exist.

Kurdish youths who honed their urban warfare skills against the Islamic State in Syria are now using them against security forces in Turkey. Others continue to take up arms with the YPG in Kobani.

Meanwhile, Turkish nationalist sentiment has been further inflamed by the Ankara bombing.

Erdogan’s polarizing politics have already divided the country. The specter of intercommunal violence looms.

Achieving some rapprochement between Turkey and the Kurds would be a sure step toward defeating the Islamic State. More critically, it’s the only way to ensure that Turkey does not descend into civil war — or go to war in Syria.

Some suggest the United States should use its leverage over the YPG to get the PKK back to the negotiating table. But it is the YPG that takes its cues from the PKK — not the other way around.

Either way, the idea that the Syrian Kurds would ditch their ties with the PKK to preserve their alliance with Washington is outright naive. There will always be others — the Russians or the region’s perennial mischief-maker, Iran — to step into the breach.

The only true way forward is for the United States to lean on both Turkey and the PKK to come to their senses. But the reality is that there is only so much prodding Washington and Turkey’s other Western friends can do. It ultimately falls on Turkey’s elected leaders to extricate themselves from this mess. Unfortunately, past experience suggests that Erdogan is more likely to dig his country into an even deeper hole.


Buttonwood

Liquid leak

Can weak markets be explained by changes in bank balance-sheets?
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ECONOMISTS have been a bit puzzled by the market turmoil of early 2016. It seems to be driven, in part at least, by fears of either an American recession, or a sharp Chinese slowdown, neither of which looks likely from the data. Perhaps the answer to the conundrum is that market movements are not being driven solely by fundamentals but by recent developments in market liquidity.

Central banks’ support for markets, via quantitative-easing (QE) programmes, is well known.

Emerging-market central banks have also been big buyers of government bonds as they have built up their foreign-exchange reserves. But the Federal Reserve stopped its QE programme in 2014 and, in recent months, Chinese foreign-exchange reserves have fallen by around $700 billion. This means the Chinese authorities are net sellers, rather than buyers, of financial assets. Low oil prices mean that sovereign-wealth funds in oil-producing countries may also be selling assets.

CrossBorder Capital, a research firm, says that the combined balance-sheets of the Federal Reserve and the People’s Bank of China were growing at more than 10% a year for much of the past decade—and reached a peak of 64.5% growth in 2008. But over the past year, they have actually contracted (see chart). Both the European Central Bank and the Bank of Japan are still adding assets, of course. Nevertheless, CrossBorder’s global liquidity index, which reflects changes in the balance-sheets of a range of central banks, has fallen to 35; a world recession, says the firm, is signalled when the index drops below 30.

Central banks may not be the only factor affecting market liquidity. Matt King, a credit strategist at Citigroup, highlights a number of oddities in a recent research note. The first is the relationship between government-bond yields and the cost of interest-rate swaps. A swap involves two parties agreeing to exchange a fixed-rate payment for a floating rate based on a variable measure, such as Libor. Since the counterparties to such deals tend to be from the private sector (notably banks), the fixed-rate element of the swap has tended to pay a higher yield than the equivalent government bond, to reflect the greater risk. But the cost of swaps has fallen below Treasury-bond yields, a phenomenon dubbed a “negative swap spread”.

The other shifts are in the corporate-bond market. Investors with a strong view on where the bond market is heading can buy or sell individual bonds, or they can use a derivative called a credit default swap (CDS). A CDS is a kind of insurance policy, which pays out if the bond defaults; when corporate-bond prices are falling, the cost of a CDS rises. Mr King points out that the cash market has recently, and unusually, underperformed the derivative (ie, the spread, or excess interest rate, on corporate bonds has risen faster than the cost of insuring against default via a CDS).

In a similar shift, the cost of insuring against the default of individual companies has risen faster than the cost of insuring a corporate-bond index. These changes in relative prices are the opposite of what happened in the crisis of 2008. Back then, the most liquid markets were the quickest to show the pain.

Mr King’s explanation is that this is all to do with the reluctance of banks to tie up their balance-sheets, thanks to new rules on leverage ratios. Derivatives like swaps require banks to put aside very Little capital compared with owning cash bonds, and so reduce demand for the latter. Banks are also unwilling to provide finance to traders who want to arbitrage such price disparities away; profiting from small price differences requires lots of borrowed money.

Another sign that liquidity is shifting can be seen in the world of exchange-traded funds (ETFs)—portfolios of assets that can be traded on the stockmarket. According to BlackRock, which operates the biggest high-yield ETF, daily trading in the fund was briefly worth a quarter of the value of all American corporate-bond trading in December. Buying and selling an ETF has become a more liquid way of shifting an investor’s asset allocation.

Since the crisis commercial banks seem to have retreated from their market-making role. The impact of this shift has been disguised by the huge amounts of liquidity injected by central banks. But as central banks scale back their support, the underlying investors (pension funds, insurers, hedge funds and the like) will have to rely on each other to act as willing buyers and sellers. That seems highly likely to result in more volatile markets than in the past, especially when the outlook for the economy is unclear. Buckle up.


Fed must act on ‘economic anger’, says oficial

 
 
The US Federal Reserve must do a better job of responding to the rising tide of economic anger in America that is leading to a surge in protectionist rhetoric on the presidential campaign trail, according to the newest member of its policy committee.
 
In an interview with the Financial Times, Neel Kashkari, who took over as head of the Minneapolis Federal Reserve at the start of the year, warned that the Fed needed to work harder to rebuild public trust and communicate with American citizens. Economic anger, he said, was “all around the country and it is non-partisan”.

Mr Kashkari’s first public forays this week have quickly positioned him as an outspoken voice among the central bank’s policymakers.

As a senior treasury official in the administration of George W Bush and during President Barack Obama’s first term, Mr Kashkari was a key architect of Wall Street’s 2008 bailout. But on Tuesday, in his first speech since joining the Minneapolis Fed, he called for regulators to consider breaking up the largest US lenders, which he said remained “too big to fail”.
 
In his interview with the FT he blamed the bailouts he oversaw as one of the “root causes for the loss of trust” in the US’s economic managers. Those actions had “really violated a core American belief” that risk takers had to bear the consequences of things going wrong, he said, and “it really leads to great anger if you violate the core beliefs of a society”.

The impact, he said, had been made worse by a history of opacity at the Fed and a past institutional reluctance to explain monetary policy clearly to the American public.

The Fed was now paying the price for decades of “very poor” communications during which it “adopted this Wizard of Oz routine that ‘We are so mysterious and you can’t understand what we are doing’,” he said, “and that really hurt trust between the people and the institution”.
 
Anger about the economy was also fuelling support for those advocating the erection of new barriers to protect US industry. “I don’t think protectionism is the right path. I think we need to promote free markets around the world. But some of the anger is understandable,” he said.

“We need to promote free markets on both sides. It can’t just be the American economy that is free and our trading partners are not free. So I understand that anger that is there. We need to push back against that [protectionist rhetoric] but also push out globally for free markets everywhere.”

His words come amid a presidential election campaign that is being dominated by frustration among voters about the sluggish growth since the 2007-09 financial crash. Some 72 per cent of the electorate feels the economy is still in recession, according to the American Values Survey released in November — even though economic analysts date the Great Recession as having ended in mid-2009.
 
That frustration has spilled over into antipathy towards the Fed itself, which is being expressed on both sides of the political divide. Democratic lawmakers have questioned the central bank’s decision to lift interest rates, warning it could stifle wage growth, while Republicans are calling for greater scrutiny of the Fed’s decisions amid lingering anger over the scale of its interventions during the crisis.


Trump and Sanders nomination poll of polls
 
 
But above all it has helped fuel the rise of populist candidates such as Bernie Sanders, a self-described democratic socialist, and Republican frontrunner Donald Trump, both of whom have called for the US to do more to protect its own industry from cheap imports and foreign competition, and found support for those policies.
 
Mr Kashkari praised the work of Janet Yellen, the current Fed chair, in speaking directly and candidly in explaining the central bank’s policies, but said the central bank needed to go even further still.

Mrs Yellen was “trying to do the right thing for the country”, and if people got to know her and other people across the Fed system “they would be very proud we have this institution in our country”. However, he added, “we don’t really let them see in”.

“I think we could do a better job,” he said. “The press conferences [held quarterly by the Fed chair] are a step in the right direction and Chair Yellen is very candid in those press conferences and addresses the questions directly. That’s positive.”

But the Fed needed to “look for more opportunities like that. It has to happen on all levels.”
Monetary policy was hugely complicated, and it was not possible to explain every twist and turn of the debate to the whole population. That meant it was critical that the public trusts the central bank, he explained.

“You are not going to have the population as a whole understand all the nuances of what we are talking about here. They need to trust us. They need to know that we care. If they trust us and know that we care, they are going to give us the benefit of the doubt on some of the complexities they may not fully understand.”


Investor Jitters: What to Do in Volatile Times
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Personal Investment Strategies for Volatile Times

          
Financial markets have been taking a hit lately. This rout is causing many individual investors to wonder if there are ways to reduce volatility in their personal portfolios. This article offers some ideas on how to do so.

For investors, 2016 has started like a highlight reel of all that can happen: gut wrenching plunges in stocks followed by breathtaking rebounds; dire forecasts and interludes of optimism; bond yields falling despite predictions they’d rise; economic turmoil around the world, especially in China and other emerging economies. It seems certain this will continue to be a volatile year for investors.

So how can one address all this risk?  

Many investors will choose the simplest response — do nothing. And there’s a lot to be said for that given that the broad markets have always recovered from downturns and gone on to new heights. Dumping holdings in a dip — or buying more — can backfire when the market doesn’t do what you’d expected.

“Trying to time the market is not a good idea and has been shown to produce lower returns over time,” says Wharton economics professor Kent Smetters.

Still, even a buy-and-hold investor with a long-term view should be aware of various techniques for reducing risk and minimizing losses — everything from buying “put” options to issuing stop-loss orders, bulking up on cash or simply boosting long-term prospects by minimizing taxes and other costs.

Most experts say that if you were happy with your asset allocation before the year began it’s probably best to stick with that mix for the long term. Asset allocation guides provided by financial services firms assume a long-term strategy that means simply riding out the downturns.

And yet, a minor change in allocations will not necessarily rock the boat. A $100 portfolio of 60% stocks, 30% bonds and 10% cash would rise to $109 if the stock and bond portion rose by 10% and cash earned nothing. Reduce the stock and bond holdings to 80%, and increase cash to 20%, and the entire portfolio would grow to $108 under the same conditions — not a big price to pay for peace of mind. The extra cash could be put back into securities when the rough ride appeared to be over.

The simplest way to boost cash: Tell your broker or fund company to divert dividends, interest and funds’ capital gains distributions to a money market fund instead of reinvesting in stocks and bonds.

It also pays to look at each holding from time to time and ask, “Regardless of how it’s done in the past, would I buy it today?” If the answer is no, it might be smart to get rid of it.

To hedge against losses, sophisticated investors often use put options, which gives its owner the right to sell a block of stock at a set price for a given period of days, weeks or months, insuring the investor can get today’s price no matter how far the price falls during that period. A basket of stocks can be insured with puts on exchange-traded funds (ETFs), such as the SPDR S&P 500 (Ticker: SPY), which tracks the Standard & Poor’s 500.

Unfortunately, put prices — “premiums” — rise when the market grows more volatile. In mid-February, for instance, a SPY put insuring $18,600 in holdings through the end of June cost about $1,100. The cost could be reduced by purchasing a less valuable put — one that would pay off only after the market had already fallen by 10% or more, for instance — but costs would nonetheless grind away at a portfolio if options hedging were used all the time.

Another form of insurance — and a free one — is the stop-loss order, an instruction for one’s broker to automatically sell a block of stock after the price falls to a set level, to escape deeper losses if the price keeps going down. However, there is no guarantee there will be a buyer at the stop-loss price, so the shares might be sold at a lower price – so low the investor might prefer to hold on and bet on a rebound. The investor can add a “limit,” specifying the shares not be sold for less than a given price, but if there is little demand the shares might not be sold at all.

Other risk-control strategies aim not so much at preventing losses as enhancing the investment portfolio through greater efficiency.

One is to minimize annual taxes by being careful to avoid sales that trigger capital gains taxes.

Trading that can’t be avoided, such as mutual fund sales and purchases to keep to the desired asset allocations, can be done in tax-favored accounts like 401(k)s and IRAs, which have no annual tax bills. These accounts are also suitable for mutual funds that, in taxable accounts, can incur big tax bills by spinning off lots of cash through dividends, interest or year-end capital gains distributions.

Mutual fund investors can also minimize annual taxes by shifting from actively managed funds that do lots of buying and selling to index-style funds that simply buy and hold stocks in an underlying index like the S&P 500. Less selling means less tax on “realized” capital gains. The fund’s returns are simply reflected in the fund’s share price, and are not taxed until after those shares are sold. Index funds also charge lower fees than actively managed funds, enhancing returns over time.

There also are some “tax-managed” funds that make special efforts to minimize annual tax bills — such as selling, and later reacquiring, money-losing holdings to offset taxable gains on other investments.

While many investors are focusing on recent stock market gyrations, Smetters urges investors to address another risk.

“The biggest risk people face is not market falls but inflation,” he says, noting that the long period of unusually low inflation will eventually end. Higher inflation, of course, erodes investment returns by making each dollar less valuable.

“Just 2% inflation can erode a portfolio’s value by up to 40% over 25 years,” Smetters says.

Investors can hedge against this risk with Treasury Inflation-Protected Securities, a type of U.S. government bond that rises in value at the inflation rate, in addition to paying interest, which is currently around 1% for a 30-year bond. So if inflation were 2% the investor would earn 3%.

The Series I U.S. Savings Bond works much the same way, combining a fixed yield with one based on inflation. Currently I Bonds yield 1.64%, which isn’t much but will go higher if inflation kicks up.

“You never hear about I Bonds because the high-fee [financial services] market hates the competition,” Smetters says. “But it’s an easy way to build a solid low-risk portion of one’s portfolio over time.”