Hoisington Quarterly Review and Outlook – Second Quarter 2015

John Mauldin

Jul 22, 2015

 In today’s Outside the Box, my good friend Lacy Hunt of Hoisington Investment Management reminds us that since the 1990-91 recession, the 30-year Treasury bond yield has dropped from 9% to 3%, a downward move nearly identical to the decline in the rate of inflation, which fell from just over 6% in 1990 to 0% today. Therefore, Lacy says, “(I)t was the backdrop of shifting inflationary circumstances that once again determined the trend in long-term Treasury bond yields.”

During that 25-year period, though, there have been nine significant backups, when yields rose an average of 127 basis points, despite weakening inflation. Lacy attributes these periods to an “intermittent change in psychology … a strong sentiment that the rise marked the end of the bull market, and a major trend reversal was taking place.”

It’s happening again today, Lacy asserts; and he ticks off four misperceptions that have pushed Treasury bond yields to levels that represent significant value for long-term investors. They are:

1.       The recent downturn in economic activity will give way to improving conditions and even higher bond yields.

2.      Intensifying cost pressures will lead to higher inflation/yields.

3.      The inevitable normalization of the Federal Funds rate will work its way up along the yield curve causing long rates to rise.

4.      The bond market is in a bubble, and like all manias, it will eventually burst.

Lacy builds a strong case that fundamental economic forces are exerting downward, rather than upward, pressure on inflation. It’s a contrarian view – certainly not mainstream at this moment – but considering that Lacy has been right for well over 30 years, consistently pointing out through the nine periods when everybody was proclaiming the end of the bond bull market that the fundamentals were still pointing in the direction of lower interest rates.

I’ve had some late-night discussions with Lacy trying to figure out what would make him a bond market bear, and we have discussed what it would take for rates to truly rise long-term. I look around, and right now I don’t see those conditions.

Inflation is close to zero (as measured by the CPI) over the last 12 months. Commodity prices are back where they were 13 years ago (Bloomberg Index in chart below). The Fed is on track to, maybe, kind of, sort of, timidly, slowly raise interest rates starting sometime this fall, with Janet Yellen suggesting in her latest testimony that September might be the date. If trading runs to form, that will make the dollar stronger and put further pressure on price inflation. Just because rates go up on the short end of the curve does not mean the long end will follow. The tail does not necessarily wag this dog.

Make no mistake, I think that one day rates are going to rise and we will see the end of this bond bull market. I’ve been on the record for multiple years now that we’re going to see a final low in interest rates in the next recession, whenever that is. When that time comes you need to be ready to back up the truck and refinance every bit of debt that you can. In the meantime take advantage of the low rates at the low end of the curve. And pay attention to Lacy.

I was in the gym this afternoon training with The Beast. He normally plays rock ’n roll and heavy metal and we pump iron to a heavy beat. For whatever reason today, he was playing pop country. I know I’m from Texas and all, but I’ve just never been a big fan of country music. My kids didn’t hear it growing up, but several of them have become big country-western fans. Even my middle son, Chad, who likes to listen to rap and other similarly worthless attempts at music, has now become a country-western fan. That was one I didn’t see coming.

One of the singers started talking about the things he liked about growing up country: sweet tea, juicy cantaloupe, cane poles, and rebel flags – a litany of growing up in simpler times in the country. Each image in the singer’s long list brought back good memories. I doubt many of the younger generation have ever actually fished with a cane pole and cork bobber with twine, but the image still seems to make them wax nostalgic.

It’s a symbol, and like all symbols it invokes emotions and feelings. A good writer is constantly using symbols to create a mood for his readers, giving us word pictures that move us or inspire us, make us angry or fearful, make us joyous or peaceful.

Interestingly, I seem to find that same nostalgic mix everywhere in the world I go. I suppose it’s tied up with family and friends. In a world that seems to change around us moment by moment, we want to hold on to a few things we think are dependable.

Right now my plans are to drive down to the south of Austin on Sunday and spend the evening with George and Meredith Friedman. George has a home deep in the hills of Texas, and it’s been too long since we’ve been able to sit down and review what’s happening in the world. What better way to spend a summer day? I’m really looking forward to it. I have reason to believe we might be able to find a country station or three or four on that road trip. A little nostalgia every now and then is good for the soul.

Have a great week. Maybe I’ll even see if Lacy is around and drop by his office on the way back to Dallas. But for right now, let’s take a look at his latest essay.

Your watching the world go by too fast analyst,

John Mauldin, Editor
Outside the Box

Hoisington Quarterly Review and Outlook – Second Quarter 2015

Misperceptions Create Significant Bond Market


From the cyclical monthly high in interest rates in the 1990-91 recession through June of this year, the 30-year Treasury bond yield has dropped from 9% to 3%. T
This massive decline in long rates was hardly smooth with nine significant backups. In these nine cases yields rose an average of 127 basis points, with the range from about 200 basis points to 60 basis points (Chart 1). The recent move from the monthly low in February has been modest by comparison. Importantly, this powerful 6 percentage point downward move in long-term Treasury rates was nearly identical to the decline in the rate of inflation as measured by the monthly year-over-year change in the Consumer Price Index which moved from just over 6% in 1990 to 0% today. Therefore, it was the backdrop of shifting inflationary circumstances that once again determined the trend in long-term Treasury bond yields.

In almost all cases, including the most recent rise, the intermittent change in psychology that drove interest rates higher in the short run, occurred despite weakening inflation. There was, however, always a strong sentiment that the rise marked the end of the bull market, and a major trend reversal was taking place.

This is also the case today.

Presently, four misperceptions have pushed Treasury bond yields to levels that represent significant value for long-term investors. These are:

  1. The recent downturn in economic activity will give way to improving conditions and even higher bond yields.
  2. Intensifying cost pressures will lead to higher inflation/yields.
  3. The inevitable normalization of the Federal Funds rate will work its way up along the yield curve causing long rates to rise.
  4. The bond market is in a bubble, and like all manias, it will eventually burst.

Rebounding Economy and Higher Yields

The most widely held view of these four misperceptions is that the poor performance of the U.S. economy thus far in 2015 is due to transitory factors. As those conditions fade, the economy will strengthen, sparking inflation and causing bond yields to move even higher. The premise is not compelling, as there is solid evidence of a persistent shift towards lower growth. Industrial output is expected to decline more in the second quarter than the first. This will be the only back-to-back decrease in industrial production since the recession ended in 2009 (Chart 2). Any significant economic acceleration is doubtful without participation from the economy’s highest value-added sector. To be sure, the economy recorded higher growth in the second quarter, but that was an easy comparison after nominal and real GDP both contracted in the first quarter.

Adding to a weak manufacturing sector, other fundamentals continue to indicate that top- line growth will not accelerate further this year, and inflation will be contained. M2 year-over-year growth has slipped below the growth rates that prevailed at year-end. The turnover of that stock of money, or velocity, is showing a sharp deceleration. Presently M2 velocity is declining at a 3.5% annual rate, and there are signs that it may decline even faster. If growth in M2 or velocity subsides much further, then nominal GDP growth is unlikely to reach the Fed’s recently revised forecast of 2.6% this year (M*V=Nominal GDP).

At year-end 2014 the Fed was forecasting nominal GDP growth to accelerate to 4.1% this year, compared with 3.7% and 4.6% actual increases in 2014 and 2013, respectively. In six months the Fed has once again been forced to admit it's error and has massively lowered its forecast of nominal growth to 2.6%. Additionally, the Fed formerly expected a 2.8% increase in real GDP and now anticipates only a 1.9% increase in 2015, down from 2.4% and 3.1% in 2014 and 2013, respectively. The inflation rate forecast was also lowered by 60 basis points.

Transitory increases in long Treasury bond yields are not likely to be sustained in an environment of a pronounced downward trend in growth in both real and nominal GDP. However the expectation of lower long rates is also bolstered by the well-vetted economic theory of “the Wicksell effect” (Knut Wicksell 1851-1926).

Wicksell suggested that when the market rate of interest exceeds the natural rate of interest funds are drained from income and spending to pay the financial obligations of debtors. Contrarily, these same monetary conditions support economic growth when the market rate of interest is below the natural rate of interest as funds flow from financial obligations into spending and income. The market rate of interest and the natural rate of interest must be very broad in order to capture the activities of all market participants. The Baa corporate bond yield, which is a proxy for a middle range borrowing risk, serves the purpose of reflecting the overall market rate of interest. The natural rate of interest can be captured by the broadest of all economic indicators, the growth rate of nominal GDP.

In comparing these key rates it is evident that the Wicksell effect has become more of a constraint on growth this year. For instance, the Baa corporate bond yield averaged about 4.9% in the second quarter. This is a full 230 basis points greater than the gain in nominal GDP expected by the Fed for 2015. By comparison, the Baa yield was only 70 basis points above the year-over-year percent increase in nominal GDP in the first quarter.

To explain the adverse impact on the economy today of a 4.8% Baa rate verses a nominal GDP growth rate of 2.6% consider a $1 million investment financed by an equal amount of debt. The investment provides income of $26,000 a year (growth rate of nominal GDP), but the debt servicing (i.e. the interest on Baa credit) is $48,000. This amounts to a drain of $22,000 per million. Historically the $1 million investment would, on average, add $2,500 to the annual income spending stream. Over the past eight decades, the Wicksell spread averaged a negative 25 basis points (Chart 3).

Since 2007 however, the market rate of interest has been persistently above the natural rate, and we have experienced an extended period of subpar economic performance. Also, during these eight years the economy has been overloaded with debt as a percent of GDP and, unfortunately, too much of the wrong type of debt. The ratio of public and private debt moved even higher over the past six months suggesting that the Wicksell effect is likely to continue enfeebling monetary policy and restraining economic growth and inflation.

Cost Push Inflation Means Higher Yields

The second misperception is more subtle. The suggestion is that higher health care and/or wage costs will force inflation higher. It follows, therefore, that Treasury bond yields will rise as they are heavily influenced by inflationary expectations and conditions. Further, this higher inflation will cause the Fed to boost the federal funds rate.

Some argue that health care insurance costs are projected to rise very sharply, with some companies indicating that premiums will need to rise more than 50% due to the Affordable Care Act. Even excluding the extreme increases in medical insurance costs, many major carriers have announced increases of 20% or more. Others argue that the six-year low in the unemployment rate will cause wage rates to accelerate.

Four considerations cast doubt on these cost- push arguments. First, increases in costs for medical care, which has inelastic demand, force consumers to cut expenditures on discretionary goods with price elastic demand. Goods with inelastic demand do not have many substitutes while those with elastic demand have many substitutes. When an economy is experiencing limited top-line growth, as it is currently, the need to make substitute-spending preferences is particularly acute. Thus, discretionary consumer prices are likely to be forced lower to accommodate higher non-discretionary costs, leaving overall inflation largely unchanged.

Second, alternative labor market measures indicate substantial slack remains and evidence is unconvincing that wage rates are currently rising to any significant degree. The U.S. Government Accountability Office (GAO) released a report that looks at the “contingent workforce” (Wall Street Journal, May 28, 2015). These are workers who are not full-time permanent employees. In the broadest sense, the GAO found these workers accounted for 40.4% of the workforce in 2010, up from 35.3% in 2006. The GAO found that this growth mainly results from an increase in permanent part-timers, a category that grew as employers reduced hours and hired fewer full-time workers. The GAO also said that the actual pay earned was nearly 50% less for a contingent worker than a person with a steady full time job.

The process portrayed in the study undermines the validity of the unemployment rate as an indicator because a person is counted as employed if they work as little as one hour a month. Additionally there is an upward bias on average hourly earnings due to the difference in hours worked between full-time and contingent workers.

Third, corporate profits and closely aligned productivity measures are more consistent with declining, rather than strengthening, wage increases. After peaking in the third quarter of 2013, profits after tax and adjusted for inventory gains/losses and over/under depreciation have fallen by 16% (Chart 4). Over the past four years, nonfarm business productivity increased at a mere 0.6% annual rate, the slowest pace since the early 1980s. A significant wage increase would cut substantially into already thin profits as top-line growth is decelerating, and the dollar hovers close to a 12.5 year high. Together the profits and productivity suggest that firms need to streamline operations, which would entail reducing, rather than expanding, employment costs.

Fourth, experience indicates inflationary cycles do not start with rising cost pressures. Historically, inflationary cycles are characterized by “a money, price and wage spiral” and in that order. In other words, money growth must accelerate without an offsetting decline in the velocity of money. When this happens, aggregate demand pulls prices higher, which, in turn, leads to faster wage gains.

The upturn leads to a spiral when the higher prices and wages are reinforced by another even faster growth in money not thwarted by velocity. Current trends in money and velocity are not consistent with this pattern and neither are prices and wages.

Normalizing the Federal Funds Rate

A third argument is that the Fed needs to normalize rates, and as they do this, yields will also rise along the curve. It is argued the Fed has held the federal funds rate at the zero bound for a long time with results that are questionable, if not detrimental, to economic growth. Proponents for this argue that the zero bound may have resulted in excessive speculation in stocks and other assets. This excess liquidity undoubtedly boosted returns in the stock market, but the impact on economic activity was not meaningful. At the same time, the zero bound and the three rounds of quantitative easing reduced income to middle and lower range households who hold the bulk of their investments in the fixed income markets.

Thus, to reverse the Fed’s inadvertent widening of the income and wealth divide, the economy will function better with the federal funds rate in a more normal range. Also, by raising short-term rates now, the Fed will have room to lower them later if t he economy worsens.

Normalization of the federal funds rate is widely accepted as a worthwhile objective. However, achieving normalization is not without its costs. In order to increase the federal funds rate, the Fed will raise the interest rate on excess reserves of the depository institutions (IOER). Also, the Fed will have to shrink the $2.5 trillion of excess reserves owned by the depository institutions by conducting reverse repurchase agreements. This is in addition to operations needed to accommodate shifts in excess reserves caused by fluctuations in operating factors, such as currency needs of the non- bank public, U.S. Treasury deposits at the Fed and Federal Reserve float. If increases in the IOER do not work effectively, the Fed will then need to sell outright from its portfolio of government securities, causing an even more significant impact out the yield curve. The Fed’s portfolio has close to a seven-year average maturity.

A higher federal funds rate and reduced monetary base would place additional downward pressure on both money growth and velocity, serving to slow economic activity. Productivity of debt has a far more important influence on money velocity than interest rates. Nevertheless, higher interest rates would cause households and businesses to save more and spend less, which, in turn, would work to lower money velocity. Such a policy consequence is highly unwelcome since velocity fell to a six decade low in the first quarter and another drop clearly appears to have occurred in the second quarter.

These various aspects of the Fed’s actions would, all other things being equal, serve to reduce liquidity to the commodity, stock and foreign exchange markets while either placing upward pressure on interest rates or making them higher than otherwise would be the case. Stock prices and commodity prices would be lower than they otherwise. In addition the dollar would be higher than otherwise would be the case deepening the deficit between imports and exports of goods and services.

Increases in the federal funds rate would be negative for economic activity. As the Fed’s restraining actions become apparent, however, the Fed could easily be forced to lower the federal funds rate, making increases in market interest rates temporary.

The predicament the Fed is in is one that could be anticipated based on the work of the late Robert K. Merton (1910-2003). Considered by many to be the father of modern day sociology, he was awarded the National Medal of Science in 1994 and authored many outstanding books and articles. He is best known for popularizing, if not coining, the term “unanticipated consequences” in a 1936 article. He also developed the “theory of the middle range”, which says undertaking a completely new policy should proceed in small steps in case significant unintended problems arise. As the Fed’s grand scale experimental policies illustrate, anticipating unintended consequences of untested policies is an impossible task. For that reason policy should be limited to conventional methods with known outcomes or by untested operations only when taken in small and easily reversible increments.

Bond Market Bubble

The final argument contends that the Treasury bond market is in a bubble, and like all manias, it will burst at some point. In The New Palgrave, Charles Kindleberger defined a bubble up as ..." a sharp rise in the price of an asset or a range of assets in a continuous process, with the initial rise generating expectations of further rises and attracting new buyers". The aforementioned new buyers are more interested in profits from “trading the asset than its use or earnings capacity”. For Kindleberger the high and growing price is unjustified by fundamental considerations. In addition Kindelberger felt that the price gains were fed by ‘momentum’ investors who buy, usually with borrowed funds, for the sole purpose of selling to others at a higher price. For Kindleberger, a large discrepancy between the fundamental price and the market price reflected excessive debt increases. This condition is referred to as “overtrading”. At some point, perhaps after a prolonged period of time, astute investors will begin to recognize the gap between market and fundamental value. They will begin to sell assets financed by debt, or their creditors may see this gap and deny the speculators credit. Charles Kindleberger called this process “discredit”. For Kindleberger, the word discredit was designed to capture the process of removing some of the excess debt creation.

The phase leads into the popping of the bubble and is called “revulsion”.

The issue in determining whether or not a bubble exists is to determine what constitutes fundamental value. For stocks this is generally considered to be after-tax earnings, cash flow or some combination of the two and the discount rate to put these flows in present value terms. Most experts who have addressed this issue of economic fundamentals have confined their analysis to assets like stocks or real estate. In the Palgrave article Kindelberger did not specifically cover the case of bonds. We could not find discussions by well- recognized scholars that explicitly defined a Treasury bond value or a market bubble. The reason is that there is no need.

To be consistent with well-established and thoroughly vetted theory, the economic value of long-term Treasury bonds is determined by the relationship between the nominal yield and inflationary expectations, or the real yield. To assess the existence of a Treasury bond bubble one must evaluate the existing real yield in relation to the historic pattern of real yields. If the current real yield is well above the long-term historic mean then the Treasury bond market is not in a bubble.
However, if the current real yield is significantly below this mean, then the market is in a bubble. By this standard, the thirty-year Treasury bond is far from a bubble.
In the past 145 years, the real long bond yield averaged 2.1%. At a recent nominal yield of 3.1% with a year over year increase in inflation of 0.1%, the real yield stands at 3%, 50% greater value than investors have, on average, earned over the past 145 years. Indeed, the real yield is virtually the same as in 1990 when the nominal bond yield was 9%. Contrary to the Treasury bond market being in a bubble, errant concerns about inflation or other matters have created significant value for this asset class.

In summary, economic theory and history do not suggest the secular low in inflation, or that its alter ego, Treasury bond yields, is at hand. The excessive debt burden, slow money growth, declining money velocity, the Wicksell effect and the high real rate of interest indicate that the fundamental elements are exerting downward, rather than upward, pressure on inflation. Inflation will not trough as long as the US economy continues to become even more indebted. While Treasury bond yields have repeatedly shown the ability to rise in response to a multitude of short-run concerns that fade in and out of the bond market on a regular basis, the secular low in Treasury bond yields is not likely to occur until inflation troughs and real yields are well below long-run mean values. We therefore continue to comfortably hold our long-held position in long-term Treasury securities.

Multilateral Surveillance

Monetary Policies in Advanced Economies: Good for Them, Good for Others
IMF Survey

July 23, 2015
  • Actions to close output gaps in advanced economies will help other economies too
  • Emerging markets more resilient than in the past to effects of dollar appreciation
  • Corporate debt buildup in emerging markets bears watching

Seven years after the onset of the Great Recession, economic activity in many advanced economies remains below potential. In the euro area, for example, the output gap—how far output is below where it could be if all productive resources such as labor and capital were being fully utilized—is nearly 2½ percent.
Central banks in the so-called systemic advanced economies—the euro area, Japan, the United Kingdom, and the United States—have responded with monetary policies that should help close output gaps. The IMF staff estimates that the euro area output gap will decline from nearly 3 percent in 2014 to about 1 percent in 2017. In Japan, the output gap, which was more than 1½ percent in 2014, is expected essentially to close by 2016.
The closing of output gaps, in turn, will help lower unemployment and raise investment in these economies, as the IMF’s First Managing Director, David Lipton noted recently. But what impact will these policies have on other economies? This was the focus of the 2015 Spillover Report.

Good for others

There are fears expressed in some circles about the adverse impact on other economies of an increase in interest rates in advanced economies as they start to recover. The report, however, finds that closing output gaps in systemic advanced economies will on balance be good for other economies.

Why interest rates are rising in advanced economies proves to be critical. If interest rates are going up because of improved economic prospects in these economies, that turns out to be beneficial for other economies. As advanced economies recover, they will increase their imports from other countries, providing a boost to those economies, offsetting the tighter financial conditions.
As Chart 1 shows, a 1 percentage point increase in bond yields in either the United States or the euro area because of improved growth prospects leads to substantial increases in industrial production in other economies in the year following the increase. In short, good news about U.S. or euro area growth is good for others. These positive spillovers are amplified when there is good news about growth in both the United States and the euro area and dampened when there is good news about one but not the other.

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A Background Note issued with the report shows that if advanced economy interest rates rise for reasons other than improved growth prospects, this could be associated with lower economic activity in other economies. However, since monetary policy actions are expected to close output gaps (i.e. improve growth prospects), the likely scenario is the one shown in Chart 1.
Greater resilience to strong dollar

Differences in monetary policies among systemic advanced economies, together with changes in expectations about growth, have been reflected in exchange rate movements, notably a sustained appreciation of the U.S. dollar during 2014. Past episodes of sustained dollar appreciation have been associated with crises in emerging markets (for instance, during 1980–85 and 1995–2001). Could past be prologue? The report suggests reasons to hope otherwise.

Since the mid-1990s, the net international investment position (that is, the value of foreign assets owned by a country’s public and private sectors, minus the value of assets in that country owned by foreigners) of emerging markets has improved considerably (Chart 2), making them less vulnerable to changes in currency movements. Emerging markets have also been able to reduce their dependency on debt, and their debt is increasingly in domestic rather than foreign currencies.

A second Background Note, however, points out some reasons not to be sanguine. Although net positions have improved, large gross amounts of debt in foreign currencies could still make countries more vulnerable to rollover and interest rate risks. Domestic-currency external debt, though not vulnerable to exchange rate changes, is also not without risk. Finally, although overall exposures to foreign exchange risk have decreased in most cases at the country level, corporate sector exposures have picked up considerably.

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Corporate debt buildup

Corporate debt denominated in foreign currencies has risen substantially, particularly on average in emerging markets in Latin America and Europe (Chart 3). However, an assessment of the risks from this buildup has to account for a number of factors:

Hedging: Countries are more vulnerable to U.S. dollar appreciation if they have large amounts of dollar debt while their income streams are mostly in other currencies. Though firms in such countries may be actively hedging this risk, data limitations make the extent of hedging hard to quantify.

Sectoral differences: Though sectors such as utilities and real estate tend to have lower foreign-currency debt than others, they also generate less income in foreign currencies, and hedging is rather uncommon in these sectors. Hence countries where such sectors loom large may be more vulnerable to exchange rate movements.

Maturity structure: Over time, the composition of countries’ debt has shifted from bank loans to corporate bonds. The fairly long-term maturity of these bonds makes them less vulnerable to developments such as the U.S. dollar appreciation.

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Overall, the report suggests that corporate sector risks remain moderate at present but have risen and bear watching.

China Wind Chills U.S. Earnings

China’s slowdown is showing up in U.S. companies’ earnings, and the worst may be yet to come.

By Justin Lahart

July 22, 2015 3:46 p.m. ET
A China Shipping Container Lines Co. ship is seen near the Port of Los Angeles. The Chinese slowdown is beginning to take a toll on U.S. companies.  A China Shipping Container Lines Co. ship is seen near the Port of Los Angeles. The Chinese slowdown is beginning to take a toll on U.S. companies. Photo: Patrick T. Fallon/Bloomberg

Don’t think the Chinese economy is doing as well as Chinese government statistics say it is? A lot of companies seem to agree.

When China reported last week that second-quarter gross domestic product was up by 7% from a year earlier—steady with the first quarter and better than the 6.8% economists anticipated—it raised more eyebrows than glasses. The GDP figure was conveniently in line with the government’s target for the year, yet the fiscal and monetary support Beijing has been ladling on the economy and stock market suggested growth was hardly on track.

Indeed, results this week from companies doing business in China suggest the environment softened rather than stabilized in the second quarter. Meanwhile, other companies are struggling with an influx of Chinese goods in their markets that are pushing down prices.

The risk is that amid high indebtedness, declining property values and an unsettled stock market, China’s government will struggle to continue propping up growth. That could further weigh on corporate results for scores of U.S. companies in the quarters to come.

For the many companies that have built out their Chinese operations over the past several years, things are tough enough already. On Wednesday, Whirlpool WHR -0.31 % reported that demand in the country was down 3%, while Illinois Tool Works said revenue fell by 2%.
On Tuesday, United Technologies said that orders for its Otis elevators were down 10% in China from a year earlier, and saw a sharp drop in heating, ventilation and air conditioning orders, too. And on Monday, International Business Machines reported that revenue in China was down by 25%.

Trade activity underscores the depth of the slowdown. According to the Commerce Department, the value of U.S. exports to China was 6.1% lower this year through May than the first five months of last year. That weakness appears to have extended into June, with the ports of Long Beach and Los Angeles reporting a 9.7% drop in loaded outgoing containers versus a year earlier.

Not all companies are suffering. In an otherwise disappointing report Tuesday, Apple said sales in China were strong. But even among technology companies, it seems more the exception than the rule. Microsoft on Tuesday said that macroeconomic conditions in China were challenging, while software maker VMware said that for the first time it had seen a significant slowdown in its China business.

The silver lining in the Chinese cloud is that while the impact may be notable at individual companies, the effect should be muted on the overall U.S. economy. Goldman Sachs economists note that exports to China account for only about 1% of U.S. GDP—most of what large, U.S.-based multinationals sell in China they make in China. Financial linkages are also limited.

The downward pressure that China is putting on commodity prices could also turn out to be a boon for many U.S. consumers. The same can’t be said for many companies, though.

A weaker Chinese economy is helping depress prices for commodities like crude oil and copper, hurting producers. A step up the supply chain, many companies are dealing with a glut of China-made goods that China can no longer absorb.

Discussing steel and specialty-metal maker Allegheny Technologies’ second-quarter loss Tuesday, Chief Executive Rich Harshman said that a “surge of low-price imports of standard stainless products from China created significant pressure on base selling prices.”

Such pressure looks to be extending to many other industries. Last week, the Labor Department reported that the overall price of imports to the U.S. from China was down 1.2% from a year earlier. That is part of why inflation remains so low, and why the Federal Reserve, when it starts raising rates, is likely to do so only slowly.

U.S., Russia: The Case for Bilateral Talks

Phone calls between relatively low-level diplomats are normally not newsworthy. But Monday's conversation between U.S. Undersecretary of State Victoria Nuland and Russian Deputy Foreign Minister Grigory Karasin on the simmering conflict in Ukraine is an exception. The bilateral nature of the conversation and its timing amid mounting claims of cease-fire violations from the Ukrainian government and separatist forces makes it uniquely significant. Moreover, it reaffirms that the evolution of the Ukrainian conflict — whether toward a settlement or toward escalation — will be most strongly shaped not by Kiev but by the actions of and relationship between Moscow and Washington. 

Since the Ukrainian crisis started nearly 18 months ago, two negotiation formats in particular stand out among numerous talks and meetings. The first is the Minsk talks between representatives from the Ukrainian government, the pro-Russia separatists and the Organization for Security and Co-operation in Europe, which address the conflict on a tactical level. The other is the Normandy talks between representatives from Ukraine, Russia, Germany and France, which consider the conflict on a broader, political level. Notably absent from both talks, despite being a major political, economic and security player in Ukraine and the broader standoff between Russia and the West, is the United States. Washington has been diplomatically active in the conflict, but U.S. and Russian officials have met at various times only on an ad hoc basis.

However, this practice may have changed over the weekend, when Russian Presidential Chief of Staff Sergei Ivanov said in an interview that Russia and the United States had come to an agreement to set up a "special bilateral format" of talks between the two countries — talks that would involve Nuland and Karasin. In explaining the formal announcement, Ivanov said that expanding the Normandy format to include the United States would simply be too "risky," adding that the two countries would coordinate talks on Ukraine bilaterally "for the time being." Thus the phone call between Nuland and Karasin took place to discuss the implementation of the Minsk agreement and the constitutional reform process in Ukraine, with further discussions likely to follow.

The Ukraine conflict is at its core a conflict between two geopolitical imperatives. Russia wants to protect its interior by using its surrounding territories to establish a buffer. The United States wants to prevent the rise of regional powers that could potentially challenge U.S. hegemony. These imperatives collided in Ukraine, which of all the countries in the former Soviet periphery has the most strategic importance for modern Russia. If Ukraine supports Moscow, Russia becomes a regional power on the rise. If Ukraine supports the West, Russia becomes vulnerable from without and within. The Euromaidan movement of February 2014 reversed Russia's position from the former to the latter. Moscow responded by annexing Crimea and supporting the separatist insurgency in eastern Ukraine in a bid to undermine or neutralize Kiev's pro-Western government.

So far Russia's plan has been unsuccessful. Ukraine aligned itself even more closely with the West by pursuing greater economic and political integration with the European Union and greater security and military cooperation with NATO. Ukraine's close relationship with NATO is particularly worrisome for Russia, which has long feared the military alliance pushing up against its borders. Moscow has made multiple efforts to keep NATO's influence at bay, putting diplomatic pressure on Georgia in 2008 when Georgia declared its alliance with NATO, for example. It showed its concern about NATO even more dramatically in the conflict in eastern Ukraine. And of all the NATO countries, the United States has the strongest military and the most assertive policies challenging Russia throughout the former Soviet periphery.

Russia's long-held suspicion of U.S. influence in its periphery makes the decision to start regular bilateral talks a significant step. In some ways, these two countries wield more power to shape the political and military outcome in Ukraine than the Ukrainians and separatists themselves. But holding such talks does not necessarily indicate that a resolution or even a de-escalation of the conflict is imminent. Issues still divide the two sides, particularly what kind of autonomy Ukraine's central government should give the rebel regions.

All the major parties in the Ukrainian conflict support some level of decentralization, or the granting of greater powers to regional governments. The disagreement is over the timing and extent of the process. Russia sees decentralization as a way to maintain a buffer zone in the east outside of Ukraine's direct control, while Ukraine sees it as a way to compromise but still effectively retain control over the entire country. Ukraine wants to see separatists implement the Minsk agreement and lay down their arms before officials amend the national constitution to grant the eastern territories more regional autonomy. But separatists want the constitutional changes first, and they want a role in determining those changes. Only then, they say, can they fully implement the cease-fire.

Broadly speaking, the United States supports the Ukrainian position; Russia supports the separatists.

However, during a recent visit to Ukraine and preceding her phone conversation with Karasin, Nuland weighed in on the Ukrainian legislature's debate over the constitutional amendment. Nuland urged Ukraine to give the country's eastern regions a controversial and highly debated "special status" under the law. Officials had not included the term in the constitutional amendment draft, but U.S. pressure to deliver more on the sensitive issue could be seen as a nod to Russia.

But Nuland's actions could also be a more nuanced effort to help Ukraine: The more substantial and unimpeachable Ukraine's constitutional reforms, the less room Moscow and the separatists have to criticize the changes and justify their own cease-fire violations. Washington has echoed Kiev in demanding that the separatists abide by the cease-fire, threatening Russia with more sanctions and — according to some leaked reports — restrictions on Moscow's access to credit, if separatists continue to violate the Minsk agreement. 

Russia's reactions have also been mixed. The Kremlin has spoken somewhat positively of the reform process, but Russia is still influencing the Ukrainian battlefield while demanding more political concessions for the separatist territories. Russia is also seeking U.S. concessions on Ukraine for its help in facilitating the Iran nuclear agreement. Moscow and Washington are trying to reach an accommodation while keeping their threat options open as well. With more talks between Nuland and Karasin set to take place, the evolution of Ukraine's conflict and the political reform process will be the true test of the effectiveness of this new bilateral dialogue between the United States and Russia

July 22, 2015 7:15 pm

To balance the nuclear deal, defeat Isis and confront Iran

Philip Zelikow

US should now develop a serious strategy to defeat the terror group, writes Philip Zelikow

Isis fighters in Syria©AP
Isis fighters in Syria
In the next couple of months, the US Congress will debate whether the Iranian nuclear deal is likely to work as arms control. But the bigger debate is whether the agreement, with its relaxation of sanctions, means America is halfhearted — at most — in confronting Iranian sponsorship of so much of the violent chaos that is spreading across the Middle East. That is why the US should choose this moment to develop a serious, full-bodied strategy to defeat the barbaric Islamic State in Iraq and the Levant (Isis) in Syria as well as Iraq.
This strategy confronts Iranian ambitions in both places and would therefore be the ideal companion to diplomacy that stops an Iranian nuclear threat. Such an exertion of US power to build a powerful coalition would reassure many in Washington and around the world who are ambivalent about the deal. It would also be the right move to protect America and its allies.

The terrorist danger Isis presents is rising towards the level that al-Qaeda presented in the years immediately before the 9/11 attacks on the US. Leaders should ask themselves: if Isis carries out a truly catastrophic attack, in the region or in America, what would they wish they had done before that day? Those post-catastrophe plans must be prepared now, before such an event. Surely no one thinks the current level of effort really is all America could or would do.

As executive director of the 9/11 Commission, I saw that cycle of horror, recrimination and reaction close up. I remember all too well what people wished they had done in the preceding years. There were political and military options short of an invasion and indefinite occupation of Afghanistan but they were deemed too risky. So, having refused to take limited risks to prevent a catastrophe, Americans have paid and are still paying a far heavier price.

A powerful coalition to defeat Isis must lead with a new political strategy before the military one. And that means confronting Iranian ambitions.

In the case of Syria, Sunni Muslims, including Turkey, will unite against the terrorist Isis only if the effort is aimed equally at the terrorist Assad regime. That regime is propped up by Iran and its expeditionary Hizbollah fighters.

In the case of Iraq, Sunni Muslims will unite against Isis only if effort is aimed equally at sheltering them from terrorist Shia torture squads. Those Iraqi torturers are also becoming an expeditionary wing of Iran’s Revolutionary Guards. Flush with the vast funds to be released by the nuclear deal, by 2016 Iran will have much more money to invest in all these creatures.

The military side will need more Americans — on the ground — to offer meaningful combat support, show commitment and mediate among coalition members. In this case, military effort is not an alternative to diplomacy. It is the enabler of diplomacy. In addition to Syrians and Iraqis fighting to liberate their towns and lands, such a coalition would involve Turkey, Jordan, Saudi Arabia, the United Arab Emirates, Kuwait and Qatar, and Kurdish authorities in both Syria and Iraq.

This coalition effort would be a formidably difficult undertaking. But the US can either face it now or face it later. Waiting is not likely to make the job any easier. Nor will it reduce the risk of yet another cycle of catastrophe, recrimination and reaction (or overreaction).

Meanwhile, such a regional initiative is the ideal counterweight to the controversy over the Iranian nuclear deal. There is a precedent. Though in America both Democrats and Republicans may prefer to forget it, the diplomatic outreach to Iran that produced the current deal originated in the administration of President George W Bush.

It was in 2006, after much internal argument, that the Bush administration and its European friends offered direct negotiations with Iran in the same kind of process as the one that has produced the present deal. This opening was accompanied by ingenious and powerful financial sanctions developed at the same time. UN Security Council support for those sanctions was attainable only because of the Bush administration’s readiness to negotiate. And the diplomacy was matched by a tough, and at the time successful, battle against Iran’s proxies in Iraq.
As US President Barack Obama has made clear, the nuclear deal has a narrow but important role: to curb the Iranian nuclear threat. That threat is ultimately restrained by military deterrence. And the nuclear deal may actually strengthen that deterrence. With that big picture firmly in view, it should become part of a maximum multinational effort to avert broader catastrophes in the Middle East and beyond.

The writer is a professor at the University of Virginia and was executive director of the 9/11 Commission

Sexy Janet's Dollar Problem

By: Hans Brinkmann

Wednesday, July 22, 2015

I guess it is the fault of the media that hardly anybody has noticed Janet Yellen's shapely legs and her elegant shoes. Besides that Wall Street bankers will be all too happy to see her since her accommodative monetary policy makes them lots of money and this may be even sexier than her legs.

Unfortunately a problem has arrived - the strong Dollar. The strength of the currency has certainly many good points. It keeps inflation low at a time of high fiscal deficits and record low interest rates.

It also muffles the voices of critics who describe the US economy as being one gigantic money printing press with a gun shop attached to it. However there is a downside too. It becomes ever clearer that the dear Dollar has a negative effect on US corporate earnings. The US Treasury estimates that a 10% appreciation of the Dollar reduces real GDP by 0.5% in the first year and 0.2% in the next. Since early last year the Dollar has gone up by more than 20%. There are other less visible dangers.

The overvalued currency essentially subsidises the efforts of foreign competitors to establish a US beachhead and expand from there. This is particularly acute in manufacturing. Is it a coincidence that the share price of General Motors has fallen 10% below the floatation price of 2011 of 33 Dollars? It appears to me that US manufacturing is being eaten alive by a pack of very hungry competitors, like some cattle in a Piranha infested river.

The impact of the strong Dollar coincides with a drastic slowdown in US growth. JP Morgan talks about 1.5% of annual GDP growth as being the new normal. What if it is lower?

Bloomberg already worries about a new recession. At the same time analysts talk about a rate hike in September.

I understand why the Fed would like to raise interest rates. It would add a little bit to their empty toolbox whilst talk about rate hikes can deter speculators from hyping up the market to unsustainable levels. Unfortunately this Fed policy could very well be the trigger for the next recession.

The current economic cycle that started in 2009 is getting old and statistically it is time for a downturn. It will be too late to prevent this if the Fed waited until the writing is on the wall.

The Federal Reserve must be proactive and the time window is closing fast. If they don't change course before September it may be too late.

Are we prepared for another US recession? The world was never as much indebted in peacetime as it is now. A research paper by McKinsey, published this year shows that global debt has gone up by $57trillion since 2007. Almost all asset markets in the developed world are in bubble territory. US sub prime lending is booming again, anybody with a heartbeat can get a car loan. The junk bond market is heading for a massive correction, at the forefront are shale oil producers facing bankruptcy.

40% of US citizens live pay check to pay check, more than half of all households have not enough savings to cover an unexpected $1,500 shortfall. Almost 50 million US citizens live on food stamps and more than 90 million Americans of working age have dropped out of the unemployment statistics. The situation is dire.

What can the Fed do if it is faced with another recession? According to HSBC it looks like the Titanic without lifeboats. The toolbox is empty. There is only one thing left - the printing press.
How will the Fed stop a collapse of the bond market and a spike in yields? - By printing money to buy bonds. How will the Fed stop a rout in the stock market? By printing money to buy S&P futures. Printing money will become the panacea for everything. A collapse in the financial markets will also feed through to the real economy and cause new unemployment, bankruptcies and spiralling fiscal deficits, triggering even more money printing.

The US Dollar will fall one way or another. Either because of Federal Reserve and US Treasury intervention. Or as a result of a new downturn. Take your pick.

Doom And Gloom For Gold Overdone? - Are There Positives Ahead?

by: Lawrence Williams            

Seldom has the media been more bearish on gold's prospects, and this will undoubtedly present itself in a further retreat from gold derivatives and gold stocks.

China seems to be being fingered for the latest gold price crash, but should it be? A truly Machiavellian argument might be that the crash was perpetrated by those elements seen as anti-gold, seeking to gain maximum advantage at a time when gold was already under pressure.

And by undertaking some of the activity on the Shanghai markets, seeking to try and apportion the blame to Chinese hedge funds, but also to dampen the appetites of the gold-purchasing Chinese people and institutions who may be seen as standing in the way of a major manipulated gold price downturn.

What is the evidence here? The gold price crash was actually initiated in New York with an enormous futures sale - which then continued in Shanghai, with a reported double whammy of a large 5 tonnes of physical gold being sold into the Shanghai Gold Exchange and another massive futures trade on the Shanghai Futures Exchange. As the U.K.'s Ambrose Evans Pritchard puts it, writing in The Daily Telegraph -
"Spot prices slumped by more than 4 percent to $1,086 an ounce in overnight trading after anonymous funds sold 57 tonnes of gold in Shanghai and New York, choosing the moment of minimum market liquidity in what appears to have been a synchronized strike intended to smash confidence."
Indeed, the initial COMEX futures sales, conducted at around 11.29 pm on Sunday night, when activity on the exchanges would be around their lowest, was so great that it forced two 20-second automatic trading halts because of the volumes - virtually unprecedented. The chart below, from Reuters, shows the activity as noted by Bron Suchecki of the Perth Mint in his analysis of what took place. The red-circled initial drop was over a period of precisely 4 seconds! If anyone tells you the gold price can’t be manipulated, here is an almost perfect counter-argument. The two green stars are when the automatic trading halts took place.

(click to enlarge)

China's recent announcement of a far-lower-than-expected increase in its gold reserves after a six-year denial of any increase (although few believe the Chinese figure), coupled with a U.S. Fed interest raising start date now expected to be in September, had already weakened the gold price, and with what seems to have been a concerted anti-gold media campaign in most Western mainstream media, seldom have gold investors been at the end of a more gloomy array of prognostications.

Yet, when sentiment is as low as it is at present, this often represents the turning point. Readers of my articles on Mineweb may recall one of May last year entitled "Gold to fall to $1,100 then skyrocket - silver, platinum in behind." In it, we discussed a prediction by Elliott Wave analyst Peter Goodburn on a scenario as suggested in the title of the article - and indeed, gold has now, as he then suggested, fallen to the $1100 mark, although perhaps a year behind the timing his initial premise may have suggested - but these things are always difficult to time accurately. Now we shall see if gold does indeed recover from this level, and if it does, on the Goodburn projections, the reversal in fortunes could be both rapid and very large indeed. We shall see. Personally, I'm not a great believer in such chart analysis, but I have to recognise that the chartists are often - though not always - right in their predictions.

Goodburn's company, WaveTrack International, has put out a note today reminding clients of the prediction in a note entitled "Gold Bullion - Time to be a Contrarian." We will have to wait and see if this is indeed a good predictor of the gold price, but if it is, we shouldn't have long to wait.

Another possibly bullish point for gold is the IMF's pending announcement - probably in October - of any revision in the make-up of its Special Drawing Rights (SDR), which is broadly regarded as an indicator of global reserve currencies. If, as many expect, the Chinese yuan is to be included, it would have to be at least close to pari passu with the US dollar, which could, over time, lead to a major reduction in the dollar's current role as the world's principal reserve currency and be a major game changer in the dollar's global influence. And with China and the countries seen as already in its zone of influence (like India, Russia, Brazil and South Africa) seen as pro-gold nations, this could well herald a significant change in sentiment for the yellow metal.

So could gold have reached its low point, with the only way now upwards? It's not beyond the bounds of possibility. The recent move to drive the price down noted above has been so blatant that maybe some kind of counter-reaction will be set in place. Perhaps by China, which has already demonstrated its capability of halting a stock market collapse in its tracks in the interests of stabilising its economy. With so many of its citizens holding gold, could it be prepared to do the same here, particularly if it feels the blame for the latest price collapse has unfairly been attributed to its financial elements?

Oil Warning: Crash May Be Much Worse Than You Think

By Tom Randall                                              

Morgan Stanley has been pretty pessimistic about oil prices in 2015, drawing comparisons to the some of the worst oil slumps of the past three decades. The current downturn could even rival the iconic price crash of 1986, analysts had warned—but definitely no worse. 
This week, a revision: It could be much worse
Until recently, confidence in a strong recovery for oil prices—and oil companies—had been pretty high, wrote analysts including Martijn Rats and Haythem Rashed, in a report to investors yesterday. That confidence was based on four premises, they said, and only three have proven true.
1. Demand will rise: Check 
In theory: The crash in prices that started a year ago should stimulate demand. Cheap oil means cheaper manufacturing, cheaper shipping, more summer road trips. 
In practice: Despite a softening Chinese economy, global demand has indeed surged by about 1.6 million barrels a day over last year's average, according to the report. 
2. Spending on new oil will fall: Check 
In theory: Lower oil prices should force energy companies to cut spending on new oil supplies, and the cost of drilling and pumping should decline. 

In practice:  Sure enough, since October the number of rigs actively drilling for new oil around the world has declined by about 42 percent. More than 70,000 oil workers have lost their jobs globally, and in 2015 alone listed oil companies have cut about $129 billion in capital expenditures. 
3. Stock prices remain low: Check 
In theory:  While oil markets rebalance themselves, stock prices of oil companies should remain cheap, setting the stage for a strong rebound. 
In practice:  Yep. The oil majors are trading near 35-year lows, using two different methods of valuation. 
4. Oil supply will drop: Uh-oh 
In theory: With strong demand for oil and less money for drilling and exploration, the global oil glut should diminish. Let the recovery commence. 
In practice: The opposite has happened. While U.S. production has leveled off since June, OPEC has taken up the role of market spoiler.  
OPEC Production Surges in 2015
For now, Morgan Stanley is sticking with its original thesis that prices will improve, largely because OPEC doesn't have much more spare capacity to fill and because oil stocks have already been hammered.
But another possibility is that the supply of new oil coming from outside the U.S. may continue to increase as sanctions against Iran dissolve and if the situation in Libya improves, the Morgan Stanley analysts said. U.S. production could also rise again. A recovery is less certain than it once was, and the slump could last for three years or more—"far worse than in 1986."
"In that case," they wrote, "there would be little in analysable history that could be a guide" or what's to come.