Hoisington Investment Management – Quarterly Review and Outlook, Second Quarter 2016

John Mauldin

It has come to be a near truism that high levels of government debt and deficit spending suppress economic growth, but how exactly does that happen? In today’s Outside the Box, Dr. Lacy Hunt and Van Hoisington of Hoisington Investment Management give us a very detailed explanation of the dynamics involved.

On the deficit spending front, the authors state that the best evidence suggests that the US government expenditure multiplier is -0.01, which means that each additional dollar of deficit spending reduces private GDP by $1.01, resulting in a one-cent decline in real GDP. Additionally, the authors say, the multiplier is likely to become drastically more negative over time since the mandatory components of government spending (Social Security, Medicare, veteran’s benefits and the Affordable Care Act, etc.) will represent an ever-increasing share of the federal budget.

With regard to government debt, the authors describe a 2012 study by Carmen Reinhardt, Vincent Reinhardt, and Kenneth Rogoff (RR&R) that identified 26 major public debt overhang episodes in 22 advanced economies since the early 1800s, characterized by public debt-to-GDP levels exceeding 90% for at least five years. RR&R determined that these debt overhang episodes reduced the economic growth rate by slightly more than 33%, on average. As of last year, the US economy has met these criteria for reduced growth: government debt first exceeded 90% of GDP in 2010 and surpassed 100% in each of the past five years.

It is very significant, too, say Hoisington and Hunt, that while debt begins reducing economic growth at relatively low levels of government debt-to-GDP, as the debt level rises the debilitating impact on growth speeds up. That is, the impact increases nonlinearly.

The bottom line, say our authors, is that with global debt levels moving ever higher, we can expect that worldwide business conditions will continue to be poor and that the slowdown ahead will cut the already weak trajectory of nominal growth. We are at risk, they warn, of falling into a global “policy trap.”

Hoisington Investment Management Company (www.hoisington.com) is a registered investment advisor specializing in fixed-income portfolios for large institutional clients. Located in Austin, Texas, the firm has over $5 billion under management and is the sub-adviser of the Wasatch-Hoisington US Treasury Fund (WHOSX).

I will be off to Las Vegas tomorrow, where I will be attending FreedomFest and doing a few presentations. I will be interviewing my friends Steve Forbes and Rob Arnott at 5:20 PM Vegas time for 20 minutes. You can watch that live over the Internet at this link. If you’ll be there, I will also be doing a presentation on Saturday afternoon called “The Invisible Hand, Evolution, and Why I Am an Economic Atheist.” Guaranteed to offend almost everyone, and there wil l be plenty of time for Q&A. This is one speech I will not be giving to very many audiences. But if you are not happy with current monetary policy and its direction, you might actually find yourself nodding in agreement here and there.

I’m actually looking forward to Vegas, which is not something I would normally say. But I have so many friends attending this event, including Bill Bonner, Steve Moore, George Gilder, Steve Forbes, and a score of others, that I will be “catching up” and sharing ideas on the issues of the day. We do live in interesting times.

And of course we may catch a few shows. I know for a fact that I’m going to once again take in the “Love” Cirque du Soleil show featuring the music of the Beatles, which is one of my favorite music-themed presentations of all time, right up there with The Jersey Boys.

Honestly, it could only get a little better if Cirque du Soleil did a presentation around the music of the Beach Boys. I know, that dates me, but I recently read that 74-year-old Brian Wilson and some of the others were once again doing a concert at the Hollywood Bowl, and just reading that made me happy and wishing I could be there. I’m pretty sure Brian Wilson has more hit records than just about any songwriter in the country.

I hope you’re having a great summer. I’ve got to try to figure out how to get my regular letter written in between hanging out with friends this weekend, but it will be appear in your inbox. Count on it.

Your getting a little nostalgic analyst,

John Mauldin, Editor
Outside the Box

Hoisington Investment Management – Quarterly Review and Outlook, Second Quarter 2016

By Dr. Lacy Hunt and Van Hoisington 


The Separate Constraints of Deficit Spending and Debt

Real per capita GDP has risen by a paltry 1.3% annualized since the current expansion began in 2009. This is less than half of the 2.7% average expansion since the records began in 1790. One of the most persistent impediments to growth has been the drag from fiscal policy, a constraint that is likely to become even more severe in the next decade. The standard of living, or real median household income, has only declined in the 2009-2016 expansion and stands at the same level reached in 1996.


Six considerations indicate federal finance will produce slower growth: (1) the government expenditure multiplier is negative; (2) the composition of spending suggests the multiplier is likely to trend even more negative; (3) the federal debt-to-GDP ratio moved above the deleterious 90% level in 2010 and has stayed above it for more than five years, a time span in which research shows the constriction of economic growth to be particularly severe. It will continue to move substantially further above the 90% threshold as debt suppresses the growth rate; (4) debt is likely to restrain economic growth in an increasingly nonlinear fashion; (5) the first four problems produce negative feedback loops from federal finance to the economy through the allocation of saving, real investment, productivity growth and eventually to demographics; and (6) the policy makers force the economy into a dow nward spiral when they rely on more debt in order to address poor economic performance. More of the same does not produce better results. It produces worse results, a situation we term a policy trap.

Deficit spending is a separate matter from debt. If the starting point were a situation of no federal debt, a discussion of expenditure multipliers would be sufficient. However, that is not the case. Federal debt levels are already extremely elevated, and the trend is escalating steadily higher.

When deficits and debt impair growth, a sequence of events impacting other critical barometers of economic performance takes place. Saving is increasingly misallocated, shifting income that generates public and private investment into investments that are either unproductive or counterproductive. Real investment in plant and equipment falters, which in turn pulls productivity, employment and economic growth down. When the policy response to poor economic performance is ever-higher levels of debt, the economy’s growth becomes more feeble, which over time causes demographics to erode, a common pattern in highly indebted countries. Then the deterioration in real investment, productivity and demographics reverberate to the broader economy through negative feedback loops that suggest that as debt moves ever higher, the restraining effect on economic growth turns nonlinear. While som e economists have called these headwinds, they should be more appropriately viewed as symptoms that originated with the deficits and the debt. And these symptoms will persist as long as the debt problems continue.

These indirect influences of debt on economic growth, as well as how this process has proceeded in Japan, illustrates these points. Japan, burdened by a massive debt overhang for almost three decades and a 25-year policy trap, provides a road map for the United States, which is in a much earlier stage of debt overhang.
Deficit Spending Restrains Economic Growth

Negative multiplier. The government expenditure multiplier is negative. Based on academic research, the best evidence suggests the multiplier is -0.01, which means that an additional dollar of deficit spending will reduce private GDP by $1.01, resulting in a one-cent decline in real GDP. The deficit spending provides a transitory boost to economic activity, but the initial effect is more than reversed in time. Within no more than three years the economy is worse off on a net basis, with the lagged effects outweighing the initial positive benefit.

More negative. Although only minimally negative at present, the multiplier is likely to become more negative over time since mandatory components of the government spending will control an ever-increasing share of budget outlays. These outlays have larger negative multipliers. In 2015, the composition of federal outlays was 68.3% mandatory and 31.7% discretionary; the composition was almost the exact opposite in 1962, around the time this data series originated (Chart 1). Mandatory spending includes Social Security, Medicare, veteran’s benefits and the Affordable Care Act. All of these programs are politically popular and conceptually may be highly laudatory. However, federal borrowing to sustain these programs does not generate an income stream for the economy as a whole to pay for these programs. As history has evidenced, the continual taking on of this kind of debt will eventually cause bankruptcy.

Due to the aging of America, the mandatory components of federal spending will accelerate sharply over the next decade, causing government outlays as a percent of economic activity to move higher. There have been proposals for increased infrastructure spending and others for additional federal entitlements like Social Security. However, the existing present value of all unfunded federal entitlements already totals $60 trillion, about ten times the amount held in the trust funds. When funds flow into these accounts, they are immediately spent to cover the federal deficit, with the Treasury issuing an IOU to the trust fund. Thus, the trust funds merely hold U.S. government debt.

Theoretically, increased infrastructure spending could serve to reverse or halt the trend to a more negative multiplier, if true infrastructure spending were to be substituted for transfer payments, but that is not what has been proposed. The new infrastructure spending would be in addition to existing government programs. Any new infrastructure projects must generate a cash flow for the aggregate economy that is greater than what would have been generated by the private sector.

The rising unfunded discretionary and mandatory federal spending will increase the size of the federal sector, which according to first-rate econometric evidence will contract economic activity. Two Swedish econometricians (Andreas Bergh and Magnus Henrekson, The Journal of Economic Surveys (2011)), substantiate that there is a “significant negative correlation” between the size of government and economic growth. Specifically, “an increase in government size by 10 percentage points is associated with a 0.5% to 1% lower annual growth rate.” This suggests that if spending increases, the government expenditure multiplier will become more negative over time, serving to confound even more dramatically the policy establishment and the public at large, both of whom appear ready to support increased, but unfunded, federal outlays.

Deleterious Levels. Federal debt has subtracted, to at least some degree, from U.S. economic growth since about 1989 when debt broke above 50% of GDP, a level to which this ratio has never returned (Chart 2). The macro consequences of the debt are becoming increasingly significant. This may seem surprising to many because of confusion about the scholarly work of Carmen Reinhardt and Kenneth Rogoff (R&R) in their 2009 book, This Time is Different.

The misinterpretations pertain to a key point in R&R’s book and accusations of data inaccuracies in the statistical calculations. R&R said debt induced panics run their course in six to ten years, with an average of eight years. The last panic was in 2008, so according to their early work the time span has either ended, or is close to ending. However, the six to ten year time reference does not apply when debt levels continue to move higher over that time period.

In the latest quarter, gross federal debt was 105.7% of GDP, compared to 73.5% in the final quarter of the 2008 panic.

A number of other studies (see Appendix for list), along with R&R themselves, superseded the 2009 conclusions. In 2012 in The Journal of Economic Perspectives (a peer reviewed publication of the American Economic Association), R&R joined by Vincent Reinhardt (RR&R) identify the 26 major public debt overhang episodes in 22 advanced economies since the early 1800s, characterized by public debt-to-GDP levels exceeding 90% for at least five years. The five-year requirement eliminates purely cyclical increases in debt and most of those caused by wars.

RR&R find that public debt overhang episodes reduce the economic growth rate by slightly more than a third, compared with growth rates when the debt metric is not met. Additionally, among the 26 applicable episodes, 20 lasted more than a decade, and the average duration of the debt overhang episodes was a staggering 23 years. The length contradicts the notion that the correlation is caused mainly by debt buildups during business cycle recessions and confirms that the cumulative shortfall in output from debt overhang episodes should be massive. Finally, it is interesting to note that in 11 of these episodes interest rates are not materially higher; thus, the growth-reducing effects of high public debt are not transmitted exclusively through high real interest rates.

The U.S. has currently met RR&R’s criteria for slowing growth. Gross government debt exceeded 90% of GDP in 2010 and has continued to move higher since then, thus exceeding the consecutive five-year benchmark. Equally important, the debt problem is worsening. At the end of this year the government debt-to-GDP ratio will have surpassed 100% in each of the past five years, thus debt is moving into a significantly higher range.
Nonlinear Effects, Causal Factors, Feedback Loops, and the Policy Trap

Research has found that debt begins reducing economic growth at relatively low levels of government debt-to-GDP, and that this impact increases as the debt level rises. In addition, as the debt ratio moves extremely high, the debilitating impact on growth speeds up. Or, as the mathematician would say, the effect is nonlinear.

European researchers, as well as RR&R, offer causal explanations for the heavy drag on economic growth. They argue that the debt effects are explained, at least partially, by a misallocation of the limited amount of private saving as well as the likelihood that the private saving is less than in situations when debt is relatively low. In turn, these adverse savings effects reduce real investment in the private sector, which then leads to a deterioration of productivity growth, profitability, labor market dynamics and economic growth.

This line of reasoning is complicated, but the linkage can be explained as follows. As the government takes on more debt to support household income, consumers believe that saving for retirement or contingency is not as necessary since the government promises to fund income and medical care needs for those retiring. The saving rate is, therefore, lower. Since saving from income must equal real investment, the latter drops. With real investment weaker, productivity, profitability and economic growth follow suit.

The presumption of policy makers is that more deficit spending and debt is needed to address economic underperformance. While the intentions are well-meaning, the policy makers unwittingly cause an even faster rate of economic deterioration. In view of the future levels projected by such impartial sources as the Congressional Budget Office, debt will increasingly bite into the economy’s growth rate, which is a situation well documented in Japan.
Japan's Debt Linkages

For the past quarter century, Japan has illustrated the nonlinear debt/growth trap. The ratio of government debt-to-GDP has more than quadrupled, increasing from 50.9% in 1989 to 209.2% in 2015. And, as indicated by the aforementioned research, the Japanese household gross saving rate fell from 26.6% in 1989 to 6.6% in 2015. Productivity growth averaged 3.2% from the start of the data in the early 1980s through 1991, and dropped to 0.5% in the latest 10-year period, just as the academic studies suggested would happen. Finally, Japan reached the RR&R threshold of 90% government debt-to-GDP in 1999 and has exceeded that level every year since then.

These effects occurred even though the Bank of Japan (BOJ) tried to ameliorate the consequences with massive purchases of Japanese government debt. By 2015, the BOJ owned one-third of total Japanese government debt outstanding. The non-linear relationship is evident. In spite of these efforts, nominal GDP in Japan contracted 0.12% from 2000 to 2015, sharply worse than the 1.9% increase from 1990 to 2000, a growth rate that was already quite subpar for Japan.
Deteriorating Demographics: A Consequence of Extreme Indebtedness

Although not identified in the studies, another linkage may also explain the increasingly negative economic performance. Demographics deteriorate when excessive debt overhangs persist. In their panic year of 1989, Japan’s demographics were poor compared to those of the United States. Importantly, after more than a quarter century of trying to solve a debt problem with higher levels of debt, their demographics are far worse. For example, the number of births fell by 19.3% from 1989 to 2015 (Chart 3). With fewer births, labor force entries decline, and eventually so does employment. As time passes this will place rising debt burdens on a falling number of people, thus prolonging the economic misery in Japan.

While the U.S. demographics are considerably more robust than in Japan, they did start exhibiting a parallel decline 25 years ago when high levels of U.S. government debt began reducing the trend rate of economic growth (Chart 4). The U.S. birth rate fell from the highs in the 1940s and 1950s until the mid-1970s, on what was generally believed to be lifestyle changes.
However, from the mid-1970s until 1990 the birth rate moved irregularly higher, reaching 16.7 per 1000. The latest year available recorded the second lowest year of the past 25 years, at only 12.5 per 1000. A case could be made that debt could shove the U.S. economy along the downward growth/population spiral so evident in Japan.

A Forward Look

In the opening remarks to her June 15th press conference, Chairwoman Yellen used the phrase, “headwinds weighing on the economy.” She further explained, “These headwinds—which include developments abroad, subdued household formation, and meager productivity growth—could persist for some time.” These domestic and foreign items that she correctly sighted, however, are merely symptoms of the massive debt overhangs existing worldwide. Transitory growth spurts, like the one in the quarter just ended, are unlikely to be sustained. Sporadic but weakening growth will remain intact as long as the debt problems continue to worsen.

Elevated debt levels are producing poor business conditions worldwide. According to the Netherlands Bureau of Economic Policy Analysis’s (NBEPA) World Trade Monitor, the year-over-year change of the three-month average in the value of goods that crossed international borders has been hovering around 0% for the last six months. This is a dramatic slowdown from the 4.5% average growth rate registered since the end of the 2009 recession. Moreover, the last six months constitutes the weakest period since the recession. United States exports and imports confirm this deteriorating trend. In the latest twelve months, real U.S. exports and imports both contracted 1.6%. Such declines could only reflect a predominance of fragile global conditions and confirmation that the world lacks an engine of growth.

For 2016 as a whole, we expect nominal GDP to subside to around 2.5%, down from 3.1% in 2015. Year-over-year M2 growth has been above 6.5%, but M2 velocity dropped to the lowest level since early 1950 in the first quarter. Such a slump is to be expected when the wrong type of debt increasingly dominates the total.

Surging energy, rents and insurance costs boosted the year-over-year rise in the inflation rate to 1% in May, compared with several negative readings in 2015. These costs are likely to push the 12-month inflation rate slightly higher, but the bulge in these relative prices will not lead to higher aggregate inflation. Slow top-line growth in nominal GDP will ultimately force consumers to bid down prices on discretionary goods and services. As such, the faster currently observed inflation should pass.

With slowing nominal economic growth, treasury bond yields are likely to continue working lower. Stressed conditions in major overseas economies have pushed 10- and 30-year government bond yields in Japan, Germany, France, and many other European countries much lower than in the United States. In fact, the 10-year yield has turned negative in both Japan and Germany. Foreign investors will continue to be attracted to long-term U.S. Treasury bond yields. Investment in Treasury bonds should also have further appeal to domestic investors, as the second quarter likely marks the high point of economic performance this year. The slowdown ahead will cut the already weak nominal growth trajectory. Consequently, with the normal lag, the annual inflation rate, which most importantly impacts 30-year treasury yields, should begin to turn down as the year moves to a close.

From Brexit to the Future

Joseph E. Stiglitz
. Newsart for From Brexit to the Future

NEW YORK – Digesting the full implications of the United Kingdom’s “Brexit” referendum will take Britain, Europe, and the world a long time. The most profound consequences will, of course, depend on the European Union’s response to the UK’s withdrawal. Most people initially assumed that the EU would not “cut off its nose to spite its face”: after all, an amicable divorce seems to be in everyone’s interest. But the divorce – as many do – could become messy.
The benefits of trade and economic integration between the UK and EU are mutual, and if the EU took seriously its belief that closer economic integration is better, its leaders would seek to ensure the closest ties possible under the circumstances. But Jean-Claude Juncker, the architect of Luxembourg’s massive corporate tax avoidance schemes and now President of the European Commission, is taking a hard line: “Out means out,” he says.
That kneejerk reaction is perhaps understandable, given that Juncker may be remembered as the person who presided over the EU’s initial stage of dissolution. He argues that, to deter other countries from leaving, the EU must be uncompromising, offering the UK little more than what it is guaranteed under World Trade Organization agreements.
In other words, Europe is not to be held together by its benefits, which far exceed the costs. Economic prosperity, the sense of solidarity, and the pride of being a European are not enough, according to Juncker. No, Europe is to be held together by threats, intimidation, and fear.
That position ignores a lesson seen in both the Brexit vote and America’s Republican Party primary: large portions of the population have not been doing well. The neoliberal agenda of the last four decades may have been good for the top 1%, but not for the rest. I had long predicted that this stagnation would eventually have political consequences. That day is now upon us.
On both sides of the Atlantic, citizens are seizing upon trade agreements as a source of their woes. While this is an over-simplification, it is understandable. Today’s trade agreements are negotiated in secret, with corporate interests well represented, but ordinary citizens or workers completely shut out. Not surprisingly, the results have been one-sided: workers’ bargaining position has been weakened further, compounding the effects of legislation undermining unions and employees’ rights.
While trade agreements played a role in creating this inequality, much else contributed to tilting the political balance toward capital. Intellectual property rules, for example, have increased pharmaceutical companies’ power to raise prices. But any increase in corporations’ market power is de facto a lowering of real wages – an increase in the inequality that has become a hallmark of most advanced countries today.
Across many sectors, industrial concentration is increasing – and so is market power. The effects of stagnant and declining real wages have combined with those of austerity, threatening cutbacks in public services upon which so many middle- and low-income workers depend.
The resulting economic uncertainty for workers, when combined with migration, created a toxic brew. Many refugees are victims of war and oppression to which the West contributed.
Providing help is a moral responsibility of all, but especially of the ex-colonial powers.
And yet, while many might deny it, an increase in the supply of low-skill labor leads – so long as there are normal downward-sloping demand curves – to lower equilibrium wages. And when wages can’t or won’t be lowered, unemployment increases. This is of most concern in countries where economic mismanagement has already led to a high level of overall unemployment.
Europe, especially the eurozone, has been badly mismanaged in recent decades, to the point that its average unemployment is in double digits.
Free migration within Europe means that countries that have done a better job at reducing unemployment will predictably end up with more than their fair share of refugees. Workers in these countries bear the cost in depressed wages and higher unemployment, while employers benefit from cheaper labor. The burden of refugees, no surprise, falls on those least able to bear it.
Of course, there is much talk about the net benefits of inward migration. For a country providing a low level of guaranteed benefits – social protection, education, health care, and so forth – to all citizens, that may be the case. But for countries that provide a decent social safety net, the opposite is true.
The result of all this downward pressure on wages and cutbacks in public services has been the evisceration of the middle class, with similar consequences on both sides of the Atlantic.
Middle- and working-class households haven’t received the benefits of economic growth. They understand that banks had caused the 2008 crisis; but then they saw billions going to save the banks, and trivial amounts to save their homes and jobs. With median real (inflation-adjusted) income for a full-time male worker in the US lower than it was four decades ago, an angry electorate should come as no surprise.
Politicians who promised change, moreover, didn’t deliver what was expected. Ordinary citizens knew that the system was unfair, but they came to see it as even more rigged than they had imagined, losing what little trust they had left in establishment politicians’ capacity or will to correct it. That, too, is understandable: the new politicians shared the outlook of those who had promised that globalization would benefit all.
But voting in anger does not solve problems, and it may bring about a political and economic situation that is even worse. The same is true of responding to a vote in anger.
Letting bygones be bygones is a basic principle in economics. On both sides of the English Channel, politics should now be directed at understanding how, in a democracy, the political establishment could have done so little to address the concerns of so many citizens. Every EU government must now regard improving ordinary citizens’ wellbeing as its primary goal. More neoliberal ideology won’t help. And we should stop confusing ends with means: for example, free trade, if well managed, might bring greater shared prosperity; but if it is not well managed, it will lower the living standards of many – possibly a majority – of citizens.
There are alternatives to the current neoliberal arrangements that can create shared prosperity, just as there are alternatives – like US President Barack Obama’s proposed Transatlantic Trade and Investment Partnership deal with the EU – that would cause much more harm. The challenge today is to learn from the past, in order to embrace the former and avert the latter.

The Implications of the Coup in Turkey

The recent coup attempt highlights the secular-religious divide in Turkey.

By George Friedman

Mid-afternoon on Friday in the U.S. (late evening in Turkey), we started to receive reports that tanks were deploying in Istanbul and two bridges over the Bosporus had been closed by Turkish army troops. A bit later, we got reports that armor had been deployed in Ankara and that there was fighting going on between Turkish army special forces and national police around the parliament. Turkish F-16s were seen in large numbers in the skies. A military coup was underway.

Military coups were fairly common in the world 30 or 40 years ago. Turkey last had a coup in 1980. Having a full-dress coup, with tanks in the streets and government buildings under attack, seemed archaic. Yet here it was. For us, it was a complete surprise. True, the army was Turkey’s institutional guarantee of secularism. Kemal Atatürk’s post-World War I revolution was dedicated to secularism, to the point that head scarves on Muslim women were banned for decades. When the Justice and Development Party, President Recep Tayyip Erdoğan’s party, won the 2003 election and pledged to speak for devout Muslims’ interests, a clash with the army was inevitable. Erdoğan managed this challenge with surprising skill and even ease. He first blocked and then broke the army’s power. In spite of grumblings, and some arrests over coups that never quite happened, Erdoğan made the military subordinate to his wishes.

Yet here were tanks in the street. Somehow, certainly out of our sight – and out of the sight of people who now say they always knew it was coming – a coup had been organized. Organizing a coup is not easy. It has to be carefully planned many weeks before. Many thousands of troops, as well as tanks, helicopters and all the rest, must suddenly and decisively appear in the streets and take over. And all of this planning has to take place in complete secrecy, because without the element of surprise there is no coup.

This began our first conversation: How did the military organize a coup without a word of it leaking? Turkey’s security and intelligence services are professional and capable, and watching the military is one of their major jobs. A coup requires endless meetings and preparation. In this day of intrusive surveillance, how did the military keep its intentions under wraps?

The only explanation we could find is that the intelligence organizations must have been in on it. If so, then the game was over for Erdoğan. A source we had in the military, someone fairly senior, said he had no idea the coup was happening. He did know that Erdoğan was at a hotel in Marmaris, on the Mediterranean. The coup was planned while Erdoğan was away from Ankara and it would be easy to isolate and arrest him. Perfect planning, without a leak.

A few hours after the coup began, troops loyal to the coup makers entered some television studios and newspaper offices and had broadcasters announce that a coup had taken place and that the traditional secular principles of Kemal Atatürk had been restored. Since we had been told by our sources that the coup was being run by very senior officers (though not the chief of staff), it appeared to us that it had succeeded. Erdoğan was being held in a resort town, apparently unable to return to Istanbul or Ankara, as airports were held by the military. The communication centers had been secured. There were even troops in Taksim Square, the major gathering place in Istanbul, which meant the city was saturated. The coup looked as if it was nearing its end.

Then suddenly everything changed. Erdoğan started making statements via FaceTime on Turkish TV channel NTV. Well, instead of Erdoğan’s being arrested, as we’d been led to believe, maybe it was just that troops were outside his hotel, and he was still free enough to do this. Sloppy work on the part of the coup. Then Erdoğan got on a plane and flew in to Istanbul’s Atatürk Airport, which had reportedly been secured by the military conducting the coup. Again, sloppy work. It was clear that Erdoğan was free, because he was making threats. Then we got reports of Turkish troops surrendering to policeman in Taksim Square, and the bridges that had been closed were abandoned by troops and reopened. Erdoğan ordered loyal F-16s to shoot down helicopters attacking the parliament building in Ankara.

The situation morphed from business as usual to a successful coup to a failed coup in a matter of hours. And we still had no explanation as to why the people staging the coup hadn’t been detected by the intelligence services.

It is time for “tin foil.” We could speculate that Erdoğan wanted the coup. He knew he could defeat it, and the attempt now gives him the justification to utterly purge the army. Perhaps he went to Marmaris for his own security. Then, as I write this, there are reports from the Greek military that a Turkish frigate was seized by Turkish troops opposed to Erdoğan, that the Turkish navy’s commanding officer was being held hostage, and that Erdoğan had sent a text urging all Turks into the streets. The coup is either over, or it’s not. The coup planners either evaded detection, or they were allowed to walk into Erdoğan’s trap. All that will become clearer in the next few hours.

But there are deeper meanings and geopolitical implications of the coup attempt. We know that there are deep tensions between Turkey’s secular population, centered in Istanbul and long grounded and comfortable in Atatürk’s philosophy, and Erdoğan’s more religious supporters in Anatolia and elsewhere. (Anatolia is the rather vast, less densely populated, region east of the Bosporus and is generally more conservative but also includes a large Kurdish region and a few other minority ethnic groups.)

These religious minorities of Anatolia had been marginalized since World War I. Erdoğan came to power intending to build a new Turkey. He understood that the Islamic world had changed, that Islam was rising, and that Turkey could not simply remain a secular power. He understood that domestically and in terms of foreign policy. There have been persistent reports that Turkey is at least allowing the Islamic State to use the Turkish financial system, sell its oil in Turkey and move its people through Turkey. Erdoğan has been, until recently, reluctant to attack them. He shifted his strategy in recent months, resulting in IS attacks on Turkey, apparently in retaliation.

Erdoğan is caught between two forces. One is a jihadist faction, which it seems he has tried to manage, to deflect it from hitting Turkey. This effort has put him at odds with the United States and Russia simultaneously. He has also been under pressure from a domestic secular faction appalled by his strategy. Recently the strategy shifted. He reopened relations with Israel and apologized to Russia. He got rid of what many saw as a pro-Islamist prime minister. He appeared to be trying to rebalance his policy. The people who staged the coup likely saw these moves as weakness and sensed an opening.

Turkey has become the critical country in its region. It is the key to any suppression of IS in Syria and even in Iraq. It is the pivot point of Europe’s migrant policy. It is challenging Russia in the Black Sea. The United States needs Turkey, as it has since World War II; and Russia can’t afford a confrontation with it. Neither country likes Erdoğan, but it is not clear that either country has options. Interestingly, Russian Foreign Minister Sergey Lavrov and U.S. Secretary of State John Kerry were having marathon meetings on Syria as the coup was taking place.

The room for conspiracy theories is endless now, because there actually were conspiracies – and likely conspiracies within conspiracies. So let’s end with the obvious. Turkey affects the Middle East, Europe and Russia. It is also a significant force in shaping jihadist behavior. Erdoğan’s behavior has been increasingly erratic, as if trying to regain his balance. The coup meant that some within the military thought he was vulnerable. His supporters are now trying to re-establish control.

The coup appears over, but the repercussions of follow-on actions are not. Erdoğan will unleash as much political intimidation as he can and conduct purges to frighten the military. However, reigns of terror don’t work well if they frighten men with guns and make them feel they have nothing to lose by fighting back. There is no evidence that major military formations came to Erdoğan’s aid. The military seems divided among those who staged the coup, those who were neutral and the national police who backed Erdoğan. Though Erdoğan is a master of appearing stronger than he is, he looked weak calling for people to come into the streets to demonstrate their support. But he can’t afford to look weak, so he has to make a decisive countermove. If he can.

Election 2016

The dividing of America

Donald Trump’s nomination in Cleveland will put a thriving country at risk of a great, self-inflicted wound

FROM “Morning in America” to “Yes, we can”, presidential elections have long seemed like contests in optimism: the candidate with the most upbeat message usually wins. In 2016 that seems to have been turned on its head: America is shrouded in a most unAmerican pessimism.

The gloom touches race relations, which—after the shooting of white police officers by a black sniper in Dallas, and Black Lives Matter protests against police violence, followed by arrests, in several cities—seem to get ever worse. It also hangs over the economy. Politicians of the left and right argue that American capitalism fails ordinary people because it has been rigged by a cabal of self-serving elitists. The mood is one of anger and frustration.

America has problems, but this picture is a caricature of a country that, on most measures, is more prosperous, more peaceful and less racist than ever before. The real threat is from the man who has done most to stoke national rage, and who will, in Cleveland, accept the Republican Party’s nomination to run for president. Win or lose in November, Donald Trump has the power to reshape America so that it becomes more like the dysfunctional and declining place he claims it to be.

This nation is going to hell
The dissonance between gloomy rhetoric and recent performance is greatest on the economy.

America’s recovery is now the fourth-longest on record, the stockmarket is at an all-time high, unemployment is below 5% and real median wages are at last starting to rise. There are genuine problems, particularly high inequality and the plight of low-skilled workers left behind by globalisation. But these have festered for years. They cannot explain the sudden fury in American politics.

On race relations there has, in fact, been huge progress. As recently as 1995, only half of Americans told pollsters that they approved of mixed-race marriages. Now the figure is nearly 90%. More than one in ten of all marriages are between people who belong to different ethnic groups. The movement of non-whites to the suburbs has thrown white, black, Hispanic and Asian-Americans together, and they get along just fine. Yet despite all this, many Americans are increasingly pessimistic about race. Since 2008, when Barack Obama was elected president, the share of Americans who say relations between blacks and whites are good has fallen from 68% to 47%. The election of a black president, which seemed the ultimate proof of racial progress, was followed by a rising belief that race relations are actually getting worse.

What explains the divergence between America’s healthy vital signs and the perception, put with characteristic pithiness by Mr Trump, that the country is “going down fast”? Future historians will note that from about 2011 white and non-white babies were born in roughly equal numbers, with the ageing white population on course to become a minority around 2045.

This was always going to be a jarring change for a country in which whites of European descent made up 80-90% of the population for about 200 years: from the presidency of George Washington to that of Ronald Reagan.

Demographic insecurity is reinforced by divisive partisan forces. The two parties have concluded that there is little overlap between the groups likely to vote for them, and that success therefore lies in making those on their own side as furious as possible, so that they turn out in higher numbers than the opposition. Add a candidate, Mr Trump, whose narcissistic bullying has prodded every sore point and amplified every angry sentiment, and you have a country that, despite its strengths, is at risk of a severe self-inflicted wound.

Reshaping politics
The damage would be greatest were he to win the presidency. His threats to tear up trade agreements and force American firms to bring jobs back home might prove empty. He might not be able to build his wall on the border with Mexico or deport the 11m foreigners currently in the United States who have no legal right to be there. But even if he failed to keep these campaign promises, he has, by making them, already damaged America’s reputation in the world. And breaking them would make his supporters angrier still.

The most worrying aspect of a Trump presidency, though, is that a person with his poor self-control and flawed temperament would have to make snap decisions on national security—with the world’s most powerful army, navy and air force at his command and nuclear-launch codes at his disposal.

Betting markets put the chance of a Trump victory at around three in ten—similar to the odds they gave for Britain voting to leave the European Union. Less obvious, but more likely, is the damage Mr Trump will do even if he loses. He has already broken the bounds of permissible political discourse with his remarks about Mexicans, Muslims, women, dictators and his political rivals. It may be impossible to put them back in place once he is gone. And history suggests that candidates who seize control of a party on a prospectus at odds with that party’s traditional values tend eventually to reshape it. Barry Goldwater achieved this feat for the Republicans: though he lost 44 states in 1964, just a few elections later the party was running on his platform. George McGovern, who fared even worse than Goldwater, losing 49 states in 1972, remoulded the Democratic Party in a similar fashion.

One lesson of Mr Trump’s success to date is that the Republicans’ old combination of shrink-the-state flintiness and social conservatism is less popular with primary voters than Trumpism, a blend of populism and nativism delivered with a sure, 21st-century touch for reality television and social media. His nomination could prove a dead end for the Republican Party. Or it could point towards the party’s future.

When contemplating a protest vote in favour of tearing up the system, which is what Mr Trump’s candidacy has come to represent, some voters may ask themselves what they have to lose. (That, after all, is the logic that drove many Britons to vote for Brexit on June 23rd.) But America in 2016 is peaceful, prosperous and, despite recent news, more racially harmonious than at any point in its history. So the answer is: an awful lot.

The Bail-in Strategy and Europe’s Crisis

The EU’s approach to banks in crisis carries high risk and huge consequences.

By George Friedman

The current Italian banking crisis carries with it the possibility of bank failures. The consequences of these failures pyramid the crisis because of European Union regulations.

Essentially, the position of the European Union is that the European Central Bank (ECB) and the central banks of member countries cannot bail out failing banks by recapitalizing them — in other words, injecting money to keep them solvent. EU regulations go so far as to prohibit Italy from using its state funds to shield investors and shareholders of banks from losses, unless there is risk of "very extraordinary" systemic stress. Rather, the European Union has adopted a bail-in strategy.

The bail-in strategy is in theory a mechanism for ensuring fair competition and stability in the financial sector across the eurozone. It protects countries, like Germany, from spending their money on bank failures in other countries, and keeps the ECB from printing extra money and exposing Europe to inflation that would reduce the position of creditors. The fear of inflation is remote at this moment but it still is an institutional principle of the ECB. And controlling national expenditures on banks imposes fiscal discipline on countries that seek to bail out not just banks, but the equity holdings of investors, who will lose their investment when the bank fails.

The issue is this: who is considered an investor? In the view of the EU, depositors are, in cases of a bank resolution, investors in the bank. The bail-in process can potentially apply to any liabilities of the institution not backed by assets or collateral. There is some insurance available, and there are EU regulations on deposit insurance, but there is no EU-wide system of deposit insurance. This is because creditor nations do not want to share the liability for bank failures in other nations. This means that while the first 100,000 euros ($111,000) in deposits are protected, in the sense that they cannot be seized, any money above that amount can be.

On the surface, 100,000 euros is a substantial amount of savings. But if you consider the position of a professional who has saved all his life for retirement, he may have substantially more. And at interest rates available today, even a bank account with a million euros would not generate enough income through interest to sustain a planned retirement. The principal would have to be used, and in a bail-in, both the planned income and principal (above 100,000 euros) would be dissolved. As for businesses, particularly small and medium-sized enterprises (SMEs), the bail-in could evaporate payroll accounts and other working capital. 

The idea of the bail-in obliterates a distinction that has become fundamental to European and American banking since the massive banking failures of the 1920s and 1930s. It was understood that the purpose of a savings account was to find a safe haven for your savings or your operating capital. The depositor paid for the safe haven by accepting extremely modest interest rates. In contrast, an investor takes on greater risk and is responsible for evaluating the financials of an investment. The bank is an institution that is an alternative to riskier investments.

We saw the consequence of a bail-in procedure during the Cypriot banking crisis. Claiming informally that Cypriot banks contained primarily Russian money meant for laundering, Germany insisted that the bail-in process should prevail. There was undoubtedly illegal Russian money in Cypriot banks, but there were also retirement funds for British expatriates who retired to Cyprus and accounts held by Cypriot businesses. The result was devastating.

Money that had been prudently deposited in a bank — so the depositor believed — was lost as depositors discovered they were considered investors. Employees of hotels, for example, were not paid for a month and then received about half a paycheck for a while. The hotels lost their investments in the banks, without ever having realized that they were investors and without any opportunity to participate in the banks’ success, while unwittingly being exposed to failure.

There is one tremendous consequence in this bail-in strategy. It increases the possibility of runs on banks, particularly by large depositors. As it becomes known that depositors are investors — rather than creditors — and that their assets will be forfeited to pay debtors, the bank ceases to be a safe haven.

The more aware the depositor becomes that he will be treated as an investor, the more he will behave like an investor. Realizing that his bank deposit is all risk with no upside, any indication that risks are mounting will cause a rational actor to withdraw his money, and this will increase the risk of a run and collapse.

It is not clear what the EU is thinking. The American approach to the 2008 banking crisis was that some companies and banks were “too big to fail.” The concept operated on many levels.

One was that the federal government ensured that the Federal Deposit Insurance Corporation (FDIC) had enough money to cover all guarantees. The relatively generous guarantees of the FDIC might not have been sufficient to deal with the crisis. The FDIC insures $250,000 in individual deposits and $500,000 for a married couple. In addition, it insures the same amount at the same bank in different types of accounts. So, if an individual had a personal account, a small corporate account and a foundation account, he could have $750,000 in guarantees at the same bank. And if he had more money, he could open accounts at another bank. The FDIC would cover all of it and the federal government was prepared to ensure the FDIC was able to do so.

Another aspect of the American approach was the infusion of capital into banks to guarantee that the banks could honor their debts. This protected liabilities between financial institutions.

It also protected SMEs and individual depositors. Whatever the vices of the bank management, it guaranteed not only that interbank debt was secure, but that the depositors were treated as depositors and not investors — nor even creditors. This, plus aggressive intervention as banks failed, reduced the possibility that depositors would panic, and prevented the economic and political meltdown that a bail-in solution might create.

This was possible because the United States is a single country. Texans might not be happy stabilizing banks in California, but there is no systemic way for Texas to withdraw from the process. In some wild theoretical sense, Texas might have the option to secede, but in practical terms, there is no difference between Texas’ liabilities and California’s. It is a single integrated system.

Europe, for all the discussion of integration, is not integrated. Italy is not Germany, and Italy’s problems are not Germany’s problems. There is no EU-wide deposit insurance system because liability is not distributed at an EU level. Nor, as there is only one currency, are the devices available to the ECB available to Italy. And finally, the European ethos of austerity creates liabilities among the most vulnerable classes.

The consequence of large banks failing is significant. The destruction of large numbers of deposits in what was regarded as a safe haven can also have significant consequences, and not just financial ones.

The sense of vulnerability that the bail-in concept creates among individuals has two consequences. One is a shift in the pattern of saving. Some will decide that if savings are investments without an upside, they might as well get into the equity markets. The risk in these markets is high. Or they may decide that they are better off with their money in gold or hidden under their mattresses. The consequences of that on a large scale are also substantial.

But the biggest consequence is political. If retirees and others lose their savings, and SMEs are unable to pay their staff, the political impact on the established parties, which are already under attack, could transform Europe. If this strategy works to contain the crisis in Italy, fine.

But if it spreads into a panic, which is not unlikely, it will resonate for a long time.

The Waiting Game

Playing for Time After Brexit

By Christoph Scheuermann in London

 Photo Gallery: Anger and Void in BritainTwo weeks after the EU referendum, Britain's political elite is crumbling and the country still has no plan for Brexit. The next government -- and also the Europeans -- will have to pick up the pieces.

British democracy these days is reminiscent of a crumbling building. And that isn't just a metaphor. Parts of Westminster Palace, home to the House of Commons and the House of Lords, is wrapped in scaffolding and plastic tarps. The façade is brittle, water is seeping in through the roof and pipes are leaky. The renovations are expected to take years and cost billions. On Monday, the prime minister's spokeswoman had to repeatedly interrupt her weekly press briefing because of the hammering of workers outside.

Similar cracks are visible across the United Kingdom. The entire country is suffering from the hangover of a revolution no one thought possible. Since the Brexit vote, many assumed certainties have been called into question, like the idea that parliament should be the heart of democracy. Or the binding force of the major political parties. The war over who will become David Cameron's successor in the Conservative Party is playing out before the public's hungry eyes, with all the betrayal and intrigues that entails. Within Labour, the antipathy between the fraction and leader Jeremy Corbyn is so great that it could lead to the division of the party.

It's easy to lose track of all that is happening. Here's an abridged version of all that has taken place in the past two weeks: Britain's prime minister is resigning because he doesn't want to manage a crisis of his own making. His likely successor was then tricked by the justice secretary, who himself wanted to become prime minister but has failed on a grand scale.

Meanwhile, members of parliament with the Labour Party are blaming their own leader for Brexit and Scotland is hoping for a second chance to vote for independence. Finally, the man responsible for unleashing everything in the first place -- Nigel Farage -- is sauntering into retirement before Britain's exit from the European Union is even complete.

Now, a woman is going to be left to clean up the mess left behind by her predecessor. On Thursday, Tory members of parliament selected two candidates, both women, to become head of the party.

Party members will have until September to pick one of the two.

Theresa May, 59, currently home secretary, has the best chances of moving into 10 Downing Street. She's viewed as a Euroskeptic technocrat who has taken a hard line against illegal immigration and has very few allies in Westminster. After the boy clique from Eton and Oxford surrounding Cameron, she would represent a fresh choice for turbulent times.

Her challenger, the former banker Andrea Leadsom, 53, who is an opponent of the EU and backed by the Brexit camp, also wasn't seen by many as possible prime minister material until recently. But the outcome of the referendum has shaken British politics, ending the careers of prominent politicians and exposing a deep-seated nihilism.

Cracks in Society

Even during the referendum campaign, all sense of shame seemed to have vanished in the country, with lies peddled as facts. Now everyone is battling everyone, damn the consequences.

London journalists are outdoing each other with comparisons to "House of Cards" or "Game of Thrones," but the political carnage in Westminster has almost reached a level that would be hard for fiction to beat.

Right in the midst of the tumult, a report by an independent commission on Britain's role in the Iraq war appeared, an immense document claiming that former Prime Minister Tony Blair drove his country into a war based on thin evidence.

Of course, the invasion of Iraq cannot be compared to the EU referendum. In Iraq, huge numbers of people were killed. In the Brexit referendum, it was the truth that died. But in both cases, an unscrupulous elite was exposed that would use whatever means necessary to retain or attain power.

What began with Blair and continued with Cameron is the impression that the actors in Westminster care only about peddling their policies -- it's about spin. Power as an end in itself.

The EU referendum did not cause these cracks in society, it just helped to lay them bare. The gap between the liberal big cities and people in rural areas, between the young and the old, the educated and the less educated, between the establishment and the lower classes.

The referendum shook the foundations of representative democracy. Members of the House of Commons now face the task of facilitating a divorce they never wanted. They must face the question as to whether they still represent their voters. At the same time, snap elections are unlikely right now because neither the Tories nor Labour would stand to profit from them.

Either way, the House of Commons -- precisely the institution that the Brexiteers had supposedly sought to strengthen -- will have little say in the negotiations with Brussels.

Forget About Foreign Policy

One consequence of the June 23 vote is that Britain will be focused almost exclusively on itself for the foreseeable future. Large parts of the government will be involved in exit talks. It's very unlikely that any kind of coherent foreign policy will emerge under these conditions, not to mention the rapidly negotiated trade agreements with countries like India, China, Australia and the rest of the world that Brexit campaigners like Michael Gove promised over and over again. That's the yardstick against which the new government will be measured. But in terms of foreign policy, Britain can be written off for the next few years.

Initially, cutting the cord with the hated Brussels bureaucracy will create new layers of bureaucracy. Cameron has said that negotiations with the EU will be the greatest challenge for British public officials in decades. He has even appointed a Brexit unit in his Cabinet Office.

Oliver Letwin, a cabinet minister, will lead the task force -- the man responsible for leading Britain out of the EU.

Letwin is currently bringing together experts from different departments, including the Foreign Office and the Department for Business, Innovation and Skills. But even that won't be enough. The Financial Times reported this week that the government has requested assistance from London law firms and consultancies in preparing for Brexit talks. Britain only has 20 trade negotiators compared to 600 specialists in Brussels, the article noted. Another seemingly absurd consequence of Brexit is that Britain will now have to recruit specialists from abroad in order to help it part ways with the EU.

Government Failed to Plan for Worst-Case Scenario

On Tuesday, Letwin appeared before parliament after being summoned by the Foreign Affairs Committee. It was a minor appointment during a momentous week, but it also showed just how precarious the situation has become in the eye of the hurricane. Members of the committee had only one question for him: What's the plan for withdrawal? Letwin's answer: no idea. No one in the government had expected the worst-case scenario to materialize. The Bank of England and the Treasury are currently doing what they can to reassure investors and the financial markets. But that's it. Letwin is on his own.

It's conceivable that Britain could have a future relationship with Europe similar to what Norway has now, with access to the single market, but also the obligation to allow the freedom of movement for EU nationals -- a soft-landing Brexit. That, along with some limitations, is the variant that Theresa May would prefer. She has made clear that she would invoke Article 50 at the end of the year at the earliest were she to succeed Cameron. The negotiations could then last until 2019.

The alternative would be a free trade agreement similar to the one being negotiated with Canada. This would come with major disadvantages for the services and financial sectors, but it would mean that Britain would have the power to determine how many immigrants it allows into the country. This would be a hard-landing Brexit.

Politically, the EU referendum was the most expensive bad bet made by a British prime minister in decades. Cameron will go down in history like Lord North, the premier who accidentally lost the colonies in America, or Tony Blair, who has been known almost exclusively as Tony "Bliar" since the Iraq war. All three are tragic figures.

The challenge facing the new government will be that of reuniting a divided kingdom. In a number of regions in England, the people no longer have any faith in the government following the country's 2009 parliamentary expenses scandal and the billions spent to bail out the banks during the financial crisis. Many are only looking for an answer to questions of prosperity and social advancement: Will my life be better than it is today if I make an effort? Or is everything already lost no matter what I do?

A Decision Born Out of Spite

Cynicism is a disintegrating force in a society. The majority of British no longer trust their elites. At some point, Britain's economic pragmatism -- which always used to be a fixture -- disappeared. The population has lost faith in the state and the conformity it had following World War II. EU opponents noticed, and Brexit was born out of spite.

Is it still possible to prevent Brexit? The simple answer is: no. Lawyers working on behalf of EU supporters are currently reviewing whether parliamentary approval is required before the government can invoke Article 50 and start the exit proceedings. But even then, it seems unlikely that parliament would ignore the will of the electorate.

Over 17 million Brits voted in favor of leaving the EU, 1.3 million more than voted to stay. Even if many in Britain have since come to the conclusion that they don't actually want Brexit, the results of the referendum cannot be reversed. It would be good for the rest of Europe to accept this reality, as difficult as this may be given the howls of triumph from a populist like Nigel Farage.

Farage had never been more than a blustering heckler in the big pub of British politics. His departure from the political stage shows that he never wanted to take any responsibility. From his perspective, it was logical that he would disappear. The broader mistake had been not taking the people attracted by his message more seriously.

What's left now is the acrimony and the void. "I can't remember a time when there was so much anger so close to the surface in British life," historian Timothy Garton Ash wrote in his column for the Guardian.

From the German perspective, it would be tempting to respond to the Brexiteers' triumph with defiance and firmness. In the short term, that might be satisfying, but it would be counterproductive in the longer term. German Chancellor Angela Merkel rightly wants to link Britain as closely as possible to the Continent for historic, economic and geostrategic reasons, because one thing has not changed after June 23: the country's geographic location -- and its importance as a market for German exports.

We Shouldn't Abandon Britain

As such, it would be prudent and correct if the Europeans played for time and waited until there is unity in Britain about what they want. A new government will not take shape before September.

When it does, that government may come to the conclusion that it is better to convince its people of the advantages of more controlled immigration than to entirely scrap access to the single market. Germany in particular would have considerable power in those negotiations.

In the end, a new form of associate membership in the European Union could rise out of the ashes of the referendum. Many countries -- like Norway and Switzerland, but also Ukraine and Turkey -- aren't likely to ever be fully integrated into the European club. But it is in the EU's interest to have long-term relationships with them.

Europe has to find a way of not losing Britain entirely in the coming years. The 48 percent on the island who voted to remain in the EU are still there. That's almost half the country who are disappointed in the other half and are now looking to Europe. The greatest mistake possible would be to abandon this part of Britain.


Safe as office blocks

British property funds suspend redemptions           

THE first concrete signs of post-Brexit financial stress in Britain emerged this week. The asset-management arm of Standard Life, an insurer, suspended redemptions from its £2.9 billion ($3.8 billion) British property fund. It was followed by a flurry of rivals: Aviva, Canada Life, Columbia Threadneedle, Henderson and M&G. Another fund, run by Aberdeen, said it would apply a 17% discount to redemptions.

The decisions highlighted the mismatch between the open-ended nature of such funds—allowing retail investors to buy and sell on a daily basis—and the illiquid assets they hold: office blocks and shopping centres. But the announcements also reflected the shock to the property market caused by the Brexit vote. London has attracted lots of businesses both because of its perceived openness and because it provides an English-speaking base for doing business in the EU; the vote has caused a reassessment of its attractiveness as a corporate home.

According to the Financial Times, German and Spanish buyers pulled out of £650m-worth of property deals in the week after the referendum. Russell Chaplin of Aberdeen says many deals had a “Brexit clause” allowing purchasers to walk away if Britain voted to leave. This has happened to Aberdeen’s property fund in two cases: one buyer abandoned a purchase altogether while another asked for a discount, which has not been accepted.

Mutual property funds tend to have monthly valuations (conducted by outsiders) to determine the “fair value” of their assets. Given the uncertainties after the referendum, valuers thought it prudent to apply a discount and fund-management groups took their advice. Henderson reduced its fair-value estimate by 4%, M&G by 4.5%, and Standard Life by 5%.

The funds keep some liquid assets on hand in order to meet the kind of redemptions they face in normal circumstances; as of May 31st, Standard Life had 13% of its assets in this form.

Some of these liquid assets will be stakes in big property companies like British Land and Land Securities, so the big falls in their share prices (see chart) may in part be a contagion effect from funds meeting redemption requests.

There may be other knock-on effects. In a report on financial stability published on July 5th, the Bank of England worried that forced sales of assets by property funds may exacerbate the market’s weakness; it has eased capital requirements for banks to encourage lending.

Problems have been growing for a while. The central bank said that foreign capital inflows into British property fell by almost 50% in the first quarter, perhaps as investors waited for the Brexit vote to be resolved. The purchasing managers’ index for the construction industry fell in June to its lowest level since 2009.

Mike Prew of Jefferies, an investment bank, has been predicting a commercial-property downturn since last year. Two areas stand out. Central London has been on a building spree, with 26m square feet of offices currently being added (or refurbished) in a market with around 200m square feet of space. Mr Prew thinks 100,000 jobs in London are at risk of moving to the EU—enough to free up 10m square feet. Office rents could fall by as much as 18% in central London, he warns.

The second problem area is retail premises, to which the Standard Life fund was heavily exposed (its five biggest tenants were all retailers). High-street shops have been squeezed by the rise of the internet; BHS, a department-store chain, recently went under. If the economy does slow in the wake of the referendum, retailers’ troubles will intensify.

Comparisons with the financial crisis of 2007-08 are inevitable; that too saw property-fund suspensions in its early stages. But they should not be overdone. For a start, open-ended property funds do not borrow and own only around 5% of British commercial property. Few investors are likely to have devoted a large part of their savings to this asset; they will have known that they might lose money. The systemic risk is limited.

Furthermore, with interest rates near zero and ten-year bond yields below 1%, property funds still offer a decent income; even in London, prime rental yields are 4-4.5%. Vacancies are below the historical average, according to Jones Lang LaSalle, an estate agent. A big sell-off would surely attract some bargain-hunters.

Still, fund suspensions are not a good sign. At the very least, they should make regulators question whether open-ended funds are suitable for property investing. There is nothing liquid about bricks.

What Evil Lurks In The Hearts Of Men?

I Will Retire. Dave Fry

lurk animated GIF

This headline and theme for the day should do well given French terrorism once again.

Separately some believe there is market manipulation taking place, a theme making the rounds on the street this week.Notable commentator Art Cashin highlighted commentary from Keene Little at Options Investor that fleshed out this "conspiracy theory" even more. The first point that Little makes is that the market has been seeing huge gains in overnight trading, immediately opening higher and then barely moving during the day.
"This is frustrating for traders on both sides since there's been very little to trade during the day," Little suggested.
"It's much easier (cheaper) to manipulate the market higher with overnight futures than it is during RTH (regular trading hours)."
 7-15-2016 2-55-14 PM
Additionally, Little noted that much of the timing and movement of this action appears to have something to do with central banks and Brexit. Here's his breakdown, via Cashin (emphasis ours):
"Many are questioning how the stock market could possibly be rallying so strong on what appears to be very weak fundamentals.Since the spike down into the June 27th low (post-Brexit reaction) there's been much speculation that the central banks panicked and injected a lot of liquidity into the markets to prevent a sell-off.After all, this has been their mission for quite some time, now readily admitted by them. They certainly succeeded at their mission (again) with the big spike back up this month.
Essentially, while there have been statements from central banks after the UK's decision to leave the European Union saying something to the effect of "we are ready to support markets," Little believes central bank infusions are a significant part of what is driving the rally.”
Friday markets saw another attempt by some to ramp markets higher at the open. This gave a similar after hours price gap higher which didn’t hold but still allowed markets to recover closing unchanged for the most part. Economic data was quite mixed with inflation data higher led by higher rents (no surprise) and health care. Consumer Confidence fell sharply to 89.5 vs 93.5. Empire State Manufacturing slid to 0.55 vs 6.6 but Industrial Production gained to 0.6% vs 0.2%.
The Financial and Bank sectors which had been offered some leadership disappointed as Citigroup (C) and Wells Fargo (WFC) earnings disappointed. Below is the Below is a heat map from Finviz reflecting those ETF market sectors moving higher (green) and falling (red). Dependent on the day (green) may mean leveraged inverse or leveraged short (red).
7-15-2016 2-55-41 PM
Volume was moderate and breadth per the WSJ was positive. 

7-15-2016 2-57-18 PM

12-17-2015 9-04-44 PM Chart of the Day
 7-15-2016 3-02-37 PM FXE

Charts of the Day
















    The McClellan Oscillator is a market breadth indicator that is based on the difference between the number of advancing and declining issues on the NYSE. When readings are +60/-60 markets are extended short-term.


    The VIX is a widely used measure of market risk and is often referred to as the "investor fear gauge". Our own interpretation has changed due to a variety of new factors including HFTs, new VIX linked ETPs and a multitude of new products to leverage trading and change or obscure prior VIX relevance.

I have to go along with whatever central banks, or others, are doing to prop this market since there isn’t any other reason stocks should be higher.

And yes I know the old expression, when stocks rise for no reason, that’s bullish.

Nevertheless, we have new more active players in the markets these days.

As indicated reports are fewer these days.

Let’s see what happens.