Posts Tagged ‘wisdom’

Mr President: spend, spend, spend

Wednesday, November 26th, 2008

John Maynard KeynesThe United States is ready to roll towards prosperity, if a good hard shove can be given in the next six months

John Maynard Keynes

The following is an abridged text of an open letter [PDF] by John Maynard Keynes to the US president.

Dear Mr President,

You have made yourself the trustee for those in every country who seek to mend the evils of our condition by reasoned experiment within the framework of the existing social system. If you fail, rational change will be gravely prejudiced throughout the world, leaving orthodoxy and revolution to fight it out. But if you succeed, new and bolder methods will be tried everywhere, and we may date the first chapter of a new economic era from your accession to office. This is a sufficient reason why I should venture to lay my reflections before you, though under the disadvantages of distance and partial knowledge.

At the moment your sympathisers in England are nervous and sometimes despondent. We wonder whether the order of different urgencies is rightly understood, whether there is a confusion of aim, and whether some of the advice you get is not crack-brained and queer. If we are disconcerted when we defend you, this may be partly due to the influence of our environment in London. For almost everyone here has a wildly distorted view of what is happening in the United States. The average City man believes that you are engaged on a hare-brained expedition in face of competent advice, that the best hope lies in your ridding yourself of your present advisers to return to the old ways, and that otherwise the United States is heading for some ghastly breakdown. That is what they say they smell. There is a recrudescence of wise head-waging by those who believe that the nose is a nobler organ than the brain. London is convinced that we only have to sit back and wait, in order to see what we shall see. May I crave your attention, whilst I put my own view?

You are engaged on a double task, recovery and reform - recovery from the slump and the passage of those business and social reforms which are long overdue. For the first, speed and quick results are essential. The second may be urgent too; but haste will be injurious, and wisdom of long-range purpose is more necessary than immediate achievement. It will be through raising high the prestige of your administration by success in short-range recovery, that you will have the driving force to accomplish long-range reform. On the other hand, even wise and necessary reform may, in some respects, impede and complicate recovery. For it will upset the confidence of the business world and weaken their existing motives to action, before you have had time to put other motives in their place. It may over-task your bureaucratic machine, which the traditional individualism of the United States and the old “spoils system” have left none too strong. And it will confuse the thought and aim of yourself and your administration by giving you too much to think about all at once.

My second reflection relates to the technique of recovery itself. The object of recovery is to increase the national output and put more men to work. In the economic system of the modern world, output is primarily produced for sale; and the volume of output depends on the amount of purchasing power, compared with the prime cost of production, which is expected to come on the market. Broadly speaking, therefore, and increase of output depends on the amount of purchasing power, compared with the prime cost of production, which is expected to come on the market. Broadly speaking, therefore, an increase of output cannot occur unless by the operation of one or other of three factors. Individuals must be induced to spend more out of their existing incomes; or the business world must be induced, either by increased confidence in the prospects or by a lower rate of interest, to create additional current incomes in the hands of their employees, which is what happens when either the working or the fixed capital of the country is being increased; or public authority must be called in aid to create additional current incomes through the expenditure of borrowed or printed money. In bad times the first factor cannot be expected to work on a sufficient scale. The second factor will come in as the second wave of attack on the slump after the tide has been turned by the expenditures of public authority. It is, therefore, only from the third factor that we can expect the initial major impulse.

Now there are indications that two technical fallacies may have affected the policy of your administration. The first relates to the part played in recovery by rising prices. Rising prices are to be welcomed because they are usually a symptom of rising output and employment. When more purchasing power is spent, one expects rising output at rising prices. Since there cannot be rising output without rising prices, it is essential to ensure that the recovery shall not be held back by the insufficiency of the supply of money to support the increased monetary turn-over. But there is much less to be said in favour of rising prices, if they are brought about at the expense of rising output. Some debtors may be helped, but the national recovery as a whole will be retarded. Thus rising prices caused by deliberately increasing prime costs or by restricting output have a vastly inferior value to rising prices which are the natural result of an increase in the nation’s purchasing power.

The set-back which American recovery experienced this autumn was the predictable consequence of the failure of your administration to organise any material increase in new loan expenditure during your first six months of office. The position six months hence will entirely depend on whether you have been laying the foundations for larger expenditures in the near future.

I am not surprised that so little has been spent up-to-date. Our own experience has shown how difficult it is to improvise useful loan-expenditures at short notice. There are many obstacle to be patiently overcome, if waste, inefficiency and corruption are to be avoided. There are many factors, which I need not stop to enumerate, which render especially difficult in the United States the rapid improvisation of a vast programme of public works. But the risks of less speed must be weighed against those of more haste.

The other set of fallacies, of which I fear the influence, arises out of a crude economic doctrine commonly known as the quantity theory of money. Rising output and rising incomes will suffer a set-back sooner or later if the quantity of money is rigidly fixed. Some people seem to infer from this that output and income can be raised by increasing the quantity of money. But this is like trying to get fat by buying a larger belt. In the United States to-day your belt is plenty big enough for your belly. It is a most misleading thing to stress the quantity of money, which is only a limiting factor, rather than the volume of expenditure, which is the operative factor.

It is an even more foolish application of the same ideas to believe that there is a mathematical relation between the price of gold and the prices of other things. It is true that the value of the dollar in terms of foreign currencies will affect the prices of those goods which enter into international trade. In so far as an over-valuation of the dollar was impeding the freedom of domestic price-raising policies or disturbing the balance of payments with foreign countries, it was advisable to depreciate it. But exchange depreciation should follow the success of your domestic price-raising policy as its natural consequence, and should not be allowed to disturb the whole world by preceding its justification at an entirely arbitrary pace. This is another example of trying to put on flesh by letting out the belt.

These criticisms do not mean that I have weakened in my advocacy of a managed currency or in preferring stable prices to stable exchanges. The currency and exchange policy of a country should be entirely subservient to the aim of raising output and employment to the right level. But the recent gyrations of the dollar have looked to me more like a gold standard on the booze than the ideal managed currency of my dreams.

You may be feeling by now, Mr President, that my criticism is more obvious than my sympathy. Yet truly that is not so. You remain for me the ruler whose general outlook and attitude to the tasks of government are the most sympathetic in the world. You are the only one who sees the necessity of a profound change of methods and is attempting it without intolerance, tyranny or destruction. You are feeling your way by trial and error, and are felt to be, as you should be, entirely uncommitted in your own person to the details of a particular technique. In my country, as in your own, your position remains singularly untouched by criticism of this or the other detail. Our hope and our faith are based on broader considerations.

If you were to ask me what I would suggest in concrete terms for the immediate future, I would reply thus.

In the field of domestic policy, I put in the forefront, for the reasons given above, a large volume of loan-expenditures under government auspices. It is beyond my province to choose particular objects of expenditure. But preference should be given to those which can be made to mature quickly on a large scale, as for example the rehabilitation of the physical condition of the railroads. The object is to start the ball rolling. The United States is ready to roll towards prosperity, if a good hard shove can be given in the next six months.

I put in the second place the maintenance of cheap and abundant credit and in particular the reduction of the long-term rates of interest. The turn of the tide in great Britain is largely attributable to the reduction in the long-term rate of interest which ensued on the success of the conversion of the War Loan. This was deliberately engineered by means of the open-market policy of the Bank of England. I see no reason why you should not reduce the rate of interest on your long-term government bonds to 2.5% or less with favourable repercussions on the whole bond market, if only the Federal Reserve System would replace its present holdings of short-dated Treasury issues by purchasing long-dated issues in exchange. Such a policy might become effective in the course of a few months, and I attach great importance to it.

With these adaptations or enlargements of your existing policies, I should expect a successful outcome with great confidence. How much that would mean, not only to the material prosperity of the United States and the whole World, but in comfort to men’s minds through a restoration of their faith in the wisdom and the power of government!

With great respect,
Your obedient servant

JM Keynes

Originally published as “An open letter to President Roosevelt” in the New York Times, December 31, 1933.



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McCulley: The Paradox of Deleveraging will be Broken

Monday, November 24th, 2008

Paul McCulley, Managing Director and Portfolio Manager, PIMCO, earlier this year wrote a landmark discussion piece titled, “The Paradox of Deleveraging,” in which he postulated that the deleveraging of the credit market would have a profoundly negative impact that only a government sponsored plan could subdue, as no other party could be big enough to slay the affliction of credit abuse in the housing, investment and banking industries. Here is the follow up:

I’ve only written this essay once since the Kansas City Fed’s annual symposium in late August.1 But it hasn’t been because I’ve been lazy. Rather, I’ve been working virtually around the clock ever since, in my day job as head of PIMCO’s Money Market and Funding Desk. On Wall Street, this desk is frequently viewed as a backwater, a temporary home for new MBAs getting their feet wet before moving on to higher-value-added desks, or a retirement home for those with more senior moments than fresh ideas.

That’s never the case here at PIMCO, even though a number of now PIMCO partners spent their first days trafficking in the money markets and I, of ever-graying hair, still make my home here in the early hours of the day. Money markets frequently are a backwater, except when they are not, in which case they are cascading rapids. Liquidity pressures inevitably are the precursor of solvency and/or going-concern problems. Just ask Wall Street’s independent investment banks.

We here at PIMCO have always known this. Accordingly, we’ve always been conservative beyond conservative in our money market operations, on both sides of the balance sheet - no asset-backed commercial paper (ABCP) for us, and no tri-party repo without regard to collateral types or haircuts either. Meat and potatoes only, no fancy garnishes necessary. But the meat and potatoes must be cooked properly.

Hence, the work load of PIMCO’s money market and funding desk. My new deputy, Jerome Schneider, hit the ground running in early August, a most propitious time, just before the global money markets became not just cascading rapids, but roaring waterfalls. The financial world will never be the same after the U.S. Treasury and Federal Reserve’s fateful decision of the weekend of September 13-14 to stand aside as Lehman Brothers plummeted to death on the rocks below.

Whether that decision was the right one or not, we will never know. Yes, I know that many are quick to take the Treasury and the Federal Reserve to task, maintaining that the on-going global financial crisis - and, thus, growth crisis - would not be nearly so severe if Lehman had been tossed a life line. I simply don’t know. What I do know is that the global financial system was fundamentally broken long before Lehman’s watery death.

Thus, I believe the powerful, systemic policy responses that have unfolded in the post-Lehman world were destined to come about. Lehman was but the unfortunate tipping point. My heart still aches for the pain suffered by my many friends there. Fate is not always fair and at times, is arbitrary and capricious.

But what ailed Lehman was but a manifestation of what ailed, and ails the global financial intermediary system: the presumption that grossly levered positions in illiquid assets can always be funded, because those doing the funding will always assume the borrower is a going concern.

To understand the nature of this systemic malady, we need to return to first principles. Bear with me, please; this is going to be a bit academic. But, I submit, it was the loss of understanding of first principles that lies at the heart of the on-going paradox of deleveraging, which is the proximate cause of the on-going downward spiral of asset and debt deflation.

The Nature of Banking
When I studied the origins of banking in college, we started with the Medici Family of 15th century Italy. I’m quite sure banking existed long before then, just that I haven’t studied it. But regardless of the origins of banking, its founding premise has always been the same: In normal times, the public’s collective, ex ante demand for access to at-par, immediately-available bank money is always greater than the sum of the public’s individual, ex post demand for access to such liquidity.

Thus, the genius of banking, if you want to call it that, is simple: a bank can take more risk on the asset side of its balance sheet than the liability side can notionally support, because a goodly portion of the liability side, notably deposits, is de facto of perpetual maturity, although it is notionally of finite maturity, as short as one day in the case of demand deposits.

It’s the same alchemy that permits mutual funds to commit to next-day redemption at tonight’s NAV, even though all reasonable people know that a mutual fund - with the possible exception of a money market fund - could not possibly liquidate all assets on the wire tomorrow at tonight’s NAV marks. Systemically, it’s the illusion of liquidity, as so elegantly described by John Maynard Keynes:

“The spectacle of modern investment markets has sometimes moved me towards the conclusion that to make the purchase of an investment permanent and indissoluble, like marriage, except by reason of death or other grave cause, might be a useful remedy for our contemporary evils. For this would force the investor to direct his mind to the long-term prospects and to those only. But a little consideration of this expedient brings us up against a dilemma, and shows us how the liquidity of investment markets often facilitates, though it sometimes impedes, the course of new investment.

For the fact that each individual investor flatters himself that his commitment is ‘liquid’ (though this cannot be true for all investors collectively) calms his nerves and makes him much more willing to run a risk. If individual purchases of investments were rendered illiquid, this might seriously impede new investment, so long as alternative ways in which to hold his savings are available to the individual. This is the dilemma.

So long as it is open to the individual to employ his wealth in hoarding or lending money, the alternative of purchasing actual capital assets cannot be rendered sufficiently attractive (especially to the man who does not manage the capital assets and knows very little about them), except by organizing markets wherein these assets can be easily realized for money.”2

Yes, liquidity for all at last night’s marks is an illusion. But for banks, unlike mutual funds, it’s not so much an illusion after all, for two simple reasons: banks have access to deposit insurance underwritten by fiscal authorities and to a discount window underwritten by the monetary authority (and one step removed, the fiscal authority). Thus, banks are unique institutions, providing a “public good:”

*
Liquidity on demand at par for their depositors, because of the safety net underwritten by the sovereign, yet
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The ability to invest in longer-dated, more risky, not-always-at-par loans and securities, because the existence and credibility of the public safety net systemically renders the public’s ex post demand for liquidity at par below the public’s ex ante demand.

Yes, banking with a sovereign safety net against deposit runs is a really cool business. Indeed, the difference between the public’s ex post and ex ante demand for at-par liquidity could be called the banking system’s “float,” similar to that of a Buffet-style insurance company.

But since it’s a really cool business and since the sovereign providing the liquidity safety net is a de facto equity partner in the business, the sovereign quite rationally wants a say in how the business is run - the degree of leverage, corporate governance, risk management controls, etc. Kinda like I do when I pay the insurance premium on my 19-year old son’s car. Jonnie doesn’t like it, and neither do bankers. Or would-be bankers.

Thus, both bankers and would-be bankers have, from time immemorial, sought to get the benefits of the sovereign’s liquidity safety net without shouldering the associated regulator nuisance. And I’m sure that 19-year old sons and daughters, too, have been doing the same for just as long.

Over the last three decades or so, the growth of “banking” outside formal, sovereign-regulated banking, has exploded, in something that I dubbed the Shadow Banking System.3 Loosely defined, a Shadow Bank is a levered-up financial intermediary whose liabilities are broadly perceived as of similar money-goodness and liquidity as conventional bank deposits. These liabilities could be shares of money market mutual funds; or the commercial paper of Finance Companies, Conduits and Structured Investment Vehicles; or the repo borrowings of stand-alone Investment Banks and Hedge Funds; or the senior tranches of Collateralized Debt Obligations; or a host of other similar funding instruments.

The bottom line is simple: Shadow Banks use funding instruments that are not just as good as old-fashioned sovereign-protected deposits. But it was a great gig so long as the public bought the notion that such funding instruments were “just as good” as bank deposits - more leverage, less regulation and more asset freedom were a path to (much) higher returns on equity in Shadow Banks than conventional banks.

And why did the public buy such instruments as though they were “just as good” as bank deposits? There are a host of reasons, not the least of which was lust for yield. But most fundamentally, Keynes again gives us the systemic answer (his italics, not mine):

“In practice we have tacitly agreed, as a rule, to fall back on what is, in truth, a convention. The essence of this convention - though it does not, of course, work out quite so simply - lies in assuming that the existing state of affairs will continue indefinitely, except in so far as we have specific reasons to expect a change. This does not mean that we really believe that the existing state of affairs will continue indefinitely. We know from extensive experience that this is most unlikely.

The actual results of an investment over a long term of years very seldom agree with the initial expectation. Nor can we rationalize our behavior by arguing that to a man in a state of ignorance errors in either direction are equally probable, so that there remains a mean actuarial expectation based on equi-probabilities. For it can easily be shown that the assumption of arithmetically equal probabilities based on a state of ignorance leads to absurdities.

We are assuming, in effect, that the existing market valuation, however arrived at, is uniquely correct in relation to our existing knowledge of the facts which will influence the yield of the investment, and that it will only change in proportion to changes in this knowledge; though, philosophically speaking, it cannot be uniquely correct, since our existing knowledge does not provide a sufficient basis for a calculated mathematical expectation. In point of fact, all sorts of considerations enter into the market valuations which are in no way relevant to the prospective yield. Nevertheless the above conventional method of calculation will be compatible with a considerable measure of continuity and stability in our affairs, so long as we can rely on the maintenance of the convention.

For if there exist organized investment markets and if we can rely on the maintenance of the convention, an investor can legitimately encourage himself with the idea that the only risk he runs is that of a genuine change in the news over the near future, as to the likelihood of which he can attempt to form his own judgment, and which is unlikely to be very large. For, assuming that the convention holds good, it is only these changes which can affect the value of his investment, and he need not lose his sleep merely because he has not any notion what his investment will be worth ten years hence.

Thus investment becomes reasonably “safe” for the individual investor over short periods, and hence over a succession of short periods however many, if he can fairly rely on there being no breakdown in the convention and on his therefore having an opportunity to revise his judgment and change his investment, before there has been time for much to happen. Investments which are “fixed” for the community are thus made “liquid” for the individual.

It has been, I am sure, on the basis of some such procedure as this that our leading investment markets have been developed. But it is not surprising that a convention, in an absolute view of things so arbitrary, should have its weak points. It is its precariousness which creates no small part of our contemporary problem of securing sufficient investment.”4

And so, Keynes provides the essential - and existential - answer as to why the Shadow Banking System became so large, the unraveling of which lies at the root of the current global financial system crisis. It was a belief in a convention, undergirded by the length of time it held: Shadow Bank liabilities were viewed as “just as good” as conventional bank deposits not because they are, but because they had been. And the power of this conventional thinking was aided and abetted by both the sovereign and the sovereign-blessed rating agencies.

Until, of course, convention was turned on its head, starting with a run on the ABCP market in August 2007, the near death of Bear Stearns in March 2008, the de facto nationalization of Fannie and Freddie in July, and the actual death of Lehman Brothers in September 2008. Maybe, just maybe, there was and is something special about a real bank, as opposed to a Shadow Bank!

And indeed that is unambiguously the case, as evidenced by the on-going partial re-intermediation of the Shadow Banking System back into the sovereign-supported conventional banking system, as well as the mad scramble by remaining Shadow Banks to convert themselves into conventional banks, so as to eat at the same sovereign-subsidized capital and liquidity cafeteria as their former stodgy brethren.

The new conventional wisdom: levered capitalism is good, and made even better with a bit of socialism to protect the downside.

Well Maybe
I’m quite sure that last sentence is not going to sit well with some of you. It’s not supposed to sit well. It doesn’t sit well with me, I must acknowledge, nay confess. Like most of us, I’ve always had a separation in my mind between strictly capitalist activities and strictly public activities. Not that the demarcation is always clean. But it’s a useful way of thinking.

As far as I know, the place where I buy my fishing tackle is a capitalist outfit. If we customers don’t buy enough rods and reels, the owner will go broke; his operation is simply not systemically important enough to be bailed out by the taxpayers, including my neighbors who don’t fish. In contrast, the local Department of Motor Vehicles, sometimes called the DMV, is unambiguously not a capitalist outfit, but a public outfit. It cannot go broke, as evidenced by our tolerance of its fluctuating service level, because it provides a public service that the private sector can’t provide. To be sure, AAA can get you new plates for your car, but you can’t renew your driver’s license at the AAA; for that, you have got to go to the monopoly called the DMV.

Well actually, that’s not entirely true, either. The DMV is actually an oligopoly, with offices in many surrounding neighborhoods. And rumor has it here that the service is a lot quicker at the San Clemente office than the Costa Mesa office, which serves Newport Beach. So the consumer does have the choice of driving to San Clemente, a form of time arbitrage versus going to the Costa Mesa office. However, rumor also has it that this rumored better service in San Clemente is so widespread that, as Yogi Berra might say, the San Clemente office has become so popular nobody goes there anymore.

But you get the point: there is private enterprise and there is public enterprise. And then there is banking, a hybrid of the two. There is no way ‘round this, for good or bad, because fractional reserve banking depends upon the sovereign’s safety net against liability runs, a safety net that the private sector definitionally can’t universally supply. In this sense, the safety net is like national defense: we all need it, but since nobody individually has the incentive to pay for it, we collectively tax ourselves to pay for it.

Yes, sometimes we collectively end up paying $800 for military toilet seats, as was the case about 25 years ago. But that doesn’t change the proposition that public goods do exist, and a stable system of intermediation of private savings into private investment is indeed a public good. The maturity transformation power of a fractional reserve banking system provides an unambiguous benefit to society and as such, must be underwritten by society.

Bottom Line
I could regale you yet again about the power of the analytical thinking of Hyman Minsky, complete with his Forward Journey turning into his Moment, followed by his Reverse Journey.5 But I don’t need to do that any more: we’ve collectively lived it and are now caught in the debt-deflationary pathologies of “the paradox of deleveraging.”6 Not everybody in the private sector can delever at the same time without creating a depression. Accordingly, the sovereign must go the other way, levering up the public balance sheet. And Washington has finally started to do so with appropriate vigor and enthusiasm.

It’s not a pretty picture. In fact, it’s repugnant, giving proof to the proposition that breaking the paradox of deleveraging does involve socializing the downside of previously profitable private sector activities. In a recent speech, I called it “creeping socialism” and was interrupted by an irate, older man in the back of the room bellowing, “It ain’t creeping socialism, it’s galloping socialism!” I really didn’t have a soothing come back, noting that many things are what they are only in the eye of the beholder. But his point wasn’t lost on me or anybody else in the room.

And it is not lost on Washington, DC either, I can assure you. If the sovereign must backstop a private sector activity that produces a public good, then the sovereign will, at least in a democracy, rightfully demand both bottom-up and macro-prudential rules to harness the greed that lubricates the invisible hand of capitalism. Yes, the visible fist of government and the invisible hand are presently engaged in a massive arm wrestling contest in the provision of financial services. And the fist is winning.

At least for now. Capitalism, and especially financial market capitalism, brought this outcome upon itself through greed and hubris. Capitalism is now re-grouping and learning how to play by new rules, which are still being written. And ultimately, I’m sure, capitalistic bankers will once again bend those rules in the pursuit of higher profitability. And that’s okay, I think. In the end, we really don’t want to turn our banking system into the DMV. At the same time, we also don’t want our banking system to be nothing more than a betting parlor.

Or, in the famous words of Keynes again:

“Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.”

Paul A. McCulley
Managing Director
November 13, 2008

You can download a complete PDF here.


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Tony Blair: Power is moving East

Saturday, May 31st, 2008

In his recent speech at Yale Class Day, Tony Blair had the following to share with students. The speech is well worth reading on many fronts, but if you’re an investor, then you’ll be interested in knowing what one of the great leaders of the free world has to say about what this century holds for both the West and the East. 

For the first time in many centuries, power is moving East. China and India each have populations roughly double those of America and Europe combined.

In the next two decades, these two countries together will undergo industrialisation four times the size of the USA’s and at five times the speed.

We must be mindful that as these ancient civilisations become somehow younger and more vibrant, our young civilisation does not grow old. Most of all we should know that in this new world, we must clear a path to partnership, not stand off against each other, competing for power.

The complete speech can be read here:

The Office of Tony Blair - Yale Class Day Speech

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Goldman Sachs: BRICs and Beyond

Thursday, March 27th, 2008

Mar. 27, 2008 - In November 2008, Goldman Sachs’ Chief Global Strategist, Jim O’Neill, and associates, who coined the “BRICs” term, have followed up with a complete updated report on the fundamentals for each of Brazil, Russia, India and China. The report goes on to cover the markets of the Next 11 frontier markets. Click the following link to download the complete report, BRICs and Beyond (Goldman Sachs).

Here are some excerpts:

India’s rising growth potential
…We argue that there has been a structural increase in India’s potential growth rate since 2003 on the back of high productivity growth. In this paper, we explain why productivity (by which we mean total factor productivity, or the manner in which all inputs are combined to achieve more output) has surged, and why we think this is likely to continue over the next decade.
… Industry is increasingly becoming an important growth driver, contrary to conventional wisdom that growth in India is only services-led. A quarter of services are directly linked to industry, in sectors such as trade, transport, electricity and construction.
…In India, labour is nearly four times more productive in industry and six times more productive in services than in agriculture, where there is a surplus of labour. Economic theory tells us that as labour moves from low-productivity sectors (such as agriculture) to high-productivity sectors (such as industry or services), overall output must improve.
…In absolute terms India will remain a low-income country for several decades, with per capita incomes well below its BRIC peers. But if it can fulfil its growth potential, it can become a motor for the world economy and a key contributor to generating spending growth.
 

…India’s imminent urbanisation process has implications for demand for housing, urban infrastructure, location of retail and demand for consumer durables. We expect the coming onstream of major highways (especially the Golden Quadrilateral) to drive growth in the transportation sector, spur demand for vehicles, increase real estate values along the corridor and potentially boost construction of suburban homes as people escape congested cities. The SEZs hold out substantial investment opportunities in all spheres of activity.
 

Russia: A smooth political transition
 

…There are signs that investment has begun to accelerate over the last 12 months, with capital expenditures up over 21%yoy in 2007H1. Private investment growth may suffer a brief interruption due to the recent troubles in the local credit markets. But public investment may make up some of the shortfall: after repairing its balance sheet and accumulating a substantial ‘rainy-day’ fund, the government has announced ambitious plans to invest over $1-trillion over the next ten years in roads, rail, ports, pipelines and other infrastructure projects.
 

…The BRICs dream is not even a best case scenario in fact, Russia’s recent performance has been considerably better than projected in the original BRICs papers. But it does assume that the necessary conditions for long-run growth are in place, conditions that we have tried to capture in our Growth Environment Scores (GES). Russia scores well above the emerging market mean on education, government deficit and external debt; marginally above average on openness and life expectancy; lower but still above average on technology (phones, PCs and internet access per capita); and somewhat below average on inflation, which is now in the high single digits.
 

…Our equity strategists’ favourite themes are the consumer, telecoms and retail sectors, as well as steel and pipe companies, and other names poised to benefit from the state’s infrastructure spending. They also see opportunities in domestic restructuring stories, such as power generation and gas. With significant segments of the economy still private, we see considerable opportunities in direct investment.
 

China: Will China grow old before getting rich?
 

…China’s unrivalled economic growth over the past quarter-century has surpassed all records and created a new standard in the history of economic development. With an average annual real GDP growth rate of 9.6% from 1978 to 2004, China’s pace of growth is faster than that achieved by any East Asian economy during their fastest-growing periods.
 

China’s investment strength is sustainable
 

…One of the most widely-held misconceptions about China is that the economy contains an over-investment time-bomb, which will soon result in a sharp correction in both investment and GDP growth, resulting in rising non-performing loans (NPLs) and in deflation. The reasoning behind this theory is that fixed asset investment (FAI) is growing at above 20% year on year, while the investment-to-GDP ratio is already above 45% (higher than the levels reached by Asian economies before the 1997 crisis). Furthermore, this investment boom is financed by misallocated bank credits and generates few returns.
 

Although this is a popular view, we believe it is wrong for two reasons. First, the conclusion is based on macro data that is deeply flawed, leading to a substantial overstatement of the investment-to-GDP ratio. Second, a high investment-to-GDP ratio is consistent with China’s rapid growth. The fact that the return on capital is high and generally has been climbing over the past decade supports our thesis that Chinas investment strength is sustainable.
 

The “B” in BRICs: Unlocking Brazil’s growth potential
 

We remain confident about Brazil’s growth potential, at least in terms of what we have envisaged in our BRICs studies. The main reason for Brazil’s underperformance is that, until now, the government had been in the process of implementing a stabilisation programme, with a view to achieving macroeconomic stability. This is a key precondition for growth. Thanks to these adjustment efforts, macroeconomic conditions are more favourable now than they have been for decades. The large balance of payments surpluses have been used to prepay external debt and accumulate reserves, while a credible central bank (BACEN) has reduced inflation to 3.0% in 2006.
 

We believe that the Lula II administration will sustain sound macroeconomic policies and make some progress on structural reforms. Stability should allow real GDP growth rates to move gradually towards Brazil’s potential rate of about 3.5%, which is near our BRICs potential growth rate of 3.7%.
 

We also believe that Brazil could grow much faster, perhaps at a secular growth rate of about 5.0%. For this to happen, the government will have to tackle four difficult structural problems:
 

·         Brazil saves and invests too little. To address this issue, the government will have to deepen and improve the quality of the fiscal adjustment.
·         The economy should be opened to trade.
·         The government must improve the overall quality of education.
·         The government should implement structural reforms to improve institutions, with a view to increasing total factor productivity.
 

We do not believe that the Lula II administration and Congress will be ambitious enough to implement this politically difficult agenda. Therefore, while Brazil has the potential to grow at or above 5.0%, this is unlikely to happen during the next four years.
 

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Age Old Wisdom on Predictions

Thursday, February 14th, 2008

Hat tip to Chris Perruna - chrisperruna.com - for this collection of quotes on the subject of predictions. 

  • “Those who have knowledge, don’t predict. Those who predict, don’t have knowledge.” - Lao Tzu
  • “He who knows, does not speak. He who speaks, does not know.” - Lao Tzu
  • “Never make predictions, especially about the future.” - Casey Stengel
  • “Trying to predict the future is like trying to drive down a country road at night with no lights while looking out the back window.” - Peter Drucker
  • “If one could foresee the next three days, one could become rich for several thousand years.” - Anonymous
  • “If you learn one thing from having lived through decades of changing views, it is that all predictions are necessarily false.” - M. H. Abrams
  • “I figure lots of predictions is best. People will forget the ones I get wrong and marvel over the rest.” - Alan Cox (the MEDIA!)
  • “History can predict nothing except that great changes in human relationships will never come about in the form in which they have been anticipated.” - Johan Huizinga
  • “You can only predict things after they have happened.” - Eugene Ionesco
  • “In the future, instead of striving to be right at a high cost, it will be more appropriate to be flexible and plural at a lower cost. If you cannot accurately predict the future then you must flexibly be prepared to deal with various possible futures.” - Edward de Bono
  • “You never know what the next day is going to bring. That goes for football, goes for off the field, and I gave up a long time ago trying to predict the future and trying to deal with things I couldn’t deal with.” - Brett Favre
  • “Predictions of the future are never anything but projections of present automatic processes and procedures, that is, of occurrences that are likely to come to pass if men do not act and if nothing unexpected happens; every action, for better or worse, and every accident necessarily destroys the whole pattern in whose frame the prediction moves and where it finds its evidence.” - Hannah Arendt
  • “To predict the behavior of ordinary people in advance, you only have to assume that they will always try to escape a disagreeable situation with the smallest possible expenditure of intelligence.” - Friedrich Nietzsche
  • “The unpredictability inherent in human affairs is due largely to the fact that the by-products of a human process are more fateful than the product.” - Eric Hoffer
  • “My predictions are notably inaccurate.” - Robert Caro

And Finally…

  • “The best way to predict the future is to invent it.” - Alan Kay

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How Solid are the BRICs? (Part 2)

Sunday, February 3rd, 2008

Feb. 3, 2008 - The nature of the economic strength and stability of the BRIC (Brazil, Russia, India, China) countries is a less well known or understood fact among investors. There remains a wide gap between perceptions and reality.

Remember 1997 and 1998? Many investors, excited about the growth of Asian and emerging countries in the late nineties and invested their money found out about credit related risk first when the 1997 ‘Asian Contagion’ occurred and was followed upon by the Long Term Capital Management bailout which unfolded in 1998. These events destabilized global markets and investors were taken by surprise as markets melted down.

For this reason, its important to go back to that time and re-examine Malaysia and Thailand, as examples, of where investors were excited by the rapid economic growth, but ignored the then inherent high credit risk, much to their expense. A decade ago (yes, a decade ago) when all of this was happening, only 3% of the grand total of emerging markets sovereign debt was rated as investment grade by any of the ratings agencies.

In 1997, only 10 out of 120 companies that form the MSCI Emerging Markets Index, had ADRs. 

Excited by the G7 debt-financed growth, investors made bets that were inherently risky to their preservation of capital, not simply volatile. Circa 1997, emerging markets were in debt to the industrialized world by about $100-billion in the current account deficit column, and dependent on the kindness of their G7 financiers.

When the Malay and Thai governments were unable to meet current account obligations, and started printing money in order to meet them, the Fed blew the whistle upon discovering that sufficient reserves were not available to support the currency valuations. Hence the overnight slashing of Asian currencies.

At best, the general sentiment surrounding emerging markets has remained sceptical, and for this reason, as fundamentally sound as the BRIC countries economies are today, the market has been adopting the BRIC investment story very gradually. This time though, it is credit worthiness that is being overlooked.

 

Source: Merrill Lynch October 2006

 

Source: Merrill Lynch, October 2006

Today, emerging markets sit atop a current account surplus in excess of $700-billion, and it is the industrialized G7 who are in debt, by the same amount. Longer term surpluses in excess of $3-trillion are to be found on the balance sheets of mostly the BRIC countries today in the form of Foreign Exchange surpluses, and trade surpluses. China alone now nurses a trade and forex surplus nearing US$1.5-tillion. Russia, has managed to build up reserves of US$450-billion as well as Putin’s US$150-billion ‘contigency’ fund, set aside so that it may sidestep any kind of financial shock. India has amassed a forex surplus of around US$275-billion. Brazil’s forex reserves now stand at US$178-billion.

BRIC countries have been financing the debt, and driving the growth of G7 countries for the last 5-7 years. China has emerged as the worlds manufacturing hub, while India has come on very strong as its counterpart hub in services, both providing Western firms access to inexpensive educated and -or- highly-skilled labour. Russia, under Putin, has successfully emerged as a highly profitable energy and raw materials producer, second in oil and gas reserves to Saudi Arabia. Brazil has changed the regional balance in the Americas by turning itself into the winds of east-west trade in hard and soft commodities and using its strength to bolster its new economic clout in relation to North America. 

China’s growth is less dependent on the health of the US economy, as is commonly perceived. A recent Economist article points out that China’s true exports-to-GDP ratio is actually below 10%, that China has been quite successful to date at rebalancing its economy in favour of domestic growth as a driver. As for India, 87% of its GDP is consumed domestically, making it quite independent from the risk of the US threatened consumer hegemony. Russians are enjoying three times the disposable income of 7 years ago and driving consumption growth, as are Brazilians.

North American and European companies are looking to these consumers to drive demand and growth to their top and bottom lines.

In a word, things have changed.

They have changed in a very meaningful, very important way. The relationship that now exists between emerging markets and G7 countries is ‘symbiotic.’ and interdependent.

Source: Merrill Lynch, October 2006 

Today, around 60-70% of emerging markets sovereign debt is investment grade rated and all 120 companies that form the key MSCI Emerging Markets Index have ADR listings.

In 1997-1998, the world’s biggest western banks took advantage of bailout conditions to take ownership of Asian banks, once protected by thousand-year-old protectionist laws. Today, powerful and wealthy Sovereign Wealth Funds (SWFs) are bailing out the same banks, Citigroup, Merrill Lynch, and Morgan Stanley.

On Wall Street in the past few weeks, the sums have been bigger and the actions more benign—at least so far. This week Merrill Lynch and Citigroup became the latest to get the sovereign-wealth treatment, picking up a further $6.6 billion and $14.5 billion respectively, much of it from governments in Asia and the Middle East (see article). Sapped by the subprime crisis, rich-world financial-services groups have been administered nearly $69 billion-worth of infusions from the savings of the developing world in the past ten months, according to Morgan Stanley.

 

SWFs

  

Commodities are not the only source of sovereign wealth. Many Asian emerging markets have been running current-account surpluses at the same time as they have been managing their exchange rates. As they have mopped up dollars, using government bonds, they have accumulated reserves. At first these went into safe, liquid assets like American Treasury bonds—the Asian financial crisis of 1997-98 was still a recent memory and many countries were keen to amass reserves. But economies like China, South Korea and Taiwan now have more reserves than they need to defend themselves against shocks. Their governments understandably want to earn a higher return than Treasury bonds will pay, so they create a fund to manage their assets. Source: The Economist, Jan. 17, 2008, Asset-Backed Insecurity

It has become such that neither Emerging Markets nor the G7 can allow each other to be destabilized, as evidenced by the large, noted, SWF investments, as they have each other’s economic ‘lives’ in the balance.

You might get the idea that emerging markets are correlated more to the US than they actually are, when you see that they have suffered like western stock markets, from a selloff. Their correlation is low, between .30 and .40, not zero or negative. There are those who would have us believe that the decoupling thesis is suffering from the same disease as the bull market. Those are probably the same folks, who last year began to re-write their theses from decoupling to recoupling to suit themselves this year, as the need to raise cash by selling the last two year’s profitable trades became an increasingly inevitable requirement, in order to shore up balance sheets.

Our expectation is that the credit squeeze ailing the market will come to a reversal point, at some point over the next 2-4 weeks as the banks round the corner on the cash call that has forced the wholesale liquidation of emerging markets and commodities related investing.

Emerging Markets are strong, and some of their [inflationary] growth pressures may get somewhat solved by a slowdown in the US, in the form of an imported soft landing. This is by no means advice, but if you subscribe to this thesis, then there is reason (for those of us on the buy-side) to believe that there will be a recovery in the decoupling thesis, and thus emerging markets equities throughout the second half of the year, from the current lows.

First, however, until the cash call is complete, and the future of the monoline insurers (MBIA, ABK) is resolved in the form of perhaps a bailout, we may continue to see more downside.

Now may prove to be a good time to nibble at emerging markets and commodities again and add or gain exposure as they are far more attractively priced. Here are a variety of ETFs and open ended funds (Canadian fund companies with offerings) that provide broad (diversified) and narrow exposure (country and regional funds) to BRIC and emerging markets.

On the AMEX

“Total” Emerging Markets ETFs
iShares MSCI Emerging Markets Index Fund (EEM)
PowerShares FTSE RAFI Emerging Markets Portfolio (PXH)
SPDR S&P Emerging Markets ETF (GMM)
Vanguard Emerging Markets ETF (VWO)
   
Dividend Emerging Markets ETFs
WisdomTree Emerging Markets High-Yielding Fund (DEM)

Multi-Region (but not Total) Emerging Markets ETFs
BLDRS Emerging MKTS 50 ADR Index Fund (ADRE)
Claymore/BNY BRIC (Brazil, Russia, India, China) ETF (EEB)
streetTRACKS SPDR S&P BRIC (Brazil, Russia, India, China) 40 ETF (BIK)
iShares MSCI BRIC Index Fund (BKF)

Latin America Regional ETFs
iShares S&P Latin America 40 Index Fund (ILF)
SPDR S&P Emerging Latin America ETF (GML)

European Emerging Markets Regional ETFs
SPDR S&P Emerging Europe ETF (GUR)
Middle East and Africa Regional ETFs
SPDR S&P Emerging Middle East & Africa ETF (GAF)

India - Barclays iPath India ETN (INP)

On the Toronto Stock Exchange
Claymore BRIC ETF  (CBQ.T)
Open Ended Funds (Canadian)

Broad Mandate Emerging Markets

Tmpleton Emerging Markets
AGF Emerging Markets
Pro FTSE RAFI Emerging Markets Index
TD Emerging Markets 
United-Emerging Markets Pool Cl A
CI Emerging Markets
United-Emerging Markets Pool Cl W
BMO Emerging Markets
Brandes Emerging Markets Equity
CIBC Emerging Markets Index
National Bank Emerging Markets

Region/Country Mandates
Excel India Fund
Excel China Fund
Excel Chindia Fund
Excel Emerging Europe Fund
Templeton BRIC Fund

 

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Remain Heavily Underweight Banks

Wednesday, January 2nd, 2008

Welcome to the GreenLightAdvisor Blog! We will do our very best to share our thoughts, insights and observations on markets, economics and investing. We spend a great deal of time looking around for the really important stories in any given week and the point of this blog is to attempt to put it all together the way that we see it. We don’t claim to be omniscient, but whatever we do find out we will try to share with you. You too are free to share your thoughts and opinions with us. We would love to hear from you.

We kick off this blog with some of our thoughts on the stories that we have selected.

One of the finer pieces that we have read recently was Don Coxe’s Basic Points, consistently one of the best monthly letters in the investment universe. In his most recent letter, Mr. Coxe shares his thoughts on 2007, the right and the wrong, and his recommendations for 2008. Here are his recommendations:

1. Remain heavily underweight banks, particularly investment banks that have displayed monumental stupidity. Do not assume that a change at the top will automatically convert them nto temples of wisdom, (unless it is accompanied by demands for the departing to repay bonuses based on bets that turned out disastrously). Better to assume that, like subprime-based CDOs, there are layers of rot that can make the entire product dangerous  to your financial health.  

2. Remain overweight Emerging Markets, emphasizing those that are oil, gas, and/or food exporters.  

3. Soaring food costs threaten stability for some Third World economies. We have been ardently endorsing India since we returned from our leave of absence a year ago. We are now more cautious, because a weak monsoon could be politically and economically destabilizing at a time of $4 corn  and $10 wheat.  

4. Remain heavily overweight gold—both stocks and the ETF. Gold is almost as good a protection against banking problems as SKF—the UltraShort Financials ETF—a security which may not be a suitable investment in some portfolios.  

5. We continue to believe that the Agricultural stocks are the pre-eminent investment class of our time. Farm incomes are rising rapidly, and, in the US, farms and farm land are the real estate assets that are rising in value and are virtually immune to foreclosures. That means the leading Ag companies have great pricing power and minimal credit problems. We now hear suggestions that because food inflation has finally made it to the cover of The Economist, it is time to start moving toward the exits. Not so: We think that fine cover story could be the atonement—At Last!—for the magazine’s famous 1999 cover: $5 Oil. 

6. Remain overweight oil and gas producers, including the Alberta oil sands producing companies. As disappointed as we are with the new royalty schemes in that province, Alberta certainly remains more attractive than Nigeria or Angola—and much more attractive than Russia, Kazakhstan,  or Venezuela.  

7. We think it is time to begin accumulating the refiners that are equipped to handle heavy high-sulfur crude. The collapse of the crack spread has savaged refiners’ earnings, but that will eventually rebound. The Saudis have virtually turned out the Light, and less and less of the oil that the Gulf states will be lifting will be of the most desirable grades.  

8. Retain the base metals stocks that have long-life unhedged reserves in secure areas. Even if there is a global recession caused by global collapses of subprime paper and LBO loans, it will not be deep enough to drive base metal prices back to 2004 levels—but would be worrisome enough  to push further mine development even farther into the future.  

9. When borrowing, borrow where possible in dollars. When investing, invest  where possible in other currencies.  

10. Stagflation is a bad backdrop for bonds—and for non-commodity stocks. The central bankers could have headed it off had Wall Street behaved with a modicum of morality, but the Fed and its brethren are forced into sustained reflation because of the global solvency crisis. Corporate earnings for most sectors will not meet current optimistic Street forecasts, and rising  inflation will reduce the market’s P/E.        

In our opinion recommendation #1 is advice that should be taken very seriously, as financials may be the current market’s proverbial falling knife, and for the time being, it could be that just as investors may think they are getting a bargain in the sector, that they may find themselves with more risk right now than they bargained for. It is going to be some time before the banking and credit market situation unwinds. I would stay away from financials until things in the credit market clear up some more or the bad news no longer has any downside effect. Junk bond and counterparty risks remain an issue.