Wednesday, March 31, 2010

The CRE time bomb

I have written before about the prospects of economic time bombs everywhere. While potential problems such as another round of pending residential resets have been well highlighted, the commercial real estate (CRE) time bomb is now as well documented. Recently, Elizabeth Warren stated on CNBC that ½ of all CRE mortgages will be underwater by the end of 2010:

By the end of 2010, about half of all commercial real estate mortgages will be underwater, said Elizabeth Warren, chairperson of the TARP Congressional Oversight Panel, in a wide-ranging interview on Monday.

“They are [mostly] concentrated in the mid-sized banks,” Warren told CNBC. “We now have 2,988 banks—mostly midsized, that have these dangerous concentrations in commercial real estate lending."

As a result, the economy will face another “very serious problem” that will have to be resolved over the next three years, she said, adding that things are unlikely to return to normalcy in 2010.

Serious CRE problems
In February 2010, the Congressional Oversight Panel released a report entitled Commercial Real Estate Losses and the Risk to Financial Stability, which contained a number of disturbing data points. The report documents rising CRE vacancy rates:

…falling property prices:

…and rising CRE delinquency rates:

A fragile banking system
All of these conditions exist in the context of a fragile banking system. The chart below shows the percentage of banks whose loan loss provisions, or Allowance for Loan and Lease Losses (ALLL), exceed non-performing loans (NPL). If ALLL is greater than NPL, then banks will need to increase their provisions for NPLs.

Can an already fragile banking system withstand another round of loan write-downs?

Add one more thing to the list that keeps me lying awake at night.

Monday, March 29, 2010

Life in Extremistan, or Minskyville

I got some interesting feedback about my recent post when is diversification important. To paraphrase, some of the reasoned responses said that my approach of focusing on the event extremes is highly dependent on the likelihood of extreme events, or the fatness of return distributions. Already, there are warnings from the likes of BCA Research and Greg Mankiw, who was the head of George W. Bush's Council of Economic Advisors, to prepare for the next financial crisis:

A few years ago, some people thought that major financial crises were a thing of the past. We know that was wrong. Despite our best efforts, more financial crises are likely to occur. As we recover from the last one, we should prepare for the next.

How likely are extreme events?
Most people in finance recognize that while capital market returns are distributed in a bell-shaped Gaussian curve, the distribution isn’t the standard normal distribution that we all learned in school. The distinguishing feature is that the tails are fatter, i.e. there is a higher probability of extreme events than assumed by the normal distribution model.

That’s why we seem to seem to see the proverbial “100 year flood” every few years, such as the Lehman Crisis, 9/11, Argentina Crisis, Russia Crisis, etc.

How fat are the tails of the return distributions? One way of determining the amount of fatness is kurtosis measure. Wikipedia explains that “a high kurtosis distribution has a sharper peak and longer, fatter tails, while a low kurtosis distribution has a more rounded peak and shorter thinner tails.” In other words, a kurtosis measure of zero indicates that returns are normally distributed, a negative kurtosis has thin tails while a positive kurtosis has fat tails.

Hedge funds pay a lot of attention to kurtosis, largely because of the leverage in their trading books. When I worked at a hedge fund, the risk manager explained to me that a kurtosis measure of 2-3 is somewhat acceptable, but if the kurtosis of a strategy were to balloon beyond 4 or so, they would get nervous because the possibility of extreme loss would be unacceptably high.

Capital market returns are incredibly fat-tailed
The chart below shows the kurtosis of the various asset classes over the last 10 years. The US bond market was proxied by the total returns of the iShares Barclays Aggregate Bond Fund (AGG) and the Canadian bond market was proxied by the total returns of iShares CDN Bond Index Fund (XBB).

Kurtosis was incredibly high across all asset classes. US bonds, as measured by AGG, showed an astonishing level of kurtosis at 69.0. Canadian bonds, which were less affected by the Lehman Crisis, were still relatively high at 5.1. As a point of reference, I looked at the 10-year trailing kurtosis of the S&P 500 before the Lehman Crisis and it came in at 2.1.

Recall my previous comment that my hedge fund risk manager said that a kurtosis of 2-3 was ok, but beyond 4 they would get nervous.

So is the risk of extreme events so high that we should all be nervous?

A series of Minsky moments?
For some historical context, the chart below shows the rolling 10 year kurtosis of daily returns for the Dow Jones Industrials Average back to 1928 (so this analysis includes the Crash of 1929). It appears that these fat tailed episodes, or high kurtosis, aren’t unusual at all. In fact, the Lehman Crisis was just a blip compared to the Crash of 1987. Periods of stability are followed by periods of instability, or Minsky moments. (John Maudlin also has a good essay on Minsky and the threats from "fingers of instability".)

Back to the 1970s?
The chart below shows that that the level of macro-economic volatility is rising. I shudder whenever someone says “this time it’s different.” Well, this time isn’t different, you just have to look back far enough in history. We experienced similar levels of macro-economic volatility back in the 60’s and 70’s. Unfortunately, most investment professionals weren’t in the business back then and may not be mentally equipped to deal with the new environment.

Living in Extremistan
Nicholas Nassim Taleb, the author of The Black Swan, coined the term Extremistan, a state where one's wealth can change massively in a very short time. Under those kinds of circumstances, investors should have the necessary tools to deal with this new environment.

Friday, March 26, 2010

Time to drink the (Chinese) Kool-Aid?

There have a lot of concerns expressed about the property bubble in China. The latest missive comes from Edward Chancellor’s ten signs of manias and financial crises as applied to the analysis of the “China dream”. Here is his checklist, all of which apply to China:

1. Great investment debacles generally start out with a compelling growth story.
2. Blind faith in the competence of the authorities.
3. A general increase in investment is another leading indicator of financial distress. Capital is generally misspent during periods of euphoria. Only during the bust does the extent of the misallocation become clear.
4. Great booms are invariably accompanied by a surge in corruption.
5. Strong growth in the money supply is another robust leading indicator of financial fragility. Easy money lies behind all great episodes of speculation from the Tulip Mania of the 1630s – which was funded with IOUs – onward.
6. Fixed currency regimes often produce inappropriately low interest rates, which are liable to feed booms and end in busts.
7. Crises generally follow a period of rampant credit growth.
8. Moral hazard is another common feature of great speculative manias. Credit booms are often taken to extremes due to a prevailing belief that the authorities won’t let bad things happen to the financial system. Irresponsibility is condoned.
9. A rising stock of debt is not the only cause for concern. The economist Hyman Minsky observed that during periods of prosperity, financial structures become precarious.
10. Dodgy loans are generally secured against collateral, most commonly real estate.
A China put?
Will China’s boom end badly? No doubt it will. The question is one of timing.

Stephen Roach recently turned sanguine on China. Roach's former Morgan Stanley colleague Andy Xie also indicated that while the Chinese economy may go down, it likely won't be a hard landing because the authorities have signaled to the market that they will put a floor on the market:

It seems we have seen this movie before. Beijing launched property-tightening measures several times in the past but then relaxed them as soon as the market felt the bite. The bottom line is that local governments, and Beijing through them, depend very much on property for fiscal revenues. And now, the market does not believe the government will cut off the hand that feeds it.

Despite the signs of official tightening, the markets are getting ready for another upleg [emphasis mine]:

Contrary to Beijing's policy intent, local governments are readying for another round of property inflation. Local governments have been using bank loans to resettle residents, and resettlement costs have skyrocketed since those being moved need enough compensation to buy properties at today's prices. Unless property prices rise considerably, local governments will end up losing money, which they cannot afford.

Such resettlements played an important role in supporting demand for property last year. The overwhelming majority of end-user purchases probably came from resettled residents who used their compensation cash for down payments. Resettlement compensation is the biggest transfer of wealth from the government to the household sector since the privatization of low-cost public housing a decade ago. It is probably the most important government action supporting today's economy.

Despite the signs of excesses, investors should remember the lessons of the dot com bubble. Stupid valuations can get stupider.

So the Greenspan put, which morphed into the Bernanke put, has become the China put.

If there is indeed a China put out there, then while China bubble may take a pause, any weakness won’t be the hard landing the apocalyptic crowd expect but a buying opportunity. Bears need to respect the possibility that the China bubble may inflate further.

Is the "dark cross" a sign of the Apocalypse, or a false prophet?
The Shanghai Composite is seeing a "dark cross" where the 50-day moving average is crossing below the 200-day moving average, a bearish technical sign. Traders should be extremely cautious near for any near-term weakness. Investors, on the other hand, may want to lighten up some positions but also watch the evolution of government policy to see if this is indeed a great buying opportunity.

Thursday, March 25, 2010

Just when you thought it was safe to go back in the water...

With the Dubai news and the Greek/Eurozone crisis seemingly winding down, investors might have thought that it was time to take on risk again. Then this story from the WSJ came across my desk:

Just when you thought it was safe to go back into the water...

Wednesday, March 24, 2010

When is diversification important?

There has been some minor buzz in the blogosphere over a study showing that the benefits of international equity diversification are falling (see comments from Paul Kedrosky and FT Alphaville). Moreover, I recently had a discussion with another investment professional about issues surrounding portfolio construction and diversification. His comment to me was a textbook one: “I would rather try and get… reduction in volatility through more diversification.”

Diversification when you need it the most
To someone as simple-minded as me, diversification during "normal" periods is nice and the higher correlations exhibited by global stock markets is a minor concern, but the most valuable form of diversification occurs during panics and crisis episodes - when virtually all asset classes go down. That's when you want something in your portfolio to save you.

Consider example of the crisis in 2008. During that and other periods of financial stress, the correlations of seemingly uncorrelated asset classes tend to converge to 1. Balanced fund portfolios, which were advertised as to be sufficiently diversified to withstand these kinds of shocks, were down 20-30%.

Max Darnell of First Quadrant addressed this diversification problem by explaining that you have to take a bet somewhere. Even though you may be diversifying your asset betas across asset classes, the fact that you are taking on beta generally means that you are making a bet on risk [emphasis mine]:

In short, diversification is not intended to be a tool for risk avoidance. Rather, it is meant to be used as though it were an acid that dissolves away impurities, i.e., uncompensated risk, leaving a pure risk that is more desirable principally because we are rewarded for holding it. The remaining risk will be risky. Otherwise, we wouldn’t be compensated for it.

Correlation isn’t causality
I wrote before that you shouldn’t confuse correlation with causality. Standard MPT style correlation analysis of asset returns are based on statistical correlations. Statistical correlations will tend to move around. Most critical to downside risk protection, don’t expect statistical correlations to hold up in accordance with historical experience during periods of extreme global volatility.

I prefer to look for diversification more analytically. For example, hard assets tend to perform well during periods of rising inflationary expectations, but default-free fixed income assets such as government bonds will perform poorly. Conversely, we can expect that during a credit crisis, which is associated with heightened default risk, prices of default-free government bonds with good credit will rise, while hard asset prices would be under pressure.

Alpha from beta?
Supposing you had a model that could identify macro-economic regimes, then a strategy of buying hard assets during periods of inflation; default-free assets during periods of deflation; and equities during periods of benign macro-economic risk would make good sense.

That would be creating alpha from diversification beta.

Monday, March 22, 2010

Another step down the road to Argentina

I have written before about how U.S. may be making the same mistakes as Argentina did a century ago. Now there is one more worrying data point that America is going down the Argentina road.

The New York Times is reporting that American firms are offshoring high tech research jobs to China. As an example, Applied Materials built its biggest lab in China, and Chief Technology Officer Mark R. Pinto plans to move there. Another disturbing sign of the loss of competitiveness: Some US companies are licensing technology from Chinese developers for use in the US.

Is America innovating?
Michael Mandel, former chief economist for BusinessWeek magazine, recently wrote that “Innovation makes up the main comparative advantage for the U.S., since we can’t compete on cost with lower-wage countries (at least not yet).” Unfortunately, American leading edge industries haven’t been creating jobs.

Policy makers have to get out of their ideological straitjackets if they are to make a significant headway on innovation. Standard macro drivers such as lower tax rates don’t seem to have a significant impact on innovation. In fact, there are indications that higher innovation regions have higher tax rates.

I believe that other factors espoused by Michael Porter, such as industry clustering, infrastructure availability, etc., have a much higher impact on how creative and high value-added industries locate themselves.

Disaffected youth?
At the heart of innovation is a country’s education system. The top American universities remain the envy of the world, but troubling statistics indicate that youth labor participation rates have been falling.

Is innovation even the answer?
Even worse, Andy Xie argues that innovation may not save an economy [emphasis mine]:

Many economists argue for freer and cheaper economic structure to stimulate innovation. But, in the Internet era, innovations rapidly disseminate around the world. It's not clear if innovation benefits can be contained in any country anymore. For example, even though the United States is more innovative than Europe, it hasn't outperformed by much. Its celebrated prosperity during the Greenspan era turned out to be an old-fashioned bubble, not a reflection of superior innovation.
Andy Xie does have a point. Innovation isn't enough, by itself, to insure success. Even if you build a better mousetrap, the world will not beat a path to your door. To be successful, you need marketing, distribution channels, reliable manufacturing processes, etc. Your resulting wealth also depends on your relative bargaining power within the value chain. We have had this private running joke in our family. Where other parents may have wished for their child to discover the cure for cancer, ours was that our child would commercialize the cure for cancer.

Nevertheless, until the US begins at least reverse itself on the innovation front, the loss of position on the innovation front has to be regarded as long-term negative for the US Dollar and long-term bullish for commodities.

Thursday, March 18, 2010

Be careful what you wish for

File these stories under “be careful what you wish for”:

Now even the World Bank has called for China to re-value the RMB. Moreover, there have been calls within the US to get tough with China on a number of fronts, e.g. label her a “currency manipulator”. Mish has an insightful post that discusses the effects of a possible Chinese re-valuation:

Let's consider the global shock effect of a sudden large revaluation of the Renmimbi. The key is the RMB does not float. To get a 40% rise in valuation, China must buy or sell unlimited amounts of RMB against the dollar to maintain the desired price. That might mean a huge hike in Chinese interest rates to make holding the RMB attractive.
In turn, sharp interest rate hikes would likely cause a huge slowdown in China, decreasing China's demand for imports. This is yet another factor that Krugman and those crying "currency manipulator" miss.

And should the US impose a revaluation via tariffs, I would like to point out a little thing called Smoot-Hawley.
Over on the other side of the pond, Macro Man also mused on the comparisons between Germany and China:

Each, in their own way, has locked in an uber-competitive exchange rate with its major trading partners: Germany via EMU and China via serial piss-taking in currency markets. Each in their own way is acting hypocritically: neither wants their major customers to borrow profligately, but neither do they wish for them to quit buying.
His conclusion was the same as Martin Wolf in the FT: “the most feasible country to leave EMU is Germany itself.” So what would happen if the US were to leave the Chimerica marriage of convenience? Here is Macro Man [emphasis mine]:

However, unlike Greece, the US is not part of a formal de jure currency union, merely a de facto one. The implication is that with sufficient political will, the United States can extricate itself from the current arrangement. To be sure, there may be demerits associated with such a move: higher borrowing costs as China stops buying/sells Treasuries.

I return to the theme discussed in my previous post entitled Time bombs everywhere. Are America's political leaders willing to grit their collective teeth and choose the heart attack option by plunging the country and the world into a double-dip recession (or depression) now in return for the long term gain of the correction of global imbalances in savings and consumption?

Be careful what you wish for, you might just get it.

Tuesday, March 16, 2010

Time bombs everywhere

John Maudlin once observed that western governments and societies were behaving like teenagers:

In a way, we were like teenagers. We made the easy choice, not thinking of the consequences. We never absorbed the lessons of the Depression from our grandparents. We quickly forgot the sobering malaise of the '70s as the bull market of the '80s and '90s gave us the illusion of wealth and an easy future. Even the crash of Black Friday seemed a mere bump on the path to success, passing so quickly. And as interest rates came down and money became easier, our propensity to acquire things took over.

And then something really bad happened. Our homes started to rise in value and we learned through new methods of financial engineering that we could borrow against what seemed like their ever-rising value, to finance consumption today.

We became Blimpie from the Popeye cartoons of our youth: "I will gladly repay you Tuesday for a hamburger today."

Today, the bill is coming due. There are now time bombs in budgets everywhere. Reuters has a story out entitled Forget Greece: Italy derivatives also ticking. Local governments in Italy were eager to reduce their financing costs and did so through complex derivatives contracts. When interest rates increase, many cities will face substantial losses.

The cover of Barron's features a story about the $2T public pension hole. David Merkel also has a terrific post about the unfunded obligations of the US and EU governments. Mish has been railing about the ticking time bombs embedded in state and local government obligations, see one of many examples here.

Death by cancer or heart attack?
I go back to my analogy from the Star Trek episode, where Spock’s line was “The guilty party has his choice-- death by electrocution, death by gas, death by phaser, death by hanging...”

Governments have the choice of cancer (inflation) or heart attack (deflation). They can either spend and print money like crazy in order to put off the day of reckoning, or they can bite the bullet now by defaulting on debt, raising taxes or drastically cutting spending. We just don’t know which path they will choose or whether the markets will allow them to choose.

As investors, we need to prepare and watch in order to react accordingly.

Monday, March 15, 2010

China and the double dip recession

Further to my last post about Stephen Roach turning more sanguine on China and her property bubble, a number of items have created further concerns about the risks of a double-dip recession.

First, the WSJ resports that Premier Wen Jiabao warned that the world economy might face a double-dip recession, given financial-system risks and continued high unemployment in some countries.

Meanwhile, there are more and more stories about the Chinese property bubble. Consider this tidbit about the Miami-like parabolic move in property prices in Haikou.

Haikou: The "Miami" of China?

…or how even Time magazine has picked up the story about the Chinese property bubble. (If Time is focusing on the story, is this contrarian bullish?)

What pricks the bubble?
Even though prices may be stratospheric, they may not necessarily come back to earth. Overbought assets can become more overbought, as value investors found out during the Tech craze of the late 1990’s. The question then becomes one of what is the catalyst that pricks the bubble?

Here are some data points that may be of concern. Recent data from shipping indices indicates that rates for shipments from China to US East Coast fell 13%

... and to the West Coast fell 12.3%:

Does slowing trade with the US dragging down Chinese exports induce a crash in Chinese property? Or should we short a country with $2T in foreign exchange reserves?

Stay tuned.

Thursday, March 11, 2010

A perennial bear turns sanguine

I shudder whenever someone proclaims that we are entering a New Era, or this time it’s different. There are certain things in life that I have come to depend on, such as a bearish Stephen Roach, the chairman of Morgan Stanley Asia and former global strategist. His writing used to be so depressing that you had to read King Lear to cheer up. He was such a perennial bear that I used to joke with my Morgan Stanley sales contact that Morgan Stanley needed to throw a huge party when he turned bullish.

Maybe it’s me, maybe it’s Roach in his old age. Lately I have detected a note that this perennial bear is turning sanguine.

The China bubble debate
In the post-crisis era, China has been the bulwark of growth and stability in a growth-starved world and there are signs that the Middle Kingdom economy may be at risk. The Chinese economy has shown signs of growing a property bubble. As examples, consider this commentary about the China property bubble and the video below of, not only see-through buildings, but a see-through city:

Most recently, I noted that the central government took steps to nullify financing guarantees by local governments, which would further put the brakes on an overheating economy. The Chinese authorities are trying to engineer a soft landing, but fiscal and monetary authorities have had a nasty habit of overshooting and turning intended soft landings into hard landings.

The debate in China is now becoming one of hard landing or soft landing.

Stephen Roach a (sort of) bull?
I nearly fell off my chair when I read the FT Alphaville post entitled Roach pooh-pooh to Chinese bubbles. In it, Roach is reported to believe that the Chinese authorities are in a better position to respond to the current because they are being proactive with the emerging property bubble:

Unlike policy circles in the West, where there is no appetite to pre-empt bubbles and crises, China views these risks very differently. In the depths of the Asian financial crisis of the late 1990s, the Chinese leadership first adopted a “pro-active” policy strategy—a forward-looking approach that relies on the combination of fiscal, monetary, and regulatory tools to lean against bubbles and financial crises.

Similar tactics were deployed with great success in the global downturn of 2000–01 and again in the Great Crisis of 2008–09, he continues. In fact, Chinese authorities repeatedly have stressed pre-emptive policy discipline over the reactive self-regulation practiced in the West. “Bubbles, and the imbalances they spawn, were to be addressed early rather than after the fact”.

Wow! Not quite turning bullish, but an un-bearish Stephen Roach.

Is this truly a New Era?

Wednesday, March 10, 2010

9 women can't have a baby in a month

I have written about the Peak Oil thesis before, Gregor Macdonald over at his site has a new post entitled The Myth of Energy Breakthroughs that gives a great perspective on that viewpoint [emphasis mine]:

It’s common among those who sell the idea of energy breakthrough to invoke electronic or digital adoption narratives. Breakthroughs in medicine, in electronic networks, and in other intellectual achievement distribute more easily upon existing systems. This is why I continue to believe that many (not all) in Cleantech Venture dont’ really understand the scale of our energy problem. Or, having understood the scale of our energy problem, many apply adoption pathways learned from other systems–that simply don’t translate to energy, and the built environment.

If the world is to transition from oil to another energy source, the amount of time and scale of the process is enormous. Gregor Macdonald went on to a chart that shows how long it to nuclear to reach levels of electrical generation by hydro.

Simply put, nine women can't have a baby in a single month.

Monday, March 8, 2010

The canary keels over?

I have written before that Britain and Pound Sterling (GBP) could be the canary in the mine for the US because of the similarities in their economies, except that the UK is not in the envious position of being the issuer of a major reserve currency.

These days Pound Sterling is falling apart. What's more, the UK housing market seems to be moving into double-dip territory:

The housing market seems set to undergo its own "double-dip" recession, with Halifax announcing yesterday that there was a 1.5 per cent fall in house prices between January and February, and with the slow economic recovery now on course to depress sentiment for the rest of the year.

Are the troubles in Britain a bad omen for America? Across the Atlantic, there are signs that the US could face a 2Q contraction. James Hamilton at Econbrower points out that a new financial conditions index is plunging which indicates further near-term deterioration. What's more, Patrick Chovanec highlighted that Bloomberg reported that China, which has been the bulwark of growth and stability in a growth-starved world, is moving to further cool down her economy by nullifying financing guarantees by local governments [emphasis mine]:

Many of the stimulus projects undertaken this past year have been financed, not by the central government directly, but by local governments, including cities, counties, and provinces. For the most part, however, they have limited funds and face official restrictions on their ability to borrow directly. To circumvent these limits, they set up special investment vehicles to borrow the money instead. Because these debts are supposedly guaranteed by the local governments (meaning they would step up to pay if the immediate borrower couldn’t), banks and other lenders tend to treat the loans as essentially risk-free. Northwestern University Professor Victor Shih calculates that local governments have already accumulated RMB 11 trillion (US$ 1.7 trillion) in outstanding debt, with RMB $13 trillion (US$ 1.9 trillion) in available credit lines, belying China’s low reported levels of public debt.

Now comes news, from top regulators in Beijing, that “China plans to nullify all guarantees local governments have provided for loans taken by their financing vehicles as concerns about credit risks on such debt surges.” (According to the report, the Ministry of Finance is also drafting rules to ban local governments from issuing any more such guarantees in the future). Without the guarantees in place, Shih believes, China could face a “gigantic wave” of bad debts and halted projects.

A hard landing in China?
While I recognize that the Chinese authorities are trying to engineer a soft landing, but fiscal and monetary authorities have had a nasty habit of overshooting and turning intended soft landings into hard landings. What happens to risk aversion should the US consumer slows (even more) at the same time that China slows? What does that do to the risk of a Chinese hard landing?

Heightened downside stock market risk
Meanwhile, Mark Hulbert reported that there is too much bullishness in stocks and in gold, which are contrarian bearish signs.

John Hussman believes that "the Market Climate for stocks was characterized by unfavorable valuations, overbought conditions, and hostile yield pressures". To put the current conditions into perspective Hussman gave a market history lesson:

Based on the current overbought status of the market, there are only three similar periods that we can identify in post-war data: August-October 1999 (which was followed by an abrupt air pocket of greater than 10%), September-October 1987 (no comment required), and September-December 1955 (which was followed by a 10% correction, a brief recovery, and a secondary decline to re-test the initial low).

The top-down macro, fundamental, technical and the sentiment pictures are all lining up bearishly. Don't say you weren't warned.

Thursday, March 4, 2010

Inflation AND deflation

Over at his blog, Tim Duy is worried about the risks of persistently low inflation or deflation and asks if the Fed is underestimating the macro risks of deflation. He concludes that:

[T]he Fed did find ways to maneuver around the zero bound constraint this time, I am more concerned with the next recession than this one. Recent history suggests that each recession necessitates lower interest rates than the last. I would prefer to pull the economy up to a point where we had some distance from the zero bound such that we did not have revert back to managing economic activity via ballooning the balance sheet. And while the balance sheet proved to be an effective tool for defrosting frozen financial markets, would it be as effective if the next time around the problem was simply too little demand in the presence of functioning financial markets? I would rather not endure the experiment.

What do you mean by inflation?
I firmly believe that central bankers are looking at the issue of inflation and deflation in the wrong way. The Cleveland Fed has median and trimmed-mean CPI figures that show that inflation is well under control. The Dallas Fed has a trimmed mean PCE that tells the same story.

If central bankers monitor these kinds of core inflation measures, they will conclude that inflation is well under control.

The alternative view is that global monetary and fiscal authorities are engaged in synchronized prime pumping policies that amount to competitive devaluation. However, because the stimulus is more or less synchronized, devaluation pressures aren’t showing up in the forex markets but in the commodity markets. So when central bankers analyze core inflation statistics, which is ex-food and energy, or trimmed mean inflation-like statistics, commodity inflation doesn’t show up because that the precise segment that’s getting excluded.

Different kinds of risks
I agree with Tim Duy that the macro-economic risks of deflation are higher than what the consensus is. I would add that the risk of inflation, in particular commodity inflation, is also higher than anyone expects.

That’s why my Inflation-Deflation Timer model focuses on commodity inflation as an indicator of inflation for investors.

Tuesday, March 2, 2010

Global cooling: Profitable contrarian investing?

I have penned a new monthly newsletter for the folks at Qwest Investment Management entitled Global cooling: Profitable contrarian investing?

Here is the abstract:

While it is critical that we take serious our collective responsibility for the health of our global community, scientists today are debating the real cause of global warming and most recently the cooling trends. Prudent investors should monitor these debates as they may have an impact on their portfolios. For example, if scientists conclude we are now going through a global cooling phase, this would certainly impact pricing and/or demand for certain agricultural and energy commodities and subsequently affect portfolios.
This is a controversial topic. For those readers who would label me a denier, I would reply that I stand in the same camp as Phil Jones of the CRU when he stated in a BBC interview that:

It would be supposition on my behalf to know whether all scientists who say the debate is over are saying that for the same reason. I don't believe the vast majority of climate scientists think this. This is not my view. There is still much that needs to be undertaken to reduce uncertainties, not just for the future, but for the instrumental (and especially the palaeoclimatic) past as well.
Notwithstanding Al Gore's latest op-ed in the New York Times, I remain agnostic about whether the Earth is warming or cooling, or what the possible causes of any warming trend is. As an investor, however, we have to be aware that the consensus may be shifting and the big money can be made by correctly going against the crowd, especially when the crowd turns in your direction.

Monday, March 1, 2010

AEI says "Why can't we be like Canada"???

I sat here on a lazy Sunday night at my house in Vancouver, which is about 15 minutes away from Cypress Bowl, one of the venues of the Vancouver 2010 Olympics. I contemplated the friendly* but fierce rivalry in men’s hockey between Canada and the United States.

A change of heart?
Down south, there was an article from Mark Perry, a visiting scholar at the American Enterprises Institute, entitled Due North: Canada’s Marvelous Mortgage and Banking System. In the article, Perry pointed out some of the marvelous features of the Canadian banking system, which made it more stable.

I found it curious that a conservative think tank like the AEI would publish such a piece, particularly when conservative commentators have derided liberal commentators for comments like “Why can’t we be more like foreigners, like Denmark, or France…”

Now the AEI is publishing a piece that essentially says “Why can’t we be like Canada” ?!

Nothing in life is every free and choices have tradeoffs. In another era, the AEI would have been denouncing some of the anti-competitive practices of the Canadian system. Today, Mark Perry is extolling the Canadian banking system for its stability and points to the following reasons (comments in parenthesis are mine):
  • Full Recourse Mortgages in Canada. (Agreed.)
  • Shorter-Term Fixed Rates in Canada. (These are the equivalent of ARMs in the US, with terms of 1-5 years, though 7-10 year terms are available in Canada. Wasn’t the existence of low-rate teaser ARMs what got the US system in trouble in the first place?)
  • Mortgage Insurance Is More Common in Canada than in the United States. (Agreed, though that just puts potential stress onto mortgage insurance. Remember that the CDS didn’t solve any problem, but exacerbated them.)
  • No Tax Deductibility of Mortgage Interest in Canada. Home mortgage interest has never been tax-deductible in Canada, so there is no tax advantage to home ownership in Canada over renting. (In Canada, there is no capital gains tax on the sale of a principal residence. There are ways of making mortgage interest deductible. For example, if you fully owned your house and mortgaged it to make an investment, the interest is deductible.)
  • Higher Prepayment Penalties in Canada. (Agreed.)
  • Public Policy Differences for Low-Income Housing. To promote affordable housing for low-income households, the Canadian government has not used public policies like the Community Reinvestment Act in the United States. (The gap between rich and poor in Canada is far lower than the US. The impetus for legislation like the Community Reinvestment Act is therefore lower.)
  • Differences in Canada’s Bank Concentration and Greater Diversification. (The tradeoff is oligopolistic practices. Banks are stodgy up here and act like the Post Office. Notwithstanding Paul Volcker’s remark about the only useful banking innovation is the ATM, Citi has a useful online credit card tool where you can generate a credit card number for one-time use, which is handy for internet transactions. I have never seen a Canadian bank come up with innovations like that.)
  • A Few Other Differences that Contribute to Bank Safety in Canada. There is a much lower rate of loan originations by mortgage brokers in Canada (only 35 percent) than in the U.S. (70 percent), far less mortgage securitization in Canada than here, and a much smaller subprime mortgage market. Banks in Canada keep and service 68 percent of the mortgages on their own balance sheets that they originate and underwrite, which encourages prudent lending since banks are putting much of their own capital at risk. Finally, almost all mortgage payments in Canada are made electronically by an automatic payment arrangement, which minimizes late payments. (I am not sure the size of the benefits that electronic or automatic payment confer. However, during the boom years, conservative think tanks like the AEI would have been decrying the lack of imagination of Canadians in fully developing a mortgage securitization market.)

There is no free lunch
The Canadian banking system represents a low-beta system, whereas the US system is a higher beta system. It just so happens that the financial system underwent a shock - an environment where low-beta systems outperform. During the boom years, the AEI would have been celebrating the "innovative" nature of the higher beta US system.

Richard Nixon famously said “we are all Keynesians now.”

In light of Canada's record setting gold medal haul at the Winter Games, are we all Canadians now?

Do we want to be?

Addendum: I was initially ambivalent about the Olympics in my city, but now that the Closing Ceremonies have come and gone, I am glad that to see that our visistors had such a marvelous time.

[*] TV coverage showed the Canadian troops in Afghanistan holding a sign that read Brothers in arms, but not on the ice.