- Gold price seems more likely to rise than fall
- Weak US non-manufacturing ISM survey increases downside risk to payrolls (13.30 BST)
- Not a great start to the second quarter for the UK service sector

Key Market Themes

The lack of a reliable income stream makes gold notoriously hard to value objectively. We think there are three plausible outcomes for the next year or two: a “central” scenario where the price of gold climbs to a new nominal record of $2,200; a “high” scenario where it surges to $5,000; and a cautionary “low” scenario where it drops back to $1,000. Our forecast is for the price to rise to the “central” scenario level of $2,200 by the end of this year, before falling back to $2,000 in 2013.

Our central scenario is that the global economy remains weak and vulnerable to financial shocks, the most important of which is the potential exit of one or more small countries from the euro-zone. In this scenario, the break-up is relatively orderly and the US economy remains relatively strong, supporting the dollar and deterring the Fed from further quantitative easing. But gold is still likely to benefit from safe haven demand and the continuation of ultra-loose monetary policy, including in the US. For the purpose of the Update, we assign a 60% probability to this outcome.

In our “high” scenario for gold prices (10% probability), a chaotic break-up of the euro might cause an even more serious global crisis than that which followed the collapse of Lehmans. Central banks could then be forced to monetise government debts, leading to a complete loss of faith in paper currencies. In this scenario the price of gold might rise as high as $5,000. Other components of this scenario could include a prolonged military conflict between Iran and the West and a surge in oil prices.

Nonetheless, we think the “low” scenario (30% probability) is more likely than the “high”. Here the global economic recovery gathers pace, the euro-zone holds together, and central banks led by the Fed start to tighten monetary policy much sooner than generally anticipated. The downside for gold should still be limited by strong and rising demand from emerging economies and we would not expect to see a return to the November 2008 lows. But if US Treasury 10-year real yields returned to more normal levels of 2% or so, gold might drop back to around $1,000.

What to watch for today: North America

The disappointing 119,000 increase in the ADP measure of private sector employment in April means the risks to our forecast that non-farm payroll employment (13.30 BST) rose by 175,000 in the same month are on the downside – particularly following the drop in the employment index of the ISM non-manufacturing survey released on Thursday (see below). That said, even an outturn similar to the 120,000 increase in payrolls in March would not be a disaster. It is possible that the unusually warm winter weather brought forward some hiring from the spring, meaning that recent data are a bit weaker than the true underlying trend.

The fall in the ISM non-manufacturing index in April, to 53.5 from 56.0 in March, was the second fall in as many months and took the index back to December’s level and below the long-run average of 53.9. It also took a lot of the shine off the rise in the ISM manufacturing index reported earlier this week. The weakness in the non-manufacturing survey was broad-based with the new orders index slipping to 53.5 from 56.0, the business activity index dropping to 54.6 from 58.9 and the employment index declining to 54.2 from 56.7.

Nonetheless, we’re not convinced that we are seeing the beginnings of a spring-time slowdown much like last year’s. An average of the ISM manufacturing and non-manufacturing indices is still consistent with annualised GDP growth in the second quarter of 2%. And with the recovery having touched the autos, construction and banking sectors, we think it is a bit more robust this time.

Meanwhile, non-farm productivity declined by 0.5% annualized in the first quarter. (Data also released on Thursday.) The annual growth rate was just 0.5% and has now been below 1% for five consecutive quarters. The good news for firms (and bad news for employees) is that compensation per hour only increased by 1.5% annualized in Q1. As a result, overall unit labor costs increased by 2.0% annualized. The annual growth rate of unit labor costs dropped back to 2.1%, from 3.1%. At the margin, that makes us (and presumably the Fed too) a little more confident that core CPI inflation will eventually drop back below the Fed’s 2% target.

Continental Europe

As widely anticipated, the ECB left its main refinancing rate on hold at 1% at its Governing Council meeting on Thursday. Developments on inflation were deemed to be in line price stability over the medium term, with risks described as “broadly balanced”. But Mr. Draghi repeated that the ECB was prepared to act in a “firm and timely manner” to meet this target should the need arise. Meanwhile, on growth, the outlook in the euro-zone continues to be subject to “downside risks”. Mr. Draghi made a point of distinguishing between the economic indicators seen during Q1 this year – consistent with a stabilization in economic activity – and the very latest ones, which showed “uncertainty prevailing”. There was no discussion of interest rate changes at the meeting.

One key message from the press conference was that the ECB was not obviously prepared to sanction additional support measures for the euro-zone economy, despite recent signs of weakness in the business survey data. Mr. Draghi was content to re-iterate that the ECB’s monetary policy stance was “accommodative”, with liquidity “abundant”, concluding (as in April) that any exit strategy would be “premature”. With no urgency to sanction further measures to boost growth, Mr. Draghi was keen to stress the need for governments to ensure fiscal sustainability alongside structural reforms. In fact, he did not believe that a “growth compact” and a “fiscal compact” were at all inconsistent. This is because fiscal consolidation, by lowering sovereign risk premier, fosters stronger growth in the medium term. In short, “austerity”, not “growth”, won the day. (Mark Miller)

UK

April’s CIPS/Markit report on services echoed the other surveys released this week in suggesting that the second quarter has gotten off to a soft start. The drop in the business activity index from 55.3 to 53.3 (consensus 54.1) took it to its lowest level since last November. That said, it is still consistent on past form with reasonable services output growth of about 0.4% q/q. What’s more, the other balances point to an uptick in growth in services employment and continued expansion in new business.

US Economy

The sharp fall in stock markets on Friday in the wake of the reported 115,000 increase in US non-farm payrolls in April suggests fears are growing that the recovery is fading fast, just like it did at this time last year. However, we still think the true health of the labor market lies somewhere in the middle of the strength seen in the first two months of the year, when the average monthly payrolls gain was 267,000, and the weakness in the last two months, when the average gain was 135,000. Over the next couple of months we expect the monthly gains to settle back into a 150,000 to 200,000 range.

The overall Employment Report wasn’t quite as bad as the headline gain suggests. For a start, the gains in February and March were revised up by a combined 53,000. Moreover, a lot of the weakness in April was in construction, which fell by 2,000, and leisure & hospitality, which increased by only 12,000, about a third of the average monthly gains seen in the few months before that. This weakness looks like some weather payback after the unusually mild winter. Although the figures are supposed to be adjusted, the early Easter may have played a role too. On the plus side, retail payrolls increased by 29,000 and temporary help increased by 21,000. The recent gains in temporary help point to a pick-up in private payroll gains soon.

In addition, despite a 169,000 decline in the household survey measure of employment, the unemployment rate still edged down to a three-year low of 8.1%, from 8.2%, as the labor force fell by an even bigger 342,000. The participation rate slipped from 63.8% to 63.6% last month, which is a 30-year low. Normally we would characterise the contraction in the labor force as a big negative. But this is a volatile series and the labor force increased by almost 1,000,000 in the first two months of the year, so some drop back was to be expected.

In the US this week we expect to learn that the recent small drop back in gasoline prices was enough to leave the producer price index unchanged in April and to generate a small boost in consumer confidence. Otherwise, our calculations suggest that the trade deficit widened again in March, in part thanks to a rebound in the volume of oil imports.

This week, attention will focus on the results of the French Presidential election and the Greek general election – both of which will take place over the weekend on Sunday. A victory for François Hollande in the French election, the most likely outcome, would be seen as a boost for those advocating a more growth-friendly solution to the euro-zone’s problems. But Hollande’s fiscal plans are only marginally less onerous than President Sarkozy’s and his economic plans are unlikely to boost economic growth in the longer term.

The week’s main euro-zone economic data releases include March’s industrial production figures for the region’s main economies. Our forecasts of flat production in Germany and falls in France and Italy imply that the slowdown in the region as a whole continued. Meanwhile, in Norway the Norges Bank is widely expected to leave interest rates on hold at 1.5% this Thursday. We see little reason to disagree.

Last week’s appallingly weak UK bank lending figures, as well as the softer business surveys for April, have intensified the dilemma facing the MPC ahead of its meeting on Thursday. For now, we think that the MPC will put more weight on the sticky inflation figures and pause the asset purchase program. It will be a closer-run decision than looked likely a few weeks ago, Our view remains that more QE is likely to be announced later this year as it becomes clearer that inflation is on course for a well-below target rate.

March’s industrial production figures will indicate whether the preliminary GDP estimate is likely to be revised. While we think that there is a reasonable chance that manufacturing output will be a bit stronger in March than the ONS assumed in its GDP estimate, we doubt that this will be enough to prompt an upward revision to GDP growth. Meanwhile, we expect the BRC retail sales monitor (Wednesday) to show that sales growth has eased back after March’s pick-up and for April’s producer prices figures to reveal a fairly sharp fall in the annual rates of both input and output price inflation.

Of note, most of China’s key monthly data will be released towards the end of this week. The trade data (Thursday) will be worth a look for clues to the state of both domestic and foreign demand. But most closely-watched are likely to be the April lending figures (due sometime between Friday 11th and the following Tuesday 15th), amid concerns that weak loan demand is undermining government efforts to stimulate the economy.

As always we will make the appropriate portfolio adjustments according to the defined risk levels of our strategies and clients.

Be well.

“The Great Escape: Delivering in a Delevering World”

“•When interest rates cannot be dramatically lowered further or risk spreads significantly compressed, the momentum begins to shift, not necessarily suddenly, but gradually – yields moving mildly higher and spreads stabilizing or moving slightly wider.
•In such a mildly reflating world, unless you want to earn an inflation-adjusted return of minus 2%-3% as offered by Treasury bills, then you must take risk in some form.
•We favor high quality, shorter duration and inflation-protected bonds; dividend paying stocks with a preference for developing over developed markets; and inflation-sensitive, supply-constrained commodity products.

Article Main Body

About six months ago, I only half in jest told Mohamed that my tombstone would read, “Bill Gross, RIP, He didn’t own ‘Treasuries’.” Now, of course, the days are getting longer and as they say in golf, it is better to be above – as opposed to below – the grass. And it is better as well, to be delivering alpha as opposed to delevering in the bond market or global economy. The best way to visualize successful delivering is to recognize that investors are locked up in a financially repressive environment that reduces future returns for all financial assets. Breaking out of that “jail” is what I call the Great Escape, and what I hope to explain in the next few pages.

The term delevering implies a period of prior leverage, and leverage there has been. Whether you date it from the beginning of fractional reserve and central banking in the early 20th century, the debasement of gold in the 1930s, or the initiation of Bretton Woods and the coordinated dollar and gold standard that followed for nearly three decades after WWII, the trend towards financial leverage has been ever upward. The abandonment of gold and embracement of dollar based credit by Nixon in the early 1970s was certainly a leveraging landmark as was the deregulation of Glass-Steagall by a Democratic Clinton administration in the late 1990s, and elsewhere globally. And almost always, the private sector was more than willing to play the game, inventing new forms of credit, loosely known as derivatives, which avoided the concept of conservative reserve banking altogether. Although there were accidents along the way such as the S&L crisis, Continental Bank, LTCM, Mexico, Asia in the late 1990s, the Dot-coms, and ultimately global subprime ownership, financial institutions and market participants learned that policymakers would support the system, and most individual participants, by extending credit, lowering interest rates, expanding deficits, and deregulating in order to keep economies ticking. Importantly, this combined fiscal and monetary leverage produced outsized returns that exceeded the ability of real economies to create wealth. Stocks for the Long Run was the almost universally accepted mantra, but it was really a period – for most of the last half century – of “Financial Assets for the Long Run” – and your house was included by the way in that category of financial assets even though it was just a pile of sticks and stones. If it always went up in price and you could borrow against it, it was a financial asset. Securitization ruled supreme, if not subprime.

As nominal and real interest rates came down, down, down and credit spreads were compressed through policy support and securitization, then asset prices magically ascended. PE ratios rose, bond prices for 30-year Treasuries doubled, real estate thrived, and anything that could be levered did well because the global economy and its financial markets were being levered and levered consistently.

And then suddenly in 2008, it stopped and reversed. Leverage appeared to reach its limits with subprimes, and then with banks and investment banks, and then with countries themselves. The game as we all have known it appears to be over, or at least substantially changed – moving for the moment from private to public balance sheets, but even there facing investor and political limits. Actually global financial markets are only selectively delevering. What delevering there is, is most visible with household balance sheets in the U.S. and Euroland peripheral sovereigns like Greece. The delevering is also relatively hidden in the recapitalization of banks and their lookalikes. Increasing capital, in addition to haircutting and defaults are a form of deleveraging that is long term healthy, if short term growth restrictive. On the whole, however, because of massive QEs and LTROS in the trillions of dollars, our credit based, leverage dependent financial system is actually leverage expanding, although only mildly and systemically less threatening than before, at least from the standpoint of a growth rate. The total amount of debt however is daunting and continued credit expansion will produce accelerating global inflation and slower growth in PIMCO’s most likely outcome.

How do we deliver in this New Normal world that levers much more slowly in total, and can delever sharply in selective sectors and countries? Look at it this way rather simplistically. During the Great Leveraging of the past 30 years, it was financial assets with their expected future cash flows that did the best. The longer the stream of future cash flows and the riskier/more levered those flows, then the better they did. That is because, as I’ve just historically outlined, future cash flows are discounted by an interest rate and a risk spread, and as yields came down and spreads compressed, the greater return came from the longest and most levered assets. This was a world not of yield, but of total return, where price and yield formed the returns that exceeded the ability of global economies to consistently replicate them. Financial assets relative to real assets outperform in such a world as wealth is brought forward and stolen from future years if real growth cannot replicate historical total returns.

To put it even more simply, financial assets with long interest rate and spread durations were winners: long maturity bonds, stocks, real estate with rental streams and cap rates that could be compressed. Commodities were on the relative losing end although inflation took them up as well. That’s not to say that an oil company with reserves in the ground didn’t do well, but the oil for immediate delivery that couldn’t benefit from an expansion of P/Es and a compression of risk spreads – well, not so well. And so commodities lagged financial asset returns. Our numbers show 1, 5 and 20-year histories of financial assets outperforming commodities by 15% for the most recent 12 months and 2% annually for the past 20 years.

This outperformance by financial as opposed to real assets is a result of the long journey and ultimate destination of credit expansion that I’ve just outlined, resulting in negative real interest rates and narrow credit and equity risk premiums; a state of financial repression as it has come to be known, that promises to be with us for years to come. It reminds me of an old movie starring Steve McQueen called The Great Escape where American prisoners of war were confined to a POW camp inside Germany in 1943. The living conditions were OK, much like today’s financial markets, but certainly not what they were used to on the other side of the lines so to speak. Yet it was their duty as British and American officers to try to escape and get back to the old normal. They ingeniously dug escape tunnels and eventually escaped. It was a real life story in addition to its Hollywood flavor. Similarly though it is your duty to try to escape today’s repression. Your living conditions are OK for now – the food and in this case the returns are good – but they aren’t enough to get you what you need to cover liabilities. You need to think of an escape route that gets you back home yet at the same time doesn’t get you killed in the process. You need a Great Escape to deliver in this financial repressive world.

What happens when we flip the scenario or perhaps reach the point at which interest rates cannot be dramatically lowered further or risk spreads significantly compressed? The momentum we would suggest begins to shift: not necessarily suddenly or swiftly as fatter tail bimodal distributions might warn, but gradually – yields moving mildly higher, spreads stabilizing or moving slightly wider. In such a mildly reflating world where inflation itself remains above 2% and in most cases moves higher, delivering double-digit or even 7-8% total returns from bonds, stocks and real estate becomes problematic and certainly much more difficult. Real growth as opposed to financial wizardry becomes predominant, yet that growth is stressed by excessive fiscal deficits and high debt/GDP levels. Commodities and real assets become ascendant, certainly in relative terms, as we by necessity delever or lever less. As well, financial assets cannot be elevated by zero based interest rate or other tried but now tired policy maneuvers that bring future wealth forward. Current prices in other words have squeezed all of the risk and interest rate premiums from future cash flows, and now financial markets are left with real growth, which itself experiences a slower new normal because of less financial leverage.

That is not to say that inflation cannot continue to elevate financial assets which can adjust to inflation over time – stocks being the prime example. They can, and there will be relative winners in this context, but the ability of an investor to earn returns well in excess of inflation or well in excess of nominal GDP is limited. Total return as a supercharged bond strategy is fading. Stocks with a 6.6% real Jeremy Siegel constant are fading. Levered hedge strategies based on spread and yield compression is fading. As we delever, it will be hard to deliver what you have been used to.
Still there is a place for all standard asset classes even though betas will be lower. Should you desert bonds simply because they may return 4% as opposed to 10%? I hope not. PIMCO’s potential alpha generation and the stability of bonds remain critical components of an investment portfolio.

In summary, what has the potential to deliver the most return with the least amount of risk and highest information ratios? Logically, (1) real as opposed to financial assets – commodities, land, buildings, machines, and knowledge inherent in an educated labor force. (2) Financial assets with shorter spread and interest rate durations because they are more defensive. (3) Financial assets for entities with relatively strong balance sheets that are exposed to higher real growth, for which developing vs. developed nations should dominate. (4) Financial or real assets that benefit from favorable policy thrusts from both monetary and fiscal authorities. (5) Financial or real assets which are not burdened by excessive debt and subject to future haircuts.

In plain speak –

For bond markets: favor higher quality, shorter duration and inflation protected assets.

For stocks: favor developing vs. developed. Favor shorter durations here too, which means consistent dividend paying as opposed to growth stocks.

For commodities: favor inflation sensitive, supply constrained products.

And for all asset categories, be wary of levered hedge strategies that promise double-digit returns that are difficult in a delevering world.

With regard to all of these broad asset categories, an investor in financial markets should not go too far on this defensive, as opposed to offensively oriented scenario. Unless you want to earn an inflation adjusted return of minus 2-3% as offered by Treasury bills, then you must take risk in some form. You must try to maximize risk adjusted carry – what we call “safe spread.”

“Safe carry” is an essential element of capitalism – that is investors earning something more than a Treasury bill. If and when we cannot, then the system implodes – especially one with excessive leverage. Paul Volcker successfully redirected the U.S. economy from 1979-1981 during which investors earned less return than a Treasury bill, but that could only go on for several years and occurred in a much less levered financial system. Volcker had it easier than Bernanke/King/Draghi have it today. Is a systemic implosion still possible in 2012 as opposed to 2008? It is, but we will likely face much more monetary and credit inflation before the balloon pops. Until then, you should budget for “safe carry” to help pay your bills. The bunker portfolio lies further ahead.

Two additional considerations. In a highly levered world, gradual reversals are not necessarily the high probable outcome that a normal bell-shaped curve would suggest. Policy mistakes – too much money creation, too much fiscal belt-tightening, geopolitical conflicts and war, geopolitical disagreements and disintegration of monetary and fiscal unions – all of these and more lead to potential bimodal distributions – fat left and right tail outcomes that can inflate or deflate asset markets and real economic growth. If you are a rational investor you should consider hedging our most probable inflationary/low growth outcome – what we call a “C-“ scenario – by buying hedges for fatter tailed possibilities. It will cost you something – and hedging in a low return world is harder to buy than when the cotton is high and the living is easy. But you should do it in amounts that hedge against principal downsides and allow for principal upsides in bimodal outcomes, the latter perhaps being epitomized by equity markets 10-15% returns in the first 80 days of 2012.

And secondly, be mindful of investment management expenses. Whoops, I’m not supposed to say that, but I will. Be sure you’re getting value for your expense dollars. We of course – perhaps like many other firms would say, “We’re Number One.” Not always, not for me in the summer of 2011, but over the past 1, 5, 10, 25 years? Yes, we are certainly a #1 seed – with aspirations as always to be your #1 Champion.”

William H. Gross
Managing Director
————————————————
Bill Gross and his well-connected macro strategists at Pimco have in my opinion done an excellent job at looking across the asset class spectrum to determine opportunities and risks as global macro economies continue further down their chosen (or inappropriately guided) paths. One point I would like to raise in connection with Mr. Gross’ article is that when most people think of the term de-levering they assume that a natural person or other entity will under consume less relative to their income while paying down debt for some period. This orderly and healthy process would cause economic growth (GDP) rates to decline somewhat until the process was complete. If the consumer is estimated to represent 70% of GDP (not anymore!) and government is estimated to represent 30% (much higher today) then we could easily determine( based upon which cohort was doing the de-levering) how much growth would be sacrificed in favor of debt repayment.

As in all things in the current age, it’s much more complex than that because global governments are at various stages of the economic cycle, with some essentially defaulting on some portion of their debt, and some simply using economic tools at their disposal to keep the cost of the excessive borrowing down. In all cases, however one thing is certain – GDP growth rates are not rising as they should, and in fact it can be well argued that as Europe and China, the largest and second largest economies in the world continue to slow, other economies will experience a dramatic slowing as well (Argentina, and New Zealand have publicly stated that as China goes, so goes their economies).

Anyone who has ever had to de-lever personally or with their businesses will tell you that you cannot accomplish this difficult task on a slowing or shrinking cash flow (without default at some point). The slowing macro environment will demand its own set of decisions, often acute and extreme depending on how the expected outcome is perceived by the leverage offenders counter parties. One thing is certain, even if the counterparties- those that own the debt, or who would typically be expected to buy the debt react calmly; they will most certainly demand higher returns for their accepted risk.

It wasn’t that long ago (think junk bond era) that debt default was rare indeed, but times they are a changing and the debt default cycle is moving from the individual level to the governmental level unless the governments spend declines, or its income (TAXES) goes up – either one or both of those will simultaneously cause GDP to decline.

Asset classes which run counter to this developing and changing macro-economic cycle will destroy wealth unless they are sold, or owned short. These ongoing changes are both risks and opportunities dependent on one’s own behavior.

Be well.

ART CASHIN: The Unemployed Are Now Going On Disability And It’s Costing The Government Billions

In this morning’s Cashin’s Comments, Art Cashin points to some disturbing research regarding the recent bump in disability benefit applications:
I’m Sick Of Being Unemployed – A couple of strange and rather disquieting reports circulated among the Friends of Fermentation yesterday. The topic was unemployment or, more specifically, where do those people go who have stopped looking for work. Their absence is credited with distorting the unemployment rate and making it lower than most expect or believe.

The reports I allude to, contended that many went on disability. In fact, they projected that nearly 25% of those not actively seeking a job had applied for, and been accepted, by disability – mostly Social Security.

One of the reports came from a site called SoberLook.com (a perfectly logical place for the Friends of Fermentation to be browsing). The Sober report quoted extensively from a report by JPMorgan. I was unable to locate the original JPM report but we’ll assume that Sober quoted from it correctly. Anyway, here’s a bit from SoberLook:

But how does one survive after losing the unemployment benefits? Clearly people struggle. One way to pay the bills however is to file for and receive the federal disability benefits – assuming of course one has a disability. Interestingly enough, the Great Recession and the slow recovery somehow generated many more disability recipients.

JPMorgan: As of January over 8.5 million individuals were receiving federal disability payments (an additional 2 million spouses and children of disabled workers also received disability payments). Since the onset of the recession and the subsequent slow recovery, this figure has accelerated and grown faster than the overall size of the potential labor force— currently 5.3% of the population aged 25-64 is on federal disability, up from 4.5% when the recession began. The Sober report then goes on to look at the makeup and maladies of those going on disability.

JPMorgan points out that increases in the number of disability benefits recipients account for about a quarter of the decline in employment participation. Furthermore during recessions the number of new disability claims actually increases, even though the number of jobs with higher injury incidence (such as construction) generally declines. Try explaining that one…

Half of the benefit recipients suffer from “mental disorders” and “musculoskeletal disorders” (such as back pain). “Mood disorders” alone account for over 10% of this group. And once someone starts receiving these benefits, it’s almost impossible to take the off the program. In 2011 only 1% of the recipients lost their benefits because they were no longer deemed disabled. So how much is this program costing the US taxpayer? Apparently quite a bit.
JPMorgan: The cost to the federal budget of these programs has escalated along with the number of claimants, and now runs around $200 billion per year—more than the budgets of the Departments of Commerce, Energy, Homeland Security, Interior, Justice, and State combined.

Thus a quarter of people who drop out of the workforce and come off unemployment benefits, simply move to receiving disability payments. And most stay there until they roll into the social security program when they retire – from their disability. The same source, a different program.

Cashin also refers to a piece by Robert Samuelson, who references the research of MIT’s David Autor, which confirms the unusual relationship between unemployment rates and disability applications.

So, are these people acting out of desperation? Or are they just crooks? Or are that many people actually disabled?

Anyway, Cashin signs off with a little bit of sarcasm:
So, when your unemployment benefits are running out and no potential jobs are visible, it’s almost natural to look in the mirror and wonder why you aren’t feeling good…..er…..make that well.

It’s clear to everyone that published employment data are manipulated as needed by reducing the numbers of people who are considered to be looking for work, more disturbing is that me is the $200 Billion annual cost of the Disability program, and that there are going to be people with true disability needs turned away at some point because the program has been abused by others.
Is this really progress in the employment picture?

Be well.

First and foremost, Europe’s problems stem from a difference in competitiveness among European countries, and you can’t solve it by lending money to the less competitive countries. The solution is to deflate wages and prices in the south, and inflate in the north. But given Germany’s history, it will never inflate.

Proof that the ECB does not understand the problem lies in the December agreement among European countries that each country could have a structural deficit of no more than half a percent of GDP. If a deficit goes above 3% of GDP, the country would be sanctioned. This agreement is awaiting ratification by all countries. When you agree to a prescription like this and you are uncompetitive, your currency is terribly overvalued, you can’t devalue, and your interest rates are too high, that is a recipe for depression. It is an economic death sentence, worse yet is that several countries won’t ratify it, and their financial markets will be repriced accordingly. They will then exit the Euro, and the world will witness the turmoil escalate to the next level.

Greece is bankrupt, yet it has no capacity to devalue its currency by the required 50% to try to recover. When the Greek banking system goes bust, people will realize that the Greek private sector is also bust and worse yet is that banks in other countries will be in trouble, requiring nationalization (government takeover). Governments don’t have the funds to pay for nationalization, thus they will be forced to issue more debt.

There are three main problems in Europe. The first is that most of the banks are massively insolvent, because they have 30 times their capital invested in the second problem, which is the sovereign debt of countries that are incapable of paying the debt. If the banks have to write down the debt to what its real value is, or what it soon will be, then they will be bankrupt on a scale far worse than 2008. Countries cannot operate properly without functioning banking systems.

The third and largest problem I hinted at early in this blog post is the massive trade imbalances. I have written recently in blog posts that Germany exports products to the peripheral European countries, which run trade deficits. A country cannot reduce private sector leverage and deficits (balance its budget), and run a trade deficit all at the same time. Folks, it’s no different for a country than it is for an individual, you must run a cash flow surplus if debts are going to be reduced.

Greece runs a 10% trade deficit, when one considers the leveraged nature of their government two things must happen, the first is cutting budgets, the second is raising taxes, both of which will cause their economy to continue to shrink, it’s a vicious spiral that will ultimately suck in all of Europe – the world’s largest economy. As I have said in the past, if you want to fix governmental and banking systems problems, the first thing you have to do is stop rewarding the bad behavior. In our example, governments keep kicking the can down the road avoiding the unthinkable, which simply makes the unthinkable a larger, more global problem.

We estimate that a long and painful period of debt restructuring and austerity is in store not only for Europe, but global markets as the world’s largest economy sabotages growth in all other economies around the world. In a separate future blog post I will discuss the ridiculously high 2012 GDP estimates currently endorsed by all the major investment banks, for now let’s simply say that these estimates currently at 3-3.5% will likely be reduced to 2-2.5% in the coming months, and ultimately we believe the Europe effect will sap 1% of the 2-2.5% reduced GDP forecasts.
A long only stock and bond asset allocation strategy will likely be impaired on both fronts in 2012.

Be Well.

On everyone’s mind today is the EU crisis which is certainly part of a developed world crisis brought on by too much debt that must be deleveraged, a process that will take many years in both the EU and the U.S. I often hear comments from people about how small Europe really is and they believe this is not really our problem, but theirs to solve – let’s discuss.

The EU debt crisis is leading to greater fiscal austerity and is rapidly pushing most of Europe into recession. As was the case with subprime mortgages, this is not someone else’s problem and it is certainly not an isolated event. The EU nations combined constitute the single largest economy in the world and they are major importers from both the U.S. and other emerging nations often discussed as hot growth economies. A significant reduction in EU imports will have a major impact on global GDP. In addition, as European banks take necessary steps to strengthen their balance sheets and raise capital, they will impair credit availability and world trade.

A major domestic investment bank just estimated that the EU crisis could cut U.S. GDP by 1%, stating that a reduction in the lending of foreign banks to U.S. counterparties could have a meaningful impact on U.S. growth. France’s third largest bank, Credit Agricole SA, is leaving 21 of the 53 countries in which it operates. Germany’s Comemerzbank is negotiating to transfer suspect assets to a government owned “bad bank”. This is likely just the tip of the iceberg, as massive loan losses can severely impair the ability of the European banking system to function.

Another major domestic headwind is consumer spending in the U.S. Despite a modest improvement in recent economic releases, consumer spending has been propped up by a decrease in the household savings rate from 5% of disposable personal income (DPI) in June to 3.5% in October, disturbing when one considers that most U.S. households have much savings to make up after the economic destruction of recent times. In order to deleverage debts, the savings rate will have to rise with the associated negative effect on spending. Consumers will also be restrained by the slow rise in incomes brought on by continuing high unemployment, lack of credit and low house prices.

GDP growth for 2012 is likely to be pressured by tightening fiscal policy. The number of tax and spending measures expiring at year end may reduce GDP by an estimated 1.7%. If Congress can come together on the payroll tax cut the GDP reduction would likely come in around 1%. Am I the only one disgusted by the absence of economic motivation and service to our country from both the Senate and Congress? Political motivation is an expected part of this process, but it should not be the ONLY motivation our chosen leaders pursue. In this season where parents tell their children Santa’s watching, I wish to express to politicians that voters are watching, we are looking for an overhaul of the power we allow our chosen leaders to wield, we are going to demand results accountability.

Jumping to reliability I would like to drop a huge bomb on you, economists have pretty much no idea what will happen next year! Economic forecasting is very much like driving fast at night. Thanks to your headlights you can see what’s coming a few hundred feet in front of you, but you can’t see beyond that. And if you’re going too fast, by the time you see the curve or deer (black swan), it’s probably too late.

What analysts and economists do have is a general idea of what will probably happen next year. They base their forecasts on an understanding of what has happened in prior years, with a bias toward what has happened in very recent years. In other words they conclude that next year will be pretty much like the last few years.

Given the confidence with which most analysts and economists speak, it’s easy to forget that their performance track records suggest that they have no idea what will happen. Think I’m being too harsh on this mostly hard working group of men and women? The long term average growth for the economy is 4%, this is also precisely the number economists always predict that the economy will grow at in the future, because it gives them the best odds of being generally right (or at least not too embarrassingly wrong).

The headwinds are daunting, volatility is excessive, and thus opportunity is closest at hand, it may come in the form of a short term stock market run, moves in physical commodities, or interest rates – but come it will.

Happy Holidays!

Recently the ECB announced that instead of Greece filing for bankruptcy, all parties who owned Greek debt would suffer a 50% loss to their capital – thus debt balances were reduced by 50% – this was an attempt to prevent contagion in the financial system; we are very concerned about the unintended consequences of these actions.

First, remember that all governments will continue to need to sell bonds as a refinance measure for increasing deficits and existing debt which is continuously maturing; the risk of default on this debt is managed by institutional debt buyers thru several credit derivatives including Credit Default Swaps (CDS). The ECB’s declaratory 50% haircut to debt levels along with a lack of contractual remedy in the recently struck October 26 agreement for substantially higher minimum capital ratios for the banks substantially increases the odds of a serious credit contraction.

If support for Greek growth in the form of debt forgiveness coupled with tougher capital rules causes European banks to stop lending, the eurozone economy will be the victim of these policy initiatives.
Unfortunately, this issue is addressed in just one line of the 15-page document, and all it says is that, “National supervisors must ensure that banks’ recapitalization plans do not lead to excess deleveraging.”

The lack of any mention of how supervisors are supposed to prevent this outcome suggests a complete lack of understanding among those who drew up the agreement. This is because this is not an issue that can be resolved by national bank inspectors.

Banks will try to raise capital ratios by deleveraging; not raising fresh capital.

Shrinking the balance sheet is synonymous with calling in loans. While that would present no problem if carried out by only one or two institutions, it could trigger a sharp credit crunch in the broader economy if the entire banking sector goes down that road.
This is exactly what the large Italian Bank Unicredit (10,200 branches in 22 countries) announced today:
“…Proactive balance sheet management and ring-fencing of non-core performing assets in a €43bn (RWA) run-off portfolio. With around 80% of the portfolio expected to run-off by 2015, the ring-fencing initiative will free-up substantial capital and liquidity during the Plan’s implementation period.”
In other words, Unicredit is going to massively reduce its risk in an attempt to meet capital and liquidity requirements.

It’s almost certain that Unicredit won’t be the last, and so there’s about to be a big vortex sucking credit out of Europe.

Solutions to the Eurozone Debt Problem in our opinion will likely be framed around four possible outcomes. (hence we wonder if leadership is present to recognize the correct choices at the correct times).

1. The Germans can take their export surplus, taxes, and savings and pay for the deficits in the southern zone until such time as they can be brought under control. Or they can bail out all banks across Europe – the European banking system operates differently than US banks in that they use their excess cash to buy European Government debt (oops, the banks are now seriously undercapitalized because the debt is still held on the books at cost, but worth considerably less). Why would Germany bail out banks across Europe? They need the exports, and a customer without a banking system cannot buy your goods. Politically this option won’t fly.

4. Problem countries leave the Eurozone. If this option is chosen and it is not managed in a highly organized fashion, the financial chaos will reverberate around the globe.

Where’s the leadership opportunity you may ask? Well, none of these options are pretty paths and will mean a banking crisis and potentially long term recessions – that is of course only if many of the most optimum choices are made!

OK, I cannot end on that note, at Alpha Fiduciary we spend a great deal of time focused on asset class diversification – but for the short duration of this report I want to focus on a different type of asset allocation – allocation of capital to Entrepreneurs and free market capitalism!

Let’s look at a fictitious restaurant business in need of a new strategy to improve its results.

Would you wipe out 50% of the businesses debt? Perhaps give it a government loan of $1,000,000 to spend on the restaurant? If you did, it’s likely the few frequenting customers would see nice new furniture and fancy plates. This may present an improved look, but the business will likely just fail with new furniture and plates!

Put a CEO like Ray Kroc (founder of McDonalds) in charge of that business and he will innovate modern franchising and return the money ten times.

It is not how much you spend; it is what you spend it on. So how do you get the money to a Ray Kroc or a Steve Jobs instead of a bureaucrat? It is called capitalism – the efficient allocation of capital. Our problem today is not a “balance sheet recession” (that’s our symptom), it is that capitalism is broken, due to moral hazard from enormous government intervention and Fed stimulus. The wrong people have the capital. They are not the Ray Kroc’s, the guys who earned it hamburger by hamburger.

Substitute any business for the above scenario including the management of the global credit system, and I can assure you creative hard working people if allowed to operate in a capitalist system will fix it by giving the customer exactly what they want at a price they are thrilled to receive it at!

Be well.

“The situation feels increasingly like one that has little chance of materially improving until some extreme pressure is on the correct people to act. It may or may not come to a head this week, but the signs are not good that we can avoid an extreme situation emerging soon”.

This morning LCH Clearnet increased overnight the amount of collateral to be posted as initial margins on trades. They have used a tiered approach: 0-3 months at 3.5%, 9m to 3.25 yrs at 4%, 4.5% increase from 3.25 to 7 yrs, and finally 5% increase from 7yrs to 30 yrs, and index linked go from 9% to 14%.

We participated on two conference calls early this morning to discuss the ramifications of this move by clearing houses and surmise that while this is not the haircut increases being feared in the European markets over the last few days, this is clearly removing liquidity from the system and implies about e5.5bn of cash to be posted on top of what was posted yesterday. One thing is clear, there are a lot of sellers on the sidelines in Italian bonds and the news is creating more margin selling while the only proper buyer for Italian debt is the ECB, and despite their average clip size, they have so far failed to keep yields from spiking past the key 7% level where most experts consider sustainability a low probability outcome.

One key takeaway from both conference calls this morning was that American and Asian investors are still far too hopeful of a great solution in Europe. Even with Berlusconi’s resignation the last few weeks have shown disappointing actions out of Europe and lots of promises and few hard facts about a solution.

Three potential outcomes were discussed on the call as follows:

1. A coalition based on Berlusconi’s old coalition would ally the parties that supported him, and reach out to a few smaller parties. This coalition has already shown support for EC/ECB/IMF austerity measures, but many fear it will not do a job much better than Berlusconi. Under this scenario bond yields are not expected to decline – a decisive negative for Italian borrowing costs.

2. A coalition of centrist “technocrat government”. This could produce a government more amenable to reforms that encourage growth and improve governance. Markets would likely approve of this kind of coalition and bond yields are expected to decline by 50-100 bps – still a difficult cost structure for Italian debt.

3. General elections are called after Berlusconi’s resignation (which will take place once the 2012 budget is passed next week) for January at the earliest. This would be the worst case scenario for the markets.
Traders, across the financial markets will likely stay transfixed on Italian bonds the balance of this week. Italy is the third largest debtor nation, and as of this writing has not demonstrated that it is serious about reining in spending, this has now been complicated by concern over future forms of government and whether sufficient time exists for beneficial changes to be implemented. Until the markets see that leadership can be quickly assembled and will enforce austerity packages, yields and tensions are likely to rise.

Italy remains a key unresolved component in the European debt crisis and we will of course provide future updates as needed until the specific risk is abated.

Be Well

The specific path exhibited above is the level of nominal GDP in 2007 (pre economic collapse) extrapolated forward at 4 ½% per year. You may think of this number as the sum of real potential GDP growth of 2 ½% and inflation as measured by the GDP deflator of about 2%. The specific number matters less than the Fed’s willingness to target a path that is anchored to a point like 2007, when the economy was near full employment, and that they indicate they will pursue this target aggressively.
So the question is why this move? Goldman sees it as a natural extension of the Fed’s dual mandate – price stability and full employment, bent more towards full employment. Many economists will find this a pretty sexy idea, as they have spoken of the benefits of nominal growth GDP (NGDP) targeting for some time.
Advocates of NGDP targeting claim that it would achieve greater macroeconomic stability because when recession hits, real output falls but prices tend to adjust more slowly. This means that by targeting nominal GDP, central banks could smooth output fluctuations better. They could also react more appropriately to supply shocks. As an example, take an economy that is hit by a negative supply shock through high oil prices depressing output and raising inflation. An inflation targeting central bank may be compelled to tighten policy, worsening the slump in output, whereas one mandated to hit NGDP would be more flexible.
Perhaps a bit forward thinking, but I think a major consideration of this type of strategy appears in the case where a positive supply shock through productivity enhancing new technology boost real GDP growth while lowering inflation. An inflation targeting central bank would respond by easing monetary policy, which could produce asset bubbles, whereas a NGDP targeting central bank would hold steady. The most visible effect of a nominal GDP (NGDP) policy would be more volatile inflation, but overall a less volatile economy.
Perhaps Goldman’s greatest selling point for this type of Fed strategy is that it believes a shift towards this kind of policy could bring down unemployment much faster than the current path foresees.

There are of course considerations extraneous to the Fed which could influence its decision to pursue an NGDP strategy. For one the political will for asset purchases may be a difficult sell given the public seems to be favoring a deficit and ultimately debt reduction approach. In addition many people believe that an overhaul of the United States tax system is the first step toward improving the unemployment problem in that on the global stage our current tax structure is less favorable to employers than many other global structures available to them. I have obvious concerns about the government potentially increasing its daily role in the economy and interfering with the free hand of the markets and economic forces at hand. Will the government successfully manage the delicate balance of intervention versus allowing the markets to float freely?

A tremendous level of faith must be placed in a government to regulate its own actions, perhaps of some solace is the fact that Americans are no longer content as long as gas and Big Mac’s cost under $5, think less about the details of uprisings such as occupy Wall Street and more about the big picture – Americans are increasingly frustrated with both political parties and willing to organize beyond the traditional “vote the offending party out next time”. Americans want solutions to the difficult problems they live with day to day, will these actions produce benefit? Stay tuned.
This week we will see a significant flow of economic data beginning with the Empire Fed survey, and Industrial Production on Monday, Tuesday’s Producer Prices, and Wednesday’s Housing Starts, and Fed Beige Book. Thursday Jobless claims will be reported (estimate 404k), as well as existing home sales – estimated to decline 2.5% after the 7.7% jump in August.
While all of this economic data will certainly catch the eyes of investors, they will likely be more focused on Europe news, as Sarkozy and Merkel have promised a solution on banks and debt within just a few days.

More to come shortly!

Be Well.

Alpha Fiduciary has been monitoring a growing minority of economists who believe that there will be a double-dip recession largely because of the insurgence of high unemployment and the still faltering housing market. The notion of a “jobless recovery” has been around since the recession of the 1950’s and 1960’s. It is a concept built on a simple idea: employment lags during a recession but is always part of a recovery cycle. Production rises as businesses see the end of a downturn and anticipate improving sales. They are reluctant to hire new workers until a recovery is confirmed, but once it has been, hiring picks up.
The 2008 recession was (if it’s over) different from any other both in depth and its causes. This recession was a balance sheet recession triggered by a downturn in housing prices, which robbed many people of their primary access to capital. That access evaporated along with their access to credit. Consumer buying power vanished and businesses cut inventory and production, joblessness rose, and finally consumer confidence plunged.

The depth of this recession was so severe that in some months more than 500,000 people lost their jobs. The unemployed now number well over 14 million and more gravely, over 6 million people have been out of work for over 27 weeks so they may no longer be eligible for unemployment benefits in early 2012. This segment of the population has already begun to add to the number of indigent Americans and will continue to do.

The second dip of the recession, according to economists and the federal government, is likely to begin within the next two quarters. Alpha Fiduciary has been of the opinion that unemployment would be a long term structural challenge to this recovery as unemployment claims have been running well above expectations, recently passing 400,000 almost every week. The four week average of initial claims rose to 414,740 this week. August unemployment figures showed the economy added no jobs last month.

To conclude our discussion about jobs, the federal, state and local governments are in no position to lend assistance to businesses, most of which lack access to capital. President Obama has just proposed spending $447 billion on job creation, but the Republican drive for austerity will likely keep the President’s proposal from becoming law. Banks are also not prepared to lend to small businesses, especially those with modest balance sheets – a problem given that companies with fewer than 100 workers have traditionally been the largest creators of jobs.

The bottom line for employment is that we are in a state of low level disequilibrium, and we cannot shift to a state of high level equilibrium (consumers spend because employers hire, employers hire because consumers spend) until the balance sheet problem is addressed. This will require debt restructuring and potentially mortgage restructuring. This will be difficult to achieve as banks deal simultaneously with exposure to debt in Europe.

While it would be nice to be able to close this discussion with “here is how this ultimately plays out” that is of course not possible. We at Alpha Fiduciary believe continued volatility in the financial markets will provide both challenges and opportunities depending on one’s investment strategy; you can count on us to provide our insights at the appropriate intervals.


Be well.

Our regular readers may remember our prior posts (June 16, 2011 Special Update, July 26, 2010 The EU Stress Test that wasn’t, and May 26, 2010 Greek debt crisis on verge of “going Global” by Pimco’s El-Erian) predicting that some EU banks would likely have trouble raising capital. And given the “web of debt” in which troubled EU countries and banks all own each other’s debt, the ability to raise capital would be critical in the event of defaults, as banks holding restructured debt would themselves be forced to recapitalize.

The truth of the matter is that many of the world’s governments currently lack credibility with investors, and until politicians stop kicking the can’s down the road and they allow inevitable events such as Greece failing and exiting the EU to occur, we will simply postpone at great cost that which must occur for healing to begin.
As to the US, domestic banks have little direct debt exposure to PIIGS debt. Though they do have some $200 Billion counterparty risk to European banks, including $10 Billion from Greece. Greece has suffered a loss of 60 Billion Euro’s in private sector bank deposits, for which it has turned to the European Central Bank to fund. Italy on the other hand has suffered no loss of deposits yet, but spooked the markets last week when it too turned to the ECB for aid.

In the absence of leadership investors globally are left to react fearfully to the headlines of any particular day. While I am at it, let’s be clear that despite Warren Buffet’s now famous quote about fear and greed, fear is a useful emotion and one that each investor should pay attention to. Fear is your brains way of asking you if you have a credible plan, don’t answer yes to that question carelessly.

For the benefit of all readers, I am going to state the obvious that to begin to address our debt, we must first fully solve our deficit, which Republican and Democrat Congressman failed to make material progress on recently, given that 65% of the smaller than required spending cuts they passed were pushed out to 2013. Once again in the absence of leadership….

Goldman Sachs just slashed (about time) third and fourth quarter 2011 GDP estimates to 1%, and 1.5% respectively. It is almost incomprehensible that post recession and with two massive Fed induced quantitative easing programs in our rear view, that the US economy is expected to grow sub 1.5% in the second half after sub 1% growth in the first half of 2011.

The credit crisis which began at the consumer level, then elevated to the banking level, has officially infected the Federal level, yet many Americans still choose to listen to and entrust their wealth to the same conflicted institutions that paved the way to these formidable challenges we now face.

Let’s focus on what investors must do to survive the effects of poor leadership and bloated governments. First and foremost you absolutely must abandon your primary belief that opportunity only exists in stocks and safety in bonds. Second you must abandon your belief that you want performance in each quarter and recognize that performance over a 1-3 year period will be much better if you don’t force yourself or your wealth managers to “do something”. Embracing a new correct paradigm will reward investors as the balance of this decade produces devastating results for those who prefer adherence to a stocks, bonds, and cash mentality.

As world governments employ increasingly bold actions, which are likely to fail to achieve lasting improvement, until leadership becomes fashionable, Investors should expect increased volatility and rolling trending patterns across all asset classes. Some asset classes must be shorted to be useful, while others must be owned long with a disciplined approach to loss mitigation. All of which must be reevaluated in a rapidly evolving economic climate.

A portfolio rooted in global assets, directionally and tactically managed across the asset class spectrum is simply the best way for investors to mitigate headline risks and promote calm thinking in an otherwise shaken investor universe, where the extraction of returns will evade novice and professional investors alike if they cling to old paradigms.

Portfolio’s rooted in new correct paradigms have significantly outperformed the old stocks, bonds, and cash yellow brick road of investing paradigm thus far in 2011. You will recognize those investors who have embraced the new paradigm as those focused on the financial welfare of friends, family, and acquaintances when fear grips those who did not, on the journey thru the balance of this decade.

Be well.