November 29, 2013

'Small Business Saturday'-- Marketing Ruse Or Do-Gooder Campaign?

'Small Business Saturday' is set for Nov. 30 this year, the day after Black Friday.
The campaign, sponsored by American Express (AXP_) and now in its fourth year, is intended to boost to sales for independently-owned business of the non-corporate, Main Street economy.

It all sounds great, but is this just a feel-good marketing effort for the credit-card operator, or a campaign that truly helps smaller-sized businesses?

"Do I think it's a marketing ploy? Of course. But they've also created a culture that's made people aware of shopping small every day and the importance of it," says Alison Dodson Anderson, owner of A. Dodson's, an eclectic lifestyle store selling a variety of products from apparel to home decor in Suffolk, Va. Dodson Anderson just opened a second location two months ago. "I don't really care where the movement came from I'm just glad it's here."

Dodson Anderson says Small Business Saturday is the third busiest shopping day of the year at her store, behind a biannual open house the store hosts.

"People are conscious about the day," she says hopefully, noting a recent Facebook status she posted on the store's page, which got more than 100 likes, a big response for a typical post by the store.

Small-business owners have quite an uphill battle this Thanksgiving weekend and all holiday season long, when up against big-box retailers like Best Buy (BBY_) and Wal-Mart Stores (WMT_) as well as online behemoths like Amazon (AMZN_) luring customers with cheap deals and fast, free shipping. The shortened holiday selling season this year has retailers in a further promotion frenzy to boost sales.

American Express situated the day smack in the middle of Black Friday and Cyber Monday to encourage consumers to "shop small."

Plenty of naysayers are pointing fingers to American Express, such as the Main Street Alliance, a national network of small-business owners, who criticize the credit card company for "championing small-business shopping," while at the same time having the highest credit card swipe fees at 3.5%, among other things, it says.

Instead, the organization wants to encourage shoppers to pay for their purchases with cash at small businesses this season.

But does it really matter whether it's marketing to get more people to use their American Express cards or a genuine do-good initiative? Because in the end, the growing awareness of the day is becoming a movement that isn't just about using American Express cards.

Last year consumers spent $5.5 billion at independent merchants during Small Business Saturday. (AmEx cardmember transactions specifically rose 21% compared to the 2011 event, AmEx says.)

While the number is small compared to the $59.1 billion spent over last year's Thanksgiving weekend, according to the National Retail Federation, the point is -- the initiative is working.

"We feel strongly that it's driving traffic," says Scott Krugman, a spokesman for American Express OPEN. "We're hearing nothing but positive things from small-business owners. [But it's] still in its infancy."

According to this year's Small Business Saturday Consumer Insights Survey, awareness of among U.S. consumers has improved to 44% of survey respondents, up from 34% a year earlier.

Among those aware of the day, 77% said they planned to shop at a small business. The survey was sponsored by the National Federation of Independent Business and American Express and conducted during the first week of November by polling 1,000 consumers at least 18 years of age.

Once again American Express is offering cardmembers (consumers) a $10 statement credit if they shop at a small business with their card on Nov. 30 this year.

But Krugman says that's not the point. "Small Business Saturday is not about that," he says, insisting that it doesn't matter whether customers pay with cash, card or check, but the important point is that they buy something from a small business.

"If it was just about American Express there would be no credibility to it," Krugman says.

Each year the movement keeps expanding. And this year its morphing into incentive for entire communities to hold events on Nov. 30.

Last year, American Express added the U.S. Chamber of Commerce to its list of partners for the day. This year, American Express created "Neighborhood Champions" program to help local chambers throw community events. It is also working with business organizations that include not only the U.S. Chamber of Commerce, but the American Independent Business Alliance, the U.S. Black Chambers, the Latino Coalition and the American Chamber of Commerce, it says.

"This year we have close to 1,500 events and activities happening in all 50 states," Krugman says. "In some cases it could be block parties or it could be as simple as a community providing free parking or shuttle services [to stores]."

Besides business organizations, companies like FedEx, Foursquare, Twitter and the U.S. Postal Service are offering merchants services like free printing and free online advertising to businesses.

"It's basically about finding these organizers to rally at least 10 local businesses, tell us what they want to do on the day and we give them an 'event in a box' -- banners and shopping bags and doormats helping them with the marketing materials that they need to really promote to make Small Business Saturday special," Krugman adds.

The event has spread globally as well, with Small Business Saturday happening in the U.K., Australian, Israel, Canada, South Africa and Asia, AmEx says.

"Our members are big supporters of Small Business Saturday," Bill Brunelle, spokesman for Independent We Stand, a grass roots campaign of independent business owners to educate communities to buy local and another partner with American Express. "It has become big part of the holiday shopping experience and it reminds consumers to 'shop small' all year round."

'Small Business Saturday' isn't the only day created to counteract the big-box retail mentality. #GivingTuesday, a national day dedicated to doing good deeds and encouraging others to do the same, was created in 2012. The idea was for a day of giving coming on the heels of the big retail events of Black Friday and Cyber Monday. #GivingTuesday falls on Dec. 3 this year.

November 28, 2013

Howard Marks: "Markets Are Riskier Than At Any Time Since The Depths Of The 2008/9 Crisis"

In Feb 2007, Oaktree Capital's Howard Marks wrote 'The Race to the Bottom', providing a timely warning about the capital market behavior that ultimately led to the mortgage meltdown of 2007 and the crisis of 2008 as he worried about "carelessness-induced behavior." In the pre-crisis years, as described in his 2007 memo, the race to the bottom manifested itself in a number of ways, and as Marks notes, "now we’re seeing another upswing in risky behavior." Simply put, Marks warns, "when people start to posit that fundamentals don’t matter and momentum will carry the day, it’s an omen we must heed," adding that "the riskiest thing in the investment world is the belief that there’s no risk."

Excerpted from OakTree Capitals' Howards Marks most recent letter to investors:

Of all the cycles I write about, I feel the capital market cycle is among the most volatile, prone to some of the greatest extremes. It is also one of the most impactful for investors. In short, sometimes the credit window is open to anyone in search of capital (meaning dumb deals get done), and sometimes it slams shut (meaning even deserving companies can’t raise money).
The cycles I describe aren’t predictable as to timing or extent. However, their fluctuations absolutely can be counted on to recur, and that’s what matters to me. I think it’s also what Mark Twain had in mind when he said “History doesn’t repeat itself, but it does rhyme.” The details don’t repeat, but the rhyming patterns are extremely reliable.

Competing to Provide Capital

When the economy is doing well and companies’ profits are rising, people become increasingly comfortable making loans and investing in equity. As the environment becomes more salutary, lenders and investors enjoy gains. This makes them want to do more; gives them the capital to do it with; and makes them more aggressive. Since this happens to all of them at the same time, the competition to lend and invest becomes increasingly heated.

When investors and lenders want to make investments in greater quantity, I think it’s also inescapable that they become willing to accept lower quality. They don’t just provide more money on the same old terms; they also become willing – even eager – to do so on weaker terms. In fact, one way they strive to win the opportunity to put money to work is by doing increasingly dangerous things.

This behavior was the subject of The Race to the Bottom. In it I said to buy a painting in an auction, you have to be willing to pay the highest price. To buy a company, a share of stock or a building – or to make a loan – you also have to pay the highest price. And when the competition is heated, the bidding goes higher. This doesn’t always – or exclusively – result in a higher explicit price; for example, bonds rarely come to market at prices above par. Instead, paying the highest price may take the form of accepting a higher valuation parameter (e.g., a higher price/earnings ratio for a stock or a higher multiple of EBITDA for a buyout) or accepting a lower return (e.g., a lower yield for a bond or a lower capitalization rate for an office building).

Further, rather than paying more for the asset purchased, there are other ways for an investor or lender to get less for his money. This can come through tolerating a weaker deal structure or through an increase in risk. It’s primarily these latter elements – rather than securities merely getting pricier – with which this memo is concerned.

History Rhymes

In the pre-crisis years, as described in the 2007 memo, the race to the bottom manifested itself in a number of ways:
There was widespread acceptance of financial engineering techniques, some newly minted, such as derivatives creation, securitization, tranching and selling onward. These innovations resulted in the creation of such things as highly levered mortgage-backed securities, CDOs and CLOs (structured credit instruments offering tiered debt levels of varying riskiness); credit default swaps (enabling investors to place bets regarding the creditworthiness of debtors); and SPACs (Special Purpose Acquisition Companies, or blind-pool acquisition vehicles). Further, the development of derivatives, in particular, vastly increased the ease with which risk could be shouldered (often without a complete understanding) as well as the amount of risk that could be garnered per dollar of capital committed.

While not a novel development, there was an enormous upsurge in buyouts. These included the biggest deals ever; higher enterprise values as a multiple of cash flow; increased leverage ratios; and riskier, more cyclical target companies, such as semiconductor manufacturers.

There was widespread structural deterioration. Examples included covenant-lite loans carrying few or none of the protective terms prudent lenders look for, and PIK-toggle debt on which the obligors could elect to pay interest “in kind” with additional securities rather than cash.

Finally, there was simply a willingness to buy riskier securities. Examples here included large quantities of CCC-rated debt, as well as debt issued to finance dividend payments and stock buybacks. The last two increase a company’s leverage without adding any productive assets that can help service the new debt.
Toward the end, my 2007 memo included the following paragraph:
Today’s financial market conditions are easily summed up: There’s a global glut of liquidity, minimal interest in traditional investments, little apparent concern about risk, and skimpy prospective returns everywhere. Thus, as the price for accessing returns that are potentially adequate (but lower than those promised in the past), investors are readily accepting significant risk in the form of heightened leverage, untested derivatives and weak deal structures. The current cycle isn’t unusual in its form, only its extent. There’s little mystery about the ultimate outcome, in my opinion, but at this point in the cycle it’s the optimists who look best. (emphasis in the original)
Now we’re seeing another upswing in risky behavior. It began surprisingly soon after the crisis (see Warning Flags, May 2010), spurred on by central bank policies that depressed the return on safe investments. It has gathered steam ever since, but not to anywhere near the same degree as in 2006-07.
  • Wall Street has, thus far, been less creative in terms of financial engineering innovations. I can’t think of a single new “modern miracle” that’s been popularized since the crisis.
  • Likewise, derivatives are off the front page and seem to be created at a much slower pace. A full resumption of derivatives creation and other forms of financial innovation appears to be on hold pending clarification of the regulatory uncertainty surrounding acceptable activity for banks.
  • Buyout activity seems relatively subdued. In 2006-07, it seemed a buyout in the tens of billions was being announced every week; now they’re quite scarce. Many smaller deals are taking place, however, including a large number of “flips” from one buyout fund to another, and leverage ratios have moved back up toward the highs of the last cycle.
  • “Cov-lite” and PIK-toggle debt issuance is in full flower, as are triple-Cs, dividend recaps and stock buybacks.
It’s highly informative to assess how the other characteristics of 2007 enumerated above compare with conditions today:
  • global glut of liquidity – check
  • minimal interest in traditional investments – check (relatively little is expected today from Treasurys, high grade bonds or equities, encouraging investors to shift toward alternatives)
  • little apparent concern about risk – check
  • skimpy prospective returns everywhere – check
Risk tolerance and leverage haven’t returned to their pre-crisis highs in quantitative terms, but there’s no doubt in my mind that risk bearing is back in vogue.
Perhaps most tellingly, the November 19 Bloomberg story referenced above included the following observation from a strategist whom I’ll allow to go nameless: “The analysis at some point shifts from fundamentals to being purely based on the price action of the stock.” When people start to posit that fundamentals don’t matter and momentum will carry the day, it’s an omen we must heed.

While the extent is nowhere as dramatic as in 2006-07 – and the psychology behind it isn’t close to being as bullish or risk-blind – I certainly sense a significant increase in the acceptance of risk. The bottom line is that when risk aversion declines and the pursuit of return gathers steam, issuers can do things in the capital markets that are impossible in more prudent times.

Why Is Risk Bearing on the Rise, and What Are the Implications?

To set the scene for answering the above questions, I’m going to reiterate and pull together some observations from recent memos.

Psychologically and attitudinally, I don’t think the current capital market atmosphere bears much of a resemblance to that of 2006-07. Then I used words like “optimistic,” “ebullient” and “risk-oblivious” to describe the players. Returns on risky assets were running high, and a number of factors were cited as having eliminated risk:
  • The Fed was considered capable of restoring growth come what may.
  • A global “wall of liquidity” was coming toward us, derived from China’s and the oil producers’ excess reserves; it could be counted on to keep asset prices aloft.
  • The Wall Street miracles of securitization, tranching, selling onward and derivatives creation had “sliced and diced” risk so finely – and directed it where it could most readily be borne – that risk really didn’t require much thought.
In short, in those days, most people couldn’t imagine a way to lose money.

I believe most strongly that the riskiest thing in the investment world is the belief that there’s no risk. When that kind of sentiment prevails, investors will engage in otherwise-risky behavior. By doing so, they make the world a risky place. And that’s what happened in those pre-crisis years. When The New York Times asked a dozen people for articles about the cause of the crisis, I wrote one titled “Too Much Trust; Too Little Worry.” Certainly a dearth of fear and a resulting high degree of risk taking accurately characterize the pre-crisis environment. But that was then. It’s different today.

Today, unlike 2006-07, uncertainty is everywhere:
  • Will the rate of economic growth in the U.S. get back to its prior norm? Will unemployment fall to the old “structural” level?
  • Can America’s elected officials possibly reach agreement on long-term solutions to the problems of deficits and debt? Or will the national debt expand unchecked?
  • Will Europe improve in terms of GDP growth, competitiveness and fiscal governance? Will its leaders be able to reconcile the various nations’ opposing priorities?
  • Can Abenomics transform Japan’s economy from lethargy to dynamism? The policies appear on paper to be the right ones, but will they work?
  • Can China transition from a highly stimulated economy based on easy money, an excess of fixed investment and an overactive non-bank financial system, without producing a hard landing that keeps it from reaching its economic goals?
  • Can the emerging market economies prosper if demand from China and the developed world expands more slowly than in the past?
Looking at the world more thematically, a lot of questions surround the ability to manage economies and regulate growth:
  • Can low interest rates and high levels of money creation return economic growth rates to previous levels? (To date, the evidence is mixed.)
  • Can inflation be returned to a salutary level somewhat above that of today? Right now, insufficient inflation is the subject of complaints almost everywhere. Can the desired inflation rate be reinstated without going beyond, to undesirable levels?
  • Programs like Quantitative Easing are novel inventions. How much do we know about how to end them, and about what the effects of doing so will be? Will it prove possible to wind down the stimulus – the word du jour is “taper” – without jeopardizing today’s unsteady, non-dynamic recoveries? Can the central banks back off from interest rate suppression, bond buying and easy money policies without causing interest rates to rise enough to choke off growth?
  • How will governments reconcile the opposing goals of stimulating growth (lower taxes, increased spending) and reining in deficits (increased taxes, less spending)?
  • Will prosperous regions (e.g., Germany) continue to be willing to subsidize profligate and poorer ones (e.g., Spain and Portugal)?
As to investments:
  • When the Fed stops buying bonds, will interest rates rise a little or a lot? Does that mean bonds are unattractive?
  • Are U.S. stocks still attractive after having risen strongly over the last 18 months?
  • Ditto for real estate following its post-crash recovery?
  • Can private equity funds buy companies at attractive prices in an environment where few owners are motivated to sell?
As I’ve said before, most people are aware of these uncertainties. Unlike the smugness, complacency and obliviousness of the pre-crisis years, today few people are as confident as they used to be about their ability to predict the future, or as certain that it will be rosy. Nevertheless, many investors are accepting (or maybe pursuing) increased risk.

The reason, of course, is that they feel they have to. The actions of the central banks to lower interest rates to stimulate economies have made this a low-return world. This has caused investors to move out on the risk curve in pursuit of the returns they want or need. Investors who used to get 6% from Treasurys have turned to high yield bonds for such a return, and so forth.

Movement up the risk curve brings cash inflows to riskier markets. Those cash inflows increase demand, cause prices to rise, enhance short-term returns, and contribute to the pro-risk behavior described above. Through this process, the race to the bottom is renewed.

In short, it’s my belief that when investors take on added risks – whether because of increased optimism or because they’re coerced to do so (as now) – they often forget to apply the caution they should. That’s bad for them. But if we’re not cognizant of the implications, it can also be bad for the rest of us.

Where does investment risk come from? Not, in my view, primarily from companies, securities – pieces of paper – or institutions such as exchanges. No, in my view the greatest risk comes from prices that are too high relative to fundamentals. And how do prices get too high? Mainly because the actions of market participants take them there.

Among the many pendulums that swing in the investments world – such as between fear and greed, and between depression and euphoria – one of the most important is the swing between risk aversion and risk tolerance.

Risk aversion is the essential element in sane markets. People are supposed to prefer safety over uncertainty, all other things being equal. When investors are sufficiently risk averse, they’ll (a) approach risky investments with caution and skepticism, (b) perform thorough due diligence, incorporating conservative assumptions, and (c) demand healthy incremental return as compensation for accepting incremental risk. This sort of behavior makes the market a relatively safe place.

But when investors drop their risk aversion and become risk-tolerant instead, they turn bold and trusting, fail to do as much due diligence, base their analysis on aggressive assumptions, and forget to demand adequate risk premiums as a reward for bearing increased risk. The result is a more dangerous world where asset prices are higher, prospective returns are lower, risk is elevated, the quality and safety of new issues deteriorates, and the premium for bearing risk is insufficient.

It’s one of my first principles that we never know where we’re going – given the unreliability of macro forecasting – but we ought to know where we are. “Where we are” means what the temperature of the market is: Are investors risk-averse or risk-tolerant? Are they behaving cautiously or aggressively? And thus is the market a safe place or a risky one?

Certainly risk tolerance has been increasing of late; high returns on risky assets have encouraged more of the same; and the markets are becoming more heated. The bottom line varies from sector to sector, but I have no doubt that markets are riskier than at any other time since the depths of the crisis in late 2008 (for credit) or early 2009 (for equities), and they are becoming more so.
However, Marks has a silver lining,
No, I don’t think it’s time to bail out of the markets. Prices and valuation parameters are higher than they were a few years ago, and riskier behavior is observed. But what matters is the degree, and I don’t think it has reached the danger zone yet.

Over the last 2-3 years, my motto for Oaktree has been consistent: “move forward, but with caution."

November 27, 2013

China Is On A Debt Binge And A Buying Spree Unlike Anything The World Has Ever Seen Before

When it comes to reckless money creation, it turns out that China is the king.  Over the past five years, Chinese bank assets have grown from about 9 trillion dollars to more than 24 trillion dollars.  This has been fueled by the greatest private debt binge that the world has ever seen.  According to a recent World Bank report, the level of private domestic debt in China has grown from about 9 trillion dollars in 2008 to more than 23 trillion dollars today.  In other words, in just five years the amount of money that has been loaned out by banks in China is roughly equivalent to the amount of debt that the U.S. government has accumulated since the end of the Reagan administration.  And Chinese bank assets now absolutely dwarf the assets of the U.S. Federal Reserve, the European Central Bank, the Bank of Japan and the Bank of England combined.  You can see an amazing chart which shows this right here.  A lot of this "hot money" has been flowing out of China and into U.S. companies, U.S. stocks and U.S. real estate.  Unfortunately for China (and for the rest of us), there are lots of signs that the gigantic debt bubble in China is about to burst, and when that does happen the entire world is going to feel the pain.

It was Zero Hedge that initially broke this story.  Over the past several years, most of the focus has been on the reckless money printing that the Federal Reserve has been doing, but the truth is that China has been far more reckless...
You read that right: in the past five years the total assets on US bank books have risen by a paltry $2.1 trillion while over the same period, Chinese bank assets have exploded by an unprecedented $15.4 trillion hitting a gargantuan CNY147 trillion or an epic $24 trillion - some two and a half times the GDP of China! 

 Putting the rate of change in perspective, while the Fed was actively pumping $85 billion per month into US banks for a total of $1 trillion each year, in just the trailing 12 months ended September 30, Chinese bank assets grew by a mind-blowing $3.6 trillion!
I was curious to see what all of this debt creation was doing to the money supply in China.  So I looked it up, and I discovered that M2 in China has grown by about 1000% since 1999...

So what has China been doing with all of that money?
Well, they have been on a buying spree unlike anything the world has ever seen before.  For example, according to Reuters China has essentially bought the entire oil industry of Ecuador...
China's aggressive quest for foreign oil has reached a new milestone, according to records reviewed by Reuters: near monopoly control of crude exports from an OPEC nation, Ecuador.
Last November, Marco Calvopiña, the general manager of Ecuador's state oil company PetroEcuador, was dispatched to China to help secure $2 billion in financing for his government. Negotiations, which included committing to sell millions of barrels of Ecuador's oil to Chinese state-run firms through 2020, dragged on for days.
And the Chinese have been doing lots of shopping in the United States as well.  The following is an excerpt from a recent CNBC article entitled "Chinese buying up California housing"...
At a brand new housing development in Irvine, Calif., some of America's largest home builders are back at work after a crippling housing crash. Lennar, Pulte, K Hovnanian, Ryland to name a few. It's a rebirth for U.S. construction, but the customers are largely Chinese. 
"They see the market here still has room for appreciation," said Irvine-area real estate agent Kinney Yong, of RE/MAX Premier Realty. "What's driving them over here is that they have this cash, and they want to park it somewhere or invest somewhere."
Apparently a lot of these buyers have so much cash that they are willing to outbid anyone if they like the house...
The homes range from the mid-$700,000s to well over $1 million. Cash is king, and there is a seemingly limitless amount. 
"The price doesn't matter, 800,000, 1 million, 1.5. If they like it they will purchase it," said Helen Zhang of Tarbell Realtors.
So when you hear that housing prices are "going up", you might want to double check the numbers.  Much of this is being caused by foreign buyers that are gobbling up properties in certain "hot" markets.

We see this happening on the east coast as well.  In fact, a Chinese firm recently purchased one of the most important landmarks in New York City...
Chinese conglomerate Fosun International Ltd. (0656.HK) will buy office building One Chase Manhattan Plaza for $725 million, adding to a growing list of property purchases by Chinese buyers in New York city. 
The Hong Kong-listed firm said it will buy the property from JP Morgan Chase Bank, according to a release on the Hong Kong Stock Exchange website. 
Chinese firms, in particular local developers, have looked overseas to diversify their property holdings as the economy at home slows. Chinese individuals also have been investing in property abroad amid tight policy measures in the mainland residential market. 
Earlier this month, Chinese state-owned developer Greenland Holdings Group agreed to buy a 70% stake in an apartment project next to the Barclays Center in Brooklyn, N.Y., in what is the largest commercial-real-estate development in the U.S. to get direct backing from a Chinese firm.
And in a previous article, I discussed how the Chinese have just bought up the largest pork producer in the entire country...
Just think about what the Smithfield Foods acquisition alone will mean.  Smithfield Foods is the largest pork producer and processor in the world.  It has facilities in 26 U.S. states and it employs tens of thousands of Americans.  It directly owns 460 farms and has contracts with approximately 2,100 others.  But now a Chinese company has bought it for $4.7 billion, and that means that the Chinese will now be the most important employer in dozens of rural communities all over America.
For many more examples of how the Chinese are gobbling up companies, real estate and natural resources all over the United States, please see my previous article entitled "Meet Your New Boss: Buying Large Employers Will Enable China To Dominate 1000s Of U.S. Communities".

But more than anything else, the Chinese seem particularly interested in acquiring real money.
And by that, I mean gold and silver.

In recent years, the Chinese have been buying up thousands of tons of gold at very depressed prices.  Meanwhile, the western world has been unloading gold at a staggering pace.  By the time this is all over, the western world is going to end up bitterly regretting this massive transfer of real wealth.

Unfortunately for the Chinese, it appears that the unsustainable credit bubble that they have created is starting to burst.  According to Bloomberg, the amount of bad loans that the five largest banks in China wrote off during the first half of this year was three times larger than last year...
China’s biggest banks are already affected, tripling the amount of bad loans they wrote off in the first half of this year and cleaning up their books ahead of what may be a fresh wave of defaults. Industrial & Commercial Bank of China Ltd. and its four largest competitors expunged 22.1 billion yuan of debt that couldn’t be collected through June, up from 7.65 billion yuan a year earlier, regulatory filings show.
And Goldman Sachs is projecting that China may be facing 3 trillion dollars in credit losses as this bubble implodes...
Interest owed by borrowers rose to an estimated 12.5 percent of China’s economy from 7 percent in 2008, Fitch Ratings estimated in September. By the end of 2017, it may climb to as much as 22 percent and “ultimately overwhelm borrowers.” 
Meanwhile, China’s total credit will be pushed to almost 250 percent of gross domestic product by then, almost double the 130 percent of 2008, according to Fitch. 
The nation might face credit losses of as much as $3 trillion as defaults ensue from the expansion of the past four years, particularly by non-bank lenders such as trusts, exceeding that seen prior to other credit crises, Goldman Sachs Group Inc. estimated in August.
The Chinese are trying to get this debt spiral under control by tightening the money supply.  That may sound wise, but the truth is that it is going to create a substantial credit crunch and the entire globe will end up sharing in the pain...
Yields on Chinese government debt have soared to their highest levels in nearly nine years amid Beijing's relentless drive to tighten the monetary spigots in the world's second-largest economy. 
The higher yields on government debt have pushed up borrowing costs broadly, creating obstacles for companies and government agencies looking to tap bond markets. Several Chinese development banks, which have mandates to encourage growth through targeted investments, have had to either scale back borrowing plans or postpone bond sales.
This could ultimately be a much bigger story than whether or not the Fed decides to "taper" or not.

It has been the Chinese that have been the greatest source of fresh liquidity since the last financial crisis, and now it appears that source of liquidity is tightening up.

So as the flow of "hot money" out of China starts to slow down, what is that going to mean for the rest of the planet?

And when you consider this in conjunction with the fact that China has just announced that it is going to stop stockpiling U.S. dollars, it becomes clear that we have reached a major turning point in the financial world.

2014 is shaping up to be a very interesting year, and nobody is quite sure what is going to happen next.


November 26, 2013

Mario Seccareccia: Larry Summers, Secular Stagnation, and the Crisis of the New Consensus Model

Over a week ago Lawrence Summers stunned the world of economics by the remarks he made at the IMF‘s 14th Annual Research Conference on the Economic Crisis, where he pronounced the dreaded “SS” words: “secular stagnation”. His comments seem to have shocked much of the mainstream that still believes that the economy will return to the pre-2008 potential growth. Indeed, he surprised many by stating that, after effectively preventing the complete collapse of the financial system in 2008 through the government bailout and liquidity measures undertaken by the US Fed, there is still no real evidence that there will be a restoration of “normal” growth and that the “new normal” may well be secular stagnation. According to Summers, the principal culprit is the simple fact that nominal interest rates cannot fall below zero and that this zero lower bound will remain “a chronic and systemic inhibitor” of growth. While agreeing that Western economies are headed towards long-term stagnation, in this commentary I would like to question the analysis of the cause of this problem, as well as the solution being offered to address it.

In listening to his speech, it is obvious how many economists, including not only Summers but also Paul Krugman, are still wedded to variants of the now not-so-new “New Consensus” framework that was so popular among economists before the financial crisis. Being in some ways a natural extension of the original Hicksian IS-LM model along the lines, for instance that David Romer reformulated over a decade ago, the New Consensus macro model of the economy suggested that the economy can get temporarily stuck in some sort of “liquidity trap”, a concept that Keynes never really made much of. One must say that the notion that the economy can remain trapped in a stagnant state because interest rates cannot fall below zero is hardly a new idea. Readers well versed in the history of economic thought would know that there had been much debate over this issue, especially during the 1940s, after the publication of Keynes’s General Theory. 

The problem raised by Summers is perhaps best described in a famous article published in the American Economic Review by Don Patinkin in 1948 in which he adopted the old Wicksellian loanable funds model with the usual depiction of the neoclassical Investment/Saving relations. In this account, the investment relation is presumed downward sloping and the saving relation is upward sloping vis-à-vis the rate of interest. Patinkin pointed out that, in times of crisis, these investment/saving curves could cross only at negative interest rates. However, because of the zero lower bound in the nominal interest rate, the economy would find itself stuck in a non-market-clearing disequilibrium state, dubbed a liquidity trap. However, unlike Patinkin who sought a solution in terms of the workings of the real balance (or “Pigou”) effect, in which flexible wages and prices eventually generate deflation, which then shifts the saving function in such a way that eliminates the disequilibrium gap (as real balances rise), no one nowadays believes in the significance of the real balance effect in a world of an essentially endogenous “inside” money to which the New Consensus model formally subscribes. In terms of Patinkin’s vocabulary, “inside” money is simply private money that is created within the commercial banking system and appears in the economy in the form of bank (deposit) liability, while “outside” money was government money, that is to say, central bank-issued money, constituting the country’s monetary base. As Michal Kalecki had noted also in the 1940s, without the assumption of significant “outside” money, the real balance effect cannot work, leaving supporters of the New Consensus nothing to resort to that could bring the system back to “normal” growth. 

Hence, the explanation offered by Summers, Krugman et al., is nothing more than what neoclassical economists were saying over half a century ago: because of the crisis, the expectations-determined Wicksellian “natural” rate remains persistently negative, but the money rate has a zero lower bound, which implies that the economy remains stuck in a Patinkinesque disequilibrium state. Indeed, one wonders what the controversy is really all about since, except for the use of the “secular stagnation” words, which, by the way, had been used by Great Depression economists, such as Alvin Hansen during the late 1930s, there is nothing new that Summers is saying. This is all déjà vu not only from before the financial crisis, but actually ever since the 1940s! Our economics profession appears to be stuck in a time warp or has succumbed to some sort of collective amnesia by continuing to repeat the same old controversies!

Within this neoclassical theoretical box, there is only one solution offered to move the economy out of secular stagnation. One must boost the Wicksellian “natural rate” by strengthening expectations of return. More precisely, the solution offered by both Summers and Krugman is to promote asset bubbles. Hence, instead of aborting the bubble that will ineluctably end in a crisis, we are told that we should be sustaining these bubbles and keeping them aloft. It is truly ironic that, while these economists would probably never recommend wage inflation (because it would supposedly cause unemployment), they have no problem in promoting sustained asset price inflation that would redistribute wealth towards those who already own too much of it! But even if one wanted seriously to contemplate this proposal, regardless of its equity considerations, how would you do it? Monetary policy has already been doing all that it can to sustain asset inflation via reducing interest rates and keeping them extremely low, and, as Summers and his allies recognize, the monetary authorities are constrained by the zero lower bound. 

If this liquidity trap is really a problem and if they wish to be consistent with their loanable funds theory and remove the disequilibrium gap, why does the central bank not pay a premium to any bona fide borrower at banking institutions so that the effective real borrowing rates become negative even with a positive inflation rate? Instead of charging positive interest rates, borrowers would be receiving an interest transfer for borrowing until the bank rate reaches or falls even below the negative real natural rate. Such a policy of negative real interest rates would certainly be consistent with their hybrid Wicksellian framework and this type of policy could well trigger an asset bubble. However, in reality, instead of being a monetary policy, this would actually turn out to be a very peculiar, and rather perverse, type of fiscal policy measure. Surely one could think of much better measures than subsidizing across-the-board bank borrowing just because it would be consistent with their theory. 

As I have argued elsewhere, if Summers et al., are really worried about secular stagnation and truly want to kick-start the economy, what is needed is an expansionary Keynesian fiscal policy of massive public investment, not as a temporary measure (as partly happened during the financial crisis with the disjointed implementation of fiscal stimulus packages internationally), but as a long-term measure that would sustain aggregate demand in the long term. This measure will support not only employment growth in more well-paying and highly skilled jobs, but also long-term productivity growth, thereby encouraging private investment as well. To a large extent, this is what happened during the early postwar period that produced a virtuous cycle of growth, now remembered as the “Golden Age” of western capitalism. Instead of secular stagnation, with the precise political commitment and policy mix in favor of activist fiscal policy cum public investment, we could actually be looking forward to a world of strong expansion and a truly full employment environment that had largely characterized much of the early postwar era. 

It is time to abandon that outmoded New Consensus model that seems to be keeping even some of the brightest in the profession stuck in an intellectual cul-de-sac. The real inhibitor of growth is not the zero lower bound, but the lack of desire to venture outside the neoclassical box. This lack of desire to pursue new fiscal policy measures that would commit government to long-term spending and full employment is not because the latter is not a viable alternative, but perhaps because, as Kalecki had long surmised also in the 1940s, it is the political fears of the wealthy who would benefit from asset booms that overrides good common sense and prevents the enhancement of the welfare of the majority who, under the existing policies, are faced with the continued spectre of long-term austerity and secular stagnation.


November 25, 2013

Banks Warn Fed They May Have To Start Charging Depositors

The Fed's Catch 22 just got catchier. While most attention in the recently released FOMC minutes fell on the return of the taper as a possibility even as soon as December (making the November payrolls report the most important ever, ever, until the next one at least), a less discussed issue was the Fed's comment that it would consider lowering the Interest on Excess Reserves to zero as a means to offset the implied tightening that would result from the reduction in the monthly flow once QE entered its terminal phase (for however briefly before the plunge in the S&P led to the Untaper). After all, the Fed's policy book goes, if IOER is raised to tighten conditions, easing it to zero, or negative, should offset "tightening financial conditions", right? Wrong. As the FT reports leading US banks have warned the Fed that should it lower IOER, they would be forced to start charging depositors.

In other words, just like Europe is already toying with the idea of NIRP (and has been for over a year, if still mostly in the rheotrical and market rumor phase), so the Fed's IOER cut would also result in a negative rate on deposits which the FT tongue-in-cheekly summarizes "depositors already have to cope with near-zero interest rates, but paying just to leave money in the bank would be highly unusual and unwelcome for companies and households."

If cutting IOER was as much of an easing move as the Fed believes, banks should be delighted - after all, according to the Fed's guidelines it would mean that the return on their investments (recall that all US banks slowly but surely became glorified, TBTF prop trading hedge funds since Glass Steagall was repealed, and why the Volcker Rule implementation is virtually guaranteed to never happen) would increase. And yet, they are not:
Executives at two of the top five US banks said a cut in the 0.25 per cent rate of interest on the $2.4tn in reserves they hold at the Fed would lead them to pass on the cost to depositors.

Banks say they may have to charge because taking in deposits is not free: they have to pay premiums of a few basis points to a US government insurance programme.

“Right now you can at least break even from a revenue perspective,” said one executive, adding that a rate cut by the Fed “would turn it into negative revenue – banks would be disincentivised to take deposits and potentially charge for them”.

Other bankers said that a move to negative rates would not only trim margins but could backfire for banks and the system as a whole, as it would incentivise treasury managers to find higher-yielding, riskier assets.

“It’s not as if we are suddenly going to start lending to [small and medium-sized enterprises],” said one. “There really isn’t the level of demand, so the danger is that banks are pushed into riskier assets to find yield.”

All of the above is BS: lending has never been a concern for the Fed because if it was, then one could scrap QE right now as an absolute faiure. Recall that as we showed recently, the total amount of loans and leases in commercial US banks has been unchanged since Lehman, with the only rise in deposits coming thanks to the fungible liquidity injected by the Fed.

Furthermore, contrary to what the hypocrite banker said that "the danger is that banks are pushed into riskier assets to find yield”, banks are already in the riskiest assets: just look at what JPM was doing with its hundreds of billions in excess deposits, which originated as Fed reserves on its books - we explained the process of how the Fed's reserves are used to push the market higher most recently in "What Shadow Banking Can Tell Us About The Fed's "Exit-Path" Dead End."

What the real danger is, is that once the Fed lowers IOER and there is a massive outflow of deposits, that banks which have used the excess deposits as initial margin and collateral on marginable securities to chase risk to record highs (as JPM's CIO explicitly and undisputedly did) that there would be an avalanche of selling once the negative rate deposit outflow tsunami hit.

Needless to say, the only offset would be if the proceeds from the deposits outflows were used to invest in stocks instead of staying inert in some mattress or, worse (if only from the Fed's point of view) purchase inert assets like gold or Bitcoin.

Which brings us back to the first sentence and the Fed's now massive Catch 22: on one hand, shoud the Fed taper, rates will surge and stocks will once again plunge, as they did, in early summer, just to teach the evil, non-appeasing Fed a lesson.

On the other hand, should the Fed cut IOER as a standalone move or concurrently to offset the tapering pain, banks will crush depositors by cutting rates, depositors will pull their money from banks en masse, and banks will have no choice but to close on a record levered $2.2 trillion in margined risk position.


November 22, 2013

China Announces That It Is Going To Stop Stockpiling U.S. Dollars

China just dropped an absolute bombshell, but it was almost entirely ignored by the mainstream media in the United States.  The central bank of China has decided that it is "no longer in China’s favor to accumulate foreign-exchange reserves".  During the third quarter of 2013, China's foreign-exchange reserves were valued at approximately $3.66 trillion.  And of course the biggest chunk of that was made up of U.S. dollars.  For years, China has been accumulating dollars and working hard to keep the value of the dollar up and the value of the yuan down.  One of the goals has been to make Chinese products less expensive in the international marketplace.  But now China has announced that the time has come for it to stop stockpiling U.S. dollars.  And if that does indeed turn out to be the case, than many U.S. analysts are suggesting that China could also soon stop buying any more U.S. debt.  Needless to say, all of this would be very bad for the United States.

For years, China has been systematically propping up the value of the U.S. dollar and keeping the value of the yuan artificially low.  This has resulted in a massive flood of super cheap products from across the Pacific that U.S. consumers have been eagerly gobbling up.

For example, have you ever gone into a dollar store and wondered how anyone could possibly make a profit by making those products and selling them for just one dollar?

Well, the truth is that when you flip those products over you will find that almost all of them have been made outside of the United States.  In fact, the words "made in China" are probably the most common words in your entire household if you are anything like the typical American.

Thanks to the massively unbalanced trade that we have had with China, tens of thousands of our businesses, millions of our jobs and trillions of our dollars have left this country and gone over to China.

And now China has apparently decided that there is not much gutting of our economy left to do and that it is time to let the dollar collapse.  As I mentioned above, China has announced that it is going to stop stockpiling foreign-exchange reserves...
The People’s Bank of China said the country does not benefit any more from increases in its foreign-currency holdings, adding to signs policy makers will rein in dollar purchases that limit the yuan’s appreciation. 
“It’s no longer in China’s favor to accumulate foreign-exchange reserves,” Yi Gang, a deputy governor at the central bank, said in a speech organized by China Economists 50 Forum at Tsinghua University yesterday. The monetary authority will “basically” end normal intervention in the currency market and broaden the yuan’s daily trading range, Governor Zhou Xiaochuan wrote in an article in a guidebook explaining reforms outlined last week following a Communist Party meeting. Neither Yi nor Zhou gave a timeframe for any changes.
It isn't going to happen overnight, but the value of the U.S. dollar is going to start to go down, and all of that cheap stuff that you are used to buying at Wal-Mart and the dollar store is going to become a lot more expensive.

But of even more importance is what this latest move by China could mean for U.S. government debt.  As most Americans have heard, we are heavily dependent on foreign nations such as China lending us money.  Right now, China owns nearly 1.3 trillion dollars of our debt.  Unfortunately, as CNBC is noting, if China is going to quit stockpiling our dollars than it is likely that they will stop stockpiling our debt as well...
Analysts see this as the PBoC hinting that it will let its currency fluctuate, without intervention, thus negating the need for holding large reserves of the dollar. And if the dollar is no longer needed, then it could look to curb its purchases of dollar-denominated assets like U.S. Treasurys. 
"If they are looking to reduce these purchases going forward then, yes, you'd have to look at who the marginal buyer would be," Richard McGuire, a senior rate strategist at Rabobank told CNBC in an interview. 
"Together, with the Federal Reserve tapering its bond purchases, it has the potential to add to the bearish long-term outlook on U.S. Treasurys."
So who is going to buy all of our debt?

That is a very good question.

If the Federal Reserve starts tapering bond purchases and China quits buying our debt, who is going to fill the void?

If there is significantly less demand for government bonds, that will cause interest rates to rise dramatically.  And if interest rates rise dramatically from where they are now, that will set off the kind of nightmare scenario that I keep talking about.

In a previous article entitled "How China Can Cause The Death Of The Dollar And The Entire U.S. Financial System", I described how China could single-handedly cause immense devastation to the U.S. economy.

China accounts for more global trade that anyone else does, and they also own more of our debt than any other nation does.  If China starts dumping our dollars and our debt, much of the rest of the planet would likely follow suit and we would be in for a world of hurt.

And just this week there was another major announcement which indicates that China is getting ready to make a major move against the U.S. dollar.  According to Reuters, crude oil futures may soon be priced in yuan on the Shanghai Futures Exchange...
The Shanghai Futures Exchange (SHFE) may price its crude oil futures contract in yuan and use medium sour crude as its benchmark, its chairman said on Thursday, adding that the bourse is speeding up preparatory work to secure regulatory approvals. 
China, which overtook the United States as the world's top oil importer in September, hopes the contract will become a benchmark in Asia and has said it would allow foreign investors to trade in the contract without setting up a local subsidiary.
If that actually happens, that will be absolutely huge.

China is the number one importer of oil in the world, and it was only a matter of time before they started to openly challenge the petrodollar.

But even I didn't think that we would see anything like this so quickly.

The world is changing, and most Americans have absolutely no idea what this is going to mean for them.  As demand for the U.S. dollar and U.S. debt goes down, the things that we buy at the store will cost a lot more, our standard of living will go down and it will become a lot more expensive for everyone (including the U.S. government) to borrow money.

Unfortunately, there isn't much that can be done about any of this at this point.  When it comes to economics, China has been playing chess while the United States has been playing checkers.  And now decades of very, very foolish decisions are starting to catch up with us.

The false prosperity that most Americans are enjoying today will soon start disappearing, and most of them will have no idea why it is happening.

The years ahead are going to be very challenging, and so I hope that you are getting ready for them.


November 21, 2013

Let's Hear It For The Volcker Rule: Goldman Loses Over $1 Billion In FX Trade Gone Bad In Q3

With such a spectacular source of impeccably timed, if always wrong, FX trading recommendations as Tom Stolper, who has cost his muppets clients tens of thousands of pips in currency losses in the past 5 years, and thus generated the inverse amount in profits for Goldman's trading desks, the last thing we expected to learn was that Goldman's currency traders, who by definition takes the opposite side of its Kermitted clients - because prop trading is now long forbidden, (right Volcker rule?) and any prop trading blow up in the aftermath of the London Whale fiasco is not only a humiliation but probably illegal - had lost massive amounts on an FX trade gone wrong. Which is precisely what happened.

According to the WSJ, "a complex bet in the foreign-exchange market backfired on Goldman Sachs Group Inc. during the third quarter, people familiar with the matter said, contributing to a revenue slump that prompted senior executives to defend the firm's trading strategy. Revenue in Goldman's currency-trading business fell sharply in the third quarter from the second. Within that group, the firm's foreign-exchange options desk posted a net loss during the period, the people said." The trade in question: "A structured options trade tied to the U.S. dollar and Japanese yen steepened the decline, according to the people. It isn't clear how large the trade was or how long it was in place."

Curious: does this perhaps explain why just after Q3 ended, on October 3, Goldman's head FX strategist Tom Stolper came out with an FX trade in which Goldman "recommend going short $/JPY at current levels of about 97.30 for a tactical target of 94.00, with a stop on a close above 98.80." Obviously, we promptly took the inverse side: "The only question we have: will the length of time before Stolper is once again Stolpered out be measured in days, or hours?" Naturally, Stolper was stolpered stopped out in a few short days, leading to a few hundred pips in profits for those who faded Stolper... and yet we wonder: was Goldman merely trying to offload its USDJPY exposure gone wrong on its clients in the days after the "trade tied to the USD and the JPY steepened the decline"? If so, that would be even more illegal than Goldman pretending to be complying with the Volcker Rule.

As for the size of the total loss we had a hint that something had gone very wrong when we reported Goldman's Q3 earnings broken down by group. Back then we said "the only bright light were Investment banking revenues which were $1.7 billion, unchanged from a year ago, if down 25% from Q2. It's all downhill from here, because the all important Fixed Income, Currency and Commodities group printed just $1.247 billion, down a whopping 44% Y/Y, well below expectations." Indicatively, Goldman had made $2.5 billion in FICC the prior quarter, and $2.2 billion a year prior. Obviously something bad had happened.

We now know that that something was an FX trading crashing and burning in Goldman's face. Reuters added:
Goldman Sachs Group Inc lost more than $1 billion on currency trades during the third quarter, recent regulatory filings show, offering some insight into why the firm, considered one of Wall Street's most savvy traders, reported its worst quarter in a key trading unit since the financial crisis.

Goldman's currency-trading problems came from the way the bank had positioned itself in emerging markets, two sources familiar with the matter said.

Specific positions could not be learned, but the bank was anticipating that the Federal Reserve would begin winding down its monetary-easing programs, the sources said. When the Fed unexpectedly announced that it would keep its massive bond-buying program in place, Goldman was left with positions that, "absolutely got annihilated," as one person familiar with the matter put it.
Since as the WSJ first reported the position involved the USDJPY, which first spiked then plunged following the Fed's non-taper announcement, and kept sliding until it hit 96.50 in early October just when Stolper suggested putting on the short USDJPY trade (when USDJPY soared), it seems that at least this one time both Goldman's prop traders and the trade recommended by Stolper were on the same side.

Which resulted in a $1+ billion loss for Goldman.

Congratulations Tom: that in itself is worth ignoring that Goldman completely made a mockery out of any and all Volcker prop-trading prohibitions. In fact, keep it up and keep those trade recommendations coming.