November 28, 2014

Mainstream Media Negativity On Swiss Gold Referendum Conceals the Truth

Gold prices may surge if Swiss vote on reserves passes ... Global gold prices may surge in the coming week if Swiss voters approve a controversial measure that would force their country's central bank to keep at least a fifth of its assets in gold. If the referendum Sunday passes and the Swiss government is forced to start beefing up its reserves, the price of gold could jump to more than $1,350 an ounce — an increase of 18%, Bank of America predicts ... – USA Today 

Dominant Social Theme: This referendum won't pass. The Swiss are too smart to approve it. 

Free-Market Analysis: USA Today has weighed in on the upcoming gold referendum in Switzerland with a predictable anti-gold article. 

In fact, the anti-gold tone when it comes to the mainstream media is overwhelming. Central bankers hate the yellow metal because it restricts their freedom to manipulate fiat currency as they choose – and the media reflects this prejudice. 

There are many reasons to believe the plight of gold is not so grave as it is being made out to be, but you wouldn't know that from the USA Today article, or other recent ones in the mainstream media. 

The paper reminds us that the latest poll, now a week old, by Swiss Television and the GFS Institute showed 38% in favor of the referendum, 47% opposed and 15% undecided. These numbers are actually lower than those in previous polls. ZeroHedge provides a more detailed breakout, as follows: 

The poll shows that in Italian speaking areas, the yes vote was actually ahead with 47% in favour, versus 28% against. In the German speaking region, the results were 40% yes versus 50% no, while in the French speaking region it was 29% yes versus 41% no. The 'Undecided' were a low 10% in the relatively decisive German speaking region, 24% in the Italian region, and a significant 30% in the relatively indecisive French speaking region. 

Importantly, support for the gold referendum diminished after the Swiss National Bank made statements indicating that holding so much gold with no ability to sell it would severely limit the flexibility of monetary policy. 

Here's more from the article:

 ... Investors apparently are not too bullish about the referendum passing, as gold prices have risen less than 5% in the last few weeks. 

Still, Sunday's vote is setting off alarm bells within the Swiss parliament and among business groups. They argue that forcing the central bank to stockpile gold it cannot sell would diminish the bank's ability to set monetary policy and react quickly to changes in the market. In recent years, for instance, the central bank had printed 400 billion Swiss francs ($412 billion), deflating its value against the euro and capping the exchange rate below 1.20 francs ($1.24) to the euro. 

The central bank took that step to protect Switzerland's economy from the European debt crisis and boost its exports to the European Union, but the Swiss People's Party has been critical of the move. "To tie the franc to a weak currency like the euro and a weak economic area like the Eurozone is a recipe for disaster," the party claims on its website. 

Backing up the currency with increased gold reserves, the group argues, would keep the franc strong and the Swiss economy impervious to global financial crises. 

Some analysts counter that a law requiring increased and unmovable gold reserves might have a negative effect on the currency market and the economy in general. "The (central bank) will think twice about buying unlimited amounts of foreign currencies in order to keep its cap for the euro at 1.20 francs," says Teodoro Cocca, professor at Swiss Finance Institute in Zurich. "Most likely, the cap would have to be lifted, the franc will appreciate, and that would be a burden for Swiss exports." 

Always, we learn that a strong currency is a hindrance to national economic health. In fact, this doesn't seem to make a lot of sense. A strong currency would attract investment and that in turn would create additional industry for the country in question. 

Could the additional industry sell goods and services abroad? Probably so. The market itself would adapt to higher prices and strategies to lower those prices would be pursued. The net effect of a strong currency might be increased by industrial might and prosperity not national penury. 

These are perhaps academic arguments, but the reality is that at some point central bankers may have to get used to a resurgence in the yellow metal, given continued demand. 

In fact, the negativity of the mainstream media is concealing some interesting developments. Over at Sprott Money, as posted at ZeroHedge, we find the following article, entitled, "Global Gold Demand Will Overwhelm the Manipulators." 

The article makes the startling point that the European Central Bank may become a net buyer of gold: 

Western central banks know that they need to massively increase inflation. This is the only way in which they can alleviate the huge debt levels that have been accumulated by their misguided wars and spending. 

To help assist in increasing this inflation the ECB has indicated that it may begin acquiring gold, shares and ETF's. This news comes as a shock to many, given the ECB's previous resistance to all things gold and the fact that their fiat currencies are in direct competition with the yellow metal. 

The article also summarizes current gold demand worldwide, something we have reported on several occasions. 

No longer are people fooled by the paper price of precious metals. Premiums have remained relatively high through this price correction and demand has been so intense, that the US Mint was forced to cease sales of their ever-popular Silver American Eagles. 

Nation states, such as China and Russia are well known for their affinity to gold and have also continued their accumulation of precious metals. Russia, which officially became the fifth largest holder of gold recently, announced that it has once again increased their gold reserves by another 150 additional tonnes in 2014. An increase of 8.4% year over year. 

The demand from China, Russia and India are well known, but now a previous seller of gold products could be entering the arena. The ECB, a long time disbeliever in precious metals is currently battling stubbornly low inflation and may be forced into a very unconventional strategy. 

The current price of the dollar against gold is a mystery considering worldwide demand – one that has given rise to predictable charges of manipulation. Price anomalies are rife; demand seems to exceed supply despite a surging dollar price against gold. Even the Sprott article doesn't mention the inability of German officials to repatriate gold from US safekeeping. 

When the Swiss referendum doesn't pass – and it seems likely not to – we will no doubt be treated to more negativity regarding gold and its place in the modern economy. But as the Sprott article points out, gold remains a historical and established international money. 

The idea that gold and silver, too, are outdated barbaric metals has already proven to be questionable, given gold's ascension to US$2,000 an ounce not so long ago. But there are so many stresses and strains on the current global fiat system that we wonder along with Sprott how long the dollar can be propped up against either metal. 

Sooner or later, the value of these metals will see another resurgence. Of course, we don't know when that will be. But we do know the mainstream media is not telling the truth about gold's role in the world, nor about the demand for gold and silver worldwide. 

Conclusion The failure of the Swiss referendum may constitute another opportunity to bash gold and "gold bugs" but such observations will be facile ones. The truth is a good deal more powerful: Gold is a historical money and in all likelihood will remain so, no matter endless negative reports in Western media. 


November 27, 2014

Presenting Bubbleology: The Science Of Bubble Money

On the 12th November 2014 - some 10 years after it was launched - lander module Philae which accompanied the Rosetta spacecraft touched down on Comet 67P/Churyumov-Gerasimenko (67P) to begin extra-terrestrial scientific observations. The on-board telemetry communicated back to Earth some 28 light-minutes away revealed that the lander had bounced twice off the surface of 67P. The first bounce may have lasted two hours and over 1 kilometre and is considered the largest space bounce in history which we would put it on a par with the incredible bounces in the US and Japanese stock markets this past month!

Back here on Earth Japanese monetary policy has similarly taken a giant leap forward for mankind by conducting its own scientific experiment. On the 31st October 2014 Bank of Japan Governor Kuroda-san implemented an addition to his ‘Qualitative & Quantitative Easing’ (QQE) policy begun a year ago. The surprise event was less the timing and magnitude but the clear brazen coordination of monetary and fiscal policy using the conduit of the Japanese Government Pension Fund to implement it. The QQE drove stock markets into a frenzied rally.

Central banks have been conducting a seemingly coordinated financial program of unconventional monetary policy – assuringly scientific in its nomenclature of QE and QQE – media commentators marvel at the boldness (stupidity) of policymakers ‘to go forth where no man has gone before’ and eradicate the spectre of debt deflation.

Policymakers have been studying and implementing ‘Bubbleology’ – the science of bubble money. The impact of this earthly science on both economies and financial markets has been truly dismal. It is clear it is creating a divergence between economic and financial reality.

Far from eradicating the perils of debt deflation it is clear this program has merely initiated more fiscal and private sector balance sheet irresponsibility, as both continue to lever up. The capital (‘near money’) allocation of such leverage has resulted in rising asset classes, primarily housing stock, equity and bonds where the pursuit of yield has ignored all credit risk sensibilities. All this has occurred at the expense of daily living standards and the misdirection of capital.

We are witnessing the continuation and completion of the financialization of our economies and markets which began at the instigation of governments and central bankers in the years leading up to the 2008 crisis. There is no attempt to foster sustainable capital and income through innovation and production which ultimately drives healthy employment. Rather financialization of asset classes driving elevated prices which creates an inequality of wealth, albeit illusionary wealth. Land, housing stock and excessive equity price growth in reality drains productivity away from entrepreneurship and the employment which enables sustainable taxable income for nations to run prudent fiscal surpluses.

We are in the butterfly vortex of a momentary illusion of ‘hyperinflated’ wealth - for the value of money is sinking rapidly - destroying the purchasing power of the global majority. Markets have a memory and from the first moment central banks expanded their balance sheets the flap of Lorenz’s wing has cast a shadow over financial and economic stability. In this HindeSight I endeavour to highlight where the echoes of monetary history are manifesting themselves in systemic risk across the globe.

The Delicious Science of Bubble Money

About 15 years ago I went on a three week stint to Tokyo to cover the overnight US Treasury trading seat at Greenwich NatWest. I remember many cultural delights about that trip, not least of all the clubs and hostess bars of Roppongi! But one of my abiding memories was Bubble Tea. I was addicted to it but other than the side-effects of a sugary rush it’s fair to say this was perhaps a less troublesome elixir for a young single gaijin and one with a rather large company expense account at that.

Bubble Tea, also known as 'pearl milk tea' actually originates from Taiwan. It is essentially a tea mix of your choice infused with rich creamer served cold with natural large, chewy tapioca balls which you suck up through a big fat straw. The term bubble is an anglicized derivation from the Chinese word 'boba' which itself refers to the 'large' tapioca balls or pearls.

Fast forward 15 years and whilst meandering around London I saw a bunch of neon Bubbleology signs. Turns out they are Bubble Tea shops and they practice the ‘science of bubble tea’ making. Imagine my joy. I have finally been reunited with my favourite beverage on my home soil.

In an era of serial financial bubble blowing I thought to myself how apt to use this name to refer to central bank money printing on account of its clear ability to create one asset bubble after another with rich infusions of money.

So Bubbleology – the new ‘delicious science of bubble money’ - looks to serve grateful market participants with rich creamy rushes of infused tea, intravenously administered through the conduits of repressed and fiscally dominated financial institutions.

Every central bank has its own set of magical ingredients. The BoJ administers a rich elixir of ‘Macha Bubble Money’ adding more creamer to every new infusion by which to keep the Pavlovian market salivating. The FED and BoE offer their own special potion of ‘English Breakfast Money’ superbly rich in its enunciation, crisp and firm on the pallet, whilst the PBOC offers up a soothing medication of ‘Oolong-some Bubble Money’. The ECB version, however, is somewhat more fruity and zesty in its consistency - more Tapioca ‘Money Balls’ than bubbles – well, at least for now.

Monetary Echoes, Memories & Markets

Greenspan was the maestro of bubble money science and presided over almost two decades of monetary bubble infusions in an attempt to save us from perceived threats of dastardly deflation. Except a decade ago the debt levels were trivial in comparison with what exists today. Greenspan initiated the largest global bubble money experiment on earth being implemented on Earth today. It is risible to me that he now promotes ‘gold’ – the ultimate anti-bubble money asset.

It is the echoes of this monetary history which reverberates strongly today creating a seemingly stable equilibrium of economic and financial asset growth. Nothing could be further from reality.

Markets have a memory effect whereby future price movements have a higher probability of repeating recent behaviour than would otherwise be suggested by a purely random process. At the moment I believe market behaviour is a reverberation of the memory of past credit cycles propagated by central bankers who never fully allowed the cycles to complete from boom to bust. So the cycle heights either run higher and/or longer until such time as no amount of credit keeps the well-oiled financial markets rising and the economy ticking over.

This is a classic example of the law of diminishing returns - each new dollar printed exacts less and less return or output.

I have always intuitively believed that markets have significant order in their chaos and that we could predict this by looking at the relationship between credit cycles and market behaviour. I believe the inherent structure of a market carries a multitude of participants (economic agents) all with different rationale for making a purchase or a sale. Rational or irrational is in the eye of the beholder; what seems rational to one person may seem quite the opposite to another. Linear systems of econometrics that follow equilibria models do not allow for human action which is why the efficient market hypothesis has long been disproved.

This classic financial theory which assumes markets are efficient was first introduced by Louis Bachelier (mathematician) in the 1900s. The concept assumes that competition among a large number of rational investors eventually lead to equilibrium and the resulting equilibrium reflects the information content of past, present and even anticipated events. So an event of the magnitude of 19th October 1987 statistically should never occur if one were to subscribe to conventional financial wisdom. This was the day the Dow Jones Industrial Average plunged more than 20% in one day, an unlikely 20-standard deviation event whose probability of occurrence is less than one in ten to the 50th power. It is intuitive to me that the financial markets are one large consciousness - a conscious mind. The price and 'value' beliefs that are embedded in a market have a memory and a history based on decades of interconnected economic agents, all with different agendas, motivations and needs. Traders/ Investors think themselves largely independent souls but they are not. They are interconnected by a neural network, figuratively and actually both in the past and present which all impacts a future outcome in the markets.

Its rather analogous to a field of mushrooms which appear to be individual plants, when in fact they are a merely the temporary component of a fungal network, known as a mycelium, that exists underground all year round almost indefinitely.

What is increasingly evident is that market participants are increasingly embroiled in a reflexive relationship between central bank actions, guidance and price action. The more the market moves contrary to central bank desires – ie downwards - the more the central bank injects the bubble money and reassures markets with the promise of more infusions of its rich elixir. This reflexive behaviour has led to a mindset that extends beyond institutional traders and investors but to populations as a whole. We are observing a complete financialization of the global economy and markets by this mindset. The speculative mindset that my house is now my investment, that my 401K or pension pot is my productivity for the future or that oil is some kind of arcade game rather than a highly productive resource for our economy is accepted as normal behaviour. This is the behaviour of the maddening crowd.

An Austrian economic scholar and market participant quipped to me - "after six years and trillions of dollars of intervention, the only truly unconventional policies that remain are those which practice sound money, official inscrutability, and an approach which is a good deal less Hjalmar Schacht and a good deal more Adam Smith."

Although humorous, this is a deadly serious point to consider. As you will see from the economic charts in the following sections this enormous global experiment is not working. The overhang of too much debt and moribund growth continues to threaten national balance of payments and the well-being of populations.

Much more in the full presentation, including numerous pretty charts, which can be found here

November 26, 2014

Who Will Wind Up Holding the Bag in the Shale Gas Bubble?

We’ve been writing off and on about how the sudden fall in gas prices has been expected to put a lot of shale gas development on hold. In fact, quite a few analysts believe that one of the big Saudi aims in refusing to support oil prices was to dent the prospects for competitive energy sources, not just renewables like wind and hydro power, but shale gas.

Even though OilPrice reported that US rig count had indeed fallen as oil prices plunged, John Dizard at the Financial Times (hat tip Scott) gives a more intriguing piece of the puzzle: the degree to which production is still chugging along despite it being uneconomical. The oil majors have been criticized for levering up to continue developing when it is cash-flow negative; they are presumably betting that prices will be much higher in short order.

But the same thing is happening further down the food chain, among players that don’t begin to have the deep pockets of the industry behemoths: many of them are still in “drill baby, drill” mode. Per Dizard:
Even long-time energy industry people cannot remember an overinvestment cycle lasting as long as the one in unconventional US resources. It is not just the hydrocarbon engineers who have created this bubble; there are the financial engineers who came up with new ways to pay for it.
And while the financial engineers will as always do just fine, lenders are another matter:
By now, though, there is an astonishing amount of debt that continues to build up on the smaller E&P companies’ balance sheets. According to Gavekal, the research group, even before the oil price plunge, aggregate debt-to-equity ratios in the smaller publicly traded energy companies are now at 93 per cent, up from around 70 per cent in 2012 and 2013, and around 50 per cent between 2005 and 2011. This in a highly cyclical industry that used to go through periodic banker-driven shakeouts and even bankruptcies.
One example is a KKR deal gone a cropper, Samson. As an aside, it is hard to think of an industry less suited to private equity investing than oil & gas development, since the companies have a great deal of operating leverage and the industry is highly cyclical. KKR apparently did not learn that lesson in bankruptcy of its giant energy play turned mega bankruptcy TXU. Or maybe it did. While the other lead investor in that deal, TPG, has had a hard time fundraising as a result of the TXU debacle, KKR has sailed on unscathed. This early November Reuters article describes how KKR is struggling to rescue this transaction*:
KKR & Co which led the acquisition of oil and gas producer Samson Resources Corp for $7.2 billion in 2011 and has already sold almost half its acreage to cope with lower energy prices, plans to sell its North Dakota Bakken oil deposit worth less than $500 million as part of an ongoing downsizing plan, according to people familiar with the matter. 
KKR, one of the world’s biggest private equity firms with $96 billion in assets under management, overpaid for Samson, and persistently low natural gas prices have hampered its ability to finance the company and added to its debt burden, the people said. KKR’s plan was to shift Samson’s assets from natural gas production more into oil and liquids. 
With U.S. crude oil futures down 25 percent since June, Samson has hired Bank of Nova Scotia (to sell the Bakken assets, and the company is contemplating more asset sales to raise cash, the people said, without specifying which other assets. 
In the medium-term, Samson may look at acquiring higher-income properties, turning to its private equity owners or external investors for financing, one of the people said.
KKR closed on Samson in November 2011. Industry experts believe one of the reasons they overpaid is they used conventional oil and gas models that showed much longer production lives for each well. Yet by spring of 2012, there were reports in conventional media about how shale gas wells have short production lives. So how could KKR have missed this issue?

In the new normal of lower energy prices, developers are apparently playing a game of chicken, hoping that competitors will cut production first. Dizard again:
Particularly in the gas and natural gas liquids drilling directed sector, every operator (and their financier) is waiting for every other operator to stop or slow their drilling programmes, so there can be some recovery in the supply-demand balance. I have been hearing a lot of buzz about cutbacks in drilling budgets for 2015, but we will not really know until the companies begin to report in January and February. Then we will find out if they really are cutting back, using their profits on in-the-money hedge programmes to keep their debt under control, and taking impairment charges on properties that did not really pay off. 
One gas-orientated industry man in Houston I know thinks that the banks are going to call a halt to the madness of permanent negative operating cash flows. “What is the timing of their borrowing base renegotiations (with the banks)? That is the most important thing; can they borrow more money?” If not, he believes drilling and producing on uneconomic terms will slow or stop, and with the high depletion rates of unconventional reserves, such as shale gas, supplies will fall and gas prices will rise.
In other words, if the industry doesn’t discipline itself, the money sources will. Or will it?
If the bankers reduce the borrowing base for the E&P companies, there could be a lot of private equity or high-yield investors with covenant-light deals to offer who might take their place. Not to mention cash-rich majors who would like to take the billions they can no longer put into Russia or Venezuela, who would not mind picking up more North American properties on the cheap.
Although Dizard does not discuss the downside directly, he sets forth a fact pattern that could lead to some ugly ends. US shale gas production needs to get to $6 per mBtu or more for players who aren’t very leveraged to get to break-even cash flow; they hope to make more two to three years after that on presumably higher prices.

But if super low interest rates keep money flowing into the shale bubble, another set of issues emerges: US production is set to considerably outstrip domestic uses:
So much gas is being developed in the Marcellus and Utica resources of the northeastern US that it really cannot be absorbed by the US market. Suzanne Minter, manager of oil and gas consulting at Bentek in Denver points out: “Over the next five years, daily production in the US is forecast to grow by more than 16bn cubic feet per day, with about 10bcf of that coming from the northeast. Of that, at least 8.5bcf has to be exported. Domestic demand does not grow enough.”
That means a lot of infrastructure like pipelines and storage facilities needs to be built. But that requires regulatory approvals and possibly government intervention. And even then, with US shale gas production projected by the IEA to peak in 2020 and fall slowly over the next decade, this extraction boom is nowhere near as durable as development of conventional oil has proven to be.

An additional question is whether investment in infrastructure will look attractive if fracking continues to be shown to have safety risks (water supply contamination, earthquakes). The New York Times just released an impressively-researched story on regulatory abuses in North Dakota. It does not make for pretty reading. And if Dizard is right, that bottom-fishers swoop in to pick up producers gone bust, headlines about bankruptcies and distress are not conducive to downstream development.

In other words, there’s a not-trivial possibility, as Dizard explains, that US production does not get throttled back much by falling oil prices, that the wall of money willing to invest in energy overcomes normal supply and demand factors. If that takes place, there could be a further leg down if US producers lack the capacity to send enough production overseas.

Now remember, Dizard already warned that smaller E&P players were already overlevered. Some, perhaps many, lenders will take losses. Private equity bottom fisher-wannabes will also come in using other people’s money. But cheaper doesn’t necessarily mean cheap enough. Recall all the sovereign wealth funds that took equity stakes in banks in 2007 thinking they had gotten a good deal.

A reader points out that this all feels a lot like the last oil boom gone bad. I’m old enough to remember how pretty much every bank in Texas was sold as a result (and that helped speed the liberalization of interstate banking, since no one in state had the wherewithall to act as a rescuer). Via e-mail:
This whole situation is very similar to the oil and gas boom of late 70′s and early 80′s. It was driven by letters of credit deals which were used to secure debt. A little bank called Penn Square Bank upstreamed those loans to Continental Illinois and Sea First in Seattle. All financed by debt and wells being drilled which were not economical. When the music stopped the debt came crumbling down taking down Continental and Sea First (two of the ten largest banks in the US) as well as many others. Many banks did not even know they were lending to oil and gas because they were lending on like real estate. Well when the oil and gas industry collapsed so did real estate. Practically every significant bank in Oklahoma and Texas failed due to this.
Is the Fed teeing up an even bigger energy boom and bust? Admittedly, several adverse scenarios have to play out in succession for the downside case to kick in. But the first one, of shale gas producers not cutting very much despite the plunge in energy prices, is already under way. One might peg the odds of a major levered energy bust at 20%. That’s still uncomfortably high for the amount of damage that would result.

November 25, 2014

Global Business Outlook “Darkest Picture Since Financial Crisis”

The plunging price of oil since June has been a leading indicator: global economic growth is in trouble, despite six years of unprecedented central-bank free-money policies that caused asset prices to soar but has accomplished little else. This scenario has now been confirmed by businesses that help drive the economy forward – not by economists and Wall Street hype mongers: their outlook for the next 12 months has plummeted since June to the worst level since crisis year 2009.

Business leaders are an optimistic bunch. Projecting a 12-month period that is worse than the past 12 months is frowned upon; because business leaders are supposed to make their business grow, even when it looks tough out there. They’ve been optimistic over the years, despite multiple recessions in the Eurozone, a slowdown in China, a quagmire in Japan, and disappointing growth in the US, where “escape velocity,” dangled out in front of our noses for five years, has become a figment of Wall Street imagination. Throughout, business optimism has been fairly strong, according to Markit’s Global Business Outlook, a survey taken in February, June, and October.

But results from the October survey, released today, are a doozie. The number of businesses around the globe that expect activity to rise over the next 12 months exceeded the number expecting a decline by 28%, the worst in the survey history going back to 2009.

This “net balance” was down from 39% in June. The peak of global business optimism in the survey’s history was in February 2011, when the net balance hit 48%. Manufacturing wasn’t that much of a problem; optimism fell “only” to the level of June 2013. But in the all-important service sector, by far the largest sector in most economies, optimism plunged to the lowest level in the survey’s history.

It was all-around lousy. In the UK, where businesses were among the most upbeat, so to speak, optimism about future activity fell to the lowest level since June 2013. In the Eurozone, which has been battered by a series of apparently intractable problems, optimism dropped to the already low levels of June 2013. The big drags on optimism in the Eurozone were in the two largest economies, Germany and France.

In France, the number of businesses expecting activity to rise over the next 12 months exceeded the number expecting a decline by only 12.6%. This was the second worst net balance of all countries in the survey. These businesses were the only ones in the survey projecting on average a cut in staffing levels. The report described the mood as “gloomy.”

In Japan, optimism hit a two-year low and came to rest even below the low level in the Eurozone, as businesses “have become increasingly disillusioned” with Abenomics.

In the emerging economies, business expectations about future activity plunged to new lows. While optimism edged up in China, it was barely off the near-record low in June. In India, it stagnated at low levels. In Brazil, optimism fell to match the previous record low. And Russia, oh my!

Russian businesses have struggled with sanctions, the swooning ruble, the shrinking price of oil, high interest rates, and waning domestic demand. They’ve been cut off from crucial Western funding sources. And key partnerships with Western companies have been thrown into turmoil. So the number of Russian businesses expecting activity to rise exceeded the number expecting it to drop by a tiny 9.8% – the most pessimistic of any country in the survey.

But the biggest hit on a global scale came from the largest economy, the US. While manufacturing businesses showed a decline in optimism, the big problem was the far larger service sector.

The Flash Service PMI for November, released today, hammered home the point: service sector growth slowed with nerve-wrecking consistency for the fifth month in a row, from its peak of 61 in June (above 50 denotes expansion) to 56 now. It was, the report said, a signal of “a sustained loss of momentum since the post-crisis peak seen in June.”

And so the outlook of US companies about future activity – “reflecting domestic concerns and a subdued external demand environment” – dropped to the worst level since the survey began in 2009. While hiring intentions remained positive, expectations for corporate profits fizzled, and the already weak link in the US economy, plans for capital expenditures, established a new post-crisis low.

The net balance of US businesses expecting an increase in activity over the next 12 months plunged from 69% in February 2012, when post-crisis hopes of escape velocity were at their peak, and from 51.4% in June this year, to 31.2% now, the worst on record. While manufacturers were hanging in there, with a net balance of 42.5%, the all-important service sector saw its net balance descend to a new low of 28.9%.

These businesses listed among their concerns “fragile global economic growth, heightened geopolitical risk, ‘Obamacare,’ domestic policy uncertainty, and strong competition for new work.”

On a global basis, businesses in the survey had a “long list of worries,” including:
  • Fears of a worsening global economic climate
  • A renewed downturn in the Eurozone
  • Prospect of higher interest rates in the UK and US
  • Geopolitical risk from crises in Ukraine and the Middle East
  • Growing political uncertainty in many countries, notably the US, UK and Japan.
“Clouds are gathering over the global economic outlook, presenting the darkest picture seen since the global financial crisis,” explained Markit Chief Economist Chris Williamson. “Companies’ hiring and investment intentions have both fallen to post-crisis lows alongside the bleakest outlook for future business activity seen over the past five years.” And the rapid deterioration in US business optimism and expansion plans was “of greatest concern.”

The plunge in business outlook since June parallels the plunge in the price of oil, indicating that businesses expect a tough slog going forward, even in the US, the engine, presumably, of global economic growth. None of this, nor anything else other than central-bank jawboning and the continued flood of free money, seems to have any impact on the stock markets where the shares of these increasingly gloomy companies are being traded at record high prices.

But even as big money is gushing from all directions at US startups, there are new – and in my opinion, hilarious – indications that the resulting excesses are hitting limits. Read…  This Is a Sign the Startup Bubble Is Totally Maxed Out: It Resorts to (um, Sexy) Junk Mail to Disrupt.

November 24, 2014

American CEOs Sum Up The Economic Outlook: "Softness, Stagnant, Cautious, Challenging"

Since May, CEO confidence among America's largest companies had stagnated - even as stocks did what they do and rise, rise, rise. That changed when Bullard (now explained as "misunderstood" by the market) set fire to stocks with his QE4 hints and Plunge Protection Team rescue. However, the last 2 weeks have seen a noticable collapse once again in CEO confidence, according to Bloomberg's Orange Book index, even as stocks reach new higher all-time-er highs. As Bloomberg's Rich Yamarone notes, recent earnings calls highlight the headwinds companies face: Executives cite “softness in consumer spending,” a “challenging” climate, “fairly stagnant economy,” and “cautious” optimism. Currency valuations are front and center.

Quite a drop from the kneejerk exuberane after Bullard...

As these CEOs suggest:

Harley-Davidson [HOG] Earnings Call 10/21/14: “Foreign currency exchange was $11.5 million unfavorable for the quarter. This was driven by significant weakening of our key currencies within the third quarter. The euro, yen, Brazilian real and Australian dollar devalued an average of approximately 7 percent from the beginning to the end of the quarter. This resulted in an unfavorable revaluation of foreign-denominated assets on the balance sheet.”

McDonald’s [MCD] Earnings Call 10/21/14: “For 2014, we see continued pressure in the fourth quarter, reflecting on the factors that were impacting the third quarter. The biggest factor driving the U.S. decline vis-à-vis the decline in the second quarter was less pricing. And so we would expect less pricing to still be a factor in the fourth quarter as well as the 3 percent commodity increase. Those were the two biggest factors driving this quarter and, as best we see it now, will impact the fourth quarter as well.”

Brinker International [EAT] Earnings Call 10/21/14: “Our franchise business, our U.S. com sales were up 1.7 percent. Domestic Chili's franchises continue to align with our sales-driving initiatives and deliver a consistent Chili's experience for our guests. Our international franchise comp sales were down 0.5 percent, driven by soft sales in Puerto Rico. The economy there is struggling right now.” 

Coca-Cola [KO] Earnings Call 10/21/14: “We continue to face a challenging macro environment, more challenging than was expected when we started the year. In many of our key emerging markets, we see deteriorating economic environments, coupled with the continued softness in consumer spending in the U.S. and particularly in Japan and Europe. This is placing strong pressure on the short-term performance of our business.”

Kimberly-Clark [KMB] Earnings Call 10/21/14: “In the quarter, we had negative away-from-home price in KCP in North America, and so we’re seeing some price erosion on the low end of that business, and so any net price gain has been pretty minimal at this point in time. And I think we’re seeing a fairly stagnant economy is probably not helping much on that front.”

A.O. Smith [AOS] Earnings Call 10/21/14: “We are cautiously optimistic about the developing recovery in U.S. housing and the strength in demand for commercial water heaters, driven by replacement and retrofit activity. We successfully implemented a mid single-digit price increase for wholesale water heaters in May, related to higher steel prices and inflation of other costs.”

Illinois Tool Works [ITW] Earnings Call 10/21/14: “Our Construction business in North America [has] been bouncing around. Quarter-to-quarter, it's up a little, down a little, and I think we're still waiting for some traction overall. There's a fair amount of good progress we're making inside the business on the margin front, but from an overall demand standpoint, I think we're still not seeing any consistent trends, whether it's housing starts or commercial construction activity."

November 21, 2014

Wall Street Stunned As Iceland Dares To Jail Banker Involved In 2008 Crash

The impossible is possible. Never say never. Wall Street bankers are staring agog at headlines coming from Europe where, in Iceland, the former chief executive of one of the largest banks in the country which was involved in crashing the economy in 2008 has been sentenced to jail time. As Valuewalk reports, in receiving a one year prison sentence, Sigurjon Arnason officially became the first bank executive to be convicted of manipulating the bank’s stock price and deceiving investors, creditors and the authorities between Sept. 29 and Oct. 3, 2008, as the bank’s fortunes unwound, crashing the economy with it. It appears he was as shocked by the verdict as Wall Street-ers are, "this sentence is a big surprise to me as I did nothing wrong." It was likely all for the people's own good...

Some thought it would never happen. But in Iceland, the former chief executive of one of the largest banks in the country which was involved in crashing the economy in 2008 has been sentenced to jail time.

Iceland banker the first to manipulate bank’s stock price

In receiving a one year prison sentence, Sigurjon Arnason officially became the first bank executive to be convicted of manipulating the bank’s stock price and deceiving investors, creditors and the authorities between Sept. 29 and Oct. 3, 2008, as the bank’s fortunes unwound, crashing the economy with it.  Landsbanki was one of three banks that had tallied nearly $75 billion in debt before the final curtain was drawn.

What, me guilty? was the bank executive’s response upon learning of his fate. “This sentence is a big surprise to me as I did not nothing wrong,” Arnason was quoted as saying in a Reuters article after he learned of his punishment.  Amason had not decided if he was going to appeal the decision to the supreme court, as the appeal process might take longer than his sentence.

Other Iceland bank executives also convicted

The Reykjavik District Court had lopped off nine months of Arnason’s sentence, saying they were suspended.  Other bank executives involved in the situation were convicted: Ivar Gudjonsson, the former director of proprietary trading at the bank, along with Julius Heidarsson, a former broker at the bank. They each received nine-month sentences and six of those nine months were immediately suspended by the court.

All pleaded innocent to the charges, as the the fallout from the 2008 crisis continues to this day in the north Atlantic island and around the world.  As a sign of thawing in the crisis, Reuters reported that earlier in the week Landsbanki, the successor to the failed Landsbankinn, agreed to extend a deadline to restructure bonds to the end of the year. If a bond restructuring agreement is reached, it could help the government lift capital controls which were imposed due to the crisis.
It appears he needs to 'donate' more to the nation's leaders.


November 20, 2014

Exposing More Super Secret Private Equity Limited Partnership Agreements

Private equity fund managers keep insisting that private equity limited partnership agreements need to remain confidential or their businesses will suffer irreparable harm. We’ve already shown that claim to be ludicrous.

We published a dozen of these supposedly sacrosanct documents at the end of May. They had been accidentally made public by the Pennsylvania Treasury, but no one seemed to have noticed. They included funds of major industry players such as KKR, TPG, and Cerberus. Yet miraculously, they sky has not fallen in on their businesses as a result of the release of this information. We have obtained ten more limited partnership agreements from a source authorized to receive them who is not bound by a confidentiality agreement. These include limited partnership agreements from Blackstone, Oak Hill, and New Mountain, as well as smaller players. You can see all these limited partnership agreements here.

There is a vital public interest in having this information in the open. Public pension funds, which are government bodies, are the biggest single group of investors in private equity, representing roughly 25% of total industry assets. Yet private equity limited partnership agreements are the only contracts at the state and local government level that are systematically shielded from public scrutiny, through state legislation or favorable state attorney opinions.

Yet in countries less captured by rampant free market ideology and private equity political donations, a revolt is underway against this secrecy regime. As the Financial Times reported:
Anger has erupted over the practice of asset managers coercing pension funds into signing non-disclosure agreements. Pension schemes argue it is uncompetitive and prevents them from securing the best deals for their members. 
The imposition of confidentiality agreements means pension funds are not able to compare how much they are being charged by fund managers, potentially exposing them and their scheme members to unnecessarily high fees. 
The practice is of particular concern with respect to public sector pension plans, which are effectively funded by the taxpayer. 
David Blake, director of the Pensions Institute at Cass Business School in London, said: “Local authorities are not allowed to compare fee deals, and that is an outrage. It should be made illegal that fund managers demand an investment mandate is confidential.”
How do private equity kingpins justify their extreme demands for confidentiality, their assertion that limited partnership agreements in their entirety are trade secrets? Consider this “we’ll fight them on the beaches” argument from this Monday’s Private Fund Management, that if general partners, meaning the private equity funds, are forced to divulge fees, they’ll eventually have to expose more of the limited partnership agreement. And of course they claim that would do them competitive harm:
It’s impossible to have a debate about public pension plans disclosing their fee payments without first acknowledging why GPs want them kept private in the first place… 
In this context, GPs are being portrayed as secretive and heavy-handed. But so far, what hasn’t been addressed properly is why GPs are apparently so keen to prevent fee receipts from entering the public domain in the first place. 
Speaking to pfm off the record, no manager has ever told us that they consider management fees a vital trade secret. No one has defended the idea that disclosing them can make or break a firm. 
What we are hearing instead is that GPs perceive the fee debate as a proxy battle for disclosing other data that really are sensitive to the firm’s ability to do business, such as the finer points of their investment strategies, key man clauses and the like. All these things are documented in the LPA, and if the LPA can no longer be subjected to non-disclosure, then sooner or later demands will be made to publish other types of fund-specific information also.
We pointed out when we released our initial round of limited partnership agreements that in fact, when you looked at the sections the general partners again and again cited as being hugely sensitive, there’s in fact nothing deserving of special handling:
For decades, private equity (PE) firms have asserted that limited partnership agreements (LPAs), the contracts between themselves and investors, should be treated in their entirety as trade secrets, and therefore not subject to disclosure under Freedom of Information Act laws in any jurisdiction. These private equity general partners argued that the information in their contracts was so sensitive that it needed to be shielded from competitors’ eyes, otherwise their unique, critically important know-how would be appropriated and used against them. In particular, PE firms have made frequent, forceful claims that their limited partnership agreements provide valuable insight into their investment strategies. The industry took the position that these documents were as valuable to them as the formula for Coca-Cola or the schematics for Intel’s next microprocessor chip. 
Now that we can look at the actual language in limited partnership agreements, we can see what any sophisticated user of legal instruments would guess: the PE firm lawyers describe the strategy in the broadest, most general terms to give the private equity fund as much latitude as possible. For example, here is the investment strategy language from the KKR 2006 Fund:
2.1 Objectives The objective and policy of the Partnership are to invest in (i) Securities of Persons formed to effect or which are the subject of management buyouts or build-ups sponsored by the General Partner or any Affiliate thereof and (ii) Securities of Persons the investment in which the General Partner reasonably expects to generate a return on investment commensurate with the returns typically achieved in previous KKR-sponsored buyouts, build-ups and growth equity investments.
Claiming this statement is a trade secret is analogous to the U.S. Navy claiming classified status for the fact that it operates ships on oceans. 
Moreover, if you read the balance of section 2.1 (“Objectives”), you see that that most of the remainder of the paragraph deals with the goal of tax avoidance, with 195 words in the paragraph dedicated to this issue. When KKR claims the limited partnership agreement is a trade secret, it’s not hard to surmise that these tax games are a big part of what they are really trying to hide. But now that we can look across a series of limited partnership agreements, it’s clear that the tax strategies are highly parallel across funds. To the extent that there is anything distinctive, it’s in minor details relating to the implementation of the tax scheme, and not its objective or design… 
Key person terms are another provision of LPAs that PE firms have asserted rise to trade secret status. The idea behind a “key person” provision is that certain individuals are critical achieving the sought-after investment returns and the investors thus depend on their expertise and experience. The agreements provide that if any of these “key persons” depart or otherwise can no longer work for the private equity firm, the limited partners can stop contributing capital to a fund or even force its dissolution. 
Let’s look at Milestone Partners IV, where in section 3.2(h), you can see that both John P. Shoemaker and W. Scott Warren are defined as the sole “key persons”. Are we supposed to be surprised by this? Both Shoemaker and Warren are described on the firm’s website as Milestone’s sole managing partners. So there is nothing really a secret about this either, nor is it easy to see how disclosure of Shoemaker’s and Warren’s key person designation, even if it were previously a secret, would hurt Milestone upon disclosure.
We see more of the same, the absence of any specific or sensitive detail regarding investment strategies in this new round of limited partnership agreements. In fact, you’d expect, just like the “Use of Proceeds” section in a public securities offering, for the investment strategies to be described in the most vague and general terms possible so as to give the general partner maximum flexibility in executing his mandate. And that’s what you see again and again. For instance, from Oak Hill Capital Partners III:
Purpose. The Partnership is organized for the purposes described in the Confidential Private Placement Memorandum of the Partnership, including: making investments; owning, managing, supervising and disposing of such investments; sharing the profits and losses therefrom and engaging in activities incidental or ancillary thereto; and engaging in any other lawful acts or activities consistent with the foregoing for which limited partnerships may be organized under the Partnership Law. The purposes of the Partnership may be carried out through activities conducted by the Partnership or through investments in corporations or any other Person, or participation therein, organized and conducted in the United States or elsewhere.
And this is the language from Blackstone V:
Purpose. Subject to the express limitations set forth herein, the principal purpose of the Partnership is to seek out opportunities for investment utilizing the investment skills of the General Partner and the Advisor and that are generally consistent with the purposes and objectives set forth in the Offering Memorandum. 
Specific activities permitted are committing capital to acquisitions, dispositions,
restructurings, workouts, management acquisitions, private equity investments and any other situations deemed appropriate by the Advisor without restriction thereon, except as expressly set forth herein (“Investments“).
Amusingly, the definition of Investments (which is what the underline is meant to signify) refers back to the very same section, 2.4, for the meaning:
“Investment” shall have the meaning specified in paragraph 2.4, and when the
context requires, that portion thereof allocated to BCOM as provided in paragraph 3.9 or as otherwise set forth in Article Five.
Without going into mind-numbing details, Section 3.9 doesn’t give any secret sauce about how Blackstone might compete in the marketplace (as in find or do deals) but instead the financial arrangements relating the rights Blackstone has in managing this fund related to competing fund of its own, Blackstone Communications I, and other parallel investments. The section is impressively difficult to parse. Article Five is the section on rights and duties of the general partner, with a strong emphasis on rights.

Similarly, Blackstone names only Steve Schwartzman and Hamilton James as key men; it also states that if a majority of the other unnamed Senior Managing Directors as of the closing date become incapacitated or “cease to devote the time required by paragraph 5.3.1….” the limited partners must be notified of a Key Man Event. The notion that Steve Schwartzman and Hamilton James are important to Blackstone hardly constitutes a state secret, and the document avoided naming any of the other Senior Managing Directors.

In fact, as we’ve stressed, what the industry does not want to see is other critical provisions of these documents, which we and the media have only started to dig into. Those include the extensive and often impenetrable tax provisions, the egregious indemnification agreements, the waiver of fiduciary duty, weak oversight provisions for limited partners, and lack of adequate disclosure of performance and all expenses and fees paid to general partners by portfolio companies.

There’s good reason for the general partners to want to keep these contracts secret. They don’t reflect well on them or on their captured investors.

Update 9:00 AM: An alert reader e-mailed us with more confirmation of how absurd it is for private equity funds to claim that their limited partnership agreements contain competitively valuable information. This section from a 2011 paper by Peter Morris and Ludovic Philappou of Said Business School refers to another type of information that private equity firms insist much remain secret, namely portfolio company financial results. However the same logic applies to the issues we raised:
A second objection [by GPs to improved disclosure] might be competitive disadvantage. Private equity firms might suggest that this kind of disclosure would involve giving away valuable trade secrets. This is disingenuous: it misrepresents what private equity does, and the nature of the information involved. 
Success in private equity does not depend on a simple, repeatable formula, like the recipe for Coca Cola. [emphasis added] Private equity firms try to run companies better by improving their governance. Governance involves qualitative issues like organisational structure, hiring decisions, leadership and internal incentives. Historic financial reports reveal nothing significant about what those decisions were or how they were implemented; all they reveal is the financial outcome. It follows that when a private equity firm discloses historic financial results of an individual portfolio company or a fund as a whole, in the way we suggest, it runs no risk of disclosing any proprietary trade secrets. We fail to see how reporting the information we propose creates any real competitive disadvantage. Buyouts which file public quarterly reports with the SEC or elsewhere do not seem to have suffered as a result.

November 19, 2014

3 Of The 10 Largest Economies In The World Have Already Fallen Into Recession – Is The U.S. Next?

Are you waiting for the next major wave of the global economic collapse to strike?  Well, you might want to start paying attention again.  Three of the ten largest economies on the planet have already fallen into recession, and there are very serious warning signs coming from several other global economic powerhouses.  Things are already so bad that British Prime Minister David Cameron is comparing the current state of affairs to the horrific financial crisis of 2008.  In an article for the Guardian that was published on Monday, he delivered the following sobering warning: “Six years on from the financial crash that brought the world to its knees, red warning lights are once again flashing on the dashboard of the global economy.”  For the leader of the nation with the 6th largest economy in the world to make such a statement is more than a little bit concerning.

So why is Cameron freaking out?

Well, just consider what is going on in Japan.  The economy of Japan is the 3rd largest on the entire planet, and it is a total basket case at this point.  Many believe that the Japanese will be on the leading edge of the next great global economic crisis, and that is why it is so alarming that Japan has just dipped into recession again for the fourth time in six years
Japan’s economy unexpectedly fell into recession in the third quarter, a painful slump that called into question efforts by Prime Minister Shinzo Abe to pull the country out of nearly two decades of deflation. 
The second consecutive quarterly decline in gross domestic product could upend Japan’s political landscape. Mr. Abe is considering dissolving Parliament and calling fresh elections, people close to him say, and Monday’s economic report is seen as critical to his decision, which is widely expected to come this week.
Of course Japan is far from alone.

Brazil has the 7th largest economy on the globe, and it has already been in recession for quite a few months.

And the problems that the national oil company is currently experiencing certainly are not helping matters
In the past five days, 23 powerful Brazilians have been arrested, with even more warrants still outstanding. 
The country’s stock market has become a whipsaw, and its currency, the real, has hit a nine-year low. 
All of this is due to a far-reaching corruption scandal at one massive company, Petrobras. 
In the last month the company’s stock has fallen by 35%.
The 9th largest economy in the world, Italy, has also fallen into recession
Italian GDP dropped another 0.1% in the third quarter, as expected. 
That’s following a 0.2% drop in Q2 and another 0.1% decline in Q1, capping nine months of recession for Europe’s third-largest economy.
Like Japan, there is no easy way out for Italy.  A rapidly aging population coupled with a debt to GDP ratio of more than 132 percent is a toxic combination.  Italy needs to find a way to be productive once again, and that does not happen overnight.

Meanwhile, much of the rest of Europe is currently mired in depression-like conditions.  The official unemployment numbers in some of the larger nations on the continent are absolutely eye-popping.  The following list of unemployment figures comes from one of my previous articles

France: 10.2%

Poland: 11.5%

Italy: 12.6%

Portugal: 13.1%

Spain: 23.6%

Greece: 26.4%

Are you starting to get the picture?

The world is facing some real economic problems.

Another traditionally strong economic power that is suddenly dealing with adversity is Israel.
In fact, the economy of Israel is shrinking for the first time since 2009
Israel’s economy contracted for the first time in more than five years in the third quarter, as growth was hit by the effects of a war with Islamist militants in Gaza. 
Gross domestic product fell 0.4 percent in the July-September period, the Central Bureau of Statistics said on Sunday. It was the first quarterly decline since a 0.2 percent drop in the first three months of 2009, at the outset of the global financial crisis.
And needless to say, U.S. economic sanctions have hit Russia pretty hard.

The rouble has been plummeting like a rock, and the Russian government is preparing for a “catastrophic” decline in oil prices…
President Vladimir Putin said Russia’s economy, battered by sanctions and a collapsing currency, faces a potential “catastrophic” slump in oil prices. 
Such a scenario is “entirely possible, and we admit it,” Putin told the state-run Tass news service before attending this weekend’s Group of 20 summit in Brisbane, Australia, according to a transcript e-mailed by the Kremlin today. Russia’s reserves, at more than $400 billion, would allow the country to weather such a turn of events, he said. 
Crude prices have fallen by almost a third this year, undercutting the economy in Russia, the world’s largest energy exporter.
It is being reported that Russian President Vladimir Putin has been hoarding gold in anticipation of a full-blown global economic war.

I think that will end up being a very wise decision on his part.

Despite all of this global chaos, things are still pretty stable in the United States for the moment.  The stock market keeps setting new all-time highs and much of the country is preparing for an orgy of Christmas shopping.

Unfortunately, the number of children that won’t even have a roof to sleep under this holiday season just continues to grow.

A stunning report that was just released by the National Center on Family Homelessness says that the number of homeless children in America has soared to an astounding 2.5 million.

That means that approximately one out of every 30 children in the United States is homeless.

Let that number sink in for a moment as you read more about this new report from the Washington Post
The number of homeless children in the United States has surged in recent years to an all-time high, amounting to one child in every 30, according to a comprehensive state-by-state report that blames the nation’s high poverty rate, the lack of affordable housing and the effects of pervasive domestic violence. 
Titled “America’s Youngest Outcasts,” the report being issued Monday by the National Center on Family Homelessness calculates that nearly 2.5 million American children were homeless at some point in 2013. The number is based on the Education Department’s latest count of 1.3 million homeless children in public schools, 
supplemented by estimates of homeless preschool children not counted by the agency. 
The problem is particularly severe in California, which has about one-eighth of the U.S. population but accounts for more than one-fifth of the homeless children, totaling nearly 527,000.
This is why I get so fired up about the destruction of the middle class.  A healthy economy would mean more wealth for most people.  But instead, most Americans just continue to see a decline in the standard of living.

And remember, the next major wave of the economic collapse has not even hit us yet.  When it does, the suffering of the poor and the middle class is going to get much worse.
Unfortunately, there are already signs that the U.S. economy is starting to slow down too.  In fact, the latest manufacturing numbers were not good at all
The Federal Reserve’s new industrial production data for October show that, on a monthly basis, real U.S. manufacturing output has fallen on net since July, marking its worst three-month production stretch since March-June, 2011. Largely responsible is the automotive sector’s sudden transformation from a manufacturing growth leader into a serious growth laggard, with combined real vehicles and parts production enduring its worst three-month stretch since late 2008 to early 2009.
A lot of very smart people are forecasting economic disaster for next year.
Hopefully they are all wrong, but I have a feeling that they are going to be right.