Tuesday, December 4, 2012

Nancy Pelosi and the Dismal Science

Arguably the most interesting quote springing from our nation's capitol over the past several years was the now infamous Nancy Pelosi's remark on Obamacare:  "We have to pass the bill to find out what's in it".  Poor Nancy was ridiculed for a comment that, ironically, may have shown great insight into the inner workings of our federal government.

She's now at it again, but in a more subtle context in offering her guidance on the Fiscal Cliff.  We're paraphrasing, but it was something to the effect of "we all know what needs to be done: raise taxes, promote growth and cut spending".  We could hear the snickers from economists as this seemingly bipartisan but economically paradoxical statement was offered.  What Nancy failed to grasp is what every Econ 101 student learns, that higher taxes and lower spending do not produce growth, at least not in the short term.

The fiscal cliff, as we are calling it, is thus a choice between austerity and stimulus.  Since our fiscal stimulus cannot be paid for from revenue, it is also a choice between austerity and debt.  To avoid the cliff in its fullest sense, would therefore require postponing (yet again) the measures to which gave its rise.  This would mean reauthorizing the Bush era tax cuts, the payroll tax cut, capital gains and estate tax provisions, while kicking the can down the road further on spending cuts, by postponing the sequestration measures. 

This solution would cause the least fiscal drag in the short run.  Essentially, the fiscal cliff would be resolved with no more fanfare than the Y2K problem.  The concern, though, is that by punting our fiscal issues down the road it will magnify them in the long run, as deficits continue to spiral out of control.  The equity markets would like rally on the news, however, as many have suspected the market to be trading for quite some time more on government intervention than economic fundamentals.

The other extreme solution is to do nothing.  This would produce the greatest short term negative impact on the economy, but also slice the federal deficit in half in one-year.  This would also likely cause a deeply negative reaction in the stock market.

The argument that's ensuing in Washington, then, is between taking on some fiscal discipline in the form of higher taxes, per the Democrats' position, or in lower spending, per the Republican platform.  Our bet is that the cliff gets resolved in favor of neither.  Responsibility will give way to practicality.  Politicians despise austerity: even if they know it to be prudent, no one has ever been reelected on it.

The problem is, Nancy, you simply can't have it both ways.

Monday, November 26, 2012

The Fiscal Cliff

Ben Bernanke's ominous metaphor of a fiscal cliff to describe the pending economic contraction brought on by expiring tax cuts and mandated spending cuts has now embedded itself in the lexicon.  We've heard the beltway buzz surrounding the fiscal cliff described as "cliff diving", we've heard the cliff characterized as "more of a fiscal slope" and by one Citigroup equity strategist even as a "bungee jump".  Leave it to the ingenuity of Americans to turn a phrase.

The concern, however, is that many Americans are confusing the issues that may impact the economy in the very near term, with prudent fiscal policy in the longer term.  The markets, for their part, are largely discounting the whole affair, believing that at the 11th hour the politicians will "compromise" and, therefore, avoid the cliff.

But let's take stock as to what is on the table and what it means to compromise.  At year end, absent any political tinkering, roughly $600 billion of fiscal tightening is scheduled to trigger in the federal budget.  Approximately $100 billion of this total will come from sequestration of expenditures and the balance from the expiration of the Bush era tax cuts, the payroll tax, estate, AMT and capital gains taxes. In a word: austerity.  This is the do-nothing scenario, the dreaded fiscal cliff.

With politicians being as they are, however, the do-nothing scenario is largely discredited to the muddle-along.  Each party has drawn lines in the sand, and then another and another.  The question is what does it really mean to compromise.  The "grand bargain" as it's been discussed (there's that turning of the phrase, again) would involve the Republicans conceding to tax increases on the wealthy and Democrats agreeing to some level of spending cuts.  Should this come about, both measures will place fiscal drag on the economy, just less than the do-nothing scenario, rendering the cliff into something more of a fiscal slope.

And this is precisely our dilemma.  We all recognize that the government cannot go on endlessly racking up $1 trillion plus annual deficits, yet any measures to narrow the deficit or impose austerity, contribute to the cliff.  In the do-nothing scenario, the annual budget deficit would be cut in half in one year, but the fiscal drag on the economy would amount to as much as 4% of GDP.  This takes us then to the very nub of the problem: with the current level of federal deficit spending amounting to 8% of GDP any effort to rein in the deficit, poses a significant drag on the economy.  In essence, our economy is on life support and we are between a rock and a hard place.

Now, what's most curious about this is the Obama position.  Immediately following the election he came out swinging:  any proposals to resolve the fiscal cliff must involve higher taxes on the wealthy.  Ok, we get it.  He's Robin Hood and we're all living in the Sherwood Forest.  While this approach might hold populist appeal, it's curious in terms of its economic impact.

The CBO estimates that allowing the Bush era tax cuts to expire on the wealthy would raise approximately $42 billion per year - or roughly 4% of the budget deficit.  Four percent.  So, Obama is willing to endure $42 billion of fiscal drag because he's now preoccupied with fiscal prudence? And if it's an insignificant level of drag, at 4% of the deficit isn't it also an insignificant amount of budget savings?

It hardly sounds reasonable.  Rather, it seems Obama is searching for a grand political statement cloaked as a grand bargain.  He is saying that America is unfair.  Income disparity is unfair.  The tax system is unfair. The rich are unfair.  Capitalism is unfair.  It's all just so stinking unfair.  And we have to do something about it.  Little, but something.  Perhaps insignificant in the scheme of things, with little hope of tackling America's real economic issues, but something.  

Friday, September 14, 2012

Is the Federal Reserve Evil?

We ask this question facetiously, but with the most recent actions of the Federal Reserve Bank, the argument for nefarious activity and hidden agendas certainly increases.  It has long been speculated throughout this economic recovery that the Fed's four year policy of zero interest rates (ZIRP) and Quantitative Easing (QE) is really designed to debase the dollar and, in so doing, lessen the burden of the Federal Government in paying off the mountain of Treasury indebtedness, growing larger each day.  Commonly referred to as "monetizing" the debt or a "soft default", the argument is that paying back the Treasury debt in dollars of lesser value, forces a "haircut" on holders of the debt.

The Fed, as you might expect, vehemently denies this charge.  And, of course, Treasury Secretary Geithner is a proud proponent of a strong dollar policy (at least in speech).  But it has long been known that a strong dollar favors creditors and a weak dollar, debtors.  It's the solution of choice in most third world debt crises:  devalue the currency, diminish the debt.

Yesterday's action by the Fed to purchase an "unlimited amount of mortgage bonds", however, ratchets up the QE stakes to new bounds.  With no evidence, academic or anecdotal, that QE has had any effect whatsoever on job creation, Bernanke's argument that this new policy is designed to meet the Fed's mandate of full employment, is suspect at best, diabolical, at worst.  In his statement, Chairman Bernanke said that the Fed will continue to purchase mortgage back securities each month until there is evidence of "substantial improvement" in the labor markets. How will we know?

We think it's time for Americans to stand up and question just what the heck the Fed is up to. This much we know: last fiscal year, the Fed purchased 80% of net new Treasury debt. It then rebated 100% of the debt service the Treasury paid on those securities back to the US Treasury. That means the Government only shouldered 20% of the burden of funding the Government's huge $1.3 billion budget deficit.  Not bad.  Can you imagine if your mortgage interest was not only deductible, but if you were given an 80% direct credit?

The Fed's new plan to purchase an unlimited amount of mortgage backed debt comes suspiciously close on the heels of a recent Treasury policy directive that forces 100% of all Fannie and Freddie profits to the US Treasury. In so doing, in one stroke of the pen, the Treasury jumped ahead of Fannie and Freddie's private sector creditors and effectively nationalized the two mortgage lenders. WIth the Fed now purchasing an unlimited amount of Agency mortgages, they will undoubtedly funnel these interest payments similarly back to the GSEs (to be remitted to Treasury) or to the UST directly. In substance, the Fed has just announced that it will be monetizing Fannie and Freddie debt, in addition to direct UST debt. Lucky us, the taxpayers.

But for the Fed to take these actions under the guise of lowering unemployment, or to not make public its plans to remit the interest expense on these mortgages back to the Treasury, it is an inescapable fact that the Fed is being deceitful.

So now we return to our original question:  is the Federal Reserve Evil?

Wednesday, September 5, 2012

A New Democratic Party Elite?

Last night like millions of Americans, we watched the opening speeches at the Democratic National Convention:  Julian Castro, Mayor of the City of San Antonio and Michelle Obama were undeniably eloquent.  Castro was introduced by his brother, also a rising star in the party and like Julian, also a graduate of Stanford University and Harvard Law School.  This fact was mentioned several times, both in introductions and then in Julian’s speech, as it was similarly mentioned by Michelle that she was Princeton undergrad and Harvard Law.  Barack, we know, is Columbia University and Harvard Law (as well as a graduate of the elite prep school, Ponahou School in Hawaii).

This all seems kind of odd.  On the one hand, each politician emphasizes their dire poverty in upbringing in an effort to connect with the mass constituencies that they are courting for votes:  blacks, Hispanics, the middle class and the poor.  Yet at the same time, it's hard for us to associate Princeton, Harvard and Stanford with anything but the most privileged elements of American society.  So which is it, are they poor or privileged, or both at the same time?

According to the Harvard Law School website, tuition and the estimated cost of living in today’s dollars is approximately $75,000 per year.  Adjusted for inflation, it wasn’t any bargain when Michelle, Barack, or the Castro brothers attended.  Not many people can afford to send their kids to Harvard Law School and most would consider a graduate, a person of great privilege in our society.

But this is the pedigree of the new Democratic Party elite.  We were compelled to do a bit of digging to see where and when this all started. We guess with Bill Clinton, a Georgetown, Oxford and Yale Law grad. Kennedy and Roosevelt were both Harvard men, but were privileged beyond modern imagination, so our sense is that this phenomena is more recent and best traces back to Bill Clinton.  

To confirm our suspicions, we were prompted to check on other recent Democrats to see if they too were members of the society of elite university graduates:  Jimmy Carter, Georgia Southwest College and the US Naval Academy;  Lyndon Johnson, Texas State University; Harry Truman, Spalding Commercial College (dropped out).  Now, this is the stuff of the party of the common man!

But watching the DNC last night, there's an undeniable shift in the Democratic elite these days.  How well this new elite will connect with the constituencies they most desire will remain to be seen.

Wednesday, July 18, 2012

An Economy of Contradiction

Many of the country's most prominent economists are perplexed by the seeming contradictions in the economic data in the wake of the Great Recession. The very nature of this contraction, however, presents its own set of novel events. Moreover, the extraordinary actions of the Federal Reserve have too, set the stage for outcomes that are perhaps contradictory and certainly unpredictable.

We're seeing just such a contradiction in the capital markets, as many have identified. The bond market, with record low yields is suggesting a looming depression or further economic contraction. The equity markets, however, continue to push against record highs, forecasting optimism about the economy and continuing corporate profits. So who is right?

This may not be a contradiction at all, though, as the markets may be trading on forces far more powerful than fundamentals. This is the stage set by Federal Reserve policy.  Bond prices rise as yields fall, or stated more accurately for the nature in which this market operates, yields fall as bond prices rises. This seemingly insignificant distinction is being made to highlight the following. There really is no contradiction in stock and bond markets. Both are moving in the same direction - up. Driven by excess liquidity all financial assets are moving higher in price. This is one of the many distortions that are being forced by the Fed. Hence, the predictive properties of these markets can no longer be trusted.

The other glaring contradiction of consumer spending, outpacing personal income growth appears to now be self-correcting. Following three straight months of declines in retail sales, the consumer's ability to outspend income may have reached the limit of their savings and borrowing power. This presents a great challenge for corporate profits and GDP, as large corporations exposed to the consumer like P&G and Intel are already feeling the pinch.

The question on all our minds now, is what happens next. As the Fed (or at least market participants) contemplate a QE3, the limits of intervention may already be upon us. If this is true, and the consumer no longer has the resources to drive corporate gains, then the disequilibrium in the financial markets may soon also self-correct.

Monday, March 19, 2012

Risk On

Risk on, Risk off!  The common cry of trading floors around the world these days.  Every new release of high frequency economic data and utterance of political theater seemingly inspires a new round of risk on, risk off trading.  Over the past three years, these wholesale investment forces drive markets dramatically, confounding professionals and individual investors alike with how seemingly correlated markets have become. We've all seen those risk on days where virtually every asset class rises, including corporate bonds, high yield bonds, municipal bonds, commodities and of course stocks, of every stripe and color.  The risk off days, show investors shunning every asset class and scampering into the safety of Treasuries to ride out the storm.

Ben Bernanke has been quoted on several occasions articulating his risk on argument. The Fed's ZIRP (the zero interest rate policy) is calibrated to coerce investors to move cash out of money market funds and from beneath the mattress into "risky" assets.  And so, each new economic release is greeted by investors with a perception of how either the economy or the Fed will respond.

We can't help thinking, though, that investors eager to jump on the latest momentum trade are all too conveniently glossing over the word "risk".  What's articulated as risk on becomes understood as long on. Bernanke is equally cavalier in the use of the term, positing that senior citizens who now earn .25% on their savings should be looking to extend along the yield curve or move into more risky asset classes in search of return.

Well, maybe, but let's pause for a moment on the word risk.  Webster's defines risk as "peril: the possibility of loss or injury".  In the investment world, what goes up in a favorable market fueled by Fed policy and election year politics, just might turn around and bite you in the behind.  Markets that move in wholesale up or down and that are highly correlated with other asset classes, belie fundamentals and possess a weak foundation for growth.

Monday, February 27, 2012

Are Markets in Denial?

The first quarter of 2012 is off to a heady start for equities, with the S&P up 24% from its October 2011 lows.  Dow laggards like Bank of America are up in excess of 40% over this period.  The Dow now at our about 13,000, is at levels last seen at its peak in the 4th quarter of 2007. 

At the same time, US Treasury Bond prices also continue to test all time highs, with the 30-year yield down to 3.05% and the 10-year yield once again falling below 2%.  High yield bonds (once known as junk bonds is a less optimistic era) are at similarly lofty levels with many sub-investment grade companies raising capital in the 6.00% range.

Intuitively, of course, none of this makes sense.  In the latter part of 2007 when the Dow first crossed 13,000, we saw a GDP print at just under 5%, versus the 1.8% in the 4th quarter of 2011.  Unemployment stood at 4.6% versus the 8.3% today and residential housing prices were some 30-40% higher than where they now stand.  Perhaps more to the point of this article by June 2007, the 10-year US treasury bond stood at 5.2% (versus 1.91% today).

So what's driving these appreciated valuations in both equity and debt markets that, historically, perform inversely?  Bond market yields fall (and prices rise) when the economy is forecasting dark days ahead, with muted growth and low inflation, and this would appear to be what bonds are now signalling.  At the same time, the stock market has put the risk of further recession firmly in the rear view mirror, plowing ahead to new highs. 

So, what's up?  Liquidity and lots of it.  As we're all aware, the world is awash in cheap money as central banks in the US and around the world continue to print new money at unprecedented levels.  Financial assets are posting new highs, but if cheap money is propelling all asset classes, why hasn't housing recovered? 

We think the reason for this anomaly lies in the velocity of money and the banks' role in expanding credit.  Of the markets listed above (stocks, government bonds and junk bonds) none of these markets rely upon credit expansion to drive prices higher (although returns are often leveraged with debt).  Housing, is a very different story, where the home mortgage and the buyer's willingness to take on debt have long been a staple of this market. With mortgage credit constrained (due to higher lending standards) and individuals either not qualifying for or apprehensive about taking on a mortgage, housing languishes in the doldrums.

So what do we know?  We know that equity and bond prices continue to push new highs, while home prices skirt along the bottom.  And we know that the underlying economic data for GDP growth and employment are now far less robust than they were when we last visited these levels in equities and bonds.  Thus, we can only conclude that the values reflect the excess liquidity finding a home in financial assets rather than a fundamental analysis of the prospects for growth in the economy. If we are correct, then the markets for credit and risk, both equities and junk bonds, may be in denial and headed for a major correction.

Friday, January 6, 2012

The 1 Percent

With most of the 99% ers being uprooted from their occupations by police throughout major cities, the movement continues with somewhat dubious goals and ideology. The fundamental argument of income inequality in America is, however, undeniable.  And things are getting worse.  The concentration of income has actually grown far more severe over the past three years of the Obama administration, although to be fair it's hard to see how the Administration's policies have at least directly fostered this outcome.

The Federal Reserve, however, is fairly open about their role in pushing inequality to new limits, although they wouldn't state it quite so candidly.  Bernanke is on record before Congress testifying that Fed policy is designed to inflate the value of risk assets.  Bernanke's argument is that by making (safer) assets like bank deposits and Treasury bonds so utterly painful to own (due to negative inflation adjusted returns) Americans are in effect forced into investment in higher yielding and riskier assets.  The greater the demand for risk assets, the higher the values.  These risk assets, however, including stocks, corporate bonds and high yield bonds are disproportionately held by the most wealthy of Americans.

As these assets generously appreciate due to increasing investment, Americans - albeit already wealthy Americans - realize a greater wealth effect, thereby promoting more consumption of the stuff we already own way too much of.  This conspicuous consumption promotes economic growth and in the long run (perhaps the very long run) employment gains.

Democrats used to scoff at this age old economic argument, applying the term "trickle down economics" to deride the notion that the rich get richer and then, eventually, everyone else will benefit as the crumbs trickle down to the masses.  Hard to swing this argument too aggressively now, though, with a liberal Democrat in the White House.

Be this as it may, our thoughts center around this 1% and the growing chorus of concern about income inequality.  For the most part, this topic of inequality is seldom raised without the parallel discussion of raising marginal tax rates, in an effort to make the progressive tax system so much more progressive.  Truth be told, raising the top tax bracket to 100% will do little to address the issue of income inequality in America.

Higher tax rates, of course, will only impact after-tax incomes and have no impact on the fundamental issue of what people earn.  We raise this point, not facetiously, but rather to address a more profound conundrum in contemporary American society:  why is there such great income inequality?

To begin with, let's look at the most wealthy of income earners in America.  And we need not look any further than the Entertainment Industry.  Lady Gaga, earning $70 million last year, will dwarf by six or seven-fold the income of Lloyd Blankfein, CEO of Goldman Sachs, or Jamie Dimon of J. P. Morgan.  Perhaps the occupy movement should have started out as Occupy Hollywood?  To be far more relevant, though, the movement should of course be an Occupy Washington effort, for this is where the rules are made by which income inequality is allowed to exist.  Hardly reasonable to blame Gaga or Blankfein for simply playing the game so well.

But why do such income disparities exist?  For the answer, we need to understand the economics of the labor markets.  According to Sports Illustrated, Eli Manning of the New York Giants, at #50 on the list of highest paid athletes in 2010, made $15 million.  The top paid athlete that year was Tiger Woods, who together with endorsements earned a staggering $128 million.  By comparison, according to Forbes magazine, James Gorman, CEO of Morgan Stanley made a paltry $6.5 million - chump change for a top paid athlete.

Moving beyond Tiger, film, TV and music celebrities are at the very top of the 1%, leaving their sports celebrity counterparts to park their cars.  Again, per Forbes, the top 10 actors in Hollywood took down a combined $350 million in income in 2010.  Talk about income inequality!

It might be interesting for us to ponder the forces that create such income disparity and what could be done to address it.  It's far easier though, for the American public to bite down hard on the idea of a system to ameliorate after-tax income inequality through higher tax rates.  After all, Americans have a secret love affair with taxes - that is of course, as long as they're paid by someone else.  Call it rightful vengeance.  It simply feels good to see others pay their "fair" share of taxes, almost primal.

This is why most of us are happy to raise taxes on cigarettes (because most of us don't smoke) and why taxes to support schools are overwhelming more popular with renters than with homeowners (because in most states, schools are supported by property taxes on owned residences).  As Huey Long said, "Don't tax you, don't tax me, tax the man behind the tree".

But the real question of income inequality is worth considering.  Why is it that Mel Gibson has earned so much money that he can afford to pay his ex-wife a divorce settlement of $450 million? Is his value to society so infinitely greater than that of a school teacher teaching your children, a doctor who treats them when they're sick or the police who protect them?

Two reasons.  The first one is plainly societal.  If we turn back the clock 100 years, actors were broke.  They acted in small, underfunded acting companies where the actors worked for pennies. Babe Ruth, the undisputed greatest athlete of his day, died with barely a dime in the bank. Somewhere along the road, though, these dynamics changed and boy did they ever.

Today the fact is, the simple reason the studios can pay Johnny Depp $50 million per movie is because they expect they will earn this back and far more at the box office.  So, it's really us - those of us who go to see his films that are offering Depp a seat at the front of the 1% bus. This is, of course, equally true of Derek Jeeter, Kobe Bryant, Lebron James and so on.

The interesting question to ask then, is why isn't this equally true of your family doctor, dentist or kids' school teacher.  And the reason is that we as a society don't place the same value on their contributions, because we aren't willing to transfer the same economics to these sectors that we gladly shell out for our own entertainment.  And we're willing to voice our support not with our votes or our words, but with our wallets!  It's like bemoaning how awful it is that celebrities are hounded by the paparrazi as we scoop up tabloid magazines at the supermarket that, of course, create the opportunities for the paparrazi to sell their photos.

The second reason for this great income inequality is that those whose nests aren't feathered by Americans' tastes for consumption are deftly aided by their friends in Washington.  You may think, "no way Blankfein is worth $10 million".  The guy can't act his way out of a paper bag (as we saw in the Senate hearings) and he doesn't look nearly as good as Gaga in a leotard.  Points well taken. But what Lloyd and execs on Wall Street, along with big Pharma, Oil, Defense, Aerospace and many other industries have long since realized is that they can tip the scales of profitability strongly in their company's favor by cozying up to those on the hill who regulate, purchase products and services and provide funding incentives for their businesses.  As long as elections cost increasing amounts of cash to fund, politicians will increasingly listen and listen hard to whomever hands it out to them.

So there you have it.  Income inequality.  Look no further than Washington and your living room to get a better understanding of it.