US consumers on the way back to their old ways?

Today US Retail Sales data gave the markets a positive surprise. It appears that the US consumer is indeed getting back to the old ways, spending when possible and not caring about tomorrow. Or what is going on?
Already late last year I stated that the recovery would be slow and protracted, as the US consumer would have to rebuild balance sheets after a long period of overspending and overborrowing. The positive side of this consolidation was that it would have a positive effect on the US trade deficit. For those of us who believe in some kind of celestial justice, it appeared fully justified that 7 fat years would be followed by 7 meagre years. Indeed, for a while it appeared as if everything would be on track for this scenario to unfold. Modern-day hubris and nemesis, so to speak.
The US trade deficit has indeed narrowed in spite of a record budget deficit. Private households have saved more, pushing the savings rate upwards. Economists were talking about a return to the 7 per cent savings quote within a short period of time. Just before the sub-prime crisis blew up, the private sector savings rate had shrunk below 1 percent and in periods in fact it was negative.
So where does this new rebound in Retail Sales come from. Well, it comes from a falling savings rate. In April of this year the savings rate stood at roughly 6 percent and everything looked fine (at least from this narrow perspective). Since then the savings hate has gone down below 3 per cent and it appears heading lower. At this pace the savings rate may return to the region of 1.5 per already this year, bringing one of the perennial American vices to the forefront: living on borrowed money. If the savings rate does indeed fall that far, the US trade account deficit will widen again. There will not be any improvement in the twin deficits which are ultimately at the root of the current market instability. So maybe we should begin to cry wolf again.
It might be wise, but that is at least not what the markets are thinking. Market participants are notorious for being able to focus only on news confirming their current beliefs. They are interested in seeing a quick return to growth and prosperity in order to justify the continuation of the current market rally. Hence they focus on the headline numbers (in this case the Retail Sales) and on the "surprise" they bring. Nothing could be more irrelevant to the market sentiment than some esoterical accounting entries that may influence us next year or later. It is entirely irrelevant that the effect will ultimately prove a further negative factor for the dollar's position in both medium and long term.
One could wonder what a fall in the Savings Rate would mean for the Obama administration. One could hope that some brave men and women would stand up and try to introduce tax structures designed to increase the Savings Rate – technically not really that difficult, indeed. Chances are that they will not. Obama will be up for re-election in 2012 and most of that year will likely be totally devoted to campaigning. This leaves us with two years to rebuild consumer confidence if Obama is to avoid the fate of being a one-term president. My guess is that consumers (i.e. voters) are easier to convince with the shopping cart in the mall than with some abstract element about the waning economic influence of the US of A. No matter how irresponsible it is, I believe that the political instincts will hail the "surprisingly good" Retails Sales data. The twin deficits will be for later....
Meanwhile, the stock market rally will continue. And maybe even deliver a blow-off into the New Year driven by all those who have been blindsided by the strength of the recovery.

Intellectual flexibility – or plain greed

Sometimes it is hard NOT to smile when confronted with the ability of players in the financial markets to adjust their thinking to the circumstances. Does anybody remember July 2008 when Crude Oil was trading about 140$/barrel. We all had to endure explanations that this phenomenon was based on sound facts (oil reserves were to be depleted next Wednesday) and that speculative moves in the very small market for sweet light crude had nothing to do with it.

Yet on July 14 2009 (Crude oil trading below 50$/barrel) the US Commodity Futures Trading Commission (CFTC) Chairman Gary Gensler presented data to a congressional panel that 71% of the oil futures traded on the NYMEX in 2007 had been speculative. And this number even omitted the trades over the London-based ICE – the so-called London Loophole. One of the peculiarities of the legislation in place was that CFTC allowed exactly oil futures to be regulated by the exchanges themselves instead of following standard trade rules. Another peculiarity was that the mandatory reporting of the oil futures was sufficiently light that it was impossible to establish a normal overview of the total market positioning. The Congress granted the CFTC powers to regulate the oil market - accompanied by a howl of protests from the market players.

But that was then. Now the US congress is struggling with something far bigger, the regulation of Over-The-Counter (OTC) derivatives. Some months have passed since the CFTC hearings, the economy is recovering and the financial market players are trying to display some kind of normalcy. Bonuses at silly levels are but one example of this return to normal.

Obama's administration have committed themselves to introducing legislation to regulate the OTC market. OTC is short for a class of derivatives where essentially no contracts are standardised, every transaction takes place on a bilateral basis, and where transparency is non-existing. One famous type of derivative is the Credit Default Swap, the CDS. A CDS is a contract between two parties that one will pay the other an amount if a third party defaults on repaying its corporate bonds. The nominal value of these bets is often many times bigger than the corporate bond issue itself.

Remember AIG? The main reason for the fall of AIG was exactly that the company had been the issuing counterparty of CDS's to the tune of astronomical nominal amounts. A large part of the government money poured into AIG went towards honouring the company's liabilities related to unregulated OTC products. Tax payer money went into paying off gambling debt.

Now the US Congress is discussing to introduce legislation aiming at standardising the products, making sure they are traded in something akin to a regulated market, and introducing a clearing house, so settlement can happen in a transparent way. The purpose is to make it possible to create an overview of the total number of OTC products – in the honourable intention of exposing the risks taken by the banks active in the market for OTC products.

Guess what. Industry representatives are now lobbying hard to avoid just that. We are now told that OTC products are necessary for the consumers, because manufacturers need the products to hedge their raw material costs. We are told that standardisation is an evil because the markets will then not be able to offer customers precise hedging. In other words, the kind of products that one year ago were clear to have played a pivotal role in disguising the risks taken by banks are now again necessary to reduce market risks??

Using Rule #1 of the Private Snoop: Follow the Money, one arrives at a rather more sobering picture. The largest operators in the OTC market have made tons of money in non-transparent OTC product, simply because the bid offer spread on such contracts is astronomical. Forcing the market into standardised products and an organised market would cause bid-offer spreads to narrow sharply, undermining the earnings of the biggest players. So their sudden concern for the consumers' needs is probably just a way of not really telling that derivatives should continue contributing to their earnings.

One can only pray that the US Congress in this instance is not swayed by highly paid lobbyists. What the world needs now is NOT that the financial markets continue dealing with derivatives in the usual hush-hush way. Derivatives are indeed useful, but there has to be some possibility of overseeing the total exposure, and so on. The financial markets have always thrived on the ability of clients and politicians to have very short memories. This time is no exception to that rule.

Maybe there is some hope. John Maynard Keynes – a UK economist, whose teachings were behind the reorganisation of the world economic system after WWII – was quietly dropped from university reading lists across the world. His books have seen a remarkable pick-up in sales over the past months. It is reassuring that there are people who still believe that the government has an important role to play in regulating the economy and the markets. It is particularly reassuring now that the financial markets are back fighting regulation after a combination of unregulated products very nearly blew us all out of the water.

Will Bernanke steal the punch bowl any time soon?

Remarks by US Federal Reserve Chairman Ben Bernanke regarding the return to more normal monetary policy are quoted widely today. Apparently, quite a number of pundits interpret his remarks as yet another indication that Federal Reserve will begin to tighten monetary policy "soon". Bernanke was thus taken as a character witness for the many strategists who believes that NOW is the time to sell stocks.

I profess to have great respect for seasoned "Fed Watchers", who have deep knowledge of monetary policy and of the political games around the Federal Reserve. Their insights are invaluable when it comes to understanding the current policy situation. Unfortunately, these market professionals had taken a day off yesterday and left the scene to rather more lightweight commentators.

In fact, Bernanke said the following: "My colleagues at the Federal Reserve and I believe that accommodative policies will likely be warranted for an extended period. At some point, however, as economic recovery takes hold, we will need to tighten monetary policy to prevent the emergence of an inflation problem down the road". This could have been taken right out of any of his speeches of the past two months or so. There is nothing new in his statement, and no reason to spill tons of ink because of it.

Bernanke marked right from his inauguration a change from his often Delphic predecessor Alan Greenspan. Whereas Greenspan according to his memoir took pride in making statements so convoluted that US lawmakers did not know what he really meant, Bernanke believes in straight talking. With the exception of the onset of the financial crisis where then-secretary of the treasury Hank Paulson did all the talking, Bernanke has indeed mostly been clear in his statements.

Even if Bernanke is a straight talker, he is, however, also a part of the political game. It makes it so much easier to interpret his statements. There is a simple rule that one can apply. It goes something like: If you take a given statement and wonder what it means, try and negate it. If what comes out is meaningless nonsense, then the original statement is simply idle talk. Let us try this on the quote above. The last phrase would then turn into

At some point, however, as economic recovery takes hold, we will NOT need to tighten monetary policy to prevent the emergence of an inflation problem down the road.

Now that would be something. A central bank director stating that he will do nothing to fight inflation? He would be without a job faster than you can say "Federal Open Market Committee".

Try and use this simple principle in other situations. It is a very strong tool to identify idle talk, statements made simply because they have to be made, no matter how obvious they are. It will free up time and energy to focus on what is really important, namely to identify the many elements that together will mark the real turn of the monetary policy. Do not worry too much about Bernanke's various statements. When he wants to make himself heard because he has something to tell the markets, he will do so.

And by the way, no, the punch bowl will not be moved right now. US monetary policy will remain accommodating at least through this quarter and quite possibly through 2010Q1 as well.

The dollar’s days are numbered, or...

A couple of days ago, UK daily "The Independent" published an article according to which a group of countries, most notably China, Russia, Japan, France, Saudi Arabia and some other Arab states have secretly met and discussed to replace the USD as the main trading currency for oil. Instead they would be interested in using a basket of currencies and to phase it in over a period of nine years.

Predictably, this information created some buzz in the financial markets: are the dollar's days numbered? In response to such talk, the value of the USD fell immediately. It did not immediately recover, and now a couple of days after the event it all looks like an episode in the dollar's weakening trend which has been in place for some months. In this time perspective, the newspaper articles probably have little importance as they do not affect the actual business cycle trends. USA has repeatedly in the past months proven to be lagging the rest of the world in recovering after the downturn. Since many investors had managed to convince themselves that the US would lead the rest of the world back to economic growth, the current situation has created some turmoil. The reaction to the newspaper article was just another example of how the market selects news that fit in with the current thinking.

Yet, the reported meeting has quite an importance for the longer term prospective for the dollar, say, for the next 10 years or so. The reported story about the decline of the dollar is not new, however, except in the degree of details that have emerged, and that it in itself is worrying enough. Led by China, several large and influential countries are openly challenging one of the pillars of the dollar system put in place after WWII. By placing the dollar as the world's reserve currency, USA helped the world economy to pull out of devastations of the war – and granted herself enormous powers of leverage over the rest of the world.

In economic terms, this dominance has for more than 50 years given the USA more leeway to conduct irresponsible economic policies than would otherwise have been the case. The Reagan-Bush era was a first indication of what were to come. The Clinton years were characterised by relatively prudent economic policies that almost balanced the current account deficit, before the George W Bush administration let go completely.

This situation has worried quite a number of observers. The U.S. government's budget deficit together with the current account gap represent "unsound underpinnings" in an otherwise "good" economic landscape, Already in 2006, Robert Rubin, chairman of Citigroup Inc.'s executive committee and former Treasury Secretary in President Bill Clinton's administration, said the following in an interview:

"At some point, these kinds of deficits are not viable," Rubin said. "The probabilities are extremely high that if we don't address these imbalances, then at some point, and it could be years down the road, we'll pay a very big price."

That price is obvious now. After years of living above its means, the US is now losing economic influence, and it is symbolised by the moves by the countries mentioned above to reduce the role of the dollar in trading oil. It is more than a symbolical move. The US has used the fact that oil is traded in dollar as a means to exert influence over the oil producing countries and no single move could do more to undermine the dollar's position as a reserve currency. In other words, the threat to the US economic world dominance is utterly real. Apart from being the result of failed economic policies, it is also a move that will happen as the fast growth of the Asian economies will reduce significantly the relative weight of the USA in the world economy.

The problem is what US policy makers can do. The answer is: very little. Gone are the days where US military power could be used to impose certain policies on reticent states. Posturing angrily would only have negative effects. So apart from some shrill comments from commentators from the more silly part of the right-wing establishment, US officials have wisely kept shtumm. Expect to see a wave of comments trying to persuade us that the US administration is really happy at the current levels of the USD. Such comments will change nothing on neither short nor long term.

Australia hikes interest rates

Overnight, the Royal Bank of Australia hiked its money market rate from 3% to 3.25%. This action is being hailed worldwide as a first sign we are moving out of the deep global recession. Some economists even profess to be surprised that the move came now and not in 4 weeks. Apart from the fact that Israel hiked rates already on 24 August, the question is whether RBA's move signals the turning point for anything at all.

We all know that interest rates eventually will go back up. Central banks do not continue rescue missions forever, particularly not as it becomes increasingly clear that the patient, i.e. the global economy, did in fact survive. Recently, there has been a lot of writing about the coming wave of monetary policy tightening and many pundits have concluded that given the interest rates will increase, the stock markets are overvalued, and the only reasonable thing to do is to SELL.

Well, maybe not quite. Yet, at least. It is true that the past weeks have seen some volatility in the stock markets that might give a first indication that the uptrend that began in March is running its course. But in all probability it is too early to panic.

There is no shortage of analyses pointing out that the economic recovery may well be a rather anaemic one, as several of the large economies are saddled with consumer debt that will block the way for a strong recovery. Instead we appear to be headed for a longer period of sub-par growth, as consumers are working to rebuild their balance sheets. This outlook appears to be close to a consensus by now.

Then there is what happened in the stock market. Far from being subject to a U-shaped or L-shaped recovery, the markets have seen a profit recovery that by some measure has been surprising. Obviously, there has been no help from the demand, so virtually all of the good news for the stock markets have come from the massive cost reductions that have taken place – and which were at the heart of the very steep fall in economic activity in Q4 of last year and Q1 of 2009.

As if on cue, companies worldwide cut orders, stocks and production capacity. And thereby they made the first moves to rebuild profitability and profitability did indeed come back almost with a vengeance. Stock markets reacted correctly and we have seen a 50%+ recovery.

And then to the 64 bn question: why would it continue? A 50% recovery after a 50% loss sums up to a 25% loss. Aren't the markets priced fairly for the slower economic growth ahead? Should we prepare for a setback? Probably not. Or maybe just not yet. There are two reasons for that.

One is that the Australian interest rate hike is obviously a signal, but it is no signal that the interest rates worldwide will now be pushed up in and the brakes put on. All indications from G20 and down are that central banks are in absolutely no hurry. And a finer point: the arsenal of weapons put in place by the central banks is so much wider than just interest rates. The term "Quantitative Easing" that was so in fashion long time ago – like last Monday – covers a number of initiatives to create liquidity and to bolster bank's balances. The QE will be phased out slowly before short term interest rates are hiked. It will be a relatively slow process and most market participants will not really notice until the monetary tightening is a reality. And only then the interest rates will begin to hike.

This scenario has not been lost on the bond markets, where the yield curves have steepened in anticipation of the policy changes.

The second reason is that as long as the liquidity boost is intact, investors will remain willing to take on more risk. In the time-honoured way of the financial markets, this implies that arguments will be sought and found that the markets can go higher. It is not that difficult: while cost reductions can restore profitability at a given activity level, they cannot provide for profit growth. Profit growth will in the medium term have to come from top-line growth. There is a possibility that the improved profitability from the cost reductions can carry the better results all the way until demand begins to show some life, probably sometime next year.

So yes, at some point in time this strong rally in the stock markets will end and for all the right reasons. The profit recovery will peter out, monetary policy will tighten, and the risk appetite will drop. It is probably just not now and the Australian rate hike has preciously little to do with it.

Ready to adjust your portfolio

Are you ready for the next piece of chocking news? The financial crisis is over. Well, maybe not quite, but I am pretty confident that the financial markets will beat this drum roll over the next weeks. The result is likely to be that the stock markets will run up further and that there will be significant moves in selected commodities. Oil has started and it will likely continue. Government bonds should technically suffer significantly, but probably will not, as they are subject to central bank manipulation at a historical scale.

All of this sums up to a change in the market sentiment. Governments and financial institutions across the world will latch on to it for reasons easy to understand. But the underlying situation has in fact not changed a lot since, say, the beginning of March.

True, over the past weeks we have seen the first signs of a slowing of the downwards momentum in the US economy. The rest of the world still has not yet seen such signs, but some good news could be in the offing in the coming weeks. Look out for the New Orders component in the ISM statistics and for rebounds in the property market as early indicators.

True, the US has more or less put a banking rescue plan in place. It is a terrible, expensive muddle, but it will eventually work. Yesterday's partial suspension of the Mark-to-Market rule by the FASB is another element in propping up the banks' balance sheets. It has now been replaced by a Mark-to-Whatever-You-Like rule for toxic assets which greatly helps the banks annointed as winners. European governments and banking regulators have also put in place a series of packages that will secure the survival of the banks. None of the plans have attacked the issue of expelling the boards and the CEO's responsible for the mess, so the same people will maintain their influence, once the party gets going again.

Quite significant stimulus packages have been introduced, USA, Germany and China are leading the pack, and some more may come from Europe. Over the past weeks, virtually all economic institutions with OECD in the lead have been revising downward their growth estimates for 2009 but expressed more optimism for 2010.

Last but not least, the stock market rally that began on March 9 has pushed past some important levels. At the beginning of March, the market rallied on a significant short squeeze, and optimism that the US plan to rescue banks would actually work. Since then the rally has been fed by investors who wanted to bring up their equity holdings, and now we are on the cusp of breaking out of the downtrend that has set the tone for the past many months. On top of that, remember the magical 9 months. That is the time the market is supposed to lead the real economy. It just forgot that in early 2007, but it surely has learnt from its own mistakes.

Of course we will now be persuaded to cheer up, things are not that bad. Most people still have their jobs, most houses will not be repossessed: Above all your country wants you! It wants you to start spending so demand for goods and services can grow. Your pension plan will recover.

I believe this rally still has some legs. Unfortunately there is no doubt that the foundation for the rally is not that strong – to say the least. Consumers still need to reduce their debts across the world. The CDS bubble is still out there. So are resets on the US mortgage loans. France, Italy, Spain have not done a lot for their national economies. Eastern Europe is still a mess. Long term interest rates will have to go up worldwide and the Euro-zone will have to come to grips with the fact that the Euro has been the victim of "competitive depreciations" and will eventually have to weaken. Government deficits will have to be curtailed. Banks are still not lending.

In other words, not a lot has changed, except for the subjective perception of risk. But for now, that is not really important. It will be important later.

A true capitalist solution to the banking crisis

In an interview in the London Financial Times, former Federal Reserve Chairman Alan Greenspan has made a stunning turnaround: he now believes that a temporary nationalisation of significant portions of the US banking sector is required.

Well, one could be sarcastic about those words coming from a man whose near-religious beliefs in the self-regulating forces of capitalism led him to introduce still more lax standards of regulation and work for the same to happen across the world. But strangely enough, aged 83, he appears to be faster on the button than many of his younger students.

Of course what leads Greenspan to this 180 degree turn is that despite mind-numbing amounts having already been thrown at banks have not had the desired effect. Bank lending remains seriously constrained, the banks are notoriously unwilling to come out and be honest about the correct amount of losses, and, most provoking of all, bankers appear to believe they still deserve bonuses. Even if the funds come from the tax payers.

Banks have no incentive to be honest
The key here is that the banks are still not honest about the real amount of losses. There are probably two reasons for that. One is that they do not know, since now where the economic downturn is hitting the loan books, it is a difficult call to guess delinquency rates in the near future. Except of course that credit losses will begin to mount in the coming months. The other is that there is a stand-off between the banking sector and the US lawmakers. By proxy, the outcome of this standoff will probably set the standard for what will happen elsewhere.

Banks of course hope to receive a maximum amount of cash while to the fullest extent trying to avoid limitations to their activities. Lawmakers have been struggling to find various models to avoid that banks receiving cash injections spend the received money in unwanted ways. Hence the suggestions that in order to receive more money, the banks should comply with certain rules.

This situation is not to be understood in the terms of bankers being immoral (which may indeed be the case), but in terms of banks being competitive entities trying to maximise their long term survival and profits. Their strategies are obviously determined by the existing playing field. In this case the playing field is determined by the models for rescue being discussed.

Getting out of the pinch
Being a bit crude, there are three ways out of the current stalemate. Two are being mulled over again and again in these weeks all over the world. One is to create a government-sponsored bad bank which will buy the bad assets off the banks, who after this cleaning will have much healthier balance sheets and hence can go back to their intended activity, namely taking deposits and giving credits. Another is to recapitalise the banks and issue a guarantee for their bad assets.

In both cases the banks will have an interest in receiving a maximum amount of money for their bad assets, as this will position them favourably for the titanic struggle for dominance which will break out once the downturn ends. So either the government will overpay for bad assets or issue too large guarantees while being in a situation that they will have to continue pouring money into the banks as credit losses mount. We have already seen the effects of lining up the choices this way. In the US banks have received some €350bn in help and it is fair to say that this amount has not helped at all. The banks are not saying it openly, but a lot more money is needed if the banks are to be rescued. In the UK, where we are bit further down the road than in the US, nationalisation is creeping in as losses mount.

For buffs, it is a simple game theoretic situation where the banks hope to maximise their pay-off (at the expense of tax payers) by not supplying the correct information to the public. A sort of "Liar's Poker" if you want....

Given this situation, it is surprising that politicians are not discussing the third option right away: a temporary nationalisation. Sweden set a precedent for that in the early '90s, where the banks had got themselves in a pinch by excessive lending to the property sector. Banks were simply taken over, management and boards were kicked out, bad assets lifted off the balance sheets and sold off in the market a few years in a bundle. After some years, the banks were again sold in the market, and actually, Swedish tax payers appear to have made a small profit on the whole transaction. In the meantime, it did not really matter at what price the bad assets were evaluated or indeed how the balance sheet of the banks looked, since it all was part of the government balances.

A capitalist model
But this sounds as pure socialism, so for sure it should not be used as a model?? Think again. The Swedish model is in fact more conforming to the market than any of the models currently being discussed in the US or elsewhere.

If you own a substantial part of a business, but do not put in place a board who controls the management properly and act in your interests, you may lose the business and with it of course the money invested initially. If you do it right, you win. If you screw up, you lose. Nothing could be more capitalist. But strangely enough, this principle is apparently not popular when it comes to the banks across the world right now.

Instead the owners (i.e. the shareholders), who have not put in efficient oversight, and who have permitted the management to run the banks into the ground, now argue that taxpayers should compensate them for lack of business success? This is more socialist than to let the banks fall and let shareholders, board and management pay for their follies.

Apart from being yet another sign of the monumental greed and talent for self preservation rampant among bank managements, arguing that the taxpayers should bail out the banks is based on a serious misunderstanding of what needs to be saved and what is not really necessary.

The Swedish politicians were very clear that what needed to be saved were not the individual banks, but a banking system that would be able to act as the all-important intermediary between savers and borrowers. And that will not work without confidence and a high degree of transparency. They created that by acting swiftly and radically.

A lot of banking activities are nice to have, but definitely not "need to have". Securitisation of dud mortgage loans is an example of something we could do without. Or totally unregulated credit default swaps, to name another.

In the current situation, every bank across the world knows that the next competitor is economical with the truth. So the entire banking system, despite astronomical amounts already spent, is still not in a situation to resume normal lending activities.

Meanwhile the world economy is contracting at a disturbing phase. Every major financial institution has postponed the end of the downturn to 2010. Banks will begin to see serious losses on normal commercial loans in a few months.

The quicker we progress towards the true capitalist solution, and nationalise the banks, the better.