Bill Gross Bets On Deflation

Via Bloomberg:

Bill Gross, who runs the world’s biggest bond fund at Pacific Investment Management Co., said he’s been buying longer maturity Treasuries in recent weeks as protection against deflation.

“There has been significant flattening on the long end of the curve,” Gross said in an interview from Newport Beach, California, with Bloomberg Radio. “This reflects the re- emergence of deflationary fears. The U.S. is at the center of de-levering as opposed to accelerating growth.”

Gross had said during the midst of the credit crunch that Treasuries offered little value as investors seeking a refuge from turmoil in global financial markets drove yields to record lows in December. He boosted the $177.5 billion Total Return Fund’s investment in government-related bonds to 44 percent of assets, the most since August 2004, from 25 percent in July, according data released earlier this month on Pimco’s Web site. The fund cut mortgage debt to 38 percent from 47 percent.

…Officials at Pimco have forecast a “new normal” in the global economy that will include heightened government regulation, lower consumption and slower growth. The economy will likely expand at a 2 percent to 3 percent rate going forward, Gross said.

The world’s largest economy shrank at a 1.2 percent annual rate from April to June, more than the originally reported 1 percent contraction, according to a Bloomberg News survey before the Commerce Department’s Sept. 30 report. The jobless rate climbed to 9.8 percent this month, from 9.7 percent in August, according to a separate Bloomberg survey before the Labor Department reports figures on Oct. 2.

Read the full article here

Is Jim Grant the Latest To Be Drinking the Kool-Aid?

David Rosenberg of Gluskin Sheff comments on Jim Grant’s WSJ column:

The Weekend Journal ran with an article by James Grant, which admittedly took us by surprise (he is a true giant in the industry, as an aside) — From Bear to Bull and in the article, he relies mostly on the thought process from two economic think-tanks — Michael Darda from MKM Partners and the folks over at the Economic Cycle Research Institute.

We highly recommend this article for everyone to read to understand the other side of the debate. But we have some major problems with the points being made.

1. Mr. Grant starts off by saying that “as if they really knew, leading economists predict that recovery from our Great Recession will be plodding, gray and jobless.” Well, frankly, it doesn’t really matter what “leading economists” are saying because Mr. Market has already moved to the bullish side of the debate having expanded valuation metrics to a point that is consistent with 4% real GDP growth and a doubling in earnings, to $83 EPS, which even the consensus does not expect to see until we are into 2012. We are more than fully priced as it is for mid-cycle earnings.
2. Nowhere in Mr. Grant’s synopsis do the words “deleveraging” or “credit contraction” show up. Yet, this is the cornerstone of the bearish viewpoint. Attitudes towards homeownership, discretionary spending and credit have changed, and the change is secular, not merely cyclical. After all, didn’t consumers just see a record $20 billion of outstanding credit evaporate in August?
3. Mr. Grant emphasizes (the Darda argument) how we had a huge bounce in the economy after the worst point of the Great Depression (in fact, the subtitle of the article contains: “The deeper the slump, the zippier the recovery”). Well, we didn’t have the Great Depression this time around — real GDP did not contract 25% but rather by 3.7%. We probably have to go now and redefine what a massive slump is. But all we had in the mid-part of the 1930s — between the worst point in 1932 to the 1937-38 relapse — was a statistical recovery, and nothing more than that. Nobody from that era will recall that any year was particularly good — each one was just different shades of pain and sacrifice. By the end of the decade, the unemployment rate was still 15%, the CPI was deflating at a 2% annual rate and the level of nominal GDP, as well as industrial production, still had yet to re-attain its 1929 peak. The equity market in 1941 was no higher than it was in 1933 (and long bond yields were heading below 2%) and even a child knows that it was WWII that brought the economy out of its malaise, not the seven years of New Deal stimulus.

So, to concentrate on the wiggles in the GDP data in the 1930s, no matter how large, totally misses the point about what the decade was really about, which was social change, a focus on family, less discretionary spending, and a trend towards frugality that few market pundits seem to comprehend. But the 1930s were the antithesis of the 1920s — not unlike what we are witnessing today. To concentrate on a bungee jump that wasn’t even sustained is akin to focusing on the noise around the trend-line as opposed to the trend-line itself.

4. The very sexy argument about how all the government stimulus is going to give the economy a really big lift — combined monetary and fiscal measures are worth 19.5% of GDP. This is viewed as a good thing, of course, but nowhere in the analysis is there a comment about how this “stimulus” is just there to cushion the blow and smooth the transition as wide swaths of private sector credit vanish. We are at the point where 85% of housing activity is still being supported by government interventions. Is this really desirable? According to BusinessWeek, it’s not just the FHA financing 40% of new mortgage originations but the USDA is also allowing builders and lenders to take advantage of rural mortgages that require no-money down and with 100% financing through “a little-known loan program”.

Well, as with most bulls, this new era of state capitalism is a reason to rejoice. But from our lens, what would be more noteworthy would be an article explaining that the massive government incursion with all this “stimulus” is actually more a reason to be concerned than be jubilant — what it really symbolizes is an economy that is so sick that it continues to require massive doses of medication.

It’s not what all the stimulus does that matters — of course, it is there to act as a cushion — but it is what all the stimulus has come to symbolize. A fundamentally weak economic backdrop and a precarious banking system that has government guarantees to thank for its survival.

Inflation or Deflation?

George Washington of Washington’s Blog writing in Naked Capitalism:

As Absolute Return Partners wrote in its July newsletter:

The most important investment decision you will have to make this year and possibly for years to come is whether to structure your portfolio for deflation or inflation.

So which is it, inflation or deflation?

This is obviously a hot topic of debate, and experts weigh in on both sides. I’ve analyzed this issue in numerous posts, but every day there are new arguments one way or the other from some very smart people.

Because the arguments for inflation are so obvious and widely-discussed (bailouts, quantitative easing, Fed purchasing treasuries, etc.), I will not discuss them here (other than pointing to an interesting new argument for inflation by Andy Xie).

How Bad Could It Get?

The biggest deflation bears are rather pessimistic:

• David Rosenberg says that deflationary periods can last years before inflation kicks in

• Renowned economist Dr. Lacy Hunt says that we may have 15-20 years of deflation

• PhD economist Steve Keen says that – unless we reduce our debt – we could have a “never-ending depression”

These are the most pessimistic views I have run across.  Most deflationists think that a deflationary period would last for a shorter period of time.

The Best Recent Arguments for Deflation

Following are some of the best arguments for deflation…

Read the full post here

Fed Growth Effort May Be Undermined by ‘Tight’ Credit

Via Bloomberg:

Federal Reserve Chairman Ben S. Bernanke’s efforts to stoke a U.S. economic recovery may be undermined by the central bank’s other goal of restoring the banking system to health.

The Federal Open Market Committee, at the conclusion tomorrow of a two-day meeting, will probably maintain its assessment that “tight” bank credit is impeding growth, said economists including former Fed Governor Lyle Gramley. Lending contracted for five straight weeks through Sept. 9, a drop that in part reflects Fed orders to banks to raise more capital and toughen lending standards, analysts say.

A failure to restore the flow of bank credit carries the risk that the economic recovery will be slower than the Fed anticipates, or even that the U.S. lapses into another recession, economists say. That would make it more likely the Fed will keep its main interest rate close to zero for a longer period.

————

“Even though from a technical perspective the recession is very likely over at this point, it’s still going to feel like a very weak economy for some time,” Bernanke said in response to a question after a speech in Washington. Fed officials in June predicted that GDP will expand 2.1 percent to 3.3 percent next year after shrinking 1.5 percent to 1 percent this year, according to the central tendency of their forecasts.

Banks have plenty of reasons to hold back on lending, analysts say.

Americans fell behind on their mortgage payments at a record pace in the second quarter, with delinquencies rising to 9.24 percent, according to an August report by the Mortgage Bankers Association.

“Consumers aren’t necessarily that creditworthy a proposition right now,” said John Ryding, chief economist and founder of RDQ Economics LLC in New York.

Falling values of commercial real estate are also a problem for banks, with an “uncertain degree of losses” to come, said Ryding, a former Fed researcher. Loans made for commercial property will probably sour and lenders will need to raise more capital to cover credit losses, Mike Mayo, a banking analyst at CLSA Ltd., said today at a conference in Hong Kong.

Read the full article here

HSBC Bids Farewell to Dollar Supremacy

Via Ambrose Evans-Pritchard of Telegraph.co.uk:

“The dollar looks awfully like sterling after the First World War,” said David Bloom, the bank’s currency chief.

“The whole picture of risk-reward for emerging market currencies has changed. It is not so much that they have risen to our standards, it is that we have fallen to theirs. It used to be that sovereign risk was mainly an emerging market issue but the events of the last year have shown that this is no longer the case. Look at the UK – debt is racing up to 100pc of GDP,” he said

Crucially, China and rising Asia have reached the point where they can no longer keep holding down their currencies to boost exports because this is causing mayhem to their own economies, stoking asset bubbles. Asia’s “mercantilist mindset” of recent decades is about to be broken by the spectre of an inflation spiral.

The policy headache was already becoming clear in the final phase of the global credit boom but the financial crisis temporarily masked the effect. The pressures will return with a vengeance as these countries roar back to life, leaving the US and other laggards of the old world far behind.

Read the full article here

Stephanie Pomboy: Immediate Threat is Deflation, Not Inflation

Alan Abelson from his Up And Down Wall Street column in Barron’s. Stephanie Pomboy believes there will be inflation, but it’ll be in assets, not goods. The immediate threat is deflation:

The indomitable Stephanie Pomboy, who beguiles us week-in, week-out with her feisty, funny and very much with-it MacroMavens commentary, is a member of the small but hearty camp (number us among them) who believe that the immediate threat is deflation, not inflation.

As, among other things, the glistening rise in gold and the heavy shorting of long-dated Treasuries strongly suggest, she notes, the popular investment view is pretty fixated on inflation. And Stephanie mulls whether Jeff Lacker, president of the Federal Reserve Bank of Richmond, “isn’t sure the Fed will be able to make a graceful exit before all inflation hell breaks loose,” shouldn’t we all share his concern? Her answer is a qualified “no.” Qualified because she believes there’ll be inflation, but it’ll be in assets, not goods.

For she’s convinced the consumer’s new-found prudence is no passing fancy, but a behavioral sea change, and that the repair of consumer balance sheets so badly thrown out of whack by a quarter of a century of credit overindulgence will continue. So while equities and commodities, as their recent explosive runs demonstrate, may run hog-wild, the massive decline in consumer credit represents a daunting barrier to a kindred climb in consumer prices.

Yet despite mounting evidence of the new frugality on the part of the populace, Stephanie points out, retail stocks are posting their strongest relative performance since March 2007, and junk spreads are the narrowest since October 2002. “Investors,” she shakes her head, “are discounting an environment in which retail sales register 3%-style annual gains.”

To notch such an increase, she gauges, retail sales, now declining at an annual rate of $331 billion, would have to make a U-turn and rise $470 billion! As she says, “An $800 billion swing? You’d have to be certifiable to bet on that.”

Stephanie felt “there’s no way professional investors are betting real money (even if it’s other people’s money) on such an outcome. Is there?” So she went back to the drawing board hoping to arrive at a less frightening conclusion.

Specifically, she turned to what she calls the “broadest proxy of risk appetite,” namely stocks versus bonds, to discover what types of gain in overall consumer spending it implied. The divergence between the two, she explains, is at extremes last seen when consumer spending was chugging along at a 6% clip.

“To reach that milestone today,” she sighs, “would require one whiplash-inducing U-turn if ever there was one, with the present $165 billion annualized decline in spending giving way to a $779 billion gain.” Even these days, that’s a big number.

If the demand for credit revives or employment and income begin to grow, neither of which seems to us likely to happen anytime soon, Stephanie says that’ll be the time to start worrying about inflation in the traditional sense. At the moment, the only serious inflation is in stuff like financial assets, because all the surplus “liquidity” that has been pumped into the economy has nowhere else to go.

She tabs the equity rally as exceedingly long in the tooth. Earnings expectations, she submits, “have never been so far afield of economic reality, and the market’s banking on a $1 trillion spending swing over the next 12 months.”

Related: Stephanie Pomboy is featured in the book The Great Financial Crisis: Causes and Consequences

Taleb: We Still Have the Same Disease

Nassim Taleb did an interview with the Globe And Mail. You can always count on it being interesting with Mr. Taleb. Below are some highlights:

Central bankers have no clue. In the first place, the financial crisis was not a black swan. It was perfectly predictable. They ignored the phenomenal buildup in leverage since 1980. They acted like airline pilots who’d never heard of hurricanes.

After finishing The Black Swan, I realized there was a cancer. The cancer was a huge buildup of risk-taking based on the lack of understanding of reality. The second problem is the hidden risk with new financial products. And the third is the interdependence among financial institutions.

…Today we still have the same amount of debt, but it belongs to governments. Normally debt would get destroyed and turn to air. Debt is a mistake between lender and borrower, and both should suffer. But the government is socializing all these losses by transforming them into liabilities for your children and grandchildren and great-grandchildren. What is the effect? The doctor has shown up and relieved the patient’s symptoms – and transformed the tumour into a metastatic tumour. We still have the same disease. We still have too much debt, too many big banks, too much state sponsorship of risk-taking. And now we have six million more Americans who are unemployed – a lot more than that if you count hidden unemployment.

…Ben Bernanke saved nothing! He shouldn’t be allowed in Washington. He’s like a doctor who misses the metastatic tumour and says the patient is doing very well. The first thing I would tell Chinese officials is, how can you buy U.S. bonds as long as Larry Summers is there? He’s a textbook case of overconfidence. Look what happened to Harvard’s finances. They took a lot of risk they didn’t understand, and it was a disaster. That’s the Larry Summers mentality.

Read the full interview here

Some Fires Are Best Left To Burn Out

A great piece from the FT:

The current Keynesian mindset rightly observes that we have a shortage of aggregate demand. It then concludes that demand stimulus, from whatever quarter, is to be welcomed. However, in addition to the undergrowth problem on the demand side, we can also have an undergrowth problem on the supply side. This was the core of Friedrich Hayek’s position when he debated Keynes in the early 1930s. In response to demand stimulus over recent decades, with investors implicitly assuming that the future would be like the recent past, there has been a massive increase in supply potential in many industries. The upshot is that many of them are now too big and must be wound down. This applies to automobile production, banking services, construction, many parts of the transport and wholesale distribution industries, and often retail distribution as well. Similarly, many countries that relied heavily on exports as a growth strategy are now geared up to provide goods and services to heavily indebted countries that no longer have the will or the means to buy them.

In this supply side context, policies such as “cash for clunkers” and value added tax cuts in countries with very low household saving rates and massive trade deficits are clearly suboptimal. So too, in countries with large trade surpluses, is resistance to exchange rate appreciation along with a continuing reliance on export demand. Such policies are equivalent to trying to resuscitate a patient long since dead. Not only will time prove that such attempts are futile, but they also impede the desirable adjustment from declining industries to those that should be expanding. In effect, relying solely on macroeconomic stimulus may well head off a more violent downturn, but only at the expense of a more protracted recession. Maybe this is the principal lesson to be drawn from Japan’s almost two decades of sub-par performance. Indeed, resisting structural adjustment could also imply a decline in the level of “potential growth” in the years ahead. This would bring with it the threat of a stagflationary outcome, if the demand stimulus from Keynesian policies were not to be adjusted downwards in consequence.

Read the full article here

Janet Yellen’s Superb Speech

Ask and you shall receive. Here’s your double dose of Rosie for the evening. From today’s daily letter:

San Francisco Fed President Janet Yellen delivered a superb speech last night that really resonated with us — a true reality check for a stock market which has galloped ahead by 54% from the lows, purely on a record eight point expansion of the P/E multiple. The move in equity valuation suggests that stock market investors are anticipating 4% real GDP growth in the coming year. Janet Yellen has proven to be one of the more astute economic forecasters at the Federal Reserve and so we thought it prudent to re-print part of her sermon.

First, the good news

“I’m happy to report that the downturn has probably now run its course. This summer likely marked the end of the recession and the economy should expand in the second half of this year.”

A slow motion recovery lies ahead

“But I regret to say that I expect the recovery to be tepid. What’s more, the gradual expansion gathering steam will remain vulnerable to shocks. The financial system has improved but is not yet back to normal. It still holds hazards that could derail a fragile recovery. Even if the economy grows as I expect, things won’t feel very good for some time to come. In particular, the unemployment rate will remain elevated for a few more years, meaning hardship for millions of workers. Moreover, the slack in the economy, demonstrated by high unemployment and low utilization of industrial capacity, threatens to push inflation lower at a time when it is already below the level that, in the view of most members of the Federal Open Market Committee (FOMC) best promotes the Fed’s dual mandate for full employment and price stability.”

Sorry, but the credit crisis is not over

“Unfortunately, more credit losses are in store even as the economy improves and overall financial conditions ease. Certainly, households remain stressed. In the face of high and rising unemployment, delinquencies and foreclosures are showing no sign of turning around. The delinquency rate on adjustable-rate mortgages is now up to about 18 percent, and, on fixed-rate loans, it’s about 6 percent. Delinquencies on both types of loans have increased sharply over the past year and are still rising. This trend is consistent across other major loan categories, and is affecting high- and low-quality borrowers alike. Even recent-vintage loans are experiencing rising delinquency rates …

…As I said, financial conditions are better, but not back to normal. And the likelihood of continuing losses by financial institutions will add new fuel to the credit crunch. In particular, small and medium-size banks could experience damaging losses on commercial real estate loans. Thus far, the largest losses have been on loans for construction and land development. Going forward, however, rising loan losses on other commercial real estate lending is likely because property values are falling, office vacancy rates are rising, and credit remains tight or nonexistent for those many property owners that will need to refinance mortgages over the next few years. Financial contagion from this sector is one of the most important threats to recovery.”

Severe consumer headwinds

“The chances are slim for a robust rebound in consumer spending, which represents around 70 percent of economic activity. Of course, consumers are getting a boost from the fiscal stimulus package. But this program is temporary. Over the long term, consumers face daunting issues of their own. In fact, it’s easy to draw a comparison between the financial state of households and that of financial institutions. For years prior to the recession, households went on a spending spree. This occurred during a period that economists call the “Great Moderation,” about two decades when recessions were infrequent and mild, and inflation was low and stable. Credit became ever easier to get and consumers took advantage of this to borrow and buy. Stock and home prices rose year after year, giving households additional wherewithal to keep spending. In this culture of consumption, the personal saving rate fell from around 10 percent in the mid-1980s to 1½ percent or lower in recent years. At the same time, households took on larger proportions of debt. From 1960 to the mid-1980s, debt represented a manageable 65 percent of disposable income. Since then, it has risen steadily, with a notable acceleration in the last economic expansion. By 2008, it had doubled to about 130 percent of income.

It may well be that we are witnessing the start of a new era for consumers following the traumatic financial blows they have endured. The destruction of their nest eggs caused by falling house and stock prices is prompting them to rebuild savings. The personal saving rate is finally on the rise, averaging almost 4½ percent so far this year. While certainly sensible from the standpoint of individual households, this retreat from debt-fueled consumption could reduce the growth rate of consumer spending for years. An increase in saving should ultimately support the economy’s capacity to produce and grow by channeling resources from consumption to investment. And higher investment is the key to greater productivity and faster growth in living standards. But the transition could be painful if subpar growth in consumer spending holds back the pace of economic recovery.”

Read more »

It’s Not “Liquidity” Driving the Market

What’s that? You need more cowbell David Rosenberg? Here’s Rosie in his daily letter explaining how it’s not liquidity that’s driving the market:

You can always rest assured that a peak is at hand when you read and hear about how “liquidity” is driving the market.  For one, nobody even has a clue as to how “liquidity” is even defined.  It’s basically a catch-all term for “I don’t know”.  But what we do know is that short covering remains an important source of buying power for equities as the bears bail out — short interest on the NYSE, for example, shrunk 2.4% in the second half of August, and was down 2.9% on the Nasdaq.  Just in case you were wondering how it was that the S&P 500 managed to advance 20 points in the second half of the month.

The truth of the matter is that investment grade corporate bonds have outperformed the S&P 500 by 70 basis points so far this year — income at a reasonable price remains a primary theme.  The problem with the equity market is that dividends no longer comprise a critical part of the total return pie as it used to.  The reliance now is almost purely on capital appreciation, which can be secured when unit labour costs are falling at annual rate of at least 5%, as has been the case over the last two quarters.  However, that rate of decline cannot possibly be sustained.  But what can be sustained, and likely will be, is the deflationary backdrop in private sector demand, which influences the revenue line.  Take note that 250 S&P 500 companies cut their dividends in 2Q, the highest number in over 50 years (and as per the WSJ, stock buybacks have declined now for six quarters in a row).

Take note that the Fed is now pumping reserves aggressively into the banking system again, with the monetary base accelerating at a 141% annual rate over the past four weeks.  But the money multiplier is still contracting — over this time frame, M1 has contracted at a 28.7% annual rate; M2 has fallen at a 4.9% annual rate; and MZM has shrunk at a 6.2% annual rate.  In other words, and with all deference to the excitement that a 50%+ bear market rally can engender in the media, the credit system is still … broken.  When the investment community eventually figures out that the economy is not in, or even is it entering, a V-shaped recovery there will undoubtedly be a new round of deflated price discovery, followed by years of anemic economic growth, persistently high unemployment, ongoing consumer frugality, rising savings rates, and a prolonged period in which portfolios will move further towards strategies that provide income and preservations of capital rather than a focus on aggressive capital appreciation potential.