Pimco Says ‘Fear Not,’ Weak Dollar Will Spur Growth

Via Bloomberg:

Pacific Investment Management Co., which runs the world’s biggest bond fund, said the dollar is poised to fall and the decline may help spur the U.S. economy.

“Fear not the falling dollar,” Scott Mather, head of global portfolio management at Pimco, wrote in an article on the company’s Web site. “A gradually weakening dollar may help heal the U.S. economy” by encouraging demand for the nation’s exports, he wrote.

“There are few viable alternatives,” Mather wrote. “No other currency offers the size and liquidity — not to mention the political and legal stability — necessary to match the dollar as reserve currency of choice.”

“Deflation is a bigger near-term threat than inflation…”

Read the full article here

Mauldin: Elements of Deflation

Via John Mauldin’s Thoughts From the Frontline:

One of the advantages of travel is that it gives you time away from the tyranny of the computer to think. (Am I the only one who feels like I am drinking information through a fire hose?) But getting the information is important too, as it gives you something to think about. And I have been thinking a lot lately about deflation.

I get asked at almost every venue where I stop, whether I think we will see inflation, or deflation. And I answer, “Yes.” And I am not trying to be funny. I think the primary forces in the developed world now are deflationary. When asked if I don’t think that the Fed monetizing debt of all kinds won’t eventually be inflationary, I answer, “We better hope so!”

Let’s quickly summarize some of the ideas from the last few months of this letter. Just as water is made up of two parts hydrogen to one part oxygen, so deflation has its own elemental structure.

The first element is Rising Unemployment. There has never been a sustained inflationary period without wage inflation. Wages are basically flat and falling. With 9.8% unemployment, 7% underemployed (temporary), and another 3-4% off the radar screen because they are so discouraged they are not even looking for jobs, and thus are not counted as unemployed (who made up these rules?), it is hard to see how wage inflation is in our near future.

Think about this. Only a few years ago, less than 1 in 16 Americans was unemployed or underemployed. Today it is 1 in 5. That is a staggering, overwhelming statistic. Mind-numbing.

Keynes said that you should stimulate the economy in recessions in order to bring back consumer spending. That is not going to happen this time. As my friends at GaveKal point out, this time we will have to have an Austrian (economic) recovery, or a business-spending recovery. My argument will be, when I am with them in Dallas in December at their conference, “Where are we going to get business-investment spending when banks aren’t lending and capacity utilization is at an all-time low?” This, of course, leads the Keynesians to jump in and say, “The government has to step up and jump-start consumption!” Which means more debt. Wash. Rinse. Repeat.

The next element of deflation is massive Wealth Destruction. Two bear markets and a housing market collapse have put the American consumer on the ropes. And the next bear market will bring him to the canvas.

Then we have Reduced Borrowing and Lending, as consumers are paying down debt and banks are reducing their lending. Both are necessary in a credit crisis-caused recession. Bank lending is basically back to where it was two years ago, and shows no sign off rebounding. Banks, as I have written, are buying US government debt in an effort to shore up their balance sheets. Lending to small business, the real engine of job creation, is sadly decreasing each month. (See graph below.)

Next up in our elemental list we have Decreased Final Demand and its counterpart Increased Savings. Although the savings rate has come back down to 3% from 6% a few months ago, almost every expectation is that it will rise over the next 3-5 years back up to the 9% level where it was only 20 years ago. The psyche of the American consumer has been permanently seared. Consumption and savings habits are being changed as I write.

And of course we must address the element of Low Capacity Utilization. While capacity utilization is rebounding, it is still lower than at any time since the data has been collected, other than the last few months. It is hard to see where businesses are going to get pricing power, when not only US but world capacity utilization is still extremely low. The chart below is not the stuff that inflation is made of.

And let’s just quickly throw in Massive Deleveraging and $2 trillion in Bank Losses and a Very Weak Housing Market. Which brings us to a Slowing Velocity of Money.

As I have written on several occasions, prices are a function of the amount of money times the velocity of money. If the velocity of money is slowing, the amount of money can rise without bringing about inflation. It is a delicate balance, but nonetheless the hyperventilation in some circles about the coming hyperinflation is, well, overinflated. Simplistic. Economically naive.

The Fed is going to do what it takes to bring about inflation (in my opinion). But they will not monetize US government debt beyond what they have already agreed to. If they need to “print money” to fight deflation, they can buy mortgage or credit-card or other forms of private debt, which have the convenience of being self-liquidating. Read the speeches of the Fed presidents and governors. I can’t imagine these people will recklessly monetize US debt. You don’t get to their level without having a stiff backbone. (Yes, I know the gold bugs will call me terminally naive. We will have to wait to see who is right. Peter Schiff, care to make a bet on this one?)

Bernanke warned Congress again last week about rising deficits. Watch the deficit rhetoric coming from the Fed after the next two governors are appointed next year, side by side with Bernanke’s reappointment. There will be a line drawn in the sand. Some in Congress will not be happy, but my bet is that the Fed will maintain its independence. If they do not, then my recent letters will prove far too optimistic (and many of you protest my rather less-than-positive suggestion of a double-dip recession). But I must admit I cannot imagine that happening. And there are not enough votes in Congress to change that independent status. There is a day of reckoning coming with the US debt. And thank God for that.

Bottom line: The Fed will do what it takes to keep us from deflation. They will deal with the problems of the ensuing inflation. I wrote six years ago that the best outcome from all the easy monetary policy and budget deficits would be stagflation. I see no need to change that assessment. I am not happy with stagflation, but as I came into my young adult life in the ’70s (see below), I know that we can deal with that. The far more worrisome prospect is continued trillion-dollar deficits.

Read the full newsletter here

Don’t Fear the Inflation, Goldman Says

Via FT Alphaville:

Goldman Sachs is putting an end to the deflation vs inflation debate, once and for all!

In a 30-page research note out on Wednesday, the bank comes down firmly on the side of (moderate) deflation in the near-term.

Here, GS analyst Andrew Tilton says, is why:

• Inflation is already low, with the core CPI down to 1.4% on a year-overyear basis and the overall CPI in deflation territory.

• Excess capacity in the economy is huge, probably at least 6% of GDP and possibly at its highest level since the Great Depression.

• Spare capacity is likely to persist for years [see below table]. While the financial crisis and recession probably have reduced the economy’s production capacity somewhat, we do not see strong evidence for persistently lower growth of capacity going forward. Even if we assume substantially above-trend real GDP growth of, say, 5% per year, it will take more than three years to get back to equilibrium in the labor market and two in the manufacturing sector. Our own assumptions of a somewhat slower recovery suggest it could well take more than five years to reach equilibrium in the labor market and nearly as long in housing.

• Monetary policy is arguably too tight despite a near-zero funds rate and unconventional easing. Our own calculations using estimated Taylor rule parameters, as well as those in recent research from the San Francisco Fed, point to an `appropriate’ funds rate of -5% or below.
  

• The default path of current policy is for removal of stimulus. Fed asset purchase programs are scheduled to end within the next several months and its balance sheet will begin to shrink after that point, while the growth impact of fiscal stimulus is already peaking.

Nevertheless, Goldman’s Tilton gets why investors are worried about inflation, and the bank itself is not oblivious to the possibility, given the massive unconventional fiscal and monetary policies undertaken by the Federal Reserve. In fact, Tilton says, there are a few inflationary warnings signs investors should be looking out for.

Continue reading the 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.

You Can’t Handle the Truth About Stocks

CNNMoney.com interviews Boston University School of Management professor Zvi Bodie. I do not totally agree with Mr. Bodie, but he does have some interesting points. Here are some highlights:

The advice rolls off the tongues of financial planners and appears frequently in the pages of financial magazines such as Money: To have any shot at retiring well, you need to invest a good portion of your money in stocks.

But mention this to Boston University School of Management professor Zvi Bodie, author of “Worry-Free Investing,” and you’ll get a stern reminder of how equities often betray investors. And you’ll get an earful about how millions of us are taking too much risk with our nest eggs.

……….

But don’t you need the growth that stocks provide to combat the risk of inflation?

Inflation is exactly what Treasury Inflation-Protected Securities (TIPS) and I bonds were created to protect against. Even if equities did perform well in periods of inflation, you’re exposing yourself to an even greater risk of a stock market decline. And as it turns out, anytime there’s been significant inflation, equities have been a terrible investment. Just look at the 1970s.

So you’d tell an investor to have 100% of his retirement money in TIPS?

Yes. In fact, I have 100% of my own retirement money in TIPS. I do have a small account of nonretirement funds in which I invest in bonds, options, and stocks.

Currently, long-term TIPS earn just 2% after inflation. How is anyone going to be able to retire on so little growth?

If you look at most online retirement calculators, they make two assumptions: one, that you want to retire at age 65, and two, that people will be able to save only a certain amount — say 10%. As a result, they spit out risky portfolios to get a higher return. Well, who says we all want to retire at 65 and can save only 10%? What if I retire at 70 or 75? What if I save 30%? Suddenly, you don’t need to take so much risk in your portfolio. Now, if you put 100% in TIPS, you will have to save upwards of 20% of your annual pay, even if you’re young, to retire at age 65. But I think it would be more reasonable to expect to retire at a later date.

Read the full interview 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

Nation Currently Experiencing Both Inflation AND Deflation

Here are some words of insight from Jeffrey Saut, who writes the Investment Strategy letter for Raymond James Financial:

In last week’s letter we suggested that the nation currently is experiencing both inflation AND deflation. Consider this, it appears that the country’s top quintile of wage-earners (the folks with the most assets) are experiencing deflation as their house prices have collapsed, their 401(k)s are substantially below where they were in October 2007, their bonuses have been “whacked,” and the list goes on. Meanwhile, the lower income households are experiencing inflation with their healthcare costs rising, food prices escalating, insurance premiums climbing, etc. In such an environment it is logical that Treasury Bonds would rally in the short-run. Longer term, however, we continue think inflation will win out over deflation, which is why we agree 30-year Treasury Bonds are a “bad bet.”

On the dollar, after being bearish from 4Q01 until 4Q07, we turned neutral to moderately bullish on the “buck” in November 2007. At first that “call” was wrong, then it was right, yet all said the Dollar Index is no lower, or higher, now than it was in November 2007. Hereto, over the longer term we think the greenback is likely headed lower. But as the economy recovers, so too should the dollar. Accordingly, in the short term, we remain neutral to slightly positive on the U.S. dollar.

Speaking to the stock market, we have, and continue, to argue that at the March 2009 “lows” stocks were three to four standard deviations below “norms;” and that all we have done is rally back to normalized valuations. Given the severity of the 17-month decline (October 2007 to March 2009), there is no reason why the equity markets can’t rally to one, or two, standard deviations above “norms.” Moreover, stocks don’t necessarily need outsized economic growth to rally. All they need is growth. As our friends at the consummate GaveKal organization, whose service we highly recommend, note:

“The reality is that equity markets do not need high growth to thrive – they just need some growth. In fact, one could argue that a low-growth environment is preferable to one of stellar growth, since low growth is often accompanied by low interest rates and plentiful liquidity. Today, this is the environment which we will likely face for years to come. The latest Beige Book does a good job of summing up this story: the quarterly Fed survey reported that wage and price pressures were non-existent, that retail spending is lackluster in most areas, and that manufacturing activity has moderately improved. This will likely be the story for the foreseeable future. Consumers and banks will remain cautious, but interest rates will stay low, allowing for a gradual recovery in output. This is an ideal environment for corporate profit growth and also helps to explain why equities keep creeping higher.”

And, last week stocks continued to “creep higher” with all of the indices we follow trading higher for the holiday-shortened week. That action left most of those indices at new rally reaction “highs,” putting even more pressure on underinvested money managers. A case in point was an article from a few weeks ago whereby a money manager disclosed that he still has 80% of his $850 million under management in cash. I read the article with both amazement and amusement. Amazement because I was surprised that any portfolio manager would admit he had that huge of a hoard of cash after more than a 50% rally from the March lows. Amusement because he probably allowed himself to be quoted believing that the September 1st Dow Downer, of 185 points, was the beginning of the long anticipated correction.

Mr. Saut’s recommendation:

Our answer to this dilemma, in the current environment, is to scale “buy” into large-cap, dividend-paying, stocks. Manifestly, stock returns are a function of corporate earnings, the price-to-earnings ratio investors are willing to pay for said earnings, and the dividends they receive over time from those stock investments. That’s all you really need to know about the stock market! To reiterate, “If, however, you don’t embrace our near-term caution, we suggest doing what the underinvested money managers are being forced to do – buy lower volatility stocks with dividends.

Book: Where Keynes Went Wrong

If you are not only looking for a good read, but one that is also relevant to our current economic situation, then I would recommend Where Keynes Went Wrong: And Why World Governments Keep Creating Inflation, Bubbles, and Busts. You hear a lot about Keynes now days, especially from Paul Krugman. But what did Keynes actually say and should we be relying on his policies.

From the Product Description:

In responding to the financial crash of 2008, both the Bush Administration and the Obama Administration have relied on prescriptions developed by John Maynard Keynes, the most important economist since Marx. But should we be relying on Keynes? What did Keynes actually say? Did he make his case? Hunter Lewis concludes that he did not. If Keynes was wrong then so are the economic policies of virtually all world governments today.

Robert Blumen from Mises.org has a mini-review of the book. Below is an excerpt:

This book fills a missing niche in the literature: a debunking of Keynes for the general reader. I believe that this book would also be useful as a supplement in a macro course. But its most important contribution in my view is that it demystifies Keynes. The ideas in The General Theory form the foundation of modern macro-economics, which is the basis for the modern practice of central banking and pretty much all monetary policy around the world. What I mean by the mystification of Keynes is that, because his theories are so long-established and deeply embedded in academic economics, government, and the public consciousness, it is difficult not to think that there must be something really deep and profound there. Upon reading Lewis’ book, it is somewhat shocking to see how weak his arguments are and how poorly they stand up to any kind of logical examination.

Krugman: How Did Economists Get It So Wrong?

Paul Krugman wrote a lengthy piece in the New York Times Magazine today. It is a very hard critique and analysis of the failure of current macro and financial economic thought, which didn’t even come close to predicting the current financial malaise. I don’t agree with all of it, particularly his love affair with Keynesian economics. But it is still very worthy of your time and a recommended read. A point where I agree with Krugman: the failure of EMH.

Below is an excerpt:

As I see it, the economics profession went astray because economists, as a group, mistook beauty, clad in impressive-looking mathematics, for truth. Until the Great Depression, most economists clung to a vision of capitalism as a perfect or nearly perfect system. That vision wasn’t sustainable in the face of mass unemployment, but as memories of the Depression faded, economists fell back in love with the old, idealized vision of an economy in which rational individuals interact in perfect markets, this time gussied up with fancy equations. The renewed romance with the idealized market was, to be sure, partly a response to shifting political winds, partly a response to financial incentives. But while sabbaticals at the Hoover Institution and job opportunities on Wall Street are nothing to sneeze at, the central cause of the profession’s failure was the desire for an all-encompassing, intellectually elegant approach that also gave economists a chance to show off their mathematical prowess.

Unfortunately, this romanticized and sanitized vision of the economy led most economists to ignore all the things that can go wrong. They turned a blind eye to the limitations of human rationality that often lead to bubbles and busts; to the problems of institutions that run amok; to the imperfections of markets — especially financial markets — that can cause the economy’s operating system to undergo sudden, unpredictable crashes; and to the dangers created when regulators don’t believe in regulation.

It’s much harder to say where the economics profession goes from here. But what’s almost certain is that economists will have to learn to live with messiness. That is, they will have to acknowledge the importance of irrational and often unpredictable behavior, face up to the often idiosyncratic imperfections of markets and accept that an elegant economic “theory of everything” is a long way off. In practical terms, this will translate into more cautious policy advice — and a reduced willingness to dismantle economic safeguards in the faith that markets will solve all problems.

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Debt and Deflation

Second Quarter 2009 Quarterly Review and Outlook by Van Hoisington and Dr. Lacy Hunt

DEBT ACTS AS A BRAKE ON THE MONETARY ENGINE

One of the more common beliefs about the operation of the U.S. economy is that a massive increase in the Fed’s balance sheet will automatically lead to a quick and substantial rise in inflation. An inflationary surge of this type must work either through the banking system or through non-bank institutions that act like banks which are often called “shadow banks”. The process toward inflation in both cases is a necessary increasing cycle of borrowing and lending. As of today, that private market mechanism has been acting as a brake on the normal functioning of the monetary engine.

For example, total commercial bank loans have declined over the past 1, 3, 6, and 9 month intervals. Also, recent readings on bank credit plus commercial paper have registered record rates of decline (Chart 1). The FDIC has closed a record 52 banks thus far this year, and numerous other banks are on life support. The “shadow banks” are in even worse shape. Over 300 mortgage entities have failed, and Fannie Mae and Freddie Mac are in federal receivership. Foreclosures and delinquencies on mortgages are continuing to rise, indicating that the banks and their non-bank competitors face additional pressures to re- trench, not expand. Thus far in this unusual business cycle, excessive debt and falling asset prices have conspired to render the best efforts of the Fed impotent. The 100% plus expansion in the Fed’s balance sheet (monetary base) has done nothing to rekindle borrowing and lending or revive even the smallest spark of inflation. What is clear is that as long as private market factors in the monetary/credit creation process are shrinking, as they are now, the risk for the economy is deflation, not inflation.

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