Thursday, June 15, 2006

6/15 Bernanke Talks Down Risky Assets: Another “Hot Money” Temper Tantrum, or a Major Economic Trend Change?

June 15 (Econotech) – In my last article on June 2 link, I noted the usual “belief by the global hyper-speculators that the central banks and governments don’t have the incentives and/or guts to take them on, a usually safe assumption most of the time.”

Global Market Decline Doing Some of the Central Bankers Tightening for Them

The very next working day, June 5, Bernanke gave his inflation fighting credentials speech, which sent the global markets on the second down leg of its sharp decline since May 10, with key indexes slicing through March-April short-term support levels on their charts, declining to, or below, their 200-day moving averages.

So far Bernanke and his colleagues on the Fed have managed to talk down the most risky asset classes that were threatening to spiral out of control in March-April, especially industrial and precious metals, emerging equity markets and Japan, without having to actually slightly raise rates as of yet.

Through June 14 the GS industrial metals commodity price index, gold price and MSCI emerging market index were all down around -20% since May 10, Japan’s Nikkei fell -19% from its high on April 7.

I.e., skittish global markets have been doing some of the central bankers’ tightening for them. That is not to say that global monetary conditions are tight, especially in Japan, where the BoJ’s ending of its “zero interest rate policy” may be pushed back from July after it has sopped up much excess liquidity after stopping its five-year old “quantitative easing” regime in March.

Bernanke’s Current Inflation Fighting Act a Mirror Image of His "Helicopter" Money Deflation Fighting One

Bernanke’s current inflation fighting act almost seems like the mirror image of the performance Greenspan and Bernanke pulled off in late 2002-early 2003.

Back then, those two conjured up a threat of deflation, even though U.S. real estate prices and consumer spending were rising, unlike in actually deflationary Japan, fear of which was invoked to justify a super-loose 1% interest rate policy. That’s when Bernanke said the Fed could go even further if it had to fight deflation with its printing press and helicopter money. It “worked,” creating a massive reflationary real estate refi bubble to slingshot upward the consumer spending recovery.

Of course monetary/credit inflation is in the DNA of the Fed. Especially in the Greenspan era, the Fed found it much easier, economically and politically, to create multiple bubbles than to achieve a “soft landing” trying to deflate them.

Withdrawing Global Excess Liquidity without Major Problems Easier Said than Done

It’s easier for Bernanke to talk tough when the economy seems to be still doing okay, if slowing. We will see how strong an inflation fighter Bernanke really is if the economy does start to slow more sharply this year and early next below trend growth.

The problem facing the world’s central bankers as they withdraw liquidity was addressed by Mervyn King, the governor of the Bank of England, in a major speech June 12:

“One risk is that during the fastest three-year period of world economic growth for a generation, monetary policy around the world may simply have been too accommodative. In the main industrialised regions – the US, Euro area and Japan – official interest rates were very low for a long period. The liquidity created by low official interest rates around the world has helped to push down long-term real interest rates and compress credit spreads to unusually low levels. That monetary stimulus is now being withdrawn. Since January, long-term interest rates have moved up, and now other asset prices are responding. So far we have seen little more than a modest correction to the prices of a wide range of assets that had risen sharply over the previous two years. The realisation that such levels of asset prices were unlikely to be sustainable, coupled with a tightening of monetary policy in many countries, has injected uncertainty into financial markets. And it is hardly surprising that, as investors searching for yield realised that they might have underestimated the uncertainties, the price of risk moved up. Even though the monetary stimulus around the world is now being withdrawn, its effects are still being felt. There are some signs of inflationary pressures in the main industrial countries.” [bold emphasis added]

King captured the central bankers dilemma. If even minor attempts to rein in years of excess liquidity growth fueling massive asset bubbles has resulted in what he calls a "modest correction to the prices of a wide range of assets," imagine what a more serious effort would do to the global economic/financial system?

Any New Bubbles Left for Global Hot Money?

Global hot money inflates new asset classes while the previous ones deflate. Since last summer, when real estate started peaking, hot money started flowing in earnest into commodities, and equities in emerging markets and Japan. Japan’s stock market was mainly driven up by foreign, not domestic, hot money. Japan corporate profit growth fell to 4.1% in the first quarter from 11% in the fourth.

What if these latest hot money targets have peaked after their huge moves in Mar-Apr 2006? That is not a forecast, just a “what if” question. Are there any asset classes left that the hyper-speculators can now run into that are large enough to accommodate them, following previous global real estate and global equity bubbles.

Emerging markets have long since been “discovered,” as a quick glance at the volume on a three year chart of the EEM ETF shows (it has increased about tenfold).

As noted below, with the Fed having raised its rates and the BoJ at least beginning to get back to a more “normal” policy, liquidity growth in China and India remain extremely high and a concern for its officials. Will they attract even more of the stateless hot money, e.g. into their real estate markets, hindering their officials’ efforts to achieve strong but stable growth?

Market Volatility as an “Asset Class”

According to May 23 FT article titled “Volatility becomes an asset class”:

"Volatility is becoming an asset class in its own right. A range of structured derivative products, particularly those known as variance swaps, are now the preferred route for many hedge fund managers and proprietary traders to make bets on market volatility … among the advantages of the contracts are that they are almost as liquid as S&P 500 listed options, with spreads that are just as tight and with smaller capital requirements … One hedge fund manager, added: ‘As volatility, in the form of options or variance swaps are sold into the market, volatility drops. We invariably take more risk and the price of risky assets goes up. The introduction of these derivatives in the market then creates a situation that when volatility begins to rise, these trades must be rehedged and/or unwound. This makes volatility rise again.’”

Is Fed Now Trying to Subtlely Signal Not to Go Overboard on Inflation Fears?

John Berry’s June 14 Bloomberg column titled “Fed Doesn’t See Inflationary Spiral” may come as a seeming surprise to global financial and commodities markets obsessed with every tweak in U.S. economic data and every statement of concern about inflation by Fed officials. But Berry, along with Greg Ip of the Wall Street Journal, is considered well-connected to the Fed, and his columns are often viewed as a not-too-subtle conduit for conveying Fed thinking to the global markets.

In his lead, Berry says, “financial markets have been spooked by irrational fears of surging inflation. The result: an imagined need for endless interest rate increases to bring prices under control.” He concludes: “with wage increases so subdued, [UC Berkeley economist] DeLong said, the odds are ‘that there will be no significant uptick in inflation and no significant increases in interest rates from now forward to the end of the business cycle.’ Would that the markets could accept that quite reasonable forecast.”

As King of the BoE said June 12: “Pay pressures in the [UK] labour market are muted, reflecting in part the need of employers to adopt a tough stance in wage bargaining when faced by such large increases in other input costs … The rapid rise in input prices and the muted degree of pay pressures are not independent of each other." The same goes for the U.S. and globally.

Family Quarrel Between Central Bankers and Global Hyper-Speculators

I’m not inclined to take sides in family quarrels over inflation between central bankers and global hyper speculators, whom I view as two sides of the same inequitable global financial system. Price indices seem rather inaccurate anyway (“owner’s equivalent rent” being just one of the flaws). Inflation is a lagging indicator, and most importantly the debate almost always ignores the fundamental issues of massive monetary/credit expansion and an unprecedented series of huge asset bubbles.

The howls of derision and rage coming from the speculators directed at the modest efforts of the central bankers to make a small impact on their previously free liquidity largesse provided for the benefit of the former indicates just how out of hand the situation has become in favor of the global hyper speculators the past few years, once again reflected in the continued huge profits reported this week by Goldman Sachs (slightly down from the even larger first quarter record results) and Lehman Brothers.

As I’ve previously dubbed it, this is truly the “Golden Age of Goldman Sachs,” which now makes most of its money speculating, as a symbol for all the global hyper speculators.

Declining Gold Price, Rising Bond Market, and Credit Default Swaps Reflect Concern about Slowing Growth?

Despite the obsessive pre-occupation of some markets with inflation, other markets, specifically gold and bonds, don’t seem overly concerned about it. Since May 10, gold’s price is sharply down while the U.S. 10-year bond has slightly risen in value. Inflation-protected TIPS also don’t indicate a strong concern over inflation. The dollar also has recently strengthened, also hurting gold, again due to favorable yield differentials and a “flight to quality.”

Credit default swaps are beginning to indicate more concern about a slowing economy. From a June 14 Bloomberg article titled “Credit Derivatives Jump, Signaling Decline in Corporate Bonds”:

“The threat that U.S. growth could slow to less than 2 percent from 5.3 percent last quarter raises ‘significant’ risk of defaults, Banc of America Securities LLC said in a June 12 report. ‘It is this concern in turn that likely is contributing to the increase of spreads,’ wrote strategist Jeffrey Rosenberg. Rosenberg said a growth rate of 2 percent would cause defaults to surge to 6 percent … The credit derivatives market has grown to $17 trillion from almost nothing in eight years … ‘Credit spreads are likely to struggle to make any positive headway over the next few weeks if not longer; more likely, they will come under incremental pressure until or unless this period of interest-rate uncertainty ends,’ said Edward Marrinan, head of North American credit strategy at JPMorgan Securities in New York. “

Will Increase in Credit Risk Impact Huge “Cynical Bet” of Private Equity Firms?

From a June 13 WSJ article titled “High-Risk Debt Still Has Allure For Buyout Deals”:

“The resilience of poorly rated corporate debt ... has buoyed private-equity firms. They are plowing ahead with ambitious takeover plans of companies that often involve loading them up with debt … It isn't just banks eager to lend feeding the froth. Demand also comes from new groups of investors, including hedge funds and other money managers … there will be little warning when the turn comes. That is because one of the more popular structures, so-called PIK, or payment-in-kind, loans, allow private-equity firms to load up their portfolio companies with debt that they defer repaying. Such back-ended structures can amount to a cynical bet that, by the time the real burden of repayment comes, the private-equity firms no longer will be the owners … part of the traditional early-warning system of the debt markets comes when ailing companies ask lenders to relax loan conditions. These days, terms have become even more relaxed, or even nonexistent … when defaults come, they will come suddenly. Moreover, recoveries are likely to be lower. That is because there are so many layers of debt, compared with previous cycles. Also, private-equity firms have taken a lot of cash out of their portfolio companies while putting more debt on the balance sheet, leaving less for creditors when these companies finally hit the wall … The smart money is starting to plan for less-robust debt markets.”

Broad Global Equity Market Indexes Uptrend in Question but Seems Still Intact, for Now

As I asked in the title of my last June 2 article link, is the more than 3-year cyclical bull market uptrend definitively broken? Obviously it seems a lot closer after June’s sharp down leg, but it still hasn’t happened just yet, at least judging by the broadest global equity indexes.

Again, stepping back for the “big picture,” it still seems to me that the MSCI, FTSE and DJ world indexes have come down at the moment to right around their rising 200-day moving averages, whose slope was higher in 2006 than 2005. In this longer cyclical bull time frame, there are not lower highs (May 2006 is the last peak) and lower lows (the last one being in Oct 2005) yet on their charts.

Thus, needless to say, the quality of any rally, which may have begun June 14 (starting as a typical mid-week short covering bounce induced during options expiration week) from these short-term deeply oversold market conditions will go quite a way toward indicating whether the long-term trend has changed. Specifically, a failure to take out the previous high in early May would be very significant.

Energy and Broker-Dealer Stocks Are Leaders in Cyclical Bull Market

Energy stocks have been among the best and most consistent performers in this bull market due to their favorable cyclical and secular story. The energy sector has been the story of this cyclical bull market, just as tech was for the previous one. The oil services stock index has come down to right around its rising 200-day ma, which has held as support in its huge uptrend since Nov 2003. Uranium prices for nuclear energy remain strong.

Another strong group, broker-dealer stocks, is now just below its rising 50-day ma, on its uptrend line since its July 2005 lows, and well above its 200-day ma, as Goldman and Lehman sold off after strong quarterly earnings reports this week. Besides its traditional role of indicating the amount of optimism about financial markets, this sector is even more important now then in previous cycles, given the dominance of hyper-speculators in the global economy.

A much less known bank index of global shipping stocks, which should be sensitive to trends in world trade, has been flat since early 2005, after tripling from late 2002 to early 2005.

Homebuilding Stocks Reflect Continued Concern about Real Estate

Less talked about lately by the financial media but a key area of concern for me continues to be the homebuilding stock index and new etf.

However you draw the “neckline” of a topping pattern on the HGX chart from its Jan and April 2005 lows (horizontally or up-sloping), it has clearly been broken on this last leg down in June, with the 50-day ma also now well below the 200-day. Given the critical importance of real estate paper “wealth” to the U.S. economy, this breakdown is a serious warning.

From a June 12 story on titled “More housing markets overvalued”:

“according to a study based on government data released Monday by Global Insight and National City. In the first quarter, 71 housing markets, representing 39% of all U.S. housing, were deemed to be ‘extremely overvalued’ based on median sales prices, median income, population and historic values. That's up from 64 markets accounting for 36% of housing in the fourth quarter. In the first quarter of 2004, just 1% of housing was considered overvalued. To be ‘extremely overvalued,’ homes had to be valued at least 34% more than "normal." When prices do fall from overvalued levels, they typically fall by about half the overvaluation, DeKaser said. The correction usually takes three and a half years … California and Florida accounted for 17 of the top 20 overvalued markets, economists at the two firms said.” (Link for the 27-page report.)

Emerging Markets a Replay of 2004’s Decline in Growth of OECD’s Leading Indicators?

Another large area of concern, the MSCI emerging market index, is currently a couple of percent below its still rising 200-day ma.

The last decline in this index of similar magnitude occurred in April-May 2004 due to concerns about China tightening to slowdown an overheating economy, demand from which helps drive the commodities of emerging markets.

One can see that on the chart on page 1 of the June 9 OECD release link showing the 6-month rate of change of the Composite Leading Indicators (CLI) for the OECD and for China, which lead changes in industrial production growth.

Back in the first half of 2004 both CLI’s growth rates rolled over, which was discounted in the sharp Apr-May decline in the MSCI emerging market index. Currently, the rates of change of both CLI’s are rising through April (which doesn’t factor in the sharp stock market declines since then).

Very Strong Growth in China and India Continues, along with Excess Liquidity

So, the same concerns in emerging markets about a turndown in the CLI’s growth rates could be re-surfacing. Once again China’s growth rate is even higher than expected, indicated in the spate of latest economic statistical releases.

China fixed-asset investment rose 30.3% through May. According to a June 15 Bloomberg story, “Premier Wen Jiabao yesterday told local governments and banks to limit lending to stop excessive investment that the World Bank says could cause the world's fastest-growing major economy to slow abruptly. The central bank, which raised lending rates in April for the first time in 19 months, today announced plans to step up operations to drain funds from the financial system.”

China’s industrial production was up 17.9% in May, the largest since April 2004 after adjustment, beating all 22 economist forecasts surveyed by Bloomberg. To put this is some perspective, China’s steel production is currently nearly four times that of the U.S.

Also in May, China’s exports were up 25.1%, a record $13 billion trade surplus for the month, a surplus for the year to date up 57% from last year. Retail sales are up 14.2%, the highest in 17 months. M2 money supply is up 19.5% through May, the fastest since Dec 2003 and above a 16% target. China’s bank lending in May was almost double that of a year ago.

Similarly, manufacturing in India was up 10.4% in April. I saw India’s finance minister on Bloomberg tv recently defend the central bank’s surprise decision to nudge up its policy interest rate, one of several rate hikes by central banks last week, by saying that credit was growing 30% over the past 24 months and widely available.

In other words, seemingly excess credit growth in these two largest emerging markets has barely begun to be reined in so far.

Real estate speculation remains a key concern of China's central government. According to a June 7 AP story:

“more than 60 percent of recent land acquisitions for construction in China are illegal, with the figure rising to 90 percent in some cities, the government said in a report demanding investigations of such deals. The increase in violations comes despite repeated calls by the central government for local officials to stop selling land use rights for unauthorized construction, often for industrial parks, luxury housing and showcase projects such as convention centers. In a warning posted on its Web site Wednesday, the Ministry of Land and Resources said any land deals lacking its formal approval are invalid. The ministry, which oversees all land use, reported that more than 60 percent of new land deals since September 2004 were illegal, the official Xinhua News Agency and other state media reported Wednesday.”

How Long Will Rest of World Put Up with Global Hot Money?

As officials in emerging markets countries once again try to achieve “soft landings” in this over-heated environment, the increasing volatility of global hot money is not making things easier. One wonders how long the rest of the world will put up with this, since this hot money is not economically critical to emerging markets, unlike foreign direct investment.

There have been major changes since the flight of hot money exacerbated (some say caused) the many major emerging markets crises of the 1990s, which were enormously destructive for their poor populations. The emerging markets in East Asia are now much stronger, with current account surpluses (elsewhere Turkey has a deficit), huge forex reserves, somewhat more flexible currencies, etc. Meanwhile, the U.S, with its massive, unsustainable current account deficit, and Japan, with its mountain of government debt, are arguably financially weaker than they had been.

Increased global market volatility from the flight of hot money seeking to protect its recent gains is causing concern about hedge funds from non-U.S. officials, most recently expressed in the ECB’s latest “Financial Stability Review,” and by Hong Kong’s second highest-ranking official in a June 7 speech to international securities regulators.

One key battleground is the “opening up,” to global hyper speculators, of the financial sectors of China and India. In China, a decision is expected soon on Citigroup’s effort to control Guangdong Development Bank. In India, the issue is currently being fought over how much foreign control of insurance joint ventures.

Geopolitical Efforts to Dampen Energy Inflation from Multilateral “Realist” Elite Faction

Raising interest rates does not seem to be a very effective way of controlling energy and commodity price inflation.

It seems that the “realist” multilateral factions of the U.S. foreign policy elite, i.e. the conservative Bush Sr. crowd (Baker - Scowcroft) and the more liberal wing of Colin Powell - Richard Armitage - Richard Haass (pres of Council on Foreign Relations) may have, finally, had a little more impact on the Bush administration, through Rice, who is an opportunist, not a neocon, with long-standing ties to the Bush Sr crowd.

The multilateral realists increasingly had been clamoring for direct talks between the U.S. and Iran. This was usually couched in foreign policy terms, including the U.S. being overstretched in Iraq.

But it is quite possible that some of the "realist" foreign policy elite finally realized that the global economy was too fragile to take another huge spike up in oil prices during an Iran confrontation, and are attempting to minimize that hit to the global economy (e.g. Haass’ May 15 Newsweek article, “Let’s Not Play the Oil Game").

The outcome of the U.S. recent diplomatic opening to Iran is very unclear, and I remain skeptical until proven otherwise. Even such a staunch ally of the U.S. as Koizumi’s Japan is evidently wary of Iran sanctions, which takes 22% of Iran’s oil exports and “has more at stake in Iran financially than any other potential sanctions partner,”according to a June 13 Washington Post story.

The presidents of Iran and Pakistan have been in China this week as observers at the Shanghai Cooperation Organization meeting, which included Russia's Putin and four central Asian states. India, with which the Bush Administration has been trying to create closer ties through a special nuclear deal, was represented by its Oil, not Prime, Minister.

Rumsfeld earlier expressed his displeasure at Iran’s presence at the SCO meeting. According to a June 13 Bloomberg story, “the U.S. government today froze the assets of four Chinese companies and one American company accused of helping Iran to develop missiles. The Treasury Department said the companies supplied Iran with missile components or with technology that can have military uses.”

Real Solutions to Global Economic Issues Remain as Distant as Ever

The recent volatility in global markets continues to obscure the fact that the key underlying problems are simply not being dealt with.

In the absence of a strong domestic high-tech industrial economy (the growth of China's exports of high-tech items is now outstripping its low-tech goods), best indicated by the huge and unsustainable U.S. current account deficit and the -17% decline in worker average real weekly earnings since 1972, the U.S. economy is now mainly being driven by the impact of bubble psychology on huge speculative asset classes creating so-called paper “wealth.”

This paper wealth is heavily concentrated at the top of the wealth/income pyramid, as most recently indicated by the Fed’s first quarter flow of funds report showing rising U.S. household net worth and the federal government’s stronger than expected tax receipts from capital gains.

Much sooner rather than later, the U.S. needs to wean itself from dependence on bubble economics, or the global financial markets will become overly concerned about its resulting unsustainable current account deficits.

Meanwhile, Everyday Assault on Global Labor Unabated

Real wage growth still seems non-existent though measured productivity is quite high, given the huge success of the unrelenting global assault on labor ushered in long ago by Thatcher and Reagan.

A June 9 article in the S.F. Chronicle titled “Train your replacement, or no severance pay for you” gives an honest, if rare in the mainstream media, look at what goes on everyday throughout corporate America, as anyone who works there knows full well:

“Bank of America has been steadily moving thousands of tech jobs to India. The latest to go are about 100 positions that handle BofA's internal tech support. While many of the bank's Bay Area techies accept the inevitability of their jobs heading abroad, what rankles them is the fact that, in many cases, they're being told they have to first train the Indians who are getting their gigs … a BofA spokeswoman … acknowledged. 'What we ask associates to do as part of getting severance is that they stay on the job until the job is transitioned.' 'It's a common practice when your job is being transferred from one person to another that you train the new person,' she added. 'We expect our people to stay until their jobs are consolidated.' Making workers train someone from India to take their jobs away isn't unique to BofA. Other U.S. companies reportedly have done the same in recent years.”

The comments by the BofA spokewoman are only unusual for their candor, she is simply describing standard operating procedure in corporate America, where “employment at will” is now widespread.

My “Blog” Focuses on Key Trends, Not Trading Advice Per Se

Needless to say sharp declines of the magnitude recently experienced in some markets are usually not fully anticipated, even if they were long overdue after their huge run-up without a major correction, topped off in March and April.

I should make it clear that my intention is not to give direct investment advice, but rather to discuss general trends, in part because I’m not writing a daily blog that addresses rapidly changing market conditions.

In retrospect, the title of my March 24 article, “Potential Tipping Points Could Make Spring Very Interesting” link seems understated. I did mention there that “it perhaps wouldn't take too much to start the mass psychology pendulum downward in the other direction,” that “the U.S. stock market may top out in the next month or so, then decline, perhaps much more sharply then many might currently expect, into an October low.”

I also mentioned in a May 11 article link, just as the global market declines began in earnest, “with hedge funds and other hot money crowding into smaller asset classes such as precious metals, emerging markets and anything else going up, liquidity issues are important, in both directions.”