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Posted by Douglas R. Terry

The Fed announcement today was tainted by 3 dissenting votes.  This was the first time since 1992 that 3 members of the committee had voted against the decision.  The key sticking point was the commitment to current interest rate policy for a period of 2 years.

Other comments of note:

“economic growth so far this year has been considerably slower than the Committee had expected”

“a deterioration in overall labor market conditions in recent months”

“ Household spending has flattened out, investment in nonresidential structures is still weak, and the housing sector remains depressed”

“downside risks to the economic outlook have increased”

The average Price/Book ratio of the banking industry reported by Morningstar is .6 .  This is a main concern for the Fed, they will attempt to get this number back toward 1 and the Fed seems resigned to a path of nominal growth as the most expedient way.

As you have read here before, this type of policy gives rise to the potential for run away inflation which in the end destroys the buying power of our currency and hurts the middle class.  I’m sure this is the reason for dissent; committing to current policy for 2 years puts the Fed at risk of being handcuffed in the future and of losing more credibility.  Recent resignations from the Board of Governors only supports this opinion.

Possibilities of QE3 have been put in place, but I am of the opinion that existing dissents will make this a more politically difficult endeavor for Bernanke and other Fed doves to put through the committee.

For the full press release click below.

http://www.federalreserve.gov/newsevents/press/monetary/20110809a.htm

Posted by Joseph Y. Calhoun, III

The deal to raise the debt ceiling, agreed to last week, obviously wasn’t enough to calm markets and no wonder. The deal was just more of the same smoke and mirrors we’ve come to expect from the small, petty people who populate the halls of power in Washington, D.C. Finding anything in this deal that remotely addresses our long term budget issues is like trying to find the proverbial needle in a haystack. The “spending cuts” do no such thing, merely reducing the rate of growth by a rounding error. And even that assumes that some future Congress actually adheres to the plan, the economy continues to grow and interest rates don’t rise, none of which is assured by any stretch of the imagination. The fiscal commission set up to find the other half of these mythical budget savings was given a wake-up call by the market last week and a slap in the face late Friday by Standard and Poor’s downgrade of US debt to AA+. Let’s hope they take it seriously.

The issues facing the global economy did not change last week. US and global economic growth is still waning. We still have no long term plan to reduce the deficit or reform our byzantine tax code. Europe is still in the throes of a debt crisis that neither the ECB nor the member states of the EU seem to have a clue how to solve. Emerging markets and China specifically, are still fighting an inflation problem. The world’s major fiat currencies are still falling against the sin qua non of money, gold. What did change was that any remaining confidence in government to address these problems was completely and utterly destroyed.

The finger pointing that ensued after the S&P downgrade Friday gives one little confidence that the politicians have gotten the market’s message yet. Democrats blamed Republicans for not raising taxes. Republicans blamed Democrats for not cutting spending enough. This problem will not be solved by raising the tax rate on the wealthy by a few percentage points. It won’t be solved by taking more capital out of the private sector for politicians to spend on pet projects that benefit their largest campaign contributors.  It can be solved by a real – and large - cut in government spending but that path without offsetting pro-growth policies is unnecessarily cruel for the millions who have become dependent on government for their very existence. Americans need not don a hair shirt of austerity to atone for the sins of our politicians. Policies that enhance growth will naturally reduce the need for government spending.

We need wholesale changes in our economic system from the tax system to the monetary system to the social safety net. We are long past the point where tinkering around the edges will be sufficient to restore growth and provide opportunity for all Americans to be productive members of society. The tax system as it currently exists is a labyrinth of social and industrial policy that has failed miserably. It is a product of political influence, corruption and disinformation. It is inefficient, riddled with loopholes and incomprehensible to even the IRS. Meanwhile the social safety net is fraying and will eventually fail completely without reform that puts Social Security, Medicare and Medicaid on sound financial footing.

The monetary system is, in my opinion, in the most dire need of reform and it isn’t even on the radar of the political class with the exception of a few like Ron Paul. The market was rife with rumors last week of a new quantitative easing program from the Federal Reserve. The first two efforts were miserable failures for the economy, raising both commodity prices and interest rates. Why anyone except speculators would welcome a third round is beyond me but hope springs eternal among traders and ivory tower economists alike. The expectation that the Fed can and will ride to the rescue for any economic ill needs to completely excised from the market and the minds of politicians. Reform needs to acknowledge the limitations of monetary policy. The only suitable role for monetary policy is to provide a stable value for the dollar – preferably in terms of gold.

We at Alhambra will be watching the coming debate of the fiscal commission closely. It is still possible that the shock delivered by the markets and S&P will be sufficient to convince the politicians that large scale reform is not only needed but necessary. The global economy is not yet in such dire condition that better long term policy would not produce immediate results.

The economy, while not great, continues to muddle through despite the dithering of the politicians and a new recession is by no means assured by last week’s market rout. Stocks are fairly cheap – not that they can’t get cheaper of course – and sentiment is extraordinarily negative, conditions that would normally have us salivating with our fingers on the buy button. The S&P downgrade after the market close Friday and the situation in Europe does give us pause though. We see little reason to rush at this point. Our cash, short term Treasury and gold positions have served us well over the last few months and missing the bottom is not our greatest concern at this point.

The economic data last week continued to be on the weak side but not extraordinarily so. The trend of a slowing but still expanding manufacturing sector, steady consumer activity, a housing market bumping along what we hope is a bottom and a jobs market that is just good enough to keep the unemployment rate from rising, continued.

The ISM manufacturing survey dropped to 50.9 primarily due to a drop in new orders. That is still above the 50 level that represents expansion though and in the past it has taken readings under 45 to signal outright recession. Employment was also down but still at 53.5, indicating continued hiring. Factory orders were down 0.8% in June with all the drop in the durable category. The ISM non-manufacturing survey was a bit firmer at 52.7. Taken together these reports indicate slow growth, not a recession.

Construction spending was slightly higher, up 0.2% in June led by private non-residential outlays up 1.8%. Residential construction fell 0.3%. Year over year the rate of decline in construction spending slowed to 4.7% from 7.1% last month. Low interest rates led to a rise in mortgage applications last week, up 5.1% and 7.8% for purchases and refinancing respectively. Housing and construction are slowly healing but these readings are not robust enough to get excited about.

Personal income and spending were both soft in June up 0.1% and down 0.2% respectively. The spending side was mostly affected by a drop in motor vehicle sales and falling gas prices. It isn’t a rosy picture by any stretch but neither is it recession territory. More recent data on motor vehicle sales and chain store sales were a bit more upbeat. Of course, there is no way to measure the psychological impact of the US debt downgrade and how that might affect future activity. That is something we’ll  be watching closely in the coming weeks.

The news on the jobs front was mixed. Challenger reported a rise in layoffs but jobless claims were flat and the employment report Friday showed a gain of 154,000 in private payrolls. Jobless claims remain elevated at 400k but that is still consistent with the job growth reported Friday. The layoffs from Challenger have yet to happen in most cases though so an uptick in new claims in the coming weeks would not be surprising.

As I said at the beginning of this section, the economy continues to muddle through. For now, I see no reason to expect a renewal of recession but the psyche of the public is fragile and the future is, as always, impossible to predict. We are facing a crisis of confidence as much as anything else and the antics of the politicians don’t help in that regard but our economy and the American people are resilient. Hopefully that is enough to keep us muddling through until we get real reform.

With Alhambra’s recent expansion we have added some new features to our weekly lineup. John Chapman’s weekly column, Thinking Things Over, has its third installment this week. Doug Terry joins the weekly lineup with Contrarian Alert. Joe Gomez provides a report on market technicals and details of various market indicators.

If you’d like to receive this free weekly commentary by email, Click Here.

Weekly Chart Review, Click Here.

Posted by Joseph Y. Calhoun, III

Musings on the Markets from Inside the Beltway

By John L. Chapman, Ph.D.                                             Vol. I, No.3  080711

In this note:

·       Repassage: debt ceiling deal and implications for your net worth

·       ‘Balance sheet’ versus ‘aggregate demand’ recessions: worrisome, or much ado about nothing?  How to invest in any case?

Next week:

·       Nixon’s most tragic mistake, forty years later – and its lessons for policy (and for investors) today

I. Debt ceiling deal – one more time

The downgrade of U.S. Government debt by Standard & Poor’s on Friday night was as historic as it was sad, but it was also inevitable.  That a great power, the world’s strongest beacon for individual liberty and a vibrant market economy for the better part of two centuries, should now be less credit-worthy in Standard & Poor’s eyes than the Isle of Man, Principality of Liechtenstein, or for that matter, the City of Syracuse, NY is terribly sad.  Yet S&P signaled as far back as April 18 that this was a distinct possibility and given the growing awareness of long term, glaring fiscal imbalances now – even the Congressional Budget Office’s baseline scoring out to 2085 never once shows an annual budget balance – it would have been stranger for one of the ratings agencies to not downgrade.

Cynics that we are now about the ways of Washington, we can assure our Alhambra family of readers of the following:

·       There was, no doubt, tacit collusion among the ratings agencies for at least one, but not all, of them to move to a downgrade status.

·       This is the “perfect” way to send a message and yet minimize disruption to global capital markets:  institutional investor covenants that demand the holding of only triple A-rated sovereign debt can still rely on the credit judgments of Fitch and Moody’s, so there will not be massive turmoil in bond markets this coming week (still, that is not to say there will not be some downdraft and sell-off in bonds; S&P was sufficiently worried about any such effects to make their announcement after markets closed on a Friday, to give investors the weekend to digest the news).

·       Treasury Department officials lobbied hard against the downgrade, though less because of the costs this will impose on the hard-pressed American people, and more because of the political effect this will have on President Obama.  There was, after all, 30 months to ensure maintenance of the rating, had that been paramount.

And what are the repercussions, near and long term? In short:

·       Secretary of the Treasury Timothy Geithner is now almost certain to go (reporting in the WSJ notwithstanding), perhaps before Labor Day.  Mr. Geithner is not viewed positively by either Main Street or Wall Street, and it may be more than coincidence the rumor mill had him worrying about spending more time with his family this spring.  For our part, while the policy decisions regarding the public fisc and the dollar are ultimately the President’s, we think Mr. Geithner’s departure is both good politics and good for the markets.  As far back as mid-April he had assured the American people there would “certainly not be any downgrade”, continuing a hapless run of bad economic news while at the Treasury, and on back to his stint at the New York Fed, prime agent for the credit bubble that led to the present mess.  And then there is the matter of Mr. Geithner’s inability to read his TurboTax software manual, and unfortunate hole in his resume with respect to his tenure in the private sector: other than a three year stint in the ‘80s as an analyst with Kissinger Associates, his entire career has been in government, this limiting his perspective on how the real world economy works.  We cannot but think his replacement – any replacement — will have a better discernment about out-of-control federal spending that must end; that the weak dollar policy of the last decade has greatly harmed capital formation and job growth in this country; and that raising taxes on effective producers in this environment is foolhardy, because in fact, this recession did not really end in June 2009.  We do not wade into politics here, but nonetheless would say, good riddance to what we consider to be a G. William Miller-clone, if and when Geithner moves on.

·       We expect some volatility in global credit markets this week, mostly on Monday, but then a settling in.  Long term, U.S. government debt is not priced via the U.S. credit rating agencies so much as it is by the world’s investors, and their analysis hardly includes what S&P thinks: far more important is the value of the dollar and prospects for U.S. growth.

·       That being said, it is reasonable to assume that all interest rates edge up at the margin, which will be tantamount to a tax increase on the U.S. economy.  With $40 trillion in total debt outstanding, an increase of 10-20 basis points across the board would mean a total increase of $40-80 billion in interest expense, a non-trivial amount, and undesirable in this economy.

·       The longer term issue is the warning that his downgrade effectively issues to our political class: there is clearly a tidal wave off our shoreline, seen in the distance and barreling toward us.  It represents a fiscal and monetary collapse and a Greece-like blow-up to our economy.  Or, said better, a blow-up akin to Germany in 1923 in its effect.  Its arrival is not so many years distant now (given the trajectory of entitlement spending), and its crashing ashore represents a long-awaited “day of reckoning” for the U.S. economy, in which the internal contradictions of a generous welfare state and borrowed consumption, all driven by a fiat dollar whose continual long term decline in value has been partially offset thanks to its global demand as a reserve currency, must end.  How the U.S. meets this challenge in the next few years – that is to say, via tax increases that kill job growth, or spending and entitlement rationalization that minimizes the harm to progress — will determine the trajectory of our standard of living for a long time to come.  For investors, the long term is clouded by this approaching storm, as there is “no good place to hide” in such a scenario that would clearly draw down the entire global economy.   But in a fiat money world, the hard asset classes – the traditional hedges against a market volatility that is fed by monetary mismanagement, such as land, commodities, or natural resources – will, as usual, be a big part of any long term portfolio holdings, regardless of any possible near-term asset deflation thanks to deleveraging (as long as deleveraging leads to deflation, consumer staples will be prime investments, and hence we would want to own, say, Procter & Gamble; but we assume that a fiat money regime will never permit a deflation from deleveraging to ensue for long, and indeed, are witnessing a mini-version of this at the moment with multiple [and massive] rounds of quantitative easing; hence our preference for commodities and natural resources in the long run).

II. ‘Balance Sheet’ versus ‘Aggregate Demand’ Recessions

We have recently been reading the analyses of Richard Koo, the Taiwanese-born Chief Economist of Nomura Research Institute in Tokyo, and author of the excellent 2009 book entitled The Holy Grail of Macroeconomics - Lessons from Japan’s Great Recession, published by John Wiley & Sons.  We do not think Koo would disagree with our characterization of him as a post-Keynesian economist, and while we do not agree with all he says, his writings have certainly gained traction in the economics profession, with no less than Nobel-winner Paul Krugman signing on in support of his ideas concerning a “balance-sheet” recession versus those caused by (traditionally) a deficiency in aggregate demand, leading to excess manufacturing output and a build-up in un-cleared inventory.  What follows is a short description of Koo’s thesis, and our critique of his analysis, along with what it means for investors.  It is important to follow this debate in the months ahead as Koo’s rising influence may indeed affect policy, which in turn will affect the capital markets.[1]

Types of Recessions

Koo argues that the Great Recession through which we are now living in the United States is akin to that suffered by Japan in the fifteen (and some would say twenty) years after 1990.  Both Japan in 1990 and the U.S. in 2007-08 fell into deep recession following the bursting of real estate bubbles that also pulled down equity markets substantially.   Recessions caused by the bursting of asset bubbles that were fueled by high leverage on corporate and household balance sheets are termed “balance sheet downturns” by Koo, and this is in contrast to those caused by a drop-off in aggregate demand.  In the latter case, the fall in demand is caused by the whims of investors, their shifting “animal spirits”, and this leads to excess production and thus unsold inventory of some goods in the economy.  This excess can only be worked off via layoffs and a reconfiguration of the economy’s resources during the ensuing correction.

Koo and Krugman (and now many others) assert that there are fundamental differences between these two types of recessions:

·       A balance sheet recession caused by an asset bubble burst and ensuing crisis is more severe and long-lasting in effect.  According to economists Carmen Reinhart and Kenneth Rogoff in their long-run study of financial crises, the typical duration of employment downturn is 4.8 years, far longer than the one year of the typical 20th century recession due to aggregate demand shortfall.  In another study, Reinhart and her husband Vincent Reinhart showed that economic growth rates can be slower for a full decade after the onset of the financial crisis.

·       In recessions caused by aggregate demand shortfall, the typical corporate balance sheet is appropriately capitalized, and there is positive net worth.  For balance sheet recessions, as the name implies, the balance sheets of corporations (and especially banks) are impaired, due to high leverage, and may involve negative net worth.  This necessitates a painful deleveraging, which can involve what Koo calls a “paradox”: as banks and others deleverage, their demand for goods and services declines, causing a decline in both the money supply and real incomes, which can further impair balance sheets by causing asset values to decline.  And this caused the whole cycle to repeat: indeed if left unattended this “death” spiral can cause a depression, and Koo points to 1929-33 as an example of this.

·       The nature of these two recession types causes several macroeconomic parameters to differ: in a traditional aggregate demand-shortfall, profit maximization is still the rule for companies; in a balance sheet recession, debt minimization becomes paramount.  Prices are inflationary in the former, and deflationary in the latter thanks to the deleveraging process.  Monetary policy is effective in typical recessions to ignite the growth process, but ineffective in a balance sheet recession, as even zero interest rates cannot incite investment and job-creation.  Fiscal policy however is ineffective in a typical recession, as the economy merely needs a rebalancing, essentially via relative price shifts to clear inventories and redirect resources to better uses.  But fiscal policy is very powerful in a balance sheet recession, where the government must, according to Koo and Krugman, pick up the slack in spending that deleveraging prevents from private sector agents.  And for this reason saving, normally a virtue, is seen as harmful in balance sheet recessions, as it contributes to a lessening in consumptive demand thanks to the deleveraging process.

Koo asserts that in Japan, it was only massive government spending and activist fiscal policy after 1997 that prevented a true depression (though growth has been anemic there for the better part of 20 years), and that the U.S. must learn from this experience.  Along with Krugman and others, Koo recommends massive increases in federal spending in the years ahead, and an end to any attempt at Fed-induced stimulus.

How Real Is This Distinction between Recession Types?

There is no question that Koo has identified different attributes of downturns involving debt deflations versus those that yield “stagflation”, or declining aggregate demand coupled with rising prices.  And from the vantage point of investors, it is true, different asset classes hold up better under each scenario: again, in any inflation, commodities, natural resources, and real property are all effective hedges.  In a debt deflation, consumer products that are staples will be preferred relative to other classes suffering declining asset values.

But we think Koo is too clever by half with this distinction. In short:

·       One must ask, why does aggregate demand decline in typical recessions?  And similarly, what causes asset bubbles that eventually burst into a financial crisis?

·       The answer to both has a common origin: monetary disturbance.  An inflation in the quantity of money and credit leads to a lowering of interest rates artificially.  That is to say, the lower interest rates are not due to an increase in societal saving, and a shift in societal time preferences between present and future consumption; the lower nominal interest rates are due to the credit expansion and creation of money “out of thin air”.  This in turn induces investment to be undertaken under false pretenses, and it also causes a shift in the relative price structure in the economy, not only between consumer and capital goods, but also between consumer goods (period).

·       The economy’s structure of production will thus be distorted, leading to both errant investment of capital that cannot be sustained by real effective demand, and distorted consumption goods as well that will have to be corrected with further relative price (and production) shifts.

·       All of this will lead to a “cluster of entrepreneurial errors”, as Murray Rothbard described it – errors that can only be corrected by losses, liquidation, and unemployment.

·       In such an environment then, coming through a business downturn, the monetary  malfeasance is a cause of the waste, or destruction, of real capital.  The resultant capital shortage can only be corrected by a recapitalization that can only happen thanks to increased saving.  So for us, saving is always a virtue, and we do not worry as Koo and Krugman do that hoarding and non-spending will systematically occur, economy-wide.  The scarcity of capital is permanent, and the demand for consumer goods insatiable, so in a globally interconnected world, we expect those savings to be profitably intermediated and channeled to productive uses.

·       We also cannot agree with Koo on the relative effectiveness of monetary or fiscal policy in his alternate scenarios.  There is no case in world history, none, of a country achieving prosperity in the long term via a weak and manipulated currency.  Strong and stable-valued currencies promote trust and confidence in long-horizon investment, which is the mainspring of job creation and indeed, human progress.  The dollar has fallen 38% against a global basket of currencies in the last decade and this has had deleterious consequences in the U.S. via a capital flight (we do not count the investment in housing circa 2002-2007 as that was driven by misguided federal policies; excepting this, capital flows were highly negative in the U.S. during this time) that has cost jobs and harmed income growth.

·       Further, while we concede that some federal spending uses are better than others – we like infrastructure spending that is long lasting, as opposed to transfer payments to favored constituent groups for immediate consumption – we still insist that there is a crowding out effect, or opportunity cost, to all federal spending in terms of lowered consumption and investment from the private sector.   By definition this is bound to lower living standards and growth, in a comparative sense, and indeed, federal spending’s harmful effects linger for decades in higher taxes (tomorrow) to pay for today’s spending.

We will have more to say on this in the months ahead as policy is developed around the theme of a balance sheet recession: the incumbent Administration is already arguing that this recession was much more severe than had been previously thought because it was a balance sheet recession, and its supporters such as Krugman and Koo are thus calling for massive increases in federal spending stimulus as the ongoing policy response.   We think this is a big mistake and the threat of its continuance contributes to the fiscal imbalances that threaten us (see above discussion).  But certainly the investment implications of policies designed, in Koo’s fashion, to ramp up federal spending, are very different from those that are more aligned with private sector-led growth.  We therefore are watching this closely in the months ahead.

Dr. Chapman, an economist with Hill & Cutler Co. in Washington, D.C., is an advisor to Alhambra Investment Partners’ family of actively managed portfolios as well as a contributor to Alhambra’s research services. He and Alhambra founder Joe Calhoun are writing a book on how to invest and preserve wealth in today’s complex and turbulent markets.