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The Economist has an interesting commentary about the relationship between countries with high GDP growth and the returns for shareholders. Since corporate profitability is a central driver for economic growth in the first place, one would expect that high GDP growth should be a prerequisite in determining the viability of an investment.

This was not the case when considering 2 testing strategies for 17 countries:

  1. There was a negative correlation between investment returns and growth in GDP per capita
  2. In sorting the economies by growth rate into quintiles (highest to lowest), the fastest growing countries yielded an average 6% return, while the slowest yielded 12%.

The obvious problem with these statistics lie in the year of the study (2005) since the US was still achieving 4-5% GDP growth, and would be considered apart of the “slowest growing quintile”. Perhaps Thailand and North Korea were in the top quintile, but for obvious reasons (political instability, risky currencies) they weren’t great investments.

I do agree with this logic, however:

Why might this be? One likely explanation is that growth countries are like growth stocks; their potential is recognised and the price of their equities is bid up to stratospheric levels. The second is that a stockmarket does not precisely represent a country’s economy – it excludes unquoted companies and includes the foreign subsidiaries of domestic businesses.

Yes; the first is an issue of valuation (when is it unsustainable for China to have a higher P/E multiple than the US?) while the second is an issue of internal vs. external business growth; would we rather own a US run company with 30% of its exports to emerging markets, or a foreign company with 100% of its sales to consumers in its own country?

IBM, for example, is an American run multinational company which contributes to the GDP growth of many countries overseas – however the tangible returns are realized by the shareholders (who are probably from the US), which explains why the “slowest growing” GDP statistic isn’t very relevant for investing, since the geographical scope of most businesses is very wide.

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From the Financial Times:

ft-japan-comparison1

The point of the FT article was to describe how it is extremely difficult for the private sector to deleverage, or reduce debt levels, during periods of falling prices…As the charts show, the US is witnessing debt balloon to levels not seen since the 1950’s (as a percentage of GDP), while asset prices have fallen precipitously.

As the author describes;

It has long been argued that the US could not suffer like Japan. This is wrong. It is true the US has three advantages over Japan: the destruction of wealth in the collapse of the Japanese bubble was three times gross domestic product, while US losses will surely be far smaller; US non-financial companies do not appear grossly overindebted; and, despite efforts by opponents of marking assets to market, recognition of losses has come far sooner.

Basically, our situation is more similar to that of Japan circa 1990-2005 than we had anticipated – not to mention some  economic characteristics which are considerably less desirable (a global recession, leaving little room for other countries to pick up the slack in our budget/trading deficit by buying our debt and consuming our exports).

Surprisingly, part of the reason the author included all of this background was to advocate for a bigger stimulus package, not to be depressing.

Unfortunately, there is no discernible solution to the problems brought up in this article, other than the old “we’ll have to tough this one out” analysis:

The bigger point, however, is not that the package needs to be larger, although it does. It is that escaping from huge and prolonged deficits will be very hard. As long as the private sector seeks to reduce its debt and the current account is in structural deficit, the US must run big fiscal deficits if it is to sustain full employment.

There will be a Part II to this author’s column in next week’s FT, if at all interested.

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The Federal Reserve took advantage of the new powers it was granted in the financial stabilization bill by announcing that it will begin to pay interest on reserves it holds on behalf of depository institutions. This gives the Fed the ability to engage in a quantitative easing of monetary policy and which can be as powerful as interest rate cuts, probably more so in the current environment.

From Bloomberg:

Today’s steps follow a hoarding of cash by banks that sent the premium on the three-month London interbank offered rate over the Fed’s benchmark interest rate to a record.

Implementing part of last week’s emergency legislation to shore up the financial industry, the Fed said today it will begin paying interest on the cash reserves banks hold at the central bank. The step should give Fed officials greater power to inject cash into banks without interfering with their benchmark interest rate, which stands at 2 percent.

They have also managed to double the size of the Term Auction Facility (a short term liquidity metric used by banks) from 150 to 300 billion, which would not have been possible without this new provision of paying interest on banks reserves.

Here’s some analysis from Tony Crescenzi, an economist and CNBC contributor:

In the past, when the banking system has been flush with cash, banks have attempted to sell their excess money to other banks, often chasing the fed funds rate lower in an effort to avoid holding balances earning no interest

(remember: supply and demand. When there are more sellers than buyers, there will be a change in price. In this case, money rates will not go from the targeted 2% to a lower 1.5%, because banks will choose to “sell” their excess money to the FED instead of dumping it on the open market). Here’s some more:

In recent weeks, for example, the funds rate has fallen to close to 0% nearly every day because banks are competing with other banks to find buyers (borrowers) for their excess funds.

the expansion of the Fed’s balance sheet will be new money, which if lent can multiply substantially. The rule of thumb is that each dollar of reserves can result in $10 of new lending (because the first bank can lend 90 cents; the second bank 81 cents; and so forth, after deducting the 10% reserve requirement).

Whether this happens is, of course, up in the air and depends upon a restoration of confidence first.

This sounds like a recipe for inflation, to me, but financial stability is on the top of the FED’s list at the moment.

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There have been comparisons of Lehman Brothers to Long-Term Capital Management throughout the week, particularly the allusion to the scene at The New York FED; any financial CEO that matters, gathering to help stage yet another rescue through a consortium of banks.

It seemed like it would happen: with Barclays and Bank of America leading the negotiations, we saw 2 contenders with ample capital to facilitate the take over. But then, for a series of reasons, it looks like the plan of all plans has fallen apart just at the finish line:

Unable to find a savior, the troubled investment bank Lehman Brothers appeared headed toward liquidation on Sunday, in what would be one of the biggest failures in Wall Street history.

The fate of Lehman hung in the balance as Federal Reserve officials and the leaders of major financial institutions continued to gather in emergency meetings on Sunday trying to complete a plan to rescue the stricken bank.

But Barclays, considered the leading contender to buy all or part of Lehman, said Sunday that it could not reach a deal without financial support from the federal government or other banks, making a liquidation more likely.

The leading proposal had been to divide Lehman into two entities, a “good bank” and a “bad bank.” Under that scenario, Barclays would have bought the parts of Lehman that have been performing well, while a group of 10 to 15 Wall Street companies would agree to absorb losses from the bank’s troubled assets, according to two people briefed on the proposal. Taxpayer money would not be included in such a deal, they said.

But that plan fell apart on Sunday, making it likely that Lehman would be forced to liquidate.

Here’s the rest of the NYT’s article.

From here, we are entering uncharted territory – the bankruptcy of a major financial institution on the heels of a government takeover, one which guaranteed a class of assets which exceeds the value of the entire United States equity market. Yes, Drexel Burnham Lambert went bankrupt in 1992, but they had hundreds of millions in outstanding obligations, not hundreds of billions. Come Monday, we will see what happens to Lehman’s counter parties, chiefly AIG. Robert Willumstadt, AIG’s CEO, is expected to announce his plan to save the company. For the sake of our financial system, I hope its not too late.

One thing is for sure; there will be one hell of a book written about the events that transpired in the past 2 weeks.

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That short-term relief rally I conjured up over the weekend lost steam awfully fast. The euphoria of the GSE bailout was quickly negated by the realization that our government will be out of bullets for a while, and will be able to do very little in the light of more “too big to fail” type banks (Lehman today, maybe Wamu and Wachovia tomorrow). The scary thing about Lehman, was first their lack of noise since Erin Callan touted their alleged sound financial condition, and now, they are particularly stubborn about finding a good buyer…haven’t they heard the saying “beggars can’t be choosers?”

Their newest trick is spinning off their really bad stuff into its own entity, and having Blackrock help them con someone into buying it.

Lehman is “formally engaged with” with BlackRock Inc., the biggest publicly traded U.S. fund manager, to sell about $4 billion of the investment bank’s U.K. residential mortgage holdings, according to today’s statement. Lehman said the transaction would help reduce the firm’s stake in home mortgages by 47 percent to $13.2 billion.

Non-amortizing U.K. mortgages…Just GREAT. If you choose to read the rest of their plan, don’t faint at the size of their exposures relative to the value of the company/assets.

………….

While this is next bit is pretty off topic, I think it is something of note as an individual investor who is thinking about catching the next bottom. The author (Rev Shark) is a contributor to Jim Cramer’s RealMoney.com, but often clashes with Cramer, which is funny. This is a segment from one of his daily updates:

Unfortunately, Wall Street is in the business of keeping people in stocks. However, you would think that every once in a while, even for a little while, they might acknowledge that maybe it’s not a good idea to be 70% or 80% exposed to equities, especially when things are downtrending.

One of the big farces on Wall Street is the whole idea of “defensive stocks.” There are very few, if any, safe havens in bear markets, but Wall Street will pretend that you are better off holding some “safe” stock rather than cash. In most cases, these safe stocks simply don’t go down as fast as the broad market, which is great for mutual funds concerned about relative performance, but not so good for people trying to make money.

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September 7th:

The plan is out, and there is a lot to comprehend.

The WSJ article is very long, and believe it or not, This Bloomberg write up is more to the point. I did however cut it down, so the full version can be found here:

Sept. 7 (Bloomberg) — The U.S. government seized control of Fannie Mae and Freddie Mac after the biggest surge in mortgage defaults in at least three decades threatened to topple the companies making up almost half the U.S. home-loan market.

The FHFA will take over Fannie and Freddie under a so-called conservatorship, replacing their chief executives and eliminating their dividends. The Treasury can purchase up to $100 billion of a special class of stock in each company as needed to maintain a positive net worth. It will also provide secured short-term funding to Fannie, Freddie and 12 federal home-loan banks, and purchase mortgage-backed debt in the open market.


Treasury Gets Stock

Under the plan, the Treasury will receive $1 billion of senior preferred stock in coming days, with warrants representing ownership stakes of 79.9 percent of Fannie and Freddie. The government will receive annual interest of 10 percent on its stake.

As a condition for the assistance, Fannie and Freddie eventually will have to reduce their holdings of mortgages and securities backed by home loans.

The portfolios “shall not exceed $850 billion as of Dec. 31, 2009, and shall decline by 10 percent per year until it reaches $250 billion,”

TRANSLATION: De-leveraging.

the Treasury said. Fannie’s portfolio was $758 billion at the end of July, and Freddie’s was $798 billion.

Officials are aiming “to prevent the mortgage market from falling apart,” said former Federal Reserve Bank of St. Louis President William Poole. The Treasury’s funds “will be flowing in for quite a long time,” Poole, a Bloomberg contributor, said on Bloomberg Radio.

Herbert Allison, 65, former chief executive officer of TIAA- Cref, will take over as Fannie’s new CEO. David Moffett, 56, who was vice chairman of US Bancorp, will head Freddie, Lockhart said. They will work with existing management, he added.

Something of Note: In case you didn’t know, Herb Allison was the orchestrator of the LTCM rescue…this is just a little bigger than that, though.

Here’s the important part for direct investors:

Subordinated Debt

Lockhart added that interest and principal payments will continue to be made on the companies’ subordinated debt.

The government is taking an increasing role in financial markets, after the Fed six months ago provided $29 billion of financing to prevent Bear Stearns & Cos.’s collapse. Chairman Ben S. Bernanke praised today’s action in a statement.

The plan doesn’t answer all of investors’ questions about the companies’ long-term prospects. It also doesn’t address the question of whether the companies will be nationalized, privatized, or kept as government-sponsored enterprises that are shareholder owned. Paulson said that “only Congress” can tackle the “inherent conflict” of serving shareholders and a public mission.

“Keeping them alive is the wrong approach,” said Peter Wallison, a fellow at the American Enterprise Institute in Washington and a former Treasury general counsel. “They need to be sustained, they’re essential to financing housing right now. But it doesn’t mean that they have to be maintained as GSEs.”

Wallison added that if Fannie and Freddie return to profitability, “then what the shareholders have is worth something.”

No End Date

The FHFA will aim to “preserve and conserve” the companies’ assets and property and put them “in a sound and solvent condition,” according to a fact sheet distributed by the Treasury. There is “no exact time frame” for when the conservatorship will end, the statement said.

Fannie and Freddie own or guarantee almost half of the $12 trillion in U.S. home loans and the government had been leaning on the companies to help pull the economy out of the housing crisis.

Concern over the companies’ capital pushed their borrowing costs to record levels over U.S. Treasuries, sent their common and preferred stocks tumbling and boosted mortgage rates. Fannie is down about 66 percent in New York Stock Exchange trading since the end of June. Freddie has fallen about 69 percent.

Paulson briefed Republican presidential candidate John McCain, Obama, and the Democratic and Republican leaders of the House and Senate. Senate Banking Committee Chairman Christopher Dodd and House Financial Services Committee Chairman Barney Frank and their Republican minority counterparts were also informed.

Losses Mounted

As losses on the mortgages grew late last year, the companies recorded $14.9 billion in combined net losses, eating into their capital. Fannie raised $14.4 billion since November and Freddie sold $6 billion of preferred securities. Plans for a $5.5 billion sale were delayed as the company’s fortunes sank.

Fannie had $47 billion of capital as of June 30, according to company filings. The company is required by its regulator to hold $37.5 billion. Freddie’s capital stood at $37.1 billion, compared with a requirement of $34.5 billion, filings show.

Fannie’s market capitalization is now $7.6 billion, down from $38.9 billion at the end of last year. Freddie‘s has fallen to $3.3 billion, from $22 billion over the same period.

Bernanke participated in the meetings because the central bank was given a consultative role in overseeing Fannie’s and Freddie’s capital under legislation approved in July.

The FHFA was scheduled to release its assessment of the companies’ capital levels as early as last week as part of a quarterly appraisal of their finances.

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August 24th:

*Actual results may differ.

Chris, your noble Economic Equity…ist .. has asked me if I’d care to write something in his stead – a kindness to which I am not unresponsive. However I no longer teach Economics: I’m a fully-fledged Health Economist again, in another country, and I take no responsibility for knowing what I’m talking about. I’ll probably also only do this in one draft.

Specifically, he asked what I thought of the new strength of the of the US dollar, given my ongoing classroom criticism of the US dollar, and my predictions of it’s decline. So here’re a couple of pictures worth a quick couple of thousand words (Chris can fix the formatting):

What’s our narrative? Besides poetic justice to ‘the speculators’ and a reminder that money, invariably, passes from the hands of the speculators, the dilettantes, the under-prepared managers of their own life’s savings, the managers of public pension schemes … into the hands of investors.

Don’t believe me? Go to vegas, sit down at the table of unsmiling heavy-set gentlemen who look like they’ve lived there their whole lives. See how you get on.

The real question is, is the US economy storming back? Will Bush turn out to have been right all along? Will Bernanke and Paulson turn out to have been the best type of idiots of all: the idiots savant?

No. Of course the answer is no. Nobody wastes their time with rhetorical devices.

This resurgent dollar story is, sad to say (with sincerity), a story not of the new strength or resilience of the US economy, but the wobbly legs and knees of the UK and Europe (if you’ll forgive my dichotomising them). It is the story of the UK and European economies catching up to the US in the doldrums, as they surely would.

I stress the surety of their joining you because, typically, another narrative is out there: one in which the red, white and blue greenback can’t be given a black eye. The Financial Times, in fact, managed to cover nearly every base in their reporting of 8 August, this year:

The moves marked a key reversal of a trend that many investors had followed profitably for months – betting that high commodity prices would keep the dollar weak.

“This is the watershed week for the US dollar,” said Marc Chandler, currency strategist at Brown Brothers Harriman. “The magnitude of the dollar’s moves and the breaking of key technical levels suggest that a major shift in the outlook towards the dollar is occurring as massive positions are adjusted.” Other analysts described the widespread buying of dollars as “capitulation”.

Traders said the violence of the move was testimony to the extent to which the market had been surprised by economic weakness outside the US.

“Mr Trichet was unable to convince the public that the ECB had not been surprised by the Eurozone’s economic downturn,” said Ulrich Leuchtmann at Commerzbank. “Therefore, the last remaining rate hike expectations were taken off the table.”

UK economic data has shown increasing weakness this week; officials in Japan warned that the economy was headed for a recession; and the Reserve Bank of Australia said it was planning to start cutting interest rates to head off an impending economic slowdown.

You can look, yourself, for others. I don’t have the inclination to do harm to my own psyche. I will say, however, that this is not a knock on the US or US media: you’ll find it all over.

First, the weakness of the dollar has been driving up commodities, not the other way around. Now, if one invests not according to fundamentals but according to an eye for increasing prices (even on stocks or goods that are overpriced already) then one is basically watching, always, for the realisation of that gain – not to mention the first sign of a peak. So (i) the big ‘other’ economies falter, (ii) their future GDP looks weak relative to yesterday’s comparison with US GDP, (iii) returns on your investment won’t be so high, therefore (iv) it is time to move your investment.

Why, one might ask, did this not simply push commodities higher still? If people fled the US dollar for oil and gold, why would other people not flee the Pound and the Euro similarly? Partly because the gains were already made, mostly because – I suspect – we’re not talking about speculators, we’re talking about investors, who buy and make capital gains (remember those types?) and people who need to hedge in currency.

It’s also, as any first-year student and reader of the Economist magazine’s Big Mac Index can tell you, the simple, clean and ruthless crunch of Purchasing Power Parity, Interest Rate Parity (which had been behind the initial decline in the value of the greenback. We’ll return to this) or any other kind of parity you like. International currency arbitrage is a force to be reckoned with, and it enforces equilibria faster, possibly, than anything else.

When the UK and Eurozone economies stop being bigger, better, stronger than the US economy, so do their currencies. It’s that simple. The US dollar did not appreciate because the US economy is doing well. A sinking tide lowers all boats, too.

So. Having bashed up the US enough to secure a by-line at the Exile, let us return to economics.

We know – let us assume – that, in the event of declining economic activity and macroeconomic contraction, monetary policy responds by lowering interest rates. Lower the official rate of interest: increase borrowing, increase investment, increase consumption, increase jobs; problem solved.

However, interest rates – broadly speaking, now – are not just the cost of borrowing, they are the returns on lending. So if you’re an investor (say, Warren Buffet, or China), you’ll think twice about leaving your money in that economy. You’ll look at another economy.

This is the cause of the declining value of the US dollar, way back when. The US economy, rightly, faltered first – and how. With no fiscal policy upon which to draw, Bernanke got it all with not even a blindfold to keep him company. Rates were slashed, time and again. Meanwhile, the UK, Europe and any number of other economies were (i) not faltering, yet, but as importantly (ii) more concerned with inflation which, while still measured dodgily and with political expedience in mind, is nevertheless still measured more accurately, and taken more seriously, everywhere better than in or by the US.

As of recently, however, such is not the case. Despite the best of intentions, my copy of the FT Weekend loudly declares the UK economy to be at a standstill (“UK economy shudders to a halt”, I believe, is the phrase employed). The Eurozone economy (if you want to kill some time, narrow it down: look up Italy, or Germany) likewise.

The FT’s quote above had Trichet being caught unawares. As the author of this august blog can tell you, I’ve yet to buy into the argument that such people truly can be caught unawares (seriously, give me a break). However, if ‘the market’ is anticipating an interest-rate hike and, instead, gets talk that sounds more like rates will be held or, maybe, lowered, it’s time for that Interest Rate Parity to take hold.

Thus my argument. The US dollar is not appreciating in value because it is normalising upward: it is appreciating because the rest of us are normalising downwards, and don’t let anybody tell you otherwise.

So what does this mean for us? Most likely it means that there’s a decent chance that the US economy will lead us out of these same doldrums. There’s also a decent chance that it won’t: the problems began in the US and the ability to re-start half-intelligent regulation is hindered more in the US. But the US is the OECD’s dynamo.

This is only another bear market rally: play it only if you have the time, the nouse and the willingness to lose your pants by making a wrong bet. It doesn’t mean one shouldn’t look out for the real recovery, though. Look out for it. Buy the dollar, if you like gambling, then sit tight for a couple of months and buy the Pound/Euro when it reverse the process currently underway. Then send me my cut.

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