Heck of a Soft Patch, But Recovery Still Intact

After a string of better-than-expected economic reports in the U.S., especially for labor markets, the government’s nonfarm payrolls report landed with a heavy thud yesterday. New jobs came for August came in at less than 100,000, well below consensus expectations, and prior months were revised down by a hefty 41,000.

Our working thesis is that the U.S. economy is exiting a heck of a soft patch which various forward-looking indicators were hinting at in the second half of 2011 (one of our recession warning models was even triggered briefly in August), but it’s over barring any sudden shocks. Those same indicators are pointing to positive growth and continuing but still painfully slow labor market improvement in the quarters ahead, not just in the U.S. but also abroad, including Europe.

Warren Mosler’s staff also posted some interesting observations on historic revisions to labor market data that support the glass-half-full-for-investors thesis. A five-figure upward revision to August, should that occur, would affirm our positive outlook.

All that said, markets have gained significant ground from their most recent panic lows, and inaction by Congress on the steep spending cuts and tax hikes set to take effect in 2013 is not fully priced in. (While the possibility of the fiscal cliff is known, market action is currently implying that something will be done; if not, the result could be pretty ugly, even if temporary.)  And this latest air pocket was the closest scrape with recession in the U.S. since the 2009 recovery began—a heck of a soft patch indeed.

In the next one or the one after that we might not be so fortunate, especially as we continue moving in the direction of moderate austerity or worse. (The weak manufacturing environment could be a canary in the coal mine, as it was in the late 1990s, although China’s recent stimulus announcements may provide some help to the sector.)

Did Michael Woodford Endorse NGDP Targeting? Hell, No.

Not as NGDP targeting is currently articulated, anyways.

Famed economist Michael Woodford gave a speech at the Federal Reserve’s annual conference in Jackson Hole, Wyoming recently that is stirring a lot of interest as it allegedly advocates nominal GDP (NGDP) targeting.

The NGDPers should take a more careful look, however. As we read it, Woodford argued that policies relying solely on expectations—the nom-de-guerre of monetary policy and monetarists—is likely to prove as fruitless when interest rates are near zero as the types of forward guidance he critiqued in the paper. Therefore, in order to stimulate economic activity, some combination of fiscal policy, monetary policy that essentially acts like fiscal policy (such as mortgage-backed security or MBS purchases), and coordination between fiscal and monetary authorities is almost certainly required.

Woodford’s remarks, rather than being claimed as an endorsement of (so far only half-baked) NGDP-targeting concepts should be a huge wake-up call to NGDPers and other pure monetarist types that fiscal policy still matters.

In Woodford’s own words (emphasis added):

A more logical policy would rely on a combination of commitment to a clear target criterion to guide future decisions about interest-rate policy with immediate policy actions that should stimulate spending immediately without relying too much on expectational channels. Neither a program of expanding the supply of bank reserves nor a program of expanding the central bank’s holdings of longer-term Treasury securities is a good example of the latter kind of policy. Additional purchases of MBS by the Fed might instead still be useful as a way of reducing the cost of mortgage borrowing, though it is hard to be certain that additional purchases now would reduce MBS yields by the amount that the Fed’s purchases under LSAP apparently did, given the less perilous situation of private financial intermediaries now, and it is hard to be certain that reductions in MBS yields would be passed on to mortgage rates. A kind of policy more certain to expand mortgage lending would be one like the Funding for Lending Scheme (FLS) recently announced by the Bank of England and the UK Treasury, which subsidizes lenders for increasing the amount of loans that they make.

Of course, it is not necessarily up to the central bank alone to institute policies of that kind, that can more directly influence private-sector decisions, for such actions are more properly viewed as part of fiscal policy. It is probably no accident that the FLS is a joint project of the Bank of England and the Treasury. And indeed, more generally, the most obvious recipe for success is one that requires coordination between the monetary and fiscal authorities. The most obvious source of a boost to current aggregate demand that would not depend solely on expectational channels is fiscal stimulus—whether through an increase in government purchases, tax incentives for current expenditure such as an investment tax credit, or subsidies for lending like the FLS. At the same time, commitment to a nominal GDP target path by the central bank would increase the bang for the buck from fiscal stimulus…

Looking around the blogosphere, it appears that NGDPer David Beckworth was indeed too hasty in claiming Woodford’s affirmation when he posted on August 31, “Michael Woodford Endorses Nominal GDP Level Targeting.” For example, fellow NGDPer acknowledged Scott Sumner clearly understood that Woodford’s paper sought to “brush aside the monetarist approach.”

Dimitri Papadimitriou, the president of the Levy Economics Institute of Bard College in Annandale-on-Hudson, New York, is also wondering how the Fed would put a strategy of targeting nominal GDP into practice. “How do you do this?” he asks. “There is no reliable transmission channel from monetary policy to GDP. The evidence is clear about that,” he says. “[Federal Reserve Chairman Bernanke] will, I think, proceed with another bond purchasing program, if there is no improvement in GDP growth and decrease in unemployment,” says Papadimitriou, noting that monetary policy won’t solve the unemployment problem. “It is only fiscal policy that is potent to improve economic conditions,” he says. But Bernanke, “being a student of the Great Depression,” doesn’t want to be blamed for not doing everything he could possibly do to lower unemployment, he says.

That highlighted statement from Papadimtrou is anathema to monetarists and the ‘Chicago school’ of macroeconomics. Without digging into the historical, institutional, and technical reasons, suffice to say that if NGDP targeting were successfully implemented, it would require the central bank to take actions that have historically fallen under the purview of fiscal authorities, or at other times, the mining and minting of precious metals.

That’s not to say they couldn’t succeed. Rather, it exposes the fact that macroeconomists need to come to some sort of agreement on what monetary, fiscal, and government roles really constitute in today’s monetary system.

As one pair of co-authors recently put it, in 1973, when the U.S. officially went off the gold standard, everything changed—except the macro textbooks!

Jamie Dimon: Not the Smartest Guy in the Room

This post relates to news that is from way back in mid-June but is becoming increasingly relevant with (a) the “sequestration” idiocy of 2011 (thank you, GOP) and “sunset” stupidity of 2001-2003 (thank you, Democrats), a/k/a the fiscal cliff, fast approaching and (b) both national party conventions featuring plenty of speeches on why their party is best positioned to slash deficits and restore ‘fiscal order’—which, if they ever bothered to define and think through, might make clear how dangerous all of this nonsense is.

While we’re at it, we can add Clinton Treasury Secretary Bob Rubin to our “not the smartest guy in the room” list of the rich and powerful, as it was he who almost singlehandedly got the entire press corps and Democratic Party to believe that government “borrowing” causes higher interest rates and “crowding out” of private sector financial activity. Dishonorable mentions go to Peter Orzag and William Gale, as well as Newt Gingrich, although the list could be much longer.

So why does being (or not being) the smartest guy in the room matter? Or more appropriately, when does such a normally irrelevant question matter? It matters when the rest of us contemplate the advice of people who are powerful and influential, but not necessarily correct or even well intentioned. Because when we assume that such people are more intelligent than us and guided only by their better angels, we do ourselves no favors by accepting their advice at face value.

There is one small irony in this matter though, given that the fiscal cliff is now only four short months away. And that is that Simpson-Bowles, despite its sadly mistaken foundational assumptions and ill-informed objectives, probably would be preferable to the big bath awaiting us in January. Granted, there may be ways to cushion the blow in 2013 if nothing is done; taxes could be lowered significantly, which the Tea Partiers and GOP should be willing to support (if not for their consistent errors in asking how to ‘pay’ for it), and counter-cyclical spending increases would occur automatically. But both of those are likely to kick in only after real damage has been done.

In any case, here’s what Dimon said to Congress back in June, and why, at least on fiscal matters and their impact on financial markets and economies, he is decidedly not the smartest guy in the room, despite what his HBS credentials and professional success might seem to imply.

…the banker’s most passionate plea to the lawmakers was one that Republicans most emphatically don’t want to hear: Enact the Simpson-Bowles debt proposal, a package of spending cuts and — gulp — increased tax revenue that was largely scuttled by House Republicans.

“If we had done something remotely like Simpson-Bowles,” Dimon said in response to Sen. Michael Bennet (D-Colo.) at the end of the hearing, “you would have increased confidence in America. You would have shown a real fix of the long-term fiscal problem. I think you would have had . . . a more effective tax system that is conducive to economic growth.”

First, there is no “long-term fiscal problem” for a government that is the sovereign issuer of our currency. (For credit-obsessed and trade-obsessed viewers, read that as “the only net issuer of our currency.”)

Second, it’s a stretch worthy of Rex Reed to argue that fiscal issues have caused a confidence problem that is now the main headwind to U.S. economic performance.  Several competing explanations are far more compelling, although admittedly less helpful to someone trying to turn the spotlight back onto his—”fawning,” according to the article—interrogators. They include the fallout from the most severe U.S. financial crisis since the 1930s, a massive household balance sheet recession, and shifting demographic internals, all of which point to a widespread shortage of aggregate demand. And even the most bitterly opposed macroeconomic paradigms tend to agree that such a condition argues for more, not less federal government spending and lower, not higher taxes.

Mr. Dimon is absolutely right that we should make the federal tax code more conducive to economic growth. We just shouldn’t do it in the anti-long-term-growth manner he prescribes.

…he said, not enacting such a plan “helped cause a downturn last year.”

As I remember it, most of the upheaval in the last two years has emanated from the eurozone, which was founded on the misinformed ideas (let’s call it what it really is—economic malpractice) of Dimon, Rubin and most of the modern economic and financial profession. The eurozone crisis has repeatedly threatened the solvency of Europe’s financial system and, much as Dimon’s profession did in 2008, the global payments system itself. Yet in 2008, the fiscal ‘issues’ that have now worked Dimon’s policy passions into an urgent lather were largely nonexistent.

And when the U.S. debt ceiling impasse was finally “resolved” in 2011, the U.S. economy and markets got back to business, despite the fact that there was absolutely no action taken that echoed the debt commission’s. (On a side note, a more accurate name for the debt commission might be the ‘non-government sector savings commission’.)

…Dimon had a more deserving target for his criticism than Democrats and regulations: a demand to “get our fiscal act in order” before the election and before automatic tax increases take effect next year. The Simpson-Bowles plan “is a road map which I like,” he said, and the important thing is “getting something like that done.”

If Dimon is the senators’ best friend, as their fawning suggests, perhaps they’ll take this advice seriously.

Let’s hope not.

Again, to be fair, the 2013 spending cuts and tax hikes are like a loaded cannon pointing at the gut of the American economy, and Simpson-Bowles pales in comparison as far as doing a lot of damage in a short time. But neither the fiscal cliff nor the commission recommendations are good policy, and it would be especially nice to hear at least one of the major parties admit it.

Instead, we’re treated to Bill Clinton’s fond remembrances of budget surpluses, President Obama’s disdain for deficits, and Representative Ryan, like Newt Gingrich 15 years before him, throwing dirt on the true legacy of supply-side Reaganomics—that in our current institutional framework, sufficiently large federal deficits are conducive to economic growth under most conditions. Clearly, David Stockman, the architect of the late Reagan-era tax hikes (the last time we forcefully “broadened the base”), also deserves dishonorable mention. Let’s throw David Walker, Jagadeesh Gokhale and Kent Smetters on there while we’re at it. Heck, there’s even room for Art Laffer.

Unfortunately, it seems very unlikely that either party will dare to embrace the deficit-enlarging aspects of FDR’s, Kennedy’s, Reagan’s, and G.W. Bush’s fiscal policies. And that means that both the risk of future recession and the staggering underemployment of human beings remain higher than they need be.

Add Some Risk, Take Some Lumps

It’s a bit strange to suddenly find ourselves in a position of ultra-bullishness, but strategically, we think investors should consider reducing exposure to safe-haven assets like U.S. Treasuries in favor of riskier assets, or at the very least, use recent market dislocations as an opportunity to rebalance a well-designed strategic allocation.

Market volatility and political uncertainty are likely to remain elevated, so adding risk to a portfolio will almost certainly involve taking some lumps (and may therefore not be appropriate for every investor). But risk is widely on sale at the moment, while perceived safety is extremely pricey, at least for now. We also think investors with a global focus may want to consider tilting risk exposures away from the U.S. in favor of overseas markets until there is more clarity over the 2013 balance of power and direction of policy in Washington, DC. The observations and opinions upon which our view is based are outlined below.

Europe:

• At current levels, markets appear to be pricing in a prolonged recession. But financial indicators continue to signal a short recession in the first or middle half of 2012 and a quick (though tepid) recovery.
• Germans have been the primary beneficiaries of the euro currency area (EMU). Despite their stubborn insistence on austerity, reality may slowly be dawning on them (if not, it eventually will).
• If Spain experiences fiscal failure, the euro experiment is over for all intents and purposes, and Germany’s export markets will contract considerably.
• The most recent can-kicking measures reflected the importance placed on preserving Spain and Italy’s EMU membership. Spain simply cannot be allowed to fail.
• Recent measures such as the ECB’s long-term refinancing operations (LTRO) have run out of steam much faster than prevailing macro paradigms expected. This should not have been a surprise.
• If a recent Bank for International Settlements workshop is any indication, the mainstream macroeconomics profession is in as anxious and uncertain a position as it was in 1932.
• Recent multi-national summits have produced little in the way of public announcements, but there appears to be a flurry of activity behind the scenes, especially in Europe.
• Although none of its actions over the past several years have solved the currency area’s primary defects, the European Union (EU) has eventually blinked every time markets forced its hand.
• Don’t underestimate the political power and influence of Europe’s banks or the fragility and stress they are experiencing. Europe’s banking system will not be allowed to implode.
• The ECB announced it would stay pat on its interest rate target. This looks preposterous from most macro points of view, but may not be, as it (1) reflects operational reality, wherein the EMU framework prohibits the ECB from adding to net financial assets (thereby assuring that its financial system repeatedly ends up in a state of Ponzi-like fragility), and (2) intensifies the growing pressure on the EU (and by extension, the G-20?) to come up with a durable fiscal framework for the EMU (if not the entire EU).
• The rumor mill seems likely to churn out plenty of hope in coming weeks, which could make for a nice June rally. The Wall Street adage is to “Sell in May,” but we’ve been buying.
• What agreements arise from the EU and possibly G20 by late June, if any, will determine how long a rally can continue.
• European markets are worth consideration given (1) how hard they’ve sold off, (2) potential for positive policy surprises,  and (3) the likelihood of rising political and fiscal uncertainty in the U.S.
• Among individual issues, there are some table-pounding, high-quality franchises in Europe selling at very cheap prices.
• The U.K. government may be floating ideas meant to undo some of its ill-advised austerity programs—and “growth bonds” sure beat war bonds, which is how the world last emerged from a synchronized balance sheet recession.
• Certain European countries that are outside the EMU (and thus remain monetarily sovereign) are interesting from a macro standpoint.

Europe caveats:

• Germany’s confidence in morality-based economics may be shaken, but there will be limits on how much upside is actually permitted in Europe (which is far more conservative than conservatives in the U.S. believe).
• As the experience of Japan shows, neoliberal tendencies can screw up otherwise good policy ideas in short order—negative surprises are still very probable at some point.

U.S. Treasuries:

• For the first time in my 12-year career, U.S. Treasury prices appear to be overdone. We believe long bonds could experience a 10-20% correction in 2012 or early 2013.

Treasury caveats:

• Beyond such a correction, we don’t see huge downside for (truly, i.e., monetarily) sovereign bonds, which (beyond some short-term maturities) will provide a positive overall yield to maturity.
• The U.S. Congress is an unwelcome wildcard as long as certain members are willing to play political chicken with the U.S. debt-ceiling limit.
• Given the right mix of policy errors, yields in developed markets could still see Japan-like levels in the years ahead (prices and yields move inversely).

China:

• Chinese stocks have been pricing in a slow growth regime for two years now.
• A great deal has been made of falling power consumption, manufacturing indices, demographics, and public statements about lack of planned easing measures.
• However, policymakers have been moving in the direction of easing on both the fiscal and monetary fronts.
• The government’s focus on domestic consumption appears to be gaining some traction, which might help to explain lower power consumption and crummy manufacturing PMIs.
• While they are a minefield of agency risks and other complexities (which in capital markets is always a matter of degree), there appear to be some deep values among Chinese equities.

Japan:

• Japanese equity markets are cheap. Cheap, cheap, cheap.
• The Japanese government continues to commit the kinds of policy errors that have put its economy and financial markets where they are.
• Internal demographic trends (as opposed to overall population growth rate) should be growth supportive in coming years (though perhaps not immediately).
• Once Japan’s economy and equity markets gain traction, Japanese Government Bond (JGB) yields could rise. This will NOT be a harbinger of Japan’s imminent fiscal collapse. The hedgies and others betting on such an outcome have no idea how a modern monetary economy operates.

Emerging Markets:

• Most key EMs have room for policy easing and are beginning to use it.

EM caveats:

• U.S. fiscal tightening and a strengthening dollar could have negative macro impacts in many countries, as they did in the late 1990s.
• Those pressures may be offset to some extent by weakening of domestic currencies and economic evolution (e.g., toward domestic services over lower value activities).

On the U.S.:

• This is where the outlook gets interesting. Much of the world is now offering upside surprise potential, which the U.S. has already been doling out for a couple of years.
• The U.S. economy and financial markets have outperformed most of the world, thanks to our divided government’s inability to similarly punish its domestic economy.
• A sweep by either party in November elections could unleash a whole bunch of stupidity (worst case) or legitimate pro-growth policy (best case, but low probability).
• A continued split between the Executive and two Legislative branches seems more likely, but either outcome risks no action on the so-called fiscal cliff of 2013, when a raft of deficit-inducing measures (deficits are a good thing in a prolonged balance sheet recession) are set to expire, and significant deficit-reduction measures (thanks to the Tea Party and other GOP’s debt-ceiling brinksmanship in 2011) will take hold (a bad thing).
• It does not look like the Fed is contemplating concerted action or a new round of ‘unconventional’ policy measures.
• It’s reassuring that the federal budget has turned back into deficit after recording the largest surplus in four years in April (h/t Mike Norman), but the overall trajectory is still down, which eventually leads to a financial breakdown of some kind and/or recession.
• If efforts to address the fiscal cliff fall apart, which is not outside the realm of possibility, we would expect some significant carnage in U.S. markets, similar in magnitude to Europe’s recurring meltdowns of recent years.

U.S. caveats:

• That said, we expect the U.S. economy to continue growing in 2012, albeit at its subpar pace. Our internal models are putting a near-zero probability on recession this calendar year.
• Earnings estimates for U.S. stocks should surprise modestly to the upside in coming quarters. As long as earnings multiples don’t contract, that should support U.S. stock markets.
• Overall, U.S. stock markets should continue to perform reasonably well for another year or two, as long as there is a reasonable probability that the fiscal cliff will be addressed constructively.

Finally, a parting thought—we subscribe to the notion that prevailing approaches to macroeconomic theory, modeling, and policy design and implementation are broken. The profession must work to close the gap in order to avoid intellectual bankruptcy, but this will take courage and, unfortunately, the passing on of influential but wrongheaded figures (Alan Greenspan’s recent comments on the bond market come to mind).

Sadly, professional courage is rare, and passing on, while inevitable, can take a long time before sufficient room is made for new ways of thinking. However, looking at Japan as the ultimate example of modern macro policy and financial practices gone awry, there are at least three distinguishing features between its experience and that of the entire developed world now struggling with output gaps, de-leveraging, and slow growth or recession. Since the peak of its bubble around 1989, Japan’s population has hovered around two percent of the world’s population, and its political system rarely fostered radical change (until very recently, and on the policy front, it’s still been a disappointment). Today, more than 10% of the developed world is struggling with slow growth and excessive unemployment and underemployment, and many of those people live in countries with fairly reactive political institutions. The world’s capacity for the free exchange of ideas has also expanded exponentially since 1989. In short, as the shortcomings of the economics profession continue to be exposed by the ongoing struggles of millions if not billions of people in the current malaise, the coming years may prove fertile for advancing the understanding and application of macroeconomics—perhaps spurred on by electorates, like those in France and Greece, that insist there has to be a better way than the status quo. This might just be wishful thinking. Time will tell.

In the meantime, we are advising our clients to add some risk and lower their exposure to safe havens where appropriate, with the understanding that although these moves might eventually pay off, their portfolios could take some lumps in the meantime. At some point, we believe hindsight will confirm that today’s markets present opportunities to savvy, patient, long-term investors.

Yoga with Brad and Larry

In a timely and somewhat interesting paper, economists Brad DeLong and Larry Summers argue that fiscal policy has an important role to play when monetary policy is constrained by the zero bound on interest rates. From the abstract:

“This paper examines logic and evidence bearing on the efficacy of fiscal policy in severely depressed economies. In normal times central banks offset the effects of fiscal policy. This keeps the policy-relevant multiplier near zero. It leaves no space for expansionary fiscal policy as a stabilization policy tool. But when interest rates are constrained by the zero nominal lower bound, discretionary fiscal policy can be highly efficacious as a stabilization policy tool. Indeed, under what we defend as plausible assumptions of temporary expansionary fiscal policies may well reduce long-run debt-financing burdens. These conclusions derive from even modest assumptions about impact multiplier, hysteresis effects, the negative impact of expansionary fiscal policy on real interest rates, and from recognition of the impact of interest rates below growth rates on the evolution of debt-GDP ratios. While our analysis underscores the importance of governments pursuing sustainable long run fiscal policies, it suggests the need for considerable caution regarding the pace of fiscal consolidation in depressed economies where interest rates are constrained by a zero lower bound.”

Of course, it’s too large of a paradigm shift for them to admit, for example, that (1) fiscal and monetary approaches are largely interchangeable insofar as additions to and subtractions from the stock of net financial assets go, or (2) that Clinton-era Rubinomics “succeeded” thanks to ongoing and demographically supported credit expansion in the private sector (and was an utter disaster for U.S. dollar-dependent entities such as Argentina, Mexico, Russia, and Asian Flu countries).

Their paper extends earlier work done by sympathetic economists on fiscal policy in low interest-rate environments. While it offers the right policy prescription, it’s also an effort to preserve and protect some prevailing but defective macro models.

One particular point of interest is that DeLong and Summers cite MMT stalwart Randy Wray on page three, however briefly. Fortunately, fellow MMT economist Bill Mitchell posted a critique of the zero-bound or ‘liquidity trap’ argument just yesterday, concluding:

The reason the mainstream promoted monetary policy to the fore was because they were really advocating smaller government and more free market space. Hence they had to undermine the case for fiscal policy. In doing so, they have created three or more decades of persistent underutilisation of labour resources in most nations; virtually zero growth in per capita incomes in the poorest nations; and set the World up for the current crisis.

By continuing to see quantitative easing as the solution, the more progressive mainstream economists have also caused the current crisis to be extended.

Fiscal policy expansion is always indicated when there is a spending gap. It is a direct policy tool ($s enter the economy immediately) and can be calibrated and targetted with more certain time lags. Liquidity trap or not, fiscal policy is the best counter-stabilisation tool available to any government.

Like Diet & Exercise for Pneumonia

An important post at FT Alphaville from Izabella Kaminski regarding looming capital tightening at European banks this summer (bold passages are Kaminski quoting economist Richard Koo):

As a practical matter, the only way banks can satisfy the new capital requirements if raising capital is difficult is by reducing the denominator in the capital ratio: total assets. If all banks try to do that at the same time, the result will be a destructive credit crunch.

So, no new capital = need to sell-off assets = brand new credit crunch.

Hardly constructive.

And that, Koo says, is exactly what happened when stricter capital rules from the BIS were introduced in 1997 in Japan:

Although Japan’s bubble burst in 1990, it was not until October 1997 that the economy experienced a serious credit contraction. The decision by the Ministry of Finance’s Banking Bureau to unveil the details of new BIS-based capital rules on 1 October that year—a time when most Japanese banks were struggling under the weight of bad debts—triggered a destructive credit crunch. Discussions about the new BIS standards had been ongoing for a number of years, but it was the announcement of the specifics on new rules in October 1997, when the bubble’s collapse had left Japanese banks in an extremely weakened state, that prompted a major credit contraction.

It’s perhaps no coincidence then that the first mention of the [stricter capital rules for European banks] coincided with a marked deterioration of the crisis in the summer of 2011. Also, coincidentally, the moment when Italy became fully ensconced in the quagmire too.

It’s surprising in that context, says Koo, that no-one has yet called for a revision of the rule and/or government-led capital injections into the banking system ahead of the June 2012 deadline to discourage further asset sell-offs.

…not scrapping the [stricter capital rules], says Koo, could be the equivalent of telling a patient with pneumonia to do some exercise and to go on a diet.

While it’s possible that Europe can limp through the twin shoals of tighter capital requirements and the risk of private-sector haircuts on much greater swaths of troubled government debt, both of which will lead to renewed financial crisis and contagion, it seems just as possible that it will threaten to smash itself between the two.

As a result, we decided today to take off clients’ long positions in European equity funds for the time being, booking very small gains in the European Equity Fund (EEA) and the SPDR Euro STOXX 50 ETF (FEZ) since late January. While it may be premature, Europe still looks to us like a classic case of risk  outweighing potential reward.

Investors must also keep in mind that the European Central Bank’s Long-Term Refinancing Operation (LTRO) offered loans to eligible banks for no longer than three years. The LTRO, largely a life-support measure for bank and government balance sheets, will need to be extended, probably more than once, for European financial markets and economies to remain stable.

If the ECB issued sufficient net financial assets, and/or national governments were permitted to run large enough deficits, financial stability and economic growth would both be possible. But the current situation in Europe (as well as the United Kingdom) is eerily reminiscent of the lead-up to the Great Depression, when a nominal gold price target that was probably half of what is should have been—or said another way, a chronic and substantial shortage of net financial assets—forced national economies and their central banks into a game of musical chairs that eventually came unhinged.

Near-Term Looking Rosy, Longer-Term Not So Clear

One of our firm’s recession models, based on the Philadelphia Federal Reserve’s State Leading Indices, is now putting a near-zero percent probability on a U.S. recession in the next six to 18 months given the January 2012 readings. This is a sharp turnaround from the recession warning triggered in August 2011:

Exhibit 1 – Symmetry Capital Recession Model

While that probability is sure to fluctuate in the months ahead, there are some interesting facets to the underlying data, and some caveats for the longer term outlook.

• The current outlook for all 50 states is positive, an event that has only occurred in 11% of the monthly observations since January 1982.
• At 2.29, the median state outlook is in the top quintile of monthly observations since 1982.
• The median is higher than its last peak in the second half of 2003 and its prior high of late 1999 (Exhibit 2).
• Historically, U.S. GDP has almost always been positive when the median outlook is at current levels.

Exhibit 2 – Median State Leading Index and U.S. GDP

This report continues a string of economic surprises that have unfolded since late 2011:

• In late summer 2011, the U.S. Congress abandoned (however temporarily) its hellbent intent to welch on existing financial commitments, and U.S. budget deficits have remained high.
• In the fourth quarter of 2011, The European Central Bank (ECB) forcefully (but quietly, given the Continent’s morbid fears of waking the ghosts of Weimar) committed to ring fencing the government debt of Italy and Spain for at least the next three years through its Long-Term Refinancing Operations (LTRO).
• Japan’s economy and Asia-based supply chain linkages have recovered following the natural and nuclear disasters in Japan.

All in all, the immediate economic outlook looks fairly upbeat. There are some caveats though:

• The post-2008 recovery (as well as the strongest GDP readings during President George W. Bush’s administration) have been accompanied by significant federal deficits. A resurgence of irrational deficit/debt phobias and policy prescriptions poses a significant risk to markets. Given that 2012 is an election year, perhaps Congress will take a more constructive (or at least less dramatic) approach to fiscal affairs than it did in 2011.
• It’s speculative at this point, but given recent income improvements, the current tax season may take a bite out of those currently large net budget deficits, leading to an economic soft patch at around the same time that equity markets typically start their ‘summer break.’
• As economist Diane Macunovich has demonstrated, demographic shifts in the U.S. do not augur well for domestic GDP in the rest of this decade (see Exhibit 3). The proportion of young adults of household-formation age is set to begin dropping sharply. Thanks to the large current crop of ‘boomerangers,’ there may be significant pent-up demand for household formation that would be unleashed if employment and incomes continue to improve. But such a possibility remains highly dependent on a continuation of easy fiscal policy in our view, and is unlikely to completely offset the negative effects of a sharp contraction in this age group.
• A widely under-appreciated risk (hat tip to Warren Mosler) is the threat of more private-sector haircuts for holders of troubled European government debt. However one might feel about the fairness of such an approach, it would impose a severe shock on the asset side of banks’  balance sheets, leading to a replay—and perhaps an intensification—of the global market turbulence and stress caused by Greece’s debt travails. If unmanaged, it has the potential to threaten the global payments system as badly as the collapse of Lehman Brothers and near-collapse of AIG did in 2008. That would completely undo the benefits realized thus far from the ECB’s LTRO, which already suffers from the extreme policy conservatism of the European Union.
• It’s also important to realize that Europe is still wearing the fiscal straitjacket rather tightly, which limits the ultimate effectiveness of the ECB. As long as this continues, it will pose a risk to the EU economy. It’s important to note that the UK government is making similar mistakes, with similar effects.
• China’s economic growth rate will continue to slow. The extent to which this impacts global financial markets and the world economy remains to be seen.
• And of course, there are always the ‘unknown unknowns.’ Japan in 2011 and the attacks of September 11, 2001 are good examples.

Exhibit 3

Source: Diane Macunovich

Our Current Asset Class Views

In terms of investment assets, we think it’s worth weighing in on the recent back up in U.S. Treasury yields, given the loud told-ya-so’s from the Death-of-the-U.S.-dollar-and-American-way-of-life Cassandra Chorus. While we have defended long-term Treasury yields in the past, they are much less attractive (at least at this point in time, but if policymakers lead us the way of Japan, that would change) at sub-2% on the 10-year and circa 3% on the 30-year. Furthermore, the recent string of upside economic surprises strongly argues for higher yields. However, this is not the beginning of some fancifully imagined “end,” and we would be likely to add significantly to long bonds once again for the appropriate clients if 30-year yields were to re-approach the 4% level or higher.

In the current environment, non-sovereign corporate credit looks interesting to us, although spreads have come in dramatically since the second half of 2011, and a strengthening dollar could present a meaningful risk to riskier credits (high-yield to some extent, but externally denominated emerging-market debt especially). And as attractive as the world of preferred stocks has been since the last forceful hiccup in Europe, the risk of more private sector haircuts could cause renewed turmoil in that asset class due to intensifying concerns over banks’ balance sheets (financial companies are a significant proportion of preferred issuers). Such an event might present an opportunity judging by policymakers’ and regulators’ behaviors since 2008, but for current preferred holdings, attention to risk seems warranted.

Among equities, we continue to believe that Japan presents a rare opportunity. Although its overall population growth is nothing to write home about, its internal age structure should be in the years ahead (Exhibit 4). And after twenty bitterly disappointing years for Japanese equity investors, its stock markets are ridiculously cheap. One must always be attentive to exchange rate risks and the risks associated with exposure to a single country—the 2011 disasters are instructive in this regard—but the current risk-reward calculus makes Japan a no-brainer in our view.

Exhibit 4

Source: Diane Macunovich

This leads us to one prediction that I have total confidence in—if Japan’s economy improves as expected over the coming decade, the Japanese Government Bond zombie-vigilantes will shout victory from the rooftops as domestic interest rates rise in Japan. However, if they do so while ignoring an improving economy and equity markets and the fact that their predictions of inflationary collapse aren’t materializing, then they’re being completely disingenuous. Take their words with a grain-of-salt chaser, or better yet, ignore them.

A Disturbance in the Force

A Jerry-Maguire like shot emanated from Goldman Sachs yesterday. Greg Smith, an executive director and longtime employee of the firm, published a stinging resignation letter in the New York Times:

I believe I have worked here long enough to understand the trajectory of its culture, its people and its identity. And I can honestly say that the environment now is as toxic and destructive as I have ever seen it. To put the problem in the simplest terms, the interests of the client continue to be sidelined in the way the firm operates and thinks about making money.

The rest of the letter is heavy on drama, but also passion and emotion—Smith clearly cares about the firm and its direction. We can only assume that during his successful decade-plus stint at Goldman, he has put away a large enough financial cushion (and/or has a big enough book deal in the works!) to absorb both the resulting legal fees and the possibility that he just committed career seppuku.

Far more important to the rest of the galaxy was this eerily similar and closely timed resignation: http://www.thedailymash.co.uk/news/society/why-i-am-leaving-the-empire%252c-by-darth-vader-201203145007/

Neither the firm nor its clients (in accounts that the firm manages) presently hold or intend to hold positions related to Goldman Sachs.

The Three True Interview Questions

Good, interesting post by George Bradt at Forbes, who argues that all interview exchanges answer one of three questions:

The only three true job interview questions are:

1.  Can you do the job? [Strengths]
2.  Will you love the job? [Motivation]
3.  Can we tolerate working with you? [Fit]

…every question, however it is phrased, is just a variation on one of these topics: Strengths, Motivation, and Fit.

IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC (SCM) is a Pennsylvania registered investment advisor that offers discretionary investment management to individuals and institutions. SCM is not affiliated with or related to Symmetry Partners, LLC. This publication is for informational, educational, and entertainment purposes only. It is not an offer to sell or a solicitation to buy securities, or to engage in any investment strategy. Past performance is not indicative of future results. This material does not take into account your personal investment objectives, your personal financial situation and needs, or your personal tolerance for risk. Thus, any investment strategies or securities discussed may not be suitable for you. You should be aware of the real risk of loss that accompanies any investment strategy or security. It is strongly recommended that you consider seeking advice from your own investment advisor(s) when considering any particular strategy or investment.  We do not guarantee any specific outcome or profit from any strategy or security discussed herein. The opinions expressed are based on information believed to be reliable, but SCM does not warrant its completeness or accuracy, and you should not rely on it as such. All views and positions are subject to change without notice.

The UK Has Run Out of Money

File under preposterous utterances—UK Chancellor of the Exchequer, George Osborne, believes his government, the monopoly producer of Great British Pounds, which are essentially created out of thin air, has somehow managed to run out of them (hat tip to Warren Mosler). According to UK newspaper The Telegraph (emphasis added, bold):

The Government ‘has run out of money’ and cannot afford debt-fuelled tax cuts or extra spending, George Osborne has admitted.

In a stark warning ahead of next month’s Budget, the Chancellor said there was little the Coalition could do to stimulate the economy.

Mr Osborne made it clear that due to the parlous state of the public finances the best hope for economic growth was to encourage businesses to flourish and hire more workers.

“The British Government has run out of money because all the money was spent in the good years,” the Chancellor said. “The money and the investment and the jobs need to come from the private sector.”

This statement is so astoundingly wrong that a well-informed and daring-enough media outlet should be able to quickly rip it to shreds, along with Osborne’s credibility. Unfortunately, most of the media is just as ill-informed on the subject as he is, as evidenced by the use of ”admitted” in the quote above, as well as the following poll question which excluded any choice that reflects the actual realities of Britain’s fiscal and monetary operations (e.g., ”The UK government cannot run out of the money that is is the monopoly and near-zero cost supplier of”).

What should George Osborne do to provide a tax cut?

Tax the rich more to allow the income tax rate to be lifted to £10,000
Borrow more and worry about reducing national debt in future years
We can’t afford any tax cuts 

Meanwhile, the latest economic data out of the UK have been welcomed with subtitles like:

“Least downbeat outlook since April 2010″ for household finances, even though the Index has remained stuck between the low 30′s and low 40′s since the global recession ended (a positive outlook has a value of more than 50).

“Business Expectations Index recorded single biggest monthly rise in survey history,” while the level remains rangebound about 10% below its level of the prior decade.

Meanwhile, the UK labor market continues to look stagnant despite a slight improvement in January, remaining at the lower end of a decline that began around the same time as the passage of concerted austerity measures (fortunately, at least one UK media outlet has been able to discern that connection).

IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC (SCM) is a Pennsylvania registered investment advisor that offers discretionary investment management to individuals and institutions. SCM is not affiliated with or related to Symmetry Partners, LLC. This publication is for informational, educational, and entertainment purposes only. It is not an offer to sell or a solicitation to buy securities, or to engage in any investment strategy. Past performance is not indicative of future results. This material does not take into account your personal investment objectives, your personal financial situation and needs, or your personal tolerance for risk. Thus, any investment strategies or securities discussed may not be suitable for you. You should be aware of the real risk of loss that accompanies any investment strategy or security. It is strongly recommended that you consider seeking advice from your own investment advisor(s) when considering any particular strategy or investment.  We do not guarantee any specific outcome or profit from any strategy or security discussed herein. The opinions expressed are based on information believed to be reliable, but SCM does not warrant its completeness or accuracy, and you should not rely on it as such. All views and positions are subject to change without notice.