Paul Ryan on the U.S. and Greece

Rep. Paul Ryan (R-WI) is a smart, sharp guy. He really is, and his constituents have affirmed that in more than one election. We agree with him that “The US needs low and predictable tax rates, as well as predictable regulations.” He’s well versed in economics, finance, and business, and he knows about Bretton Woods and its collapse in the 1970s. But he often says things that make me wonder if he grasps the significance of that event. From a report of his recent CNBC appearance:

The country needs to do its reform on its own terms or it will be force into a vigilante-led, “Greek-style reform,” Ryan added.

Illinois and/or California might well be forced into a Greek style “internal devaluation” (a very polite way of saying ‘dumping severe adjustment costs on those who are unable to avoid them’). But the U.S. cannot and will not be.

Ryan was mentored by Jack Kemp, one of the original supply siders. He needs to dust off some of Robert Mundell’s writings. A government that issues the non-interest bearing debt used to service its interest bearing debt — something that Greece and other EMU states, state and local governments in the U.S., and all private sector actors cannot do – faces only one constraint, and that’s inflation.

The Fed, QE2, and Inflation

Short but interesting article from the WSJ (via Yahoo! Finance), indicating that the Fed is engaging in QE2 in an attempt to preemptively manage inflation expectations upward. This graphic really drives the point home:

From various talking heads in recent days, it sounds like the understanding in D.C. is that the Fed is doing what it can, because the federal government isn’t going to be doing much. That’s a shame, as the fiscal lever is often the more powerful one in conditions like those prevailing today, and is less likely to fuel carry trade foolishness.

We’ll learn eventually. What did Churchill say about America always doing the right thing, once it had exhausted all other alternatives?

Demographic resources

There are a couple of pages on Seeking Alpha that might be of interest for anyone looking into demographics:

http://seekingalpha.com/instablog/104402-hedged-in/104054-demographic-trends-a-guide-for-investors

http://seekingalpha.com/tag/demographics

Hat tip to SA contributor “Hedged In” for both of those.

The Census Bureau also has an invaluable database available online (hat tip to Diane Macunovich): http://www.census.gov/ipc/www/idb/country.php

Interest Rates, Asset Prices, and Carry Trades

It’s been a crazy couple of weeks in financial markets.  Chief among the events has been a major correction in debt markets, with long term Treasury yields backing up by 40 basis points or about 10% since the start of the month:

Of course, there’s plenty of chatter about what it all means, and the debt and deficit Cassandras are having a field day with it, arguing that excessive federal spending is finally bringing the bond vigilantes out of the woodwork,  the dreaded “crowding out” of expanded federal debt is rearing its head, etc, etc. These assertions don’t hold up under critical examination, however.

For example, over the same period, the dollar has reversed course and begun strengthening, while the Japanese Yen has weakened noticeably, and China, which allegedly holds great power and influence over the U.S. because of its sizeable holdings of Treasury debt, saw its equity markets get absolutely hammered.  So what might really be going on?

Obvious catalysts include China tightening lending standards and monetary policy, and market stresses around Ireland’s banking systems and sovereign debt. Less obvious, but perhaps just as important, is what the recent break in USD and JPY trends might be indicating. “Follow the money,” as someone once told Bob Woodward.

Consider that for much of the past decade, the Yen was the carry trade funding currency of choice — borrow in Yen, and lever up investments in just about anything else (oh, and don’t forget to exit before the greatest fools are left holding the bag; that’s how the ‘smartest guy in the room’ game gets played these days).

With overnight interest rates near zero since the financial crisis, the USD has become a favorite funding vehicle for the carry trades. As long as the dollar falls, and riskier assets rise, the ‘smartest guy’ game plays on. But when the underlying trend breaks…watch out. Riskier assets will sell off and correct; and let’s not forget that Dodd-Frank and new Basel regulations haven’t done a damn thing to resolve the problem of excessive financial leverage. As we wrote back in March, “…the roach bait [of funding currencies] isn’t going anywhere soon. That means that sound regulation absolutely must fill the void in order for the gains from financial market speculation to approach something resembling a social optimum.” Maybe we’ll end up with sound financial regulation one day, but the way it’s been teed up, the roaches get to run rampant for at least another five years.

So when the USD does this in the space of five trading days…

…at the same time that riskier assets like Chinese equities and commodities start to roll over…

…then it’s very reasonable to infer that carry trades are being closed out apace. And that, along with global politicial and investor uncertainty, can cause plenty of dislocation.

According to this thesis, and accompanied by a strengthening USD, any hiccup in Treasury yields should be temporary. This case becomes even stronger when you consider (1) what impending personnel changes in Congress imply for federal spending, deficits, and debt, and (2) what our “right shoulder level” hypothesis implies for real economic growth and for inflation.

At the margin, relatively lower spending and debt levels mean a scarcity of dollars, at least relative to earlier expectations. And value is a function of scarcity.

And slower population growth, as well as falling proportions of the age cohorts that drive economic growth, credit demand, and price level movements, imply both lower real GDP growth and lower inflation. Added together, they’re probably less than the 4.2% to 4.3% that long bond offers were putting up earlier today, i.e., T-bonds were suddenly compellingly priced again.

So beyond attractive prices in longer term Treasury bonds, where might we go from here?

If the federal government does clamp down on spending, and private sector credit demand and economic growth remain relatively flat, then the USD may not remain as the favorite carry trade funding currency. Instead, we’re looking for the Yen to revolve back into favor, as recent political developments there seem to augur for a weaker currency and stronger equity markets (note that among major national stock markets, the Nikkei may be the only one that is up so far for the month of November; that could be due to an improving outlook for corporate profits, but then again, it might simply mean that the ‘smartest guys’ were levering up in dollars, buying Yen, and shorting Japanese equities).

If we’re right about the Yen, then the ‘smartest guys’ will start to borrow heavily in it again, and wade back into all of the risky stuff that made them look and feel smart (and richer!) over the past couple of months. What will really be interesting is whether as a group they choose to short U.S. equities. Assuming equity markets will continue to be range bound, and observing that they are near the top of their ranges and market momentum appears to be breaking downward, that is a possibility. Smart guys feel smartest when they’re running with the herd after all. But if we see a major correction as a new Congress is installed, it might call part of our electoral common sense into question; savvy voters and policymakers might want to start thinking about what comes next if austerity accomplishes even less than profligacy has.  

Our advice is to avoid the thundering herd of smartest guys in the room to the greatest extent possible. Instead, we’re continuing to focus on fundamental, intrinsic values in asset classes and particular securities, buying when prices are far enough out of line to justify the risk, and looking for clever, cost effective ways to dampen portfolio volatility.  With knitting like that, no one is ever going to refer to us as the smartest guys in the room or beat on our door offering private jet services.  That’s just fine with us, as long as we’re helping our clients get where they need to go.

For clients whose future liabilities can be met, in whole or in part, by 4.25%+ annual yields and a guaranteed return of principal, we added to long bonds this morning. We’re also selectively buying short term corporate and high yield debt, while avoiding munis (though that market could get interesting if things get ugly enough…).

In our active ‘Special Opps’ strategy, we took some profits in a couple of names yesterday, while increasing and updating our equity put option allocation. We also took a long call option position in the USD using equity options on an ETF.

IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC (“SCM”) is a Pennsylvania registered investment advisor that offers discretionary investment management to individuals and institutions. 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.  Some clients of the firm hold long positions in DBC, TLT, and/or call options on UUP. Neither the firm nor its principals hold positions in any securities mentioned.

Grantham on QE2

Jeremy Grantham hits several out of the park in this interview, e.g.: Fed tool kit is extremely limited, and its use of them has led to widespread distortions; fiscal policy is the appropriate lever for dealing with a stubborn recession and unemployment; Congress needs to get its act together and enact sensible stimulus policies; if it does not, we’ll live through an interesting experiment in muddling through.

Hat tip to Cullen Roche at PragCap:

http://pragcap.com/grantham-fed-blowing-bubble

Midterm Election Reflections and Outlook

MIDTERM ELECTION

Some thoughts on yesterday’s election outcomes, in no particular order:

It was a very powerful showing for the GOP, with the largest swing in the House since Dems in the 1940s!  We put two hypotheses out over the last year. One was Rebecca Kaplan’s interesting thesis that the Dems’ fate would be less like their Waterloo of 1994, and more like the Republicans’ showing in 1982. The other was our July prediction that, thanks to the constraints imposed by New Democrat thinking, Dems were likely to be tossed out on their ears:

Instead of continuing to laud the Clinton-Dole-Gingrich era surpluses, Democrats and others on the left should read and re-read the Wray piece, in which he endorsed the deficits likely to result from the Bush tax cuts (if not the particular types of cuts themselves). The longer they hew to the ‘fiscal discipline’ dogma of the New Democratic Leadership Council and the old Bentsen-Rubin-Summers axis of Clinton Treasury Secretaries, the more likely they are to be turned out on their ears in 2010…

We’ve made the argument that Dems were elected to Congress in 2006 primarily in response to dissatisfaction with the GOP’s handling of Iraq and concerns about corruption, and that perceiving a significantly broader mandate than that could get them into some trouble. Looks like it did.

The ghost of Andrew Jackson – the only President to preside over the retirement of all U.S. Treasury debt, which precipitated a brutal depression — is running rampant. David Stockman is on another publicity push, arguing that the first priority of policymakers must be to (a) slash the federal deficit and (b) start paying down the federal debt. It’s out sincere hope that David fades into obscurity sooner rather than later.

Unfortunately, Stockman isn’t the only budget fetishist out there. Ed Rendell, the almost former Dem governor of PA, was on CNBC this morning agreeing with deficit phobe extraordinaire Judd Gregg (although Rendell did say some compelling things about the need for politicians to govern once elected).

Newly minted Senator from KY Rand Paul has made balanced federal budgets a central plank of his platform. We explain this in more detail further on, but the basic and inescapable fact is that under our current monetary system, balanced federal budgets will make the USD incredibly scarce, causing a renewed round of debt defaults, financial crisis, and recession, and if not promptly corrected, global depression. It is absolutely fair to say that Dems’ policies haven’t done enough to turn the real economy around. But in the unlikely event that Tea Partiers get their way with deficits, the last two years won’t look so bad after all.

Former MI GOP governor John Engler was also on CNBC this morning, and said a lot of good things. Deficit and debt reduction were not at the top of his list.

ECONOMIC & INVESTING OUTLOOKS

So where does this thrashing of the Dems leave our economy, and us as investors? It’s not entirely clear yet. First and foremost, it’s important to keep in mind that, although the immediate focus is the political damage inflicted on Democrats, as we pointed out earlier in the year, “the real costs of policymakers’ stupidity and timidity are [still] being borne by the unemployed and the newly destitute.”

On the hopeful side, former Clinton advisor Paul Begala mentioned a payroll tax holiday on CNN last night, possibly the best stimulus in our arsenal for current conditions, and an eminently bipartisan idea. On the pessimistic side, there’s now a lot of chatter about balancing the federal budget – Rand Paul in his victory speech, Judd Gregg on CNBC this morning – which is, quite simply, the worst possible idea, or at least tied for worst with raising taxes.

Thus far, it appears that, other than wanting to extend the tax cuts, the GOP is running from the things it did right during the Bush years, which included (believe it or not), “squandering” the “Clinton ‘surplus’” (see the piece by Randy Wray that we cited back in July, for example). Familiar readers will recall the observations that our current policy preferences are based on: 

• The age composition and lower expected growth rate of the U.S. population — which could be aggravated by the poor employment and income experience of today’s young adults – does not augur well for robust private sector activity in the decade ahead.
• A severe balance sheet recession in the household sector, and resulting budget troubles at the state and local levels of government, mean that private sector demand is not likely to rebound to the same extent that it did while the baby boomers were in their household formation and peak earning years (1970s, 80s, and 90s).
• Under the gold standard (Are you listening, Senator Paul?!?), gold mines were the only source of new money. When conditions were recessionary and pessimistic, increased gold mine production had favorable effects on the economy. In fact, the system trended towards equilibrium in the long run precisely because shortages of gold incentivized expanded production of gold. So the last thing you would want to do is slow or shut down gold mine production.
• The USD’s ties to gold were finally severed in the early 1970s, which means that the U.S. Treasury effectively replaced the gold mining industry as the source of new money. As a result, the federal government first has to spend every new dollar into existence before it can be used for anything else. The process is somewhat obscured by the Federal Reserve’s role in it, and bank lending in the private sector does create new reserves. But the inescapable fact is that new money comes about via federal budget deficits. Under a gold standard, we would never limit or shut down gold mine production under these kinds of economic conditions. So why do it now with budget deficits?
• Deficit and debt phobias are red herrings, even though most of its sufferers are sincere believers. As the sovereign issuer of US dollars, the Treasury can never “run out of money”, nor does it have to fund its budget deficits with debt. More importantly, every dollar used to pay taxes or purchase treasury debt has its origins in a prior federal budget deficit. The only meaningful budget constraint is inflation, and that is not a significant risk at the moment.
• A smaller trade deficit (i.e., higher exports relative to GDP) could accomplish some of the things that a fiscal deficit does, but it certainly doesn’t appear that our trading partners are going to let that happen via a weaker USD. If that’s what we want, then some offsets to our higher costs of labor and tighter environmental and occupational regulations are needed – lower corporate taxes, for example (a payroll tax holiday would have a more immediate impact than corporate income tax cut, but the two could complement each other nicely over a period of years).
• While there are some key differences, the risks facing the U.S. economy are very similar to those that have afflicted Japan since 1989. That we have thus far avoided the same fate, at least to some extent, has a good deal to do with the forcefulness of our policy responses. If there’s enough political pressure to undo those efforts prematurely, then we do risk sliding into a Japan-style malaise, which, given differences in our labor markets, could lead to much greater social unrest in the U.S. than it did there.

With those observations in mind, putting deficit concerns at the back of the line is the right thing to do (though as we’ve acknowledged, Ricardian Equivalence, even though it shouldn’t always hold true, always will hold true as long as politicians talk and act as if all current deficits must be “paid back” in the future). Instead, it appears that we’ll get (1) establishment GOP members trying to undo (or sweeten!) recent legislative actions on behalf of key constituencies, and preventing or limiting further favors to Democrat constituents, and (2) Tea Partiers trying to take a machete to federal spending, which, if you follow the bullet points above, is like shutting down the gold mines during a 19^th century recession, which no one in their right mind then would ever have proposed.

Constraining federal deficits, whether through spending cuts or tax hikes, is essentially the same thing today, and just as foolish. Watch for PAYGO to raise its ugly head yet again — the analogous measure under a gold standard would have been to re-bury the same amount of additional gold that was produced in a given year. We’ll have to wait and see how it all turns out. As we wrote earlier in the year:

Our take is that a GOP win of the House could be a negative for the economy, if it allows the deficit phobes in D.C. to have their way. But that’s not a given. There are always surprises in politics. The Dems might hold on, as Kaplan suggests, or the GOP might start crafting policies more appropriate to the times and/or accepting good ideas in compromise (assuming good ideas materialize)…To us, whichever outcome pushes policy towards [lower taxes and sustained spending]  is the one to hope for — unless we’re wrong and the austerians are right.

One important observation to keep in mind is that the private sector has proven extremely resilient and robust during recent decades, largely due to the ascendance of the baby boomers, a default luxury that is no longer there. The sooner this is grasped by policy makers arguing for government to simply get out of the private sector’s way, the better. If we’re right, they’re going to learn it one way or the other, eventually.  

ASSET CLASSES

Curiously, the recent market environment has reminded us a bit of the post-9/11 era, when Treasuries sold off, and equities rallied, for no sound fundamental reason whatsoever (how much this has to do with QE2 versus the GOP’s Congressional roll is unclear). But the equity party has stalled of late, and Treasuries have been enjoying a bid whenever ten year yields are at 2.6% or more. Seasonally, and thanks to continuing tailwinds from massive federal deficits, we think equities could fare OK until at least early 2011 (though as an asset class, they are already fairly valued or better). Beyond then, watch out. We think there’s a significant probability of a recession unfolding between 2011 and 2013, based on impending demographic shifts (pdf) and rising political pressure for austerity measures (keep in mind that even a sizeable deficit can be austere, if the real economy is calling for larger one).

We also expect secular movement up the capital structure to continue, as baby boomers shift portfolios from stocks to bonds. At the moment, Treasuries don’t offer much out to ten years, though some corporate paper looks attractive to us. But further out the Treasury curve is interesting, despite all the fear mongering; for example, for investors seeking a reasonable yield with a guaranteed return of principal, thirty year paper should be considered a steal whenever yields to maturity push 4% (they’ve fallen below 3.9% today). The great interest rate back up simply isn’t coming, despite its countless champions. “Right shoulder up” has been a historic anomaly in financial markets. The new normal is actually the old normal,  and deficit reduction will only reinforce that reality.

On the commodity front, we were obviously dead wrong about gold earlier in the year (though like any typical investment strategist, I hedged mightily):

A couple of [news] outlets…have recently been pondering the decline in gold’s price. It’s a no-brainer in our view, but we’re still wary that the bubble has yet to run its course, and it could gain traction again if the pro-stimulus crowd eventually wins the debate.

And commodity prices are following gold in train, as they tend to do over any meaningful period of time. That has created some interesting investment possibilities, but we’ve been stubbornly reluctant buyers, so the commodity train might end up pulling out of the station without us. But if we see a sharp enough spike in oil and gas prices, then the probability of a recession in the U.S. goes that much higher. If that coincides with a commodity price bubble, then it won’t be pretty for the folks still holding the bag. That being said, we’re not speculating on downside commodity risk at the moment, but a budget filibuster in the coming months could be a harbinger of things to come. If there is a contrarian play available here, it’s to go long the USD, as incoming members of Congress (and foreign central banks and treasuries) do all in their power to make them more scarce.

IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC (“SCM”) is a Pennsylvania registered investment advisor that offers discretionary investment management to individuals and institutions. 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.  SCM is a participant in the Amazon.com Associates program, and earns a revenue sharing fee for qualified click through purchases from the Amazon.com website.  Neither the firm, nor its principals, nor its clients own securities issued by Amazon.com.