Good News, Bad News

Several data points today were indicative of both continued expansion (good news) and higher inflation (bad news). 

Chicago NAPM Purchasing Managers Index (PMI, see report here) popped above 60 in March after printing slightly bearish numbers in January and February (50 is considered neutral). Interesting comments were appended to some of the index components: "largest leap since August 1996" in production; "largest increase in the history of the series" for new orders; jump in order backlogs was the "highest since April 1999"; prices paid fell, which is a positive sign for inflation. On the bearish side, the employment outlook declined for the fourth month out of the last five, and stands at a seasonally adjusted 45.

The Fed’s favored inflation indicator, Core PCE, came in at 0.3% for February, above expectations, and still outside of the Fed’s stated comfort range of 2% annual inflation. That’s bad news for those expecting the Fed to cut its target rate in 2007. Personal income and spending both exceeded forecasts, which is positive, but again doesn’t support the case for Fed easing.

Things remained fairly orderly in the Treasury market, though the retreat from end of February highs continues.

Domestic Debt & Global Discrepancies

Standard & Poor’s released its current ‘U.S. Distressed Debt Monitor’ yesterday, noting that the distress ratio of U.S. corporate issuers has fallen to another all-time low, continuing a three-and-a-half year long trend (to access the full S&P report, start here). This datapoint does not fit well with bearish outlooks on financial conditions and the economy. Some thoughts:

• While certain sectors of markets and the economy are facing challenging conditions, these situations have to be looked at in context. For example, the current recession in the homebuilding industries is occurring in the wake of a long boom period. Home values have finally returned to a rough parity with incomes, and positive effects from more favorable tax treatment of home sales (1997) may have run their course by now; both factors would tend to flatten the trajectory of home price increases. Differences in domestic and global conditions also play a role, as noted below.
• U.S. consumers are leveraged, but labor markets remain tight, and corporate cash flows and balance sheets are healthy. As long as the U.S. continues to enjoy a reasonable proportion of global economic activity and investment, a slow and steady expansion should continue.
• According to the report, the positive impact of a low distress ratio is offset by the  negative effects of an inverted yield curve. This brings us back to the ongoing bond market "conundrum", the current episode of which has yet to play itself out. If the Treasury market is right, then corporate distress levels will eventually increase, thus justifying the some pessimism about the economy. On the other hand, if long term interest rates correct to a higher level, then the outlook for corporate debt performance–and the economy–should improve even further. And as fellow finance nerds will acknowledge, the lower duration of higher coupon speculative credits should help keep a lid on the distress ratio.
• The most important takeaway from the report, which is supported by the bullish state of industrial commodities and similar markets, is that financial liquidity remains plentiful overall. That comports well with what the Bernanke Fed has been saying, and contradicts what the bond market’s inverted yield curve is telling us. When liquidity is plentiful, higher output and inflation are the more prevalent risks, and for that reason, we continue to bet on the Fed’s hawkishness and against Treasury market dovishness.
• Theoretically speaking, the Treasury market will be proven correct only if (when?) the Federal Reserve sets a target rate that (plus inflation) is higher than the "natural" rate of return in the economy. There are two important things to consider here. First, we must keep in mind that global economies are increasingly integrated, and that the U.S. dollar is still the primary currency of choice for global transactions and reserves; thus, to a great extent, it is the natural rate of return in the global economy that determines whether the Fed’s target rate is likely to be expansionary or restrictive. Second, given the high returns on capital currently available in the global economy, the Fed is likely to surpass "neutral" only after another 50-100 basis points of rate hikes. That is the difficult reality that faces certain sectors of the U.S. economy (subprime lenders and borrowers, for example), where the cost of capital now exceeds expected returns on capital. As we’ve noted before, leveraged sectors of the U.S. economy face a situation similar to that faced by emerging markets in the mid to late 1990s, and that portends a domestically painful combination of either a higher fed funds with additional economic dislocation in certain sectors of the economy, or a higher rate of inflation and its attendant problems.

That last observation is getting some public attention, albeit in a piecemeal way, as commentators and politicians fret about things like consumer leverage, and advocate measures like tighter regulations and/or household budgeting. Looking at the situation in total, it’s our view that the best solutions are those that would remove constraints to economic activity, and thus raise the "natural" rate of return here at home; there are politically palatable measures that can be undertaken to lower barriers to investment and entrepreneurship, but it’s unclear how effective these would be in the long run–especially when compared to a measure that, while far more more controversial politically, would offer the biggest bang for the buck–lower corporate income taxes! In fact, the most powerful approach would be to drop taxes altogether on productive activities (income and investment) and replace them with a simple, efficient, consumption based system. We can think of nothing that would do so much to: (1) level out domestic/global discrepancies roiling certain parts of our economy and (2) allow us to avoid the nostrums of ‘root canal’ economics.

Of course this same ‘Wicksellian‘ framework illustrates how a downturn might come about: if the Fed remains hawkish in coming years in order to contain inflation expectations (i.e., a level or higher real rate) and politicians enact measures that lower the natural rate of return (e.g., by allowing tax rates on capital to increase via expiration of the 2003 tax cuts) then contraction and deflation could very well follow.

Bond Market Reflections

Contemplating the continuing "conundrum" of a dovish bond market and a (relatively) hawkish Fed, we came across these pertinent lines in Alan Blinder’s Central Banking In Theory and Practice: 

I was not at the Federal Reserve in late 1993 and early 1994, just before it started tightening monetary policy. But I am fairly certain that the Fed’s own expectations of future Federal funds rates were well above those presumably embedded in in the term structure at the time, which seemed stuck at the unsustainably low level of 3%. A year later, I was at the Fed and I am certain that the market’s expectations of how high the funds rate was likely to go–to as high as 8% according to various asset prices and Wall Street predictions–were well above my own. In both cases, the markets got it wrong–once on the high side and once on the low side. In both cases, the faulty estmate was largely attributable to misapprehensions about the Fed’s intentions. And in both cases, the bond market swung wildly when it was corrected….. There is no more reason for central bankers to take their marching orders from bond traders than to take their orders from politicians. [emphasis added]

Astute readers will realize that Blinder’s position on marching orders doesn’t square entirely with positions we’ve previously taken. However, his personal experiences lend support to our assessment that the bond market is not currently priced in line with economic fundamentals.

More Global Warming Sources

Two additional sites we’d recommend for those following the global warming issue:

AccuWeather.com’s Global Warming Center does a nice job following new developments and treating them in an even handed way.

The RealClimate website is authored by scientists who are capable proponents of AGW. It’s a good source for technical and non-technical rebuttals/debunking of AGW skeptics (a crowd we still count ourselves among), and some of their posts are followed by lively debates among their readers.

Gore, Crichton, Lomborg

Vice President Gore was on the Hill last week testifying about anthropogenic global warming (AGW). If you only caught excerpts, your impression is likely to differ depending on where you get your news. Predictably, different media outlets have produced different images: the wise, impassioned, and morally compelling leader, versus the hypocritical and unreasoning alarmist. Our take is that Gore is a romantic, an impassioned idealist, and a true believer in his cause. Gore is also frightened. A parallel and related example of the ‘impassioned fear’ mindset can be found in a profile of Laurie David in the April 2007 issue of More magazine ("An Inconvenient Woman"). David is the politically connected Hollywood producer behind "An Inconvenient Truth", and the head of a project called Stop Global Warming. She is also apparently prone to rash acts, such as chasing down and harassing SUV drivers from her hybrid (which brought to mind the South Park episode "Smug Alert!") and opining that Michael Crichton is "a little crazy" while speaking at a school that his children attend. From the article:

What makes David run? Fear is a great motivator, and David says she is frightened. "…we have 10 years at most to take dramatic action or face irreversible planetary changes. I’m terrified about this summer,’ David says. ‘Last summer was the hottest on record. It feels very personal to me because all the things I care about are at stake." [emphasis added]

Her fear and personal capital have clearly motivated David to ’do something’. This may be an admirable cultural principle, especially prized in Hollywood and among environmental and other activist groups, but our study of history has convinced us that ’do something’ movements aimed at relieving fear and anxiety can embody both our most noble and our most destructive impulses. Putting on our amateur psychologists’ hats, we’d bet that urgent social issues like these get David (and Gore) jazzed up, and are an important raison d’etre in her life–an assertion supported by some of the biographical details in the article. But too often, jazzed up crusaders do not grasp the full range of consequences implied in their designs, nor do they take a full and honest inventory before imposing their will on others. Perhaps we’re lilting into Whiggish old age, but life has taught us that impassioned fear is best balanced with sober skepticism (unlike the ‘do something’ crowd, we don’t plan on hiring a publicist to help us share this wisdom with the rest of the world, as we believe that most of the world already gets it).

Returning to Gore, he is a heck of a salesman when he believes in his product (and please note that in our lexicon, "sell" is a good word, and selling an honorable profession). However, he’s also prone to bizarre metaphors and hyperbole, as in his emphatic claims that "the planet has a fever", and metaphorical urgings to heed the pediatricians’ nostrums(!). That part of his testimony seemed to include a swipe at popular author and AGW critic Michael Crichton, when Gore claimed that concerned parents would not consult a science fiction novel to learn how to cure their child’s fever. There are several things to critique here. First, the sci-fi novel assertion is simply false, as the existence of the Church of Scientology demonstrates. Second, Michael Crichton is no L. Ron Hubbard, and a diverse array of skeptics and proponents should be included in any debate concerning predictions of an uncertain future. And third, the metaphorical notion that the Earth is helpless and dependent upon our wisdom, moral clarity and technological expertise for its well-being is bizarre and irrational, and substitutes drama for constructive debate. While it may be difficult to accept the diminished stature this entails for our species, we must accept that the planet’s continuing existence does not depend on us in any way–it existed for eons without us, and will continue to exist with or without us, at least until our solar system expires–at which point it will easily outlast those of us who still call it home.

Although his testimony received scant press attention, Bjorn Lomborg testified alongside Gore. For those unfamiliar with him, Lomborg is neither a tennis star from the 1970s nor the arch villain in Office Space, but rather a political economist and favorite pariah of many environmentalists. His work has been the subject of controversy, but his political economist’s perspective on the global warming debate is important, because it incorporates the elements of risk, uncertainty, and opportunity cost, and without these, societies are far more likely to make poor decisions about the future. Lomborg accepts the AGW hypothesis, but offered several tempering observations, such as: an exaggerated sense of alarm is at work in some of the popular claims being made about climate change, while the scientific projections have become less dire over time; tradeoffs are not being fully discounted, for example, while heat related deaths might rise, cold related deaths might fall further; policy recommendations should be driven by cost-benefit analyses; public health challenges should be prioritized based on ROI, meaning that each buck should be spent where it will get the biggest bang, and this might very well mean focusing on concerns like malnutrition, disease, and pollution before climate stabilization; and finally, alternative institutional arrangements to Kyoto need to  be explored, as they could provide greater incentives and higher payoffs to reducing AGW. Lomborg closed with something close to our hearts, a demonstration of crowd wisdom. He reported that three separate surveys by the Copenhagen Consensus–of economists, college students, and UN ambassadors–produced similar rankings of social investment priorities. On the basis of dollars returned for dollars expended, all three placed diseases and nutrition near the top, and climate change near the bottom.

Like other important policy areas, we’ll be surprised to see a significant shift away from the status quo before 2008, and then only if federal control swings to either party. If it does, we take some solace in what economist Reuven Brenner claims is the most important aspect of our political system–if and when mistakes are made, they can be corrected relatively quickly.

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Mauboussin on Crowd Wisdom

Here’s a wonderful article by Michael Mauboussin of Legg Mason, on recent advances in understanding the ‘wisdom of crowds’ and the importance of cognitive diversity when making decisions under certain types of conditions (including predictions about the future).

Carbon Offsets = Feel Good Hype?

A new Business Week article, "Another Inconvenient Truth", reports on the reality behind the public relations claims surrounding carbon offset programs and similar "products marketed to checkbook environmentalists."

http://www.businessweek.com/magazine/content/07_13/b4027057.htm

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Business Buzz

Two items that grabbed our attention:

First is the announcement of private equity firm The Blackstone Group’s planned IPO. Some commentators have remarked on the irony that a private equity firm plans to go public, but we would point out that there are similar (if not identical) business lines in major public companies, including Wall Street banks, some other financial firms, and Warren Buffet’s Berkshire Hathaway. Others are quipping that this could be a sign of a top in private equity activity, with the most cynical calling it a PT Barnum ’sucker sale’; perhaps, but we certainly doubt it. A more compelling argument put forth by Scott Rothbort at TheStreet.com is that the firm’s founders are engaged in some heavy duty financial planning. While we have no current intentions to invest in Blackstone equity on the long or the short side, we think that their presence as a publicly traded entity is likely to enhance public information flows regarding the state of the economy, public markets, and private equity activity, and that’s a positive.

Second is an apparent press skirmish between Google and Wikipedia that could develop into a real dogfight. The cover story on the April 2007 issue of Fast Company, on Wikipedia’s plans to enter the search engine business, is entitled "Google’s Worst Nightmare". This morning, a trailer run on CNBC implied that Brian Williams will be doing a spot on NBC about alleged shortcomings of Wikipedia as a research tool for college students. Now anyone who’s seen the news world operate up close knows that many news topics are chosen, not because they’re interesting, but because someone has a vested interest in pushing them into public view. However, we would be speculating wildly (wishfully?) if we assumed that there were some corporate intrigue behind the story; in fact, judging by a January entry on Brian Williams’ blog (scroll down to the entry titled ‘Controversialpedia’), it might have been inspired by his son’s history teacher.* In any case, the Google-Wikipedia relationship could get interesting in the years ahead. Stay tuned.

* As Williams points out, the shortcomings (tradeoffs, actually) of Wikipedia are well known and widely discussed. However, in his blog post, he overlooks the most compelling features of Wikipedia: like any well designed financial or political market, it is reasonably efficient at self-correcting; it is also a valuable aggregator of all information, both accurate and inaccurate. On that latter point, if not for Wikipedia, John Seigenthaler’s family might never have known that he was assumed dead in some quarters, and would not have been able to correct the error. Clearly, Wikipedia and similar information sharing networks are not the same animal as Encyclopedia Brittanica. Unfortunately, rather than perceiving this, Mr. Williams resorts to an elitist (and increasingly anachronistic) tradition when he claims that "Americans have voted with their keyboards not to let a few facts get in the way of convenience." Ah, if only the masses could be as wise as the chosen few…

Skeptical Warming

Two interesting items for the skeptics and undecideds on anthropogenic global warming:

(1) The full ‘Deniers‘ series is available from the National Post (Canada) website

(2) A British television feature, ‘The Great Global Warming Swindle‘ *

* Aging punk rockers (bipeds and quadripeds alike) might wonder if Malcolm McLaren wasn’t part of the production team, given the title’s similarity to a certain controversial mockumentary.

Contagion, But What’s Catching?

In a word, fear. World financial markets, after 7 months of glassy-smooth sailing, have encountered some serious chop in recent weeks. Some pundits have claimed that markets are reawakening to the fact that risk is alive and well, after pricing it out of many assets during their last leg up. That’s not a bad way to look at it–we accept the idea that markets can overshoot in any direction, but we also believe that they self-correct with reasonable efficiency. We are also stubborn believers in cause and effect, and specifically the idea that the words and deeds of public officials can have a blunt impact on financial market behavior. So what’s behind the current downdraft? Our early assessment is that both market data and government actions have motivated a significant repricing of financial risk.

Market data continues to point to a huge divergence between healthy and unhealthy sectors of the economy–service industries appear to be doing quite well, manufacturing appears to be middling along, and residential industries are in pretty bad shape. A prevailing notion among bears is that the residential correction will undermine consumption and thereby lead to recession, but in our view, this balance sheet focus is too narrow, as real incomes continue to rise, and labor markets are tight overall. What matters going forward are cash flows relative to debt service and current consumption. It is disconcerting to us that leveraged U.S. consumers (and some marginal corporate debtors) are now in a similar position to that of many emerging markets in the mid to late 1990s. If the Bernanke Fed were to go on an ‘asset bubble pricking spree’ in the spirit of Alan Greenspan and Robert Shiller circa 1996, the domestic wreckage would be immense, and pose an even greater ‘pandemic’ threat to the world than ‘Asian Flu’ did in 1997. However, at this point, we believe that sector specific wreckage will remain sector specific, and that its roots lie in the overly easy period of Fed policy at the end of Greenspan’s tenure, and not an overly restrictive Fed under Bernanke. We expect the economy to remain in pretty good health overall in the coming year.

Among government actions, there are three of note. First, a leading culprit in the initial market downturn–which originated in Asia–was talk in China of imposing capital gains taxes on stock market holdings, in an effort to curb domestic retail speculation. Since capital gains taxes raise the required return on investment, they have a powerful and negative effect on asset prices (there is a countervailing pressure to hold on to appreciated assets, as those in favor of cap gains taxes love to point out, but this debate has received only limited academic attention, and recent research indicates that the longer term effect is indeed negative–something of a no-brainer, in our view). A second factor might have been Alan Greenspan’s claim to a Hong Kong business conference that there is roughly a 30% chance of recession this year as the current business cycle matures (we’re lumping Greenspan in with government because we speculate that few in Asia would know his name if not for his 20+ years at the Fed). And third, Congressional bluster over China is picking up intensity here at home again. Most recently, significant, across-the-board tariffs have been proposed as a competitive response. We’ve been down that road before with the Hawley-Smoot Tarriff Act of 1929, which marked the continuing demise of the first age of globalization, and a period that, as history clearly shows, did not end well. We should avoid making that kind of mistake again. If Congress sincerely wants to help our manufacturing base compete globally–and in our view, the loss of low end manufacturing employment is an important social concern–then politicians need to engage in a critical discourse about how expensive it has become to employ people in this country. That would require some self-critical reflection in Washington, indeed at all levels of government, which is something we don’t place a high probability on, unfortunately. As far as China and global trade go, it gives us some comfort that Treasury Secretary Paulson is currently the man at the margin.

Summing it up, what’s catching is simply fear, the other side of greed according to Wall Street wisdom–fears of recession, a global credit crunch, higher taxes on capital, increased barriers to trade, and so on. Our models are placing a low probability on the first two at present, and while higher taxes and trade barriers are an ever present risk in a modern democracy, we don’t expect any significant shifts on those prior to the 2008 elections.