Wednesday, 7 May 2014

Obamacare will be vindicated by history: From JFK to FDR, here’s how the nation’s memory works

The following piece originally appeared on Salon

Not everyone viewed the introduction of Obamacare as cause for national celebration, but that doesn’t mean history won’t remember it as such. Time has a habit of changing the perception of presidential initiatives.

The Gettysburg Address may be the most iconic speech made in America, but not everyone shared that sentiment in 1863. Far from being revered as an affirmation on human equality, Lincoln’s words were roundly criticized by the Democrats of the day, while the Chicago Times described the president’s efforts as “silly, flat and dishwatery utterances.” Moreover, Lincoln’s words weren’t even the actual Gettysburg Address; they were brief dedicatory remarks following on from Edward Everett’s two-hour oration.

Many moments that seemingly define American ideals have been repackaged as occurring in a society much different from their time. Often, the prevailing political landscape has been toned down to allow the depiction of a nation unified by positive thought.

Today, John F. Kennedy’s space exploration efforts of the 1960s are rightfully spoken of in the context of the successful moon landing, an effort that confirmed America’s unyielding ambition. Yet the public scorn of the era’s numerous failed rocket launches is long forgotten.

Many commentators unfavorably compare Obama’s foreign policy struggles to Ronald Reagan’s supposedly sterling record. Reagan’s foreign achievements are highlighted by bold initiatives that weakened the threat of the Soviet Union and ultimately brought victory in the Cold War. But the passing of time has faded memories of the clandestine Iran-Contra weapons affair in which the Reagan administration supplied weapons to Iran and aided the contras in Nicaragua.

Such unsavory incidents are inconveniences to a rosy narrative. Instead, it brings great comfort to look back at great achievements of the past and nostalgically reminisce of a time when America cheered on the enterprise of its leaders. Rarely is it mentioned that throughout the 1960s a majority of Americans did not believe NASA’s Apollo project was worth the cost. Nor is attention given to the hawks within Reagan’s own party that lambasted his decision to ease tensions with Soviet leader Mikhail Gorbachev.

While seemingly difficult to imagine, decades from now history will note that the Affordable Care Act symbolized one of the great presidential efforts to fight inequality in America. Long forgotten will be today’s headlines of a temperamental website, deadline delays and mixed messages about keeping existing plans. Instead, it will be heralded that Barack Obama made a superior healthcare service available to the masses.

It may be noted that the initiative was not an instant success and needed retooling in subsequent years, but only one man will be given credit as its instigator.

The short version of Barack Obama’s bio will not reference the failure to implement his intended education and energy reform, or that a reset of Russian relations went sour. Perceptions of the Afghanistan and Iraq withdrawals may change with time, but Obama will still be remembered as a fighter against society’s widening income gap.

Thankfully for Republicans, the manner of their opposition to affordable healthcare will become a minor footnote. History will record that Obamacare passed both houses of Congress, was signed by the president and approved by the Supreme Court. Long forgotten will be the details of how Republicans ignored the legislative process, did everything in their power to repeal the law and bowed to extremist elements who forced a government shutdown for the first time in 17 years.

Romanticism will prevent people from caring about such details. We like to look back on great moments and imagine ourselves as part of a unified society bounded by optimism. Who doesn’t like to think they would have saluted Lincoln’s words, cheered on the bold Apollo missions and admired Reagan’s bravery in opening the Iron Curtain? It can seem incongruous that monumental changes occurred without universal support. But they do because humans are not of one mind. And in a land where ideas can be expressed freely, such a state of unity can never exist.

Moreover, future generations will struggle to believe that one party so vigorously opposed affordable healthcare without presenting a coherent alternative.

The Obamacare system may be flawed, but it is a start. Some people have lost their existing coverage and must enroll in a plan that meets the improved standards demanded by Obamacare. This can incur greater costs for the individual, but subsidies are needed to provide healthcare for those uninsured with low incomes. It will be a moot point in years to come; popular history looks favorably on inconveniences of the few for the benefit of the many.

The only viable conservative alternative to Obamacare is no system at all, but nobody will want to think that such a large portion of the political establishment was happy with such a state. Even if some believe that the previous situation of 48 million uninsured without any prospect of coverage is better, repeal is unattainable. Republicans were aware of this before the government shutdown, but the party bowed to fanatics and went on a campaign for maximum disruption for the sake of an unattainable goal. The current political system, effective for more than 200 years, means that changes to law cannot be made without going through the legislative process.

With more than 7 million enrolled, Obamacare is here to stay. Regardless of future modifications, of which there will be many, affordable healthcare has been instituted in the United States, dragging millions away from the threat of imminent bankruptcy and terminal illness.

Those opposing Obamacare may not be as ignoble as the politicians who opposed the Civil Rights Act of 1964, but the racial significance of affordable healthcare will not be lost. At present 55 percent of the uninsured are non-white. In time Obamacare will help break down the barriers between rich and poor.

Obama will be appreciated as the first black president who also made healthcare a reality for everyone. It will define his legacy, with his political missteps whittled from his narrative. Republicans are on the wrong side of history, but their obstructionism will fade from public consciousness. We like to think that a time will return when the nation supported the conviction of its leader. But great achievements aren’t born from support from the masses, they happen when someone risks derision to surpass the status quo.

As President Kennedy said: “We choose to go to the moon in this decade and do the other things, not because they are easy, but because they are hard.”

Wednesday, 30 April 2014

Canadian Economy Headed for a Wake-Up Call?

The Canadian dollar, commonly known as the loonie, derives its nickname from the North American loon, an aquatic bird known for diving to great depths. Similarly, the currency has taken a plunge since the start of 2013, falling 10 percent against its American counterpart from parity to C$ 1.1.

The period marks a sharp reversal for the Canadian dollar, which enjoyed a strong rally in the aftermath of the global financial crisis. Last month the loonie declined to its weakest in nearly five years, reflecting an increasingly fragile economy.

Canada proved an attractive safe haven for investors in the post-crisis years, with the currency being viewed as a reliable alternative to the uncertainty surrounding the US dollar and euro. A stable environment underscored by relatively robust banks and a global commodity boom allowed the central bank maintain higher interest rates than the US for much of the past five years, meaning that holders of Canadian assets could obtain a greater yield.

However, in recent years the commodity rally has stalled and despite a pickup over the last few months, prices remain far from the lofty levels of 2010. While a focus on commodities once gave Canada an advantage over other nations, it could now prove a detriment. Too much reliance on exporting its natural resources has resulted in reduced investment in the manufacturing sector.

Over the past decade the number of Canadian manufacturing firms has fallen by 20% and the sector’s share of GDP has shrunk from 16% to 12%. It is a worry trend, possibly indicating that the commodity boom has masked vulnerabilities in the core economy; something that could be painfully highlighted if food and energy prices tumble.

Improving US growth should boost demand for Canadian goods (it takes in about 70% of Canada’s exports) but the central bank recently warned that Canada’s non-commodity exports were becoming uncompetitive, even at C$1.1. The country’s growth outlook isn’t particularly encouraging either, with real GDP expected to increase 2.4% this year after rising 2% in 2013, marking a third straight year of slowing growth.

Canadian policymakers face a difficult challenge in supporting the economy while trying to manage an overheating housing sector. House values have ballooned, with the average price of a home more than doubling since 2002. Moreover, household debt has climbed to record levels of about 100% of GDP, on par with the US at the peak of its housing bubble. Similarly, at 7% of GDP, residential investment has become an unhealthily large part of the economy, outdoing the pre-crash US and rising much faster than population growth. The sector is undoubtedly on an unsustainable trajectory.

While interest rates were kept at 1% last year, the central bank had a tightening bias, intimating that it would raise rates in the near future to cool excessive spending. But new governor Stephen Poloz adopted a neutral stance in October, recognizing weakness in the broader economy. His dilemma is that low rates could add fuel to the housing boom, encouraging indebted households to increase borrowing, while higher rates could strangle business activity.

Inflation pressures are minimal at present, with the consumer price index rising 1.1% in February from a year earlier, well below the central bank’s 3% upper target. This has built up expectations that rates will be maintained at 1% until at least mid-2015. The prospect of no rate hikes should keep the Canadian dollar at relatively weak levels, helping boost the competitiveness of exporters.

This will help with a necessary longer-term goal of shifting the economy’s growth drivers, which have been imbalanced over the past decade. A transition is needed from reliance on debt-driven household consumption and residential construction to an export-led economy boosted by strong manufacturing investment.

Such a goal involves discouraging housing speculation through tighter mortgage conditions and limits on residential investment, hopefully resulting in a gradual stabilization of house prices. Policies targeted at revamping the much-neglected manufacturing sector will also help provide sustainable growth, effectively sheltering the economy from fluctuating commodity prices.

The deleveraging from an excessively indebted economy will take time and be somewhat painful, but that is the consequence of years of largess. Action now can prevent a severe hemorrhage later. For inspiration, policymakers just need to remember what happened to the housing market south of the border.

Monday, 14 April 2014

What’s Behind America’s Soaring College Costs?

Article originally appeared at Quartz and The Atlantic

The growing $1.1 trillion student debt burden in the US has been well documented, yet concerns are subdued. That’s because the burden, unlike the housing crisis, won’t cause a sudden economic crash. Instead, it will prompt a slow strangulation of spending spread over many years. Congress has made some minor efforts to reduce interest rates on debt, but the necessity for such large loans must be scrutinized. And that means confronting the indulgences of colleges.

Tuition costs have soared in recent decades. In 1973, the average cost for tuition and fees at a private nonprofit college was $10,783, adjusted for 2013 dollars. Costs tripled over the ensuing 40 years, with the average jumping to $30,094 last year. Even in the last decade the increase was a staggering 25 percent.

The ability of colleges to raise costs has been facilitated by a sharp increase in federal student aid. Lenders freely dispense credit to students, safe in the knowledge that all loans are guaranteed by the government. Between 1973 and 2012, federal aid (inflation-adjusted) increased more than 500 percent. Looking at a shorter period, between 2002 and 2012, total federal aid to students ballooned an inflation-adjusted 106 percent to $170 billion.

Colleges have effectively been guaranteed an income stream and have used that certainty to partake in an arms race against each other by constructing lavish facilities and inflating administrative processes. The pursuit of education has turned into a vicious circle in which students need bigger loans to pay for higher costs, and colleges charge higher costs because students are getting bigger loans.

Notably, hours spent preparing for classes fell at a similar rate, while there was little change in time devoted to research. Administrative bloat fueled by excessive spending seems to be diminishing the focus on what college is supposed to be about, with the study showing that almost a quarter of professors at four-year universities do not consider teaching their “principal activity.”The apparent escalation in college bureaucracy may be reflected in changing patterns of teaching hours. A national survey conducted by the Higher Education Research Institute found in 2011 that 43.6 percent of full-time faculty members spent nine hours or more per week teaching (roughly a quarter of their time), which is a down from 56.5 percent in 2001 and a considerable decline from a high of 63.4 percent in 1991.

Time spent teaching may be declining, but compensation for those at the top has increased sharply in recent years. Presidents are now paid like the CEOs of successful businesses, as evidenced by the Chronicle of Higher Education’s latest report. The findings showed that 180 presidents at private colleges earned more than $500,000 in 2011, compared with just 50 in 2004. Moreover, the top two highest paid presidents each received more than $3 million.

All this spending has been encouraged by a flawed student loan system that enables unwieldy inefficiencies. Today’s loan model was built with good intentions, tracing its roots back to Lyndon Johnson’s Great Society ambitions, but it was not designed for extended periods of stagnant wage growth and a widening gap in pay scales.

Education is more important than ever, with the comparative return on a degree still high relative to those without college qualifications. But to lower the costs of tuition, government support must be reduced. Lending institutions are too lax in giving out credit, knowing that the taxpayer will support 100 percent of defaulted loans. Without that firm safety net, lenders will be more discerning about borrowers’ fields of study; the expected income for a humanities graduate is not the same as an engineer. Less student aid will also make colleges think twice about their excesses.

Moreover, loans should not be an entitlement. There are too many colleges offering too many places to students. A study last year indicated that more likely to default than graduate, while about 40 percent of students have to take at least one remedial course during their studies, slowing their possible graduation date and increasing debts. These stats indicate that many students are not prepared or capable for college-level academics.

Both colleges and employers must embrace three-year bachelors degrees; the traditional four years is an arbitrary number that just extends the time in education. Institutions can also reduce costs by adapting to the modern age and offer more online learning. But they will only do this is if the government limits the ability of students to pay the prevailing high tuition costs.

The current model has inflated spending beyond the nation’s means, with colleges reaping the rewards while the government takes all the risks and graduates drown in debt. With an abrupt crisis unlikely, hard action may be delayed for years, allowing the noose to tighten on an already fragile economy.

Thursday, 20 March 2014

History Suggests Putin Is Likely To Pause At Crimea

Taking back a gift is frowned upon across the globe, except in Russia. Soviet leader Nikita Khrushchev handed Crimea as a gift to Ukraine in 1954, but 60 years later Russian president Vladimir Putin made a swift reclaim.

After spending the last few years making efforts for recognition as a prominent member of the globalized world, Russia has managed to isolate itself in a matter of days. Fittingly, the Crimean Peninsula also represented Russia’s estrangement from Europe in the 19th century. After building up favorable relations with European allies by cooperating against Napoleon, Russia abruptly alienated itself by launching an unexpected attack on the Ottoman Empire in 1853.

Assuming the role as protector of the Empire’s oppressed Orthodox Christians, Russia attempted to take control of the Black Sea during the three year Crimean War. Its efforts were thwarted after Britain and France intervened, forcing Russia to abandon its plans and accept a peace deal.

Russia no longer uses religion as a mantra for expanding its influence and instead styles itself as a guardian of ethnic Russians, regardless of their location. That was the excuse used in separating two regions from Georgia in 2008; a conflict mirroring this week’s annexation of Crimea.

While Putin targeted Crimea following Ukraine’s ambitions for European Union integration and ousting of its pro-Russian president, desires of joining NATO were the catalyst of his aggression towards Georgia. Putin still views Russia as the empire victimized by the Mongols, Vikings, Napoleon and Hitler, and reacts with alarm whenever one of its former subjects expresses a desire seek relationships with outside powers.

Like Crimea, the Georgian regions of South Ossetia and Abkhazia are primarily populated by ethnic Russians. Similarly, Russia managed to maintain a military presence in the regions following the fall of the Soviet Union. This enabled Putin to easily occupy Crimea and in 2008 helped stir up tensions in Georgia’s troubled territories.

After Georgia took a step closer to NATO membership in April 2008, Putin responded by authorizing official ties with South Ossetia and Abkhazia. The two regions had long endured uneasy relations with Georgia, but the moves from Putin amplified tensions that led to local skirmishes. This provided him with the perfect excuse to send in ‘peacekeeping’ troops to protect the ethnic Russians, emboldening the regions’ separatist movements. When Georgian troops responded to attacks from South Ossetian rebels, Putin sent his army into Georgia-proper, laying waste to any resistance over a five-day conflict that resulted in 850 deaths.

Ultimately, Russia never assumed South Ossetia and Abkhazia into its federation, but did officially recognize their independence from Georgia. The tumult was intended to send a clear message to neighbors that aspired to western relations. Yet the EU and US acted as if unaware that Russia might take action against Ukraine if it sought European integration. When Putin coerced Ukrainian president Viktor Yanukovich to reject the EU’s proposed trade deal late last year, the West stayed silent; neither voicing strong support for Yanukovich against the larger bully nor warning Russia of interference. Of course, Western leaders hoped things would be resolved quickly so that it could maintain the stability of its Russian business interests.

But when Yanukovich was chased out of power, Putin realized he had to take things another step further. The seizing of Crimea was designed to remind the new Ukrainian government that looking west brings headwinds from the east.

Today, Putin seems to be following the template from the Georgian conflict. Things have been calm since ceasefire was reached there in 2008 and Georgia remains outside NATO. As long as Ukraine does the same then Russia will not encroach beyond Crimea.

Putin is likely wary that further provocation in Ukraine could incur additional sanctions from the West, akin to the severe measures on Iran that restricted access to the global financial system and choked its economy. But Western powers will be reluctant given that Russia plays a more important role in global trade than Iran ever did. Moreover, even if sanctions are intensified, Putin’s desire for regional authority cannot be underestimated. Since the days of Peter the Great, Russian rulers have put a high value on the power of the nation, often above the health of its citizens.

Crimea will never be returned to Ukraine, but further Russian expansion is unlikely. As with Georgia, Putin is probably content that his work in Ukraine is done, for now. He has conveyed a stern warning to the new leadership while invigorating the nation’s large pro-Russian population. Calm will be solidified if May’s Ukrainian elections restore power to eastern-leaning politicians; something that will bring relief to Putin, and the West.

Labeling Ukraine’s new government “legitimate” is not endorsement of democracy

The word “legitimate” is given three definitions by the Merriam-Webster dictionary, but it seems like none are known by those in the White House. Earlier this month President Obama declared that “any discussion about the future of Ukraine must include the legitimate government of Ukraine.” Illogically, he was referring to the new unelected leadership headed by acting prime minister Arseniy Yatsenyuk, who was subsequently welcomed to Washington by Obama to send a message that the US “strongly supports… the legitimacy of the new Ukrainian government.”

While the Obama administration is correct in vigorously opposing Russia’s attempt to truncate Ukraine, continually describing the latter’s new government as legitimate is a spurious and damaging pretense. Much of the media has made the same error. Inaction from Western powers allowed Russia intimidate recently-ousted president Viktor Yanukovich and saw a panicked opposition bypass democratic principles in its ascension to power. The US now looks hypocritical as a promoter of global democracy.

Let’s put the current government in the context of the dictionary’s first definition of “legitimate”: allowed according to rules or laws. Yanukovich was overthrown in a single day on February 22nd. Earlier that morning he declared in a televised address that he had no intention of resigning from power. Regardless, with Yanukovich and many of his allies chased out of Kiev, a rushed emergency session vote was held under the specter of violence in which the majority of the parliament agreed to depose the president.

The legality of the move is dubious. The Ukrainian constitution states that there are four circumstances in which a president may be removed between elections. The first three are moot in Yanukovich’s case as resignation, incapacitation and death were not applicable. The fourth, impeachment, is what the new leadership uses as its justification for the president’s removal. Yanukovich’s alleged act of authorizing troops to fire at protesters would certainly be worthy of prosecution, but the parliament alone cannot administer impeachment. A committee investigation and judgment from the Constitutional Court must also be dispensed; neither of which happened.

Even if the US chooses to ignore the legal technics, after all Yanukovich tried to tamper with the constitution for his own gain in 2010, it doesn’t seem to adhere to the dictionary’s second explanation for “legitimate”: fair or reasonable.

The day prior to his removal, Yanukovich signed into law constitutional changes that diluted his powers, formed a caretaker government and allowed early presidential and parliamentary elections in May. While these concessions didn’t bring an immediate step towards the catalyst issue of the EU trade agreement, it was a European-mediated deal expected to ease social unrest. But belligerent mobs of protesters continued to rout the city, effectively taking control of Kiev as police were forced into retreat. Yanukovich didn’t hang around and fled for Russia amid claims his car came under attack from gunfire, allowing the parliament to call the emergency session about the president’s removal. It was in nobody’s safety interest to oppose the motion.

The third explanation for “legitimate” is: real, accepted, or official. As recent years have demonstrated, mass demonstrations can result in constructive political changes. But Ukraine is not experiencing an Arab Spring. Unlike the despotic regimes of Arab nations, Yanukovich was elected to power in 2010 under conditions deemed fair by international observers from the Organisation for Security and Co-operation in Europe (OSCE). Yanukovich won 49% of the vote versus 45.5% for the incumbent Yulia Tymoshenko.

The 2010 and 2004 elections illustrated Ukraine’s political divisions, with the east of the country supporting the traditionally pro-Russian Yanukovich, while most of the west voted for pro-Europe candidates. From afar it may have appeared like there was a mass uprising against Yanukovich in recent months, but Kiev's geographical location in the Western-leaning heartland magnified the negative sentiment against him.

Yanukovich’s ascension to power was real, accepted, and official; adjectives that should not apply to the reigning US-supported government. Of course, a fair election does not give a leader free reign over a nation, but Yanukovich was not a Putin proxy. While depicted as a rigid puppet, last September Yanukovich forcefully vowed to his party at a private meeting that "we will pursue integration with Europe." He was originally in favor the EU trade deal but those plans were spoiled by a combination of Russian trade threats and a $15 billion investment in fragile Ukrainian debt which lessened the attractiveness of Europe’s proposal.

Yet Yanukovich attempted to appeal to both sides of Ukraine by suggesting an arrangement involving trade deals with the EU and Russia. Such notions were quickly dismissed by European Commission President Jose Manuel Barroso who indicated that Ukraine must choose between the EU and Russia. "When we make a bilateral deal, we don't need a trilateral agreement," he said. Yanukovich didn’t sign and so ensued anarchy in Kiev.

Yanukovich received no sign of US backing when Russia pressured him into rejecting the EU deal. The Obama administration only spoke out when it became embarrassingly clear that Russia felt it could do what it wanted with its neighbors. Putin’s boldness grew as the US government struggled with inertia.

Threatening Russia with sanctions, increasing NATO presence in the region and facilitating aid through the IMF will help with Ukrainian security. But while the Obama administration believes that saluting the new government will encourage stability, in reality it is appeasing one mob and breeding contempt in another. The EU trade deal that spurred the unrest was not a unanimous desire. A poll by German group GfK in November found that just 45% of Ukrainians supported the deal.

On Friday President Obama said he “supports Ukrainian democracy and self-determination”, while concurrently throwing his symbolic weight behind a government that came to power via blunt force. While it would be wrong for the US to condemn the current Ukrainian leadership, it should dial back its warmness in the public arena. At the moment the US is trying to make a strong statement to Russia, but the message to Ukrainians is that storming parliaments counts as “legitimate” democracy.

Friday, 14 March 2014

Growing pains for China’s financial system

A corporate default is rarely reason to celebrate, but nor is it always a sign of impending crisis. Last week’s declaration by Shanghai Chaori Solar Energy Science and Technology Co that it could not to make a $14.5 million interest payment is bad for the company and its bondholders, but not for China. Several analysts have erroneously labeled this as the Chinese “Bear Stearns moment” whereby the failing of one entity portends a broad breakdown in the financial system.

As with most matters surrounding China, any sign of stress in the burgeoning nation is treated with fearful hysteria by sections of the Western media. That is not just the fault of the West, but also a reflection of the existential obscurity of information from China. There are reasons for anxiety about the world’s second largest economy, but the recent missed bond payment is not one of them.

While Chaori is the first onshore Chinese corporate default since the regulation of the market in 1997, many more would likely have happened by now if the government had not provided generous assistance to avoid such consequences of a liberalized financial system. But it’s not known for sure. That is why the allowance of Chaori to default should be regarded as an indicator of progress in China’s slow transition to an open marketplace.

The inability of Chaori to make payments reflects weakness with the company and China’s long-struggling solar industry. It does not indicate any weakness with the country. Moreover, the default was not a surprise to analysts. Chaori’s difficulties have been flagged for some time and problems in the sector were highlighted in the past, with China’s formerly largest solar firm, the US-listed Suntech, defaulting on bonds last year.

In a worst case scenario Chaori could default on $163 million, but that is hardly substantial given the scale of China’s $14 trillion corporate debt market. Defaults on corporate debt are not unusual. Even in 2007, before the Western world’s financial turmoil, there were defaults on agency-rated debt in the US that totaled more than $5 billion. Investors take a risk any time they purchase a financial instrument, and the inability of a struggling company to repay its debts is part of the system. It is vital that corporate defaults are allowed to occur so that markets can efficiently weed out zombie companies.

Panic is understandable when defaults become widespread, but there is no evidence of that in China. Instead, there are reasons to think that the Chaori default could strengthen China’s corporate debt process. Until now, the system had never dealt with bankruptcy proceedings or wrangled with the pecking orders of bondholders; aspects of the market that are undesirable but a component nonetheless. The default may also give reckless investors reason for pause, while other struggling companies may disclose their limitations now that it is apparent markets won’t collapse when defaults are announced.

Above all, China’s comfort with the default indicates a growing confidence in opening up its own system. The government didn’t feel the need to offer a bailout and is content to live with the consequences of corporate defaults and the accompanying media hype. Beijing’s acceptance of Chaori’s difficulty coincides with a tolerance for greater exchange rate fluctuations in its formerly rigid currency. The renminbi, which has historically moved within tight ranges, has been allowed to trade with increased volatility over the past month, likely indicating a recent acceptance for market forces.

Of course, as with many aspects of Chinese policy the extent of the government’s role in market operations cannot be determined with certainty. But there is little doubt that some improvement has been made in opening up to outside influences, and it is important than these transitions are done gradually. The government is in the midst of undertaking a profound shift in its economic model, transitioning from a reliance on exporting cheap goods to sustainable consumption in which growth is generated by domestic spending.

Changing an economic model presents challenges and in China’s case they are clearly evident. To rely on domestic consumption, the nation’s finances must be in a healthy position. However, there are signs of an over-reliance of borrowing, with China’s total debt-to-GDP level jumping more than 80% since 2008. The level now stands at 210%, a number lower than many advanced economies, but its rapid increase is cause for concern. History has shown that similar credit expansions in emerging nations have resulted in financial crises as the floods of investments inefficiently distort asset prices.

But there has never been a test case like China. It can be argued that it has the infrastructure and resources to cope with the swathes of borrowed money. This seems to be the attitude of China’s policymakers, as reports this week indicated the central bank was prepared to cut reserve requirement ratios for banks if growth shows signs of falling below its 7.5% target toward a 7% annual rate. If implemented, banks would have to keep less in reserves and will be free to lend more. Facilitating more credit must be done carefully, but the current reserve requirement of 20% is relatively conservative and any cut figures to be limited. Moreover, aside from spurring additional economic activity, this move also aims to dampen demand for the sizeable shadow banking sector.

Encouragingly, China also has plans to liberalize interest rate markets, effectively allowing banks to offer savers more attractive yields. The imposed ceiling is currently 3% annual interest for benchmark one-year household deposits and just 0.35% on demand deposits. Allowing banks to introduce more competitive rates should boost saving and further lessen the shadow banking reliance.

Moving towards open markets is a delicate process that needs incremental steps while trying to maintain a difficult balance between economic growth and sustainable reform. Along with the Chaori default, there will be plenty more hiccups along the way as the increasingly liberalized financial system matures and adjusts to market forces. Some of the obstacles could be potentially damaging, but a missed $14.5 million payment in a $14 trillion market is not one of them.

Wednesday, 12 March 2014

Fannie and Freddie reform is necessary, but not at expense of private sector investment

Private investors and the government don’t always make easy bedfellows and nothing exemplifies this more than the case of Fannie Mae and Freddie Mac. After verging on collapse in 2008, the government-backed mortgage groups are now turning significant profits, but investors are not happy.

Since their inception, the structure of Fannie and Freddie has been a point of contention. Established by government charter, the entities are owned by private shareholders and guarantee the vast majority of US mortgages, buying and selling loans from financial institutions to provide money for the banks to facilitate lending to home buyers. For much of their existence the groups’ configuration has drawn criticism as private investors enjoyed the profits while losses were felt by taxpayers. Things have changed since then.

Even after receiving a $188 billion government bailout during the height of the financial crisis in 2008, the future of Fannie and Freddie seemed precarious. The common shares of both entities, which traded at $60 in 2007, declined sharply and were delisted from the New York Stock Exchange in 2010. By mid-2012 shares were worth just $0.14. But some investors had faith in the companies and as loan delinquencies declined and house prices rose, profits were generated.

Fannie and Freddie shares have now jumped more than 1,000% over the last 12 months. Fannie had a net income of $84 billion in 2013, while Freddie's was $48.7 billion. Yet investors are not reaping any profits. And that’s because the government changed the rules.

During the 2008 bailout the government took preferred shares carrying a dividend of 10%, along with almost 80% of common stock. It also placed Fannie and Freddie in “conservatorship”, meaning the government had administrative powers for the foreseeable future. Nobody seemed to care too much at the time, but interest picked up once the entities started making money. In 2012 the government used its conservatorship powers to change the bailout terms to ensure that all profits from Fannie and Freddie went to the Treasury.

Fannie and Freddie have now paid back more in dividends than they received in the 2008 bailout. Understandably chagrined, investors have launched a myriad of lawsuits against the government alleging that the 2012 amendments constitute a taking of private property without any compensation. A recently revealed 2009 Treasury memo stated that the conservatorship of Fannie and Freddie “preserves the status and claims” of preferred and common shareholders. But illogically, the government doesn’t seem to think future earnings are a claim for shareholders.

Regardless of arguments about the efficiency of Fannie and Freddie (some laud their ability to facilitate 30-year mortgages, others denounce their facilitation of reckless greed), or that most shareholders are hedge funds, it cannot be overlooked that investors who backed the companies’ survival are now being punished. Private investment in government-backed initiatives cannot be discouraged. The government was not in a position to nationalize Fannie and Freddie, the $4.9 trillion obligations were understandably too large, so it had to rely on investors to keep the mortgage groups alive.

Profit-saga aside, there is still the issue of deciding what to do with Fannie and Freddie. The Obama administration has rightly voiced support for overhauling the entities and it is true that the historic structure can no longer work; in the boom times it was overly imbalanced in favor of private investors and now the roles are reversed. Several reform bills are sitting in Congress, with some calling for a complete dissolution of Fannie and Freddie. An alternative proposal was made by a group of hedge funds and private equity companies late last year in which the entities would be replaced with two private firms, backed with an initial capitalization of $50 billion. Yet neither proposal is expected to gain widespread approval.

In reality, the most efficient solution involves a scenario in which the balance of responsibility is shifted so that private investors carry the larger share of the burden. On Tuesday the Senate Banking Committee released a bipartisan plan to unwind the mortgage companies and create a new system in which the private sector would be required to take the first 10% of losses before any government guarantee would be triggered. This is a step in the right direction, allowing the government to take the position of secondary guarantor and spare itself from the role of loss-absorber to private sector bets.

Yet the proposal does not include any provision for investors to share in the companies’ profits. Investors did not back Fannie and Freddie for the good of the US mortgage system; they bought shares with future profits in mind. Even so, private investment is needed for such government-backed entities to function efficiently and should not be discouraged.

Monday, 3 March 2014

Does The Keystone XL Pipeline Still Matter?

Last month it seemed the Keystone XL pipeline was nearing approval, but as with most things surrounding the project, things weren’t as they seemed. A US state department report reviewed the Alberta, Canada–Nebraska pipeline and indicated the project was unlikely to have a significant impact on climate change. This seemed like a significant positive step for pipeline, but within the details of report were critical comments from the Environmental Protection Agency.

Environmental concerns have been the most publicized aspects of the pipeline, with opponents arguing that the project could accelerate climate change by enabling increased production from the oil sands of Alberta, which creates 17% higher greenhouse gas emissions than the average crude used in the US. President Obama will make the final decision on the pipeline and given his campaign to battle climate change, it is difficult to imagine him defying the EPA and his core Democrat base, especially with Midterms later this year. Then again, labor unions will be angered if he blocks the pipeline and the thousands of potential jobs it could create. It is not surprising that he has taken so long to make a decision.

TransCanada first proposed the project seven years ago and a lot has changed since then. Back in 2007 there were still concerns that “peak oil” was imminent and demand for energy was booming in the pre-financial crisis environment. The pipeline was initially viewed by many as a much needed tool to bring down oil from Canada and ease supply concerns. But now the US is apparently nearing energy independence and the Keystone project is seen as an environmentally unsafe method of transferring oil to major refiners in the Texas Gulf (via Nebraska).

But oil companies have not been sitting idly during the prolonged approval process and have been working on other methods of getting the oil from Canada. The refiner Valero signed on to receive oil from the Keystone pipeline early in the project and has spent billions upgrading its equipment to handle the type of heavier crude produced in Canada. So to make good on their investment, the firm has invested in rail terminals at its refineries to help get the oil in. Last month Exxon Mobil announced the construction of a rail facility in Alberta that will be completed early next year.

Oil-by-rail has attracted scrutiny following a series of recent accidents, most notably a crash in Quebec last year that killed 47 people. This might bring additional regulation such as railcar modifications, but such developments will only result in a short-term slowdown in the rail expansion. Companies will continue to aggressively pursue this transportation method as long as the Keystone XL pipeline remains in limbo.

The economic impact of the pipeline has also generated much debate, but despite heated arguments from both sides its effect is unclear. TransCanada claims Keystone XL will support approximately 42,100 direct, indirect and induced jobs in the US and will and provide a substantial increase in tax revenues for local counties along the pipeline route, with 17 of 27 counties expected to see revenues increase by 10% or more. It added that the project will result in “spending $7 billion stimulating the local economy.”

These claims are countered by the Cornell Global Labor Institute which says the project budget that has a direct impact on US employment is between $3 and $4 billion. Moreover, any jobs created would be temporary and between 85-90% of the people hired to do the work would be non-local or from out of state. It also warned of the economic risks from possible pipeline spills, pollution and the rising costs of climate change. But there is no way of quantifying these risks.

Another argument revolves around the possible impact on oil prices. Intuition would say that the more oil that comes into the US, the cheaper prices will become. But the market isn’t so straightforward. Since 2011 refineries in the Midwest have benefitted from a glut of oil produced in the region and Canada which has been easily accessible thanks to an array of pipelines that were granted approval. This has seen US WTI crude oil trade up to $20 less than the global benchmark, Brent over the last year. The spread was about $8 last week.

However, if the Keystone XL pipeline enables the efficient transport of oil from Canada to the Gulf, then more refiners will be bidding for the oil. It is feared that increased competition for the Midwest oil glut will see an increase in prices.

Yet, just like predicting anything in financial markets, there is no certainty about future prices. Nobody knows where how much oil will cost next year but the logical policy is to create the most efficient oil transportation network so that supplies can be maximized, thus lessening the impact of a price shock brought about by unexpected events.

Efficiency involves the full development of the Keystone pipeline. Even if Obama rejects the proposal, companies will pursue other methods of transporting oil from Canada, and as has been evidenced, oil-by-rail is not a risk-free alternative. Rejecting Keystone XL won’t reduce the production of heavy oil in Alberta. That will only happen when better energy alternatives are promoted.

Monday, 6 January 2014

Major Economic Themes for 2014

This time last year, the majority of financial commentators held a downbeat outlook for the global economy in 2013. The potential for instability was seemingly high, but in reality it turned out that the greatest shock was a lack of any major shocks.

In the United States, the Federal Reserve reduced its monetary stimulus measures and stock markets actually rallied on the news. Unemployment fell to a five-year low of 7% and a government shutdown came and went without hysteria. An unfamiliar calm reigned over the eurozone through the year, resulting in a welcome decline in bond yields for the weaker “periphery” nations. China successfully reversed its slowing growth, while Japan’s extraordinary stimulus policies helped reinvigorate an economy that has suffered a quarter century of stagnation.

By year end there was synchronized growth from the major global economies, pointing to an optimistic outlook for 2014. The smooth navigation through so many potential shocks naturally bodes well for this year, but enough headwinds remain to keep growth modest.

US Growth Gaining Momentum

Expectations are relatively high for the US economy, with growth forecasts broadly surpassing the expected final 2013 figure of 2%. The economic drag caused by the sequestration budget cuts will no longer be a factor and significant progress has been made in reducing corporate and household debt. Moreover, developments in shale energy will aid US manufacturing, particularly in the petrochemical sector. A stable environment should bring near-term benefits to rising asset prices and the housing market.

Yet several issues cloud the positive outlook. The Federal Reserve may have begun tapering its quantitative easing strategy without market panic, but the timeline of its ultimate exit from the stimulus program remains unclear. And while there are signs that political gridlock in Congress may abate somewhat, it is unlikely that there will be any development of progressive fiscal policies. Moreover, household income levels are expected to remain stagnant, meaning that a robust increase in consumer spending is unlikely, casting doubt on whether the US economy can make a smooth transition from central bank stimulus to self-sustained growth.

Japan’s Stimulus Measures Fruitful, For Now

The aggressive monetary expansion launched by Japanese Prime Minister Shinzo Abe in late 2012 has delivered on its intention to reverse deflation. The rationale behind the initiative is that sustained inflation will see depressed wages rise and boost consumer spending as households realize that prices will no longer follow a downward trajectory. Growth and inflation both rose last year and 2014 should see a continued increase.

A potential risk to growth exists in the introduction of a 3% sales tax increase which may dampen economic activity. Abe has promised further stimulus to offset any negative impact from the tax; a strategy which should prove successful. But the need for the rise in sales tax is a more serious issue. Japan must ease its huge public debt burden, which is forecast to reach 230% of GDP in 2014. Financing such debt can be treacherous, and a sharp rise in Japan’s sovereign bond yields would make debt-servicing costs unsustainable. Such an outcome would prove disastrous for the Japanese economy.

Eurozone: The New Japan?

While Japan recovers from decades of deflation, the eurozone risks falling into its own trap in 2014. 2013 was good for the eurozone largely because nothing much happened; financial markets interpreted no news as good news. Fears of a breakup have cooled and the 17-country bloc emerged from recession last year. But growth in 2014 is expected to be minimal, inflation is anemic and major structural issues remain.

Eurozone unemployment remains stubbornly high at 12.1%, with several of the bigger nations hampered by a lack of competitiveness due to high labor costs and a strong currency. The leadership may be moving away from the ideology of severe austerity measures, but public debt levels remain elevated and nations will need to continue to improve their financial balances to attract foreign investors. Similarly, banks will remain in deleveraging mode, especially following region-wide stress tests, resulting in a continuation of tight credit conditions.

Some support should come from the ECB through easier monetary policy, aiding market sentiment over the near-term. But progress on a banking union shows signs of remaining painfully slow and developments on fiscal union are nonexistent.

Economic and Debt Growth in China

Ballooning debt growth in China has been a burgeoning issue over the last couple of years. In 2012, China’s central bank made efforts to tighten credit, but these initiatives slowed economic growth. That was an undesirable outcome for the leadership, so last year credit conditions were eased and infrastructure investment was increased. Chinese economic growth rebounded quickly, calming fears of a “hard landing.”

Creating more debt will not help China in the long-term. Beijing is attempting to change its model from a reliance on foreign demand for its exports to an economy driven by sustainable domestic consumption. But households do not have adequate wealth to drive the economy, and have therefore relied on debt to maintain growth. The Chinese leadership will need to introduce significant economic and political reforms to reduce its reliance on debt. However, during the transition it must be careful to maintain growth and avoid any crash that would have a far-reaching impact.

2013 turned out to be a pleasant surprise for global markets, spurring optimistic forecasts for the year ahead. 2014 will likely be a better year for global growth and many near-term risks have dissipated. Yet such upbeat sentiment should not distract from the political dysfunction and absence of progressive reform policies in some of the world’s most significant economies.

This piece was written for 

Sunday, 15 December 2013

Why The Fragile US Economy Isn’t Impacting Stocks - Yet

There is a reason why asset management firms don’t employ legions of economists to do their investing. Providing accurate economic forecasts is very useful, but financial markets generally don’t reflect the state of the world.

US stock markets have rallied strongly over the last two years, while economic growth has been weak. Appetite for stocks has been driven by central bank action, not forecasts of skyrocketing consumer demand. The Federal Reserve has held its interest rates close to zero for the last five years while implementing vast amounts of quantitative easing - printing money to buy government bonds.

These purchases effectively lower bond yields, resulting in lower financing costs for companies while simultaneously encouraging investors to buy assets such as stocks since the return on fixed income is so low.

Moreover, when economic news does noticeably move markets, it is typically due to “surprises” in data releases rather than the absolute level of growth. So if the economy is weak, but a GDP figure is unexpectedly strong, markets will often rally and appetite for riskier assets increases. A longer-term rally can ensue when an economy appears to be on a turning point; transitioning from recession to a period of growth.

In recent years US markets have also been boosted by upbeat corporate earnings that have continually surpassed estimates. While this is clearly beneficial for stock market performance, it does not necessarily reflect well on the economy.

The focus on quarterly results has led to aggressive cost-cutting, aiding corporate profits. Earnings per share have also been augmented by a large number of stock buybacks, in which repurchases by companies lead to fewer shares. This can be beneficial for shareholders, but is not an indication of improvement in a company's performance.

Worryingly, earnings have been rising but revenue has remained little-changed. Hence, earnings have grown while actual demand for a company’s product has not. Moreover, there has been no increase in private sector capital expenditure in 2013; something that will be necessary to fuel economic growth when the Fed reduces its monetary stimulus.

Strong momentum and near-zero central bank rates may see the stock market rally continue into 2014, but without an active consumer the longer-term picture is not so optimistic. While the US unemployment rate has declined to 7%, much of the job creation has been in low income roles, and the rate is enhanced by a fall in labor force participation to its lowest level since 1978. Notably, real median wages (adjusted for inflation) have fallen just over 3% since the start of 2009.

There was a better-than-expected retail sales number for November and consumer confidence improved, but Morgan Stanley forecasts that this year will see the weakest holiday spending since 2008. In addition, projected gift spending per person will decline for first time since 2009. The possibility that a reduction in the Fed’s bond-buying program may lead to rising yields is not a good sign for the housing market. This year’s jump in long-term yields, spurred by the Fed’s first mention of “tapering” in May, has resulted in a slowdown in US housing activity as higher borrowing costs make homes less attractive. For example, in May a $1,000 mortgage payment could attain a house worth $225,000, while the same payment now buys a $195,000 house.

However, an important milestone was reached this week following the release of Q3 data showing the first rise in outstanding mortgage debt since the beginning of 2008. Over the last five years, the US has been in a deleveraging phase in which the private sector focuses on minimizing debt, thus sacrificing spending. But the recent rise in mortgage debt indicates that US households are making some progress in their deleveraging efforts and are demanding more credit. This is good news, but the growth in credit demand is from extremely low levels.

Some additional optimism has been fueled by a rise in US household net worth in Q3 to $77.3 trillion, an increase in approximately $2 trillion from the previous quarter. Proponents of the “wealth effect” theory assume that an increase in households’ net worth will lead to a rise in consumer spending. However, the source of last quarter’s increased wealth should temper cheer.

Rising stock markets were attributable for $917 billion of the wealth increase, while $428 billion came from higher house prices. Essentially, most of the increased in wealth is going to the population that invests heavily in stocks - the wealthy. They will likely use this new wealth to re-invest in stocks, helping to fuel the bull market momentum. Since rising house prices accounts for a much smaller percentage in added household wealth, most Americans will not feel much wealthier and consumer spending will unlikely see a sizable increase.

The outlook for US economic growth remains positive for 2014, but not strong. Most forecasts fall below 3%, yet the absolute level of growth won’t impact the stock market. Instead, momentum, central bank action, earnings and data surprises will likely dictate movements. For the rally to sustain beyond next year there will need to be more consumer spending, otherwise companies will have to increase their own expenditure as they run out of methods to artificially boosting earnings.

Monday, 9 December 2013

Eurozone: A story of stability in 2013, but aggressive action awaits

It all started in October 2009 when George Papandreou’s new Greek government revealed a black hole in their accounts that was vastly underestimated by the previous administration. Several years of tumult followed, bringing the eurozone project to the brink of failure. But 2013 proved to be a lucky year for the 17-nation group. Relatively few economic surprises and heightened attention on events elsewhere brought a welcome calm to European financial markets.

This year the eurozone emerged from six quarters of economic contraction and the weaker nations enjoyed a strong rally in asset prices. Stock markets in the so-called PIIGS (Portugal, Ireland, Italy, Greece, Spain) have all rallied more than double figures year-to-date, while demand for each nation’s sovereign bonds has risen strongly, resulting in a significant decline in their borrowing costs.

Structurally, notable progress has been made on the enormous budget deficits that plagued the region. Optimism has been augmented by the imminent exit of Ireland and Spain from their respective EU/IMF bailout programs, with both countries set to make the transition to self-financing without the safety net of an emergency EU credit line.

The catalyst for positive sentiment came from the European Central Bank in July last year when president Mario Draghi said the phrase: “the ECB is ready to do whatever it takes to preserve the euro”. Those words were soon supported by a conditional bond-purchase program called OMT ( Outright Monetary Transactions) - a facility that has yet to be used.

The ECB’s actions signaled to financial markets that the central bank would indeed be a “lender of last resort”, effectively acting as guarantor for assets if the eurozone did verge on collapse. With that reassurance, markets have instead focused on the probable unwinding of the Federal Reserve’s bond-buying program and the slowdown in emerging market economies. 

Yet even though there is less likelihood of a eurozone breakup, eventually markets will demand to see evidence of a return to eurozone prosperity. Incongruously, that objective is being hindered by the nation currently driving growth. Germany, the region’s largest economy, is expected to grow by 1.7% in 2014, which should lead to a 1.1% eurozone increase. However, Germany is vastly imbalanced - it has a huge current account surplus of 6.3% of GDP, meaning that it exports far more than it imports from the rest of the world. (A current account surplus of more than 6% is deemed excessive by the European Commission, but this limit is not enforced).

The strong influence of Germany on eurozone policy directives has resulted in the weaker nations enduring strict austerity and relying on export-led growth. The austerity has somewhat succeeded in reducing labor costs, thus boosting the competitiveness of eurozone products in global markets. Subsequently, most periphery nations are now running current account surpluses, but instead of stable economic models, these imbalances highlight worrying vulnerabilities. An over-reliance on exports may work for a strong economy such as Germany, but it is impossible for the whole eurozone to rely on such a model; the region is simply too big. There can not be enough continuous demand from the rest of the world to provide prosperous stability for all individual eurozone economies. 

An absence of strong domestic demand makes eurozone growth extremely fragile. Additionally, austerity without stimulus leads to weak consumer spending and risks facilitating a deflationary environment. The eurozone is nearing this scenario. The ECB predicts eurozone inflation of 1.1% in 2014, significantly below its 2% target. The weak number is a symptom of high unemployment and stagnant household income growth, highlighting the fragility of the region’s recovery.

Deflation is harmful to an economy as expectations of falling prices make consumers less inclined to spend. Moreover, deflation is particularly damaging for the periphery economies since it is difficult to further enhance competitiveness by cutting depressed wages, while the value of debt burdens cannot organically erode. 

The ECB reacted to the deflation concerns in November by cutting its benchmark interest rate (at which banks have to pay when they borrow money from the ECB) from 0.5% to 0.25%. This cut has come too late. The move was opposed by the German, Austrian and Dutch central banks, illustrating the divide between the sturdy and struggling eurozone economies. Germany’s resistance to an easier monetary policy comes from a fear of hurting their exporters’ competitiveness and perhaps lingering ghosts from the nation’s struggle with hyperinflation in the 1920s. 

Such was Germany’s influence over the ECB in 2011 that the benchmark rate was increased 0.5% over the year to 1.5%. Mario Draghi’s presidential appointment in late 2011 has resulted in a much-needed decline in rates, greater ECB commitment to eurozone stability and a decline in Bundesbank influence. 

Now the ECB must do more than prevent a eurozone collapse. The region cannot export away its problems; real growth must be spurred from within. The delay in reducing its benchmark rate may now force the ECB into unconventional action. Among the options are quantitative easing (creating new money to lower bond yields and borrowing rates), negative deposit rates (effectively charging banks to keep excess cash at the ECB) and long-term refinancing operations with strict lending conditions (providing cheap funding to banks that agree to lend to companies). 

Financial markets should maintain a favorable view of the eurozone into 2014 as exports help steady, if slow, growth. But the time will come when slow growth is not enough, forcing the ECB into a standoff with Germany over aggressive stimulative actions. It may have been avoided if smaller measures were made earlier.

Wednesday, 25 September 2013

Primer on US budget and debt ceiling negotiations

The ongoing political wrangling in Congress is the source of bewilderment for many, with even major media outlets getting the federal budget talks confused with the debt ceiling.Bloomberg is the latest victim, failing to distinguish the difference between the two issues. In essence, budget spending must be agreed by October 1st to avoid a government shutdown, while the debt ceiling must be extended later in October so that the Treasury Department can continue to borrow and honor its sovereign debt obligations.


The 2013 budget expires at the end of this fiscal year (September 30th) and if a new bill is not agreed upon the US will face its first federal government shutdown in 17 years. The consequences involve hundreds of thousands of federal employees facing furlough (temporary unpaid leave), a possible delay in payment of military personnel and the closure of national parks and some administrative departments. Of course, members of Congress will be paid as normal.

Last week the Republican-controlled House of Representatives passed a resolution that would fund the federal government until December 15th. However, this bill would deny funding to the Affordable Care Act (Obamacare); a requirement insisted by a group of uncompromising Tea Party members. The bill is now with the Democratic-majority Senate, which will likely add in the funding for Obamacare before sending it back to the House.

However, it is not clear when the Senate will actually have its resolution ready for the House as several Republicans, and some Democrats, are pledging to use every measure possible to prevent the Senate from restoring Obamacare funding. The measures should be unsuccessful, but they will likely delay the final vote until late on Sunday (September 29th). That will leave John Boehner and his Republican House colleagues with just a day to decide if they want to anger the Tea Party by allowing Obamacare funding or appease the hardliners by forcing a government shutdown. While the economic impact of a shutdown will be relatively minimal, such a situation will do little to aid the GOP’s fractured image.

Debt Ceiling

Presuming that a budget bill is soon resolved, the focus will turn to the US Treasury’s $16.7 trillion debt ceiling. This will garner much more international attention as failure to extend the debt limit will heighten expectations of a possible sovereign default. Essentially, the Treasury issues billions of dollars in new debt each month to fund various government departments because tax revenue isn’t enough to cover spending. But without a higher limit, the Treasury will be unable to issue enough debt to meet the government’s needs.

Treasury secretary Jack Lew says that by October 17th there will only be about $30 billion to meet the nation’s commitments. This is worrying given that a $60 billion social security payment is due on November 1st. He warns that without sufficient funds the US will fail to meet all of its obligations for the first time in its history. The protracted debt ceiling negotiations in 2011 marked another first as the US debt rating was downgraded from AAA, the highest level. In addition, an agreement was only reached on the condition of spending cuts. And the political situation seems even more divisive now.

Like with the budget bill, funding for Obamacare will be the major point of contention. Boehner says that House Republicans will only vote to raise the debt ceiling if the full implementation of Obamacare is delayed for 12 months. President Obama counters that there will be no negotiations over the debt limit. Ultimately, someone will have to give-in, otherwise US credit-worthiness will be damaged and financial markets will react with gusto.

While prices on US Treasury bonds rose after the downgrade in 2011, market conditions are different today. Prices have been on a downward trend since May, with rates subsequently rising. Even though rates have fallen somewhat in the last week as markets reacted to the Federal Reserve’s tapering delay, they seem set to resume an upward trend when quantitative easing slows. Failure to increase the debt ceiling will add further impetus to rising rates as investors sell their holdings of Treasuries.

The consequence will be higher mortgages and corporate borrowing costs. Moreover, it will see a further deterioration in people’s opinion of the political system as partisan wrangling chokes the fragile economic recovery.

Sunday, 15 September 2013

MacroWatcher: Fed Tapering and Weekly Notes

The Federal Reserve’s quantitative easing program, announced in November 2008, has coincided with many positive developments. Equity markets have rallied strongly, the housing market has begun to recover, unemployment figures are improving and banks have recapitalized. This week the Fed holds a two-day meeting and may subsequently declare a tapering of QE; something eagerly anticipated by markets.

Two-thirds of economist respondents to a Wall Street Journal poll expect some form of tapering to be announced Wednesday, but that number is surprisingly small. Markets appear to have priced in a taper, with bond yields rising sharply since Fed Chairman Ben Bernanke first hinted at the possibility back in May. The recent improvement in the unemployment rate, falling to 7.3% from 8.1% last year, has further bolstered expectations of a reduction in the Fed’s asset purchases. If the Fed were to postpone a tapering decision this week there could be a swift reaction. Market volatility would increase and the Fed’s ability to communicate effectively to markets will be cast into doubt.

The central bank will be keen to avoid a jolt in markets and will likely reveal some form of QE reduction. Currently, the program involves $85 billion of monthly bond-buying and this number will likely be decreased to $70 billion, probably involving a reduction in both mortgage and treasury purchases.

Economic fundamentals may prevent the Fed from tapering by a larger number. While the unemployment rate has declined, labor force participation has also fallen markedly, dampening the significance of a lower jobless figure. Moreover, monthly nonfarm payrolls were disappointing in July and August. Therefore, a relatively small $15 billion tapering will not significantly upset the impact of QE while also allowing the Fed time to analyze future economic data before committing to further reductions. This number should be enough to satisfy markets that already have tapering priced-in, while also setting in motion the Fed’s efforts to normalize monetary policy.

To assuage any economic concerns, Bernanke will likely emphasize that the reduction in QE is not indicative of future tightening by saying that monetary policy will remain accommodative. The Fed has said that a 6.5% unemployment rate and 2.5% inflation are targets for monetary tightening, but given the decline in labor force participation it may be communicated that a realization of these figures will not result in immediate changes in policy.

Of course, the Fed could announce a larger or smaller taper than the widely expected $15 billion. A larger reduction seems unlikely given the mixed US data of late, while a smaller number could see some volatility in bond markets. Markets will also be watching the Fed’s revisions of its GDP, unemployment and inflation projections from 2013 to 2015 and also its new forecasts for 2016. An interesting dichotomy will emerge if the Fed announces tapering while also revising GDP lower. However, such an outcome is unlikely given that the Fed has overestimated GDP in recent forecasts.

Dangers of Single Data Point

The validity of the US initial weekly jobless claims was cast into doubt last week. On Thursday the Bureau of Labor Statistics reported that the previous week’s claims were 292,000; the lowest level since April 2006 and 38,000 below economists’ consensus expectations. The number was surprising, but was devoid of any credibility when the Bureau revealed that most of the decline was due to two states retooling their computer networks, resulting in faulty reporting. The incident highlights the dangers of allowing one stream of data to influence an economic perspective.

Japan’s Tax

Good news came from Japan last week as prime minister Shenzo Abe will risk his domestic political popularity to implement an increase in sales tax next April. Although not yet officially announced, the decision to raise value-added consumption tax from 5% to 8% will help address the nation’s growing public debt burden [expected to be 230% of GDP by 2014].

There were some concerns that Abe may renege on the locally unpopular tax. But such a development would cast doubt on whether the government was committed to addressing its finances while simultaneously increasing the likelihood of future ratings downgrades and Japanese sovereign bond sell-offs. Abe is expected to pacify concerns about the economic impact of the tax hike with additional stimulus spending of up to Y5 trillion [$50 billion].

Week Ahead

While markets will be focusing on the Fed’s meeting, there is also the release of US industrial production data on Monday, consumer price index inflation figures on Tuesday and the Leading Economic Indicators report on Thursday. In Europe, the key release is the German ZEW economic sentiment survey on Tuesday, while the nation will go to the polls at the weekend as Angela Merkel is expected to retain her position as Chancellor with the makeup of the ruling coalition still unclear.

Sunday, 8 September 2013

Macro Weekly Overview

Last Friday was a good example of the incongruity that often exists between economic indicators and financial markets. The US Labor Department announced that 169,000 new jobs were added in August, falling short of economists’ forecasts of 175,000 to 180,000. The Department also announced that the number for July was revised lower from 162,000 to 104,000. Yet stock markets subsequently jumped higher despite figures indicating employment sector weakness.

The phenomenon of stocks rising on bad economic news has been a common occurrence recently as investors feel a weak labor market may spur the Federal Reserve to maintain its monetary stimulus policies and delay tapering plans. However, it does raise the question of how weak economic data needs to get before stocks would fall?

On a broader scale, the disconnect between stocks and the economy has also been driven by companies’ cost-cutting, which has resulted in profit margins rising to all-time highs and boosted the attractiveness of stocks. Of course, neither the Fed’s stimulus nor companies’ cost-cutting are sustainable measures over the long-term and soon markets will cease their positive reaction to negative news.

Unemployment Rate

Adding to the feeling of disconnect, Friday’s releases showed that the US unemployment rate fell to 7.3% in August, even though consensus expectations were for a 7.4% rate and fewer jobs were added than forecast. The decline in the unemployment rate was actually a case of good news being bad news. The drop was due to a shrinking labor force, meaning that fewer people are seeking employment. The smaller labor force can be caused by people becoming discouraged from seeking work, staying in college longer and changing age demographics. But its decline is masking weakness in the employment sector. Interestingly, data using the trendline average labor force participation rate [compiled by Zerohedge] shows that the unemployment rate actually rose from 11.2% to 11.4%.

M&A Activity

While US economic data has been inconsistent lately, some optimism can be taken from a rise in M&A activity. Last week Verizon announced a deal to take full control of its wireless unit from Vodafone while Microsoft said it will buy Nokia’s mobile phone business, pushing this year’s global M&A volume to $1.56 trillion [data from Thomson Reuters]. Total M&A was $2.6 trillion in 2012. Cash-rich companies seeking cheaper assets is a sign they are optimistic about growth and indicates a re-leveraging in the economy.


While Italy verges on further political turmoil as prime minister Enrico Letta stands firm in support of removing Silvio Berlusconi from parliament, there are some signs of stabilization in other periphery economies. Last week it was announced that Spain’s manufacturing sector grew for the first time since April 2011 according to an unexpectedly strong PMI reading of 51.1 (greater than 50 indicates expansion). Spain has also succeeded in lowering unit labor costs, thus boosting competitiveness and aiding its export market. While unemployment remains a major concern, at least it fell slightly in August to 26.3%, marking a decline for a sixth consecutive month.

Unemployment is even worse in Greece at 27.6%, but the rate of the economy’s contraction in the second quarter was revised lower last week to 3.8% from an initially estimated 4.6%. It was the best reading for Greece in three years and while there is no reason for cheer, it is some evidence of stabilization.


Market activity was heavily influenced by developments surrounding Syria last week and that is likely to continue in the near-term. President Obama will be seeking support from Congress for his military strike plans but it’s not clear what route he will take if there is a vote not to intervene. If a strike does go ahead, the reaction of Syrian allies will be crucial. Iran's deputy foreign minister is scheduled to visit Moscow next week to discuss Syria with Russian officials. Russia has already sent naval ships to the Syrian coast and anxiety looks set to escalate in the coming weeks.

Week Ahead

Upcoming US economic data will not bring much clarity to the Fed’s tapering date as the only releases are producer price inflation and consumer sentiment indices on Friday. However, political wrangling is set to begin as Congress returns from its summer break and gets set to tackle Syria and negotiate the federal debt ceiling. Elsewhere, China will release keenly-watched industrial production data on Tuesday and Europe will follow suit with its number on Thursday.

With such a variety of market-moving factors looming, volatility looks set to escalate and the nervousness of investors is evidenced through data that shows a $15.3 billion withdrawal from stock funds in the past three weeks and $7.7 billion in redemptions from Pimco’s flagship bond fund in August.

Friday, 6 September 2013

Italy To Bring Anxiety Back to Eurozone

For the first time in five years the eurozone has had a relatively quiet summer. With German elections looming it was unlikely there would be any significant developments in Europe and positive economic data has added to the recent calm. But with summer ending it’s possible that political turmoil in Italy could be the catalyst for eurozone anxiety.

The coalition government has been tenuously held in place by prime minister Enrico Letta over the last four months, but it is now in grave danger of splitting. Once again Silvio Berlusconi is at the heart of unrest. Political upheaval is a recurring theme in Italy and Berlusconi’s presence is preventing the establishment of reforms to help rejuvenate a contracting economy.

Despite being convicted of tax fraud, the 76-year-old still plays a role in government through his People of Liberty party. To-date the coalition has survived by Letta avoiding key decisions and agreeing to the demands of Berlusconi’s party on issues of government personnel and tax. Last week Letta agreed to cancel a property tax even though the European Commission, OECD and IMF advised that the tax remain in place to help tackle the country’s 2 trillion euro public debt. The government has not yet announced how the lost revenue from the property tax will be recouped. Such assuaging to Berlusconi led former prime minister Mario Monti to label the government “gutless and spineless”.

Letta has thus far done everything to maintain a stable government, aware that financial markets would not take kindly to disorder. Indeed, the mere preservation of the coalition following the property tax negotiations helped Italy auction off its target of 6 billion euro worth of bonds last week.

While Letta has seemingly bowed to Berlusconi on many issues, he is standing firm in his support of a law that should remove the former prime minister from parliament - and that may be the coalition’s undoing. Berlusconi’s tax conviction has been held up by Italy’s highest court of appeal and on September 9 a Senate committee meets to begin deciding his fate. A full Senate vote on the issue is expected in October.

Letta’s support for the process has predictably drawn ire from Berlusconi’s camp. On Thursday, People of Liberty member Daniela Santanche claimed that Berlusconi has made a video that could announce his decision to withdraw support for Letta, effectively bringing down the coalition government. Berlusconi also plans an appeal to Italy's constitutional court against the tax fraud verdict and his party says the Senate should wait for that ruling before passing judgment on him. It is obviously a delaying tactic and if the constitutional court agrees to hear his case it could take years before a decision is made. Such an outcome would keep Berlusconi on the scene and dim the prospects of significant economic reform.

There is little evidence of a recovery in Italy. The economy has contracted for eight consecutive quarters with the manufacturing sector experiencing a striking decline as output has fallen more than 25% from its peak in 2007. The nation’s unemployment rate is 12%, but this would be higher if not for a government policy introduced in the 1970s which aids struggling factories by paying “unused” workers 80% of the salaries while their employer attempts to solve its problems.

Earlier this week there were headlines trumpeting a rise in eurozone manufacturing aided by a surge from Italy. Export sales drove output in August but the same manufacturing survey also showed that employment in the factory sector fell for the 25th month running, and at a slightly faster rate than in July. On Wednesday it was announced that Italy’s services sector contracted by more than economists’ consensus, highlighting weak domestic demand. Overall, the manufacturing and servicing reports illustrated that while the wider global economic recovery is gathering steam, Italy remains stagnant.

In the stock market Italian bank shares are strongly outperforming those of other European nations this year. Much of this performance is due to the relatively sound nature of Italian banks as their conservative philosophy saw most of the major institutions avoid excessive leveraging and emerge from the financial crisis intact. Yet continuing economic sluggishness will soon deteriorate balance sheets and limit profitability.

The spread, or extra yield investors require to hold Italian 10-year bonds instead of German counterparts has risen in recent weeks to about 2.5% after touching a year-to-date low of 2.27% on August 19. Current levels are still significantly lower than this year’s high of 3.61% reached in March and nowhere near the 5.75% record set in November 2011. That record was spurred by the tumult surrounding Berlusconi’s prime ministerial resignation and it looks like he’ll have a role to play in spreads widening again.

Thursday, 29 August 2013

Macro Risks Loom in September

Volatility has returned to markets this week and it seems set to escalate in September. Aside from events in Syria and behavioral factors such as September being the worst month for US stocks, there are a variety of macro developments that could heighten market instability.

Fed Tapering

The most dominant issue over the summer has been speculation surrounding the Federal Reserve’s tapering of its monthly $85 billion asset purchases. The consensus among economists is for tapering to begin in September after the Fed concludes its meeting on the 18th, but that is not yet a certainty. Between now and then US economic data will be scrutinized, and possibly overreacted to by markets, as analysts try to gauge the mindset of Fed officials. Better-than-expected data is likely to boost expectations of Fed tapering in September, while weak data could influence the central bank to refrain from a reduction.

Debt Ceiling

The return of Congress will also bring drama as the issue of the $16.69 trillion US debt ceiling must be addressed. The US Treasury warned on Monday that it will reach its borrowing limit in mid-October, earlier than many analysts had expected. But for the limit to be raised, Republicans want significant new spending cuts and constrictions on Obamacare. President Obama said he will not negotiate on the debt limit, while House speaker John Boehner stoked the flames this week by saying he is ready for “a whale of a fight”.

It was initially hoped that agreement could be achieved without the type of last-minute wrangling in August 2011 that resulted in the downgrade of US debt and stock market sell-offs. The US budget deficit has decreased significantly, with the Congressional Budget Office forecasting $642 billion for 2013, which will likely equate to 4% of GDP, down from 2009 when the deficit was $1.4 trillion or 10.1%. But the recent rhetoric implies that despite budgetary and economic improvements the upcoming negotiations could be just as fractious as two years ago.

Eurozone Politics

Europe is also set for political anxiety. German elections take place on September 22nd and the outcome is significant given that current chancellor Angela Merkel is effectively the eurozone leader. The upcoming elections resulted in a quiet summer for the eurozone, but the calm is not indicative of looming threats.

Strong German performance saw the eurozone economy grow in Q2 but this followed six quarters of contraction. There is still no lasting solution to the region’s problems. Little has been done regarding bank reform while Greece, Cyprus, and Portugal will need additional financial aid later this year. Moreover, Italian bond yields have jumped recently as an imminent vote on whether to expel former prime minister Silvio Berlusconi from parliament may threaten the stability of the coalition government.

Angela Merkel’s approval ratings in Germany are high and she will likely be re-elected to lead a coalition, but celebrations will be muted by thoughts of the eurozone periphery.

Japan: Pillars of Abenomics

The Japanese government has been meeting with economists and business leaders this week to gauge opinion on whether a series of planned sales tax hikes should be implemented. Last year it was agreed that sales tax would rise to 8% from 5% next April and then to 10% in October 2015. The tax hike is necessary to ease the government debt burden, helping to pay for the aging population’s welfare costs. But now the government is trying to ascertain if the economy is strong enough to handle the tax increases. Economic data will be watched carefully before prime minister Shinzo Abe makes the final decision, expected before October 7th.

Implementing the tax hikes would be a sign that Japan is serious about enacting structural reforms, in effect the “third pillar of Abenomics”, following on from the previous two measures of renewed fiscal stimulus and aggressive monetary easing. If Abe reneges on the tax hikes he risks casting doubt on whether his government is committed to reducing public debt, which is projected to reach 230% of GDP by 2014. Japan needs to address its finances to avoid potential ratings downgrades; an outcome that could result in a sharp Japanese bond sell-off. Given that Japan’s financial institutions hold significant amounts of government debt, a spike in bond yields will result in severe losses for the banking sector.

VIX Volatility

Earlier in August the VIX, a gauge of the market’s expectation of future volatility based on the premium for S&P 500 options, was trading near six-year lows. However, the VIX has historically been a very imperfect measure of future market volatility. Still, the financial media regularly referenced how the low VIX or “fear gauge” reading implied that investors were anticipating low volatility over the next 30 days. But what most outlets didn’t report was a significant rise in the volume of VIX calls; options that are profitable if the VIX index rises. So while the VIX was at relatively low levels, the buying of options to protect against a rise in the VIX was rising sharply, and ignored by much of the media.

In effect, many investors were positioning for future volatility, even if this was not reflected in the VIX price. This is an example of the disconnect that can exist between markets and the dangers of reading too much into a single measurement. It brings to mind the Malayan proverb: Don't think there are no crocodiles because the water is calm.

Sunday, 25 August 2013

MacroWatcher: Weekly Analysis

August is one of the most popular vacation periods, but few expected the Nasdaq to take a three hour holiday on Thursday. The shutdown was blamed on a technical glitch, and the blame lies squarely with Nasdaq software unlike previous outages in 1987 and 1994 when the group accused squirrels of tampering with power lines. Regardless, the incident serves as a reminder that no matter how much technology changes, market challenges remain the same.

Market Recap: August 19th-23rd

The most notable moves on the week were in emerging market currencies as the anticipated tapering of the Federal Reserve’s QE3 monthly bond purchases saw investors buy back US dollars. The Brazilian real, Indian rupee and Indonesian rupiah all fell to notable lows on expectations of an end to cheap liquidity. While minutes from the Fed’s July meeting contained few surprises, they reinforced perceptions that members are “comfortable” with Chairman Ben Bernanke’s plan to reduce the $85bn-a-month bond buying later this year if the US economy continues to improve. Some officials called for tapering to begin in September while others want to wait for more data.

Bonds fluctuated through the week, with the US Treasury 10-year yield touching a two-year high above 2.93% Thursday before reversing lower on Friday. Stock markets were choppy, lacking direction on an absence of significant US economic releases. European data was generally upbeat, particularly UK and German GDP, while an unexpected expansion in Chinese manufacturing provided some optimism of stability in the world’s second largest economy.

Fed Tapering

The Federal Reserve Bank of New York conducted a survey of 21 primary dealers last week and found that most believe the Fed will start its tapering in September, with reduced bond-buying of $15bn per month. The dealers also expect the Fed to keep interest rates on hold until 2015. Despite all the nervousness surrounding the tapering, a $15bn reduction would still make the Fed’s monthly purchases larger than when QE3 was first announced in September last year [the program was unveiled at $40bn per month and increased to $85bn in December].

Moreover, an analysis from two economists at the San Francisco Fed asserted that the effects of large-scale bond-buying “depend greatly on the Fed’s guidance that short-term interest rates would remain low for an extended period” and that “interest rate forward guidance probably has greater effects than signals about the amount of assets purchased.” Yet even if the economic impact of tapering is negligible, don’t expect markets to react with much efficiency.

Emerging Markets Drama

The BRIC [Brazil, Russia, India, China] emerging markets are getting caught in a perfect storm of negative sentiment. Expectations of higher US rates, a reduction in cheap financing, falling commodity prices and country specific issues are combining to lead some commentators to warn of an “emerging market crisis”. Such statements seem excessive. Unlike in the late 1990s, exchange rates are more flexible today and reserve holdings are far greater. During the 1997-98 currency crises global reserves were $76bn; today Bloomberg data shows BRIC currency reserves alone are $4.4tr.

Markets settled down late last week as Brazil launched a $60bn currency intervention program and India pledged to cut its current account deficit [imports > exports] and will consider a sovereign bond issuance. Recent moves imply a correction rather than impending crisis, but that shouldn’t mask some of the problems facing the BRICs. Most notably, Brazil and Russia are overly reliant on commodity markets, Indian inflation is escalating and China’s banks are overleveraged. Hopefully recents events may spur the BRICs to reform their long-held protectionist policies and large state sectors.

Eurozone Recovery

Positive sentiment in Europe was aided by eurozone purchasing manager indices that showed expansion in manufacturing and services. Encouragingly, the periphery economies showed improvement. Yet periphery bond yields failed to continue their downward trend, generally finishing higher on the week likely due to thin markets and decreased risk appetite spurred by the emerging markets sell-off.

German bund yields maintained their ascent, touching a 17-month high near 1.94%, a knock-on effect of the Fed’s expected tapering and an improving eurozone outlook. While it has been a quiet summer on the political front, the governments of the periphery nations remain under intense pressure and there is still much work to do in reducing debt burdens and increasing funding for Greece, Portugal and Cyprus.

China Stabilizing

Chinese PMI manufacturing data suprised to the upside, rising to a four-month high. This followed on from upbeat July data, easing some “hard landing” slowdown concerns. The PMI sub-indices also showed increased domestic demand, a key goal of the Chinese government as evidenced by last month’s “fine-tuning” policies of tax cuts for small companies and new funding for transport infrastructure.

Yet rising house prices are a burgeoning problem. For July, prices rose 6.7% year-on-year, up from 6.1% in June according to data obtained by the Wall Street Journal. Higher prices have been aided by a sharp increase in lending in the first half of 2013 and a relaxation of strict controls on home purchases in some cities, particularly Wenzhou which has suffered from China’s exports slowdown.

“Real World” Analogy 

Trading analogies are pretty common, but I didn’t expect to be thinking of one while attending a mixed martial arts event in Boston last weekend. Halfway through one of the bouts a Brazilian fighter, who was on his back, grabbed the leg of his standing American opponent. Using his weight to hook himself around the American’s leg, the Brazilian attempted a painful-looking knee-lock hold.

While instinct would be to resist the move and attempt to remain on one’s feet, the American did something different. Even though it was a situation the American hadn’t wanted, or expected, to be in, he didn’t resist the submission attempt. Instead, he relaxed his body, allowing himself to be dragged to the ground, going along with his opponent’s momentum. By keeping his leg muscles relaxed, and aided by copious amounts of sweat, the American used the momentum to roll out of the Brazilian’s grip and managed to reverse the move into a hold of his own.

The American fighter typified the discipline of a good macro trader. He didn’t forecast the Brazilian’s knee-lock attempt, but was nimble enough to adapt and didn’t try to go against the strong momentum. Ultimately he took advantage of the Brazilian’s attack. Similarly, a trader should know when not to fight against markets, even if he doesn’t agree with the fundamentals behind a strong move. Markets will go where they want to go, sometimes irrespective of logic. Unforeseen situations will arise and a macro trader must be able to recognize when his views are out of sync while simultaneously adapting to market conditions to profit from strong momentum. But if all else fails, just like the American fighter was assisted by sweat in his escape, traders will do well to stay in liquid markets.