Tuesday, October 28, 2014

Taming the Deflation Dragon

The Deflation Dragon is roaring and Keynesians are licking their chops. Like those who promote fad diets and weight loss pills, Keynesians are appealing to your inner anxiety and love of easy solutions rather than telling you the truth about what ails the world economy. A typical article on this topic is one that appeared at Bloomberg.com last week --  http://www.bloomberg.com/news/2014-10-22/currency-wars-evolve-with-goal-of-avoiding-deflation.html

This Bloomberg article does a few things. First it does a nice job of reporting deflation changes in various spots around the world. There is plenty of it. I have no argument there. Second, it connects exchange rate depreciation wars with these deflation occurrences. Finally the article concludes that if exchange rate depreciations will not successfully end deadly deflations, then we should deal with it with “whatever means is necessary.”

Clearly more people are coming to the conclusion that widespread deflation needs to be reckoned with and that typical Keynesian approaches that boost aggregate demand must be administered. These approaches include depreciating your exchange rate, goosing money and credit, and having larger government deficits and debt.

The intuition is simple but deceptive. Draw a supply and demand curve diagram. Shift the demand curve downward. Notice the resulting lower equilibrium price. Now shift the demand curve rightward. Viola – the equilibrium price rises back to normal. Furthermore, equilibrium output (and presumably employment) increases. QED. Demand is the problem. The problem is evidenced by deflation or falling prices. The problem is rectified by increasing demand. Don’t you just love economics! Now I can drink my JD and spend the rest of the day watching leaves fall.

I agree with the whole Supply and Demand story but disagree with how the world can best push that lagging Demand Curve back to a better position.  Conventional Keynesian wisdom reflexively wants the government to manage the Demand Curve through exchange rate, monetary, and fiscal policies. But in 2015 world economic problems require a very different potion. Even the master of all this theory – J.M. Keynes, if alive today would have looked at today’s situation and balked at the traditional Keynesian remedies.

Why would Keynes balk with Keynesianisms? Because Keynes lucidly and powerfully expressed the idea that confidence and fear were important motivators. When writing about the Great Depression it was Keynes who explained that monetary policy would be like “pushing on a string.” This meant you could push money into the system but because of lacking confidence, banks or firms or households would simply hold onto the money. They would save or hoard it. They would not spend it. He called that “the liquidity trap.”

So Keynes established why fear made monetary policy ineffective. Living today and seeing how governments have backed themselves into huge debt corners, he might also conclude that fiscal policy won't work in an environment where governments were defaulting on debt. I am not sure what Keynes would say today about exchange rate policy but such policy is not one that every country can employ. This is a zero-sum game. If one country depreciates its currency to stimulate demand for its products, then another country has to endure an appreciation and a reduction in demand for its goods and services. Already the US is getting unhappy with Japan and other countries that are making gains at US expense.

Larry you are so depressing! I am not. I am fun! There is a solution to deflation but it involves not calling the 800 number for another fast acting pill. Think about what most countries have been through in the last years. Think about the real credit and financial problems faced by household, firms, and governments. It might sound humane and nice to tell US families that they can now borrow 97% of the price of a new house with less stringent income requirements. But surely all those stories about under-water mortgages are still fresh enough to make potential home buyers know that this is not an attractive option.  Basically it is snake oil.

The solution is the same one the doctor gives to the patient undergoing rehab. Keep at it. Keep doing those exercises and someday you will regain better use of that limb. There is no easy way. There is no pill or diet. Just keep sweating and grunting and pushing to get stronger.

Today the sweating and grunting has a lot to do with reducing previous levels of debt among households, firms and governments. Either under- or over-regulation of what the IMF calls legacy problems are also part of the problem of uncertainty and insufficient demand. Under-regulation means that governments should do more to clear up financial, housing, and other problems. Over-regulation means they have done too much and have handicapped the very patients doing the rehab. Do those exercises with a 100 pound sack of potatoes on your back!

Nutshell. Deflation does exist and is a challenge. Aggregate demand is deficient in many places and needs to be prodded upward. Aggregate demand will only be worsened by policies that do not address fundamental problems. Most Keynesian remedies fall into that category. Policies that are tough but will make us stronger are what we need. We need to cleanup debt. We need to give workers and companies stronger incentives and remove impediments to work, innovate, and produce. The IMF pays lip service to such “restructuring” policies but alas in the real world the snake oil salesman seems to have more influence. 

Tuesday, October 21, 2014

The Fed, the IMF, and Stock Market Gyrations

The Fed spoke last week and the markets looked like a food-o-holics meeting at a Hardees Restaurant. I am not exactly sure what that means but I am trying to paint a picture of chaos. Got it?

What is a little different this time is that we are getting a refresher lesson in international macro. The bad news is that international forces could weaken the US economy. While we are used to news about how events in Syria and Iraq threaten us, the latest salvo has to do with exchange rates and softness in the world economy. We point our fingers at various allies when it comes to them lagging at supplying ground troops in Syria and Iraq – and now we point our fingers at China, Germany,  the EU, and various other places for not doing enough to buy our US exports. Those places are blamed for not stimulating spending enough and have let their currencies depreciate too much against the dollar.

Since the US government is incapable of managing the US economy the Fed is left as the last bastion of help to defend Main and Wall Streets. And the markets loved the idea that the Fed is truly “left” or liberal enough to think that keeping interest rates near zero for a while longer will make all the difference in the world.  It is strange that zero interest rates have been unable to spur the economy sufficiently when foreign countries were stronger – and now that our neighbors are weaker we cheer the same policies. Wow – please give me more of that allergy medicine now that I am really sick. It didn’t work for mild symptoms so maybe now it will have me dancing the jig since I am really sick. Huh?

What is interesting about all the light and fury last week is that there wasn’t any real news about the global economy. It is no secret that the dollar has been appreciating and no secret that much of Europe and Asia were struggling with growth. But aha – a report was published last week that underscored what we already knew. Somehow that underscoring of the old information was the news. Joe is 5’2” and cannot play for the Indiana Pacers. His girlfriend tells Joe that he probably won’t get a contract from the Pacers. Joe immediately becomes despondent and orders a case of JD.

The report that was published last week is the semi-annually published IMF World Economic Outlook. The October 2014 report is now widely available. Some of you believe all sorts of horrible things about the International Monetary Fund and have already changed the channel. But these reports from the IMF are well regarded and many economists and analysts come close to spiritual rebirth each time a new report is published. So let’s take a little walk down IMF Outlook lane and (  http://www.imf.org/external/pubs/ft/survey/so/2014/NEW100714A.htm ) and see what these folks told us that made us so crazy last week.

Let’s start with report’s Table 1 which lists annual growth rates for real GDP for various geographies. The last column of the table tells by how much the IMF revised its 2015 forecasts since July. Thus, the only real news is in that last column. Below I duplicate some of their findings for next year:

·        World economic growth revised down from 4.0% to 3.8%. Note 3.8% in 2015 is faster growth than in 2012, 2013, and 2014. Notice also that 3.8% is almost exactly equal to the average world growth of 3.9% per year from 1996 to 2005.
·        USA no revision – remained at 3.1% for 2015.
·        Euro Area revised down by -.02 to 1.3%. That 1.3% in 2015 compares to negative growth in 2012 and 2013 and 0.8% in 2014.
·        Japan revised down by -.2 to 0.8%. This is the slowest growth rate in the last three years.
·        Canada revised up 0.1 to 2.4%, highest in three years
·        Mexico revised up .1% to 3.5% faster than the last two years but down from 2012.
·        China no revision at 7.1% but lower than the average of about 7.6% over the last three years.

So this is what we are all getting blathered about? These are the revisions that contributed to a huge stock sell-off last week? Basically the US forecast was unchanged while NAFTA as a whole improved. Improved! The US and its closest trading partners had better forecasts for 2015 than from last July. Europe’s growth was knocked down a bit from July but growth is expected to improve in 2015 – Europe will have stronger growth than experienced in the last three years! Japan and China will have off years but notice that the world economy is predicted to grow faster than it has for three years.

There are some who say that the tone and words used in the IMF Report were more startling than the numbers I described above. So let’s see what the IMF said in its Forward – the part most people read.

It is easy to summarize. The IMF believes there are two problems facing the world right now. One is continuing to deal with the legacies of the past financial crisis. That means dealing with government debt and high unemployment. The second problem is that potential GDP is slowing.  Because of these two factors, confidence is declining.

The overall message says nothing about new shocks that might have caused them to revise downward their forecasts for 2015. Why have financial legacies and potential growth deteriorated since July? The truth is that the IMF simply saw some bad months in some bad places and decided to jump on the bandwagon of negativity. If growth is getting worse in Japan or the EU or Brazil – then surely they will continue to get even worse. Or will they?

Which brings us to the IMF’s policy remedies. First, despite noting government debt risks and pointing out that current Keynesian policies have not succeeded, the IMF wants countries to use even more Keynesian aggregate demand expansion to stimulate economic growth. Spend on infrastructure and if that isn’t enough then spend on “whatever”. Second, they recommend to most countries to use structural fiscal policies that improve the workings of labor markets, commodity markets, financial markets, government over-regulation and so on.

What I recommend is that the IMF not publish global forecasts until they actually have something to say. The above stuff is nonsense if not drivel. They want more Keynesian stimulus when it hasn’t worked and when it will explode national debt problems. They want to solve long-term issues with monetary policy that keeps interest rates low. They have been advising countries to restructure and free up their economic systems for decades with little result. Is Putin’s Russia really going to embrace more capitalism now that the IMF has asked them to do it for the hundredth time?

Despite all the geopolitical and other risks, the world economy is growing at an improving rate. Not all countries are sharing in that growth but that is usually the case. The last thing we need is for the IMF or anyone else screaming that the sky is falling. 

Tuesday, October 14, 2014

Guest Blog by Buck Klemkosky*: As the World Turns

Intro by Larry Davidson

I was in the process of writing something about recent global events when Buck beat me to it. I still have plans to write about the recent IMF World Economic Outlook report that was released last week. But in the meantime Buck brings up two very recent and potentially threatening global trends. The first one finds that the value of the dollar is rising lately and is creating new challenges for a still fragile US economy. Buck explains why dollar value changes are not that simple, however. The other interesting issue concerns global commodity prices. Most of us worry when prices of energy, steel, copper, aluminum, and various other commodities rise too much. But what happens when international prices of these items begin to decline?  I hope you enjoy Buck's take on these things.

The Dollar is Back

In the last year, the U.S. dollar has appreciated (strengthened) 10 percent against the euro and 15 percent against the Japanese yen. Most of the decline in the euro has been in the last six months, while the yen has fallen almost 40 percent in the last two years. It is not just the euro or yen either. The U.S. Dollar Index, which measures the value of the dollar again a basket of currencies, has climbed to its highest level in more than four years. Even the venerable Swiss franc has fallen 9 percent against the dollar since June, as well as emerging market currencies. About the only currency that hasn’t changed is the Chinese yuan, which is controlled by the government and unofficially pegged to the U.S. dollar.

Why do we care about the value of the dollar relative to other currencies? A strong dollar makes foreign goods cheaper and thus helps control inflation. However, a strong dollar also makes exports more costly and thus less competitive, resulting in slower economic growth. It has been estimated that a strengthening of the dollar by 10 percent reduces economic growth by 1 percent. It always pays to invest in a country with a strong currency, so a strong dollar had made U.S. financial assets more attractive to foreign investors; it has helped lower bond yields and other interest rates and supported stock prices.

Why is the dollar so strong? The U.S. has experienced better economic growth than either Europe or Japan. Both are on the verge of recession and have lower inflation or deflation and lower interest rates. The European Central Bank has initiated a bond purchase program, and Japan has an ongoing one just as the U.S. Fed will stop its program this month. Plus the Fed has already given guidance that U.S. interest rates will be increased in the future, while Europe and Japan have given no such guidance. In a broader context, the dollar remains the world’s primary reserve currency and a safe harbor in terms of crisis and geopolitical risks. The dollar will continue to anchor the world’s financial system in the foreseeable future. In the shorter term, one will not notice the effects of a stronger dollar unless traveling abroad; things will be cheaper.

Commodity Prices Tank

The closely watched Bloomberg Commodity Index, which tracks 20 commodity prices, has fallen in recent weeks to a four-year low. And the fall has been broad-based, including agricultural, energy and metal prices. How things have changed; between 2000 and 2011 commodity prices tripled, referred to as the commodity super-cycle, and there was talk of eventual shortages of almost all commodities. Since then commodity prices have fallen by about 25 percent, and 11 percent since June alone. The only commodities not to experience price declines have been cocoa, coffee, cattle and hogs.

Commodity prices are a function of supply and demand and both have had an impact this year. On the demand side, annual global economic growth has slowed from 5 percent to 3 percent this year. Global growth may not improve much in the short term as the Eurozone, Japan and other emerging countries are teetering on the brink of recession. China, the largest user of most commodities in recent year, is struggling to achieve annual growth of 7 percent. Christine Lagarde, head of the International Monetary Fund, recently declared that the global economic recovery was “brittle, uneven and beset by risks” and slow global growth may be the norm for a long time.

The supply side may be summarized by two words: “supply glut.” Agricultural commodities have benefited from good growing weather, record acreage planted and high yields, resulting in bumper crops and the lowest prices in seven years. The oversupply of most metals can be blamed on the huge investments made at peak prices to satisfy China’s appetite for raw materials and recovering global economic growth. Oil prices have fallen 16 percent since June and are at the lowest level since 2012. Much of this decline can be attributed to the shale boom in the U.S. as it replaces Saudi Arabia as the largest oil producer in the world. The U.S. imports less oil today – 3 million barrels daily – then it did two years ago. Oil prices would be lower if countries such as Libya, Iraq, Iran and Venezuela could produce at full capacity.

What are the positive and negatives of falling commodity prices? It depends on whether a country is a net importer of commodities or a net exporter. Producing countries that export suffer when prices drop and could be a drag on global economic growth. For the net importing countries, falling commodity prices are like a tax cut, leaving households with more disposable income. Since many commodities, such as oil, are priced in dollars, the stronger dollar helps the U.S. but hurts other countries where currencies have weakened again the dollar. In general, falling commodity prices are probably signaling slower global economic growth.

*Buck is Market Strategist at Wallington Asset Management.

Tuesday, October 7, 2014

Is the Stock Market Over-Valued?

The stock market swooned last week and has been bouncing around ever since. “Surely the market is over-valued” is a comment that you hear frequently.  Agreement with such a statement means that many people will be very worried because it implies that stocks have peaked and will stop rising.  Retirees never like to hear that since their future incomes are tied to future growth in stock values. But all of us are concerned – no one wants to see wealth disappear. Simply – whether you are young and beginning to save or old enough to be on a regular diet of prunes – it hurts when stock prices stop rising. It hurts even more when they fall.

So what is the truth here? Are stocks going to stop rising? Fall? Or is all of this nonsense and stocks will continue rising?

Below you will see why I am not pessimistic about stocks. But let’s begin at the beginning. What does it mean when people say stocks are over-valued? If your boss tells you that you are over-valued, you know it isn’t a compliment and it probably means no wage increase is imminent. The word “value” is a common one that most of us understand. All things have value. Even my old pair of jeans has value to someone. 

Value, however, can be a tricky thing. How about those old jeans? Some of my well-dressed friends would toss a pair of old jeans as soon as the fading begins. In contrast, my hippie friends won’t even wear a new pair of jeans until they have washed them enough times that they are not only faded but have holes in the knees. Point – the same product might have very different values to different people.

Economists recognize this dilemma but point out that markets are places where values are assigned through prices. If a house sells for 1 million dollars, that’s the value of the house. The seller may be unhappy with that price and the buyer ecstatic – but the economist records $1 million. That’s the price at which both parties agreed to the transaction.  So – implicit values can be almost anything but market price is an objective criterion widely accepted as value. If we want to know if stocks are over-valued then we use stock prices. 

What does it mean for stock prices to be under-valued? There is no single meaning. The popular way is to use something called a price/earnings ratio. P/E has two parts – a stock price and an earning figure. Think of a single firm. Suppose its stock price closed at $100.  When you buy that stock for $100 you are hoping it will be a good investment. For the moment forget the capital gain you might receive by buying low today and selling high in the future. What’s left is a dividend you might receive from that share. Let’s suppose the earnings of the company are only $1. In that case, since dividends reflect earnings, the most you would expect to receive for your $100 investment is $1. That’s a 1% return. Ugh.  That stock is over-valued at $100. If you had paid $20 for the stock, then your return would have been a much better 5%.

Some of you are waving your hands! Larry – when you pay $100 for a stock you have it for more than one year. So what matters is not just one year of dividends or earnings – but what happens to earnings over the future. And for that question/comment you get a gold star. But that’s what gets us into trouble with this price/earnings approach. The current price and earnings data are known but are not perfect. But to use future earnings brings in unknowns and expectations and lots of different opinions. Ron might think a stock is vastly under-priced because he sees large increases in future earnings. James is more pessimistic about earnings and thinks today’s stock is highly over-priced.

So while the price/earnings approach is one that is widely used – it isn’t perfect for determining when and if the stock market will fall or rise in the future. It is a valuable approach but it leaves room for other ways to think about stock prices. Since I am about as boring as a rock in a stream, I like intuitive simple approaches. Consider some facts about the market. Here I am using the S&P500 price index. I downloaded data for the time period from 1950 to September 2014 from a website (https://finance.yahoo.com/q/hp?s=%5EGSPC+Historical+Prices ).  I then graphed the data. I converted all this daily data to annual averages. My limited abilities mean I couldn’t get the graph on this page. But you can find a graph at the link above.

·        Similar to my waist size – the S&P500 has had up and down cycles many times but it has trended upward.
·        The value of the S&P index in 1950 was about 17 and now hovers at about 2000. You math jocks can figure out the rate of return of $100 invested in 1950.  It is a pretty big number. If you gave that money to Uncle Charlie (or Uncle Sam) in that year, your return might not have been so good.
·        During those years there were many times when the market surged ahead only to return to more sober (lower) values. Many analysts point out a period from the early 1970s to the early 1980s when the market was essentially flat. But that is about the only time since 1950 when the market did not pop back in a more reasonable period of time.
·        Looking at the graph from 1995 to 2000 and then from 2003 to 2007 the increases where spectacular. Both peaks were followed by declines that lasted 2-3 years. The declines were followed by more increases.
·        There were also interesting time periods when stock prices rose precipitously but did not fall for extended time periods. If you start in about 1975 the market rises through the early 2000s with several major spurts followed by shorter setbacks.

The above points are pretty well known but they do underscore one fact – market gains always have setbacks but those time periods vary greatly in their intensity from a couple of months to several years. Gains do not necessarily imply a seriously stagnant market price.

Now one more point. If you put money into the S&P500 in 1995 or 1996 and held it until it reached 2000 last month – your annualized continuously compounded yield would have been around 7%. That annual appreciation is very much in line with stock returns over a much longer period. An average market, therefore, is expected to give you about 7% per year. Now consider the recent time periods of so-called explosive growth. If you invested money in the year (first column below) and sold when the market hit 2000 recently*, your investment would have earned the average compounded rate (column 2) over those number of years (column 3):

1997      4.5%   17
1998      4.3%   16
1999      3.0%   15
2000      2.4%   14
2001      5.2%   13
2002      7.8%   12
2003      6.5%   11
2004      6.0%   10
2005      5.6%    9
2006      5.2%    8
2007      3.9%    7
2008      9.4%    6
2009    13.6%    5
2010    15.1%    4
2011    20.9%    3
2012    17.8%    2
2013    18.9%    1

*Rates of return in the table are calculated from September of each year given through September of 2014.

From the above table you can see dramatic growth of the last five years. Those are indeed spectacular returns. But if your eyes move up the table you see that even with these fantastic stock increases, the annual average returns from money invested anytime between 1997 and 2007 yielded below historical averages. Thus even with spectacular growth of the last few years – the longer term returns in the market are well below average.

What do you make of this? The answer is that there is no way to know the future. Price/earnings ratios are interesting but don’t tell the whole story. Returns of the last five years are indeed spectacular. But even with stock price increases in those five years, money that got invested 7 to 17 years ago are not impressive. Stocks could rise several more years before that money earned the average annual return.

Will the market peak soon and swoon? Will it remain at present levels for 10 years? I don’t know. But the answer is clearly not a slam dunk. 

Friday, October 3, 2014

Econo-Quickie: Good News is Now Good News

This is a bit of an experiment today with my blog. Usually I stick to my long and boring Tuesday posting . Today I am seeing how you will respond to an off-cycle quickie. Charles -- no wise cracks.

Anyway, I was taken by the fact that the employment release this morning was strong -- employment grew more than expected and the nation's unemployment rate fell below 6% for the first time since some of you were wearing short pants.

In the recent past such "good" news was taken as a bad sign for the stock market. That's because good economic news might cause the Fed to quit holding interest rates down. And rising interest rates are thought to be bad for the market. But yikes. As I type the market is almost up 1% and some of the talking heads are saying stocks are rising because of good employment  news. So my question to you is -- if good news used to be bad news -- then why is good news now taken as good news?

Aren't we having fun? :-)