Marc Lasry Dips into his European Shopping List

A few months back I had the privilege to attend a panel with Marc Lasry and several other big shots in the hedge fund business.  Lasry is one of my personal favorites.  It’s not just that he’s a lawyer by academic training (in fact that might be more a negative than positive sometimes), it’s that he tends to have the best research and one of the more objective, clearheaded and apolitical views on markets.

When I last heard Lasry speak, he made it clear that he was developing a shopping list in Europe; however, he had yet to take a big splash into markets.  In particular, Lasry was looking for signs of a recapitalization plan for European banks in order to create a “crisis firewall” that would prevent further contagion.  My understanding was that an aggressive bank recapitalization was more important than a sovereign debt backstop, because it would allow for a temporary escape from the panicked environment, thus affording time to develop a longer term solution to the structural problems plaguing the Euro.

Yesterday morning, Lasry made a guest appearance on CNBC’s Squawk Box where he discussed the latest in the Eurozone mess.  Sure enough, despite the fact that many remain wary of Europe, Lasry disclosed that he was putting capital to work in the region, operating on a 2-4 year time-frame.  This is telling, because in the eyes of many, Europe continues to “kick the can down the road,” yet with someone like Lasry stepping in its a little clearer that a) the value is there from an investment perspective, and b) amongst those with good research and access to information there is an endgame clearly within reach.

Go ahead and give it a watch to learn more about Lasry’s perspective on Europe and a little further depth on precisely where he is making these investments (hint: the value is not in the PIIGS).

I’m having trouble getting the video to embed, so if it’s not working click on this link to check it out.

http://plus.cnbc.com/rssvideosearch/action/player/id/3000060922/code/cnbcplayershare

How to Appease the Deficit Hawks Without Hurting the Economy

The Deficit Paradox

So despite the fact that Treasury markets are showing no signs of impending doom, many argue that we need to act in order to preempt a buyer’s strike of US government debt.  Deficit cutting is a dangerous path for our country to head down right now, as doing so leads to the shrinking of aggregate demand/GDP.  I went through this in my recent post on a Different Shade of Political Risk:

As Bill Gross astutely observed, “Tougher sovereign budgets produce government worker layoffs, pay cuts, reduced pension benefits and a drag on consumption and the ability of the private sector to accept an attempted hand-off from fiscal authorities. Recession becomes the fait accompli, and the deficit/GDP ratio moves ever higher because of skyrocketing risk premiums and a plunging GDP denominator.  In many cases therefore, it may not be possible for a country to escape a debt crisis by reducing deficits!” [emphasis Gross']  While conventional wisdom may hold that reducing spending will close a deficit gap, reality has consistently demonstrated that reducing spending ultimately increases deficits.  Aggregate demand is equal to the sum of consumer expenditures + investment + government expenditures +/- the balance of trade (at the same time, ΔAD=ΔC+ΔI+ΔG+ΔBalance of Trade).  A drop in government spending triggers a drop in aggregate demand, which resultingly triggers a further drop in consumption and investment.

There are two ways for a country to make the deficit shrink as a percentage of GDP: one is to cut the deficit, the other is to increase the rate of GDP growth.  The quote from Bill Gross above is particularly apt, as Gross is a huge owner of US Treasuries, and as such, his words give us insight and perspective into what market participants really think.  Cutting deficits is a difficult paradox, in that doing so can lead to a drop in GDP and subsequently INCREASE the government’s deficit as a percentage of GDP.  I am utterly baffled at how many are calling for the immediate cutting of US government spending, while simultaneously calling for tax cuts, as if that is a solution to this problem (I’m looking at YOU Larry Kudlow…I can’t listen to the guy anymore).  This is especially true considering the budgetary troubles on the state level.

While cutting government spending would not be the best idea right now for the broader economy, there are two areas in which the government CAN cut spending without unleashing negative consequences on the economy at large, and possibly even helping the economy.  One such way is one of the most politically popular areas of the budget to cut (and something in which both Keynesians and Free-marketers alike agree should be cut) and the other is one which seems too politically taboo to even mention.  Let’s start with the popular–agricultural subsidies.

Agricultural Subsidies

As of 2009, agricultural subsidies in the US totaled $20 billion, or the rough equivalent of 0.5% of our entire federal budget.  While the percentage may sound small, that amount can have a major impact over the long run.   I propose to completely abolish agricultural subsides in this country altogether.

An Economist/YouGov poll from early April of 2010 found that aside for foreign aid (which is pathetically small in our country relative to other spending areas) and the environment (I guess people think we treat it well enough as is), agricultural subsidies were the component of our budget enjoying the most support for cuts (27% of Americans polled).  I am sure much of this has to do with the changing nature of agriculture in the country.  When these subsidies first began, we were largely an agrarian nation in which much of the population earned their livelihood via farming.  Today things are completely different.  In Making Globalization Work, Joseph Stiglitz offers the following statistical breakdown of the state of agricultural subsides in the US today:

…the vast bulk of the money goes to large farms , often corporate ones.  These subsidies have become simply another form of corporate welfare.  Looking across all crops, some 30,000 farms (1% of the total) receive almost 25% of the total amount spent, with an average of more than $1 million per farm.  Eighty-seven percent of the money goes to the top 20 percent of the farmers, each of whom receives on average almost $200,000.  By contrast, the 2,440,184 small farmers at the bottom–the true family farmers–get 13 percent of the total, less than $7,000 each.  The huge subsidies…actually drive out the small farmer.

Additionally, 90% of these subsidies are for staple crops, such as corn, wheat, soybeans and rice.  It is neither in our economic nor nutritional interest to focus so extensively on grain subsidization.  Besides, a large portion of the corn in this country isn’t even grown for food consumption purposes.  Ten million hectacres of arable land are used to grow corn for ethanol, adding up to a subsidy of $0.45 per gallon.  Ethanol is demonstrated to have only a marginal improvement in environmental efficiency at best, and this subsidization is leading to an economic inefficiency in our agricultural markets.  More land than would otherwise be used for corn is used for corn solely because of these subsidies. This cheapens corn relative to alternative edibles and drives up the price of other food staples, such as fruits and vegetables.

We hear many deficit hawks talk about the stimulus as “socialist” , deficit spending crowding out the private sector, and the inefficient allocation of capital from the public sector, yet very rarely do we hear anyone lambaste agricultural subsides.  Somehow health insurance for Americans is evil and un-American while agricultural subsidies are what exactly?

The Politically Unmentionable

Let’s end the wars in Iraq and Afghanistan.  Forget about the past debate.  With the benefit of hindsight, we know we went into Iraq for the wrong reasons and we still know of no “end-game” through which a “victory” can be achieved.  Not much more needs to be said here; however, one thing that is particularly interesting is that most people do not even realize that the wars in Iraq and Afghanistan are not accounted for in our regular budget.  Rather, wars receive special budgetary treatment.

Despite not being included in the regular budget, these wars have a major impact on our fiscal balance.  It would go a long way towards quelling any potential bond market jitters to make clear that an end is in site for these wars and that US dollars will stop going down this completely unrewarding sinkhole of simultaneous foreign quagmires.

Conclusion

If we cut both of these areas of our fiscal spending, not only can we appease deficit hawks, but as a country we might even have some more wiggle room for more stimulus.  Speaking of stimulus, should China actually let the Yuan rise relative to the dollar, they would be doing the US a major favor in stimulating the economy.  That is why market futures went up so much ahead over the weekend following the announcement.  It works like this: through all this time in pegging the Yuan to the dollar at an artificially low price, China has been accumulating a horde of US dollar reserves.

Effectively, this policy allowed the US to export inflation to China.  In allowing the Yuan to rise, China will slowly release some of these stored dollars into the global economy, ultimately providing a stimulant to global aggregate demand.  This is just what the doctor ordered at a time when it is needed most.  Let us just hope that China follows through on their promise, as this could help grow the US GDP, thus decreasing the fiscal deficit as a percentage of GDP.

Book Review: The Myth of the Rational Market

I just finished reading The Myth of the Rational Market: A History of Risk, Reward and Delusion on Wall Street ,by Justin Fox, and wanted to share some of my thoughts.  The book begins with the story of Irving Fisher and his attempt to apply mathematics in developing a theory for investment in the stock market and journeys through the history of the development of the rational market theory (a.k.a. rational choice theory, efficient market theory, etc).  Fisher’s mathematical approach is placed in contrast with Charles Dow‘s technical analysis and Roger Babson’s trend-lines, both of which incorporate the emotive element of market participants as key elements in predicting future prices.

Running throughout the book is the underlying tension between those who take a mathematical approach to finance, investment and economics and those who add the behaviorist element to the discipline.  Although the title suggests otherwise, Fox does not proceed to debunk the rational choice theory in a step-by-step manner.  Rather, he tracks the history and development of the theory from its originals as an investment thesis through its transition into a macroeconomic philosophy.  Much of the book is spent defining the theoretical underpinnings of the “efficient market theory,” a term first coined by Eugene Fama and the “random walk” theory of equity pricing.

In his historical account, Fox incorporates the theoretical contributions of those who sought out flaws in the rational market theory–people like Daniel Kahneman, Robert Schiller and Joseph Stiglitz–and emphasizes the fact that even these opponents of the rational market theory begin their analysis with the efficacy of the theory to an extent, in refuting the broader-based application of its specific precepts.  The narrative is tied up with a reflective take on the rational market theory from Fama and an analysis of the broader theory in the wake of the financial crisis.

For my readers, I am sure you know that I am particularly fond of Hyman Minsky and his theories with regard to the financialization of the economy and the influence of the cyclicality in leverage on business cycles.  I was pleased to see that Fox found Minsky to be a poignant and relevant figure in light of current events and an influential in his reapplication of Keynes’ “animal spirits” to modern financial theory.  Interestingly, Fox cited John Mills (not to be confused with John Stuart Mills), who wrote “Credit Cycles and the Origin of Commercial Panics” in Manchester, England in the 1860s as the first to identify leverage cycles as a force behind the business cycle.

To investors, Fox’s narrative offers some important lessons: mainly the idea that price history is far more analogous to Brownian Motion (i.e. chaos) than it is to something rational.  The two “technical” strategies proven to work best over time have been momentum and relative strength.  For those who believe in backtesting, this is an important observation.  Momentum and relative strength are the only two to have statistical merit.  Perhaps most importantly, the fact that pricing is so emotional and chaotic provides an advantage to those who can identify a value and invest only in those times in which prices become dislocated from reality, thus offering value investors an opportunity profit.

For those interested in economics and investment, the book is an intellectual thriller which weaves a subtle conclusion through an intriguing historical narrative.  As with many thrillers, Fox includes a Cast of Characters in the end which gives a brief account of each person’s contributions to the central plot–the creation or refuting of the rational market theory–and offers readers an easy reference through which to refresh on who is who along the way.  The conclusion succinctly ties up the key themes that play out over time and also leaves the reader with some intriguing questions to contemplate about our financial markets moving forward.  All in all this is a great book for who like thinking about how and why to invest and what factors influence broader economic cycles and a must read for anyone interested in investment and/or economics.

Yuan Small Step

Heading into the weekend the big news  on trading desks was a blown call in Friday’s US soccer match against Slovenia.  Friday’s “Quadruple Witching” was about as uneventful as possible.  Over the weekend China decided to stir up the pot by announcing that it “has decided to proceed further with reform of the RMB exchange rate regime and to enhance the RMB exchange rate flexibility.  To do so, China will place continued emphasis…[on] reflecting market supply and demand with reference to a basket of currencies.”  As is evident by the reaction of index futures over the weekend, this news was somewhat unexpected and a largely positive development.  In anticipation of the G-20 summit set to kick off in Toronto next week, China and US Treasury Secretary, Tim Geithner alike were both facing mounting pressure with regard to China’s exchange rate policy.  Both should now be breathing a sigh of relief.  The question begs whether the news is as significant as the market reaction to it.

It remains unclear as to how exactly China will pursue a more market-based exchange rate.  The statement itself is particularly vague as to this point and leaves a lot of room for speculation.  I agree with Barry Ritholtz’ statement that “the Chinese announcement is only that — an announcement which may or may not be followed through. As such, we should treat it as a precursor, and not the significant shift the market seems to be making of the announcement.”  Until there is clarity of action and an actual plan, these words are merely conjecture.  That being said, these words are significant conjecture and reflect a change in policy and posture from China on a significant issue of international significance.

In order to discuss the impact, we first have to understand the policy as to why China pegs the yuan to the dollar.  As a result of the Asian crisis in the late 1990s, countries learned that in order to whether an economic storm in which a currency crisis is but one component, countries need to stash a reserve of the dominant global currency (the dollar) in order to intervene and maintain an equilibrium for export prices.  These countries were very reliant on the international export market for domestic demand, and as such, exchange rate volatility led to export volatility.  Additionally, the IMF’s response to the crisis called for currency protection (i.e. the raising of interest rates) in a time when monetary policy should have been deployed to stimulate the domestic economy (i.e. the cutting of interest rates).  With a stash of US dollar reserves, countries learned that they could increase their level of control over their domestic economies, without having to rely on international decision-makers whose preference was to protect international players.

The stashing of reserve dollars overall results in the suppression of a large chunk of global aggregate demand and ultimately leads to large, pervasive imbalances in trade between nations.  This heightens global economic volatility (in a sense, these countries w/ dollar reserves gain stability by exporting volatility to the global market at large).  The impact of the change in policy from China (should it truly materialize) will be reflected in three key areas: 1) the price of exports from China to the US will increase; 2) the pricing of other countries’ exports to the US will be increasingly more competitive in international trade markets; and 3) China’s purchasing power on a global level will increase.  Each of these are significant in their own right.

In pegging the Yuan to the dollar, China has placed a significant burden on other global exporters and resource rich countries in order to compete internationally.  China’s policy directly led to Brazil placing capital controls on foreign purchases of assets and to New Zealand’s direct intervention in currency markets in order to make their dollar more competitive internationally.  Furthermore, the pegged Yuan has been one factor in the US undertaking an unprecedented trade deficit.  To many, this is the most significant component to watch as this news lays out.  While a freer floating yuan should have some impact, it remains to be seen whether this alone is enough of a step in order to really change the situation.  As Joseph Stiglitz said in March of this year, the rebalancing of the Yuan  “won’t do very much for the U.S. trade imbalances….the adjustment to the exchange rate will not be the full answer for global imbalances.”  We run a significant trade imbalance with the oil producing nations of the world, and until we figure out another way to harness energy, the bigger imbalance problem will persist.  All in all, I see this as one small step that deserves an optimistic, but tempered response.

Can the Market Rally Without the Financials?

Many analysts and pundits alike have proclaimed that this market cannot rally without the financial sector participating.  The story goes a bit like this: financial stocks led us down in 2007, they led us up in 2009 and their weakness of late will lead us lower for the duration of 2010.  The question has been asked during each move, both up and down, since the March ’09 bottom.  Many operate under the assumption that financial sector strength is not only necessary for the market to rally, but essential for the economy to continue.  Let’s take a look at the charts to test out this thesis.

The Financials vs. the S&P 500 and NASDAQ

In looking at a chart of the financials (as represented by XLF) against the S&P 500 and the NASDAQ (as represented by the QQQQs) since the October 2007 market highs, one can clearly see that the financials suffered the largest decline from peak to trough.  Since that time, the financials have recouped some of their losses, yet since July of 2009 they have remained stagnant while the broader markets continued higher.  Moreover, the NASDAQ in particular has exhibited significant strength and prices are now just 10% off of their 2007 highs.  While this is well below the all-time high set back in March of 2000, the index looks poised to regain a leadership roll.

This bodes particularly well for the longer term outlook of our economy and stock market.  Clearly the markets on the whole have been able to move higher without the help of the financial sector.  We are in a rolling credit crisis environment and pain in the financial sector does have implications for the broader economy, but from what we have seen since the 2009 bottom, there has been an impressive recovery, and even more impressive growth in some key sectors of our economy.  Pervasive weakness in the financials would not bode well for our economy, but stagnation (and under-performance) is a different story altogether.

The Financial Sector and its Roll in our Economy

Volatility tends to be cyclical by nature.  Slow and non-volatile moves tend to be followed by fast and dramatic volatility.  Just like anything else, volatility itself ebbs and flows over time.  From 2007 to July 2009, the financial sector went through a period of exceptional volatility and it would only be natural for the volatility to level off and the sector to stagnate.  As has often been the case, prices tend to overshoot to the upside, overshoot to the downside and level off at some sort of psychological equilibrium.

Following the popping of the Tech Bubble in the early 2000s, the financial sector went from being a relatively modest component of the S&P 500 to being a dominantly large sector.  Moreover, since 1960, the financial sector on the whole went from accounting for 4% of our GDP, to a high of 8% prior to the 2006 peak.  To an extent, this was the result of significant innovations in portfolio theory and money management; however, as we have subsequently learned, the explosion in financials from 2003 to 2007 was largely illusory in that it was built upon an explosion in leverage without the necessary economic growth to justify the rate of credit expansion.

In order for our economy to recover and reemerge on a growth trajectory, it is essential for new areas of innovation and growth to emerge.  That is certainly taking shape with the technology sector making an aggressive increase in its stature within the S&P 500 since 2008.  Whereas at the time, Tech accounted for 15.3% of the overall S&P, as of today it is now at 18.9% .  Technology remains well off its highs of 29.2% set back in 1999, but it is once again emerging as a leadership sector.

A Balanced Financial Sector Model of Growth

Not only is it possible for our economy to grow without the financial sector, many prominent economists think (or thought) it would be the preferable model.  Such thinkers include Hyman Minsky, Joseph Stiglitz and Paul Krugman, among others.  The line of thinking holds that in order to maximize investment and for the economy to grow, it is preferable to pursue policies of stabilization to constrain volatility in the financial sector.  A less volatile financial sector allows, and more importantly, encourages investment to flow into innovation and new technologies–the real sources of economic and job growth.

Many fear that the structural shift in debt from the private sector to the public and growing government debt as a percentage of GDP bode poorly for our growth prospects.  Jeff Miller at A Dash of Insight takes a pragmatic and optimistic view on our deficit “problem”:

If you want to understand how governments  (or large private organizations) deal with problems, you need to quit thinking in terms of your family, your small business, or a chess game.  This is not a situation where you see a problem, analyze alternative, identify a solution, and make a choice.  It is decision making under extreme uncertainty.  Most observers get this wrong.

Here are the paths that I see as plausible, and even likely:

1.  The economic rebound will increase tax revenues, reducing the non-structural part of the budget deficit.  (The structural deficit (simplified) is what we would still face if we were operating at full employment).

2.  The consideration of the Bush tax cuts will lead to a number of compromises.  Taxes will be increased, but some of the cuts will be preserved — at least in part.  Like all compromises, everyone will hate the result.  The final tax rates will be lower than we had in the Clinton era.

3.  Entitlement benefits will be cut.  This will require success from the Deficit Commission.  Once again, most will hate the result, but these commissions are the only way to achieve change.

With a patient and forward-looking approach, there will be exceptional investment opportunities as we continue to rebound from the 2009 lows.  With interest rates and Treasury yields historically low, there is little choice for investors to chase yield outside of equities.  This does not mean that every sector has to rally, and it places an increasing premium on stock selection and identifying the right themes and trends, but this can be done.  The more the growth areas of our economy continue to outperform the tradition, the more optimistic our future looks.  Not only CAN the market rally without the financials, should we do so, the better things look for our recovery chances.  All this is not to say that the financials will not go up if/when the market does, but it does mean that the financials can become a laggard sector rather than a leader.

A Theoretical Trip to Walden in the Wake of the Gulf Oil Spill

Our village life would stagnate if it were not for the unexplored forests and meadows which surround it.  We need the tonic of wilderness….At the same time that we are earnest to explore and learn all things, we require that all things by mysterious and unexplorable, that land and sea be infinitely wild, unsurveyed and unfathomed by us because unfathomable.  We can never have enough nature.  We must be refreshed by the sight of inexhaustible, vigor, vast and Titanic features….We need to witness our limits transgressed, and some life pasturing freely where we never wander….I love to see that Nature is so rife with life that myriads can be afforded to be sacrificed and suffered to prey on one another….With the liability to accident, we must see how little account is to be made of it.  The impression made on a wise man is that of universal innocence.

–From Walden, by Henry David Thoreau.

Lately I have been relatively quiet about the Gulf Oil Spill and I am now ready to dive into the topic headfirst.  I had felt all along that little new can be said about the crisis, other than the venting of frustration or posting some links to sites and organizations that are doing good things to proactively help (for those who have not done so, check out my post on Animal Rescue in the Gulf which has numerous links to helpful organizations and please send a text message to 20222 with the word “WILDLIFE” in order to give a $10 donation to the National Wildlife Federation).   What I wanted to do was take a step back from this whole situation and view it through a different lens, a philosophical lens.  Rather than rant and rave through my emotional thoughts, I wanted to think about the bigger implications of the oil spill and put it in context of where we are today in the progression and evolution of mankind.  I wanted to think a lot about the relationship between humans and nature and the ebbs and flows with which humans have nurtured and exploited Mother Earth. And that’s exactly what I have done.

Ideally to engage in this sort of thought exercise I would have taken some time and visited a National Park, camped out in a wild enclave and hiked and explored a new outdoor domain.  Unfortunately work and life would not permit such an endeavor at the moment (and had I been able to go away anywhere, I would have sent myself right out to the Gulf area in order to contribute in any possible).  In order to partake in this philosophical exercise I decided to do the next best thing–live vicariously and “deliberately” by rereading Henry David Thoreau’s Walden.  While I won’t dig into the specifics of Thoreau’s thinking, I will hopefully tap into his spirit.

A lot of what I have been thinking about cuts at the heart of the debate between John Muir and Gifford Pinchot that took shape over a century ago: that of preservation verse conservation.  Preservationists, like Muir argue for prioritizing the protection of natural resources from expropriation, exploitation and destruction, while conservationists call for a balance between the protection of natural resources and their use for economic benefit.  Preservation takes the idea of conservation one step farther.  People have constantly debated the balance that maximizes economic growth while protecting Planet Earth.  In this country, we have predominantly lived under the premise that the right balance should ultimately lead in aggregate to quality of life gains: i.e. the speed with which we use resources should not exceed a certain point in which the harm done in extracting those resources is greater than the economic benefit derived from their expropriation.  This is a utilitarian cost-benefit analysis in which society pursues the means which maximize overall utility and benefit.  With the 2000s bull market in energy and commodity prices the balance of that equation shifted dramatically in favor of the economic rather than the environmental.

Today to a large extent the shape of discourse positions the environmentalists (both preservationists and conservationists alike) in opposition to the resource expropriators (and to a larger extent the corporate world).  Rarely do we ever hear of the tensions within the environmental camp between outright preservationism and the more moderate conservationism.  With the impressive economic and quality of life gains over the past century combined with the strong bull market in commodities over the past decade, environmentalists have increasingly been marginalized in recent years as “radical” “wussies” who just don’t get “it” regardless of which side of the environmental camp one may subscribe to.

Further compounding the marginalization of environmentalism is the fact that life itself has become so incredibly abstract that people are increasingly removed from the source of our vitality–the Earth itself–altogether, to the point where there is a diminished sense of connection to our environment and ecosystem.  When one can wake up in a steel building, ride a steel vehicle which burns some kind of fossil fuel in order to arrive at a different steel building in which one communicates and connects via a collection of copper and plastics to the entire world all at once, while eating food sold in plastic wrapping and metal cans it’s very easy to forget that trees and water don’t just make for pretty vacation scenery, but rather, that they are absolutely necessary for living life itself.

With the rhetoric surrounding the “debate” over global warming, it has become clear that the environment has taken a back seat to the economic growth side of the utilitarian equation.  To me, this is abundantly clear considering the fact that IF, just IF, global warming is possibly real, why are we not doing anything possible to prevent it from getting worse?  In terms of risk/reward, the risks of doing nothing so clearly outweigh the risks of doing something and the threat never having been real.  Moreover, regardless of whether global warming is real or not, there are severe risks of maintaining our addiction to fossil fuels.  Their consumption alone causes major problems (including semi-rampant childhood asthma), but what we have learned from the Gulf Spill is that their expropriation too causes massive problems.  We are lucky in America in that the expropriation of natural resources (including oil) generally takes place so far away from our major population centers.  This is lucky because in other places around the world control over resources has and is resulting in long deadly wars (too many examples to list, but the Iraq war is in some ways an example and the trouble in Sudan is long-standing one) and environmental problems of the small (mountaintop removal mining) and sometimes catastrophic variety (Massey Energy mine blast and obviously the BP Gulf Oil Spill).

We need to rethink our energy paradigm and we need to re-embrace the utilitarian calculation of the costs and benefits of how we pursue resource consumption.  To wrap this all up for now (don’t worry, I am nowhere near through my thoughts about this topic), here is a quote from one of my previous entries on alternative energy that gets a little into the cost/benefit calculation of fossil fuel alternatives:

Much of the debate over fossuel fuel emission reduction focuses on whether the economy can absorb the costs of a shift to more climate-friendly forms of energy consumption.  The discourse takes a cost-benefit analysis to the change and attempts to rationalize whether the the risks justify the rewards, or simply whether the ends justify the means.  As an idealist who enjoys outdoor activities, I can easily come to the conclusion that the ends justify the means myself—to me, a cleaner environment is worth a significant cost–not everyone sees eye to eye on the issue.  Political constituents with exposure to the energy and manufacturing sector in particular do not see it this way.  The false dilemma is that our choices are not mutually exclusive.  We do not have to choose between a cleaner environment or a more robust GDP.  The real choice is whether we want a robust and profitable energy sector, or whether we want to increase the size of our alternative energy industry.  What we are debating is a massive shift in wealth from the owners of our resources to the owners of innovative technologies.

In the end, the ultimate question is do we want policies that promote growth, or do we want to take a utilitarian approach once again towards improved quality of life?  At some point growth comes with diminishing marginal returns in terms of quality of life, whereby each additional unit of production comes with a correspondingly smaller improvement in quality of life (and sometimes even a net subtraction from quality of life as is evident with the Gulf Spill).  Some worry about the costs of alternative energy.  Costs in and of themselves are not bad things.  Costs are worthwhile so long as they come with some sort of tangible gain.  Naysayers only want to talk about the costs costs costs of a transition to cleaner energy alternatives without even acknowledging the benefits.  It’s about time for that to change and I can only hope that President Obama’s upcoming speech (and subsequent actions) addresses some of these issues.

A Turning Point in Afghanistan?

Last night the New York Times reported that the US Geological Survey discovered vast mineral resources in Afghanistan worth up to $1 trillion.  This is potentially an incredible break for the deeply impoverished war-torn country whose GDP is a mere $12 billion per year.  The US intervention in Afghanistan is now the longest war in America’s history, and despite these vast mineral discoveries, there remains no end in imminent site.  While this is an incredible breakthrough, it requires patience and a balanced approach in order to ensure that this new-found wealth ultimately ends up a positive development for the country.

Natural resources often are a double-edged sword for developing countries, particularly those divided by persistent ethnic strife and civil war.  Just look at a country like Sudan in which the Muslims in the north and Christians in the south continue to wage a never-ending battle with one of the contentious points being oil rights in a war that has plagued the country essentially since obtaining its independence from Great Britain.  Often times much of the wealth from mineral deposits ends up in the hands of foreign international corporations who benefit from discreet handshake deals for mineral rights with corrupt government officials.  Additionally, the pricing of resources are incredibly volatile, and a country with a volatile political landscape needs to ensure that it deploys these new economic resources in the most stable way possible.

Article Nine of the Afghan constitution declares that “Mines, underground resources are properties of the state.  Protection, use, management, and mode of utilization of the public properties shall be regulated by law.  Clearly the constitution grants ownership of such resources to the national government of Afghanistan; however, the country continues to be plagued by regional allegiances and alliances that trump the interests of national unity.  Pursuant to the constitution, the nation’s Ministry of Mines manages the “research, exploration, development, exploitation, and processing of minerals and hydrocarbons.”  On the Ministrky website, they proclaim that “The long term vision…is the creation of an effective administration, utilization of natural resources, creation of jobs, the encouragement of private investment in the mining…sectors, and increasing government revenue.”  The right idea is in place, but the execution needs to remain consistent with this mission.

It is essential that the government maintain an ownership interest in these mines and use it in order to build equity in the country.  Many will argue for the privatization of these resources, but it is incredibly important that the US and World Bank prevent this from happening.  Creating jobs is not nearly enough.  The people of Afghanistan need to believe that they have a stake in the success of this new wealth and that its benefits will be allocated for the good of the country. In order to do so, the country needs to build upon some of the developing world’s top success stories in order to bring these minerals to market.  Petronas in Malaysia is a prime example for how best to proceed with a development program.  From Joseph Stiglitz’, Making Globalization Work comes the following observation:

Malaysia did not just turn over its oil to foreign oil companies, but had them help it develop its resources, learning all the while; today its government-owned oil company, Petronas, is providing training for other developing countries.  By managing its own oil company, it was able to ensure that more of the value of resource stayed in Malaysia, rather than being sent abroad as profits….(pages 33-34).

Malaysia’s former prime minister…says his country receives a larger fraction of the value of its resources than countries elsewhere who have privatized, and a larger fraction than it would have received had it privatized (page 142).

Malaysia’s success sits in stark contrast to the failures of the Russian state to equitably expropriate their resources in the wake of the collapse of the Soviet Union.  We know the good, we know the bad.  It’s important to take these lessons to heart and pursue things the right way this time around.

All in all, this is an incredibly optimistic development for a country badly in need of something to rally around.  This can be a major generator of some sort of national cohesiveness and unity, but with the delicate situation in Afghanistan it is even more important that the nation itself reap the benefits of these discoveries.   This is a war in which one of the underlying issues has been and remains the fact that the country feels as though it has been exploited as a tool in the war of ideas between more significant global powers (and to a large extent, it has).  Even amongst the regions loyal to the US there is a sense that the country does not control its own destiny.  Some of these ideas stem from the sharing of ideas between the Taliban in Afghanistan and Al-Qaeda coming from oil rich Muslim nations in the Middle East.  Regardless, we must acknowledge this underlying tension and use it to our advantage in nation-building around these resources.

It will be impossible for the US to “win” our longest war ever without winning on the battleground of ideas.  This is not just an opportunity for Afghanistan, but also one for the US and other big international players to deploy a new model for pursuing development and equitable management of resources in an impoverished nation.  Successful execution on the expropriation of these minerals can go a long way towards building a unified civil society in the country.  This discovery provides that opportunity, let’s do it right.

A Different Shade of Political Risk

While many (myself included) were far more concerned with the discourse surrounding the political risk of the government’s microeconomic policy and its treatment of firms and industries, a new variety of political risk has emerged with a thunderous force. This weekend, the deficit hawks took a major step forward towards influencing macroeconomic policy across the globe. Whereas last year the G-20 countries expressed a commitment to fiscal stimulus, this year, that sentiment is muted: “Those countries with serious fiscal challenges need to accelerate the pace of consolidation,” it said. “We welcome the recent announcements by some countries to reduce their deficits in 2010 and strengthen their fiscal frameworks and institutions.”  This is a very troubling development for the global economy and in my opinion, is its primary risk at this point in time.

As Bill Gross astutely observed, “Tougher sovereign budgets produce government worker layoffs, pay cuts, reduced pension benefits and a drag on consumption and the ability of the private sector to accept an attempted hand-off from fiscal authorities. Recession becomes the fait accompli, and the deficit/GDP ratio moves ever higher because of skyrocketing risk premiums and a plunging GDP denominator.  In many cases therefore, it may not be possible for a country to escape a debt crisis by reducing deficits!” [emphasis Gross']  While conventional wisdom may hold that reducing spending will close a deficit gap, reality has consistently demonstrated that reducing spending ultimately increases deficits.  Aggregate demand is equal to the sum of consumer expenditures + investment + government expenditures +/- the balance of trade (at the same time, ΔAD=ΔC+ΔI+ΔG+ΔBalance of Trade).  A drop in government spending triggers a drop in aggregate demand, which resultingly triggers a further drop in consumption and investment.

Now many would say that “the markets want smaller deficits” and I personally really don’t like that response.  Anyone who claims to know with certainty what markets should already own vast amounts of wealth.  Such a person, who can read through intuition the markets desires, would simply have to be an outstanding investor.  Bill Gross, an outstanding investor and one of the global sovereign debt markets’ largest private sector participants understands the dilemma facing international policy makers today.  He understands the reality that contracting government expenditures will ultimately result in shrinking aggregate demand and end up with debt taking up a higher percentage of GDP.  That’s exactly why this situation is a dilemma.  There will be pain no matter which path is chose and the common sense solution exacerbates the problem rather than alleviates it.

Most troubling is that people who advocate the cutting of deficits as the mechanism to escape this lingering financial crisis are making a conscious preferential choice to deflate, rather than inflate the economy, in many cases without even knowing of the consequences.  Deflationary times are incredibly dangerous.  In a time of deflation, there is less risk in hoarding cash than there is in investing.  Those who hold cash are rewarded with positive returns without even deploying their capital at all.  Investment drops substantially in a deflationary environment. Economies essentially collapse amidst the snowballing rush for cash and absence of consumption and investment.

As everyone knows, we are in a crisis where too much debt is the problem.  In the long-run, inevitably, the global economy needs to decrease its indebtedness as a percentage of GDP.  The deficit hawks and the Keynesians both understand this reality.  The question then begs itself: if too much debt is the problem, how does increasing government debt solve it?  Well the solution to the problem lies first in cleaning up private sector balance sheets.  Our aggregate level of societal indebtedness has not been expanding during this crisis.  Rather, to the contrary, the destruction of dollars in the private sector has consistently outpaced the level of fiscal and monetary expansion.  Despite the aggressive blend of monetary and fiscal policy, our economy has not been inflating as many of the deficit hawks would have predicted/expected.  This is both a good and bad thing.  One the one hand, it means that we are actively implementing the correct remedy, while on the other, it indicates that we are not using quite enough of that remedy.

So all that being said, first and foremost, the aim of policy-makers has been (and should continue to be) to clean up the balance sheets of the private sector.  This alone comes with increasing indebtedness in the public sector.  If we go back to our aggregate demand function above, an increase in government spending can help maintain aggregate demand at its present level by offsetting the increasing savings (or lack of spending) in the private sector.  Once healthy balance sheets are restored in the households and businesses of America, only then should the government look to decrease its deficit with a combination of decreased spending and increased taxation to pay for the previously lax and expansionary tax policy.  It’s far too early to change courses.  This stuff takes time and already has started working, why stop now?  Should we change courses now, we will inevitably be faced with a “lost decade” ala Japan and we will have wasted all of the strong policy decisions made to date.

A brief lead-in to a future post:

One of my primary gripes with the deficit hawks at this point in time is their attack on “entitlement” programs as the means through which to restore fiscal order.  Our country started the 2000s with  a balanced fiscal budget and a healthy outlook.  President Bush then proceeded to cut taxes while leading the country into two wars.  This has not been, nor is it a matter of entitlements increasing our nation’s debt load.  There were very distinct policy decisions made with known consequences and responses.  It is far easier for economists to attempt to take a “neutral” policy stance while attacking entitlements and ignoring past tax cuts and two wars, but unquestionably, the simultaneous wars in Afghanistan (which as of today is our country’s longest war EVER) and Iraq, completely altered our fiscal balance sheet for the worse.  If we want to seriously talk about cutting government spending, there is no more obvious place to start than with questioning our continued involvement in these two wars.  (This entire discussion is a post of its own, but I could not help but starting the thought here…)

What Next?

As uncertainty reigns supreme amidst these volatile/choppy markets of today, investors and traders alike are trying to assess whether we are on the brink of a “double-dip recession” or merely just a experiencing a blip–or correction–in the recovery from the throes of the 2008 deflationary spiral.  The answer to this question opens the door for vast opportunity; however, it’s increasingly difficult to deduce exactly where we stand on the road to recovery.  With the markets sitting just above their breakdown levels, the rhetoric and tone are increasingly bearish.  Each attempted rally gets sold with increasing force.  Yet still, the market remains above what many investors perceive to be a solid “value”/breakdown level for the market–S&P 1,040.   I want to “dumb it down” and focus on just a couple of metrics to watch for each side and simply offer some of the competing arguments as food for thought (but inevitably, I’ll give my brief personal conclusive thoughts in the end).

The Bear Case:

Without getting into too much detail about Europe, I want to focus on some key indicators at home in the US that do not bode well for the sustainability of the recovery (I am not altogether ignoring Europe, as the indicators I will discuss account for Eurozone risks).  First, let’s look at a weekly chart of the 20 year Treasury Note (as reflected by TLT) dating back to late 2006.  This has been my personal favorite risk-sentiment gauge during the course of the crisis and in its wake.

The Treasury market is a great risk sentiment indicator.  When the notes spike and the yields drop, we know that investors are more risk averse and looking for a liquid source of safety.  Over the course of the last month, Treasuries reached levels not seen since July 2009′s failed head and shoulders breakdown.  This is a significant sign, considering that thus far in 2010, Treasuries traded consistently in a tight range.  So long as the TLTs remain above the highs of their early 2010 range, the markets will be in “flight-to-safety” mode. Demand for US sovereign debt is to many “irrationally” high considering the increasing budget deficits the government continues to run; however, in the zer0-sum game of global finance, this is the most liquid market in the world and is the natural source of safety when things are hitting the proverbial fan.

Along with the rallying Long Bond came a stronger US dollar.  This both poses risks to the recovery in increasing the prices of US exports and is reflective of decreasing risk tolerance on the part of investors.  A strong dollar means that there is increasing demand for dollars in the global economy, and such a move is deflationary (I’ve written about this several times in the past).  Considering we are in the dawn of a recovery from a major credit crisis, such deflationary signs are scary in light of the troubles in Europe and the lack of monetary and fiscal policy ammunition as tools to place a bid under snowballing selling pressure in global asset prices.

Moreover, the Gulf disaster generates economic risk in its own right.  As the destruction of one of our nation’s important ecosystems and economies continues, the unquantifiable nature of the damage makes it difficult to gauge the overall impact.  There will be significant job losses from the seafood and travel industries which rely on the Gulf as their source of livelihood.  Additionally, companies who rely on offshore drilling will face increasing scrutiny, regulation and diminished earnings in the near-to mid-terms.

The Bull Case:

This arena holds what I believe to be one of the more surprising and optimistic indicators seen emerge over the past month: the recent rally in the Baltic Dry Index (BDI).  Click on this link to check out a Bloomberg chart of the index.  For those unfamiliar, the Baltic Dry Index is an index that tracks the prevailing rate on global shipping.  Strong up moves in the index are reflective of increasing demand for shipping, and vicariously, increasing global trade.  Surprisingly, this index marched steadily higher despite the deterioration in the Eurozone.  Now this uptick may be demonstrative of a desire on the part of resource owners to clear out inventory before wave 2 of the crisis widens, yet for some reason that seems unlikely.  Consumer confidence also checked in nicely higher in May despite the growing Eurozone crisis and this move seems more consistent with the positive developments in the BDI–consumption is making a strong recovery.

Furthermore, the Eurozone’s troubles can become the US’s strengths.  The crumbling Euro has come hand-in-hand with cheaper commodity prices, thus lowering the cost of important input goods such as oil and copper.  A stronger dollar helps boost America’s purchasing power on the global level, leaving consumers with excess wiggle room in their budgets with which to save.  Savings will go a long way towards strengthening the awful balance sheets of America’s households and businesses and this is THE critical step in moving from a stimulus induced recovery to self-sustaining private sector growth.  The rising Treasury rates that go hand-in-hand with Euro troubles  help keep the cost of financing US deficits much more manageable.   These are tangible long-run benefits.

In the words of Rahm Emanuel, “never waste a good crisis” and the Gulf situation should be no exception.  There are important lessons to learn out of this that can lead to long-term improvements and real economic gains.  Yes this comes with a hefty cost; however, rarely is there progress made without some sort of accrued cost.  This disaster clearly highlights the nature of negative externalities when dealing with resource expropriation and provides a much clearer picture of the true supply/demand equilibrium of oil in our economy.  We now know with a higher degree of certainty that alternative energies come with a fairer price-tag than original closed-ended calculations projected.  This is the catalyst that should help lead us to reconsider how we generate energy for consumption.

In Sum:

There you have it.  The key points at the moment for both sides of the coin.  Ultimately should the S&P break the 1,040 level, everything will change and technical selling pressure will highlight and lead to further fundamental weaknesses; however, should that level continue to hold this could be an actionable “long and strong” value level to use as a line in the sand for a portfolio.   Personally I am a believer in the longs, but will quickly change my stance should 1,040 break.  This is so because I give much weight to the improved consumer confidence and Baltic Dry Index numbers despite the multitude of negative sentiment and indicators swamping the headlines.  If today’s rally can hold, and the S&P can once again retake 1,100 this impressive rally off of the March 2009 lows will/should take another leg higher.

Steve Wynn Misses the Point

…in proclaiming the Chinese government more favorable to investors than the U.S. government.  Wynn proclaimed that “Macau has been steady. The shocking, unexpected government is the one in Washington” along with a handful of other choice words directed at the U.S. government’s handling of the credit crisis.

Of course Steve Wynn likes working in China.  He’s dealing only in Macau, a province much like Hong Kong in that it is one of the “one country, two systems” regions in China.  Macau enjoys freedom and liberties unthinkable on mainland China.  To equate Macau with all of China is just wrong.  Moreover, to equate China with the United States is not only morally reprehensible, but economically naive.  Question the economic policy of the U.S. government all you want, but this country unquestionably has one of the least spotty human rights records.   Sure from Steve Wynn’s perspective tax policy is important.  But there are serious risks when dealing with a country that can change its stance towards your business and your customers on a whim.  Until China improves its track record on human rights and civil liberties there will be an implicit risk to any investment in the country.  Of course totalitarianism opens the door for profit opportunities.  Favoritism, protectionism and corruption, all inherent elements of totalitarianism, come with exceptional money-making opportunities.  It’s easy that way!  But watch out, because as quickly as you can come into favor and profits, you can fall out of it.

Not too long ago CNBC’s Jim Cramer said something echoing that sentiment and I offered Cramer the following fake news story in response:

A new survey of portfolio managers revealed a shocking new trend developing in the investment universe: portfolio managers prefer investing in countries with Communist dictatorships, military coups within the last five years, oligarchies who dominate wealth coupled with a former lieutenant colonel in the KGB pulling the strings, and a civic society which largely favors strong-handed rule to democracy than they would the world’s longest-standing and most free democracy. Investors cited concerns over “wealth destruction” as the primary catalyst for this shift in sentiment, as they believe only strong-handed rule, with high barriers to entry can adequately protect their hard earned wealth.

Following this alarming survey, President Obama declared that “Although I am not a socialist, after learning the results of this poll, I have decided to ask Congress to put together a bill that would pave the way for a movement towards totalitarian Communism.” Not to be outdone, the Republican National Committee hired Goldman Sachs as an outside consultant in order to explore the availability of former global military and intelligence leaders available at this time to orchestrate a military style coup in the United States in order to attract investments to the slumping domestic economy. A spokesman from Goldman revealed that this is a new line of business for Goldman Sachs and revealed that the opportunity in political orchestration came from a message that G-d left Lloyd Blankfein on his voice mail during the week of January 15th.

In response to these latest developments, stocks initially flew on the news that the United States would explore alternate forms of government. What started as a morning rally turned into an afternoon collapse, as investors expressed concerns over the ability of Democrats and Republicans to reach a consensus as to the most beneficial form of totalitarianism.

I urge Wynn and Cramer alike to speak with some Australians and/or Rio Tinto about some of the complexities of working in China.  Just recently, China jailed several Rio Tinto employees on charges of bribing officials and “stealing commercial secrets.”  The Australian Foreign Minister Stephen Smith had the following words to say about the secretive trial and murky process: “This was an opportunity for China to bring some clarity to the notion or question of commercial secrets….As China emerges into the global economy, the international business community needs to understand with certainty what the rules are in China.”  All the charged employees surprisingly plead guilty, and were “tried” in a closed trial in which Australian officials were wrongfully denied access to.  Many insist that these actions by China were in response to aggressive pricing negotiations over iron ore, an essential input good in steel production.

Whether these officials were guilty of bribery or not, there is seemingly rampant bribery in China.  Not only that, the country places significant limitations on civil liberties and its human rights record is far from clean.  While there have been improvements, China uses capital punishment on political dissenters, censors dissent, limits religious freedoms, discriminates against ethnic minorities and exposes its poorer workers to inhumane conditions.  These are substantial issues that companies and investors must consider in allocating capital to Chinese endeavors and significant barriers to entry in working in China.  Just ask Google about their experience in the country.  Google refused to succumb to China’s harsh censorship laws, and as a result, the company was forced to shutdown their Chinese search engine.  Sure there are profit opportunities in China, but there are also very real obstacles created by the People Republic’s spotty and inconsistent record on human rights and civil liberties.  The country is inherently unpredictable with arbitrary spurts of complacency and aggression.

I am well aware of the challenges faced by the U.S. in the midst of this rolling credit crisis.  These are frequent themes that I discuss and dissect.  Yet despite our troubles, to remotely equate conducting business in and with a country with questionable regard for its citizen’s lives is rather absurd.  Talk about the world’s largest population maturing in one country.  Talk about the urbanization, modernization, industrialization of a major global power.  Talk about these things and invest accordingly.  But please don’t compare the governments of the two and say that China is more predictable and stable than Washington.  (Off-point, but relevant: Ever notice how there is an inverse relationship between tax policy and civil liberties from presidential administrations.  Ronald Reagan gave us supply side economics, but he also supported some oppressive regimes around the world in the name of “anti-communism.”  George W. gave us lower taxes, but he also gave us the Patriot Act.  Also interesting is that the same people who lambaste America’s “socialist policies” offer glowing praise for China’s government and their preferable treatment to investors.)

Economic policy is but one element as to what a government does.  This overemphasis on tax policy is a big part of why some greatly over-exaggerate the political risk in this country right now.  There are way more variables to governing than just how you approach taxes.  Policy generally speaking is much broader than how governments treat investors.  Our system is stressed, but it is not broken.  We in this country have longstanding principles and traditions that have withstood the test of time and have afforded generations of people an opportunity to partake in the American Dream.  If a cheaper tax rate for Steve Wynn is worth assuming the political risk of China that’s his choice, but in the grand scheme of things, there is just no way to compare the governments of the two countries.