From My Cold, Dead Hands...


Much has been discussed about the need for China to rebalance their economy away from fixed asset investment towards domestic consumption. The future of the Chinese economy, and implicitly their political and social stability, appears to be in the hands of a relatively small elite who run the state owned enterprises (SOEs).  


But with  the lack of a social safety net provided by the government and growing lack of jobs outside of the SOEs, consumers aren't buying. Privitising the SOEs might be the most effective way to energize the small and medium enterprise business sector, unlock resources needed to once again recapitalize banks and initiate a social safety net, and finally create the rebalancing path needed to move away from an investment led economy.


Sounds good on paper, but maybe the warlords of China's past are now SOE leaders and their entourage? They have a gold egg laying machine and they will not give it up without a fight. They have influence at the highest level of leadership and likely view their SOE power platform as a province of their own. The path to a stable and growing China is through these wealthy mooks and their grasp on power brings up images of Charlton Heston barking for the NRA.   

Status Report

A new year with old problems: slow growth in the US, an imbalanced economy with insolvent banks in the EU and a slowing China. In the near term for the US: will the jobs numbers continue to improve? Will the government lead a deal to clear the single family home inventory? Will the government act on anything? When will the US worker and investor realize the 3%+ growth days are behind us? 

In the EU the next milepost is the Greek bond refunding in late March. They must reach an agreement on a debt restructuring deal with the private sector in order to receive more funding. The deal must be "voluntary" or it will mean default and CDS contracts will come into play and we don't really know the size of various financial institutions' sovereign EU CDS exposure.

We do know the EU is likely in recession and the US must be close and we do know the ECB must continue to provide liquidity by buying sovereign debt. They introduced a long term funding program in December that provided about 500B euros in liquidity, using sovereign debt as collateral, and they are expected to introduce a second facility in excess of 1T euros in February, god willing.

For China, we don't know how to use their "official" statistics, but we do know the transition from a fixed investment focused economy to a consumer driven economy must happen soon. New leadership comes at the end of the year so we must also assume any tough adjustments will be delayed. While that might mean a return to easy money, they are not in a position to spend like '09.

Governments everywhere continue to delay the long, slow deleveraging process as much as they can to ease the correction. They are searching for some balance between short term deficit issues, long term obligations and an aggressive monetary policy that will allow for a solution. For the US and the EU, this solution must include higher inflation and negative real rates to deflate the debt to manageable levels, and improved productivity to rebalance current accounts.

Deficit Panel


This is a big deal. If any legislation passes that comes even close to the proposals of the deficit panel, the US could finally begin to see the kind of change in the machinery of government that has long been needed - less fraud, influence, lobbying, etc. Economic stakeholders want clarity, uniformity and stability in the institutional rules and procedures. These proposed changes would provide for these stakeholder needs, likely resulting in increased investment and risk taking, with proper incentives in these activities that would lead to fewer economic imbalances.

This will be almost impossible to accomplish. The interests that will be lined up against this proposal are huge, powerful and wealthy. Perhaps the biggest change is the elimination of the mortgage interest write off. If there was ever a time to be able to get support for this kind of massive change from consumers, it is now. Given the total number of mortgages underwater/jingle mailed/foreclosed and the age of the average mortgage that is above water, this is the best time to get consumers behind this change. But the institutions such as home builders, with massive political influence, will fight this all the way. This will be an important battle to watch over the coming months and years.

As Goes Housing...


...so goes the economy. It will be hard enough to sustain consumer spending in the coming years in the face of retiring boomers, lower real wages and continued debt reductions assuming housing stabilizes and shows an ability to recover some value. But without a housing recovery, savings rates will be higher than needed, making a consumer recovery worthless. Get ready for some major league new thinking in how to resolve the housing problem. As a reminder: massive unsold home inventory, massive shadow inventory in the wings, millions of homeowners underwater and millions more close to underwater...

A New American Model


It has become almost trendy for news commentators to note the end of the American Way - optimism, courage, ambition, faith in the system, etc. The old model is flawed: it is about time it ended. The old model is based on debt for consumption, for financing businesses and government and for investing in assets. This model has built in limits - how much debt can be serviced by an asset or individual across an economic cycle.

The reality is that creating wealth is hard work and may take a lifetime. Saving, building, investing, growing - these are ideas that take time in any normal economic system, even one with low taxes. The new American model will reflect these ideas but only after we have paid down debt to sustainable levels, including government debt. This means a new tax policy that actually generates the necessary receipts from the wealthy. There is no getting around this - the wealthy have the assets and income and they have access to the resources to create additional wealth.

We will need both political parties to recognize that we cannot return to the old system. There is a grieving process in there, as ideology changes and practical minds come to the fore. This kind of political change takes time, but the American economy isn't going anywhere: we have the time. The only part of the American Model that will stay intact is the ability to adjust.

The Grind


I guess the double dip question still stands. US, UK and China growth are all heading down. For the US market you add in growing volatility and cross correlation and an increasing probability of deflation and it's pretty tough to be an investor in equities. The only happy way out of the western debt crisis was growth.

But without a consumer that can spend, growth will be difficult - whether it's the US consumer who is to broke or the German and China consumer who is too smart to spend. Fiscal spending can help but only to a point - it is debt financed spending that quickly produces diminishing returns. I guess we will have to wait for the US consumer to pay down debt, retrench and change behavior and expectations built up over a generation. We will certainly need to see housing stabilize, finally.

Without growth, we can devalue our debt through inflation. This is the job of the central bank and short of handing out money at the western union stores, they are doing pretty much all that they can. But there is no guarantee that a central bank can create inflation no matter how hard it tries. If banks don't lend, borrowers don't borrow, and consumers don't spend, then the money doesn't move and inflation turns into deflation. Add in lots of excess Chinese production capacity and an undervalued RMB. Japan has struggled with this for 20 years. It is not clear how the US will avoid this without some additional extraordinary and unconventional fiscal and monetary stimulus.

This outcome suggests the dollar will continue it's long term decline, particularly against the export currencies like China's RMB, but also against the safe haven currencies like the Swiss Franc, the Kronor and maybe the commodity currencies. Gold still looks good given the lack of clarity provided by the European bank stress test, the ongoing lack of GDP growth and the sovereign balance sheet issues still lurking in the PIIGS.

Ireland has more bad bank loans to nationalize, pushing their economy perilously close to a debt tap: GDP is down 20% from the peak, debt close to 100% of GDP and growing. Spain has yet to realize the full impact of bad mortgage loans resulting from declining house prices - down 10% from the peak given the overbuild seems a bit lite. When the house price decline becomes clear, it will further crush the Spanish consumers and  banks and therefore the Spanish government balance sheet. It will also likely feedback into the British market given the level of UK exposure to the Spanish housing market.

The China question is equally unclear. We can all talk about the downside to social stability if growth drops for too long, but blowing the country's balance sheet on worthless investments might be equally bad. The government is trying to slow the economy down and it is becoming clear there are natural limits to growth - things like pollution. But it may be the stimulus to growth that is the bigger problem: if the West slows significantly, then China could be hit by both a decline in the export markets and a decline in Chinese consumers. It is not clear China has the mechanisms and policy in place to meet this type of challenge.

This line of thought is interesting: stagnant growth in China would mean (aside from social instability) a decline in commodity volumes, hammering the Australian, Canadian, OPEC, Russian and Brazilian economies. The only antidote to this is for the China infrastructure machine to kick into even higher gear and I guess it's a question of how much money the state can spend through this channel. At $2.5T they have the foreign reserves to do it, but if they need to spend $400B a year on growth and their trade turns negative, those reserves could disappear fast.

So the chip rebound looks like a failure - inventory restocking and heavy reliance on cars and consumer electronics, all bets off there. Gold is still a long with increased uncertainty in western growth and the need for US inflation (it is our only way out). The US rate declines look set to continue. The long GBP trade is off and the short EWP trade is on. The UK will run into problems getting their austerity program through while keeping the coalition intact, not to mention the changes to the electoral system. Spain has more declines in housing prices ahead.

I like RIG long in the low 50's. It's as uncorrelated to the S&P as you can get and less correlated to oil than normal. It's dirt cheap, has limited liability to the GoM exposure and will be paying a dividend again. And it has the best in class fleet of off shore drillers. Oil would have to get hammered for RIG to go below $45. And that's it for conviction. If you have a retirement portfolio, you should be in a fixed income ladder, some equity with big dividends to top up income (and maybe some highly rated apartment REITs as well) and a long term S&P put to protect that equity capital exposure.

Backed into a Corner


The governments of Germany, France and Spain have officially made the commitment to open the financial kimono towards the end of June/early July and reveal banking stress test results. Based on the stated objections of the head of Germany's landesbanken, I'd say there will be some ugly results. But this is an absolute necessity to move forward.

Ever since the Minsky Moment, the eurobanks have played the carry game, borrowing for free from the ECB and buying sovereign debt. Their capital requirements are low for this type of asset but still allow some yield with PIIGS sovereign debt. So while the US and the UK forced their banks to clean up and recaptialize with proper funds (we think), the ECB simply allowed banks to lower asset risk, lowering capital requirements and  allowing them to avoid a costly recapitalization.

Unfortunately, the banks now own a ton of PIIGS sovereign debt, so what was until now a concern about the sovereign solvency of the PIIGS has moved to a concern about the solvency of the core euro country banks, and by association, the core euro sovereign solvency. It seems a fair bet that Germany is facing the double whammy of low grade PIIGS sovereign and impaired commercial assets. Spain has the impaired commercial assets plus Portugal and France maybe only the PIIGS sovereign exposure.

Collectively, the sovereign balance sheets backing the Euro are about to get a lot worse in the mark to market event that is the stress test. The good news is that should be the end of the bank solvency uncertainty and allow investors to operate with better information. The bad news is that the results will likely put more pressure on the core countries to cut budgets, kill near term GDP growth and set the western world up for a very tough 2H'10 and '11.

That suggests monetary tools will be more important and low rates for longer and more deflation. It seems that in order to avoid an insolvency debt trap, the budget cuts will be big and economic growth ugly for a while. I don't know if that's the right decision, but it is the one that governments appear to be making. I am starting to wonder if one of the results of the stress test reveal will be a big hit to gold; after all, we will finally have known financial balance sheets. Gold is for the unknown.

Still liking the rally, looking for a bigger right shoulder. Have been hugely oversold and expect more bounce. Micron numbers coming in a couple weeks, should kick off a strong tech rally into the quarter. Own oil - the GoM crisis is hideous, but doesnt it make oil more expensive? The counter argument and I think longer term one is that the above notes on crap GDP growth mean oil goes lower. Long the GBP, ISSI, AAPL, BAC, AMAT. Starting to look at long dated S&P Taleb puts...