CFA Hiatus

As the final months of preperation for Level II have taken a toll on posting, please be aware the members of Abrnomal-Return are on hiatus until early June.

More Non-Traditional Monetary Policy, Finally

The FOMC announced today that it intends on purchasing up to $300 billion in long-term treasuries over the next six months. Additionally, it is open to further expansion of it's balance sheet through the purchase of up to $750 billion of agency mortgage-backed securities.

This is the type of policy that we feel can be extremely effective in the current environment, especially through the creation of inflation expectations. An increase in inflation expectations will likely stimulate spending in the private sector (creating the feeling among consumers and small businesses that my $1000 dollars today won't be worth $1000 a month from now). I will be the first to admit that this won't return us to the level of consumption we saw pre-financial calamity, but it will have a positive affect on economic activity in the near term (more so than building a skate board park in East Wichita).

This is certainly a step in the right direction in terms of policy.

Is the ECB Still Worried About Inflation?

As I argued previously, I feel that the Fed should be employing a more aggressive monetary policy in the current economic environment (liquidity trap theories and all). However, we should be thankful that we have Bernanke, and not Trichet running the central bank. The actions taken by the ECB thus far seem mind boggling. The fact that they are still at 1.5% target rate given the extreme adversities facing the Eurozone is amazing and will in hindsight prove to be a massive policy mistake. The weakness associated with the rigidity placed on monetary policy given a diverse set of individual economies under a single currency is rearing its ugly head.

Ambitious Budgeting

Today President Obama released a draft budget that promises to cut the deficit, reducing it, as percentage of GDP, from 12% to 3%. The President fulfilled his budgeting promise by no longer excluding various outlays such as wars and natural disasters (which was common under George Bush). However, many economists believe that although the plan might be more transparent then previous budgets, the assumptions built in seem “wildly optimistic”.

The President’s budget assumes that from 2010-2013 the US economy will grow by a brisk 4% per year. This growth estimate is above the latest private sector estimates that were released in January. Since then, the likelihood of an economic recovery in 2009 has dropped, and the next private sector estimates will likely be even lower.

Even if the economy does not slip into a very lengthy recession or period of stagnation, the President’s 3% goal is extremely ambitious according to Alan Auerbach of The University of California at Berkley and William Gale of The Brookings Institute. The two predict the deficit will bottom out at 5% of GDP in 2013 but then climb to 6% by 2019.

Such lofty revenue assumptions could indicate that President Obama is trying to prove to the country that he truly believes in the optimistic vision outlined during his first address to Congress.

Monetary Policy

The following is a comment I posted on the recently established blog of Scott Sumner, a very intelligent economist who provides an interesting outlook on the role of monetary policy in the
current economy, and more broadly:

Certainly, further use of monetary policy should play a role in the current stimulus efforts as the policies outlined thus far are likely to be ineffective in terms of closing the output gap and generating substantial economic activity. Its evident that the latest iteration of the stimulus package is relying on the traditional Keynesian framework, based on substantial spending multipliers. Given the current economic condition, the effects of the proposed fiscal spending policies will likely fall short of expectations (too small, likely to be allocated extremely inefficiently, Ricardian equivalence as a real factor in consumer and business behavior, etc). Furthermore, the tax cuts that have passed are also unlikely to generate the desired effects. We would have been better served with payroll tax cuts as suggested by Mankiw.

As a result of the aforementioned shortfalls of the current stimulus policy it seems necessary that an effective use of non-traditional monetary policy will have to be employed alongside the current stimulus in order to generate economic growth. While the fiscal spending and tax cuts are likely to have some stimulus effect, albeit
multipliers are likely to fall short of expectations, it seems likely that monetary policy can indeed be effective in the current environment despite the fact we are facing a zero bound.

Take as an example, the very entity that most economists are relying on to lead us out of this economic slump, the consumer. Over the past decade a significant increase in household debt has fueled the type of PCE that has sustained economic growth. As a matter of fact, household debt as a percentage of PCE reached an all time high of 140% in 2008 and as you would expect there is a significant correlation between the increase in household debt outstanding and the percentage change in PCE, in real terms and on and annual basis (p value <.001). It is reasonable to suspect that the absence of a proper stimulus will lead to a significant de-leveraging in household debt outstanding and in turn further decreases in consumer demand (why should the financial institutions have all the fun).

As previously mentioned, it seems unlikely that the proposed fiscal policy will be effective in containing the de-leveraging in the consumer sector, and a significant
increase in the money supply coupled with aggressive inflation rate targeting rhetoric from the Fed could better serve to stabilize current household debt levels, increase consumer demand, and in turn support PCE.

Sumner appears to be one of the only economists consistently pointing to the fall in aggregate demand (recently Martin Wolf has noted the same) resulting from a contractionary monetary policy and a failure by the Fed to prevent a crisis from spreading following the sector-specific sub-prime collapse, as the basis of the current crisis. While other economists have reverted back to traditional Keynesian models, Sumner has shown consistency in his belief that it is monetary policy primarily (if not solely) that should be used to stimulate the economy. As a student of the Great Depression, much like Bernanke, his views certainly warrant consideration.

All 20+ of Sumner's posts so far are worth a read by anyone truly interested in getting a fresh take on the current economic situation and potential solutions.

Zombie Bank Apocolypse: Greenspan Gives Nationalization the Nod

As more and more economist, politicians, and citizens accept the reality that at least some of the major U.S. banks are insolvent, and that a temporary nationalization and restructuring may be the only way to remove toxic assets from their balance sheets and repair the credit markets, it is not suprising that the whisper of nationalization continues to grow.

”It may be necessary to temporarily nationalise some banks in order to facilitate a swift and orderly restructuring,” said Alan Greenspan (a major contributor to the current crisis through policy that left interests rates too low). “I understand that once in a hundred years this is what you do.”

“We should be focusing on what works,” Lindsey Graham, a Republican senator from South Carolina, told the FT. “We cannot keep pouring good money after bad.” He added, “If nationalisation is what works, then we should do it.”

President Obama is correct in noting that, “We need to end a culture where we ignore problems until they become full-blown crises,” unfortunately, his administration is doing just that with TARP2.

While the "stress test" of the major banks continues to be a centerpiece of anticipation (especially given so few details), my concern is that if the Obama adminsistration is against nationalization, the likelihood that the test reveals insolvency and a need for restructuring decreases.

Reiteration of the Ridiculousness - A "Buy American" Update

To reiterate the "Buy American" clause included in the latest stimulus package is a representation of the flawed understanding of both basic economic and financial principles continually displayed by those people responsible for engineering the fiscal stimulus package, republicans and democrats alike. As outlined previously, a "Buy American" clause is EXTREMELY effective at accomplishing the following:

1. Enriching selected industries, such as the steel manufacturing industry, at the expense of the economy as a whole (steel manufacturers collect additional revenues, but the artificially high prices divert demand away from other industries).
   
2. Not increasing employment for the US economy as a whole (steel manufacturers see a decrease in unemployment , but as mentioned above the artificially high prices serve to dampen demand in other industries leading to job cuts in those industries).
   
3. Angering our trading partners with a protectionist trade policy

China does not agree with the policy and has vowed to keep a "Buy Chinese" clause out of their stimulus package. Maybe we can get Chinese policy advisors to talk some sense into US politicians.

Zombie Bank Apocolypse: Semantics & Acknowledgement

Our favorite Hardvard Economist Greg Mankiw points out what "pre-privatization" should be.

Paul Krugman emphasizes further my point that nationalization may be unavoidable.

UPDATE: Robert Reich draws similiar nationalization conclusions.

Zombie Bank Apocolypse: Updates & Agreement

As noted previously, vagueness and a lack of willingness to admit insolvency could be potentially plagueing the Geithner Plan and the US Banking problems respectively. Many others have reached similiar conclusions:

Rober Reich points out Geithner's Plan: It's Not Transparent and It's Still a Bailout

The FT's notes that the US can learn from Japan’s crisis

The NYT's explains that In Japan’s Stagnant Decade, Cautionary Tales for America

The overall conclusion? If the US doesn't do something about the zombie banks (or at least recognize they exist!) we are headed down the same path as 90's Japan. As our crisis reaches much further than the banking/financial sector alone, we could be in for more than a lost decade.

Zombie Bank Apocolypse: The Potential Case for Bank Nationalization

Following Secretary Timothy Geither's outline of the Treasury's and Obama Administration's "New Financial Stability Plan" there was an immediate and negative reaction in the marketplace, primarily driven by a lack of details, and concerns over the "stress test" to be conducted on the nation's largest banks. Noticeably absent from the plan, too, was any language that indicated a "bad bank" scenario (thankfully), or any form of nationalization (seemingly replaced with the Public-Private Investment Fun). Ultimately, based on leaks in recent weeks, the plan seemed weaker than what was anticipated, and was revealed to still be largely a work-in-progress.

Although it is difficult to gauge the likelihood of success, or lack thereof, in the new TARP plan given so few details, an analysis of the planned "stress test" is warranted, as it clearly has posed significant cause for concern. It would be foolish to assume that the Nation's largest banking institutions were not already swarming with regulators and in-house analysts prior to this announcement, indicating that even more scrutiny is required to comprehend the situation, and, that reality of insolvency may finally need to be acknowledged. The NY Times, in fact, noted that "nearly 100 federal banking regulators descended on Citigroup Wednesday morning". Furthermore, at least for now, the test will continue to stifle bank's desire the make the loans other parts of the plan seek to reinforce. No intelligent board of directors would do anything but hoard cash, as regulators scrutinze their balance sheets. The "stress test," logically, will place banks into one of three categories:

• No assistance required



• Need for additional assistance (Capital Assistance Program)



• Liquidation/Nationalization

Clearly, this "stress test" attempts to continue to avoid zeroing of shareholders, discounting lenders to these institutions, nationalizing, and reorganizing the banks if at all possible, however, as Martin Wolf explains, such a notion may be fundamentally flawed:

"All along two contrasting views have been held on what ails the financial system. The first is that this is essentially a panic. The second is that this is a problem of insolvency. Personally, I have little doubt that the second view is correct and, as the world economy deteriorates, will become ever more so.

But this is not the heart of the matter. That is whether, in the presence of such uncertainty, it can be right to base policy on hoping for the best. The answer is clear: rational policymakers must assume the worst. If this proved pessimistic, they would end up with an over-capitalised financial system. If the optimistic choice turned out to be wrong, they would have zombie banks and a discredited government...

...Why then is the administration making what appears to be a blunder? It may be that it is hoping for the best. But it also seems it has set itself the wrong question. It has not asked what needs to be done to be sure of a solution. It has asked itself, instead, what is the best it can do given three arbitrary, self-imposed constraints: no nationalisation; no losses for bondholders; and no more money from Congress. Yet why does a new administration, confronting a huge crisis, not try to change the terms of debate? This timidity is depressing...

...The correct advice remains the one the US gave the Japanese and others during the 1990s: admit reality, restructure banks and, above all, slay zombie institutions at once."

So what is President Obama's thoughts on the scenario, the driver behind the Treasury's "stress test", continued bailout, and unwillingness to even consider true insolvency?:

PRESIDENT OBAMA:

"Well, you know, it's interesting. There are two countries who have gone through some big financial crises over the last decade or two. One was Japan, which never really acknowledged the scale and magnitude of the problems in their banking system and that resulted in what's called "The Lost Decade." They kept on trying to paper over the problems. The markets sort of stayed up because the Japanese government kept on pumping money in. But, eventually, nothing happened and they didn't see any growth whatsoever.

Sweden, on the other hand, had a problem like this. They took over the banks, nationalized them, got rid of the bad assets, resold the banks and, a couple years later, they were going again. So you'd think looking at it, Sweden looks like a good model. Here's the problem; Sweden had like five banks. [LAUGHS] We've got thousands of banks. You know, the scale of the U.S. economy and the capital markets are so vast and the problems in terms of managing and overseeing anything of that scale, I think, would -- our assessment was that it wouldn't make sense. And we also have different traditions in this country."

Speaking of pumping money in:

Obama clearly believes American culture will not warrant or allow the case for nationalization. I'm a strong proponent of free-market capitalism, but failure on the part of the government can become much more damaging than the failure of the invisible hand. I'm also not convinced that public perception of nationalization is so damaging it is impossible to execute, against a scenario where the private sector enjoys the upside while the taxpayer is exposed to all the downside as is likely to be the case with the Public-Private Investment Fund. Perhaps more frightening in Obama's statement is the comparison of number of banks. Sweden may have only had "like 5 banks", but the problem in the U.S. is concentrated in the 6 largest institutions. Insolvency may ultimately be an unavoidable reality, and it lays the basis for a case for bank pre-privatization.

Retail Sales Rose 1% in January, Now Back to Reality

Retail sales increased 1% in January on a M-O-M basis. This is the first increase we have seen in this measure in seven months. However, there is still little room for optimism as unemployment rates continue to soar and the stimulus plan becomes more watered down, and in our opinion less effective with each iteration. It seems evident that consumer activity and more specifically the marginal propensity to consume will remain at depressed levels through most of 2009 despite the efforts of the public sector to provide a stimulus to the economy. Politics as usual (Republicans focused on tax cuts, Democrats focused on spending, when in reality it should be an effective combination of permanent tax cuts, strategic spending initiatives, and continued use of non-traditional monetary policy) have adversely affected the stimulus plan and in turn left us with a package that is too small and feeble to address the massive output gap and effectively stimulate economic activity.

Stimulus Bill Reconciled

Congress has reconciled the competing stimulus bills.

1.) Final cost of $789 billion
2.) $35 billion cut from state stabilization fund
3.) Pared down tax cuts, both the earned income tax cut and tax credits for buyers of autos and real estate
4.) Despite the sparse details at this point, it appears to resemble the Senate's version more than the House's
5.) Nobody seems to be happy about the bill

My biggest disappoinment: cuts from the state stabilization fund, where arguably better spending decisions could be made then by federal agencies, and where jobs could be immidiatly saved.

Treasury Secretary Timothy Geither Outlines New Comprehensive Financial Stability Plan

Treasury Secretary Timothy Geither outlined plans for a "New Financial Stability Plan" comprised of primarily four things:

1. Stabilization of the system and restoration of confidence in markets- Federal bank regulators will come together to institute uniform standards to help clean up and strengthen banks, and conduct "stress tests" to ensure the nation's largest banks can withstand a worsening economy.

2. Revitalization of lending and increasing much-needed credit flow to consumers and businesses - The Treasury and the Fed are creating a new consumer business lending initiative to leverage up to $1 trillion dollars to stimulate the secondary lending markets, bringing down borrowing costs for worthy borrowers and unfreezing credit markets.

3. Get financial markets working again- Creation of a new Public-Private Investment Fund which provide government capital and financing to leverage private capital to buy up the "toxic assets" impacting lending. This would allow financial institutions to clean up their balance sheets while letting private sector buyers determine the price for previously illiquid assets.

4. Curb the housing crisis - Treasury will work with the Federal Reserve to commit $50 billion to reduce monthly payments and establish loan modification guidelines for government and private programs. The Financial Stability plan will also require all firms receiving federal funds participate in foreclosure mitigation plans to stem the housing crisis.

As a response to the public perception of the first half of the TARP dollars, a new framework of oversight and transparency has been developed.

At first glance, this plan seems to be a much more logical approach to the remaining TARP dollars (and potentially an additional $2.35 trillion) that addresses many of the underlying problems of the current crisis instead of narrowly focusing on bank re-capitalization. Lowering mortgage rates and enforcing forclosure mitigation could be a solid first stem in stopping the free-fall of housing prices (although I still anticipate at least a 10% decline). Furthermore, the creation of the Public-Private investment fund, is a very creative response to the removal of bad assets from lending institutions to solidify the balance sheets; using private valuation and incentives to price the assets, with government gurantees supporting transactions. This certainly is meant to replace the "bad bank" scenario, and, at least for now, does not head in the direction of zeroing out shareholders and discounting creditors. It should be noted, however, that these two approaches seemingly appear to work against one another.

Full text of speech

Stimulus Bill: House & Senate

Over the past several weeks, the two sides of Congress have been developing two related but distinct versions of the Stimulus bill.

The House plan totals $819 billion and includes:

• $637 billion in spending; $182 billion in tax cuts
• $80 billion in state stabilization to assist states with budget problems
• $91.3 billion in education (spending), including $20 billion to renovate schools and $17 for student grants
• ~$135 billion for unemployed assistance and increases in federal Medicaid assistance (tax cuts)
• $82.1 billion in additional tax credits, which combined with the Medicaid assistance provides for a credit of the earned income tax for some taxpayers (tax cuts)

The $827 billion Senate plan is similar, but some notable differences include:

• ~$100 less in spending, including less allocated to renewable energy
• ~$100 more in tax cuts, including tax credits for buyers of new cars and for buyers of any primary residence

Some notable features of both plans:

• The Congressional Budget Office estimates that it will take years for the entire stimulus to filter through the economy, with the spending portions being the slowest. About $525 billion, or 64% of the House's total plan, will make it into the economy within a year and a half. The majority will make it into the economy by 2014.
• Infrastructure spending on "shovel-ready" projects (at about ~$50 billion) is a relatively modest percentage of the entire stimulus package.
• State stabilization may be the most important element of either plan: the states are in such poor shape that $80 billion is needed to simply stop the cuts in jobs and services right now.
  

A graphical look at the House Plan.

"Buy American," Give me a Break

The so-called "Buy American" clause that has found its way into the latest iteration of the fiscal stimulus package has attracted a lot of attention, and rightfully so. Are we really so desperate that we are willing to revert back to a protectionist trade policy and in the process destroy decades of trade reform that has benefited US businesses and consumers alike? Let's take a look at the two main objectives this brilliant policy will accomplish (using the example of a "Buy American" provision on concrete):

1. We piss off (excuse my French) our trading partners including the Euro zone and China by distorting the international open market for concrete. Is it a good idea to upset your trading partners in a time of economic crisis, especially when exports were one of the biggest contributors to GDP in H208? The EU has already publicly acknowledged that they will file a trade claim against the US if the "Buy American" provision finds its way into the stimulus package.

2. A few players in the concrete industry along with concrete workers benefit, while the cost is transferred to the rest of the nation. For example, we end up spending $300m building a school using overpriced US concrete as opposed to spending $200m using cheaper imported concrete. Is this really beneficial to the taxpayer who is on the hook to pay for this school? And while this provision benefits the concrete workers it is extremely disadvantageous to the remaining US workers, employed in other industries that are adversely affected by the high prices (stifles demand in non-concrete related industries) and artificially inflated wages in the concrete industry.

This fiscal stimulus plan continues to become more unimpressive by the day.

UPDATE: OBAMA AND COMPANY SMARTEN UP

GDP Contraction in Q4

GDP contracted in the fourth quarter at a 3.8% annualized rate. The silver lining of this very dark cloud is that the GDP figure beat the consensus estimate, which forecasted GDP contraction at 5.4% for the quarter. GDP saw most of its contribution come from a combination of built up inventories and continued strength in exports. This should be of little comfort as both of these contributors are likely to be decimated in 2009 as consumer demand continues to plummet and the dollar strengthens amid continued monetary easing on a worldwide basis. The moral of the story is we can expect further declines in economic activity in 2009 as the culture of de-leveraging continues in America and abroad.

Good Read

Article from December issue of Portfolio.com by Michael Lewis

"It Will Get Worse Before It Gets Better"

While on business travel I enjoy watching the local news in the morning to get a sense of what issues are important to people in the viewing area I happen to be visiting. This morning in Fort Walton Beach, FL the top story was the cold front that might bring snow to the Tennessee valley later in the week. What was not the top story but was included in the broadcast was the fact that this county in Florida has an unemployment rate of 9.3%. I am guessing that the producers realize that reminding people of the economic reality around them will not exactly give them a lift to start their day.

Just as people here in Fort Walton Beach no longer want to hear about the economic troubles that face this nation, it looks as though Wall Street might becoming slightly immune to bad news. On a day where California announced its unemployment rate was getting very close to 10% and 6 major companies announced they would be laying off a combined 68,000 employees, the markets didn't sell off but actually managed to hold onto some positive ground.

Some economists are hoping that the onslaught of negative news will make it easier to pin point when the economy bottoms out. Just as quickly as the recession came, it can turn around in a period of just a few months and we will then start hearing about companies re-hiring many of the same people that had to lay off during this downturn and at that point we will know it is over.

Obama, Optimism, and Equities - A Rational Viewpoint

There is no doubt a feeling of unbridled optimism among many U.S. citizens who feel that President Obama will undoubtedly bring "change" to the United States. If we are to take yesterday's mass euphoria as an indicator of this coming "change" it will likely result in 0% unemployment, 10% GDP growth, and the re-emergence of a pre-ABS financial system (excuse the sarcasm).

While I feel that our new President will surely take the actions he sees necessary to stimulate economic activity it seems almost inevitable that the results will fall short of expectations. This is especially true when we look at the latest iteration of a fiscal stimulus package based on ineffective government spending and tax cuts aimed at a consumer whos marginal propensity to consume is at its lowest level in over 60 years. This ill-planned and undersized fiscal stimulus package coupled with the limitations now facing monetary policy (as we are up against the zero bound) equates to a long road to economic recovery.

As the realization that Obama will not be able to wave a magic wand and return the United States to economic prosperity in the blink of an eye results in a drastic reassesment of people's expectaitions we can expect further and increased contraction in economic activity (i.e. decreased consumer demand, capital investment, etc.), and as a result further downward pressure on the equity markets as we work our way through 2009.

International ETFs

The “BRIC” Countries (Brazil, Russia, India, and China) are the 4 developing nations likely to continue to have strong domestic growth over the next decade and beyond. These countries have rapidly growing middleclass’ that will prevent their economies from topping out anytime soon. The easiest method to get exposure to the economies of these countries is through ETFs. Risk adverse investors have crushed these ETFs over the past 6 months and after a huge pull back from 52 week highs these international ETFs could have huge upside potential. The question is which one? I would immediately knock off any ETF tied to the Russian indices. The Russian economy is tied to energy prices and there is currently a lot of political instability in the area. I would also take India off my list. Much of India’s growth was a result of companies from the US and Europe outsourcing to India. As the US and Europe go through a downturn, the growth of those jobs will slow and put pressure on the fledging middle class that relies on them in India. Which leaves Brazil and China. The two ETFs I would look at are EWZ (iShares MSCI Brazil Index ETF) and FXI (iShares FTSE/Xinhua 25 China ETF). See comparison charts below:

The performance of these ETFs is almost identical. However, the sector weighting of each ETF is very different. (see charts below).

52% of EZW is in Energy and Materials and 40% of FXI is in financial services. Knowing this makes the decision easier. If you believe energy and material prices will rebound, EZW is the best pick, but if you think Chinese banks will be stimulated by government assistance FXI is a buy. To hard to make a decision? There are also ETFs that have exposure to each of the BRIC countries.