Idle labor, idle capital, perverse austerity

The great recession of 2008-09 has left us persistent high unemployment, record low interest rate, large corporate and bank reserves. Consumers are struggling to repair their balance sheets, yet neither governments nor large corporations are doing much to help solve the economic slump.

What's going on? Can "market" solve the problem on its own? And what do we mean by that, anyway?

The only sensible diagnosis I've seen so far by economists is that the "advanced world, accounting for 70 percent of world GDP at market prices, is in a liquidity trap."

What should be done?

In the words of Nobel Laureate Peter Diamond:

On the nation’s unemployment problem and how infrastructure spending could help solve it:

–Most of [the 9.1% unemployment rate], more than half of it, is inadequate aggregate demand and what we need now, very badly, is more fiscal stimulus and the continuation by the Fed of rolling out monetary stimulus as it fits their projections of what’s going on.

–Right now we have idle labor, idle capital… [and] interest rates are low, so doing it sooner has that advantage compared to doing it later. And third we do get a Keynesian multiplier out of it. –The fact that infrastructure spending will be phased in slowly doesn’t seem to me a shortcoming right now, because all the forecasts we’ve seen say coming out of this [malaise] is going to be a slow process.

Are we headed for another recession?

–There’s no question that we’re vulnerable….. It’s really important to put into place policies that would have the long-run effect of reducing debt growth. But there’s nothing on the debt side we need to do immediately. We do not have a debt crisis. We have a long-run debt problem and austerity today is perverse from the point of view of unemployment, and insofar as the economy is vulnerable that will make it more vulnerable, and of course a double-dip [recession] will lose us a lot of tax revenue.

Professor Diamond is known for his "search" model of labor market, which brings in a form of market friction to explain the lack of clearance in labor market. Even he thinks the unemployment problem is mostly an aggregate demand problem. The rest could perhaps be attributed to "structural" problems such as skill mismatch.

The interview with WSJ's Kelly Evans shows these takes and views:

Doing a lot more with a lot less

The U.S. corporations have recovered remarkably well. Revenues and earnings are growing in a slow-growth economy. As Jack Welch puts it: The American corporations have learned to do a lot more with a lot less.



Large corporations have a lot going for them: extremely competitive labor market and technologies allowing them to cut costs. On top of that, cost of capital has been driven to historical low as the Fed fights the great recession. They're also able to tap into the fast-growing emerging market economies for demands on their goods and services. The Fed is lending a helping hand here too by maintaining the easy money policy which tends to drive down the dollar.

A natural question to ask the government is why can't it do a lot more with a lot less? The Republicans are clearly on the affirmative. But can austerity really help small businesses and help create jobs? You just can't run a government as if it's a corporation.

Can labor or consumers manage to do a lot more with a lot less? Somehow you just can't push that logic very far with tens of millions of unemployed and under-employed.

Obama's job bill may be too little too late, if it gets passed in some form at all. The Fed's latest "operation twist" (a double twists) may be too little as well. A twisted QE may have more sense given the grim outlook. More firepower should be concentrated on the mortgage market. At least the Fed is trying.

Luxury resilience and operation twist

The mainstream de-leveraging consumers continue to struggle in face of persistent high unemployment and housing market slump. The great recession hit both their income and their wealth hard. Low-end retailers such as JC Penny and Walmart are not doing well.

The mainstream consumer is powerless in driving the recovery.

Consumer spending is now overwhelmingly the story of the luxury shoppers. While a small segment of consumers, they wield an outside impact on the broader economy, earning roughly 50% of the total income in the U.S. and making about 48% of total expenditures.

The newly rich in emerging economies are also making their spending power felt around the globe from luxury accessories to luxury cars and homes. Here are some interesting recent reports:

Hermès cannot meet demand for luxury.

LVMH Sees No Slowdown in Luxury Goods Demand.

Urban luxury homes are back in demand, aided by new foreign buyers from Russia, China and Brazil.

Luxury spending picks up even as economy sputters (The Detroit News).

Even the recent market volatility hasn't affected their mood to spend.

The stock market recovery since 2009 has a lot to do with it. The Fed's easy money policy has a lot to do with it.

If the Fed wants to stimulate the economy, the wealth channel is both obvious and effective. This segment of the consumers are credit-worthy, cash-rich and asset-rich. They're the most likely candidate to lever up somewhat. If the banks want to lend, who else would they want to lend to?

Businesses catering to their needs are expanding, both domestically and internationally (see the recent earnings reports from Tiffany, Raulph Lauren, Nordstrom for example).

The recovery on the highend will trickle down. The Fed must pay a lot of attention to this most promising pillar of economic recovery where monetary policy has been and will continue to be effective.

If the Fed twists this Wednesday, risk-premium would be lowered. Investors would be chased out of safe-haven to take on more risks. Risk assets would be supported to some extent to counter the fear of Euro/Banking crisis and the fear of recession. This is not to create another asset bubble, but to ensure the recovery is in-tact.

Higher inflation rate may be allowed by the Fed

Interesting two-part interviews with Charles Evans, Chicago Fed president. He argues that the Fed's accommodative policies have been working, and he would support further aggressive easing.





In particular he mentioned that a high level of inflation rate (say, 3% per anum) should be allowed.

He also mentioned a recent opinion piece on Financial Times by Professor Michael Woodford, a leading monetary macro economist, which focuses on setting inflationary expectations as a policy tool.

Stiglitz: reverse tax, medical benefit, war & downturn

He touches on the wrong focus in Europe, the broad policy reversal that are needed, and what the Fed can and should do.

What are the options on the fiscal side?

For a serious discussion on tax reform and practical options to create jobs, here.

Was QE2 effective?

Slow growth and market turmoil have brought us back to QE. Markets are expecting QE3, to be telegraphed perhaps as soon as the end of August at Jackson Hole.

It's important at this juncture to ask if QE2 has been effective. Most financial commentaters have dismissed its effectiveness out of the casual observation that the economy is still not growing very much and unemployment rate is still very high. Here is an example.

John Mauldin's latest newsletter "The Beginning of the Endgame" asks the same question about QE2:

What about QE3? Let’s look at how that last move turned out. We ended up with more money on the Fed’s balance sheet and higher commodity prices. The NFIB survey I cited last week showed there was no great demand on the part of small business for loans. 91% had what they needed. What they want are sales and customers! The trade data yesterday showed exports fell by over $2.3 billion last month. That suggests a slowing world economy. Which is borne out by numerous other indicators.

Is this a fair assessment of QE2? Would one expect QE2 to create sales and customers for small businesses such that they demand for more laons? The Federal Reserve has no such power and one should not expect anything like this to start with. A fiscal stimulus may have that effect if it's designed to create final demands for these businesses. As to trade, a weaker dollar has helped. But again, the Fed can't control the world demand for U.S. goods and services. Is a slowing world economy the failure of QE2?

This type of off-hand, sloppy remarks help to cloud the general perception of monetary policies.

St Louis Fed's assessment is a good starting point. It's mostly effective, but its effect is difficult to be disentangled with the effects from other adverse shocks such as the Japanese earthquake and the European debt crisis.

One can argue perhaps QE2 wasn't large enough.

We also hear very often that normal transmission mechanisms (e.g. multiplier effect via banking system) for monetary policy have been broken, therefore QE2 or QE3 would not be effective. Paul Krugman has a different take. There are a wealth effect and a weak-dollar effect. These two effects have important investment implications.

QE is probably not the best tool to stimulate growth when the economy is weighed down by heavy debt loads. But it's probably the only viable tool to save the economy from slipping into another recession.

Fed should maintain QE and create moderate inflation

Dow dropped another 634 points today. A lot of fear in the market. This isn't because of the S&P downgrade. Investors are panicking over slowing growth or a potential contraction. Are we heading right back to recession? What can one expect from the Federal Reserve which is having a FOMC meeting tomorrow?

Ken Rogoff expressed a clear view in this interview. He thinks that the Fed should have never stopped QE2, in fact he thinks that the Fed should make it open ended and make it clear the objective is to create inflation.

Quoting Bloomberg:

Rogoff recommended the Fed say in “very clear statements” that it’s trying to create “moderate inflation.” “In the classic classroom QE, it’s open-ended,” Rogoff said. “You say, ‘I’m trying to create inflation of, let’s say 2 or 3 percent, and I’m going to do whatever it takes.’”

The Fed should also avoid repeating that officials are trying to boost stocks, Rogoff said, calling that a “bad idea.”

The Standard & Poor’s 500 Index tumbled 6.7 percent yesterday to 1,119.46 in New York trading, its biggest decline since December 2008. The benchmark Stoxx Europe 600 Index dropped 4.1 percent yesterday in London to 228.98, its biggest retreat since March 2009.

The Fed should have extended its asset-purchase program, “as controversial as it was,” instead of ending it, Rogoff said. The central bank completed the second round of bond buying in June, purchasing $600 billion of Treasuries.

“They need to move much more decisively,” Rogoff said.

Liquidity trap and the parodox of thrift

How to interpret the economic paralysis we're in and how to think about the options we have? Here is another pretty coherent Keynesian view.



The arguments are pretty much in line with Paul Krugman's diagnosis.

QE3 maybe the only stimulant

However imperfect, Quantitative Easing round 3 may be the only option to prevent the economy slipping back into recession.

Is US making the same economic mistakes as Japan?

Difficult times call for heroic measures. But we are not seeing much of that in the government... It's difficult to sort things out. You want to read commentaries that are at least self-consistent. Paul Krugman represents such a view, in favor of the Keynesian intervention. However, that requires a heroic adminstration and a collaborative Congress which we probably don't have.

See his prognostic for the next few years.

Buffett on Stocks, Bonds and Commodities

CNBC's Squawk Box team has done a long interview with Warren Buffett. This is one of the segments I like.

Two types of assets to buy: One type of asset itself will deliver a return to you; the other type will depend on what the next guy will be willing to pay for it.

Resilient market

Despite so many headwinds including the uprising in the Middle East, market is heading up higher. Consumers are buying more. Corporations are spending more, but still not hiring.

Corrections have been shallow and short.

Why market is so resilient?

There maybe a lot of buying on dips from retail and institutional investors. There have also been a steady stream of corporate share re-purchasing.

We feel that the Fed's accommodative monetary policy is the key here. Perhaps the wealth effect is creating the crucial virtuous cycle, which eventually will reach the lagging housing market and labor market.

But inflation is becoming a threat with $100 oil and $3+ gasoline.

What the bond markets are saying

It's often very important for equity investors to look at what the bond markets are saying.

The long-term yields of US Treasuries have stabilized after the December FOMC meeting. They were creeping up since the Fed indicated its intention to do QE2, and especially after the bi-partisan decision to extend Bush-era tax cuts. US government has no trouble borrowing. The upward sloping yield curve is re-assuring for bank stocks and general equities.

European countries are a different story. The Euro crisis is pretty much still with us. Credit spreads for Greece and Ireland continued to climb in recent weeks. The Greek bond spread is now wider than it was in May, 2010 before it was bailed out by EU and IMF (see Atlanta Fed Financial Highlights). All eyes are now on Portugal as its government are trying to convince investors that they can narrow their budget gaps. The yield on Portuguese 10-year bonds stood at over 7 percent as of last week, according Bloomberg. Can ECB and IMF manage the situation before the crisis spreads to Spain? Investors are not convinced.

In the US, a worrisome development continues to be the muni market and state budget crisis. Illinois is the poster-child of the fiscal mess. The state's bonds have the highest spreads of any state. Illinois's 10-year bond spread has widened in recent weeks to 2.1 percent above the benchmark. A year ago, that spread was less than 1 percent... meanwhile, Bernanke's testimony last week made it clear that the Fed has very limited power to bail out the states.

The bright spot is US corporate bonds. Companies are taking advantage of investors' hunger for yield and the general belief that the corporate sector is healthy and may be poised to deliver the much-needed hiring. Corporations have sold more than $35 billion of investment grade bonds in the first week of 2011, according to the Wall Street Journal, on track to reaching the highest amount sold in the year-opening week since 1995.

Taken together, we agree that it may be wise to invest in US equities, and focus on companies that conduct businesses in states that are relatively healthy and can take advantage of the needs from the emerging markets. Avoid European exposures for now. And be vigilant about systemic risks posed by the Euro crisis and the US state budget crisis.

We do not think China's and India's inflation problem pose such a systemic risk to global financial markets, but it's something to watch out for.

Happy holidays, but be worried about global risks

The year end rally has been strong. It's not all surprising given the steady climb in auto and other retail sales. Consumers maybe back from more than two years of belt-tightening. That's a big deal.

Retail investors may be tip-toeing back to equity markets as well, moving away from bond funds as the long-term rates are rising.

Institutional investors may be pushing the winners all the way to the end of December. We don't know. But given the predominately bullish commentaries we read everywhere, there is a great likelihood the market is setting itself up for a big correction comes January.

Here is an interesting indicator of the extreme bullishness.

Banks and other financials may be in a good position to benefit from the firmer recovery undergirded by the Fed's QE2 and the Congress's tax deduction extension. We have benefited a great deal from our large positions in WFC, BAC, USB, and some home builders.

But, this is the time to be very cautious. Dark clouds are swirling, people just don't talk about them much. European debt crisis is very much alive and not going away anytime soon. US unemployment rate will be elevated for years to come. Deficit problem is not been tackled in any systematic way. China's inflation problem may require much more severe measures than expected. These are known problems. Granted, market's tolerance is higher when these problems are known. Still, it seems very likely that more surprises may be lurking around the corner.

Andy Xie, an independent economist, has this piece about US and China. His main point:

China may have won the last race. To win the next one, China must tackle its inflation problem, which is ultimately a political and structural issue, in 2011. If China does, the U.S. will again be the cause for the next global crisis. China will suffer from declining exports but benefit from lower oil prices.

On the other hand, if China has a hard landing, the U.S.’s trade deficit can drop dramatically, maybe by 50%, due to lower import prices. It would boost the dollar’s value and bring down the U.S.’s Treasury yield. The U.S. can have lower financing costs and lower expenditures. The combination allows the U.S. to enjoy a period of good growth.

One could describe the global economy as a race between the U.S. and China, to see who goes down first.

We're now 50% cash, increased our shorts. We'll be even more defensive if the market continues to rally next week.

State Budgets: Day of Reckoning

While the VIX has been trending down to below 16%, the lowest level since April of 2010, the Muni bond market may be telling us something quite different. The yield spread (against an index of the highest-rated muni bonds) on debt issued by the State of Illinois, for example, has been increasing rapidly from pre-crisis level of about 0.2% (2008) to about 2% in late 2010.

The video below from CBS 60 Minutes is a must see.


Will weak local governments create a similar systematic financial problem posed by the weak Euro members?

Rising mortgage rates goes with rising housing starts?

Housing starts have been in the dump for most of 2010, especially after the experiation of the tax credits. This morning's report shows some life in this important sector. Perhaps the sector is now ready to stand on its own feet.

Mortgage rates however have been rising rapidly since the Congress and the Administration started to work on extending the Bush-era tax cuts. Investors have been shunning Treasuries, in favor of cash, commodities, or equities. This is not necessarily a reflection of rising inflation expectations, although that could be part of the reason (judging from the implicit inflation rate priced into TIPs). On balance, investors are probably betting that the expansionary monetary policy as expressed in QE2 should work well in the thort term with the accommodative fiscal policy should it passes the House. Rising long-term T rates, which causes the T yield curve to steepen, is a sign that the economic recovery may quicken 2011-2012.

The Fed's goal was to stimulate the economy via asset inflation. It has so far succeeded in chasing investors away from the "safe haven" of the Treasuries, into more risky assets that are more tied to the US and global economies.

That's only the beginning. For this twin stimulus to work, the private sector needs to move up in a big way to employ more works. Millions more. More jobs would help housing starts. And more housing starts would jump start more construction jobs.

For people looking to buy a house, mortgage rates in 5-6% are still relatively low. The dominating variable is job security. Besides, when the rates rise to a certain level, bond funds and foreign government would purchase more long-term US government bonds to help hold down the rates.

In this mix, banks that have repaired their balance sheets and have successfully re-positioned themselves to take advantage of the steep yield curve and the economic recovery should be ready to print profits in the boat loads. One of the prime beneficiaries will be Wells Fargo, whose market cap has again overtaken that of JP Morgan today with its share rising over $30. A recent Barron's article has put WFC's shares at $35-40 range based on its normalized earnings power, which it should start to show itself in 2011 when Wachovia branches are all converted.

Investors should hold on to these bank shares, and some of the home builder shares for an interesting "rabbit ride" in 2011. 

Job news so bad that the market doesn't care

It was a lousy headline: the economy added only 39,000 jobs in November against the expectation of 150,000. Unemployement rate creeped up to 9.8% from 9.6%. You would think that the Dow should take a nose dive and gave up all gain from the two previous sessions. Instead all major indices held their grounds pretty well.

The BLS report stands in stark contrast to recent data from ADP (+93,000 jobs), and modest Challenger layoff announcements (+48,711).

The employment index from the ISM Non-manufacturing release today also showed a pick up in hiring.

So, perhaps the market is looking forward to upward revision in the BLS data.

Or, perhaps that the market takes the bad news as a piece of good news in the sense that the Fed now can use it to strengthen its bond-buying program announced in November. The next FOMC meeting is only 10 days away. The Fed's support was essential for the market's run from late August to early November.

If the headline had been a positive surprise, the market may actually get worried.

Gold runs up either way...

Consumers back in the driver's seat

Car sales have been strong. So both Ford and GM are doing well. GM just had a big and successful IPO. What a change.

Holidays sales are going up strong for this season. Expect to see increased traffic in malls.

The big surprise today is the pending sales of existing homes. They rose a record 10% in October, aided by low mortgage rates and improving consumer confidence. That should help clear out more of the bloaded inventories. Home builder stocks are gaining grounds.

After two years of belt-tightening, are American consumers ready to take charge?

The graph below shows that the Personal Consumption Expenditures (PCE, the largest component of GDP) are on track to grow back to its trend line.

Much of this improved picture will continue to depend on job creations. Governments can help. Central banks can help. But it looks like the private sectors are slowly moving ahead to expand. 2011 will probably be slow going, interrupted by lingering credit flare ups (Euro zone especially). But if consumers start to take charge, we expect to see some acceleration of growth in the 2nd half of 2011.

It was a good day for the market today. Tomorrow's good news in employment number may have already been baked in. As Dow is closing in onto the height of the year, it would be wise to raise cash.

Jeremy Grantham: QE may be blowing bubbles

Investors are pressed to choose between lousy returns and speculations. Well, there is a third choice: cash reserve.