Other comments of note:

“economic growth so far this year has been considerably slower than the Committee had expected”

“a deterioration in overall labor market conditions in recent months”

“ Household spending has flattened out, investment in nonresidential structures is still weak, and the housing sector remains depressed”

“downside risks to the economic outlook have increased”

The average Price/Book ratio of the banking industry reported by Morningstar is .6 .  This is a main concern for the Fed, they will attempt to get this number back toward 1 and the Fed seems resigned to a path of nominal growth as the most expedient way.

As you have read here before, this type of policy gives rise to the potential for run away inflation which in the end destroys the buying power of our currency and hurts the middle class.  I’m sure this is the reason for dissent; committing to current policy for 2 years puts the Fed at risk of being handcuffed in the future and of losing more credibility.  Recent resignations from the Board of Governors only supports this opinion.

Possibilities of QE3 have been put in place, but I am of the opinion that existing dissents will make this a more politically difficult endeavor for Bernanke and other Fed doves to put through the committee.

For the full press release click below.

http://www.federalreserve.gov/newsevents/press/monetary/20110809a.htm

The issues facing the global economy did not change last week. US and global economic growth is still waning. We still have no long term plan to reduce the deficit or reform our byzantine tax code. Europe is still in the throes of a debt crisis that neither the ECB nor the member states of the EU seem to have a clue how to solve. Emerging markets and China specifically, are still fighting an inflation problem. The world’s major fiat currencies are still falling against the sin qua non of money, gold. What did change was that any remaining confidence in government to address these problems was completely and utterly destroyed.

The finger pointing that ensued after the S&P downgrade Friday gives one little confidence that the politicians have gotten the market’s message yet. Democrats blamed Republicans for not raising taxes. Republicans blamed Democrats for not cutting spending enough. This problem will not be solved by raising the tax rate on the wealthy by a few percentage points. It won’t be solved by taking more capital out of the private sector for politicians to spend on pet projects that benefit their largest campaign contributors.  It can be solved by a real – and large - cut in government spending but that path without offsetting pro-growth policies is unnecessarily cruel for the millions who have become dependent on government for their very existence. Americans need not don a hair shirt of austerity to atone for the sins of our politicians. Policies that enhance growth will naturally reduce the need for government spending.

We need wholesale changes in our economic system from the tax system to the monetary system to the social safety net. We are long past the point where tinkering around the edges will be sufficient to restore growth and provide opportunity for all Americans to be productive members of society. The tax system as it currently exists is a labyrinth of social and industrial policy that has failed miserably. It is a product of political influence, corruption and disinformation. It is inefficient, riddled with loopholes and incomprehensible to even the IRS. Meanwhile the social safety net is fraying and will eventually fail completely without reform that puts Social Security, Medicare and Medicaid on sound financial footing.

The monetary system is, in my opinion, in the most dire need of reform and it isn’t even on the radar of the political class with the exception of a few like Ron Paul. The market was rife with rumors last week of a new quantitative easing program from the Federal Reserve. The first two efforts were miserable failures for the economy, raising both commodity prices and interest rates. Why anyone except speculators would welcome a third round is beyond me but hope springs eternal among traders and ivory tower economists alike. The expectation that the Fed can and will ride to the rescue for any economic ill needs to completely excised from the market and the minds of politicians. Reform needs to acknowledge the limitations of monetary policy. The only suitable role for monetary policy is to provide a stable value for the dollar – preferably in terms of gold.

We at Alhambra will be watching the coming debate of the fiscal commission closely. It is still possible that the shock delivered by the markets and S&P will be sufficient to convince the politicians that large scale reform is not only needed but necessary. The global economy is not yet in such dire condition that better long term policy would not produce immediate results.

The economy, while not great, continues to muddle through despite the dithering of the politicians and a new recession is by no means assured by last week’s market rout. Stocks are fairly cheap – not that they can’t get cheaper of course – and sentiment is extraordinarily negative, conditions that would normally have us salivating with our fingers on the buy button. The S&P downgrade after the market close Friday and the situation in Europe does give us pause though. We see little reason to rush at this point. Our cash, short term Treasury and gold positions have served us well over the last few months and missing the bottom is not our greatest concern at this point.

The economic data last week continued to be on the weak side but not extraordinarily so. The trend of a slowing but still expanding manufacturing sector, steady consumer activity, a housing market bumping along what we hope is a bottom and a jobs market that is just good enough to keep the unemployment rate from rising, continued.

The ISM manufacturing survey dropped to 50.9 primarily due to a drop in new orders. That is still above the 50 level that represents expansion though and in the past it has taken readings under 45 to signal outright recession. Employment was also down but still at 53.5, indicating continued hiring. Factory orders were down 0.8% in June with all the drop in the durable category. The ISM non-manufacturing survey was a bit firmer at 52.7. Taken together these reports indicate slow growth, not a recession.

Construction spending was slightly higher, up 0.2% in June led by private non-residential outlays up 1.8%. Residential construction fell 0.3%. Year over year the rate of decline in construction spending slowed to 4.7% from 7.1% last month. Low interest rates led to a rise in mortgage applications last week, up 5.1% and 7.8% for purchases and refinancing respectively. Housing and construction are slowly healing but these readings are not robust enough to get excited about.

Personal income and spending were both soft in June up 0.1% and down 0.2% respectively. The spending side was mostly affected by a drop in motor vehicle sales and falling gas prices. It isn’t a rosy picture by any stretch but neither is it recession territory. More recent data on motor vehicle sales and chain store sales were a bit more upbeat. Of course, there is no way to measure the psychological impact of the US debt downgrade and how that might affect future activity. That is something we’ll  be watching closely in the coming weeks.

The news on the jobs front was mixed. Challenger reported a rise in layoffs but jobless claims were flat and the employment report Friday showed a gain of 154,000 in private payrolls. Jobless claims remain elevated at 400k but that is still consistent with the job growth reported Friday. The layoffs from Challenger have yet to happen in most cases though so an uptick in new claims in the coming weeks would not be surprising.

As I said at the beginning of this section, the economy continues to muddle through. For now, I see no reason to expect a renewal of recession but the psyche of the public is fragile and the future is, as always, impossible to predict. We are facing a crisis of confidence as much as anything else and the antics of the politicians don’t help in that regard but our economy and the American people are resilient. Hopefully that is enough to keep us muddling through until we get real reform.

With Alhambra’s recent expansion we have added some new features to our weekly lineup. John Chapman’s weekly column, Thinking Things Over, has its third installment this week. Doug Terry joins the weekly lineup with Contrarian Alert. Joe Gomez provides a report on market technicals and details of various market indicators.

If you’d like to receive this free weekly commentary by email, Click Here.

Weekly Chart Review, Click Here.

By John L. Chapman, Ph.D.                                             Vol. I, No.3  080711

In this note:

·       Repassage: debt ceiling deal and implications for your net worth

·       ‘Balance sheet’ versus ‘aggregate demand’ recessions: worrisome, or much ado about nothing?  How to invest in any case?

Next week:

·       Nixon’s most tragic mistake, forty years later – and its lessons for policy (and for investors) today

I. Debt ceiling deal – one more time

The downgrade of U.S. Government debt by Standard & Poor’s on Friday night was as historic as it was sad, but it was also inevitable.  That a great power, the world’s strongest beacon for individual liberty and a vibrant market economy for the better part of two centuries, should now be less credit-worthy in Standard & Poor’s eyes than the Isle of Man, Principality of Liechtenstein, or for that matter, the City of Syracuse, NY is terribly sad.  Yet S&P signaled as far back as April 18 that this was a distinct possibility and given the growing awareness of long term, glaring fiscal imbalances now – even the Congressional Budget Office’s baseline scoring out to 2085 never once shows an annual budget balance – it would have been stranger for one of the ratings agencies to not downgrade.

Cynics that we are now about the ways of Washington, we can assure our Alhambra family of readers of the following:

·       There was, no doubt, tacit collusion among the ratings agencies for at least one, but not all, of them to move to a downgrade status.

·       This is the “perfect” way to send a message and yet minimize disruption to global capital markets:  institutional investor covenants that demand the holding of only triple A-rated sovereign debt can still rely on the credit judgments of Fitch and Moody’s, so there will not be massive turmoil in bond markets this coming week (still, that is not to say there will not be some downdraft and sell-off in bonds; S&P was sufficiently worried about any such effects to make their announcement after markets closed on a Friday, to give investors the weekend to digest the news).

·       Treasury Department officials lobbied hard against the downgrade, though less because of the costs this will impose on the hard-pressed American people, and more because of the political effect this will have on President Obama.  There was, after all, 30 months to ensure maintenance of the rating, had that been paramount.

And what are the repercussions, near and long term? In short:

·       Secretary of the Treasury Timothy Geithner is now almost certain to go (reporting in the WSJ notwithstanding), perhaps before Labor Day.  Mr. Geithner is not viewed positively by either Main Street or Wall Street, and it may be more than coincidence the rumor mill had him worrying about spending more time with his family this spring.  For our part, while the policy decisions regarding the public fisc and the dollar are ultimately the President’s, we think Mr. Geithner’s departure is both good politics and good for the markets.  As far back as mid-April he had assured the American people there would “certainly not be any downgrade”, continuing a hapless run of bad economic news while at the Treasury, and on back to his stint at the New York Fed, prime agent for the credit bubble that led to the present mess.  And then there is the matter of Mr. Geithner’s inability to read his TurboTax software manual, and unfortunate hole in his resume with respect to his tenure in the private sector: other than a three year stint in the ‘80s as an analyst with Kissinger Associates, his entire career has been in government, this limiting his perspective on how the real world economy works.  We cannot but think his replacement – any replacement — will have a better discernment about out-of-control federal spending that must end; that the weak dollar policy of the last decade has greatly harmed capital formation and job growth in this country; and that raising taxes on effective producers in this environment is foolhardy, because in fact, this recession did not really end in June 2009.  We do not wade into politics here, but nonetheless would say, good riddance to what we consider to be a G. William Miller-clone, if and when Geithner moves on.

·       We expect some volatility in global credit markets this week, mostly on Monday, but then a settling in.  Long term, U.S. government debt is not priced via the U.S. credit rating agencies so much as it is by the world’s investors, and their analysis hardly includes what S&P thinks: far more important is the value of the dollar and prospects for U.S. growth.

·       That being said, it is reasonable to assume that all interest rates edge up at the margin, which will be tantamount to a tax increase on the U.S. economy.  With $40 trillion in total debt outstanding, an increase of 10-20 basis points across the board would mean a total increase of $40-80 billion in interest expense, a non-trivial amount, and undesirable in this economy.

·       The longer term issue is the warning that his downgrade effectively issues to our political class: there is clearly a tidal wave off our shoreline, seen in the distance and barreling toward us.  It represents a fiscal and monetary collapse and a Greece-like blow-up to our economy.  Or, said better, a blow-up akin to Germany in 1923 in its effect.  Its arrival is not so many years distant now (given the trajectory of entitlement spending), and its crashing ashore represents a long-awaited “day of reckoning” for the U.S. economy, in which the internal contradictions of a generous welfare state and borrowed consumption, all driven by a fiat dollar whose continual long term decline in value has been partially offset thanks to its global demand as a reserve currency, must end.  How the U.S. meets this challenge in the next few years – that is to say, via tax increases that kill job growth, or spending and entitlement rationalization that minimizes the harm to progress — will determine the trajectory of our standard of living for a long time to come.  For investors, the long term is clouded by this approaching storm, as there is “no good place to hide” in such a scenario that would clearly draw down the entire global economy.   But in a fiat money world, the hard asset classes – the traditional hedges against a market volatility that is fed by monetary mismanagement, such as land, commodities, or natural resources – will, as usual, be a big part of any long term portfolio holdings, regardless of any possible near-term asset deflation thanks to deleveraging (as long as deleveraging leads to deflation, consumer staples will be prime investments, and hence we would want to own, say, Procter & Gamble; but we assume that a fiat money regime will never permit a deflation from deleveraging to ensue for long, and indeed, are witnessing a mini-version of this at the moment with multiple [and massive] rounds of quantitative easing; hence our preference for commodities and natural resources in the long run).

II. ‘Balance Sheet’ versus ‘Aggregate Demand’ Recessions

We have recently been reading the analyses of Richard Koo, the Taiwanese-born Chief Economist of Nomura Research Institute in Tokyo, and author of the excellent 2009 book entitled The Holy Grail of Macroeconomics - Lessons from Japan’s Great Recession, published by John Wiley & Sons.  We do not think Koo would disagree with our characterization of him as a post-Keynesian economist, and while we do not agree with all he says, his writings have certainly gained traction in the economics profession, with no less than Nobel-winner Paul Krugman signing on in support of his ideas concerning a “balance-sheet” recession versus those caused by (traditionally) a deficiency in aggregate demand, leading to excess manufacturing output and a build-up in un-cleared inventory.  What follows is a short description of Koo’s thesis, and our critique of his analysis, along with what it means for investors.  It is important to follow this debate in the months ahead as Koo’s rising influence may indeed affect policy, which in turn will affect the capital markets.[1]

Types of Recessions

Koo argues that the Great Recession through which we are now living in the United States is akin to that suffered by Japan in the fifteen (and some would say twenty) years after 1990.  Both Japan in 1990 and the U.S. in 2007-08 fell into deep recession following the bursting of real estate bubbles that also pulled down equity markets substantially.   Recessions caused by the bursting of asset bubbles that were fueled by high leverage on corporate and household balance sheets are termed “balance sheet downturns” by Koo, and this is in contrast to those caused by a drop-off in aggregate demand.  In the latter case, the fall in demand is caused by the whims of investors, their shifting “animal spirits”, and this leads to excess production and thus unsold inventory of some goods in the economy.  This excess can only be worked off via layoffs and a reconfiguration of the economy’s resources during the ensuing correction.

Koo and Krugman (and now many others) assert that there are fundamental differences between these two types of recessions:

·       A balance sheet recession caused by an asset bubble burst and ensuing crisis is more severe and long-lasting in effect.  According to economists Carmen Reinhart and Kenneth Rogoff in their long-run study of financial crises, the typical duration of employment downturn is 4.8 years, far longer than the one year of the typical 20th century recession due to aggregate demand shortfall.  In another study, Reinhart and her husband Vincent Reinhart showed that economic growth rates can be slower for a full decade after the onset of the financial crisis.

·       In recessions caused by aggregate demand shortfall, the typical corporate balance sheet is appropriately capitalized, and there is positive net worth.  For balance sheet recessions, as the name implies, the balance sheets of corporations (and especially banks) are impaired, due to high leverage, and may involve negative net worth.  This necessitates a painful deleveraging, which can involve what Koo calls a “paradox”: as banks and others deleverage, their demand for goods and services declines, causing a decline in both the money supply and real incomes, which can further impair balance sheets by causing asset values to decline.  And this caused the whole cycle to repeat: indeed if left unattended this “death” spiral can cause a depression, and Koo points to 1929-33 as an example of this.

·       The nature of these two recession types causes several macroeconomic parameters to differ: in a traditional aggregate demand-shortfall, profit maximization is still the rule for companies; in a balance sheet recession, debt minimization becomes paramount.  Prices are inflationary in the former, and deflationary in the latter thanks to the deleveraging process.  Monetary policy is effective in typical recessions to ignite the growth process, but ineffective in a balance sheet recession, as even zero interest rates cannot incite investment and job-creation.  Fiscal policy however is ineffective in a typical recession, as the economy merely needs a rebalancing, essentially via relative price shifts to clear inventories and redirect resources to better uses.  But fiscal policy is very powerful in a balance sheet recession, where the government must, according to Koo and Krugman, pick up the slack in spending that deleveraging prevents from private sector agents.  And for this reason saving, normally a virtue, is seen as harmful in balance sheet recessions, as it contributes to a lessening in consumptive demand thanks to the deleveraging process.

Koo asserts that in Japan, it was only massive government spending and activist fiscal policy after 1997 that prevented a true depression (though growth has been anemic there for the better part of 20 years), and that the U.S. must learn from this experience.  Along with Krugman and others, Koo recommends massive increases in federal spending in the years ahead, and an end to any attempt at Fed-induced stimulus.

How Real Is This Distinction between Recession Types?

There is no question that Koo has identified different attributes of downturns involving debt deflations versus those that yield “stagflation”, or declining aggregate demand coupled with rising prices.  And from the vantage point of investors, it is true, different asset classes hold up better under each scenario: again, in any inflation, commodities, natural resources, and real property are all effective hedges.  In a debt deflation, consumer products that are staples will be preferred relative to other classes suffering declining asset values.

But we think Koo is too clever by half with this distinction. In short:

·       One must ask, why does aggregate demand decline in typical recessions?  And similarly, what causes asset bubbles that eventually burst into a financial crisis?

·       The answer to both has a common origin: monetary disturbance.  An inflation in the quantity of money and credit leads to a lowering of interest rates artificially.  That is to say, the lower interest rates are not due to an increase in societal saving, and a shift in societal time preferences between present and future consumption; the lower nominal interest rates are due to the credit expansion and creation of money “out of thin air”.  This in turn induces investment to be undertaken under false pretenses, and it also causes a shift in the relative price structure in the economy, not only between consumer and capital goods, but also between consumer goods (period).

·       The economy’s structure of production will thus be distorted, leading to both errant investment of capital that cannot be sustained by real effective demand, and distorted consumption goods as well that will have to be corrected with further relative price (and production) shifts.

·       All of this will lead to a “cluster of entrepreneurial errors”, as Murray Rothbard described it – errors that can only be corrected by losses, liquidation, and unemployment.

·       In such an environment then, coming through a business downturn, the monetary  malfeasance is a cause of the waste, or destruction, of real capital.  The resultant capital shortage can only be corrected by a recapitalization that can only happen thanks to increased saving.  So for us, saving is always a virtue, and we do not worry as Koo and Krugman do that hoarding and non-spending will systematically occur, economy-wide.  The scarcity of capital is permanent, and the demand for consumer goods insatiable, so in a globally interconnected world, we expect those savings to be profitably intermediated and channeled to productive uses.

·       We also cannot agree with Koo on the relative effectiveness of monetary or fiscal policy in his alternate scenarios.  There is no case in world history, none, of a country achieving prosperity in the long term via a weak and manipulated currency.  Strong and stable-valued currencies promote trust and confidence in long-horizon investment, which is the mainspring of job creation and indeed, human progress.  The dollar has fallen 38% against a global basket of currencies in the last decade and this has had deleterious consequences in the U.S. via a capital flight (we do not count the investment in housing circa 2002-2007 as that was driven by misguided federal policies; excepting this, capital flows were highly negative in the U.S. during this time) that has cost jobs and harmed income growth.

·       Further, while we concede that some federal spending uses are better than others – we like infrastructure spending that is long lasting, as opposed to transfer payments to favored constituent groups for immediate consumption – we still insist that there is a crowding out effect, or opportunity cost, to all federal spending in terms of lowered consumption and investment from the private sector.   By definition this is bound to lower living standards and growth, in a comparative sense, and indeed, federal spending’s harmful effects linger for decades in higher taxes (tomorrow) to pay for today’s spending.

We will have more to say on this in the months ahead as policy is developed around the theme of a balance sheet recession: the incumbent Administration is already arguing that this recession was much more severe than had been previously thought because it was a balance sheet recession, and its supporters such as Krugman and Koo are thus calling for massive increases in federal spending stimulus as the ongoing policy response.   We think this is a big mistake and the threat of its continuance contributes to the fiscal imbalances that threaten us (see above discussion).  But certainly the investment implications of policies designed, in Koo’s fashion, to ramp up federal spending, are very different from those that are more aligned with private sector-led growth.  We therefore are watching this closely in the months ahead.

Dr. Chapman, an economist with Hill & Cutler Co. in Washington, D.C., is an advisor to Alhambra Investment Partners’ family of actively managed portfolios as well as a contributor to Alhambra’s research services. He and Alhambra founder Joe Calhoun are writing a book on how to invest and preserve wealth in today’s complex and turbulent markets.

World Allocation Portfolio

The world allocation portfolio is our flagship tactical strategy.  The level of risk exposure in the portfolio will vary between conservative and aggressive risk profiles depending on Alhambra Partner’s assessment of the global investing environment.   This portfolio gives investors diversified exposure to all return producing assets around the globe.  It is suitable for all investors.

Portfolio Overview

Objective:

Our World Allocation Portfolio is a diversified, global, dynamic asset allocation portfolio designed to give investors superior, risk-adjusted, real returns.

Construction:

In order to provide investors the protection and return they desire, this portfolio combines Alhambra Investment Partners strategic asset allocation philosophy with our proven tactical investment process.  Our strategic allocation philosophy has been thoroughly researched and gives investors consistent inflation adjusted returns along with optimized diversification benefits from correlations among the 5 primary global assets.  Utilizing our investment process to assess global risk factors in today’s rapidly changing investment environment, the management team will periodically adjust asset exposures to both protect client wealth and take advantage of beneficial risk/reward opportunities.

Dynamic Investment Process:

Alhambra’s proven investment process sets long term market expectations and determines optimal risk exposures based upon our macroeconomic assessment of the global investing environment.  As a supplement, we continuously monitor monetary and fiscal policy around the globe along with key cyclical indicators.  Thus, we are able to monitor shorter term investment trends and adjust exposures in the portfolio to take advantage when opportunity presents itself and to be defensive when risk levels are elevated.

Asset Allocation:

Current Target Asset Allocation

Performance:

World Allocation Portfolio Performance

The first items to spotlight are the terms for raising the debt ceiling and cutting of government spending hashed out on Capitol Hill last weekend. Many market watchers had thought lifting the short term liquidity issues of the US government would ease market fears and allow us to go about our business. The debate in Washington brought to light the reality of our government finances and the vulnerability of the underlying economy. It was as if a layer of fog had lifted to reveal an economy that isn’t even growing at half the rate of inflation. While prices have been moving higher, real economic activity has been stagnant. History has taught us that these 2 series moving in opposite directions can be an ominous sign; just reflect back to 1974. We are also aware that these two indicators simultaneously moving down can also be a bad sign. Here’s what we see:

CPI is moving higher but has flattened. Printing greenbacks to buy cheap stuff from China only to have China turn around and buy commodities from South America, Australia and Canada merely causes prices around the world to rise. Policy in China is causing the intended slow down and this has been reflected in places like Brazil and Chile both incurring 20% market drops ytd. Real US GDP growth is falling, reflecting underlying debt issues in the US, the end of stimulus and QE2 as well as lower aggregate global demand from a slowing China and broken Europe.

Unemployment remains stubbornly high but is to date not getting worse. What we need is investment and innovation in order to get real progress and job growth; not the government spending newly printed dollars on clunkers and the Fed using new money to fill in debt holes in bad banks. The market didn’t think the decisions coming out of DC were all that grand. There is still a lot of waste in Washington; they continue to produce negative returns. While prices have stabilized here, their future trajectory is any one’s guess. My fear is that the Fed could infer that deflation is back on the table and rush to QE3 to prevent prices from moving lower. As most of you know, we believe monetary policy should concentrate on a stable dollar and given the stock pile of money sitting in corporate coffers and in excess reserves at the Fed, we would hope that the Fed would give the economy a chance to find an equilibrium rather than add an inflation problem to our list of worries. As some frantically rushed for the doors this week, we were not taken by surprise and will be monitoring these developments for a more concrete indication of market direction.

The second issue of the week was Europe. European banks are busy restructuring their balance sheets, a result of haircuts taken on Greek debt, dropping equity values and an inability to find external funding. It was reported today that the largest Italian bank, Intesa SanPaolo Spa, whose equity value has dropped 60% since 2010, was forced to take a loan from the ECB for about 16bln euros, equivalent to the entire market capitalization of Intesa. (http://online.wsj.com/article/SB10001424053111903885604576490283480370392.html) We are also seeing signs of struggle in the banking sector of stronger countries. France’s three largest banks are all down significantly from their 2011 highs: BNP -32%, Credit Agricole -44%, and SocGen -48%. As assets on their balance sheet are written down, they must recapitalize and with no private funding to be found they are forced to sell other assets to raise cash. The resulting liquidity issues played out in global markets this week. It will be interesting to watch as the ECB and some European countries may be getting fed up with throwing good money after bad.

The final item to discuss is sentiment, often used as a contrarian market timing indicator . AAII sentiment plunged from +17% bulls at the beginning of July and +6.5% just last week to -22.7% this week. Bullish percent index indicators popular on the street such as the NYSE or SPX bullish percent index (thanks Glenn Malloy of UBS for the heads up this week) plunged from readings of above 70 last week to levels below 30 on Friday, see chart below. The volatility index shot from below 20% to a high of 40% mid-day Friday before settling the week at 33%. Capitulation was apparent by weeks end, especially mid-day Friday. As contrarian types, this does not surprise us. We are aware that risk levels are elevated but will be watching for indications of a resolution to short term liquidity issues and better valuations as US equities may present a buying opportunity in our tactical portfolios.

These are very interesting and challenging times we live in.  The lessons from this week are that risk is elevated, liquidity is king and patience is needed.

]]> http://alhambrainvestments.com/blog/2011/08/07/this-week-in-play/feed/ http://alhambrainvestments.com/blog/2011/08/07/markets-in-review-2/ http://alhambrainvestments.com/blog/2011/08/07/markets-in-review-2/#comments Sun, 07 Aug 2011 22:02:26 +0000 jgomez http://alhambrainvestments.com/blog/?p=10853 Since the beginning of 2011, the S&P 500 had been trading in a tight range between 1250 and 1350. All the while, a noticeable formation called a “head and shoulders” was developing. An important support level was apparent at the 1250-1251 level which is called a “neckline”. Technical analysts were carefully watching this important level. Unfortunately, the culmination of headlines from Europe, Japanese Central bank intervention and Congress’s vote to increase the debt ceiling caused massive liquidation of equities on a global scale on Thursday. With the carnage of 2008 and 2009 still fresh in investor’s minds, those that are still fortunate enough to be employed on Wall Street are taking no chances on getting stuck again. The next level of support is the 1180-level, which at the time of this writing is approximately 2% away.

S&P 500 Sector Returns

The U.S. market began the week with a heavy economic calendar. Beginning with the ISM Index, Personal Spending and ending with Nonfarm Payrolls. On Thursday, August 04, 2011, the markets were spooked (down over 500 points) by events in Europe which sent Italy’s and France’s markets down 5% and 4% respectively. The S&P 500 dropped 7.2% for the week and is now down 4.5% for the year. Below is a breakdown of the S&P 500 by sector.

Key Market Statistics S&P500

Treasury Yield Curve

Nothing, however beat the U.S. Treasury this week as it continues to remain the ultimate “safe-haven” bet. As a result, Treasury prices spiked higher and yields actually went negative in the 2-year maturity briefly.

Also of note is the flattening of the treasury yield spread curve structure.

Source: Bloomberg

Commodities

A report by HDFC Bank (Housing Development Finance Corporation) says emerging market central banks have put $10 billion into gold year-to-date, buying nearly 180 tons of gold this year, more than twice the 73 tons bought by central banks around the world last year.

World Markets *Based on U.S. listed stocks only

Currencies

Volatility in the currency markets reflected investors’ flight to safety. The U.S. dollar was up against its major counterparts with the exception of the Swiss Franc.

Investment Style Returns

Source: Morningstar.com

Sentiment Indicators

Source: American Association of Individual Investors

Musings on the Markets from Inside the Beltway

By John L. Chapman

Vol. I, No.2

07/31/11

In this note:

“Balance sheet-” versus “Aggregate demand-” recessions: is there a difference, and does it matter for investors? What is our investment strategy in light of our findings?

Two days before the debt ceiling “deadline”, it appears the two major parties are close on a deal. ABC News is reporting the following outlines:

• A debt ceiling increase of $2.1 to $2.4 trillion (depending on the size of the spending cuts agreed to in the final deal).
• Spending cuts of roughly $1.2 trillion over 10 years.
• The formation of a special Congressional committee (likely a “Gang of 12”) to recommend further deficit reduction of up to $1.6 trillion (whatever it takes to add up to the total of the debt ceiling increase)
• This deficit reduction could take the form of spending cuts, tax increases or both
• The special committee must make recommendations by late November (before Congress’ Thanksgiving recess)
• If Congress does not approve those cuts by December 23, automatic across-the-board cuts go into effect, including cuts to Defense and Medicare
• Cuts in Medicare will be on providers and not on beneficiaries.
• This “trigger” is designed to force action on the deficit reduction committee’s recommendations by making the alternative painful to both Democrats and Republicans. For example, Republicans could be forced into accepting either tax increases, or automatic cuts in Defense spending.
• A vote, in both the House and Senate, on a balanced budget amendment.

Our brief comments are as follows:

• With the exception of the Balanced Budget Amendment vote, this is pretty well exactly what Dick Morris predicted it would be the other day, and we are continually amazed at Morris’ perspicacity when it comes to the “inside political game” in this town. Having met many of the so-called Beltway pundits personally, we can assure our Alhambra family, stay in touch with Morris (www.dickmorris.com) if one wants deep insights into the reality here. Morris is not without his biases, and he does not bat 1.000 by any means, so we always caution readers to think through what he is saying and why. But that said, he does hit .600 or more, and that is far above anyone else we have met in town here.
• We will leave dissection of “winners” and “losers” in this political game to people like Morris, but from an investment standpoint, we are of two minds:

• The great economist Thomas Sowell is almost certainly correct that the debt ceiling law ought to be repealed. From a cost/benefit perspective, it is ineffective: it is pushed back every time it is broached, and will be again in 2013 when the debt hits $16.7 trillion, around the new “limit”. And indeed, it might be counterproductive to have it as statutory law: it clearly has no real effect on the credit ratings assigned to U.S. government debt (see below). Meanwhile, when it is approached, the incumbent party demands an increase, while the opposition party may balk, depending on the political moment. But the opposition cannot be seen to be permitting a “default” (again, this was demagoguery, as there was never a chance that interest would not be paid or maturity capital not returned to U.S. bondholders), and thus they always sign on in the end to the incumbent’s desires for an increase — often, as is the case here, therefore ratifying the outsized spending programs of the incumbent. At least with no law in place at all, any incumbent pushing continued spending increases against the will of the opposition “owns” the spending, for good or ill. Indeed the law may fuel spending to the degree it provides a ruse for the political class – both parties – to appear to have constraints in place, but indeed are able to continue ramping up federal spending unabated.
• This episode alarms us for the long run for what it says about the depth of the “brokenness” of our politics. Two-thirds of the American people are exorcised by this issue and against more federal debt, and a significant election last November was centered on this as a core issue. In theory there was momentum to force more discipline on Washington. But in the end, the “cuts” are mostly phony, indeed non-existent, mere lowering of the arc of baseline increase. It is telling that when this passes, it is likely that House Republicans will mostly vote against this, and it will pass narrowly thanks to all Democrats voting for it with Boehner and a very few of his colleagues.   The Senate will pass it mainly along party lines though some Republicans (e.g., John McCain, Scott Brown) will vote for it; while Democrats running for reelection in 2012 will vote against it (e.g., Claire McCaskill, Sherrod Brown). This will provide cover for them to say they are for fiscal austerity. It is episodes like this that give us confidence that gold at $1630 is still cheap, long term; that is to say, we fear for the U.S. economy in the long run if this runaway spending train is not curtailed.
• We see it as a near certainty that one of the Big Three ratings agencies will downgrade U.S. debt; but not all will. We believe there is collusion on this matter between them, with the tacit knowledge of the SEC and U.S. Treasury authorities, who seek to limit any volatility across the maturity spectrum. This is the continuation of a slow water torture for the U.S. bond market and the dollar, and the collective Fed/Treasury policy here, of being the “tallest midget in the room”, is a fool’s errand, long term (more on this over time, as this is a major theme of our research moving forward and informs our investment decisions).
• The only other thing to say is, this was a missed opportunity for all. What if a “grand bargain” had been reached here, with Reagan-Tip O’Neill type drama per their 1986 tax rate cuts and loophole closings, coupled with deep spending cuts. It is merely a fantasy given the actors, but equities and bonds and the dollar would have all rallied strongly. All of that will happen – but perhaps only after a collapse.

In closing, our research has us reading a great deal lately at the intersection of three different “literatures”, which all converged this week in this debt ceiling issue: (1) monetary reform based on gold (and specifically, for the gold enthusiasts here, the viability of the recommendations set forth in the latter part of the 1953 edition of Theory of Money and Credit, by Ludwig von Mises – more on this in the time ahead in detail, as a gold-linked dollar is axiomatic before this decade is out), and elimination or at least curtailment of Federal Reserve power;  (2) the nature of recessions based on drop in aggregate demand versus those caused by bubbles and financial market crashes (and whether that distinction is real, or important, see next week); and (3)  government spending and control thereof in a constitutional republic which over time has morphed into a democracy (as classically understood – and discerning readers understand the distinction).

The conclusion is that this country is in trouble now because not only is the political system broken, but there seems to be little ability to force the bipartisan political “elites” to do what is in our interest – but for the most part not theirs – to end this economic torpor.   It is not a hopeless situation and it is a fight worth having, as the history of economics and economic theory clearly point to what policy needs to be to turn things around.  And by “trouble” we mean, for investors, higher volatility, lower long term real returns, and more frequent recessions (if indeed we are now in a recovery of two years). But we earn our fees at Alhambra scanning the globe to defend against this environment, and so shall.

Even in the 20-year sclerosis that has been Japan, or the high-unemployment welfare states of Western Europe, life muddles along (albeit they have done so always able to import American progress, as a general matter, allowing them to live with many of their own fiscal “sins”; alas, there is no United States-like engine to backstop us once we backslide to a permanently-lowered standard of living trajectory, if that is our fate), and there are winning investment strategies that at least preserve capital accumulated over time: this remains our focus. But readers should know, a hundred year call on a day of reckoning first elicited by Woodrow Wilson, and enshrined by big spenders such as FDR, LBJ, Nixon et al., is now soon approaching, given the entitlement and demographic math we face in the years ahead.

II. Investing in China

We will have much to say in time about China, holder of $1.15 trillion in U.S Treasury debt and seemingly an endless trade surplus country. But we offer here a preliminary thought on how we will frame our thinking about opportunities there. Many of the world’s best and most famous investors are in China and bullish on its economy long term. Jim Rogers, who moved there (to Singapore). Warren Buffett. KKR. Well-known economists and ardent pro-free market supporters such as Nobel winner Bob Mundell, John Rutledge, and Jim Dorn are all bullish long term. So it has become conventional wisdom that China offers an ex-U.S. opportunity, where needed, which can diversify away from dollar assets and co-opt the years of 9-10% growth. It is important to understand China, if the U.S. is indeed in a “new normal” of 2% (or less) GDP growth indefinitely.

In truth, China has been good to Alhambra portfolios, but what of the future there, and how to play it?

We have concerns, so will step into this closely, but are watching:

• A third round of non-performing loans in its banking system; clearly there has been significant mal-invested capital in China, the losses of which have not yet been booked
• The threat of domestic inflation, as the Bank of China has expanded pari passu with the Federal Reserve.
• An over-extended real estate market in many major cities
• Municipal debt problems that, while opaque, are known to be significant. Bloomberg ran an article July 21 about the Olympic sports complex being built at Loudi, a city of four million people in Hunan, replete with a 30,000 seat stadium, swimming complex, and landscaped sunken concrete Olympic rings – with no prospective Olympic Games in sight. The city sold a $185 million bond issue, and intends to pay off this debt via sales of wildly overvalued municipal land (i.e., the land there is valued at $1.5 mm per acre with per capita annual incomes of $2300). The city may feel Beijing will bail them out in the event of a negative cash flow problem, but if so, this has repercussions for the value of U.S. assets which would be sold.
• Residential land values have dropped 30% this year and many Chinese banks and mutual funds that own debt collateralized by this land will realize significant losses – at least $75 billion, says Standard Chartered.

Hence, there are warning signs. Our larger long-term concern about investment there at this point is macroeconomic: China, in our view, cannot be fully modern until it is more fully Western. Here we do not refer to any sort of cultural jingoism; indeed, we respect the historic nature of Confucian and later dynastic China. But the West IS modernity, because the West IS civilization itself. The West is not a place, so much as it is an IDEA, or rather, bundle of ideas wrapped around a core concept: the sacred worth of the individual. The West in this sense has venerable historical antecedents: the Roman republic, Greece, Magna Carta, English Common Law, John Locke, all of which were progenitors of a society built upon the primordial worth of the individual. And what flows from the individual? Liberty, property, the rule of law, limited government, viz., the institutional conditions under which civilized life can flourish – and, for our narrow purposes, by which open and liquid and transparent capital markets can fully develop.

This is why, for the most part, the rest of the world emulates what happens or develops in the United States, and not the other way around. This is NOT to say that Americans are any better than anyone else, or smarter, or work harder. But Western civilization is an IMMENSE idea and fact, and the U.S. is the epicenter of it. To say all this colloquially, here as nowhere else, human beings can chase their dreams and become whom they wish, subject only to the physical constraints of the universe. Self-determination in liberty is a dear thing – in the sense of rare – and it is worth propagating to the rest of the world as able, including China, which has enormous promise.

Given this as an “undergirding” for investment, we will move slowly. While we are already and will be selective there for now, the political environment matters. In contrast to China, we have fewer fears in Japan, South Korea, and Taiwan. All are “Western’ in the sense they have imported Western institutions to a significant degree: rule of law, rights of free speech, parliamentary democracy, and Western cultural proclivities, such as respect and equal treatment of women, greater class mobility and tolerance, et al. Indeed, to the degree a country is NOT as modern as others, e.g., in Asia, say, Indonesia, it is because it is not as “Western”. To say this differently, non-Western societies are institutionally inferior precisely because they are more illiberal politically.

In time, we agree China will more fully “Westernize”: baseball, McDonald’s, Coca-Cola and the like are already there, and all this can only portend political liberalization, which ensures more foreign direct investment. But for now, the level of state intervention is so significant, that for Alhambra it is a case-by-case analysis with respect to any further diversification there. Certainly the hope is that China’s liberalization is per force sooner in time rather than later, as it can then help lead a revival of world growth in the years ahead.
Dr. Chapman, an economist with Hill & Cutler Co. in Washington, D.C., is an advisor to Alhambra Investment Partners’ family of actively managed portfolios as well as a contributor to Alhambra’s research services. He and Alhambra founder Joe Calhoun are writing a book on how to invest and preserve wealth in today’s complex and turbulent markets.

Canada reported last week that GDP fell by 0.3% in May and second quarter growth is now expected to come in much less than the BOC’s forecast of 1.5%. The strong Canadian dollar is adversely affecting their manufacturing sector while mining and oil and gas production are also falling. Growth estimates for Australia are also falling with private sector economists now expecting growth of just 2% over the next year. In addition, inflation is near a 4% annual rate, consumption is stagnating and business confidence is falling. Stagflation is a real possibility.

In Latin America, the problem is inflation. Brazil’s most recent read on inflation showed prices rising at an annualized 6.7% and the central bank just hiked rates to 12.5%. The Brazilian Real is still rising as capital continues to flow into the country but stocks have stagnated for nearly two years. Consumer debt burdens are higher than the US and probably as high as they can go. The Brazil Development Bank has fueled a spending boom ahead of the World Cup and the Olympics by ramping up subsidized corporate loans. Brazil’s boom is built on state directed credit and selling raw materials to China, neither of which looks sustainable. Peru, Colombia and Chile have similar capital inflow and rising debt problems. Argentina and Venezuela are economic basket cases with high inflation and weak growth. Argentina has taken to criminally charging private economists who dare to question the official inflation rate of 10%. As for Venezuela, it’s economy is as sick as its Caudillo.

In Asia, the key to growth is obviously China and while we believe it may offer significant opportunity over the long term, there is ample reason for concern near term (read John Chapman’s weekly update for more detail). China has been fighting an inflation problem with higher bank reserve requirements and interest rates but continues to restrain a needed rise in the Yuan. The measures so far seem to be hitting growth more than inflation. In addition, the new five year plan calls for a shift to greater domestic consumption from the investment fueled growth of the last decade and that transition seems unlikely to occur without some disruptions. The rest of Asia will be affected by a slowdown in China but countries such as Korea, Taiwan and Japan should be less affected than, for instance, Thailand and Vietnam which are more directly dependent on China for growth.

A slowing in China, if it were coupled with a pick up in US growth, would likely be very beneficial for the global economy. A big part of the problem in Latin America, Australia and Canada is an excessive capital inflow as investors have fled the US dollar. Much like the US in the late 90s, these capital inflows have raised growth through investment - and to a lesser degree consumption - and created an inflation problem. Much of the investment has gone to resource extraction to meet Chinese demand. If China slows as we expect, the demand for natural resources will fall and at least some of the investment will prove unprofitable or even foolish in hindsight. Better growth in the US would cushion the blow of slower Chinese growth while also drawing investment back to the US dollar and relieving the inflation problems.

The question, of course, is whether growth in the US will improve from the first half malaise. On that score, I had hoped that our politicians might finally see the light and strike a grand bargain on spending and tax reform. It appears as I write this that I may have been overly optimistic on that front. The debt ceiling deal being discussed today doesn’t cut spending (it merely slows the rate of growth minimally) and defers more substantial reform to a later date. I don’t believe we have to suffer a new normal of slow growth but major policy changes are needed to avoid it. Right now, I just don’t see it.

In the short term, however, there is still some hope of a cyclical rebound in housing that could support higher growth over the next year or so. Last week’s economic data hinted at that possibility although most of the attention was on the backward looking GDP figures released Friday. As a whole the data continues to be mixed to weak with relatively weak consumption and slowing - but still growing - manufacturing.

The Goldman and Redbook retail reports showed decent if not exciting growth in same store sales. Year over year gains are in the neighborhood of 3.5%. Durable goods orders were much less than expected at -2.1% with most of the decline in transportation. Ex-transport sales were up 0.1%. On the investment front, non defense capital goods ex transportation fell 0.4% but shipments were up 1%. The Chicago Purchasing Manager’s report was more positive at 58.8. There was growth in new orders and backlog although the employment component fell to 51.5 from the recent readings over 60. Overall, manufacturing is still growing but at a slower pace.

The hope for a cyclical rebound in construction was bouyed by the New Home and pending home sales reports. New home sales were down 1% to a 312k annual rate but prices rose with the median price up 7.2% and the average up 4.8% year over year. Supply remains very low on an absolute basis at 164,000 so even at this low rate of sales homebuilders have just 6.3 months of supply. The pending home sales index was up 2.4% month to month and 19.8% year over year. This is a seasonally strong time of year but the year over year rise gives some hope.

For the housing market to truly rebound though will require more growth and more jobs. On the jobs front, new jobless claims finally fell below the 400k level to 398K. That is still way too high and there may be some problems with seasonal factors due to the auto industry but claims at least appear to be heading in the right direction again.

As for growth, the headline numbers were pretty bad and hard to argue with but there were some positives. Overall, 2nd quarter growth was 1.3% which was up from a revised and dismal 0.4% in the first quarter. The big drag was on the consumption side with drops in both durables and non durables. The drop in durables was in autos and household equipment while the non durable side was mostly in gasoline. By contrast, it was all positive on the investment side with GPDI rising 7.1% led by an 8.1% rise in structures. Even residential investment added to GDP rising 3.8%. While the headline growth rate is disappointing, the underlying data is more positive. If the slowdown in autos is Japan related - and I have no idea whether it is or not but that seems to be the consensus - and construction starts to pick up, growth may surprise on the upside in the second half.

Stocks sold off last week based on the lack of a debt ceiling deal and the weak economic data. The S&P 500 is now near the low end of its recent range and if a deal is struck next week a relief rally seems likely. Whether it is sustainable will depend on the outlook for economic growth and earnings. For now, it seems more likely that the economic data will continue to worry for a while longer. Earnings have been good again this quarter so far, but with profit margins near all time highs, further upside is dependent on sales growth. With the global economy slowing that seems less likely. We remain very conservative in our allocations as we wait for more evidence that US growth is picking up.

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