Tuesday, July 29, 2014 - How Do you Feel?

How Do You Feel?
by Sinclair Noe

DOW – 70 = 16,912
SPX – 8 = 1969
NAS – 2 = 4442
10 YR YLD  - .03 = 2.46%
OIL - .63 = 101.04
GOLD – 4.70 = 1299.80
SILV un = 20.66

How are you feeling? Are you confident? Apparently more people are. The Conference Board’s consumer confidence index increase to 90.9 in July, up from 86.4 in June; it’s the highest level in almost 7 years; it marks a significant rebound from the February 2009 low of 25.3. The people who compile the index say: “Strong job growth helped boost consumers’ assessment of current conditions, while brighter short-term outlooks for the economy and jobs, and to a lesser extent personal income, drove the gain in expectations,” and the improved confidence “suggests the recent strengthening in growth is likely to continue into the second half of this year.”

Home prices dropped in May compared to April. The S&P/Case Shiller composite index of 20 metropolitan areas declined 0.3% in May on a seasonally adjusted basis, its first decline since January 2012. Prices in the 20 cities rose 9.3% year over year, the slowest year-over-year gain since February 2013. The Phoenix area posted a 0.4% increase from April to May, non-seasonally adjusted.

In a separate report form the Commerce Department, home ownership rates dropped to 64.8% in the second quarter from 65% in the first quarter.

A fairly startling report was published today by the Urban Institute and TransUnion, the credit reporting firm, showing more than one-third (35%) of Americans with credit files had debt in collections in 2013. Non-mortgage delinquent debt totals $11.23 trillion. Which sounds like a lot, and it is, but it’s down from $12.68 trillion in delinquent debt in 2009; this includes debts such as credit cards, auto loans, student loans, utility bills, or even a phone bill or gym membership.  The study looked at debts that had been reported to a credit bureau as delinquent, and turned over to collection; that means the debt is at least 180 days old, but it also means the debt can stay on the credit report for up to 7 years, maybe longer. The share of people with debt 30 days past due is about 5.3%. What this means is that when a debt becomes past due, it lingers on a credit report.

The report on delinquent debt may tell us more about debt collection methods than about deadbeat American consumers. It is very easy for a company to turn over a debt to a credit rating bureau or a debt collection company; it is very hard for a consumer to get a debt removed from a credit report, even if the debt is disputed, or in many instances, even when the debt is paid. Consumers filed 204,000 complaints with the Federal Trade Commission last year, up nearly 3% from 2012, even though the amount of delinquent debt dropped. The most common complaint concerned debt collectors that lied about the amounts a consumer owed and the nature of the delinquency.

The European Union has imposed new sanctions on Russia for its involvement in supporting separatists in Ukraine. The US also toughened its sanctions further. The latest American actions took aim at more Russian banks and a large defense firm, but they also went further than past moves by blocking future technology sales to Russia’s oil industry in an effort to inhibit its ability to develop future resources. The Euro Union agreed to restrictions on trade of equipment for the oil and defense sectors, and "dual use" technology with both defense and civilian purposes. Russia's state run banks would be barred from raising funds in European capital markets. The measures would be reviewed in three months. Previously Europe had imposed sanctions only on individuals and organizations accused of direct involvement in threatening Ukraine, and had shied away from wider "sectoral sanctions."

The orchestrated actions on both sides of the Atlantic were designed to demonstrate solidarity in the face of what American and European officials say has been a stark escalation by Russia in the insurgency in eastern Ukraine. Until now, European leaders have resisted the broader sorts of actions they agreed to today.

Though Europe’s commerce with Russia will probably slump because of the sanctions, the measures are expected to hit Russia more severely, especially the restrictions on Russian banks’ ability to raise money in Europe and the United States. European companies have been warning for some time that their earnings could suffer because of sanctions against Russia. Today, the oil company BP warned that sanctions could hurt earnings. BP owns a 19.75% stake in the Russian oil company Rosneft.

We are about halfway through second quarter earnings season. Here are a few of today’s reports:

The pharmaceutical company, Pfizer posted earnings that beat estimates, while revenue dropped; they also said they expect earnings to drop in the third quarter. Merck had a similar story, beating earnings estimates while revenue slipped. United Parcel Service missed profit forecasts, even as profits and revenue were higher than a year ago. Herbalife, the multi-level marketed nutritional supplement company posted weak earnings after the close yesterday; shares were clobbered today. Corning, the glass making company reported a sharp drop in earnings due to acquisition costs; also clobbered.

Twitter reported a net loss of $145 million, or 24 cents a share, compared to a loss of $42 million a year ago. More people used the Twitterverse during the World Cup; revenue was up 124%, but then the users fade away; globally, usage was down 7% from a year ago. Twitter shares have jumped about 30% in after-hours trading. Go figure.

The Federal Reserve FOMC started its two-day meeting today. They will issue a statement tomorrow. The Fed is in the midst of reducing the amount of money it is pumping into the financial system by way of large purchases of mortgage backed securities and Treasuries, a process of tapering the Quantitative Easing. So far, the Fed has reduced purchases from $85 billion a month to $35 billion a month, and tomorrow they are expected to drop that down to $25 billion a month. QE is scheduled to end in October.

Then the Fed will shift their focus to raising its target for short-term interest rates, which have been near zero for more than 5 years. The Fed has already said they will take their time in raising rates. That exit from an accommodative policy is considered dangerous, and today the International Monetary Fund, the IMF, said it could reduce output in the United States by as much as 2% through 2016.

Volatility in the US could ripple through to emerging markets and likewise depress growth, but even worse; cutting growth by as much as 9% in more vulnerable developing countries due to higher interest rates and tighter financial conditions; and then it gets worse, with larger declines coming in time due to lower productivity, weaker trade, and falling commodity prices.

In addition to when the Fed will raise rates, it is also important to consider how high they will raise rates, and if they will wait long enough for liftoff to occur first. Liftoff is when the US economy has regained its strength and momentum and is able to cope with higher rates because of its economic strength. Fear of inflation could prompt the Fed to raise rates before liftoff; there is an even greater chance the Fed will raise rates before emerging markets could bear the burden of higher rates. If the Fed gets it wrong, we could end up stuck in sluggish or permanently lower growth.

Swiss bank UBS and German bank Deutsche Bank have disclosed that they are facing inquiries from the New York attorney general’s office. The UBS inquiry deals with dark pools, or alternative trading platforms, generally used by larger institutional clients such as pension funds and hedge funds, trying to hide orders from public observation. At its core, the dark pools are a form of price manipulation. Deutsche Bank is facing inquiry into high frequency trading and dark pools.

The Financial Times reports: “The Federal Reserve Bank of New York is stepping up pressure on the biggest banks to improve their ethics and culture, after investigations into the alleged rigging of benchmark rates led officials to conclude bankers had not learnt lessons from the financial crisis…

“Fed officials were surprised that some of that reported behavior occurred after the 2008 crisis, leading them to believe bankers had not curbed their poor conduct. To make sure the biggest banks are paying enough attention to ethics and culture, NY Fed bank evaluations have begun incorporating new questions emphasizing such issues. Topics include whether the right performance structure is in place to punish bad behavior, especially when it comes to compensation.”

Well, that is just great, the NY Fed suggests banks pay smaller bonuses when they encounter unethical behavior by the banksters. We’ll file that one under “Cruel and Unusual Draconian Punishment”.

But if you’re really looking for a funny story about banksters, check out the New York Times Dealbook. It seems the banksters are cashing in on advising companies how to do inversion deals to evade taxes. Inversions are behind the recent rash of merger deals in which major US corporations have renounced their citizenship in search of a lower tax bill offshore. It is important to understand that inversion does not in any meaningful sense involve American business moving overseas; all they’re doing is dodging taxes on those profits.

Investment banks are estimated to have collected, or will soon collect, nearly $1 billion in fees over the last three years advising and persuading American companies to move the address of their headquarters abroad (without actually moving).

The leaders in this growing field include Goldman Sachs, JPMorgan, Morgan Stanley, and Citigroup; they’ve made hundreds of millions aggressively promoting these transactions to major corporations, arguing that such deals need to be completed quickly before Washington tries to block them. These same banks received hundreds of billions from US taxpayers in the form of bailouts. The Joint Committee on Taxation estimates these inversion deals are expected to cost taxpayers nearly $20 billion over the next decade.

Wednesday, July 09, 2014 - Waiting for Liftoff

Waiting for Liftoff
by Sinclair Noe

DOW + 78 = 16,985

SPX + 9 = 1972
NAS + 27 = 4419
10 YR YLD - .02 = 2.54%
OIL – 1.46 = 101.94
GOLD + 7.00 = 1327.60
SILV + .08 = 21.10

The Federal Reserve released the minutes of the most recent FOMC policy meeting from June 17-18.

The Fed is going to take away the punchbowl. As of October, no more punchbowl. That’s it, QE is drying up. I think we all knew that was coming. And then after the Fed stops buying Treasuries and mortgage backed securities, they will get around to probably raising their target on interest rates, but rates would remain near zero for a “considerable time” (probably the spring of 2015) after the Fed halts its program of bond purchases.

According to the minutes, there continues to be division over when the Fed should stop reinvesting proceeds of the $4.2 trillion in assets it purchased to support financial markets. Ending reinvestment will put the central bank's balance sheet on a declining path, and some members argue that should not take place until interest rates have been increased. Fed officials also agreed that the rate of interest on excess reserves would play a “central role” in moving rates higher when the time comes.

And this is a fluid timeline for all this; it is partly dependent on “liftoff”; that’s the new word from the Fed – liftoff. At some point, the economy will slip the surly bonds of earth and wheel, soar, and swing high in the sunlit silence, and do a hundred things we haven’t dreamed of for such a long, long time. Someday, we’ll have liftoff.

The market players looked at the minutes and pulling away the punchbowl, while painful, was an indication of economic strength. Fed officials expressed overall confidence that moderate economic growth will continue and unemployment and inflation will gradually move towards the central bank's targets. A couple of participants noted that consumer spending had been supported importantly by gains in household net worth while income gains had been held back by only modest increases in wages. So, an important element in the economic outlook was a pickup in income, from higher wages as well as ongoing employment gains that would be expected to support a sustained rise in consumer spending. Which is correct in theory; we just haven’t seen the pickup in income.

At the press conference after the June meeting, Fed Chairwoman Janet Yellen said that recent inflation readings were “noisy.” According to the minutes, the Fed staff was not concerned with inflation despite some recent higher readings. Although the Fed staff revised its inflation forecast up “a little” in the near term, the medium term projection was revised down slightly.

Yesterday I talked about an anomaly in the jobs number from Thursday. How could we have negative 2.9% GDP in the first quarter while we were adding all those jobs? I concluded that the problem was that productivity was declining.

New data was released this morning showing US productivity growth was the worst since the recession. The data from the Labor Department looks at multifactor productivity, and it includes the impact of capital, new machines, investment in technology, and such. The measure of capital services input grew 1.9%, which is the best showing since 2008, but that is more a reflection of the bounce from the 1st quarter, and still far from the pre-recession levels that were consistently above 3%. So, the data in this morning’s report is consistent with an economy coming out of a recession but nowhere near its pre-recession rate of growth. Bottom line is that productivity needs to increase if the economy is going to get better.

One of the concerns for Fed monetary policy is inflation, which isn’t a problem right now and when we have seen a problem in the past 20 years of so, the Fed has been able to tamp it down. The problems with inflation right now are tied to energy and food prices. Food prices are largely tied to weather, and we have seen some nasty weather, and the Fed can’t control the weather. Extreme weather will be an ongoing problem, and rising food prices will be an ongoing challenge, but for now, it’s a short term inflation problem.

Energy prices are largely tied to geopolitical problems in the Middle East. Iraq, Israel, Syria, and other problems could explode out of control at any given moment, but we’ve seen crude oil prices dropping for 9 sessions. The problem in Iraq may very well result in the country splitting apart, but the southern regions, which produce and export the most oil, will likely continue exporting oil. So, the oil traders don’t seem concerned about Iraq divided in 3 parts. Meanwhile, Ukraine hasn’t unfolded as Putin planned. Kiev did not roll over. Sanctions are painful. Putin doesn’t look like he wants to escalate the fight; at least not today.

Meanwhile, the US is more or less on track to pass Russia and Saudi Arabia as the world’s largest producer of crude oil within the next 5 years. Domestic crude output is increasing but the increase is coming from shale and shale is notoriously tricky and expensive to extract. The US will continue to extract more shale oil but certain projects, even mega-projects, have been abandoned because of the expense. We know that there are huge reserves in the US, but it doesn’t always pay to pump it; so the increase in output may not be as strong as hoped. For now, prices are high and oil extraction is soaring at shale formations from Texas to North Dakota as companies split apart rocks using high-pressure liquid, or fracking. The result is that now Oklahoma has more earthquakes than California, and we are less dependent on foreign oil.

The United States has just become the world’s biggest oil producer, at least when you consider crude oil plus natural gas together. The US has been the top global nat gas producer for the past 4 years, but a new report from Bank of America says that in the first six months of this year the US overtook Saudi Arabia and Russia to become the top producer of petroleum product, that is oil and natural gas and the liquids that are separated from nat gas.

Annual investment in oil and gas in the US is at a record $200 billion, reaching 20% of the country’s total private fixed-structure spending for the first time, but it will take some time for that investment to work its way through the rest of the economy. We now produce about 11 million barrels a day of crude oil and we consume about 18.5 million barrels a day. So despite the boom, we still import oil and we are still dependent on OPEC. If we converted from oil and gasoline to nat gas, starting running more cars on compressed natural gas, we could become energy independent in short order.

The other side of the equation remains conservation and not just a switch to nat gas but a switch to renewable energy. You think green energy is too expensive? Tosh; tosh and falderal. Global energy markets are reaching a tipping point. For the first time, a large fraction of the world's fossil fuels could be replaced at a lower cost by clean energy, with today's renewable technologies and prices. And virtually no further investments in fossil fuels make long-term economic sense because higher fossil fuel prices over their useful life will be exorbitant.

Barclay's Bank recently downgraded the entire US utility sector in fear that it would not respond to the disruptive challenge of distributed solar. The Barclays credit team believes that, over the next few years, the “confluence of declining cost trends in distributed solar photovoltaic (PV) power generation and residential-scale power storage is likely to disrupt the status quo.” The new government in India is cutting fossil fuel subsidies and promising to provide rooftop solar for 400 million homes. Conservation is another important element. Profitable building retrofits would cut fossil fuel used for heating and cooling by 20%, and displace another 15% of fossil fuel electricity demand.

International oil companies are hitting the wall on the price they will pay for big new oil projects. There is plenty of oil in Ohio but BP, in its last quarterly report, announced it would halt development of the Utica shale fields. Along with BP, Chevron, Shell, Total, Statoil, and Exxon have all cancelled or delayed mega projects or even sold off major investments in US oil projects

The latest Bloomberg New Energy Finance projection suggests that 2/3 of incremental global power generation over the next fifteen years will come from renewables. Declines in coal use in developed economies will be sharp enough to cut the global share of fossil fuels from 64% today to only 44% in 2030.

Electricity currently provides only 1% of global transportation energy; EV's and rail could today replace the first 15% of the oil used by cars and trucks at with an internal rate of return higher than 15%. Fossil fuels generate 63% of the world's power, renewables less than 5%, but 1/3 of fossil electricity now costs more than competing wind and solar. And that doesn’t even begin to factor in the externalities associated with fossil fuels.

A couple of quick notes as we wrap up. Citigroup is reportedly close to paying about $7 billion to resolve a probe into whether it defrauded investors on billions of dollars’ worth of mortgage securities in the run-up to the financial crisis. A majority of the settlement is expected to be in cash, but the figure also includes several billion dollars in help to struggling borrowers. An announcement of the settlement between the bank and the Department of Justice could come as early as next week.

This bit of economic data came in late this afternoon. The Arizona Regional Multiple Listing Service shows the Phoenix market saw overall sales in June drop 11% year over year; now back to the lowest sales since 2008. Non-cash sales were up 6% year over year, but cash sales were down 40%; so it looks like investors are moving on. Active inventory is up 43% year over year and at the highest level for June since 2011. So, sales are down, inventory is very high, and cash is scarce.

When do we start QE4?

Monday, May 20, 2013 - Daily Scandals and Distractions

Daily Scandals and Distractions

by Sinclair Noe

DOW – 19 = 15,335
SPX – 1 = 1666
NAS – 2 = 3496
10 YR YLD + .02 = 1.96%
OIL + .58 = 96.87
GOLD + 33.90 = 1395.10
SILV + .66 = 23.02

I suppose we should start with the scandal du jour, since this is where most of the news has been fixated recently. I'll try to focus on how it affects the economy and the markets, but it's hard to ignore the bluster. One quote I heard over the weekend was "add Watergate and Iran Contra together and multiply by ten" to calculate the tyrannical evil of the Obama scandals.

Actually, the current scandals are not even close (I'm old enough to remember the enemies list and plumbers). I don't think the scandals are inconsequential but I think some historical perspective might help. The rhetoric without perspective might actually backfire. But what we concern ourselves with here is the economic and financial impact. And it's likely there will be limited economic impact. We've seen worse, and the markets survived and sometimes even prospered.

Remember Iran Contra? It happened to coincide with one of the greatest bull runs the market has ever seen. And remember the Lewinsky scandal? It coincided with a market that was described as irrationally exuberant; this is often attributed to gridlock in Washington, or some sort of moderation. Actually, the old idea of gridlock being good for markets, doesn't really hold water.

When one party controls both the White House and Congress – Republicans or Democrats – the markets perform about 5 times better than when the president and Congress are from opposite parties. It doesn't seem to matter for the current administration; the market is enjoying big gains, with the S&P 500 up 149% since the lows of March 2009. And when things look bad, the market goes higher.

The explanation may come from the Federal Reserve. Weak numbers on any front are viewed as a sign that the Fed will remain accommodative as will other central banks around the world. The old adage "don't fight the fed" has really become "don't fight the feds' - as in plural. Trillions of dollars on the sidelines have to be put to work and are hungry for yield, especially from stocks. 

The trillions of dollars worth of central banks stimulus has put into play the past few years have socialized risk. The game used to be private gains and private losses. Now it's private gains and socialized losses. Businesses that have under-invested for years are beginning to capitalize on a distracted Washington using the breathing room to make new investments.

Anyway, the markets appear to be propped up, for now at least.

Remember the Libor rate rigging scandal? Several of the biggest banks were rigging Libor, the interest rate that is used worldwide for just about everything. When the Libor Scandal broke it raised the question, what else is rigged? We learned that derivatives, specifically the nearly $400 trillion dollar market in interest rate swap prices were subject to possible manipulation of the ISDA fix.

The latest revelation is oil price rigging. A review ordered by the British government last year in the wake of the Libor revelations cited “clear” parallels between the work of the oil-price-reporting agencies and Libor.

They are both widely used benchmarks that are compiled by private organizations and that are subject to minimal regulation and oversight by regulatory authorities. To that extent they are also likely to be vulnerable to similar issues with regards to the motivation and opportunity for manipulation and distortion.

Last week, the European Commission raided the offices of Shell, BP and Norway’s Statoil as part of an investigation into suspected attempts to manipulate global oil prices spanning more than a decade. None of the companies have been accused of wrongdoing, but the controversy has brought back memories of the Libor rate-rigging scandal.

The inquiry also involves Platts, the world's largest oil price reporting agency. Europeans have long complained that retail gas prices have not seemed to match wholesale prices. In fact, complaints that retail prices at gas stations were noticeably slow to fall when wholesale prices fell prompted the U.K.-based Office of Fair Trading last year to conduct a cursory inquiry into possible anti-competitive behavior in the fuel markets.Early this year, they announced that they hadn't found enough evidence to warrant a full-blown investigation. But complaints persisted.

Reuters points out that the probe may be expanding to the U.S.:

“In Washington, the chairman of the Senate energy committee asked the Justice Department to investigate whether alleged price manipulation has boosted fuel prices for U.S. consumers.

“Efforts to manipulate the European oil indices, if proven, may have already impacted U.S. consumers and businesses, because of the interrelationships among world oil markets and hedging practices,” Sen. Ron Wyden (D-Ore.), chairman of the Senate Energy and Natural Resources Committee, wrote in a letter to Attorney General Eric H. Holder Jr. Wyden also asked Justice to investigate whether oil market manipulation was taking place in the United States.”

Not only are petroleum products a multi-trillion dollar market on their own, but manipulation of petroleum prices would effect virtually every market in the world.

There's a lot riding on the price of oil, including how much money OPEC nations need to keep their governments funded. At $100 a barrel, there's enough profit to produce the oil and to fund the governments. Things get dicey around $80 a barrel; $60 dollar a barrel oil spells big problems for almost all OPEC countries.

Meanwhile, the International Energy Agency (IEA) in its Oil Market Report claimed that America's shale boom is growing even larger than expected. It's also set to have a profound effect on OPEC. OPEC is also set to produce, or have the capability to produce, a lot more oil. One main driver of that supply growth is Iraq. After a turmoil-filled decade, Iraq is coming back on line in a big way -- and could add another 3 million barrels per day to the oil mix by 2018.

So the U.S. has lots of oil, and we're producing it at an ever-growing rate. And OPEC has a lot of oil and is either producing it or sitting on it.

And what's funny is that if OPEC continues to cut supply via quotas, all it will do is help the U.S. oil boom. They'll essentially be crimping supply to boost prices... and we'll benefit. So why are prices still high? Central banks are still printing money. The Fed and the BOJ are printing away, and it's probably only a matter of time before the ECB joins in. Maybe that explains something. Then there is the fear premium. Then there is the idea that prices are rigged. Nobody wants to upset the situation, at least not right now.

The Saudis aren't happy that Iraq is coming online with about 3 million barrels a day by 2018. This could lead to a round of infighting among OPEC -- with each nation trying to eke out the most money. Frankly, the Saudis have massive incentive to see Iraq fail. The same goes for Iran. There are sanctions against Iranian oil, and that has as much to do with the price of oil as any specific act of craziness from the Iranian crazies.

The U.S. and OPEC are set to produce much more oil. And even though US and Euro demand is falling, demand from the oil-thirsty East is set to ramp up. So, we have an uneasy equilibrium in the oil markets right now.

The Federal Reserve Bank of San Francisco points out: When gasoline prices increase, a larger share of households’ budgets is likely to be spent on it, which leaves less to spend on other goods and services. The same goes for businesses whose goods must be shipped from place to place or that use fuel as a major input (such as the airline industry). Higher oil prices tend to make production more expensive for businesses, just as they make it more expensive for households to do the things they normally do.

Oil prices indirectly affect costs such as transportation, manufacturing, and heating. The increase in these costs can in turn affect the prices of a variety of goods and services, as producers may pass production costs on to consumers. Oil price increases are generally thought to increase inflation and reduce economic growth.

Oil price increases can also stifle the growth of the economy through their effect on the supply and demand for goods other than oil. Increases in oil prices can depress the supply of other goods because they increase the costs of producing them. In economics terminology, high oil prices can shift up the supply curve for the goods and services for which oil is an input. One major area that could feel the pinch is agriculture, and the prices of the food we eat.

There are some important scandals, just don't get distracted.

Monday, February 25, 2013 - Playing With Fire

I will be speaking at the 2013 Wealth Protection Conference April 5 & 6. Click here for more information or call 800-494-4149

Playing With Fire

by Sinclair Noe

DOW – 216 = 13,784
SPX – 27 = 1487
NAS – 45 = 3116
10 YR YLD - .07 = 1.90%
OIL - .86 = 92.27
GOLD + 12.30 = 1594.80
SILV + .26 = 29.12

Let's make sure you're prepared for the week.

Late Friday, Moody's cut Britain's sovereign credit rating by one notch to Aa1 from Triple-A, with a stable outlook. Moody's cited the prospect of a further slow-down in the British economy, which would in turn undermine the government's deficit reduction plans. The official word from the Bank of England is that the downgrade will not affect deficit reduction targets, but there are calls for stimulus spending, specifically infrastructure spending, where a one pound investment results in 3 pounds of economic growth. Alternatively, the risk is that too great a focus on deficit reduction could further squeeze the economy and domestic corporate revenues.

This was a vote of no confidence in Britain's austerity policies which have only served to worsen the economic outlook. The pound sterling dropped to $1.51 earlier in the morning, a two-and-a-half year low. UK sovereign debt actually strengthened in late trading. The Triple-A rating may be lost but it has not resulted in a surge in UK borrowing costs, at least not yet. It's difficult to figure exactly how a lower credit rating effects a soverign nation which prints its own currency. The Brits, though, are playing with fire.

The revival of sovereign debt fears have largely been buried under several rounds of QE around the world. As for precious metals, the impact may be mixed: A stronger dollar is bearish, while the revival of sovereign debt risk is bullish for precious metals. And with the EU crisis back in the headlines, we have a brief repreive in the US Treasury bond tumble, with rates dropping for the first time in a long time. On the other end of the continent, the Italians are likewise, playing with fire.

One of the reasons for sterling pound's recovery is the twists and turns in the Italian election. The European economic crisis and the austerity policies that came in its wake have had a destructive effect on democracy in almost every member state. Politicians, some out of conviction and some simply in pursuit of advantage, have identified a constituency of anger and discontent ripe for exploitation.

The Italians are voting for a new Prime Minister and the candidates include an old Prime Minister. Silvio Berlusconi is trying to tap into the populist anger by promising to repeal a tax on primary homes introduced last year. We'll wait to see, but Berlusconi might have drummed up enough support to stop the front running coalition of Bersani and Monti and create a deadlock in Parliament. Again, we'll wait and see but any surprises here could re-ignite sovereign debt issues in Europe; so,don't be surprised if we see Italian bonds shoot into the stratosphere again.

Meanwhile, Fed Chairman Ben Bernanke goes to Washington to deliver his two-day testimony before Congress. Wall Street traders will be looking for clarifications of the Fed minutes. Most notably, whether the Fed will seek an exit from QE before the economy reaches the target numbers of 6.5% unemployment or 2.5% inflation. The rate-sensitive sectors, most notably housing and autos, are kicking into a higher gear.

Lawmakers criticized Bernanke during past outings; they questioned the effectiveness of his strategy and fretted about inflation, all the while trying to deflect criticisms of fiscal policy, or the lack thereof. The most recent Fed minutes seem to point to Bernanke talking about an improving economy. "Most participants" at the central bank's Jan. 29-30 meeting said the asset purchases have helped "stimulate economic activity, and many pointed, in particular, to the support that low longer-term interest rates had provided to housing or consumer-durable purchases.”

Of course the Federal Reserves Quantitative Easing Stimulus Plan doesn't have a broad reach through the economy, and limits were on display with a fourth quarter cut in defense spending, leading to a 0.1 percent contraction in GDP. Government outlays dropped 6.6 percent from October through December, subtracting 1.3 percentage points from growth. The Fed has an extra job to do because it has to offset some of this austerity.

The central bank might not be able to offset further reductions, as well as the impact of taxes that rose in January. The automatic budget cuts known as sequestration would reduce 2013 gross domestic product growth by 0.6 percentage point and pare about 700,000 jobs by the end of 2014. And the sequester hits on Friday, unless Congress can work out a deal before then; don't hold your breath.

The Murdoch Street Journal reports Congress has already given up on Friday's deadline and is now looking forward to the next deadline, which is March 27^th, when Congress will need to pass a new federal budget or a continuing resolution or face the prospect of shutting down the government. Congressional leadership, if that's not too much of an oxymoron, has already started discussing a bill to fund government operations through September. The lack of action on the sequester is strange, to say the least. One line of thinking is that it won't be resolved until we see long lines at airports, or kids kicked out of Head Start, late arriving tax refunds, or some other ugly optic. The other line of thinking is that the bigger cuts will come to defense programs, so some of the economic impact will fall on overseas activities, which would blunt the domestic impact.

The effects of the sequester should not be underestimated, especially because it would hit at the same time as the Japanese and British and Euro-zone are looking at the negative effects of austerity programs and fiscal contraction. In the stock market, the S&P 500 has now gone 505 days without a 10% correction; that's only happened 6 times in the last 50 years. We're ripe for a bit of a pullback.

Still, it doesn't necessarily spell doom and gloom. The interest rate sensitive housing and auto sectors have improved; this could not occur without the zero interest rate policy of the Fed, and also because household finances are looking more solid than they have in years. Of course, one reason for the improving household financial situation is that many people defaulted on debt, which is the fastest course for most people to increase net worth. The point is that it works, and we're finally on the cusp of what almost looks like a normal recovery.

This hint of normalcy suggests the slow improvements in the labor market over the past few years can now provide a bigger boost to consumer spending, which will in turn create more jobs; the virtuous cycle. This is not to say the sequester doesn't matter; it does. It will slow growth, but the growth may now have enough momentum to where it won't be stopped in its tracks.

Even after the austerity shock recedes, nobody is expecting a boom. Credit is still hard to come by, especially for the millions of Americans who defaulted on their debts during the depression. Europe's debt crisis and higher gasoline prices also pose constant threats to recovery. Of course, we've heard the refrain before: recovery is just around the next corner, just a couple of quarters away. And that is where the recovery has remained; just out of reach; an ongoing promise of tomorrow; just out of reach.

Today also marked the first day of the BP trial, the federal civil trial against the operators of the doomed Deepwater Horizon oil rig. The trial is a high-dollar showdown pitting oil giant BP's cash wealth against the legacy of one of America's richest, yet most troubled wildlife habitats.

The April 20, 2010 spill that began with an explosion that killed 11 rig workers and ended three months later with over 200 million gallons of light crude spilled into the Gulf still resonates physically and psychologically in the five coastal states affected, even as BP has gone to massive lengths to clean up the mess while paying billions in damages to residents and communities along the sullied coastline. The trial which started today is about answering the still-critical question: Did BP exhibit "gross negligence" in its operation of the rig, causing the largest offshore oil spill in US history? If so, the company could be on the hook for up to $17 billion in damages, after having already paid out $24 billion.

The trial judge (there is no jury) will have to decide what percentage of responsibility each of the three major players - BP, the speculator; Transocean, the rig owner; and Halliburton, a key drilling consultant - will have to bear if found responsible. While BP has claimed responsibility, the ultimate legal liability is not cut-and-dried as the judge has made clear that the two other companies also may bear blame for what became a domino effect of missed signs and overlooked problems that finally led to the explosion. And that is really a big part of the case. Was the accident ultimately avoidable or did the companies carelessly and negligently cut corners as they hunted for profit. Gross negligence is a very high bar that BP believes cannot be met in this case. They will contend this was a tragic accident, resulting from multiple causes and involving multiple parties, but not gross negligence.

The trial could drag out for 3 months, or BP could seek a settlement. One reason for the states’ difficulty in shaping an offer has been their disagreement over how the money would be paid. Some states, like Florida, prefer to see the company pay more in economic damages because those would give the states greater flexibility in spending the payouts. Payments for pollution-related penalties typically must be used for environmental purposes.

There's a lot of talk about currency wars these days, but very little understanding about what that means for specific countries, economic growth, inflation, and your pocketbook. Let's fix that.

First of all, there has been no declaration of any currency war. And won't be. Currency wars lead to global crisis. Currency adjustments, however, are happening all the time. Here's an over-simplified explanation about how currency adjustments affect you.

If Japan exports cars to America and America exports grain to Japan, each has to pay the other. American grain exporters want to get paid in dollars, so they can spend those dollars in the US. The Japanese want to get paid in yen so they can pay their workers in yen, pay their taxes in yen, and spend their money in Japan.

American car importers can "buy" yen with their dollars to pay the Japanese for their cars, or the Japanese can accept dollars as payment and then use those dollars to buy yen themselves. Of course it works the other way around if you're a grain farmer selling to Japan.

But the value of yen to dollars, or dollars to yen, isn't constant. There is no set exchange rate. Exchange rates are set in open currency trading markets where currencies are bought and sold to the tune of several trillions of dollars a day, every day. One day a dollar might buy 100 yen and the next day it might buy only 98 yen, or it could buy 102 yen. Lots of factors determine exchange rates, but the biggest, by far, is interest rates.

Currency adjustments are all about the value of your "home" currency relative to other countries' currencies. Our home currency in America is the dollar, in Japan it's the yen, and so on.

Countries that export a lot of goods want their currency to be "cheap" relative to other countries, especially those countries who are buying the home countries' exported goods. If the value of American dollars to Japanese yen is strong, meaning a dollar can buy a lot of yen, when you buy a Japanese car, for example, it will take fewer dollars to pay for it.

Because Japan exports a lot of cars it wants its currency to be "cheaper" than other currencies so it doesn't take as many dollars, or euros, or pounds to buy a Japanese car, or any product exported from Japan.

Here's the problem. America is a huge exporter of goods and services, too. So is Germany, and of course so is China. All governments want to support their exporting industries. It's about manufacturing and jobs, and revenue and profits, and economic growth and standards of living. The easiest way to facilitate an export-driven economy is to keep the home currency "cheap" relative to other currencies.

If exporting countries, especially those that don't have big domestic demand bases, meaning less-developed and "emerging-markets" economies, are all trying to export their way to growth and they all want to have their currencies be "cheap" on a relative basis, that can't happen. Everyone's currency can't be cheap at the same time.

So, adjustments are made. Governments who want to stimulate growth through exports take measures to lower the value of their currencies. Japan's new Prime Minister, Shinzo Abe, in an unusual exception to the pacifist approach to currency skirmishes, recently fired a shot heard round the world. To lower the value of the yen, Abe is demanding domestic monetary easing, aggressive stimulus, and more dangerously, has openly been talking down the yen.

Sound familiar? That's because the US has been involved in its own stimulus program, which includes more American exports. Also, the Federal Reserve has kept interest rates low, as in very low. One of the ways the Fed has done this is by "printing" money. The Fed has the ability, beyond the reach of Congress or the President, to buy what it wants, which is most often US Treasury government bonds. It pays for what it buys by simply issuing "credits" as payment.

Those credits are turned into money as they are spent by the government whose bonds the Fed buys, or by banks who sell the Fed their underwater mortgage-backed securities. Thus, the banks supposedly have money to lend.

Because the Fed has kept interest rates so low in America, investors are parking their money in other countries where interest rates are higher. In order to put your money into a bank in another country that offers higher interest rates than banks offer in the US you have to first buy that country's currency. And that bids up that country's currency relative to the dollars that you are selling.

In addition to the dollar being weakened, by investors selling dollars to buy and invest in other countries currencies, the amount of money being printed by the Fed means that at some point in the future all that money in the system will cause prices to rise, and causing the dollar to fall further. And if the dollar is falling relative to the Japanese yen or the euro, other countries who want to grow their exports are going to eventually do what they have to in order to lower the value of their own currencies.

That's how we get into currency wars.

You'll know when it's starting to spread. Interest rates will start to rise; watch the yield on the U.S. 10-year treasury. There are no real safe havens in a currency war. Commodity prices will rise; you'll see it in your grocery bills. Eliminate your debt and accumulate cash, and when prices crash, be ready to buy.

Friday, November 16, 2012 - Externality and Inequality

Externality and Inequality

by Sinclair Noe

DOW + 45 = 12,588
SPX + 6 = 1359
NAS + 16 = 2853
10 YR YLD -.02 = 1.57%
OIL + 1.05 = 86.50
GOLD – 2.40 = 1714.70
SILV - .29 = 32.41

Top Congressional leaders met with President Obama today at the White House. Democrats said they recognized the need to curb spending. Republicans said they agreed to put revenue on the table. They sang a chorus of Kumbaya; they left the meeting and talked to the press. Mitch McConnell, John Boehner, Nancy Pelosi and Harry Reid all shared the microphone; both sides pledged cooperation; both sides agreed that driving over the fiscal cliff was a big bucket of crazy; no blood was shed today. Don't hold your breath.

Former Federal Reserve Chairman Alan “Bubbles” Greenspan says allowing taxes to rise would be a small price to pay to get lawmakers to accept spending cuts on entitlement programs, even if it leads to a moderate recession. So, what is on the negotiating table is starting to emerge, even though the goal posts are still moving targets. What is most interesting at this point is not the proposals that are on the table but the proposals that never make it to the table. How can we really have a debt to GDP ratio problem when we have a non-convertible fiat currency, a floating exchange rate and debts in currencies not our own? Yea, that isn't going to be part of the discussion.

And that brings us to today's main topic: externalities and inequality.

You may have noticed that the markets don't always produce the best possible social outcomes. The pollution generated by a factory imposes costs on those who live downstream or in the path of its airborne emissions. The risks assumed by banks leading up to the recent financial crisis imposed costs on just about everybody. Market transactions often generate “externalities”, or side effects, sometimes positive but often negative, that affect people who do not participate in the transaction. What's the solution? Well if you want less of something you tax it. You could tax the negative externalities and subsidize the positive externalities.

Does the fact that hedge-fund manager rakes in 100 or 1,000 times what office manager earns impose costs on everybody else? Plenty of Americans think not. Defenders of our income inequality point out that a free-enterprise system requires some inequality. Unequal rewards give people an incentive to work hard and acquire new skills. They encourage inventors to invent, entrepreneurs to start companies, investors to take risks. It’s fine in this view that some people get astronomically rich.

On the other side, many of us have a gut feeling that inequality has gone too far. Our times are reminiscent of the Gilded Age’s worst excesses.

The conventional strategy for fighting inequality is to tax the rich. The idea is based on a foundation of fairness, and the question of what’s fair and what’s unfair turns out to cut different ways, depending on your point of view. You may find it unfair that the very rich take in so much more than others. Somebody else might wonder why the rich should be taxed so heavily. Don’t they already pay disproportionately more than everyone else? These arguments hit a dead end. So, the lemming politicians are ready to run off a fiscal cliff over marginal top tax rates of 35% or 39%, that have already demonstrated negligible effects in reducing inequality. No one even discusses top rates that might make a difference. So what we need to look at is how skewed income distribution imposes costs on the rest of us.

Between the end of World War II and 1973, the top marginal tax rate never dropped below 70%, and for a while it was more than 90%, and growth in real domestic product per capita averaged close to 2.5%; in other words: Good Times. Since the the economy has continued to grow, an average of about 2.1%, but the median household income has only increased 0.4%. The average income of the top 1% has increased more than 300% but the median household income has increased by less than 20%. From 1975 to 2008, the median household income rose by a total of $8,000 (in today’s dollars). Had the distribution remained the same as it was in the postwar years, the increase would have been $40,000. Instead of its current level, $50,000, the median income of US households today would be $86,400. So, that might be considered a real dollar cost.

Also, there is the cost of people who focus narrowly on getting richer. For young people, going where the money is becomes more attractive than a career in science, education, or public service. As late as 1986, only 18 percent of Harvard graduates planned any sort of business career. In 2011, the figure was 41 percent, including 17 percent going into finance.

The new incentives affect the behavior of anyone with a decent shot at getting rich. CEOs of large corporations expect astronomical compensation packages. Wall Street executives pursue riskier lines of business in search of higher profits than they could earn through traditional banking or brokerage; and if they commit fraud, they pay a partial fine and move on to their next risky venture. Doctors and lawyers have an incentive to train for lucrative subspecialties, leaving a shortage of general practitioners and public defenders. All these brain drains and unnecessary risks impose costs on everyone else.

There is yet another cost to democracy. Despite fundamental principles such as one person, one vote, the wealthiest Americans have always wielded disproportionate political influence, but with Buckley v. Vallejo and Citizens United, the courts have granted personhood to corporations and ruled that money is speech not property. The result is politicians are bought and paid for, or at the very least, influenced by legions of lobbyists.

Little wonder, then, that disaffected citizens on the right, on the left, and in the middle; whatever their views on inequality, believe that the very rich and organized business interests have hijacked America’s political process. Sustained economic growth depends on open and inclusive political institutions.

Based on the examples it appears that a highly skewed income distribution results in negative political externalities. The most evident solution? Slap a tax on vastly unequal incomes, and watch the externalities shrink. Then we must ask the question “why” this is a viable solution. First, its purpose is to reduce inequality, not to make everyone pay a “fair share.” This goal cuts through the complaint that the rich are already paying far more than their share in taxes. Second, the tax should seek to change incentives. That is, its goal is to alter the pretax distribution of income, not just the after-tax distribution, to discourage people from seeking to earn exponentially more than their fellow citizens. With higher tax rates, a job in finance might lose some of its appeal to talented young people. CEOs might be happy with salaries averaging 20 times the typical worker’s earnings (the ratio in 1965) instead of 351 times the average, as was the case in 2007.

Finally, a tax on externalities is not designed to stop activity; a tax on pollution is not designed to eliminate industrial production, and a tax on inequality is not designed to equalize outcomes. It seeks only to reduce inequality from a level that threatens democracy to a level compatible with democracy, while still encouraging plenty of work and innovation. There would still be super-rich Americans, just not as many; some of them would be merely rich. And remember that after World War II top tax rates never dropped below 70% and the economy posted the strongest quarter-century of growth in its history. And we know that inequality increases when the top tax rates fall.

It might be argued that this only shows a correlation not causation; and that is possible. So, you might argue that high marginal tax rates are a threat to overall economic growth, but that argument doesn't hold up. There simply is no correlation; the economy grows more with higher marginal tax rates. How is this possible?

In every economy there are positive-sum games, in which market interactions benefit both parties, and zero-sum games, in which one party loses and the other wins. In a positive sum equation, we know the rich don't produce 351 times more widgets than the average worker. The answer is found in zero-sum activities, where the gains come at somebody else's loss. Zero-sum actions include increasing corporate earnings by holding down wages, taking advantage of financial customers by creating and gambling on complex or risky products that customers don’t understand, and lobbying Congress for protection from competition. As these examples suggest, some individuals in the top income group pursue quite a number of activities that others might be glad to see them spending less time on.

The lack of any limit to outsize economic rewards turns out to have a measurable cost, which Americans who aren’t so wealthy keep getting asked to pay. The way to change this is to recognize the externalities exist and to shift the incentives.

Yesterday we talked about the big settlement BP reached with the Department of Justice and the SEC over criminal charges related to the Deepwater Horizon oil rig explosion and spill of a couple years ago. One day later, and there is a new oil rig explosion in the Gulf of Mexico. It appears that 2 people are missing and 4 people have been evacuated; there were unconfirmed reports that 2 people died. The fire has been extinguished. The oil rig is run by a company called Black Elk. They've been fined for safety violations within the past year. The CEO of Black Elk used to work for BP.

JPMorgan and Credit Suisse have reached settlements with the SEC over civil charges that they fraudulently misled investors in residential mortgage backed securities. JPMorgan will pay $296 million, while Credit Suisse will pay $120 million. Both agreed to settle without admitting or denying the charges.

The SEC accused JPMorgan of making materially false and misleading statements about the quality of home loans that backed a $1.8 billion residential mortgage-backed securities (RMBS) offering it underwrote in December 2006. It also held JPMorgan responsible for the failure of Bear Stearns Cos, which the bank bought in 2008, to disclose its practice of keeping cash settlements from loan originators on problem loans that Bear sold into mortgage loan trusts.

Credit Suisse failed to disclose similar cash settlements, and also made misstatements in regulatory filings about when it would buy back mortgage loans when borrowers missed their first payments, known as first payment defaults.

Earlier this week, we learned the euro-zone has relapsed into double-dip recession as the austerity shock in the Mediterranean region spreads to the core countries of the north. The Club Med countries had a debilitating jolt of austerity without the juice of stimulus and the result has been contraction across the entire euro-zone. Unemployment across the EU has hit a record high 11.6%, and GDP has turned negative everywhere except Germany and France; give them time. I imagine Greenspan would find this acceptable, but its not real popular in Athens or Madrid. Even the International Monetary Fund looked at the past few years of harsh austerity and concluded that contractionary policies are contractionary

Palestinian missiles landed in areas around Jerusalem and Tel Aviv. Israel extended its bombing of the Gaza Strip and took steps to escalate. Israeli prime Minister Netanyahu is talking about calling up 75,000 reservists, which could signal a ground incursion into Gaza. About 550 rockets have been fired into Israel over the past two days, with 197 intercepted by their missile defense system. Israeli air strikes have hit more than 600 targets in Gaza. Israel’s air strikes have eliminated most of the long-range missiles in Gaza but there is still a threat. Israel said yesterday that it’s ready to step up its operation if rocket fire continues.

Maybe the Mayans were right.