How good is austerity: good and bad deficits (Woody Brock (2))

Tuesday Woody Brock was at our office and also this time he suggested the US and UK should have more good deficits (deficits because of more government investment in infrastructure (or education, research).


China and India demonstrated after 2008 how well you can boost economic growth with infrastructure spending to get only small decelerations of growth. They have big good deficits.

In the West all deficits are bad.

This distinction between good and bad deficits (in the past the golden rule for government deficits) doesn’t get enough attention in the drive to push austerity. It is seen, but it is not leading to action.

In Europe Hollande wants a growth pact, but he is not pushing infrastructure funds for France/ PIGS etc.

Somewhat new (but not to the readers of his new book American Gridlock: Why the Right and Left Are Both Wrong -- and What Can Be Done About It , discussed by http://www.huffingtonpost.com/dr-h-woody-brock/american-gridlock-book_b_1269227.html) is his scheme when a goverment needs big or small deficits, bad and good deficits.

Animal spirits are low now and the relative yield of infrastructure investments is in the UK and US high because of the extremely low bond yields.

That means you should get very high government deficits in the US/UK, as well good as bad deficits.

In the Clinton years the animal spirits were abundant and the bond yields were high for infrastructure investments (private investments yielded more). And indeed in the Clinton years you had surplus on the government budgets.

Woody had no opinion about changing multipliers of government spending when the output gap is high (more and more studies are pointing to a bigger multiplier when the output gap is big, so that means you should not do austerity, especially not when bond yields are low).

Why remained volatility so low (theory of Woody Brock)

Equities in the world react since the credit crisis (the period of the Great Moderation has ended) more violent on economic surprises than before (the red line in the chart fluctuated before the crisis more compared to the S&P, afterwards it is in line according to the chart of economic surprises in the G10 versus the three month change of the world equity index from MS.


The last few years the volatility moves with the economic news, but not extra. One should expect that because of the euro crisis especially the last year the S&P should have moved much more than on macro news alone.

Why is it that the S&P only seems to react on macro economic news and not at all seems to suffer from contagion from the euro crisis? What is Woody’s theory?

We are used now to the fact that equities fluctuate much more than alone can be attributed to news about fundamentals. Shiller has found already quite some time ago that 80% of the fluctuations of equity prices cannot be explained by underlying news about the fundamentals.

There has been a lot of research why equities move so much more than fundamentals indicate. In the efficiente market theory this was a conundrum: everybody knows everything and has the same rational expectations. Why then all that volatility?

First one tried to find an answer with Behavioral Finance, but that didn’t offer a satisfactory explanation.
Arrow/Kurz had a better theory: it is all about changes in the belief structures. When everybody has different beliefs (expectations) then people will trade a lot. Especially with lots of leverage and strong beliefs you will see plenty of trading. So doing Kurz could explain more than 90% of the volatility.

Price changes are caused by corrections on mistakes, wrong correlated beliefs. In some periods one sees strongly correlated beliefs. Then everybody will be right or wrong. When you were wrong there were massive price reactions (for example the housing market after 2006, nobody believed prices could decline, almost nobody saw the credit crisis coming).

Last year we saw a lack of conviction in the beliefs, there was almost no leverage on the bets. Everybody was wrong in all directions (not in one direction). The beliefs were uncorrelated (there were the most diverging stories ever over deflation or hyperinflation arriving). This caused quite orderly declines and rises of the equity markets. It was only the economic news that did all the job to move the prices.

In sentiment surveys you see now there are not many bulls and bears, but an exceptional amount of advisors that don’t know (they see not big moves, only a correction). So there is a lack of conviction in the forecasts for the markets, there are no strong beliefs and the beliefs are also uncorrelated. There is also less leverage. So it is understandable that equities only react on news about fundamentals and don’t show high volatility.

This is a plausible theory, but difficult to support with empirics. An old theory is saying that when central bank liquidity is high volatility is going down to low levels. That also explains why volatility is not high, even when people are now forecasting euromageddon and taxmageddon.

Bianco's conference call (2): the hope rally

According to Bianco (and others) it is strange that while Europe is perishing, the macro of the US disappoints, China is not to the rescue, there are almost no bears.

Since the 70s there were not as many people who saw a correction, not a bear or bull market. They don’t want to be surprised by the hope rally because internationally coordinated a mountain of money (the now so normal one trillion or more) will be thrown to the PIGS and MBS. Everybody knows, only not when and how many zillion.

Hilsenrath has solemnly promised in the Wall Street Journal: there will be action from the FED and he knows: he is the official allowed messenger of the FED to bring the gospel of QE etc.

And so everybody knows that Bernanke like Obi One Kenobi will save the universe from disaster with unconventional means. This will succeed, also for the fifth time.

Bianco: QE3 will arrive, employment growth to deteriorate

On his monthly conference call Jim Bianco showed his bearish feelings again. That has become quite common in the last years, but he warns that you will get a new wave of monetary easing (QE) when the pessism gets rampant and that has been excellent fuel for equity markets and commodity prices.

The FED hast been erratic in the last weeks about QE3. The majority of Fed governors is more and more against even more QE because of its dark influences on (implicit) inflation expectations. But the troika that determines everything (Bernanke, Yellen and Dudley; dthe others are muppets) is addicted to QE and will seize every opportunity to enact a new round of QE. That will not happen as long as Operation Twist is still going on (=until the end of June), so long they can control their selves, but from their meeting on June 25 on it will become exciting.

QE3 don’t has to arrive when they maintain their norms and values for inflation: PCE (personal consumption expenditures, weighted as in the GDP) has to get below 2% (according to their expectations). To keep the interest rates at 0% the inflation must remian below 2%, otherwise they have to write a note like the Bank of England that the inflation is too high at the moment, but, mark my words, the inflation will go down soon, be patient.

The realised PCE inflation in the VS is already for quite some time above 2%, especially because of higher commodity prices. The coming months you can safely bet according to Bianco that the PCE inflation will not decline below 2% thanks to the higher gasoline prices and the higher core inflation. That is no problem for the FED, because of their trick with the inflation expectations of all Fed governers. They revealed all (including the hawks) that the inflation at the end of 2014 will be below 2%. As long as those forecasts will remain low enough the FED has a perfect excuse to perform a QE3 in emergency cases (=when equity markets fall too much).
The track record of the FED inforecasting inflation has been very poor according to many studies, but the rules are for the time being as the troika have instated. .

For the time being, because the bond vigilantes can spoil the party. When they see too many rounds of QE coming they can send implicit inflation expectations to all time highs and then the FED has to listen (otherwise: Bernanke= Von Havenstein, the bank president of the Weimar republic).

QE3 will arrive according to Bianco, because Bernanke is right and the US economy will prove too weak to get a good sustainable recovery. Bernanke had three reasons for that:
1. The employment growth has accelerated, but only unproductive people got work.
2. It is very well possible that the potential growth of the US is overstated; it will not be 2.5% but 1.75-2%. That is a disaster scenario, then all risk on investments are 20-30% overpriced.
3. Because of record hot winter weather (3 degrees C more than normal) 72.000 more people got work in December/February each month (Global Macro Advisors calculations) than normal. That will be a drain on the employment growth in the coming month (March was the first one).

To summarise, economic growth will fall back. Profit growth in the US will be very bad in Q1 and Q2 according to Bianco. The guidance is since January horrible (see chart) and profits are now growing less than inflation. Profits will no longer support equity markets, especially when the GDP growth falls back.
But thanks God, then QE3 will arrive and the S&P500 can get with some luck an all time high over some time.

Roubini and Barrons as contrary indicators

Nomura had the chart above about how well the timing of two very renowned pessimists Roubini and Rosenberg have been in the last years. They were excellent contrary indicators.
Bianco warned with the front cover of Barrons last year where Epstein (the writer of Dow 15,000) did forecast an oil price of $150. Unfortunately the oil price first had to go down to $80.

Barrons (Siegel/Epstein): Dow 15,000

Gene Epstein had this week the honour to write the cover story of Barrons. As usual he had something bullish to tell: Enter the bull; Dow 15,000.


For this forecast he leans on Siegel (writer of Stocks for the Long Run). He has, as is so often the case vexed the numbers of the S&P500 since 1871. After cycles of five year with disappointing returns you normally get good returns. That is now the case. Epstein/Siegel see with 2/3 probability the Dow rising above 15,000 in the coming two years and with 50% probability above 17,000.

Siegel thinks that will be possible even when you get almost no profit growth. The big sorrows (the Euro crisis and the American fears for a recession) will gradually diminish. Siegel thinks 10-15% rise of the S&P as too pessimistic, he goes for 20%+.

These forecasts are not at all very optimistic (when the consensus is right at 15,000 the PE will only be 12.8), but lots of people will use the cover of the Barrons and say that you have to go short based on the contrarian cover theory (when something is at the front page of an important journal the trend is at its highest point and will go in the other direction; so now the Barrons is overoptimistic and that has to be punished by the markets).

Dow 15,000 is a quite modest target. We have had bestsellers with Dow 36,000 and 100,000 at the cover. Because since then the Dow has plummeted nowadays everybody is too much of a coward to impress with a Dow at e.g. 25,000 or 50,000 in 2018 even while that is possible. For 25,000 you don’t need much, only about the current profit margins, continuing implementation of innovations and nice growth in the Emerging Markets.

Buffett: bonds dangerous for your financial health, gold overvalued

It is time for the yearly happening of Warren Buffett speaking to the shareholders of Berkshire Hathaway. The Fortune had already a preview with several of Buffets wise words.

Like all investors that talk about investing in the long run he definitely thinks it is not good to invest in bonds (Bianco reacted on that: Buffett forgets that the buyers of bonds are not investors but forced buyers like the FED, the central banks of China and Japan. So bonds are not an investment but still can give good returns). Buffett thinks the yields have become too low because of manipulation of central banks and so you don’t get a fair compensation for inflation and inflation risks. Bonds should be sold with a warning just like cigarettes: it will damage your financial health.

Also gold was bashed by Buffett. All the gold in the world fits in a cube of 68 feet and has a value of about $ 10 trillion. For that money you can buy all the crop land in the US and 16 Exxons and you still will have $ 1 trillion left for doing nice things. That is all producing income what is not the case with gold [comment: the difference can be quite small because gold normally is not taxed and income is].
At the moment the gold mines make now every year $160 billion new gold and that is c. 1.5% new inventory have to be bought by new fearfuls. Take care when they diminish in numbers.
[My comment: that 1,5% is more than the growth of the world population and less than the growth of the middle class in the coming decade(s), so for the time being the demand for gold could be high enough, certainly when the Asian central banks want in earnest a decent percentage of their reserves be invested in gold].
Buffett says that the only buyers are now investors thinking the price will rise further, this means in a Minsky cycle that gold is in the bubble phase. According to Buffettt that can last for some more time, but then the gold price will decline (and a lot).

Buffett advices to buy equities, they are much safer for the long run than gold or bonds at zero % yield. As has been often the case in the past 50+ years Buffett could be right.


The chart of Data Stream shows the total return of an investment in equities (S&P500) versus gold and at the right hand the total return of government bonds (10 year US Treasuries) indexed at 100 in 1980.
You see huge runs up and down. Initially gold was the bad investment, but this century Gold lets equities and bonds bite in the dust. It deserved a prominent place in an investment portfolio. When the central banks continue to print money at a huge scale than the gold price has to go up further especially versus bonds.

BCA: the bull market will climb the wall of worry further: the future will be better than we have seen, tail risk is exaggerated.

The equity markets rose nicely in the last few months, but still is everybody very cautious, seeing disasters and tail risks everywhere. People are not impressed by the macro numbers in the past quarters. Those were indeed not what was normal in economic recoveries, but that was the past and the only thing that counts is the future: that is what Zhao from BCA is saying, while one cannot accuse BCA of overoptimism in the past years.
The economic climate is improving while the tail risk in Europe is declining pretty fast.

Most people underestimate the favourable influence of the three years deposits (LTRO) from the ECB and the big monetary easing that China will give us. In the US small and mid sized companies at long last can get credits easier. Central banks are now creating liquidity more energetic than ever. In thepast investors knew what to do: buy, buy, buy.
Investors underestimate growth in the US. That will remain c. 2.5%. The housing market is improving and business is slowly getting more brave with investing.
The equity markets are pricing in a mild recession, while the ISM is pointing to an above normal economic climate.

Everywhere in the world pessimism reigns. Transport shares indicate that the world economy is not at all in a bad condition. The consensus hears the whole day long we are in a crisis.
The quantitative models of BCA are very optimistic, evrywhere it is green aaand BCA advices to buy lots of beta. The only cloud at the horizon is the strong dollar and its bad influence on US profits.
I think that equity market can rise further as long as the ISM goes up and in Europe no new disasters develop while Iran is not exploding.
The BCA story is of course approved by the club of optimists.

Saunders: the Japan scenario is way too good for Europe, it is worse than the thirties

Yesterday Michael Saunders of Citi spouted out about the macro fundamentals. He was not pessimistic about the US, but for Europe he is very negative. -1.5% growth for Europe (including Germany) in 2012 and in 2013 the recession will continue (-0.4%). In the US fiscal austerity will depress growth in 2013.
He showed several charts about how several countries in Reinhart-Rogoff style recovered after getting in a deep financial crisis. You see that Japan did very well and the US is also doing reasonably well.

In Europe they have to thank God on bended knees to get economic growth as high as in Japan after 1990. Because of the credit crisis at least 10% growth is definitely lost and there will be no end to the sufferings of Europe in the coming years because there has not yet made any progress in the deleveraging of banks, private sector, the healing of the housing markets while government debts are exploding over sustainable levels in many countries.

QE2 and the path of Arthus

The chart shows the economic growth of the US according to several models/ theories.

In the long run the US economy followed the path of the law of Okun: the growth was about equal to 3% plus two times the decline of the unemployment rate, so structurally 3%.
Since the credit crisis is the US economy more and more deviating from the 3% path of Okun.
The economy is growing according to the best path of Arthus, the guru of Natixis. He is more or less a supporther of the New Normal theory. The loss of growth according to the Okun path is permanent he says and you will see no convergence to the Okun path in the coming few years. That is because of deleveraging the consumption cannot faster than income (something that in the past happened after every recession and that caused higher growth than 3%.
Even with the best path of Arthus the Fed cann't live, that forbids their mandate (and triggers impeachmeant of bernanke over some time). If the US economy continues to follow the path of Arthus the unemployment rate will not decline (but stabilise)enough reason for Obama to fire Bernanke, but than he has to be quick because he cannot be reelected on the path of Arthus.

So the Fed had to do something else thean normal, somthing that makes it possible to get the moderate V Bernanke path. That is why the Fed has to print tons of money even while there is not much danger for a recession in the coming quarters. Those hundreds of billions must restore confidence by blowing up the stock market, easing financial conditions so business get more credit and mortgages are easier to get also.
Obama will start to mr. nice guy for the republicans (as also Clinton did) and extend the Bsh tax cuts for at least one, probably two years, making the moderateV Bernanke path now the most probable path

Shame on me: Dylan Grice (2)

To my (and hendrik Jan's) surprise also Dylan Grice called his column last Friday something with shame (Shame On Me). Hendrik Jan touched an open nerv with is remark that Dylan Grice has lost his bearishness on Emerging Markets.
In his Friday column Grice wittingly described how the humans are quite inventive for over a 50.000 years without needing quantitative easing.
I utterly agree with him that productivity growth is the most important for economic growth and that crying about deleveraging is not that important when you want to explain economic growth % (but of course, Grice wanted to tell the opposite, that we are lost for quite some time because of deleveraging; but now he wanted to divert the attention to put the shame on the Fed because of QE2 what will be a success I think).
Grice makes plausible in his charts based on valuations according to the Shiller-PE's that you should not expect too much of equities in the coming years (valuation are not good enough according to him, but I'm quite satisfied with current valuations).
But then he gives the expected returns of the most important emerging markets, the Bric's. And suddenly you see lots of optimism. So it is not yet clear what has happened with Dylan Grice, maybe he is indeed a fraud as he describes himself and is he no longer a bear on everything, since he is writing something positive on emerging markets for the second time.

Shame on you Mr Dylan Grice

My collaegue Hendrik Jan has annoyed seriously überbear (ursus major) Mr Edwards of Socgen and his side kick Dylan Grice with his reaction that Dylan Grice as super bear suddenly adviced to buy equities of Emerging Markets. No, even not equities but call options.

The reaction of Edwards was this weak a piece with the same title as Hendrik Jan had sent to us (Shame on you Mr Dylan Grice) (in which he had written among other things: I will not bore you to death with his previous recommendations, but instead summarize his view and that of his close colleague, Albert Edwards for the last year: we are all toast, extra crispy. Equities would fall, as would earnings, the double recession was around the corner, etc etc.

You can probably guess how Dylan squares the circle: the Fed's new round of quantitative easing. Huh? This is coming from the same guys who brought you the balance sheet recession which would "depress growth for at least a decade". Or the wonderful: "the Fed is pushing on a string". The best question to ask him is "would emerging market equities not have risen if the Fed did not do QE2").

Edwards started this week with: “A very good client complained that we were doing a U-turn, ditching our previous Ice Age bearish stance on equities and becoming vastly more bullish – using QE as the excuse. And to be fair, Dylan’s last two notes, suggesting that the Nikkei could go to 63 million in 15 years and that emerging markets could double, might be construed as being a tad bullish. In this note I will make MY view crystal clear and tie it into Dylan’s recent work”.

Edwards is insulted because he is still bearish: he underwaits equities with 25% (this not yet producing very favourable results for the time being). That double dip will arrive, no doubt about it and those people from ECRI that suddenly said last week that no way we will get a new recession are misunderpretating the facts edwards says. In 2008 you had also a tremenedous liquidity push and that was not helping, so this time it also will not rescue us. Edwards included some more pictures (see above) in which he makes the call of Grice even stronger to buy Emerging Markets.