Don’t worry, here comes the three horsemen of the apocalypse!

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Ambrose Evans-Pritchard has neatly summed up some industry think in his latest piece, “Global banks see market rally on Greek exit”. 

But this type of industry thinking is also likely to scare away the retail investor, through rational cognitive dissonance or otherwise. 

Apparently, we are set for a big rally, once Greece leaves the Euro, as Central Banks the world over pump yet more liquidity into the financial system.  This will either be via LTRO Repo type (temporarily exchange your securities for cash) transactions or the better for the banks and sovereigns, QE (buy your duff securities for a price you would not be able to dream of otherwise). 

Here is my very quick, write it as you think it, opinion on this “play”.

Either way, securities markets will be saved yet again (?).  But for how long say the now wary and scarred investor?  Because this is now so many times bitten, irreversibly cynically shy!

The fact we are now in a position where further central bank liquidity fests are needed to restore confidence in asset markets, banks, sovereign debt, yet again, should create inexorable and ineffable discomfort.  This is surely, the last redoubt before the final collapse of capitalism’s contrived byzantine complexity. 

Liquidity does not equal lending, or demand, and it does not offset declines in balance sheet asset values per se.   In order to generate demand from QE/liquidity operations, these operations need to restore confidence in markets, the financial system and the economy.  We need people to spend more and we need banks to lend more.  But we know that this has not necessarily happened to the degree required to generate a lasting long term recovery in the last few attempts. 

At this stage of the cycle we need to get rid of non performing, or at risk of non performing liabilities, thereby creating the necessary imbalance between money supply and economic consumption capacity.  This means central banks facilitating the buying/writing off of all or part of non performing loans and leases in the banking system, and/or buying up and writing off beleaguered sovereign debt at the margin.   

Further liquidity at this stage of the cycle does imply an acceptance of the need to debase the money supply.  As discussed, it is not the increase in money supply that is the problem, but the implied write off of assets and asset values required to create the necessary imbalance between money supply and consumption capacity.  Money will be backed by fewer assets, and there will be more of it.

Now obviously this needs to be done with “care”, because you do not want to create too large an imbalance – although how you can do this type of anarchic exercise with care is doubtful. 

Now, this also means that asset prices will need to readjust to the change in dynamics: bond prices will have to rise in low yield economies (they will fall in debt ridden economies) to account for higher inflation, and equity prices will need to adjust for a jump in nominal demand – this may just as easily result in a drop in prices in response to the uncertainty over the inflation and demand impact or a rise in prices as investors realise the dynamics favour equity based investments.

The risk is that low risk, safe harbour assets will be annihilated so that equity based risk assets are favoured.  That is if the outcome is positive.  One problem with all this is that banks will still be loathe to lend and consumers unable or unwilling to borrow, meaning that governments will need to lead the way, meaning that government debt will likely re-expand, creating yet further declines in low risk asset prices and higher bond yields, thereby creating secondary negative shocks to the equity markets.        

Additionally, you have the problem of coordinating all of this globally and making sure that the economic activity does not accentuate existing structural imbalances.  In other words, the risk is that we move further away from efficient market structures and relationships.   A mistake at this stage has very, very, very large risks.

The only other route is deflation and depression, and this implies a rise in bond values for some, a collapse in others, a collapse in most equity markets and a wholesale restructuring and cleansing of the economic order. 

There is too much debt in the world: to right the imbalance we need to wipe off the debt and inequitably favour equity, or write off the equity and inequitably favour the debt.  We have been muddling in the middle ground, for too long, effecting neither outcome.

Japan GDP

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Japanese GDP data is taken from the Cabinet Office.  Real GDP has yet to recover its pre recession high but Q1 data appeared strong at first sight:

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But the year on year increase shows a relatively sharp rebound (due in part to the impact of the earthquake, tsunami and nuclear crisis).  

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Adjust for this effect by taking a 5 quarter growth rate (annual is 4 quarter growth), and we see the current growth profile is much weaker:

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Household consumption growth has led the way, both before and after adjustment for the effects of March 2011:

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But private non residential investment has been weak:

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What if the contribution of net exports to growth could be exposed going forward?

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GDI has lagged relative to GDP:

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But, increasingly so over the recent past:

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While the differential has increased, the rate of change of the differential has slowed:

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The risks of modern finance

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Why do we need such a vast universe of derivative contracts and synthetic investment vehicles?

Answer because it allows the financial industry to re-circle assets many more times, each time earning a cut of the transaction.   It is not to manage risk: this is the argument that they give you to keep this behemoth, this apocalypse going.

In order to keep earning a return from this universe the cycle needs to a) keep moving and b) keep expanding.  Once the universe contracts, you not only cease to earn a return, but you start to take on the risk of the contracts themselves.  But the damage starts before you cease to earn return, in fact when the rate of growth starts to decline.

The ratio of derivatives is ultimately related to the supply of real underlying assets, and  the absolute incremental increase of the derivative universe needs to keep expanding at a greater rate (relative to the underlying assets) just to keep the rate of growth of return constant.  

The monster takes over the machine!

The universe can collapse even though it is still growing, because it is not growing fast enough to counteract its equilibrating forces.  The risk of such a collapse increases the greater the number of contracts needed to keep the rate of growth of return constant.

ADR Chambers versus OBSI

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This is ongoing: Flaherty has agreed to independent third party contractors to arbitrate consumer banking complaints in Canada. You should know my views on this, I did a blog, but the guy who is doing most of the work on this at the moment is Ken Kivenko.  Here is a further and interesting comment from him:

What is the real status of the ADR Chambers Banking Ombudsman (ADRBO)?:

According to our research, ADRBO , used by TD Bank and RBC Bank for banking disputes, for “independent” dispute resolution does not fall under the Joint Forum Framework [ OBSI does ,which makes it a legitimate third party resolver ] ADRBO is not monitored by FCAC either, mostly because Finance Department approval rules for contracted Ombuds services don’t yet exist. In effect, no one provides oversight of ADRBO. Also, under most provincial Limitation Acts ,bringing a dispute to a independent third party complaint resolver stops the limitation time clock. Is ADRBO really an independent third party resolver? A lack of transparency of ADRBO’s operations , compensation statistics and governance structure is another concern. Finally, there’s the question of third party – is ADRBO a third party if the financial consumer has no choice but to accede to a decision from a party paid for by the banks? That’s why we ask:Is the limitation clock really stopped in law? This is a tenuous situation for retail banking consumers. [ In Ontario ,the limitation period is set out in s. 4 of the Limitations Act, 2002: it is a mere two-years]

Weak Euro Growth before revisions

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I have yet to see the detailed summary figures, and we still have to go through a couple of revisions, but Eurozone growth (Euro 17) failed to expand year on year and quarter on quarter. 

While it is hard to define on a technical basis just what the current growth profile is, I am sure most would agree that a simple recession would be the least of our worries.   The “two quarterly declines in GDP” heuristic that most use to define recession is, in reality, overwhelmed by the larger period of economic distress (depression) that has been ushered in post 2007.  

A simple recession brought about by monetary or fiscal tightening, and/or inventory  adjustment and cut backs in fixed capital investment, would have been much easier to wipe off the brow.  We remain, as we will be for some time, in an intense period of adjustment, with problems of a magnitude that make those once very large hills seem like valleys from the mountain top view.

From the Certainty of Efficient Markets has come Moral Hazard!

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In my previous post I picked up on a statement in a Dan Solin article.  My concern was that the article appeared to express a level of certainty regarding an investment outcome that to me reflected the type of moral hazard that has, in my opinion, negatively impacted the world financial and economic system, in particular, since the latter half of the 1990s.  This is not to say that moral hazard has not always been a feature of human decision making, just that I believe MPT helped legitimise it.

However, before I go on, I just want to make clear that I have nothing but praise for the IFA line of funds: this is not an attack on IFA funds, which I believe have relevance irrespective of your view of the efficiency or otherwise of world markets.  Management and transaction fees kill performance and elevate risk and there is no place for the vast majority of actively managed funds in this universe, especially if you live in Canada, where high fees are a protected species.      

But, I wish to revert back to the point I was making: if you are making decisions on the assumption that markets are efficiently pricing risk, and that the mean of the distribution of expected returns is going to be positive, then you risk creating a framework in which the certainty of the investment outcome has, to all intents and purposes, been decided.  If you increase certainty of return, you reduce risk, and the discounted present value of future returns increases. But, worse than a more highly valued asset in an efficient market, which may only reduce the order of the positive magnitude, is a more highly valued asset in an inefficient market with outsized, out of equilibrium systematic risks.  

I believe that the greater level of “certainty” that MPT has brought to decision making has endorsed a higher level of systematic risk taking.  MPT helped introduce a level of certainty that simply should not have existed, which obscured the risk being built up in the system.  It created an imbalance in the valuation metric, a ghost in the machine.   

There may indeed be times when the risks to future return are such that a given investor is likely to experience negligible to negative real equity returns over their life expectancy. I think if you are managing assets and liabilities and expectations to boot, you need to be able accept that markets are not guaranteed to produce positive “expected” returns and manage/discount this risk accordingly.  The assumption of efficient markets and expected positive returns does not allow for the management of outsized, out of equilibrium risks.

If risks are not being properly priced, then what of investment planning disciplines that ignores these risks and effectively extrapolate the returns of the past into the future.   Ultimately, even MPT devotees are forced to use historical return relationships to forecast the future, because this is the only “equilibrium” they know.      

I provide an excerpt from an Ibbotson Associates report “Stock Market Returns in the Long Run: Participating in the Real Economy” which elucidates some of my concerns.

We forecast the equity risk premium through supply side models using historical information.   Contrary to several recent studies on equity risk premium that declare the forward looking equity risk premium to be close to zero or negative.  The equity risk premium is estimated to be 3.97% in geometric terms and 5.90% on an arithmetic basis. This estimate is about 1.25% lower than the straight historical estimate.…..Also our models interpret the current high P/E ratios as the market forecasting high future growth, rather than a low discount rate or an overvaluation.  Our estimate is in line with both the historical supply measures of the public corporations (i.e., earnings) and the overall economic productivity (GDP per capita).

Our estimate of the equity risk premium is far closer to the historical premium than being zero or negative. This implies that stocks are expected to outperform bonds over the long run. For long term investors, such as pension funds or individuals saving for retirement, stocks should continue to one of the favored asset classes in their diversified portfolios. Due to our lowered equity risk premium estimate (compared to historical performance), some investors should lower their equity

But what of the past performance of markets?  The following shows the real capital value of the S&P 500 from January 1997 to May 2012, and is taken from Robert Shiller’s data. 

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Many European markets have fared even worse, as has the Japanese market.  Additionally, a great many investors depend on their their equity capital for dividends and do not have the luxury of reinvesting and compounding dividends at lower valuation levels. 

If we look at real dividend growth on the S&P 500, we find that this has fared slightly better than its capital return, but in real terms, today’s real S&P dividend as a percentage of its January 1997 index value is 2.4%, of its July 1997 value, 2%, and of its March 2000 value 1.7%. 

What has invariably made things worse for investors is that their investment planning and withdrawal strategies have been based on far higher real return assumptions. These return assumptions I might add were too high and emboldened by modern portfolio theory dogmas and belief in efficient markets.    This is not something i am saying in hindsight, I was making these concerns known at the time and modelling risk/return assumptions that ex post have more closely mirrored actual returns than MPT assumptions.

Modern portfolio theory knows nothing and everything about the future (the future is uncertain but it knows the probability of the distribution, its mean, standard deviation and covariance) but knows everything and nothing about the present (all information is known and no analysis needs to be conducted by those using inferential statistics to construct, plan and manage portfolios).

Dan Solin’s “A Rational Response to Irrational Market Anxiety”

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There is much on which I agree with Dan Solin: I agree that index funds, as a way of accessing an asset allocation component within the market, are very efficient and effective, and that it is impossible for everyone to try and beat/time the market, consistently, at any one point in time.   Most people, most of the time, are better off with the index and doing nothing!

I also agree that you are best off ignoring the papers and the hype, but I disagree that you should ignore issues relevant to valuation, and this is essentially where we part company.

Dan and Co believe in efficient markets and equilibrium pricing and I do not, and therefore, in particular, I disagree with the main thrust of the article:

“the function of a stock and bond market exchange is to price risks of economic uncertainty so that investors have a future probability distribution of returns with a positive expected return. The prices set by the millions of traders in the market represent their assessment of current and forecasted risks and the cost of capital associated with those risks.”

The statement depends on a general equilibrium assumption, which is necessary to support the randomness and independence (especially the independence) of price movements that drive the probability distribution of future returns/price movements. 

In this type of model, a) future information is not known, b) all markets and all economic relationships are in equilibrium (price equates demand and supply), and new information, when it comes, is rapidly incorporated into asset prices.  Predicting the future direction of the market is impossible.

It is the nature of the evolution of the relationships that comprise a general equilibrium and the nature and stability of exogenous forces acting on this equilibrium that underlies returns (expansion/contraction of the universe).  It is the uncertainty over the future path of equilibrium, that is the size, shape and timing of new information, is not known, that lays the basis for risk and the pricing of returns under uncertainty.  All pricing, equilibrium or not will need to factor in the degree to which future returns are exposed to uncertainty.

If we know the historical sensitivities of assets to new information, and the relative price movements of different assets, given this sensitivity, in this universe to new information, we can price return under uncertainty, with provisos:

We have to assume that we know the average expected return, either derived from historical information, or from current market prices, assuming that the market is correctly estimating expected return (efficient markets), and that this return relationship is stable, as are equilibrium relationships.

We have to assume a normal probability distribution of return, otherwise the tail outcomes risk dominating the average.  It is the nature of the normal probability distribution, the concentration of most returns close to the mean and narrow tails, that allows you to rely on expected return distributions as a risk management platform.

We have to assume that the expected return and the distribution of returns accurately reflects the true profile of equilibrium over time, because we are only occupying one particular run of the equilibrium.  The historical data and market expectations could easily be biased by the size, frequency and direction of historical events.   

There are therefore two parts to risk under equilibrium: the sensitivity of an investment’s price movement to new information and the uncertainty over the size, shape and frequency of new information.  Under equilibrium pricing there is also the risk that an asset may cease to have value, but this risk is covered by diversification and via other implied dynamics of an equilibrium model – a stable equilibrium reallocates capital, meaning that a diversified allocation will pick up the reallocation of capital. 

But, if we are out of equilibrium, then the future path of returns are dependent to lesser or greater extent on the out of equilibrium relationships.  And how do we move out of equilibrium?  One way is to assume a higher level of certainty than actually exists, extrapolating returns and return friendly environments far further into the future than is safe.   Another is to set up asymmetric reward structures (banks, brokers, fund managers) that allows greater risk taking, thereby disrupting efficient pricing of risk in financial markets.   In a way, this belief in efficient markets, and general equilibrium risk pricing is what has led us to this point in time. 

While there still remains uncertainty over the size, shape and frequency of new information, the sensitivity and relative price movements of assets are now to a far greater extent influenced by out of equilibrium relationships, and the actual risk and return relationships are no longer those represented by a normal probability distribution or implied/historical returns.   Under efficient markets with rationale economic agents, it is impossible to reach such a position. 

In my opinion markets moved out of the range would could have supported an equilibrium type risk/return distribution of outcomes from about 1996 onwards.   It has not been new information that has driven risk and return, but excesses that have skewed economic, financial and market relationships and severely impacted risk/return relationships.   I remember value biased investment disciplines, that would have tempered the rise of markets in the 1990s being marginalised and ostracised: the market went for higher returns and assumed greater certainty of those returns, because markets were efficient and the risks of being out of the market, in the short term, were too great for a great many people – these markets were irrational!  

To say that prices today are efficiently and effectively pricing the risk of uncertainty is dangerous.  This is asking investors to place blind faith on a dogma and a system that has failed investors for close to two decades. 

There is always risk in the stock and bond markets. Risk is the source of returns. The greater the risk, the higher the expected return. Here’s an example:

Only in a stable equilibrium where we know the true mean and distribution of uncertainty can the greater risk equal the higher return, and only then, on average, over the full distribution of outcomes, which is a reality which we do not inhabit.

The current price of publicly traded stocks and bonds represents the collective judgment of tens of millions of buyers and sellers….. Their judgment is what places a value (the “price”) on these shares. It takes into account all levels of economic uncertainty.   We all know there is a risk that Greece, Italy and Spain may default on their sovereign debt. As that risk level increases, buyers of that debt demand a higher rate of return to compensate them for that risk.  When you hear financial pundits discuss economic uncertainty and recommend buying or selling certain assets, you should reject their advice. Whatever facts they are relying on have already been priced into the asset they are recommending you buy or sell. That asset is fairly priced. Trying to find a misplaced asset flies in the face of this basic reality.

If the checks and balances on the rewards and the risks of a financial system are flawed, then we cannot blindly rely on market prices, and if economies and markets and the financial systems that underpin them are out of alignment, then we cannot ignore risks that have influenced the direction of markets to greater extent than new and unknown information.  

And of course, the time to have made changes to your asset allocation, to bring your asset allocation into line with your ability and willingness to accept risk, was long ago.  But this would have meant acknowledging that markets had not properly priced path dependent risks.   It is not the risk of equities that is forcing investors to reassess their allocation to this asset class, but the greed, corruption and shameless blissful ignorance that has led to this point in time.

I find these edicts from MPT’s high priests to be disquieting, and this of course, what I have written, is blasphemy.

http://www.huffingtonpost.com/dan-solin/market-anxiety_b_1484794.html?ref=business

The truth

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“Art” is where the truth now resides..

the truth

too dark, too real, too embarrassing its true…

Art because its frame is clean and bought and sold….its meaning, its truth divorced…

But art in truth is in the shadows hidden dark, real, embarrassing.. its true..

Meaning has little value that can be bought or sold….embarrassing its true..for who but the few would want to hold?

Man tells what does not upset, challenge, confuse, or take too far….

Truth is conflict for the compromised!

Seek comfort in words, mercenaries they can be, for they lie closer to where we are than where we need to be….but they are close, always…

OBSI Public Consultation: Investment Suitability and Loss Assessment Process–stakeholder comments

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I am not going to delve too deeply here, but the list of comments from industry and industry interest groups clearly show the emphasis that they place on the boundaries of suitability and the importance of the constrained KYC in this process.   They also have regulation and precedent on their side, something which those advocating higher standards do not.  In this light, the comments of those advocating higher standards appear woefully exposed to the reality of minimum standards and limited “advisor” accountability.  All the while, we have the ability to market promises that cross these boundaries at will.   As I have said repeatedly (blue in the face with repeating), the retail investor needs to be told that they are responsible for the investment decision and that the advice they receive is more or less limited to the alignment of the transaction with the fuzzy boundaries of the KYC.

Is behavioural economics becoming a kind of modern portfolio theory Gestapo

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I am referring to an article in Money Sense that appeared to suggest that investors aversion to going back into the market place was based on behavioural biases built up over the last 3 years, and that this was irrational. 

What concerned me was the last paragraph:

“Investors should keep in mind the concept of reversion to the mean. This principle is based on the premise that stock market cycles and asset classes, over the long run, tend to return to their historical average (or mean). For example, the historical average for stock returns is in the range of 8% to 12%. A non-emotional approach to long-term decision making will help investors avoid mental mistakes, control impulsive, emotional judgments and earn a share of what the markets have to offer.”

Global developed markets have gone sideways since the late 1990s, enough time for a great many people to have retired and departed to the great whatever in the sky.  Add in management fees and transaction costs, and you are not dealing with irrational aversion but a justified response to the academic and industry cheerleading for absurd return expectations at the end of the 1990s; these were expectations that were often spurred on by naïve beliefs in general equilibrium/efficient market theories.   The same people who are castigating investors for not investing, through some misplaced behavioural bias, were pontificating on long term market returns of 8% to 12% at the end of the 1990s, blithely ignoring all the valuation excesses.  

To take only a 3 year view is not only irrational and ignorant of investment risk, but absurd. So I guess the writer is saying everybody should get back on the roller coaster, because after 3 years markets have cleared and we are back to the type of equilibrium that supports mean returns of 8% to 12%.

But, it is not clear from the article as to whether the writer understands what he means by mean returns within a modern portfolio theory context:

Mean reversion within a modern portfolio theory context rests on a belief in a stable market equilibrium and a normal probability distribution of returns.  If you average the distributions derived from say a Monte Carlo simulation, and you inputted a mean return of x%, you would get, more or less the mean return.  What the writer does not say is that on any one probability distribution run, ex post returns could be below the mean, and that the mean return, even in equilibrium cannot be guaranteed. If you live 1,000 or more lifetimes, then on average, returns will revert to the mean, but the mean itself is unknown and will probably never ever be known.

Also, the equilibrium’s parameters, the return, the standard deviation and the correlation, are all dependent on the nature of the equilibrium – mean expected returns can shift and are not guaranteed to be in the 8% to 12% range even in a general equilibrium.  This is mindless academic insanity! 

The writer assumes, erroneously that a) the return relationship of the past will be repeated, b) that the one distribution of returns that we have experienced is representative of the mean of all distributions and c) that we are in a general equilibrium.  All 3 assumptions are wrong!

We are not in a general equilibrium and for many years leading up to 2007 we have spent moving further and further away from equilibrium conditions.  In other words the distribution of future returns were no longer a bell shaped normal, but warped and effectively heavily negatively skewed distribution.  

Underlying all returns are earnings, and it is this fundamental, as opposed to valuation based returns, that is more likely to revert to a mean type figure.  But, because we are more often than not out of equilibrium, in order to get back to the average return over time, we also have to correct on the downside, which means that as earnings readjust for periods of unsustainable excess that they are just as likely to move well below a certain period.  You cannot do this in a general equilibrium context: there is no theoretical basis for undershooting the mean. 

Earnings growth is dependent on the long term growth profiles of global economies, which may well be impaired for many reasons at this point in time.   An 8% to 12% range is also a nominal figure which may not translate to current economic dynamics.  Additionally, since earnings relative to GDP are also way above their historical averages (and I am not talking statistical means here), there are many reasons to believe, that at a more fundamental non equilibrium level, that we should be taking the opposite stance to that recommended.  I am not saying that this is what people should do, just that the unwinding from a long period of excess has yet to work its way out of the system and could easily place downward pressure on real earnings growth for some time to come.  Such an outcome does not compare well to an 8% to 12% expected mean return.

It would appear that behavioural economics is being used to support modern portfolio theory outcomes and dogma than what it really should be doing, which is to explain why markets and economies move outside of equilibrium relationships rendering ineffective the ordered systematic risk framework of modern portfolio theory.

IAP Webinar: which way is up?

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The OSC’s Investor Advisory Panel was holding a Webinar for retail investors to provide input into a number of issues this week. 

“The webinar is a great opportunity for investors to present their views to the Panel about issues that are important to them. We look forward to hearing from individuals across Ontario.”

I was asked by some if I was going to take part?  No.   I feel that those who are informed and who have long been involved in trying to argue for change are well past the ABCs and so should the IAP be.  So the webinar in my opinion was to garner the opinion of the less, to varying degrees, well informed.  There is nothing wrong with the ABCs, of course, but these should be clear by now, and it is a worry that the IAP is still interested in finding out what they are.

A cynical person might suggest, “tongue in cheek”, that the “let us hear and understand investor issues” is more of a marketing exercise: how can we package regulation and the industry’s services in a way that consumers will understand it, in a way that will be less confusing?  As if the problems are more of perception, the message more than the integrity of the system.  

If we are just investigating the ABCs, the building blocks, if that, then we are well away from the necessary complex analysis needed to thrash out what needs to be done.  It is how things are compounded, how they interact and corrupt over time that is more important.  This is where we are!

The real question is not what investors think, but why are we still here, why has nothing changed?  I think I can answer that? 

Why is OBSI under threat?  Because the host is rejecting what is essentially a foreign body, because the foreign body is wishing to change the cell structure and operation.

Implant any functional but foreign entity into a host without an immune suppressor and the entity will likely be rejected.   The IAC was rejected, OBSI is in the process of being rejected, and so will the IAP, ultimately be rejected – it may even be that the OSC’s Office of the Investor is already doing this.  It is worthwhile noting that the Office of the Investor will be much better funded than the Independent IAP and few if any of the IAP’s requests for greater funding and a wider mandate have been accepted by the OSC, but the OSC has planned their own internal response, one which cannot be accessed in a transparent manner by the public.   

How can organisations like OBSI and consumer panels operate effectively in the public interest?  Grant them a guaranteed life expectancy and operational powers and funding that are independent of the whims of the host. 

Research on what consumers understand and do not understand is of course important, but you do not need to speak to me for a few minutes (or indeed many of those who have been campaigning for change) to find out the substance of my views: my views are clear, well documented and publicly available.  This goes for most of the issues that are germane to investor protection: they are well known, unambiguous, in the public domain, well documented and exist largely because the consumer lacks the sophistication and purview to be able protect their own interests. 

There would be no need for regulation if investors were rationale, knowledgeable and intellectually capable, and information about services, products, risks, costs and responsibilities were all freely available and transparent.  Regulation exists because of the actions and integrity of the few who have taken responsibility for the needs and inadequacies of the many, yet here we are, apparently, feebly asking what is wrong!  Regulation is most often the effect and not the cause.  

I do not think, therefore, that the webinar is for those who understand, and who have well documented stances on regulatory and industry issues, because this is not the type of forum for the delivery of such rich context and synthesis.  It is for the uninformed to briefly and succinctly express their feelings and views on issues upon which they may have limited understanding. 

This is not to say the feedback of the investor is unimportant, because it is, but it is not important in defining the problems and the issues as of now.  Such feedback is however key to implementing measures designed to protect the consumer and to enhance the effectiveness and efficiency of the market place.  But to rely on what an uninformed consumer says about issues, in order to define the structure and physics of a problem is like the medical profession deciding that doctors no longer need to go to medical school to learn medicine and can rely on the communications of their patients to decide what is wrong with them.  This is absurd!  

If this was the first time in Canadian history that it was realised that the needs of Canadian retail investors might be important, then possibly, this data gathering exercise of views and wishes at a very basic level might be important.  But it is not such a time. 

Perhaps the IAP feels it lacks a mandate from the people, or it is insufficiently aware of the fundamental issues itself in order to be able to take an effective stance.  Without the necessary elucidation, I fear the IAP are treating the current problem as an ill founded academic exercise: find out what consumers want, assess whether what they want is reasonable and practicable, and where so attempt to educate regulators and industry over these issues and negotiate improvements based on consensus. 

The issues we are dealing with are not emotive issues that can be assuaged by empathy and understanding, but real physical problems that are impacting the integrity and efficiency of the market place and the financial security and rights of Canada’s consumers.

The IAP it would appear does not know which way is up and is unable to shape its own arguments.

Besides, when all is said and done, we are caught in a wider drama, for the host, the financial services industry is itself in decline, under attack from many structural economic and financial quarters.  The IAP and the consumer right is another unwanted enemy at the gate and consulting the views of the uninformed will not bend these timbers.  No matter how well meaning this all is, at least on the surface, it is not going to deliver as is.

No Man’s Land

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We have, most likely, recession in Europe (confirmed already in a number of countries) with very weak data on both the manufacturing and the service sector side. 

We have ambiguous growth in China on the same metrics, and uncertainty with regard to its main engine, investment led growth.

We have a pedestrian crawl in “bad demographics” Japan.

And, we have a weak US recovery hitherto dependent on good winter weather (recently),  the consumer (lower savings, a rise in debt, marginal improvements in employment framed within historically weak income dynamics) and central bank intervention, but a recovery logically, from here on in, ultimately dependent on growth in global demand for its goods and services. 

Yet growth in world exports is slowing down (-ve Japan and Europe), with the strongest showing in the US in terms of recent growth rates.

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This is all before we add into the mix sovereign debt and the expected austerity to come, or if things get worse, the pump priming demand and silly money framework of QE and QE financed government deficit finance. 

We are currently in a no man’s land, a point where whatever is happening now may have little or no relevance to what lies beyond. 

We need growth that is not being cajoled by low interest rates and asset price manipulation, that is not at any point in time ready to collapse as demand disappears and the financial system slows to a crawl or inverts upon itself.   But since we are some way from fully working through the various debt and structural imbalances set in the years leading up to 2007, such an outcome is more wishful thinking than structural reality.  And of course, let us not forget all the other dynamics working away at the economic cliff face: demographics, pensions, medical and social security time bombs.

One cannot help but feeling that we are at yet another turning point, where the weight of the past’s debt dynamics in developed economies, and debt financed investment led growth in emerging, impinge on the momentum going forward.  Sovereign debt in many economies has continued to expand, yet the contribution of government expenditure to real GDP growth is now negative in many areas. 

Recent ISM Manufacturing PMI data shows moderate growth in US manufacturing, but one wonders whether the PMI is being overly influenced from a position of fuzzy relatives.  It is now more than 4 years since the onset of the last US recession, and we have been led to expect the worse for so long that a longer than usual period of marginal improvement may lead to false coordinates: good weather has helped domestic demand, so weather factors may well have combined with the traditional seasonal upturn to lead to a relatively good feel good factor and now are now in a period traditionally associated with higher manufacturing activity.  In other words if our coordinates are all screwed up, we may think things are better than they actually are.    

What happened behind those closed doors? A Faustian pact?

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Everyone knows how much Flaherty covets a National Securities Regulator.  Yes, a lot more than he wishes for an independent arbiter of consumer complaints against financial institutions.   This is especially so if he needs the banks’ support for a National Regulator.

The trouble is, as a member of the governing political party he is there to represent the electorate (those who voted for as well as against the Tories), but he has sold their souls above their heads.

Yes, he has agreed to allow banks to use independent mediators, paid for by the banks, and who will depend on the patronage of the banks for their remuneration.  Note that two banks have already ditched an ombudsman they disagreed with, and it will be a lot easier the next time to tilt the deciding hand.

No rules or regulations can ensure that a bank contracted mediator will be independent and impartial, and, don’t banks already have their own internal ombudsman? 

I do find it hard to decide which political party to vote for in this country!  Whichever one is in power always seems to end up filling their own boots or placing their own ends above that of the nation. 

In the end Canadians are are left with conflicts of interests, the status quo and a tar sands’ full of asymmetric information.   Daylight robbery!  But then again, if robbery is part of a competitive market, then I guess robbery is OK.

“He said Ottawa’s role is to set out the rules, “and if the banks want to use the services available in the private sector, as long as the private sector obeys the rules, that’s okay.””

Flaherty fails to see that the ombudsman is an alternative to the legal system, the only other independent option for individuals with a complaint against the financial system.  Private mediators do not provide this option.  And in the private market place you can buy just about anything, for this is what the Banks are shopping around for: the choice which best suits their business model.

So what next?  Will Flaherty privatise the judiciary, the police, customs and excise, the CRA? Surely the private market can handle all these functions just as well? 

Money can buy you anything, in Canada, but democracy!    

Income Growth (US) dynamics are a risk to growth

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Real per capita increase in personal disposable income remains a fundamental weakness constraining recovery and growth going forward:

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Declining savings ratios continue to support current consumption, falling from 4.7% in December to 3.8% in March:

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Overall nominal personal income growth has slowed from 6% in February of 2011 to 3.2% in March 2012, the lowest annual growth rate since May 2010.  

Where is the plot in Euro monetary data?

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The European Central Bank Press release shows annual increases for money supply of 3.2% for M3 and 2.7% for M1.  

There are number of issues here:

Money supply growth over the last few months is likely to have been impacted by the exchange of money for securities (Long Term Repurchase Operations) by the ECB.

Annual inflation was running at 2.7% in March, so real money supply growth is much lower.

But the real side of the story is loan growth and it is via loan growth that money supply impacts economic activity: annual loan growth to the private sector has risen 1.3% (adjusting for securitisations), or a negative 1.4%. 

Looking at more recent data, loans to households have risen by an annualised 0.57% since January, buoyed by lending for house purchase – credit for consumption declined in both February and March.

Loans to non financial corporations, rose by 0.3% in the year to March, but both February and March showed declines in lending, so effective recent growth is negative.

But this data is seasonally adjusted and it is possible that lending data would have been worse had it not been the for the above seasonal winter temperatures, which may have boosted lending for home purchases.

Monetary interesting

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Growth in bank lending relative to the growth in broader money supply growth and bank liabilities is likely to be a more important metric than asset prices in deciding whether or not to pursue further quantitative easing.

Broader money supply growth (M2 less M1), in the US, has been strong over the last year or so, and as one would expect with a QE driven economy, at a faster rate than nominal GDP:

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Bank lending has also been growing:

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And the annual growth rate of commercial bank lending has eclipsed the growth rate of commercial bank liabilities:

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Recent lending growth data is strong relative to historical periods – that is the end of December to the middle of April, and may have some weather related bearing.

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The above chart shows the rolling quarterly annualised increases in bank lending in 2012 from the last week in December 2011 for 16 weeks relative to data in prior years.  Relative loan growth data (unadjusted for inflation) has been strong of late relative to 2011, 2009, 2002 and 1999, which were hardly competitive years.  Most of the current increase however was concentrated in the 4 weeks ending 1 February to the 4 weeks week ending 22 February. 

In the year to 11 April, commercial bank lending % growth was some 60% of M2-M1 % growth, relative to 31% in December 2011 and was –45% in June 2011.

Growth in bank lending relative to the growth in broader money supply growth and bank liabilities is likely to be a more important metric than asset prices in deciding whether or not to pursue further quantitative easing.

Weekly unemployment claims and Chicago Fed National Activity Index..

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Again the weekly unemployment claims data shows relative weakness, delivering the worst performance trend for the most recent 11 weeks since at least 1997.  In the latest week that relative gap has increased from last week:

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The starting index of 100 is the weekly claims starting point for all time series, with relative increases/decreases in claims resulting in increases or declines in the index. 

The Chicago Fed National Activity index also declined: the current run of the monthly index since the start of the recession has been one of the weakest on record:

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Data, data, data and faith based economics…

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Debt, and global structural economic and financial imbalances remain the key factors behind growth potential and risks to growth.  These have changed little, and if anything, dynamics and absolutes have worsened in many areas: think Eurozone sovereign and financial system debt; Japan sovereign debt; China dependence on investment led growth and also China debt; US sovereign debt and still significant consumer debt dynamics.

We remain in a low growth dynamic with plenty of downside risk, with little leeway to stimulate and support economic growth in the event of economic contraction – note low interest rates, high sovereign debt and still significant legacy capital allocated to unproductive assets.   The dynamics of growth in a high debt environment where there is a greater dependence on structural change (consumption versus investment) and complicated by monetary debt dynamics are complex.  

What we have seen as growth in many areas recently may not be sustainable, or capable of itself being used as a base on which to compound.  We are  living in a faith based economic paradigm supported by central bank machination: “if we can ignore the risks and keep plodding on then hopefully, just hopefully, some of the positives may stick and remain and prove real” is the implicit mantra. 

We need to expect low growth, as an upper bound, of some 1% to 2% below what we may consider normal growth, and significant downside risk for some time.   Recent growth in say the US, has probably been above that which the economy is capable of delivering on its own and, as implicated, growth abetted by short term stimulus, is just as easily rolled back.

Data from the Eurozone flash (PMI) and political developments (Holland) reinforce the force to the downside.  Note also the relatively weak China flash PMI data, although the major player as far as China goes is gross fixed capital investment.  

US durable goods order trends are also weakening:

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Led by a decline in transport, in particular aerospace:

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As have non defense capital goods ex aircraft:

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US weekly unemployment claims also remain weak relative over the last 10 weeks relative to data going back to 1997:

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US retail sales however are showing their best quarterly results since at least 1993:

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Note also:

The UK has moved back into recession: an economy free of Euro constraints on interest rates, currency and money supply (QE), but belaboured with high consumer, financial system and sovereign debt, and this despite monetary stimulus and low interest rates.  Note also the deteriorating sovereign debt outlook and continued implementation of austerity measures.

Chart data is taken from US Census Bureau data sources.

Denuded Data!

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US weekly unemployment claims are trending up with previous figures being consistently revised upwards.  A focus on current trends is meaningless, which is why I have been comparing current unadjusted data with historic data.  I have looked at the last 9 weeks to 7 April, and historic 9 week periods over the same time frame, and found that current trends represent the worse weekly claims outcomes since at least 1997:

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European industrial production data would appear at first glance to offer a positive spin on economic activity in Europe.  In February, industrial production rose 0.5%: but, when we exclude energy output, which rose 7.7% over the month, key consumer durable and non durable goods output fell 2% and 1.6% respectively.  Capital goods output rose by 0.7% over the month, contributing the vast majority of a modest 0.8% annual increase.  Overall industrial production was down 1.8% over the year, supported largely by annual energy output growth of 3.6%.

NFIB Small Business Optimism–and so the mosaic builds

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The following are Excerpts taken from the NFIB Small Business Trends March survey.  This is not about pounding on one month’s data: the optimism index is still in a recession range and the two recent data humps are not consistent with a stable GDP trajectory.

And so the mosaic builds:

“Six monthly gains in the Index of Small Business Optimism were reversed in March, as the index fell almost 2 points to 92.5. Nine of the ten Index components declined, only increasing satisfaction with inventory stocks added one point to the Index computation. It looks like a replay of 2011, a few months look good early on and then it all fades.”

NFIB small business optimism index

Small business optimism dropped in March

“The March survey results were bad news, ending what promised to be steady, albeit glacially slow, improvements in the small business sector of the economy…Inflation pressures are building and reports of rising worker compensation are the highest since 2008….The March employment numbers were a bit of a surprise and a disappointment. …..we added seasonal adjustments to January and February numbers that were not as low as they usually would be with bad winter weather. So, they looked good. Then March hiring was low because a substantial share of it was done in the prior two months, and the seasonal adjustment couldn’t overcome the advance hiring. In short, the current employment stats are not seasonally typical so the seasonal adjustments mislead us. …The pattern of losses in retailing is a puzzle, especially since retail sales growth has been positive, confirmed by the rise in the net percent of owners reporting improving sales trends. This raises a second inconsistency, if employment is doing so well, where is the Gross Domestic Product (GDP) that they are producing?

The NFIB models based on the percent of owners reporting “poor sales” as their top business and on the percent with hard-to-fill job openings and job creation plans have tracked the unemployment rate quite well. If March data were to be the same as the April survey, the forecast would add half a point to the unemployment rate for Q2.

The Federal Reserve has become more active in the media, trying to be more “transparent” about policy but adding little clarity. The basic message is that rates will remain low as long as the economy is weak but no one knows at what point the economy will be deemed strong again by policymakers – creating more uncertainty.”

ISM Manufacturing–PMI 12 month pre and post recession relatives

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Divide the current PMI by the prevailing level the year before and take away 1 and you have a trailing 12 month PMI relative.

What did the ISM Manufacturing PMI look on this basis for all 12 month periods up to and including the month in which previous recessions started?

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Assuming the current PMI is at the same point as all other historical points (dotted light green line), its relative dynamics are more or less average for all prior recessions, excluding that started in July 1981.

What is the point of this?  One point is obvious, current PMI data, in terms of relative strength, offers little obvious support to growth going forward.  You could say that the weak recovery to date has some unsettling dynamics.

But let us be fair, let us look at the post recovery picture.  The following chart looks at 22 months after the end of prior recessions and looks at PMI relatives for 12 months – which takes us to the current point in time, March 2012:

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So the current PMI “relative profile” is weak compared to historical periods, especially on a post recovery basis and in the zone, as it were, for pre recession periods.

Inertia?

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US economic growth is weak when compared to historical post recession growth rates – just look at the depth of the downturn and the peak of the uptick.    

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It has yet to rebalance away from PCE led growth: over the year (2011) the private consumption expenditure component of GDP represented some 80% of GDP growth, while net exports have detracted from growth.  Problems in Europe and weakening growth in China would appear to limit growth options here.  

Debt remains high for many reasons: it is likewise is expected to detract from growth going forward.   

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If consumer credit growth is close to peaking in the current cycle, then we may be in trouble.  Indeed, take out debt financed growth and today’s real growth rate is probably not that low at all, and do not forget, what little growth we have is being forced to a certain, if not great, extent.

Add to this a still weak housing market, weak income fundamentals and still very high unemployment, and wealth driven debt factors (mortgage debt) may also be absent as a key driver of real GDP growth going forward.  

So where is the growth going to come from?  This may be a good question when we consider that warm winter weather may have helped economic growth over the last 3 months.   

If we cannot rely on the consumer, debt, overseas markets and the government, then what of investment: gross fixed private investment can act as both a drag (too much historic investment in unproductive assets) or a boost to growth as capital is reallocated: but for such to be a boost we need capacity constraints and strong demand fundamentals.

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But in order to invest, we need to save:

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If growth dynamics are slowing before the economy has gone any significant way towards reducing a serious debt overhang and high levels of unemployment, let alone remedying significant structural economic imbalances, then it is a question of when the forces acting against recovery gain the upper hand.  The economy appears to lack the necessary momentum to carry its weight going forward.   

In order to meet our liabilities going forward and to generate the growth in output needed to justify current asset valuations, we need stronger and sustained growth.  Asset values, in a post excess asset focussed money supply growth binge, are key to keep the whole edifice together.  But there is only so much we can do with QE without destroying the integrity of the system itself.

Inertia – the real (non influenced) growth rate of the global economy is much slower than we have seen over the last few years, and as the force of efforts made to bolster growth weaken, we are more likely to move back to a slower rate of growth, but not without a shock/adjustment needed to register the difference between the energy of the two paradigms.

I would like to take many of these issues further in a Capitalism in Crisis recap, because their number and their importance is more meaty than this short ad lib. 

Data is sourced from the US BEA, Census Bureau and Federal Reserve.