The Centre of Gravity of Risk and its Sensitivity has long since shifted towards the financial.

China is a key piece of the puzzle and much more so than people understand.  Without weighty Chinese domestic demand growth the transition out of untoward monetary policy towards financial and economic stability is jeopardised further.  Monetary policy had stabilised and propelled markets higher, but the time horizon for economic and financial normalisation is highly dependent on the timing of key transitions. 

The world economy is changing, decelerating, maturing and transitioning.  The world’s central banks, from the late 1990s onwards, co-opted the financial system to drive growth forward.  We have suffered a number of shocks as a result, but the strategy of juicing growth has continued. 

Our biggest immediate problem is not that the growth rate of expenditure is decelerating, or that populations are aging, but that the debt (and other contingent liabilities) that has been built up through a low interest rate and asset focussed monetary policy in the developed world and more recently, through infrastructure and other capital investment expenditure in the developing world, has created a mismatch between the supply and pricing of assets (debt and equity) and the economic growth rate on the other hand.

It is not that the fundamentals of underlying economic growth have become more volatile but that the relationship between monetary policy and assets and that growth has widened. 

I have written on this issue many times in my posts: it is not the economy we should fear but the financial system, its volatilities, risks and divergence.  Many still are ignorant of the shift in sensitivities from the economic to the financial: whereas in previous asset market history asset market movements had less impact on the here and now, their impact has become increasingly important.  The centre of gravity has shifted as the weight and importance of assets and debt to growth and the financial system has ballooned.

There are of course other problems that are making things worse: increasing income inequalities and falling productivity growth and of course the global structural imbalances that have arisen as China took centre stage in global manufacturing supply chains.

Slower growth and aging populations are likely inevitable and natural depreciation of the capital stock at the margin, in the absence of a shift upwards in productivity, via a shift of flows towards current consumption and away from investment is natural and self adjusting.  As flows shift away from capital investment we will also likely see lower growth rates in debt and money supply growth and the natural dynamics of decline means that this shift in flows may ultimately result in a decline in endogenous money supply growth, loans and other forms of debt and declining asset values. 

What is happening  is that the financial system is fighting demographic shifts, income inequality dynamics, transitional shifts between developed and developing economies, productivity stagnation in the hope that these dynamics are all transitory.  Apart from the transitional shifts between global economies there is much less certainty with respect to the other factors.  Importantly within discounted present value calculations, the largest component of value is held within the short to medium term horizon. So even if certain dynamics are transitory, the horizons are in conflict.

I see much potential volatility in the near term and much uncertainty with respect to fiscal and central bank accommodation of the divergence itself.   What the slowdown in China is bringing into the open is the divergence, the importance of the time horizon and the risk that normalisation of the growth trajectory is not going to happen, at least within a time frame meaningful to supporting the asset price/GDP dynamic divergence.  This is why markets are currently highly volatile and the major reason why the price adjustment is likely to continue.

See also:

A world in transition, but so many straws in the wind, some thoughts!

Not a “Savings Glut” per se but a monetary excess amidst a period of complex global structural economic change!

Was the US Q2 GDP revision so great?

The main changes to Q2 GDP came from revisions to non residential fixed investment, inventories and government spending.  But we must a) also remember that the prior GDP base had also been reset lower following the most recent GDP revisions and b) consumer credit growth has become increasingly important to GDP growth of late (as it has in places like UK):

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The Zone of Interest…I think Ellen has argued very forcefully for best interest standards!

The Zone of Interest is a book by Martin Amis that fictionalises the administrative zone of Auswchitz (and I highly recommend it).  An investment world without best interest standards, where the old, the infirm, the weak and vulnerable are maligned, abused and consumed, is too a Zone of Interest:

I was particularly drawn to a recent article by Ellen Bessner, a lawyer representing financial firms and “advisors”, entitled “Serving senior clients is becoming a more risky endeavour”.

The article is about the increasing prevalence of complaints made by elderly investors and highlights a generalised case of a senior who complains, with the help of a family member, about investment performance (i.e. losses) brought about by unsuitable investments for his or her age.

The article then goes on to flesh out 4 reasons as to why this is happening, none of which discusses the fact that “advisors” are rarely trained to professional standards; commissions drive advice and transactions drive commissions; suitability standards drive transactions and not portfolio and hence risk management structures; recommendations and rationale are not required to be in writing and little or no point of reference with respect to the risk/return/asset & asset allocation/liability profiles of the often mixed bag of investments are ever provided.  Moreover no disclosure of the true nature of the relationship is likewise provided, and this has not changed under the CRM.  The construct is designed to deceive, designed to place people in a place where they are least likely to be able to accept the risks of the transaction relationship they have been guiled into. 

And, according to Ellen, the reasons why there are more complaints:

Number 1

Perversely Ellen blames the fact that aging populations has led to a drive to educate investors about their rights in contractual relationships: this education and information she says has led seniors to take their advisors to court, to seek independent judgement on their advice via the financial services ombudsman (OBSI) or to take their complaints to the regulators.  Perhaps Ellen would like no education over contractual investment relationships or dare I say it human rights: ignorance does indeed breed a blissful transaction relationship.

Number 2

The second point is really point 1 again, but I will elucidate: it complains about the fact that there is no cost to taking a complaint to OBSI, that you can hire a lawyer for free (though she does not let this one hang) and that “lawyers” see dollar signs when they see an elderly client with a financial complaint…those damned lawyers!  Ellen tends to omit a great deal of the road that often leads people to the point where they have no other option but to seek help from OBSI, lawyers and regulators, as well as the road beyond, and she also omits to opine on those “advisors” who never pay their regulatory penalties or those firms named and shamed by OBSI who refuse to pay up.  The picture has not been fully painted, but one point is clear, investors have rights and this a problem.

Number 3

Point 3 is about investors buying the highest yielding investments available, the highest risk investments available, because they have not saved enough and they need the highest returns possible to meet their expenditure needs.  So we have here an admission that yes, investments were not suitable but that the “advisor” was not responsible.  Responsibility is an important issue and present “suitability standards” allow “advisors” to avoid this nicety, this responsibility to balance risk/return and financial needs through portfolio structure, advice and education.   Ask yourself this question?  Where is the record of the process whereby the “advisor” made recommendations over structure and content appropriate to financial needs and risk aversion, the client declined and wanted something much more risky?  Well, it ain’t there and that is the problem, or a good part of it.

Number 4

Point 4 is a different matter and I am not sure why it has been slid into this argument, but it has its uses and I will aside here: in a best interests standard regime, advice and recommendations would focus on the needs and disposition of the investor of interest and manipulations of the sort described would find it very hard to survive. 

I think Ellen has argued very forcefully for best interest standards!

No need to worry!

I recently came upon an article entitled “What You Can Do About The Upcoming Stock Market Crash”.  The title was tongue in cheek and perhaps unfortunately so given recent events.  Nevertheless, it made a number of important points about the difficulty of knowing when a market is at its peak and when a market is at its lows, and of knowing in which direction and by how much a market is going to move at any given point in time.  Much of this I agreed with, but not all:

When you think about it that risk and fear will always be there no matter how far the market goes up, down, or sideways. So what can you do?

Be prepared for a crash at any time. If you need to withdraw money in the next few years or you want to cushion the blows, then you need to diversify your portfolio with enough bonds, cash, or other assets that won’t fall along with the stock market.

Once you figure out what is right for your current situation you don’t have to worry about what happens because you are controlling the risks instead of letting them control you. That means you are safe to invest your money today and start earning your way to the freedom you want for yourself and your family.

Points 1 and 2 noted above are more or less correct, but the last point I have emboldened is where I diverge.  You are never ”controlling” risk, just diversifying it relative to return, and if possible, its covariance, itself a function of risk.  You cannot control risk, only minimise its impact through structure.  You are certainly not safe to invest your money today and there is no guarantee that you will earn your way to freedom. 

Return is an important consideration when accepting risk and many today who use simple mean variance models assume that expected returns are invariant and that risk is only volatility around this return.  In a general equilibrium, random, independent price movement model it does not pay on average to delay or defer investment (any benefit is purely attained by chance), but even here you are hostage to the probability distribution since the expected return in Monte Carlo land is only the average of many outcomes, some of which turn out to be quite disastrous from any level.

But expected returns do matter and while timing your investment to maximise your returns and minimise your losses is impractical and impossible for the market as a whole to do, making value judgements about market valuations and economic cycles to inform you of the boundaries of return and its significance is I believe worthwhile if you possess the expertise..  Where people run into trouble is where they either lack the knowledge and expertise to make the type of judgements needed to define the boundaries of expected return, and its impact on structure, as markets and economic cycles mature or react to market falls and meteoric rises as if one is the end of the world and the other its never ending bliss.

Deferring new risky investment at high market valuations is a value call and a discipline, but it is an act which relies on knowledge of the significance of valuation differentials.  It is one of my concerns that “we” have been taught that we should invest in markets at all times irrespective of the valuation, the cycle and the specific characteristics of either.  One of the reasons the world has been through innumerable crises since the late 1990s is because we have ignored significant accumulating structural economic and financial imbalances and the differential between asset valuations and economic fundamentals.  In a well balanced world we could probably ignore valuations and invest at will, ignoring volatility. 

But then again context is everything.  While one may not invest/sell at cyclical highs/lows there is little reason to sell all (high) and then attempt to reinvest all (lows) at perceived key turning points.  Portfolios should adjust to the relationship between valuation risks and the time frame of their liability profiles and it is here where we need to pay attention to valuation risks since these do have material impact.   As markets rise returns fall and the risks to the ability of assets to meet future needs increases, and vice versa.  When returns and risks pass barriers of significance that is where changes at the margin need to be made.  It is therefore not a question of timing but of tangible discipline and its benchmarks.

And, of course, I believe we are in the middle of a very long period of global economic and financial fragility, so safe is a word I would eschew for some time.

Making sense of US employment data and the interest rate decision.

We have relative strength in certain sectors supported by a steady increase in employment and growth in consumer credit. The backdrop is weak domestic productivity and income growth, an unsettling composition of employment growth and global economic weakness, in particular a possible global trade shock centred in China. The US is still growing slowly and while there are signs the labour market is tightening there remains considerable structural slack and remaining structural imbalances of concern.

A rise in interest rates may well be needed in the light of growth in consumer credit, but I have concerns over the fact that wage growth has yet to ignite, that capital investment expenditure remains weak and that the Federal Reserve’s own views of economic growth potential may well be above that which the economy itself is able to produce. Has the US economy returned to the normalcy envisioned by policy makers and with it its interest rate setting policy? I think not, but I also feel that the divergence between income growth and consumer credit growth is a considerable problem and one that may come back to bite the US if China weakens further.

Has demand moved to a level that would generate capital expenditure that many feel is necessary to push growth back to higher levels and would a rising interest rate scenario cut this particular and necessary part of the cycle short? This critical intersect may be a key consideration in any interest rate decision.

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US – Some interesting charts on income, GDP and new manufacturing orders from recent data

There are some interesting patterns and trends in US data: so I do ask myself, are we at the peak of the current cycle, are we as far as debt and low interest rates can take us?

US income growth has long been acknowledged to have weakened considerably yet recent data shows that the trend has indeed been weaker than first thought.  Note the following chart showing pre and post revisions to chained per capita personal disposable income:

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Compromised by its many biases the Brondesbury report completely misses the point about fees!

From one critical perspective this report appears to blame consumers of advice for the outcomes of a business model compromised by transaction remuneration.  Little is said of the inadequacies of suitability standards and their regulation or of the failings of investment processes focussed on the transaction.  Lacking such balance the report appears to advocate for the transaction model and thus is pared of its credibility!

If you had stopped reading the Brondesbury report into Mutual Fund Fees at the first summary conclusion on page 6, you might have walked away thinking the report was in favour of fees for the right reasons:

“Evidence on the impact of compensation is conclusive enough to justify the development of new compensation policies.”

If you had read on you should be left in some doubt as to how much of a marginal benefit a move to fees would have on investor outcomes.  The report appears to build an argument that suggests investor behavioural biases are the most important vitiating impact on outcomes and that advisors are merely responding to their transaction requests.    

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The Brondesbury Report & Cultural Bias in the Regulation of Canadian Retail Financial Services…

I am going to delve into the Brondesbury report shortly, but first we need to step back and look at the frame we are in, because neither the Brondesbury report nor the CSA have fully explained this.

The CSA have unfortunately addressed mutual fund fee issues separately from the wider problems in the Canadian financial services industry and, most notably, separate from that of best interest standards.  There may well be a reason for this!

Aside from the investment counselling/discretionary client portfolio management segment of the industry, whose standards and responsibilities appear, to all intents and purposes, to be ignored as valid reference points in current deliberation, the frame we are looking at is the one that holds the advisory segment. 

The advisory segment is still regulated on a transaction by transaction basis with responsibility for the transaction effectively lodged with the individual investor.  This is a simple parameter to parameter model that aligns risk preferences and investment objectives, adjusted for some nebulous assessment of investment experience (often arbitrarily assigned), to a product recommendation.  The product recommendation passes through the parameters.   In the Securities Act, for instance, the provision of a transaction recommendation within an advisory registration capacity is not technically considered to be advice.

The KYC is not a portfolio/optimisation process.  In fact, if you were to hand a KYC to an investment professional they would have to bypass it to a more sophisticated investment process to construct, plan and manage an asset allocation and security selection that matched a given investor’s risk preferences/asset liability profile. 

The current culture assumes that investors come with requests on a transaction by transaction basis, that the KYC process is effective and sufficient and because of its simplicity is therefore simply understood.  An investor in this frame should be able to own the transaction with the advisor only responsible for the product advice and not the management, or the construction or the planning.  If we refer to the careful delineation in the Securities Act, the investor is not actually being advised. 

In this frame “the culture” assumes that it is the investor’s own behavioural biases that drive mis-selling and that the advisor must accommodate these biases or risk losing business: I phrase this with reference to comments that I will, in a later post, draw from the Brondesbury report.

I have a number of issues with this framing of the KYC process and so, it would seem, did the OSC way back in the late 1990s and the early 2000s –note the FAIR DEALING MODEL and earlier Financial Planning Project initiatives: 

In 1999, the Canadian Securities Administrators committee on financial planning proficiency standards identified conflicts of interest in financial planning advice as a more significant concern than representatives’ proficiency. The CSA committee undertook to pursue this area as the second phase of the Financial Planning Project. Around the same time, OSC Chair David Brown determined that changes in the social and economic environment, and in the business structures and objectives of the securities industry, warranted a fundamental re-examination of the regulations governing the delivery of financial advice to retail investors. He recognized that our regulations are still product-based, as they have been for decades, even though the industry has moved to an advice based business model. In early 2000, the OSC launched the committee that has led to this Concept Paper.

The promise of service has long since exceeded that of the simple transaction. It has long since extended to the provision of advice that relates to overall financial needs and financial assets.  The process needed to manage these needs and assets is more sophisticated/complex than that provided by the KYC parameter model.

Today the KYC remains as the barometer of the suitability of product advice and the assessment of the suitability of advice.  In order to deliver the promises that the industry is effectively making the investor today you would need to move your focus of attention to a more complex and integrated service process.  In truth investors should be paying for the process and not the transaction.  Unfortunately the industry remains mired in a culture that rewards the transaction and not the process, and hence focus has remained on the transaction and transaction remuneration. 

If we are to deliver on the service promises being made we need to develop our processes and thereby raise our standards of advice.  By removing remuneration from the transaction and aligning it to the process, i.e. a fee for service process and advice, we change the industry from one focussed on transactions delivered by a rudimentary process to one focussed on advice delivered by modern technology and knowledge that better matches the promise.   At the moment advisors can effectively promise best interests yet remain regulated on the transaction.  This risks a disconnect between the processes needed to deliver the wider promise and those needed to satisfy minimum standards.

The Brondesbury report, along with many others, is stuck in the transaction mindset: 

It believes in a world where investors initiate and are able take control of their investment decisions, where the KYC is simple and effective in delivering investment solutions, where advisors are not promising a higher standard of advice and are hostage to investor behavioural biases and where advisors are not responsible for educating the investor over their process and disciplines.  It believes in a world where the cost to the investor of delivering the transaction solution is of equivalent value to the investor and where there is no other promise than the transaction and no other alternative spectrum of advice.  The report ignores the fact that today’s promises exceed the boundaries of KYC suitability and require more advanced processes that naturally differ from those required to deliver stand alone product recommendations.

The Brondesbury report is looking at the problem through the rear view mirror, replete with longstanding cultural biases that have impeded the development not only of higher professional standards but more efficient and cost effective wealth management solutions.  This is a very complex area. I will address some of the wider issues as I explore the Brondesbury report in subsequent posts. 

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I discuss issues with the current parameter to parameter suitability model in my submission to the CSA on Best Interest Standards in Appendix A.  Also in this document are a number of excerpts from many of my blogs on best interests and the KYC process. 

Also worth reading is “Fiduciary Obligations of Broker-Dealers and Investment Advisers” by Arthur B Laby. 

Are Canadian regulators ring fencing consumer investing behavioural biases in favour of transaction returns?

“we suspect that much of what we see as impact of compensation is just investors failing to make rational decisions.” P53 of the Brondesbury Report on Mutual Fund Fees.

I am in the midst of reviewing the CSA commissioned Brondesbury Report on Mutual Fund Fees and am ploughing through the reference material which supposedly underpins its conclusions.  Amongst the many nuggets I have unearthed is the following taken from “Investors’ Optimism: A Hidden Source of High Markups in the Mutual Fund Industry” :

Previous works have identified investors’ optimism bias towards equities issued in their domestic market. In particular, academic research on mutual funds has focused on investor’s lack of financial literacy. …These empirical findings of investor’s deviation from rationality are in line with our model’s emphasis on investor’s limited financial knowledge of the mutual fund industry.

Investors’ optimism bias can be closely related to their lack of knowledge of the fund market, leading them to choose sub-optimal benchmarks such as bank savings instead of low-cost index funds or ETFs. Besides, investors’ optimism bias is probably influenced and reinforced by the marketing practices of mutual funds, which promote the sale of fund shares.

The reference to sub-optimal benchmarks is both noteworthy and ironic because both the new Point of Sale disclosure documentation for mutual funds and the performance reporting requirements laid down in the CRM2 lack mandated performance benchmarks. 

Interestingly the Canadian Securities Administrators had earlier proposed a GIC or cash based benchmark for Point of Sale mutual fund disclosure documentation, but baulked at the last minute for a number of reasons. 

So why were Canadian regulators looking to implement “sub optimal benchmarks”?  Were they ring fencing consumer behavioural biases in the interests of transaction remuneration or were they themselves acting in ignorance?  We may never know but the point is an interesting one and much more so given the deeper contextual focus in the  Brondesbury report on investor behavioural biases (chapter 5):

“Behavioral biases of investors are not easy to overcome. Behavioral biases affect advisor behaviour (just as advisors affect investor behaviour), investor choices of investment, and ultimately, investor outcomes”

“Time is a precious commodity to most advisors. There is only so much time an advisor can afford to spend to overcome the behavioral biases of investors, regardless of how they are compensated”

Investor behaviour biases lead to sub-optimal returns and these biases can be confused with compensation impacts

Behavioral biases of investors are not easy to overcome and they are a key factor in sub-optimal returns on investment. This poses a real limitation of the conclusions we can draw from the research literature, when we look solely at clients of commission-based advisors.

If there is no comparison between different forms of compensation, one can easily be misled into believing that sub-optimal behaviour is the result of the advisor’s recommendations and not, at least in part, the behavior and attitudes of the investor.

There are two issues related to behavioral biases that must be mentioned here. The first is the question of who is responsible for overcoming the behavioral biases of individual investors. While helping clients to do so may be something that a top-notch advisor will choose to do, we are not aware of any rule or principle that points to de-biasing as an advisor or a firm responsibility, regardless of compensation scheme unless a failure to do so impacts ‘investment suitability’ in some way.

“we suspect that much of what we see as impact of compensation is just investors failing to make rational decisions.” P53 of the Brondesbury Report on Mutual Fund Fees.

This quick post introduces some of my concerns with the Brondesbury report and my belief that many of its conclusions and analysis remain mired in a transaction mindset that continues to beset regulation of advice in Canada.   Regulators and, it would seem, some esteemed others appear mired in a perplexing behavioural bias towards “what does and does not represent investment advice”. 

How far can we defer the next asset price crisis? Depends on how fat the tail of the distribution is!

I have blogged on fundamental liquidity issues recently and one point that I want to bring out is that the greater the divergence between asset values and GDP and the greater the divergence between broad MS growth and GDP growth, especially in slower growth frames, the “fatter the tail of the distribution”.  

Volatility at one level is a measure of the sensitivity of an asset’s price to new information, shocks to the system/de facto changes in the energy of the system.   It reflects changes in demand flows for assets which can reflect changes in risk preferences and risk/return expectations.   In a general equilibrium volatility is meant to be a static physical characteristic reflecting the fundamental nature of the asset and its relationships, but we do not currently have general equilibrium relationships and volatility is not a stable measure of anything.

Essentially when we have excess asset focussed money supply growth (EAFMS) amidst a slowing growth frame the “accumulated liquidity in” decisions exceed the “present value of future liquidity out” (PVLO) decisions.  In a sense liquidity (at its heart a function of the relationship between asset allocation decisions and C/S/I/P decisions) becomes more sensitive to short term  changes in demand flows and risk/return expectations, risk preferences and other factors.   As the ratio of EAFMS to PVLO rises so does the natural volatility of the system.

Why the tail?   Why not volatility at 1 standard deviation?  During periods of excess monetary flows demand changes are not in totality covariance issues (ie. relative attractiveness of one asset to another) but absolute flows that suppress relative price reaction.   In other words we see a fall in volatility throughout most of the distribution.   All the while the system due to EAFMS/PVLO imbalances becomes more sensitive to changes in flows, preferences, expectations and shocks.  

Given that the system because of its imbalances becomes more sensitive to small changes in any one factor, the bigger the divergence noted in paragraph A the greater the probability of an extreme risk event.   The greater the accumulated liquidity in to PVLO the larger the tail: the risk event and its probability increase. 

In reality, from a given point on, we can effectively discount the rest of the distribution in any analysis as a dynamically widening tail is merely a statistical constraint on the way we should be viewing risk.  We are only exposed to the wider risk distribution if forces suppressing risk remain influential.  

A Foray into the Fundamentals of Austerity in Anticipation of the Outcome.

A recent IMF report pointed out some supposed vast amounts of room available for the world’s economies to step up government borrowing to finance consumption, investment and production decisions.   Oddly the report appeared to ignore other forms of debt and material deterioration in key areas of the economic frame.  

When the crisis broke back in 2007 it was clear to me that monetary and fiscal policy would likely need to go for broke to support economic growth and employment at a time of collapsing asset values, debt defaults and a world wide retrenchment in expenditure of all kinds.   As it happened a great deal of that support went into asset prices and financial institutions.

But some years after the crisis, after a slow and drawn out recovery with interest rates locked to the floor, economies still appear to be borderline reliant on debt financed government expenditure.  Any attempt to reduce borrowing, to either raise taxes or cut expenditure to pay back debt would be considered by many to have an adversely negative impact on economic growth, especially at such low growth rates. 

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On the question of market liquidity and the liquidity time bomb.

In a recent tweet I made the comment “Not a paradox: ratio of MS to assets & of asset prices to GDP, and hence to GDP functions C/I/S/P out of synch”.

Given the sensitivity of markets to even small changes in demand should anyone stand ready to provide liquidity at the onset of the tail of a distribution?

If a liquidity decision eventually exits, then there is a maximum amount of divergence which any given financial system can accommodate before the dynamics of the reverse flow overwhelm any attempt to keep it afloat. We must bear this in mind.

A recent article by Nouriel Roubini “The Liquidity Time Bomb”, to which the tweet responded, commented on the apparent paradox between vast amounts of financial stimulus and monetary expansion alongside a decline in market liquidity for assets.  

Why do we need liquidity in the market place?  There are a variety of fundamental economic reasons.  Entities wishing to purchase assets (from savings out of income or from loans) in either new/existing issues, entities who may be dissaving and wish to sell assets in exchange for cash for either consumption (debt repayment) or to purchase higher yielding assets, businesses that wish to raise capital and other entities like governments that wish to borrow.  That is markets function as an important medium for saving, consumption, investment and production decisions…they facilitate the allocation, pricing, accumulation (and the reverse) and transfer of capital ownership rights.

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In the context of interest rate decisions you have to ask yourself just what are we waiting for?

I have seen that the IMF has asked the Fed to defer interest rate increases until we see clear signs of wage increases and inflationary pressure.

The request IMO is both scary and rationale given that so much of today’s National Income Accounting Identity (output=C+I+X-M) relies on factors that lie outside of its operation.  I speak of new bank generated loan growth given that income growth/distribution and investment growth still appear to be weak in the scheme of things..i.e. C+I the drivers. 

The last time the FRB delayed interest rate increases we had a debt financed consumption boom in the US followed by IR increases and a de facto financial collapse.   By raising rates we likely restrict one of the few modes of generating consumption growth in the US (note auto loans) and many other countries.  We also likely raise the impact of existing debt burdens on what are to date still historically low rates of income/wage growth.  

As such you have to ask yourself just what are we waiting for?  Well we need higher income growth, but not just higher income growth: we need a more equitable and fair distribution so that economic growth itself becomes less reliant on debt and low interest rates, and less exposed to the scary divergence of asset values. 

But the world is also changing in ways that question whether we can effectively outwait the inevitable: populations are aging and declining.  Areas where the frame can still expand in consumption terms, areas such as China, may be heading into their own period of slow growth and low IR debt support. 

Importantly will the status quo submit to a reconfiguration of the pie and can the world assume a less debt dependent economic raison d’etre?  

So yes, the rationale to defer interest rate rises is both scary and realistic, but it fails to answer important questions: what are we waiting for, how long can we wait, and are our hopes realistic? 

This is just a quick 3 minute post, but the issues are critical!

US Manufacturing Orders

After a strong mid 2014 new orders had fallen heavily with nominal order data especially hard hit.  After an initial slide the trend seems to be levelling out, but levelling out is not what the economy needs.

Long term, the order profile is flat if we adjust for prices – note I have adjusted for producer prices not order prices, although over time I expect little difference.

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Annual growth rates have taken a punch to the gut, but if we adjust for monthly variance and producer prices we find that the downturn is less marked, although not necessarily insignificant:

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What I do find interesting, and which backs up my thoughts re last summer’s surge in activity, is the fact that the rise in activity towards the middle of last year is more or less reflected in the downturn in the early part of this year.   This pattern comes about after adjusting for PPI and basing % changes on rolling 6 month average data to arrive at a better fix of actual capacity and order flow:

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Motor vehicles and parts seems to be the notable exception, but I do have concerns over debt financing and weak income growth.

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World Trade

Some charts and brief comments I forgot to post:

Growth in world trade volumes has fallen off significantly since summer 2014:

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Interestingly US trade data shows a tail off in US auto exports and a rise in Auto imports.  Imports rose strongly in March and fell back in April (opposite for exports), although much of this has been ascribed to the impact of West Coast port strike issues.

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Comments on “Developments in credit risk management across sectors”

A recent BIS report on “Developments in credit risk management across sectors:” raised some interesting points regarding the stability of the financial system.  What I found interesting was the increasing use of collateral agreements and in particular higher quality/more liquid assets.   If the financial system is exposed to a risk event there is a risk that this collateralisation of higher quality assets could increase the correlation of these assets to the risk event and may well end up drawing liquidity from other areas.  Likewise as risk in the system increases the need to hedge and hence post collateral may further infect expected price reactions.

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Is Private Investment Expenditure in the US really looking strong?

Is investment expenditure in the US really looking strong?   I picked up some tweets on this the other day which stated that it was indeed.

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The above graph shows domestic investment of US private business net of capital depreciation. A couple of points should strike you immediately: one nominal expenditure peaked back in the late 1990s; two, a lot of the retracement (or the pluck as Friedman might have said) is a consequence of the unprecedented decline seen during the dark days of 2009.  

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Overtaxing the rich: A cautionary tale

We need to look at increasing inequality as an unfair tax on social and economic stability.  And so, my brief thoughts on this Tim Cestnick article in the Globe & Mail;

At a very simple level the economy spends what it earns  (Output=expenditure=C+I=C+S, where S is income spent but not consumed).  In reality the picture is somewhat different in that we have monetary loan expansion that over time has served to increase the demand/expenditure for goods/services and investment expenditure.

Economic growth is the growth of expenditure whether it be consumption or investment goods.   If we start to allocate increasing amounts of income towards a very small % of the population what we end up doing is to constrain the ability of the economy to grow. 

For one lower income growth limits borrowing ability (something which had sustained GDP growth) and it may retroactively impact the ability to repay previous loans based on lower ex post income growth.

Greater allocation of income to one small segment of society also risks a higher allocation of money towards assets and away from consumption.  Increasing income inequality results in lower recycling of income into demand, and as the growth rate of demand slows so does the growth rate of investment.  

Importantly future flows determine the valuation of assets, so rising inequality amidst weaker GDP growth poses risks to assets prices.  The significance of this circularity has been lost on the very wealthy in a time when monetary policy has been outwardly in favour of asset price support in a weakening growth environment.

If we had less income inequality then tax rates would also likely be lower and we may also have a smaller state and a more outwardly capitalist economy.   The need for higher tax rates is partly due to structural imbalances like income inequality: think of two monkeys swinging through the trees, one with all its limbs and the other with only one arm.

Clearly we need incentives for people to take risks with capital, but we also need to make sure that the system has the necessary circularity of flow.  The income of the very wealthy is dependent on the expenditure of all and the valuation of their assets too.  This is something many have lost sight of: today’s high market valuations relative to historical benchmarks (note the Shiller CAPE) are assumed by some to reflect a different set of dynamics supporting valuation whereas many of the growth engines of the past are collapsing.  

At a time when there are so many negative forces impacting the stability of the economy a more efficient, though still incentivised, distribution of income would go a long way to alleviating economic and geo-politic stress.  Otherwise we risk increasing social instability and greater threat to income and wealth.  

The post World War II years are a very short space in time and certainly not long enough to assume that the having your cake and eat it too mentality is a natural economic dynamic.  In reality increasing income inequality is a de facto tax on economic and social stability in that shifting income and wealth from one set of people to another creates dangerous imbalances and inefficiencies.  The present need to raise taxes is an ex post not an ex ante action.

http://www.theglobeandmail.com/globe-investor/personal-finance/taxes/how-splitting-the-dinner-bill-relates-to-tax-cuts/article24441644/

“Marketplace lenders step out of the shadows in Canada — should we be worried?”

Brief thoughts re a recent Barbara Schechter article: Marketplace lenders step out of the shadows in Canada — should we be worried?

I tweeted on this. Some additional comments.  Peer to peer lending is different from bank lending in that it does not result in an increase in money supply growth.  It may result in an increase in velocity of money supply, something which has been dropping of late in many economies as a result of quantitative easing and a number of other dynamics.  It should also increase the efficiency of the intermediation system by offering lower interest rates and quicker access to credit to many borrowers.   There are some cons: one of which is that it will increase the liquidity risks in the system in the event of an economic downturn/ financial market crisis.  This of course depends on how many may view their loans as money like when they have been transformed and how this market place securitises the loan book.   At the present moment in time it may also increase the amount of consumer debt over and above safe levels, although this would not necessarily be an issue in less leveraged environments.  

Critical perspectives on US Market Valuations 2…includes 17 charts

Many say that lower interest rates should raise asset valuations by lowering the rate at which future income streams are discounted.  This may be fine for high quality government bonds where coupons are fixed, but is not necessarily the case for equities where we are dependent on future flows (earnings, dividends, economic growth, CAPEX). 

What is the major determinant of long term real equity returns?  Earnings growth, and long term earnings growth is dependent on real economic growth.  If we look at real growth rates they are falling, and have been falling for some time.  This is part of the reason why interest rates have been falling; that is to accommodate falls in nominal and ultimately real flows.

The following shows annualised annual growth rates over rolling 15 year time frames (in other words geometric returns) compared to the Shiller Cyclically Adjusted PE ratio:

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A world in transition, but so many straws in the wind, some thoughts!

Everybody is asking and at times hoping to answer the question as to why world economic growth is slowing down, why is it so sub par, why has it not recovered post the turbulence of 2007 to 2009?   There are many straws in the wind, but which ones are cause, which ones are consequence and which are accommodation linking both?  In a world where diverging tiny margins can accumulate into significant distances it is hard to determine just what and which is the key.

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