Christine Lagarde, the former finance minister of France who succeeded the hapless Dominique Strauss-Kahn as head of the IMF after the gentleman's career was brought up short after a to do with a hotel maid, warned of a "dangerous new phase" that would see a "fragile recovery derailed". Other central bankers, including Federal Reserve chairman Ben Bernanke and the European Central Bank's Jean-Claude Trichet, warned of risks emanating from the sovereign debt crises in Europe and the decline of US credit ratings.
The background to Jackson Hole (or "the hole" in common slang) couldn't have been more fraught if the central bankers had been
concerned about media coverage explicitly. Over the past few weeks, one question has come up repeatedly given recent market gyrations - namely, are we back to a 2008 situation for the markets. The first two weeks of August witnessed significant spikes in volatility. The much-heralded recovery looks not just anaemic but also poised for a reversal.
If indeed the pace of negative economic data continues - and I have no reason to expect this not to happen - then the key question of whether 2008 is about to repeat itself must be answered thus: no, 2011 is not 2008 but rather its much worse. The reason is the same that a doctor would give if a patient lapses back into symptoms of a disease after receiving treatment for a period of time: not only does he know that the patient has a particularly virulent form of the disease, he also understands that the disease is able to resist the treatments he knows.
In much the same way, a downturn in economic data in 20111 comes after three years of pump-priming by the Fed and ECB, among others. If there is no recovery - and I have argued that for a while - then market reaction has to be concomitantly worse than it was in 2008.
The first clue of the market's glass jaw came when Ben Bernanke refused to give in to market hopes for another round of quantitative easing (or QE3 as it is dubbed). After the initial market disappointment that pushed stock markets lower, the recovery in the form of corporate earnings expectations helped to create ideal conditions for a sell-off in gold, which tumbled over 7% over just two days.
However, it is my view after reviewing the speeches at the hole that QE3 will be announced by the end of September, particularly if markets continued to drift downwards in the interim. In that event, the safest asset for investors to hold is gold.
Poor economic data aside, the other key concern for the markets is a recurrence of a crisis in financial companies just as in 2008. By the summer, various companies including big investment banks (Lehman Brothers, Morgan Stanley, Merrill Lynch), financial institutions (AIG, Fannie Mae, Freddie Mac) were rumored to be in all sorts of trouble.
This time around, the dubious distinction has fallen at the feet of the giant Bank of America, which saw its equity trading to around 40% of book value (a sign of poor investor confidence in the stated figures). It did not help matters that various folks on the Internet - who may or may not have known what they were on about - started publishing estimates of new capital required by the bank exceeding $100 billion. For context, the bank's stock price implied a capitalization of $65 billion at its lowest point last week.
The famous investor Warren Buffett, aka the Sage of Omaha, after failing to rescue Lehman Brothers in 2008 (he instead invested $5 billion each in GE and Goldman Sachs), jumped to the rescue of Bank of America by plonking in $5 billion on preferred stock carrying a 6% coupon (against 10% in 2008 that he charged Goldman Sachs and GE), leading to a smart recovery in the company's share price.
On paper, the fact that Mr Buffet's $5 billion was made available for less coupon than in 2008 is good news. However, the move itself does beg a bunch of questions:
a. Berkshire Hathaway owns 6.67% of Wells Fargo, valued at $8.6 billion, and has $5 billion each invested in Goldman Sachs and GE Capital. All three firms will see their stock prices blown to bits if something happened to Bank of America. In that context, the money may be considered more of a safeguard of existing investments than "risky" money. In any event, with over 10% of American deposits in its coffers, it is extremely unlikely that any government will allow Bank of America to go bust: Mr Buffett is a preferred shareholder rather than a common stock shareholder, therefore he will (or at least most likely) not be wiped out by a government takeover. b. The timing of the investment, a day after Bank of America publicly rebuked Internet rumors and reiterated that it had no need for capital, left much to be desired; suggesting as it did that not only was the bank in need of capital, it also could raise rather expensive capital. c. Then came reports of the bank wanting to sell down at least half of its 10% stake in China Construction Bank: another sign of weakness.
All that said, it is not as if Bank of America is the only problem in global banking today. A casual look at the LIBOR - OIS spreads for the euro on Bloomberg shows a recurrence of the "credit / counterparty" worries that rollicked the markets sharply over the course of 2008. (The spread between the London Interbank Offered Rate or LIBOR and the Overnight Indexed Swap or OIS shows the relative risk for banks to lend to each other rather than merely exchange floating rate versus fixed rate payments. This spread, which no one in the financial markets paid attention to before 2007, has since then assumed great importance.)
In contrast to the widening spread in the euro, the picture for the US dollar is relatively stable. This would suggest (all other things being equal including the "natural" demand for a currency) that euro-domiciled banks are poorer credit risks than US-domiciled banks.
The primary area of market concern for markets with respect to European banks is their exposure to highly indebted European sovereigns. Weeks after a much-heralded 135 billion euro (US$196 billion) rescue of Greece, the dust hasn't yet settled, with a number of questions that I raised at the time still being unaddressed.
Worse (if that is indeed possible), Greece on Friday warned it may scrap the 135 billion euro swap if less than 90% of private investors voted in favor of the deal. Here is a borrower playing tough with its lenders who are going quite literally out of their way to accommodate its various requests and conditions ... gee, thanks Keynes.
No wonder Christine Lagarde of the IMF at the hole over the weekend, called for a "mandatory" capitalization of European banks, which would suggest a number of equity shareholders are in for a bit of shock when they return from their long European summer holidays.
As an expert on the Great Depression of the 1930s, Bernanke knows that a further round of quantitative easing (QE3) will lead to negative interest rates in the US, and the danger of debt deflation. He also implied, in his oracular way, that the only solution to current problems lies in fiscal action through taxation or spending, which is not within his power.
In other words, the Fed steering wheel has come off in his hands, so forward progress will be difficult. But if he were to look in the rear view mirror, he would see that the recent completion of the
QE2 round of US$1.6 trillion of Fed purchases of US Treasuries might now be having unforeseen consequences.
The concept of "hedging inflation" was originated in the mid-1990s by the "smartest kids on the block", Goldman Sachs, as a marketing narrative for their Goldman Sachs Commodity Index (GSCI) fund. This innovative fund was invested in a portfolio of commodities - of which oil had the greatest share - through buying and "rolling over" futures contracts from month to month.
This concept gradually gained traction among investors over the years, and by 2005 other market participants were cottoning on to the potential. Oil producers wishing to lay off or hedge the risk that oil would lose value relative to the dollar found that these risk averse 'inflation hedgers' aimed to do precisely the opposite by hedging the risk that the dollar would lose value relative to oil.
Investment banks and traders, for their part, found that there are huge advantages in bringing these two opposing but complementary constituencies together. Based upon their superior market knowledge, massive profits may be made, at little risk and use of capital, by providing financial services to these funds, such as brokerage and liquidity provision/market -making.
These financial investments in the oil market were accommodated by oil producers such as BP - which has had a long association with Goldman Sachs, for 12 years of which they had the same chairman - and from 2005 by Shell's transparent relationship with a provider of Exchange Traded Funds, ETF Securities.
Through opaque sale and repurchase transactions in off-exchange Brent/BFOE (Brent, Forties, Oseberg, Ekofisk) crude oil contracts, oil producers were essentially able to lend oil to the funds and in return to borrow dollars interest-free from the funds.
Accompanied by a drumbeat of hype in respect of oil market supply and demand, the price was inexorably ramped up, until in early 2008 there was a "spike" in price to $147/barrel; US gasoline prices reached painful levels, and demand reduced.
At this point, not only did speculators/manipulators (according to who you believe) liquidate their positions, but speculators actually reversed their position to go "short" of oil. The oil price fell rapidly, and in late 2008 many of the "inflation hedgers" - who are the complete opposite of speculators and had by now taken a beating - also pulled out, and the oil price fell as low as $30/barrel, which was an extremely painful level for oil producers that had so recently been laughing all the way to the bank.
In October 2008, the collapse of Lehman Brothers led to extraordinary measures by the Fed to keep the sinking dollar-based global financial system afloat. Firstly, the zero interest rate policy (ZIRP), and secondly, QE1 - massive injections of freshly manufactured dollars by the Fed as emergency liquidity - which was analogous to a massive transfusion into an accident victim.
But while this patient's visible wounds were stitched up by capital injections to banks, internal bleeding from the colossal overhang of unsustainable property loans has continued, and this led to the need for $1.6 trillion of what became known as QE2.
Now, these new Fed dollars had to go somewhere, and with dollar interest rates at zero, investors wanted anything but dollars, whether potentially income-bearing (equity), or not (commodities); and whether useful (oil; base metals; agricultural commodities) or not (gold). A tidal wave of dollars flowed into the markets, and in the oil market the sheer scale of these financial purchases could be accommodated only by two producers: either Saudi Arabia - a long-standing US partner - or Russia, a long standing rival.
From early 2009, for well over a year, there was clearly an accommodation between the Saudis and the United States whereby the Saudis leased oil - through sale and repurchase agreements - to financial intermediaries, who in turn either leased it to the flood of new inflation hedging funds, or sold complex - and remunerative - structured products instead.
Through this market manipulation on a cosmic scale, the global oil price was kept pegged between an upper level, which would not endanger US presidential prospects of re-election, and a lower level, which would provide sufficient funding to meet the needs of an increasingly restless young Saudi population.
To all intents and purposes the Saudis have - through the good offices of the best financial brains money can rent - been printing oil, which as Bernanke has jokingly said, even the biggest central bank in the world cannot do.
For over a year, this strategy went swimmingly and the secretary-general of the Organization of the Petroleum Exporting Countries routinely said at completely boring OPEC meetings how comfortable his membership was with the oil price, albeit ignoring half-hearted complaints by price hawks like Iran.
Unfortunately, this strategy was fundamentally unstable, like a car ferry with its bow doors open and with water swilling around on the car deck.
Water on the car deck
In March 2011 the oil market vessel was hit almost simultaneously by two waves. Firstly, and literally a wave, the Fukushima tsunami shut down a large part of Japan's energy supply and created an energy demand shock; while in Libya a supply shock took over a million barrels of high quality oil out of the market.
Genuinely speculative investors poured in, and the oil price spiked to over $120/barrel - a distinctly "uncomfortable" level for the Saudis, since it led to US gasoline prices rising to politically dangerous levels. The US and Saudis discussed an oil swap of US reserves against Saudi production, but apparently could not agree on price, and in the end the International Energy Agency (IEA), led by the US, released strategic reserves on the oil market, to little apparent effect.
But all is not as it seems. The US and their financial agents must keep up their side of the grand Saudi bargain by putting a financial floor under the oil price at just the point that the QE2 tap has been turned off. So fresh "inflation hedging" investment is now desperately sought, enticed by forecasts of increasing energy demand in countries which themselves rely as a market for their production on Western economies that are increasingly illiquid, insolvent, or both.
In the opinion of this observer, peddlers of inflation hedging are both wasting their time and opening themselves up to regulatory retribution for mis-selling, since investors will have little idea of the true risks to which their investment has been exposed.
The writing on the wall
The future market price of commodities may have one of two states: it is either in contango, when future prices are higher than today's price, or in backwardation, when the future price is below today's price.
Typically, markets are only ever in backwardation when current demand is high. But at the moment. market commentators are at a loss as to why it is that an over-supplied market can be in such a massive backwardation. There is in fact so much oil available that the Saudis - no doubt cheered on by the US - are making predatory offers to buyers of Iranian crude oil aimed specifically at undercutting Iran and thereby applying further financial pressure.
In my analysis, what we are seeing is what happens when the virtual oil claims printed by the Saudis and their collaborators are being liquidated. The resulting financial sales of oil depress the forward market price in a mirror image of the way that financial purchases inflated the forward price when funds were flowing into the oil market.
In other words, I suspect that the switching off of the QE2 dollar pump might be leading to the deflation of an oil market bubble. I hope I'm wrong, because while high oil prices may be bad for economic growth, they are good for the planet ... a statement which itself speaks volumes about the dysfunctional nature of a global financial system now once again at crisis point....
By Peter Morici
Forecasters expect the US Labor Department on Friday to report the economy added only 67,000 jobs in August - my estimate is 63,000. Either would be much less than the 130,000 the economy must create each month to stay even with adult population growth.
Overall, gross domestic product (GDP) and employment are growing more slowly than the population, and the private sector is much smaller than before the recent Great Recession, even with big boosts in federal spending on private health-care services and federal mandates for similar outlays by the states.
Employment grew in the second and third quarters despite very slow GDP growth, because labor productivity fell the first half of 2011. Consequently, real wages, per capita income and living
standards are dropping - all exacerbated by hungry state and local tax collectors who refuse to tighten belts as quickly as households and businesses.
A downsizing private sector, falling productivity per capita GDP, and a shrinking share of the adult population employed or even seeking employment are ominous signs of economic decline.
Recent economic data - retail sales, consumer spending, surveys of business sentiment, and housing/auto market activity - indicate an economy in neutral, and one that could slip into permanent stagnation or recession.
Near term, employment in healthcare, retail, and manufacturing should post modest gains, and construction may exhibit some bounce, because it fell to such low levels during the recent recession.
State and local governments will continue to shed jobs because state payments for Medicaid services are rising too rapidly and a downsized private sector generates too few tax receipts - together those shrink resources available for other public services.
The economy must add 13.9 million jobs over the next three years - 386,000 each month - to bring unemployment down to 6%. Considering layoffs at state and local governments and likely federal spending cuts, private sector jobs must increase at least 400,000 a month to accomplish that goal.
Growth in the range of 4 to 5% is needed to get unemployment down to 6% over the next several years. Recent GDP data put first-half growth at less than 1% .
Jobs creation remains weak, because temporary tax cuts, stimulus spending, large federal deficits, price raising health care mandates, and tighter but ineffective business regulations do not address, and indeed exacerbate, the permanent structural problems holding back dynamic growth and jobs creation - dysfunction energy and trade policies that cause a huge trade deficit.
Oil and trade with China account for nearly the entire $600 billion trade deficit. This deficit is a tax on domestic demand that erases the benefits of tax cuts and stimulus spending.
Simply, dollars sent abroad to purchase oil and consumer goods from China, that do not return to purchase US exports, are lost purchasing power and cannot be spent on US made goods and services. Consequently, the US economy is expanding at less than 1% a year instead of the 5% pace that is possible after emerging from a deep recession and with such high unemployment.
Also, America is not playing its advantages well. Strengths in finance, telecom and backbone technologies, pharmaceuticals, aerospace and autos, and other industries are not generating exports as much as those are creating offshore jobs. Mass layoffs recently announced in these sectors bode poorly.
Without prompt efforts to produce more domestic oil, redress trade imbalance and better regulatory and industrial policies, the US economy cannot grow and create enough jobs.
Weak demand, excessive and ineffective regulation, and the generally pessimistic outlook offered by Treasury Secretary Geithner and White House advisers depress consumer and business confidence.
The appointment of Alan Krueger to head the Council of Economic Advisors indicates business can expect continued emphasis on new spending, taxes, cumbersome regulation, and limits on domestic energy production, and few effective efforts to confront Chinese mercantilism or generally improve US trade competitiveness.
Until this policy direction is altered, the economy will continue to grow slowly or slip into recession, unemployment will rise, living standards will fall, and American standing in the global economy will decline.
An American policy of decline by design....! LOL, LOL, LOL....
Bill Gross is one of this generation’s great investors. On several occasions, as the head of research groups at Credit Suisse and Bank of America, I called on him and his team, and no shower is so cold as an interrogation by the Nabob of Newport Beach. One disagrees with him only with trepidation; nonetheless, I felt constrained to do so this evening, responding to his comments on Larry Kudlow’s CNBC show.
First, he’s too pessimistic about the US economy. The aggregates stink — and I’ve argued for two years that they would — but the enduring desolation of the post-bubble part of the economy (and the bubble burst on Main Street) is outweighed by a stealth boom among large corporations, as I’ve argued before. If big corporations can engage the globalized economy, so can others, once the leaden lid of regulation and taxes is lifted off the startup sector.
Secondly, he does not appreciate how drastically the world has changed. Treasury bonds are no longer income instruments but rather put options on the price level (just as gold is a call option on the price level). That’s why gold and bonds have traded in lockstep: they’re both priced by volatility.
Bill was right the first time: stocks rather than bonds are the right thing to own. He was too early in the trade, and seems to have exited too early as well....lol lol lol ....
Chris Cook is a former director of the International Petroleum Exchange.