The story below is referenced whenever the phrase "Peso Problem" pops up. I have to admit that I was unware of it, or rather, I was unware of that particular phrase. I soon realized that Peso Problem is just a cute phrase for what statisticians call a "tail risk". If you google Peso Problem you get all kinds of financial variables from interest rate curves to equity risk premium linked to Peso Problem.
Krugman aruges on his blogthat Friedman should not be credited for coining the phrase "Peso Problem" but rather him or his MIT classmate Bill Krasker. Go figure.
Equity prices and the ``peso problem''
The Hindu, 1-Oct-2000
B. Venkatesh
INFOSYS Technologies currently trades at a price-earnings multiple of over 100 whereas BHEL trades at just five times its earnings.
What drives investors to pay over 100 times the current earnings to buy one share of Infosys? Or, why are they reluctant to pay more than five times the earnings to buy one share of BHEL?
Research papers on asset values contain answers to this question. One such research paper by Mr Keith Sill, an economist at the Federal Reserve Bank of Philadelphia, states that a financial asset is valued after factoring the possibility of some unprecedented event in the future.
For argument's sake, BHEL may be trading at only five times its earnings because the market fears the company will be eventually forced out of business by ABB.
Such an event may or may not occur. But at this point in time, it may be just that the market is factoring the improbable event into the stock price.
Economists call such a condition the ``peso problem''; for, such a condition was observed by the Nobel laureate, Milton Friedman, in the Mexican peso market in the early 1970s.
At that time, the exchange rate between the Mexican peso and the US dollar was fixed. The interest rate in Mexico was, however, far higher in the US.
Such a situation presented investors opportunity for easy profits. How? An investor could borrow at a lower rate in the US, convert the money into peso and invest in Mexican bonds. On redemption of the bond, the investor could reconvert the peso at the same exchange rate, pay the loan and pocket the gains.
Milton Friedman stated that the interest differential between the two countries may have been due to the market expecting the peso to be devalued against the US dollar. And sure enough, in 1976, the market expectation actually came true as the peso was allowed to ``float'' against the dollar.
Hence, the next time you find an otherwise good stock trading at low levels, think for a moment whether it is because of some ``peso problem''!
Wednesday, July 16, 2008
Saturday, July 12, 2008
Gas Prices versus Income
One of the interesting debates in the macro-land is how rising gas prices in the US is going to affect employment growth. Given increasingly difficult job market, a potential employee might have to take a job that requires long commute, but the question then becomes, will he or she take it if she spends disproportionate amount of income on gasoline. Well, that depends on how much of income is spent on gasoline. According to the New York Times cartographers, it depends on where one is based. In the densely populated east and west coasts, spending on gas, even at the current high prices is minimal - less than 5%. So it is unlikely that gas prices will affect people's willingness to take jobs or in econo-speak, the labor force participation rate should not affected by high gas prices.
The Varying Impact of Gas Prices
New York Times
Gas prices are high throughout the country, but how hard they hit individual families depends on income levels, which vary widely.
The Varying Impact of Gas Prices
New York Times
Gas prices are high throughout the country, but how hard they hit individual families depends on income levels, which vary widely.
Tuesday, July 01, 2008
Bear (Stearns) Story
The collapse of Bears Sterns on the weekend of March 14th 2008 was unprecedented in the history of Wall Street. As an observer myself, the zig-zagging of BSC's stock price around that time was quite unnerving. I have always wondered about the details of the collapse. The Wall Street Journal had a 3-piece report on it couple of weeks ago but I don't think it did a good job at identifying the critical events. The Vanity Fair article does that, and it boils down to 2 words "novation" and "repos".
Bringing Down Bear Stearns
Vanity Fair, August 2008
Bryan Burrough
On Monday, March 10, the rumor started: Bear Stearns was having liquidity problems. In fact, the maverick investment bank had around $18 billion in cash reserves. But soon the speculation created its own reality, and the race was on to keep Bear’s crisis from ravaging Wall Street. With the blow-by-blow from insiders, Bryan Burrough follows the players—Bear’s stunned executives, trigger-happy reporters at CNBC, a nervous Fed, a shadowy group of short-sellers—in what some believe was the greatest financial scandal in history.(>>>...)
Bringing Down Bear Stearns
Vanity Fair, August 2008
Bryan Burrough
On Monday, March 10, the rumor started: Bear Stearns was having liquidity problems. In fact, the maverick investment bank had around $18 billion in cash reserves. But soon the speculation created its own reality, and the race was on to keep Bear’s crisis from ravaging Wall Street. With the blow-by-blow from insiders, Bryan Burrough follows the players—Bear’s stunned executives, trigger-happy reporters at CNBC, a nervous Fed, a shadowy group of short-sellers—in what some believe was the greatest financial scandal in history.(>>>...)
Sunday, June 29, 2008
Backwardation without Speculation
The unprecedented rise in oil price has given birth to many theories about the cause. Everything from the imbalance of demand & supply to the weakness dollar to the onset of credit crisis and the collar-strategy implemented by oil producers is blamed on the rapidity of the rise in oil price. Another is of course the speculation in the oil market given that there is no "contango" in the oil future market. Mr. Krugman points why there may not be "contango" without speculation on the oil market.
Speculation and Signatures
Paul Krugman
June 24, 2008
One of the problems in the debate over the role of speculation in oil prices is that hardly anyone, even among the economists, is writing down models. As a result, it’s not always clear what people are saying; and I’d argue that some of my colleagues aren’t clear on the implications of their own analysis.
So here’s some quick and dirty modeling that I think captures the essence of the debate.
A point of agreement between Guillermo Calvo and myself is that there’s a downward-sloping relationship between the current price of oil and the expected change in prices. Suppose, for example, that investors believe that the price one year from now will be PF, and they cling to that belief whatever the spot price P is. Then the expected rate of change of the oil price is (PF – P)/P. You don’t have to believe in this specific relationship; all I need is that there is a downward-sloping relationship between the spot price and the expected rate of change in the spot price.
Figure 1 shows that relationship. It also shows the cost of holding oil in storage, which consists both of the rent on the tank, or whatever, and the interest foregone by tying up wealth in physical commodities. (Yes, the independent variable is on the Y-axis. There’s a reason for that.)
Figure 1
Now, what Calvo and others suggest is that speculative expectations are currently determining the spot price – that the spot price is determined by the intersection of the two blue curves in Figure 1.
This certainly could happen – but only under certain circumstances. To see what those circumstances are, look at Figure 2, a back-to-back diagram that adds the flow supply and demand for oil – that is, the oil pumped by producers and burned by consumers.
In Figure 2, the horizontal dashed line indicates the spot price. We have a short-term equilibrium in which the quantity of oil produced exceeds the quantity consumed, but speculators are willing to buy up the excess supply and store it, believing that the spot price will rise enough to make that a good investment. In this case expected future prices – and, speaking loosely, the futures market – are determining the spot price.
This isn’t unheard of. In fact, the market for wholesale gasoline normally looks like this in the late fall, winter, and early spring, as refiners accumulate stocks for the summer driving season.
Figure 2
But notice that this kind of speculatively driven spot price has two “signatures” – things one should see in the markets that go along with that kind of equilibrium. First, the point I’ve emphasized a lot: because of the excess flow supply, somebody must be accumulating inventory.
But the second signature is probably just as important: for this kind of situation to occur, the future and spot markets have to be in “contango”: futures price above spot, sufficiently so to make storage worthwhile.
What if that’s not true? Then the market looks like Figure 3:
Figure 3
Here the spot price, again indicated by the dotted line, is determined by flow supply and demand. Inventories aren’t growing, and the futures market is characterized either by “backwardation” – futures price below spot – or by a contango too weak to make storage profitable.
And here’s the thing: the actual data we have on crude oil don’t show the signatures of a market driven by speculative demand. Inventory data don’t show a big accumulation; and the market has mostly been in backwardation, not contango. It made news when, late last month, a slight contango developed – because until then there had been backwardation.
Maybe I’m misinterpreting what the advocates of a speculative story are thinking. But in that case, what are they thinking? I’m curious.
Speculation and Signatures
Paul Krugman
June 24, 2008
One of the problems in the debate over the role of speculation in oil prices is that hardly anyone, even among the economists, is writing down models. As a result, it’s not always clear what people are saying; and I’d argue that some of my colleagues aren’t clear on the implications of their own analysis.
So here’s some quick and dirty modeling that I think captures the essence of the debate.
A point of agreement between Guillermo Calvo and myself is that there’s a downward-sloping relationship between the current price of oil and the expected change in prices. Suppose, for example, that investors believe that the price one year from now will be PF, and they cling to that belief whatever the spot price P is. Then the expected rate of change of the oil price is (PF – P)/P. You don’t have to believe in this specific relationship; all I need is that there is a downward-sloping relationship between the spot price and the expected rate of change in the spot price.
Figure 1 shows that relationship. It also shows the cost of holding oil in storage, which consists both of the rent on the tank, or whatever, and the interest foregone by tying up wealth in physical commodities. (Yes, the independent variable is on the Y-axis. There’s a reason for that.)
Figure 1
Now, what Calvo and others suggest is that speculative expectations are currently determining the spot price – that the spot price is determined by the intersection of the two blue curves in Figure 1.This certainly could happen – but only under certain circumstances. To see what those circumstances are, look at Figure 2, a back-to-back diagram that adds the flow supply and demand for oil – that is, the oil pumped by producers and burned by consumers.
In Figure 2, the horizontal dashed line indicates the spot price. We have a short-term equilibrium in which the quantity of oil produced exceeds the quantity consumed, but speculators are willing to buy up the excess supply and store it, believing that the spot price will rise enough to make that a good investment. In this case expected future prices – and, speaking loosely, the futures market – are determining the spot price.
This isn’t unheard of. In fact, the market for wholesale gasoline normally looks like this in the late fall, winter, and early spring, as refiners accumulate stocks for the summer driving season.
Figure 2
But notice that this kind of speculatively driven spot price has two “signatures” – things one should see in the markets that go along with that kind of equilibrium. First, the point I’ve emphasized a lot: because of the excess flow supply, somebody must be accumulating inventory.But the second signature is probably just as important: for this kind of situation to occur, the future and spot markets have to be in “contango”: futures price above spot, sufficiently so to make storage worthwhile.
What if that’s not true? Then the market looks like Figure 3:
Figure 3
Here the spot price, again indicated by the dotted line, is determined by flow supply and demand. Inventories aren’t growing, and the futures market is characterized either by “backwardation” – futures price below spot – or by a contango too weak to make storage profitable.And here’s the thing: the actual data we have on crude oil don’t show the signatures of a market driven by speculative demand. Inventory data don’t show a big accumulation; and the market has mostly been in backwardation, not contango. It made news when, late last month, a slight contango developed – because until then there had been backwardation.
Maybe I’m misinterpreting what the advocates of a speculative story are thinking. But in that case, what are they thinking? I’m curious.
David Einhorn - The Hedge Fund Man of the moment
Interesting article on the Hedge Man of the moment, David Einhorn. It is truly encouraging that he is willing to go public with his negative investment thesis on Lehman. As New Yorker magazine points out, he is truly "The Confident Man".
The Confidence Man
New York Magazine, Jun 15, 2008
By Hugo Lindgren
Hedge-fund manager David Einhorn believes his public attack on Lehman Brothers wasn’t just about making money. So what was it about?
Six years ago, hedge-fund manager David Einhorn made a speech at an annual investment conference about a stock he didn’t like—a mid-cap financial company called Allied Capital—and the world came crashing down on top of him. He was investigated by the Securities and Exchange Commission for conspiring with other investors to sink the stock. Allied stole his personal phone records in an attempt to prove the conspiracy. An article in The Wall Street Journal compared his treatment of Allied to “a mugging.” New York’s then–Attorney General, Eliot Spitzer, vowed to do his own investigation. And Einhorn’s wife, an editor at the financial weekly Barron’s, mysteriously lost her job. (...>>>)
The Confidence Man
New York Magazine, Jun 15, 2008
By Hugo Lindgren
Hedge-fund manager David Einhorn believes his public attack on Lehman Brothers wasn’t just about making money. So what was it about?
Six years ago, hedge-fund manager David Einhorn made a speech at an annual investment conference about a stock he didn’t like—a mid-cap financial company called Allied Capital—and the world came crashing down on top of him. He was investigated by the Securities and Exchange Commission for conspiring with other investors to sink the stock. Allied stole his personal phone records in an attempt to prove the conspiracy. An article in The Wall Street Journal compared his treatment of Allied to “a mugging.” New York’s then–Attorney General, Eliot Spitzer, vowed to do his own investigation. And Einhorn’s wife, an editor at the financial weekly Barron’s, mysteriously lost her job. (...>>>)
Friday, May 02, 2008
Tuesday, October 02, 2007
Buttonwood: Action replay
There current credit crisis has been compared to many things in the financial press - 1987 crisis, LTCM etc - and the Economist seems to think that it is a more protracted like 2001, where initial Fed was received with euphoria but the subsequent ones were taken with trepedition given their implications about the economic growth trends. The Economist think that the final shoe to fall will be the dollar.
Buttonwood: Action replay
The Economist
Sep 27th 2007
Was the script for the recent turmoil written in 1998, 1990, or is it new?
LIKE generals condemned to fight the last war, investors seem fated to hark back to the last financial crisis. When markets plunged on “Black Monday” in October 1987, people feared a repeat of the Wall Street crash of 1929. Central banks cut interest rates in part because they wanted to avoid a re-run of the 1930s' depression.
But the world has suffered a lot of financial crises and it is not always clear which one to use as a benchmark. Take the central banks' responses to the recent problems in the credit markets. Do they suggest that we are looking at a repeat of 1998, when Long-Term Capital Management, a hedge fund, wobbled, or at 1990, when there was a financial crisis at savings-and-loans banks, then the main providers of American mortgages?
As David Bowers of Absolute Strategy Research points out, it makes an enormous difference which crisis (if either) is being replayed. In 1998 rate cuts quickly restored the animal spirits of investors and the dotcom bubble followed. If that pattern is to be repeated, investors should be piling into growth-sensitive sectors like emerging markets and commodities.
But in 1990 several rate cuts failed to stop the American economy from sliding into recession. That may be what happens once again now, especially as most observers believe it takes 12-18 months for changes in interest rates to have much economic effect. Figures released on September 25th showed that the inventory of unsold American homes is at its highest level since 1989. If we are following the 1990 script, then investors should be opting for the safety of Treasury bonds.
The strength of the world's stockmarkets since the Federal Reserve cut rates on September 18th indicates that most investors are, to misquote Prince, “partying like it's 1998”. The MSCI emerging-markets index reached a record high on September 24th, and the best-performing industries in share-price terms over the past month have been economically sensitive ones, such as mining and chemicals.
Ajay Kapur of the hedge fund First Horse Capital says that America's stockmarket normally returns 7.2% over the six months after the first rate cut in the cycle, even in periods when the economy is slipping into recession. When a downturn is avoided, the average six-monthly gain is 20.1%. Mr Kapur says the world is dominated by “fiat currency democracies” in which governments and central banks tend to give in to popular pressure and “print money” to avoid hard times. He believes the recent actions of the Fed, the European Central Bank and the Bank of England endorse his view.
Those bears who believe the drama is more likely to resemble 1990 than 1998 base their case on what they think are excessive levels of consumer debt. Clearly, many of them were far too early in predicting a debt-driven crisis; Peter Warburton's jeremiad “Debt and Delusion”, for example, was published back in 1999.
But they have a point now. As economies become more sophisticated, it may make sense for consumers to take on more debt as a means of smoothing their consumption over their lifetimes. Indeed, this should add to economic stability. Ironically, however, greater stability only encourages consumers to take on more debt since they are less fearful of losing their jobs in recessions.
Consumer debt cannot keep growing faster than income forever. That evil day has been delayed, over the past 20 years, by the downward trend in interest rates. But the bears think the crunch has now arrived, as it did in Japan in the 1990s.
The world may not have to wait too long to see whether they are right. As David Rosenberg, an economist at Merrill Lynch, recalls, the stockmarket rallied in response to a half-percentage-point rate cut in early January 2001. But by the time the Fed lowered rates again at the end of that month, its move was seen by investors as a sign of desperation.
Three months ago Buttonwood pointed to three portents that would suggest investors should prepare for the worst. One of those, higher credit spreads, has indeed appeared. Another was a resurgence of inflation. Although that looks unlikely in the short term, especially if economies weaken, the long-term chances of higher inflation must surely have gone up. Gold is at its highest level since it last peaked in 1980.
The final sign was a burst of yen strength (which would indicate an unwinding of speculative bets). The yen has risen against the dollar since June but there has been no sharp lurch higher; perhaps because the Japanese economy is itself weak. But if the gloomsters are to be proven right, we must surely see some turmoil in the currency markets first.
Buttonwood: Action replay
The Economist
Sep 27th 2007
Was the script for the recent turmoil written in 1998, 1990, or is it new?
LIKE generals condemned to fight the last war, investors seem fated to hark back to the last financial crisis. When markets plunged on “Black Monday” in October 1987, people feared a repeat of the Wall Street crash of 1929. Central banks cut interest rates in part because they wanted to avoid a re-run of the 1930s' depression.
But the world has suffered a lot of financial crises and it is not always clear which one to use as a benchmark. Take the central banks' responses to the recent problems in the credit markets. Do they suggest that we are looking at a repeat of 1998, when Long-Term Capital Management, a hedge fund, wobbled, or at 1990, when there was a financial crisis at savings-and-loans banks, then the main providers of American mortgages?
As David Bowers of Absolute Strategy Research points out, it makes an enormous difference which crisis (if either) is being replayed. In 1998 rate cuts quickly restored the animal spirits of investors and the dotcom bubble followed. If that pattern is to be repeated, investors should be piling into growth-sensitive sectors like emerging markets and commodities.
But in 1990 several rate cuts failed to stop the American economy from sliding into recession. That may be what happens once again now, especially as most observers believe it takes 12-18 months for changes in interest rates to have much economic effect. Figures released on September 25th showed that the inventory of unsold American homes is at its highest level since 1989. If we are following the 1990 script, then investors should be opting for the safety of Treasury bonds.
The strength of the world's stockmarkets since the Federal Reserve cut rates on September 18th indicates that most investors are, to misquote Prince, “partying like it's 1998”. The MSCI emerging-markets index reached a record high on September 24th, and the best-performing industries in share-price terms over the past month have been economically sensitive ones, such as mining and chemicals.
Ajay Kapur of the hedge fund First Horse Capital says that America's stockmarket normally returns 7.2% over the six months after the first rate cut in the cycle, even in periods when the economy is slipping into recession. When a downturn is avoided, the average six-monthly gain is 20.1%. Mr Kapur says the world is dominated by “fiat currency democracies” in which governments and central banks tend to give in to popular pressure and “print money” to avoid hard times. He believes the recent actions of the Fed, the European Central Bank and the Bank of England endorse his view.
Those bears who believe the drama is more likely to resemble 1990 than 1998 base their case on what they think are excessive levels of consumer debt. Clearly, many of them were far too early in predicting a debt-driven crisis; Peter Warburton's jeremiad “Debt and Delusion”, for example, was published back in 1999.
But they have a point now. As economies become more sophisticated, it may make sense for consumers to take on more debt as a means of smoothing their consumption over their lifetimes. Indeed, this should add to economic stability. Ironically, however, greater stability only encourages consumers to take on more debt since they are less fearful of losing their jobs in recessions.
Consumer debt cannot keep growing faster than income forever. That evil day has been delayed, over the past 20 years, by the downward trend in interest rates. But the bears think the crunch has now arrived, as it did in Japan in the 1990s.
The world may not have to wait too long to see whether they are right. As David Rosenberg, an economist at Merrill Lynch, recalls, the stockmarket rallied in response to a half-percentage-point rate cut in early January 2001. But by the time the Fed lowered rates again at the end of that month, its move was seen by investors as a sign of desperation.
Three months ago Buttonwood pointed to three portents that would suggest investors should prepare for the worst. One of those, higher credit spreads, has indeed appeared. Another was a resurgence of inflation. Although that looks unlikely in the short term, especially if economies weaken, the long-term chances of higher inflation must surely have gone up. Gold is at its highest level since it last peaked in 1980.
The final sign was a burst of yen strength (which would indicate an unwinding of speculative bets). The yen has risen against the dollar since June but there has been no sharp lurch higher; perhaps because the Japanese economy is itself weak. But if the gloomsters are to be proven right, we must surely see some turmoil in the currency markets first.
Monday, October 01, 2007
Todays Reads
Bill Gross Still Mr. Bond Bull
Bill Gross is still bullish on bonds owing to the housing downturn that shows not end in sight and the potentially larger impact of housing than of stock prices. His firm (PIMCO) has rule out of thumb that says a "Fed easing cycle historically has required a destination of 1% real short rates or lower. Under a conservative assumption of 2.5% inflation, that implies Fed Funds at 3.75% or so over the next 6-12 months." And he suggest that such forecast is not totally out of the realm of possibility give than the Bernanke Fed might have asymmetric reaction to asset price movements al la Governor Kohn emulating an escalator on the way up (25bp increases) and an elevator on the way down (50bp reduction).
Investment Outlook - What Do They Know?
October 2007
Bill Gross
If you’re struggling to find something that symbolizes the transition from the old-fashioned markets of yesteryear to the seemingly inexplicable wildness of today’s derivative-driven, conduit-imploding financial complex, you need look no further than the contrast between old television’s Louis Rukeyser and thoroughly modern Jim Cramer. Calm, stately, with deep-throated baritone certainty, Rukeyser was the spokesman for aging boomers who wanted assurance that a nostril-snorting bull market would reign supreme. No less a cheerleader, but with soprano-inflected importuning decibels louder than any rival on the flat screen, Cramer, in recent weeks at least, has been willing to recognize that the momentum could turn in favor of the visiting bears. At a moment of courageous yet seemingly reckless abandon during a week when Treasury, Fed, and White House officials were trying to calm investors with an “all clear” story line, Cramer screamed at the CNBC camera, “They know nothing, they know nothing!” Just who “they” were was left to the imagination, but it was clear that in Cramer’s world Rukeyserian bullishness was not the order of the day. (more... )
Chinese Economy Will Continue to Roar Ahead
The Chinese economy continues to surprise the doubters. But given several macroeconomic headwinds - US economic slowdown, Chinese food price inflation, rising non-performing loans, stock market bubble - the article argues that they are actually a blessing in disguise. It looks like the Chinese economy is here to stay.
China's economy - How fit is the panda?
The Economist
Sep 27th 2007
NO COUNTRY in history has sustained such a blistering rate of growth over three decades as China. Its economy grew by a staggering 11.9% in the year to the second quarter. Since 1978 it has grown by an average of almost 10% a year—more than Japan or the Asian tigers achieved over similar periods when their economies took off. But eventually every sprinter trips. Japan's growth averaged 9.5% in the two decades to 1970, but slowed to 4.7% in the 1970s and to only 1% by the 1990s. (more...)
Bill Gross is still bullish on bonds owing to the housing downturn that shows not end in sight and the potentially larger impact of housing than of stock prices. His firm (PIMCO) has rule out of thumb that says a "Fed easing cycle historically has required a destination of 1% real short rates or lower. Under a conservative assumption of 2.5% inflation, that implies Fed Funds at 3.75% or so over the next 6-12 months." And he suggest that such forecast is not totally out of the realm of possibility give than the Bernanke Fed might have asymmetric reaction to asset price movements al la Governor Kohn emulating an escalator on the way up (25bp increases) and an elevator on the way down (50bp reduction).
Investment Outlook - What Do They Know?
October 2007
Bill Gross
If you’re struggling to find something that symbolizes the transition from the old-fashioned markets of yesteryear to the seemingly inexplicable wildness of today’s derivative-driven, conduit-imploding financial complex, you need look no further than the contrast between old television’s Louis Rukeyser and thoroughly modern Jim Cramer. Calm, stately, with deep-throated baritone certainty, Rukeyser was the spokesman for aging boomers who wanted assurance that a nostril-snorting bull market would reign supreme. No less a cheerleader, but with soprano-inflected importuning decibels louder than any rival on the flat screen, Cramer, in recent weeks at least, has been willing to recognize that the momentum could turn in favor of the visiting bears. At a moment of courageous yet seemingly reckless abandon during a week when Treasury, Fed, and White House officials were trying to calm investors with an “all clear” story line, Cramer screamed at the CNBC camera, “They know nothing, they know nothing!” Just who “they” were was left to the imagination, but it was clear that in Cramer’s world Rukeyserian bullishness was not the order of the day. (more... )
Chinese Economy Will Continue to Roar Ahead
The Chinese economy continues to surprise the doubters. But given several macroeconomic headwinds - US economic slowdown, Chinese food price inflation, rising non-performing loans, stock market bubble - the article argues that they are actually a blessing in disguise. It looks like the Chinese economy is here to stay.
China's economy - How fit is the panda?
The Economist
Sep 27th 2007
NO COUNTRY in history has sustained such a blistering rate of growth over three decades as China. Its economy grew by a staggering 11.9% in the year to the second quarter. Since 1978 it has grown by an average of almost 10% a year—more than Japan or the Asian tigers achieved over similar periods when their economies took off. But eventually every sprinter trips. Japan's growth averaged 9.5% in the two decades to 1970, but slowed to 4.7% in the 1970s and to only 1% by the 1990s. (more...)
Thursday, April 26, 2007
Of Markets & the Economy
The US market has roared mightily since the dip in mid-summer last year but the GDP growth profile has only become less optimistic during the same period (see chart). This divergence is very puzzling. Is the market move driven by fundamental factors (i.e. expecting growth to rebound in H2 07) or is it more a technical phenomenon - AMZN jumped 25% yesterday because of short covering post good earnings numbers (15% of the stock outstanding has short position)? It is hard to know for sure but Wall Street Journal tries to address the debate over the fundamental underpinning of the stock movements.
The stock market has been a lousy barometer of the economy.
From the beginning of 2004 through the first quarter of 2006, economic growth averaged an impressive 3.4%. The Dow Jones Industrial Average rose just 6%. Since then, economic growth has slowed to a little more than 2%, yet the blue-chip index has leapt 18%, ending yesterday's session at a record 13089.89, the first time it has closed above 13000.
So, is the stock market providing reassurance? Or is it out of touch? (more >>>)
The stock market has been a lousy barometer of the economy.
From the beginning of 2004 through the first quarter of 2006, economic growth averaged an impressive 3.4%. The Dow Jones Industrial Average rose just 6%. Since then, economic growth has slowed to a little more than 2%, yet the blue-chip index has leapt 18%, ending yesterday's session at a record 13089.89, the first time it has closed above 13000.
So, is the stock market providing reassurance? Or is it out of touch? (more >>>)
Friday, April 20, 2007
Bernanke Music Video - "Every Breath You Take" -
Every Breath You Take
Columbia Business School Follies
Spring 2006
Lyrics
[George W. Bush:] "Ben Bernanke is the right man to build on the record that Alan Greenspan has established. I will urge the Senate the act promptly to confirm Ben Bernanke as the fourteenth Chairman of the Federal Reserve."
Every breath you take
Every change of rate
Jobs you don't create
While we still stagflate
I'll be watching you
Every single day
Bernanke takes my pay
When growth goes away
Inflation will stay
I'll be watching you
Oh can't you see?
The Fed's where I should be
How my poor heart aches
With each of your mistakes
First you move your lips
Hike a few more BPS
When demand then dips
And the yield curve flips
I'll be watching you
Since you came supply's lost without a trace
I dream at night that I punch you in the face
Your interest policies I cannot embrace
I feel so wronged and I long for Greenspan's place
I keep cryin': Benny! Benny! Please...
Oh can't you see?
The Fed Chair should be me
How my poor heart aches
When prices escalate
Every move you make
Every oath you take
Hope your models break
Bet that beard is fake
I'll be watching you
CBS is great
Wouldn't change my fate
But we'll be watching you
We'll be watching you
Columbia Business School Follies
Spring 2006
Lyrics
[George W. Bush:] "Ben Bernanke is the right man to build on the record that Alan Greenspan has established. I will urge the Senate the act promptly to confirm Ben Bernanke as the fourteenth Chairman of the Federal Reserve."
Every breath you take
Every change of rate
Jobs you don't create
While we still stagflate
I'll be watching you
Every single day
Bernanke takes my pay
When growth goes away
Inflation will stay
I'll be watching you
Oh can't you see?
The Fed's where I should be
How my poor heart aches
With each of your mistakes
First you move your lips
Hike a few more BPS
When demand then dips
And the yield curve flips
I'll be watching you
Since you came supply's lost without a trace
I dream at night that I punch you in the face
Your interest policies I cannot embrace
I feel so wronged and I long for Greenspan's place
I keep cryin': Benny! Benny! Please...
Oh can't you see?
The Fed Chair should be me
How my poor heart aches
When prices escalate
Every move you make
Every oath you take
Hope your models break
Bet that beard is fake
I'll be watching you
CBS is great
Wouldn't change my fate
But we'll be watching you
We'll be watching you
Thursday, April 19, 2007
Daily Musing: Sino-Phobia
One of today's business headlines was a surprisingly strong Chinese GDP growth for Q1 2007 (11.1% vs 10.4% expected). The Bloomberg story, Asian Stocks Post Biggest Drop in a Month on China Rate Concern promptly declared that unexpectedly strong growth will prompt Chinese authorities to hike rates - which will slow Chinese growth and also weaken the US$. That could impact the rest of Asia, thus the fallout on Asia equities today.
Let's analyze the facts. Chinese interest rates matter to the world only to the extent that they impact Chinese growth. Chinese growth is very important for global growth and inflation. But a worry about China's growth at this time is unwarranted. China needs to grow, and grow at a high single-digit rate to absorb the vast number of rural migrants pouring into the cities everyday. It is the key to the legitimacy of the Communist Party. Other issues like huge foreign reserve, current account surplus, pollution, human rights et. al. are secondary. So I won't lose my sleep over the China's economy.
Interest rates in China are very low. The benchmark rate, the so-called 12-month lending rate is at only 6.39% compared to 10%+ growth in real GDP (see Figure). A rule of thumb says that equilibrium real rate should be equal to real GDP growth. So if anything, China's rate should be higher (in fact at least double the current rate if we take into account 3.3% CPI) notwithstanding today's strong GDP number. Btw, the Economist magazine argued for higher rate in its Mar 22 issue. The article also discussed why Chinese monetary policymarkers have penchant to change rates in 27bp increments versus 25bp increments by their western counterparts (read the article).
Let's analyze the facts. Chinese interest rates matter to the world only to the extent that they impact Chinese growth. Chinese growth is very important for global growth and inflation. But a worry about China's growth at this time is unwarranted. China needs to grow, and grow at a high single-digit rate to absorb the vast number of rural migrants pouring into the cities everyday. It is the key to the legitimacy of the Communist Party. Other issues like huge foreign reserve, current account surplus, pollution, human rights et. al. are secondary. So I won't lose my sleep over the China's economy.
Interest rates in China are very low. The benchmark rate, the so-called 12-month lending rate is at only 6.39% compared to 10%+ growth in real GDP (see Figure). A rule of thumb says that equilibrium real rate should be equal to real GDP growth. So if anything, China's rate should be higher (in fact at least double the current rate if we take into account 3.3% CPI) notwithstanding today's strong GDP number. Btw, the Economist magazine argued for higher rate in its Mar 22 issue. The article also discussed why Chinese monetary policymarkers have penchant to change rates in 27bp increments versus 25bp increments by their western counterparts (read the article).
NY Fed Conference on, "The euro and The dollar: Pillars in Global Finance"
"The euro and The dollar: Pillars in Global Finance"
Participants
H.E. Ambassador John Bruton, Delegation of the European Commission to the United States
Timothy F. Geithner, President and Chief Executive officer, Federal Reserve Bank of New York
JoaquÃn Almunia, Commissioner for Economic and monetary Affairs, European Commission
Richard Clarida, Professor of Economics and International Affairs, Columbia University
Mickey Levy, Chief Economist, Bank of America
Nouriel Roubini, Professor of Economics and International Business, New York University
Charles Wyplosz, Professor of Economics, Graduate Institute of International Studies, Geneva
Andrew Crockett, President, JPmorgan Chase International
William Dudley, Executive Vice President, Federal Reserve Bank of New York
Alberto Giovannini, Chief Executive Officer, Unifortune Asset management SGR
Jacques de Larosière, BNP Paribas
Paul Volcker, Chairman of the Board of Trustees, International Accounting Standards Committee
Pervenche Berès, Chair, Committee on Economic and monetary Affairs, European parliament
Kathleen l. Casey, Commissioner, US Securities and Exchange Commission
William Rutledge, Executive Vice President, Federal Reserve Bank of New York
David Wright, Director, DG Internal Market and Services, European Commission
Jan Hatzius, Chief US Economist, Goldman Sachs
Caio Koch-Weser, Vice Chairman, Deutsche Bank Group
Edwin M. Truman, Senior Fellow, Peterson Institute
Sir Nigel Wicks, Chairman, Euroclear
Jean-claude Trichet, President, European Central Bank
Participants
H.E. Ambassador John Bruton, Delegation of the European Commission to the United States
Timothy F. Geithner, President and Chief Executive officer, Federal Reserve Bank of New York
JoaquÃn Almunia, Commissioner for Economic and monetary Affairs, European Commission
Richard Clarida, Professor of Economics and International Affairs, Columbia University
Mickey Levy, Chief Economist, Bank of America
Nouriel Roubini, Professor of Economics and International Business, New York University
Charles Wyplosz, Professor of Economics, Graduate Institute of International Studies, Geneva
Andrew Crockett, President, JPmorgan Chase International
William Dudley, Executive Vice President, Federal Reserve Bank of New York
Alberto Giovannini, Chief Executive Officer, Unifortune Asset management SGR
Jacques de Larosière, BNP Paribas
Paul Volcker, Chairman of the Board of Trustees, International Accounting Standards Committee
Pervenche Berès, Chair, Committee on Economic and monetary Affairs, European parliament
Kathleen l. Casey, Commissioner, US Securities and Exchange Commission
William Rutledge, Executive Vice President, Federal Reserve Bank of New York
David Wright, Director, DG Internal Market and Services, European Commission
Jan Hatzius, Chief US Economist, Goldman Sachs
Caio Koch-Weser, Vice Chairman, Deutsche Bank Group
Edwin M. Truman, Senior Fellow, Peterson Institute
Sir Nigel Wicks, Chairman, Euroclear
Jean-claude Trichet, President, European Central Bank
Wednesday, April 18, 2007
What Spending Slowdown?
The BusinessWeek article adds to the current debate on capex. The debate centers around government data (non-defense capital goods ex-air in M3 release) showing slowdown in corporate capex and the impact it could have on future economic growth and productivity trends. Basically the article argues that one can't take the government's data on face value because the issue has become complex owing to globalization. There is a huge discrepancy between what the government is saying about capex and what the businesses are saying and that ought to give pause to anyone who is worried about the state of capex.
When is a slowdown not a slowdown? On the face of it, the government's statistics tell a very convincing story about cautious companies and weak business investment. For example, so far in 2007 new orders for nondefense capital goods, such as computers, trucks, and machinery, are barely higher than they were a year ago, an omen, perhaps, of tough times ahead for corporate profits.
There's only one problem. Corporate America is still spending big time, just increasingly outside the U.S. A BusinessWeek analysis of financial reports from more than 1,000 large and midsize U.S.-based companies shows that global capital expenditures in the fourth quarter of 2006 were actually up 18.1% over the previous year, a number that includes nonresidential construction as well as info-tech equipment and machinery. The comparable growth for domestic business investment, which is all the government reports each quarter: only 8.9%, without adjusting for inflation. (more >>>)
Debunking Messrs Roubini & Hatzius
Read a blog, "Explaining the Mystery of Why Housing Jobs Have Not Fallen Much...and the Worsening Housing Recession... " by Prof Roubini where he discusses the apparent discrepancy between "dismal" housing sector and "apparently" strong construction employment numbers. He cites two possible reasons (1) according to Goldman Sach economist, Jan Hatzius, homebuilders have not started laying off workers (2) undocumented workers hide the actual job losses in the construction industry. May be I am not looking at the same (correct?) data as Mr. Hatzius and Prof Roubini but I come with different conclusions.
Data I look at do not support Mr. Hatzius' argument. Homebuilders have been laying off workers. If you look at employment in S&1500 Homebuilders (BZH, CHB, CTX, DHI, HOV, KBH, LEN, MDCj, MHO, MTH, NVR, PHM, RYL, SKY, SPF, TOL), they have declined in 2006, to 78,000 from 104,000, a whopping 25% decline (first chart). If you look at the data for the broad construction industry, all the available sources - BLS (second chart), Manpower Survey (third chart), Challenger Survey (fourth chart) - show dismal trends in construction employment. What is interesting however is that the woes in construction sector have not permeated into the broader economy. Private payroll growth in the non-construction sector is ok; hiring is fine; and layoffs are actually trending lower.
Prof Roubini's argument about undocumented workers can cut both ways, so net-net it should have no impact. If undocumented workers were not recorded in the current construction employment slowdown, I bet they were not recorded during the boom time either. The anecdotes from the New York Times article are just anecdotes.
So what's my point? My point is that unlike Messrs Roubini & Hatzius, I believe that the problems in the residential housing sector are well-established by the data. That should not be the debate. The debate should be whether that problem is going to spread to the rest of the economy and when. Of course there are people on both sides of the fence. Homebuilders' stock prices seem to suggest that the worst is over for housing but there are others who think that "we ain't seen nothing yet" by pointing out to the housing inventory data. My gut feeling based on variety of housing data is that housing has bottomed and will start to become less of an issue past the summer. Of course, I could be dead wrong. The current slump could persist for another 6-9 months prompting consumers to curtail their holiday spending, and that’ll be the end of the current cycle.
Data I look at do not support Mr. Hatzius' argument. Homebuilders have been laying off workers. If you look at employment in S&1500 Homebuilders (BZH, CHB, CTX, DHI, HOV, KBH, LEN, MDCj, MHO, MTH, NVR, PHM, RYL, SKY, SPF, TOL), they have declined in 2006, to 78,000 from 104,000, a whopping 25% decline (first chart). If you look at the data for the broad construction industry, all the available sources - BLS (second chart), Manpower Survey (third chart), Challenger Survey (fourth chart) - show dismal trends in construction employment. What is interesting however is that the woes in construction sector have not permeated into the broader economy. Private payroll growth in the non-construction sector is ok; hiring is fine; and layoffs are actually trending lower.
Prof Roubini's argument about undocumented workers can cut both ways, so net-net it should have no impact. If undocumented workers were not recorded in the current construction employment slowdown, I bet they were not recorded during the boom time either. The anecdotes from the New York Times article are just anecdotes.
So what's my point? My point is that unlike Messrs Roubini & Hatzius, I believe that the problems in the residential housing sector are well-established by the data. That should not be the debate. The debate should be whether that problem is going to spread to the rest of the economy and when. Of course there are people on both sides of the fence. Homebuilders' stock prices seem to suggest that the worst is over for housing but there are others who think that "we ain't seen nothing yet" by pointing out to the housing inventory data. My gut feeling based on variety of housing data is that housing has bottomed and will start to become less of an issue past the summer. Of course, I could be dead wrong. The current slump could persist for another 6-9 months prompting consumers to curtail their holiday spending, and that’ll be the end of the current cycle.
Saturday, March 31, 2007
The Economist - Browsing the bourses
Browsing the bourses
The Economist, 29-Mar-2007
Companies scour global exchanges to find a better price for their shares
BASED in Toronto, Golden China Resources is a mining company with the kind of scary but alluring profile you might expect for a firm that goes prospecting for gold. Established only three years ago, it is still losing money. But it boasts an intriguing technology using bacteria in the refining process, promising rights in China and what appears to be a growing inventory of established reserves.
With bullion prices rising and economic doubts gathering, times should be good for gold producers. But on the Toronto Stock Exchange, Golden China has lost its lustre. Its share price has fallen by half since early 2006. In response, the company has embarked on a different kind of prospecting. It is studying how different bourses around the world value companies like itself. Its findings are a challenge to anyone who believes financial markets are consistent or rational.
Take, for example, the market's view of “in situ” ounces, meaning gold that is in the ground. According to an outside analysis, Canadian exploration companies are valued at $75 an ounce on average. As refined gold now sells for more than $650 an ounce, this leaves some margin for processing and mining risk.
If the deposits controlled by these Canadian companies are in China, the valuation slips to $43 an ounce. This may reflect worries that China's methods of verifying potential assets are less stringent. It may also be a consequence of more general fears about property rights in China.
That would be the end of the story were it not for an odd detail. Golden China then went on to look at the valuation of gold producers listed in Hong Kong or on the Chinese mainland. The results were striking: they were valued at $180-240 an ounce. Sino Gold, an Australian company which on March 16th made a secondary listing on the Hong Kong exchange, is priced at about $190 an ounce.
There may be some simple explanations for these big disparities. For example, the Chinese companies in the study all turn a profit. But investors in gold exploration probably care more about the treasure to be unearthed than the trickle of income from ongoing sales.
In fact, Golden China has hit on a broader seam of market discrepancies: the value of a share often depends on where the stock is floated. The most glaring examples are provided by Hong Kong-listed firms that also list in Shanghai, where they almost always get a better price for their shares. No wonder Hong Kong feels threatened by the migration of listings to its mainland rival.
More subtly, global exchanges disagree about the value they put on everything from food companies to banks, even after taking account of differences in a firm's local prospects. Perhaps investors feel better protected and better informed by some bourses rather than others. Exchanges often claim that stiff auditing and disclosure standards add a premium to the shares listed on them. But strangely, valuations right now seem highest in murky stockmarkets like China's.
Bourses may also attract their own distinctive base of investors, interested in some sectors more than others. America's markets attract the technophiles, China's lure the gold bugs. Like retail arcades, exchanges each seem to draw their own tribe of customers who know what they want, pay a premium for it and ignore bargains that would fetch much higher prices elsewhere. Golden China is like an electronics store trying to sell its wares (cheaply) on London's Savile Row rather than Tokyo's Akihabara market.
To profit from such disparities, enterprising investors have long combed the world's bourses looking for cheap stocks. It makes perfect sense for companies to do the reverse: scour the world for markets that will pay high prices for their shares, thus reducing the cost of their capital.
Unfortunately, bagging a higher valuation is not always as easy as listing on a different exchange. For example, lots of international companies coughed up for a Tokyo listing in the late 1980s, hoping to share in the euphoric multiples then applied to Japanese firms. But they were disappointed; their share prices remained tied to those back home.
Golden China is considering a more dramatic migration. Already most of its 700 employees work in China. The company's executives are thinking about joining them, and shifting their primary listing from Toronto to Hong Kong in the process. At the moment, they reckon the company's $50m market value plus its debt is worth only as much as its plant and outside investments, giving it no credit for its 1.5m ounces of gold. If more appreciative customers for their shares exist elsewhere, why not bring the company to them? It would appear the only rational response to an irrational market.
The Economist, 29-Mar-2007
Companies scour global exchanges to find a better price for their shares
BASED in Toronto, Golden China Resources is a mining company with the kind of scary but alluring profile you might expect for a firm that goes prospecting for gold. Established only three years ago, it is still losing money. But it boasts an intriguing technology using bacteria in the refining process, promising rights in China and what appears to be a growing inventory of established reserves.
With bullion prices rising and economic doubts gathering, times should be good for gold producers. But on the Toronto Stock Exchange, Golden China has lost its lustre. Its share price has fallen by half since early 2006. In response, the company has embarked on a different kind of prospecting. It is studying how different bourses around the world value companies like itself. Its findings are a challenge to anyone who believes financial markets are consistent or rational.
Take, for example, the market's view of “in situ” ounces, meaning gold that is in the ground. According to an outside analysis, Canadian exploration companies are valued at $75 an ounce on average. As refined gold now sells for more than $650 an ounce, this leaves some margin for processing and mining risk.
If the deposits controlled by these Canadian companies are in China, the valuation slips to $43 an ounce. This may reflect worries that China's methods of verifying potential assets are less stringent. It may also be a consequence of more general fears about property rights in China.
That would be the end of the story were it not for an odd detail. Golden China then went on to look at the valuation of gold producers listed in Hong Kong or on the Chinese mainland. The results were striking: they were valued at $180-240 an ounce. Sino Gold, an Australian company which on March 16th made a secondary listing on the Hong Kong exchange, is priced at about $190 an ounce.
There may be some simple explanations for these big disparities. For example, the Chinese companies in the study all turn a profit. But investors in gold exploration probably care more about the treasure to be unearthed than the trickle of income from ongoing sales.
In fact, Golden China has hit on a broader seam of market discrepancies: the value of a share often depends on where the stock is floated. The most glaring examples are provided by Hong Kong-listed firms that also list in Shanghai, where they almost always get a better price for their shares. No wonder Hong Kong feels threatened by the migration of listings to its mainland rival.
More subtly, global exchanges disagree about the value they put on everything from food companies to banks, even after taking account of differences in a firm's local prospects. Perhaps investors feel better protected and better informed by some bourses rather than others. Exchanges often claim that stiff auditing and disclosure standards add a premium to the shares listed on them. But strangely, valuations right now seem highest in murky stockmarkets like China's.
Bourses may also attract their own distinctive base of investors, interested in some sectors more than others. America's markets attract the technophiles, China's lure the gold bugs. Like retail arcades, exchanges each seem to draw their own tribe of customers who know what they want, pay a premium for it and ignore bargains that would fetch much higher prices elsewhere. Golden China is like an electronics store trying to sell its wares (cheaply) on London's Savile Row rather than Tokyo's Akihabara market.
To profit from such disparities, enterprising investors have long combed the world's bourses looking for cheap stocks. It makes perfect sense for companies to do the reverse: scour the world for markets that will pay high prices for their shares, thus reducing the cost of their capital.
Unfortunately, bagging a higher valuation is not always as easy as listing on a different exchange. For example, lots of international companies coughed up for a Tokyo listing in the late 1980s, hoping to share in the euphoric multiples then applied to Japanese firms. But they were disappointed; their share prices remained tied to those back home.
Golden China is considering a more dramatic migration. Already most of its 700 employees work in China. The company's executives are thinking about joining them, and shifting their primary listing from Toronto to Hong Kong in the process. At the moment, they reckon the company's $50m market value plus its debt is worth only as much as its plant and outside investments, giving it no credit for its 1.5m ounces of gold. If more appreciative customers for their shares exist elsewhere, why not bring the company to them? It would appear the only rational response to an irrational market.
Wednesday, March 28, 2007
The Great Inflation - Anatomy of a hump
Anatomy of a hump
The Economist, Mar 8th 2007
What caused the Great Inflation? And what might bring it back?
IF YOU were to draw the path of inflation in the typical big, rich economy over the past half century, your picture would look much like a dromedary's back: a low flat line in the 1960s; a knobbly hump of high and volatile price rises in the 1970s; dramatic disinflation in the 1980s; and low, stable inflation rates since. Japan and Germany, which were quicker to quell inflation, are well-known exceptions. But for the rest, the shape and timing of the Great Inflation bulge look remarkably similar.
This is a bulge that today's central bankers are anxious not to repeat. So it is no surprise that several governors from America's Federal Reserve are attending a conference on March 9th to discuss a new report* on the Great Inflation, written by a weighty group of macroeconomists from academia and Wall Street.
Most scholars agree on a basic explanation of the hump, placing both blame and credit squarely on central bankers. Consumer prices accelerated in the late 1960s because monetary policy was too loose. German and Japanese central bankers realised this earlier than others and tightened policy accordingly. Eventually others followed suit, and general disinflation began in the early 1980s. Since then inflation has stayed under control because central bankers are credibly committed to price stability and far better at their job.
Beyond that broad tale lie several debates about important details. Economists differ on how much non-monetary phenomena, such as closer trade integration, affect the inflation process. They also offer competing explanations for why central bankers botched things so badly a generation ago. One possibility is that they simply got the numbers wrong, consistently overestimating their economies' speed limits. Others blame theoretical misjudgments, particularly the belief that higher inflation could buy a lasting drop in unemployment. A third approach emphasises political pressure. Inflation got out of hand because central banks were under the thumb of politicians who preferred rising prices to higher joblessness.
In this latest report the authors subject such controversies to painstaking cross-country forensics. They show that price stability across the G7 countries has been far more closely correlated than economic stability. Almost everywhere, inflation took off between 1969 and 1970. And every country, except Germany and Japan, failed to tame it until the mid-1980s. Output, however, was less tightly synchronised. Although recessions in many countries have become less wrenching in recent decades, output volatility began to ease in the mid-1980s in America, but not until the early 1990s in Britain, Canada and France.
What to make of these differences? The Great Inflation, because it was felt simultaneously across countries, must have had a common cause. This cannot have been the 1970s oil shocks, because consumer prices started accelerating long before the price of crude did. Easy money is the only remaining suspect. And although the Great Disinflation was also simultaneous across many countries, GDP growth settled down at very different times. This implies that better monetary policy cannot take full credit for today's less painful recessions.
The statistical magnifying glass also casts doubt on some favourite alibis for monetary misrule. Bad data, for example, do not get central bankers off the hook: revisions to statistics on trend growth and unemployment were not big enough to excuse the scale of inflation. Instead, monetary policy was simply too loose. The authors show that the central bankers of the 1970s failed to adhere to the modern “Taylor rule”, a formula that links the appropriate level of short-term interest rates to the deviation of output from its trend and inflation from its target. Of course John Taylor, a Stanford economist, did not formalise his rule until 1993. But even without this guide, central banks should not have flunked the basic tenets of sound money.
Hawks v camels
Neither the Taylor rule, inflation targets nor any other bits of the modern central bankers' toolkit were necessary to end high inflation. But the scholars think these tools have helped to keep inflation down, which, in turn, has spawned a virtuous circle. When inflation is low and stable, a temporary uptick in consumer prices has far less impact on long-term price trends. The economists' model implies that less than 1% of a temporary price surge is translated into a permanent rise in inflation today, compared with 60% three decades ago.
That may give today's policymakers more leeway than their predecessors enjoyed. But since this wiggle-room is the legacy of low inflation volatility, it cannot be taken for granted. Were central bankers to lose their guard, inflation could soon resurge.
More worrying, the economists pour cold water on many a policymaker's favourite gauge of his own performance, namely the public's expectations of future inflation. Central bankers often cite low inflation expectations as evidence that monetary policy is appropriate. That may be a mistake. This paper argues that expectations were a good guide to future price pressure only when inflation was high. But now, if anything, inflation expectations are a backward-looking indicator, lagging measures of actual inflation.
All told, this statistical sleuthing suggests today's central bankers have little room for complacency. Inflation remains low and stable because policymakers are vigilant, not because any deep, structural changes insulate the modern economy from price pressure. If central bankers relax, higher, more volatile inflation could easily return. Rudyard Kipling's camel, remember, got its hump for being “most 'scrutiatingly idle”.
"Understanding the Evolving Inflation Process" by Stephen Cecchetti, Peter Hooper, Bruce Kasman, Kermit Schoenholtz and Mark Watson
Fed Governor Mishkin, "Inflation Dynamics"
The Economist, Mar 8th 2007
What caused the Great Inflation? And what might bring it back?
IF YOU were to draw the path of inflation in the typical big, rich economy over the past half century, your picture would look much like a dromedary's back: a low flat line in the 1960s; a knobbly hump of high and volatile price rises in the 1970s; dramatic disinflation in the 1980s; and low, stable inflation rates since. Japan and Germany, which were quicker to quell inflation, are well-known exceptions. But for the rest, the shape and timing of the Great Inflation bulge look remarkably similar.
This is a bulge that today's central bankers are anxious not to repeat. So it is no surprise that several governors from America's Federal Reserve are attending a conference on March 9th to discuss a new report* on the Great Inflation, written by a weighty group of macroeconomists from academia and Wall Street.
Most scholars agree on a basic explanation of the hump, placing both blame and credit squarely on central bankers. Consumer prices accelerated in the late 1960s because monetary policy was too loose. German and Japanese central bankers realised this earlier than others and tightened policy accordingly. Eventually others followed suit, and general disinflation began in the early 1980s. Since then inflation has stayed under control because central bankers are credibly committed to price stability and far better at their job.
Beyond that broad tale lie several debates about important details. Economists differ on how much non-monetary phenomena, such as closer trade integration, affect the inflation process. They also offer competing explanations for why central bankers botched things so badly a generation ago. One possibility is that they simply got the numbers wrong, consistently overestimating their economies' speed limits. Others blame theoretical misjudgments, particularly the belief that higher inflation could buy a lasting drop in unemployment. A third approach emphasises political pressure. Inflation got out of hand because central banks were under the thumb of politicians who preferred rising prices to higher joblessness.
In this latest report the authors subject such controversies to painstaking cross-country forensics. They show that price stability across the G7 countries has been far more closely correlated than economic stability. Almost everywhere, inflation took off between 1969 and 1970. And every country, except Germany and Japan, failed to tame it until the mid-1980s. Output, however, was less tightly synchronised. Although recessions in many countries have become less wrenching in recent decades, output volatility began to ease in the mid-1980s in America, but not until the early 1990s in Britain, Canada and France.
What to make of these differences? The Great Inflation, because it was felt simultaneously across countries, must have had a common cause. This cannot have been the 1970s oil shocks, because consumer prices started accelerating long before the price of crude did. Easy money is the only remaining suspect. And although the Great Disinflation was also simultaneous across many countries, GDP growth settled down at very different times. This implies that better monetary policy cannot take full credit for today's less painful recessions.
The statistical magnifying glass also casts doubt on some favourite alibis for monetary misrule. Bad data, for example, do not get central bankers off the hook: revisions to statistics on trend growth and unemployment were not big enough to excuse the scale of inflation. Instead, monetary policy was simply too loose. The authors show that the central bankers of the 1970s failed to adhere to the modern “Taylor rule”, a formula that links the appropriate level of short-term interest rates to the deviation of output from its trend and inflation from its target. Of course John Taylor, a Stanford economist, did not formalise his rule until 1993. But even without this guide, central banks should not have flunked the basic tenets of sound money.
Hawks v camels
Neither the Taylor rule, inflation targets nor any other bits of the modern central bankers' toolkit were necessary to end high inflation. But the scholars think these tools have helped to keep inflation down, which, in turn, has spawned a virtuous circle. When inflation is low and stable, a temporary uptick in consumer prices has far less impact on long-term price trends. The economists' model implies that less than 1% of a temporary price surge is translated into a permanent rise in inflation today, compared with 60% three decades ago.
That may give today's policymakers more leeway than their predecessors enjoyed. But since this wiggle-room is the legacy of low inflation volatility, it cannot be taken for granted. Were central bankers to lose their guard, inflation could soon resurge.
More worrying, the economists pour cold water on many a policymaker's favourite gauge of his own performance, namely the public's expectations of future inflation. Central bankers often cite low inflation expectations as evidence that monetary policy is appropriate. That may be a mistake. This paper argues that expectations were a good guide to future price pressure only when inflation was high. But now, if anything, inflation expectations are a backward-looking indicator, lagging measures of actual inflation.
All told, this statistical sleuthing suggests today's central bankers have little room for complacency. Inflation remains low and stable because policymakers are vigilant, not because any deep, structural changes insulate the modern economy from price pressure. If central bankers relax, higher, more volatile inflation could easily return. Rudyard Kipling's camel, remember, got its hump for being “most 'scrutiatingly idle”.
"Understanding the Evolving Inflation Process" by Stephen Cecchetti, Peter Hooper, Bruce Kasman, Kermit Schoenholtz and Mark Watson
Fed Governor Mishkin, "Inflation Dynamics"
Tuesday, March 27, 2007
The Economist - What's it all about, alpha?
What's it all about, alpha?
Mar 22nd 2007
Demystifying fund managers' returns
TOO many notes. That's what Emperor Joseph II famously said to Mozart on seeing his opera “The Marriage of Figaro”. But surely to think of a musical work as just a series of notes is to miss the magic.
Could the same be said about fund management? It is the fashion these days to separate beta (the systematic return delivered by the market) from alpha (the manager's skill). Investors are happy to pay high fees for the skill, but regard the market return as a commodity. Distinguishing the two is, however, difficult.
A fund manager might beat the market because of luck or recklessness, rather than skill, for example. Suppose he packed his portfolio with oil stocks. When the crude price rises that would pay off, but it would be a pretty risky portfolio. More generally, alpha sceptics often attribute eye-catching returns to “style bias”, such as favouring stocks with a high dividend yield.
But should they be biased against style bias? After all, the only portfolio utterly free of bias would be one that included the entire market. Were a Britain portfolio to exclude just one stock, such as BP, it would have a small-cap bias, a sector bias and a currency bias (most of BP's revenue is in dollars). Hence any excess return must stem from some element of style.
Academics have entered this debate, trying to pin down the factors that drive a fund's performance. These might include the difference in returns between small-cap and large-cap stocks (fund managers tend to favour the former) or the level of credit spreads and so on. Bill Fung and Narayan Naik of London Business School have come up with a seven-factor model which, they say, can explain the bulk of hedge-fund performance. After allowing for these factors, the average fund of hedge funds has not produced any alpha in the past decade, except during the dotcom bubble.
This approach suggests the whole idea of alpha might be an illusion. Academics can explain most of it, and the only reason they cannot explain all of it is because they are not clever enough to think of the missing factors.
However, it is also possible to take the opposite tack. This type of analysis gives managers no credit for choosing the systematic factors—the betas—that drive their portfolios. Yes, these betas could often have been bought for very low fees. But would an investor have been able to put them together in the right combination?
It is as if a diner in Gordon Ramsay's restaurants were brave enough to tell the irascible chef: “This meal was delicious. But chemical analysis shows it is 65% chicken, 20% carrot, 10% flour and 5% milk. I could have bought those ingredients for £1.50. Why should I pay £20?” The chef's reply, shorn of its expletives, might be: “The secret is in the mixing.”
This debate matters because people are now trying to replicate the performance of hedge funds with cloned portfolios. Indeed Messrs Fung and Naik have shown that their model would have produced an annual return over the past four years of 11.6%, well ahead of the average fund of hedge funds. Their performance was purely theoretical. But Goldman Sachs and Merrill Lynch have launched cloned hedge funds on the market.
There are two potential criticisms of the cloned approach. One is that it will simply reproduce all the systematic returns that hedge funds generate and none of their idiosyncratic magic. However, this “magic” is hard to pin down. Even if it does exist, Messrs Fung and Naik suggest it may be worth no more than the fees hedge funds charge, so the managers are the only ones to benefit from their skills.
The second criticism is that the clones will always be a step behind the smart money. You cannot clone a hedge fund until you know where it has been. But by then it may have moved on. As a result, the clones may pile into assets that the hedge funds are selling, making the classic mistake of buying at the top. This may not be a fatal flaw, however. It is possible to imagine some clones taking contrary bets, buying the betas that seem temporarily out of favour, in the hope that they will be purchasing what the hedge funds are about to buy.
There are some nice ironies at work here. Hedge-fund managers often rely on secretive “black box” models: the investor puts his money in at one end and sees the returns spat out at the other, but no more than that. Now, armed with just that information, academics are coming up with their own models, which almost match the hedge funds' performance.
Mozart might have sympathised. His operas were more than the sum of his notes. But even if the great composer had no peers, he has had plenty of imitators.
Mar 22nd 2007
Demystifying fund managers' returns
TOO many notes. That's what Emperor Joseph II famously said to Mozart on seeing his opera “The Marriage of Figaro”. But surely to think of a musical work as just a series of notes is to miss the magic.
Could the same be said about fund management? It is the fashion these days to separate beta (the systematic return delivered by the market) from alpha (the manager's skill). Investors are happy to pay high fees for the skill, but regard the market return as a commodity. Distinguishing the two is, however, difficult.
A fund manager might beat the market because of luck or recklessness, rather than skill, for example. Suppose he packed his portfolio with oil stocks. When the crude price rises that would pay off, but it would be a pretty risky portfolio. More generally, alpha sceptics often attribute eye-catching returns to “style bias”, such as favouring stocks with a high dividend yield.
But should they be biased against style bias? After all, the only portfolio utterly free of bias would be one that included the entire market. Were a Britain portfolio to exclude just one stock, such as BP, it would have a small-cap bias, a sector bias and a currency bias (most of BP's revenue is in dollars). Hence any excess return must stem from some element of style.
Academics have entered this debate, trying to pin down the factors that drive a fund's performance. These might include the difference in returns between small-cap and large-cap stocks (fund managers tend to favour the former) or the level of credit spreads and so on. Bill Fung and Narayan Naik of London Business School have come up with a seven-factor model which, they say, can explain the bulk of hedge-fund performance. After allowing for these factors, the average fund of hedge funds has not produced any alpha in the past decade, except during the dotcom bubble.
This approach suggests the whole idea of alpha might be an illusion. Academics can explain most of it, and the only reason they cannot explain all of it is because they are not clever enough to think of the missing factors.
However, it is also possible to take the opposite tack. This type of analysis gives managers no credit for choosing the systematic factors—the betas—that drive their portfolios. Yes, these betas could often have been bought for very low fees. But would an investor have been able to put them together in the right combination?
It is as if a diner in Gordon Ramsay's restaurants were brave enough to tell the irascible chef: “This meal was delicious. But chemical analysis shows it is 65% chicken, 20% carrot, 10% flour and 5% milk. I could have bought those ingredients for £1.50. Why should I pay £20?” The chef's reply, shorn of its expletives, might be: “The secret is in the mixing.”
This debate matters because people are now trying to replicate the performance of hedge funds with cloned portfolios. Indeed Messrs Fung and Naik have shown that their model would have produced an annual return over the past four years of 11.6%, well ahead of the average fund of hedge funds. Their performance was purely theoretical. But Goldman Sachs and Merrill Lynch have launched cloned hedge funds on the market.
There are two potential criticisms of the cloned approach. One is that it will simply reproduce all the systematic returns that hedge funds generate and none of their idiosyncratic magic. However, this “magic” is hard to pin down. Even if it does exist, Messrs Fung and Naik suggest it may be worth no more than the fees hedge funds charge, so the managers are the only ones to benefit from their skills.
The second criticism is that the clones will always be a step behind the smart money. You cannot clone a hedge fund until you know where it has been. But by then it may have moved on. As a result, the clones may pile into assets that the hedge funds are selling, making the classic mistake of buying at the top. This may not be a fatal flaw, however. It is possible to imagine some clones taking contrary bets, buying the betas that seem temporarily out of favour, in the hope that they will be purchasing what the hedge funds are about to buy.
There are some nice ironies at work here. Hedge-fund managers often rely on secretive “black box” models: the investor puts his money in at one end and sees the returns spat out at the other, but no more than that. Now, armed with just that information, academics are coming up with their own models, which almost match the hedge funds' performance.
Mozart might have sympathised. His operas were more than the sum of his notes. But even if the great composer had no peers, he has had plenty of imitators.
Wednesday, February 14, 2007
Why hard assets are not easy to find
Why hard assets are not easy to find
By Raghuram Rajan
Financial Times, Feb 12 2007
Signs of extremely benign financing conditions are plentiful, ranging from low long-term interest rates to historically narrow credit spreads on risky assets. Many observers call this a liquidity glut, thereby implicating central banks and their accommodative policies. But in my view, these conditions may primarily be driven by a global shortage of hard assets.
My argument relies on two global ingredients. The first is that, in spite of substantial worldwide income growth, if anything there has been an increase in the desire to save out of it. In emerging markets where income growth is rapid, savings increase. Household consumption in developing countries takes time to catch up with higher incomes – either because households take time to be confident that the increase is permanent or because credit constraints prevent them from borrowing to consume against future incomes.
Also, emerging market governments, including oil producers, not only have higher revenues but have become more careful about expenditure, given past experiences with deficits.
But perhaps most intriguing is the increase in corporate savings, especially in industrial countries. Profitable corporations, made more profitable by lower taxes and interest rates, retain earnings rather than hand them back as dividends to shareholders.
This is where we come to the second ingredient. Nominal corporate investment in hard assets – such as inventories, property, plant and equipment – has been restrained, especially relative to the quantities that might be warranted by the tremendous productivity growth of the past few years. Instead, more corporate savings have been invested in financial assets.
A number of possible explanations exist. Some sectors may have invested too much during the technology boom and be still working it off. A competitive need to improve inventory management and, more generally, utilisation of capital may also be at work. The cost of capital goods has fallen, which implies that less nominal investment is needed to achieve the same level of real investment. Furthermore, the nature of required investment may be changing, especially in industrial countries – from physical capital to human capital.
Perhaps the key factor, though, in holding back investment in hard assets may be economic uncertainty – ranging from corporate takeover threats to the increasing cost-competitiveness of emerging markets. Indeed, it makes less and less sense for corporations in industrial countries to make large domestic investments in the manufacturing sector. But as they look to invest in non-industrial countries, they become subject to the uncertainties of policy there. Not only do they have to worry about whether China is a better place to invest than Vietnam but also whether it will continue to be better 10 years from now. No wonder many corporations are focused on trying to improve the efficiency of their existing capital and stock of knowledge.
The mismatch between unabated global desired savings and lower realised investment has led to a financing glut, particularly pronounced in debt markets. With subdued investment in hard assets, there are fewer assets that can be used as collateral on which to base corporate debt. Given that a substantial portion of the world’s desired savings are put to work by central banks and financial institutions, many of which have statutory requirements (or matching considerations) to buy debt, we have many buyers for debt but too few debt instruments being issued.
Consider some implications. First, given that markets are integrated, the glut has spilt over into areas such as property and pushed prices higher. Especially affected have been the most illiquid markets and assets that have a debt-like character, such as utilities, which pay a steady dividend. Some of these markets are frothy, given the long-term prognosis for the savings-investment balance.
Second, while corporations may have learnt to be cautious through recent experience, builders and households have not faced adversity for some time and may have a greater propensity to over-invest. Third, sophisticated financial systems such as that of the US, have been particularly adept at creating instruments the market wants. This has helped the smooth financing of the US current account deficit and may be partly a cause of the deficit.
Finally, easy financing conditions the world over are not primarily because of the accommodative policy followed by the Group of Three central banks in recent years, though clearly monetary policy can add or subtract at the margin by affecting liquidity conditions and carry trades.
What is hard to forecast is how financing conditions will change. As capacity constraints tighten and as the policy environment in emerging markets becomes more clear, more investment will naturally be undertaken, reducing the financing imbalance and pushing up long-term interest rates. If this happens smoothly, the froth in exchange and asset markets will dissipate without much disruption. If long-term rates move more rapidly, for instance because of an inflation scare, the ride could be far more volatile.
The writer is a professor of finance at the Graduate School of Business at the University of Chicago
By Raghuram Rajan
Financial Times, Feb 12 2007
Signs of extremely benign financing conditions are plentiful, ranging from low long-term interest rates to historically narrow credit spreads on risky assets. Many observers call this a liquidity glut, thereby implicating central banks and their accommodative policies. But in my view, these conditions may primarily be driven by a global shortage of hard assets.
My argument relies on two global ingredients. The first is that, in spite of substantial worldwide income growth, if anything there has been an increase in the desire to save out of it. In emerging markets where income growth is rapid, savings increase. Household consumption in developing countries takes time to catch up with higher incomes – either because households take time to be confident that the increase is permanent or because credit constraints prevent them from borrowing to consume against future incomes.
Also, emerging market governments, including oil producers, not only have higher revenues but have become more careful about expenditure, given past experiences with deficits.
But perhaps most intriguing is the increase in corporate savings, especially in industrial countries. Profitable corporations, made more profitable by lower taxes and interest rates, retain earnings rather than hand them back as dividends to shareholders.
This is where we come to the second ingredient. Nominal corporate investment in hard assets – such as inventories, property, plant and equipment – has been restrained, especially relative to the quantities that might be warranted by the tremendous productivity growth of the past few years. Instead, more corporate savings have been invested in financial assets.
A number of possible explanations exist. Some sectors may have invested too much during the technology boom and be still working it off. A competitive need to improve inventory management and, more generally, utilisation of capital may also be at work. The cost of capital goods has fallen, which implies that less nominal investment is needed to achieve the same level of real investment. Furthermore, the nature of required investment may be changing, especially in industrial countries – from physical capital to human capital.
Perhaps the key factor, though, in holding back investment in hard assets may be economic uncertainty – ranging from corporate takeover threats to the increasing cost-competitiveness of emerging markets. Indeed, it makes less and less sense for corporations in industrial countries to make large domestic investments in the manufacturing sector. But as they look to invest in non-industrial countries, they become subject to the uncertainties of policy there. Not only do they have to worry about whether China is a better place to invest than Vietnam but also whether it will continue to be better 10 years from now. No wonder many corporations are focused on trying to improve the efficiency of their existing capital and stock of knowledge.
The mismatch between unabated global desired savings and lower realised investment has led to a financing glut, particularly pronounced in debt markets. With subdued investment in hard assets, there are fewer assets that can be used as collateral on which to base corporate debt. Given that a substantial portion of the world’s desired savings are put to work by central banks and financial institutions, many of which have statutory requirements (or matching considerations) to buy debt, we have many buyers for debt but too few debt instruments being issued.
Consider some implications. First, given that markets are integrated, the glut has spilt over into areas such as property and pushed prices higher. Especially affected have been the most illiquid markets and assets that have a debt-like character, such as utilities, which pay a steady dividend. Some of these markets are frothy, given the long-term prognosis for the savings-investment balance.
Second, while corporations may have learnt to be cautious through recent experience, builders and households have not faced adversity for some time and may have a greater propensity to over-invest. Third, sophisticated financial systems such as that of the US, have been particularly adept at creating instruments the market wants. This has helped the smooth financing of the US current account deficit and may be partly a cause of the deficit.
Finally, easy financing conditions the world over are not primarily because of the accommodative policy followed by the Group of Three central banks in recent years, though clearly monetary policy can add or subtract at the margin by affecting liquidity conditions and carry trades.
What is hard to forecast is how financing conditions will change. As capacity constraints tighten and as the policy environment in emerging markets becomes more clear, more investment will naturally be undertaken, reducing the financing imbalance and pushing up long-term interest rates. If this happens smoothly, the froth in exchange and asset markets will dissipate without much disruption. If long-term rates move more rapidly, for instance because of an inflation scare, the ride could be far more volatile.
The writer is a professor of finance at the Graduate School of Business at the University of Chicago
Wednesday, January 31, 2007
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