Fears Rise in Europe Over Potential for Deflation - NYTimes.com

More on the deflation watch.


Fears Rise in Europe Over Potential for Deflation - NYTimes.com

US money supply plunges at 1930s pace as Obama eyes fresh stimulus - Telegraph

More deflationary news.

Larry Summers, President Obama's top economic adviser, started calling for more fiscal stimulus a couple of weeks ago. At first I found this puzzling, since much of the economic data seems to be showing improvement. However, it could very well be that Summers (who is a first-rate economist) and others in the White House are seeing signs in the data that they don't like.

Here's a key section of the article:

Mr Summers acknowledged in a speech this week that the eurozone crisis had shone a spotlight on the dangers of spiralling public debt. He said deficit spending delays the day of reckoning and leaves the US at the mercy of foreign creditors. Ultimately, "failure begets failure" in fiscal policy as the logic of compound interest does its worst.

However, Mr Summers said it would be "pennywise and pound foolish" to skimp just as the kindling wood of recovery starts to catch fire. He said fiscal policy comes into its own at at time when the economy "faces a liquidity trap" and the Fed is constrained by zero interest rates.

Mr Congdon said the Obama policy risks repeating the strategic errors of Japan, which pushed debt to dangerously high levels with one fiscal boost after another during its Lost Decade, instead of resorting to full-blown "Friedmanite" monetary stimulus.

"Fiscal policy does not work. The US has just tried the biggest fiscal experiment in history and it has failed. What matters is the quantity of money and in extremis that can be increased easily by quantititave easing. If the Fed doesn’t act, a double-dip recession is a virtual certainty," he said.

US money supply plunges at 1930s pace as Obama eyes fresh stimulus - Telegraph

Congress Weighs Bailout of Pension Plans - WSJ.com

Yesterday I posted a note on the puzzling move by the state of New Mexico's pension investment board to reduce its stock exposure in favor of low yielding bonds and private equity.

As I mentioned, to me this move seems totally inconsistent with how a pension fund should be run. With most of its liabilities being of the "long tail" nature, pensions should invest in the areas that offer the best possibility of achieving solid longer term returns.

The history of the capital markets would suggest that common stocks - especially stocks paying attractive dividends - offer superior investment results to either bonds or cash.

True, the last 10 years have been poor ones for stocks. However, some of this reflects the incredible overvaluation of the market at the beginning of the 21st century.

For example, the price/earnings ratio of the S &P 500 at the beginning of the year 2000 was 30x, and the dividend yield was barely above 1%. Now that same price/earnings ratio on trailing 12 month earnings is under 17x - using the depressed earnings of corporate America during the past year - and the dividend yield is about 2%. Both today's P/E ratio and the dividend yield (as paltry as it is) compare favorably to historic averages.

In other words, today's valuations would argue that the odds of superior returns for stocks over the next decade are much higher than most other asset classes.

So what happens if the pension boards decide to make decisions that harm the longer term returns of the plans they are supposed to administer?

Today's article in the Wall Street Journal tells the story - you don't even need to read the whole story to get to the conclusion.

The current shortfalls in many pension plans are the result of many factors, but one of the biggest ones is poor investment decisions made by committees focused only on yesterday's results. And in the end all of us - the U.S. taxpayer - will wind up paying.

Congress Weighs Bailout of Pension Plans - WSJ.com

NM Adopts Plan to Boost State's Investment Returns - NYTimes.com

Warren Buffett often describes investor behavior as similar to someone driving down the road.

Rather than focusing their attention on the road ahead, investors are driving with their eyes fixed firmly in the rear view mirror.

In other words, rather than look forward, and make investment decisions based on the outlook for the next few years, many investors tend to base their decisions on the most recent investment history.

As we all know, the last 10 years for stocks have been dismal. Although returns in 2009 turned out to be very strong, the market swoon of the last few weeks has moved returns YTD into the red again.

And yet, if you consider today's valuations, it seem logical that stocks - especially large cap, dividend-paying US stocks - offer the best potential for reasonable returns over the next 5 to 10 years.

However, public pension plans continue to reduce their allocation to stocks in favor of either bonds or private equity in a desperate attempt to close their funding gaps.

Here's another example from today's New York Times.

After years of disappointing returns, the investment board for the state of New Mexico has decided that stocks are too risky for them. Instead, they are cutting their exposure to the stock market in favor of bonds (probably yielding around 3%) and private equity.

Consider the latter allocation. Private equity returns, for the most part, have been disappointing. There have been numerous studies finding that, after fees, most private equity investors would have been better off in corporate bonds or even higher quality stocks, yet the appeal of a "black box" approach sold by very smart (and very rich) private equity managers continues to sway investment committees.

This is a perfect illustration of why public pension plans are in such dire straits.

Pension boards - whose investment horizons ought to very long term, given the nature of their liabilities - are fleeing an asset class which probably offers the best chance of achieving their objectives based mostly on past history.

Here's an excerpt from the piece; I have added the highlights:

To help reduce volatility and improve earnings, the council on Tuesday approved a new allocation of fund assets. The plan calls for reducing investments in equities, such as stocks, and shifting more to other investments, including fixed income and alternatives such as private equity. Hedge fund investments also will be trimmed.

''Ultimately we would like to reduce the peaks and valleys we're seeing in performance by reducing that equity exposure,'' Charles Wollmann, a spokesman for the council, said Wednesday.

The two permanent funds have 61 percent to 62 percent of their assets in equities. The council, which is responsible for overseeing management of the funds, decided that should be about 55 percent.

''When the markets are running well that's where you get a lot of your performance, but when they are down that's where you take the big hit,'' Wollmann said.

In other words, according to Mr. Wollmann, you want to be invested in stocks after they have done well, but sell them if they have moved lower i.e., buy high, sell low.

Hope the taxpayers of New Mexico are ready to pay more taxes to close future shortfalls.

NM Adopts Plan to Boost State's Investment Returns - NYTimes.com

Preview of Our Next Client Meeting?

From Greg Mankiw's Blog: Sometimes there's too much truth in humor!

U.S. debt reaches level at which economic growth begins to slow - The Hill's On The Money

Another depressing blog post from me - Sorry!

Here's an excerpt, with the entire piece linked below:

When gross debt hits 90 percent of GDP, Reinhart told the commission during a hearing in the Capitol, growth "deteriorates markedly." Median growth rates fall by 1 percent, and average growth rates fall "considerably more," she said.

Reinhart said the commission shouldn't wait to put in place a plan to rein in deficits.

"I have no positive news to give," she said. "Fiscal austerity is something nobody wants, but it is a fact.


U.S. debt reaches level at which economic growth begins to slow - The Hill's On The Money

Italy Adopts $30 Billion of Cuts in EU Deficit Push (Update3) - Bloomberg.com

A faithful reader of this blog called me yesterday to josh me a little bit. My last few posts, he said, were unnecessarily bearish.

And perhaps he is right. The news from corporate America remains strong, and there are even signs of more hiring going on. Even the housing market is doing better - the Boston Globe reported this morning that housing sales in April were +46% higher than a year ago, for example.

And yet there remain gathering clouds that concern me, mostly emanating from Europe.

Most of the financial types I socialize with are quick to say, "Well, those European countries running big deficits are just going to have to live within their means." What never seems to be discussed is the economic and human costs these tightening measures will entail.

Italy announced yesterday that it would try to reduce its fiscal deficits through a combination of public employee wage freezes and a "crackdown" on tax evasion (in a country that has taken tax evasion to a new level). This follows similar moves in Portugal, Spain, and Ireland:

Italy Adopts $30 Billion of Cuts in EU Deficit Push (Update3) - Bloomberg.com

However, these moves could eventually come back to hurt the US, as this morning's New York Times noted:

Europe Pain May Impede U.S. Upturn

Here's an excerpt:

There is no shortage of storm clouds to bolster a gloomier take. Japan and Europe are perched near the edge of deflation. And as one European leader after another takes a vow of austerity amid talk of layoffs and deep spending cuts, American manufacturers — which have led the domestic recovery — could find their goods piling up in warehouses and on docks.

“We were counting on a weak dollar and a strong European economy; instead we got a strong dollar and a weak Europe — that is clearly not good for our economy,” said Joseph E. Stiglitz, former chief economist of the World Bank and a professor of economics at Columbia University. “It certainly increases our likelihood of a double-dip recession.”

http://www.nytimes.com/2010/05/26/business/economy/26recession.html?hpw

So while I think that the recent stock market swoon may have left the market oversold, and due for a near-term rally, I am also wary that Europe's bad news may be something to monitor carefully.

FT Alphaville » $47bn and counting

Good post today on BP in the FT.

We hold BP in a number of accounts, and continue to think that it will eventually recover. As the FT article notes, the market cap of BP has declined by $47 billion since the beginning of the crisis, which would seem to fully incorporate all legal liability and possible hits to operations.

That said, I am concerned that our view seems to be the consensus. Most of the Wall Street and UK analysts continue to have either a "buy" or "hold" on the stock, noting the cheap valuation and huge dividend yield (8%).

As the FT post also notes, the big risk to the company is that it is forced to cease operations in the Gulf of Mexico. This would be a big hit to the company:

...BP makes a third of its profits in the US and its Gulf of Mexico activities are the highest margin.

BP is obviously in the most vulnerable position of the parties involved – a net effect of the ongoing disaster besides financial liability could be the risk that no further GoM leases are awarded to them in the future and even a retroactive removal of the Macondo licence.

Which would leave BP dependent on its low growth downstream operations.

FT Alphaville » $47bn and counting

FT.com / UK - The world teeters on the brink of a new age of rage

I've been getting calls and questions about the world and the markets, so I thought I would share some of what I'm reading.

First, there was this article written by Simon Schama in the FT this weekend. Schama is a great historian (he wrote a three part series on the history of Britain that I recommend for summer reading) and so brings a different perspective to the current euro situation.

And his thoughts are troubling only because they could possibly foresee considerable social unrest. Here's an excerpt:

...Objectively, economic conditions might be improving, but perceptions are everything and a breathing space gives room for a dangerously alienated public to take stock of the brutal interruption of their rising expectations. What happened to the march of income, the acquisition of property, the truism that the next generation will live better than the last? The full impact of the overthrow of these assumptions sinks in and engenders a sense of grievance that 'Someone Else' must have engineered the common misfortune. The stock epithet the French revolution gave to the financiers who were blamed for disaster, was "rich egoists". Our own plutocrats may not be headed for the tumbrils but the fact that financial catastrophe, with its effect on the "real" economy came about through obscure transactions designed to do nothing except produce short-term profit aggravates a sense of social betrayal.


FT.com / UK - The world teeters on the brink of a new age of rage

Then there was Ambrose Evans-Pritchard's column today which notes that current events in Europe are fueling a move back towards rage against capitalism and a move towards socialism:

Europe's deflation torture is a gift to the Far Left

Ambrose makes the point that Germany is far from the innocent victim in all of this. Instead, he notes that a good deal of German growth in recent years has come from their policies in regard to the Southern European nations:

It was refreshing to read "The Euro Burns" by Michael Schlecht, Die Linke’s economic guru, arguing that the primary cause of Euroland’s crisis is "German wage-dumping". He shows from Eurostat data that German labour costs rose 7pc between 2000 and 2008, compared to 34pc in Ireland, 30pc in Spain, Portugal, and Italy, 28pc in Greece and Holland, and 20pc in France. Again, my loose translation.

Germany ran an accumulated trade surplus of €1,261bn over the period, while Spain ran a deficit of €598bn, and Portugal €273bn. This shell game was kept afloat by recycling German capital to Club Med debt markets beyond sustainable levels until it all blew up over Greece. The Club Med victims are now trapped.

http://www.telegraph.co.uk/finance/comment/ambroseevans_pritchard/7756879/Europes-deflation-torture-is-a-gift-to-the-Far-Left.html

I hope these concerns are not real but I'm afraid they are. I'm also not sure of the investment implications of all of this other than to continue to emphasize higher quality stocks and bonds, and realize that while the government may be trying to help the situation, their cures could possibly lead to more serious problems ahead.

The Intelligent Investor: You Should Be Worried - WSJ.com

This article appeared over the weekend in the Wall Street Journal but I didn't have the chance to post it.

Seth Klarman is an investing legend, as the article points out, and only occasionally makes comments in public about the markets and investment ideas.

I don't necessary agree with his apocalyptic views on currencies and the fate of the world, but I do agree with one key point: By keeping interest rates at 0%, the government is essentially forcing savers to buy more risky assets. While this might help in the short term - the banks, for example, have considerably more capital cushion than they had a couple of years ago - it is not clear that the longer implications of this policy have been fully considered.

Here's an excerpt from the article:

Some members of the audience gasped audibly when Mr. Klarman said, "The government is now in the business of giving bad advice." Later, he got more specific: "By holding interest rates at zero, the government is basically tricking the population into going long on just about every kind of security except cash, at the price of almost certainly not getting an adequate return for the risks they are running. People can't stand earning 0% on their money, so the government is forcing everyone in the investing public to speculate."

"We didn't get the value out of this crisis that we should have," Mr. Klarman told the audience. "For our parents or grandparents, it was awful to have had a Great Depression. But it was in some ways helpful to carry a Depression mentality throughout their later lives, because it meant they were thrifty with their money and prudent in their investment decisions." He added: "All we got out of this crisis was a Really Bad Couple of Weeks mentality."

The Intelligent Investor: You Should Be Worried - WSJ.com

FT Alphaville » On the edge of a deflationary precipice…

Only a few months ago my thoughts that deflation, not inflation, was one of the major risks facing investors was essentially dismissed by most people.

Now it seems that it is gaining more traction. Here's a couple of posts, first from the FT which discusses the possibility of the Treasury 10 year yielding 2% (even I'm not that bearish!):

FT Alphaville » On the edge of a deflationary precipice…

And then this piece from Bloomberg, which discusses the increased demand for zero coupon long maturity Treasurys as a hedge against the possibility that rates could move significantly lower from current levels:

Strippers Declare Inflation Dead in Zero-Coupon Bonds

http://www.bloomberg.com/apps/news?pid=20601087&sid=awQGVKfQ5rlI&pos=5

Only problem with all of this is the investing truth that any widely held opinion is probably already reflected in market prices. Thus, in an ironic way, if we start seeing more discussion about deflation and lower interest rates, I may have to revisit my outlook.

Op-Ed Columnist - Lost Decade Looming? - NYTimes.com

From Paul Krugman's column in this morning's New York Times.

Unfortunately, I tend to agree with most of what he discusses. Here's an excerpt:

Let’s talk first about those interest rates. On several occasions over the past year, we’ve been told, after some modest rise in rates, that the bond vigilantes had arrived, that America had better slash its deficit right away or else. Each time, rates soon slid back down. Most recently, in March, there was much ado about the interest rate on U.S. 10-year bonds, which had risen from 3.6 percent to almost 4 percent. “Debt fears send rates up” was the headline at The Wall Street Journal, although there wasn’t actually any evidence that debt fears were responsible.

Since then, however, rates have retraced that rise and then some. As of Thursday, the 10-year rate was below 3.3 percent. I wish I could say that falling interest rates reflect a surge of optimism about U.S. federal finances. What they actually reflect, however, is a surge of pessimism about the prospects for economic recovery, pessimism that has sent investors fleeing out of anything that looks risky — hence, the plunge in the stock market — into the perceived safety of U.S. government debt.

And then there's Professor Krugman's conclusion:

This isn’t really surprising: you expect inflation to fall in the face of mass unemployment and excess capacity. But it is nonetheless really bad news. Low inflation, or worse yet deflation, tends to perpetuate an economic slump, because it encourages people to hoard cash rather than spend, which keeps the economy depressed, which leads to more deflation. That vicious circle isn’t hypothetical: just ask the Japanese, who entered a deflationary trap in the 1990s and, despite occasional episodes of growth, still can’t get out. And it could happen here.


Op-Ed Columnist - Lost Decade Looming? - NYTimes.com

Death Tax Lives in Estate Repeal for Heir Who Must Sell Assets - Bloomberg.com

Estate planning is not known for its funny situations. People who help others in planning for the disposition of their assets in anticipation of their death are always looking for ways to lighten what can often be a fairly serious discussion.

And so in recent years it had become a standard joke to say, "Well, if you're going to die, 2010 is a good year to do so, since there's no federal estate tax."

But, as it turns out, this is not exactly the case. When Congress changed the estate laws in 2001, it inserted some provisions that many not know about that can affect estate tax returns in 2010.

For example, while there is not a federal estate tax in 2010 (although there still is state estate tax), but there also is not the usual step-up provision for inherited assets that historically had been the case.

The capital gains tax does not kick in until after the first $1.3 million in capital gains, but stock that had been held for a long time it possible that the gains could be considerably more than this figure.

Here's an excerpt from an article in the June issue of Bloomberg Markets:

A sole heir who sells inherited assets valued at more than $1.3 million must account for their original cost. So if Grandpa bequeaths 100 shares of Google Inc. he bought in 2004’s initial public offering at $85 a share to a granddaughter and those shares were worth $600 each in January when he died, the granddaughter would pay a 15 percent capital-gains tax on $51,500 if she sells the stock, or $7,725.

Last year, the granddaughter might have paid nothing because the old estate-tax law effectively reset the securities’ worth to fair market value on the day they were inherited.

It gets more complicated. People who inherit stock have to reconcile the original price paid for each share with decades of splits and reinvested dividends. Heirs also must account for the initial price of coins or stamps in a collection.

The recipient of Grandma’s Renoir or Monet has to determine how much the grandmother paid for the painting -- or its value at the time she may have inherited it. For collectibles such as art and jewelry, the capital-gains tax rate is 28 percent.

Death Tax Lives in Estate Repeal for Heir Who Must Sell Assets - Bloomberg.com

FT.com / Columnists / Martin Wolf - Eurozone plays ‘beggar my neighbour’

Martin Wolf's column in yesterday's FT.com had a good discussion about possible outcomes for the current eurozone crisis.

To me, there will be several overriding conclusions, but the one of the most important is that all of these events are very deflationary.

In addition, I think that European companies that compete globally will be major beneficiaries. Global competitors - especially the Chinese - will suffer as their cost advantages melt away.

Here's my thinking:

When the markets settle down, European countries will lose the appearance of euro unity - every country will do what is in their own best interests.

Although the euro block was originally billed as a counterweight to the United States, we are different in that we have a common federal government governing the 50 states.

The euro, on the other hand, is really more of a convenience to its 16 member states; that is, it's great when times are good, but when the going gets tough, governments will do whatever is best for own political survival.

For example, think about the close physical proximity of France to Spain and Portugal. Let's just say that the euro leaders to jettison its weaker and less fiscally responsible members. Good-bye, says the ECB, to Greece, Italy, Portugal, and Spain - you're on your own.

If you lead one of the Southern European governments, you are now worried about keeping your citizens happy (not to mention trying to keep your position). You have 20% unemployment, and are hugely in debt to capitalists throughout the world. Your only hope is growth - a growing economy can generate jobs and tax revenue. So what do you do?

You depreciate your currency, cut labor costs, and invite companies in the euro block to come set up shop in your country.

This what happened in Europe when the Berlin Wall came down. Lots of companies closed factories in Germany, for example, and transferred operations just a few miles away to the Czech Republic, where business could be done at a fraction of the cost but the same if not better than their German counterparts.

The obvious losers in this scenario are the big euroblock countries.

Here's the second implication of the market turmoil, in my opinion.

If "beggar thy neighbor" becomes the norm, deflationary pressures hit hard. Prices will fall everywhere. While interest rates would move lower as well (for higher quality credits, at least), deflation makes it harder for debtors to repay their obligations.

Although they might suffer in trades amongst European counterparts, European companies will now be able to compete aggressively in the global marketplace without sacrificing their own profit margins. That's why I have begun adding to my positions in European stocks.


FT.com / Columnists / Martin Wolf - Eurozone plays ‘beggar my neighbour’

New Retirees Often Make Poor Decisions

Last week I posted a note discussing the dangers of trusting your instincts in making investment decisions.

Loss aversion, and extrapolating recent market actions into the future, can often lead retirees to make decisions that don't take into account the longer term prospects for any given investments.

Investment professional are no different, by the way. A month ago, interest rates were rising, commodity prices were up, and the stock market had recovered from the poor start in January. The talk among my investment friends was all about boosting allocation to stocks.

Now, a month later, the turmoil in the euro block has smacked the world markets, and the market mood has turned 180 degrees. Investors who shunned bond investments when the Treasury 10 year note was yielding 4% now think that Treasurys yielding 3.35% are a good deal.

Meanwhile, the news from corporate America (and Europe, for that matter) continues to improve. For example, one of my favorite analysts Ken Hoexter from Merrill Lynch posted this note about an analyst meeting yesterday at Union Pacific. Here's an excerpt:

Meeting upbeat...Vols, Pricing, Coal, Op leverage & Buyback
Yesterday, we hosted meetings with Union Pacific's management in Omaha, which had a bullish overtone, as volumes continue to surpass expectations, coal inventories are no longer outsized relative to daily burn levels (first time since 7/06), pure pricing is gaining strength through the year, its leverage could drive its operating ratio into the 60's (mgmt didn't commit, we're just doing the math), and it has launched a $2.4 billion stock buyback (or 32.6 million shares, 6% of total).

Volumes running more than 500 bps ahead of target
For the third quarter in a row, we increased our volume targets intra-quarter, as carloads are currently up 19% vs. our 13% target, according to AAR weekly carload data. We increased our 2Q10 target to 17% from 13% (comps bottomed during 2Q09). Our largest increases are at Industrial (+21% vs. our prior +13% target), Intermodal (+22% vs. +17%), and Coal (+6% vs. +3%). Additionally, management noted it anticipates a peak season for the first time in 3 years.

The longer term prospects for stocks continues to look favorable, despite the recent swoon. Focusing the fundamentals, and the data, rather than on "gut instinct" should serve all of us well.


New Retirees Often Make Poor Decisions

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Staying healthy may cost you in retirement Robert Powell - MarketWatch

Staying healthy may cost you in retirement Robert Powell - MarketWatch

Posted using ShareThis

Are Charity Fundraisers Spying on You?

My wife Christina has been involved in raising fund for various charities and nonprofits for years. She enjoys the work and the rewards that go with helping others.

In the last couple of years, as the stock markets have swooned, the call for people like Chris to help has grown, as the demand for services grows but the resources available shrink. Non-profits are turning to all sorts of new methods to try to find donors, including some methods that the new data mining techniques allow.

This article from Smart Money talks about some of the ways that nonprofits are using data gleaned from a variety of different sources to help nonprofits.


Are Charity Fundraisers Spying on You?

Merkel Protests Too Much: Are German Banks Short The Euro? – 24/7 Wall St.

There have been a surfeit of articles recently bashing Goldman Sachs for playing both sides of the fence when it comes to dealing with their clients.

For example, this morning's New York Times notes the unease that Washington Mutual management felt in their dealings with Goldman, believing that the Goldman traders were shorting WaMu stock at the same time Goldman was providing financial advice to the bank.

(Turns out that WaMu management was correct, by the way - Goldman made millions correctly betting on the eventual demise of the largest S&L in the United States).

Now it appears that Goldman is not the only financial institution which plays this game.

According to the blog 24/7, one of the reasons that German Chancellor Merkel imposed the short selling ban on certain euro debt instruments as well as selected financial institutions was to try to restrain the activities of some major German institutions:

But, the real reasons behind Merkel actions may be more complex and sinister. There is a great deal of evidence that some of Germany’s large banks have bet against both the euro and sovereign debt in the weakest nations in the region. If so, these banks, like other speculators, probably made billions of dollars on such deals.

Merkel may have to deal with the accusation, probably an accurate one, that Germany allowed its banks to take sides against the euro as the government helped drive its value down. How would it look if Germany then left the Eurozone and its banks became, under a set of circumstances helped by Merkel, rich in the process?

When I first heard about the short selling ban I was puzzled, since a unilateral ban on German transactions seems to make little sense in a global marketplace. If this story is true, however, the actions seem more logical.

Merkel Protests Too Much: Are German Banks Short The Euro? – 24/7 Wall St.

Europe’s Debt Crisis Casts a Shadow Over China - NYTimes.com

OK, fair warning: earlier this year I probably wrote too many posts on the threat of deflation and lower interest rates to the American investor.

I still think these are major issues, but now I am hung up on how to invest in the time of the Trials of the Euro Block.

So, if you visit my blog in the next few days, be warned that you're going to see a lot of articles on the euro - hopefully a few will be useful.

Yesterday's New York Times had a interesting article. While the fixation of most U.S. investors is on the euro/dollar relation - and what it might mean for business - the focus in Asia is elsewhere. And here's a key paragraph:

The steep rise of the renminbi prompted a Commerce Ministry official in Beijing to warn Monday that China’s exports could be threatened.

The official’s comments were the most explicit yet on the implications for China of Europe’s recent financial difficulties. The comments also suggest that even China — the world’s fastest-growing major economy and increasingly the engine of global growth — is not immune to the crisis that started in Greece and threatens to spread across much of Europe.

“The yuan has risen about 14.5 percent against the euro during the last four months, which will increase cost pressure for Chinese exporters and also have a negative impact on China’s exports to European countries,” Yao Jian, the ministry’s spokesman, said at a news conference in Beijing, according to news services, using another term for China’s currency.

Europe’s Debt Crisis Casts a Shadow Over China - NYTimes.com

Euro Zone Likes a Weaker Euro (Within Reason) - NYTimes.com

I continue to think that the recent turmoil in the euro block represents an opportunity to invest in quality European companies. That said, I might be earlier, particularly if the decline in the euro turns into a rout.

This morning's New York Times talks about how European business is benefiting from the euro weakness. Here's an excerpt:

To be sure, a big euro devaluation would be good for some of the countries that have the most serious problems. Besides alarming debt levels, countries like Greece, Spain and Portugal have allowed wages to rise faster than productivity, and now have trouble competing on world markets.

A depressed euro would make their products cheaper in foreign markets, and help restore competitiveness. A stronger dollar would also help tourism, which is an important industry in Mediterranean countries. Bookings from the United States at Silversea Cruises are up about 10 percent, said Manfredi Lefebvre d’Ovidio, deputy chairman of the cruise ship operator. But he attributes most of the gain to the improved American economy.

Euro Zone Likes a Weaker Euro (Within Reason) - NYTimes.com

Europe's fiscal Fascism brings British withdrawal ever closer

Excellent post today from Ambrose Evans-Pritchard in today's U.K. Telegraph.

The whole article is worth a read, but here's a key paragraph:

...Club Med governments have built up €7 trillion sovereign debt under the cover of monetary union, which shut down the warning signals for borrowers and creditors alike. We are now near – or beyond – the point of no return. Eurozone states must go along with this cynical entrapment, or risk economic catastrophe. The conspirators have succeeded. The €750bn shock and awe package agreed over the weekend clearly alters the character of the European Project, crossing the line towards an EU debt union and an EU Treasury. How long will it be now before the EU acquires direct tax-raising powers?


Europe's fiscal Fascism brings British withdrawal ever closer

Spain’s Core Inflation Turns Negative for First Time (Update3) - BusinessWeek

I've been talking about global deflationary trends for some time now, and I continue to think that deflation, not inflation, is what most investors should be worried about.

Although most observers shake their heads when they discuss inflation, the truth is that inflation is generally easier to handle than deflation. True, the purchasing power of your savings declines, but during inflationary periods interest rates move higher, pay packages go up, and debt burdens become more manageable.

Deflation, on the other hand, can be depressing - interest rates move to extremely low levels (see Japan) and the massive leverage that has built up in the system becomes very difficult to repay.

I believe that the turmoil in the euro block will lead to even more deflationary trends if the latest rescue package doesn't work. Today's evidence comes from Spain, which has 20% unemployment and huge fiscal debts. I suspect the Spanish government would welcome a little inflation but that's not what is happening:

Spain’s economy emerged from an almost two-year recession in the first quarter, even as unemployment rose to 20 percent. After the third-largest budget gap in the euro region prompted a surge in Spain’s borrowing costs, the government announced a 5 percent reduction in civil servants’ wages this week and said the measures could undermine the return to growth.

“It’s the start of a trend,” said Luigi Speranza, an economist at BNP Paribas in London who first forecast deflation in Spain more than a year ago. “It’s an adjustment mechanism, a way of gaining competitiveness.”

Spain’s Core Inflation Turns Negative for First Time (Update3) - BusinessWeek

The New Poor - The Economy Shifts, Leaving Some Behind - NYTimes.com

We all read a lot about a "jobless recovery", and this morning's New York Times carries an article about a woman's struggles to find work.

Here's an excerpt:

But there is reason to think restructuring may take a bigger toll this time around. The percentage of unemployed workers who were permanently let go has hovered at a record high of over 50 percent for several months.

Additionally, the unemployment numbers show a notable split in the labor pool, with most unemployed workers finding jobs after a relatively short period of time, but a sizable chunk of the labor force unable to find new work even after months or years of searching. This group — comprising generally older workers — has pulled up the average length of time that a current worker has been unemployed to a record high of 33 weeks as of April. The percentage of unemployed people who have been looking for jobs for more than six months is at 45.9 percent, the highest in at least six decades.

At their analysts' meeting yesterday IBM indicated that it believes it can earn $20 per share by 2015. While this would undoubtably be good news for shareholders (IBM is currently trading around $132 per share), it probably would not be good news if you worked at IBM, since they're probably going to make some of these earnings gains through layoffs.

In short, what is good news for Wall Street is not necessarily good news for society.


The New Poor - The Economy Shifts, Leaving Some Behind - NYTimes.com

Tell Your Gut to Please Shut Up - Michael Schrage - Harvard Business Review

A friend of mine named Bob Quinn first got me interested in behavioral finance. Bob is a portfolio manager, and is in the process of getting an advanced degree on the subject from Harvard.

In my business, people tend to rely on their instincts far more than they should. We all get emotional, and make decisions based on what we're feeling at the moment. While this is not a bad thing in some situations, "gut" decisions can be pretty expensive in the investment world.

I saw this post today from the Harvard Business Review which I thought was pretty good. Here's a key passage:

Daniel Kahneman and Philip Tetlock, among many others, have conclusively demonstrated that experts tend to be remarkably overconfident about their abilities to make accurate predictions or quickly solve problems. Ironic, isn't it? The entire field of behavioral economics has been built on the intensifying recognition that people, particularly smart ones, are suckers for cognitive illusions and heuristic biases that pretty much guarantee that "gut-trusting" will, on average, yield heart burn. Dan Ariely didn't call his best-selling book "Predictably Irrational" because instant intuition was a recipe for success. It's not just that high IQ types mistakenly over-rely on their gut instincts; it's that they make the same mistakes over and over again. They're overconfident about their ability to manage their overconfidence. That's beyond ironic; it's perverse.


Tell Your Gut to Please Shut Up - Michael Schrage - Harvard Business Review

Time to Buy More Global Stocks?

About 18 months ago, the Fed unleashed massive amounts of liquidity into the system, which set the stage for a huge stock market recovery.

It seems very possible that the ECB's actions over the weekend might have the same effect. Here's a post on the subject from the blog Clusterstock:

Tax bills in 2009 at lowest level since 1950 - USATODAY.com

This article appeared yesterday in USA Today. However, when I mentioned the data to some of my colleagues this AM, no one believed it:

Amid complaints about high taxes and calls for a smaller government, Americans paid their lowest level of taxes last year since Harry Truman's presidency, a USA TODAY analysis of federal data found..

Some conservative political movements such as the "Tea Party" have criticized federal spending as being out of control. While spending is up, taxes have fallen to exceptionally low levels.

Federal, state and local taxes — including income, property, sales and other taxes — consumed 9.2% of all personal income in 2009, the lowest rate since 1950, the Bureau of Economic Analysis reports. That rate is far below the historic average of 12% for the last half-century. The overall tax burden hit bottom in December at 8.8.% of income before rising slightly in the first three months of 2010.

Tax bills in 2009 at lowest level since 1950 - USATODAY.com

Welcome to the Inflation Zone: The Dangers of the Euro Bailout - SPIEGEL ONLINE - News - International

More on the European bailout.

The key player in all of this, of course, is Germany. And from what I can tell - and what recent local elections have indicated - the average German citizen is less than thrilled with the role they are being forced to play in bailing out Southern Europe.

Modern Germany has always had a focus on fiscal probity and a strong currency. I can well remember Helmut Schmidt in the late 1970's lecturing Jimmy Carter about US economic policy, when we were experiencing a plummenting dollar and double-digit inflation rates.

The famous announcement (well, famous to me at least) that then-Fed Chairman Paul Volcker made in October 1979 that the Fed would be targeting money supply rather than interest rates was made in direct response to huge pressures by the Germans.

One of the reasons that Germany has always focused on inflation was due to the horrific experience the country had with hyperinflation in the 1920's. The onerous reparations that the victorious Allies had forced on the country in the aftermath of World War I lead the country to print money to try to repay debt burdens it could not possibly bear. When the inevitable economic collapse came, it eventually gave rise to Hitler and World War II.

In any event, it is probably not surprising that the German reaction to the European Union's proposal was to fixate on the possibility of inflation. This article appeared today in the on-line version of Der Spiegel, a German business magazine. Here's the key passage:

The sell-off on the markets was no attack by speculators. It was a vote of no confidence by investors in the euro and in the Europeans' crisis management. But when everyone rushes to the exit at the same time, panic spreads. That was the situation on Friday. The politicians feared the markets' reactions -- and they began to panic. In response, they approved a rescue plan that will go down in economic history. It is, after all, unique.

And uniquely dangerous. The Europeans and the International Monetary Fund want to make €750 billion available to shore up foundering euro-zone states if they find themselves in a financial emergency. They don't seem to be bothered by the fact that the EU treaties don't contain provisions for such aid. Indeed, they had already ignored the no-bailout clause in the Maastricht Treaty when they agreed to rescue Greece.

But that wasn't enough for the rescuers of the euro -- they wanted to send a message that they were truly serious. So they sacrificed the independence of the European Central Bank (ECB) -- and paved the way for a European Inflation Union.

Welcome to the Inflation Zone: The Dangers of the Euro Bailout - SPIEGEL ONLINE - News - International

Europe’s Free Lunch? - The Source - WSJ

I'm trying to sort out the longer term implications of the moves by the European Union (helped by the Fed) last night. These actions - a nearly $1 trillion package of loan guarantees, government debt purchases and direct loans to Greece - were meant to calm the continuing euro crisis.

The markets today are roaring ahead, so the plans so far seem to be well-received.

My preliminary thought is that all of this sounds very much like the plans that the quantitative easing policies that the Fed and the Treasury put together in the fall of 2008.

Our government's actions seemed to have worked: US economic data continues to show signs of improvement, and now most of the official discussion in Washington seems to revolve around when some of the liquidity should begin to be removed from the capital markets.

The question that I have revolves around whether the euro block - a group of independent countries bound together for the sake of mutual economic benefit - will be able to work together like a single country, like the United States.

The euro works, it seems to me, so long as the majority of countries benefit. Once the costs of maintaining the euro become too great, however, the whole concept become endangered.

As I read the press, it appears that the ordinary European is far from convinced that the euro zone is worth bearing huge economic burdens. There is of course the rioting in Greece, with three bankers killed. Then there was the huge losses that German Chancellor Merkel's party suffered over the weekend in regional elections. French President Sarkozy's popularity rests at all-time lows. And while Britain is not part of the euro block, the incumbent Gordon Brown was crushed in U.K. elections, and resigned today due to widespread dissatisfaction with the Labor Party's economic policies.

I came across this note today from in a blog from the Wall Street Journal. The full link is below, but here's a key paragraph:

...In order to ensure quantitative easing doesn’t trigger rampant consumer price growth, {Germany} will make every effort to enforce austerity across Greece, Spain and Portugal. Governments will be made to stick to their promises of fiscal probity, of tax hikes and spending cuts, come what may. This, in turn, will drive peripheral Europe into depression and deflation. Their debt loads will remain as onerous as they’ve ever been, but they also won’t have much in the way of growth.

For these countries, this free lunch won’t seem free and it won’t have felt like lunch either. Germans will come to be seen as mercantilists, benefiting at the expense of their European partners. The euro will be seen as a straight jacket for them, boosting German exports but keeping peripheral Europeans in permanent recession.

Europe’s Free Lunch? - The Source - WSJ

The Way We Live Now - Students of the Great Recession - NYTimes.com

I found this article in yesterday's New York Times surprising, although not necessarily in a good way. Here's the key paragraph:

Over the last few decades, the number of teenagers who enroll in college has actually been rising fairly steadily. But graduation rates have fallen. Less than a third of all students who enroll in community colleges with the intention of getting a two-year degree — a degree leading to jobs in nursing, auto repair, preschool education — ever do so at any college, statistics suggest. The United States still leads the world in getting students to start college, notes Lawrence Katz, co-author of a recent history of education. But we no longer lead in what really matters: educational attainment.

Since I think that most of us would agree that in an "information age" getting a good education can play a crucial role in one's future, what does this trend mean?

The Way We Live Now - Students of the Great Recession - NYTimes.com

Comments on Credit: Will The Circle Be Unbroken? - Outlook Web Access Light

I thought this summary from Robert DiClemente at Citigroup was a very good description of where we stand now at the end of a tough week in the stock market (I have added the highlights):

• Renewed risk aversion and eroding liquidity in money and capital markets stemming from events in Europe pose new threats to financial stability necessary for continued U.S. economic recovery.

• Heading into this storm, financial conditions were vastly improved, including signs of a further thawing in tight bank credit.

• Solid private sector payroll gains in recent months reveal a key element of self-sustaining recovery and represent an important milestone for Fed policymakers. A traditional sequence of rising productivity, profits and job growth is poised to bolster overall income gains.
  
  
• Plummeting Treasury bond yields suggest that one possible channel of contagion from sovereign debt woes is not operative in the U.S. case and in fact may help buffer some of the drag from a rising dollar.
  
  
• Nonetheless, the deterioration in financial markets, if not arrested, would signal a return to subpar growth that could shelve indefinitely further unwinding of extraordinary monetary policy accommodation.

I would add a few points.

First, the economy is continuing to show signs of economic recovery. Today's jobs report of 290,000 new jobs is another data point confirming this trend.

Second, there is no doubt that the credit markets are spooked by what is going on in the euro block. I don't know what the solution is, but I suspect the end game will probably involve at least Greece dropping out of the euro block.

Finally, I think all of this is very deflationary. I think we will begin to see "beggar thy neighbor" policies adopted by governments desperate for job growth and tax revenue. The dollar will likely strengthen in this scenario, and could actually help our capital markets.

High quality stocks and bonds should continue to be favored.

Comments on Credit: Will The Circle Be Unbroken? - Outlook Web Access Light

Longtime Tigers Broadcaster Harwell Dead at 92 - WSJ.com

Even though I have lived in the Boston area for many years - and am now officially a Red Sox fan - I grew up in the Midwest, rooting for the Detroit Tigers. And the voice of the Tigers was Ernie Harwell.

In the days before cable TV, sports on television happened only occasionally, usually on the weekends. If you wanted to follow your favorite team, then, you did it on radio, following the action and cheering for your heroes as the announcer described the action.

Ernie Harwell was, in my opinion, one of the best broadcasters who ever lived. His voice filled my summer days and nights with vivid yet relaxed descriptions of the Tigers. Even when the Tigers were on television, we usually turned down the sound and turned up the radio to hear Ernie.

I was sad to hear that Ernie Harwell had died recently. Reading his obituary this morning brought back a lot of great memories, so I thought I would share this article with you.

Longtime Tigers Broadcaster Harwell Dead at 92 - WSJ.com

As Britain Goes to Polls, Economic Clouds Hover - NYTimes.com

Today is election day in Britain. The campaign has been hard-fought, and while it appears that the Conservative Party's David Cameron will win, it is not clear that any party will have a clear majority in Parliament.

The stakes are high - Britain faces a huge fiscal crisis, and the choices are going to be unpopular. Here's the key paragraph from the piece in this morning's New York Times:

One man who knows more than most about the scale of the problem is Mervyn King, governor of the Bank of England, Britain’s central bank. David Hale, a Chicago-based economist, said last week that Mr. King had told him that “whoever wins will be out of power for a whole generation because of how tough the fiscal austerity will have to be.” Mr. Hale, speaking on Australian television, met in off-the-record sessions with Lord King in London in March, according to a bank spokesmen, who did not deny the accuracy of the American’s account.

Our housing bubble was similar to the U.K. experience, and the fiscal problems we face today are also similar. Here's hoping we can move faster than the British, and address some of the issues sooner.

As Britain Goes to Polls, Economic Clouds Hover - NYTimes.com

Catching a Falling Knife?

As I'm sure you have been reading in the last few days, the oil spill in the Gulf continues to vex both the companies involved as well as government officials.

We spent a considerable amount of time this morning at our regular Wednesday Investment Policy Committee (IPC) meeting talking about the companies involved. Specifically, a number of our clients hold significant positions in both BP and Transocean (ticker: RIG), which are the companies most affected.

While I can't say that we came to any consensus, most of us agreed that the stocks remain good long term positions. In particular, BP pays a very healthy dividend (6.6% yield) and now sports a P/E of around 8x trailing 12 months earnings. It seems like a safe bet, then, that both companies will emerge from this disaster with their reputations tainted but their financials largely intact.

That said, the question then becomes: Should we be buyers of BP and RIG?

Here again there was no consensus, but I'll give you my opinion.

One of the lessons that we have learned from the last decade of stock investing was that it usually makes sense to be patient when investing in stocks that have declined precipitately, which is certainly the case for both stocks (BP has declined by -15% since the rig explosion on April 20, while RIG has dropped -21%). True, the market might be overreacting, but what do we really know at this point?:

• The oil continues to gush out at 5x the rate that officials originally forecast, with no end in sight;
• While the current legal liability for offshore drilling is capped at $75 million, legislation was just introduced to raise this limit to $10 billion - and the bill would include the current crisis;
• There is growing frustration voiced by political figures from the President on down as to the appropriateness of the response by the companies involved.
  

In other words, on a purely financial level, you can say this is the time to back up the truck on both stocks, yet it seems to me that the huge uncertainties surrounding the situation urge caution.

When the tech stock bubble first began to burst, investors tried to argue with the stock market, believing the future was brighter than market reaction would suggest. However, in retrospect it seems that the collective wisdom of the market was often correct after all, and that investors who bought positions in good companies whose stocks were in freefall were way too early.

And so I feel this is where we are today on these stocks. For accounts that hold the stocks (and probably have pretty big gains, even after the recent swoon), I don't see any reason to sell. However, I also believe that buying stocks that are dropping like falling knives is a dangerous way to invest, and so I believe in being wary at this point.

Dealbook Column - From Buffett, Thought-Out Support for Goldman - NYTimes.com

Last week I wrote a piece about "Learning the Boring Stuff". I basically said that there have been numerous situations where people who took the time to actually study and understand complex documents like prospectuses and legislation seem to have an uncanny ability to succeed.

Apparently Warren Buffett said something similar last weekend at the Berkshire Hathaway annual meeting:

To {Buffett}, investors should make their investment decisions based on the quality of the securities, not on who helped put them together or who else was betting for or against them. He suggested those factors were irrelevant.

“I don’t care if John Paulson is shorting these bonds. I’m going to have no worries that he has superior knowledge,” he said, adding: “It’s our job to assess the credit.” The assets are the assets. The math either works or it doesn’t.

And then further in today's article:

Mr. Buffett, who has always approached investing as a dispassionate exercise based on his reading of the numbers, said IKB and ACA had all the relevant facts that any investor would need. They were able to see all the mortgages, which were referenced in full, and yet they made what turned out to be a very bad bet.

“It’s a little hard for me to get terribly sympathetic,” he said. When he makes his investments for Berkshire, he said, “we are in the business of making our own decisions. They do not owe us a divulgence of their position.”

To me, most of these major investment firms have large staffs of research people whose job it is to do independent research and study the deals that their firms are investing in. If they simply relied on the rating agencies, or the smooth talk of a Goldman salesman, whose fault is that?


Dealbook Column - From Buffett, Thought-Out Support for Goldman - NYTimes.com

BP Says Crews Make Progress Stemming Oil Leaks - NYTimes.com

At this writing there seems to be at least a glimmer of good news from the Gulf of Mexico - let's hope it continues.

In this morning's New York Times there was a long article about the disaster. For investors,there is a key paragraph for investors towards the end of this article that may not get much attention:

He (President Obama) stopped to speak to several fishermen, assuring them that BP would reimburse them for lost earnings. But reimbursement may be one of the largest battles to come, given that federal law sets a limit of $75 million on BP’s liability for damages, apart from the cleanup costs.

“It’s going to be extremely tricky” to reimburse fishermen and others if economic damages tally above $75 million, said Stuart Smith, a New Orleans-based lawyer who is pushing for Congressional action to amend the law. “They may not be obligated to pay more than that unless they agree to do it.”

There is a federal fund, generated from a tax on oil, that may cover as much as $1 billion in damages.

Now, if this is true, this means that the financial liability to BP is not nearly as great as the stock market drop would indicate.

In the last few days, since the news of the explosion hit the press, the market cap loss of BP stock has been over $25 billion. However, if the legal liability is $75 million, and the clean-up costs are running at $6 million a day or so (at least what I have read), then the market must be anticipating a significant change in the law.

And while that might happen, it was only last month that the President reaffirmed his administration's commitment to offshore drilling. If the President and/or Congress were to try to overturn the cap, what would this mean for future exploration activities? And would the Republicans really allow this to happen (remember "Drill, Baby, Drill" at the 2008 Republican convention?).

When the Valdez sunk off the coast of Alaska in 1989, Exxon was embroiled in countless lawsuits and legal actions for years. However, if memory serves, they did not start paying until 2005, and the total cost was less than $5 billion - not a big issue for Exxon.

Finally, BP earned more than $5.6 billion in the first quarter of 2010, up 119% from the same quarter in 2009. If the total cost of the GOM debacle runs around $300 to $500 million, it will only hit full year earnings by around 2%.

This is not to diminish the scope of this problem. BP (and Transocean, which was actually running the rig) has taken a huge hit to their reputation - deserved so, in my opinion. However, I would guess that the stock market has overreacted, and the chance to buy one of the major multinational oil companies with a 6.5% dividend yield and a P/E less than 8x will probably be eventually viewed as a buying opportunity.

BP Says Crews Make Progress Stemming Oil Leaks - NYTimes.com