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Christopher Mahoney
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I spent eight years at Bank of America in New York (1978-86) covering Wall Street, then moved to Moody's Investors Service where I worked for 22 years, covering banks, sovereigns and corporates. I chaired the Credit Policy Committee for four years. I retired in 2007 as vice chairman. PLEASE... More
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Capitalism and Freeedom
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  • The Outlook: Continued Stagnation

    Investment thesis: The markets will continue to reflect economic stagnation until the Fed takes effective steps to meet its mandates. Bond prices should be supported, while earnings growth will moderate further. However, strong corporate buybacks support current equity valuations.

    Readers may recall that last month the third quarter real growth number was raised to 4.1%, which is quite high. Market economists and pundits believed this number, and said that it signaled an accelerating recovery. You may also recall that I said at the time that the revised third quarter number was a meaningless blip, and that the outlook for growth and employment remained bleak.

    Well, the December employment data support my negative view (not that one month of data is in any way conclusive). Nonfarm payrolls rose by only 74,000 in December, the smallest increase in three years and far short of the growth that economists had predicted: the median forecast of 90 economists called for an increase of 197,000. The labor force participation rate fell to 62.8%, its lowest level since the Carter administration. The broader U-6 unemployment rate remained unchanged at 13.1%, about double what it should be at this stage of a recovery, and much higher than the peak level of prior recessions. We are looking at a weak, stagnant economy.

    The lead steers in the market and the media just don't spend enough time looking at the data. They seem to be overly headline-sensitive, and to lack a coherent model of the economy. Once the lemmings pick up the mantra of a "stronger recovery", they won't let the data stand in their way:

    "If there ever there was a curveball, this was it," said Marcus Bullus, trading director at MB Capital in London. "These limp numbers are as puzzling as they are surprising."
    Not to readers of this blog.

    The pundits recommend that we ignore the December data, either because it was cold in December*, or because, as CNBC says: "Anyone reading the Labor Department report can see that the focus is on the trend, and according to the Labor Department and other general economic observations, the trend is still favorable". Convinced?

    I hope it didn't come as too big of a shock to the economists at DoL that it was cold in December. Are they aware that it could be cold in January and February too? They can improve their forecasts by consulting the Farmer's Almanac.

    It has been said that the best prediction of a future datapoint is that number today, and that you need a coherent rationale to predict otherwise: the future will resemble the past, ceteris paribus. When I look at the macro dashboard, what I see is stagnation at a low level, with a flat or downward trendline. Money growth is declining, as is velocity; inflation is declining; nominal and real growth are flat at low levels; the overall employment picture is recessionary; fiscal policy is contracting.

    I scratch my head when I read that "the trend is still favorable". To what data are they referring? My data just aren't going that way.

    What does this mean for the new Fed chairman, Ms. Yellen? It means that the burden will fall heavily on her to spur the Fed to adopt more effective policies. I can't imagine that her to-do list says "Continue current ineffective policies in order to miss both statutory mandates and further erode the Fed's credibility".

    It may be a bit impolite to unearth a "discredited" and "outdated" economic theory, but the old Phillips Curve still explains a lot of the current economic phenomena: there is a trade-off between inflation and unemployment. The Fed has elected to choose "low inflation and high unemployment". The unemployed are standing guard to ensure that we don't experience 2% hyperinflation. The Fed needs to select "higher inflation and lower unemployment", just as it was forced to do in 1933 and 2008-09.

    Investment Conclusion

    My 2014 forecasts** assumed that the newly-energized Yellen Fed would meet its mandates this year. But nothing has been done on that score yet; it's a prediction not an observation. For now, the outlook is for continued stagnation and stable bond and stock prices (until Yellen can change policy).

    If you don't buy my "Yellen wins" scenario, then you should expect falling bond yields and some negative earnings surprises. With NGDP growing at around 3%, the outlook for topline growth is modest, and post-recession productivity gains are almost exhausted. Supporting stock prices is strong free cashflow funding continued buybacks--instead of wealth-destroying M&A. Animal spirits in the boardroom are always bad for stockholders--even in Omaha.

    That is why I am still moderately bullish.

    _________________________________________________________

    *"The Labor Department data included signs that the hiring slowdown was at least partly due to colder-than-usual weather last month, a factor that suggests the December reading isn't necessarily the beginning of new downward trend." (WSJ)

    ** "My 2014 Predictions: Still Bullish", Seeking Alpha, 3 Jan. 2014.

    Jan 15 2:28 PM | Link | Comment!
  • The Taper: Monetary Nonfeasance

    The Fed's long-awaited taper has finally begun.

     

    Having added $1 trillion to its assets in 2013, and having failed to achieve either of its statutory mandates, the Fed has decided to reduce purchases while predicting eventual victory: "The Committee expects that, with appropriate policy accommodation, economic growth will pick up from its recent pace and the unemployment rate will gradually decline toward levels the Committee judges consistent with its dual mandate." Not tomorrow, but someday.

    And what about deflation risk, Bernanke's personal bete noir? "The Committee recognizes that inflation persistently below its 2 percent objective could pose risks to economic performance, and it is monitoring inflation developments carefully for evidence that inflation will move back toward its objective over the medium term." "Monitoring" will prevent deflation; that's a new policy tool. Bernanke said today that "inflation can't be picked up and moved where you want it." This from the man who said that a central bank could always create inflation using the printing press.

    It is noteworthy that, unlike Draghi who talks through all of the data including money growth, Bernanke does not. This saves him from having to explain why he has no control over money growth. Instead he repeats the line that the Fed is providing a "highly accommodative stance of monetary policy". Which is actually not true, when we are looking at 6% money growth, 1% inflation and 3% nominal growth. That is not a highly accommodative stance.

    In point of fact, the Fed has been tightening for the past two years, with M2 growth falling from 10.5% to 6.0%, inflation falling from 2.0% to 1.1%, and nominal growth from 5% to 3% (YoY). QE3 has had no impact on money growth. At present, using its current policy instruments, the Fed has no control over the independent variables in the Quantity Theory: the money supply and velocity. This is why nominal GDP has been sliding sideways.

    Where is Chairman-to-be Janet Yellen in all this? We don't know. Bernanke says that she is on board with tapering, although I doubt it. I think that she is keeping a low profile until she takes the helm. Then we will find out what she really thinks.

    I hope that Obama nominates Stanley Fischer* as vice chair, which would add a lot of heft to a weak team, and might add some firepower to the doves. He's a monetarist, not an Austrian. At MIT, he was the thesis adviser for Ben Bernanke, Mario Draghi, and Greg Mankiw. You can't beat that!

    ____________________________________

    *Who would be the first African native to sit on the FOMC.

     

    Dec 18 10:52 PM | Link | Comment!
  • Why China Behaves So Badly

    Western observers say that China's behavior is "puzzling", and that its policy goals are "enigmatic". In fact, China's behavior is neither puzzling nor enigmatic; its behavior is shrewd, pragmatic and realist. China's internal and external behavior can be explained once one grasps that China is a rational actor operating under enormous economic pressure.

    Below are some of China's sins against the "international community":

    >UN obstructionism on many important matters such as nuclear proliferation;

    >Jingoist, xenophobic ideology at home and abroad;

    >Pursuit of regional hegemony, bullying regional neighbors;
    >Support for the evil Kim regime and its multitude of international provocations;

    >Militarism, military buildup, military threats;

    >Authoritarian domestic policy;

    >Abysmal human rights record: Tibet, Uighurs, Falun Gong, prison factories, etc.

    >Currency manipulation;

    >Threats to stop buying US Treasuries and to dump the dollar;

    >Unfair trade policies, mercantilism, flouting of WTO;
    >Massive intellectual theft.

    All of this behavior can be explained.

    China was a filthy dirt-poor agricultural nation of half-starved peasants when Chairman Mao died in 1976. Looking at China's weak position in the world at that time, Deng Xiaoping made the decision that a poor China could not be a strong China. Under Deng's leadership, the CCP launched a program of export-led industrialization which has continued uninterrupted to this day. Like Japan's a century earlier, China's modernization proceeded at a rapid pace. Starting with modest experiments in Guangdong and Shanghai, China quickly built an industrial economy that is now the second largest in the world, and will soon be the the largest. The success of Deng's plan has been nothing short of amazing.

    The CCP's plan then and now was to free China's one billion peasants from the poverty of low-productivity agriculture, and to channel this bottomless reservoir of low-cost labor into manufacturing. The overarching challenge is to match the constant inflow of low-skilled peasants from the west with the creation of new manufacturing jobs in the east. This is no small task: it requires rapid real growth year in and year out, and massive infrastructure investment. As the model is export-led and focused on manufacturing, it requires ever-higher manufactured exports. And therein lies the world's "China Problem".

    China's manufacturing potential is so huge that within a few decades its output could exceed that of the the rest of the world combined. The world's central problem is that China is simply too big to be neatly inserted into global trading system. When countries like Guatemala or Bangladesh seek to grow exports, they can do so without affecting markets or hurting competitors. By contrast, China at its full potential is a Panzer tank at Tiffany's. For China to succeed in implementing its development plan, it will have to destroy the world. China's national development strategy compels it to wreck everyone else's manufacturing economy. This is economic warfare, with Chinese characteristics.

    China has succeeded in massive export growth without currency appreciation by an idiosyncratic set of economic policies. China has ignored virtually all of the self-serving economic precepts of the West, which prescribe open capital accounts, elimination of currency controls, and freely-floating exchange rates. It was this suicidal advice that caused the East Asian financial crisis of 1997-98, which China survived unscathed.

    China's more prudent policy has been to: maintain very large external reserves; impose capital and exchange controls; peg its currency to the (weak) dollar; and mop up currency inflows and park them in the reserve account. No manufactured imports, thank you, just exports and an ever-greater reserve mountain. This unorthodox policy has enabled one of the greatest growth stories in modern economic history.

    So, an American will scratch his head and ask: Why does the US allow China to undersell its manufacturing sector, and to capture entire markets? How can the US permit the price of its unskilled labor to be globalized? What are American high school graduates supposed to do for a living? Why doesn't the US impose punitive tariffs as punishment for China's mercantilist policies? The answer to these questions is that China has used a variety of geopolitical maneuvers to keep the West off-balance and confused.

    China simply cannot allow the West to focus its attention on China's trade policies. She must do whatever it takes to distract, confuse and otherwise change the subject. China has a myriad of geopolitical levers at her command to divert the world's attention. (which I have listed above).

    The more trouble China creates, the more the West is distracted. When Joe Biden flies to Beijing to talk about trade, China declares an air defense zone in the East China Sea. What does Biden end up talking about? The air defense zone; trade policy is forgotten. The ADIZ crisis was manufactured to prevent trade negotiations.

    China explains its international behavior as anti-hegemonist, but that is a smokescreen for self-interest. China doesn't care very much about peripheral things like Sudan, Iran or the Middle East; what she cares about is international leverage. When western leaders huddle to discuss the latest crisis, what do they usually end up talking about? How to get China to cooperate with the "international community". The inevitable upshot: someone flies to Beijing to beg for China's help. The small price to pay for China's "help": ignore China's trade surplus.

    The EU wants to talk about non-tariff trade barriers? China arrests some hapless poet, which changes the subject. Other available "negotiating" tools: launch a new weapon; stake a new territorial claim; foment anti-Japanese protests; have North Korea shoot a rocket over Japan, or shell a South Korean fishing village. China explains much of its antisocial behavior as a response to domestic "public opinion"--which she manipulates at will. Chinese nationalist fervor serves the state, discourages dissent, and prompts Western "concern": providing yet another reason not to press too hard on trade. North Korea is just an extension of this policy by proxy.

    China pursues a policy of provocation, poking at the rest of the world, particularly the US Congress. Do you want to prevent Iran from going nuclear? Do you want peace in the East China Sea? Do you want to have influence over the Kim Dynasty? Do you want internet freedom? Do you want a free Tibet? Do you want to sell your country's products in China? Then you must go to Beijing and beg. Begging is your only leverage; pleading is your only strategy.

    I offer above an explanation for China's bad behavior. I can also suggest a solution: impose tariffs on Chinese exports. If China retaliates by selling dollars and Treasuries, she will have done exactly what we desire: America needs a stronger yuan, a weaker dollar, and a revived manufacturing sector to employ our unskilled labor. As a society, we cannot allow the price of our unskilled and semiskilled labor to be globalized. (Raising the minimum wage only makes China more competitive.)

    Another benefit to "fair trade with China" is that, by wielding a big stick (tariffs) and playing the international bad boy, America regains geostrategic leverage beyond trade policy. All of a sudden, the Politburo would have to worry about America's behavior. Problems such as North Korea would become more tractable.

    But what about America's treaty obligations under WTO? A "fair trade" policy involves what is known as "national treatment": we will trade with you as you trade with us. To confront China's realpolitik, the US needs to start thinking and acting like a normal country which protects its own interests and makes no pretensions otherwise.

    Dec 16 7:49 PM | Link | Comment!
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