Thursday, October 20, 2011

Federal Reserve Capital Management

Is the Federal Reserve essentially a giant hedge fund? Can it fail?

Check out this new essay (Click Here), which explores the Fed's role within the context of financial stability/instability in markets. Included are primers on endogenous money and chaos theory vs. neoclassical models in quantitative finance.

Monday, October 10, 2011

Private Domestic Investment and Real Economic Growth: Why the Dearth?

RealGDP Jun 11

RealPrivInvest Jun 11

Those connected with econometric data are all too aware of the first chart. Less attention and focus goes to the components of real gross domestic product (GDP) and their trends, particularly private domestic investment (PDI), which historically leads to real economic growth and job creation. The correlation for this comes from looking at the change in real GDP, which responds to changes in PDI [1].

The historical trend for PDI has been relatively weak and muted, despite its multiplier effects on real growth and jobs. The period of the greatest compounded annual growth rate (CAGR) in PDI since 1947 occurred from June 1992 to June 2000 (9.3%; $985B to $2.01T). At the same time, growth in government expenditures was relatively flat (1.4%). Speaking to our trade deficit crisis, net exports (exports-imports) increased negatively at a CAGR of -36.6% (-$36B to -$439B). Personal consumption grew steadily (4.2%) with real GDP growth (4.0%), confirming the moniker "consumer-driven economy."

Since the "prolific" 1992-2000 period, the trend has reversed on PDI. From June 2000 to June 2011, PDI shrank with a negative CAGR of -1.1%, and the current value is stuck at around 2001 levels. While it is true that real GDP and the components kept growing until the 2006-7 pop in the mortgage bubble, PDI has not robustly recovered since the 2008 plunge. A large contributor came from the plunge in residential fixed investment, which we may classify as synonymous with personal consumption, given the hefty progression of homebuyers and speculators that took on mortgage debt and refinancings to finance further consumption. But what about nonresidential fixed investment? Why is it not showing healthy robust growth? Embarrassingly, government expenditures have outpaced at a 1.6% CAGR, and real GDP and employment remain flat to down.

What are the plausible causes of the dearth in PDI, specifically the contributions coming from nonresidential fixed investment? I provide a list below, which is by no means complete:

  • Government regulations are too many, too costly, without justifiable cost benefits
    • EPA, Labor Dept (employment regulations), Sarbanes-Oxley, Dodd-Frank, ...
  • Monetary and tax policies support/induce consumption/speculation, not investment (nonresidential PDI) that leads to solid job creation
    • Zero interest rate policy (ZIRP) and quantitative easing (QE) induce speculation and malinvestment, distorting risk-reward
    • Significant overseas profits remain unavailable for domestic investment due to punitive corporate tax policy
    • Tax code growth has coincided with providing vote-buying tax subsides linked to consumption; increasing complexity and uncertainty in the code represent a fundamental drag on business growth
  • Government expenditures crowd out PDI, and may have as damaging an effect in the future as mortgage debt consumption did in the recent past
    • Government stimuli (including subsides), social "entitlements" and welfare ($9T+ marketable Treasury debt, $5T+ non-marketable debt, $100T+ off-balance-sheet liabilities)
    • False safety in Treasuries and the sovereign credit rating

The bottom line is that unless we address the inhibitors to PDI, specifically nonresidential fixed investment, we risk stagnant growth (or worse) for the foreseeable future.

[1] The charts showing the correlated trend between real GDP and PDI, and total non-farm payroll and real GDP, are shown below:

ChangeRealGDP Jun 11

ChangeRealGDPvsPDI Jun 11ChangeNFPayrollvsRealGDP Jun 11

Tuesday, October 4, 2011

Credit Market Redux, Copper and China

TED Oct4 11 1yrMarkit iTraxx Europe Oct4 11

Markit CDX Oct4 11

Markit iTraxx Asia Oct4 11

China 5yr CDS Oct4 11

FCX Oct4 11VWO Oct4 11

GLD Oct4 11XOM Oct4 11

The credit markets are rumbling again, as measured by the TED (LIBOR-OIS) spread and widening credit default swap (CDS) spreads. Though the latter have been intensely worse for European debt indices over the last 3-4 months from the play-out over Greece and faltering European banks holding PIIGS sovereign debt, increasing spreads are seen across global CDS indices (Europe, NA, Asia - see Markit curves above), a potential precursor to a global slowdown.

In the initial throes of the credit market induced selloff in October 2008, certain asset classes sold off quickly with sharp declines: Emerging Market (EM) equities and debt, commodities (especially copper, gold and oil). During the month of September 2011, we've seen a similar sharp selloff in these asset classes, minus commensurate participation from oil (so far). The declines in copper have come with speculation that China and other major copper holders are dumping copper onto the open market, creating selling pressure, in anticipation of a slowdown in Chinese housing and manufacturing growth.

If these selloffs are a true reflection of a coming global slowdown, then we may anticipate lower lows in copper (a futures curve asymptote to $2 and the equity proxy FCX below $20) as well as EM equities (VWO proxy $20 range). Though oil has not participated for a variety of reasons, it too could follow, leading to sharp declines in the majors and the commodity. Gold may be the exception again this time — it reached a relative low October 24, 2008, and rebounded from there, never looking back.

The flip side is that what we are seeing is a head fake, created by selling pressure from hedging activity.

The question then becomes: what are the catalysts to sharp market reversals to the upside with a sustained rise? European debt restructuring is a foregone conclusion, and may not lead to significant sustenance, given the debt levels involved and the uncertainty and disorder within the EU in general. Another quantitative easing binge by monetary authorities may give a lift, but as we've seen, the result leads to an uptick in commodity inflation mixed with stale real growth, while promoting continued debt accumulation and preventing debt deleveraging. Negative real interest rates and economic uncertainty from regulatory, tax and fiscal policies are hampering private investment.

Given this outlook, continued volatility is the most likely outcome. Hiding out in the Treasury and muni markets may not be a panacea, given the negative real returns and the latent risks. As commodities, equity majors and proxies reach lower lows, their attractiveness to acquire and hold rises, given the probability of continued inflation growth. Disinflation from debt deleveraging (while it is allowed to occur!) provides significant opportunities.