Thursday, December 30, 2010

Long Term Forecasts: Often Wrong, Never in Doubt

Think back to the middle years of the "Japanese Economic Miracle." American consumers were buying Japanese-made cars by the millions, first made in Japan, then made in Fremont and Marysville. Japanese banks were getting into equity research and investment banking. Japanese companies were buying trophy American real estate, like Rockefeller Center. We were all going to work for Japan, Inc. That forecast was outrun by reality.

The Japanese auto industry made its mark, and it made some smart moves by taking minority stakes in future manufacturing leaders like Hyundai. Eventually, however, companies like Toyota got too big and lost their way. They are entering the inevitable adjustment period. Japanese investment banks lost hundreds of millions of dollars, and they never took their places at the table of the Wall Street elite. Much of the real estate was bought at the absolute top of the market, and the buyers got whipsawed into selling near the bottom. Global economics and currencies forced adjustments that destroyed any myths about Japan, Inc. Political, social and demographic issues, forgotten by most quantitative forecasters, led to a Lost Decade.

Fast forward to the current forecasts about the Chinese economic juggernaut. The capitalist enterprise in China is growing up in a Wild West atmosphere, unfettered by economic, financial, legal or environmental regulation. Our western gold rush eventually turned into fools gold. We see occasional reports about homeless Chinese construction workers building Olympic venues, major health and pollution problems in the countryside, a forgotten prison population, and a central government that blithely believes it will forever keep the genie of political and social change in the lamp.

Martin Feldstein, not usually optimistic about economic trends, writes about self-corrective, economic mechanisms at work in adjusting the global savings-investment imbalance. He believes that we will see an increase in both U.S. private and government savings, the latter being driven by increased fiscal responsibility in future budgets. Feldstein also sees rising Chinese consumption, both public and private, driven by both income effects and by a real appreciation of the renminbi, which he estimates is already rising at a nine percent annual rate.

He estimates that a potential rise in the US savings rate to 7 percent of GDP, which after absorbing some of this to increasing fixed investment, would leave enough to reduce the current account deficit to about 1 percent of GDP without any large government regulatory changes. He could very well be overly optimistic, but it doesn't seem unreasonable.

If we as a nation were to to invest in rebuilding our manufacturing base into an efficient machine by global standards, and improve the productivity and training of our work force, then we could reap significant benefit from these medium to long-term adjustments. Forget those long-term forecasts, and Happy New Year!

Wednesday, December 22, 2010

What Did Ben Bernanke Say?

Commentators are hyperventilating about the Fed Chairman's apparently contradictory statements about the potentially inflationary impacts of QE2. Since Mr. Bernanke is now a full-fledged political figure, contradictory statements and a lack of clarity are basic tools in the sound bite arsenal.

He said that the effect of QE2 was not to increase currency in circulation, and therefore there was no need to worry about inflationary expectations increasing. This may be correct, but it is off the point and misleading. The unprecedented expansion of the Fed's balance sheet has not increased the amount of currency in the hands of the nonbank public. True enough.

However, the truth is that nobody really knows the effect of such a huge expansion of the monetary base on inflationary expectations. Historically, the impacts of other such expansions in foreign countries is mixed. Generally, if the expansion is viewed as temporary, and market participants believe that imbalances will be redressed in our case by fiscal policy restraints and budget balancing, then the expansion will serve its limited purpose and not have an inflationary effect. However, there is no reason to believe that our politicians will show any fiscal leadership or restraint. Where is the experience to show that they can rise to the occasion?

If the monetary base expansion is viewed as permanent, then it will almost certainly lead to higher inflationary expectations, and we will be in uncharted territory..again.

Boone Pickens: The Wind Dies Down

From today's Wall Street Journal, "The Dallas-based entrepreneur, who has relentlessly promoted his "Pickens Plan" since July 4, 2008, announced earlier this month that he's abandoning the wind business to focus on natural gas."

"Two years ago, natural gas prices were spiking and Mr. Pickens figured they'd stay high. He placed a $2 billion order for wind turbines with General Electric. Shortly afterward, he began selling the Pickens Plan. The United States, he claimed, is "the Saudi Arabia of wind," and wind energy is an essential part of the cure for the curse of imported oil. " There's nothing like a Texan hyping energy--except that Mr. Pickens didn't understand very much about wind as an energy source nor about relative prices.

Wind may have a minor role to play in a US energy portfolio, but for all the ancillary investment in grid connectivity, storage issues and the sheer visual and auditory blight of the towers, it is clear that natural gas and nuclear can have bigger impacts on curbing greenhouse gas emissions than wind ever will. Increasing fleet efficiency for cars and trucks, and cutting commercial and residential energy use are also ready channels for reducing electricity demand growth and hence the need for new plants, which means less greenhouse gas emissions than the current baseline trends.

Monday, December 20, 2010

An Unrepentant Financial Sector

What's wrong with the economic picture as we get to the end of 2010? There's a wide divergence of opinions about inflationary expectations. Looking at economic statistics, we don't see where non-monetary, demand-induced inflation is going to originate. We've always looked at the core inflation statistics, namely excluding food and energy prices. However, research from the Cleveland Fed has shown that focusing on this series alone reduces the power of inflation forecasts. Its Median CPI, or trimmed CPI, shows inflation rates on a trailing twelve month basis at 0.5%. Taking their approach to extract the forecasts embedded in financial asset prices, they come up with an expectation of 1.5%. Again, there are no alarm signals here.

Yet, the Treasury market has really tanked in December, and it's been reflected in the breathtaking drops in some of the best known bond mutual funds, including Pimco Total Return and Harbor Bond, also advised by Pimco. Both funds employ the "shake hands with the Government strategy" taken early in the crisis by Pimco, and consequently both funds are replete with government obligations. In some measure, though, this is the reversal of a few weeks ago when Treasuries rocketed in the wake of the Irish debt crisis and a flight out of the Euro. This latest move down is seen as a signal of higher expected inflation, but it seems hard to read higher inflation in the tea leaves based on this latest move in bond funds.

So, we believe there is almost no pricing power for manufacturers in the face of diminished consumer interest and limited consumer buying power in developed markets, apart from those consumers buying Louis Vuitton (lawyers, investment bankers and Keith Richards). The financial sector is virtually unaffected post-crisis, and there is even some optimism for near-comatose patients like Citi. The Financial Reform Commission has been an abject failure, and both parties are supplying duelling narratives about what caused the crisis.

In the meantime, on the real side, companies remain flush with cash and there is talk about a strong M&A market in 2011, probably driven by foreign buyers in US and European markets. There is precious little investment in new manufacturing capacity to pursue future growth in profits and employment. Share buybacks get the CEO's headlines, and not investing in the core businesses.

We've said this for almost three years now, but until the financial sector stops wagging the dog and the US manufacturing sector reinvents itself, it's difficult to imagine what will drive a durable recovery, a reduction in unemployment or a meaningful acceleration of inflation.

Friday, December 10, 2010

Tata's Nano Experiment: Lessons Learned?

The Tata Nano experiment was a very noble undertaking. Ratan Tata, the Chairman of Tata, is said to have tasked his engineers to build an affordable car for Rs. 100,000. This is the repeat of the Volkswagen undertaking, which was to create the "people's car." When Fiat came to the United States market, it came with low end 128's aimed at students and new graduates taking their first jobs. The first Datsuns weren't bad, but they were cars powered by motor cycle engines. When the Yugo came to these shores the mission was the same: affordable transportation that would launch a brand and open up other market segments.

What went wrong in all these cases? First and foremost, they were all lousy cars, but the Volkswagen's were the best of the lot. Mr. Tata should have modified his charge to his engineers: "Build me a Rs. 100,000 car that's safe, reliable, fun, and that you and your families wouldn't be ashamed to be seen in!" That would have ruled out the Fiats and the Yugo right away. The next, primary mistake is that these cars weren't really designed for their markets or their customers. The Fiats were badly underpowered and couldn't merge onto an onramp at 55 mph. The Yugo was a laundry list of disasters: incompetent, post-Soviet style engineering and low manufacturing quality were the real problems.

The Nano has the advantage of derivative styling that looks stolen from Nissan and others, but it's passable. The wheels are way too small, and the tires way too narrow for the awful Indian roads. Building small cars well is not a skill that confers itself automatically from being able to build light trucks or large sedans. It's a completely different engineering and consumer mindset. The Chief Minister of Gujarat is photographed supposedly entering the passenger side of a Nano in the NY Times, but judging from his girth and the opening of the door, he might have needed a shoehorn. Again, this is a design issue that a small car maker should be able to deal with.

The worst part of this story? The communications debacle. The Nano has been reported to have experienced a small number of fires. Instead of dealing with it quickly and decisively, foot-in-mouth disease broke out. First the company denied there were any issues. Beating a retreat from that untenable position, the company blamed the problems on "foreign electrical equipment." I'm sure that their supplier-partners loved to read that news. Just to be mensches about it, the company extended the warranty period marginally and said that they were going to improve the exhaust and electrical equipment, just for kicks. This pattern is the same one followed by Suzlon when their carbon fiber composite wind turbine blades failed on deployment in Minnesota. The excuses were just that. Not understanding the markets, not doing the homework, and not dealing with issues head on are present at every post-mortem of these commnication fires.

Tata will eventually get better, but the corporate mindset will have to become more open to change and listening to the market.