France Reappears To Support Greece?

From the very beginning of our posts on the Euro, dating back to 2011 we have talked about the fundamentally divergent interests of France and Germany. For a while, French President Sarkozy made a concerted effort to have arms outstretched for his partner, Chancellor Merkel.  Since the next regime, things have become somewhat aloof, if not frosty.

We noted in a recent post, that French President Hollande was not visible as Chancellor Merkel was playing the despotic aunt, refusing to finance her profligate nephew, Greece.  The Wall Street Journal reports that President Hollande is visibly counseling about the risks of continuing to play hardball with Greece and a consequent default and Grexit.

It comes down to the original conception of  the European Union, which dates back to 1950-51 and initiatives championed by French foreign minister Robert Schuman, whose work we studied in our European economics seminar at the University of York, which I attended as an overseas student during my junior year of college. Here is a quote ascribed to Schuman,

• "Europe will not be made all at once, or according to a single plan. It will be built through concrete achievements which first create a de facto solidarity."

Customs union, currency union, free movement of capital and labor, harmonization of regulation, abolition of non-tariff barriers, and the unspoken political union.  It was a grand vision, to be sure, but more than half a century later, its defects and limitations continue to show.  

Looking at the history and origins of the two world wars, one would be very hard pressed to make a case for the notion of 'solidarity' across national boundaries, when solidarity within those same boundaries is becoming more questionable.  

Greece and its vaunted talent bank of American-trained economist/politicians have been irresponsible, but their actions are rational responses to the sometimes perverse incentives built into the whole currency union operations.  If money and credit are being given away, why not take it?  

We may now see the consequences of that strategic gambit. 

The EU and Greece Share a Cup of Hemlock

Since 2012, we have written about the inevitability of the events the European union are facing today, a Greek sovereign debt default, an exit from the euro currency zone, political chaos at home, and a fundamental failure of the grand European experiment.

To reach this conclusion, no complex economic models are needed.  The design of the system and the notion of divergence, along with the history of relationships within the zone, point the way.

To be sure, along the way, there were many false dawns, as European politicians do what they do best summit meetings and consultations with smiling faces and bowed heads, walking in some countryside.  Hedge fund managers used their tools to call a bottom in bond prices and got involved.

Fast forward to today, and there are no financial markets to impose any discipline on Greece.  Hedge funds have gone home chastened with their losses, and Greek sovereign debt is owed to the IMF and to the ECB, with the biggest chunk being owed to Germany.

For all the Ph.D.s among the Greek expat intelligentsia, for all the worship of game theory and Nash equilibria, Greek politicians have gone beyond brinksmanship to simple economic lunacy.  Asking the EU to wait for a Greek national referendum was irresponsible. Greek government pensioners don't want any changes in the status quo and blame outsiders, like the IMF, for their problems.  A "No" to acceding to further fiscal discipline may be a vote against the EU, but it is also a repudiation of failed Greek political parties.  It does no one any good, except to save face for the Tsipras leadership failure.

For Germany, not how French President Hollande is no longer at the Chancellor's side, as they were inseparable a few years ago, co-leaders of the European experiment, along with the IMF, now led by a French national too.  Chancellor Merkel is now by herself forcing Greece over the cliff.  Of course, she has no real choice.

The Greek alternative to fiscal austerity has been a plan in which, for example, pension payouts were guaranteed, and a plan dependent only on revenue raising through taxes on small businesses, with no more fiscal austerity.  No Ph.D. is needed to see how this plan would turn out.  So, any rational observer has to realize that Greece is no longer serious about reforming its economy to meet substantially higher growth targets.

But, since the Maastricht Treaty is silent about unilateral exits and the mechanics thereof, a Grexit really calls into question the whole value of the euro, the ECB, the ESM, and all the bureaucratic empire that has been created in Brussels.  Which peripheral member would be the next to take bitter medicine?

Although Plato took liberties with the poisoning of Socrates, in terms of describing symptoms and a drawn out death, it probably applies well to Greece and to European Union.  If Greece takes its bitter medicine and defaults, leaving the Eurozone, there will be great economic weeping and gnashing of teeth.  But, Greece will have made Europe pay a price too, finally exposing the emptiness and futility of the eurozone as it has been laid out and administered so far.

Greece Is One Problem of Many for the European Union

Here's something we wrote in 2013, writing about Greece and its possible exit from the euro:

• The European monetary system still has fundamental design and execution flaws that make it unstable in most environments;
• It offers peripheral members few real benefits except access to easy credit; 
• Unless the peripheral countries undertake real economic reforms, the austerity medicine may make the patient better, if it hasn't killed him first;
• French, European and Italian banks need to take their medicine and acknowledge the diminished economic values of sovereign debt on their balance sheets;
• The continuing struggle for EU power between France and Germany is very analogous to the struggle between our two sides in Congress.  Despite all the nice rhetoric and the ECB posturing, their divergent interests still limit the effectiveness of the monetary union. 

What has changed, after all the posturing by the Greek governments,ECB, the Eurocrats, Chancellor Merkel, President Hollande, the IMF and all the other zombie actors on the European stage? In terms of events, lots; fundamentally nothing has changed.  

Greece has sung out of the austerity hymn book, and it has received substantial transfers, all with different names.  Although its ratio of debt to GDP has come down from its peak, it is still unsustainable and no amount of austerity can save the situation without a currency devaluation lever to help the demand side; the euro has taken this instrument away.  So, point number one is still true, as is point number two.  Greece got its bailout money, much of which comes due in 2015-2016 and which cannot be repaid, only re-restructured. 

The austerity medicine is killing the patient, as no real reforms have been undertaken.

Economic storm clouds lie over several economies, some peripheral and one core.  Dumpster diving was prevalent in nice Barcelona neighborhoods several years ago.  The latest Eurostat numbers for 2013 show youth unemployment rates of 42% for Spain, 29% for Portugal and 49% for Greece.  What's worse, the rate is 30% for Italy, a much larger economy.  

There can never, and should never, be any fiscal harmonization as the Eurocrats advocate, solely for their own perpetual employment.  Right now, the individual social compacts between Spanish voters and their government is at risk.  If their leaders really have no real economic levers to make their economies more globally competitive, and Spanish leaders look to Bonn and Brussels for a handout, then why not just take to the streets and kick them all out?  The last time I looked, the ECB does not have an army, so they would be no help. 

Chancellor Merkel has beaten on the fiscal responsibility drums for several years, and Germany voters couldn't accept mutualization of EU peripheral country debt.  Fine, but if the euro is to be something beneficial for all its members, the current system and its architecture have to be razed.  Germany has to show leadership, but it can't.

It's self-appointed co-star, France, will always be on the stage beside Germany, and its economy continues to need fundamental reforms on the domestic front. France will never let Germany take the lead in defining a new European monetary system. The Brussels bureaucracy won't let itself be unwound. 

I have listened to several webcasts from really smart economic and financial economists from Chicago Booth and various European think tanks. They are out of ideas. A Grexit would be "catastrophic," but all of the various costumes put on maintaining the status quo can lead to a Greek tragedy eventually. 

China's Slowing Growth Rate

China's economic growth rate is characterized as "slowing," to 7% per annum; but, this means that the giant economy can be extrapolated to double in ten years.  Given recent economic and financial developments, is this really plausible?

The Chinese Economic Miracle was predicated on two key slogans, "Privatization," and the evergreen "Growing Middle Class."  In the intervening decades, we know that privatization meant a selective treatment of some private companies and more the creation of grossly inefficient state-owned enterprises.  Financing of the latter in an environment of low, falling interest rates and growing state surpluses of foreign exchange wasn't an issue as far as the eye could see.

As the Chinese economy grew to the sky, the ruling members embarked on a strategy to corner all the key resources needed to fuel the growth of an industrial economy, from recycled PET to paper, rare earth minerals, copper, and food commodities.

Prices for clean, post-consumer baled PET began a rapid ascent about fifteen years ago, and when I called some of the companies gathering this commodity from municipal waste streams, they all told me that the demand was Chinese and "insatiable."  Chinese consumers also wanted their clear beverage bottles for water and soda.  Today, prices are quite different.

Chinese companies owning copper mines in Chile have seen prices collapse recently.

Again, risk is one thing for a private company with lots of debt and relatively small equity, but it is another thing for the Chinese central banking system.  However, economics ultimately carries the day, especially in an environment when the music appears to be stopping, i.e. rates may be rising.

However, it is also difficult to see what would justify raising rates when Europe, apart from Germany and Switzerland, is a basket case.  Traders are reported to be hoarding oil in a carry trade awaiting normalized, higher prices. Great Britain has an economy where consumers are being offered credit cards on television with 50% A.P.R.s.

Barron's columnist and legendary investor Jim Rogers recently said that he was long Indian equities, which have done extremely well.  However, he said too that he had his doubts about the intentions of the Modi government to really deregulate and reform the Indian economy so as to unleash a real economic miracle consistent with all the press releases.  I think that his skepticism is well warranted.

In the U.S., talk of higher taxes, redistribution and a U.S. National Health threatens the longevity of what has been a slow, lethargic recovery.  As Bill Gross said in a different context, the U.S. may be the "cleanest dirty shirt," among global economic leaders, and it still has the primary reserve currency and liquid markets, so far....

Oil Prices Collapse: Everyone Got This Wrong

Financial pundits routinely make howler forecasts, but the good news is that they forecast so often and the public has no memory. so it doesn't matter.  Industry executives are supposed to be closer to markets, smarter and more circumspect, and they often are.  But, just as often, they assume the trend is their friend.

Here's a quote from the CEO of Chevron,
"This past year was expected by many to bring stable, triple-digit oil prices. Chevron Corp. ’s chief executive declared in March that “the $100 barrel is the new $20,” and traders complained that several years of low volatility had made it difficult to make money buying and selling oil."

Boy, was this ever off the mark!  We've never been a participant in this game, except to say, 
"If there are intrepid forecasters out there who could explain $100 a barrel oil for me, I'd love to hear from you." (2011)

Short-term supply interruptions aside, it was impossible to justify prices above $100/bbl on economic fundamentals.

The one year price chart for crude oil is remarkable, showing a decline from $100 in July to $54 presently, with some industry forecasters projecting $60 in a year.

Longer-term sources of crude oil will be more expensive, technologically difficult to access, and fraught with political risk for multinationals in areas like the Arctic or deep ocean sources. Current prices have taken these off the table.

It is ironic that activists still talk about solar as the global savior, except that it is little more than a hobby farm for NGOs and their patrons.  Natural gas and nuclear which are better from a rational environmental calculus have been bullied off the table by sheer volume of propaganda.

The winners, of which there are many, and the losers, of which there are fewer big ones, are shaking out in predictable economic fashion.

The oil price consensus forecast was probably one of the biggest consensus market misses of 2014.

Catching Up With the Financial Press: Nothing Has Changed

U.S. equity markets have had five consecutive record closes. Governments in the U.S. and Europe continue to view financial sector public companies as ATM machines, with a steady stream of announcements of higher reserves for legal settlements.  Everybody's happy.  Where are we now compared to the dark days of 2006-2007?

• Our banking system is more concentrated than ever, with the top 4 banks controlling 47% of domestic banking assets.  Weighed down by an unending stream of regulatory and capital constraints, their business models need revision. 
• Despite all the research on the role of Fannie Mae and its central role in the subprime mortgage debacle, no meaningful diminution of its role has occurred through legislation or regulation. According to Goldman Sachs in "The Mortgage Analyst," May 2014: "Mortgages implicitly or explicitly guaranteed by the government are 90% of all loans originated, compared to two-thirds before the crisis." To cap it off, a new executive has called for Fannie to once again increase home ownership by loosening credit standards!
• QE has been a windfall to some market participants but a policy bust.  Even career Fed watchers can't make sense of pronouncements about the path of interest rates.  We have long said there is no fundamental economic case for raising rates. Minneapolis Fed President Kocherlakota let the cat of the bag first when the noted that the Fed couldn't right size its balance sheet for decades.  
• Europe's Fed-lite and QE-lite have been even worse failures, and their banking system still hasn't done its penance.  What's worse, economic fundamentals remain weak, with capital spending reflecting the negative sentiment of business executives.  
• The marriage of IFRS and GAAP was called off when bride and groom refused to show and the minister went home.  More than a decade worth of meetings, workshops, presentations, interim proposals, and investors have more verbiage and less clarity in disclosures than ever.  
• The IMF, of all players, has opined that a risk heat map for some markets like high yield, leveraged loans, and even corporate bonds show levels comparable to the 2006-2007 peaks!

I'm going to cut the list off at this point, but you get the picture, dear reader.  Words over action, form over substance, special interest politics above all, that's 'market reform' American style. 

T-Mobile Still Rudderless

T-Mobile's meringue-like offer from a French billionaire evaporated, since it was all spidery sugar and so substance.

The company's network is still woeful compared to its competitors, and it has dead spots in major metros and is often more challenged in buildings than its competitors.  Despite disingenuous promises from its CEO, it's only strategy now amounts to giving away data and grabbing more unprofitable subscribers.

Meanwhile, Deutsche Telekom's ownership of an established carrier in a major market has added no value, and their continuing, failing efforts to divest their stake also drives down TM's value.

Wireless needs to be priced like any other utility: giving away more and more goodies to no-profit customers will do nothing to provide funds for building out the network.  TM seems to be stuck in the worst place now, despite all the CEO preening for the cameras.

Fed Policy Risks

Back in 2011 we were pretty lonely writing about the future risks of the unprecedented monetary accommodation that became today's monetary policy. We noted this comment from Minneapolis Fed President Kocherlakota,

"In the Stern book, the authors quote Minneapolis Fed President Narayana Kocherlakota as saying that the Federal Reserve's balance sheet in twenty years will likely still have $250 billion of mortgage backed securities on the books.  Unwinding the Fed's $2 trillion balance sheet will not be easy, as we've written about before."

He was right and he was early: it made perfect sense to me, but this view was quietly squelched with assurances that the Great Unwind would have several tools in its armamentarium.  Hold this thought as we summarize the Fed's policy risks from Dr. Ward McCarthy of Jefferies.

Ward says that the Fed's recent parsing language meant to say that it is "in no rush to raise rates."  We have long said that there is no fundamental economic case for raising rates.

To the point above, McCarthy says "unwinding this extraordinary accommodation carries...risks that policy makers had not previously had to consider."

He says that if the Fed waits too long to raise rates in response to rising inflation, the markets would overreact and a subsequent move would be roiling to bond markets.  This risk, in my opinion, is one of the lower ones.  There are many data points for inflationary changes, both real and in expectations. At present, there is almost no sign of economy-wide pressure from commodities, wages, or capacity constraints, which are the traditional harbingers.

If the Fed were to remove its accommodation too early, and the economy were to again enter a recession, it would very few options.  Negative rates, Dr. McCarthy says, are not politically or institutionally feasible in the U.S.

The Fed has now defined the federal funds rate as the key policy rate.  Dr. McCarthy agrees with us in saying that the reverse repo facility tool is not the best solution resetting the floor for interest rates. He notes that Fannie, Freddie and the Federal Home Loan banks are not eligible to collect interest on their reserves at the Fed.  Given their continuing enormous influence in the housing market, this makes the RRP program of limited reach, not to mention risky to the system, as others have written.

The IPO market's backlog will comfortably start coming to market given the benign outlook from the Fed.

Fed Announces Upcoming Clarification of Monetary Policy Outlook

Fed's rate guidance on chopping block, new exit plan nears

Thu Sep 11, 2014 1:02am EDT

By Ann Saphir and Michael Flaherty
(Reuters) - The U.S. Federal Reserve is facing perhaps its most pivotal meeting of the year next week, as it debates a potential overhaul of its guidance on interest rates and seeks to nail down a plan for exiting its extraordinarily easy monetary policy.
It remains to be seen whether decisions will be taken on either, but it is clear that details on a so-called exit plan are nearly complete, while discomfort is growing internally over a pledge to keep rates near zero for a "considerable time."
Investors will parse the central bank's words closely for any clues on the timing of the first U.S. rate hike in more than eight years. Any major tweaks to its policy statement could cause ructions in financial markets as investors recalibrate bets on benchmark rates in the world's biggest economy.
A strong run of U.S. economic data has led Fed Chair Janet Yellen and other top officials to acknowledge the possibility they may need to raise rates sooner than they thought just a few months ago, although a surprisingly soft reading on jobs growth in August could provide some breathing room.
"The discussion itself is a testament to the underlying shift in monetary policy," said TD Securities analyst Gennadiy Goldberg. He said ditching the "considerable time" phrase would open the door to a rate hike as soon as March, several months earlier than most investors currently expect.
The Fed has kept overnight rates near zero since December 2008 and has more than quadrupled its balance sheet through a series of bond-buying programs designed to push down borrowing costs and boost investment and hiring.
Fed policymakers have said they do not expect to raise rates until 2015, and their meeting next Tuesday and Wednesday looks certain to end with no change in policy beyond a well-telegraphed reduction in the central bank's asset purchases.
But officials will release fresh economic and interest-rate projections, extending their forecast horizon through 2017. Those, coupled with even minute changes in the Fed's post-meeting statement, could reshape expectations for how soon and how fast the central bank is likely to raise rates.
GROWING STALE
Fed officials from both ends of the policy spectrum have stepped up calls recently to change what Cleveland Fed President Loretta Mester termed the "stale" language on the likely timing of the first rate hike.
The Fed has said since March it expected a "considerable time" to elapse between the end of its bond buying, which is now slated for October, and its first rate hike. "I believe it is again time for the (Fed) to reformulate its forward guidance," Mester said last week.
A few hours after Mester's remarks, Boston Fed President Eric Rosengren, a stalwart backer of the central bank's aggressive monetary policy easing, also called for ditching the calendar-related guidance, while Philadelphia Fed President Charles Plosser, who dissented against the language at the central bank's last policy session in late July, reiterated his concerns on Saturday.
Top economists at a number of Wall Street firms, including Michael Feroli at JPMorgan, Paul Ashworth of Capital Economics and Lewis Alexander at Nomura, now see at least even odds that the Fed will drop the "considerable time" phrase.
It could simply note that it can be "patient" in determining when to raise rates or could emphasize, as Yellen did with a speech in August, that the timing of a rate hike could move forward if economic data comes in stronger than expected.
The guidance is only one of the tricky questions facing the Fed. Officials also need to finalize details on how they plan to move rates higher and keep inflation from igniting, given the extraordinary liquidity sloshing around the financial system from their purchases of government and housing-related debt.
Minutes from their July meeting show officials now generally agree on several important changes to a set of exit principles first published in 2011, including steps to prevent the Fed's balance sheet from shrinking before rates rise. Most of them also now think the Fed should hold on to most of the housing-backed securities it has purchased.
Still under intensive discussion is how to use a newfangled tool developed by the central bank's New York branch to help sop up excess liquidity when the Fed starts tightening policy.
Minutes of the last meeting show it is increasingly likely the Fed will relegate the new overnight reverse repurchase facility to a supplementary and maybe temporary role, in part due to worries it could spark "runs" from more risky markets in times of financial stress.
Agreement on that matter could pave the way for public release of an exit blueprint as soon as next week.

(Reporting by Ann Saphir in San Francisco and Michael Flaherty in Washington; Editing by Tim Ahmann and Paul Simao)
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Germane to yesterday's post, there are several interesting items;

• The extended projections to 2017 give cover for a change in guidance or for removing the "extended period of time" label for low rates.
• Reverse repos now are relegated to a Ph.D. thesis project.
• A "new tool?" 

Dodge and Cox: Views on Fixed Income Markets

We recently received the periodic report for the quarter ended June 30, 2014 from the managers at Dodge and Cox Income Fund (DODIX), with $28 billion of NAUM and a performance record built on a long-standing investment process, a well defined process of internal employee development and portfolio manager succession, and a tradition of all the partners putting their money in their own stable of funds.

DODIX outperformed its benchmark, the Barclays U.S. Aggregate Bond Index by 70 bp, with the fund generating a total return of 4.6% for the six months ending 6/30/14.

"Demand rose for U.S. Treasuries which as a sector returned 2.7% in the first half, reflecting growing expectations that the Federal Reserve will raise the Fed funds rate at a slower pace compared to previous tightening cycles. with a lower end target."

So, with the new paradigm of Fed Presidents and the Chair thinking out loud about monetary policy philosophy, tools and targets, this is how savvy, conservative, low turnover fixed income managers interpret the Fed's future policy pathway unfolding.

It is hard to understand a fundamental, economic case for tightening in 2015.  Indeed DODIX managers wrote about, ",,,the somewhat confounding environment of the first half of 2014--with a brightening macroeconomic outlook coinciding with rates declining to one-year lows--we reversed the duration extension of mid-2013."

The managers believe that the market rate structure fails to incorporate "the more positive underlying fundamentals of the U.S. economy or the possibility that Fed policy could deviate from the glacial pace of tightening currently reflected in market expectations."  We'll have to see whether this is true or not, but the folks at Dodge and Cox are always worth listening to.

This fund made a brilliant move several years back when they positioned the fund massively over weighted corporate credits relative to the benchmark, with the issuers' strong cash flows, clean balance sheets, and strong management teams providing equity-like returns early in the economic recovery.

Today, they are making a more nuanced comment about corporate credits.  DODIX has been reducing the corporate sector weighting on an issuer-by-issuer basis while shifting the sectoral composition of corporate credits away from Financials, for example.  With regulators making comments about mega-banks "choosing" to get smaller, this rebalancing might be very prescient.

Mega-cap, global technology companies are outdoing each other with big share repurchases and rapid dividend increases.  We've written many times about the formulaic, value insensitive manner in which these buybacks have proceeded.  Dodge and Cox fund managers write, "This (higher amounts of leverage at a low cost) is a source of down side risk for holders of investment-grade corporate bonds."  Further, they write that credits pruned from the portfolio will include those companies which "are likely to alter their capital structure in a manner adverse to current bondholders." (read buybacks and other financial engineering)

Draghi and the Euro: Low Rates Haven't Changed Fundamentals

From an October 2013 post, we noted:

• The European monetary system still has fundamental design and execution flaws that make it unstable in most environments;
• It offers peripheral members few real benefits except access to easy credit; 
• Unless the peripheral countries undertake real economic reforms, the austerity medicine may make the patient better, if it hasn't killed him first;
• French, European and Italian banks need to take their medicine and acknowledge the diminished economic values of sovereign debt on their balance sheets;
• The continuing struggle for EU power between France and Germany is very analogous to the struggle between our two sides in Congress.  Despite all the nice rhetoric and the ECB posturing, their divergent interests still limit the effectiveness of the monetary union. 

Today's financial press acknowledges that "Europe Crisis is Resistant to Medicine of Low Rates."  Really! How could anyone but the eurocrats, the IMF, and their press cronies have seriously believed otherwise?  

Meanwhile, the same article notes,

"While some borrowers (global multinationals) are benefiting from ultralow or even negative interest rates, it does not appear that the easy money is reaching the struggling businesses in countries like Spain and Portugal that need it most. That is why the European Central Bank may still need to do more to unlock credit to those countries and avert deflation, a ruinous downward price spiral."

The peripheral countries have gained little from trying to please the ECB, which they thought in turn would please private lenders, who in turn would give them easy credit to continue business as usual.  There has been no benefit to the peripheral countries dancing with the ECB and the IMF, but they really do need to sit down, perhaps directly, with private, non-bank lenders and have a serious conversation about regulatory, tax and fiscal reforms that would generate capital on the appropriate terms.  Continuing to believe in the ineffective European experiment as it is will only generate political turmoil in the periphery.

Meanwhile, in Poland and in the Czech Republic, there are outside investors who are noting manufacturing capabilities, trained workforces, and an openness to foreign trade.  There are some shoots of spring in these economies, but not because of any ECB experiments.

Some of the banks have had bombs go off in the basement, and no amount of ECB regulation and oversight saw any of it coming.  Banco Espirito Santo is the laughable example, with Credit Suisse and Goldman Sachs having their eyebrows singed by the opaque structure.

France appears to be acting like a patient with congestive heart failure, still alive and moving around, but seemingly incapable of rising to its domestic economic and foreign policy responsibilities.  This leaves Germany as the strong voice, for the moment.  Don't expect Mr. Draghi to produce anything useful apart from press releases for the current economic crisis.

Sayonara to T-Mobile

We've always thought that Masayoshi Son was a breath of fresh air for the U.S. wireless industry. However, we had doubts about what he paid for Sprint and about the potential for a disruptive model in domestic wireless.  Then came the announcement of a proposed deal for T-Mobile, which surely had to attract regulatory scrutiny, not so much for its own merits, but probably because of regulatory "regret" about their having let the U.S. industry evolve into a classic duopoly, with higher priced plans than would emerge from more competition.

What Mr. Son hasn't done is to really "white board" the Sprint business model.  Now that our regulators have put the kibosh on the Sprint/T-Mobile deal, this is precisely what he should do.  Putting some billionaire in place as CEO is going to have investors scratching their heads.   Making a face saving announcement about regulators reconsidering won't make his Japanese shareholders happy, since Mr. Son's full time PR blitzkrieg in pursuit of the merger has distracted him from the core business in Japan.

Meanwhile, T-Mobile has attracted another billionaire, this time from France, who has made a merger proposal which looks long on words and short on both money and value-enhancing strategy.  With T-Mobile itself finally starting to grow its postpaid customer base again, the last thing it needs is another distraction for management and employees.

Wireless pricing continues its irrational ways, with T-Mobile recently announcing that it will allow data-hog users to stream music continuously without counting against their plan data limits. Now, it's possible that there's incremental revenue from the streaming services paid to T-Mobile for serving up their customers, but I'd like to understand the economics of this deal.

Until later, sayonara to T-Mobile from SoftBank.

Purdue Brings A Politician's Face to Cost Cutting.

"It was the first of many steps (former Indiana Governor) Mr. Daniels has taken as he seeks to reorganize Purdue's sometimes-antiquated systems. A year and a half into his tenure, Mr. Daniels has frozen tuition (for the first time in 36 years), cut the cost of student food by 10% and introduced volume purchasing to take advantage of economies of scale." Wall Street Journal 

Since the biggest piece of a college's expenses are for salaries and benefits, it's laughable that making administrators purchase office supplies at Costco and cutting food costs will make any difference to the skyrocketing costs of college education.  Freezing tuition, other things equal, just means that the endowment gets eroded to make up the difference, or the college incurs more debt.  This would make perfect sense to a politician.  

Having a look at my own undergraduate alma mater, one sees a huge, bloated academic and professional infrastructure, some of it mandated by Federal law and much of it mandated by empire building Presidents who are in arms races to build shiny, new facilities and to outdo their predecessors with capital campaigns.  

Since university financial statements are as useful as municipal statements, with lots of funds lying around invisible to the outside eye, it is nigh impossible to subject universities to the same level of scrutiny to which corporations are accustomed.  I invite readers to try their hands at their own universities and share what they come up with. One reporter in California reports that City College of San Francisco spends 92% of its budget on salaries and benefits. 

We bemoan student debt loads without asking why these debt loads were incurred.  Although the reasons may be manifold--duplicative and unproductive departments which grant few degrees, bloated administrative staffs, deadwood tenured staff--the universities are not delivering value to the students for all their federal and state subsidies.  They are selling a subprime product at superprime prices. In most markets, like food, finance or healthcare, this would provoke outrage, but in education, it's all about the future and that's good enough. 

Don't Count on Putin Blinking On Ukraine

With the EU rumored to be moving to Tier 3 sanctions by Tuesday,the emerging view among Western commentators who form opinions by talking to each other, is that Russian President Putin may have gone too far and may "blink" and reverse his Ukrainian strategy.

While is it encouraging to see how the Ukraine seems to be rallying its military forces and crowd funding drones to better target Russian-led separatists, it is another thing to believe that President Putin will suddenly say "Hold on, let's reconsider here." 

In the long run, there is no doubt that the Russian experiment, tied by the ultimate "cult of personality" to one man, is doomed for economic and demographic reasons, as well as by the very oligarchs who were created by plundering national resources at the start.  It's another thing to think that it stops here.

A "on again, off again" strategy of maintaining a continuing, low level instability in Ukraine, whose economy was already a basket case, through a winter will probably erode what looks like a unified domestic political front now. Also, President Putin knows that once U.S. election cycles kick into full swing, domestic issues like border security, young refugees, and corporate malfeasance will take center stage over foreign affairs.

Putting in place a meaningful menu of sanctions coordinated among North America and Europe is something that must be completed.  That will serve as an effective counterweight to a strategy of simmering tensions in Ukraine until next Spring, when a new crisis can manifest itself.

As Dmitri Trenin suggests, were President Putin to back down now, he would face the prospect of appearing to break faith the right wing Russian nationalists, perhaps one of the few political constituencies he has solidly in his pocket.

The Market Continues to Ride the Wind

A healthy market, according to the fundamental and technical watchers of yore, climbed a "wall of worry." Right now, our equity markets continue to ignore both poor macroeconomic and corporate developments in ways that resemble the already forgotten 2006 period.

Looking at our own economy, what are some of the facts we've discounted?

• According to Fed presidents, the labor markets remain weak, unhealthy, in flux or whatever euphemism is acceptable to the Yellen regime;
• The housing "recovery" has stalled, weakened, sputtered.
• The Fed won't tie monetary policy to rules, but some Fed Presidents feel that rates may rise sooner rather than later. 
• Our larger, more concentrated banking sector is shelling out billions in shareholder equity to the government without admitting any crime they've committed.  Meanwhile, their fundamental businesses, with some lending growth, are lackluster.
• Trading revenue continues to flounder for the investment banks.
• Top line revenue continues to be hard to come by, and earnings gains continue to be of low quality, especially in the tech sector, where retirement plan commitments are excluded from "normal" earnings.

Let's move to Europe, where strategists have said the better values were from the fourth quarter of 2013.

• From daily press releases, Chancellor Angela Merkel has gone missing, to be seen only at the World Cup in shades suddenly becoming a fan of the Champions.  
• Is anyone still in the Elysee Palace?  
• Britain put on a dismal performance at the World Cup, but the semi-comatose Roy Hodgson declared satisfaction with his efforts. The British economy seems to be like a Morris Minor with vapor lock.  
• The Russian wolf is reconstructing his empire a bit at a time, alternatively threatening and blaming vast Western conspiracies.  Merkel and Hollande have gone from hectoring the EU periphery to becoming like pet poodles to the Russian wolf. 
• No one knows what's going on in the EU banking sector, and Banco Espirito Santo wasn't on anyone's top ten list of troubled banks, but they are shown to have no clothes. 
• What will a cold winter do to Russian gas prices coming through Europe?  

In the rest of the world, there's a mixed bag at best.

• China's hoarding of raw materials seems to be an expensive and inefficient use of their assets.  Growth rates continue to be strangely high and no one seems worried.
• India's elections were won on an anti-corruption platform, but what's really needed now is a pedal to the metal for infrastructure construction to match the pace of construction (much not completed) growth, apartment and condo development, and new corporate parks.  This will be impossible due to the corrupt program of rural subsidies to buy votes.  Economic policy for the past five years under the former Congress regime was an unmitigated disaster.
• Brazil hosted a World Cup, spent $11 billion or so, and gave up their veneer of artistic and technical supremacy in the beautiful game.  The corporate environment is rife with inefficiency and corruption, the state enterprises leading the way.  Interested in issues of inequality?  Take a walk in a favela---with armed guards and an armored car, though.  
• The Middle East has finally begun to be redrawn.  No one knows how it will settle out, and what the costs will be, especially for the U.S. and Israel.  Normally, this should cause some alarm. Not for these heady markets. 

NY Fed's Bill Dudley on Business Investment

Here's an excerpt from a recent speech by New York Fed President William Dudley:

"Business fixed investment and housing are two key areas where activity has been disappointing.  They need to kick in more forcefully for the economy to grow at an above trend rate for a sustained period.
With respect to capital spending, the recent trajectory has been very soft relative to the apparent strong underlying fundamentals.  Corporate cash flows have been strong, profit margins are high, balance sheets are healthy and financing generally appears readily available at low interest rates.  Moreover, the absolute level of capital outlays is low so that the capital stock is expanding only slowly.  Despite these positive fundamentals, real business spending on equipment and software has risen only 3.2 percent over the past four quarters and contracted in the first quarter.   This is a bit of a puzzle to me.  But, I expect it to be resolved by a pickup in capital spending.  Recent trends in durable goods orders and conversations I have had with businesses in my district suggest that such a pickup may finally be occurring."

 Since the earliest days of QE and the long march of this unconventional monetary policy, we have never wavered about two issues, (1) the efficacy of an unknown policy mechanism that transmits this policy to the real economy, and (2) the problem of unwinding the balance sheet, about which fears were expressed by the President of the Minneapolis Fed, who has since recanted and who now sees the light. 

Here too, the NY Fed  President's remarks are instructive:

"Turning first to economic activity, the trajectory of economic growth continues to disappoint.  Since the downturn ended in mid-2009, real GDP growth has averaged only 2.2 percent per year despite a very accommodative monetary policy."

Productivity Growth and Corporate Underinvestment

Share buybacks have entered the realm of the new corporate orthodoxy.  Much as we have liked, and ourselves implemented, buybacks, they are now being used somewhat mindlessly, especially by mature technology companies, like Cisco and H-P.

When a corporate CFO says that "We see no better investment than our own shares," that statement shouldn't be allowed to pass without some clarification.  Likewise when the target of returning fifty percent of quarterly free cash flow to shareholders in the form of dividends and share repurchases is adopted, a question should be raised about how the math works on this kind of capital utilization.

These statements co-exist with the statements that cloud computing, for example, is the most disruptive technological change since Silicon Valley became a brand.  If this is true, and earnings are under pressure from short-term and long-term trends, then wouldn't it be better to invest in corporate internal projects to position the company for the new future?

Likewise, acquisitions when public market valuations are at local historical highs wouldn't seem to be obvious choices for use of cash.

Where may some of the fallout from these trends be seen?  Productivity, which is measured in many different ways, e.g. output per hour worked, total factor productivity, and capital per worker.  The macroeconomic analysis of productivity has always been a relatively weak area of economic research, but the various time series put out by our BLS do have the advantage of going back a long way.

Looking at one series, real output per hour worked for non-financial corporations, something noteworthy can be seen. The series is indexed to 2009=100, to coincide with the business cycle recovery. The linked chart shows the index at 107.1 in January of 2012, and stuck at 107.7 as of October 2013.

On a broader front, U.S. GDP growth fell to 1.9 percent in 2013, while hours worked rose by 1.1 percent, according to the Conference Board. So output per hour grew by 0.8 percent, and output per hour in manufacturing actually fell.

None of these trends bode well for labor incomes.  Companies like Exxon which are increasing their exploration and capital budgets are largely doing it outside of the U.S. as environmental regulations and energy policy politics make it rational for them to look for opportunities elsewhere.  Tech companies with huge cash hoards held abroad, which are then leveraged for share buybacks and dividends don't serve the long-term interests of shareholders.

Surely, there must be some politicians somewhere who could team up with corporate executives to create a framework for better capital allocation and investment in our businesses rather than in financial engineering. Continuing down this pathway may feed equity markets, but it won't fuel the economic future for the next generation of our labor force.

China Has the Strong Hand in the Russian Gas Deal

Using energy resources, particularly natural gas, as an instrument of foreign policy and for restoring Russian hegemony won't work in the long run. The Russian economy rests on fragile demographic, market, human capital and social foundations.  Actually, the same could be said for China, but they have demonstrated a more flexible pragmatism than has the monomaniacal President Putin, and the Chinese hold the stronger hand in this energy deal with Russia.

Morena Skalamera's piece for the Geopolitics of Energy Project of Harvard's Belfer School is a good summary of the history leading up to this deal and its implications.

The Sino-Russian relationship dates back to the 1950s, when as Skalamera puts it, Russia viewed China as a younger brother to be assisted and guided, especially in the area of technology and nuclear development. With Khrushchev's renunciation of Stalin, Chairman Mao saw an opening for China to take the reins of the global Communist movement.  This was seen as overreaching, and the brothers fell out.  Their subsequent relationship has been distant and aloof, based on mutual suspicion that has continue to the present moment. The writer correctly points out Henry Kissinger's adroit interposition of the U.S. into the bilateral relationship, making it a strategic troika. Our gains have been meaningful over time, our mistakes legion, and our future leverage is significant.

Analyzing this particular natural gas deal without the historical political context leads to making this appear more significant than it really is.

As President Putin mentioned in one of his communiqués, Sino-Russian bilateral trade is some $90 billion, making China the single largest trading partner of Putin's Russia. The bilateral trade was some $6 billion in 2000.  Russia, by contrast, is China's ninth largest trading partner.  The composition of their bilateral trade is important to consider.  Russia exports raw materials, especially energy, while China exports finished consumer and industrial good to Russia.  

None of this is lost on the Chinese leadership, and they have very clear objectives for their ongoing economic relationships with the Russian energy sector, which go way beyond cutting checks for overpriced natural gas. 

China has massive liquid resources to invest, and they are looking for equity ownership in Russian energy companies, especially upstream.  Why?  Because, deep down the Chinese leadership is rightly suspicious about Russia's reliability as a secure source of supply for gas.  Where would they get this idea?  From President Putin's own statements and gleeful manipulation and strangulation of Ukraine.  

Russia and its oligarchs don't want anybody from outside the brotherhood getting under the covers at Gazprom or any other energy company.

According to the Harvard report, 30 billion cubic meters of natural gas are covered by the agreement, beginning in 2018 for a period of thirty years.  Nice, big round numbers, for sure.  The Chinese government certainly won't want any part of the great deal that Russia gave to the Ukraine.  As Skalamera's piece points out, natural gas is not a global commodity like oil, which can be priced globally as soon as it hits the water for transport.  Natural gas is a regional commodity, where pricing is clouded by the high fixed cost and indivisibilities of pipelines that can't be switched on and off, or have flows reversed for arbitrage. Beijing, the report says, has an eye on a price close to that of gas on the Kazakhstan-China border.  Russia tried to foist off a formula based on Henry Hub-driven indexes.  Billions in pipeline construction won't begin until the real meat and potatoes of this deal are consummated, and we are far from that.

Our shale bonanza has resulted in diverting gas from our relatively low consumption to LNG exports to Europe where it has driven prices down.  This has not beneficial to Russia.  Each dollar/BTU drop in natural gas prices in Europe costs Russia $4 billion in annual revenue, according to a Citibank report cited by the Harvard researchers. Further, Russia needs oil prices above $107/barrel in order to balance its internal finances, or in other words to keep oligarchs and restless people happy.

China has a very large, well drilled and equipped military, so Russia cannot have any leverage from threats, implied or real. Russia knows well that China could, in a pinch, have ambitions for the sparsely populated areas of Eastern Siberia.  Russia doesn't come into this energy "deal" with the kind of power it is exerting over an enfeebled Ukraine.

Look at this photo of the two leaders.  The gentleman on the left looks very calm, relaxed and understands exactly who and what he is dealing with. The gentleman on the right is thinking, "So what do I really have here besides a photo op?  Dealing with Obama was fun: this isn't."

Morgan Stanley on Emerging Markets

We have posted before about the fact there many fewer diamonds than paste among emerging market mutual funds touted to individual investors.

Today, Ruchir Sharma of Morgan Stanley Investment Management, whom we cited in the above post, has revisited the whole lure of emerging markets in the Wall Street Journal. What he says in this piece effectively outdates some of the material in his book.

Mr. Sharma writes,

"Commodity prices rose 160% in the 1970s, and the number of nations that were rapidly catching up to the West rose to 28, compared with the average of 22 in the typical decade. In the 1980s and 1990s, when commodity prices stagnated, the number of rapidly converging nations fell to just 11. Commodity prices then doubled in the 2000s, another golden age for convergence, with 37 nations catching up at a rapid pace.

But commodity-driven economies such as Russia and Brazil tend to stop catching up as soon as commodity prices spiral downward. According to the World Bank, of the 101 middle-income economies in 1960, only 13 had become and still remained high-income by 2008: Equatorial Guinea, Greece, Hong Kong, Singapore, Ireland, Israel, Japan, Mauritius, Portugal, Spain, Puerto Rico, South Korea and Taiwan. Of those 13, only Equatorial Guinea is a commodity-dominated economy.

Last decade's mass convergence was a freak event that caught the world's imagination." 

The things that will ultimately limit the progress of all countries, especially the continuing rapid advance of emerging markets will be social and political factors, like a viable social contract, property laws, an ability to forge a democratic model that fits various social customs, social responsibility and accountability for business moguls, and a commitment to regulation, ethics and transparency in capital markets. Even where countries show gains in these areas for a while, they are difficult to entrench into a national consciousness because of the long histories of corrupt governments and business in many emerging economies.  

Emerging market investment opportunities are always present, but how accessible will they be through public markets?  Time will tell. 

The Chrysler UAW Bailout

The auto industry bailouts during the financial crisis completely overturned our traditional legal statutes governing how creditors are treated during bankruptcies. With today's announcement that Fiat is buying out the 41.5% of Chrysler which it does not already own, these issues are as evident as ever.

A 2012 Backgrounder from the Heritage Foundation gives good information and references which are very consistent with the most recent October 2013 report from the SIGTARP Inspector General.

Chrysler has been mismanaged for many decades, and it has had several turnarounds.  None of them ever really addressed their operational and product development mismanagement, or their labor costs which were among the highest in the American automobile market.  Pre-bankruptcy labor costs at Chrysler were $76 per hour in May 2012, higher than both GM and Ford at the time and significantly higher than costs at Honda, Toyota and Nissan.

Pre-bankruptcy, Chrysler has $6.9 billion of senior secured liabilities and $2.9 billion of junior secured liabilities, according to the figures in the report.  $5 billion was owed to unsecured trade creditors.  Chrysler owed $8 billion to the VEBA (Voluntary Employee Beneficiary Association) formed in 2007 to assume the liabilities of the employee retirement plans.

Bankruptcy allows the corporation to restructure its contracts, subject to two heretofore inviolable principles. Secured creditors stand first in line for recoveries, including the ability to seize encumbered assets if necessary.  Unsecured creditors are considered the great unwashed, and they are traditionally wiped out or in unusual circumstances get pennies on the dollar as recoveries.

Because of Chrysler's long, troubled financial history its bonds were secured debt, which wasn't typically the case.  Senior secured creditors of Chrysler who were owed $6.9 billion recovered $2 billion, or $0.29 on the dollar.  The junior secured creditors somehow recovered $0.0 on $2 billion owed.

In this kind of structure,  which is very unusual, the unsecured creditors, including the UAW/VEBA, should have expected nothing except to be wiped out. Instead, the Obama administration converted the $8 billion into a 41.5% stake in the reorganized Chrysler, along with a 9% note.  The total 2012 PV of the Chrysler bailout, which only benefited the UAW and its membership, was estimated at $9.2 billion in the report cited.

Labor agreements and labor costs are traditionally renounced and reset in bankruptcy agreements.  While labor costs were adjusted to close the nominal gap to Honda/Toyota/Nissan to around $56 per hour, Chrysler workers will still earn substantially more than the average U.S. manufacturing sector worker, with no ties to productivity or work rule flexibility.

The exercise of Federal control and intervention in financial markets and in matters like executive compensation of corporations in which it has bought a stake at gunpoint will surely be regarded as a weakening of our economic system whose virtues we trumpet so loudly.  The government's facilitating of rent seeking by its favored political constituencies, like auto unions, is also an unprecedented manipulation of the bankruptcy process in which the role of the judges and administrative apparatus have also been marginalized. "If there's money up for grabs, I might as well be the one grabbing," a client once told me. He was a greenmailer, but his motto is still relevant today.