Coxe On The Power Of Zero

The one "must read" report this weekend comes from Coxe Advisors LLC. A phenomenal summation of all the relevant economic, financial, and political trends and how these will impact both the near- and the longer-term.

Key highlights from the report:

On the big picture:

• Highlights: takeovers of General Motors and Chrysler, a deficit of 12% of GDP, $790 billion in handouts and assistance under the rubric of economic stimulus, a costly new national health care system, and a vast array of tax and trade global warming programs whose tentacles will reach into almost every sector of the economy.
• Only Lehman was allowed to experience the Schumpeteresque-slaughter reserved for capitalist cupidity and stupidity. Operating with scripts and strategies conceived on the fly, varying prescriptions of emergency assistance were extended, under panic conditions, to Citigroup, Merrill Lynch, Morgan Stanley, AIG and Goldman Sachs.
• The cheerful Reagan charmed voters by teasing his opponents. He summed up Democratic economics as, “If it moves, tax it; if it keeps moving, regulate it; and if it stops moving, subsidize it.” He summed up the goal of his policies toward the Soviets: “We win; they lose.”
• The Pelosi-Obama stimulus package passed with no Republican votes in the House, despite heavy lobbying from some segments of the business community, notably General Electric, which became Obama’s most dedicated corporate cheerleader—itself and through MSNBC [let's not forget CNBC here]—after receiving many billions in low-cost loans to its flagging finance subsidiary, GE Capital.
• [Obama] remains the most charming and charismatic President of modern times, and is still, quite probably, liked by more Americans—and more people abroad—than any American President. He and his radiant wife are, as The New York Times notes, America’s greatest global brand. But the reality of the Presidency is that handsome is as handsome does. His approval ratings have descended from the Heavenly to the ordinary. All polls disclose that while most Americans still like and admire him personally, they disapprove of his policies.
• Despite a brilliant campaign, adoration from the media, a divided Republican party, and a flagging economy, he was actually behind the Bush-baggaged McCain in the polls until Lehman imploded, and suddenly it looked as if the world could end. As Larry Summers would later joke, a new Messiah was what was needed. (It hasn’t come to an end, although a recent New Yorker cartoon shows a gentleman consoling a friend, saying, “It isn’t the End of the World.” Just around the corner, riding furiously toward them, are the Four Horsemen of the Apocalypse.)
• Based on our recent trip to visit European clients, and numerous emails from foreign clients across much of the world, many global investors are alarmed about Obama’s policies and are reducing their exposure to US assets accordingly. The dollar’s decline may be one symptom of these doubts about the actions of Obama and the Democratic Congress.

On Zero interest rates:

• Why shouldn’t the economic recovery be at least as strong as Reagan’s—if not even more robust? It’s because those Zero rates tell us that the financial system’s problems that triggered the economic collapse aren’t going away quickly—and could even be getting worse.
• The Administration’s forecast through 2019 assumes that foreign creditors’ appetites for Treasurys will grow at least as fast as the national debt. It predicts sustained real GDP growth of 3% per year, with no recessions, no increases in taxpayer cost for health care, and—despite sustained deficits and a doubling of the national debt-to-GDP ratio (excluding Fannie and Freddie debt) from 41% to 82%—long Treasury yields will not rise more than 1%. (We spoke at a Canadian financial conference last month at which Niall Ferguson was the star. He flashed that forecast up on the screen and said, “Those aren’t real forecasts: they’re Mickey Mouse numbers.”)
• There has been one little-remarked change in the investment strategy of America’s Sugar Daddy #1: in recent months, China has been rolling over its maturing Treasury notes into T-Bills. It thereby chooses to forgo interest of 2%–3.4% in favor of near-Zero yields. What power, one wonders, does Beijing think, comes from a Zero return in a weakening currency? And why is that putative power growing so relentlessly?
• Led by the Fed, central banks across the OECD have been Japonized.
• Wherever his spirit rests, Benjamin Franklin must be livid. When the hardearned savings of ordinary people are looted to enrich greedy bankers, and when they are told that this process is necessary to make America prosperous again, no wonder so many citizens have displayed so much anger at “Tea Parties.”
• Amid all the enthusiasm about soaring stocks and an economic recovery, it is wise to retain one’s perspective about what has happened to investors. Last week, the Bank of America summed up the disappointments of our era for institutional investors. It noted that there were 42 trading days left this year, and the S&P would have to rise 42% to deliver a Zero rate of return for the past decade. By some calculations, on a compounded basis, long Treasurys have outperformed the S&P since the beginning of the Reagan bull market. The problem with those data is that they assume sustained reinvestment of interest at the long end of the curve, but most bond managers would have been below benchmark duration for extended periods, which meant their cash income would have been reduced.

On excess reserves

• The amount of Cash and Excess Bank Reserves in the US economy is at all-time records, mostly because of Bernanke’s panicky doubling of the Fed’s balance sheet. But this is a construct, not a solidly-based financial reality.
• Cash was splashed among the B5 to array their balance sheets, which were looking Gandhian in their skinniness. But the B5 re-deposited a huge slug of those funds with the Fed as excess reserves: why go through all the nuisance involved in making loans to individual companies? They also bought up the Treasury curve. These bankers toil not much, but they spin like mad: they keep trying to convince us that they didn’t cause the Crash, and they really deserve their big bonuses.

On the biggest threat with mortgages:

• All those math and physics PhDs who built the products, and the bankers who distributed them, never thought about a principle in mortgages that dates back to the 14th century and the emergence of Courts of Equity. (That’s where the word “equity” comes from.)
• Equity was based on the Chancellor’s religious-based concern for welfare of people of the middle- and lower-classes who suffered under the rigors of Common Law.
• If more US courts decide that those ancient protections for homeowners need to be protected against derivatives, the results for the B5, Fannie and Freddie would be very…..interesting.

On market and portfolio volatility and risk:

• Zero Cash means big problems for overall construction. Assuming that a Fund needs to earn a nominal 7% overall, net of fees and costs, then the higher the Cash component, the higher must be the rate of return assumptions for the other asset classes. Without tinkering with those assumptions, then the higher the Cash component, the higher the risk and volatility the portfolio must assume. Such asset classes as Junk Bonds, Leveraged Loans, and small Emerging Markets might have to be quite big commitments for the Fund to meet its objectives
• The price of oil in recent months has traded almost in inverse lock-step with the value of the dollar. This isn’t the longer-term adjustment that characterized the 1970s—it’s occurring in real-time. This daily activity mocks the reliance traders used to place on actual data about oil supplies and demands—particularly the weekly data about US supplies of oil and refined products. Many of the metals—notably aluminum—no longer trade primarily based on LME inventory data. They dance to the global risk music of the markets. Stocks trade together globally on a day-to-day basis. Yes, Emerging Markets continue to outperform the S&P, rising more than New York on bullish days, and not falling as hard, on days risk is being unwound.
• The Barons of the B5 are reporting record trading profi ts, which means, as Nouriel Roubini warns, that systemic risk is increasing, not decreasing. The locus of this new risk has moved from toxic, untraded products whose values are shielded against market pricing to marketable investments of nearly all stripes.

On those "easily forgotten" daily problems like CIT:

• CIT’s bankruptcy is a synecdoche for Main Street America’s problems. As the largest factoring company, it has been—for many decades—a reliable backstop for small and medium-sized businesses across America. Companies assigned their receivables to CIT, thereby allowing them to continue to sell their output profitably, even to sophisticated giants such as Walmart and Amazon, which are famously successful at boosting their cash flows by delaying their payments to suppliers for months. Their local banks would assist in financing inventories and making loans for capital investment secured by real estate liens and owners’ personal guarantees. CIT is now operating in bankruptcy, but it is hardly in shape to perform its historic functions as demand for factoring rises in response to an economic recovery.

On the outlook for the middle class and small and medium-sized businesses:

• The realization that the trillion-dollar deficits are destined to continue, even when the economy gets back to sustained growth, frightens the [small and medium sized businesses]. They hear that they will be subject to much higher taxes on “the rich,” and hear that the term “rich” means people who earn more than $500,000 a year. (According to The Wall Street Journal, if the tax rate in 2007 were 100% on Americans earning over $500,000 a year, that would have generated just over a trillion in Treasury receipts.)
• The 1990-page health care legislation not only has the “millionaire’s taxes” on those earning above $500,000, but imposes high extra taxes on small businesses which do not offer health care to their employees. Doubtless, local bankers will be looking at the effects of these permanent tax increases and mentally marking down their customers’ ability to service their loans in future years

On Gold:

1. It’s a risk asset, so it’s benefiting from the rush to risk.
2. Borrowing at Zero to buy something with Zero yield is income-neutral.
3. It’s the only asset that, based on history, outperforms under both horror stories—Depression and Hyperinflation.
4. Its upside breakout came at the time of Halloween.
5. India announced purchase of half the hoard on offer from the IMF, which had been weighing on gold prices, and there are rumors that China will take up the rest. This was the second surprising announcement from India within a fortnight. The other was that the United Arab Emirates had displaced such nations as the US, China and Germany as India’s biggest trading partner in recent months. Apart from tea, and gold in the form of baubles, bangles and beads, what big-ticket exports other than bullion could India be sending to that collection of gold-loving states? It’s no longer exporting rice or sugar.
6. Statistics from across the world confirm that the economic recovery is gaining steam, so the specter of inflation is moving stealthily from deep in the primeval forest toward the main path. Travelers beware.
7. Barrick CEO’s statement in London about the continuous decline in new gold mine output, suggesting, “There is a strong case to be made that we are already at ‘peak gold’.’’ The golden rule of commodities has been that the cure for high prices is high prices: when the price of stuff goes up, big new production always follows, and the price goes down. Gold’s price has more than quadrupled, but new-mine production keeps falling. With central banks apparently switching from the sell to the buy side, this may be a new world for the oldest store of value.
8. All of the above.

• Is gold overvalued? In terms of a reliable historic indicator, it may depend on how you define a gentleman. The Economist once sought to fi nd a true value of gold with a study showing that, for most of the time since the Middle Ages, an ounce of gold would buy a gentleman’s suit in London. That was not the case on Jermyn Street from 1981 through 2007 even for the less prestigious tailors. With the recent decline in the pound, it is now applicable to the shops located more than two blocks from St. James’s Street. (It hasn’t, we believe, applied at Savile Row since King Edward’s time.)

The outlook:

1. The root cause of the financial and economic collapse—the demographically driven plunge in real estate prices at a time of serious over-leverage in the housing sector—remains a clear and present danger to banks and other financial institutions.
2. All the US government’s home mortgage lending institutions are experiencing rising losses, despite the slight uptick in house prices. That barely-observable bounce is due to most drastic price maintenance program in history—taxpayer bailouts of lending institutions, the Fed’s huge subsidy to mortgage rates through purchases of Fannie and Freddie paper, and 10-year notes, and the First-Time Homebuyer Subsidy of $8,000. It took all those trillions to get house prices to rise 4% from their panic lows. Why should investors be confi dent the rally will continue? “Stein’s Law”, which has never been repealed, may be ready to be proved anew: “If something cannot go on forever, it will stop.”
3. Bernanke will have used up his entire declared quota of purchases of long Treasurys and mortgage-backed paper within a few months. Then what?
4. Commercial real estate grows sicker each month, as office and condo vacancy rates rise, and more and more regional banks go to the wall.
   
5. The biggest contributor to the 3.5% economic growth of the Third Quarter came from the Cash for Clunkers program. That is gone.
6. The only US auto company to report positive cash fl ow in the Third Quarter—Ford—still struggles with a boom-year-negotiated UAW contract that means its labor costs are much higher than the other members of what used to be known as The Big Three. Since the UAW and Washington effectively own those competitors to Ford, there’s slim chance the union
   will do anything to strengthen Ford: if Ford collapses, so much the better for the union-owned Big Two. Chrysler has no hot new products in the pipeline and an ambiguous management agreement with Fiat. GM is adjusting to a shrunken product base and its finance subsidiary, GMAC, has already received four emergency cash infusions from Washington since the bankruptcy. Hyundai, no friend of the UAW, is the hottest company in US sales. The current noise on Detroit assembly lines could turn out to be a death rattle.
7. What may have been the most useful consumer economic stimulus—the collapse in gasoline prices—is fast becoming a cherished memory. Gasoline prices have already retraced roughly half their plunge. That most useful of all “tax cuts” is being chipped away, as other taxes at federal, state and local levels face inevitable increases.
8. Although overall consumer inflation remains near the Zero level, food prices continue to rise relative to other costs, and natural gas prices are no longer at remarkably cheap levels.
9. And it looks to be a cold winter—atmospherically and otherwise.

Full report:

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BMO CM Basic Points Nov 2009.pdf	672.9 KB