Oct 5, 2009

In his Saturday radio address, President Obama acknowledged the White House is exploring “additional options to promote job creation.” It’s about time. This is the worst job market in seventy years — including the longest duration of steep job losses.

If anyone had any doubt that something far more dramatic must be done, listen to former Federal Reserve Chairman Alan Greenspan. He warned Sunday against further stimulus because “we are in a recovery, and I think it would be a mistake to say the September numbers alter that significantly.” Greenspan has turned into an inverse soothsayer. After his cataclysmic error about where the economy was headed before the meltdown, his views about the future should be carefully noted as being the exact opposite of what’s likely to be in store.

The economy may be in a technical recovery but this is not a real recovery and the “green shoots” or “positive signs” that Wall Street cheerleaders love to shout about are phantoms of their ever-optimistic imaginations. The stimulus is working but it is far from adequate. Before the stimulus, we were losing more than 500,000 jobs a month. Now that 40 percent of the stimulus has been spent, we are losing more than 250,000 jobs a month.

What to do? With the debt ceiling approaching and the gravitational pull of the 2010 elections increasing, the White House can’t go back to Congress with a formal bill to enlarge the stimulus package. Four simpler moves would be to:

(1) Use existing authority under both the stimulus package enacted earlier this year and the nefarious TARP bailout fund — extending and combining them into a fund to make up for state and local cuts in public school budgets, childrens’ health, public health (we need workers to administer swine flu vaccine) and public transportation. Instead of bailing out banks and giant automakers, we should switch to bailing out public services that average people need.

(2) Propose a one-year payroll tax holiday on the first $20,000 of income. Republicans as well as Blue Dog Dems could go along with this, and it would be a highly progressive tax cut since 80 percent of Americans pay more in payroll taxes than they do in income taxes.

(3) Give small businesses a “new jobs tax credit” for every net new job created over the next year. Granted, under normal circumstances this sort of jobs credit doesn’t have much effect, and it’s difficult to separate hires that would have happened anyway from net new ones. But we’re not in normal circumstances; small businesses, which are responsible for most new jobs, still aren’t hiring. They need a boost.

(4) Dramatically expand the Small Business Administration’s lending programs and have the Fed buy up the SBA’s debt. Big banks are not lending to small businesses. TARP has been an utter failure in this regard. The SBA and the Fed should circumvent them and help small businesses get the capital they need, so they can start hiring again.

The politics of these four steps aren’t difficult. It would be hard to get a new stimulus package through Congress, but no member who’s up for reelection next year when unemployment is likely to be in double digits wants to be accused by rivals of voting against steps to help small businesses, public schools, childrens’ health, and average working people who need a tax cut.

Certainly the rate of fall in the number of layoffs has not been smooth—it never is.  But the trend is clear.  Earlier projection of a bottoming in the third or forth quarter of this year are still looking accurate.

Fewer layoffs also resulted in a slight drop in the rate of unemployment.  The chart below shows this:

It should be pointed out that much of the drop in the rate of unemployment was a result of 400,000 workers leaving the labor market.  This “discourage worker” effect is well known in economic circles.  When job get harder to find, many workers become so discouraged that they cease actively looking for work.  It happens in every recession, and the effects are reversed when the labor market improves with recovery.

Another effect of discouraged workers is that while it  cushions the rate of unemployment during the downturn, it is a drag on unemployment rates during the recovery.  As jobs become easier to find, many of those who left the labor market because of their discouragement, re-enter the market when things get better.  A higher participation rate of the labor force thus causes the unemployment rate to rise, or fall less, when things get better.

All in all, this is good news.  The economy does appear to be bottoming.  I guess that by October on November, the fall in GDP will reach zero, and there should be some recovery in December or January of 2010.

The picture has changed over the last few months, however, as the graphs below show. The first chart shows prices of the Mexican peso ETF of Rydex Investments (FXM) over the last year. The prices are the dollar value of 1000 pesos. From its peak in August of last year, the peso fell over 35% to its low in early March of this year, at which time it began something of a comeback.

Mexican Peso/Dollar 1-Year Prices

Almost all of the emerging market currencies have made similar recoveries from their lows, and they continue to improve as the world’s economies head to recovery–we hope!

Even the developed currencies like the Euro and pound sterling have taken their licks. The pound fell about 30% over the same period.

£/Dollar (FXB) 1-Year

There is another casualty of the financial carnage of last year. Prior to August of last year, ETF and ETN providers were flooding the SEC with proposals for foreign currency exchange traded products. I was running out of disk space trying to keep up with all the new filings. The collapse of the currency markets brought all these plans to a virtual standstill, and there were no new offerings for the rest of 2008.

Now, however, things have changed enough for one of the providers, WisdomTree, to follow through with their plans. On Wednesday, May 6, they brought the WisdomTree Dreyfus Emerging Currency Income Fund (CEW) to market.

This new EM bundle includes 11 currencies, ranged around the world from Central Europe, Africa, Latin America and Asia. WisdomTree chose to put their new ETF under the Investment Act of 1940. This means, among other things, investors will have daily transparency of holdings and prices for their new product.

Initial sales look robust, with an average daily volume over 100,000 shares. It carries an estimated interest yield of about 4.6%.

This is a most interesting product. The inclusion of 11 currencies provides a degree of diversification not provided by single-currency ETFs. The list includes: Turkish lira, Brazilian real, South African rand, Polish zloty, South Korean won, Chilean Peso, Mexican peso, Israel shekel, Indian rupee, Taiwanese dollar, and the Chinese yuan.

I like the geographic diversity: it covers all the continents except Australia. I also like the equal weighting scheme they use to determine how much of each currency to hold. The fund will be rebalanced quarterly, and WisdomTree will remove a currency if, in their assessment, the political or economic environment becomes hostile to an orderly currency market.

This new ETF is similar to an older currency product, the Global Emerging Markets Strategy ETN, (JEM). I covered this ETN when it was first introduced in my June 26, 2008, article, Currency Bundles Pegged to the Dollar. JEM has fifteen currencies represented in their bundle. Ten of the currencies are the same as CEW, but JEM includes Russia rather than China, and it includes currencies in five countries not covered by the WisdomTree product: Columbian peso, Philippine Islands peso, Argentine peso, the Indonesia rupiah, and the Hungarian forint.

The recent price history of JEM is shown below. The share price fell from about $51 in July to its low of about $38 in February of this year, a 25% fall.

JEM was introduced at a decidedly unfortunate time, with political and financial instability just beginning in some of its target currencies. The results show in the relatively few assets this ETN has gathered since its inception (Bloomberg lists $2.98 million in assets in their latest data).

Yields on this bundle have been quite good, however, with the last dividend yielding about 9% annualized, but this return has been swamped by falling prices of some of the more unstable currencies.

I prefer the bundle offered by CEW, because some of the more volatile currencies have been omitted. For example, it does not have Russia, Hungary, Argentina, or the Philippines in its mix. Plus, the inclusion of China, which follows a relatively tight peg to the dollar, will help stabilize price fluctuations.

I also prefer the ETF form to the ETN. With last year’s carnage of supposedly unsinkable financial giants, I wonder if the ETN has much of a future.

WisdomTree’s website goes into detail about the expected interest earnings and the standard deviation of the returns of each country.

Although listed as an “income” fund, it will not behave like a normal income fund that is denominated in U.S. dollars. The dividend comes from interest earnings on short term cash instruments in each of the markets they include in their basket. Currency price fluctuations can eat up the interest earnings in a hurry.

Investors must also be aware that by including 11 countries in the mix does not necessarily completely diversify the risks of systemic failure. Emerging Market currencies are prone to move in the same direction during major disturbances, as they recently proved, so the normal safety in numbers is trumped by the herding instincts of investors.

WisdomTree properly recommends keeping currency investing to a 10% maximum of your total portfolio’s value. Part of their case for holding currencies is to moderate the downside risks of portfolios dominated by equities and fixed income holdings. Currencies are remarkably uncorrelated with equity and bond prices, so there is an advantage of lowering total portfolio volatility when currencies are included in the mix. In this case, adding a volatile currency may actually lower overall portfolio volatility because of the counter-cyclical properties of currency holdings.

Depending on your own preferences for risks, and whether you want to hedge your emerging markets equities against possible dollar depreciation, this new ETF may provide your portfolio with some important benefits. I welcome this new offering as a potential tool in balancing the risks when taking on emerging market equity investments. I hope that as the market recovers, some of the other filings of 2008 will see the light of day. Currency investing is not for everyone, but for those who can use it, a wider set of options is welcome.

The economy shrank at a 0.3 percent annual rate in the third quarter, its sharpest contraction in seven years as consumers cut spending and businesses reduced investment in the face of rising fears that recession was setting in.

The Commerce Department said the third-quarter contraction in gross domestic product was the steepest since the corresponding quarter in 2001 though it was slightly less than the 0.5 percent rate of reduction that Wall Street economists surveyed by Reuters had forecast.>

The culprit was what all of us expected: consumer spending, which has propped up GDP growth for the last few years, finally succumbed to higher oil prices, lower home prices, and the shut-off of the second mortgage spigot that had fueled the borrowing binge of the last few years.

>Consumer spending, which fuels two-thirds of economic growth, fell at a 3.1 percent rate in the third quarter — the first cut in quarterly spending since the closing quarter of 1991 and the biggest since the second quarter of 1980. Spending on nondurable goods — items like food and paper products — dropped at the sharpest rate since late 1950.

Continuing job losses coupled with declining gains from stocks and other investments have put consumers under severe stress. The report showed that disposable personal income dropped at an 8.7 percent rate in the third quarter — the steepest since quarterly records on this component were started in 1947 — after rising 11.9 percent in the second quarter when most of economic stimulus payments still were flowing.

Consumers cut spending on durable goods like cars and furniture at a 14.1 percent annual rate in the third quarter, the biggest cut in this category of spending since the beginning of 1987. Car dealers have said that sales have virtually stalled, in part because tight credit makes it hard for even creditworthy buyers to get loans.<

These are not good numbers, and point to a protracted downturn.  If there is some kind of symmetry in business cycles, then the seven years of credit boom would be followed by seven years of credit bust.  I hope it won’t be that way, and there will certainly be efforts by our political establishment to crank out another stimulus package, soon.  There is already one on the table in Congress, and it is hard to see that it will not be passed.

The statistical evidence that stimulus works is quite high, so that is good news.  The economy desperately needs a shot in the arm.  But, whether it will be enough to turn things around and stay turned around, is another question.  It is unlikely to be large enough to make a miracle, and that is what is needed for now.  But it looks as if there could be several quarters of decline, putting the recovery at or beyond June of 2009.  And that’s the best outlook. It may be even worse, but I think there will be a Herculean effort from our new president to shorten the cycle once he takes office in late January.

Chinn avers:

Onebig caveat to the argument for infrastructure spending is that it usually takes a long time to plan such projects. Hence, it is not clear when the spending for such projects would actually occur, and hence the stimulus to the economy (this is called an outside policy lag, in the jargon). The "one-year horizon" shown in the table is for the horizon of one year from beginning of spending, not the beginning of planning and appropriation.

I have two observations here. First, if the spending could be directed to the states which had construction about to start, but hindered by financing or state revenue issues, then the problem of timing could be partly mitigated. I admit that it is unlikely that there are a tremendous number of such projects (although I am happy to be corrected). That leads me to my second observation.

The CBO study Options for Responding to Short-Term Economic Weakness (January 2008) laid out three principles for effective stimulus, loosely characterized as "timely, targetted, and temporary". Spending on infrastructure is problematic on this first count if one believes the recession will be short. If one believes that it will be prolonged (in the now outdated lingo, "L-shaped" instead of "V-shaped"), then this drawback is not so significant.

“We are concerned about the recent excessive volatility in the exchange rate of the yen and its possible adverse implications for economic and financial stability,” the G-7 statement said. “We continue to monitor markets closely and cooperate as appropriate.”>

If intervention were carried out, central bankers would likely sell yen for other currencies, driving down the yen and providing support to other currencies.

Although I am bullish on the yen over a long period, it does look as if its rise in value has been to fast for too long, so be prepared for a downturn of some duration.

<Shoichi Nakagawa, the Japanese finance minister, said he was watching the currency market with great interest. His comments were read in the market as a warning of possible intervention in the currency markets. The yen’s appreciation to alarming heights against other key currencies, to the detriment of exporters, who are seeing their international competitiveness eroded as a result. >

If this program is carried out, look for the exchange traded fund, UUP, to rise dramatically.  This ETF is long on the U.S. dollar and short on the yen and other developed market currencies.  A dramatic fall in the yen plays into this short position.

However, in a late development: French Finance Minister Christine Lagarde said the Group of Seven nations doesn’t plan to intervene to sell the yen after warning today against the currency’s “excessive volatility.”

“The yen has over the past 48 hours seen brutal trading that reflects a great volatility that’s linked to current market moves,” Lagarde said in an interview with Bloomberg News in Montpellier, France. “We wished to support this possible intervention of Japanese authorities knowing this would be about a purely Japanese intervention.”

Asked specifically if the G-7 would intervene to sell the yen, after it rose to its highest in almost 13 years against the dollar, Lagarde said “no.”

Japan, however, will probably enter the market to keep the rise in check. This may be enough to satisfy the G7 members, and allow them to keep out of the market.

Their currencies have also taken a significant hit. The chart below shows the U.S. dollar as measured against developed market currencies over the same period, with EEM and JEM, a basket of emerging market currencies in Asia, Latin America, Europe, the Middle East and Africa.

While the currency hit has been only about a 25% loss, it is about a 45% difference with the U.S. dollar. Also shown are the Mexican peso (FXM) and the Brazilian real (BZF), to show how similar the currency drops have been for all emerging markets. However you look at it, it has been a grim picture.

There are a couple of driving forces that explain the reaction of investors. The first is that everyone is concerned that the slowdown in America and European economies will disproportional affect emerging markets, since the western nations buy much of all EM goods. During a downturn, demand for many of the goodies the EM countries produce will fall, and their export trade, which largely drives their economies, will falter.

A second reason is an extension of this phenomenon. Hedge Funds have been particularly large investors in the EM economies over the last decade. And, their investments have covered the complete range of securities: currency holdings, equities investments and their sovereign debt. But, now that the party is over, the Hedge funds are having to pony up on margin. This leads them to dump much, if not all, they bought. This is exacerbating the downturn, just when it is hurts the most. Isn’t that always how it goes?

During this huge sell-off, two currencies have become safe haven plays: the U.S. dollar and the Japanese yen. The number one and two economies in the world, regardless of how bad it looks, are still the safest places to put one’s confidence—or at least that is what the financial markets around the world are telling us.

This concentration of trends does, however, bring with it a potential upside.

• Given the serious decline in currency prices in the emerging markets, and
• Given that most all of them have financed much of their expansion of export production capacity with debt, and
•   Given that much of that debt is owed to the U.S., Japan and western Europe,
• Therefore, the banks and Treasuries of all the lending countries are getting antsy about being repaid.

Debt repayment by the EM countries is partially impaired by their falling economies. That is to be expected, because economic downturns are always expected after a period of rapid expansion. But, the problem is made much worse by the fact that their currencies are falling at the same time. Much of the debt they owe is denominated in dollars, so they now have a double whammy to face. Their revenues are falling because of their shrinking production, and their currencies are depreciating at the same time that the U.S. dollar and yen are increasing. Now, they have twice to three times as much problem in repaying their debt.

Lenders are quite upset. But, the lenders (large banks) have the ears of their respective governments, and no one in any government want more bad news to capture the headlines of the financial pages. They are working as hard as they can to contain the carnage that has already been unleashed. If they add defaults of some of the major EM countries to the list, it would set off a new round of tumbling confidence and stock prices.

Therefore, there is a move afoot to help the EM countries by a coordinated effort of the developed nations to enter the foreign exchange markets and buy EM currencies—helping prop them up, at least until things settle down a bit. If this rescue effort comes about, then look for EM currencies to have a good bump. ETNs such as JEM would benefit, as would individual currencies such as Brazil, Mexico, South Africa, Russia, etc..

This is far from a done deal, and any monies put into this type of speculation would be an usual risk. The deal may not come off, and their currencies could continue their decline. If there is intervention, then I would take a short term view of the improvements in currency prices, and have a strong idea of when to get out. For those with a strong risk appetite, this may be a good place to look.

I’m still bullish on the Dollar (UUP) and the Yen (FXY), and I consider these currency plays to be much less risky than betting on an intervention in the EM currencies.

The number of homeowners ensnared in the foreclosure crisis grew by more than 70 percent in the third quarter of this year compared with the same period in 2007, according to data released Thursday.
Nationwide, nearly 766,000 homes received at least one foreclosure-related notice from July through September, up 71 percent from a year earlier, said foreclosure listing service RealtyTrac Inc.

By the end of the year, RealtyTrac expects more than a million bank-owned properties to have piled up on the market, representing around a third of all properties for sale in the U.S.

Six states — California, Florida, Arizona, Ohio, Michigan and Nevada — accounted for more than 60 percent of all foreclosure activity in the quarter, with California alone making up more than a quarter of all U.S. foreclosure filings.

Last month, foreclosure resales accounted for more than half of existing home sales in California last month, as home sales jumped 65 percent from a year ago, while the statewide median home price fell 34 percent to $283,000, according to MDA DataQuick.

Alan Greenspan’s Testimony (From NY Times)

Alan Greenspan, the former Federal Reserve chairman, said Thursday that the current financial crisis had uncovered a flaw in how the free market system works that had shocked him.

Mr. Greenspan told the House Oversight Committee on Thursday that his belief that banks would be more prudent in their lending practices because of the need to protect their stockholders had proved to be wrong.

Mr. Greenspan said he had made a “mistake” in believing that banks operating in their self-interest would be enough to protect their shareholders and the equity in their institutions.

Mr. Greenspan said that he had found “a flaw in the model that I perceived is the critical functioning structure that defines how the world works.”

China’s Growth in Question

BEIJING — For three decades, China has fueled its remarkable economic rise by becoming the world’s workshop and unleashing a flood of low-priced exports. But faced with a possible global recession and weakening demand for Chinese exports, the question now is whether the ruling Communist Party can prevent the financial crisis from derailing the country’s economic miracle.

This question is pressing not just for China but also for the rest of the world. American officials and many economists say continued Chinese growth is vital to the global economy as the United States and Europe face severe downturns.

Yet to navigate the crisis, many analysts say, China will need to recalibrate its economic model, stoke domestic investment with heavy government spending and promote policies to increase consumer demand in a nation known for high savings rates.

At the geopolitical level, China would seem well positioned to expand its influence. It sits on $1.9 trillion in foreign exchange reserves, accumulated from giant trade surpluses and heavy foreign investment in China, and it could acquire discounted stakes in Western banks and industrial companies.

But for now, most analysts say China’s top priority is protecting its own economy. Chinese leaders say the domestic financial system is largely insulated from the global crisis — China’s banks remain domestically focused and have relatively small exposure to toxic securities sold by American and European banks. But economic growth has fallen to the lowest level in five years, unemployment is a growing concern, and scores of factories are closing in the country’s export region. Domestic stock exchanges have lost 65 percent of their value, and real estate sales have plummeted.

China still seems likely to avoid an outright recession, but a significantly slower growth would pose a political challenge for the Communist Party, which derives much of its legitimacy from delivering jobs and increasing wealth. Conventional wisdom holds that China’s output must grow at a minimum of 8 percent for the economy to produce enough jobs to absorb increases in the working-age population, and many economists expect growth to drop below that level next year.

Economic hard times inspire two contradictory responses. One is to simply to want it to stop hurting. The other is to want the system purged and cleansed, at whatever up-front cost. The two are not mutually exclusive; indeed it’s quite common to wish for each in turn, or even simoultaneously. But they point in opposite directions, and underly pretty much all the debate we’re hearing among economists, policymakers and talk-show guests—such as this one .

Sorting them out, however, is necessary before you can intepret news such as today’s about U.S. homebuilding. From Aaron Smith:

Builders slashed housing starts and residential building permits in September to their lowest level since early 1991 as they worked to realign supply and demand. Housing starts dropped 6.3% to an annual rate of 817,000 units, and permits fell 8.3% to an annualized pace of 786,000 units. The rate of decline in homebuilding has clearly intensified: Housing starts over the past three months have contracted at a 68.3% annualized rate, the worst such reading since March 1980.

You can see this as disastrous, an economic train wreck. All those lost housing jobs, all that idle investment in land, lumber and equipment. The ripple effects—on employment, retail sales, overall growth—will be severe. Somebody—like maybe a presidential candidate?—should propose a plan to boost housing construction and save the economy.

Or not. As Aaron also writes:

Although significant progress has been made in lowering the supply of new homes to a level more consistent with the current low demand, we think further cutbacks in homebuilding will be forthcoming to more quickly draw down inventories.

Progress? Yes. Remember that what ails the economy—the financial side of it, at least—stems from the plunge in house prices that followed the end of the recent bubble. Rising defaults, underwater mortgages, frozen securities markets and the global banking crisis all began there. Any recovery, therefore, depends on house prices stabilizing. But house prices can’t stabilize if builders keep pumping inventory into an already glutted market. Something’s got to give. And the faster and deeper it gives, the sooner we can begin to climb out of this hole.

Let me amend that. The faster and deeper it gives, up to a certain point. That being the point at which all those lost construction jobs and all that idle investment is enough to sink demand for new houses, so that even as prices plummet and "affordability" rises in some technical sense, it still doesn’t revive the economy.

At which point we abandon all talk about system-cleansing, and just hope someone can make it stop hurting.

Andrew Cassel in West Chester on October 17 at 11:45 AM