Tag Archives: economics

Forecasts of US Fiscal Armageddon Are Wrong

080519_USEconomy1My Comments: Over the years I’ve had people wonder why I’m an optimist. They’ve decided I’m simply blinded by whatever it is that causes me to lean to the left instead of the right. To their mind, the world, and in particular America, is going to hell in a handbasket.

I believe that for centuries, every generation, as they age, thinks the landscape of society is doomed, and that the younger generation is hopeless. But over my 70 plus years, I’ve enjoyed a very satisfying life. Yes, there  was WW2, the Vietnam War, rock and roll, every crisis de jour you can imagine. There have been bad days, but they’re far outnumbered by the good days. If I have a regret, it’s that I’ll not live to see the next 70 years.

I’m baffled by the attitude of the blathering pundits on TV, especially those on the right, who do everything possible to turn back the clock. They sound like 4th graders. And many of those who get to Congrass act like 4th graders. But nothing I say will change that since it’s been this way ever since.

I was and am hoping Jeb Bush decides to run for President in 2016. Not because I agree with what his party says, but because he is about the only leader on the right who has graduated from the 4th grade. And now has an advanced degree in life.

As an immigrant to this country, I believe one of America’s great strengths is the capacity to allow a spirited dialog that effectively moves all of us toward the future as it evolves. But I’ve yet to encounter a 4th grader with the ability to articulate what is best FOR ALL OF US.

This article suggests there is a strong positive in our future.

By Robert Barbera / April 7, 2014 / The Financial Times

Conventional wisdom has it that the American national debt is out of control, and that cutting the federal deficit is an urgent task if the US is to avoid a budgetary crisis. The logic is beguiling. But it is wrong – and the influence it exerts on policy makers may put a brake on future economic recovery.

Anxiety about US budget deficits has been a reality in the US for most of the postwar period. But today’s Cassandras argue that the aftermath of the financial crisis, superimposed on to the reality of an ageing America, has made the problem sharply worse. Eighteen months of recession, followed by decades of tentative recovery, mean that the burden of financing retiring baby boomers is set to overwhelm US finances in the years ahead.

The Congressional Budget Office believes that within 25 years the government’s accumulated debt will equal an entire year’s worth of economic output. Some analysts fret that interest payments will then be so onerous that cripplingly high taxes will be the only alternative to a ballooning debt and eventual default.

Such forecasts of a federal debt disaster depend on an assumption that is rarely mentioned: that interest rates will normalise even though economic growth will not. Combine decades of tepid expansion with traditional real interest rates, and an unsustainable debt burden quickly comes into view. But that combination would represent a dramatic break with history. It goes against everything we know about the mechanisms that determine real interest rates. It is, therefore, a slim reed on which to base a radical departure for economic policy.

In its February report the CBO serves up the consensus view in elaborate detail. Deficits swell over the decades ahead and the debt climbs to 100 per cent of gross domestic product. The subsequent discussion centres on how best to rein in these fiscal excesses.

This is strange. The fact is that federal deficits have fallen precipitously over the past few years. In 2011 the watchdog projected that government spending (excluding interest payments) would exceed receipts by 7 per cent of GDP in 2038. It now states that this “primary deficit” will instead be 1.6 per cent of GDP, hardly cause for panic.

Yet despite this relatively sanguine view of the deficit, the CBO continued to sound the alarm about an incipient US debt crisis. Why? Because it believes that rising interest rates will amplify the debt burden at the same time as a weak economy saps the country of the strength needed to service the growing debt.

According to the CBO, the American economy will on average create a meagre 164,000 jobs a month during 2014, slowing to monthly gains of only 66,000 four years later. Nonetheless, the CBO projects that by 2018 the US Federal Reserve will have tightened monetary policy, raising the funds rate to nearly 4 per cent from close to zero today. It thinks the government will be paying an interest rate of 5 per cent on 10-year borrowings.

It is easy to imagine a scenario in which interest rates rise – the CBO projections envisage real or inflation-adjusted interest rates not far from the average seen over the period from 1955 to 2005. But real growth during that period averaged 3.5 per cent; far higher than the feeble expansion the CBO expects in the coming years. Yet if the US is doomed to endure a period of tepid growth then interest rates, too, will surely be lower.

It is not only the base rate that can be expected to fall in the weak economy envisioned by the CBO. The “term premium” – that is, the extra reward that investors demand for holding long-term debt – will also decline as fears of future inflation subside. In the 1980s and 1990s, when investors worried about the possibility of sustained increases in the price level, long-term bonds were perceived as risky assets. No longer. Now, financial instability and recession are the risks that keep investors awake at night. Long-term bonds are a good hedge against these risks. In such a world the term premium should be lower. Of course, this could change: a more traditional pace for economic growth could return, together with more worries about inflation. In that case, however, tax receipts would be substantially higher and the deficit and debt outlook much improved.

What happens if we combine tepid growth with tame interest rate increases? The “crisis” all but disappears. If the government pays a real interest rate of 1.5 per cent, instead of 2.7 per cent as the CBO expects, then government debt in 2038 will amount to 78 per cent of GDP, a far cry from the CBO’s forecast of fiscal Armageddon.

Is this rosy scenario an unhistorical fantasy? Far from it. From 1955 to 2005 the government’s real borrowing cost was about 1 per cent below the economy’s real growth rate. It is the CBO forecast, with the US compelled to borrow at real rates dramatically higher than its growth rate, that breaks with US history.

The writer is director of the Johns Hopkins Center for Financial Economics

A Deal Over Ukraine is Ugly But Unavoidable

UkraineMy Comments: Now that the University of Florida’s march to the national title game in basketball is behind us,  (Congratulations, guys, for giving us several months of enduring pleasure as we watched you grow and succeed!) it’s time to come back to earth and consider how life is likely to play out on other fronts.

What I see happening in the Ukraine and in Crimea brings, for me, a level of unease that suggests we need to really pay attention to this. It’s a reversion to what used to be the defining method of resolving conflicts that resulted in the Great War (WW1) and my fathers war, WW2. It involves some of the same players, is state on state, and could end badly for millions of people in Europe.

The dilemma for us is that we have little stomach or even ability to respond in kind to what the Russians are doing. True, not a lot of people have died, but the end game is a long way off. The internal rhetoric in this country is essentially mindless blather. There’s little, if anything, we could have done to prevent it, and now that the game is afoot, little we can do to reverse things.

All we can do is pay attention, and where possible, pull strings and hope for the best.

By Gideon Rachman / March 31, 2014

Any western leader negotiating over the fate of smaller countries in central or eastern Europe does so in the shadow of two bitter historical experiences: the Munich agreement of 1938 and the Yalta agreement of 1945. At Munich, the British and the French agreed to Adolf Hitler’s demands for the dismemberment of Czechoslovakia – without the participation of the Czech government, which was not represented at the talks. At Yalta, the British and the Americans made a deal with Josef Stalin that, de facto, accepted Soviet domination over postwar Poland and other countries under Russian occupation – again, without the participation of those concerned.

These parallels – in particular, Munich – are weighing heavily on western leaders as they attempt to chart a way forward over Ukraine. “We will not accept a path forward where the legitimate government of Ukraine is not at the table,” said John Kerry, the US secretary of state, at the conclusion of weekend talks in Paris with Sergei Lavrov, the Russian foreign minister.

Wolfgang Schäuble, the German finance minister, on Monday compared President Vladimir Putin’s claim that he is acting in defence of the rights of ethnic Russians in Ukraine to Hitler’s claim that he was acting to defend the rights of ethnic Germans in Czechoslovakia. The parallel has also been made by Mr Kerry’s predecessor, Hillary Clinton.

Yet even as Mr Kerry pledged not to strike deals over the heads of the Ukrainians, he was negotiating directly with the Russians – without a Ukrainian representative in the room. The reality is that if a Kerry-Lavrov agreement is eventually reached, accommodating Russian demands for a federal system in Ukraine and safeguards for Russian speakers, the government in Kiev will come under enormous pressure to accept it.

So are the Americans violating crucial principles in discussing the fate of Ukraine in bilateral talks with Russia? Or is some form of Russian-American negotiation both inevitable and necessary?

The bleak reality is that, as things stand, it is in the interests of both the west and Ukraine that talks are held with the Russians. To understand why, it is necessary to imagine the alternative scenario. There are at present thousands of Russian troops massed on Ukraine’s eastern border.

The US and the EU have made clear they will not go to war over Ukraine. Given that fact, a refusal to negotiate with Moscow is likely to be interpreted as a display of indifference rather than a display of strength. It could actually encourage a Russian military intervention, which would have tragic consequences for all concerned.

However, if further rounds of talks are going to be held with the Russians, it is crucial that they are not simply a fig leaf for a Munich-style capitulation. Fortunately, even though the west has made it clear that it will not fight over Ukraine, it still has real leverage over Russia. But if that leverage is to be used it has to be applied to protect principles that are genuinely defensible, both morally and in terms of the resources that the west can credibly threaten to deploy.

So what should those principles be? First, it is clear that the Russians would like the west simply to accept the annexation of Crimea as a fact – and move the discussion on to the rest of Ukraine. The west should reject this idea – a stance that would, incidentally, mark a clear difference with the Munich agreement, where the UK and France signed off on the annexation of the Sudetenland. A refusal to recognise Crimea’s legal incorporation into Russia could impose significant costs on the Kremlin. Crimea would become a black hole in terms of foreign trade and investment and a drain on Russian resources.

The second principle is to make clear that any Russian military move into eastern Ukraine would lead to a complete rupture in the west’s economic relationship with Russia. The EU is already studying the possibility of further sanctions. The nature and extent of any such measures should be spelt out as soon as possible – and they should exceed Moscow’s expectations.

Finally, the principle that the Russian government cannot demand changes in the constitution of a neighbouring state should be spelt out. That is simply too dangerous a precedent to establish.

Within that package of principles, however, there should be room for discussion of other Russian proposals – such as the idea of a federal Ukraine, guarantees for Russian speakers and an assurance that an independent Ukraine would not join Nato, or have a relationship with the EU that damaged Russia’s economic interests.

Any understanding that the Americans arrive at with the Russians cannot be imposed on the Ukrainian government in Kiev – both as a matter of principle and because Ukrainian politicians remain independent actors. Given that an informal Russian-US proposal on Ukraine would not come with the backing of a western military guarantee, or any certainty that it will be respected by Russia, the Kiev government will rightly be highly suspicious. But, unfortunately, Swiss standards of prosperity and security are not on offer.

For beleaguered Ukraine, a Russian-American deal, underpinned by the threat of the west’s economic isolation of Russia if it is violated, is probably the best prospect on offer at the moment. If that deal can be made to stick, it might just buy Ukraine the time to build a properly independent state.

What’s Happening In China These Days?

China dragonsMy Comments: China is today the 2nd largest and arguably the 2nd strongest economy in the world. It differs from us in a material way in that it has few of the myriad infrastructure elements of our economy, which have evolved over the past 235 years. In China, it’s very much a work in progress.

Which means there are going to hiccups along the way. We’ve had our share, and indeed we still have hiccups, as we saw in 2008-2009. But China is a different animal and if it sneezes, there is going to be snot everywhere. That’s not a pleasant thought, is it? Which is why as an investor, you need to pay attention. Or at least have someone managing your money who is paying attention on your behalf. Then perhaps all you need is a handfull of tissues.

Will it result in another crisis like we had a few years ago? Unlikely. Those seem to come along about once every 65 – 75 years. Lots of time to condition our grandchildren for that eventuality. In the meantime, just keep chugging along, especially if you have someone you can trust looking over your shoulder.

Investors Take Note: China’s ‘Lehman Moment’ Is Looming, Help Is Not On The Way / Steve Picarillo / Mar. 21, 2014

• Recent defaults in China are threatening to change investor perceptions of the safety of Chinese investments.
• The weakening property markets in China could slow the Chinese economy and potentially weaken Chinese banks.
• Investors have seen this before with Bear Stearns, Lehman and the Irish Banks, so we know how the book could end.
• Help may not be on the way as it appears that the Chinese government is willing to see defaults as it shifts to a more market-driven economy.

China’s first-ever default of a corporate bond may not have been China’s “Bear Stearns moment” or its “Lehman moment” but China’s Lehman moment can happen at any time and investors should take note.

Unlike the fall of (the independent) Bear Stearns and the demise of Lehman, Chaori Solar’s recent default did not change the market’s perception of credit risk inherent in the Chinese economy and Chinese investments. The reason? It was widely known that the solar company was in distress and at risk of being the country’s first corporate default. Moreover, unlike Lehman and Bear, the Chaori default did not add uncertainly as to the government’s intentions.

The Lehman and Bear events caused market panic as investors believed that the US government would have provided some form of support to prevent such a material default. Indeed, the fall of the independent investment bank Bear Stearns and the bankruptcy of Lehman Brothers marked key market events during the great recession. Investors across the globe certainly noticed these events which trigger other defaults across the globe. It is fair to say that investing and banking in the US has been altered for years to come. Chaori’s default did not trigger such market events; however, it led to fears that it could be the start of a surge of Chinese bond defaults. This fear remains well founded and may prove to be very accurate.

In the weeks since the Chaori default, shares in various Chinese property firms have fallen after the Chinese developer Zhejiang Xingrun Real Estate collapsed as it could not repay its estimated $500 million of outstanding loans. This default may be the defining event in China as it is the latest sign that the Chinese government will like to see some “dead bodies” as it moves toward a more market-driven economy. Government help does not appear to be on the way, as China’s central bank has denied reports that it is in emergency negotiations with the company.

China’s property sector is the main threat to the stability of the world’s number-two economy. Property developers in China have been a particular source of concern as many have increased their debt loads in recent years to buy land and build. The ripple effect of a deteriorating economy in China may very well lead to market disturbances across the globe. Investors will shift funds from China seeking investments that they perceive as safer. Moreover, a struggling Chinese economy, given its size and scale, will negatively impact exports of its major trading partners, thereby threatening to weaken the global economy.

Chinese financial institutions are at risk due to the brewing housing bubble. The average price of a new home in 70 Chinese cities increased at a slower pace than in recent months. Indeed, average new home prices in major Chinese cities rose 8.7% (year on year) in February, according to the National Bureau of Statistics, cooling from a 9.6% rise in January. While this does not sound all that concerning on its face value, however the trend is certainly worth noting.

Cities in China have taken to battle rising home prices amid fears of a bubble, and banks have increasingly tightened lending to real estate firms. This disturbing trend is extremely similar to those that led to the Great Recession in the US, the UK and in Europe. So we may know how this book ends.

As demand slows, developers will feel financial strain. The concern is this most recent default will trigger a series of similar distressed situations across weaker companies in the property sector. The most recent financial crisis in Ireland was sparked by the same types of events, a weakness in the property sector, leading to the near nationalization of the country’s banks. Similarly, Chinese banks have significant exposure to the property sector. Should defaults increase, banks would need to set aside more funds for bad loans and would likely become more risk averse, thereby further slowing growth or worst, potentially de-stabilizing the balance in Chinese banking.

The property sector has become a backbone of growth for the Chinese economy, accounting for 16% of gross domestic product, 33% of fixed asset investment and 25% of new loans in 2013, according to market estimates. Slowing property markets lead to a slowing economy.

There are a many potential triggers for a correction in the property market including a rise in interest rates, decreased credit availability or the introduction of a property tax. This risk of spreading “ghost towns” across China is a real reality as developers abandon projects due to lack of demand and financing.

Given the magnitude of property to the Chinese GDP, if this sector slows severely, there is no obvious replacement to support economic growth. So whether it is a Bear Stearns, Lehman or Irish bank moment, a defining moment is looming.

About the author: Steve Picarillo is an internationally known and respected financial executive, analyst and author. Steve has spent most of his career on “Wall Street” as a lead analyst covering large financial institutions, corporates and sovereigns in the US and in Europe. In addition to being an expert on global banking, credit ratings, banking regulations and compliance, Steve is a student of the global economic environment, a motivational speaker and an active philanthropist. The opinion in this article and other articles are the opinions of the author and of Creative Advisory Group, Inc.

Health Care Costs: Still Going Up

healthcare reformMy Comments: Many, if not most of us, are sick and tired of the arguments about ObamaCare, the nickname for the PPACA, passed by Congress and essentially OK’d by the Supreme Court. Between you and me it’s here to stay, and yet needs a lot of adjustments to make it realistic and meaningful over time.

What seems to be lost in the discussion is the absolute certainty that before the PPACA, the trend lines involving health care costs per capita were increasing at an unsustainable rate. Without change, they would eventually consume virtually all of anyone’s earned income.

What also seems to be infrequently talked about is the changing demographic where a larger and larger percentage of the population is reaching 65 – 85,  which is where most of us “enjoy” spending so much of our money on health care issues. If you don’t want to die just yet, then you spend money getting stuff fixed. Those on the far right are strongly in favor of this. As am I.

So, yes, health care expenditures are increasing. And they will until such time as enough of us die that the trend line shifts. Then as our children reach ages 65 – 85, the trend line will again shift. What is critical is whether we are able to shift the cost per person expense trend line. No one seems to know yet.

And they probably won’t for some time to come. In spite of everything most politicians say, the PPACA was not intended to create a short term fix. It was intended to put as many people as possible on the rolls of insurance companies, each person spending some of their money rather than having the rest of us pay for all of it.

For example, the language of the PPACA incentivises med school participants to gravitate toward primary care and away from esoteric specialities, where income opportunities are greater. The intent is to help make sure preventive medicine plays a larger role in society. The results of that effort are going to take at least 20 years to be fully recognized. But my children and grandchildren will benefit.

The short term dilemma is that small group, primary care physicians are increasingly burdened with administrative costs, pushing a lot of them to become employees as opposed to entrepreneurs, which in my judgement is counter productive. That’s one of the “fixes” that has to happen but which the House of Representatives considers irrelevant to their larger goal of reversing the whole idea.

With enough Tea Party “patriots”, we can get back on the road to ruin.

Steven Hansen, Global Economic Intersection / Mar. 1, 2014

When I read informed opinion on health care costs going up or going down, I visualize the scenes in the Exorcist (Linda Blair’s head rotating a complete 360 degrees or her pea soup hurling). It really depends on what data set you pull, how you view the data in that data set, or if you are really looking for the truth (and not just trying to “prove” Obamacare is good or bad).

Going back to Professor Krugman’s now infamous statement:
The health exchanges are off to a famously rocky start, but many, though by no means all, of the cost-control measures have already kicked in. Has the curve been bent? The answer, amazingly, is yes. In fact, the slowdown in health costs has been dramatic.

If one is trying to convince you that health care costs are falling, the “go to” place is the health sector data in the Consumer Price Index. Figure 1 – Change in Medical Care Costs – Index (blue line, left axis) and Year-over-Year Change (red line, right axis)
Figure 1 “proves” that the rate of growth of medical care prices have been decelerating – although it also proves health care prices are still rising. One pundit, using the medical care components of the PPI and PCE, argued the opposite:
“Healthcare inflation has begun to accelerate,” wrote Deutsche Bank’s Joe LaVorgna pointing to the new producer price index numbers. “The price of “selected health care industries” rose +0.3% in January following gains of +0.2% in December and +0.3% in November.”

These numbers are likely to have an amplified effect when we get an updated reading on the PCE deflator, the preferred inflation measure of the Federal Reserve.

( for many readers, this discussion of an arcane topic is putting you to sleep. While it is important, I understand that. So here is WHERE YOU NEED TO GO to finish the story along with the rest of the charts. – TK )

Are We Looking At A Bond Bubble?

Interest-rates-1790-2012My Comments: There are just as many ways to lose money with bonds as there are with stocks. The risk is different; what happens to interest rates in the future vs corporate earnings and their relative size. That’s an oversimplification but you get the idea.

The chart above shows interest rates from 1790 – 2012. You can draw your own conclusions about where they are likely to go next. It won’t surprise anyone if it happens this year or three years from now, but happen it will. And yes, I’m sensitive to the length of the horizontal axis.

When it does, you need to be positioned to not only avoid losses, but to potentially make money. It can be done and smart people will make money. Who you talk with and when you act is up to you.

By Gillian Tett / March 13, 2014 / The Financial Times

The more money that floods into fixed income, the more risky any reversal

Seth Klarman, the publicity-shy manager of the $27bn Baupost hedge fund, has given investors a slap. In his quarterly investment letter, he declared capital markets are in the grip of a wild bubble.

“Any year in which the S&P jumps 32 per cent and the Nasdaq 40 per cent while corporate earnings barely increase should be a cause for concern,” he wrote, pointing to “bubbles” in bond and credit markets, and “nosebleed stock market valuations of fashionable companies like Netflix and Tesla”.

It might sound reminiscent of 1999, when “fashionable” technology stocks last soared on this scale. But there is a twist: today it is not equities but bond markets that may yet be the most significant cause of concern.

In recent years an astonishing amount of money has quietly flooded into fixed income funds, which buy corporate bonds, emerging markets bonds and mortgage debt. And as the US looks more likely to raise interest rates, creating potential losses for bondholders, the flows could reverse – creating destabilising shocks for regulators and investors alike.

Consider the numbers. Just after Mr Klarman issued his warnings, the investment research group Morningstar produced analysis that suggests US investors have put $700bn of new money into the most mainstream taxable US bond funds since 2009. Since bond prices have risen, too, the value of these funds has doubled to $2tn. That is striking. But more notable is that these inflows to fixed income have outstripped the inflows to equity funds during the 1990s tech bubble – in both absolute and relative terms.

Meanwhile, Goldman Sachs estimates (using slightly different forms of calculation) that $1.2tn has flowed into global bond funds since 2009, compared with a mere $132bn into equities. And a new paper from the Chicago Booth business school estimates that inflows to global fixed income funds have been almost $2tn since 2008, four times that of equity funds.

Given this, it is no surprise that investment grade companies have been rushing to sell bonds at rock-bottom yields (this week General Electric, Coca-Cola and Viacom were just the latest). Nor is it surprising that junk bond issuance hit a record last year; or that Moody’s, the US credit rating agency, warned this week that investors are so desperate to gobble up bonds that they are buying instruments with fewer legal protections than ever before.

But the $2tn question is what might happen if, or when, those flows change course. Until recently it was often presumed that corporate bond investors were a less skittish group than equity investors; fixed income funds were not prone to quite such wild sentiment swings.
However, the four economists who penned the Chicago Booth paper argue that this is no longer the case.

Analysing market data since 2008, they conclude bond market investors have an increasing tendency towards volatile swings and herd behaviour. That is partly because of fears that the US Federal Reserve could soon raise rates. But the sociology of asset managers is crucial, too.

“Delegated investors such as fund managers are concerned with relative performance compared to their peers [because] it affects their asset-gathering capabilities,” they note. “Investing agents are averse to being the last one into a trade [which] can potentially set off a race among investors to join a sell-off in a race to avoid being left behind.” And while such behaviour can affect all fund managers, the Chicago analysis suggests bond fund managers have recently become much more skittish than their equity counterparts.

One sign of this occurred last year when bond markets, fearing the Fed was about to tighten monetary policy, had a “taper tantrum”, the Chicago Booth authors say. They warn that “bond markets could experience another tantrum” when the “extraordinary monetary accommodation in the US is withdrawn”. And since it is now the bond funds, not banks, that hold the lion’s share of corporate bonds, if another taper tantrum does take hold that could be very destabilising.

Today, as in 1999, nobody knows when that turning point might come. But the more money that floods into fixed income, the more dangerous any reversal could be. Investors and policy makers alike need to heed the message from the Chicago paper – or from Mr Klarman. History may not repeat itself; but, when bubbles occur, it does have a tendency to rhyme.

Energy Price Spread: Natural Gas Vs. Crude Oil In The U.S.

My Comments: Followers of this blog may remember my frequent mention of Thomas P.M. Barnett, a prolific writer and thought leader on global economics and political forces. Years ago he said that within a couple of decades, the US would become a net exporter of energy. He asserted this transformation would re-write a lot of the rules as time marches on.

Today, the shift from being a net importer, complete with our reliance on crude oil from the middle east and Venezuela, is happening faster than most of us realize. And here we have, in dollars and cents, why the dynamics are changing the way our economy is going to operate in the coming decades.

Does it mean renewable energy sources will go away for a while? To some extent perhaps. But if you are an investor, of any description, this is background information that has the potential to change your life.

Samantha Azzarello / Feb. 11, 2014

The energy production boom in the United States over the last seven years has led to a very interesting and dynamic relationship between natural gas and crude oil. From the vantage point of units of energy, the price spread between natural gas and crude oil is significant, with natural gas giving a lot more energy bang per buck compared to oil. In BTU terms, $1 of natural gas can obtain 200,000 units of energy (at a spot rate of $5/million BTU) compared to $1 of WTI oil which garners 60,000 units of energy (at a spot rate of $97/barrel). This is a whopping 330% energy content price gap – even after the polar vortex and deep freeze have raised natural gas prices. This massive energy price gap raises questions about how long it may persist, and our read of the market consensus appears to measure the time required to narrow the gap in decades, while our own base case scenario is that it could happen in just three to five years. Our objective in this report is to frame the issues that may decide the future of the energy price gap between US natural gas and crude oil.

This chart shows the cost trend in dollars to generate one BTU ( British Thermal Unit ).
Energy cost in $ per BTU

Round I: Shale enters the Ring
A brief historical perspective is useful. In tandem with large discoveries of shale-related natural gas, new technologies (fracking and horizontal drilling) have allowed shale-related natural gas production to increase by a tremendous 417% between 2007 and 2012. This surge made up a large portion of the overall increase in natural gas production, which expanded by over 20% in that same period. With a much larger supply, natural gas prices fell by over 50% from 2006 into 2013. Natural gas prices averaged just over $7/million BTU during the 2003-2008 period, with the average price dropping to below $4/million BTU during 2010-2013. Regardless, natural gas like many commodities has been susceptible to price spikes – with a high in the period of $13/million BTU reached in 2005 and a sustained period of $10/million BTU occurring in 2008. Indeed, natural gas prices have tended to display even more volatility historically than crude oil prices. And recently, the extreme deep freeze and stormy weather experienced in the Midwest, Eastern and Southern parts of the US in the winter of 2013/2014 has resulted in increased demand pushing Henry Hub Natural Gas spot prices above $5/million BTU, at least temporarily, although still lower than the average price in 2002-2006 before the production boom.
Crude oil supply has also increased within the US, by 23% since 2007. Yet, WTI crude oil prices have risen from approximately $72/barrel in 2007 to $98/barrel in December of 2013. While not as volatile as natural gas, there have been some temporary periods of high prices, and no one should forget crude’s staggering high of $145/barrel in June of 2008, preceded by prices maintained above $120/barrel in May of 2008. Looking through the price spikes, on average crude oil prices are some one-third higher now than in the years preceding the expanded production in the US, with a trading range over the last 12 months of $92-$106 per barrel, displaying a tendency toward reduced volatility.

With both crude oil and natural gas production rising in the US, and despite some temporary price spikes, average natural gas prices are lower and crude oil prices higher than before the production revolution began. As noted already, this differential price behavior has resulted in the wide energy price gap, whereby natural gas provides three times the BTUs per dollar that crude oil does. As potential substitutes in some cases, and as future substitutes as technology and uses evolve, the unusual price spread patterns between the two sources of energy are likely to result in a dynamic relationship, which could play out in the US energy markets over the next 5 to 10 years.

That is, such a significant energy cost gap would logically set in motion market forces leading to a shift in usage patterns having the potential to close the spread over time. Decisions to invest and develop new or expanded uses for natural gas depend in part on whether or for how long one expects natural gas to remain the less expensive source of energy. We would note that direct competition is not a necessary condition for the price spread to close. Before 2005, a BTU price gap did not exist, and there was little direct competition between crude oil and natural gas as sources of energy.

Our perspective, however, is that structural change in the natural gas market is re-setting conditions in a way such that the energy price spread between natural gas and crude oil may close faster than expected. When two energy sources have only limited direct competition, closing the energy price gap may take decades. If the natural gas and crude oil come more directly into competition with each other as sources of energy for end-users, then the energy price gap might be closed in a matter of years.

Round II: Shifting Usage Patterns
Crude oil is an energy source mainly used by only one sector. According to the US Energy Information Administration (EIA), 71% of total crude usage in the US is related to transportation, while industrial sector uses account for approximately 20%, and power generation and commercial use is negligible. Natural gas, contrastingly, is a much more diversified energy source in terms of use. Usage is currently split amongst the power generation, industrial, and residential/commercial end-use sectors at approximately 30% each. For our analysis, however, the sector of most interest is transportation, where natural gas usage is only a modest 3%, but growing quickly. From 2007 to 2012, natural gas consumption in the US transportation sector increased by 22%.

This report will discuss the potential interplay between natural gas and crude oil in each of the principal end-use sectors in turn, starting with where there is indirect competition (residential/commercial use and power generation), followed by some direct competition (industrial) and finally focusing on the transportation sector where there is the most potential for a direct, head on battle between the two energy sources that could profoundly influence relative price dynamics in future years in the US.


How Strong Is The Stock Market?

retirementMy Comments: For many years, more than I care to remember, I searched for wisdom from among the many magazines and more recently, the many emails that cross my desk on a daily basis. How and what was going to happen and how could I help my clients benefit from the insights that surely came my way?

Last week, the S&P500 hit a new high water mark. And since we are now in unchartered waters, what rocks, sandbars and whirlpools lurk in the shadows?

I don’t have a clue. All that wisdom imparted to me by those magazines and emails mean very little. All I can do is review the past and whenever possible, draw conclusions that will hopefully presage the future. The best thing I know to do is position yourself in such a way that folks smarter and wiser than we are assume a caretaker role, one that we can monitor and make changes when it’s obvious we and they were wrong,

By Chad Karnes / Feb. 27, 2014

The S&P made a new intraday all time high on Monday, 2/24, hitting 1,858. Although it couldn’t hold that level and sellers sent prices back below the all time closing high of 1,848 from January, the market’s strength is undeniable.

Or is it?

Real Strength
The S&P 500 is a market cap weighted index whose price is derived from a basket of 500 stocks within it. The change in its value is derived by adding up all the weighted changes of its 500 individual components. Multiplying a company’s change in price by its weight in the index gives its weighted change and thus effect on the overall Index.

The top three companies by weight in the S&P 500 are Apple (AAPL), Exxon Mobil (XOM), and Google (GOOG). Together these three companies make up 7.5% of the total S&P 500′s price. If they collectively move up 10%, the S&P would move up 0.75%.

On the flipside, the three smallest companies in the S&P 500 are Diamond Offshore Drilling (DO), AutoNation (AN), and Graham Holdings (GHC). Collectively, these three companies make up only 0.06% of the S&P 500. If they all doubled in price, the S&P would not even budge, only rising 0.06%.

80/20 Rule
Just 200 of the S&P 500 stocks make up 80% of the entire index’s value. The bottom 300 companies are essentially dominated by the larger market cap ones.

The above breakdown of the S&P 500 displays one of the key weaknesses of the S&P and most stock indices. They can be misleading.

The S&P just made a new all time high which on the surface seems like a great development but take a look at the chart below.

What the above chart shows is the number of S&P 500 stocks in an uptrend as measured by whether their price is above their 200 day moving average. Quite clearly this chart is not making new all time highs and in fact is in a downtrend, showing that less and less stocks in the S&P 500 are participating in the rally. 19% of companies in the S&P 500 are in downtrends, the most at any new S&P price high since the rally from 2009 began. More so, the declining trend in companies above their 200 day moving average is also a first as the market makes new high after new high.

In our 1/20 Technical Forecast, just as the markets were topping and on their way to a 6% pullback, I provided a similar chart along with other indicators and commentary for our subscribers with this warning:
“The % of stocks above their 50 day moving averages peaked in February and again in May along with new all time highs. Since then, the peaks have not shown as much participation and display a market that makes new all time highs, but on the backs of less and less stocks. A breakdown of 60% (of stocks above their 50 day) accompanied all the market pullbacks in 2013 and again will be a warning that a majority of stocks are nearing downtrends and a larger selloff is likely.”

A decline below 60% occurred later that week as the market was on its way to a 6% pullback.

The declining breadth (as the chart above shows) continues through today and helped us warn subscribers of the overall weakening trend in stocks, regardless what the broader index was suggesting. This development makes the markets more susceptible to a large pullback.

The broader index may be making new all time highs, but less and less of its components are. This means the market is being driven higher by fewer and fewer companies and solely by those companies with the biggest market caps that have the larger effects on the Indices.

These stocks will only be able to pull the market higher for so long as valuations and momentum eventually become too lofty for sustainability. The increased risk of a rising market on less and less support was foreshadowed with January’s 6% pullback.

A market that rises on less and less support is one that is very fragile as there are less companies to pick up the slack if one of the leaders goes out of favor. The declining trend in stocks above their moving averages (and new 52 week highs) also shows a market that is tiring.

Treading Water: Four Economic & Market Trends Likely to Continue in 2014

profit-loss-riskMy Comments: Understanding how markets work over time is a very helpful skill set if you are advising clients about their money. Especially if they are worried about where money will come from to pay their bills far into the future.

For many, the short term “noise” that comes from what one reads in papers and magazines, and hears on TV, greatly influences their day to day thinking about their concerns. And so there is a huge tendency to let emotions rule the day when in fact it should be rigorous analytical thought.

Here is today’s attempt to provide you with a bridge between the “noise” and a longer term basis for making rational decisions about your money.

By Russ Koesterich, CFA

Like stocks last week, economic fundamentals are treading water. Russ explains the economic and market trends that are likely to continue in coming months.

Though there was quite a bit of back-and-forth stock market movement last week as investors reacted to some mixed economic data and earnings reports, stocks ultimately finished the week little changed.

Like stocks, economic fundamentals are also treading water, and I see more of the same ahead. As I write in my new weekly commentary, I expect a number of key economic and market trends to continue in the coming months.

Low inflation. Last week’s January’s Consumer Price Index reading showed that inflation remains well contained. Two factors are helping to keep inflation contained and less volatile than in the past – soft wage growth and dampened oil price volatility. If wage growth stays soft, I don’t expect to see any near-term acceleration in inflation.

Low rates. Low inflation is good news for the economy, and for markets. It means that the Fed is under no immediate pressure to raise rates, and we expect short-term rates to remain low for the remainder of 2014 and into 2015.

Moderately higher market volatility. The VIX Index, a measure of U.S. stock market volatility, has fallen a bit since it spiked in early February, but it’s higher than it was at the start of the year.

Given the uncertainty surrounding the U.S. economy, the Fed’s tapering, and the still fragile environment in emerging markets, I expect the relatively higher levels of equity market volatility to persist. To be clear, I’m not forecasting unusually high levels of volatility; rather, I anticipate volatility will continue to rise from what have been unusually low levels. Specifically, I expect the VIX to head from its current level of just under 15 back toward its long-term average of around 20.

More M&A activity. Corporate deal activity has been on the rise in recent weeks. In a world of relatively slow growth, and fewer opportunities for organic growth, it’s no surprise that companies are willing to deploy cash – and in some cases rich stock valuations – to buy growth. The willingness to engage in mergers and acquisitions may also be a precursor to rising capital spending.

So what does this mean for investors? Low rates should support equity valuations and help keep long-term Treasury rates from rising too aggressively. In addition, higher levels of deal activity and higher capital spending levels also tend to act as tailwinds for equity markets. You can read more about my economic outlook in my latest Investment Directions monthly market commentary.

Russ Koesterich, CFA, is the Chief Investment Strategist for BlackRock and iShares Chief Global Investment Strategist. He is a regular contributor to The Blog and you can find more of his posts here.

Bad Is Stronger Than Good

DOW-114My Comments: Yesterday, I reposted an article that claims virutally all economists are in agreement that the stimulus pushed by this administration served to keep us from falling into a drepression, and that the major argument was whether the stumulus should have been stronger.

Here is an article from last week that considers the mental aspect of the voting public and how come we prefer to focus on bad things as opposed to good things. Perhaps we are so conditioned by local TV news where the focus seems to be on who had a wreck, who got whacked, etc. It’s easier for ad salesmen for the TV station to sell into fear than it is to sell into success. Our politicians know this, so we essentially get what we deserve.

Cullen Roche, Orcam Financial Group Feb. 10, 2014

We humans are a fickle bunch. If there’s one thing you can pretty much guarantee, it’s that things are never really good enough. We seem to focus excessively on the negatives in our lives at all times. You’ve probably heard a lot about how the economy is terrible in recent years, how we’re in a “depression” or how we’re right on the verge of sinking into the abyss that we came close to falling into in 2008. This isn’t all an exaggeration. But a lot of the focus on the negative seems to be the result of a natural bias of ours – negativity bias. And it can be extremely destructive if it’s not understood.

Negativity bias is the tendency to emphasize and recall negative events relative to positive events. That is, fear of bad events plays a much more substantial role in our thought processes than positive events. This bias was discussed in some detail in a 2001 study in the Review of General Psychology in a study titled “Bad is Stronger than Good.” It’s a natural evolutionary bias – we fear that which can harm us. And when it comes to financial markets and economics, we tend to see this bias in spades. Just look at the last 5 years of economic recovery during which negativity seems to have swept over the economic outlook with alarming regularity. But how bad has this recovery really been relative to past recoveries?

If we look at some of the broader indicators we can get a better grasp of the overall picture here. For instance, if we look at real GDP, the data looks pretty weak, but not exactly a nightmare. This chart shows the number of months since the economic trough of each downturn:
Real GDP 1

What about industrial production? The 2009 recovery actually ranks up there with the past three recoveries. In fact, it looks extremely strong:
Real GDP 2

What about private sector employment? The 2009 recovery is middle of the road (bear in mind that almost all of the employment weakness in the last 5 years has been the result of government job cuts).

This doesn’t tell the most amazing story in the world. It’s all certainly consistent with the “muddle through” theme I’ve been working with for the last 3-4 years. But it’s also not the nightmare that the mainstream media and doom and gloomers sometimes imply. In fact, there’s a fair amount of good stuff that’s gone on in the last 5 years. And one can only imagine how much better things might have been had the policy response not been so underwhelming and misguided at times. But I digress.

The point is, it’s a good thing that we often focus on the negatives in our world. That makes us more likely to make improvements, resolve problems and avoid the same problems in the future. But when we analyze the current state of affairs we have to also avoid falling victim to our negativity bias. An excessive focus on the negatives in our financial markets will generally lead one to fall into the trap of believing that things are actually much worse than they really are. And that can lead to very bad decisions. Instead, it’s better to understand this bias and try to analyze the economy and the financial markets with a more balanced and pragmatic perspective. That will help you understand the problems we face without falling into the trap of focusing so much on the negatives that you wind up thinking that the end of the world is always around the corner.

The Future Still Belongs to the Emerging Markets

question-markMy Comments: As someone who has helped clients manage their money for almost four decades, I’m still often caught up in the “crisis de jour”, what’s happening TODAY, as opposed to stepping back and looking at things from further away. Our society has become obsessed with WHAT IS HAPPENING NOW, and often fails to put that in a larger context.

For the last few weeks, the markets have been in turmoil. Everyone is running helter skelter to explain this. Is China about the implode? Terrorists in Sochi and the Olympic Games! 2013 was a good year so 2014 has to be a bad year!

Not to imply that tactical approaches to investment are not appropriate for long term investors, ie someone with a ten year need for money, what appears to be happening is the expected correction of 2014 is happening now, and not waiting for warmer weather. This artcle from the Financial Times helps put what is happening TODAY in a larger context, one that will hopefully put your mind at ease a little bit.

By Gideon Rachman / February 3, 2014 / The Financial Times

Just as the west has emerged from crisis before, the newcomer economies will return to growth.

In 1996 a friend of mine called Jim Rohwer published a book called Asia Rising. A few months later, Asia crashed. The financial crisis of 1997 made my colleague’s book look foolish. I thought of Jim Rohwer (who died prematurely in 2001) last week as a I listened to another Jim – Jim O’Neill, formerly of Goldman Sachs – defending his bullish views on emerging markets in a radio interview.

Mr O’Neill coined the term Brics for Brazil, Russia, India and China, just before the emerging market boom of the past decade really got going. He was rewarded for his prescience, and his ability to coin a good acronym, with guru status. Now Mr O’Neill is back, talking up the delicious-sounding Mints (Mexico, Indonesia, Nigeria, Turkey) as the next group of rising economic powers. But this year his timing is a bit off. Investors are panicking about emerging markets and Turkey – the pay-off in the Mint – is at the forefront of the crisis.

One moral of these stories is that in punditry, as in investment, timing is everything. It is possible to be right at the wrong time – and that is what happened to Rohwer. His bullishness about Asia was fully vindicated in the 17 years after the appearance of his book. It just looked badly wrong in the crucial months after publication, as the International Monetary Fund was forced to bail out South Korea, Thailand and Indonesia.

The speed of the recovery in Asia was just as startling as the speed of the collapse. South Korea is once again regarded as a model economy, and its per capita gross domestic product has almost tripled since the near disaster of 1997. Thailand and Indonesia also bounced back.

Those stories are worth remembering amid the current panic. The next year could make boosters of emerging markets, such as Mr O’Neill, look like false prophets. But over the course of the next decade, they will be proved right – again.

The reason for this is that the factors that have propelled the rise of non-western economies in the past 40 years still apply. These include lower labour costs, rising productivity, huge improvements in the communications and transport that connect them to global markets, a rising middle class, a boom in world trade as tariffs have fallen and the spread of best practice in everything from management techniques to macroeconomic policy. Added to this is the drive of people all over the world – from factory hands to entrepreneurs – who have realised that they are not condemned to poverty, and that a better life is there for the taking.

In the past half century, these powerful forces have allowed emerging markets (or developing nations or rising powers, if you prefer) to grow much faster than the developed world. In their recent book, Emerging Markets, Ayhan Kose and Eswar Prasad show that the economies of a group of the most prominent emerging markets (including China, India and Brazil) have grown by about 600 per cent since 1960 – compared with 300 per cent for the richer, industrialised nations. Even over the past 20 years, they write, “emerging markets’ share of world GDP, private consumption, investment and trade nearly doubled”.

The effect has been to transform the global economy. Michael Spence, a Nobel Prize-winning economist, writes that in 1950 only about 15 per cent of the world’s population lived in developed economies. In the intervening 65 years, the benefits of industrialisation, trade and rapid economic growth have spread to large parts of Asia, Latin America – and now Africa.

The story is far from over. Professor Spence argues that we are in the midst of a “century-long journey in the global economy. The end point is likely to be a world in which perhaps 75 per cent or more of the world’s people live in advanced countries.” If anything, the pace is likely to increase as the implications of the communications revolution become clearer and more entrenched.

The rise of the emerging markets will, however, be punctuated by crises such as the one we are experiencing today. These, too, have been part of the story all along. The Asian financial crisis of 1997 was not an isolated event. There was the tequila crisis in Mexico in 1994 and the Indian financial crisis of 1991. If you enter the words “Latin American financial crisis” into Google, it helpfully offers to complete the phrase with the dates – 1980, 1990s, 1998 and 2002. Yet despite all this, most of the leading economies of Latin America – Brazil, Mexico, Chile and others – have experienced real improvements in living standards and reductions in poverty.

The emerging markets have also sometimes been rocked by political crises that led investors to panic. Most dramatically of all, there were the protests in Beijing’s Tiananmen Square and subsequent massacre in 1989. Who at the time would have predicted that – in spite of all this political turmoil – the Chinese economy would more than double in size over the next decade, and then do the same again in the decade after that?

The moral of the story is that the rise of non-western economies is a deeply rooted historic shift that can survive any number of economic and political shocks. It would be a big mistake to confuse a temporary crisis with a change to this powerful trend. The bursting of the dotcom bubble in 2001 did not mean that the internet was massively overhyped, even though some people jumped to that conclusion at the time. In the same way, today’s turmoil will not change the fact that emerging markets will grow faster than the developed world for decades to come.