Genesis 1:31 says “And God saw every thing that he had made, and, behold, it was very good. And the evening and the morning were the sixth day.“  A few millennia later, we find that the world’s most popular book can be applied metaphorically to the US House of Representatives, as it labors in the creation of clunker-nomics.

The first billion voted by the Congress for the $4500 clunker rebate program was exhausted in 6 days.  Practicing for deity status, the House beheld and determined “it was very good.”  They immediately passed a $2 billion addition.  That bill now goes to the Senate, which will pass something similar, and then to a conference committee to resolve some differences about rules.  We expect additional funding will be forthcoming quickly.  Congress loves to spend and Americans love to receive.

In the spirit of Genesis, Adam and Eve American, otherwise affectionately known as John and Jane Doe, recognize a good deal when they see one.  They had an old clunker worth a few hundred.  Suddenly they can exchange it for $4500 if they buy the new one now.  The rest they can finance at very low interest rates, thanks to the Federal Reserve and the Treasury for extending TARP and other funds so that lenders can offer them liberal terms.  They seized the moment    who can blame them?

This will boost short-term activity in the US.  Neil Soss of Credit Suisse estimates, “Our math suggests that vehicle sales could spike in July, perhaps to a run rate near 12.5 million units (at a seasonally adjusted annual rate) from the 9.6mn average of Q2.”  He adds that “in response to cash-for-clunkers … the personal savings rate will drop sharply in the next months, even as the longer run trend is still headed higher.”  That will ramp up auto production in the 3rd quarter.  Neil concludes, “As a consequence, we are revising up our Q3 real GDP forecast to 2.0% (from 1.3%) and our Q4 forecast to 2.5% (from 2.0%).

Okay.  We know that older and fuel-inefficient cars are supposed to be scrapped.  That is supposed to be an environmental improvement.  And we know that the United Auto Workers like this stimulus, for obvious reasons.  So do the government-owned or government-sponsored auto manufacturers.  The last private firm, Ford, will benefit, too. 

Does the clunker stimulus result in enough gain to offset the net present value of the perpetual cost to finance it?  Fair question?  We think so.  Is there an answer?  Maybe, but the proof is very difficult to establish.  It you are interested in this discussion, invite a few friends over for a beer and talk about it.  But make sure the beer is brewed in America by the United Beer Brewer Workers.  And when you toast, toast Ford and be a patriot.

Did anyone ask how many of these car sales are being “borrowed from the future?”  We didn’t see it in the Congressional commentary.  If it was there, it did not influence the political decision. 

Has anyone looked at what we have done in a macro sense?  We will try.

The United States borrowed 1 billion dollars.  It is unlikely to ever pay it back.  The annual interest will add $50 million to the federal budget each and every year, forever.  We are assuming it is financed today with 30-year Treasury bonds.  The additional $2 billion of borrowed clunker money will add another $100 million in interest.  So clunker-nomics has committed the nation to make this interest payment forever.

Practicing an industrial policy by inserting government into a mixed economy is the new America.  No one measures the exchange of short-term gain being substituted for longer-term taxes or inflation or debt-burdened slower growth.  Those economists who are full believers in expectations analysis argue that the market will immediately adjust prices to reflect this exchange.  Maybe so in the mathematical models that they use to justify that argument.  

We think this expectations analysis fails in the real world.  Adam and Eve American are not economists.  They make their decisions for their individual benefit and in terms they can understand and assess.  They know what a $4500 free gift is.  They understand it.  They do not deal with trillions of dollars; they do not conduct ever-increasing auctions of Treasury notes and bonds; they do not deal in foreign exchange and reserve transfers.  That is not their fault.  The have daily lives to live and they are facing their own struggles. 

So they delegate some of these borrowing and spending decisions to the Congress because they have no other choice.  In the House the long term is limited to the two years until the next election cycle is faced.  So the House will easily exchange $1 billion in spending for $50 million in added budget interest.

Thus we have an asymmetric exchange.  We gratify now; we borrow to do it; we defer the day of reckoning; it grows bigger and bigger but seems to be perpetually deferred.  Every once in a while a crisis unfolds and the system fails, as it did with Lehman Brothers last September.  That triggers a new round of upward ratcheting of this asymmetric system. 

When does it end?  First question without an answer?  Will the end be fire, or ice?  Also, no answer.  What should we do to protect ourselves?  Much harder, but there are some answers.  Diversify worldwide.  Seek a mix of investing to protect wealth.  Lastly, enjoy life and the weekend in the spirit of Genesis.  Rest on the seventh day, if you can.

And remember that God gives you only so many days on the planet but doesn’t count the ones you spend fishing.  We will wink at CNBC viewers on Friday, August 7 from Leen’s Lodge at the annual Shadow Fed fishing retreat, where 35 of us will debate and dissect asymmetric information and deficit finance.  For now, we hope your seventh day is restful for you. 

A further unsettling factor is the large number of companies planning to list for the first time. The ban on new listings was lifted by Beijing in June. The first new listing on the Shanghai exchange in over a year, the Sichuan Expressway, more than tripled upon its debut. This is seen as an indication of the readiness of Chinese investors to speculate.

Going forward, while we would not characterize this year’s advance of the Hong Kong H share market or even that of the Shanghai A share market as having reached bubble proportions, the latter market certainly has become “frothy,” and the risk of a bubble developing is significant.  The Chinese bull market still has legs and probably will continue for some time yet. But the road ahead looks likely to be a more volatile one. In view of the growing risk of a correction in the A-share market that would spill over to the Hong Kong H share market, we have reduced the China overweight positions in Cumberland’s international portfolios back to close to benchmark levels.

Is it Bubble Time in China Again?

On Tuesday, July 29, Chinese stocks were down by 7.7% at one point before finishing the day down 5%, and the ripple effects were felt in markets around the globe. There were fears that this year’s bull market in Chinese stocks could be brought to a sharp halt by central bank action to curb the explosive growth in liquidity. Chinese financial policy makers as well as domestic and international investors remember well the precipitous fall in Chinese equities last year, when the bubble burst. Is the China market headed down that same path again?

Chinese stocks have certainly been on a tear this year. The largest China ETF sold on the US market, FXI, which tracks the 25 largest Chinese firms listed on the Hong Kong Exchange, is up 79% since the March 9 low (45.6% YTD). The MSCI China A shares index, which tracks stocks listed on the domestic Chinese market and available to domestic Chinese investors, is up 93.28% YTD. These numbers illustrate  the much more volatile nature of the Shanghai exchange.

As there are severe restrictions on the ability of domestic Chinese to invest in the Hong Kong market and other markets outside of Mainland China, significant differences can develop between the Hong Kong shares (H shares) and the A shares of the same Chinese companies. Currently, A shares are priced at about a 40% premium to the H shares of the same companies. The Hang Seng China AH Index that measures the average premium (or discount) between these markets is now at 139.44.  Back in January of 2008 this index reached 208; that is, the premium exceeded 100%.

The reasons to be concerned about possible development of speculative bubbles relate much more to the mainland market than the Hong Kong market, but developments in the former are usually echoed to some extent in the latter. The 56% YTD advance  in China H shares, as measured by the MSCI China H shares index, which covers many more firms than the 25 largest tracked by the FXI ETF), is not much out of line with the 47% increase in the MSCI Emerging Markets Index when one considers that the Chinese economy is advancing more rapidly than other major emerging markets. However, should the more frothy A shares market pull back sharply, the China H shares market (and the China ETFs based on that market) would be hit.

We do not question the strong growth of the Chinese economy going forward. The Chinese economy advanced at 7.9% in the second quarter, and the growth rate in the second half looks likely to approach and possibly exceed 9%. We would not be surprised to see 10% growth in 2010.  This growth will be very favorable for the global economy. While China is the world’s greatest exporter, recently surpassing Germany, it is also the biggest market for many countries, including Japan. Exports have begun to improve, pointing to a likely recovery in profits in the second half. Importantly, the Chinese consumer is becoming a central driving force in the economy, taking over from exports. While, as noted below, loan growth has been very robust, neither consumers nor businesses appear to be overly leveraged.

Rising valuations are one possible source of concern. The price-to-trailing-earnings ratio for the MSCI China Index was 15.7 as of July 10.  The consensus P/E is 15.2. These compare with the five-year average of 16.3. This is well below the P/Es of 30.3 for Taiwan and the 21.1 for Korea and is slightly below the 16.6 of India. However, it is well above the EM average of 13.8 and Brazil’s 10.9.  China H shares do not appear yet to be significantly overbought.  Our friends at BCA Research estimate that the price-to-normalized earnings for A shares is now 28 as compared to 19 for H shares. Nevertheless, they find that A-share prices are “neutral,” having just returned to their long-term trend.  Similar conclusions result from looking at the PEG ratio (P/E relative to expected earnings growth)

Our concerns, rather, relate to the explosive growth in bank loans this year, which is far in excess of what has been required for the pace of the underlying economy. The Chinese magazine Caijing reports that total lending for the first half of the year totaled “a record 7.37 trillion yuan – 2.3 times the amount of loans issued during the same period last year.” This lending has been a result of the highly stimulative government policies. Indeed, in part this loan growth is actually fiscal spending through state-controlled banks. The “Big Four” state-owned banks accounted for more than 3.47 trillion yuan of the lending.  In May medium sized banks took over the lead for lending growth.  It is likely that some of this lending, perhaps a considerable amount, has gone into the equity markets, fueling the surge in equity prices and real-estate.

Recently, several monetary policy officials have expressed concerns that the liquidity expansion could get out of control and lead to bubbles in the Chinese equity and real-estate markets. On July 27, banks were ordered to ensure that loans are channeled into the real economy. Some analysts have argued that the authorities will wait until 2010 to take steps to control asset price inflation. We would agree that with deflation still a concern, a withdrawal of the stimulus or policy interest-rate increases are unlikely this year.

On Wednesday, July 28, Su Ning, Vice Governor of the People’s Bank of China (the central bank), sought to reassure markets by saying that a proactive fiscal policy and a moderately easy monetary policy are crucial for sustained growth. In the second half the PBOC would seek to coordinate a “reasonable credit structure based on “market rules.” That seems to rule out strict quotas. However, moral suasion in the form of administrative guidance to slow down some undesired aspects of the loan expansion is already being felt in the markets. Such fine tuning should be beneficial for the economy but could well lead to a sharp correction in the Shanghai market that would spill over to the Hong Kong market.

A further unsettling factor is the large number of companies planning to list for the first time. The ban on new listings was lifted by Beijing in June. The first new listing on the Shanghai exchange in over a year, the Sichuan Expressway, more than tripled upon its debut. This is seen as an indication of the readiness of Chinese investors to speculate.

Going forward, while we would not characterize this year’s advance of the Hong Kong H share market or even that of the Shanghai A share market as having reached bubble proportions, the latter market certainly has become “frothy,” and the risk of a bubble developing is significant.  The Chinese bull market still has legs and probably will continue for some time yet. But the road ahead looks likely to be a more volatile one. In view of the growing risk of a correction in the A-share market that would spill over to the Hong Kong H share market, we have reduced the China overweight positions in Cumberland’s international portfolios back to close to benchmark levels.

Being in the Sweet Spot (Twice)

At the moment we are in the “sweet spot” in markets and soon, in Maine.  We must enjoy it while it lasts.  Some bullets follow.

1.    Fed policy is on hold at Quantitative Easing (QE), which means short-term interest rates near zero and plenty of liquidity in the financial system.  The Fed has said it will continue this posture for a period of time.  Markets do not expect any change until well in to 2010 at the earliest.

2.    The much-feared Obama healthcare initiative seems to be stalled.  Markets are relieved, because this initiative, as it was presented, amounted to a huge transfer payment that would be funded by future tax increases.  The tax hikes would come on top of those already discounted by markets.  Lifting the double tax whammy has given stocks a boost.

3.    Foreigners are buying US Treasury securities again, and that has quieted the fearmongers who have been crying that the US will be abandoned and the dollar will face a crisis.  That may still occur, but the day of reckoning for our fiscal profligacy seems to be postponed.  Markets like dodging this bullet.

4.    Markets have not priced in any risk premium on the Bernanke-stays or Bernanke-goes debate.  Markets are also not pricing any risk premium on how and when the Fed will exit the QE strategy.  Right or wrong, markets are now powered higher by bullish momentum coupled with positive economic signs.  The Fed and other central banks in the world are on hold.  Markets like stasis and have it for the time being.

5.    Markets are not pricing any substantial inflation risk in the near term.  TIPS yields are a market-driven indicator of this measure.  Longer-term inflation risk is priced higher, but it is derived from forward rates and is subject to change as conditions unfold.  That means it is not impacting short-term market movements.

In our view the biggest news this week will arrive on Friday.  There will be an advance estimate of second-quarter GDP.  But that is not what I mean.  In fact, that estimate has little meaning to money managers, and markets are likely to ignore it as old news.

The really big news will be the revisions in the benchmark national income and product accounts.  These are revisions done infrequently and substantively.  They are the basis for much of the work done by analysts and economists.  These numbers are critical to the development of national policy and to the longer-term valuation of financial markets.

We do not know what the release will say, of course, but we do have some expectations.  We think the revised savings rate will be higher than the currently computed series.  If so, that will give the markets some comfort.  The newly revised numbers will also help in the projection of a longer-term growth rate for the United States, and they will give guidance on inflation and productivity.  We believe that the forthcoming revisions will be positive on both counts.

If we are correct, the revisions will become an economic data platform that will support arguments for a higher movement of stock prices.  The upward trend that has been powerfully active since March 9 will continue.  In Cumberland’s ETF accounts, we are fully invested and have taken our target for the SP 500 index to over 1100 by the early part of 2010.  Our global ETF accounts are similarly positioned.

Our managed bond accounts continue to favor spread positions over Treasuries.  That is true for tax-free municipal bonds, which are very cheap for individual investors, and also taxable securities.  We are placing a lot of emphasis on Build America Bonds.  We caution investors to do the homework on each issue and to understand the cash flows that secure these bonds.

We continue to expand our use of certain ETFs that offer protection from interest-rate risk in accounts that are large enough to justify their use.  These securities can lower the overall risk profile of an account when they are properly used.  We note that many retail investors are trading these securities, and we caution that they may be doing something they do not really understand.  Duration matching against a parallel yield-curve shift is a complex task.  It takes a lot of effort on our part to do it.  Folks who are doing so without fully understanding how these securities work travel at their own peril.

Next week is very busy, so Cumberland market missives may be in short supply.  Bob Eisenbeis, Bill Witherell, and I will be presenting at the National Business Economic Issues Council (NBEIC) meeting in Samoset, Maine on Tuesday and Wednesday.  This is a closed meeting that operates under Chatham House Rule, so no information will be published about it without specific permission of a presenter. 

At the end of next week, Peter Demirali and John Mousseau will join us at another sweet spot, in the village of Grand Lake Stream, Maine at Leen’s Lodge for the annual Shadow Fed fishing retreat (nicknamed Camp Kotok by Becky Quick).  CNBC will be broadcasting live on Friday, August 7, starting very early in the morning and running for much of the day.  We are 34 attendees, plus Steve Liesman, Matt Greco (a Squawk Box producer), and the CNBC crew.  The attendees are by invitation only and have traveled from as far east as Abu Dhabi to as far west as Vancouver and Newport Beach and from as far south as Dallas.  We have booked the entire camp and will be testing its capacity.

Be Careful What You Ask For

Oh, Ben.  Why did you offer this?

In his Q&A session at the Senate on the second day of his testimony, Federal Reserve Chairman Ben Bernanke offered a response to a question about the Fed’s role in consumer protection.  He suggested that the Senator reopen "the Act" and add the consumer-protection role to the Fed’s mandate. 

I cringed.

So did several others within the Federal Reserve who were in disbelief at what they heard.  So did many others outside the Federal Reserve who have been championing the Fed’s independence when it comes to monetary policy.  In Bernanke’s defense, he also added that any law changes must not alter the independent ability of the Fed to formulate monetary policy.  Those words mean the Fed’s ability to raise interest rates when it deems it has to fight inflation. 

But by inviting the Senate to open the law to changes while asking to remain independent is like putting your head in the lion’s mouth and asking the beast to be considerate.  Chairman Bernanke is now engaged in a high-risk gambit.

Reopen the Federal Reserve Act?

I am now seriously worried that the Congress will take Bernanke up on his offer.  Once an amendment to the Federal Reserve Act is on the table (which it is), anything may happen.  Remember, this would be a bill that has to clear the Senate and the House (Pelosi, Frank, and company) and then get to a conference.  

In the famous Geithner “white paper” which will receive Congressional discussion today by various witnesses including Bernanke, there is a proposed provision to give the Treasury Secretary a veto over the Fed’s use of emergency powers.  Remember, the Treasury Secretary meets weekly and one-on-one with the President.  What could be more political than that? 

Picture a situation where there is a need for one of the Fed’s emergency actions, such as we have seen in recent months.  If the Geithner proposal comes to pass, how would that work?  And can we ever be assured that the policy positions of the Fed would be taken from a neutral starting place?  I wonder.

Fed policy could easily become asymmetric and therefore inflation-biased.  Imagine a situation where the Treasury has invested TARP funds and doesn’t want to admit losses.  Isn’t it easier for them to have the Fed keep an entity alive with hope for a miracle rather than be embarrassed by a failure?  Is it possible for a politician to admit an error and take a small loss rather than defer the loss, even though the final cost will be much larger?  Decision-making biases are hard enough to overcome without imbedding a structure that worsens them. 

Bernanke knows this.  So why did he invite the Senate to reopen the Act?

Maybe his political advisors are not guiding him well.  They may be telling Bernanke that this proposal will be disarming and soften the Fed’s critics.  Maybe he is following a protocol of open democratic process that is a result of his academic career.  Or maybe he believes the Act will be reopened anyway and it is better tactically to propose changes proactively, and try to modify the outcome, rather than resist it.  No matter how one plays out this sequence, it is hard to find a good outcome.  We fear the politicization of the central bank.

That said, markets are not focused on the Fed and political risk.  Markets are looking only in the shorter term for Fed policy that remains highly stimulative.  That means continued very low short-term interest rates are in the cards.  For Treasury bonds that means retrenching (higher rates, lower prices) as the risk of an economic Armageddon subsides and as signs of a bottoming economy recur.  

We continue to emphasize spread product on the bond side.  Tax-free and taxable Munis offer good values in the bond turf.

Stocks have an upward bias.  In the stock markets our accounts are fully invested.  So far, the summer has been beneficial to clients in both fixed-income and equity asset classes.  We are pleased with our ETF strategies as the stock markets of the world recover from the March lows.  In the United States, we are targeting 1100 on the S&P 500 index by early next year.


Dennis Gartman, Ben Bernanke & Congress

Dennis Gartman’s letter today hit so many key points with an economy of words that I have excerpted it and scratched my own text on Bernanke’s testimony.   Dennis doesn’t mention the changes in “velocity” which is too technical a subject for this missive.   Maybe later.   He does perfectly characterize our Congress.  

Go, Dennis, go.  Give me a chance and I will vote for you.  Next year we will get you on the annual fishing retreat when your calendar is not so conflicted.   For the rest of our readers, on Friday, August 7, CNBC will start in the early morning with Steve Liesman and a live truck at the annual fishing gathering at Leen’s Lodge in Maine. 

Readers are encouraged to try the Gartman letter.  The subscription is well worth the price.  See:

On July 21, 2009, Dennis Gartman wrote”

“That having been said, we do indeed note that Dr. Bernanke is headed to “The Hill” today and this should make for very interesting testimony, firstly before the House Financial Services Committee and then tomorrow before the Senate Banking Committee [Ed. Note: We always look to the first “performance” for the real meat of what Dr. Bernanke…or any Fed Governor for that matter… shall say, for they repeat their comments almost entirely when before the other house of Congress the following day. However, we look especially forward to the House’ questioning of Dr. Bernanke today for we can never underestimate the sheer idiocy of House members when it comes to all things economic. We have an especially “warm” spot in our hearts for Ms. Maxine Waters (D. California), who is capable of the most fantastically idiotic statements at almost any time. One must always be alert when Ms. Waters speaks. One never knows what idiocy shall come forth.].

This shall be especially interesting testimony from Dr. Bernanke for the market is concerned that his position is somewhat in jeopardy, and an awkward appearance today and tomorrow could do damage to the odds of him being reappointed for a full term in office. Dr. Bernanke will update the Congress on the Fed’s macroeconomic views and will of course be asked how long the Fed expects the recession to last. The House members, unable to understand the seriousness of the situation, will likely ask the Fed Chairman his views on salaries on Wall Street, on the Madoff Affair, and other such effluvia, and Dr. Bernanke will try his very best not to appear angry or despairing as he answers these questions. Quite honestly, we do not know how he retains his honour and dignity at some of the questions, and does not leap over the table, grab one of the Congressmen or women who ask these idiotic questions by the neck and shake them from limb to congressional limb; but he does retain his composure and his answers will be measured a bit more seriously this time than previously.

The real debate, and the one we think shall not be made, is what the Fed can do and intends to do in withdrawing the excess reserves from the system when the time comes for that to be done. Firstly, we shall go on record and say that the time to withdraw these excess sums of money (and by “money” we mean the adjusted monetary base) injected forcefully into the system last autumn is not now, and it shall not be until such time as unemployment has begun to turn down rather than marching inexorably upward as it is at present. However, why this debate is so shrouded in obscure language is quite beyond us, for the Fed has several very clear tools with which to withdraw these reserves. It can sell Treasury securities, or Agencies, or whatever collateral it has accumulated back into the system through direct sales to Fed dealers, or it can withdraw the money via long term “reverse” repurchase agreements. We suspect that the Fed shall use both methods, for the former is a permanent change and the latter is a shorter term, reversible one that will allow the authorities to fine tune its actions.

All we do know is that the Fed seems already to have begun the process of removing those reserves for the monetary base has not grown since the turn of this year. The Base stood last week (as accounted for by the Fed St. Louis, the “keeper” of such data) stood at $1700 billion, and that is almost perfectly where it stood at the end of December. In other words, the Fed has clearly not increased the base, and that is the first step toward reducing it.”

We thank Dennis and his counsel for giving us permission to quote him today.  

Meredith Whitney and 13%

Meredith Whitney moved markets when she called the Goldman earnings and raised her nearer-term outlook for banks.  The widely heralded CNBC interview became a forecast promptly validated by the results of the reporting banks.  Her premier star quality remained intact.

But Whitney also ventured away from her bread-and-butter turf.  In doing so, she may diminish her forecasting success.  In the final segment on Squawk Box, she said that the unemployment rate would reach “13%.”  Readers may find these interviews at, search under Whitney.  Please note that the 13% forecast is found in the 8:50 AM segment on July 13.

We disagree with Whitney.  13% unemployment rate is not in the cards.  By the way, if she is right and we are wrong, the banks will fail the stress tests miserably, there will be another capital crisis and the stock markets of the world will crash.  

Let’s bring in some others to help clarify the unemployment rate and what it means.  Granted, the numbers are pretty bad right now.  The unemployment rate is expected to break above 10% in the next month or two.  That is the consensus view of most economists who specialize in this type of prognostication.  It is our view as well.

But after the double-digit level is reached, there is considerable evidence to suggest that it may peak this summer.  Ed Yardeni wisely notes that the unemployment rate is improperly called a lagging indicator.  He examined the 10 cyclical peaks that have occurred since World War II.  The lagging mantra was applied because of an averaging method, and just two data points cause the average to show this lag.  They are the recessions of 1992 and 2003.  Exclude them, says Ed, and the other eight peaks had an average 1.6-month lag, with 4 months being the longest.  If Ed is right, the unemployment rate and the business cyclical trough will be nearly simultaneous.  No lagging indicator here, claims Dr. Ed.

Bill Dunkelberg uses his survey data of the membership of the National Federation of Independent Business to forecast a future unemployment rate.  He asks the members about their hiring plans and runs the collected results with an algorithm that has a pretty good track record.  Dunk has the unemployment rate peaking soon and then falling to “8.8%” in less than a one-year time horizon

Barclays Capital’s Tim Bond focuses on the payroll report and on ISM data.  His method models a three-month moving average of changes in monthly payroll data.  He believes a “sharp improvement in payrolls should be visible in July and August.”  He expects weekly unemployment claim data to confirm the changes he forecasts.  Tim’s ISM-based regression “displayed an R-squared of 0.87.”

Asha Bangalore of Northern Trust notes that the seasonal adjustments may be sending an errant message due to a holiday-shortened work week and auto industry anomalies.  Asha looked at year-over-year unadjusted jobless claims and concluded that “the worst in the labor markets is most likely behind us.”

We respect Meredith Whitney’s work on banks and must credit her with some very good calls as the financial crisis unfolded.  But when it comes to the unemployment rate we must join Ed, Bill, Tim, and Asha and our other colleagues and disagree with Ms. Whitney.  13% unemployment doesn’t seem to be in the cards.

If she is right and we are wrong, there will be a fierce W in the economy and in the stock markets.  If however the peak of employment deterioration occurs this summer, as we believe, then the stock market rally since the March 9 low is for real and a cyclical recovery is underway.  Such a rally can easily carry the S&P 500 index to 1100 by year-end or early 2010.  At Cumberland, our US ETF accounts are fully invested in accordance with this strategic view.

Since monetary policy makers at our Fed are unsure, they will keep policy rates very low until the economy is safely out of the woods.  That means ample liquidity to power markets higher.  It also means the yield curve stays steep.  Borrowers are wise to lock in their financing now.  Bond buyers like our clients should focus on the spread side of the bond markets and not on Treasuries.

We are in the transition period when liquidity is still abundant and when the economic turn generates strong profit comparisons.  The peaking of the unemployment rate doesn’t mean it will quickly return to the 5% level of yesteryear.  Too much damage has been done, so a high unemployment rate is likely to be with us for a long time.  But not at 13%.

Viacialevitra in Reverse

Too big to fail has become smaller.  CIT was not on the original Geithner-Summers-Bernanke-designed list of 19 organizations deemed to be too large to fail.  In the post-Lehman environment, this has become the norm.  Failing is not permitted.

Now we see the making of this policy unfolding to a new level.  CIT has received $2.3 billion in TARP money.  The government has a stake.  Therefore the government will now infuse additional money in order to “protect” the taxpayers.  They will do this under the guise and umbrella of “helping small business.”  That means a million small and independent businesses will not be incented to go to their local banking institutions but will instead be involved with a weakened CIT, operating under duress. 

CIT has experienced a “run," as those who are able withdrew their cash are doing so.  We have an insolvency crisis at CIT becoming a liquidity crisis, because the cash is drained.  Now, in steps the new industrial policy of the United States, as developed under the Obama administration and designed by the Secretary of the Treasury.  Loan more, reconfigure the balance sheet, alter the form, assign the collateral that is workable, and otherwise find ways to pretend to be more secure while pouring more capital into a sinking ship. 

I heard the former president of the St. Louis Fed summarize the dilemma well.  Bill Poole said, “If you are in a hole and the hole is deep, stop digging!”  With CIT they are going another layer deeper.  Too big to fail is growing – Washington does not know how to stop digging.

Markets will like this in the short term, because markets like free lunches and bailout money.  We as money managers will continue to position advantageously for the purpose of benefitting our clients in this continuing, post-crisis saga.  But to policy wonks this is a disaster in the making, and it is getting bigger. 

What to do as an investor?  You see the result of government bailout money applied to Goldman Sachs.  Who won? Goldman, the shareholders, the debt holders, and others who are less transparent like the former NY Fed director who traded Goldman stock for a profit.  Who lost?  You may argue no one, since GS paid everything back to the TARP and is now free to operate.  Maybe.  But they made it through the crunch on the back of a federal guarantee by the FDIC, one of the few remaining credible entities in Washington, thanks to Sheila Bair’s vigilance.  Was there a price?  Yes, but it is called “moral hazard” and it is difficult to measure until there is a failure like Lehman.

Who lost?  Maybe no one.  Maybe us?  There are those of us citizens who understand that there is no free lunch and that a transfer of risk at a subsidy has a cost, even if you can’t see it at first glance.

Investors need to be vigilant.  In my dinner conversation tonight with my colleagues Michael Comes and Peter Demirali, we talked about exit strategies, not for the Federal Reserve but for our clients.  We have had a good run, going from Treasuries to spread products on the bond side and using our strategies on the ETF side.  Now what do we do?  

The conclusion tonight, and subject to change at any time is: stay the course with spread positions for now.  They are narrowing and there is still value.  Stay the course with an ETF strategy that favors emerging markets in the global view and is very selective and focuses on a broadening stock market in the domestic view.  Avoid Treasuries and seek Build America Bonds and tax-free Munis. 

And lastly, and most importantly, recognize that the US is heading for trouble and that we are in a benign period that will be followed by a troubled period.  Right now it is good to be invested.  We will keep a watchful eye on the exit.  Too soon is not a good option.  Too late is not a good outcome.  In between is hard to discern.  We need to work more and harder than normal.  Stay tuned. 

Watch the deal outcome for CIT.  It is defining the new limit of too big to fail.  Our title is a metaphor for getting smaller.  Too big to fail is downsized.   Now I am going to sleep.

Financing Massive deficits. Also, John Mauld

John Mauldin has put together a thought-provoking piece on the growing global debt burden and how it must be financed.  In five minutes you can read the entire essay, graphs included. 

Find it on Barry Ritholtz’s website: .    Also, it’s found at, where you can sign up for a free subscription to John’s weekly Thoughts from the Frontline and Outside the Box e-letters.

First excerpt: “Over the last ten years, the government (Japan) has seen the level of debt-to-GDP rise from 99% to over 170%, not including local governments. They ran those deficits to try and pull themselves out of the doldrums of their Lost Decade of the ’90s, following the crash of their real estate and stock markets, starting in 1989. They built bridges and roads to nowhere, all sorts of programs, quantitative easing, etc. Sound familiar?”

Second excerpt: “The government kept borrowing, and rates stayed in the area of 1%. Today, a ten-year bond yields 1.3% in Japan, so they could run up a very large debt and the interest-rate cost was not a big factor in the budget.”

Third excerpt: “Interest-rate expense is now about 18% of the Japanese government budget. What if rates went to a lofty 2%? That would over time double the interest-rate expense. And the Japanese are borrowing between 30-40% of their annual budget.”

John segues to the US: “The graph shows the US will need to issue $3 trillion in debt. ‘Wait,’ I asked, “I thought it was only 1.85.’  The answer is that the number has grown to almost $2 trillion. Then you need to add in off-budget items like TARP, state and municipal debt, etc. Pretty soon it adds up to another trillion.”

Readers may see the rest of the details about the global need for savings in order to finance the sovereign borrowing.  We congratulate John Mauldin, who put together a straightforward depiction of the issues.

We will add a few comments about the United States.  For about a half-century our federal deficits ranged between 0% and 4% of GDP.  Our economy grew; thus, we have been able to handle the rising interest burden.  Over the last thirty years, nominal interest rates declined as inflation expectations were reduced.  Lower interest rates meant ease of financing for new borrowings and of refinancing maturing government debt.  Meanwhile, state and local governments operated with balanced budgets.

The Bush deficits broke this pattern.  The Obama deficits have sent this curve into a parabolic form.  Meanwhile, state and local budgets are deteriorating rapidly, and mayors and governors are clamoring for federal aid.  They are succeeding and many new programs are structured to be an indirect form of federal assistance to the states and to local governments.  At Cumberland, we do not expect states to default.  Instead the Obama Administration is advancing a larger governmental structure.  That also means states will be raising taxes and not reducing programs.

So the United States will combine its on-budget borrowing with its off-budget borrowing and access the global credit markets for an estimated $3 trillion, according to Mauldin.  Cumberland’s estimate is a few hundred billion smaller, but the exact number is not relevant to this analysis.  Fact: We are in uncharted waters on governmental debt issuance for a large economy that is hugely financing its consumption during a peacetime period.

The US will be able to succeed with this financing, because the world is in an economic slowdown and private-sector demand for credit is tepid.  And because savings rates around the world are rising as households and firms borrow less and spend less and hence provide marginal-money balances that can be used to buy this debt.  Also because the world’s central banks have taken short-term interest rates to or near zero.

This is the benign period of the debt explosion.  We enjoy a “free lunch” by consuming now and dealing with the debt later.  Once the economy levels out and resumes an upward path, the chickens come home to roost with a vengeance. 

Then the result is either a much higher level of taxation to restore budgets to some balance, or a monetary policy that allows inflation to cheapen the “real” burden of the debt.  Or it is a repudiation of the debt burden, with all the consequences ensuing therefrom.  As Joe Mason reminds us in a recent essay, states did default in the early part of the 19th century.  Sovereigns also default and repudiate; witness Argentina a few years ago and Ecuador recently.  Taxation, inflation, repudiation or variations of them — that is what happens when debt gets out of control.

But will the US follow this path?  Not likely in the near term.  More likely the adjustment will come in the value of the US dollar relative to the other major currencies.  Some food for thought: The total government debt burden being financed in the current year in the Eurozone, in relation to its GDP, is about one-third of that in the US.  The European Central Bank has an inflation target, a clear policy, a transparent process, and its central bank status is protected by a treaty.  We have written several times about the risk to the US central bank that is being debated in Congress, in the form of changing the Fed’s role and decision-making construction.  

Longer-term strategy at Cumberland is oriented toward a weaker US dollar.  We must not be misled by short-term swings in relative dollar strength when market volatility rises and there is a temporary trading-based flight to quality.  We saw that in the last three weeks.  The dollar strengthens and the Treasuries market rallies (prices rise and yields fall).  Barclay’s David Woo has done some excellent work on dissecting this trading phenomenon out of the longer-term trend in foreign-exchange rates.  See our website for references, .

Massive structural change is occurring in global government finance.  Central banks are in uncharted areas of policy making.  Look for the changes to reflect first-hand and violently in currency relationships.

In the Cumberland Global Multi Asset Class model, the US now is a minority position.  The fixed-income portfolios are biased toward taxable and tax-free municipal bonds of high quality and issued by state and local governments, with backing by general-obligation pledges or liens on essential-service revenues.  Sometimes the revenue bond is a superior structure to the G.O.  We have sold Treasuries and are taking advantage of the spread areas in fixed income.

Meanwhile, the heavier lifting with financing the Obama deficits will unfold in the second half of this year.  Stay tuned.

Interest Rates go Negative: Compare Riksbank (Sweden) with our Federal Reserve

Negative nominal interest rates are very hard to understand intuitively.  That said, we now have a central bank using them.

In its July 2, 2009 press release, Sweden’s central bank explained that it cut its policymaking “repo rate” to 0.25%.  Its penalty lending rate was cut to 0.75%.  Most observers expected it to cut its reserve deposit rate to zero.  The observers saw zero as the realistic lower bound of interest rates.  They were wrong.

Sweden’s reserve deposit rate was set a -0.25%.  That’s right.  A negative interest rate is now at work in one of the G-10 countries.  This rate means a penalty is charged against a deposit placed in the central bank under the reserve deposit rules.  The banking institution that deposits with its central bank will receive an actual deduction from the deposit account.  It will get back less money than it puts in.

Negative nominal interest rates are designed to discourage an activity.  They are rare.   The most dramatic one that I remember in my professional career was instituted by Switzerland several decades ago.  At that time there was a flight from the US dollar into other hard currencies around the world.   The US was leaving the Bretton Woods fixed exchange rate regime which had prevailed since the end of World War II.  Massive inflows into the Swiss franc were resulting in a build up of interest bearing deposits in Swiss banks.

The Swiss banking system could not process the deposit inflows from around the world in a way that enabled them to maintain traditional banking spreads and functionality.  These flows were motivated by global money transfers out of the US dollar.  After lowering rates did not stem the incoming flows the Swiss authorities finally imposed a 5% negative interest rate on non-Swiss citizens.  That‘s right.  You put a hundred francs in a savings account and at the end of the year you got back 95 francs.  That is how a negative interest rate works. 

The Swiss accomplished their purpose.  Massive inflows from US dollars into Swiss francs came to a screeching halt and promptly reversed.  Human behavior changed.

The Swedish central bank is trying to use negative interest rates to alter risk taking behavior in Sweden.  It wants its member banks to use excess reserves to acquire risk assets rather than just place them with the central bank.  Hence it has moved its reserve deposit rate to a negative number.  It did this because it has lowered its other policy rate to near zero and it decided to maintain its band around them. 

Time will tell if this policy works.  It will be observed closely by the other G-10 central banks including our Federal Reserve.  They should observe with good reason.  

Policy interest rates in most parts of the world are now near zero.  Gradually the world’s central banks are committing themselves to a longer period of these very low rates.  In Sweden the term repo loan to its member banks is now out to 1 year.   The European Central Bank recently did a large infusion of reserves with a 1 year facility.  The US Federal Reserve has not followed this pattern and favors the shorter term.  Shorter terms mean more uncertainty.  More uncertainty means higher risk premiums.  Higher risk premiums mean more market volatility and tepid economic recovery.

In the US, our Federal Reserve seems to be behind the eight ball.  It still uses shorter facilities and it still tries to communicate without press conferences after every meeting and with the arcane language of “fed speak.”   The financial crisis notwithstanding, our Fed has not achieved transparency and still functions with a foggy cloud of opacity.

Our Fed is also threatened politically and fears an attack on its central bank independence.  It has been held political hostage at the Board of Governors level by Senator Christopher Dodd and the Senate Banking Committee.  Dodd kept two of the seven governor seats vacant by refusing to hold a confirmation hearing for the Bush presidential appointees.  He is personally responsible for the failure of the United States to operate with a full Board of Governors during the recent financial crisis.  We will never know how many actions didn’t happen because of Dodd’s obstinacy.  We will never know how many homes were foreclosed in the United States because the Chairman of the US Senate Banking Committee played politics with our central bank.

So far President Obama has continued this political structure.  Obama promised “change.”  In monetary affairs we’ve gotten worsening actions, and tax scofflaw appointments. And, due to politics, we still only have five of the seven governor positions filled.  The Fed still has to achieve unanimity to make an emergency decision.  The law is designed for the Fed to operate under a super majority rule and NOT a unanimity rule.  The law is not designed to give every sitting Fed governor a veto over any emergency decision.  Yet that is how it has operated for three years.  Thank you, Senator Dodd and now, thank you, President Obama.

This appalling behavior is still ignored by most market observers and most media.  That is the citizen’s loss and the journalist’s failure.  We hope the price paid for this political interference with central bank independence doesn’t become a repeat of the US dollar crisis we saw in the 1970s when President Nixon revoked dollar/gold convertibility and the US left the Bretton Woods regime. 

There will be some discussion about central bank independence today at 1:15 on CNBC Power Lunch.  I do not know who else will be in the conversation and how long a time span it will cover.  But this writer has been asked to be one of those interviewed.  And, I have been advised that there is an opposing point of view.  The issue to be discussed is the role of the Fed as a regulator.  For me that means the role of the central bank in an even more intense political role and that means with even less independence. 

Readers may want to read the monetary policy report of the Swedish central bank to see what a clear and understandable monetary policy explanation can look like.  Check out and the July 2 release and the full report.   Imagine if our Federal Reserve presented the monetary policy outlook for the United States and the view of the rest of the world with such descriptive clarity of the policy options being considered.  Maybe if they did that, maybe if they realize how deeply damaged the Fed is and how the political forces in the US are threatening central bank intendance, maybe if the country realized how important this issue is for the value of the currency, maybe, just maybe, we might get enough attention to reverse this slide that is taking our country into a monetary abyss. 

If there is no warehouse fire or other breaking news, we may just have some serious discussion about central bank independence and what a central bank is supposed to do to maintain and preserve the store of value characteristic of the nations’ money, provide a medium of exchange and set the standard for a unit of account.   That is the job of the central bank.  Its second task is to explain that job to the citizens.

To see how to do both in the midst of a financial crisis we may want to look to Sweden.  They are trying and have learned the hard way with the Scandinavian banking and financial crisis two decades ago.  And they have managed to report their methods and actions in English as well as Swedish. 


Should the BRussiaICs Become the BICs?

At Cumberland Advisors, our answer, from the perspective of a global portfolio manager, is a strong “Yes.”  As we write, President Obama is in Moscow for his first Russian-American summit with his counterpart, President Dmitri Medvedev, along with Prime Minister Vladimir Putin.  The stated objective of both sides is to “reset” American-Russian relations. The agreements reached on slashing nuclear arsenals and military cooperation are certainly positive developments. But we have not seen anything that would make us more willing to invest our clients’ funds in the Russian economy and equity market. Below we summarize the various reasons behind our negative evaluation of Russian equities in comparison with those of China, Brazil, and India.

In 2001 Goldman Sachs coined the acronym BRIC to refer to the large and rapidly developing economies of Brazil, Russia, India, and China. The equity markets of these four economies have indeed outperformed others in the emerging-market asset class. The MSCI BRIC Index, through the end of the first half of this year, advanced at an average annual rate of 20.4% over the past 5 years in comparison with the 12% average annual increase for the MSCI Emerging Market Index. This outperformance was maintained over the past 10 years as well, with the corresponding annual rates being 11.6% versus 6.3%.  And in the first half of the current year the BRICs continued to lead, registering a 45.76% increase, as compared with a 34.26% increase for the emerging markets index.

Ever since Russia’s invasion of Georgia, and particularly in the past month, strong doubts have arisen as to whether Russia should continue to be considered to be in the front rank of emerging market economies along with China, Brazil, and India. The Russian equity market has become increasingly decoupled from the other BRICs and emerging markets. From a peak on June 3, the Russian Trading System Index (RTSI$: IND) tumbled 21% by June 23, as investor confidence in the economy weakened and the upward advance in oil prices encountered headwinds. The Russian economy is facing a steep decline this year.  The economy plunged by 10.2% in the first 5 months of 2009.  A decline of 8.5% for the full year is projected by the Russian Economic Development Ministry (we had been expecting a 7% drop).  In marked contrast, the decline for Brazil is likely to be only 1.5%, while the Indian economy should advance by 8% and the Chinese economy looks to be on track for annual growth approaching 9%.

Unlike the diverse Chinese, Brazilian, and Indian economies, that of Russia is heavily dependent on the oil and gas sector and other raw materials.  This is evident from the sector composition of the DAX Global Russia Index, which is tracked by the Market Vectors Russia ETF, RSX. Oil and Gas account for 38.5%, Other Energy 6.9%, and Iron and Steel 18%.  We particularly do not like the dominant position of Gazprom, the leading holding of RSX, accounting for 12.6% of the ETF’s holdings.  Granted, investors in Gazprom have done well.  But this firm, majority-owned by the Russian state, has a quasipolitical profile and is spending its dwindling cash flow excessively. This spending is focused on expansion abroad, while huge domestic investment requirements remain unmet.  Other major positions are in Surgutneftegaz, 8%, Rosneft Oil Co., 7.8%, and LUKOIL 7.8%.  An investment in this ETF is essential a play on the global oil price. We would prefer to do this in a way that avoids the country risk presented by Russia.

One of the factors behind the steeper fall of the Russian economy compared with the other BRICs is a huge debt restructuring problem. Russian companies and banks face a $200 billion refinancing requirement over the next 12 months. The Russian Central Bank is seeking to recapitalize a banking sector that has all but ceased to lend. The steep recession is moving this year into a substantial deficit, amounting to more than 8% of GDP.

We were pleased to see President Medvedev signal a new initiative to “strengthen the rule of law” in Russia and call corruption a threat to national security, but we remain skeptical that meaningful steps to reform serious deficiencies in this area will be taken. A new trial with strong political overtones – of Mikhail Khodorsky, the former head of Yukos Oil Co., once Russia’s richest man and political opponent to Putin, along with his former business partner Platon Lebedev, has been underway since March. As the Economist magazine said in its July 2, 2009 issue, Russia is “courting disaster” with its “dismal investment climate.”  The CFA Institute’s report, “Shareholder Rights Across the Markets,” summarizes the situation in Russia as follows:  “Shareholders face various challenges to their rights in Russia.  Inconsistent law enforcement, growing state intervention in business, and challenges in corporate transparency are among the obstacles to stronger shareholder rights in the Russian market.”  IKEA has announced that it is suspending its operations in Russia because of the “unpredictable character of administrative procedures.”  This is not surprising when one refers to the 2008 Corruption Perception Index, calculated by Transparency International. Russia ranks 147, just one place above Syria and one below Kenya.  In contrast, China ranks 72, Brazil, 80, and India, 85.

In sum, we are continuing to invest our International, Emerging Market, and Global Multi-Asset Class portfolios in the three BIC markets (Brazil, India, and China). We sold our Russian holdings when Russia invaded Georgia and do not expect to invest our clients’ assets in such a market until conditions there improve.