Category: zerohedge

"Debt matters… even if it is possible to pretend for many years that it doesn't," is the painful truth that, author of "Avoiding The Fall", Michael Pettis offers for the current state of most western economies. Specifically, Pettis points out that Japan never really wrote down all or even most of its investment misallocation of the 1980s and simply rolled it forward in the form of rising government debt. For a long time it was able to service this growing debt burden by keeping interest rates very low as a response to very slow growth and by effectively capitalizing interest payments, but, as Kyle Bass has previously warned, if Abenomics is 'successful', ironically, it will no longer be able to play this game. Unless Japan moves quickly to pay down debt, perhaps by privatizing government assets, Abenomics, in that case, will be derailed by its own success.

Will Debt Derail Abenomics?
by Michael Pettis of China Financial Markets blog,

It seems to me that one of the automatic, if not always intended, consequences of Abenomics is to force up Japan’s current account surplus, and in fact to force it up substantially. This will have to do at least in part with deciding how to manage the country’s enormous government debt burden, which easily exceeds 200% of the country’s GDP.

If I am right, this should create two concerns.

First, in a world struggling with insufficient demand and excess capacity, and in which the growth strategies of too many countries implicitly involve a significant increase in exports relative to imports, a major increase in Japan’s current account surplus could easily derail growth recovery elsewhere. The US for example has to worry that policies aimed at increasing domestic demand don’t simply result in rising debt as US demand bleeds out through the current account, while both China and Europe need strong external sectors to make their own difficult domestic adjustments less painful.

 

Second, it is not obvious that the world will be able to absorb a significant increase in the Japanese exports, and if Abenomics implicitly forces up the Japanese savings rate relative to investment (which is all that we mean when we say that economic policies force up current account surpluses), these policies can resolve themselves either in the form of high growth and soaring exports, or much lower growth and slowing imports. The former implies that Abenomics will be successful, while the latter that it will fail. It is not obvious, in other words, that Abenomics can succeed in a world of weak demand, and its failure is likely to make Japan’s domestic imbalances worse, not better.

It may seem a little quixotic to worry about a surging Japanese current account surplus just now when in fact Japan’s external balance has declined substantially and is surprising analysts on the downside. According to an article in last week’s Financial Times:

Japan’s current account balance plummeted by nearly two-thirds in August from a year ago, surprising forecasters that had assumed it would grow nearly a fifth. The current account is a broad measure of trade. A fall indicates Japan is receiving less income from overseas investments, despite help from the falling yen.

 

The current account surplus fell nearly 64 per cent in August, versus forecasts expecting an 18 per cent gain. The unadjusted balance in the month was Y161.5bn, against forecasts at Y520bn and down from Y577.3bn in July. Within the data, trade of goods and services was in deficit of more than Y1tn for a second consecutive month, while income fell to Y1.253tn from Y1.794tn a month before.

My concern, however, is unlikely to be played out over the next few quarters but rather over the next few years as Abenomics is implemented, and so Japan’s external position in the immediate future doesn’t matter. What matters, I think, is that in order to generate growth Tokyo is planning to implement polices aimed at raising both inflation and real GDP, and these policies are likely to force up the national savings rate relative to investment.

What is more, to the extent that these policies are successful in generating higher nominal GDP growth, they create a problem for Tokyo in how it decides to set domestic interest rates. Japan has never really resolved the overinvestment orgy of the 1980s. Instead of writing down bad debt it effectively transferred much of it to the government balance sheet, and now this huge debt burden is itself becoming, I think, a constraint on the success of policies designed by Tokyo to spur growth.

Before addressing the debt constraint, let me start by listing the reasons why I think Abenomics is likely to affect the trade surplus. First is the impact of Abenomics on pushing down the value of the yen. As I discuss in the first two chapters of my January book, The Great Rebalancing, currency depreciation does not affect the trade balance directly by changing relative prices. It does so indirectly by changing the relationship between savings and investment (the difference between the two being the current account balance). A depreciating currency reduces the real value of household income by acting effectively as a consumption tax on imported items. This also reduces the real value of household consumption.

The proceeds of this tax are used implicitly to subsidize the tradable goods sector, which effectively increases production in that sector. Of course as production rises relative to consumption, the difference between the two – the national savings rate – must also rise.

This means that as the yen depreciates, the consequence is likely to be an increase in the Japanese savings rate. If there is no commensurate increase in investment (and I assume that with excess capacity Japan does not need to increase investment much in order to produce higher output), Japan’s current account surplus must automatically rise. In the near term the investment rate is likely to rise, largely in response to greater confidence, but over the longer term downward pressure on the consumption share of GDP (which is the likely consequence of downward pressure on the household income share) will also put downward pressure on investment growth.

Savings is the obverse of consumption

But it doesn’t end there. Japan seems to be taking other steps to force up its domestic savings rate. Here is last Tuesday’s Financial Times:

Shinzo Abe, Japan’s prime minister, pledged to press ahead with the first increase in sales tax for over 15 years despite objections from some of his closest advisers, gambling that measures to address the country’s massive debts would not hinder his attempts to jump-start the economy.

 

Mr Abe said on Tuesday he would couple the consumption tax hike with roughly Y5tn in new public works spending, cash grants and other stimulus in order to blunt any negative impact on the economy.

 

…The plan to increase the tax from 5 to 8 per cent next
April had been approved by a previous government with the support of Mr Abe’s Liberal Democratic Party. But it was opposed by economists who had helped the premier draft his Abenomics strategy, as well as by some LDP politicians. The last time Japan increased the levy, in 1997, a deep recession followed that shook the party’s grip on power.

The increase in the consumption tax, part of the proceeds of which will be used to increase infrastructure investment, will accomplish many of the same results as the deprecation of the yen. A consumption tax, like a tariff, is effectively a kind of back-door currency devaluation, with a slightly different mix of losers among the household sector and winners among the producing sector.

By boosting production and reducing consumption, however, it automatically forces up the national savings rate in the same way as does currency depreciation. Even if 100% of the proceeds of the tax were used to fund increased infrastructure investment (and the article suggests that part, but not all, of the consumption taxes will be directed towards higher investment), because at least some of the investment spending will go to workers in the form of wages, who will save part of those wages, the net result will be that total savings will rise faster than total investment. Once again this must force up Japan’s current account surplus even further.

So far this all looks like an attempt by Abe to increase Japanese competitiveness and so increase its total share of global demand, but not by increasing Japanese productivity, which is the high road to growth, but rather by reducing the real Japanese household income share of what is produced. Japan (like Germany and China have done over the past decade) is attempting to increase employment by reducing wages, and this means that its workers will be able to purchase a declining share of what they produce. This effectively means Japan will be growing at the expense of its trading partners. As the Japanese become less able to consume all they produce, the excess must be exported abroad.

If the world were in ruddy good health, we might not worry too much about policies aimed at Japan’s pulling itself out of the mess created in the 1980s, but with the whole world struggling with weak demand and with country after country trying to reduce domestic unemployment by selling more abroad – effectively exporting unemployment (with Germany in particular hoping to resolve the European crisis not by increasing its net domestic demand, as it should, but rather by forcing German surpluses outside Europe) – there is a real question in my mind as to how successful the Japanese program of Abenomics is likely to be if it implicitly requires a burgeoning trade surplus.

Remember that if one country increases its savings rate, unless there is a net increase in global investment there must be a commensurate reduction in the savings rate of the rest of the world so that savings and investment always balance globally. There are broadly speaking two ways this can happen. In the pre-crisis days this reduction in the savings rate of the rest of the world occurred mainly in the form of soaring consumption fueled by credit, and in this way unemployment stayed low. Since the crisis – which because of the negative wealth effect saw credit-fueled consumption drop – foreign savings have been reduced by a rise in foreign unemployment

This means that if Japan forces up its savings rate, and assuming that we are unlikely to return in the next few years to a credit-fueled consumption binge, the only way the world can respond to a structural forcing up of the Japanese savings rate is either by higher unemployment outside Japan or, if Japan’s trade partners take steps to protect themselves from higher Japanese trade surpluses, higher unemployment inside Japan.

The debt-servicing cost of nominal GDP growth

But there is more, perhaps much more. Japan is struggling with an enormous debt burden, and perhaps this explains why Tokyo is so eager to engage in policies that force up the Japanese savings rate. As long as more than 100% of Japanese borrowing is funded by domestic savings (if Japan runs a current account surplus is must be a net exporter, not importer, of capital), it doesn’t have to rely on fickle foreigners, who might not be satisfied with coupons close to zero, to fund its enormous debt burden.

But the debt burden creates its own very dangerous source of trade instability. To understand why, we need to consider what happens to interest rates in Japan if nominal growth rates rise.

In Japan interest rates are currently very low, close to zero. With total government debt amounting to more than twice the country’s GDP – which puts it among the most heavily indebted governments in the world – it is not hard to see how low nominal interest rates benefit Japan. With interest rates close to zero, there is very little cashflow pressure on the government from servicing its debt.

Some people might argue that nominal interest rates do not matter. We should be looking at real interest rates, they would argue, and with Japan’s having experienced deflation for much of the past two decades, real interest rates in Japan are high and the nominal rate is largely irrelevant.

This is true, real interest rates do matter, but it doesn’t mean that nominal interest rates do not. In fact both real and nominal interest rates matter, albeit for different reasons. Real rates matter for all the obvious reasons – they represent the real cost to the borrower in terms of a transfer of resources from the borrower to the lender. But nominal rates also matter because they effectively determine the implicit amortization schedule of principal payments.

When the nominal rate is zero or close to zero in a deflationary environment, in other words, interest is effectively capitalized in real terms. In fact whenever the real rate exceeds the nominal rate, as it has in Japan for much of the past two decades, the cashflow cost of servicing the debt is lower than the real cost, and the difference is effectively converted into real principal and deferred. In real terms, in other words, Japanese debt is growing by the difference between the real rate and the nominal rate, and this effectively represents a reduction in the cashflow cost of servicing its debt.

When nominal interest rates are positive and higher than the real rate, however, there is effectively an acceleration of real principal payments. This means that as long as nominal rates are very low, the real cost of servicing the debt is low and the principal payments are postponed, with some of the interest even being capitalized. As nominal rates rise, however, the real cost of servicing the debt during each payment period consists of interest plus some real principal.

This is just a long, perhaps pedantic, way of pointing out that even if the real interest rate in Japan declines, debt servicing is likely to be much more difficult as the nominal rate rises. Japan might be paying a lower real rate, but it is also implicitly paying down principle, instead of capitalizing it. Tokyo would need a significant increase in revenues, or a significant decrease in expenditures, to cover the cost.

So what would force Japan to raise its nominal interest rate? In principle the nominal interest rate should be more or less in line with the nominal GDP growth rate. If it is higher, growth generated by investing capital is disproportionately retained by net savers (including mainly the household sector). There is, in other words, a hidden transfer of resources from net borrowers to net savers.

If the nominal lending rate is lower than the nom
inal GDP growth rate, as is the case in China today and Japan during the 1980s, the opposite occurs. There is a hidden transfer from net savers to net borrowers, and because net savers are mainly the household sector, this will put downward pressure on the household share of income even as it gooses investment growth. This hidden transfer has been at the heart of the rapid economic growth that typically occurs in financially repressed economies during the earlier stages, and is also at the heart of the investment misallocation process that typically occurs during the later stages. We have seen this very clearly in China.

Will Tokyo raise interest rates?

Japan is trying to generate both positive inflation and real GDP growth, so that it is trying urgently to raise the growth rate of nominal GDP. What happens if and when it is successful? For example let us assume that Japan’s GDP is able to grow nominally by 4-5% a year – what will happen to the nominal Japanese interest rate?

Tokyo can either raise interest rates in line with nominal GDP growth rates or it can keep them repressed. In the former case, debt-servicing costs would soar, ultimately to 8% of GDP or more. This would create a problem for Tokyo in its ability to service its tremendous debt burden. It would need a primary surplus of around 8% of GDP just to keep debt levels constant, and it is hard to imagine how such a huge surplus would be consistent with nominal GDP growth rates of 4-5%.

If it were to raise income taxes it would create a huge burden for the household sector and almost certainly force up the national savings rate by forcing down the household share of GDP. Remember that during the 1980s Japan, like China today, generated rapid growth in part through financial repression, and one of the consequences of that rapid growth was an extraordinarily high savings rate along with a huge current account surplus, both of which were ultimately unsustainable. Japan has spent much of the past twenty years rebalancing GDP back in favor of the household sector, and to reverse this process may provide relief in the short term, but it is hard to see how I can be helpful in the medium term.

On the other hand if, in order to make its debt burden manageable Tokyo represses interest rates to well below the nominal GDP growth rate, it is effectively transferring a significant share of GDP from the household sector to the government in the form of the hidden financial repression tax. This is what Japan was doing in the 1980s, with all of the now-obvious consequences.

Japan’s enormous debt burden was manageable as long as GDP growth rates were close to zero because this allowed both for the country to rebalance its economy and for Tokyo to make the negligible debt servicing payments even as it was effectively capitalizing part of its debt servicing cost. If Japan starts to grow, however, it can no longer do so. Unless it is willing to privatize assets and pay down the debt, or to impose very heavy taxes of the business sector, one way or the other it will either face serious debt constraints or it will begin to rebalance the economy once again away from consumption.

As this happens Japan’s saving rate will inexorably creep up, and unless investment can grow just as consistently, Japan will require ever larger current account surpluses in order to resolve the excess of its production over its domestic demand. If it has trouble running large current account surpluses, as I expect in a world struggling with too much capacity and too little demand, Abenomics is likely to fail in the medium term.

Perhaps all I am saying with this analysis is that debt matters, even if it is possible to pretend for many years that it doesn’t (and this pretense was made possible by the implicit capitalization of debt-servicing costs). Japan never really wrote down all or even most of its investment misallocation of the 1980s and simply rolled it forward in the form of rising government debt. For a long time it was able to service this growing debt burden by keeping interest rates very low as a response to very slow growth and by effectively capitalizing interest payments, but if Abenomics is “successful”, ironically, it will no longer be able to play this game. Unless Japan moves quickly to pay down debt, perhaps by privatizing government assets, Abenomics, in that case, will be derailed by its own success.

via Zero Hedge http://feedproxy.google.com/~r/zerohedge/feed/~3/8VR4hhJ9r2U/story01.htm Tyler Durden

"Debt matters… even if it is possible to pretend for many years that it doesn't," is the painful truth that, author of "Avoiding The Fall", Michael Pettis offers for the current state of most western economies. Specifically, Pettis points out that Japan never really wrote down all or even most of its investment misallocation of the 1980s and simply rolled it forward in the form of rising government debt. For a long time it was able to service this growing debt burden by keeping interest rates very low as a response to very slow growth and by effectively capitalizing interest payments, but, as Kyle Bass has previously warned, if Abenomics is 'successful', ironically, it will no longer be able to play this game. Unless Japan moves quickly to pay down debt, perhaps by privatizing government assets, Abenomics, in that case, will be derailed by its own success.

Will Debt Derail Abenomics?
by Michael Pettis of China Financial Markets blog,

It seems to me that one of the automatic, if not always intended, consequences of Abenomics is to force up Japan’s current account surplus, and in fact to force it up substantially. This will have to do at least in part with deciding how to manage the country’s enormous government debt burden, which easily exceeds 200% of the country’s GDP.

If I am right, this should create two concerns.

First, in a world struggling with insufficient demand and excess capacity, and in which the growth strategies of too many countries implicitly involve a significant increase in exports relative to imports, a major increase in Japan’s current account surplus could easily derail growth recovery elsewhere. The US for example has to worry that policies aimed at increasing domestic demand don’t simply result in rising debt as US demand bleeds out through the current account, while both China and Europe need strong external sectors to make their own difficult domestic adjustments less painful.

 

Second, it is not obvious that the world will be able to absorb a significant increase in the Japanese exports, and if Abenomics implicitly forces up the Japanese savings rate relative to investment (which is all that we mean when we say that economic policies force up current account surpluses), these policies can resolve themselves either in the form of high growth and soaring exports, or much lower growth and slowing imports. The former implies that Abenomics will be successful, while the latter that it will fail. It is not obvious, in other words, that Abenomics can succeed in a world of weak demand, and its failure is likely to make Japan’s domestic imbalances worse, not better.

It may seem a little quixotic to worry about a surging Japanese current account surplus just now when in fact Japan’s external balance has declined substantially and is surprising analysts on the downside. According to an article in last week’s Financial Times:

Japan’s current account balance plummeted by nearly two-thirds in August from a year ago, surprising forecasters that had assumed it would grow nearly a fifth. The current account is a broad measure of trade. A fall indicates Japan is receiving less income from overseas investments, despite help from the falling yen.

 

The current account surplus fell nearly 64 per cent in August, versus forecasts expecting an 18 per cent gain. The unadjusted balance in the month was Y161.5bn, against forecasts at Y520bn and down from Y577.3bn in July. Within the data, trade of goods and services was in deficit of more than Y1tn for a second consecutive month, while income fell to Y1.253tn from Y1.794tn a month before.

My concern, however, is unlikely to be played out over the next few quarters but rather over the next few years as Abenomics is implemented, and so Japan’s external position in the immediate future doesn’t matter. What matters, I think, is that in order to generate growth Tokyo is planning to implement polices aimed at raising both inflation and real GDP, and these policies are likely to force up the national savings rate relative to investment.

What is more, to the extent that these policies are successful in generating higher nominal GDP growth, they create a problem for Tokyo in how it decides to set domestic interest rates. Japan has never really resolved the overinvestment orgy of the 1980s. Instead of writing down bad debt it effectively transferred much of it to the government balance sheet, and now this huge debt burden is itself becoming, I think, a constraint on the success of policies designed by Tokyo to spur growth.

Before addressing the debt constraint, let me start by listing the reasons why I think Abenomics is likely to affect the trade surplus. First is the impact of Abenomics on pushing down the value of the yen. As I discuss in the first two chapters of my January book, The Great Rebalancing, currency depreciation does not affect the trade balance directly by changing relative prices. It does so indirectly by changing the relationship between savings and investment (the difference between the two being the current account balance). A depreciating currency reduces the real value of household income by acting effectively as a consumption tax on imported items. This also reduces the real value of household consumption.

The proceeds of this tax are used implicitly to subsidize the tradable goods sector, which effectively increases production in that sector. Of course as production rises relative to consumption, the difference between the two – the national savings rate – must also rise.

This means that as the yen depreciates, the consequence is likely to be an increase in the Japanese savings rate. If there is no commensurate increase in investment (and I assume that with excess capacity Japan does not need to increase investment much in order to produce higher output), Japan’s current account surplus must automatically rise. In the near term the investment rate is likely to rise, largely in response to greater confidence, but over the longer term downward pressure on the consumption share of GDP (which is the likely consequence of downward pressure on the household income share) will also put downward pressure on investment growth.

Savings is the obverse of consumption

But it doesn’t end there. Japan seems to be taking other steps to force up its domestic savings rate. Here is last Tuesday’s Financial Times:

Shinzo Abe, Japan’s prime minister, pledged to press ahead with the first increase in sales tax for over 15 years despite objections from some of his closest advisers, gambling that measures to address the country’s massive debts would not hinder his attempts to jump-start the economy.

 

Mr Abe said on Tuesday he would couple the consumption tax hike with roughly Y5tn in new public works spending, cash grants and other stimulus in order to blunt any negative impact on the economy.

 

…The plan to increase the tax from 5 to 8 per cent next April had been approved by a previous government with the support of Mr Abe’s Liberal Democratic Party. But it was opposed by economists who had helped the premier draft his Abenomics strategy, as well as by some LDP politicians. The last time Japan increased the levy, in 1997, a deep recession followed that shook the party’s grip on power.

The increase in the consumption tax, part of the proceeds of which will be used to increase infrastructure investment, will accomplish many of the same results as the deprecation of the yen. A consumption tax, like a tariff, is effectively a kind of back-door currency devaluation, with a slightly different mix of losers among the household sector and winners among the producing sector.

By boosting production and reducing consumption, however, it automatically forces up the national savings rate in the same way as does currency depreciation. Even if 100% of the proceeds of the tax were used to fund increased infrastructure investment (and the article suggests that part, but not all, of the consumption taxes will be directed towards higher investment), because at least some of the investment spending will go to workers in the form of wages, who will save part of those wages, the net result will be that total savings will rise faster than total investment. Once again this must force up Japan’s current account surplus even further.

So far this all looks like an attempt by Abe to increase Japanese competitiveness and so increase its total share of global demand, but not by increasing Japanese productivity, which is the high road to growth, but rather by reducing the real Japanese household income share of what is produced. Japan (like Germany and China have done over the past decade) is attempting to increase employment by reducing wages, and this means that its workers will be able to purchase a declining share of what they produce. This effectively means Japan will be growing at the expense of its trading partners. As the Japanese become less able to consume all they produce, the excess must be exported abroad.

If the world were in ruddy good health, we might not worry too much about policies aimed at Japan’s pulling itself out of the mess created in the 1980s, but with the whole world struggling with weak demand and with country after country trying to reduce domestic unemployment by selling more abroad – effectively exporting unemployment (with Germany in particular hoping to resolve the European crisis not by increasing its net domestic demand, as it should, but rather by forcing German surpluses outside Europe) – there is a real question in my mind as to how successful the Japanese program of Abenomics is likely to be if it implicitly requires a burgeoning trade surplus.

Remember that if one country increases its savings rate, unless there is a net increase in global investment there must be a commensurate reduction in the savings rate of the rest of the world so that savings and investment always balance globally. There are broadly speaking two ways this can happen. In the pre-crisis days this reduction in the savings rate of the rest of the world occurred mainly in the form of soaring consumption fueled by credit, and in this way unemployment stayed low. Since the crisis – which because of the negative wealth effect saw credit-fueled consumption drop – foreign savings have been reduced by a rise in foreign unemployment

This means that if Japan forces up its savings rate, and assuming that we are unlikely to return in the next few years to a credit-fueled consumption binge, the only way the world can respond to a structural forcing up of the Japanese savings rate is either by higher unemployment outside Japan or, if Japan’s trade partners take steps to protect themselves from higher Japanese trade surpluses, higher unemployment inside Japan.

The debt-servicing cost of nominal GDP growth

But there is more, perhaps much more. Japan is struggling with an enormous debt burden, and perhaps this explains why Tokyo is so eager to engage in policies that force up the Japanese savings rate. As long as more than 100% of Japanese borrowing is funded by domestic savings (if Japan runs a current account surplus is must be a net exporter, not importer, of capital), it doesn’t have to rely on fickle foreigners, who might not be satisfied with coupons close to zero, to fund its enormous debt burden.

But the debt burden creates its own very dangerous source of trade instability. To understand why, we need to consider what happens to interest rates in Japan if nominal growth rates rise.

In Japan interest rates are currently very low, close to zero. With total government debt amounting to more than twice the country’s GDP – which puts it among the most heavily indebted governments in the world – it is not hard to see how low nominal interest rates benefit Japan. With interest rates close to zero, there is very little cashflow pressure on the government from servicing its debt.

Some people might argue that nominal interest rates do not matter. We should be looking at real interest rates, they would argue, and with Japan’s having experienced deflation for much of the past two decades, real interest rates in Japan are high and the nominal rate is largely irrelevant.

This is true, real interest rates do matter, but it doesn’t mean that nominal interest rates do not. In fact both real and nominal interest rates matter, albeit for different reasons. Real rates matter for all the obvious reasons – they represent the real cost to the borrower in terms of a transfer of resources from the borrower to the lender. But nominal rates also matter because they effectively determine the implicit amortization schedule of principal payments.

When the nominal rate is zero or close to zero in a deflationary environment, in other words, interest is effectively capitalized in real terms. In fact whenever the real rate exceeds the nominal rate, as it has in Japan for much of the past two decades, the cashflow cost of servicing the debt is lower than the real cost, and the difference is effectively converted into real principal and deferred. In real terms, in other words, Japanese debt is growing by the difference between the real rate and the nominal rate, and this effectively represents a reduction in the cashflow cost of servicing its debt.

When nominal interest rates are positive and higher than the real rate, however, there is effectively an acceleration of real principal payments. This means that as long as nominal rates are very low, the real cost of servicing the debt is low and the principal payments are postponed, with some of the interest even being capitalized. As nominal rates rise, however, the real cost of servicing the debt during each payment period consists of interest plus some real principal.

This is just a long, perhaps pedantic, way of pointing out that even if the real interest rate in Japan declines, debt servicing is likely to be much more difficult as the nominal rate rises. Japan might be paying a lower real rate, but it is also implicitly paying down principle, instead of capitalizing it. Tokyo would need a significant increase in revenues, or a significant decrease in expenditures, to cover the cost.

So what would force Japan to raise its nominal interest rate? In principle the nominal interest rate should be more or less in line with the nominal GDP growth rate. If it is higher, growth generated by investing capital is disproportionately retained by net savers (including mainly the household sector). There is, in other words, a hidden transfer of resources from net borrowers to net savers.

If the nominal lending rate is lower than the nominal GDP growth rate, as is the case in China today and Japan during the 1980s, the opposite occurs. There is a hidden transfer from net savers to net borrowers, and because net savers are mainly the household sector, this will put downward pressure on the household share of income even as it gooses investment growth. This hidden transfer has been at the heart of the rapid economic growth that typically occurs in financially repressed economies during the earlier stages, and is also at the heart of the investment misallocation process that typically occurs during the later stages. We have seen this very clearly in China.

Will Tokyo raise interest rates?

Japan is trying to generate both positive inflation and real GDP growth, so that it is trying urgently to raise the growth rate of nominal GDP. What happens if and when it is successful? For example let us assume that Japan’s GDP is able to grow nominally by 4-5% a year – what will happen to the nominal Japanese interest rate?

Tokyo can either raise interest rates in line with nominal GDP growth rates or it can keep them repressed. In the former case, debt-servicing costs would soar, ultimately to 8% of GDP or more. This would create a problem for Tokyo in its ability to service its tremendous debt burden. It would need a primary surplus of around 8% of GDP just to keep debt levels constant, and it is hard to imagine how such a huge surplus would be consistent with nominal GDP growth rates of 4-5%.

If it were to raise income taxes it would create a huge burden for the household sector and almost certainly force up the national savings rate by forcing down the household share of GDP. Remember that during the 1980s Japan, like China today, generated rapid growth in part through financial repression, and one of the consequences of that rapid growth was an extraordinarily high savings rate along with a huge current account surplus, both of which were ultimately unsustainable. Japan has spent much of the past twenty years rebalancing GDP back in favor of the household sector, and to reverse this process may provide relief in the short term, but it is hard to see how I can be helpful in the medium term.

On the other hand if, in order to make its debt burden manageable Tokyo represses interest rates to well below the nominal GDP growth rate, it is effectively transferring a significant share of GDP from the household sector to the government in the form of the hidden financial repression tax. This is what Japan was doing in the 1980s, with all of the now-obvious consequences.

Japan’s enormous debt burden was manageable as long as GDP growth rates were close to zero because this allowed both for the country to rebalance its economy and for Tokyo to make the negligible debt servicing payments even as it was effectively capitalizing part of its debt servicing cost. If Japan starts to grow, however, it can no longer do so. Unless it is willing to privatize assets and pay down the debt, or to impose very heavy taxes of the business sector, one way or the other it will either face serious debt constraints or it will begin to rebalance the economy once again away from consumption.

As this happens Japan’s saving rate will inexorably creep up, and unless investment can grow just as consistently, Japan will require ever larger current account surpluses in order to resolve the excess of its production over its domestic demand. If it has trouble running large current account surpluses, as I expect in a world struggling with too much capacity and too little demand, Abenomics is likely to fail in the medium term.

Perhaps all I am saying with this analysis is that debt matters, even if it is possible to pretend for many years that it doesn’t (and this pretense was made possible by the implicit capitalization of debt-servicing costs). Japan never really wrote down all or even most of its investment misallocation of the 1980s and simply rolled it forward in the form of rising government debt. For a long time it was able to service this growing debt burden by keeping interest rates very low as a response to very slow growth and by effectively capitalizing interest payments, but if Abenomics is “successful”, ironically, it will no longer be able to play this game. Unless Japan moves quickly to pay down debt, perhaps by privatizing government assets, Abenomics, in that case, will be derailed by its own success.

via Zero Hedge http://feedproxy.google.com/~r/zerohedge/feed/~3/8VR4hhJ9r2U/story01.htm Tyler Durden

Wolf Richter   www.testosteronepit.com   www.amazon.com/author/wolfrichter

There has been a symphony of calls for American investors to take their money, after the outsized gains in our gravity-defying stock market, and plow it into European stocks. Net inflows into European equity funds have been strong since April and have recently set all-time records. In October, allocation to Eurozone equities hit the highest level in over six years.

Excitement was palpable when Eurozone PMIs stopped dropping in most countries, and started rising in some, and things appeared to be getting less worse, giving rise to euphoria that a recovery was on the way, that profits would flow in profusion, and that equities would soar.

Equities did soar. But reality has bad breath. Total Q3 estimated earnings by the 286 companies in the STOXX 600 that have quarterly estimates, according to Thomson Reuters IBES, dropped €17.3 billion from a year ago, or -14.5%. That’s right, earnings are plunging. And they're plunging the most in Italy (nearly -50%), Austria (-22%), France, Germany, and Spain (around -20%), followed by Britain…. It’s tough out there.

And the recovery-fueled revenues? Estimated Q3 revenues dropped by €39 billion, or -2.4%. The revenue quagmire covered all sectors except consumer cyclicals and non-cyclicals. Hardest hit: basic materials down 5%, telecom down 6.2%, financials down 6.4%, and tech down 6.5%.

Estimated earnings for the full year dropped by €20.5 billion, or -3.1%. That includes the still optimistic estimates for Q4. Of course, estimates for 2014 are sky-high because reality is still too far away, and hype organs can’t smell its bad breath yet.

Yet there are whiffs of it. When Euro Disney reported earnings yesterday for the year ending September 30, it disclosed that the number of visitors to Disneyland Paris dropped by 1.1 million, or 7%, to 14.9 million. Two-thirds of the decline was due to French visitors (who make up about half of total visitors). The remaining third of the decline was due to Italian and Spanish visitors. They no longer have the moolah to do fun things!

It wasn’t “disenchantment,” explained Euro Disney CEO Philippe Gas, but an “economic problem.” Other companies in the industry suffered similar declines. Compagnie des Alpes, which operates the Parc Astérix and the Futuroscope, saw traffic fall by 7.5%. For the Paris region, tourist count for 2013 is expected to be down 2%, largely due to fewer Spanish and Italian visitors.

To make up for lower traffic, Disneyland Paris cut promotions and raised prices. And so, overall revenues were down only 1.1% to €1.31 billion. And it doesn’t expect a rebound. It’s trying to fill the hole left behind by French, Italian, and Spanish visitors the best it can with visitors from other countries, such as Russia and Brazil. There is only so much blood you can still wring out of Eurozone dwellers.

In France, the troubles continue. There has been an avalanche of announced of 736 mass layoffs so far this year, though layoffs are difficult to impossible, very expensive, and often associated with political battles, labor unrest, plant occupations, vandalism, and taking local bosses hostage.

The list includes Alcatel-Lucent [Hype Collapses: Alcatel-Lucent “Could disappear,” Says CEO], Alstom, La Redoubte (whose labor unrest with strong support from political heavy weights is making the evening news), pork giant Gad, automaker PSA…. And this, even while the economy, as measured in GDP, is hopefully going to grow, at the brisk rate of, well, 0.9% in 2014 and 1.2% in 2015.

So, job creation in 2014? Nope. Companies are overstaffed by 250,000 people, according to recent estimates – due to the difficulties of laying them off. This has been confirmed by polls of CEOs who consistently say that they could raise output without having to hire. They have large productive reserves on their payrolls that now sit more or less idle. So growth, if any, in France's anemic private sector won't create new jobs. Instead, companies will try to shed workers.

For 2013, total job destruction will likely reach 91,000. Fewer jobs for more people: the working age population is growing by about 115,000 this year – France being one of the few European countries with that toxic combination of job destruction and a rapidly growing working age population. So unemployment will get worse, estimated to hit 10.9% next year. There simply is no letup in sight.

Not surprisingly, the French are having a field day, now that the EU Commission has joined the US Treasury in slamming Germany for its export-focused policies that are bleeding France, the rest of Europe, the US, and the rest of the world to death, somehow.

But even in Germany, exports are down 0.9% for the year through September, and imports are down even more, 1.9%. Germany, the locomotive of the Eurozone? Its economy has been crummy. Production, including construction and energy, dropped in September after rising in August in its typical zigzag manner, but still has not reached the level of 2007 – as the dreary graph shows (Destatis):

Same with the industrial orders. They’re still running way below their peak of 2007 (Destatis).

Retail sales look even drearier. In September, they dropped 0.4% from August, seasonally adjusted, but edged up year over year a measly 0.2% adjusted for inflation. On an annual basis, retail sales since 1994 have been on a bumpy downward slope. When sales for 2013 are available, chances are, this won’t look much better:

The economies of Italy and Spain have been wracked by long recessions, dreadful unemployment fiascos, decomposing assets in the banking sector…. Yet, Eurozone stock markets have been oblivious to reality’s ba
d breath.

The German DAX jumps from new high to new high. It’s up about 150% from its March 2009 low and 17% for the year so far. It didn’t even stop to take a breath when the economy shrank in Q4 last year. The French CAC 40, up 14% so far this year, knows no crisis. The Italian FTSE MIB, oh my! It soared 29% so far this year (though it’s still down 62% from its peak in 2000). The Spanish IBEX 35? What a dizzying ride! Up 29% just four months (though it’s still down 52% from its 2007 real-estate bubble peak)!

Another sign that the sea of trillions that central banks have been printing, particularly in the US, floats even the leakiest boats. The bad breath of reality? Ignored. For the time being.

The euro, its dexterous management, the “whatever-it-takes” guarantees by ECB President Draghi, the trillions being shifted around to prop up banks and governments – all these efforts to keep the Eurozone duct-taped together have hit countries differently. Including France and Germany, that are now shooting at each other, but hitting the ECB. Read…. France Clamors for Currency War, Bundesbank Warns Of Housing Bubble

And here I am on RT with Max Keiser. High-octane, pungent, and funny! Risk of whiplash…. Wolf Richter On The Keiser Report: Debtonomics And The NSA

via Zero Hedge http://feedproxy.google.com/~r/zerohedge/feed/~3/dvU1Pgda3Ws/story01.htm testosteronepit

Last week, over a year after we first forecast a major short squeeze-driven outperformance of the most shorted small- and micro-cap stocks, none other than Goldman jumped on the “buy the most shorted names” bandwagon, which promptly led us to wonder if the rally in both the most shorted names, and also in the small cap Russell 2000 index, is finally coming to an end.

The reality, as the chart below shows, is that despite 2013’s rate-driven headfake, where Russell 2000 stocks have outperformed the S&P in close approximation with the 10 Year yield, whose surge was incorrectly translated as an indication of economic strengthening when it was merely reacting to fears about the Fed’s gradual tapering, that the Russell is still solidly outperforming the S&P year to date.

In fact, to many buying the Russell 2000 is merely the highly levered bet with which the bulk of institutions (recall that almost all hedge funds, and a majority of mutual funds, are underperforming the S&P for a 5th consecutive year) seek to make up for losses in their portfolios. Which is why as the next chart below shows, in a furious scramble to catch up by year end, the institutional Russell net futures (i.e. levered) positioning just hit a record high: the biggest investors are now all-in the smallest names.

And once again, as so often happens, flows are confused for fundamentals. Because even Goldman edmits that the entire outperformance of the small cap sector is purely due to multiple expansion, not from actual fundamental improvement.

So is the massively overbought small cap sector due for a correction?

With these manipulated, centrally-planned markets, nobody has any idea. However, for those who have once again bet all in, which just happens to be most plain vanilla dumb money, it may be time to reevaluate. Below is Goldman’s David Kostin with his take on what has emerged as the most overbought small cap sector in history:

From Goldman

Investors have cast their ballots, and so far in 2013 the vote goes to small cap US equities. 2013 has been an excellent year for US equities in
general, and an even better one for small caps in particular. The Russell 2000 has returned 28% YTD, outperforming the S&P 500 by 370 bp. Its 36% return over the last 12 months ranks a standard deviation above historical averages both in absolute terms and relative to large caps.

Small caps have outperformed large caps in almost every sector. Most notably, Russell 2000 Consumer Staples have returned nearly 40% YTD and outperformed their large cap counterparts by 15 pp. Info Tech is another notable difference, with investors citing the lack of growth among S&P 500 Tech as the reason for the small cap sector’s 33% return and 14 pp outperformance relative to the lagging large cap sector.

The two major drivers of Russell 2000 returns are US economic growth and valuation. We highlighted in April that the prospect for accelerating US GDP combined with undemanding valuation set the stage for strong returns. From May through September, the Russell 2000 returned 14%, outperforming the S&P 500 by 800 bp. After lagging by 300 bp in the last month, however, investors wonder whether the small cap rally is over.

The opposing forces of improving US GDP growth and above-average valuation suggest that the Russell 2000 will post a decent but less impressive return of 6% in the next 12 months. This compares to a historical average of 11% and implies that small caps will trade in line with large caps. We forecast the S&P 500 will reach 1850 in 12 months (also +6%).

One core pillar of small cap performance, growth, remains supportive. We expect US GDP will accelerate above-trend to a 3% pace in 2014 from under 2% this year, and remain at that rate at least through 2016. Strong expectations for earnings growth reflect the economic picture. We forecast 2014 EPS growth of 23% for the Russell 2000 compared with 8% for the S&P 500. Consensus expects earnings growth of 33% and 11%, respectively.

The other major driver, valuation, is the strongest obstacle to small caps, and the most common concern raised by investors. The Russell 2000 P/E multiple has risen 25% YTD, explaining more than 80% of the index return. It now stands above 10-year averages both in absolute terms and relative to the S&P 500. Price/book, our preferred metric for small caps, has similarly risen from a standard deviation below to nearly a  standard dev. above average levels during the last two years.

Rising interest rates should be a tailwind for Russell 2000 returns. From a fundamental perspective, small cap borrow costs, and therefore  margins and earnings, have a low sensitivity to changes in Treasury yields. Russell 2000 performance relative to the S&P 500 tracked the general path  of yields this year, with small caps garnering most of their excess returns as 10-year yields rose from 1.7% in May to nearly 3% in September. Our rate strategists forecast the 10-year will rise to 2.75% by YE 2013 and 3.25% by YE 2014.

Several other macro factors that supported small cap outperformance of large caps this year may become headwinds in 2014. The Russell 2000 has historically outperformed the S&P 500 during periods of accelerating EPS growth, expanding P/E multiples, and a strengthening dollar. We expect S&P 500 EPS growth to decelerate to 8% in 2014 from 11% this year, and that P/E multiple expansion has largely run its course. The current S&P 500 forward multiple of 15x is in line with our year-end 2014 forecast level. Our FX strategists expect USD to weaken against EUR and GBP but strengthen relative to JPY during the next 12 months.

The Russell 2000’s leverage to domestic growth boosted the index this year but may be a detriment as growth in foreign markets improves. Roughly 80% of Russell 2000 sales are derived domestically compared with 66% for the S&P 500. This benefitted the small cap index earlier this year as investors worried about growth in Europe and Asia. Both data and sentiment have improved, however; Eurozone and China PMIs are back above 50, and regional equity markets have responded.

Positioning also poses a risk to small cap performance. Small cap mutual fund and ETF flows have totaled $22bn (5% of AUM) YTD, putting 2013 on pace to be the strongest year on record. Institutions are currently $6bn net long Russell 2000 futures, the largest position since the data start in 2006. Leveraged funds have a modest $2bn net short, a decline from their $2bn net long earlier this year but enough to rank in the 85th percentile historically.

Micro data are also mixed. 81% of Russell 2000 companies have reported 3Q results. 41% of firms beat on earnings by at least a standard deviation of
consensus estimates, 25% missed, and the average surprise was 3%. These metrics are all in line with the 10-year historical average. In 3Q the NFIB Small Business Optimism Index averaged its highest level since 2007, but remains well-below average levels prior to the crisis. According to the survey, revenue growth concerns are fading, and respondents continue to point to government requirements as their most important problem.

via Zero Hedge http://feedproxy.google.com/~r/zerohedge/feed/~3/usHoLJZIyWo/story01.htm Tyler Durden

Last week, over a year after we first forecast a major short squeeze-driven outperformance of the most shorted small- and micro-cap stocks, none other than Goldman jumped on the “buy the most shorted names” bandwagon, which promptly led us to wonder if the rally in both the most shorted names, and also in the small cap Russell 2000 index, is finally coming to an end.

The reality, as the chart below shows, is that despite 2013’s rate-driven headfake, where Russell 2000 stocks have outperformed the S&P in close approximation with the 10 Year yield, whose surge was incorrectly translated as an indication of economic strengthening when it was merely reacting to fears about the Fed’s gradual tapering, that the Russell is still solidly outperforming the S&P year to date.

In fact, to many buying the Russell 2000 is merely the highly levered bet with which the bulk of institutions (recall that almost all hedge funds, and a majority of mutual funds, are underperforming the S&P for a 5th consecutive year) seek to make up for losses in their portfolios. Which is why as the next chart below shows, in a furious scramble to catch up by year end, the institutional Russell net futures (i.e. levered) positioning just hit a record high: the biggest investors are now all-in the smallest names.

And once again, as so often happens, flows are confused for fundamentals. Because even Goldman edmits that the entire outperformance of the small cap sector is purely due to multiple expansion, not from actual fundamental improvement.

So is the massively overbought small cap sector due for a correction?

With these manipulated, centrally-planned markets, nobody has any idea. However, for those who have once again bet all in, which just happens to be most plain vanilla dumb money, it may be time to reevaluate. Below is Goldman’s David Kostin with his take on what has emerged as the most overbought small cap sector in history:

From Goldman

Investors have cast their ballots, and so far in 2013 the vote goes to small cap US equities. 2013 has been an excellent year for US equities in
general, and an even better one for small caps in particular. The Russell 2000 has returned 28% YTD, outperforming the S&P 500 by 370 bp. Its 36% return over the last 12 months ranks a standard deviation above historical averages both in absolute terms and relative to large caps.

Small caps have outperformed large caps in almost every sector. Most notably, Russell 2000 Consumer Staples have returned nearly 40% YTD and outperformed their large cap counterparts by 15 pp. Info Tech is another notable difference, with investors citing the lack of growth among S&P 500 Tech as the reason for the small cap sector’s 33% return and 14 pp outperformance relative to the lagging large cap sector.

The two major drivers of Russell 2000 returns are US economic growth and valuation. We highlighted in April that the prospect for accelerating US GDP combined with undemanding valuation set the stage for strong returns. From May through September, the Russell 2000 returned 14%, outperforming the S&P 500 by 800 bp. After lagging by 300 bp in the last month, however, investors wonder whether the small cap rally is over.

The opposing forces of improving US GDP growth and above-average valuation suggest that the Russell 2000 will post a decent but less impressive return of 6% in the next 12 months. This compares to a historical average of 11% and implies that small caps will trade in line with large caps. We forecast the S&P 500 will reach 1850 in 12 months (also +6%).

One core pillar of small cap performance, growth, remains supportive. We expect US GDP will accelerate above-trend to a 3% pace in 2014 from under 2% this year, and remain at that rate at least through 2016. Strong expectations for earnings growth reflect the economic picture. We forecast 2014 EPS growth of 23% for the Russell 2000 compared with 8% for the S&P 500. Consensus expects earnings growth of 33% and 11%, respectively.

The other major driver, valuation, is the strongest obstacle to small caps, and the most common concern raised by investors. The Russell 2000 P/E multiple has risen 25% YTD, explaining more than 80% of the index return. It now stands above 10-year averages both in absolute terms and relative to the S&P 500. Price/book, our preferred metric for small caps, has similarly risen from a standard deviation below to nearly a  standard dev. above average levels during the last two years.

Rising interest rates should be a tailwind for Russell 2000 returns. From a fundamental perspective, small cap borrow costs, and therefore  margins and earnings, have a low sensitivity to changes in Treasury yields. Russell 2000 performance relative to the S&P 500 tracked the general path  of yields this year, with small caps garnering most of their excess returns as 10-year yields rose from 1.7% in May to nearly 3% in September. Our rate strategists forecast the 10-year will rise to 2.75% by YE 2013 and 3.25% by YE 2014.

Several other macro factors that supported small cap outperformance of large caps this year may become headwinds in 2014. The Russell 2000 has historically outperformed the S&P 500 during periods of accelerating EPS growth, expanding P/E multiples, and a strengthening dollar. We expect S&P 500 EPS growth to decelerate to 8% in 2014 from 11% this year, and that P/E multiple expansion has largely run its course. The current S&P 500 forward multiple of 15x is in line with our year-end 2014 forecast level. Our FX strategists expect USD to weaken against EUR and GBP but strengthen relative to JPY during the next 12 months.

The Russell 2000’s leverage to domestic growth boosted the index this year but may be a detriment as growth in foreign markets improves. Roughly 80% of Russell 2000 sales are derived domestically compared with 66% for the S&P 500. This benefitted the small cap index earlier this year as investors worried about growth in Europe and Asia. Both data and sentiment have improved, however; Eurozone and China PMIs are back above 50, and regional equity markets have responded.

Positioning also poses a risk to small cap performance. Small cap mutual fund and ETF flows have totaled $22bn (5% of AUM) YTD, putting 2013 on pace to be the strongest year on record. Institutions are currently $6bn net long Russell 2000 futures, the largest position since the data start in 2006. Leveraged funds have a modest $2bn net short, a decline from their $2bn net long earlier this year but enough to rank in the 85th percentile historically.

Micro data are also mixed. 81% of Russell 2000 companies have reported 3Q results. 41% of firms beat on earnings by at least a standard deviation of consensus estimates, 25% missed, and the average surprise was 3%. These metrics are all in line with the 10-year historical average. In 3Q the NFIB Small Business Optimism Index averaged its highest level since 2007, but remains well-below average levels prior to the crisis. According to the survey, revenue growth concerns are fading, and respondents continue to point to government requirements as their most important problem.

via Zero Hedge http://feedproxy.google.com/~r/zerohedge/feed/~3/usHoLJZIyWo/story01.htm Tyler Durden

As reported yesterday, Typhoon Haiyan – potentially the strongest storm to ever make landfall, and stronger than Katrina and Sandy combined – has come and left the Philippines (currently heading for Vietnam), and now the time has come to evaluate the damage and count the dead. Sadly, as Reuters reports, the devastation is absolutely massive and especially in the hardest hit city of Tacloban in the central Leyte province, may match the aftermath of the Fukushima tsunami: "This is destruction on a massive scale. There are cars thrown like tumbleweed and the streets are strewn with debris." Airport manager Efren Nagrama, 47, said water levels rose up to four metres (13 ft) in the airport. "It was like a tsunami. We escaped through the windows and I held on to a pole for about an hour as rain, seawater and wind swept through the airport. Some of my staff survived by clinging to trees. I prayed hard all throughout until the water subsided."

And it's not over yet: the following clip from The Weather Channel summarizes the current position and heading of the Typhoon:

But while the worst may be yet to come, for the Philippines it is bad enough as Reuters explains:

A day after Typhoon Haiyan churned through the Philippine archipelago in a straight line from east to west, rescue teams struggled to reach far-flung regions, hampered by washed out roads, many choked with debris and fallen trees.

The death toll is expected to rise sharply from the fast-moving storm, whose circumference eclipsed the whole country and which late on Saturday was heading for Vietnam.

Among the hardest hit was coastal Tacloban in central Leyte province, where preliminary estimates suggest more than 1,000 people were killed, said Gwendolyn Pang, secretary general of the Philippine Red Cross, as water surges rushed through the city.

"An estimated more than 1,000 bodies were seen floating in Tacloban as reported by our Red Cross teams," she told Reuters. "In Samar, about 200 deaths. Validation is ongoing."

She expected a more exact number to emerge after a more precise counting of bodies on the ground in those regions.

Witnesses said bodies covered in plastic were lying on the streets. Television footage shows cars piled atop each other.

The Philippines has yet to restore communications with officials in Tacloban, a city of about 220,000. A government official estimated at least 100 were killed and more than 100 wounded, but conceded the toll would likely rise sharply.

The airport was nearly destroyed as raging seawaters swept through the city, shattering the glass of the airport tower, levelling the terminal and overturning nearby vehicles.

"Almost all houses were destroyed, many are totally damaged. Only a few are left standing," said Major Rey Balido, a spokesman for the national disaster agency.

Local television network ABS-CBN showed images of looting in one of the city's biggest malls, with residents carting away everything from appliances to suitcases and grocery items.

Airport manager Efren Nagrama, 47, said water levels rose up to four metres (13 ft) in the airport.

"It was like a tsunami. We escaped through the windows and I held on to a pole for about an hour as rain, seawater and wind swept through the airport. Some of my staff survived by clinging to trees. I prayed hard all throughout until the water subsided."

Across the country, about a million people took shelter in 37 provinces after President Benigno Aquino appealed to those in the typhoon's path to leave vulnerable areas.

"For casualties, we think it will be substantially more," Aquino told reporters.

* * *

Photos of the damage via the Weather Channel:

 

Finally, here is video evidence of what the stronger typhoon in history looks like on the ground:

via Zero Hedge http://feedproxy.google.com/~r/zerohedge/feed/~3/wpO8fb7we5U/story01.htm Tyler Durden

As reported yesterday, Typhoon Haiyan – potentially the strongest storm to ever make landfall, and stronger than Katrina and Sandy combined – has come and left the Philippines (currently heading for Vietnam), and now the time has come to evaluate the damage and count the dead. Sadly, as Reuters reports, the devastation is absolutely massive and especially in the hardest hit city of Tacloban in the central Leyte province, may match the aftermath of the Fukushima tsunami: "This is destruction on a massive scale. There are cars thrown like tumbleweed and the streets are strewn with debris." Airport manager Efren Nagrama, 47, said water levels rose up to four metres (13 ft) in the airport. "It was like a tsunami. We escaped through the windows and I held on to a pole for about an hour as rain, seawater and wind swept through the airport. Some of my staff survived by clinging to trees. I prayed hard all throughout until the water subsided."

And it's not over yet: the following clip from The Weather Channel summarizes the current position and heading of the Typhoon:

But while the worst may be yet to come, for the Philippines it is bad enough as Reuters explains:

A day after Typhoon Haiyan churned through the Philippine archipelago in a straight line from east to west, rescue teams struggled to reach far-flung regions, hampered by washed out roads, many choked with debris and fallen trees.

The death toll is expected to rise sharply from the fast-moving storm, whose circumference eclipsed the whole country and which late on Saturday was heading for Vietnam.

Among the hardest hit was coastal Tacloban in central Leyte province, where preliminary estimates suggest more than 1,000 people were killed, said Gwendolyn Pang, secretary general of the Philippine Red Cross, as water surges rushed through the city.

"An estimated more than 1,000 bodies were seen floating in Tacloban as reported by our Red Cross teams," she told Reuters. "In Samar, about 200 deaths. Validation is ongoing."

She expected a more exact number to emerge after a more precise counting of bodies on the ground in those regions.

Witnesses said bodies covered in plastic were lying on the streets. Television footage shows cars piled atop each other.

The Philippines has yet to restore communications with officials in Tacloban, a city of about 220,000. A government official estimated at least 100 were killed and more than 100 wounded, but conceded the toll would likely rise sharply.

The airport was nearly destroyed as raging seawaters swept through the city, shattering the glass of the airport tower, levelling the terminal and overturning nearby vehicles.

"Almost all houses were destroyed, many are totally damaged. Only a few are left standing," said Major Rey Balido, a spokesman for the national disaster agency.

Local television network ABS-CBN showed images of looting in one of the city's biggest malls, with residents carting away everything from appliances to suitcases and grocery items.

Airport manager Efren Nagrama, 47, said water levels rose up to four metres (13 ft) in the airport.

"It was like a tsunami. We escaped through the windows and I held on to a pole for about an hour as rain, seawater and wind swept through the airport. Some of my staff survived by clinging to trees. I prayed hard all throughout until the water subsided."

Across the country, about a million people took shelter in 37 provinces after President Benigno Aquino appealed to those in the typhoon's path to leave vulnerable areas.

"For casualties, we think it will be substantially more," Aquino told reporters.

* * *

Photos of the damage via the Weather Channel:

 

Finally, here is video evidence of what the stronger typhoon in history looks like on the ground:

via Zero Hedge http://feedproxy.google.com/~r/zerohedge/feed/~3/wpO8fb7we5U/story01.htm Tyler Durden

Moments ago BitCoin hit $395, and will likely cross $400 in the immediate future (the chart looks a little less scary in log scale).

So as more and more pile into the electronic currency, some due to ideological reasons, some simply to chase momentum, some out of disappointment with the manipulated gold price looking to park their savings in an alternative, non-fiat based currency, which a year ago traded 40 times lower, the attention of the government is finally starting to shift to what has been the best performing asset class in the past year, outperforming even the infamous Caracas stock market.

Which means one thing: Congressional hearings.

From Bloomberg:

The U.S. Senate Committee on Homeland Security and Governmental Affairs will meet on Nov. 18 “to explore potential promises and risks related to virtual currency for the federal government and society at large,” it said in a statement today.

 

The hearing, titled “Beyond Silk Road: Potential Risks, Threats, and Promises of Virtual Currencies,” will invite witnesses to testify about the challenges facing law enforcement and regulatory agencies, and include views from “non-governmental entities who can discuss the promises of virtual currency for the American and global economies.”

 

“Bitcoin is obviously getting a lot of attention from the federal
government on the regulatory side,” Nicholas Colas, an analyst at ConvergEx Group, said in an interview. “Given the involvement of the currency in illegal activities, that is entirely warranted. I expect these hearings to be largely informational, which is good for Bitcoin.”

 

“The architecture of the system is elegant from a computer-science perspective, but hard for a non-tech person to understand,” Colas said. “Getting industry professionals to close this gap will be very helpful.”

Or not. Because the only thing the government does when its interest is piqued by something, anything, especially things that have to be looked in log-scale, is to promptly regulate it and then tax it, not necessarily in that order. Just how it will achieve this with Bitcoin remains unclear but one thing is certain: it will try.

Especially, now that even the Fed is looking at BitCoin when a few days ago the Chicago Fed issued ‘Bitcoin: A primer” in which the Fed states quite simply:

So far, the uses of bitcoin as a medium of exchange appear limited, particularly if one excludes illegal activities. It has been used as a means to transfer funds outside of traditional and regulated channels and, presumably, as a speculative investment opportunity. People bet on bitcoin because it may develop into a full-fledged currency. Some of bitcoin’s features make it less convenient than existing currencies and payment systems, particularly for those who have no strong desire to avoid them in the first place. Nor does it truly embody what Hayek and others in the “Austrian School of Economics” proposed. Should bitcoin become widely accepted, it is unlikely that it will remain free of government intervention, if only because the governance of the bitcoin code and network is opaque and vulnerable.

Finally, while the Fed may be late to the game, the ECB has already made its feelings on BitCoin well-known long ago: recall from over a year ago: “The ECB Explains What A Ponzi Scheme Is; Awkward Silence Follows” in which the European central banks didn’t mince its words: BitCoin is nothing but a ponzi scheme to the central bank tasked with preserving the viability of an entire insolvent continent, and a a currency which unlike BitCoin would never survive absent regulatory intervention.

So while the electronic currency is soaring exponentially as it goes through its appreciation golden age, will the one thing that can finally end the dream of BitCoin holders arrive soon: when the government, and existing monetary authorities, start taking it seriously.

Full Chicago Fed paper on BitCoin

via Zero Hedge http://feedproxy.google.com/~r/zerohedge/feed/~3/6i1wfWCpdgQ/story01.htm Tyler Durden

The title is deliberately provocative to relay the extent of my concerns with recent market action. Regular readers will know of my bearish long-term outlook for stocks based on the view that we remain in a secular bear market which began in 2000 and extraordinary central bank policies have only delayed an eventual bottom. But the recent activity in stocks and other asset markets is sending a clear signal that dangerous bubbles are building everywhere thanks to printed money and low interest rates. And central banks are unwilling to intervene as economic recovery remains as elusive as ever. The likely endgames are obvious enough: either recovery happens and central banks move too late to quell inflation or recovery doesn’t happen at all. Those forecasting a happier outcome either don’t know of the long history of consistent central banking failure or, more likely, are beneficiaries of the current policies.

Many commentators have rightly pointed out the froth building in the U.S. stock market with Twitter jumping 73% on debut, margin debt at record highs and extreme bullishness among institutional and retail investors. But the bubbles developing in Asia, arguably much larger in size not just in stocks but across all asset markets, have been largely ignored. Today’s post will focus on three red flags:

1. The Indian stock market reached record highs over the past week despite all of the country’s problems and a currency recently in free fall.
2. Australians have been increasingly using their superannuation funds as collateral to buy residential property, helping reflate one of the world’s biggest housing bubbles.
3. The Japanese bond market has effectively died with the government becoming the dominant player in the market due to its massive bond buying program. This isn’t just a Japanese phenomenon with central banks now owning a third of the world’s bond markets. Free markets, these ain’t.

I’ll also explore why the excesses are developing. And a key underlying reason, little acknowledged, is that the fiat money system – paper money without an anchor to something of solid value – is becoming stretched and perhaps reaching breaking point as central bankers print endless money without constraints. Some may see this as an extreme point of view but that ignores the relatively short history of the system and subsequent sharp increase in asset price volatility.

Asia Confidential isn’t so arrogant as to predict an imminent downturn in asset prices. No-one knows exactly how this will play out. But increasing asset price volatility would seem relatively assured. Given this, it would make sense to keep your assets diversified, resist taking on too much debt (asset price risk outweighs attractive rates) and, most importantly, avoid areas that investors are salivating over (such as hyped IPOs).

Red flags everywhere

If alarm bells aren’t going off for investors, they should be. And it’s not just the IPO of a certain social messaging company which is valued at close to US$24 billion despite never earning a dime. I saw one portfolio manager describe the IPO as a great thing and the best of capitalism in action. I’m not sure who’s more stupid: this investor, the Twitter founders who under-estimated public demand and left money on the table, the investment bankers who under-priced it or the retail investors who are holding onto the shares, which will probably go the way of RIM in a few years time.

The largest signs of excess instead lay in Asia. I’ve mentioned the Indian stock market reaching record highs. It was only in July that the country was in turmoil with a currency in free fall. Since then, stocks have surged, out-performing all other major markets in Asia.

Below is India’s Sensex index.

For the record, I advocated accumulating Indian stocks during the turmoil, but the market has run extraordinarily hard since then, making it prudent to take some money off the table.

The country’s problems haven’t gone away. The economy is still growing at decade-lows. The current account deficit remains one of the largest in emerging markets. And politics remain uncertain ahead of a general election next year.

Now some will argue that the stock market is just forecasting a better economy ahead. Maybe. But you’re starting point is a market at record highs, on a not-so-cheap 16x trailing earnings, arguably distorted by low interest expenses given low rates.

More prominent warnings signs are outside of stock markets though. Everyone knows that residential property prices remain elevated in the likes of China, Hong Kong, Singapore and Australia. The latter has taken it to a whole new level, however.

The latest trend is Australians using their superannuation as collateral to buy residential property, as well as other forms of property. Residential real estate now accounts for 14% of so-called self managed super funds. That’s helped drive an 8% year-on-year increase in house prices in September.

Now I’m not sure if the practice of using superannuation or pensions as collateral to purchase property is used in any other country but the dangers are pretty obvious. Particularly when many developed countries, including Spain, are raiding pension funds to finance their QE programs.

Australia has added risks given the extent of its housing bubble. Demographia says the Australian housing market is the most expensive in the developed world, with property prices at 5.6x annual income, with 3x or below considered affordable. Meanwhile, The Economist magazine suggests Australia is the world’s fourth most expensive housing market, with pric
es 44% overvalued versus rents and 24% versus wages (which are undoubtedly grossly inflated).

The risks to Australia from the inflated housing market are systemic also. Housing assets of A$4.9 trillion are 3.3x larger than Australia’s GDP. Moreover, residential property represents more than 60% of the big four Australian banks total loan books. Given these banks have an average leverage of 20x (equity/assets), it would take less than a 10% fall in residential property prices for equity in these banks to be wiped out.

One word comes to mind: bail-outs!

Lastly, there’s been unsurprising news over the past week that the Japanese bond market has become dysfunctional. I’ve previously talked about how the massive bond buying program of the Japanese central bank, equivalent to 70% of new bond issuance, would crowd out private investors and thereby significantly increase volatility.

Now one of Japan’s larger brokers, Mizuho, has come out to declare that the sovereign bond market is effectively dead. The firm’s chief bond strategist Tetsuya Miura told Bloomberg:

“The JGB [Japanese government bond] market is dead with only the BoJ [Bank of Japan] driving bond prices.

These low yields are responsible for the lack of fiscal reform in the face of Japan’s worsening finances. Policymakers think they can keep borrowing without problems.”

Recall that Japan is attempting U.S.-style stimulus on steroids to lift the country out of 20 years of deflation. It hopes to increase inflation without a rise in bond yields and interest rates. Rising rates would kill Japan given that interest rates of just 2.8% would mean interest expenses on government debt equaling all of current government revenues. An unsustainable situation.

Japanese government bond yields have behaved so far, though there was a huge spike in volatility earlier this year. Given the central bank has now effectively swallowed the bond market, you can expect to see increased volatility hitting headlines again very soon.

Below is a chart of 10-year Japanese government bond yields.

By the way, this isn’t just a Japanese issue. Central banks now own a third of the world’s bond markets. That number could substantially rise given plans for further QE. And it makes an eventual bond market revolt more likely at some stage.

The system reaching breaking point?

It would be easy to blame the above excesses simply on money printing and low interest rates. But that would ignore some of the key underlying causes. A few weeks ago, I highlighted how the significant trade imbalances between the U.S. and China played a major role in the financial crisis and subsequent policy.

But reading through the former publisher of highly-regarded Bank Credit Analyst Tony Boeckh’s book, The Great Reflation, has reminded me of a larger issue at play. Namely, the central role of the paper money system in increasing asset price volatility:

“The Great Reflation now underway should be seen as another chapter extending the long-running saga of inflation – excess money and credit expansion – that began in 1914. A hundred years of financial background may seem a little esoteric to some, but it is important to understand that we have been living for a very long time in a monetary world that is without an anchor. When there is no anchor, the monetary system has no discipline. And it is this lack of discipline that is fundamental to where we are now and where we may be going. The Age of Inflation is deep-rooted and enduring but it is not sustainable forever. Anything that is not sustainable has an end point. When that time comes, it will not be pretty.”

Boeckh goes onto explain the traditional anchor to prevent excesses was gold, and to a less extent, silver. In other words, central banks couldn’t print money without additional metallic reserves, prior to 1914.

The big change came in 1913 with the formation of the U.S. central bank, the Federal Reserve. The anchor with gold was gradually wound back until the seminal event in 1971 when the U.S. broke the link to gold and floated the dollar. This allowed central banks to print money without any constraints.

What that’s meant is that at the sign of any downturn, central banks have opted for the easy, most painless, solution: inflation. Which has resulted in increasing asset price volatility:

“The Great Reflat
ion experiment now underway, while critical in avoiding a 1930s debt deflation spiral, ensures that we are a long way from writing the last chapter on the post-1914 Age of Inflation. The managed paper money system has been a huge failure, and lies at the root of the persistent tendency to inflation, instability, and debt upheavals. There are obvious political advantages to inflation in the short run, and a paper system with no brakes is a great temptation to politicians with one eye always on the next election.”

It’s important to understand that Boeckh doesn’t necessarily predict inflation ahead. He views, as I do, inflation and deflation being two sides of the same coin as inflation always begets deflation and vice versa. Right now, you’re seeming asset inflation, but disinflation (declining inflation) in the price of goods (reflected in CPI numbers). Whether we get asset deflation or inflation flowing through to CPI remains to be seen.

And it’s imperative to realise that inflation doesn’t aid economic growth. This is contrary to the views of just about every economist on the planet. But the fact is that the U.S., for instance, experienced superior economic growth in the 19th century when there was practically zero inflation. And during that time, there were fewer economic downturns than has occurred over the past century.

The warped belief that economies need inflation for growth was aptly on display in a recent New York Times article entitled “In Fed and Out, Many Now Think Inflation Helps”. A more silly and misinformed article you won’t find readily, but it certainly furthers the agenda of the new Fed chief to keep on printing money in the hope of reviving the economy.

Getting back to Beockh and what he does suggest, and I totally agree with, is that the current paper money system is being stretched to breaking point. Consequently, you should expect heightened volatility in future:

“The fragile state of the economy and financial system will continue to require inflation of money and credit, heavy government intrusion into the private sector, and frequent resorting to subsidies and support programs. This will continue to distort relative prices of labor, goods, services, and assets. It will sustain the economy in an artificial state and will compound instability and make it impossible to understand what is real and what is not.”

If this is right, the question then becomes how best to protect your assets in what is likely to be a treacherous environment going forward. Let’s turn to some specific recommendations.

How best to preserve your capital

Given no-one, including your author, knows exactly how events will unfold, diversification of your assets should be a key priority. A traditional stock and bond portfolio is fraught with danger given the significant distortions in these markets. Real estate, cash and precious metals should all be considered.

Under different scenarios, you want to protect your capital. If excessive inflation occurs, as happened in the 1970s, then stocks and bonds will get slaughtered. Real estate and gold are better inflation hedges. If there’s mild inflation, stocks will do well, as might gold, while bonds and cash should under-perform. If there’s mild or extreme deflation, bonds and cash should outperform. Gold could also do ok if faith is lost in the paper money system.

For stock exposure, the U.S. looks pricey, while parts of Asia and Europe offer opportunities. In my neighbourhood of Asia, banks in Singapore and Thailand offer reasonable value, beaten down energy and gold socks are worth a look, and inepensive gaming stocks such as Genting Berhad (KLSE:GENT) and Crown Ltd (ASX:CWN) should prove resilient.

For bonds, try to avoid sovereign bonds, barring perhaps prudently run countries such as Singapore. Corporate bonds are worth considering, but remember that these bonds have quasi-equity type qualities. Which means if stocks tank, corporate bonds will suffer too.

For property exposure, residential property in many countries looks elevated. That’s particularly the case in Asia. Office real estate offers better value but is at risk if economies don’t recover. Meanwhile retail property is largely unattractive given the continuing loss of retail market share to the internet. Industrial real estate is probably the most defensive property exposure. Historically this sub-segment has proven less cyclical as significant oversupply is rare given the quick time that it takes to build industrial versus office and retail.

Cash is the world’s most hated asset right now and that’s part of the reason why you should have some in reserve. Central banks want you out of cash and into risk assets, so having some cash is akin to flipping the bird at the Fed. More seriously, you’ll need cash in reserve to take advantage of any opportunities should there be a major shake-out in markets.

Which currencies to own? Ah, that’s the difficult part. The Singapore dollar remains a stand-out. Other than that, there’s not a lot else to like. A basket of Canadian loonie, Thai baht, Malaysian ringgit, U.S. dollar (at least in the short-term), New Zealand dollar and Norwegian krone should be considered.

Now to precious metals. You own gold if you believe there’s even a small chance of a breakdown in the current financial system. It’s disaster insurance. It’s why China is buying as much gold as it can get its hands on. Not because it wants to become the world’s leading currency, as many suggest, but because it doesn’t trust the U.S. dollar or current paper money system (more on that topic at a later date). It foresees the possibility of a new monetary system with the partial or full backing of gold. You might be wise to follow the Chinese when it comes to gold.

This post was originally published at Asia Confidential: http://asiaconf.com/2013/11/09/3-signs-of-bloodbath-ahead/

via Zero Hedge http://feedproxy.google.com/~r/zerohedge/feed/~3/uYzzcHSZAII/story01.htm Asia Confidential

The socialist paradise that is Venezuela has already shown the Federal Reserve just how the world’s greatest “wealth effect” can be achieved courtesy of the Caracas stock market returning over a mindblowing 475% in 2013. Of course, while the US inflation is still slightly delayed (if only for non-core items and those that can’t be purchased on leverage) Venezuela’s own 50%+ increase in annual prices is only part of the tradeoff to this unprecedented “enrichment” of society, or at least 0.001% of it – after all, it’s all about the égalité. More problematic may be the fact that in addition to a pervasive toilet paper shortage, a collapse in the currency, a creeping mothballing of the local energy industry due to nationalization fears, and a virtual halt of international trade as the country’s FX reserves evaporate, Venezuela’s relatively new government had adopted arguably the best and brightest socialist policy wielded by both Hollande and Obama, namely the “fairness doctrine.”

However, in this case it is not about what is a “fair” tax for the wealthy (as taxes in the Venezuela socialist paradise will hardly do much to build up much needed foreign currency reserves), but what is a “fair” price for electronic appliances like flat screen TVs, toasters, and ACs. The result is that Maduro’s government now determines what equilibrium pricing should be.

The reason for this latest socialist victory over the tyranny of supply and demand is that overnight Venezuela’s President Nicolas Maduro ordered the “occupation” of a chain of electronic goods stores in a crackdown on what the socialist government views as price-gouging hobbling the country’s economy. Various managers of the five-store, 500-employee Daka chain have been arrested, and the company will now be forced to sell products at “fair prices,” Maduro said late on Friday.

In essence Maduro is simply going now where Abe soon, and Mr. Chairwoman will go eventually, and in an attempt to offset inflation (at last check Y/Y inflation was over 50%) has effectively “nationalized” prices by forcing retail managers to ignore such trivial things as import prices, and to see well below cost, or at what the government has determined is a “fair” price. Maduro has stopped short of more outright nationalizations, in
this case saying authorities would instead force Daka to sell at
state-fixed prices. Needless to say outright nationalizations are the next step.

That this is the absolute idiocy of any socialist regime in its final, pre-hyperinflation dying throes is well-known to anyone who had the privilege of visiting Eastern Europe just after the collapse of the USSR. However, for the Millennial generation it should serve as a harbinger of things to come to every socialist country that thinks it can rule by central-planning ordain, through a monetary politburo, and is absolutely certain can contain inflation in “15 minutes” or less.

From Reuters:

State media showed soldiers in one Daka shop checking the price tags on large flat-screen TVs. And hundreds of bargain-hunters flocked to Daka stores on Saturday morning to take advantage of the new, cheaper prices.

 

“We’re doing this for the good of the nation,” said Maduro, 50, who accuses wealthy businessmen and right-wing political opponents backed by the United States of waging an economic “war” against him.

 

“I’ve ordered the immediate occupation of this chain to offer its products to the people at fair prices, everything. Let nothing remain in stock … We’re going to comb the whole nation in the next few days. This robbery of the people has to stop.”

 

The measure, which comes after weeks of warnings from the government of a pre-Christmas push against private businesses to keep prices down, recalled the sweeping takeovers during the 14-year rule of Maduro’s predecessor Hugo Chavez.

Venezuela’s people obviously are delighted:

“Inflation’s killing us. I’m not sure if this was the right way, but something had to be done. I think it’s right to make people sell things at fair prices,” said Carlos Rangel, 37, among about 500 people queuing outside a Daka store in Caracas.

 

Rangel had waited overnight, with various relatives, to be at the front of the queue and was hoping to find a cheap TV and air-conditioning unit.

 

Soldiers stood on guard outside the store before it opened.

But how is that possible: is the wealth effect from a 475% YTD return in the Caracas stock market not enough to make everyone perpetually happy and content?

Or did the uberwealth of the 0.001% not trickle down just yet? No worries: it will only take another executive decree to strip the wealthy of their assets, just like it took one order to determine what is “fair pricing” on 50 inch plasma TV, and to enforce “trickle down” economics in this utopia gone bad.

As for what is left of the remaining retail sector, they have gotten the message:

Opponents also blame excessive government controls and persecution of the private sector for shortages of basic goods ranging from flour to toilet paper, and for price distortions and corruption caused by a black-market currency rate nearly 10 times higher the official price.

 

“This ridiculous show they’ve mounted with Daka is a not-very-subtle warning to us all,” said a Venezuelan businessman who imports electronic goods and is an opposition supporter.

 

Under price controls set up a decade ago, the state sells a limited amount of dollars at 6.3 bolivars, but given the short supply, some importers complain they are forced into a black market where the price is nearly ten-fold higher.

 

Maduro showed astonishment at a fridge on sale in Daka for 196,000
bolivars ($31,111 at the official rate), and said an air-conditioning
unit that goes for 7,000 bolivars ($1,111) in state stores was marked up
36,000 bolivars ($5,714) by Daka.

 

“Because they don’t allow me to buy dollars at the official rate of 6.3, I have to buy goods with black market dollars at about 60 bolivars, so how can I be expected to sell things at a loss? Can my children eat with that?” added the businessman, who asked not to be named.

Who expects your children to eat, citizen? After all they didn’t build that negative profit margin. Just eat your peas, be replete of hopium, sell for a “fair price”, be happy you don’t have to sign up for healthcare.ve under gunpoint, and don’t forget to sing the praises of a socialist central-planning utopia. And always remember: BTFATH!

via Zero Hedge http://feedproxy.google.com/~r/zerohedge/feed/~3/O7p8VjxcVRk/story01.htm Tyler Durden