James Saft

Rather than fear the spread of people power revolutions, investors should welcome them.

Just don’t expect an easy ride in the near term.

Lots of people have made lots of money out of dictatorships, but you, dear reader, are probably not one of them and are likely to do better, in the long run, as they fall.

A spreading revolt in Libya, following closely on the overthrow of the Egyptian and Tunisian governments, sent a scare into global financial markets on Monday, hitting share prices and prompting a near six percent spike in the price of oil.

First the bad news: risk markets, already in a bullish delirium prompted by easy monetary policy, are ripe for a correction, and the threat of higher energy prices could easily be the catalyst.

Economist Nouriel Roubini points out that spikes in energy prices related to wars or conflict in the Middle East preceded three of the last five global recessions.

True enough, and a bout of stagflation, as rising energy prices drives inflation and suppresses growth, is not out of the question. There can be no assurances that whatever follows if Gaddafi falls will be more peaceful, less aggressive or even more democratic. Periods of transition are risky, and when they happen where energy is concentrated the risks are both global and economic. To the extent that unrest spreads to other states with or near oil, it is reasonable for markets to adjust for these risks and sell off.

It is also fair to draw a line between the very loose monetary policy of the U.S. and the rising food and commodity costs which may have increased discontent.

It is also reasonable, though, to assume that whomever controls Libya will want to export oil, just as whomever controls Egypt will wish to make as much as they can from ships transiting the Suez Canal.

In the long run, you can’t help but believe that investors, especially small ones, will do better out of a world where there are fewer dictators or authoritarian governments diverting resources to their families, supporters and friends.

Less corruption and more respect for property rights, combined with a population that has better reason to believe that it will get a fairer share in the fruits of their labor means more growth and a better distribution of growth.

This is deeper than extrapolating from the market capitalization tied to the countries involved. While there may be many companies traded on the London or Milan stock exchanges which are making money out of Libya and which will feel the impact if Gadaffi falls, the amount is a heck of a lot less than it would be if he was gone and the tax of corruption was lower.

SOCIAL MEDIA FOR SAVERS
The same forces which are making these revolutions possible – decentralized communications and increased transparency will also tend to level the playing field between investors and the companies they invest in and, crucially, through.

Investors, as a class, do well when property rights are protected, when information moves freely and when the share of economic growth commanded by intermediaries falls. Think of a dictator as just another intermediary taking his fat cut of the profits and directing capital in ways which benefits him and his kin to the detriment of both citizens and investors. Kind of like a bank with a bad board of directors.

In the same way in which the internet will tend to drive down fees charged by investment funds or companies, it has also made it possible, via Facebook or Twitter, for people more easily make easier comparisons between their government and others.

The internet is really bad for people who profit from a huge positional and information advantage. Just as life insurance companies saw premiums plummet in the light of the internet, so it is for dictators.

None of this, of course, is inevitable. China has had both an authoritarian government and a high rate of economic growth. It has to be said though, that China has proved dangerous for outside investors, many of whom are unable to work the system and find their capital working hard for someone else.

Nor is it inevitable that things work out benignly, in Egypt, Libya or any place else. Wars, embargoes and strife may come and if they do will hit markets very hard.

Better returns, over the long haul, will tend to be where there is more transparency and democracy.

Thinking about the Middle East as a source of oil and natural resources rather than as a market and a fund of human capital is not just wrong, it is ultimately profitless.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.)

Poor Mervyn King — damned if he doesn’t raise interest rates, futile if he does.

The Bank of England governor is in the unenviable position of having to steer interest rate policy during a period when living standards are being battered, his inflation target is being mocked by even small boys in the street and there is no obvious course of policy which can reconcile the two problems.

The BOE on Wednesday released its quarterly inflation report which judged the chances to be about equal of inflation being above or below its 2 percent target in two years’ time, this despite predicting that it will spike above its current 4 percent rate in the near term.

You might think that presiding over inflation double your target would merit raising rates immediately from all-time lows, but you would, the Governor hastened to imply, be wrong.

“We’re not in the business of futile gestures, we’re in the business of trying to make a dispassionate analysis of the balance of risks to inflation in the medium term,” King told reporters.

Futile is probably just about right, and perhaps a little generous. British inflation has spiked because of global energy and food prices, which will not respond to BOE policy, and because of a rise in consumer taxes which will not be repeated.

At the same time wage growth in Britain is extremely subdued, about 1.8 percent, the economy still has a massive amount of unused capacity and is embarking on a plan of public spending cuts which will throw many out of work and hit government suppliers hard.

The chances of British workers being able to convert rises in inflation into a spiral of wage and further price rises is pretty small at this point.

On top of this, the UK faces two risks, which because they have been around a while get less attention than they should: a weak banking system and a vulnerable property market.

The BOE’s inflation report points out some uncomfortable facts for the banking system: Commercial property, which accounts for about half of loans outstanding, has slid 35 percent in price and many borrowers are in breach of loan terms. Banks have made provisions against some of these loans, but a widespread practice has been to extend terms and wait for a hoped-for recovery in values.

At the same time, the planned removal of government support of banks means between 400 and 500 billion pounds of debt is expiring by the end of 2012, money that will need replacing or will mean a drastic and probably disastrous shrinking in balance sheets.

SHRINKING STANDARD OF LIVING
At the same time, residential property, which has had a miraculously gentle decline, is looking shaky.

So, despite real divisions on the Monetary Policy Committee and expectations among many economists of a rise in rates this Spring, it is very hard to see. The economy might weather the austerity, but then again it might not. The banks and property market may come out OK, but also might not.

As King was quick to point out, the real problem is that the British economy needs reshaping and must do so while paying huge bills racked up by lousy decisions made before the crisis.

Households “are now suffering a squeeze on real living standards for which the current rate of inflation is the obvious symptom but that squeeze on real living standards is going to happen one way or another,” King said.

“It is the price we are all paying for the financial crisis and the subsequent need to rebalance the economy. The only question is, is it better to allow it to happen with a temporary rise in prices or to push down money wages even further …?”

So, no jam today and perhaps no jam tomorrow, an honest assessment if not a popular one.

There is a large danger that the inflation which King says will be “temporary” does not prove to be, a danger that is exacerbated by perceptions that the BOE is reacting to events, perhaps sensibly, but not in strict accordance with their mandate.

My guess is that King is right to allow himself to be damned but to refuse futile acts intended to show his intolerance of inflation.

There may well be a large global bout of inflation, and if there is, Britain will get hurt badly along with the U.S. and most everyone else. If it happens it will be made in Washington, by far more powerful monetary policy, and in Beijing and other emerging markets by demand.

Britain will have to take its lumps and hope for the best.

At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.  email: jamessaft@jamessaft.com

Will bond investors keep faith with U.S. government debt amid signs of growing global inflation?

In the end, as with all banks, even central banks, it boils down to trust.

Asked on Wednesday at an appearance before the U.S. House of Representatives Budget Committee if the Fed’s $600 billion programme of quantitative easing amounted to monetization — that Peter to Paul transfer when a government prints money to pay for a shortfall — Ben Bernanke said an interesting thing:

“Monetization involves a permanent increase in money supply though money creation. (QE) is a temporary measure that will be reversed. Money will be normalized and there will be no permanent increase in outstanding balance sheet or inflation.”

So, because he intends to undo it later, he’s not doing it now.

This is both demonstrably false and deeply, at least for now, true.

False because, of course, money is being created to fund the purchase of debt issued by the Treasury. True because Bernanke can avoid the disaster often associated with monetization so long as he retains the faith of the world’s investors that he not only intends to unwind QE but will be able to do so at the right time in the future.

Monetization is an inflammatory term because so often in the past the practice of funding a revenue shortfall by buying debt with newly printed money has worked out poorly, resulting in an inflationary spiral that beggars creditors and kills the real economy.

You can bet your last Confederate dollar that all the previous central bankers who bought their own bonds with their own printed money promised that they too would withdraw before it was too late. And some of them actually did withdraw the extra money, including some of Bernanke’s predecessors at the Fed during and for a time after World War II.

Daniel Thornton, a vice president at the St Louis Fed,  suggests a slightly broader but still self-referential definition of monetization, in essence saying that it can only be judged not by action but by comparing a central bank’s performance against its targets. <http://research.stlouisfed.org/publications/es/10/ES1014.pdf> That is well and good, but really leaves investors with nothing to rely upon but faith.

NO SIGN OF PANIC
So far, at least, the signs are that the world’s bond buyers believe Bernanke; so-called 5yr5yr forwards, a measure of inflationary expectations in five years’ time, show an uptick of about a percentage point since QE2 came on to the agenda last August, but only up to a pretty tame 2.8 percent or so. It is likely that some of that move represents rising risk of runaway inflation, but it also reflects rising confidence in growth.

Despite medium- and long-term concerns about the budget and the economy, Bernanke is in a reasonably strong position; he represents the world’s largest economy and its principle reserve currency.

That said, the loss of confidence, if it came, would be swift and devastating, more all of a sudden than little by little.

While Bernanke’s recent comments give little indication that a rethink of QE is coming soon, his colleagues are now sounding a lot less enthusiastic.

“Barring some unexpected shock to the economy or financial system, I think we are pushing the envelope with the current round of Treasury purchases,” Dallas Fed President Richard Fisher, a noted hawk, said in a speech on Tuesday.

“I would be very wary of expanding our balance sheet further; indeed, given current economic and financial conditions, it is hard for me to envision a scenario where I would not use my voting position this year to formally dissent should the FOMC recommend another tranche of monetary accommodation.”

Fisher goes on to blame Congress for creating the debt, but the message and fear are clear: monetization should be rolled back.

In speeches the same day, Jeffrey Lacker of the Richmond Fed recommended that the Fed consider adjusting QE in light of improving data while the Atlanta Fed’s Dennis Lockhart said he thought no more bond buying would be needed after the expiry of the current $600 billion plan at the end of June.

Those are still minority views, and will be until Bernanke changes his tone. Given the very mixed signals coming out of the U.S. jobs market, don’t expect that to happen any time in the next month. Remember too what happened last year, when the Fed stepped back from QE1 only to see the economy weaken undesirably as the year wore on. Markets only revived once Bernanke all but promised another round of bond buying at the end of August.

For now, the controls are still in Bernanke’s hands, but keep watching the bond market.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. email: jamessaft@jamessaft.com)

Looking to hedge against a spike in inflation? Equities may not be much help.

Neither, for that matter, will you do all that well over the longer haul with bonds, cash or even commodities, at least on the historical evidence. In short, when it comes to investing, inflation is a real drag.

It’s impossible to know if, much less when, the current very stimulative monetary policy in the developed world will spur inflation, but increasingly indicators are raising concerns. Emerging market economies show signs of overheating, while prices of food and many other commodities are surging.

The traditional view has been that equities are an effective hedge against inflation, in least over the long term, because companies will, all things being equal, eventually pass on inflation to their clients as higher prices.

That’s the theory, but the practice may prove to be much different, according to a study by IMF economists Alexander Attie and Shaun Roache, who examined the performance of a range of traditional asset classes in the aftermath of inflation shocks.

“Among traditional asset classes, inflation hedges are imperfect at best and unlikely to work at worst,” according to Attie and Roache.

First, the authors looked at returns in the 12 months after inflation shocks in the period after the 1973 end of the Bretton Woods system of fixed currencies. The results were not surprising; bonds got killed, equities did badly, as did cash, while commodities were an effective hedge. Real estate investment trusts (REITs) did about as badly as equities, somewhat undermining the argument for real estate during inflationary periods.

All well and good, but really only of use for the small number of daredevils who are willing to make big asset allocation shifts over a short period of time.

For most savers, not to mention pension funds and endowments, the more useful question is how do you hedge against inflation for the longer term?

The results for equities were not encouraging.

“Equity returns decline in the months following an inflation shock and do not experience a meaningful recovery thereafter, leaving them as the worst performing asset class in our sample,” according to the study.

“Our findings are consistent with evidence from a range of earlier studies and add further weight to the evidence against the theoretical arguments for equities as a real asset class providing inflation protection when inflation is rising.”

Over the 18 months after the shock, real returns were negative, though less negative than bonds, which get hammered by inflation. Equities improve a bit over the next couple of years, but even when looked at in the long run of more than five years an inflation shock makes for losses in real terms.

IN THE LONG RUN WE’RE ALL …
As for the other asset prices, inflation proves very difficult to hedge against even over the longer term. Take commodities, the star performer in the first 18 months after inflation bites; spot prices decline in the medium term and when you get above five years after the inflationary event you are looking at actual losses in spot prices. This might be because inflation hits demand, but also might be because high prices spur greater investment in efficiency, which over the long term also moderates demand.

While bonds get killed in the first couple of years after an inflation shock, after about three years returns improve, presumably partly because investors demand higher yields to make up for nasty recent experiences.

Cash returns do a bit better, but even cash, which can go where it likes in search of better returns as inflation increases, fails to serve as a perfect hedge over the longer term.

So, how to hedge against inflation? Inflation-protected bonds such as TIPS would work, but to be a hedge you have to buy and hold to maturity, as outside forces can easily distort returns through the life of a given bond.

Given that inflation is a portfolio killer, why then are equity markets booming? Well, in emerging markets where inflation is kicking in first they are not. In developed markets, investors seem to be placing a touching amount of faith in central bankers. After all, if the Federal Reserve and ECB don’t pull the plug on stimulus in time, inflation can easily get out of control.

Or perhaps equity markets are betting the central banks will fail to stoke growth and be forced to blow a larger asset market bubble as a consequence.

Or maybe everybody thinks they will be the genius who gets out in time.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. email: jamessaft@jamessaft.com)

Markets are busy speculating on which country might follow Egypt on the revolutionary road, but watch out for the impact on a country where bellies are full and the chances of revolt are exactly nil: Japan.

The same inflation in food and energy which fanned discontent in Tunisia and Egypt could badly hit real wages and purchasing power among Japanese citizens, potentially undermining their willingness to hang on to the debt which the government desperately needs them to own.

That’s right, deflation could actually ease in Japan and, that’s right, its demise could help tip the country into the long-awaited financing crisis.

It is not the bond market vigilantes who are likely to precipitate a debt crisis in Japan, it is Mr and Mrs Watanabe, the archetypal small saver, who have patiently held Japanese government debt in huge amounts despite very low interest rates.

It is the existence of the Watanabes (domestic holdings of Japanese debt are about 94 percent vs about 50 percent in the U.S.) who have allowed Japan to run its debt up to 196 percent of GDP, trailing only Zimbabwe. By comparison, Greece’s debt to GDP ratio is just 137 percent.

With a massive and passive domestic lending base, Japan has never faced the interest rate squeeze which its long-term outlook justifies, and unlike the U.S., is far less vulnerable to sales by foreign investors or central banks. For a country which is borrowing 50 cents of every dollar it spends, this is both a key support and a significant vulnerability.

But why have the Watanabes held on to their Japanese bonds, which are usually held through intermediaries such as via savings products? Partly it’s a matter of culture and habit, but deflation has almost certainly played a mollifying role. Japanese domestic investors hold less than 5 percent of the government bond market directly, but are much larger investors through accounts and instruments sold by financial institutions, the yield of which track government bond yields. A paltry 1.2 percent yield on a 10-year bond is a lot easier to swallow for retirees and investors if purchasing power appears to be rising as prices fall in a deflationary spiral. If prices rise sharply they may demand more.

BE CAREFUL WHAT YOU WISH FOR
But that deflationary spiral, especially as it affects households, may be coming to an end courtesy of very loose U.S. monetary policy and related strong emerging market demand.

Inflation in perishables, such as meat and fruit, hit 10.3 percent in December, and overall food prices hit an all-time record, according to Japanese data. Energy prices are moving upward as well, and are vulnerable to increasing shocks from the Middle East. Overall, and not even depending on a falling yen, Japanese consumers look to be suffering a terms of trade shock, where their ability to command wages is left far behind by rising prices of the things they must buy.

Deflation has not been that terrible for Japanese households, at least to judge by their own reports: 63.9 percent of people said they were content with their standard of living last year, as against 63.1 percent in 1989.

Ratings agency Standard & Poor’s downgraded Japan’s sovereign credit rating last week to AA- from AA, citing the difficult math of an aging population and its expectations that government debt ratios would continue to rise. Reaction was muted in bond markets, though the yen fell. The price to insure Japanese bonds against default over the next five years rose to about 0.85 percent, near highs reached last summer during the European debt crisis.

To be sure, Japan is still in deflation and even with food and energy playing a heavy part of price measure, overall prices are likely to continue to fall.

Japan doubtless has much with which to protect itself in a bond sell-off; massive overseas assets, a positive current account balance and a cohesive and biddable financial sector. That said, the following scenario is one to watch — domestic holders, stung by inflation, rapidly increase their holdings of overseas debt and other investments, cutting back on government bonds. This drives yields up and the yen down, catching the eye of foreign investors who pile on, selling Japanese bonds aggressively. Events take on a momentum of their own, and a year from now people are shaking their heads over how it was possible the Japan bond bubble lasted as long as it did.

If so, the damage globally will be profound, attention will focus on the U.S. and its heavy debts, and quantitative easing, which helped to unleash the inflation, will prove to be a powerful tool best left in its box.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.  email: jamessaft@jamessaft.com)

If you have forgotten the credit crunch it appears you have company: U.S. banks are lending again.

Bank earnings reports and data from the Federal Reserve confirm that, at long last, banks are beginning to step up lending, a much-needed ingredient for a stronger and more sustainable recovery.

The good news is that lending is growing to commercial and industrial companies — exactly where you want to see growth if the U.S. is going to address its unsustainable dependence on domestic consumption. That’s good so far as it goes, but with a fragile euro and an undervalued yuan the upside is decidedly limited.

That’s because, in part, consumers are still quite restrained, or are being restrained, at least to judge by weak to middling lending levels to consumers and to support house purchases.

With 17 of the top 25 U.S. banks by assets having reported earnings, a lending turnaround is in evidence. Among the 10 largest regional banks, loan books expanded by 0.6 percent in the fourth quarter, according to FBR Capital markets, and nudged up slightly at the four mega-banks. This compares to a 2 percent shrinkage in the previous quarter and real carnage in the two years before that.

According to Federal Reserve data, commercial bank loans and leases shrank by 10.3 percent in 2009 and 6.3 percent last year, both a cause and a result of the recession and the sluggish and largely jobless growth which followed. Fed data from December shows business lending growing at a very good 7.4 percent annual clip, with continued weakness in home equity, commercial real estate and consumer lending.

The growth in commercial and industrial lending is significant, given the strength of the turnaround, but that sector is going to have to row very hard if consumers are unable or unwilling to spend freely.

A look at the Fed data for the first two weeks of January shows continued mild expansion of business lending combined with stability in real estate lending and a small fall in consumer lending.

NECESSARY NOT SUFFICIENT
It is for this reason, if none other, that the U.S.’s seeming inability to convince China to allow the yuan to strengthen poses such a threat to U.S. growth and to its medium-term prospects. Even if the Federal Reserve engineers asset price inflation, there is really little chance that domestic demand over the next few years can provide strong growth. The U.S. must export more, both for its own sake and for those of its creditors.

Consumer credit has actually been stronger than the headline figure if you adjust for loans the banks consider unlikely to be repaid, according to James Marple, senior economist at TD Economics.

“Correcting for charge-offs shows that household deleveraging did lead to a slowdown in credit issuance. On a year-over-year basis, revolving consumer credit was slightly negative in early 2010 — a new phenomenon for credit cards — while nonrevolving net credit issuance slowed, but did not actually contract,” Marple wrote in a note to clients.

“Importantly, over the last several months, there has been a considerable improvement in consumer credit growth. Even with the impact of charge-offs, total consumer credit rose in both October and November — the first two consecutive monthly gains since June and July of 2008.”

Remember, in a fiat money economy the creation of credit is the creation of money. The Federal Reserve couldn’t make banks lend by dropping interest rates, but it appears that its program of quantitative easing may have worked, at least on this measure.

The Fed’s recent Survey of Senior Credit Officers, which measures conditions in the business of lending to hedge funds and other securities firms, showed a similar thawing of conditions.

Banks are more willing to take on risk, according to the survey, and are making money available to financial markets more cheaply and on less stringent terms.

If QE has prompted the banking system to begin to create money again, will inflation be unleashed? My guess is that there is still too much slack in labor markets for that to happen, but there is every chance that we will see, or are already seeing, bubbles in asset markets.

While credit creation can be a self-reinforcing cycle, it is only a virtuous one if the credit is invested in areas that are productive.

The sweet spot for the U.S. would be consumer stability combined with a gently falling dollar so the country can, over years not months, export its way out of its woes.

The rest of the world is not, judging by recent events, going to want to cooperate.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.  email:jamessaft@jamessaft.com)