Friday, May 13, 2011

Double, double toil & trouble -- volatility burn & assets bubble

Hopefully the Bard won't be turning over in his grave with the co-opting and changing of the famed lines from Macbeth.
Who do the 3 Witches represent today?
If the scene with the three witches can teach us anything about the market activities of the fortnight past -- from the commodity sell-off on May 5-6 to the rebound in risk off strategies this week in light of market concerns about Greece's (in)ability to meet its debt obligations, it is that the three antagonists of the financial markets of 2011 -- China's mercantilism; Eurozone's sovereign debt overhang; and financial capital flows abetted by the America's easy money policy -- are contributing to the whipsaw volatility and asset price frothiness that the modern investor should now take as "normal".

The symptoms are to be seen everywhere.
Commodity currencies
Let's recap where we have been (in the medium run) by starting at home with what the world's investors view as an archetypal commodity currency: the Canadian dollar. In a previous post, I argued that while CAD was seen as a petrocurrency, it didn't necessarily entail a steady upward movement beyond parity with USD whenever there was a concomitant rising of oil prices; my contention was that this was due to the Canadian economy's inability (at the firm level) to absorb the cost of a higher terms of trade. Moreover, Canadian consumers do not benefit from a strong loonie unless they shop across the border as Canadian retailers are uncompetitive and rarely adjust prices for to match those of US retailers. I suggest considering the framework below when forecasting CAD, AUD, and other so-called commodity currencies especially given that flow of funds, technical and sentiment factors outweigh PPP in the short-medium term.

$CAD vs. Oil
Here is an update to some of that earlier analysis where we see the $CAD relationship versus the price of oil (specifically NYMEX futures 1 month forward) in two segments: 1990s (top chart) and 2000s (bottom chart).

Remembering the '90s
Evidently, the relationship was weak in the 1990s and strengthened during the 2000s. Recall that during the 1990s the world was supposedly "Drowning in oil" (The Economist, March 4, 1999), there was a meaningful strong dollar policy in the aftermath of the Plaza Accord during the Clinton Administration, and Canada --while getting its fiscal house in order during Jean Chr├ętien's time as Prime Minister -- still had a manufacturing sector (to speak of) that was addicted to a falling loonie as a means to remain competitive and export to the important American market.
$CAD = function of Oil and Stock Market
In providing some more colour to this relationship, my economics professor from business school, Perry Sadorksy, suggested that I consider the relationship with Canadian stocks in addition to oil as an independent variable driving $CAD.
Here is a time series from the 1990s to 2011YTD.

Taking this a step further, here are the multiple regression results of the above relationship (click on the image to the right to expand):

To add some rigour to the analysis, Professor Sadorsky computed dynamic correlations between the S&PTSX composite, the $CAD exchange rate and oil during the sample period.

Takeaway: Correlations between these assets have increased in the past 10 years - while portfolio diversification is a positive, one would not get far diversifying risk amongst these assets during times of stress.

What does the addition of the Canadian equities index to the analysis in the multiple regression tell us? Professor Sadorsky used a vector autoregression to generate impulse response functions for the S&PTSX composite, oil and $CAD exchange rate. Basically, this approach looked into the dynamic interaction between the variables -- what is the effect on the variables in the system to a shock to one of the variables? -- and here the contention that oil's increased influence over time remains viable.
Takeaway: Oil has had a greater impact on the S and PTSX index in the post 2000 period.

What can the $CAD relationship show?
Fundamentally, capital is flowing to the areas where there is the best opportunity for a risk adjusted return --this is nothing new-- even when investors have not accurately considered the risk situation; the flow of financial capital to the lower cost developing world coincided with the steady demand for commodities (due to heightened development in those regions) which subsequently has led to a steady appreciation of commodity currencies such as CAD and AUD. Canada is correctly perceived as a hewer of wood and drawer and will be hard pressed to stave off a serious bout of Dutch Disease unless there is enlightened industrial policy at the Federal and Provincial level. Canada is not Norway: meaningful discourse on the role of the state in providing an effective policy shock absorber to potential supply shocks remains unlikely.
In my opinion, it is in the casino-like nature of financial capital flows that will to lead to a continued boom and bust cycle as advanced economies following the Anglo-Saxon model of neoliberal development have been increasingly de-industrialized thanks to many of those sectors being "exportable".
An obvious retort to this point of view would be why now given that the past two decades has seen none of this prior to The Great Recession -- a period that has mythically been described as The Great Moderation.
In answering this, we must remember that the reduced macroeconomic volatility in the post Cold War period was not due to the factors as described by Ben S. Bernanke. Instead, think of the downward pressure of wages in an aggregate sense that was influenced primarily by the full entry of, China, a true economic dragon --with its vast labour pool and incomparably competitive manufacturing sector; and secondarily by the cautious entry of India, a once plodding elephant now surging tiger, where the country's multinationals also have had access to a relatively low cost (on a global scale) english speaking skilled labour pool. India's success would not have been possible without the post-industrial pipes --broadband technology-- which made the idea of IT servicing "exportable". Meanwhile, China's success came as a result of the technology transfer combined with an insatiable demand for consumption of affordable goods by Americans who were increasingly becoming more indebted in order to keep up with the Joneses in maintaining an affluent and aspirational lifestyle.
The downward pressure on wages globally made inflation targeting domestically more effective by central banks in the advanced economies. That job will become more challenging in the coming decades.

Think Again

In retrospect, the massive capital expenditures during the 1990s which at the time was incorrectly perceived as the "technology or" boom was rather the catch up of long overdue business investment.

Traditional view of bubble formation
Conventional neoclassical economic analysis argues that American monetary policy -- we focus on America as the world's largest economy and Fed Funds rate as arguably a proxy for a "global interest rate" for adherents of the Mundell-Fleming model view-- had been too loose since the terrorist attacks of September 11, 2001, mastermind by America's (now vanquished) nemesis, Osama bin Laden.

This loose monetary policy, in turn, led to the real estate bubble that was popped in the aftermath of the 2007 credit crunch, and prior to the full blown financial crisis in 2008. For an illustration of the conventional view, see below, where the Fed Funds rate is graphed against the Taylor Rule.

While I have neither bought into the orthodoxy of the primacy of monetary policy nor been a fan of John Taylor's policy views, there is relevance to the point that sub-optimal interest rates -- specifically to the low side-- leads to greater risk taking, over investment in risk assets (e.g. real estate, stocks, commodities) and the severe mis-allocation of a nation's resources over the short to medium term.

Spain and Ireland, under the EMU, are in the throes of adjusting after many years of sub optimal policy courtesy of the ECB.
And Greece's travails in meeting its debt obligations --absent significant fiscal transfers from primarily Germany and the surplus nations of the Eurozone--will ensure a pathway of debt default to restoring drachmas.

I have argued in a previous post that the diminished purchasing power of American workers has been brought to light in the aftermath of the Great Recession because of a lack of access to credit and the paying down of debt in personal balance sheets. Robust economic growth in America is possible if the access to credit is restored to the consumers directly and the small businesses who see it as a lifeline; without it the story is one of sub-trend growth going forward.

Enter The Dragon: China's Mercantilism
Now, with the ascent of China in particular, we must expect a return to the business cycles of hard landings in the West and be satisfied with sub-trend growth in the most advanced economies due to the difficulties of households in coping with the boom and bust of foreign originated supply shocks and the realities of balance sheet repair.

Let's revisit China's mercantilism: the yuan remains undervalued by most measures; cleverly executed import restricting and export subsidizing policies are reflected through massive foreign exchange reserve growth. The bulk of the capital, in turn, is funneled through China's rentier class and those just beneath on the social ladder --think of the friend's of the People's Party-- where the rocketing of Chinese liquidity has fed into the inflating of real estate bubbles.

Why has this shown up in Chinese real estate and not the stock market?
This is a flavour of the month issue; the current cycle has seen real assets in general and commodities in particular as the asset class of greatest interest to investors and speculators. Chinese authorities skilfully sterilize the monetary effects of reserve accumulation but will find it increasingly difficult to maintain such actions over the longer term as the central bank struggles with the asset as well as goods and services price inflation genie after having raised reserve requirements for the fifth time in 2011.

There is popular notion in the financial press that "surplus countries are stealing growth from the deficit countries and not allowing them to adjust to external and internal disequilibrium" which I think --while true in a superficial manner if one believes in the equilibrium concept-- masks a greater fault in terms of economic policy on the part of the now debtor nations. History has shown that overreach via debt portends the fall of empire.

Mercantilism was successful for Britain when the sun didn't set on the British empire so why shouldn't China pursue this policy? It has been a "success" while maintaining an export based macroeconomic model which helps it increase its hard power through an increasingly muscular military. This helps bolster the CPC position through overt nationalism and permits the access to inputs vital for China's continuing growth.

But no growth story is exponential forever without adjustments and corrections.
How China affects the US (and the rest) today:
Consumers feel the pinch every time they fill up the gas (petrol) tank and the cheap goods at WalMart are now getting a bit dearer:

But China will be slowing down:

Source: Sacha Tihanyi, Senior Currency Strategist & Mark Ellerbeck, Director - Scotia Capital
Even the outsourcing story is getting more expensive:

Loose U.S. Monetary Policy won't save housing
In thinking of the United States, notwithstanding the positive air of relief in a post bin Laden world, the unwinding from the real estate bubble still has some way to go:

Source: Barry Ritholtz's blog, The Big Picture

Alternative view on bubbles
It is important to break things down to the basics here: a capitalist economy has two sets of prices: one for assets, the other for goods and services. They do not necessarily move together -- that should be obvious through empirical observation and does not require a peer reviewed journal with graduate level mathematics to substantiate the claim.

When consumers hear a central bank's inflation figures, there is bewilderment at how understated it seems. But fundamentally, inflation for policy makers is the growth rate of an index of prices of goods and services not assets.

The fact that central banks do not explicitly target asset prices is a failing of the current dominant paradigm of economic thinking because we live in a credit economy; in a fractional reserve banking system banks have the ability to create money and the notion of "what is money" has moved on considerably from the time of Jevons, Walras and Marshall. There is sometimes a belated attempt to talk down asset prices through moral suasion of central bankers (e.g. "irrational exuberence") but it is often left to the tinkering of fiscal policy to do the job where the influence of politicians weighs heavily with short term opportunism trumping long term reason.

For all of its flaws capitalism remains the most dynamic economic system but a society must come to terms with the form of capitalism to embrace in order for it to function in its interest. However, but one thing is undisputed: asset bubbles are intrinsic to capitalism: they are driven by economic actors who lever up in order to buy more assets with rising prices with the intention of selling for a profit. The story of real estate always rising is taylor made for the Greater Fool Theory; what happens when the bubbles bursts is a potential debt deflation dynamic.
It need not be this way. Asset bubbles are often not as noticeable due to the countervailing forces of reasoned policy, the power of the state, and sustainable growth in line with the real wage appreciation. When the former is not in place, the crash occurs.
What, in 2008 was incorrectly attributed as a Minsky moment is actually a continuation of a Minsky half century (as described by L. Randall Wray). For Minsky to get a greater following in policy circles would require more scholars to expand on his ideas in an persuasive and rigorous fashion because, unfortunately, his writing style is not engaging enough for the average analyst to read and the layperson to comprehend. If you have picked up a copy of "Stabilizing an Unstable Economy" then you would agree with me.

What is so interesting in the current situation are the opposing forces:
commodity and asset inflation driven primarily by development in the BIC of the BRIC nations --think of this leading to a higher velocity in terms of the quantity theory of money-- and abeted by the Federal Reserve's loose money policy in the growing surplus and/or developing nations
contrasted against
the long-term deflationary trends of balance sheet repair and aging demographics leading to lower growth in the developed industrialized nations.

Add to the mix the never ending economic policy root canal that is the Eurozone sovereign debt crisis and you can observe a further fracturing of the growth story in the developed West.

In aggregate, this adds to the continued volatilty of markets as finance capital continues to seek the best risk adjusted return possible free of capital controls. Asset bubbles won't go away; they are an intrinsic part of the system we have--our leaders and policy makers must decide the beest means to deal with them.

Fearless forecasts

  • CAD, AUD weakening in the short run in light of reduced demand for commodities against a slowing China and India struggling to tame inflation.

  • EUR correlated to the politics of EMU: will fiscal transfer be enforced or will the charade of EFSF morphing into ESM continue ad nauseum?

  • Volatility in EURUSD and the crosses will continue until fiscal union is formalized and the debtor nations are willing to lose some sovereignty..

  • GDP contraction on the back of supply shocks as consumers in advanced economies adjust to the burden of higher gasoline (petrol) costs against the inelastic demand of an oil based economy; lower consumption, fiscal retrenchment at the government level will not be counterbalanced by business investment.