Alfred Capital Insights

The current decline in US asset prices has wiped away at least $13 Trillion of market value from US equity and housing markets.   US stock markets have lost $7 trillion in market capitalization since they peaked at the end of October 2007.  In addition to these declines in equity markets, the total inflation-adjusted decline in the US housing stock as measured by the Case Shiller index is quickly approaching $6 trillion.   Yes, you heard that right, a total of $13 trillion of asset value declines in just over 2 years.  To bring this in to perspective consider the fact that US GDP is roughly $13.8 trillion.  In 2 years the US, while not technically in a “NBER ordained” recession has seen its assets decline in value by the same amount as its entire GDP.  The shockwaves these price declines will send through the world economy will surely tip the world economy into recession.  The question is how deep and how painful that recession will be.  I will leave that discussion for another day.

One final note:  The total value of subprime securities as of 2007 was estimated at roughly $1.3 Trillion.  So to make a long story short, this is no longer a “Subprime Meltdown” it is a global solvency crisis and one which will require substantial government intervention to contain.

Hat Tip:  Bespoke

Our quarterly newsletter has been posted on the Alfred Capital Management website. Feel free to take a look and give us your feedback.

GMO also published its July newsletter today. As I was reading through it I began to realize that Grantham’s pessimism about the state of the economy and asset prices is very similar to our own. Our recommendations are also very similar. Here is Grantham’s:

Our advice until now was very simple: take as little risk as possible except for emerging markets. Now it is even simpler: take as little risk as possible. The more complex issues, as always, involve timing. Both emerging markets and commodities (especially oil) have a creative tension between the negative and risky short term (1-2 years) and the attractive long-term (5-10 years) prospects. In the short term, slowing world economic growth combines with credit, currency, and inflation problems to dominate the outlook and offer poor prospects for emerging markets and commodities. Longer term, the reverse is true and they look like the assets to own. But for those who can keep some of their powder dry, there are likely to be much better investment opportunities in a year or two (or three) than we have seen for 20 years.

I agree with Grantham in part, in order to find where Alfred Capital is different I encourage you to read our newsletter.

This is my second piece on the Global Savings Glut Hypothesis, the first discussed the case for the hypothesis. This second piece addresses the major arguments against the hypothesis and the response of the proponents. It seems that those who disagree with the savings glut have a few key arguments:

1. The political argument that the savings glut is a “scapegoat” for U.S. economic problems. Why is it the case that the country with the world’s largest economy, the country that has been the world leader for years and years is blaming its own economics problems on the developing world?
2. The argument that the level of global savings has actually not risen that much at all over the past 10 years. The numbers don’t actually show any increase in global savings over the last 10-15 years.

The proponents answer the first claim by arguing that the global savings glut is just one of many causes of the situation in which the the U.S. finds itself. Many of the problems we face are self-inflicted — overspending and overlending to name two — but the global savings glut is an enabling element to both of those self-inflicted wounds. The bottom line is that arguing that the global savings glut argument is just a way for the U.S. to deflect blame for its problems doesn’t address whether or not the glut actually exists.

In addition, most proponents of the hypothesis are sensitive to the risk that people may assume political motivations. In his speech on the Savings Glut Bernanke sought to preempt this criticism:

To be clear, in locating the principal causes of the U.S. current account deficit outside the country’s borders, I am not making a value judgment about the behavior of either U.S. or foreign residents or their governments.

But, few in China or elsewhere probably take much comfort in Bernanke’s insistence on a lack of “value judgment.” To many people, it probably sounds like the U.S. is deflecting blame for its own economic ills. But, whether or not some proponents of the hypothesis for political means should not effect whether or not the hypothesis has any economic validity — which is of course the primary aim of this blog.

The answer to the second argument is similarly straightforward. The idea of a savings glut does not require an increase in global savings but rather a shift in the composition of global savings, in which the share of savings in the “glut” countries increases while the share of savings in the equilibrating countries decreases. It does not require, and in fact cannot require, an increase in total savings:

Because saving can cross international borders, a country’s domestic investment in new capital and its domestic saving need not be equal in each period. If a country’s saving exceeds its investment during a particular year, the difference represents excess saving that can be lent on international capital markets.

I think this counter-argument makes a lot of sense, particularly when them major savers are governments themselves rather than individuals. When governments save and seek a return on their savings they have a much more immediate effect on international capital markets than family savings, particularly in the developing world. This effect is less obvious in the efficient banking systems of the developed world.

Larry Summers has an interesting way to place the hypothesis in historical perspective. James Fallows from the Atlantic sums it up nicely:

He (Larry Summers) calls today’s arrangement “the balance of financial terror,” and says that it is flawed in the same way that the “mutually assured destruction” of the Cold War era was. That doctrine held that neither the United States nor the Soviet Union would dare use its nuclear weapons against the other, since it would be destroyed in return. With allowances for hyperbole, something similar applies to the dollar standoff. China can’t afford to stop feeding dollars to Americans, because China’s own dollar holdings would decline in value substantially if it did. As long as that logic holds, the system works. As soon as it doesn’t, we have a big problem.

Hat Tips:

Chinese Savings and U.S. Deficits - Michael Pettis

What Global Savings Glut? - Stephen Roach

Rebalancing Economic Growth in China - IMF, Stephen Dunaway and Eswa Prasad

Put succinctly the global savings glut hypothesis describes the shift in GDP from the lower-saving developed world to the higher-saving developing world that is purportedly increasing the global supply of savings, suppressing long term real interest rates and leading to current account deficits in the developed world. As evidence economists often point to the fact that China’s national savings rate is over 50% and the U.S. national savings rate is negative at the same time that our GDP hovers under 1% and China’s is still in the double digits.

Our two most recent Fed Chairman — Alan Greenspan and Ben Bernanke — are fans of the Global Savings Glut hypothesis. And it seems every major newspaper and reputable blogger has chimed in on the issue at one point or another (Just google “global savings glut” and you will find articles by Business Week, the Washington Post, DeLong, Roubini, Mish, and the Cato Institute — all on the first page of Google results). It begs to reason then that a thorough understanding of the arguments for and against the hypothesis are critical if one is to understand U.S. monetary policy, since many influential U.S. policy makers subscribe to it in one form or another.

Here is Ben Bernanke’s view of the role of the global savings glut:

. . . over the past decade a combination of diverse forces has created a significant increase in the global supply of saving–a global saving glut–which helps to explain both the increase in the U.S. current account deficit and the relatively low level of long-term real interest rates in the world today. . . a particularly interesting aspect of the global saving glut has been a remarkable reversal in the flows of credit to developing and emerging-market economies, a shift that has transformed those economies from borrowers on international capital markets to large net lenders.

Alan Greenspan goes one step further in The Age of Turbulence:

. . . global economic forces that had driven long-term interest rates lower and ignited a sharp rise in home prices in many parts of the world. In the United States homes had increased in value so much that households, feeling flush, seemed more willing to spend.

So there you have it, Bernanke blaming the current account deficit and Greenspan blaming the housing bubble on this supposed savings glut. So the question becomes is this even possible? Why do households in the developing world save so much of their incomes? Well there are two components of savings, household saving and national saving. IMF research using household-level data from China provides some clues on the household side:

The precautionary motive for saving is very strong among Chinese households because of the lack of an adequate pension system and the sharply rising costs of health care. Demographic factors add to this saving motive: The one-child policy instituted in the 1970s to control population growth has intensified the aging of China’s population. The need to finance education expenses has also bolstered saving.

The slow development of financial markets in China has meant limited availability of credit, so that households generally have to save in order to purchase big-ticket items, like houses and cars, rather than being able to borrow against future income. It also has meant that there are low returns on households’ financial assets and limited opportunities for portfolio diversification, since there are few alternatives to depositing savings in state-owned banks.

But it isn’t just household savings that lead to China and other countries high national savings rates, it is government savings in the form of accumulated foreign reserves. James Fallows describes the process of how China sterilizes foreign capital inflows, leading to increased “national” savings:

Let’s say you buy an Oral-B electric toothbrush for $30 at a CVS in the United States. I choose this example because I’ve seen a factory in China that probably made the toothbrush. Most of that $30 stays in America, with CVS, the distributors, and Oral-B itself. Eventually $3 or so—an average percentage for small consumer goods—makes its way back to southern China.

When the factory originally placed its bid for Oral-B’s business, it stated the price in dollars: X million toothbrushes for Y dollars each. But the Chinese manufacturer can’t use the dollars directly. It needs RMB—to pay the workers their 1,200-RMB ($160) monthly salary, to buy supplies from other factories in China, to pay its taxes. So it takes the dollars to the local commercial bank—let’s say the Shenzhen Development Bank. After showing receipts or waybills to prove that it earned the dollars in genuine trade, not as speculative inflow, the factory trades them for RMB.

This is where the first controls kick in. In other major countries, the counterparts to the Shenzhen Development Bank can decide for themselves what to do with the dollars they take in. Trade them for euros or yen on the foreign-exchange market? Invest them directly in America? Issue dollar loans? Whatever they think will bring the highest return. But under China’s “surrender requirements,” Chinese banks can’t do those things. They must treat the dollars, in effect, as contraband, and turn most or all of them (instructions vary from time to time) over to China’s equivalent of the Federal Reserve Bank, the People’s Bank of China, for RMB at whatever is the official rate of exchange.

With thousands of transactions per day, the dollars pile up like crazy at the PBOC. More precisely, by more than a billion dollars per day.

As you can see there are several logical arguments that would lead one to believe that this savings glut hypothesis is a major factor in many of the global monetary imbalances we have witnessed over the past 10-15 years. But, while many people subscribe to this theory there are several other prominent economists who disagree. I will cover their arguments next week.

Hat Tips:

The Global Savings Glut and the U.S. Current Account Deficit - Ben Bernanke

The $1.4 Trillion Dollar Question - James Fallows

The Age of Turbulence - Alan Greenspan

Senior VP of Product Development at Google, Jonathan Rosenberg, describes Google’s secret sauce: the 15 things that Google does differently that make it great. My personal favorites are Numbers 1, 3, 5, 6 and 9. Below the list is a 44 minute video that is recommended viewing for anyone looking for a glimpse inside Google strategy. (Yes, I did say a 44 minute video, apparently when you own YouTube you have the power to relax the limits on video length!)

1. Hire Great People.
2. Ideas Come from Anywhere. Reward Innovation.
3. Embrace Sharing and Openness.
4. Morph Ideas, don’t Kill Them.
5. Users Come First, Not Money.
6. Data Drives All Decisions.
7. Iterating Products.
8. Share Your Vision.
9. 20% Time.
10. Think Big.
11. Bet on a Trend or Fall Victim to One.
12. Accept a Smaller Piece of a Larger Pie rather than Hogging a Bigger Pie.
13. Feed the Winners, Starve the Losers.
14. Don’t Surrender to the Lawyers, Accountants and Bureaucrats (unless they’re right).
15. Learn How to Learn.

One final interesting note: Greg Mankiw — Harvard Economics Professor and President of the Pigou Club — would certainly enjoy Jonathan’s minute 38 comments about a gas tax. I’ve emailed Greg the link, hopefully he will put it to good use!

Disclosure: Long shares of GOOG at time of writing.

The long Democratic primary season punctuated by Hillary Clinton and Barack Obama’s repeated attacks on free trade have served to heighten interest in the free trade debate. While I will refrain from reviewing my personal stance on free trade, I will note that the increasingly shrill arguments against China in particular are a bit disturbing. New York Times staff writer James Surowiecki notes that while the “pick on China” strategy is politically effective it actually amounts to nothing more than “shooting yourself in the foot”:

At times, the campaign has looked like a contest over who hates free trade more: Obama has argued that free-trade agreements like NAFTA are bought and paid for by special interests, while Clinton has emphasized the need to “stand up” to countries like China. Two weeks ago, both senators signed on as sponsors of a new bill that would effectively impose higher tariffs on China if it doesn’t revalue its currency. The candidates are trying to win the favor of unions and blue-collar voters in states like Ohio and West Virginia, of course, but their positions also reflect a widespread belief that free trade with developing countries, and with China in particular, is a kind of scam perpetrated by the wealthy, who reap the benefits while ordinary Americans bear the cost.

It’s an understandable view: how, after all, can it be a good thing for American workers to have to compete with people who get paid seventy cents an hour? As it happens, the negative effect of trade on American wages isn’t that easy to document. The economist Paul Krugman, for instance, believes that the effect is significant, though in a recent academic paper he concluded that it was impossible to quantify. But it’s safe to say that the main burden of trade-related job losses and wage declines has fallen on middle- and lower-income Americans. So standing up to China seems like a logical way to help ordinary Americans do better. But there’s a problem with this approach: the very people who suffer most from free trade are often, paradoxically, among its biggest beneficiaries.

The reason for this is simple: free trade with poorer countries has a huge positive impact on the buying power of middle- and lower-income consumers—a much bigger impact than it does on the buying power of wealthier consumers. The less you make, the bigger the percentage of your spending that goes to manufactured goods—clothes, shoes, and the like—whose prices are often directly affected by free trade. The wealthier you are, the more you tend to spend on services—education, leisure, and so on—that are less subject to competition from abroad.

I encourage you to read the article in full here.

I have been convinced for quite some time that the growth of internet users in the world will be parabolic and that 75-80% worldwide internet penetration within a decade or two is a foregone conclusion. With this dramatic shift there will be many winners and many losers. There will be new business models that succeed wildly (Amazon, Google etc.), other new business models that fail miserably, and old business models that either prove resilient or fall by the wayside.

The internet will also spawn a whole bunch of big new trends. One of those big trends is the rise of collaboration on a massive, worldwide scale. If you are looking for a quick summary of the growing field I recommend picking up Wikinomics, a great book by Don Tapscott and Anthony D. Williams that covers mass collaboration very well. The hallmark of this new mass collaboration is Wikipedia, the free online user-edited encyclopedia that boasts nearly 2.4 million articles in English and millions more in other languages. The total amount of time that went into editing all of those articles? Roughly 100 million hours of thought.

For some the first question they ask when encountering the amazing amounts of hours that go into collaborative projects online is: Where do these people find the time? I always bristled at this question because it seemed so unknowingly condescending. I mean if you are going to use your free time for anything isn’t contributing to world knowledge by editing a free encyclopedia a noble way to do so? But, to be perfectly honest I didn’t have a great response to this question . . . . until now. The following is a video from a Clay Shirky - author of Here Comes Everybody - speaking at at a Web 2.0 conference about what he calls our “Cognitive Surplus.” I think you will find his argument compelling (if a bit simplified for his 15 minutes of allotted time):

Hat Tip: Ritholtz

Many of my readers have noticed that I write frequently about Mohamed El-Erian. There are numerous reasons for this. In this post I will attempt to lay out some of those reasons as well as discuss El-Erian’s “Outdated Equipment” argument and his new book When Markets Collide due out in June.

So now, back to those reasons:

1. First and foremost, I regard him as one of the few economic analysts who offers consistently high quality, practical insights on markets. Or perhaps better stated, El-Erian is one of the few market analysts who offers consistently high quality, practical insights on economics.  Whichever way you spin it, most economists sound as if they read from the same textbook, and most market analysts sound as if they are reading straight out of the Wall Street Journal. El-Erian on the other hand offers a thorough understanding of markets, of economies and the increasingly complex linkages that tie them together.
2. Second, El-Erian seems to have a deep understanding of how complex global markets have become. His years as an emerging market bond whiz and running the world’s largest endowment honed his awareness of how markets have changed over the past 25-30 years. His perspective is perhaps unmatched by any other economist or analyst.
3. Finally, his advice is imminently practical for the average investor. El-Erian is an investor who has traded and managed individual asset classes as well as managed entire portfolios. He innately understands the decision making process of investors building portfolios and gives advice that is implementable.  Of all the current and former endowment managers, perhaps only David Swensen is better at convincingly laying out an investment strategy.

Unfortunately El-Erian doesn’t offer his insight as often as I would like. He did however recently speak with Foreign Policy Magazine. In the interview he discussed the “outdated equipment” argument which is the subject of his new book. The argument in El-Erian’s words:

The problems that have emerged are largely reflections of some major structural changes in the global financial system. Yet, the tools that are available to policymakers as well as a lot of Wall Street firms haven’t evolved as quickly as the system has evolved. So, you get a lot of effort but less-than-perfect outcomes.

El-Erian is not original in his thinking that policymakers are using hammers and chisels to deal with complex issues.  All you have to do is look at how Bernanke’s initial monetary policy response to the current credit crisis seemed to have had little effect on controlling the crisis. The Fed Funds rate is a crude instrument with which to attack a crisis built upon years of loose credit and widespread financial engineering. The problem is indeed a central bankers worst nightmare and reflects the incredible inadequacy most central bankers must feel in the face of a truly modern crisis. But for all of their inadequacy if you give a central banker a hammer he will either regard every crisis as a nail, or he will reach back into the toolbag and re-tool.  As evidence of this fact, Bernanke lowered the Fed Funds rate significantly, but ultimately began stretching the limits of his power in order to address a crisis that seemed to be beyond his reach. The collateral damage of his moves and moves of other similarly ill-equipped central bankers in the future has the potential to lead to a decline in confidence in financial markets and increased protectionism between economies, ultimately leading to slower global growth.

As a response to this “outdated equipment” problem El-Erian advocates for a significant re-tooling of the outdated economic infrastructure: the tools of Central Bankers, the Federal Reserve System, the IMF, the World Bank and others all need to be re-worked. Presumably many of the changes El-Erian seeks are fairly forward thinking and at odds with those currently in positions of power. To lay out his re-tooling plan El-Erian has authored a new book, When Markets Collide: Investment Strategies for the Age of Global Economic Change. The book is a must read and will figure prominently in the Summer Reading blog post I have planned for later this month. I suggest you head on over to Amazon to pre-order your copy.

For more on El-Erian’s most recent interview with Foreign Policy click here.

Today is the middle of a busy week of economic data.

1. Home Prices: The Case Shiller home price data released on Monday confirmed what many of us have predicted, mainly that the housing market is not showing any signs of stabilization. In fact, the recent trends show an accelerating decline. In the Fed statement released today Bernanke and Co. described the situation as a “deepening housing contraction,” hardly comforting words coming from our central bankers. Here in San Diego, home prices are off 24% since their peak:

When you look at the month over month, year to date and year over year numbers you can also tease out some interesting trends. First of all, Charlotte — the only city posting a year over year in price increases — is starting to see declines. Second, tract homes in the desert have a hard time holding their value. Just look at Las Vegas and Phoenix over the last 2 months, both are down nearly 10%. Finally, the cities that ran up the most during the upturn are the ones getting hit the hardest now during the downturn. All in all, no surprises here, and certainly no signs of a stabilization:

2. Then we had a dismal consumer confidence report that shows that consumers seem to be well aware of the fragile state of the economy.

I don’t put too much weight on the consumer confidence data, but it does give me pause that the people who make up 70% of US GDP and 18% of Global GDP are uncomfortable with their current economic situation.

3. This morning we got the Q1 advance GDP numbers which showed that the economy is still scraping along, helped by stronger than expected inventory numbers and continued growth in net exports. Residential investment still represents an enormous drag (on the order of 1%) on GDP growth and business fixed investment dipped negative for the first time in over a year:

4. Just a few moments ago the Fed decided to lower the Fed Funds Rate and the Discount rate by 25 bps, to 2% and 2.25% respectively. The Fed has moved dramatically this year to address concerns about economic growth. You can see the path of the Fed Funds and Discount Rate in the chart below:

The good news is that the Fed did signal that they have a more balanced approach to its targets of economic growth and price stability going forward. I think it is unlikely that the Fed will aggressively lower rates from where they stand which should put pressure on commodity prices to fall and may further strengthen the nice bottom the dollar is forming.

5. Finally the end of the week is “Labor Market Friday” in which we will get our first glimpse of how weak the employment situation really is. The consensus among economists is for a tick up in the unemployment rate to 5.2% and for the NFP numbers to be negative on the order of 50 or 100 thousand.

In recent months China has made some much-expected moves to lock in their ability to procure commodities to feed their growing economy. First, Chinalco (Aluminum Company of China) bought a $14.1 billion stake in Rio Tinto, in part to help Rio fend off a takeover bid from BHP. Now, realizing that BHP may still win their prey, China has decided to play both sides and is allegedly looking to buy a stake in BHP Billiton that could be as large as 10%. China must realize that with the world’s largest population and with an economy growing in the double digits it is very exposed to spikes in commodity prices. As a result, commodity-rich Australia - due to its proximity and mining prowess - is the best bet for continued supply. In fact China makes up between 15-20% of Rio and BHP’s demand:

“Australia’s proximity to Asia makes it extremely attractive,” said Mark Freeman, who helps manage $6 billion as chief investment officer of Australian Foundation Investment Co. “Metal consumption is still on the rise, and all the graphs still show us there is a long way to go. Australia is very important in meeting China’s demand.”

I think this change in China’s strategy makes much more sense than buying shares in troubled financials or in IPO’s of private equity firms. In fact, using back of the envelope math, if China had bought BHP back in May 2007 instead of buying Blackstone they would be significantly richer -to the tune of $2.9 Billion. Here’s my math (note: China bought into Blackstone at 95.5% of the IPO price of $31/share):

And here is a chart of the stock performance since China’s purchase of BHP:

China is in the early stages of planning to buy a bigger holding in BHP than the 9 percent of Rio Tinto Group acquired by state-owned Aluminum Corp. of China, or Chinalco, and Alcoa Inc., the newspaper said today, citing unidentified people in Beijing.China, the fastest- growing major economy, has been hurt by a threefold gain in commodity prices since 2002. Chinalco bought a 9 percent stake in Rio in February, hindering BHP’s plan to acquire the London-based company and create the biggest supplier of aluminum and coal and control a third of the iron ore market.

“China would be hurting badly, fearing they will be shelling out a lot more for commodities,” Peter Arden, a Melbourne-based mining analyst at Ord Minnett Ltd., an affiliate of JPMorgan Chase & Co., said today. “Buying a piece of BHP helps offset that.”

Hat Tip: Bloomberg and Bloomberg

As China comes under increased pressure at home due to the declining value of its forex reserves and its miserable investment track record they would do well to seek investments that are a strategic fit for their economy. I believe BHP falls into that category, but whether the deal gets done remains to be seen.

Disclosure: No position in any security mentioned in this article at time of writing.