Friday, February 19, 2010

They Applauded the Plastic Dummy

Last night Ms. FitN and I went to the Ballet, the advantage of living in the Great White North is that these events are reasonably priced – compared to London and New York.  Anyway, we have season tickets for the Montreal Ballet season (among many other cultural events).  Generally, I like the ballet, having lived as a student in London (London is cheapish when you are a student), a saw great productions, and an appreciative audience.

That was not the case last night.  Ms. FitN and I saw “La Sylphide”, one of the world’s oldest romantic ballets and not only was the performance wooden and out of synch with the music – considering it was canned music (as opposed to a live orchestra) it’s rather remarkable..

Now Montreal audiences in general believe that any performance is deserving of a standing ovation, in fact, I suspect that this is our compass to a good show, you would never have an audience in Montreal booing (as they have done in recent year at La Scala or Carnegie Hall).  “It was so good, they got a standing ovation”, justifying the amount of money spent to see a cultural event.

Last night was a new low, as the lights we lowered the public began applauding (sometime spectators applaud the conductor as he arrives when the music is live – it was canned here), then at the end of the Overture (which lasted a few minutes) people again applauded – again canned music.  So far no performance had occurred, Ms. FitN joked that it was a bit like passengers applauding the performance of the autopilot on a flight (note:  Montrealers are the only people in the world who applauded when a flight lands – don’t know if they are surprised that the whole thing didn’t end in disaster, ok so the Pope kissed the ground…).  Anyway, the ballet started, we both noted that the whole show felt flat, manly because the dancing and the music seemed incidental, the dancers out of tempo never allowed the music to get in the way of their performance.  The surprising thing here is that the Guangzhou ballet company that performed here has a rather good technical reputation.

From time to time there would be a dance solo, at the end of which the dancer would approach the front of the stage and bow for applauses – I’ve never seen that before, thankfully Montrealers applauded on cue (although at one point even they had enough).  It is one of the first times ever I have almost fallen asleep during a performance; I felt absolutely no connection to the show.  Finally, I don’t know who “wired” the stage but the sound quality was dismal.

The absolute low point of the evening were the applauses for the dummy;  The story is a little boring but bottom line a Scottish guy falls in love with a Sylph (forest elves), at one point the Sylph flies across the stage, but instead of using a real dancer they used a dummy (it crosses quickly and there are no movement), you guessed it Montrealers applauded that,

Yep, Montrealers applauded the dummy.


Friday, February 12, 2010

Debt as Heroin

A shocking title, but I just read a fascinating analysis by Albert Edwards (from SocGen).  Edwards has been working on the sovereign debt problem.  Those investors who benefited the most from shorting Greece will remember his Q3/09 commentaries [around US Thanksgiving] where he mentioned that the PIGS were in immediate danger of defaulting on their debt obligations.  Earlier this week he wrote a more comprehensive analysis based in part on the work of Jagadeesh Gokhale (Senior Fellow at the Cato Institute – a rightwing think-tank…).

Edwards’ analysis is fascinating.  He makes a very interesting observation: those countries that suffer from the worse structural deficit – a government deficit even when the economy is operating at full steam, are behaving like heroine addics; they will promise anything as long as they can get their next fix!  Edwards takes the view that those same countries that have the largest gap are those who historically been the worse at managing their debt burden.  The guiltiest parties are the usual names plus a few surprises (Norway...):

Difference between required and actual primary surplus (% of GDP)

It gets worse, much worse, if “off balance sheet” obligations are included the operating surplus certain European countries need to generate are staggering.  


Taking France as an example, their structural deficit is around 1.75%, currently the French government is running a government deficit in the range of 8.2% (depending on a number of assumptions).  Because of France’s “unfunded liabilities” the total surplus it needs to generate is slightly north of 9%.  The difference is almost 12%, which is simply unmanageable, there is no way (politically or socially) for France to move to this type of surplus.  A solution will require not only a reduction services but also a dramatic reduction in benefits; retirement age will have to increase (e.g. truckers retire with full benefits when the turn 55).  Canada is in somewhat of different position.  In fact, it can run structural deficit because of the nature of its economy – natural resources exporter (Canada’s government also aggressively tackled its fiscal deficit in the mid 90s).  

The assumptions on which Gokhale makes his “unfunded liabilities” projections are fraught with risk (Generational Accounting) especially with regards to their magnitude. However, for the purpose of this analysis it is largely irrelevant because the gulf between where we are and where we need to be is so large that error factor is irrelevant.  In the case of France whether the structural surplus is 8% or 12%, doesn’t impact the overall message of social and economic dislocation.

It would appear that the European central bank and Germany are not buying the "addicts" line that after this one fix they will change their way.  This morning Angela Merckel indicated that there would be no German guarantee forthcoming for Greece.  

This should be interesting!

Thursday, February 11, 2010

Greece and the EU

Europe seems to have decided on a "September 2008" response to the Greek crisis: 
                 Announce a rescue plan before you've decided 
                 on any of the details. 

Wednesday, February 10, 2010

Inflation Vs. Deflation

Revisiting the inflation debate requires first stating my own view, I am strongly in the deflation camp; the data doesn’t entirely support my position, but it is important that the readers know my bias.

A few days ago, one of the Bank of Canada’s deputy Governor made a speech yesterday in Quebec City was any indication of that institutions view of Canada’s growth prospects, the error term surrounding the BoC’s optimistic base-case economic scenario are far too high for any rate hike on the horizon.
the recovery will be difficult… a good deal of the recovery is supported by expansionist budgetary and monetary policies and we are still waiting to see some momentum from the private sector” …”we’re not out of the woods yet”.

The case for Inflation

(a) Output Gap

The primary method by which the Bank of Canada (BoC) determines the risk of inflation within the Canadian economy is the size of the output gap, the difference between economic growth and potential growth.  Early in February 2010 the BoC stated that the Canadian output gap was just short of 4%, which is substantial.

But what if the numbers are wrong? There are in fact two assumptions that are left mostly unsaid (both from the IMF, and BoC) (1) that there is no production destruction; the output gap is a big fat guess, and (2) the presumption is that the government can monitor what production capacity is available.  In an industrial economy this is a very useful barometer, because you can “count stuff”, but what about a post industrial economy?  Services account for ¾ of Canada’s GDP, these are much more difficult to account for. In fact, we now know that BoC has a very poor record of determining the size of the output gap.

It is more than likely that the numbers above are a poor indicator, and that the Canadian economy is closer to full capacity utilization (yes, I know still no jobs!).  We are seeing some of this full capacity with the housing market, where prices across Canada are back to their pre-crisis level (except Calgary and British Columbia).  Demand for housing is outstripping supply, with historically low

(b) Asset inflation

The second factor is asset inflation, which appears to become a problem in Canada.  Housing has never been so affordable because of extremely low interest rates.  The demand supply structure is out of balance with a substantial drop in the number of houses for sale, and a very rapid increase in the number of new homes under construction.   

It would appear that Canada’s monetary policy is far too accommodative.  As a percentage of GDP, homes have never been cheaper

This is caused by the extremely low interest rates, although most Canadian finance their home on the basis of 5 year fixed mortgages – there is no 30 year fixed mortgages in Canada.  Building new homes is a solution, but at the same time there has to be a dramatic shift in the monetary policy to reduce  

(c)        Debt Monetization

This is not driven by Canada, but bad money drives out good.  Over the past few days Greece and its liquidity crisis seems to have transformed itself into a funding crisis, with the European Union offering what appears to be a blanket guarantee with virtually no concession on the part of Greece (which today also announced that its deficit was 16% of GDP and not 12%).


There’s not much point on quibbling on Canada’s total debt most of the 2009 quantitative easing is already being unwound, with the BoC assets having already shrunk from $40 billion to $30 billon (in the space of 5 months) with further reduction on 2010 down to a historical level of…ZERO.  Most of the assets the BoC acquired are high quality s/t term instruments or Canadian mortgage back securities – where real estate prices are now back to their pre 2008 levels.

The problem is the rest of the planet, the American’s will need to finance $3.5 trillion in government bonds – today there is a $700 billion predicted shortfall, which could easily be made up by domestic savers should the U.S. saving rates remain at the current 5% level.  The “decision” of core Europe to provide Greece with guarantees solves the short term systemic problem, but creates a much more important funding problem for Europe; since its 2010 funding requirements will be around Euro 1.7 trillion.  Something may have to give and some form of debt monetization will probably occur which could give rise to inflation. 

Overall, the risks are that the BoC misjudged the strength of the Canadian economy.   Aside from misjudging the output gap, cost inflation is largely exogenous to the system, largely outside the control of the Bank of Canada.  There is a real risk that inflation could arrive on our shores. 


(a)        Industrial Product Prices Index

Total production inflation over the past three years is near zero, even after taking into consideration the dramatic increase in energy prices spiking at $148 per barrel in September 2008.  Between January 2009 and December 2009 oil prices rose from $48 to $72 per barrel with virtually no impact on producer price index.  First, this is a demonstration that producer input costs are volatile but generally consistent.  In Canada, the single most important factor in determining the IPPI is the exchange rate.  

The BoC recognizes that the strength of the Canadian dollar has a dramatic impact on the inflation factors affecting the economy.

12-month change: The appreciation of the Canadian dollar is still the main factor in the decline of the IPPI

(b)        Aging Population

Aging population has a huge impact on consumer behavior (remember buying Christmas gifts for your parents – they’ve already got everything…in triplicate) Canada is better positioned than virtually any other OECD country.  Yet Stephen Gordon (University Laval) has been following the trend for several years now, and amazingly Canada’s demographics follow his worse case scenario.  Everyone has heard of Japan, Italy and China the three countries that face the most immediate concern.  

Aging population is an economic deflator, because consumption patterns change, as an example Japan has seen no economic growth for nearly 22 years, some of the blame for this rests on aging demographic.  Households are no longer forming, demand for consumer goods drifts down.

This factor is more of a long term trend, but not yet a “live” treat to Canada

(c)        Deleveraging

The McKinsey Global Institute recently release a report: Debt and Deleveraging:  The global credit bubble and its economic consequences.  It is a document that makes sobering reading.  Again the issue for Canadians is that most OECD economies have too much leverage (concurrently with aging population).  The study (see above link) has three key conclusions:

(i)                   Empirically, a long period of deleveraging nearly always follows a major financial crisis.

(ii)                 Deleveraging episodes are painful, lasting six to seven years on average and reducing the ratio of debt to GDP by 25 percent. GDP typically contracts during the first several years and then recovers.

(iii)                If history is a guide, many years of debt reduction are expected in specific sectors of some of the world’s largest economies, and this process will exert a significant drag on GDP growth.

I agree that my method is somewhat disingenuous, since the dices are loaded.  Bottom line, a global economy in  deleveraging mode will face greater risk of deflation than inflation.  The consequence of the excess of the last decade are already “bake-in” the next five years.  Meager economic growth will result in deflation

Friday, February 5, 2010

The Baltic Dry Index

The Baltic Dry index is an interesting index, because it shows in real time the demand and supply for non-containerized goods transport. In other words the “old style” shipping. The reason the index has over the past few years attracted the attention of analysts like me is that it provides a very good indicator of what is happening, on a global basis, to the shipping of raw materials.

However, like all index it works best when there is no externalities. Earlier in my career I was very involved in shipping finance – lots of colorful characters, but one of those ship owners told me that in his business, a single excess vessel is a glut of shipping capacity. In fact, he was just restating the sector's reality of very low demand elasticity; price rise dramatically when there is shortage, and fall equally dramatically when there is even a small surplus.

The Baltic dry peaked in early 2008 at 10,000 but today trades around 3,000. Several commentator have indicated that the fact that the BDI never recovered after the fall of early 2009 is a clear signal that there could be no V shape recover. Personally I never believed in V shape recover, most OECD economies are in deleveraging mode (or thinking about it) so there is less appetite for “stuff”. If the American consumer is going to begin saving some of his income it will have a dramatic impact on demand.

The reason that BDI is not moving relates partly to the strength of the index over the past 3 years; it takes 24 to 36 months to order and have a Panamax vessel delivered. Where as in the past the fleet of such vessels (all categories) was rising at a maximum of 40-60 vessels per month, not really a huge increase as the fleet capacity replacement rate is around 45, in 2010 the new vessels will average 120 per month. Poor demand elasticity means that even if there is a recover in raw material shipping the BDI will be a very poor indicator of recovery.

Analyst will have to find something new!

Wednesday, February 3, 2010

Tightening of Canada’s Monetary Policy

2009 was a year when OECD government (excluding Germany) decided that it was a good idea to fully open the economic stimulus faucets. Nobody doubts the amount of economic stimulation undertaken by various governments. The U.S. federal government went full blast with a $1 trillion (OK I know that this was the headline number, and actual stimulus money was a fraction of this amount, still…). China also stimulated its economy with $1 trillion (in their case the amount underestimates that level of stimulation).

Now that the “worse of the crisis” is over, governments are re-adjusting their policies; here in Canada there is little question that the Bank of Canada’s accommodative monetary policy will come to an end the odds are for changes to occur this summer, but at the latest next winter. Canada’s monetary policy is largely driven by externalities. If Canadian monetary policy becomes too restrictive when the rest of the world continues to suffer from economic stagnation, the impact on Canada’s economy could be dramatic, and tip it back into recession. Two very recent changes would appear to indicate that extreme caution is being exercised: (a) Australia’s central bank just put on hold its monetary tightening, and (b) Jim Flaherty Canada’s finance minister announced that the Federal government’s budget will remain stimulative.

Canada’s economy like that of Australia is one of the most open. As such externalities have a significant impact on the BoC’s monetary policy. Canada’s drivers are (a) recovery of the US, (b) continued growth in China and (c) No major disturbance in Europe. We take a short detour to each of those aspects.

US Recovery: Cash for Jobs

The current U.S. administration has undertaken a further stimulus program; $80 billion “cash for jobs”, where companies will receive cash (up to $50k) for each new job they create. At $50k per job, the federal government is proposing subsidies for slightly less than 2 million jobs. However, the ranks of the unemployed (and underemployed – U6) is near 15 million. Last week the U.S. government released its Q4 GDP figures which came out at an impressive 5.7%, substantially above all estimates. David Rosenberg of Gluskin Sheff’s has written extensively on U.S. GDP figures

  • A 5.7% GDP quarter has never before occurred in the context of a 40bps increase in the unemployment rate (the fastest growth ever posted amid such a poor labour market backdrop was 3.6%). On average, real GDP contracts at a 0.5% annual rate when the jobless rate backs up that much in a given quarter.
  • If you take the GDP report at face value, then potential growth must be close to 7%. That is ludicrous.
  • Never before has real GDP managed to muster such strength with hours worked down 0.5%.
  • With all the dramatic stimulus from the government, demand growth should be 10% and not sub-2%. That tells you just how strong the headwind is from the ongoing deleveraging process.
  • It usually takes 4-5 quarters to re-attain the pre-recession peak in GDP. This time around, eight quarters later, and the economy is still, in real terms, 1.8% smaller than it was when the recession began. By now, in a “normal” cycle where recessions are mere corrections in GDP in the context of a secular credit expansion, hardly what we have on our hands today, real GDP is already 8% above the old highs posted in the prior up-cycle.

That’s Rosenberg’s take on the U.S. GDP growth for Q4/2009, there will be a drastic revision, equal or larger than that which occurred for Q3 numbers (3.5% Vs. 2.2%). Others take far more bullish view, in fact one economist of my acquaintance bet me a good bottle of whiskey that non-farm payroll for January will be +100k (consensus is +8k). The bet will be settled in the next 48 hours.

Bottom line the jury is still out on America. V shape recovery is now out of the question, corporate earnings are excellent for the last quarter of 2009, well ahead of expectations, but most of the 2009 growth is the result of government stimulation. Companies that do not have access to the debt capital market are largely unable to borrow (read here: HIRE). Despite figures showing that banks are more open to lending, small and medium sized companies are still largely unable to borrow.

China – the big fix:

Last week Jim Chanos made a presentation on the topic of China’s property bubble. His point was that currently, in the 20 largest urban centers, commercial property vacancy rates are in the order of 20% (this was the lowest estimate he found – some were higher). Shanghai in particular has vacancy rates of almost 50%. The problem is that currently, under construction, there is nearly 30 billion square feet of office space under construction (not a typo) . At one point the madness will have to stop, and it will be the government that puts the breaks – as they will on most aspect of infrastructure spending.

We are not concerned with the Chinese economy; because they will find a solution or will have a crisis (they’ve had several already). It is the impact on Canada that is of interests here – one wonders if the Australian central bank didn’t come to the same conclusion. If demand for infrastructure spending moderates, price for natural resources will fall (Canada and Australia are the biggest OECD players in this segment). In fact, what was interesting in Chanos’ statement was not that he was going to short China, rather he was going to short “the first derivative” suppliers (e.g. mining companies, CAD). Chanos’ point was that China is the marginal buyer for many of these goods that are used to “over-build” their infrastructure.

At one point the building of excess capacity will have to stop, there may already be signs that government policy is shifting here. Nevertheless, for Canada this is a major factor, as an exporter of natural resources this could have a dramatic impact on the balance of payment and on economic growth.


The arrival of a closer unity in Europe in the early 90s and the creation of the Euro was seen as a catalyst to faster pace economic growth. Unfortunately most European government have been living beyond their means. In 1990, an agreement was forged that imposed a strict limit on the size of each government’s deficit (3%). Almost immediately France broke the agreement, as a core European country it gave license to others to emulate its irresponsible behavior. At the same time, an agreement was struck that total government deficit could not exceed 60% of GDP. As as of January 31st 2010 only Finland and Spain are still below this threshold.

In fact, Spain has like Portugal, Ireland Greece, very serious problems because their annual deficit is growing as such high rates. Looking at all government liabilities the picture in Europe becomes depressing (although the U.S. are not looking so hot).

I’m not sure that anybody believes that the Greek “solution” will last the year. First, reducing the budget deficit from 12.5% of GDP to 3% is the right direction, but it is far from clear that Greece will be able to stay the course. It would not be the first time that government “hard line” on expenses is derailed by public opinion (already strikes are growing by the day). By the way for those who wonder how France got to be the king of the hill in terms of total net liabilities, it is because among European countries, none of its public sector pension obligations are funded (also partially true for Germany). In fact, Germany's problem is even more severe, since most company’s pension funds are unfunded…

These are the factors which will influence the Bank of Canada’s decision on the direction of interest rates in particular and monetary policy in general. The odds that all three aspects of "Canada's economic drivers" remain positive is slight. The U.S. economy seems to be heading for a double dip recession as housing continues to be a problem. According the figures released yesterday, vacant house at 18 million unites is the higher number ever (average is around 10 million) this shadow inventory is equal to two times the current "homes available for sale" number. The Chinese government seems to realize that they have a potential real estate bubble problem, the elegance of a command economy is that they can easily change the rules of the game. The impact on prices for natural resources could be dramatic on Canada's economy. Finally, Europe seems to be between a rock and a hard place; support Greece, and moral hazard grows for Portugal, Ireland and Spain, play hard ball, and there is the possibility that the edge of the Euro zone may start to disintegrate. Canada's economy thrives when its partners are doing well. The European situation seems precarious.

Note: To give a sense of proportion, Manhattan Island is 22 square miles, which translates into 14,720 acres. 30 billion square feet translates into 688,705 acres, so the current projects under construction in China is the equivalent of covering Manhattan Island with a single 46 story building, which covers the entire Island... makes you think!

Monday, February 1, 2010

With Appologies to Macro Man Blog

The Devil's Dictionary Of Financial Terms

Monday, February 01, 2010

With apologies to Ambrose Bierce....

agency, n. A criminally negligent organization that purchased and securitized mortgages; a criminally negligent organization that rated mortgages and mortgage securities. The agencies were late in downgrading the Agencies.

bailout, n. A notorious regressive tax; the public underwriting of stupid bets made by overpaid morons. Can you believe their bonus pool was $16 billion a year after the bailout?

bail out, v. To selflessly save the global economy from depression and mass unemployment. If we hadn’t bailed out AIG, the unemployment rate would be 25% right now!

bubble, n. Part of the dual mandate; the monetary policy goal of the Federal Reserve and the People’s Bank of China.

carry trade, n. A financial proposition that concludes with its adherents supine, carried out on a stretcher.

CDS, n. The simultaneous purchase of kindling, lighter fluid, matches, and fire insurance on your neighbour’s house.

conspiracy, n. The only possible explanation for certain types of irrational price action. There’s a government conspiracy to support the stock market; how else could it have rallied 70% since March? A crackpot theory held by nutjobs who can’t admit when they’re wrong. Have those conspiracy theory whackos never heard of an oversold bounce before?

credit, n. An asset universally reviled by financiers during a crisis and claimed by politicians after it.

crisis, n. A frequently occurring one-in-a-lifetime event, generally deemed impossible by those under the age of 28.

exotic, adj. Strange; unusual; rarely-seen. I didn’t think it was possible to lose $200 million in fifteen minutes, but the exotics book just did.

hedge, n. A line of closely-grouped shrubberies; a clever way of adding correlation and volatility risk to one’s portfolio.

hedge, adj. A type of investment fund generally accepted to be dedicated to the proposition of ignoring hedges of every description.

house, n. An abode; an investment. Formerly an asset, now a liability.

leverage, n. The act of turning your problem into our problem.

mine, adj. Trader-speak for a desire to make a purchase. 50 EUR/USD mine, shagger. The sole source of responsibility (and thus the rewards) for a successful trade.

option, n. A financial instrument that offers multiple ways of losing money. If being long vega doesn’t kill you , the decay will.

quantitative easing, n. An unorthodox monetary policy that targets increases in high-powered money rather than interest rates; the act of throwing sufficient sums at the financial system to ensure that the stock market starts to rally.

restraint, n. An undesirable spending habit rarely observed in public; an offense punishable by a targeted taxation regime.

risk, n. A binary analytical framework for the simpleminded; can be either off oron. A characteristic of investment that was largely forgotten in the mid-Noughties

SAFE, n. An organization dedicated to perpetuating dangerous global imbalances.

sales, n. The art of separating a customer from his money.

seat, n. The world’s most valuable furniture; a place at a market-making franchise desk at a bank. Fred made $15 million quoting prices last year, but the seat is worth $25 million!

subprime, n. An ingenious method of granting credit to the poor, thereby narrowing the wealth gap between the classes. Dick Fuld lost $650 million after Lehman’s subprime bets went sour.

volatile, adj. The temperament of your average trader on a bad day; the likely future state of financial markets after long periods of low interest rates.

Warren Buffett, n. Ebenezer Scrooge with better PR.

yacht, n. A monetary black hole; an aquatic trophy rarely seen in close proximity to banking customers.

yours, adj. Trader-speak for a desire to make a sale. 500 e-minis, yours!! Whose responsibility the average bank, insurance company, or housing agency thinks it is to pay for the financial crisis.