Greece is again backpedaling on its austerity pledges, and the ECB (European Central Bank) is making statements that, “technically, a Greek exit can be managed. Not fateful but not attractive” (Financial Times). That comment comes from Luc Coene, the central bank governor of Belgium, not Mario Draghi, president of the European central bank. Draghi refused to even discuss the possibility of a country exiting the Euro (Financial Times). Other EU officials have stated that, while a year or two ago a Greek exit would have been a “Lehman” event (i.e. threatening the stability of the global financial system), it wouldn’t be one now. This is all in response to the rising popularity of (and possibly Greece’s next prime minister) Alexis Tsipras of the far left (anti-austerity) Syriza party. The concern is that a new Greek government, one that denied the austerity-inducing loan agreements negotiated with the EU and the IMF, could force Greece to exit the Euro. EU officials have stated that the firewalls put in place over the past year would thwart any kind of financial contagion effect. I doubt that, and it would certainly be tested with a Greek exit.

Among the more stark prognostications for Europe are those from Hong Kong-based Gavekal, which argues that the European options are simple and stark: Either, (1) we get a significantly more federalist Europe in fairly short order, or (2) the Euro is no more. Among the more positive strategists are Jefferies’ David Zervos, who argues that global GDP growth is hitting 3%+ without Europe (who needs em?), and that fiscal integration (which means more European Socialism and hence the most likely outcome) reduces downside risk there, which also limits their upside but increases ours. Wells Capital strategist James Paulson says, “Here we are again, this time it was European election results which sent the Euro-Wolf howling about the end of the euro zone, the end of global economic recovery and the end of the stock market. How many times will U.S. investor[s] [become] convinced to ’sell’ because of breaking euro-zone news?” (Wells).

Here’s what I think is going on. I’m somewhat suspicious of frameworks that draw from the 1990s, a time when the U.S. could post great GDP and stock market growth, even while Europe was stuck in low growth "Eurosclerosis" along with Japan (the second largest economy in the world at the time). That’s because the world is more globally integrated now than it was then, so country GDP growth rates appear to be more correlated. The problem is that no one can really quantify how big this difference is. They can (and do) try, but I wouldn’t hang my hat on these educated guesses. I think Gavekal (above) is closest to the mark, but here’s how I see it: Exiting the Euro would be a disaster for Greece, particularly the Greek people (no lines of credit, no ability to attract investment capital, etc). They know this, which is why polls show that 80%+ prefer to stay in the European Union. But the threat of a Greek exit and ensuing financial contagion in Europe kind of puts the healthier European economies at Greece’s mercy. They know this, which is why there are so many “we can manage a Greek exit if it comes to that-but it’s not our preference” statements lately. I think they’ll work it out in an agonizingly drawn-out way, because that’s what they both want.

Europe:  I would describe the market’s reaction to Francois Hollande’s defeat of President Nicolas Sarkozy as muted. Either the market doesn’t see a whole lot of difference between the outgoing Sarkozy’s minimalist reform agenda (Sarkozy was elected in 2007) and Hollande’s, or the market already priced in a Sarkozy defeat. Hollande doesn’t want to negate March’s “fiscal pact” among European nations (he’s committed to reducing France’s budget deficit to 3% of GDP next year and eliminating it by 2017), but rather wants to add measures to boost growth. This is where it gets interesting, as his measures involve slowing austerity measures (i.e. slowing but continuing cuts in government spending) and raising taxes on businesses and the wealthy. Greece, too, is experiencing an austerity backlash (though 1/10th France’s size). There is a lot going on in the next few weeks, including the 38th G8 summit in Chicago this June. It will be interesting to see how markets in general and European markets in particular view these different perspectives on how to achieve fiscal integration and growth. European stocks sold off a bit last week, but year-to-date the Stoxx Europe 600 index is up about 6% (almost 18% annualized) and the S&P 500 is up about 9.5% (27% annualized). That’s well above average for both, which is quite remarkable given the amount of global concerns.

Most of the European writing I see tilts more towards the hysteria side than the muddling through side. But the most insightful historical perspective I have seen suggests that the multi-year muddling through view is the most likely outcome. It was given by 2011’s Nobel Prize winner in economics, Thomas Sargent, in his Nobel prize lecture titled, “United States Then, Europe Now.” Sargent likened Europe today with the new United States in 1783, with big debts and a constitution that disabled the central government (a weak fiscal union). This was during the period of the Articles of Confederation. Federal taxes required unanimous consent of the 13 states. The states and the central government had accumulated large debts in the War of Independence, and at 40% of GDP, the post-war debt was huge, because tax revenues at most were 2% of GDP. Fast-forward to Europe today, and you find a similar situation: The power to tax lies with member states. Unanimous consent by member states is required for many important EU-wide fiscal actions (Sargent). Following the 1787 Constitutional Convention, the framers of the new Constitution (replacing the Articles of Confederation) wanted to make good on the promises originally made to Continental and state debt holders to finance the war. So the federal government got more power to tax, which annoyed some states but pleased their creditors. That, according to Sargent, is where Europe is now (oversimplifying a bit). I don’t know if I’d give the fiscal treaty being debated in Europe today the same gravity as the U.S. Constitution, but if you think about it, the similarities are striking. Striking enough at least to be the subject of an economics Nobel Prize acceptance speech. So the fiscal pact in Europe today might not be a go on the first round, or the second. Or the third.

I encourage you all to view the First Quarter Webcast if you have not already. Click here to view STMM 1st Quarter 2012 Review and Outlook.  As always, your comments are very appreciated.

In Europe, Spain is again in the news as Standard & Poor’s downgraded its credit rating to BBB+ from A. Spain’s GDP also contracted in the 1st quarter by 0.3%, which indicates recession (because the prior quarter was negative as well). None of this was really a surprise to the market. Interest rates and credit market derivatives like Credit Default Swaps have been rising in Europe for several weeks, so markets have been keeping abreast of the slogging, back-and-forth political developments there. But global risk measures like the St. Louis Fed and Kansas City Fed financial risk indices have not risen appreciably. These market-based measures contain forward-looking data like LIBOR-OIS spreads and global bond market rates. In the extreme, a case can be made that these “price” (rather than quantity) data contain the collective knowledge of the market and are “smarter” than any single economist or analyst. While perhaps overstated, I’ve always been somewhat sympathetic to this view. And what markets are telling me is that Europe still has plenty of problems to work through, but that the global financial system is ok. We continue to monitor these European and global data points on an ongoing basis.

That’s all for today. If interested, I was given some questions by a Boston reporter this morning, and my very brief answers are given below.

Q: Problems persist in Europe and Asia. Is there substantive evidence that the world economy is improving?

A. The direction of the IMF’s recently increased GDP forecast is a pretty good indicator that on balance the outlook (what’s ahead, not behind) is more positive than negative globally.

Q: What is your evaluation of this earnings season?  Are stocks getting too expensive?

A. Over 300 of the S&P 500 companies have reported 1st quarter earnings, and 70% beat analysts’ estimates. Many of these estimates had recently been revised downwards, so this probably isn’t as great as it seems. But overall the earnings picture remains positive. You can’t really predict the market, but what I see this year is a reversal of the spike in the equity risk premium that peaked around the end of November. A normalization if you will. So I don’t see stocks as being particularly under or overvalued.

Q: Why does inflation feel higher than what is reported by the government?

A. What a great question. The “man on the street” view is always that inflation is higher. Sometimes that’s right, sometimes it’s not. I think it is because people tend to downplay (1) improvements in quality which make apples-to-apples comparisons over time of purchased items difficult, (2) substitution effects, or the fact that people rarely buy the same basket of goods when the prices of some of them rise but, rather, substitute towards cheaper alternatives, and (3) many large ticket consumer durable items have actually fallen in price (cars, flat screens, computers, cell-phones, etc.).

Q: Are you more concerned about inflation or deflation, going forward

A. Neither right now. Inflation is like a statistical process control chart that’s in check. Given the huge amount of excess reserves I’d tilt towards inflation if I had to choose, but policy (tax/regulation) uncertainty has to come down for that to happen – I mean before the demand for and supply of credit expands to an inflationary extent.

The other big news was the $430 billion increase in the IMF’s financial resources. These funds were contributed primarily for the purpose of helping to keep the European debt situation from causing systemic global financial risk. The list of countries that contributed – China, Japan, Russia, Saudi Arabia, Switzerland, etc. (not the U.S. or Canada) is a testament, in my opinion, to the general recognition around the world of global interdependence. When combined with recent increases in the European Financial Stability Facility (provided mostly by Europeans), the sums available now total in excess of $1.5 trillion, and that excludes anything from the European Central Bank. In the words of the Financial Times, “That is enough to rescue Spain. It ought to be enough to ensure liquidity for Italy in anything but the most devastating circumstances.”

With major elections going on in Europe, it is pretty easy to get whiplash from the newspaper headlines, but here’s what I think is the gist of the whole matter. There is a major tension that has to work its way out between solvent Europe, troubled Europe, and the rest of the world, and there’s just no smooth way for it all to happen. That doesn’t mean it won’t happen, it just means that it won’t happen smoothly. First of all, there is tension between the solvent European countries (Germany, Switzerland, etc.) and the troubled or insolvent ones (Greece, Portugal, Ireland). The solvent countries have to lend money to or bail out the troubled ones, but if they do it too casually they won’t get the fiscal reform concessions that have to be made in order for the troubled periphery to have an economic future. Second, I think there is truth to the notion that the larger the financial backstop for Europe, the less likely that it will have to be used. That’s because the financial backstop keeps interest rates or refunding rates in Europe from rising too quickly (panic), which would increase the probability of default, bank failures, and global liquidity concerns. So the funds have to be lined up to backstop the system, and they are. The Europeans have to do a lot of the heavy lifting, and they are. And finally, the troubled countries – including Spain and Italy – have to enact fiscal and labor market reforms, which they seem willing to do in practice only when threatened with withheld funds. I think that’s the pattern for the next few years in Europe.

One last thing of interest from last week: total state tax collections in the U.S. in the fourth quarter of 2011 exceeded for the first time the peak 2007 levels at the beginning of the recession. States are certainly not flush with cash (costs have risen), but I would bet that the “man (or woman) on the street” assumes that revenues are well below prior peak levels.

Inflation: Finally, U.S. consumer price indices were also released last week by the BLS (Bureau of Labor Statistics). Here's what I wrote for the press. Some of this is redundant for Kee Points readers, so I put it at the end!

Today's Consumer Price Index (CPI) release for March is good news, as it shows continued, modest increases in both the CPI and the core index, or all items less food and energy. Believe me, what you don't want to see after three years of Fed credit easing is falling indices, or disinflation threatening to turn to deflation. That would tell you that something is seriously wrong or broken here in the U.S. But today's numbers are consistent with continued, modest expansion in the U.S. economy. Interestingly, housing (shelter) and cars and trucks drove about half of the 0.2 percent increase in the core rate. That's a good sign too.housing and autos typically lead economic recoveries, but they have largely been on their back during this one. I hope this indicates that the trough in housing and autos is behind us. As for the Fed's room to maneuver, there is nothing really that implies restriction in this month's releases. Prices in the underlying goods and services that make up price indices ebb and flow, and the Fed knows that. Most increases and decreases in the indices are transient as these underlying prices run their course. Think of the CPI numbers along the lines of a statistical process control chart. The Fed's long-run inflation target is about 2% for the core rate, and I'd say they allow variability of plus or minus two percent. So anything in the 0% to 4% range is roughly "in control" and anything out of that range implies a "breakout" that constrains policy. So every tick up isn't an inflation break-out, and every tick down isn't a deflation signal. That's the way I think about it, and that's how I feel investors should think about it.

Otherwise, it looks like the global economy is improving, or at least ceasing to deteriorate. Global manufacturing PMIs (Purchasing Managers’ Indices) suggest “stabilizing” (rather than contracting) economic activity (Wells Fargo). PMIs from Europe suggest less contraction in the first quarter of this year than the 1.3% annualized rate of contraction reported for the fourth quarter of 2010. That would be consistent with the mild recession scenario for Europe. And the Chinese manufacturing PMI for March came in at close to a twelve-month high. This mirrors manufacturing PMIs in other Asian economies, which have registered expansion (>50) over the past few months. Hong Kong-based Gavekal asserts that most Chinese indicators, including the Chinese property market, have probably already troughed or will in Q2, so they forecast stronger Chinese growth in the second half of 2012. Finally, retail sales in the United States grew by .8% in March, which was more than double the .3% consensus estimates.

Earnings note: Companies are reporting their earnings or profits for the first quarter. The month following a quarter, when companies report, is known as “earnings season” (January, April, July, and October). Wall Street analysts typically forecast company earnings, with some companies having no analysts cover them while others are covered by over 20 analysts. The combined estimates of Street analysts are known as consensus estimates. The current line, which we think is accurate, is that the fairly strong macro data we are seeing, along with prior earnings estimate “downgrades” (when analysts lower their forecasted earnings estimates, or “revise downward”), should make it easier for companies to “beat” the consensus when they report. If they do, it is called a “positive earnings surprise.” If they fall short, it is called a “negative earnings surprise.” As an aside, I spent several years in my research career with very talented quantitative analysts trying to build models that used things like “upgrade/downgrade” ratios and positive/negative earnings surprises in order to forecast aggregates like industries, large versus small caps, and even relative country performance. It didn’t work. Even peer-reviewed papers that suggested that upgrade/downgrade ratios could be used to build international asset allocation models couldn’t be replicated by us. So company earnings are very important to stay on top of, but they are not as prescient as you would think for forecasting broad asset class performance.

Chinese Renminbi: China has agreed to “loosen” the band around which their currency (the Renminbi) trades. It can now rise or fall by 1% each day relative to the dollar versus the previous .5% band. China wisely gained instant currency credibility by linking its currency to the U.S. dollar back in 1994. Today, there is widespread conviction here in the U.S. that China has been keeping its currency or exchange rate too low (a belief I don’t share). Since China exports a lot to the U.S., it is believed that a floating rate would see the Renminbi bid up or appreciate. That’s because buyers of Chinese goods ultimately have to exchange their dollars for Chinese currency. Buying more Chinese goods leads to a flow of dollars into China, which would bid up the Renminbi relative to the dollar in a floating rate regime.  And in general, when the Chinese have loosened the peg (since 2005) it has appreciated. But allowing it to float freely, that is, completely severing its link to the U.S. dollar, is another thing entirely! As Nobel Laureate Robert Mundell, who advises the Chinese government, pointed out in 2005, a new, freely floating paper fiat (not backed by anything) currency issued by a communist country could very well fall like a rock if severed from the dollar. I think that has a lot to do with the Chinese government’s hesitancy to allow the currency to freely float.

Inflation: Finally, U.S. consumer price indices were also released last week by the BLS (Bureau of Labor Statistics). Here’s what I wrote for the press. Some of this is redundant for Kee Points readers, so I put it at the end!

Today’s Consumer Price Index (CPI) release for March is good news, as it shows continued, modest increases in both the CPI and the core index, or all items less food and energy. Believe me, what you don’t want to see after three years of Fed credit easing is falling indices, or disinflation threatening to turn to deflation. That would tell you that something is seriously wrong or broken here in the U.S. But today’s numbers are consistent with continued, modest expansion in the U.S. economy. Interestingly, housing (shelter) and cars and trucks drove about half of the 0.2 percent increase in the core rate. That’s a good sign too…housing and autos typically lead economic recoveries, but they have largely been on their back during this one. I hope this indicates that the trough in housing and autos is behind us. As for the Fed’s room to maneuver, there is nothing really that implies restriction in this month’s releases. Prices in the underlying goods and services that make up price indices ebb and flow, and the Fed knows that. Most increases and decreases in the indices are transient as these underlying prices run their course. Think of the CPI numbers along the lines of a statistical process control chart. The Fed’s long-run inflation target is about 2% for the core rate, and I’d say they allow variability of plus or minus two percent. So anything in the 0% to 4% range is roughly “in control” and anything out of that range implies a “breakout” that constrains policy. So every tick up isn’t an inflation break-out, and every tick down isn’t a deflation signal. That’s the way I think about it, and that’s how I feel investors should think about it.

China’s central bank Governor (Zhou Xiaochuan) and Chinese Premier Wen Jiabao made statements last week regarding China’s need and intention to reform and liberalize its state-run “oligopoly” banking system (there is a “big four” of state banks in China). This is another step towards “being like us,” to use Tony Blair’s phraseology. China’s banking system has been predicted to collapse for years, along of course with the Chinese economy. But the bold public statements by Chinese leaders to force banks to compete for capital there are a good sign. China’s GDP grew 9.2% in 2011. Estimates for first quarter growth will be published on Friday, and expectations are for around 8.4% growth, which is above the downward revised official target of 7.5%. The official target was 8% over the past six years (Financial Times). By the way, the fact the that U.S. waits 3 months after a quarter in order to publish its preliminary GDP estimates, while China only waits 2 weeks, is a big reason why few analysts trust Chinese data.

Spain’s bond prices fell last week following a weaker than expected bond auction. Spain’s stock market has largely missed the year-to-date rally in European stocks, a rally which has trailed slightly the rally in U.S. equities. Investors know that Spain is just getting startedwith implementing the labor market and spending reforms that are supposed to take place there. Interest rates in Spain had briefly touched below 5% following the European Central Bank’s LTRO (long-term refinancing operations), but they have now risen to 5.7% (today). In order to meet EU targets, Spain has to reduce its budget deficit from 8.5% of GDP in 2011 down to 5.3% this year. Officials there are expected this week to accelerate into law an EU-influenced budget act, so I’ll be watching Spanish bond yields. On-going headline risk from Europe is to be expected for the foreseeable future, but I hope and expect to see the overall stock market reactions to the headlines settle down as time goes on.

Most of the data was better than expected last week for the U.S. and for key Eurozone economies like Germany and France. Home sales in the U.S. came in strong, consumer spending accelerated, and durable goods orders excluding aircraft/defense were stronger than expected. That’s also consistent with today’s ISM manufacturing index reading of 53.4, which beat last month’s 52.4 as well as expectations of 53. Germany also reported strong data across the board last week (retail sales, employment data) as did France (consumer spending). Even Japanese retail trade and household spending beat estimates. All in all, it was a week in which the worst seemed to be behind us rather than ahead of us with regard to the global economy. We need more of those kind of weeks!

As promised, below are my notes from last week’s Washington policy conference of the National Association for Business Economics:

Ben Bernanke: Fed Chairman Ben Bernanke’s keynote speech focused on two things. The first was his ongoing contention that, despite the vast opinion to the contrary, today’s high unemployment rate is more cyclical than structural. In other words, high unemployment is not so much a mismatch between jobs and skills, or a housing construction crash, or other structural causes, but rather weak growth/aggregate demand. The average growth rate of the U.S. economy during expansions (post WWII) is about 4.1%, while the current expansion has been in the 2% growth range. So Bernanke argued that we need stronger growth.

The other issue that Bernanke discussed was the more recent paradox (given the assertion above) of improving labor markets in the face of ongoing sluggish growth.  Here’s what I think is happening: Kee Points readers will recall that the number of jobs lost during this past recession, relative to the decline in GDP, was historically high. For example, total job loss was more than 6% of all jobs (previous post-Depression record was 5.2%). So a lot of strategists felt that companies were probably running “too lean” with respect to employee count, hence some were calling for an upside “hiring surprise” over the past several years. That never happened, but with GDP (total output of market valued goods and services) now at an all-time high, but with 5.5 million fewer workers than the previous GDP peak, I’d say companies are finally giving into hiring pressure. That’s pretty much the case that Bernanke made as well. He felt that this positive labor market surge would be temporary unless or until the pace of growth really picks up. Alan Blinder, a Princeton Democrat, agreed with Bernanke (a Republican) that today’s high unemployment was largely cyclical, not structural. He argued that structural factors always get exaggerated in downturns, but then during expansions they seem to dissipate.

Europe: Speakers from Europe included economists from the Bank of England, Deutsche Bundesbank (Germany’s central bank), the Official Monetary and Financial Institutions Forum, and Joh. Berenberg Gossler & Co. (Berenberg Bank, one of the oldest in the world). The one thing these speakers had in common was that they were surprisingly bullish long-term for Europe and the Euro. Here are some points I jotted down: We are a bit beyond half-way through the European debt saga – the worst is behind us; a reformed Eurozone can emerge stronger from the crisis; popular support for Greece staying in the Euro/European union is strong, about 75%. That’s stronger than, say, support in Canada for Quebec staying in Canada(!); 3  tiny members have worse problems than the U.S., namely, Greece, Portugal, and Ireland, or 6% of European GDP. The rest of Europe is in better fiscal shape than U.S., Japan, or the UK.

The Europeans speakers also talked about how the Federal Reserve failed to act as a lender of last resort during the Great Depression, but did the opposite during the Great Recession (2007/08) and things turned out much better. They claimed that, going into the crisis, the European central bank was limited in its discretion, forcing them into the Fed/Great Depression scenario. But recent actions and ongoing deliberation are aimed at expanding the ECB’s role to be more comprehensive (and effective) like the Federal Reserve’s. Also, the speakers pointed out that 10 years ago Germany was the “sick old man of Europe.” But due to structural labor market reforms (less rigidity) and austerity measures enacted in 2004, Germany had a huge turnaround by 2006. That seems to be the overall blueprint for Europe going forward. All in all I’d say the European economists were the most attended lectures…a little kool-aid to be sure (i.e. everything’s great), but they made some pretty good points.

Elections Outlook: Charlie Cook of The Cook Report said that the presidential election would be decided by independents, but that you have to be more precise. Within self-described independents there are subgroups. “Independent-Left” tends to vote Democrat. “Independent-Right” tends to vote Republican. In the middle are “True Independents.” They determine the outcome. Overall Cook said to forget all of the polls and just focus on the President’s approval rating. Less than 50% means he’s in trouble. Greater than 50% means that he’ll probably be re-elected (I’ve mentioned that “50% rule” in Kee Points before). Greg Valliere, who will be speaking out our STMM 2012 Energy Conference, argued for a 75% chance of the Republicans keeping the house, and 50/50 chance on the Senate. He felt that “wealthy” would probably be redefined upwards to about $500,000 or more for tax purposes, and that dividend taxes might go up, but not all of the way up to the maximum personal rate.

Finally, Federal Express CEO Fred Smith outlined his view of what needs to happen in the U.S. going forward: (1) reduced dependence on foreign oil, (2) deregulation, and (3) tax simplification. Interestingly, Lawerence Lindsey, who with Smith was among the most conservative of the conference’s speakers, argued in favor of a broad value added tax (VAT), echoing the Harvard econ department’s alleged token conservative Robert Barro. I’ll probably talk about taxes more as the election develops and specifics emerge.

The existing inventory of housing on the market and the “shadow inventory” (people wanting to put their house on the market as soon as they think they can sell it) could keep prices down for some time. In any market, demand is met through either price or quantity (volume) adjustments. In housing, typically price does most of the adjusting in areas where supply – for whatever reason-is relatively fixed. That would include the populous areas of the East Coast (because available new development is limited) and the West Coast (because new development is discouraged, e.g. California’s land restrictions). When the economy expands and the demand for housing increases along with it, housing prices in these areas tend to rise. On the other hand, in areas where available land is cheap and development restrictions are few, quantity does most of the adjusting because supply is not fixed. An increased demand for housing leads to an increase in the quantity supplied, thus quantity does most of the adjusting. This latter scenario is what characterizes a lot of the housing market today, so I’m watching for increased sales volumes, not necessarily increased housing price indexes. Housing experts are really eyeing this Spring season closely.

By the way, this same supply responsiveness (“elasticity”) concept is used by economists to shed light on seemingly unrelated topics such as wages and executive compensation. The argument is that careers and positions with stagnant wages are typically characterized by elastic supply where quantity does most of the adjusting. That is, any slight increase in wages/salaries due to an increase in demand leads to quick entry by new workers from other areas. But when supply is relatively fixed or rare, like the supply of professional athletes or entertainers – and yes, even CEOs – it is price that does most of the adjusting, and so you see high wages and salaries.

In Europe, declines in the Eurozone purchasing managers’ indices and a rise in Spain’s borrowing costs (interest rates) has stirred up some renewed angst there. The market’s reaction to this has been relatively muted thus far, reflecting (I hope) a lessening of the market’s sensitivity to European news due to decreasing concerns of financial contagion and of a global financial crisis repeat.

But Europe does impact China, because Europe is China’s single biggest export partner. Manufacturing activity in China shrank for the fifth straight month in March (Reuters). Chinese analysts had expected that the Lunar New Year (China’s biggest holiday event) had disrupted manufacturing for the first two months of the year, so the lack of a March rebound was a disappointment.  Emerging markets, particularly commodity intensive ones like Brazil, Australia, and Russia, tend to have the highest “China betas,” meaning that they are particularly sensitive to China’s growth. But most analysts expect that loosening monetary policy there will keep growth in the 7% range. This is something that China has already initiated, beginning somewhat subtly in October (Goldman Sachs). Hong-Kong based GaveKal is not “losing much sleep over this,” their argument being that China’s economy is so large now that you don’t need 10% growth there to get large absolute demand from China. By the way, China’s economy is now about half the size of the U.S. economy.  In fact, the more optimistic (but sober) views of China contend that it is switching from targeting the “quantity” of growth to the “quality” (more capital efficiency). Nevertheless, we are paying very close attention to China here at STMM.

Well, I’m also headed to the National Association of Business Economics 2012 Economic Policy Conference this week. Fed Chairman Ben Bernanke is one of the Keynote speakers. I’ll let you know what I hear in next week’s Kee Points!

Are stocks headed for a pull-back? Probably. The S&P 500 has gained over 20% over the past five months, one of the longest and strongest uninterrupted rallies on record (GaveKal). Pull-backs are “expected but not predictable,” in my opinion. U.S Treasuries have done well too, as bond prices are up 20% over the past year. And according to Hong Kong-based GaveKal, this bond market gain is far more rare than a five-month, 20% rally in equities. Equities have gained 20% in a year or less eight times over the past 20 years, while bond prices have only achieved this once. The equity gains were “generally followed by nothing more painful than a slowdown,” while the bond markets, in contrast, were followed by pretty memorable “bond meltdowns” whenever they got in the range of a 15% annual gain (1994, 1999, 2003/4, and 2009).

That’s not to say that we expect a bond market collapse, but we do expect interest rates to rise as the economy expands and credit markets continue to normalize. Rising rates means lower bond prices, but some of the recent demand for bonds (which has led to high bond prices) is probably more permanent than transient. For example, today’s higher savings rates (relative to the 2007/08 crisis) translate into “preservation and protection,” which means bonds, and more people are owning bonds as insurance against equity market losses. There has also been a lack of speculative buying in bonds, and speculative buying is a key characteristic of asset “bubbles.” Finally, regulators are pushing banks and insurance companies to own more bonds. We continue to see high quality municipal bonds as being in the sweet spot for safety and yield.

Bonds and stocks: But GaveKal also points out that, of the seven serious bear markets in bonds since 1982 (involving losses of 15% to 20% in 30 year Treasury prices), “not a single one of these major bond corrections has caused a bear market in equities.” Two have coincided with flat equity markets, while five have coincided with big equity gains. That’s consistent with research at Credit Suisse, which argues that the currently elevated equity risk premium should put a floor on any correction that might occur in the equity market, meaning most bad news is already priced in. That might seem strange after such a sharp run-up in stocks, but remember that the market was trading in its current range (S&P 1400) ten years ago, even though the earnings and cash flow generation since then has been tremendous. So valuation levels are lower than they were in the past.

Finally, STMM’s Financials sector specialist, Jay Hammond tells me that the Fed completed its annual bank stress tests last week (“Comprehensive Capital Analysis and Review”), which tests banks against severe economic scenarios in order to see if they can maintain minimum regulatory capital requirements or ratios. 18 of 19 companies passed, which was expected, but the results were much stronger than anticipated. The Fed’s assumptions were much stronger than previous tests – an 8% GDP decline, 13% unemployment, 52% stock market decline (from Q3 2011), 20% housing decline, and severe global macroconditions.

I’m in New York doing some media interviews. The following are questions I have received, so I thought I would share the dialogue for this week’sKee Points. For most of you this will be redundant, so I apologize in advance!

Question 1: What are the three most important things every investor should have on their radar today?

I feel like I’m supposed to say “European debt crisis,” “Slowing China growth,” and/or “US debt/deficit problems.” Those are all important, but I think they are more accurately described as“things that take your eye off the ball.”Nobody knows how Europe is going to turn out but, frankly, I’m more encouraged than discouraged by what I see coming out of Europe. Its two steps forward and one step back for sure (with concomitant headline risk), but the tangible actions taken by independent governments and union members overall seem to be in the same direction: (1) working towards keeping the union intact, (2) matching the monetary union with the member fiscal union (at least better than what currently exists), and (3) avoiding a global financial/credit freeze. As for China, just know one thing: China fears high unemployment and the social unrest that follows, and it will do everything in its power to avoid a hard landing. That includes monetary and fiscal policy, like lowering reserve requirements (monetary) and accelerating 5-year infrastructure spending plans (fiscal). As for the U.S., the big issue is the future “entitlement tsunami,” particularly Medicare, which will be felt in earnest after 2020. The thing to keep in mind here is that this problem will be handled not with debt default or hyperinflation, but rather through “means testing” benefits, that is, the more you have (income/net worth) the less you get (benefits). There are 1001 ways to do this. Means testing is in addition to small tweaks that make big differences, like changing inflation adjustment procedures for benefits, and/or changing eligibility (like age) requirements.

Rather, I think investors should keep the following in mind:

Avoid short-term forecasts and focus on the longer-term relationships among asset classes.Usethe markets through disciplined diversification rather than trying to outsmart them.Think “process over guru.”Be cognizant of history. Bull markets with above average returns began in periods like the depths (1932) of the Great Depression, or going into and through the largest global war in history (WWII), or during the highest escalations of the Cold War. It is just not true that the world today is more treacherous for investors than it has been in the past (though recent daily volatility has been high!).The things that are going to drive investment returns going forward aren’t what people are talking about now; that’s known and priced in. It’s the balance of unforeseen shocks – positive and negative – that will determine the future performance of various asset classes.

Question 2: What is the most important thing you are watching right now?

Oil prices and U.S.policy uncertainty, both tax and regulatory policy. Higher oil prices – particularly if they are supply-driven or driven by speculative activity – can act like a tax on producers and consumers and slur growth. But the U.S. is less energy intensive (energy use per unit of output) than it used to be, so I don’t see this as a recession threat. Policy uncertainty is another concern, because too much policy “churning” or uncertainty about taxes and regulations will put business decision-making regarding capital spending and hiring (both of which are forward-looking) on hold. This promises to be a particularly raucous elections cycle, and policy uncertainty is pretty high right now. It could come down in the coming months, which is what I’d like to see. But there’s no way to know in advance. We just have to watch it all play out.

It should be helpful to focus on four things: Autos, housing, exports, and business investment. Normal expansions are driven or led by autos and housing, but these two sectors have been largely on their backs for the past few years. Fortunately, exports and investment spending have been a bit above average, which has filled the gap. But that also means the U.S. economy is more sensitive than normal to global GDP growth (exports) and the overall policy environment (investment spending). And these could slow, because of both policy uncertainty (bonus depreciation, etc) and because of a Euro area recession and slower emerging markets growth (exports). So it is important that autos and housing start to turn up, and it looks like they are. That’s why oil prices and policy uncertainty are so important, in my opinion. I don’t want them derailing what looks to be a nascent recovery in housing and autos here in the U.S.

So it’s not one thing I’m watching, but a lot of things!

Question 1: What are the three most important things every investor should have on their radar today?

I feel like I’m supposed to say “European debt crisis,” “Slowing China growth,” and/or “US debt/deficit problems.” Those are all important, but I think they are more accurately described as “things that take your eye off the ball.” Nobody knows how Europe is going to turn out but, frankly, I’m more encouraged than discouraged by what I see coming out of Europe. Its two steps forward and one step back for sure (with concomitant headline risk), but the tangible actions taken by independent governments and union members overall seem to be in the same direction: (1) working towards keeping the union intact, (2) matching the monetary union with the member fiscal union (at least better than what currently exists), and (3) avoiding a global financial/credit freeze. As for China, just know one thing: China fears high unemployment and the social unrest that follows, and it will do everything in its power to avoid a hard landing. That includes monetary and fiscal policy, like lowering reserve requirements (monetary) and accelerating 5-year infrastructure spending plans (fiscal). As for the U.S., the big issue is the future “entitlement tsunami,” particularly Medicare, which will be felt in earnest after 2020. The thing to keep in mind here is that this problem will be handled not with debt default or hyperinflation, but rather through “means testing” benefits, that is, the more you have (income/net worth) the less you get (benefits). There are 1001 ways to do this. Means testing is in addition to small tweaks that make big differences, like changing inflation adjustment procedures for benefits, and/or changing eligibility (like age) requirements.

Rather, I think investors should keep the following in mind:

1. Avoid short-term forecasts and focus on the longer-term relationships among asset classes. Use the markets through disciplined diversification rather than trying to outsmart them. Think “process over guru.”
2. Be cognizant of history. Bull markets with above average returns began in periods like the depths (1932) of the Great Depression, or going into and through the largest global war in history (WWII), or during the highest escalations of the Cold War. It is just not true that the world today is more treacherous for investors than it has been in the past (though recent daily volatility has been high!).
3. The things that are going to drive investment returns going forward aren’t what people are talking about now; that’s known and priced in. It’s the balance of unforeseen shocks – positive and negative – that will determine the future performance of various asset classes.

Forecasting in general: 2011 was a pretty good year to observe the limitations of professional forecasters. The Federal Reserve employs hundreds of Ph.Ds, as does the IMF and World Bank. All have pretty much upgraded or downgraded their forecasts based upon the latest data releases throughout the year.  Nothing wrong with that, but it is helpful to recognize that this is as much an exercise in extrapolation as it is of forecasting. In fact, two professors, one from Oxford (Jerker Denrell) and one from New York University (Christina Fang) recently (2010) published a paper that analyzed the Wall Street Journal Survey of Economic Forecasts. They concluded that success in forecasting, that is, making a "big hit" that the consensus missed, was an indicator of poor judgment! The authors found that the poorest forecasters made the most extreme predictions. And because poor forecasters were more likely to make extreme forecasts, "they are also more likely to make extreme forecasts that turn out to be accurate." (Journal of Management Science). Anyone who has ever tracked a "guru" for any period of time experiences this. Gurus get that status by being at odds with consensus in a visible way that turns out to be right, but they typically fail with the follow-up act (e.g. Nouriel Roubini advising against stocks at the March 09 bottom, or Bill Miller suggesting that it was gold, not housing, that was in a bubble back in 2005). The important lesson here, I think, is to avoid the subsequent pattern of then finding another guru (until he or she blows it), essentially going from guru to guru. I've seen this pretty frequently throughout my career. That's why I'm such a big fan of relying on an investment process rather than an investment guru – particularly when uncertainty is high.

Looking globally, there seems to be a growing sense that "tail risks" (big negative shocks) have diminished. In Europe, Greece seems more likely to avoid a disorderly default, as the latest bailout plan includes an offer for existing Greek debt holders to exchange their debt for new 30-year securities with new (lower) coupon payments. The details are complex and the deadlines vague, but overall this is part of the "tough medicine" (the so-called haircut given to existing debt holders) that is a necessary prerequisite to rest-of-the-world aid. The European dynamic right now is an interesting one: G20 leaders (> 80% of world GDP) are hesitant to extend loans to Europe until Europe does more on its own. That's because, overall, Europe's debt/GDP ratio is actually slightly less than the U.S.'s, so it is economically capable of doing more on its own. But politically, the voters of solvent countries like Germany oppose bailing out countries like Greece, while the leaders in those solvent countries (e.g. Angela Merkel) fear a contagion effect and disorderly default (which would be catastrophic economically) if they don't help. So far it looks like markets are optimistic. Global demand for Euros is increasing (Financial Times), a bullish sign of confidence regarding the European situation. This is corroborated by global risk indicators, which have been improving.

Europe: Greece’s creditors – the IMF and the European Union – are demanding what Greeks consider to be drastic reductions in living standards in return for a second tranche of bail-out funds. Measures include a 22% reduction in the Greek minimum wage (32% for workers under 25). The economics of this are that the minimum wages might force companies to pay employees more than they are worth to the firm, that is, pay them more than the value they add. Since younger and less experienced workers tend to have the lowest value-adding skills, it makes sense to set a lower minimum wage for them. The politics are such that minimum wage cuts lead to cries of favoring the rich over poor, and those are starting to rise in Greece. But they are little play in the rest of Europe, at least for now. The European Trade Union Confederation (organized labor in Europe) is having little success in mobilizing workers Europe-wide against austerity (Reuters). That’s because sympathy for Greece is lacking from other European countries (the lenders) in general, old and new (Spain, Italy, Germany, Finland, Lithuania, Slovakia). From an investment perspective, my feel is that the stock market’s resiliency to recent Greek headlines reflects the effectiveness of the European Central Bank’s LTRO (Long Term Refinancing Operation) program at reducing fears of a European-driven global liquidity or credit freeze. European region GDP numbers will be released on Wednesday. The expectations are for growth throughout the region to decline by 0.4% to 0.6% in the fourth quarter of 2011. We will discuss the results next week.

The consensus on China continues to be for a soft landing, meaning growth below the 9%-10% range but certainly above 5% (the Financial Times cites “greater than 8% this year”). In fact, a recent report by the global consulting firm McKinsey & Company indicates that their firm expects China to “maintain a rapid rate of growth,” largely through government policies that should spur consumption and investment (McKinsey Quarterly). What’s more, Hong Kong-based GaveKal points out that beginning-of- the-year data from China is distorted by the impact of the Chinese New Year, the biggest holiday in China, in which many businesses shut down for up to two weeks. You have to wait until the end of February to get a good read on how the Chinese economy is doing so far for 2012. We’ll keep that in mind and pay extra attention to the February data.

Europe: Greece’s creditors – the IMF and the European Union – are demanding what Greeks consider to be drastic reductions in living standards in return for a second tranche of bail-out funds. Measures include a 22% reduction in the Greek minimum wage (32% for workers under 25). The economics of this are that the minimum wages might force companies to pay employees more than they are worth to the firm, that is, pay them more than the value they add. Since younger and less experienced workers tend to have the lowest value-adding skills, it makes sense to set a lower minimum wage for them. The politics are such that minimum wage cuts lead to cries of favoring the rich over poor, and those are starting to rise in Greece. But they are little play in the rest of Europe, at least for now. The European Trade Union Confederation (organized labor in Europe) is having little success in mobilizing workers Europe-wide against austerity (Reuters). That’s because sympathy for Greece is lacking from other European countries (the lenders) in general, old and new (Spain, Italy, Germany, Finland, Lithuania, Slovakia). From an investment perspective, my feel is that the stock market’s resiliency to recent Greek headlines reflects the effectiveness of the European Central Bank’s LTRO (Long Term Refinancing Operation) program at reducing fears of a European-driven global liquidity or credit freeze.  European region GDP numbers will be released on Wednesday.  The expectations are for growth throughout the region to decline by 0.4% to 0.6% in the fourth quarter of 2011.  We will discuss the results next week.

In Europe, 25 of 27 European Union members signed a fiscal pact that is designed to reduce budget deficits and restore investor confidence there (Britain and the Czech Republic declined). It is a positive step, but it is only a step. For example, French President Nicolas Sarkozy wants to hold off on French ratification of the treaty until after the Spring elections, and his opponent (Francois Hollande) has vowed to renegotiate it if he wins (Wells Fargo Securities). Greece continues to drag its feet on reforms, although today the government agreed to lay off 15,000 public-sector workers by the end of 2012, a concession made to help secure loan funds. Portugal appears to be next on-deck, particularly since Standard & Poor's downgraded it to junk status on January 13th. But Portugal's overall debt load is smaller than Greece's, and it has a lower (but still high) debt-to-GDP ratio of 110% versus 160% for Greece. Other concerns include an increasing number of downward earnings revisions for U.S. companies. It is important to keep in mind, however, that profit margins haven't yet peaked in the U.S., and historically the stock market doesn't peak until about 5 quarters after earnings peak, on average (J.P. Morgan).

In the U.S., last week's positive ISM manufacturing and non-manufacturing reports pointed to expansion. That's consistent with Friday's payroll report (the Bureau of Labor Statistic's monthly Employment Situation Report), which indicated that non-farm employment rose by 243,000 in January – better than expectations. The unemployment rate fell to 8.3% (from 8.5%).  There are some seasonal factors at play here, like unusually warm weather, which reduces construction industry job loss from what normally occurs. But overall, the BLS (Bureau of Labor Statistics) reported that "job growth was widespread in the private sector, with large employment gains in professional and business services, leisure and hospitality, and manufacturing."

Fourth Quarter Real GDP increased at an annual rate of 2.8%. That was a little below most consensus estimates (there are multiple surveys that industry insiders point to as the consensus–WSJ, Bloomberg, etc), but inline with continued “modest” growth (to quote the Fed). In fact, 2011 was a year of continuously accelerating growth, starting with the first quarter’s abysmal .4 and continuing with 1.3% (Q2), 1.8% (Q3), and 2.8% (Q4). We expected the second half to be stronger than the first, but 2011’s overall real GDP growth rate of 1.7% was pretty weak. Modest gains in consumer spending and business investment were offset somewhat by weakness in government spending (that’s to be expected). Inventory rebuilding accounted for a good chunk (1.9%) of 4th quarter growth. By the way, this “inventory investment,” as it is called, can be a good omen or a bad omen. For example, inventories can grow because demand is slowing, which is bad, or they can grow because firms anticipate higher future sales, which is good. Anyway, looking to 2012, the Federal Reserve lowered its forecast slightly, from the 2.5%-2.9% range down to the 2.2%-2.7% range. I think that kind of spurious precision is silly. Call it “expected GDP growth somewhere between 2% and 3% for 2012.” That’s what we at STMM expect.

Europe continues its (hopefully) two steps forward, one step back routine. The consensus among global leaders last week at “Davos,” the Swiss World Economic Forum which holds its annual meeting in Davos, Switzerland, seemed to be that the most dangerous phase of the eurozone crisis could be over, largely due to European Central Bank President Mario Draghi’s efforts over the past few months to provide liquidity and funding to European banks. Let’s hope so. Tentative evidence for this is the fact that ongoing, if not increasing, concerns regarding Greek and Portuguese indebtedness have not lead to contagion fears as they would have a year ago. (Financial Times). Germany has warned Greece that it must “implement reforms, not just announce them.” It’s a little surreal to hear German Finance Minister Wolfgang Schauble cite U.S. research (Rogoff and Reinhart) suggesting that high public debt is a drag on economic growth. “I don’t know how it’s best done in America,” said Schauble, “but in Germany it works like this: If you want more private demand, you have to take people’s angst away” (referring to credible commitments to fiscal discipline–WSJ). I think that’s how it works in America too.

Another big story from last week’s headlines was the Federal Reserve’s FOMC (Federal Open Market Committee) statement. The Fed did two noteworthy – so bound to be misinterpreted – things. First, it specified projections for interest rates through 2014 and published the individual projections of the 17 officials who participate in the policy meetings. “Vintage Bernanke” is how this has been described, and rightly so. This is part of Fed Chairman Bernanke’s ongoing efforts to increase Fed transparency and to minimize the need for the private sector to be constantly guessing at what the Fed might do next. The second thing Bernanke did was more explicitly spell out inflation and unemployment goals. While other central banks like the European Central bank have explicit inflation goals, the Federal Reserve’s goals have had to be inferred. Here again, Bernanke is just trying to eliminate conjecture as to the Fed’s intentions, which should facilitate private sector decision making.

A little discussion on this point might help. The Fed has a so-called dual mandate to address inflation and unemployment. This was the outcome of the Humphrey Hawkins Act of 1978, which was written when both inflation and unemployment were rising. There seems to be a layman’s consensus that these two goals are conflicting, i.e. that controlling inflation is bad for unemployment, the so-called Phillips Curve trade-off. But many economists, and I’d count Bernanke among them, assert that the maximum (or optimal) impact that monetary policy can have on growth and employment is through price stability, which best facilitates production and exchange (which is how wealth is really created). So controlling inflation is also the most effective way to minimize unemployment. That’s what Bernanke meant last week when he stated that the goals of controlling inflation and maximizing employment are complimentary. The idea is that the Fed can’t create output and employment by playing with the money supply, or not permanently anyway. It can facilitate wealth creation, however, by ensuring the value and stability of the medium of exchange (money). That’s largely what Bernanke was alluding to last week when he said, “The maximum level of employment is largely determined by nonmonetary factors that affect the structure and dynamics of the labor market.” It’s a point he’s been making softly for about two years now, namely, that slow growth and high unemployment is a fiscal policy problem.

The most interesting thing I saw last week: The Conference Board has changed the way it calculates its Leading Economic Index by, among other things, removing the M2 measure of the money supply and replacing it with a “Leading Credit Index.” It’s about time! Money supply figures are horrible indicators by themselves, as they can be demand driven or supply driven, with components that can be both endogenous (created within the economy) and exogenous (central bank). That’s all I’ll say on it for now, but if I start hearing bad reporting on this in the press (e.g. “a conspiracy to secretly cover up inflation!”, etc.), then I’ll surely address it in future Kee Points.

Here's what I think about all of this: Most U.S. expansions are led by housing and autos, also known as "consumer durables." But both housing and autos have been on their backs during the current expansion. Fortunately, export growth and business investment spending have been stronger than normal, and these two categories have helped to off-set the housing and auto sectors. Now with China (and hence exports) slowing and the 100% expensing of capital purchases (and hence business investment) expiring (dropping down to 50%), these two drivers of growth could weaken. Fortunately, it appears that the auto and housing sectors are finally bottoming and starting to turn up. You can see why that's so important.

In Europe sentiment seems to be improving, as interest rates are down there (a good sign). There is still debate regarding Greece's debt and the terms of an orderly restructuring, meaning a debt swap in which current debt holders get new bonds worth less (the so called "haircut"). This "debt swap" and new fiscal program (with spending reform) must be in place before Greece is allocated funding from a second rescue package led by the IMF. So Greece is still a question mark for investors. But for the rest of Europe, the overall response to December's long-term refinancing operation (LTRO), which allows banks to borrow from the European Central Bank on favorable terms, has been more positive than many investors and economists expected. For example, the yield on Italian two-year debt is 3.9%, down from a peak of 7.8% in late November (WSJ). Let's hope that continues!

Ratings agencies: One story that's getting more play in the press these days, and rightly so, is the historical evolution of credit rating agencies or Nationally Recognized Statistical Rating Organizations (NRSROs) like Fitch, Moody's, and Standard & Poor's. The origins go back to the 1800s as companies emerged to provide detailed analysis of the risks associated with railroad bonds (Jefferies). The business model that evolved was one in which these companies made their money by selling books and subscriptions to investors who were interested in investing in various companies and loaning them money (buying their bonds). By the 1970s the development of things like photocopiers made it hard to protect the proprietary information of these ratings firms. This is a situation that economists call "non-exclusion" or difficulty excluding non-payers from a good or service (the classic example being national defense). As a consequence, a significant change in the business model of these companies occurred, essentially going from an investor fee-based model towards an issuer fee-based model. Jefferies analyst David Zervos deems this a "game changer" in that, with the issuers of the securities being rated paying the bills, "the agencies had a new master – issuer revenues." Zervosí conclusion is that this is really what created the era of mis-rated securitized products which ultimately produced "one of the greatest misallocation of resources in financially history." Perhaps overstated, but I think there's something to it.

The most interesting thing I saw last week: Princeton economist and former Federal Reserve vice Chairman Alan Blinder had an intriguing article in the Wall Street Journal last week entitled, "Four Deficit Myths and a Frightening Fact." Few economists would agree with all of Blinder's points, but I think they would agree on his main point; namely, that America's real debt and deficit problem will come in the 2020s and 2030s and beyond, and will be driven by Medicare and Medicaid spending. In Blinder's words, "we don't have a generalized overspending problem for the long run. We have a humongous health care problem." Again, the first part of that statement is open for debate, but not the second: health care entitlement reform is what will drive budget politics in the future.

Finally, please join us for our Corpus Christi Market Update & Outlook this Friday January 27th at the Corpus Christi Town Club at 11:30am. Please rsvp to Josie Dorris/jdorris@stmmltd.com or 210-824-8916.

Bernanke and the Fed were in the news a lot last week due to recycled headlines about the Fed failing to see the housing crisis coming. This has been known by anyone who bothered to read Bernankeís (or Vice Chairman Yellen's) public statements over the past few years. What the press should be reporting on is Bernanke's letter (representing the Board of Governors) to Congress concerning the "egregious errors and mistakes" in recent press articles about the Federal Reserve's activities. Kee Points readers should find the following assertions of interest. They are cold hard facts that seldom get mentioned:

1. "First, these articles have made repeated claims that the Federal Reserve conducted "secret" lending that was not disclosed to the public or the Congress. No lending program was ever kept secret from the Congress or the public."
2. "One article asserted that the Federal Reserve lent or guaranteed more than $7.7 trillion during the financial crisis. Others have estimated the amounts to be $16 trillion or even $24 trillion. All of these numbers are wildly inaccurate. As disclosed on the Federal Reserve's balance sheet, published weekly and audited annually by independent auditors, total credit outstanding under the liquidity programs was never more than about $1.5 trillion; that was the peak reached in December 2008."
3. "To be sure, that is a very large amount, but it was a necessary response to ensure that the crucial mistake made during the Great Depression – failing to prevent the collapse of the financial system – was not repeated. Importantly, such lending helped support the continued flow of credit to American families and businesses."
4. "Other inaccuracies may occur if total potential lending is counted as actual lending. For instance, the TALF program was authorized at $200 billion, but its total lending never exceeded $40 billion… although the articles never stress this point, it is important to note that nearly all of the emergency assistance has, in fact, been fully repaid or is on track to be fully repaid… The articles also fail to note that the lending directly helped support American businesses by providing emergency funding so that they could meet weekly payrolls and on-going expenses. The commercial paper funding facility, for example, provided support to businesses as diverse as Harley-Davidson and National Rural Utilities, when the usual market mechanism for their day-to-day funding completely dried up."
5. "And the articles fail to mention altogether that one facility, the TALF, supported nearly 3 million auto loans, more than 1 million student loans, nearly 900,000 loans to small businesses, 150,000 other business loans, and millions of credit card loans... Most of the Federal Reserve's lending facilities were priced at a penalty over normal market rates so that borrowers had economic incentives to exit the facilities as market conditions normalized, and the rates that the Federal Reserve charged on its lending programs did not provide a subsidy to borrowers."

Europe: Of course, the big story continues to be Europe and the push there for fiscal integration among the European Union members (to match the monetary integration, i.e. the Euro). The bottom line from last week’s developments is that a “small step” was taken towards fiscal union. Germany and France in particular are insisting upon a tighter fiscal union before they back European Central Bank bond purchases of European Sovereign debt (BCA). That makes sense, as buying bonds (lending money) without a commitment from the profligate to reform rarely turns out well, whether for children or for countries(!). And Mario Draghi, the new European Central Bank President (succeeding Jean-Claude Trichet) is Italian, so ECB debt-buying would obviously fuel charges of favoritism towards Italy. But the ECB did decide to cut rates last week (25bps) and passed a few other measures to improve access to funds by European banks. Meanwhile, Italian Prime Minister Mario Monti proposed an austerity plan that included pension reform, tax increases , and raising retirement ages. And the Greek parliament approved a 2012 budget which includes pension reform and wage cuts (and higher taxes).

And expanded role for the IMF is also in the works, as global governments (that’s where the IMF gets its funds) are eager to help backstop the European financial system, provided that Europe retains the most skin in the game. Moving too quickly with IMF funding is tricky, because as former IMF Director of Research Raghuram Rajan points out, “the problem with some of these countries now is you’re getting to a point where debt is large enough that defaulting on the IMF is attractive enough if you want to reduce your debt.” In other words, you still want to make sure that the bulk of the burden of disorderly defaults falls within Europe – not the rest of the world through defaulted IMF loans. That way the pressure to make tough decisions within member countries stays high. But the clock is ticking, as Italy needs to roll over about $445 billion in debt next year, Spain about $157 billion. So the key is to move as quickly as possible without moving stupidly!

US Economic Data last week continued to point to modest expansion: Both manufacturing and service PMI’s were up slightly over September’s readings and were in expansion territory (in contrast to Europe). There were also modest gains in factory orders, chain store sales, construction spending, and private payrolls. The unemployment rate fell slightly to 9 percent. There are very few longer-term optimists out there, which I find a little curious. Because monetary policy is extremely accommodating and likely to remain so for some time, fiscal policy - taxes and spending - will become the key determinant of US economic growth going forward. It is hard to imagine not getting more clarity on these over the next twelve months, which should be bullish. Markets are pretty nimble, and the US economy can adjust to any level of inflation, interest rates, taxes, and regulation. It is when changes in these variables are on the table and uncertainty is high that you get muted economic activity. I would not go as far as Art Laffer did recently in Lubbock, where he predicted that Republican victories in Congress and the White House will lead to an economic recovery and a bull market greater than that of the Reagan years (Lubbock Avalanche-Journal). In fact, the consensus of economists and politicos that I have seen, have President Obama remaining in the White House and a narrowly Republican Congress – a prescription for conflict. But a case can be made to temper the doom and gloom a little bit.

On that note, I was at a large West Coast investment conference last week where former British Prime Minister Tony Blair was the keynote speaker. I jotted down a few items that I thought would be of interest to Kee Points readers. Blair is an optimist but pretty conservative, so I hope this is not too offensive:

 “It is true that China will be a major force, but it is also true that it is doing so by opening up and becoming more like us and will continue to do so.”

“Yes, technology is changing everything at a breath-taking pace, but where’s the hub of that activity? Right here in California.”

“There are reasons to take heart. Ask yourself, are people trying to get into your country or trying to get out? That’s the measure of how a country is doing.”

“Democracy is a state of mind...the freedom to speak, freedom of religion, economic freedom. These are all at least as important as the freedom to vote.”

On Occupy Wall Street: “One of the things I learned as Prime Minister was that those who shout the loudest don’t necessarily need to be heard the most.”

“If you think investing is tough right now, try the Middle East Peace Process...we live in an era of uniquely low predictability.”

 “The dominant issue right now is not how to keep another financial crisis from occurring, it is how to get the economies growing.”

And here was the show stopper, which got a standing ovation – surprising to me given it was in San Francisco: “America wants to be liked. It should give up trying to be liked. Just be strong. People around the world might never say publically that is what they desire for America, but it is.”

Europe: Anything that reduces the perceived risk of financial collapse is going to have a positive impact on markets. Basically, European leaders brokered a package last Thursday that would bolster their bailout fund, help recapitalize European banks, and reduce Greece’s debt load (WSJ). Although the actual details won’t be known for a few weeks (or even months), the gist of it is that the European Financial Stability Facility (EFSF) will have the expanded capacity to provide guarantees for $1.4 trillion in bonds (up from about $600bb). It is hoped that some of these funds will come from countries such as China, Japan, Brazil, and even Russia, perhaps with the IMF acting as the intermediary. Another key plank in the proposal was halving the value of Greek government bonds in private hands (the 50% “bondholder haircut”), which was also a crucial step towards a European solution. Of course, the European debt problem is ongoing, and I think it is safe to say that markets will be swinging up and down based upon European news – positive and negative – for months if not years to come. European economic growth is already waiting in the wings as the new headline concern when and if the debt problem gets resolved. And many feel that the act of writing off Greece’s debts will slow the implementation of necessary fiscal austerity measures there.

US GDP grows by 2.5% in the Third Quarter. We expected the second half to be stronger than the first, and Thursday’s 2.5% third quarter GDP number reaffirms those expectations (the economy averaged about 0.9% growth in the first half). Though 2.5% is not enough to generate new jobs, it does reflect an acceleration of growth throughout this year. Business spending on equipment and software surged 17.4% (even non-residential fixed investments rose 16.3%), and consumer spending increased (2.4%) as well. This supports the observation that many of the relationships between widely watched indicators and the economy have not held up during this expansion. That includes the ISM Purchasing Managers Indices, the Philly Fed index, and even the UCLA-Ceridain Pulse of Commerce Index. Kind of recalls the first lesson I learned as a macroeconomist, which was, prices lead quantities. Market-based or “price” data like interest rates, the slope of the yield curve, and credit spreads, contain more forward-looking information than quantity data like employment, GDP, or even industrial production (quantity data is sample-based, backward looking, and usually gathered with a lag). Since price-based indicators have not been signaling recession (while many quantity-based indicators have been ambiguous), the notion that prices lead quantities continues to be a piece of wisdom worth hanging on to. Also, Kee Points readers know that GDP exhibits strong seasonality. That is, some quarters are regularly weaker or stronger than others. The first quarter is by far the weakest on average. Keep that in mind when the headlines start anticipating firstquarter numbers. Finally, various estimates for the fourth quarter and for 2012 GDP growth seem to fall in the 2% range.

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Billionaire Sam Zell, father of the REIT (real estate investment trust), who in 2007 sold Equity Office Properties Trust for $39 billion, the largest private equity transaction in history at that time.Dr. George Friedman, Founder of STRATFOR (strategic forecasting) and author of several books including The Next 100 Years: A Forecast for the 20th Century.George Roberts, Co-founder of KKR (formerly Kohlberg Kravis Roberts), a private equity firm and pioneer of the leveraged buyout industry.Jim O’Neill, Chairman of Goldman Sachs Asset Management who first coined the acronym “BRIC” (Brazil, Russia, India, China).Global investment strategists from Goldman Sachs, JP Morgan, Morgan Stanley, etc.Here are what I felt were the 16 most provocative statements and insights. I don’t have the entire transcript so I will not attribute statements to individuals.My biggest take away is how at odds very informed people can be on the same issue.
The consensus was a recession in Europe, slow growth in the U.S., but improving and continued growth in emerging markets. “The emerging or ‘growth markets’ are more important than what’s happening in Europe, it’s ridiculous to call them emerging. The BRICS will be larger than the U.S. by 2020.”China’s growth going forward will be slower (6-8% vs. 10%+) by design as China transitions from an export-oriented economy to a consumer oriented economy. “They are focusing on the quality of growth now instead of the quantity of growth.”Most felt that this would constitute a soft (gradual slowing) landing rather than a hard (plunge in growth) landing, but several dissenters felt that a hard landing is already showing up in the data, and that China has nothing but massive income inequality and growing unrest in its future. “The vast bulk of the population is extremely poor….China is a very poor country.”Latin America was favored by just about all, particularly Brazil: “Go where your money (investment capital) is most valued. China has tremendous growth opportunities but doesn’t need your money. Brazil has tremendous growth opportunities and does need your money.”“Slower China growth means lower energy and commodity prices, which increases developed world incomes.”“Biggest problem in China is lack of rule of law.” “……I wouldn’t invest a dime in Russia; it’s a kleptomaniac economy with no rule of law.” A different presenter noted that he thought the best investments were in Russia and Japan.“Japan is and will continue to be the real center of gravity in Asia, not China or India. Japan has the human capital, the physical capital, the know-how, and the culture to dominate the region.”“The key to emerging markets is the tremendous pent-up demand for mobile phones, cars, and air conditioning.”“There is nothing in the world for which there is greater demand than low cost housing.”“The next election in the U.S. is the most important in U.S. history and will determine the U.S.’s fate for some time to come.”“Any economic statistic with a decimal point is nonsense. For example, China doesn’t have any idea how fast it is growing, nor does anyone else.”“The Soviet collapse was a defining moment, as is the current crisis in the European Union. The United States, by contrast, is remarkably stable.”“In emerging countries, don’t look at the BMWs and Mercedes. Look at the tires. That will tell you how they are really doing. Always look at the tires.”“China is becoming much more repressive internally.”“China is buying global assets just like Japan did before they blew up (e.g. Rockefeller center)…what happened to the common sense notion of doing what the insiders are doing? The insiders in China are investing everywhere except China!”“India is not one country but several countries…makes no sense to talk about “India” as a single country”
DISCLOSURES
This e-mail is for general informational purposes only and sets forth the personal opinions of its author as of its publication date. This e-mail contains no recommendations to buy or sell securities or a solicitation of an offer to buy or sell securities or investment services or adopt any investment position. This e-mail is not intended to constitute investment, legal or tax advice and should not be relied upon as such. Market and economic views are subject to change without notice and may be untimely when presented here. You are advised not to infer or assume that any securities, sectors or markets described in this e-mail were or will be profitable. All material and information presented is compiled from sources believed to be reliable, but accuracy cannot be guaranteed. Past performance is no guarantee of future results. There is a possibility of loss. South Texas Money Management, Ltd. and/or its employees may engage in securities transactions in a manner inconsistent with the above.

©2011 South Texas Money Management, Ltd. All rights reserved.

Jim Kee, PhD, President & Chief Economist
South Texas Money Management
100 W. Olmos Drive, Suite 100
San Antonio, Texas 78212
(210) 824-8916
www.stmmltd.com

Going back to the 1920’s, the third quarter is by far the worst quarter for stocks (first quarter is the worst for GDP), but this third quarter was truly awful! And there was no shortage of reasons for it: a raucous debate over raising America’s debt ceiling, a downgrade of the world’s risk-free asset (U.S. debt), Europe’s intensifying debt problems, a President who would rather impose on the “rich” than make a move toward the middle, and, of course, hurricanes and earthquakes (Strategas). I certainly hope the fourthquarter has a few more positives!

We will bereleasing ourthird quarter webcast this week, and I usually give a summary of my portion in theMonday Smart Points. Here are 12 key ideas:
Even though U.S. economic data is weak, it still points to continued, moderate expansion, not recession. That’s true of production data, jobs, sales, durable goods orders, etc.The same can also be said for some of the more reliable recession indicators.Remember that recessions are usually preceded by declines in housing and autos (“consumer durables” spending), but these cyclical drivers have already “crashed.”Unfortunately, they also normally lead expansions, but they haven’t this time, not yet anyway. Fortunately, business investment spending and exports have filled the gap.Until these consumer durables rebound, the U.S. will be more dependent upon and sensitive to exports and global growth (i.e. China), than it normally is.As an aside, housing and auto purchases require confidence in employment, which comes from more overall job creation, which comes from business confidence to hire.Business confidence to hire has probably not been helped by regulatory uncertainty and change in healthcare, energy, financials, and stepped up actions by agencies like the EPA.An interesting conclusion to be drawn from this is that more certainty on the policy/regulatory front should make us less dependent upon exports for growth because it would likely lead to an upturn in hiring and discretionary (“consumer durables”) spending.That’s not the only reason why global forces matter. The world’s economies, not just their stock markets, are more synchronized or correlated now than they once were. In the 1990s, for example, a lot of the world – Japan, Europe, Asia – could be mired in recession, low growth, or outright collapse while the U.S. economy could continue to chug along. However, increased global interdependence means that this is probably less true today, and a given international macro-shock could affect the U.S. economy more than it would have in the past.10) Europe’s inability to deal seriously with its debt crisis after almost two years is causing concern in this new globally interconnected market. We didn’t think the Japanese tsunami, the rise in energy prices that peaked in May, or Middle East disruptions could move the U.S. economy from expansion to contraction, but a mishandled European debt crisis probably could.The Europeans need to move quickly to expand their lending facilities, and profligate countries need to make good on commitments to make some cuts. I think they will.Global financial stress indicators seem to be saying the same thing: heightened concerns but not a 2008 repeat.Conclusion: We have to see how things unfold, pure and simple. One guidepost I’m watching is the third quarter GDP number, to be released at the end of this month. If it is stronger than the second quarter (1.3%), then things are on track. If it is weaker, then they aren’t.

DISCLOSURES
This e-mail is for general informational purposes only and sets forth the personal opinions of its author as of its publication date. This e-mail contains no recommendations to buy or sell securities or a solicitation of an offer to buy or sell securities or investment services or adopt any investment position. This e-mail is not intended to constitute investment, legal or tax advice and should not be relied upon as such. Market and economic views are subject to change without notice and may be untimely when presented here. You are advised not to infer or assume that any securities, sectors or markets described in this e-mail were or will be profitable. All material and information presented is compiled from sources believed to be reliable, but accuracy cannot be guaranteed. Past performance is no guarantee of future results. There is a possibility of loss. South Texas Money Management, Ltd. and/or its employees may engage in securities transactions in a manner inconsistent with the above.

©2011 South Texas Money Management, Ltd. All rights reserved.

Jim Kee, PhD, President & Chief Economist
South Texas Money Management
100 W. Olmos Drive, Suite 100
San Antonio, Texas 78212
(210) 824-8916
www.stmmltd.com

We are anxious to get our quarterly webcast out a little early this week so clients can view it before the holiday. For my part I’ll be discussing the generally weak economic numbers, and why the data suggest that they are likely due to transitory, not permanent, factors. In fact, data glimpses are already pointing to continued global recovery, strong recovery in Japan, and a “soft-landing” in China (JP Morgan). Here are a few thoughts regarding last week’s news flow:

Greece: It appears that an agreement has been reached between Greece and the European community regarding a new Greek rescue plan (Financial Times), though the process is likely to take several weeks as details are ironed out between the EU, the IMF, France (Sarkosy), Germany (Merkel), and Greece’s austerity pledges. On a humorous note, one cynical strategist summed up Greece’s acceptance of austerity measures in return for cash from the European Central Bank (ECB) by saying… "that’s pretty much how Greece has always operated, taking cash up front and dealing with the debt later. Why should anything change?” (Jefferies). Stratfor makes the point that France and Germany and other European member countries are trying to “circle the wagons” around the debt-ridden European periphery through loans while at the same time responding to the populist sentiments of their own people to force austerity measures on the profligate. A decisive vote over the permanent rescue mechanism will take place in the fall. Stratfor forecasts that “Germany and other eurozone countries will give in to the crisis in Greece, and will forward whatever loans are required to get over this political crisis.” That seems pretty consistent with the unfolding developments.

Be cautious regarding reports of U.S. Banks’ exposure to troubled European sovereign debt (Greece, Portugal, Ireland, Spain, and Italy). For example the Bank for International Settlements (BIS) issued a report stating that U.S. bank exposure could be 25% of the European total, smaller than Europe’s but substantial. Much of this is in the form of loan guarantees like credit default swaps. But JP Morgan notes that this appears to be a gross number, and that the net number (which would include off-setting guarantees and collateral) would be much lower. They cite Chase CEO Jamie Dimon, who noted that the bank’s exposure to the five countries was disclosed at over $100 billion, but that “doesn’t include collateral or hedges”; true economic exposure “was $20billion” at the end of 1Q11, and “is now $15 billion or less.” JP Morgan estimated the maximum possible exposure to these five countries of each large US bank and argues that a worst-case scenario would be neither trifling nor life-threatening to the banks.

Finally, I attended a national conference of my peers (other money managers) last week and wanted to share 2 observations in Smart Points:

(1)At the fixed-income panel there was near-unanimous consensus that municipal bonds represented the most attractive fixed-income investment from a risk/reward perspective. This is consistent with the view of our own Director of Fixed-Income, Hutch Bryan.

(2)I am increasingly bothered by international asset allocation discussionsbecause of what is“missing from the narrative.” Specifically, the following 4 points are missing: (1) Because of globally integrated markets, the “home country bias” in which an internationally-oriented domestic company trades in line with its domestic-only peers is disappearing, so you get a bigger diversification benefit from owning these international U.S.- domiciled companies than you used to (2) companies in the same sector from different countries tend to move together, so there might be some truth to the notion that sector diversification is getting to be more important than country diversification (3) emerging markets have primitive, export-oriented (rather than consumer-oriented) banking systems and tend to be concentrated in cyclical industries like manufacturing. That, and the lack of a long-term record of property rights/contracts protection, is why their equity markets traded at lower multiples. At least that’s what we economists thought. But emerging markets are no longer trading at lower multiples, though some of these characteristics still describe emerging markets. Just another thing that’s missing from the narrative (4) managers are fond of pointing out the outperformance of international equities over domestic equities during the past decade. But that decade followed the now-forgotten collapse of the emerging markets in the late 1990s, and the unforecasted global boom that followed. Expectations were low (growth not priced in) for many international equities 10 years ago. That’s certainly less true today.

DISCLOSURES
This e-mail is for general informational purposes only and sets forth the personal opinions of its author as of its publication date. This e-mail contains no recommendations to buy or sell securities or a solicitation of an offer to buy or sell securities or investment services or adopt any investment position. This e-mail is not intended to constitute investment, legal or tax advice and should not be relied upon as such. Market and economic views are subject to change without notice and may be untimely when presented here. You are advised not to infer or assume that any securities, sectors or markets described in this e-mail were or will be profitable. All material and information presented is compiled from sources believed to be reliable, but accuracy cannot be guaranteed. Past performance is no guarantee of future results. There is a possibility of loss. South Texas Money Management, Ltd. and/or its employees may engage in securities transactions in a manner inconsistent with the above.

©2011 South Texas Money Management, Ltd. All rights reserved.

Jim Kee, PhD, President & Chief Economist
South Texas Money Management
100 W. Olmos Drive, Suite 100
San Antonio, Texas 78212
(210) 824-8916