"Kee" Points with Jim Kee, Ph.D.

Italy: As I mentioned in last week’s Kee Points, markets have had a pretty good run without a solid pull-back, and the best candidate for causing one would probably be this week’s elections in Italy. Almost on cue the market declined precipitously today as Italian election results indicate a lack of unity there. This was the consensus view of professional economists, not some great insight on my part. Like all of the troubled southern European periphery, Italy’s problems go from tractable to intractable if its borrowing costs rise, so I’m not sure how much flexibility (of choice) they really have. Let’s see what the week brings.


The on-going budget crisis - two views from the Journal: Over the past week the Wall Street Journal published op-eds from Princeton’s left-of-center economist Alan Blinder (former Vice-Chairman of the Federal Reserve) and Harvard’s right-of-center economist, Martin Feldstein (former chairman of the Council of Economic Advisors under President Reagan). Blinder (Princeton) pointed out that because of the Budget Control Act of 2011 and the American Taxpayer Relief Act of 2013, the projected 10-year deficit picture has been reduced substantially, taking us over two-thirds of the way towards the $4 trillion deficit reduction target of the “grand bargain” which fell apart back in 2011. That’s worth keeping in mind this week as the headlines focus on spending sequestration and the continuing resolution that Congress is anticipated to pass by the end of March in order to continue funding the federal government. Feldstein (Harvard) outlined the three ways to avoid a pending entitlement spending-led crisis: (1) change the age at which individuals are eligible to receive benefits, (2) modify the inflation adjustments applied to future benefits, and (3) increase copayments in Medicare (“means testing”). As I’ve mentioned before here, that’s where I think we’re headed (those 3), not debt default or hyperinflation.


How to think about emerging markets: Emerging markets continue to be the high-growth areas of the world, and investors are rightly trying to understand them. This, from La Jolla Economics, is the best I’ve seen: An investment that adds more in returns to a portfolio than it does in risk is called “adding alpha.” On the other hand, an investment that goes up a lot when the market (or a portfolio) goes up, but goes down more when the market or portfolio goes down, is called “high beta.” For several years now, money managers have hoped that emerging markets had become “decoupled” from developed markets. That is, they hoped that if developed markets go down or crash, the higher growth emerging markets could continue growing. And since emerging markets have a lower “P/E” ratio in the sense that their total market cap (value of publicly-traded equities) is lower relative to their GDP than that of developed markets, their market caps (i.e. stock market valuations) should rise faster than those of the developed world. That’s the alpha case for owning emerging market stocks. Unfortunately, the facts of the 2007-09 bear market and the 2011 correction show quite clearly that when developed markets go down, emerging markets go down a lot more (and they go up more when developed markets rise). That means we are still in the “high beta” phase for emerging markets, rather than the decoupled “adding alpha” phase (La Jolla Economics).