Gleanings II – 478 Compliments of Nick Rost van Tonningen Posted by John on September 23, 2012

In the mid-60’s Vietnam War spending started fueling inflation & the Fed’s monetary policy stance shifted to accepting more inflation as the price of lower unemployment (which trade-off failed).  In the 70’s there were two oil price “shocks”, the first, in 1973, drove the price of oil from US$2, where it had been almost since the beginning of time, within months to US$10 & the second, in 1979, after the fall of the Shah of Iran, to nearly US$40. This led to the “Misery Index” (the sum of the inflation- & unemployment rates) rising from 6.1% (1.6% + 4.5%) in 1965 to 20.7% (13.5% + 7.2%) in 1980 as inflation became a self-fulfilling prophesy, with business foreseeing more inflation & responding, not with hiring more staff but with anticipatory price hikes that stuck because buyers’ inflationary expectations boosted its pricing power. This created what the late Paul Samuelson called “stagflation” (i.e. a combination of low growth & high inflation) that peaked in 1979.

In 1978 Paul Volcker had become Fed Chairman with a mandate from President Carter to “wring out” inflation. So he jacked up the Discount Rate to 14% (for two days in early May 1981) & kept the Federal Fund Rate at 20%, or close thereto, for ten months starting in December 1980 (i.e. after Reagan was first elected). While this prompted the worst recession since the Depression, with unemployment in the Fourth Quarter of 1982 exceeding 10% & accusations flying of his “cold-blooded murder of millions of jobs”, by the late summer of 1982 the job was done & the Federal Fund Rate fell from 14% in early November 1981 to 8½% a year later, setting the stage for a seven-year period of economic expansion the length & vigour of which was all but unprecedented.

Bernanke’s September 13^th announcement has put paid to the resultant three decade-long era in which the Fed’s priority was to keep inflation within bounds & threw any doubts anyone may have had about his stand on inflation under the bus. He may be an expert on the Great Depression & wanted not to repeat the decisions that he believes aggravated it, but with his QE3 initiative he likely has, wittingly or unwittingly, entered a 1970’s-like inflation minefield. And his commitment that “A highly accommodative stance on monetary policy will remain appropriate for a considerable time after the economic recovery strengthens”, is akin to saying ‘we will keep our foot on the gas pedal, even after the car approaches the speed limit, until the sirens start wailing behind us’ (his use of the word “appropriate” on this occasion was purely judgmental & likely highly inappropriate). The question also remains how appropriate the rating agencies will view his plans & for how long they will continue to condone it, even if ceasing to do so could create a mess.

The Fed’s QE3 initiative also blew new life into the price of gold. After declining a bit before the announcement, it jumped US$50 to a seven months’ high afterwards. And what’s more interesting the chart seems to suggests that no attempt is being made to drive it down. This may be what drove TD Securities’ analyst Greg Barnes to comment “a higher gold price is indirectly one of the objectives of Fed Chairman Ben Bernanke’s open-ended QE. A higher gold price suggests a weaker dollar and increasing inflation, both of which are needed to spur economic growth and reduce its debt levels” – if so, QE3 heralds the onset of a ‘Brave New World’

The near-to-medium term consequences for the US government bond market could be serious. For it raises the spectre of the Fed going from being an incidental player in it for policy reasons  to becoming its only player of significance. If so, this could ‘knee cap’ what has historically been the largest, broadest & deepest financial market in the world. And at present 5-year UST securities yield < 1% & the 10-year maturity < 2%; so even non-taxable investors now can at best expect a negative real return on the former & barely break even in real terms at 10 years (assuming of course that the official inflation number is anywhere near realistic – for more on that, see below). The question is how Bernanke expects to keep the lid on rates when his new policy stance results in higher inflation & how he expects to get investors to accept significant negative real returns on their bonds which would contravene Rule No. 1 of investment, capital security (one way to achieve this presumably would be, as critics have been warning about for some time, to force US institutional investors by regulation to buy them willy nilly). And given the massive, & growing, size of the US government bond market, even a relatively minor diversion of funds spilling out of it into other markets would reinforce the already inflationary pressure therein from the unprecedented liquidity infusions of recent years (the effect of which could be further reinforced if the uptick in the velocity of money that may be underway were to be sustained). So the US bond market now appears to be “pricing in” higher inflation expectations.

US politicians have been baying like hound dogs about the “assassination” of the US Ambassador to Libya. But the Concise Oxford Dictionary of Current English, Seventh Edition (1982) defines it as “kill (especially a political or religious leader) by treacherous violence” & the general public thinks of it in terms of targeted killings by the likes of the contract killer in Frederick Forsyth’s The Jackal or the real life Carlos, or in an earlier era by misfits like Lee Harvey Oswald or Jack Ruby. But it appears he died from smoke inhalation inside an ‘inner sanctum safe room’ in the US consulate building set on fire by a mob incited to violence by people who, whether associated with al-Qaeda or not, believe they stand to gain from such mayhem or who, like the makers of the film, get their rocks off by inspiring it. And calling it an “assassination” plays right into their hands & is almost as thoughtless, inappropriate & stupid as Bush 43’s “crusade” talk after 9/11. The actors in the film now say they were misled, that the dialogue creating all the ruckus was dubbed in afterwards & that, when the movie says “Mohammed”, the actor can actually be seen mouthing the word “George”. Although quickly perverted by those desirous of fishing in troubled waters, the demonstrations all over the Muslim world appear to have started out spontaneously. This is in sharp contrast with those throughout China over the Senkaku/Daiyou Islands which were government instigated from the get-go, with those in Beijing being actually managed by the riot police that organizes demonstrators in groups of one hundred to throw eggs at the Japanese Embassy. And, as luck or bad management by Tokyo would have it, they coincided with the September 18^th National Day of Remembrance Holiday commemorating the Japanese invasion of China in 1931 & the suffering of the Chinese people at the hands of their Japanese occupiers in WW II (apart from its timing, Tokyo clearly misread what Beijing’s reaction would be, when it announced it would purchase the islands from their private owners as a pre-emptive move to prevent them from being developed by nationalists intent on poking a stick in Beijing’s eye). There are now fears that Beijing’s retaliation may include the dumping of Japanese government bonds (just as the last time there was a hassle over these rocks, two years ago, they limited the export of rare earth metals of critical importance to Japan’s electronics industry); if so, this would set a precedent that ought to strike fear in Washington’s heart.    .

On September 6^th Beijing announced it now has the systems in place to let any country wishing to buy, sell or trade oil to do so in Yuan. And it was no coincidence that the very next day Russia announced a deal with China which, among others, will allow Beijing to pay in Yuan for any oil it purchases from Russia – in the short run the former will help Iran circumvent the sanctions on its oil sales & financial transactions, and longer term both combined are a deliberate step in the process of undermining the US dollar’s reserve currency role.

The latest from America’s agricultural heartland is that, as in other drought years, USDA may be marginally overestimating the damage done to the corn crop, & that the recent rains came still in time to do the soybeans some good. Futures prices have started reflecting that.

In 2011 iPhones accounted for half of Apple’s total sales. When the iPhone 3 came out, one investment banking boutique had its techies take one apart & cost its components; they concluded their cost was greater than those of iPhone2 & that therefore, if sold at the same price as the iPhone 2 as Apple planned, it would have to sell more units to generate the same earnings. And amidst all the carefully-staged hype about its new iPhone 5, it is on many people that, while Apple may be selling more iPhones than ever, it appears to be losing market share to makers of devices using Google’s Android operating system since, according to one research firm, at mid-year Android devices accounted for 68.1% of all smart phones on the planet, up from 46.9% YoY, while Apple’s market share had dropped from 18.8% to 16.9% – Apple is also eating its own young; for much of the demand for its new products comes from iPhone owners upgrading from earlier versions; thus at last report 75% of iPhone owners plan to buy the iPhone 5). The problem with this business is that a company is only as good as its last product & that investors develop unrealistic expectations; then one misstep, or one shortfall from expectations, &, BOOM, their greatest supporters become their severest critics, and yesterday’s darlings become today’s dogs – look at RIM or Nokia &, long ago, at Microsoft!

On Wednesday September 13^th the C.D. Howe Institute, a Toronto-based, right-of-centre think tank, issued a report saying that house prices in Canada in recent years have risen faster than calculated by StatsCan & that, if a truer measure of house price growth had been used, inflation in Canada in recent years would have been almost 1% a year higher and that, if the ‘real’ inflation rate had been used, the Bank of Canada would have long since hiked interest rates – this seems to bolster the case of those in Canada & the US who been saying for some time that the official  inflation numbers are (intentionally) lowballing the real world situation.

Attracted by the abundance of cheap natural gas, South Africa’s Sasol is proposing to spend $8BN to build a plant near Edmonton that would use it as feedstock for a plant producing as much as 100,000 bbld of diesel fuel (with naphta as a by-product) that it claims is cleaner-burning than traditional diesel – this could be a big deal : Sasol is a world class company that has a number of similar plants all over the world & and the process it uses is well-proven, it’s almost one hundred years old & is what kept the wheels turning in Nazi Germany during WW II & in South Africa during the Apartheid era sanctions.

This may be heretical in the eyes of some, but would there really be that much difference in principle in the control that might be exercised by CNOOC/Beijing over Nexen if it were allowed to acquire it & that by Exxon over Imperial Oil? One problem with foreign takeovers in the past has been that the acquiror will promise Ottawa the moon & the stars beforehand only to renege on them afterwards. One way for Ottawa to gain ongoing leverage & eliminate that risk in this & all future major foreign takeovers would be to make a “golden  share” provision part of the approval process (i.e. we will happily leave you alone as long as you do as you undertook to do, but have a real hammer if you don’t!).

A 60-page report entitled The Results of the 2012 Chicago Council (on Global Affairs) Survey of Public Opinion and US Foreign Policy contains reams of data on how Americans feel on many foreign policy issues that, with one exception, will be reported on in more detail in the next Special Edition, the exception being that, while 70% believe US troops should be used to stop genocides & mass killings and 66% to deal with humanitarian crises, only 49% would approve their use if Israel were attacked & 28% if China attacked Taiwan (the latter of which cannot help but undermine the credibility of the Obama Administration’s strategic shift in military priorities to Asia). It notes that after a decade in which anti-terrorism was the focus of US foreign policy during which Americans endured two costly wars, a deep financial crisis & a slow economic recovery, they now find themselves in a world in which their traditional allies in Europe are waist-deep in a crisis of their own, dramatic changes are afoot in the Middle East, China is becoming a global power, and Iran & North Korea hard at work to improve their nuclear arms’ capability. So Americans are recalibrating their views on their country’s foreign policy & thinking of less costly ways to project its influence in the world, and less inclined to support the use of force abroad & more likely to endorse spending cutbacks in defense. The “Millennials’ ”, the 18-29 year-old age cohort, is in the van of this trend. They are less alarmed than older Americans about possible major threats to their country’s security from international terrorism, Islamic fundamentalism & China’s emergence as a world power. While most Americans still think their country is the greatest & most influential one in the world, they want it to have a lower profile. They don’t want to disengage from the Middle East but want fewer military bases there. They endorse a diplomatic-, rather than military-, solution on Iran. They appreciate the importance of Asia & admire its dynamism more than seeing it as a threat, even though they understand that in time Asia’s development could be a negative factor for the US. The survey also found that the media-hyped polarization on foreign policy is more fiction than fact : Americans in “red” & “blue” districts see foreign policy in remarkably similar ways & the foreign policy differences between the Republicans & Democrats are less a matter of substance than degree.

While it has received little, if any, mention in the Western media, according to WHO, the Democratic Republic of Congo is experiencing another Ebola outbreak : since May it has identified 72 confirmed, probable or suspected cases (one-third of them among health care workers), & 32 deaths. One reason healthcare workers are vulnerable is that misdiagnosis in their early stages causes them to take not enough precautions. WHO also suspects the actual number of cases & deaths is much higher because patients cannot be gotten to hospital in good time, because the locals have learnt that, once sick with Ebola, there is little a hospital can do, &  because early misdiagnosis gives the disease a head start in being spread.

GLEANINGS II – 478

Thursday September 20^th, 2012

LEAD IT OR LEAVE IT (G&M, Chrystia Freeland)

• That is George Soros’ message for Germany in the face of the CW in Europe that all the survival of Europe/the Eurozone needs is more decisive leadership & bigger cheques from Germany. In Vienna over the September 7^th weekend, & in a speech in Berlin on the 10^th, he joined those who believe Southern Europe’s fate needn’t be decided by Germany. He thinks the Eurozone could weather an “amicable” departure of Germany, but not a weaker member’s exit & that, left to their own devices, the currently sickly economies would soon be OK : “If Germany left, the common market could hold together and actually it would be a remarkable relief … The euro would fall in value, so the debt which is denominated in euro would also fall in value and the competitiveness of the debtor countries compared to Germany and other creditor countries would remarkably improve … when you look at the Latin euro – the euro excluding Germany – it actually compares very favorably, not only with Britain, but with the United States and Japan.”  And he warns the existing policy is dividing the continent into “debtors and creditors, with the creditors, led by Germany, … in charge and calling the shots, and the debtors relegated to an inferior status … threatening to become permanent.”

Don’t the creditors always “call the shots”? And his appearing to mix up Europe,the common market & the Eurozone must have been a ‘slip of the lip’. Having said that, those who last week waxed euphoric about the German Constitutional Court’s removal of the last barrier to Germany’‘s ratification of the ESM (European Stabilization Mechanism Treaty) may not have read the fine print or looked beyond the end of their collective noses. For not only did it “cap’” Germany’s participation to 190BN Euros (& ruled anything more would require the approval of both houses of parliament – & in the eyes of some approval by referendum), but its ruling also called on Berlin to ensure Germany could opt out of it in the event of a disregard for its interests & specifically noted “The Federal Republic of Germany must make it clear that it does not want to be bound  by the ESM Treaty as a whole if any reservations it might have shall prove ineffectual.” Meanwhile, Cyprus has become the latest mendicant, seeking a 16BN Euro bailout & Portugal’s 10-year bond yield has risen by 70 bps to above the “unsustainable” 8% level. 

TOP FED POLICY MAKERS DIFFER ON QE 3’s EFFECTIVENESS (G&M, Ann Saphir)

• On September 18^th Chicago Fed President Charles Evans told local businessmen “I am optimistic … we can achieve better outcomes through more monetary policy accommodation.” On the other hand, literally minutes before he said this, his counterpart at the Dallas Fed, Richard Fisher, currently a non-voting member of the FOMC, told CNBC “I would argue that it is less impactful right now because you have other things inhibiting businesses from making decisions on capex and employment … I don’t think this program will have much efficacy …and I would have voted against it.”

The ‘dove’ “is optimistic” & the ‘hawk’ “thinks”. One thing about nearly four years of super-low interest rates is that it has made life difficult for people living off their savings & exaggerated pension funds’ unfunded liabilities. But that hasn’t stopped the President of the Minnesota Fed, Narayana Kocherlakota, to go from being a mild hawk to a mild dove & the Atlanta Fed Chief Dennis Lockhart telling a business audience in his city on September 21^st that he had come to the recent FOMC meeting believing “there was indeed a call for action falling out of the discouraging conditions of slowing growth and still high unemployment.”to announce on September 20^th to declare that he had. These guys are like gamblers trying to beat the house!  

OBAMA GAINS IN OHIO, FLORIDA, VIRGINIA (Newsmax, Paul Hobin)