How the world looks in May 2010- AM

1. Economic reports in US remain strong including solid ISM manufacturing and non manufacturing data, increasing business investment and inventory building, positive retail sales, improving auto market, as well as stabilizing home sales; all signs towards 3% GDP growth for rest of the year.
2. Inflationary pressures have not yet manifested, partially due to strengthening USD
3. Consumer spending is improving and taking over from manufacturing in leading the recovery
4. US continues to display ability to finance its deficit at record low levels historically, which should further help economic activity for businesses and individuals by lowering their financing costs
5. European contagion has almost confirmed US Dollar's strength for the rest of the year
6. Chinese economy's structural flaws that include over-reliance on fixed asset investment as an economic growth vehicle, as well as the huge stimulus that was wastefully spent in real estate, are finally manifesting themselves. The inflationary concerns on top of the real estate bubble whose existence is no longer denied, threaten to derail not just the Asian role in the fledgling global recovery, but growth of commodity exporting nations like Australia. Also, it does not help that Eurozone is China's biggest trading partner, and a slower growth in Eurozone shall ensure lower exports growth; importantly it places a bigger leverage in US hands as it becomes China's most important export market by a long margin.
7. Risk recalibration is on, and shall change the growth expectations, as growth seeking capital returns to US shores due to increased perceived risk in Eurasia, with the US proving to be an Oasis of growth in a world of troubled markets.
8. China's chance of a hard landing are increasing driven by following chief reasons, a) real estate speculation is a cultural phenomenon, and will prove very hard to control, b) Financial system is extremely young and the stimulus loans will return very high delinquency rates, purely because of poor risk management practices, driven by misalignment of economic objectives between different players in the real estate supply chain,especially local governments who depend on property sales for majority of their revenues.
9. This will have an adverse effect on commodity exporters, especially Australia whose recent decision to impose a 40% tax for mining profits, along with the real estate bubble of their own, combined with extremely leveraged consumers whose debt to income exceeds even US, makes for very disturbing next few years.

Framework of Life

Purpose: Set of guidelines that should help us determine the action in almost all spheres of lives (personal, professional,family, friends):

1. Be Fair, Be Ruthless.
2. Boldness in execution, Patience in declaring victory.
3. You can't achieve your aspirations just by pure effort, you need good karma too!
4. Short term pain might be needed on occasion to achieve long term gain
5. Surround yourself with better people and by better I mean: more enthusiastic and positive towards life, more hungry for knowledge, more humble. Also, a person who has all these qualities and been through your aspired path makes the best mentor. Who is your mentor?
6. Truth suffers from too much analysis. Identify the basic premises of the most complex problem structures, and then ask yourself, what does it do.
7. Never accept arguments at face value; Question the basic assumptions irrespective of source credibility.
8. When the facts change, I change my mind. What do you do, Sir??
9. Differences between friends & family is analogous to free markets and central planning. In other words, family setting is like socialism and friends like capitalism. Understand the choices you make within this context.
10. Expose yourself to the black swan events.
11. There is never just one cockroach - especially true with markets, scandals and wrongdoings in and around you.
12. Nature abhors a vacuum.

Q4 Forecast - AS

1) Auto sales break 10.5 million mark, pointing to a second month of sustained demand after expiration of C4C.
2) Payroll losses will come down to 110,000, while unemployment rate climbs down to 10.2% in November, and 10.1% for end of 2009
3) Retail sales will continue to exceed the YonY comparisons, and GDP growth of 4 % in the last quarter
4) Job creation to begin from Q1 (positive payroll numbers), earlier than expected
5) Equity markets will see the dip
6) Dollar Index will continue to fall to 72
7) New normal

Q4 Forecast

End of the year forecasts for major metrics

1) Auto sales break 10.5 million mark, pointing to a second month of sustained demand after expiration of C4C.
2) Payroll losses will come down to 100,000, while unemployment rate climbs down to 10 % in November, and 9.9% for end of 2009
3) Retail sales will continue to exceed the YonY comparisons, and GDP growth of 3.5 % in the last quarter
4) Job creation to begin from Q1 (positive payroll numbers), earlier than expected
5) Equity markets will continue to lead the way, as the signs of a firm recovery begin to strengthen
6) Foreclosure rates will start declining from Q1-2010, and follow the path of credit card delinquencies which are already on the way down in Q4 2009.
7) Back to the old normal

Dislocation In The Credit Markets

As we are becoming more optimistic about the sustainable recovery, there is a question being asked: “have we returned to pre-Lehman Brothers collapse norms in the credit markets?” In analyzing the different dislocations, many pundits and policymakers have expressed concerns about the persistence of a negative 30 year swap spread which occurred on 23^rd October 2008 for the first time. As we know, a swap spread is the difference between the fixed leg of the interest rate swap and the treasury of same maturity. In other words, the swap spread reflects the risk premium for money market rates over treasury yields. A simple minded interpretation of this fact would be that US is more likely to default on its debt than the banks transacting in the money market. Now, after a year of negative 30-year swap spreads – which shows little sign of turning positive - some in the market are becoming comfortable with the notion, particularly as the US government continues to fund a surge in borrowing. In my opinion, this analysis and interpretation is simply false. The government which has enabled these banks to stand and walk can’t be more risky than those banks themselves. That leads to what the reason is?

I believe this is a technical dislocation in the market arising due to the limits to the arbitrage arising from inadequate capital, leverage and cautious move from players who invest at the long end of the curve – pension funds, mortgages. The assumption which we have made for long period in Finance that treasury is less risky and any arbitrage arising out of this violation will be wiped out is not at play because of four main reasons. First, the trade requires capital – commissions and collateral for the repurchase agreement and swap. Repurchase agreement allows a borrower to use a financial security as collateral for a cash loan at a fixed rate of interest. Given the losses suffered by financial institutions, there is little risk capital in the marketplace. Second, when the contracts written by Lehman disappeared, some dealers were forced to take significant write downs. This highlighted the under appreciated risk of counterparty exposure in the interest rate derivative markets. Given the counterparty risk concerns present currently an arbitrageur may be reluctant enter a swap. Lastly, driven by the policy need to meet deleveraging standards, firms continue to sell the 30 years treasuries on their balance sheets. This deleveraging has continued to keep the yield high (more supply -> less price -> high yield).

Another important player that is driving the demand for the fixed leg of long term interest rate swap is pension fund. Pension funds need to hedge long-term liabilities (30 years and beyond) by receiving fixed or floating on long-maturity swap rates. Some pension funds concerned about falling rates (which will make the NPV of their liabilities higher) put on new swaps. They could have also achieved their goals by purchasing 30-year bond, but many were trying to preserve their liquidity, focusing instead on swaps. The perseverant demand for the fixed leg of 30 year swap has kept the yield low. In my mind, this is a technical dislocation which should come back to normal in due course of time. I strongly reject the notion that increased borrowing by US has increased the long term risk of default by the US and the risk of default is lower for banks.

However, rejecting this fact by just terming it as a dislocation will be injustice. If prices on such a simple trade are distorted because normal arbitrage forces do not operate, what is the state of the pricing on more complicated assets? What other assets trade with such a long term trade horizon? I see MBS and its derivatives such as CDO and CMO. The spread on GNMA mortgages used to be around 75 basis points (Treasury yield + 75 bp). This spread has gone up to 150 bp in the recent past. A simple explanation would be that investors value the liquidity of treasuries during crises and the yield on all other securities goes up, asking for extra premium. However, as the confidence is restored and the volume of transactions pick up, this should shrink. For financial institutions, this is important because it suggests that the value of financial claims reflecting future mortgage risk is especially low. As the spread tightens, the value of those cash flows will increase. Hence the losses on financial institutions balance sheets are larger than they would otherwise be if prices were at fundamental value.

Unemployment: "The new normal" or back to normal?

As we enter the final stretch of the year, the consensus is being formed that the worst is indeed behind us, and the conjecture is being focused on how the shape of the recovery for the US economy is going to look like. From the federal reserve, to leading economists everywhere as well as the central bankers of the G-20, all seem united in their opinion that the lows reached by the financial markets in United States during spring 2009 are now firmly behind it

Having said that, the key economic indicator that will define the nature of recovery are the unemployment levels, and the ability of the US economy to replenish the 7.2 million jobs lost since the recession began in December 2007 ( maybe 8 million based on recent reports). In addition to replacing the 7.2 million jobs, the economy needs an additional 1.2 million jobs a year just to keep up with population growth. The key question becomes, where will the new jobs come from. Health care is among the usual suspects, but the Labor department estimates health care will add only about 300,000 jobs a year through 2016. Other sectors could include alternative energy and education. President Obama envisions the US to create 5 million “green” jobs in the next decade, from solar and wind to energy efficiency, and with a “new normal” in crude prices establishing itself quietly ( >$60 a barrel) , alternative energy might just finally deliver in accordance with its long awaited potential.

As noted by George Friedman (Stratfor) in his latest book, “the next hundred years“, technology developments in US has seen a pattern, starting with the basic research done resulting in conceptual breakthroughs, modest implementations and some commercial applications. Next comes a pressing crisis that forces the government to infuse large amounts of money into the project to speed development towards specific needs. Finally, the private sector takes advantage of commercial applications of this technology to build entire industries and drive economic growth. He mentions this in context of the two big technological developments of the 20th century that drove unprecedented growth in American economy,. First was the Interstate system started by the Eisenhower administration inspired by the German autobahn’s immense utility in the World War II. Next was the development of ARPANET out of defense funding to improve distant communications, that ultimately spawned the internet industry. Whether this pattern will extend itself to alternative energy, is a question that might hold the key to the recovery of jobs lost.

Finally, let us look at how historically unemployment has fared. Since 1948, the average rate of unemployment has been 5.6 percent, and the figure is similar at 6 % for the last 30 years. To reach this historic normal of 6 %, the US economy will need to add around 10 million jobs in the next five years, translating to roughly 2 million jobs in a year. Good news is that in 1990s. on an average 2.15 million private-sector jobs were added annually, so this pace of job creation has a historical precedent.

To conclude, based on current forecasts, the annually averaged unemployment rate for calendar year 2009 will be around 9.2 %, which compares with rates of 9.7 percent in 1982, and 9.6 percent in 1983. This would suggest unemployment levels will remain in the high 9 percent in 2010, which is comparable to most economists forecasts of low 10 percent unemployment. However, the silver lining in this cloud just might be 2011, like 1984 was in the previous recession, when the unemployment rate fell from 9.6 to 7.5 within a year. I believe the unprecedented speed of the correction waves in the labor markets that we have seen so far in this recession that surprised everyone on its way down, carries in itself the seeds of recovery. And when the recovery wave starts to rebound before 2011, it will surprise the consensus again on its way up.

The shape of recovery - L,U,V,W -- English Alphabet is falling short ..

“It’s the level, stupid – it’s not the growth rates, it’s the levels that matter “– said governor of Bank of England Mr. Mervyn King. Mr. King expressed serious concerns about where we are in recovery, especially because of the fact that people had no patience in declaring victory. As Paul McCulley from PIMCO said ‘boldness in execution is not a vice but patience in declaring victory is indeed a virtue’. Mr. King is reminding us of that virtue. When we look at the absolute value of key drivers of economy such as wealth, debt, unemployment, consumption and investment, we are far from what would be a desired and required level to put us on the track of robust recovery. This brings us to the question: Going forward, what shape of recovery would we see?

Most of the optimism is coming from the recent rally in stock markets. I did a simple analysis by looking at the revenue of top 25 performers of S&P and as is widely being talked about, and noticed that these firms didn’t show much increase in revenue. In fact, in 9 cases, revenue went down but the firm improved its net income and the stock price. Moreover, when I look at the valuations of a lot of companies, a growth rate of 4-5% has been priced into the equity value. So the current valuation is not realistic because 1) A growth rate of 4-5% in the US economy is not achievable anywhere in the near future and 2) When the firms are increasing their free cash flows by cutting cost and not increasing revenues, I don’t see how consumption and employment are going to increase. In my opinion, the US is going to see 2-3% of growth in 3-years timeframe.

So far, the growth in the economy has been driven by government support. Government took exceptional measures, rightly so, to avoid another great depression, and in the process, injected lot of money. This has created huge deficit, a level that is unprecedented, and in order to cover the deficit, US will have to increase taxes. If we look at the value created by corporate America, there are three pieces in it: 1) corporate profit 2) Return on Investments in the US and 3) Taxes. As the tax will increase, corporate profit will reduce. People are wounded after the collapse of US investments and have are not inclined to put the money back here. Secondly, a weak US Dollar will make the absolute return on investments less valuable than they would have been otherwise. Together, it would mean that either firms employ less people or they move outside of the US in order to save taxes. We already witnessed an unprecedented event in 2nd quarter when the US firms filed higher taxes abroad than they did in the US for the first time in history. I cannot stress the point enough that the current unemployment levels would persist. Going forward, I believe the dominating theme would be deleveraging (in the financial sector), reregulation and conservative spending. Deleveraging and reregulation would increase government’s intervention and reduce private firms’ ability to take risk and hence will suppress innovation. Spending cuts would mean lesser cash flows to scientific institutions, research and development and academia, all of which are the lifeline of this country and have ensured this country’s lead over the rest of the world. This lead would be in serious jeopardy and will seriously undermine the key strength of Corporate America.

70% of US GDP comes from consumer spending. With increase in private savings rate (not to be confused with national savings rate) and the destruction of household wealth, it is easy see that consumption will go down, shrinking the US GDP and bringing it down to much lower levels from what we saw in 2006. In addition, credit is not going to be easily available (another pre-requisite for the entrepreneurial spirit of this country). Looking at outstanding commercial and industrial loans, we see that credit has been continuously shrinking from October’08 to September’ 09. Cash assets in all commercial banks have gone up. Banks are still sitting on cash and not providing money to consumers. Cash reserves are still in the range of 800B-1150B USD, compared to 370B USD which we saw between 2004 and 2008. Consumption will continue to be low and credit availability stringent. This will put us into a New Normal – a term coined by Mohammed El-Erian at PIMCO. (This is in sharp contrast to China where consumer behaviors are already changing and with one of the fastest recoveries of any country, it is poised to overtake Japan as the second largest economy three years sooner than had been forecasted for a long time).

The broader point I am trying to make is that the fundamental problem with the US economy hasn’t been solved. Recovery has been made possible by government spending and the spending needs to be continued. I definitely see that Ben Bernanke is willing to do so but will the politics let him do that? This poses a big policy risk. Policymakers in the US will support a weaker USD in the short term in order to reduce debt by promoting export but how will that impact the global economy? In a recent interview the French Finance minister said- “no one likes weak US Dollar”. China definitely doesn’t (being the largest external holder of US treasury) and since US imports the most amount of oil from Canada, Canadians don’t like it either.

I believe that no letter in English alphabet can define the shape of recovery but if you force me, I say it would be the combination of L and V with few dips on the way. The path to recovery will depend not only on the decisions made by policy makers in the US but also how cooperative the global leaders are. If all countries are committed to ‘no matter what it takes to get back to normal’, I will be more optimistic. In between, not only fiscal and monetary policies but also the foreign policy will be critical. The political risk of a policy implementation is high, what with recent developments in Afghanistan, Iran and Russia’s ever so non committal stance to solving the Iranian crisis. Any non action can change L+V to W.