Euthanasia of the Economy?

by John Mauldin

Today's Outside the Box comes to us from my good friend and business partner Niels Jensen of Absolute Return Partners in London. Niels gives us an excellent summary of how QE has affected the global economy (and how it hasn't). I have found myself paraphrasing Niels all week.

I also want to call to your attention an interview first posted at ZeroHedge between my friends Chris Whalen and David Kotok. This is an inside-baseball view of a not-so-minor issue involving central banks and ZIRP. The FDIC charges 7-10 basis points on deposits for the national deposit insurance scheme. At close to the zero bound, the fee means that banks can lose money on deposits. As Chris and David point out, this is just another distortion being fed into the system. David was the first to introduce me to this concept (and rather passionately). I have not written about it because it gets complicated quickly, but it highlights a very serious problem and one that is not dissimilar to the deflationary aspects of the Basel III requirements, working at odds with what central bankers are trying to do. This goes with my long-held contention that the models the Fed and all central banks are working with are simply inadequate to describe the complexity of the global economy, and we have no true idea what we are doing, just a guess and a hope.

Then there's this quote that appeared in the Wall Street Journal this weekend, from Friedrich A. Hayek's lecture "The Pretense of Knowledge," delivered upon accepting the Nobel Prize in economics, Dec. 11, 1974:

To act on the belief that we possess the knowledge and the power which enable us to shape the processes of society entirely to our liking, knowledge which in fact we do not possess, is likely to make us do much harm. In the physical sciences there may be little objection to trying to do the impossible; one might even feel that one ought not to discourage the over-confident because their experiments may after all produce some new insights. But in the social field the erroneous belief that the exercise of some power would have beneficial consequences is likely to lead to a new power to coerce other men being conferred on some authority.

Even if such power is not in itself bad, its exercise is likely to impede the functioning of those spontaneous ordering forces by which, without understanding them, man is in fact so largely assisted in the pursuit of his aims. We are only beginning to understand on how subtle a communication system the functioning of an advanced industrial society is based—a communications system which we call the market and which turns out to be a more efficient mechanism for digesting dispersed information than any that man has deliberately designed.

If man is not to do more harm than good in his efforts to improve the social order, he will have to learn that in this, as in all other fields where essential complexity of an organized kind prevails, he cannot acquire the full knowledge which would make mastery of the events possible. He will therefore have to use what knowledge he can achieve, not to shape the results as the craftsman shapes his handiwork, but rather to cultivate a growth by providing the appropriate environment, in the manner in which the gardener does this for his plants.

There is danger in the exuberant feeling of ever growing power which the advance of the physical sciences has engendered and which tempts man to try, "dizzy with success," to use a characteristic phrase of early communism, to subject not only our natural but also our human environment to the control of a human will. The recognition of the insuperable limits to his knowledge ought indeed to teach the student of society a lesson of humility which should guard him against becoming an accomplice in men's fatal striving to control society—a striving which makes him not only a tyrant over his fellows, but which may well make him the destroyer of a civilization which no brain has designed but which has grown from the free efforts of millions of individuals.

Finally, and speaking of Zero Hedge, I want to offer a personal note about what I think is an egregious affront to the integrity of a close friend. Zero Hedge published and then expanded upon a rather silly article written in the Toronto Globe and Mail about the “sweet” deal that Gluskin Sheff chief economist David Rosenberg gets, noting that his $3,000,000 salary seems high for a top-five executive at a public firm, and implying that Rosie decided to turn bullish in return for the pay increase, that in essence his opinion could be bought.

Let me state that Rosie is a close personal friend and that we try to spend as much time as possible together and keep up with each other on the phone about our views on the world. Since we are more or less in the same business (writing and speaking on investments), we also share rather deep data on our personal business situations. I know Rosie’s business situation first-hand. I have offered Rosie advice on that compensation package.

First, the sweet deal is Gluskin Sheff’s. I have argued to some of their management that Rosie is underpaid. I think I might have used the word massively. Why? Because he writes a newsletter that has 3,000 subscribers who pay a $1,000 a year – roughly equal to his salary. But in addition GS gets his brand – and it is a valuable one– more or less for free and still works Rosie's ass off traveling the country meeting with clients, all while he puts out a lengthy daily letter. The man is a machine. Now, kudos to Gluskin Sheff for getting that deal. I wish I could get him for that for Mauldin Economics. But Rosie is not overcompensated, based on his actual production numbers.

Rosie is one of the most popular speakers at my annual conference. This year, after having been bearish for years, he turned bullish while at my conference and presented the reasons why. He had been at GS for several years as a very firm, committed bear. He gets no more money contractually whether he is bearish or bullish. Like me, he just wants to get it right. We win some and lose some, but we call it the way we see it. To suggest that someone like Rosie can be bought (with what I think of as his own money from his newsletter sales) is ridiculous. Zero Hedge owes Rosenberg a major apology.

And one final point. The “author” of the ZH piece is “Tyler Durden,” which is a pseudonym. The name comes from a movie character in Fight Club. If you are going to trash someone, at least have the testosterone to do it using your real name. Man up, guys. And kudos to my readers, who when they respond to my letters almost always do with their real names and photos. None of this hiding behind the web BS. I notice that even when my thoughts get trashed, it is done civilly and with the respect of people arguing different opinions. As opposed to the situation on some other websites. But then, I always knew my readers were a cut above.

Time to hit the send button, as another meeting here in NYC is coming up in a few minutes. Tomorrow should be a very interesting day, and I will report what I learn at the CIO Investment Summit this weekend.

Your thanks for letting me vent analyst,

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Low Labor Force Participation Is Not Due To Demographics

by Lance Roberts

"Son, someday robots are going take my job."  It was the late 70's and my father was convinced that these "new fangled" computers were going to steal his job. At that time no one believed him but as it turns out he was right.  I have written extensively since the end financial crisis about the structural change to employment in the U.S. and the push to increase productivity to reduce employment costs and boost profitability.  I addressed this issue specifically in "The Great American Divide" stating:

"Suppressed wage growth, layoffs, cost-cutting, productivity increases, accounting gimmickry and stock buybacks have been the primary factors in surging profitability. However, these actions are finite in nature and inevitably it will come down to topline revenue growth. However, since consumer incomes have been cannibalized by suppressed wages and interest rates - there is nowhere left to generate further sales gains from in excess of population growth."

"This is why the gap between corporate profits and the number of working employees is the highest level on record.  Fewer workers, higher productivity and longer hours for the same pay, or less, equals higher corporate profits. This is great for executives, primarily the top 10% of wage of earners, who are compensated from rising share prices, bonuses and other performance related compensation.  However, for the 'working stiff,' there is little reward for their labor."

This "shift" has been critical to the employment landscape in the U.S. over the past 5-years as the number of individuals that are no longer counted as part of the "labor force" has risen above 90 million individuals which equates to roughly 36% of the entire working age population that are 16 years or older.  The chart of the labor force participation rate shows this problem graphically.

The dramatic drop in the LFPR since the turn of the century has been dismissed as a function of the "baby boomer" generation reaching retirement age.  The problem with that assumption is that a large portion of the "boomer" generation is unable to financially retire and are holding onto their jobs for both incomes and healthcare.  Secondly, even assuming that the "boomers" do all retire it does not fully account for the drop in the labor force participation rate.

In a recent study entitled "Labor Force Participation And Monetary Policy In The Wake Of The Great Recession," by Christopher Erceg and Andrew Levin of the Federal Reserve Board, the authors provide solid evidence that the decline in the labor force participation rate since 2007 has been due to cyclical factors–the recession and slow recovery–rather than to demographic factors.  The chart below shows the estimate of how large the US unemployment rate would be without this abnormal decline in the labor force, and they produced this amazing chart which summarizes their findings.

In other words, due to the weak economic recovery a large number of people have simply "dropped out" of the labor force but are not retired. Since the unemployment rate does not count the people who dropped out of the labor force it no longer gives a good reading of the state of the labor market. The unemployment rate would be much higher without this large decline in the labor force participation.

There really is no longer a debate over labor market performance during the recent recovery as both are unusually weak.  This also no clear way to measure the millions of individuals who have disappeared into the abyss of the uncounted.  Many of the 90 million individuals that are currently unemployed, and not counted by the BLS, would likely be more than happy to work given the opportunity.  However, in the current economic environment, those options are not widely available which is why there is very much a silent "depression" running through the underbelly of this economy. While we may not see the breadlines and soup kitchens that existed in the 30's, it is simply because they exist electronically and in the mail.

The real debate needs to be over the current economic policy makeup which is deterring real employment growth in the U.S.  The lack of fiscal policy from Congress, and dependence on monetary policy from the Fed, is not the prescription that this particular ailing patient needs.

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Brazil's markets deteriorating on rising uncertainty

by SoberLook.com

Brazil's economy contracted in the 3d quarter for the first time since the Great Recession. This was not entirely unexpected, though the drop was worse than economists had estimated.

Reuters: - Brazil's economy contracted in the third quarter for the first time since early 2009 as a steep drop in investment showed flagging confidence in what was recently one of the world's most attractive emerging markets.
The economy shrank 0.5 percent between July and September from the prior three months, government statistics agency IBGE said on Tuesday, missing forecasts in what has become a disappointing routine over the last three years. Gross domestic product had been expected to drop 0.2 percent, according to the median forecast of 40 economists polled by Reuters.
The weak quarter reinforced a dimming economic outlook for Brazil, which has struggled to contain inflation and stay competitive in recent years, tarnishing the reputation earned with a decade of robust growth.

All that wonderful government stimulus the Rousseff administration poured into the nation's economy recently has done little to rejuvenate growth. At the same time its withdrawal, combined with the Fed's taper, could create some serious headwinds for Brazil going forward.

Reuters: - The tax breaks and cheap loans unleashed by Rousseff have yielded meager results, and their withdrawal is now clouding the outlook for carmakers and furniture factories.
Public spending grew 1.2 percent in the third quarter, the economy's strongest driver of new demand, but officials have warned there is no room for more stimulus as tax revenues dry up and the government misses budget targets.
That leaves Rousseff without much fiscal firepower at the end of her first term. Next year promises to be a handful for the president, as she juggles preparations for hosting the World Cup, skepticism from business leaders and a likely withdrawal of monetary stimulus in the United States.

Some were hoping that the fourth quarter will bring better news, as October seemed to show improvements for the nation's manufacturers. But the latest data from Markit suggest that is not the case.

Markit: - The HSBC Brazil Manufacturing PMI fell to 49.7 in November, from 50.2 in October. After contracting at the margin for the entire third quarter, economic activity in Brazil’s manufacturing sector was unable to sustain October’s rebound and fell back below the 50 mark. Firms reported that output continued to climb, but at a slower pace than in October, while other key components such as new orders and employment all lost momentum.

With the 2014 general elections coming up and economic conditions deteriorating, the markets have been pricing in a difficult year ahead. The fact that the upcomong FIFA World Cup could bring massive and possibly violent protests is not helping. The nation’s equity market has underperformed materially against both the global and emerging indices, down over 17% for the year.

Blue: Brazil BOVESPA, Green: iShares EM Index ETF

What's particularly troubling is the sharp increase in long-term interest rates, as investors dump domestic government bonds. The 10-year rate broke 13.25% today.

Source: Investing.com

Some consider this a buying opportunity. Perhaps. Given such tremendous uncertainty however, it may be some time before Brazil's debt and equity markets begin to recover.

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China's swelling sugar stocks bode ill for prices

by Agrimoney.com

Sugar prices may stage a recovery in the spring, but could fall back below 16 cents a pound by the end of next year, dynamics from one of the market's most important drivers, Chinese imports, indicate.

A "sharp jump" in Chinese imports has been a "driving factor" in supporting sugar prices over the last four years, when they have, even at current levels, remained well above historic averages, Australia & New Zealand Bank said.

Indeed, China looks this year on track to import more than 4m tonnes of sugar for the first time in a calendar year since at last the mid-90s, thanks to an opening up of an arbitrage against elevated domestic prices.

Sugar values are being underpinned by high production costs, pegged by US Department of Agriculture staff in Beijing at 5,300-5,400 yuan ($870-886) per tonne, equivalent to about 40 cents per pound, besides by state purchasing to offer support for cane growers.

Imports were at one point in the summer some $200 a tonne cheaper than domestic supplies, even when the out-of-quota tariff rate and VAT on buy-ins were factored in, ANZ said.

Indeed, China's sugar imports hit a record 709,873 tonnes in October, and are likely to have remained strong last month, given the "persistence" of the arbitrage in August and September.

'Natural cap on prices'

However, while growing demand will swallow up much of the imported sugar, much is ending up in inventories too, with China's sugar stockpiles to end 2014 up 4m tonnes in two years to the equivalent of five months' supplies.

This will reduced the need for imports next year, "placing a natural cap on global sugar prices in 2014", ANZ senior ag economist Paul Deane said.

Imports may well halve to 2m tonnes next year, assuming the, unusual, arbitrage on imports closes – an outcome rendered increasingly likely by a rise in the price of Brazilian export supplies, by $70 a tonne quarter on quarter, and an increase in freight rates on the Brazil-China route of 20%.

'Prices vulnerable'

While it was "likely" that sugar prices "will need to trade above 17 cents a pound" in the first quarter of next year to curtail imports to China, "on the flip side, in the second half of 2014, this [price] level will act as a cap on the market", Mr Deane said.

"If [world] prices persist above 17 cents a pound in the second half of 2014, a lack of discretionary sales to China will occur.

"This leaves prices particularly vulnerable in the second half of 2014," and they may need to fall below 16 cents a pound "to help entice Chinese buyers to absorb Brazil's exportable surplus".

Market prices

Raw sugar futures actually rose in early deals in New York, adding 0.4% to 16.87 cents a pound as of 06:00 local time (11:00 UK time) for March delivery.

However, this follows a 10-session losing spree which has taken the contract to a nine-week low.

"The current focus on strong Indian and Thai production prospects continues to provide significant headwinds for the global sugar market," Luke Mathews at Commonwealth bank of Australia said.

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Drop in corn values to depress food prices in 2014

by Agrimoney.com

A slump in values of the likes of corn and soymeal will feed through into a fall in food prices for a third successive year in 2014, before a small recovery kicks in in 2015, Macquarie forecast.

The bank, launching its own food price index, said that food prices would fall by 9.6% next year, only marginally short of the 10.9% expected for 2013.

However, prices will return to growth in 2015, of 2.8%, with values rising across a range of agricultural commodities, with soymeal, wheat and cocoa notable among exceptions.

"The index entered the downside in 2012 and will stay in this overall bearish trend until 2015, when we expect both agricultural and soft [commodity] prices to recover," Macquarie said.

Corn to fall

The prospects for prices of feed ingredients, which Macquarie is using in its index as a proxy for meat values, look particularly poor for next year, with losses for corn and soymeal forecast at more than 20%.

"The animal feed components will again drive the index lower," said the bank, which is relying largely on futures, rather than physical, prices in compiling the index, called the MacPI.

However, staple grains, a segment including rice and wheat, will be the weakest performer in 2015.

"All commodity groups, except staple grains, should finally turn bullish by the end of 2015, with the animal feed and sugar components contributing the most to the MacPI recovery."

'Fill a gap'

The food price index adds to those already compiled by the likes of the UN Food and Agriculture Organization, the International Monetary Fund and the World Bank.

However, Macquarie said that its index, which is compiled from 28 agricultural commodities, also including the likes of arabica coffee, sorghum and rapeseed meal, differed in being weighted towards consumption, rather than trade.

"We believe that trade volumes can at times incorrectly interpret the significance of a commodity in terms of global consumption and thus under- or over-estimate the contribution of an item to the whole index."

Furthermore, the MacPI, which will be updated every Monday, offers a predictive element which the bank hopes will "fill a gap in the market" and appeal to the likes of economists, agribusinesses and food producers.

Political importance

Food prices, which have a rich history on a rising trend of causing social unrest, have also increased back up the political agenda with growth in prices of many agricultural commodities to levels well above past averages.

However, ironically, it is low prices of one crop, coffee, which is currently causing particular unease, among rural populations of the likes of Brazil and Colombia for which the bean is a key earner.

Macquarie's estimate of a 10.9% drop in food prices in 2013 compares with a World Bank figure of 12% drop over the past year.

The UN FAO index sees prices down 5.3% in the year to October.

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Russian Banks Most Exposed As Ukraine's "Precarious" Finances Spike Risk To 3 Year High

by Tyler Durden

Ongoing anti-regime demonstrations in Ukraine are weighing on investor's risk perceptions as CDS spike to near three-year highs today (up over 100bps). At a minimum developments lower president Yanukovich's chances of remaining in power beyond the spring 2015 elections and possibly undermine his hold on power earlier, further decreasing the likelihood of sizeable financial support from Russia. With Moody's earlier comments on the nation's "precarious external liquidity" position; as Goldman warns, with even higher political uncertainty ahead, an acceleration of capital outflows might also follow and while they think the authorities will eventually turn to the IMF to avoid a disorderly sell-off of the currency, recent events arguably raise the risks to that view. However, the capital outflows are already having an impact as Reuters notes, Russian banks are considerably exposed as Ukrainian banks should deposit runs escalate.

Some background from Guy Haselmann of Scotiabank:

Ukraine is a strategically important country of 45 million people. A trade pact with the EU was close. However, it appears that a rival bid (or other means of influence) arose during two closed door meetings with Vladimir Putin. The press often reports that President Yanukovich’s corrupt government has shown an instinct for self-preservation often at the expense of the expense of the nation.

The Ukraine economy is in recession. The country has only $20 billion of foreign reserves which is 2 ½ months of imports (worse than Egypt). The IMF’s red flag level is 3 months. Ukraine has $10bln of external debt maturing in 2014. Its CDS rose over 100 bps this week to near 1100. Debt-to-GDP is only 43%, but Argentina defaulted with its debt-to-GDP at 50%. Its currency (Hryvnia), which was devalued in 2008, is pegged to the dollar. The current account deficit is 7% and herein lies the biggest problem.

The IMF is unlikely to help until after the 2015 election. The EU is unlikely to provide any aid. Russia may be enticed to help via loans. The President is on his way to China - who may help - but he may return no longer in power.

And Goldman notes the situation is fluid but highly likely that anti-regime protests will persist with several possible scenarios developing:

1) President Yanukovich declares a state of emergency and/or uses force to prevent protests from developing further;

2) President Yanukovich agrees to talks with the opposition and to a roadmap for signing the EU association agreement at some point in 2014 (our understanding had been that this would not be possible on the EU side, but EU leaders have recently suggested otherwise);

3) President Yanukovich does nothing and protests persist.

From the macroeconomic standpoint, these protests come at a time when the National Bank of Ukraine (NBU) has had to defend the currency peg through sizeable interventions, which have depleted the reserve cover to 2.5 months of imports, and when the government is arguably unable to roll its debt in the market. Goldman fears the further risk is that, due to the heightened political uncertainty, capital outflows could intensify, putting further pressure on the peg.

While there had been some press reports suggesting sizeable Russian financial help in exchange for the country not signing the EU association agreement, the recent developments, in our view, call this further into question. We think that Russia is unlikely to extend substantial help without guarantees. Given that it appears that President Yanukovich's chances of holding on to power beyond the 2015 spring election have decreased following the protests and schisms in his administration might even weaken his powers earlier (splits in the Region's Party, for instance, might deprive him of a majority in parliament) he might very well not be in a position any more to give those guarantees.

As indicated by polling and by the participation in street protests, the decision to suspend preparations for signing the EU association agreement was an unpopular one, at least with a significant part of the population. Goldman believes that President Yanukovich may have underestimated the political ramifications of doing so.

At this stage, it is difficult to forecast how the situation will evolve. Apart from the size of the protests it also matters to what extent the president can hold on to his own power bases in the Regions Party and the eastern part of the country. Given that the economy is in recession and the heavy industries in the east in particular are suffering, his support there might very well be more brittle than in the past.

But perhaps there is a silver lining - in an odd twisted way - the concerns about Ukrainian banks and the currency peg have seen deposit outflows increasing the risk to the country's financial system and creating a particularly acute headache for Russian banks. The silver lining, of course, is that Russia may be forced to provide more assistance in a Cyprus-style save for its own banks (lenders) and depositors...

As Reuters notes,

While other foreign lenders have cut their Ukraine exposure in the five years since - to 20 percent of Ukraine banking sector assets in 2012 from 40 percent in 2008, according to a Raiffeisen Research survey - Russian banks have maintained a strong market presence, still accounting for 12 percent.

Among foreign banks, the Russians have easily the biggest exposure, more than twice that of Austrian lenders, the next biggest.

...

"[Moodys] estimate that these banks' exposure to Ukrainian risk is $20-$30 billion, a sizeable amount indeed, considering that their combined Tier 1 capital was $105 billion in June," Moody's said.

...

Moody's, which estimated that 35 percent of all bank loans in Ukraine were problem loans, said the country's severe economic problems would keep local borrowers under pressure and could result in higher loan losses for the Russian lenders.

In the absence of the association agreement with the European Union, Russian-Ukrainian trade is likely to rise, and the four big Russian banks may well increase their exposure to Ukraine, it added.

...

Dimitry Sologoub, head of research at Raiffeisen in Kiev, said the banks had learned lessons from the 2008 crisis, so were much less exposed to credit risk, liquidity risk and forex risk, and the central bank was calming matters by providing liquidity and foreign exchange.

"The question is how long it will go? The reserve cushion of the national bank is not so big."

In the meantime, Ukraine might secure short-term benefits from its closer ties with Russia, enough perhaps to stave off the kind of currency crisis that nearby Belarus suffered in 2011, said Charles Robertson, chief global economist at Renaissance Capital in London.

"In the long run, it will probably keep Ukraine poor. This is bad for Ukrainians and bad for Russia," he added.

"Instead of being a strong, successful economy on Russia's borders, able to buy plenty of Russian exports, Ukraine risks becoming another Belarus."

Which - after all - could be just what Putin wants...

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