Whistling Past the Junkyard

To this day, I still count by the flash of lightning and the thunderclap to guesstimate a storm’s distance. To this day, I make sure all trees are trimmed to be absolutely positive they’re clear of any window in my home. Such is the impression Poltergeist left on yours truly’s psyche back in 1982. For those of you who need reminding, Robbie, the name of the character who played the son in Poltergeist, would count the seconds between the lightning and the crashes of thunder for comfort knowing that the longer the pause, the more distant the storm. In the end, as the unsettled spirits rose through the floorboards beneath which they were buried, the time spans grew frighteningly shorter, culminating in Robbie’s being snared right out of his bedroom by a possessed tree. Though Robbie was rescued from the storm’s grasp, his fictional sister Carole Anne was not so lucky. The demons in the TV grabbed her very body and soul and didn’t let go until her determined mother went into the netherworld to get her back.

For the credit markets, the storm sounds as if it’s closing in. In a genuinely spooky “They’re here” moment, just last week, Zerohedge broadcast the news that the UBS Managed High Yield Plus Fund had announced it would be nailing the doors shut and liquidating their holdings. Slowly. The doomsday blog warned that the illiquidity Minsky moment was finally knocking on hell’s door; big banks’ bond inventories have been decimated and funds’ ability to liquidate in an orderly fashion would be stress-tested and fail. Forget for a moment that UBS is also the name associated with the first stressor to emanate from the burgeoning subprime crisis. This fund, which opened to investors in 1998, had survived both the dotcom bubble bursting and the credit collapse that accompanied the subprime crisis.

There’s no doubt the time should be nigh. Credit spreads, a measure of the extra compensation over Treasurys investors command for the risk of taking on corporate credit risk, for both high grade and junk bonds have gapped out in recent months. Investors are now demanding seven percentage points above comparable maturity Treasurys to hold the riskiest credits, the most in three years. Though nowhere near their post-crisis highs that exceeded double-digits, spreads are nonetheless flashing red. They’re cautioning investors that the distress emanating from commodity-dependent global economies and signs of a slowing U.S. economy could create enough turbulence to derail one of the most glorious credit cycles in the history of mankind.

Aside from macroeconomic indicators, what exactly are spreads tuning into? A recent report by Deutsche Bank’s Oleg Melentyev, whom I’ve known long enough to spell his last name by heart, suggest that the stage is set for the next default cycle. For starters, the current credit cycle is pushing historical boundaries. Going back to the 1980s, high-yield debt creation waves have lasted between four to five and a half years resulting in 53-68 percent debt accumulation from the baseline starting point. Where are we in the current cycle? Over the past four and a half years, junk credits have tacked on 55 percent growth when you take into account the combination of bonds and leveraged loans on bank balance sheets, putting the cycle, “comfortably inside the range of previous cycles,” according to Melentyev.

But that’s just one omen. Issuance aggressiveness is another way to test the credit cycle winds. Cumulative credit cycle issuance volumes of companies rated CCC and below, the junkiest of the junk, half of which can be expected to default over the next five years, casts a light on investors’ true pain thresholds. The mid-1990s and the mid-to-late 2000s saw highly toxic issuance swell by 20- and 18-percent, compared to the current cycle’s 17 percent.

Melentyev hedges the two metrics’ signals with the caveat that he’s using 2011 as a starting point despite clear evidence that the markets were expanding by the latter half of 2010. Erring on the conservative side, in other words, leads him to the ominous conclusion that, “the pre-requisites for the next default cycle are now in place.” Pre-requisites, though, do not make for certain outcomes though other fundamental benchmarks validate Melentyev’s premise.

At the most basic level, companies reassure bond investors by demonstrating they can cover the coupon they’ve promised can be clipped. The higher a company’s credit rating, the greater the probability the firm can make good on its commitment. The question is, what does it say when the presumptive pristine credits that populate the investment grade universe, the ones who disdainfully look down their noses at their lowly junk-rated brethren, begin to emit signs of balance sheet stress? The ratio of debt-to-earnings before interest, taxes, depreciation, amortization and whatever else is left in the kitchen sink for this superior cohort rang in at 2.29 times in this year’s second quarter. That tops the 1.91 clocked in June 2007 before the onset of the financial crisis. So a less cushioned starting point – that is, if this is the starting point and the storm really is fast approaching.

There are plenty of guideposts that indicate we haven’t yet arrived at the beginning of the end. Topping the list is the furious merger and acquisition (M&A) activity dominating the news flow. At $3.2 trillion globally, 2015 was already on track to take out the 2007 record of $4.3 trillion in M&A volume. And then the big guns came out. Michael Dell’s ambitions as a private market tech mogul became crystal clear with the announcement that Dell, partnered with Silver Lake, would take out EMC in a $63 billion transaction that requires at least $40 billion in debt to finance. The kicker is that $15 billion would be junk bonds – the biggest of its kind in history.

To not be outdone, Anheuser-Busch InBev muscled in to buy SAB Miller with a sweetened $106 billion offer giving new meaning to “This Bid’s for You!” As for the financing to consummate this tie-up? A cool $70 billion in debt financing, a figure that tops Verizon’s one-for-the-history-books $49 billion in bonds that helped pay for its acquisition of Vodafone.

In the event these figures have induced a bit of debt indigestion or indignation, rest assured, Standard & Poor’s (S&P), that other mighty credit rating agency, is on the case. In the first nine months of the year, S&P downgraded companies 297 times, the highest pace since that dark year 2009, with liquidity in the bond market one-tenth what it was, caveat clearly emptor.

And yet…there’s that sticky issue of the dumb money that’s on the prowl. This is not some reference to a pile of mutual fund “money on the sidelines,” which history has proven can be as ephemeral as a poltergeist you wrongly conclude has been exorcised. Nope – we’re talking about brand-new allocations to the credit markets.

Brian Reynolds of New Albion Partners, whose name has graced these pages in the past, helpfully keeps a real time score of the number of public pensions allocating fresh funds to the credit markets since August 2012. His most recent reckoning: 782 votes amounting to $169 billion in new monies being put to work in credit funds. Assuming a conservative five times leverage (which beats the 10-50 leverage multiples deployed in pre-crisis days), some $1.2 trillion in new credit flows have goosed the debt markets since late 2012.

What, pray tell, do stock market gyrations the likes of which we’ve seen since August do to pensions’ collective pain thresholds? In a nutshell, it strengthens their resolve to diversify, diversify, diversify away from their stock market exposure. August, September and the first half of October have set a three-month record for new pension allocations. Taking the cake in the “you-just-can’t-make-this-stuff-up” category, the Louisiana Firefighters’ pension is putting $50 million to work in an unconstrained fixed income fund; the funding will be sourced from an equity fund liquidation. On second thought, maybe it’s a good thing they’ve got access to plenty of firehoses.

Looking ahead, Moody’s high yield soothsayer Tiina Siilaberg, (I can spell her name from memory as well), sees clear evidence that refunding risk is building in the pipeline. Tiina’s barometer is the credit rating agency’s proprietary index that gauges the future ability of companies to roll over their maturing debt in three years’ time. The last time this indicator was at its current level was in the depth of the 2009-2010 credit crunch. “A significant contributor to the decline in the index is the increase in upcoming maturities. We currently expect $109 billion of speculative-grade bonds maturing over the next three years vs. $88 billion at the beginning of this year.” Indeed, refinancing volumes are down by some 37 percent over the last year.

Eric Rosenthal, at Fitch, which rounds out the Big Three credit rating agencies, foresees some messiness in the statistics to come thanks to the degradation of issuer balance sheets coupled with the less-than-friendly refinancing landscape. Rosenthal, whose last name practically spells itself, now expects the corporate bond market default rate will end the year around 3.5 percent and keep moving up in 2016. This rate, he cautions, is materially higher than the 2.1-percent average rate that coincides with non-recessionary times. In an conscious nod to $45 oil, nearly half the energy and metals & mining issues are trading below 80-cents on the dollar (par is 100-cents) compared to seven percent for the whole of the high yield universe. Still, the beat goes on, Rosenthal concedes – which is good news for Michael Dell. Issuance may be down 35 percent over last year for the aforementioned beleaguered commodities space but it’s up three percent for the rest of the junk market.

Are the conditions for a meltdown in the bond market firmly in place? Are investors deluding themselves, whistling past the junkyard? Absolutely. But that shouldn’t necessarily keep you up at night, counting the seconds in between lightning flashes and thunderclaps. Or, as Deutsche Bank’s Melentyev’s quips, “A stack of hay is not a fire hazard in and of itself; someone being careless with matches nearby makes it so.” By that same token, Poltergeist’s greedy real estate developer could have ponied up the extra moola to move the coffins of the dead and buried under the subdivision he so profitably erected. Instead, he rolled the demonic dice and simply removed the headstones, whistling past the houses until the unsettled corpses rose through the floorboards, shattering the illusion of suburban serenity.

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PEAK 2 PEAK

As long as you don’t look down, it really is a lovely ride. But then, that is the stated goal of British Columbia’s PEAK 2 PEAK Gondola ride, the longest and highest lift in the world connecting Whistler and Blackcomb Mountains. Make no mistake, there’s no hype on that ‘world record’ claim. At nearly two miles, the ride crosses the longest unsupported (which one definitely senses) span that also boasts being the highest, some 1,427 feet above the valley floor. For suspended suspense of a different kind, I highly recommend taking this 11-minute journey in June. That way, you can see two seasons in one – elegant, be-downed skiers at the very top of the mountains and, if you dare peer below towards terra firma, mountain bikers in summer garb bounding down the mountain. Luckily, 56-millimeter-thick cables allowed me to live to tell the tale of the surreal sight of witnessing live performances of both winter and summer Olympic sports in tandem.

The occasion for my trip to the pristine northwest was a Vancouver speaking engagement hosted by an international group of foresters. Their one query, back in 2012:  when would American homebuilders recapture the 2005 glory year pace of annual construction of over two million new homes? (Spoiler alert: they’re still waiting) In fact, there’s a solid chance the mill owners and loggers will be forced to play the waiting game for another generation. Such is the case when demand is pulled forward causing an unnatural rise in prices culminating in a burst bubble, which has to then be unwound in painstakingly slow order. Of course, I refer to home prices rising at an unsustainable rate due, in part, to loose monetary policy facilitating bad behavior, basically all around.

Today, policymakers find themselves staring down the barrel of another bubble that’s burst. This year’s International Monetary Fund’s annual meeting concluded with the world’s greatest minds in policy and economics agreeing that there will be no easy solutions to the problems facing emerging markets in coming years thanks to the bursting of the commodities bubble, which has also pulled forward demand on a global scale.

In an October 11 speech at the IMF confab, Fed Vice Chair and Reining Godfather of Central Bankers, Stanley Fischer, nodded to the dilemma facing U.S. monetary authorities. It is unwise to devise policy in a domestic vacuum given the, “increasing influence of foreign economic developments on the United States economy, both through imports and exports, and through capital account developments.” Beyond the slowdown in U.S. job growth, “the possibility that shifting expectations concerning U.S. interest rates could lead to more volatility in financial markets and the value of the dollar, intensifying spillovers to other economies, including the emerging markets.” At a mere word count of four, Fischer’s speech was relatively judicious in citing the ‘dollar’ by name as a concern. Contrast that to the September Fed meeting minutes wherein references to the strength of the ‘dollar’ made a record 19 appearances.

The bursting of the housing bubble, which to this day remains a thorn in the lumber industry’s side, and today’s commodities bubble, currently plaguing the global economy, are two bubbles bound by a troubling ‘flation’ paradox. The reaction to the PEAKing in home price inflation led to the PEAKing in commodities inflation. Meanwhile, boom/bust cycles, which stretch back in history as far as black tulip mania and characterize the current era of policymaking will inevitably usher in deflation scares that emanate from bursting bubbles. The debt Band-Aids applied provide an easier path than the restructuring of economies that would make them more productive over the long haul. The absence of such structural reforms leaves countries reliant on re-igniting their sputtering export engines. The only catch is, not everyone can play the same game at once.

Where in today’s boom/bust cycle does the U.S. find itself? According to the latest WSJ headlines, “Worry Over Low Inflation Kept Fed at Bay.” And yet, eight days earlier, another headline, this one from the Dallas Morning News angsted over, “Area Apartment Rents Rising at a Record Rate.” Well, which is it? According to two of the brightest minds in investing, Van Hoisington and Jim Grant, the answer is BOTH.

At a recent conference, fixed income investing legend Van Hoisington explained why the Fed cannot technically “print” money, at least when gauged by true M2, which is cash, checking and savings deposits and money market mutual funds. Recall that at its simplest, inflation is too much money chasing too few goods. Buying up all manner of debt with the hopes of inducing inflation only works if what the Fed spends circulates back into the economy in the form of M2 chasing goods. But that hasn’t happened. Rather, Fed purchases have been deposited right back at the Fed where they now sit fallow generating a pittance of income that sadly beats the negative rates they’d get otherwise. In Hoisington’s words, these reserves are simply not ‘transactable.” Hence the conundrum: M2 was growing at about six percent in 2008 where the rate remains today despite $2.5 trillion in Fed purchases. When money growth stagnates, the economy won’t slip into gear, which is just what we’ve seen for over six years now. (True money printing involves depositing money directly into checking accounts and happens to be illegal for those of you wondering.)

Jim Grant of Interest Rate Observer fame concedes that while we have seen little in the way of inflation of goods in recent years, we remain real time witnesses to the effect of the extraordinary amount of credit chasing asset prices from stocks, bonds and commercial real estate to the mountain PEAKs and beyond. Rising asset prices have no place in traditional inflation metrics as they are viewed as misleading economic growth signals. Or, as Grant  “The distortion of prices puts us in a Hall of Mirrors.” It is thus an illusion of prosperity via the prism of asset bubbles that deludes us into believing anything of economic value has been produced.

But back to those paradoxical inflation/deflation headlines. The two gentlemen above, along with some acknowledged defects within the Fed’s preferred inflation measure, help solve the riddle. The creation of debt in debt-laden economies accomplishes a whole lot of economic nothing, hence incomes grow at no faster pace than the rest of the economy. That’s what happens when debt levels cross a line in the sand of the whole of a given country’s economic output. (Look no further than Japan’s debt to GDP of 670 percent to understand why that country is flirting with recession yet again.)

At the same time, credit has been chasing high-end apartment construction and prices to what is hoped are PEAK levels. Dallas, with its influx of jobs, may be the economic exception given the ease with which companies can actually conduct business there, but seven percent over the past few years will quickly extinguish a defining attraction of the area – that of reasonable housing costs. At a national level, apartment data miners find that rents are rising at something more along the lines of a five-plus percent pace. The core consumer price index (CPI), which excludes food and energy, meanwhile, reports a more subdued 3.6-percent pace in rental inflation.

But that still isn’t the number that poisons the ‘flation’ worry well. The Fed’s “preferred measure,” the core personal consumption expenditures (PCE) gauge, most recently crawled in at a worrisomely low 1.3-percent rate, a level sufficiently shy of the Fed’s formal 2 percent target. When numbers are this low, four-tenths of a percent is material. That’s exactly the size of the difference between core PCE and CPI, the latter of which last clocked in at 1.7 percent. The main difference between the two comes down to their shelter weightings. In the CPI, shelter has a 31-percent weight, which reflects an ideal but modern-day unrealistically low proportion of a household budget. The PCE’s 15-percent weighting insults households struggling to keep a roof over their family’s heads.

Tellingly, the core PCE also came under scrutiny during the PEAK years of the housing boom because it failed then, as it fails today, to capture the immense drag housing puts on household budgets. Harvard’s Joint Center for Housing Studies most recent data find that almost half of all renters spend more than 30 percent of their income on rent; they call this cohort ‘burdened’ and I’d have to agree. More than a quarter of all renters are ‘severely cost burdened,’ and spend more than half their income, half, on rent. The Harvard data reveal that lower income individuals are even more disproportionately burdened, which distressingly stands to reason.

In a recent report titled, “The Burden of Shelter,” Michelle Meyer, Bank of America economist and renowned housing expert, nodded to policymaker’s dilemma: “If renters have to allocate more of their disposable income on shelter, there is less money to spend elsewhere, contributing to the disinflationary pressure for consumer goods.”

And that’s just what we’ve seen. The Liscio Report’s latest survey of sales tax receipts picked up a distress signal being emitted from household budgets crimped by the factors discussed here and others: Only 30 percent of states met their forecasted sales tax collections in September, down from 68 percent in August.

Impeding policymakers’ future efforts are further downward pressures building in the pricing pipeline for goods. Though exporters to the U.S. don’t see it this way; the silver lining of a strong dollar is that it makes the goods we import cheaper. Indeed, import prices overall are down 10.7 percent over the last year, which largely reflects the bloodletting in the energy complex. Zero in on nonpetroleum import prices, though, and they have slid 3.3 percent from year ago levels. Even the supposedly Teflon services sector has failed to generate the level of inflation associated with economic recoveries. At last glance, services inflation was running at a 2.6-percent rate, far shy of the pre-crisis highs that exceeded 3.5 percent.

As for the prospects for truly normalizing interest rates one day, demographic trends only promise to increase the ranks of severely cost burdened renters in the coming years. Harvard’s data project that due to the rise in minorities and elderly as Baby Boomers age, those who spend more than half on rent will increase by 11 percent over the next decade and that’s IF rental inflation slows to that of income growth.

Of course, the opposite scenario unfolding would be ideal – that income growth begins to outpace that of rent inflation. Such an economic miracle, though, will only be possible with a radical change of thinking among policymakers. Policymakers are either blind, or worse, willfully blind to the financial asset price inflation that flashes red today, just as it did during the dotcom and housing bubble eras. If that is the case, the bust to come will be followed by yet another boom in asset prices, one that will require firehoses to douse the flames of impending deflation.

At the core of policymakers’ Catch 22 is the fact that there is no easy way out. To borrow from Hoisington’s philosophy – developed countries such as the U.S. are simply too large to devalue their way out of debt by using a depreciating currency to reduce debt loads. That leaves belt tightening which generations of central bankers have been trying to avoid at all costs.

Can the same brands of debilitating debt loads that leveled the global economy during the Great Depression be sustained indefinitely? That’s surely the hope as the frequent application of additional debt-creation bandages over the open wounds of high debt levels seem to be the only solution politicians find palatable. Perhaps the privileged skiers atop the world’s financial markets will be nimble enough to avoid sliding on the ice as one season of asset bubble glides into the next creating the illusion of a powdery permanent winter wonderland for a chosen few. Perhaps they can be magically transported from PEAK to PEAK with little in the way of collateral damage.

But what of the hard landing on the fully-thawed bare earth at the bottom of the mountain that must be endured by the millions of workers who cannot choose a more accommodating trail to escape their budgetary shackles? Will central bankers always be seemingly divinely endowed with soothing words to calm and assure the masses?  After all, inflation in the wise words of central bankers, is only an illusion and does not exist. Except it does exist in a very real way for the masses far below the rarified air of the lofty PEAKS.

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Fear Factor

I sure hoped that instruction manual was in the same Spanish I was trying to perfect. My life had already flashed before my eyes as the propeller plane was violently tossed to and fro in the furious thunderstorm on that thankfully fate-less flight to Isla Margarita from Caracas. It was 1995 and I was taking a weekend away from my summer internship with some Caraquenos, as I learned to call them. The teeny south Caribbean island, 25 miles from the Venezuelan mainland, was supposed to be a quick hop across the sky. Instead, the storm was so intense, it had knocked the pilot senseless. Back before cockpits were sealed tight, one could simply peer down the aisle straight into the cockpit. Doing just that for some reassurance, I was instead horrified to see our obviously less-than-capable captain reach under his seat for what appeared to be an instruction manual. Let’s just say there was no comfort knowing I was in the hands of someone who just happened to be reaching for Flying for Dummies. The moment rendered new meaning to the term, Fear Factor, or Factor Miedo for those of you Spanish speaking readers.

According to the jubilant stock market, the September jobs report packed just enough fear factor of its own to paralyze the Fed into further inaction. As Morgan Stanley’s Ted Wieseman sagely wrote, “The market more decisively priced out a December rate hike and started to ponder if asking when the Fed is going to raise rates is even the right question anymore.” I couldn’t have said it any better if I had tried. And that’s the problem.

My Caracan summer internship at Sivensa, a steel conglomerate, and the events unfolding in America’s labor force are actually linked at the hip. Back in 1995, the current commodities supercycle hadn’t even been born, at least according to the history books which peg the advent year at 2001. But Sivensa was already in the global hunt. In 1993, the pre-Chavez-era government privatized SIDOR, the then-state-controlled steel company. Sivensa was all too happy to play a leading role. Into this happy marriage, this summer intern stepped, tasked with comparing Sivensa’s business model, using my accounting skills (which were about to get severely stress tested) to that of a potential benchmarking partner in the U.S. steel industry. In three months.

It was clear overnight fluency was in the cards following a naïve attempt to get Microsoft Excel, the English version, that is. Instead I was forced to learn that “FILE” is “ARCHIVO” and got to work. The high point of my internship (in a good way, as opposed to that heart-stopping flight) was an excursion to Puerto Ordaz to see how the sausage was made, or in this case, how the hot steel was rolled. Sivensa was kind enough to put me up at the Hotel Intercontinental replete with air conditioning and cable TV. I spent the better part of that summer in a current affairs vacuum looking like I had smallpox as I was no match for the mosquitos that swarmed my Caracas boarding house room. Imagine my dismay at 24-hour OJ trial coverage the minute I found CNN.

Puerto Ordaz, founded in 1952 as an iron ore port and one of Venezuela’s fastest growing cities, is spectacularly situated at the intersection of the Caroni and Orinoco Rivers, the former the color of the darkest of night and the latter a light brown – who knew sediment could be so influential?

Though the hard-hatted plant tours were fascinating – Sivensa was on the cutting edge of producing hot briquetted steel, a premium form of direct reduced iron — the real marvel was the port itself, bustling with Asian tankers. That image, it turns out, is one for the ages. Back then, the developing world didn’t even contribute one-quarter of the world’s economic output; today it accounts for 40 percent of global gross domestic product. Narrow the focus to the now infamous BRICS – Brazil, Russia, India, China and South Africa; these resource-driven five countries at the forefront of the commodity supercycle accounted for 56 percent of developing countries’ GDP in 2014 and 22 percent of global GDP.

The recent reversal of fortunes for the BRICS was the main reason for trepidation on the Fed’s part when it last met. Now they have something much closer to home to ponder. As has been widely broadcast, September’s job creation was punk. But the real news was the downward revisions of the prior two months’ payrolls data. We still have another revision for August, and both revisions for September, so maybe the long-term trend of upward revisions to those two months will save the day.

A deeper delve into the recent trend in revisions proves more worrisome. Though it can’t be proved on a month by month basis, economists tend to associate a trend of upward revisions with an economy that’s gaining steam. As things currently stand on the payroll front, a string of positive revisions at the turn of the year has switched to a string of negatives. My Liscio partner, Philippa Dunne, long an expert in gleaning hidden nuances in labor market data, has never been one to be satisfied with superficial analysis. She notes that the final word on payrolls, the annual benchmark revision, although within the long-term average, took out jobs through March 2015, meaning the BLS’s models were too positive on the contribution of new business formation to the monthly job churn. And since young businesses are the engines of job growth, that’s not a good thing going forward.

To make matters worse are the less-than-lucrative types of jobs being churned out. The Liscio Report’s tallies find that the eat, drink and get sick sectors – health care, bars and restaurants – accounted for 47 percent of private job creation in September, two-and-a-half times their share of private employment. Mining and logging, which captures energy and the recent re-downdraft in oil prices, lost 12,000 positions (to think that last year at this time, the sector had been adding an average of 4,000 a month over the prior 12-month period). Meanwhile, manufacturing’s rolls fell by 9,000, the flipside of factory’s average gain of 9,000 over the last year.

Extrapolate this trend to encompass the rest of the world and you can imagine the bar at the Intercontinental in Puerto Ordaz just ain’t moving and shaking like it used to. For starters, the Chavez government did a number on the Puerto Ordaz private sector when he re-nationalized SIDOR, among others. (Actually, the hotel has been expropriated by the Venezuelan government as well. A recent visitor commented on Trip Advisor that though the food and beverages were reasonably priced, the waiters were much too serious.)

Perhaps the waiters used to be employed in a factory and have taken a seriously painful pay cut. The good but sad fact is they still have a job, albeit one increasingly at risk if jobs that rely on resource industries are being cut at a rate similar to that of the U.S. market At this time last year, jobs that support our own mining industry were seeing gains averaging 2,000 a month over the prior year. Flash forward to today and support positions have been pared by 81,000 in the last 12 months.

The question is, will the contagion spread beyond the network that supports the mining industry? The non-manufacturing ISM report, which captures the economically dominant service sector, reported four sectors had contracted outright in September – mining, arts and entertainment, retail trade and miscellaneous services. Granted, 11 of the 18 sectors surveyed still report expanding new orders, but the pace of gains has slowed to the lowest level of the year.  A sister report that captures global services activity also fell to its lowest level of the year.

Corroborating the weakening trend is a fairly new measure of labor market conditions the Fed has devised which captures 19 indicators harvested from hard data on job creation and wages to survey results and job opening postings. Like the nonfarm payroll report, this diffusion index – it denotes expansion when positive and contraction when negative — is also subject to revisions. The latest September read was a goose-egg, as in zero, balancing on a high wire between an expanding and contracting labor market. Incorporating downward revisions to June, July and August, the average for the year is 1.1 compared to an average of 5.4 in 2014, 4.0 in 2013, 3.8 in 2012 and 5.9 in 2011.

Why the death by numbers? I won’t say “hindsight” in my next sentence. During my tenure at the Fed advising Richard Fisher, I argued against launching successive iterations of quantitative easing, what some refer to as money printing (OK, QE1 was DEFCON 1 and I was on board with that). But back in 2011 and 2012, the economy was not perfect, however the need to begin tightening nevertheless outweighed the emerging financial market imbalances. And I battled mightily to taper swiftly and raise rates in 2013 and 2014. It was real time and it was never going to be an easy decision but the time to remove the punch bowl was at hand. Instead, policymakers appear to have waited for so long that it’s too late. Cycle missed.

If nothing else, the mighty dollar has come off its high boil; that will hopefully provide relief to that stoic Venezuelan mesero (Spanish for waiter) given inflation at upwards of 60 percent (some reports say 200 percent) puts the price of an iPhone 6 at $47,700 in local currency terms. A weaker dollar could hold the key to forestalling the global recession many seem convinced is in the cards. A recent International Monetary Fund (IMF) report is making the media rounds with a clear message to the Fed: Stay on hold, or else. The IMF, which convenes in Lima this week for its annual meeting, cites the quadrupling of non-financial emerging market corporate debt in the past decade to $18 trillion as an accident waiting to happen that would be catalyzed by a Fed interest rate hike. Tack on the fickleness of today’s ample bond market liquidity at times of market stress and the formula for igniting systemic risk is squarely in place, the IMF warns.

The Economist’s latest cover, Dominant and Dangerous, referring to the globalized greenback, takes an even deeper (recommended reading) dive into the vulnerabilities the dollar’s expanding empire presents. The bottom line is the entire offshore dollar system is twice its 2007 size; by the 2020s it could rival America’s banking system. During the heat of the financial crisis, the Fed opened the spigot to the tune of $1 trillion in emergency credit facilities to foreign and central banks. The magazine rightly asks if the political wherewithal will still be in place in the event the swollen dollar-denominated global financial system needs rescuing again.

One thing is for certain. With its questionable allies, rampant corruption and most recently, waging of war on its own people, it’s highly unlikely the U.S. will proffer aid in any form to our hobbled western hemisphere neighbor to the south. December 6th’s parliamentary elections appear to be the best hope for the country to begin to heal its economy. In what can only be deemed a small world coincidence, Maria Corina Machado is one of the main voices of the opposition. Her father is the Chairman of the Board at Sivensa and Maria, who is my age, started her own career in the hot and dusty steel mills.

Though I learned many things that summer about commodities and cockpits, the trickiest lessons were on the dance floor. The two-step was as complicated as things got on Saturday nights for this South Texas girl. Salsa, though, is a dance that engages couples on a cerebral level. Let’s just say that missteps were frequent until midsummer when my brain and feet finally connected. The Fed would do well to take some salsa lessons of its own, especially in light of some “truths” it still holds dear.

All dance moves aside, in a Wall Street Journal op-ed by Ben Bernanke shared some memorable nuggets of wisdom about the challenges of executing crisis-era monetary policy. There was this one line, though: “By mitigating recessions, monetary policy can try to ensure that the economy makes full use of its resources, especially the workforce.” Only history can judge the sanctity at the core of the Fed’s intractable operating assumptions. As is the case with perfecting salsa’s intricacies, dancing against the beat starts at the beginning of the song, not the end.

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Tiny Bubbles

A recent trip to Piero’s, an old-school Rat Pack-era Las Vegas institution, a place with high-backed banquette seating, white-glove waiters and even today, a real-life Pia Zadora entertaining in the restaurant lounge, brought back memories of my very first trip to Sin City. I was not even 21 and had traveled there with my best friend’s family, who I later came to appreciate with having had a long history of operating casinos. There on the Strip, at the Flamingo, I wore a bonafide, albeit borrowed, evening gown for the first time, as opposed to something better suited to prom night. My friend’s mother, bedecked and bejeweled, with her hair piled high, had insisted we adhere to, for the times, the city’s strict evening dress code. Surrounded by men in black tie and bevies of glamorous women, we took in the pomp and circumstance required to hit the blackjack table or spin the roulette wheel.

These days, Vegas is conspicuous in its absence of any dress code. And one wonders if the next stop for slot machine installers will be bathroom stalls. In truth, as football season rages on, any mobile phone will serve as an adequate conduit for those inclined to throw the cyber-dice. For that matter, a land line and a quick call to your friendly bookie or stockbroker, as the case may be, will work in a pinch. Such is the backdrop of today’s global financial markets, which increasingly resemble casinos. The stakes are rising for investors cum gamblers as markets are increasingly fizzing with tiny ticklish bubbles rising up to their surface and threatening to pop.

Evidence of any bubbles forming in the financial markets are criticized as inflammatory in nature and roundly dismissed. After all, are we seeing a repeat of the dotcom era wherein profit-bereft firms are given VIP access to an IPO private reception…en masse? Well no. Are average-income-earning Americans financing exceptional mansions using fraudulently-underwritten, nefariously-negative-amortization mortgages? Well, not exactly. Have investment bankers the world wide wrapped $23 trillion in high-yielding contracts around a fraction of notionally physically deliverable commodities? Without question – absolutely not.

To be precise, not one glaring market is jockeying to be crowned the singular bubbly culprit of the current era of ultra-loose monetary policy. Therein lies the challenge for policymakers and investors alike. The latest bout of market upheaval certainly has all parties on high alert. But no one, including yours truly, can lay credible claim to soothsaying what’s to come.

That’s not to say there aren’t plenty of suspicious bit players, hence those Vegasesque lyrics of Don Ho’s from way back when. High-end housing, high yield bonds, marquee market office buildings, emerging market debt, luxury apartments and hotels, for that matter, go-go momentum stocks, fine art, private market tech financing, student debt and runaway commercial lending and commercial real estate are just a few that jump out.

Valuation is a subjective endeavor, even at history’s most blatant evidentiary junctures. Think of the insistence of market cheerleaders in early 2000. Forget tech IPOs. At the time, when I was still on Wall Street, I couldn’t even get a straight answer as to why our firm’s energy analysts wouldn’t budge on their Enron price target. Or even more egregiously, the circa 2006 reader hate mail I received during my stint as a columnist. These allegations called into question my allegiance to my country simply because I had the audacity to disagree with the Maestro himself on home prices, which, after all, had never, and never would decline on a national level. (See the many Liscio Reports that focused on this misunderstanding back in the day.)

Today’s criticism is more nuanced, though no less pointed. The U.S. banking system is purportedly clean as a whistle. Regulators have made sure of that. I’ll agree that most of the pre-crisis toxic rot has been jettisoned, but serious imbalances have emerged on bank loan books. Never before have banks held such a small proportion of residential mortgages and hence had such concentrated exposure to commercial and industrial (C&I) loans on their books. Regulators have begun to sound warning bells about some industry-specific risks, such as energy loans.

But as banking expert and good friend Joshua Rosner recently pointed out, the harm to the system has already been done. Since 2011, C&I loan volumes have expanded by more than 60 percent while the loans’ average yields have declined to under three percent from five percent. Meanwhile, the terms of these loans have shortened meaningfully. If these were your grandfather’s conservative credit borrowers, these statistics wouldn’t be so worrisome. But once again, lower for longer has allowed sickly companies to stay alive purely because credit has been cheap for long enough to sustain them. The quick resetting of so many of these loans presents a massive challenge to the Fed in lifting interest rates.

As for student debt, the emerging consensus is that new laws ensure it cannot be a bubble. As long as the cottage industry, designed to help students expunge rather than pay off their debts, continues to grow and thrive, student loans are simply a future taxpayer headache. Furthermore, student loans outstanding are nowhere near the size of the mortgage market when it blew, so no harm, no foul. (A trillion here, a trillion there. Moral Hazard, anyone?)

Unicorns are rainbow-hued and mythical creatures, especially for the deep-walleted investors who have ventured as far out West as the eye can see on the risk spectrum. Don’t be anxious, we’re assured, these sophisticates who have poured money into the current stable of 133 unicorn startups, valued at $1 billion or more, know exactly what they’re doing. If they should, for example, lose money by eventually valuing such a unicorn darling as Uber at a higher valuation than that of all Nasdaq stocks combined. That’s their contained problem. Except that niggling issue of mutual funds that invest in unicorns, some of which are distressingly on offer to unsuspecting, less sophisticated 401k plan participants in companies all across America.

At least, as we are constantly comforted, the publicly traded stock market is soundly valued. While some froth has certainly come off the top since the August 24th Chinese yuan devaluation, it’s still nearly impossible to make heads or tails of stock valuation. For one thing, low interest rates have flattered profits while reducing the pressure on corporate captains to grow the bottom line the old-fashioned way. But that’s not where the real juice is. To get to that Shangri La of financial engineering, you have to actually reduce share count via debt-financed buybacks, regardless of whether you’re referring to companies buying back their own stock or buying other companies outright.

While the usual effervescent suspect in bond land is today’s high yield debt market, I worry about yesterday’s and tomorrow’s junk bonds. Looking back in time, it’s difficult to gauge the ramifications of the stunting of the last credit meltdown’s default rate cycle. We know certain companies should have gone into full blown bankruptcy but have avoided that fate thanks to the Fed’s rolling out of unconventional monetary policy. And our public’s inattention to the whole affair. Less appreciated is the potential for a good number of today’s poshest-credit companies losing their investment grade status. And yet, the potential for a dramatic fall from grace is on full display in the case of mining giant and commodity trader Glencore as it battles to dispel rumors that its $30 billion debt load could cause the company to implode. Shares of the company have lost about two-thirds of their value and analysts say another five percent fall in commodity prices will suffice to strip the company of its precious investment grade credit rating.

Further afield, emerging market (EM) debt, of both the sovereign and corporate sort, is a black box. The asset class could prove to be a safe haven. But the preponderance in EM debt of commodity issuers and the lenders that banked the resource-dependent industry does give pause. If you harbor any doubts, just ask Bill Gates about his views on Petrobras, the Brazilian oil behemoth that’s buried itself alive in a corruption scandal for the history books. The Gates Foundation is suing both the company and its auditor for failing to flag signs of bad corporate behavior. Petrobras’ stock has lost more than 90 percent of its value and has been downgraded to junk by the credit rating agencies.

Meanwhile, back in Manhattan, commercial real estate (CRE) continues to trade at bespoke levels. Prices in midtown have long since surpassed their 2007 highs. And showing they can’t be left out of the party, banks’ loan-to-value ratio on their CRE loans nationwide is perched at 118 percent; they’re just as far out on an underwriting limb as they were in the heady months leading up to the 2008 crisis. You could just as easily substitute in similarly bubblicious valuation stats for penthouses in top tier markets, presidential suites anywhere a luxury hotel stands, high-end speculative home construction, fine art, classic cars, wine and partridges in pear trees of the sweetest red D’Anjou variety (OK, I made that last one up).

Perhaps, in hindsight, it’s the very preponderance of prickly little bubbles that market historians will chastise the masses for having dismissed. For now, the lack of an individual, identifiable bubble perpetrator gives the bully pulpit free reign to calm any hint of anxiety. No need to debunk red herring books salaciously titled, “Dow 36,000,” circa November, 2000 or its successor, “Are You Missing the Real Estate Boom?” published in February 2005.

There’s no book I can point to so I’ll stick with Robert Shiller’s take on the current euphoric era. (Sorry, Mr. Icahn – I find it troubling that less than a year ago you were pounding the table for Apple to buy back its shares and now you’re vilifying CEOs who do just that.) In any event, in Shiller’s estimation, we’re in a “fear” bubble, much like that which preceded WWI, a time where people rushed out to secure gold for fear of what was to come. Today’s equivalents are mutual funds and exchange traded funds which promise investors immediate liquid convertibility despite underlying holdings that could prove to be as liquid as dried mud.

Over the years, the Nobel Laureate has defined bubbles in many ways (oddly, he’s had plenty of material to work with since 1987). The one that most aptly captures the mood of the day is as follows: “People are motivated by envy of others who made money….regret in not having participated and gambler’s excitement.”

Do tiny bubbles make you happy? That’s the funny thing about bubbles, especially when they’re so numerous as to delude the beholder into perceiving innocuity. They never play out according to script. So we’ll have to settle for some lyrics to tide us over in the interim, in honor of the dearly departed Don Ho who oft delighted the adoring crowds of blue-haired denizens on that Flamingo stage all those years ago. If not for our subject matter du jour, you’re almost tempted to raise a glass when you hear these two lovely lines in your mind: “So here’s to the golden moon. And here’s to the silver sea.” If only we could know our greedy illusion won’t pop when the sun rises on our collective party. Even in Vegas, night eventually succumbs to day.

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Angels Manning Heaven’s Trading Floors

He could have passed for Yul Brynner’s twin if it wasn’t for those eyes. He was 57 years old, 6’2” tall, tan and handsome with a shining bald head. But his eyes, those elfish eyes dared those around him to partake of anything but his infectious happiness. It was those eyes I will never forget.

It was Labor Day weekend, 2001. One of my best friend’s college buddies from UCLA was in town and his uncle had a boat. So we had the good fortune to be invited to take a cruise around Shelter Island on that long holiday weekend 14 years ago. I was 30 years old at the time and I can tell you there was no “boat” about this Yul Brynner look-a-like’s 130-foot yacht. The crystal champagne flutes, the hot tub on the deck, the full crew – none of these accoutrements faintly resembled the boats I’d been on as a middle class girl spending summers off Connecticut’s stretch of Long Island Sound. The thing is, our friend’s uncle was none other than Herman Sandler, the renowned investment banker and co-founder of Sandler O’Neill.

I wasn’t sure what to expect of Sandler and I had no idea that this chance meeting would make a soon to happen unspeakable act that much more real. Would Sandler exude that same pomposity so common among the Ivy League investment bankers who had underwritten the Internet Revolution? In a word, hardly. Sandler personified self-made man. After introducing me to his family, of whom he was immensely proud, he graciously offered me something to eat or drink. And then, he told me a story about a man who knew the value of never straying the course. It haunts me to this day.

It was a good old-fashioned American Dream story about a man and some friends who started an investment bank to banks and built their firm to the top of the world. Literally. The secret to his success, which he enjoyed from his place in the clouds, on the 104th floor of the south tower of the World Trade Center was simply hard work, he said. He prided himself, relaying to me in what I could tell was a tale he’d repeated time and again, not only on making it to the top of the tallest building in the city, but on beating the youngest and hungriest to the office in the mornings and turning off the lights at night. Never forget where you come from. Never take for granted what you have.

In 2001, I had been on Wall Street for five years and was enjoying my own success and experiencing firsthand what money could buy. Given the choices my world offered, most would not have chosen night school. But I was determined to fulfill a lifelong dream and attend Columbia where I was to earn my master’s in journalism to complement my MBA in finance from the University of Texas. I guess I was not like most others. I wanted something tangible to open the next door in my career, which I knew would involve both the markets and writing. I called it my retirement plan.

Throughout this Wall Street by day, student by night chapter of my life, the minute the stock market closed at 3 pm, I would rush to the west side subway lines to trek north to Columbia’s campus. Just before Labor Day that year, I had turned in a class project, exploring the world of the famous Cornell Burn Center at New York-Presbyterian Hospital. During my time on the project, the unit was quiet save a few occupants, which apparently was not the norm. So those brave nurses had to paint a picture for me of what it was like when the floor was bustling with victims of fire-related disasters. Many of the stories of pain and suffering were so horrific I remember being grateful for the relative calm and saying a little prayer the unit would stay that way.

I returned to work on Tuesday, September 4, after that long weekend that proved to be fateful, with a new perspective on life and work, inspired by Sandler’s humility. Little did I know we were all living on precious borrowed time. It was impossible to conceive that one short week later, Sandler’s inspirational tale and those nurses’ surreal stories would collide in a very real nightmare.

It’s the Pearl Harbor of my generation. Most Americans can tell you where they were on the morning of September 11, 2001. I had walked part of the way to work that day, so picture perfect was the blue of the blue sky. I was in my office at 277 Park Avenue in midtown watching CNBC’s Mark Haines on my left screen and pre-market activity on my right screen. As was most often the case, it was muted as live calls on economic data and company news came over the real life squawk box on my desk. My two assistants were seated outside my office going through their pre-market routine, fortified as was usually the case with oatmeal, yogurt and coffee. In retrospect, the mundaneness of the morning’s details are bittersweet.

It was almost 9 am and out of the corner of my eye, I noticed that a live picture of the World Trade Center had popped up on CNBC. Haines reported, as did many initially, that a small commuter plane had hit the north tower of the World Trade Center. As distracting as the image was, I tried to go back to my own morning routine, preparing for the stock market open in what had ceased to be one-way (up) trading after the Nasdaq peaked in March 2000.

And then, at 9:02 am, time stood still. A scream pierced the floor as one of my assistants watched a second plane, a second enormous plane, fly straight into what appeared to be Morgan Stanley’s office floors in the south tower, where her father was at work. As things turned out, it didn’t matter where the plane had hit for the employees of Morgan Stanley that morning. They had Rick Rescorla, the firm’s Cornish-born director of security and a Vietnam veteran who had been preparing for this day for years. He knew the Twin Towers were an ideal target for terrorists. Thanks to his efforts and years of constant drilling – every three months, which some thought overzealous — all but 13 of Morgan Stanley’s 2,687 employees and 215 office visitors survived that day. With the evacuation complete, Rescorla heroically reentered the buildings to continue his rescue efforts and in doing so, paid the ultimate price.

Ironically, as was the case with Morgan Stanley’s Rescorla, some at Sandler O’Neill had lived through the first attack on the World Trade Center. When the young firm had outgrown its previous office space, it chose the south tower as its new home, moving in the same week it was bombed on Friday, Feb. 26, 1993. Many who struggled their way down over 100 flights in crowded stairwells, through seas of discarded women’s shoes, learned the lesson that they would have been just as well staying put. It was that very hesitation, borne of that lesson, that cost many of the firm’s employees their lives.

In the 16 minutes between the time the first and second planes struck the towers, the Port Authority had announced over the south tower’s intercom system that the issues were isolated to the north tower and to stay put. That didn’t mean the scenes across the way at the north tower were any less horrifying as rather than suffocate or burn to death, some leapt to their deaths before the very eyes of those across the way in the south tower. Amid this mayhem, Jennifer Gorsuch, a Sandler employee, emerged from the ladies room just in time to hear Sandler shout, “Holy shit!” Gorsach rushed to find a friend and fellow Sandler employee who had survived the 1993 ordeal and knew of an escape route. Together, the two set off down an open stairwell.

Sandler, though, going off his 1993 experience, told one investment banker who did survive 9/11 that the safest place to be was in the office. He added, though, that anyone who wanted to leave was welcome to do so. Of the 83 employees in the office that morning, 17 chose to leave right away. The bond traders and most of those on the equity desk chose to remain. Only three other Sandler employees would make it out alive. The rest, including Sandler himself, were never aware that one, and only one, open staircase offered them safe passage; the building’s intercom system had been knocked out at the time of the second plane’s impact.

From the little we know, many that day above the crash site tried to get to the roof. Though it would not have made a difference in the end, it is nevertheless deeply disturbing that the door to the roof was found to have been locked. The towers were exempt from a city code that required roof access to remain unlocked. The Port Authority and Fire Department had agreed that the safest evacuation route was down, not up. Plus, enforcing the exemption delivered a loud and clear message to vandals, media-mongering pranksters and those contemplating suicide.

For me, the sweetest sorrow came down to the nobility of those brash, boisterous traders. Many that day, at Sandler O’Neill and Keefe, Bruyette & Woods and Cantor Fitzgerald, among others, were among the 1,500 who could have possibly escaped but chose to do right by their firms’ clients. You see, once it was understood that the attacks were an act of terror, the markets began to flash angry red, promising to crash at the open, handing certain victory to the evil, soulless weaklings who took aim at the economic heart of this great country. It is the traders who chose to man their stations I mourn to this day, those I have always called, with utter reverence, the real Masters of the Universe.

The helplessness I felt when the buildings fell was matched only by my horror at the silence that followed. At some point between 9 am and 10 am that morning, I found myself praying the deafening fire engine and ambulance sirens tearing down Park Avenue would just stop blaring. The cacophony had filled the 102 minutes that followed the initial plane striking the north tower at 8:46 am. But then the buildings did fall. Although the second to be struck by a plane, the south tower was the first to fall at 9:59 am. In the 29 minutes that followed, we all prayed the north tower would escape the fate of its sister to the south. But it was not to be. The unthinkable, the impossible happened, not once, but twice. And then it was quiet, quiet for days and months and now, 14 years.

Of course, there were miraculously 12,000 who walked away, mainly those who had evacuated the floors beneath the impact zones in both buildings. No doubt, the survivors paved a pathway of hope to help the country heal. But the dearth of rescues was nevertheless heartbreaking as we collectively sat vigil praying man and dog would pull a survivor from the pile. Hence the devastation wrought by the silence. It was unfathomable to contrast those who had braved the fires and lost, and the mere 22 survivors admitted to the no longer nearly vacant Cornell Burn Center of my Columbia class project experience. As if to punctuate the pain, four hospital EMS employees had been lost along with 408 other rescue workers that dark day.

Normalcy was suspended in the days and hellish nights that followed. We financial markets survivors, weighed down by guilt as we were, were told to do what those in those towers had done so bravely. We stayed on call in the event Dick Grasso and the other powers that be were able to open the markets for trading. We were prepared to be the calm in the stormy market seas that were sure to follow the initial open.

Unlike the markets, Columbia resumed classes on Wednesday, September 12th. The moment I stepped out of my cab on 125th Street that evening, the memories of the sounds of 9/11 were lost in the overwhelmingly toxic smells of its aftermath. Buffered as I was, at home in the middle of the island on Fifth Avenue, I had only experienced the tragedy’s aftermath from the nonstop playback news images of the towers that were, and then ceased to be. But Columbia, with its proximity to the Hudson, is an inescapable spot to take in what the winds carry. That evening it was the sad novelty of the smell of burning computers, steel and God knows what else, something I hope to never know again.

On Friday, September 14th, I was set free to travel north to Connecticut to the loving arms of my family who were worried so. They tried to bolster my spirits, what with my 31st birthday set to arrive on Monday. But I was in no place to find the will to celebrate. I was short the markets, poised to profit the minute trading opened on Monday morning and beating myself up as a traitor to my country for being so. The moment I was able to do so on the morning of September 17th, I closed out my position. And I manned my station.

That night, most of my friends dragged me out to my favorite Italian restaurant. But one of us was absent from the table. My dear friend, whose UCLA friend had introduced us to Herman Sandler, found herself in the right place at the right time to begin to help the healing process. At the time, she was working at Bank of America in midtown. The very day the towers fell, the bank had offered Sandler O’Neill survivors temporary office space in the same midtown office at which my friend worked. Jimmy Dunne, who found himself running Sandler O’Neill in the flash of an eye, gratefully accepted. Dunne had been out of the office on 9/11 trying to qualify for the U.S. Mid-Amateur Classic; he survived by chance and chance alone. So devastated was my friend that she chose to stay late every night, on her own time, to help Dunne write condolence letters to the families of the 66 Sandler employees who had lost their lives. She would eventually end up working at Sandler.

On my birthday, six days after 9/11, my friends insisted that robbing us all of joy, the very ability to celebrate life’s little occasions, would represent yet another feather in the caps of the cowards who attacked our fearless traders, our Masters of the Universe who were now all, and would be forever, on heavens’ trading floors. We raised our glasses to them that September evening and I remember thinking I hope Smith & Wollensky delivers in the celestial realm.

But I don’t digress. I never do on 9/11. I never shy away from remembering the worst day of my life. To do so would be an unforgivable dishonor to the 2,759 victims who gave their lives on that painfully beautifully September morning. And so, I never will.

 

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Illiquid Plumber

There’s nothing quite so disgusting as falling out of bed to squeeze in a predawn workout and having the brushing of one’s teeth be greeted by the stench of rotting something. That offending olfactory jolt is just as efficacious but decidedly less pleasant than a hit of espresso for awaking the senses. An emergency run for the purchase of Drano accomplished nothing. Successive days and applications of said remove-it-now saw only an escalation of the nasal assault. The spreading of our by now unbearable mystery odor made it clear that after hours or no, a professional was needed NOW. The dollar signs we saw twinkling in our intrepid plumber’s eyes added a healthy helping of monetary fear to the desperation already so evident in our own eyes. He naturally adjusted his time value of money accordingly, inquired as to the access point of crawlspace and soon enough extracted a most malodorous dead rat. I’m delighted to report that the deceased and I never crossed paths.

Federal Reserve policymakers are wrestling their own anxieties over a very different already way after-hours sort of plumbing problem as they contemplate keeping their collective word to hike interest rates in 2015. In theory, December is the only option left as policymakers are sure to prefer the first increase in nine years to be accompanied by the explanatory venue, the Chair’s press conference. But December is a tricky month to test the plumbing of the vast global fixed income markets. Looking ahead, March is the next scheduled press conference. As Deutsche Bank’s observant Chief International Economist Torsten Slok points out, March is no better in terms of historic liquidity levels in the bond market than this December.

Any plumber can tell you that strong liquidity is the critical element to maintaining a highly functioning and flowing system. Without strong liquidity in our overnight rates markets, we end users will be left feeling about as frustrated as if we had found ourselves standing in a shower waiting for that first blast, but instead christened with a tepid tap. Few market players fully comprehend (yours truly, among them) how the initial one-quarter-of-a-percentage-point interest rate increase is going to filter through to the overnight market.

A bit of background is essential here. Traditionally, banks lent money to one another in what we refer to as the fed funds market. In the good old days, when interest rates were positive, this process was rote. Federal funds were literally excess reserves that commercial banks deposited at their regional Federal Reserve banks. These funds could be lent unsecured to other banks that had insufficient reserves to meet what regulators require to be held. The rate at which they borrowed these funds overnight was thus referred to as the ‘federal funds rate.” The Federal Open Market Committee traditionally set a target rate for the overnight fed funds rate using its open market operations to control the rate, which is the cost to lend and borrow in the economy. In inflationary times of excessive lending, such as the early 1980s, the fed funds rate approached 20 percent.

 

The financial crisis changed everything. By December 2008 the traditional role played by the fed funds market was effectively nullified. Endeavoring to stimulate the economy, the Fed lowered fed funds to a de facto zero rate at the conclusion of 2008’s final meeting. And here is where things get interesting. Before that time, the Fed did not pay interest on excess reserves (IOER). Enter a Congressional Act, authorized in 2006, which allowed the Fed to begin paying IOER starting October 2011. As the financial crisis barreled towards the world economy, an emergency act accelerated this start date to October 2008. To be sure, the blank check to pay banks interest on their excess reserves did not pass quietly into the night.

 

In a Fed October 6, 2008 press release, policymakers justified their moves to, “eliminate the opportunity cost of holding required reserves, promoting efficiency in the banking sector.” In practice though, at a level of 0.25 percent, the Fed was paying banks more than they could earn in other cash alternatives. This opened policymakers to the criticism that they were paying banks to sit on monies that could be used to induce economic growth via lending, the exact opposite of what the economy needed at the time. Policymakers’ stock answer was along the lines of – this is no biggie in the grand scheme of things, we’re merely demonstrating that we have an effective tool to rein in inflation when the time comes. License, in other words, to rev up the printing presses and grow the Fed’s balance sheet, maneuvers critics say invite the future degradation of the value of money. Forget the pros and cons – the proverbial water has long since flowed under this bridge. Since December 2008, the Fed’s balance sheet has swelled from less than $900 billion to $4.5 trillion. The trick is figuring out what to do with the $4.2 trillion mountain of bonds amassed over the years absent the political will to earmark it to rebuild the Main Street economy.

Without getting too far into the reeds, banks today sit on $2.6 trillion in excess reserves. Using round numbers, banks would sacrifice a small appendage to jettison $2 trillion of these weighty reserves. Why is that? Post-crisis regulations require banks to hold a six-percent capital cushion against institutional depositors’ excess reserves. The more capital is encumbered, the less a bank can lend. IF the Fed raises rates, the roar of the tsunami of reserves rushing off bank balance sheets is likely to be very audible to those on Wall Street. In the words of the original navigator of the financial system, former New York Fed and now Credit Suisse’s Zoltan Pozsar, “Gone would be the penalty banks have to pay as they line up at the equivalent of an all-you-can-eat T-bill buffet.”

In the event you are not comatose at this point, things begin to get really complicated. The Fed has created a facility it uses to emulate that T-bill buffet. It has a name but you won’t like it – the Reverse Repo Facility. The explanation may as well come straight from the NY Fed’s website: “A reverse repurchase agreement, also called a “reverse repo” or “RRP,” is an open market operation in which the Desk sells a security to an eligible RRP counterparty with an agreement to repurchase that same security at a specified price at a specific time in the future. The difference between the sale price and the repurchase price, together with the length of time between sales and purchase, implies a rate of interest paid by the Federal Reserve on the cash invested by the RRP counterparty.”

Who in their right mind would dream up such a cruel devise? The reality is, the fed funds market has atrophied to such an extent (hard to trade something with a positive interest rates to control market rates when interest rates are zilch) that today there is a pittance of $50 billion in trades executed daily. Contrast this to the last time the Fed raised rates, in June 2006, when trading in fed funds was five times that much – and that was BEFORE the explosive growth in the level of excess reserves in the system.

Critically, the size of the RRP facility, which deals with money market funds (see “counterparty” above) COULD be infinite. In this base case scenario, all of the money flooding off bank balance sheets would find a home in a facility controlled by the Fed – think of the RRP as creating equivalents to Treasury bills, as being a cash alternative. If uncapped, the RRP would be able to absorb cash from money market funds and in doing so tighten monetary policy. Money market funds, on the other hand, would be attracted to the higher rate on offer from the Fed after an increase in interest rates. This would allow them to trade out of what they own today, loads of U.S. Treasury bills, which would be a win-win as so many other types of foreign and domestic investors have an appetite to buy U.S. government paper.

The best part is there is an optical victory for the Fed to go whole hog and slough off all of their excess reserves. The Fed, in turn, could quit paying that old IOER. Today, the fed funds rate is at zero and IOER is 0.25% — actual interest rates exist in a band. For reasons beyond the scope of your patience, when (be optimistic with me, folks!) the Fed raises rates, it will have to also raise the IOER by the same amount – say 0.25% to 0.50%. But the fed won’t have to pay squat if banks get rid of their prohibitively expensive excess reserves, which would please the Fed’s critics to no end. Counterintuitively, banks would be freed up to lend more if they escape their excess reserves’ regulatory shackles.

For now, we know not what fate awaits for the future of the RRP; it’s been capped at a fixed rate since concerns emerged on several fronts. Some policymakers were concerned the RRP would take the banks out of the funding equation, or “disintermediate the banking system.” In truth, banks are anxious to shed their excess reserves given they drag down return on equity and dilute net interest income. The sanctioning of the tremendous growth of the money market fund industry was also frowned upon as they are not regulated by the Fed. But as Pozsar points out, the funds are much more transparent than banks and easier for the Fed’s fellow regulators at the SEC to understand.

Inflation hawks have also raised concerns that the full allotment of the RRP would guarantee the Fed had to maintain a large balance sheet, which they fear to be inflationary. But the Fed can just as easily use the RRP to raise all overnight interest rates; the fed funds rate would necessarily follow its counterparts upwards. It is not inconceivable that the fed funds market be rebuilt as the size of the Fed’s balance sheet begins to shrink. Policymakers have clearly stated that interest rate hikes will be followed by the cessation of reinvestment of principal repayments. The clever folks at the NY Fed would hopefully be able to engineer a baton handoff – as bonds matured and rolled off the balance sheet, the fed funds market would assume a progressively greater role in the overnight rates market.

If all of these contingencies bring to mind a camel threading the eye of a gate, it’s by design. Exit mechanics will not be elegant and clean, nor can they be expected to be in the aftermath of one of the most magnificent experiments in all of central banking history. If you must, look at it this way. Consider a messy exit to be the lesser of two evils. We all know how the book on the alternative ends. Think of how long that much despised dead rat would have fouled the air if that oh so intrepid plumber hadn’t done his job by squeezing into that extremely constricting crawlspace to dispense with the rot.

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Help Wanted: Fearless & Grounded Central Banker

To abrogate is to renege, to put aside, to treat as nonexistent. When history looks back on the current era of extremely easy monetary policy, it is likely to conclude that two supposedly-do-no-harm entities abrogated their responsibilities to our country. Both the Federal Reserve and Congress have failed to do what they could to employ more Americans.

One anecdote and one data point recently illustrated the damage that has been inflicted by Fed policy and Congressional misfeasance. Both started with help wanted postings. The first occurred over Labor Day weekend. Feeling the holiday spirit, I acquiesced to my four children’s and two of their friends’ pleas for an escape-the-heat treat at Baskin Robbins. Pushing into the small space, we were filled with a sense of anticipation at the sheer number of frozen options. That didn’t last long. Not only was the sole employee underwhelmed by the throng of sweet-toothed customers, she was categorically impervious to the building melee as the doorbell dinged time and again announcing more patrons. There was no hurry-up about the crowd control, and this was further punctuated by the taped-on Now Hiring sign I noted a half hour later when I finally emerged with my irritated brood of children and their playmates. Perhaps Baskin Robbins should pay by the scoop.

But that’s just one little instance. And we didn’t emerge any worse for the wear though there were quite a few sticky fingers about. Contrast our ice cream outing with a different type of wait experienced by parents alarmed at discovering pneumonia was hitting some of our Dallas elementary school students the first week of school, which for us happens to be the last week of August in the sweltering Texas heat. Though fortunate enough to not be among those queuing up for lung X-Rays, I was nevertheless concerned about my friends’ extremely long wait times. Then, upon examining the details of the July job openings data, which are released with a one-month lag, I noted the continuation of a trend in a growing demand for X-Ray technicians; openings have more than doubled to one million since bottoming in 2010. This trend speaks volumes to lengthening wait times. While in comparison, openings for other positions such as construction, which while they have improved in recent years, are still relatively flattish reflecting the hangover from the last crisis.

This divide is what some economists believe to be a skills mismatch between labor market needs and the available pool of workers on offer. The disconnect also shines a harsh light on Fed policy nearly seven years after policymakers reduced interest rates to the zero bound. Maximizing employment may well be one of the Fed’s formal mandates but it’s become abundantly clear that low interest rates are the wrong hammer to nail that mandate home. Wax Scandinavian for a moment, a culture known for its retraining bent, and imagine a beautiful labor market renaissance had taken place rather the current morass. Picture for a moment that a decent percentage of the American workers who have dropped out of the workforce had instead been re-trained to be X-Ray technicians or dental hygienists, which require associates degrees, or even home health aides, which only require a high school diploma plus required training.

Now think about this. Though an example in the extreme, the rapidity with which Baby Boomers are retiring is no figment of the collective imagination. If there is one given in this equation, it is that there will be an abundance of future demand for health care workers and their need to be familiar with the innovative technology changing how medical services are delivered as far as the eye can see. Training for these positions wouldn’t have required much more of an investment on government’s part than the monies spent on extended periods of unemployment insurance featured in the early years of the current recovery. Of course, such programs have nothing to do with Fed policy. That’s the point.

In conversation recently with a colleague, I raised this Scandinavian, utopian path. He laughed and said Congress would never do such a thing. It’s just not in our culture to force people to work. While I understood his argument, it didn’t make it any easier to accept, especially in light of how well some of the most in demand and unfilled jobs pay. Forget health care for a moment and consider the last time you paid a plumber or an electrician and felt as if you had undergone and paid for an invasive procedure without ever having been admitted to a hospital.

Retraining programs do not grow on trees. Congress would have to vote them into being. But I can’t help but notice in this political season, politicians do go on and on about apple-pie-in-the-sky plans to create jobs in America. This at a time when the practical Scandinavians, who have proven actions speak louder than empty words, have already provided a neat blueprint for us to follow. But it’s not just Congress and our other political leaders who have failed to push for less convenient programs to incentivize job growth and wage gains. No, the credit for failing the country also rests on the shoulders of central bankers who refuse to recognize the limitations of monetary policy. Consider the last two paragraphs, a de facto footnote, in a Wall Street Journal story about the U.S. deficit narrowing to the lowest level in seven years in August: “Deficits have also narrowed faster than budget analysts predicted in part because the government has enjoyed ultralow borrowing costs. U.S. debt held by the public has increased nearly $7 trillion since 2008, or 120%, but debt-service costs for the U.S. last year were about $20 billion below their 2008 level.”

It’s disgraceful that more has not been done to stimulate economic growth with the debt that’s been tacked onto the nation’s balance sheet. More shameful yet is the public back slapping on full display as politicians take credit for taming the deficit. On the other hand, the obfuscation of the true state of the nation’s finances is easy enough to accomplish with the Fed’s blessing in the form of perpetually artificially low interest rates.

The Fed itself also indulges in its own form of public high-fiving when it comes to the great healing of U.S. household balance sheets. Granted, the congratulatory venue is anything but the Sunday morning news programs. Rather they take the form of brilliant papers published in prestigious economic journals. But the conclusions of many of these papers ring as hollow as politicians’ carefully phrased sound bites. It goes without saying that at 9.9 percent of their disposable income, households’ cost to service debt is the lowest on records dating back to the early 1980s. But that shouldn’t take away from the fact that consumer credit itself, which doesn’t take into account mortgage debt, climbed to a record $3.45 trillion in July. The monthly growth rate is nothing short of magnificent in historic terms. July’s $19.1 trillion gain was trounced by an upwardly revised June level of $27 billion, the largest one-month figure since November 2001.

The household debt figure has been infamously pushed upwards by student and car loans, which are up eight percent over the last year. Even credit card borrowing has again picked up of late; it’s up four percent on an annual basis. It’s no wonder that retail sales have perked up a bit. But the consensual conclusion that the explosion in borrowing bodes well for sustainable economic growth is as flawed as it’s been every other time economists have rolled it out.

It is high paying jobs which catalyze true and self-sustaining economic growth, not borrowing to live beyond your means. No wonder the markets are paralyzed ahead of every Federal Open Market Committee meeting, transfixed on whether the Fed is going to raise interest rates for the first time since June 2006. If low-cost debt growth is all we’ve got going for us as a country, the Fed had better not ever hike rates.

It should go without saying that this line of thinking is ridiculous. Adding insult to the disservice wrought on the country are the risks the Fed is allowing to build in the financial system. To take the most egregious example, public pensions, “braced” for lower returns, are reducing the rate of return they are assuming their portfolios will generate; some return assumptions could fall to as low as 7.0 percent from the current 7.7 percent. Where 7.0 percent fits into reality is as questionable as its predecessors’ return assumptions were it not for the extra monies states and municipalities would have to pony up to make up for what can no longer be “assumed” in returns. In a letter to the Wall Street Journal, American Enterprise Institute’s Andrew Biggs rightly points out the true travesty – that the risk premium pension managers had to earn over safe investments such as Treasurys has grown to 5.3 percent from 3.0 percent in 2001 care of interest rate declines. That’s the real headline – that pensions were forced by ill-conceived Fed policy to load up on risk to compensate for what they couldn’t generate in reasonably prudent investments.

At-risk pensions, hobbled by broken accounting and strapped municipal benefactors, are certainly not the only irrefutable evidence that rates have been too low for too long. Consider a sampling of just one week’s Wall Street Journal headlines:

  • Private Equity Plunges Back into Oil
  • ETF-Only 401(k)s
  • VIX Bets Behaving Badly
  • How a U.S. Visa-for-Cash Plan Funds Luxury Apartment Buildings

And my favorite, which covered individual investors increasingly asking about “unusual and exotic ways to raise the yields on their portfolios,” — What to Ask Before You Reach for Yield

How can policymakers fail to recognize the distortions building in a global financial system starved for yield, in reckless investor behavior that threatens to inflict yet another blow to both pensions and individual investors alike? It’s entirely feasible that global markets are not fully prepared for a rate hike. They never will be. It is thus with eyes wide shut that the Fed has consciously chosen time and again to take no action. When will monetary policymakers comprehend that not making a move is a huge move in and of itself. Perhaps it’s high time we post a new Help Wanted sign on the nation’s front door, one for a fearless and grounded central banker.

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Trumped Towers

If you drill it, they will come. Last summer, I met with two Dallas-based energy hedge fund players to chat about the state of the energy sector. The two young men made mention of all manner of reasons that for the foreseeable future oil might just hang in there, above $100 a barrel. One anecdote, however, had given them pause. It had to do with plans to build a 58-story tall skyscraper at 303 Wall Street. That is, 303 West Wall Street in Midland, Texas. It would be the sixth largest in the state and the tallest between Dallas and Los Angeles. Did this tall tale, I asked, seem a bit, well, much? It did indeed, they replied, especially in light of the last time something so bold had happened upon the streets of this West Texas outpost, population 111,000. The skyscraper announcement echoed stories of an ill-fated Rolls Royce dealership, which in 1983 had optimistically opened its doors for a less-than-one-year Midland run. The oil price collapse laid ruin to not only the dealership but also one of the most spectacular energy booms in Texas history. And as we all know, Silver Ghosts don’t run well on cheap oil. Just ask any Saudi.

Of course that was then. Today, Texas has an appreciably more diverse state economy than it did the last time oil prices tanked. And that wasn’t the part of the story that struck the most worrisome chord. Rather, it was the source of the financing for the proposed lofty development that proved arresting – that is, private equity (PE) from near and far. ERP, or Energy Related Properties, a PE fund founded and headquartered in Midland, was to be the developer of the proposed $400 million project. Wexford Capital, a multibillion investment firm with over $6 billion in PE investments, was to be, but as it turned out, alas not to be, the financial partner on the deal. Wexford, for its part, calls Greenwich, Connecticut and Palm Beach, Florida home – depending on the season, that is.

It’s no exaggeration to say there’s been a fevered rush of money flooding commercial real estate (CRE) in recent years – private equity financed and otherwise. It’s also reasonable to characterize the land grab as global in scope. When Hong Kong and Singapore skyscrapers became too rich even for the rich folks’ blood, investors turned to the streets of London for relative bargains. When Canary Wharf eye candy was also deemed too pricey, the double-barreled money cannon was aimed squarely across the pond at New York’s fabled canyons, where iconic cloud kissers were downright cheap by comparison. Marquee markets always retain their value, the thinking goes, hence the justification for paying record prices.

By the time last summer rolled around, CRE prices had fully recovered their 2007 peak levels. It’s the since then that’s presumably caught Federal Reserve Chair Yellen’s eye. “Valuation pressures in commercial real estate are rising as commercial property prices increase rapidly,” the Chair said in a mid-July Congressional testimony. She then added, redefining understatement along the way, that, “underwriting standards at banks and in commercial mortgage-backed securities have been loosening.”

Maybe the fair chair has been added to the distribution list of Richard Hill, who I’ve come to know well over the years. Morgan Stanley’s eagle-eyed CRE analyst sets himself apart by following trends beyond commercial mortgage-backed securities to form a more holistic view of the broad landscape. Richard, working closely with his capable teammate Jerry Chen, was the first to point out that the Fed’s paring of purchases associated with its quantitative easing campaign, which threatened to push up interest rates, would trigger a reversal of money that had been fleeing US markets for years in search of higher yielding opportunities overseas.

As it so happens, the tapering of Fed open market purchases coincided with an explosion in foreign CRE purchases, which clocked in at $48 billion last year, amounting to 10 percent of transaction volume. Canada has traditionally been the biggest buyer of US CRE and led the way in 2014 with $16.7 billion in buying. But Asia wasn’t far behind. Investors from the Far East scooped up $10.7 billion in properties comprising 22.5 percent of cross-border transactions. The Chinese alone poured $3.4 billion into the U.S. to buy some 55 properties.

It could be that what has the Fed in a tizzy is the fact that 2015 sales have already wiped 2014 off the map. So far this year, foreign buyers have plunked down over $54 billion to fund cross-border investment. More notably, their share of the purchase pie has doubled to 20 percent. But here’s where things get really interesting. Asia’s share has leapt to 33.6 percent of transaction volume this year – that’s $18.2 billion in buys. And Singapore has unseated Canada as the biggest buyer, which is saying something about the depleted buying power of our neighbor to the north’s loonie (somehow discussion these days always leads back to oil prices) as well as Norway, which has traditionally come in second (did someone mention oil?).

If you’re beginning to detect a trend, don’t. Yes, weakening currencies have played their part in the changing composition of foreign CRE buyers this year. But at the very core of this frenzied buying is a recurring word that keeps appearing in one news item after another following Chair Yellen’s red flag raising (Any time the world’s most powerful central banker shines a harsh light on an asset class, it’s sure to garner attention in the media). That word is “stable,” which raises a huge red flag for me, and should for you as well. Not only do hard dollar assets shelter weakening currencies, they offer the promise of “stability” during times of market turbulence. If only.

Have I been struck with a bout of obtuseness? Do I not understand the basic diversification capabilities of hard assets when stocks and bonds are misbehaving so?

Maybe it’s the devil inside the transactions that torments me. Dig into the figures and the fastest area of growth this year is in sales of brick-and-mortar properties. Yep, retail stores are selling like hotcakes with transaction volumes up by a third over last year. This less than fashion worthy trend is being fed by activist shareholders, many of whom are akin to Gladys Kravitz of yesteryear’s Bewitched sitcom, busybody neighbors with too much time and other’s people’s money on their hands.

This is where the devil enters stage left. These shareholder activists – think spotlight-grabbing hedge funds – have been strongly encouraging failing retailers (we know who they are) to “unlock” the true value of their name brands by selling off their real estate holdings while prices are at record high levels and then leasing them back. So, cash out and then proceed to fail, but as a tenant instead of an owner. To think that a few brave analysts have dared question these moves which have effectively increased the risk in real estate investors’ portfolios by loading up on overpriced properties with shaky tenants.

Of course, the fastest and loudest money activists will shed their exposure to these retail properties faster than a molting snake in the hot desert sun. Not to mix metaphors, but really, who can blame them for being the bullies on the playground? Muscling weak retailers who won’t be with us in years to come to capitalize on an overheated real estate market can’t hurt their investors, at least in the short term.

The problem is someone on this playground will end up holding the proverbial deflated ball. If you harbor any doubts about the state of retail CRE, consider that through the first six months of this year, retailers have announced 5,130 store closings, nearly the same number as 2014 as a whole. Is it any wonder that retail prices have recouped the least among major CRE sectors compared to their respective 2007 peaks? Of course, this stands to reason. At 13 percent, the eCommerce share of retail sales is over three times what it was 20 years ago. Meanwhile, the average selling price of a unit of apparel has plunged 12 percent since 2001 to $21.75. What value, exactly, are activists “unlocking” by monetizing the structures that house the floundering merchants?

Not all that much given the recent performance of securities backed by commercial loans. Pardon the jargon but to ascertain performance, one must understand the basic concept of net operating income, or NOI, which is the annual cash flow generated by an income-producing property after accounting for all expenses incurred to operate said property. According to Morgan Stanley’s Richard and Jerry’s latest August tally, 42 percent of loans underwritten in the five years through 2014 have NOIs that are less than what was baked into the loan’s original underwriting. Delving deeper into the data, negative NOIs rise steadily from 21 percent for the 2010 vintage to 55 percent for 2014. To not be outdone, two loans that were underwritten this year went delinquent in August. One of these was an East Orange, NJ apartment complex. The other – wait for it – was a mixed-use retail development in Ft. Worth, Texas. (Oil anyone?)

Is commercial real estate in a bubble? The media attention following the Fed’s public angst that this could be the case prompted one publication to ask just that of 13 “top economists.” Twelve denied, denied, denied. One, though, Texas A&M Real Estate Center’s Mark Dotzour, ventured this far: “It’s a tale of two markets in the US commercial real estate market. Properties that are purchased by REITs, pension funds and foreign sovereign wealth funds are clearly in a bubble. But the vast majority of properties across America are highly priced, but not in a bubble.”

Being a Texas Longhorn myself, even on the eve of football season, I’ve got to give Mark this much – he is brave, even for an Aggie. The problem goes back to those aggressive foreigners. So far this year they’ve quadrupled their CRE purchases in non-major U.S. markets. Clearly they’re having a hard time stomaching the astronomical price tags in such trendy cities as San Francisco and Chicago.

Foreign investors could just say no. But that’s a bit of a challenge when total property allocations earmarked by sovereign wealth funds now top $6.3 trillion, more than double their 2008 levels. To make matters worse, foreign investors are having to compete with others who are equally yield-starved, all of whom are desperately seeking the philosopher’s stone of “stability.” Life insurers are serious contenders as are U.S. pension funds that have 7.7 percent of their assets invested in property, up from 6.3 percent in 2011. And they’re both increasing their allocations to the sector aggressively.

The big daddy though is private equity (PE) dry powder. PE real estate has racked up the fastest growth rate within the broad PE fund-raising universe: they’re sitting on $254 billion in highly combustible dry powder as of the end of June. Not only is this dollar figure unprecedented, it’s up 37 percent from year-end 2014 when it stood at $185 billion. Color me cynical but PE bigwigs, one of whom purchased the old Sears Tower in Chicago for $1.3 billion earlier this year based on a multiple of two times his past year’s personal income, don’t tend to return investors their committed capital. Rather, they deploy the capital, perhaps with regret. Perhaps not.

In the case of the Midland tower that never was, the potential deal proved to be too pricey, even for the powder-toting PE guys to ignore. If prudence prevails, 2015 will not be a record year for sales. As things stand, the year-to-date transaction volume of only $366 billion suggests a run rate just shy of a half trillion, which will fail to dethrone 2007’s record volume of $574 billion. But what if Trump does end up needing some extra moola to fund his runaway campaign after all? If the PE kingpins get really crafty, they could unlock some more big paydays by collaborating with the Donald. The hotly contested value to license the name of the world’s most bombastic man is purportedly topped only by his commercial real estate claims to fame, that is unless you throw into the running the overblown height of his ridiculous hair.

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Sunset at the Bakken Club

SUNSET AT BAAKENChristmastime socializing, oil patch style, was one of the first casualties of the collapse in energy prices that began last summer. It was December 2014 and an eviction notice had been served at 413 Main Street, Williston, North Dakota. The occupant, for all of 12 of the prior months, had been The Bakken Club, a limited-member social and business club which featured a bar and a restaurant. It’s sort of feasible that West Texas Crude (WTI) commanding $110 a barrel justified the cost to cavort. Individual memberships started at $5,000 initiation with $3,000 annual dues. Corporate memberships, which commanded a $15,000 one-time fee and $9,000 annual dues allowed three additional members to be included in the camaraderie. How very generous indeed.

That is, until oil fell out of bed. Something about that 46-percent decline from 2013’s to 2014’s Christmas Eves rendered the Club’s business model inoperable. The above referenced holiday-affronting eviction arrived before those poor souls on the blustery plains could even ring in the New Year. I’m just guessing here, but something tells me the initiation fee return-on-investment didn’t pan out the way the inaugural and final members envisioned.

The Bakken Club may have been one of the first oil-infused establishments to fold, but it certainly wasn’t and won’t be the last, not with the price of WTI dipping below the $40-level; it’s now down a further third from its 2014 closing price. A seminal piece of research produced by Deutsche Bank (DB) economists at the turn of the year resolved a good bit of the “conundrum” that’s kept economists scratching their heads. Why in Sam Hill have households not spent the resulting gasoline price windfall in an aggressive manner?

The DB team endeavored to gauge the potential economic blowback by estimating first the excess economic benefit the U.S. economy had enjoyed since 2006 thanks to the 12 states that benefitted most from the shale revolution. As of the end of last year, the U.S. energy sector was a $1 trillion annual industry with $250 billion in new capital expenditures and $700 billion in annual expenditures related to materials, labor, taxes and financing costs. DB’s analysts estimated that the annual pullback in capital expenditure plans – not current spending that can’t be curtailed – amounted to 30 percent of the $250 billion in existing plans, or $75 billion a year in lost economic output, or gross domestic product (GDP).

But that’s just half the story that’s led the economy to the precipice of the slippery slope on which it’s precariously perched. The number and quality of jobs created really digs down into the black gold the economy has pumped in recent years. According to DB, the furious quest for shale resulted in two million more jobs being created than otherwise would have been the case. More importantly, in this world where wages are as flat as Queen Isabella thought the world way back when, average wages would be $1.10 per hour lower in shale states had they grown at the national rate since 2006. Tally the dollar value of these two critical components and you get to an exceptional excess of $130 billion per year. Assuming (with the recollection that this math was done $25 a barrel ago) a 30 percent decline in this excess gets you to a $40 billion cutback.

Marry together the troublesome three — foregone capital expenditures, lost job creation and missing higher wages — and you get to $115 billion per annum as a starting point. Bear in mind, this hit does not incorporate the nasty economic side effects that accompany reduced shale drilling. We’re talking about lower consumption of electricity and production inputs such as steel, water, and chemicals, to say nothing of reduced demand for housing, and lest we forget, social club fees and annual dues.

To be absolutely sure, as I’m pleasantly reminded every time I fill up my gas-guzzling SUV, there’s been a tremendous and immediate benefit to drivers all across America. Economists putting pen to paper arrive at savings of around $120 billion annually. While that’s nothing to sneeze at, DB concluded that, “The benefits of lower energy prices are likely to be largely offset by costs associated with sector readjustment.”

As sure as today’s less convivial night follows tomorrow’s lower production day, Goldman Sachs recently commented on the latest “surprisingly” lackluster wage report: “Declines in wage growth in the shale states have been larger than changes in their unemployment rates would imply, reflecting both the sharp drop-off in wage growth in the mining sector and possibly also the reduced earnings that former energy sector workers are likely to face outside of the sector.” For the record, earnings at private employers were growing at a 2.1-percent rate as of the latest July data, right in line with the average since the current expansion began over six years ago. A separate gauge, the employment cost index, showed that wages grew by 0.2 percent in the second quarter, the measliest gain in over thirty years.

You may note the Goldman comment mentions the mining sector. Make no mistake, outside the perceived safe-haven of gold, commodities from aluminum to iron ore to steel to zinc are scraping 16-year lows. By that yardstick, throwing in agriculture for good measure (the Bureau of Economic Analysis does not separate out mining just yet – perhaps we are returning to an agrarian age, which would render those data-meisters visionaries), Wyoming is the most exposed state. Some 36 percent of the Cowboy State’s economy depends on agriculture and mining. The top ten list is rounded out, in order of dependence, by Alaska (27%), North Dakota (21%), West Virginia (18%), Oklahoma (16%), Texas (15%), New Mexico (12%), South Dakota (10.4%), Louisiana (10.1%) and Montana (9.8%). Another six states’ economies are at least six-percent dependent on the sectors compared to 3.9 percent for the nation as a whole.

Or, let a recent Liscio Report map do the talking. Here’s inflation-adjusted wage growth in manufacturing around the country, both from the 2009 wage trough and the 2010 peak. In terms of wage growth it matters, a lot, if you’re sitting on valuable natural resources. (Note to the gimlet-eyed: slightly different definition of “rig states” in this exercise, which has no effect on the overall point.)

 

Real Wage Changes in Manufacturing

My labor market guru and new partner Philippa Dunne’s latest communications with shale state revenue officials back the wage malaise story with lamentations that energy patch jobs are being replaced with positions in the leisure and hospitality industry. The retail sales and mall traffic data provide further validation – while back to school sales are up over last year’s, bargain hunting still rules the day. The one area middle class families are letting loose with their pump price savings is eating out. The problem with jobs being created that require the ability to take a BLT order is that each server-job created generates an annual income of between $7,000 and $35,000. But slice that paycheck range right down the middle and a given wait staff’s annual take, including tips and what few perks are on offer, is about $21,000. That level of income can’t hold a candle to even the lowest paying oil patch job where salaries tend to start in the $75,000-range.

The above picture, of course, only captures what’s going on inside U.S. borders. Although some policy makes, including within the FOMC, may think that policy can be set in a vacuum, the uncomfortable truth is that the rest of the world matters – like a whole lot. Heading into the year, the general consensus was twofold. 1) The economic benefits of falling oil prices would outweigh the costs (see above). 2) The U.S. economy, and other oil importing nations, would be largely indemnified from the pain felt in beleaguered commodity exporting countries such as Brazil, Chile, Russia and Venezuela, to name but a few.

Closest to home, Canada and Mexico are both seeing their economic waters roiled by the double whammy of falling energy prices and its close compadre, the strengthening dollar, which both pressure downward export revenues and push higher imported goods prices for domestic consumers. Both the Canadian loonie, smarting at an 11-year low to the dollar, and the Mexican peso, which has crashed to a record low, reflect the downward stress being exerted on  those countries’ economies. Stories of cratering cross-border sales to the south and rising mortgage delinquencies to the north increasingly populate the headlines.

But the real story is China, whose currency was, until recently, pegged to the U.S. dollar. When you’re in the business of dumping all manner of commodities on the world markets, that peg can start to feel more like a thorn in the side. As anyone anywhere on the planet is now fully aware, the most miniscule of devaluations can catalyze contagious calamities, at least in the financial markets. At the risk of being overly simplistic, the further the Chinese yuan falls against the dollar, the more the dollar is pressured upwards and hence, other countries’ currencies woes are magnified.

Stepping back, there’s no such thing as a win-win in currency wars exacerbated by the unwinding of one of the most magnificent speculative bubbles of all time. For any who doubt commodities were in a bubble, or worse, believe oil at these levels is the buying opportunity of a lifetime, I’ll share with you some parting thoughts care of New Albion Partners’ Brian Reynolds. The commodities bubble began to deflate towards the end of 2013. At that same time, pensions, desperate for a hedge against the threat of inflation accompanying the Fed’s last (failed) stab at tightening monetary policy, were players too big to buy directly into the commodities markets due to position limits. So they turned to their all-too-amenable Wall Street bankers to devise a way to obtain said inflation protection via the derivatives market. Before all was said and done, there were an estimated $2.3 trillion of these securities outstanding backing ten times that level of underlying commodities.

In other words, the Street, in its infinite avarice, was able to create securities worth multiples of the value of the underlying assets (if that theme elicits a feeling of deja vu, it’s because bankers did the same thing in cycles past with fiber optics and subprime mortgages). Once the unwind of these trades was triggered by this or that commodity hitting the lower contracted bound, an avalanche of money broke the dams, flooding out of the sector and befuddling market veterans. As Brian summed up: “Few analysts in those sectors grasped that the structuring dwarfed the physical supply and demand for those assets.”

If there’s one thing I learned during my time on Wall Street during dotcom mania, it’s that once bankers’ sights have shifted to a new target, their past darlings never return to favor. There will be no saving grace for the commodities complex. The Bakken Club, and the boost to economic growth and conviviality it personified, ain’t coming back any time soon.

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Drafting the Dodge – A Mother’s Battle Plan to Combat the Currency Wars

Wars are funny the way they bring people together. I wouldn’t exist if not for Vietnam. It was 1966. My father was studying at UCONN in Storrs, Connecticut and he had discovered his draft number was coming up. Rather than risk coming home in an Army-issued body bag, he did as many boys did back then and rushed out to join the Air Force. To this day, basic trainees are shipped to Lackland Air Force Base for that grueling six-week introduction to serving Uncle Sam. And that’s where he met my mom, a girl from South Texas who commuted to the big city where she was starting a 37-year career as a civil servant.

Wars also rip things apart; never does a true ‘victor’ emerge, and many lives are ruined. That was certainly the case in World War II, which also claimed the economic casualty of the British Pound Sterling. And that brings us to why the Chinese greeting “Nihao,” elicits all manner of drama in my home. Such is the reaction of my four children when the time comes twice a week, every week, to sit down and endure their Mandarin lessons.

There is no conspiracy afoot but rather prudent parental planning. History has a tendency to rhyme, we’ve all been told, even if it doesn’t exactly repeat verbatim. If the Chinese do indeed have their eye on their currency reigning supreme once again, as was last the case during the Liang Dynasty in the 5th Century AD, better to be prepared rather than unprepared for a potential military conflict such as the one which preceded the British pound’s decline and King Dollar’s ascent. Let’s just say that the knowledge that my four children will be fluent in Chinese helps me sleep at night. We know from history that the State Department places a premium on language skills during times of war. Call it the mother of all insurance policies.

Debating Chinese politicians’ motivation for the August 10th devaluation of the yuan, the first such move since 1994, is de rigueur among financial market players and economists alike. Questions abound. Is this move simply a defensive maneuver to prevent their currency from continuing to appreciate vis-à-vis the dollar? There’s no way the past five years’ 30-percent inflation-adjusted broad effective exchange rate appreciation has been easy to stomach for the Chinese, despite the yuan’s undervalued starting point.

No doubt, a weaker yuan will benefit China’s ailing, over-capacitated manufacturing sector by making its exported goods more affordable to its trading partners. But a three-percent devaluation in the currency won’t even begin to nudge the needle on the world trade speedometer. The hobbled Chinese export machine needs a whole heck of a lot more than a one-off adjustment to get back up and running. And that’s assuming the rest of the world is capable of absorbing higher imports, a steep assumption if there ever was one.

Some theorize that the devaluation is the first baby step towards abandoning the link to the dollar on the road to eventual independence or perhaps an Asian currency block. While the Chinese policymakers have not been coy about their intentions to segue to a market-based pricing mechanism for their currency, once again, the magnitude of the devaluation is insufficient to conclude this qualifies as a base case. That said, it has been eye-opening to witness the applause of the International Monetary Fund, and even our own Treasure Department. In the IMF’s words, the yuan reforms could bring the currency “close” to a full floating rate status.

Of course, the road to floating-rate nirvana is not paved with gilded ease. Some estimates put the annual level of capital flight at $800 billion. Any further devaluation will push more capital out the red-lacquered door. Moreover, Chinese companies are saddled with $1.2 trillion in dollar-denominated debt. The cheaper the yuan, the more expensive the debt to service. As for my former employer, the Fed is loath to withstand any kind of dramatic devaluation. The strong dollar is already acting as an anvil on US multinationals, not that currencies are technically an operative that falls under the Fed’s directive.

What is formally mandated, however, is that the Fed maintain price stability. It’s difficult to succeed in doing so when the Chinese are importing lower prices into the US faster that the domestic economy can pressure prices upwards. The deflationary Chinese cards were stacked against the Fed even before the early August surprise devaluation. The increasingly rapid pace of Chinese import price declines can only be exacerbated by a weaker yuan. Consider today’s starting point: the currency’s 2.3-percent annualized slide over the past three months is the deepest in two years. Interest rate strategists at Morgan Stanley figure that every subsequent two-percent depreciation in the yuan results in a 0.5-.10 percentage point pass through to lower core consumer prices here in the US.

Central bankers worth their salt will tell you that lags matter. We know there’s little chance that the yuan depreciation will filter through to consumer prices before the Fed convenes on September 16th and 17th to decide if they will lift interest rates for the first time in nine years. In true economist speak – on the other hand, with their inherent appreciation of lagged effects in hand, policymakers will have full knowledge that deflationary pressures are building in the pipeline. So will they hike? Or will they heed to the risk of a policy mistake? (Spoiler alert: they have yet to blink at the risk of the latter).

For now, I’m sticking with my friend, Leland Miller’s take on the situation. Lee is the Chairman and CEO of the China Beige Book (CBB), the ultimate weapon to combat the sometimes questionable reliability being distributed by Chinese policymakers labeled as “economic data.” (If you must know, Lee doesn’t think things in China are near as dire as the media and most doomsayers purport).

In Lee’s view, China has not just launched an all-out currency war. The move to devalue is better described as “tweaking around the edges.” That said, it also, “raises global uncertainty, annoys the US Congress, and is part of a silly cat-and-mouse routine with the IMF. But China knows how to take decisive steps, and this isn’t one.”

Perhaps it’s not so much what China has done that concerns me. Rather it’s how the rest of the economically stressed world reacts, especially as it pertains to emerging markets that are directly affected. My favorite anecdote that best captures the damage wrought by Chinese hyperactive industriousness is that between 2011 and 2013, the Chinese produced more cement than did the US in the entire 20th century. At some point, some move by China could sufficiently anger its already testy trading partners who are exhausted by the deflationary effects of China’s never ending flooding of the world’s commodities markets.

Lee nods to this as a potential risk: “What China’s trading partners do now is a harder question. In light of their own behavior, they are not justified in treating this as aggressive on China’s part. But they might anyway.”

Which brings us back to the gnashing of the teeth by my offspring when the ever patient Ms. Li walks through the door to school my unruly brood in the national language of the People’s Republic of China. Navigating the aftermath of one of the most extraordinary build-ups of debt in the history of mankind could prove to be too tall of an order for Chinese policymakers, even ever-equipped as they always are with strong-armed maneuvers. If the Chinese do intend to introduce a full blown currency regime shift, if this is not a small chess move, if this is an orchestrated first step towards assuming reserve currency status, well then that could be a game changer, not just for the global economy and financial markets, but potentially for the balance of nations as we know it today.

It’s been five years since China overtook Japan as the world’s second largest economy, exactly how long Mandarin has been taught in my home. Along the way, tensions between Japan and China have been building as the larger of the two nations needles the other by engaging in inflammatory tactics such as building airstrips in the middle of the disputed South China Sea. The alarming thing about superpower squabbles is they could spill out onto the world stage with disastrous results.

Most acknowledge that there’s no turning back from a world that’s gone global. The alternative, back-tracking and economic isolationism, introduces the potential for conflict. Either way – continued economic integration or brewing conflict if the globe looks inward – my kids are reluctantly but effectively covered. The dodge has been drafted.

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http://dimartinobooth.com/drafting-the-dodge-a-mothers-battle-plan-to-combat-the-currency-wars/