Friday, September 12, 2014

Apple’s Smartwatch May put Biotech on Silicon Valley Time

By Patrick Cox


Tech sites are buzzing right now about the new Apple smartwatch and iPhone. Having been a part of or close to the tech industry for a long time, the excitement that builds over new products doesn’t normally move me much. This time, though, it’s a little different because of reports that the phone and watch will be integrated to support healthcare apps.

The technological convergence was never just about bringing entertainment to mobile devices. Finally, we’re seeing the convergence expand into areas that directly impact health. The timing is perfect.

The history of medicine is as old as the history of humankind. Even prior to the rise of Egyptian and Indian civilizations, humans were treating medical ailments with varying success. If you haven’t looked at the research regarding Ötzi the Iceman, I recommend it. In 1991, the mummified and frozen body of a man who died approximately 5,300 years ago was found in the mountainous border between Austria and Italy.

The objects on his body have inspired extensive research and surprise, but several things stand out to me. One is that his weapons and clothing, especially his shoes, required skills and materials that couldn’t have been available to every individual at the time. They were, therefore, constructed by skilled specialists and traded across considerable distances.

Clearly, commerce and trade were not only common among prehistoric humans, the practice of voluntary trade clearly gave practitioners enormous advantages in the struggle to survive and raise their families. Trading is not something outside of human nature, as antibusiness forces want us to believe. It is ingrained in our DNA.

The most interesting item found on Ötzi, in my opinion, was a fungus, the Piptoporus betulinus mushroom that grows on birch trees. Like the penicillin fungus, it has antibiotic and anti-inflammatory properties and was probably traded and used by ancient Europeans to treat stomach ulcers and parasites, which Ötzi suffered from. In the Americas, native populations were also developing effective medicines such as anti-inflammatory tobacco poultices for insect bites and other injuries.

Obviously, the body of medical knowledge accumulated by our species since then has grown in volume and sophistication. In truth, it’s actually overwhelming. This collective information is an enormous resource for doctors and healthcare professionals of all types. Dozens of online libraries, catalogs, and databases are available for help in diagnosis and treatment design.

This rich volume of knowledge, however, has a downside. No individual can possibly know everything about modern medicine. While the specific, pertinent pieces of information needed for a given diagnosis or treatment are almost guaranteed to be out there somewhere, sifting through it all can be menacing. Even if time were not a factor when a patient is suffering, finding the one detail that makes the difference can be difficult. In the hospital scenario, this is a particular problem because time so often is precious.

Healthcare professionals are integral members of our society, and while not all are fantastic, a large majority do tremendous work and are incredibly knowledgeable. Even the most well-trained, experienced doctor still has the flaw of being human, however. Expecting physicians to hold the entirety of human medical knowledge in their working memory and to be able to recall the most obscure details at a moment’s notice is to expect the impossible. This only represents one of the many challenges a physician may face, but this one perfectly matches the skillset of computers.

Mobile AIs with diagnostic capacities and access to all databases will help doctors narrow down the choices significantly by giving them access to information wherever they are. Another technology that will eventually have a huge impact on the healthcare field is virtual reality. Immersive visual technologies like Oculus Rift plus a haptic feedback technology that delivers feelings to the user will allow surgeons to practice rare, dangerous, and difficult surgeries to maximize the safety of the procedure.

Not only would technologies like Google Glass allow doctors to find information on the fly, it would enable expedited communication between doctors, not only in the same hospital but hundreds of miles away as well. Stories like that of South Dakotan Tom Soukup illustrate the transformation of the healthcare system toward one where all medical knowledge is made available to doctors and of use to the consumer.

In Mr. Soukup’s case, he was badly injured by a cow on a ranch outside of the small town of Wagner, South Dakota. The closest hospital’s doctor, however, didn’t have expertise in the kind of surgery that Soukup needed. If it had been a different era, Soukup’s story might have been found in an obituary, but that is not the case.

The doctor in Wagner’s hospital got on a video conference with experts in a Sioux Falls hospital, who were able to direct Soukup’s doctor, most likely saving his life. On the international scale, the ability to get the opinion and guidance of any expert in the world at a moment’s notice has the potential to break down borders between the healthcare communities of all different countries. In time, patients will have access to the very best medical wisdom no matter where they’re located.

The iPhone-smartwatch combination may not seem to be a great step toward the realization of this goal, but time runs at a faster pace in the world of computer technologies than it does elsewhere. With Apple’s entrance into mobile health, we’re going to see a new breed of entrepreneur pushing the envelope of biotech progress.

For too long, medicine has been held back by the glacial pace of last century’s regulatory model. IT executives have a very different attitude, and they’re getting better at influencing policy makers. Biotech progress is already surpassing Moore’s law in many areas, but the arrival of Apple into this area is going to accelerate the industry, compressing time further. This may be the most significant aspect of the company’s newly launched smartwatch.

Sincerely,

Patrick Cox

To learn more about the new research driving Patrick's investigations at his Transformational Technology Alert letter for Mauldin Economics, click here.

Thursday, September 11, 2014

[Alert] Encore Training TONIGHT

I hope you were one of the lucky ones that made it on John Carters webinar on Tuesday because I know that a lot of you tried, but weren't able to.
How do I know? I'm basing that on the number of support tickets John received from people that got locked out begging for a chance to see it.

8:00pm Eastern
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Hedge Fund University

Floating Rate Funds Poised to Profit as Interest Rates Rise

By Andrey Dashkov

Money can’t be this cheap forever. In other words, one of the most likely scenarios the U.S. economy faces is rising interest rates. The current low interest rate climate is simply unsustainable. At some point—as it always does—the trend will turn around. We want to be prepared for that turn, and the right floating-rate fund can help.

A floating rate loan is a bank loan with interest that’s tied to some benchmark rate, often the London Interbank Offer Rate (LIBOR). When the LIBOR changes, so does the loan’s coupon. The rate is adjusted every 30 - 90 days. Floating rate funds are pools of capital that invest in these loans, earn variable-rate interest, and pay dividends that are themselves flexible.

Variable Dividends Boost Immunity


Variable dividends are the key feature of floating rate funds. They’re what separate floating rate funds from the rest of the debt market. Flexible dividends make shares of the bond funds immune to rising interest rates; the prices of the bonds and the fund’s shares don’t get punished when rates go up. What the investor sees is higher dividends; his principal is safe.

A note of caution is in order here: Even though floating rate bonds don’t have the same inverse price-yield relationship as fixed rate debt instruments, their prices can still go down. Although the automatic coupon adjustments mostly eliminate the first major risk of any debt instrument—interest-rate risk—floating-rate funds still hold the other major risk: credit risk. As a reminder, credit risk is the risk that the borrower won’t make payments on time or will default on the debt entirely.

The credit risk of floating rate loans is high because the companies that borrow under these conditions are usually rated below investment grade. They can’t go to capital markets for money because fixed rate loans would be too expensive, so they turn to banks that provide funds on floating rate terms.

Since the companies borrowing these funds are below investment grade, their default rates are close to those of speculative grade bonds. Vanguard Research reports that the average annual default rate from 1996 to 2012 for speculative grade bonds was 4.5%; for senior floating rate loans, it was 3.4%. Better, but still much higher than investment-grade bonds at 0.1%.

High Post - Default Recovery Rates


Does this mean that you should avoid floating rate loans in favor of AAA-rated debt? No. First, floating-rate loans are high in a companies’ debt structure, which means that if the borrower defaults, investors holding floating rate debt have a priority claim on the company’s assets. This leads to very high recovery rates for senior floating rate loans in the event of default: 71.1%, or more than 70 cents on the dollar. Compare that to the next class of loans, senior secured, which are recovered at a rate of 56.8%.

Second, floating rate loans outperform both high yield loans and the aggregate U.S. bond market. According to Vanguard, during the last three rising rate periods (January 1994-February 1995, June 1999-May 2000, and June 2004-June 2006) floating rate bonds outperformed high yield instruments by 2.5 percentage points (pp) and the aggregate bond market by 4.3 pp.

After the rising rate periods end, however, floating rate funds tend to underperform both high yield instruments and the overall bond market. This is why we’re buying them now, when rates have nowhere to go but up. We don’t know when that will happen, but when it does, we want to be positioned to profit.
In addition to their excellent performance in rising interest rate periods, floating rate funds are good for diversification. Their correlation with the overall US bond market is close to zero, which makes them especially good for a portfolio focused on fixed-rate US bonds. However, they also belong in our retirement portfolio—the Money Forever portfolio—where we use them to diversify our allocation across various debt instruments and to make sure we are well positioned to profit from rising interest rates.

Entrée into the World of Big Money


To sum it up, floating rate funds provide a way to diversify into an investment class that is almost immune to rising interest rates. Like business development companies, floating rate funds offer retail investors entrée into an area of finance usually reserved for big money and institutions. In exchange for these opportunities, investors accept credit risk due to the low credit ratings of the borrowing companies. With that in mind, we pay close attention to the sectors of the funds we consider investing in, and prefer more defensive and crisis-resistant industries.

At Miller’s Money we closely monitor the bond market, constantly scouting out the best options for seniors and savers. Learn more need to know information about bonds and the role they play in today’s low-interest rate environment by downloading our free special report, Bond Basics today.



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Wednesday, September 10, 2014

Did You Miss Tuesdays Free "Options Trading Made Easy" Webinar?........Don't Worry

Due to an even higher then usual demand for this weeks free webinar we have added a second webinar this Thursday evening. Our trading partner John Carter is now going to make this even easier to understand with another one of his wildly popular free webinars, “How to Beat the Market Makers using Weekly Options”, this Thursday September 11th at 8 p.m. EST .

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- How to determine the safe levels to take weekly options trades

- The best way to protect yourself and minimize risk while increasing the probability of maximum reward

- How to choose the right stocks for weekly options and which stocks you want to avoid like the plague

- A simple and powerful strategy that you can use whether you’re a beginner or advanced options trader

- How to consistently trade this current market using weekly options

- And much more…

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See you on Thursday evening!
Hedge Fund University

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Tuesday, September 9, 2014

Europe Takes the QE Baton

By John Mauldin


If the wide, wide world of investing doesn’t seem a little strange to you these days, it can only be because you’re not paying attention. If you’re paying attention, strange really isn’t the word you’re probably using in your day-to-day investing conversations; it may be more like weird or bizarre. It increasingly feels like we’re living in the world dreamed up by the creators of DC Comics back in the 1960s, called Bizarro World. In popular culture "Bizarro World" has come to mean a situation or setting that is weirdly inverted or opposite from expectations.

As my Dad would say, “The whole situation seems about a half-bubble off dead center” (dating myself to a time when people used levels that actually had bubbles in them). But I suppose that now, were he with us, he might use the expression to refer to the little bubbles that are effervescing everywhere. In a Bizarro French version of very bubbly champagne (I can hardly believe I’m reporting this), the yield on French short term bonds went negative this week. If you bought a short-term French bill, you actually paid for the privilege of holding it. I can almost understand German and Swiss yields being negative, but French?

And then Friday, as if to compound the hilarity, Irish short term bond yields went negative. Specifically, roughly three years ago Irish two year bonds yielded 23.5%. Today they yield -0.004%! In non-related un-news from Bizarro World, the Spanish sold 50-year bonds at 4% this week. Neither of these statistics yielded up by Bloomberg makes any sense at all. I mean, I understand how they can technically happen and why some institutions might even want 50-year Spanish bonds. But what rational person would pay for the privilege of owning an Irish bond? And does anyone really think that 4% covers the risk of holding Spanish debt for 50 years? What is the over-under bet spread on the euro’s even existing in Spain in 50 years? Or 10, for that matter?

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We might be able to lay the immediate, proximate cause of the bizarreness at the feet of ECB President Mario Draghi, who once again went all in last Monday for his fellow teammates in euroland. He gave them another round of rate cuts and the promise of more monetary easing, thus allowing them to once again dodge the responsibility of managing their own economies. The realist in me scratches my already well scratched head and wonders exactly what sort of business is going to get all exuberant now that the main European Central Bank lending rate has dropped to 0.05% from an already negligible 0.15%. Wow, that should make a lot of deals look better on paper.

We should note that lowering an already ridiculously low lending rate was not actually Signor Draghi’s goal. This week we’ll look at what is happening across the pond in Europe, where the above-mentioned negative rates are only one ingredient in a big pot of Bizarro soup. And we’ll think about what it means for the U.S. Federal Reserve to be so close to the end of its quantitative easing, even as the ECB takes the baton to add €1 trillion to the world’s liquidity. And meanwhile, Japan just keeps plugging away. (Note: this letter will print longer than usual as there are a significant number of graphs. Word count is actually down, for which some readers may be grateful.)

But first, I’m glad that I can finally announce that my longtime friend Tony Sagami has officially come to work for us at Mauldin Economics. Tony has been writing our Yield Shark advisory since the very beginning, but for contractual reasons we could not publicize his name. I will say more at the end of the letter, but for those of you interested in figuring out how to increase the yield of your investments, Tony could be a godsend.

The Age of Deleveraging

Extremely low and even negative interest rates, slow growth, unusual moves by monetary and fiscal authorities, and the generally unseemly nature of the economic world actually all have a rational context and a comprehensible explanation. My co-author Jonathan Tepper and I laid out in some detail in our book End Game what the ending of the debt supercycle would look like. We followed up in our book Code Red with a discussion of one of the main side effects, which is a continual currency war (though of course it will not be called a currency war in public). Both books stand up well to the events that have followed them. They are still great handbooks to understand the current environment.

Such deleveraging periods are inherently deflationary and precipitate low rates. Yes, central banks have taken rates to extremes, but the low rate regime we are in is a natural manifestation of that deleveraging environment. I’ve been doing a little personal research on what I was writing some 15 years ago (just curious), and I came across a prediction from almost exactly 15 years ago in which I boldly and confidently (note sarcasm) projected that the 10-year bond would go below 4% within a few years. That was a little edgy back then, as Ed Yardeni was suggesting it might go below 5% by the end of the following year. That all seems rather quaint right now. The Great Recession would send the 10-year yield below 2%.

Sidebar: The yield curve was also negative at the time, and I was calling for recession the next year. With central banks holding short-term rates at the zero bound, we no longer have traditional yield curve data to signal a recession. What’s a forecaster to do?

I was not the only one talking about deflation and deleveraging back then. Drs. Gary Shilling and Lacy Hunt (among others) had been writing about them for years. The debt supercycle was also a favorite topic of my friend Martin Barnes (and prior to him Tony Boeckh) at Bank Credit Analyst.

Ever-increasing leverage clearly spurs an economy and growth. That leverage can be sustained indefinitely if it is productive leverage capable of creating the cash flow to pay for itself. Even government leverage, if it is used for productive infrastructure investments, can be self sustaining. But ever increasing leverage for consumption has a limit. It’s called a debt supercycle because that limit takes a long time to come about. Typically it takes about 60 or 70 years. Then something has to be done with the debt and leverage. Generally there is a restructuring through a very painful deflationary bursting of the debt bubble – unless governments print money and create an inflationary bubble. Either way, the debt gets dealt with, and generally not in a pleasant manner.

We are living through an age of deleveraging, which began in 2008. Gary Shilling summarized it this week in his monthly letter:

We continue to believe that slow worldwide growth is the result of the global financial deleveraging that followed the massive expansion of debt in the 1980s and 1990s and the 2008 financial crisis that inevitably followed, as detailed in our 2010 book, The Age of Deleveraging: Investment strategies for a decade of slow growth and deflation. We forecast back then that the result in the U.S. would be persistent 2% real GDP growth until the normal decade of deleveraging is completed. Since the process is now six years old, history suggests another four years or so to go.

We’ve also persistently noted that this deleveraging is so powerful that it has largely offset massive fiscal stimuli in the form of tax cuts and rebates as well as huge increases in federal spending that resulted in earlier trillion dollar deficits. It has also swamped the cuts in major central bank interest rates to essentially zero that were followed by gigantic central bank security purchases and loans that skyrocketed their balance sheets.  Without this deleveraging, all the financial and monetary stimuli would surely have pushed real GDP growth well above the robust 1982–2000 3.7% average instead of leaving it at a meager 2.2% since the recovery began in mid-2009.

The problems the developed world faces today are the result of decisions made to accumulate large amounts of debt over the past 60 years. These problems cannot be solved simply by the application of easy-money policies. The solution will require significant reforms, especially labor reforms in Europe and Japan, and a restructuring of government obligations.

Mohammed El-Erian called it the New Normal. But it is not something that happens for just a short period of time and then we go back to normal. Gary Shilling cites research which suggests that such periods typically last 10 years – but that’s if adjustments are allowed to happen. Central banks are fighting the usual adjustment process by providing easy money, which will prolong the period before the adjustments are made and we can indeed return to a “normal” market.

How Bizarre Is It?

We are going to quickly run through a number of charts, as telling the story visually will be better than spilling several times 1000 words (and easier on you). Note that many of these charts display processes unfolding over time. We try to go back prior to the Great Recession in many of these charts so that you can see the process. We are going to focus on Europe, since that is where the really significant anomalies have been occurring.

First, let’s look at what Mario Draghi is faced with. He finds himself in an environment of low inflation, and expectations for inflation going forward are even lower. This chart depicts inflation in the two main European economies, Germany and France.



Note too that inflation expectations for the entire euro area are well below 1% for the next two years – notwithstanding the commitment of the European Central Bank to bring back inflation.



But as I noted at the beginning, ECB policy has already reached the zero bound. In fact the overnight rate is negative, making cash truly trash if it is deposited with the ECB.



With inflation so low and a desperate scramble for yield going on in Europe, rates for 10-year sovereign debt have plummeted. It is not that Italy or Spain or Greece or Ireland or France is that much less risky than it was five years ago.

Note that banks can get deposits for essentially nothing. They can lever those deposits up (30 or 40 times), and the regulators make them reserve no capital against investments made in sovereign debt. Even after their experience with Greek debt, they essentially claim that there is no risk in sovereign debt. If your bank’s profits are being squeezed and it’s hard to find places to put money to work in the business sector, then the only game in town is to buy sovereign debt, which is what banks are doing. Which of course pushes down rates. Low interest rates in Europe are as much a result of regulatory policy as of monetary policy.

Next is a chart of 10 year bond yields. We’ve also included the US, Japan, and Switzerland. Note that Japan and Switzerland are in the 50-basis point range. (Japan is at 0.52%, and Switzerland is at 0.45%). Italy and Spain now have 10 year bond yields below that of the US.



The following chart is a screenshot of a table from Bloomberg, listing 10 year bond yields around Europe. Note that Greece is at 5.48%. Hold that thought while you look at the table.



This next chart requires a minute or two of analysis, and looking at it in black and white probably won’t work. Essentially, this is the spread of the yields of 10-year bonds of various European countries over German bunds. Note that only two years ago Greek debt paid 25% per year more than German debt did. Anyone who bought Greek debt when that country was busy defaulting has scored big. (While I probably take far too much risk in my portfolio, I will readily admit to not having enough nerve to do something like that.) The other thing to note, and it is a little bit more difficult to see on this chart, is that for all intents and purposes the market is treating European-wide EFSF debt as German debt. There are only 10 basis points of difference.



Now let’s take a little stroll through history and view a chart of the yield curve of French debt. The top dotted line is where the yield curve was on January 1, 2007. We took our first look at this chart last Tuesday in preparation for this letter, noting that short-term French debt was at the zero bound. It went negative on Thursday, and negative all the way out to two years! Note that a 50-year French note (which I’m not sure actually trades) yields a hypothetical 2.5%, only modestly more than a 30-year would yield. You might have to have the patience of Job, and I’m not sure quite how you would go about executing the trade, but that has to be one of the most loudly screaming shorts I’ve ever seen!



Here is the equivalent chart for the German yield curve going back to January 2007. Note that German debt has a negative yield out to three years!!!



While it should surprise no one, German long-term bond yields are at historic lows. I recall reading that Spanish bond yields are lower now than they have been at any other time in their history. I actually applaud the Spanish government for issuing 50-year bonds at 4%. I can almost guarantee you the day will come when Spain looks back at those 4% bonds with fondness. (I assume that the buyers are pension funds or insurance companies engaged in a desperate search for yield. I guess the extra 2% over a ten-year bond looks attractive … at least in the short term.)

And finally, let’s really widen our time horizon on German yields:



Time to Ramp up the Currency War

The yen hit a six-year low this week (over 105 to the dollar), creating even more of a problem for Germany and other European exporters to Asia. The chart below shows that Germany’s exports to the BRIICS except China are down significantly over the past few years, partially due to competition from Japan as the yen has dropped against the euro.

The yen-versus-euro problem (at least from Germany’s standpoint) is exacerbated by the remarkable appetite of Japanese investors for French bonds. This has been going on for over a year. In May and June of this year alone, Japanese investors bought $29.3 billion worth of French notes maturing at one year or more (presumably, this was before rates went negative). Note that even with minimal yields, the Japanese investors are up because of the currency play. (Interestingly, Japanese investors are dumping German bonds, again a yield play.)

Japanese analysts say that Japanese investors are hesitant to take the risks on the higher-yielding Italian and Spanish bonds, but for some reason they see almost no risk in French bonds. (Obviously not many Thoughts from the Frontline readers in Japan.) This behavior, of course, helps to drive down the price of the yen relative to the euro. (Source, Bloomberg)



Interesting side note: the third-largest country holding of US treasuries behind Japan and China is now Belgium. When you first read that, you have to do a double-take. Digging a little deeper, you find out there’s been a 41% surge in Belgian ownership of US bonds in just the first five months of this year. As it turns out, Euroclear Bank SA, a provider of security settlements for foreign lenders, is based in Belgium and is where countries can go to buy bonds they are not holding in their own treasuries. This buying surge is helping hold down US yields even as the Federal Reserve is reducing its QE program. Further, there is serious speculation, or rather speculation from serious sources, that Russian oligarchs are piling into US dollars by the tens of billions, again through Belgium.

Europe Takes the Baton

It is probably only a coincidence that just as the Fed ends QE, Europe will begin its own QE program. Note that the ECB has reduced its balance sheet by over $1 trillion in the past few years (to the chagrin of much of European leadership). There is now “room” for the ECB to work through various asset-buying programs to increase its balance sheet by at least another trillion over the next year or so, taking the place of the Federal Reserve. Draghi intends to do so.

Risk-takers should take note. European earnings per share are significantly lower than those of any other developed economy. Indeed, while much of the rest of the world has seen earnings rise since the market bottom in 2009, the euro area has been roughly flat.


Both the US and Japanese stock markets took off when their respective central banks began QE programs. Will the same happen in Europe? QE in Europe will have a little bit different flavor than the straight-out bond buying of Japan or the US, but they will still be pushing money into the system. With yields at all-time lows, European investors may start looking at their own stock markets. Just saying.

Draghi also knows there is really no way to escape his current conundrum without reigniting European growth. One of the textbook ways to achieve easy growth is through currency devaluation; and as we wrote in Code Red, the ECB will step up and do what it can to cheapen the euro in competition with Japan.
Just as the world is getting fewer dollars (in a world where global trade is done in dollars), Draghi is going to flood the world with euros.

Bank of Japan Governor Kuroda has steered the BOJ to where it now owns 20% of all outstanding Japanese government debt and is buying 70% of all newly issued Japanese bonds. The BOJ hoped that by driving down long-term rates it could encourage Japanese banks to invest and lend more, but bond-hungry regional Japanese banks are still snapping up long-term Japanese bonds, even at 50 basis points of yield. Given the current environment, the Bank of Japan cannot stop its QE program without creating a spike in yields that the government of Japan could not afford. Hence I think it’s unlikely that Japanese QE will end anytime soon, thus putting further pressure on the yen.

The BOJ is going to continue to buy massive quantities of bonds and erode the value of the yen over time in an effort to get 2% inflation.

In a world where populations in developed countries are growing older and are thus more interested in fixed-income securities, yields are going to be challenged for some time. Those planning retirement are going to generally need about twice what would have been suggested only 10 or 15 years ago in order to be able to achieve the same income. Welcome to the world of financial repression, brought to you by your friendly local central bank.

Introducing Tony Sagami

When we first launched Mauldin Economics some two years ago, my partners and I thought there was a need for a good fixed-income letter with a little different style and focus. My very first phone call was to my longtime friend Tony Sagami, to ask if he would write it. I have known Tony for almost 25 years. We have worked together, he has worked for me, and we have been competitors, but we’ve always been good friends.

Even though he now lives in Bangkok most of the year, we still visit regularly by email and Skype, and try to make a point of catching up in some part of the world at least twice a year. In addition to his talents as a writer, Tony brings a seasoned perspective and huge experience as a trader and investor. (Seasoned is a technical term for getting older, having made lots of instructive mistakes in your early years.) He has a way of taking my macro ideas and efficiently and effectively putting them to work. I know Yield Shark subscribers must be happy, because our renewal rates are very high by industry standards.

As I mentioned early in the letter, for contractual reasons we haven’t been able to name Tony as the editor of Yield Shark. I’m really pleased that we can do so now. Tony was recently in Dallas, and we did a short video together so that I could introduce him. You can watch the video and learn more about Tony here. You will soon be receiving information from my partners about a new newsletter that Tony will also be writing, which we are tentatively calling The Rational Bear.

San Antonio, Washington DC, Chicago, and Boston

My respite from travel will be over in a few weeks as I head to the Casey Research Summit in San Antonio, September 17-21. It actually takes place at a resort in the Hill Country north of San Antonio, which is a fun place to spend a weekend with friends. Then the end of the month will see me traveling to Washington DC for a few days.

I'll be back in Dallas in time for my 65th birthday on October 4, and then I get to spend another two weeks at home before the travel schedule picks back up. I will make a quick trip to Chicago, then swing back to Athens, Texas, before I head on to Cambridge, Massachusetts, for conferences. There are a few other trips shaping up as well.

My time at home has been well spent, as I’m catching up on all sorts of projects, spending more time in the gym, and just enjoying being home. Surprisingly, being at home has allowed me to see more friends than usual as they’ve come through town. Dennis Gartman was in yesterday, and we spent two pleasant hours catching up over lunch. He is one of the truly consummate gentlemen in our business and a bottomless reservoir of great stories. A perfect evening would be Dennis Gartman and Art Cashin holding court at the Friends of Fermentation after the market closes. You’d just sit there and scribble notes.

The other thing about being home is that it makes me want to get on a plane and go see even more friends! Yesterday I caught up with George and Meredith Friedman on the phone, and we realized it has been well over a year since we’ve seen each other, which is unusual for us. I really enjoy them, and they are their own source of endless stories. George and Meredith travel much more than I do, and all over the world at that, doing speeches and research and the like; but we agreed that sometime in October we will make a visit happen, whoever is doing the flying. I think one of the reasons that God made planes was so that friends could see each other more often.

A special hat tip goes to my associate Worth Wray for finding and creating most of the charts for this week. Plus helping me think through the letter. He has been a huge help this last year.
You have a great week and take a friend who tells great stories to lunch. It will do wonders for your outlook on life.

Your still can’t believe negative French interest rates analyst,



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Monday, September 8, 2014

Free Webinar: How to Beat the Market Makers Using Weekly Options

You’ve downloaded his free eBook and you have watched the video. Our trading partner John Carter is now going to make this perfectly clear with another one of his wildly popular free webinars, “How to Beat the Market Makers using Weekly Options”, this Tuesday September 9th at 8 p.m. EST

Click Here to get your reserved spot, they go fast!

In this free webinar John Carter will discuss…..

  *   How to determine the safe levels to take weekly options trades

  *   The best way to protect yourself and minimize risk while increasing the probability of maximum reward

  *   How to choose the right stocks for weekly options and which stocks you want to avoid like the plague

  *   A simple and powerful strategy that you can use whether you’re a beginner or advanced options trader

  *   How to consistently trade this current market using weekly options

And much more…

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We’ll see you on Tuesday evening!







Saturday, September 6, 2014

What does a “good” Chinese adjustment look like?

By John Mauldin


People of privilege will always risk their complete destruction rather than surrender any material part of their advantage. Intellectual myopia, often called stupidity, is no doubt a reason. But the privileged also feel that their privileges, however egregious they may seem to others, are a solemn, basic, God-given right. The sensitivity of the poor to injustice is a trivial thing compared with that of the rich.
– John Galbraith, The Age of Uncertainty

Malinvestment occurs when people do stupid things with free money. One of the characteristics of malinvestment is its dominance; i.e., other investments have little chance of competing. Malinvestments always bust and end in liquidation.
–  Joan McCullough, writing yesterday in her daily commentary

Worth Wray and I have been writing for some time now about the problems that are developing in China. Worth is somewhat more pessimistic about the outcomes than I am, but we agree that China is problematic. China is the number one risk, in my opinion, to global financial economic stability, more so than Europe or Japan, which are also ticking time bombs.

I contend that Xi and Li are the most radical leaders of the Chinese nation since Deng Xiaoping, with the emphasis being on Xi. He is shaking up the current power structure by going after some of the entrenched leaders for corruption. He has earned rebukes from a former president for his actions in op-eds in the Financial Times. This is extraordinary pushback and clearly shows that what is happening is beyond the normal regime-change shakeups we have seen in China.

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For today’s Outside the Box, we turn to my friend professor Michael Pettis to get his latest take on China. Michael’s biography describes him as a “Wall Street veteran, merchant banker, equities trader, economist, finance professor, entrepreneur – iconoclast – Michael Pettis is a unique individual living and working in China, at the heart of the world’s most exciting and vibrant economy.” He is certainly all that and more and just an all-around fun guy to hang out with. I mean, where else do you get a professor who also helps found an indie rock club in Beijing? I should note that he is a professor at Peking University’s Guanghua School of Management. He is published everywhere and gets to talk to “everyone” in China. So I pay attention to what Michael Pettis says when it comes to China. Michael writes a free blog but also has a subscription service that you can get to on his website.

He posted a blog on Monday asking the question, “What does a ‘good’ Chinese adjustment look like?” Which of course assumes there might be a bad Chinese adjustment.

And while the consequences of a smooth transition would be important for those who live in China, the consequences if Xi and Li get it wrong would be significant for the world. We need to be paying attention. This piece is a good overview of what “we” would like to see happen. But as Michael points out, there are some in China who very much don’t want our favored scenario to play out.

For most of the Western world, summer is officially over with the beginning of September, although technically the equinox will not arrive for another 20 days. For the most part, I enjoyed a lazy Labor Day (apart from the obligatory workout), ending with a cookout by the pool with family and friends, joined by David Tice (formerly of the Prudent Bear and my neighbor in the building) and his crew.

My kids gave me a lot of grief because I mentioned Henry’s birthday last week as being his 31st. It is his 33rd. In my defense I at least got the birthday part right. I cannot believe how fast my kids are growing up / have grown up. To see them interacting as adults is both pleasurable and unsettling. I don’t feel any older than they look, although my body complains every now and then and more than it used to. But I know that technically speaking I am anywhere from 29 to 45 years older.

But for the nonce I think I will ignore the technical part and go with my feelings. At least until reality issues a true wake-up call.

Your not ready to give up the game analyst,
John Mauldin, Editor
Outside the Box

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What does a “good” Chinese adjustment look like?

By Michael Pettis
Michael Pettis’ China Financial Markets

I have always thought that the soft landing/hard landing debate wholly misses the point when it comes to China’s economic prospects. It confuses the kinds of market-based adjustments we are likely to see in the U.S. or Europe with the much more controlled process we see in China. Instead of a hard landing or a soft landing, the Chinese economy faces two very different options, and these will be largely determined by the policies Beijing chooses over the next two years.

Beijing can manage a rapidly declining pace of credit creation, which must inevitably result in much slower although healthier GDP growth. Or Beijing can allow enough credit growth to prevent a further slowdown but, once the perpetual rolling-over of bad loans absorbs most of the country’s loan creation capacity, it will lose control of growth altogether and growth will collapse.

The choice, in other words, is not between hard landing and soft landing. China will either choose a “long landing”, in which growth rates drop sharply but in a controlled way such that unemployment remains reasonable even as GDP growth drops to 3% or less, or it will choose what analysts will at first hail as a soft landing – a few years of continued growth of 6-7% – followed by a collapse in growth and soaring unemployment.

A “soft landing” would, in this case, simply be a prelude to a very serious and destabilizing contraction in growth. Rather than hail the soft landing as a signal that Beijing is succeeding in managing the economic adjustment, it should be seen as an indication that Beijing has not been able to implement the reforms that it knows it must implement. A “soft landing” should increase our fear of a subsequent “hard landing”. It is not an alternative.

Surprisingly enough, until the announcement last month that Zhou Yonkang was under investigation, Premier Li has been pretty insistent that China will make its 7.5% growth targets, even as many analysts have lowered their expectations (Moody’s and the IMF are now saying that 6.5% is a possibility), and it is clear that President Xi is taking far more responsibility for and control of the economy than any recent president. My guess is that as the problems of the real estate sector kick in, with lower prices causing a drop in real estate development, which matters for employment, we are likely to see additional stimulus spending aimed at managing the threat of unemployment and, perhaps more importantly, at managing the possibility of rising anger among provincial elites as the glorious prospect of easy money continues to retreat.

This, to me, is the explanation for the rather surprising insistence by Premier Li in June that 7.5% GDP growth was a hard target. GDP targets are part of domestic signaling about the expected pain of adjustment. I suspect that lower growth targets are likely to generate greater opposition.

Certainly it does seem that growth has temporarily bottomed out. According to this June’s Financial Times, “Expenditure by local and central governments in China jumped nearly 25 per cent from the same month a year earlier, a sharp acceleration from the 9.6 per cent growth registered in the first four months of the year, according to figures released by the finance ministry,” and HSBC’s Flash PMI index suggests for the first time in six months that there has been an expansion in manufacturing, although the flash index is, of course, preliminary and may be revised.

Can Beijing rein in credit?


There should be nothing surprising about the improvement in some of the numbers. The “soft landing” that we are seeing is a consequence of credit growth. It means that it is proving politically hard to implement reforms as quickly as some in the administration would like, and it also means that we are getting closer to debt capacity constraints. We would be better off with the long landing scenario, in which GDP growth rates drop sharply but manageably by 1-2 percentage points every year.

I have written many times before that what will largely determine the path China follows is the political struggle the Xi administration will have in imposing the needed reforms on an elite that will strongly resist these reforms – mainly of course because these reforms must necessarily come at their expense. As an aside my friend, Ken Miller, with whom I was having a very different discussion last week, just sent me one of his favorite John Galbraith quotes (from The Age of Uncertainty) that seemed apropos.

People of privilege will always risk their complete destruction rather than surrender any material part of their advantage. Intellectual myopia, often called stupidity, is no doubt a reason. But the privileged also feel that their privileges, however egregious they may seem to others, are a solemn, basic, God-given right. The sensitivity of the poor to injustice is a trivial thing compared with that of the rich.

Although I don’t think China’s economy is adjusting quickly enough, especially credit growth, I remain cautiously optimistic that Beijing knows what it must do and will be able to pull it off. In an older issue of my blog, I tried to place the last 3-4 decades of Chinese growth in a historical context that recognizes four different stages of this growth process. By doing so I try to show how China’s own recent history can help us understand how to consider the policies President Xi must implement.

The first stage of China’s growth story, which occurred mainly during the 1980s, consisted of liberalizing reforms that undermined the Communist elite and which were strongly opposed by them. Because power was highly centralized under Deng Xiaoping, however, including a loyal PLA, he and the reform faction were nonetheless able to force through the reforms.

The next two stages of growth, I argued, required policies that had a very different relationship to the interests of the Chinese elite. Because they involved the accumulation and distribution of resources to favored groups whose role was to achieve specific economic targets, they helped to reinforce the wealth and power of a new elite, many of whose members were, or were related to, the old elite. Not surprisingly this new elite strongly supported the growth model imposed by Beijing during these stages.

The fourth stage, I argued, is the stage upon which we are currently trying to embark. In an important sense it involves liberalizing reforms similar politically to those that Deng imposed during the 1980s, making it vitally important to their success that the current administration is able to centralize power and create support to overcome the inevitable opposition, which it seems to be doing.

This is why, even though Beijing doesn’t seem to have yet gotten its arms around the problem of excess credit creation, I nonetheless think it is moving in the right direction. For now I would give two chances out of three that Beijing will manage an orderly “long landing”, in which growth rates continue to drop sharply but without major social disruption or a collapse in the economy. In this issue of the newsletter I want to write out a little more explicitly what such an orderly adjustment might look like.

Will financial repression abate?


The key economic policy for China over the past two decades has been financial repression. There have been three components to financial repressive policies. First, by constraining the growth of household income and subsidizing production, China forced up its savings rates to astonishingly high levels. Second, by limiting the ways in which Chinese households could save, mostly in the form of bank deposits, Beijing was able to control the direction in which these savings flowed. Finally, Beijing controlled the lending and deposit rates and set them far below any “natural” level.

Very low interest rates had several important impacts. First, because they represented a transfer from net savers to net borrowers, they helped to exacerbate the split between the growth in household income (households are net savers) and the growth in GDP (which is generated by net borrowers), and so led directly to the extraordinary imbalance in the Chinese economy in which consumption, as a share of GDP, has declined to perhaps the lowest level ever recorded in history.

Second, by making credit extremely cheap for approved borrowers, it created among them an almost infinite demand for credit. Financial repression helped foster tremendous growth in economic activity as privileged borrowers took advantage to borrow and invest in almost any project for which they could get approval.
Third, when China desperately needed investment early in its growth period, this growth in economic activity represented real growth in wealth. But low interest rates, along with the moral hazard created by implicit guarantee of nearly all approved lending, led almost inevitably to a collapse in investment discipline. Financial repression has been the main explanation for the enormous misallocation of capital spending we have seen in China during the past decade.

This is why understanding financial repression is so important to understanding the way in which China will adjust. There are two ways to think about the “cost” of financial repression to net savers. The least sophisticated but easiest to explain is simply to look at the real return on loans and deposits. In this case you would subtract the appropriate deflator from the lending or deposit rate.

In the US we usually use CPI inflation as the deflator, but for many reasons this won’t do in China. Consumption is a much lower share of GDP in China than in the US or anywhere else, so that it is less “representative” of economic activity, and there is anyway a great deal of dispute about the rate at which the consumption basket is actually deflating (Chinese households seem to think it seriously understates inflation). I prefer to use the GDP deflator, which until about 3-4 years ago was in the 8-10% region and currently runs around 1-2% or even less, depending on the period you are looking at.

Using the GDP deflator suggests that the real rate for savers has been very negative for most of this century until the past three years – with savers implicitly losing perhaps as much as 5-8% of their real savings every year. It also suggests that the real rate for borrowers has also been negative, perhaps by 1-3% for most of this century. Clearly these interest rates are too low, especially for a very volatile, poor, and rapidly growing economy.

The more appropriate measure of financial repression is not the deflator, whichever one we choose to use, but rather very roughly the gap between the nominal lending rate and the nominal GDP growth rate, the latter of which broadly represents the return on investment within the economy. Until a few years ago nominal GDP grew at around 18-21% while the lending rate was around 7%.

This is a huge gap. In this case the “cost” of financial repression to households was the gap between nominal GDP growth and nominal lending rates, plus an additional 1-1.5% to account for the larger than normal gap between the lending rate and the deposit rate. This is because in China the gap between lending and deposit rates during this century has been much higher than in other developing countries, probably as part of the process of recapitalizing the banks after the last banking crisis at the turn of the century.

If you multiply the sum of these two gaps by the total amount of household and farm deposits (very roughly around 80-100% of GDP a few years ago, when I last checked), you get an estimate of the total transfer from the household sector to banks and borrowers. Because I think China’s nominal GDP growth has been overstated by a substantial amount because of its systematic failure to write down bad loans, I usually have subtracted 2-4 percentage points from the nominal GDP growth rate before I did my very rough calculation. This was how I got my 5-8% of GDP estimate for the amount of the annual transfer from households to savers. This of course is a huge transfer, and can easily explain most of the decline in the household share of GDP over this period.

It is worth noting by the way that a recent widely-discussed study by Harry Wu of the Conference Board claims the China’s average GDP growth from 1978 to the present was not 9.8% but rather 7.2%. The main reason for the revision, according to Wu, is that the GDP deflator had been significantly underestimated which, if even partially true, means real interest rates were even lower (more negative) than I have assumed.
There is some controversy about whether it is true that the nominal lending rate should be broadly equal to the nominal GDP growth rate. In fact most studies of developed countries suggest that over the medium and long term this is indeed the case. UBS tried to show that this was not applicable to China and did a study several years ago showing that among developing countries this relationship didn’t hold. Their studies suggested that among developing countries nominal lending rates had on average been around two-thirds on nominal GDP growth rates (although China, at around one-third, was still well below anyone else’s at the time).

I had a real problem with their sample of countries however. Their sample included a lot of small OPEC countries, who necessarily had high growth and low interest rates when oil prices were high, as well as a lot of Asian countries that followed the Japanese development model and themselves practiced financial repression, which of course made them pretty useless as points of comparison. Neither group of countries, in other words, could help us determine what a “normal” interest rate is compared to nominal GDP.

But regardless of the debate, the point to remember is that when the nominal lending rate is much below the nominal GDP growth rate, two very important things happen. First, it helps eliminate capital allocation discipline. If GDP is growing nominally at 20%, for example, and you can borrow at 7% (which was the case in China for much of this century), you should rationally borrow as much as you can and invest it into anything that moves, no matter how poorly thought out the investment. Imagine a totally ineffective investor, or one whose incentives do not include earning a reasonable return on capital, who manages to earn on his investment only half of nominal GDP. This would be a pretty poor use of capital.

Adjusting the repression gap


But with nominal GDP is growing at 20%, this extremely incapable investor still makes a substantial profit by borrowing at 7% and earning 10%, even though his investment creates no value for the economy. His “profit”, in this case, is simply transferred from the pockets of saving households.

Under these conditions it should be no surprise that borrowers with access to bank credit overuse capital, and use it very inefficiently. They would be irrational if they didn’t, especially if their objective was not profit but rather to maximize employment, revenues, market share, or opportunities for rent capture (as economists politely call it).

The second point to remember is that in a severely financially repressed system the benefits of growth are distributed in ways that are not only unfair but must create imbalances. Because low-risk investments return roughly 20% on average in a country with 20% nominal GDP growth, financial repression means that the benefits of growth are unfairly distributed between savers (who get just the deposit rate, say 3%), banks, who get the spread between the lending and the deposit rate (say 3.5%) and the borrower, who gets everything else (13.5% in this case, assuming he takes little risk – even more if he takes risk).

This “unfair” distribution of returns is the main reason why the household share of income has collapsed from the 1990s until recently. I calculate that for most of this century as much as 5-8% of GDP was transferred from households to borrowers. The IMF calculated a transfer amount equal to 4% of GDP, but said it might be double that number, so we are in the same ballpark. This is a very large number, and explains most of why the growth in household income so sharply lagged the growth in GDP.

This was why financial repression, although useful in the early stages of China’s growth period because it turbocharged investment, ultimately became one of the county’s biggest problems once investment no longer needed turbocharging. For many years nominal GDP growth in China was 18-21% and the official lending rate was around 7%. This, combined with widespread moral hazard, had inevitably to result in both tremendous misuse of capital and a sharp decline in the consumption share of GDP (as the household income share declined) – both of which of course happened to a remarkable degree in China.

In the last year or so, however, the official lending rate has risen to 7.5% and nominal GDP has dropped to 8-9% (and just under 8% in the first quarter of 2014). This changes everything in China. First, it is now much harder for borrowers to justify investment in non-productive projects because they can no longer count on the huge gap between nominal GDP growth and the lending rate to bail them out of bad investments. Of course this also means a dramatic slowdown in economic activity, but because this slowdown is occurring by the elimination of non-productive investment, the slowdown in Chinese growth actually represents higher wealth creation and greater real productivity growth. China is getting richer faster now than it did before, even though it looks like wealth creation is slowing (the difference is in the slower required accumulation of bad debt).

Second, the huge transfer from net savers to net borrowers has collapsed, so that growth in the future must be far more balanced. Over time this means that households will retain a growing share of China’s total production of goods and services (at the expense of the elite, of course, who benefitted from subsidized borrowing costs) and so not only will they not be hurt by a sharp fall in GDP growth, but their consumption will increasingly drive growth and innovation in China.

Interest rates are still too low, but not by nearly as much as in the past, and over the next two years as nominal GDP growth continues to drop, the financial repression “tax” will be effectively eliminated. When this happens solvent Chinese businesses will be forced to use capital much more productively, and slowly they will learn to do so. In that case the PBoC will be able to liberalize interest rates (although not without tremendous political opposition from those that have depended on having great access to very cheap capital for their wealth) without worrying about either the deposit rate of the lending rate surging.

There is, however, one group of wasteful borrowers for whom higher interest rates will not represent a more careful approach to borrowing and investing and these, of course, are borrowers that are already effectively insolvent or otherwise unable to repay loans coming due. In that case as long as they can borrow they will do so, no matter the interest rate. It is not clear to me how many such borrowers exist, but I’d be surprised if there weren’t an awful lot of them. These borrowers can only really be disciplined by constraining credit growth and eliminating government support, including implicit guarantees, but this might not be happening.
One of the ways Beijing seems to be reducing the pain of more expensive borrowing (relative to nominal GDP growth) is to loosen credit in a targeted way. We have heard talk of targeted bond purchases although it is not yet clear what exactly Beijing plans to do.

An article in Caixin suggests that regulators may also be trying to relax the loan to deposit constraint:
The China Banking Regulatory Commission (CBRC) will change the rules for figuring the loan-to-deposit ratio so banks can have more money to lend to businesses, an official with the regulator says. The requirement that the ratio not exceed 75 percent – meaning banks cannot lend more than 75 percent of their deposits out – would remain the same, but the way ratio is calculated would be adjusted, Wang Zhaoxing, deputy chairman of the CBRC, said June 6.
The regulator would consider broadening the scope of deposits to include “relatively stable” funds that are not now used to calculate the ratio, he said. He did not say what the funds could be, and added that a precondition for doing this was keeping the money market stable.

I suspect that over the next few months we are going to get very inconsistent signals about credit control. But as long as the PBoC can continue to withstand pressure to lower interest rates – and it seems that the traditional poor relations between the PBoC and the CBRC have gotten worse in recent months, perhaps in part because the PBoC seems more determined to reduce financial risk and more willing to accept lower growth as the cost – China will move towards a system that uses capital much more efficiently and productively, and much of the tremendous waste that now occurs will gradually disappear. Just as importantly, lower growth will not create social disturbance because Chinese households, especially the poor and middle classes, will keep a larger share of that growth.

So what does “good” rebalancing look like?


It seems pretty clear to me that the great distortions in the Chinese economy that led both to rapid but unhealthy growth and to the consumption imbalance (by forcing down the household income share of GDP) are gradually being squeezed out of the system. One distortion has been the excessively low exchange rate, but after seven years of 30-40% net appreciation against the dollar, the RMB is far less undervalued today than it has been in the past. I still do not agree, however, with analysts who say the currency is actually overvalued and call for a depreciation, nor, more importantly, does the PBoC seem to agree.

Another one of the great distortions that led to China’s current imbalances was the very low growth in wages relative to productivity. This too has improved. The surge in wages in 2010-11, and their continued relatively rapid pace of growth, has reduced this distortion significantly, especially as it is becoming increasingly clear that productivity growth has been overstated in recent years.

Most importantly, with nominal GDP growth rates having dropped from 20% to 8-9%, the greatest of all the distortions, the interest rate distortion, has been the one most dramatically to adjust in the past three years. This is why even though many people I respect are still insisting that China has not really rebalanced, I am moderately optimistic that in fact China is adjusting as quickly as could be expected. Credit growth remains a serious problem, but the forces that put China in the position of relying on excess credit growth have genuinely abated.

And it is this abatement of the great distortions that have caused growth to slow so rapidly, and although we haven’t seen much evidence of significant rebalancing yet, it should take a few years for the effects fully to be worked out. Chinese growth is less dependent than ever on the hidden transfers from the household sector, and these transfers both encouraged massive waste and created the imbalances that required this massive waste to continue.

China is still vulnerable to a debt crisis, but if President Xi can continue to restrain and frighten the vested interests that will inevitably oppose the necessary Chinese economic adjustment, he may in the next one or two years be able even to get credit growth under control, before debt levels make an orderly adjustment impossible.

It won’t be easy, and already there are many worried about the politically destabilizing impact his measures may have. The Financial Times, for example, had the following article:

Mr Xi came of age in that turbulent time and watched as his elite revolutionary family and everything he knew were torn to pieces. Now it seems it is his turn to wreak havoc on the cozy networks of power and wealth that have established themselves in the era of “socialism with Chinese characteristics”. In recent weeks, the president’s signature campaign against official corruption appears to have spilled into something more significant and potentially destabilising for the increasingly autocratic regime.

Clearly there are many risks to Xi’s political campaign, and unfortunately I have no special insight into how these are likely to play out, but if Xi is able to consolidate power enough to impose the reforms proposed during the Third Plenum, Chinese growth rates will continue to decline sharply but in an orderly way. Average growth during the decade of his administration will drop to below 3-4%, but an orderly adjustment means that not only will the hidden transfers from the household sector be eliminated, they will also be reversed.

If China can reform land ownership, reform the hukou system, enforce a fairer and more predictable legal system on businesses, reduce rent-capturing by oligopolistic elites, reform the financial system (both liberalizing interest rates and improving the allocation of capital), and even privatize assets, 3-4% GDP growth can be accompanied by growth in household income of 5-7%. Remember that by definition rebalancing means that household income must grow faster than GDP (as happened in Japan during the 1990-2010 period).

This has important implications. First, the idea that slower GDP growth will cause social disturbance or even chaos because of angry, unemployed mobs is not true. If Chinese households can continue to see their income growth maintained at 5% or higher, they will be pretty indifferent to the seeming collapse in GDP growth (as indeed Japanese households were during the 1990-2010 period). Second, because consumption creates a more labor-intensive demand than investment, much lower GDP growth does not necessarily equate to much higher unemployment.

A “good” and orderly adjustment, in other words, might look a little like this:

1.  GDP growth must drop every year for the next five or six years by at least 1 percentage point a year. If it drops faster, the period of low growth will be shorter. If it drops more slowly, the period of low growth will be stretched out. On average, GDP growth during President Xi’s administration will not exceed 3-4%.

2.  But this does not mean that household income growth will drop by nearly that amount. Rebalancing means, remember, that household consumption growth must outpace GDP growth, and the only sustainable way for this to happen is for household income growth also to outpace GDP growth. If consumption grows by four percentage points more than GDP, Chinese household consumption will be 50-55% of GDP in a decade – still low, but no longer exceptionally low and quite manageable for the Chinese economy. This suggests that if investment growth is zero and the trade surplus does not vary much, 3-4% GDP growth is consistent with 6-7% household income growth. It might be in principle possible to pull this off if Beijing is able to transfer 2-4% of GDP from the state or elite sector to the household sector by reforming the hukou system, land reform, privatizations, and other transfers, but of course we shouldn’t assume that this level of household income growth will be easy to maintain once investment growth, and with it GDP growth, drops sharply.

3.  What about employment? If investment growth falls sharply, especially investment in the real estate sector, it should cause unemployment to surge, which of course puts downward pressure on household income growth as well as on consumption growth, potentially pushing China into a self-reinforcing downward spiral. This, I think, is one of the biggest risks to an orderly adjustment. The good news is that if large initial wealth transfers to households can kick start a rise in consumption, growth driven by household consumption, especially growth in services, tends to be much more labor intensive than the capital-intensive investment growth that too-low interest rates have forced onto China. A transfer of domestic demand from investment to consumption implies, in other words, that employment growth can be maintained at much lower levels of GDP growth.

4.  What about the debt, which is the other great risk to an orderly and successful Chinese adjustment? There are two things China can do to address its substantial debt problem. First, it can simply transfer debt directly onto the government balance sheet so as to clean up banks, SOEs and local governments, thus preventing financial distress costs from causing Chinese growth to collapse. As long as this government debt is rolled over continuously at non-repressed interest rates, which will be low as nominal GDP growth drops, China can rebalance the economy without a collapse in growth. This, essentially, is what Japan did in the 1990s.

The problem with this solution is that it is politically attractive (no wealth transfers from the elite to ordinary households) but it does not fundamentally address China’s debt problem, but rather simply rolls it forward. In that case the burgeoning government debt will itself prevent China, once the economy is rebalanced, from ever regaining rapid growth. I have previously explained why the debt burden can prevent growth in my discussions of why I do not think Abenomics can succeed, if by success we mean raising inflation and real GDP growth. What’s more, if a relatively poor, volatile economy like that of China cannot bear the debt levels that a country lie Japan can bear, it is not clear that this solution will work even during the rebalancing period.

A real solution to the debt problem, in other words, may involve initially a transfer of debt onto the government balance sheet, but ultimately Beijing must then take real steps to lower debt relative to debt capacity. This may involve using privatization proceeds to pay down debt, higher corporate taxes, and even higher income taxes if other forms of wealth transfer are robust enough to support them, but one way or another total government debt must be reduced, or at least its growth must be contained to less than real GDP growth.

5.  Although it may be hard to see it in the economic ratios, or in any real restraint in credit expansion, in fact Beijing has already taken serious steps towards rebalancing, although it may take a few more years to see this in the consumption share of GDP. The three most important of the transfers that created the imbalance have all reversed. The currency may still be undervalued, but not by nearly the extent it has been in the past, wages have risen quickly in recent years, and, most importantly by far, the financial repression tax has collapsed, and even nearly disappeared, which it will do fully in the next two years as nominal GDP growth continues to fall (as long as the PBoC does not reduce rates by much more than one or two percentage points over the next two years). Even the much-ballyhooed decision to improve the environment represents a partial reversal of one of the sources of the household share imbalance.

All of these mean that the hidden transfers that both generated spectacular growth in economic activity (if not always in economic value creation) and the unprecedented drop in the household income share of GDP no longer exist, or do so to a significantly reduced extent. It will take time for the elimination of these transfers to work themselves fully though the economy, but we are already seeing their very obvious initial impacts in the much lower GDP growth numbers, even as credit creation remains high.

Credit creation remains the great risk to the economy. It is still growing much too quickly. I think there are few people in Beijing who do not understand the risk, so my guess is that political constraints are the main reason that credit has not been more sharply reduced. I believe that the president cannot allow too sharp a contraction in credit growth until he feels fully secure politically, and for me the pace at which credit is brought under control is, to a large extent, an indication of the pace of the process of power consolidation.

The best-case scenario


Although I am still cautiously optimistic that Beijing will pull off an orderly rebalancing, I want to stress that the scenario described above is not my predicted scenario. It is, instead, an examination of the best case of an orderly transition towards a more balanced economy.

As regular readers know I am not very comfortable making predictions, preferring instead to try to understand the structure of an economic system and work out logically the various ways in which that system can evolve. The description above is one of the ways in which it can evolve, and because I think this is probably the best-case scenario, I thought it might prove useful as a way of framing thinking about the adjustment process for China.

One caveat: This is not necessarily the best-case assumption. I can make certain assumptions, which I haven’t made because I believe them to be implausible, although not impossible, that lead to a better outcome. If the global economy were to recover much more quickly than most of us expect, and, much more importantly, if Beijing were to initiate a far more aggressive program of privatization and wealth transfer than I think politically possible, perhaps transferring in the first few years the equivalent of as much as 2-5% of GDP, the surge in household income could unleash much stronger consumption growth than we have seen in the past. This could cause GDP growth over the Xi administration period to be higher than my 3-4% best-case scenario.

The amount of the direct or indirect wealth transfer from the state sector to ordinary households is, I think, the most important variable in understanding China’s adjustment. The pace of growth will be driven largely by the pace of household income growth, which will itself be driven largely by the pace of direct or indirect wealth transfers to ordinary Chinese households. If we could guess this right, much else would almost automatically follow.

Academics, journalists, and government and NGO officials who want to subscribe to my newsletter, which sometimes includes potions of this blog and sometimes does not, should write to me at chinfinpettis@yahoo.com, stating your affiliation, please.  Investors who want to buy a subscription should write to me, also at that address.

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Friday, September 5, 2014

What Market Makers Don't Want YOU to Know (Free video)

It's no secret, the market makers are out to beat you and have been for years. But in this free video from John Carter he shows us how to level the playing field and even how to beat them!

What Market Makers Don't Want You to Know (video)

In this free video John shares......

  *   Why your trading goal is not to be right

  *   Why Wall Street is designed to suck traders into doing the wrong thing

  *   Whether or not account size matters when trading weekly options

  *   What Market Makers don’t want you to know that I’ll show you in this free video

  *   What trading instruments you should use to trade weekly options

Watch the video HERE...before the Market Makers get a chance to Beat YOU!


Make sure to get John's new Free eBook "Understanding Options"....Just Click Here!