Time to Fight the Fed

Most people get it when they see a sign reading “Free beer tomorrow” hanging above a bar. The few who are naive enough to show up the next day, only to find the same sign, get it at that point. Only sophisticated investors and economists keep coming back. Again and again. Maybe on the third or fourth day, beer will indeed be free? Their elaborated mathematical models give them insights that mere experience cannot. As the saying goes, why believe your own lying eyes?

For more than four years now, the Fed, economists, the administration and the media have hung their own versions of the free beer sign: “Recovery Around the Corner”. Sometimes they changed the words. They promised “green shoots” and then a “summer of recovery”. Sometimes the recovery was going to lead to 4% growth (last year), then 2.5% was going to do it (this year). None of these predictions materialized, but investors, like the guy in the bar, kept looking forward to tomorrow. In early 2013, markets once again rallied on expectations of a sustainable recovery. Economists, who make a living predicting recoveries that never happen, are at it again: this time it is for real! The Fed needs growth to justify its reckless money printing. No wonder, then, that it continues to see the economy through rosy glasses.

Unfortunately, last Friday’s jobs number is again questioning the power of Bernanke’s crystal ball. Fewer jobs were created in the first quarter of 2013 than in the same quarter last year. In spite of all the propaganda, it is becoming increasingly obvious to non-economists that money printing is not creating growth. GDP last year did not expand by the announced 4%. It barely achieved 1.7%, decelerating to 0.4% in the last quarter. 2013 is not different. Look for more downward revisions.

The question is: how many more failed predictions will it take before the Federal Reserve Bank finally loses credibility? And what happens then? We have given the Fed so much power that one wonders how painful it will be to revert back to a free market economy.

Flawed Statistics.

GDP predictions based on flawed models is not the only problem for investors. Do we really believe in official CPI numbers whose largest component is the vaguely defined “owners’ equivalent rent”? Even the Bureau of Labor Statistics admits, “Clearly, the rental value of owned homes is not an easily determined dollar amount, and Housing survey analysts must spend considerable time and effort in ESTIMATING this value (my highlight). In the years before the housing bubble burst, owners’ equivalent rent failed spectacularly to send a warning signal to the Fed. This guessed element of the CPI (30% of core CPI) can easily cause an underestimation of what the real inflation number is.

Now, let’s assume that the CPI is indeed underestimated by 2% (as shadowstats.com suggests). That means that real GDP growth last year was not 1.7%, but -0.3%.

Similarly, what credibility should people give official unemployment numbers? Do we have to accept the notion that 7% of the population has vanished because they are “discouraged”? Such nonsense always allows for nice headlines. When people disappear from official statistics, the unemployment rate declines. When unemployment resumes its upward trend, bulls can then point to the fact that these zombies are rejoining the community of happy workers. Always look at the bright side.

A New Crowding Out Effect

Forecasters are overly optimistic. Economic statistic are dubious. But the biggest problem with the Fed lies elsewhere: it is the crowding out effect. Here again, what you see is not exactly what you get. One may think there is no crowding out effect today. In spite of large amounts of capital borrowed, interest rates are not going up. But look again.

First, these rates are kept below market rates through direct intervention from the central bank. The Fed has taken market forces out of the bond market. Furthermore, banks are taking advantage of free money to buy Treasuries, cashing in the 2%-or-so spread without any work or risk. Since there is so much public debt available, it becomes the only game in town. Why take the risk to lend to individuals and businesses? Shellshocked, over-regulated bankers have no incentives to lend to the real economy.

This is what happened in Japan in the last two decades. As a result, Japanese banks now lend more money to the government than to the private sector. The irony is that today the Japanese look to Bernanke for guidance. Instead, Bernanke should look to the Japanese experience. If he did, he would understand how cheap money combined with an overinflated public debt has deprived the private sector of the liquidity banks used to provide.

That is the fundamental reason why the American economy is not and will not resume its traditional growth rate. Do not believe the Fed. Don’t trust economic statistics. It is time to fight the Fed. Do not heed its call to take on more financial risk.

Stock Market Implications

Another year of sub-par growth will make it difficult for companies to grow their top line. Already profit margins are at historic highs. So, the market rally can only come from PE expansion.

US profit margins as a percentage of GDP have hovered around 10% for 3/4 years now. Before reaching this stratospheric level, profits peaked around 8% of GDP only a few times in recent history.* Through cost cutting, companies have now reached profitability levels never seen since World War II, a period when the average was somewhere around 6%. I think it prudent thus to assume that US profit margins will not go up from here.

That means earnings growth has to come from top line growth. But, as we have seen, the economy continues to disappoint in the US. At the same time, Europe is mired in a lasting recession and many emerging market economies are slowing down. Even Japan, the markets’ new darling, is only hoping to get out of its deflation through the world’s most ambitious money printing program yet.

If one has to participate in today’s equity inflation, extreme prudence is required. Companies with strong pricing power should be privileged to cyclical stocks that depend on volume growth. Apple (AAPL) comes to mind, especially after the recent correction.

Some turnaround stories also offer nice opportunities. Nokia (NOK) most prominent among them.

* Source: John Hussman

Mexico’s Trust Buster

The decade of the BRIC countries is over. Let’s not be fooled by summits or proposals to create a new world financial order. Today, Brazil is struggling with government overreach and a slowdown in demand for commodities. Russia is still the same kleptocracy. China is dealing with the mother-of-all credit binge hangovers. India too is slowing down, mired in corruption.

The action today is elsewhere. The growth engines in the emerging markets are now Turkey, Indonesia, Malaysia, Colombia, Peru and Mexico. These are countries opting for structural reforms. Their policy priorities are security, fighting corruption and deregulation. In a nutshell: free markets and the rule of law. No money printing, no ballooning deficits, no out of control debt, no gimmicks to avoid hardship at all cost. How refreshing. 

The transformations are already visible, sometimes in a spectacular way. Medellin, for example, is now a prospering, even trendy place. It was even voted most “Innovative City of the Year” by the readers of the Walls Street Journal. That’s right, Medellin of Escobar fame is now up there with Brooklyn. 

The New Latin America.

In Latin America, a sad chapter was seemingly closed for good in the early 1990s. Swept by globalization, one country after another turned its back on military dictatorship. Since then, two distinct groups of countries have emerged. The first group embraced populism, mostly defined by a rejection of capitalism, a love of fancy names and a propensity to deify their leaders. Peronists, Sandinistas or Bolivarians are all variations on an old romantic dream of social revolution and wealth redistribution. Like their predecessors, the Castro dinosaurs, unfortunately, they cannot point to much economic success.

Then, there is the other group of Latin American countries, the one that is embracing modernity, democracy and free markets. These countries have in common a growing middle class as well as impressive GDP expansion.

Chile paved the way for the second group. Even before rejecting its dictatorship, Chile embraced free markets and a strong middle class. It has since been a beacon of democracy and free market orthodoxy in the Latin world. Other countries including Colombia, Peru and Mexico are following in their foot steps. In Colombia, President Uribe is rightly credited with ending civil war and turning around the economy. His successor is building on that success.  Peru is the fastest growing economy of the region. However, the next big story could very well be Mexico. Already, it is replacing Brazil as investors’ new darling.

Mexico.

The evolution of Mexico has been gradual. It did away with dictatorship and then with one-party rule. It voted for NAFTA and opened its markets. The previous President fought the drug cartels head-on, with mixed results. Now, with the election of President Enrique Pena Nieto, Mexico is embarking on an acceleration of reforms that should unleash market forces like never before. Arguably the most important measure has already passed the lower house. It creates a new regulatory body that will have the power to enforce anti-trust laws.

For years, the Mexican judicial system lacked the independence and authority to break down monopolies. This is about to change. As a result, numerous sectors that have been choked by overwhelmingly dominant companies will be revitalized. Prices will come down thanks to renewed competition in industries as varied as telecoms, soft drinks, media, retail, cement or beer. It is not difficult to imagine what this will do to domestic consumption.

But Mr. Pena Nieto’s ambition goes beyond his desire to be Mexico’s Trust Buster. His ambitions go beyond emulating Theodore Roosevelt. He is also tackling outdated labor laws dating back to the 1930s that include more than 1,000 articles and have not been significantly modified in more than 40 years. Even if the law which went into effect a week ago does not seem too ambitious at first glance, it is an encouraging start. It will give employers a bit more flexibility, like the right to offer part-time jobs, hourly wages and the freedom to outsource when see fit. Such a law is of course welcome to employers, but it is also designed to take a number of jobs out of the informal economy. This, in turn, will help government revenues.

Together with outright corruption, the size of the informal economy is an ongoing problem in most emerging economies. Mexico is no exception. In fact, the International Labor Organization estimates 34.1% of Mexican workers labor in the informal sector – a high number by any standards. That’s why the government hopes to bring more workers out of the shadows by relaxing temporary jobs regulations. More labor flexibility would help, but is politically difficult. Maybe fighting corruption in entrenched labor unions is a step in that direction. That would explain the arrest of Elba Esther Godillo for embezzlement on February 26. If anything, replacing him after 25 years of flamboyant leadership of the Mexican Teachers Union will allow for new blood and new thinking.

What is most remarkable is the astonishing consensus among political parties in support of these reforms. The anti-trust laws were passed with 414 yeas and only 50 nays. Even the new labor laws were passed with support from the main opposition party, the PAN. And more is in the making. Mexico is willing to address another taboo: the declining national income from oil production due to an inefficient nationalized industry. Measures to open up the oil industry to private and even foreign investments are now envisioned.

If these reforms come to fruition, economic activity will greatly benefit. The new President has a long “to-do” list with reducing violence at the top. Attracting more foreign investments would be easier if one no longer read about severed heads displayed along highways.

Already GDP per capita is a respectable $14,610*, although one wonders how much of that is due to Carlos Slim alone! The economy is growing at 4%*, unemployment is down to 5.3%* and inflation is under control at 3.4%*. In contrast to major economies stuck with huge debt burdens and more top-down so-called solutions, Mexico resisted moving towards more deregulation and resisted inflating public spending at the height of the financial crisis. Government expenditures as a percentage of GDP peaked in 2009 at a very reasonable 28.3% and were down to 24.5% in 2012 according to the IMF. 

All this is welcome news for multinational companies growing more and more disenchanted with China. Producing south of the border of the largest economy in the world becomes increasingly appealing as China suffers from wage inflation.
According to Andres Rozental from the Brookings Institute, studies show that the all-in cost for an average factory worker in a Chinese industrial zone is more or less equal to a Mexican working in a maquiladora near the US border.**
Furthermore, China’s rather unique concept of the rule-of-law and increasing bullying of companies the government disapproves of makes Mexico look like an employer’s paradise.

If the US economy manages to muddle through, Mexico should be a good place to invest. However stock selection matters. Deregulation will hurt the likes of (AMX), as the recent stock price correction indicates. Others, like Grupo Televisa (TV) could be net winners. Even as Televisa will have to give up market share (which stands at 70% today) in broadcasting business, it will also be able to grow its market share in the telecom business at the expense of AMX. Overall, the overwhelming winner will be the consumers. And there in lies the other opportunity for Televisa. Its media business may be forced to keep a smaller share of pie, but the pie could grow substantially. A more competitive and growing economy will multiply and inflate advertising budgets. A JP Morgan report puts Mexico’s total ad revenues at 0.48% of GDP. In the US, this ratio is 1.02%, in line with most developed countries. But what if that ratio in Mexico climbs to Brazil’s 1.14% or even Panama’s 1.61%?

Global investors struggling with depressed European economies, slowing emerging markets and overactive central banks will appreciate the soundness of the Mexican reform story. It will not hurt them to also do some research at the Riviera Maya.

Source: http://www.heritage.org
**Source: http://www.brookings.edu

Japan Rings In The End Of Globalization

After confirmation by the Diet, Mr. Kuroda will become the head of the Japanese Central Bank. Prime Minister Abe’s choice is an unmistaken signal that Japan is serious about reflating its economy. Both men agree on the need for Japan to take drastic monetary measures to get out of two-and-a-half decades of stagnation. The Bank of Japan will print money. The yen will weaken further, much further. Asset prices will be inflated.

To make sure his message is not diluted, Abe appointed Iwata to the job of Deputy Governor of the Bank of Japan. The latter did not wait long to make his intentions clear. He told Japanese Diet Members that the Bank should have the ability to buy assets even beyond treasuries. He also wants to buy corporate bonds and equities.

In a rather Japanese way, after decades of deliberation, Japan is going all in. Kuroda is promising to be Bernanke on steroids (yes, it is possible). He will print money, devalue the yen – already down 15% since Abe’s election* – and push all asset prices up. Iwata even hinted at negative nominal interest rates.

Japanese voters approve. Prime Minister’s Abe popularity is up in the 70′s**.

This is good news for Japanese blue chips. For years they had to compete with their hands tied behind their back. Because of the overvalued yen, Korean, Taiwanese or Chinese companies had a field day. For electronic products, Samsung has now replaced Sony as the coveted brand. Hyundai cars compete in the global automotive market with Toyota, Honda and Nissan. Lenovo is the world’s largest PC maker while Toshiba laptops have virtually disappeared. For years, Japanese companies were on the defensive. Some resisted well, others not so well.

Like their German counterparts, Japanese companies have been stellar exporters despite a strong currency. One could even argue that they did so thanks to a strong currency. As in “deutsche mark Germany,” the Japanese have responded to an overvalued currency by increasing the quality and the value added element of their products. A strong currency has continuously pushed them further up the quality curve. This logic, though, had reached its limit.

Well run blue-chip exporters like Toyota (TM), Fanuc (FANUY.PK) or Komatsu (KMTUY.PK) have spent decades adjusting to an uncompetitive currency. Through cost management and product differentiation, they remained competitive and profitable, often dominant. Just imagine what a devaluation of the yen is doing to their bottom line.

Other companies like Sony (SNE) or Panasonic (PC) have not fared as well. Currency devaluation may not save them. But Mr Iwata’s declared intention to buy securities will surely have the same result as Bernanke’s wealth effect. It will lift all boats. If you missed Bernanke’s latest bubble, join the party in Japan. It is just beginning. The Japanese are notorious for copying and then surpassing the West. Go long Japanese exporting blue-chips and hedge the currency.

There is unfortunately one caveat to this rosy scenario. South Korea, Taiwan or China are not going to stand still.

It is every man for himself now. The US started a stealth currency war under the disguise of quantitative easing. Japan makes it official. Decades of globalization are coming to an end.

$1 was worth 84.18 yen on December 16, 2012. On March 11, 2013 the rate was 96.04 yen to the dollar.
** Yomiuri poll Feb 8 – 10 has him just under 70%.

We Are All Contrarians Now

Let’s agree to buy tulips. If many of us do, the price of tulips will go up and all of us will feel richer. We’ll then start spending more money, which in turn will create an economic boom. This is called the wealth effect. Now, replace tulips with 401 Ks and it will also look like a sophisticated economic plan.

Another smart way to promote consumption is to have the government borrow money and inject it in the economy. The money spent creates more economic activity and this results in job creation.

It seems simple, doesn’t it? Unfortunately, history tells us that asset bubbles end in tears and Keynesian stimulus programs never work.

The main problem with the latter is the lack of a multiplier effect. Give someone a fish for a day and he will survive another day. It will also give a fisherman some work for a day. But what happens if you do not give him another fish? The fisherman is unlikely to increase his capacity based on such short term, unsustainable demand. Nor will he hire any help.

History Tells Us Keynesian Stimulus Does Not Work.

Markets have now anticipated 5 of the last zero recoveries. After throwing trillions of dollars at the economy, all we have to show for it is feeble GDP growth. At least it is positive growth, optimists argue, but isn’t it time to wonder why the world economy is not responding the way the Fed expected? Remember the over-optimistic projections of 4% growth that led to last year’s January rally?

Einstein famously defined insanity as doing the same thing over and over again and expecting a different result.
So, why are we still in a world of Keynesian deficits monetized by central banks? Why are people still expecting results from Keynesian fiscal stimulus? We know from history that unless one’s definition of success is “things could have been worse”, Keynesian economics never works. It also always leaves a very large bill at the end.

Three of the most obvious examples of Keynesian failures are well documented. Popular misconception notwithstanding, the New Deal did not reduce unemployment. Nor did it get the economy growing. European experimentation with fiscal profligacy in the 1970‘s lead to stagflation and Eurosclerosis. Japan’s repeated stimulus programs over the last 25 years only helped prolong the lost decades, or should one say lost generations. Can anybody in Princeton give one example in real life where Keynesianism has worked? Furthermore, if reducing government spending – now labeled “austerity” – automatically leads to recessions, why did the US economy do so well in the 50‘s after the massive cuts which followed WW II?

Let’s be clear. This is not an attempt to get involved in today’s ideological debate. The problem is not ideology. Rather, one has to ask: why would it work this time? Do we really believe–pace Paul Krugman–that the economy is not bouncing back because we are not spending enough? Are trillions of dollars just not enough?

Capitalism Up-Side-Down

By monetizing the debt and by manipulating the price of long bonds, the Federal Reserve Bank is making bond vigilantes irrelevant. With the wealth effect, he makes a mockery of capitalism. In fact, the Bernanke put is one-upping the Greenspan put. It not only sets a floor on asset prices to avoid big losses; it also raises the strike price above today’s levels to guarantee profits!

The goal is clearly stated. Chairman Bernanke wants asset prices to go up in order to create a growing wealth effect. Bond prices, house prices and stock prices are all “encouraged” to go up. As far as we know, tulip prices are not yet part of this scheme!

Our modern Federal Reserve Bank has turned the free market upside down. Whereas market prices were once a reflection of economic activity, in this brave new world, the economy is supposed to be a reflection of the markets. Stock prices are used to send signals that the economy is supposed to follow. Maybe this is Soros’ reflexivity theory pushed to its full logic. Prices no longer reflect wealth created and markets no longer function as a price discovery mechanism. Instead, the monetary powers decide where prices need to be in order for people to feel wealthy. This, then, is supposed to generate spending and economic activity. Only a college professor could come up with such a scheme.

The Exit Strategy.

Combined fiscal and monetary stimulus is supposed to be temporary. It was meant to ease the transition to a healthier economy. Five years and trillions of dollars later, one might thus reasonably expect the exit is near. The Fed has at least begun to debate timing.

This is the tricky part. Spending fiat money does alleviate pain for a while, but the time will come to slow down and then to unwind the stimulus program. How can it be done without creating havoc? At what point will the economy accustomed to massive cash injections be able to stand on its own feet? For now, the majority of directors at the Fed thinks it is too early. But they know the time will inevitably come. Open ended money printing cannot go on for ever.

The longer this goes on, the more difficult it will be to undue. Habits die hard. An economy used to living off government handouts enabled by the central bank does not revert to free markets easily. Ask the Europeans. A man used to receive a fish every day, tends to forget the urgency of becoming independent. He could learn how to fish, but why bother?

However, Keynesians do not see it that way. They do not seem to be concerned about new habits creating a very different economy. Instead, they believe time allows for a smooth transition and an abrupt end to stimulus would create another crisis like the crash of 1937.

Keynesians believe FDR was wrong to try to get public finances under control at the start of his second term. Eight years after the start of the Great Depression, the economy had not yet fully recovered. According to the narrative more deficits were needed. Hence today’s question for investors is simple: how many years do the Keynesians believe we need this time to get out of the Great Recession?

Decades after the New Deal, in the 1970s, Europeans tried a different exit strategy. They attempted to inflate their way out of what seemed at the time like unthinkable levels of debt. That did not end well either. A full generation later, it is particularly sobering to see that the public debt as a percentage of GDP in most European countries is still where it was then. In spite of numerous austerity programs, tax hikes and a very favorable global economic environment, Italy’s debt-to-GDP has not changed at all.

In Japan, no exit strategy has yet been seriously considered. There have been a few attempts to reduce the deficit through higher taxes as well as to normalize monetary policies. All were quickly abandoned after sell-offs in the markets. Now, the newly elected Prime Minister is doubling down. In spite of a debt-to-GDP ratio of more than 230% and a double-digit yearly deficit, Abe-san is launching another fiscal stimulus plan equal to 4.4% of GDP. To top it all, he is also forcing the once-independent central bank to start another ambitious quantitative easing policy. Japan too can print money! Japan too will join the currency war.

Maybe we are smarter this time. Maybe the economy will finally recover. Maybe we have found a way to manage the exit without causing another crisis. Maybe. But, history is not on our side.

Implications for Investors.

Central bankers have succeeded. Investors have gotten the message: be complacent, do not worry. Buy on any dip, regardless of the fundamentals. Because of the Bernanke put, markets never go down very much and always bounce back to new highs. Any correction is an opportunity to buy. Take more risk. Actually, Uncle Ben has taken the risk factor out of the stock market. Just look at the VIX. It is at an all-time low.

What’s wrong with this picture? We have a central bank that enables 13-digit public deficits every year and pushes soon-to-retire baby boomers to speculate in the markets. Not to be outdone, their European, British and Japanese counterparts are making sure too that no one can retire on income alone.

The End of Risk On/ Risk Off?

Stock prices’ correlation with the S&P 500 index has reached 85% recently, up from a historically more normal rate of about 50%. Investors no longer differentiate between good and bad companies. Instead of trying to identify winners and losers, investors focus on ETFs. The Fed is announcing more fiat money? Risk on. Buy cyclical ETFs. Buy commodity ETFs. Buy emerging market ETFs, etc. Economic figures disappoint? Risk off. Buy defensive ETFs like those that focus on high yielding stocks, pharmaceuticals or utilities. At least for now, fundamental analysis is over.

However, thanks to the Bernanke put, we know risk on never takes too long to follow risk off. When stocks sell off, buying always pays off. That’s why we have all become contrarians when markets turn sour.

“Earnings aren’t growing very much overall, but expectations are so low that I don’t think earnings are going to hurt the market much” according to one investment strategist. Flat earnings are the new normal. It could be worse.

Volkswagen is Stepping Up to the Plate

Jaguar is a subsidiary of the Indian Tata. Volvo belongs to the Chinese Geely. Dacia is French and Rolls Royce German. Opel, Vauxhall, Citroen, SEAT, Skoda, Lada, Leyland, Porsche or Audi have all been absorbed by rivals. Other brand names have disappeared. Simca, DKW, DAF and Trabant are names few young Europeans even recognize. Saab is the latest victim. Under new Asian ownership, it will produce nothing but electric cars.

No doubt, the car industry in Europe has had its fair share of restructuring. But the mass market industry still suffers from overcapacity. Four years of declining new registrations have exacerbated the problem. From 2007 to 2011, annual car sales fell by 2 million units to a paltry 13 million. To make things worse, newcomers from Korea are aggressively building a presence. Already, Hyundai and Kia have managed to carve out 6% of a declining market.

The trend did not improve in 2012. French automotive sales were down another 14% year-on-year. Italy’s car market reached a 30 year low and Spain was not far behind.

Prolonged European recession is shrinking the pie. Weak players are feeling the heat. For the past fiscal year, Renault, PSA Peugeot-Citroen, Fiat, Opel (GM) and Ford Europe are expected by analysts to report combined total losses of $8 billion. PSA alone lost $2 billion last year and was given a life line by the government. Opel has announced a 10% production cut for the new year. Renault is again moving capacity to North Africa. Fiat is unlikely to break even before 2015. Ford will completely close down its factory in Genk, Belgium.

Nor is the outlook for 2013 any better. European car sales are forecast to fall another 4%. A fifth year of abysmal sales will bring a final consolidation phase in the industry. We are approaching the end game. It is the bottom of the ninth inning. The bases are loaded and the sweeper is stepping up to the plate. Here comes Volkswagen.

Weak players are rapidly getting weaker. Strong players are getting stronger. Volkswagen is steadily building market share and so is the Hyundai/Kia conglomerate. Their competitive advantage is just getting better and better.

Volkswagen’s breakeven capacity utilization has already been brought down to 45%. Its most efficient competitors can only manage 70%.That’s before the massive investments in more flexible production facilities they have budgeted for the next 5 years.

VW is also helped by geographical diversification. In contrast with Fiat, Renault and PSA who are very dependent on the Club Med countries, VW’s sales are strong all over Europe and in emerging markets like China.

Product wise, VW enjoys a worldwide reputation for great engineering. Furthermore, it offers a complete range of products. VW, Skoda and SEAT ( over 4% EBIT margin) cover every segment of the low end market while Audi (12% EBIT) and Porsche (18% EBIT) are up there with BMW and Mercedes. All that while enjoying a strong pipeline of new models. In contrast, Renault, Peugeot or Fiat’s mere survival is highly dependent on the success of one or two yet-to-be-launched models.

Finally, as recently described in the WSJ, Volkswagen is using its very strong balance sheet to offer superior financing. Even after major acquisitions and large capital expenditures, VW still had a net cash position of 9.2 billion euros ($12 billion) at the end of September. There is no way a bankrupt Peugeot can match – let alone sweeten – VW’s low monthly payment programs. Nor can cash-strapped Fiat and Renault.

But even this is not the whole story. All the stars are aligning in favor of this German behemoth. Already, they are major players in the booming Chinese market. But the nationalistic fever which has overtaken the Middle Kingdom lately is giving them an additional boost. Volkswagen is arguably the biggest beneficiary of Chinese consumers’ boycott of Japanese models.

Volkswagen shares are a buy. The fundamentals, as just described, are strong, while the valuation is still very much in line with its peers’. This inconsistency is most likely due to today’s world of risk on/risk off. Investors buy or sell indiscriminately across an industry according to “risk tolerance”. Stocks’ correlation with markets is at an all-time high. This may continue for a while. However, long term investors can count on fundamentals to separate the strong from the weak.

VW deserves a hefty premium to the 0.4 times sales it is trading at today, especially considering its valuable, more profitable Audi and Porsche brands. At the least one can expect VW shares to trade in line with struggling Toyota (TM), which is trading at 0.6X sales. If so, VOW.GR has another 50% upside.

The Viagra Economy Is Not Dead Yet

Judging from how the markets reacted when our dear leaders finally decided to talk to each other last week, solving the Fiscal Cliff will most likely trigger another rally. That is just brilliant. Markets, who have been going up on any hint of more stimulus, are now rejoicing at the coming austerity.

That’s right. Austerity is bad for Europe, but great for the US. Go figure. Europeans are just not smart. They should not have left the labeling of their policy to the Germans. Austerity evokes Teutonic discipline. It implies painful sacrifices. We don’t want that. Avoiding a cliff sounds much better. It implies great relief.

How are we going to avoid the Fiscal Cliff? By agreeing to reduce government profligacy and increasing taxes. But how exactly is that different from European austerity?

There is something so predictable in economic cycles that only Nobel prize winners cannot see it: after running up the credit card, one has to pay. The Europeans found that out many years ago and are still paying. Japan found that out a couple of lost decades ago and are still refusing to pay. Now it is America’s turn to deal with such a predictable problem. How we tackle it will greatly influence the markets for many years to come.

In the US, however, we still have one trick up our sleeves to postpone the pain. The Fed calls it the wealth effect. Higher asset prices give people the needed confidence to consume more. It is the stated policy of the Federal Reserve Bank. Bernanke has not been shy about claiming credit for it and he fully intends to continue whatever medicine is needed to keep asset prices up. Call it the Viagra economy, if you know what I mean.

Little Blue Pills aside, fiscal austerity is coming to a neighborhood near you. The only question is: what form of austerity? Looking around the world, one can indeed learn that not all austerity programs are alike.

First, there is the French version of austerity. Every time the government runs out of money, create a new tax and give it a fancy name. Grow the role of government (with state bureaucrats spending only 56% of GDP*, there is still 44% to go) and blame Indian businessmen.

There is the Irish model (shared with the Baltic countries) of brutally cutting government programs to immediately live within one’s means. Raise taxes on individuals, but keep corporate taxes substantially below the average (12.5% in the case of Ireland*). Then, resist the French attempt to bully you into aligning your tax rates with theirs.

The most popular model in Euroland today is the German austerity model. The Spaniards, the Italians and the Portuguese are following it. They all are greatly encouraged to continue reduce welfare benefits somewhat, increase tax revenues somewhat and combine these measures with a touch of increased labor flexibility. It worked very well for Germany 10 years ago, probably because on a relative basis, it seemed drastic at the time.

Finally, there is the Japanese model: bury your head in the sand.

Sometimes, markets forget to differentiate between all these austerity policies. However, outcomes vary widely. The Japanese model leads to decades of stagnation, even lost generations. The French way inevitably leads to disaster. The German recipe, on the other hand, does not apply to the US. Labor flexibility is not an issue here.

The best outcome, looking at recent examples, is when the Irish/ Baltic model is applied. These countries took it on the chin. GDP nosedived. But shortly after, the economy bounced back.

To get the crisis behind us, drastic measures are needed. It will hurt, but it will be short. It will also allow for a huge bounce in a relative short period of time thanks to a strong, new foundation.

This model has a different name here in the US. It is called the Fiscal Cliff. Once again, traders are cheering for the wrong outcome in Washington.

Oh, and then there is the Greek model.

*Source: Eurostat

China: The End of The Deng Era.

As I write, the Chinese political black box is preparing to spit out a new team of leaders. At their coming November Party Congress, the Chinese nomenklatura will designate the first generation of leaders not handpicked by the late Paramount Leader Deng Xiaoping.

The Eighteenth Party Congress comes at a difficult time. The economy is in a relative slump. The country is trying to digest both a housing bubble and an excessive investment boom. Many government-favored industries are facing substantial overcapacity problems. Exports are under pressure and trade tensions are mounting. GDP growth is slowing. After three decades of breathtaking expansion, China has reached a new crossroad.

The Chinese Economic Miracle.
Chairman Mao left China in a shambles. The country had suffered massive famine during The Great Leap Forward. Then, Mao upped the ante with the Cultural Revolution, which added more hardship to an already devastated country.

The Cultural Revolution was a purge like none other. Instead of targeting the incompetent leaders responsible for tens of millions of deaths, Mao Tsetung launched a vendetta against whoever questioned his judgement. Prominent among them was President Liu Shaoqi. His crime? Trying to reverse some of the catastrophic policies of the Great Leap Forward. Many others in Mao’s entourage suffered the same fate. Anybody with a brain was considered a menace. Teachers and “intellectuals” were prime targets. Kids were forced to condemn their parents. Anybody that could perpetrate the idea of a calamity induced by Mao’s absurd policies had to be silenced by death. Mao’s Cultural Revolution was in fact the greatest exercise of forced amnesia in human history. Many in the West fell for it. That too was quickly forgotten.

When Mao finally passed away in 1976, the Middle Kingdom was longing for stability and, above all, some sanity. Deng Xiaoping’s steady hand would take them to a very different place.

It took Deng a couple of years to push aside Hua Guofeng, Mao’s designated heir. By then, Deng was already in his late 70’s. He was in a hurry. He rapidly launched a number of reforms that eventually lead to the Chinese economic revival of the last 30 years.

Deng first stabilized the country and then put it on a path to a free market economy. However, unlike his fellow reformist Gorbachev in Russia, the new Red Emperor believed in a carefully managed transformation. Too much freedom at once could lead to more chaos. More economic freedom did not have to go hand in hand with political freedom. The communist party’s firm grasp on power was not to be challenged.

Ever the pragmatic, Deng famously declared that the color of a cat does not matter, as long as he catches mice. Gone were Marx’s teachings. It was all right to become rich again. But it was not alright to challenge the communist party’s hold on power. That’s where the old revolutionary drew the line. Gorbachev lost control of Perestroika. Deng was not inclined to make the same mistake.

The Global Wind of Freedom Stopped in Tiananmen Square in 1989.
Soon after returning to power, the aging Deng had put Hu Yaobang in charge of continuing China’s economic transformation. Hu and his liberal policies were immensely popular. However, the Party took umbrage. Hu Yaobang’s “bourgeois liberalization” was too much for the old guard to swallow so Deng pushed him aside. Still, Deng did not give up on economic reforms. He promoted another liberal, Zhao Ziyang, to the top job.

Hu’s death soon afterwards lead to the Tiananmen Square massacre. Young people gathered en masse to pay tribute after his funeral. The movement evolved rapidly from grief to demands for what Hu Yaobang had stood for: a more free society. Some in the communist party, including President Zhao, were sympathetic to the students’ aspirations. Zhao even tried to negotiate with the students for several days. The world was mesmerized. Was communist China going to fall so soon after the Soviet Union?

Eventually Deng lost patience. He was still pulling the strings and ordered Zhao to send the army to quell the movement. Zhao bravely refused, which led to his house arrest. Mao would have killed him.

However, Deng Xiaoping did not give up. He was still intent on liberalizing the economy, if not the political system. He promoted Jiang Zemin to the presidency. Jiang, with the help of the very capable Prime Minister Zhu Rongji, continued the economic reforms during the 1990’s. The Chinese economic miracle was born. However, it had a major flaw.

Years later, Zhao Ziyang’s illicit memoirs were smuggled out of the country. In them, Zhao warned of the incompatibility of a free economy with dictatorship, even one of the so-called proletariat. His contention is that entrepreneurship will be held back by monetary extortion from those with political power. An authoritarian regime leads to an unfair system that rewards the connected at the expense of the talented and/or hard working. Zhao writes that without political reforms, China will continue to suffer from “commercialization of power, rampant corruption and a society polarized between rich and poor.”

Hu Jintao and Wen Jiabao Proved Zhao Right.
In 2002, power was peacefully transferred to the next generation in accordance with Deng’s plans. Even though he had already passed away (in 1997), his orders to pass the torch to Hu and Wen were dutifully followed. This was a remarkable feat. How often do dictators give up power? Deng’s instructions were still respected and implemented years after he had rejoined Mao and Karl Marx. In death, Deng had outdone Chairman Mao himself.

Unfortunately, this time Deng may have overreached. He misjudged the next generation and overestimated their free market credentials. His chosen political grandchildren, Hu and Wen were no reformers.

Using growing inequalities as an excuse, the new leadership reversed the policies put in place by their predecessors. Privatization was stopped and the public sector was again favored over the private sector. Today, for example, state-owned enterprises (SOEs) enjoy an effective tax rate two thirds less than the private sector’s, as well as cheap capital from a state-comtrolled banking sector.

Then, at the time of the global financial meltdown, Prime Minister Wen doubled down with a huge economic stimulus plan that favored mostly the SOEs. No longer a communist economy, China today has nonetheless moved back toward top-down decision making, focusing investments on “strategic industries”. In the process, Wen and his family managed to accumulate an immense fortune. Many members of the nomenklatura are similarly wealthy today.

For a decade, under President Hu, the Chinese people have watched bureaucrats distribute resources to state companies and their friends. Whereas the early reforms created explosive growth, new entrepreneurs and a trickle-down wealth effect, current neglect of free-market principles has led to corruption and profiteering by the well-connected. The stock market is a case in point. (In recent years it has been used mainly to list state owned companies at inflated prices, “raising money from outsiders (including foreigners) to redistribute to insiders”, according to The Economist. Small investors did not fare as well. The Shanghai Composite Index, after peaking at 6,000 before the financial crisis, is now back to the 2,000 mark, about where it was twelve years ago.

Wealth disparity, always a sensitive issue, becomes explosive when it is the result of a rigged system.

A Middle-Income Trap.
Without reforms, experts now fear China will slide into a “middle-income trap”, i.e., rapid growth followed by stagnation. China is indeed at risk of duplicating what many Latin American economies have experienced. Corruption and a huge income gap will prevent the country from becoming the economic superpower many believe inevitable. Already capital is fleeing the country, a sure sign of how locals feel about the future. Real estate in Cyprus seems to be the fad among the wealthy Chinese.

The irony is that China desperately needs to develop a “bourgeois class”. Its growth depends on what is also known as a middle class.

This is China’s predicament on the eve of the 18th Congress of the Communist Party which is expected to elevate Xi Jinping to the top job. Li Keqiang will take Wen Jiabao’s job. Astonishingly, no less than 70% of the aging leadership bodies—the Party, the army, and the government– are also expected to be replaced.

Can Xi get the country back on a free market track? Does he intend to? Will he have the authority to do it? Or is the old guard going to continue to pull the strings to keep the status quo? After all, if I were Mr. Wen I would worry about letting others decide if my accumulated wealth could stay in the family.

Like Father Like Son?
China’s communist system is opaque and nobody seems to be able to assess where it is taking the country next. There is very little known about Xi’s personality or his intentions. Neither have I read any story about how he got chosen to be the next head of the most populous state in the world. All we know is that he is a member of the new communist aristocracy, also known as princelings.

Aristocrats, when they are not crashing their Ferraris, are usually inclined to paternalistic behavior. If so, is Xi going to implement a strong social agenda more in line with European socialist redistribution policies? Or does he feel he has to continue in the footsteps of his father, Vice Premier Xi Zhongxun, who was instrumental in setting up the first free economic zone of Shenzhen?

Xi Senior was a true reformer and a bit of a trouble maker. Three times in his career he opposed the supreme leader. Mao sent him to internal exile in 1962. Deng brought him back. The elder Xi’s rehabilitation under Deng, however, did not prevent him from speaking out publicly against the Tiananmen Square massacre.

One can only hope Xi Liping is a more patient version of his father. But there is no way of knowing at this time.

Time to Bottom Fish in China?
Here is what investors need to see before committing money to the Chinese market. They should wait to see if President Xi will tackle fundamental problems currently impeding sustainable growth. In my opinion, investors should only re-enter the Chinese market if he goes that route. I do not agree with traders who want China to come up with yet another stimulus program. This would only aggravate long-term problems, including crony capitalism and further misallocation of capital and resources by the government.

The reforms which should head Xi’s agenda include: restarting privatizations; changing the one-child policy; abolition of the hukou system; and quickly addressing the looming nonperforming loan crisis.

Xi should also phase out the remaining dominance in many key industries of state-owned enterprises. This would allow the private sector, the real driver of the economy, to boost growth.

Unlike rapidly-aging Japan, China is getting old before it is getting rich. The one-child policy needs to be ended quickly if the Chinese do not want to be buried by the cost of an aging population.

Using the hukou system to control migration is an anachronism. The rigid urban residency system was a logical part of a true communist system that controls every aspect of one’s life. Today, in China’s post-communist economy, it only creates more disruptions. Migrants have become the new underclass. When moving to where the jobs are, all migrant workers are denied health care, education and welfare benefits because of this outdated system. Being vulnerable, they have to settle for lower wages to boot.

Finally, state-controlled have been told to lend money to SOEs without regard for profitability or viability. By consequence they are now sitting on an explosive number of non-performing loans. The sooner this is dealt with, the better for the overall economy. Pretending, as Japan did for years, that the problem is minimal will only prolong economic stagnation.

And then there is the issue of escalating nationalism. Considering the many challenges the country is facing, one would think this is not a good time to look for trouble with neighboring countries. De-escalating the bellicose rhetoric would help. Nationalist anger directed at Japan, for example, is harmful in many ways, not least by severely discouraging foreign direct investment.

Conclusion
More and more investment advisors seem to be attracted by the Chinese stock market. It has had a long correction and valuations may start to look attractive. However, China today is a good illustration of something most investors have forgotten about emerging markets: political risks justify lower valuations.

The Euro Crisis is Over.

> It was in the late 1970’s that President Giscard d’Estaing and Chancellor
> Helmut Schmidt launched the european monetary system. Already, most pundits
> knew it would never work.
>
> How could a fixed exchange rate (with some flexibility at first) between
> Germany and France ever work? The inflation differential between the two
> countries was just too big and structural. If not cultural.
>
> Without a periodic devaluation of the franc, French companies would
> quickly loose their competitiveness. France would have to make unlikely
> fundamental reforms to bring their long term inflation rate in line with
> Germany for this new currency system to work. That, the overwhelming
> majority of experts believed would never happen.
>
> I clearly remember a German manager of a leading company licking his
> chops. The fixed exchange rate was a wonderful opportunity to run over the
> economic Maginot Line.
>
> Fast forward. From the “currency snake” to the “ECU”, Europe gradually
> built a common currency, the euro. Pundits again told us the latter would
> never work. Even before it got off the ground, financial experts in the
> City condemned it to inevitable failure.
>
> A decade later, these experts thought they were finally being vindicated.
> Club Med countries were coping with growing deficits and the Northern
> European countries were balking at more wealth transfer programs. Whereas
> the euro had brought cheap money to Italy and Spain in the early days, now
> markets were pushing these rates to stratospheric levels. Something was
> about to break.
>
> It didn’t. Instead of whining, member states decided to follow the logic
> of a common currency. If a country cannot devalue its way out of misery,
> structural changes are the only solution. If debasing one’s currency is
> not an option, something else has to give. In an open economy, cost has to
> adjust.
>
> In particular, labor cost has to come down and that includes more labor
> flexibility. Don’t tell anybody: the euro is all about supply-side
> economics. This cannot be mentioned in socialist Europe. But make no
> mistake about it: Europe has put in place a mechanism that gives
> politicians the needed cover to implement obvious structural reforms. The
> socialist Gerhard Schroder understood this ten years ago. Today, his more
> conservative successor is telling the rest of Europe to follow his example.
>
> The euro has now been tested as never before in its short history. Over
> the last three or four years, politicians have been pushed by the financial
> markets. They responded the way one expects them to. They moved only when
> confronted with potential disaster. They took tepid decision after tepid
> decision. But, gradually, the Europeans have moved to solve the euro crisis.
>
> Here is how it works in Euroland. The southern Europeans have been
> dragged, yelling and screaming, to more fiscally responsible policies. The
> northern European countries led by Germany, have been dragged, yelling and
> screaming, to more monetary flexibility. And now, after many tentative half
> measures, we have a credible framework to deal with the euro crisis.
>
> It is quite simple. The European Central Bank, under the strong leadership
> of Mario Draghi, has announced an arbitrage policy between the different
> bond markets of the member states. The ECB will buy bonds in Spain to push
> interest rates down when the spread with German bonds gets too wide. By
> doing so, it makes the Spanish bond market more attractive and will
> encourage the private sector to participate. In return, Draghi conceded to
> the very sceptical Germans to a sterilization program. The way I understand
> this is that the ECB will keep its balance sheet at today’s (high) level.
> Whenever it buys more sovereign debt with one hand, it will sell other
> assets with the other hand. For example, buying Spanish bills while selling
> German bills.
>
> There is another concession made to Germany. Countries will have to ask
> the ECB to intervene in their bond market. The ECB, in return, will be able
> to ask for more structural changes as a condition for help.
>
> Indeed, this is again about supply-side economics. So far, the markets
> are buying it. Spain and Italy have not had to ask for help. The mere
> possibility of such a policy has pushed down their cost of financing.
>
> All this, of course, means that euroland is accepting a tough recession.
> That’s the good news! The reforms are hurting. But so did the German
> reforms ten years ago. Schroder even lost his reelection because of them.
> However, he built the foundation of Germany’s industrial revival and today
> the country is better off for it.
>
> Finally, as often stated by pundits, the euro may very well be a
> fabrication of the elites. However, what one has to understand is that the
> euro is popular. The Dutch elections have once again demonstrated it. The
> pro-euro parties won an overwhelming electoral victory last week. This in
> spite of the fact that they too, like their neighbors, are major financial
> contributors to the many European bailout programs.
>
> But what about the high unemployment rate? Will the Southern European
> countries tolerate it much longer?
>
> It all depends on the definition of unemployment.
>
> Let’s face it. Most people do not want to be unemployed. But with all the
> European social networks in place, this is not what Americans go through
> when they lose their jobs. Just imagine yourself on a piazza sipping an
> espresso after collecting your benefits and waiting for your year end
> bonus. You do not make much money, but life is not too stressful and you
> still have your medical expenditures all paid for by the government. Once
> in a while, you can even make some extra money doing a “unofficial” job.

Nokia and the Wow Factor

On Wednesday September 5, Nokia announced its new smart phone to the public. All the analysts agreed: the phone is good, maybe even great.

The stock price tumbled 16%.

Yet, the Lumia phone’s bold design was pretty well received. It looks good, feels good and comes with a choice of bright colors that differentiates it from all the grey phones out there.

The new device also comes with interesting, innovative features. It has a wireless charger. It has an impressive 8 megapixel camera that automatically compensates for shaky hands and which is extremely sensitive to light. This camera takes the quality of pictures in dim or bright light to a totally new level, which the Facebook generation will appreciate.

The Lumia has a curved screen that allows for daylight viewing by adjusting the amount of light. It has the fastest LCD display ever installed on a smart phone and a touch screen so sensitive it can be used with gloves. A feature called City Lens allows one to read restaurant reviews just by pointing at the establishment. All this on top of an upgraded offline GPS system and a navigation system Nokia is already famous for.

As someone wrote elsewhere, all these features would have impressed analysts if the device had had a fruit as its logo.

But this being Nokia, a company analysts love to hate, the wow factor was kept in check. Instead, investors focused on the company’s failure to provide a release date. They dumped the stock.

So, why did Nokia’s management rush it while they were not in a position to announce an actual release date and a list of carriers that will partner with them? Is the market right that management is just inept?

Let me venture another explanation.

Nokia was looking for the wow factor. It did not get it. But they may have taken the wow factor away from the iPhone5 and that is significant.

Next week, we may find out that Nokia actually got its communication policy right by putting Apple on the defensive.

Whatever the merits of the Lumia 920, launching it after the new iPhone would have reduced it to a me-too product. Apple would have remained the standard that Nokia is trying to emulate. A good effort, but probably not good enough to challenge the real thing.

Now, that narrative has been turned upside down. The roles are reversed. Next week, the new iPhone will now be compared to the Lumia, not the other way around. The pressure is on Apple. Can they once again come up with something that wows analysts? Maybe, but Nokia just made the task more difficult. If, on the other hand, the iPhone5 is not materially different from the Lumia 920, consumers may start questioning the rationale for paying a huge premium.

With the right pricing strategy and the help of the carriers eager to promote alternatives to the duopoly of Samsung and Apple, Nokia may have finally found the right product to become a player again in the smart phone business.

The proof will be in this year’s Christmas pudding.

The Great Manipulation

“Volatility may be scary, but it is not necessarily bad for long term growth. The Great Moderation of recent decades did nothing to increase the long term growth rate of the United States.” Ruchir Sharma’s statement in his excellent book “Breakout Nations” sums up the problem of economic policies based on avoiding a recession at all cost. Sharma further states that “nations with the wherewithal to pay for a soft landing out of recession frequently end up sinking in this expensive pillow.” Japan’s two – soon to be three – lost decades illustrates this best. Even though Japan went through the greatest bubble in human history, when the bubble burst there was no pain. “Like falling off Everest without breaking a bone” writes the economist Andy Xie. “There was never a major round of foreclosures or bankruptcies, as the government kept bailing out debtors.” We have all become Japanese now. In recent years, the Federal Reserve Banks’s self-imposed goals have been a series of moving targets. When the Lehman bankruptcy first hit the markets in 2008, central banks around the world followed the Fed’s lead in pumping liquidity into a system that was imploding. Once the initial crisis was past, the Fed took an a new mission: avoiding a major recession. After that, its next mission was to avoid a double dip. Next, it became keeping the economy growing at all cost. This it hopes to achieve through asset inflation. The modern hyperactive Fed is the new Big Nanny. It is here to protect us from the ills of capitalism. The central bank under Greenspan thought it had finally found the twentieth century’s Holy Grail: an economy without down cycles. It was called the Great Moderation. A financial crisis later, Bernanke has taken the world to the logical next step. Call it the Great Manipulation. To be fair, the Fed has been forced into this role by its dual mandate. Congress wants the Fed to keep inflation under control and at the same time avoid unemployment. What a shock. Congress wants to have its cake and eat it too. At the core of Bernanke’s policy is the conviction that a wealth effect will reinvigorate consumption. When feeling materially well off, people start spending again. That, in turn, gets the economic engine going. Based on paper wealth, Americans are encouraged to spend their savings again. Greenspan also talked about the benefits of the wealth effect. At the time, “wealth” came from high housing prices, greatly encouraged by an aggressive interest rate policy. It did not end very well. Yet, the central bank is back at it again, and then some. What is new in Bernanke’s era is the extent of the manipulation of asset prices by a few unelected officials. From QE1 to QE2 to whatever number is deemed necessary, the Fed has embarked on a massive manipulation of the bond market, the housing market, the mortgage market and the stock market. THIS is unprecedented in the short history of capitalism. The Fed has a stated policy of pushing bond prices up. Mortgage rate manipulation is similarly part of the Fed’s known intentions. By buying the long end of the interest rate curve and by taking bad mortgages off banks’ balance sheets, the Fed is actively supporting the mortgage market, and thus the housing market. Manipulation of the stock market is not as clearly stated. It just happens to be a side effect of well timed policy announcements. A rising stock market is also something Bernanke likes to point to once in a while. Could it be that the Federal Reserve Bank is pushing major indexes up just before the markets open for the day, or when there is too much selling pressure? One can only wonder. What we do know is that the buying pressure is not coming from retail investors. They are still shying away from what many perceive as a rigged game. Japan, on the other hand, is not shy about supporting stock prices. The central bank of Japan has made it official. In the early 1990’s, investors in Tokyo used to call markets’ magic rebounds as the central bank’s “PKO”, or Price Keeping Operation. Whatever the level of direct manipulation of the stock market, traders have behaved with Pavlovian predictability to any hint that a central bank is about to make an announcement. Good news is good news. Bad news is also good news for the market. It triggers a buying spree on the hope of more intervention. Mediocre earnings only affect stocks for a day or two. Then they snap back to previous levels. Even central banks’ inaction no longer triggers a selling frenzy. Traders are too scared to be caught on the short side. Nothing can bring this market down. Short sellers are licking their wounds. Fundamentals are to be ignored. The Fed will not let you make money speculating against a recovery. This is working. There is no question central banks have been successful at pumping up assets. Unfortunately, the Great Manipulation has not helped revive the global economy. The wealth effect has not delivered the anticipated economic growth. The US is treading water. Europe is already back in a recession. Asia is facing a hard landing. Many Latin American countries are moving back to the economic policies that have made them the perpetual success stories of tomorrow. The Markets. So, with valuations relatively high on peaking earnings margins and slowing economic growth, what can the markets expect next? The new contrarians point out that markets always climb a wall of worry. Maybe. But it would make more sense if there was a better future on the other side. Take a look. Fiscal consolidation as far as the eye can see is not a recipe for growth. Whatever policies developed countries choose, it will involve dealing with an enormous amount of accumulated debt. In the aftermath of the 2008 crisis, companies cut costs aggressively, which allowed for a dramatic rebound in corporations’ earnings margins. These reached historic high levels. From here, only top line growth will push companies’ earnings higher. Indeed, that’s what the markets anticipated in the first months of the year. Remember the 3.5 to 4% GDP growth projections? Economic growth was lifting earnings estimates. But now corporate earnings are projected to be flat. Yet the bulls are still in charge and the stock market is back to its year high. How quickly we forget and move on to the next reason to own stocks. In spite of the many warnings, optimism is still predominant. From Nouriel Roubini’s prediction of the perfect storm coming in 2013 to Bill Gross’ calling of stocks a Ponzi scheme, a lot of smart people are worried. Traders, on the other hand, are still pushing markets higher. The tyranny of short term performance is just too strong. If markets are going up, one has to be on board. But missing in today’s bullish view is a clear path to better times. The printing press and short term thinking has kept the prolonged bull market alive. Is it reasonable to believe it will continue without economic growth? At the end of the day, fundamentals do matter. Unreasonable optimism about small economic bounces do not justify today’s unusually long market rally. Foreign markets are particularly vulnerable to a major correction because they have often moved in tandem with US’ optimism, no matter the deteriorating local economic situations. Here is the problem: how can anybody seriously envision a real recovery without an attempt to clean up the fiscal mess? Ironically, today’s markets’ villain, Europe, is ahead of the curve. Government deficits in Euroland add up to less than half that of the US. Germany is pushing the southern European countries to get their fiscal houses in order. Time for gimmicks has come and gone. Structural reforms are needed, and without question,they will be painful. Greece is in a depression. Spain, Portugal and Italy are struggling to regain financial markets’ confidence. These stories make the headlines. But already Ireland is no longer in the news. Here is why: Ireland’s tough medicine is paying off. Having faced its problems head on, the country can now look forward to rebuilding on a sound basis. If Mrs. Merkel holds firm, the rest of Europe will soon be a much better place to do business. And yes, the euro will survive. Japan is a totally different story. Having kept their heads in the sand for more than two decades, the Japanese can no longer remember what a rising sun looks like. They have settled for stagnation. To an outside observer, it is mind boggling that with a debt to GDP ratio of more than 200%, the Japanese do not see any political urgency. Curiously, the Japanese yen continues to defy gravity. The mysterious Orient… Most Asian countries have copied the Japanese export-led economic model. They are now facing a crossroads. Global trade is slowing down. Western countries’ previously insatiable demand is waning. Furthermore, protectionism is showing its ugly head. Either Asian countries rapidly reinvent themselves or a Japanese-style slow decline awaits them. China’s sharp correction should be a warning. The Shanghai SE is down 20% over the last 12 months and is trading 40% below the peak reached at the end of 2009.