A Wealth Effect That Did Not Trickle Down

Many pundits who dismiss trickle down economics also support the Fed’s multiple QE’s and its stated goal to create a “wealth effect”. This I find ironic since the Fed’s manufactured wealth effect was meant to boost the economy by trickling down.

In The Washington Post , Ben Bernanke wrote on November 4, 2010: “the Federal Reserve has a particular obligation to help promote increased employment and sustain price stability.”

If you thought the Fed had only two mandates, think again. Since 1987, the Federal Reserve Bank has unilaterally added “managing asset prices” to its responsibilities of managing inflation and unemployment levels. Bernanke also explains why this is important:

“higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending”.

It is fair to say that this scenario did not work out as he had planned. Asset prices did go up and rich people with assets may feel better – much better – today. However, spending continues to be subdued because asset inflation does not translate into income. Household incomes today stand 6.4% below they were at the beginning of the recession, even 4.7% below where they were at the end of the recession when asset prices started to climb*.

Let’s think this through. Suppose we give a number of people tulips (not everyone in America owns assets). Then, we push tulip prices up. Tulip owners feel good. Some will sell their tulips, cash the money and buy a nice car. But now the guy who sold feels bad because tulip prices keep going up and he is missing out. He buys tulips again. Others, who have been on the sidelines now want to join the party. Tulip prices go higher as a result, and so forth. The big money goes to speculation, not to consumption. We all know the story and how it ends.

Here is why such analogy is not as far fetched as you may think. Paper wealth due to asset inflation is ephemeral. Real wealth is created by generating return on investment. Tulips are bad investments because they don’t yield any income. The return on an investment in tulip is zero. That is also the problem with Bernanke’s complete neglect of return on investment. His orchestrated universal asset inflation did not eliminate returns on investment all together, but it greatly diminished them.

An economy with low returns cannot grow healthily. Investments seek returns. When adequate returns are not available, companies don’t invest. Has anybody noticed the amazing contradiction in companies hoarding record amounts of cash while generating profit margins 70% above their historic average? With that kind of profit margin and return on sales, shouldn’t companies put their low-returning cash to work? Yet, they cannot find new investments yielding sufficient returns. Obviously, asset inflation has not created investment opportunities yielding proper income.

Furthermore, consumers spend their income. Feeling rich may induce someone to indulge for a short while, but it is the recurrent income generated by good investments that makes the consumer spend money.

Return on Investment is the obvious missing link in the wealth effect’s implementation. Actually, the Fed’s policy has been an unprecedented exercise in the destruction of returns on investments. Pensioners, a growing percentage of the population, has seen their returns on bonds melt to ridiculous levels. Cash in bank accounts no longer yield even a small return. Housing reflation has greatly diminished returns** and stocks’ earnings yield keep coming down as PE ratios (the reverse of earnings yield) go up and up.*** Hence, in taking away the markets’ pricing mechanism, the Fed has greatly distorted the economy’s return on investments. Maybe it should consider a fourth mandate.

Trickle down economics worked in the last two decades of the twentieth century because it was based on organic growth and high returns on investments, which resulted in higher asset values. This, in turn, created a virtuous circle and the benefits did trickle down, admittedly unevenly. Bernanke’s QE experiment tried to put the cart in front of the horse and it did not work.

Asset inflation actually reduces returns on investment.

* Politics & Ideas, The Wall Street Journal of February 12, 2014

** S&P Case-Shiller 20-City Composite Home Price Index peaked at 206 in August 2006, bottomed at 134 in February 2012, was at 166 in November 2013 and is expected to be up another 5% or so in 2014 (which would bring it at 174, 15.5% below the all time/spike). The Vanguard REIT Index ETF now yields 4.14%.

*** Companies’ profits margins, which are at historic highs, are calculated on sales. Yet earnings yields for an investor today are above historic averages, hence the high PEs. If one “normalizes” earnings by assuming more average profit margins, the PE ratios look very overpriced.

History Did Not End. The Emerging Markets Story Did.


Warsaw, Poland

In a famous book * published in 1992, Fukuyama boldly proclaimed the end of history. By this he meant that the world had finally reached a consensus on the best form of government. History, he opined, was on an irreversible journey toward liberal (i.e. free market) democracy. There would be setbacks, but the end point, according to him, was a world in which all countries would eventually adopt Western style free markets and democracy.

Fukuyama went even further. He suggested that a “post-historical world” would be established on a transnational rule of law, something like the European Union. “God, national sovereignty and their military” would be things of the past.

Tell that to Vladimir Putin, Shinzo Abe and Xi Jiping!

Without getting into an academic debate that I am sure to lose (Mr. Fukuyama’s credentials are much higher than mine and he has since nuanced his views) let’s agree that with hindsight all this seems a bit optimistic.

Nonetheless, the brief burst of capitalism around the world at the end of the last century has substantially influenced investors’ behavior. After having shied away from international funds, American investors suddenly became enamored with frontier investing. They flooded ever more risky emerging markets with ever more money. The less developed a country was, the better the opportunity it appeared to be. This was because of the greater distance it had to travel on the supposedly clear path to prosperity.

For two decades, massive liquidity flows turned the emerging market story into a self-fulfilling prophecy. They have slowed down recently.Today, the Morgan Stanley Emerging Markets Fund Inc. (EMF) trades at the $15 level it traded four years ago. Even worse, the flow of money into emerging market funds has reversed.

Investors are taking their cue from local capital which usually knows best. Already in 2011, $946.7 billion of illicit capital fled from developing countries according to he non-profit organization Global Financial Integrity . This trend has likely continued.

While this reduction in flows may not prove permanent, for the time being at least, it is clear that appetites for risky country investments have diminished. Emerging market growth has disappointed and many regimes have shown their true colors. It appears simplistic now to paint emerging markets with broad brush strokes. The BRIC countries, for example,no longer appear to have much in common. India is mired in corruption. Russia is a kleptocracy wholly dependent on commodity cycles. Brazil is again “the country of the future”; it always is. Only China is still enjoying rapid growth, although this miracle economy is also beginning to experience growing pains.

If humanity is on a long march to political and economic freedom, countries are taking very different paths. Declaring the End of History was premature.

I trust our children are happy to know they are not irrelevant, after all.

The World After it Ended.

The global flirtation with free markets and democracy has been short lived. Francis Fukuyama – and so many other pundits – mistook the global wave of freedom set in motion by the Thatcher/Reagan revolution for the inevitable march of history. One problem here: history is written by men and women. Different generations have different views and priorities. So do different leaders.

Countries around the world are returning to more comfortable ideologies. Tony Blair and Bill Clinton may have kept the flame of economic freedom burning for awhile, but they are similarly fading in people’s memories.

Well into the new century, there is no denying that the pendulum of history is swinging back. In the developing countries, interventionism, stronger regulations and money printing have replaced supply side economics, deregulation and monetary orthodoxy of yesteryear. Add to the mix a strong dose of isolationism in the US, currency manipulation and militarism in Japan, bland social-democracy in Europe, fascism in China and the glorious uniform world imagined by Fukuyama starts to look more like a messy patchwork. Not to speak of Russia’s ambition to recreate a Soviet-Lite empire.

Implications for Investors.

International investors should pay attention. Political risk has been absent from our lexicon for too long. Flows of funds and commodity cycles should not be confused with structural changes. In other words, Brazil is not Mexico. Asset inflation is not wealth creation, no matter what the Federal reserve Bank wants us to believe. Mexico’s difficult road to competitive capitalism is much more promising than Brazil’s commodity induced boom.

Similarly, earnings in Egypt are obviously not the same as earnings in Germany. PE ratios should reflect that. Too often in the past two decades earnings multiples have been determined by growth projections with no regard for risk. It was thus not uncommon to see emerging markets trade at a premium to mature ones. Today, some sectors in China or India are still trading at multiples that do not take political risks into account.

Political and economic systems do matter when making asset allocation. Once the effects of massive liquidity fluxes evaporate, fundamentals will reassert themselves. When that finally happens, would you rather overweight Greece or the Netherlands?

Asset Bubbles

The Japanese know a few things about excessive liquidity. The Tokyo stock market is actually the poster boy of bubble-burst cycles. Japan’s experience has therefore been studied at length by economists around the world. Ben Bernanke, for one, has paid close attention.

So, how did Japan react to the stock market crash of 1989? It spent money, lots of it. The country has since been a revolving door of Prime Ministers, each trying to outdo his predecessor with a better Keynesian stimulus program. And what does Japan have to show for it? Growth remains elusive and the country’s public debt load is now crippling.

Something is changing now, but for reasons people do not talk about much. Japan has enjoyed a new dawn with Shinzo Abe’s well publicized “Three Arrows” policy: deficit spending, money printing and vague structural reforms. It all sounds refreshing, but these arrows have been shot before. What makes Prime Minister Abe’s plan substantially different from his predecessors’ lies elsewhere: two more stealth arrows consisting of a currency war and remilitarization.

The effects of the former are clear to see. The yen has lost 25% against most currencies over the past year. The orchestrated devaluation has resulted in an explosion of earnings at most export-oriented blue chip companies, further instilling a new sense of optimism that greatly benefits the domestic economy as well.

Japan is back. The stock market is rebounding and GDP is growing again. The temporary wealth effect is fueling consumption and it is not unreasonable to expect it to go on for a while. In spite of the coming sales tax increase, redistribution of wealth Japanese style should keep the economy going.

Prime Minister Abe wants the private sector to help him increase people’s buying power. Keidanren, the influential employers’ organization, got the message. It is thus officially encouraging its members to help create a virtuous circle by raising wages. This being a disciplined and egalitarian society, companies are likely to comply.

In light of these developments, how can one not be bullish on the country’s stock market prospects? Next year Japan is going to experience the continuation of its current very loose monetary policy combined with wage inflation and more debt financed public stimulus, focused on the defense industry this time. Being long Japanese stocks while hedging the currency should pay handsomely for a little while longer.

However, history buffs will notice some worrying parallels with the 1930’s here. In a depressed world economy, seeking advantage through a weak currency has been tried before. Even more worrisome is the possible repeat of 1930’s military adventurism. Abe is rearming Japan. He is changing Japan’s pacifist laws. The escalation of tension with China is even bringing Japan to conduct military exercises with unlikely allies like India.

So, while watching with great apprehension the military build up in the region, I am still overweighting Japanese stocks. The portfolio includes export champions like Komatsu (KMTUF) and Toyota (TM) as well as leading internet consumer stocks, including Rakuten (RKUNF) and Yahoo Japan (YAHOY). The best way to play Japan’s defense sector is Mitsubishi Heavy Industries (MHVYF).


It is difficult to know what is really happening in China. Rumors abound of pending destabilizing bankruptcies. Many large state owned enterprises (SOEs) and their bankers are most certainly insolvent. So are many local governments that have been unwisely encouraged to spend recklessly in the aftermath of the global financial crisis. Furthermore, the volume of non-banking loans has exploded. According to an article in MarketWatch*, nearly half of the $2.3 trillion credit growth in the first 10 months of 2013 in China came from non-bank institutions.

Does this mean that China is about to experience a financial meltdown similar to the US five years ago? Some believe so. But, even though it is possible the incoming administration will be able to clean up the mess without creating a liquidity crisis, one thing is clear: China, like all command economies, is suffering from gross misallocation of resources. What happens after such misallocation is a game of whack-a-mole where the central planners attempt to solve one problem only to see another popping up elsewhere, always in an unforeseen place.

Many have touted China’s efficiency. But China is efficient the way Mussolini’s fascism was. Isn’t fascism famous for making trains run on time?

Twenty-first century China has an authoritarian form of government that is closely linked to corporatism and is strongly nationalistic and militaristic. China advocates a mixed economy with the goal of achieving autarky. It is hostile to liberal democracy and it believes in dirigisme or industrial policy. All this defines fascism. Unlike European-style fascism, however, the Chinese version does not bother to add a social element to it.

Again, this matters to investors. History teaches us that fascism is dangerous for neighboring countries. Even if an economic policy directed from above often appeals to the rational mind, the eventual negative effects are far larger than the early positive ones. This is becoming more obvious today in China with all the money wasted in solar energy, for example. Furthermore let us not forget that fascism and the rule of law, notably property law, never go well together.

Ultimately, in spite of the spectacular growth in dirigist China, brownian capitalism is much better at allocating capital and resources in the long run. A system where economic power is highly concentrated also breeds corruption. Finally, China may be good at producing copy cats, but creativity cannot flourish in an authoritarian regime. A Chinese Silicon Valley is unthinkable as long as free thinking is not allowed.

To top it all, China’s major competitive advantage is fading. Wage inflation greatly diminished China’s appeal as a production hub. It now costs less to produce spun yarn in the US than in China! According to the Wall Street Journal, Brian Hamilton’s Ph.D dissertation puts these costs at $3.45 per kilogram in the US vs $4.13 in China**.

For all these reasons, at this point, I am willing to sit on the sideline. I have no investments in China. A safer way for the audacious investor to participate in that area’s still superior growth is thru US or European companies. Yum Brands (YUM) or Danone ( DANOY) come to mind. Even Apple (AAPL) is a good bet now that they have secured a deal with China Mobile (CHL).


For many, the biggest surprise of last year has been the strength of the euro. Every Anglo-Saxon investor and his brother has now predicted the end of the euro at one stage or another. It did not happen. Neither will it happen in the foreseeable future. On the contrary, the euro club keeps growing as new candidates beg to join, Latvia being the last example. American investors need to face it. The euro exists because of an overwhelming political consensus. Europeans want it. Even in the south of Europe, they realize that adopting the common currency is a way to import German-style social democracy.

What does that mean? Simply put, social democracy is socialism with your eyes wide open. French socialism always runs into a wall because of unrealistic social programs, choking regulations and prohibitive taxes. Social democrats, on the other hand, are realists. Germans like socialism as much as the French, but Germans know how to keep the economic engine going. When it sputters, Germans are wise enough to introduce a little less regulation, fewer benefits and even lower taxes in order to get it going again.

The euro, a mechanism to export Teutonic pragmatism to the more emotional or less disciplined members of Euroland, has worked marvels. Because Spain, to pick one, wants to stay in the euro zone, it has to make structural adjustments. A little less regulation, fewer benefits, etc.. The result is a more business-friendly Europe. How can one argue with that?

Now, with the euro crisis firmly behind us, Europe is calmly reverting back to its long term objectives: sharing the relative wealth and the benefits of modest growth. Europe has fully embraced its place in the world as a demilitarized zone with a me-too economy and pedestrian growth. It is not exciting, but the Continent and the British isles offer some decent companies to invest in.

Among the European world class companies, internet leaders like Sports Direct (SDISY) or Schibsted (SBSNY) stand out. Volkswagen (VLKPY) is likely to overtake Toyota (TM) as the world’s biggest car manufacturer and some technology companies like Gemalto (GTOMY) or Carmat (FR:ALCAR), the artificial heart maker, look attractive. Finally Nokia (NOK) still offers good value at $8.

The End of History and the Last Man ( by Francis Fukuyama, 1992) 
* Illicit Financial Flows from Developing Countries 2002-2011, published by Blobal Financial Integrity 
China Hard Landing is Likely by Andy Xi, MarketWatch of November 20, 2013 
“The Latest Chinese Export to America: Textile Jobs”, The Wall Street Journal of December 20, 2013

Abe’s Three Arrows Or Japan’s Hail Mary Pass?

“You cannot bring about prosperity by discouraging thrift.”

Margaret Thatcher is said to have carried a piece of paper with this and two other lines attributed to Abraham Lincoln in her famous handbag.

Needless to say, Bernanke is not carrying such reminders in his wallet. The most powerful unelected man on the planet wants people to spend, not save. Our Central Bank wants Americans to spend on consumer products and to spend on “investments”. The latter supposedly creates a “wealth effect”, which in turn encourages the former. This thinking has now caught on in Japan, with a twist.

Broadly speaking, the industrialized world has opted for three different economic solutions to the lingering crisis. One, the US is inflating assets and “temporarily” monetizing public debt. By avoiding a recession at all cost, America hopes to muddle through to the next up cycle.

Two, Europe ( i.e. Germany ) does not mind a recession. Teutonic discipline and short-term pain is needed for long term-gains. Using the currency union, Europe is imposing long-needed structural changes on the laggard countries commonly known as the Club Med nations. Incidentally, France did not get the message.

A third economic policy has recently been initiated by Japan and is best described as “all the above”. The new policy has been dubbed Abenomics. It consists of three “arrows”: fiscal stimulus, money printing and structural reform.

This Time is Different.

Stock markets in the US and Europe keep hitting new highs. Paper wealth is indeed being created even though the underlying economies are not doing as well. The US economy stubbornly refuses to take off, no matter how much fiat money Bernanke throws at it. Europe is still suffering from chronic recession disease.

Therefor some investors are rightfully turning to Shinzo Abe’s Japan. This time Prime Minister Abe has not disappointed, at least not so far. In his second attempt at governing, Abe is showing uncharacteristic boldness. He has managed to awaken animal spirits and Japan has gotten its mojo back. The Nikkei is soaring. GDP is rebounding. Optimism is returning.

For more than two decades, Japan has tried to stimulate its economy with the usual Keynesian programs. But many bridges to nowhere and a record public deficit later, the economy remained in the doldrums. The immediate solution was clear to some veteran observers: devalue the currency. More reform of structural rigidities would help too.


Enter a very unlikely savior. Abe-san, whose first stint as PM did not last a full year, has managed to reinvent himself with a very aggressive economic plan.

First, he launched the usual fiscal stimulus package. This is an old trick that helps the well-connected and lies behind Japan’s 240% debt-to-GDP ratio. This time however, he combined these goodies with a raid on the formerly independent central bank. He put likeminded Kuroda at the head of Japan’s Central Bank with a clear mandate: print money as if there were no tomorrow. Depreciate the yen, reflate the economy and create the now-fashionable “wealth effect”. If needed, buying stocks is permissible too.

Having shot these first two arrows, Prime Minister Abe now needs to accomplish the most difficult part of his strategy. He needs to follow through by making good on the promised supply side reforms. Without reforms, the recovery will fizzle.

According to The Economist magazine, “Mr Abe talks of ending the protection enjoyed by Japan’s farmers, doctors and pharmaceutical companies; breaking open the labour market’s rigidities; improving education; cutting through boundless regulation; opening utilities up to competition; encouraging innovation and spurring business investment.” (1)

For good measure, Abe also threw a few tax incentives for corporations in the mix. All this may prove a challenge. One might doubt that Abe’s “third arrow” will land anywhere near its target. Even the very popular maverick Prime Minister Koizumi failed to implement any meaningful reform. So, what is different this time?

Trans-Pacific Partnership.

Prime Minister Abe needs to follow up on his recent landslide victory in the Lower House with another clear win in the coming Upper House elections. This will give him the undeniable mandate to carry out real reform. Remarkably, he is not hedging his bets. He is campaigning on reforms that will upset his historical constituencies, including farmers. But polls show it might actually work. Japan is fed up with business as usual.

Even a strong mandate could prove to be insufficient, though. Changes come slowly. Entrenched interests are hard to overcome in any democracy, let alone consensual Japan. That’s where joining the Trans-Pacific Partnership (TPP) comes handy. Shinzo Abe has learned from the Europeans.

Remember it was the popular idea of joining the common market that gave European politicians the courage to implement long-needed reforms. Spain, Greece or Italy, for example, had to open up their economies to be part of the club. They privatized companies, slashed tariffs and non-tariff barriers, merged corporations, reduced taxes and social benefits all to comply to the shared ambition of a European union. No politician would have accomplished these changes without committing their country to a higher and popular ambition. When implementing difficult reforms, they had – and still have – the convenient excuse of being forced by the union’s requirement. The ECB is a good lightening rod in hard times. In good times, politicians will know how to take credit.

The Trans-Pacific Partnership is not as ambitious as the European Union. But it is clearly inspired by it. It could similarly be the catalyst to supply side changes.

Economic Growth.

The weakness of the yen is good for exporters. Toyota (TM) or Komatsu (KMTUY) were profitably exporting cars and excavators at 80 yen to the dollar. With the currency hovering around 100, margins are exploding.

For decades, an overvalued currency relentlessly pushed Japanese blue chips to lower their cost base and to increase the value-added element of their products. It was tough, but the hardiest remained competitive. Others lost ground. Today’s devaluation of the yen will rescue some of the latter and put the former in a doubly strong position.

But exporters are not the only winners. Lifted by renewed optimism, the overall economy rebounded at an annualized 4.1% in the first quarter. Consumers are feeling more upbeat too. Be it thanks to gains in the stock market or anticipation of better times and wages, there are strong signs that Japanese consumers’ attitudes are already changing. Corporate investment will follow.

Avoid Banks and Insurance Companies.

Mr. Kuroda is determined to create inflation through a doubling of the monetary base in two years. That’s not good news for bonds. Financial companies replete with JGBs, mainly banks and insurance companies, will have to take large right offs if this scenario unfolds.

Two and a half years ago I wrote about Japanese banks’ addiction to government bonds. (Click here to read.)

I argued at the time that the government was siphoning too much capital out of the real economy. Banks were financing a gargantuan public debt at the expense of the corporate sector. We can expect this trend to reverse now. Kuroda’s Bank of Japan is picking up the slack. Newly printed money will take care of the debt (yes, Japan too can monetize it) and banks will need to redirect their loans to the private sector.

The Kuroda Put.

Japanese stocks have come a long way over the last 6 months. The Nikkei rallied back from the 8,000 level in no time. It reached 15,000 before pulling back momentarily. Such a rally may scare some investors off, but let’s not forget that the Nikkei was trading just below 40,000 a quarter of century ago. It is still 60% below its all-time high reached in 1989. In spite of the rally, the market price/earnings ratio is well below 20. Yet, if the yen drops to 125 to the dollar, today’s earnings estimates will have to be substantially revised up and PE’s will fall.

And then, there is the Kuroda put. Kuroda-san is committed to doubling the monetary base in two years. In the process he will not shy away from supporting the stock market as well as the bond market. QE programs, after all, are about manipulating asset prices. That includes bonds, mortgages, equities and currencies.


Of course, nothing is without risk. The proliferation of fiat money around the world could lead to uncontrolled inflation. The fact that it has not happened yet does not mean we can keep doubling down forever.

Japan does not operate in a vacuum. Highly leveraged hedge funds can momentarily derail the yen’s trajectory. With the carry trade back in vogue, these managers borrow cheaply in yen. They leverage to the wazoo and invest that money in high yielding bonds in a strong currency. When all works fine, they cash in the interest rate differential on top of a currency profit.

Sometimes, as we have seen recently, the one-way bet backfires and they all run for the exit at the same time. How else does one explain the dramatic correction from 103 to 95 to the dolllar in less than a week?

On the political front, one can also expect a backlash in Asia. Chinese, Korean and Taiwanese exporters are all directly affected by the currency war started in Tokyo (or was it earlier in Washington?). It is difficult to believe these countries will sit quietly.

All in all, Japan’s weight in any international fund should be increased. The sun is rising again, albeit over a very cloudy horizon.

(1) “Once More With Feeling”, The Economist of May 16, 2013

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.


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.

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.