Francisco Azuero's List: Coyuntura mundial 2010

• While Anglo-Saxons were throwing money around, Germans kept saving. Domestic  investment has not kept pace. The result of Germans’ prowess at exporting,  combined with their reluctance to spend and invest, has been huge trade  surpluses.

• Chart 3 shows the move to negative 10-year swap spreads in the United States –  that is, the interest rate on interbank 10-year interest rate swaps is  lower than the yield on 10-year U.S. Treasury bonds. This is another  sign that the traditional relationships between relative asset prices are being  dislocated by developments in government debt markets.

• This has several consequences for asset pricing models and risk management  systems. It means that such models will have to incorporate various degrees of  credit risk as a factor in explaining the slope of government yield curves, the  pricing of corporate and other securities relative to sovereigns, and the way  asset prices would be expected to move under various stress scenarios. Corporate  securities, for example, have typically been priced at a positive yield spread  to the sovereign, reflecting the presumption that corporations bear credit risk  that government securities do not. That presumption is being challenged in  Europe, where multiple corporations are trading at lower credit default swap  premiums than the European governments in which they are based.
• The problem now confronting the industrialized world is that the increase in  debt levels is a secular, not cyclical phenomenon; and it is also increasingly  structural in nature.
• It is not a matter of belt-tightening during the recovery phase to bring debt  levels down to pre-crisis levels and pave the way for fiscal policy to come to  the rescue during the next downturn. Rather the belt-tightening is needed to  prevent the medium-term debt path from becoming explosive. Therefore, even under  generous assumptions, the degrees of freedom that industrial countries have to  navigate future shocks will be considerably less than has been the case in the  past
• This reality is amplified by the international mobility of capital in the modern  global economy. Before the collapse of the Bretton Woods system in the 1970s,  restrictions on cross-border capital flows gave governments additional freedom  of maneuver, since many of the investment funds that they relied upon to finance  themselves domestically were captive. Similarly, the home bias of the largest  pools of Japanese capital helped Japan’s government finance enormous budget  deficits beginning in the 1990s. Combined with zero-interest rate policy and  chronic deflation, this helped keep long-term interest rates low despite massive  levels of government debt.
• Investors in industrialized countries, however, are becoming progressively more  international in their asset allocations, leaving less cushion for governments.
• There are several acknowledged drawbacks of market capitalization-weighted  indexes. For example, market capitalization indexes tend to increase the weight  of securities that may be becoming overvalued.
• This was illustrated most prominently in the late 1990s, when market-cap  weighted equity indexes induced investors to increase the weighting of  overvalued tech stocks immediately prior to the bursting of the tech bubble.
• Market-capitalization weighted bond indexes have an additional bias: they tend  to reward large issuers of debt. Larger issuance is correlated with larger  market capitalization, which means larger weight in the index.
• Industrialized country government debt is by far the largest component of global  fixed income indexes. Market capitalization weighted bond indexes are poised to  increase this concentration further, particularly in countries where debt is  growing the most.
• But unlike in previous episodes of financial distress, emerging market countries  generally entered the crisis with strong balance sheets. This was especially  true in China, where low levels of government debt enabled an aggressive program  of infrastructure investment and government-sponsored credit growth that not  only supported economic growth at home, but also had a strong positive  spill-over to growth in other emerging markets and commodity-exporting  industrial countries like Australia.
• In the second quarter of 2009, the contribution of the twenty largest emerging  markets, excluding China, to global demand growth turned positive, at a time  when domestic demand in the United States was still contracting. The emerging  world as a whole, with the critical role played by China, was an agent of its  own recovery in this crisis to a degree not previously seen.
• Emerging markets now have a seat in the cockpit of global economic governance.
• Long positions in the Chinese yuan and other Asian currencies like the Korean  won, Philippine peso, and Singaporean dollar reflect the thesis that exchange  rate appreciation in emerging Asia will have a critical role to play in the  rebalancing of global economic activity.

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• Even a drop in the unemployment rate, from 9.7 percent in May to 9.5 percent in  June, represents a pullback, not an improvement. The rate fell because 652,000  people left the work force last month. Since they were neither working nor  looking for work, they were not counted as unemployed. If they had been counted,  the jobless rate in June would have been 9.9 percent.
• Stocks fell every day last week, as investors anticipated and then confronted  the worse-than-expected jobs report. In May, factory orders for manufactured  goods hit their lowest point in over a year. Home sales in May were abysmal, and  retail sales fell for the first time since last fall; auto sales in June  declined. Perhaps most ominous, budget cuts at the state and local level are  expected to result in mass layoffs in the next year or so; in June, state and  local governments cut 10,000 jobs.

• The single currency was always supposed to drive structural reforms, as  once-profligate countries were forced by the rules, and their peers, to live  within their means.
• Instead, France and Germany led a rebellion against the disciplines of the  “stability and growth pact” on the first occasion it looked about to catch them.
• In the words of one senior German, the root cause of the sovereign credit crisis  in the euro zone was that markets at last “realised that giving credit to Greece  is riskier than giving credit to Austria.”
• Northern governments also blocked early attempts at peer pressure. EU leaders,  it is said, knew Greece was lying about its deficit figures back in 2008. Yet  attempts to confront the then Greek prime minister, Costas Karamanlis, a  conservative, came to nothing. Mr Karamanlis was shielded by fellow centre-right  leaders, including some of those who now shout loudest for budgetary discipline

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• It was supposed to be the brave new world of “originate and distribute” and for  a while it was, until it wasn’t
• Now and for the foreseeable future, we are in a world in which average outcomes  – for growth, inflation, corporate and sovereign defaults, and the investment  returns driven by these outcomes – will matter less and less for investors and  policymakers. This is because we are in a New Normal world in which the  distribution of outcomes is flatter and the tails are fatter
• As such, the mean of the distribution becomes an observation that is very rarely  realized, creating at least three fundamental consequences for investment  strategy.
  
• There are a range of possible outcomes for the eurozone. At one extreme is  successful fiscal adjustment, the creation of a deeper fiscal union and the  creation of a European Monetary Fund – built on the foundations of the special  purpose vehicle (SPV) – to ensure that this never happens again. At the other  extreme it could involve exit from the eurozone by one or more countries, and it  may not be just the eurozone’s weakest members that will have to leave. It is  possible that Germany may one day see the benefits of a return to the  deutschemark outweighing that of European solidarity. The unthinkable has become  thinkable.
• In the Great Moderation years (roughly 1987–2007) of predictable policy, low  inflation, and modest business cycles, generating alpha meant adding leverage to  boost the returns realized by bunching close to the mean. As more leverage was  piled on to the system, spreads shrank, which induced adding even more leverage  to reach return targets. In a New Normal world, the cost of debt financing to  fund speculative trades must go up. The lender does not benefit from the fatter  right tail of borrower profits if that right tail is symmetrically matched by a  fatter left tail of borrower losses. And the bias against leverage is only more  pronounced if (as I suspect) left tails are not only fat but asymmetrically  larger. As my colleague Paul McCulley likes to say, “Markets usually don’t melt  up.” 

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• A number of euro zone members, notably those in southern Europe, have to make  very difficult fiscal adjustments. They do not have the benefit of independent  monetary policy or flexible exchange rates. There is the question of how they  will be able to grow into more sustainable debt dynamics at the same time as  delivering the fiscal policy cuts.

• I think we would all agree that, for much of the world, the task of economic  recovery and repair remains far from complete
• In many countries, including the United States and most other advanced  industrial nations, growth during the past year has been too slow and  joblessness remains too high. Financial conditions are generally much improved,  but bank credit remains tight; moreover, much of the work of implementing  financial reform lies ahead of us. Managing fiscal deficits and debt is a  daunting challenge for many countries, and imbalances in global trade and  current accounts remain a persistent problem.
• For a sustained expansion to take hold, growth in private final demand--notably,  consumer spending and business fixed investment--must ultimately take the lead.  On the whole, in the United States, that critical handoff appears to be under  way.
• However, although private final demand, output, and employment have indeed been  growing for more than a year, the pace of that growth recently appears somewhat  less vigorous than we expected. Notably, since stabilizing in mid-2009, real  household spending in the United States has grown in the range of 1 to 2 percent  at annual rates, a relatively modest pace.
• The prospects for household spending depend to a significant extent on how the  jobs situation evolves
• But the pace of spending will also depend on the progress that households make  in repairing their financial positions. Among the most notable results to emerge  from the recent revision of the U.S. national income data is that, in recent  quarters, household saving has been higher than we thought--averaging near 6  percent of disposable income rather than 4 percent, as the earlier data showed.
• the overhang of foreclosed-upon and vacant housing and the difficulties of many  households in obtaining mortgage financing are likely to continue to weigh on  the pace of residential investment for some time yet.
• In the business sector, real investment in equipment and software rose at an  annual rate of more than 20 percent over the first half of the year. Some of  these gains no doubt reflected spending that had been deferred during the  crisis, including investments to replace or update existing equipment.  Consequently, investment in equipment and software will almost certainly  increase more slowly over the remainder of this year, though it should continue  to advance at a solid pace. In contrast, outside of a few areas such as drilling  and mining, business investment in structures has continued to contract,  although the rate of contraction appears to be slowing.
• Bank-dependent smaller firms, by contrast, have faced significantly greater  problems obtaining credit, according to surveys and anecdotes.
• Private-sector employment has grown only sluggishly, the small decline in the  unemployment rate is attributable more to reduced labor force participation than  to job creation, and initial claims for unemployment insurance remain high.  Firms are reluctant to add permanent employees, citing slow growth of sales and  elevated economic and regulatory uncertainty. In lieu of adding permanent  workers, some firms have increased labor input by increasing workweeks, offering  full-time work to part-time workers, and making extensive use of temporary  workers.
• The substantial recovery in international trade is a very positive development  for the global economy; for the United States, improving export markets are an  important reason that manufacturing has been a leading sector in the recovery.  Like others, we were surprised by the sharp deterioration in the U.S. trade  balance in the second quarter. However, that deterioration seems to have  reflected a number of temporary and special factors. Generally, the arithmetic  contribution of net exports to growth in the gross domestic product tends to be  much closer to zero, and that is likely to be the case in coming quarters.
• Much of the unexpected slowing is attributable to the household sector, where  consumer spending and the demand for housing have both grown less quickly than  was anticipated. Consumer spending may continue to grow relatively slowly in the  near term as households focus on repairing their balance sheets.
• On the fiscal front, state and local governments continue to be under pressure;  but with tax receipts showing signs of recovery, their spending should decline  less rapidly than it has in the past few years.
• I see the evidence as most favorable to the view that such purchases work  primarily through the so-called portfolio balance channel, which holds that once  short-term interest rates have reached zero, the Federal Reserve's purchases of  longer-term securities affect financial conditions by changing the quantity and  mix of financial assets held by the public.
• The logic of the portfolio balance channel implies that the degree of  accommodation delivered by the Federal Reserve's securities purchase program is  determined primarily by the quantity and mix of securities the central bank  holds or is anticipated to hold at a point in time (the "stock view"), rather  than by the current pace of new purchases (the "flow view").
• In support of the stock view, the cessation of the Federal Reserve's purchases  of agency securities at the end of the first quarter of this year seems to have  had only negligible effects on longer-term rates and spreads.
• we adopted a policy of re-investing maturing Treasuries in similar securities  while allowing agency securities to run off as payments of principal were  received.
• At their most recent meeting, FOMC participants observed that allowing the  Federal Reserve's balance sheet to shrink in this way at a time when the outlook  had weakened somewhat was inconsistent with the Committee's intention to provide  the monetary accommodation necessary to support the recovery. Moreover, a bad  dynamic could come into at play: Any further weakening of the economy that  resulted in lower longer-term interest rates and a still-faster pace of mortgage  refinancing would likely lead in turn to an even more-rapid runoff of MBS from  the Fed's balance sheet.
• Thus, a weakening of the economy might act indirectly to increase the pace of  passive policy tightening--a perverse outcome
• In response to these concerns, the FOMC agreed to stabilize the quantity of  securities held by the Federal Reserve by re-investing payments of principal on  agency securities into longer-term Treasury securities
• We decided to reinvest in Treasury securities rather than agency securities  because the Federal Reserve already owns a very large share of available agency  securities, suggesting that reinvestment in Treasury securities might be more  effective in reducing longer-term interest rates and improving financial  conditions with less chance of adverse effects on market functioning
• By agreeing to keep constant the size of the Federal Reserve's securities  portfolio, the Committee avoided an undesirable passive tightening of policy  that might otherwise have occurred.
• Notwithstanding the fact that the policy rate is near its zero lower bound, the  Federal Reserve retains a number of tools and strategies for providing  additional stimulus. I will focus here on three that have been part of recent  staff analyses and discussion at FOMC meetings: (1) conducting additional  purchases of longer-term securities, (2) modifying the Committee's  communication, and (3) reducing the interest paid on excess reserves. I will  also comment on a fourth strategy, proposed by several economists--namely, that  the FOMC increase its inflation goals.
• the expected benefits of additional stimulus from further expanding the Fed's  balance sheet would have to be weighed against potential risks and costs. One  risk of further balance sheet expansion arises from the fact that, lacking much  experience with this option, we do not have very precise knowledge of the  quantitative effect of changes in our holdings on financial conditions. In  particular, the impact of securities purchases may depend to some extent on the  state of financial markets and the economy
• for example, such purchases seem likely to have their largest effects during  periods of economic and financial stress, when markets are less liquid and term  premiums are unusually high.
• Another concern associated with additional securities purchases is that  substantial further expansions of the balance sheet could reduce public  confidence in the Fed's ability to execute a smooth exit from its accommodative  policies at the appropriate time. Even if unjustified, such a reduction in  confidence might lead to an undesired increase in inflation expectations
• A second policy option for the FOMC would be to ease financial conditions  through its communication, for example, by modifying its post-meeting statement
• A step the Committee could consider, if conditions called for it, would be to  modify the language in the statement to communicate to investors that it  anticipates keeping the target for the federal funds rate low for a longer  period than is currently priced in markets. Such a change would presumably lower  longer-term rates by an amount related to the revision in policy expectations.
• A third option for further monetary policy easing is to lower the rate of  interest that the Fed pays banks on the reserves they hold with the Federal  Reserve System
• such an action could disrupt some key financial markets and institutions.  Importantly for the Fed's purposes, a further reduction in very short-term  interest rates could lead short-term money markets such as the federal funds  market to become much less liquid, as near-zero returns might induce many  participants and market-makers to exit. In normal times the Fed relies heavily  on a well-functioning federal funds market to implement monetary policy, so we  would want to be careful not to do permanent damage to that market.
• A rather different type of policy option, which has been proposed by a number of  economists, would have the Committee increase its medium-term inflation goals  above levels consistent with price stability. I see no support for this option  on the FOMC
• However, such a strategy is inappropriate for the United States in current  circumstances. Inflation expectations appear reasonably well-anchored, and both  inflation expectations and actual inflation remain within a range consistent  with price stability.
• In this context, raising the inflation objective would likely entail much  greater costs than benefits. Inflation would be higher and probably more  volatile under such a policy, undermining confidence and the ability of firms  and households to make longer-term plans, while squandering the Fed's hard-won  inflation credibility
• Inflation expectations would also likely become significantly less stable, and  risk premiums in asset markets--including inflation risk premiums--would rise.
• The combination of increased uncertainty for households and businesses, higher  risk premiums in financial markets, and the potential for destabilizing  movements in commodity and currency markets would likely overwhelm any benefits  arising from this strategy
• Falling into deflation is not a significant risk for the United States at this  time, but that is true in part because the public understands that the Federal  Reserve will be vigilant and proactive in addressing significant further  disinflation.
• It is worthwhile to note that, if deflation risks were to increase, the  benefit-cost tradeoffs of some of our policy tools could become significantly  more favorable.

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• Since then GDP has risen in only one quarter. GNP (a better guide to Irish  living standards, because it excludes the net flows of income to parents of the  country’s many foreign-owned firms) has fallen for nine quarters in a row.