November 2010
November 26, 2010 04:00 p.m.
China and the Fed
I apologize for some data errors in the December 2010 issue of Retirement Watch. The allocations in the recommended portfolios are incorrect. Also the buy above and sell below prices of Harbor High Yield are inverted. A corrected PDF of the data is posted to the web site.
China’s been in the news a lot the last week or so.
Fed chairman Ben Bernanke gave a speech blaming a lot of the world’s economic imbalances on China’s policy of fixing the currency against the dollar. He effectively joined those in Congress who believe China is a currency manipulator and should be forced to change its policy. But a number of countries peg their currencies to the dollar and don’t create these imbalances. It’s more complicated. Which explains other reasons China was in the news.
When China pegs its currency to the dollar, it takes U.S. monetary policy. China is importing inflation from the U.S. and becoming concerned about it. That’s why Chinese officials criticized the Fed’s QE 2 policy, and it’s why China for the last few months have been raising bank reserve requirements and taking other steps to curb domestic inflation. It’s also why the Chines currency has been allowed to rise some against the dollar and probably will rise more in the next year or so.
A bigger picture look at China was written by historian Niall Ferguson in the Wall Street Journal. (Subscription might be required.) Ferguson believes the interplay between China and America, which he calls Chimerica, has been mutually beneficial. He believes the Asian Century already has begun and China is on the way to eclipse the U.S. in a number of economic areas. Yet, he doesn’t see the U.S. being hurt by the currency war or China’s expansion. The most likely victims are other emerging nations, such as India and Brazil, that don’t tie their currencies to the dollar. Also exporters of commodities and other goods used by China will benefit (such as Australia).
The problems in the tax-exempt bond market continue, and next year could be worse. States still have serious budget problems. Revenues are down, and demand for their spending is up. They patched up their budgets in 2009 and 2010 because they received a lot of cash transfers from the federal government. They’re not likely to receive those amounts in the next year, and that could lead to higher defaults on tax-exempt bonds. A major problem is the biggest issuers of the bonds are the states with the worst budget problems, California and New York.
Also, the problems with Medicare continue to mount. Doctors are shifting their practices away from Medicare, because they can make more money with other work. Those who continue to participate in the program might be “overtreating” to boost their incomes.
November 18, 2010 02:30 p.m.
A News-Worthy Week
A flurry of finance- and investment-related news filled the last week or so. Let’s sort through the headlines for what we need to learn from these events.
European debt crisis. It’s not over. The Greece crisis in the spring raised alarms and sank markets. But many people thought it was over. Ireland was this week’s source of concern. In each case the real concern is not with the country’s finances but with the number of European banks holding their debt and how significant those holdings are to the capital positions of the banks.
The real lesson here is to expect more of these financial shocks. The period of 1980-2000 was unusual for how few financial shocks occurred. The period since 2000 is more normal. We should expect a pattern of debt problems, markets falling, governments stepping in to delay or paper over the problem, and then a rally in markets.
Quantitative easing. When the Fed telegraphed QE 2 in August, markets rallied and few people voiced concerns. Since QE 2’s actually been implemented, criticisms were voiced from a range of sources. Foreign governments, members of Congress, economists, and others argued the program is a mistake.
This is a classic case of buy on the rumor, sell on the news. The rally aided by QE 2 stalled once the program was official. I don’t expect QE 2 to do much more than keep the economy stable at 1% to 2% annual growth. With little help on fiscal policy from Congress and the Administration, the Fed is working on its own to offset the effects of deleveraging. There’s a concern over whether the Fed will be able to withdraw the excess money once deleveraging is over. That’s a legitimate concern, but we’re a long way from that point. Those expecting QE 2 to have the powerful QE 1 had in 2009 will be disappointed, and those concerned about harmful effects I think are worried prematurely.
Group of 20. The leaders of the largest economies met last week, and the meeting was close to a disaster. The U.S. left with none of the agreements it wanted and received a lot of criticism for various policies. Most importantly, no actions were agreed to reduce the international imbalances of some nations with large trade deficits and others with large surpluses.
China. China’s been the tail that’s been wagging the dog of the global economy the last few years. China has a problem. It pegs its currency to the dollar. But China is not deleveraging, so it doesn’t need all the monetary stimulus. It’s been trying to avoid importing inflation from the U.S. by buying the dollars that make their way into China and then taking other measures to remove the excess yuan from its economy. But the policy is becoming less effective, so it’s taken other measures such as increasing bank capital requirements. Chinese inflation is rising. It really needs to let its currency rise against the dollar, but it doesn’t want to hurt its exports to the U.S. China’s attempts to control inflation raise fears that it will slow its economic growth, and that roils global markets. How China works out this puzzle will affect global economies and investors. It clearly doesn’t want to adjust its currency value much, so it’s hoping these other measures will work.
U.S. inflation. The Consumer Price Index reported a very low reading this week, seeming to support the Fed’s fears of deflation. But commodity prices have been rising for a while. As food and energy prices rise, people wonder why the Fed focuses on core inflation that excludes these items. The main reason is history shows food and energy to be volatile in the short run in response to forces other than monetary policy.
Another question is how the CPI could be low when those items are rising. The CPI is composed of a basket of goods and services. Since unemployment is high, the cost of services is stable or falling, according to the government surveys. Also, housing makes up a big chunk of the CPI. The government uses a measure of housing that essentially is the cost of renting. Because of the housing crisis, rents have been falling. That accounts for a lot of the low CPI. As the rental market tightens, rents could rise soon and cause the CPI to rise. Wal-Mart has an internal survey of prices that shows the prices its customers pay for things are rising.
All in all, these events paint a picture of a sluggish economy that is likely to struggle along with below-average growth. The Fed will be fighting the effects of deleveraging and deflation with modest success. Events in China bear watching, because they likely will affect most economies and markets.
November 12, 2010 03:30 p.m.
Tax-Exempt Funds Hammered
It hasn’t received much media attention, but mutual funds that hold tax-exempt bonds have been declining steadily since Labor Day, and the declines are accelerating.
Closed-end funds are being hit especially hard. They have two high risk factors. Many of them use leverage to amplify their returns. The leverage amplifies the downward moves in addition to the upward moves. The other high-risk factor is most of them are thinly-traded. When a few investors decide to bail out and there isn’t strong demand for the shares, the prices drop like stones. Take a look at this chart for Nuveen Municipal Value (NUW: a closed end fund), Vanguard Intermediate Tax-Exempt Investor (VWITX), and Vanguard Intermediate Investment Grade Bond (VFICX: shown for comparison to other types of bonds).
There’s no secret why this is happening. State and local government finances are deteriorating, and their long-term pension burdens are making a lot of headlines. The states with the worst fiscal problems (California and New York) also are the biggest borrowers and biggest issuers of bonds. Another factor is investors are more attracted to the federal government-subsidized Build America Bonds and are turning from traditional tax-exempts.
We’ve avoided tax-exempt bonds throughout the crisis. While their after-tax yields have been attractive at times, their risks are too high and often are unknown because of incomplete disclosure.
Walgreen could be your primary care provider in the near future, especially if you’re on Medicare. Walgreen believes one way to hold down medical costs without hurting the quality of care is to have more routine treatments, tests, and diagnoses performed by nurses, nurse practitioners, and other trained non-M.D.s in retail establishments such as Walgreen’s. It’s lobbying to give pharmacists a greater role in medical care and planning to take a greater role in managing chronic problems such as diabetes and high cholesterol.
November 5, 2010 11:30 a.m.
Overlooked Events, and Reactions to QE 2
This week was full of significant events: elections, economic data, and central bank statements. I want to focus your attention on a few items that didn’t receive as much commentary as they should have.
Early in the week Wilmington Trust was purchased by M&T Bank. There’s nothing unusual about bank mergers, of course, but the timing and price of this one points to hidden problems in the banking sector. The bank sold for about half its closing stock market value last week. This is a big comedown for the bank. It was founded 107 years ago, was the leading bank in Delaware, and had many prestigious associations, including the DuPont family. It also is a leading wealth manager for high net worth families.
The problems for Wilmington Trust seemed sudden. It announced significant write downs in its loan portfolio as it announced the merger, indicating it arranged the merger as the quarter progressed because it knew its situation was deteriorating. We don’t hear much about problem banks these days, but that’s because the accounting rules were changed in early 2009. Banks don’t have to write down their loan losses as rapidly as they did in 2007 and 2008. That prevents the sharp changes in solvency many banks experienced in those years, but it also is hiding weaknesses. Loan losses, particularly in commercial real estate, probably are understated. That’s one reason why the Fed was quick to begin Quantitative Easing 2.
Which brings us to the criticisms of QE 2. U.S. investors liked it, pushing up stock prices. But the dollar fell sharply, and commodity prices are rising. Less positive reactions came from emerging market countries. Those that peg their currencies to the dollar don’t need the easing the U.S. needs. Their economies are doing well. By pegging their currencies to the dollar, they adopt U.S. monetary policy. Since they have much less unused capacity in their economies, they are at risk of importing inflation from the U.S. In some countries already housing prices are in sharp upswings. Their central bankers are worried about coming consumer price inflation and already are taking steps to counteract QE 2. They’re likely to let their currencies increase in value relative to the dollar, making emerging market currencies a good investment. But QE 1 and 2 brought a lot of “hot money” into emerging markets, and policymakers there are worried the hot money could be causing asset bubbles.
We’ve covered the cost increases faced by seniors in the Medicare program. Here’s another article summarizing the changes for 2011, especially those facing higher income seniors.
