Gold and the Market Selloff

The U.S. stock markets began the year with a noticeable decline. It is the worst start to a year ever, although a 10% decline is far from the end of the world or a repeat of 2008. However, these events always get attention and often bring interesting questions from clients, friends, or other professionals. This week, a client expressed confusion that the stock markets were falling, commodities were falling, yet the price of gold was not spiking. Many folks think of gold as a safe haven asset, and expect it to rally when markets are in turmoil. Yesterday, I saw a similar question raised by one of the better professional economists and bloggers. So, here's my attempt at an explanation.

Consider the financial crisis of 2007-2009. Before the crisis began, inflationary forces were at work. As the crisis developed, the Federal Reserve did nothing to combat this inflation, and in some ways, exacerbated those effects (by cutting interest rates). In addition, political conflicts with Russia, Iran, and even China were in the headlines. These risks push up the gold price. As a result, the dollar price of gold rose sharply from August 2007 to April 2008 (news the Fed would stop cutting rates hit in April). So, early in the crisis, gold was rising, but for inflationary and geopolitical reasons. From April to September, the gold price actually declined as policy makers convinced the markets that contagion was unlikely and inflation expectations declined. Then, when the crisis hit its peak, at the bankruptcy of Lehman Brothers, gold did spike. However, this spike was temporary, and the gold price in October was lower than it was before Lehman failed. In other words, the scariest moment of the crises saw a short term spike, but no lasting rise in the gold price. 

Today, conditions are much different. The dollar has been getting stronger (gold price has been falling) for over two years. This is likely due to slowing growth and declining geopolitical tensions.  The recent Fed rate hike and completion of the Iran nuclear deal only exacerbate this trend. So the market selloff is occurring within a context of a deflating dollar (whereas in 2007, it was an inflating dollar). In a deflationary environment, gold is not a safe haven. 

Where's the Republican Outrage?

Republicans are known for questioning the efficiency, and thus the value, of government operations. Well, at least some government operations. They rarely criticize waste and inefficiency in the parts of government they favor, such as defense and law enforcement. It seems, for Republicans, these operations do much with too little resources but all other programs do little with too much. 

My own view is that poor incentives and structural issues make all government programs more inefficient than necessary. I'm willing to point that charge at social programs as well as defense. I view it as the consistent, intellectually honest approach. I wish Republicans shared my outrage. Fiscal responsibility must  include the defense budget.

So far, I've seen no such outrage for this story. 

The Defense Department is a Fiscal Train Wreck

P.S. Not that it matters, but I am a veteran, and I support the armed forces and those who serve.

Review: The Accidental Super Power by Peter Zeihan

Peter Zeihan is an impressive analyst. In The Accidental Super Power, The Next Generation of American Preeminence and The Coming Global Disorder, Zeihan demonstrates a tremendous knowledge of history and politics, viewed through the unique lens of geography. The book provides a fascinating, perhaps excessive, recap of the history of the world up to the end of World War II, followed by a comprehensive global review of the past 70 years under the Bretton Woods accords. Zeihan then turns his analytical eye toward the future, and makes several intriguing, perhaps controversial predictions about the next 30 years as the Bretton Woods paradigm unravels. Several real world events since publication (Ukraine, Syria) validate Zeihan's insights, and give credibility to his worldview. Still, Zeihan's surprisingly conventional, and sometimes vague understanding of economics provide sufficient reason to question his predictions.

I recommend this book to anyone interested in geopolitics. Zeihan is a capable writer who methodically lays out his view of history and sets the stage for some intriguing predictions. Ultimately, this work should, be judged by the accuracy of Zeihan's predictions. Instead of waiting 10-30 years for that review, I'll share a few observations on his likelihood of being proven correct. 

Zeihan's book is an attempt at expert political judgment. He certainly has the credentials. Unfortunately, the record of political prognosticators is notoriously poor, even for highly trained analysts. As Phillip Tetlock's research has shown, "forecasters were often only slightly more accurate than chance, and usually lost to simple extrapolation algorithms".  Tetlock did note some experts are more accurate than others. He uses Isaiah Berlin's paradigm of the fox and hedgehog to classify how experts think. Berlin's article quotes a Greek proverb, "the fox knows many things, but the hedgehog, one important thing". Tetlock found experts with a singular idea driving their worldview (hedgehogs) were less accurate than those more open to various philosophies (foxes). On this scale, Zeihan is a mixed bag. He begins his introduction in pure hedgehog mode: "Geopolitics is the study of how place impacts...everything." However, as the book progresses, Zeihan expands his influences from geography to demography, technology, and economics. As he expands his worldview, Zeihan shows as much mastery of demographics and technology as he does geography. His one weakness is his understanding of economics.

Zeihan refers to the importance of capital throughout the book, yet he never explicitly defines the term. He implies capital is simply money. In the early portions of his book, where he describes how geography impacts everything, he links capital formation to quality river networks. The assumption is, capital is where people gather, and historically, that was near quality rivers. But is that the only place capital gathers? Is his thesis still true today? For example, what of the migration of capital from San Francisco, California to Austin, Texas? Capital in all forms (human, physical, intellectual, financial) flows to where it is treated well. Technology exists today that enables people (and their capital) to live and thrive far from riverine cities and ocean ports. Zeihan's book discusses human migration among nations, but is mostly silent on the migration within large nations such as the United States. A second example of Zeihan's conventional economics is his insistence on equating consumption with economic growth. In classical economics, production is the key to growth (because none of us can consume until we first produce). Production is still linked with demographics, but in a less dire way. In Zeihan's future, as societies age, they save more and spend less, limiting growth and forcing taxes higher. In a classical model, this higher savings, if treated well, flows to innovation, so that fewer young people can produce more. In short, a capital friendly environment can overcome the negative consumption patterns Zeihan predicts will be driven by demographics.

The biggest reason to question Zeihan's work, is his total omission of any reference to the primary reason the Bretton Woods accords took place: a global monetary standard. Zeihan's central tenet (and his entire first chapter) focus on the accords of Bretton Woods, the world they created since 1944, and how that world is about to quickly unwind. Zeihan describes Bretton Woods as a pact for global free trade, subsidized by America's promise to make the global waters safe for transport. Yet there is no global trade without a global currency. As other books have detailed, discussion of the new monetary standard was the key issue of the Bretton Woods talks. Zeihan does speak to the importance of currency, most notably in his predictions on China. He predicts in the coming years there will be no major competition for the U.S. dollar. In that discussion he dismisses gold as a viable currency, noting that there is far too little gold relative to the value of global economic activity (a common critique of those who do not understand gold based money). What Zeihan misses or ignores, is that the world was on a gold based monetary standard prior to WWII and that the Bretton Woods world he otherwise describes perfectly, was a gold based system. At least until 1971. Bretton Woods established the U.S. dollar as a global currency, subject to the constraint that the dollar would be held steady at a value of $35 per ounce of gold (because stable money is best for economic growth). This system allowed globalization to flourish, until mercantilism came back in vogue. In 1971, President Nixon floated the dollar (removed the stable tie to gold) and ended the Bretton Woods system. Zeihan's premise is that the end of Bretton Woods will usher in his predictions in the near future. Yet, the fundamental arrangement of Bretton Woods ended 45 years ago.

Zeihan's predictions may still come to pass, but it seems odd for him to omit discussion of these monetary issues, from an otherwise educational, detailed, and worthwhile book.

FURTHER READING: For those who are interested in this topic, but not willing to commit to Zeihan's lengthy book, here is a nice interview Zeihan gave to the Gavekal Capital. Here is part one, part two, and part three.

Cheering on the Fed

The hot financial topic of the day, likely the year, is Federal Reserve policy. The wait is finally over. The Fed did raise rates today (among other actions). The move was widely expected and cheered. My twitter feed was very pleased. I was not. 

I've already discussed why this was not a wise move. I'll simply add one more observation. Many of the fans of this rate hike are pleased because the Fed is finally moving away from the policies of easy money and Quantitative Easing. They cheer "normalization". This seems result driven, as they never approved of QE. Yet the same people (mostly) and the same theories which produced QE, are now unwinding it. I for one would not be so quick to cheer the policies and timing of a group I so roundly criticized. Put another way, for some errors, the correction is to stop acting, not to reverse the action.

Benghazi

Listening to an old episode of the Tim Ferriss Podcast, I had a thought about the controversy concerning the 2012 attack on the US Embassy in Benghazi. The original explanation from the White House, Obama, and the State Department was that the attack was a response to an anti-Muslim video posted on YouTube. Republicans and critics of the administration quickly responded that this explanation was weak, and the attack was a premeditated attack on American interests (later proved to be correct). 

My thought is that Republicans and critics of the administration missed the more obvious objection. Anyone who would commit cold-blooded murder in response to a video (or cartoon, or joke, etc.) is inhumane and barbaric. For the administration to accept that as justification is insane., and should be called out. Critics of the administration should not have said "the administration is wrong" but rather critics should have pointed out that the administration was endorsing the idea that murder was a justified response to speech you don't like or agree with .

 

What Will the Fed Do?

The U.S Federal Reserve will hold its next two-day meeting this week, on September 16th and 17th. At the conclusion of the meetings, the Fed will announce whether it will raise interest rates (the Federal Funds Rate). The benchmark rate has been near zero (targeted between 0 and 0.25%) since December 2008. This is the Fed's primary tool for achieving its goals. Those goals are mandated by law:

“The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates.”
— https://www.chicagofed.org/publications/speeches/our-dual-mandate

This is commonly called the "dual mandate", to maximize employment while keeping prices stable (i.e. low inflation). Ignoring Hayek's warning of the folly of trying to plan something as complex as the world's largest economy, we can try to anticipate the Fed's action by evaluating how close they are to achieving their mandated goals.

The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.
— F. A. Hayek


Growth is positive, but is still below the long term average, and thus cannot be said to be up to long term potential. In short, there is room for the Fed to remain accommodating without violating their mandate.

Unemployment is low, and near the long term average, but is still above the low point of recent recoveries. In short, there is room for the Fed to remain accommodating without violating their mandate.

Prices are relatively stable, as inflation is low. Specifically, inflation remains below the Fed's informal inflation target of 2%. Recent data suggests inflation is likely to decline in the near term. In short, prices meet the Fed's definition of stability, and there is room for the Fed to remain accommodating without violating their mandate.

Interest rates, by any measure, remain moderate. There is room for the Fed to remain accommodating without violating their mandate, but there is also room for rates to rise.

This last point, the current level of rates, which appear quite low historically, is the most often cited reason why the Fed should hike rates. Rate hawks are focused on the absolute level of rates. However, in economics, it is usually the marginal impact of a change that matters most. A 0.25% hike in the Fed Funds Rate, would be an effective doubling. The impact on consumer rates would be approximately 8% (.25% on 3.25% Prime rate). That may not seem like much, but it far exceeds the rate of growth, the rate of wage growth, or the rate of productivity gains. The tightness of credit would be significantly impacted by a simple 0.25% rate hike, and this will put significant pressure on consumers and entrepreneurs.

When facing complex decisions, it can be instructive to consider the Outside View. What are other central banks doing?  It turns out the other central banks are all easing credit (lowering rates and expanding or considering quantitative easing). As Charlie Bilello notes, central banks are averaging 7 rate cuts per month so far in 2015. (Here's his eye opening table.)

One key way to try to read the Fed is to think like them. Many of the voting members of the FOMC believe the trade-off between unemployment and inflation as described in the Phillips Curve. With unemployment now back to normal, many Fed members are ready to hike rates to thwart the inflation that the Phillips Curve predicts. Although the Phillips Curve theory is quite flawed, we should be pleased with its failure. Unemployment has declined to a very low level without any resulting troublesome inflation. As Vlad Signorelli at Bretton Woods Research has suggested, the Phillips Curvers at the Fed should declare "mission accomplished" and take a victory lap rather than acting on their dogma.

We shall see on Thursday.

 

Keep it Real

You may have heard that the NASDAQ stock market index hit a new all-time high yesterday. The index set new records for both the intraday mark and the closing value. For many, this conjures up images of the NASDAQ "bubble" of the late 1990s. Don't be afraid dear reader. Nominal thinking can be quite misleading. If you fear the new highs, perhaps the below chart will calm you down. It plots the NASDAQ in real terms (i.e. priced in ounces of gold) since inception. Nothing to see here. 

 

real.nasdaq



On Trend

I have no meaningful opinion on how the stock market will perform in the near future. However, I'm not convinced the market is significantly out of norm on the high side. As the chart below shows, the S&P500 is currently right on it's long-term trend (log scale of SP500 index, scaled to begin at 1.0 on 1/3/1950, +/- one standard deviation)

Emerging Markets Investing

I generally endorse indexing, but there are some obvious problems. It matters how the index is constructed. Here's an example. The financial indexers have grouped several large, unrelated financial markets together and called them "Emerging Markets". Take a look at the last two years. The four major countries, Brazil (EWZ), Russia (RSX), India (PIN), and China (FXI) have very dispersed returns. The index (EEM) is simply the muddle average of these four. (Click for a more dispersed image). Note, other EM index funds are similar to EEM, in this aspect. The issue is that the four major markets are very diverse, and they respond to different macro-economic factors.