How inept can a ruler be?

No, I'm not thinking of George W. Bush right now. Guess which long-standing national leader uttered this infamous phrase recently:

"Where money for projects has not been found, we will print it," xxx was quoted as saying.

The answer is: Robert Mugabe of Zimbabwe. Not surprisingly, inflation in that country, currently over 4,500% a year, is going to infinity and beyond. If I were a betting man, I'd wager Mugabe's regime will collapse in less than a year.

If you're interested in why Zimbabwe technically got into this mess, check out this paper.

Economic tortoise, financial hare

Other than in soccer, Latin America has (mostly) lagged behind (east) Asia in nearly all indicators, specially in terms of economic growth. But, as BCA Research recently noted, Latin American stocks have outperformed their Asian peers by a wide margin over the last 20 years. Capital Spectator looks at some explanations, but finds no clear answer.

Actually, there's a pretty simple explanation.

In the 1980's, Latin America was stuck in a huge economic and financial crisis after many nations defaulted on their foreign debt and commodity prices plunged. At the same time, the Asian Tigers were roaring along quite nicely. Hence, Latin American stocks at that time had very high risk premiums incorporated into their valuations. Those risk premiums have fallen dramatically as LA has put its finances in order during this time frame. Thus, starting from a lower base, the region's stocks have outperformed.

One could aslo add that the LA sector is dominated by a few fantastically profitable monopolies/oligopolies and that Asian markets were and are much more liquid, so that a falling liquidity premium might be helping LA stocks.

Contagion in the credit markets?

The markets were once again singin' the ol' sup-prime mortgage blues today. However, I believe that fears of a meltdown in the credit markets are way overblown. For one, corporate balance sheets are pretty healthy after years of record-high profits and modest leverage. In fact, spreads between BAA corporates and Treasuries have stayed pretty stable (however, I don't have data for the past couple of days).



The real problem lies with consumers and certain financial firms, where leverage has grown strongly, as this graph shows.



Outside the financial sector, my one big worry is what impact falling home prices will have on consumers. So far, American consumers have, as always, withstood the storm. But for how long? Only time will tell, but in the meantime I'd avoid stocks exposed to U.S. consumer demand.

A bubble in emerging market stocks?

This graph says yes. It compares the evolution of the Nasdaq Composite between June 1994 and June 1999 and the MSCI Emerging Markets index between June 2002 and June 2007.




We know how the Nasdaq story played out after a few more months of spectacular rises. But appearances can deceive. The main difference between these two? The Nasdaq's P/E was well north of 100x at its peak, while the P/E for emerging markets as a whole is around 15x today.

Of course, this doesn't guarantee that emerging market stocks are a good investment opportunity today, but at least they're not obviously overvalued.

The red economy and the red metal

No one doubts that China's dramatic growth spurt over the past 4 years has been the driving force that has pushed commodity prices higher. Even though the Chinese economy is still going at full blast (industrial output is growing 16% yoy), past experience has taught us that there are limits to how much commodity prices can go up.

For one, with higher prices there are more incentives to ramp up production. In addition, price increases blunt demand, as buyers turn to cheaper alternatives (for example, according to INCO, the nickel content of stainless steel has fallen in response to higher prices for this metal).

The market for copper offers a great example of how these forces work, sometimes in a very odd fashion.

While Chinese copper demand has remained robust, in the industrialized nations it has plunged this year due to high prices, leading to an overall drop in world consumption of 1.4%, according to this forecast. According to the IMF, copper prices rose 43% last year and 38% in 2003.

Yet, despite the fact that refined supply is forecast to grow 3.1% this year, prices have risen an additional 36% (up to November).

What gives? Well, in 2003 and 2004 demand --driven by China and other emerging economies--far outstripped supply, depleting existing stocks. With latent demand very strong, the market has needed dramatic price hikes to partially close the demand-supply gap.

Obviously, it's hard to ramp up the production of minerals in the short run. But eventually market incentives lead to the expected response: in 2006, the ICSG forecasts that supply will rise 8%, surpassing demand for the first time in 3 years (although prices will likely stay high while inventories are built back up)

Moving on to football

Don't miss this article by Michael Lewis on how a coach of a minor Texas university is turning football (or American ovoid handball, as a tetchy friend would have it)strategy on its head. Basically, it involves a pass-heavy approach that seeks to stretch the field as much as possible, both horizontally and vertically.

This is definately the wave of the future. Besides the violence, what I really lack about football is that it has a much larger strategic component compared to other sports. Alas, the sad fact is that most NFL coaches stick to very conventional/conservative playcalling, wasting the potential to achieve victory through greater creativity and flexibility (with some partial exceptions, such as the Patriots, Eagles and, until recently, the Rams).

This is not precisely a new idea. Bob Oates, who writes for the LA Times, has consistently favored this approach.

By the way, if you like football, go visit Football Outsiders if you haven't done so already. Aaron Schatz and his crew are doing a great job by applying statistical modelling to evaluate performance on the gridiron. It simply is a must read, although I do hope that in the future they'll also include --to the extent possible--on the impact of stategy.

The manufacturing rat race

Last week, Brad DeLong speculated that one of the reasons that U.S. auto manufacturers faced such daunting legacy costs was that the wages and benefits paid to their employees reflected the expectation of maintaining oligopolistic profits.

I don't know that much about the auto industry, but I reckon that if those profits existed, they couldn't have lasted much beyond the 1970's.

But, in any case, the auto industry does illustrate the degree to which even a relatively sheltered industry (in terms of barriers to entry) is a rat race.

Taking some BLS data, I found that new cars today cost around 60% less in inflation and quality adjusted terms than they did in 1953 (the first year with data). This number is in line with the trend observed for durable goods as a whole.

This basically means that you face constant pressure to become more efficient or develop some type of competitive advantage to protect your pricing (such as better design or some other form of strong intellectual property). Obviously, U.S. car producers haven't kept up, at least with their Japanese counterparts, event though they've surely made huge gains in productivity over the last few decades.

Foreign policy amnesia

Why does the U.S. never learn from its foreign policy mistakes? I can't find a good answer. But to my horror they just keep coming. As if the Irak debacle weren't enough, the idea of treating Mexicans as the Israelis treat the Palestinians is gaining ground.

Let's start with President Bush's big speech this week, in which he laid out (again) his plan to deal with the large flow of illegal immigrants to the U.S.

The President's proposal --a hybrid guest-worker programme that includes the possibility of obtaining citizenship, but also contemplates measures to crack down on illegal immigration---sounds fairly sensible. Nonetheless, it is, as expected, very flawed and it faces substantial opposition from his own party. As a result, it's fairly likely that something far worse than the President's proposal will be enacted.

Why is it flawed? Simple. It assumes that the U.S. can --by itself--fully regulate the flow of immigrants.

Bush's plan aims to admit "enough" workers to satisfy the needs of its farmers and firms while keeping out all others who wish to come by cracking down on the employment of illegals and stepping up security on the Mexico-U.S. border.

Let's start with Economics 101. There is a huge, huge number of people willing to come and work in the U.S. There is no way the U.S. will allow all of them to come, even if there are enough jobs available. In other workds, supply will always exceed (artificially regulated) demand. Hence, the proposal's mechanisms to limit supply.

Will they work? Not likely. As the President himself admits, the greatly increased spending on border security has not made a dent on the flow of immigrants. There is no reason to believe that further spending, short of building a 2,000 mile Israeli-style wall on the border and massive deportations.

Such a wall would, undoubtedly, reduce the flow (but not stop it, by far). But just think for a second about the symbolism (let alone the expense). It would mean that the U.S. is turning its back --literally--on Mexico and the rest of Latin America. (Am I exaggerating? Just read what the people who want to build such a wall say).

Let that sink in. In a world where the U.S. has few friends, it will work to alienate (even more) a region to which it already has significant cultural, economic and ethnic ties.

Is there a better way? Yes. Actually, a very simple way: be more generous. The U.S. provides its "friends" in the Middle East (Egypt, Israel, Jordan) more foreign aid in one day than it has ever given to Mexico. Why not propose a bold development partnership to Mexico and Central America? Sure, it would cost money, but probably no more than the cost of fences and the like. It would engender goodwill and reduce immmigration in the long-run. And it would give the U.S. a lever to push for reforms in Mexico.

A guest-worker programme should be established, but it will only be a net positive if it is realistic (for example, it actually deals with issues such as the workers' families). And, yes, the U.S. whould have more control in areas such as employment.

Sadly, there is little or no chance of something like this happening. Bush never even mentioned talking to Mexico in his speech and the fence-builders don't give a damn about anything south of the border. The only hope I have is that the American people at least seem to recoil at some of the nastier policy options in this area.

Legacy costs

By now, we all know that most nations face a nasty pension crisis in the not so distant future. For some corporations, like GM, that future is now. Yet, it is hard to find creative and serious policy debates on how to tackle this huge problem.

Sure, many people have put forward what can only be called the "Scrooge" alternative: longer working lives and/or lower benefits. These may (specially the former) have some merit, but they do seem rather unfair, notably to older workers.

In the case of firms facing bankruptcy, the solution (at least in the U.S.) has been fobbing off pension liabilities to the government's Pension Benefit Guarranty Corp., which takes over the pension plan (but has no claim on the sponsoring firm's assets). For many firms --take Delphi as a good example--the ability to ditch pension liabilities is very attractive. Unless the system is reformed, this trend threatens to snowball massively (the government already projects that the PBGC's deficit at over 100 billion dollars).

I want to make it clear that many firms have to go under and eliminate liabilities such as these to survive. After all, large pension deficits increase borrowing costs and restrict borrowing facilities, besides making labor relations very tense.

For this reason, I'm very pleased that Dick Berner of Morgan Stanley has put forward a serious proposal to deal with this problem. It basically involves having the PBGC fund the outstanding net pension liabilities in exchange for having the firm cover this cost (with interest) over a certain period of time. It would also give the PBGC priority over other creditors and force firms to fully fund new pension/retirement promises.

I like this idea, which (as noted by the author) has parallels in the S&L bailout and, to a degree, on the Brady-bond restructuring of Third World debt. While these plans involve upfront costs for society--no getting around that--they work quite well in the long-run.

However, I do believe it doesn't go far enough. For one, it doesn't address a very big issue: firms with large pension liabilities are often badly managed and also need to reduce current labor costs. This calls for greater involvement of workers in corporate governance, as Brad De Long has pointed out, perhaps through equity-for-concesions swaps. This sounds fairly obvious, but they don't seem to have worked well in the airline industry (I don't know the details too well).

What the hell are the markets thinking?

After months of denial, yesterday I finally accepted a very basic point: I can’t explain anything anymore.

To do my job, I need to develop a good idea of global economics and politics and how they translate into asset prices in order to develop successful investment strategies. But right now I see a breakdown between “objective” reality and its reflection in the Matrix-like world of financial markets.

This may sound extreme, but bear with me. At first glance, things are not going badly. The world economy is growing at a very good rate and it has proved very resilient to the recent shock in energy and commodity prices. As a result, stock markets the world over are doing great and long-term interest rates are still at or near the lowest levels in decades.

Yet, the political superstructure on which economic prosperity depends is crumbling.

The United States is, for all practical purposes, does not have a functional government. I say this with amazement, dismay and consternation. George Bush has lost even the limited grasp of reality he had and has no idea how to correct his past mistakes, which are rapidly eroding his authority, let alone set a coherent policy agenda. The less we can say about his second in command, the better. And let’s not forget that his party is in disarray, while the opposition does not have the standing, intelligence or leadership to defend the nation’s vital interests.

And we have three more years of this to look forward to.

Looking abroad, things are not much better. Western Europe’s heads of state are discredited (Chirac, Berlusconi and now, to some extent, Blair) or inexperienced (i.e. Merkel). Japan’s Koizumi seems like a strong leader, but he leads a timid nation. Russia is ruled by a thug and China has still not developed a strong, effective voice in international affairs.

In addition, many of the world’s leading multilateral organizations, such as the U.N., the World Bank and the WTO, seem paralyzed or ineffectual.

Basically, this implies that if a crisis that requires effective coordination arises, we probably won’t get it, with predictably negative consequences.

Yet, the bond market isn’t worried one bit: risk spreads are actually below the average of the past 15 years (the BAA/10 yr-Treasury stands at 184 basis points, vs. an average of 208 basis points). Stocks are rising and emerging market assets are once again in full bloom.

Even if the probability of a nasty, unforeseen crisis is very low, the damage would be severe given the above conditions. My impression is that asset prices are not pricing this in.

Why? I have no idea.

Oh, and have I mentioned that GM is about to go bankrupt? Even though this firm is a shadow of its former self, it is still huge by any measure except market value. When a CEO writes to all employees to categorically state that the firm won’t go bankrupt, a Chapter 11 filing is a sure thing (unless the aforementioned CEO is quickly fired and replaced by someone who can act correctly and decisively).