Tuesday, May 25, 2010

The Importance of the Macro-Political Landscape and How David Einhorn Used It to Predict 2010

Submitted by Qasim Khan

Perhaps one of the most overlooked phenomena in this world is the relationship between cause and effect. Financial markets and economics in general are often noteworthy exhibitions of a lack of recognition of this principle. In just a few minutes watching CNBC, you are bombarded with statistics that PROVE our miraculous economic recovery. The macro data has become better; anyone who denies that is disconnected from reality. However, as the markets have vehemently demonstrated recently, the fact is that these numbers have become increasingly irrelevant. Why you ask? Because we don’t live in a society where these numbers represent organic, secular conditions anymore; instead, they reflect the increasingly contradictory and escalating political tension of the world.

Importance of Geo-Politics

While CNBC talks about things like CPI, PMI, and Cramer’s PMS instead of bigger picture geo-political developments, their importance cannot be understated. And while many traders and investors do not heavily account for such macro elements (evidenced by the fact that the global economy could be brought to its knees by a largely unforeseen housing bubble), David Einhorn, whom I have had the fortune of meeting, perfectly explains the importance of this in a speech to the Value Investing Conference in October 2009. Einhorn, known for his bottom up investment style, found a greater appreciation for the importance of macro developments after the recent financial crisis. In the speech he offers several extremely poignant predictions based upon this macro-political perspective, almost completely vindicated by the events in 2010. He said:

At the May 2005 Ira Sohn Investment Research Conference in New York, I recommended MDC Holdings, a homebuilder, at $67 per share. Two months later MDC reached $89 a share, a nice quick return if you timed your sale perfectly. Then the stock collapsed with the rest of the sector. Some of my MDC analysis was correct: it was less risky than its peers and would hold-up better in a down cycle because it had less leverage and held less land. But this just meant that almost half a decade later, anyone who listened to me would have lost about forty percent of his investment, instead of the seventy percent that the homebuilding sector lost.

I want to revisit this because the loss was not bad luck; it was bad analysis. I down played the importance of what was then an ongoing housing bubble. On the very same day, at the very same conference, a more experienced and wiser investor, Stanley Druckenmiller, explained in gory detail the big picture problem the country faced from a growing housing bubble fueled by a growing debt bubble. At the time, I wondered whether even if he were correct, would it be possible to convert such big picture macro thinking into successful portfolio management? I thought this was particularly tricky since getting both the timing of big macro changes as well as the market’s recognition of them correct has proven at best a difficult proposition. Smart investors had been complaining about the housing bubble since at least 2001. I ignored Stan, rationalizing that even if he were right, there was no way to know when he would be right. This was an expensive error.

The lesson that I have learned is that it isn’t reasonable to be agnostic about the big picture. For years I had believed that I didn’t need to take a view on the market or the economy because I considered myself to be a “bottom up” investor. Having my eyes open to the big picture doesn’t mean abandoning stock picking, but it does mean managing the long- short exposure ratio more actively, worrying about what may be brewing in certain industries, and when appropriate, buying some just-in-case insurance for foreseeable macro risks even if they are hard to time.


This ideological change has become apparent in the market more generally as well. CNBC can toot all the numbers and expectations they want, the truth is economic data has taken a back seat to political circumstances in the new market.

To understand the causal dynamics of the current recovery it is necessary to ask “how” and “why” instead of asking the much trumpeted CNBC question of “what”. From this perspective it becomes clear that the “recovery” that we have experienced draws heavily on exceptionally generous intervention. The government response was in all likelihood necessary and has resulted in improved economic data; however, it seems that the stimulus improved the (certain) numbers simply for the sake of improving (certain) numbers. As this has become increasingly apparent, there has been a paradigm shift where political conditions and events increasingly overwhelm economic data and appear to continue to do so for the foreseeable future.

Perhaps the most pressing question is: “How much longer can sovereign governments afford to provide extremely loose conditions and subsidize private sector debt?” So how early is too early to remove stimulus? Einhorn wisely prophesied that government response to the financial crisis would make previously economic issues become subject to politics:

Imagine, in our modern market, where we now get economic data on practically a daily basis, living through three years of favorable economic reports and deciding that it would be “premature” to withdraw the stimulus.

An alternative lesson from the double dip the economy took in 1938 is that the GDP created by massive fiscal stimulus is artificial. So whenever it is eventually removed, there will be significant economic fall out. Our choice may be either to maintain large annual deficits until our creditors refuse to finance them or tolerate another leg down in our economy by accepting some measure of fiscal discipline.

This brings me to our present fiscal situation and the current investment puzzle.

Over the next decade the welfare states will come to face severe demographic problems. Baby Boomers have driven the U.S. economy since they were born. It is no coincidence that we experienced an economic boom between 1980 and 2000, as the Boomers reached their peak productive years. The Boomers are now reaching retirement. The Social

Security and Medicare commitments to them are astronomical.

When the government calculates its debt and deficit it does so on a cash basis. This means that deficit accounting does not take into account the cost of future promises until the money goes out the door. According to shadowstats.com, if the federal government counted the cost of its future promises, the 2008 deficit was over $5 trillion and total obligations are over $60 trillion. And that was before the crisis.

Over the last couple of years we have adopted a policy of private profits and socialized risks. We are transferring many private obligations onto the national ledger. Although our leaders ought to make some serious choices, they appear too trapped in short-termism and special interests to make them. Taking no action is an action.

In the nearer-term the deficit on a cash basis is about $1.6 trillion or 11% of GDP.

President Obama forecasts $1.4 trillion next year, and with an optimistic economic outlook, $9 trillion over the next decade. The American Enterprise Institute for Public Policy Research recently published a study that indicated that “by all relevant debt indicators, the U.S. fiscal scenario will soon approximate the economic scenario for countries on the verge of a sovereign debt default.”

As we sit here today, the Federal Reserve is propping up the bond market, buying long-dated assets with printed money. It cannot turn around and sell what it has just bought.

There is a basic rule of liquidity. It isn’t the same for everyone. If you own 10,000 shares of Greenlight Re, you have a liquid investment. However, if I own 5 million shares it is not liquid to me, because of both the size of the position and the signal my selling would send to the market. For this reason, the Fed cannot sell its Treasuries or Agencies without destroying the market. This means that it will be challenged to shrink the monetary base if inflation actually turns up.

Further, the Federal Open Market Committee members may not recognize inflation when they see it, as looking at inflation solely through the prices of goods and services, while ignoring asset inflation, can lead to a repeat of the last policy error of holding rates too low for too long.

At the same time, the Treasury has dramatically shortened the duration of the government debt. As a result, higher rates become a fiscal issue, not just a monetary one. The Fed could reach the point where it perceives doing whatever it takes requires it to become the buyer of Treasuries of first and last resort.


The unsustainable nature of the interventionist mandate is becoming increasingly apparent, evidenced by the explosion of sovereign debt concerns this year. This crisis has resulted in a reexamination of the importance of fiscal discipline and introduction of austerity plans in Europe. While the US states do not face the same difficulties as their European counterparts, their problems may be just as difficult to overcome.

This past week, the great city of Central Falls, Rhode Island was placed in receivership, which comes as a tremendous surprise because the city website’s slogan led me to believe that Central Falls was “A City with a Bright Future.” It’s funny that their website failed to mention that its public school system was universally accepted to be well below satisfactory standards; so poor in fact that in February the Board of Trustees voted to fire the ENTIRE teaching and administrative staff of the school system. As misplaced or harsh as this measure may have been (clearly such systemic problems have more than one causal source), being labeled as “persistently lowest-performing” and having a 48% graduation rate is simply unacceptable. It is not surprising to find this result was an product of monetary union conflict. The articles points out:

Duncan is requiring states, for the first time, to identify their lowest 5 percent of schools — those that have chronically poor performance and low graduation rates — and fix them using one of four methods: school closure; takeover by a charter or school-management organization; transformation which requires a longer school day, among other changes; and “turnaround” which requires the entire teaching staff be fired and no more than 50 percent rehired in the fall.

Gallo and the teachers initially agreed they wanted the transformation model, which would protect the teachers’ jobs.

But talks broke down when the two sides could not agree on what transformation entailed.

Gallo wanted teachers to agree to a set of six conditions she said were crucial to improving the school. Teachers would have to spend more time with students in and out of the classroom and commit to training sessions after school with other teachers.

But Gallo said she could pay teachers for only some of the extra duties. Union leaders said they wanted teachers to be paid for more of the additional work and at a higher pay rate — $90 per hour rather than the $30 per hour offered by Gallo.

After negotiations broke down, Gallo said she no longer had confidence the high school could be transformed and instead recommended the turnaround model. Gist approved Gallo’s proposal Tuesday morning and gave the district 120 days to develop a detailed plan.

So let’s get this straight: the students were performing so poorly that in order demand more commitment from teachers, they should be paid an even greater amount? It’s no wonder why the school system would be so fundamentally unproductive. While I don’t believe a teacher would purposely sabotage their students, the breakdown of talks demonstrates that the teachers were not committed to the job they should already be doing. Talk about moral hazard. But it turns out that the problem of paying its current teachers was minor in comparison to the true problem of paying retired teachers, as this article points out:

“The pension plan is nearly broke,’’ said Joseph Larisa, a lawyer who argued in court yesterday for the receivership. “It’s really reached a breaking point where the budget cannot be balanced, whoever is in charge.’’

And if you believe that Central Falls is the only municipality struggling with its pension commitments, you might find this NYT piece quite enlightening. While Central Falls may be insignificant in the larger scheme of things, make no mistake, austerity measures will take place within the US and they will result serious consequences.

Geo-political Tension

And while the fiscal difficulties of the public sector are the flavor of the day, potentially much more dangerous geo-political tensions are developing throughout the world.

While posting a trade deficit in March has calmed the domestic calls for the appreciation of the Yuan, I doubt anyone would characterize the US-Chinese dynamic as warm. The Google censorship conflict presents an altogether different political challenge and I’m sure Hilary Clinton’s remarks today calling for China to increase corporate freedom and transparency failed to improve relations. Slowly but surely, we are seeing China capitalize on its economic power to gain political power, something that the US has largely had a monopoly upon the previous century or so.

While Thailand has seen its share of troubles, the conflict between the Koreas dominates the Asian soft-power political landscape. North Korea just happened to torpedo and sink a South Korean naval ship, killing 46 sailors. SoKo, understandably, wanted to make a strong statement of retaliation, but then remembered North Korea is nuclear and it isn’t. So they’re taking their case to the almighty UN Security Council, where they are left at the whims of regional giant and their biggest trading partner, China, which has yet to state a formal policy on the sinking of the ship. Can’t piss off China, can’t piss of North Korea… something will have to give eventually.

Speaking of nuclear issues, Iran continues to pose the biggest threat to the global economy and it does not appear likely to improve any time soon. Not only did the US fail to secure the release of three jailed American journalists in Iran despite having released two Iranian citizens held by US forces in Iraq and their mothers visiting them in Iran, it appears that it is losing credibility in the nuclear development conflict as well, evidenced by a recent interview with President Ahmedinejad on Al Jazeera:

In an exclusive interview conducted by the Al Jazeera network on Friday, Ahmadinejad stated that no country has the power to confront Iran, and added that Tehran advocates diplomacy as the ideal way to deal with international issues, the Fars news agency reported.

Ahmadinejad said Iran does not even take Israel into account and noted that Tel Aviv is not able to wage a war against the Islamic Republic.

On the deteriorating relations between Tehran and the West, Ahmadinejad said Western countries don’t have problems only with Iran but actually have problems with every country.

While the last quote is surprisingly insightful, once again Ahmedinejad leaves observers miffed. Don’t have the power? Apparently he missed the massive naval buildup in the Persian Gulf that the US has begun

Our military sources have learned that the USS Truman is just the first element of the new buildup of US resources around Iran. It will take place over the next three months, reaching peak level in late July and early August. By then, the Pentagon plans to have at least 4 or 5 US aircraft carriers visible from Iranian shores.

This situation is quite literally a perfect storm combining a lunatic head of state, nuclear weapons, oil and of course Israel. Particularly with respect to crude, who knows how long Obama can stick to his pro-drilling position as the oil spill has gone on for so long now that everyone seems to have either forgotten about the issue or submitted their best idea to BP. Just today, Iran threatened to abandon shipping some of its nuclear stockpile abroad as was planned if the US pursued increased sanctions against it; it will be interesting to see just how far the Obama administration is willing to press Iran on its nuclear aims.

The Moral Bankruptcy of Hamid Karzai

Oh and did we forget to mention the US is still conducting military operations in Iraq and Afghanistan? The economic costs of which, pointed out here perhaps somewhat satirically by Congressman Alan Greyson, are completely ignored. The situation in Afghanistan is particularly perplexing, epitomized by the enigma that is Hamid Karzai.

Here is a situation where we have a president who is quite literally telling us he supports the American effort while speaking English and the Taliban when speaking Pushto. No that’s not an exaggeration. He literally threatened to join the Taliban.

This is the same president who needed to commit severe election fraud to prevent a runoff election with a man named Abdullah Abdullah (if you’re not supposed to trust a man with two first names, how in the hell do you even consider trusting a man with two first names that just happen to be the same?). The same president who had one-third of his votes thrown out by a UN-backed fraud commission. The same president who then tried to take over the investigation commission that was supposed to look into fraud in last August’s election and then accused the UN of rigging the election, despite the fact that it was the UN who backed the investigation that revealed the massive fraud. The same president whose brother just shut down the regional council in Kandahar while he is being investigated for illegally appropriating government land. Oh and by the way, our success in the operation absolutely depends entirely upon securing Kandahar, the Washington Post points out. While Will Smith doesn’t believe in backup plans, I don’t think this is exactly what he envisioned.

Of course, not all of these tensions will escalate to have significant economic ramifications, but they just serve to show there is no lack of exogenous catalysts posing a threat to an increasingly global economy.

Politics and Gold

Perhaps the most politically contentious investment currently is gold. Gold, the asset that has no yield and no obvious pragmatic purpose has breached all time highs; and with such success inevitably comes much abuse, confusion and controversy. As seen by the recent Goldline-Glenn Beck- Anthony Weiner situation, the value of gold is primarily driven by political expectations. With the rise of the Tea Party movement producing legitimate candidate threats (although Rand Paul may have shot himself in the foot) gold will only continue to become more contentious. Once again, Einhorn shrewdly foretold:

I have seen many people debate whether gold is a bet on inflation or deflation. As I see it, it is neither. Gold does well when monetary and fiscal policies are poor and does poorly when they appear sensible. Gold did very well during the Great Depression when

FDR debased the currency. It did well again in the money printing 1970s, but collapsed in response to Paul Volcker’s austerity. It ultimately made a bottom around 2001 when the excitement about our future budget surpluses peaked.

Prospectively, gold should do fine unless our leaders implement much greater fiscal and monetary restraint than appears likely. Of course, gold should do very well if there is a sovereign debt default or currency crisis.

A few weeks ago, the Office of Inspector General called out the Treasury Department for misrepresenting the position of the banks last fall. The Treasury’s response was an unapologetic expression that amounted to saying that at that point “doing whatever it takes” meant pulling a Colonel Jessup: “YOU CAN’T HANDLE THE TRUTH!” At least we know what we are dealing with.

When I watch Chairman Bernanke, Secretary Geithner and Mr. Summers on TV, read speeches written by the Fed Governors, observe the “stimulus” black hole, and think about our short-termism and lack of fiscal discipline and political will, my instinct is to want to short the dollar. But then I look at the other major currencies. The Euro, the Yen, and the British Pound might be worse. So, I conclude that picking one these currencies is like choosing my favorite dental procedure. And especially now, where both earn no yield.

I believe there is a real possibility that the collapse of any of the major currencies could have a similar domino effect on re-assessing the credit risk of the other fiat currencies run by countries with structural deficits and large, unfunded commitments to aging populations.

I believe that the conventional view that government bonds should be “risk free” and tied to nominal GDP is at risk of changing. Periodically, high quality corporate bonds have traded at lower yields than sovereign debt. That could happen again. [editor's note: a possibility mentioned on ShadowCap on multiple occasions]


The final piece of the political-financial landscape is regulation, a topic that has seen dramatic developments recently in the US. Here, perhaps more so than anywhere else, the global economy is purely subject to the flighty whims of politics. As such, regulation, while theoretically desirable, may pose the greatest threat of all because it never seems to deliver on its intended aims. Einhorn:

Rather than deal with these simple problems with simple, obvious solutions, the official reform plans are complicated, convoluted and designed to only have the veneer of reform while mostly serving the special interests. The complications serve to reduce transparency, preventing the public at large from really seeing the overwhelming influence of the banks in shaping the new regulation.

In dealing with the continued weak economy, our leaders are so determined not to repeat the perceived mistakes of the 1930s that they are risking policies with possibly far worse consequences designed by the same people at the Fed who ran policy with the short- term view that asset bubbles don’t matter because the fallout can be managed after they pop.

That view created a disaster that required unprecedented intervention for which our leaders congratulated themselves for doing whatever it took to solve. With a sense of mission accomplished, the G-20 proclaimed “it worked.”

And that is the message that the Administration is trying to send with the new financial reform bill that passed the Senate: Mission Accomplished. And that is how you end up with a new “consumer protection” agency, when we already have a obfuscated system of overlapping and redundant institutions.

Anyone who objectively observes the incentives of the current political establishment objectively is forced to admit that what regulation produces more so than anything else is more regulation. So while the SEC is busy surfing the web desperate waiting for the new Kendra sex tape, we have a new institution to place the blame upon when the next crisis inevitably occurs.

Financial reform was clearly passed now so the administration can claim a win for upcoming mid-term elections, however it is beyond all hilarity that the “reform” completely leaves the issues with GSEs and rating agencies unaddressed. Bill Gross has recently been on a campaign against rating agencies. Once again, Einhorn points out:

And, of course, these structural risks are exacerbated by the continued presence of credit rating agencies that inspire false confidence with potentially catastrophic results by over-rating the sovereign debt of the largest countries. There is no reason to believe that the rating agencies will do a better job on sovereign risk than they have done on corporate or structured finance risks.

My firm recently met with a Moody’s sovereign risk team covering twenty countries in Asia and the Middle East. They have only four professionals covering the entire region. Moody’s does not have a long-term quantitative model that incorporates changes in the population, incomes, expected tax rates, and so forth. They use a short-term outlook – only 12-18 months – to analyze data to assess countries’ abilities to finance themselves. Moody’s makes five-year medium-term qualitative assessments for each country, but does not appear to do any long-term quantitative or critical work.

Their main role, again, appears to be to tell everyone that things are fine, until a real crisis emerges at which point they will pile-on credit downgrades at the least opportune moment, making a difficult situation even more difficult for the authorities to manage.

Hm… we haven’t seen this exact problem in the Eurzone now have we? Globally we are seeing the effects of increased regulation, as Chinese tightening has set off a wave of fear in the region and a recently proposed mining tax on the heavily commodity based economy in Australia helped send the AUD plunging this past week. In the US, financial reform has spilled into the electoral arena, complicating an already far too convoluted project.

Take for example the new derivative amendment proposed by Arkansas Senator Blanche Lincoln, which almost no one takes seriously. Hell, even Paul Volcker opposes the amendment. Yet surprise, surprise with an upcoming election it was created for political gain and has remained because of political risk. A recent Bloomberg piece points out:

Regulators “have come out in a really unusual way and said, and I’m paraphrasing here, that this is a really, really stupid idea,” Senator Judd Gregg, a New Hampshire Republican, said in a recent floor speech. “Where this idea came from is hard to fathom because on the face it makes absolutely no sense. Yet for some reason it has found its way into this bill.”

Regardless of the outcome, Lincoln has reaped political gain. In a fundraising letter sent April 16, she said she was “proposing sweeping legislation that would drastically change the way Wall Street does business.”

On May 4, her campaign began airing a radio advertisement featuring President Barack Obama. “Blanche is leading the fight to hold Wall Street accountable and make sure that Arkansas taxpayers are never again asked to bail out Wall Street bankers,” Obama said.

And this is why all I can do is laugh when I see politicians crucifying Goldman for having conflicts of interest. Because if anyone has a conflict of interests, it is politicians. The recent actions of Blanche Lincoln and Arlen Spector demonstrate just how repulsive politics is ethically. Arlen Spector quite literally admitted his only reason for changing parties was to save his job, so it’s not really a wonder that he couldn’t secure the primary bid.

But such actions are the rule, rather than the exception. Every time I turn on the news to see a headline that reads something like BREAKING NEWS: State Attorney General Cuomo Declares Gubernatorial Candidacy, I am reminded at how seriously flawed the political environment currently is and its dominating influence over financial markets. For example, any reasonably intelligent human being could surmise that Cuomo already did this when he started conducting criminal investigations into Wall St practices that will undoubtedly result in absolutely nothing of substance.

So while I agree the Fed opacity presents a concern, I would be far more concerned if it had to report to the GAO or any other Congressional body because while Bernanke is certainly guilty of hubris, many Congressman are guilty of the far worse crime of absolute idiocy. Checks and balances are extremely important in theory, however, they can be equally unproductive if involved parties are incompetent.

However, that’s exactly where we are today; financial markets are a game of politics right now. It’s nice to see the unemployment rate tick up one-tenth of one percent or manufacturers gaining confidence, however when you understand the causal sources of these changes, they truly become much less important. When the Fed has a balance sheet of over $2T, Fannie and Freddie are still backing every mortgage in sight, and ZIRP is fueling banking profits (while will continue for a significant amount of time), it is no wonder. This trend looks like it will continue as well.

Everyone knows that such a path is unsustainable (although the United States enjoys a clear advantage in maintaining such conditions because of disastrous game theory political implications). Make no mistake, the intervention has had tremendous effects; however, the effects are not done and there will be a day of reckoning.

(from ShadowCapitalism, May 24, 2010)

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