“The union of these States is perpetual. No state, upon its own mere motion, can get out of the union. The central idea of secession is the essence of anarchy.” So said Abraham Lincoln in March of 1861. On the other hand: “to exercise self determination through secession is to blow apart the union, to pit people against one another and to sow discord, bloodshed and death”. That was Mikhail Gorbachev in March of 1990. Same idea but looked at from different vantage points and very different political goals.

Withdrawing from a union has proven difficult in the past. The U.S. Constitution of 1787 did not envisage a separation and the southern states’ perceived right to secede led eventually to the the American Civil War, over 600,000 deaths and ruin for the four year Confederacy.

There have been attempts to unify Europe in the past, none of which endured: the Pax Romana, the empires of Charlemagne, Napoleon and Hitler. They were all attempted “vi et armis”, by force of arms, and the subjugated nations could not wait to break free and throw off the tyrant’s yoke. It is a curious fact that the countries of the old Soviet Union yearned to get rid of the hated oppressor and exist on their own, while the old democracies of the west could not wait to band together in an economic and political union to avoid future conflicts. How that was to be done was the key but all agreed that the rules put in place were to be comprehensive and durable.

The 1957 Treaty of Rome laid the groundwork and it eventually led to the more detailed Maastricht Treaty of 1992. But in the euphoria to join together voluntarily, no thought was given to what a member would do if it actually ever wanted to leave the union. There was no Plan B, no escape clause, because it was unthinkable that anyone would want to leave and no scenario was envisioned where that would even be possible or probable.

Not every country that is a member of the EU accepts the euro and not every country that accepts the euro is a member of the EU. Those who originally opted out of the euro but remained within the EU include Great Britain, which refused to give up the pound, and Sweden. Norway, alone of the Scandinavian nations, joined neither but is closely associated with the EU through the European Economic Area. Switzerland, because of its professed neutrality, joined neither the EU nor the euro and is doing just fine.

Maastricht set the parameters for the European Union and the eventual unified currency, the euro. Because of the strictures of the Growth and Stability Pact – the 3% budget deficit to GDP ratio and 60% national debt to GDP ratio – many nations have found it impossible to adhere to the rules and punishment has been lax. The opportunity for lesser lights to borrow at undeserved low rates brought the chickens home to roost, to use that well worn phrase. Once in the euro and monetary policy is controlled by a supra-national body like the European Central Bank, you lose the ability to devalue your currency to get yourself out of trouble and the conditions levied upon you to borrow money to help are so onerous that the cure is worse than the disease, what can you do?

Well, the unthinkable has finally happened and central bankers are now talking openly about an exit from the euro as a solution to Greece’s problems. Could it leave the euro and re-introduce the drachma and still exist inside the European Union? Eventually maybe but not initially. From a purely practical point of view, new currency notes would have to be printed and new coins minted and it could take weeks if not months.

The EU’s founding fathers did nothing initially to address the possibility of voluntary exit, let alone a putting in a provision to expel a country which would involve treaty amendments. That could really be very messy. It would also be counter the spirit of unity and the driving force of union in the first place. So that is very unlikely to happen.

But there are movements in various member countries who would like to see their nations exit from the euro but as of this date, none of them has gained sufficient ground to be a threat. Voluntary exit only became a consideration 15 years after the intial 1992 treaty with the Lisbon Treaty of 2007 which came into force in December 2009. Section 50 of that pact states that if a country wanted to leave the euro, it would have to leave the EU and that could be done by simple notification to the European Council “in accordance with its own constitutional requirements”, the terms to be worked out later. Those terms could be quite complicated but the agreement would eventually have to be ratified by the European Parliament. Down the road, an economic association for Greece with the EU might again be possible and even desirable.

All the political parties in Greece, apart from the extreme left and extreme right, have said they want to remain in the EU and maintain the euro, though the austerity conditions mandated for awarding future funds to bail them out are the sticking point. They have to form a government first and that will probably mean new elections since they are at an impasse. Without a functioning government, the “troika” bankers, the EU, the ECB and the IMF, are unlikely to want to continue to channel funds to Greece and money will quickly dry up. So, if Greece did depart, the drachma would fall drastically and it would have a deleterious effect on its own GDP. Unemployment would climb, consumption would plummet, inflation would rise and savings would be wiped out. Other countries, like Argentina 10 years ago, have gone through such hardships and emerged the wiser at the end of it. The question is whether Greeks, looking into the abyss, want to experience that kind of pain after so much already.

If they do decide to break free, then it would set an uncomfortable precedent for the EU with other nations in difficulty. Greece may not exit for a while yet, but if they go, then others could follow suit and at a faster pace. The printing presses of those companies that produce banknotes for the world would have to start working overtime but at least it might help alleviate some unemployment.

Volume II, Number 19: Fundamental Monetary Reform Is Coming…(Part One) 

By John L. Chapman, Ph.D.      Washington, D.C. 

The monetary system is to the economy what circulating blood is to the body: the former enables the latter to function.  If the former is plagued with a virus, the latter will degrade and ultimately break down if the “disease” is not vitiated.  Some people in Washington understand this, and are trying to effect necessary change before it is too late.  Investors need to understand these are not mere parlor games anymore. 

Big-cap U.S. equities were down 1.7% last week, as nerves about even the blue-chips were frayed by the $2 billion hit to J.P. Morgan’s balance sheet via trading losses.  In the wake of this unsettling news that also took more than 9% out of JPM‘s equity value in one swoop, no less than the well-connected star of bond market investing, PIMCO’s Bill Gross, all but guaranteed a new round of quantitive easing later this year.  This, even though Mr. Gross readily admitted in the same discussion that this may not be a wise thing in the long run.

Mr. Gross may well be correct in his thinking, and indeed, the bond king is not shy about talking his book: PIMCO has invested heavily in mortgage-backed securities of late, holdings that would surely rise in the event of a “QE3.”  In the short run, we confess to not understanding the thinking at the Fed: the Producer Price Index (PPI) declined 0.2% in April, versus the consensus expectation of no change.  But producer prices are up 1.9% versus a year ago (the consumer price index [CPI] is announced Tuesday, but has lately been running at a +2.7% annual rate), and core intermediate producer goods prices (that feed final PPI) are accelerating at a +7.5% annual rate since the year’s beginning.  We think inflation is headed higher this year in any case, and therefore it can only mean a QE3, if it happens, is intended to prop up bank balance sheets.  Given this, rumors of more easing make sense: the J.P. Morgan loss that rattled investors around the world may be one more stake in the ground along the way toward another Bernanke-triggered QE round. After all, if JP Morgan can seemingly make such big errors in trading bets, the Fed Chairman may well reason, what of the majority in the banking sector who are less well-capitalized? And, the broader measures of the money supply that hold Mr. Bernanke’s attention, M2 and MZM, are both growing near their long run trends (see M2 here), and not inordinately:

Chart I. M2 Growth, 1980-Present, Log Scale

Indeed, while approaching a mind-boggling $10 trillion level, M2 has grown at less than 6% per annum since the end of the recession, not far above its historic growth rate.  And, given the plunge in M2 velocity to lower levels than have ever been recorded since the Fed began tracking this data series in 1958, Mr. Bernanke clearly believes it is a better than even money bet that another round of QE will do little to consumer prices in the United States.

In the short run, he may well be right, and a QE3 would likely provide some sort of temporary lift (and in our view, no more than that) to asset prices in the U.S. and, by extension, perhaps to Eurozone and other major bourses around the world.  But at what cost?  Monetary policy, reform, and money’s effect on the economy are increasingly in the news lately (e.g., Herman Cain advocates a return to the classical gold standard in the May 14 Wall Street Journal), and were in a major way on Capitol Hill this past week.  Congressman Ron Paul (R.-TX), the Chair of the House Financial Services Committee’s Subcommittee on Domestic Monetary Policy and Technology, held a hearing to examine the Fed’s statutory dual mandate (to promote price stability and maximal employment and growth), and broached long run reform as well.  Specifically, the panel looked at policy options in the face of a Fed balance sheet that has grown enormously in the last four years, per this graph of the adjusted monetary base:

Chart II. Federal Reserve’s Monetary Base, 1918-Present (Log Scale)

This graph is illustrative because it provides historical context to show just how far out of the ordinary recent Fed policy has been: the monetary base had been growing at a fairly steady pace since 1960 (about 6.5% per annum), right up into the spring of 2008.  In the last four years, however, the base exploded at a 34% annual pace, from $850 billion to $2.646 trillion last week (this, after a 3.9% drop from the all-time high of $2.753 trillion at the end of February).  Clearly, the Fed is operating in uncharted waters now, and it is hard to see how this can end well, based on prior histories of rapid base money creation around the world.

Congressman Paul’s subcommittee hearing addressed this circumstance, and was evenly balanced: defending the Fed’s recent actions and dual mandate were former Fed Vice Chair Alice Rivlin, now back at the Brookings Institution after her time on the Bowles-Simpson Commission, and University of Texas economist James K. (“Jamie”) Galbraith, the son of John Kenneth Galbraith and a former congressional staffer who helped draft the Humphrey-Hawkins dual-mandate legislation back in 1978.  Stanford University economist John Taylor, author of the famed “Taylor Rule” of monetary policy, was on the panel occupying a “middle ground”: he advocates a more focused and rules-bound Fed concentrating on price stability only, and asserts that the emphasis on employment and output growth can often be counterproductive, since stop-go monetary policy has historically been destabilizing and a cause of boom-bust cycles.

A harsher assessment of Fed performance was offered by the University of Missouri’s Peter Klein, and Grove City College economist Jeff Herbener, both of whom advocate the Fed’s abolition.  Messrs. Klein and Herbener would replace the Fed-centered commercial banking system with an industry in which financial firms issued their own notes, competitively, backed by a commodity that would likely be gold.  Their arguments are worth reviewing as a harbinger of what is in store, and we do so next week in this space.

No Good Options Now?      

The size of the Fed’s balance sheet was remarked upon by all five economists, all of whom agreed it had grown large enough for now.  Professor Galbraith and Dr. Rivlin are, however, like Chairman Bernanke himself not worried that it will be destabilizing or inflationary, while Messrs. Herbener, Klein, and Taylor are.  Clearly, if Mr. Bernanke fears weakness in the U.S. banking system — or the potential need for dollars in an imploding Eurozone — he is loath to shrink the balance sheet much now.

But even Dr. Rivlin is worried about the gargantuan size of Fed holdings and wants to see a paring back.  There are of course three tools on hand for the Fed to shrink the banking system’s level of free reserves when it decide to move, and in changing contexts that might materialize in the near future, all are worrisome for the three doubting subcommittee witnesses (Klein, Herbener, and Taylor): 

(1) Sell Assets to Pare Down the Balance Sheet.  The Fed could very directly shrink its balance sheet by selling assets out of its mortgage-backed and Treasury portfolios, reversing its heavy purchasing on the open market in the last few years during multiple rounds of quantitative easing.  But this will of course cause interest rates to jump.  While a negligible problem initially given today’s low interest rates across the yield curve, higher interest rates will of course hurt those real estate and financial firms (banks and other lenders) the QE policies were most designed to help.   Higher rates will also dampen any ongoing recovery, such as it is, and will likely herald a new recession in the United States (as rising rates usually do).  But the longer the Fed abstains from doing this, the likelier that inflation will rise, also stunting growth and investment, not to mention pounding consumers and creditors who are already hard-pressed.  Professor Taylor in particular fears a new episode of stagflation is likely in the offing as spending velocity picks up, which he foresees.

(2)  Raise bank reserve requirements.  The Fed could accomplish the same goal of extinguishing these current excess reserves — though not cutting its own balance sheet — by raising required reserve levels — in other words, turn the current $1.49 trillion in free reserves into mandated holdings.  It is hard to see how such a move would not be destabilizing, for multiple reasons, however.  For one thing, it would represent a one-time windfall to the government for spending the money initially that found its way back into the banking system to be re-lent.  Prices would, at the margin, be higher than otherwise, permanently.  And, investors would likely reason the Fed and Treasury might coordinate to do this again, so psychologically it would be a terrible precedent. 

Secondly, this move hamstrings commercial lending activity as surely as the Fed selling assets would be, and is ultimately more harmful to bank growth than any open market operations.  This is so because in the latter case the participating banks at least would obtain interest-bearing assets in return for drawing down their own reserves.  A freezing-in-place of current excess reserves would impinge banks’ degrees of freedom and deaden lending, freezing bank liabilities as well.

(3)  The Fed could elect to increase interest payments on free reserves.  This would also not shrink the Fed’s balance sheet assets, but would, like Option #2 above, immobilize these free reserves. Again, it is hard to see how financial markets would not react very negatively to this.  As interest rates rose in the economy generally, this would become very costly to the Fed — and to the U.S. taxpayer footing the bill.  Psychologically, paying banks not to lend after creating reserves to impel them to do just that would be seen as both self-defeating and a very transparent harbinger of future inflation.   It might also over time prove to be very costly to the Fed.  Currently the Fed is paying around $4 billion in annual interest, a small but significant aid in banking system recapitalization.  But if interest rates move back to where they were in the “normal” 1990s, that $4 billion becomes $40-80 billion quickly, completely wiping out Fed profits.   Again, the lending immobilization and hit to investor psychology would soon represent a serious toll on the economy.

Reform Is Coming to the Fed

Messrs. Herbener, Klein, and Taylor were all critical of the current Fed’s discretionary gambles in recent years, and Mr. Bernanke’s reliance on a “tallest midget in the room” argument that, given turmoil in Europe and slow-growth in Asia, demand for U.S. dollar-denominated assets would remain elevated for years to come — thus allowing the Fed to continue its quantitative easing programs.  All three are wary of the license the Fed’s dual mandate gives to the Bernanke Fed to pursue further QEs; in their view, none of the three options above comes without risk, and indeed all feel further hard times are unavoidable as real losses on Fed holdings materialize. And at the least, current monetary policy, if unchanged, portends years of a sideways stock market, similar to 1966-83 here in the United States.

The crux of the matter, as Mr. Taylor reminded the subcommittee, is that the dual-mandate is itself riddled with an internal inconsistency, if not outright contradiction in mission.   For a stable dollar presupposes accuracy in profit-and-loss accounting to promote maximal levels of job-creating investment.  But QE programs enable the government-led distortion of profits and ability to hide (or, “socialize”) losses; that is to say, the Fed has itself created serious moral hazard in our financial system.

The late economist Herbert Stein once famously said that if something cannot go on forever, it won’t.  As Congressman Paul’s subcommittee heard last week, a reckoning lies ahead, as pricing and investment distortions are promulgated by current policy that are only later revealed and corrected.  It may not be as severe as, say, the current tragedy in Greece, but if policies of fiscal prudence along with improved economic growth in the U.S. do not soon materialize to allow for the Fed to unwind its current highly-leveraged balance sheet, years of a sclerotic economy are guaranteed, and a monetary breakdown cannot be ruled out, pending developments with current U.S. Treasury holders.  All of this gives voice for calls to re-examine the sound-money policies of days long gone, policies that involved gold.  These classical policies of sound monetary doctrine were summarized by Messrs. Herbener and Klein in their respective testimonies, and we examine these next week, for we are of the view that their return in some form is now axiomatic.

For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, John Chapman can be reached at john.chapman@alhambrapartners.com. The views expressed here are solely those of the author, and do not necessarily reflect that of colleagues at Alhambra Partners or any of its affiliates.

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The Dow Jones-AIG Energy Total Return Index ((JJE)) consists of Natural Gas, Crude Oil, Heating Oil, and Unleaded Gas. The index has failed in its attempt to cross over the 50-day MA after breaking support a couple of months ago, and as a result has continued its tumble. A silver lining? Falling energy prices can have the potential to be a boon to consumers and the economy as a whole.

The DJ-AIG Grains Total Return Index ((JJG)) consists of Corn, Wheat, and Soybeans. The index is the best performing commodity index, despite the fact that it recently broke both the 50-day and 200-day MA and its the uptrend line. Look for the index to test support at the $43 level.

The DJ- AIG Industrial Metals Total return Index ((JJM)) includes Aluminum, Copper, Nickel, and Zinc. The index peaked late in the 1st quarter, before failing at the 200-day MA and breaking support at the 50-day MA. Weakening industrial metal prices such as copper tend to predate weakening economic statistics.

The DJ-AIG Precious Metals Index ((JJP)) includes Gold and Silver. With the Fed in no hurry to restart another round of quantitative easing (money printing), the index has broken down, breaking below the 50-day, 200-day, and short-term uptrend line.

The DJ-AIG Softs Index ((JJS)) includes Coffee, Cotton, and Sugar. Along with energy, it is one of the worst performing sub-indices.

The problem with entitlements is that once they are in place, they are extremely difficult to amend or even take away. Many seniors in the US for example, once intitially fearful of the Medicare Part D drug plan, have come to accept it and enjoy its economies of scale. It was put in place under President Bush in 2003 to deal with the astronomical costs of prescription drugs, not covered by Medicare in 1965, but it wasn’t paid for and added to the growing deficit.

The recent changes enacted by the 2009 Affordable Healthcare Act means also that the so-called “doughnut hole”, the gap between the initial coverage for drugs and the catastrophic coverage, will gradually diminish over time and for many seniors who still have to contend with the high cost of brand name drugs, that is a welcome feature. Reformers in Washington who want to repeal the law might well have a hard time with seniors of all political persuasions who like it and have grown used to it. Whatever they replace it and other entitlements with is going to have to be very carefully crafted.

That, essentially, is the problem that faced some European politicians this past week as they learned that the people don’t trust them. The reforms they had put in place or proposed to enact for their various systems to get their finances in order were met with solid resistance from electorates all over Europe. Austerity means different things to different people. It can mean cutting actual spending or just cutting the growth in spending. For many, the pain associated with such austerity was too much to bear and they made sure the politicians knew it.

President Nicolas Sarkozy was not able to engineer the change he promised in 2007. One telling example: he found that even trying to tamper with the retirement age by raising it to 62 was met with huge resistance, riots in the streets even. The French are able to retire almost on full salary after working for 41 years. If they left school early, then that could put them in their mid fifties at retirement. Better healthcare and perhaps the “red wine paradox” meant they were living longer and no reformer was going to mess with that! So he lost to challenger François Hollande whose election promises a seismic economic, social and political shift. He has vowed to bring the retirement age back down to 60 which should please a lot of French men and women.

His views on the integration of some of the positions of the eurozone’s governing bodies, the euro and the recent bailouts, and relaxation of the recent austerity measures could also bode ill for the Franco-German alliance and with Chancellor Angela Merkel personally, despite her immediate protestations of friendship. She is facing her own challenges with a federal election next year and recent regional contests too. She made it clear that she wanted to see M. Sarkozy win a second term but now has to contend with resurgent social democracy in France for the first time in 17 years. It could mean that Frau Merkel might be placed in an uncomfortable secondary position and jeopardise the whole bailout strategy. German voters are none too thrilled about having to rescue irresponsible partners and may want to send her a clear and unmistakable message of her own.

Even Britain’s Prime Minister David Cameron’s Conservative Party lost heavily in local elections. He is not directly affected by the euro crisis, but he has neverthless tried to bring reform to Britain. He took a beating and is facing the wrath of his backbenchers after leaning too far left to accommodate his Liberal Democrat coalition partners. Get back to basics, said the backbenchers, “bread and butter issues like jobs and mortgages”, otherwise he might suffer the fate of all leaders who do not deliver the goods and lose his position in a “palace coup” just as Margaret Thatcher did.

The reaction to austerity in Greece has been on view for all to see with riot police battling demonstrators armed with Molotov cocktails. There has been high drama in the parliament too. Reformers lost this past weekend and the two parties who gained ground were representatives of extreme left and right, former Communists and neo-Nazis. The fact that Greeks thought they might prove a better combination to get Greece out of its dilemma says more about the Greek mentality and their frustration, and less about these parties’ actual ability to effect change.

In the world of Greek politics, the extreme left and extreme right are not given a mandate to try and form a government. By turns, therefore, the other parties who gained seats in parliament got the chance to try. By the end of the week, all attempts had failed. If President Papoulias is not able to form a unity government as a last ditch effort this weekend then the stage looks set for new elections. The leader of the winning leftist party, Syriza, Alexis Tsipras, had more or less stated that austerity hadn’t worked and was basically null and void. This suggests that the spigot might well be turned back on jeopardizing Greece’s future inside the EU and/or the eurozone.

Little wonder then, that markets were jittery. The Athens stock market sank to levels not seen for 20 years though overseas markets fared somewhat better. But whereas the initial reaction was to shrug off the news of the French and Greek elections, by midweek, sentiment started to turn sour. By the end of the week, the market had recovered some of its poise. Still, concern that a financial fiasco in Europe could have knock-on consequences in the United States was hovering in the background. Our banks are exposed to Europe, it is our third largest export market and many companies are heavily invested overseas and rely for those markets on profitability. Once all that starts to erode, market operators will run for cover as the dominoes fall.

Sweden took a different path (via the Spectator):

When Europe’s finance ministers meet for a group photo, it’s easy to spot the rebel — Anders Borg has a ponytail and earring. What actually marks him out, though, is how he responded to the crash. While most countries in Europe borrowed massively, Borg did not. Since becoming Sweden’s finance minister, his mission has been to pare back government. His ‘stimulus’ was a permanent tax cut. To critics, this was fiscal lunacy — the so-called ‘punk tax cutting’ agenda. Borg, on the other hand, thought lunacy meant repeating the economics of the 1970s and expecting a different result.

Three years on, it’s pretty clear who was right. ‘Look at Spain, Portugal or the UK, whose governments were arguing for large temporary stimulus,’ he says. ‘Well, we can see that very little of the stimulus went to the economy. But they are stuck with the debt.’ Tax-cutting Sweden, by contrast, had the fastest growth in Europe last year, when it also celebrated the abolition of its deficit. The recovery started just in time for the 2010 Swedish election, in which the Conservatives were re-elected for the first time in history.

Sweden’s GDP fell more than the US in the great recession (-5.0% vs -3.5%) but the bounce back was bigger too (+6.1% vs +3.0% in 2010). And Sweden has a balanced budget as the tax cuts basically paid for themselves.

One can’t help but wonder what might have happened to the US economy if Christina Romer had put together a plan that was true to her academic research. Where would the US economy be if we had cut spending and made permanent tax cuts? Obviously, there is no way to prove a counterfactual, but it probably isn’t coincidence that that formula proved equally effective in the 1920-21 depression here in the US. Oh, what could have been….

Exchange-traded funds, commonly called ETFs, are index funds (mutual funds that track various stock market indexes) that trade like stocks. As such, they have all of the benefits of plain old index funds with some added punch. The fees for ETFs are often — but not always — cheaper than index funds, and they may cost you less in taxes.

Read the rest….

I emigrated to the US in 1983 and became an American citizen in 1987. It was the second best thing I ever did though it confounded some of my British friends. There cannot be too many American citizens who can say they voted for Margaret Thatcher but I can certainly lay claim to that. The election of May 3rd 1979 was a turning point in British politics. After years of turmoil and inept governance by the socialist Labor Party, Britain was ready for a change. Socialism and calling someone a socialist seems to be a dirty word in America but unless you have lived under such a regime, you can’t know. That election was transformational because it was the first time that a woman was elected as Prime Minister of Great Britain. She was a polarizing figure and you either loved what she stood for or you did not. There were plenty of people on both sides.

That’s why the new movie about her with Meryl Streep was such a disappointment. While the performance was very near spot on, I was always aware that it was just that – a performance. What I objected to was the distasteful way, at least for me, it depicted her in the early stages of dementia roaming around her apartment talking to her dead husband Denis. While it is undeniable that her health has suffered in recent years, that is not how I choose to remember her.

She was the leader of the opposition Conservative Party from 1975 to 1979 defeating Edward Heath for the leadership. Heath had taken Britain into the European Community in 1973 but Mrs. Thatcher had strong views about that and the later drive to have Britain join the euro, about which more later. Yet he had given her a cabinet position as Minister for Education and Science. Her policy of ending waste in government and ending the free delivery of milk to older school children earned her the title “Mrs. Thatcher, Milk Snatcher”.

Americans cannot really appreciate what it was like to live through the 1970s in Britain. The battle of wills between the public sector unions and the Labor government over the wage freeze to keep a lid on inflation led to strikes by a variety of workers including garbage collectors and grave diggers amongst others. This inability to control the unions, notionally on the same side politically as the Labor government, led to Conservative victory in 1979. Because the winter of 1978/79 was quite cold, it became known as “The Winter of Discontent”.

But it wasn’t just that. All the way through the seventies, many unions and in particular the coal miners and the railway workers struck often leading to a three day work week and rolling black outs. It got to the point where, in order to maintain constant staff, my bank (and others too) were putting staff up in hotels and paying them £5.00 a night for the inconvenience of being away from family. If you really wanted to rough it, you got £8.00 a night for sleeping on a camp bed inside the bank. Being young and in constant need of money, many of us opted for sleeping in the bank. But we were all much younger then!

You cannot really imagine what it’s like to be in a trading room underneath a jerry-rigged metal structure on top of the main desk with hurricane lamps swinging from it and trying to make money for your company. While it all had a sense of cameraderie and the “spirit of the blitz” while we all helped each other as the bombs were falling, so to speak, it was nevertheless extremely aggravating and little wonder therefore that when Labor went to the country in 1979, they lost quite handily.

A test of her character and steely resolve was not long in coming to the fore. Taking on the unions head on domestically (“the enemy within”) and Argentina over the Falkland Islands dispute (“The Empire Strikes Back!”), she won both handily. In the Meryl Streep movie, you see glimpses of all that. I would have preferred much more concentration on these battles than her own personal health struggles.

For financial market participants however, it is her attitude towards the euro which is of particular interest. “During my lifetime most of the problems the world has faced have come, in one fashion or other, from mainland Europe, and the solutions from outside it.” “A single currency is about the politics of Europe. It is about a federal Europe by the back door.”

She was a euro-skeptic from the start. As she had on this and other policies, she had opposition from within her own party, known as “the wets”, but she was well aware of the phobia that Germany had and still has about inflation. With memories of the great Weimar inflation within living memory for many in Germany, the attitude was that “2% inflation is 2% too much” and that’s how it was expressed to me by a Bundesbank official. A single European currency, grand though its aims might be, would not be able to handle the pressure and strains of economies at different stages of their economic cycle and, putting it kindly, different management styles. It would only be a matter of time before it all blew up. How prescient of the lady!

There is a word in German, “Schadenfreude”, which means taking pleasure in someone else’s pain and perhaps only the Germans could come up with that. But while it would be unkind to attribute that sentiment to all the euro-skeptics, there is certainly an element of “I told you so, but you wouldn’t listen!”

Brian Cronin worked in banking for 40 years, 35 of them in currency sales and trading. His last post was with ANZ Bank as VP, Markets Division where he produced a widely followed weekly commentary on currency markets. He is now retired and living in South Carolina – at least until we can coax him into joining us here at Alhambra.

Earnings have been pretty darn good. Yes, I know, profit margins are near all time highs and will inevitably revert to the mean, making stocks a lot more expensive than they now seem. But the timing of that reversion is something no one can predict and in the meantime those big profit margins are producing good earnings. Growth has certainly slowed but earnings are still rising and absent an external shock, seem likely to continue doing so in the near term. The impact from any slowdown in China and its dependent resource providing countries may be offset by any drop in commodity prices that results. Europe is already in deep recession and further weakness seems unlikely to upset the US earnings Applecart.

Commodity prices, despite the Fed’s herculean monetary efforts, may also emerge as a positive and not just because of a global slowdown. West Texas Intermediate – the US crude oil benchmark – has traded in a 10% band around $100 since mid-October and has yet to exceed the peak near $115 set early last year. Oil prices and commodities more generally are a long ways from the peak set in mid-2008. Crude oil inventories in the US are at 21 year highs thanks to shale drilling and while the glut isn’t as significant as the one in natural gas, prices may be set to fall further. That natural gas glut is also having a positive effect on the economy although I’m a bit skeptical of its durability as many of the wells drilled over the last few years are not profitable at these prices. If crude prices fall further, many of the shale oil wells drilled recently will fall into the same category. Breakeven prices are hard to pin down and depend on the area but somewhere around $60 – $70/barrel, many of these wells are not economic. But for now, the supply/demand picture for energy is very positive and the potential for lower oil prices has to be seen as a positive for the economy as a whole.

Central to the oil/commodity pricing picture is the new found steadiness in the value of the dollar. The US dollar index is at roughly the same level now as late 2010. It did weaken during QE 2 but has since settled into a steady, if unspectacular, upwardly rising trend. More importantly, the dollar has steadied against gold as well. Gold peaked just over $1900/ounce right near the end of QE 2 but has since settled into a range of roughly $1500 – $1800 with the current price around $1650. The monetary base peaked in late February and has now contracted below the QE 2 peak while M2 money supply growth has fallen from double digits last year to a mere 4.4% recently. Meanwhile, inflation expectations as measured by TIPs spreads have stabilized around 2%. I don’t know what the Fed will do from here but at least for now, the monetary situation appears to have stabilized.

The credit markets also appear to be doing better at least if you measure that by lending. Total bank credit has expanded by roughly 5% in the last year while commercial and industrial loans are up nearly 15% over the same time frame. One could argue – and I have – that a lot this new lending will be proven to be just more malinvestment somewhere down the road, but until it ends, malinvestment is hard to distinguish from I guess what should be called bon-investment. Overall, the recovery in investment has been fairly weak – and distorted by Fed policy – since the end of the recession but it is rising. On top of that, residential investment, which is obviously a big part of the investment gap in GDP, is now at least adding modestly to the recovery.

The most obvious positive for the US economy has been the manufacturing sector which is benefitting from several trends. The large devaluation of the dollar over the last decade has made US manufacturing more competitive as aggressive monetary easing here has narrowed the wage gap with China. Chinese wages have been rising at double digit rates while wages here have stagnated. Now, I don’t believe the proper way to encourage manufacturing in the US is to impoverish American workers through devaluation but it does get the job done eventually. The natural gas glut has also made it cheaper for many industries to locate in the US as prices in Asia are 7 to 8 times the US price. High oil prices – for now – have also benefitted US manufacturers as the cost of shipping goods back to the US has risen. Manufacturing will never be the employer it was in the past thanks to improvements in productivity, but it is improving and looks set to continue.

Lest you think I’ve gone soft, I’d like to emphasize that most of these positives are of a short term nature and the long term challenges facing the global economy remain. The debt levels in the US and Europe in particular must eventually be reduced as a percentage of GDP. The best way to accomplish that is through higher growth but the sclerotic pace of growth in the developed world cannot be improved through monetary policy alone. Fiscal policies must improve and become more pro growth to complement monetary policy. Merely cutting spending would get the job done eventually but as European politicians are now discovering it is politically difficult to sustain. France’s election of Francois Hollande would seem to point in the wrong direction by the way. You won’t cut the Gordian debt knot with higher taxes alone either.

As always seems to be the case, there are positive things going on in the US economy but make no mistake, the long term outlook is still not as bright as it could be with better economic policy. I am still quite cautious about the near term outlook for all the reasons I’ve detailed in this space over the last few months. But I also have to acknowledge the positives. Whether they prove sufficient to overcome the negatives we’ll only find out in hindsight and as you might have surmised from reading these commentaries recently, I have my doubts, but as an investor I’ve learned to stay open to even the most unlikely of events.

As for stocks, I still expect a correction but it may not be as deep as I’ve feared. The economic statistics have turned mixed over the last two months but the US economy has proved surprisingly resilient. I have previously characterized our markets as enjoying a cyclical recovery in the context of a secular bear market and I have not changed my mind. But the cyclical upturn may continue for a while as some of these positives continue to feed through to the economy. We have not changed our investment stance yet but if last week’s selloff develops into a larger correction over the coming weeks, we’ll be watching the data closely for signs of strength.

Last week’s employment report got most of the attention but as has been the case for the last two months, it was another mixed week with some good reports and some bad. On the positive side of the ledger were Personal income and spending, the Chicago PMI, the ISM manufacturing report and jobless claims. On the negative side were the Dallas Fed manufacturing survey (which turned negative), car sales, construction spending, factory orders, productivity and costs, the ISM non manufacturing survey and the aforementioned employment report. (John Chapman has a full analysis of the employment report here.)

Next week is light on US data but the fallout from the European elections may provide some direction. With the election of Hollande, I expect to see some turmoil as the market sorts out whether he can enact his agenda. The most immediate reaction may be a weakening of the Euro. With monetary policy a global affair now, it will be interesting to see how the ECB and the other central banks react to such a development.

For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, Joe Calhoun can be reached at: jyc3@alhambrapartners.com or 786-249-3773.

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As expected, once the Latin America Index broke the 50-day MA, it was headed to the 200-day. Now that it has tested support at the 200-day, it looks very likely that that will fail as well. Latin America is strongly correlated to the performance of the commodity markets, and as the global economy worsens, so does the demand for commodities.

The EMU index, or the European Economic and Monetary Union, is breaking down. The Euro crisis has taken a toll on the European markets of late.

More of the same for Eastern Europe. The index broke strong support at the 26 level.

The Russian economy is also very dependent on commodities, so as commodities go, so goes Russia. The index has lost over 6% in the last few days.

The Middle East has performed much better than most despite turmoil in Syria and the Israeli-Iran friction. It’s currently right at support at 15.15.

Africa is solid technically, but looks likely to break the 50-day MA.

Pacific x-Japan just broke support at the 50-day. Look for it to test the 200-day.

Japan

Volume II, Number 18: The Facebook Phenomenon and Its Economic Impact

By John L. Chapman, Ph.D.   Canton, Ohio.

Facebook, Inc. begins its investor roadshow this week in anticipation of an initial public offering on May 18.  The company’s potential is virtually unlimited, though business history is replete with should-have would-have could-have stories.  Regardless of its fate in the future, its economic impact has been impressive, and its success to date is a testament to the capitalist ethos still embedded in a uniquely American entrepreneurial culture.

Mark Zuckerberg may have a visage that suggests unfamiliarity with razor blades, but the youthful 27-year old college drop-out is about to be confirmed as one of the world’s richest men.  The Facebook CEO, who will control about 58% of the company’s voting shares post-IPO, will have his stake valued at around $18 billion — in a company that could float at $96 billion on its opening.  In a post-Great Recession economy that is still hard-pressed by continuing global convulsions, Facebook’s IPO is a ray of good news, and a testament to the possible in a world whose job-creating entrepreneurs are now prone to fear.    

From a cold start in his Harvard dorm room eight years ago, Mr. Zuckerberg has grown a company that now boasts more than 900 million monthly users (488 million of them mobile), 500 million of them daily — and the firm will pass $5 billion in revenues this year.  As the firm’s online roadshow prelude video details, market penetration is still in its infancy in many places around the globe (but already includes versions in 70 languages), as is revenue capture from both its customized and targeted advertising potential and fee-sharing from ancillary third-party service offerings.  It is hard to see how the firm will not grow dramatically in coming years, particularly when China opens up (Facebook is currently banned there) and as global ad revenues gravitate more toward online media.  Beyond enriching its founders and senior managers, though, the biggest story in the IPO of Facebook is the lesson it offers to both investors and students of public policy concerned with economic growth.     

First, consider the magnitude of the firm’s accomplishments in just eight years. It is now a global brand soon to rival Coca-Cola and McDonald’s, yet has less than 3,500 employees, most all of them in California.  Its first day market capitalization will likely surpass the entire U.S. automobile industry (Ford, $41 billion; GM, $35 billion; Chrysler/Fiat, $6 billion), and rival Amazon’s hefty valuation ($101 billion).  It jousts with Google as being the first or second most heavily trafficked site on the Internet, long ago achieving a trillion page views per day.  It has spawned 125 billion “friendship” connections, and daily takes on 300 million photo uploads, one billion comments or messages, and two billion ”likes.”  Facebook now boasts of more than 3.2 million actively managed small business pages, and has 100% of the Ad Age 100 (e.g., Coke, IBM, Procter & Gamble) as users and advertisers.  Last year, in a sign of changing fortunes in Silicon Valley, the firm left its Palo Alto HQ and occupied the former million square foot-campus of Sun Microsystems in next door Menlo Park, with a 5-year option to buy the eleven buildings; the firm has also bought nearby acreage, has lease-hold options remaining in Palo Alto, and is well-positioned for rapid (exponential?) growth in the years ahead.

Is the stock a buy, at any point of its anticipated flotation price of $28-35 per share?  Certainly investors would prefer to see $28, implying an $80 billion valuation on a firm with anticipated operating earnings of around $2 billion in 2012.  The initial P/E will be well above NASDAQ market comparables in any case, and of course will not pay a dividend any time soon.  The biggest question mark surrounding valuation is whether the business model can be ramped up, via advertising and fee-for-service cash flows, to generate earning to support the out-sized valuation.  Further, while Mr. Zuckerberg possesses undeniable vision and tenacity as the firm’s chief product architect, it is not clear to us that Sheryl Sandberg is the right person for the de facto CEO job there.

On the other hand, the firm has — for the most part — a very strong Board of Directors, and there is every expectation the key members of the Board, including Accel’s Jim Breyer, Netflix’ Reed Hastings, Internet icon Marc Andreessen, and middle market M&A veteran Erskine Bowles will remain post-IPO for a period of growth.  Additionally, revenues from advertising and service fees  are likely to grow, potentially substantially enough to protect already-healthy 30-40% operating margins.  $600 billion was spent on advertising in 2011, but only 12% of that was online, and only a small fraction of that for mobile users.  Facebook, which had less than $300 million in revenues in 2008, went cash flow positive in September 2009 and was up to $3.7 billion in revenues in 2011.

The reason ad revenues may well explode is both due to increased gravitation toward online and mobile media, and advertisers’ demands for customized, targeted personalization in their campaigns in a hyper-competitive and networked world.  Facebook claims that a wedding photographer in Minneapolis spent $1500 last year on a campaign targeting females in the Twin Cities between the ages of 24-30 who listed their status as “Engaged”; he generated many sales leads from this and had a personal best earnings year of $70,000 as a result.  Mass customization of messaging on digital platforms is still in its infancy, but Facebook is now in the enviable position of being a virtual duopolist (along with Google) in possessing so much user information that can be exploited and tailored to individual demand curves.  And vis-a-vis Google, Facebook arguably has far higher quality information about individuals, or to say it differently, a higher degree of profitable exploitability per user. For mobile applications in particular, we are moving toward a world where Facebook will take user preferences, match them to location, and offer pinging services — tailored and customized offers on-the-spot (e.g., a Facebook user from Chicago who has “Liked” a steak-house chain is in Houston on business, and will receive a text as to the nearest restaurant there in town, with a special dinner offer).  The possibilities here are — literally — endless, and for Facebook investors, there is comfort in knowing the firm is now a quasi-monopolist in offering such future services, with substantial entry barriers for others trying to replicate these revenue capture opportunities.     

Additionally, Facebook has the option to invade at least some of Amazon’s turf, and Google’s as well (or, offer new services to compete with firms like Match.com), but the converse is not necessarily true (though Google is looking as though it seeks to build social connection platforms now).  But at the least, the firm earned more than $500 million last year in very high margin fees from third-party application developers, predominantly game purveyors.  This is in line with Facebook’s conscious — and correct, from a strategic perspective – decision to be the core “connector” platform for a whole ecosystem of service providers.  Again, the growth potential here is virtually limitless, and it is here where Facebook may well engage in partnerships with existing online service providers or be able to compete with other vendors, given its ready universe of what will soon top a billion users.  In the modern world, having a lock on a distribution channel — that has in this case already imposed significant entry barriers on others trying to compete against what is now a de facto “Facebook standard” — allows a firm to then control the content flowing through the channel.  Depending on the industry, a proprietary channel can be as valuable as proprietary content; Facebook in some ways may be said to tap into both, a fact of singular importance for competitive positioning and future valuation (and indeed, Facebook is already aggressively exploiting these opportunities by building online links to literally thousands of other sites, such as, say, the New York Times; if it be said that Coca-Cola wants to be in every retail location in the world, Facebook equally wants to be connected to every online page in the world, apparently).

From a public policy perspective, the lesson here is clear as well: the spontaneous trial-and-error of entrepreneurs leads to all sorts of outcomes, often after the entrepreneurs themselves have changed directions in sense-and-respond exploitation of opportunities to serve unmet needs.  There are no such visionaries inside central planning boards of governments; neither the relevant information nor the incentives are in place for such opportunity discovery to take place.

Further, Facebook is but the latest example, following Amazon, Google, and others, of information-age services being offered alongside the co-optation of economies of scale and scope. The economics of “network effects”, where the value of an asset increases as more users are attached to it, are well-known; and they offer one answer, through the phenomenon of increasing returns to scale, to a world starved for economic growth through gains in efficiency and productivity.  It seems to us as though investors have every reason to be bullish on Facebook’s prospects long term, and we must say, we can only hope that governmental organs in Europe and the United States do not pursue oversight of ‘FB’ as it grows, as they once did of ‘IBM’ and ‘MSFT’ in bygone days.  For as those two behemoths learned, “all glory is fleeting” applies to businesses as well as commanders of Rome’s legions.         

For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, John Chapman can be reached at john.chapman@alhambrapartners.com. The views expressed here are solely those of the author, and do not necessarily reflect that of colleagues at Alhambra Partners or any of its affiliates.

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