GDP rose at a 2.4% rate from April to June. First-quarter growth was revised up, but estimates all the way back to 2007 were revised lower.
The U.S. economy lost momentum in the second quarter as consumers remained frugal and a cycle of restocking by businesses, which helped propel growth in previous quarters, showed signs of petering out.
The latest and broadest snapshot of the U.S. economy, released Friday by the Commerce Department, said that gross domestic product—the value of all goods and services produced by the economy—grew at a 2.4% annual rate in the period. That is down from an upwardly revised 3.7% in the first quarter and 5.0% in the final quarter of 2009.
The growth slowdown bodes poorly for the rest of the year, and some economists indicated they would cut growth estimates for the second half based on the report. Also Friday, the government released revised GDP numbers for the past three years, which showed the recession was worse than previously thought.
The downbeat GDP reports come as businesses are logging high profits, underscoring a wide divide between companies and ordinary consumers. With 70% of companies in the S&P 500 having reported earnings through Thursday, second-quarter earnings are running 42% higher than a year ago, even though sales were up only 9%.
The Dow Jones Industrial Average fell 1.22 points Friday to 10465.94. For the year, it has risen 0.36%.
In the second quarter, businesses increased spending on equipment and software by 21.9%, while a category that includes home building grew amid a rush by consumers to take advantage of tax credits for homes. But overall spending by consumers remained sluggish, rising just 1.6%. The first quarter's total was revised downward.
Two other reports Friday showed consumers have seen little growth in their wallets and remain skittish about the economy's prospects. The Labor Department said compensation costs rose 1.8% for civilian workers in the second quarter compared with a year ago, a sluggish pace and about half the rise in the early stages of the recession. The Thomson Reuters/University of Michigan consumer-sentiment index was 67.8 in July, up from a preliminary reading of 66.5 but still extremely weak.
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Despite profit growth at businesses, the economy can't continue to grow without help from consumers, because their purchases account for about 70% of economic activity.
Bob Husband, chief executive of Heritage Golf Group, a San Diego company that owns and operates courses in six states, says profits have stabilized but he doesn't expect business to pick up until consumers feel better about their prospects. "Our business is directly related to people having jobs and having disposable income," he said.
Economic growth in the U.S. during the second quarter slowed to 2.4%, indicating that the recovery has been weaker than previously expected. David Wessel, Dennis Berman and Evan Newmark discuss. Also, Dennis Berman tells the story about one of the leaders at Tiananmen Square who is now one of the top candidates to manage Berkshire Hathaway's investment portfolio.
After slashing costs over the past three years, Mr. Husband says his company has the same level of cash flow as it did last year, despite a single-digit decline in revenue through the first half of this year. The company is using less energy and water, and has become vigilant about sending hourly workers home early on days when it rains. But despite the newfound stability, Mr. Husband says his company won't be adding workers until there are clearer signs of recovery.
"We're very hesitant to hire anybody unless we absolutely have to," Mr. Husband said. "You just want to have enough money in the bank to withstand another downturn." GDP growth in the second quarter was bolstered by several factors that are likely to be temporary. Spending by state and local governments added to growth in the latest period, but that factor is likely to fade as governments grapple with budget gaps and begin to see federal stimulus dollars fade away.
Deputy Editor Daniel Henninger explains why the economy isn't growing faster, and Senior Editorial Writer Joseph Rago on the incentive effects of tax increases.
Inventory growth contributed just more than one percentage point to GDP, less than half the contribution it made in the first quarter of 2010 and the last quarter of 2009. Inventory building—the result of companies moving to restock shelves depleted during the deep recession—has been a driver in the previous two quarters. The slower second-quarter pace suggests that the restocking cycle is at or near its end.
"It suggests less growth in the second half," said Ben Herzon, an economist at St. Louis Forecasting firm Macroeconomic Advisers.
The report showed imports and exports both grew, but imports grew faster, shaving a net 2.78 percentage points from GDP growth. Still, the strong demand for imports is a good sign: It indicates growing domestic demand. Indeed, final sales to domestic buyers grew 4.1% in the second quarter, the fastest pace since the first three months of 2006, before the recession.
The second-quarter slowdown in GDP growth is likely to reinforce concerns at the Federal Reserve that the recovery is losing momentum, prompting a debate about what steps, if any, to take if the slowdown continues. But policy options look limited: Deficit angst in Congress and partisan gridlock makes any additional fiscal stimulus extremely unlikely unless the economy deteriorates further. Meanwhile, it remains to be seen whether the profit surge can continue without a broader upturn in jobs and consumer spending. Many businesses have logged higher profits thanks to demand growth from better-performing economies overseas and by finding new ways to keep labor and other costs low.
One of them is Timken Co., a Canton, Ohio, maker of roller bearings, gear boxes and other industrial goods, which on Thursday reported a 37% jump in second-quarter sales and raised its profit forecast for the year. Timken has seen stronger demand—including a $26 million order from China for wind-turbine equipment and services—and has hired about 500 people in the U.S. this year. As of June 30, Timken had nearly 17,000 employees world-wide.
But new software and more efficient procedures for handling inventory and raw materials mean the company has eliminated some jobs for good. The chances of returning to the employment levels of 2008 look "pretty remote," said Don Walker, a senior vice president who handles personnel. Business investment is often followed by hiring, but that hasn't been the case in this recovery. One reason is that much of the investment is being used to maintain or upgrade existing equipment, not to produce more products, according to the Federal Reserve's "beige book" on Wednesday. Meantime, companies are investing in technology that cuts jobs. Write to Luca Di Leo at luca.dileo@dowjones.com
Weak economy, strong profits? Not as strange as it sounds.
Gross-domestic-product figures due Friday are expected to paint a disappointing picture of U.S. economic performance. Second-quarter GDP is likely to show growth roughly in line with the first quarter's 2.7% annualized pace, an unusually weak result for this stage of recovery.
Investors may find that difficult to square with what is shaping up to be a decent run for corporate profits. Second-quarter earnings among S&P 500 companies are on track to post 35% growth over the same period last year.
But the seemingly contradictory developments aren't as inconsistent as they might at first appear.
For one, the disparity partly reflects the way the figures are presented. GDP growth, which is seasonally adjusted, is usually reported on a quarter-to-quarter basis. Corporate profits, which can be highly seasonal, are typically expressed in year-on-year terms. When GDP growth is viewed on an annual basis, the story is more consistent: Growth turned positive in the fourth quarter, the same time S&P 500 earnings growth resumed after nine quarters of declines.
Meanwhile, earnings figures have been sharply inflated by the rebound in profits from financial firms following their spectacular collapse during the crisis. For example, the 205% leap in fourth-quarter earnings was a gain of only 17.5% excluding financials, according to Thomson Reuters. And revenues over the same period increased by just 2.9%, excluding financials.
Revenue growth among S&P 500 companies is today higher, so far up 11.6% in the second quarter from a year ago, excluding financials. In contrast, Friday's report is expected to show year-on-year GDP growth of only 3.2%. But companies often rebound at a quicker pace than the overall economy. For consumers and governments to rebuild their balance sheets and start spending again is a much lengthier, and painful, process.
Companies' global exposure also plays a role. About half of S&P 500 revenues come from foreign countries, according to OppenheimerFunds. Meanwhile, exports account for only about a tenth of U.S. GDP.
The apparent paradox of a sluggish U.S. economy coinciding with strong corporate profits won't last forever. But, with companies still very disciplined on costs, it isn't something for investors to get too worried about just yet.
Share Business ExchangeTwitterFacebook| Email | Print | A A A By Susanne Walker and Daniel Kruger
July 31 (Bloomberg) -- Treasury notes gained for a fourth consecutive month, pushing two-year yields to the lowest ever, as data that showed U.S. economic growth is cooling fueled demand for the safest securities.
The two-year yield fell for a ninth straight week, the longest since February 2008, as a report yesterday showed gross domestic product expansion decelerated to an annual rate of 2.4 percent rate last quarter, lower than forecast. A Federal Reserve report July 28 underscored central bankers’ view that the recovery is progressing more slowly. U.S. payrolls shed jobs in July for a second month, a report next week may show.
“There’s concern about growth being low for an extended period,” said Michael Cloherty, interest-rate strategy head in New York at Royal Bank of Canada, one of 18 primary dealers that trade with the Fed. “That’s the theme that keeps pushing things along. We’ll need continued bad news to extend this rally.”
The two-year yield dropped 4 basis points on the week, or 0.04 percentage point, to a record low of 0.5461 percent yesterday in New York, according to BGCantor Market Data. It has declined 6 basis points in July and 22 basis points since the week ended May 28.
The 10-year note yield fell 9 basis points on the week and 26 basis points this month to 2.91 percent. The 30-year bond fell for the first month since March, with its yield rising 10 basis points to 3.99 percent.
Growth in gross domestic product from April through June decelerated from a revised 3.7 percent pace in the first three months of the year and from 5 percent in the last quarter of 2009, Commerce Department data showed yesterday. The median forecast in a Bloomberg News survey was for a 2.6 percent rate.
‘Moderate Recovery’
“The moderate recovery looks likely to continue but for now, at least, risks to growth are skewed to the downside,” Zach Pandl, an economist at primary dealer Nomura Holdings Inc. in New York, wrote in a note to clients. “The report’s many details were on net a negative for the economic outlook.”
The Fed’s regional business survey, known as the Beige Book, said that over the past two months “nearly all districts reported sluggish housing markets” since a tax credit for homebuyers expired April 30. Several of the bank’s 12 districts reported manufacturing “slowed or leveled off.” Still, it said, “economic activity has continued to increase, on balance, since the previous survey.”
The survey was issued two weeks before the central’s bank’s next policy meeting, scheduled in 10 days.
Note Auctions
Treasuries rose this week even as the U.S. sold $104 billion in 2-, 5- and 7-year securities. The $38 billion 2-year note offering drew a record low auction yield of 0.665 percent, and the $37 billion 5-year notes yielded 1.796 percent, the lowest level at an auction of the debt since December 2008.
U.S. employers eliminated 60,000 jobs in July, according to the median forecast in a Bloomberg survey before the Labor Department reports the data on Aug. 6. The economy lost 125,000 jobs in June in the first monthly decline this year.
The worst U.S. recession since the 1930s was even deeper than previously estimated, reflecting bigger slumps in consumer spending and housing, according to the Commerce Department’s annual revisions, issued yesterday. The economy shrank 4.1 percent from the fourth quarter of 2007 to the second quarter of 2009, compared with the 3.7 percent drop previously on the books, the report showed.
Fed Chairman Ben S. Bernanke said last week the central bank is prepared to take further policy actions if the world’s largest economy “doesn’t continue to improve.” The Fed cut the benchmark interest rate to a record low range of zero to 0.25 percent in December 2008 and bought $300 billion in Treasury securities, in addition to purchasing housing-agency and mortgage-backed securities, as a tool of monetary policy.
Quantitative Easing
The central bank should resume purchases of Treasuries if the economy slows and prices fall, Fed Bank of St. Louis President James Bullard wrote.
“The U.S. is closer to a Japanese-style outcome today than at any time in recent history,” Bullard wrote in a research paper July 29 about the possibility of deflation. “A better policy response to a negative shock is to expand the quantitative easing program through the purchase of Treasury securities.”
A resumption of such purchases isn’t on the horizon, according to primary dealer Citigroup Inc.
“Further balance-sheet expansion is unlikely given the concerns around size of current balance sheet and the diminishing returns to further asset purchases,” Citigroup strategists led by Amitabh Arora in New York wrote in a report issued yesterday.
Fed’s Balance Sheet
Assets on the Fed’s balance sheet totaled $2.33 trillion as of July 28, according to central bank data.
Futures on the CME Group Inc. exchange yesterday showed traders have reduced the probability that policy makers will raise their target rate for overnight lending between banks to 33 percent by April, from 54 percent a month ago.
The difference between yields on 10-year notes and Treasury Inflation Protected Securities, a gauge of trader expectations for consumer prices, yesterday narrowed to 1.76 percentage points from this year’s high of 2.49 percentage points in January. The five-year average is 2.13 percentage points.
To contact the reporters on this story: Susanne Walker in New York at swalker33@bloomberg.net; Daniel Kruger in New York at dkruger1@bloomberg.net;
No executive would dispute that analysts’ forecasts serve as an important benchmark of the current and future health of companies. To better understand their accuracy, we undertook research nearly a decade ago that produced sobering results. Analysts, we found, were typically overoptimistic, slow to revise their forecasts to reflect new economic conditions, and prone to making increasingly inaccurate forecasts when economic growth declined.
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Moreover, analysts have been persistently overoptimistic for the past 25 years, with estimates ranging from 10 to 12 percent a year,4 compared with actual earnings growth of 6 percent. Over this time frame, actual earnings growth surpassed forecasts in only two instances, both during the earnings recovery following a recession. On average, analysts’ forecasts have been almost 100 percent too high.
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Here are my Five Reasons Explaining this Phenomenon.
Reasons for Nonsensical Earnings Estimates
Analysts do not do their homework on what is really happening and why. Instead they see rising earnings and take them at face value, nearly always figuring following quarters will be better yet.
Analysts do not understand the dynamics of debt deflation, peak credit, the baby boomer retirement dynamics, etc. In short, Analysts do not understand the global macro picture is bleak.
Analysts look at a steep yield curve and think the Fed can lift the economy.
Analysts have not yet caught on to the fact that consumer spending and bank lending attitudes have changed for good.
Analysts in general have a vested interest in getting the public to buy stocks, annuities, etc. because that is how they make money.
Given that debt deflation, and attitudes were not issues in many past blown estimates, a second look suggests points #1 and #5 (especially 5) are the real reasons in play.
Regardless of the reasons, the key point is forward earnings estimates have been ratcheted up several times in the past year and are now wildly optimistic. I don't believe them and history suggests you should not either.
The moment the market has been waiting for is now upon us. After the close of trading on Monday, July 12, Dow component Alcoa (AA) will report its earnings results for the second quarter. That report will officially mark the start of the reporting period for the June quarter.
There has been a good deal of angst leading up to this reporting period. The performance of the S&P 500 has suggested as much.
From its intraday peak of 1219.80 on April 26 to its intraday low of 1010.91 on July 1, the S&P 500 dropped 17%. That decline was precipitated by sovereign debt problems in Europe, signs of a slowdown in China, a historic oil spill in the Gulf of Mexico, increased regulatory efforts, and a string of economic data in the U.S. that cast doubt on the sustainability of the economic recovery.
To be sure, there is a lot going on in the world around us that is creating a sense of uncertainty. At the end of the day, though, it all comes back to earnings; and what has transpired in recent weeks has left the market questioning the achievability of earnings growth estimates.
Those questions do not relate so much to second quarter earnings. Rather, they pertain more to earnings in the back half of the year and 2011.
While there is a realistic prospect of a relief rally during earnings season, we would be sellers into the strength, reducing exposure to cyclical sectors. Conversely, we recommend increasing allocation toward counter-cyclical sectors where volatility is lower and dividend yields are generally higher.
A Brief Look at Q2 Reporting
The second quarter results should go the way the results have gone the last two quarters. That is, the vast majority of companies reporting results should exceed consensus earnings estimates. The main factor behind that assumption is that there have been few warnings.
According to Thomson Reuters, there have been 71 negative EPS preannouncements for the second quarter compared to 60 positive EPS preannouncements. The negative-to-positive ratio computes to 1.2 for the S&P 500, which is less than the 1.3 ratio for the first quarter, when 78% of S&P 500 companies topped estimates, and well below the long-term average of 2.1.
In thinking of the second quarter specifically then, there are three questions left to be answered:
How large will the earnings surprise factor be in aggregate?
What type of top-line growth will we see? and
What will the quality of earnings be?
The latest report from Thomson Reuters indicates share-weighted earnings for the S&P 500 are estimated to be $182.6 bln for the second quarter, which translates to an estimated growth rate of 27%.
Second quarter revenues are estimated to increase 9% to $2202 bln.
From April Fool's Day to Judgment Day
Over the last five quarters, S&P 500 companies have easily topped consensus earnings estimates. In the process, they have demonstrated the extent of their cost-cutting capabilities and have shown that analysts have been well behind the curve in accounting for the economic recovery from the depths of late 2008, early 2009.
In the first quarter, S&P 500 companies in aggregate topped the consensus earnings estimate by 14.3%. It would surprise us to see similar outperformance for the second quarter, especially since analysts have continued to bump up their growth estimates in the face of the market impediments noted above.
On April 1 the estimated second quarter earnings growth rate stood at 22.7%.
A lot has happened since April Fool's Day to get in the way of accelerating growth. That, however, has not stopped analysts from raising their estimates.
The third quarter earnings growth rate increased from 23.4% on April 1 to 25.6% on July 1, according to Thomson Reuters, while the fourth quarter growth rate increased from 31.5% to 32.6%.
There is little doubt given the scope of earnings surprises in recent quarters that analysts have been playing catch up with their estimates, yet we are left to wonder if they have finally caught up only to be left behind again with economic conditions softening.
A much smaller earnings surprise factor for the second quarter would speak to this concern.
The stock market, though, has not been content to wait on the second quarter results. Since the end of April, it has traded on the belief that analysts are too disconnected to what is going on in the world around them. That statement rings true in the charts below, which show the trend in the forward four quarter consensus earnings estimate and the S&P 500.
The correlation between the trend in estimates and the price trend in the S&P 500 weakened substantially in mid-May. The disparate moves make it apparent that one body is going to be proven wrong during the second quarter reporting period.
Either the stock market is too pessimistic or analysts are too optimistic. Accordingly, much is riding on the guidance from S&P 500 companies.
Lonely Analysts
There are a few markers in particular that must have analysts feeling like castaways on a deserted island.
The first marker is the Treasury market, which clearly thinks analysts are missing the boat on the economic outlook. On April 5, the yield on the 10-year note was bumping up against 4.00%. On July 6 it hit 2.93%. While the 10-year yield has recently moved back above 3.00%, the rush to own 10-year paper sporting a curiously low, real yield shows the level of concern about economic growth prospects.
Conversely, no one seems to be in a hurry to buy stocks despite a forward four quarter earnings yield that hit 8.6% on July 2. Granted there was a nice rebound in the S&P 500 in the past week, yet the 5.4% spike had a lot to do with short-covering activity if the extreme bearish sentiment readings, yet moderate volume totals throughout the week were any indication.
The significant equity risk premium is either a gift from the value gods or a bedeviling indication that earnings growth estimates are going to need to be marked down considerably. The reluctance to buy stocks at this juncture is supportive of the latter view.
On a related note, it was interesting to see that some of the worst sector performances in the second quarter were in those sectors that are expected to deliver the strongest earnings growth in the second quarter, as well as in the third and/or fourth quarters.
For example, earnings for the S&P 500 Materials sector are projected to increase 91% for the second quarter -- the highest of all sectors -- 46% for the third quarter and 45% for the fourth quarter, according to Thomson Reuters.
In the second quarter, the S&P 500 Materials sector declined 15.7% -- the worst performance of all sectors -- versus an 11.9% decline for the S&P 500.
Obviously, there is a big expectations gap that needs filling there, as well as in other S&P 500 sectors like Financials, Energy, Industrials, and Technology -- all of which are expected to deliver some of the strongest earnings growth in the second quarter and all of which underperformed the S&P 500 in the second quarter.
The List of Uncertainties Grows
There is a pervasive sense that the stock market has priced in what is expected to be disappointing guidance. That sets the stage presumably for a relief rally should S&P 500 companies come through on the guidance front.
Simply holding the line on prior guidance, or providing initial guidance that matches the consensus estimate, would qualify as coming through in this instance. Raising prior guidance, or providing initial guidance above the current consensus estimate, would be even better (to state the obvious).
A caveat for any relief rally is in order.
The short-covering spike in the past week was driven in part by not wanting to get whipsawed by any relief rally that might arise during the reporting period. Therefore, it is possible that some stocks will not go up as much as one might think if they deliver on the guidance front.
Nonetheless, barring an exogenous shock, the prevailing trend should be one of higher stock prices in the near term for companies that live up to reporting and guidance expectations.
What happens in the near term, though, is unlikely to change our view that tougher return conditions lie ahead.
The specter of higher taxes sits on the horizon; the EU and China are both implementing measures that should slow the pace of their economic growth; and the labor market in the U.S. remains a very troubled place.
Separately, politics risks adding uncertainty to the economic outlook.
Although the Treasury Department patted China on the back for not being a currency manipulator, there is still a strong current of rancor in Congress regarding that stance, which raises the potential for passing protectionist legislation, or at least jawboning about it, ahead of the mid-term elections.
On a related note, it seems likely that Republicans will stonewall on economic matters in the coming months in a bid to paint Democrats in a negative light for the electorate and to undo their majority control in Congress.
If successful, we could be looking at gridlock in Washington in 2011. That is apt to be looked upon favorably by the market if it were to occur. In the meantime, though, the road to gridlock could be a bumpy one if it entails keeping a new jobs stimulus bill from passing.
The Department of Labor has indicated that 3.3 mln people will lose extended jobless benefits at the end of July if a new stimulus bill is not passed.
Unemployment insurance payouts totaled $141.1 bln in Q1 2010, with $75.2 bln coming from extended benefits. The rise in extended jobless benefits contributed just under 0.2 percentage points to income growth. While this may seem small, total income increased only 1.0% during the quarter.
If extended benefits decline by 3.3 mln by the end of July, all of the income gains would be lost in the second and third quarter. This could be a significant hindrance to consumption growth over the next few months.
This is just one more uncertainty to consider.
--Patrick J. O'Hare, Briefing.com
Patrick J. O'Hare is the Chief Market Analyst for Briefing Research, Briefing.com's new strategic research service. To request a free trial of Briefing Research, please email researchsales@briefing.com.
Corporate Borrowers Feast on Cheap Debt; McDonald's to Pay Record Low Interest
By MARK GONGLOFF, CHRIS DIETERICH And ALEX FRANGOS
The global corporate-bond boom is gathering steam as companies rush to take advantage of some of the lowest borrowing costs in history.
Companies from global giants McDonald's Corp. and Kimberly-Clark Corp. to Indonesian telecommunications company PT Indosat Tbk are rushing to sell debt.
[CORPBONDS]
This month has been the busiest July on record for sales by U.S. companies with junk-credit ratings. Asia's debt market is on pace for a record year, and European companies are also raising money apace.
The low borrowing costs are the culmination of an unprecedented bond-market rally that began in the depths of the credit crisis in late 2008 and early 2009 and has defied every prediction that it would soon run out of steam. But individual and professional investors continue to plow money into the bond market, giving companies a constant source of funds to tap.
With each new leg higher, the bond market gets more expensive and interest rates, which move in the opposite direction of price, fall even lower. If the economy heats up and rates rise, investors gobbling up bonds will get burned as bond prices fall.
But for now, many of the conditions that got bonds rolling in the first place still hold sway. The Federal Reserve has short-term interest rates near zero, investors are leery of stocks, and the economic outlook is too sluggish to spark a robust stock boom but not so bad that it causes companies to default.
Companies big and small are taking advantage of the low rates to bolster their balance sheets and lower their interest costs by millions of dollars for years to come. "I think we are accessing the market at precisely the right time, and a very opportune time," said Stephen De May, treasurer of Duke Energy Indiana, whose subsidiary in early July borrowed $500 million at 3.75%, the fourth-lowest rate on record for a large U.S. corporate borrower, according to Bank of America Merrill Lynch.
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* Vote: Is it a good time to invest in corporate bonds?
McDonald's this week raised $450 million in 10-year debt at 3.5%, a record low yield for a large batch of debt issued by a U.S. corporate borrower. The U.S. government paid more than 3.5% for its 10-year debt as recently as May.
The financial sector has been the busiest player in the bond market so far this year, as it was last year, raising about 48% of total debt issuance globally. Financial firms are paying higher borrowing costs than companies like McDonald's, but their rates are still historically cheap. J.P. Morgan Chase just issued $2.5 billion in 10-year debt at 4.4%.
Interest rates on investment-grade corporate bonds recently averaged just 4%, according to Barclays Capital, the lowest in more than six years, and just 1.7 percentage points above relatively risk-free Treasury debt.
Lower borrowing costs are a boon to corporate profits, which could in turn benefit the broader economy and hiring. Duke Energy Indiana used its debt proceeds to fund power plant construction among other things.
But many companies are simply borrowing to refinance old debt. And many are leaving the cash haul on their balance sheets, bracing for the possibility of fresh crises or leaner growth ahead. That suggests the economic benefit of the borrowing boom could be limited.
[CORPBONDSjmp]
"They're not looking to invest or to take on assets to try and build their business," said Justin D'Ercole, head of Americas Investment Grade Syndicate at Barclays Capital, who helps companies sell new debt.
Corporate bond sales around the world so far have reached about $1.4 trillion this year, lagging behind the record $2.1 trillion for the same period in 2009, according to data provider Dealogic. But offerings were largely put on hold during May and part of June as the sovereign-debt crisis grew in Europe.
As more and more investors pour money into the bond markets—helping fuel the debt sale bonanza—the risks increase they are just hopping on the latest bubble. Observers question whether the bond market can continue to generate such returns and wonder if investors are paying too dearly for corporate bonds that still have risks. "I looked at McDonald's debt and felt marginally the same as if I'd eaten five Big Macs in a row," said Jason Brady, portfolio manager at Thornburg Investment Management in Santa Fe. "It's a great company, but I don't need to own a low-A-rated corporate risk at 3.5%."
Bond investors have enjoyed healthy returns from corporate debt so far. Investment-grade bond returns, which include both the money given back to investors in the form of price increases and regular coupon payments, are up nearly 8% this year. In contrast, stock returns have been slightly negative.
For now, investors seem willing to finance companies at ever-lower rates. And analysts say a large number of companies are waiting in the wings to raise money. "There is a big calendar building," said Steven Miller, the head of Leveraged Commentary and Data group at Standard & Poor's. Many U.S. companies are waiting until after the Labor Day, the unofficial end to the U.S. summer. "If the market stays strong, we will see a burst of issuance," he said.
—Neil Shah contributed to this article.
Share Business ExchangeTwitterFacebook| Email | Print | A A A By Jeff Kearns and Andrew Frye
July 29 (Bloomberg) -- A bullish stock market trade embraced by the smartest money is backfiring. And that has investors wondering if what Warren Buffett and Goldman Sachs Group Inc. know about derivatives is obsolete.
Goldman Sachs, the world’s most profitable securities firm, reported losses from derivatives last quarter after selling insurance that protected clients against stock swings during the Standard & Poor’s 500 Index’s biggest retreat in more than a year. Buffett, the chairman of Omaha, Nebraska-based Berkshire Hathaway Inc., underwrote $37 billion of the contracts since 2004, filings with the Securities and Exchange Commission show.
The combination of hedging by insurance companies, tighter regulation of bank speculation and reluctance among securities firms to write derivatives known as variance swaps means speculators who sold them are now facing losses, according to Morgan Stanley and Societe Generale SA. Money-losing trades in both rising and falling markets show the hazards of the business for even Wall Street’s most sophisticated investors.
“It’s as extreme as I’ve ever seen,” said Neil Davies, head of structured equity products at SunTrust Robinson Humphrey Capital Markets in Atlanta. “There’s a lot of uncertainty in the over-the-counter volatility market, illustrated by the fact that long-dated volatility levels are reminiscent of October 2008. Rumors abound, specifically that some institutions are closing out short positions.”
Playing Volatility
Goldman Sachs said its bets that stock swings would narrow lost money in the second quarter, according to its earnings statement. While the firm didn’t break out the loss, Goldman Sachs said revenue in the division arranging the trades slumped 62 percent from a year earlier to $1.21 billion. Ed Canaday, a spokesman for the New York-based company, declined to comment.
“Primarily in response to our client needs, our equity derivatives business was short volatility entering the second quarter and posted poor results,” Chief Financial Officer David Viniar said on a conference call with reporters on July 20. “We took the other side because you know we deal with our clients all the time,” he said. “We had that position going into the quarter and volatility just spiked.”
The Chicago Board Options Exchange Volatility Index, which ended the first quarter at 17.59, rose as high as 45.79 on May 20 as the S&P 500 lost 8.4 percent. The VIX, a measure of investor expectations for stock swings known as implied volatility, has since decreased to 24.25, or 19 percent above the average over its two-decade history, while the equity index has rebounded 3.2 percent, data compiled by Bloomberg show.
‘Consenting Adults’
“Either they took the position on purpose or they took it because they couldn’t get anyone else to take it,” said Jason Brady, a managing director at Thornburg Investment Management in Santa Fe, New Mexico, which oversees about $57 billion. “There are two consenting adults to every trade on the over-the-counter market or on an exchange. They consented at some level, and maybe their hedges were bad. Maybe they sincerely believed in the trade and they got hung out to dry.”
While demand for insurance against declines in the next 30 days retreated as shares rallied this month, prices for longer- dated protection surged to a record. Ten-year variance swaps, contracts that pay buyers when stock swings increase, are trading at levels that imply S&P 500 volatility is poised to exceed its rate during the 2008 credit crisis, Paris-based Societe Generale’s data show.
Sellers’ Strike
Swaps are agreements between parties to exchange one right for another, while variance swaps let investors speculate on the magnitude of movements by an index. They are a type of derivative, or contract whose value is derived from stocks, bonds, loans, currencies and commodities, or linked to specific events such as changes in interest rates or price fluctuations.
Over-the-counter variance swaps have appreciated so rapidly that firms that sold swaps in January at a volatility level of 28.5 and $1 million per point faced paper losses of as much as about $8.2 million this month when swap rates rose to a record 38.5 points, according to data compiled by Bloomberg and Societe Generale. Their expected gain based on past volatility levels would have been about $5 million, according to Societe Generale.
Life insurers, which sell retirement products with guaranteed minimum returns even in declining markets, rely on derivatives to hedge against stock slumps. Variable annuity sales rose 5 percent in the first three months of the year to $32.4 billion, the first quarterly increase in two years, according to Limra International, a trade group.
‘Liquidity Shortage’
“Wall Street historically has been able to meet demands for longer-dated volatility products,” said Pav Sethi, chief investment officer of Chicago-based hedge fund Gladius Investment Group, which uses variance swaps. “Regulations, tighter risk limits at the banks and a limited number of interested participants have created a large liquidity shortage.”
The financial regulation bill signed into law July 21 by U.S. President Barack Obama strengthens oversight of derivatives and forces banks to take less risk with their own capital. How that will affect banks and insurers isn’t clear yet, causing some institutions to scale back their use of derivatives, Morgan Stanley analysts said in the July 15 note.
“Originally it was large institutions hedging their long- dated exposures,” said Anand Omprakash, an equity derivatives strategist at BNP Paribas SA in New York. “After that started pushing implied volatility levels up, there were other parties who started to cover their short positions. This drove the price up significantly.”
Margin Call
Berkshire lobbied Congress against a higher collateral requirement for previously written derivatives trades under the financial reform law, David Sokol, the head of the company’s energy business, said in April. Buffett, who uses derivatives to speculate on the direction of stock markets, has about $37 billion at risk in equity-linked contracts, whose pricing may be influenced by the variance swaps market. Buffett didn’t reply to a request for comment e-mailed to an assistant.
“He handcuffed himself during the crisis by selling puts at the top of the market,” said Jeff Matthews, author of “Pilgrimage to Warren Buffett’s Omaha,” a Berkshire investor and founder of hedge fund Ram Partners LP. “His whole company is a bet on a rising market over a very long period of time. So to then sell derivatives on the basis of that is doubling the chips on black. And that limits his flexibility when he gets the chance to really deploy massive amounts of capital during the crisis.”
Equity Premium
Berkshire got premiums of $4.9 billion on the equity index puts and is free to invest that cash over the lifetime of the contracts, Buffett said in his letter to shareholders last year. At the time he estimated Berkshire would owe about $9 billion if the four indexes it covers fell 25 percent from their levels when the contracts were written. Buffett has said Berkshire sold the swaps from 2004 to the first quarter of 2008. Buffett’s contracts mature between June 2018 and January 2028.
“We are delighted that we hold the derivatives contracts that we do,” Buffett said in his letter to shareholders in February. “If Berkshire ever gets in trouble, it will be my fault. It will not be because of misjudgments made by a Risk Committee or Chief Risk Officer.”
Berkshire posted $550 million in collateral on the equity index derivatives and its credit default swaps at the end of 2008. As markets recovered in 2009, the requirement plummeted to $35 million at Dec. 31. In the second quarter of 2009, Buffett renegotiated six of the equity index puts to shorten the durations and lower the strike prices.
More Cash
Buffett drew down Berkshire’s $44 billion in cash during the 2008 credit crisis to finance companies whose traditional sources of funding pulled back. Deals to inject $5 billion into Goldman Sachs and $3 billion into General Electric Co. pay 10 percent coupons and boosted Berkshire’s investment income. The premiums gave Buffett more cash to invest, said Thomas Russo, a partner at Gardner Russo & Gardner in Lancaster, Pennsylvania.
“What really did matter was that he had ready cash to invest, $5 billion of it, during one of the great buying opportunities of all time,” Russo, a Berkshire shareholder, said. “He’s been historically unrivaled by his willingness to take on short-term pain for long-term risks.”
The stock market’s retreat from its 2007 peak has led to billions of dollars of charges against Berkshire’s earnings. As of March 31, the Omaha, Nebraska-based company listed a liability of $7.13 billion related to the contracts on its balance sheet, up about 55 percent from the end of 2007.
Investment Income
Buffett says Berkshire has no counterparty risk because it collects premiums at the inception of each contract, and that the collateral requirements are minimal. The 79-year-old investor says he expects the contracts to be profitable, even if Berkshire has to pay out, because of investment income he expects to generate over the decade or two he holds the premium.
“The shadow of Warren Buffett really impacts the psychology of both positive and negative market bets,” said Michael Yoshikami, who oversees about $1 billion as chief investment strategist at YCMNet Advisors in Walnut Creek, California. “Him exiting these trades will impact variance, because his movement alone will increase the anxiety levels in these markets.”
Berkshire Equity Index Options Positions, in Billions:
2010 Assets Liabilities Maximum loss
1Q -- $7.131 $36.760
2004
4Q $0.069 $0.380 $4.626
To contact the reporters on this story: Jeff Kearns in New York at jkearns3@bloomberg.net, Andrew Frye in New York at afrye@bloomberg.net.
By LUCA DI LEO
U.S. economic activity rose only modestly in June and the first half of July, the Federal Reserve said in a report Wednesday, in another sign that the recovery may be running out of steam.
In its latest beige book report, the Fed said economic conditions continued to improve in most of its 12 regional districts, but the advances were modest, with retail sales posting only small gains and housing and construction remaining weak. Bank lending, meanwhile, was still tight.
The Fed said overall activity was broadly flat in the Cleveland and Kansas City districts compared to the previous beige book, while Chicago and Atlanta reported that the pace of economic activity recently slowed. The Atlanta district -- which includes Alabama, Florida, Georgia, and portions of Louisiana and Mississippi -- noted concerns about lower leisure travel to the Gulf Coast.
The U.S. economy has been expanding at a moderate pace for most of the past year, gradually recovering from the deepest recession in many decades. However, economic data for June have pointed to a possible slowdown, especially in consumer spending and in an already weak housing sector.
The beige book is a summary of economic activity prepared for use at the U.S. central bank's next policy-setting meeting Aug. 10. The latest report, prepared by the Federal Reserve Bank of St. Louis, examined economic conditions across the Fed's 12 districts based on information collected on or before July 19.
In its previous report, released June 9 and referring to May and April, the Fed said economic activity had improved across all of its 12 districts.
"Manufacturing activity continued to expand in most districts, although several districts reported that activity had slowed or leveled off during the reporting period," the Fed said. Manufacturing has been leading the recovery.
Retail sales reported during the early summer months were generally positive, the Fed said, although the increases were small in most regions. Most Fed districts that reported on auto sales noted declines in recent weeks.
Meanwhile, bank credit remained tight in most of the country and some areas noted soft or lower levels in overall loan demand.
At their last meeting June 22-23, Fed officials trimmed their forecast for U.S. economic growth, citing the deterioration in financial markets that followed Europe's sovereign debt crisis.
Last week, Chairman Ben Bernanke warned there was "unusual uncertainty" over the economy's outlook. He told Congress the Fed, which has already slashed interest rates close to zero, was ready to take further measures to support the economy if necessary.
District-by-District Summaries
View Interactive
* More photos and interactive graphics
Sluggish housing markets were reported across most areas since the homebuyer tax credit expired at the end of April. While Boston and St. Louis reported an increase in May and June home sales on a year-over-year basis, the Fed said some of its contacts noted that these sales may reflect closings of homes under contract by the April tax credit deadline.
"The Boston, Philadelphia, Atlanta, and Kansas City Districts reported that home sales are expected to weaken going forward," the central bank said.
Tourism increased across the Fed districts, but the Atlanta district noted concerns about decreased travel to the Gulf Coast, which has been ravaged by a massive oil spill.
Labor market conditions improved only gradually in most parts of the U.S. The Fed districts of New York, Chicago, Minneapolis, Richmond, and Atlanta all reported improved job market conditions, albeit modestly in some cases. Boston and Dallas reported that employment was steady.
The U.S. economy shed jobs in June for the first time this year and the unemployment rate remained high, adding to concerns that the pace of the recovery could slow in the second half. The number of U.S. workers filing new claims for unemployment benefits jumped in the July 17 week, the latest week for which data are available, reversing declines posted the prior week and signaling there is still little improvement in job-market conditions.
FRANKFURT—Germany outlined its objections to the revised Basel banking rules proposals announced Monday, but its concerns didn't deter investors who drove bank stocks sharply higher across Europe.
The Basel Committee is part of the Bank for International Settlements, shown above in Basel, Switzerland.
.German officials balked at the new rules aimed at shoring up the global banking system, referred to as Basel III, saying the rules would unfairly penalize the thousands of saving and cooperative banks that provide financing for many of the small and medium-size businesses that power Germany's economy.
European bank stocks, including German banks, rallied Tuesday because the revised Basel III rules, while tougher than current regulations, are considered less severe than the initial Basel III proposals announced last December. A bank-led surge helped boost the Athens ASE index 4.1%, the strongest country performance in Europe Tuesday.
The U.K.'s Barclays PLC was another beneficiary; its shares rose 7.6%. Analysts had worried that a provision of the original Basel proposal, revised Monday, would have punished the bank for its stakes in U.S. money manager BlackRock Inc. and South African bank Absa.
Not everyone sees the new rules as positive. The package agreed to Monday in Basel included a footnote that "one country still has concerns." Germany's central bank, the Bundesbank, and its financial regulator, Bafin, confirmed Tuesday that Germany was the holdout.
"Germany wants to give its approval, but not until all the details are on the table," a Bafin spokesman said.
A person familiar with the German position said the vote on Basel III should never have gone ahead so early. Delegates didn't have all the information they required before taking a vote, the person said, recounting the German position. A spokeswoman for the Basel Committee declined to comment.
Germany's hesitance is centered on the use of "silent participations" in its savings banks, known as Sparkassen, and state-sector regional banks, known as Landesbanks. Silent participations are nonvoting shares, including government loans, that buffer bank capital positions and often come with a set date for repayment to the investor.
Germany had successfully lobbied for full recognition of silent participations when the current Basel II framework was negotiated.
But other countries want only a minimal share of banks' core capital to come from sources other than common equity and retained earnings. The Bundesbank has said it wants a bigger share to be eligible.
Germany's cooperative banks, another pillar of the banking system, have also expressed dissatisfaction with the proposed rules, saying they lacked clarity about future capital ratios.
Other countries have cooperatives and savings associations, but those networks are much more extensive in Germany, where they make up as much as half of bank assets. Unlike private banks and the Landesbanks, savings banks and cooperatives weren't highly exposed to mortgage-backed securities during the financial crisis. Instead, they tended to remain focused on lending to local firms in their regions, limiting their exposure to the global financial crisis. Germany has recovered from the recession faster than its peers in Europe, and is expected to have grown as much as 5%, at an annualized rate, in the second quarter.
German officials insist a deal is reachable. "It would be wrong to say that we won't be able to find an agreement," said German finance ministry spokesman Martin Kreienbaum. Officials are under pressure to wrap up new capital requirements before the Group of 20 summit meeting in November, in Seoul.
Ultimately, Germany's acceptance of a final agreement will hinge on two key issues: a definition of acceptable capital and how much capital a bank must hold to meet Basel III criteria, the person familiar with Germany's position said. Germany argues that the two issues are so interconnected that a change in the definition of capital would require an adjustment in the calibration of minimum holdings. German officials believe the two issues must be decided at the same time, this person said.
Despite its reservations, Germany didn't come away empty-handed from the Basel negotiations. Officials in recent weeks lobbied the Basel committee to rework the proposed "leverage ratio," which is intended to restrain banks from bulking up on risky assets without holding large capital buffers. Monday's agreement said changes to leverage ratios wouldn't be mandatory until 2018.
German officials had resisted the proposal partly due to concerns about its impact on Deutsche Bank AG, according to people familiar with the Basel negotiations. The bank said it welcomed the revisions. announced Monday
Germany's withholding of its support from Monday's Basel agreement marks the second time in four days that the country has stood alone on a key banking issue. Last week, when the European Union disclosed the results of its stress tests of 91 banks, most banks revealed their holdings of EU government bonds, hoping to address a key source of investor anxiety in recent months.
But several German banks refused to follow suit. The surprise move caused investors to wonder what sovereign bonds were on the banks' books.
On Tuesday, Deutsche Bank reversed course and disclosed its sovereign-bond portfolio. The lender said it is holding more than €10 billion ($12.99 billion) of debt issued by the Greek, Italian and Spanish governments—considerably more than the bank previously had disclosed.
Germany's failure to release details of its bank's sovereign-debt holdings Friday was unintended, the Bafin spokesman said.
"Due to a misunderstanding in the communication, six German banks failed to publish their levels of sovereign debt Friday," the spokesman said. "The details have since been published."
—Geoffrey T. Smith and David Crawford contributed to this article.
Write to Brian Blackstone at brian.blackstone@dowjones.com and David Enrich at david.enrich@wsj.com
Daily trading volumes in Australia soared by 54% in the year to April. Above, pedestrians are seen reflected on a foreign currency exchange board in Sydney.
The global currency-trading business expanded at a double-digit rate in the six months to April this year, data from key monetary authorities around the world showed Monday.
The strong growth puts the foreign-exchange market on track to top a record $4 trillion in daily trading volume, extending its recovery after the global recession caused activity to dry up in the first part of 2009.
Worries over the euro zone's sovereign debt crisis and concern over the pace of the global recovery are likely to keep volatility—the main driver behind the currency market's recent trading rebound—high. At the same time, the growth in Australian trade volume is a reminder of a deeper underlying shift as investors and companies move their exposure from the advanced economies of Europe and the U.S. toward Asia and emerging markets.
Still, that is a longer-term trend. For the most recent half-year, "no question, front and center was the euro," said Jeff Feig, managing director and global head of Group of 10 foreign exchange at Citigroup and the chairman of the Foreign Exchange Committee sponsored by the Federal Reserve Bank of New York.
"The volume growth was really a result of the volatility and the fact that you had real end users actively hedging their exposures." Worries over the euro zone's debt crisis prompted corporations and other investors to shield themselves from sharp swings in the common currency by turning to the perceived safety of the dollar, yen and Swiss franc.
Currency trading flows in the U.K., the world's biggest dealing hub, grew by 15% in six months to April, taking the daily average to $1.747 trillion, data released by the Bank of England showed Monday.
In the U.S., daily currency flows grew by a slightly more modest 12% to $754 billion in the six months to April, but that total was just shy of the record $762 billion seen in October 2008. The total includes spot transactions as well as currency derivatives.
London grabs roughly one-third of global currency-trading flows, with New York taking around one-fifth. Other trading hubs around the world account for the remaining half. Central banks and other monetary authorities in each of the major trading center compile trading volume statistics on an annual, or semiannual basis.
Daily trading volumes in Australia soared by 54% in April from a year ago, taking the total to $191.2 billion as the Australian dollar, with its commodities-related exposure to China, was traded as a proxy for the Chinese yuan, analysts said. Japanese flows grew by 16% to $294.1 billion over the same period.
The world-wide daily foreign-exchange market should now stand at more than $4.1 trillion, according to an HSBC report. That is a 28% jump from the $3.2 trillion figure established in 2007 by the Bank for International Settlements in its latest survey. The BIS is due to update the official figure later this year. Still, the pace of growth is slower than the previous three-year period, when volumes grew 63%.
In daily trading action late Monday in New York, the euro was at $1.2997, from $1.2918 late Friday; the euro advanced as far as $1.3006. The dollar was at 86.89 yen from 87.45 yen late Friday, while the euro was at 112.91 yen from 112.98 yen. The U.K. pound was at $1.5485 from $1.5432. The dollar was at 1.0485 Swiss francs from 1.0527 francs.
—Michael Casey contributed to this article.
Write to Katie Martin at katie.martin@dowjones.com and Bradley Davis at bradley.davis@dowjones.com
Jul 26th 2010, 16:34 by The Economist online | SÃO PAULO
WHEN, in 2001, Goldman Sachs dreamt up the acronym BRICs for the largest emerging economies, the country that most people said did not belong in the group was Brazil. Today, the leading candidate for exclusion is Russia. But some prominent observers are still sceptical about Brazil’s prospects. A notable example is Martin Wolf, the chief economics commentator of the Financial Times, who recently (and very reasonably) pointed out that Brazil’s share of world output has actually fallen over the past 15 years, from 3.1% in 1995 to 2.9% in 2009 at purchasing-power parity. “Brazil cannot become as big a player in the world as the two Asian giants”, China and India, Mr Wolf concludes.
At a recent meeting with a group of investors in Hong Kong, Rubens Ricupero offered an intriguing counterargument. A long-serving and respected Brazilian diplomat, Mr Ricupero was the secretary-general of the United Nations Conference on Trade and Development from 1995 to 2004. Although he has links to the opposition to Brazil’s ruling Workers’ Party—he previously served as finance minister in the government of a rival party—his analysis is not party-political. “For the first time in its history,” he argues, Brazil is enjoying “propitious conditions in four areas that used to pose serious limitations to growth.” They are:
Commodities. Commodity production used to be regarded as either a curse or, at best, something countries ought to diversify away from as quickly as possible (which Brazil itself did in the 1970s). But over the next fifty years, Mr Ricupero notes, half the expected increase in the world population will come from eight countries, of which only one—America—is not sucking in commodities at an exponential rate of increase. The others are China, India, Pakistan, Nigeria, Bangladesh, Ethiopia and Congo. China alone will account for 40% of the additional demand for meat worldwide, he points out. This demand will remain strong partly because of rising population and partly because of urbanisation, which increases demand for industrial commodities (like iron ore to make steel) and meat (because urbanisation changes eating habits). Brazil is already a large iron-ore producer, and has transformed itself into an agricultural powerhouse over the past 10 years, becoming the first tropical country to join the ranks of the dominant temperate-climate food exporters such as America and the European Union. It is well-placed to benefit from the emerging markets’ commodity boom.
Petroleum. Mr Ricupero argues that the success of the Brazilian state oil company, Petrobras, in offshore oil exploration has transformed Brazilian energy. “Although no precise and final estimates can be made yet of the [so-called] pre-salt oil reserves potential of the Santos Basin,” he says, “all serious indications point to the high likelihood that Brazil is poised to become at least a medium-sized net oil-exporting country.” New oil and gas deposits far away from the volatile Middle East should increase Brazil’s strategic importance, as well as improving its balance-of-payments position.
Demography. Brazil is reaping a big demographic dividend. In 1964, its fertility rate (the average number of children a woman can expect to have during her lifetime) was 6.2. It fell to 2.5 in 1996, and is now below replacement level, at 1.8, one of the sharpest drops in the world. The result has been a collapse in the dependency ratio—the number of children and old people dependent on each working-age adult. As recently as the 1990s, that ratio was 90 to 100 (ie, there were 90 dependents, mostly children, for each for every 100 Brazilians of working age). It is now 48 to 100. Thanks to this, Brazil no longer has to build schools, hospitals, universities and other social institutions helter-skelter to keep pace with population growth. Eventually, the ratio will creep back up as today’s workforce enters retirement, but such problems remain decades ahead. In the meantime, Brazil can pay more attention to the quality rather than the quantity of its social spending, which should, in theory, improve the population’s education, health, and work skills.
Urbanisation. Urbanisation both encourages economic growth and accompanies it. But it also causes problems. “Many of the worst contemporary problems in Brazil,” Mr Ricupero says, such as “lack of educational and health facilities, poor public transportation, marginalisation and criminality, stem from [an] inability to cope with internal migrations in an orderly and planned way.” That is now changing, he argues. The waves of migrants out of the countryside and into the cities have more or less finished. Brazil is now largely an urban country: about four-fifths of the population lives in cities. “For Brazil,” he concludes, “the period of frantic and chaotic growth of big cities that is now taking place in Asia and Africa is already a thing of the past.”
Mr Ricupero is relatively cautious about the conclusion. “The four sets of conditions outlined above,” he says “are by no means sure guarantees of automatic success.” He admits Brazil has fallen behind in infrastructure, for example, and says that, if it had the sort of infrastructure you see in Costa Rica and Chile (the two best examples in Latin America), economic growth would be about two percentage points higher per year. On the other hand, Brazil also has some other advantages: unlike China, Russia and India, it is at peace with its neighbours (all 10 of them). Whether you think all this really amounts to a rejoinder to Mr Wolf is a matter of doubt. Brazil might still remain a relatively small player in the world. Still Mr Ricupero’s points are, at least, actually happening (not things expected in future), can be measured in concrete terms and are long-term (they should continue for decades). Who knows? Perhaps they might even be right.
Conventional economic models failed to foresee the financial crisis. Could agent-based modelling do better?
Jul 22nd 2010
MAINSTREAM economics has always had its dissidents. But the discipline’s failure to predict the financial crisis has made the ground especially fertile for a rethink.
Critics tend to agree on what is wrong with current macroeconomic forecasting. A hearing of the House of Representatives Committee of Science and Technology on July 20th targeted the “dynamic stochastic general equilibrium” (DSGE) models used by the Federal Reserve and other central banks. The hearing aimed to “question the wisdom of relying for national economic policy on a single, specific model when alternatives are available.” The Institute for New Economic Thinking in New York, which had its inaugural conference in April, has attacked many of the assumptions, including efficient financial markets and rational expectations, on which these models are predicated. These assumptions were clearly too simplistic. But there is less agreement on what should replace the old ways.
One of the most promising options was the topic of a workshop in Virginia at the end of June. The workshop was funded by America’s National Science Foundation and attended by a diverse bunch that included economists from the Fed and the Bank of England, policy advisers and computer scientists. They were there to explore the potential of “agent-based models” (ABMs) of the economy to help learn the lessons of this crisis and, perhaps, to develop an early-warning system for the next one.
Agent-based modelling does not assume that the economy can achieve a settled equilibrium. No order or design is imposed on the economy from the top down. Unlike many models, ABMs are not populated with “representative agents”: identical traders, firms or households whose individual behaviour mirrors the economy as a whole. Rather, an ABM uses a bottom-up approach which assigns particular behavioural rules to each agent. For example, some may believe that prices reflect fundamentals whereas others may rely on empirical observations of past price trends.
Crucially, agents’ behaviour may be determined (and altered) by direct interactions between them, whereas in conventional models interaction happens only indirectly through pricing. This feature of ABMs enables, for example, the copycat behaviour that leads to “herding” among investors. The agents may learn from experience or switch their strategies according to majority opinion. They can aggregate into institutional structures such as banks and firms. These things are very hard, sometimes impossible, to build into conventional models. But in an agent-based model you simply run a computer simulation to see what emerges, free from any top-down assumptions.
Although DSGE models are also based on microeconomic foundations, they accept the traditional view that there exists some ideal equilibrium towards which all prices are drawn. That this is often approximately true is why DSGE models perform well enough in a business-as-usual economy. They do badly in a crisis, however, because their “dynamic stochastic” element only amounts to minor fluctuations around a state of equilibrium, and there is no equilibrium during crashes.
ABMs, in contrast, make no assumptions about the existence of efficient markets or general equilibrium. The markets that they generate are more like a turbulent river or the weather system, subject to constant storms and seizures of all sizes.Big fluctuations and even crashes are an inherent feature. That is because ABMs contain feedback mechanisms that can amplify small effects, such as the herding and panic that generate bubbles and crashes. In mathematical terms the models are “non-linear”, meaning that effects need not be proportional to their causes.
These non-linearities were clearly on show in the credit crunch. At the workshop Andrew Lo of the Massachusetts Institute of Technology presented a model of the American housing market, inspired by ABM approaches, which showed how a fateful conjunction of rising house prices, falling interest rates and easy access to refinancing created an awesome burden of debt. John Geanakoplos of Yale University explained how the debt cycle in remortgaging—high amounts of leverage during booms, low amounts during recessions—can act like an out-of-control pendulum to create instability. Sujit Kapadia of the Bank of England is trying to model the web of interdependencies created by the use of complex derivatives. These “network-based vulnerabilities” are just the kind of thing that ABMs are good at capturing.
Model behaviour
Another big lesson of the crisis is the role of interactions between different sectors of the economy—housing and finance, say. Although conventional models can incorporate these, ABMs may be better tailored to modelling specific sectors. The organisers of the Virginia workshop—Doyne Farmer of the Santa Fe Institute and Robert Axtell of George Mason University—wanted to explore the feasibility of constructing an immense ABM of the entire global economy by “wiring” many such modules together.
What might be required for such an enterprise? One vision is a real-time simulation, fed by masses of data, that would operate rather like the traffic-forecasting models now used in Dallas and in the North Rhine-Westphalia region of Germany. But it might be more realistic and useful to employ a suite of such models, in the manner of global climate simulations, which project various possible futures. In either case, the models would need much more data on the activities of individuals, banks and companies.
Such data-gathering raises privacy fears but is essential. Seismologists may not be able to forecast earthquakes precisely but it would be deplorable if they were to resign themselves to modelling just the regular, gradual movements of tectonic plates. Instead they have developed ways of mapping the evolution of stress patterns, identifying areas at risk and refining heuristics for hazard assessment. Why not do the same for the economy?
upply of Homes Set to Grow .ArticleComments (17)more in Real Estate Main ».EmailPrintSave This ↓ More.
Sales of new homes are near 47-year lows, yet the supply of new and existing homes is expected to grow in the months ahead as construction ramps up and a wave of foreclosed homes hits the market.
In June, new-home sales were running at a seasonally adjusted annual rate of 330,000 units, the Commerce Department said Monday. While that was up 23.6% from the all-time low of 267,000 in May, the June figures were the second lowest on record.
Guillermo Hurtado walks through a single-family home under construction this month in Thornton, Colo.
."What we're really seeing here is that new-home sales are at what I'd call rock bottom," said Steve Blitz, an economist at Majestic Research in New York. "The last time we were running these kinds of numbers was the 1982-1983 recession, when we had 100 million less people."
LPS Applied Analytics, a firm that tracks mortgage data, said Monday that there were 4.56 million loans in default or in some stage of foreclosure in June, down slightly from May. But the number of new foreclosures initiated on properties backed by Fannie Mae and Freddie Mac increased sharply, rising 21% in June from May.
The rise in foreclosures on Fannie and Freddie properties reflects the failure of many troubled borrowers to receive permanent loan modifications plans, analysts said. Having exhausted all options to rescue their homes, many troubled borrowers may now be giving up.
Is Mr. Market Being Too Harsh on KB Home?. Access thousands of business sources not available on the free web. Learn More ."Looking at the numbers you're seeing about this pickup in foreclosure starts, it's hard to see how it's not going to translate into elevated levels of [properties taken over by banks] down the road," said Herb Blecher, an analyst at LPS.
Home builders, which began buying up land lots late last year in anticipation of an economic and housing rebound, are stuck with thousands of acres that are prone to lose value as the market struggles. Many will build homes on the land, rather than write off its value and wait for the market to improve.
"Builders are willing to pay a premium to not have that risk on their hands. They're still facing a tremendous amount of stress," said Brad Hunter, chief economist at Metrostudy, a housing-market research firm based in Houston. "They're discounting the homes, they're making very small profit margins, but they're building homes. They're very interested in securing market share."
Several former bubble markets are seeing the biggest increase in home construction. According to Metrostudy, new-home starts in the second quarter show signs of rising 68.1% in South Florida, 83.7% in Naples/Ft. Myers, 65.1% in Las Vegas and 59.7% in Denver from the same period in 2009.
Other indicators also point to builders preparing to increase home construction, despite lagging sales. The number of finished vacant lots, or parcels of land that have been developed and readied for building, stands at about 1.2 million nationwide, according to Metrostudy, or just 5% below the peak in late 2008.
Most metro areas are flush with vacant homes as well: Metrostudy found that of the 48 metro areas the firm covers, only four—northern Virginia, San Antonio, Houston and Baltimore—have what is considered a "balanced" inventory of unsold homes, or about three months' supply or less.
Coastal Southern California, which includes many of the cities near Los Angeles, has an ample supply of builder-ready land—about two years' worth—owned by banks, developers, investors, the government and the builders themselves, which are starting construction in earnest.
Irvine Co., a large land developer and master planner in the coastal region, said it presold 570 homes in the northern portion of its Irvine Ranch project in the first six months of the year, and the $300 million construction will begin soon. The company also has plans to start 700 to 800 additional homes in the coming months, using builders both public and private, including KB Home Inc., TRI Pointe Homes Inc., Van Daele Homes and Brookfield Homes.
"We're doubling down," said Dan Young, who heads Irvine Co.'s community-development and home-building division. "While the national home builder is probably still right to say things are still weak, and the mass market is not back, we are seeing improvements in local markets."
But as inventories grow, it could put further downward pressure on home prices. The median price of a new single-family home has been falling steadily since its 2007 peak of $247,000. Monday's numbers put the median price in June at $213,400.
Credit Suisse analyst Dan Oppenheim wrote in a note Monday that sales are probably worse than the Commerce Department's initial report and predicted further declines in home prices, based on continued weak demand.
"The low level of activity [even with the reported increase] is well below desired absorption levels of builders and will lead to additional pressure on home prices," he wrote.
Underinvestment in
infrastructure
manufacuturing/tradable sector
By Michael Spence
As the International Monetary Fund warned on Thursday, America’s economy shows worrying signs of weakness. Worse, and in common with other developed countries, it also lacks a credible strategy for longer-term growth. Without such a strategy, a strong global recovery is unlikely.
The structural evolution of the US economy over the past 15 years has been driven by excess consumption, enabled by debt-fuelled asset inflation. The crisis put a stop to this, but structural deficiencies remain.America’s export sector is too small and underdeveloped. The financial sector became outsized, and is down-sizing.
A pattern of underinvestment in infrastructure has left the economy less competitive than it should be. Energy pricing issues have been ignored, causing underinvestment in urban infrastructure and transport. The education system has widespread problems with efficiency and effectiveness. Elsewhere, state budgets are in distress as a result of insufficiently conservative budget policies.
Even with a fiscal strategy that balances short-term stimulus and longer- term stability, America must still address the composition and size of expenditures, investments and revenues.To finance growth-supporting long-term investments, domestic private consumption has to shrink. This means higher taxes.In addition, existing government expenditure must be shifted away from consumption and towards investment, meaning fewer government services. Restoring fiscal balance in a way that supports longer-term growth will therefore be painful.
But even that is not enough. The real issue is employment: not just stubbornly high unemployment, but a bigger problem described recently in a thoughtful article by Andy Grove, the long-time chief executive of Intel. He argued that manufacturing is vanishing in the US, a trend that must be reversed. The question is how.
There is little doubt that America’s social contract is starting to break. It had on one side an open, flexible economy, and on the other the promise of employment and rising incomes for the motivated and diligent. It is the second part that is unravelling.
Incomes in the middle-income range for most Americans have stagnated for more than 20 years. Manufacturing jobs are moving offshore. Globally the set of goods and services that is tradable is expanding, but the US and other advanced countries are not competing successfully for an adequate share of the tradable sector.
The employment effects of these trends over the past 15 years have been masked by excess consumption and the overdevelopment of sectors such as finance and real estate. The latter are now set to shrink, as multinational companies grow where they have access to high-growth emerging markets in Asia and Latin America. Such companies will locate their operations where market and supply chain opportunities lie. In the tradable sector, in manufacturing and in a growing group of services, that means outside advanced countries.
The availability of low-cost, disciplined labour forces in developing countries reduces the incentive for these companies to invest in technologies that enhance labour productivity in the tradable sectors of the advanced economies. As a result, the evolving composition of advanced economies is increasingly weighted towards the non-tradable sector, combined with a set of high-end tradable services where both human capital and proximity matter. The rest of the tradable sector is shrinking.
The shrinkage creates problems. Over-specialisation could threaten independence and national security. Spillovers between R&D, product development and manufacturing will be lost if manufacturers leave. Employment will stagnate. Income distribution will move adversely and the social contract will erode further.
Solutions to these problems are not easy to find. The unequal distribution of income can be dealt with through the tax system, although this does not attack the underlying problem. Protectionism could alter the pattern of out-migration of manufacturing, but only by imposing costs on domestic consumers and risking the breakdown of the open global economy model.
To avoid an outbreak of protectionism, there has to be an alternative. President Barack Obama’s new export council, announced on Wednesday, is a step in the right direction. But a bolder move is needed: a broad public-private partnership to invest in the development of technology in parts of the tradable sector where there are opportunities to make advanced countries competitive.The goal must be to create capital-intensive jobs that have labour productivity levels consistent with advanced country incomes.
Would this damage developing countries? Clearly not. The US (or even developed economies combined) does not have hundreds of millions to employ. A targeted programme would leave the vast majority of labour-intensive manufacturing right where it is now: in the developing world. With new credible growth strategies in America (and other advanced countries) developing countries may even be willing to play an important complementary role in restoring global demand through, for example, the reduction of excess savings.
We are already on a lengthy and bumpy road to a new normal. That is unavoidable. The risk is that without a new direction in American economic policy, the new normal may be as unpleasant as the journey.
The writer received the 2001 Nobel memorial prize in economics and chairs the Commission on Growth and Development
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