Wealth Effects

Shared by my friend David Kotok:Image

More on Markets and Wealth Effects
February 23, 2013

We are scheduled for a half hour with Pimm Fox on Bloomberg TV, Monday, February 25, at 5 PM.  We plan to discuss our recent commentary on markets and wealth effects.  See www.cumber.com  for a copy. We are also scheduled for a half hour on Bloomberg radio on Tuesday morning, February 26, at 8 AM with Tom Keene and Mike McKee.  I suspect the subject of wealth effects and markets will be on the agenda. We look forward to these discussions on Monday night and Tuesday morning.


Many thanks to readers for the comments on the “wealth effect” piece.  Thanks also for the links to other research on this subject.  Let’s try to hit a few key points raised in emails.


Liz Webbink, a skilled economist and long-time friend, noted a technical error.  I believe, on rereading my text, that she is correct.  She suggested a slight change.  Many readers do not know that a reduction in debt is an increase in savings.  How that debt is reduced is not part of the calculation.  So if you pay down your mortgage, your household savings rate rises.  And if you sell with a short sale and the mortgage is reduced because a bank takes a loss, your household savings rate also rises.


I wrote, “For the extended, ’93-’12 period, including the financial crisis, the elasticity level reached 0.99. That is, under present circumstances nearly 100 percent of income in the US is spent on personal consumption, when it is adjusted into real terms.”


Liz suggested “For the extended, ’93-’12 period, including the financial crisis, the elasticity level reached 0.99. That is, for each dollar of additional income, 99 cents was spent on personal consumption. Consumers were able to save 5 cents per incremental dollar of income because of the reduction in debt through foreclosures.”  Liz also suggested I give readers a link for those who want to delve into this detail.  Thank you, Liz. 


Readers may find this useful:   “A Guide to the National Income and Product Accounts of the United States (NIPA)”.  See: http://www.bea.gov/national/pdf/nipaguid.pdf .


Some readers asked how high the stock market would have to go to offset the payroll tax hike.  That is difficult to estimate, but we will try.  Think of it like this.  The payroll tax hike is about $125 billion in a permanent shift.  If the Credit Suisse elasticity estimates are correct, we would need to multiply that number by about 100 in order to derive the wealth effect needed from stock prices that would offset the reduction of income.  That means stocks would need to rise about $12.5 trillion in market value, implying a 60% permanent upward market move.


Of course, that silly calculation assumes there is no change in the housing wealth effect.  But we know there would be one, and we have the Credit Suisse estimates that housing has about 3 times the elasticity of stocks.  Let’s simplify.  A $4 trillion increase in the value of the housing stock would generate about the same consumer spending as a $12 trillion increase in stock prices.  Either one would be about enough to offset the $125 billion negative effect of the payroll tax hike.


If we think of the housing stock as worth about the same as the stock market in this post-crisis recovery period, we can estimate a combined housing and stock market outcome.  Let’s assume that housing and stocks each start from a present base of around $18 trillion.  A crudely estimated 12-15% increase in the national housing stock value and a crudely estimated 25-30% increase in the stock market price level would combine to give us enough positive wealth effect to offset the 2% payroll tax hike.


Now, I hope you can see why the 2% hike delivered to us by President Obama, the Democrats in the Senate and the Republicans in the House was about as dumb a thing as one can conceive.


Dear clients, consultants, professional colleagues, and all readers.  At our firm we do not manage policy.  We manage portfolios.  We do not like this policy of taxing working Americans while engaging in class warfare against wealthy Americans.  If we were the czar, we would not do it.  But our job is to look at markets and what they will do and why.


The present tax policy combined with very slow growth and cheap money will widen the divide between the rich and poor.  If you work and live in America and earn $113,700 or less, you have been kicked in the gut by your president, your senator and your congressman; it makes no difference which political party she or he belongs to.  They have all hurt you. 


If you have accumulated some wealth, you now face a prolonged period of rising asset prices.  Stocks, real estate, precious items, art, collectibles and anything else that benefits from a widening class divide is a target for appreciation.  You also face a long period of very low income on your savings.  That means you must change the way you invest. 


In the very long run this is a terrible policy for America.  In the next few years it means a very bullish investment climate.


David R. Kotok, Chairman and Chief Investment Officer


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Will you be my Valentine?

So asked my friend David Kotok:

Meredith, Will You Be My Valentine?
February 14, 2013

Meredith, Will You Be My Valentine?

On Thursday, February 7, as I do most days, I watched Bloomberg Television’s Surveillance from an exercise bike while sipping my morning coffee.  Sara Eisen, Scarlet Fu, Tom Keene, and Mike McKee were interviewing Meredith Whitney.

First disclosure: Meredith Whitney and I have had our disagreements over municipal bonds and municipal bond strategies.  This was exacerbated by her infamous call on 60 Minutes, in December, 2010.

In the recent Bloomberg interview, Meredith sponsors the notion that the banking sector is improving and that the results will reflect in bank stocks. The case she makes for the sector is bullish.

We completely agree with her on this issue. We think her recommendations and her arguments are sound. In the banking sector, she is our Valentine pundit.

Second disclosure: Cumberland has been overweight the banking sector and financials since this bull market started. We use only ETFs.  The ones we own represent regional banks, big banks, insurance companies, and small specialty types of financial institutions. Those ETFs as a group are overweight banking relative to the benchmark index. We are fully invested, according to our internal asset-allocation weighting models.  We believe these assets will attain much higher prices over time.

Meredith Whitney established herself in the banking sector with a famous call about Citigroup. We agreed with her call then, and we agree with her banking sector call now. While our job is not to make calls but to manage portfolios, we believe it is correct to praise where praise is due.  In the banking sector, Meredith has and does earn that praise.

One of the big issues that prompted our public disagreement with Whitney involved her call on municipal bonds. In that call she articulated a prediction that “hundreds of billions of dollars worth of defaults” would occur.  Furthermore, she expected that it would happen in 2012.  We disagreed.

Our view on Munis has several components.  First, some municipal bonds default every year.  Most of them are in the junk-credit category or are tied to specific projects.

Second, we see no way that annual defaults could reach Meredith’s massive numbers.  This is especially true with the ongoing quantitative easing by the Federal Reserve.  Furthermore, municipal finance is slowly improving in credit quality in many jurisdictions due to the ongoing economic recovery. That recovery, underway since 2009, is proceeding at a slow but gradually increasing pace.

Third, Meredith ignored the idiosyncratic nature of tax-exempt municipal securities. There are approximately ninety thousand issuers in the US, which fall under the governance of nearly that many state and local jurisdictions; and the claims upon them are equally various. You cannot paint the tax-free or taxable municipal bond sectors with a single broad brush. That just does not work. It did not work with her 60 Minutes prognostication, and it did not work for those investors who thought that they could buy insured bonds and that those bonds were all gilt-edged.  That is and was a fundamental flaw in certain bond funds.

In order to successfully invest, own, or lend your money to a municipality, or to otherwise place capital in the municipal bond sector, you must carefully research the credit and structure of the specific instrument. There is a vast difference between the nature of a general-obligation pledge versus a budget funded by an annual appropriation in a city in California.  There are very strongly monopolistic government franchises, such as the NJ Turnpike. Essential-service revenue bonds are available with tight liens and claims to secure the bond holders.  Many Munis are quite solid when it comes to credit.

In the February 7th Bloomberg interview, Meredith Whitney was asked specifically about her history with the municipal bond call. Readers can judge her response for themselves.   See her interview on www.Bloomberg.com  at http://www.bloomberg.com/video/meredith-whitney-on-banks-muni-bonds-s-p-10giez13Snq8LNMtkVZX~g.html  .

Her famous “100 billion dollar default” interview is here:  http://www.youtube.com/watch?v=hI-rIGyLri4  .

Our view is that one must do the analysis on credit.  There are many opportunities in the municipal bond sector.  Default on them is unlikely and default in a massive scale is also unlikely.

To Meredith and to all readers, we wish you a happy Valentine’s Day.

David R. Kotok, Chairman and Chief Investment Officer

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Currency War

Has come at a time when the Water Snake ushers in the Lunar New Year and this is a reminder from my friend David Kotok:

Currency War?
February 11, 2013

“Currency War” is the latest hot title. It’s now on the front pages, triggered by the policy change in Japan. In only two months the Japanese yen has weakened about 15% against the US dollar.


Let’s reflect on this important development.


First, a simple case study.  Suppose there were just two countries and just two currencies.  Suppose country A decided to try to weaken its currency so it could sell more stuff at cheaper prices to country B, thus undercutting B’s domestic producers.  B could resist by raising a tariff on the incoming stuff that A was trying to sell. Or it could retaliate by cheapening its own currency to counter the price differential.  The first form of retaliation is a trade war; the second is a classic currency war. The economic history of the 1930s is replete with examples of each and combinations of both.  History shows us that the results were disastrous for the global economy and led to a world war.


But is there a third alternative? What about the role of interest rates?


Suppose A announced that it wanted to weaken its currency by 5% against the currency of B.  Furthermore, suppose A said it would do so over the course of one year.  Then A proceeded to print more currency and use it to buy B’s currency, changing the exchange rate between A and B.  Now let’s assume that B knew from earlier experience that retaliation would only lead to war, so B decided to do nothing.  B also knew that in the longer term its citizens would benefit from a stronger currency, and B was confident enough and self-sufficient enough to allow A to cheapen itself for short-run gain.  By doing nothing, B allowed the markets to make an adjustment.  Suppose, also, that interest rates were not influenced by central banks’ actions.  The markets would quickly price a 5% spread in the interest rate.  At the one-year target maturity, the interest rate on debt denominated in currency A would be 5% higher than the rate on equivalent debt denominated in currency B.  In a normal, clearing market, that is the way the adjustment occurs.


Japan is the leading candidate for the role of country A, given the policy changes announced and those still to come.  The rest of the world is trying to figure out how to be a country B while being savvy enough to avoid deterioration into a trade war or currency war.


In our modern world there are more than two currencies.  Four of them make up the bulk of the world’s reserves.  The US does not hold much reserve in foreign currency; instead, the US dollar is the dominant reserve choice of the others.  US dollars amount to about 60% of the world’s reserves and the euro about 25%.  The yen and the pound are each about 4%.  Add in a little gold, and you have tallied most of the world’s reserves.  The rest of the countries are nice places to visit, but their currencies are bit players in terms of global impact.


Since November, one of the major (G4) currencies, Japan, has dramatically changed policy.  Furthermore, Japan has directed its change in a way that causes another G4 currency, the euro, to strengthen.  This action and ensuing reaction has triggered energetic discussion of a possible currency war.


Will we see one?  Maybe.  Are the currency moves we are seeing volatile and abrupt enough to ignite one?  Yes.


The reason we’re on the brink of a currency war is that the central banks of the G4 have taken their policy interest rates to near zero.  By doing so, they have collectively reduced the ability of market forces to adjust interest rates in response to the policy changes.


Let’s go back to our two-country example to see how this works.  In our simplified model, interest rates were the adjusting mechanism.  They were permitted to work when B decided not to engage in a policy change in response to A.


But what would have happened if the central banks of both A and B had taken their interest rates down to the near-zero boundary? And if, furthermore, A and B had committed to this policy because their respective economies were now attempting to recover from serious recessionary or deflationary damage?  In this situation, interest-rate changes could no longer offset the exchange-rate mechanism.  That is the outcome when the interest rates are managed by central banks.  The normal market clearing forces cease to work.  Instead, we get currency exchange-rate moves that deliver jolts to economies – bumps in a road that must be driven without shock absorbers.  That is what happens when the mitigating effects of interest-rate changes are removed from the equation.


The world now finds itself in this position in response to the Japanese policy change.  Here is a quick inventory of the G4.


Japan is committed to a weaker currency and to further central bank balance-sheet expansion.  It is trying to get its economy to grow, and it is targeting an increase in inflation to 2%.  Some forecasts expect the yen to reach 110 to 115 against the dollar within a year.


Meanwhile, the UK is trying to avoid a triple-dip recession.  Expectations are that it, too, will engage in another round of monetary easing.  We shall learn more as its new central bank governor gets established.  With certainty, the UK will not tighten any time soon.  Its short-term interest rate will hover at the near-zero boundary.  And no one knows where the pound will trade as this next round of policy moves unfolds.


The US is likewise following its announced central bank balance-sheet expansion.  The Federal Reserve affirmed that policy only a few days ago.  Fed Vice-chair Janet Yellen reaffirmed it today. The Fed’s target for unemployment is 6.5%.  (Currently the unemployment rate is 7.9%.)  We have several more years before the Fed’s target rate will be reached.  The Fed’s inflation target is 2.5%, and the US is operating at a lower inflation rate.  Thus US policy is predictable for a while.  US policymakers ignore the exchange value of the US dollar in making their decisions.  They may talk about it, but FX is not the driver of decisions.  As long as the US dollar maintains its current status as the dominant reserve choice, our nation will continue a practice of benign neglect with regard to our currency exchange rate.


On the other side of the Atlantic, the euro is strengthening in spite of all the difficulties in Europe.  It is the G4 default choice because of the Japanese initiative and because the US and UK are in easing mode, while the European Central Bank has just reduced its excess reserves with a policy-changing transaction.  Now ECB President Mario Draghi is worrying about his action being too much, too soon.  We may see the euro trade up in strength against the others in the G4.  That will compound Europe’s economic slowdown.


Note that in all cases interest rates remain very low, and the tendency of the central banks is to continue and to enlarge quantitative easing.  We track that trend weekly at www.cumber.com . Also note that the economies we have discussed are not growing with any robustness, subjected as they are, in most cases, to higher taxes and anti-growth policies.


We believe that fears of a huge sovereign debt collapse are in error and misplaced.  While they may eventually be realized, they do not loom in the near future.  Meanwhile, currency volatility is likely to rise.


Our bond portfolios are slowly adjusting duration.  We are using some strategic hedging of interest rates where that fits within the account objectives.


The central banks have the power to keep interest rates low for a prolonged period.  They also have the power to influence the currency exchange rate.  They do not have the power to do both at the same time unless it is a coincidental policy.  It is going to be an interesting decade.


David R. Kotok, Chairman and Chief Investment Officer


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Needed, so said my friend  David Kotok:

Duped Again
February 4, 2013



Bob Eisenbeis is Cumberland’s Vice Chairman & Chief Monetary Economist. Prior to joining Cumberland Advisors he was the Executive Vice President and Director of Research at the Federal Reserve Bank of Atlanta. Bob is presently a member of the U.S. Shadow Financial Regulatory Committee and the Financial Economist Roundtable. His bio is found at www.cumber.com.  He may be reached at Bob.Eisenbeis@cumber.com.



In Wednesday’s WSJ, journalists who follow the Fed reported on a new Fed working paper that provided detailed simulations of how the exit strategy that the FOMC laid out in June 2012 would affect the size of Federal Reserve remittances to the Treasury.  The focus of the article was on how potential capital losses might affect the flow of so-called “profits” back to the Treasury from interest received on the Fed’s SOMA (System Open Market Account) portfolio.


We have written extensively in the past about why it is misleading to view Fed remittances as “profits” and why it is totally inappropriate for the Treasury to treat those remittances as income for budget purposes.  Briefly, when the Fed is correctly viewed as part of the government rather than a private-sector entity, payments of interest to the Fed are nothing but an intragovernmental transfer of funds.  The Fed extracts its operating costs, required dividend payments, and contributions to capital, and remits the remainder back to Treasury.  The net effect of these intragovernmental funds transfers is always a net payment by the Treasury to the Fed to cover its operations.  There is no profit made nor is it appropriate to refer to the transfer from the Fed to the Treasury as “profit,” as is done in the WSJ article.  Equally misleading is the practice of scoring Fed remittances as income for budget purposes, which is a bit of pure accounting gimmickry.  The Fed working paper avoids the use of the word profit but does refer to the remittances as net income, which might mislead those not familiar with the true nature of the funds transfers into thinking that the Fed made a profit.


As for the simulations presented in the paper, the authors are meticulous both about describing the Federal Reserve’s balance sheet and detailing the assumptions they make to generate their alternative simulations.  The relevance of the simulations is, however, questionable, for two reasons.


First, their estimates of losses on the Fed’s portfolio as interest rates rise are based upon what are likely to be unrealistically optimistic assumptions about how market participants, and hence interest rates, will respond to the Fed’s exit. Specifically, the losses experienced on asset sales would be quite different if market participants were to respond immediately to a shift in FOMC policy and interest rates and if the term structure were to shift abruptly upward to what might be the new equilibrium, long-run expected interest rates.  The simulations assume, for example, that it would take 7 or more years for the 10-year rate to move from its current level to about 4.9%.  It is totally unrealistic to assume that investors will stand by and tolerate a serial decline in the value of their portfolios without running for the exit as quickly as possible.  Second, tracking the flow of remittances back to the Treasury is important only to the Treasury and its budget scoring, and is unrelated to FOMC policy.


At Cumberland we have been focusing on the Fed’s balance sheet for more than four years.  But  rather than focusing on the flow of net interest payments and losses that might accrue from asset sales, we have instead used estimates of the durations of assets in the Fed’s portfolio and what parallel shifts in the yield curve might mean for the economic value of the Fed’s net worth.  Those estimates currently indicate that an upward shift of only 33 basis points would be sufficient to push the market value of the Fed’s capital account to zero.  In short, the Fed’s balance sheet would be worth substantially less and in a much shorter period of time than the simulations posed by Fed staff suggest.  The realization of those losses is solely the discretion of the Fed.


The Fed working paper also provides a useful discussion of the accounting of assets and how losses would be handled.  It outlines three valuation methods: face, amortized, and market value.  Typically, the Fed reports asset values at face, and thus if interest rates were to increase and the Fed sold assets, it would have to book a loss.  If losses exceeded interest payments from the Treasury, then remittances would cease; but instead of booking the additional losses against the Fed’s capital account, a deferred-asset account would be created.  That accounting gimmick creates a claim on future Treasury interest payments that would be used to write down the value of the deferred-asset account when the payments are received.  The working paper claims this meets GAAP accounting standards and parallels how corporations treat tax loss carry-forwards, for example. Ultimately, however, it is nothing but a way to avoid recognizing a loss against capital that would reveal that the Fed might be insolvent.


It can be argued that the question of whether the Fed is insolvent is meaningless as long as the country is solvent and functioning, but a broke Fed would still look bad in the eyes of the rest of the world.


Bob Eisenbeis, Vice Chairman & Chief Monetary Economist


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GIC conferences for 2013

The following events are ready for registration, according to my friend David Kotok:

GIC is off and running to Sarasota, Philadelphia, Dubai and Milan, plus early registration for Jackson Hole!
January 31, 2013



Cumberland Advisors is proud to be a sponsor of the GIC.


Join the Global Interdependence Center at the following events:



February 7, 2013  
Too Big to Fail” in Sarasota, FL
Join GIC as we partner once again with New College of Florida and welcome Harvey Rosenblum, Executive Vice President, and Director of Research, Federal Reserve Bank of Dallas.
Location: Sarasota, Florida. Registration now available online.

February 12, 2013
“How to Predict the Next Financial Crisis”
in Philadelphia, PA

Richard Vague, President of the Governor’s Woods Foundation and Managing Partner, Gabriel Investments and Steve Clemons, Washington Editor-At-Large, The Atlantic and Senior Fellow at the American Strategy Forum at the New American Foundation will discuss the findings from their recent article in the Atlantic “How to Predict the Next Financial Crisis”
Anthony Santomero, Senior Advisor to McKinsey& Co. and former President of the Federal Reserve Bank of Philadelphia , and Paul McCulley, Retired PIMCO Senior Partner and Chair, GIC Global Society of Fellows, will follow the presentation for a discussion of the issues presented by Richard Vague and Steve Clemmons. Peter Burns, GIC Board Member and Senior Payments Advisor, Heartland Payment Systems, will moderate the discussion.
Please visit our website to register!

March 24-26, 2013
GIC Central Banking Series/Energy and Employment in Gulf Region
in Dubai, UAE

In Partnership with University of Pennsylvania’s Wharton School of Business and the Higher Colleges of Technology.
Speakers include:

Richard Fisher, President and CEO of the Federal Reserve Bank of Dallas
Michael Drury, Chief Economist, McVean Trading & Investments and GIC Vice Chair of Programs
Gıyas Gökkent, Chief Economist, National Bank of Abu Dhabi
Essa Abdulfattah Kazim, CEO and Managing Director of Dubai Financial Market
John Silvia, Chief Economist, Wells Fargo
David Kotok, Chairman & Chief Investment Officer, Cumberland Advisors and GIC Vice Chair of Central Banking Series
Catherine Mann, Professor of Global Finance, Brandeis University and GIC Board Member
Don Rismiller, Chief Economist, Strategas Research Partners

Registration is open!

May 15-17, 2013
GIC Central Banking Series: Recovery 2013 – Strength or Stagnation?
in Milan, Italy

Confirmed speakers include

  • Charles Plosser, President & CEO, Federal Reserve Bank of Philadelphia
  • Eric Rosengren, President, Federal Reserve Bank of Boston
  • John Silvia, Chief Economist, Wells Fargo
  • David Kotok, Chairman & Chief Investment Officer, Cumberland Advisors
  • Matteo Ferrazzi, Senior Economist, UNICREDIT
  • Francesco Giavazzi, Professor of Economics, Bocconi University
  • Catherine Mann, Professor of Global Finance, Brandeis University
  • George Tsetsekos, Drexel University, LeBow College of Business
  • John Mousseau, Managing Director and Portfolio Manager, Cumberland Advisors.

Generously sponsored by Wells Fargo

Register today!

July 12, 2013
5th Annual Rocky Mountain Economic Summit
in Jackson Hole, WY

Registration is Open! Please visit our website

Speakers already confirmed:
Charles Plosser, President, Federal Reserve Bank of Philadelphia
Jim Bullard, President, Federal Reserve Bank of St. Louis
David Kotok, CIO, Cumberland Advisors and GIC Vice Chair
Paul McCulley, Chairman, GIC Global Society of Fellows
Julian Callow, Head of International and European Economics, Barclays Capital
George Tsetsekos, Dean Emeritus, Drexel University & GIC Board Chair
Axel Weber, Chairman of UBS, former President, Deutsche Bundesbank and visiting professor, Booth School of Business at the University of Chicago
Charles Silverman, EVP & Group Head  Global Financial Institutions Wells Fargo
Bill Dunkelberg, Chief Economist, National Federation of Independent Business & GIC Board Member
Michael Drury, Chief Economist, McVean Trading & Investments & GIC Program Chair
Steve Sexauer, Chief Investment Officer, Allianz Global Investors Solutions & GIC Board Member
Tim Walsh, Director, NJ Division of Investment

Please join us. For registration details please click on the link below.
GIC is off and running to Sarasota, Philadelphia, Dubai and Milan, plus early registration for Jackson Hole!





David R. Kotok, Chairman and Chief Investment Officer


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