TAA Vol. 1 Iss. 8 - Set Up to Fail

8/4/2019 TAA Vol. 1 Iss. 8 - Set Up to Fail

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The Aspiring Analyst Vol. 1 Iss. 8

Set Up To Fail? [email protected]

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What was the biggest news in August? It must have been the downgrade of United States sovereign

debt rating and the subsequent rally in treasuries a counterintuitive move to say the least. It appears

investors are keener to lend to an AA+ USA rather than an AAA USA, defying S&Ps downgrade and

giving the US a vote of confidence. Or is it because investors fear recession and see US treasuries as

relatively safer than stocks? Its always fun to read headlines as journalists try to connect the dots, often

incorrectly.

Congratulations to Yoshihiko Noda for becoming the sixth prime minister of Japan in the last 5 years. We

hope he has better luck tackling Japans multitude of problems than his predecessor although his

record as finance minister does not give us much confidence (as finance minister, Mr. Noda is only

remembered for his recent valiant but failed efforts to devalue the Yen1).

In this months newsletter, we posit an idea from Roger Martin that I find very interesting. Why do we,

as a society, place so much reliance on man (or woman) to do the job of a superman (or woman)? The

more reliance we place on individuals in critical positions, the more likely we will be disappointed when

they inevitably fail. Helicopter Ben is a prime example.

We also start the first of hopefully many discussions on whether emerging markets have de-coupled

from the developed markets (North America, Europe, Japan) and thus could be a safe place to hide

while the rest of the world blows up.

Jason Chen

The Aspiring Analyst

1Bloomberg, retrieved September 4, 2011: http://www.bloomberg.com/news/2011-08-31/japan-s-incoming-

leader-noda-oversaw-biggest-yen-intervention-since-2004.html


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The US Downgrade Pt 2

As we wrote in our previous letter, S&Ps downgrade of the United States sovereign debt rating to AA+

sparked much controversy and was ultimately blamed for causing more than $1 Trillion in stock market

losses2

(is it a loss when the gain was on paper in the first place?) and costing S&Ps CEO his job3. After a

months time to reflect on the implications of the downgrade and reading all the finger-pointing, scape-goating and name-calling (including one particularly nasty post on Reuters by Roger Martin4), we feel

the topic is important enough to warrant a second look.

Yes, we agree S&P did an indefensible job in the prior crisis, when they gave AAA ratings to CDOs

(collateralized debt obligations) built from subprime mortgages. But so did two other agencies Fitch

and Moodys. We also agree that the credit rating business model is inherently full of conflict of interest

when the issuer pays the credit agencies to issue credit opinions on the issuers debt securities (imagine,

if the US had actually paid S&P, do you think S&P would have downgraded the US?).

We are not defending S&Ps record. But we do not agree that because of their past misdeeds, S&Ps

message should be ignored. Our position is that instead of addressing the real issues of political gridlock

and ballooning entitlements, politicians and pundits chose to attack S&P for pointing out that the

emperor had no clothes.

In our minds (notwithstanding S&Ps $2 Trillion math mistake5), the S&Ps message is simply that the

political gamesmanship leading up to the debt ceiling raise has tainted the US previously sterling

reputation. One could argue that this was more of a qualitative downgrade, rather than a quantitative

downgrade, since a sovereign fiat currency issuer can never technically default on debt obligations

denominated in its own currency. But can anyone really refute this message, when Secretary of State,

Hilary Clinton admitted as much6:

"It does cast a pall over our ability to project the kind of security interests that are

in America's interests," she said. "This is not about the Defense Department or the

State Department or USAID. This is about the United States of America. And we need to

have a responsible conversation about how we are going to prepare ourselves for the

future."

2Bloomberg, retrieved September 2, 2011: http://www.bloomberg.com/news/2011-08-25/s-p-prompts-1t-stock-

loss-with-u-s-rating.html3 McGraw-Hill, retrieved September 2, 2011: http://investor.mcgraw-hill.com/phoenix.zhtml?c=96562&p=irol-

newsArticle&ID=1599011&highlight=4

Reuters, retrieved September 2, 2011: http://blogs.reuters.com/great-debate/2011/08/09/why-does-anyone-

take-sp-seriously/5

Bloomberg, retrieved September 4, 2011: http://www.bloomberg.com/news/2011-08-06/s-p-downgrade-may-

cloud-obama-re-election-bid-even-as-it-damages-congress.html 6

Foreign Policy, retrieved September 4, 2011:

http://thecable.foreignpolicy.com/posts/2011/08/16/clinton_debt_debate_is_hurting_america_s_ability_to_lead


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For those who appreciate the finer points of S&Ps message, we would recommend you read Caroline

Baums Bloomberg editorial on the subject:

http://www.bloomberg.com/news/2011-08-19/larry-summers-s-bad-math-is-s-p-informed-opinion-

caroline-baum.html

Set Up To Fail

The more interesting question one should ask (with full credit to Roger Martin for the idea, although we

couldnt tell from reading his article in Reuters4

that this was really his message; we had to go through a

lengthy and querulous email exchange before the real message got out) is why we, as a society, put so

much reliance on certain individuals, in this case, S&P credit analysts, to perform critical jobs that would

require supermen (or women)to do? Being only human, these individuals are destined to fail.

When these individuals eventually do fail, such as when they incorrectly rated CDOs as AAA, we have all

these fiduciary institutions such as banks and pensions ending up with billions of dollars in losses and

peoples live savings being wiped out.

And this problem is not isolated to credit rating agencies; it is pervasive in our society. We have auditors

and their failure to perform proper audits leading to accounting frauds such as Enron, Worldcom, and

most recently Sino-Forest. We have incompetent board of directors and cronyism leading to Lehman

Brothers and Hollinger. We have CIA analysts and their false claims of weapons of mass destruction

leading to the Iraq War. And the list goes on.

Bernanke AKA Atlas The Titan

The latest iteration of being set up to fail is Ben Bernanke and the Federal Reserve. He has become Atlas

the Titan in Greek Mythology, carrying the weight of the world on his shoulders. Rarely has so much

responsibility the fate of the world economy, befallen one man. We have analysts whose sole job is to

analyze the implication of whether Bernanke and the Federal Reserve choose to use the word extended

or not in describing the period of low interest rates! What if Ben is wrong in his assessment of the

economy or his prescription for faster economic growth? After all, hes only human.

Leading up to his Jackson Hole Speech last week, the whole world was expecting Ben to announce a

third round of quantitative easing, to help the moribund economy, with stocks rallying in anticipation7.

Unfortunately, he did not announce QE3 in his Jackson Hole Speech.

No matter, pundits and economists say. Surely, he must, simply must, announce QE38, now that the US

Economy has laid a nice fat egg of a non-farm payroll number9? Our worry isnt on whether Ben

7Bloomberg, retrieved September 3, 2011: http://www.bloomberg.com/news/2011-08-23/u-s-stock-futures-rise-

on-fed-stimulus-speculation-china-manufacturing.html8

Bloomberg, retrieved September 3, 2011: http://www.bloomberg.com/news/2011-09-02/pimco-goldman-rbc-

say-fed-to-revisit-operation-twist-as-growth-slows.html 9

Bloomberg, retrieved September 3, 2011: http://www.bloomberg.com/news/2011-09-03/job-growth-stagnates-

in-u-s-as-unemployment-holds-at-9-1-.html


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Bernanke will announce QE3, QE4, or QEn+1. Our question is whether quantitative easing is really the

right medicine for the patient?

Why, if QE1 didnt help the real economy (aka Main Street; although QE1 certainly helped Wall Street

with stocks doubling off their March 2009 lows), and QE2 didnt help the real economy (but again, it

helped Wall Street with a short-lived stock rally through the end of 2010), we should expect QEn+1 tohelp the real economy now and in the future?

The problem right now isnt that interest rates are too high and people cannot borrow. The problem is

that banks cannot find enough credit-worthy customers to lend to. The problem isnt that people are

saving too much and need to be prodded too spend (actually, prudent savers are being penalized with

ultra-low interest rates). The problem is that people have too much debt, and will need time to work off

those debts. The problem isnt about liquidity; its about solvency.

Contrary to what politicians and economists would like to believe, there is no magic bullet. The average

banking/housing recession takes 6 years to work through, according to economists Carmen Reinhart and

Ken Rogoff10

. We are in year 3.

Have The BRICs Decoupled?

Interestingly, even though a developed world recession (North America, Europe, Japan) is starting to get

priced into stocks (some would say the real economy have yet to recover from the last recession) and

many consumers and businesses are battening down the hatches, somebody forgot to tell the

commodities complex. Leaving aside gold for the moment (the price of gold reflects fear

simultaneously reflecting both fear of inflation and deflation, a concept which needs a whole other

column to explore), most commodity prices are not reflective of a recession. Copper is still at $4.00 / lb.

Brent is still near $100 a barrel. Whats going on?

The conclusion bandied about by economists is that as emerging markets shrug off growth concerns and

continue their voracious appetite for commodities, they have supplanted the advanced economies as

the principal driving force behind commodity prices. Emerging markets have de-coupled, so to speak. Is

this a reasonable claim?

We are not convinced that emerging markets have de-coupled. How can we have both globalization and

de-coupling at the same time? Historically, when advanced economies sneeze, emerging economies

catches pneumonia:

10Reinhart & Rogoff, 2009, Figure 14.1, pp. 227, This Time Is Different


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Figure 1: Considering all recessionary episodes from 1960 to 2007 in advanced economies and 1978 to 2007 in emerging

economies. Source: Kose & Prasad: Asian Development Bank, February 14, 2011, "Emerging Markets, Resilience and Growth

Amid Global Turmoil".

Although, to their credit, emerging economies performed relatively well in the most recent global

recession in 2008/09 (although the experience varied amongst different regions):


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Figure 2: Emerging markets GDP growth in 2009. Source: Kose & Prasad: Asian Development Bank, February 14, 2011,

"Emerging Markets, Resilience and Growth Amid Global Turmoil".

We think the key difference in the latest recession was that the emerging markets had retained ample

fiscal flexibility to offset global declines in demand. For example, in 2008, China announced a RMB 4

Trillion stimulus plan, equivalent to 10% of the countrys GDP. An equivalent fiscal stimulus in America

would have required $1.5 Trillion, more than double the size of the $700 BB TARP stimulus program.

However, Chinese stimulus led to massive over-investments in infrastructure (please see our April

newsletter, 64 Million And Counting...) and associated inflation, from which China is still recovering.

Can the Chinese Politburo stomach more stimulus, inflation and possible social unrest (highly possible,

since there is a changing of the guards in the fall of 2012, it is likely the Chinese government would do

everything in its power to keep the economy growing for another 12 months)? Can China deflate its real

estate bubble without a hard landing? We dont know.

What we do know is that emerging market stocks are not looking rosy. The Shanghai Composite Index is

lower today than one year ago. In fact, you could choose any emerging market and the results would be

roughly the same:


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Figure 3: Shanghai Composite vs. S&P500. Source: Yahoo Finance, The Aspiring Analyst.

In future newsletters, we will try to find more data and evidence to support the argument, one way or

another, on whether the BRICs have de-coupled, and thus could be a good place to hide while

Ameuropan (America-Europe-Japan) implodes. But for now, all we can say is, stay tuned.

Disclaimer: Our goal through this blog is to provide analysis and ideas that you, the reader, might find useful in forming your

own investment decisions and hopefully improve our analytical skills in the process. We are not soliciting for the management

of your investments nor seeking to provide financial advice. The Aspiring Analyst blog and letters will not take responsibility for

any investment losses incurred by readers through the trading of securities and strategies mentioned in this blog or its

accompanying letters. The views expressed in this blog and its accompanying letters reflect the author(s) personal views about

the subject company(ies) and its (their) securities. The author(s) certify that they have not been, and will not be receiving direct

or indirect compensation in exchange for expressing the specific recommendation(s). Readers are cautioned to seek financial

advice from qualified persons such as a Certified Financial Planner prior to taking any action in regards to the securities and

strategies mentioned in this blog or its accompanying letters.

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TAA Vol. 1 Iss. 8 - Set Up to Fail