Central Bank Bingo with Mohamed El-Erian

The world’s largest central banks are once again dominating the chatter among traders and economists. Last week, the European Central Bank announced additional measures to simulate the moribund Eurozone; this week, the Bank of Japan will weigh potential action after its surprise decision to adopt negative interest rates in January; and the U.S. Federal Reserve will likely refrain from a rate hike at its two-day policy gab fest. The heightened central bank focus made last week a perfect time to interview Dr. Mohamed El-Erian, author of The Only Game in Town: Central Banks, Instability, and Avoiding the Next Collapse. El-Erian is Chief Economic Advisor at Allianz, chair of President Obama’s Global Development Council and a LinkedIn Influencer. Between December 2007 and March 2014, he was chief executive and co-chief investment officer of global investment management firm PIMCO.

I sat down with El-Erian during a LinkedIn webcast to discuss how far the economy and markets had come since the bear market lows of March, 2009 (the S&P 500 has soared over 240 percent, including reinvested dividends), as well as the significant challenges that still lie ahead for investors and for the global financial system.

As markets bottomed seven years ago, El-Erian and his PIMCO colleagues coined the phrase “The New Normal” to describe what was likely to be a slow growth economic recovery. That prediction was spot-on: the U.S. is now in the seventh year of 2 to 2.25 percent GDP. El-Erian credits the actions of central banks for even that measly pace. When it became clear that government stimulus plans were not large enough, central banks were forced to adopt a “Whatever it takes” mentality. In doing so, they were able to avoid a multi-year depression.

Unfortunately, the unintended consequence of aggressive central bank actions was an environment where investors relied on monetary policy to do the heavy lifting to promote growth. That reliance encouraged excessive risk taking, which helped drive up asset prices beyond economic justification and turbo-charged income and wealth inequality. (Those who already owned assets were the biggest beneficiaries.)

It’s not as if the Fed, the ECB and the Bank of Japan don’t get it, but just when global central banks are looking to hand off the responsibility of promoting growth, there seem to be no takers.

So where do we stand right now, seven years after we bottomed out? We have come to what El-Erian calls a “T-Junction”. As we approach the end of this recovery road, there is an equal probability that we turn left and right. On one side of the T, we remain in a stable, but slow growth world, riddled with high unemployment, increasing income inequality and political extremism. On the other side, we have politicians who wake up and get serious about creating an inclusive economy; make pro-growth structural reforms, remove debt overhangs in problem areas like student loans and get the overall architecture right. The result would be higher growth, job creation, decreasing income inequality and a drop in financial instability.

Could the stakes be any higher this political season? That’s why El-Erian says that we desperately need candidates to acknowledge the anger that the “inequality of opportunity” can breed; and then to address that anger with policies that promote inclusive growth and restore faith in the system. In other words, we need an “Economic Sputnik” moment. Perhaps that seems like a distant possibility this moment, but El-Erian remains optimistic that one can occur.

MARKETS:

• DJIA: 17,213 up 1.2% on week, down 1.2% YTD
• S&P 500: 2022 up 1.1% on week, down 1.1% YTD
• NASDAQ: 4748 up 0.7% on week, down 5.2% YTD
• Russell 2000: 1087, up 0.5% on week, down 4.3% YTD
• 10-Year Treasury yield: 1.98% (from 1.88% a week ago)
• Apr Crude: $38.50, up 7.2% on week 7.2%, 4th straight weekly climb
• Apr Gold: $1,250.80, down 0.9% on week
• AAA Nat'l avg. for gallon of reg. gas: $1.92 (from $1.81 wk ago, $2.45 a year ago)

THE WEEK AHEAD:

Mon 3/14:

Tues 3/15:

Bank of Japan meets

FOMC Meeting Begins

8:30 PPI

8:30 Retail Sales

8:30 Empire State Mfg Survey

10:00 Business Inventories

10:00 Housing Market Index

Weds 3/16:

8:30 CPI

8:30 Housing Starts

9:15 Industrial Production

2:00 FOMC Decision

2:00 FOMC Economic Projections

2:30 Janet Yellen Press Conference

Thursday 3/17:

8:30 Philadelphia Fed Business Outlook Survey

10:00 JOLTS

Friday 3/18:

10:00 Consumer Sentiment

Greek Fatigue

Greek Fatigue: Condition affecting investors and news junkies, caused by five years of reporting on the exact same topic. Symptoms include weariness, eyes glazing over and sleepwalking through broadcasts/columns/blogs predicting doom and gloom. (See: “US Debt Ceiling” and “The Boy Who Cried Wolf”.) I know you don’t want to hear about Greece again, but we’re getting down to it. Euro group leaders (the European Central Bank (ECB), the European Commission (EC) and the International Monetary Fund (IMF)) were banking on weekend progress to restructure outstanding loans to Greece, which would unlock €7.2B of the total €15.3 billion in rescue funds. Without that money, Greece will not be able to make a €1.54 billion ($1.73B) payment due to the IMF on Tuesday. In order to get the lifeline from the Euro group, Greece must agree to more taxes and an increase in employee pension contributions.

THEN, in a twist worthy of a Broadway “11 o'clock number” (“Rose's Turn” from Gypsy being hands-down the best, ever!), in the wee hours of Saturday morning, Greece’s Prime Minister Alexis Tsipras went on television and called for a surprise referendum for July 5^th, where Greek citizens will have the opportunity to vote on the euro group’s demands. Tsipras called on Greeks to vote “no to the ultimatum” and at the same time, sent his Finance Minister Yanis Varoufakis into the Euro group meeting to ask for a one-month extension on the talks to allow time for the vote. European officials quickly rejected the request, saying there was “no support for that.”

Over the weekend, Greek Prime Minister Alexis Tsipiris stunned the world with an announcement of a surprise referendum next weekend, where citizens will have the opportunity to vote on the euro group’s demands for an increase in taxes and pension contributions. Concurrently, Greece asked the euro group for a one-month extension to the negotiations, which officials quickly dismissed.

Then the European Central Bank announced that it would not increase short term funding which has allowed Greek banks to meet withdrawal demands. Without the lifeline, Greece had no choice but to announce that banks would be closed for a week and to impose capital controls, which limit how much money citizens can withdraw from the banks (€60/day, though no limit if drawing from a non Greek bank card, so foreign tourists are not affected) and transfer out of the country.

Barring a last minute-effort, Greece is now likely to fall into technical default on the IMF loans, though not necessarily on other debts. That puts the country in a dubious club that includes Cuba, Zimbabwe and Somalia, but it would not immediately lead to cascading problems. That is, unless Greek bank depositors make a more fervent dash out of the banks and investors get antsy, during the week leading up to the vote.

The total outstanding amount extended to Greece is nearly $270B, of which the European Central Bank’s exposure stands at about $170 billion. About 80 percent of the ECB’s money is keeping the Greek banking system afloat and the rest is in the form of longer-term Greek bonds, which require a $3.9B installment on July 20^th and the remainder must be paid by the end of August.

I know that it’s easy to paint Greece as the screw up, prodigal son in this story, but Irish economist Karl Whelan wants to set the record straight. Whelan cited the EC’s report on Greece from last year, which found that total public sector employment declined over 25 percent from 2009 to 2014. During the same time, Greece reduced its fiscal deficit from 15.6 percent of GDP to 2.5 percent, according to the OECD.

Perhaps because Euro group members are not willing to discuss the progress that Greece has made or the pain that ordinary Greeks have endured, Tsipiras and many within Greece’s ruling Syriza party are balking at even more austerity, which the party had promised to bring to an end when it successfully won seats in parliament in January.

The defiant Greek posture only inflames emotions more, leading many in Europe to posit that a default and exit from the euro zone, combined with a new (and much devalued) currency and structural reforms, would be best for Greece in the long run. The Financial Times Martin Wolf is not so sure: “Far more likely is a period of chaos and, at worst, emergence of a failed state…Neither side should underestimate the risks.”

While a deal between Greece and its creditors may finally emerge, “it still looks unlikely to include the substantial debt relief needed to end the crisis and eliminate the risk of Grexit”, according to Capital Economics. That’s a shame, because the answer seems so clear: European financiers pushed the ultimate drug into Greece—cash. Now that the addicted country is coming off the stuff, it would be foolhardy to go cold turkey.

US Jobs Report in a holiday-shortened week: Here in the US, there continues to be evidence of economic improvement. New and existing home sales reached 6 to 7 hear highs; personal income and spending jumped in May; and sentiment came in at a 5-month high. The better than expected results overall is prompting some economists to increase their projections for the June employment report from 215,000 to closer to 250,000. And there may be even more progress on wages: “Adjusting for inflation, disposable income for the first five months of the year is up a strong 3.6 percent compared to the same period last year,” according to Joel Naroff. Just a reminder, the report will be released on THURSDAY at 8:30ET, due to the Friday observance of Independence Day.

MARKETS:

• DJIA: 17,946 down 0.4% on week, up 0.7% YTD
• S&P 500: 2101, down 0.4% on week, up 2.1% YTD
• NASDAQ: 5,080 down 0.7% on week, up 7.3% YTD
• Russell 2000: 1279, down 0.4% on week, up 6.2% YTD
• 10-Year Treasury yield: 2.47% (from 2.27% a week ago, highest yield in 9 mos)
• August Crude: $59.63, down 0.6% on week
• August Gold: $1,173.20, down 2.4% on week
• AAA Nat'l avg. for gallon of reg. gas: $2.78 (from $2.80 wk ago, $3.68 a year ago. AAA predicts that 35.5 million people will drive over Independence Day weekend, the most since 2007 and they will pay the lowest price at the pump since at least 2010)

THE WEEK AHEAD:

Mon 6/29:

10:00 Pending Home Sales

10:30 Dallas Fed

Tues 6/30:

GREECE PAYMENT DUE TO IMF

9:00 S&P Case Shiller Home Price Index

9:45 Chicago PMI

10:00 Consumer Confidence

Weds 7/1:

Motor Vehicle Sales

8:15 ADP Private Sector Jobs Report

9:45 PMI Manufacturing

10:00 ISM Manufacturing

10:00 Construction Spending

Thurs 7/2:

8:30 June Employment Report

Fri 7/3: MARKETS CLOSED IN OBSERVANCE OF INDEPENDENCE DAY

Super Mario to the Rescue, Greek Election, Fed Fun

After four years of doing absolutely nothing to propel the moribund Euro Zone economy, European Central Bank President Mario Draghi (aka Super Mario) finally unveiled the ECB’s version of bond buying last week, where it will buy €60 billion ($68 billion) of bonds a month in an effort to boost stagnant growth and fight falling prices. The ECB will fire up the printing presses in March and will conduct the purchases “until we see a sustained adjustment in the path of inflation.” So although the European version of QE at first seemed half the size of that in the US and UK, the open-ended prospect seemed to quell fears that it was not enough.

While on the topic of Europe, it is worth noting that there is a big election in Greece today, where Alexis Tsipras, the leader of the leftwing, anti- austerity Syriza party is leading in the polls. There are fears that Tsipras might lead Greece out of the euro zone (the so-called “Grexit”), but it now seems more likely that he will seek a restructuring of debt with the Troika (the European Commission, the European Central Bank and the International Monetary Fund).

As a reminder, Greece has suffered through six years of economic contraction, triggered by over-the-top spending, the financial crisis and then exacerbated by fiscal belt-tightening imposed by the Troika. According to Capital Economics, Greek “gross domestic product is now a quarter smaller than it was in 2008. A quarter of the working age population is out of work. Only half of the eligible young have jobs.” Both the Troika and Greece have reason to come to terms, which should prevent a Grexit, at least for now.

Here in the US, the week ahead should be a little less dramatic. The Federal Reserve will conduct a two-day policy meeting, where it is widely expected to maintain its recently adopted language that it “can be patient in beginning to normalize the stance of monetary policy.” With wage growth tepid, no meaningful increase in core inflation and global uncertainty swirling, the Fed is likely to sit still and do nothing.

On Friday, the first reading of fourth quarter growth is due. GDP is expected to increase at a 3.2 percent annualized rate. That would be downshift from the strong 5 percent gain in the third quarter, but would still be a lot better than the 2.25 percent pace of the recovery.

Finally, there was some concern late last week, after the National Association of Realtors released its Existing Home Sales report. While sales accelerated in December, for all of 2014, existing home sales dropped by 3.1 percent from 2013, the first annual decrease since 2010. The problem was a lack of inventory, but as Bill McBride of Calculated Risk points out, “the NAR inventory data is ‘noisy’ and difficult to forecast based on other data.” The good news is that “distressed sales were down sharply - and normal sales up around 7 percent.” With the economy strengthening, confidence building and mortgage rates at 18-month lows, home sales should accelerate in 2015.

MARKETS: Stocks rose, snapping a three-week losing streak and the euro dropped to its lowest level ($1.12) in 11 years.

• DJIA: 17,672, up 0.9% on week, down 0.8% YTD
• S&P 500: 2051, up 1.6% on week, down 0.3% YTD
• NASDAQ: 4757, up 2.7% on week, up 0.5% YTD
• Russell 2000: 1189, up 0.3% on week, down 1.3% YTD
• 10-Year Treasury yield: 1.79% (from 1.84% a week ago)
• March Crude Oil: $45.59, down 7.2% on week
• February Gold: $1,292.60, up 1.2% on week
• AAA Nat'l average price for gallon of regular Gas: $2.04 (from $3.29 a year ago)

THE WEEK AHEAD:

Mon 1/26:

DR Horton, Microsoft, Texas Instruments

Tues 1/27:

3M, Apple, AT&T, Caterpillar, Coach, DuPont, Pfizer, P&G, Yahoo

FOMC 2-day meeting begins

8:30 Durable Goods Orders

9:00 Case Shiller Home Price Index

10:00 New Home Sales

10:00 Consumer Confidence

Weds 1/28:

Boeing, Facebook

2:00 Fed Policy Announcement

Thurs 1/29:

Amazon, Conoco Phillips, Ford, Harley Davidson, Visa

8:30 Weekly Jobless Claims

10:00 Pending Home Sales

Fri 1/30:

Altria, Chevron, MasterCard

8:30 Q4 GDP (1^st estimate)

9:45 Chicago PMI

9:55 U Mich Consumer Sentiment

Will the US Become the Next Deflation Nation?

Since the Great Recession, the Federal Reserve has worked hard to boost the economy. Part of the Fed’s mission was to keep core inflation (the price of goods and services excluding food and energy), at a pace of two percent annually. Although there have been instances over the past six years when either energy or food prices jumped, temporarily raising the specter of inflation, throughout the financial crisis and the recovery, the central bank has been much more focused on deflation, which is defined as a drop in the price of goods and services. For those who were around during the inflationary 1970s and 1980s, deflation is an alien concept. But according to data released by the government last week, the near-60 percent plunge in oil prices pushed down consumer prices by 0.4 percent in December from the previous month, leaving the CPI just 1.6 percent above where it stood a year ago, below the 1.9 percent annual rate over the past ten years.

Although the idea of falling prices seems like a good thing, when deflation is persistent, it can put into a motion a scary, downward spiral. It starts when the economy cools, which prompts companies to reduce prices in the hopes of luring customers and maintaining sales volume. But as companies make less money, they could then cut jobs and/or wages, which could then cause consumers to spend less in order to service their fixed costs, like taxes and mortgages/rents.

The longer that deflation goes on, the higher the risk that consumers’ and businesses’ become accustomed to the situation and delay spending, hoping they will eventually be able to buy goods more cheaply and to invest more efficiently. They also become less willing to borrow.

The vicious deflationary cycle can mire an economy in a deep recession or even worse, a depression. As an example, between 1929 and 1933, US consumer prices fell by a cumulative 25 percent. More recently, Japanese consumer prices have been stuck for the past 20 years and the Euro Zone and the United Kingdom are both currently battling falling prices.

Besides the obvious harm that deflation can cause, the other problem is that central bankers have limited tools to fight it. (In contrast, when there is inflation, hiking interest rates may hurt in the short-term, but it is effective in combating higher prices.) In a deflationary environment, policy makers would likely return to bond buying (Quantitative Easing), which depending on the magnitude of price declines, may not stop the downward spiral. (FYI, there will be an excellent test case in the efficacy of QE coming up. This week, the European Central Bank is expected to unveil its version of bond buying to boost prices in the euro zone.)

Back to the US, where the big question is whether the current drop in prices is temporary or whether there is something scary brewing. Analysts at Capital Economics believe that odds are that while negative readings on headline inflation could persist at least for the first half of the year, “it is hard to see why this renewed slump in oil prices, which is developing against a backdrop of a rapidly improving real US economy, will lead to anything more than a temporary drop in inflation.” They are quick to point out that even when crude oil collapsed from a 2008 peak of $140 per barrel to $40, amid a deep recession, prices recovered and the economy avoided a prolonged bout of deflation.

That said, they also add that “Deflation may be just one recession away,” which is probably why Fed officials continue to err on the side of adding more stimulus to the economy than less and are taking a “wait and see” attitude towards increasing short-term interest rates. Currently, the consensus is for the first rate hike to occur in the third quarter of this year. But any indication of an economic slowdown, accompanied by a more substantial drop in core prices, could put the Fed on hold longer, to avoid a dangerous deflationary downward spiral.

MARKETS: Last week, the Swiss Central Bank’s decision to discontinue its 3½ practice of pegging the Swiss Franc to the Euro sent ripple effects throughout global markets. (The policy was intended to halt the rise of the Swiss currency, which made it difficult for Swiss exporters to remain competitive in the global market.) Meanwhile, the punk US Retail Sales report unnerved investors, who continue to worry about a slowdown in global growth.

• DJIA: 17,511, down 1.3% on week, down 1.8% YTD
• S&P 500: 2019, down 1.2% on week, down 1.9% YTD (still within 4% of all-time highs)
• NASDAQ: 4634, down 1.5% on week, down 1.5% YTD
• Russell 2000: 1176, down 0.8% on week, down 2.3% YTD
• 10-Year Treasury yield: 1.84% (from 1.97% a week ago)
• February Crude Oil: $48.69, up 0.7% on week (oil CAN rise!)
• February Gold: 1,276.90 $1,216.10, up 5% on week
• AAA Nat'l average price for gallon of regular Gas: $2.08 (from $3.33 a year ago)

THE WEEK AHEAD:

Mon 1/19: Markets closed in honor of MLK Day

Tues 1/20:

Baker Hughes, Coach, Haliburton, Morgan Stanley, Netflix

2014 Tax Season begins

10:00 NAHB Housing Market Index

State of the Union address

Weds 1/21:

American Express, eBay

8:30 Housing Starts

Thurs 1/22:

Southwest Air, Starbux, Verizon

European Central Bank Policy meeting

8:30 Weekly Jobless Claims

Fri 1/23:

General Electric, McDonald’s

8:30 Existing Home Sales