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"The moment of critical mass, the threshold, the boiling point"
The tipping point is the critical point in an evolving situation that leads to a new and irreversible development. The term is said to have originated in the field of epidemiology when an infectious disease reaches a point beyond any local ability to control it from spreading more widely. A tipping point is often considered to be a turning point. The term is now used in many fields. Journalists apply it to social phenomena, demographic data, and almost any change that is likely to lead to additional consequences. Marketers see it as a threshold that, once reached, will result in additional sales. In some usage, a tipping point is simply an addition or increment that in itself might not seem extraordinary but that unexpectedly is just the amount of additional change that will lead to a big effect. In the butterfly effect of chaos theory , for example, the small flap of the butterfly's wings that in time leads to unexpected and unpredictable results could be considered a tipping point. However, more often, the effects of reaching a tipping point are more immediately evident. A tipping point may simply occur because a critical mass has been reached.
The Tipping Point: How Little Things Can Make a Big Difference is a book by Malcolm Gladwell, first published by Little Brown in 2000. Gladwell defines a tipping point as "the moment of critical mass, the threshold, the boiling point." The book seeks to explain and describe the "mysterious" sociological changes that mark everyday life. As Gladwell states, "Ideas and products and messages and behaviors spread like viruses do."
Gladwell describes the "three rules of epidemics" (or the three "agents of change") in the tipping points of epidemics.
PROCESS OF ABSTRACTION
SOVEREIGN DEBT & CREDIT CRISIS
MUNI BOND OUTFLOWS
RESIDENTIAL REAL ESTATE - PHASE II
COMMERCIAL REAL ESTATE
2011 will see the largest magnitude of US bank commercial real estate mortgage maturities on record.
2012 should be a top tick record setter for bank CRE maturities looking both backward and forward over the half decade ahead at least.
Will this be an issue for an industry that has been supporting reported earnings growth in part by reduced loan loss reserves over the recent past? In 2010, approximately $250 billion in commercial real estate mortgage maturities occurred. In the next three years we have four times that much paper coming due.
Will CRE woes, (published or unpublished) further restrain private sector credit creation ahead via the commercial banking conduit?
Wiil the regulators force the large banks to show any increase in loan impairment. Again, given the incredible political clout of the financial sector, I doubt it.
We have experienced one of the most robust corporate profit recoveries on record over the last half century. We know reported financial sector earnings are questionable at best, but the regulators will do absolutely nothing to change that.
So once again we find ourselves in a period of Fed sponsored asset appreciation. The thought, of course, being that if stock prices levitate so will consumer confidence. Which, according to Mr. Bernanke will lead to increased spending and a virtuous circle of economic growth. Oh really? The final chart below tells us consumer confidence is not driven by higher stock prices, but by job growth.
9 - CHRONIC UNEMPLOYMENT
There are 3 major inflationary drivers underway.
1- Negative Real Interest Rates Worldwide - with policy makers' reluctant to let their currencies appreciate to market levels. If no-one can devalue against competing currencies then they must devalue against something else. That something is goods, services and assets.
2- Structural Shift by China- to a) Hike Real Wages, b) Slowly appreciate the Currency and c) Increase Interest Rates.
3- Ongoing Corporate Restructuring and Consolidation - placing pricing power increasingly back in the hands of companies as opposed to the consumer.
FOOD PRICE PRESSURES
RICE: Abdolreza Abbassian, at the FAO in Rome, says the price of rice, one of the two most critical staples for global food security, remains below the peaks of 2007-08, providing breathing space for 3bn people in poor countries. Rice prices hit $1,050 a tonne in May 2008, but now trade at about $550 a tonne.
WHEAT: The cost of wheat, the other staple critical for global food security, is rising, but has not yet surpassed the highs of 2007-08. US wheat prices peaked at about $450 a tonne in early 2008. They are now trading just under $300 a tonne.
The surge in the FAO food index is principally on the back of rising costs for corn, sugar, vegetable oil and meat, which are less important than rice and wheat for food-insecure countries such as Ethiopia, Bangladesh and Haiti. At the same time, local prices in poor countries have been subdued by good harvests in Africa and Asia.
- In India, January food prices reflected a year-on-year increase of 18%t.
- Buyers must now pay 80%t more in global markets for wheat, a key commodity in the world's food supply, than they did last summer. The poor are especially hard-hit. "We will be dealing with the issue of food inflation for quite a while," analysts with Frankfurt investment firm Lupus Alpha predict.
- Within a year, the price of sugar on the world market has gone up by 25%.
US STOCK MARKET VALUATIONS
WORLD ECONOMIC FORUM
Potential credit demand to meet forecast economic growth to 2020
The study forecast the global stock of loans outstanding from 2010 to 2020, assuming a consensus projection of global
economic growth at 6.3% (nominal) per annum. Three scenarios of credit growth for 2009-2020 were modelled:
• Global leverage decrease. Global credit stock would grow at 5.5% per annum, reaching US$ 196 trillion in 2020. To
meet consensus economic growth under this scenario, equity would need to grow almost twice as fast as GDP.
• Global leverage increase. Global credit stock would grow at 6.6% per annum, reaching US$ 220 trillion in 2020.
Likely deleveraging in currently overheated segments militates against this scenario.
• Flat global leverage. Global credit stock would grow at 6.3% per annum to 2020, tracking GDP growth and reaching
US$ 213 trillion in 2020 – almost double the total in 2009. This scenario, which assumes that modest
deleveraging in developed markets will be offset by credit growth in developing markets, provides the primary credit
growth forecast used in this report.
Will credit growth be sufficient to meet demand?
Rapid growth of both capital markets and bank lending will be required to meet the increased demand for credit – and it is
not assured that either has the required capacity. There are four main challenges.
Low levels of financial development in countries with rapid credit demand growth. Future coldspots may result from the
fact that the highest expected credit demand growth is among countries with relatively low levels of financial access. In
many of these countries, a high proportion of the population is unbanked, and capital markets are relatively undeveloped.
Challenges in meeting new demand for bank lending. By 2020, some US$ 28 trillion of new bank lending will be
required in Asia, excluding Japan (a 265% increase from 2009 lending volumes) – nearly US$ 19 trillion of it in China
alone. The 27 EU countries will require US$ 13 trillion in new bank lending over this period, and the US close to US$
10 trillion. Increased bank lending will grow banks’ balance sheets, and regulators are likely to impose additional capital
requirements on both new and existing assets, creating an additional global capital requirement of around US$ 9 trillion
(Exhibit vi). While large parts of this additional requirement can be satisfied by retained earnings, a significant capital gap in
the system will remain, particularly in Europe.
The need to revitalize securitization markets. Without a revitalization of securitization markets in key markets, it is doubtful
that forecast credit growth is realizable. There is potential for securitization to recover: market participants surveyed by
McKinsey in 2009 expected the securitization market to return to around 50% of its pre-crisis volume within three years.
But to rebuild investor confidence, there will need to be increased price transparency, better data on collateral pools, and
better quality ratings.
The importance of cross-border financing. Asian savers will continue to fund Western consumers and governments:
China and Japan will have large net funding surpluses in 2020 (of US$ 8.5 trillion and US$ 5.7 trillion respectively), while
the US and other Western countries will have significant funding gaps. The implication is that financial systems must
remain global for economies to obtain the required refinancing; “financial protectionism” would lock up liquidity and stifle
US$ RESERVE CURRENCY
Société Générale fears China has lost control over its red-hot economy and risks lurching from boom to bust over the next year, with major ramifications for the rest of the world.
Société Générale said China's overheating may reach 'peak frenzy' in mid-2011
- The French bank has told clients to hedge against the danger of a blow-off spike in Chinese growth over coming months that will push commodity prices much higher, followed by a sudden reversal as China slams on the brakes. In a report entitled The Dragon which played with Fire, the bank's global team said China had carried out its own version of "quantitative easing", cranking up credit by 20 trillion (£1.9 trillion) or 50pc of GDP over the past two years.
- It has waited too long to drain excess stimulus. "Policy makers are already behind the curve. According to our Taylor Rule analysis, the tightening needed is about 250 basis points," said the report, by Alain Bokobza, Glenn Maguire and Wei Yao.
- The Politiburo may be tempted to put off hard decisions until the leadership transition in 2012 is safe. "The skew of risks is very much for an extended period of overheating, and therefore uncontained inflation," it said. Under the bank's "risk scenario" - a 30pc probability - inflation will hit 10pc by the summer. "This would cause tremendous pain and fuel widespread social discontent," and risks a "pernicious wage-price spiral".
- The bank said overheating may reach "peak frenzy" in mid-2011. Markets will then start to anticipate a hard-landing, which would see non-perfoming loans rise to 20pc (as in early 1990s) and a fall in bank shares of 50pc to 75pc over the following 12 months. "We think growth could slow to 5pc by early 2012, which would be a drama for China. It would be the first hard-landing since 1994 and would destabilise the global economy. It is not our central scenario, but if it happens: commodities won't like it; Asian equities won't like it; and emerging markets won't like it," said Mr Bokobza, head of global asset allocation. However, it may bring down bond yields and lead to better growth in Europe and the US, a mirror image of the recent outperformance by the BRICs (Brazil, Russia, India and China).
- Diana Choyleva from Lombard Street Research said the drop in headline inflation from 5.1pc to 4.6pc in December is meaningless because the regime has resorted to price controls on energy, water, food and other essentials. The regulators pick off those goods rising fastest. The index itself is rejigged, without disclosure. She said inflation is running at 7.6pc on a six-month annualised basis, and the sheer force of money creation will push it higher. "Until China engineers a more substantial tightening, core inflation is set to accelerate.
- The longer growth stays above trend, the worse the necessary downswing. China's violent cycle could be highly destabilising for the world." Charles Dumas, Lombard's global strategist, said the Chinese and emerging market boom may end the same way as the bubble in the 1990s. "The basic strategy of the go-go funds is wrong: they risk losing half their money like last time."
- Société Générale said runaway inflation in China will push gold higher yet, but "take profits before year end".
- The picture is more nuanced for food and industrial commodities. China accounts for 35pc of global use of base metals, 21pc of grains, and 10pc of crude oil. Prices will keep climbing under a soft-landing, a 70pc probability. A hard-landing will set off a "substantial reversal". Copper is "particularly exposed", and might slump from $9,600 a tonne to its average production cost near $4,000. Chinese real estate and energy equities will prosper under a soft-landing,
- The bank likes regional exposure through the Tokyo bourse, which is undervalued but poised to recover as Japan comes out of its deflation trap. If you fear a hard landing, avoid the whole gamut of Chinese equities. It will be clear enough by June which of these two outcomes is baked in the pie.
PUBLIC SENTIMENT & CONFIDENCE
SHRINKING REVENUE GROWTH RATES
PIMCO'S NEW NORMAL: According to PIMCO, the coiners of the term, the new normal is also explained as an environment wherein “the snapshot for ‘consensus expectations’ has shifted: from traditional bell-shaped curves – with a high likelihood mean and thin tails (indicating most economists have similar expectations) – to a much flatter distribution of outcomes with fatter tails (where opinion is divided and expectations vary considerably).” That is to say, the distribution of forecasts has become more uniform (as per Exhibit 1).
Ever since the advent of QE2, few if any, sellside analysts employed by Too Big To Fail banks have dared to voice a negative opinion of the Chairman's third mandate, that of raising stock prices (for obvious reasons: nobody will bite the hand that feeds them trillion in taxpayer bailout money). Which is why we continue to believe the BofA credit strategist Jeffrey Rosenberg is one of the few men standing who dares to call it how it is. In his latest piece, Rosenberg lays out what is the most harshly (yet diplomatically) worded criticism of QE we have read to date. "In our view, the longer term problem with such a strategy is that in delaying the adjustment to the root causes of the credit crisis, namely excessive leverage in the economy and financial markets, the essential vulnerabilities from that excessive leverage remain. What triggers their realization again is the inflationary shock leading to an interest rate shock that undermines the cheap cost of that debt that currently enables its maintenance." As for the implicit assumption that savings and wealth are inversely correlated, Rosenberg points out the glaringly obvious: "Inflation erodes the value of those savings and decreases their standard of living." The only option left: "Lowering the value of savings creates a powerful incentive to take on investment risk to maintain the real purchasing power of those savings." And while everyone getting aboard the investment ship at the same time is a horrible idea when it happens in one country, it is a guaranteed disaster waiting to happen when it occurs at the global level. Which is precisely what has happened: "Today, we see that same pattern again at play. But this time, it’s not limited to just the US Fed policy. Globally, central banks are pursuing coincident easy money policies. And even in Emerging Markets where the inflation fears stand most acute, the policy rate increases are just keeping up with inflation increases. The result: global negative or zero real policy rates." The entire global "economy", which really means stock market, is now one timebomb, just waiting for the first central banker error-induced 'crack' to appear in the windshield, following which the destruction will be unprecedented.
From Jeffrey Rosenberg:
Monetary policy goal: raise stock prices?
The Fed pursues a dual mandate: maintain stable inflation consistent with maximum employment. The Fed’s justification for QE2 in this context, to help raise stock prices, would seem at the least surprising. Yet, the Fed now understands the critical role asset prices play in the functioning of the real economy. Figure 5 below highlights the strong and persistent inverse relationship between savings and wealth.
The destruction of wealth during the financial crisis fed a collapse in spending that led to a real economy recession. So the quickest way back to recovery? Reflate the assets to bring back the confidence. And so far that strategy has worked. In our view, the longer term problem with such a strategy is that in delaying the adjustment to the root causes of the credit crisis, namely excessive leverage in the economy and financial markets, the essential vulnerabilities from that excessive leverage remain. What triggers their realization again is the inflationary shock leading to an interest rate shock that undermines the cheap cost of that debt that currently enables its maintenance. If that happens before debt levels can be brought down then the future adjustment in debt will extract even a greater burden. Those remain our longer term concerns, as we recently summarized (see nearby links). For now however, don’t call us bullish, call us “bubblish”.
There's an increasingly widespread view in the market that investors are becoming complacent and that all this bullish sentiment is a negative signal for stock prices. With sentiment surveys from both Investors Intelligence and AAII both showing levels of bullishness above 50%, sentiment is anything but negative. That being said, in the last several weeks we have begun to see some signs that investors are becoming less bullish as stock prices rise.
The chart below compares the S&P 500 to the Investors Intelligence weekly survey of advisor bullish sentiment. For most of 2010, the two moved step for step with each other. When the S&P 500 rose, bullish sentiment increased, and when the market declined, advisors turned less bullish. Curiously though, towards the end of 2010, bullish sentiment stopped rising even as the S&P 500 kept on chugging along. Since peaking at 58.8 on 12/22, bullish sentiment has declined by 6.6 points (11.22%). At the same time the S&P 500 has risen by nearly 6%. The big question now is, are investors correctly anticipating a correction, or will they be sucked (or as bears would say suckered) back in at higher prices?
Plans for a merger between Deutsche Börse and NYSE Euronext
Deutsche Börse is taking a majority share in the newly merged company, concerns of a foreign takeover are probably less pronounced in Germany than in the U.S., where fears that the Germans are stealing the heart of American capitalism have flourished.
Germany financial newspaper “Boersen-Zeitung” was more specific on the merger weaknesses, and suggested that Deutsche Börse could have better partnered with one of the fast growing Asian exchanges. “The criticism that the Deutsche Börse has allied with an aged and footsore icon from the old exchange world is unfortunately accurate,” the newspaper writes.
Germans also still remember NYSE’s “merger of equals” with France’s Euronext, which was quickly dominated by the New York company and is sometimes attributed to Paris’ loss of influence as a financial capital.
The muni loan market emerges
When I was worrying about munis last week, I said that “the amounts here are far too big for states to go to the loan market instead: if investors won’t buy bonds, banks won’t lend the states the money they need.”
Which might be narrowly true, when it comes to state borrowers in particular. But other borrowers are finding the banks quite eager to lend to them:
J.P. Morgan Chase & Co. is devoting billions of dollars to direct loans this year to both refinance deals and for new projects, according to a bank official. Last year, the bank made a few hundred million dollars of direct loans to municipalities. Now, the bank would consider making a single loan for hundreds of millions of dollars, the official said. It also is dispatching teams to explain the concept to wary public borrowers.
Citibank also is courting municipal borrowers with direct loans, according to several bond issuers. A spokesman for the Citigroup Inc. unit declined to comment.
“This used to be unheard of,” says Eric Friedland, managing director of public finance at Fitch Ratings…
For banks, this is a potentially lucrative business at a time when they are sitting on cash that isn’t earning huge interest and are reluctant to make loans for mortgages and other areas they see as risky…
When word got out that Riverside, Calif., was floating a bond recently, several bankers called offering direct loans.
This is a welcome development, I think. It brings a whole new investor class to the muni market, as well as a lot more serious underwriting in an area where the amount of diligent credit analysis has always been much lower than it should be given the size of the market.
That said, if banks start picking off the most attractive borrowers in the muni market, that might only serve to reduce the overall quality of outstanding municipal bonds. Every time a municipality issues a bond from now on, potential investors will start asking themselves whether they’re being offered the sloppy seconds which various banks have all passed on. Direct loans might be very attractive, on a case-by-case basis, to both borrowers and lenders. But if people continue to look for reasons to mistrust the municipal bond markets, this isn’t going to help
Money and Reserves
If the Fed didn't print any money as part of QE2 and earlier asset purchases, how did it pay for the stuff it bought? The answer is that the Fed simply credited the accounts that banks that are members of the Federal Reserve System hold with the Fed. These electronic credits, or reserve balances, are what has exploded since 2008. The blue area in the graph below is the total currency in circulation, whose growth has been pretty modest. The maroon area represents reserves.
Are reserves the same thing as money? An individual bank is entitled to convert those accounts into currency whenever it likes. Reserves are also used to effect transfers between banks. For example, if a check written by a customer of Bank A is deposited in the account of a customer in Bank B, the check is often cleared by debiting Bank A's account with the Fed and crediting Bank B's account. During the day, ownership of the reserves is passing back and forth between banks as a result of a number of different kinds of interbank transactions.
To understand how the receipt of new reserves influences a bank's behavior, the place to start is to ask whether the bank is willing to hold the reserves overnight. Prior to 2008, a bank could earn no interest on reserves, and could get some extra revenue by investing any excess reserves, for example, by lending the reserves overnight to another bank on the federal funds market. In that system, most banks would be actively monitoring reserve inflows and outflows in order to maximize profits. The overall level of excess reserves at the end of each day was pretty small (a tiny sliver in the above diagram), since nobody wanted to be stuck with idle reserves at the end of the day. When the Fed created new reserves in that system, the result was a series of new interbank transactions that eventually ended in the reserves being withdrawn as currency.
All that changed dramatically in the fall of 2008, because (1) the Fed started paying interest on excess reserves, and (2) banks earned practically no interest on safe overnight loans. In the current system, new reserves that the Fed creates just sit there on banks' accounts with the Fed. None of these banks have the slightest desire to make cash withdrawals from these accounts, and the Fed has no intention whatever of trying to print the dollar bills associated with these huge balances in deposits with the Fed.
Of course, the situation is not going to stay this way indefinitely. As business conditions pick up, the Fed is going to have to do two things. First, the Fed will have to sell off some of the assets it has acquired with those reserves. (YEH RIGHT!! - SEE CHART)
The purchaser of the asset will pay the Fed by sending instructions to debit its account with the Fed, causing the reserves to disappear with the same kind of keystroke that brought them into existence in the first place. Second, the Fed will have to raise the interest rate it pays on reserves to give banks an incentive to hold funds on account with the Fed overnight.
Doing this obviously involves some potentially tricky details. The Fed will have to begin this contraction at a time when the unemployment rate is still very high. And the volumes involved and lack of experience with this situation suggest great caution is called for in timing and operational details. Sober observers can and do worry about how well the Fed will be able to pull this off.
But that worry is very different from the popular impression by some that hyperinflation is just around the corner as a necessary consequence of all the money that the Fed has supposedly printed.