TIPPING POINTS

"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."

The three rules of epidemics

Gladwell describes the "three rules of epidemics" (or the three "agents of change") in the tipping points of epidemics.

• "The Law of the Few", or, as Gladwell states, "The success of any kind of social epidemic is heavily dependent on the involvement of people with a particular and rare set of social gifts."According to Gladwell, economists call this the "80/20 Principle, which is the idea that in any situation roughly 80 percent of the 'work' will be done by 20 percent of the participants." (see Pareto Principle) These people are described in the following ways:

• Connectors are the people who "link us up with the world ... people with a special gift for bringing the world together." They are "a handful of people with a truly extraordinary knack [... for] making friends and acquaintances". He characterizes these individuals as having social networks of over one hundred people. To illustrate, Gladwell cites the following examples: the midnight ride of Paul Revere, Milgram's experiments in the small world problem, the "Six Degrees of Kevin Bacon" trivia game, Dallas businessman Roger Horchow, and Chicagoan Lois Weisberg, a person who understands the concept of the weak tie. Gladwell attributes the social success of Connectors to "their ability to span many different worlds [... as] a function of something intrinsic to their personality, some combination of curiosity, self-confidence, sociability, and energy."

• Mavens are "information specialists", or "people we rely upon to connect us with new information." They accumulate knowledge, especially about the marketplace, and know how to share it with others. Gladwell cites Mark Alpert as a prototypical Maven who is "almost pathologically helpful", further adding, "he can't help himself". In this vein, Alpert himself concedes, "A Maven is someone who wants to solve other people's problems, generally by solving his own". According to Gladwell, Mavens start "word-of-mouth epidemics" due to their knowledge, social skills, and ability to communicate. As Gladwell states, "Mavens are really information brokers, sharing and trading what they know".

• Salesmen are "persuaders", charismatic people with powerful negotiation skills. They tend to have an indefinable trait that goes beyond what they say, which makes others want to agree with them. Gladwell's examples include California businessman Tom Gau and news anchor Peter Jennings, and he cites several studies about the persuasive implications of non-verbal cues, including a headphone nod study (conducted by Gary Wells of the University of Alberta and Richard Petty of the University of Missouri) and William Condon's cultural microrhythms study.

• The Stickiness Factor, the specific content of a message that renders its impact memorable. Popular children's television programs such as Sesame Street and Blue's Clues pioneered the properties of the stickiness factor, thus enhancing the effective retention of the educational content in tandem with its entertainment value.

• The Power of Context: Human behavior is sensitive to and strongly influenced by its environment. As Gladwell says, "Epidemics are sensitive to the conditions and circumstances of the times and places in which they occur." For example, "zero tolerance" efforts to combat minor crimes such as fare-beating and vandalism on the New York subway led to a decline in more violent crimes city-wide. Gladwell describes the bystander effect, and explains how Dunbar's number plays into the tipping point, using Rebecca Wells' novel Divine Secrets of the Ya-Ya Sisterhood, evangelist John Wesley, and the high-tech firm W. L. Gore and Associates. Gladwell also discusses what he dubs the rule of 150, which states that the optimal number of individuals in a society that someone can have real social relationships with is 150.

 

RESEARCH METHODOLOGY

 

PROCESS OF ABSTRACTION

 

 

SOVEREIGN DEBT & CREDIT CRISIS

 

MUNI BOND OUTFLOWS

RISK REVERSAL

 

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
growth.

 

US$ RESERVE CURRENCY

SocGen crafts strategy for China hard-landing

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.

SocGen crafts strategy for China hard-landing Pritchard

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).

If you think the recovery is firm and the risk of deflation has vanished, look at the three following numbers: $100, 3.44 and 20.

The first, everyone knows, is the price that New York crude oil touched briefly on Wednesday, driven 14 percent higher in just five trading sessions by conflict in Libya and concern over the reliability of supply elsewhere.

The second is the yield on 10-year U.S. Treasury notes, and if you are keeping score, they have dropped a rapid 28 basis points from early February, a drop that is telling you that bond investors do not believe the U.S. economy can easily withstand $100 oil.

The third, that 20 percent, is perhaps the most poignant, as it represents the current level, an all-time high, in the ratio of their disposable income that Americans are getting from government benefits.

That’s right: social security, food stamps, unemployment insurance and the like account for two out of every 10 dimes Americans have once they have paid their tax.

Those three numbers don’t say self-sustaining recovery, they say pressure on consumption, on wages and on asset prices.

The economic growth outlook for the BRIC remains strong. A combination of robust economic growth and rising commodity prices has pushed up inflation in all BRIC, and overheating concerns have mounted. BRIC currencies have been appreciating in real terms. In particular, the Brazilian real has strengthened by 40% within the last two years, albeit from depressed post-crisis levels. It is not surprising therefore that the Brazilian authorities took the most aggressive measures aimed at slowing capital inflows. Brazil, followed by India, remains the BRIC country most likely to take further measures, if necessary. Continued FX reserve accumulation also points towards a desire on the part of the authorities to prevent (further) nominal exchange rate appreciation. Despite the recent outflows in EM-related funds, capital flows to the BRIC are forecasted to remain strong, barring a significant revision of G-3 inflation and interest rate outlook

Of the nine members of the Bank of England’s (BoE) policy committee, three voted for rate hikes, which is one more than at the previous meeting. One of the three dissenters called for a 50 bps rate hike, while the other two voted for 25 bps.

Inflation continues to be the sore point: The CPI has been above the upper limit of the BoE's inflation target since January 2010, creating angst among some policymakers that temporary inflation pressures are becoming permanent. Indeed, the BoE expects inflation will remain well above the 2% target throughout 2011, boosted by the increase in the VAT, higher energy prices and higher import prices. But the Governor of the Bank, Mervyn King, continues to believe that beyond these one-off effects, the economy is still broadly disinflationary. We agree and expect that growth will be a greater concern than inflation in light of the massive fiscal cutbacks in the pipeline. Nonetheless, as highlighted in several recent Insights, the BoE is much more of a consensus body than the Fed, so Mr. King will need to be very persuasive in order to not get outnumbered by his fellow members. Financial markets are pricing in a 25-basis point rate hike as early as May with another one by the end of the year, taking the base rate to 1%. We doubt these expectations will be realized, but stay tuned.

A statistical hub containing key data from all the countries of the Arab League SINCE Tunisians rose up and ejected their leader, Zine el-Abidine Ben Ali, who had ruled the country for 23 years, the scent of jasmine has spread through the Arab world. Egyptian protesters ousted their president, Hosni Mubarak, in just 18 days, after three decades under his rule. This week, Algeria, Libya, Yemen, Jordan, and Bahrain have all seen brave demonstrations by people fed up with being denied a voice and a vote. The map below presents key indicators for each member of the Arab League.

 

The Fed is caught up in a 'Phillips curve' philosophy that only equates economic growth and prosperity with inflation. In short, Bernanke believes that slow growth and rising unemployment rates equate to deflation, despite plentiful contrary examples in history.

Since he believes rising commodity prices are deflationary and have nothing to do with his own loose monetary policy, the Fed is likely to expand its balance sheet to a greater degree. The fact that the Fed’s massive money printing effort is the progenitor of global food riots completely escapes him. As more damage is done, the Fed will use the resulting contraction in GDP to justify a third round of quantitative easing – further harming the GDP.

Unfortunately, the vicious cycle of stagflation will grow more acute with each iteration of the Fed’s love affair with counterfeiting. Countries that make the mistake of continuing to peg their currencies to the US dollar will suffer more inflation and more destabilization. Since it will be hardest for the US to ditch the dollar, our hopes are dimmer.

oThe United Nations announced in early February that global food prices were at an all-time high.

o The USDA indicated this week that 2011 corn inventories will be the lowest since 1974.

o Despite the fact that farmers have boosted the output of wheat, rice, and feed grain by 16% since 2000, demand has outstripped supply by 4 percentage points.

o Corn is up 95% and wheat has increased 70% since their year-ago levels.

o Overall, global food costs have jumped by 25% YoY since January 2009.

It is evident that global consumers continue to get pummeled by rising food and energy prices. Meanwhile, in addition to coping with rising inflation rates, the US consumer is also being hurt by the continued contraction in the price of houses – which are typically their primary assets. S&P/Case-Shiller indicated on Tuesday that their National Index dropped 4.1% from Q4 2009 thru Q4 2010. Home values have now dropped for 6 consecutive quarters and clearly indicate the real estate sector is suffering a double dip.

The ramifications of all the above data are foreboding for US GDP growth. Most importantly, anemic economic growth will worsen our debt-to-GDP ratio and thereby place further pressure on our already damaged balance sheet.

The Fed’s reaction will be as predictable as ever.

The market is up 100% in two years for the first time since the depression era in the 1930s, and is overbought, overextended and overvalued. It is therefore likely that the Mid-East turmoil is the catalyst that finally ends this secular bear rally and starts the market on a downward course.

ELEVATED OIL PRESSURES

The Mid-East turmoil is not over, and, most likely, has only begun.  The revolt in Tunisia spread to Egypt, and now Libya, a nation that produces 2% of the world's oil. There have also been demonstrations in other Arab nations such as Bahrain, Yemen, Algeria and Iran.  Others may be next.  History tells us that revolutions of this type are contagious once the first nation shows what could be done.  This was true hundreds of years before the age of the internet and cell phones, and is therefore even truer today. 

We also know that revolutions seldom end in benign fashion and that violence and chaos are more the norm.  This is particularly valid in the Mid-East where revolts have never ended with the formation of stable democracies.  It is therefore likely that turmoil in this section of the world will continue for some time with unpredictable results.

As a result of this unpredictability and the extremely small chance of a quick and benign outcome, oil prices have already soared and will remain high and volatile for an extended period of time.  Libya produces 2% of the word's oil, an amount that could probably be replaced by Saudi Arabia within a reasonable period.  What is particularly worrisome is that demonstrations in largely Shia Bahrain could spill over into neighboring Saudi Arabia, whose provinces bordering Bahrain produce most of its oil.  This area also contains most of the minority Shia in a mostly Sunni country.  In addition Bahrain's rulers are Sunnis as well.  Therefore it is easy to see that the potential for trouble is not insignificant.

The upshot of all this is that oil prices will probably remain high and could very well rise significantly even from current levels.  For the U.S., studies indicate that every $1 rise in the price of a barrel of oil is about equivalent to a 2.5 cent increase in a gallon of gas.  Oil prices have already jumped about $10 a barrel since the start of the crisis and $22 since November, translating into an eventual 55 cent a gallon rise in the price of gas.  Since every 1 cent rise in a gallon of gas costs consumers about $1.2 billion the increase to date will cause a $66 billion rise in spending for gas alone alone without even including the gas components in the price of such items as airline tickets, express mail and anything that is transported by truck.  This is virtually the same as an increase in taxes since it means less money available for spending on discretionary goods.  When we consider the possibility of even further increases in oil prices and then add in the prospective rise in food prices, it is easy to see the highly negative effect on economic growth in the period ahead.

This all in addition to high unemployment, modest income growth, lower housing wealth, high rates of mortgage foreclosures, elevated inventories of unsold homes and tight credit conditions.  Furthermore, don't overlook the impact that higher oil and other commodity costs will have on overly optimistic earnings forecasts that will have to be revised down.

CONCLUSION

Ordinarily, in order to combat such a headwind to growth the Fed would ease monetary policy and the Administration and Congress would provide fiscal stimulation.  At this time, however, this policy is not feasible as the interest rates under Fed control are already near zero and Congress is pressing to reduce the deficit.   When we also consider that QE2 ends in June, we think that current economic growth forecasts are subject to important downward revisions in the months ahead.