COLLATERAL TRANSFORMATION - Quality Collateral Supply Is Determining "TAPER" Schedule

From Less Repo, To Less Collateral Transformation, To Less Quantiative Easing In One Shadowy Step 08-05-13 Zero Hedge

First it was the TBAC's May presentation "Availability of High Quality Collateral" piggybacking on reasoning presented previously by Credit Suisse. Then JPM's resident "flow and liquidity" expert Nikolaos Panigirtzoglou rang the bell on regulatory changes to shadow banking and how they would impact the repo market and collateral availability (and transformation) in an adverse fashion. Now, it is the turn of Barclays' own repo chief Joseph Abate to highlight a topic we have discussed since 2009: the ongoing contraction in quality collateral as a result of transformations in shadow banking and the Fed's extraction of quality collateral from traditional liquidity conduits (i.e., QE's monetization of bonds). To wit: "Several recent regulatory proposals will increase the pressure on banks to reduce assets that carry low risk weights. Repurchase agreements are a large source of banks’ low-risk assets, and we expect banks to reduce their matched book operations in response to these proposals."

Abate's highlights:

• Given inelastic demand for repo, we expect banks to increase margins to offset reduced volumes.
• The implications for market liquidity are potentially more severe, as banks and dealers may become less willing to facilitate short positions and warehouse risk.
• A reduction in repo activity will reduce the supply of investible assets for short-end investors, widen bid-ask spreads and could encourage the development of riskier substitutes for collateralized borrowing.
• Smaller securities inventories could reduce cash market liquidity. In the Treasury market, these banks may become less aggressive bidders at auctions.
• Likewise a reduction in repo balances will limit the market’s ability to transform weaker collateral into the high quality assets necessary to meet new margin requirements.

What this means explicitly for repo volumes is nothing new and has been covered here extensively in the past, and can be seen quite vividly in the periodic slide of OTR repo into "special" status, usually just ahead of Treasury auctions:

We expect repo volumes to fall for both U.S. and foreign banks. Repo in the U.S. has already fallen by 40% since its pre-crisis peak (Figure 1). We believe the U.S. repo market can reasonably be expected to decline 10% and possibly more across domestic and foreign banks as a result of these new rules and their proposed revisions. In fact, we believe this has already begun, although empirical evidence is difficult to find outside of discussions with money market funds regarding the decline in repo availability.

The most concrete evidence that the pressure on repo has already begun is the occurrence at quarter-end of plunging bank repo borrowings as primary dealers tighten their balance sheets ahead of end-of-period reporting. This is particularly acute for money market funds, whose repo balances from primary dealers typically fall 15% ($75bn) in the final day of a quarter, only to recover over the first two months of the following one. Money funds have attempted to replace some of these lost balances from non-primary dealers, but the credit ratings of these other institutions prevent much of this potential repo replacement. We estimate that nonprimary dealer collateral replaces only about $5bn of the $75bn lost on quarter-end from primary dealers. Unsurprisingly, since money fund balances generally have the same amount of cash to invest at quarter-end, the closing out of primary dealer repo positions results in a steep plunge in repo rates on the final day of the quarter.

The danger from the imposition of a "higher supplementary leverage ratio" is that while on the surface banks may demonstrate stronger balance sheets and less counterparty exposure, it will simply force them to seek "near-substitutes" that behave not exactly according to plan. See Lehman.

Lower repo and bill yields may seem like a small price to pay for stronger bank balance sheets, but there is a strain of research that argues that such scarcity encourages the creation of near-substitutes that may not behave quite like the original. Auction rate securities are an example of an imperfect substitute that under normal market conditions was a perfectly adequate liquidity investment, but ultimately became illiquid during the financial crisis.

Digging into the implications of "thinner dealer inventories" which is already a direct result of changes in the repo market:

In addition to maintaining inventories of securities for proprietary trading and their own portfolios, as significant capital market’s players, these banks hold stockpiles of Treasuries and other securities as part of their market making operations. Net positions in Treasuries across all the primary dealers totalled $80bn in mid-July. Market making – along with hedging inventories – are generally financed in the repo market so a reduction in repo balances will translate into thinner market-making inventories. Similarly, with less dedicated balance sheet, we expect banks to become less aggressive participants in the Treasury’s auctions. This could result in sloppier auctions with bigger tails and ultimately, higher borrowing costs for the Treasury.

A significant reduction in repo might reduce the ability of a dealer or other investors to short securities – without fear of delivery fails. In the Treasury market, a higher risk of failing and consequently incurring the 300bp fails charge, might influence how aggressively dealers participate in auctions and might affect actual auction pricing – even though fails are currently very low (Figure 2). Further, the possibility of increased fails could mean greater volatility in rates as dealers’ willingness to make markets and intermediate between buyers and sellers declines. To avoid the risk of fails, banks and dealers will spend more time searching for available supply to short. Higher search costs reduce the ability of the market to match buyers and sellers, further widening bid-ask spreads.

Repo also plays an important role in intermediating between buyers and sellers outside the Treasury market. Any activity in which banks act as securities “distributors” requires some amount of financing. Whether this financing is done via the repo market will depend on the asset’s underlying liquidity. By reducing balance sheet capacity, the leverage rules are likely to reduce market liquidity as banks ration their available inventory capacity. We expect this rationing will increase bid-ask spreads in any market where banks act as market makers between buyers and sellers.

Finally, and getting straight to the heart of the TBAC's May warning, we focus on the biggest issue of all: collateral transformation, or literally getting something from nothing (or absolute junk) courtesy of the murky, off-balance sheet transformations that take place in the shadow banking system:

In a typical transaction, the customer pledges weaker collateral to the bank in return for higher quality collateral, such as Treasuries or cash. These are then used to meet the customer’s margin requirements on derivatives trades. Since these trades are typically structured as repo transactions using the bank’s balance sheet, they are sensitive to the new supplementary leverage requirements, especially as other regulations are expected to increase the demand for this type of collateral transmutation significantly.

Dodd-Frank sections 731 and 764 change the margin rules for cleared (trades over an exchange) and un-cleared or bilateral derivatives transactions. These are expected to boost the demand for high-quality liquid assets over the next six years. According to estimates from the U.S. Treasury, the incremental demand for high-quality liquid assets to meet the new margin rules will be $1.6-3.2trn. These estimates grow considerably larger if, during the six-year interval estimated, there is a financial crisis or shock that results in a sudden, sharp increase in the demand for safe assets.

Although the supply of high quality collateral to meet this new demand source is likely to come from government issuance as deficits persist globally, we expect banks also to play a role via collateral transformation. After all, most of these derivatives customers are likely to be naturally long non-eligible collateral – such as equities or corporate bonds – but somewhat less so with respect to Treasuries and cash. As intermediaries, banks can use their balance sheets and repo transactions to “extend” the supply of eligible margin collateral for their customers – for a price. As noted above, this is the type of higher margin business for which banks might be willing to use their capacity constrained balance sheets, provided the spread between lower and higher risk collateral is sufficiently wide. To the extent that the supply of government collateral is insufficient to meet the new margin demand, transformation trades are an important safety valve if bank balance sheet capacity is available.

Note the highlighted, underlined text above, because it gets to the bottom of the tapering discussion: in a world in which "deficits persist", the Fed has all the liberty to do as much QE as needed, and absorb quality collateral as much as new gross collateral is injected via the Treasury (i.e., deficit funding). However, as deficits decline, as they have been in the US for the past few quarter (at least until the housing picture inevitably deteriorates again and the GSEs go from source of government funding back to use, and the demographic crunch hits in 2015 and deficits explode higher once again), ongoing monetization means collapsing the high quality collateral pool of assets far more than the TBAC advises. In fact, it is the TBAC that is pulling the strings on the Fed and making it clear, as it did in May, that the Fed has no choice but to taper as long as deficits don't return on their normal, upward trajectory (whether this means a war is inevitable to boost contracting defense spending remains to be decided).

However, it is this aspect of the Fed "cornering itself" that is the underlying driver of all behind the scenes tapering discussions, which have nothing to do with the economy. Because while all the rhetoric and regulatory discussion focuses on the economy, the open markets, and deficits - this is all for general popular consumption. What the Fed and the BIS are truly concerned about, and have been for the past four years, is ongoing instability in the repo world, and other aspects of shadow banking. The last thing the Fed, and Treasury, will want to do is override the TBAC on its advice to moderate collateral extraction and plough on with even more quality asset imbalances in shadow banking. And this is why, at least until the Treasury proceeds to spend itself back into "drunken sailor" mode, that all hopes that the Fed will monetize everything that is not nailed down, will have to be deferred indefinitely.

And with Credit Suisse, the TBAC, JPM and Barclays all having now covered this issue, we look forward to that final "liquidity" guru, Citi's Matt King to chime in on precisely this topic, and make it clear just what the real considerations driving the Fed's tapering "logic" are at this moment.

CHINA - Sustainability Requires A Slowdown in Investment

China’s Sustainability Requires Slowdown in Investment 08-05-13 Mark Williams, Chief Asia economist at Capital Economics in London.

There has been a sea change recently in how investors view China’s economic prospects, with a growing belief that the slowdown reflects structural constraints rather than cyclical weakness. These constraints are often linked to demographic changes such as the fact that the working-age population last year declined for the first time in the modern era. However, population growth was never a big part of China’s growth story. Demographic changes this decade will account for only about 1 percentage point of the slowdown in economic growth.

The roots of the continuing slowdown lie elsewhere, mostly in investment spending.

Investment has increased to 46 percent of total spending from 36 percent in the last 10 years, well above the emergingworld average of 30 percent of GDP.

There are three reasons why such a high rate is a problem.

• First, it increases the vulnerability of the economy to shocks. Companies are far more likely to cut back on investment when conditions worsen than households are to reduce spending.
• Second, rapid investment growth also raises the risk of a financial crisis if it has been underpinned by a large increase in credit. Before 2008, credit in China was expanding at roughly the same rate as the economy. Since then, the country has depended on much faster credit increases to generate growth, with credit rising to 200 percent from 130 percent of GDP in just five years.
• Third, a high investment rate raises the chances investment is misallocated and resources wasted. This is particularly a problem for a country like China with an undeveloped financial system.

Evidence on how bad the problem of misallocation is in China is mixed. One way to think about this is to ask what the current return is on capital. If a lot of investment is going into areas where it is not used productively, then profits will be hurt.

• In the steel industry, for example, 40 percent of domestic producers are running at a loss.
• Construction equipment and shipbuilding are other sectors currently under pressure.
• The sector where oversupply threatens to have the largest economic impact is housing. In value-added terms, real estate construction accounts for 9 percent of economic output. Once the indirect links to durable goods production and infrastructure construction are factored in, real estate’s role in the economy is even larger. There are plenty of reasons to be concerned at this. Housing completions have doubled in six years. If real estate investment continues to grow at the recent rate, they will double again by the end of the decade, leading to massive oversupply.

PESSIMISM OF OVERCAPACITY: Against the backdrop of increasing pessimism, such evidence of overcapacity is fueling talk of an imminent crisis. Even so, the troubles of individual sectors do not tell the story of the whole economy.

Stepping back to look at industry overall, profit margins continue to hold up relatively well. There has been no repeat of the margin compression of 2009, let alone a return to the despair of the late 1990s, when overcapacity and investment misallocation in state-owned industry forced a wholesale restructuring.

Similarly, there has been only a small decline recently in the returns firms generate on capital. And, unlike in previous downturns, there has been no industry-wide spike in inventories. Indeed, there are a couple of reasons to believe growth may stabilize or even pick up a little in the short term.

Credit is still expanding at a 20 percent annual rate and there are tentative signs this is finally feeding into stronger activity.

Meanwhile, the government has signaled it intends to keep growth above 7 percent and has announced some targeted measures to boost spending.

We expect policy makers to do more over coming months and years to steer the economy onto a new path. While this will be a healthy development, it almost certainly means that the pace of growth will slow further. One important feature of the slowdown so far is that, although it has been led by weakening investment, this has still not been enough to pull down investment’s share of GDP.

As long as investment remains the main driver of growth, the risks will loom large.

US BUDGET - Everyone Hates Sequestration, But Few Can Agree On What to Cut

The GOP's Entire Budget Strategy Collapsed Yesterday, And Almost No One Noticed 08-01-13 BI

House Republicans' latest fiasco confirms the suspicion: The GOP loves the Paul Ryan budget in theory, but even Republicans can't get it to work in practice.

That was the result of a seemingly nonchalant debate over a bill to fund the Departments of Transportation, and Housing and Urban Development, which blew up in House Republicans' faces on Wednesday.

The THUD bill was, well, a thud, and it was pulled from the House floor amid the realization that it did not have close to the 218 votes of GOP support it needed. Republicans couldn't garner the votes while abiding by their standards — billions in cuts on top of the levels of spending under sequestration.

House Majority Leader Eric Cantor said that the House will return to appropriating the bill after Congress' August recess. But a furious House Appropriations Committee Chairman Hal Rogers said that was "bleak at best," and other GOP sources said there's little chance of that, as well.

What happened here? This bill to fund the THUD served as Republicans' starting point in negotiations with Democrats. The GOP used the Ryan budget — which it passed more than four months ago — as a blueprint for the cuts they would need to make.

But the problem with Ryan's budget is that it works in abstractions, and is never binding. And Republicans learned that, for the sake of saving face while going back to their districts, the heavy cuts projected in the Ryan budget just weren't workable.

In a scathing statement, the normally measured Rogers blasted his colleagues.

"With this action, the House has declined to proceed on the implementation of the very budget it adopted just three months ago," Rogers said. "Thus, I believe that the House has made its choice: sequestration – and its unrealistic and ill-conceived discretionary cuts – must be brought to an end."

That last sentence is what Democrats have been saying since sequestration took effect in March. Predictably, House Democrats seized on the news, with Budget Committee ranking member Chris Van Hollen using Rogers' statement as proof of validation for Democrats.

Talking Points Memo's Brian Beutler explains how this latest failure could affect the coming battle over the fight to fund the government with a complete continuing-resolution bill:

If House Republicans can’t establish a position of their own, then the Senate will drive the whole process (its Transportation/HUD bill will probably pass on a bipartisan basis this week) and appropriations will be extended past September one way or another on the strength of Democratic votes.

It also suggests that the GOP’s preference for permanent sequestration-level spending, particularly relative to increasing taxes, is not politically viable. If they want to lift the defense cuts, they’re going to have to either return to budget negotiations with Democrats, or agree to rescind sequestration altogether.

Republicans passed the unspecific outlines of the Ryan budget earlier this year, because they look good in abstraction. But when it comes to specifics, the knife cuts too deep. Meanwhile, the Senate will move Thursday to the next step in its version of the THUD bill.

OBAMACARE - A Flawed Public Policy Implmentation

America: Where Hard Working, Productive Members Of Society Pay For The Health Care Of Everyone Else 08-04-13 Michael Snyder of The Economic Collapse blog via ZH

Everybody in America wants health care - but most Americans seem to want someone else to pay for it.  In the United States today, the way that our system works is that the hard working, productive members of society pay for the health care of everyone else.  At least under socialism everyone gets the same benefits.  Our system of health care is a very twisted version of socialism where millions upon millions of very hard working people are forced to pay for the health care of others, but often can't afford to purchase decent health insurance for themselves. 

Personally, I don't have a big employer paying for my health care so I have to buy it myself, and I just got a letter from my health insurance company telling me that I have another massive rate increase coming up.  Have you gotten a similar letter?  Health insurance premiums are going up all over America, and this is just the beginning.  In fact, the CEO of Aetna says that health insurance rates for many Americans will double when the major provisions of Obamacare kick in next year.

It would be bad enough if hard working Americans just had to pay for their own health insurance.  But no, they are also expected to pay for the health care of members of Congress, employees of the IRS and other federal agencies, state and local government employees, their adult kids (because they can't afford health insurance), the elderly, the poor, and now under Obamacare they will also be expected to subsidize the health plans of tens of millions of other Americans that are not poor enough to qualify for Medicaid.

When you add it all up, the hard working, productive members of society are at least partially subsidizing the health care of well over half of all Americans while having to pay for their own health care at the same time.

Needless to say, it isn't too hard to see who is getting the raw end of the deal.

Members of Congress certainly don't want to pay for their own health care.  There was panic in the halls of Congress recently when they started realizing that due to certain provisions in Obamacare they may soon be forced to pay for their own health insurance plans.  There was widespread moaning and complaining about how they would be facing "thousands of dollars in additional premium payments" every year.

Things got so bad that Barack Obama got personally involved in the effort to find a solution.  Thankfully, members of Congress can relax because a ruling is being issued that will allow the federal government to continue to subsidize 75 percent of the cost of their health plans...

Lawmakers and staff can breathe easy — their health care tab is not going to soar next year.

The Office of Personnel Management, under heavy pressure from Capitol Hill, will issue a ruling that says the government can continue to make a contribution to the health care premiums of members of Congress and their aides, according to several Hill sources.

A White House official confirmed the deal and said the proposed regulations will be issued next week.

And the IRS, which has been put in charge of imposing the rules of Obamacare on all the rest of us, is freaking out about the fact that some members of Congress would like to force them to personally participate in Obamacare...

The union that represents IRS employees is urging its members to write to their congressmen to help get the union out of Obamacare.

The following are some excerpts from a letter that the union that represents IRS employees sent to members of Congress...

“H.R. 1780 would put federal employees in a special class where they would be prohibited from receiving health insurance through their employer. It would treat federal employees differently from state and local government employees and most employees of large private sector companies who receive health insurance benefits through their employer. The primary purpose of the Affordable Care Act was to provide a marketplace for the sale and purchase of health insurance for those who do not have such coverage – not to take coverage away from employees who already receive it through their employers,” the letter reads.

“I work hard and am proud of the services that I provide to your constituents every day. One of the main benefits I receive as a federal employee is the ability to purchase health insurance coverage through the FEHBP with an employer contribution towards those benefits. Please let me know your views on this legislation. I look forward to hearing back from you,” the letter concludes.

This is just shameful.  If the IRS is going to impose Obamacare on the rest of America, then it should be good enough for them too.

Just check out acting IRS chief Danny Werfel begging for employees of his agency not to have to go on Obamacare...

But we have always had to at least partially subsidize the health plans of federal, state and local government workers.

The big change under Obamacare is that we will soon be subsidizing the health plans of tens of millions of our fellow Americans.

CNN says that 26 million Americans will be eligible for health insurance subsidies, but others believe that the true number is far, far higher than that.

For example, according to CNBC, a family of three in New York that earns $78,120 a year would be eligible for a subsidy of more than five thousand dollars...

In New York, a family of three whose annual income totals $78,120, would pay $12,784 for the second-lower-priced silver plan on that state's insurance exchange. After getting a $5,363 tax credit, the family's net cost for the insurance would be $7,421.

So who pays for that?

You and I do through our tax dollars.

And if you can believe it, Obamacare actually provides an incentive to not work too hard, because if you make too much money you could lose your health insurance subsidy...

Working more could ultimately mean thousands of dollars less for you under a quirk in the new health-care law going into effect this fall. This could prompt some people to cut back on their hours to avoid losing money.

"Working more can actually leave you worse off," the price-comparison site ValuePenguin.com notes in a new analysis.

"It's sort of an absurd scenario," said Jonathan Wu, ValuePenguin.com's co-founder. "It's something for people to be aware of."

In that scenario, an individual or family whose annual income surpasses maximums set by the federal government—if only by $1—will totally lose subsidies available to buy health insurance under the Affordable Care Act.

What a perverse system.

And of course Obamacare will allow young adults to stay on the health insurance policies of their parents until they reach 26 years of age.  As I mentioned the other day, 36 percent of all young adults in the 18 to 31 age bracket are currently living with their folks.  In most of those cases, the parents have to end up footing the bill for health care because the kids simply cannot afford it.

Medicaid continues to expand as well.  Certainly helping the poor is a very good thing, but unfortunately the number of poor just continues to explode.

Back in 1965, only one out of every 50 Americans was on Medicaid.  Today, one out of every 6 Americans is on Medicaid, and things are about to get a whole lot worse.

Right now, there are more than 56 million Americans on Medicaid, and it is being projected that Obamacare will add 16 million more Americans to the Medicaid rolls.

It is going to take a whole lot of money to support 72 million Medicaid patients.

And then of course there is Medicare.

When Medicare was first established, we were told that it would cost about $12 billion a year by the time 1990 rolled around.

Instead, it actually cost the federal government $110 billion in 1990, and it will cost the federal government close to $600 billion this year.

But if you think this is bad, just wait until all of the Baby Boomers retire.  It is being projected that the number of Americans on Medicare will grow from a little bit more than 50 million today to 73.2 million in 2025.  By then, we would be spending well over a trillion dollars a year on Medicare.

As you can see, under Obamacare the vast majority of all Americans will have their health care at least partially subsidized.

And it expected that our tax dollars will somehow be enough to pay for all of this.

The truth is that we have a deeply broken system.  Costs are spiraling out of control and nobody is quite sure how to fix things.  The following statistics come from one of my previous articles entitled "50 Signs That The U.S. Health Care System Is A Gigantic Money Making Scam"...

-This year the American people will spend approximately 2.8 trillion dollars on health care, and it is being projected that Americans will spend 4.5 trillion dollars on health care in 2019.

-The United States spends more on health care than Japan, Germany, France, China, the U.K., Italy, Canada, Brazil, Spain and Australia combined.

-If the U.S. health care system was a country, it would be the 6th largest economy on the entire planet.

-Back in 1960, an average of $147 was spent per person on health care in the United States. By 2009, that number had skyrocketed to $8,086.

The sad thing is that many hard working Americans in the private sector are being forced to subsidize the health care of others, but they can't even afford decent health care for themselves.

For example, I know of one hard working couple that has a health plan that has a $1,000 deductible.  Even with that deductible, their health insurance premiums are absolutely ridiculous.  Their health care strategy is simply to avoid going to the hospital or visiting a doctor as much as possible.

And of course health insurance companies make money by providing as little health care as possible.  Many Americans have discovered that when you need them the most, some health insurance companies will try to get out of covering you any way that they possibly can.

The reality is that just because you have health insurance that does not mean that you are "covered".

According to a study that was published in The American Journal of Medicine, medical bills are a major factor in more than 60 percent of all personal bankruptcies in the United States.  Of those bankruptcies that were caused by medical bills, approximately 75 percent of them involved people that actually did have health insurance.

So what is the bottom line?

The bottom line is the system stinks, and Obamacare is going to make things a whole lot worse.

HOUSING - Household Formation Drives Residential Real Estate

Record 21 Million 'Young Adults' Now Live With Their Parents 08-02-13 PEW Research via ZH

Just about a year ago we questioned the "demographic demand" thesis for why the US housing 'recovery' would become self-sustaining and lead to yet another fiscal and monetary 'nirvana'. However, while the 'household formation' meme remains front-and-center among bloviating Fed apologists; the sad facts are that not only is household formation actually still falling but, as a recent Pew Research study finds, a record 21 million young adults are now living at home with their parents.

Since 2007, young adults have grown increasingly likely to live at home. This is a new trend with a stunning 45-year high 36% (21 million) of 18-31 year-olds back with mom-and-pop. By way of corollary, with one-third of all Italian adults living at home (and 61% of young-adults), it would seem arguing that a housing renaissance in the US is around the corner on the basis of demographics is risible at best.

Household formation is falling among the young adults (a new trend)...

as 18-31 year olds continue to be forced to move back in with their parents...

But as we warned 10 months ago, there is massively more room for this to increase...

as we see in Italy, it can get considerably worse...

According to a report published on Wednesday, almost a third of Italian adults (31%) live with their parents.

The highest proportion was among 18- to 29-year-olds, for whom unemployment is particularly high, with 60.7% reported living at home.

So with mortgage rates up, household formation down, and the rotation from full-time to part-time jobs, we suspect the exuberance priced into a 'housing recovery'-based growth renaissance is as unlikely as Ron Paul becoming the next Fed Head.

EMPLOYMENT - Low-Wage Jobs Bias Continues to Hamper U.S. Recovery

Low-Wage Jobs Bias Continues to Hamper U.S. Recovery 08-05-13 Bloomberg Brief

Economic data last week revealed the economy is plodding along at sub-par pace, incapable of engendering a solid pace of living-wage job creation.

The Bureau of Economic Analysis estimates the U.S. economy advanced an annualized 1.7 percent in the second quarter, or a lowly 1.4 percent over the last year.

This has traditionally raised recession alarms; since 1948, anytime the year-over-year pace has fallen this low, the economy has entered recession within three quarters.

Low wages and incomes will probably continue to stymie household spending and business investment, and impede the recovery efforts.

The economy’s weak path is consistent with findings in the Bloomberg Orange Book and its associated Orange Book Sentiment Index, which was at 49.26 during the week ended August 2 — the twenty-fifth consecutive sub-50 reading for this indicator.

The economy added 162,000 jobs in July while the unemployment rate slipped a tenth of a percentage point to 7.1 percent. While these numbers were considered favorable by some pundits,

• The current pace of new jobs is only half the gain registered in February (332,000), and
• The number of persons at work part time because of economic reasons increased 19,000 to 8.245 million workers — the same level as in June 2012.
• As long as the trend rate of economic output softens the labor market will remain weak.

Even with the seemingly improved headline figures, the underlying jobs trends remain disheartening:

• The number of people no longer counted in the labor force climbed by 240,000 in July to 89.957 million — the second-highest reading of all time.
• The labor force participation rate slumped to 63.4 percent, a step away from equaling the three-decade low of 63.3 percent posted in March and April, and
• the growth rate of real incomes remains stagnant.
• Of the 162,00 jobs added last month, 92,900 (or 57 percent) were in the low wage industries of retail (46,800), food & drinking establishments (38,400), and temporary workers (7,700).
• This isn’t surprising since the level of average hourly earnings fell 0.1 percent in July. It’s only 1.9 percent higher than year-ago levels. Incomes and wages facilitate spending, which is the fuel for economic growth, and the engine is running on empty.
• Real disposable personal incomes — adjusted for taxes and inflation — fell 0.1 percent in June, and are a mere 0.6 percent higher than in June 2012.
• The primary issue running through the economy today is that most Americans lack a sufficient wage capable of boosting spending and getting the economy operating at a desirable pace.
• Real consumer spending is clinging to the critical 2 percent pace over the last 12 months. A sub-2 percent pace is typically associated with recession.

The risks to economic expansion are definitively to the downside since the slightest blow to the consumer or business sector would push growth rates of real GDP, incomes, and spending even lower, thus ensuring recession.

SOUTH KOREA - Korean Peninsula a Black Swan Possibility

A Korean Black Swan? 08-04-13 John Mauldin

Last week I was in Newport, Rhode Island, at the Naval War College, where I participated in a summer study group focused on possible futures and how they might affect the strategy of the US Defense Department. The discussions were wide-ranging and mind-expanding, at least for me. As readers know, I believe that Japan has begun a long-term process of continually devaluing its currency. For reasons I have written about at length in previous letters, I think the yen could go to 200 to the dollar in the next five years. I don’t see a precipitous move, simply a steady erosion as Japan tries to bring back inflation and export its deflation.

While the yen at its current valuation is not a particular problem for the rest of the world, when it
hits 120 we will start to see raised eyebrows and political speeches from the countries most
affected. At 140 we could start to see serious reactions.

One of the countries that I think is put into a most difficult situation is South Korea. Their options
for responding to a weakening yen are quite limited. If they respond by printing more of their own
currency, they are likely to engender a debilitating inflation, which is of course not a good thing.

Protectionism will have little real effect vis-à-vis Japan. Remember that the Japanese yen was 357
to the dollar about 40 years ago. The Japanese watched their currency rise by almost 400% in the
decades since. The only real response available to them was to simply become more competitive
and more productive as their currency got stronger, and to their great credit they did.

Honing their competitive edge may also be the only real option for South Korea. But it is not an
easy one, of course, and you will hear lots of complaints from Korean politicians and businessmen.
Not an easy environment, to be sure.

Now let’s shift our focus to North Korea. Everyone (including your humble analyst) is worried
about the isolationist regime in North Korea having access to nuclear weapons and the ability to
deliver them on missiles. But a few conversations I had this past week led me to think there is
another scenario we should consider.

A side conversation at the study group began with an observation by a senior officer about the
ability of the North Korean military to actually project power. As this information is nothing more
than what you can find in the newspapers, I feel comfortable discussing it here. Everyone knows
that North Koreans have been malnourished for multiple decades. Studies suggest that North
Koreans may be up to three inches shorter than South Koreans and have diminished IQs because of
malnourishment as children. The latter is a known effect on human beings anywhere who are
subjected to a starvation diet. The North Korean population has suffered from severe diet
restriction for decades.

How capable is the North Korean military of actually mounting an offensive when their soldiers are
simply not physically able to withstand the pressures of combat? I was also able last week to visit
with one of the great geopolitical strategists of our time, Professor Ian Bremmer of Columbia, who
is the president and founder of Eurasia Group, with some 100 geopolitical analysts working for
him. I shared with him my concerns about the Korean peninsula. He immediately said that he was
more worried about the Korean peninsula than any other part of the world, including the Middle
East. One of the interesting things that he shared is that an increasing number of cell phones are
being smuggled into North Korea from China and that the North Koreans are beginning to get the
real story about the world rather than just the propaganda fed to them by their government.

While there is little ability for the North Korean population to actually stage a revolution, as they
do not have the weapons and hungry people really have difficulty mounting military operations,
there is the possibility of the country becoming increasingly difficult to manage. Combine that with
the potential for a disastrous food-production year, and the potential for the collapse of the
government is not all that far-fetched.

There were not many people forecasting the collapse of the USSR in 1987. Yet as we look back, the confluence of causes that resulted in its collapse seems rather obvious. Probably, the current
dictatorship will maintain its stranglehold on North Korea. That is the tendency with repression and
tyranny – witness Cuba and any number of other countries. But one cannot dismiss the possibility
of a collapse of the North Korean state.

If that were to happen it would be a humanitarian disaster. In the long run it might be better for the
North Korean people, but in the short run it would be catastrophic. It is not unreasonable to expect
that South Korea would have to do the bulk of the heavy lifting, especially after the first year or so.
And should the world no longer have to focus on the ability of North Korea to create mischief with
nuclear weapons, North Korea could soon become page 16 news.

No matter how positively you would want to view Korean unification, the process would be
enormously expensive for South Korea. Assimilating a population long challenged by hardship into
a new reality, not to mention incorporating it into a modern economic model, is a daunting
challenge. I think the task would be more difficult and more expensive on a per-capita basis than
the unification of Germany.

And this could happen while the attention of South Korea is focused on dealing with the
devaluation of the yen and the need to become progressively more competitive to maintain its
export and business model. There is also the possibility of massive refugee movements into China.
That is a significantly different issue than worrying about a million-man army crossing the DMZ
into South Korea.

I’m not saying this will happen, but it is a possibility we need to keep an eye on.

VALUATIONS - Shiller PE of 24X Historically Signals An Approaching Top

Can It Get Any Better Than This? 08-04-13 John Mauldin

To many investors:

• Developed markets appear healthier and stronger than they have in years.
• Major equity markets are rallying to record highs;
• Corporate credit spreads are tight versus US Treasuries and getting tighter; and
• Broad measures of volatility continue to fall to their lowest levels since 2007.

This kind of news would normally point to prosperity across the real economy and call for a celebration – but prices do not always reflect reality. Moreover, the combination of high and rising valuations, low volatility, and a weakening trend in real earnings growth is a proven recipe for poor long-term returns and market instability.

Let’s take the S&P 500 as an example. It returned roughly 42% from September 1, 2011, through August 1, 2013, as the VIX Index fell to its lowest levels since the global financial crisis. Over that time frame, real earnings declined slightly (down about 2% through Q1 2013 earnings season), while the trailing 12-month price-to-earnings (P/E) ratio jumped 44%, from 13.5x to 19.5x. That means the majority of the recent gains in US equity markets were driven by multiple expansion in spite of negative real earnings growth.

This is a clear sign that sentiment, rather than fundamentals, is driving the markets higher.

Of course, the simple trailing 12-month P/E ratio can be misleading at critical turning points if you are trying to handicap the potential for long-term returns. For example, the collapse in real earnings during the global financial crisis sent the S&P 500’s trailing P/E multiple through the roof by March 2009. So, while trailing P/E is a useful tool for understanding what has already happened in the market, the “Shiller P/E” is far more useful for calculating a reasonable range of expected returns going forward.

This approach won’t help you much with short-term market timing, but current valuations have historically proven extremely useful in forecasting long-term returns.

In his book Irrational Exuberance (2005), Robert Shiller of Yale University shows how this approach “confirms that long-term investors – investors who commit their money to an investment for ten full years – did do well when prices were low relative to earnings at the beginning of the ten years. Long-term investors would be well-advised, individually, to lower their exposure to the stock market when it is high … and to get into the market when it is low.”

As you can see in Figure 6, compared to the more common trailing 12-month P/E ratio in Figure 5, the Shiller P/E metric essentially smooths out the series and helps us avoid false signals by dividing the market’s current price by the average inflation-adjusted earnings of the past ten years. \

Historically, this range has peaked and given way to major market declines at around 29x on average (or 26x excluding the dot-com bubble), and it has bottomed in the mid-single digits. Not only does today’s Shiller P/E of 24x suggest a seriously overvalued market, but the rapid multiple expansion of the last two years in the absence of earnings growth suggests that this market is also seriously overbought.

John Hussman helps us keep current valuations in historical perspective:

The Shiller P/E is now 24.4, about the same level as August 1929, higher than December 1972, higher than August 1987, but less extreme than the level of 43 that was reached in March 2000 (a level that has been followed by more than 13 years of market returns within a fraction of a percent of the return on Treasury bills – and even then only by revisiting significantly overvalued levels today). The Shiller P/E is presently moderately below the level of 27 at the October 2007 market peak. It’s worth noting that the 2000-2001 recession is already out of the Shiller calculation. Moreover, looking closely at the data, the implied profit margin embedded in today’s Shiller P/E is 6.3%, compared with a historical average of only about 5.3%. At normal profit margins, the current Shiller P/E would be 29.

While it may be impossible to accurately predict when this policy-driven market will break, history suggests it would be very reasonable for the secular bear to eventually bottom at a P/E multiple between 5x and 10x, opening up one of the rare wealth-creation opportunities to deploy capital at truly cheap prices.

Some of these technical details are rather dry, but I hope you'll focus on the main idea: We are not talking about the potential for a modest 20% to 30% drawdown in the S&P 500. If history is any indication, we are talking about the potential for a 50%+ peak-to-trough drawdown and ten-year average annual returns as bad as -4.4%, according to the chart above from Cliff Asness at AQR. Such a result would fall in line with somewhat similar deleveraging periods such as the United States experienced in the 1930s and Japan has experienced since 1989. There is no way to sugarcoat it: too much equity risk can be unproductive and even destructive in this kind of economic environment.

PROFIT MARGINS - Revenue Recession and Eroding Operating Profits

S&P 500 Profit Margins Plunge To Three Year Lows 08-03-13 Zero Hedge

That S&P500 revenues are contracting for the second quarter in a row (i.e. a revenue recession) is by now well-known even to CNBC. This is just as we predicted in June of last year, because in a world devoid of growth capital expenditures (and judging by the amount of train, plane and other crashes lately, maintenance capex as well), there can be no organic growth.

What, however, may come as a surprise to the market cheerleaders (who unknowingly, or knowingly, are merely cheering Ben Bernanke's magic bubble blowing machine, see final chart) is that that other key component of bottom line improvement, profit margins, are not only not at record highs contrary to what conventional wisdom may incorrectly believe, but have been consistently sliding for three years now, and while earnings margins are 'only' back to June 2011 levels at 8.7%, it is the far more critical Operating Margin which has tumbled in the past two years after peaking in Q3 2011 and is now back down to 8.4%, a level not seen since mid-2010.

In other words, absent aggressive levered stock buybacks (which are virtually over with rates rising once again), the S&P500 EPS would now be in free fall.

Don't worry though, just like in 2010, 2011, and 2012, there is a hockeystick for that. As the Goldman chart below shows, one just needs to believe in unicorns and that maybe, finally, this time things will simply surge higher just because the Fed wishes them to.

What is even more disturbing is that a few more quarters of contraction and margins will slide right back to the levels last seen during the past peak of 2006-2007, when companies still had millions of full-time workers they could fire or simply replace with part-time equivalents. This time around, they don't have that gross profit-boosting luxury. And with interest rates once again rising, the benefits from refinancing corporate capital structures at ever lower rates are now forever gone.

Of course, the charts above are completely irrelevant, as is all fundamental information in a centrally-planned world, as long as the one all important chart remains. The one shown below.

Manipulating Bad Financial Data

Bad government policy has created a years-long unemployment problem. But instead of fixing the problem, the government is trying to paper over it. We’ve known for a long time that the Bureau of Labor Statistics fudges the numbers to make unemployment look lower than it is really is. BLS itself has admitted that its “adjustments” skew unemployment data during recessions. Indeed, the former head of the BLS recently said BLS statistics are B.S. … and that unemployment is much higher than the government is letting on.

The Bureau of Economic Analysis is revising 84 years of economic history … which will make the economy magically look better.

The U.S. and British governments encouraged interest rate manipulation. And central banks have been directly manipulating interest rates for hundreds of years.

Government agencies have helped banks manipulate commodities prices for decades.

The government twisted statistics and intentionally lied when it pretended that the banks it was bailing out were solvent

The government has long ignored energy and food prices when reporting on inflation.

Fraud is Wall Street’s business model, which is – unfortunately – being supported by the government.

The government helped cover up the crimes of the big banks, used claims of national security to keep everything in the dark, and changed basic rules and definitions to allow the game to continue. See this, this, this and this.

It is not only a matter of covering up fraud that has already happened. The government also created an environment which greatly encouraged fraud.Here are just a few of many potential examples:

• The SEC has shredded financial documents for decades, to help cover up financial shenanigans

• The government-sponsored rating agencies committed massive fraud (and see this)

• The Treasury department allowed banks to “cook their books”

• Business Week wrote on May 23, 2006:

“President George W. Bush has bestowed on his intelligence czar, John Negroponte, broad authority, in the name of national security, to excuse publicly traded companies from their usual accounting and securities-disclosure obligations.”

• Regulators knew of and allowed the use of debt-hiding accounting tricks by the big banks

• Tim Geithner was complicit in Lehman’s accounting fraud, (and see this), and pushed to pay AIG’s CDS counterparties at full value, and then to keep the deal secret. And as Robert Reich notes, Geithner was “very much in the center of the action” regarding the secret bail out of Bear Stearns without Congressional approval. William Black points out: “Mr. Geithner, as President of the Federal Reserve Bank of New York since October 2003, was one of those senior regulators who failed to take any effective regulatory action to prevent the crisis, but instead covered up its depth”

• The former chief accountant for the SEC says that Bernanke and Paulson broke the law and should be prosecuted

• Freddie and Fannie helped to create the epidemic of mortgage fraud

• The government knew about mortgage fraud a long time ago. For example, the FBI warned of an “epidemic” of mortgage fraud in 2004. However, the FBI, DOJ and other government agencies then stood down and did nothing. See this and this. For example, the Federal Reserve turned its cheek and allowed massive fraud, and the SEC has repeatedly ignored accounting fraud. Indeed, Alan Greenspan took the position that fraud could never happen

• Bernanke might have broken the law by letting unemployment rise in order to keep inflation low

• Paulson and Bernanke falsely stated that the big banks receiving Tarp money were healthy, when they were not

• Arguably, both the Bush and Obama administrations broke the law by refusing to close insolvent banks

• Congress may have covered up illegal tax breaks for the big banks

• Of course, deregulation by Larry Summers, Robert Rubin, Phil Gramm and many other high-level politicians and regulators also helped to grease the skids for fraud

Economist James K. Galbraith wrote in the introduction to his father, John Kenneth Galbraith’s, definitive study of the Great Depression, The Great Crash, 1929:

The main relevance of The Great Crash, 1929 to the great crisis of 2008 is surely here. In both cases, the government knew what it should do. Both times, it declined to do it. In the summer of 1929 a few stern words from on high, a rise in the discount rate, a tough investigation into the pyramid schemes of the day, and the house of cards on Wall Street would have tumbled before its fall destroyed the whole economy. In 2004, the FBI warned publicly of “an epidemic of mortgage fraud.” But the government did nothing, and less than nothing, delivering instead low interest rates, deregulation and clear signals that laws would not be enforced. The signals were not subtle: on one occasion the director of the Office of Thrift Supervision came to a conference with copies of the Federal Register and a chainsaw. There followed every manner of scheme to fleece the unsuspecting ….

This was fraud, perpetrated in the first instance by the government on the population, and by the rich on the poor.

***

The government that permits this to happen is complicit in a vast crime.

Manipulating Bad Nuclear Facts

When the Fukushima nuclear plant melted down, the government didn’t announce that these antiquated nuclear designs which were common throughout the United States were dangerous and needed to be scrapped. Instead, American (and Canadian) authorities virtually stopped monitoring airborn radiation, and are not testing fish for radiation.

The U.S. government increased allowable radiation levels so that we could be exposed to radiation.

The U.S. government pressured the Japanese government to re-start its nuclear program, and is allowing Fukushima seafood to be sold in the U.S.

And U.S. nuclear regulators actually weakened safety standards for U.S. nuclear reactors after the Fukushima disaster.

And the U.S. government has been covering up nuclear meltdowns for 50 years.

Manipulating Oil Spill Info

When BP – through criminal negligence – blew out the Deepwater Horizon oil well, the government helped cover it up (and here).

As just one example, the government approved the massive use of a highly-toxic dispersant to temporarily hide the oil.

The government also changed the testing standards for seafood to pretend that higher levels of toxic PAHs in our food was business-as-usual.

Manipulating Data on Other Environmental Issues

The Bush administration covered up the health risks to New Orleans residents associated with polluted water from hurricane Katrina, and FEMA covered up the cancer risk from the toxic trailers which it provided to refugees of the hurricane.

The Centers for Disease Control – the lead agency tasked with addressing disease in America – covered up lead poisoning in children in the Washington, D.C. area.

The government also underplayed the huge Tennessee coal ash spill. As the New York Times noted in 2008:

A coal ash spill in eastern Tennessee that experts were already calling the largest environmental disaster of its kind in the United States is more than three times as large as initially estimated, according to an updated survey by the Tennessee Valley Authority.***

The amount now said to have been spilled is larger than the amount the authority initially said was in the pond, 2.6 million cubic yards.

(The former head of the National Mine Health and Safety Academy says that the government whitewashed the whole coal ash investigation.)

And the government allegedly ordered Manhattan Project scientists to whitewash the toxicity of flouride (flouride is a byproduct in the production of weapons-grade plutonium and uranium). As Project Censored noted in 1999:

Recently declassified government documents have shed new light on the decades-old debate over the fluoridation of drinking water, and have added to a growing body of scientific evidence concerning the health effects of fluoride. Much of the original evidence about fluoride, which suggested it was safe for human consumption in low doses, was actually generated by “Manhattan Project” scientists in the 1940s. As it turns out, these officials were ordered by government powers to provide information that would be “useful in litigation” and that would obfuscate its improper handling and disposal. The once top-secret documents, say the authors, reveal that vast quantities of fluoride, one of the most toxic substances known, were required for the production of weapons-grade plutonium and uranium. As a result, fluoride soon became the leading health hazard to bomb program workers and surrounding communities.

Studies commissioned after chemical mishaps by the medical division of the “Manhattan Project” document highly controversial findings. For instance, toxic accidents in the vicinity of fluoride-producing facilities like the one near Lower Penns Neck, New Jersey, left crops poisoned or blighted, and humans and livestock sick. Symptoms noted in the findings included extreme joint stiffness, uncontrollable vomiting and diarrhea, severe headaches, and death. These and other facts from the secret documents directly contradict the findings concurrently published in scientific journals which praised the positive effects of fluoride.

Regional environmental fluoride releases in the northeast United States also resulted in several legal suits against the government by farmers after the end of World War II, according to Griffiths and Bryson. Military and public health officials feared legal victories would snowball, opening the door to further suits which might have kept the bomb program from continuing to use fluoride. With the Cold War underway, the New Jersey lawsuits proved to be a roadblock to America’s already full-scale production of atomic weapons. Officials were subsequently ordered to protect the interests of the government.

After the war, … the dissemination of misinformation continued.

Manipulating Food Safety Data

The government’s response to the outbreak of mad cow disease was simple: it stopped testing for mad cow, and prevented cattle ranchers and meat processors from voluntarily testing their own cows (and see this and this)

The EPA just raised the allowable amount of a dangerous pesticide by 3,000% … pretending that it won’t have adverse health effects.

In response to new studies showing the substantial dangers of genetically modified foods, the government passed legislation more or less pushing it onto our plates.

Manipulating Health Safety Data

When one of the most respected radiologists in America – the former head of the radiology department at Yale University – attempted to blow the whistle on the fact that the FDA had approved a medical device manufactured by General Electric because it put out massive amounts of radiation, the FDA installed spyware to record his private emails and surfing activities (including installing cameras to snap pictures of his screen), and then used the information to smear him and other whistleblowers.

After drug companies were busted for using fraudulent data for drug approval, the FDA allowed the potentially dangerous drugs to stay on the market.

Manipulating Metrics for War

The U.S. has drastically underestimated the amount of innocent civilians killed by drone, and repeatedly announces that it has just killed some terrorist that it had previously reported killing.

When USA Today reporters busted the Pentagon for illegally targeting Americans with propaganda, the Pentagon launched a smear campaign against the reporters.

When the American government got caught assassinating innocent civilians, it changed its definition of “enemy combatants” to include all young men – between the ages of say 15 and 35 - who happen to be in battle zones.

When it got busted killing kids with drones, it changed the definition again to include kids as “enemy combatants”.

After the U.S. congratulated the government of Yemen for killing Al Qaeda terrorists within its country – but a Yemeni journalist photographed the scene, discovering that the U.S. had fired a cruise missile to make the kill, and that children and other shepards will killed, instead of Al Qaeda – president Obama insisted that the journalist be indefinitely detained to shut him up (he was also tortured).

Al Qaeda was labeled as the main enemy in the War on Terror. But now Al Qaeda and other terrorist groups have somehow become our close allies. They have somehow become the “good terrorists” which we are using to fight our enemies.

Indeed, groups are listed as official “terrorist” organizations and then de-listed to suit the convenience and ambitions of particular U.S. political leaders.

Indeed, the U.S. literally labels others as terrorists when they do exactly what we do (although no one does it to the extent we do).

The Core Problem

Corruption at the top leads to lawlessness by the people.

But – while conservatives blame the government for our problems, and liberals blame big corporations – the core problem is the malignant, synergistic intertwining between the two.