Monday, January 29, 2007

pimco´s gross on liquidity / hall of fame

wow. another "must read" from pimco. they are really connecting the dots. and gross has it right with his quote:

my critical point is that asset prices are no longer entirely a function of the real economy: it can be just the reverse.....

donnerwetter. noch ein geniales teil von pimco. hier werden schön alle punkte zusammengeführt. und das zitat von gross (oben ) sagt alles.

The twin barrels of financial innovation and globalization have significantly complicated the forecasting of asset returns in recent years. Two domestic bubbles in the last decade are testimony to the power of levered money and the recirculation of price insensitive reserves back into U.S. financial markets.

......, what now appears to be confirmed as a housing bubble, was substantially inflated by nearly $1 trillion of annual reserve flowing back into U.S. Treasury and mortgage markets at subsidized yields, as well as innovative funny money mortgage creation which allowed anyone to buy a house at escalating and insupportable prices. Bond, stock, and real estate trends then, have recently been increasingly at the mercy of relatively price insensitive and levered financial flows as opposed to historical models of value or the growth of the real economy itself. ..... This foreign repatriation produced artificially low yields, (perhaps 50-100 basis points confirmed in numerous Federal Reserve staff reports and speeches in recent years) which in turn drove housing values to unsustainable levels as recently as six months ago – the estimated peak in national home prices. (add to this china........)
...., my critical point is that asset prices are no longer entirely a function of the real economy: it can be just the reverse. The real economy is being driven by asset prices, which in turn are influenced by financial flows of non-historic origin, composition, and uncertain longevity. What used to be an Economics 101 “CIG + exports-imports” analysis leading to predictions for interest rates and stock prices has turned into an Economics 2007 analysis of corporate buybacks, international reserve flows and hedge fund/private equity positioning seeking to front run or take advantage of the first two. And it’s not simply a question of analyzing the animal spirits or “exuberance” of investors wherever they may be. Corporations are buying back stock with their historically high profits not really because they’re enthusiastic about their own company’s value, but because they have little else to do with the money.Likewise, foreign central banks and petroreserve recyclers are turned on more by capping their own currencies or geopolitical considerations in the Middle East.

Investors have no more significant example of the influence of financial flows on asset prices than tracking the pace of the U.S. trade deficit in the 21st century.... there is likely near unanimity that it is now responsible for pumping nearly $800 billion of cash flow into our bond and equity markets annually. Without it, both bond and stock prices would be much lower, the $800 billion for instance representing 3 - 4x our current federal budget deficit. Almost perversely, then, an increasing current account deficit supports and elevates U.S. asset prices as the liquidity from it is used to buy stocks and bonds.......
Notice that in 2001 a monthly trend reversal of $10 billion ($120 billion annually) neatly coincided with a 20% decline in stock prices and a flat bond market despite a developing recession. ..... The draining of $120 billion from the foreign cash flow pump appeared to have magnifying, “it’s different this time,” effects on both. ......

Although the above historical analysis is subjective and vulnerable to “sampling error” (economist speak for too short a modeling timeframe) there is an inherent logic to it:

more money in the “bank” – asset prices go up; fewer deposits – asset prices go down or perhaps up less.

..... Financial derivatives ....allowing homeowners to lever home prices, institutions to compress risk spreads, and almost all assets to occupy a seemingly permanently higher plateau based on increased liquidity and perceived diversification of risk across the system. I have my doubts about this permanent plateau, but the market seemingly does not......

With that important caveat, let me proceed to analyze another source of increased cash flow that has markedly influenced asset prices in recent years. I refer to corporate profits and their meteoric rise since the 2001 recession, increasing from 5¼% to nearly 9% of GDP as shown in Chart 2.

While normally much of that rise of over $400 billion after tax dollars (almost identical to the pump provided by our increasing trade deficit over the same period) would have been reinvested in physical plant and equipment, this time it was not. more

Combined, the total rise in corporate share buybacks and the financing for bond and stock markets via the increasing trade deficit have injected an average of perhaps $1 trillion annually of purchasing power into our asset markets since the end of the 2001 recession. Because hedge funds and levered players of all types have been aware of this trade deficit/share buyback “put” and have acted upon it, the incalculable but conservatively estimatable pump from these two sources alone have poured in several trillions of purchasing power per year. Take that money and use it to invest in further high powered and levered financial instruments such as CDOs, CPDOs, and 0% down funny money mortgages of all varieties and you can understand why asset markets have done so well in recent years, and why, as my initial Outlook sentence suggested, it is so hard to analyze “value” in asset markets these days. Prices are increasingly being determined by value insensitive flows and speculative leverage as opposed to fundamentals. (read this full block twice! diesen absatz zur not zweimal lesen)

...... The suggestion of no more bottles of beer on the wall comes from several sources, the first of which appears in Chart 1 as a recent reversal in the trade deficit. While some of this improvement is due to the standard dollar weakness of the past 12 months and its dampening impact on imports, much of it is due to the decline of oil since August/September of 2006. Follow with me if you will a projection by PIMCO analyst Ramin Toloui in Chart 4 that depicts the change in trade flows at a given dollar price of oil. read this excellent piece on the topic

As you can see, the recent $20 reversal in per barrel oil prices results in a reduction of $100 billion or so in the annual trade deficit, and a like amount of liquidity extraction from bond and stock markets, much more if associated leverage is unwound. Granted, some would claim that there will still be $700 billion or so of purchasing power coming into our markets, but higher asset prices in a levered economy are dependent on greater and greater injections of liquidity, not less. Should oil hold in the $55 range, this extraction of high powered 100+ proof alcohol from the markets will be noticeable. (chart shows the 10 year yield in the timeframe when oil has plunged. in large part due to some very poor bond auctions with low indirect/foreign bidders..... zeigt die rendite der 10 jahresanleihe während öl stark gefallen ist. zurückzufüren auf einige schwache bondauktionen mit einem niedrigen auslandsanteil....)

The second source of vulnerability comes from the corporate buyback stash, a trend itself as Chart 3 points out that is beginning to level off and reverse. Peter Bernstein, in a recent January missive, suggests that corporate profits as a % of GDP cannot continue to grow at the same pace. “Everybody else” he writes “is going to want a piece of that juicy action. Employees will demand higher wages, customers will demand lower prices, and the government will levy higher taxes.”
.... share buybacks could be cut back by a good $100+ billion in the near term future.
..... The risk markets (including bond term premiums) if not drunk, are definitely not walking a very straight line.
Stocks, credit spreads, and yes intermediate and long term bonds relative to a likely unwavering Fed Funds rate in 2007’s first half, may stagger shortly.

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