[World Economic Forum] Top 10 Risks for the Decade Ahead

Here are the top 10 risks for the decade ahead as outlined by this year's World Economic Forum Global Risks report.

"Here is a list of the top 10 global risks of highest concern in 2014, according to the report:

1. Fiscal crises in key economies

Fiscal crises feature as the top risk in this year’s Global Risks report. Advanced economies remain in danger, while many emerging markets have seen credit growth in recent years, which could fuel financial crises. A fiscal crisis in any major economy could easily have cascading global impacts.

2. Structurally high unemployment/underemployment

Unemployment appears second overall, as many people in both advanced and emerging economies struggle to find jobs. Young people are especially vulnerable – youth unemployment is as high as 50% in some countries and underemployment (with low-quality jobs) remains prevalent, especially in emerging and developing markets.

3. Water crises

Environmental risks feature prominently on this year’s list. Water crises, for instance, rank as the third highest concern, illustrating a continued and growing awareness of the global water crisis as a result of mismanagement and increased competition for already scarce water resources.

4. Severe income disparity

Closely associated in terms of societal risk, income disparity is also among the most worrying issues. Concerns have been raised about the squeezing effect the financial crisis had on the middle classes in developed economies, while globalization has brought about a polarization of incomes in emerging and developing economies.

5. Failure of climate change mitigation and adaptation

Even as governments and corporations are called upon to speed up greenhouse gas reduction, it is clear that the race is on not only to mitigate climate change but also to adapt. Failure to adapt has the biggest effect on the most vulnerable, especially those in least developed countries.

6. Greater incidence of extreme weather events (e.g. floods, storms, fires)

Climate change is the key driver of uncertain and changing weather patterns, causing an increased frequency of extreme weather events such as floods and droughts. The Global Risks 2014 report draws attention to the combined implications of these environmental risks on key development and security issues, such as food security and political and social instability, ranked 8th and 10th respectively.

7. Global governance failure

The risk of global governance failure, which lies at the heart of the risk map, was viewed by respondents as one of the risks that is most connected to others. Weak or inadequate global institutions, agreements or networks, combined with competing national and political interests, impede attempts to cooperate on addressing global risks.

8. Food crises

One of the top societal risks in the report, food crises occur when access to appropriate quantities and quality of food and nutrition becomes inadequate or unreliable. Food crises are strongly linked to the risk of climate change and related factors.

9. Failure of a major financial mechanism/institution

Over five years after the collapse of Lehman Brothers, the failure of a major financial mechanism or institution also features among the risks that respondents are most concerned about, as uncertainty about the quality of many banks’ assets remains.

10. Profound political and social instability

At number 10 is the risk that one or more systemically critical countries will experience significant erosion of trust and mutual obligations between states and citizens. This could lead to state collapse, internal violence, regional or global instability and, potentially, military conflict."

Source: http://forumblog.org/2014/01/top-10-risks-decade-ahead/

[The Economist] It's Back

This thoughtful article in The Economist on the apparent resurgence of securitization gives us the opportunity to think back and reflect. How did securitization hurt the markets and the macroeconomy? How can it help in the future (if used correctly)?

http://www.economist.com/news/leaders/21593457-once-cause-financial-worlds-problems-securitisation-now-part-solution-its 

Book Review: Liar's Poker, by Michael Lewis

I know I am behind the ball, but I just recently finished reading Michael Lewis's first book Liar's Poker. I have long been told it was a must-read first-hand account of what Wall Street felt like in the "good 'ol days" of the Milken-esque, high margin LBO, junk-bond fueled '80's. At it totally is.

First of all, I hope Lewis is no stranger to my roughly 3.1 million (HA) regular readers. With titles including (but not limited to) The Big Short and Moneyball, Lewis is (at worst) a fantastic gateway-drug into the larger world of finance and economics reads, and (at best) a staple of our literary diet. Unlike many financial writers, Lewis's work reads like that of an author interested in finance, rather than a quant trying to info-spam journal editors into publishing an incomprehensible paper, making even Lewis's most sincere and serious tomes feel like page-turning beach reads. Ok, that is a bit of an overstatement (or, understatement?), but the larger-than-life characters in his non-fiction certainly exhibit features of the best constructed literary protagonists.

Onto the actual book. As an aspiring bond-jammer myself...I mean, finance professional (did I just say that?)...it is nothing short of fascinating to read Lewis's first-hand account of his introduction, training, and professional exploits at the (then) formidable Salomon Brothers, first through the newly-created mortgage trading desk (that more-or-less invented the collateralization that led to our most recent recession), and later bond sales in London. While I sincerely hope much has changed in the business since 1986, I fear the sophomoric and fraternal nature of Salomon's associates observed by Lewis is still alive and well in the fast-paced, winner-take-all roulette wheel that is our modern capital markets. In the final chapters of the book, Lewis recounts being paid a quarter-million dollar bonus just months after the crash of 1987, and just two years out of training. Being the sharp guy he is, Lewis knew something was up; should people really be paid that way to do what they did? To jam paper and be the first one to the bank? Lewis even comments (paraphrased) if employee compensation was based on what he contributed to society, he should be fined not paid! Clearly an audacious claim that only an insider-turned-outsider could make.

Endlessly thought-provoking and entertaining, go grab a copy and enjoy!           

[Zero Hedge] Is Inflation Understated

As always from our friends at Zero Hedge, a thoughtful commentary on inflation from the perspective of macro fundamentals, rather than the "headline" (CPI) data.

[Zero Hedge] Is Inflation Understated?

Tech Stock Bubble a la '99 - '00? Not according to Forward P/E

With the NASDAQ recently hitting 4000, a number not seen since the year 2000, the tech bubble hoopla is again center stage. However, as it was so eloquently put on CNBC, there is more to the story. Looking at the NASDAQ's forward P/E ratio, we are nowhere near the exorbitant and unjustifiable multiples we saw during the last bubble:

As you can see, even looking at the low end of the Forward P/E range in '99 and '00 and the high end of this year, we are significantly below undisputed trouble. However, as I have said before, we cannot use any one metric alone to judge this complex market. Be that as it may, at least we are not judging the viability of tech companies by "eyeballs" anymore...

[Motley Fool] Be Careful With Forward P/E And PEG Ratios

http://beta.fool.com/thebargainbin/2013/03/05/be-careful-forward-pe-and-peg-ratios/26033/

[Zero Hedge] "Everyone Was Talking About A Stock Bubble... Just Before The Last Bubble Burst"

http://www.zerohedge.com/news/2013-11-27/everyone-was-talking-about-stock-bubble-just-last-bubble-burst

Consumer Confidence

A super interesting article on Zero Hedge breaking down the latest disappointment:

http://www.zerohedge.com/news/2013-11-26/consumer-confidence-misses-again-tumbles-lowest-7-months

View The Conference Board's release here:

http://www.conference-board.org/data/consumerconfidence.cfm

Bubble Discussion (cont.): Volume

Continuing from my last post, I had another thought on the definition and subsequent analysis of an equity bubble. One calling card of a bubble I forgot to mention yesterday is increased volume. Many site higher than average trading volume in conjunction with unjustifiably high prices in diagnosing a bubble. So, with that in mind, I took a look at market volume (YTD, since I'm not made of time here) to see what trading volume has to say about this supposed bubble.

In short, trade volumes do not seem to be supporting the bubble theory. In fact, volume has actually been a little light in the past few weeks, comparatively speaking. Since October, only 1/3 of trading days had S&P 500 volumes above the 2013 annual average, and both the 200 day and 50 day moving averages have edged below the annual average as well. These results could be less than telling due to a number of factors, including seasonality, holidays, fund rotation, and my overly simplistic analysis. This is further evidenced by NASDAQ volumes showing nearly the exact opposite: days since October with volumes above the YTD average are a whopping 70%, with the 50 day simple moving average crossing above the 200 day and the YTD marks. Could this be due to sector rotation? Rebalancing? Hard to say.

While far from conclusive, I do feel fairly comfortable stating that the volume data do not support defining the current domestic equity market as a bubble. Needless to say, we will keep an eye out for any changes, however I do not expect volumes to pick up dramatically through the end of the year due to the holidays.

The Dreaded "B" Word

Hello readers! It has been a while (2+ years) since my last post; life somehow has a way of getting in the way of our daily rituals. In any event, my goal is to resume writing regularly again, so here it goes:

 So, the "B" word. Bubble. There seems to be an increased volume of the B-word lately, particularly with regards to equities. While some talking heads have a vested interest in stirring the pot, increasing volatility, and drumming up more short interest, it is difficult to ascertain how Main Street Joe feels about current stock prices and (more importantly) valuations. In any event, to properly judge weather or not we are "actually" in "bubble" territory, we must first define (or at least set some parameters) bubble. Even here at this most basic phase of our analysis we see some inconsistencies. I heard one pundit on CNBC attempt to define an equity bubble as a market environment where the financial news is playing at her dry cleaner's, or when her doorman asks her how much she is up today. While these decidedly unacademic measures are (at best) difficult to quantify, this person's analysis was that we were not anywhere near an equity bubble. Others begin to feel gaseous when equity indices are trading at historic highs, or at least above their averages. According to this S&P 500 P/E Ratio, we are currently kissing 20x earnings, with the 100+ year mean and median at 15.5 and 14.5x, respectively. While this is nowhere near the record high, we are also not anywhere near value territory. Being that we are not in value land, let us venture to world of growth analysis. Looking at one of my favorite statistics, the PEG ratio, we are currently looking at anywhere from 4.4x to 5.5x earnings on the S&P (depending on who's numbers you use for P/E and EPS growth). The author of this Seeking Alpha article seems to think that is too high compared to the widely accepted multiple of 2.5x. I was taught (as a value guy, admittedly) to look for a number closer to 1. This is to say, the P/E ratios we are seeing don't seem to be justified by current, or even projected growth rates.

 But bubble? That's a fighting word, to be sure. Truth be told, most economists seem to think bubbles can only truly be diagnosed in hindsight, and I (unfortunately) tend to agree. Trying to define the current market as a bubble or anything else is all but impossible. We are up more than 20% YTD. Make no mistake, that is a huge and largely unprecedented gain. But we can't really say for sure if this is a bubble until it is too late... 

Currently I am long equities with put options as a hedge.

Third Times the Charm? A Commentary on the Most Recent European Debt Crisis 'Fix'

Early yesterday morning, word trickled out that a new "comprehensive" deal to "fix" the euro-debt crisis had been cemented. Investors in Europe and abroad were thrilled; markets rallied an average of 3%. Analysts were less enthusiastic, somehow universally agreeing to use the term "cautious-optimism" to qualify the deal. While the media and analysts are still digesting the hard data (many in the negotiations were quoted saying they had trouble understanding many of the components of the deal), a few things are certain. Greek debt holders will take a 50% haircut on the face value of their paper (much more than previously agreed upon this summer), banks will have to raise their tier-1 capital to 9% of the banks' holdings, and the EFSF will be leveraged to a total of 1.4 trillion euros to meet all previous obligations without being totally zapped.

While this is indeed great news (primarily because we now know the EU has come to their senses and will not expect Greece to fully pay all of its unrealistic debt), many details remain to be determined. One particularly interesting detail yet to be negotiated is the fate of credit-default swaps (CDSs) on the Greek bonds. The EU deal has chosen to classify the 50% haircut as a "voluntary" write-down. While these losses are, in reality, far from voluntary, the deal is trying desperately to avoid a "credit event" that would trigger pay-outs of the CDSs. However, if this massive write-down isn't a "credit event", despite the fact that it is clearly a default (albeit an "orderly" default), what the heck is? With the EU saying the nearly 4 billion euros worth of CDSs purchased on Greek bonds wont be triggered (think your fire insurance refusing to pay because only half of your house burnt down), this will, in my opinion, trigger a credit-event of a different kind. The liquidity of the CDSs market will all but disappear, at least on sovereign paper. What would make sense, at least to me (and we all know I am more of the outsider-looking-in than any kind of real expert), would be for the CDSs to pay out what is written down. That was the original intention of the CDSs in the first place, to insure against losses of any kind. In theory, the sellers of swaps should not be all that surprised that Greece is defaulting, and should have more than enough cash to cover half of the losses. The risk of default, when calculated accurately, should be reflected in the price of the CDSs. I have a hard time believing that banks (or whoever originated the CDSs, or later bought the puts) would sell a Greek bond swap at the same rate as a US swap. And they didn't. The International Swaps and Derivatives Association would be far better suited to NOT bend to the will of the EU, and declare the haircut a credit event, therefore triggering payouts. After all, the negative implications on future derivatives markets should be of much bigger concern to the association in charge of it than a puny €2 billion, since the default was only on 50% face value). For the sake of the future of swaps and derivatives (at least on sovereign debt), I hope the ISDA holds firm.

(sources: The Economist)

Moody's and Fitch Downgrade Europe, Dexia bailed out...where does it end?

This week will surly go down as one of the worst, in global economic terms, since October 2008. Fitch downgraded the credit worthiness of several European countries, including Italy, Spain, Portugal, as well as placing some countries once presumed totally solvent up for review, such as Belgium. Between this, the Moody's downgrade of 12 UK banks, Greece's struggle to meet austerity requirements for their next bail-out tranche, and the forced recapitalization of Franco-Belgian bank Dexia, it looks like the catastrophe in Europe is coming to a head. And all of this coming on the heels of a bad end to a bad quarter...what comes next?

Well, as the markets this week reflect, I think the solution is coming sooner rather than later. With ECB President Jean-Claude Trichet scheduled for retirement next month, we can only hope that the new regime will take into consideration the aforementioned crisis and deal with the real issue at hand: deflation. While Trichet has been spending much political and actual capitol on battling inflation with more than one rate hikes since January, the money flow has all but ground to a halt. If I were a betting man, I would gamble that we are going to see a real-life TARP-like bail-out of banks in Europe, as well as a few shotgun mergers just to be safe. What is to be done about Greece is a different battle, and personally I think Europe would be better without Greece in the Euro.

S&P Downgrades US Debt

To top off the worst week in recent memory, the ratings agency Standard & Poor's downgraded the long term United States debt from triple A to AA+. While most US based banks and institutions that hold these bonds have recently renegotiated self-imposed restrictions against holding lower than perfect rated debt in their vaults, the effects this downgrade will have on international institutions is has yet to be determined. But one question remains: why did S&P downgrade T-Bonds, even after the debt ceiling deal?

For weeks now, S&P has been threatening to downgrade US debt if the government did not improve its ability to meet payments. The agency said it would spare the US if the debt ceiling deal included at least $4 trillion in cuts over the next decade. According to the bipartisan Congressional Budget Office, the deal cut less that $2 trillion. Despite a $2 trillion dollar mathematical error that postponed S&P's downgrade announcement Friday, the agency stuck to its guns. Politically, this controversial move was necessary if only to show the public that the agency would make good on its threats. This is especially important when reminded of the role the ratings agencies played leading up to the financial crisis; many highly questionable mortgage backed securities were stamped triple A with little or no due diligence performed.

Despite S&P's claims that politics in Washington threaten the ability of the government to pay its bills, and the historical contextual importance of proving the agency is both comptent and willing to judge financial instruments faithfully, one question remains: what about Fitch and Moody's? How can two of the "big three" ratings agencies believe the US to be triple A worthy and not the third? Judging by their ratings of other nations' debt instruments, it is not accurate to say that S&P is consistently more critical, while the other two are consistently more generous. By and large, the only reasonable explanation I can come up with to account for the lack of consensus amongst the agencies regarding our credit worthiness is the high degree of subjectivity that comes with rating debt. The actual difference between a bond rated triple A and AA+ would be difficult to quantify. Although I cannot prove this theory, it is possible that the complex bureaucratic web that makes up an agency (and the nuanced differences between the makeups of the three agencies) permit different conclusions between them, even if their mathematical models were identical (and we must assume they are not). It will be interesting, if nothing else, to see how the international markets react to this news. All we can do is wait and see.

Debt Ceiling: Is the US Government Still Threatened by a Downgrade?

In an article on thestreet.com, Robert Holmes tells the story of Jeffrey Sica, a money manager, and his politically unpopular view that Standard and Poor, the ratings agency, should make good on its threat to downgrade US paper, despite the debt ceiling deal reached today. This move would be nothing short of necessary for the ratings agency to retain its credibility, especially after a dismal track record of rating dangerous securities triple-A during the pre-recession MBS bubble. This statement resonantes with many Americans still frustrated with the trajectory of federal spending, many noting that no individual or corporation could possibly maintain access to cheap capital with anything close to the spending/revenue ratio we are currently seeing. While S&P has not yet issued a statement regarding this latest debt deal, the markets have reflected the continuing uncertainty felt by many regarding the recent revisions of the first quarter's GDP, and well as recalculations of inflation and manufacturing outputs. Treasury rates are also up, indicating bond investors are not yet willing to embrace "mission accomplished" on the debt problems plaguing the government. Could we be witnessing the decline of modern Keynesian Economics?

EU Sets Terms of Greek Bailout, Bond Holders Take a Hit

Recently, European Union policy makers agreed on the terms for the next round of bailout money to be released to Greece. While much of the plan is formulated around minimizing the moral hazard of yet another large bailout of a sovereign nation, the terms are rather generous (interest rates on the bailout loans have been cut by a third), not to mention placing some of the fiscal responsibility upon private debt holders as well as the country itself.

By far the most debated aspect of the new plan was bond holder participation, so-called private sector involvement (PSI) in the bailout. This complex and somewhat paradoxical scheme intended to save Greece billions by restructuring much of its forthcoming bond debt actually punishes bondholders and EU taxpayers. The problem with the outstanding bond debt is the outrageous interest rates and face-value discounts Greece had to offer to induce investors to purchase the bonds. Now, not surprisingly, Greece cannot afford to pay these rates, and as each payment cycle arrives, the debt total climbs almost exponentially. The solution ---a mercifully favorable solution for Greece --- is what is referred to as debt restructuring. This means that the issuer alters the terms of the loan, or bond in this case, to be more favorable; in this case, cheaper for Greece. This, however, means the bondholders are getting the short end of the stick, about 21 percent less on average than what was stated at the time of purchase. To avoid what could become a riotous situation in the banking community, the debt restructuring program is being offered as "voluntary", as forcing the debt holders to take a hit would be nothing short of criminal. Despite being elective, the EU expects more than 90 percent of all eligible debt will be restructured in one of four offered options: three different swap plans, a rollover option, as well as some buybacks.

Now here's the rub. Except for banks that hold these bonds in their vaults, I cannot see any incentive for the individual investor to participate in these restructuring options (perhaps individuals only account for 10 percent of the outstanding debt held, and was therefore already taken into account, I am not sure). It would clearly behoove a non-institutional bond investor to take at least a small speculative position on Greek bonds when the interest rates were at all-time highs. For that investor, nothing could compel him to take a 21 percent hit unless his only other option was to not get paid at all.

Institutionally on the other hand, this is exactly what banks want to hear. €35 billion is to be used as collateral for the new bonds issued in exchange for the old, to guarantee a triple-A rating. While this does mean the interest rate is substantially lower, it also means banks in Europe are allowed to carry them on their banking books (as opposed to trading books that have more lenient debt quality requirements). For the banks, this is a welcome solution. However, for the taxpayer, this means €35 billion that could be used in other ways (and there are many in Europe today) is doomed to sit in a government vault in Athens to guarantee payout of these new bonds.

While this deal is far from ideal from every perspective, it is a leap in the right direction for a sustainable future in Greece as well as the greater European Union.

Gof6 Budget Plan: Will it Help Raise the Debt Ceiling?

For some reason, the answer appears to be, no. Surprisingly enough, the criticisms regarding the plan drafted by the "Gang of Six" and its inclusion into debt ceiling negotiations came from both sides of the aisle. House republicans have already begun to critique the plan because of inclusion of "tax hikes" in the plan. Senate Democrats have been cited saying the proposal comes too late to be included in the debt ceiling negotiations.

Despite what is being said, it does not appear that any new taxes are included in the proposal. While 26% of the dollar total of the bill comes from "revenue", as I read it, the proposed money comes from closing tax loopholes and streamlining the confusing tax codes. While this will generate up to $1 trillion in revenue over the next ten years, the technical data reveals an actual "$1.5 trillion tax cut".

While this is a leap in the direction of austerity that America desperately needs, the implementation of any plan resembling this one is likely not to be even discussed in Congress until August 3rd (assuming the debt ceiling is raised).

Breaking News: Gang of Six Proposes Budget Plan

http://online.wsj.com/article/SB10001424052702303661904576456042405686316.html?mod=e2fb

Balanced Budget Amendment; Would it Solve...Anything?

Next week the House of Representatives is set to vote on the so-called "Cut, Cap, and Balance" bill, aimed at achieving a viable path towards a more sustainable future. While the intentions of such a plan are indeed admirable, we learn from studying economics that intentions are meaningless; only incentives and results matter in the end. A most interesting aspect of this "Cut, Cap, and Balance" plan is the "Balance", meaning implementing a balanced budget amendment to the Constitution. A recent Sachs/Mason-Dixon poll revealed 65 percent of Americans support a balanced budget amendment. But would requiring the federal government to balance the books solve anything? And what does it mean to balance the budget?

While it sounds simple enough, there are some common misconceptions regarding both balancing a budget and how requiring the government to do so every year could affect the economy. Let us begin with what it means to "balance a budget". To have a balanced budget is to equate revenues with expenditures. In other words, you bring in as much as you put out, or spend. The literal meaning of a balanced budget is to run neither a deficit (to spend more than you bring in during a given year) nor a surplus (to bring in more than you spend). This particular definition is very narrow, implying that every cent is matched exactly a year in advance. Some would concede that running a budget surplus would not be excluded under a balanced budget amendment, however I have no reason to believe, based on my research, that this provision is included in this particular bill.

As counter intuitive as it may be, running a strict budget could actually create an environment that incentivize unnecessary spending. This can be seen in the corporate world all the time. For example, if the R&D department at a particular company ran under budget (producing a budget surplus) for a year, it is very likely that the budget for that department would be cut the next year to reflect the fact that they had been allotted "too much" the previous year. The provides incentives for every department of the company to spend every penny of the budget, whether it is needed or not. It would not be hard to imagine a branch of the government spending their way up to their limit at the end of the fiscal year in order to maintain the maximum available appropriation for the next year.

In addition, many economists prefer to have a degree of elasticity to run a surplus during the "boom times" and a deficit during the "bust times". Requiring every dollar to be accounted for would not allow the government to efficiently reap the benefits of good times or to borrow in times of great need, as we did in the wake of the 2008 recession. Most economists prefer what is referred to as a "cyclically balanced budget", which is to balance a budget not annually but per economic cycle. This, however, can only be interpreted and analyzed in retrospect, after each economic cycle is completed, and would therefore be impossible to regulate.

While a balanced budget amendment may not solve our nation's woes, it is clear to most Americans that something must be done to hold the government accountable for its spending. However, if it was possible to regulate or legislate our way to fiscal responsibility, I am sure we would have implemented it by now.

News Corp: What does Les Hinton have to do with News of the World?

News broke today that Dow Jones CEO Les Hinton resined as part of a damage control campaign in Rupert Murdoch's News Corp empire. While most media outlets did not make much of this, I was perplexed! Why would a largely liked CEO of an American news corporation resign because of a scandal involving a British tabloid? Granted, Dow Jones is held by News Corp just as NotW was, but if the incidents in England were isolated as they have been reported by Murdoch, why is Hinton resigning? Now, I am far from a specialist in the field of corporate formalities, but as an FBI investigation is underway in America, it seems that the resignation of Hinton could be a case of abdicating responsibility. When viewed through the lens of a skeptic, this act looks an awful lot like admission of guilt, rather than polite formality.

Follow up: News Corp

An interesting graph from The Economist regarding News Corp's operating profit by division: