“In the science of physics, we know that water freezes at 32 degrees. We can predict with immense accuracy exactly how far a rocket ship will travel filled with 500 gallons of fuel. There is preciseness because there are constants, which do not change and upon which equations can be constructed.” – Robert Wenzel, Editor of the Economic Policy Journal, speaking at the New York Fed

In the science of economics there are no such constants, yet investors often behave as if they operate in a world of logic and certainty. Because such assumptions are made, history is littered with investors who have failed miserably.

Before I go any further, allow me to take you back in history for a moment – more precisely to year 1,012. My Viking forefathers had already raped and pillaged their way through the British Isles for more than a century and King Knut was only six years away from bringing the Danish and English crowns together for the first, and last, time. Having been captured by the Danes the previous year in a raid on Canterbury, 1,012 was also the year that Ælfheah, the Archbishop of Canterbury, was brutally murdered by a Danish mob after he refused to be ransomed.

It was also in year 1,012 that little Johnny was born. He was a thrifty lad and, almost immediately, put £1 into his piggy bank. It didn’t take him long to realise that the piggy bank wouldn’t earn him any interest so he began to lend money to the farmers in his village, allowing them to harvest ever larger areas of farmland. All Johnny demanded was a modest rate of interest amounting to inflation + 3% which was not unreasonable. After all, he took risks that he should be paid for. It was a perfectly rational request.

Johnny was not only thrifty; as he grew into a young adult he taught his own children some business acumen, so, long after Johnny had perished as an old but wealthy man, his children and their children continued to earn a modest 3% over inflation, year in, year out. 40 generations later, Johnny’s great-great… grandson is now easily the wealthiest man on earth with a personal fortune of no less than £6.87 trillion. That’s the power of compounding.

Now, we all know that there is no single person on this planet worth anywhere near £7 trillion, so something is wrong with my maths. Apart from the evil called the tax man – the obvious mistake I make is not taking into account the value destruction which has decimated our wealth at regular intervals since the sun rose for the very first time – due to war, disease, bursting asset bubbles, or because some odd meteor from outer space chose to crash land in our backyard. The reasons are many but the end result the same.

The point I want to make here is that our brains are not calibrated to deal with the unexpected. Most of us believe we are good risk managers but in reality we are not. Most of us trust that risk can always be quantified and expressed through some fancy modelling whereas, often, it cannot. When I went to lunch on the 11th September, 2001, little did I know – or expect – that less than an hour later I would get a call from my assistant suggesting that it was probably best if I came back to my desk as quickly as I possibly could.

The world is not normal, yet universities continue to teach our young students the wisdom of Markowitz and Sharpe which brought us modern portfolio theory and, more specifically, the capital asset pricing model. Garbage In, Garbage Out, as they say. One of the fundamental assumptions behind modern portfolio theory is that asset returns are normally distributed random variables. I suggest you take a glance at chart 1 below. The bright (smooth) blue line depicts a perfect normal distribution. The darker (uneven) blue line represents actual equity market returns over the past couple of decades. Even the untrained eye can see that the return profile of US equities fairly closely matches that of a normal distribution with the exception of large negative returns. They have come about more frequently than one would or should expect.

Chart 1:  The Return Distribution of Equities is Non-Normal

Source: “Global Volatility Outlook 2012”, Barclays Capital.

Note: Histogram of 3-month overlapping returns of S&P500 since 1990.

You can’t model risk, yet armies of risk managers all over the world attempt to do so every day of the year. Value-at-Risk (VaR) is a prime example of such thinking. If a risk manager notifies the portfolio manager that his one day 1% VaR is $8 million, he basically tells the manager that there is a 1% probability of losing more than $8 million in one day’s trading. VaR assumes normally distributed returns. We already know that large negative returns occur more frequently than one might expect, so a use of the VaR model in isolation or relying on the absolute numbers only is likely to lead to the risk manager underestimating the frequency and magnitude of large losses. That is not the only problem, though.

We know from experience that periods of relative calm – and hence low volatility – often precede panic. VaR falls when volatility drops so, following a period of low volatility, the risk manager will often allow the portfolio manager to increase his risk taking, for example through increased use of leverage. In other words, the portfolio manager may walk straight into a financial storm with far too much risk on his books, if such storm has been preceded by a period of more benign market conditions.

Furthermore, VaR establishes the largest loss that the portfolio manager is likely to lose 99% of the time (assuming the risk manager uses 1% VaR) but it says nothing about what might happen in the remaining 1% of cases. Isn’t that at least as important and probably more so? After all, 1% still accounts for two, maybe three, trading days every year. VaR is a quasi useful tool in the right hands but a highly toxic one in the wrong hands.

The brilliant economist Hyman Minsky understood this only too well. Whilst lecturing at University of California, Berkeley, he developed the thesis that stability in itself is destabilising – an idea that led to his Financial Instability Hypothesis. Not surprisingly, Minsky’s ideas have attracted widespread attention more recently, following the worst financial crisis of three generations which came about after years of unprecedented prosperity.

Stability breeds instability for several reasons – key amongst them is our inclination to look in the rear mirror for clues about the future. Portfolio managers, risk managers and regulators all tend to do so when looking for clues as to where the system is vulnerable. U.S. residential mortgage loans offer a prime example of such behaviour (see chart 2).

Chart 2:  Charge-Off Rates for Residential Mortgage Loans and Business Loans

Source: www.soberlook.com, Federal Reserve Bank of St. Louis.

During the recession of 1990-91, charge-off rates (i.e. bad loans) on U.S. residential mortgage loans (the red line in chart 2) hardly changed. Broadly the same picture emerged during the 2001 recession. Business loans, on the other hand, demonstrated a classic cyclical pattern with a significant rise in charge-offs during both those recessions (the green line in chart 2). Based on this knowledge, going into the 2007-09 recession, consensus was that residential mortgages would do relatively well in a recession whereas business loans would experience a significant pick-up in charge-offs. As we all know now, this turned out to be the mistake of the century and one which I, to my great regret, made myself. Never fight the last war when managing risk! 

Whether we like it or not, we will continue to make mistakes. It is simply part of human nature. However, the effect mistakes have on financial markets are compounded when they are correlated. A “correlated” mistake is one in which investors share a common forecast that proves to be wrong. An “uncorrelated” mistake is one where investors’ forecasts are widely spread out symmetrically around the eventual outcome (the Truth). Our economic adviser Woody Brock makes the following observations on correlated versus uncorrelated mistakes:

 “The more correlated the forecasting mistakes of the individuals in a market are, then the greater the market correction (and hence volatility) will be in the market once the Truth is learned. When forecasts are uncorrelated and distributed symmetrically around the Truth, then once the Truth is learned, for every seller there will be a buyer and market price does not change. There is no volatility. In the case of a correlated structure, the reverse is the case: everyone becomes either a buyer or a seller in unison, resulting in sharp changes in price.”

Leaning on Kindleberger’s work, Woody Brock goes on to conclude:

“In applying this insight to help explain the case study of the Global Financial Crisis three years ago, I arrived at what I have termed the Fundamental Theorem of Risk: A Perfect Financial Storm will occur when (1) investors have bets based upon very similar forecasts, (2) their bet is a “big” one, for example, a bet on the price of their principal asset (their house), and (3) both investors and their banks are maximally leveraged. It can be demonstrated formally that these three conditions will generate a Perfect Storm of maximal volatility — and note how perfectly these three conditions were met in the US housing market collapse. The role of excess leverage is to non‐linearly amplify market distress.”

Woody Brock’s work is critical in terms of understanding why 2011 turned out so differently from 2008 and, more importantly, why the painful experience of 2008 is not likely to be repeated any time soon, at least not in Europe or the United States. In 2011, investors were (and still are) deeply divided as to the longer term consequences of the policy being pursued – witness the great deflation vs. inflation debate – so Woody’s first condition (investors having bets based upon very similar forecasts) was not met in 2011 and is still not met today unlike in 2008 where all three conditions were fulfilled in abundance.

Abuse of statistics is another source of poor risk management in our field. One such example is the widespread confusion between correlation and causation. Just because a statistician can prove a correlation between ice cream consumption in Angola and the number of single mums in Panama doesn’t mean that there is causation (i.e. one is a function of the other).

Neither are correlations stable over time as so amply demonstrated in chart 3 below. Those who based their risk management approach around 1999-2000 on the assumption that US Treasuries and US equities were positively correlated were in for a rude awakening. Today everyone takes for granted that the two are negatively correlated. For now they are but for how long?

Chart 3:  Rolling 5-Year Correlation of US LT Treasuries vs. S&P 500

Source: Richard Bernstein Advisors. Note: Total returns, Dec 1980 – Dec 2011.

My favourite case of data abuse is unquestionably Reinhart and Rogoff’s work on debt versus economic growth (see here). In their much quoted research paper they state the following:

“We have shown that public levels of debt/GDP that push the 90 percent threshold are associated with lower median and average growth; for emerging markets there are even stricter thresholds for external debt while growth thresholds for advanced economies remain an open question due to the fact only very recent data is available.”

These four rather innocuous sounding lines have since become gospel in many quarters. It is now widely accepted that 90% debt-to-GDP is the invisible line in the sand. Once crossed, you are doomed. Economic growth will tank and you will ultimately default on your obligations, or so many believe.

The reality is that Reinhart and Rogoff’s work is based on a relatively small sample of countries of such disparity in socioeconomic profiles that providing an average figure is almost meaningless. It is akin to suggesting that yesterday was a very pleasant day with an average temperature of about 20C when in fact it was -10C at night and +50C during the day – both highly unpleasant. However, and for the record, I don’t blame Reinhart and Rogoff who did caveat their findings; no, the blame lies firmly with all those who have taken those findings at face value and used them out of context.

Another example of poor risk management is the one-dimensional thinking so often exuded by investors. It manifests itself in a number of ways.  More recently it has become clear to me that investors are incapable of focusing on more than one crisis at any given point in time. 2011 became the year of the euro crisis; pretty much nothing else mattered. The inability to apply multi-dimensional thinking is also clear from how markets treat economic news. In the U.S., (un)employment data have stolen most of the headlines in recent months with less emphasis on other, and equally important, economic statistics. This could have significant implications for financial markets. Here is why.

I suspect that the U.S. economy is in the process of inheriting Europe’s long standing problem of high structural unemployment. If my fears are well founded, investors are likely to underestimate the strength of the U.S. recovery as they will mistakenly conclude that continued high unemployment is synonymous with persistent economic weakness. It may not necessarily be the case if the unemployment is structural in nature. Allow me to show you a chart supporting my suspicions (chart 4). The green line is a proxy for the output gap and used by the Fed. The red line is the Fed funds rate. Two observations immediately stand out: (1) The two correlate relatively well over time, and (2) The output gap has now all but evaporated since it peaked in late 2009. In plain English: the economy is stronger than suggested by the employment data and, more importantly, the Fed may be forced to raise rates as they are increasingly at risk of falling behind the curve. This may also explain why there is growing dissent inside the ranks of the Fed.

Chart 4:  Is the Federal Reserve Bank Behind the Curve? 

Source: UBS, Bloomberg

I could go on and on. I could mention (some) investors’ one-dimensional focus on the absolute level of P/E ratios when it makes little sense to assess P/E ratios without taking the level of interest rates into consideration. Following this logic, investors should pay more attention to the equity risk premium and less so to the absolute valuation of equities.

Or I could talk about the effect the ‘risk on – risk off’ mentality has had on the ability to diversify risk. In today’s environment asset classes fall into one of two categories – they are either risk assets or safe haven assets. Traditional diversification techniques have stopped working with significant implications for asset allocation and portfolio construction.

Perhaps I should also have allocated more time and energy to one of the classic traps of investing – investor overconfidence. Most investors have a remarkable and deeply fascinating ability to blame others for their mistakes whilst giving themselves credit for all the correct investment decisions. As my old boss used to say – Don’t confuse genius with bull market.

The list goes on and on. Instead I will finish this letter by looking into the future and give my response to the all important question: Where should investors look for the next big crisis? Many pundits are pointing to the bond market as an accident waiting to happen. Andy Xie says that the current policy “will lead to catastrophic bond market collapse”. Frank Veneroso says “bonds and bunds at these yields are a sheer madness”. Both men are widely respected and very astute observers of financial markets; however, if Woody Brock’s logic proves correct, betting on the bond market as a major accident waiting to happen may prove rather futile. My money is on Asia. Here is the logic.

We know from experience that an asset bubble that bursts is likely to create what are often referred to as echo bubbles. An echo bubble is a follow-on bubble from the initial asset bubble and is usually created when monetary and/or fiscal policy is relaxed in response to the bursting of the initial bubble. Some market observers have actually argued that the financial crisis of 2008 was in fact the bursting of an echo bubble created by the very lax monetary policy created in response to the bursting of the dot com bubble in 2001-02.

We also know the effect artificially low interest rates can have on a country. Think Spain or Ireland, both of which adopted artificially low interest rates when they first joined the eurozone; however, rates were low at the time to accommodate a rather weak German economy. The low rates did wonders for Ireland and Spain in the early years of the eurozone membership but it is now painfully clear that enormous excesses were created as a result.

Now switch your attention to Asia. Many Asian currencies are pegged to the U.S. dollar, either directly or indirectly. As a result, the central banks of those countries are forced to keep the policy rate at a level which may be entirely inappropriate for the rapidly growing Asian economies. Obviously, removing the dollar peg would address this dilemma, but that is a pie in the sky so long as the mercantilist approach that most Asian countries subscribe to prevails.

The Bank for International Settlements published a paper recently where it pointed out just how lax monetary policy is throughout Asia. With the exception of Japan, every single country in the BIS study appears to be behind the curve (see chart 5). This raises all kinds of issues for Asia longer term – increased use of leverage, inflationary pressures, asset price bubbles, etc. Does it sound familiar?

Chart 5:  Policy Rates and Those Implied by the Taylor Rule

Source: BIS Working Paper No 378

To me it looks and sounds like a potential re-run of Europe. When it looks like a fish and smells like a fish, it usually is a fish. The parallels are certainly there for everyone to see, although Asia’s crisis may take years to unfold. Investors in Spain and Ireland had six or seven years of exceptional returns before the tide turned and those who exited prematurely left an awful lot of money on the table. At this stage we are merely monitoring events, but the yellow flag has been raised.

Perhaps the best the Asian monetary authorities can hope for is that the Fed takes a very hard look at chart 4 above and concludes that perhaps the U.S. does need higher interest rates after all. Such swift action might still save Asia from a repeat of the European malaise.

“Is the rich world aware of how four billion of the six billion live? If we were aware, we would want to help out, we’d want to get involved.” – Bill Gates

Dear Eduardo Saverin (if I may call you that),

You were, as I’m sure you’re aware, born in Brazil to a wealthy family, and were moved to Miami when you were a child. To America, the land of opportunity. And boy, did you ever have a lot of opportunities. Your parents sent you to Harvard, where according to Wikipedia you “took advantage of Brazil’s lax insider trading regulations and made $300,000 via strategic investments in the oil industry”. Well played! I bet that made your parents proud. In 2004 you were vaguely instrumental in setting up Facebook – a thriving startup which you helped turn into the world’s most overvalued company – and in 2009 you moved to Singapore. In 2011, just before Facebook’s IPO, you renounced your US citizenship, once again to exploit loopholes in international law for your own personal gain.

You are the worst kind of capitalist. You’re the kind of capitalist who shows up in a new country and sees only spoils to be pillaged, other people’s property to make your own. The opportunity you see is for yourself and yourself alone; you fail to realize that every opportunity comes with a cost. Your goal – as Marx observed of the obnoxious pseudo-capitalists of his own day – is to accumulate, accumulate, accumulate. But you don’t even have the chutzpah to stick around: you run away with your loot to a rather dull little tax haven in the South China Sea, sticking your former countrymen with your bills.

Real capitalists build nations. They understand they can only profit if society does too: that society enables them to profit in the first place by providing political stability, a system of finance for raising capital, security from our enemies, courts of law in which to settle disputes, roads on which to transport goods and workers, Internet links through which to channel data, and on and on. Real capitalists tend, nourish, and grow their communities so that they may reap an even greater harvest of profits next year, to everyone’s mutual benefit. You raided the vegetable garden.

You give capitalism a bad name, and I no longer wish to be associated with you or your company. Thus I have deactivated my Facebook account and switched to Google+. I hope your American customers understand that because of your oh-so-clever legal maneuverings you will be paying less tax on your billions, and they will have to make up the difference. And I hope next time you visit America you’re made to feel as welcome as you deserve.

You, Mr Saverin, are no Bill Gates.

Ross Thomas

PBoC, China’s central bank, is having trouble stimulating lending. The trouble now seems to be more demand driven, as the economic slowdown sets in.

Bloomberg: – Combined net lending by Industrial and Commercial Bank of China, China Construction Bank Corp., Bank of China and Agricultural Bank of China Ltd. was almost zero in the two weeks through May 13, Shanghai Securities News reported today, citing an unidentified person familiar with the matter.

The slowdown (particularly the lack of demand for loans) is driving interest rates lower. The one-year SHIBOR swap rate is registering the sharpest decline since 2008. Again, swap rates show the market “consensus” of short term-rates in the future – a rate at which someone is willing to “lock in” short term rates for a year or longer (in this case locking in the 3-month SHIBOR rate for a year).

1-year SHIBOR swap rate

When we discussed China’s inverted yield curve a couple of months back, many dismissed it as supply/demand aberration. But as has been the case in the US, an inverted curve continues to be the best predictor of economic downturns.

SHIBOR swap curve move

Now, if we back out and take a 30,000 foot view here we can put things in slightly better perspective.  I’ve attached a chart of the TCU data going back to 1965.  You can clearly see three things in this chart:

1)  The US economy is operating well below capacity.  The average TCU level of 81 during this period is still quarters if not years away from being achieved.  This means the economy is still weak even if the trend is in the right direction.

2)  This also tells us quite a bit about the inflation story.  With an economy operating below capacity it’s unlikely that we’ll see high inflation.

3)  Each of the 7 recessions displayed here were preceded by long periods of decline or stagnation in the TCU data.  This doesn’t mean it’s impossible that a recession could begin soon, but this data certainly isn’t consistent with that view.

Given the substantial global headwinds that are developing currently, I am kind of laying my head on a slab by sticking with the “no recession” call that I’ve been making for a long time now.  I’m making the forecasting mortal sin by giving you both a time and a prediction!  Clearly, the risks are rising and the uncertainty surrounding the “fiscal cliff” is likely to exacerbate that.  But I just don’t see recession in the USA for now.  We’ll revisit this outlook in the coming quarters.

“Unlike the US, UK or Eurozone, Japan’s corporate sector over the last 20 years faced a daunting prospect of having to de-leverage against the backdrop of deflation and flat nominal GDP. In our view, the Japanese corporates have performed a near “miracle” of reducing US$6 tn of debt without help from growing economy and despite the reluctance of BoJ to embrace a more aggressive monetary policy. It seems there is growing evidence that after 20 years, the Japanese corporate sector is finally “healing”. We focus on three signs: (1) the corporate sector is no longer reducing debts or increasing cash; (2) private investment is no longer declining; and (3) ROE and ROIC are gradually recovering (though from depressed levels). At the same time, Japan’s labour productivity growth rates continue to offset the poor demographics, while competitiveness, innovation and complexity indices remain strong. It seems likely that the corporate sector could surprise on the upside.”

Source: Credit Suisse

A couple of weeks ago, we pointed out that the performance of corporate bonds and equities were starting to diverge suggesting that credit spreads were reflecting risks emanating from Europe and their escalating debt crisis while stocks were focused elsewhere. Furthermore we added that an astute investor may consider moving toward a defensive posture in their corporate bond portfolio by either selling risk outright and into U.S. Treasuries, positioning on the shorter end of the corporate yield curve, rotating out of more volatile corporate sectors like Banks and Finance and into safer Industrials, or incorporating some combination of the three.

Since that time, the yield on the Barclay’s U.S. Corporate Bond Index has widened 8 basis points to a spread of 193 over comparable maturity U.S. Treasuries while the S&P 500 has significantly declined by more than 60 points or a drop of 4.5 percent. Now with the uncertainty of Greece exiting the Euro back on the table, equities have in essence caught up, to some degree depending on your view, to express risks that face many investors.

Bond Trading – Corporate Spreads & SPX

While equities are on full alert with any news from across the pond that could rock the markets, not all asset classes are taking a beating as of late. In particular, cash bonds in the High Yield sector has for the most part, held their own in recent days. The yield differential on the Barclays’s U.S. Corporate High Yield Index which covers close to two thousand non-investment grade debt, closed yesterday at 596 basis points over comparable maturity U.S. Treasuries for a month-to-date increase of just 14 basis points.

So when we compare the change between the High Grade Corporate Bond and High Yield indices, the moves by the latter is somewhat underwhelming. In other words, when High Yield has a spread that is almost three times as much as the other, one should expect a much greater change.

To quantify this, we utilize linear regression analysis over the past five years of data to gauge the appropriate change.  Without going into too much statistics, we note that the multiplier (or Beta or slope) of the basis point change between the two indices should be about 2.9. So given the 8 basis point change of the high grade corporate bond sector, the High Yield index should widen by about 23 to 24 basis points. When compared to the actual recent activity of 14 basis points, it appears that cash bonds in the High Yield sector are at risk for further underperformance.

Now High Yield bulls could argue that spreads have held in simply because of fundamentals such as low historical default rates. Also, the reason for widening in High Grade corporates could be due to the fact that many companies in that sector are more exposed to Europe in terms of global business. Furthermore, the financial sector which is the epicenter of contagion risk is a larger component of the High Grade sector.

In addition, High Yield investors in the cash bond markets may have chosen not to sell in fear of not being able to re-enter the market at a later date given the limited supply due to bare inventories on Wall Street. This may be why there is a strong divergence between cash bonds and derivatives where supply and liquidity is less of a constraint in the latter in wanting to reflect a bearish view. The benchmark 5-Year High Yield Credit Default Swap (Markit CDX HY Series 18 June 2017) which is an index that consists of 100 high yield entities has widened by 95 basis points to a spread of 672.

Bond Trading – High Yield Cash Bonds & Derivatives

In any event, the fact remains that a Greek exit from the Euro could lead to contagion which is evident in rising debt yields in other peripherals such as Spain and Italy. Risks are escalating that could ultimately affect all investors in every asset class where even the strongest of disciplines may be challenged. Unfortunately, there is no analogue or blueprint of such an event of this magnitude. Even the most experienced investors cannot gauge how deep this European rabbit hole may go. We do know that rising volatility will not be kind to risky sectors like High Yield, not to mention equities. Hence and until the risks are justified, a defensive posture as mentioned a couple of weeks ago may be warranted in the coming days or weeks.

No last minute miracle has the Greeks headed to new elections next month. Syriza’s Tsipras appears to believe he has much to gain from a new round of elections. Polls put Syriza in first place, though the margin of error makes it look more like a dead heat with the New Democracy, led by Samaras. Samaras was a significant obstacle to reaching agreements earlier but now has been outflanked by Tsipras. Tsipras apparently did not drink a sufficient amount of the kool-aid that made Samaras more of a realist.

Many observers are confusing the Greek opposition to austerity regime with a desire to leave monetary union. Judging from the electoral results, a majority of Greeks are critical of the EU/IMF/ECB demands in exchange for assistance. However, polls show that 80% or more Greeks want to keep the euro.

There is room to compromise. Can any one doubt, for example, Keynes’ loyalty to the UK even though he passionately warned that the Treaty of Versailles was poorly thought out and would lead to no good? Are not the Greek people saying the same thing as Keynes was saying then?

First, as Keynes noted then, there is a limit on how much people would sacrifice current output to service foreign held debt. Up until earlier this year, aid to Greece seemed to be largely a stealth bank bail out. After the PSI, upwards of three-quarters of Greek debt is in the hands of the Troika (ECB/IMF,EU). They purposely acted to avoid participating in Greece’s debt relief even though, by most accounts, Greek debt was still not on a sustainable path.

Second, under the conditions of the modern era, Greece has been occupied by its creditors. It was forced to pass a law that prioritizes servicing debt (largely in foreign hands) over other claims on the public purse. Is this not the kernel of truth in Tsipras’ claim that the EU has imposed “barbarous demands” on Greece?

Third, France’s new president wants to renegotiate the fiscal compact that his predecessor helped draft and support. Why shouldn’t a new government in Greece seek to renegotiate the terms of its aid, which is not really so much aid for Greece as it is aid to keep its (now largely official) creditors whole?

Fourth, exacting onerous concessions from Greece threatens to destabilize Europe as much as the onerous demands at Versailles undermined European stability.

Given the extent of the international assistance, TARGET 2 exposures, and commercial bank activity, a total default by Greece could cost Europe (and IMF) an estimated 400 bln euros. With new firewalls (IMF/ESM) and the liquidity provisions (LTROs), Europe is in a better position to cope with this than say a year ago, which belies the derogatory epithet of “kicking the can down the road”, nevertheless, it cannot be confident that the extent of the contagion can be known a priori (see Lehman, six months after Bear Stearns).

There is no mechanism to eject a member of the euro zone any more than there is to evict a state of the United States. Still, life can be made unbearable for Greece within the euro zone. Without a printing press, the Greek government can run out of currency to pay social security and public sector wages. This is partly because Greece still runs a primary budget deficit (budget balance excluding debt servicing costs). That means that tax revenues continue to fall short of spending.

The ECB could also stop lending to Greek banks and refuse to sanction any more emergency lending (ELA) from the Greek central bank. These two steps would leave Greek officials little choice.

German Finance minister Schaeuble who is likely to replace Juncker as the head of the Eurogroup is touting a tough line. No room to compromise. Either Greece adheres to the agreements or it can leave monetary union. We have seen this tactic before. Schaeuble is the bad cop so Merkel can be the good cop.

Spain and Italy have openly acknowledged they will not achieve the budget targets agreed to with the EU. The new EU forecasts showed that other countries will unlikely meet their targets. That is not a cause for ejection, but a case for forbearance.

There is plenty of room for compromises and there is a great deal of posturing, which is part of the brinkmanship tactics. New EIB funds and structural funds are available (and already earmarked for Greece) can be deployed. There is some flexibility with the timing of budget goals.

It is preferable to the alternative of Greece leaving. The contagion impact of Grexit is unponderable. We argue that Greece is largely a symptom of the crisis not the cause. A Grexit could trigger a new banking crisis. It could heighten the pressure on Spain and Italian sovereigns, which in turn would squeeze domestic banks. It could lead to pressure on Portugal (if not others) to join Greece. It would be understood as a failure of European elite in general and Germany in particular.

We have argued that exiting EMU would not solve Greece’s problems. It would exchange them for a more dire set of problems, which would include a collapsed banking system, a deeper recession/depression, higher unemployment and higher inflation.

Leaving EMU and the EU could also impact geo-strategic interests of the US and Europe. An aggrieved Greece could turn to Russia for financial assistance, perhaps in exchange for basing rights, or Iran for its energy needs.

We recognize the risks of a Grexit to have increased primarily as a consequence of brinkmanship tactics from multiple parties. However, we continue to see a Greek exit as an expensive folly for all concerned.

The CRB commodities index broke through the apparent support level discussed earlier. Commodities continue to be pressured by the global slowdown and Eurozone driven market stress. Recent dollar strength also added momentum to the selloff.

CRB Commodities Index

With the correction in the commodities markets, US dollar inflation expectations are down sharply.  The 2×2 (two-year forward) TIPS implied inflation measure went from some 2.25% in March to under 1.5% now. As long as Europe continues to flare up and commodities are under pressure, inflation expectations should stay subdued.

2×2 TIPS implied forward inflation expectation

Not surprisingly, the headline has reverted to the core as it tends to do.  Despite all the mainstream media commentary about headline prices, these more volatile components have proven “transitory” as Dr. Bernanke predicted so long ago.  Still, the core rate of 2.3% is above the Fed’s target of 2% and likely to keep the Fed at bay regarding further QE.

My housing adjusted CPI ticked down to a 1.1% year over year reading.  Clearly, when adjusted for the depressed housing market, inflation is much weaker than the headlines say.  This index has tended to be more volatile than the BLS figures over the last 20 years so it’s not surprising to see the figure we have today.  Nonetheless, all of this is consistent with other independent readings on inflation which point to low inflation.  So, the bottom line is, inflation is low and unlikely to spike higher any time soon even though I still believe we’re likely to see the CPI data trend higher as the year moves on.  ”Higher” is a relative term though.  Remember, the CPI has averaged about 3% over the last 50 years so a move from 2.3% towards 3% is hardly something to get worked up over….

Many people don’t know it, but many of Buffett’s earliest bets were essentially corporate raider type bets.  He knew the insiders at Geico (Ben Graham was a board member) and after becoming the largest shareholder at Berkshire he removed the executives and replaced them with his own people.   The buy and hold strategy that many people attribute to Warren Buffett is not at all the strategy that made him money.  The brilliance in Buffett was how he structured his own company.   See my piece on the “Many Myths of Warren Buffett” for more.

When you go all-in on Apple stock for instance, you’re just betting the farm on other people’s ability to manage a company.  That’s a big difference in my opinion.  Buffett didn’t make all his money betting on the ability of other people to manage a company.  Far from it.  Berkshire was a far more complex company than that.  The country boy from Nebraska is a bit savvier than that….Here’s more via Market Folly:

Berkshire Hathaway’s Warren Buffett recently met with MBA students from the Richard Ivey School of Business and the legendary investor talked about how his investing principles have changed over time along with numerous other topics.  Here are some highlights and notes:

Question:  The key to your early career was essential information arbitrage. Given the  changes in the world and that information now moves at the speed of light, how do you continue to have such great successes? 

Buffett: People have better information now, but they still act irrationally … Sometimes you have to work a little bit hard to get the good deals.  And looking through the Korean stock manuals I’ve found some of these same opportunities today.  But ultimately, the key to success is emotional stability.  You don’t need a high IQ to get rich.

Q: Explain your overall investing strategy

Buffett: Invest in equities slowly over time.  And invest in yourself.  Enhance your own talents and weaknesses.  And look to buy companies that will go on forever, like Coca Cola.  For the more serious investor, buy equities strategically, opportunistically.  And go all in when you can, and when there is a good deal.  I had a limit in my fund on the amount I could put in to one investment.  There was a fantastic opportunity so I approached my investors and told them I wanted to increase that amount.  I ended up putting 75% of the fund in that investment and it worked out well.  And I’m sure I will do it again.  Don’t use leverage, and sit on cash if there are no good investment opportunities.

Q: What is the most important thing you have learned in life?

Buffett: Find your passion.  You will know it when you see it.  It is more important than money.  You want to ask the question, “Where am I going to have most fun?”