Sunday, January 30, 2011

US New Homes Sales Reveals Weakness


US New home sales data came out this week and it got a lot of people excited. In particular, the hike in the annualised sales to December seemed to suggest better days. For the record, the number went from 280k in November to 329k. An impressive increase.

Unfortunately, on deeper inspection, it is not that good. Much of the increase was due to a large jump in sales in California because purchasers were rushing to meet a tax credit deadline in the State. Looking closer at the numbers for annualised sales...





(100's)
US
US 3 Month Av
US Ex-West 3 Month
Dec
356


Jan
349


Feb
347
351
268
Mar
384
360
274
Apr
414
382
285
May
282
360
272
Jun
310
335
259
Jul
283
292
237
Aug
274
289
234
Sep
317
291
232
Oct
280
290
230
Nov
280
292
232
Dec
329
296
222

source: US Census Bureau, Earnings View


....reveals that the data is not so impressive. Excluding the West region shows that the three month average actually fell. Moreover, even if the West is left in, the three month average is only marginally up.

Inventories are coming down but it looks like the housing recovery still hasn't taken place yet.


Source:

U.S. Census Bureau News

Friday, January 21, 2011

US Housing Market Set for Subdued Recovery


The US housing market was at the epicentre of the financial crises so it is reasonable to assume that it needs to recover in order to confirm a full recovery. This is especially important as the 'wealth effect' of rising house price values has a direct correlation with US consumption demand. Ultimately, housing will recover as new household generation catches up with reducing inventory, but is 2011 the year when the housing market will definitively recover? Ultimately, the answer to this question will lie in a combination of inventory, affordability and employment.


Existing Home Sales Data

The latest existing homes data from the National Association of Realtors is out and I've incorporated them into this table




2008
2009
Mar 2010
Jun 2010
Sep 2010
Dec 2010
Inventory (m)
3.7
3.28
3.63
3.89
4
3.56
Sales (yearly rate)
4.91
5.16
5.36
5.26
4.53
5.28
Months Supply
10.4
8.1
8.9
10.6
10.6
8.1
Av Price (k)
198.1
172.5
169.6
183
171.5
168.8
source: National Association of Realtors, Markets and Culture

As a rough guide, a 'normal' months supply data is 6 months, but this number can reduce dramatically given a pick up in sales.  I think a normal inventory could be around 3m. Transactions should improve given ongoing employment gains. However, prices appear to be weakening, even though, Robert Shiller doesn't believe they have gone far enough...

schiff

Frankly, I'm not convinced by the Case-Shiller 'Long-Term Trend', as the US economy has seen a marginal shift increase in home ownership.


Shadow Housing Inventory

Unfortunately, the inventory data is not the whole story. Their is a whole load of shadow inventory in the pipeline from banks and repossessions. Corelogic gave some estimates for how much this could be to August...
CoreLogic Visible and Pending Inventory 
   and the future inventory looks like it will hold back housing...

CoreLogic Shadow Inventory

The real key to understanding how much future shadow inventory will be to look at serious delinquency rates are faring. I've compared October 2010 delinquency rates with 2005, on single and multiple family serious delinquency rates.

  • Single family rates at 4.52% vs. .77% in 2005
  • Multiple family rates at .71% vs. .27% in 2005
Clearly there are more foreclosures in the pipeline. So for 2011, it looks like a subdued recovery in housing.





Source:

Corelogic Report

Fannie Mae Monthly Report

National Association of Realtors

Saturday, January 15, 2011

Free to Choose? Why Free Market Economies Create Happier Populations

Adam Smith

In a previous article I discussed the moral foundations of market institutions and touched upon a subject which will be the focus of this piece. Specifically, whether the concept of the ‘satiability of needs’ is valid? 
If needs are satiable then it could be argued that they could be defined and, there is a valid argument for centralized provision.  If they cannot, then the best solution appears to be to allow market provision. Note that, the former argument does not imply a loss of autonomy, since autonomy is only seen as having a value if it leads to needs being satiated and-according to the theory-these needs can be satiated. 

I want to explore this problem of choices and needs from the perspective of the work of behavioral psychology in consumer choice.


Too Much Choice: People Only Want Jam Tomorrow?

One of the most cited pieces of research on consumer choice is Sheen Iyengar’s ‘When Choice is Demotivating: Can One Desire Too Much of a Good Thing?’ which is most famous for its study of jam selection. The lessons of this study (which is just one part of the work) are oft referred to in the ‘Apprentice’ television series, whereby contestants have actually received challenges which replicate the decision making in this research.

When faced with a large number of jars of jam, consumers appear bewildered by the options and bought less jam. Moreover, they were less satisfied with their purchases. On the contrary, faced with a smaller selection, consumers bought more and were happier with their selections.

Overall, in this work, Iyengar argues…

‘psychological theory and research affirm the positive affective and motivational consequences of having personal choice. These findings have led to the popular notion that more choice is better, that the human ability to desire and manage choice is unlimited. Findings from three studies starkly challenge the implicit assumption that having more choice is necessarily more intrinsically motivating than having fewer options.’

So it seems that consumers do not actually value having unlimited choice over limited choice. So long as that limited choice fulfills their needs. This argument appears to strengthen the idea that needs can be satiated, or at least, that a market with a few suppliers could in fact be better than one with many. An idea, that opens up the possibility of centralized creation of oligopolies, as opposed to completely free markets.


Heuristics in Consumer Choice

Iyengar’s work seems to conform to the principles of the work of Kahneman & Tversky. These two cognitive behavioral psychologists built up a body of research that affirmed the usage of heuristics or ‘short cuts’ in decision making under uncertainty. When faced with many options, humans go through a process of cognitively narrowing the options via using learnt rules or heuristics. If the effort expended in applying this process out cedes the marginal utility in making it, then the process tends to be discarded. In other words, no one can be bothered to decide over what jam to buy.


Free to Choose?

If you put the arguments- in the sections above- together than the case for needs being satiable, appears to be a strong one. However, they appear to go against common preconceptions over the benefit of more choice. Moreover, they also appear to go against the common experience of consumers being offered multiple choices in the marketplace. Supermarkets are full of multiple choices of goods and the internet is booming with long tailed retail. In Chris Anderson's 'The Long Tail' this growing aspect of consumer preferences is discussed in length.

So is this just academic research that falls apart in real world? In addition, is there something intrinsically valuable in having choices that consumers do not necessarily want to use? I suspect so.


Consumers Need Choices That They Don’t Use

It appears that the consumer values having a wide range of options even if it doesn’t appear to be the optimal way for them to make decisions. This perplexing conclusion is only elucidated if one accepts that the value lies in consumers feeling that they are free to make purchasing decisions of their own volition. In a later work, Iyengar expresses this view succinctly in “Knowing What You Like versus Discovering What You Want: The Influence of Choice Making Goals on Decision Satisfaction

‘Despite the detriments associated with choice overload, consumers want choice and they want a lot of it. The benefits that stem from choice, however, come not from the options themselves, but rather from the process of choosing. By allowing choosers to perceive themselves as volitional agents having successfully constructed their preference and ultimate selection outcomes during the choosing task, the importance of choice is reinstated.’

I am sympathetic to this argument. However, this should not be taken as a validation of the argument that all that need be done is make sure that consumers feel they are making autonomous choices, when in fact they are being manipulated.

The value not only lies in feeling autonomous but also in being part of the epistemic process of the market, whereby tacit knowledge of wants and purchasing desires is expressed through market pricing mechanisms. Consumers want to feel they are part of this process, not only because it is the best way to utilize resources, but people value being free to choose.


Satiability of Needs?

So what does this mean for the satiability of needs? I think that it should be recognized that market mechanisms and freedom to choose should be seen as an end, rather than a means to achieve wants. Whilst needs are not necessarily satiable, consumers are happier when they are presented with choice and the feeling that they are part of the iterative process of defining consumer choice.

In conclusion, being part of the market process appears to be as important as having needs satiated. The implications for social cohesion are clear. Consider two economies which happen to have equal provision of the same type of goods. One has them provided by the market, the latter via centralized control. The one that has it provided via the market mechanism is likely to have a happier population than the latter.  Moreover, it could be the case that the poorer segments of free market economies are happier than those equally poor in a command economy, even though they share the same amount of ‘autonomy’ in terms of being able to enjoy goods.




Source:

Anderson, Chris 'The Long Tail'  Random House Books, 2007

Iyengar, Sheena ‘Knowing What You Like versus Discovering What You Want: The Influence of Choice Making Goals on Decision Satisfaction’

Iyengar, Sheena ‘When Choice is Demotivating: Can One Desire Too Much of a Good Thing?’ Columbia University
 

Wednesday, January 12, 2011

More Good News for the UK Housing Market?

If ever you needed conclusive proof that the UK housing market is rigged in order to transfer wealth from the young to the old, then please read this from Barratt Developments statement this morning...


Today we are also announcing a tie-up with Hitachi Capital (UK) PLC that will allow parents to borrow money to help their children onto the property ladder.  The product is unique in the market and is specifically designed to address current mortgage restrictions on loan to value.
In other words, we've given up focusing on getting young people into debt in order to prop up UK house prices. Instead, let's cut out the middle man and just get the parents directly into debt instead.

Meanwhile, in the six months to December, their completions were down to 4,832 from 5,053 last year. However, the average selling price was up 6% to £176k. As for the growth outlook...

Mortgage lending remains at unusually low levels and we view this restricted availability of mortgage finance as continuing to be the key constraint on market growth in the near term.
So much for the restructuring in the banking sector.

Although, one thing that has gone back to normal is that Lloyds CEO Eric Daniels looks set for a £1m bonus, whilst Stephen Hester has £2.5m lined up. Meanwhile, Bob Diamond thinks its time for the banks to stop apologising for the credit crunch.

Aside from the moral issues, the banking sector underperformed benchmark indices in 2010.


Conclusion

Prices up, supply growth slowing, the banking sector not lending money and now, parents are having to borrow money to pay for their parents houses. Meanwhile, the banking sector looks set to award itself £7bn in bonuses-of which Savile's estimates 1.6bn will go into the London housing market- after having seen increases in their salary in 2010 to counter weight the tax last year.

When will this madness end?

Saturday, January 8, 2011

A New Approach to The Causes of Inflation and Inflation Targeting

Inflation is a fascinating phenomenon from an investment perspective. Naturally most of the focus and analysis comes from the bond markets, where inflation expectations largely guide the movements in bond prices. However should the rest of the investment community analyse inflation expectations in the same way? Moreover, is the focus on headline inflation the key to understanding economic prospects? In this article, I will answer 'no' to both of these questions.


Inflation Policy is Influenced by Historical Events

Political actions or ideologies only really acquire strength if they are accompanied by emotional involvement and, it takes significant macro events in order to get the public involved with the details of economic policy. However, when they happen, the ramifications can become deeply embedded.

In terms of inflation, consider the hyper inflation experienced by the Germans in the inter-war period. This has had a lasting cultural effect on the willingness of Germans to agree to anti-inflationary Governmental measures. Similarly, the inflationary period in the 70's has caused no end of academic spilt ink to be devoted to formulating headline inflation busting policies. Whatever it took, headline inflation had to be controlled.

Moreover, this approach can be seen in the remits of both the ECB and the Federal Reserve. Although the Federal Reserve is supposed to oversee growth and inflation, very few people argue for a focus on the former if it compromises-in the slightest- the latter.


Academic Focus on Inflation

However, the focus on inflation is not just limited to executive political decision making. Indeed, it is fascinating how this is the one area of policy that the free marketeers (Milton Friedman etc) will insist requires action. Friedman's work focused on the control of monetary aggregate growth as the key to beating inflation. Friedrich Hayek has suggested that currencies be allowed to 'compete' with one another, in order to impose an anti-inflationary discipline upon issuers. Most of the economists focusing on this area of research would advocate inflation targeting in order to keep the economy out of recession.

Inflation Induces Misallocations of Capital

However, it is to an earlier insight of Hayek's that I think attention should be focused. In 'The Pure Theory of Capital'. In this early work, Hayek attempts to explain the cyclical nature of industrial output in a systematic theory of capital. He warns of the dangers of misallocations of capital that are caused by the availability of cheap credit during the boom period. The resulting recession is lengthened by the difficulties inherent in restructuring this capital. Furthermore, this 'cheap credit' is induced by rapid relative movements in pricing.

So for example, if house prices are booming-after the dot com bust, housing, commodities and hedge funds became the new 'dot-com'-then credit issuers will be psychologically induced to issue cheap credit. I need not explain the outcome of this and how much misallocated capital was thrown at new house build in the US. Just look at this chart...



The greatest insights into how economic agents are induced into doing this is given in the behavioural finance research of Kahneman and Tversky. They demonstrate how people tend to use heuristics in order to make decisions under uncertainty and, rapidly changing prices (inflation) are a significant cause of uncertainty.

In this article, I am arguing that it is the effects of these misallocations that are the symptoms and the cause is the psychological inducements. However, you can have these misallocations-with significant effects-without having head line inflation.


Inflation without the Inflation?

As noted above, for historical reasons, the focus on fighting inflation has been on the headline numbers. However, it strikes me that recent history has highlighted the dangers of inflation without, err, the inflation! Combating head line inflation is, in my opinion, far too narrow a political course to guide. In the last few years, we have seen inflation in the risk seeking within housing, mortgage bonds, CDO's etc. All of which was watched over by the Federal Reserve.

 Indeed, Greenspan spoke of a 'bond conundrum' as he had tried to raise rates only to see the markets keep market rates low. Ultimately, was this a problem to Greenspan, given that his remit is headline inflation? I suspect not, or at least, not enough to propel him to act further. Unfortunately, the inflation remit of the Federal Reserve is set up to fight yesterday's battles.

Similarly, with European Sovereign Debt, the market merrily priced in peripheral debt at close to Bund levels for most of the naughties. The Greeks never had it so good. Again, the subsequent misapplications of capital are being dealt with today. Again, the ECB's inflation busting remit does not allow it to make considerations. Bizarrely of all, the history of Communist control in China has created an environment whereby their central authorities can look at these issues in isolation. 


Fighting Inflation in Future

I think a fundamental rethink in inflation targeting is needed. I do not argue for an abandonment of current head line inflation targeting however I do think that policy responses-as with Greenspan and the 'bond conundrum'-should be encumbered because of a narrow focus on inflation targeting. Indeed, Greenspan repeatedly warned of the dangers of derivative issuance. Moreover, Mervyn King has been devastatingly succinct on what he thinks about the banking system.

It's time to rethink Central Banks remits and, to stop forcing them to fight yesterday's battles.




Source:

Hayek, F.A "Denationalization of Money: An Analysis of the Theory and Practice of Concurrent Currencies" , Hobart Papers, Transatlantic Arts, 1977

Hayek, F.A "The Pure Theory of Capital", The Collected Works of F.A. Hayek, University of Chicago Press, 2007

Kahneman, Daniel and Tversky, Amos "Judgement Under Uncertainty: Heuristics and Biases", Cambridge University Press, 1982

Saturday, January 1, 2011

More Austerity Measures are Likely in 2011

As we start a new year, I thought it would be interesting to assess the performance of the leading countries in addressing their public deficits. After a 2010 characterized by a European sovereign debt crisis, it is time to think about whether 2011 holds similar prospects.

In summary, I think there are significant issues ahead for Sovereign Debt in 2011. In particular, Spain appears set to follow the path of Greece, Ireland and Portugal. Similarly, I think that the next in line of the major countries is the US and UK. However, those countries are likely to benefit more from a cyclical pick up because their Governments were purchasing assets in the crisis. If growth is stronger than expected than these assets could perform well (or be sold back to the private sector) and their financial situation could be improved.

However, on trend, the US and UK will have to implement more austerity measures. Italy and France will also have to take measures. I am particularly worried about Italy, but I will start by looking at Spain.

Spain Set for a Bail Out?

According to reports, the ECB has not yet been buying Spanish debt but it has been buying Portuguese and Irish. This is why after the recent ECB action, Portuguese 10 year bond yields are below their November highs…

One-Year Chart for Portugal 10 Year (GSPT10YR:IND)

but the Spanish 10 year yield is not…

One-Year Chart for Spain 10 Year (GSPG10YR:IND)

This is a clear indication that the Portuguese bond market is being held by European Stabilization Fund (ESF) buying. It should be noted that, according to the BIS, Spanish banks hold over $108bn worth of Portuguese sovereign debt. Moreover, the market doesn’t seem too keen to insure Spanish debt. See 5 year CDS pricing here…


One-Year Chart for SPAIN CDS USD SR 5Y (CSPA1U5:IND)

So what is in store for 2011?


Stabilizing European Deficits?

Not for nothing is Trichet insisting that any usage of the European Stabilisation Fund should be accompanied by implementation of budgetary austerity measures. I wanted to see how this plays out by trying to estimate how much Governments will have to cut back in order to try and stabilise their deficits.


 Firstly I've compared current 10 year yields with nominal GDP forecasts and included gross debt as a percentage of GDP. The last two columns are for Government Financial Balances as a share of GDP.



Nominal GDP Growth
Gross Debt % GDP
Gov Fin Balances

10 Yr Yld
2011
2012
2011
2012
2011
2012
Belgium
3.43%
3.30%
3.50%
104.30%
105.20%
-4.50%
-3.60%
France
3.36%
2.60%
3.10%
97.10%
100.20%
-6.10%
-4.80%
Germany
2.96%
3.60%
3.40%
81.30%
82.00%
-2.90%
-2.10%
Greece
12.47%
-0.30%
1.50%
136.80%
142.20%
-7.60%
-6.50%
Ireland
9.06%
2.20%
3.70%
112.70%
115.60%
-9.50%
-7.40%
Italy
4.82%
2.50%
2.70%
132.70%
133.00%
-3.90%
-3.10%
Japan
1.00%
0.90%
0.50%
204.20%
210.20%
-7.50%
-7.30%
Portugal
6.60%
1.10%
3.00%
98.70%
100.60%
-5.00%
-4.40%
Spain
5.45%
1.10%
2.10%
78.20%
79.60%
-6.30%
-4.40%
UK
3.40%
3.70%
3.20%
88.60%
94.50%
-8.10%
-6.50%
USA
3.29%
3.40%
4.10%
98.50%
101.40%
-8.80%
-6.80%
source: OECD Forecasts

The next step is to calculate what these Governments need to do in order to stabilise their debt. I can do this by calculating this number from the following equation


Stabilising deficit= (Debt % GDP *(i-g))/(1+g)


This gives the following results in the second and third columns.




Stabilising Deficit          
Adjustment
2011201220112012
Belgium0.13%-0.07%-4.63%-3.53%
France0.72%0.25%-6.82%-5.05%
Germany-0.50%-0.35%-2.40%-1.75%
Greece17.52%15.37%-25.12%-21.87%
Ireland7.56%5.97%-17.06%-13.37%
Italy3.00%2.74%-6.90%-5.84%
Japan0.20%1.05%-7.70%-8.35%
Portugal5.37%3.52%-10.37%-7.92%
Spain3.37%2.61%-9.67%-7.01%
UK-0.26%0.18%-7.84%-6.68%
USA-0.10%-0.79%-8.70%-6.01%
source: Markets and Culture ,OECD Forecasts

The last two columns (adjustment) are the key to this exercise. So for example, the UK has to cutback 7.84% and 6.68% in 2011 & 2012 respectively from their proposed spending, just in order to stsabilise the debt/GDP ratio. They illustrate how much these Governments need to do in order to stabilize their deficits at the levels they are at now. Of course, they do not necessarily need to do this, but I would hope that they would realize the importance of reducing their overall debt burdens.

Incredibly, given current bond yields, the US, UK and Germany could run slight deficits and still eat away at debt in 2011. However, I would caution that this relationship exists as long as the bond markets have confidence in them.

Frankly, Spain and Portugal are going to have to make more cutbacks. This will be very hard for Spain given that their economy looks weak and their housing market remains a drag on growth. I would expect downwards pressure on their GDP growth numbers. Moreover, if the market continues to doubt them then their debt servicing costs will only increase.


US and UK Debt Positions Helped By Asset Purchases

Turning to the UK and US, they too look like they are going to have to make more cutbacks. However, there is a mitigating circumstance. Going into the financial crisis these two economies had a higher share of GDP in financial services than the others. They ended up buying assets, therefore their net financial position is liable to be positively impacted by growth.




% of 2011 & 2012 GDP

               
Gross Financial Liabilities
Net Financial Liabilities
Belgium
104.3
105.2
84.2
85.0
France
97.1
100.2
61.8
64.7
Germany
81.3
82.0
51.6
52.0
Greece
136.8
142.2
105.1
110.1
Ireland
112.7
115.6
69.7
74.6
Italy
132.7
133.0
104.7
105.0
Japan
204.2
210.2
120.4
127.1
Portugal
66.7
67.4
67.6
70.0
Spain
78.2
79.6
49.3
52.8
UK
88.6
94.5
57.6
62.3
USA
98.5
101.4
74.3
78.2

 source: OECD Forecasts

Clearly, Italy’s overall debt burden is a cause for concern and I feel that ECB buying of Spanish debt is highly likely. Moreover, the Spanish are likely to have to deal with a failing housing market, which will further exacerbate their banking sector difficulties. I think fears over Italy will be next after Spain. The interesting thing about Spain is that their net financial deficit is relatively low and they have Government assets that they can sell off. However, it is their lack of growth and fears over their housing market which is causing all the problems.


The Political and Economic Will for More Bail Outs?

Whether the political and economic will exists for this is another question. The ECB seems keen to talk of defending the Euro and its members’ sovereign debt, but this is likely to be politicking in order to hold up peripheral bond yields. Unfortunately, it’s not working. Moreover the knock on effects of falling Spanish and Portuguese debt (not to mention Italian) could be significant upon the European banking sector.

I’m not long European Banks.



Source:
OECD Forecasts