Category Archives: markets

The U.S. is banker to the world

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Timothy Taylor writes,

Alexander Monge-Naranjo, in “The United States as a Global Financial Intermediary and Insurer” (Economic Synopses: Federal Reserve Bank of St. Louis, 2020, No. 2) delves into the return on these international investments. He calculates that from 1952-2015, the average annual return on assets that US investors was 5.2%, while the average annual return on assets held by foreign investors in the US economy was 2.5%.

Why does this difference exist, and how can it persist? As Monge-Naranjo argues, the typical pattern is that US investors in other economies are relatively more likely to invest in higher-risk asset–like investments in companies. Conversely, foreign investors in the US economy are relatively more likely to put their money into a safer asset, like US Treasury debt. In this sense, the patterns of international investment in and out of the US economy look like an insurance arrangement for the rest of the world–that is, investors in the rest of the world are trading off lower returns when times are good for safer and steadier returns when times are bad.

I often say that households and nonfinancial businesses seek to issue risky, long-term liabilities and to hold riskless, short-term assets. Banks and other financial intermediaries allow this by doing the opposite. So a bank will make business loans funded by deposits.

The rest of the world treats us link a bank. They issue risky, long-term liabilities (investments in companies) and hold riskless, short-term assets (our Treasury securities), while we do the reverse. Woe to us if there ever is a run on our bank.

The EMH in view of the crisis

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Question from a reader:

I’d be very interested to hear your thoughts about what we should conclude about the efficient markets hypothesis based on the recent events.

I’ve always been convinced in the truth of (semi-strong) EMH and handled my finances accordingly. However, my conviction was greatly shaken by the recent events. It seems clear that in the weeks preceding the financial crash earlier this month, the markets had completely ignored the evidence of the coming COVID-19 pandemic and the shock it would cause.

One month ago, on March 1, I sent the following to family members.

Folks,
Here are my thoughts on the stock market. Basically, I think that there is a chance that it could fall much further, and my own reaction will be to sell some stock market mutual fund shares and park them in a money market fund for a while. You might want to look into doing that with some of the stock market mutual funds you have in retirement accounts–shift them from stock mutual funds to money market funds, still within the retirement account family. No tax implications from doing so.

My thinking is that with the coronavirus, the number of shutdowns and travel restrictions is going to increase. The economic adversity this is likely to cause is not something that can be mitigated by the Fed, even though some people seem to attribute magical powers to the Fed..

If I thought that people would get over the initial panic and get back to normal soon, I would not be so pessimistic. But my guess is that instead the panic will get worse. even if the virus itself were to turn out to be a non-event. Hence, the economic consequences of the reductions in trade, travel, and tourism will still be quite severe.

My $.02

This was very unusual for me. I cannot remember ever offering market timing advice before. Incidentally, the first big market move after I sent this was the huge “Biden rally.” So for a couple days I looked pretty bad.

My general view of the Efficient Markets Hypothesis is that I don’t believe it, but I act as if it is true. I treat the market as ignorant, so I do not interpret stock market movements as if they forecast the economic outlook. But I figure I am at least equally ignorant, so I almost never try to outguess the market.

If we are back to me being equally ignorant, then it probably would make sense to get back in. But I have such a negative view of the stimulus compared to the Wall Street view that I am willing to wait a while for proof that I am the one who is stupid.

On a somewhat related note, some angry commenters asked me where I am putting my wealth in light of my post on the inflation virus, with which they vehemently disagreed. I am glad that so many people refuse to believe the inflation scenario, because that gives me more time to think about it. The hard assets that I might want to buy are going to remain cheap for a while.

I know that there are inflation-indexed Treasury securities (TIPS), and they may turn out to be the best choice, but I am not sure. Remember, what I foresee is a scenario in which the government is printing money as a last-ditch desperate attempt to pay its bills. Owning the debt instruments of a government in such dire straits does not strike me as risk-free.

Price discrimination explains pharmaceutical prices?

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Note: before the virus crisis dominated the news, I had composed and scheduled a lot of posts. There are still a few left to run. This is one of them.

Pragya Kakani, Michael Chernew, and Amitabh Chandra write,

Annual inflation of list prices was 12% while that of net prices was 3%, implying that financial rewards to manufacturers per unit sold have not grown proportionally to list prices. This pattern is mirrored in 19 of the 20 top drug classes by revenue including insulins, where list and net price inflation were 16% and 2% annually respectively. Finally, we find price growth explains 76% of revenue growth when measured by list prices but 31% of revenue growth when measured by net prices. Moreover, new product entry is the most important factor affecting pharmaceutical revenue growth. These findings provide a cautionary note on using list prices for policy analysis.

Of course, we already knew about price discrimination in the form of lower prices charged in foreign countries with price controls. If demand is more elastic in foreign countries, then that sort of price discrimination might be efficiency-enhancing.

Macroeconomics of the virus crisis, 3

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First, I think that this article from MIT Technology Review is essential reading, if you have not already seen it.

According to Duane Newton, the director of clinical microbiology at the University of Michigan, the biggest limitation in diagnostics is not the technology, but rather the regulatory approval process for new tests and platforms. While this process is critical for ensuring safety and efficacy, the necessary delays often “hamper the willingness and ability of manufacturers and laboratories to invest resources into developing and implementing new tests,” he says.

Case in point: FDA rules initially prevented state and commercial labs from developing their own coronavirus diagnostic tests, even if they could develop coronavirus PCR primers on their own. So when the only available test suddenly turned out to be bunk, no one could actually say what primer sets worked.

Read the whole article.

Next, today’s WSJ has many editorials and op-eds that discuss measures to help households get through the crisis. But the most interesting piece is by Hal Scott on the financial sector. He says that after the 2008 financial crisis abated

there was growing public concern about “moral hazard”—that government backstops and guarantees created incentives for risky behavior. In response, the Dodd-Frank Act of 2010 limited the Fed’s lender-of-last-resort powers for nonbanks, an increasingly important part of the financial system. Fed loans to nonbanks can now be made only with the approval of the Treasury secretary. They must be done through a broad program, unlike the one-off rescue of AIG, and must meet heightened collateral requirements. Loans to nonbanks must be disclosed to congressional leaders within seven days and to the public within one year.

I agree that we should be concerned about the financial sector, because of the way that it can magnify an economic crisis. But just as in 2008, I would try to avoid loans to financial institutions and other forms of bailouts. Back, then, I proposed “forbearance,” meaning allowing banks to fall below regulatory capital standards for a while. I still prefer this approach. It might reduce the contraction of the financial sector without providing a direct transfer of resources from taxpayers to banks.

Commenter Jeff thought along similar lines.

I wonder if you couldn’t mitigate some of the worst effects of defaults with some kind of mass forbearance policy. After all, if Southwest no longer has the cash flow to cover the financing costs of it’s fleet, what are its creditors going to do in the middle of a public health crisis? Come and repo the jets? In order to do what with them?

Finally, the headline yesterday that stock had fallen 20 percent from their peak caused me to wonder whether that is too much. Here are the arguments for and against a sizable stock market drop.

The case for a sizable drop:

–When we have a recession, not only does GDP drop but the ratio of corporate profits to GDP also drops. This “double whammy” on profits is a reason that stocks should fall farther than the economy. Another way to think of this is to treat an index fund as a levered position in GDP. If GDP falls by X percent, then the index fund should fall by a multiple of X percent.

–A significant share of corporate profits of U.S. firms now depends on overseas activity. Some important trading partners appear likely to be hit particularly badly by both the virus and by their financial fragility.

The case against a sizable drop:

–Although trade and tourism are big industries, they are a relatively small share of the U.S. economy overall.

–This, too, shall pass. At some point, even trade and tourism will recover.

Profits in financial markets

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Reviewing Gregory Zuckerman’s book on the trading firm Renaissance Technologies, I write

Much of the book consists of tales of the gifted mathematicians who ran the firm, along with their foibles and conflicts. These are entertaining enough, but I want to focus instead on two deeper economic issues that arise from the story.

1) Does the success of Renaissance show that financial markets are inefficient?

2) Are the social benefits of the trading conducted by firms like Renaissance commensurate with the profits that they earned?

The Monopoly Capital Theorem

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Jose Azar writes,

In an economy where everyone holds the market portfolio, all the companies have the same shareholders. If, in addition, firms act in the interest of their shareholders (i.e., if the agency problem is solved), the equilibrium outcome is equivalent to an economy-wide monopoly.

This is one of those theorems, like the Modigliani-Miller theorem, that tells you more about what has to be false than about what is actually true.

When I was at Freddie Mac in the 1990s, some of the economists there asked, “Why do our shareholders want us and Fannie Mae to compete?” Here you had a situation where we were a duopoly, with a lot of room to charge higher fees without mortgage lenders finding another outlet for their business, and many of our investors also owned shares in Fannie. Yet if a Countrywide Funding or a Prudential Home Mortgage wanted to play Freddie and Fannie off against one another, they could do it. We would cut fees to the bone and lower the standards on the mortgages that we would buy.

Actually, there was one instance where we colluded. Around 1990, there was an outbreak of “low-doc” lending, and Freddie’s CEO went to Fannie and obtained an agreement that neither firm would buy low-doc loans. Of course, low-doc loans made a big comeback during the housing boom, and this time around under different management Freddie and Fannie went all in on “no income, no job, no assets,” meaning that what those lines stated on the loan application went unverified by supporting documentation.

In fact, if there is going to be collusion, the initiative is not going to come from shareholders. Shareholders are represented by the Board of Directors, but you don’t see two companies in the same industry with Board members in common. And if you did, it wouldn’t take a particularly aggressive anti-trust regulator to make an issue out of it.

The bond gamble

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In the WSJ, James Mackintosh writes,

with lower yields, bond prices move more for the same change in the yield, a concept known in the industry as duration. Bonds are riskier than they used to be.

The government of Austria has issued hundred-year bonds, which now yield 1.1 percent. If the interest rate were to fall to 0.55 percent, investors would double their money. If the rate were to rise to 2.2 percent, investors would lose half their money.

As a short-term speculation, maybe bond holders will get lucky. Long term, I would bet against them.

A separate WSJ story captures my sentiment.

“You’re either going to make very poor returns from government bonds going forward or you’re going to make extremely poor returns,” said Tristan Hanson, a fund manager at M&G Investments, who recommends investors buy equities and avoid bonds issued by Group of Seven governments.

Some 13% of the £117.27 million ($141.71 million) that M&G Episode Macro Fund is placed in a short bet against negative-yielding German government debt, Mr. Hanson said. The rationale is that “there is a limit on how far those yields can go even in an adverse economic scenario,” given the European Central Bank has set negative benchmark rates, he said.

Of course, it is superfluous to write stories about investors who are bullish or bearish on any class of securities. At any one instant, half the market sentiment is bullish on a security and half the market sentiment is bearish. If it were otherwise, the excess weight on one side or the other would move the price.

But in the case of bonds, my guess is that there are extreme differences of opinion. The short side of the market feels strongly bearish, and the long side feels strongly bullish. The bullish bond investors look crazy to me. By the same token, I must look crazy to them.