Thursday, March 20, 2008

America’s accounting recession

Last September I wrote an article entitled “Accounting side of sub prime”, as it was evident from that time that the real problem with the sub prime crisis in the US is one of accounting, and not economics. And this could in fact be a reason supporting the fact that the other major economies seem not be to be suffering as much from the credit squeeze in the US, as the underlying cause was not initially economics. At the time I stated that because of the accounting rules being used by the US, the sub prime crisis would deepen because they were not, and still are not, aware of what the full extent of the problem was/is. Initial estimates were that the total sub prime write off would be US$60 Billion and now it is being touted as over US$300 Billion.

Goldman Sachs in reporting its last results (1 ½ weeks ago) stated very importantly that they have always believed in “marking to market” their securities. Thus they have not been affected by the problem facing other financial institutions, such as the now defunct Bear Stearns, which “marked to model” and therefore became stuck with instruments that they have no idea what the real value is.

Underlying problem
This is the underlying problem of the sub prime crisis that continues to cause a tail spin in global financial markets, and is the cause of global inflation and global growth slow down. America is truly great. They not only caused the world pain by invading Iraq, but also had to create a global financial crisis by first of all being irresponsible with risk management practices, and secondly compounding this by wide monetary policy swings in the form of interest rates.

It is no secret that the current recession in the US is “made in America”, as it was the quick moves up and down in interest rates that caused the problem in the first place, and then the delayed action by the Bernananke led Fed that put the final nail in the coffin. So the US messes up and we all suffer.

But at a micro level the real problem is that the US’s rules based accounting means that financial institutions were allowed to mark to mythical model (self created) rather than value their instruments at what the market says they are worth. Similarly, the same accounting rules allowed events such as Enron and WorldCom to happen. The global accounting agenda should see some convergence taking place between US GAAP and IFRS come 2009, and my fervent hope is that it will be more like an acquisition of US GAAP by IFRS rather than a merger. We need to take what is good from their standards and incorporate it into ours.

So the effect of all this risk management is that global economies are being affected by higher inflation, and slow down in economic growth caused by reduced consumption patterns. The fact is that people in the US are seeing their wealth plummet because of a falling stock market and house prices. The weaker US dollar has also caused massive increases in prices of commodities such as corn, wheat, gold, and oil, which has resulted in significant inflationary pressures. This has occurred because the US dollar is a reserve currency. Hence a fall in the US dollar has seen investors buying commodities such as gold and oil to maintain the real value of their investments, while fleeing the weakening US dollar.

This fall off in US dollar has been caused by the change in relative interest rates. What drives currency values is interest rate expectations by investors, so as the expectation (followed by action) is that interest rates will fall in the US, and at the same time as interest rates in countries such as Australia and Europe rise or remain stable, then the spread between the US and these other rates become wider. As we all know, the return on money is interest, and so if the interest one can get from the Euro is higher than that on the US dollar then investors will buy the Euro and sell the US dollar. The result is that the price of the US dollar relative to the Euro depreciates, causing the weakening US dollar.

Consideration of risks
The reason for the Fed decreasing interest rates is to create more liquidity by providing cheaper money to the market, and thus encourage greater spending and investment to spur economic growth. Thus as long as the US economy is seen to be at great risk then the Fed will continue to decrease interest rates and the value of the US dollar will fall, followed by an increase in oil and gold fueled by greater speculative demand.

The decision of whether to decrease, increase, or keep interest rates stable is determined by whether the Fed believes that there is a greater risk to the consumer from a weaker economy or higher inflation. The irony is that as interest rates come down, and more cash is in the system then it means more spending that drives inflation. The Fed must therefore consider all economic data, for example inflation and housing sales, to determine whether to increase or decrease rates.

The important barometer for the Fed’s next move will be what happens with the financial institutions. If there is threat of another Bear Stearns then they most certainly will move rates lower. If the institutions show sign of stability, or increased profits however, they will either hold rates stable or increase, depending on the strength of the economic data. So this is the decision that the Fed faces, and to get an indication of what will happen globally then one only needs to look at the economic data coming out of the various countries.

The latest interest rate reduction, and provision of liquidity, seems to have temporarily stabilized the markets. The next three to four weeks will indicate whether it has worked to permanently, and this all depends on the value of the sub prime instruments. If house prices continue to fall then this could negatively affect the perception of the value of these instruments, which would imply further write downs and possibly another Bear Stearns. If house prices stabilize then this would be good for the US dollar and the global market. The difficulty is because there is no market to value the securities then the uncertainty of where the bottom is will drive the US dollar and equity markets lower. This uncertainty is caused primarily because the securities were not being marked to market.

In fact the real US economy, where companies sell tangible products, such as technology, food, etc. is not doing badly, and companies such as Pepsi and Apple are awash with cash. So the US does not have a problem with the economy, as the companies in the real economy are still doing well, with the exception of discretionary expenditures such as retail and autos, as consumer purchasing power is affected. The prayer for countries like Jamaica is that house prices will begin to stabilize but analysts are expecting housing prices to go down at least until June 2008, so let’s hope they are wrong.

I have heard some compare the “US accounting recession” to our own 1990s meltdown, and in some ways they are similar, especially with some calling for a bail out by the US government.
There are many others who are warning against a bail out, however, and it seems that they may eventually win. In any event the intervention by the Fed thus far into the Bear Stearns situation is of a different complexion from the way we approached the 1990s meltdown, which makes the difference in the after event, which will be the subject of a presentation I will today.

Thursday, March 06, 2008

Where will oil go?

Over the past couple of weeks the media has in large part ignored the most important threat to Jamaica today for a soap opera type event. The most important threat of course being the price of oil and the soap opera event the arrest of Kern Spencer. As far as I am concerned the arrest and charge of Kern Spencer, and his colleagues, should merely be mentioned and left to the court to determine their innocence or guilt, which is really of no consequence to mention repeatedly in the form that it is being continuously carried.

To be fair though the media is just reflecting news that they think will sell and the deep interest in this is really a reflection of Jamaicans desire for gossip instead of the real challenges that face us. Even in the reporting of the “soap opera” we have ignored the substantive points for the more superficial news, while seeming to forget that the real lesson from this is the need for accountability of politicians and the public sector rather than presuming guilt in a system that is known to have made “Bob Woolmer” type announcements.

So for me the most important debate that we should be having today is what will happen to the price of oil and consequently Jamaica, and not the role playing of the PNP in the “Silence of the Lambs” Light Bulb Scandal. The oil threat is something I wrote about again just two weeks ago and will continue to do so to try and encourage the much needed debate on this subject that will affect Jamaica’s fiscal accounts, balance of payments, inflation, and the life of every ordinary Jamaican.

Record oil prices
Last Thursday oil hit a record high of US$105.72 per barrel (at the time of writing) and by all indications is set to rise further. I had indicated that it was expected to go to between US$110 to US$120 per barrel by April/May 2008 and at the current rate could very well get there before then. What is even of more fundamental importance is that the analysts are now positing that there may be some fundamental demand problem, and not just the previous speculative pressure that was being touted. This is significant as if there is a demand problem causing the price to increase then it means that this is a greater support for oil prices to rise than any speculative reason.

There is no doubt that if something is not done to check the consumption of oil in Jamaica that we could soon be faced with a US$3 Billion bill annually. The NYMEX Crude Oil Futures chart shows the upward trend of the price of oil since March 1, 2007 when it was around US$62 per barrel to its present level of over US$105 per barrel. This is an increase of over 2/3, or 67%, in one year. If Jamaica, or any country, had inflation of 67% in one year we can just imagine the devastation to every day economic life.

What is even more important is the trend that is illustrated in the chart. The 90 degree line, labeled R, is the up trend support line, which shows that the price of oil is definitely trending up. For there to be a convincing start to a down turn in the price of oil, it would have to fall below this trend line support, which would mean a fall below the US$88 to US$90 per barrel, at current prices. But of some significance supporting the up trend argument also is that oil has consistently broken though key resistance levels, consistently making new highs. As long as new highs are being achieved then there is little hope of any reversal. The first major resistance it broke through was around October 2007 when it passed US$88 per barrel (S2) and secondly in February 2008 when it passed US$100 (S1) per barrel.

What we have to look for to determine if the up trend is weakening is if the next move up to another major resistance level is at the same rate, and of the same size as the move between US$88 and US$100. In other words, it took four months to move from US$88 to break through US$100, and it was a move of US$12 per barrel. If it takes us six months to move from US$100 to US$110, then this would be an indication that the trend could be slowing and could mean that demand for oil at the higher price is becoming less as consumers adjust their consumption patterns.

Immediate fiscal policies
All indications though are that in the near term there is a strong up trend, which means that unless there is some increase in supply or drastic reduction in demand then the price will continue to move up. The evidence is also pointing to the fact that the US economy will continue to weaken into the second quarter, which means that the pressure will be maintained for the price of oil to continue its upward trend.

If the price grows at the same rate then we would be looking at US$110 per barrel by April 2008 and US$120 by June 2008. This would mean that for the six months oil would be averaging over US$100 per barrel. This is quite significant for Jamaica and will certainly have some amount of inflationary pressures, in addition to the other imported inflation we are experiencing. For oil prices to show any significant move down it will first have to go down past the current major support level now of US$100 (S2) and then break the uptrend support line (R) before closing below US$88.

The implication for Jamaica is that immediate fiscal policies are needed to address this fundamental threat, as longer term energy solutions, such as alternate energy sources may be too little too late. Even the more immediate alternate energy possibility of solar energy in homes and businesses would take time to implement any support and the equipment itself. This means that the greatest benefits will only come from fiscal policies to drastically curb consumption.
In the mean time I expect that the US economy will continue to weaken and the interest rate reductions by the Fed will not have any effect short term effect on the causes of the underlying weakness. If the Fed had significantly reduced rates six months ago that would have been a different story but they have waited too long, and so consumer demand has been affected. This is what could happen to Jamaica’s economy is we wait too long to curb our energy consumption patterns, as economics is as much about timing as it is about behaviour.