Mixed feelings…

Kotok

 

David R. Kotok, Cumberland Advisors, Inc.
Source: Global Interdependence Center

There’ a lot going on. But let me start out with David Kotok’s remarks (with a copy here) which I picked up from John Mauldin’s mail. I recommend subscribing to both mail newsletters –they’re free and their advice is sound and most of all thought provoking.

Kotok argues that globalization allows us to determine one set of global real interest rates for the different maturities (3 mo, 1 yr, 2, 5, 10, 30 yrs). I’m sure he’s singling out the developed countries (US, UK, EC and Japan) in his determination of the global rate, because they do carry most of the debt weights; as for the rest, in order to determine their real rates, we would have to add each country’s risk rate.

Nevertheless, he stresses the globalization nature of finance nowadays.
Money managers look for alternatives to their deposits all over the
world. They operate like farmers selling their crop in advance at a
future’s exchange, at harvest they deliver their crop at the
prearranged future price. Let me give an example. In the case of euro
deposits, the manager must compare the local US rate with the resulting
foreign rate; which considers buying euros, depositing this money in a
foreign bank, selling EUR future contracts for the term (at
the expiration date) of the deposit, when he will deliver the EUR in
exchange for US dollars –change euros for crop in the farmer story,
and you get the picture.

070126yieldcurve
US Treasury interest rates. 25 January 2007.
Source: Bloomberg

To make a long story short, Kotok’s global real rates stand at a
little over 2 % –implying a US inflation rate slightly under 3 %, with a flat term curve (30 yr bond yield almost the
same as the 90 day bill), which is quite a poor return. As a
consequence, he sees investments moving into growth sectors –which
would explain the stock index rally as of late.

Bill Gross confirms the above statement, we read his whining about shrinking bond profits here.

Looking at this situation from a different angle, it confirms the
liquidity glut –there’s so much money going around that it’s difficult
for lenders to get reasonable returns. BTW, investment bankers are
making a killing; yearly earnings increases of 48 % and 93 % are
common. It would seem that managing the glut has paid of handsomely to
the bankers involved.

With a global growth rate expected at 4.5 % for 2007, Kotok
continues to argue that eventually the real and the growth rates must
converge –expecting a rise in the real lending rate to bring down the
growth rate –to a potential recession.

In Kotok’s own words,

Low real interest rates and higher real growth rates mean good things for
stocks. They also mean the outlook for bonds is more problematic. Risk can be
assessed but must be monitored closely. Central bank credibility is paramount
but must not be taken for granted.

[…]
 

The peak core real interest rate in the US has been trending lower. This has
been apparent during the last 25 years as interest rates and inflation rates
fell from the double digit era a quarter century ago. This leaves us with an
unanswered question: should we use the average or the trend?   

[…]

That real rate peaked around 7% prior to the 1974-5 recession. It peaked there
again (7%) when Paul Volcker attacked inflation in the 1980-81 recessionary
period. It peaked at 5.5% before the 1990-91 recession. It peaked at 4% in
advance of the 2001-02 recession. Today, the US real interest rate is around
2.4%-to-2.5% depending on how you measure it. If we use the downward trend of
the last 25 years, The US economy is near the point where a recession will be
triggered. If we use the average of 5.5% for the last 40 years, the real rate is
way below the average and should not trigger a recession.
 

We thank Credit Suisse for this data. They use the average. We are not sure
which method is correct.
 
Also, globalization and this new paradigm did
not exist until quite recently. We are just learning about its benefits. We are
also just learning about its risks.
 
The jury is still out on this real
rate peaking indicator. At Cumberland, we believe that a real interest rate of 2
½% is too low to trigger a full recession. In our view it will only bring the
growth rate to trend and that is exactly what we have seen to date. At
Cumberland, we also believe that a real rate of higher than 3% would be enough
to alter this view. If we saw a credible move to a 3% real interest rate, we
would begin to buy TIPS and to lighten our allocation to stocks.
 
History
gives us no guidance here. Stay tuned.
 

With the continuing deterioration of the housing sector, and its
debilitating consequences in growth and employment, I still hold that
we may be in for a slowdown shock –or, it could get worse before it gets better.

According to Bloomberg,

Jan. 25 (Bloomberg) — Sales of previously owned homes in
the U.S. declined in December for the first time in three months,
capping the biggest annual drop since 1989, a slide that’s shown
signs of bottoming.

Purchases dropped 0.8 percent to an annual rate of 6.22
million, the National Association of Realtors said today in
Washington. For the entire year, sales fell 8.4 percent from
2005’s record. In a sign the slide may be nearing an end, the
number of homes on the market decreased for a second month.         

“This grinding sort of correction will continue for much of
this year,” said Joshua Shapiro, chief U.S. economist at Maria
Fiorini Ramirez Inc. in New York. “Housing will make a negative
contribution to the economy this year, but the declines won’t be
as big as those we have seen in the most recent past.”         

We’ll further the analysis in my next post…