Sowing and Reaping

Many wonder what will get the US economy moving again. For them I have one word:

Wheat.

Our farms are about to experience perhaps their best harvest ever. A combination of ideal weather at home, crop failures abroad, and increasing global demand for cereal grains have created a perfect anti-storm, in which high prices and record yields combine in a cash-flow bonanza for the American farmer.

Some of the beneficiaries of this prosperity will be the usual suspects: states like North Dakota and Nebraska, which already have the lowest unemployment in the country; farm machinery makers like Deere and Case New Holland; or seed-engineers like Dupont. These companies supply the raw materials that farmers need to turn sun, rain, and seeds into a global harvest.

But a secondary beneficiary will be our financial system. Banks across the Midwest will be awash with deposits, and their loan quality will improve as local economies see the stimulus a growing economy provides.

It’s likely that demand will continue to increase, even with higher prices. Globalization means hundreds of millions of new consumers can afford to buy more meat, which means more demand for grains.

A stronger agricultural sector and increased global trade may provide the spark that the US economy needs to get out of its funk. If the grain-belt gives us that, you should thank a farmer.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Low Hanging Fruit

If we told our leaders that there was a magical way to stimulate the economy, generate new tax revenues, increase demand for housing, and boost wages for American workers, would they go for it? Not a chance.

The magic is through immigration. The San Francisco Fed recently published a study which showed increased immigration leads to higher wages for everyone. Over the long run a net inflow of immingrants equal to 1% of employment increases income per worker by around .7%.

Nobel laureate Gary Becker of the University of Chicago has a way for the U.S. Treasury to benefit immediately from increased immigration: charge immigrants a significant fee—say $50 thousand—for the privilege of coming to America. We’re known around the world for our open, opportunity-filled society, and we naturalize about a million immigrants per year. Why not allow immigrants to reduce the deficit by $50 billion?

But the San Fran Fed’s argument is economic, not political: they compared the economies of states with high immigration to states with low immigration. The effects were delayed, but significant. Increased immigration leads to more specialization, higher productivity, and higher wages. Over the period from 1990 to 2007, immigration may be responsible for perhaps 25% of the real wage gains workers enjoyed during this period.

No matter how convinced economists are that immigration creates jobs, though, most voters won’t buy it. It’s too easy to see the short-term issues—another job taken—and miss the long-run effects. But what is unseen is often of more import than what is seen.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Good News?

The economy turned out to be weaker than expected. Why is this good news?

On Friday the Commerce department reported that the economy grew at a rate of 1.6% during the second quarter rather than 2.4% as originally reported. That’s down significantly from the growth rate of the first quarter, which was almost 4%. So if the economy is slowing, why did interest rates rise, stock prices rally, and oil prices go up? Isn’t slower growth bad news?

It is if you’re a doom-and-gloom forecaster. Robert Shiller, author of “Irrational Exuberance,” claims that the risk of a second recession is more than 50%. He also noted that home prices could decline, as they did in Japan, for up to 15 years. The other usual gloom-sters could be seen on TV over the weekend.

But when you look into why growth was revised, you see a very different picture. This isn’t a case of consumer demand being revised downwards. Demand was actually stronger than last quarter. But we imported a lot more than Commerce originally estimated. Stronger imports are a sign of strength, not weakness. Only this time we exported some of our strength to the rest of the world. They responded in kind and our exports went up, too. But they couldn’t keep up with imports, the deficit widened, and that took away from GDP.

The recent surge in imports is atypical, and curious. My own hunch is that it is due to all the foreign content in much of our domestically produced goods. Did you know that the new Malibu built in Kansas City has 25% of its parts produced outside North America? Or that the iPad, designed in California, is assembled in China from parts in Korea Japan, and Texas?

All this trading makes for slower growth in the short-term, but a more efficient and robust global economy in the long term.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Charging Around

Have we become a plugged-in nation?

In the US there are now over 285 million active wireless devices, and that number could double in 7 years or less. All those devices are taxing our outlets and taxing our minds. A couple of recent studies show that all our time on-line may be affecting our brains. The constant stimulation of Facebook, Twitter, and texting can alter our brain’s neuro-pathways and make it difficult to think deeply and creatively.

But it’s also affecting our power grid. With so many devices looking for so many outlets, it’s inevitable that topping off our batteries will become as important as tanking up our cars. Airline terminals especially need more. At Jet Blue’s new Terminal 5 at JFK Airport in New York, they have 806 plugs available. During peak times it can resemble a computer lab.

All this time plugged in is changing the kinds of demands our power system faces. It is no longer an option to tune in, drop out, and go off the grid when a critical business contact promises to email you the information you need. And heaven help you if your battery is running low.

But adjustments to our mental and physical infrastructure come slower than changes in the social pathways we use. We may have reduced our need to commute physically, from place to place, but our virtual travels will place demands on us that we are just beginning to understand.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Counting Change

The nation’s chief accountant is stepping down. What does it mean for investors?

Robert Hetz, the Chairman of the Financial Accounting Standards Board, is stepping down as its chief two years ahead of schedule. This comes at a time of tremendous financial uncertainty and as the body is enmeshed in a battle over expanding the use of mark-to-market accounting, which requires companies to use market prices rather than management estimates to value financial holdings.

The fight over mark-to-market has been every bit as contentious as the Mr. Hetz’s signature battle, the struggle to get executive options grants into the income statement. At one hearing on that issue held back in the ‘90s in California, opponents of expensing options had a high-school marching band accompany protesters outside the meeting. Accounting can get people riled up.

The accounting controversies of today are every bit as volatile. The mark-to-market controversy has been derided by both sides, with cost-based pricing disparaged as “mark-to-make-believe,” and the market-pricing approach criticized as “managing for liquidation.” Mr. Hetz had some tough times in 2009 when Congress grilled him over rules for banks. Those rules were subsequently adjusted.

For now, any changes in accounting rules are on hold as the FAS looks for a replacement. As the markets roil over economics and the risk of a double dip, one thing is certain: accounting counts.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Retirement Benefit?

Is the 401(k) good for what ails us?

Recent discussion of municipal finance has focused on pensions. It seems that the State of New Jersey lied to investors when it masked the massive underfunding of its two biggest pension plans. Because of Article X of the U.S. Constitution, the Federal Government cannot sue a state. But that doesn’t mean that they can’t investigate fraud!

But New Jersey’s fraud is one thing. Underfunded pensions are another. Around the country, state pensions are underfunded by some $500 billion, according to their own accounting. But that probably understates the problem by $1 trillion or so. Thank goodness we live in New Hampshire. We’re only underfunded by some $4 billion. Since our state has a $60 billion economy, the 7% funding gap isn’t so far from NJ’s 10% gap. Hmmm.

So maybe state workers ought to have their own plans. Most of the rest of us do. Since lifetime employment hasn’t been part of the employment landscape for a long time, the 401(k) allows us to build our own retirement nest-egg and carry it with us from employer to employer. How about we give State employees the same privilege? We can’t do anything about folks who have already retired. But we could keep the problem from getting bigger by bringing state employees into the 21st century.

When you’re in a hole, the first rule is, stop digging. If our pension plans are underfunded, we ought to come up with a way to stop the problem from getting worse.

Douglas R. Tengdin, CFA
Chief Investment Officer
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The Kindness of Strangers

The Big Agency Discussion (BAD) is in the bag. What did we learn?

The consensus is that the Government’s guarantee of Fannie Mae and Freddie Mac will be part of the picture for a long, long time. Bill Gross, the proverbial fox guarding the chicken coop, chaired a Treasury-sponsored conference on the housing market. At that conference he noted that without Fan and Fred, mortgage rates would be 1 or 2 percent higher, curbing demand and putting downward pressure on the housing market.

Gross, of course, benefits from any government guarantee of the Agencies. If Treasury nationalizes them, taking their debt onto the US’s balance sheet, it will create a massive windfall for owners of those bonds and for some trillion dollar bond funds.

But even if Gross is talking his book, he does have a point. The private mortgage market collapsed when thousands of AAA securities were downgraded to junk in the blink of a sub-prime eye. Now investors don’t know what to think, but once bitten twice shy, and they don’t trust Moody’s any more. They face an n-dimensional risk-matrix involving credit, interest rates, structure, prepayments, and new regulations, all of which are evolving.

An expanded government role could ease some of this uncertainty and keep rates low. But at what cost? To this point generational lows in mortgage rates don’t seem to be lifting home prices very much. If the world’s most advanced financial market needs a permanent Federal role in order to make a mortgage, we have indeed all become dependent upon the kindness of strangers.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Car Talk

Is the GM stock sale anything new?

It sure seems like it. By selling stock to the public the automaker may be able to reduce the Government’s 61% stake. Many are impressed by GM’s sales in China and Brazil, where the company plans to launch nearly 20 new models over the next several years.

But there’s a problem in the auto market. It’s called overcapacity. Every country under the sun seemingly has a car company or two. France has Renault and Peugeot. Italy has Fiat. Sweden has Volvo. Germany has VW, BMW, and Daimler. These national automakers are a source of national identity and pride. They also employ scads of well-organized laborers, who form a political block. As a result, auto companies are political machines, as well as engineering and financial entities.

The result has been that car companies around the world have been propped up or supported in some way by their governments, irrespective of their competitiveness. As a result we now have the ability around the world to build some 100 million cars per year. The problem is there’s only demand for some 70 million cars per year. Thi means chronic oversupply and lower prices and margins.

Years ago an S&P analyst said that the only thing propping GM up was massive cash flow. Unless GM can buck the trend and turn that cash into profits, they’ll need government support again before long, and stockholders will be hurt again.

Douglas R. Tengdin, CFA
Chief Investment Officer
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(Un)usual Uncertainty

Is the Fed on hold for the next two years?

A lot of folks think so. Bill Gross of PIMCO noted that the two-year Treasury Note is essentially predicting that Fed policy will be unchanged until mid-2012. Jim O’Neill of Goldman Sachs thinks the Fed won’t raise short rates until almost 2013, a year and a half away

We know market economists are paid to make predictions, and that the structure of the Treasury market implies a rate forecast, but this is nuts! No one knows what the economy will do 6 months from now, let alone three times that time-frame. What the Fed has always said is that future policy depends upon the economy’s direction. If the economy accelerates, they’ll raise rates. It’s that simple.

This is rather amusing. Six months ago there was almost universal consensus that the next direction of rates was higher. The general opinion was that the massive stimulus would prime the Keynesian pump and jump-start the economy. Interest rates would then have to rise. Besides, they couldn’t fall any more. Right?

But the market never seems to act according to plan. Since everyone expected rates to go up, they went down. Now that everyone now expects rates to go down, will they go up? Time will tell.

Amid the current ambiguity, one thing is sure: Bernanke was right when he called the outlook uncertain. But he was totally wrong when he said that such a state was unusual.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Blowing Bubbles?

Is Hong Kong real estate in a bubble?

It’s easy to think so. After all, prices have surpassed their previous highs, and speculation is rampant. A wave of buying from the mainland has pushed housing prices up over 30% in the past year, on top of a 45% jump last year. If the past is prologue, a contraction in real estate will wipe out property owners equity and saddle Hong Kong banks with massive real estate holdings at a loss.

But the Hong Kong government is pulling out the stops trying to bust any bubble. They recently increased down payment minimums from 30% to 40%. The funny thing about bubbles is, when you’re in one, most people don’t think you are. From Dutch Tulips to South Sea speculation to internet stocks, people at the time think that some social or technological change has permanently altered the landscape and the new reality will lead to a new era.

In Hong Kong’s case it’s easy to see what’s driving the market. New wealth in an export-driven China is pushing up demand for luxury homes, and there’s not that much land available in the port city. Is this a new era?

Maybe. Or they might be continuing to react to the slide in prices from ’97 to ’04. The only certain thing about a bubble is, six months after it pops, everyone predicted it.

Douglas R. Tengdin, CFA
Chief Investment Officer
Hit reply if you have any questions—I read them all!

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