James Saft

James Saft is a Reuters columnist. The opinions expressed are his own.

Tough times make dependable excellence even more valuable, which is why we just might see the rise of a new “Nifty Fifty” of elite shares.

During their heydey in the 1960s and early 1970s the Nifty Fifty were a group of U.S. large cap companies which managed a spectacular period of outperformance during a generally downbeat and low growth period.

Featuring such household names as IBM , Coca-Cola , Procter & Gamble and Disney , the Nifty Fifty delivered strong and dependable earnings and dividend growth during a period where those were in short supply.

They were rewarded by a fantastic run of outperformance and a dizzying re-rating, or expansion of price/earnings multiples, which eventually drove valuations well into bubble territory.

Similar to the 60s and 70s, the world is staring at structural problems that will make a recovery from the long secular bear market unlikely for quite a while.

Back then inflation and choppy economic growth sent the stock market on a volatile, largely sideways journey for several years.

Today we face perhaps deeper problems in the wider global economy, such as debt, deflationary forces and huge fiscal deficits. Expecting strong growth to lift all boats is not going to be a winning strategy.

We could easily be looking at a long period where stocks remain in a wide trading range, as often happens after extended bear markets. So if we can’t get structural growth from the overall economy, best to find some structural growth stocks that will manufacture their own.

For a graphic on the S&P 500 and bear markets since 1929, click here.

“In a low growth, low return environment, companies with a sustainable growth or competitive advantage should significantly outperform, similar to the Nifty Fifty in the 1960/70s,” Ronan Carr, an equity strategist at Morgan Stanley, wrote in a note to clients.

Carr, who specializes in European equities, thinks that a select group of companies in the region, many with strong exposure to emerging markets, will end up fitting the bill. My guess is that it will be a global phenomenon, with a small cadre of outperformers from a range of markets.

PICKING WINNERS OR RIDING TRENDS?

The Nifty Fifty beat the overall markets by 15 percentage points annually for eight years from 1964 to 1972. It was a dual effect; the companies were able to increase earnings steadily and pleasingly predictably, beating their peers, and at the same time investors began to re-rate them, driving price/earnings multiples higher as confidence in the Nifty Fifty grew. That very predictability was a big part of the brand; almost none of the stocks had cut their dividends since World War II.

That kind of growth and predictability will be in short supply in coming years, and those companies that can produce consistency will see their brands grow and their shares go up. Not all will be dividend stocks, though the very low interest rate environment we will have to live with will put a premium on income, especially for the growing cadre of retired or semi-retired affluent investors.

Apple, which pays no dividend, is a great example of a stock that has turned itself into virtually a one company Nifty Fifty. (A “One and Done” Nifty Fifty, if you will.)

Apple displays a lot of the characteristics to look for – it harnesses emerging technologies to give it a dominant franchise and as a result, pricing power.

Others will doubtless emerge, some as emerging market success stories (and that may include Western companies selling into EM), some will benefit from new technologies, such as companies that do well out of the ocean of natural gas that has now become exploitable in the U.S.

In some ways, the better choice might not be to make big bets on finding the Nifty Fifty, but rather wait until the market identifies them and then ride their coat tails. The important fact is that in a world of lousy growth and high uncertainty, growth and the whiff of certainty will be in huge demand.

The Nifty-Fifty phenomenon was also partly psychological. As the years rolled on and the results stayed strong, investors became increasingly confident about making very long-term earnings assumptions about their favored stocks, as hedge fund legend Michael Steinhardt, a veteran of the period, pointed out in an interview on CNBC on Thursday.

No one makes those sorts of forecasts today, partly because we live in a quarter-by-quarter world. The more confident investors become in future income streams the higher the valuation they will be willing to assign them, especially given the dearth of confidence everywhere else.

Remember too, how badly the Nifty Fifty period ended for many investors. A mix of institutional and individual money drove valuations sky-high, to 80 and 90 times earnings in some cases. When the bear market and inflation of the mid-70s hit, they de-rated severely, burning many of the last-minute investors.

Still, it was a good ride while it lasted, and the kind we will be lucky to find in the coming decade.

At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.

James Saft is a Reuters columnist. The opinions expressed are his own.

HUNTSVILLE, Ala. – Right about now, even the most committed capitalist investor ought to be hoping for one thing: that labor soon has the upper hand.

That’s because the whole edifice: the global economy, the consumption-based developed economies and the share prices they power are crumbling because average workers simply haven’t got enough earning and buying power to play their central role.

Wages in the U.S., for example, have been stagnant for the best part of 40 years, during which time the consumption merry-go-round has only been kept spinning through a combination of artificially high asset prices and spending borrowed money.

Consumer incomes actually fell in August for the first time in almost two years, according to new data, and consumer spending only eked out a modest gain due to a sharp fall in the savings rate. Given that people are living longer and have stressed balance sheets, dis-saving is a tactic that will only work for so long.

This state of affairs has allowed corporate profits, as a share of the economy, to hit their highest point in the second quarter since records began in 1947, and on track to hit an annual high since at least 1929. Even the stock market no longer sees that as evidence of rude health, as shown by the steady, grinding decline in prices relative to earnings.

To be sure, this long-term stagnation in wages is in substantial part because of globalization. Some of what labor in the developed world lost has been converted to gains for labor in emerging markets, where income has surged over the past decade. Nonetheless, the system is predicated on consumption in the west and that consumption is crimped by stagnant incomes and high debt loads.

Up to a point this will be self-correcting. Wages in China, for example, have grown strongly, which will eventually lead to domestic consumption there and to a balancing out in the relative costs of production. Sadly, that long-term solution is not going to arrive in time to save this morning’s equity investors, which is perhaps why so many of them are deciding to become this afternoon’s debt investors.

This is the catch for equities; a vibrant economy depends on a rebalancing of negotiating power between labor and capital, but that very process is going to undermine corporate profits, and with them stock prices. The best strategy may well be to remain structurally underweight equities until that rebalancing has happened or until the stock market moves ahead to price it in.

UNSUPPORTIVE POLICY

There has, rightly, been a great focus on debt in the current malaise, with much head-scratching over how to deal with Greek sovereign debt and individual mortgage debt. That’s natural because debts come due and when defaulted upon have a nasty habit of causing a chain of defaults through the economy. Even so, the focus then has been on how to protect debt holders from the consequences of their foolishness and the foolishness of the parties they loaned money to.

“Almost all remedies proposed by global authorities to date have approached the problem from the standpoint of favoring capital as opposed to labor,” bond giant Bill Gross of Pimco wrote in a note to clients.

“If the banks could just be stabilized, if the ‘markets’ could just be elevated back in the direction of peak 401(k) levels, if interest rates could just be lower so that borrowers would inevitably take the bait, then labor — job creation — would inevitably follow. It has not.”

In the case of Greece, that is because austerity only makes it weaker and less able to bear the debt’s burden. In the case of over-indebted mortgage holders it is because most loan modifications leave the borrower with more than they can afford.

All of what we are describing is deflationary, which makes the epic rally in government bonds seem not so much a bubble as a down payment on future gains.

Investors hoping, as they will and as they should, to make profits need to get some things straight in their own minds: who, exactly, is going to buy all of these goods and services and where are they going to get the money?

It is not clear that monetary policy can address this. Its success rate so far is not great. It is far less clear that fiscal policy will even be given a chance.

It is reasonable to expect that eventually western labor will make gains, and that emerging market labor’s new buying power will slowly build and provide a buttress to global demand. That’s not happening any time soon, to judge by the run of events, which is a good reason to remain shy of equities.

At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.

If you think the recovery is firm and the risk of deflation has vanished, look at the three following numbers: $100, 3.44 and 20.

The first, everyone knows, is the price that New York crude oil touched briefly on Wednesday, driven 14 percent higher in just five trading sessions by conflict in Libya and concern over the reliability of supply elsewhere.

The second is the yield on 10-year U.S. Treasury notes, and if you are keeping score, they have dropped a rapid 28 basis points from early February, a drop that is telling you that bond investors do not believe the U.S. economy can easily withstand $100 oil.

The third, that 20 percent, is perhaps the most poignant, as it represents the current level, an all-time high, in the ratio of their disposable income that Americans are getting from government benefits.

That’s right: social security, food stamps, unemployment insurance and the like account for two out of every 10 dimes Americans have once they have paid their tax.

Those three numbers don’t say self-sustaining recovery, they say pressure on consumption, on wages and on asset prices.

They also will put pressure on the dollar and will loom over any attempts to normalize Federal Reserve monetary policy. How on earth do you raise rates or end quantitative easing if gasoline goes to $4 per gallon (readers from outside the U.S. may laugh bitterly here, but this is a heck of a shock to the pocketbook, even if it is a tiny fraction of European or Japanese prices).

“It is also interesting to see how government bond markets are reacting to the oil price surge — by rallying, not selling off. In other words, bond market investors are treating this latest series of events overseas as a deflationary shock,” David Rosenberg of Gluskin Sheff wrote in a note to clients.

“Because oil demand is relatively inelastic over the near term, this price shock is going to cut into real global economic growth and the question is by how much,” Rosenberg writes, before bringing up a real concern, a U.S. debt and political situation where further stimulus is highly unlikely.

“In the past, we would see governments trying to cushion the blow but with the public sector nearly everywhere grappling with sky-high fiscal deficits and debts and moving towards restraint, and with monetary policy already in uncharted accommodative waters, there is no leeway to provide any antidotes.”

MARGIN KILLERS
To be sure, oil prices may well fall back if supplies are not interrupted and if concerns, especially about the potential for serious unrest in larger oil-producing states such as Saudi Arabia, prove baseless. While oil shocks in the recent past have usually led to recessions, they tended to be sustained rises in prices.

Earnings at Wal-Mart <WMT.N>, the massive retailer which looms large at the bottom end of U.S. retailing, tells a story not of recovery but continued hard times, conditions which are tough to square with recent risk market ebullience. Revenues were weak and the company noted a growing trend of customers paying for goods in the U.S. with government assistance, a half a percentage point rise in just three months.

Wal-Mart shoppers will feel every penny increase in the price of gas keenly, and are going to be very unwilling, or unable, to accept further price rises driven by commodity inflation.

This could easily undermine company profits. While companies report rising prices on the things they buy, prices on the things they sell are not keeping pace, presumably because they find it difficult to raise prices without driving hard-hit customers away.

Significantly, regional grocery store chain Wegman’s announced on Wednesday a price freeze on 40 basic necessities for the year, saying they will absorb $350 to $400 in price increases themselves for a family of four over the next nine months. That is the kind of thing which hits margins, and not just at grocery stores.

Meanwhile, the political situation in the U.S. is not going to be sending any shoppers running for the stores. A bitter dispute in Wisconsin over public sector workers’ pay, benefits and collective bargaining rights will likely give many workers, and not just in the public sector, the idea that what they thought was theirs may be taken away. Disputes in Washington over budget cuts will only serve to reinforce the sense that the ratio of transfers to disposable income is headed down ultimately, recovery or not.

So, what might the Federal Reserve do? If the oil price hike is sustained but price rises do not feed through to wage pressure, they will keep rates at rock-bottom and leave their options open over quantitative easing.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. Email: jamessaft@jamessaft.com)

The reform of U.S. housing finance proposed by President Obama will drive the price of mortgages higher and be a disaster for house prices, construction and the real estate industry.

In other words, in helping to kill the illusion that a whole nation can grow rich by living in ever more expensive houses, it will be a very good thing.

The U.S. released a range of proposals for scaling back government involvement in housing last week, all of which are aimed at transforming a mortgage market in which 92 percent of new loans currently carry a government guarantee.

In addition a budget proposal from the Obama administration on Monday included a call to cut across the board by 30 percent a range of tax exclusions for better off Americans, including the mortgage interest deduction so long considered sacrosanct.

The proposal for housing finance reform from the U.S. Treasury Department includes three scenarios for debate, all of which include the gradual winding down over a period of years of Fannie Mae and Freddie Mae, the government sponsored mortgage companies which had to be taken into public conservator ship as losses mounted.

Option one is an almost full privatization of the mortgage market, with small involvement from some agencies which will provide mortgages to narrowly targeted groups such as the less well off.

Option two is similar to option one but with a pre-planned government guarantee of mortgage securities which would come into play only in times of financial stress when the mortgage market might otherwise freeze or suffer a drought.

Option three adds to the mix a government reinsurance plan which would pay off if private market insurers failed, thus increasing liquidity.

So far, the betting is on something close to option two, though to be clear, the very fact that house prices and the housing industries will be so badly hit by this means there is a very good chance it is watered down or never come about at all.

Don’t get me wrong, Fannie and Freddie weren’t principally responsible for the housing bubble and all the ills of an overly financialized and debt-dependent economy.

That being said, the death of the mortgage giants will lead pretty clearly to the following outcomes:
First, mortgage rates will rise, pushing the shakiest borrowers out of the ownership pool and into rental or shared housing.

Second, more expensive mortgages, not to mention diminishing tax breaks, will lead to less expensive housing. People will be able to afford less, will pay less, and will make different, and to my mind better, decisions about what risks to take, how to save and what to consume.

Construction, real estate brokerage and other industries allied to the proposition that we can all grow rich by living in bigger, shinier and more elaborate houses will see less capital flow their way and will, all things being equal, shrink relative to the size of the economy.

COMPETITION PRODUCES LOSERS TOO
The capital that has for generations been diverted from the rest of the economy into housing will trickle back towards where actual productive returns are higher.

Theoretically, that’s great. The U.S. can address its export problem by putting more of its money to work developing things and services that the rest of the world wants to pay for, rather than covering all available counter space with granite.

The problem of course is that it is very possible that a goodly bit of that capital which previously kept the nation’s construction crews and real estate agents busy might not flow to U.S. investment but might very well see better opportunities abroad.

That’s probably simply a risk the U.S. will have to face, but it is going to produce even more pressure to improve education and training. While manufacturing jobs in the U.S. have shrunk from 25 percent of private employment to just over 10 percent since 1980, construction fell by far less, from 6.0 percent to 5.0.

That probably understates the extent to which housing has absorbed lower skilled labor over the past 30 years. Think about industries such as “staging,” the tarting up of houses for sale, which simply did not exist 15 years ago.

That, like the fallacy that housing is more investment than consumption, will slowly be squeezed in coming years as house prices suffer.

Take for example the rise and rise of the size of an average new house, from 1660 square feet in 1973 to a peak of 2521 in 2007.  That was partly a reflection of higher living standards, but also partly the result of a government subsidized speculative bubble in which people believed they were being paid to live in nicer, larger houses. This is especially true given the stagnation of real wages in much of the same period.

The end of the housing illusion, and of the subsidies which fed it, will be difficult, but must be counted as a good thing.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. email: jamessaft@jamessaft.com)

Looking to hedge against a spike in inflation? Equities may not be much help.

Neither, for that matter, will you do all that well over the longer haul with bonds, cash or even commodities, at least on the historical evidence. In short, when it comes to investing, inflation is a real drag.

It’s impossible to know if, much less when, the current very stimulative monetary policy in the developed world will spur inflation, but increasingly indicators are raising concerns. Emerging market economies show signs of overheating, while prices of food and many other commodities are surging.

The traditional view has been that equities are an effective hedge against inflation, in least over the long term, because companies will, all things being equal, eventually pass on inflation to their clients as higher prices.

That’s the theory, but the practice may prove to be much different, according to a study by IMF economists Alexander Attie and Shaun Roache, who examined the performance of a range of traditional asset classes in the aftermath of inflation shocks.

“Among traditional asset classes, inflation hedges are imperfect at best and unlikely to work at worst,” according to Attie and Roache.

First, the authors looked at returns in the 12 months after inflation shocks in the period after the 1973 end of the Bretton Woods system of fixed currencies. The results were not surprising; bonds got killed, equities did badly, as did cash, while commodities were an effective hedge. Real estate investment trusts (REITs) did about as badly as equities, somewhat undermining the argument for real estate during inflationary periods.

All well and good, but really only of use for the small number of daredevils who are willing to make big asset allocation shifts over a short period of time.

For most savers, not to mention pension funds and endowments, the more useful question is how do you hedge against inflation for the longer term?

The results for equities were not encouraging.

“Equity returns decline in the months following an inflation shock and do not experience a meaningful recovery thereafter, leaving them as the worst performing asset class in our sample,” according to the study.

“Our findings are consistent with evidence from a range of earlier studies and add further weight to the evidence against the theoretical arguments for equities as a real asset class providing inflation protection when inflation is rising.”

Over the 18 months after the shock, real returns were negative, though less negative than bonds, which get hammered by inflation. Equities improve a bit over the next couple of years, but even when looked at in the long run of more than five years an inflation shock makes for losses in real terms.

IN THE LONG RUN WE’RE ALL …
As for the other asset prices, inflation proves very difficult to hedge against even over the longer term. Take commodities, the star performer in the first 18 months after inflation bites; spot prices decline in the medium term and when you get above five years after the inflationary event you are looking at actual losses in spot prices. This might be because inflation hits demand, but also might be because high prices spur greater investment in efficiency, which over the long term also moderates demand.

While bonds get killed in the first couple of years after an inflation shock, after about three years returns improve, presumably partly because investors demand higher yields to make up for nasty recent experiences.

Cash returns do a bit better, but even cash, which can go where it likes in search of better returns as inflation increases, fails to serve as a perfect hedge over the longer term.

So, how to hedge against inflation? Inflation-protected bonds such as TIPS would work, but to be a hedge you have to buy and hold to maturity, as outside forces can easily distort returns through the life of a given bond.

Given that inflation is a portfolio killer, why then are equity markets booming? Well, in emerging markets where inflation is kicking in first they are not. In developed markets, investors seem to be placing a touching amount of faith in central bankers. After all, if the Federal Reserve and ECB don’t pull the plug on stimulus in time, inflation can easily get out of control.

Or perhaps equity markets are betting the central banks will fail to stoke growth and be forced to blow a larger asset market bubble as a consequence.

Or maybe everybody thinks they will be the genius who gets out in time.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. email: jamessaft@jamessaft.com)

The trans-Atlantic economic contrast is shaping up as pitting British austerity against, not U.S. investment, but a do-little American muddle.

President Obama’s State of the Union Address offered him the opportunity to hold up a beacon of policy that invests for the future while taking credible steps to control future deficits.

Speaking not long after Britain, in the process of making severe cuts in spending, reported a shrinking economy in the fourth quarter of 2010, Obama instead delivered a vague mix of un-costed investments and symbolic cuts in discretionary spending.

This of course is not entirely the U.S. administration’s fault; it must work with an austerity-happy Republican party that controls the House of Representatives and in service to an electorate which appears to have lost faith in the ability of its leaders to invest wisely. That virtually ensures a muddle in which serious cuts will be elusive and investments watery.

In contrast, even a delicate coalition like the one in power in Britain can ram through Parliament a full-bodied program of spending cuts and tax hikes.

Britain on Tuesday recorded a 0.5 percent decrease in gross domestic product in the quarter ended Dec. 31 compared to the three months before, far below not only consensus but even the most pessimistic of forecasts.

While the data is partly explained by the coldest December in more than a century, there appears to be an excellent chance that Britain is in the process of double-dipping back into recession. That would be extremely awkward for the Tory-led coalition which last summer embarked on a plan of austerity that aims to cut spending at national agencies by 25 percent by 2014. It is unlikely that this plan by itself sank the economy in the fourth quarter, but it will certainly help to sink it going forward.

The argument in favor of austerity is pretty straightforward; Britain is small, is deeply in debt, its pound is not a reserve currency and so it must maintain the confidence of global investors in its debt or face a disastrous eventual buyers strike. Britain, this argument goes, has no choice but to take its lumps. As Bank of England Governor Mervyn King pointed out on Tuesday real British wages are likely to have showed no growth in six years to 2011, the worst such period since the 1920s.

RESERVE CURRENCY; BLESSING OR CURSE?
Looked at from this point of view the U.S.’s inability to both invest and cut is even more of a wasted opportunity. While there are important differences between the British and U.S. economies — the U.S. is more diverse and carries less debt –  one crucial one is that the dollar is the premier global reserve currency.

That gives the U.S. a lot of built-in credit in global markets and makes possible policies which Britain simply could not risk, much less get away with. If the U.S. made up its mind to do it, it could make massive investments in infrastructure and other high-yielding projects while at the same time addressing its deficit over the medium term. That has the chance, not the certainty, of increasing growth and making the deficit melt proportionally.

The privilege of being a reserve currency also gives the U.S. the illusion that it can dawdle and in-fight indefinitely as it is not being punished in markets for its policies. Market confidence for the U.S. though may prove to be something that doesn’t erode, as it did for Greece, but shatters after long and hard use.

With the U.S. politically unable to get to grips with its economic future, the Federal Reserve is left as the one institution with the power and the means to act, and act it has, launching a successful attempt to drive up asset prices and a less successful one to drive down the dollar.

That of course is the problem, and the same one the U.S. had in the last decade; loose money leads not to long-term investment in great infrastructure or human capital but to speculative bubbles and financial chicanery. The contrast is not between a free market which will respond to price signals and inefficient central planning, but between inefficient central planning and a casino in which the house lends the players money to bet.

In the end, in both the U.S. and Britain, austerity or not, investment or not, the next several years will involve at best scant gains in real living standards as the bills for the financial crisis and the rebalancing of the global economy are paid.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. email: jamessaft@jamessaft.com)

If you have forgotten the credit crunch it appears you have company: U.S. banks are lending again.

Bank earnings reports and data from the Federal Reserve confirm that, at long last, banks are beginning to step up lending, a much-needed ingredient for a stronger and more sustainable recovery.

The good news is that lending is growing to commercial and industrial companies — exactly where you want to see growth if the U.S. is going to address its unsustainable dependence on domestic consumption. That’s good so far as it goes, but with a fragile euro and an undervalued yuan the upside is decidedly limited.

That’s because, in part, consumers are still quite restrained, or are being restrained, at least to judge by weak to middling lending levels to consumers and to support house purchases.

With 17 of the top 25 U.S. banks by assets having reported earnings, a lending turnaround is in evidence. Among the 10 largest regional banks, loan books expanded by 0.6 percent in the fourth quarter, according to FBR Capital markets, and nudged up slightly at the four mega-banks. This compares to a 2 percent shrinkage in the previous quarter and real carnage in the two years before that.

According to Federal Reserve data, commercial bank loans and leases shrank by 10.3 percent in 2009 and 6.3 percent last year, both a cause and a result of the recession and the sluggish and largely jobless growth which followed. Fed data from December shows business lending growing at a very good 7.4 percent annual clip, with continued weakness in home equity, commercial real estate and consumer lending.

The growth in commercial and industrial lending is significant, given the strength of the turnaround, but that sector is going to have to row very hard if consumers are unable or unwilling to spend freely.

A look at the Fed data for the first two weeks of January shows continued mild expansion of business lending combined with stability in real estate lending and a small fall in consumer lending.

NECESSARY NOT SUFFICIENT
It is for this reason, if none other, that the U.S.’s seeming inability to convince China to allow the yuan to strengthen poses such a threat to U.S. growth and to its medium-term prospects. Even if the Federal Reserve engineers asset price inflation, there is really little chance that domestic demand over the next few years can provide strong growth. The U.S. must export more, both for its own sake and for those of its creditors.

Consumer credit has actually been stronger than the headline figure if you adjust for loans the banks consider unlikely to be repaid, according to James Marple, senior economist at TD Economics.

“Correcting for charge-offs shows that household deleveraging did lead to a slowdown in credit issuance. On a year-over-year basis, revolving consumer credit was slightly negative in early 2010 — a new phenomenon for credit cards — while nonrevolving net credit issuance slowed, but did not actually contract,” Marple wrote in a note to clients.

“Importantly, over the last several months, there has been a considerable improvement in consumer credit growth. Even with the impact of charge-offs, total consumer credit rose in both October and November — the first two consecutive monthly gains since June and July of 2008.”

Remember, in a fiat money economy the creation of credit is the creation of money. The Federal Reserve couldn’t make banks lend by dropping interest rates, but it appears that its program of quantitative easing may have worked, at least on this measure.

The Fed’s recent Survey of Senior Credit Officers, which measures conditions in the business of lending to hedge funds and other securities firms, showed a similar thawing of conditions.

Banks are more willing to take on risk, according to the survey, and are making money available to financial markets more cheaply and on less stringent terms.

If QE has prompted the banking system to begin to create money again, will inflation be unleashed? My guess is that there is still too much slack in labor markets for that to happen, but there is every chance that we will see, or are already seeing, bubbles in asset markets.

While credit creation can be a self-reinforcing cycle, it is only a virtuous one if the credit is invested in areas that are productive.

The sweet spot for the U.S. would be consumer stability combined with a gently falling dollar so the country can, over years not months, export its way out of its woes.

The rest of the world is not, judging by recent events, going to want to cooperate.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.  email:jamessaft@jamessaft.com)

If the euro is going to survive without a Depression, German consumers are going to have to behave in ways that are, well, distinctly un-German.

While attention is focused on the suffering that the euro zone debt debacle is inflicting on the weak and the political anger the costs of bailouts are engendering among the strong, it is important to understand that the belt-tightening won’t just be a Gaelic and Mediterranean phenomenon.

German consumers will (rightly) regard events as likely to increase their taxes while doing precious little for their incomes and job prospects. If they react to this like Americans and spend like there is no tomorrow, well then, perhaps the euro zone can handle the local recessions in the Austerity Provinces. If, on the other hand, Germans behave anything like the way they have in the past, they will save more and only increase spending marginally, if at all.

“Over the four quarters to 2011 Q4 it is hard to see (German consumer spending) growth exceeding 1 percent, and easy to see it falling short, especially if budgetary rigour, rising food and energy prices, and the need for further Club Med subsidy provoke the normal reaction from German consumers,” Charles Dumas of Lombard Street Research in London wrote in a note to clients.

Against the wider backdrop this is not encouraging; U.S. demand will be weak, China is trying to stomp on inflation and the euro zone periphery will very likely be contracting. That really does leave German consumers as the engine of euro zone growth — a role that is, for them, unusual.

To put this in context, since the fourth quarter of 2001 German consumer spending is only up a bit more than 2 percent in real terms, a truly measly expansion. During the same period the household savings rate has risen from about 9 percent to just above 11 percent.

During this time, you will recall, the world experienced a go-go real estate bubble with seemingly free money, much of it German in origin, available to plough into collateralized debt obligations and the like.

If German consumers reacted soberly to the good times, imagine what they will do in coming years when confronted with the risks and costs of either staying in or exiting the euro.

Part of the reasons for German consumer reserve was a policy that constrained wage growth savagely, but again, to look for strong wage growth to emerge at this stage is wishful.

NICE RECOVERY?
Much has been made of the fact that Germany’s economy grew strongly last year, rising 3.6 percent, the strongest showing since its east and west were reunified. While this is a fine start, Germany did shrink by 4.7 percent the year before and its economy is still 2 percent smaller in real terms than it was at its peak.

While European, including German, officialdom is absolutely opposed to a euro exit, repeatedly characterising it as disastrous and unthinkable, it might not actually be that bad for German consumers, at least after a while.

Dumas of Lombard Street argues that the hit to competitiveness from a newly risen new-deutschemark would be offset by gains in consumers real income and confidence.

“A higher exchange rate would probably cause a healthy redistribution of income from business to labour, ie, consumers — the lack of which is closely connected to undervaluation and excess savings and net export surpluses in Japan and China, as well as Germany.

“Since Germany is unlikely to follow China’s route of real exchange rate appreciation by means of wage inflation, giving some possibility of a shift to consumption from exports, a break-up of EMU may actually be the only hope for achieving an increase of welfare for ordinary Germans.”

Given the current alignment of opinions that is not the most likely outcome, to put it mildly.

What does seem likely is some combination of the following: a recession among the weak in the euro zone exacerbates and is exacerbated by a failure of German demand in the face of uncertainty and limited global demand.

That will raise the rhetoric of euro zone discord and will weaken the euro, causing a problem for the dollarized world, including China. China’s willingness to spend billions to prop up demand for euro zone debt is in no small part because of this.

Europe will remain a strongly deflationary force in the global economy and the biggest risk in the near term as a force to upset the giddiness that is now dominant in global markets.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. Email: jamessaft@jamessaft.com)

Iceland’s remarkable return to growth shows once again that in this crisis the best policy is often the one that will make international partners most angry.

Having been reviled and chastised when it refused to make good the outsize debts of its banks, Iceland this week capped a striking turnaround when it announced that its economy expanded by 1.2 percent in real terms in the most recent quarter, its first such rise in two years.

This is in stark contrast to Ireland, whose pliability and inability as a member of the euro zone to act unilaterally leaves it with a still crashing economy which must service ever more debt by making ever deeper cuts to public spending.

Iceland, which sailed into the crisis in 2008 as essentially a small fishing fleet with a massive hedge fund attached, looked its predicament square in the eye and followed a set of policies seemingly designed to tick off both its friends and enemies, doing its small but mighty best to beggar its neighbors by letting its currency crash, imposing capital controls and, crucially,  refusing to make whole the global creditors of its three failed international banks.

While an International Monetary Fund and multilateral package was eventually agreed, and a deal with Britain and the Netherlands over debts from Icesave Bank are currently being hammered out, Iceland’s leaders, at least the current ones, seem convinced that making bank creditors share its pain was the right course.

“The difference is that in Iceland we allowed the banks to fail. These were private banks and we didn’t pump money into them in order to keep them going; the state should not shoulder the responsibility,” Iceland’s president, Olafur Grimsson, said last month, tweaking the nose of EU officials who are insisting that Ireland make good all senior creditor calls on its own distended banking system.

“Bondholders should not rely on the government stepping in and bailing them out,” Iceland Central Bank governor Mar Gudmundsson said last week. “They should do their due diligence.”

“I think the Irish are accepting that they were probably too fast in guaranteeing the whole liabilities of banks. Now this is turning out to be a big burden because the assets of these banks turned out to be much worse than they thought.”

Indeed. Though Iceland has a 6.3 percent budget deficit this year, it is on track to soon record a surplus, while Ireland’s deficit this year is 32 percent if the cost of bank bailouts is included. Similarly, Iceland’s unemployment rate has fallen by almost a quarter to 7.3 percent, as against more than 14 percent in Ireland.

LEARNING FROM MAHATHIR
It is all strangely reminiscent of Malaysian leader Mahathir Mohamad, who attracted international condemnation when in 1998 he rejected IMF measures, instead pegging the ringgit to the dollar and imposing widespread capital controls. Your correspondent was among those who stroked his chin and said that Malaysia would rue the day it cut itself off from international capital, but of course this proved to be far off the mark.

Malaysia recovered robustly, foreign capital eventually flowed and more to the point, the country and its Asian neighbors learned the importance of being able to self-insure against the vagaries of global capital flows, leaving them by and large better prepared for the most recent crisis than the rest of the world.

While Mahathir was a strongman acting against international and internal advice, Iceland’s mulishness has been a model of democracy. In a March referendum 93 percent of voters rejected a deal with Britain and the Netherlands to repay 3.9 billion euros of Icesave losses. Even more striking, and a contrast with a singular lack of prosecutions elsewhere, was the decision of Iceland’s parliament to refer to the legal system  criminal charges surrounding the crash against former Prime Minister Geir Haarde.

To be sure, Iceland may have succeeded in rejecting the international consensus precisely because it is so small — many argue that a default by Irish banks would cause another global banking crisis costing far more than 30 or 50 percent of Irish GDP.

Quite possibly it would, but that does not mean that the policy of pretending that banks are not insolvent and loans not underwater is wise. The tepid, halting and largely jobless recovery argues that it is not, that debts need to be properly purged before both borrowers and lenders can play their respective roles.

Regardless, the great victory of Icelandic stubbornness is not just in its recovery but in winning a fairer division of the burden than in Ireland, Greece, or for that matter, the U.S.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. email: jamessaft@jamessaft.com)

From Dublin to Paris to Budapest to inside those brown UPS trucks delivering holiday packages, it has been a tough few weeks for savers and retirees.

Moves by the Irish, French and Hungarian governments, and by the famous delivery company, showed that in the post-crisis world retirees, present and future, will be paying much of the price and taking on more of the risk.

This goes beyond merely cutting back on pension benefits, rising to actual appropriation of supposedly long-term retirement assets to help fund short term emergencies.

Let’s start with Ireland, which is kicking in 10 billion euros from its National Pensions Reserve Fund into an 85 billion euro package of support for its banks.

Trust me, this does not reduce the risk profile of the NPRF, which was set up as a sovereign wealth fund to help pay for state retirement benefits.

Putting aside jokes about sovereignty and wealth, of which there is appreciably less in Ireland than formerly, this is effectively a transfer of wealth from the Irish people to its banks. Or rather, to the institutions, mostly European banks, which hold Irish bank debt, none of whom as senior creditors will share in the pain.

In many jurisdictions if Ireland were a corporation and the NPRF part of the corporation’s pension fund, then making such a move would be illegal, and quite rightly so.

Of course this is not the first time that the NPRF has been used in this way. It has already “invested” 7 billion euros into Irish banks and has pledged another 3.7 billion to struggling Allied Irish Banks.

Also under consideration is a regulatory move that would effectively compel some private Irish pension funds to hold more Irish government debt, thereby providing the state with a captive investor base but hugely raising the risks for savers.

On to Hungary, which is seeking to cut its very high level of public debt as it prepares for entry to a euro single currency which may well self-destruct before it ever gets the chance to join. Hungary’s government last week finalized new rules designed to force members of private pension plans to opt back into a state controlled pay-as-you go option.

The idea, such as it is, is that participants in the private plans will fork over their $14 billion or so in savings, equal to about 10 percent of Hungary’s GDP, to the government in exchange for a pledge of a pension from the state. Hungary plans to use the funds to make pension payments to current retirees this year and next as well as to pay down government debt.

It is, in short, an outrage.

PACKAGES SOMETIMES GET LOST
Earlier this month France launched a move similar to Ireland’s as part of legislation that raised the age of retirement.

France is transferring more than 20 billion euros of assets belonging to its Fonds de Reserve pour les Retraites (FRR), a funded portion of its retirement system, to Cades, a fund designed to be run down to pay for social benefits.

The transfer will take place over a number of years and the mix of assets held by the FRR in the meantime will shift radically, implying a large shift to government debt. Very convenient for the French Treasury but perhaps not so good for future retirees.

Finally, let’s turn to UPS, which earlier this month became one of the most notable of a string of U.S. companies to sell bonds in order to fund its obligations to its underfunded pension fund. UPS sold $2 billion of bonds due in 2021 and 2040, with the longer dated portion yielding about 5.0 percent.

A decade of paltry equity market returns and current low bond yields, which are used to calculate future liabilities to retirees, have left many firms, including UPS, with funding deficits.

Debt financing pension obligations is in essence a plan to try and make a spread between the cost of financing and the returns the company is able to make on its pension assets.

Borrowing to speculate in financial markets to make up for a lack of previous saving; what could possibly go wrong?

To be fair, UPS, which is one of many large U.S. corporations making similar moves, can’t be equated with Ireland or Hungary. UPS has the same legal obligation to its pension fund no matter how it chooses to fund it, so the bond issue from that perspective does not raise the risk for retirees.

That said, a participant in a company pension plan is dependent on the ability of the company to meet its obligations. The more debt the company takes on, the higher that risk is.

Savers of all types are being asked to shoulder risks they did not sign on for, the costs of which they will inevitably bear.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.email James Saft at jamessaft@jamessaft.com)