Big Losses Sustained by the UNC Investment Fund

The Rise of National Champions

Fed Remains Unchanged on Interest Rates

Can the UN Climate Conference Really Lead to Change?

German Elections: Implications of the New Coalition

Alternative Investments Still Being Hit Hard

Despite Violence, Mexican Economy Pushes On

Advocating “Health” in Healthcare Reform

December-2009

The prospect of this departure likely will keep defense company stocks depressed for an extended period of time as investors wait to get an indication of where future demand for military equipment will come from.

One market that could yield promising growth for the defense industry is developing countries.  Many developing countries have long relied on the U.S. Navy and other U.S. armed forces to protect them against foreign invasion.  The U.S. has acted as the world’s watchdog, but as developing countries are gaining economic strength they likely will want to augment their military strength to flex their newfound power.

Another development that supports this premise stems from the implications of a unipolar world shifting to one with many dimensions.  With the rise of new powers you can expect to see many new disputes and power grabs, as demonstrated by the intensifying border dispute between China and India.

As these countries vie to establish their place in the new world order, it will become necessary for them to bring their militaries into the twenty first century to put muscle behind their words.  Many developing countries still rely on weapons that were formerly donations from the U.S. or Russia during the Cold War.

This increase in demand for high tech weaponry should provide a boon to U.S. based defense contractors.  These companies are the world leaders in defense technology, thanks in part to the U.S.’s historical proclivity for a lofty defense budget.  It seems likely that many countries will come to these U.S. companies to meet their defense needs rather than trying to develop their own weapons because of the enormous research costs involved in creating new technology.

However, it is probable that some of the largest developing countries will attempt to produce their own military technology because of their mistrust of the U.S.  They will not want to rely on the U.S. to provide them with weapons because they may perceive this as a weakness, as they do not want the U.S. having specific knowledge of the state of their military.

The evidence seems to point to a rise in the demand for U.S. defense contractors in the coming future, and now could be the ideal time to buy these stocks at their troughs thanks to depressed valuations based on the impending U.S. withdrawal from the Middle East.

-Brian Stockton

When AIG came out and announced that it was going to pay $218 million in bonuses to the employees of its financial services division, there was quite an uproar from the public and policymakers alike.  This is the same division that has contributed to the systemic collapse of the world economy, and has managed to build up a $170 billion tab with the American taxpayer.  Without question, there is something wrong with this scenario, and in order to find an efficient solution, regulators and the public must avoid making snap judgments and decisions which result in unintended consequences.

When the Federal Government decided that AIG presented a systemic risk to the economy, it decided that the company was too big to fail.  In doing so, the government made sure that AIG was able to uphold its contractual obligations of paying off credit-default swaps.  The problem occurred when the stimulus bill passed in February didn’t earmark the money sent to AIG.  As such, AIG received a blank check to decide where and what to spend the bailout money on.  Part of their contractual obligations was the payment of bonuses to many of its employees.  Thus two questions are raised: Why wasn’t this caught in Congress and why are the bonuses written into employee contracts?

The answer is that Congress was only given a day to review the thousands of pages long stimulus bill before it was voted on.  It is impossible for the government to provide efficient regulation and transparent usage of taxpayer dollars if officials continue to strong arm legislation through without proper and thorough consideration.  It would be very surprising to find out that there wasn’t any other problems created by forcing the nearly $800 billion stimulus package through Congress.

The problems and outrages over contractual bonuses are more complex.  These contractual bonuses were ‘invented’ after the income tax was changed such that all income earned above $357,700 was taxed at 35%.  Thus, companies found a loophole whereby an employee’s base salary would be paid for up to this highest tax bracket, and the rest of their compensation would be paid through contractually binding bonuses which are taxed at a lower rate.  In effect, these bonuses are supposed to be built into their base salary anyway, and stand as a reflection of how much the employee is worth to the company.  If these bonuses were taken away through a 90% punitive tax, the ‘talent’ at AIG or other bailout receiving institutions would have a strong incentive to jump ship, thereby hurting the companies and the recovery effort.  As such, the debate over the payment of these bonuses has been misinterpreted, and instead should be looked at as a debate over who should control executive compensation and how best to minimize the principle-agent problem.

With the ousting of General Moter’s CEO, Rick Wagoner by the President, and the executive order to cap executive income at TARP receiving companies at $500,000, it is clear that the government is taking a more active role in the management of America’s private sector.  Also, there has been Washington chatter of somehow extending these limits to all private companies and corporations.  Surely this is just populist grandstanding, but it is important to recognize a popular sentiment.  More reasonably, many politicians have been arguing for increased rules and regulations of compensation.

The most interesting ideas for minimizing this principle-agent problem and for increased regulation have recently come from Goldman Sachs’ CEO Lloyd C. Blankfein.  He suggests that “all equity awards should be subject to future delivery and/or deferred exercise over at least a three-year period.”  Furthermore, the percentage of equity received should increase with income, and senior employees should be required to retain the majority of their equity until they retire.  These regulations would theoretically decrease the problems of excessive risk-taking in the short term by executives, and help to align the goals of executives with those of the owners.

Unfortunately, in asking for the government to provide a framework or regulation for executive compensation, Blankfein is inviting the government into other workings of his business.  One problem is that government regulations are sticky and can take a long time to remove if the results are undesirable.  Also, not all businesses are homogeneous (a lot of people make the majority of their money based on commission, or the number of hours they bill to the client), so it doesn’t make sense to have a standard of rules and regulations that apply to all companies.  Moreover, there is no evidence that owners cannot institute the rules that Blankfein suggested without government involvement.

Excessive risk-taking caused by the principle-agent problem was one of the main catalysts for leading the world into depression.  In order to avoid repeating our mistakes, owners and regulators must work together without political or financial motivation to find the most efficient solution.  It is a good sign that we have moved beyond death threats and screaming on television to a more productive debate.

-Graham Lovin

However, a recent study by New York University conducted in low income areas of New York has challenged this assumption.  In fact, the research shows that the average amount of calories ordered from a sample group of fast food restaurants rose from 825 calories to 846 calories after the enactment of the labeling law.

The results of this study demonstrate that low cost overrides health concerns in the minds of low income families.  William Mitchell of Harlem evidenced this finding by saying, “It’s just cheap, so I buy it. I’m looking for the cheapest meal I can.”

Tameka Coates had another reason for eating so much fast food.  She explained, “I don’t really care too much…I know I shouldn’t, ’cause I’m too big already.”  Whether for better or worse, Tameka values the satisfaction she receives from eating greasy food over her own health.

Every American has the right to consume as many calories as he or she pleases.  Tameka should have the right to eat as many Big Macs as her heart desires because this personal decision should not have a great impact on other people.  However, if the proposed healthcare bill passes in its current form, Tameka’s freedom to be unhealthy would need to be reconsidered.  The healthcare bill would subsidize low income Americans that lack insurance, which essentially means that Americans with insurance will be taxed to help cover those without it.  Subsidizing people like Tameka will obviously frustrate many taxpayers because they will be covering the high medical costs that will arise from her indifference to her own health.

Despite all of its complexity, the current healthcare bill fails to address such issues.  The bill was crafted in a way that sought to avoid offending or upsetting anyone, and in the process it has lost any ability it may have had to decrease healthcare costs in the long term.  Rather than slowing the growth of healthcare costs, it appears that the goal of the legislation has shifted to expanding coverage.  While this is certainly a noble goal, relying on bureaucrats to conciliate expanded coverage and cost reductions reeks of idealism.

If the administration was serious about creating a long term change in healthcare costs, they would look to the root of the problem: America’s health (or lack thereof).  Currently, one in three Americans is obese.  It is no coincidence that the rise in American body weight has been matched by a rise in healthcare expenses.  By focusing on measures that improve health itself, trips to the doctor will be reduced and medical costs will naturally fall.

The reason that this seemingly obvious solution gets so little consideration is because health is a sensitive subject to Americans.  No one likes to be told that they have a problem to begin with.  Also, the idea of the government coming in and telling people to put down that second Big Mac will go down with voters about as easy as an extra large serving of chili cheese fries.

However, the goal of making America healthier can be achieved through indirect means that focus on providing the right incentives for consumers.  As demonstrated by Mr. Mitchell, many Americans frequent greasy fast food restaurants on a regular basis because of the low costs.

One of the reasons that fast food costs so little is because of the subsidies that large scale farmers receive from the government.  While farmers that produce massive quantities of food that supply the popular fast food chain restaurants receive benefits to help keep their prices low, local farmers receive no such help and as a result must charge higher prices.

Food prices in America are artificially low because of government interference, and lowering farmer subsidies would decrease the amount of food produced and subsequently increase the price of food to its natural level.  Locally produced goods would become relatively more attractive from a cost standpoint, and perhaps higher prices would discourage many of America’s overweight from persisting in their gargantuan eating habits.

Another way to incentivize Americans to be healthy would be to encourage insurers to charge lower premiums to people that exercise and maintain good health.  It is reasonable that people who put themselves at less risk for health problems by taking care of their body pay less for insurance.

While these measures would benefit the physical and fiscal health of America, initially they would add burdens to low income citizens.  However, the government could cushion the blow to these people in a variety of ways, and the cost of such aid would be miniscule compared to the long term savings achieved through a change in culture.

In healthcare reform, the Obama administration has an enormous opportunity to bring a positive change to America.  Let us hope at some point they realize that addressing our problems directly is more effective than putting all of our faith into a byzantine plan that circumvents the fundamental issues.

-Brian Stockton

It was not long ago that the U.S. was lecturing countries like China and Indonesia on the necessity of free markets, but now with the U.S. stuck in a plodding recovery and many developing countries experiencing robust growth, numerous of these countries have determined that their own methods may be best.

These countries pride in their economic prowess has brought out nationalistic fervors, despite the fact that most developing countries’ growth can be attributed to mass urbanization and technology transfers.  This tenuous confidence has brought formerly impoverished countries like China to the forefront of international policy debate, which can be seen in China’s rally to replace the dollar as the world reserve currency.  The U.S. has bent and allowed such new comers to the world stage, as demonstrated by President Obama’s recent comment that the sphere of power in global affairs is drifting away from the U.S.

Perhaps the most astounding aspect of this colossal geopolitical shift is the sheer number of developing countries emerging on the international scene.  The result is a hyper competitive atmosphere of “new wealth” countries looking to assert their newfound power.  An example of this nascent competition can be seen in the heated space race between China and India.

Many countries have used the performance of their top companies, or “national champions”, as a means to confirm their nation’s superiority.  Countries have allowed these ambitions to supersede fundamentals of free market economics, as they have used their political muscle to drive these select companies forward.  Currently, China is trying to consolidate its sprawling steel industry into a few select companies that can be global heavyweights.  South Africa recently put pressure on the Swiss mining company Xstrata to withdraw its bid for one of South Africa’s prominent companies, Anglo American.  A change from communism was not enough to break Russia from its relationships with its energy firms like Gazprom.  Brazil is a part owner in its titan Petrobras.  South Korea has long supported the growth of huge conglomerates, or “chaebols”, such as Samsung.  The list goes on and on.

In emerging countries where free market principles are often viewed with skepticism, national champions receive many benefits from implicit and explicit government support.  When one country starts subsidizing its companies, others naturally follow so that their own companies can continue to compete on the global level.

This government fostering of national champions is a form of protectionism that greatly conflicts with the U.S.’s traditional stance towards free markets.  Rather than oppose these new developments, the U.S. has contributed to their proliferation through the Buy-American provisions in the stimulus bill and the recent tariff on Chinese tires.  After seeing the United Steelworkers Union receive government assistance, many other U.S. industries have started to clamor for special “protection” from Uncle Sam.

Despite the world’s newfound sophistication, it continues to be plagued by a problem that has haunted humanity for centuries: hubris.  Currently, the world economy is on a path to higher prices, lower trade, and less wealth because of national egos.  In recent years, the world has propelled so far forward thanks to free trade of technologies and goods; let us hope that we will not allow these gains to come undone because of selfish vanity.

-Brian Stockton

The issue I have been most drawn to recently has been the late Cash for Clunkers program.  There has been a lot of media coverage about it, and there have been no shortage of people looking to give their opinion.  In large measure, this national interest stems from the fact that Cash for Clunkers is such a strange and foreign concept to many people.  Certainly too, the goals of reducing carbon emissions, and helping out struggling automakers are issues of very heated debate in the country.  What is less certain is how dire the costs of the program are.

In 1850, Frederic Bastiat wrote a seminal essay entitled That Which Is Seen and That Which Is Unseen about the costs involved with destroying other people’s property.  Bastiat puts forth an argument that he has heard before and is popular with the politicians of his time: destroying property to spur on an economy.  In the book, he uses the example of a child running around breaking people’s windows.  Bastiat wonders: Is the child doing the community a service?  The politicians would believe that the kid is providing more work for the window repair people, and maybe some unemployed people will be able to get work because there is a big demand for window repairs.  But unfortunately, as Bastiat points out, it is not so easy to spur on an economy.  The people forced to buy new windows will not be able to spend their money on something they would prefer, thus the resources of the economy are being inefficiently allocated.

Even though Bastiat figured the broken window fallacy out over a century and a half ago, every now and again there comes along a group of people who have the brilliant new idea to destroy something to help stimulate the economy.  Those who argue that World War II helped us out of the Great Depression fall into the same fallacy;  and so it is today with the new fangled Cash for Clunkers program.  Bastiat would probably find the whole idea of providing subsidies for clunkers, and then forcing dealerships to destroy them very strange.

When clunkers are removed from the market, the market for these cars is going to have an increase in price across the board.  Since the people who buy clunkers are predominately poor, they are going to be the subset of the economy most negatively affected by the program.  The winners of the program are the auto dealers.  Even if people hid the fact that they were trading in clunkers, the dealers  engaged in price negotiations like they did, so cars were sold a good deal more than they would have been if not under the program.  It would seem then that Cash for Clunkers is simply a subsidy to auto dealers so that they can clear their inventories.

Of course, the benefits of the program may in fact be immeasurable.  It could be that there would be some boost in consumer confidence brought on by an increase in auto sales.  Also, a faster moving economy could attract a lot of the money which has been sitting on the sidelines since the collapse.  This Keynesian explanation is about eighty years newer than Bastiat’s, so it may be the case that the townspeople who all have broken windows will be more motivated to be productive.  This was almost certainly the case during World War II, because the prospect of losing the war would have been a huge motivator to be as productive as possible.  Nevertheless, I am skeptical that Cash for Clunkers will provide increases in productivity that will yield positive economic returns in the long run.  Though, it is very likely we will never know.

-Graham Lovin

Click to download the PDF.

-Alex

China makes a strong case for its new international presence, as it claims its massive reserves and importance to the world economy warrant more say in a decision-making process typically dominated by Western powers.  While traditional authorities like the United States and the United Kingdom are in an all out battle against depression, China is still growing at a reasonable rate and has the cash to make acquisitions of firms and assets that are extremely undervalued due to derelict market conditions.

When making this argument, China also points to its sheer size, and with approximately 1.3 billion citizens, this girth is hard to ignore.  Many of these people save a large proportion of their income rather than spend and stimulate the economy, and China realizes that reducing this saving rate in addition to encouraging subsistence farmers to move to cities for different occupations would be a powerful driver to domestic demand.  Currently, China produces goods with the purpose of exporting them to richer countries, but if it could stimulate local demand then China would have a huge supply of new customers for its goods.

While China’s bulk is certainly the foundation for its great potential, this great strength could potentially become an enormous liability in the future.  Despite China’s successes, there is still great unrest among its workers who do not enjoy a satisfactory standard of life.  China’s healthcare system remains light years behind the developed world, and if China wants to have the influence of a developed country then it must act like an advanced nation and reform its social aid.

The costs of these advancements will not come cheaply, especially since the standard for government assistance to the needy is currently being raised to new heights by the Obama administration.  Transfer payments are a big deadweight on developed countries, especially in Europe, and while it has been proven that they are often times economically inefficient, these measures help ensure the stability of a society by providing the people who cannot help themselves with aid to make the best of their lives.  In China, a country where countless numbers of people would be eligible for such aid, making such reforms would certainly be a short run damper on economic growth.

Human rights activists will be sure to pester countries like China as they gain stature in the world economy.  China has been able to fend off issues such as global warming by claiming that such regulations would damper its developing economy, but by making the claim it is now a force in the global market China is opening itself up to more complaints about its inaction.

With great power comes great responsibility, and while China seems ready to wield the staff of authority, it is far behind in addressing basic issues within its own borders that are necessary to resolve before it can be taken seriously as a global power.

-Brian Stockton

For the most part, the recent rally from 6,547 to 7,395 (a gain slightly less than 13%) since March 9^th has been broad based and spread across all sectors.   Financials, technology, consumer discretionary, and energy sectors have contributed most to the rally. Volume remains to be relatively low so it is reasonable to assume that, on a large scale, investors remain reluctant to fully enter back in the market and the rally might be unsustainable.   

Despite the recent rally, market participants were not confronted with the most inspiring news this week.  Alcoa announced that they are cutting their dividend by 82% in an effort to stabilize their financial situation by improving the company’s liquidity.  Nucor is warning investors of a first quarter loss and contributed it to deterioration in demand for steel which does little to suggest an economy that is turning around.  Nokia is cutting up to 1,700 jobs.  Furthermore, recent export/import data for January have investors shivering over continued weakness in global trade.  But maybe investors were more excited about the small rise in February building permits and housing starts apparently suggesting a housing bottom may be near the bottom.  Many investors strongly believe that the housing crisis is at the center of this financial chaos and unraveling in housing will ultimately spawn unraveling and more predictability in the rest of the economy. 

The volatility very may well continue into the week with investors awaiting a Federal Open Market Committee decision Wednesday (2:15 p.m.) and an update on the Capital division of General Electric on Thursday. Known as a bellwether for the economy, the dour performance of GE has recently scared many investors so any transparency regarding their capital division is highly anticipated.

In addition, GE is one of the few companies that still have an AAA rating.  Data on the Consumer Price Index for February will also be released on Thursday.  Aside from options expiration on Friday, investors are awaiting Ben Bernanke’s speech “The Financial Crisis and Banking Community” and what inspiration, if any, it will provide for investing under current market conditions.    

-Andrew Byrd