Making The Nut

Thursday, September 17th, 2015

Many people in businesses ranging from finance to bicycle repair commonly use the term “making the nut” as a way to gauge how they are faring vis-à-vis the bottom line. Far fewer people, however, know the origin of the term. It dates from the 1500’s in England when vagabond theatrical troupes traveled around the countryside plying their trade. The players would reside in a local inn while they performed in a given township before moving on and repeating the pattern in the next one. Since they were not the most credit-worthy types, the innkeeper demanded some security, which would be his taking and holding the large nut from one of their wagon wheels. This was a convenient and symbiotic transaction for both parties: the players short of gold or possessions would not have to part with anything dear in advance, and the innkeeper was assured they could not skip town before paying their bill. When their performances generated enough in coins or goods to pay the innkeeper and redeem the critical piece of equipment, the performers “made the nut,” and the troupe could leave.

Since 2010 the IMF and other Eurozone creditors have had a version of this system in place for Greece, where Germany effectively holds the nut. Greece, after decades of dismal economic growth coupled with generous benefits, admitted in 2009 that their deficit was far greater than they had stated to the European Union. Since the other member nations held the majority of outstanding Greek debt, the country was rescued from bankruptcy. But to keep the bailout payments flowing, the holders of the nut insisted that Greece raise taxes, spend less, and take steps to become a functioning economy. For starters, Greece needed to get their citizens to actually pay their taxes. Whatever was done—or not—has not worked, so the creditors said in June “without more stringent measures from Athens they would turn off the tap, forcing a Greek exit from the Eurozone.” In response, the Greek government, headed by a charismatic socialist determined to keep his political power, decided to play chicken and said they were not going to redeem the nut.

In truth very few sovereign states do make their nut and—like the United States—print new money to pay existing and future debts. The Greek economy measured by their GDP is about the size of Alabama, but nowhere near as robust. Their high quality olive oil, for example, is sent to Italy and repackaged as an Italian export because of restrictive government regulations. The total outstanding debt of Greece, which is causing such great concern, is $350 billion, which according to most estimates is roughly what the US borrows in half a year. John D. Rockefeller back in the 1920’s accurately noted that when someone owes their bank a thousand dollars and can’t pay it back then the bank has a problem; but when someone owes their bank a million dollars and can’t pay it back, then the bank has a partner. The US creditors, including its largest ones Japan and China, are very comfortable being partners and don’t need to hold a nut for security. The situation, however, is very different for the Eurozone Greek “partners” who hold the nut and are often at odds about the terms of redemption. When matters came to a head in June, the Greeks, at the urging of their populist leader, and to no one’s surprise, voted no in their referendum regarding the EU’s bailout demand. In an article coinciding with the vote (Wall St Journal 06/30/2015), a journalist spoke to an 83-year-old woman waiting in a long line in the scorching heat at an ATM to withdraw her 60 Euros of daily rationed cash. She loudly cursed both her situation and the Greek Prime Minister saying, “ Tsiparis is turning my country into North Korea.” Yet a few days after the “no vote”, the same Prime Minister in what most are calling a “huge surprise U-turn,” proposed more stringent austerity measures and higher taxes than his voters had nixed and quickly pushed them through his Parliament. In the end, a new bailout agreement was reached which satisfied Germany and the EU but must be totally confusing to the Greek electorate, who probably wish that Iran had handled their negotiations with the IMF. It took some time but Prime Minister Tsiparis and his team had figured out that the Greek wagon was not going to move without the nut.

WHAT WE LEARNED IN AUGUST

The summer months are usually a languid stretch for the markets while many participants enjoy other activities. But first Greece then China disrupted the normal calm. The Chinese major stock market index dropped 8% in one day after government interventions intended to bring calm did the opposite. In response the Chinese government surprisingly devalued their currency sending shockwaves through the global capital markets. Unlike China, Greece is at best an economic anorexic and will likely remain that way. The Greek financial markets, however governed by the EU do function as advertised when they are open for business. China, on the other hand, according to an article by Princeton Economist Burton Malkiel (WSJ July 27, 2015) has done the right things to promote economic growth but has fallen short in the development of stable and functioning capital markets. In a speech on foreign policy in 1960, President John F Kennedy noted that the Chinese word for “crisis is composed of two characters, one representing danger and the other, opportunity.” Since then, countless politicians and speakers ranging from Richard Nixon to Al Gore have invoked the quote to suggest that a crisis can become an opportunity, and hopefully the Chinese government will interpret the word the same way. Investors around the globe nervously await that outcome.

Despite these brewing international disruptions and much consternation regarding the Federal Reserve plans to begin raising interest rates, the US markets traded in a very narrow range during the first half while investor sentiment turned negative. The Dow Industrials were off less than 1% for the year as of June 30th. What is perhaps more noteworthy is that in the first 6 months of 2015, investors pulled $70 billion from stock funds and added $77 billion to bond funds SOURCE. Pessimistic investors voted with their feet, and negative investor sentiment has been a reliable contrary indicator: in 1987 and 2008, for example, negative sentiment was at all-time-highs and multi-year stock market rallies followed. This is worth remembering as we continue to digest the August correction.

By most important criteria, the recent stock market decline is not related to economic fundamentals. The US economy is growing steadily, private sector job growth has increased every month for over five years; property values and construction grew at 10% this past year and auto sales are back to pre-financial crisis levels. The boost in auto sales and property purchases are significantly correlated to increased lending by financial institutions—a positive trend not receiving enough attention. Even if the Federal Reserve as expected adds 0.25% (25 basis points) to short term rates this year, it is doubtful that increased lending will slow significantly. Despite fearful daily headlines about slower Chinese economic growth, the impact of China on our economic numbers is rather immaterial: US exports to China are less than 1% (roughly 0.70%) of GDP. Even iPhone sales in China did not slow in July and August according to Apple CEO Tim Cook. The decline in energy prices is starting to show some positive impact on US consumers, and energy-producing states such as Texas have diversified their economies in the past two decades so that oil dropping from $80 to $40 is not the end of the world. Addressing the August decline, one well respected investment strategist who has been around over 30 years and seen many such drops, compared periodic short-term technical stock market corrections to Supreme Court Justice William Douglas’s well known comment on pornography: You know it when you see it. The healthy combination of investor negative sentiment and the characteristics of the August decline strongly suggest that it will not be a long term or damaging affair, and like past corrections will in hindsight be viewed as an opportunity to buy quality at a discount. That said, the road could be bumpy and volatile: but when a skeptical economist such as Mohammed El-Erian who oversaw investments for the Harvard Endowment and Pimco describes the August 2015 correction as a “once in a decade buying opportunity”, to quote playwright Arthur Miller, “Attention must be paid.”

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