December 2008 – Page 3

Officially in a Recession

The National Burueau of Economic Research has announced that the US has been in recession since December 2007. The average length of a recession in United States after World War II has been 10.5 months. So this recession has already been longer than average recessions.

It won’t be surprising if this recession is declared a deep recession, but that will happen much after the recovery has begun. What amazes me is that it took more than the length of an average recession to declare that there is one going on!

The official definition of a recession is that the GDP contracts for two consecutive quarters. The US GDP actually grew in the first two quarters of this year. Even, then, the National Bureau of Economic Research decided to call it a recession based on other indicators like Payroll data.

It also said that the economy received an artificial boost because of the stimulus checks that were sent to taxpayers at the beginning of the year. If that was an artificial boost and its impact, only temporary, then how are the current bailout packages and stimulus plans any different?

The US Economy is the biggest economy in the world and about 71% of it is domestic consumption. So, the government can’t allow that consumption to go down and let the economy collapse. On the other hand, the only thing that the government can do is print money.

It seems that they are enjoying this and printing, like, there were no tomorrow. I don’t blame them, if I could print money, I would too. But by printing such a lot of currency, the dollar is surely getting devalued. That the dollar has gained steadily over other currencies in the last few months has been a result of deleveraging and people playing it safe, and moving out of other asset classes.

This can’t go on for long though, once the financial markets stabilize and investors return to other assets, the dollar will lose its value much faster than it appreciated. The fall in asset prices is always much faster than the rise in them.

Maybe at that time, someone at the top will realize – you can’t spend your way out of all troubles.

What is an ETN

ETN stands for an Exchange Traded Note and should not be confused with an ETF. It shares some attributes of Index Funds and Equities but differs from them significantly.

ETN is really a debt instrument and not an equity instrument, and that is what makes it different from ETFs and Index Funds. ETNs are issued by banks or other financial institutions and are a relatively new phenomenon. The first ETN was issued by Barclays Bank in 2006.

ETNs track an underlying asset and right now there are four type of ETNs:

Currency
Commodity
Emerging Market
Strategies

Despite being a debt instrument; ETNs do not offer capital protection. Neither do they make any interest payments till maturity. Instead they track the price of the underlying asset. The redemption price that you pay depends on the price of the underlying asset.

There are two factors that impact the price of an ETN:

The price of the underlying asset
The credit rating of the issuing bank or financial institution

Since it is a debt instrument, the credit ratings make a difference in the valuation of the ETN. So the asset price may go up but the value of your ETN may still go down if the credit rating of the issuer is hit.

ETNs fall under the category of unsecured debt so the impact of credit ratings get accentuated on their price. Also, ETNs track an asset price but they don’t actually go out and buy the asset itself like ETFs.

We talked about the differences, let’s look at some similarities between ETFs and ETNs now:

Both can be bought and sold in a stock exchange
Both track the price of an underlying asset

Tax Implication

The most important reason for the popularity of ETNs is their tax treatment. They are treated as prepaid agreements and as a result the gains from an ETN is taxed only at maturity.

On the other hand, the dividends from an ETF or the gains at the time of rollover are taxable at every instance.

This has been the primary reason for the growing popularity of ETNs.

Risks

There are two type of market risks that an ETN faces. One is the movement in the underlying asset prices. So an ETN that tracks oil prices will go down if oil prices were to go down.

The second market risk is the solvency of the issuer itself. If the bank which issued the ETN were to go down, then the ETN will be worthless too. This risk is absent in ETFs.

Then there is the question of liquidity. ETNs are relatively new and much smaller in size than ETFs. This poses some liquidity questions.

Conclusion

If you were to select between an ETN and ETF tracking the same asset, you need to consider two factors to make your decision.

Your tax bracket and whether you are a long or short term investor
The risk that the issuing bank carries

The last thing to keep in mind is that when you are buying an ETF, you are buying real assets, but when you buy an ETN, you are essentially buying a “promise by the bearer of the note”, since it is a debt instrument.

Why did countries get off the gold standard?

Gold standard means that the currency that is printed cannot exceed the gold reserves of the country. Since the supply of gold is limited to the amount that can be mined, the government cannot print money on their own discretion. This prevents Central Banks to provide stimulus to the economy in downturns and the economy can get into a downward deflationary spiral.

This is what happened during the Great Depression. At that time when the economy started heading downwards; the central bank increased interest rates. This was done to prevent people from demanding gold and to increase the value of the dollar.

Compare this to the current situation where the Fed and other central banks around the world are reducing interest rates to stimulate demand in the economy. This can be done because money can be printed and used to pump liquidity in the economy. If this liquidity is not present then the economy will see a downward deflationary spiral, much like the depression.

Most proponents of the gold standard are in its favor because it limits the ability of the government to print money at their discretion and cause inflation.

However on balance, having a gold standard is much worse than not being on a gold standard. In any case, there is very little chance of going back to the gold standard because the currency in circulation around the world today is much more than the available stock of gold.