Leaders of the western industrial nations and emerging economies are gathering together to participate in G20 summits for the first time in Asia to negotiate an agreeable global economic solution to prevent economic protectionism that satisfies both the developed western nations and the emerging economies.

Developed western economies with very low growth rate are facing the challenges of high unemployment and massive deficits. Emerging economies with high growth rate presently need western markets for their exports.

G20 Ministerial meeting couple of weeks ago has put trade imbalances and forex exchange rates on top of the agenda of the two days G20 head of states summit beginning tomorrow.

United States has been pushing China to quickly increase the value of yuan by 20-40% and to decrease the trade imbalance by 4%. China has refused US demand to drastically appreciate yuan by 20-40% calling it a “shock therapy” that will lead to social and economic unrest in the country.

Higher yuan and lower dollar can bridge the gap in trade imbalance between United States and China as it will enhance Chinese buyers’ purchasing power and make American products competitive.

The second round of United States policy of “quantitative easing” has intensified the currency row and it is criticized by Germany and China for weakening the value of dollar.

A weaker dollar to enhance U.S. exports will result in depreciation of forex reserves traditionally kept in dollars in all the countries, and it will also lower U.S. national debt.

Drop in the value of U.S. dollar will adversely affect China the most being the leading lender to United States and having US $2.65 trillion in forex reserve.

Japan and Brazil had intervened in forex markets earlier to limit the appreciation of their currencies.

China has refused to accede to pressures from western developed countries with dwindling economies especially from USA.

After G20 ministerial summit US treasury secretary visited China. British premiere David Cameroon visited China before heading for G20 head of states meeting. German finance minister visited China and criticized US tactics to bog down China. Germany is expecting to have $100 billion trade with China.

All the western countries are wooing China to partake in its massive and growing economy.

China is leading the emerging economies because they are facing the same economic challenges from within and from the western world as China.

The G20 summit is fraught with challenges for developed western countries and emerging economies. A positive outcome of the meeting is not expected and a negative conclusion can lead to further national economic protectionism.

On the eve of the summit, World Bank president Robert Zoellick said the largest economies “need pro-growth policies, structural reforms, open trade and an anti-protectionist agenda”.

Global economy is a fact and without cooperation every other way leads to loss for all the western economies and emerging economic nations including United States and China.

United States and China have to stand up to the global historic moment of shifting economic power from western developed nations to the massively populated nations with emerging economies and learn cooperation and co-existence. Paranoia will only lead to protectionism.

America has lost its financial canine teeth and China has newly acquired financial canine teeth. Both United States and China have to settle down from gnashing false teeth and grinding baby teeth, as it will hurt the newly lost teeth just as much as it will hurt the newly acquired baby teeth.

The campaign for US Congress election has united democrats and republicans in China bashing for all their economic woes. Republicans are expected to win majority seats in Congress and participate in US governance with Democrats to tackle with difficult economic challenges of high unemployment and massive deficit.

United States needs to invest more in research, development and capacity building to create new jobs for Americans, while cutting its defense spending to stall its exponentially growing deficit. Criticizing China for United States economic woes will not help republican and democrat politicians in earnestly focusing on the challenges and resolving them.

US defense spending accounts for 46% of world’s total defense expenses. Two wars in Afghanistan and Iraq have added more than a trillion dollars to American deficit and neither war has yielded any financial dividends for American people.

China can neither be blamed for extraordinary US consumption of 70% of the GDP, nor for providing cheaper labour for US manufacturers. The consumption spree worked for US during 1950s economic downturn and later, transforming US into world’s largest market. US spending on research and development and ‘ease of business’ helped it in becoming the top producer of advanced technology and the biggest manufacturer of industrial goods.

Global communication and global economy today has evolved emerging markets with cheaper skilled labour attracting enterprises to shift their manufacturing base from US to Mexico or China for instance.

Shifting manufacturing bases from US has caused job loss for US skilled workers. When GM motors can pay $7 an hour to Mexican workers for the same job that they have to pay $14 to a US workers, then it makes less economic sense not to move their plants from US to Mexico.

Fareed Zakaria recently published an incising analysis to restore the American dream in Times magazine. He mentions that the American dream is no longer the only dream in the world today. Emerging economies have given birth to new dreams.

Fareed suggests a multi-pronged approach to United States to overcome economic challenges of high un-employment and alarming national debt to restore the American dream.

He recommends a shift from consumption to investment, investing more in research, technology, development and training by controlling health care costs, and pensions at the state level.

Fareed writes “My proposals are inherently difficult because they ask the left and right to come together, cut some spending, pare down entitlements, open up immigration for knowledge workers, rationalize the tax code — and then make large investments in education and training, research and technology, innovation and infrastructure.”

Like all other leading journalists of US mainstream media, Fareed avoids mentioning US defense budget that has ballooned over the years adding exponentially to US deficit.
Democrat and Republican politicians are not discussing curtailment of US defense budget either.

US president Dwight Eisenhower had warned American public of the dangers of developing a huge military industrial complex in his speech in 1961 and his words still resonate. He said, “We annually spend on military security more than the net income of all United States corporations. In the councils of government, we must guard against the acquisition of unwarranted influence, whether sought or unsought, by the military industrial complex. The potential for the disastrous rise of misplaced power exists and will persist.”

What are Leveraged ETFs?

Leveraged ETFs can be defined as Exchange Traded Funds that use a combination of derivative and debt to enhance returns for investor. Here is a simple example of how a leveraged ETF works. Let us say a leveraged ETF tracks the S&P 500 Index.

Assume that for every invested dollar in the fund, it uses $1 in debt. Now, if the index moves up by 1%, the fund will give the investor a return of 2%. So, for every $100 invested by the investor, they will get a return of $2 in a leveraged fund, whereas in a normal ETF, return will be merely $1.

Of course, there will also be transaction cost, management fees and the interest on the debt, which will reduce some of the return on a leveraged fund. So, the investor who invests $100 in such a fund will probably make $1.50, if the index moves up by 1%. That is 50% more than what they will make in a normal fund.

But, is the risk worth taking?  We don’t think so.

Why Leverage is not a great idea?

Well, a lot could go wrong if you are leveraged. One just needs to look back at the financial crisis and see how dangerous leverage can be.

Banks and hedge funds that went bust during the financial crisis were all highly geared. Even before the financial crisis, there have been hedge funds that have gone bust because they were highly geared.

From Long Term Capital Management, the famous hedge fund that had Nobel laureates in its ranks, to Amaranth, whose star trader was one of the highest paid hedge fund managers in the world at one time; there have been many funds that have collapsed due to high leverage.

Lehman Brothers, the investment bank that survived the Great Depression, collapsed in the financial crisis as it was geared 40 times, i.e. for every $1 of equity; Lehman was using $40 in debt.

Now, you stand to make a stellar return on equity if things go in the direction you want them to go, but can go horribly wrong if they go only slightly against you. And leveraged ETFs are no different.

So what could go wrong with a Leveraged ETF?

Let us look at an example of how things could go wrong in a leveraged ETF. Suppose you have a leveraged ETF that is tracking the Japanese Index. Now, let us assume that the fund is geared 3 times, i.e. for every $100 invested in the fund; it uses $300 in debt. If the Japanese Index moves up 1% – the direction you want it to move because you are long the index – you make $3. After deducting all the costs, you are left with $2.50. A decent return, and more than what you could have made in normal fund. But, if the index moves in the opposite direction, i.e. it goes down by 1% you have lost 3% of your equity.

And imagine how the loss will accentuate if the index drops by 10%. You would lose 30% of your equity in just one day. And let us say you were geared 4 times instead of 3. Now you lose 40% of your equity. No wonder that highly geared banks and hedge funds were wiped out in a day.

Understanding how leveraged ETFs work

One very important thing for investors is to understand is how these leveraged funds work. A fund that is geared two times, promises to generate double the return of the index it is tracking. Theoretically, this means that if the Dow Jones returns 20% in a year, a 2x fund should return 40%. However, this is not the case as the fund tracks daily changes in an index and so they may double your daily return, but things could be different when we talk about annual returns.

Let us get back to the $100 we had invested earlier. To simplify the example, we are not assuming any costs and management fees for the fund. Now, if the index goes up 10%, you gain 20%, assuming the fund is geared 2 times.

So, your $100 is now $120. Because the fund has to balance the leverage ratio and keep it at two times, it will have to adjust the debt level by increasing it by $20. So, now you have $120 in equity and $120 in debt.

Now, the next day the same index drops 10%. You lose $24. Your equity is now down to $96. So, you have lost more than the index. Yes, on a daily basis, your gains and losses are double that of index. But over a two day period you have lost $4, 4 times what the index lost. If you were invested in a normal ETF, you would have been at $110 after the 10% gain on day one, and been down to $99 after the 10% loss on day two. So, overall, you would have lost $1. But with a leveraged ETF, you stand to lose $4, 4 times what you would have lost in a normal ETF.

Tracking Emerging and Frontier markets

Till now, we have only spoken about leveraged ETFS. What if you have a leveraged ETF that tracks an index of an emerging or frontier country? Yes, you can make a lot of money by investing without using any leverage. Imagine the returns you can make if you are geared. There are ETFs that track indexes of some of the most volatile stock markets in the world. Some of these markets see huge jumps and falls on daily basis. And like we explained earlier, daily changes can have tremendous impact on leveraged ETFs.

Leveraged ETFs on indexes of volatile markets can generate stellar returns, if the markets go in the favored direction. But, investors stand to lose big time, if their bet goes wrong.

A final word

Through this article, we have explained the effect leverage can have on your returns. Using leverage to enhance returns is a great idea, if you can predict the direction in which the markets will move. Some years ago, Long Term Capital Management thought it could do this, with the help of a star studded team and the most sophisticated investing strategies.

But, it only took a few days of losses and the fund went bust.

Compared to November’s gain in jobs (the first gain since the recession began), December’s loss has brought many questions about the U.S. recovery.

The NASDAQ index gained 0.53% today while S&P 500 dropped 0.11%, falling from a 15 month high.

The dollar index which gauges the U.S. currency against those of six major trading partners declined 0.5 percent to 77.509.

However, despite this bad news, investors seem to still be heading towards the U.S. economy for a few reasons.

U.S. Inventories rose 1.5% to $386.26 billion, the Commerce Department said Friday while a 0.3% decline was expected on Wall street, making it the largest since a 1.5% climb in October 2004.

The U.S. economy seems to be headed in the right direction, especially compared to European countries including the U.K. who are facing a large burden of debt at the moment amongst other problems. 

The loss of jobs in December, as troubling as it may seem is not as severe as many are making out to be. After all, 741,000 jobs were lost in January of 2009 just a year ago, when numbers like 600,000 and 700,000 jobs lost a month were common.

The fact that the U.S. has decreased unemployment down to 85,000 of the past year is a sign of long term improvement, not failure. 

 This is something investors realize. They realize that the job sector is lagging behind every other sector of the economy, and do not use it as a measure of the total economies worth. Rather they use times like these when the dollar is weak as a good buying opportunity.

Government backed securities witnessed the largest drop since August, before the U.S. tomorrow announces the sizes of two-, five- and seven-year auctions next week.  

Treasuries were unchanged today with 10-year yield near the highest level in four months, on concern the government’s final figure for third-quarter gross domestic product will add to fears inflation is poised to accelerate.

The benchmark 10-year note yielded 3.67 percent. The 3.375 percent security due November 2019 traded at 97 19/32. The two-year yield held at 0.86 percent.

The difference between 2- and 10-year Treasury note yields increased to as much as 282 basis points yesterday. It rose from 145 basis points at the beginning of the year, with the Federal Reserve anchoring its target rate at virtually zero and the U.S. extending the average maturity of its debt.

The yield curve reached its previous record of 281 basis points on June 5, when Treasuries plunged after a government report showed the smallest decline in U.S. payrolls in eight months. Ten-year note yields touched 4 percent the following week, the highest level in 2009.

The world’s largest economy expanded at a 2.8 percent annual rate, matching last month’s estimate, according to the median estimate of economists surveyed by Bloomberg before today’s Commerce Department report.

A separate report tomorrow will probably show consumer spending rose 0.7 percent in November, the same as the previous month, further adding to signs recovery is picking up.

The U.S. plans to sell two-year notes on Dec. 28, five-year notes on Dec. 29 and seven-year bonds on Dec. 30. The package will total $118 billion, according to Wrightson ICAP LLC, an economic advisory firm in Jersey City, New Jersey.

President Barack Obama is borrowing unprecedented amounts for spending programs. U.S. marketable debt increased to a record $7.17 trillion in November from $5.80 trillion at the end of last year. Treasuries of all maturities have fallen 3 percent this year through yesterday, according to Bank of America Corp. Merrill Lynch indexes.