India Food Inflation

It's interesting what gets picked up in the mainstream news and niche publications. Often, stories like the government selling its Citi stake spread like wildfire and drive the stock up.Viewing the remainder of this article requires a Subscription

The Silver Lining to the Debt Crisis

Here's the by line from the article in Barron's: "Could a Japanese debt crisis help spur a rally? Perhaps, if it fuels the yen carry trade."

But rather than precipitating a panic, a decline in the overvalued yen would serve as a tonic in two ways. The most obvious would be to give a lift to Japanese exporters, which have been hampered by the yen's strength, not only against the dollar but even more so against other currencies.

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Soros in the FT, Munger in Slate

When some of the biggest investors in the world go so mainstream, you might want to at least listen. Below is the article by George Soros discussing the continuing problems for the euro. After, read Charlie Mungers parable about a country that came to financial ruin.Viewing the remainder of this article requires a Subscription

Fed raises discount rate

Yesterday, after the close, the Fed raised the discount rate from 50 to 75 basis points.Viewing the remainder of this article requires a Subscription

What we’re watching unfold…

Warning: This post has nothing new for readers of our newsletter.Viewing the remainder of this article requires a Subscription

China, Yuan, and Bubbles

I have never been a big fan of the Chinese story, not because I doubt that there is growth there, but rather, because I doubt any numbers coming out of a command economy.Viewing the remainder of this article requires a Subscription

It makes me uneasy when too many people agree with me…

All over the place, I see signs that people agree with me, and it’s making me increasingly uncomfortable:

1. The End of the Bond Bull Market: Barry Ritholz writes in The Big Picture that the bond bull market we’ve been seeing since 1981 looks like it might be ending. He uses charts to like this to make his point:The problem is that I agree with his assessment. The model for the monetary authorities was Japan, which was able to ramp up QE, keep zombie banks alive for 20 years, and borrow at 0%. The US, however, is not in the same position. We are not a nation of savers, like the Japanese, so we can’t self fund our low rates, for starters. Our QE will not end with low rates.
2. We spoke weeks ago about going long the dollar versus the Euro and the Yen. Part of the motivation of that trade was that speculative positions had gotten too one-sided against the dollar. Another part was the insight that Europe and Japan were not in better economic positions as the currency market was implying. Well, that too seems to have become more mainstream as the DXY has gone from low 70’s to high 70’s-low 80’s. And then I read that there are the largest ever speculative short positions against the Euro: http://www.ft.com/cms/s/0/0330ba78-149f-11df-9ea1-00144feab49a.html. Now $8 billion might not sound like a lot given the numbers our Congress throws around, but it is a large floor (implied bid) for the Euro as these shorts need to cover at some point.

Just some morning thoughts.

Bank of England Halts Bond Purchases, Obama Supports Free Trade, where we went wrong, and more

The carnage from yesterday masked a lot of interesting news bits, some good, some bad, some just plain confusing:

• For starters, CBS Marketwatch ran a story about Bank of England Halts Bond Purchases. As central banks around the world face up to the reality that even they are not bigger than the markets, quantitative easing programs are likely to be pulled back. We’re seeing it in England, but as the PIIGS come under continued fire, they’ll also be mandated to cut back fiscal spending. Unlike the US, the PIIGS are closer to states in that they have limited leeway on deficits and printing. It might actually end up being their saving grace if they can get their PR story straight.

• On our side of the pond, President Obama made a step in the right direction by going against his party, and coming out in support of free trade. The NY Times ran the following story: White House Unveils Plan to Double U.S. Exports. While encouraging, the language did not contain the commitment that we’d prefer to see, and I’m afraid that this is all just talk.

But in announcing the new strategy, the commerce secretary, Gary Locke, did not say when the administration might send Congress three completed free-trade accords — with Colombia, Panama and South Korea. Many trade specialists say that is essential to prod other countries to negotiate with the United States. But the move is likely to cause a rift with Mr. Obama’s liberal supporters in the Democratic Party, as well as free-trade opponents in the Republican Party.

So we’re left holding our breath. I don’t think the Obama administration will have the political will or power to go against their base of unions and left and right wing protectionists. In fact, I wouldn’t be surprised to see protectionist measures implemented over the course of the year.

• Obviously, Australia left it’s interest rates unchanged. Screwed the carry trade for a lot of people yesterday, but was not that surprising to us. Remember, we’re long USD vs. JPY and vs. EUO. We just believe that USD will still be the beneficiary of the unwinding of risk as must happen. We should have been like Wells Fargo, who shorting the carry trade on the yield curve, and taken more aggressive positions in long USD.

• Where we went wrong: We’ve allocated a small portion of our portfolio to a metals portfolio. We built a position in gold and maintained it. We increased our exposure by building positions in SLV, PALL, and PPLT. We got in too late and should have diversified some of our gold holdings earlier. We are down between 8-18% on the positions. While it’s painful, we continue to hold these positions. First, the individual positions are small. Second, the entire position in metals is relatively small. Third, we maintain that the reasoning behind owning exposure to physical metals continues and we’re happy about the diversification into metals other than gold. We’re not in copper at all. Additionally, today we added a small exposure to GDX as the spread between GDX and GLD seems to imply that there is more potential for outperformance in the miners than in the physical. Here’s the chart from StockCharts.com:

This is the ratio of GLD:GDX. It’s not at the hyperextended levels of Oct. 2008, when the ratio was over 4, but it still looks like the valuation of the miners is low relative to the price of gold.

• Lastly, I want to discuss Treasuries. In 1992, as Soros was breaking the Bank of England, the trade was a simple understanding that no entity nor government is stronger than the market on a long term basis. We have been getting comments and notes about how we can see a continued debt deflationary environment, with a stronger dollar, and lower Treasuries. In the 1970’s, the thinking was that inflation and growth went hand in hand. Stimulate inflation and you’ll get to full employment (sound familiar?). Instead, we had a previously unimaginable situation where we had inflation and no growth, and with it a new term: stagflation. In my mind, we can enter a period where people will want to hoard dollars and not lend it out to the government. It’s the worst possible world for the Fed, whereby they will face higher borrowing costs without stimulating any inflation since the velocity of money will go down. If fiscal policy doesn’t cut government spending, we will be in a very weak position with very few places to hide. Once spending does start, we will face the specter of inflation that will continue to put downward pressures on Treasuries, this time on the short end. We are stuck and the losers will be the holders of long-dated Treasuries. For the Treasury market to rally from here, an investor would have to believe that the Fed, Treasuries, and government can orchestrate a “soft-landing” where domestic savings rates inch up, foreigners continue to want to finance our deficits, trade balances magically and incrementally improve, etc. I’m not a big believer.

Anticipation and why we’re not writing about the Euro

I’m seeing stories left and right about Greece…and Portugal…and Spain…and the EURO. I’m not surprised, but I feel like this is by now an old story for our readers. Europe is facing an unsustainable situation and it was only a question of timing for when would the “Union” come under fire. So now, everyone is talking about the PIIGS, or Greek spreads (not taramosalata), etc. but I feel like they should have been discussing these issues months ago. Instead, just a few months back, everyone was talking about the death of the dollar and shifting to the Euro to diversify reserves. I just couldn’t believe that Russian central bankers would get that right. For investors (as opposed to traders), you had to be set up months ago, and had to wait a while. Traders can now try to jump on the bandwagon, but the investor who was looking at the valuations and positioning of the major player could sit back and look at it unfold. So for us, there’s nothing to write about the Euro here. It’s still in trouble. We’re maintaining our short position versus the dollar (not adding, not taking anything off), and we continue to wait.

So now the question is how do we position ourselves for the future. Looking forward, the bond market seems to be the area that needs the attention. Why? Because it is the most heavily manipulated market right now. Let’s try to describe the real estate market to an outsider (in it’s current form): well, homeowners can’t afford the houses on the market, so the government taxes them so that they can give them a credit, then it provides them with cheaper financing than they deserve, thereby taking on risk, which it (the government) doesn’t know how to value and keeps off its balance sheet. Does that sound like a market you’d want to invest in? Probably not. Taking that description to the Treasury market, the government provides 0% financing (look how well that worked out for GM) to banks so that they can in turn lend it out, which they do. They lend it out to the government by buying longer dated bonds, which in turn is given right back to the banks for more cheap financing. If this sounds like an Enron type scheme, where there’s no economic value to the transaction, only the middle man gets a cut, or a large Ponzi scheme that is bound to fail as soon as one party runs out of suckers, then you understand our contention that the Treasury market is unsustainable. We are probably off on the timing, but we usually are early as we try to build positions in anticipation.

The inflation/deflation debate will be meaningless for the bond market. We can have deflation and declining bonds (just like we can have inflation with no growth, which was assumed to never happen prior to the 1970’s). Rates have to go up to reflect how expensive it is to lock up money and provide financing in an uncertain environment. The government can manage short term rates, but it’s the long-term rates that will tell the story. Bonds might stage safe-haven rallies, but the support will ultimately fail, as investors shy away from providing the US government with cheap financing. How many times can the Senate increase the debt ceiling? See related story: http://www.bloomberg.com/apps/news?pid=newsarchive&sid=as..HY4pCfZc.

If you haven’t seen it, please read Reinhart and Rogoff’s piece This Time Is Different piece, highlighting the tipping points for debt to GDP levels (happens to be 90%, the US is currently at 84% if you don’t use accrual methodology and don’t count Fannie and Freddie as government liabilities).

So now, we wait in anticipation. And once everyone realizes what’s happening, we’ll already have to start searching for the next place to wait. Investing is all about the waiting.

Is deflation winning out?

In the ongoing debate between inflation and deflation, we’ve heard both sides, tried to look to the historical record for guidance, sought comfort from statistics and experts, yet in the end have come up with strong arguments on all sides. We’re not even sure all the information is conflicting anymore, but in the end, we have to define and quantify a bias, a world view, a story that binds the different pieces together. We find ourselves continually biased towards deflation. It’s colored our decisions, and impacted our investments, and still we find ourselves now with seemingly conflicting investing ideas: short bonds and long metals sounds like it might be inflationary trades, underweight equity and long cash sound like they are deflationary trades. Underweight real estate, overweight India and zero weight to China – how do those all fit in? Are they hedges against each other? Compounding each other?

Let’s start with some basics. Deflation happens when an organization loses pricing power. It happens when organizations need to find lower market clearing prices. It can happen in positive ways (for example, by paying $500 for a laptop with the computing power that cost $5,000 a few short years ago) or negative ways (for example, when you’re house sells for 15% less than it did 3 years ago). It is initially painful to the seller, and especially painful to the levered seller. For the buyer, it feels great – initially. Until it doesn’t. At some point, the buyer decides that it’s worthwhile to wait longer for an even better deal. At some point after that, the buyer realizes that whatever product of service he/she is selling will probably also need to be discounted in order to clear, at which point a bit of fear sets in. And there’s the danger. On a more macro level – organizations that lose pricing power face a squeeze on margins. Those that are levered then face a squeeze on financing. On a more macro level – trade goes down, protectionism looks like a good idea, and then it’s over. At some point market clearing prices are reached, companies that survive with strong balance sheets regain pricing power, etc.

Why go through this exercise? Let’s think through the organizations we have to analyze: people, households, companies, governments. As we go through each organization, we find deflationary forces:

1. People – labor is not in control these days. Wages are stagnant, at best. Unemployment is at 10% and if you’re using good statistics, closer to 18%. If anything, wages will be put under pressure in the near future.
2. Households – continue to be indebted, even though many are trying to lower it. Residential real estate has been nationalized, with 95% of new mortgage originations occurring through GSE’s. Real estate has not stabilized, and commercial real estate is about to roll over.
3. Companies – retails has actually held up better than expected, but credit card defaults are rising and the consumer will require more and more sales (deflation) to purchase. Internal demand from Asia hasn’t materialize (yet). Most importantly, margins have risen to such high levels off the back of squeezing costs. Margins going forward will be tough without an increase in revenues, which hasn’t come.
4. Governments – governments can lose pricing power as well. Japan has been a startling anomaly, but I wouldn’t depend on it continuing or working for others. With debt to GDP starting to hit important levels, government bonds will lose their appeal, and with it, their pricing power. So, prices will have to go on sale. We’re seeing it already in the municipal bond market. We’re seeing it with sovereigns like Greece. We’ll see it with Treasuries as well. If the US government loses pricing power, won’t the dollar fall as well? Actually, it might not. The dollar will still be needed for trade, for a safe haven, and as a relative trade against the worse government situations in Japan and Europe, so we can have a situation where the dollar is up and the Treasuries are down.

All of these organizations seem to me to point to a contraction of margins on all fronts, loss of pricing power, consolidation, retrenchment, and balance sheet rewinds to the pre-”stock option/insanely low interest rate/agency-moral hazard games of manager vs. owner/etc.” times.

We continue to mistrust rallies at these valuations, and are wary of people screaming to buy the dips.

China reigns in monetary policy…

and the world catches a cold. We wrote about this a few weeks ago, whereby the Fed’s fear of being 1937′ers is completely misguided given that China might thwart any efforts to re-inflate. We are no longer living in a world where domestic monetary policy is sufficient. Interestingly enough, for you gold bugs out there, it is a better argument than historically for using physicals (gold being the most prominent) as the reserve currency. So China is telling banks to slow, or even halt, lending.

My main question is why now? Depending on your frame of reference…

If you believe the Chinese government is ahead of the curve, then China is reigning in inflationary pressures, making sure it’s banks are in strong shape, and this is a net benefit to China. Conversely, if you believe the Chinese command economy is not as strong as the numbers suggest, then this might be a sign that government officials are scrambling because the proverbial “stuff” is about to hit the fan, and they are scared. Guess what I think…

China needs a way to save face as it’s numbers start to come down quickly. If it’s part of a design, they might look smart. The growth stats are going to come down one way or the other, the only question is who will get blamed, which politicians will be lost along the way, and how the government squelches social unrest.

This is net positive for gold (although it doesn’t seem that way today), maybe USD (flight to safety?), and net negative at least in the short term for Asian block. Also, I think here a negative for China, might end up being a positive for India

Soon, it might be cheap to go to Europe

I top-ticked it, pretty much, by going to Europe this summer. A cup of coffee was over $7 USD. Meals at cafes were obscene. And the list goes on. Forget about taxis to meetings. Had I waited a few months, I would have gotten a nice discount. If I wait a few months from now, I might even find a bargain.

The euro is not a currency. It is a global experiment. There is a mismatch between fiscal, political, and monetary policy on a scale that is much bigger that when dealing with a single country. It is an experiment that is bound to fail at some point, except that it has had a lot of positive impacts for European investors. For one, they have ease of comparison. Sounds simple, but is quite important for business and trade. Second, the capital markets are now bigger, broader, and most importantly, deeper, with companies able to access previously difficult markets. For example, imagine that you are a company based in Italy. Previously, your capital markets, lending activity, securitization, etc. were pretty much domestically based. Germany was the only country that was large enough to have deep capital markets. So the euro worked on that level. Another benefit is the benefit to countries that wanted an alternative to the dollar. In my mind a flimsy benefit, not because everyone should love the dollar, but because they could have managed a portfolio of smaller currencies and it might have actually had a net benefit.

So again, we might turn the Euro around? Short term, obviously a pickup in world trading activity. Political will to cut social programs. Breaking the unions. Natural resource discoveries. Long term, either we’ll see a common political structure develop (highly unlikely, except in war) or the euro will be doomed – slowly, but surely.

1937′ers: We were all looking in the wrong place for them

While Bernanke & Co. continue to fear pulling liquidity to early, we might be learning that the Fed is not as in control as we would like to believe. Today’s story about China increasing reserve requirements and nudging up interest rates provides an interesting canary for our coal mine. As readers are aware, I don’t believe any numbers coming out of China, but that being said, the reported growth is truly astounding:

Data released over the weekend showed mainland China’s exports rose 17.7% in December from the year-earlier month, trouncing the 4% rise expected by economists in a Reuters survey and marking a sharp rebound from the 1.2% fall in November.

At the same time, imports vaulted 55.9% during the month, also comfortably beating the 31% jump estimated by economists. The surge helped narrow China’s December trade surplus to $18.43 billion from $19.1 billion in November.

For full story, click here.

While we can argue about fake growth, or inefficient growth, or government stimulus making the bulk of this fake demand, the real issue becomes forward-looking. If China takes liquidity out of their own market, might it cause liquidity to be lower in the US? I believe it will. It might happen through higher rates, it might happen through decreased international trade, it might happen as our exports (already lagging where you’d expect given the dollar) continue to disappoint. The truth is that I’m not really sure of how this will play out, but I think the Chinese might be realizing they are in serious trouble and can’t sustain the absurd numbers they’ve conjured up, and like any ponzi scheme they will crumble under the pressure…eventually. I think they are trying to ward that off, but if I were a Chinese national with money in the bank, I’d be looking for ways to get it out, and this might have incredibly bad ripples for the US monetary authorities as our most valuable buyer of Treasuries faces serious problems that it was able to hide for the past decade.

If I were Bernanke, I’d be very worried about the Chinese monetary and banking games being played out right now – more so than any currency manipulation of the past.

http://www.marketwatch.com/story/analysts-divided-on-pboc-tightening-2010-01-12

Pimco’s Gross boosting cash position

Yes, cash is an asset class. And yes, some of the best managers use it, especially if they see opportunities on the way. This move by Gross (to raise cash) is actually incredibly deflationary on his part. It’s saying that cash will outperform bonds. Cash hoarding in anticipation of lower prices is a deflation bet and I believe others are moving in that direction more and more, not willing to lend out their cash, even to sovereigns…even to Uncle Sam.

http://www.bloomberg.com/apps/news?pid=20601087&sid=afujGCGEdlp8&pos=3

The fact that Congress is raising the debt ceiling, certainly doesn’t lend confidence to the Treasury market, especially given last weeks performance : http://www.marketwatch.com/story/house-aims-to-pass-debt-increase-jobs-bill-2009-12-16

Confirmatory bias: Yup, I don’t like the Euro

A national government that willingly gives up its sovereignty is not going to last, which is exactly what a common currency requires. In the US, States did it only after a lot of turmoil and war. Will the Euro-zone be able to pull it off long-term? I highly doubt it. It’s another soon-to-fail experiment. http://globaleconomicanalysis.blogspot.com/2009/12/eh-tu-germany-finance-minister-says-no.html

What’s interesting is that I’ve been hearing rumors that some Middle East countries are considering a common currency (Dubai is upset because the Saudis hope to be at the center of this movement). This comes about every few years as oil producing countries get tired of accepting dollars. The only thing worse than the dollar for them is their neighbors currency, which they know for sure they won’t be able to trust, so I doubt it will get anywhere, probably to the benefit of all players.