The Silver Lining to the Debt Crisis

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.

Chinese labor shortages?

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.

Crude Oil

If crude hasn’t gone down by now, do you think it will? Unless demand crumbles, what will push it down from here? Oil is now in limbo and I believe geopolitical tensions will provide a support.

Here are a couple of scenarios:

We’ve seen inflation remain tame. If jobs do not pick up, inflation may remain tame (Phillips curve), at which point oil should stay stable, as it has. If jobs do pick up, then inflationary pressures may ensue, at which point you probably want to be long oil. So let’s assume that oil goes down to 30% from here to the $55 range, which isn’t unlikely if there’s major deflation or continued global economic slowdown. If there’s inflationary pressures and even some geopolitical plays, then oil could easily surpass any previous high. Then you have to put weights to get an expected return. It appears to me that at this stage, the risk/reward for oil might be attractive. I do not have any direct exposure at the time of this writing, but this is one of the areas we’re exploring now.

For those interested in Phillips Curve stuff, click here for the latest research from the San Fran Fed.

Deflation vs. Inflation, Pritchard vs. Rosenberg

It might seem unrelated, but a couple of stories came across my desk almost simultaneously.

The first is an article by Ambrose Evans-Pritchard about why deflation is ahead. In essence, his argument is that real estate prices haven’t stabilized, so what inflation can there be. For the full article, click here.

Then at the same time, I received this article about Bright Food, the biggest food company in Shanghai, buying the sugar unit of Australian CSR. Why would it buy CSR after prices more than doubled? Seems like they are either late to the game or they know something we don’t. Chinese companies have been trying to secure access to materials of all kinds with long-term trade agreements and outright purchases.

Conflicting signals? Yup. As for me, I see both sides and am still not sure. One thing that does make me want to secure my own access to resources (and clients’) is the geopolitical risk that I believe is rising. For example, click here.

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

Maybe I was wrong on inflation

In my last post, I wrote that I don’t see the increased PPI as necessarily pointing to inflation, yet, in the spirit of showing the other side, I must address the following announcement from Coke.

Coke banks on smaller packs to counter commodity price rise

Press Trust of India / New Delhi December 15, 2009, 17:17 IST

Pressed hard by rising input costs, especially that of sugar, global beverages major Coca- Cola is turning towards smaller packs for its products in order to push volumes and keep pressure on margins in check.

“The (rising) commodity prices are putting pressure on our margins…We have done cost rationalisations of our products. Besides, a lot of innovations in terms of new products and different packages have helped us,” Coca-Cola President and Chief Executive Officer Atul Singh told PTI.

Speaking on the sidelines of the Global Sports Summit held here, he said increasing commodity prices, especially that of sugar has “clearly impacted our cost structure”.

In order to reduce the pressure on margins, Coke has come out with smaller packs for its products, which are priced slightly lower than bigger packs. For instance, it has launched its fruit drink ‘Minute Maid Pulpy Orange’ in a tetrapack of 250 ml priced at Rs 15 compared with 500 ml PET bottles for Rs 25.

Earlier this year, the firm also introduced its popular carbonated drink ‘Sprite’ in a 350 ml bottle for Rs 15, which was available in a 500 ml bottle for Rs 22.

Singh said cost rationalisation and innovative packages have helped in maintaining volume growth that the company has witnessed in the last 13 quarters.

Coca-Cola has posted 37 per cent volume growth in India during the third quarter ended September, 2009.

For anyone who remembers what a real Hershey’s bar looks like, one of the ways inflation can creep in without notice is when prices remain the same, but packages gets smaller. So choose your positions carefully.

Coke banks on smaller packs to counter commodity price rise

Press Trust of India / New Delhi December 15, 2009, 17:17 IST

Pressed hard by rising input costs, especially that of sugar, global beverages major Coca- Cola is turning towards smaller packs for its products in order to push volumes and keep pressure on margins in check.

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“The (rising) commodity prices are putting pressure on our margins…We have done cost rationalisations of our products. Besides, a lot of innovations in terms of new products and different packages have helped us,” Coca-Cola President and Chief Executive Officer Atul Singh told PTI.

Speaking on the sidelines of the Global Sports Summit held here, he said increasing commodity prices, especially that of sugar has “clearly impacted our cost structure”.

In order to reduce the pressure on margins, Coke has come out with smaller packs for its products, which are priced slightly lower than bigger packs. For instance, it has launched its fruit drink ‘Minute Maid Pulpy Orange’ in a tetrapack of 250 ml priced at Rs 15 compared with 500 ml PET bottles for Rs 25.

Earlier this year, the firm also introduced its popular carbonated drink ‘Sprite’ in a 350 ml bottle for Rs 15, which was available in a 500 ml bottle for Rs 22.

Singh said cost rationalisation and innovative packages have helped in maintaining volume growth that the company has witnessed in the last 13 quarters.

Coca-Cola has posted 37 per cent volume growth in India during the third quarter ended September, 2009.

US PPI

Producer price index rose 1.8% in November, seasonally adjusted. Here’s the statement:

The Producer Price Index for Finished Goods rose 1.8 percent in November, seasonally adjusted.
This increase followed a 0.3-percent advance in October and a 0.6-percent decrease in September. The index for finished goods less foods and energy rose 0.5 percent in November.

So what does it mean? No one knows . . . yet. One month in the busy holiday season does not a trend make. But it might be pointing to a pickup in inflation (if it flows through to the finished goods). That would be a positive and a negative. It would be a positive in that it would mean that companies have pricing power, can raise the prices of goods and thereby maintain margins. It would be a negative in that Treasuries would continue selling off and rates would rise. All in all, I don’t think companies will have the pricing power to match the increase in PPI. Best Buy came out today with great numbers, except for the fact that the things people are buying are the lower margin items. If PPI goes up but companies do not have the ability to raise prices, that means pressure on margins, which are already cyclically high. Net, this might signal lower bottom line earnings, so I don’t see this as a sign of inflationary pressure. Also, with real estate still not stabilizing, owners equivalent rent will continue to put downward pressure on the CPI, and coupled with 10+% unemployment, decreased new lending, and lots of spare capacity for utilization by factories, I don’t see this as immediately inflationary.

The currency markets and Treasuries…

That’s where you need to keep your eye on as we come into year-end. Tonight, there’s a lot of data coming out of China:

Producer Price Index: cons -2.4% y/y
Purchasing Price Index: cons -4.0% y/y
Consumer Price Index: cons +0.4% y/y
Retail Sales: cons +16.5% y/y
Industrial Production: cons +18.2% y/y (some are saying this might disappoint, but I’m not sure what impact it will have given the other numbers.)
Trade Balance (not sure when): it is expected to show a surplus of $24.30 billion, up slightly from the October reading of +$23.99 billion.

We’ll review some of these tomorrow after they are released. Will one set of data make the difference? No. But right now we are looking to see if there are more threats on the horizon for the Treasury market. It could be very dicey for Bernanke and the Obama administration if Treasuries sell off (remember, the Fed has more impact on short term rates than long, but a lot of liabilities, such as mortgages are priced of the longer-end).

From a monetary perspective this could be another “new” development in the field. Before the 1970’s, there was a consensus that inflation came with reduced unemployment, so in order to stimulate employment, all government had to do was stimulate inflation. The 1970’s brought us “stagflation”, namely, higher inflation but no jobs. Now, we might have a new term, let’s call it: CONTRAFLATION. In a CONTRAFLATION world, everything economists think is exactly the opposite. For example, you CAN have a strong dollar with rising long term rates. We’ll continue to explore these themes later, but we maintain our short Treasury, long dollar positions. The new Bizarro world, has one thing in common with all other environments, you don’t want to be in the same trade as everyone else, and the marginal money is still short dollar long risky assets.

Is the reflation trade dead?

The short dollar / long every risky asset trade is incredibly crowded. The dollar as a funding currency worked for a long time, but for the late-comers, I’m afraid that this will be the time of reckoning. We may see a serious correction in risky assets, and that is negative for emerging markets, negative for equities, and negative for Treasuries (yes, they are a risk trade, as banks were surfing the curve for net interest margin, NIM).

Just because it shows up on Bloomberg doesn’t make it so, and there’s definitely some confirmatory bias here, so take it for what it’s worth: Reflation Trade Is Dead

Treasury auction “sloppy”

The government didn’t get the subscription levels it was hoping for, yields are up, and the market is facing a new reality. We have come to depend on foreign purchases of our debt. The recent norm has been about 45% of buying coming from foreign lenders (foreign governments, banks, etc.). In contrast, this auction had only 35% coming from those same lenders. (http://www.marketwatch.com/story//treasurys-under-pressure-before-10-year-note-sale-2009-12-09) Where are they? In my mind, sovereigns need to buckle down and keep their cash on hand in case they need it for domestic spending. In that case, they wouldn’t want to pile it into UST. Yes, they are probably afraid of currency fluctuations and the US credit rating, but I think they are more afraid that 1. they get no return on their money and 2. they might actually need it.

We’ve discussed the short Treasuries trade for a while and are still holding on to our TBT position. We are in an environment where we could see a stronger dollar and declining Treasury prices simultaneously. In the past, a strong dollar led people to park their cash in Treasuries, but now, I think people will want to hoard their cash (deflationary) and not lend it to the government. It will be good for the savings rate – at least that. In every other respect it will pose big problems. For one, it’s deflationary, which scares the Fed. Interest rates rising may lead to another leg down in real estate (I believe this is happening already, and can be especially troublesome with the tighter lending standards).

One of our readers talks about “deflation in wants, inflation in needs”. I think he’s probably right on a relative basis, as needs will go down less than wants, but overall, both will be impacted. Yesterday, Kroger reported that even without writedowns, profits would have been down 26% (http://markettalk.newswires-americas.com/?p=6822), so the needs vs. wants might not be so clear-cut.

So the disconnects continue, and the fear of deflation continues to haunt Bernanke. But maybe, just maybe, deflation isn’t that bad. Maybe deflation is the economy’s way of rewarding the savers, despite all attempts to reward the over-spenders. Maybe for those who have savings and cash on hand, the time might come in the not-too-distant future when spending and investing (namely, putting your cash to work) will make a lot of sense. See also: Mike Shedlock’s piece from a couple of months ago (click here).

Gamestop and deflationary signals

Continued deflation in wants. First it was the Wii. Now the games (unfortunately, we own GME in client accounts – we thought they’d come out better than most). Next stop the retailers? Will margins getting clipped across the board. With margins at cyclical (secular) highs and revenue stalling, P/E’s look awfully high.

http://www.bloomberg.com/apps/news?pid=20601087&sid=apB3tUG1UVxA&pos=7

Notes from underground – Yra Harris

Not comfortable going into the weekend

Japan back in deflation mode (http://www.ft.com/cms/s/0/44fea966-d59c-11de-b80f-00144feabdc0.html), USD unstable, weak government officials who will need to make bold statements over the weekend, yields going negative (but everyone saying don’t worry)…this doesn’t smell right. Problem is, if you’re not already positioned, it will be tough to do in the next 12 minutes. But the currency markets are the ones I’ll be watching especially closely this weekend.

OK, I’ll say it, I don’t completely agree with Richard Russell

Here are some excerpts from Russell’s latest commentary. I’ll start with the parts with which I agree.

…Clearly [based on an earlier quote] Buffet is expecting inflation in the years ahead. I just received the latest “Insight” report from my brilliant friend, A. Gary Shilling. The report is entitled, “Investment Strategies In An Era of Slow Growth and Deflation.” Gary is convinced that the trend ahead is deflation. Buffett or Shilling, who are we to believe? No wonder the stock market is so erratic with the Dow up 100 points one day and down 100 points the next.

I agree. Inflation and deflation are slugging it out and so far, both are winning and both losing. The long end of the curve is pricing in deflation, expecting rates to stay low, growth to be anemic at best, and depreciation in all classes of assets, from residential and commercial real estate to equities to art. Simultaneously, inflation is winning, with the dollar being used as a cheap currency to buy anything and everything: Brazil, equities, gold.

Russell continues…

…OK, then how about this? You can take the phoney money that the Fed creates and you can actually buy something real with it. That “real something” can be gold or it can be a foreclosed home or it can be top-grade stocks like the thirty stocks that make up the Dow. Trade Fed-created junk for something real? Why not, it certainly makes a lot of sense.

This is the essence of the carry trade and I’m definitely not sure that it makes sense on any fundamental basis. In fact, in a few paragraphs Russell highlights how there’s a big disconnect between the financial and real economies right now, yet he still favors owning these irrationally priced assets. Hmmm.

But there’s something else. Sophisticated investors are beginning to distrust ALL fiat or central bank-created “money.” Moreover, they distrust a situation where central banks all over the world are creating huge additional amounts of their phoney money. Knowledgeable investors are starting to place all fiat money into a single class. And they distrust that class. They distrust it because they think of it as “junk money gone wild.” Their reaction — turn in your junk money for the one type of intrinsic money that has represented wealth for 6000 years — gold.

He’s right. A lot of sophisticated investors are turning to gold, but that doesn’t mean that they are right nor that there are fundamental reasons to buy it here.

…The other situation I’ve been thinking about is where the greater safety lies, in gold or in stocks. In his column in today’s New York Times, Paul Krugman calls what we’re going through the “greatest collapse in world trade in history.” Ordinarily, that would call for a bear market in stocks. But the enormous expansion in liquidity has trumped the fundamentals. The Dow continues to rise — as an ocean of money is flowing into the stock market. The rising Dow rubs off on other stocks as they start to look “cheap” compared with the stocks in the Dow.

But the fundamentals in the economy are leaving big holes in the bull arguments. Can a nation be prosperous when millions of its citizens can’t find jobs? Can a nation be prosperous when it can only sell the world (exports) when its currency is weak? Can a nation be prosperous when it’s losing its manufacturing base? Can a nation be prosperous when there’s a disconnect between its stock market and its economy? Can corporations be doing well when their so-called profits are higher but their revenues are lower?

I fully agree with this sentiment. In an economy with decreasing trade, decreasing manufacturing, rising unemployment, decreasing velocity of money, and all the other things he mentions, where does he see inflationary pressures coming from? There is a disconnect in the argument and in the arguments I’ve heard from every inflation-monger.

But remember, in this business we don’t buy fundamentals or logic, we buy direction and the flow of funds.

I do not. I do not try to catch the train, and if anything, often find myself in unpopular trades. In fact, not too long ago, I discussed here my initiation of the short Euro and short Yen trade vs. the Dollar. I will be looking to add to it. Russell has been around a long time and I really admire his insight, but there is too much riding on the inflation trade that I can’t get comfortable with.

Some here have spoken of “deflation in wants and inflation in needs”. I thought about that recently, and think that as unemployment or fear of unemployment rises to 13% or higher, consumers will reign in the spending, go out less, etc. and in the process, buy less of everything or just buy cheaper versions. Additionally, there will be one other great deflationary pressure: the dollar can go up. For those of us who like the contrarian trade, or at least believe in a reversion to the mean, what would you rather own: an asset that has gone up about 300% or one that is down about 40% in the last 10 years? Just some food for thought.