Soros in the FT, Munger in Slate

What we’re watching unfold…

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

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.

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.

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.

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.

Austria – fears of contagion

Looking at all the news out there, it would appear that between Dubai, Greece, Spain, and others are not as contained as originally thought (by some unnamed government officials, you know who you are.) So it was with no surprise that I read about fears of the contagion spreading to Austria, a nation that was hoping to become the link between eastern and western Europe: http://www.ritholtz.com/blog/2009/12/bank-collapse-in-austria-brings-debt-in-eastern-europe-center-stage/

What’s actually interesting is that there was a clear sign months ago about Austria: The Economist had them profiled in a cover story that spoke about the unique geographical, historical, etc. foundations that placed Austria in such a unique position. Now, I tried looking for the cover, but I just can’t seem to find it, BUT I know it’s there somewhere. If anyone has a picture of it, please send it along.

Notes from underground – Yra Harris

Notes from underground – Yra Harris

Bloomberg reports: Greece/Ireland may leave Euro

How long will Germany want to hold up and finance the Euro? It was fine for a few years, but there’s a limit to everything. Herein lies the underlying problem with the Euro: it requires one to sacrifice national interests for the benefit of monetary stability; it’s a pegged currency – which never works! Politicians, who are beholden to local populations, would want to print money when the economy goes down, but that isn’t possible when you’re currency is pegged. In the end, the peg always ends in pain and a revaluation occurs. In this case, either Greece has to leave the Euro completely (makes one question the currency anyway) or Greece will have to be revalued. I don’t even know if the Euro charter has any mechanism to deal with sovereign spreads this wide. Why did no one think of this at the time, you ask? People did, but no one wanted to listen as the idea of having a balance to US supremacy, and visions of pan-European cooperation went wild. Ironically, how much stronger would the Euro be now had they accepted Turkey? Turkey is thanking its lucky stars for unanswered prayers, as it will end up coming out of this period significantly stronger in the geopolitical world.

http://www.bloomberg.com/apps/news?pid=20601102&sid=a3SIOdqSGOtE

Notes from underground – Yra Harris

Greece in the news, but it’s just one part of the picture

Readers of our newsletter won’t be surprised to learn that the world cares about Greece (and Dubai) – still.

From The Big Picture:  Yesterday no one cared about Greece, today they do

From the FT:  Fitch strips Greece of A-grade credit rating

As I mentioned, my view is that this is a big net negative for the Euro, and may thwart Bernanke’s reinflation plans as USD gets squeezed up. I also have a feeling that Dubai and Greece aren’t the only ones. Smaller countries in the eurozone may also be in trouble, which will place added pressure on Austria (which has built it’s recent economy on lending to emerging Europe). In my mind, Austria and Spain are the big ones to watch. If they hold, the euro will have a fighting chance. If they go down like Greece and Germany needs to finance increasingly large neighbors, we’re going to see the euro crack.

Notes from underground – Yra Harris

Very little news and action after the wild ride on Friday’s unemployment. The DOLLAR stayed relatively strong after its significant rally on Friday. The YEN regained some ground on all the crosses as we have word of a stimulus package out of Japan. The DPJ finally approved a 80.6 billion dollar stimulus plan and this gave some immediate support to the YEN, but we don’t expect this to last as the Japanese are nervous about a strong currency while deflation is renewing its vigor. Now that a stimulus program has been approved we need to be watchful of some type of intervention to stem the recent YEN strength.

Tomorrow morning [8 a.m. CST] we will hear from the Bank of Canada. We expect no change in their current interest rate as the CANADIAN DOLLAR remains relatively firm and this has been a concern of the Bank. If the currency weakens after the no change we would look for the LOONIE to regain its strength as its fundamentals remain the most attractive. Wednesday will bring the PBR from Britain. Chancellor Darling will deliver his outlook for the British economy and we are waiting to see if the budget will reign in the massive amount of stimulus that has run the current deficit to over 12% of GDP. The question is curtail spending or raise taxes. If the budgetary stance is for cuts in spending we don’t anticipate much movement in the STERLING but we believe that higher taxes would have a negative effect. Britain has to be careful to not tax the financial jobs out of LONDON as some hedge funds and private equity groups have already announced their intentions to move to more favorable business environs. This coupled with the anti anglo-american sentiment emanating from Brussels the British need to keep their financial markets globally competitive or risk losing the golden goose. The euro/sterling cross will be very directional for this sentiment —as always check the technicals to ascertain the real story. If Euro/sterling holds support we will see continued weakness in the British currency.

Initiating new position

Over the past several weeks, a big focus for me, my clients, and our community has been currency, and especially the relationships of gold and the equity markets to different currency pairs. As I’ve mentioned, I initiated a position in long USD vs yen and long USD vs. Euro a couple of weeks ago, and am facing a slight loss so far, but I’m holding on for now. I now also initiated a short Treasuries position, via TBT. Using levered ETF’s is not my favorite because of the daily compounding effects which we’ve spoken about before. However, they also often provide a cheap, easy implementation tool, which is how I view them here. All these positions are relatively small (less than 3%). This is not a recommendation in any way, but just wanted to keep you posted. For the record, my position was initiated late in the day (purchased TBT at 46.03).

We are also working with our tech group on constantly offering new improvements to the site. We are working with tech people and our compliance group to see how to show a portfolio, tracking trades, ideas, etc. so be on the lookout in the next couple of weeks.