Going where the crowd isn’t

If you’ve ever watched 6 year olds play soccer, you’ll recognize the phenomenon – 20 kids constantly running towards the ball. Where-ever the ball goes, so do the kids. Investors are often quite similar in their need to go to the ball, and we often discuss some of the heuristic biases that lead us to follow that pattern. While there are numerous studies to support the value of some momentum strategies, I prefer the more staid value strategies that tend to produce better results without as much running.

In that light, let’s examine where the crowd is and isn’t. Certainly, the days of gold being a side-show are over. Can gold go to $5,000? Maybe, but it was easier to get in when it was at $800 than it is now at $1,300 when everyone is talking about it. I still hold gold and gold related shares, but as I wrote about a year ago, I also hold silver, platinum, and palladium. I’m not selling here, but not buying more either.

Where is the crowd definitely gathered? Treasuries are one place. Institutions have no choice but to be buy the little yield that is available to them. So we’re not only staying away, but staying short. It has been a difficult position to hold, but then again, standing alone on the field while everyone is running to the ball can feel lonely. At the same time, everyone is running away from the dollar. And to what? To the yen? To the euro? Well, we should have focused less on G3 and G8 crosses, but I continue to maintain that the picture is worse for Europe and Japan long-term than the US.

So what is the crowd really missing? I think geopolitics continues to be the most underpriced risk/opportunity in the market. Oil, energy, and defense companies are not much appreciated. We have positions in all, including specific names (such as NOV, RTN and others), ETF’s (such as NLR – nuclear – and others, etc. Oil is just starting to awaken, and I think it has a lot more room to go:

Commodities such from corn to coffee have also been all the rage, but I think if you don’t have a position already, you might be late to the party.

In a debt deflation cycle, I think there are also opportunities for companies with strong balance sheets, low debt, and an ability to maintain some margins. Companies that are issuing a lot of debt, even at cheap prices, are putting themselves at risk if their margins get squeezed. In a rising inflation period, levered companies are in a better position, but retailers are dropping prices, which means that the debt will become relatively more expensive. The new debt issues seem like a high risk low return trade to me.

Deflation in assets, Inflation in goods

I didn’t know what to title this post as it will contain links to a number of articles and charts that are meant to tie together some themes we’ve been exploring together and trying to get at the “end game”. The question on every investor’s mind right now is where are we heading with our current policy path? The question is not isolated to what should baby boomers do, nor China’s currency, nor movements in the corn market. It is all of it. So let’s attempt to put it together (albeit messy)…

Let’s begin with the most obvious crack – deflation in assets. In the entire G8, and certainly in the US, real estate is the single biggest asset for most households. In the wake of easy monetary policy this asset rose, then fell. We all know the story, so I won’t go too deep into it. (For reference IYR went from 92 to 24 in less than 3 years.) Easy monetary policy continued, and I was quite sure that inflation pressures would begin, but we didn’t see them. In fact, real estate hasn’t stabilized and luxury is under pressure from every corner.

In late 2009, as the world was pronouncing the death of the USD, I went long and shorted the euro and yen believing that there was no way the rest of the developed world would not be affected. I was right on the euro and wrong on the yen. What has been interesting this year is that the euro continues to face structural difficulties from its member-nations, yet investors have started believing that it still represents a safer haven than the USD.

The yen too “should” be crying uncle, and yet, even a commitment from the BoJ to defend the USD!!! has not forced any significant sell-off of the yen. What is going on here?

Bernanke must be happy to get a little USD weakness, but the rest of the world is starting to worry that their efforts at weakening their respective currencies aren’t working. I expect Germany to come out with slower economic numbers in the next two quarters and thereby face fresh calls for increasing efforts to weaken the euro.

Investors are aware that this is no longer zero-zum, but rather a negative sum game. Brazil is issuing debt to buy USD! This is competitive devaluation at its worst. Keynes must at least be enjoying the experiment, especially since he won’t have to pay for its fallout.

On the other side of the currency world are the commodities. Again, we’ve discussed corn and wheat and MOO ad nauseum. But it’s so important, not just for understanding input prices. After currency intervention, access to raw materials and food stuff is the next prong of the economic war being waged. China’s dependence on world gran has gone from 0% 10 years ago to 15% currently. Countries from Russia to Malaysia are putting limits on exports of certain goods and its only a matter of time before each government is forced in to increasing protectionist regulations. Commodity prices are up and I suspect they will correct, but the structural changes are in place to provide a base of support and a springboard for some commodity prices to soar. I’m on the lookout for talk of “strategic reserves”, “national security”, and s”trategically important industry” to increase across the world.

Throughout, competitive devaluation will continue. People will spend money on goods – generic foods, household necessities, etc. but they won’t spend money to bid up assets. Agricultural real estate will win, but commercial real estate will not recover in the near to medium term.

As promised, some links:

• This is a must read from Albert Edwards at SocGen.

…[T]he biggest threat is that this most recent invocation of the nuclear option is coming at a time when the world is least prepared to handle it – social imbalances are at unprecedented levels, and if, as many predict, the price of key food products is about to surge (courtesy precisely of these failed central bank policies) to a point where the great unwashed end up on the wrong side of hungry, from there, to armed conflict, the line is very, very thin.

From John Murphy Intermarket Analysis (1991):

Consider the sequence of events going into the fall or 1987.  CRB prices had turned sharply higher, fueling fears of renewed inflation.  At the same time interest rates began to soar to double digits.  The USD which was attempting to end its 2yr bear market, suddenly went into a freefall of its own (fuelding even more inflation fears).  Is it any wonder, then, that the stock market finally ran into trouble?  Given all of the bearish activity in the surrounding markets, its amazing the stock market held up as well as it did for so long.  There were plenty of reasons why stocks should have sold off in late 1987.  Most of those reasons, however, were visible in the action of the surrounding markets and not necessarily in the stock market itself.

I’m not suggesting things are the same as 1987, by the way. But Murphy touches on one of the most important issues we discuss in our newsletter – different markets that might seem far-flung are interconnected and investors need to understand or at least explore the relationships between them. To that end, commodity prices are telling a different story than bond prices. Commodities are telling us that CB’s may succeed in stimulating inflation, but it can come faster than they can control. (YTD CORN is up 30% – just one example.)

Throughout, the CB’s will probably continue to print money in a race to the bottom. Make no mistake – this is economic warfare, with national strategies (witness the Chinese buying JGB’s to force the BOJ’s hand), egos (witness “Helicopter Ben” needing to prove his theories right), and sacrificial pawns (witness 43 million Americans living below the poverty line).

Throughout it all, I continue to scream from the rooftops that the market is underpricing geopolitical risk. Chinese ship movement toward the Indian Ocean, Iran, North Korea, and the random sociopath (plenty of those out there) are just a few of the current “knowns”, not to mention the “unknowns” that will be coming out of the woodwork as social instability and civil unrest rise.

I started this post as an exploration, but realize now that it is incredibly depressing and negative. I’ll end on a positive note: Zynga, the biggest social gaming company in the world, moves 1 petabyte of data EACH DAY! and adds as many as 1,000 servers each week! They site is producing more information in a day than was available in the entire world just a few decades ago. Pretty astounding. And for those who WANT to end on a depressing note, read this in relation to the information on Zynga (I’ll give you a hint: Fahrenheit 451 and 1984 as dystopian novels are eery predictions of social gaming and reality TV.)

For a look at how the economy is really doing – CAG

While everyone was waiting and watching an incredibly boring session pre-Fed, then a 30 minute interlude of head fakes, the real story today was ConAgra.

CAG cut their fiscal year outlook due to consumers buying less of the high margin products and higher cost inflation. This is a continuation in the theme we’ve discussed where luxury at every level is going to get discounted. Premium milk brands at DF were our focus a few weeks back, but it’s happening at every level. On the flip side, generics should be relative beneficiaries and companies positioned as low-price brands.

This also made me come back to the restaurant business, which one of (in not THE) largest employer in the country. Consumers cutting back spending – not good for restaurants. Higher price inflation in everything from corn to cheese – not good for restaurants. In the meantime, investors in YUM don’t seem to notice, but I think they soon will. Restaurants might be like retail in 2007-2008 – when investors start heading for the exits, there will be a lot of spilled milk.

So while the Fed continues to be the focus of attention, I think the real story today is CAG. At its heart, the news from the company confirms what most people already know – this isn’t a recovery by any standards and everyday costs are rising while assets (homes being our collective largest investments) are declining.

For the record, at the time of this writing I have no position in any of the stocks mentioned, but that is subject to change. This is not investment advice in any way, shape, or form, and readers are encouraged to do their own research.

Inflation stories starting to surface

Deflation has been all the rage the past few month as bond prices continue to astound bringing yields down, and analysts like David Rosenberg at Gluskin Scheff turn out to have been right. And, I admit, I too have been in the deflation camp, arguing that a global slowdown, and a Chinese slowdown especially, will cap any upward price pressures. I’m still in that camp, but not as adamant as I used to be. There are a few major trends on the horizon that are starting to tilt me to the other camp.

The first is structural. Globally, governments are all in stimulative mode, trying to outdo each other on the easing fronts. Japan is the classic story of the government continually being thwarted with higher yen, but if there’s one thing a government can do effectively is devalue the currency, so I expect the government to eventually win. But Japan is not alone. Ireland is issuing debt to itself, in an apparent twist on the ponzi scheme – in the Irish version, they’re actually pyramid-ing themselves, without bringing in new investors. Hmmm. Probably not going to work out well for them. The US too is in easing mode, which will eventually mean yields will rise. So, while I’m not in the inflation scare camp yet, global easing continues to make me fear fiat currencies.

Then, there are the stories, apparently unrelated, but sounding incredibly similar. Coffee prices up by a third in the past few months as reported by the WSJ. How about Russia banning exports of wheat, sending the prices higher? What about gold hitting new highs? Check out the corn ETF:

True, energy hasn’t skyrocketed, but it also hasn’t broken down in the face of global slowdown. How about POT getting Chinese interest? Or the increase in rare earth materials? For now, a lot of these prices moves are supply disruptions and not being driven by demand, but could they lead to an increase in consumer prices and a flight to “needs” in the near future? Very possibly and it’s something to keep an eye on. For now, economic slowdown and consumer retrenchment are the orders of the day, as is debt deflation (coming soon) on the corporate and sovereign sides, and depressed equity valuations. But at least on a relative basis, if not on an absolute basis, the recent moves in the above mentioned markets might give us insight into where to invest.

Spoiled milk

The markets seem to be in a cheery mood, as does everyone on TV; so why am I still down? Spoiled milk.

Dean Foods came out with earning earlier today, and it wasn’t pretty. The company posted a profit of $44.79 million, or 25 cents per share, on revenue of $2.95 billion. That compares to a profit of $64.14 million, or 38 cents per share, on revenue of $2.67 billion during the same period last year. We’re talking a 30% drop in profits. The stock is down roughly 7% as I write this, but that’s not why I’m down (I have no position in the stock at the time of writing). I like looking at consumer staples for messages, and this one is loud a clear – consumers aren’t buying the brand name milk! They’re buying generic. They’re not buying less of it, just buying the cheaper version. That’s the problem, by the way, of selling commodities. When pressured, demand will flow to the lowest priced substitutes.

Anyway, if it was just DF, I’d hear the message, but not give it too much credibility. But Proctor & Gamble (PG) had the same message waiting. Earnings fell 12% from a year ago. Are people really switching out of their premium-brand toothpaste for the store brand generics?

DF already broke down a few months ago, so the market shouldn’t be THAT surprised. Could it go lower? Obviously. But in my mind, PG, which has held up well is even more vulnerable. It hasn’t participated in the recent rally, and its bretheren like JNJ, had a crappy month when the rest of the market was pricing in who-knows-what.

What’s next? Switching to generic drugs? Is there no end to the sacrifice? For all the inflation talk out there, these companies are sending us a message from the consumer. Spending is coming in, savings rates will rise, luxury and “wants” will be pressured, while “needs”-spending will flow to the lowest cost producers, pressuring margins and (I guess – eventually) valuations.

Disclaimer: no position in any stock mentioned. Not investment advice and should be used for informational purposes only.

Random thoughts mid-morning

• Consumer sentiment plunges – surprised? If so, then you’ve been living in a cave. Of course it’s down.
• CPI is flat (ex-food and energy) to down (slightly). Gives the Fed breathing room for QEII if they need it, except the dollar is weakening anyway in different pairs, most notably…
• Yen!!! Someone is squeezing the shorts in yen and BOJ isn’t stepping in (yet?) to fight them. Is China buying it up? Is this just a massive unwind? I don’t know, but something here doesn’t smell right. The yen is one of the fundamentally weakest currencies.
• Financials are taking it on the chin, and rightfully so. The market is recognizing the games these companies are playing. In a normal market, these accounting moves would border on fraud, except that the government either has a stake in them, or is afraid to move against them. Either way, I’m staying away.
• GS – of course they settled. The Obama administration thought first that demonizing GS would help them look tough on investment banks. When the markets turned south, the administration thought that a settlement would help lead the market higher. In both cases, they got it wrong.
• This is the time to be a challenger as every seat at every level of government is up for grabs. Doesn’t matter what side of the aisle you’re on – if you’ve been in office during the past 2 years, your seat is up for grabs.
• Iran. North Korea. Geopolitics in general. Just to quiet for me to feel safe. I’m a city guy, so I feel safe with noise. The summer quiet time on the global scene is not conducive to my sleep.

Connecting the Dots 7-15-2010

We haven’t done that in a couple of weeks, but the time has come…

Let’s start with the Baltic Dry Index ($BDI) which continues to head down:

Call it triple top, call it Stanley, call it whatever you want, but recognize that it is weak. It’s true that it’s backward looking, so we also want to keep an eye on forward shipping rates. Comments from a subscriber:

ShippingOcean freight rates for the C4 route (capesize vessel from Richards Bay to Rotterdam) were down $0.10 to $10.90/MT for Q4 2010, unchanged at $11.00/MT for 2011, and unchanged at $11.88/MT for 2012

A pretty flat curve.

Certainly not inducing inflation fears.

Next up, we look at mortgage applications, which continue to show weakness:

Just how bad is the U.S. housing market? After falling off a cliff in May, due to the expiration of the home buyer credit, sales continue to decline further and further. Last week, mortgage applications for home purchases fell by 3.1%, according to the Mortgage Bankers’ Association. That broke through the worst levels seen in 1997, to hit a point not seen since 1996. They’re now down 69.1% compared to their 2005 peak. (Source: The Atlantic Monthly)

Certainly not encouraging. 2 months after government support evaporated, we see that the real estate market has not stabilized.

With household formation running at just 0.9 million while the US is still building 0.6 million new homes annually, only 0.3 million of the oversupply will be absorbed per year. As there are currently 4 million too many homes, it may take years to mop up the huge oversupply of houses. (Source: The Big Picture)

While I’m a value guy through and through, I can’t help but look at the global environment on a relative basis as well. So it’s no surprise that currencies are perplexing:

Once again everyone is talking about the death of the dollar, and how Europe saved itself. P-lease. Spanish banks are toast. Portugal is toast. And Germany is going to be called on in the next couple of months to pay up for the next installment of financial chicanery from one of it’s partners.

But the most dangerous currency in the world, continues to be the almighty yen!

Heading towards a new high, this is the currency with one of the worst fundamental pictures in the world. The only explanation I have is that the carry trade was SO big that this represents an unwinding of risk – EXCEPT that risk assets have gone up in tandem?! It’s a conundrum that I don’t understand. There is a disconnect there that will get flushed out and in my mind, the yen’s support is limited. I remain short via YCS – not my favorite implementation tool, but it’ll do the trick for the magnitude of moves I believe are coming.

Lastly, I have to comment on JP Morgan (JPM):

The Wall Street giant posted earnings of $4.8 billion, or $1.09 cents a share for the quarter, compared to $2.7 billion, or 28 cents in the same period last year.

Excluding the reserve release and a $550 million charge to cover the U.K. tax on banker bonuses, J.P. Morgan (JPM) earned 87 cents a share in the latest quarter.

Analysts polled by FactSet Research had, on average, been expecting earnings of 74 cents a share. Net revenue on a managed basis fell 8% to $25.61 billion. Analysts had expected the group to report revenue of $25.81 billion. (Source: CBS MarketWatch)

We should all be so lucky as to get a 30% boost to earnings from accounting changes. In the end, though, the market is smarter than that, and anyway, accrual accounting has a wicked bite when it needs to be reconciled with cash. These games are one of the reasons that I avoid financial companies in valuation comparisons and accounting-based screens – they look great on paper, but tend to be misleading.

Oh, yeah, and another couple of odds and ends: retail sales fell 0.5% in June (CalculatedRisk), PPI fell by 0.5% (TheAtlantic.com), and if those didn’t convince you that we still had a recession in our future, ShadowStats has this for you:

Plotted below is the year-to-year change in real (inflation-adjusted) M3 (updated for the Fed’s revisions) versus U.S. recessions, as recognized  by the National Bureau of Economic Research. Whenever annual real change in M3 has turned negative, the economy always has fallen into  recession, or if already in recession, the economy has entered a period of intensified downturn, usually within six to nine months of the initial M3  downturn. The signal for economic trouble ahead is the annual real M3 growth first turning negative, as happened in December 2009.

(For the full article, click here.)

While I really don’t want to be a Debbie Downer, connecting the different dots should at least highlight the fact that significant risks remain, that the threat of recession is far from over, and that calls for economic recovery, at best, misguided. While different analysts have been talking about the markets recent moves higher as signs that conditions are improving, I think they are premature. During every big recession, analysts and government officials continually claimed an end, with short lived rallies that brought in new buyers (think Japan for the past 20+ years). I continue to underweight equities, continue to hold my short euro and yen positions, and continue to be wary of equity run-ups.

NY Times profiles Prechter

Interesting read regardless of your personal persuasion. Here are the main highlights:

Mr. Prechter is convinced that we have entered a market decline of staggering proportions — perhaps the biggest of the last 300 years.

…Originating in the writings of Ralph Nelson Elliott, an obscure accountant who found repetitive patterns, or “fractals,” in the stock market of the 1930s and ’40s, the theory suggests that an epic downswing is under way, Mr. Prechter said. But he argued that even skeptical investors should take his advice seriously.“I’m saying: ‘Winter is coming. Buy a coat,’ ” he said. “Other people are advising people to stay naked. If I’m wrong, you’re not hurt. If they’re wrong, you’re dead. It’s pretty benign advice to opt for safety for a while.”

His advice: individual investors should move completely out of the market and hold cash and cash equivalents, like Treasury bills, for years to come. (For traders with a fair amount of skill and willingness to embrace risk, he suggests other alternatives, like shorting the market or making bets on volatility.) But ultimately, “the decline will lead to one of the best investment opportunities ever,” he said.

Buy-and-hold stock investors will be devastated in a crash much worse than the declines of 2008 and early 2009 or the worst years of the Great Depression or the Panic of 1873, he predicted.

For a rough parallel, he said, go all the way back to England and the collapse of the South Sea Bubble in 1720, a crash that deterred people “from buying stocks for 100 years,” he said. This time, he said, “If I’m right, it will be such a shock that people will be telling their grandkids many years from now, ‘Don’t touch stocks.’ ”

The Dow, which now stands at 9,686.48, is likely to fall well below 1,000 over perhaps five or six years as a grand market cycle comes to an end, he said. That unraveling, combined with a depression and deflation, will make anyone holding cash “extremely grateful for their prudence.”

The article also quote Ralph Acampora:

The “mathematics don’t work,” Mr. Acampora said, because such a big decline would imply that individual stocks would need to trade at unrealistically low levels. Furthermore, he said, “I don’t want to agree with him, because if he’s right, we’ve basically got to go to the mountains with a gun and some soup cans, because it’s all over.” (Emphasis added.)

I thought it was particularly intriguing that one of the reasons Acampora doesn’t agree with Prechter is because he doesn’t “want to” – a classic heuristic bias (and a completely illogical argument). I don’t know if Prechter is right or wrong, but coming at it from a fundamental valuation and macro analysis perspective, there are definitely reasons to think he might be right. In that case, any analyst needs to place some probability on his scenario (even if low) and see whether the expected return on the range of probabilities warrants caution – I think it does.

Morning notes

A lot of huffing and puffing around town, but you should have already been positioned:

• Euro is taking out 1.22, on it’s way to 1.20 and lower. 3M Libor is going up, as we discussed a few weeks ago. European lending/borrowing costs will rise, banks will be hurt, and sovereign debt will need to be repriced. Spanish banks are especially vulnerable given the liquidity crunch coming up once European facilities need to be rolled over in July.
• China can’t hide the numbers any longer. Why would they lie? Because THEY”RE COMMUNISTS! Government numbers in general are massaged, but in communist regimes, it’s on a different scale. For those who remember 5 year plans, pictures of stocked Russian supermarkets, talk of the US falling behind on every level, this is just more of the same – in the end, communism and state directed economies fail. Not a value play (yet?) for me.
• USD is getting stronger and weaker: stronger vs. euro (duh) and weaker vs. yen (huh?). Continued unwinding of the carry trade? Domestic yen coming home from international allocations?
• 10 year yields are saying deflation, and they’re saying that the US government has some leeway since investors still think it’s credible. So good so far.
• Are we on the brink of massive quantitative easing on a never-before-attempted scale? Competitive devaluations? Against what – each other? USD? Gold?
• Real estate: how come when I say real estate is vulnerable you don’t listen but when Meredith Whitney says it 6 months too late, everyone is up in arms. And now Barry Ritholtz and John Mauldin are confirming? Nice, but I hope my readers were already out of the space for the time being.

Rising rates AND deflation? How?

I have been writing for months about a possible new scenario for economists: rising rates in the face of a deflationary environment. See, most people are either deflationists and believe that rates will go down, or inflationists and believe that rates will rise. What if they’re both half right (or half wrong)?

Foreign ownership of U.S. assets, particularly Treasury bonds, has increased significantly over the last two decades. Foreigners now own 57% of outstanding U.S. Treasurys, up from 37% in 1997. The chart above shows that this growth has been driven entirely by government purchases, notably China’s. In the two years ending in March 2005, official sector purchases accounted for 60% of new issuance, compared to about 40% historically back to 1960. The increasing significance of government participants, whose motivations are not always profit-driven, may help to explain Alan Greenspan’s famous “conundrum” — the question of why long-term interest rates declined in the face of strong economic conditions and rising short-term rates in late 2004 and early 2005. This disruption to the mechanism through which monetary policy normally affects the broader economy may one day work in reverse if governments choose to reduce their exposure to Treasurys back to 1960s levels. The resulting “reverse conundrum” — rising long-term interest rates in the face of weak economic conditions and falling short rates — would be far more unpleasant than the Greenspan version.

Source: Council on Foreign Relations

US Treasuries and US households

From Fortune:

The U.S. household sector bought $147 billion of Treasury securities in the first quarter, the Federal Reserve said in its quarterly flow of funds report. That pushes Americans’ holdings of Treasury debt to $796 billion, the highest level since 1999.

The article goes on to mention…

U.S. banks bought $64 billion worth of Treasurys in the first quarter; the Federal Deposit Insurance Corp. said last month that federally insured banking institutions boosted their Treasury holdings by 53% in the first quarter.

Government-sponsored enterprises such as Fannie Mae (FNM) and Freddie Mac (FRE) went on an even bigger binge, nearly tripling their holdings of federal debt.

Some wonder how strapped consumers can afford to spend billions on low-returning government bonds. One hard-core critic of U.S. fiscal laxity, Toronto hedge fund manager Eric Sprott, has questioned the massive reported purchases by the household sector. He claims the government is manipulating its data for the sake of running a giant “ponzi scheme.”

For the full article, click here.

As my readers probably know, I don’t like Treasuries here, fully acknowledging that the deflationary argument supports bond prices for a while yet. I continue to view bonds as return free risk – a bet that the US government 1. won’t inflate their value away and 2. exogenous forces like a failed auction won’t occur.

More than anything, I’m afraid for the US investor who goes from one fire to the next having lost wealth in pricking of the stock bubble, only to be burned by the crash of the real estate bubble, and now facing the end of the bond bubble, perhaps. All in all, I don’t think there is a lot of room for continued internal financing as long as jobs are missing, savings are missing, and international sources are more and more internally focused and won’t be able to sustain our debt. (We do not make specific recommendations, but are short treasuries.)

China’s export boom, a lagging indicator

China reported an export boom that was, quite frankly, unbelievable. I wrote about it yesterday, but then came upon an interesting article that I must point out.

Assuming that the numbers are correct, they should have been expected. Chinese exports follow US imports:

The article then went on to point out that US imports lag ISM imports, which in fact have rolled over and are coming down. The implication being that China’s export boom, which is being credited with a whole lot of bullish power, is topping.

I encourage everyone to read the article in full here.

Atlanta Fed President confirms: rates might rise with high unemployment

I have pointed out numerous times that the current zero-interest-rate environment has some quirky implications for policy makers and investors alike. For one, we might see a deflationary environment, with no wage pressures, yet face an increasing interest rate environment. However, for a long time I felt like I was on the fringe, with deflationists and inflationists agreeing on only half of my equations, just not the same halves.

Yesterday, Dennis Lockhart, president of the Atlanta Fed made a speech in which he mentioned just such a scenario. The full speech is below, but here is the important (second to last paragraph):

I’ve put forward the view that inflation is not currently a major concern. So one might ask, do you believe the base interest rate must remain near zero—at its current level—until unemployment is reduced substantially and most of the employment lost in the recession has been restored?

I’m not convinced that will be necessary. I continue to support the current stance of interest rate policy. But the time is approaching when it will be appropriate to consider recalibrating interest rate policy. I do not believe that time has yet arrived. The conditions that require a change of policy are not yet at hand. However, as the economy continues to improve and financial markets find firmer ground, extraordinarily low policy rates will not be needed to promote recovery and will become inconsistent with maintaining price stability.

The implication is that the policy rate may have to begin to rise even while unemployment is considerably higher than before the recession. I’m very concerned about unemployment, and certainly employment trends should be a critical consideration in setting policy. But I accept that good policy, even in circumstances of unacceptable levels of unemployment, may incorporate higher interest rates.

For the full speech:

Sources of Employment Uncertainty

Dennis P. Lockhart
President and Chief Executive Officer
Federal Reserve Bank of Atlanta

Atlanta Technical College
Business and Industry Breakfast
Atlanta, Ga. June 3, 2010

Thank you for the opportunity to speak at the college’s annual business and industry breakfast. I want to congratulate Atlanta Technical College on being named the best community college by Washington Monthly. ATC certainly deserves such praise, but I think community and technical colleges in general deserve praise for their essential role in so ably preparing students for America’s always fluid and still weak employment market. I am aware that a high percentage of community and technical college students are older than 30. In the case of ATC, almost 45 percent are over 30 and more than 21 percent are over 40. ATC and its sister institutions do a tremendous service in upgrading the skills and retooling workers in our economy and smoothing the adjustments—both macroeconomic and personal—that are necessary in a dynamic, open economy.

This morning I want to focus on what might be viewed as a puzzling and frustrating aspect of the economic recovery that is under way. Most indicators suggest that overall economic activity stopped contracting and began growing again starting around July 2009. So the economy is approaching 12 months of sustained recovery, and yet not much has happened in employment markets to reduce the high level of joblessness. How can that be? During the last three quarters, gross domestic product (GDP) has expanded at an average annualized rate of 3.6 percent. Current estimates point to GDP growth of around 3 percent in the current quarter. These numbers are not off-the-charts strong, but they represent solid aggregate economic performance. Why haven’t we seen rehiring accompany this growth? Why hasn’t employment recovered at the same pace as the overall economy? Well, employment always lags recovery to some extent. Following the previous two recessions, where recovery has been modest, we’ve seen weak job growth.

The answer also lies in a surge in labor productivity growth, that is, output per hour of work. This productivity growth has allowed the economy to expand and firms to record better sales and profits without yet adding many workers to payrolls. Historically, productivity has always been strong just after recessions. So the pattern we’re seeing is not abnormal.

Recently my staff and I have been trying to gauge the sustainability of recent strong productivity growth and its impact on prospects for reduction of unemployment. In the long run, labor productivity growth is the friend of all of us. It fuels broad-based improvement of living standards. Short term, productivity gains may be the nemesis of those whose prospects depend on job creation.

The Federal Reserve’s monetary policy mandate from Congress is to pursue both maximum employment and low inflation. The possible tension between productivity and employment is a subtext of the larger story of economic growth and inflation and the question of whether there is a short-term tradeoff between the two. So I will try to connect the employment and productivity outlook to my views on appropriate monetary policy.

I should emphasize that what you’ll hear this morning are my personal views. They are not necessarily shared by my colleagues on the Federal Open Market Committee or in the Federal Reserve System.

Economic summary
Let me set the scene with a quick summary of current economic conditions. As stated earlier, the broad national economy is in recovery as indicated by GDP growth for almost a year.

In the middle of last year government spending stimulated most of the economic growth. In the fourth quarter of 2009 and the first quarter of this year, inventory adjustments drove a lot of economic activity. Consumer activity over the last few months has exceeded the expectations of many analysts. This activity has occurred even while American households continue to deleverage, that is, pay down their debt. Business investment in equipment and software has been surprisingly strong considering the consensus forecast of modest growth ahead. Both consumer spending and business investment in capital goods may just be evidence of short-term and temporary satisfaction of pent-up demand following deferral of spending during the recession. The end game of this evolution is solid and broad-based final demand.

Although, as I have suggested, risks remain to a forecast of sustained growth, I think confidence is warranted. The mix of sources of strength underpinning the recovery will evolve. Former contributors to growth will beget new contributors.

As a consequence of the growth we’ve seen and the positive outlook, employment market conditions have begun to improve. Payroll employment is estimated to have risen by about 560,000 during the first four months of this year.

We will get another important reading on employment markets tomorrow. Even if that report shows further gains in employment (some forecasters expect 500,000, with 400,000 being U.S. Census jobs), it’s fair to say there will remain a large excess of workers looking for jobs relative to the demand for workers in the economy. Total jobs lost in the recession and immediate aftermath approach 8 million. This gap is likely to close only gradually. And, further, the resulting slow growth of wages and salaries has the potential to limit growth of consumer spending for a while.

I’ll round out this snapshot of the economy with a couple of comments on inflation. Because of the downward pressure exerted by the recession and the relatively modest recovery so far, the rate of consumer price inflation has slowed quite a lot. This recent disinflation has not yet translated into decline of longer-term inflation expectations. Most measures of inflation expectations have remained pretty stable. Overall, for now, the inflation picture is not a major concern, in my view.

So, to sum up, we’ve had growth of the economy and improvement in jobs markets. Among the factors pushing the economy forward—along with personal consumption, business investment, and inventory effects—is labor productivity. I’d like to take a deeper look at this element of economic progress and its relationship to employment.

Role of productivity as an element of economic growth
To simplify a bit, there are two causes of labor productivity growth. The first is improvements to technology that help people work better. The second is people working harder. People might be working harder because the companies they work for have cut employees in response to tough economic times and are trying to keep production levels, revenues, and earnings up with fewer people. Technological improvements tend to be durable, but squeezing more and more out of a diminished and, in many cases, reorganized workforce may not be sustainable.

In recent months, the U.S. economy has enjoyed especially strong productivity growth in the business sector (averaging 6 percent per quarter over the last three quarters versus the long-run average of 2.6 percent). I suspect that much of this productivity growth is of the second, work-harder type. Many employers reacted to the downturn by aggressively cutting their workforces, reorganizing remaining workers, and cutting other costs. They have reacted to the upswing by holding employment at or near recession levels, seeking efficiencies in supply chains, investing in labor-saving automation, and generally tweaking their business models to operate more efficiently than before the recession. We’ve heard this story frequently in anecdotal accounts of our directors and business contacts across the Southeast.

As long as efficiency and productivity gains can be achieved in this way, employers may remain hesitant to hire. So a key question with immediate relevance for the recovery and employment is, how long can firms ride this productivity growth before having to yield to new hiring to support greater activity?

International comparison
Before venturing a view on that question, let me frame an international context for better perspective on the ups and downs of labor productivity in this country. Even though the timing and extent of the economic downturn were similar in most advanced economies, resulting labor productivity patterns have varied widely. For instance, in the United States the level of GDP declined by 3.7 percent, while the unemployment rate rose 4.5 percentage points during the recession. By contrast, in Germany the cumulative GDP decline was about 6 percent, while unemployment rose by only about 1 percentage point. Germany—and several other advanced economies—experienced a serious recession but a significantly smaller increase in unemployment in comparison with the United States.

It’s striking that the United States, even in good times, tends to see much greater flows into and out of unemployment rolls than other countries. This is an aspect of the vigorous turnover of jobs in our economy—the regular destruction and creation of jobs in a dynamic market economy. Other countries tend to experience relatively less such movement in labor markets over time. Their experience probably reflects institutional factors such as social laws that make separating employees more expensive and lower quotients of entrepreneurial activity.

It can be argued that the comparative absence of labor market rigidity in the United States results in comparatively large movements over time of workers between industries and sectors and across geography. We in the United States simply have more flexible employment arrangements across the economy, allowing employers to adjust rapidly and aggressively to downturns and requiring workers to be agile in response to changing conditions.

There is a point to be made for the benefit of ATC students here: Beyond the specialized skills you are acquiring in the college’s excellent programs, there will be a high return to work skills that make you versatile and mobile—for example, computer and IT skills.

Outlook for labor productivity and employment
To return to the question I posed earlier, slightly rephrased: Will high productivity growth continue and have the effect of impeding employment growth?

I do not expect the recent outsized productivity growth to continue indefinitely and become a new, permanently higher trend rate. Some degree of “wait and see” behavior is at work and is no doubt reflected in the productivity numbers. With growing economic momentum, deferral of hiring will become riskier.

Some employment gains should result as labor productivity levels out and falls back over time to something resembling the historic trend rate. But the pace of hiring is likely to be gradual. Current data on the use of part-time workers suggest that businesses have some scope to increase hours without hiring new full-time employees. And there are other, more structural obstacles to the rapid reemployment of the jobless. Some jobs in the construction sector and certain manufacturing industries are likely permanently lost, requiring some amount of migration of workers to other sectors. And, for a time, skill and geographic mismatches may frustrate employers willing to hire.

Also, the weight of uncertainty about the future business environment makes a gradual pace of employment progress a reasonable assumption. I hear often from members of the business community that uncertainty regarding federal, state, and local fiscal fundamentals and regulatory rules-of-the-game are feeding reticence to pull the trigger on new ventures, new hires, and new investments. The recent European sovereign debt and banking pressures have added to uncertainty in financial markets.

Sizing all this up, I expect recovery in the medium term to be neither jobless nor job rich.

Appropriate monetary policy
As the recovery proceeds—as I believe it will—a central concern of monetary policy will be when and by how much the Federal Reserve raises the base level of interest rates.

The Fed has held its interest rate policy at close to zero for about a year and a half. This has been done to foster conditions that would end the contraction of the economy and then encourage recovery. Again, I believe a modest recovery has been under way for almost 12 months.

As I stated earlier, the Fed has a dual mandate from Congress to keep inflation low and promote maximum employment.

I’ve put forward the view that inflation is not currently a major concern. So one might ask, do you believe the base interest rate must remain near zero—at its current level—until unemployment is reduced substantially and most of the employment lost in the recession has been restored?

I’m not convinced that will be necessary. I continue to support the current stance of interest rate policy. But the time is approaching when it will be appropriate to consider recalibrating interest rate policy. I do not believe that time has yet arrived. The conditions that require a change of policy are not yet at hand. However, as the economy continues to improve and financial markets find firmer ground, extraordinarily low policy rates will not be needed to promote recovery and will become inconsistent with maintaining price stability.

The implication is that the policy rate may have to begin to rise even while unemployment is considerably higher than before the recession. I’m very concerned about unemployment, and certainly employment trends should be a critical consideration in setting policy. But I accept that good policy, even in circumstances of unacceptable levels of unemployment, may incorporate higher interest rates.

Again, I want to acknowledge the vital role that Atlanta Technical College plays in our community in equipping young people, and some slightly older people, to prosper even in difficult times. You do important work.

10 year treasuries – the time has come

I shorted 10 year treasuries today, as mentioned in an earlier post; and there’s a good chance that I’m early, also discussed. I decided to share some of the thought process, if not all the financial assumptions, because I received a lot of questions on the post.

Since some of the comments had similar themes, I’ll combine and paraphrase:

Is shorting treasuries an inflationary position?

The answer is a definite maybe. Historically, the thinking has been as inflation goes up, interest rates will rise and treasury prices will fall. Makes sense. The real issue is one of causality. It’s true that inflation might cause rates to rise, but so could other things (for example, China not showing up for an auction).

Is shorting treasuries a risk trade?

This series of questions revolved around the belief that the run-up in treasuries was a manifestation of risk being taken off the table. Agreed. But at some point, being long treasuries becomes its own manifestation of the risk trade. Locking in 3.2% (or less) for 10 years seems pretty risky to me in an environment of increased quantitative easing, increased taxes, slower growth, etc. Some of the comments suggested that instead of shorting treasuries, I should go long equities as a better expression of the risk trade. If that was the trade, I’d agree, but I believe there is a strong chance that we can have slower growth AND higher long term rates.

What are possible scenarios where we could see treasuries fall AND equities head lower?

Stocks and bonds might have low correlation on a short term basis, but on a longer term basis, equities had their biggest bull market run from the early 1980′s through 1999/2000 – a twenty year bull market. Simultaneously (correlation or causation?), interest rates went from 17+% down to 3+% in the greatest bond bull market in history. Looking forward, why wouldn’t we expect their bear markets to coincide as well? Asset allocation works well as long as assets aren’t correlated, yet throughout the investing public’s experience, all asset classes that they invested in (stocks, bonds, real estate being the major ones) went up. So one scenario is just a simple correlation without trying to explain the cause, but we can do better.

Digging deeper, let’s examine the famous deflationary argument (to which I happen to ascribe). Deflation is the ultimate fear trade. Investors get scared of holding long term investments and begin hoarding shorter term investments, ultimately preferring cash to pretty much everything else. There are a few commodities that end up being safe havens in deflationary environments (gold, perishable foodstuffs, etc.), but financial assets as a whole are not them. On a valuation perspective, if companies lose pricing power, margins erode, people spend less, and people have less money that they are willing to invest/lend believing that by waiting things might go on sale. So stocks go down. At the same time, governments are forced to pump ever increasing amounts of stimulus and spend increasing amounts on social services. How? Well, they print more and they borrow more, thereby increasing the supply of treasuries available. You get the picture.

But let’s assume you don’t believe we’re going that route. Here’s what really took me over the edge as I started looking at the different scenarios: China, Japan, and the Middle East. My argument is that being long treasuries is being long China, Japan, and the Middle East – none of which I want to be long. Let’s take China as the poster child. Equities are in a bear market. Social unrest is always a risk. Rural/urban disparity continues to worry those in power and the overcapacity built over the past 10 years is unprofitable. At the same time, their biggest trading partner, Europe, is facing its own problems and slower growth, rendering its investments in infrastructure, capacity, and stashes of commodities foolish (at best). And oh yeah, their surplus is concentrated in US treasuries, with the risk that Bernanke & Co. will inflate their deficits away. What’s a bureaucrat to do? One day (I believe soon), there will be a failed auction. By failed I don’t mean that the Chinese (or Japanese or Middle East block) won’t show up at all, just that they won’t bid aggressively, they won’t take down as much, or they won’t take down the long end. Guess what, they need to spend that money domestically, not lend it to the US so that we can lend it to Greece. No inflationary pressures, just fewer bids. A scary proposition and a huge game theory nightmare since all the other players will have to scramble to front run each other. FUBAR.

I’m probably early in my assessment, and treasuries might still be the safe haven trade tomorrow, and later in the week, as we get more auctions, everyone will show up as usual. However, the scenarios are real, and if nothing else, pose a serious risk to those who chose to use longer term treasuries to lock in 3+% for the next 10 years.

For reference and for those who like charts:

Hugh Hendry’s Eclectica Fund Letter

This is a must read for investors. Hugh Hendry is one of a handful of fund managers that I believe actually get it: it’s not about style or asset class, it’s about finding undervalued opportunities around the globe.

His letter details why he’s pessimistic on Japan, and is therefore NOT shorting the yen. Pessimistic on China because THEY ARE COMMUNISTS (my emphasis) and you cannot trust a totalitarian regime – a point I’ve often made on these pages. He sees (hyper)inflation coming, but first deflation – I tend to agree. And, oh yeah, he’s buying corn – we’ve discussed ag here recently (although I believe that exposure through financial instruments might be tested in the near future as liquidation of ALL financial assets takes hold).

For the full letter, click here.