Inflation fears are back

Inflation fears and fear-mongering are back in full swing, but I don’t buy it. I have to admit that I have benefited on multiple levels from the inflation fears making their rounds, as I have short exposure to treasuries, and long exposure to precious metals including palladium and platinum, which have outperformed gold and silver. I’ve also faced some headwinds, as I have been long the dollar versus the euro and yen for a long time. Separately, I’ve been overweight energy for a whole host of reasons, but inflationary pressures have certainly helped keep the price high.

So why am I doubting the recent fear mongering over ever-higher corn prices and the run up in everything from lean hogs to cocoa? My main reason is the consumer. First, on an anecdotal level: Go into any department store. These days, they’re seeing more traffic than in the recent past, a positive. Yet, almost everything is on sale. 30-50% sales are now the norm, and quite honestly, I don’t know why anyone would buy without the sales, especially given that you can buy so many things pre-sale, namely, buy it now, put it on hold, and get the sale price, while the store gets the carry. That’s fine for cashflows, but it’s only borrowing from future revenue; I guess it’s a cheap loan. Second, inflation in staples can seep through, but we’re not seeing it keeping up with the rise in inputs, which necessarily means a squeeze on margins. Don’t believe me, just check out MCD, which just came out with earnings. This is great for the midwestern farmer (voter) and land owner, fine for the coastal consumer, and crappy for everyone in between. Certainly it’s not a net positive for stocks that won’t be able to keep up earnings and meet these valuation expectations.

But back to our mongering…The question remains of what happens to the firms in between that are getting squeezed? For starters, I don’t think employment can pick up, which in turn will lead to continued low savings. In fact, numbers just released show that consumers are dipping into their savings at unprecedented levels. Considering the fact that these funds aren’t coming from HELOCS, they must come out of investable and liquid assets. That can only go on for so long. In a debt deleveraging cycle, which we are facing, the main problems will be margin contraction coupled with more difficult financing. Inflation fears today will end up being ephemeral and much deeper, scarier structural problems will surface. For traders playing the rotation, this is a fine time to look at underperforming commodities and just consistently rotate into them. For investors, the commodity space, except some very specific exposures, will not provide the anticipated returns.

Relevant ETFs: MOO, COW, DBA, GLD, SLV, PALL, PPLT

Separating the noise from the louder noise

There’s obviously been a lot of news since last night and I’ve been trying to wrap my head around it, but for starters let’s mention some of the big items:

Belgium and Spain are only the latest, but not the only(!), reasons for the euro to fall…and fall it did. We’re back to a 1.32 handle. Why do I say that they’re not the only reasons? Well, for starters, I thought the euro was structurally flawed before any downgrade, and continue to think so. The euro is now trading by default since there’s no alternative in Europe. Imagine for a moment if Germany came out tomorrow and said that it would start issuing Marks. The euro would be DOA.

On our side of the pond, we have treasury yields continuing to move up. 10 year yield is now above 3.5%! We’ve discussed the phenomenon before where we can have deflation AND rising yields at the same time. Locking in 3.5% for 10 years isn’t that attractive afterall. We’ve been calling it biflation, but I’ve been researching some underlying elements to help explain the phenomenon. Each time I come to the same issue: What cause yields to rise?

• If yields are REACTING to inflation and inflation expectations, then they are lagging commodities, but still part of the same message we’re getting from other asset classes. This could be bullish for equities and real estate, as well as supporting the runup of commodities in general (such as copper, industrial commodities, etc).
• If they are LEADING and are a result of fear over solvency, or frontrunning the pack (e.g. fear China will sell their holdings), then the recent run-up could be part of a debt-deflation cycle which is very negative and could be a harbinger of increased real costs of borrowing, economic slowdown, deflation across asset classes, etc. This would be very bearish for industrial commodities such as copper, but still supportive of precious metals as stores of value.

This dichotomy is the debate being had across the street. The first case is easier to deal with – we have the fiscal and monetary tools to stop inflation, and while painful down the road, we know it. The second case is similar to what happened during the Great Depression (and I don’t use that comparison lightly). It’s a world where fiscal and monetary policies are powerless, and it’s the scenario Bernanke fears most. Unfortunately, increased government spending does not and will not stop scenario two from occurring, so it just leaves us more vulnerable. We are maintaining our short treasury exposure.

Gold down. Oil up. Noise for me, since these are long term positions.

Muni bonds have gotten hit recently (as we predicted a few months ago). Noise for me at this point since we cut all exposure. At some point, yields will become attractive enough to take long term positions, but for me, not yet.

Tax bills, healthcare constitutionality, and WikiLeaks – all noise.

David Rosenberg (Rosie) discussing the rise of inputs versus no retail pricing power causing the mother of all margin squeezes?

The U.S. PPI, at +0.8% MoM in November and the core (which removes the effects of food and energy) at +0.3%, were both above expected but skewed by a seasonal rebound in auto pricing. Outside of that, core would have been as expected at +0.2%.

What is striking, however, is how cost trends are accelerating at the early stages of production in lagged response to the recent leg of the commodity boom. The “core crude” PPI jumped 3.1% MoM and is now up 30.2% on a year-over-year basis. This is the very early pipeline stage.

At the same time, core intermediate PPI leapt 0.7% and is up 4.7% from a year ago. When we get to final core goods PPI, the YoY trend is running at a mere 1.2% (and -0.7% on a three-month annualized basis).

In other words, the closer you are to the commodity complex, businesses have greater pricing power. And, the closer you are to the consumer at the final stages of production, the less pricing power you have. (emphasis mine)

That’s not noise. It’s just further confirmation that equity valuations are too high.

The Fed can’t manage the economy, but they can still do interesting research

The Breadth of Disinflation

By Bart Hobijn and Colin Gardiner

In recent months, inflation as measured by the personal consumption expenditures price index has been trending lower. This slowdown, known as disinflation, has raised concerns that inflation might actually drop below zero and enter a period of deflation. An examination of the distribution of inflation rates across the range of goods and services that compose the index suggests that downward pressures on inflation are relatively high by historical standards.

For the full paper, click here. I continue to believe that debt deflation will put downward pressure on the traditional stores of value (real estate, equity, bonds), while monetary and fiscal policies will haphazardly put pressures on “needs” or inputs – biflation. This will have the effect of squeezing margins, and increasing pricing uncertainty, which in turn will make it difficult for businesses to invest and plan. Coupled with high unemployment, increasing unfunded pension liabilities, and geopolitical instability, the “fingers of instability” which we have discussed in the past are now long and networked – meaning a small disturbance can have large consequences.

Brazil tries to push money away

LOS ANGELES (MarketWatch) — The Brazilian government has raised the tax on fixed-income foreign investment to 6% from 4%, according to news reports Monday evening. It also raised the tax on margin deposits on futures markets to 6% from 0.38%. Earlier this month, the government, in its bid to cool the rise of its currency /quotes/comstock/21o!x:susdbrl (USDBRL 1.6720, +0.0078, +0.4687%) , doubled the so-called IOF tax on foreign fixed-income investment, multi-market funds and equity funds to 4%. “We continue to believe that the authorities will continue to tinker with its toolbox to find the right combination of policies to curb excessive [real] appreciation,” wrote Win Thin, global head of emerging markets strategy at Brown Brothers Harriman, in a note late Monday. “The tax on margin deposits appears to be geared towards addressing speculative, leveraged bets on the currency,” he wrote.

From Marketwatch.com.

As emerging markets try to cool speculative appreciation, the pressure is on Bernanke & Co. to print more if they want to continue down the path of stimulating inflation. The real question is whether emerging markets will be more careless and flamboyant than Bernanke. I happen to think that we’re at an inflection point and even Bernanke won’t be able to debase the dollar that much more against the emerging markets, Europe, Japan, and the rest of the world. He might try, but they’ll try harder. It’s a scary situation regardless of who “wins”, since we’ll all be the worse off for it.

Next up: protectionist measures, tarriffs, increased taxes on foreign investors, and roadblocks to trade. Not a great situation.

10 o’clock check in

Where to begin today? We’re a little late on the uptake because so much is new and so much is old.

The dollar continues its downward spiral with Singapore joining the rest of the world against the USD and Bernanke’s campaign for inflation. The currency wars are raging, and I’m not sure if winning is good.

Meanwhile, August trade balance is at -$46.3 billion – worse than expected. Assuming it doesn’t get revised even lower, it will still have a negative impact on GDP revisions for Q3. At the same time, the China bashing continues in Washington (as if that’s the problem).

PPI came in a 0.4%. We have been discussing the duality of the market – inflation in expenses, deflation in wealth. Well, food and energy were the main drivers of the increase. Sans those, and PPI was only 0.1%. That being said, most people don’t exclude energy and food prices from their monthly bills, so the average person is feeling it in their pocketbook.

Jobless claims came in at 462K (up from 445K), and the prior number was revised higher (no surprise).

On the other side of sanity, Paul Krugman discusses the need to increase QE by $8-$10 Trillion, while on the same day, the St. Louis Fed comes out with a report on why QE is bound to fail. It’s a mad world.

“So much news”, or, “Are we living through a modern war?”

Confirmation bias is a tricky thing: how do you know if you’re picking up on news because of your confirmation bias or because there actually is a confirmation of your beliefs? That’s what I’m facing today. After yesterdays post discussing continued deflation in assets, the coming inflation in goods, and the end game – economic war (starting) and maybe (not a prediction) physical war, I was struck by the different news coming out today:

1. Starbucks is raising prices on some of its more complicated drinks (not the regular ‘ol coffee – for now). Again, inflation in coffee is starting to flow down the chain. This was a mild story, so I didn’t even link to it.
2. Then I saw this from the FT.com: The Great Race (to the bottom) – OK, a definite case of confirmation bias.
3. But then I also saw this in the FT.com: Ireland’s subordinated bond ATTACK! What struck me was not the content, which is old news (Ireland may default, CDS spreads rising, etc.) but the choice of language (“ATTACK!”). OK, so it’s probably still my bias looking for confirmation.
4. How about China blocking rare earth shipments to Japan? Is that still just my bias? Read about it here. Politically, it might be China testing the limits and ultimately might prove to be a disastrous move as now the world will look for alternative sources of rare earths. By the way, rare earths are available in other parts of the world, they’re just difficult (read: expensive) to isolate, but they’re available. China just made it more political and more strained.
5. Maybe it’s no longer my bias, but I (along with many, many others) discussed the possibility of German growth stalling with the recently stronger euro. Lo and behold German Economic Contraction Begins As Both Mfg And Services PMI Prints Miss Expectations. Now it’s starting to fall into place.
6. Then, here’s the clincher. Yahoo News discusses Stuxnet – new cyber security threat designed to make the crossover from malware to physical destruction.

I hope I’m wrong and that all these stories will turn out to be unrelated and of little significance, but if nothing else, investors should at least price in the possibility that I’m right and that the economic damage will continue and eventually show up in the repricing of risk and in turn, asset classes globally.

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.

Lots of noise

I know the market feels like it’s gone up – a couple of up days, even on low volume, make everyone feel giddy inside. But let’s review where we are:

The S&P 500 has done a lot of moving without getting anywhere. It’s about where it was at the beginning of the year, which is roughly where it was in mid 2008 (and by the way, about where it was in 1998 for those keeping longer term track).

Meanwhile, the 10 year yield is roughly where it was in mid-2009:

On the other side of the Pacific, we’ve been looking at the yen for a long time. And yes, I told my readers that I went short in late 2009. Guess what…I’m still short and the yen is pretty much right were I got into my position. Not that I’m proud of a slightly down position, but the reasons to get into the trade haven’t changed and none of the factors that would get me out have been seen. Can it get stronger from here? Of course and I wouldn’t even be surprised.

But all of this talk of yen being a store of value misses the point of the fundamental challenges Japan is facing with no easy way out. Multiple people have recently recommended books like When Money Dies: the Nightmare of The Weimar Hyper-Inflation by Adam Fergusson and Dying of Money: Lessons of the Great German and American Inflations (see for example this recent article HT MacroMan). I’m not opposed to the possibility, but surely Japan is in much greater danger of the hyperinflation mentioned than the US.

But I digress, because the point of this posting was to mention that we have had a lot of noise. I can show other charts, from EEM to different currencies, but the themes are the same. I continue to look to fundamentals as the critical guides for valuation and long term opportunities, and at least in equities, valuations are expensive – so we wait.

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.

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

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.