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

Silver

If yesteryear someone asked you how would silver react in the face of a 10% drop in gold, what would you say? I doubt many would say that it would hold up so well. And yet, it has.

From Sprott Asset Management:

TORONTO, Jan. 10 /CNW/ – Sprott Asset Management LP is pleased to provide investors with an update on the delivery status of silver bullion purchased by the Sprott Physical Silver Trust (NYSE ARCA: PSLV, TSX: PHS.U) (“Trust”).

As of November 10, 2010, the Trust had contracted to purchase a total of 22,298,525 ounces of silver bullion. As of December 31, 2010 a total of 20,919,022 ounces of silver bullion had been delivered to the Trust. The Trust expects to take delivery of the final 1,379,503 ounces of silver bullion by January 12, 2011 and will subsequently publish the serial numbers of all bars held by the Trust on its website: www.sprottphysicalsilver.com.

“Frankly, we are concerned about the illiquidity in the physical silver market,” said Eric Sprott, Chief Investment Officer of Sprott Asset Management. “We believe the delays involved in the delivery of physical silver to the Trust highlight the disconnect that exists between the paper and physical markets for silver.”

For 10 years I’ve been hearing about silver shortages, but the voices are starting to be louder and more frantic. I have no way of knowing since I don’t trade the physical, but I like silver anyway and have had exposure to SLV as part of my precious metals allocation. Earlier today I added a little bit more through PSLV (Sprott’s physical exposure). This is adding to a significant winning position, which I don’t generally tend to do, but I still like the precious metals space, so I’m more comfortable with it.

OK, there are other things to look at

There are some funky moves happening in commodities and it will take time, perhaps even years, for all the dirty laundry to be aired and balance sheets to be cleared. At the center, of course, is JP Morgan (JPM) which has been rumored as getting squeezed in silver, while at the same time holding a dominant position in copper. One thing is for sure, there are big players afraid of revealing their hands.

Look at copper:

And now at silver:

And here’s just one of dozens of articles on JPM: this one from ZeroHedge.

Now if silver is going to squeeze higher, would that make copper the easier position to unload to cover any margin calls? Is JPM actually short, or just short against forwards from clients? In other words, is JPM getting squeezed on a timing issue or is it taking a prop directional position?

I have a long position in the precious metals and continue to see opportunity for them to be stores of value in a volatile time, but I’m not a big fan of the industrial inputs as I see a major slowdown coming. This might would put fundamental pressure on copper, which could result in a magnified move if indeed JPM gets squeezed as (if?) their silver:copper spread goes crazy.

Euro and Pound

It’s been relatively quiet on the equity front, even with the market going up – but the currency front continues to be a big focus.

The euro continues its slide:

I’m still amazed that the yen has continued to stay strong, but I guess this is part of unwinding various carry trades. Still, I can’t help but think that once those unwinds occur, the yen will completely fall apart. (Short yen positions.)

Today, though, the story is GBP. The pound has been weak recently, but not as weak as it should have been, and today it looks like the pound is showing increasing signs of stress:

These moves are providing some support to the Treasury market with safe-haven buying, but we’re wary of the long bonds for security. So are other people, with gold as the original safety outlet, and now silver looking like its receiving some of the flows.

We’re maintaining our positions in silver, gold, gold miners, palladium, and platinum, along with our short euro, short yen, and short treasury positions.

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

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

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

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

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

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

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

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

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

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