Sunday, 15 November 2009

Money for nothing... Buffett style

BBC 2's Evan Davis met the world's greatest investor and summed up Buffett's simple strategy like so...
  1. Invest... don't speculate. It's the cash flows from the asset that generate your return, not the movement in the price.
  2. You don't have to diversify. "If somebody owns 50 stocks, can they really like the one they rank as number 50 as well as the one they rank as number 1? Can they know it as well? I don't think so."
  3. Be a business owner. Don't just buy shares.
  4. Allocate capital efficiently. Take the profits of one business and invest them in another.
  5. Don't get into debt. "If you're smart you don't need it, and if you're dumb you've got no business using it."
The mark of an intelligent person is one who can make the complicated sound simple. Buffett and his investment style embody this in spades.

Monday, 9 November 2009

The deflation vs. inflation debate continues...

On Thursday I went to a presentation by Charles Dumas of Lombard Street Research and Ian Harnett of Absolute Strategy Research. Here are the key messages…

Charles Dumas in the deflation corner 

US fails all 4 of the Friedman's 4 steps to inflation (his evidence is in brackets):
    1. Rapid growth of broad money (money supply collapsed)
    2. Asset price boom (markets 25% off peaks)
    3. Overheating of economy (US in recession)
    4. Inflation (CPI falling)
    US M3 growth c. 4% but underlying this, the picture is different. Bank lending to private sector -6% so M3 growth coming from QE and govt stimulus 

    US unemployment rising (currently 9% which is highest since 1982), therefore wage growth negative. Dumas expects unemployment to continue rising & then stabilise as GDP next year will be way below normal recovery rates. Given the NAIRU (non accelerating inflation rate of unemployment) is 5-6% in the US, don't expect any wage growth (and by extension inflation) any time soon. Indeed, hourly wage growth of only 0.5% + rising unemployment rising CPI  

    US trend growth is c. 3%. Going forward, trend growth will be lower at 2.2% due to the collapse of key industries such as financials. In this recession, GDP has fallen -5.6% so output gap is c. -7.8%. If the US economy grew by +4% to +5% p.a. for 3 years the output gap would be closed. He therefore believes CPI will stop falling in 3 years time, although this is optimistic given lower expected growth rates. Dumas notes that the coefficient between the US output gap and CPI is c. 25% (i.e. if gap is -4%, CPI = -1%). 

    Finally, CNY/ USD peg has reduced Chinese export prices, which has increased China's market share. So, China wins if USD is weak, as does the US since their exports are also cheaper. However, this is negative for Japanese and European exports. 

    Conclusion slide shown below…

        Ian Harnett in the inflation corner 

        Inflation will be caused by 2 factors:
          1. Low inventories will result in frictional inflation due to supply shortages
          2. Liquidity creation is causing asset price inflation 
          This is more of a corporate rather than a consumer recession (e.g. US consumption contribution to GDP is still positive while investment & inventories are negative contributors). This is causing a supply shock. Supply chains have been built on the Great Moderation and are therefore unable to cope with economic volatility and associated sudden pick ups in demand. To demonstrate this he looks at US ISM prices paid and ISM inventories minus shipments (orders), which move in tandem (see chart). Both are positive as prices paid are rising due to sudden inventory rebuild.

            The corporate response to the credit crunch has been to slash costs & capex in order to preserve free cash flow. However, this can't continue and Harnett expects employment to pick up in the near future (see chart of claims [lagged 6 months] & unemployment). This, will also increase monetary velocity.
              Asset prices are rising across the board (he highlights the 14% annualised growth in UK house prices over the last 3 months as well as the rise in the oil price). This combined with the fact that the Bank of England appear to be targeting nominal GDP growth of +5% (MPC member Charles Bean Feb 09 speech re targeting "growth in overall economy of circa 5%"). A focus on price levels of assets such as house prices will keep policy looser for longer. The BoE will therefore tolerate much higher CPI in order for prices to get back to pre crash levels.

              Inflation will appear in asset prices before consumer prices, which will be the catalyst for rising yields (e.g. US 2 year currently below level of US core CPI, a relationship that will not hold for much longer).

              So there you go. Please excuse my crude attempt to distil such complex arguments and make your own mind up.

                Friday, 30 October 2009

                The bull is rolling over

                SPX falling out of bullish channel, closing below 1,060 suggests weakness to come. SELL!!

                Friday, 9 October 2009

                Beware of gravity!

                The equity market is in a gravity defying 'sweet spot' of low interest rates, QE, returning M&A, cash rich, yield hungry investors, and earnings and economic fundamentals are working off ultra low bases. Of these elements, the most likely tap to be closed off first is QE, then interest rates, which will probably be the catalyst for gravity to take over.

                Why have bond and equity markets been rallying in tandem?

                The answer is simple. Equities have rallied BECAUSE bond yields have fallen, reducing the cost of capital and forcing investors to take more risk to maintain their yield. This amounts to a universal carry trade driving everything including corporate bonds, equities and currencies.

                Moreover, the fall in long bond yields is being driven by the short end, on which they are anchored. So, as the 2 year yield is squeezed lower by FSA liquidity requirements and lower for longer base rates, longer dated yield shave also benefited from the carry offered by the steepest yield curve in over 20 years. This interplay is demonstrated by the 2's 10's spread, which has remained stable, as the 2 year has hit a record low...

                Wednesday, 16 September 2009

                Anatomy of a liquidity trap

                Liquidity trap: A situation in which prevailing interest rates are low and savings rates are high. As a result, monetary policy is ineffective.

                The effectiveness of QE is being compromised by unwillingness on behalf of UK banks to lend. As a result, for every £1 spent on QE, less than £1 is being lent out, which means banks are hoarding the money in order to bolster their balance sheets. This is clearly demonstrated in the charts below, which are based on weekly data from the Bank of England. The first chart shows how a large part of the BoE's ballooning balance sheet has come from reserve balances. The second chart suggests that the cumulative Gilt purchases by the Bank of England have been responsible for the increase in commercial bank reserve balances held at the Bank.

                Having initially been about increasing “the amount of money that’s held by the wider economy”, the purpose of QE has been refined by the Bank of England to restoring M4 (ex Intermediate OFCs) growth to 5% per annum. Therefore, the Bank of England acknowledged in the August Inflation Report that QE is not meeting their 5% target:

                One potentially useful diagnostic of the impact of the Bank’s asset purchases is the extent to which they boost the stock of broad money. Broad money growth remained weak in Q2. That reflected continued underlying weakness in nominal demand: nominal GDP fell by 3% in Q1, and is likely to have fallen further in Q2. Absent asset purchases, it is likely that money growth would have been even weaker.

                Indeed, despite QE, M4 is moving further away from their target...

                Given the ineffectiveness of circa £150 billion of Gilt purchases to date, speculation is mounting that the Bank will resort to increasing the QE programme to £200 billion and charging negative interest rates on reserve balances at the BoE in order to boost the money supply and force banks to lend. This, coupled Mervyn King's prognosis of a "slow and protracted recovery", explains why yesterday the two year Gilt yield reached an all time low of 0.74%, Cable sold off two big figures and interest rate futures are pricing in low interest rates will continue for the foreseeable future…

                Thursday, 10 September 2009

                Let's party like it's 2009!

                The recovery party is in full swing, fuelled by an enormous punch bowl of monetary and fiscal stimulus. Having initially threatened to call time by discussing exit strategies, the G20 has agreed to leave the stimulus in place. In doing so, the world's finance ministers have unilaterally committed to underwrite the economic recovery.

                Thus, cheap money has increased the price of everything from oil to stocks. Furthermore, in the short term the rally has become a self perpetuating virtuous circle, pushing sentiment indicators higher which in turn sustain further gains. However, easy money and sentiment can only take markets so far. In the end, unless they are supported by above consensus earnings, GDP and clear signs of demand, markets will falter.

                Indeed, beneath the benign exterior of lower for longer interest rates lurks a liquidity trap and an economy delicately poised on a knife edge (more on both of these to come).

                It is usually sensible to leave a party while it is still in full swing.