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.

The bull is rolling over

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

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...

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.

The long & winding road to recovery

Labelling the recovery with letters of the alphabet such as 'W' or 'V' is such a cliché. Song titles are far more effective. For example, the Vapors' Turning Japanese describes Japan-style deflation and Yazz's The Only Way Is Up describes a bullish 'V' shaped recovery. So, which song best describes the outlook for the world economy and markets… The Beatles' The Long & Winding Road?

Faced with considerable headwinds of reduced credit supply, corporate and consumer deleveraging, and falling house prices, GDP will remain below its long term average. The road to recovery is therefore going to be both long and winding. Indeed, the IMF noted last week that:

The global economy is beginning to pull out of a recession unprecedented in the post–World War II era, but stabilization is uneven and the recovery is expected to be sluggish. Economic growth during 2009-10 is now projected to be about ½ percentage points higher than forecast by the IMF in April, reaching 2.5 percent in 2010… the global recession is not over, and the recovery is still expected to be slow as financial institutions remain weak and credit intermediation impaired, support from public policies will gradually diminish, and households in countries that suffered asset price busts will rebuild savings.

So, although GDP growth is receiving a short term boost from fiscal and monetary stimulus and an inventory rebuilding cycle, the durability and strength of the recovery will ultimately depend on consumer spending. Since the US consumer accounts for c. 70% of GDP, US growth is likely to remain subdued until consumers save less and spend more. Furthermore, this is a global recession, which means that exports are unlikely to provide sufficient impetus to either GDP or consumption.

Equities
So, what does a prolonged period of below trend GDP mean for equity markets? Lower GDP growth implies lower earnings growth (see charts below). Therefore, P/E ratios will remain lower for longer since equity prices cannot move substantially higher unless supported by earnings growth.

Moreover, suffering from a debt hangover, management at over-leveraged companies are being distracted from growing earnings. Instead, they have to focus increasingly on reducing debt and balance sheet restructuring. Thus, companies who went into the credit crunch with robust balance sheets are likely to steal a march on their over-indebted peers. Anecdotal evidence of this includes Greene King's equity raising to buy pubs from distressed seller, Punch Taverns. In the housebuilder sector, Berkley Group learnt it's lesson from the last housing crash and went into this crash debt free, whereas Taylor Wimpey was in bad shape and returns on equity suffered…

However, even if equity prices remain stagnant for the next year, investors can still earn 5-7% p.a. in dividends, which is substantially higher than 12 month LIBOR at 1.5%. So, provided one invests in companies with sound balance sheets and dividend cover of over 2 times, the equity market is likely to be an attractive source of return.

Interest Rates
There is a limit to how high long bond yields can go while base rates are anchored at or near zero. With unemployment in the developed world converging on double figures and GDP remaining below trend, base rates will remain lower for longer. Thus, if longer yields rise too far, the carry becomes too attractive for them to rise further and institutions that can take advantage of low-cost funding from central banks will start buying, pushing yields lower.

However, this is a risky game and the stakes are high due to the many risks facing the government bond markets (QE overhang, record issuance and inflation to name but a few). Thus, in the UK at least, the yield curve has never been steeper, implying that investors are demanding a substantial risk premium over shorter yields to hold Gilts.

Inflation
As discussed previously in Inflationistas have been smoking too much 'green shoots'! inflation is being kept at bay by a wide output gap. If GDP remains below its historical average then it will take longer than average to close the output gap, postponing inflation in the process.

In conclusion, the recovery has started in earnest, but it's going to be a long and winding road to recovery. However, provided one is positioned accordingly and with realistic return assumptions, there is no reason why the road shouldn't be a profitable one.

BlackRock's Bob Doll on the outlook for equities

The following is an article written by Bob Doll and published in the FT on 3rd June 2009...

A different kind of rally

It would be an understatement to say that global equity markets have been volatile in 2009.

After sinking sharply in January and February as economic data continued to worsen and as investors grew uncertain about policymakers' next steps in combating the credit crisis, global equities went on the rise in the next couple of months and now seem to have entered a period of uncertainty.

Is the recent rally for real, or merely a blip in a longer bear market? Does it represent the start of a new bull market? Will we see less volatility from here, or should we expect the roller coaster to continue?

Since the bear market began in earnest last September (with the collapse of Lehman Brothers marking an important inflection point), several global equity rallies have failed to take hold. In our opinion, however, the rally that started in March is different. That rally (which, from trough to peak, has resulted in global price advances of more than 30 per cent) is based on a combination of technically oversold conditions, aggressive global policy actions and a general sense that the global economic recession is moving past its period of greatest weakness.

The question now is whether the rally marks the end of the bear market, or if it merely represents a temporary bounce from oversold conditions. It would be premature to suggest that a new bull market has emerged or that we have seen the end of the see-saw patterns that have been in place since last autumn.

Nevertheless, we do believe there are several important differences between current conditions and the failed rally attempts that previously occurred. From a technical perspective, this rally has been marked by strong momentum and expanding volume on the upside, and diminishing momentum and volume on the downside. Additionally, lower quality and more cyclical areas of the market have been outperforming, as have emerging markets when compared with developed markets, trends that occur when more sustained recoveries begin.

The extent to which equities are able to continue to advance will depend largely on the degree to which the global economy is able to recover. On balance, our view is that the global economy is still in the midst of a severe and dangerous recession, but, importantly, the massive policy initiatives around the world have begun to bear some fruit. The dramatic interest rate cuts, spending increases, tax cuts, capital injections, bank rescues and plethora of new government programmes have all helped to combat ongoing credit-related deflation risks.

We believe the fourth quarter of 2008 and the first quarter of 2009 will mark the low points for economic growth. We expect a small gain in world economic growth by the third quarter of this year. We also expect to see modestly positive levels of growth in the United States at some point in the second half.

While investors have grown more optimistic in recent months in the face of some "less bad" economic news, it is important to remember that less bad is not the same as actual good news. As such, we believe the rally that started in early March may be running out of steam and that a resumption of the rally will require more solid evidence of an economic recovery.

At present, we believe equities are entering a correction phase, although we believe this correction will be marked more by sideways action and less by a sharp decline. We think it is extremely unlikely that prices will retreat back to their early-March levels, but we could see some modest near-term declines and believe that continued volatility is likely. Typically, such corrections result in a give-back of between one-third to one-half of recent gains (which, in the United States, would result in a short-term drop to between 800 and 850 for the S&P 500 Index).

Over the longer term, however, we expect improving economic conditions will help equities to rise, and we believe that stocks will outperform bonds and cash over the next 12 months.

The writer is vice chairman and global chief investment officer of equities at BlackRock

Inflationistas have been smoking too much 'green shoots'!

After the recent deflation scare, inflation expectations have normalised (see chart below of UK 10 year breakeven inflation). Nonetheless, the 'inflation-deflation' debate continues. Indeed, inflationistas such as Marc "Dr Doom" Faber would have us believe that the US is headed towards Zimbabwe-style hyperinflation!


However, while the risk of inflation has certainly increased, fuelled by monetary stimulus and rising commodity prices, to believe that inflation is about to take off requires a large leap of faith. Inflation does not just happen, it requires a transmission mechanism - usually an increase in credit supply. Increased credit supply facilitates increased demand which drives prices higher. However, given we are in a 'credit crunch', it is unlikely that the financial system will provide the transmission mechanism necessary for inflation. Moreover, until house prices trough, there is unlikely to be a recovery in the securitisation market, and therefore credit growth.


Even when the credit taps are turned back on, there is enough spare capacity to absorb increased demand and wage inflation is being kept in check by rising unemployment. Thus, with the output gap in the US at its widest since 1982, it is unlikely that inflation will make a comeback anytime soon.


Finally, if the market is pricing in inflation prematurely, then the additional 250 basis points of risk premium investors can receive by moving out of 2 year Gilts into 10 year Gilts looks extremely attractive. Indeed, the Gilt curve hasn't been this steep since 1992!

Cautious optimism

Three months into a near 40% rally in equities it is time to take stock and assess the economic outlook. Talk of a new bull market is still premature and further upside will depend on a sustained improvement in economic fundamentals and company earnings, or at least their ability to surprise on the upside.

The improvement in economic fundamentals suggests Q1 2009 marked the point of greatest weakness. Indeed, had activity continued to fall off a cliff before long we'd be back in the Stone Age!

However, despite talk of green shoots, most economic data is still negative:

Moreover, after such a sharp and synchronised cut in output, to what extent is the improvement down to restocking as opposed to a sustained demand growth? Whilst forward looking indicators such as OECD leading indicators have ticked up, measures of actual demand such as consumer spending are still in decline. Indeed, consumer demand is unlikely to improve until unemployment and the savings rate stop rising and the supply of credit increases.

Indeed, in an interview with CNN this week, US Treasury Secretary Timothy Geithner suggested consumer demand and credit supply will remain weak for some time.

"You're going to see less credit flowing, as people go back to the point when they're living within their means. That's a healthy process for the economy... But it means that you're going to see a slower recovery than what you normally see."

So, as the G8 finance ministers noted in their communiqué this week:

"There are signs of stabilization, including a recovery of stock markets, a decline in interest rate spreads, improved business and consumer confidence, but the situation remains uncertain and significant risks remain to economic and financial stability."

Bear market rally (March - May 2009) R.I.P.

It takes nerves of steel to remain in cash, on the sidelines of a 30%+ equity market rally. With every 1% that the market moves higher, the greater the temptation to join the party for fear of missing out or being proved wrong. So it is strange that the recent rally coincides with a growing consensus that large amounts of cash await a correction before being invested. Thus, in the absence of improved economic data or company earnings, the market cannot move substantially higher while this cash pile remains uninvested.

An improvement in inter-bank lending alone, as measured by the falling TED spread, is not cause for a sustained bull market. Nor is the thawing of the primary credit market. What started as a financial crisis quickly spread to the real economy with devastating effect. Therefore, the problem is wider than the banks and is not solved, but rather one important part of the puzzle (the financial system) appears to be falling into place. However, there remains a lot to be done before we can say the financial system is fixed.

Since, this recession is unlike any other in living memory, it will take even more time to fix the real economy. What makes this recession different is the almost total collapse of the financial system coupled with a synchronised global slowdown in trade and growth. This combination will make this recession more severe in terms of both length and depth than any other in recent history. Whilst the worst of GDP and financial Armageddon may be behind us, unemployment and consumer deleveraging are likely to continue to deteriorate beyond 'normal' levels, extending the duration of this slowdown in the process.

On the plus side, the extent and speed of the response matches the severity of the problem. Trillions of dollars of toxic alphabet soup (CDOs, SIVs, CDS etc.) have been replaced with equal amounts of state-funded acronymed stimulus such as TARP, TALF, APF, QE... Excessive private sector debt has been replaced with public sector debt, something of which ratings agencies are well aware. Indeed, Moody's and S&P have put the UK on negative watch and this recession will undoubtedly claim more sovereign AAA ratings.

However, while the stimulus undoubtedly made the difference between depression and recession, we have effectively borrowed from the future to pay for the present. The huge increase in money supply and public debt: GDP ratio adds its own set of risks and will lower growth in the future. In an environment of higher perceived risk, investors demand higher risk premiums.

So, expect higher bond yields and lower p/e ratios, which will increase the cost of capital and constrict economic growth. Don't be fooled by the current euphoric bear market rally.

Chaos theory: a pig flaps its wings in Mexico...

Swine flu is a sideshow, blown out of proportion by the media. Having rallied over 25%, equity markets were vulnerable and looking for an excuse to go lower even before the outbreak.

To date, and tragically, swine flu has accounted for 149 deaths in Mexico, a country of 111 million people. This represents 0.0001% of the population.

So, if swine flu is no more of a serious and lasting issue to world health than SARS or bird flu were, there are bargains to be had in those sectors particularly hit by pandemic hysteria.

Airlines, in particular, come to mind, as do other travel sectors such as hotels. However, these sectors were already struggling in the face of the global slowdown, and companies with stressed balance sheets may be at risk.

George Soros interview with Bloomberg

The following are excerpts taken from a transcript of Bloomberg interview with George Soros on 6th April 2009...

The effect of the Western financial crisis on 'periphery' countries
After the bankruptcy of Lehman, the countries - the United States and the European countries - felt obliged to effectively guarantee their banking systems. And saying no other financially significant company will be allowed to go into bankruptcy. But countries at the periphery were not in a position to provide similarly convincing guarantees. And there was a flight of capital from the periphery to the centre. And that is what precipitated the crisis in Eastern Europe; and of course, in Brazil as well. So that was the unintended side effect of this artificial life support. And now that some support is extended by empowering the IMF, and also coordinating better the banking regulations.

China
China is now also simulating domestic growth. They have a pretty big stimulus package. And it is not enough. They are going to use more because not being a democracy, they know - the leadership knows - that their very survival, the avoidance of social unrest, requires them to generate growth. So they will - that’s for them the top priority. And they are in a position to do it. And so China is going to be coming out of their recession before the end of the year. And they will also try to maintain exports by providing credit to other countries. After all, they provided a lot of credit to us. Now they just made a swap agreement with Argentina. And they will similarly do the same with other countries in Africa, Latin America. And so they will actually restart their export industry, too.

Brazil
I think Brazil is another country that’s relatively well-situated. It was doing very well until the Lehman bankruptcy and the sudden collapse. And then you had a crash in Brazil. It did a certain amount of damage. But I think Brazil will also be a country that’s coming - will come out of the recession relatively soon. They have a big deal with China, I think invested something in the neighbourhood of $10 billion to develop the new oilfields there. China will be an avid buyer of Brazil’s soybeans and so on. And eventually will again buy their iron ore. So I think Brazil, actually - together with China, will be among the recovering countries. I don’t know about rapidly recovering, but I think the outlook for Brazil is better than for most other countries.

Oil
It’s very much a question of when does the economy recovery. Because when the world economy recovers, the price of oil will recover. And since the world economy suddenly collapsed, the price of oil collapsed. It hit a low below $40 from $140. And now it’s slowly climbing up. But the longer-term future deliveries never fell that far. And in fact now oil is about $50. And it will probably recover perhaps to $70 or so because the marginal cost of developing new oilfields is around $70. Maybe that will fall if prices fall. So it may be lower. But $50 to $70, somewhere in there.

You see, this is a clear example where you have that conflict between the short term and the long term. Because in the long term, there is no question that first of all, the cost of discovering oil is getting bigger and bigger. And the really large oilfields are getting exhausted. There hasn’t been that much new very large discoveries, except, let’s say, in Brazil in very, very deep and very far out waters. And as the Arctic ice melts, then under the Arctic Ocean, we will find oil. But that’s going to be quite expensive. So long term, price of oil has to rise. And we do have this very serious problem of global warming, which really requires us to develop alternative forms of energy, which are also initially, more expensive than the existing sources. The big difference between the new - the alternative sources that with time, their costs may decline. So right now, let’s say solar energy, is more expensive than natural gas. However, as you develop the technology, those prices may rise. So we have no alternative but to develop those. But the collapse in prices short term has really pulled the rug out from under all these alternative sources of energy. And that is directly counter to what we need in the long term. So here’s another example where the short term is directly contradictory to our long-term interests.

Banks & financial system
The banks are functioning. But they are weighed down by a lot of bad assets, which are still declining in value. So the banking system as a whole is seriously under water. The amount is difficult to estimate. But I think it’s in the region of maybe $1.5 trillion.

I am afraid that we are basically setting ourselves up on a route which will lead to preserving the banking system, preventing it from collapsing, but not recapitalizing them, but allowing them to earn their way out of the hole. And that is going to weigh on our economy for a considerable length of time and set - instead of providing new energy in terms of new loans, it will actually sap our energies by the banks charging heavy fees and restricting credit in order to improve their own earnings, in order to first of all survive so they don’t have to put themselves into hands of the government; and if possible, to buy themselves out by repaying the loans that they have got.

HSBC just raised $18.5 billion and I also subscribed.

On when to cut losses
If it isn’t working, I re-examine it. And it depends on the re-examination. It may be that I find nothing wrong and I can explain why its not working the way it’s supposed to. And I might actually increase my position. Or, I discover something that I left out of account,
and then I cut my loss. So - and I don’t cut my losses automatically. And sometimes, actually, I greatly increase my positions because the - I find the situation more attractive.

INTERVIEWER: So you still do your analysis and just - even if it’s going against you for a while, if the argument that got you there still working, you stick with it?

SOROS: Yes, yes.

Has the rally got legs?
I think it’s a bear market rally because we have not yet turned the economy around. What people don’t seem to understand, that something quite profound has happened. It doesn’t happen very often that the financial system actually collapses. So this is not a financial crisis like all the other financial crises that we have experienced in our lifetime.

The US Dollar's role as reserve currency
To some extent it has already been replaced because it’s not the sole reserve currency anymore. The euro is an important alternative. But there aren’t other alternatives. And the special drawing rights, which I think is a very good thing to use for other reasons, is not an alternative currency. Those are merely bookkeeping entries at the IMF. They can’t be used to buy goods. You know, to use them that way, you have to convert them into useable currency.

US fiscal deficit
You are not going to have a widening U.S. deficit, because there isn’t any more the desire to finance those deficits. And we are not in a – the households are not in a position to use the appreciating house values to savings. And so the savings rate of U.S. households will increase substantially. So the deficit is already falling, and it will continue to fall. So we will actually get back into closer to balance than we were. That’s not a very optimistic view because it’s very painful because it means that we are - economy will not grow that much.

The only way is not up, it's sideways

Equity markets have probably stopped falling, but that doesn't mean they are now on an upward trajectory. They were pricing in Armageddon, which hasn't materialised, so the rally brings markets back in line with fundamentals, which are weak. However, it is fair to say that we have seen the lows of this bear market, since a further severe decline in fundamentals would be required to push prices to new lows.

From an economics standpoint, the fall in output has caught up with the fall in demand, which should prevent further deterioration in industrial production. Indeed, whilst retrospective indicators show no sign of improvement, current sentiment & demand indicators such as US & UK Manufacturing PMIs show signs of improvement, as the chart below demonstrates.

Indeed, Fed Chairman, Ben Bernanke, commented this week that:

"Recently we have seen tentative signs that the sharp decline in economic activity may be slowing, for example, in data on home sales, home building and consumer spending, including sales of new motor vehicles... A levelling out of economic activity is the first step toward recovery... [However,] we will not have a sustainable recovery without a stabilisation of our financial system and credit markets"

However, this is not cause for celebration as it is unlikely there will be a substantial bull market or significant economic recovery, merely a period of low growth punctuated with large fluctuations in asset prices, both up and down, for the foreseeable future. Indeed, this was the case in Japan, where, despite having peaked in December 1989 and falling 75% to March 2009, the TOPIX had a number of very large bear market rallies over the period (see chart below).


In fact, Barclays Capital noted this week that:

"US data have surprised to the upside to some extent over the past month or so. But sooner or later, the recovery in risky asset prices is unlikely to be sustained if some of the more important economies do not show convincing signs of recovery."

So, failing a sustained improvement above expectations, the current 25%+ rally in world equities may yet turn out to be another in a series of bear market rallies to come.


Therefore, expect interest rates to be kept low for the foreseeable future and inflation to remain subdued whilst growth remains stagnant. Moreover, given the amount of monetary stimulus that will eventually have to be removed, there is a high margin for policy error, increasing inflationary risks on a longer term perspective.