A Tectonic Intermission: World to Turn and Churn

By: Hahn Investment | Thu, Jun 26, 2008
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-- Internal Document: Hahn Investment Stewards & Company Inc. --

The HITCH Update -- (The HAHN Intellectual Tap-dancing & Chicken Heroics Update)

Quarterly Strategy Comments & Updates
- June 26, 2008

Key Considerations & Decision Points: See page 2.

Major Current Investment Themes

  1. Global economic slowdown: Consumer retrenchment in North America continuing.
  2. Further global economic impact of liquidity crisis, commodity spikes & tightening.
  3. A split world: A stagflation environment in West; inflationary in rest-of-world (ROW).
  4. Foundations for global re-inflationary boom being set ... but first facing intermission.
  5. Bond Trap Phase I now near over: After intermission, we expect Phase II.
  6. Liquidity hoarding/financial system balance sheet compression continues.
  7. More combative policy responses to #3, #4, #5 and #6 expected ... though delayed.
  8. Eventually high likelihood that investment markets will enter "asset velocity inflation."
  9. USD: A failed recovery rally ... now anticipate further softness. Phase II.
  10. Non-correlated asset focus continues.
  11. US Supply-side boomlet ongoing.
  12. Back to selected parts of Asia, China.

Significant Event (SE) Watch

Significant Events currently being monitored, that are anticipated to either support or trigger future strategy shifts.

Triggered:

  1. US financial and economic coupling with ROW. (Europe next to slow.)
  2. BRIC/Emerging markets slowdown in 2008. Latin America overdone.
  3. US dollar rally (if it can be called that) is probably over. Weakness against pegged currencies now likely the last phase of dollar decline yet ahead.
  4. US households further moving into recession mode.
  5. Housing downturn still ongoing.
  6. Major credit & insolvency watch. Ongoing and still high alert.
  7. Reverse "Bond Conundrum" again in force. Policy reactions to #4, #5, & #6 above (Multiple interventions yet ahead!)
  8. Geopolitical Developments/Interventions: SWFs, China, Middle East financial flows.

Pending and New:

  1. Top in major commodities? (But, oil in a different world? Yes ... and no.)
  2. Global imbalances starting to narrow. Which of 3 scenarios will play out? Watch gold!
  3. A wealth preservation "Velocity Inflation" still expected longer-term.
  4. Counter responses of Euro, Yen and Yuan central banks to USD policy.
  5. US recession bottom: When?
  6. Signs of global infrastructure boom - 2009?

Investment Stance - Key Distinctions

Risk Assessment: (Overall Financial Markets) Above Average with High Volatility.

7-Year Return Outlook: Between 7% and 10% per annum (average of HAHN balanced portfolios).

Other Strategy Resources: Global Strategy Chart Panorama

 June 2008 Global Wealth Perspective - July 2008

 

HITCH -- June 2008

SECTION I: KEY CONSIDERATIONS & DECISION POINTS

Summary: Anticipated Opportunities and Decision Points (1 to 3 year view).

Summary View

June 2008

This quarter, though financial trends and developments indeed remain momentous, we have made only modest shifts in investment policy. Yet, most all of them are in the direction of again lowering risk. As such, some of these shifts represent partial reversals of those made last quarter. These reflect the view that our expected scenarios (all still in force) will play out over a longer time period, rather than in the more compressed form as initially believed. Also, given the further rises in commodity and oil prices, it is clear that the world is now much more vulnerable to an "economic intermission." Until we have a confirmed sense of the extent of this global slowdown, we think it is best to remain underweighted in equities. Should, commodity prices peak and begin to drop (even if precipitously), we believe the bond market will be the first beneficiary rather that the stock market.

SECTION II - THE NEXT BIG SHIFTS

The bubble has burst ... its foundation having found itself perched upon American real estate. That's history. Yet, the deflationary influences of collapsing collateral values are still battling with the interventions of the policymakers. It may be a long drawn-out battle. However, at this time of advanced globalization, it is impossible that its fall-out will not extend its fingers around the globe.

Markets today are still reacting to the perceived realities of recent history ... not the future ... and all of these retrospective perspectives are liable to change. How so?

Consider the consensus views of just 3 years ago: Then, the world specter that held everyone riveted was centered around Iraq and Iran. America and its dollar were still held to be unassailable and powerful. Global disinflation was entrenched. Yet, today -- a few short years later --the prime focus has changed almost completely. Food and oil are the concerns of the day ... and, relatedly, inflation. Iraq and the ongoing US intervention and its costs are now seemingly an afterthought.

It is also significant that the world's power axis has changed significantly in relatively short order. For example, only 3 years ago it was still reasonable to speculate that Saudi Arabia and its parade of princes might topple. Today, Saudi Arabia sits secure, being able to buy its stability at any price.

In the meantime, enormous global imbalances continue to exist ... and, supposedly, are expected to continue. Consider these popular perspectives of today:

All of the above are trends that cannot continue indefinitely, just as the US housing bubble could not. Yes, they may continue for a time longer, however, they cannot be eternal. As said Herbert Stein famously, "If something cannot go on for ever, it will stop."

More likely, the bells have rung on the sustainability of current conditions. Without question, our portfolio policies need to contemplate the outcomes should previous trends "stop."

We argue that the tide is turning ... though developments may seemingly churn slowly for the time being.

More and more central banks around the world are decrying the weak US currency and reluctant to either continue their dollar-pegs or increasing/maintaining their dollar reserves.

As Asia starts to allow its currencies to rise, this acts to impede capital outflows and spur the repatriation of money that is invested abroad. This will mean that the capital supply that has supported the US mortgage bubble and over-consumption in the West is beginning to recede.

Most economists continue to puzzle over the uphill flow of capital -- capital flows from the developing world, to the high-income developed. While international capital mobility exploded far faster that anyone might have imagined, it was the rich that borrowed from the poor. It is still a palpable risk that the end of this cozy arrangement could yet occur. It would be a shock much greater in size than the subprime crisis of 2007-2008.

We therefore stop to consider the possible scenarios that could lead to a "stop" to current apparent trends. How might global trade, savings, and funds flow imbalances be corrected? We pose three possible scenarios or courses that could lead to a rebalanced world.

  1. Global Recession. Global recession. The world recouples. Consumer price increases slow; commodity prices fall sharply, financial systems wobble (triggering further meltdowns) stark consumer hardships continue in North America (contributing to much lower import levels.) The US current account deficit begins to narrow rapidly. Effectiveness: HIGH Financial Danger: HIGH, over the interim Popular Desirability: LOW ... not politically expedient. Inflation: LOW
  2. Muddle Through. America/Europe muddle through, and the Rest of World (ROW) increases internal consumption (i.e. less export intensity). USD stays soft. International imbalances slowing equilibrate in a managed and coordinated way over the next 3 to 5 years, commodity prices plateau, declining slowly. US exports increase relative to imports. Effectiveness: Survivable ... a trend in the right direction. Financial Danger: MODEST Popular Desirability: NOT POPULAR Inflation: Stagflationary conditions in developed world, remaining inflationary in ROW.
  3. Crack Up Boom. World governments pursue own independent interests, fending for themselves, as global coordination falters. Emerging world engages in an infrastructure boom as constituent nations continue to financialize and increase consumption. America and Europe pursue act to minimize economic slowdowns, debt fall-out, and to provide further triage to its financial systems. Effectiveness: UNCERTAIN Financial Danger: MIXED (ULTIMATELY DESTRUCTIVE) Popular Desirability: HIGH Inflation: HIGH, leading to a Minsky-type crack-up boom conditions.

But Now ... Slow Motion

Events throughout the past few quarters have been extreme. Numerous of our anticipated Significant Events (SEs) were triggered. Also, many new ones were mandated. As during any time of crisis -- be it a volcanic eruption, an earthquake, a torrential storm or just general financial bedlam -- time compresses. During the crisis phase, emergency actions -- ambulances and fire trucks speeding to the rescue -- are inclined to be rapid and decisive. Then comes the aftermath ... the relative quiet of re-assessment, damage appraisal, and the licking of wounds. People get out the shovels and slowly dig out from under the wreckage. As such, recently, time again seems to elapse more slowly and causal relationships appear stretched out as rebuilding and fortification efforts unfold. All the same, will more shocks erupt?

Pretty much, a slowing of expected changes is the only perspective that differentiates our expectations this quarter from previous updates. That and the fact that sharply rising commodity and oil prices are increasingly exerting a sizable tax on global economic growth. The basic constructs of our outlook remains basically the same but now with the threat of a greater-size intermission. Markets and economies are now likely to settle into a long grinding phase, working their way along the grating crevasse between the two tectonic plates of the bipolar world. The series of mountain tops stretching into the distance that we described in the previous HITCH Update, now appear to have longer and deeper valleys in between. Right now, markets are trying to gauge the depth of the first of these valleys.

As for the main outlook, the major features remain the same. A global inflationary cycle has begun, it being the result of massive monetary malfeasance around the globe. Global conditions remain highly imbalanced and unsustainable ... and in some respect are worsening at this time. As such, conditions are not sustainable, and major global adjustments lie ahead. As we have argued, this most certainly will include a global economic slowdown.

None of the Significant Events that frame our outlook and contribute to our active strategies are changed in character or substance ... just the speed. We continue to expect that policy responses over the next year and more -- around the world, as an economic slowdown spreads -- will be inflationary in the developed world (though expressing itself in stagflation) while the rest of the world battles inflationary conditions.

For the US, the only sure way out of its economic slump and over-indebtedness is to inflate household earnings (any which way possible) and to continue to expand exports. These policies imply a "non strong" US dollar policy over this transition period.

The main global shift to anticipate over the next several years is this: Expect the developed world -- the major burden falling upon the US -- to be gradually squeezed off the capital supply of the developing world. Capital will likely no longer flow uphill (from lower-income nations to high-income countries).

When a Decoupling World Recouples

It remains a confusing specter at present ... both in world economies and financial markets. Usually, such times are a hallmark of a changing secular era. A new landscape is in the process of emerging. Once the financial market gyrations and volatilities again return to quiescence, we can expect that new secular trends and regimes will already be well entrenched. The unsustainable trends will morph into new trends ... soon to be recognized as the next enduring investment themes. We already commented on the popular perceptions of the trends to date.

Can we already discern which changes will likely be underway?

We can certainly make some probability-weighted projections. Some of the big shifts and forces for change are obvious. Consider these trends and features:

Splitting Tectonics

In the meantime, financial destruction continues apace inside the developed world financial system. Money and capital is being destroyed. Yet, the "industrial circulation" of money saunters along and the pools of long-only portfolio assets remained complacent and fixed on the hopes of verdant upward slopes on the "other side of the valley."

To date, though one of the deepest and longest financial disembowelments since the 1930s has occurred, the disposition of public capital markets and perceptions has remained remarkably sanguine. It is tempting to submit to a growing sense of systemic invincibility. Could it be possible that the world's largest sector -- its very financial backbone and key monetary transmission mechanism -- can be mortally crippled and in tatters, yet it not matter for portfolio capital and economies?

Otherwise, the world has split into two general orbs --1. A late-cycle, financially hobbled developed world; and 2. A collection of surplus, export-oriented nations, including among them both petrol princes and NICs (newly industrializing countries). Of course, there are countries that do not neatly fall into any one of these two general categorizations. All the same, they must orient themselves in accordance with these two emerging polarities.

Unfortunately, schisms have developed within the "high-income" world of late. The European Central Bank has taken a more hawkish course on its monetary affairs, a policy that Japan and the US can ill afford.

Here again, another hope of invincibility (global economic immortality) is on display. The rapidly emerging/growing economies of the world are believed to be virtually impervious to the troubles of the other side of the economic world. Or, at least, so it is popularly theorized.

Unfortunately, in an era of advanced globalization, the arguments for a global decoupling cannot be correct. While most observers focus on trade connections in their arguments for global economic tranquility, they overlook the myriad other channels of connection, from intertwined monetary influences and external account imbalances to common worldwide commodity markets.

On the one hand, a large part of the developed world is entering an economic slowdown. Slumping real estate activity -- from the Netherlands to Las Vegas -- and a hampered financial system continue to argue for caution. Consumers in North America, are under duress and have indeed begun to change their behavior.

Financial Bust II: An Encore?

Is the financial bust over or will other cracks further emerge? A quick review of the facts suggest that it is much too early to be sanguine on this question:

Also, it is instructive to realize that the financial crisis of late, while certainly different in detail (and also being the biggest financial implosion in at least 70 years), is not that different in form than many other banking, currency and sovereign crisis that have occurred around the globe in recent decades. We quote one opinion from a recent paper authored by Kenneth Rogoff and Carmen Reinhart:

"First, most countries in history, especially rapidly growing developing countries, have experienced periodic financial crises and sovereign defaults. Furthermore R/R argue something that is well-known to financial historians: there are regular patterns of periods of global debt crises, with a significant share of the world's countries in crisis or default, followed by periods where the occasional sovereign default is the rare exception. They point out that "the current period can be seen as the typical lull that follows large global financial crises" (pp. 3) and then follow up two pages later with the rather chilling comment: "each lull has invariably been followed by a new wave of defaults."

In conclusion, systemic conditions remain troublesome, arguing that further interventions will be required. (Please see the Addendum to this quarter's HITCH report for a review of the varied forms of intervention that could be expected.)

The ramifications of the financial bubble will be with us for some time yet. To date, the major impulse rattling financial markets has been a financial event ... excess optimism, debt leverage and insolvent financial instruments. The main economic effect -- the after shock -- is still in the pipeline and expected to be ongoing.

The Bond Trap - Part II

We have been on record as anticipating a "massive bond trap." While investors earlier stampeded into government fixed-income securities as the interbank systems locked-up -- in the process driving interest rates across the spectrum to negative real rates -- at the same time the longer-term outlook for bonds became grim. (Money fund assets expanded at a rate of 46% during the first quarter of this year, according to Fed Funds Flow Data.)

Not only was inflation expected to increase, continuing monetary malfeasance, a soft US dollar, and again booming government deficits pointed to the high likelihood of a disastrous bond market ... at least at some point in the future.

As such, last quarter we implemented our first response (Phase I) to this expected scenario. We moved our bond exposures from an overweighted position to neutral and maintained bond durations that were modestly below benchmark. However, we did not move to a deeply underweight position, thinking that we would yet have a better, low-risk opportunity at a later date given our expectation of an oncoming economic recession and additional shoes to drop with respect to faltering financial institutions.

Indeed, parts of this scenario appear to be playing out, however to date, bond markets have not yet offered a better selling opportunity. Actually, they now offer a short-term buying opportunity, we think. Longer-term rates have recovered (more rapidly than we even thought) to levels higher than prior to the last phase of the financial crisis (February 2008) though still below the original onset point of July/August 2007. The realization of rising inflation pressures and a rapidly growing US federal budget deficit (May 2008 reporting shows that US government spending has risen 9.7% year-on-year, while receipts have risen only 0.3% over the same period) have contributed to the rapid back-up in long-term interest rates.

Admittedly, longer-term there are additional pressures looming for the US bond markets. Rising Asian currencies will be negative for US bonds. Given the pressures of soaring food and energy prices, we expect that these currencies must yet rise. That occurrence will impede capital outflows (the lifeblood of the US bond and ABCP markets).

As such, we have 4 forces going against the bond market longer-term: 1. Rising government deficit; 2. Rising or high inflationary pressures; 3. Unprecedented acts of monetary malfeasance and still-declining credit quality; 4. Rising Asian currencies (and possibly also Middle Eastern currencies.) Against that black cavalcade, stands the deflationary impact of an economic recession. While we are reasonably sure of a long, drawn-out economic slump, we are not so sure that ameliorative Fed actions will be taken as a fillip by the bond market. Yet, given the growing likelihood of a slowing economy globally, a break in commodity prices and the fact that US longer-term rates have risen so rapidly, now is not the time to sell bonds. In fact, simply clipping coupon rates we think will beat stocks for the next quarter or two. That said, we can also imagine an upcoming scenario where we may be called to slash our bond market weightings once the "economic intermission" nears its end.

Why Inflationary Cycle Has Taken Off

Viewed over the longer-term, there are strong reasons to believe that the world has moved into an inflationary "price cycle." We say "price cycle" as inflationary conditions have existed almost continuously in recent decades. The difference is that inflation (as defined in a monetary sense) has vented into different channels, displaying its traces and impacts in different forms and symptoms.

Over the past decade or so, globalization continued its acceleration to the point of near resistant-free conditions with respect to cross-border capital flows and trade in goods and services. As such, we must keep in mind that the world is now in a post-sovereign era, where global monetary conditions and money flows over-ride the impact of any one country's policies. Therefore, the results of any one nation's policies can be counter-intuitive. Inflation conditions today can express themselves differently -- different time lags, different symptoms and in far away places outside of a country's borders.

As such, inflationary conditions in one country (for example, excess consumption in the US) can actually produce disinflationary conditions provided that low-price imports can be substituted for higher-price domestic products and services. As long as the resulting trade deficit continues to rise as a ratio of GDP (and imported prices stay significantly below domestic levels) it yields an attractive result. Corporate earnings rise, inflation stays low and productivity statistics soar. In due time (provided that the exporting nations wish to peg their currencies to that of the importing country) a self-perpetuating (though unsustainable) cycle is produced that also serves to repress interest rates in the importing country.

As is well known, a significant repositioning of the world's manufacturing hub has occurred over this period, a transitioning that is now beginning to slow as it must. (What tradable manufactured good is not today dominated by Asian-based companies ... excepting automobiles?) This process has finally bumped up against its speed limits. On the one side, the "inflation ridden" importing country, which has stimulated its spending through rising indebtedness (both nationally and at the household level) ran up against underlying income constraints. On the exporting side, nations have begun to be impaired with huge depreciating reserves (as these have been mostly invested in the importing nation's dubious investment paper) and their inability to sterilize capital inflows. As such, inflation pressures have burst out as monetary aggregates and credit have surged, boom conditions have emerged and, incidentally, demand has begun to outrun short-run supply of many commodities that are key inputs to either manufactured goods or infrastructure spending.

Finally, after a number of years, this unsustainable arrangement has reached both external limits as well as official concern.

Inflation has manifested itself in various forms around the globe. As already mentioned, it is not possible that world reserve growth can continue to boom at an annual pace of 25% per annum and more and not eventually break out into multiple inflationary symptoms somewhere.

Anecdotal Inflation Statistics

In the UK producer prices have risen 8.9% over year earlier levels. Core prices are contributing to this rise.

Inflation in Asia has broken out to untenable levels ... i.e. in Vietnam rising to 25.2%, the highest since 1992. Across Asian, according to UBS the average real rate (short term interest rate) is 1.7%.

Foreign CPIs are moving up ... meaning an eventual impact on US imports.

The developing world, along with its hyperactive NICs has burst the inflation seams. Consumer price indices are now rising at an average of 8.0% plus in these regions of the world.

As occurred in the 1970s when an inflation spiral was underway, inventories expanded. The same is likely to occur at present. Already, for example, such firms as Costco have boosted their advance purchase in order to maintain low prices.

The above conditions directly facilitates the "Reverse Bond Conundrum." This means that even as the US (and other countries) try to maintain modest interest rates through a slow economic periods, the reduction in the international supply of funds will force up longer-term interest rates.

Oil Price Bust Coming?

Consider the specter in regards to oil prices today:

We recall the conditions of 1998-1999 in the oil markets. We remember being deeply perplexed at the time. Oil prices kept falling despite a strong world economy and booming developing countries. China's economy by the late 1990s had already doubled in size twice since the beginning of its mercantilist and expansionary economic policies launched in the 1970s. Yet, oil prices continue to fall to as low as $12 a barrel. The editors of Economist magazine at the time thought it plausible that crude oil prices might yet fall as low as $5. A number of large mergers took place in response to these low prices. It was thought that strict cost-savings were necessary in order for the big oil majors to survive.

Now, let's fast forward less than a decade. Oil prices are 10 times higher. Yet, most analysts are convinced that prices will surge yet higher ... most probably doubling again to $250 per barrel and higher.

While we hazard to guess when oil prices might peak (on a cyclical basis), it would not be surprising that popular consensus could be turned on its head. A sharp correction in the price of oil is likely. Some analysts, in fact, even worry about a short-term crash. We would not be surprised to see oil prices fall to $85 a barrel or less. Should this occur, we expect the equity markets of low-income (emerging markets, China ... etc.) countries to surge.

SECTION III - FURTHER MISCELLANEOUS COMMENTS

Gold

We continue to maintain our weightings in gold bullion and gold-related securities, despite their continuing high volatility.

The gold correction may be near over. Consider that the oil-to-gold ratio is now very compelling. Also, the announced IMF sale of 4.3 tonnes of gold reserves is actually a miniscule amount ... only worth $11 billion at today's rates. Approximately one week of China's external surplus would sop up this metal. In the meantime, the temptation to "monetary malfeasance" are as high as ever around the world.

Interventionism

We cannot imagine why government intervention and enhanced economic stimulus will not heighten over the next several years.

We still think that desperate situations require desperate responses. While a few quiescent months seem to have intervened since the Fed's sponsored bail-out of Bear Stearns, the crows are coming back.

Before the current malaise in the US is over, we must expect massive spending policies to take place. (Please see the Addendum to this quarter's HITCH report for a review of the varied forms of intervention that could be expected.)

US Dollar View

The ultimate fate of the US dollar continues to remain vulnerable for the interim.

Yes, the US dollar has been soaring against the Zimbabwean dollar (ZWD) of late. Recently, the value of one US dollar soared past $1 billion in ZWD, up from $700 million the previous week.

All the same, we are reconsidering our view on the dollar. While we have been stalwart bears of the USD for many years, we had begun to look for a turning point as of late last year. Admittedly, there were reasons that suggested a turn is possible ... at least for an interim counter rally. Indeed, even here we had only expected a interim counter move, certainly not signaling an all-clear as fundamental conditions were still deteriorating conditions for the longterm.

To date, no strong counter rally has emerged, despite the best jaw-boning (witness the recent calls for a strong dollar policy by various notables in the US.) Whatever rally there was, it has happened for now.

We now must expect the last phase of the Dollar Bear. However, this decline will take place against the pegged currencies ... that group of parasitic, hangers-on who chose to ride down with the dollar against the euro and the yen. They must now take leave of the US dollar (their now sapped host) in order to save their own economies and banking systems. Inflation is looming, food prices have been soaring (causing restless constituencies) and credit supply has been running rampant.

However, it remains very likely that once a final bottom has set in for the USD, markets will be vulnerable to very sharp and steep rallies.

US Slowdown

As of the second quarter, US households have begun to receive rebate cheques (approximately $500 per household). This is likely to produce a modest lift in retail spending. However, this effect is expected to be only temporary for a number of reasons.

Consider that many households are in severely impaired financial shape. Nearly 1 in 10 American homeowners (about 60% of all households have mortgages) fell behind in their payments in the first 3 months of 2008. The foreclosure process is still in its acceleration phase.

A high percentage of the 5.85 million sub-prime mortgages are in danger of defaulting in the next 12 months.

Spending pressures are evident in the fact that record numbers of Americans are pulling money out of their retirement savings. Administrators of 401k plans report a growing number of early withdrawals. Also, sadly, Craiglist has experienced a surge of sell listings for household items.

A major harbinger is now in the fact that household wealth has begun to decline as of the 3Q of 2007. Typically, such periods coincide with slowing consumer spending.

Continue to Part II

 


 

Hahn Investment

Author: Hahn Investment

Hahn Investment Stewards & Company Inc.

Hahn Investment Stewards & Company Inc.
Global Fund Management & Investment Counsel
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