A Tectonic Intermission: World to Turn and Churn
-- Internal Document: Hahn Investment Stewards & Company Inc. --
The HITCH Update -- (The HAHN Intellectual Tap-dancing & Chicken Heroics Update)
- June 26, 2008
Key Considerations & Decision Points: See page 2.
Major Current Investment Themes
- Global economic slowdown: Consumer retrenchment in North America continuing.
- Further global economic impact of liquidity crisis, commodity spikes & tightening.
- A split world: A stagflation environment in West; inflationary in rest-of-world (ROW).
- Foundations for global re-inflationary boom being set ... but first facing intermission.
- Bond Trap Phase I now near over: After intermission, we expect Phase II.
- Liquidity hoarding/financial system balance sheet compression continues.
- More combative policy responses to #3, #4, #5 and #6 expected ... though delayed.
- Eventually high likelihood that investment markets will enter "asset velocity inflation."
- USD: A failed recovery rally ... now anticipate further softness. Phase II.
- Non-correlated asset focus continues.
- US Supply-side boomlet ongoing.
- 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.
- US financial and economic coupling with ROW. (Europe next to slow.)
- BRIC/Emerging markets slowdown in 2008. Latin America overdone.
- 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.
- US households further moving into recession mode.
- Housing downturn still ongoing.
- Major credit & insolvency watch. Ongoing and still high alert.
- Reverse "Bond Conundrum" again in force. Policy reactions to #4, #5, & #6 above (Multiple interventions yet ahead!)
- Geopolitical Developments/Interventions: SWFs, China, Middle East financial flows.
Pending and New:
- Top in major commodities? (But, oil in a different world? Yes ... and no.)
- Global imbalances starting to narrow. Which of 3 scenarios will play out? Watch gold!
- A wealth preservation "Velocity Inflation" still expected longer-term.
- Counter responses of Euro, Yen and Yuan central banks to USD policy.
- US recession bottom: When?
- Signs of global infrastructure boom - 2009?
Investment Stance - Key Distinctions
- Cautious: Few asset classes attractive. Now extend bond duration for intermission.
- Tilting towards a "Stagflation" scenario in developed world (inflationary boom ROW)
- Emphasis upon big cap equities.
- High reliance upon non-correlated and quality yield assets.
- Asian currency bloc, Asian real estate.
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).
It is becoming ever more convincing that the world's economic tectonic plates will continue to move apart. But for now, the bells have rung ... the world is up against cyclical constraints. Major imbalances need to be reconciled ... somehow. We lay out 3 possible scenarios how this might happen. We are not advocates of the "decoupling theory" -- i.e. that the ROW (rest of world) will not be affected by the economic troubles in the highincome countries. A "globalized" world cannot be decoupled. Two different sets of conditions will continue to define the world.
Therefore, over the next several years, we anticipate a continuing specter of a bi-polar world. America (and other parts of the high-income world) will face a weaning off of surplus capital flows that were running uphill (from the emerging, newly industrialized world and the oil exporters to the high-income countries). That means slow growth, stagflation and higher interest rates in the former, and more bubbly, inflationary conditions in the latter. One group is stepping on the gas and the other on the brake.
This bi-polar world leads to the contrasting policy initiatives of 1. Direct economic intervention and monetary stimulus, slower economic growth, lower currencies and higher interest rates in the "deficit world" and; 2. A continuing overheated infrastructure boom in the ROW (though vulnerable to busts and volatility). Like a split climate system in a car-- heat for one passenger, air conditioning for the other -- this leads to a swirl of air dynamics and an average temperature somewhere in the middle.
But first, a global "economic intermission" is likely to unfold ... and it may look rocky at times. External imbalances are at the breaking point, high commodity and energy prices are acting as a brake and effectively high trade tariff, and runaway inflation and/or consumer deleveraging threatens in a number of countries. These are all indications of impedance, not stimulus. All the same, the mixture of expected policy responses to deleveraging and reaccelerating economies in the ROW (revved by infrastructure and new energy spending) will likely soon resurrect underlying inflationary biases.
Commodity prices are expected to soften substantially ... including oil. While we would hazard to guess when prices might peak, we surely are in the "bubble camp." Speculative behavior and hoarding are part of recent dynamics. Crucially, the Baltic Dry index has again begun to decline, possibly signaling that the hording phase is coming to an end across the spectrum of traded goods ... not just petroleum. Rising inflation fears has contributed to much "advance ordering" to lock in lower prices. (It was puzzling why the Baltic Dry Index again soared the last half year, when clearly, economic momentum was losing stream.) When all these speculative forces unwind under the duress of a global economic slowdown, the consensus--as it usually is--stands to be dismayed at the extent of cyclical price declines with commodity complexes.
Eventually a global boom? Assuming that the current financial crisis is bridged in the anticipated manner, and that a global economic "intermission" is successfully forded, a new, world-wide inflationary boom will likely unfold ... one centering on massive infrastructure spending both in emerging markets as well as America. But when? Dare we say that world growth will again be gurgling along again in 2009-2010?
Bail-outs -- what to expect? As we have mentioned frequently in our comments of the past year, we expect unprecedented levels of government intervention to take place before the current financial instabilities are over. This is happening ... and more measures are expected to be invoked. To date, the most significant of these interventions (outside of harried rate reductions) have been new lending programs of treasuries backed by greatly relaxed collateral requirements, the defacto bail-out of Bear Stearns, an increase in the mortgage size limits, reserve requirements ... and other back-door machinations. These actions, in addition to expected maneuvers in the future, are sure to continue driving up long-term inflationary expectations, but also will eventually succeed in restoring value to real estate collateral in the financial system.
After a snap back, the next shoe to drop? Early this year, the incentives to again taking on risk became alluring. Yield curves were widening, spreads blew out, and huge pressure was building to force investors out of cash (i.e. inflation ... etc.), the carry trade was looking attractive again (the yen at 97 to the USD!), and Japan again stood to be a source of funds ... to mention a few factors. Now that this has indeed unfolded, what next? We think the best that can be expected is a sideways market. More likely, aftershocks will cause new declines before the intermission is over.
Bond Trap Phase I now over. We have been on record as anticipating a "massive bond trap." We anticipated 4 forces going against the bond market longer-term (1. Rising government deficits; 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. We are reasonably sure of a long, drawn-out economic slump, which should now intercept with an intermission in the bond market. Yet, we are not so sure that ameliorative Fed actions will be taken as a fillip by the bond market given the "Reverse Bond Conundrum" effect which sees to be back after a "crisis" interlude. All the same, now that US treasury yields have "exploded to the upside," value has again emerged for the interim.
We are shifting our views on the US dollar. While we never did argue for a long-term USD uptrend, at the very minimum we thought that a sharp USD counter rally would be likely at some point. In a blink, this already may have happened. Yes, at some point (we are gun-shy about exact prediction here), it would be reasonable to expect a global rebalancing to take place which then ultimately could contribute to a major turn in the USD. A decisive turn in the dollar could trigger a rush of portfolio capital back to the US. But for now, the US must retain a weak dollar given its current economic dilemma. The final phase of the USD bear market very likely will involve the capitulation of the dollar-peg currencies.
With respect to equities and "hard" assets, we continue to expect a "velocity-type" inflation to emerge over the next few years (again including many soft commodities.) But an economic intermission is first likely to intervene. In the past, we have also referred to this scenario as the Stagflationary Jungle -- an environment where the prevailing challenge is the relative preservation of wealth. Structurally, the world of financial assets is well primed for just such a velocity inflation.
Why have stock markets not yet succumbed to the overwhelmingly negative economic news and rising interest rates along the experience of past cycles? For reasons explained in recent updates, financial capital has stratified and increasingly become delinked from the real economy. Also, equities are better suited for the upcoming world financial climate than bonds.
How long a US recession? The US economy likely has slipped into a recession as of the past quarter, if not late last year. At least a mild recession is likely in the first two quarters of 2008. Despite the grave fears and high worry levels, the jury is still out as to whether it will be a deep "V" slowdown at this time. This view may seem heretical given the high visibility of bad news and statistics. However, exports are growing sharply and increased direct government spending is likely. This will counterweigh consumer spending and residential construction downturns. As such, following the initial recession, the most likely outcome is a long extended period of slow growth -- a "U-type" valley of slow growth, groaning adjustment and consumer deleveraging. It may be an economy that oscillates between short periods of negative real growth and 2% growth plateaus.
A global recoupling is underway ... in other words, a worldwide economic slowdown. We expect that a US slowdown will soon be joined by Europe at large. Already, Spain, Ireland and the UK are experiencing downshifts. Given that most of the economies in the high-income countries will face headwinds, a not minor impact will fall upon emerging markets, particularly the BRIC group. Also, we do not expect China to escape the chillier winds as is now becoming evident.
Emerging market equities have fallen substantially (China now down over 50% from its peak). Should food and oil prices again decline, current stock market levels may soon offer a good buying point. While China's stock market decline likely presages an economic slowdown, the stock market now appears to offer reasonable value.
The US consumer sector is under heavy pressure. Significantly, consumer behavior has begun to change. Household savings rates are again likely to rise (subject to temporary intermissions as government stimulus spurs spending from time to time) supporting the narrowing of the US current account deficit. This will become much more evident once oil prices decline.
Longer-term -- possibly a period no longer than 2-3 years -- we anticipate that inflationary conditions, the effects of a much depreciated US dollar, and direct spending stimulus from government deficit spending and export growth will serve to recalibrate the carry costs of presently overindebted households through income inflation. At that point -- if not well before -- the housing slump will have stabilized, supported by strong affordability.
Anticipated Significant Events (SEs) are occurring as expected ... although timing with respect to remaining SEs are still up for debate and seem to be stretching out. This past 2 years has been marked by an inordinately large number of SEs, also signifying aboveaverage portfolio turn-over. (Our long-term portfolio turn-over remains below 30% per annum.)
Will a Deflationary Unwinding or an Inflationary Spiral scenario play out? As Martin Wolf (FT June 24, 2008) puts it, these two "storms are buffeting the world economy: an inflationary commodity-price storm and a deflationary financial one." By the standards of our definition that we have used over past decades (5% or greater producer price inflation -- PPI) we are now in an entrenched inflationary up-cycle. We do not believe that the "economic intermission" we are expecting, will eradicate this new inflationary era (only slow it down for a time.)
We expect a boom in infrastructure spending around the world to emerge in time, especially so in countries with high savings and reserve accumulations. They have the money! (Some of this spending will eventually take the pressure off energy and other selected commodity prices). Even the USA is likely to experience stronger infrastructure spending as stimulative government spending will be directed to upgrading transportation systems. All of these types of spending have a high "materials intensity."
An SE that we instituted in March of 2005 remains in force. The US housing downturn has longer to run. Supply/demand factors, affordability conditions and a tougher financing environment continue to underline this conclusion. However, we sounded our first caution on an approaching housing bust in late 2004, finally calling our SE on a housing downturn in March of 2006. As such, we are already long in the "bear tooth" on this view. We are now watching for constructive developments, although these may only transpire over the next year or more.
Corporate earnings growth is deteriorating, (certainly so for the financial sector) though still remaining at high levels. A theoretical approach that we employ suggests slowing corporate earnings growth over the next few years. Currently, cyclically-adjusted earnings are at near record-high valuations. This in turn implies that equity returns will also be generally modest over this same period. At the same time, this latest equity "bear market" did not start with P/E multiples that were as stratospherically high as in 2000.
The Canadian dollar remains overvalued, having been sustained by the US dollar troubles of late. All the same, the Canadian dollar has been among the weaker currencies in the world of late, its apparent correlation to commodities and oil price trends having been partly severed since the turn of the year. Should the US dollar begin to rally against the euro, we anticipate that the CAD will fall further. Ultimately, the CAD should be expected to settle back to the 0.85 to 0.88 USD range. During this period, global diversification will reward Canadians with attractive returns. Currently, yield differentials are not favorable.
Gold has proven itself as a hedge against inflation and a US dollar bust ... at least for the time being. We continue to hold gold as a core holding for "insurance" purposes" as risks of organized monetary malfeasance remain very high. Despite the high volatility of this asset class, given the material probability of an inflationary "wealth velocity inflation" we must continue to hold an exposure to commodities and other "hard assets."
Over past years, we have built up portfolio exposures to asset types that are non-correlated to North American equities and fixed-income. Alternative-type assets, such as commodities, Asian currency, Asian real estate, and foreign currency assets have been added to nearmaximal levels. These exposures have served well, greatly muting portfolio volatility to date this year and truncating "draw downs." However, some shifts are in order. For example, we are lowering our exposure to commodities. We anticipate a continuing high reliance on alternative assets for a time longer, although shifting their composition.
We have anticipated a move to "supply-side" of North American economy, preferring to establish these positions during an expected economic downturn. Instead, a mini "supply side boomlet" (SSB) has already occurred, as stock markets have not reacted to economic slowing signals. Actually, cyclical sectors have spurted over the past year and more. We hope to implement this sectoral emphasis following the emergence of 2 criteria: A recognition of at least a partial global recoupling, and secondly, a confirmation of a US recession bottom.
Asian currencies have performed admirably ... not to mention a soaring yen, though weakening of late. Many Asian currencies (now also pressured up by the yen) have nowhere to go but up, we still think, though high relative inflation would accomplish this equilibrating over time. We continue to hold positions in Asian currency-equivalent investments.
We continue to favor "large cap "stocks. Given the growing likelihood of a global "economic intermission" we now see reason to delay moving to an overweighted stance on equities. Bonds are again offering competition. In fact, we are modestly reducing equity positions to again raise cash modestly as well as fixed income. No deep equity weights are recommended (as was the case in 2000-2002) as equities and alternative-type assets are likely to fare best longer-term in the environment we foresee playing out over the next several years.
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:
The oil-exporting nations will continue to bask in surplus money inflow (the Middle East and Russia) forever. Their SWFs will soon take over the world, snapping up all the desirable trophy assets around the world.
More and more countries are opening up SWFs (even Canada soon?) in the quest to diversify away from US fixed-income paper. Some forecasters see them growing to a size of $25 to $30 trillion in size by 2025.
China's current-account surplus grew 49% in 2007 as its exports continued to increase. The trade surplus rose to $371.8 billion, up from $250 billion a year earlier. In the popular lore, it cannot be imagined that the Chinese trade juggernaut will ever slow its pace. But, really: how long can China's (and other) surplus continue to grow at this pace?
Food commodities can only continue to go up in price. (Doesn't everybody clearly recognize that 60% of the world's population lives in Asia and they need food and resources?) The "bullish" case (or disaster scenario ... depending on the perspective) is self evident.
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.
- 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
- 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.
- 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:
The US is facing a long period of stagflation ... if not something worse. The jury is out as to the likely long-range affects of a deleveraging and squeezed household sector upon the United States. Will it be a slow economic fade ... or be allowed to vent into a rapid, hyperinflationary descent a la the experience of various Latin American countries previous to the last decade?
Commodity prices have soared over the past 3 years, inflating more virulently than any other time in recent history. Should we expect them to continue soaring? While prices could easily rise further in future years, for now, a dangerous bubble is emerging. This is not a sustainable trend over the near-term.
An inflationary environment is confirmed and underway. Its manifestations may take the form of stagflation in the industrialized West; elsewhere an inflationary spiral similar to the 1970s is already in progress. There can be little doubt. Consider that to date, international reserve assets (as tabulated by the IMF) rose $1.476 trillion (or 26%) over the past 12 months, to a record $6.836 trillion. And, to recall, that these figures do not include China (a large reserve holder) and are also under-represented by the continuing transfer of central bank assets to state SWFs. All in all, overall growth in reserves betrays a maniacal, inflationary well-head, that must express itself in some type of inflationary symptom somewhere in the world.
A general shift is expected with respect to policymaking philosophy. Whereas the past two decades were heavily pre-disposed to "free market capitalism," a period of interventionism is now likely. The pendulum has begun to swing to the reverse. After a few decades of unbridled expansion amongst financial intermediaries and securities markets, and a widening wealth skew and rising indebtedness, there is a sense that the forces of greed and corporatism have become too extreme for popular tastes. All the same, the bills have now come due for the past excesses of free market escapades.
A number of bubbles have already begun to unravel. For example, house builder stocks have collapsed as has outstanding ABCP. Mortgage lenders have imploded. The Chinese stock market bubble has come back to earth ... having fallen over 50% from its top to date. It is likely that other bubbles (oil and commodities) will topple in the near future, as well. Big busts do not simply go right back to former highs. There next comes a long grinding phase ... sometimes followed by a new low several years later. Two actionable notions fall out of those observations: 1. Sectors involved in the bubble busts take a long time to recover and can be safely avoided. 2. Monetary excesses will soon be channeled to other areas. Which will these be? With respect to investable assets, we expect a number of systems of "velocity inflation" to emerge over the next few years.
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:
First to realize is that that housing/real estate remains the primary collateral on the balance sheet of banks and investment banks. And, presently this asset class is still deflating at the fastest pace since the Great Depression. It is always deflating collateral that is the prime detonator to a financial collapse. Japan's lost decade of the 1990s was largely attributable to shrinking collateral values. CDS (Credit Default Swaps) outstanding, essentially representing an unreserved insurance product, have continued to soar, amounting to a notional value of $58 trillion at year-end 2007. Should trouble emerge in this derivatives sector, it would be a challenge to contain losses.
Loan loss reserves remain modest in view of likely future loan defaults in the US.
There is evidence that many financial institutions have yet to fully recognize the impairments of their loan portfolio. This is especially true for the government mortgage agencies, Fannie Mae and Freddie Mac. Despite the fact that real estate prices have been falling, they have not reported any impairments of their loan portfolio to date. This begs the question of whether current reporting is accurate. Recently, Fannie Mae recategorized $155 billion of assets to Category 3. There was absolutely no recognition of imperiled assets in any way ... even despite the fact that 25% of US population is facing double digit price declines and foreclosures are soaring.
Default rates on corporate loans and bonds remain near lows. To date, while there has been a beginning upturn in defaults in this sector, these remain far below typical levels for late-stage recessionary environments. Should a full-blown recession take place, defaults should be expected to explode on the upside.
Oppenheimer (Meridith Whitney, a well-respected banking analyst) maintains that the large US banks will yet need to set aside $170 billion by the end of the year to cover expected credit and mortgage related losses.
All indications are that the credit insurers, MBIA and Ambac will ultimately end up in bankruptcy. The cost of credit protection on their own paper has recently again soared to levels that betray a deeply distressed situation. Several other bankruptcies are likely pending ... namely Country Financial Corp (CFC) though it now looks to be in the arms of an acquirer, Bank of America. (CFC originated as much as 20% of all mortgages in 2007.)
A point to keep in mind is this: If another shoe should drop, the range of responses will have narrowed significantly: SWFs have already been burned once in their previous rescue attempts. Twice shy. The average capital call by the financial sector to date has resulted in an average loss of 15%. At the same time, central bankers are now constrained by rising inflation and a depleted balance sheet.
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:
Massive protests are being reported from around the world.
High price volatility and large intra-day trading swings are being witnessed.
Huge and increasing "open interest" on derivatives exchanges.
Contango ... future prices are higher than spot prices.
Commodity mania -- the increasing proclivity to consider commodities as stores of value.
Strong consensus that oil prices will go up longer-term ... though there may be shortterm corrections. The idea that oil prices could fall is thought almost laughable ... downsides of 10% or more beyond contemplation.
The notional value of OTC commodity contracts rose to $9.1 by the end of 2007, up from $7.1 the previous year. Given that oil represents about 70% of the major commodity indices, it can be estimated that $1.3 trillion moved into oil in some way (not including the possible impact of leverage.)
According to Michael Masters, over the past 5 years, the increase in demand for index speculators (institutions, mainly) has increased by 848 billion barrels, almost equal to increase in demand from China.
The US has experienced the biggest year-over-year drop in gasoline consumption in history. Miles driven actually declined this year over previous year levels.
GM is thinking of closing down its Hummer Division.
Countries around the world are slashing oil subsidies. For example, Malaysia recently raised petrol prices by more than 40%. (Taiwan, India, Indonesia, Sri Lanka also cut subsidies recently.) China just boosted gasoline prices 18%.
Economists are forecasting a massive infrastructure boom, centering on new energy supply developments of various kinds.
CIBC World markets issued a provocative report illustrating the impact of high oil prices upon globalization. They concluded that the rising price of oil (at the $100 per barrel point) outweigh all the positive impacts of declining tariffs of all of America's trading partners. At current oil prices, they estimate the equivalent tariff level at 9%. $200 oil would take us back to pre-GATT 1960 in equivalent tariffs.
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
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.
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.
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.