Central Bankers of the World, Unite Again!
Is the Fed right to be worried about inflation, or is that so last quarter? What do musty old academic papers suggest about Fed policy? And can we translate that into something that gives us a clue as to why markets around the world are in seeming lockstep on their way to the exits? (Quick, guess which market has done the best in the last month. No peeking!) Whatever happened to the diversification of our portfolios? This week we look at a wide range of topics trying to get some insights into where the markets are headed this summer.
First, let's look at the world equity markets. I had my new assistant, Micah Davis, do a search for how the world equity markets have done this year from their recent peaks. All in all, we looked at 64 markets. I assumed we would have at least a few up markets. There always seems to be some market somewhere that can buck a downtrend.
Interestingly, all 64 markets are off their recent highs. Two-thirds of world markets are down 10% or more, with Middle Eastern markets in free fall for the past few months. Indeed, they seem to have been a warning sign of trouble, as they have led the way down.
For the curious, here are the worst performing 20 markets through Thursday.
By contrast, the broad US markets have held up relatively well. The Dow is off around 6.4% from its high, which hardly qualifies as a decent correction, and the NASDAQ is down by 10%.
But why the lockstep? Why is every market down? I think we can look at the change in major central bank policy which began a few months ago and was highlighted in this letter. In short, the central banks of the world are taking liquidity out of the system. It was the providing of massive amounts of liquidity that had driven asset prices around the world to frothy heights, and now we are seeing what happens when that process goes into reverse. It wasn't like we didn't have any warning. They made it very clear. I suggested then that the world was in for a round of volatility and a correction in world markets and prices.
As the answer as to which market fell the least? Nigeria, down a mere 0.3%. Go figure.
Central Bankers of the World, Unite!
"The Central banks are clearly not concerned with current meltdown on equities. On the contrary, they seem increasingly intent on tightening the belt. Over the past 24 hours: 1) the Bank of Korea unexpectedly raised rates by +25 bps to a three-year high of 4.25%, 2) Thailand's central bank raised rates by +25 bps to 5%, 3) India's central bank hiked rates by +25 bps to 5.75%, 4) South Africa raised rates by +50 bps to 7.5%, and finally, 5) the ECB raised interest rates by +25 bps to 2.75% (ECB head Trichet actually stated that they had considered a +50bps hike, but decided against it in the end)." (GaveKal)
All those little steps matter, of course. The Korean markets simply threw up in response to the surprise hike. India, as noted above, is in a free fall, with the world's fourth worst performing market. This is on top of what will be even more tightening by the US Fed.
But I think the real sea change is in Japan. It's worth quickly reviewing this note from my April 28 letter noting the following important chart and insights from those clever guys at GaveKal:
"The chart below shows the US monetary base, the Japanese monetary base - in dollars - and the sum of the two (also in dollars). What emerges from this graph is very simple: all the volatility in the US + Japanese base aggregate has come from the Japanese part of the component. The volatility in global M has in the past thirty years come from Japan.
"Looking at the past thirty-five years, we find that the Japanese monetary base has been allowed to double over short periods (i.e.: less than three years) three times. Each time, it led to massive bull markets (real estate, share prices, commodities, gold, etc...), followed, some time after the expansion of Japan's money supply was over, by a serious market downturn.
"... Another interesting fact drawn from the above chart is that, following the large 2001-2004 expansion in the Japanese monetary base, the Japanese monetary base is now larger than the US. That is quite impressive for an economy less than half the size."
I would also add that you can see a clear and large build-up by the Japanese prior to 2000 and then a tightening leading into the 2000-2001 stock market crash. Coincidence? I think not. Japan was the primary provider of cheap liquidity. It was a result of their desire to rid themselves of the demons of deflation. And now they apparently have.
The policy was called Quantitative Easing or QE. If they kept QE as a policy, pretty soon you could see real inflation and problems in Japan, so they announced the end of that policy. What else would you expect them to do? But the unintended consequences are that world markets are now having to adjust. We are seeing risk premiums begin to come back, and that adjustment can be painful.
Couple that with the realistic expectation that Japan is going to end its ZIRP or Zero Interest Rate Policy and you can see the end of the yen carry trade. Where do you go to get cheap risk-free leverage capital? Certainly no longer the US. Europe is starting to get pricey. Japan is the last man standing, and they are getting ready to leave the room. Is it any wonder that hedge funds are scrambling to find the exits?
History Has Not Dealt Kindly
This reminds me of a now prescient paragraph from a speech by Alan Greenspan last August. I thought it was a very important warning then and I do so even more now (emphasis is mine):
"Thus, this vast increase in the market value of asset claims is in part the indirect result of investors accepting lower compensation for risk. Such an increase in market value is too often viewed by market participants as structural and permanent. To some extent, those higher values may be reflecting the increased flexibility and resilience of our economy. But what they perceive as newly abundant liquidity can readily disappear. Any onset of increased investor caution elevates risk premiums and, as a consequence, lowers asset values and promotes the liquidation of the debt that supported higher asset prices. This is the reason that history has not dealt kindly with the aftermath of protracted periods of low risk premiums."
That last sentence has stuck with me. I think about it a lot, and so should you. We are watching risk premiums reassert themselves in markets around the world. This process is hardly over.
Getting Ben a Dog
Poor Ben Bernanke. Today I read in the Wall Street Journal in the influential "Ahead of the Tape" column:
"Ben Bernanke has been Federal Reserve chairman only since February, and many investors - used to making snap judgments - already have formed an opinion: they don't like him."
The old line on Wall Street is that if you want a friend, get a dog. From many of the comments I have been reading, Ben may need to go to pet shopping. But I think much of the commentary has been unfair.
I think Bernanke's key problem is that he does not have his predecessor's gift of timing. Easy Al knew when to leave, and Gentle Ben has to pick up the pieces of what was a very long and very accommodative monetary policy, both here and in Japan. And in the case of the US, all the inflation that is now starting to show up was created on Easy Al's watch. (Later in the letter, we will look at Peter Bernstein's thoughts that the Fed was too slow and now we have to deal with the aftermath of that policy.)
Earlier this week, the Fed chairman annoyed the markets with the following quote at a major monetary conference of central bankers:
"Core inflation measured over the past three to six months has reached a level that, if sustained, would be at or above the upper end of the range that many economists, including myself, would consider consistent with price stability and the promotion of maximum long-run growth."
Many commentators blamed Bernanke for that day's large market fall. However, that is a reach. The market was already down 115 points when he began to speak and the trend was clearly down. No matter. The intention is clear.
Meanwhile, the recent messages from other Fed officials are in keeping with the new and increased hawkish tone. Yesterday, soon to be Fed vice-chairman Donald Kohn stated he "found the recent inflation data somewhat troubling" and that "they were higher than I had anticipated, and that raises a warning flag."
Next week we will get the most important piece of data for a data-driven Fed. We will see what inflation was for the month of May. If core inflation is above a 2% annual rate, and I expect it to be, then with the recent pronouncements, the Fed has all but made it clear they will raise rates again at the June 28-29 meeting. I think this deserves a few observations.
First, that will put us back into a fully inverted yield curve, with the Fed rate at 5.25%. Notice the interest rates and graph below, with the 6-month rate higher than the 30-year rate. Another rate hike in late June should take the 3-month over the 30-year as well.
Second, there will only be one more inflation number coming out between the late June and August 8 meeting. Given the current rhetoric, another inflation number in July above an annual 2% run rate may cause them to raise yet again in August. Unless the bond market goes into the tank with yields rising 50 basis points across the entire curve, that would severely invert the yield curve. And I think getting an inflation number above 2% in July has better than a 50-50 chance.
Third, monthly inflation numbers are backward looking. While you can observe the trend, they do not project into the future. There is a set of data that does predict inflation, however, and that is the ECRI leading inflation index. And that index appears to have turned the corner. It was down 0.2% in May and has been down 3 of the last 4 quarters.
Thus the real risk is that the Fed goes too far in fighting inflation, just as inflation is actually peaking!
As Housing Goes ... So Will Employment
Higher interest rates are clearly not helping the housing market or the mortgage refinancing market. For the past few years, cash-out financing has been responsible for as much as 2% of GDP growth. My back of the napkin modeling suggests that we could see GDP off by about 1% and maybe as much as 1.5%, just from the drop in cash-out financing. That takes us back to a 2% GDP number for the latter half of the year, even if everything else stays the same. And it is almost certain not to.
Rising rates are having a follow-on effect in the employment market as well. Look at this paragraph from David Rosenberg, North American economist of Merrill Lynch:
"In the last economic expansion from Apr 1991 to March 2001 there were 23.96 million jobs created, and of those 1.64 million (or 7%) were in housing-related areas. In the current expansion which began in late 2001, there have been 4.22 million nonfarm jobs created, and of those 844k (or 20%) were housing-related. Tacking on the new series that includes 'Specialty Trade Contractors: Residential Construction,' the number is 1.34 million or fully 32% of the job creation in housing related sectors. This area has started to slow - but the declines haven't even started yet and this is after we've seen sequential slowing in the nonfarm numbers for three months in a row (200k in February, 175k in March, 126k in April and 75k in May)."
David also had a great line about yearning for the old days of no Fed transparency, as Fed governors are seemingly everywhere on the speaking circuit. And since we are quoting him, let me offer what I think is one of his better recent musings:
"We are profoundly disappointed with the Fed's implicit threat to raise rates at the end of the month in order to fight yesterday's battle, but then again this is where the Fed's strength lies - Bernanke hints at a pause in April; does not give a date but lays out the groundwork; the conditions are now in place for at least a brief wait-and-see phase - the markets were giving it to him on a platter after last Friday's payroll report - and yet he appears to be passing up the opportunity to avoid making a policy mistake. Seriously, folks - you would think that there was no meeting in August or September by the way the Fed talks - it is critical to tighten again at the 28-29 June meeting. Erring on the side of restraint after 400 bps of tightening, a flat yield curve, sliding commodity prices, faltering stock markets and a US economy that is actually slowing down earlier than the Fed had earlier predicted to catch a lagging indicator called core inflation, which at 2%+ is poised to hit its lowest cyclical peak in four decades and at a time when the flat trend in unit labor costs ensures that cost pressures will recede, is, for lack of a better term, bizarre. Then again, the Fed overshot in the other direction in 2003 after overshooting to the upside in rates in 2000, and this is what business cycles are made of - policy mistakes."
I agree. There is considerable danger of the Fed going too far, as I have been writing for over two years.
Inflation: Short and Long
That concern is shared by Peter Bernstein. In his latest edition of Economics and Portfolio Strategy, he writes about his concerns over inflation and the current economic expansion. Peter is kind of like the pope of investment analysts. He has more awards and honors than nearly anyone I know. He has been writing brilliant material for decades. Against the Gods: The Amazing Story of Risk is must reading. www.amazon.com When he writes, even central bankers pay attention. He has given me permission to quote from his recent letter (you can learn more and subscribe to his letter at www.peterlbernstein.com).
"Inflation is an environment where most prices are rising, and where the threat of building into a cumulative process is always present. In the cumulative process, you continue to raise your selling prices because you expect higher prices for everything you buy. Then inflation becomes difficult to stop without drastic policies to crack inflation expectations. Deep recession and high unemployment are the only cures for the cumulative version of the disease.
"From this perspective, the dramatic response of the markets to April's CPI data is a clear signal that the Federal Reserve has been too relaxed, too reassuring, too satisfied with their 'measured' increases in the rate for fed funds. We argue below that they were fooling themselves with flawed indicators of inflationary pressures. After all, their 'measured' increase of 400 basis points in fed funds since May 2004 has done nothing to hold inflationary pressures in check so far. On the contrary. Yet the Fed has been telling us, with no variation on the theme, that inflation expectations are 'well contained,' or words to that effect. In fact, they may have anchored expectations so firmly that a single jump in the CPI data came as a powerful shock to the markets.
"The Open Market Committee focuses on what they call 'core' inflation, which they measure as the GDP deflator for personal consumption expenditures minus price changes in food and energy. They justify this adjustment because food and energy prices are more volatile than most prices and therefore distort the underlying trend of price changes. But the name of the game in controlling inflation is to have a good grasp of inflation expectations, and the exclusion of food and energy creates a serious gap between what the Fed thinks is happening with inflation expectations and what may be really going on in American households."
Peter goes on to demonstrate that inflation, in the things that really matter to you and me, is very much present. He creates his own measure of inflation, taking out durables like cars or refrigerators, which he points out we only buy once a year or so, and which have been one of the real reason that inflation measurements show so little rise when our daily experience is the opposite.
So the Fed that Bernanke inherited is behind the curve. And now they give us the rhetoric that they understand this. Thus we get the very hawkish statements. But back to Peter's words:
"... Since the April CPI data were published, stocks have taken a hit, commodities have crashed, and bonds have been strong. This is inflation?
"What explains this curious behavior? Markets are strange but potent players in the economy. Data showing a higher inflation rate than most investors had anticipated produced precisely the kinds of signals you would expect if inflation expectations were collapsing. With remarkable unanimity, investors appear to expect a fed funds rate above 5%, and not necessarily at a measured pace.
"They may well be right. With a new chairman and with a unanimous view at the Open Market Committee that the Fed must be 'firm' or lose control over inflation expectations, the Fed is now more likely to be tough than too lenient. If so, we doubt whether the incipient outbreak of inflation is going to become cumulative in this episode. There is in fact a modest risk that the Fed's determination to prove its noble intentions will end up by executing overkill to an economy already weakening in response to a cooling boom in the housing sector. [emphasis mine - JFM]
"Most important, the U.S. is not a closed economy. Events outside this country will influence what happens to inflation here. The dollar appears to have returned to its downward path, although at a gentle slope. This development will intensify inflationary pressures unless the Fed raises interest rates to a point where the inflow of private capital is sufficient to cushion the dollar's decline. With the housing boom petering out, an expansion that has demonstrated remarkable vigor and high profitability up to this point is therefore vulnerable to strong counter forces from policy in the near future.
"Bottom line: the analysis above explains why we worry about inflation, but we worry about the life expectancy of the expansion more than we worry about inflation."
For the last 30 years, new Fed chairmen (Miller, Volcker, Greenspan) have felt the need to prove their mettle. And it has resulted in a lower stock market. It looks like this time will be no exception. I continue to think we are going to get an opportunity to buy this stock market at a much lower level.
Scholarly Publications, Ticket Arbitrage, and South Africa
It is time to hit the send button, but indulge me for a second as I speak to those who toil with me in the hedge fund world. While I do a lot of writing, and get published in a lot of places, I have heretofore never been in something that you would consider a scholarly publication. But this week, I got my copy of the Journal of Financial Regulation and Compliance (volume 14, number 2, thank you) and there it was, my first reviewed scholarly essay. Along with Keith Black, a professor at the Illinois Institute of Technology who teaches courses on hedge funds (he has also written the excellent book Managing a Hedge Fund), we looked at the implications of the research analyst rules on hedge funds. They are actually quite severe. As it turns out, the NASD has taken the position that hedge funds are subject to the research analyst rules, just like stocks. That is a significant difference from the understanding that the large majority of the industry currently has, given the quality of the material that comes past my door. Bluntly, that means if you write even a very simple report about a hedge fund, or send one out, and get paid by the fund, you may be in violation of the rules unless you are a qualified research analyst. And yes, I know your attorney will cite the recent NASD/NYSE joint committee recommendations, but they are not the current position of the NASD. You should very carefully examine your current marketing material practices.
On a much more fun topic, the Dallas Mavericks won their first home game in the NBA Finals. Even if it was ugly, it counts in the "W" column. I am amazed at the frenzy over tickets. My season tickets are very good ones. I have two front row seats right behind the chairs and across the court from the Mavericks bench. I normally keep 6-8 tickets a season and sell the rest to friends. It has taken me a couple decades to get to those seats, starting from the very top row in the corner and working down. Because I have been a season ticket holder, I also get a shot at extra playoff tickets. This year I got four pretty good ones in the platinum level. Normally, I sell them to friends, or put every other game on EBay at a premium and more or less get some "free" tickets to give to some of the kids.
Now, since I have been doing this the Mavs have never gotten to the conference finals, let alone the NBA Finals. I had no idea what people would pay for those seats. Triple face value was easy during the Phoenix series, so we got to go to the games we wanted for more or less free. Then we made the Finals. I let one of my partners have the first game floor seats. We also started to see stories about what tickets are selling for.
For fun, we listed the two tickets for Sunday night for almost $5,000. They were shockingly gone in a very short time. Oh, shucks, I have to sit in the platinum level. Basically, that paid for my next season's tickets and then some. Now before you think I am too lucky, remember I have sat through some really miserable seasons with the Mavericks, when they were the worst in the league. It is about time.
But the real dilemma will happen next week, as we face game six back at home. (No way we sweep!) Do I pass up sitting on the floor for what may be my only chance to see an NBA Finals win for the home team or do I take the obscene amount of money? The fan in me says take the seat and the investor in me says sell! Right now, the fan is winning the debate.
I am going to go to South Africa next January to speak at the Personal Finance Plexus Raging Bull Awards. After this letter, imagine me at a Raging Bull anything. I am told this is a very cool event attended by the who's who of the South African investment management industry. It has been too long since I have been in South Africa. I love the place and the entire continent, for that matter. I have been to 14 countries in Africa and have had some of my most enjoyable travel moments there, as well as a few hazardous ones.
But until then, I am trying to stay homebound and finish my book this summer and fall. I will have to get my international traveling done as an arm-chair traveler in the pages of International Living. It is a fun read, and you can find out more about it by going to http://www.isecureonline.com/Reports/IL/WILVG605/
Have a great week! I will be briefly in Chicago and then on to Las Vegas, but will be getting a lot of reading and research done, I hope.
Your loving ticket arbitrage analyst,