The Ex Ante Factor: Bizarro World
The week of January 21-25, 2008 will go down in the history books of financial markets and potentially society at large. We witnessed the largest financial debacle in history where SocGen lost $7b in index futures pushing stock markets to the brink of collapse (are we trying to one-up each other's debacles?), we received an historic 75bps inter-meeting ease from the Federal Reserve (to fix a bad trade in Europe?), the US government agreed to pass a stimulus package to head off a recession (borrowing $150 billion to save a multi-trillion $ credit bubble?) and to top it off 10YR treasury yields traded down to 3.30% just 30bps from the 2003 lows while the inflation sensitive gold contract traded at an all time high above $920/oz (is this bizarro world?).
With all the debate regarding whether or not the US will enter a recession we took a look at the conflicting messages coming from the commodity and bond markets to see if we could come up with a conclusion and trading strategy.
A recession can be defined as consecutive quarters of declining "real" GDP growth. Real GDP growth is nominal GDP minus the inflation rate. Nominal GDP is fairly transparent as it represents the total output in current dollars. It is what it is. Real GDP is adjusted for inflation and thus depends on how inflation is measured. Real GDP is currently being calculated using "chain weighted" 2000 dollars (thus nominal and real GDP are the same in 2000). For our discussion we want to use 2001 as our bogey. It's the last year we reportedly experienced negative growth, the 9/11 terrorist attacks, commodity prices bottomed, China entered the WTO and the Fed lowered interest rates from 6% to 1.75%. Between 12/01 and the most recent quarter in 2007, nominal GDP rose 37% or an approximate average of 6.15%/year. Over the same period, real GDP grew at 19% or 3.15%/year, implying a 3% inflation rate. It is this modest 3% inflation that has provided positive real growth and kept us out of recession since we last experienced declining growth in 2001. That is, if you believe inflation has averaged 3%/year since 2001.
There is no consensus measurement of true inflation so with gold, arguably the most inflation sensitive asset, hitting an all time high this week we wanted to see how nominal GDP holds up v measurements of inflation other than CPI and the GDP price deflator.
Monetarists, such as Milton Friedman argue inflation is excessive growth in the supply of money. Excessive growth or excess liquidity can be measured by Marshallian K, which we calculate as the growth rate in M2/growth rate in nominal GDP. A rising MK denotes the supply of money growing faster than the demand for money and vice versa. With the Fed priming the pump like mad in 2001, MK exploded suggesting elevated inflation pressures. Since they stopped printing in 2003, MK has subsided. In fact if you measure M2 from 12/01 you have a 37% rise, exactly the growth rate of nominal GDP over the same time frame. Net/net this is neutral for inflationary impact though the indicator has been volatile. Presumably the thrust behind the exploding MK in 2001 is being removed by the bursting of the credit bubble neutralizing the inflation through the market adjustment. Keep in mind, this dynamic showed up in the slope of the yield curve as it steepened when MK rose (tightening as the Fed eased) and flattened as MK fell (easing as the Fed tightened). This will be important as we move through this year.
Inflation can also be measured by the purchasing power of the currency. A strengthening currency denotes lower inflation and a declining currency denotes higher inflation. Since 2001 the value of the dollar lost 37% or 6%/year when measured by the DXY (a basket of currencies) and 65% or 10.8%/year when measured against the euro. Over the same time frame, the cost of raw materials, commodity prices measured by the CRB, have increased 140% or 23%/year with gold and crude oil both +260% or 44%/year. Commodity prices and the US dollar are invariably inversely linked since commodities are priced in dollars. The discrepancy in returns can be attributed to commodities carrying a higher beta (it takes more dollars to move EURUSD 1% than it does to move front month CL and GC 1%).
It's also important to realize that this inflation has been largely masked by the Chinese renminbi peg. The fact that China is one of the largest importers of raw materials and largest exporter of finished goods to the US has produced a market dislocation and ballooning trade deficit. The falling dollar has jacked up the price of raw materials but the currency peg has kept consumer prices low as the weakening dollar is not reflected in the import price. This relationship is evident in the spread between PPI and CPI since China entered the WTO. In Q1 2002 the spread between YOY growth in CPI v PPI was 4% suggesting a positive profit margin for producers of goods. Recent data in Q4 2007 shows that spread inverted by 2% or a 6% swing to negative profit margins for producers. The distortions in the calculation of the CPI have been well documented. Using core v top line, hedonic adjustments and owner equivalent rents are all often cited by the inflation hawks as suppressing actual inflation rates. We would concur with these arguments but also point to the Chinese currency peg as a major force holding down reported consumer prices.
So what's the verdict?
It's difficult to tell with so many dislocations. It's safe to say the government data is highly flawed and since their entitlement liabilities are indexed to CPI and COLA (cost of living adjustments) we don't see any incentive for them to report actual loss of purchasing power. We then must depend on freely traded markets to give us the answer. Nominal GDP has been averaging 6%/year since 2001 and has generally averaged that growth rate since the early 1990s. Measuring inflation by the declining purchasing power of the dollar and rising cost of raw materials has produced negative real growth since 2001, i.e. we've been a recession the whole time. The growth we've experienced isn't real.
If inflation is so high, why are bond yields so low?
This is further evidence that our recent growth hasn't been real. When bond yields and credit spreads were falling as credit growth exploded it suggested to us the growth was being driven by the supply of credit not the demand for credit. Had there been actual demand for money, the cost of money would have risen. It did the opposite and thus you had a credit and asset bubble.
We have argued that treasury yields tend to discount future nominal GDP growth. This is evident by the fairly consistent 6% growth since 1990 as long term yields generally traded around 6% level before falling in 2000. This theory holds up relatively well when considering that nominal GDP averaged 10%/year in the '80s when treasury yields were in double digits. The growth rate for nominal GDP has been decelerating from the 6% average coming in closer to 4.5% since the credit bubble began blowing up last year. With the yield continuing to fall we should assume the growth rate will continue to decelerate. The financial media and pundits will spend the next 6 months debating on whether we enter a recession. They will be awaiting lagging economic data and by the time we know if we had an "official" recession or not, the markets will have already discounted one. We are monitoring forward-looking markets that suggest we have been in a recession ever since the government's data showed negative growth in 2001.
We don't believe this trajectory of decelerating GDP and accelerating inflation is sustainable. The credit bubble, which was the principle catalyst behind inflationary pressures, is unwinding. Now we are at an inflection point. Will the government and the Fed be able to stimulate demand by re-inflating the multi-trillion dollar credit bubble? Maybe, but we are highly skeptical as they are running out of bullets and more inflation just makes the recession that much deeper. The inflationary pressures were a by-product of the credit bubble and presumably the cause of its bursting. Re-inflating just makes it worse.
That's great and all, but what's the trade?
We can't be sure of the outcome but we do think the results will show up in how the market trades throughout 2008. As expected the curve is currently trading steeper with the Fed easing. This is also what happened in 2001. If the bureaucrats are successful in stimulating the economy through re-inflating, the 10YR yield should stop falling, reverse higher and take the curve even steeper. This presumably would coincide with commodity prices remaining elevated as they discount stronger demand. If the economy isn't responding you should see the 10YR yield continue to fall and the curve will likely flatten. This is deflationary and in our view, would be bearish for commodity prices. We have been looking for 10YR yields to retest the 2003 lows and thought the unwinding of the credit bubble would get us there. We can see a scenario where bond prices pullback near that high (maybe already have started) as risk capital gets re-allocated in anticipation of the Fed being successful in re-inflating. However, we don't think anyone is looking for yields to fall below 3% flattening the curve and thus are leaning towards that scenario. The massive decoupling of bond yields and commodity prices is not sustainable in our opinion and one should stop rallying. We are betting its commodities.
Bottom Line: In 2001 it took you 40ozs of gold to buy the Dow Jones (Dow/Gold). Today it only takes you just over 13ozs. Over the same period, despite an inflationary environment, stock multiples contracted and the S&P 500 has returned a pathetic 2.5%/year ex-dividend reinvestment (which gets you closer to 4%). Even with the government sandbagging inflation the buy and hold investor is barely breaking even. As we conclude, either commodities or bonds are going to win the inflation/deflation battle. Since we still see a massive de-leveraging and collateral liquidation to come, we are leaning towards bonds and deflation. Regardless who wins, neither paints a rosy scenario for equity returns. They either get destroyed by inflation or deflation pulls down multiples.