Ray Dalio’s Bridgewater On The “Self Re-Inforcing Global Decline”

Thursday, July 19th, 2012

The world’s largest hedge fund is not as sanguine about the hope that remains in the markets today. The firm’s founder, Ray Dalio, who has written extensively on the good, bad, and ugly of deleveragings, sounds a rather concerned note in his latest quarterly letter to investors as the “developed world remains mired in the deleveraging phase of the long-term debt cycle” and has spread to the emerging world “through diminished capital flows which have weakened their growth rates and undermined asset prices”. Between China, Europe, and the US, which he discusses in detail, he sees the lack of global private sector credit creation leaving the world’s economies highly reliant on government support through monetary and fiscal stimulation. The breadth of this slowdown creates a dangerous dynamic because, given the inter-connectedness of economies and capital flows, one country’s decline tends to reinforce another’s, making a self-reinforcing global decline more likely and a reversal more difficult to produce. After discounting a relatively imminent return to normalcy in early 2011, markets are now pricing in a meaningful deleveraging for an extended period of time, including negative real earnings growth, negative real yields, high defaults and sustained lower levels of commodity prices. Lastly he believes the common-wisdom – that the Germans and the ECB will save the day – is misplaced.

Bridgewater Q2 Letter: Outlook and Markets Discussion

by Ray Dalio, Bridgewater Associates

The developed world remains mired in the deleveraging phase of the long-term debt cycle. The European deleveraging has been badly managed and is escalating, bringing Europe closer to either a debt implosion or a monetization and currency collapse. The impact of the European deleveraging has spread to the emerging world through diminished capital flows which have weakened their growth rates and undermined their asset prices. In the US, the deleveraging is progressing in a more orderly fashion but continues to weigh on the economy’s ability to grow without the monetary support of the Fed. Our studies of deleveragings have proven to be invaluable through this period (let us know if you would like a copy of the expanding library). Because the dynamics of deleveragings are understandable and observable throughout history, one can reasonably assess the nature of their outcomes over time. But because highly-indebted systems that are in deleveragings are also inherently unstable, the timing of discrete events is always highly uncertain (e.g., the shift from austerity to monetization, an exit from the euro, etc.). Through these studies we have continued to refine the indicators we use to measure how the forces of deleveraging are impacting various economies and markets, and we continue to make the relevant adjustments to our investment process that both allow us to anticipate these shifts and to control our risks through the unpredictable twists and turns.

At this point in time Europe is in the most critical stage of the deleveraging process, without a credible plan that will allow a transition from an “ugly” deleveraging, where incomes fall faster than debts decline, to a “beautiful” one, where income grows faster than debts. A transition from an “ugly” to a “beautiful” deleveraging requires an acceptable mix of default, redistribution and monetization. Steps have been taken in this direction, but they remain well short of what is necessary. The range of potential outcomes for Europe and the impacts on the global financial system are wide, so navigating this environment will require flexibility and an understanding of how new policy decisions will affect the path of the deleveraging.

The unresolved European imbalances and the differences in their impacts on each country have produced widening differences in the self-interests of these countries, which have led to political divergences that have magnified the risks. Unlike a year ago, Germany and France no longer stand in solidarity as backstops behind the euro system, but have been divided in their self-interest by divergent financial conditions which are leading to conflicting rather than unified political orientations. France’s deteriorating finances and economy have shifted its self-interest toward alliances with “recipient” (lower credit rated) countries like Italy and Spain and away from “contributor” (higher credit rated) countries like Germany and the Netherlands, leaving Germany more isolated as a guarantor of the risks in the euro system and in its views about how to manage the imbalances. Given these shifts in the alliances between contributor and recipient countries we think that the popular assumption that the Germans and the ECB (which requires agreement of the key factions within it) will come through with money to make all of these debts good should not be taken for granted. Said differently, we think that there are good reasons to doubt that European bank and sovereign deleveragings will be prevented from progressing to the next stage in a disorderly way, without a viable Plan B in place. This fat tail event must be considered a significant possibility.

Given the lack of global private sector credit creation, the world’s economies remain highly reliant on government support through monetary and fiscal stimulation. Now that the most recent round of global monetary stimulation has ended, world economic growth has slowed and central bankers are in the process of stimulating again. We estimate that in the past few months, global growth has slowed from about 3.3% to 1.9% and that 80% of the world’s economies have slowed, including all of the largest. The breadth of this slowdown creates a dangerous dynamic because, given the inter-connectedness of economies and capital flows, one country’s decline tends to reinforce another’s, making a self-reinforcing global decline more likely and a reversal more difficult to produce. And at this point, while actions have been taken, none of the world’s largest economies are stimulating aggressively via either monetary or fiscal policy, further reducing the odds of a reversal.

About half of the global slowdown has been due to slower growth in China. In recent years, China has been the locomotive of world growth and its recent sharp slowdown has had knock-on impacts on numerous countries and markets. China itself now makes up 12% of world GDP and its interactions with the rest of the world add to its impact. China is a large export destination for many countries and is the largest marginal consumer of raw materials in the world, so its slowdown has disproportionately hurt the economies which export to China, and its weaker commodity consumption has hurt the commodity producers. In response to this slowdown, China has begun to ease monetary policy and is contemplating more aggressive fiscal stimulation, but the actions have so far been gradual and have not yet been sufficient to produce a notable economic response.

US conditions have slipped with the rest of the world and the Fed has decided to extend its Twist operation; to end it would have been an inappropriate tightening. Last year’s hump in growth has passed as numerous temporary forces have faded, and private sector credit growth remains weak, so growth is converging on the growth of income of around 1.5%. Besides the drag from Europe and the potential for a contagious debt blowup there, numerous US federal programs will expire in the fourth quarter, and given the likely political divisions after the election it will be a challenge for the new Congress to deal with these in a timely manner. Without action, the expiration of these programs represents a fiscal drag on growth of about 2.5%. Given the lack of new aggressive Fed stimulation, the threat from Europe, the simultaneous decline in major country growth rates and the fiscal cliff, the risks to US growth are skewed to the downside.

Over the past 18 months what markets are discounting has changed radically, with a clear bias toward discounting much weaker growth for a longer period of time. This shift is reflected in the rise in credit spreads, fall in bond yields, much lower discounted future earnings growth, flattening of the yield curve, currency moves and shifts in commodity prices. But such price changes simply reflect a transition from the discounting of one set of future economic conditions to the discounting of another set of future economic conditions. After discounting a relatively imminent return to normalcy in early 2011, markets are now pricing in a meaningful deleveraging for an extended period of time, including negative real earnings growth, negative real yields, high defaults and sustained lower levels of commodity prices. This pricing is the midpoint of discounted expectations and each market has an equal probability of outperforming or underperforming. By balancing the portfolio’s exposure to discounted growth and inflation, a disappointment in one asset class will be offset by gains in another, without the necessity of predicting which it will be.

Tags: Asset Prices, Bridgewater Associates, Capital Flows, Commodity Prices, Connectedness, Credit Creation, Currency Collapse, Debt Cycle, Earnings Growth, ECB, Global Decline, Government Support, Hedge Fund, Imminent Return, Implosion, Monetization, Quarterly Letter, Ray Dalio, Return To Normalcy, Term Debt
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Is Higher Inflation on the Horizon?

Wednesday, July 18th, 2012

by Orhan Imer, Ph.D., Columbia Asset Management

For nearly two decades, inflation in the U.S. has been fairly contained except for a few periods of moderate acceleration around peak levels of economic activity. More recently, headline inflation as measured by the year-over-year change in the CPI-U (Consumer Price Index for Urban Consumers) declined from 3.9% in September 2011 to 1.7% in May 2012, driven primarily by the slowdown in the U.S. economy and the sharp drop in energy and commodity prices.

While the current level of inflation remains subdued, investors should be prepared for risk of longer-term inflation associated with highly accommodative monetary and fiscal policy actions taken by the Fed and the U.S. Government since 2008.

During the past several years, the Fed’s monetary policy decisions, intended to stimulate U.S. growth, have become less centered on containing inflation. In particular, the Fed’s near-zero interest rate policy and expanded balance sheet along with deficit spending by the government to lift the economy out of recession have raised the risk of future inflation. Other conditions that may add to inflationary pressures over the next decade and beyond include:

1. Accelerated government spending on healthcare and other non-discretionary spending programs (such as Social Security, Medicare and Medicaid) necessitating continued high levels of federal borrowing
2. Demographic shifts in the U.S. population as baby boomers begin to retire leading to lower savings and productivity
3. Higher tax rates on income and capital gains raising the cost of capital dampening capital investment and productivity
4. Weakening of the U.S. dollar due to Fed’s interest rate policy and massive monetary easing which may promote inflation through higher energy and commodity prices
5. Emerging market countries representing a growing share of global GDP and driving up the demand for scarce resources (commodities, land and other real assets)

While the recent slowdown of the global economy along with the continuing weakness in the U.S. housing market and excess manufacturing capacity in many industries may keep inflationary pressures at bay near term, investors should protect themselves against unexpected inflation, as surprises in inflation can have a meaningful impact on the performance of inflation-sensitive assets.

Read more in this week’s Perspectives.

See more Market Insights from Columbia Management.

Tags: Baby Boomers, Columbia Asset Management, Commodity Prices, Consumer Price Index, Deficit Spending, Demographic Shifts, Discretionary Spending, Emerging Market Countries, Global Gdp, Headline Inflation, Imer, Inflationary Pressures, Interest Rate Policy, Monetary And Fiscal Policy, Monetary Policy Decisions, Peak Levels, Policy Actions, Real Assets, Term Inflation, Urban Consumers
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Energy and Natural Resources Market Radar (July 9, 2012)

Sunday, July 8th, 2012

Energy and Natural Resources Market Radar (July 9, 2012)

Strengths

• Brent crude continued to advance after a proposed bill in Iran threatened to block off oil transportation through the Strait of Hormuz. This would prevent tankers from delivering oil to countries that have imposed sanctions against Iran.
• U.S. auto sales were solid in June at 14.1 million Seasonally Adjusted Annual Rate (SAAR), above expectations and better than the 13.8 million units in May. Autos remain one of the more solid parts of the commodity demand equation, with even troubled economies like Europe meeting fairly pessimistic expectations rather than deteriorating again.
• South Korea is planning to increase spending on industrial metals by 9.4 percent for 2012. Hyundai car exports were up 7.7 percent compared to last June, and continued sales growth is expected. South Korea’s demand for metal shows promise and it will definitely look to take advantage of these low commodity prices (the LMEX index, which tracks copper, aluminum, lead, tin, zinc, and nickel, has dropped 21 percent in the past year).
• Corn prices jumped to a nine-month high close of $7.68 per bushel this week and have surged more than 39 percent since June 1, as a crop-damaging drought in the U.S. Midwest shows no signs of abating. The crop’s condition deteriorated for the fourth straight week as of July 1, with 48 percent of corn rated good or excellent, the worst for that date since 1988, the U.S. Department of Agriculture said earlier in the week.
• Wheat futures also have gained 34 percent since June 1 to a 13-month high close of $8.22 this week on news that dry weather has damaged the Russian wheat crop and exports will be lower than expected.

Weaknesses

• Iron ore hit a three-week low over concerns about China’s slowing growth, and Brazilian iron ore exports saw a 17 percent drop in value for the month of June. China’s Purchasing Managers Index (PMI) was released at 50.2 for the month of June, beating expectations but still showing signs of deteriorating expansion. China consumes more iron ore than any other nation, and this backward demand will be reflected in the prices of many of these industrial commodities.
• Oil futures on the New York Mercantile Exchange dropped as the dollar gained value against the euro. This came after Mario Draghi, President of the European Central Bank, stated that economic risks remain prevalent despite interest rate cuts.
• Low natural gas prices continue to take market share from coal for power generation. Coal production in the U.S. declined 9.2 percent in June from last year’s levels, according to government data. Output totaled 80.5 million short tons in June, and year-to-date production was about 504 million, 6.2 percent lower than the same period in 2011, according to a report by the U.S. Energy Department. U.S. producers have cut thermal-coal production in response to lower consumption by power generators with output down by about 1 million tons a week compared with a year ago, Deutsche Bank AG said in a report this week.

Opportunities

• Iron ore mining in the Karnataka state of India is said to resume operations this month after being banned for the past year over environmental concerns. However, the iron ore can only be exported once domestic consumption has been met, and it must be at a price higher than auction offering.
• Six blocks of land are being auctioned off by the government of Afghanistan for exploration, and Exxon Mobil is one of the companies that have shown interest. Studies conducted by agencies such as the United States Geological Survey have indicated that there may around 1 billion barrels of oil and natural gas to be found in the region.

• Botswana reduced minimum company tax by 3 percent in hopes of attracting more non-mineral based investment and exploration projects.

• Reuters reported that BHP could tighten global copper supply starting in late 2013 if it postpones work on its single-biggest project, the $30 billion expansion of the Olympic Dam mine in Australia. This dam is the fourth-largest known copper deposit and largest uranium source in the world.

• The crude oil market may tighten on supply problems in Norway. Statoil ASA said it is likely to shut production on the Norwegian continental shelf as employers locked out striking platform workers after mediation talks failed. This lock out would halt the nation’s entire offshore production to the total of about 2 million barrels a day.

Threats

• China’s demand for West African crude oil weakened as it purchased about 12 percent less supply for July than in June. Brent crude prices may be affected if this continues as China is the top energy consumer in the world.
• Just as CaNickel Mining Ltd suspended operations at its Brucko Lake Mine due to low nickel prices, Eramet is planning to increase output 12 percent by 2015 at one of its plants with expectations of meeting a higher demand from China and India. However, growth and demand have been slowing recently, and this may be counter productive if we want to see gains in global nickel prices anytime soon.

Tags: BRICs, Car Exports, Commodity Prices, Copper Aluminum, Corn Prices, Dry Weather, Hyundai Car, Industrial Metals, Iron Ore Exports, Lmex, Market Radar, Oil Transportation, Purchasing Managers Index, Russian Wheat, Sanctions Against Iran, Strait Of Hormuz, Tin Zinc, Troubled Economies, U S Auto, Wheat Crop, Wheat Futures
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The Big Picture (in Graphs) for Markets

Monday, June 4th, 2012

by Tiho Brkan, The Short Side of Long

Equities

Equities tend to move in long term generational cycles of about 17 years on averages. Strong upward trends that last about 17 years are called secular bull markets, while sideways trends that also last about 17 years are called secular bear markets. US equities are currently in a secular bear market and have been so since the year 2000.

We seem to be creating a similar outcome to the 1970s secular bear market, where we had a long sideways trading range for about a decade and half. S&P 500 is now approaching the upper range of its trading range, with the current cyclical bull market doubling from its March 2009 lows. Bull markets usually climb a wall of worry, but there is not too many things left to worry about.

Gross profit margins are now at record highs and a mean reversion will eventually follow. Mean reversion in gross profit margins will be fundamentally bad for S&P 500 company earnings, which are also at record highs, and therefore the overall stock market value. Let us remember that all the major buying opportunities since World War 2 have been as low gross profit margins, not at highs – especially record highs.

Bonds

Interest rates, and therefore bond prices, tend to move in very long term generational cycles known as the Kondratiev Long Waves. These waves tend to last about 50 to 60 years from trough to trough or from peak to peak. The last major inflection point occurred in 1981, as interest rates on the US Treasury 30 Year Long Bond peaked around 15%. Prior to that, rates were rising for about 30 years and since than we have experienced declining rates for about 30 years as well. At the next major inflection point, which is slowly approaching, interest rates and equities should bottom while commodity prices should peak.

Viewing the global macro situation from the closer point of view puts forward a strong correlation betweens stocks and bonds due to the de-leverging cycle Western world is currently facing. Periods or phases of turmoil have so far been associated with “flight to safety” or “risk off” trade, where investors buy bonds (lower interest rates) and sell stocks (or other riskier higher beta assets).

With the risk assets prone to further crisis events out of Europe and potential up-and-coming global recession, bond interest rates have most likely not properly bottomed just yet. Nevertheless, we are definitely in the last euphoric stage of a 30 year bond bull market (from 1981 until present). The final trough in rates will also be associated with a stock market bottom, just like in late 40s and early 50s.

Commodities

Commodities also tend to move in long term generational cycles and correlate in the opposite direction to the stock market. Here the same type of time frame also applies, where strong upward trends that last about 17 years are called secular bull markets, while sideways trends that also last about 17 years are called secular bear markets. Commodities are currently in a secular bull market and have been so since the year 1999.

While the S&P 500 has been moving sideways for about 12 years, Continuous Commodity Index has been rising over the last 13 years. During the current secular bull market, commodities have experienced two major corrective periods, first during 2001 recession and second during 2008 recession. Currently, commodities are once again experiencing a cyclical bear market correction, within the overall long term secular bull market.

Summary

Risk assets like equities and commodities should remain under pressure in coming quarters, while safe havens, even though extremely over stretches, could still benefit during the turmoil. World faces many problems coming into 2013, from US to European debt issues and now a meaningful economic slowdown in Asia, after years of powerful growth. China, the worlds largest consumer of many commodities and a fertile ground for many Western company expansions (especially luxury ones), could have huge implications on risk asset prices shall it suffer a major recession. Majority of the problems will definitely come to forefront as soon as the US elections finishes by the years end, if not sooner.

While many investors think they are doing the right thing being contrarians at present and buying risk assets due to sour negative sentiment, my view is that it will only be useful for a decently strong tradable rally, which I also plan to participate in. Furthermore, these same investors also believe central bankers will backstop any problems with money printing. However, that will most likely not be the case until the QE dosage increases substantially.

At present every major risk asset from Crude Oil to Australian Dollar, from DAX to Copper and from GEM equities to Gold has retraced 100% of their Twist / LTRO multi-month rally and has also failed to better their 2011 highs during the process. This is an extremely negative price action as these types of 100% re-tracements are not common at all, if one was to assume we are in strong cyclical bull market. Most likely the inflation trade from March 2009 lows has ended for some risk assets in May 2011, while for others it has ended just recently in May 2012.

Copyright © The Short Side of Long

Tags: Bear Markets, Bond Prices, Bull Markets, Commodity Prices, Company Earnings, energy, Generational Cycles, Global Macro, Gold, Gross Profit Margins, Inflection Point, Long Waves, Lows, Mean Reversion, Record Highs, Secular Bear Market, Stock Market Value, Stocks And Bonds, Tiho, Upward Trends, Us Treasury, World War 2
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Chinese Buyers Defaulting On Commodity Shipments As Prices Plunge

Monday, May 21st, 2012

One can come up with massively complicated explanations for why the Chinese commodity bubble is popping including inventory of various colors, repos, etc, but when all is said and done, the explanation is quite simple, and is reminiscent of what happened in the US with housing back in 2007: everyone was convinced prices would only go up, and underlying assets was pledged as debt collateral at > 100 LTV… and then everything blew up. Precisely the same thing is happening in China right now, where buyers of commodities thought prices could only go up, up, up and instead got a nasty surprise: prices went down. Big. As a result, many are not even waiting for their orders to come in, but are defaulting on orders with shipments en route.

From Reuters: “Chinese buyers are deferring delivery or have defaulted on coal and iron ore deliveries following a drop in prices, traders said, providing more evidence that a slowdown in the world’s second-largest economy is hitting its appetite for commodities. China is the world’s biggest consumer of iron ore, coal and other base metals, but recent data has shown the economy cooling more quickly than expected, with industrial output growth slowing sharply in April and fixed asset investment, a key driver of the economy, hitting its lowest in nearly a decade. “There are a few distressed cargoes but no one is gung-ho enough to take them. Chinese utilities aren’t buying because they have a lot of coal and traders are also afraid of getting burnt. It’s very bearish now,” said a trader. The defaults in thermal coal over the past week has come after a fall in prices over the past 1 1/2 months, with key coal prices indices in Australia, South Africa and Europe all having fallen around $10 a tonne since early April.” And this is the country that over the weekend was rumored to be bailing out the world again? We wonder: will China also bail out FaceBook longs, or will it merely focus on preventing a collapse in its own various commodity bubbles which are starting to pop one after another?

More from Reuters:

At least six defaulted thermal coal cargoes were being re-offered at a discount, traders said, including contracts for shipments from the United States, Colombia and South Africa.

 

“Many of them signed for the spot cargoes in early April and prices have fallen around $10 a tonne since then. Say if the Chinese traders were buying a cape-sized shipment, they’d be suffering a loss of nearly $1.5 million alone,” said a trader at an international firm who has been offered defaulted cargoes.

 

“That doesn’t even take into account the losses on freight rates. So rather than being bankrupted by these deals, they would rather dishonour the contract to survive.”

 

China’s premier called for additional efforts to support growth on Sunday, signalling Beijing’s willingness to take action to bolster its sagging economy.

And if the Chinese commodity appetite is over, that means very bad news for commodity exporters the world over:

Reflecting greater caution, BHP Billiton, the world’s biggest miner, has put the brakes on an $80 billion plan to grow the company’s iron ore, copper and energy operations.

 

Slumping commodity prices and escalating costs have squeezed cash flows, pushing BHP to join rival Rio Tinto reconsidering the pace of their long-term expansion in countries such as Australia and Canada.

For another perspective of just how stuffed to the gills with commodity inventory is we again go to Reuters, which gives us the following scary summary:

When metals warehouses in top consumer China are so full that workers start stockpiling iron ore in granaries and copper in car parks, you know the global economy could be in trouble.

 

At Qingdao Port, home to one of China’s largest iron ore terminals, hundreds of mounds of iron ore, each as tall as a three-storey building, spill over into an area signposted “grains storage” and almost to the street.

 

Further south, some bonded warehouses in Shanghai are using carparks to store swollen copper stockpiles – another unusual phenomenon that bodes ill for global metal prices and raises questions about China’s ability to sustain its economic growth as the rest of the world falters.

 

Commodity markets are used to seeing China’s inventories swell in the first quarter, when manufacturing slows down due to the Lunar New Year holidays, and then gradually decline during the second quarter when industrial activity picks up.

 

This year, however, is different.

 

Copper stocks in Shanghai’s bonded storage, the biggest in China, are now double the 300,000 metric tons (330,693 tons) average of the past four years and iron ore stocks are about a third more than their 74 million metric tons average.

This time may be differernt indeed:

Four years ago, however, the global financial crisis triggered by the collapse of Lehman Brothers broadsided the economy: factories shut down suddenly, millions of workers got laid off, ports ground to a halt. The situation only perked up after the government introduced a $600 billion stimulus scheme.

Probably the biggest difference is that back then Europe wasn’t broke and the US debt/GDP was well below 100%. Both of those are no longer the case.

And to think we were wondering just last week if the biggest construction bubble in history was sustainable.

Tags: Appetite, Asset Investment, Base Metals, Cargoes, Coal Prices, Collateral, Commodities Prices, Commodity Prices, Commodity Shipments, Deliveries, Explanations, Iron Ore, Longs, Nasty Surprise, Plunge, Reuters, Slowdown, Thermal Coal, Tonne
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Hugh Hendry: Investment Outlook (April 2012)

Monday, April 30th, 2012

Hugh Hendry is back with a bang after a two year hiatus with what so many have been clamoring for, for so long – another must read letter from one of the true (if completely unsung) visionary investors of our time: “I have not written to you at any great length since the winter of 2010. This is largely because not much has happened to change our views. We still see the global economy as grotesquely distorted by the presence of fixed exchange rates, the unraveling of which is creating financial anarchy, just as it did in the 1920s and 1930s. Back then the relevant fixes were around the gold standard. Today it is the dual fixed pricing regimes of the euro countries and of the dollar/renminbi peg.”

In the letter the most surprising insight from the perpetual contrarian is his almost predictable contrary view of the dominant investing meme at the moment. To wit: “We are, as a result, long the debt saddled west and short the vastly over vaunted and over owned BRICs.“ More on this: “There is a near consensus that China will supplant America this decade. We do not believe this. We are more bullish on US growth than most. The momentous nature of recent advances in shale oil and gas extraction and America’s acceptance of the unpleasantness of debt and labour price restructuring looks to us as if it is creating yet another historic turning point. By embracing his inadequacies and leaping on his luck, the strong man may have finally broken the binds that had previously held him back. We are also more pessimistic on Chinese growth than ever. This makes us bearish on most Asian stocks, bearish on industrial commodity prices, interested in some US stocks, a seller of high variance equities and deeply concerned that Japan could become the focal point of the next global leg down. On the plus side we also believe that we are much closer than before to the beginning of a bull market of perhaps 1982, if not 1932, proportions. We just need the last shoe to drop.”

We will let readers combs through the narrative that shapes Hendry’s most recent outlook, although one chart worth pointing out is The Eclectica boss’ visual summary of the “New Economic Order” which presents precisely the tenuous relationship between the Fed and the PBOC we have been decrying for so long, and which so many commentators (ooh, ooh, the PBOC is easing any minute now… oh wait, it isn’t) fail to grasp:

Yet one thing we do want to point out is how different compared to your run off the mill 2 and 20 rent collector is the Eclectica M.O. when it comes to generating Alpha (as opposed to everyone else’s levered beta):

As you know, I have a proclivity to make money in a bear market. The Fund’s ten-year NAV progression demonstrates this survivorship bias; when bad things have happened, we have made money. We are very robust. Last year was no exception. Despite the challenges confronting speculators, I am much relieved that we succeeded in making 12% in a rather disciplined manner, and the Fund has now posted a CAGR of almost 10% for the last nine years.

Maybe that was the easy bit. The question now is just how we can make money in the tough business of global macro investing this year. As I am sure you by now know, I am nothing but a worrier. I have, I think, a soul mate in the prolific but often misunderstood Italian soccer player Pippo Inzaghi, the second highest scorer in all European club competitions. He has 70 goals behind him but he recently noted that, “the tension is always the same…I hoped to become less agitated with time, but this is also my strength”. I suspect he would have made a fine macro manager.

I meet a lot of inquisitive and extremely intelligent people in this business and I have come to think that maybe this is something of a problem. Perhaps they are just too smart. Perhaps they just try too hard. Rightly or wrongly, the highest return on intellectual capital of any endeavour in the world today comes from the management of other people’s money. So it is entirely rational (especially if you have never met a hedge fund manager) to assume the industry attracts the brightest, smartest minds. The beautiful mind, if you will. But I am not aiming to outsmart George, Stan, Julian, Bruce or the others. I do not think it is logical to try and outsmart the smartest people. Instead, my weapons are irony and paradox. The joy of life is partly in the strange and unexpected. It is in the constant exclamation “Who would have thought it?”

Why did ten year treasuries yield 14% under the vice like grip of iron-man Volker but yield just 1.8% under the bookish and most definitely Weimar-like Bernanke? Why does France in 2012 flirt with the notion of electing a socialist president intent on reducing the retirement age, imposing a top rate of tax of 75% and increasing the size of the public sector? Why do we hang on the every word of elected politicians when Luxembourg’s prime minister Jean Claude Junker openly admits, “When it becomes serious, you have to lie”?

You cannot make stuff like this up. It is simply too absurd.

That is perhaps a long way of saying that existentialism is alive and well in the 21st century. For, if the last ten years have taught me anything, it must be that the French philosopher Albert Camus, in his search for an understanding of the principals of ethics that can shape and form our behaviour, may have surreptitiously provided us with three basic principles for macro investing. I am perhaps doing him a gross injustice, but I would summarise as follows: God is dead, life is absurd and there are no rules. In other words, you are on your own and you must take ownership of your own destiny.

For me this has always meant being detached from the sell-side community. It is not a question of respect, it is just that I prefer not to engage in their perpetual dialogue of determining where the “flow” is. I cannot be reached by telephone. I suspect that I am one of the few CIOs who does not maintain daily correspondence with investment bankers and their specialist hedge fund sales teams. Not one buddy, not one phone call, not one instant message. I am not seeking that kind of “edge.” Eclectica occupies an area outside the accepted belief system.

I attempt to cultivate my own insights and to recognise the precarious uncertainty of global macro trends. I attempt to observe such things first hand through my extensive travel (I promise no more YouTube videos), and seek to understand their significance by investigating how previous societies coped under similar circumstances. But first and foremost, I am always preoccupied with the notion that I just do not have the answer. I am not blessed with the notion of certainty. Someone once said we should think of the world as a sentence with no grammar. If we do I see my job as putting in the punctuation. But above all, my job is to make money.

In keeping with this theme, I want define the three ingredients that I believe make for an outstanding macro hedge fund manager. These are, in no stringent order:

1. Successful but contentious macro risk posturing.

2. The need to choose the asset class offering the highest probability of payout should the conviction hold true whilst offering an asymmetric loss profile should the original premise prove unfounded

3. A best in class risk technique that stop losses the narrative and responds early with loss mitigation procedures (i.e. a method of staying solvent, rational and disciplined under pressure).

I have always figured that the first is the real key. That success was simply a matter of contentious macro posturing. In other words, going long very rich risk premium or buying cheap stuff. It is my assertion that what makes a great fund manager first and foremost is the ability to establish a contentious premise outside the existing belief system and have it go on to become adopted by the broader financial community. Bruce Kovner expressed the idea more eloquently when he said, “I have the ability to imagine configurations of the world different from today and really believe it can happen. I can imagine…that the dollar can fall to 100 yen”. I am sure you are nodding in agreement, except Bruce was saying this when the USDJPY was well over 200, not today’s rate of 80!

That is the kind of guy I want to be when I grow up. Recall that I have the kind of imagination that can conceive of the yen trading closer to 60. Similarly, if we look back and reminisce about previous years, the Fund’s 50% return in 2003 was derived from a legitimate but certainly contentious view that China’s WTO entry was set to boost the cyclical “old” economy of the West and that fiat hyper-management of the financial economy could propel gold into a super bull market. To think these views were once contentious; plus ça change!

Who would’a thunk it: one just needs some imagination and creativity, the ability to visualize that which most of the other ones cant or are too lazy to do it, and just wait as the bizarro market takes over and makes the impossible not only probable, but conventionally accepted by the herd.

…

And a segment that all the Whitney Tilsons of the world should read:

I fear that our no longer small community has been compromised. Funds are neglecting their hard portfolio stop limits. Last year was generally very tough for long/short strategies and I commiserate with all concerned. But last year witnessed too many world class funds lose over 15% in the space of just two months. Of course today they are celebrated once again for making double digit returns in the quarter just ended yet they still languish below high water marks and their Sharpe ratios are busted.

You could probably live with that if you are a pension scheme or a large, sophisticated fund-of-fund because you have a global macro sub-sector that is typically long gamma (just look at our credit tail fund’s 46% gain last year). The unfortunate thing is this group exercised its stop losses somewhere between 2009 and 2010. That is to say, they honoured the pact they had with clients. They adhered to the terms of their risk budget. I fear that owing to this nasty experience, today no one in macro is running much risk. I suspect daily VaR budgets are anchored at 50 bps or less. That is to say, I fear the financial world is in danger of harvesting a monoculture of fund returns that could prove less than robust should the global economy suffer another deflationary reversal…

Read the full letter below:

April 2012 TEF Commentary

Tags: 1920s, 1930s, Asian Stocks, Chinese Growth, Commodity Prices, Contrary View, Euro Countries, Fixed Exchange Rates, Focal Point, Gas Extraction, Global Economy, Hiatus, Hugh Hendry, Inadequacies, Industrial Commodity, Investment Outlook, Shale Oil, Strong Man, Variance, Visionary Investors
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The Impact of High Oil Prices on Emerging Markets

Tuesday, April 10th, 2012

Tags: Added Source, Africa Region, Balance Of Payments, Carlen, Central And Eastern Europe, Commodity Prices, Countries In Central America, Emerging Market, Export Demand, Fiscal Adjustment, Gasoline Prices, Global Growth, Gulf States, Import Prices, Market Volatility, Oil Import, Rising Oil Prices, South American Countries, South Russia, Trade Act
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Emerging Markets Radar (April 9, 2012)

Sunday, April 8th, 2012

Emerging Markets Radar (April 9, 2012)

Strengths

• The Hungarian PMI surged above expectations in March to 56.8, the strongest reading in the last thirteen months, reflecting the positive impact of the opening of the brand new Daimler AG plant. The Czech manufacturing PMI has also improved.
• Brazil’s consumer prices rose 0.21 percent in March from February, the government’s statistics agency said in a report distributed in Rio de Janeiro today. Economists surveyed by Bloomberg had expected inflation of 0.37 percent, according to the median forecast of 50 analysts.
• Chilean consumer prices rose 0.2 percent in March from the previous month, less than analysts’ forecast, bringing annual inflation back within the central bank’s target range for the first time in four months.
• China official March PMI was 53.1 versus the estimate of 50.8, rising 2.1 from February; new orders were up 4.1 points at 55.1 percent. Nevertheless, due to seasonality, March’s PMI is usually 3 points better than February’s, therefore, the market is cautious about the better-than-expected PMI for last month. PMI above 50 indicates industrial activities are expanding.
• China’s March non-manufacturing PMI was 58 versus 48.4 in February, indicating consumer consumption may be resilient.
• Philippines inflation eased to 2.6 percent on a year-over-year basis in March from 2.7 percent in February. A base-year comparison suggests inflation in the country will remain subdued in April. However, inflation trends should turn up from mid-year driven by a resumed rise in oil and commodity prices and strengthening domestic demand.
• March housing transactions increased 40 percent in Beijing, and similar increases were also seen in other tier 1 and tier 2 cities. Some analysts say buyers are encouraged by the fact that the Chinese government had historically failed in curbing housing prices, but others say March sales volume is always the equivalent of combined sales of January and February in the year and March of this year didn’t see better volume than prior years.
• Indonesia’s parliament did not pass the fuel raise bill which was to remove the fuel subsidy and raise fuel prices by 33 percent.

Weaknesses

• The Russian central bank chairman said the liquidity deficit faced by the financial industry is the “new norm” this year. One of the reasons is a continued capital outflow. Russians spent $12 billion on foreign property last year, compared with $5.5 billion a year in 2007 and 2008, according to the chairman.
• Colombian policy makers meeting last month were divided over the need to raise interest rates further to keep inflation in check. Analyst Brian Lesmes, at Grupo Bancolombia in Bogota, said that though inflation and credit demand have eased, further tightening may be needed to cool household demand.
• Thailand inflation edged up to 3.4 percent year-over-year in March from 3.3 percent in February, but base-year comparison suggests inflation in the country will remain subdued in April.
• Indonesia is to discuss an export tax on coal and base metals, which is negative for local materials companies but good for global coal and base metal producers.
• Taiwan may implement a capital gains tax on stock trading profits.

Opportunities

• Citigroup Inc. raised South African equities to overweight, the equivalent of a buy, on expected strong earnings growth and companies’ expansion into Africa’s fast-growing frontier markets, the bank said.
• In the last decade, Indonesia has restored stable economic growth and, therefore, has improved its wealth. With opportunities to build vast infrastructures and industrial complex, foreign direct investments (FDI) now are returning to the country. The increasing FDI has driven up demand for industrial estate and building materials, such as cements.

Threats

• Brazil’s tax agency said on Wednesday that intra-company commodities exports and imports by multinational traders must be settled using international prices. The country’s Federal tax authority said the measures are aimed at ending “price manipulation” of inter-company imports and exports that allow multi-national companies to evade local taxes.
• Peru is renegotiating with Mexico to cut natural gas shipments after allocating gas reserves to its domestic industry, a Peruvian government official said. Approximately half of the shipments will be cut, the president of state oil contracting agency Perupetro said this week.
• The Chinese economy is still in the process of a soft landing, but the policy response may fall behind the curve. In 2012, corporate revenue growth is predicted to be much slower than 2011, with gross margins also expected to be lower due to weaker demand and a rise in input costs.

Tags: Beijing, Brazil, China, China Official, Chinese Government, Commodities, Commodity, Commodity Prices, Consumer Consumption, Daimler Ag, Economists, Emerging Markets, Four Months, inflation, Philippines, Pmi, Radar, Rio De Janeiro, Russia, Sales Volume, Seasonality, Statistics Agency, Target Range, Thirteen Months, Tier 2
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The Fed’s Con Appears To Be Working But The Curtain Is Rising On The Third Act

Wednesday, April 4th, 2012

 
Courtesy of Lee Adler of the Wall Street Examiner

In today’s conomic news, the mainstream media focused on the disappointment surrounding the FOMC Minutes, the massaged and sanitized fairy tale about what the participants said at last month’s FOMC confab. The market was shocked! SHOCKED! that most of the members saw no need for additional QE, unless things got worse. I had concluded that a couple of months ago based on the fact that every time QE speculation arose, not only did stocks rally, but so did energy and other commodity prices. The commodity vigilantes, I thought, would tie the Fed’s hands. That and the fact that the conomic data was coming in relatively perky, at least in terms of the headline data, made it highly unlikely that the Fed would do any more money printing.

But here’s the thing. The minutes are fake. They are fabricated, false, phony, and sterilized garbage, designed for public consumption. To put it bluntly, they’re propaganda. They are what the Fed and Wall Street casino owners want you to think. They are a blatant attempt to manipulate the behavior of market participants through the use of clever turns of phrase. The Fed wants the market to go higher, but it doesn’t want commodities to go with it, so its story line is that the conomy is healthy enough to continue growing without more QE. That gives traders reason to continue buying stocks, and no reason to buy commodities, which everyone “knows” go up when the Fed prints, in spite of Bernanke’s denials. And besides, commodities are up for other reasons, not anything Ben did, according to Ben.

That’s what these “minutes” are about, self justification and market manipulation. We won’t know the real story until February 2018 when the Fed will release the transcripts of this year’s FOMC meetings. Why do they hold them back for at least 5 years? Because the Fed thinks that you can’t handle the truth. The problem is that you can and they just don’t want you to know what it is, because if you did, you’d be able to make informed investment decisions. The decisions the Fed wants you to make are to buy stocks, bay and hold Treasuries, and sell commodities. They tailored the minutes accordingly, so that the headlines would elicit the desired response. They think that they’re Pavlov, and we’re the dogs.

Admittedly, I have not yet read the minutes (I will for this weekend’s Fed Report), but I have read the news headlines. Those headlines are what the Fed-Wall Street-Media-Industrial Complex wants you to think, so you really don’t need to read the minutes. Rest assured that the Fed got the propaganda it wanted. The market reaction it wanted it hasn’t yet gotten, yet, but the Fed is betting that it will, and therein lies the rub. The Fed doesn’t always get what it wants. If traders decide to sell the Dow off 200 points in response to this news, then the next morning, the Fed’s ventriloquist dummy, Jon Hilsenrath, will float another QE3 trial balloon in the Wall Street Urinal.

So we’ll just have to see how traders respond. As for what the Fed really thinks, sorry, that will have to wait 6 years.

Meanwhile, the other datapoint the conomists focused on today was February Factory Orders. This is an item based on a Census Bureau monthly survey of a tiny sampling of US manufacturers that extrapolates that sample into a total dollar estimate of new orders and other metrics. The Bureau reports both the seasonally adjusted result and the actual result, also known as not seasonally adjusted. The only number the pundits and media pay attention to is the seasonally adjusted, fictional number. That’s just wrong, but that’s the way it is. It gives us the opportunity to look at the actual data and know what’s really going on, rather than the smoothed fiction that the Wall Street mouthpieces present on a silver platter as if it’s the grail.

The headline number for February was a 1.3% month to month increase, seasonally smoothed. That was a miss. The conomic consensus was for a gain of 1.5%. But this is a minor item in the conomic firmament–durable goods orders out the week before are more important–and the pundits managed to spin it as bullish anyway. The bullishness is wild and universal, nary a contrarian to be found in the pages of the Murdoch, Bloomberg tout sheets.

The headline number isn’t always wrong or misleading, and as it turns out, the actual, not seasonally adjusted gain in February was impressive, up 4.7% from January and up 10.6% over February 2011, both in real terms adjusted by CPI inflation. The 4.7% monthly gain compared with a decline of 0.7% in February 2011. Over the prior 10 years, monthly changes in February ranged from last year’s -0.7% to a high of +4.9% in February 2004. Any way you slice it this was a good number. Did the warm weather in February have anything to do with that? Certainly, but it’s impossible to say how much. If it pulled demand forward from March and April, we’ll see that in the next month or two.

I thought it would be interesting to overlay the ISM’s not seasonally adjusted New Orders Index on the chart of new factory orders. I am using the factory orders not seasonally adjusted data, but adjusted for inflation in order to see the real change in unit volume over time. The ISMsurvey should lead the Factory Orders. The ISM data is for March. It turns out that the correlation with the between the ISM New Orders Index, and the 12 month rate of change in the Commerce Department’s New Factory Orders data is pretty close. Lately, however, the ISM data suggests greater weakness than has been showing up in the government data. Who’s right? I don’t know, but as with the ISM and the 50 line on its chart, an annual change in factory orders of more than 1 to 2%, tends to correlate with an ongoing uptrend in stocks. It will be time to start worrying when the growth rate closes in on zero. That has correlated with a topping process in stocks.

Real Factory Orders NSA Chart- Click to enlarge

Manufacturing activity lags stock prices. By the time new factory orders go negative, stocks will have already gone through their first leg down.  Consumers and businesses take their cues from the stock market, and the stock market takes its cues from the Fed.

Everybody thinks that Dr. Bernankenstein’s monster alphabet soup experiments, and Henry Paulson’s TARP saved the world from conomic collapse. The fact is that they caused, or at least exacerbated the conomic collapse. Take the manufacturing orders data as an example of how that unfolded.

Fed, Stocks, and Factory Orders Chart- Click to enlarge

The manufacturing conomy was doing just fine until Bernanke stopped feeding the Primary Dealers and actually starved them out early in 2008. He did that by paying for his crazy alphabet soup programs with cash from the Fed’s System Open Market Account. In selling and redeeming Treasuries from the SOMA he radically shrank the cash levels in Primary Dealer accounts, rendering them  unable to maintain orderly markets. The dealers are, after all, not just market makers in Treasuries. They run all the markets, stocks, bonds, commodities, futures, options, everything. They are the big mahoffs of all the markets, and Ben is their banker and bagman.

So manufacturing  was doing just fine in 2007 and 2008 until stocks broke down. Stocks broke because of the combination of the Fed starving out the Primary Dealers in late 2007 and the first half of 2008, followed by Henry Paulson’s bravura panic performance before House and Senate committees, convincing Congress to fund the $700 billion TARP. Bernanke was best supporting actor at those hearings.

Faced with the testimony of the two dynamite strapped suicide extortionists, Congress caved, and the Treasury raised that money in a few short weeks in September and October 2008. That forced the dealers (and others) to absorb $100-200 billion a week of new Treasury supply at a time when the Fed had already cut their balls off. They were in no position to absorb anything.  The Fed had taken their manhood and all their cash.

In order to perform their function as Primary Dealers and absorb that part of the new Treasury supply not purchased by others, the dealers had no choice but to liquidate stocks. Because most economic units, both individual consumers and businesses, base their purchase decisions on the stock market, when it cratered that was their signal to consumers and business to be scared, be very scared, and hunker down in fear in their mental bunkers.

Manufacturing orders were still very strong in June 2008. They didn’t collapse until after Bernanke and Paulson triggered the panic.  In October 2008, they collapsed on the heels of  the Bernanke-Paulson Panic.

The Fed finally figured it out in February 2009, and it started a radical program of pumping hundreds of billions into the accounts of the Primary Dealers with QE1. The stock market and manufacturing orders rebounded almost immediately. When the Fed experimented with withholding funds in mid 2010, stocks plunged and manufacturing activity stalled. Double dip fears exploded and the Fed resumed pumping cash into dealer accounts.

Flash forward to today and the Fed is again on hold, although its MBS replacement purchase program helps to keep the dealers liquid. The effect of that program on dealer accounts is not reflected in the SOMA, but it does send cash to dealer accounts. The effects of the program on stock prices are clear.

The issue now is when will the Fed make its next catastrophic blunder. Just by tapping the brakes on the SOMA, it is creating conditions for another swoon. It is trying to hold back commodity prices while getting the benefit of conomic growth. The problem is that that growth is a second order bubble effect of the rising stock market. If they don’t feed the market, they won’t get their conomic growth. If they do feed the market, commodity prices will explode upward, and that will eventually put a stake in the heart of growth. For now, manufacturing activity is on a growth track. On the surface it appears that the Fed’s propaganda and manipulation is working, but in truth Bernanke has laid the groundwork for the Fed’s next blunder, panic move,  and massive dislocation.

Copyright © 2012 The Wall Street Examiner. All Rights Reserved. This article may be reposted with attribution and a prominent link to the source The Wall Street Examiner.

Tags: Bernanke, Blatant Attempt, Buying Stocks, Casino Owners, China, Commodities, Commodity, Commodity Prices, Conomy, Denials, Fairy Tale, Fomc Meetings, Fomc Minutes, Lee Adler, Mainstream Media, Market Manipulation, Market Participants, Money Printing, Public Consumption, Qe, Self Justification, Street Casino
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Mr. BRIC Trade is on Our Side

Friday, March 16th, 2012

by William Smead, CEO, CIO, Smead Capital Management

A recent article in “The National” quoted Jim O’Neil as saying that current supply and demand for oil indicates that $80 to $100 per barrel for Brent Crude would be a fair price. For those of you who don’t recognize the name, O’Neil is a very savvy economist for Goldman Sachs (GS), who coined the phrase BRIC trade back in 2001. Since that qualified him as an investment “Wayne Gretsky” (he skates to where the puck is going to be), we believe his thoughts are worthwhile.

O’Neil argues that there are no winners in a war over Iran’s nuclear capability. Therefore, he argues that the $25-35 premium in the price per barrel, which comes from supply disruption fears, would disappear by summer. We agree wholeheartedly.

We also agree with his belief that Brazil and Russia don’t benefit from lower oil and commodity prices. In our opinion, the decade long bull market for commodities is held together by oil prices stubbornly acting on a ten-year old bull case and foolish asset allocators investing in the rearview mirror. Oil is 30 percent of most commodity indexes. It hangs on while natural gas, cotton, coffee, wheat and corn are firmly in bear market territory.

When oil and gold join the bear market, we believe the race for the exits will look like the tech stock bear market of 2000-2002. Those folks who were long tech lost 80 percent from March of 2000 to October of 2002. When a non- economic market crumbles, it is like the Tower of Terror at Disney’s California Adventure Park. You drop straight down without interruption!

We disagree with O’Neil in one way. He believes lower oil prices would stimulate China’s economy, helping to promote a “soft landing”. We agree with Michael Pettis, Professor at Peking University, on this subject. In a recent NPR broadcast his opinion was summarized as follows:

“For Pettis, China’s economic miracle is just the latest, largest version of a familiar story. A government in a developing country funnels tons of money into construction. This increases economic activity for a while, but the country ultimately overbuilds — and the loans start going bad.

‘In every single case it ended up with excessive debt,’ Pettis says. ‘In some cases a debt crisis, in other cases a lost decade of very, very slow growth and rapidly rising debt. And no one has taken it to the extremes China has.’ “

In our opinion, if China slows into a recession/depression, $30-40 per barrel oil is a possibility. Or if China doesn’t grow much in the next ten years, commodity exposure will be a noose around the neck of asset allocators. Add in the likelihood that there would be poor performance among the US cyclical stocks, which have suckled on China’s bounteous teat, and you have the ideal set up for an asset allocation “nightmare”!

The information contained in this missive represents SCM’s opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. Some of the securities identified and described in this missive are a sample of issuers being currently recommended for suitable clients as of the date of this missive and do not represent all of the securities purchased or recommended for our clients. It should not be assumed that investing in these securities was or will be profitable. A list of all recommendations made by Smead Capital Management with in the past twelve month period is available upon request.

Copyright © Smead Capital Management

Tags: Asset Allocators, Brazil, Brent Crude, Bull Case, California Adventure Park, Commodity Prices, Current Supply, Economic Market, Economic Miracle, Goldman Sachs, Michael Pettis, Mr Bric, Npr, Nuclear Capability, O Neil, Oil Prices, Peking University, Rearview Mirror, Russia, Sachs Gs, Supply Disruption, Tower Of Terror
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