Posts Tagged ‘Sectors Of The Economy’

Atlas Shrugged!? (Saut)

Monday, June 11th, 2012

 

“Atlas Shrugged?!”

by Jeffrey Saut, Chief Investment Strategist, Raymond James

June 11, 2012

Stephen Moore wrote a Wall Street Journal article entitled, “Atlas Shrugged: From Fiction to Fact in 52 Years.” For those of us familiar with Ayn Rand’s classic book (Atlas Shrugged), recent events eerily mirror her writings about the economic carnage caused by big government running amok. As Mr. Moore wrote:

For the uninitiated, the moral of the story is simply this: Politicians invariably respond to crises – that in most cases they themselves created – by spawning new government programs, laws and regulations. These, in turn, generate more havoc and poverty, which inspires the politicians to create more programs … and the downward spiral repeats itself until the productive sectors of the economy collapse under the collective weight of taxes and other burdens imposed in the name of fairness, equality and do-goodism.

In the book, these relentless wealth redistributionists and their programs are disparaged as ‘the looters and their laws.’ Every new act of government futility and stupidity carries with it a benevolent-sounding title. These include the ‘Anti-Greed Act’ to redistribute income and the ‘Equalization of Opportunity Act’ to prevent people from starting more than one business (to give other people a chance). My personal favorite, the ‘Anti Dog-Eat-Dog Act,’ aims to restrict cut-throat competition between firms and thus slow the wave of business bankruptcies.

President Ronald Reagan was the first to suggest that the nine most terrifying words in the English language are, “I’m from the government and I’m here to help.” President Reagan also stated, “Government is not the solution to our problem; government is the problem.” Even President Clinton promised smaller government, but that promise ended on November 4, 2008 as voters elected President Barack Obama, ushering in an era of expanded government that Ayn Rand warned of 52 years ago (as a sidebar, we suggest watching this two-minute blurb from Milton Friedman – http://pajamasmedia.com/instapundit/69117/). Yet, last week may have marked a historic shift in the country’s ideological direction after Governor Scott Walker’s resounding win in Wisconsin’s recall vote.

Now I am not a Tea Party person, but since the historic mid-term elections I have argued the Tea Party surfaced what Adam Smith wrote about in the book “The Wealth of Nations.” To wit – the political corruption that prevents prosperity – and that is exactly what we’ve got, the best Congress (the House and Senate) money can buy. Yet, that seems to be changing punctuated by last week’s Wisconsin vote. However, the footings of the sea change began two years ago with the mid-term election where the majority of those elected were not professional politicians but rather came from the private sector. Moreover, if you talk to those newbies they will tell you they don’t really want to be in Washington, but they think the country is off course and they want to try and reverse that course. I think this is a trend toward more practical leaders that will offer simple and pragmatic solutions to our country’s ills rather than recondite laws like the aforementioned “Anti-Greed Act;” and, I think that is bullish for the stock market.

Last week the stock market thought so too as the S&P 500 (SPX/1325.66) posted its best weekly gain of the year. The weekly win left the SPX higher by 3.73% and back above its 200-day moving average (DMA), which is now at 1288.41. Of course, my email box subsequently lit up with the question, “Was last Monday’s intraday low of 1266.74 similar to the ‘undercut low’ you told us to ‘buy’ on October 4th of last year?” Early last week I really didn’t know the answer to that question because after recommending recommitting some of the cash raised in the February – April timeframe over the past few weeks, the breakdown below my key pivot point of 1290 (basis the SPX) caused me to suspend the judicious recommitment of cash until the near-term direction of the market became clearer. To be sure, in this business it’s better to lose “face” and save “skin!” By the end of the week the break below 1290 was indeed looking more and more like an “undercut low.” Recall, it was Merrill Lynch’s veteran strategist Bob Farrell who often spoke of “undercut lows” as being one of the better bottoming formations. For example, when the major averages trade below a previously well advertised stock market “low,” causing participants to panic and “sell” and then the markets “turn up” and rally, such sequences often mark tradable “lows.” This week should tell us if that is what happened last week.

Studying the market’s metrics, since the May 1st rally high (SPX 1415.32) there have been two 90% Downside Days (90% of total points and volume traded was on the downside) culminating with June 1st’s 90% Downside Day. Those two Downside Days probably exhausted the sellers, at least on a short-term basis. Consequently, what was needed was some upside demand and the stock market took a step in that direction last Wednesday with a Dow Wow of 287 points that turned out to be a 90% Upside Day. The rebound carried the senior index back above my 1290 pivot point and therefore placed it in a position to build on last week’s rally. Additionally, there is a full charge of energy in my daily internal energy model. Hence, if the SPX can surmount the overhead resistance around its recent reaction high of 1335, and stay above that level, the market should be able to move higher.

In terms of sectors, Financials (+4.71%), Materials (+4.38%), and Technology (+4.28%) saw the biggest bounces for the week, while Consumer Staples (+2.56%) rallied the least. The rally left Utilities and Telecom Services the most overbought sectors and Energy as the only remaining oversold sector. Outside of the country, Italy and Russia were better by more than 7%; and for those focused on Spain’s sovereign debt yields, maybe you should consider the fact that Spain’s equity market was up 10.41% last week. China was the worst performer as participants feared economic slowing as telegraphed by China’s interest rate cut and the lowering of gasoline prices.

Speaking to lower fuel prices, last week our airline analysts lowered their fuel assumptions for 2013 by 19% and raised their ratings on several companies. Alaska Air (ALK/$34.73) was upgraded to an Outperform with the comments from our analysts that Alaska Air has a best in class cost structure, balance sheet, and attractive valuation. Allegiant (ALGT/$65.70) was moved to a Strong Buy given its leverage to lower fuel prices and strong earnings momentum driven by a 16-seat expansion project, Hawaii service, and carry-on bag fee. The change in our fuel price assumptions produces a very large change in earnings because jet fuel and related taxes and fees on average accounts for about 38% of total airline expenses. Moreover, the impact on earnings is obviously far greater for airlines with lower margins. As an example, our analysts boosted their earnings estimates for U.S. Airways (LCC/$12.15/Outperform) by 25% this year and 46% next year. Interestingly, LCC has been showing up on our proprietary screening models for months with positive implications. Other names that have positive implications and are rated favorably by our fundamental analysts include: Allstate (ALL/$34.31/$Strong Buy); Davita (DVA/ $85.60/Outperform); Dollar Tree (DLTR/$106.72/Strong Buy); Brinker (EAT/$30.90/Strong Buy); Family Dollar (FDO/$69.58/Outperform); and JB Hunt (JBHT/$55.39/Outperform).

The call for this week: Over the weekend the eurozone agreed to lend Spain up to €100 ($126 billion) to shore up its teetering banks. That decision prompted this from my friend David Kotok, captain of Cumberland Advisors:

The fact is the absence of banking collapses is good news. That is correct. Good news! We establish that good news by what we DO NOT see on TV. We do not see banks collapsing and failing to pay depositors. This means we may not witness the euro system collapsing and failing. Bank runs and deposit failures are symptoms of liquidity constraints. Liquidity is not to be confused with solvency. A prime example: Greece is certainly insolvent. It cannot pay its debt or its governmental bills. Nevertheless, Greece’s banks still have liquidity because of Emergency Liquidity Assistance (ELA) funding. [Because] ELA exists the euro system agents know that they cannot permit euro system banks to fail to pay their depositors. Therefore, our conclusion is that liquidity issues will be addressed in the euro zone. The Spanish banking chapter is unfolding before our eyes. Markets have been pricing in a fear of systemic failure on the liquidity side. Market bears will be disappointed, because the liquidity failure is not going to happen. The next test is coming on June 17, with French and Greek elections.

Now we know why Spain’s equity markets rallied over 10% last week. As for our markets, in last week’s verbal strategy comments I said that am treating last Monday’s intraday low as a daily and intermediate term low. I still feel that way.

 

Copyright © Raymond James

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High-Yield Bonds—Extra Income, But Added Risk

Friday, June 8th, 2012

 

by Kathy A. Jones, Vice President, Fixed Income Strategist, Schwab Center for Financial Research

Key points:

  • In a world of low interest rates, high-yield (or sub-investment-grade) bonds can be a source of added income in an individual investor’s portfolio. The yield on the Barclays U.S. Corporate High-Yield Bond Index is currently 8.2%—more than double the yield on the Barclays U.S. Intermediate Corporate (investment grade) Bond Index and more than 7.0 % greater than US Treasury bond yields of comparable maturity.1
  • Over the past few years, improving economic growth and easing strains on financial markets have resulted in strong returns in the high-yield market.
  • With interest rates on Treasury bonds near 40-year lows, higher coupon-interest payments have been especially valuable during the past few years. When reinvested, the compounding of interest income can help reduce volatility in a portfolio.
  • However, extra yield comes with added risk: Companies that issue high-yield bonds are, by definition, less credit-worthy than investment-grade companies and are therefore more likely to default. In addition, the market for high-yield bonds is less liquid than for other types of bonds, and high-yield bonds tend to be more correlated with the stock market than with Treasury bond prices, potentially changing the overall diversification of your portfolio.
  • We advise limiting the amount of aggressive income investments in a fixed income portfolio to 20% to help reduce potential volatility and losses.

With the Federal Reserve holding US Treasury yields near 40-year lows, investors seeking income often expand their search for higher yields into riskier sectors of the bond market. One such sector is high-yield bonds, which are rated below investment-grade because companies issuing them are less credit-worthy. The issuers may have more balance-sheet debt and weaker earnings power, and/or they may do business in more-volatile sectors of the economy, making their earnings less predictable.

Lower Credit Quality Corresponds with Higher Default Rates

Lower Credit Quality Corresponds with Higher Default Rates

Source: Schwab Center for Financial Research, with data from Standard & Poor’s 2011 Global Corporate Default Study. The study analyzed the rating and default history of 14,654 US and non-US companies first rated by Standard & Poor’s between December 31, 1981 and December 31, 2010. The 15-year cumulative average default rate is calculated by weight-averaging the marginal default rates in all static pools. Past performance is no indication of future results.

Because of these risks, less-credit-worthy companies must offer higher yields than those offered on investment-grade bonds. As of May 31, the yield on the Barclays U.S. Corporate High Yield Bond Index—where the average maturity is four years—is 8.2%, compared to 2.8% for the Barclays U.S. Intermediate Corporate (investment grade) Bond Index, with an average maturity of 5.3 years.

Over the past 25 years, the average ratio of the high-yield index yield to investment-grade was 1.74 compared to the current ratio of 2.92. This higher-than-average ratio implies that the market is pricing in a higher degree of risk in high-yield bonds than the historical average despite the fact that default rates for high-yield issuers are currently below the long-term average.

Default rates among high-yield-bond issuers have declined since the peak of the financial crisis, and the ratio of upgrades to downgrades within the sector has improved. The most-recent figures from Moody’s indicate that average default rates are running at 2.2%, below the long-term average of 5.6% and significantly below the recent peak levels of 17.1% in 2009.

As the chart below illustrates, the high-yield market can be volatile. During times of financial distress such as the financial crisis in 2008-2009, or in the aftermath of the technology-stock bubble bursting in 2000-2001, yields spiked sharply higher—with prices declining steeply. When financial markets are under stress, liquidity can be scarce—both for companies seeking loans and in the high-yield market itself, as buyers retreat.

Recent improving financial conditions, as shown by the decline in the St. Louis Financial Stress Index, have been supportive of the high-yield bond market. (The St. Louis Fed’s index is comprised of indicators such as interest-rate yield spreads and volatility indexes that measure ups and downs in the financial sector of the economy.)

St. Louis Financial Stress Index Versus Barclays High Yield Index

St. Louis Financial Stress Index Versus Barclays High Yield Index

Source: Barclays Database and St. Louis Federal Reserve Bank, monthly data as of April 2012.

To some extent, the high-yield bond market has been experiencing a positive cycle. As interest rates have fallen and economic conditions have improved, companies have been able to refinance debt at lower levels, which has improved the measures of their financial performance. As those measures improve, investors seek out the bonds, pushing yields lower, which in turn allows for more refinancing.

Income is important

A potential benefit of high-yield bonds in the current environment is the relatively high level of coupon income. It’s obviously helpful for investors looking to use that income to meet expenses, but it can also be beneficial when reinvested, because it can help dampen volatility in an overall portfolio when interest rates rise. In a rising-rate environment, higher-coupon bonds tend to decline less than bonds with lower coupons because the current income can be reinvested at higher interest rates, all else being equal.

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Could High Oil Prices Cause A Global Economic Deflation?

Friday, April 15th, 2011

by Kurt Cobb, via EconMatters

As the European Central Bank (ECB) prepares to raise interest rates to prevent inflation, the bank cites rising commodity prices, particularly oil prices, as a sign of that inflation. What the bank and other market participants don’t seem to understand is that high commodity prices and, in particular, high oil prices are deflationary.

The logic is so simple it’s hard to understand why smart people with advanced degrees can’t see it. Commodities, particularly oil, pull money away from other sectors of the economy. When people are forced to choose between paying for heat and gasoline or paying the mortgage, they pay for heat and gasoline.

Cars don’t budge without gasoline (unless you can afford an electric one) and most people need their cars to get to work. The heat can be turned off rather quickly by the utility company in comparison to the glacial pace of a mortgage foreclosure that can take many months and sometimes more than a year.

This situation is particularly problematic because it pulls money out of the financial sector. And, despite all the nonsense about the financial industry being on the mend, the industry is actually becoming more and more vulnerable by the day as it increases its exposure and leverage to financial and commodity markets.

The speculative animal spirits of the banks, hedge funds and other large investors, buoyed by all the virtually free money available for borrowing and huge taxpayer-financed injections into zombie banks, may now be hurtling us toward another jaw-dropping financial catastrophe.

As Hyman Minsky might put it, stability and prosperity lead to instability and crisis as market participants become more and more emboldened on the upswing creating the illusion that all is well. Then, when prices and credit expansion go beyond what the economy can sustain, a decline ensues that is often dramatic as confidence suddenly shifts to revulsion and fear.

As housing prices continue to sink, the immense amount of bad mortgage debt still floating around the financial system becomes even more putrid than before. Someday the institutions which hold the debt will have to stop pretending that they are going to get paid back.

However, the prelude to that will be deflation brought on by the high prices of oil and commodities which tend to depress economic activity as household spending is reserved for essentials rather than discretionary items.

As the animal spirits in the markets get dampened by the realities in the economy, the stage is set for a crisis–a turning point when confidence and liquidity turn into fear and illiquidity as big investors try to exit positions all at the same time.

Compounding the deflationary forces inherent in high commodity prices are severe cutbacks by states hit by declining revenues, federal cutbacks, and austerity programs now being implemented across Europe. All of these add to the deflationary juggernaut.

It is certainly possible that commodity prices including oil could rise much higher before the effects described above finally topple the economy. And, it’s possible that those prices could moderate and fall gently in a way that might lengthen any economic recovery under way. But it does seem that we are much closer to a top in commodity prices than to a bottom.

The U.S. Federal Reserve Board seems to agree that high oil prices could be deflationary. One of the Fed governors indicated that the Fed’s attempts to boost the economy by buying government bonds (and thus lowering long-term interest rates) could be extended if oil prices continue to rise.

I don’t know what the interest rate policy for the ECB or the Federal Reserve should be. I think neither have good options. I do know that 10 of the last 11 recessions were preceded by oil price shocks. And, this time, we are dealing with shocks not only in oil, but also in food, just as we did in 2008. And, I don’t have to remind readers what happened after that.

Will we see a repeat of 2008 in 2011? Mark Twain once said that “history doesn’t repeat itself, but it does rhyme.” So far the stanzas of 2011 seems to be rhyming quite well with those of 2008. There have been price spikes in food and oil followed by denials that these could derail the economy coupled with unrest on the streets of many countries related in part to high food and energy costs.

Nevertheless, I’d say look for an unexpected divergence between the two periods. Whether that divergence turns out to be detrimental or felicitous will, however, not change the fact that high commodity prices are deflationary.

About The Author – Kurt Cobb is the author of Prelude, a peak oil-themed novel, and a columnist for the Paris-based science news site Scitizen. His work has been featured on Energy Bulletin, The Oil Drum, 321energy, Common Dreams, Le Monde Diplomatique, EV World, and many other sites. He maintains a blog called Resource Insights.

The views and opinions expressed herein are the author’s own, and do not necessarily reflect those of EconMatters.

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Crude Oil: $84 a Barrel This Week and Could Hit $100 By January, 2011

Sunday, October 3rd, 2010

Last week the shorts were all lined up for another bearish inventory report for Petroleum products from the EIA, but lo and behold, miracles do actually occur. We had an extremely bullish report (Fig. 1) which caught a lot of traders poorly positioned, and many fund managers underexposed to the commodity, which relative to Gold, Silver, and Copper, smelled like a bargain in the face of further quantitative easing expected by the Federal Reserve in the 4 th quarter.

The technicals indicate that upward resistance will not be found until the $84 a barrel level, so despite Crude Oil moving from roughly $75.60 before the report on Wednesday morning to close Friday`s electronic session at $81.73, a $6.13 move in 3 days, there is still more room to go for this upward move in the commodity.  (Fig. 2)

The real surprise in the report was the large drop–3.5 million barrels– in gasoline inventories, and the RBOB contract needed to re-price itself given this change which was largely due to lower imports on the supply side, as demand for gasoline is still relatively anemic year on year.

Distillate demand has recovered strongly over the last 6 weeks from the lows of the summer (Fig. 3), and is quite robust year on year, and a great sign that the double dip scenario is officially off the table. Remember, that distillate demand represents usage from the industrial and manufacturing sectors of the economy which will be the first indications of potential economic strength or weakness.

Expect crude to test the $84 level sometime Monday or Tuesday, and hold below that level before the upcoming inventory report on Wednesday morning. Even if we have another relatively bullish inventory report expect crude to have some solid resistance near $85 a barrel for the week, as the move would be a little overdone in such a short timeframe. It is natural to expect several pullbacks on volatility and profit taking during the week with a potential weekly trading range from $80.50 to $85.70 give or take 30 cents in either direction.

But the longer term trend is clear as traders and fund managers want to be strategically exposed to Oil from this point forward, as the real upward move is just now starting, expect crude oil to hit $100 a barrel by January, and only going higher from there. The signs are there for this scenario, a strengthening euro, weakening dollar, global currency devaluation races fueling all commodities, Oil Moratorium and anti-drilling sentiment from Washington, globally escalating energy needs, global QE2 programs, and natural Inflation Trends.

All one has to do for validation of this thesis is look at Silver at $22 an ounce, and realize that the only thing holding Crude Oil from a $100 a barrel was supply overhangs. It appears that those will be quickly worked off as both the US and global economy are now past the double dip scares. Expect future business confidence and spending to pick up, and with some pro business initiatives around the corner after the elections in November, expect unemployment to start dropping in a meaningful way.

All this portends for not only a monetary-inflation argument for owning Oil, but the fundamentals are now starting to turn, as illustrated by the Distillate demand recovery (Fig. 3), expect gasoline and crude to follow suit, and now you have the makings of a runaway bull market in this explosive commodity.

Moreover, the one element that has been absent from Crude Oil is the lack of a definable trend like the Gold Market.  Well, expect that to change.  From now through 2011`s Summer Driving Season, crude oil should establish a clear upward trend, which attracts further investment capital, ultimately reinforcing the momentum of the move. This is one of the ironies of financial markets, the higher an asset climbs in price, the more attractive it becomes to investors.

So Crude Oil will become the poster child for the success of the anti-deflationary campaign of the Federal Reserve, but we can all look forward to the Political Blame Game over $150 a barrel oil, Congressional hearings on Oil speculation, National Debates on Energy Policy, and attractively discounted Hummers for sale on CARMAX lots.

Disclosure: No Positions
Dian L. Chu, Oct. 3, 2010

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PIMCO’s Inflation Outlook and Investment Implications (April 2010)

Thursday, April 15th, 2010

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by Mihir Worah, Portfolio Manager and Managing Director, PIMCO, April 2010.

The continued fiscal worries of a number of economies within the eurozone and the uneven global growth trajectory have created more uncertainty around inflation forecasts than usual. Mihir Worah, managing director and head of the Real Return portfolio management team, discusses PIMCO’s outlook and examines whether inflation or deflation poses a more imminent threat for investors.

Q: PIMCO said that it sees disinflation over the cyclical horizon but expects inflation over the secular horizon of the next three to five years. Has this outlook changed?
Worah: No. This outlook has not changed. However, uncertainties around this have increased rather than decreased. We continue to expect mild or slowing inflation over the next one to two years. The slowdown in the economy and the concurrent dip in resource utilization are two major reasons for this forecast. However, we now have a new disinflationary factor thrown into the mix with the lack of appetite for fiscal stimulus injections from governments, including the U.S. and U.K., which are facing mounting fiscal pressure. To reflect this view, our inflation-linked bond portfolios are currently positioned to be underweight inflation-linked bonds as a tactical trading position.

In the longer term, we continue to expect higher and more volatile inflation than was typical in the past. There are several reasons for this, one of which is a secular decline in developed market currencies versus emerging currencies and related to that, an increase in commodity prices. We will address the issue of commodities specifically later. In addition, we expect the capacity destruction that we have seen in whole economies to play a role here. With entire sectors of the economy and many human skill sets becoming obsolete, we will find capacity constraints as economies start to recover, leading to the possibility of higher inflation. Finally, there is the possibility of policy error or political intervention, which may prevent central banks from shrinking their balance sheets in a timely fashion. All of these factors point to the possibility of higher inflation further down the road.

Q: In 2009, central bank measures such as quantitative easing programs and keeping interest rates low seemed to have helped stabilize markets and fight deflation threats. But with such programs nearing expiration, which will pose a bigger threat – deflation or inflation?
Worah: As you suggest, the quantitative easing programs were a key tool in combating financial instability and the possibility of deflation after the events in the fourth quarter of 2008. Therefore, to the extent that central banks discontinue their quantitative easing programs, I would say there is a near-term risk of flipping to deflation given our view that developed economies have not fully healed and consumers are not yet ready to stand on their own two feet. And to the extent central banks continue their quantitative easing programs then clearly they are once again truncating the deflationary tail and we can anticipate a successful reflation of the economy. But any meaningful inflation should still be a couple of years away.

Q: How do bloated balance sheets of central banks, many of which reached unprecedented levels in 2009, affect inflation?
Worah: Essentially the bloated balance sheets of central banks affect inflation in two ways. The first is the way in which the money moves out of the banks’ balance sheets and into the broader economy, which is not occurring yet. And when it does start to get there, there’s still about a two- to three-year interval between this greater money supply in the broader economy and inflation. So what these bloated balance sheets have done is simply truncate the deflation risk in some countries, which featured highly about a year ago in countries like the U.S. and U.K. In the longer term, the risk these bloated balance sheets pose for inflation is really by way of political interference. Central banks know what they need to do to unwind their balance sheets in a timely fashion once credit conditions normalize in order to control inflation. However, if they have their independence encroached upon or curtailed by political institutions, this could certainly raise inflation risk in the longer term.

Q: Will rising sovereign risk, especially within the eurozone, create inflation or indeed deflation risk?
Worah: The answer to this depends on the timeframe and on the country in question. In general, there are essentially three ways out for countries that cannot service their debt: The first is to grow their way out of it, the second is to default on their debt, and the third is to inflate their way out of it. Which option is selected is really country- and region-specific.

Countries such as the U.K. and the U.S., which have their own fiscal issues, clearly aren’t going to default on their debt. They issue debt in their own currency and control their own monetary policy. Hence, in the longer term, inflation is a likely solution to deal with their inability to grow their way out of persistent deficits. However, in the eurozone, you’re faced with a very different situation where countries like Greece cannot issue debt in their own currency. They cannot debase their currency, which makes their economy more competitive, and so it is unlikely that they can grow their way out of it. So the only possible outcome (other than an outright default) is fiscal belt-tightening and reduction of input (labor costs) in order to make the goods and services they produce more competitive – and this is deflationary. We are already seeing signs of this. Countries in Europe with the worst fiscal situations that have started the tightening process, like Ireland and Spain, are already showing strong signs of deflation and we expect to see deflation in Greece as well.

To summarize, countries that cannot grow their way out of the problem and do not have their own currency that they can debase are more likely to see deflation. Meanwhile, you should expect to see the opposite effect in countries like the U.S. and U.K., which issue debt in their own currencies.

Q: To what extent have the highly differentiated fiscal situations of countries influenced PIMCO’s inflation outlook across regions?
Worah: We have already discussed some of the relevant issues. The current focus on the creditworthiness of sovereigns leads to important differentiations in our outlook not just for inflation but for real yields and investment returns in the various countries. You can no longer adopt a one-size-fits-all or an “old normal” approach to investing. Investors should shed local biases if investing offshore offers better return on capital as well as less risky and more likely return of capital. For example, you have to differentiate not just between fiscal situations of different countries but also between countries that control their own printing press and those that do not.

For countries with strong fiscal situations, like Canada and Germany, inflation is not really an issue. In other countries like Greece, Spain and Ireland, you’re likely to see deflation. And with countries like the U.S. and U.K., which don’t have a strong balance sheet but have a printing press, there is likely to be higher inflation. So there’s a degree of differentiation in our inflationary outlook.

In addition to differentiated outlooks on inflation, investors will likely demand higher real rates of return to lend money to the high fiscal deficit countries that need to repeatedly tap the capital markets to finance their operations. This leads to the possibility of capital losses for investors in certain countries. Bottom line, we think it is important that investors shed strict local biases and allow for tactical country rotation within their portfolios, including their inflation-linked bond portfolios, in this evolving and heterogeneous environment.

Q: What is your outlook for commodity prices over the next 12 months versus the next five years and the effect this will have on inflation?
Worah: Over the next 12 months we have a fairly benign outlook on commodity prices. We think most commodities are trading at, or close to, fair price or within marginal cost of production. Inventories are at the high end of historical levels so we do not expect much pricing pressure from commodities over the next 12 months. This forecast is in line with our expectation for slower economic growth, which will further discourage pricing pressure over the next 12 months. But the longer-term story, characterized by a mismatch between supply and demand, remains unchanged. Demand continues to grow, especially from emerging economies such as China and India, and we continue to have a hard time sourcing alternatives to several key commodities.

As the unfortunate events in Chile recently pointed out, commodities, just like inflation-linked bonds, can act as a good tail risk hedge or option. While an earthquake in Chile does not necessarily affect global financial markets much, it can take 10% off the world’s copper supply! As a result, we saw an immediate 5% spike in copper prices as soon as the news of the earthquake began making the headlines. So there could be events or geopolitical risk (in regions like the Middle East) that would warrant a measured allocation to commodities, but in the absence of such events and geopolitical risks, we do not see near-term pricing pressure on commodities. However, in the longer term, we expect commodity prices to be higher for the reasons cited before.

Finally, this is a juncture where we should be thinking the unthinkable – if every country tries to debase its currency in order to remain competitive, then the only assets with value are the “real” ones. Hence, a modest allocation to commodities is warranted independent of one’s view on the near term or the direction in which commodity prices may be moving.

Q: How should investors adjust their inflation protection strategies in line with the potential headwinds?
Worah: In the last six months, we have been advising clients to adjust their portfolios along the lines of what I have said so far: We do not think inflation will be a concern for another year or so, suggesting little need to rush into an allocation. However, as a hedge against event, sovereign and commodity price risks, as well as a portfolio diversification tool, an allocation to inflation-linked bonds and commodities may make sense. Investors should take advantage of price disruptions to start building their strategic positions to hedge against future inflation. In fact, there have already been signs the market may be coming round to this point of view (little inflation concern over the next 12 months or so) when inflation-linked bonds underperformed quite significantly in the first two months of 2010. Investors may wish to take advantage of this weakness and begin scaling into a position in inflation-linked bonds.

Q: Is it more prudent for European investors to invest in U.S. Treasury Inflation-Protected Securities (TIPS), global inflation-linked bonds (ILBs) or to stay closer to home when considering inflation-linked bonds?
Worah: An extremely important question. It used to be that inflation and interest rate cycles were highly correlated across all developed economies. In such an environment it did not make much difference whether one invested in the domestic ILB market or in a global basket of linkers. The global basket opened up a greater opportunity set for active management, but a long-term passive investor would be indifferent when choosing between the two. This is no longer the case. In the medium term, and possibly even longer term, inflation dynamics and interest rate levels are likely to be widely differentiated between countries depending on the initial conditions of the country in question. The opportunity to add alpha, and more importantly to avoid capital losses, is higher for the skilled active investor. The passive investor should consider hewing closer to the home country. To stress, if investors want to take advantage of this differentiation to boost their potential returns and avoid potential losses, and if they are comfortable with some modest risk taking, they should seek out skilled active managers. As I mentioned earlier, this differentiation and real rate dynamics mean that tactical country rotation will likely be important to preserving investor capital and adding value versus indexes. Investors who are more risk averse and prefer the passive route should stay closer to home.

Thanks, Mihir.

Copyright (c) PIMCO, 2010

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Hugh Hendry: China Infatuation is Misguided

Friday, February 12th, 2010

Hugh Hendry, CIO, Eclectica Asset Management, writes in the Telegraph UK today, cautioning investors that China’s $1.4 trillion credit expansion and $586-billion domestic spend is a white elephant bet on a global recovery in consumption of its exports that remains to be seen.

“In China, investment spending has tripled since 2001 and the consequences are staggering. A country that represents just 7pc of global GDP is now responsible for 30pc of global aluminum consumption, 47pc of global steel consumption and 40pc of global copper consumption. The overriding problem is that the Chinese model leads to a deflationary spiral that is perpetual in nature. Domestic consumption never grows fast enough to absorb the supply, prompting the planners to commit to ever-higher levels of investment. Over-capacity inevitably plagues many sectors of the economy and Chinese profitability is already low.”

Read the whole article here.

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Ayn Rand: Atlas Shrugged Prophetic?

Friday, November 13th, 2009

A new book by Anne Heller about Ayn Rand, and her philosophy of objectivism is making rounds these days, re-igniting the relevance and debates about Rand’s 1957 bestseller “Atlas Shrugged.”

ayn_randLike many others before, the first time I read Atlas Shrugged it changed my life. It clarified my understanding of the world we live in, of the business world, of markets, and particular spoke to me about the obstacles of starting and building a business, and the kinds of people who could either help or hinder the entrepreneurial process. If you have not read it, you should. It is a great and epic story of what Rand felt was going wrong in America, and to a very large degree, it has been prophetic of the economic collision we are currently facing.

In her preface, Heller notes “Because most readers encounter her (Rand) in their formative years, she has had a potent influence in three generations of Americans.” I was 15 when a friend lent me The Fountainhead (he let me keep the book, a Signet paperback costing $3.50). I liked the novel, but was mystified by Dominique and Roark’s relationship. Though impressed by Anthem and We the Living, it was Atlas Shrugged that knocked me sideways.

If you are at all entrepreneurial about your business, Atlas Shrugged will clarify the world for you, move you, and speak to you.

In a Wall Street Journal column, last year Stephen Moore discussed the prophetic nature of Rand’s 50 year old multi-decade bestseller.

atlas_shrugged1For the uninitiated, the moral of the story is simply this: Politicians invariably respond to crises — that in most cases they themselves created — by spawning new government programs, laws and regulations. These, in turn, generate more havoc and poverty, which inspires the politicians to create more programs . . . and the downward spiral repeats itself until the productive sectors of the economy collapse under the collective weight of taxes and other burdens imposed in the name of fairness, equality and do-goodism.

In the book, these relentless wealth redistributionists and their programs are disparaged as “the looters and their laws.” Every new act of government futility and stupidity carries with it a benevolent-sounding title. These include the “Anti-Greed Act” to redistribute income (sounds like Charlie Rangel’s promises soak-the-rich tax bill) and the “Equalization of Opportunity Act” to prevent people from starting more than one business (to give other people a chance). My personal favorite, the “Anti Dog-Eat-Dog Act,” aims to restrict cut-throat competition between firms and thus slow the wave of business bankruptcies. Why didn’t Hank Paulson think of that?

These acts and edicts sound farcical, yes, but no more so than the actual events in Washington, circa 2008. We already have been served up the $700 billion “Emergency Economic Stabilization Act” and the “Auto Industry Financing and Restructuring Act.” Now that Barack Obama is in town, he will soon sign into law with great urgency the “American Recovery and Reinvestment Plan.” This latest Hail Mary pass will increase the federal budget (which has already expanded by $1.5 trillion in eight years under George Bush) by an additional $1 trillion — in roughly his first 100 days in office.

The current economic strategy is right out of “Atlas Shrugged”: The more incompetent you are in business, the more handouts the politicians will bestow on you. That’s the justification for the $2 trillion of subsidies doled out already to keep afloat distressed insurance companies, banks, Wall Street investment houses, and auto companies — while standing next in line for their share of the booty are real-estate developers, the steel industry, chemical companies, airlines, ethanol producers, construction firms and even catfish farmers. With each successive bailout to “calm the markets,” another trillion of national wealth is subsequently lost. Yet, as “Atlas” grimly foretold, we now treat the incompetent who wreck their companies as victims, while those resourceful business owners who manage to make a profit are portrayed as recipients of illegitimate “windfalls.”

I found this speech by Comcast Spectacor Chairman, Ed Snider, in which he describes how as an entrepreneur, Atlas Shrugged changed his life and the lives of his children, that he went on to found the Ayn Rand Institute, in order to foster teaching Rand’s Objectivism in universities across America, because he saw that so many young Americans were clueless about entrepreneurism let alone what capitalism once was.

Part 1 – 9:13 minutes

Part 2 – 2:21 minutes

Also, if it interests you, here is the original footage of Ayn Rand’s 1959 interview with Mike Wallace:

Part 1:

Part 2:

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RGE: China’s Impact on Financial Markets

Wednesday, August 26th, 2009

Nouriel Roubini’s RGE Monitor has just published a report examining China’s direct and indirect influences on global asset markets, and particularly equity, commodity and forex markets. Although the full report is only available to RGE’s subscribers, the abridged version nevertheless provides useful insight as reported in the paragraphs below.

Chinese equities
The Shanghai composite index has fallen almost 20% from its August 4 peak, putting it within the traditional definition of a bear market. Thus far this year, however, the index has risen over 50%, and it has surged even more since its low in late 2008. Yet Chinese equities remain vulnerable given the liquidity outlook and the challenges of using relatively blunt tools to guide asset markets.

Correlations between Chinese and global equities (especially emerging market equities) have increased since 2007. Economies most reliant on Chinese investment, or on the commodities consumed by China, tend to show the most significant correlations. Yet even the markets of Central and Eastern Europe have shown greater co-movements. While Mainland markets are dominated by domestic investors and foreign investment is heavily restricted, they have vaguely led global markets, being among the first to begin to fall from overheated heights in early 2008 and the first to climb in late 2008 following China’s stimulus announcement.

China’s linkages with global markets, to the extent that they exist, seem more macro than financial. The same government policies designed to avoid bubbles and limit further misallocation of capital – including the slowing of credit extension currently underway – could not only restrain frothy Chinese equities, some investors worry, but also suggest that the Chinese and global recovery will be weaker.

Thus steps taken to “fine-tune” Chinese monetary policy and cool overheating in some sectors of the economy, could contribute to more global market volatility. A burst Chinese bubble could reduce Chinese demand and prefigure poor performance in other markets as liquidity is withdrawn. While markets in the US and Europe seem more likely to take their cues from local trends–particularly the corporate earnings and economic growth outlooks than Chinese markets, a slowdown in Chinese demand, could give pause. An increase in exports to China is among factors supporting European exports in Q2.

Chinese equities were looking very bubbly in July and early August, and in our most recent economic outlook, we highlighted developing asset bubbles in China’s property and equity markets as one of several potential risks of China’s stimulus. Chinese liquidity has begun to be less loose, even if it is not yet tight and inflows to Chinese equity markets have slowed from July onwards. Several trends which supported equity markets in H1 2009—record bank lending with few restrictions, the improvement in consumer confidence, the deferral of IPOs—are no longer supportive. Inflows to the Chinese equity market slowed in July 2009 as bank lending slowed and government regulators suggested a closer look would be taken at the allocation of funds. Meanwhile price/earnings ratios are no longer as cheap, having almost doubled from their late 2008 lows. Corporate earnings may stay weak given the difficulty in passing on higher production costs. All of these factors suggest that Chinese equities might have farther to fall.

On the plus side, further correction might have only a limited effect on the Chinese economy, given lower wealth effects than in developed markets. Market capitalization is a much smaller share of GDP and equity investment is a much smaller share of savings. Sentiment is affected. New accounts opened by Chinese retail investors have fallen since their late July peak. The reluctance of retail investors to incur losses could contribute to a boom and bust cycle, negatively affecting Chinese and global asset markets.

Chinese commodity demand
Record commodity imports, particularly of metals, contributed to the commodity price climb in H1 2009 (pumped up by the ample liquidity from zero interest rate policies and quantitative easing). A sustained reduction in Chinese imports of commodities is perhaps the biggest risk to global commodity markets, particularly metals. In fact there is some preliminary evidence that the extensive stockpiling that contributed to the record volumes of commodity imports early in 2009 may be slowing as prices rise. The volume of imports of key metals like copper, tin and aluminum has slowed in either June or July 2009. While this reduction may reflect seasonal trends, with stockpiles filled and costs high, a further slowdown should not be ruled out.

Chinese imports of commodities, especially base metals, grew sharply in the first half of 2009 as China sought to restock depleted reserves and build up new stockpiles. Even the infrastructure-heavy stimulus likely absorbed only some of the imports, suggesting that China might be on the verge of a commodity glut Further purchases, particularly later in Q2, may have extended beyond the official stockpiling to include investors who took physical delivery as a hedge.

Yet, not all of the increased demand is due to stockpiling. Metal processing has been a key part of China’s fiscal stimulus – with any excess production purchased by the government. There have been reports that some of the state metal and grain reserves became net sellers domestically, suggesting the pace of imports might slow. The Baltic Dry Index, a measure of shipping costs that reflects demand for bulk commodities, has fallen from its 2009 highs. Import volumes of several key metals fell in June and July 2009. Should they fall further, and should global stock piles grow, commodity prices could correct from their current levels.

Chinese commodity purchasers are in part price-sensitive. In 2008, Chinese producers made due with cheaper alternatives to expensive ores. Purchases of scrap copper and aluminum rose in July 2009 even as the imports of higher-grade ore and materials fell. While the continued demand for scrap metal does suggest some underlying metal demand from Chinese consumers, they have their price.

Despite China’s role as the largest consumer of many commodities, it has had limited success as a price setter despite its influence as one of the largest demanders of most commodities. Unwilling to accept the 33% negotiated by Japanese companies and their ore suppliers for bulk shipments, China held out for 40-50% reductions – a concession suppliers were reluctant to give. Only one – Fortescue, a relatively small producer, agreed to a 35% price cut.

Unlike metal ore imports, whose volumes have doubled and in some cases tripled from 2008 levels, oil imports have only recently topped 2008 levels. Chinese oil imports did report a sharp increase to 19 million tons in July, well above recent levels, perhaps due to demand from new refineries. Yet end user demand in China and globally has not climbed much even as supply has inched up again – OPEC members have been increasing production. Worse than expected macro news, meanwhile, would likely contribute to a correction, to the $50 range more in line with supply/demand fundamentals.

Yet, liquid financial conditions and the improving “less bad” macro climate may keep commodity prices in their current US$ 70 range, despite weak demand and an increase in storage Should oil prices keep climbing, they could put a damper on the economic recovery and on the revival of energy demand. Yet over the next few years, supply constraints supply, limited investment and high production costs for the new supplies that are entering the market could keep prices elevated and a damper on global growth, especially among the oil importers like China, India and the US
Source: RGE Monitor, August 26, 2009.

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