Tag Archives: us gdp

2014 – Equity Flop & Commodity Hop

I thought taking a vacation at the end of 2013 might allow me to come back to the markets with a clear head and new viewpoint. My hope was that a little detachment would bring the forest back into the picture at 35,000 feet. I’ve now caught up on my reading and research and find the markets just as schizophrenic as they were when I left. While the markets remain as confusing as ever, our trip did provide me with the sense of awe that comes from physically standing in the presence of thousands of years of history. One thing is for certain; mankind always finds a way.

Continue reading 2014 – Equity Flop & Commodity Hop

Inflation/Deflation Debate Continues


Make Sure You Get This One Right
By Niels C. Jensen

“You can’t beat deflation in a credit-based system.”

Robert Prechter

As investors we are faced with the consequences of our decisions every single day; however, as my old mentor at Goldman Sachs frequently reminded me, in your life time, you won’t have to get more than a handful of key decisions correct – everything else is just noise. One of those defining moments came about in August 1979 when inflation was out of control and global stock markets were being punished. Paul Volcker was handed the keys to the executive office at the Fed. The rest is history.

Now, fast forward to July 2009 and we (and that includes you, dear reader!) are faced with another one of those ‘make or break’ decisions which will effectively determine returns over the next many years. The question is a very simple one:

Are we facing a deflationary spiral or will the monetary and fiscal stimulus ultimately create (hyper) inflation?

Unfortunately, the answer is less straightforward. There is no question that, in a cash based economy, printing money (or ‘quantitative easing’ as it is named these days) is inflationary. But what actually happens when credit is destroyed at a faster rate than our central banks can print money?

A Story within the Story

Following the collapse of the biggest credit bubble in history, there has been no shortage of finger pointing and the hedge fund industry, which has always had an uncanny ability to be at the wrong place at the wrong time, has yet again been at the centre of attention. And politicians, keen to divert attention away from themselves as the true culprits of the crisis through years of regulatory neglect, have been quick at picking up the baton. Admittedly, the hedge fund industry is guilty of many stupid things over the years, but blaming it for the credit crisis is beyond pathetic and the suggestion that increased regulation of the hedge fund industry is going to prevent future crises is outrageously naïve.

If you prohibit private investors from investing in hedge funds which on average use 1.5-2 times leverage but permit the same investors to invest in banks which use 25 times leverage and which are for all intents and purposes bankrupt, then you either don’t understand the world of finance or you don’t want to understand. Shame on those who fall for cheap tactics.

Let’s begin by setting the macro-economic frame for the discussion. I have been quite bearish for a while, suspecting that the growing optimism which has characterised the last few months would eventually fade again as reality began to sink in that this is no ordinary recession and that ‘less bad’ doesn’t necessarily translate into a quick recovery. I still believe there is a good chance of enjoying one, maybe two, positive quarters later this year or early next; however, a crisis of this magnitude doesn’t suddenly fade into obscurity, just because the economy no longer shrinks at an annual rate of 6-8%.

Going forward, not only will economic growth disappoint, but the economic cycles will become more volatile again (see chart 1) with several boom/bust cycles packed into the next couple of decades. This is a natural consequence of the Anglo-Saxon consumer-driven growth model having been bankrupted. Growing consumer spending over the past 30 years led to rapidly expanding service and financial sectors both of which will now contract for years to come as overcapacity forces players to downsize.

Chart 1: US GDP Growth Volatility

This will again lead to higher corporate earnings volatility which will almost certainly drive P/E ratios lower, making conditions even trickier for equity investors. At the bottom of every major bear market in the last 200 years, P/E ratios have been below 10. As you can see from chart 2 overleaf, few countries are there yet. The next decade is therefore not likely to be a ‘buy and hold’ market for equity investors. The combination of low economic growth and pressure on valuations will create severe headwinds. The most likely way to make money in equities will be through more active trading.

So now, two years into this crisis, where do we stand and where do we go from here? History offers limited guidance, as we have never experienced the bursting of a bubble of this magnitude before. The closest thing is the collapse of the Japanese credit bubble around 1990. As the Japanese have since learned, recovering from a deflated credit bubble is a long and very painful affair.

Governments and central banks on both sides of the Atlantic are pursuing a strategy of buying time, hoping that a recovery in economic conditions will allow our banking industry to re-build its capital base. The Japanese pursued a similar strategy back in the early 1990s. It failed miserably and set the country back many years in its recovery effort. Ironically, the Japanese approach was almost universally condemned as hopelessly inadequate. It is funny how you always know better how to fix other people’s problems than your own. A little bit like raising children, I suppose.

Chart 2: P/E Ratios in Various Countries

Another lesson learned from Japan is that once you get caught up in a deflationary spiral, it is exceedingly hard to escape from its grip. The Japanese authorities have used every trick in the book to reflate the economy over the past two decades. The results have been poor to say the least: Interest rates near zero (failed), q
uantitative easing (failed), public spending (failed), numerous attempts to drive down the value of the yen (failed); the list is long and makes for painful reading.

We are effectively caught in a liquidity trap. The Bank of England, the European Central Bank and the Federal Reserve have all flooded their banking system with enormous amounts of liquidity in recent months but what has happened? Instead of providing liquidity to private and corporate borrowers as the central banks would like to see, banks have taken the opportunity to repair their balance sheets. For quantitative easing to be inflationary it requires that the liquidity provided to the market by the central bank is put to work, i.e. lenders must lend and borrowers must borrow. If one or the other is not playing along, then inflation will not happen.

Chart 3: Broad Money versus Narrow Money

This is illustrated in chart 3 which measures the growth in the US monetary base less the growth in M2. As you can see, the broader measure of money supply (M2) cannot keep up with the growth in the liquidity provided by the Fed. In Europe the situation is broadly similar.

There is another way of assessing the inflationary risk. If one compares the total amount of credit destruction so far (about $14 trillion in the US alone) to the amount spent by the Treasury and the Fed on monetization and fiscal stimulus ($2 trillion), it is obvious that there is still a sizeable gap between the capital lost and the new capital provided.

If we instead move our attention to the real economy, a similar picture emerges. One of the best leading indicators of inflation is the so-called output gap, which measures how much actual GDP is running below potential GDP (assuming full capacity utilisation). It is highly unlikely for inflation to accelerate during a period where the output gap is as high as it currently is (see chart 4). Theoretically, if you believe in a V-shaped recession, the output gap can be reduced significantly over a relatively short period of time, but that is not our central forecast for the next few years.

Chart 4: Output Gap & Capacity Utilization

I can already hear some of you asking the perfectly valid question: How can you possibly suggest that deflation will prevail when commodity prices are likely to rise further as a result of seemingly endless demand from emerging economies? Won’t rising energy prices ensure a healthy dose of inflation, effectively protecting us from the evils of the deflationary spiral (see chart 5)?

Chart 5: The Deflationary Spiral

Good question – counterintuitive answer:

Contrary to common belief, rising commodity prices can in fact be deflationary so long as demand for such commodities is relatively inelastic, which is usually the case for basic necessities such as heating oil, petrol, food, etc. The logic is the following: As commodity prices rise, money earmarked for other items goes towards meeting the higher commodity price and consumers are essentially forced to re-allocate their spending budget. This causes falling demand for discretionary items and can in extreme cases lead to deflation. We only have to go back to 2008 for the latest example of a commodity price induced deflationary cycle.

A price increase on a price inelastic commodity is effectively a tax hike. The only difference is that, in the case of the 2008 spike in energy prices, the money didn’t go towards plugging holes in the public finances but was instead spent on English football clubs (well, not all of it, but I am sure you get the point) which have become the latest ‘must have’ amongst the super-rich in the Middle East.

For all those reasons, I am becoming increasingly convinced that the ultimate outcome of this crisis will turn out to be deflation – not inflation. Inflation may eventually become a problem, but that is something to worry about several years from now. The Japanese have pursued an aggressive monetary and fiscal policy for almost 20 years now, and they are still nowhere.

So why are interest rates creeping up at the long end? Part of it is due to the sheer supply of government debt scheduled for the next few years which spooks many investors (including us). And the fact that the rising supply is accompanied by deteriorating credit quality is a factor as well. But countries such as Australia and Canada, which only suffer modest fiscal deficits, have experienced rising rates as well, so it cannot be the only explanation.

Maybe the answer is to be found in the safe haven argument. When much of the world was staring into the abyss back in Q4 last year, government bonds were considered one of the few safe assets around and that drove down yields. Now, with the appetite for risk on the increase again, money is flowing out of government bonds and into riskier assets.

Perhaps there are more inflationists out there than I thought. Several high profile investors have been quite vocal recently about the inevitability of inflation. Such statements made in public by some of the industry’s leading lights remind me of one of the oldest tricks in the book which I was introduced to many moons ago when I was still young and wet behind the ears. ‘Get long and get loud’ it is called; it is widely practised and only marginally immoral. Nevertheless, when famous investors make such statements, it affects markets.

The point I really want to make is that the inflation v. deflation story is the single biggest investment story right now and being on the right side of that trade will effectively secure your investment returns for years to come. If I am wrong and inflation spikes, you want to load your portfolio with index linked government bonds (also known as TIPS for our American readers), gold and other commodities, commodity related stocks as well as property.

If deflation prevails, all you have to do is to look towards Japan and see what has done well over the past 20 years. Not much! You cannot even assume that bonds will do well. Recessions are bullish for long dated government bonds but a collapse of the entire credit system is not. The reason is simple – with the bursting of the credit bubble comes drastic monetary and fiscal action. Central banks print money and governments spend money as if there is no tomorrow, and all bets are off. Equities will do relatively poorly as will property prices. But equities will not go down in a straight line. The market will offer plenty of trading opportunities which must be taken advantage of, if you want to secure a decent return.

All in all, deflation is ugly and not conducive to attractive investment retur
ns. It is also not what governments want and need right now. With a mountain of debt hitting the streets of Europe and America over the next few years, as the cost of fixing the credit and banking crisis is financed, one can make a strong case for rising inflation actually being the favoured outcome if you look at it from the government’s point of view. The problem, as the Japanese can attest to, is that deflation is excruciatingly difficult to get rid of, once it has become entrenched. I am in no doubt which of the two evils I would prefer, but we may not have the luxury of choosing our own destiny.


Reasons for U.S. Dollar’s Strength


This blog is published by Andy
Waldock. Andy Waldock is a trader, analyst, broker and asset manager.
Therefore, Andy Waldock may have positions for himself, his family, or, his
clients in any market discussed. The blog is meant for educational purposes and
to develop a dialogue among those with an interest in the commodity markets.
The commodity markets employ a high degree of leverage and may not be suitable
for all investors. There is substantial risk in investing in futures.

It has been noted that the U.S. Dollar makes a high or a low for the year in January approximately 2/3 of the time. Some prominent market mavens are attributing the Dollar’s strength to “strong cyclical forces at play” while others believe that the Dollar’s time as the currency of last resort is nigh. Both positions appear, to me, to be based on more on rhetoric and black magic than on sound fundamental analysis. Those of you who’ve asked me about the Dollar have gotten the same response from me since the commodity futures market’s bottom in December. I don’t understand the Dollar’s strength. I can advise on technical levels and pattern recognition but, I don’t have a fundamental thesis to frame my trading in this market at this time. The following article by John Mauldin of www.frontlinethoughts.com has provided me with a framework I can wrap my head around. I hope it helps you as much as it has myself.Andy.

The Risk in Europe

I mentioned last
week that European banks are at significant risk. I want to follow up on that
point, as it is very important. Eastern Europe has borrowed an estimated $1.7
trillion, primarily from Western European banks. And much of Eastern Europe is
already in a deep recession bordering on depression. A great deal of that $1.7
trillion is at risk, especially the portion that is in Swiss francs. It is a
story that could easily be as big as the US subprime problem.

In Poland, as an
example, 60% of mortgages are in Swiss francs. When times are good and
currencies are stable, it is nice to have a low-interest Swiss mortgage. And as
a requirement for joining the euro currency union, Poland has been required to
keep its currency stable against the euro. This gave borrowers comfort that they
could borrow at low interest in francs or euros, rather than at much higher
local rates.

But in an echo of
teaser-rate subprimes here in the US, there is a problem. Along came the
synchronized global recession and large Polish current-account trade deficits,
which were three times those of the US in terms of GDP, just to give us some
perspective. Of course, if you are not a reserve currency this is going to
bring some pressure to bear. And it did. The Polish zloty has basically dropped
in half compared to the Swiss franc. That means if you are a mortgage holder,
your house payment just doubled. That same story is repeated all over the
Baltics and Eastern Europe.

Austrian banks
have lent $289 billion (230 billion euros) to Eastern Europe. That is 70% of Austrian
GDP. Much of it is in Swiss francs they borrowed from Swiss banks. Even a 10%
impairment (highly optimistic) would bankrupt the Austrian financial system,
says the Austrian finance minister, Joseph Proll. In the US we speak of banks
that are too big to be allowed to fail. But the reality is that we could
nationalize them if we needed to do so. (And for the record, I favor
nationalization and swift privatization. We cannot afford a repeat of Japan’s
zombie banks.)

The problem is
that in Europe there are many banks that are simply too big to save. The size
of the banks in terms of the GDP of the country in which they are domiciled is
all out of proportion. For my American readers, it would be as if the bank
bailout package were in excess of $14 trillion (give or take a few trillion).
In essence, there are small countries which have very large banks (relatively
speaking) that have gone outside their own borders to make loans and have done
so at levels of leverage which are far in excess of the most leveraged US
banks. The ability of the “host” countries to nationalize their banks
is simply not there. They are going to have to have help from larger countries.
But as we will see below, that help is problematical.

Western European
banks have been very aggressive in lending to emerging market countries
worldwide. Almost 75% of an estimated $4.9 trillion of loans outstanding are to
countries that are in deep recessions. Plus, according to the IMF, they are 50%
more leveraged than US banks.

Today the euro
rallied back to $1.26 based upon statements from German authorities that were
interpreted as a potential willingness to help out non-German (in particular,
Austrian) banks.

However, this
more sobering note from Strategic Energy was sent to me by a reader. It nicely
sums up my concerns:

“It is East
Europe that is blowing up right now. Erik Berglof, EBRD’s chief economist, told
me the region may need €400bn in help to cover loans and prop up the credit
system. Europe’s governments are making matters worse. Some are pressuring
their banks to pull back, undercutting subsidiaries in East Europe. Athens has
ordered Greek banks to pull out of the Balkans.

“The sums
needed are beyond the limits of the IMF, which has already bailed out Hungary,
Ukraine, Latvia, Belarus, Iceland, and Pakistan — and Turkey next — and is
fast exhausting its own $200bn (€155bn) reserve. We are nearing the point where
the IMF may have to print money for the world, using arcane powers to issue
Special Drawing Rights. Its $16bn rescue of Ukraine has unravelled. The country
— facing a 12% contraction in GDP after the collapse of steel prices — is
hurtling towards default, leaving Unicredit, Raffeisen and ING in the lurch.
Pakistan wants another $7.6bn. Latvia’s central bank governor has declared his
economy “clinically dead” after it shrank 10.5% in the fourth
quarter. Protesters have smashed the treasury and stormed parliament.

“‘This is
much worse than the East Asia crisis in the 1990s,’ said Lars Christensen, at
Danske Bank. ‘There are accidents waiting to happen across the region, but the
EU institutions don’t have any framework for dealing with this. The day they
decide not to save one of these one countries will be the trigger for a massive
crisis with contagion spreading into the EU.’ Europe is already in deeper
trouble than the ECB or EU leaders ever expected. Germany contracted at an
annual rate of 8.4% in the fourth quarter. If Deutsche Bank is correct, the
economy will have shrunk by nearly 9% before the end of this year. This is the sort
of level that stokes popular revolt.

implications are obvious. Berlin is not going to rescue Ireland, Spain, Greece
and Portugal as the collapse of their credit bubbles leads to rising defaults,
or rescue Italy by accepting plans for EU “union bonds” should the
debt markets take fright at the rocketing trajectory of Italy’s public debt
(hitting 112pc of GDP next year, just revised up from 101pc — big change), or
rescue Austria from its Habsburg adventurism. So we watch and wait as the lethal
brush fires move closer. If one spark jumps across the eurozone line, we will
have global systemic crisis within days. Are the firemen ready?”

While Rome Burns

I hope the writer
is wrong. But the ECB is dithering while Rome burns. (Or at least their banking
system is — Italy’s banks have large exposure to Eastern Europe through
Austrian subsidiaries.) They need to bring rates down and figure out how to
move into quantitative easing. Europe is at far greater risk than the US.

Great Britain and
Europe as a whole are down about 6% in GDP on an annualized basis. The Bank
Credit Analyst sent the next graph out to their public list, and I reproduce it
here. (www.bcaresearch.com)
In another longer report, they note that the UK, Ireland, Denmark, and
Switzerland have the greatest risk of widespread bank nationalization (outside
of Iceland). The full report is quite sobering. The countries on the bottom of
the list are also in danger of having their credit ratings downgraded.

Aggregate Sovereign Credit Risk

This has the
potential to be a real crisis, far worse than in the US. Without concerted
action on the part of the ECB and the European countries that are relatively
strong, much of Europe could fall further into what would feel like a
depression. There is a problem, though. Imagine being a politician in Germany,
for instance. Your GDP is down by 8% last quarter. Unemployment is rising.
Budgets are under pressure, as tax collections are down. And you are going to
be asked to vote in favor of bailing out (pick a small country)? What will the
voters who put you into office think?

We are going to
find out this year whether the European Union is like the Three Musketeers. Are
they “all for one and one for all?” or is it every country for
itself? My bet (or hope) is that it is the former. Dissolution at this point
would be devastating for all concerned, and for the world economy at large.
Many of us in the US don’t think much about Europe or the rest of the world,
but without a healthy Europe, much of our world trade would vanish.

However, getting
all the parties to agree on what to do will take some serious leadership, which
does not seem to be in evidence at this point. The US almost waited too long to
respond to our crisis, but we had the “luxury” of only needing to get
a few people to agree as to the nature of the problems (whether they were wrong
or right is beside the point). And we have a central bank that could act

As I understand
the European agreement, that situation does not exist in Europe. For the ECB to
print money as the US and the UK (and much of the non-EU developed world) will
do, takes agreement from all the member countries, and right now it appears the
German and Dutch governments are resisting such an idea.

As I write this
(on a plane on my way to Orlando) German finance minister Peer Steinbruck has
said it would be intolerable to let fellow EMU members fall victim to the
global financial crisis. “We have a number of countries in the eurozone
that are clearly getting into trouble on their payments,” he said.
“Ireland is in a very difficult situation.

euro-region treaties don’t foresee any help for insolvent states, but in
reality the others would have to rescue those running into difficulty.”

That is a hopeful
sign. Ireland is indeed in dire straits, and is particularly vulnerable as it
is going to have to spend a serious percentage of its GDP on bailing out its

It is not clear
how it will all play out. But there is real risk of Europe dragging the world
into a longer, darker night. Their banks not only have exposure to our US
foibles, much of which has already been written off, but now many banks will
have to contend with massive losses from emerging-market loans, which could be
even larger than the losses stemming from US problems. Plus, they are more
leveraged. (This was definitely a topic of “Conversation” this
morning when I chatted with Nouriel Roubini. See more below.)

The Euro Back to Parity? Really?

I wrote over six
years ago, when the euro was below $1, that I thought the euro would rise to
over $1.50 (it went even higher) and then back to parity in the middle of the
next decade. I thought the decline would be due to large European government
deficits brought about by pension and health care promises to retirees, and those
problems do still loom.

It may be that
the current problems will push the euro to parity much sooner, possibly this
year. While that will be nice if you want to vacation in Europe, it will have
serious side effects on international trade. It clearly makes European
exporters more competitive with the rest of the world, and especially the US.
It also means that goods coming from Asia will cost more in Europe, unless
Asian countries decide to devalue their currencies to maintain an ability to
sell into Europe, which of course will bring howls from the US about currency
manipulation. It is going to put pressure on governments to enact some form of
trade protectionism, which would be devastating to the world economy.

Large and swift currency
swings are inherently disruptive. We are seeing volatility in the currency
markets unlike anything I have witnessed. I hope we do not see a precipitous
fall in value of the euro. It will be good for no one. It is a strange world
indeed when the US is having such a deep series of problems, the Fed and
Treasury are talking about printing a few trillion here and a few trillion
there, and at the very same time we see the dollar AND gold rising in value.