What’s up with some of the grand old titans of the hedge fund industry?

It’s hardly new or a surprise to hear Jim Rogers go on about the virtues of commodities and banging on about inflation - Julian Robertson has now (probably some time ago) joined the bandwagon, but announced it in an interview given to CNBC’s Erin Burnett yesterday.

These gentlemen (and others) are very focused on the public sector debt increase and the potential problems associated herewith. Aren’t they forgetting that public sector debt is just one component of a country’s total debt - and shouldn’t this worry have been expressed years ago as the US carried on with ever rising budget and current account deficits not least as the domestic household savings rate was negative? In effect it was the ‘over-consumption’ of the US consumer that led the country down this path. China supplied the goods (or many of them) and took the dollars from the system as not to re-value the yuan and re-cycled the reserves into treasuries, which in turn kept interest rates lower than they otherwise would have been, which caused mortgage rates to be lower, which pushed up house prices, which made consumers feel richer, which made them spend more......and round and round it went.

Now things have changed......US consumers are now saving at a rate of 6-8% (of disposable income) and while it may increase further it’s not all bad news: this newfound prudent attitude can help the government with its budget deficit as these savings are finding their way into fixed income and money market funds rather than more speculative stock funds. The slack potentially left by the reduced need for ‘re-cycling’ of dollars could be taken up domestically - let’s also not forget that having a steep yield curve is one of the ways of funding a large budget deficit - you get paid to go further out the curve and even if you do not want to have the currency risk the very low short term rates makes it perfectly natural and inexpensive to hedge that risk.

While I don’t disagree completely with Mr Robertson (he mentions that a lot of pain will be necessary, while the imbalances are corrected) and I completely agree that some measures of austerity are necessary to correct primarily the budget deficit e.g. a gas tax, but I completely disagree that interest rates will shoot to 15-20% if the Japanese and the Chinese stop buying (more) treasuries. Their need to buy treasuries (apart from re-investment of coupons payments and redemptions) are predicated on a running trade surpluses with the US. If these surpluses are reduced their will be less buying, but at the same token the savings rate (and the banks) can pick up the slack.

There is a lot of focus on the public sector deficits - and with good reason - but little attention is paid to the total debt issuance, as many securitization markets remain closed and the only real mortgage lender in the US, is the government, total net debt issuance (if the QE measures are factored in) is actually lower now than it was before the crisis hit. Credit spreads have collapsed i.e. other forms of credit have vastly outperformed treasuries to a level where it is probably worth having treasuries over spread product.....!

I am a big believer in looking at the ‘black swan’ scenarios which may have low probability but high impact, but this one I think is much less likely than the world experiencing a true double-dip when the fiscal stimulus is withdrawn and the lows in equity markets are re-tested and perhaps broken. 20% inflation and 20% interest rates would be a breeze compared to that!

Inflation/Deflation.....

I will go out on a limb here and suggest that the current debate is the most divided ever on this topic, albeit with more participants in the inflation camp.

We actually do not have inflation at present - we have deflation as consumer prices (in the US) are -2.1% y/y (July 2009). German producer prices are -7.8% in the same month. These are unprecedented times as this phenomenon has not occurred since the 1940‘s.

Yet, the inflation scare mongers are abundant! Predicting that hyper inflation is just around the corner and comparisons with Zimbabwe are frequent, but where is inflation actually going to come from?

Unemployment is substantial, capacity utilization is low - it’s hard to see the theory of too much money chasing too few goods manifesting itself in the short to medium future. Ah, but I hear the inflation hawks say.........what about all the liquidity measures undertaken by the central banks and their destructive QE programmes - in effect printing money just like in Zimbabwe?

Well, that extra liquidity is in the main ending up with the same central banks that provided it in the first place in the form of extra reserves being placed on deposit with the central banks as there is little appetite for credit from creditworthy consumers and businesses and even less desire on the banks’ behalf to lend, which is why the monetary aggregates are not growing. US M2 growth is running at a seasonally adjusted annual rate of 3.2% in Q2 of this year - it is up 8.1% in july ’09 compared to July’ 08. These are hardly alarming growth rates.

At the same time when the public sectors are expanding their balance sheets the relevant private sectors and in particular households are shrinking their balance sheets - in the US this contraction far outweighs anything done by the Federal Reserve

Even with CPI falling 2.1% in the last year, producer prices are falling faster, which is why many of the large US retailers have been able to increase their margins in the last year as they have only partially passed on the decreases in the prices they pay to suppliers.

So with housing still declining (9.2% of all mortgages are now delinquent in one form or other) the job market is still getting worse as unemployment is expected to pass 10% this year in the US (official survey number - real unemployment is much higher) there will be no demand driven inflation.

So for inflation to come back it has to be caused by supply constraints and with capacity utilization at very low levels it is very difficult to see a scenario where that is going to occur, say for another oil price chock. This also looks less likely in a world that is awash with oil and short of places to store it. Last year’s spike to $147 was in effect driven by the Chinese accumulation so they could still run the Olympics had their traditional electricity sources failed them.

This year the Chinese have been stock piling again buying loads of raw materials and base metals etc, something you can do in a plan economy where no-one will get fired if it turns out to be a mistake and prices fall even further in the future. Now it seems to be over and the Baltic Dry Freight Index is heading back south again to where the freight rates for the finished goods (container shipping rates) are languishing, as these have seen virtually no recovery form the lows. Shipping rates are probably a better indicator of future inflation than so many other things and before they look like getting back to the levels of 2007, which was hardly a high inflation year, there is no need to worry.

Investors in index-linked bonds should pay heed to the fact that deflation can and will take a huge chunk out of the yield they receive. Break-evens can also go negative, as they were in Sweden in ’98.......

Lies, damn lies and statistics

Housing numbers......

Today’s release of New Home Sales brings about the usual euphoria (in the media at least) as they were up a whooping 11% at 384k houses, against the expected 350k.

34,000 houses are a lot of houses????? Well, we’re not actually talking about 34,000 houses, because this is a seasonally adjusted, annualized number - so without knowing what the seasonal adjustment is - the annualized part we can work out and in effect we’re getting excited because of less than 3,000 extra new houses sold in one month!

I read recently that there are 15-18 mill ‘vacant’ homes (as the Americans call them) in the US - these are either, newly constructed, repossessed, for sale, in the shadow inventory (banks hold back repossessed houses as not to flood the market), second homes, vacation homes etc, which all would come to the market should it improve.

Household formation is currently negative in the US according to Sanford Bernstein (that must be a first?) as kids are moving back in with their parents, at a faster rate than net immigration creates demand for houses. Clearly the kids will want to move out again at some stage, but for now the housing situation is getting worse, not better.

3,000 doesn’t really cut it, does it now?

CIT

Interesting story about this financing company. It received approval to turn itself into a bank holding company and it has received a TARP injection, but the FDIC has not yet approved its application to have new debt issuance guaranteed by the FDIC.

Most other bank holding companies have used this facility when the credit markets were more or less closed (for banks and finance companies) since last November and well into the spring.

As the FDIC approval hasn’t arrived CIT’s debt and equity have taken a severe beating - now the really interesting part is whether they will be allowed to fail - or whether the Fed and Treasury still deem the markets to be too fragile to handle and $65-70 bill bankruptcy.

As CIT has only been a bank holding company for a short time it only holds few (retail) deposits which are at least partially FDIC insured amounting to about $3.5 bill, so the rest of their liabilities are held by the market.

Clearly they are not ‘too big too fail” at a size of approximately 10% of Lehman’s balance sheet, but they are an important part of the financing system being a lender to small and medium sized businesses with 950,000 clients as well as being the third largest rail stock lessor in the US and the third largest aircraft lender in the world.

I have no idea what will happen to CIT, but I think the authorities response to their predicament will be worth watching.......!

Commercial Property

Commercial Property - the next shoe, or perhaps more appropriately the next meteor, to drop?

Various commentators and market participants have been mentioning this for a while, but it hasn’t had any real impact on the markets lately.

Of course this was one of the things that brought Lehman Brothers down, as they had huge commercial property exposure, but lately the market has been disregarding comments about problems and potential losses in commercial real estate.

Now things may be changing, as defaults are starting to occur even if the tenants in the buildings are still paying their rents - see the media coverage of billionaire Simon Halabi’s property company defaulting on £1.15 bill worth of debt.

This portfolio of nine properties include JP Morgan’s two buildings in the City of London and Aviva’s City HQ, so it is fair to say that this is a portfolio of prime property. The interesting thing is the current valuation - the portfolio was valued at £1.8 billion in 2006 - the current valuation is just £929 million, so a fall of almost 50%. If this is what has happened to prime commercial property, what has happened to the rest of that market?

In this week-end’s FT Merryn Somerset Webb writes about the US commercial property market and the story is very similar. The Boston Hancock Tower falling 50% in three years, or very similar to the London properties mentioned above. She also mentions a newly constructed office building in LA, which has just been sold for 40% less than it’s construction cost, not 40% less than it’s peak value........!

I suspect that most banks do not have adequate loss provisions to enable them to take the losses that are coming, as the loans have been performing, but with pressure on all metrics, these loans will be difficult to re-structure, if not outright impossible.......!

Watch this space!

US Petrol Tax

US Tax on petrol?

One of the (many) things I just don’t understand is the lack of any serious tax (or even discussion thereof) on petrol in the US, so I wrote the following with a view to sending it to the New York Times:

The Administration has among many other objectives an ambition of making America less dependent on (foreign) oil, reducing the budget, trade and current account deficits and saving some, if not all of the domestic auto manufacturing base in Detroit.

So it’s a bit sad to see and difficult to understand that the Obama Administration has abolished plans to increase tax on petrol at a time when it is uniquely positioned to do so!

For the first time the Administration has the car manufacturers on its side, or in its pocket, but chooses to update CAFE (minimum fuel standards for cars) with effect from 2016......What happened to not ‘kicking the can down the road’?

Detroit talks about building ‘small’ cars i.e. European sized cars, but there are some who question the public’s desire to buy smaller and thus more fuel efficient cars, but this is an attitude the government can influence:

Increase the tax on petrol!

There is nothing like the price of petrol that will make the consumer more interested in a smaller and more economical car .

In Europe petrol costs $6-7 a gallon and this has not stopped Europeans driving or having some of the worst traffic jams in the world (the M25 in the rush hour springs to mind), but it has made more people buy smaller more economical cars ever since the oil crises in the 70’s after which European governments started taxing fuel.

The effect of this is immediate as opposed to waiting for hybrid and fully electric cars to become fully mainstream and CAFE to come into effect.

Ford and GM already have the cars in their ranges and produce them - just not in the US. Of course this will hurt the owners of un-economical cars, but the economic down-turn has probably already taken its toll on residual car values.

A government subsidy to scrap older (gas guzzling) cars when a new, smaller car is purchased would help soften the blow and help stabilize sales of new cars. The ‘cash for clonkers’ scheme is about to be passed by Congress.

In Germany a similar scheme has helped boost car sales, which were actually up 18% y/y in Q1 during a period where the car industry is on its knees as sales are plummeting.

The added benefit is that even $1/gallon tax would bring in $390 million a day or $142 bill a year, if consumption does not fall.

There would be a direct reduction in the budget deficit, which is at record highs. If it were brought up to $2 and consumption fell by 30% the trade deficit would fall by $70 billion a year (at $70 per barrel) and the budget deficit would fall by $200 billion. All this can be introduced more or less immediately - I am not suggesting changing the tax by $1 or $2 overnight, but increasing it by 5-10c a month which will give the consumer/driver some time to adjust to the reality that petrol will be more expensive in the future.

It is not inconceivable that consumption would fall even further as cars doing 10-15 miles per gallon are replaced with cars doing 40-60 miles per gallon. This would reduce the demand for oil and thus, possibly, the price of oil, which would be beneficial to everyone, but the oil producing countries.

Ultimately it will give the government a way of reducing the impact (on the economy) of a dramatic rise in oil prices on the economy by reducing the tax if the price increase is deemed to be too steep, as experienced by last summer’s spike to $147 per barrel.

Obviously, this will not be a popular measure, but tax increases are never popular - I don’t remember Europeans being in favour of tax on petrol, but it happened and it has worked!

An old friend (who lives in the US), having read the first post on this blog told me that I wrote ‘without regard for the American psyche’ - he is probably right - because I listen to/watch a lot of CNBC and Bloomberg TV and this topic never comes up................!

Virgin Post

So this is my first post - having thought about blogging before - that being before the technology was readily available - it never came off, but now I feel the time has come!

The inspiration has really come from my friend Steen Jakobsen (http://steenjakobsen.blogspot.com/)

Anyway, as most of what I will have to say will have something to do with financial markets, I might as well get on to it:

It's a bit refreshing to see that some degree of sanity has returned, albeit still in a small way as the market is waking up to the fact that bear markets do not end one day with a bull market starting the next! It's a long and protracted process.

The 'green shoots' are, as David Blanchflower writes in The Telegraph today, only visible to the colour blind - it's all sentiment based. Stock market goes up a bit i.e. the world is no longer ending tomorrow, so consumer and business confidence indicators bounce from their lows, so the stock market goes up a bit further and so on. We've had three months of this self-fulfilling prophecy and finally it looks like it's over.

In my opinion the (US) economy will not rebound before the housing market bottoms and unemployment stops rising. It does not look like either is just about to happen as foreclosures are still rising at record levels after the moratorium lapsed and there is a massive number of ARMs to re-set for the rest of this year and 2010, which again will lead to more foreclosures.

The US needs to create about 150,000 jobs per month to stop the unemployment rate rising, so even after the much better than expected job losses in May there still is a gap of almost 500,000 jobs a month to stop the unemployment rate going up. This gap is not going to be closed anytime soon.

But even if the housing market bottomed and unemployment stopped rising would the US consumer be in a position to (or even want to) start spending like a drunken sailor again? After having had no visible savings rate in the US for years (it was all accumulated in the stock and housing markets) it is now 5% there's little wage growth and zero bargaining power due to the unemployment rate, you have to presume that the only rational behaviour for the consumer is to maintain the higher savings rate and prioritise paying down debts. not putting money, saved or borrowed 'to work' in the stock market, as the pundits on CNBC and Bloomberg TV are always banging on about?

The time when you would (and could) max out your credit card to buy stocks and expect to make more in the stock market than the 15% rate on the credit card are surely gone?

With the consumer being 70% of the US economy and a frightening 20% of the global economy and in effect being in a precarious financial situation with frugality, rather than frivolity, on his mind, where is the growth going to come from???????

China, I hear you say - yes China is investing heavily in infrastructure and expanding their capacity to produce goods for the American and European consumer - this is after reports of tens of thousands of factories having been closed in China and the western consumers having slashed spending, in favour of saving?

Wages in China, according to Paul Mason's report on BBC's Newsnight program last night, have fallen 20% from last year (from 5,000 to 4,000 RMB/month) in China for workers coming to the urban areas from the country side. This kind of wage destruction is clearly deflationary - western workers should be quite happy that they haven't been subjected to that - yet!

Which leads me to the next mis-conception in the market that inflation is coming and it's going to be high. It may come, but it will take a long time....Yesterday I watched JP Morgan Private Bank's chief strategist being shot down by Steve Liesman on CNBC after referring to the 7% increase in inflation in 1951, after 1950 being the last year inflation was more negative y/y than the last 12 months, as he forgot to mention that un-employment was 3.4% in 1951 - as opposed to 9.4% now. We are simply not in a situation where wage inflation anywhere, is going to be a problem anytime soon.

Capacity utilization is at the lowest level since records began (1967) just to mention another indicator.

So what now? The Fed is very unlikely to increase rates any time soon - and not before 2011 according to Pimco's Paul McCulley - so the front-end of the US curve has plenty of value, not least since Friday before last's massive sell-off, while a lot of that has come back since then, but red Dec eurodollar futures are trading at 97.61 so implying 3m libor to fix at 2.39% in December 2010 against a current fixing of 0.65% and a fed funds target of 0-0.25%. While this trade is not without risks a lot of the weak longs have probably been stopped out after a on day move of more than 50 bp's.

Equities are going to re-test their lows sometime in Q3/Q4; the lows may hold - or the markets could make new lows. In the last bear market the recession ended in November 2001, the equity market bottomed in October 2002 and tested that low again in March 2003. This is clearly a much worse situation so to expect the market to continue to go up from here without a re-test (of the lows) is in my view naive at best and plain stupid at worst!

I will be back with my views on how to fix part of the US twin deficits, while saving the planet!