Inflation/Deflation Archives

The Meaning of 7.5% Growth

China recently announced that the target for economic growth has been lowered from 8% to 7.5%. For most countries, this would hardly rate more than a line or two buried deep in the middle of the paper. However, for China, the 8% growth rate is deeply symbolic. The 8% rate has been a key metric against which the Communist Party has measured itself in this latest 10 year political cycle. Anything below 8% growth is cast as the equivalent of a recession. The success of one party rule in China hinges on the ability of that party to deliver the economic goodies.

The actual number will probably come in at least 1% over or under the official 7.5% target. But all of China’s provinces and Special Municipalities are now on notice to make sure that the numbers they serve up to Beijing are in accordance with the new policy. Conspicuous bank lending to property developers is no longer in the cards.

Looking beyond China, how does this downgrade impact markets around the world? The immediate knee jerk reaction is negative but it will be interesting to see if investors can shift their mindset from the immediate aftershock of the Global Financial Crisis. In 2008/2009, demand from China, India and Brazil amongst other emerging markets was crucial to sustaining overall global demand. The largest non-financial companies in the US and Europe would have suffered much more severely without the boost of emerging markets demand. Additionally, China was a major purchaser of US Treasury bonds as China sought to recycle its massive trade surplus with the US. That position has now shifted to the Federal Reserve.

Now, however, a slowdown in Chinese demand may not prove as catastrophic as it would have three years ago.

In the US, there is both slack in the economy and signs that domestic demand is on the mend. Bank lending growth, which had been moribund despite heroic efforts from the Federal Reserve to pump high powered money into the financial system, is finally starting to show the early signs of a recovery. Housing prices at this point are a lagging indicator because there is so much built up inventory both on the market today and likely to come onto market at any sign of better activity. The real issue for the US economy is whether the nascent recovery will get strangled by higher commodity prices feeding into inflation. A China coming off the boil at this point could be just what the Bernanke FED needs to keep an accommodative monetary policy running into 2013 without kicking off double digit inflation.

In Europe, the European Central Bank (ECB) has decided to take a page from the Federal Reserve and double down on their Long Term Refinancing Operation (LTRO) which offers troubled European Banks three year money at 1%. Like QE1 & QE2 (Quantitative Easing) rounds in the US, European banks have done the sensible thing and turned the money around into ECB deposits or matching maturity sovereign debt in order to catch the fat spreads at the lowest risk possible. Europe is more exposed to Chinese demand for capital goods than the US but it is obvious that Europe is heading into recession regardless. In fact, it is Europe’s weakness that probably tipped the scales and forced the China to downgrade its GDP target. So, basically, China’s growth is not the most burning issue in Europe’s capitals these days. A more pressing question is whether the ECB is complicit in an effort to drive down the value of the Euro so that export dependent Italy, investment dependent Ireland and tourist dependent Portugal, Spain, Italy and Greece can regain a competitive advantage.

So, interestingly, China doesn’t really matter quite as much as it has in the last three or four years as a global engine of demand. It will be interesting to see if the markets recognize the admittedly temporary change in circumstances.

The System numbers do not suggest a significant change in fortune…don’t let a 50 basis point cut in China’s GDP rate spook you unless you are overexposed to Shanghai luxury apartment units.

Presidential Cycles and Australia

This week, there will be no newsletter as we are on the road in Australia.

What does Australia and year three of the US Presidential cycle have to do with each other? Usually, there would not be much of a connection.

But this year, there is a connection.

To over simplify, we are in year three of the cycle, the time when an incumbent President has to make sure the economy is as stimulated as possible so that the voters will give him another four years in the White House. As a result, it is often a good year to invest in risk assets like equities.

In this cycle, growth is coming from government spending and monetary expansion. And, while the Republicans may still get to repeat their temporary government shutdown routine (maybe they can avoid the political backlash this time), the expansionary policies at the FED are harder to stop.

That means we will continue to see inflationary money creation in the world’s reserve currency. And, since the money cannot all be put to work in the US economy, it will continue to fuel asset and commodity price growth around the globe.

How does that money get around the globe and into local economies? Primarily through Central Banks’ efforts to keep currencies from moving up against the US dollar, the FED’s accommodative policy is being exported to countries (like China) where inflationary expectations have already taken hold.

Australia is one of the places where these pressures will become most evident. As a major producer of agricultural and industrial commodities, it is a secondary beneficiary of the FED’s inflation creating policies. Not only has China’s boom created strong demand for iron ore, coal and other resources, it has also sent a wave of investment capital towards the continent sized country. This has ignited a surge in M&A activity as well as frothy real estate markets. The Reserve Bank of Australia has moved short rates about as high as politically possible (mortgages are mostly floating rate) so the next thing to go is the currency which has just crossed the 1.05 mark (FXA). If the Aussie dollar continues towards 1.10 and 1.20 as local investors expect, that’s a strong signal that one’s investments need to be well placed for an inflationary environment.

This week, for example, the base metal ETF (DBB) nudged the S&P 500 ETF (SPY) out of the top 3 in the Seeking Alpha ETF Portfolio. The main aim of the Fund King System is to track major investment flows to keep one’s money deployed in the most promising corners of one’s investment universe. Right now, it looks like major investors are positioning even more towards the inflation trade,

Living in Interesting Times

Looking back on the first quarter, an impressive amount of the big news has hit the market. The political unrest across Northern Africa and the Middle East has entangled the US Military in its third shooting war, Japan endured the triple disaster of earthquakes, tsunami and partial nuclear meltdown, the European sovereign bailout took political prisoners in German elections and the largest bond fund manager announced that it had cashed out of US Treasuries. In the US, the housing market seems to have sprung some new leaks below the waterline.

What will the next few quarters bring?

One great place to start is ECRI’s Weekly leading index series which shows that the positive momentum is starting to taper off.This does not mean another recession is on the way, just that the current surge in the leading indicators (which correlate highly with the discussion and implementation of QE2) appears to have lost its head of steam.

ecri Living in Interesting Times
Source: Economic Cycle Research Institute

What does this mean?

Investors are right to wonder how the markets for risk assets can be bogging down when there is still an estimated one-third of the QE2 campaign to be injected into the system? Part of the reason is that the likelihood of a QE3 has become more remote as even FED governors start to question the need to continue pumping liquidity into the system. Another part of the reason is due to the fact that much of the newly created money was used by big owners of long dated treasuries (Chinese government, PIMCO and others) to purchase other assets. The increase in base money did not have the desired multiplier effect because it was not used as fuel to create new credit in the commercial banking system. In the land of M2 money supply figures where most of us live, QE2 was a fizzle.

Last Spike?

fedbase Living in Interesting Times
Source: St. Louis Federal Reserve Bank

Pushing on a String?

basegrowth Living in Interesting Times
Source: Shadowstats.com

Just over 4% growth in M2

m2 Living in Interesting Times
Source: Shadowstats.com

The other side of the coin

yieldcurve Living in Interesting TimesFor the big financial institutions who have access to cheap FED funding (or paying very little on demand deposits), the current state of affairs is still very attractive.But, as the situation remains very fluid, banks have shown a marked preference for Government paper (Treasuries, Agencies and Agency MBS) which can, in theory, be liquidated much more quickly than private mortgages and corporate loans.

But the banks are still burdened with a large backlog of toxic assets. Recent buoyant earnings reports and the cash flows behind them will not last if the whole yield curve gets shifted upwards by inflation or even just stronger economic performance.

Borrowing short and lending long works very well in flat or falling interest rate environments. Although we have seen lower interest rates recently, the FED has spent its political capital as quickly as it has built its balance sheet. Lower interest rates seem very unlikely in the medium term.

Sell in May and Go Away?

SAweek20 Living in Interesting TimesDoes this mean we will reach another “Sell in May and Go Away” moment when QE2 runs its course? The numbers have been slipping from the 20’s to the teens in most of the Systems that we track, which suggests a cautious outlook.

As investments start to fall out of the top rankings and you look around for the new investment opportunities, it might be time to take a bit of money off the table and wait to see what opportunities arise after the next bit of bad news rattles the well priced equity markets.

The commodity sector suggests that not all of the optimism in the market is warranted. Most of the strength in the short term remains in Silver (SLV), which has just hit new multi-decade highs and traditionally serves as a store of value as well as an industrial metal. And despite exclusion from core CPI figures, the energy ETFs like UGA, USO, UHN and DBE are all running stronger than economic growth in the G8 economies might warrant (or appreciate).

A Shiny Example

SLV has had a nice run since breaking north of $30 in the middle of February. That is not news but a checkable fact. For those investors who noticed that SLV was at the top of their rankings since July 12th of last year (when SLV closed at $17.62), it was a good opportunity to make money in a relatively non-correlated asset class. The only time it got sticky was at the beginning of this year when the price corrected.

The reason that we bring this up is not to brag. While SLV has done well, other investments that have made it into the top rankings have fared less well. The point is that most of those investments were eventually replaced by new market movers while SLV has hung in at the top of the lists despite the 10% correction that we saw in January. While we may have worried in these posts that the rerating between Gold and Silver may have run most of its course, the System kept pointing out that there was strong momentum behind the asset and that there were not that many more promising assets out there at the weekly measurement points.

My only slight regret…not swapping GLD for SLV a few weeks back when I was adjusting my Seeking Alpha ETF Portfolio. I would have looked very clever. But, in calmer moments, I realize that the regret and the emotion behind that regret is precisely why one should use an unemotional system to help execute one’s investment plan.

So, should you buy SLV now? Well, that all depends. Does it make sense as part of your universe? And, if it does, ask why? Make sure that you are not adding at this point because of past performance. Make sure that it is in there because you think other investors are worried about the US dollar or you think there is a chance that the Biomedical uses of silver are poised to go through the roof. In short, remember to separate the Asset Selection process from the Asset Trading process. And what happens when something better comes along in your universe? That’s easy, switch.

A Tarnished Example

Now that PIMCO has finally gotten it through to folks that, yes, they really are not keen on US Government paper (no link…too many choices), let’s look at how two bellwethers fared in the Fund King System.

TLT (which tracks 20 year plus US Treasuries) has been at or near the bottom of the US Sector ETF Universe since the beginning of November 2010. And less long term TLH (tracking 10-20 year Treasuries) has joined the bottom of the pile in another ETF portfolio since the end of November.

So, whether you were in the “Don’t Fight the Fed” or “Hyperinflation Around the Corner” camp, the Fund King System told you to steer clear of the asset class for the last three months. Even the FED could not buy up enough long dated Treasuries to keep TLT from dropping 10% over the period. Mr. Gross, the head of PIMCO noted in his newsletter that the FED has been buying as much as 70% of the newly issued Treasuries of late.

What does it mean?

There is nothing wrong with SLV , TLT or TLH in absolute terms. Each of these ETFs represents claims on perfectly good assets. The deep meaning to take away from these two examples is that it does not pay to fight the trends. If investors (on balance) are shifting money out of US Treasuries and into hard assets like Silver, there is little point in trying to stand in the way. At some point, the tides of money will change directions and other asset classes will get swept up or down. When interest rates rise a couple hundred basis points, Bill Gross and his PIMCO colleagues will be back on the bid side. Why? Because they are in the business to make money; and money is made by buying low and selling high.

An interesting read

Supporters of Ron Paul can sometimes be a prickly bunch. But, they occasionally come up with very thought provoking concepts.

I like a good bash so when I came across an article entitled: “How to End the Federal Reserve System” by Gary North, I was prepared for a rehash of the old arguments about an evil cabal on Jekyll Island in 1910. But the real strength of the article comes about halfway through when Mr. North analyzes the demise of a government agency which had also been granted monopoly powers: the US Postal Service. He draws some interesting parallels about what technology could do to the Federal Reserve System long before Ron Paul and his supporters in Congress are able to rescind the Fed’s legal mandate.

Basically, the ability to move into other currencies with a few well place computer key strokes or even to develop new mediums of exchange means that even an institution as powerful and influential as the Federal Reserve is not immune from obsolescence.

Part of the appeal of ETFs like GLD and SLV is that they are theoretically redeemable into a fixed amount of Gold and Silver respectively. While pitched as a new idea, the concept of convertibility into precious metals was once the cornerstone of the US dollar’s value (and most other currencies before that). In an interconnected world that can work with services like PayPal, it’s probably only a matter of time before someone reinvents a multinational global fractional banking and payment system backed by gold, silver or some other store of value. If it is tied into Visa, Mastercard and American Express, one need not worry about carrying about sacks of heavy metal to the grocery store. Just as email eclipsed the first class letter (something that was unthinkable as recently as 20 years ago), there is a risk of a new currency system taking the premier spot occupied by the US dollar today.

Just because the risk exists, however, does not mean it will come to pass. The biggest difference between the US Post Office and the Federal Reserve is that the latter is a privately owned, profit seeking entity. Long before we are all paid in PayPal credits or Googles, the Federal Reserve (which is owned by and represents the largest US banks) will feel compelled to take steps to shore up the value of the US dollar. That more than anything else will lead to a change in policy that will likely see higher interest rates in the not too distant future.

While you are pondering your long term investment strategy, make sure to include a plan for higher interest rates.

What happens to Japan now?

The earthquake and tsunami that hit Japan on Friday will impact the country and the economy in ways that are hard to foresee at the moment. Despite the shocking video and photos, however, the natural disasters are unlikely to have a significant long term impact on the economy. As long as the authorities can keep the nuclear fallout to a minimum, the biggest issue will be reconstruction and who will buy the fresh batch of JGBs. That points to another force for higher than near zero interest rates in the world’s #3 economy.

From an investors’ point of view, the Nikkei 225 was the best of a weak bunch (Asia has lagged since November of last year) in our universe of 11 Asian indices as of Friday’s rankings. The earthquake and tsunami do not significantly change the long term public finance fundamentals of the country and most of the familiar exporting names have transferred significant portions of their manufacturing base to locations around the world in the last few decades.

Should you buy? If your universe is only Asian Equities: then perhaps. But, if you are looking at a broader range of asset classes, there are quite a few commodity based ones that look more attractive. As Japan is import dependent for almost all of its commodity needs, there are better places to invest your money.

System Numbers Flattening

As we pan across our portfolios, we notice a definite lowering of the numbers that the System is throwing out in the rankings. The last time this happened was in April/May of 2010 and it definitely foreshadowed a weak stretch for assets at the higher range of the risk spectrum. The numbers remained flat through the summer and started to recover in September of 2010, which coincided with a strengthening of sentiment that carried through until recently.

But what about all the reports of bullishness?

There have been a number of recent articles in all the right papers which have pointed to a general bullish sentiment in the market. These reports are couched in caveats but generally reveal that asset allocators are overweighting equities and bonds and underweighting cash. But the market is not all one way; there are still magazines to sell and as we approach the second anniversary of this strange bull market, we get think pieces like this in Barron’s. Unfortunately, the thinking is not terribly original or prescient.

The problem with these approaches is that they either measure what people say (asset allocation intentions, bullish/bearish sentiment polls) or the way they think things should be (articles bemoaning the historically high CAPE, the Cyclically Adjusted Price Earnings ratio or why Gold should be trading at $5,000). They are not measuring what people are actually doing with their money.

Let’s think about how this works. If one owns equities (or property, or bonds, or gold bars), one is by definition bullish. But this is a lagging indicator because the actions surrounding the bullishness have been taken in the past and are unlikely to contribute to further upward price action in the short and medium term (unless the market has been cornered). So, after a run up, which by definition must mean a bunch of new investors have been bidding up prices and filling their portfolios with the asset-du-jour, one would hardly expect those avid collectors to “talk down” the price of their newly acquired assets. The trend can continue only with new money being attracted to the asset in question. That money can come from other asset classes, from the real economy via savings or, in the case of QE1 and QE2, from credits which materialize from FED activity on bank balance sheets. Once the new buying abates, the market pauses and often corrects.

While we make no claims that the Fund King System has any “crystal ball” properties, one of the things it will measure is the momentum of money as it flows into and between the various financial asset classes.

In this week’s survey, the assets still attracting investor favor are Energy, the US, Small Caps and Agriculture. Silver appears to have topped out after rushing to catch up to a more traditional valuation against Gold. It still ranks highly in some of the longer term portfolios but it has been dropping down with Gold on the shorter focused portfolios.

Our advice? It is time to watch the numbers a bit more closely than usual. We could be at the start of a larger correction in risk assets or it could just be a pause to see how some of the latest events turn out. The big issues are, in order of importance from an investment point of view, the level and sustainability of growth in the US, the risk of a slowdown in China induced by inflation fears and an ugly resolution to the Egyptian unrest which would upset the balance of power, peace and trade arrangements in the Middle East.

Inflation Sneaking In?

While trolling through the 24 hour news channels, one thing to watch out for is the quiet risk of inflation. The fact that the best looking assets are in the energy, agricultural and materials sectors leads one to conclude that there is more inflation running through the system than government statistics might suggest. There is no way to properly quantify how much inflation because the two most common measurements (Government Statistic and Personal Observation) are both flawed. The former is flawed because Governments collect and report the data which they use as a yardstick of successful governance. There is no question that the BLS has changed the rules over the past few decades to make the data as flattering as possible. The latter is flawed because our personal viewpoint is too narrow and we tend to focus on the things that are causing us the most anxiety. We tend to overlook those prices which are going down (unless it is our salary or house).

But how can we have inflation if growth is only in the 3-4% zone? Most of us have been schooled on the idea that inflation can only come about when the economy gets overheated (too much money chasing too few goods). When the economy is well below potential, there is little risk of inflation creeping in, right? That is the crux of the FED’s stimulative policy argument. But there is more than one way to create a bit of inflation. If we look at Zimbabwe, for example, its bout of hyperinflation did not come about from extremely robust economic growth. It came from printing up too many pieces of paper (too much money chasing too few goods).

One might be tempted to take comfort in the relatively low yields on long dated US Treasuries. But then again, one needs to look carefully at who is buying the paper. The FED is hardly going to demand an inflation premium on the US Treasuries it is buying with newly created money it created when one of its two mandates is to maintain price stability. I am not accusing anyone of “window dressing” but there is little incentive for the FED to haggle for the best price while it fills its shopping cart with long dated Treasuries.

sgs cpi System Numbers FlatteningShadowstats has an interesting take on inflation by taking the 1990 methodology and contrasting that with the current BLS methodology. There is no doubt that some spending patterns have changed since 1990 but it is interesting that the adjustments to the methodology have served to consistently show the US inflation picture in a flattering light.

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