I’m all about that base when it comes to inflation

I’m all about that base when it comes to inflation

Last week on our Cocktail Investing podcast, Chris and I spoke about how I’m not so much on board with the rising inflation camp because of the base effect, (Ok, so not quite bass, but close) which has become the phrase of the week in some circles. So what am I looking at that all those who buy into the reflation trade aren’t seeing?

First, let’s look at oil.

By mid-February 2016, the price of oil had fallen nearly 76 percent and was finally finding a bottom around $26 a barrel.

WTI Crude Oil Spot Price Chart

WTI Crude Oil Spot Price data by YCharts

In response, production cuts continued so that by the end of May 2016, rig counts in the U.S. had fallen almost 80 percent from their highs.

US Rig Count Chart

US Rig Count data by YCharts

With such a low base, under $30 a barrel, it didn’t take much for the price of oil to experience enormous gains on a percentage basis. By late February of 2017, the price had risen 108 percent from its February 2016 lows.

WTI Crude Oil Spot Price Chart

WTI Crude Oil Spot Price data by YCharts

Oil is a key input to nearly everything, giving it an outsized impact on prices. Thus a 100 percent increase in the price of oil is going to have an effect, but looking over the past 10 years, today’s price is still relatively low.

WTI Crude Oil Spot Price Chart

WTI Crude Oil Spot Price data by YCharts

To get an idea of where oil prices may head in the future, we like to look at what is happening with rig count, as that tells us about future production coming online. Remember that rig counts had dropped nearly 80 percent as the price of oil plummetted to below $30 a barrel.

US Oil Rig Count Chart

US Oil Rig Count data by YCharts

Unsurprisingly, as the price of oil rose, companies brought more and more oil rigs online, where today we are up over 108 percent from the May 2016 lows. However, we are still well below where we were in October of 2014 when oil was in the $80 range. Keep in mind though that all that pricing pressure has led to cost reductions, such that many extractors can be profitable at lower prices today than just a few years ago. We’ve been reading reports that many shale oil producers can now be profitable at as low as $30 a barrel.

US Oil Rig Count Chart

US Oil Rig Count data by YCharts

More rigs are coming online, and we are just 6 percent below the record high crude inventory levels, which tells me that we are unlikely to see crude prices rise substantially from this point, particularly on a percentage basis, barring any geopolitical shocks. Keep in mind too, that any regulatory rollback by the Trump administration on energy is likely to further reduce the break-even levels and could spur even more domestic production.

It hasn’t been just oil that has seen a dramatic rise in prices since the early parts of 2016.

^SG3J Chart

^SG3J data by YCharts

Copper, Aluminum, Natural Gas, Heating Oil, Lead, Zinc, Silver are all up well into the double-digits on a percent basis from January 2016, after having taken a serious beating early last year. However, it looks as though we may now be starting to see prices level off, which means these inputs would no longer be having an outsized impact on prices due to their exceptionally low price levels back in early 2016.

We’ll be keeping a close eye on these as we head into earnings season and get more insight into what companies are experiencing versus the sentiment that has been blowing the doors off.

Finally, when it comes to the ISM Manufacturing PMI, if we look back at historical norms, this indicator is likely to start rolling over soon, which will really give the market’s reflation narrative a conniption fit!

Adverse Weather Conditions Have Europe Importing US Vegetables

Adverse Weather Conditions Have Europe Importing US Vegetables

Weather can be a very disruptive force when it comes to the supply of food and other commodities. Crops can flourish under right conditions, but adverse weather conditions can reduce harvests we tend to see prices spike whether it be coffee, corn and the like. Following a near record corn crop, consumers in the US are experiencing the benefit of food deflation that is helping Cash-strapped Consumer dollars go a bit further. In Europe, however, cold weather has led to countries importing vegetables from the US. Shipping and freight costs, airline handling fees and the strength of the dollar make for a pricey solution for this current scarcity. If this weather continues into the March planting season vegetables could become an affordable luxury.

Due to cold weather in Europe’s key vegetable supplying countries, the continent is dealing with an extreme vegetable shortage. “The last time Europe dealt with a vegetable shortage like this was in 2005,” says Lisa Sternlicht with California-based A.M.S. Export.

In spring 2013, we exported a little bit of iceberg lettuce to the UK, but now we receive requests from the UK, the Netherlands, Germany and Switzerland. Even the Spanish might be in the game pretty soon,” continued Sternlicht.

It is uncertain how long Europe’s demand for US vegetables will last. Will the consumer continue to pay high prices for vegetables or will they switch to alternatives? “Airfreight comes with a price,” shared Sternlicht. Landed costs into Europe are around 2.3 and 2.5 euros per kg. On top of it, you have to add duties and airline handling. The strength of the dollar and the post-Brexit weakness of the GBP make it pricey.
The current supply shortage could become even bigger in March. Important vegetable growing regions like Murcia in Spain plant produce this time of the year for a March harvest. The extreme cold weather has made it complicated to plant and time will tell what the impact will be.

Source: US vegetables flown in to Europe during unprecedented shortage

Falling Prices

Looking out into the future, markets and economies will driven in large part by falling prices in a few major areas:

  • Falling Oil Prices
  • Crashing Prices and Excess Capacity in Commodities
  • Diverging Monetary Policies and the Strong Dollar

Falling Oil Prices

Last week oil fell to $36/barrel, going below $40 for the first time in six years. Earlier in December OPEC had its final meeting for the year, and at this point I think it is fair to say OPEC has become completely irrelevant.  A cartel that has no ability to control the production of its members is no cartel. OPEC can’t control its members because Saudi Arabia already learned its lesson in the 1980s, when it cut production in response to falling oil prices and ended up mostly just losing market share. Other nations paid attention. On top of that, these countries’ budgets are in dollars, as oil is priced in dollars, and they need to keep up their spending in order to maintain control over their citizen – the perpetual challenge for countries in which the primary source of national income is owned by the State.

So why are oil prices falling? Simply because while demand is growing, it is growing at a slower rate than supply. The high oil prices from years ago combined with the Fed’s ZIRP (Zero Interest Rate Policy) and technological breakthroughs in oil extraction technology, led to an influx of investing in oil production capabilities which was funded in part by a lot of high yield debt. As the price of oil continued to fall, many of the companies have found themselves in violation of debt covenants. This is leading to rising defaults, (although the default rate today in aggregate is not at historically high levels) which then leads to tightening of credit conditions as lenders are forced to rebalance their lending portfolios. This make conditions even more challenging on these distressed firms, as credit is increasingly less available, which will eventually lead to bankruptcies for many of the more highly-levered firms. We saw a similar pattern back in the financial crisis as the real estate investing boom blew up in spectacular fashion when borrowers were unable to refinance on major portions of their real estate portfolios, even on properties that may have had more than 50% equity, resulting in a complete wipeout of their clients’ invested capital in those properties.

The good news for investors is that this is also reminiscent of the heady days of the Dotcom boom when all the rage was broadband infrastructure, with high-fliers such as Global Crossing, which eventually flamed out in headline grabbing bankruptcies that wiped out most debt and equity holders alike. However, that led to the ability for those that survived the carnage to be able to pick up that infrastructure for pennies on the dollar, leading to materially lower broadband pricing, which facilitated the next wave in the Internet evolution. I think oil is likely to experience something similar, with those companies that have healthy balance sheets being able to pick up production capacity at pennies on the dollar, greatly improving their overall margins and providing the economy with lower-cost energy into the future, which will be a much appreciated tailwind.  For now, I think it best to avoid this sector, but at some point in the near-to-mid future it will provide spectacular opportunities.  This lower-price oil will also be a fantastic boon to those emerging economies that are big energy importers, helping their economies grow at a faster pace than was previously possible, providing investors with yet another great opportunity. U.S. lawmakers are also expected to lift the ban on oil exports as part of the current spending bill legislation, which will provide additional support for domestic producers.

For now, the defaults and struggle in oil will be a strain on the overall economy. For those who point out that oil and gas drilling accounts for only around 4.6% – 6.5% of GDP, residential housing makes up around 5% of GDP and we all recall just how much damage excessive investment and use of debt in that sector did.

Crashing Prices and Excess Capacity in Commodities

Commodity prices have been falling for years, with the CRB commodity index down 21% from just its May 2015 highs. An entire book could easily be written on this topic, so I’ll narrow it down to just a few illustrative points in the interest of preserving your sanity! The last major commodity super-cycle began when China was allowed entrance into the World Trade Organization. Thanks to the enormous shift in its population from rural agrarian to industrial manufacturing, it was able to supply the world with cheap labor, which meant cheaper products for exports. The money it took it was funneled into gobbling up commodities to use in its eye-popping infrastructure build out; for example, China accounts for about half of the world’s aluminum consumption.

During and after the financial crisis, the world greatly benefited from China putting its pedal to the metal on its infrastructure build out, effectively creating a floor under commodity prices and protecting commodity producers from what would have been a much more painful fall without China’s purchasing. To put in it context, in 2009, with the markets crashing, oil stood around $100/barrel and steel plate was at $600, today oil has fallen below $40 and steel is at $260.

Today China’s steel production capacity is around 400 million tons a year, which is nearly four times the U.S.’s capacity at 120 tons. With China’s slowing economy, and more importantly rapidly slowing infrastructure build, it has more and more excess capacity.  China’s steel consumption is declining for the first time in two decades, with the nation’s steel sector experiencing layoffs in the tens of thousands.  Year-to-date the one hundred largest steel companies lave lost around $11 billion with 37 steel plants closing so far.

Most of China’s excess capacity cannot be shipped to the U.S. as it is of lower quality and is barred by tariffs, but it can go to Europe where prices are crashing and has caused quite the crisis in the U.K.  European players have been forced to continually lower prices and unlike China, they can export to the U.S.; despite the tariffs, U.S. steal producers cannot be totally insulated.

Many of these steel and oil mid-cap companies have “crossover” bond ratings, which means they are in-between investment grade and junk status, (BBB and BBB-).  All it takes is one little nudge and they will be in junk territory, which means then that the funds that hold them will have to rebalance their portfolios which in turn affects the credit market as a whole. Here too, those producers that maintain healthy balance sheets and do what they can to raise cash, will be able to goggle up bankrupt production capacity at below-cost, lowering their margins and allowing for lower cost steel into the future, which will help not only domestic users, but will be particularly beneficial for those emerging market, commodity importing nations. While I’ve only talked about oil and steel in depth here, similar dynamics have and are occurring in other commodity markets across the globe.

Diverging Monetary Policies and the Strong Dollar

The strong dollar continues to be one of the most common problems cited by companies in their quarterly reports. So what does it mean, why is it happening and is it likely to continue to strengthen?

The dollar began strengthening when the Federal Reserve first pulled back on its quantitative easing programs. This directional shift marked the first step. Then it ceased quantitative easing altogether, whilst other nations continued or even accelerated their programs. Now the Fed has raised interest rates, which further strengthens the dollar against other currencies. As other nations around the world engage in stimulative monetary policies, the dollar will further strengthen against them.

Commodities are globally priced primarily in dollars. I just walked you through falling oil and steel prices and as those prices have fallen, dollars have essentially been disappearing into thin air. By that I mean, imagine you have drilled an oil well or built a steel plant. When you did so, you forecasted a certain productive capacity that would result in a dollar value of sales based on an assumption of price. Falling prices have cut your expected sales enormously, meaning dollars you expected to have in your pocket will never show up. This means that your investors and/or creditors are not in the same position they expected to be – you don’t have the dollars you were expected to have, so no wonder there is an increased demand for dollars.

This brings us to the $9.5 trillion dollar carry trade which I’ve talked about before in the October 2014 issue, where I explained how the carry trade works, and again in August of this year. The higher the dollar goes, the greater the demand for dollars to pay back that dollar denominated debt. If we look at history, there are two main dollar bull markets. The first one was in the 1980s that only ended after the world’s central bankers got together in the Plaza Accord to weaken the dollar after it had risen about 100%. In the late 1990s, we experienced a second bull run which ended in the Asian Crisis after the dollar had appreciated about 50%. During both, the dollar experienced pullbacks, but never of more than 10%, which gives us a potential metric to mark this bull run. Today, we have the largest global carry trade ever seen, which makes the bigger picture look closer to the 1980s. Looking at the data, there is a material probability that the dollar strengthening process could start to accelerate again, which will put more downward pressure on commodity prices. I think being long the dollar and even owning longer-term bonds while either being short or just staying away from the commodity complex would be the wiser move here. (Hat tip to Raoul Pal of Real Vision Television for some of the research on the dollar bull runs.)

As for longer dated bonds, if the Fed continues to raise rates and the economy is in fact slowing and the rate hikes weaken the economy further, then growth expectations will slow which will cause longer-dated bond yields to drop and bond prices to rise. If the Fed continues to raise short-term rates, an inverted yield curve, (in which short-term rates are higher than long-term rates) is possible, which would be very damaging for banks as they borrow short-term and lend long term. If the dollar continues its rally, demand for bonds will rise as well, which will push up bond prices and push down bond yields. Bond prices could however get hit if the Fed hikes, but hikes much more than is expected, which given the reasonably dovish commentary Wednesday, currently seems unlikely.

Bottom Line: We are in unchartered territory in many areas; higher levels of sovereign debt than during the financial crisis, a bigger U.S. dollar carry trade than the world has ever seen, more excess reserves at the federal reserve than ever before, tectonic shifts in global economic power and rising political tensions throughout much of the world coupled with challenging demographic trends, (aging populations) in the U.S., Europe, China and Japan while many emerging economies are blessed with a much lower median age in their populations. Never before in the modern era of high-yield bonds has the Fed hiked rates when the high-yield bond spread was greater than 6.25%; today it is 7%. Over the next decade the “it” places to invest are likely to be economies that were previously not on many investors’ radars. We are likely to face some challenging times, but those inevitably lead to wonderful opportunities. 2016 will probably give us some 

China and Emerging Markets – A tale of QE

China and Emerging Markets – A tale of QE

This week I sat down with Erin Ade on RT’s Boom Bust to discuss what is happening in China and emerging markets and how it may affect U.S. investors as well as our domestic economy.

When the Federal Reserve began its Quantitative Easing Programs, many feared that it woul16d lead to high levels of inflation. Today, after three rounds of quantitative easing, we have very little evidence of domestic inflation and with the dollar gaining strength against most all other currencies in the world, we are actually facing some deflationary forces.

First, what is Quantitative Easing and why do people say it is all about “printing money?”

Quantitative Easing refers to the process shown below wherein (1) the Treasury Department sells Treasuries to Banks in return for cash to fund the annual deficit. This money is then spent by the federal government. Banks then turn around and sell the Treasuries to the Federal Reserve in return for cash. This cash is typically in the form of a “ credit”  in their reserve account, but for all practical purposes it can be thought of as cash since these reserves can then be used to loan money to businesses and individuals, who then effectively have cash in hand.



So just how much of this did the Fed do?  The chart below from the Federal Reserves shows that it bought about $4.5 trillion dollars worth of Treasuries and mortgage-backed securities during the three rounds of quantitative easing.  To put that in context, that is over 25% of US GDP during that time.  With all that new money coming out into the economy, inflation was a very real concern, yet it didn’t happen.

2015-09-16 Fed Assets

So what did happen to all that “money printing?”  A lot of it went into emerging markets.

A recent working paper published by the Bank for International Settlements titled “Global dollar credit and carry trades” found that one of the unintended consequences of the Federal Reserve’s quantitative easing program, was the significant increase in issuance of dollar denominated corporate bonds by emerging market companies where the proceeds primarily fed into existing cash balances, a form of corporate dollar carry trade.  The paper cites a 2015 study that estimates that the outstanding USD-denominated debt of non-bank entities located outside the U.S was around $9.2 trillion at the end of September 2015, an over 50% increase from the beginning of 2010.

In an earlier post I pointed out just how much the USD has appreciated relative to most every other currency since the end of Quantitative Easing, making this carry trade increasingly untenable.  We’ve seen more and more slowing across the globe, with commodity-heavy countries like Australia, New Zealand and Canada, (who just reported that it is now in a recession after two quarters of negative GDP growth) engaging in pretty aggressive easing cycles, that will only further weaken their currencies relative to the dollar. What is even more concerning is that a rather large percentage of these firms are in mining, oil and gas sectors and we all know what has happened to prices for those commodities!  This means we have companies whose domestic currency is sliding further and further against the USD in sectors that have been utterly slammed, with outstanding USD denominated bonds, making those bonds more and more expensive every day – pushing an unwinding of this USD carry trade.  I suspect traders on Wall Street aren’t the only ones stocking up on Mylanta these days.

Our discussion begins at the 20 minute mark in the video below.


Global Picture – What Trump Doesn't Know

Global Picture – What Trump Doesn't Know

Donald Trump has been making headlines lately with his rants over China’s currency, but there is a lot more to the global picture – What Trump doesn’t know…

A little over a week ago the Netherlands Bureau for Economic Policy Analysis reported that global trade shrunk in the first six months of 2015 at the fastest pace since global trade collapsed in 2009 following the financial crisis, down 1.5% in Q1 and another 0.5% in Q2.  This is big, very big, yet very few are talking about it! Which is why we are.  According to a report from the Economic Cycle Research Institute, the last time export price deflation was this intense every G7 economy was in a recession.  



The Eurozone’s growth wasn’t as strong as expected in the second quarter, with overall GDP rising by 0.3%, (barely above stagnation) and slower than the 0.4% in Q1.  The two largest economies in Europe disappointed with Germany growing 0.4% versus expectations for 0.5% while France didn’t grow a bit versus expectations for 0.2% growth. Italy eked out 0.2% growth versus expectations of 0.3%.  The Netherlands was similar with 0.1% versus expectations for 0.3%.

Despite the massive efforts by the Bank of Japan to get the economy roaring, Japan’s Q2 GDP didn’t give us much to cheer about either, declining at a 1.6% annual pace.  Brazil also surprised to the downside, its economy contracting by 1.9% versus expectations for 1.7%, the biggest contraction for the nation in over six years!

So what may be happening here? Well, about 45% of the world’s GDP comes from commodity producing nations, and commodity prices have been taking a serious beating as is illustrated in the next chart.  If a nation can’t sell as much of its own stuff (commodities), it isn’t going to be able to buy as much stuff from the rest of the world… pretty simple! (You can see a bigger version of the image below if you click on it)



Across the board, save for a few unique standouts such as tea, (traumatizing to your Irish author here) olive oil, (thanks to a nasty bug attacking trees throughout Tuscany) and uranium, (Japan is getting its reactors back up after the horrors of the tsunami) commodity prices are falling dramatically across the board.  Even the world’s biggest producer of diamonds, De Beers, announced on August 24th that they would be lowering their prices by 9%.  Apparently, diamonds are a little bit less of a girl’s best friend. These prices are down so much for two main reasons: the strengthening dollar and growth rates are well below historical norms, both here in the U.S. and abroad, which means commodity producers need to continue to cut back on production.

The slowing global growth story shows up in many places. While the US may be the world’s largest economy, China is second and it is the world’s largest goods-producing economy.  When it is slowing, that’s telling you a lot about global demand.  For one thing, all those commodity-producing countries aren’t buying as much stuff from the Chinese. Germany is a big exporter to China so when China slows, Germany feels it and that affects the rest of the Eurozone. The decline in oil prices coupled with sanctions has seriously hurt Russia, which in turn is hurting Germany as German exports to Russia decreased by almost 31% on an annual basis in the first half of 2015. Getting hit by declining demand from both Russia and China is putting a lot of pressure on Germany, the nation that has long been the engine of growth for the Eurozone.

Now what’s the story behind the dollar’s strength?  Remember all those quantitative easing programs?  QE1, QE2, QE3…?  For those the Fed bought up tons and tons of “longer-term securities issued by the U.S. government and longer-term securities issued or guaranteed by government-sponsored agencies such as Fannie Mae or Freddie Mac” in an attempt to inject more and more money into the economy thinking that would spur demand and get the economy back on its feet.  The next chart shows the magnitude of the program.  From January 2003 to today, the Fed’s balance sheet has expanded 511% as it purchased trillions of Treasury bonds and mortgage-backed securities.  U.S. GDP today stands around $18 trillion, so this means the Fed tried to increase the amount of money in the economy by nearly 20%!  Yet we didn’t see crazy inflation, which at the time seemed a likely possibility.



Where did all that money go?  Mostly into asset prices…the ending of QE saw the dollar strengthening versus other currencies and the fall of commodity prices… with more likely to come.

While the Fed was buying up Treasuries in order to put more money into the economy, China was continuing its unprecedented reserve-accumulation exercise which, starting in 2003, amassed almost four trillion of foreign assets!  That is more than all of the Fed’s QE programs combined.  So what we really experienced on a global level was hyper-QE.

Today the story in China is a little different with the economy suffering from both a decline in exports due to the global slowdown and a shift from a primarily goods-exporting and manufacturing driven economy to a more service-oriented and internal demand driven one.  The nation’s economy has evolved into one in which about 20-25% of its citizens have a middle-class lifestyle while much the rest of the country lives more on par with Nigeria.  This is an untenable situation and Chinese leadership knows it, but is under a mountain of pressure from every angle.  Chinese state and private debt is estimated to be around 300% of GDP, if you can believe the GDP numbers.  If you think, like we do, that they are likely less than those reported by the government, then the situation is even worse.

So what’s all this about China’s crashing stock market kicking off the correction here?  The next chart shows the massive run up that China’s main index experienced, rising over 130% from last August to early June and the correction it’s suffered since those highs.  By August 26th, the Shanghai Composite had fallen over 43%. By the close of last week it had recovered a bit to be was down 37% from the highs.


The enormous run up in China’s stock prices over the past year was not due to improving fundamentals, as its economy has been slowing.This run up was based more on the assumption that the government would do whatever necessary to keep the market moving up combined with increasing use of leverage, (meaning people borrowed to buy more stocks).  Not exactly a unique phenomenon these days!

Understandably, Chinese officials took steps to rein in the use of leverage.  In January, they raised the minimum amount of cash needed to trade on margin, which would restrict the practice to wealthier investors.  They also took steps to punish companies that had been lax on enforcing the margin rules with their clients.  In April, Chinese regulators cracked down on “Wealth Management Products,” WMPs which are similar to U.S. money market funds, but in some cases WMPs were being used to generate funds that were then used to finance individual and corporate stock market investors at ratios of up to 10:1!  They also banned “umbrella trusts” which helped clients evade the margin trading limits. The market still went up.

Dissatisfied with the results of their tightening, on June 12th regulators then reduced the total amount of margin lending stock brokers could do, while also reiterating forcefully the ban on illicit margin trading through mechanisms like umbrella trusts. This time investors listened, the market bull run broke and the plummet began.

In early July regulators pulled an “Our bad” and did an about-face, reducing the amount of money required to open a margin-trading account.  Yep, first lowered this a few years ago and then raised it back up again in January and after watching a gut-wrenching slide in stock prices they reversed yet again!  Since July, the government has taken a variety of steps to try to pump the market back up.  Last week the market reversed its downward spiral only when the government announced it would engage in a large-scale asset purchase program in order to keep up stock prices.  The markets in China and around the world rallied on the news.  Then in yet another about face, (dizzy yet?) Sunday China announced that it had decided to abandon attempts to boost the stock market and will instead intensify efforts to find and punish those it suspects of “destabilizing the market” by “spreading rumors!”   Over the past two months, state-owned investment funds and institutions have collectively spent around $200 billion attempting to prop up the market, with limited success.

This weekend 197 people were arrested for “spreading rumors” and “false information” online about the recent stock market crash and the explosion in Tianjin, including a journalist and stock market officials. On August 24, Wang Xiaolu, a leading journalist at one of China’s most widely read financial publications was arrested, and admitted to causing “panic and disorder” in a public confession aired on state television. Unsurprisingly, the Committee to Protect Journalists has condemned his arrest and subsequent “confession”. I thank my lucky stars every day that I was born where I am free to say what I think.  Those who know me have assured me that I’d likely be six feet under if I’d been born under a different regime!

One final thought on China’s economy. When we take a deeper look, we see that according to official figures, gross fixed investment was 44% of gross domestic product in 2014. While figures for investment are more likely to be correct than those for GDP, does it really make economic sense for an economy to invest 44% of GDP and yet grow at only 5%? We think not! Talk about horrible returns. If these figures are to be at all trusted, investment could fall sharply going forward. That would mean further weakness in demand from China for commodities used to the enormous infrastructure projects for which it has become famous.

We’ll wrap up with China’s yuan and currencies across the world.  As we mentioned in our May issue, China is attempting to be included in the International Monetary Fund’s Special Drawing Rights, which means it needs to let its currency float more freely.  Earlier this month it took another step towards that end by loosening its hold on its currency, which resulted in the yuan falling some 3-4% versus the dollar. The following chart shows the performance of a wide range of currencies from across the globe versus the U.S. dollar over the past year. (You can see a bigger version of the image below if you click on it)

Currencies one year


The one in red is China’s, (couldn’t resist!).  As you can see, almost every major currency in the world has dropped in value relative to the dollar over the past year.  Here are a few numbers to go with the chart above:

  • Australian Dollar down 31%
  • Canadian Dollar down 22%
  • Chilean Peso down 20%
  • Euro down 16%
  • Japanese yen down 15%
  • Indian Rupee down 9%
  • British pound down 7%
  • Swiss Franc down 4%
  • Chinese yuan renminbi down 4%

Keep these numbers in mind as you hear Presidential candidates tossing insults at one another and at other countries around the world. China isn’t the only nation whose currency has declined in value against the dollar.  Furthermore, if the argument is that China has been “artificially” keeping its currency cheap relative to the dollar in order to make its exports more attractive to the rest of the world, then why did its currency immediately decline in value the moment the government loosened its hold, proving that the government’s intervention has been keeping its currency higher than it would be were it allowed to float freely?  This also makes intuitive sense.  China pegged its currency to a band around the dollar.  The dollar has been strengthening significantly while China’s economy has weakened.  It is unsurprising that the market’s pressure is to push China’s currency lower.  Yet another example of how headlines and TV talking points are often misleading.

For a broader historical perspective, the next chart shows the performance of a slightly smaller set of currencies against the dollar from 2010 through the end of 2013.  The weakening of the dollar against these currencies is directly related to the various quantitative easing programs, the termination of which was announced when the Fed released the June 2014 FOMC (Federal Open Markets Committee) notes in early July 2014. (You can see a bigger version of the image below if you click on it)

Currencies three year


Here we see that during those three years it was actually the dollar that was falling relative to global currencies.  In fact, during this time China’s yuan actually strengthened versus the dollar by 11%.  You don’t hear any candidates ranting about how the dollar devalued versus other currencies for years! There is a lot more to the situation in China than is discussed in the popular media, and it is something that could have a very big impact on the global economy and if affects the Fed’s decision on raising rates.



Not out of the woods yet with the economy

Not out of the woods yet with the economy

The Economy

While the domestic economy is strengthening a bit, the recent unemployment numbers greatly overstate the improvement as most of the gains simply came from people leaving the workforce rather than actual employment gains.  At Meritas, we mostly ignore the unemployment numbers and look simply at Civilian Employment as a Percentage of the Population.  This number remained unchanged from December and has only increased 0.2% from January of 2011 and is currently 58.5% after having bottomed out at 58.2% Dec of 2009.  We are only up 0.3% since the bottom of the employment market!  Employment numbers alone don’t tell the whole story – we have to also look at income levels.  Real household income, meaning income adjusted for inflation, was $55,962 in January 2000.  At the end of the recession it had fallen to $53,638.  It is now $50,876.  In twelve years it has fallen over 9%.  On top of that households are saddled with unprecedented levels of debt.  For decades the average household income to debt ratio was about 65%.  It peaked at 140% in 2007 and is now just below 120%.  Falling incomes and the need to reduce debt don’t make for much of an economic tailwind.

As for Commodities

The price for commodities is really a function of two things:  the supply vs. demand for the commodity and the strength of the dollar.  Most commodities, with the exception of natural gas and crude oil are over-bought today, we believe on the false assumption that the European situation is going to be well controlled and that we are economically out of the woods.  The Baltic Dry Index, which is a measure of commodity shipping costs, advanced from a 25 year low for the first time since Dec 12th, after falling rates boosted the number of dry-bulk owners dropping anchor and refusing to hire.  Rates are near or below cash break-even for every vessel class, so we are starting to see more ships anchoring and refusing to trade.  The index is down 62.8% YTD and 38.1% Year-over-Year.  We just saw how little pricing power there is in the market as P&G was forced to roll back prices after an 8% increase cost them 7% of market share.

Gold is trading more as a currency than a commodity these days.  It is a hedge against the loose monetary policy arising from pressures caused by too much debt.  Gold isn’t really going up so much as fiat currencies are being devalued.  Speculators have increased their holdings of gold for four consecutive weeks. Possibly in response to the European sovereign debt crisis and indications from the Fed to expect continued loose monetary policy.  During the last reporting period net purchases were over 33k, brining the net long position to 188k contracts.  Non -commercial energy product accounts failed to increase their holdings of oil after the Fed conference, selling 4,500 contracts on a net basis, reducing the net long positions to just over 300k positions.  This is just 0.1 Standard Deviation below the one-year average.  Copper is clearly driven by what happens in China and there are a lot of concerns about what could happen there this year.  The IMF reported that China’s growth would be cut in half from a projected 8.2% in 2012 if Europe’s debt crisis worsens.  In defense against this, China will likely continue to ease up on their monetary policy, which will push the Shanghai Stock market index up and provide a tailwind to copper.

Food commodities down YoY

  • Corn down 4.5% up 0.2% YTD
  • Coffee down 13.9% down 5.3% YTD
  • Sugar down 25.9% up 3.9% YTD


  • Aluminum down 12.0% up 10.8% YTD
  • Copper down 15.7%% up 12.4% YTD
  • Gold up 27.4% up 9.6%
  • Silver up 15% up 19.9%


    • Brent up 14.1% up 6.1% YTD
    • Gasoline up 19%% up 7.9% YTD
    • Natural Gas up 19% up 7.9% YTD
    • Natural Gas down 41.1% down 15%