Supply and demand is always a key factor for commodities be they food, energy, metals or another kind. While oil supply-demand has been the big driver of commodity talk and companies from Kroger (KR) to Sprouts Farmers Market (SFM) are talking food deflation, all may not be well in the candy aisles this Halloween season given the current cocoa crunch. One has to wonder if candy shoppers will shift to non-chocolate varieties or try to once again reformulate their offerings. Good news for other parts of candy portfolios from The Hershey Company (HSY) and Tootsie Roll (TR), but not good for chocolate bars. Was that a collective sigh we just heard from half the US population?
A lack of beans and lower quality has limited grindings in producing countries and caused the price of cocoa butter, which accounts for about 20 percent of the weight of a chocolate bar, to spike ahead of the peak demand period, when chocolate makers are preparing for Halloween and Christmas. The cost of cocoa butter relative to bean futures, the so-called ratio, climbed 24 percent this year, according to KnowledgeCharts, a unit of Commodities Risk Analysis.
Despite all the central bank intervention to date, Japan’s manufacturing economy continues to contract. May manufacturing PMI for came in at a 40 month low with falling output and orders, which of course means Abe Shinzo sees it as a call to further stimulate the Japanese economy… sounds like more of the same (more debt, low to no growth) to us.
Japan will delay its planned sales tax hike for a second time, Japan’s Prime Minister Shinzo Abe announced Wednesday, while also detailing a new stimulus package for the economy this fall.
Last week Janet (I’m not tellin’) Yellen gave her annual two-day Congressional testimony, making it clear during Tuesday’s discussion that she wants to move away from the concept that Fed guidance is a pledge and appears to still prefer more tortoise than hare policy moves, assuring the markets that while the Fed will remove the word “patient” from its forward guidance at some point, that change in wording alone will be insufficient for investors to assume a hike is imminent, leave the markets fretting, “Damn it Janet, Yellen isn’t tellin’.”
Ms. Yellen reminded Congress of the Fed’s dual mandate under Humphrey Hawkins and pointed out that while employment has improved, the participation rate is lower than expected and wage growth remains sluggish, leaving room for improvement.
So according to Yellen’s testimony, part of the Fed’s dual mandate has made progress, but not enough. The dual mandate also refers to long-run growth and stable prices. For growth, Q4 was just revised down to 2.2% for 2.6% annualized. The exceptionally cold weather over much of the U.S. coupled with the West Coast port closures/work-slowdown give little hope for a strong Q1. For example, Macy’s (M) recently reported that while at year-end the port slowdown had not yet had a material impact, “Since then… inventory levels have been negatively impacted particularly in apparel and accessories. Approximately 12% of our first quarter merchandise receipts are being delayed and this will have some impact on our sales, gross margin and expense in the first few months of the year.” The recent posts on economic data, ISMs, retail sales, NAHB, NFIB, durables and even consumer sentiment have all lined up below expectations with payroll the only bright spot, but only time will tell if that was more reflective of a drop in productivity.
As for the stable price goal, which has evolved into a quest for around 2% annual inflation, the US Producer Price index is down 0.27% as of January on a year-over-year basis. US Core Producer Price index is up 1.76% as of January on a year-over-year basis. Consumer prices are also well below the target 2%.
While Ms. Yellen did say the Fed is becoming less patient with low rates, we continue to see this Fed as more dovish and the data isn’t screaming inflation or a potentially overheating economy. Additionally, once the Fed does start rate hikes, we don’t think it will follow its usually pattern of consistent hikes with every meeting after the increase is initiated. Lastly, even though the likely vector for rates is eventually higher, investors should focus on the velocity of those increases. The initial quarter point increase would only happen if the economy could digest it, how soon and how fast subsequent increases come is what will really matter.
What does this mean for investors? First, this time really is different. The Fed has never waited this long, (five years) into a bull market to raise rates, nor has the world ever seen so much monetary stimulus coming from so many of the largest central banks. Therefore, when looking at historical norms, they need to be discounted to a degree given just how far off the reservation we are this time…perhaps even as far as Peter Pan’s Never, Never Land.
Investors also need to take into account just how many central banks around the world have been cutting rates. In the past few months, 16 central banks have cut rates: Albania, Australia, Canada, China, Denmark, Egypt, Europe (ECB), India, Pakistan, Peru, Romania, Singapore, Sweden, Switzerland, Turkey and Uzbekistan! All of the G7 and China are moving towards easing while the US alone is contemplating tightening. Today government bonds of various maturities in about ten countries are selling at negative yields! People are buying guaranteed losses. While Ms. Yellen didn’t mention the strength of the dollar on Tuesday as she did in January, the Fed is most certainly aware that raising rates in the US, with so many negative yields around the world, would increase demand for the dollar, pushing the currency up even further, which while lovely for importers, is brutal for US exporters.
I have decided that it is time for me to come out of the closet. My colleagues have for months counseled me that it is a choice, that it doesn’t have to be this way, but after considerable introspection, I came to the conclusion that I was simply born this way and there is very little I can do about it. It is simply the way I’m wired. So here it is. I tend to think macro. There, I’ve said it.
Performance of global macro strategies have been rather poor over the past five years, much to my consternation, primarily due to a coordinated global monetary policy regime, (think Fed, ECB [European Central Bank], BOJ [Bank of Japan], and BoE [Bank of England]) that has squeezed out the historical patterns of difference between geographies and asset classes and done one heck of a bang-up job suppressing volatility. But recently, this changed. Macro funds were among the best performing strategies in September, with a gain of 1.1% on average. Monetary policies are becoming uncoupled. Divergent national growth rates are making the Fed and the BoE more hawkish and the ECB and BOJ more dovish. Now every major economic region is starting to have to fend for itself, giving macro strategies room to work, much to the relief of macro fund managers and strategists all over the world.
Now that you know my secret, I can confess I’m worried. “Yeah, yeah, what’s new?” you say. Fair enough, but that’s my job and this time, my fears are a little different. For years I’ve been nervous, like many, about the unintended consequences of all this quantitative easing. The straightforward assessment was that if the world became flooded with dollars, the value of the dollar would decline. For those who are long-time readers of this blog, you know that is a potential outcome that has been discussed at length. But over the past quarter or so there’s been a shift in the markets that has me looking at a different potential outcome.
As a woman with macro-tendencies, one of my guilty pleasures is talking with other macro-minded folk about the global dynamics we see emerging. One of my favorite partners for this is Raoul Pal, who I believe is one of the smartest chaps around. Raoul was commenting on the impact of the appreciating dollar and its potentially deflationary effects, which got me thinking. What if… just what if the flooding of dollars is more akin to a really savvy drug dealer?
An enterprising dealer would be wise to flood the market with say cheap dopium, so much dopium that people who normally wouldn’t even be interested sample it and find that it can help give them an extra kick in their day (yield) when injected into their blood (carry-trade). But they tell themselves they’ll only use for just this month’s really busy workload (challenging yield-generating environment). Once things get back to normal, (normalized interest rates) they’ll get clean. But the workload (financial suppression) continues to be challenging. Meanwhile the flow of dopium continues unabated, (QE continues and the dollar remains relatively stable). So what really is the risk with a solid and steady supplier?
Recently the dealer (Fed) has come to the conclusion that to continue pushing so much dopium, (flooding the market with dollars by buying nearly all the new Treasury bonds and even MBS issued every month) may eventually be problematic, but rather than be mobbed by crazy addicts (investors) the dealer (Fed) decides to try and slowly reduce the flow. Now anyone who’s found themselves staring nervously into an empty coffee cup during an interminable morning meeting with no potential for a refill in sight knows the power of addiction. Demand becomes increasingly inelastic, i.e. price becomes less and less relevant because you just need it, leading to….
After a period of relative stability, the USD has strengthened considerably, with the US Dollar Spot Index up nearly 9% since its recent low in early May. I think three of the biggest areas of concern with a rising dollar are the carry trade, emerging market equity performance and the commodities complex, particularly with respect to China.
Here’s how the carry trade works:
1.Funds and/or traders for very large institutions borrow dollars at relatively lower interest rates than those in emerging markets. These dollars are then converted into the currency of the emerging market for the desired bonds.
2.This emerging market currency is then used to buy bonds that have a much higher interest rate than the US. The difference between the two interest rates is referred to as “positive carry.”
3.The more traders that do this, the more the price of bonds in the emerging market rises, generating champagne worthy profits. This can get particularly profitable the more leverage is used.
If the dollar continues to strengthen against these currencies, then traders need more of the emerging market currency to pay off the interest and principle for the dollars borrowed and the greater the leverage, the worse the problem. As the dollar strengthens, the value of the carry trade unravels to the point of generating loss and this can happen in an accelerating manner if enough carry trades around the world need to be unwound simultaneously.
The second area of concern is emerging market equities, which have fallen dramatically in recent weeks, down over 9% since their recent high on September 5th and down 7.6% in the month of September alone, the most since May 2012, led by China and Hong Kong. The Japanese yen fell 5.1% in September versus the dollar to the weakest level since August 2008.
When emerging market stocks underperform relative to US equities with a strengthening dollar, additional pressure is placed on already vulnerable economies leading to further capital outflows.
The third area for concern is the commodity complex as commodities are primarily priced in dollars, so if you want to buy oil or copper, for example, you need to first convert into dollars. The stronger the dollar, the more of the non-dollar currency you need and the less oil and copper you get for each dollar. It’s all relative.
Now that I’ve come out of the closet she can openly put on her macro hat and look around the world and what we see is a lot of reasons to be nervous that a flight to safety could occur… and that means a further strengthening dollar, which itself is the very catalyst to cause the flight.China is facing an economic slowdown that ought to have everyone paying attention, particularly since they’ve used their commodity inventory as collateral for borrowing. With commodity prices like copper falling, down 8% since its recent July 3rd high and oil down nearly 15% since its June 12th high commodity collateral is under pressure. China’s political stability depends on continued economic growth. The renminbi is currently tied to the dollar, so a stronger dollar means a stronger renminbi, which means Chinese exports are relatively more expensive for their customers.
Granted, China is trying to develop its internal consumer consumption economy, but that takes time and it desperately needs to keep its people working and that work is dependent on people outside the country buying stuff made in China! So… would it really be all that surprising to see China alter its monetary policy to pull away from the dollar? For that matter, with the strains in the relationship between Beijing and Hong Kong from all these protests, might China also take steps to impact the Hong Kong dollar, a major source of strength for the island? Even just the fear of that possibility could result in a capital flight for all that mainland China wealth sitting in Hong Kong dollars.
Don’t forget how this affects Russia! That country’s oil revenues are its primary source of foreign currency reserves, which it needs to service its international debt. As these reserves come under pressure, so does Russian debt.
Just to top it off, European economies continue to struggle while in recent months the S&P500 has outperformed the major European market indices, again potentially leading to inflows into the US, increasing demand for the dollar. The lack of traction from the ECB’s latest QE attempts is only exacerbating concerns.
We’ve seen this story before, starting in 1981 in Latin America and then again in 1998 in Asia. While we think it is unlikely that this unwinding and potentially explosive dollar move up will happen in the very near term, there are a lot of factors in place to give it decent odds in the coming months, perhaps into early next year, albeit with the usual bumps along the way.
If the dollar strengthening story plays out, we would likely see the following:
•Negative impact on U.S. earnings (exports become relatively more expensive to non-U.S. buyers),
•Emerging markets would suffer from capital flight
•Commodities and commodity related-securities, (think oil companies, copper mining etc.) would suffer
•Earnings for Japanese and European exporters would benefit as their goods become relatively less expensive
•U.S. Treasury yields would fall…deflationary pressures increase
With all the talk about sovereign debt problems, from the PIIGS+ (Portugal, Ireland, Italy, Greece, Spain, and now Belgium) to the U.S. unsustainable debt trends, one would imagine that the cost of debt would show some of this concern. But we’ve recently seen yields drop significantly.
Why the decline? There has been a sharp drop in inflation expectations stemming from a clear decline in growth prospects in the developed countries for at least the remainder of the year. At the beginning of this year, the vast majority of investors thought government bond yields would rise consistently over the course of the year as economies recovered and growth rates normalized. But we’ve seen growth rates fall significantly below those initial forecasts, coupled with fears of how economies will fare as fiscal stimulus is withdrawn and quantitative easing in the States comes to an end.
Yours truly is ever watchful for rising inflation, but with a stalling economy, significant, sustained inflation is unlikely. What is more likely in the near to medium term are bouts of rising inflation expectations followed by deflationary expectations as the developed economies struggle to get back on their feet.
Bottom Line: This shows the importance of having a diverse portfolio because any “obvious” trend can reverse itself, particularly in these increasingly uncertain times, when governments are so heavily involved in the markets.
I like to keep things simple, (my wee little noggin can only handle so much) thus I generally agree with the Austrian School of Economics definition of inflation, which is simply an increase in the money supply. As I mentioned in my piece on fractional reserve banking, an increase in the money supply, all else held constant, will result in an increase in prices across the board. This is rather intuitive if you think of money as simply another commodity. Imagine an economy in which the money supply is just $100 and there are only 30 apples and 20 bananas available for purchase every day. This economy can be easily modeled as
$100 = A * 30 Apples + B * 20 Bananas (where A is the price of Apples and B is the price of Bananas)
$100 = 30A + 20B
Since Apples and Bananas are the only items available for purchase in this economy, the amount spent on apples and bananas together must be $100. If the supply of money is doubled to $200, the equation would look like this.
$200 = 30A + 20B
Since the quantity of apples and bananas has remained unchanged, their prices (A & B) must go up.
So what’s all the talk about potential hyper-inflation these days?
Starting with the collapse of Lehman Brothers in September of 2008, the Federal Reserve more than doubled its balance sheet in only three months by financing its credit extensions using the electronic equivalent of printing money. At the beginning of September 2008 the Fed has $894 billion in assets, by December 17th that number rose to $2.24 trillion and now stands at $2.17 trillion. This unprecedented expansion resulted in an increase in the reserves credited to banks and a corresponding increase in the Fed’s assets. To create these reserves the Fed essentially purchased mortgage securities from the banks for 100% of the original loan amount by giving the banks credit for those mortgages in their reserve accounts as part of the bank bailouts.
As I mentioned in an early blog post, typically in the U.S. we see a 10x multiple on reserves, meaning for every $1 increase in reserves, we expect to see a $10 increase in the money supply. That has not yet occurred because for an increase in reserve funds to make their way into the economy, lenders need to be willing to lend against their reserves and borrowers need to be willing to borrow. With unemployment continuing at record high levels, households shifting from consumption to savings, and paying down outstanding debts, the demand for consumer loans is lacking. With corporations cautious about future expansions, commercial lending demands are also lower. Once demand for loans increases and banks are more confident in their own balance sheets, we could see significant increase in the money supply, which means inflation. The Fed claims to be watching for indications of this and have stated that they are willing to respond quickly by raising rates. An increase in the rate the Fed pays banks decreases the supply of money in the economy because banks and more willing to leave money in their reserves, earning interest from the Fed, rather than lending it out.
Now back to the Federal Reserve’s balance sheet. The loans the Fed “bought” from the banks are expected to be worth less than the original loan amount. Nearly 10.7 million households, or about 23% of U.S. homeowners owe more on their mortgages than the properties are worth. In addition, the states with the highest rate of underwater mortgages are, and most likely not coincidentally, non-recourse mortgage states, meaning borrowers are not held personally liable for more than the home’s value at the time that the loan is repaid. It is also highly unlikely that the Federal government will go after individual homeowners to recoup losses on underwater loans. This calls into question the quality of the assets owned by the Federal Reserve, which is of great concern to holders of U.S. debt. As we’ve seen the quality of sovereign debt globally come into question, the interest rate at which the United States is able to issue debt could rise if the perceived quality of our debt is lowered. With 71% of the marketable debt held by the public due by 2014 AND 40% individual income tax receipts already going to pay the interest on existing debt, an increase in interest rates on US debt could harm the economy, which puts the Fed in between a rock and a hard place when it comes to raising rates.
As of December 16th, 2009 the total outstanding public debt was $12.1 trillion while interest on the debt for 2009 was $383 billion (source Treasury Direct). Individual income tax receipts are estimated to be $953 billion for 2009, which means interest payments accounts for 40% of individual income tax receipts.
Data Source: Office of Management and Budget, Budget of the US Government FY 2010, Historical Tables, Table 7.1
Source: November 2009 GAO Financial Audit, Bureau of the Public Debt’s Fiscal Years 2009 and 2008 Schedules of Federal Debt (GAO-10-88)