Monday 30 September 2013

Credit - The Rambler

"Men more frequently require to be reminded than informed.", Samue Johnson, The Rambler (1750-1752).
While last week we asked ourselves if equities had not become indeed "the last refuge of the yield/returns scoundrels" given the recent inflows into the equities sphere and the "Cantillon effect" with the bubble inflated by the "wealth effect" courtesy of Ben Bernanke's, we decided this week to make another reference to English writer Samuel Johnson. 

Yes, in our numerous posts, we have indeed on many occasions been frequently "rambling". It was therefore necessary for us to pay homage to Samuel Johnson, due to the fact that some of our friends and readers have frequently told us that because of our many references to past writings we have become somewhat some kind of a "rambler". We do agree. 

But, as Samuel Johnson's quote goes, we have preferred reminding than informing as we have often based our thought process on the following premises: 
"-He who has the gold, does not always make the rules.
-The market does not learn for long.
-Human nature does not change."

When it comes to human nature and "Cantillon effect" leading to the formation of bubbles in risky assets, one might rightly ask if the last refuge of the scoundrels, being equities, are "fully valued" or not?

This week we will therefore focus our attention on "valuations".

The "Cantillon effect" at play, the rise of the Fed's Balance sheet, the rise of the S&P 500, the rise of buybacks and of course the fall in the US labor participation rate (inversely plotted) - source Bloomberg:
In red: the Fed's balance sheet
In dark blue: the S&P 500
In light blue: S&P 500 buybacks
In purple: NYSE Margin debt
In green: inverse US labor participation rate.

On that subject, Nomura's Macro Systematic Snapshot from the 26th of September made some interesting points:
"Are equities "fully valued"?
-Some high profile US investors have recently claimed equities are "fully valued".
Figure 1 shows our global aggregate value measure which has been gradually increasing since the end of 2012. 
Globally, stocks are not as expensive as they were in 2007/8 but are approaching similar levels. One caveat: this measure is based on free cash flow yield, which excludes financials. And financials look generally cheap.
-There are large regional differences in valuation. US and Japan look expensive whereas Europe and Asia ex-Japan look more fairly priced.
-This is consistent with our corporate fundamentals class where US looks weaker while Europe looks more robust.
-However, value is not the only style in town and our momentum and carry signals are more bullish leaving us net long in many markets including S&P 500 and Eurostoxx."  - source Nomura

When one looks at the relative performance of the S&P 500 versus MSCI Emerging, one can easily see EM equities have been clearly lagging. Emerging markets (MXEF). Emerging Markets have continued to underperform developed markets  - source Bloomberg:
While the absolute spread between the S&P 500 and MSCI Emerging Markets has touched a record low level in the middle of May this year, 

In our early September conversation "The Tourist Trap" we argued:
"Yes, the bounce in Emerging Markets has indeed occurred in the past after similar redemptions, but we disagree with Bank of America Merrill Lynch. We have not seen the bottom yet, and that the rebound could probably materialize at a later stage, maybe in 2014."

But, looking at the most recent inflows and the improvement we have seen towards Emerging Markets, with the lack of "tapering" leading to a compression in the 10 year US Treasury yield, had led us to reassess our current stance towards Emerging Markets. The following chart from Bank of America Merrill Lynch Flow Show from the 26th of September is indicative of the sentiment upturn:
"Weekly flows show that the Fed decision of no-taper has caused 3% to become the "ceiling" for UST10, which in turn has granted a reprieve for all the summer tapering victims. Highlights include:
-Biggest inflows to bond funds in 5 months ($4.5bn)
-First inflows to unloved EM debt funds in 18 weeks ($0.6bn)
-First inflows to Muni funds in 18 weeks (albeit small $59mn)
-Largest inflows to IG bond funds in 17 weeks ($1.0bn)
-And, for first time in 7 months EM equity inflows coincided with DM equity outflows"
- source Bank of America Merrill Lynch

And from a valuation point of view, and contrarian stance, we would have to side on Barclays take, from the 26th of September in their Equity outlook entitled "Looking beyond the US":
"• Emerging market equities in particular now appear very cheaply priced relative to their US peers, while EPS upgrades may support European stocks. In Japan, the central bank’s very determined policy easing has yet to be fully reflected in the relative performance of that market.
• So for differing reasons, we suspect that non-US equities will prove more rewarding for investors than those listed in the US.
The relative performance and valuation of emerging market stocks is especially striking. As Figure 5 demonstrates, since their relative high point in October 2010, emerging markets have underperformed the world index (ex-EM) by 31% and sit at relative levels last seen at the height of the global financial crisis.

The relative valuation attached to emerging market equities has also collapsed. As Figure 6 shows, the price/book multiple is now 40% below that of the US market. This is the cheapest they have been since 2004.
- source Barclays

MSCI EM versus Nikkei - source Bloomberg:
So we could indeed see a continuation of the bounce in Emerging Markets to the pleasure of the "yield/returns scoundrels" particularly in the fixed income space.

But as per our "rambling habits", in numerous conversations, we pointed out we had been tracking with much interest the relationship between Oil Prices, the Standard and Poor's index and the US 10 year Treasury yield since QE2 has been announced - graph source Bloomberg:
Back in April 2013 we argued in our conversation "The Awful Truth" the following:
"The decline in the oil price may prove to be another sign of deflationary pressure and present itself as a big headwind. Why is so?

Whereas oil demand in the US is independent from oil prices and completely inelastic, it is nevertheless  a very important weight in GDP (imports) for many countries. Monetary inflows and outflows are highly dependent on oil prices. Oil producing countries can either end up a crisis or trigger one.

Since 2000 the relationship between oil prices and the US dollar has strengthened dramatically.  As we highlighted in our conversation in May 2012 - "Risk-Off Correlations - When Opposites attract": Commodities and stocks have become far more closely intertwined as resources have taken on a greater role with China's economic expansion and increasing consumption in Emerging Markets."

We also quoted Bank of America Merrill Lynch on the subject:
"Whether it is high energy costs, expensive labor costs, a rising cost of capital, declining profitability, or misdirected investment into unproductive assets, the dislocations created by five years of zero interest rate policy in DMs will likely have some negative consequences in EMs. With oil demand growth exclusively supported by buoyant EM growth for years, lower global GDP trend growth (say from 4% down to 3%) could push Brent firmly out of the recent $100-120/bbl band into a lower $90-100/bbl range." -source Bank of America Merrill Lynch  - 17th of April 2013.

So could it be that the recent rebound in Emerging Markets has more road to make or is it only a temporary relief?

To that effect, we think shipping is still indicative of the powerful deflationary forces at play, which so far have prevented the Fed from "tapering", giving much need relief to many risky assets classes and are sending conflicting informations. On one hand, shipping rates continue to be weak for 40-foot containers as indicated by Bloomberg:
"Shipping rates for 40-foot containers (FEU) fell 7.9% sequentially to $1,665 for the week ending Sept. 26, the third straight decline, according to World Container Index data. Weakness was driven by Asia, with rates from Shanghai to Rotterdam falling 19% to $1,703, followed by a 14% decline in Shanghai to Genoa and a 1% decrease in the Shanghai-to-Los Angeles routes. Rates were mostly unchanged for freight moving between New York and Rotterdam." - source Bloomberg

On the other hand, the Baltic Capesize Index as increased by 114% to 4,018 since the 1st of August as reported by Bloomberg:
"The Baltic Capesize Index has increased by 114% to 4,018 since Aug. 1, spurring debate about whether the worst is over for the dry bulk market. Capesize vessels have outperformed panamax (up 38%), supramax (up 5.7%) and handysize (up 5.1%), and the broader Baltic Dry Index, which has climbed 79.3% in the same period. Shipping bulls and bears are debating if the move has been spurred by seasonality or if there is some sustainable demand behind the move." - source Bloomberg

For some, like ourselves, the relief rally can only be temporary given the deflationary forces at play and the on-going deleveraging, which is also indicated by Bloomber Chart of the Day when it comes to shipping as a leading indicator and valuation indicator:
"The biggest rally in iron-ore freight costs since 2009 is temporary and traders should bet against it lasting because there’s still a ship glut, according to an analyst who predicted the industry’s worst slump.
The CHART OF THE DAY shows, in white, how spot rates for iron-ore carrying Capesize ships rose to 34-month high of $42,211 a day on Sept. 25, one month after China’s imports of the commodity from Brazil, in purple, rose to the highest since February. Freight costs will slump 55 percent in the next three months, according to Sverre Bjorn Svenning, a director at Fearnley Consultants A/S, a research company in Oslo, who says he’s been bearish since 2007, the record year for average rates.
Brazil’s iron-ore producers accelerated exports of the commodity in July and August, compensating for shipments that slumped to a two-year low in June, Svenning said by phone today. Demand for ships will be curbed because the expansion in cargoes won’t continue at the same rate, he said. Total capacity of commodity-carrying ships expanded 62 percent since 2008, during which time global trade in the steelmaking raw material grew 40 percent, data compiled by Bloomberg show. “I can’t see that underlying demand can sustain the massive fleet,” Svenning said. “There was a massive tsunami of delivery of new vessels in 2009. The market will come off again.” His estimate for the fourth quarter is for rates to average about $19,000 a day, 34 percent below freight swaps that investors use to bet on, or hedge, future shipping prices. They traded at about $29,000 a day as of 10:21 a.m. today in London, according to data from Clarkson Securities Ltd." - source Bloomberg

While no doubt the Baltic Dry Index has indeed broken ou from its downward channel at a rapid pace since August - graph source Bloomberg:
"The dry-bulk market, which accounts for about 50% of shipped freight, is driven by steel demand, as iron ore and coking coal make up about 40% of volumes. Utility coal, grain, bauxite-alumina and phosphate are also major dry-bulk commodities. The Baltic Dry Index, a major barometer for the industry, has more than doubled ytd." - source Bloomberg

Overall the shipping industry continues to be plagued by overcapacity as the overbuilt legacy from the credit bing days continues to be dealt with - graph source Bloomberg:

When it comes to shipping and the conflicting message sent across, it might be just a case of a market of a market over extending its gains based on future expectations which have been distorted by ZIRP policies, hence the over optimistic reaction since August in that space. Last time the gap between the order book for bulk vessels and the US recession was one year. Once again, we are left wandering if the very large gap between the number of bulk vessels on order and the bulk vessel orderbook as a percentage of capacity is not a reflection of yet another "Cantillon effect" transmitted by ZIRP to the shipping industry - graph source Bloomberg:

 So from a valuation point of view and looking at the recent evolution in shipping it appears to us very difficult to point to a strong rebound in the near terms for Emerging Markets equities, although valuations for some do appear clearly enticing.
"Shallow men believe in luck. Strong men believe in cause and effect." - Ralph Waldo Emerson, American poet.

Stay tuned!

Tuesday 24 September 2013

Chart of the Day - Correlation between Small-cap earnings growth and the US economy

"An explanation of cause is not a justification by reason." - C. S. Lewis 

Our Chart of the Day is the correlation between Small-caps earnings growth and the US economy given the Russell 2000 is at all-time high and comes from a note from Bank of America Merrill Lynch from the 24th of September entitled "No taper talk has given boost to small - nearing 1100 target":
"The Fed realizes that the US economy is not growing as fast as they have forecasted and if this remains the case,it would hurt small caps more so than large caps."
"No taper = slower US economy, bad for small.
The reason the Fed chose not to taper their QE program was the fact that the economic data of late has been weaker than expected. In fact based recent economic indicators the US economy is tracking at about 1.6% and below the BofAML’s forecast of 2.0% and a higher consensus number. Earnings estimates for the third and fourth quarter are based on a reacceleration of US growth and if this down not come to fruition, it will impact small more so than large. The correlation between US GDP, based on four quarter moving average, and smallcap earnings growth stands at 0.69, while it is lower for large caps (Chart 6)." - source Bank of America Merrill Lynch

So for the Russell to stay above the clouds, we better get US growth otherwise all bets are off...

"Shallow men believe in luck. Strong men believe in cause and effect." - Ralph Waldo Emerson 

Stay tuned!

Saturday 21 September 2013

Credit - The last refuge of a scoundrel

"We love to expect, and when expectation is either disappointed or gratified, we want to be again expecting." - Samuel Johnson, English author.

While looking with interest the Fed losing its nerve or credibility in its "Forward Guidance" and generating with much abandon "uncertainties" on "Future Expectations" in regards to its "tapering" stance, we thought this week, we would make a veil reference to Samuel Johnson's famous quote:
"Patriotism is the last refuge of the scoundrel."

A scoundrel being by definition villainous and dishonorable, when one looks at the "Cantillon Effects" of Ben Bernanke's wealth effect, no doubt that the big beneficiaries of the Fed's liquidity "largesse" has benefited the most to Wall Street's "scoundrels" as so clearly illustrated by Bank of America Merrill Lynch in their recent note entitled "Tinker, Taper, Told Ya, Buy" from the 12th of September which we already displayed last week:

And if one looks at the recent inflows into the equities sphere, we wonder if equities have not become indeed "the last refuge of the yield/returns scoundrels" hence our chosen title.
"Biggest weekly inflows to equity funds on record ($26bn - Chart 1) driven by massive ETF inflows to SPY, IWM, EEM, GDX ahead of yesterday's dovish FOMC; big pre-FOMC short-covering 8th straight week of rotation/redemptions from bond funds: past 4 months $173 billion redemptions still pale in comparison to stunning $1.4 trillion inflows from Jan'09 to May'13 (Chart 2);
risk/surprise going forward is bond outflows continue despite Fed no taper (would imply Fed credibility down/risk premia up)" - source Bank of America Merrill Lynch - 19th September 2013 - The Flow Show - Record Equity Flows.

Of course, as we posited last week "Cantillon effects" describe increasing asset prices (asset bubbles) coinciding with "exogenous" liquidity induced central bank money supply. We were taken aback by Saint-Louis Fed Bullard comment:
“Using the pace of purchases as the policy instrument is just as effective as normal monetary policy actions would be in normal times,” he concluded.  “In other words, QE is an effective way to conduct monetary stabilization policy.”

We beg to differ from the Fed's view. We think not "tapering" by 5 billion as per market's expectations was a blunder and sent the wrong message. 

We agree with Bank of America Merrill Lynch from their report "Bubbling his way out of Trouble" from the 18th of September when they say the following:
"The liquidity supernova continues...and so does the Wall St. boom. In our view, the longer Main St. takes to recover, the greater the risk of asset bubbles. Equity fund inflows this week are running at record levels, investor cash levels are high, US stocks are at all-time highs and today Priceline became the first S&P 500 issue ever to trade above $1000." - source Bank of America Merrill Lynch.

This week we will therefore focus our attention to the increasing risks induced by the continued "dovishness" of our central bankers sorcerer's apprentices. 

We have long argued that the Fed is continuing on a "wrong" path and ignoring basic relationship such as Okun's law and the prolonged negative effects of ZIRP on the labor force (capital being mis-priced, it is mis-allocated to speculative purposes rather than productive purposes):
"In economics, Okun's law (named after Arthur Melvin Okun, who proposed the relationship in an empirically observed relationship relating unemployment to losses in a country's production. The "gap version" states that for every 1% increase in the unemployment rate, a country's GDP will be roughly an additional 2% lower than its potential GDP." - source Wikipedia

To that effect we wanted to illustrate more clearly this week the "Cantillon effect" of Bullard's effective way to conduct monetary "stabilization" policy, so, we plotted on Bloomberg not only the rise of the Fed's Balance sheet, but also the rise of the S&P 500, buybacks and of course the fall in the US labor participation rate (inversely plotted) - source Bloomberg:
In red: the Fed's balance sheet
In dark blue: the S&P 500
In light blue: S&P 500 buybacks
In purple: NYSE Margin debt
In green: inverse US labor participation rate.

We think this graph clearly illustrates the Fed's conundrum in the sense that with the Fed's dual mandate of promoting "maximum employment" since 1978, it cannot promote both employment and sustain the "wealth effect" through capital growth with ZIRP. The Fed tried to increase jobs by lowering interest rates, weakening the dollar in the process, boosting exports but exporting inflation on a global scale, as well as lifting stock prices, playing on the wealth effect game.
Something will have to give.

ZIRP, we think is the main culprit. 

As reported by in their latest post "Could rising rates fuel credit growth in the US?", we also agree with Deutsche Bank, that moderately higher rates would indeed improve not only lending but labor, as well as pension liabilities for corporations from a long term perspective.
"This may seem counterintuitive, but Deutsche Bank’s researches argue that "moderately" higher rates may actually improve lending. This certainly contradicts the traditional school of thought followed by the Fed, who seemingly became spooked by the recent rate spike." - source

As we posited in our conversation "Alive and Kicking":
"Counter-intuitively, rising yields should benefit US companies suffering from ZIRP due to rising  Pension Funding Gaps which have not been alleviated by a rise in the S&P 500."

And a reminder from our conversation "Cloud Nine":
"If we look at GM and FORD which went into chapter 11 due to the massive burden built due to UAW's size of "unfunded liabilities", they are still suffering from some of the largest pension obligations among US corporations. Both said this week they see a significant improvement in their pension plans liabilities because of rising interest rates used to calculate the future cost of payments. When interest rates rise, the cost of these "promissory notes" fall, which alleviates therefore these pension shortfalls. So, over the long term (we know Keynes said in the long run we are all dead...), it will enable these companies to "reallocate" more spending on their core business and less on retirees. Charles Plosser, the head of Philadelpha Federal Reserve Bank, argued that the Fed should have increased short-term interest rates to 2.5% in 2011 during QE2."

If capital cannot be re-allocated to "productive" endeavors, enabling companies to focus their resources on their core business, how can labor thrive in such a ZIRP environment? Please feel free to explain us how.

In continuation to's Deutsche Bank reference, from their note from the 20th of September 2013 entitled "Fed's fear of higher rates is overblown", we would like to point out some of their additional comments on the subject of higher rates:
"Higher rates are a source of strength, not weakness. To the extent that interest rates have risen on the expectation of less quantitative easing (QE) as the result of a healthier labor market, higher yields are a positive development because they reflect more robust economic conditions. The yield on the 10-year Treasury note is up about 100 basis points (bps) from its intrayear low. (Long-term corporate and mortgage rates are up by a similar amount over this timeframe.) Given that the move higher was mainly in response to better labor market data, which was the catalyst behind Mr. Bernanke’s comments that the pace of quantitative easing could begin to slow by year end, we do not believe it is currently having a deleterious impact on growth. As long as interest rates are increasing for the right reasons, in this case an improving labor market, then higher rates are a positive development for the economic outlook. Only when interest rates rise to prohibitively high levels will we begin to worry about their effect on the economy. In this case, we would be looking at long-term real yields up around 3.5% to 4%, but this situation will not happen until the Fed is actually well into a monetary tightening cycle. And even based on our above-trend growth forecast, with the unemployment rate falling to 7% by yearend 2013 and 6.4% by yearend 2014, monetary tightening is still a long way away. Thus, investors and the Fed should not agonize over the year-to-date rise in bond yields." - source Deutsche Bank.

What effectively the Fed has done in its latest blunder is to increase a probability of a much nastier bubble burst and a much more pronounce reaction from risky assets markets in the process. 

They have indeed made the problem down the line much bigger by not starting to take away the proverbial "punch bowl". We therefore agree as well with Deutsche Bank's concluding remarks:
"In conclusion, Fed policymakers refrained from taking a first small step toward policy normalization this week, as they remain fearful the economy is not strong enough to handle a slower pace of monetary accommodation. For reasons we discussed above, the backup in rates has not been significant enough to dent our expectations of an interest-sensitive led improvement in economic growth. Rates remain extraordinarily low, and if growth finally surprises to the upside later this year, a modest tapering of quantitative easing will commence. In the interim, long-term interest rates are poised to trend higher, reflecting these improving growth prospects. This runs the risk that when the Fed finally begins tapering, monetary policymakers witness a larger and more negative response than they might prefer." - source Deutsche Bank

And if history is could provide some "Forward Guidance" for US yields, we wanted to illustrate the evolution of the US 10 year yields from the 29th of September 1929 until the 29th of June 1949:
Graph source

Of course the key data the Fed is watching in order to start considering "dipping its toes" into normalization comes from housing as indicated by Deutsche Bank in their report:
"It would be highly unusual for builder sentiment to rise so aggressively if the sector were about to falter in the face of higher mortgage rates. The reason for this is because there is very little supply of newly constructed homes for sale and demand is recovering as the labor market normalizes and household income prospects improve. 
To be sure, higher mortgage interest rates make housing less affordable, all else being equal, but affordability is a function of house prices and income, as well. The National Association of Realtors’ Housing Affordability Index (also shown nearby) illustrates an important point in this regard. Despite the 125 basis point increase in mortgage rates year-to-date and a steep increase in home prices (10%+), housing affordability remains higher than at any point in the prior four decades—barring the ultrahigh ultrahigh levels of the past two-to-three years. 
Until affordability returns to average (or below), home buying conditions remain favorable for further improvement in prices and sales volumes." - source Deutsche Bank

Housing is indeed essential in order to assess the solidity of the "recovery" and as we reminded ourselves last week from our January conversation entitled "The link between consumer spending, housing, credit growth and shipping - A follow up":
"If there is a genuine recovery in housing driven by consumer confidence leading to consumer spending, one would expect a significant rebound in the Baltic Dry Index given that containerized traffic is dominated by the shipping of consumer products."

We therefore monitor credit and shipping very closely, but also the activity in the freight derivatives markets in order to gauge a potential rebound in global growth which seems to be anticipated as indicated by Bloomberg's recent Chart of the Day, to point to an anticipation in the global trade:
"Trading of freight derivatives is near a five-year high as hedge funds return to the market in anticipation that surging charter rates for the largest iron ore-carrying ships signal a global economic rebound.
The CHART OF THE DAY shows trading in forward freight agreements, used to bet on future shipping costs, reached the highest level since October 2008 this month, according to the Baltic Exchange, the London-based publisher of rates on global maritime routes. Hire costs for Capesize vessels jumped almost sixfold since the end of May, its data show.
Rates are rallying as China replenishes stockpiles of iron ore, a steelmaking raw material and the largest dry-bulk cargo hauled at sea. That’s drawing hedge funds and other investors back to the market, said Alex Gray, chief executive officer of Clarkson Securities Ltd., the derivatives unit of the world’s largest shipbroker. Capesize rates are still down 88 percent from the peak in June 2008.
“There’s no other commodity market out there that goes up five times multiples,” Gray said. “Freight is considered to be a very good bellwether for worldwide growth. Investors are looking at the freight market moving once again and saying, ‘Is this the beginning of something big?’”
While port congestion and delays are helping to lift rates, stronger Chinese demand can’t be ignored, Gray said. Steel production in China rose to a record 91.9 million metric tons in August, data compiled by Bloomberg show. Iron-ore imports gained to 69 million tons last month, within 6 percent of July’s all- time high, according to customs data.
Volume and open interest for dry-bulk freight swaps rose to 50,363 lots in the week ended Sept. 9, according to the Baltic Exchange. That was the highest level since the 50,445 lots tallied in the week of Oct. 20, 2008, its data showed. Daily Capesize rates as gauged by the exchange were at $29,186 yesterday, compared with $5,171 at the end of May." - source Bloomberg.

Of course when it comes to our market scoundrels and the Fed, gradually removing the "liquidity addiction" from our sugar-rushed equity markets is not going to be as easy as it was to initiate the "Cantillon effect" and its "inflationary" effects on risky assets as displayed in the below Bloomberg graph:
- source Bloomberg.

In similar fashion to QE2, QE3 triggered a significant rise in Inflation Expectations, but since the beginning of the "tapering" talks in May,  both inflation expectations as illustrated by the evolution of the 10 year US Breakeven and Gold have been sent packing, until the "untaper" time as of July which saw a significant rebound in both - graph source Bloomberg:
Of course, if you don't know where the Fed's compass is going to spin, you play the put-call parity game which is long gold (inflation and end of the dollar status) and long bonds (deflation).

Dollar index versus Gold - graph source Bloomberg:
The Fed postponing its "tap dancing" has led to a weakening of the Greenback and a bounce back of gold in the process.

On a final note, in these jitteriness, Japan has continued to shine, and we expect Japan to continue to do so to the benefit of our market scoundrels - graph source Bloomberg:

Helped by lower volatility and has indicated by tighter spreads in the Itraxx Japan - graph source Bloomberg:

For a simple reason: labor cash earnings growth - graph source - Datastream / Fathom Consulting:

"Knowledge is of two kinds. We know a subject ourselves, or we know where we can find information upon it." - Samuel Johnson, English author.

Stay tuned!

Thursday 19 September 2013

Chart of the Day: No bank Fed tightening

"Facts are stubborn things; and whatever may be our wishes, our inclinations, or the dictates of our passions, they cannot alter the state of facts and evidence." - John Adams, American President

Following the Fed's tinkering with "tapering", our Chart of the Day comes from Bank of America Merrill Lynch's note entitled "Bubbling his way out of Trouble" indicating the following:
"The Fed may taper once housing sustainably picks up. But in our view it is very unlikely to tighten until banking sectors around the world start lending again."
- source Bank of America Merrill Lynch

In their note they also make a very important point in relation to corporate cash levels:
"Fed’s asset price reflation has yet to cause corporate cash levels to fall. This may not be the Fed’s fault. Significant uncertainty over tax, health & regulatory policies as well as muted bank lending are
better explanations for the lack of corporate “animal spirits”. Until they perk up, Fed interest rates will likely remain extremely low."
- source Bank of America Merrill Lynch

In that context, as we argued in our conversation "Misstra Know-it-all":
"If the policy compass is spinning and there’s no way to predict how governments will react, you don’t know whether to hedge for inflation or deflation, so you hedge for both. Buy put-call parity, if there is huge volatility in the policy responses of governments, the option-value of both gold and bonds goes up."

Bonds are an option on the short-term interest rate, and gold is a perpetual put option on the dollar.

"If there is huge volatility in the policy responses of governments, the option-value of both gold and bonds goes up."

"All the perplexities, confusion and distress in America arise, not from defects in their Constitution or Confederation, not from want of honor or virtue, so much as from the downright ignorance of the nature of coin, credit and circulation."- John Adams, American President

Stay tuned!

Saturday 14 September 2013

Credit - The Cantillon Effects

"Labour was the first price, the original purchase - money that was paid for all things. It was not by gold or by silver, but by labour, that all wealth of the world was originally purchased."- Adam Smith 

Last week, we concluded our post by indicating of one of our "outside the box indicator" namely Sotheby's stock price versus world PMIs since 2007 - graph source Bloomberg:
We argued that the performance of Sotheby’s, the world’s biggest publicly traded auction house was indeed a good leading indicator and has led many global market crises by three-to-six months.

Of course, our reference to this "outside the box" relationship was by no mean "innocent". In fact it was the perfect way for us to justify this week's chosen title given that "Cantillon effects" describe increasing asset prices (asset bubbles) coinciding with an increasing "exogenous" (central bank) money supply.

So why choosing art as a reference market in describing Cantillon effects and asset bubbles you might rightly ask? 

Well, as posited by a very interesting study by Cameron Weber, a PhD Student in Economics and Historical Studies at the New School for Social Research, NY, in his presentation entitled "Cantillon effects in the market for art":
"The use of fine art might be an effective means to measure Cantillon Effects as art is removed from the capital structure of the economy, so we might be able to measure “pure” Cantillon Effects.

In other words, the “Q” value in the classical equation of exchange is missing all together for the causal chain, thus an increase in the money supply might be seen to directly affect the price of art.

Economic theory is that as money supply increases, the “time-preferences” of art investors decreases (art becomes cheaper relative to consumption goods) and/or inflationary expectations mean that art investors see price signals (“easy money”) encouraging investment in art." - Cameron Weber, PHD Student.

Nota bene: Classical equation of exchange, MV = PQ, also known as the quantity theory of money. Quick refresher: PQ = nominal GDP, Q = real GDP, P = inflation/deflation, M = money supply, and V = velocity of money.
-Endogenous money, PQ => MV (Hume, Wicksell, Marx)
-Exogenous money, MV => PQ (Keynes, Monetarist)

In our Cantillon Effects, we get:
Δ M  => Δ Asset Prices

"Austrian Business Cycle Theory Misunderstands Endogenous Money.  Like many other economic schools of thought, Austrian economics is predicated on a loanable funds model with a world view designed to demonize just about everything the central bank does.  As I’ve explained before, the primary purpose of the central bank is not a conspiratorial attempt to enrich bankers, but to help oversee and regulate the smooth functioning of the payments system." - Cullen Roche
As far as we are concerned, if economy is a "religion" then we are agnostic, but, we do believe that, there are some points which are valid in some theories, Austrians included.
By no mean, we would like to enter into endless economic arguments. We have no point to prove, just common sense to display. 
Our objective in this week's conversation, is rather to expand our vision (and maybe yours) to our understanding of "Cantillon effects", asset prices bubbles and "mis-behaviors" of markets (in true Mandelbrot fashion that is...).
"Cantillon effects" in the market for art:
"Money supply is “M1” based on methodology used by Bessler 1984 and Devadoss  & Meyers 1987, in order to compare results of Cantillon Effects versus money supply effects on output prices.
Art data based on 1,336 repeated sales from 1830 – 2007 on the London market. 
Data provided by Goetzmann et al 2010, data commonly used by cultural economists to measure returns to art versus other assets, updated by Goetzmann et al for error correction, contemporary art (1960s onward) and a more recent method for inflation indexing.
We find two distinct periods of monetary history, leading to the need for data bifurcation between the pre-war Classical Gold Standard (1830 – 1913) and the post-war central-banking era (1946 - 2007)."
 - source Cameron Weber, PhD Student in Economics and Historical Studies.

From the same study from Cameron Weber we learn the following interesting point:
"Bessler 1984 and Devadoss & Meyers 1987 use a VAR log likelihood model to estimate the most likely lagtimes between a monetary change and effects on output prices.  They find (using monthly data) that the most likely lagtime is 13 and 14 months with a rapidly dissipation of the price increase immediately following the most likely effect.

Using the same methodology we find that the most likely effect of a money supply change on art prices is also between the 13th and 23rd month (e.g., during the 2nd year using yearly data).

However, unlike the earlier work on output prices, we find that the effect on art prices does not decay rapidly after the monetary increase, showing perhaps that money changes are cumulative (and/or have momentum) and could lead to an ‘asset bubble’."  - source Cameron Weber, PhD Student in Economics and Historical Studies.

The most interesting part of using the art market as a "proxy" for asset bubbles is indeed that money changes (namely the monetary base) leads to the creation of "asset bubbles".

Back in December 2010, in relation to the launch of QE2, in our conversation "Inception - Bernanke's QE2 Experiment" we argued:
"Like in the movie Inception, the Fed is trying to plant an idea into people's mind. Bernanke idea's with QE2 is to create a wealth impression which would increase consumption and economic growth, with the help of rising assets prices. We had the Greenspan put and the Bernanke put, we also now have to contend with the same bubble creation plan which was initially followed by Alan Greenspan.
We all know now the results of creating asset bubbles and the consequences.
It is a very dangerous game." - source Macronomics.
And as we posited in our January conversation "If at first you don't succeed...": 
"Arguably the strategy of our "Sorcerer's apprentice" has been to try to induce a rise in velocity, but, we have shown in our post "Zemblanity" that the "relationship" between US Velocity M2 index and US labor participation rate over the years is clearly indicative of the failure of the theories of Friedman and Keynes because central banks have not kept an eye on asset bubbles and the growth of credit and do not seem to fully grasp the core concept of "stocks" versus "flows." - source Macronomics
Another illustration of the cumulative effect in the change of money leading to asset bubble has been clearly illustrated by the housing bubble leading to the financial crisis given we are now at the 5 year anniversary mark. 
Once again "Cantillon effects" were at play as clearly demonstrated by Cameron M Weber, Cameron Weber, a PhD Student in Economics and Historical Studies, in the following abstract - "The Economic History of the Recent Financial Crisis Using Cantillon and Intervention Effects as a Basis for Explanation":
"This research uses Cantillon effects and institutional, policy, incentives created in the market for home purchases in the US to show correlation and causation between an increase in the quantity of money and an increase in home prices during the housing “boom” and the subsequent financial collapse based on the “bust” of the housing boom. Initial results show that the FHA policy initiated in 1998 to encourage 0% down-payment mortgages for housing triggered a relationship between an exponential growth in housing prices with that of an exponential increase in the money supply. Initial results also show that this structural relationship ended in May 2006 when the SEC declared “accounting irregularities” at Fannie Mae, which also coincides with the downturn in housing prices." - source Cameron Weber.
When it comes to the current market conditions and "Cantillon Effects", and asset bubbles, as well as other valid economic theories, Keynes coined the term "Animal spirits" in his 1936 book "The General Theory of Employment, Interest and Money" to describe the instincts, proclivities and emotions that influence human behavior, consumer confidence, as well as speculation:
"Even apart from the instability due to speculation, there is the instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rather than mathematical expectations, whether moral or hedonistic or economic. Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits—a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities." - John Maynard Keynes, The General Theory of Employment, Interest and Money, 1936.
In similar fashion to the Cantillon Effects, which led to the Austrian Business Cycle Theory and the role of "exogenous" money, Keynes held the view that "animal spirits" lead to damaging speculation and he was a proponent for government restrictions on investment to avoid the formation of "asset bubbles".
But, the "behavioral psychologist" in us would argue that large speculative episodes throughout histories are not engendered solely by human nature. Multiple examples of boom, and bust cycles have shown that the "Cantillon Effects" leading to the formation of asset bubbles shared common trait of "stimulation". For instance the housing bubble in the US was clearly the result of government policy in conjunction with increases in the money of supply with incorrect interest rate levels leading to speculation and "mis-allocation" of capital.
In similar fashion, as we argued recently, the effect of the last few years of ZIRP has led to speculative inflows in Emerging Markets. Current outflows are due to "flows" issues rather than "stocks" issues (debt levels in many Emerging Markets remain well below Developed Markets), confirming therefore our "reverse osmosis" theory.
We did give an early warning on the risk for Emerging Markets on the 14th of April in our conversation "The Night of the Yield Hunter" though:
"The risk of a deflationary bust validates our negative stance towards commodities and emerging markets as indicated last week for the second quarter.
In similar fashion UBS in their March 2012 note entitled "The Ides of March" made an interesting point which could validate the on-going weakness in both commodities and Emerging Markets:
"The end of Federal Reserve and European Central Bank (ECB) stimuli will cause an acceleration of capital flows out of emerging markets, hitting commodity demand."  - source UBS

The work done by Didier Sornette's team relating to the prediction of the formation of asset bubbles as indicated on the "Financial Crisis Observatory" site clearly illustrates the "Cantillon Effects" at play.
For instance their recent study of the "behavior" and bubble formation for Tesla's share price is also illustrative of "bubble formation" and "animal spirits" or when "our positive activities depend on spontaneous optimism rather than mathematical expectations", to quote Keynes:
"Inflated high-tech stocks like Tesla (or LinkedIn) are particularly vulnerable during a global correction in stock markets.
Without judging the value of Tesla’s technology, innovation and management, it is a textbook example of a bubble.
See this paragraph from our recent article D. Sornette and P. Cauwels The Illusion of the Perpetual Money Machine, Notenstein Academy White Paper Series (Dec. 2012)
( and
“First, a novel opportunity arises. This can be a ground-breaking technology or the access to a new market. An initial strong demand from first-mover smart money leads to a first price appreciation. This often goes together with an expansion of credit, which further pushes prices up. Attracted by the prospect of higher returns, less sophisticated investors then enter the market. At that point, the demand goes up as the price increases, and the price goes up as the demand increases. This is the hallmark of a positive feedback mechanism. The behavior of the market no longer reflects any real underlying value and a bubble is born. The price increases faster and faster in a vicious circle with spells of short-lived panics until, at some point, investors start realizing that the process is not sustainable and the market collapses in a synchronization of sale orders. The crash occurs because the market has entered an unstable phase. Like a ruler held up vertically on your finger, any small disturbance could have triggered the fall.” 
It is also important to stress that in the same manner Tesla is the textbook example of the importance of bubbles in innovation and technological revolutions, as explained within our "social bubble'" hypothesis [1-4].
If you look at the income statement of Tesla you see that the company has been losing money consequently. This is no surprise for such a high-tech startup.
If investors would only focus on fundamental value, Tesla would not be able to raise money through the stock-market. However, because of the anticipations, hence, the bubble effect on the price, investors are nevertheless attracted by expected profits. This would not be possible if the price would be fully fundamentally driven." - source ETH, Financial Crisis Observatory.
Tesla Market value exceeded $20 billion on the 26th of August - graph source Bloomberg:
There you go, "spontaneous optimism rather than mathematical expectations" to paraphrase Keynes.
The Log-Periodic Power Law Oscillations (LPPL), is part of the methodology used by Professor Sornette  to ascertain the "bubble" level (here comes the notion of fractals and our prior reference to Mandelbrot and his book The (Mis)Behaviors of Markets).
Of course, another illustration of "Cantillon Effects", credit creation and "bubbles", as we have long ascertained, has been in the shipping industry as illustrated by the "boom" and "bust" of the Baltic Dry Index.
The Baltic Dry Index aggregates the costs of moving freight via 23 seaborne shipping routes. It covers the movement of dry-bulk commodities, such as iron ore, coal, grain, bauxite and alumina.
In similar fashion the burst of the credit bubble had a dramatic impact on housing, shipping was as well not spared as cheap credit did indeed fuel a bubble of epic proportion - graph source Bloomberg:
"The dry-bulk market, which accounts for about 50% of shipped freight, is driven by steel demand, as iron ore and coking coal make up about 40% of volumes. Utility coal, grain, bauxite-alumina and phosphate are also major dry-bulk commodities. The Baltic Dry Index, a major barometer for the industry, has more than doubled ytd."  - source Bloomberg.

The deflationary environment, and "Schumpeter" like creative destruction has enabled innovation, in the container shipping space benefiting, the fittest to survive such as Danish Maersk currently busy upgrading massively its container fleet. Maersk remains our favorite, when it comes to identifying the survivors in this game of "survival of the fittest" but we digress.

As we indicated in our January conversation entitled "The link between consumer spending, housing, credit growth and shipping - A follow up":
"If there is a genuine recovery in housing driven by consumer confidence leading to consumer spending, one would expect a significant rebound in the Baltic Dry Index given that containerized traffic is dominated by the shipping of consumer products."
We have indeed seen such a rebound in the Baltic Dry Index - graph source Bloomberg:
"Containerized traffic is dominated by the shipment of consumer products, and a resurgence in international volumes is dependent on the housing market. Furniture and appliances are some of the top freight categories imported into the U.S. and euro zone from Asia. Furniture demand has been picking up, after bottoming in 2009 following the collapse of the housing market." - source Bloomberg.
As far as the Baltic Dry Index is concerned, while US Family Housing Starts looks fairly flat, US Furniture sales have indeed been very strong explaining therefore the pick-up in the aformentioned Baltic Dry Index:
Since 2006:
- in yellow the Baltic Dry Index, 
- in orange US Family Housing Starts 
- in white US Furnitures Sales.
The "Cantillon Effects" of cheap credit led to an inflation of both the housing bubble and the baltic dry bubble. The increase of US demand led to an increase in Chinese production, and a rise in commodities prices. 
In similar fashion, we indicated the "Cantillon Effects" of QE2 has been exporting inflation in our conversation "Misstra Know-it-all":
"The Fed tried to increase jobs by lowering interest rates, weakening the dollar in the process, boosting exports but exporting inflation on a global scale, particularly in the commodities space, leading to political instability in the process with QE 2. The effect QE 2 has had on the commodity sphere has been well described in a Bank of Japan research paper entitled "What Has Caused the Surge in Global Commodity Prices and Strengthened Cross-Market Linkage?", published in 2011.
Like we said about "positive correlations", "Misstra Know-it'all" has indeed played a quick hand, lifting stock prices, playing on the wealth effect game and exporting "hot money" flows in Emerging Markets."
When it comes to inflation, the "Cantillon Effects" are another way of looking at inflationary pressures, but of different nature. Inflationary pressures are not always strictly tied up to consumer prices, but, can be transmitted first in asset prices. While inflation in the US peaked at 5.6% in August 2008 prior to the stock market crash of October, the "Cantillon Effects" witnessed in the surge of assets prices were largely ignored by the US central bank - graph source Trading Economics:
As far as markets are concerned and in respect to the current level of prices, whereas market's performance in the 5 years that followed the demise of Lehman Brothers has been stellar, we agree with Bank of America Merrill Lynch's recent note entitled "Tinker, Taper, Told Ya, Buy" from the 12th of September, the next 5 years will probably be more "problematic"
"Asset markets will not do as well in the next 5 years, no matter what “nouveau bulls” say. Central banks will be less generous, corporations less selfish. And should excess liquidity be quickly removed markets will get “CRASHy”." - source Bank of America Merrill Lynch
Truth is the big beneficiary of the "Cantillon Effects" in the reflation game played out by the Fed has indeed been Wall Street versus Main street as indicated by Bank of America Merrill Lynch in the same note:
"After Lehman…
An unprecedented financial and economic crisis, crystallized by the September 15th 2008 bankruptcy of Lehman Brothers, was followed by an unprecedented monetary policy response, which in turn has been followed by unprecedented bull markets in bonds, stocks and now real estate. Wall Street has soared, but Main Street has soured (Chart 2). The exceptional “sweet spot” engendered by generous central banks and selfish corporations has been great for owners of capital, but bad for labor.
The "race to reflate" in the developed world and faltering Chinese macro leadership dictated the winners & losers of the past 5 years: Gold, High Yield, EM debt & Asian equities have been big winners; Commodities, Government Bonds & Japanese equities have been the big losers (see Table 1 on front page).
QE was the prime driver of the ‘09 trough in stocks & the ‘11 trough in real estate, and liquidity withdrawal has driven the jump in global interest rates in 2013. A further rapid, jump in rates would destabilize asset markets, but this threat remains low in coming quarters. The 100 basis point summer surge in the 30-year Treasury yield has tethered the S&P500 index to a tight 1600-1700 range and traumatized many fixed income & emerging markets." - source Bank of America Merrill Lynch
So if markets, does indeed become crashy in the next five years, we suggest you check, once in a while the   bubble index blog:
On a final note, if indeed rates are for "normalization", in similar effect, the world is "normalizing" as well given the Syrian crisis has seen the return of the Russia to world center stage, making us believe into a new era of "bipolarization". Market wise, we believe as well the Russian ruble is poised for a rebound as indicated by Bloomberg Chart of the Day:
"The ruble is poised to rebound from a four-year low as oil’s climb to the highest since February lures investors who fled during an emerging-market selloff after the Federal Reserve said it would taper economic stimulus.
The CHART OF THE DAY shows the currency of Russia, the world’s biggest oil producer, tumbling to its weakest since August 2009 against the central bank’s dollar-euro basket, even as Brent crude futures rallied to $117.34 a barrel last month. Previously the ruble had largely kept pace with changes in the price of crude, the country’s main export earner.
About $24 billion has been taken from emerging-market bond funds since the end of May, OAO Gazprombank and Morgan Stanley said, citing EPFR Global data. That’s the same month Fed Chairman Ben S. Bernanke first said U.S. policy makers were contemplating reducing quantitative easing.
“For the past few months, the market has been fixated on the Fed,” said Dmitry Dorofeev, a trader and strategist at BCS Financial Group in Moscow. “The ruble’s relationship with oil should re-establish itself once the initial taper is out of the way, and we should get a nice bounce.
The ruble also may recover as energy exports climb from seasonal lows and local demand for foreign currency declines after annual dividend payments by large Russian companies and the peak of the tourist season, Dorofeev said. Russia is the world’s biggest supplier of natural gas and the No. 2 oil exporter, according to the International Energy Agency. The ruble has dropped 7 percent against the dollar and 7.8 percent against the euro this year, on track for its worst annual performance since the 2008 financial crisis." - source Bloomberg

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