Professional Documents
Culture Documents
Into a Bubble?
Buying Time in a Brought Forward World
S&P 500 - since 1996
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Sectors/stocks: as pressure on consumers grows, companies supplying essential goods & services will be relative beneficiaries
Strategy
October 2013
2013
Into a bubble?
Bubbling Up Megaphones and Domed Houses Polar Opposites - middle of a bull market or imminent peak? Need a Plan B? Trying to Make Sense of Bubbles
3 3 5 6 7 11 11 11 12 14 14 19 20 31
It Should Work Both Ways Theme: Essential Goods & Services Is the Cycle Slowing Again? Slowdown versus 2004-05 Style Mid-Cycle Acceleration The US Consumer The Picture Outside the US
Ambiguous Signals Bigger Picture Gibsons Paradox Interest rates and Interest Rates (Repos)
31 34 36 38
Bubbling Up
Megaphones and Domed Houses
Here we go again, creating another asset bubble for the third time in a decade and a half. This chart holds particular significance for us since our colleague, David McCreadie, has been writing about it in his daily Tactical Trader emails for nearly 5 years.
Dow Jones Industrial Average - megaphone pattern since 1996
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Eckhart Tolle was voted the most spiritually influential person in the world and teaches that: the primary cause of unhappiness is never the situation but your thoughts about it Which seems apt right now. We noticed the immediate spike to an all-time high in the S&P 500 on the release of last weeks NFP data at the same time that increasing doubts are surfacing over Whether the US economy will reach escape velocity and; The benefit of QE on the real economy rather than asset prices. Its getting increasingly difficult to argue that we havent crossed the threshold into bubble territory in equities. Are we going to bounce off the upper resistance of the megaphone pattern in the chart above and fall sharply? Another near-perfect chart set up came and went. George Lindsays Three Peaks and a Domed House pattern was forming through 2011-12, until the QE3-driven rally (pre and post the September 2012 announcement) in equities ultimately blew out the last wall of the domed house - and the chart only shows the early stages.
October 2013
2013
Similarly, the widely used equity model - ISM manufacturing index versus the year-on-year change in the
S&P 500 had an excellent long-term track record, but became almost redundant between mid-2012 and
October 2013
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01/12/2010 22/12/2010 12/01/2011 02/02/2011 23/02/2011 16/03/2011 06/04/2011 27/04/2011 18/05/2011 08/06/2011 29/06/2011 20/07/2011 10/08/2011 31/08/2011 21/09/2011 12/10/2011 02/11/2011 23/11/2011 14/12/2011 04/01/2012 25/01/2012 15/02/2012 07/03/2012 28/03/2012 18/04/2012 09/05/2012 30/05/2012 20/06/2012 11/07/2012 01/08/2012 22/08/2012 12/09/2012 03/10/2012 24/10/2012 14/11/2012 05/12/2012 26/12/2012 16/01/2013
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Which perhaps says something about the power of unconventional monetary policy?
mid-2013. Once again, it was the QE3-related rally which led to the correlation breaking down.
May-06
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ISM
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The ISM/S&P 500 model is no longer suggesting that equities are significantly overvalued. However, that is thanks to the spike in the ISM which has likely reached its zenith and should roll over shortly (see below).
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1954
This comment recently appeared on the Seeking Alpha markets forum. The two years that have the highest correlation to 2013 continue to be 1954 and 1995...In the bigger picture, both 1954 and 1995 were right in the middle of the longest and strongest two bull markets of the 20th Century. They came nowhere near the end of a bull market. In fact, they marked the beginning of the longest and strongest growth legs of those two gigantic El Toro Grande bull markets. The Dow rose another 19% in 1955 and 24% in 1996 (after 33.3% in 1995). Meanwhile, bearish commentators have pointed to similarities between the 2013 chart pattern with two infamous crash years of 1929 and 1987. Despite the similarities, we seem to have avoided the 1987 scenario, although the 1929 scenario is still in play, as Tom DeMark has highlighted recently. Weve recreated his chart here.
October 2013
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Policy makers are pushing monetary systems and experimental policies to their limit, so shouldnt we consider the possibility of correspondingly extreme outcomes in financial markets in due course... cause and effect?
No Plan B?
After Lehman, policy makers went all-in on bailouts/ZIRP/QE etc. This avoided an all-out collapse and bought time in which a self-sustaining recovery could materialise. The Feds tapering threat showed that, five years on from Lehman, the recovery was still not self-sustaining. Our study of long-wave (Kondratieff) cycles, however, leaves us concerned as to whether it ever will be. More commentators are having doubts, e.g. Andrew Law of Caxton in the recent FT interview. The problem looming into view is that we might need a new plan. Does the incoming Fed Chairwoman have a new plan and, more importantly, one which could work? We have our doubts, the default strategy being continued reliance on liquidity-driven asset bubbles, while hoping for the best in terms of traction with the real economy. Our colleague, Andy Ash, commented last week. The biggest impact of QE1 was on metals and EM (emerging markets) indicating that the result of QE was predicted to be growth. The three lowest beneficiaries of QE3 have been Gold , Metals and EM, all SIZEABLY NEGATIVE IN RETURNS. So QE3s effect unlike QE1s has been nothing to do with global growth. The biggest return on QE3 was/is Western equities. If the US is locked into low growth for the foreseeable future, should the S&P 500 be trading on a 12-month forward earnings multiple of 16.2x, slightly higher than the 15.5x long-term average? Lets not forget that Europe appears to be stuck in an even lower growth scenario and Chinas growth rate is moderating. Moreover, corporate margins are close to an all-time high and earnings forecasts are being progressively downgraded. So higher and higher valuations for more distant, and (arguably) increasingly uncertain, cash flows. With the temporary deal agreed in Washington, QE looks set to continue running at US$85bn until March 2014, maybe longer. Weve written about the QE/repo linkage a lot in recent months and its our opinion that the collateralisation of excess deposits created by QE has positively impacted equities via shadow banking conduits, e.g. repos.
October 2013
03/04/1930
S&P 500 v. Deposits minus Loans ("deposit to loan gap" in banks from QE)
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Even the US Treasury (Treasury Borrowing Advisory Committee report for Q2 2013) noted the correlation between weeks when QE exceeded US$5bn and strength in the S&P 500.
Mar09 Apr-09 May-09 Jun-09 Jul-09 Aug-09 Oct-09 Nov-09 Dec-09 Jan-10 Feb-10 Mar-10 Apr-10 Jun10 Jul-10 Aug-10 Sep-10 Oct-10 Nov-10 Dec-10 Feb-11 Mar-11 Apr-11 May-11 Jun-11 Jul-11 Sep-11 Oct-11 Nov-11 Dec-11 Jan-12 Feb-12 Mar-12 May-12 Jun-12 Jul-12 Aug-12 Sep-12 Oct-12 Nov-12 Jan-13 Feb-13 Mar-13 Apr-13 May-13 Jun-13 Aug-13 Sep-13 Oct-13
S&P 500
Have we really got to the point where its just about more and more QE, corralling more and more flow into the equity market until it becomes (unsustainably) top-heavy?
Source: TBAC
October 2013
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Summation Index
We are still in the biggest debt crisis in history and the banking sector will remain at the centre of its ebbs and flows. The divergence of the sectors performance from the broader market pre-empted the Lehman collapse in 2008. In the US, we are keeping a close eye on the breakdown in the BKX.
BKX Banks Index relative to S&P 500
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In such extreme circumstances, we should also keep an idea of crash patterns in the back of our minds in case. These often play out as a peak followed by a failure to make a new high and a subsequent break of support. Here are some notable examples.
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And we can compare these with the year-to-date chart for the S&P 500 (which is currently leading the Dow).
S&P 500: 2003 year-to-date
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October 2013
If theres one market that makes us very nervous right now (hat tip to Ben Davies of Hinde Capital), its the ChiNext...a NASDAQ-type exchange for high-growth, high-tech start-ups (Wikipedia). Besides the pattern, its also risen by 110% since last November.
ChiNext: 2013 (Mar-Oct)
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A final word on equity market indicators. In our reports since May, weve been road-testing a model for the US equity market (using the DJIA which has a longer history). It is based on cycles, not economic indicators, but cycles in time. It is created from the interaction of 18 cycles in US equities. These vary in length from just under 3 months to more than 30 years. Most of these cycles were discovered by the Foundation for the Study of Cycles (FSC), which has published a vast body of work during the last 70 years. Wed like to make contact with any readers whove also looked into this type of work, as trying to incorporate it into our research is very much work in progress. While in its very early days, the model has been a reasonably good predictor of market direction since the beginning of 2009 (having also picked out most of the market peaks and troughs since 1905). We are slightly alarmed because its predicting that the Dow should be rolling over now into the first part of 2014.
Dow Jones Industrial Average: actual versus predicted 2009-13
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Actual
Predicted
October 2013
10
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While this fits with our current view of the fundamentals (see below), it obviously flies in the face of the trend, risk-on sentiment and, most importantly perhaps, the continuation of US$85bn per month of QE for now. Please note: the Y-axes on the above chart do not represent absolute levels for the Dow. Rather, the left hand Y-axis represents the Dow Jones versus a moving average and the right hand Y-axis is a measure of the amplitude in the predicted trend.
October 2013
11
The market turmoil induced by Bernanke and his colleagues with the taper threat (quickly watered down and subsequently canned) seems entirely fitting in this light. The consequence is that the Feds ability to taper looks ever more serious with regard to asset prices. This is the two-way version of the Stockholm syndrome between the Fed and markets weve highlighted before. Boxed in? In our July 2013 report, we noted the spectacular irony that Bernankes plan to taper directly contradicted his criticism (in the Money, Gold and the Great Depression speech from March 2004) of the Federal Reserve policy in the Great Depression era of the 1930s. We noted (with our emphasis). Each mistake Bernanke highlighted during 1928-33 involved a tightening of monetary policy, exactly as the Fed has proposed recently. However, the real irony is the manner in which the Fed tightened monetary policy in 1932 VIA THE REVERSAL OF OPEN-MARKET OPERATIONS, basically reducing QE. Reversing the open market operations in 1932 caused interest rates to rise and Bernanke was scathing in his criticism. These policymakers did not appear to appreciate that, even though nominal interest rates were very low, the ongoing deflation meant that the real cost of borrowing was very high because any loans would have to be repaid in dollars of much greater value. Below is the trend in real long-term US rates (Barclays US Inflation linked 7-10 years average real yield) which havent reversed all the increase since the possibility of tapering was floated and subsequently shelved.
Barclays US Inflation linked 7-10 years real yield (%)
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Given the contradiction with Bernankes doctrine, we are slightly more sympathetic now with the view from a down the rabbit hole source who explained that the reason for the Fed floating the idea of tapering was to test the resilience of the financial system. It appears to have failed that test. Boxed in?
October 2013
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Its amusing to turn over in your mind the idea that a 3-month German Treasury Bill, on a yield of 3 basis points, could be cheap. The answer is obviously yes in an unfolding crisis (contraction in time horizon) and these Bills traded on -20.5 basis points before Draghi threatened to do whatever it takes to save the Euro (just as Spanish 10-year yields were spiking to 7.62%).
Germany: 3-month Treasury Bill
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What about commodities which are both staples and perishable. Like the raw material for bread, for example?
Wheat (Active contract)
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Aside from assets, what about the idea of goods in terms of short duration? This is Wikipedia on fast moving consumer goods (FMCG)... The term FMCGs refers to those retail goods that are generally replaced or fully used up over a short period of days, weeks, or months, and within one year. Examples include non-durable goods such as soft drinks, toiletries, etc, and grocery items...Fast-moving consumer electronics are a type of FMCG and are typically low priced, generic or easily substitutable consumer electronics, including mobile phones, MP3 players, game players, and digital cameras...Global leaders in the FMCG segment include Johnson & Johnson, Colgate-Palmolive, Anheuser-Busch InBev, Henkel,
October 2013
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2013
Kelloggs, S.C. Johnson, Beiersdorf, Mars Inc., Heinz, Nestle, Reckitt Benckiser, Unilever, Procter & Gamble, LOreal, Coca-Cola, General Mills Inc., PepsiCo, Mondelez and Kraft Foods. In the Inflationary Deflation report referred to earlier, we set out our long-term investment strategy. We argued that as pressure on consumers intensifies, equity portfolios should be progressively aligned towards stocks which are relative beneficiaries of the shifts in real disposable income. In general, we favour companies supplying ESSENTIAL ITEMS AND SERVICES as we expect that these expenditures will account for a growing share of the economic pie in future. In thematic terms, many of the sectors we highlighted: Food/agriculture; Energy; Personal & household care; Healthcare; Mobile telephony & networking; and Defence (for governments). Are, in fact, skewed towards faster moving consumer goods. Some analysts seem to be thinking along similar lines. We were interested to read Sandeep Jaitlys (of Fekete Research and portfolio manager at First International) latest Course of the Exchange report in which he argued in typically forceful fashion. When it comes to the picking of stocks going forward to capture this expected nominal rally in the global equity exchanges the concept of marketability must always be borne in mind. Companies that produce the most marketable goods such as Procter & Gamble, or Unilever will always have a ready market for their equity. However, its a question of the denomination of this ready market as fiat squeezes such stocks into being hoarded just like gold. Some companies which are just capitalised claims to fiat such as banking or insurance shares will lose all relative exchange value at some point compared to the companies that produce marketable goods of various shades. By marketable, he means acceptable. This brings gold to mind as a universally accepted currency and store of wealth. Professor Fekete argues that the marginal utility of gold declines more slowly than any other substance. I think this is relevant to the discussion about time horizons/duration but I need to think more about it.
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55.0
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45.0
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30.0
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Jan-11
The ISM has risen by 7.2 points during the last four months (June to September 2013) from 49.0 to 56.2.
US: 4-month change in ISM Manufacturing Index (since 1990)
15.0
10.0
5.0
0.0
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Apr-02
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Sep-94
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Sep-01
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Mar-98
Mar-05
Jun-10
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Mar-12
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Nov-02
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Its worth putting such a strong rise in context. In the almost 24 years (285 months) since 1990, such a strong (or stronger) rise has only happened on 15 occasions, or 5.2% of the time. Of these, 11 were within six months of the official end of a recession, i.e. when the economy was undoubtedly in recovery/bounce back mode. Currently, we are more than four years away from the end of the last recession in June 2009. The other four mid-cycle occasions were May 1992, June 1996, November 2003 and January 2004. The key question is whether the ISM is signalling a mid-cycle acceleration in US growth this time? Lets consider the four previous occasions. Within four months of May 1992, the ISM had fallen back by 6.0 points to 49.7. The month after June 1996, the ISM was back below 50.0 at 49.7 and did not exceed the June 1996 level for six months. So on two of these four occasions, things began to slow down shortly afterwards. The exceptions were November 2003 and January 2004. The ISM peaked at 60.8 in January 2004 and remained remarkably strong (above 55.0) through to March 2005. The November 2003 and January 2004 ISM readings pre-empted the strongest period of US GDP growth between the 2001 and 2007-09 recessions a genuine mid-cycle acceleration.
October 2013
15
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Source: BEA
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Is a pick-up in growth like 2004-05 in store this time? We think its unlikely and its worth comparing current trends with 2004-05. First, lets highlight one issue which could have given the ISM a temporary boost. Some keen observers noted a surge in aerospace orders in June as the supply chain geared up.
US Durable Goods Orders - Aircraft & Parts (US$m)
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Surging aerospace orders did not only benefit the US. We also saw a stronger-than-expected rebound in German manufacturing orders in June following the Paris Air Show. Alcoa led off the current earnings season and we were very interested in what the company said about trends in aerospace. Here are a couple of quotes on the fourth quarter outlook from the results presentation: Aero plate shipments continue to be impacted by high OEM inventories And: Aerospace remains strong, temporarily impacted by engine market inventory realignment and lower U.S. Defense spare parts demand
October 2013
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2013
With something of a softer spot for aerospace coming in Q4, it looks like we should expect those strong ISM numbers to roll over. Aerospace aside, lets consider other indicators of US economic strength and compare them (where possible) with 2004-05 when we experienced a prolonged mid-cycle acceleration in growth. The current situation is very different in our view. The US is a credit-driven economy and household debt growth is non-existent right now, but was running at double-digit rates during 2004-05.
15%
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5%
0%
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Outstanding balances on credit cards tend to grow during buoyant economic periods. Current growth is nonexistent compared with the acceleration from c.2% in early 2004 to a peak of 12% in late-2006.
US revolving credit outstanding (yoy %)
25.0%
20.0%
15.0%
10.0%
5.0%
0.0%
Q1 1961 Q1 1962 Q1 1963 Q1 1964 Q1 1965 Q1 1966 Q1 1967 Q1 1968 Q1 1969 Q1 1970 Q1 1971 Q1 1972 Q1 1973 Q1 1974 Q1 1975 Q1 1976 Q1 1977 Q1 1978 Q1 1979 Q1 1980 Q1 1981 Q1 1982 Q1 1983 Q1 1984 Q1 1985 Q1 1986 Q1 1987 Q1 1988 Q1 1989 Q1 1990 Q1 1991 Q1 1992 Q1 1993 Q1 1994 Q1 1995 Q1 1996 Q1 1997 Q1 1998 Q1 1999 Q1 2000 Q1 2001 Q1 2002 Q1 2003 Q1 2004 Q1 2005 Q1 2006 Q1 2007 Q1 2008 Q1 2009 Q1 2010 Q1 2011 Q1 2012 Q1 2013
-5.0% -10.0% -15.0%
Apr-95
Apr-02
Feb-94
Sep-94
Feb-01
Sep-01
Feb-08
Sep-08
Apr-09
Jun-96
Jun-03
Mar-91
Mar-98
Mar-05
Jun-10
Jul-93
Jul-00
Jul-07
Mar-12
Dec-92
Dec-99
Dec-06
Oct-91
Oct-98
Oct-05
Aug-90
Aug-97
Aug-04
Nov-95
Nov-02
May-92
May-99
May-06
Nov-09
Aug-11
Oct-12
Jan-90
Jan-97
Jan-04
Jan-11
Growth in personal consumption expenditure is also in the doldrums compared with 6-7% growth during much of 2004-05
October 2013
17
May-13
The University of Michigans Consumer Confidence survey remains below late-2003/early-2004 levels.
Optimism Index has recovered since the crisis but remains well below the peak levels reached in 2004-05.
A thriving small business culture is usually associated with a vibrant economy. The NFIB Small Business
Source: BEA
October 2013
100 110 120 -4.0 -2.0 0.0 2.0 4.0 6.0 8.0 50 60 70 80 90
100
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110
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85
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95
Jan-01 Jun-95 Nov-95 Apr-96 Sep-96 Feb-97 Jul-97 Sep-02 Jan-03 May-03 Sep-03 Jan-04 May-04 Sep-04 Jan-05 May-05 Sep-05 Jan-06 May-06 Sep-06 Jan-07 May-07 Sep-07 Jan-08 May-08 Sep-08 Jan-09 May-09 Sep-09 Jan-10 May-10 Sep-10 Jan-11 May-11 Sep-11 Jan-12 May-12 Sep-12 Jan-13 May-13 Dec-97 May-98 Oct-98 Mar-99 Aug-99 Jan-00 Jun-00 Nov-00 Apr-01 Sep-01 Feb-02 Jul-02 Dec-02 May-03 Oct-03 Mar-04 Aug-04 Jan-05 Jun-05 Nov-05 Apr-06 Sep-06 Feb-07 Jul-07 Dec-07 May-08 Oct-08 Mar-09 Aug-09 Jan-10 Jun-10 Nov-10 Apr-11 Sep-11 Feb-12 Jul-12 Dec-12 May-13 Oct-13 May-02 Jan-02 Sep-01 May-01
Jan-95 Jan-01
May-01
Sep-01
Jan-02
May-02
Sep-02
Jan-03
May-03
Sep-03
Jan-04
May-04
Sep-04
Jan-05
May-05
Sep-05
Jan-06
May-06
Sep-06
18
Jan-07
May-07
Sep-07
Jan-08
May-08
Sep-08
Jan-09
May-09
Sep-09
Jan-10
May-10
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Jan-11
May-11
Sep-11
Jan-12
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May-13
Sep-13
Then theres the much vaunted housing recovery which appears to have slowed in response to the rates spike. If it is in its early stages, which we doubt, it still has a long way to go before we return to the heady days during the middle of the last decade.
Housing Starts and MBA Mortgage Purchase Index
2500 550
500 2000
450
500
200
150
100
Sep-01
Sep-02
Sep-03
Sep-04
Sep-05
Sep-06
Sep-07
Sep-08
Sep-09
Sep-10
Sep-11
Sep-12
May-01
May-02
May-03
May-04
May-05
May-06
May-07
May-08
May-09
May-10
May-11
May-12
If there is a catalyst out there which will drive a mid-cycle acceleration in US GDP growth, we are finding it hard to see right now.
The US Consumer
The above discussion on US economic prospects makes us concerned about the prospects for the US consumer...especially when consumer discretionary stocks have seen an almost unbroken five-year run of outperformance.
S&P Consumer Discretionary / S&P 500
0.30
0.28
May-13
Sep-13
Jan-01
Jan-02
Jan-03
Jan-04
Jan-05
Jan-06
Jan-07
Jan-08
Jan-09
Jan-10
Jan-11
Jan-12
Jan-13
0.26
0.24
0.22
0.20
0.18
0.16
2009
2010
2011
2012
On the subject of the US economy and the health of US consumers, theres an indicator (we wish we could remember where we first saw it - please contact us if you are the creator for delayed attribution) which is flashing a RARE warning sign right now. This is shown in the chart below which shows a moving average of Real Personal Income minus Current Transfer Payments (RPI-CTP).
October 2013
19
2013
Real personal income less current transfer receipts per capita (3m m.a.)
10.0% 8.0%
6.0%
4.0%
2.0%
0.0%
-2.0%
-4.0%
-6.0%
-8.0%
-10.0%
Apr-82
Apr-85
Apr-88
Apr-91
Apr-94
Apr-97
Apr-00
Apr-03
Apr-06
Apr-09
Apr-12
Jul-81
Jul-84
Jul-87
Jul-90
Jul-93
Jul-96
Jul-99
Jul-02
Jul-05
Jul-08
Oct-80
Oct-83
Oct-86
Oct-89
Oct-92
Oct-95
Oct-98
Oct-01
Oct-04
Oct-07
Oct-10
Jan-80
Jan-83
Jan-86
Jan-89
Jan-92
Jan-95
Jan-98
Jan-01
Jan-04
Jan-07
Jan-10
Jul-11
Please note that recessions are marked with red boxes. Before now, there has only been one instance when this indicator turned negative without the US being in recession since 1980. Historically, RPI-CTI also correlated fairly well with S&P 500 Consumer Discretionary relative to S&P 500 Consumer Staples. In a directional sense, it broke down in 2011 as CD stocks continued to power ahead. This trend is beginning to look very extended.
RPI - CTR v. S&P 500 Consumer Discretionary / Consumer Staples
10.0% 8.0% 1.20 6.0% 4.0% 2.0% 0.0% -2.0% -4.0% -6.0% 0.70 -8.0% -10.0% 0.60 0.90 1.10 1.30
Jan-13
1.00
0.80
Sep-01
Sep-02
Sep-03
Sep-04
Sep-05
Sep-06
Sep-07
Sep-08
Sep-09
Sep-10
Sep-11
Sep-12
May-01
May-02
May-03
May-04
May-05
May-06
May-07
May-08
May-09
May-10
May-11
May-12
October 2013
20
May-13
Sep-13
Jan-01
Jan-02
Jan-03
Jan-04
Jan-06
Jan-07
Jan-08
Jan-09
Jan-10
Jan-11
Jan-12
Jan-13
Jan-05
In late-2003/early-2004, Dr Coppers price was poised for a parabolic rise from US$2,300/tonne to US$8,800/
October 2013
0% -40% 10% 20% 30% 40% 50% 60%
30 35 40 45 50
-30%
-20%
-10%
55
60
10000
11000
1000
2000
3000
4000
5000
6000
7000
8000
9000
Jan-01 Jan-01 May-01 Sep-01 Jan-02 May-02 Sep-02 Jan-03 May-03 Sep-03 Jan-04 May-04 Sep-04 Jan-05 May-05 Sep-05 Jan-06 May-06 Sep-06 Jan-07 May-07 Sep-07 Jan-08 May-08 Sep-08 Jan-09 May-09 Sep-09 Jan-10 May-10 Sep-10 Jan-11 May-11 Sep-11 Jan-12 May-12 Sep-12 Jan-13 May-13 Sep-13 May-01 Sep-01 Jan-02 May-02 Sep-02 Jan-03 May-03 Sep-03 Jan-04 May-04 Sep-04 Jan-05 May-05 Sep-05 Jan-06 May-06 Sep-06 Jan-07 May-07 Sep-07 Jan-08 May-08 Sep-08 Jan-09 May-09 Sep-09 Jan-10 May-10 Sep-10 Jan-11 May-11 Sep-11 Jan-12 May-12 Sep-12 Jan-13 May-13
2001
2002
2003
2004
2005
2006
21
BRICS exports
2007
2008
2009
2010
2011
2012
2013
Chinese real GDP growth was ramping up into the 10-12% p.a. range, not stabilising in the 7-8% p.a. range.
China Real GDP growth (yoy %)
13.0
12.0
11.0
10.0
9.0
8.0
7.0
6.0
5.0
4.0
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
When the Chinese government attempted to crack down on the shadow banking system in May/June 2013, the economy seemed briefly to go into freefall. Simon Hunt of Simon Hunt Strategic Services is the best commentator on China that weve found. He noted recently. To stabilise the economy, government had to turn to the SOE sector in the process liquefying many local governments with credit being issued directly by banks such as the China Development Bank. We understand that these credit lines do not get captured in official credit statistics. As a result, the economy went from weakening to recovering in the space of a few weeks in July as friends in the economic trenches told us. Year-on-year growth in iron ore imports rebounded sharply in July 2013 after the decline in June - these months are highlighted in the chart below.
China Iron Ore imports since January 2012 (m tonnes)
75
70
2013
65
60
55
50
Apr-12
Feb-12
Sep-12
Feb-13
Apr-13
Mar-12
Mar-13
Aug-12
Dec-12
May-12
Nov-12
October 2013
22
May-13
Aug-13
Sep-13
Jun-12
Jun-13
Jul-12
Oct-12
Jan-12
Jan-13
Jul-13
After the May/June 2013 experience, we expect the Chinese authorities to adopt a more softly softly approach to discourage excessive credit creation in shadow banking. The next chart puts the recent rise in 7-day repo rates in context.
China Interbank 7-day Repo (%)
12.00
10.00
8.00
6.00
4.00
2.00
0.00
Feb-13
Apr-13
Mar-13
Sep-13
Jun-13
Jul-13
In Simon Hunts view: The economy has stabilised; a cyclical recovery is underway but without structural reforms it is unsustainable Fears about the ChiNext market aside, we subscribe to this view and see the likelihood of reasonable growth continuing in China into the year-end and possibly early 2014. The HSBC/Markit Flash PMI for October 2013 showed another modest improvement to 50.9 from 50.2, while the latest official PMI for new orders (September 2013) showed the strongest reading since April 2012.
China: Official PMI - new orders
70
65
60
55
50
45
May-13
Aug-13
Oct-13
Jan-13
40
35
30
Sep-06
Sep-07
Sep-08
Sep-09
Sep-10
Sep-11
Sep-12
Mar-06
Mar-07
Mar-08
Mar-09
Mar-10
Mar-11
Mar-12
May-06
May-07
May-08
May-09
May-10
May-11
May-12
Mar-13
Nov-06
Nov-07
Nov-08
Nov-09
Nov-10
Nov-11
Nov-12
October 2013
23
May-13
Sep-13
Jul-06
Jul-07
Jul-08
Jul-09
Jul-10
Jul-11
Jul-12
Jan-06
Jan-07
Jan-08
Jan-09
Jan-10
Jan-11
Jan-12
Jan-13
Jul-13
If the US looks set to weaken, while China should be okay for a few months, what about the other key variable, i.e. Europe? We think that the strong rebound since the Spring will have levelled off by early 2014. The Eurozone Composite Flash PMI fell marginally from 52.2 (27-month high) to 51.5 in October.
Eurozone Composite PMI
65
60
55
50
45
40
35
30
Feb-06
Feb-07
Feb-08
Feb-09
Feb-10
Feb-11
Feb-12
Aug-05
Aug-06
Aug-07
Aug-08
Aug-09
Aug-10
Aug-11
Aug-12
Feb-13
Nov-05
Nov-06
Nov-07
Nov-08
Nov-09
Nov-10
Nov-11
May-05
May-06
May-07
May-08
May-09
May-10
May-11
May-12
Nov-12
Our economist, Stephen Lewis, also noted that: In any case, the hard data have started to lag the survey evidence of recovery. The euro zones industrial production in July and August was, on average, marginally below the Q2 level, which had been 0.7% higher than the Q1 average. We are still waiting for some signs of a pick-up in credit growth across the region as a whole - September 2013 was -0.1%.
Eurozone consumer credit
5400000 6.0%
5300000
May-13
5.0%
Aug-13
0.0% -1.0%
Source: Eurostat
4700000
4600000
Sep-08
Sep-09
Sep-10
Sep-11
Sep-12
Mar-09
Mar-10
Mar-11
Mar-12
May-09
May-10
May-11
May-12
Mar-13
Nov-08
Nov-09
Nov-10
Nov-11
Nov-12
yoy %
The acceleration in Eurozone M1 growth which preceded this years rebound in GDP has flattened off. Based on the historic correlation, GDP growth itself should level off in January/February of 2014.
October 2013
24
May-13
Sep-13
Jul-09
Jul-10
Jul-11
Jul-12
Jan-09
Jan-10
Jan-11
Jan-12
Jan-13
Jul-13
8.0
4.0
Source: Eurostat
Feb-01
Feb-02
Feb-03
Feb-04
Feb-05
Feb-06
Feb-07
Feb-08
Feb-09
Feb-10
Feb-11
Feb-12
Feb-13
GDP (yoy %)
60
40
20
Feb-14
Jun-01
Jun-02
Jun-03
Jun-04
Jun-05
Jun-06
Jun-07
Jun-08
Jun-09
Jun-10
Jun-11
Jun-12
Oct-00
Oct-01
Oct-02
Oct-03
Oct-04
Oct-05
Oct-06
Oct-07
Oct-08
Oct-09
Oct-10
Oct-11
Oct-12
Jun-13
Oct-13
-20
-40
-60
-80
-100
Apr-12
Feb-12
Sep-12
Feb-13
Apr-13
Mar-12
June-12
Mar-13
Dec-12
June-13
Sep-13
Jul-12
Oct-12
Jul-13
Aug-12
May-12
Nov-12
Looking at the periphery, the PMIs for Italy and Spain have both flattened off recently.
Spain & Italy: PMI manufacturing 2013 (year-to-date)
52
50
48
May-13
Aug-13
Oct-13
Jan-12
Jan-13
46
44
42
40
Feb-13
Apr-13
Mar-13
Spain
May-13
Italy
October 2013
25
Aug-13
Sep-13
Jun-13
Jan-13
Jul-13
continues to improve (although consumer credit growth was -5.0% year-on-year in September 2013).
Spain looks better than Italy. Retail sales have crossed into positive territory and consumer confidence
October 2013
0% 15.0 -30% -20% -10% 10% 20% 30%
0% -30% -20% -10% 10% 20% 30%
-15.0
-10.0
10.0
-5.0
0.0
5.0
Jan-01 May-99 Sep-99 Jan-00 Jul-04 Oct-04 Jan-05 Apr-05 Jul-05 Oct-05 Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Jul-11 Oct-11 Jan-12 Apr-12 Jul-12 Oct-12 Jan-13 Apr-13 Jul-13 May-00 Sep-00 Jan-01 May-01 Sep-01 Jan-02 May-02 Sep-02 Jan-03 May-03 Sep-03 Jan-04 May-04 Sep-04 Jan-05 May-05 Sep-05 Jan-06 May-06 Sep-06 Jan-07 May-07 Sep-07 Jan-08 May-08 Sep-08 Jan-09 May-09 Sep-09 Jan-10 May-10 Sep-10 Jan-11 May-11 Sep-11 Jan-12 May-12 Sep-12 Jan-13 May-13 Apr-04 Jan-04
Jan-99
May-01
Sep-01
Jan-02
May-02
Sep-02
Jan-03
May-03
Sep-03
Jan-04
May-04
Sep-04
Jan-05
May-05
Sep-05
Jan-06
May-06
Sep-06
Jan-07
May-07
26
0
Sep-07
Jan-08
May-08
Sep-08
Jan-09
May-09
Consumer confidence
Consumer credit
Sep-09
Jan-10
May-10
Sep-10
Jan-11
May-11
Sep-11
Jan-12
May-12
Sep-12
Jan-13
May-13
Sep-13
-5
-50
-45
-40
-35
-30
-25
-20
-15
-10
In spite of its President, we had been a little more encouraged by trends in France recently. Both business
October 2013
100 110 120 130 60 70 80 90
0% -40% -30% -20% -10% 10% 20% 30% 40%
10%
12%
14%
0%
2%
4%
6%
8%
Jan-04 Jan-99 May-99 Sep-99 Jan-00 May-00 Sep-00 Jan-01 May-01 Sep-01 Jan-02 May-02 Sep-02 Jan-03 May-03 Sep-03 Jan-04 May-04 Sep-04 Jan-05 May-05 Sep-05 Jan-06 May-06 Sep-06 Jan-07 May-07 Sep-07 Jan-08 May-08 Sep-08 Jan-09 May-09 Sep-09 Jan-10 May-10 Sep-10 Jan-11 May-11 Sep-11 Jan-12 May-12 Sep-12 Jan-13 May-13 May-01 Sep-01 Jan-02 May-02 Sep-02 Jan-03 May-03 Sep-03 Jan-04 May-04 Sep-04 Jan-05 May-05 Sep-05 Jan-06 May-06 Sep-06 Jan-07 May-07 Sep-07 Jan-08 May-08 Sep-08 Jan-09 May-09 Sep-09 Jan-10 May-10 Sep-10 Jan-11 May-11 Sep-11 Jan-12 May-12 Sep-12 Jan-13 May-13 Sep-13
Jan-01
Apr-04
Jul-04
Oct-04
Jan-05
Apr-05
Jul-05
Oct-05
Jan-06
Apr-06
Jul-06
Oct-06
Jan-07
Apr-07
Jul-07
Oct-07
Jan-08
Apr-08
Jul-08
Consumer credit is still in positive territory and has even accelerated during recent months.
27
Consumer Confidence
Oct-08
Jan-09
Apr-09
Jul-09
Oct-09
Jan-10
Apr-10
Jul-10
Oct-10
Jan-11
Apr-11
Jul-11
Oct-11
Jan-12
Apr-12
Jul-12
Oct-12
Jan-13
Apr-13
Jul-13
Unfortunately, the most recent data has taken the edge off things a little. August 2013 had seen the first reduction in the number of jobseekers since April 2011, only for it to immediately rebound in September.
France: Jobseekers v. Unemployment rate
3400 12.0 11.5 11.0 3000 10.5 10.0 2600 9.5 9.0 8.5 2200 8.0 7.5 1800 7.0
Apr-00
Apr-05
Sep-00
Feb-01
Sep-05
Feb-06
Apr-10
Sep-10
Feb-11
Jun-99
Jun-04
Jun-09
Jul-01
Jul-06
Mar-03
Mar-08
Jul-11
Mar-13
Dec-01
Dec-06
Dec-11
Oct-02
Oct-07
Aug-03
Aug-08
Oct-12
Nov-99
Nov-04
May-02
May-07
Nov-09
Jobseekers (000s)
The Flash Eurozone PMI report commented that France registered only a negligible expansion as its PMI dipped closer toward neutrality. Both German IFO surveys (Climate and Expectations) were slightly down in October 2013 versus the previous month, confirming the Flash PMI. The main drags were domestic, i.e. retail and services, while exports remained resilient (China?).
Germany: IFO Business climate & Expectations
120
115
110
105
100
95
90
May-12
Aug-13
Jan-99
Jan-04
Jan-09
85
80
75
Sep-01
Sep-02
Sep-03
Sep-04
Sep-05
Sep-06
Sep-07
Sep-08
Sep-09
Sep-10
Sep-11
Sep-12
May-01
May-02
May-03
May-04
May-05
May-06
May-07
May-08
May-09
May-10
May-11
May-12
Business climate
Expectations
So a plateau in activity seems to be on the horizon in the Eurozone, but we cant help feeling that some of its structural weaknesses have been brought sharply into focus again in recent weeks, although not assimilated into current sentiment. The first relates to the banking system. The ECB is gearing up for direct oversight and new (improved?) stress tests, but what caught our eye were Draghis comments to the European Parliament after the German election.
October 2013
28
May-13
Sep-13
Jan-01
Jan-02
Jan-03
Jan-04
Jan-05
Jan-06
Jan-07
Jan-08
Jan-09
Jan-10
Jan-11
Jan-12
Jan-13
We are ready to use any instrument, including another LTRO if needed, to maintain the shortterm money market rates at a level which is warranted by our assessment of inflation in the medium-term...While repayment of central bank credit is certainly a sign of normalisation, the resulting reduction in excess liquidity can reinforce upward pressures on term money market rates. So more LTROs are needed because earlier LTROs are being successfully REPAID entirely logical! We think that his comments emphasise the extreme fragility of the weaker European banks...and we wonder if this includes one or two larger ones? The comment about upward pressure on money market rates most likely refers to Eonia (Euro Over Night Index Average). This is the weighted average rate for overnight unsecured loans in the European interbank market. It is currently trading at 9.6bp - well below the 50bp for the ECBs MRO (Main Refinancing Operation) policy rate. Prior to the 2008 crisis, Eonia traded at a small positive spread to the MRO as the latter is secured. Since the 2008 crisis, the provision of excess liquidity by the ECB has pushed Eonia to a discount to MRO in the Eurozone interest rate corridor. Draghi is clearly concerned that a sudden rise in Eonia from the extremely low level of 9.6bp - could threaten the banking system. The next chart shows EONIA in a longerterm context.
EONIA (%)
4.00
3.50
3.00
2.50
2.00
1.50
1.00
0.50
0.00
2009
2010
2011
2012
European banks recovered from a 5-year low after Draghis Whatever it takes speech in July 2012. They have been on a tear as confidence in the Eurozone recovery emerged over the Summer - although the outperformance has rolled over in the last couple of weeks.
October 2013
29
2013
0.046
0.044
0.042
0.040
0.038
0.036
0.034
0.032
0.030
Apr-12
Feb-12
Sep-12
Feb-13
Apr-13
Mar-12
Mar-13
Dec-12
Sep-13
Jun-12
Jun-13
Jul-12
Oct-12
Jul-13
Aug-12
May-12
Nov-12
This sector is for braver investors than us and we would avoid. The other major structural flaw in the Eurozone is obviously the excessive level of sovereign debt. This is not lost on the authorities who are actively, it was clear from page 58 of the recent IMF report (Taxing Times, October 2013), considering ways to address it. The key section, not discussed by any mainstream media sources that we saw, is shown below without comment (although the emphasis is ours). The sharp deterioration of the public finances in many countries has revived interest in a capital levy, a one-off tax on private wealth, as an exceptional measure to restore debt sustainability. (1) The appeal is that such a tax, if it is implemented before avoidance is possible, and there is a belief that it will never be repeated, does not distort behavior (and may be seen by some as fair). There have been illustrious supporters, including Pigou, Ricardo, Schumpeter, and, until he changed his mind, Keynes. The conditions for success are strong, but also need to be weighed against the risks of the alternatives, which include repudiating public debt or inflating it away (these, in turn, are a particular form of wealth tax on bondholders that also falls on non-residents). There is a surprisingly large amount of experience to draw on, as such levies were widely adopted in Europe after World War I and in Germany and Japan after World War II. Reviewed in Eichengreen (1990), this experience suggests that more notable than any loss of credibility was a simple failure to achieve debt reduction, largely because the delay in introduction gave space for extensive avoidance and capital flight, in turn spurring inflation. The tax rates needed to bring down public debt to pre-crisis levels, moreover, are sizable: reducing debt ratios to end-2007 levels would require (for a sample of 15 euro area countries) A TAX RATE OF ABOUT 10% ON HOUSEHOLDS WITH POSITIVE NET WEALTH.
October 2013
30
May-13
Aug-13
Oct-13
Jan-12
Jan-13
3.20
2.60
2.40
1.80
Sep-12
Feb-13
Apr-13
Mar-13
Dec-12
Sep-13
Jun-13
Jul-12
Oct-12
Jul-13
Aug-12
Nov-12
The worlds reserve currency (such as it is) is currently testing the 79.0-80.0 level, but a significant break to the downside could be inflationary.
US Dollar Index
85
84
May-13
Aug-13
Oct-13
Jan-13
83
82
81
80
79
78
Feb-13
Apr-13
Mar-13
Dec-12
Sep-13
Jun-13
Oct-12
Jul-13
Nov-12
October 2013
31
May-13
Aug-13
Oct-13
Jan-13
Our preferred index for commodity prices is the Thomson Reuters Continuous Commodity Index which is composed of 17 equally weighted commodities. It recently put in a double bottom at the support level around 500, which could signal that the decline in commodity prices since 2011 is drawing to a close. The rebound has been lacklustre, though, so far.
Continuous Commodity Index
700
650
600
550
500
450
400
350
300
2009
2010
2011
2012
There are some slightly stronger signs in some of the agricultural commodities, like Wheat (shown above) and others, like Live Cattle, remain in bull (!) markets.
Live Cattle Contract (CME)
140
130
2013
120
110
100
90
80
70
2009
2010
2011
2012
Sugar has been a fairly good leading/coincident indicator for the Continuous Commodity Index and, having broken out recently, is something we are watching.
October 2013
32
2013
700 30 650
25
600
550
20
500
450 15 400
10
350
2009
2010
2011
2012
Sugar
It was notable that in the inflation-prone UK economy, inflation expectations have suddenly spiked upwards thanks to increases in utility costs and rising house prices. This was our economist, Stephen Lewis, again. According to the latest Citi/YouGov survey, for October, prices were seen rising in the year ahead by 3.2%, well above Septembers 2.5% expectation. More alarming still, because it suggested the publics confidence that price rises would be contained had started to erode, was the finding that inflation on a 5-10-year view was, this month, seen as high as 3.9%, up from 3.3% in September. The octogenarian, newsletter legend, Richard Russell, uses the gold/bond ratio, in the form of spot gold versus the TLT (iShares 20+ year Treasury bond ETF) as his inflation versus deflation indicator. This does rely on the assumption that both markets are free. Nonetheless, deflationary forces remain in the ascendancy on this basis.
Gold v. TLT
18.0
16.0
2013
14.0
12.0
10.0
8.0
6.0
2009
2010
2011
2012
A lesson for us since the announcement of open-ended QE last year has been the danger of under-estimating the power of deflationary forces during the biggest debt crisis in history. However, even if deflationary forces temporarily regain the ascendancy, its worth putting our current position in a much broader long-term perspective.
October 2013
33
2013
Bigger Picture
It strikes us that there is a major blind spot regarding the bigger picture inflationary mega-trend in which we find ourselves. We like to put our current situation in the context of previous inflationary waves, or Great Inflations, during the last millennium. We are currently in the fourth Great Inflation of the last one thousand years. The first took place during 1209-1317 - the price level is shown in the chart below. Its noticeable how inflation increased sharply in its final stages.
First Price Inflation 1209 - 1317 (index 1209 = 100)
450
400
350
300
250
200
150
100
50
The second, during 1496-1650, was focused on the Spanish Empire once again inflation increased sharply in its final stages. The people who lived through this period christened it the Price Revolution on account of the severity of the inflation. The compound average growth rate in prices across this period was 1.5% p.a. a level which todays central bankers would define as price stability.
Second Price Inflation 1496 - 1650 (index 1496 = 100)
700
1209 1211 1213 1215 1217 1219 1221 1223 1225 1227 1229 1231 1233 1235 1237 1239 1241 1243 1245 1247 1249 1251 1253 1255 1257 1259 1261 1263 1265 1267 1269 1271 1273 1275 1277 1279 1281 1283 1285 1287 1289 1291 1293 1295 1297 1299 1301 1303 1305 1307 1309 1311 1313 1315 1317
600
500
400
300
200
100
The third inflationary mega-trend was slightly shorter at 80 years during 1733-1813, but once again there was a surge in prices during its final stages.
October 2013
1496 1499 1502 1505 1508 1511 1514 1517 1520 1523 1526 1529 1532 1535 1538 1541 1544 1547 1550 1553 1556 1559 1562 1565 1568 1571 1574 1577 1580 1583 1586 1589 1592 1595 1598 1601 1604 1607 1610 1613 1616 1619 1622 1625 1628 1631 1634 1637 1640 1643 1646 1649
34
300
250
200
150
100
50
1733
1735
1737
1739
1741
1743
1745
1747
1749
1751
1753
1755
1757
1759
1761
1763
1765
1767
1769
1771
1773
1775
1777
1779
1781
1783
1785
1787
1789
1791
1793
1795
1797
1799
1801
1803
1805
1807
1809
1811
The current one began in 1896 and accelerated (not surprisingly) after the collapse of Bretton Woods in 1971.
Source: Price History of English Agriculture, Measuring Worth
2,500
2,000
1,500
1,000
500
1897
1900
1903
1906
1909
1912
1915
1918
1921
1924
1927
1930
1933
1936
1939
1942
1945
1948
1951
1954
1957
1960
1963
1966
1969
1972
1975
1978
1981
1984
1987
1990
1993
1996
1999
2002
2005
2008
Will the trajectory of the current one increase in its final stages like the other three? Its almost comical to put all four on the same axes. Earth to Alan Greenspan and Ben Bernanke...
Source: Price History of English Agriculture, Measuring Worth
2,500
2,000
1,500
1,000
500
October 2013
1 4 7 10 13 16 19 22 25 28 31 34 37 40 43 46 49 52 55 58 61 64 67 70 73 76 79 82 85 88 91 94 97 100 103 106 109 112 115 118 121 124 127 130 133 136 139 142 145 148 151 154
35
2011
1813
Gibsons Paradox
Long-term data shows that consumer/wholesale prices and interest rates have tended to rise and fall together, although the relationship has changed slightly (see below) since the collapse of Bretton Woods (BW) and the permanent adoption of floating currencies. The simultaneous rise in prices (N.B. the price level not the rate of inflation) and interest rates is known as Gibsons Paradox. Wikipedia notes. Gibsons Paradox is the observation that the rate of interest and the general level of prices are positively correlated...The term was first used by John Maynard Keynes, in his 1930 work, A Treatise on Money. In their academic paper, Gibsons Paradox and the Gold Standard, Larry Summers (the one who nearly became Fed Chairman) and Robert Barsky commented (with our emphasis). Monetary theory leads us to expect a correlation between nominal interest rates and the rate of change, rather than the level, of prices. Yet, as emphasized by Keynes (1930), two centuries of data do not confirm this expectation... Keynes referred to the strong positive correlation between nominal interest rates and the price level, which he called Gibsons Paradox as ONE OF THE MOST COMPLETELY ESTABLISHED EMPIRICAL FACTS IN THE WHOLE FIELD OF QUANTITATIVE ECONOMICS. We break down the last 230-odd years (since 1788) into four long economic (Kondratieff) cycles of which the fourth is still to be completed, helped in no small way by the unconventional monetary policies of our central banking friends. The most clear cut example of Gibsons Paradox in operation was during the third long economic (Kondratieff) wave, 1897-1933 as we define it.
Gibson's Paradox 1897 - 1933
21.0 6.50%
19.0
6.00%
17.0
5.50%
15.0
5.00%
13.0
4.50%
11.0
4.00%
9.0
3.50%
7.0
3.00%
1897
1898
1899
1900
1901
1902
1903
1904
1905
1906
1907
1908
1909
1910
1911
1912
1913
1914
1915
1916
1917
1918
1919
1920
1921
1922
1923
1924
1925
1926
1927
1928
1929
1930
1931
1932
October 2013
36
1933
However, as we noted, this relationship broke down with the collapse of BW as we transited from a Gold Standard into todays free floating US dollar. Here is the chart of the relationship since 1968, the year which saw the collapse of the London Gold Pool, and prefaced BWs subsequent demise.
Breakdown of Gibson's Paradox: CPI index v. interest rates since 1968
250.0 16.0
150.0
10.0
8.0
100.0
6.0
0.0
0.0
However, the next chart shows that, while Gibsons Paradox broke down, the relationship shifted from the level of prices to its first derivative, i.e. to the rate of inflation itself...marking the end of the Paradox.
End of Gibson's Paradox: US CPI v. 10-yr Treasury yield (since 1968)
16.0 16.0 14.0
1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
14.0
8.0
6.0
8.0
4.0
6.0
-2.0
-4.0
0.0
Its interesting to look back to the biggest inflationary spike during 1976-80 and see how interest rates lagged the rise in inflation for most of that period. It illustrates the monumental challenge facing todays policy -makers if (when!) inflation does start to increase. Back then, total debt/GDP in the US was between 160170%. Today that figure is 350% and a rise in inflation would put policymakers between the proverbial rock and hard place. Allowing rates to rise sufficiently quickly to temper rising inflation would likely crash an overindebted economy, while doing nothing, or even trying to suppress rates further, would risk runaway inflation. Policymakers could lose control... Back in 1976-80, the situation wasnt made much more hazardous by an interest rate derivative mountain and a vast shadow banking system either.
October 2013
1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
US CPI (%)
37
2.80 0.05
2.20
0.15
1.40
0.30
Sep-12
Feb-13
Apr-13
Mar-13
Dec-12
Sep-13
Jun-13
Oct-12
Jul-13
Nov-12
For much of the last 3-4 months, banks operating in the US were able to fund (leverage) their inventories of securities at an average of 5-10 b.p. (General Collateral). If it had been all about the underlying strength of the US economy, we dont believe that tapering would even have been considered. The unspoken benefit from tapering would have been to free up the QE-driven shortage of high quality collateral (i.e. Treasuries and MBS) in the repo market. In the words of the Oliver Wyman consulting firm, the repo market is the structural backbone of US financial markets and its primary source of leverage. The IMF, Bank for International Settlements, Bank of England, US Treasury (TBAC) and Janet Yellen have all warned about the risks from the repo market in recent months. We also wonder whether Dallas Fed Governor, Richard Fishers, post-FOMC quote... The largest financial institutions are a dagger pointed at the heart of the economy. ...was an oblique reference to repos?
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May-13
Aug-13
Oct-13
Jan-13
An aside: it has become noticeable in recent months how more and more equity investors are taking an interest in shadow banking, and repos in particular. If youd mentioned Long Term Capital Management, Bear Stearns, Lehman and MF Global in the same sentence as repos only six months ago, you would probably have received many confused looks. Last month, more OTC derivative trades moved on exchange (requiring additional collateral) and some Treasury repos went special implying collateral shortages. We are going to find out whether, by not tapering, the Fed makes the collateral issue worse in the short term, or whether its a problem which can stay on the back burner for a while longer. Given the increasing recognition of QE-driven collateral shortage, it might not be coincidental that the possibility of fixed rate overnight reverse repos with full allotment was proposed at the July 2013 FOMC meeting and a pilot test authorised at last months meeting. Reverse repos can drain excess cash held by banks AND (unlike the Fed Funds market) non-bank financial institutions and replace them with overnight loans of high quality collateral, e.g. Treasury securities, from the Feds balance sheet. The Fed can set the rate on these reverse repos which will give it greater control over overnight rates in money markets. The official reason for these pilot reverse repos is for the Fed to test its exit instruments, which it could employ as part of its strategy to tighten monetary policy. When Bill Dudley of the FRBNY was asked why this facility was being set up, one of the two reasons he gave (besides setting a floor for money market rates) was that it would increase the availability of a risk-free asset, satisfying the demand when the appetite for safe assets increases. Which sounds suspiciously like an acknowledgement that one of its purposes is to address collateral shortage. The reverse repo test began during the week beginning 23 September with market participants limited to US$500m at 1bp. The limit was doubled to US$1.0bn only three days later! On 30 September 2013, 87 bidders borrowed a very large US$58.2bn of Treasury collateral from the Fed. Does that really fall into the definition of a test quantity. The so-called test runs until late-January 2014. With US$3.47 trn of securities on the Feds balance sheet (US$2.06 trn Treasuries), the Fed has plenty of ammunition with which to supply the repo market if financial markets become stressed. This should provide a substantial stability buffer in the early stages of a crisis in the US. However, we are sceptical that it will be enough if there is a sharp deterioration in the global economy, or one or more major financial institutions get into trouble. For example: If the debt crisis erupts again, the natural instinct of lenders, including those in the repo market, will still be to withdraw credit. This is a frightening prospect when the majority of repo loans are overnight; and The next crisis could be a sovereign debt crisis - which would put the valuation of the vast majority of the collateral underpinning the repo market in question. We spent quite a lot of time in this report talking about duration in one form or another. Then you stop to think that theres US$4.6 trn of leverage in US financial markets which is largely OVERNIGHT.
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