Thursday, June 26, 2008

Notes To Self - End Q2 2008

This one is not for you, but for me...for the internal dialogue I run with myself - the one that integrates and assimilates the masses of new information arrival and worldly observations in order to update my forecast of the future. Necessarily, such a dialogue must be honest and as much as possible free from flowery language, normal humourous observations and effect to insure its integrity. Here goes...

Markets are pushing the commodity and the inflation meme to an extreme. And this swing of the pendulum from deflation in 2002 to the present was forecasted from the moment US authorities decided to rescue markets and the economy from cyclical recession by overly loose fiscal AND monetary policies , and in earnest from 2004 when Asian mercantilists joined the fracas by (i) continuing ZIRP and nearZIRP (ii) by not liquidating previously accumulated USDs (iii) and by unprecedented reserve accumulation by China, (iv) and other partially or unsterilized USD interventions and accumulations. Expectations in modernity are for the pendulum to swing with great speed - the speed with which epiphanies conjure themselves in market participants heads. But since these are policy-driven consequences reinforced by market feedback loops, the price and economic trends that emerge are strong and persistent. That is until the gravitational forces acting upon the pendulum assert themselves causing the pendulum and associated feedback loops to reverse direction.

By 2006 it was obvious to anyone who looked that the course was unsustainable: consumption by a tapped out consumer with a negative savings rate, the course in global house prices (particualrly in Anglo-Saxon land), putrid fiscal and monetary policies, current account deficits, reserve accumulations, currency pegs - the whole lot. YET, The Authorities chose to address these with co-conspiracy and not-so-benign neglect, and the markets requited with drawing down all manner of leverage to buy anything and everything, from "collaterized" re-packaged dogshit, to BAD art, to unimaginable large and vulgur stinkpots that apparently help compensate for the buyer's lack of natural physical endowments.

This asset-price run abruptly stopped (in things core) as the infamous Minsky moment arrived in 2007 causing said core-asset prices to begin to fall precipitously, but more importantly, its arrival marked the denoument of wanton credit expansion, the lifeblood of further asset price expansion and consumer deficit-spending, and ultimately inflation. I look around, I see carnage at the core. Carnage in real estate. credit, and equity. Look further and one sees the emerging devastation in the US consumer, financial institution balance sheets. "Wealth" has been prodigiously destroyed, with those at the center unable, unwilling and fearful of totalling up the losses. The impact is, and will be profoundly deflationary, whether people realize it or not just yet.

YET that inflation (of sorts) apparently is rife, is hard to deny. Its on the gas pump, at the supermarket, on the utility bill, and everywhere on the radio airwaves and print magazines. Its on the allocations of pension funds (be they TIPs or a dollop to the GSCI) , YET, (and this is important) IF it [inflation] is really here and going to stay, it is NOT in yet incorporated into nor discounted by equity prices (in terms of earnings forecasts and impact upon valuation ratings) , and most certainly NOT discounted by the king of financial paper, USD bond prices. What one CAN say is that food, industrial commodity and energy prices have already gone up. And that it is hurting one and all to greater and lesser effect. And that continued consumption has (in the USA) been debtor-financed courtesy of those that feel they have no other choice or are too spineless to do otherwise, leading to a BWII equivalent of "Dawn of the Dead".

But globalization, slack labour markets, wealth destruction and deflation in core asset prices has, is, and continues to place a boundary upon requiting the rise in commodities with a rise in consumer incomes necessary to afford said commodities. The result will ultimately be in diminishing quantity of demand - hardly encouraging for the forces of prolonged inflation. But for the moment, mercantilists and (to borrow Macro-Man's eloquence) the currency piss-takers, finance (still unsterilized) over-consumption, a tether that soon must, and will break, which allows the current deflation and inflation to co-exist in Olympiad Stagflation. But, unlike the 70s, this will be short-lived, because the credit-pendulum has already reached its highest point, the American consumer is more-than-spent, further commodity price rises themselves are highly destructive in terms of end-demand, real-estate in the developed world , be it commercial or residential, entirely satiated.

I am not arguing against Hubbard, or the likely continued rise in agricultural terms of trade from historically low levels, and the changes this will wring to our advanced energy-dependent consumer societies. These Malthusian trends may well be secularly robust until the emergence of cold nuclear fusion, or Craig Ventner's mass-commercialization of bacterially-produced crude oil. However, we are well on the divergent road towards demand destruction, de-leveraging and credit revulsion, and with globalization, these trends will insure that a wage-price spiral is not on the menu. And consequentially, since I believe that the world is MORE inter-dependent, not less hence, hence the hopeful panacea of decoupling is bunk -at least for the moment. I think the more interesting next question will be: "How do the EMs, mercantilists, and currency piss-takers fiscally and monetarily respond to dramatically lower demand from the US and credit availability from traditional sources ?? In the meantime, stay short of stocks, long-bonds and bad credit, rent rather own, insure your car is fuel-efficient, ride your bicycle more, and apprise yourselves in the art of market-gardening.


James said...

Everyone is hiding in commodities.

Richard said...

Agree. From what I’ve read, the Chinese, up until recently, kept diesel prices unchanged for 18 months. The recent 20% rise is to ~$3.00/gallon. I’d assume that any good businessman there would keep his tanks full to the extent possible, which is likely why there is such strong demand in China. I believe that a lot of Chinese real estate purchases were funded with dollar debt, thus getting a two-way bull market play. Along with the stock market, that party is getting a little stale- see -

China will try to keep a smile on their face through the Olympics, but afterwards? Perhaps you have a better vantage-point than I do, but is the worldwide position in borrowed US$ (effectively short) to buy emerging market and Chinese assets (not denominated in US$). In a deleveraging event, does the US$ appreciate as the sure-fire levered long assets get liquidated, with demand for US$ simply to repay debt?

It seems inconceivable to me that oil can continue to rise with what’s going on in the economy. The question is what happens to other issues when the oil and resource leadership in the stock market cracks? The stock market already feels a lot like 1973-4, with a slow water-torture dripping away of value. I’d be less concerned with the situation if there was less focus on the markets, but the extent of participation by everyone worldwide creates the possibility of a contagion. Offsetting that is the extent of cash that seems to be everywhere. The innovative ideas I see every day makes it difficult to be a permabear. But for now, ???

OldVet said...

Nice summary, C. I wonder how long the gloomy interregnum will last? 10 years? Probably until the first large scale commercially viable alternative energy plant comes on line, that proverbial 100 square miles of mirrors and solar panels in some desert. Many assume energy advances will happen in the West, but I think applications in the East will happen much faster. The other triggering "turn around" event would be the opening of a Soylent Green factory on Wall Street.

David Pearson said...


Nice post. I think, though, that it reflects a certain dollar mindset: that its basically terra firma, if you will.

Imagine Argentina in the same situation. Overstretched consumer, banks in trouble, deficit widening, inflation rising, Central Bank credibility at issue. Would you rush in to buy their bonds on the thesis that domestic demand will crater? No. You would smell a maxi-deval coming and send your money to Switzerland faster than you can say, "exchange controls."

Of course the U.S. is not Argentina. The comparison is useful, though, because it introduces the "key" that can make the inflation and deflation scenarios run in parallel: a maxi dollar deval. Not against the Euro, mind you, but against all reserve accumulators. Here's a self-feeding loop if there ever was one: lower dollar, less inflows to Treasuries, lower dollar. Does sound a bit like a drama set in the Pampas, doesn't it?

The U.S. gets inflation and recession. The rest of the world reprices commodities (in local currency), which of course staves off some of the demand destruction. More inflation for the U.S., along with high nominal interest rates, which of course deepens the recession.

Hardly a recipe for robust ROW growth, but its the dollar price of commodities we invest in, not the real volume increases.

superduperdave said...

So let me get this straight: You're saying this is a great time to buy stocks and U.S. dollars?

Anonymous said...

A pleasurable read of an unsettling process.

Blissex said...

«"Wealth" has been prodigiously destroyed, with those at the center unable, unwilling and fearful of totalling up the losses. The impact is, and will be profoundly deflationary, whether people realize it or not just yet.

YET that inflation (of sorts) apparently is rife, is hard to deny. Its on the gas pump, at the supermarket, on the utility bill, and everywhere on the radio airwaves and print magazines.»

Well yes, but you are talking two different classes of people and two different sets of countries.

The deflation/inflation story is playing out very differently depending on whether one is a worker or an owner, and whether in the USA or BRIC.