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PCE Deflator points to equity market sell-off in 2014

16 Dec

The Personal Consumption Expenditure (PCE) Deflator is a United States-wide indicator of the average increase in prices for all domestic personal consumption. Along with the CPI, it is commonly used as a measure of inflation.

The PCE has very rarely dropped below 1.0%. Global macro-economic forces, however, are pushing the PCE down towards a very dangerous level. As countries battle to devalue their currencies they become more competitive as their goods are cheaper for foreign consumers to purchase. This cheapening of goods leads to downward pressure on the average price of goods.

The recent devaluation of the Yen has is a good example of how this is affecting prices in the US presently. The drop in the Yen has substantially increased the competitiveness of Japanese manufacturers in global trade. As Asian manufacturers struggle to retain market share they also drop the prices of their USD goods. This compounding effect raises serious issues for importing nations such as the United States as their manufacturers become less competitive and consumers become accustomed with the idea that goods will continue to cheapen, hence preferring to save for when they are cheaper than to invest and buy goods today.

The chart below shows that the PCE deflator (in blue) has been dropping consistently for the past 20 months. The yellow line shows the 5-year breakeven rate, a measure of the market’s future expectation of inflation, in this case in five years’ time. The breakeven rate shows that the FED has, so far, been very successful at buoying the market’s expectation of future inflation by promising to keep monetary policy very loose for a long time.

PCE Deflator

The issue, however, is that the enormous quantity of money printed by the FED is not making its way down to consumers. Instead, it has inflated equity markets and created the largest credit market bubble in history. At some stage the perception of the FED’s efficacy in easing will fade and inflationary expectations will fall to more realistic levels.

Equity markets on the edge of a precipice

This could cause a serious re-rating of equities as market participants set more realistic expectations of companies’ future earnings.

The chart below shows that inflationary expectations tend to move in sync with equity market movements.

Breakeven vs SPX

Unfortunately, as seen in the previous chart, inflationary expectations tend to follow the PCE deflator which is most certainly on a downward trajectory.

George Magnus, the well known economic consultant and former chief economist of UBS, recently wrote an interesting article in the Financial Times link highlighting the risks of ever richer equity markets fuelled by monetary easing in a world facing anaemic growth.

Investors should always expect return when taking risk. The current environment doesn’t offer a very rewarding environment for risk takers. Savy investors would be wise to take profits and watch the events unfold from the sidelines.

Is the Topix just the Yen in disguise??

9 May

Investors love to find deep and academic excuses for the movements of markets, but sometimes things are so obvious they fail to be noticed.

The chart below shows the progression of the Japanese Yen and the Topix over the last year.

Yen and Topix

It is nothing short of remarkable how correlated the two are. One could argue that this makes perfect sense given that Japanese companies become more competitive as the Yen devalues. This is, of course, true, except that according to the World Bank exports of goods and services account for less than 15% of the Japanese economy compared to 50% in Germany. Like the US, where the figure is 14%, Japan relies far more on the domestic market and should therefore have less sensitivity to the weakness in the Yen than most other countries.

So why have Japanese equity markets been so correlated to the Yen?

The most likely answer is that it has been driven by foreign investors keen to profit from Japan’s new inflationary policy. The cheaper the Yen gets, the more USD-based investors can afford to buy Yen denominated equities.

The eventual outcome for Japanese equities could be astronomical. Domestic investors are still sitting on the sidelines, instead sitting on return-free risky government bonds. As inflation picks up, assets flowing out of bonds and into equities could be enormous. Great for equities but very damaging for bonds and the Japanese Government that will have to pay higher interest rates on its monstrous debt pile. This is clearly very bad for the Yen as panic ensues and investors seek safer havens. A currency collapse is, not only plausible, but now increasingly probable.

A long term buyer of Japanese equities could realistically make a significant return, potentially multiple times their initial investment. But only – and this is absolutely crucial – if the Yen exposure is completely hedged. The last thing you’d want is for your stocks to triple yet still lose as the Yen proves to be worthless.

 

Has gold peaked or is the bull run still underway?

16 Apr

Commentators love simplicity.  Most news sources blame gold’s precipitous fall on the expectation that the Fed will tighten monetary policy soon. If that’s the case, why have bond yields been so muted?

It doesn’t add up.

QE has been supporting numerous assets, the main one being government bonds which have been the main beneficiaries of the newly created dollars. If there was any real risk that the Fed really would stop printing, government bonds would have felt the impact immediately with yields rising sharply.

Given that 10 year Treasury yields actually fell by 4 basis points yesterday to 1.68% there is very little evidence that QE is going away any time soon.

There are a number of reasons for this. The economy continues to stall and unemployment remains persistently high. Until key economic indicators start to improve meaningfully, the Fed has little reason to stop. Ironically, the drop in food and energy prices actually takes pressure off the Fed to end QE soon.

So why has gold fallen so steeply, so fast? Data points to the closing of speculative longs rather than any significant change in demand for gold use in jewellery, which accounts for approx. 45% of gold demand.

Will it continue to fall? The risks appear to point to the upside:

QE is not going away soon (Japan has vowed to double its monetary base over the next two years) and the cost of capital remains at historically depressed levels.
At the current price, producers fail to make a profit on gold mining which should lead to a fall in production.
Central bankers continue to buy (with the possible exception of Cyprus in the short term).
Demand for jewellery in Asia and other emerging markets continues to rise.
Global currency debasement will ultimately lead to inflation.

Gold is a volatile asset but its long term fundamentals remain intact. The canary in the coalmine must be government bonds, so worth keeping yields in check.

Whatever the reason, gold is no Bitcoin!

Move aside Bernanke. Bank of Japan blows away expectations with its boosted QE

5 Apr

On April 4th the Bank of Japan announced an enormous shift in policy and the largest monetary injection ever announced by a major Central Bank. The new governor, Haruhiko Kuroda, had been expected to come up against opposition from other policy members who had been tied to the BoJ’s previous philosophy on monetary policy. The reaction was so surprising not only because of the scale of action in itself, but also because of the approval Mr. Kuroda received from all but one of the nine board members.

The flood gates are not just open, they have been blown away.

In order to change the deflationary expectations so ingrained in the Japanese psyche only a major boost in asset and consumer prices would suffice. This is exactly what the BoJ is trying to do. By committing to doubling the monetary base over the next two years from 29% to 55% of GDP (Y135tn to Y270tn) – an increase of a over 1% of GDP per month compared to the Fed’s 0.5% – the BoJ has very dramatically stated that inflation will no longer elude Japan.

The effects to equity, bonds and the Yen should be sizeable. Indeed, we have already seen a sudden drop in the Yen and, more importantly, a dramatic fall in bond yields of longer duration (up to 40 years), where the BoJ is attempting to remove duration risk from the private sector, hence encouraging investment in real assets. Equities should continue to surge as capital flows away from the bond market but investors should be very wary of inflationary expectations. Should bond yields start to rise the great monetary experiment could very easily end in disaster.

Party while the music plays but beware that the endgame for Japan has been brought meaningfully closer than ever before.

Central Banks are seeking to devalue currencies. Will it ultimately destroy trust?

22 Mar

Fiat money is worth nothing without trust. History has shown that the general populace has great distrust of paper money, hence the need for its backing with some form of physical currency such as gold, silver or copper. Yet here we are, with no such backing (the gold standard was abandoned some 40 years ago), and Central Banks appear to be acting with very little regard to the value of trust.

The new Bank of England Governor, Mark Carney wants to adopt more unconventional monetary policies, Ben Bernanke has indicated that the Fed will continue to print and the Bank of Japan’s new governor has set his sights on aggressively tackling deflation through monetary easing. When everyone is so focused on one thing, it is easy to lose sight of what is really going on.

Inflationary expectations have risen consistently over the past three years. Equity markets have more than doubled from the market lows. The top 1% of US earners now account for over 21% of US total income. Inequality, not surprisingly, has risen substantially – see chart below.

GINI

(Source: Gini Co-efficient, Bloomberg)

The Gini coefficient is a measure of equality, where 0 corresponds with perfect equality and 1 corresponds with perfect inequality. US inequality has consistently been rising since the 1970’s along with the percentage of top earners that account for a greater portion of total income:

Top earners

(Source: Dylan Grice, The Edelweiss Journal)

Every crisis has a breaking point. That day may still be a long way away, but there is no doubt that we will face greater headwinds down the line.

Dylan Grice, the former global strategist at Société Générale, has recently joined Edelweiss Holdings Limited where he published last week an very interesting report on the value of trust.

The report is very much worth a read and while there is little one can do to prevent the ensuing crisis, there is no harm in being aware of what can happen when trust disappears within a society.

How will we ever get out of this mess?

11 Mar

Developed nations are heavily indebted (governments, business and individuals), unemployment is high, prices are on the rise and income inequality is only getting worse. Is it even possible to get out of this mess?

According to Richard Duncan, author of the brilliant yet very gloomily named book ‘The New Depression“, the answer is very much a yes.

It is time for another ‘Space Age’. As Kennedy announced in 1961 that the US would put a man on the moon, today’s governments should also announce an equally ambitious space project. But instead of sending a man into space, this time our attention should be focused on harnessing the energy that’s out there in space, coming straight from the sun.

Setting a target to get the entire economy fuelled solely by solar power within a specified period could leverage the economy in many ways; such a statement of intent should cause oil prices to fall rapidly resulting in an immediate boost to consumer’s disposable income and reducing the government’s trade deficit. Military spending on energy security in volatile regions would fall, further improving the budget deficit.

Mr. Duncan estimates that a $1 to $1.5 trillion investment over 10-15 years by government (potentially in association with the private sector) would boost jobs in manufacturing, R&D and lead to considerable overseas investment into the economy.

When governments can borrow at 2% for 10 years (and having very willing domestic and overseas central bank buyers of those bonds) it is difficult to argue that such investment would not yield vastly superior returns to the government, the economy and for future generations.

If only politics didn’t have to get in the way…

NRJ

Does money printing really affect the price of gold?

28 Feb

Yes. Economic theory would suggest so and the proof appears to back the theory.

The quantity theory of money asserts that changes in the quantity of money cause a proportional change in the price level, expressed as:

MV = PT

Where M is money, V is velocity, P is price level and T is trade. PT combined would therefore  = GDP.

Economists are all fighting over whether QE will ultimately lead to inflation. I believe it will but it is fair to say that a huge number of factors affect the CPI, and it isn’t as simple as it sounds.

So let’s simplify it. Let’s just look at whether QE could lead to gold price inflation. Given both gold and the dollar are units of currency, one can simplify the equation to M = P or 1 unit of USD = 1 unit of Gold. Given that gold can’t be printed, a doubling of ‘M’, for example, should lead to a rise in P. i.e. P = 2M or 1 unit of gold now equals 2 USDs.

Has gold been rising with money supply?

The chart below shows the US Monetary Base overlaid by the price of gold going back to 1960. Given the dollar was taken off the gold standard in 1968, one would expect some deviation between the two series, but the correlation is still very striking.
US monetary base vs Gold
(Source: Bloomberg)

Another interesting chart looks at the size of the Fed’s balance sheet. The white line shows the staggering expansion of the Federal Reserve’s balance sheet which has expanded by US$2.5 trillion since 2007. To put this in context, it took almost 100 years for the Fed to build its balance sheet to US$0.9 trillion and it then almost tripled this in the last four years.

However, if we look at the Fed’s balance sheet in gold terms (orange line) we can see that it hasn’t actually expanded by anywhere near as much. In fact it’s about the same size as it was back in 1997!

Fed Balance sheet price in gold
(Source: Bloomberg)

Unemployment remains high (U6 unemployment remains at 14.4%) and the economy is yet to recover. No, we haven’t even mentioned sequestration yet. The Fed will not be stopping QE any time soon and gold’s upwards trajectory is therefore unlikely to deviate too far from the trail of the US’s highly expansive monetary base.

Don’t be fooled by the FOMC minutes. QE isn’t going away quite yet.

25 Feb

Last week’s minutes from the FOMC’s January meeting showed divided opinion on the effectiveness of QE and how much longer it should be employed for.

But reading between the lines we can get a clearer view as to why the minutes drew attention to the split and what the resulting policy going forward may be.

Why the attention on the costs of QE?

Esther George, president of the Federal Reserve Bank of Kansas City, voted against continuing asset purchases at the central bank’s January meeting out of concern about “the risks of future economic and financial imbalances,” according to the minutes. Prices “of assets such as bonds, agricultural land, and high-yield and leveraged loans are at historically high levels.”

Farmland in the Midwest was up 16% in 2012 (Iowa saw prices rise 20%), according to the Federal Reserve of Chicago, the third largest annual gain since the 1970’s.

Fed Governor Jeremy Stein is concerned with corporate debt as yields reach record lows, driven ever lower by investors seeking any form of yield. Equity markets have seen a significant rise, the S&P 500 is up almost 40% since October 2011, raising questions as to who is benefiting the most from the Fed’s ultra-loose monetary policy.

So what is the message between the lines?

In 2010 Janet Yellen  was asked to chair a new FOMC communications subcommittee to focus on central bank transparency to minimise confusion over Fed policy.

But its purpose extends far beyond that of providing markets with a transparent message. Instead, it has allowed the Fed to utilize communication as a further tool;

Communicating that certain members are concerned by specific financial imbalances enables the Fed to highlight that it is aware of these imbalances and can act if it needs to. Emphasising this concern can, they hope, dampen excessive speculation in certain areas without affecting the overall policy objective of maximising employment while maintain price stability.

Unemployment remains persistently high. The Bureau of Labor Statistics U6 unemployment figure, which unlike the reported unemployment number (U3), includes discouraged workers and those who would like to work, either full-time or part-time, but cannot due to economic reasons, is at 14.4% – some 40% above the long term average (see chart).

US unemployment U6

(Source: Bloomberg)

Inflationary expectation remain subdued. The attached chart, published in The Economist, shows that 10 year breakeven rates remain low, although Japan has seen a meaningful rise since 2011.

Breakeven rates

(Source: The Economist)

The message remains clear: until proof begins to emerge that economic figures truly reflect an improvement in the economy we will see very little change from Fed policy. Unless you believe that the fed’s communication tool can effectively dampen asset price bubbles, risk assets have some way still to go.

FOMC divided on when to end purchases

21 Feb

The minutes of the FOMC Jan 29-30 meeting show divided opinion on when to end asset purchases.

A ‘number’ of participants believe the costs of QE would materialize before the benefits, while ‘several’ participants argue that the risks of ending QE prematurely are very high.

End sooner?

The debate does raise important questions as an early scaling back of QE could materially affect a number of markets. Bond yields and mortgage rates are at or near historical lows, aiding businesses requiring financing and home owners who can refinance mortgages or purchase properties very cheaply. This ultimately helps drive a recovery in the housing market, a vital component to the health of the economy . Equity markets have also rallied significantly, boosting consumer confidence and sparking a revival in M&A, as seen recently by Mr Buffet’s recent acquisition of Heinz.

Maintain asset purchases until unemployment drops?

The ‘cost’ of QE, raised by a number of the committee, refers to the impact on future inflation that printing money is likely to have.

US inflation at 1.7%, at first, should not cause great concern. But the FOMC participants know how quickly expectations can change if central banks are seen to be irresponsible with regards to price stability, a significant objective of the Fed’s monetary policy.

It seems the Fed is stuck between a rock and a hard place and the debate will continue for some time yet. Participants will ultimately be forced to make the least worst decision.

Given Mr Bernanke’s lifelong focus on analysing the causes of the great depression, it would be a great surprise if the Fed did prematurely end asset purchases. QE, after all, is part of Mr Bernanke’s detailed and meticulous plan to ensure that we never return to the deflationary depression of the 30’s – Read here Bernanke’s 2002 speech.

His plan may well work, but at what cost?

Keep an eye on the FOMC minutes this Wednesday

18 Feb

Fed minutes from the meeting of January 29-30 are released this Wednesday.

Markets will be focusing on whether there will be any mention of future plans for ending purchases.

This seems unlikley, however, given the persistently elevated level of unemployment and subdued inflation numbers. CPI is also out on Thursday with consensus estimates for inflation to remain at 1.7% in the US.

Let us know what you think.

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