Friday, June 27, 2008

It's All About Deflation Stupid!

Amazing how many people are fixated on inflation. The media's myopic focus on inflation is understandable given the surge in oil and commodity prices.

Looking for answers, the media and politicians have decided to focus their attention on speculators like hedge funds and Commodity Trading Advisers (CTAs) that speculate on commodity trends. Pension funds have also come under close scrutiny as the U.S. Congress contemplates a proposal to ban pension funds from investing in commodity futures. The next time you fill up your gas tank or buy groceries, just remember that chances are your pension contributions are helping drive up the price of oil and other commodities.

Why are pension funds investing in passive commodity futures indexes, especially here in Canada where the S&P/TSX is dominated by energy and commodity shares? The rationale for investing into commodities and other hard assets like real estate, infrastructure and timberland is that they are "inflation sensitive" assets and since your pensions are indexed to inflation, pension fund managers decided to diversify their asset allocation and invest in these assets to hedge against unanticipated inflation.

But the diversification rationale is just as weak as the inflation concern. It turns out that in today's environment, commodities are highly correlated to other hard assets like real estate, timberland and infrastructure and just as vulnerable to a global deflationary spiral.

I quote from the article above:

"In the last five years, investment in index funds tied to commodities has grown from $13 billion to $260 billion, and the price of the 25 commodities that compose those indices have jumped 183 percent, according to congressional testimony from Michael Masters, managing member of the Virgin Islands-based hedge fund Masters Capital Management.

Mr. Masters dubs the pension and other investors as "index speculators." He estimates that in the first 52 trading days of this year, they flooded the market with $55 billion -- in a self-fulfilling prophecy of sorts since the more money they put in, the more prices rise."

Importantly, the bulk of that $260 billion is going straight into the Goldman Sachs Commodity Index (GSCI) which is composed of roughly 80% energy futures (mostly oil futures). Goldman Sachs did a great job marketing this index to their institutional clients but nobody stopped to think at what critical juncture does the marginal inflow into these commodity futures start influencing the underlying commodity prices. I guess we got our answer.

I am not just blaming pension funds for the speculative fervor that has gripped oil and commodity markets but they have to share some blame. William Engdahl states that perhaps 60% of today's oil price is pure speculation. The hitch is that regulation to curb speculation might exacerbate the problem as funds move into unregulated markets to place their bets. I quote Engdahl:

"Because the over-the-counter (OTC) and London ICE Futures energy markets are unregulated, there are no precise or reliable figures as to the total dollar value of recent spending on investments in energy commodities, but the estimates are consistently in the range of tens of billions of dollars."

So why are pension funds investing billions into commodity futures? A conspiracy theorist might argue that pension funds, the Fed and the U.S. Treasury desperately want to avoid debt deflation, lower pension liabilities and inflate their way out of their national debt by cheapening the greenback. Unanticipated inflation will bring about higher interest rates which lowers the present value of future pension liabilities. I am not into conspiracy theories but I must admit that this has crossed my mind.

But pension funds should be careful for what they wish for. An article in today's FT discusses how the spike in commodity markets is beginning to hurt leveraged buyout funds (LBOs). I recommend you read the comment posted on Naked Capitalism's site for more details. I mention this because if the BCE deal doesn't go through, Ontario Teachers' and its partners could be on the hook for as much as $1 billion. (I still do not understand how Teachers and their partners will make money from this deal. Debt financing of this scale is extremely risky given today's credit markets and good luck unlocking value from Bell Canada with its antiquated technology).

Now back to debt deflation. I agree with Todd Harrison, founder and CEO of Minyanville, that investors are missing the bigger threat of deflation (click to see video and refresh if it does not load up right away). Deflation in financial assets and housing (the latter is far more important than energy prices in the US CPI) will lead to a US and global recession, which will deflate the commodity bubble and further exacerbate the credit crisis. Most pension funds are not prepared for a long period of debt deflation. They'd better start preparing for it now.

Finally, take the time to read Michael Hudson's Counterpunch interview on the economy. It is excellent and well worth reading if you want to understand why the game is over.

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