Thursday, December 11, 2014

Is This Time Really Different?

Myles Udland of Business Insider reports, Jeffrey Gundlach Explains Why 'This Time It's Different':
DoubleLine's Jeffrey Gundlach just wrapped up his latest webcast, outlining why this time, when the Fed hikes interest rates, it will be different.

Gundlach, who said recently that the US dollar looks set to go even higher said that, if crude oil falls to $40 the 10-year yield could fall to 1%.

Gundlach also highlighted a few things that, to him, make it appear that "all is not right" in the global markets.

Oil has cratered.

Two-year yields have gone negative in Germany, meaning investors are paying the German government to keep their money.

And with the situation in Greece now appearing more unstable, Gundlach is not convinced that there isn't something wrong in the global economy.

On specific investing themes, Gundlach said that he has allocated some money to junk bonds after having almost no money in the sector at the beginning of this year.

Gundlach is also closely watching the Treasury yield curve, which has been flattening this year, meaning that short-term rates have been rising while longer-date Treasury yields have been falling.
You can read Gundlach's complete presentation here. Take the time to carefully go over this slide presentation, it's excellent and shows you why Gundlack has supplanted Bill Gross as the new bond king.

So the question everyone has on their mind, including yours truly, is this time really different? Let me begin by stating flat out that I am in total agreement with Gundlach, even if it's a "crowded trade", the mighty greenback will keep surging and U.S. bond yields will keep on declining as deflation grips the eurozone, China and Japan. Add to this another possible Greek black swan and you don't have a recipe to sour on debt.

Importantly, as long as there is severe economic weakness overseas, foreign investors will keep piling into the safest, most liquid bond market in the world, good old U.S. Treasuries.

Now, there are two ways you can view the macro environment, and I want you to all pay attention here. First, you can take a U.S. centrist view, ignoring global weakness, focusing solely on the U.S. economic recovery which right now is the envy of the world

The "Made in the USA" viewpoint rightly notes that in the past, it's always been the U.S. economy which leads the world in and out a global recession. My own research on Galton's fallacy and the myth of decoupling made me highly suspicious of American economic naysayers hailing a new economic paradigm shift was taking place where emerging market economies would lead the world.

This is utter nonsense but plenty of institutional investors are still buying this sell-side fairy tale hook, line and sinker. But while the U.S. is still the economic engine of the world, there is no denying that globalization is much more important now than at any time in the past.

This brings me to the second way of thinking of the world, the non-U.S. centrist view, which basically says we need to pay a lot more attention to what's going on in the rest of the world because it can spill over into the U.S. and wreak havoc on the global economy.

Those of you who regularly read my blog know that deflation is a central theme I obsess over. Why? Because it's THE most important theme to understand in terms of the macro environment and if you're on the wrong side of the deflation trade, you risk getting crushed.

There are plenty of global macro hedge funds which learned this lesson the hard way in 2014 --  getting their calls right shorting the yen, the euro and going long equities -- but getting obliterated on their short Treasuries trade. Many long/ short equity funds also suffered big losses in 2014 because they failed to understand the macro environment, and got clobbered on their long energy trades.

It's hardly shocking that hedge funds are closing like it's 2009. Most of these "alpha gurus" are not performing and others that are performing are ill-prepared for the storm that lies ahead.

More often than not, the plunge in oil prices is portrayed by financial pundits as and "oversupply issue" and "unambiguously good" for the global economy but this is pure rubbish.

In a recent article, Ambrose Evans-Pritchard of the Telegraph discusses why Bank of America sees $50 oil as Opec dies:
The Opec oil cartel no longer exists in any meaningful sense and crude prices will slump to $50 a barrel over the coming months as market forces shake out the weakest producers, Bank of America has warned.

Revolutionary changes sweeping the world’s energy industry will drive down the price of liquefied natural gas (LNG), creating a “multi-year” glut and a much cheaper source of gas for Europe.

Francisco Blanch, the bank’s commodity chief, said Opec is “effectively dissolved” after it failed to stabilize prices at its last meeting. “The consequences are profound and long-lasting,“ he said.

The free market will now set the global cost of oil, leading to a new era of wild price swings and disorderly trading that benefits only the Mid-East petro-states with deepest pockets such as Saudi Arabia. If so, the weaker peripheral members such as Venezuela and Nigeria are being thrown to the wolves.

The bank said in its year-end report that at least 15pc of US shale producers are losing money at current prices, and more than half will be under water if US crude falls below $55. The high-cost producers in the Permian basin will be the first to “feel the pain” and may soon have to cut back on production.

The claims pit Bank of America against its arch-rival Citigroup, which insists that the US shale industry is far more resilent than widely supposed, with marginal costs for existing rigs nearer $40, and much of its output hedged on the futures markets.

Bank of America said the current slump will choke off shale projects in Argentina and Mexico, and will force retrenchment in Canadian oil sands and some of Russia’s remote fields. The major oil companies will have to cut back on projects with a break-even cost below $80 for Brent crude.

It will take six months or so to whittle away the 1m barrels a day of excess oil on the market – with US crude falling to $50 - given that supply and demand are both “inelastic” in the short-run. That will create the beginnings of the next shortage. “We expect a pretty sharp rebound to the high $80s or even $90 in the second half of next year,” said Sabine Schels, the bank’s energy expert.

Mrs Schels said the global market for (LNG) will “change drastically” in 2015, going into a “bear market” lasting years as a surge of supply from Australia compounds the global effects of the US gas saga.

If the forecast is correct, the LNG flood could have powerful political effects, giving Europe a source of mass supply that can undercut pipeline gas from Russia. The EU already has enough LNG terminals to cover most of its gas needs. It has not been able to use this asset as a geostrategic bargaining chip with the Kremlin because LGN itself has been in scarce supply, mostly diverted to Japan and Korea. Much of Europe may not need Russian gas at all within a couple of years.

Bank of America said the oil price crash is worth $1 trillion of stimulus for the global economy, equal to a $730bn “tax cut” in 2015. Yet the effects are complex, with winners and losers. The benefits diminish the further it falls. Academic studies suggest that oil crashes can ultimately turn negative if they trigger systemic financial crises in commodity states.

Barnaby Martin, the bank’s European credit chief, said world asset markets may face a stress test as the US Federal Reserve starts to tighten afters year of largesse. “Our biggest worry is the end of the liquidity cycle. The Fed is done and it is preparing to raise rates. The reach for yield that we have seen since 2009 is going into reverse”, he said.

Mr Martin flagged warnings by William Dudley, the head of the New York Fed, that the US authorities had tightened too gently in 2004 and might do better to adopt the strategy of 1994 when they raised rates fast and hard, sending tremors through global bond markets.

Bank of America said quantitative easing in Europe and Japan will cover just 35pc of the global stimulus lost as the Fed pulls back, creating a treacherous hiatus for markets. It warned that the full effect of Fed tapering had yet to be felt. From now on the markets cannot expect to be rescued every time there is a squall. “The threshold for the Fed to return to QE will be high. This is why we believe we are entering a phase in which bad news will be bad news and volatility will likely rise,” it said.

What is clear is that the world has become addicted to central bank stimulus. Bank of America said 56pc of global GDP is currently supported by zero interest rates, and so are 83pc of the free-floating equities on global bourses. Half of all government bonds in the world yield less that 1pc. Roughly 1.4bn people are experiencing negative rates in one form or another.

These are astonishing figures, evidence of a 1930s-style depression, albeit one that is still contained. Nobody knows what will happen as the Fed tries to break out of the stimulus trap, including Fed officials themselves.
There are several points raised in this article, some of which are spot on and others that are ludicrous.  First, Bank of America is dreaming in technicolor if it thinks oil prices will rebound to $80 or $90 in the second half of next year. This is surely to help their hedge fund clients betting on a revival in energy.

But as I explained in my comment on why Canada's crisis is just beginning, all these hedge funds making contrarian bets on energy (XLE), commodities (GSC) and oil service stocks (OIH), are going to get their heads handed to them as lower oil prices are here to stay.

Where I agree with the article is in the discussion of how Fed tightening -- if it happens -- will negatively impact the liquidity cycle, risking more chaos in global markets. But as Sober Look explains, the Fed is increasingly concerned about importing disinflation and its policy trajectory is tied to the global recovery.

Importantly, the biggest policy mistake the Fed can do is ignore the bond market and underestimate the risks of deflation spreading throughout the world and possibly coming to America.

This morning we learned that U.S. import prices posted their largest drop in  2-1/2 years:
The Labor Department said on Thursday import prices dropped 1.5 percent last month, the largest decline since June 2012, after falling 1.2 percent in September. November marked the fifth straight month of declines in import prices.
Go back to read my comment on the mighty greenback and how this is a source of disinflation and possibly deflation:
What does the strong USD mean for the U.S. economy? It means oil and import prices will drop and exports will get hurt. Ironically, lower oil and import prices will reinforce deflationary headwinds, which isn't exactly what the Fed wants. But the stronger USD might also give the Fed room to push back its anticipated rate hikes. Why? Because the rise in the USD tightens up financial conditions in the U.S. economy, acting as a rate increase.

In terms of stocks, the surging greenback may be a triple whammy for U.S. earnings. Multinationals which as a group derive almost half of their revenue from international markets, will see a hit on their earnings, especially if they didn't hedge accordingly. But you should see small caps (IWM), which have been beaten down hard in September and thus far in October, rally as they're more exposed to the domestic market.

Despite the October selloff, I'm not worried of another stock market crash. I maintain that the real risk in stocks remains a melt-up, not a meltdown, but you have to pick your spots carefully or risk getting slaughtered (look at coal, gold, commodity stocks that were obliterated in 2014). This is why a lot of active managers underperforming this market will continue to do so as we head into year-end. There are a lot of things that could derail this endless rally but there is still plenty of liquidity to drive all risk assets much, much higher.

Having said this, we are at an important crossroad here. The euro deflation crisis is threatening the global economy. If the ECB doesn't act fast, it will get worse, and likely spill over to the rest of the world. Then you will see more quantitative easing from all central banks as they try (in vain) to fight the coming deflation spiral.
That is when you will see central banks really panic and a true systemic crisis in capitalism. On that last point, Jonathan Nitzan shared these thoughts with me:
This was our point since the beginning of the current systemic crisis, which started not in 2008-9, but in 2001. Our short paper "It's All About Oil" (2003, and the longer "Dominant Capital and the New Wars" (2004, argued that the experts got it all wrong. The new wars in the Middle East were meant not to lower the price of oil in order to spur economic growth, but to raise it in order to kick start inflation. Our paper "Still About Oil?" (2014, shows that this imperative is in fact stronger today than it was a decade ago.
Jonathan thinks that a "war in the Middle East is becoming more and more likely by the day." But I countered that line of thinking stating that geopolitical tensions sending oil prices higher will reinforce deflationary, not inflationary headwinds. If oil prices start rising fast, they will impede global growth, which is why I think Opec was right not to cut its production.

Finally, I want to bring to your attention a couple of things. First, another comment by Ambrose Evans-Pritchard, Greek candidate willing to call European leaders’ bluff, which rightly notes "events have rudely exposed the illusion that Greece's people will submit quietly to a decade of colonial treatment and debt servitude," but also disappointingly portrays Alexis Tsipras, the leader of the left-wing Syriza party, as some sort of courageous political leader.

He's not. Like most Greek politicians, he's a corrupt, power hungry demagogue who panders to the masses spreading dangerous lies that will set the country back decades. Greeks have every right to feel desperate and even betrayed as mindless austerity is wreaking havoc on their economy but voting for Syriza won't solve their problems, it will only make them worse.

Second, the Bank of Canada came out on Wednesday stating that Canadian housing prices could be overvalued by as much as 30 per cent, but governor Stephen Poloz maintains the country's still-chugging real estate market is likely to stay on course for a soft landing.

I think that is wishful thinking on Steve's part but given the political position he is in, I am not surprised by his comments. Read Brian Romanchuk's  latest, Peak Oil and the Cycle, to understand why you should be less optimistic on Canada.

And Jim Keohane, President and CEO of the Healthcare of Ontario Pension Plan (HOOPP), shared these thoughts with me on the Canadian housing bubble:
"There seems to be a failure to connect the dots here. The main driver of the higher housing prices is the low financing rates created by the Bank of Canada’s low interest rate policy. I would say that consumers are acting perfectly rationally – when you lend them money for free you should expect that they are going to use that free money to buy big ticket items like housing. Housing may be appropriately priced given the low level of interest rates."
Jim is absolutely right, the main driver supporting demand for housing is the Bank of Canada's low interest rate policy but there is no doubt that over-indebted consumers are taking on mortgages they can't afford if they lose their job.

Worse still, Canadian banks are still passing on most of the risk to Canada's mortgage monster but that bubble is about to burst even if Canada’s banking regulator has somewhat stupidly washed its hands of the idea of forcing banks to assume more of the risks from their mortgage businesses (shows you where OSFI's interests lie).

In this regard, things aren't different at all, regulators are still asleep at the wheel but Canada's brewing crisis will expose systemic issues that have hereto been ignored.

Below, Ray Dalio, Bridgewater Associates founder, provides his outlook on the U.S. economy and discusses why the effectiveness of monetary policy is waning. Listen closely to his comments because he understands how the deflationary boom can turn into a bust and explains why this time it's different.

No comments:

Post a Comment