Sunday, March 31, 2013

Hedge funds hurt by drop in corn, wheat prices, but the decline may be short-lived

Agricultural commodities got slammed last week as a result of two news items.

1. Corn planting acreage is expected to hit the highest level since 1936. With supplies low and prices expected to stay firm, farmers are planning to expand the number of acres used for corn. This points to an immense flexibility of the US agricultural economy.
Farm Futures: - The Farm Futures survey of more than 1,750 growers found farmers ready to plant 97.43 million acres of corn, up .3% from 2012. If achieved, the total would be the most since 1936.

The increase in soybeans could be even more dramatic. Farmers said they want to plant 79.09 million acres this spring, up 2.5% from 2012 and easily an all-time record if achieved.
2. While corn supplies are materially lower than last year, the latest USDA data showed stocks did not decline as quickly as expected. Apparently the demand for animal feed has been relatively weak.
Farm Futures: - May corn futures dropped their daily 40-cent limit this morning, after USDA shocked the market once again with a March 1 grain stocks number that showed much bigger supplies than expected.

At 5.399 billion bushels, inventories are down 10% from a year ago. The government's estimate was above even the forecast from Farm Futures survey, the largest pre-report estimate in the market, and almost 400 million bushels above the average trade guess.

The data suggests lower than expected corn feeding during the second quarter of the marketing year and perhaps greater 2012 crop production as well. Wheat stocks of 1.234 billion were also greater than expectations, implying less wheat was also fed than traders anticipated.
Anecdotal evidence suggests that a number of hedge funds got caught being long corn and were forced to unwind. CFTC data shows speculative net positions in corn as of 3/26 at the highest level (net long) for the year.

Speculative corn net contracts (source: CFTC)

The unwind forced a violent selloff across agricultural futures, particularly corn - hitting daily down-limit.

May corn futures (source:

With speculative players licking their wounds, some agricultural commodities may present a good investment opportunity. Here are some reasons the selloff in corn may be short-lived after the market digests the news.

1. Demand for soybeans from China may yet encourage a shift from corn and wheat acreage into soy. It won't take much of a shift to send prices higher.
Farm Futures: - "With stocks of both corn and soybeans projected near historic lows, strong acreage this spring is a must to rebuild inventories," says Farm Futures Senior Editor Bryce Knorr, who conducted the research. "... Some 18% of those surveyed said they could still shift 50% or more of their acres."
2. South American crops are expected to remain moderate, as logistics and weather have curtailed significant crop improvements.

3. The US may be in for another 2012-style drought in 2013.
Inside Climate News: - Drought conditions in more than half of the United States have slipped into a pattern that climatologists say is uncomfortably similar to the most severe droughts in recent U.S. history, including the 1930s Dust Bowl and the widespread 1950s drought. 
Source: U.S. Drought Monitor

The 2013 drought season is already off to a worse start than in 2012 or 2011—a trend that scientists at the National Oceanic and Atmospheric Administration (NOAA) say is a good indicator, based on historical records, that the entire year will be drier than last year, even if spring and summer rainfall and temperatures remain the same. If rainfall decreases and temperatures rise, as climatologists are predicting will happen this year, the drought could be even more severe.

The federal researchers also say there is less than a 20 percent chance the drought will end in the next six months.
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Friday, March 29, 2013

French consumer recession worse than Italy's; Euro area economy in trouble

As discussed earlier (see post) the French economy continues to struggle. The nation's consumer recession is now thought to be worse than Italy's.
Markit (Trevor Balchin): - “France has overtaken Italy as having the worst performing retail sector of the three largest euro area economies. Sales fell at a survey-record pace, as did employment. Italy registered another steep drop in sales, while German retailers witnessed a flat trend in March.”
French economic output data suggests that the GDP growth - which has been lagging the Output PMI Index - will be in the red for a good portion of 2013.

A big part of the economic stagnation in France was caused by the implementation of the country's own version of the "fiscal cliff".
WSJ: - Mr. Hollande's government responded to the weaker economy in 2012 by raising taxes by €7 billion ($9 billion) to try to limit the damage to public finances. If the government hadn't done this, along with a smaller effort to curb public spending, the deficit would have increased above 5.5% of output, finance minister Pierre Moscovici said in a radio interview Friday. Another €20 billion of taxes have since been introduced for 2013.

But there is now evidence that tax increases are hurting the economy with Insee reporting that consumer spending power fell last year for the first time since 1984. Households, who typically make up well over half of GDP, cut their spending for the second month in a row in February and haven't spent as little since June 2010, Friday's data showed.
Retail sales indicator in France now points to conditions that are worse than during the 2008 recession.

Source: Markit

As the French recession deepens, it is dragging down economic activity indicators for the Eurozone as a whole.

Source: Markit

Moreover, the current crisis in Cyprus is expected to reverberate across Europe. In spite of being a tiny portion of the EMU's GDP, the psychological impact of Cyprus' botched "bailout" on the area consumers (and possibly banks) is expected to be material. The markets have in fact begun pricing in worsening economic slump in the Eurozone, particularly relative to the US. The recent decline in the euro has been relentless.

EUR/USD (source:

The confluence of Cyprus events and the recession in France and elsewhere across the area has prompted JPMorgan economists to downgrade their expectations for the Eurozone 2013 GDP growth - once again significantly below consensus. Europe just can't catch a break.

Source: JPMorgan
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Sunday, March 24, 2013

In spite of being a horrible standalone investment, treasuries remain an effective portfolio hedge

With all the talk of the so-called Great Rotation, evidence points to investors still pumping billions into fixed income. And in spite of a fairly broad conviction that rates will be rising in the near future, investment portfolios are loaded with treasuries. Demand for US government paper continues to be strong in spite of the worst risk/return profile in decades (see post) and implied real yields deep in the negative territory (see post).

The obvious explanation is the public sector purchases by the Fed as well as other nations with significant dollar reserves. Traders continue to call the 10-year treasury the "widow-maker", given how painful it has been to short that paper. Nobody wants to get in front of the freight train in the chart below.

Securities held outright by the US Federal Reserve (source: FRB)

But there is another reason. As investors move into equities while market indices hit new records, investors need an effective hedge. And over the past few years, long-dated treasuries have delivered precisely that. As discussed in this post, the right mix of treasuries with equities dramatically reduced the daily volatility of the portfolio. That quality of longer dated treasuries persists through today. The anti-correlation between the Barclays Long U.S. Treasury Index and the S&P500 index remains quite strong (-0.7).

 Daily returns, 90 day rolling window

What's particularly interesting about long-dated treasuries as a hedge is that the anti-correlation increases during periods of stress in the financial markets. In fact the hedge effectiveness was the strongest during the Italy fears flareup in the fall of 2011, followed by another dip last summer when Spain was in the crosshairs (keep in mind the chart above shows correlation over the previous 90 days). Very few hedging instruments have the "optionality" that kicks in at the time when one really needs it. Equity options and credit instruments (such as CDX) were not nearly as effective, particularly given the cost of decay/negative carry.

Investors are therefore willing to pay the premium of negative real rates and limited upside of treasuries in order to minimize portfolio volatility. It's unclear if this relationship will hold or ultimately revert to historical levels. For now however, as Europe continues to spook investors who are piling into equities, treasuries remain in demand as an effective hedge.
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Raiding Cypriot accounts will not save the banking system

Cyprus is zeroing in on a solution to avoid getting ejected from the EMU. It's simple. Since taxing everyone's account by a few percent didn't work, it's time to raid all the larger accounts.
NY Times: - With Cyprus facing a Monday deadline to avoid a banking collapse, the government and its international negotiators devised a plan late Saturday to seize a portion of savers’ deposits above 100,000 euros at all banks in the country, in a bid to raise money for an urgently needed bailout.

A one-time levy of 20 percent would be placed on uninsured deposits at one of the nation’s biggest banks, the Bank of Cyprus, to help raise 5.8 billion euros demanded by the lenders to secure a 10 billion euro, or $12.9 billion, lifeline. A separate tax of 4 percent would be assessed on uninsured deposits at all other banks, including the 26 foreign banks that operate in Cyprus.
This action will really upset the Russian mafia, but is not going to save the the nation's banks. Once the financial system opens for business, the run on banks will ensue - no matter what sort of controls the authorities will try to impose. No sane depositor who is able to open an account in Germany, France, or even Italy would leave cash in Cyprus. As far as the depositors are concerned, if the Cypriot authorities have done it once, they can do it again. Some of those deposits will quickly move back to where they came from - Russian banks.

Given the size of deposits at Cypriot banks, there isn't enough in eligible collateral for MRO financing (short term secured borrowing from ECB) to replace these lost deposits. The flight of capital will increase the funding needs far beyond the €10bn Cyprus is trying to raise. And it's unclear if the ECB should continue to provide further emergency loans (ELA). After all, the Eurosystem's exposure to Cyprus is simply insignificant on a relative basis. The ECB's balance sheet is still massive. It can generate more than enough interest income in a few months to cover the losses of Cypriot banks' defaulting on their ECB loans. So why throw good money after bad?

Borrowing from the ECB by country

Of course there are geopolitical implications of walking away from Cyprus. Letting banks fail will likely result in Cyprus exiting the EMU and some fear that will trigger a contagion effect. However if the ECB sticks with its OMT program (commitment to buy unlimited amounts of periphery bonds) for the rest of the periphery, the effect of "Cyprexit" could be contained. But when it comes to the Eurozone, there is rarely a decisive action, and this mess will likely persist for some time.
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Saturday, March 23, 2013

Financial repression 101

Sign says: "Cristina don't **** with democracy".

Source: The Nation

That's exactly what Cristina Fernández de Kirchne's government has been doing for some time.
The Nation: - Among several reasons for these accusations could be the country’s current inflation rate (estimated by economists to be 26 percent, while the government cites it as 11.1 percent); the state’s assumption of control of private pension funds valued at 30 billion; the government’s restrictions on currency exchange, making it difficult for citizens to travel outside of Argentina; restricted freedom of speech; and, most significantly, an accusation of widespread corruption.
Argentina's actions don't just threaten the nation's democratic system. The latest policies amount to a harsh form of financial repression that will bring the nation's private sector to its knees. As confidence in Argentina's stability deteriorates, foreign reserves are becoming dangerously low. The latest move to close any loopholes that allowed outflows of dollars from the country is now impacting domestic market liquidity.
WSJ: - Argentina's stocks and bonds tumbled Friday, after the government announced new rules limiting mutual fund investments in the locally traded shares of foreign companies.

The regulations further restrict the ability of Argentines to invest offshore at a time when the Central Bank of Argentina is struggling to rebuild its international reserves due to capital outflows and low grain exports.

Starting April 30, the shares of foreign companies traded in Argentina, known as Cedears, will no longer be classified as local securities under rules that require mutual funds to invest no less than 75% of their assets in domestic securities.

"Cedears are going to have less liquidity, some mutual funds are going to have to unwind, and people are going to have to repatriate funds," said Agusto Farina, a trader at Buenos Aires-based brokerage Amirante Galitis.

Trading in Cedears hit 59 million pesos ($11.5 million) during the session. The turnover in Cedears since the beginning of the year through mid-March was about ARS360 million.

The new mutual fund rules appear to be aimed in part at businesses and sophisticated investors that use the securities market to legally skirt currency controls. The so called "blue-chip swap" transaction involves the purchase of stocks and bonds traded in Argentina, which are then sold offshore for dollars.
With currency controls shutting off hard currency outflows, the premium on dollars has reached new highs. According to JPMorgan, the dollar now trades in the "gray market" at some 70% above the official exchange rate. That's on top of the 26% decline in the peso's "official" value over the past couple of years.

Source: JPMorgan

Foreign investors are staying away. With inflation out of control and a limited ability to take earnings out of the country, investment in Argentina makes no sense. And capital looking for Latin American investments will find a much friendlier climate in Brazil or Mexico (as well as a number of smaller nations). By attempting to stem the flow of dollars out of the country with blunt policies, the government has cut off what the nation really needs - foreign investment.
JPMorgan: - Immediately after they were imposed, capital controls probably had an expansionary impact on the economy owing to the surge in domestic liquidity, bank intermediation, and consumption spending that they triggered. However, that stimulus represents a one-off and may be on the verge of tapering off. Looking ahead, capital controls threaten to exert an adverse toll on expectations of economic performance. Paradoxically, if evidence that tightening capital controls constrains inward investment continues to mount, the government will find it increasingly hard to deliver on its priority goal—economic growth.
Ironically, dollar outflows were caused in part by the government's earlier decision to confiscate private property of a large foreign investor (see post). Welcome to the world of financial repression and its "unintended consequences".
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Wednesday, March 20, 2013

Brent-WTI spread narrows - driven by US crude transport fundamentals

Brent-WTI spread touched a low not seen since July of last year. North American crude has moved closer to being priced by the international oil markets.

Source: Ycharts
WSJ: - The price gap between the world's two most-important oil contracts shrunk to the narrowest in nearly eight months Tuesday, as new transportation links helped U.S. oil futures extend gains versus Europe's Brent crude.

Increasing pipeline capacity and rising rail shipments in recent months have helped shrink an oil-supply glut in the middle of the U.S. that has weighed on domestic oil prices.

After start-up issues in January, the newly expanded Seaway Pipeline is set to increase oil shipments to the Gulf Coast later this year. Rail transport of oil also has more than doubled over the past year, according to industry statistics, moving crude to refineries along the coast that didn't have access to domestic crude output.

And last week, operators of the Longhorn pipeline reversed its flow to send oil from west Texas to refineries along the Gulf Coast, further relieving the glut.

The new transport links, part of a broader transformation of the U.S. from energy consumer to major energy producer, are showing signs of overcoming a two-year struggle to move oil from new fields in North Dakota, Texas and other regions to the refiners pumping out gasoline and other fuels.
Crude supplies in Cushing, OK - the deliverable on the WTI futures contract - are still elevated, but have stabilized relative to historical trends.

PADD II (Cushing) crude stocks (source: EIA)

It will take considerable amount of time for the "convergence" between these two markets - the infrastructure is still not fully there. There is also always going to be a basis between Rotterdam and the US Gulf delivery points. But we are seeing signs that the days of outsize spreads between the two benchmarks may be coming to an end.
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Monday, March 18, 2013

The public, investors mostly ignoring the sequester budget cuts

US politicians have been attempting to "adjust" the sequester law, as the level of pain from the spending cuts is expected to get progressively worse.
LA Times: - It was bound to happen: As the sequester budget cuts are felt around the country, lawmakers are having second thoughts — and trying to tinker with them in a way that could lead to a full-scale government shutdown.

Senators want to load up a routine spending bill with provisions to reopen the White House to tours, shield meat inspectors from furloughs and keep air traffic control towers staffed, among other changes that would rearrange the across-the-board cuts.

Nearly 100 amendments have been filed by senators on both sides of the political aisle, stalling the measure that is needed to keep the government running after March 27. Without approval, the government would shut down, a prospect lawmakers and President Obama have said they want to avoid.
The problem politicians face is that the public doesn't seem to care much. Polls show that a large portion of the voting population doesn't know what "sequester" means - in spite of it being the "law of the land". And it seems that those who do know are simply ignoring it. According to Google Trends, interest in the word "sequester" spiked at the beginning of March and has collapsed since then.

Google Trends on search for "sequester"

It's understandable to see US citizens ignore the sequester budget cuts. After all, everyone was gearing up for something to happen with the "fiscal cliff", but the last minute compromise turned it into a non-event (relative to what it could have been). The public is obviously convinced some compromise will be reached and things will go on as usual.

But unlike the public, investors are surely pricing in some risk that the current budget crisis may not proceed as smoothly as the last one. Or are they? The next chart shows how the iShares defense industry ETF (ITA) has been trading relative to the S&P500 from the beginning of the year. We certainly saw it underperform materially in February with concerns about the sequester disproportionately hitting discretionary defense spending. But just like the public at large, investors now believe the sequester law will be reversed in short order. US aerospace and defense shares have rallied to outperform the S&P500.

ITA (blue) vs S&P500 (red)

That's a great deal of reliance on Washington to come to some resolution relatively soon, albeit a temporary one. What happens if they don't?
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Key risks to China's economic growth

In spite of ongoing stream of positive economic news out of China, a number of economists have been ringing alarm bells with respect to the nation's economic trajectory. China clearly faces some major challenges, but the question remains if the country is still at risk of a "hard landing". Here are some of the issues that keep China-focused economists and portfolio managers awake at night.

1. After a slowdown, China's property prices resumed their climb. The ISI Price Diffusion Index has risen sharply over the past year, indicating that liquidity continues to flood these markets. This trend can persist for quite some time (as we've seen in the US), but it certainly introduces the risk of further inflating China's property bubble. Economists at the ISI Group are definitely concerned.

Source: ISI

2. Related to the issue above, economists from Nomura are pointing to the dependence of local governments on land sales. Severe problems with local governments could also easily spill into the banking system.
WSJ: - Local governments, which rely on land sales as their main source of revenue, could be hit as hard as property developers by a real estate crash. The problems would quickly find their way into the banking system – 14.1% of outstanding bank loans are to local government financing vehicles, and 6.2% are to property developers, Nomura’s economists say.
Moody's analysts are just as concerned about China's local government indebtedness. According to them, escalating debt levels and rising default risks at the local government levels - particularly pertaining to local government financing vehicles (LGFVs) - represent a major risk to China's growth.
Bloomberg: - Moody’s Investor Services said China’s local-government financing vehicles face greater risk of default, as regulators warn 20 percent of their loans are risky.
3. The risk of China's "shadow banking" keeps resurfacing. It's been a topic widely discussed in the media and the blogosphere, and even chastised by high-level Chinese officials. Nevertheless the issue remains unresolved.
MoneyNews: - The World Bank warned recently that the Chinese economy could overheat from an influx of capital, resulting in excessive credit growth.

The International Business Times reported that the shadow banking system in China is "growing at an alarming rate.”

In fact, nearly half of all new credit is supplied by non-banks or through off-balance-sheet vehicles of regular banks, International Business Times said, up from 10 percent a decade ago.

Of particular concern to some regulators are so-called wealth management plans (WMPs), which are yield-bearing instruments sold by banks that do not have guaranteed principal.

Xiao Gang, chairman of the board of Bank of China, wrote an op-ed in the English language China Daily in which he said the quality and transparency of WMPs are “worrisome.”

"To some extent, this is fundamentally a Ponzi scheme,” Xiao said, according to the International Business Times.
One would expect that after a statement such as this by Xiao, WMPs sales would decline sharply. Apparently they haven't.

4. As the saying goes, "a rising tide lifts all boats". And rapid economic growth solves or masks a great number of structural issues. However, China is facing a slowdown simply due to its demographics (see post), which could over time expose these structural problems. Furthermore, limited growth will restrict how much stimulus could be deployed without sparking inflation. And if the authorities don't play this slowdown correctly, it could even spark widespread political unrest.
WSJ: - ... adding to the likelihood of a crisis is China’s declining potential growth rate. It is not easy to calculate this number, which represents the maximum speed the economy can grow without generating excess inflation, but even analysts more optimistic than Nomura’s agree that it’s falling, driven by factors such as a shrinking working-age population. That gives China’s policymakers a lot less leeway to stimulate the economy than they have enjoyed in the past.
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Sunday, March 17, 2013

What's causing the sell-off in muni bonds?

Municipal bonds came under pressure last week, pushing the asset class into the red for the year. And it hasn't just been the recent rise in longer term treasury yields driving the selloff. On a year-to-date basis munis now materially trail treasuries. Some investors attribute it to seasonal factors such as sellers raising money to pay taxes. All of a sudden people realized they have a tax liability? Right. What's really pushing these bonds lower?

Source: Ycharts

There is a sad notion in Washington that requiring the wealthy, many of whom have substantial positions in munis, to pay taxes on their muni holdings will raise federal tax revenue. In reality the wealthy will simply rotate out of the muni market, forcing states and municipalities to pay significantly higher rates. And the revenue side of the equation will not increase substantially - instead forcing more capital into offshore tax exempt life insurance and annuity-based estate structures.

Nevertheless we all know how Washington operates. Fears of tax changes in the upcoming budget negotiations - as the debt ceiling debates approach - has contributed to munis trading lower. In fact according to Morgan Stanley the chances of muni bonds losing tax exempt status are at 30% (see post from Barron's).
Tulsa World: - The battle that took place over the "fiscal cliff" foreshadowed the current fights that Congress and the president are having over taxes and spending as Congress bumped up against the March deadlines on raising the debt limit, funding the government and automatic spending cuts that were delayed as part of the fiscal cliff deal.

Congress will likely consider sweeping changes to the federal income tax system either as part of this round of budget talks or in the context of comprehensive tax reform. These changes could include a revision to the current federal tax treatment of interest paid on municipal bonds.
Other threats to the muni markets are coming from state governments lowering taxes to attract families and businesses.
Barron's: - Now, proposals have surfaced to cut or eliminate state income taxes in Arkansas, Indiana, Iowa, Louisiana, North Carolina, Ohio, Oklahoma, and Wisconsin. Two factors give such proposals a decent chance. First, 39 states now have one-party control of their legislatures and governorships, the most since 1952, and 24 of these are controlled by Republicans, the party pushing hardest for lower income tax rates.

The second factor is competition. Kansas Gov. Sam Brownback succeeded last year in slashing tax rates for high earners and eliminating them for many businesses in what he calls a path to zero income tax. The cuts will cost the state more than $850 million a year in revenue, which Brownback hopes to offset by extending a sales tax that's set to expire and ending some deductions. A tax cut in one state forces neighboring ones to consider following suit in order to avoid seeing high-income residents defect, says Heckman.
These are positive developments that should generate incremental economic activity in these states. However should the economy in any of these states take a turn for the worse for some reason, state budgets could be in trouble.

What really spooked the muni markets however was the risk of underfunded state pensions. Pension funds tend to use archaic discounting methods that make the present value of their liabilities (expected payouts on pensions) look significantly lower than they really are. As pension asset returns remain weak, pension funds may require unplanned injections of capital to cover the liabilities. And when it comes to funding state pensions vs. paying on municipal debt, we all know which road state politicians and the unions who often control them will take. What's particularly troubling is that states are not above hiding pension problems in order to sell their bonds. In the case of Illinois (as well as NJ in 2010), the SEC called this lack of disclosure fraud. Market participants are asking if there are other such situations out there.
CNN: - The Securities and Exchange Commission and the Illinois state government have reached a settlement over charges that the state defrauded investors by not giving them proper information about its pension funds.

The SEC, which disclosed the charges with a filing Monday, said the fraud occurred between 2005 and 2009 when the state sold $2.2 billion in bonds without disclosing the impact of problems with its pension funding schedule. There were no fines or penalties against the state as part of the settlement.

"Municipal investors are no less entitled to truthful risk disclosures than other investors," said George S. Canellos, acting director of the SEC's Division of Enforcement. "Time after time, Illinois failed to inform its bond investors about the risk to its financial condition posed by the structural underfunding of its pension system."
The impact of course is not limited to the lower rated bonds like Illinois. The AAA muni bond yield hit a level not seen in almost a year (chart below). And as investors become jittery about long-term rates in general, the muni market will fall under increased scrutiny.

10y AAA muni yield (Bloomberg)
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The thesis for higher gold prices remains intact

A number of strategists continue to call for significant price increases in gold. Apparently investors have been ignoring those calls. In particular hedge funds have been exiting positions in precious metals recently, driving prices lower. The chart below shows changes in holdings of GLD (gold ETF) by the two major investment groups.

Source: Merrill Lynch

Hedge funds have been responding to the recent strength in the US dollar as well as a number of technical signals.

Dollar Index (DXY; source: MarketWatch)

With some of the fast money out of the market however, there is a potential for firmer gold prices. In spite of the recent talk of the Fed exiting the aggressive monetary expansion policy, so far all signs point to more asset purchases by the central bank - at least in the near future. Historically gold price roughly followed the US monetary base (or bank reserves), particularly since the Lehman collapse in 2008. Recently the two trends have diverged. But as bank reserves continue to increase at a steady clip in response to Fed's purchases, this divergence is unlikely to grow further.

Moreover, Merrill Lynch analysts point out that over time investors will play a diminished role in determining the price of gold.
ML: - The reduced importance of investors in the medium-term is heavily influenced by more affluent emerging markets, which should translate into steady increases of spending on non-essential items like jewelry in the coming years.
Their model suggests that in the next few years, even if demand from investors declines, gold price could reach new highs. In fact by 2016, investor demand would only need to be at the level of 2008 to keep the price at $2,000/oz.
ML: - Our data shows that to sustain gold prices at $2,000/oz by 2016, investors need to purchase a similar amount of gold than in 2008, when prices hovered around $872/oz.

Source: Merrill Lynch

According to these models, in the coming years even a moderate investor participation will drive gold prices higher. And it won't take much to entice investors to keep buying at least at the same pace they were five years ago.
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Tuesday, March 12, 2013

Good signs from Spain but full recovery is some time away

CNBC ran an interesting story today about the possibility that Spain may begin an economic recovery fairly soon. In particular, two items that are worth pointing out may provide some tailwinds for Spain's economy.

1. Exports:
CNBC: - ... a healthy export sector that has increased market share throughout the recession; of these exports, steel and chemicals make up for 26 percent of the total, followed by capital goods (20 percent) and automobiles (17 percent); food products, Spain's traditional source of foreign exchange, are now only 16 percent of the total. 
2. Improved competitiveness in the labor markets - something that France for example is struggling with (see post).
CNBC: - While public servants have had pay cuts of between 10 and 25 percent, cuts of 20 to 40 percent are not uncommon in the private sector. In short, Spain has regained competitiveness and is in a position to benefit from growth in her trading partners.
This second item is particularly interesting given Spain's large temp workforce which provides an additional level of flexibility (see discussion).

The one area the article didn't discuss in sufficient detail is Spain's banking system other than to say that the restructuring is nearly complete.
CNBC: - The restructuring of the banking system is nearly completed (partly at the cost of a higher public deficit), and de-leveraging of the banking sector is slowly proceeding (from 19 in 2007 to 16.7 in 2011)
Technically Spain has made the right moves toward stabilizing the banking system. More importantly the ECB has been instrumental in bringing some degree of confidence and stemming depositor flight out of the country (see discussion). But the Spanish banking system, especially among domestically focused institutions, still has a long way to go before it becomes fully functional. In particular analysts feel that the housing correction in Spain has not run its full course, which means that property loan portfolios have a long tail of failures (see post). Clearly Ireland's situation was different, but the comparison below leaves investors asking questions.

Housing price indices for Spain and Ireland (source: CS)

We are certainly going to see economic improvements in Spain in the next couple of years, but the full blown recovery may be some time away.
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Sunday, March 10, 2013

Chasing the next hot market

The slide below from Abbott Capital (a private equity fund of funds) tells an amazing story of private equity investing. The first half of the slide is a table that shows returns (IRR) for the full spectrum of private equity investing - from "early venture" to "mega buyouts". For those unfamiliar with private equity, each cell shows the annualized return for funds of that "vintage year" (the year the fund was raised) through today. For example the 2000 "large buyout" funds produced an 18.6% annualized average return over their life (typically 7-9 years).

The lower chart shows the dollar amounts raised for the two major private equity groups over the same time period: venture and buyout.

Source: Abbott Capital Management LLC (click to enlarge)

In the late 90s venture investing became fashionable. But by time large amounts of capital poured into the asset class, the party was already over. The best performing investments had been made before the wave of dollars came into venture funds. Those who came in at the height of this investing "craze" ended up with sub-par returns.

But investors don't seem to learn about chasing the next "fashionable" product. They piled into the buyout space in size during the 2005-2007 period, while most of the strong returns in the space had been made on investments from a few years earlier.

It's an age-old pattern of investors listening to their "consultants" and following each other in ever-increasing numbers/amounts into a market where returns have already peaked. Years later the same investors look back and question the whole asset class, cutting back their allocations just when it may be time to enter that market again. And analysts look at the returns of many large institutional investors (public and private pensions, endowments, and insurance firms) and wonder why their performance has been consistently poor.
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Thursday, March 7, 2013

Why Canada's economy is in trouble

Analysts are beginning to raise concerns about Canada's near-term economic growth. The nation's central bank is holding the overnight rate at 1% and will likely maintain this level for some time to come.
Toronto Star: - The [central] bank’s current stance reflects the weak performance of the economy in the last months of 2012. Canada’s gross domestic product (GDP), which measures total output of goods and services, grew by a meagre 0.6 per cent on an annual basis in the final three months of last year. For 2012 as a whole, Canada’s economy recorded growth of 1.8 per cent, down from 2.6 per cent in 2011.
This weakness in Canada's economy is clearly visible in the relative performance of the Canadian and the US equity markets. The two markets, which have traditionally moved fairly closely together, have diverged recently.

S&P/TSX (Canada): blue, S&P500 (US): red

A number of somewhat related factors are driving this weakness in Canada's growth. Here are some of them:

1. Canada's exports are heavily concentrated in energy with a big focus on the nation's largest trading partner, the US. And as discussed before, the US energy markets are now quite well supplied. The US has a tremendous domestic source of natural gas, while crude oil inventories are high relative to historical levels - reducing demand for Canadian energy product in the US.

Source: EIA

2. Over the past decade the Canadian dollar has strengthened dramatically, and in spite of some temporary weakness during the financial crisis is still close to parity with the US dollar. This makes Canadian products more expensive on a relative basis.

Number of Canadian dollars per one US dollar (USD/CAD)

3. As discussed before (see post), Canada's housing market may be facing some headwinds going forward. Valuations have materially outpaced those in the US.  There is a great deal of debate on this topic, but it's quite clear that Canadians have been pumping significant capital (materially higher than 6% of GDP) into residential housing over the recent years - even as the US housing expenditures collapsed.

Source: DB

4. Over the past decade Canada's manufacturing labor costs have sharply outpaced those in the US, making Canadian firms less competitive.

Canadian unit labor costs: blue, US unit labor costs: red

5. Mexico, with its cheaper labor and a growing manufacturing base, is increasingly taking Canada's export share into the US.

Source: Deutsche Bank

6. Driven in part by the strength of the Canadian dollar as well as worsening labor competitiveness, Canada's current account has been in the red for some time now. What's particularly troubling is Canada's deterioration of the current account outside of energy exports. The trend is making the nation increasingly reliant on its energy export just as the demand from the US declines.

Source: Deutsche Bank

These developments don't bode well for Canada's economic expansion and for the valuation of the Canadian dollar in the near-term.
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Tuesday, March 5, 2013

Argentina's downward spiral

The government's mishandling of Argentina's economy has hit new highs recently with the implementation of price controls on food. It is a notoriously ineffective policy that tends to create shortages and spawns black markets.
International Affairs Review: - President Cristina Fernández de Kirchner's temporary price freeze on food products marks the most recent instance of her gross mishandling of Argentina's economy. The price freeze applies to all major food retailers, which account for over 70% of the market. Historically, these types of economic policies have never produced positive results. Most often, food importers stop importing because they would lose money by selling their food at the prices ordered by the government. Customers of large retailers who stand in line hoping to buy at the frozen price will then find the shelves barren. This scarcity of goods will spawn a black market, where food will be sold at actual market prices. While some law enforcement officials may tolerate these black markets, other will try to dismantle them, only to discover more tenacious entrepreneurs setting up shop the next corner over.

Unfortunately, the temporary price freeze is only part of an alarming trend towards financial mismanagement, which includes the expropriation of major foreign investments. Last year’s nationalization of Repsol YPF has infuriated Spain, one of Argentina’s largest foreign investors. Kirchner’s presidency has also been marred by accusations of falsifying CPI statistics (which provoked a strong rebuke from the IMF), a weakening of central bank independence, use of the nation’s currency reserves for political payoffs, and the threat of default on its debt - again. To most outsiders it would appear that Argentina is repeating many of the mistakes that resulted in its economic crisis of the early 2000s.
In a classic case of "wag the dog", Argentina's government is trying to focus the population on external issues. Argentine officials are now taking an aggressive stance with respect to self-determination in the Falkland Islands. Knowing that the upcoming referendum will likely result in a status quo, Argentina's government declared the vote to be "illegal". Tensions with the UK are likely to escalate further.

To make matters worse, fears of Argentina's technical default on its restructured dollar bonds (see discussion) are on the rise once again. That's in spite of recent hopes that Argentina may attempt to settle with the "holdouts" (see WSJ story). As a reflection of this uncertainty, the unofficial currency market is now pricing dollars at a 54% premium to the government's tightly controlled exchange rate.

Another troubling development is the relentless deterioration of Argentina's foreign reserves. Rumors persist that the government has moved dollars into "unofficial" accounts.
JPMorgan: - ... gross international reserves have fallen US$1.6 billion ytd, driven by a US$1.2 billion ytd fall of Treasury deposits at BCRA. What is odd about this is that the decline of the Treasury’s cash position of the past two weeks cannot be related to any scheduled external debt payment.
Some have speculated that the goal is to prevent official dollar accounts from being frozen by US courts if the legal case against the bond holdouts results in an unfavorable ruling for Argentina.

Source: JPMorgan

Whatever the reason, no one expects these reserves to stabilize. That's because the largest single source of hard currency for Argentina is the export of soy and soy products. And this year's soy harvest is projected to be weaker than originally expected, putting additional pressure on foreign reserves.
WSJ: - Hot, dry weather from early January through mid-February reduced soy yields across much of the central region of Argentina's agricultural heartland.

Exports of soybeans and related products are the South American nation's single largest source of foreign currency and a key contributor to the Central Bank of Argentina's international reserves.

President Cristina Kirchner has tapped those reserves to pay foreign creditors since 2010, and her budget this year earmarks several billion dollars of reserves to fund public works projects.
As conditions deteriorate, Kirchner's government will resort to more extreme measures in order to hold on to power. And largely because of government's actions, Argentina, with its significant natural resources, a relatively large middle class, and a fairly developed industrial base is unlikely to participate in the economic stabilization seen in Brazil (see discussion) and elsewhere in emerging markets.
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Sunday, March 3, 2013

What caused the temporary spike in personal income?

The drop in personal income last week got some media attention, particularly given that it was the largest one-month drop in 20 years.
USA Today: - Personal income growth plunged 3.6% in January, the biggest one-month drop in 20 years, the Commerce Department said Friday. And consumer spending rose just 0.2% with most of it going toward higher heating bills and filling up the gas tank.

The income drop was offset by Americans' savings a hefty 2.6% rise in December. But most of that gain, analysts said, reflected a rush by companies to pay dividends and bonuses before income taxes increased on top earners at the start of 2013.

There were spending declines in January for big-ticket items that last three years or more, like cars and appliances, and non-durable goods, like clothing and food. Some economists said the declines could be blamed on a 2% federal payroll tax cut expired Dec. 31.

$MM, Source: BEA

Many immediately attributed this decline to the difference in dividend income. Companies who paid special dividend before the year-end generated an artificial one-time jump in personal dividend income in December. That made January look like a large decline on a month-over-month basis. It turns out the dividend was indeed a large portion of the "biggest one-month drop in 20 years". But as the chart below shows, it wasn't all of it.

Some have attributed a portion of January's decline directly to the increase in payroll tax and higher social security payments. However, if one adjusts for all the movements associated with "government social benefits" (payroll tax, social security, veterans benefits, etc.), the shape of the personal income trajectory remains relatively unchanged - in fact the decline in January looks worse.

Anecdotal evidence suggests that just as companies paid special dividends before the tax regime change, they also paid some bonuses and other distributions to employees (mostly executives) prior to the tax increases.

Moreover, it's important to remember that in December it wasn't at all clear who exactly will pay higher taxes - the discussion initially was focused on $250K/year and then $400K/year and higher. That could have impacted a much larger group than the fiscal cliff compromise ultimately did. Since there is generally some flexibility around the timing of income recognition, some people tried to shift as much of it into 2012 as possible. And that generated the temporary spike in personal income that can't be explained by special dividends.

When all the dust settles, the reality is that personal incomes are increasing at around 2% per year or less, just keeping up with the GDP growth. For now it's simply about muddling through, as near-term economic growth in the US is expected to remain subdued.
USA Today: - "With tax hikes and spending cuts buffeting the economy, growth in the first half of the year is likely to be at a sub-2% pace," James Marple, senior economist at TD Economics wrote in a note. "At this pace, the unemployment will not improve and pressure will remain on the Federal Reserve to continue its asset purchase program."
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