The shocking move by the SNB to remove the Euro/CHF peg resulted in seismic moves across all currency markets. Not only has the Swiss Central Bank taken a massive hit to its reputation (having assured markets only days earlier as to the viability of the peg) but we believe that this is the first chink in the armor of all Central Banks. If one believes (as we do) that the value of precious metals are partially a reflection of the markets belief in the credibility of Central Bankers, the significant rise in the price of gold is telling. If you thought Janet telegraphed her moves prior to this SNB action, one will have to be deaf, dumb and blind to not know the next Fed move. In our opinion however, a surprise move by the Fed will not ultimately be the death blow to Central Banker credibility but rather a collective realization that the efficacy of Central Bank policy has limits and that those limits were breached many QEs ago. Perhaps the greatest implications one can draw from this surprise move however is that finally a Central Bank has the fortitude to stand up and say: ” We know that these monetary science experiments have consequences and we are not fully sure what those consequences will be, to continue to backstop any currency with ones own sovereign balance sheet is foolish, we were wrong and we are stopping”. Let the currency wars rage on: Buy Stuff
Commentary on specific commodities or broader trends, such as lead and base metals
A really good market commentary by Goldman Sachs on the state of the oil markets points out that capital has become the marginal adjustment in the oil markets. Prior to the shale revolution, the price tended to be balanced around the marginal barrel of production, which in turn was micro-managed by the major producers (OPEC in particular). In this environment, barrels would be removed or added based on the target price for the major producers given their associated quotas (albeit with some cheating among the minor players). The key was that external barrels outside of OPEC never really altered the price picture significantly. Fast forward to today, and we could not be in a more different world. The shale boom in the U.S. has minimized the influence of the major producers (Saudis) as swing producers thus leaving the oil markets susceptible to the total global barrels produced. Goldman astutely points out that the barrels coming from shale production are driven by the capital employed in these very fast producing, short-lived reserves. Unlike deep, long-lived traditional oil reserves, the economics of shale plays can thus shift much more rapidly. If you think about it, the shale boom is reminiscent of the fibre optic cable buildout during the late 90’s in that they were both liquidity fueled production booms built solely on the access to capital rather than the necessity of immediate demand. The above got us thinking on several fronts about what larger takeaways we can draw from the sharp decline in oil prices. 1) The decline in oil cannot be extrapolated to other non-related parts of the commodity complex 2) The decline in the price of energy will not sustain non-economic production across the commodity complex-this is driven by the spot and forward price curve of the individual commodities 3) As we pointed out in an earlier post, the falling price of oil is not indicative of rapid deflation but rather is an outgrowth of the massive liquidity injections by the Fed and other Central Banks 4).The dislocation in the price of oil has vast implications for global geopolitics, the immediate impact of which we probably will not be able to foresee.
Keeping up with the Clampetts
The Beverly Hillbillies was probably the original reality TV show. Much like the Kardashians, the Clampetts had very little discernible talent, other than the ability to extract crude oil via an errant shotgun blast. Clearly the shale revolution that we have seen over the past several years has produced many Clampetts in places like North Dakota, Central Pennsylvania, Middle Texas, etc.. What we find most interesting about the explosion in domestic shale production is that this growth was fueled both by a mixture of technology as well as cheap credit. There is little doubt that the exploitation of previously untapped reserves will go down as a game changer in terms of domestic oil production and consumption. What is most interesting is that this unbridled growth was clearly aided and abetted by a capital market that was more than willing and able to fund all phases of production and distribution (drilling, lease purchases, tankage, storage, processing, pipelines, etc..). While this is not interesting in and of itself ( capital markets always chase what is hot), we wonder if the price deck involved in such lending took into account the self-policing nature of markets. Did anyone think that domestic production increases on the scale that we have seen over the past 5 years would not have any effect on the global price of crude oil? Well as one would expect, markets are finally waking up to the possibility of a market in oversupply, particularly in the absence of any OPEC action. One can anticipate, as in all markets, that marginally high cost production will be shut in and that( in the absence of any demand shock) prices will settle in at levels which balance global supply and demand. So this is nothing more than free markets doing what they do. Thus one can discount the following: fall is further evidence of end of the Commodity Super-cycle (never really existed), Black Swan event (hardly), China -driven demand destruction (not borne out by statistics).
As we all know in war there are rarely clear winners and losers. We have had the war on drugs, the war on terror, and now we have the war on ones one currency. The massive step up in BOJ policy, clearly designed to drive down the value of the Yen, was the right combination of surprise and heft. The question one has to ask is: if driving down the value of ones one currency is an effective monetary policy, then Venezuela should be knocking the cover off the ball. One also has to wonder whether this was also a clear shot across the bow of China, Germany, South Korea and others. If the BOJ wants to import inflation, then such a strategy can be effective, but is this really the “good” inflation that all Central Bankers so desperately seek. What is even more interesting about the market response(surprise surprise stocks rallied) was that there was so little concern about why a Central Bank would feel the need to so deeply immerse itself in the middle of their own domestic capital markets (stocks, bonds, reits,and currencies). Get ready for the criticism of Mr Draghi this week, as it would appear that whatever he does will pale in comparison to the monetary carpet bombing that just took place. The most egregious outcome however of this latest monetary science experiment is the sudden universal dislike for all things tangible. We are at complete odds to understand why the greatest brunt of the collateral damage associated with these currency wars would be that which is not a fiat currency. Don’t believe the deflation hype: BUY STUFF.
Surviving the Peace
The more we distance ourselves from the events of 2008 it has begun to feel like we survived the war (08/09) but have been completely at odds with how to survive the peace (QE ad infinitum). Maybe the reality is that the peace is not as peaceful as one might imagine. As everyone is well aware, our basic premise is that the creation of liquidity on a world wide basis by Central Banks would ultimately feed through to a devaluation of all currencies and a concurrent appreciation in the value of hard assets. Where has this thesis faltered, and ultimately will our thesis prove correct with only the path proving too difficult to assess? In other words, will we get there, but via a path that no one recognizes or anticipates. In a world of unproven Central Bank experiments, one might surmise that the way forward will look highly unlike anything we have witnessed before. We do know that the markets have once again become fixated with deflation, and as such the re-pricing of hard assets has re-commenced. In fact, it seems like there is no one that is even suggesting that we do not see deflation or at the very least dis-inflation.
The slowdown in the Chinese Economy as well as the continued drag in Euroland has many calling the end to what some have termed the ” Commodity Supercycle”. As you know, we never bought into this concept, which was made to amalgamate all commodities into one homogeneous group. While most commodities have some similar drivers, such as overall economic growth, the supply and demand drivers are quite different across the entire spectrum. Just as we did not buy into the Supercycle concept, we do not buy into the new phase of the market; which we are terming the stuporcycle. In this cycle, ostensibly driven by zero growth across all emerging markets, all commodity prices are destined to fall, commensurate with a fall in the overall profitability of extraction and production. Much like a permanent plateau, we do not believe in a permanent malaise. Prices send signals to the markets, and more importantly prices drive productive capacity shifts at the margin. Much as you would expect, outflows from commodity ETF’s were on a record pace over the last few weeks as momentum and dollar strength rule the day.
You have to start wondering if the folks around the FOMC table are actually talking to one another. Recent comments by Chairman Yellen regarding investor complacency in the face of alleged upcoming rate hikes does not seem to jibe with comments by Fed President Dudley about the recent strength in the U.S. Dollar. Perhaps the reason that investors are so ambivalent about upcoming rate hikes is because they have every reason to be. With all of the dashboard indicators arguing for a rate hike, Mr. Dudley has simply added another gauge to that dashboard. If the Fed is worried about the strength of the U.S. Dollar, they should join the queue as Japan and the EU are all in a race to debase. The ultimate winner of this race to the bottom will be hard assets with the loser being the last remaining shred of Central Bank credibility. Buy Stuff
If you did not read todays op-ed piece in the NYT by Professor Paul Krugman, it is definitely worth the read. In the piece, Professor Krugman questions the credibility of those that would even suggest that the Fed policies of the last few years are laying the ground work for higher inflation. He calls it the power of the inflation “cult”. Mr Krugman wonders why so many have adhered to a prediction that so far has failed to materialize. I won’t ruin it for you, but his general thesis is that those that would argue that endless bouts of Fed liquidity ultimately will lead to inflation are really arguing against government spending. In Professor Krugman’s view, those in the inflation camp are really opponents of social programs in disguise. As someone who never saw a government spending program he did not like, he should know. In fact, if you follow Professor Krugman’s views in the NYT, he feels quite strongly that the Fed has not gone far enough to cure everything that ails the U.S. Economy. Much like those that he criticizes, Professor Krugman constantly is pressing for more of the same, while completely ignoring the possibility of unintended consequences. Professor Krugman also fails to mention that this sea of liquidity on which the global economy currently resides has been fueled by not only the Fed, but by every other major Central Bank. As someone who puts such credence in the powers of Central Banks, one would think that Professor Krugman would at least give some deference to the possibility that they will ultimately get what they want (higher inflation).
Take my currency-Please
While the volatility in Equity and Credit markets over the past year has been quite benign, the volatility in currency markets has really heated up this year, most likely as a response to a perceived shift in Fed policy. What has really driven capital flows however has not been the relative rate adjustments by Central Banks, but the perceived economic strength of the U.S. vis-a vis almost all other G7 and non G7 countries. We have all heard the cute little analogies used to describe the relative strength of the dollar: ” The cleanest of the dirty shirts”, ” The smartest kid in summer school”, etc.. What is interesting to us is that such minuscule yield spreads are the impetus for such drastic movements in the relative value of currencies. Not only that, we are completely astonished that no one is really advocating the positioning into something which can hold its value relative to all currencies; namely hard assets. We know that our astonishment is too dogmatic however, as we are all aware that in reality Financial Markets are constructed to deliver product, most of which is designed to give people what they think they want and not what they really need. We still adhere to the precept of mean reversion (both in returns and relative currency values); a philosophy which is completely contra to todays current ideology. Kings don’t live forever, fade King Dollar and Buy Stuff
Not everything that counts can be counted, and not everything that can be counted counts
If you follow Howard Marks of Oaktree Capital, you know he is clearly one of the most astute investors around and his newsletters are among the best as well. In his latest missive, he references the above Albert Einstein quote when discussing the measurement of risk and reward. This quote got us thinking as to the state of the investment landscape today. The explosion of Algorithmic trading based on up- to- the second “information” as well as a fixation on monthly data which is itself suspect in its measurement and meaning leaves capital markets appearing to focus on only that which can be counted. The focus on what cannot be counted has never been more absent, as the prevailing thinking is that the risks associated with the unknown can be alleviated with the existing, or further iterations of, Central Bank policy. Nassim Taleb would refer to these uncountables as black swans, and it would seem as we move further and further away from the events of 2008/2009, the capital markets amnesia regarding the potential for such black swan moments becomes greater and greater. Those asset classes whose returns have been driven by leverage and momentum are most at risk when the amnesia wears off.