Capital Flight

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.


Recent comments by the Bank for International Settlements (BIS) that “Global Markets are under the spell of Central Banks and their unprecedented monetary policy settings” echoed what we and others have been saying for the past 3 years. Not only have they been under a spell, they have been put into a rate induced coma. However, as we have stated repeatedly, the aftershocks and consequences that will result once the spell is broken will be dramatic. It would appear however that neither the BOJ or the Federal Reserve are paying any attention to such talk, as both seem intent on achieving goals that are either ever-shifting or incongruous. Concurrent with these comments, was an article in the WSJ regarding the extensive security detail afforded The Fed Chairwoman. Not to be flippant, but we cannot understand why such security is directed at someone whose main activity these days is maintaing the status quo (doing nothing). Don’t be hypnotized, Buy Stuff.

Staring in the Rear View Mirror

The one singular characteristic of todays capital market environment that has been the most perplexing and frustrating has been the complete lack of concern for what “might” happen. As we have discussed, low rates and the absolute manic focus on additional yield at whatever cost, has produced an almost universal catatonic state. Nothing is more indicative of this than the markets complete lack of attention to the potential for reflation/inflation. We forgive the equity markets for their lack of focus as they have the attention span of a six year old, but it is curious that the Treasury Market continues to remain oblivious to what are emerging signs that pricing pressures are already upon us. Slack in the labor market, spare capacity, and seasonal one-off factors are only some of the reasons given as to why we should ignore what are clearly clouds on the inflationary horizon. Perception is reality however, and the reality of low long term rates will remain until the broadly held mis-perception on inflation/reflation changes. The argument is also made that inflation/pricing pressure will never come to bear primarily because we would have already seen it if it were going to take hold. Our feeling is that all of the liquidity sloshing around has flowed into the easiest parts of the capital markets (debt and equity markets), next up are the hard asset/commodities markets which will in turn lead to overall broad price increases, which will then  ultimately flow through to wages. We have never seen the kind of uncharted, unfettered Central Bank action that we have most recently experienced, so rest assured that when this inflationary cycle unfolds it will most likely not look like anything we have seen before. Buy Stuff

Central Banking 101

We all were enthralled with the new Fed Chairwomen Yellens’ speech in New York regarding the future path of Fed policy. She stuck to the script as all Fed Chairs are wont to do, but in response to a question about inflation she remarked that the “odds of deflation are much greater than the odds of inflation”. In response to a question about the potential for said inflation, she remarked that the Fed would be way out in front of a potentially damaging rise in inflation. The Fed’s inklings of this dangerous brand of inflation would be drawn from a variety of indicators, not necessarily  only a tightening of labor slack. The re-emergence of this Fed “dashboard” gave much comfort to those that were concerned that the Fed would do something reckless like normalize interest rates.These comments dovetail with Minneapolis Fed Governor Kocherlakotas’ recent talk where he stated that he is not worried about what to do in the event of escalating inflation because they already know exactly what to do “that’s Central Banking 101”. I’m not sure where they teach this class, but it would appear that they should throw out the old textbook, as the low to negative real rates of interest imposed by the Fed over the past 5 years have done almost nothing to aid real economic activity.This experiment in Central Planning is still just that, regardless of how Central Bankers may spin it.Drop your Central Banking 101 class and take something more practical like behavioral psychology( you will need it). Buy Stuff Sell Paper

Putin it to the West

The unfortunate  political and human tragedy in the Ukraine has the potential to cause significant shifts across a number of commodity markets, regardless of whether sanctions are imposed or not. We already know the obvious markets involved: Natural Gas, Nickel, Palladium and titanium but there are a number of ancillary markets and outcomes that could be affected by Mr. Putin’s aggressive actions in the FSU. Russia accounts for roughly 30% of Europes Nat Gas needs so it is clear why the Europeans are treading lightly when it comes to heavy- duty sanctions. We wonder however whether Germany and others are speaking frankly with the U.S. and others about the potential for  a step up in LNG and CNG imports. Such a shift would mark an important dynamic in world Nat Gas pricing and one only assumes that the beneficiary of such a trade shift would be China.It is not hard to envision Mr. Putin extending this policy towards other commodities as well, preferring to strengthen his alliance both politically and economically with China. While Russia has been more than happy to use its petrodollars as a diplomatic weapon, the ability to extend this reach across a wide variety of commodities might seem attractive, particularly if it is with a partner that is highly agnostic as to its politics. While the chances of such an escalation are probably not great, Norilsk  recently was in negotiations to sign a long term supply deal with a Chinese buyer for both platinum and palladium (payable in renminbi). The ramifications of such long term deals are that significant supply is taken off the market permanently, which could cause some sleepless nights among non-asian purchasing managers. Putin sees the intrinsic value of Russia’s stuff, take the advice of Obama’s spokesman who recently suggested that investors not buy Russian Stocks, we concur and instead suggest that investors should be looking to buy what Russia has stockpiled.

In Theory…

Two recent articles really highlighted the degree to which economists continue to treat the economy and markets as if they were true sciences as opposed to social sciences. The recent nobel laureate Eugene Fama was recently asked about the existence of bubbles to which he replied “I don’t know what a credit bubble means. I don’t even know what a bubble means. These words have become popular. I don’t think they have any meaning.” The other article which also illustrated this ivory tower view of reality was the NY Times front page article on inflation. This article discusses the real dangers that lie in deflation, and goes to great lengths to articulate the positive aspects of inflation: pricing power, wage inflation, etc..  However, what both fail to deal with are the behavioral nature of the economy and markets. Professor Fama and Rogoff fail to adequately account for the fact that peoples behaviors are not driven necessarily by a rational examination of the facts, but rather by their expectations of their facts as they interpret them. The credit and housing bubbles were driven by behavior  that was motivated by a set of facts that became self reinforcing (the pricing of both credit and housing would always remain advantageous). When the pricing of credit and housing became discontiguous and fractured, rationality was the ultimate victim. This type of self reinforcing behavior also becomes readily apparent in periods of rising inflation. Inflation, while it may be initially set in motion by external factors such as a drought or oil shock,  ultimately becomes a lesson in behavioral expectations as price rises become ingrained across the board. While it is true that this is temporarily a positive for producer pricing, the end result is a decline in overall purchasing power, a decline in the value of ones currency,  and a gross misallocation of resources. We continue to feel that Central Banks around the world put much credence in their own ability to micro-manage certain outcomes, many of which are not driven by fundamentals but rather by participant expectations. While we do not profess to know the future, we still strongly believe that the omniscient attitude that pervades the conference rooms of all global Central Banks will set the stage for the next secular shift towards hard assets.

Maestro Meets Real World

Alan Greenspan has been on the news circuit as of late in support of his new book: The Map and the Territory. We found some of the interviews quite telling, particularly one interview in which he discusses a revelation regarding risk. He states “Fear and Euphoria are dominant forces, and fear is many multiples the size of euphoria. Bubbles go up very slowly as euphoria builds. Then fear hits, and it comes down very sharply. When I started to look at that, I was sort of intellectually shocked”. Are you kidding me, he was shocked by the the severity of  the damage caused by unsustainable, irrational behavior (hence the term bubble) suddenly coming undone.  I do however agree with his assessment of future Central Bank behavior, when he states that the Fed’s balance sheet must curtailed as he comments ” Historically, there are no cases where central banks blow up their balance sheets or where countries print money which doesn’t hit (with higher inflation)”.  I will not pass judgement on the book as I have not read it, but it would appear that the Maestro is coming to the realization (quite late we might add) that econometric modeling when applied to markets driven by human behavior is not effective. We would suggest however that the same tools used by the Greenspan Fed, still reside in the toolkit of the current all knowing Fed.

Investing in a De-Americanized World

We were awestruck by the recent amount of ink spilled regarding the potential for the U.S. Dollar to lose its reserve currency status. Commensurate with the well deserved global piling on were comments by Xinhua ( the Chinese State News Agency) in which they stated that “It is perhaps a good time for the befuddled world to start considering building a de-Americanized world”. When we say we were awestruck, our sense of awe was derived principally from our bewilderment as to why people lavished such safe have status on a currency with such inherent and obvious flaws. While it is true that all fiat currencies are not without their own warts, it was gratifying to at least begin to  hear some dissonance as to the gold plated status of the dollar. The biggest question that investors have to address after this latest boondoggle is: Does this latest impasse represent an inflection point for peoples views on the dollar, and if so, what are the investment implications?   We are obviously in the camp that feels that there will be a slow pivot away from the dollar, and as a result proactive investors need to position themselves appropriately. Instead of considering a de-Americanized world, perhaps we should start thinking about what assets benefit from a de-dollarized world: Buy Stuff Sell Paper.


The recent proposal by the Obama administration to change the inflation index component from a simple CPI to a chain weighted CPI has caused some degree of consternation and concern. This concern comes not only from seniors but also from those involved in the TIPS markets. While the amount of the difference is relatively small, the point is that this move represents a significant step towards the active management of price data. TIPS buyers were initially drawn to this market as a hedge against core inflation.  If TIPS owners begin to feel like the Government is haircutting them for their own budgetary needs, then that market will struggle to maintain its integrity and thus its liquidity.  The more important takeaway from this latest sleight of hand, is that that we have a Central Bank desperately trying to create inflation, while at the same time we have its own Government trying to dampen its ultimate effects. While we have maintained that the timing of the unfolding inflation story is uncertain, the anecdotal evidence surrounding its emergence continues to build.

Timing is Everything

Our experience in asset management over the years has shown us, if nothing else, that the most recent market action sows the seeds of the next most likely counter trend. Thus, the “great moderation” led to something much more chaotic in the aftermath, permanently rising home prices led to an environment which virtually guaranteed prices would no longer maintain their stair step rise, and ever rising commodity prices led to unsustainable new production efforts which are now being written off. My point is that markets, built on human nature, assume that tomorrow will look much like today, when in reality the inverse tends to be more the norm. What implicit market assumptions are being priced into todays economic DNA.  1) Global rates will stay low as long as Central Banks are committed to such 2) Inflation is not a problem for the foreseeable future 3) Liquidity is abundant, particularly in public capital markets. 4) Global liquidity is not only central bank driven but central bank channeled. The challenge is to try and ascertain when these “truths” have simply become self-fulfilling prophecies, because  violent inflection points typically accompany such sudden realizations.