Please, click here to read this article in pdf format: february-25-2011

It’s the end of the month and the animal spirits nervously want to take profits on a good February. Before we start today’s letter, we want to clarify our view with respect to the impact of the developments in the Middle East on the price of oil. When we wrote that: “…A shift towards democracy in Egypt and the rest of the Middle East is bearish for oil…” we were clearly speaking of the long-term, on the assumption that chaos is followed by democratic (At least formally) governments. That time is far, far away and right now, we have chaos. But if democracy is established in the Middle East in the 2010’s, just like it was in Latin America in the ‘80s, we expect the OPEC to slowly become irrelevant, as the new political class of those countries desperately depletes any source of cash it can lay its hands on to win votes.

Yesterday, was a day full of inconsistencies, in our view. Gold had been testing the $1,418/oz level by the time the weekly jobless claims print was released at 8:30am. Post the announcement, which was bullish (22k less, to 391k), weakness in gold began. This was the first inconsistency, for a stronger job market means to us, all other things equal, a higher probability of seeing a pick-up in CPI (consumer price index) earlier. Yet, the release must have been interpreted as bullish for stocks and a reallocation trade could have been triggered.

The other nonsense we heard and read was that the S&P/TSX Global Gold Index sold off with oil. This is simply not true. The index opened the session selling off, even with the price of WTI above $99/bl. This weakness in mining stocks was immediately followed by weakness in energy stocks (here, we refer to the S&P TSX 60 Capped Energy Index). It was early in the day and both gold and oil were stable. Yet, their “derivatives” were on the downside. While stocks and credit were deciding which way to go, the confusion was enough to push us out to the sidelines, after a great February. And that proved wise, for the rest is history…

What triggered this sell-off? If anything, the developments out of Libya would suggest a higher price for oil, as we understand that it represents a loss at over 1 to 1.2 million barrels/day. We also don’t think the sell-off would have been driven by a liquidity stress, for nothing of the sort was reflected in the credit or rate markets, in our view. We think the explanation lies in the strength of the Euro.

As we write, the Euro is trading above 1.38 USD, in spite of all the noise coming out of Ireland (elections today!) and Spain (recent 1.5% increase in minimum wage). The strength is explained by the hawkish messages that have been coming out of the European Central Bank lately and, if we may add, the total absence of clarity on where the European Financial Stability Facility will end. The higher Euro, via higher rates, is simply recessive and it will push Greece and others to restructure or default sooner than later. This, in addition to the folly of the new regulations on bank capital, is the sort of things that may end up in a run against a country’s financial system on a gray Monday morning…This is the sort of thing that could explain bearishness in gold, oil and stocks simultaneously, for the sake of bearishness, in spite of a $600bn quantitative easing program, strong earnings, lower jobless claims, etc. etc.

We are not saying that the strong Euro caused the yesterday’s action. We cannot prove causality here (at least not us). What we are saying is that this explanation is more consistent than any other we’ve come across, and we like it because it means that someone out there knows something we don’t know, which is proof enough, if we follow Occam’s razor principle. On this note, we take this weekend off, preferring to remain on the sidelines until the ECB meeting, scheduled for March 3rd.

Martin Sibileau

Please, click here to read this article in pdf format: february-22-2011

During the last two weeks, we think that three self-evident macro-themes began to develop. We can even venture to add that these themes may stay with us longer than at this is imaginable. Let us explain…

Theme 1: Capital leaves the Middle East
Since the upheaval in Tunisia and the fall of Mubarak in Egypt, political uncertainty defines the Middle East. It is difficult at this time to speculate on how this will impact the price of oil in the long term but one thing we are sure of: Capital is and will continue to leave the region. We can simply post what seems to us a self-evident axiom: Capital that was funding energy exploration and production in the region will be looking for a safer place, likely in the energy sector in North America. Part of the capital that was in the form of liquid savings will likely be invested in gold. We have been trading this theme profitably since the start of February. On February 7th, we said that :

“…With regards to the political situation out of Egypt, we know as much as anyone else: Nothing! But here’s what we think, and which we understand may not be shared by many: A shift towards democracy in Egypt and the rest of the Middle East is bearish for oil. Regardless of who inherits power in the area, the new political class will need revenue to appease public employees and the people in general. Without the ability to coerce, the new leaders will need to buy peace and will not care a whit about the origin of their much needed funding. This means that the OPEC will slowly become irrelevant, as member countries need to place their produce with urgency, at any price. Along this same rationale, we should not worry about the Suez Canal. Every ruling party in Egypt needs it open to profit from the toll.
So far, we are at the very early stages of a more general transition in the Middle East. On this basis, we preferred not to trade last week’s increase in the price of oil. Instead, we chose to be net long of Canadian energy stocks, with the belief that capital within the energy sector will leave the Middle East, looking for safer jurisdictions…”

Theme 2: Capital inflows are discouraged by Emerging Markets
At the same time, the monetary experiment of the Fed is causing enormous pain in emerging markets (EMs) where the ruling lobby groups in the export industries had managed to keep the USD pegged. The mandate to keep a stable USD has pushed central banks to expand the money supply in their respective local currencies, triggering inflation.  From now on, to avoid a spiraling situation, these markets will seek to discourage capital inflows. They will tax the inflows, cut the credit expansion via higher reserve requirements or simply force exporters to clear their transactions offshore, as is the case in China, favouring Hong Kong. At “A View from the Trenches” we had anticipated this more than a year ago, when on January 21st, 2010, we wrote:

“…We would quickly see that there would be segmentation in the credit market, where exporters borrow offshore and internal consumption is financed onshore…(…)…. No central bank can simultaneously sustain a fixed exchange rate regime and control the local rate of interest…”

Therefore, the self-evident theme here is that capital should start flowing back to the developed world. Flows that went to EM stocks should now be redirected to stocks in developed markets. Flows that went to corporate EM bonds/loans, should now be redirected to corporate bonds/loans in developed markets. This, together with the QE2 bid, should provide a strong support, in our view, to the recent rallies we saw in stocks in North America, particularly in the energy sector. A disclosure here: “A View from the Trenches” does not count with the data to back these assumptions. But as we say, they seem self-evident to us.

Theme 3: Inflation can no longer be denied
The last theme is our usual theme: Inflation. On our first letter, on April 14th, 2009 (almost two years ago), we put a chart that very visually explained an inflationary process. We said it was myopic to only believe inflation could be managed tracking a CPI (consumer price index) print. We reproduce the graph below:

Only now, politicians are admitting levels of 3-5% in CPI. This means that real inflation, as they should be measuring is at least 8-10%. This is for sure what we personally witness. This fact and the ongoing disagreements within the G-20 are very supportive of gold and commodities. Patience will be well rewarded.

Martin Sibileau

Please, click here to read this article in pdf format: february-16-2011

Perhaps the most relevant factor shaping the action this week is the absence of a significant, market moving event. Investors seem to just be marking time. Every major decision is being postponed by policy makers and the drift higher in stocks is simply following the quantitative easing of central banks. In the US, this easing is explicit. In the rest of the world, it is not.

What decisions are being postponed? Some of them had been put off with anticipation, like the reform of government sponsored mortgages in the USA or the gridlock in the US Congress regarding the budget, or the rate hikes in Canada, to favour a lobby group. Other decisions are more uncertain. The first one, which we have discussed at length in previous letters, is related to the future of the European Financial Stability Facility. The second is the monetary policy of China itself, which of course, is not anticipated to change, but is “fine tuned” in small shocks.

Let’s profit therefore from this relative calm to think of a relevant issue: The unwinding of quantitative easing policies. Why would we want to discuss this issue today? Because there is no doubt in our mind (in fact, there never was, as our very first letter attests) that worse times are to come, shaped by the unfair touch of inflation.

Just as we wrote last week that the idea of a structural aspect to inflation will soon resuscitate, we came across two research notes published by Morgan Stanley’s Global Economics Team (see: “The inflation merry-go round“, of January 26th and February 9th). In these notes, it is suggested that to keep inflation within limits, coordination among central banks is required. The underlying point here is that inflation may be managed. To a certain extent, it may be true. However, when we look at it from a practical point of view, the real solution would be a world where only flexible exchange rate regimes exist. That way, if Helicopter Ben feels like printing $600bn to finance Barak’s social justice agenda, the dollar suffers a violent and swift currency crisis. That, in our view, is the only solution to global inflation, and it is anything but coordination. It’s monetary freedom!

We are not surprised to read this nonsense which, if left to run its own course, will inevitably lead to international summits where a global reserve currency, possibly managed by the IMF, will be debated. We are not only anticipating, but preparing ourselves for it, by being long of gold in our personal account.

The final solution to the problem, we think, will depend on how central banks manage the asset side of their balance sheets. Currently, those which are engaged in the business of “quantitative easing”, are steadily increasing their holdings of sovereign debt. How can they get rid of it without impacting interest rates? We think an innovative approach would be to exchange that sovereign debt for non-financial assets (real estate, infrastructure assets able to collect tolls, etc.) of the respective governments, along the lines of a massive privatization of governments’ assets….only to transfer their ownership to an independent central bank. The second step would be to gradually auction those non-financial assets to the public, withdrawing liquidity in the process.

What would be the advantage of this? First, it would preempt the market from speculating on bond sales or any other exit strategy that would bring higher yields. Secondly, when governments sell their non-financial assets, they simultaneously reduce deficits and improve their credit profile, bringing rates lower. At the same time, as the sovereign debt increases in price, financial institutions that hold it can see a capital gain. Lastly, the later auction of these assets would bring foreign direct investment, strengthening the currency and without crowding out other financial assets.

We recognize this proposal sounds creative, but if central banks were creative boosting their assets, they will need to be creative to reduce them when the time comes. In the meantime, we think any other solution would be suboptimal, with global coordination an impossible.

Martin Sibileau

Please, click here to read this article in pdf format: february-11-2011

Just after our last letter on Monday, when we wrote that “…out of  China, we expect no news on rates or credit manipulation (i.e. reserve requirement ratios) until March…” we were surprised by a 25bps increase. The fact that the increase took place during their holiday was also part of the message. But for the rest of the week, the markets chose to ignore it, with a lot of resilience.

Since our last comments, a few things appear to have changed. As time goes by, it is more apparent that the political situation in the EU is far from being conciliatory. The decision on the proceeds from EFSF funds has not been postponed. Simply, there is no agreement on whether to use them to finance ongoing deficits, to buy back sovereign debt from banks or to buy it from the European Central Bank, let alone on its final size. In the meantime, yesterday we saw that a 5-year bond sold by Portugal on Monday was being tossed off the proverbial cliff in the early hours (it widened from 360 bp to 420 bp), forcing the ECB to intervene.

The other issue that gets murkier by the day is the future of EU bank debt. On February 7th, Morgan Stanley’s Investment Grade Credit team published a note (under “European Banks”) titled: “Senior Debt: The path to all or nothing”, which for obvious reasons we cannot reproduce here, but which we highly recommend. In summary, funding difficulties are the path of least resistance, unless the EFSF funds are wisely put to use.

With all this in mind, one can hardly see a risk to the upside in the markets. However, the markets seem to shrug off any bad news, sell rates and support commodities. Jobless claims in the US continue their downward trend and all signs point to a “recovery”.

Should we be bearish or bullish? Neither, we think, is the answer. In our view, we are in a context, globally, of “passive money”. We wrote about this idea on Nov. 1st, 2010, when we said:

“Nobody seems yet to be aware of the “dynamic” nature of the problem. As we wrote before, macroeconomic theory should not be about real income determination, but about coordination. We are not concerned with determining how many bps the 10-yr Treasury yield will tighten if $100BN rather than $500BN are purchased by the Fed. What concerns us is that the market will progressively adapt to the new “rate of money supply”.

The developed world is still not used to the idea of “passive money”. Passive money is a relatively foreign concept to most contemporary economists, but its research began as a consequence of the problems Latin America faced in the ‘60s and ‘70s, when monetary policy turned accommodative, responsive to the unemployment rate. The concept of passive money was, in our view, the foundation to what was later called the “structural” explanation of inflation or the notion of “structural inflation”…(…)…We think the review of this concept is worth understanding, because we have no reason to doubt the Fed is taking the path of passive money (i.e. labour standard) and other central banks will have to soon follow. Gold, therefore, is bound to go higher…”

If, as we advised back in November, you reviewed and understood this concept, it will be clear that no matter how Ben Bernanke spins it, we are only seeing the beginning of the inflation story. Much has been and is being said on “food inflation”, being blamed upon demographics, weather, income differentials between the developed and emerging markets, etc. It will not be long until brilliant mainstream economists begin attaching the adjective “structural” to the noun “inflation” and price controls pop up everywhere. But it will be increasingly clear that the only structural thing is that central banks will be financing structural fiscal deficits.

Martin Sibileau

Please, click here to read this article in pdf format: february-7-2011

We start this week with what we ended the last one. In our view, the two main concerns or sources of volatility that remain from last week are the situation in Egypt and the uncertainty over the future scope of the EU’s European Financial Stability Facility (EFSF). The picture out of the US or the UK is decidedly one of inflation, monetary expansion with all the known consequences. Out of  China, we expect no news on rates or credit manipulation (i.e. reserve requirement ratios) until March (the PBoC recently conducted Rmb300 bn of reverse repos).

With regards to the political situation out of Egypt, we know as much as anyone else: Nothing! But here’s what we think, and which we understand may not be shared by many: A shift towards democracy in Egypt and the rest of the Middle East is bearish for oil. Regardless of who inherits power in the area, the new political class will need revenue to appease public employees and the people in general. Without the ability to coerce, the new leaders will need to buy peace and will not care a whit about the origin of their much needed funding. This means that the OPEC will slowly become irrelevant, as member countries need to place their produce with urgency, at any price. Along this same rationale, we should not worry about the Suez Canal. Every ruling party in Egypt needs it open to profit from the toll.
So far, we are at the very early stages of a more general transition in the Middle East. On this basis, we preferred not to trade last week’s increase in the price of oil. Instead, we chose to be net long of Canadian energy stocks, with the belief that capital within the energy sector will leave the Middle East, looking for safer jurisdictions.

We now want to turn the readers’ collective attention back to the European Union. If you’ve been following us, you will know by now that we have been bullish of the Euro. During the past week, uncertainty grew around the final shape that the EU will give to the EFSF. On Wednesday, Bloomberg reported that “Germans” were ruling out bond buybacks. This was a scenario that we had analyzed in detail in past letters and it was a scenario that made a lot of sense to us. Upon seeing this title, which unfortunately moved markets, we thoroughly read the article and found that the title had been horribly misleading. In the end, the EU leaders met on Friday only to postpone any fundamental decision around the EFSF, until March.

However, we understand that some speculate that the EFSF could buy sovereign debt currently being held by the European Central Bank (ECB). We really ignore what the final decision will be but warn readers that such a scenario (EFSF sourcing sov debt from the ECB) is different from the one we analyzed two letters ago. In fact, the outcome would be radically opposite to what we expect, if the EFSF bought sovereign debt from EU banks. Here’s why, in summary:

To buy sovereign debt, the EFSF must raise funds, Euros, in the market. This takes liquidity from the financial system. If the liquidity is then used to buy assets (i.e. sov bonds) from the ECB, these Euros will be taken out of circulation (i.e. assets and liabilities of the ECB will decrease). Therefore, not only will the EU witness a crowding out of private in favor of public credit. On top of it, the amounts of Euros in circulation will drop, raising rates.  This would not occur if the EFSF bought the sov bonds from the EU banks (see our letter of Jan 28th). Under both scenarios, the Euro strengthens. However, if liquidity drops because the ECB sells its bonds, the exercise is recessive, affecting the profitability of banks and the competitiveness of those countries the EFSF was set up to help. Should this occur, we think the possibilities of a successful monetary union in the EU would be seriously challenged, and we would use the initial strength in the Euro to quietly shift to a very liquid USD denominated portfolio. Remember that EU sovereign credit default swaps are denominated in USDs…

Martin Sibileau