Archive - May 2010 - Story

Our earnings are robust, our compensation has returned to its naturally high levels and, as a result, we have very nearly regained our grip on the imaginations of the most ambitious students at the finest universities — and from that single fact many desirable outcomes follow. Thus, we have almost fully recovered from what we have agreed to call The Great Misfortune. In the next few weeks, however, ill-informed senators will meet with ill-paid representatives to reconcile their ill-conceived financial reform bills. This process cannot and should not be stopped. The American people require at least the illusion of change. But it can be rendered harmless to our interests. - From Wall Street's Man In Washington

The world has been fighting the financial crisis by using every possible trick according to John Maynard Keynes‘ playbook. But, as The Great Depression taught us, extreme government spending tends to cause about as much problems as it solves. Perhaps it’s time to put Keynes back on the bookshelf, and pull out the 200 year old theories of David Ricardo.

"Most economists seem to think that QE puts us in uncharted waters. It doesn?'t. Printing money to finance government expenditure is a very well trodden path which is as old as money itself: persistent monetisation causes inflation. Of course the current monetisation need not be persistent. Central banks can theoretically just stop it at any time. But with government balance sheets in such a mess across the developed world (even with yields at historically unprecedentedly low levels), government funding crises are likely to be a recurring theme in the future. Since banks hold so much ?risk free? government debt, those funding crises point towards more banking crises which point towards more money printing. When do they stop? When can they stop?
But what does it all mean? The question to my mind isn'?t whether or not inflation will accelerate from here. If government balance sheets are in as big a mess as I think they are, inflation is inevitable. The more interesting question is what kind of inflation can we expect?" - Dylan Grice, SocGen

A week ago at the CFA Institute's 2010 Annual Dinner, Baupost's Seth Klarman stole the spotlight by announcing to everyone that he was "more worried about the world than ever" while making it clear that he was on the same Jim Grant and Julian Robertson "Treasury put" bandwagon. Yet another speaker present at the event, who undeservedly received much less attention, was CLSA'a Russell Napier, who has long been warning about precisely the thing that all asset managers are realizing rather belatedly, that Treasuries are a very "fundamental asset bubble." The only relevant questions, which Napier has previously discussed extensively, are "when do treasuries crash" and "what do you do" when that happens. The attached presentation provides some color on both.

Oh, what a tangled web we live in. On one side of the Atlantic, there is a fundamentally broke European Union. On the other, the world’s largest debtor nation, these United States. Rotate the globe and you discover China, the world’s most populous nation: a nation whose economy is desperately dependent on export revenues, without which its government may find it hard to meet the population’s soaring aspirations. And who is China’s largest trading partner? The European Union, that’s who. The web also encompasses the role that the U.S. dollar plays in the relationship between the European Union and the Chinese. Or, more specifically, the role the peg plays that China maintains with the U.S. dollar. As long as the U.S. dollar is weak, the Chinese yuan is weak and therefore competitive in European markets. The problem now is that, with the euro falling, in order to remain competitive, Chinese companies must reduce their margins. Therein lies the rub, because the razor-thin margins of the Chinese companies – estimated to be on the order of just 2% -- face the very real danger of thinning to the vanishing point. After which the best a Chinese company will be able to hope for is to make up its losses on volume. That was a joke.

As we’ve discussed recently, persistent deflationary forces do not augur for a repeat of Japan circa 1990s or the US in the 1930s. Instead, because of the inability of governments to finance their current and future debt burden (there is a dearth of domestic savings and global capital), deflationary forces will ultimately lead to severe inflation or hyperinflation. In today’s missive, we explain how this will happen but in various stages.

C'mon you wimp.  The Russians nuke these things all the time.  Here is your big chance to show up Putin.  Run with it, baby.  We'll just watch from a confortable distance.  To wit:

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Or just connect direct: http://72.13.86.66:8000/listen.pls

With concerns about implications on GoM drilling post the Macondo spill dominating the investing world, as every day millions of gallons of fresh oil spill into the Gulf of Mexico, we present reports by Bank of America and JPM which disclose possible consequences from regulatory intervention, as well as all the rigs and operators in the GoM likely to be impaired by either surging insurance premiums, or something much worse, now that US offshore drilling policy is in greater flux than even ongoing financial reform. With today's adverse BP developments, Tuesday will likely see another bloodbath within the offshore drilling space, where RIG CDS have blown out more than in 2007 when the company was rumored to be a take private candidate more often than Radioshack is today (speaking of, in breaking news, today the market did not leak a new rumor about some idiot LBOing RSH ). The attached reports should provide a sufficient perspective on which managers and which operators are most likely to suffer the wrath of a skittish market.

Over the past week, numerous people have inquired about the utility and practicality of the 2% "target" inflation rate held sacred to central banks the world over. Why 2%? And, more importantly, why not more... much more. Will the Fed ever get to targeting hyperinflation as a monetary policy goal, and if we ever get to that ludicrous position, can this be implemented in practice? Are the days of 2% target rates over? This is not just some theoretical whimsical musing - these questions are predicated by a recent IMF report which hypothesized that a 4% inflation rate "might prove superior to the traditional 2% target rate in helping to minimize the impact of future economic shocks." Furthermore, the higher the target rate, the greater the stimulus flexibility, as ZIRP would then become a perpetual component of capital markets, and recurring fiscal stimuli would be the norm as opposed to the outlier. We present a TD Securities report by Eric Lascelles which answers all questions about "why 2%", and what will happen when 2 becomes 4, then 8, then 16, etc, until the second coming of Rudolf von Havenstein is finally confirmed.

Although those of us who invest in the currency market have to pay careful attention to the daily price twitches resulting from economic releases and political speeches, the foreign exchange value of individual currencies actually moves glacially with wide emotional swings around the central value. The emotion has often run against the dollar. Before the start of the euro, the Deutsche mark was the market favorite. Two societal attributes probably contributed to this consistent bias. First, the Bundesbank and the German government preached and usually followed a more conservative monetary and fiscal strategy than the Fed and the US government did, which resulted in marginally tighter liquidity on average in Germany. The two governments’ different leanings could partly be explained by the historical accident of the ruinous hyperinflation that Germany suffered in 1923, terrifying modern Germans, but more critical was the fact that the US population was younger and growing faster than the German one. Because the tendency to consume is higher in the early years of adulthood and trails off dramatically as retirement age approaches, Americans bought more and saved less than the Germans. Furthermore, the US had to spend more on its infrastructure and social services than Germany, just to handle the higher level of household formation. Looking over the past 40 years, it seems that countries with growing populations and with faster growing economies tend to have weaker currencies than those with a more stable population and slower growing economies.

In what could one day be seen by historians as a seminal speech presented before the Paul Volcker-chaired Group of Thirty's 63rd Plenary Session in Rabat, the ECB's Lorenzo Bini Smaghi had two messages: a prosaic, and very much expected one: of unity and cohesion, if at least in perception if not in deed, as well as an extremely unexpected one, in which the first notable discords at the very peak of the power echelons, are finally starting to leak into the public domain. It is in the latter part that Bini Smaghi takes on a very aggressive stance against not only the so-called "inflation tax", or the purported ability of central bankers to inflate their way out of any problem, but also slams the recently prevalent phenomenon of fear-mongering by the banking and political elite, which has become the goto strategy over the past two years whenever the banking class has needed to pass a policy over popular discontent. The ECB member takes a direct stab at the Fed's perceived monetary policy laxity and US fiscal imprudence, and implicitly observes that while the market is focusing on Europe due to its monetary policy inflexibility, it should be far more obsessed with the US. Bini Smaghi also fires a warning shot that ongoing divergence between the ECB and Germany will not be tolerated. Most notably, a member of a central bank makes it very clear that he is no longer a devout believer in that fundamental, and false, central banking religion - Keynesianism.

In his May 28th interview with Bloomberg's Mark Crumpton and Lori Rothman, Matt Simmons of energy investment bank Simmons & Company, provides some stunning revelations on what is really occurring in the Gulf of Mexico, and proposes that the only effective way to contain the leak is to relieve BP, bring in the military, and do what the Russians have done on comparable occasions, namely explode nuclear weapons within the wellbore. Simmons knows what he is talking about. As Jim Bianco points out: "Matt Simmons gained fame with his book 2005 Twilight in the Desert where he claimed that the Saudis were overstating their oil output because they hit “peak oil.” Right or wrong Simmons claimed the price of oil was going to skyrocket and three years after the book’s release the crude oil hit $147/Barrel. In January 2009 the WSJ called Simmons one of the five most important voices in the oil industry. Simmons has been wrong in the past and his views are non-conventional and often correct. Simmons is also highly connected within the oil industry so he knows who to talk to verify his claims." In addition to his radical solution, Simmons also points out that "Top Kill" is a sideshow and the real problem is 5 to 7 miles away, where a second fissure is "releasing a plume the size of Delaware and Maryland combined." If Simmons is indeed right, and the only recourse left to Obama is to nuke the seabed, the repercussions for his already shaky political situation will be tremendous.

As the market tumbles, what does Goldman do? "We are raising our 2010 and 2011 operating EPS estimates to $78 and $93 (from $76 and $90) to reflect strong 1Q results and better net margins than we had expected. Our pre-provision and pre-writedown estimates are $83 and $93 reflecting growth of 15% and 12%. Our 3-month, 6-month, and 12-month S&P 500 forecasts equal 1160, 1250, and 1300, respectively, corresponding to 5%, 13%, and 18% returns." In the meantime clients continue to lose money both on Goldman's recommended longs and shorts: "Our recommended sector weightings have generated -14 bp of alpha YTD. Our overweight recommendations (Energy, Materials, Info Tech) have generated -33 bp of alpha while our underweight positions (Health Care, Consumer Staples, Utilities, Telecom) have generated +18 bp of alpha." But, David Kostin will be right about the S&P dammit. Also, here is how Goldman will lose clients even more money: a whole new set of unhittable targets: "Our 3-month, 6-month, and 12-month S&P 500 forecasts equal 1160, 1250, and 1300, respectively, corresponding to 5%, 13%, and 18% returns."

Openeurope.org.uk has put together a paper of the most blatant half-truths, propaganda, and outright lies, abused by Europe not only over the past month, but also over the past 10 years, for the entire duration of the now rapidly collapsing eurozone experiment. As the paper notes: "More than ten years since the euro was launched, and with the single currency facing its greatest ever crisis, the parameters have radically changed. Amid all the uncertainty, one thing has become painfully clear: the EU elite simply got it wrong on the euro." The authors demand for "a call for greater honesty about the future of European cooperation and a reminder of the urgent need to find a new model that is both politically and economically sustainable" is just as valid in Europe as it is in the US: any system based on lies and opacity is doomed to failure. Europe found this out the hard way. We will too unless somehow we restore the basic truths like transparency, honesty and integrity, instead of merely campaign promises and teleprompter soundbites.

Asia is one of the more interesting gas markets in the world. Places like Thailand and its southeast Asian neighbors have seen phenomenal demand growth over the last several years. Total has said they're in Thailand for gas. (Part of the reason I believe Thai shale gas may become an interesting play over the coming years.) Asian LNG demand has also been strong. Japan, China and Korea have helped pick up (a little of) the slack in the LNG market created by booming U.S. shale gas production displacing LNG imports. But a developing gas market brings challenges. Especially when it comes to pricing.