Cyclicality

Everyone seems to have an opinion on asset valuation these days, even commentators who are normally quiet about such matters.  Some are seeing asset price bubbles, others are just on the lookout for bubbles, and still others wonder what all the fuss is about. Simply put, our financial markets weren’t (and still aren’t) structured to be efficient, and consistently rational behavior is a pipe dream, history shows over and over that the idea of a stable equilibrium is deeply flawed. Policies focused on the short-term tend to exacerbate that cycle, as we saw when decades of stabilization policies and moral hazard exploded in the Global Financial Crisis. Maybe if macroeconomics were rooted in the reality of a perpetual cycle - where expansions eventually lead to recessions (stability breeds instability) and then back to expansions - we would see more economists and policymakers balancing near-term benefits against long-term costs. Or, another way of saying the same thing is that mainstream economists should pay more attention to Austrians and others who’ve long rejected core assumptions that are consistently proven wrong.

It’s amazing what people can trick themselves into believing and even shout about when you tell them exactly what they want to hear. It was disappointing to see Brad DeLong’s latest defense of Fed policy, which was published this past weekend and trumpeted far and wide by like-minded bloggers. If you take DeLong’s word for it, you would think that the only policy risk that concerns hedge fund managers is a return to full employment. He suggests that these managers criticize existing policy only because they’ve made bad bets that are losing money, while they naively expect the Fed’s “political masters” to bail them out. Well, every one of these claims is blatantly false. DeLong’s story is irresponsible and arrogant, really. And since he flouts the truth in his worst articles and ignores half the picture in much of the rest, we’ll take a stab here at a more balanced summary of the pros and cons of the Fed’s current policies. We’ll try to capture the discussion that’s occurring within the investment community that DeLong ridicules. Firstly, the benefits of existing policies are well understood. Monetary stimulus has certainly contributed to the meager growth of recent years. And jobs that are preserved in the near-term have helped to mitigate the rise in long-term unemployment, which can weigh on the economy for years to come. These are the primary benefits of monetary stimulus, and we don’t recall any hedge fund managers disputing them. But the ultimate success or failure of today’s policies won’t be determined by these benefits alone – there are many delayed effects and unintended consequences. Here are seven long-term risks that aren’t mentioned in DeLong’s article...

Sadly, not much in terms of macro observations this quarter or discussions of jelly donuts, but a whole lot on the fund's biggest Q1 underperformer, Apple and the hedge fund's ongoing fight for shareholder friendly capital reallocation as well as proving Modigliani-Miller wrong. And then this cryptic ellipsis: "Under the circumstances, it is curious that gold isn’t doing better." Say no more, David. We get it.

Due to decades of unreserved credit growth that temporarily boosted the appearance of sustainable economic growth and prosperity, rational economic behavior cannot produce real (inflation-adjusted) economic growth from current levels. The nominal sizes of advanced economies have grown far larger than the rational scope of production that would be needed to sustain them. This fundamental problem explains best the current state of affairs: malaise (i.e., bank system de-leveraging and economic stagnation) spreading through the means of production and the need for increasing policy intervention to stabilize goods, service and asset prices (by depressing the first three and inflating the last?). We live and work in a contrived meta-economy that can be managed through narrow channels in financial and state capitals. Given the overwhelming past misallocation of capital cited above, we think the most important realization for investors in the current environment is that price levels of goods, services and assets may be biased to rise but they are not sustainable in real (inflation-adjusted) terms. The crowd is ignoring the obvious, as all signs point towards the next currency reset.

Freight shipment volumes are rather obviously seasonal, but as Bloomberg Brief notes, the Cass Freight index shows shipment volumes have slumped for four consecutive months and are back to their worst levels in two years. This is the first year-over-year contraction since the 2007-2009 Great Recession - and places the reality of the dismal Q4 GDP print in context. If that wasn't enough good news about the real economy, the cyclicality of the shipments are losing momentum (i.e. each seasonal rebound in the last three years has been weaker - just as we saw in the lead up to 2008) and freight expenditures fell in January leading to a 1.6% drop over the last year - compared to a 27.2% rise in January 2011, and 22.2% rise in January 2012. As Cass noted, these volumes will not be enough to "have a significant impact on the unemployment numbers."

Hard assets are gaining momentum once again as market participants digest the potential impact of central bank printing initiatives. After last year's record level of central bank intervention, 2013 is gearing up to be an even more prolific year on the money-printing front. Japanese Prime Minister Shinzo Abe recently unveiled Japan's tenth Quantitative Easing program to follow the country's current $224 billion stimulus announced on January 11th. The US Federal Reserve is steadily printing US$85 billion a month under its QE3 & QE4 programs, and reports indicate that the European Central Bank is close to launching its much-awaited Open Market Transaction (OMT) program to purchase European sovereign debt. It's a money-printing party and everyone's invited. Even the new Bank of England head, Mark Carney, has hinted of plans to launch more monetary stimulus. Professional investors have noticed and are expressing concern over the consequences of concerted currency devaluation and the continuation of zero-percent interest rates. Despite being long-time precious metals enthusiasts and active investors in gold and silver, we did not focus on "the other precious metals", platinum or palladium, until very recently.

We have noted the odd cyclicality in macro data (and its leading effect on the market) and it seems Goldman Sachs has also noticed that something is different this time. For 15 years, the seasonal patterns in Goldman's macro index have been mild to totally negligible; but since 2009, something changed. As the chart below indicates, it really is different this time as the macro cycle has become extremely short and consistent (drop in H1, rise in H2) - and is evident not just top-down but bottom-up in payrolls and ISM for instance. Goldman expounds pages of statistical jiggery-pokery to show what we suspected - that this is not weather or seasonality effects, and is not just US (UK and Europe see same pattern of six month cycles); but appears driven by central-bank policy actions (which have been more concentrated in Q4/Q1). 2013 is playing out exactly as the last three years has - with a downdraft that is set to continue for the next few months - though they note that stability in oil prices this time (and recent expansion of easing efforts - Fed and BoJ) may shift the pattern. For now, it appears the macro cycle is becoming shorter and warrants concern as they are unable to find anything but 'reality' as a driver of this odd cyclical pattern as the real economy fades rapidly after each and every infusion of promises from the Central Banks.

While much has been made of the seemingly paradoxical stability of railroad traffic as the broad economy stagnates (and turns down - as we discussed yesterday), it appears the little train that could for the last four years has finally decided it can't anymore. Of course, there is an obvious cyclicality to the pattern but still the unprecedented plunge in rail traffic this week must be somewhat concerning.

"We have just spent 15 years learning that a policy of creating asset bubbles is a bad idea, so it is hard to imagine why the Fed wants to create another one. But perhaps the more basic question is: How fruitful is the wealth effect? Is the additional spending that these volatile paper profits are intended to induce overwhelmed by the lost consumption of the many savers who are deprived of steady, recurring interest income? We have asked several well-known economists who publicly support the Fed’s policy and found that they don’t have good answers. If Chairman Bernanke is setting distant and hard-to-achieve benchmarks for when he would reverse course, it is possibly because he understands that it may never come to that. Sooner or later, we will enter another recession. It could come from normal cyclicality, or it could come from an exogenous shock. Either way, when it comes, it is very likely we will enter it prior to the Fed having ‘normalized’ monetary policy, and we’ll have a large fiscal deficit to boot. What tools will the Fed and the Congress have at that point? If the Fed is willing to deploy this new set of desperate measures in these frustrating, but non-desperate times, what will it do then? We don’t know, but a large allocation to gold still seems like a very good idea."

What the Fed did was actually much more than QE3. Call it QE3-plus... a gift that will now keep on giving. The new normal of bad news being good news is now going to be more fully entrenched for the market and 'housing data' (the most trustworthy of data) - clearly the Fed's preferred transmission mechanism - is now front-and-center in driving volatility. I don't think this latest Fed action does anything more for the economy than the previous rounds did. It's just an added reminder of how screwed up the economy really is and that the U.S. is much closer to resembling Japan of the past two decades than is generally recognized. It would seem as though the Fed's macro models have a massive coefficient for the 'wealth effect' factor. The wealth effect may well stimulate economic activity at the bottom of an inventory or a normal business cycle. But this factor is really irrelevant at the trough of a balance sheet/delivering recession. The economy is suffering from a shortage of aggregate demand. Full stop. It just perpetuates the inequality that is building up in the country, and while this is not a headline maker, it is a real long term risk for the health of the country, from a social stability perspective as well.

The market has screamed loud and clear what the tangible results of the QE3 program are even without ever being implemented.

While lately not much, if anything, has changed in our and the broader secular outlook on gold, which has been and continues to remain the only currency equivalent that isolates devaluation risk, and excludes counterparty risk while being an implicit bet on the stupidity of those in charge (the fact that various tenured "Ph.D. economists" hate what it represents for their tenure prospects of course only makes the bullish case far stronger). True, in the past month it has surged from $1520 to $1660 but only Ph.D. economists (indeed, that 200 DMA proved to be a complete non-event) could not have foreseen that year end liquidations in a desperate drive to shore up liquidity (as explained here) by institutions, always end, and the reversion to the above thesis sooner or later reappears. So while it won't say much new, below we present Nomura's just released Gold Sector Initiation, which is a must read for new entrants to the field of physical and paper representations of gold, as well as a timely reminder for everyone else that in the past 3 years nothing has changed with the fundamental thesis, and in fact recent actions have merely reinforced it (and if we indeed have a €1 or €10 trillion LTRO, then watch all resistance levels in the metal get blown off).