The Show Must Go On:

“Modern capitalism has no purpose except to keep the show going” – Joan Robinson

Few people are brave enough to predict the market we are in right now over the medium term. There are too many contradictions and doubts about the fundamentals that govern markets, and it comes down to herd mentality in such situations. Equity markets have not sold off, and this makes for a truly enlightening study on investor psychology. Nothing seems to matter but interest rates. All the other news flow is superfluous, even if it is related to revolutions and nuclear meltdowns.

The current situation in Japan is still not under control. The Fukushima nuclear plant continues to emit waves of nuclear radiation, as the market capitalization of TEPCO has fallen bellow $1 trillion. There are definitely some unaddressed supply concerns that the developed world will have to take note of as a result of the productivity slowdown in the aftermath of the Japan disaster. Meanwhile, the situation in the Middle East also remains far from solved, and yet investors seem confident that the crisis is on its last legs. Oil prices have stabilized just above $100 for now, an indication that investors perceive less risk to oil supply in the coming weeks. All this confidence is coming amidst Obama announcing that he is not ruling out arming the Libyan rebels. Seems a little bit like what America did to Afghanistan when Russia was in control? There is no end game in sight if one looks at the middle-east situation based on historical perspective

The S&P 500 closed on Tuesday near one of its favourite levels of resistance at 1320. This upward surge from 1279 (after the initial post-Japan sell off) has been driven by no fundamental news. The housing slide in America continues to be worrisome- with the Case-Shiller 20-City Home Price Index falling 3.1% from year ago levels. There are supply concerns faced by auto manufacturers as a result of the Japan disaster, and unemployment has not witnessed any great slowdown. Likewise in the case of the Eur/Dollar, the risk on trade for the dollar continues through to this week with the currency pair trading above the pivotal 1.4 level.

Meanwhile, the Euro-zone continues to battle credit downgrades and risk aversion in the bond markets, even as equity markets remain calm. The Dax is nearing its key 7000 mark, and the FTSE is near 6000. Both these levels are important in assessing how much optimism is priced into the markets, and as they are crossed, the risk on trade is definitely on. Predictably, following from the pattern of equity markets in America and Japan (Nikkei comfortably above 9000), the European equity markets are not bothered by socio-economic fundamentals.

The yields on the 10 year German bonds (bunds) are within 3 basis points of the most in 14 months. This makes sense since there is clearly going to be an ECB rate hike in the very near future (next meeting is on April 7^th). The other concerns in the Euro zone are of course the credit ratings of Portugal and Greece which were downgraded once again by S&P to BBB- and BB- respectively. Now Portugal’s rating is one notch above junk status. Does not seem like thrilling news for equities at the outset does it! Furthermore, there are also political concerns in the Euro zone , with the governments in France and Germany facing political uncertainty. Merkel and Sarkozy have both lost in regional elections held recently in their countries. There seems to be a resurgence of socialist political power in the Euro zone and perhaps befittingly so given that austerity is being promoted by the right wingers.

So what does one do in a situation, where we remain in a bear market in the sense that with every jolt to the economic structure of the world, there is a knee-jerk reactionary sell off, and commodities remain expensive? Equities seem destined to remain in a sideways trend for some time to come, and as I have been pointing out all through this year, June is the key month for the markets. Given that low interest rates are probably the sole drivers of the equity markets as of today, QE3 is looking all the more probable.

 

The Week of March 14th: Speculation and the Yen

There is a common misconception about currencies and their values which goes somewhere along the lines of - the stronger the currency, the stronger the economy. This is an incorrect view which does not consider the fact that export dependant nations necessarily need to keep their currencies weak. Even the dollar is not an exception to this rule, and one of the unstated objectives of the massive quantitative easing programs being carried out by the Federal Reserve is to weaken the dollar. This is done through creating extra supply of dollars and hence affecting the balance of payments which further affects the exchange rates.

Currently there has been a great amount of discussion in the currency markets about the sharp appreciation of the yen following the massive natural disasters that hit the country last week followed by the reactor meltdowns. The increase in the value of the Yen seriously undermines the potential for a recovery in the equity markets which have been rocked by the recent spate of disasters afflicting Japan. The Nikkei fell by over 10% on a single day this week, wiping off billions in value from the equity markets. The Japanese have always been a strong and resolute people, but even they will not be able to dig themselves out of this hole if their currency continues to strengthen. The rise in the Yen has been attributed to speculative activity by traders. The Yen touched 76.375 to the Dollar on the 16^th of March, a move that gained momentum after some heavy options book selling. This was the strongest the Yen has been since the aftermath of the Kobe earthquake when the Yen hit 79.75 to the Dollar.

Fundamentally speaking, the appreciation of the yen can be attributed to risk aversion following the earthquake. The Japanese have had to repatriate their foreign assets home in order to fulfill the needs of disaster relief and reconstruction activity. This risk aversion has been strong over the last few months in any case. The happenings in the Middle East do not make the case against risk aversion strong. Furthermore, reports from hedge funds suggest that equity hedges of up to $20 billion over January-February to insure against the weakness in Japanese equities have lead to further currency appreciation.  .

Historically the Yen has been strengthening against the Dollar in the very long term. In the late sixties, it took over 350 Yen to purchase a Dollar, and these days it is hovering around 80 Yen to the Dollar. The most recent highs for the Dollar were reached at the peak of the asset bubble in June 2007 when 124.14 Yen would buy one dollar. Since that peak, the Yen has been in a long term appreciation trend against the dollar. This trend does not seem likely to reverse in the long term despite many possible central bank interventions.

The G7 have agreed to get their feet wet in the currency markets to curb the current appreciation. The exact amount of intervention has not been clarified, and indeed it does not matter. The main effect of intervention is the effect of the announcement in the minds of currency traders. Much like interest rate announcements, such an explicitly announced intervention will be priced into the market without the need for actual significant amounts of intervention. As I type this, the Yen has weakened to 81.76 to the Dollar.

The interesting effects of currency intervention could be the creation of extra liquidity in the Japanese economy. The Bank of Japan might not absorb the extra liquidity that will be generated by the current increases in supply of the currency. The economy has been in a veritable deflationary spiral for decades, and might just benefit from the series of disasters that have struck it recently in that there might actually be some inflation in Japan at the end of the current rounds of quantitative easing. Albeit unlikely given that monetary expansion has not worked so far, this would truly be a turn around moment for an economy which has more or less stagnated since the collapse of its massive asset bubble in 1991.

When the World Ends: Some Notes

There are many plausible reasons for the world as we know it today, to change drastically. The generation I belong to, has grown up after the cold war, where there has been a continuous moderation of the unstable elements within the global economic and political paradigm. There have been threats time and time again, but we as a collective human race have managed to stave off many of them, and emerge unscathed. The fact that the human population has more than doubled since the 1960s and there have been no great Malthusian consequences is some indication of this moderation. However, if one were to believe the Mayans, and if the world is actually to end in December 2012 (or according to the Hindu calendar, experience the coming of a new age bringing about a palpable shift in global consciousness), it would be interesting to build a case for the same.

The repeated aftershocks of denial:

According to the United States Geological Survey, there were 6 earthquakes of magnitude greater than 8 on the Richter scale in the 1990s. Care to venture a guess as to how many of the same magnitude since the year 2000? Double the number and then add 3, and yes the correct answer is 15. So is it just me or do the world’s tectonic plates seem to agree with the Mayans? The Japanese just experienced their biggest quake in 140 years. There are tsunami warnings all across the Pacific. That is two times in the last 7 years, that there is threat across an extremely vast surface of the planet.

People, who refute Global Warming as a phenomenon, cannot be argued with. There is no body of evidence, whether it is melting glaciers, dying species or erratic weather patterns that can change their perceived reality. It would be a good idea for such people, who hopefully believe their eyes if not established scientific facts, to take a trip to the Russian Tundra, where the permafrost is mostly melted. I remember studying about the Tundra and the permafrost on it when I was in middle school. There was certainly no reference there about melting etc, so this has to be a recent and very big development, given that the Russian Tundra covers an enormous surface of the Earth. Here is an article from the Guardian that explains this well: http://www.guardian.co.uk/environment/2009/oct/20/arctic-tundra

Hungry Tiger, Thirsty Dragon:

There are many sources of the current wave of inflation in the developing world. The leading causes are the intensification of the bull-run in commodity prices from oil to steel, and rising food inflation. In countries like India, the problem is not the shortage of food, but rather the distribution and wastage of it. If one were to assume a sort of structural rate of wastage in developing countries, and then try to account for rising populations in the coming decades, it would be a very tricky task to figure out how to feed the world without some miraculous changes in farming practices (which costs money!). The threat of a global food crisis is a serious one, and is something that everybody should strive to educate themselves about, because it is not on its way, it is here.

Fact: There is already an immense shortage of fresh water on this planet. Fiction: We can use desalination techniques to overcome this problem to a great extent. The reason for this is that the shortage of water that is experienced by peoples across the planet is of varying degrees. The problem is that Asia, which is home to 60% or so of the global population, has only 30% of the world’s fresh water reserves. This skewed distribution of water resources on a planet which already is immensely skewed in terms of per capita income, is the crux of the problem. How are desalination techniques going to change the lives of the people earning less than $1 a day? They cannot afford for such expensive treatment of water. Now some of you will be thinking, governments will intervene and things will be sorted out on a mass scale when the time comes. Think about the fact that according to the United Nations, over 1.1 billion people do not have access to drinking water. Is that a small number? When will the situation get out of hand? Investment banks are ready for the ‘commodification’ of fresh water reserves, are you?

Global  Economy:

There are few investors and market professionals out there, who would tell you that they are 100% confident that we are in a stable phase of the global economic cycle after the global meltdown. I write the words global economic cycle on purpose. It is truly a globalised world and Henry Kissinger is having the last laugh. The interdependence between nations eliminates the possibility of a world war ever happening again, and intensifies the possibilities of global economic downturns such as the one we experienced recently. If America looses everybody does!

There are essentially three clear threats to the global recovery as of now (and that is three more than most bulls may like). The first is on the list is the current crisis unfolding in the Middle East and the consequences on oil prices. There is no need for me to provide commentary on that because the situation is widely known. The following link is an excellent video that explains why the situation in Bahrain may be the real thing to watch out for: https://www.stratfor.com/campaign/dispatch-complexity-persian-gulf-unrest?utm_source=JMF&utm_medium=email&utm_campaign=WIPAJMF110303160409&utm_content=Freelist

The second threat is the situation unfolding in the Euro-zone. Moody’s cut Spain’s debt ratings by a notch to Aa2 on Tuesday and slashed Greece’s credit rating by 3 notches on Monday. As discussed on previous occasions on this blog, Spain will be the real deal breaker in the Euro-zone, if it were to default. The sheer size of the country and the economy means that problems there outweigh those of all the other peripheral countries (ie. Ireland, Portugal and Greece) combined. There are rumours that this weekend there will be decisions taken to widen the EFSF. It is yet to be seen whether this possible move may assuage bond vigilantes, but I think that it will just be a way of buying more time. Recapitalisation seems to be the key word for the Euro zone. In case the ECB decides to raise interest rates as they have been hinting in April, it would be a real test for the Euro, which has gained off some dollar weakness off late, but is again in a downtrend.

The third clear threat is the burgeoning debt of America. According to a recent study by Rheinhard and Rogoff; debt to GDP ratio above 90% compromises growth trajectory in a major way. And yet, there seems to be no overt steps taken to curb spending, especially on the military or entitlements. There is no way that America can overlook its debt and the Simpson-Bowles commission has recognised this fact. Yet with elections coming up next year, Obama and his team of trigger happy economists will most likely do nothing to reduce spending in a major way. This will not bode well for the dollar, and it will not bode well for most of the world that holds a majority of the share of dollar denominated assets.

And in the End:

Like the Beatles said, “in the end, the love you take, is equal to the love you make”. There is going to be little hope for the world until we do see a shift in global consciousness. We need to recognize that we are going to be up against some tough economic, geological and political challenges, and we need to come together to face up to the facts. Until then, brace yourselves for the next Tsunami and write out that bucket list!

The Week of February 28th: Crude is Rude

The number one question that needs answering to assess the strength of the markets going into March is whether the bulls have enough steam to outweigh the strengthening oil prices. It seems that the situation in Libya is ever worsening, and there are cries of genocide coming from within the country. Gaddafi doesn’t seem to be the type of nut who will give up until the last bullet has been shot, and until the last fragments of his armed forces still back him in the calculated massacre of his own people. Newswires are primarily concentrating on the threats of contagion, and it certainly does not seem irrational to expect oil to be making a run for $110 a barrel in the coming week.

The actual supply side situation as it stands seems to be pretty stable in the context of oil. The two biggest users of oil energy; the US and China have enough reserves to see out this Libya situation until it resolves out of its own volition. There are question marks over whether the disenchantment with the regimes in place in Qatar, Bahrain, and most importantly Saudi Arabia is going to escalate into full fledged national revolutions. The Saudis, with the largest oil reserves in the world, are definitely not taking any chances, and King Abdullah has announced a stimulus of $36 billion. This stimulus plan is definitely not inspired by Keynes, and has been issued as a pacifying force for the people of Saudi Arabia who may be on the verge of contemplating revolution. This stimulus includes provisions for interest free loans, unemployment benefits and debt forgiveness.

American equities exhibited a strong inverse correlation with oil prices for the last two weeks, and validly so. Even though there has been a barrage of better than expected data coming out of the US, markets have not rallied strongly, though the S&P 500 is managing to stay above its key psychological level of 1300 with some determination. The daily charts indicate a consolidation phase such as the one seen in November before a rally up to 1350. If however, the 1320 level does not hold during the initial phases of next week, the momentum towards the downside could shake the confidence of some of the shorter term speculators looking to get in at discounted prices.  There is going to be some added volatility due to the expiration of March futures contracts for the S&P, and the most likely scenario is that the market is going to repeat its behaviour exhibited over the last week.

It is strange to think that oil had ever been at $20 a barrel, when there is speculation of oil prices touching $200 within a few years if not less. The readiness of emerging markets to tackle the coming energy crisis is disturbing. It will certainly be a crucial time for the world, and the rise in commodities in general is certainly going to move millions of more people below the poverty line, in an antithesis to the Kuznets Theory which predicts a narrowing of the income gap between the rich and the poor after the initial widening in the cycle of development.

Another crucial development that I will be following closely over the coming weeks is the weakening of the US dollar. The Eur/Dollar handle of 1.4 has been touched on the back of weaker than expected Non Farms Payrolls (though the number has been better for January than in the previous months, touching 192,000 jobs created). It is interesting that arguments questioning the safe haven status of the dollar are being made in the light of currencies like the Swiss CHF gaining solid ground on threats of contagion in the Middle East, while the dollar weakens. I think that this pattern would be crucial to watch over the next few jolts that the world has in the form of political or economic threats. What puts me in some amount of doubt about the weakness being externally created is the fact that one of the inherent objectives of quantitative easing is to make the dollar weak. 


PS... Readers of this blog might notice the sharp spike in silver prices as foretold!