Wednesday, September 28, 2011

Economic Commentary: Deflationary Wave - Ari Paul

Investors,

A synopsis:
-Commodity complex down big, equities trading weakly in a range, treasuries on their highs
- Eurozone remains a slow motion crash despite the pro-active ECB
-Political deadlock in the US is a growing economic liability
-Consumer balance sheets remain just a couple paychecks from bankruptcy
-The long-term investment positions are long Brazil, Turkey, India, and China, neutral the US, and short the Eurozone. Shorter term this is probably priced in. The clearest part of the puzzle to me is the long emerging markets piece, but I'm not buying until I see more of the crisis priced in.
-The Fed's latest action "Operation Twist" is selling shorter dated treasury notes to buy longer dated treasury bonds. This caused the curve to "flatten", meaning long-term interest rates fell sharply. They hope this will support housing prices and encourage investment.

The trend in the market over the past month has been towards "risk off" and positioning for deflation. Copper has fallen about 25% and the commodity complex as a whole is down about 8%. Gold is at about $1650, down $250 from its highs. Silver fell more than 25%, turning my october silver puts into a nicely profitable trade. Equities have been trading in a broad range from around 1110 to 1121 in the S&P 500. This comes as more investors are accepting that we are either in a recession or very soon will be.

Europe remains a slow motion catastrophe; the European Central Bank has been incredibly proactive in coordinating aid to preempt each mini-crisis so we're seeing muted volatility. George Soros says a breakup of the EU is inevitable, but it's possible it could be done in an orderly way. He suggests that a disorderly breakup would cause economic calamity as all the Eurozone banks would be immediately bankrupt.

The markets generally like political deadlock. Usually, the less the government does, the better the stock market will fair. Today however, the "drama queen" congress is causing consternation. Most investors and economists agree that reducing spending in the short-term as the tea party demands is a recipe for disaster. The immediate effect of a reduction in government spending is lower employment and lower capacity utilization (i.e. more idle factories). Our best hope to get out of this mess is to combine an intelligent and productive increase in short-term spending with a credible commitment to decrease entitlements in 5-10 years. That was the idea behind the debt ceiling resolution, but as with all the bills coming out of congress in the past 4 years, it was so muddled and ambiguous that the market is skeptical it will meet either goal.

While the balance sheets of big companies remain healthy, the consumer balance sheet is basically holding steady just shy of bankruptcy. Take student loans for example (see attached graph). Student debt has been growing rapidly for the last 6 years and now stands at clearly unsustainable levels. The default rate on student debt rose from 7% to 8.8% in the past year. Unless the unemployment rate comes down soon, we're likely to see that number climb annually as each graduating class fights with recent graduates and the newly unemployed over the same small pool of jobs.

Over the last 3 years, emerging markets have done a tremendous amount of "catching up" to the developed world in terms of GDP growth but this isn't fully priced into the relative market valuations. If the US falls into deep recession these markets may again get hit very hard, but we want to be looking at these countries from the perspective of aggressive long term buyers. I'll write a much longer piece on this soon.

My positions: Small short S&P 500 position, small long crude oil position. Small short EUR/USD, very small short JPY/USD, very small long positions in a few equities including IPI. I covered my silver puts because they will be expiring soon but am considering buying more puts further out. My opinion on gold/silver remains unchanged - its a bubble and I'm unlikely to be able to spot the top with any confidence. Gold may have peaked or it may peak at $10,000, but in 10 years it will be lower than it is today. I really like crude oil as a long-term buy, but if we fall into global recession in the next year, it could get hit hard. I expect to gradually scale into a larger position if crude falls significantly. Around $75 is a long-term floor for crude (meaning it's highly unlikely that we spend more than a year below there). Even in a severe global recession, global crude demand is unlikely to drop much and at this point, I believe little to no growth is priced into crude.

Cheers,
Ari

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