Timing & trends
Inflationary expectations, as measured by the spread between US 10-Year Notes and Treasury Inflation Protected Securities (TIPS), have recently increased to the highest level since August 2013
- Jobs numbers in the US as measured by the ADP survey and the non-farm payroll data are showing continued strength
- A plethora of additional data including consumer confidence ISM and PMI surveys seem to echo the theme of a strengthening US economy
- This is welcome news, but is it enough to overcome the strong disinflationary forces that we have written about?
Has the Tide Turned?
For the last six months, I have been writing and speaking on the tug of war between inflation and deflation. This is a battle with no clear winner – yet. Recent economic data from the United States has most wondering if we have finally “turned the corner” and are now on the path of sustainable economic growth.
Earlier this week, the ADP Private Employment Report surprised to the upside with 238,000 jobs created in December 2013. This was in excess of the initial estimate of 205,000 – a very strong number in and of itself. Further, the previous month’s jobs number was also revised higher (a final print of 229,000 new jobs).
Despite the strong job numbers dating back to late 2010, official inflation stats remain mysteriously subdued. To be clear, there is inflation in the economy, but the cost push inflation one would expect is not fully evident. We can also argue about the “quality” of these jobs that are being created, but this is perhaps another topic for another Note.
The positive economic news extends beyond job creation. A look at the trends in select ISM data also would confirm a scenario of generally positive economic growth. As a reminder, a reading above 50 indicates economic expansion.
Other metrics, improving consumer sentiment, strong PMI readings, and upward revisions in GDP numbers reinforce the recovery thesis. Even the angriest bear would have to admit that while the economic recovery here is slow, we are at least “recovering”.
The Case for Rose-Colored Glasses May be Overstated
As is the case with any argument, there is always another side to the story. Many of the metrics we have written about in recent months still look shaky, including:
The Velocity of Money (M2):
The Money Multiplier:
and the Adjusted Monetary Base:
These metrics, along with a yawning output gap and historically low labor force participation rate are clearly still struggling to gain their footing and state the case for a stagnant economy and stoke fears of deflation.
In addition to the data above, the chart below shows just how far the U.S. economy must improve vis-à-vis job creation to stay even with the growth in the overall labor force. As you can see employment is not back to its pre-recession level in 2007. This is troubling for a consumer economy such as the U.S.
This yawning employment gap is a very real albatross around the neck of the U.S. economy.
In spite of these arguments, new data shows markets are now forecasting the first whiffs of inflation in the economy. Shown below is the spread between the U.S. 10 Year Treasury Note and the 10 year Treasury Inflation Protected Security (TIPS).
This spread is a measure of inflation expectations. As the spread widens, this tells us that market participants are anticipating increasing inflation as measured by the CPI. This is important, because it is a forward-looking indicator as opposed to so much else which is not. The benefit of owning TIPS is that since their value is indexed to the CPI, as the CPI rises, so does the value of the TIPS. The idea here is to protect the value of your investment against inflation which can, of course, erode your returns.
According to the Financial Times, inflation expectations in the US are at their highest level since August of 2013. The U.S. dollar would appear to be pricing in a higher interest rate environment, having shown sustained strength since late October 2013, despite the overall move lower since July.
The Takeaway
Despite the best intentions of Central Bankers in the U.S., the Euro Zone, and Japan, deflation/disinflation remains a much larger concern than inflation. I have said, in the past, and still believe, that QE, ZIRP, forward guidance, and other schemes put forth by Central Banks are actually deflationary in nature. The money they have created is not finding its way into the economy through expansion of credit.
Evidence of inflation in the economy should be a welcome sign – to policy makers and consumers alike. Policy makers want to see inflation as they believe it is a much simpler problem to control. Debt holders and the U.S. government should like inflation as it can push up wages and devalue outstanding debt.
Rising inflation should be a net positive for commodities, especially after the challenging environment we endured in 2013. This doesn’t mean that the now devastated junior exploration sector will immediately benefit, but there are a number of ways to play this.
We’ll be speaking about some investment strategies at the Cambridge House Resource Conference in Vancouver next week.
With the Federal Reserve in “taper mode” I will be paying close attention to these bond spreads as well as any sustained increase in commodity pricing to gauge whether or not we’ve broken free from the cold grip of disinflation. The risk, of course, is that higher interest rates choke off a nascent US economic recovery. This will be one of the key events to watch for in 2014.
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Canadian employment fell by 46,000 in December, the result of declines in full-time work. The unemployment rate rose 0.3 percentage points to 7.2% as more people searched for work. This was the worst report since March of 2013.
The Canadian Dollar continues its fall down to 91.20 from 93.85 at the start of the year.
Drew Zimmerman
Investment & Commodities/Futures Advisor
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Deflation Shock Coming? Or QE Euphoria?
Taki Tsaklanos over at GoldSilverWorlds has reprinted a series of charts fromIncrementum Lichtenstein that show a reversal in several big trends. Here are a couple of them, followed by some other supporting material.
First, US banks have not only failed to return to their pre-2008 pace of lending, but the loan growth rate is now falling back towards zero. In other words, the trillions of dollars pumped into the banking system by the Fed in recent years don’t seem to have worked:
Along the same lines, after the 2008 crash growth in the money supply spiked in the US and recovered modestly in Europe. But both trends are now declining:
To see what this means for the weakest links in the global finance chain, here’s a chart from Mike Shedlock showing how pretty much all the new credit being created in Spain is by the government, while private sector activity continues to contract.
In November, Spain’s youth unemployment rate exceeded that of Greece:
“Spain saw its youth unemployment rate rise to a staggering 57.7% in November as the country registered the worse youth jobless rate in the eurozone area.
Eurostat, the statistical information arm of the European Union, also revealed the youth unemployment rate across the eurozone remained steady at 24.2% for the second consecutive month – meaning there were 3.5 million unemployed under-25s across the region.
“There is a real danger that these young people will get trapped in the ranks of the long-term unemployed,” James Howat, a European economist at Capital Economics, told IBTimes UK.
What does all this mean? Maybe that 2014 will be a year in which Europe leads the global economy back into recession, people start focusing on how deflation makes life even harder for debtors, and pressure builds for the European Central Bank to board the QE train. The Fed, meanwhile, will find it hard to justify more tapering with big parts of Europe on the brink of explosion (an inevitable result of 50+% youth unemployment) and will be forced to reverse course sooner rather than later.
So the question becomes one of interpretation. Do equity and other financial markets freak out over incipient deflation or soar in anticipation of global, unending debt monetization? Or one then the other?
However it plays out, fundamentals will likely take a back seat to perception and manipulation, which is, for a while longer, the way of the world.
About DollarCollapse.com
DollarCollapse.com is managed by John Rubino, co-author, with GoldMoney’s James Turk, of The Collapse of the Dollar and How to Profit From It (Doubleday, 2007), and author of Clean Money: Picking Winners in the Green-Tech Boom (Wiley, 2008), How to Profit from the Coming Real Estate Bust (Rodale, 2003) and Main Street, Not Wall Street (Morrow, 1998). After earning a Finance MBA from New York University, he spent the 1980s on Wall Street, as a Eurodollar trader, equity analyst and junk bond analyst. During the 1990s he was a featured columnist with TheStreet.com and a frequent contributor to Individual Investor, Online Investor, and Consumers Digest, among many other publications. He currently writes for CFA Magazine.
Risk being an inherent and precarious element of investing, hedging is basically an investment strategy employed to reduce risk by making a transaction in one market to offset a loss in another. Put more simply, hedging is taking equal and opposite positions in two negatively correlated (meaning if security A goes up, then security B goes down, and vice-versa) securities to lower risk of loss.
Theoretically, a perfect hedge would be one that eliminates all and any risk altogether from an investor’s portfolio, but that would mean there is no potential for upside either. In the real world, therefore, hedging is used by hedge funds preponderantly to reduce volatility and risk while trying to protect principal and deliver positive (absolute) returns under any and all market conditions.
Hedge funds, actually a misnomer as not all investment strategies involve hedging, use a wide variety of alternative strategies to invest. As opposed to mutual funds, hedge funds are exempt from many rules and regulations of the SEC (and also do not have disclosure requirements). This gives hedge funds the flexibility, and advantage, of being able to invest with a wider range of strategies including hedging strategies to protect downside risk.
Some of the hedging techniques, each involving an array of financial implements and each offering different degrees of risk and reward, employed by hedge funds are outlined below and can be utilized by sophisticated individual investors to protect their own portfolio.
SHORT SELLING
While short selling by itself is not a hedging strategy (it is often used, though, as a hedging strategy in the context of a long-only portfolio), it is important to understand it in order to appreciate how it works as one leg of a hedging strategy.
When short selling, an investor sells borrowed shares with the anticipation that the price of the share will decline and with the intent of returning the shares back to the borrower. This is also referred to as taking a short position, as opposed to a long position (i.e. simply buying the security) which is opened in the expectation that the price of a particular stock will rise in the future.
If in actuality the price of the borrowed shares does drop, then the investor profits from buying back the borrowed shares sold and returning them to the borrower at the original price. To further clarify the profit made from a short transaction, let us consider this simple example: Assume that 100 shares are sold short by an investor for $5 a piece and her account is credited for $500. Say the price per share drops, as anticipated by the investor, to $3 and she closes out the position by buying back the 10 borrowed shares for $300. The investor makes a profit of $200, the difference between the short sale, i.e. $500, and the closing of the position, i.e. $300.
This all might seem simple, however, an in-depth analysis has to be undertaken by an investor to arrive at the premise that the price of a particular share will in fact fall and not rise. If the price of the share does increase, the investor will end up with the short end of the stick (no pun intended) and lose money.
Technically, the furthest the price of a share can drop to is zero and hence the upside is limited to the amount of investment, but the downside is theoretically infinite for there is no limit to what the price of a share might rise to. For this very reason the fluctuation in the price of the shares in question is followed with painstaking diligence by the investor. (Not to get ahead of ourselves, a cautious investor can hedge his short-selling risk by purchasing a call option on the same shares.)
LONG/SHORT EQUITY
Hedge funds utilize this strategy which involves buying certain stocks long and selling others short. This strategy was pioneered by Alfred W. Jones who is credited with starting the first hedge fund, A.W. Jones & Co., in 1949. Mr. Jones formulated the idea of hedging stocks by going both long and short with the aim to lessen the effects of market risk by hedging long equity positions with short positions.
To further clarify how market risk is hedged in this strategy, say that an investor might short sell a stock while buying a different one in the same industry. Now if the industry declines overall, then the short position would compensate for the loss acquired in the long position and in the case that the industry stocks rise the reverse would be true.
In either case, however, an astute balancing act has to be performed by the investor in estimating and hedging the risk to market exposure. Market exposure is determined by subtracting short positions from long positions, and the higher the difference (referred to as being ‘net long’), the higher the market risk.
ARBITRAGE
Arbitrage is the practice of simultaneously buying and selling two different, but highly correlated, stocks in the same market to profit from the unjustified disparity in their prices. Conversely, arbitration can be achieved by buying and selling the same stock in different markets and taking advantage of pricing inefficiencies (these opportunities are less and less common in today’s world of electronic trading). Ideally, an arbitrage transaction involves very little (if any) cash outflow and hence has the possibility of a very low-risk profit with very low cost to boot.
Arbitrage, sometimes referred to as ‘risk arbitrage’ or ‘merger arbitrage’, can be applied to special situations where a business is being acquired by, or merging with, another business. When a publicly traded business is being acquired, the acquiring business makes a tender offer – to the shareholders of the business being procured – which is usually higher than the market price. An investor may profit from this situation by buying the shares (at a lower price than the tender offer) of the company being acquired immediately after the tender offer has been announced, and then turning around to sell the shares back to the acquiring company at the tender price.
Practically speaking, the risk involved in jumping into the fray of special situations relies upon two main factors: Will the merger or acquisition go through? And, if it does go through, what will be the amount of the final tender offer? These two risks can be taken head-on and be classified as pre-emptive and post-tender respectively. The former being more risky as it is speculative and visceral because the investor purchases shares based upon the conjecture that the M&A deal will materialize. And assuming that the merger does go through, the final tender price may come in higher or lower than the original tender. (Again, not to get ahead of ourselves, these risks can be mitigated by being long convertible bonds and short the underlying equity.)
OPTIONS
An option, akin to a future, is essentially a derivative. A derivative is anything whose value is based upon some other asset, i.e. it derives its value from something else. Specifically, derivatives are securities whose prices are based on the prices of an underlying asset, namely equities, bonds, real estate, commodities, etc. Derivatives are prominently used to hedge and reduce risk of an investment in the underlying security. Besides futures, the most common derivatives used for hedging are options which are used to develop a hedging strategy where a loss in an investment can be offset by a gain in the option contract.
There are myriad ways of using options to hedge a portfolio. One common use of options is to curtail the possibility of losses in a specific security. An investment can be protected by buying a put option on it — this gives the investor the right to sell the investment at a specified price (known as the strike price) for a specified time period. Now, if the stock price falls below the strike price, then the losses can be compensated for by gains in the put option (meaning one does not have to exercise the put option). In the same fashion, a call option can be used to hedge losses arising from a short position in a stock, as the call option gives the investor the right to buy the stock at a specified price.
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