PIIGS Is Not Pigs

By: Michael Ashton | Tue, Feb 1, 2011
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Illiquid conditions can also cause melt-ups. I didn't anticipate that would happen, because frankly the conditions for a melt-up in stocks are really not in place: energy prices high, geopolitical uncertainty and volatility, and valuation levels that are already elevated.

But melt-up we did. Stocks soared despite signs that populist unrest has spread to Jordan (where Prime Minister Rifai resigned) and Syria (where opposition groups called for protests this weekend). "Buy on the sound of cannons"?!? The ISM Manufacturing number was stronger-than-expected, but not particularly surprising considering that Chicago had also been quite robust yesterday.

The Wall Street Journal had warned ("Cost Inflation Puts a Wrench Into the Works") that the "Prices Paid" subindex could be the "sting in [the] tail" of the ISM report, and the Prices Paid did indeed rise to 81.5, a post-2008 high. However, it is a poorly-kept secret that "Prices Paid" moves in close tandem with energy prices, especially for big moves, (see Chart) so this is anything but a shock.

Crude Chart
ISM Prices Index tracks oil price changes pretty well.

ISM, while encouraging, is certainly not a sufficient reason by itself for equities to launch x% higher - although I ought also admit that this market hasn't need much reason at all to do so for the last few months. As I mentioned yesterday, it is simply incorrect to report, as the Bloomberg headline did, "Manufacturing in U.S. Grows at Fastest Pace Since '04 as Recovery Quickens." The level of ISM has little to do with the absolute rate of growth. It has everything to do with the relative rate of growth. Things were down so long, even sideways would look like up, and a modest improvement feels great to a purchasing manager. Earnings surprises in the latest quarter were at a lower-than-usual rate - that does not suggest that the economy is suddenly booming. Those who expect it to are likely to be disappointed.

Optimism, already in surplus, was probably helped by the massive rally in periphery bond markets today, caused paradoxically by the ECB's announcement that it is halting the emergency purchase of eurozone bonds. So, a sudden cessation of buying from the buyer of last resort led...to a rally? Yes indeed, because for whatever reason investors seem to always - at least initially - give 100% credibility to anything the ECB says. If the ECB says they don't need to support periphery bond markets because the crisis is over, then investors assume the crisis is over. This is really curious timing, given what is happening to energy prices and the geopolitical landscape, although it may be intended to influence the Irish to elect pro-deal factions when it comes time for the people to decide whether they want to live literally in thrall to Brussels for the next couple of decades. But there is no doubting the effect: credit default swap (CDS) spreads on the periphery countries tightened aggressively, and the bond markets rallied sharply. Greek 10y yields fell 29bps, Portuguese 10y yields -18bps, Spanish yields -16bps, Irish yields -14bps, and Italian yields -11bps. It's suddenly good to be a PIIGS.

So, a sudden wave of optimism hits when trading desks are thinly staffed, and up go stocks. The S&P vaulted 1.7% to a new multi-year high on volume lower than each of the last two days. Bonds dropped and 10y (US) yields rose to 3.44% again. Inflation swaps rallied again and at 2.72% the 10y inflation swap rate is now higher than it has been since last May.

Higher bond yields and higher equities make sense if growth is suddenly robust, and earnings are expected to explode higher and catch up with valuations, but (a) in the most-recent quarter, there was a lower "beat" proportion than normal in earnings reports; (b) no expansion has ever begun with oil prices at $90bbl, so it is hard to handicap how much high energy prices will drag on growth; (c) a weaker dollar (the buck fell to its lowest level since November today) is stimulative, but it is also inflationary; (d) fiscal and monetary policies cannot get much looser and are likely to grow tighter in the year ahead; (e) there are now a handful of regimes in one region of the world that are either in turmoil or may shortly be in turmoil and there is a nonzero probability of a series of local turmoils turning into a broader regional turmoil; and finally (f) whatever the ECB says, there is virtually no chance for several countries in the EU periphery to ever repay their debts and banks there are undercapitalized if you consider the true value of the sovereign bonds they hold marked at par.

I don't mean for that to sound like sour grapes from a medium-term equity bear; there are also good things going on. For example, the ISM Manufacturing report is a ray of sunshine (although not as much as we want to believe), employment is improving (although not as much as we want to believe), government is likely to shrink (although not as much as we want to believe), and interest rates will remain relatively low in a historical context for a while (although not as low as we want to believe). The caveats in each case are the same, but the market is valued at the belief rather than at what I think is the underlying reality. Of course, I may be completely wrong.

Tomorrow, the first of the week's employment reports will be released. The ADP report for January is expected to show 140k new jobs. Remember that last month there was a massive head-fake as ADP printed 297k and Payrolls came in at half that. The 140k expectation is reasonable and beatable, but no one will be overreacting to this number after last month's debacle. Bonds in particular were schnockered last month, and Jan 5th marked the low-to-date. This report comes with at least a grain of salt, and you can see it in the survey ranges. Last month, the survey range was 50k-150k with a median of 100k; this month the survey range is (100k)-200k, three times as large. In situations such as this, it is often a good trading strategy to fade any dramatic move made on the data print. (However, be wary of the continued illiquidity as the CME will likely be snowed under for tomorrow as well).


I promised yesterday to write about an interesting new way you can track inflation daily. It's called The Billion Prices Project @ MIT. The BPP queries and compiles a huge number of on-line prices every day and computes a price index based on those prices. The weaknesses are as you would expect: unlike with the CPI, the basket is not controlled, but changes over time (and it isn't clear to me how they adjust for item substitutions). It only surveys things you actually can buy online, so it emphasizes things like supermarkets, electronics, apparel, and furniture but omits things like education and medical care. It does not appear to have a concept of the consumption value of a home as distinct from its investment value. It doesn't have a long history. And so on.

But with all those caveats, it gets the general shape of the price trend correct and it has the advantage of being calculated daily rather than monthly in arrears. There are daily price indices for Argentina, Australia, Brazil, Chile, Colombia, France, Italy, Russia, Turkey, the U.S., and Venezuela. For example, here is the chart for the U.S.:

Daily Online Price Index
The Billion Prices Project @ MIT: chart for US.

It's fascinating to see that some of the countries have fairly smooth price curves, probably as a result of having either some element of centralized price control or perhaps a smaller online selection. I am also interested to see that while most of the countries' official price index tracks what is being seen on-line, this isn't universally true. Take a look at Argentina and you will see what I mean.

Whether or not the BPP can be used to forecast, now or in the future as the project develops further, I suspect it is a useful check on whether inflation is accelerating or decelerating generally. We will have to wait for a good acceleration (or deceleration) to be sure. It is also helpful to dispel notions that the Bureau of Labor Statistics is somehow cooking the numbers to make inflation seem too low (but not telling the Fed, who is acting on their perception that inflation is too low). Unless the BPP is in on the conspiracy, the general level of inflation in developed countries seems to be approximately what the BLS (and other national statistics agencies) is saying it is.



Michael Ashton

Author: Michael Ashton

Michael Ashton, CFA

Michael Ashton

Michael Ashton is Managing Principal at Enduring Investments LLC, a specialty consulting and investment management boutique that offers focused inflation-market expertise. He may be contacted through that site. He is on Twitter at @inflation_guy

Prior to founding Enduring Investments, Mr. Ashton worked as a trader, strategist, and salesman during a 20-year Wall Street career that included tours of duty at Deutsche Bank, Bankers Trust, Barclays Capital, and J.P. Morgan.

Since 2003 he has played an integral role in developing the U.S. inflation derivatives markets and is widely viewed as a premier subject matter expert on inflation products and inflation trading. While at Barclays, he traded the first interbank U.S. CPI swaps. He was primarily responsible for the creation of the CPI Futures contract that the Chicago Mercantile Exchange listed in February 2004 and was the lead market maker for that contract. Mr. Ashton has written extensively about the use of inflation-indexed products for hedging real exposures, including papers and book chapters on "Inflation and Commodities," "The Real-Feel Inflation Rate," "Hedging Post-Retirement Medical Liabilities," and "Liability-Driven Investment For Individuals." He frequently speaks in front of professional and retail audiences, both large and small. He runs the Inflation-Indexed Investing Association.

For many years, Mr. Ashton has written frequent market commentary, sometimes for client distribution and more recently for wider public dissemination. Mr. Ashton received a Bachelor of Arts degree in Economics from Trinity University in 1990 and was awarded his CFA charter in 2001.

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