America The Irrelevant

By: Michael Ashton | Wed, Mar 16, 2011
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It is a bit bewildering as a predominantly U.S. analyst to spend every day analyzing events in different parts of the world. Of course, the U.S. markets are global, and it has always been the case that a flapping of a butterfly's wings in Madagascar is something we have to pay attention to and be aware of. But, since the U.S. economy is also far and away the largest economy on earth,[1] it is also usually the case that if you get the call on the domestic economy right, you'll generally get the broad strokes outcome right.

This hasn't been the case for months.

After Ireland and myriad crises in the Middle East/North Africa, we're now swiveling our heads around the other way. I alluded to this in yesterday's comment. But I seriously cannot remember ever deciding that it might be prudent to wait until the Japanese markets open before I write my commentary.

To be sure, the signs that the domestic markets are deeply concerned are fairly muted. The stock market fell 2.5% overnight, but that was in response to a 14% dive in the Nikkei (trimmed to "only" 10.5% by the close), and by the end of the day the S&P was lower by only -1.1%. Volume was, however, reasonably heavy at 1.22bln shares and the VIX jumped to 24. But after a big start to the day, bonds managed only a 5bp rally to 3.31% on the 10y note.

Apparently, 17.5% in three trading days from the Nikkei is nothing to get too alarmed about. And as of this writing, the Nikkei has bounced 6.2%. That makes me much less comfortable in Japan as a trade, because normal markets don't rally 6% without help. It doesn't much change my attitude about Japanese equities as an investment.

I wonder if the panic cycle, and its recovery, is just ridiculously foreshortened these days. There were certainly elements of panic in the ridiculous coverage of the nuclear disaster. The Wall Street Journal today wrote "Japan's nuclear crisis showed signs of spinning out of control Tuesday." That's crazy talk. A nuclear crisis can't "spin out of control." This isn't a credit crisis. There is no contagion from one plant to another. A plant is damaged, or it isn't. A particular meltdown is averted, or it isn't. And everything that is knowable about the situation is known (by someone) within a few days. Compare that to the credit crisis, where the future path of the crisis was quintessentially unknowable because the 5th step depended on what happened during the 4th step. There is no time contingency here. So nothing is "spinning out of control." It's just really, really bad.

By the way, initial estimates of the insurance losses were somewhere in the neighborhood of $180 billion. Think about what that implies about the severity of our problems. Our monthly deficits are bigger than that. If the primary budget was in balance then the current deficit would be as if the government were compensating victims of about eight 9.0-magnitude quakes, the associated tsunami and nuclear meltdowns per year.

The strangest part of today's price action in the various markets is that commodities got absolutely pounded. Wheat and Sugar were -7%. Gasoline was -5%, Crude -4%. Cocoa, Silver, Gold, Beans, Cotton, Coffee - almost everything was down by large amounts. That's odd to me because I can't think of why Wheat and Sugar would have anything to do with what is happening in Japan. If the dollar had strengthened...but it didn't. What makes the reaction even stranger is that inflation markets ended up nearly flat despite the commodities slaughter and the rally in bonds generally (which tends to be associated with tightening inflation compensation as well).

Credit spreads ended near unchanged, bonds ended near unchanged, the dollar ended near unchanged, stocks even ended up fairly near unchanged. Does this mean the impact is nil (with the exception, for some reason, of commodities)? No: if something isn't moving it either means that there are no forces acting on the thing or it means that the forces are offsetting. If a flag tied onto a rope isn't moving, it might mean the rope is just lying on the ground or it might mean there is a vicious tug-of-war that is currently drawn. That doesn't mean it will stay drawn, however. I suspect that there is a tug of war between folks who have been waiting for a long time to buy a dip, to get long spreads and other risky assets when there was a correction; they are taking positions from people who are realizing profits and reducing risk. I suppose that is always the case, but ordinarily there aren't as many people desperately wanting to get on board a train they believe is leaving the station.

I really don't think the train is leaving the station, but what do I know? The market is up an incredible 2% on the year (I say that tongue-in-cheek), and I've been underweight the whole time. On my valuation metrics, stocks are priced for 1.9% real growth per annum over the next decade. For that price, you can keep the volatility.

In all of this so far I have not mentioned the FOMC meeting today. How incredible is it to say that the Fed was completely irrelevant today? The Fed statement, as expected, did not meaningfully change anything about the directive. Recent data have made the Committee more confident, but they retained the statement that "economic conditions...are likely to warrant exceptionally low levels for the federal funds rate for an extended period." There is no change to the bond buying program. It was a statement that was more dovish than was expected on average (some people expected the Fed to consider slowing purchases or to allude to the possibility that the period would not be indefinitely "extended"), but it doesn't really matter. Right now, the biggest and most aggressively interventionist central bank in the world is mere noise.

Irrelevant too will be the economic releases tomorrow. Housing Starts are expected to fall to 566k from 596k and PPI is expected to be +0.7% (+0.2% ex-food-and-energy).

I can't predict the outcome of the tug of war. We have just been hit by a series of unknown unknowns culminating (or anyway, we sure hope that is has culminated) in the classic unknown unknown of natural disaster. If markets had gotten rocked by these events then I would be the first one to say "this too shall pass" and climb aboard. But they haven't. Stocks are still priced for continually-growing economies and continually-fattening margins. Bonds are still priced based on eternal central bank purchases and quiescent inflation. "Buy on the sound of cannons" is a maxim that only worked because most people sold on the sound of cannons so the rare buyer was getting a good price. I hear the cannons, but I don't see the re-pricing. Accordingly, I ignore the cannons and wait for good prices (I did try to buy the iShares MSCI Japan ETF (EWJ) this morning but my bid wasn't elected and I figured that if I have to chase it, then something is wrong). It's boring, but good investing usually is.


[1] I am sure some reader will want to retort that the EU is as large as the U.S. Fine, if after all that has happened you still want to argue that the EU is essentially a homogeneous bloc...but I don't buy it. "Who do I call if I want to talk to Europe?" still applies.



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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