A Serving of Leftovers

By: Michael Ashton | Thu, Dec 1, 2011
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The market on Thursday didn't correct from Wednesday's rally. I find this curious, although it may be that longs feel they have some protection from the fact that Friday's Employment Report is likely to be stronger than was generally expected a week ago. There wasn't much news of the variety that has lately been moving markets - no central bank action, no Grand Plans, no rumored bank failures. I thought that, in such a circumstance, mere gravity would pull equity prices lower.

Economic data was fine, but not terrific. Initial Claims rose to 402k, which is a mild surprise at odds with recent positive indicators but certainly within the range of normal variation. The print above 400k has bad optics, but excruciatingly-slow improvement seems to be the order of things at the moment. ISM was a bit better-than-expected, but the 52.7 print puts it still below June's level. Car sales were strong. M2 fell $35bln; I feel duty-bound to report the decline in M2 since I've been detailing the relentless rise for a while now. The year-on-year rise in M2 is still at 9.5%, and we'll have to see if this is more than a one-week zig-zag. The release is for the week containing Thanksgiving, so there may well be some seasonal volatility associated with it. One week's money numbers don't matter much anyway, bu t it bears watching over the next few weeks.

None of these things mattered much to the markets. Weirdly, almost every market closed with small losses. 10-year note prices fell as yields rose 2bps. Crude Oil fell -0.2%. Grains fell -0.5%, Livestock -0.5%, Softs -0.3%, Precious Metals -0.5%, Industrial Metals -0.7%, the dollar -0.1%, and the S&P -0.2%. That's odd, but not particularly significant - basically, markets were all near-unchanged and just happened to all close on the red side.

Since there were no new developments of note, I have a couple of 'leftover' thoughts I will share.


The first thought addresses the speculation, heard in some quarters, that the equity rally of the last couple of months has been due to expectations of QE3. I am not a believer in that theory, especially since history says that equities tend to perform poorly when inflation is rising from low levels and QE, for whatever it is supposed to do to growth, certainly increases upward pressure on inflation (that was, after all, one of the reasons the Fed gave for implementing QE2 when they did - to prevent deflation). But it is always difficult to refute speculations about why the market behaved the way it did.

But here's the thing. If QE3 is on tap, it isn't the equity market that should be the primary beneficiary. Commodities are the asset class with the highest "inflation beta," and the asset class one would expect to be the prime beneficiary of a reflationary policy. For example, in the nine-month rally from August 27, 2010 (when Bernanke first raised the possibility of QE at Jackson Hole) to April 29, 2011 (when both commodities and equities peaked), the total return of the S&P was 29.11%, the total return of the DJ-UBS Commodity Index was 33.31%, and the S&P GSCI rose 48.64%. Commodities beat stocks.

But since the rally from the stock market low on October 3rd has taken the S&P up 13.71%, the DJ-UBS has risen only 3.99% and the GSCI 11.75%. Stocks are convincingly beating commodities. If this is a QE rally, it shouldn't be led by equities. On the plus side, this implies that if the market starts to smell QE3, both stocks and commodities have plenty of room to rally!

The second most-plausible-sounding reason for the rally is optimism over circumstances in Europe. But if that's the case, it hardly seems as if the rally ought to be substantially in place since circumstances are a mite tenuous to say the least. Unless you want to score the situation by the sheer number of plans put forth, rather than by the number of concrete plans with clearly-defined steps that have been ratified by all parties (that number would be...zero), the condition of the Eurozone is manifestly worse now than it was two months ago.

I don't have the answer, although "animal spirits" seems to fit better than those other two explanations.


Second thought: how would a European recession affect the fragile U.S. recovery?

Of course, if Europe experienced a major recession it would likely drag the U.S. into recession as well. Aggregate exports to Europe from the U.S. are around $300bln, so a 10% decline in European GDP would shave a couple of tenths off of U.S. GDP from direct effects; there would also be significant secondary effects transmitted through other trade partners and it could well cut U.S. growth by enough to touch off a mild secondary recession.

But that isn't what worries U.S. policymakers. The bigger concern is 'contagion' caused if large financial institutions in Europe fail and this leads to failures here. We've all read plenty about this (and the bottom line seems to be that no one knows how bad it would be, even if it were to happen that a systemically-important institution was actually allowed to fail in an uncontrolled way).

I have another concern. Ratings agencies fret constantly about the Debt/GDP ratio, which is an income statement concern. It's analogous to the size of a mortgage you can sustain given your income. But what else do lenders look at when considering your creditworthiness, or that of a corporate client? They'll also look at the balance sheet - your assets. And here's my thought: on the balance sheet of the U.S. (which incorporates the balance sheets of all her citizens and companies), there are a lot of investments in European equities, corporate bonds, and sovereign bonds. "Foreign Direct Investment" in Europe (which includes only "the ownership or control, directly or indirectly, by one person of 10% or more of the voting securities of an incorporated business enterpr ise or an equivalent interest in an unincorporated business enterprise" according to a footnote in this link to a Congressional Research Service piece), was around $2 trillion in 2009 at historical cost. Note that's the voting securities, so it excludes corporate bonds, and excludes sovereign bonds as well. And it excludes all smaller ownership in business enterprise, such as through equity ownership. So we are talking about large numbers.

What happens if there are significant defaults, bankruptcies, sovereign restructuring or default, and "deleveraging" in Europe? Obviously there's a large direct wealth effect, which could be expected to impact consumption in the U.S. directly. But if I'm a lender to the U.S., don't I also care about the asset side of the national balance sheet? I wonder if, even if authorities prevent banks from imploding in a messy fashion, sovereign defaults could significantly impair U.S. credit as well on a longer-term basis. (My sense is that this is probably thinking far too intricately about problems when the main problems in such a case are likely to be big, blunt, and obvious, but one of the reasons I write this commentary is to explore ideas like this.)


Third thought: I keep hearing about how the economy is experiencing a 'debt deflation' cycle, a la Fisher. This seems odd, because I would think a 'debt deflation' cycle would involve...deflation. According to Wikipedia's explanation of Fisher's formulation of a debt-deflationary spiral:

  1. Debt liquidation leads to distress selling and to
  2. Contraction of deposit currency, as bank loans are paid off, and to a slowing down of velocity of circulation. This contraction of deposits and of their velocity, precipitated by distress selling, causes
  3. A fall in the level of prices, in other words, a swelling of the dollar. Assuming, as above stated, that this fall of prices is not interfered with by reflation or otherwise, there must be
  4. A still greater fall in the net worths of business, precipitating bankruptcies and
  5. A like fall in profits, which in a "capitalistic," that is, a private-profit society, leads the concerns which are running at a loss to make
  6. A reduction in output, in trade and in employment of labor. These losses, bankruptcies and unemployment, lead to
  7. pessimism and loss of confidence, which in turn lead to
  8. Hoarding and slowing down still more the velocity of circulation.

The above eight changes cause

  1. Complicated disturbances in the rates of interest, in particular, a fall in the nominal, or money, rates and a rise in the real, or commodity, rates of interest.

So it seems to me that we have a few minor problems with describing what is happening and what has been happening in the economy as a "debt deflationary" spiral. One is that we have had nothing that looks like deflation (unless you want to consider when headline inflation dipped negative on the basis solely of a decline in energy prices); core inflation never got terribly close to deflation. The second problem is that quite contrary to the prescription for a rise in real interest rates, real rates are negative all the way out to ten years - an almost-unprecedented occurrence.

Whatever you want to call what we're going through, it is most assuredly not a debt deflation cycle.


Some quick thoughts on the Employment number tomorrow. The consensus estimate for Payrolls is 150k, but after ADP printed above 200k expectations are clearly higher than that. I think if Payrolls are only 150k it is going to be a disappointment. A print above 150k, though, will mean it's the highest production of new jobs since April. If we get something over 250k, which is certainly not out of the question, it will be the highest non-Census-flattered figure since before the 2008 crisis. I think we will get something better than what the prior consensus was looking for, but unless we beat 250k I think the folks holding gains on the week will look to book some of them into the weekend.

Given the decline in the "Jobs Hard to Get" index of the Consumer Confidence report, in theory the Unemployment Rate could rise (Consensus: 9.0%, unchanged) because fewer people may be discouraged and some may have gone back to looking for jobs. It never seems to work that way, though.



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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