We May Be Losing The War, But The Battle Is Won

Denying the cyclical economic momentum the USA gained in 2010 is as cretinous as denying the structural flaws.  

The chief structural issue I see in the US economy is its general exposure to marginal activity.  

The consequence of this reality is a far more publically & monetarily managed economy.  

One possible major risk here is a divided political establishment which is unable to react effectively to a reduction in marginal activity, and economic management will likely continue to weigh more heavily on the (generally more autocratic) monetary policymakers.

I’ll admit:  Macrofugue was late in acknowledging the economic recovery in 2010, but it became too obvious to deny in July as even coincidental and lagging data had turned around.  The inflection point in most data series seems to be late 2009 through January 2010.

America’s Stunning Inflection

What’s happened since then?  We’ve gained almost a million new payrolls to begin with — not nearly enough to fill the output gap, but by no means a “jobless recovery”.  This has translated into nearly $10B more per month in Real Retail & Food Sales (starting at $163B) since January.  That new demand coincided with the largest increase in Average Weekly Hours in decades, and multiple consecutive record corporate profits.  Wages and salary disbursements rose $200B.

slideshow maker allows you to make superb photo presentations in minutes!Trade, which had crashed, came roaring back. Imports rose from $180B/mo in January to $197B/mo in October. In the same period, exports rose from $144B/mo to $158B/mo. Total monthly trade volume rose from $324B to $356B.

total trade

Photo: macrofugue

The Sick Men of Europe

The periphery of Europe had also become overly dependent (and indeed levered) on marginal economic activity.  The unsustainable and poorly allocated economies had neither the political or monetary establishments to pick them off the ground.  The surfacing of Eurozone risk shook assumptions, and a swift repricing in currencies & bonds began.

The Court is the Jester

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Perhaps to make a fool out of the maximum number of currency and macro-economic pontificators, this has led the USD into a peculiar situation:  growing the balance sheet — i.e. “money printing” — has actually led US dollar strength!

Foreign demand for the USD stemming from economic turmoil in the Eurozone is created with a liquidity crunch — where there are plenty of USD denominated transactions, a liquidity crunch means strength for the originating currency.  Additionally, the US political and monetary will to support its economy bolsters confidence — particularly coupled with the much stronger than anticipated recovery, creating demand for US assets.


From the low of 2.04% in December 2008, the 10y UST yield nearly doubled to 4% by April 2010 as the global economy recovered, and hot money ventured out in pursuit of yield and equity appreciation.  The European crisis shook the confidence in European economics, and their debt by proxy, and this realignment resulted in the 10y yield compressing almost entirely back to the crisis low.  This prompted, in order:

  1. Fixed income managers fleeing European markets for US debt
  2. Fears of “double-dip” recession
  3. Risk-fleeing cash piling into bonds
  4. Renewed expectations of new Federal Reserve bond purchases
  5. Money flowing into bonds in anticipation of new bond purchases

Given that:

  1. Europe has somewhat stablised
  2. Double-dip fears were nonsense
  3. Money flowed back into dirt cheap risk assets
  4. The announcement of the Fed’s second bond purchasing programme came inline with expectations

…the trepidation over what is historically a fairly normal move is completely unfounded.

total trade

Photo: macrofugue

“The Ben Bernank”

Apart from the amusing chart which demonstrates that (caused or correlated, it doesn’t really matter) the expansion of the Fed balance sheet has moved in sympathy with the strength of the US dollar. Inflation in the US since Ben Bernanke took office on February 1, 2006 is a far more nuanced subject than most will give it credit for.

Two very critical things have happened under Bernanke’s tenure:  peak oil seems to be a reality (which is the most significant input into every other commodity price, particularly soft commodities) and the rise of China.

Of course, ironically, Bernanke is responsible for the increase in prices over the past 21 months:  were it not for his actions (and the actions of the Obama administration), we’d be mired in a global depression where demand, prices, wealth and production would have evaporated.  It would have been entirely indefensible to do anything else.

Core Arguments

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It is my view that we are in the middle of a structurally depressed cyclical upswing.

The leading and even lagging indicators are simply “V-shaped”.

Coincident to this is a stubborn output gap, bloated by a nearly 10% persistent unemployment rate.

total trade

Photo: macrofugue

This is a different style of recession and recovery than past post-war recoveries, however, the timing of data recovery is still following the same path.

There are threats to the economy in the form of ever increasing resource extraction costs, the resultant cost-push inflation, organic growth not outpacing stimulus, and political fiscal contraction risk.  In our estimation, these will not weigh in substantially until at least the 2nd half of 2011.

I will be looking at leading production and sales datapoints for signs of these risks materialising, but until I see them, I remain a confident buyer of risk assets.

My S&P 500 2011 FY EPS guesstimate is $89, which is discounted by my estimated unaccounted effects of cost-push inflation and structural employment.  This valuation leaves some reasonable room for prices on both sides, and I expect the year will largely be spent between 1,157 (13x) and 1,424 (16x).  My strategy will continue to be buying on negative sentiment, and lightening up on overly frothy sentiment using the aforementioned range as fair value guidance.

The Year of the Red-crowned Crane



The biggest deflator of Japanese equities has been the meteoric rise of the Yen.  One of my favourite measures of currency valuation is the Big Mac Index Implied PPP.  Rather curiously, the Yen had found support very close to its implied PPP valuation of 85.7.  I think the bottom is in, and the epically under-owned Nikkei will finally get some long-awaited allocation.The vertically integrated synergy (sorry – it’s only word that came to mind) between Chinese production and Japanese ingenuity is just beginning.  Japanese manufacturing equipment should do particularly well, as equivalent German manufacturing equipment makers (Siemens) have huge backlogs, but I also see openings in consumer product design and banking.

Smaller is Better

slideshow software for high-quality photo presentations.I’ve casually expressed keenness in regional banking for several months, playing KRE long for a few points. The inverse size effect will continue to pay off in 2011 as the regional banks are more profitable, had been less reckless, are better managed and are juicy buyout targets.

The Trendy Euro is Dead

Long live the trendy Euro.  After nearly a decade of being a major proxy for risk momentum, the Euro infallibility myth is debunked, and the price will oscillate between risk-taking and structural weakness.  The first decade saw it rise from 0.83 to 1.60.  However, it has traded between 1.1876 to 1.4579 just in the past year!  We suspect that the Euro will range from 1.28 to 1.34.  Any move substantially beyond that which is not predicated by new information is fadeable.

My rough calculation puts Eurozone trade equilibrium presently between 1.28 and 1.30.  The implied PPP valuations are actually substantially lower (some near parity) with the USD.  We think that Chinese demand for German productivity will continue to provide support closer to the trade equilibrium value.

Most of the value of ECB debt absorption would lead to productivity gains.

Chief Risks

The largest risk on my radar is cost-push inflation cutting into the margins of both corporations and households.  OECD margins are not nearly as threatened as Asian emerging markets.  Food makes up 1/3 of Chinese CPI — double that of either American CPI-U or CPI-W.  American buying power is significantly superior.  It will displace global emerging markets with high Purchasing Power Parity during margin compression which are generally areas which with the highest sensitivity to food prices.

Americans will always(*) have corn in their guts and gas in their tanks.  If food or energy shortages compress household margins, they will respond by buying fewer goods from the emerging markets. (*): Assuming the absence of alien invasion or Zimbabwe-style inflation

Food inflation consequently will likely lead withdrawing emerging market investment.  Emerging Asian economies would get hit thrice: their own production investment would diminish as it was displaced by input cost margin compression, foreign investment would be yanked, and foreign demand for their products would get displaced by agricultural production and consumption.

The real risk we see here is the misidentification of the source of the inflation, and monetary policy responses would treat it for the wrong disease.  There is almost no example of accommodative monetary policy in the East or West that is responsible for present inflation. A potential exception is Chinese residence cost +5.8% y/y (which is actually half the weighting of food in Chinese CPI — and only about half the rate of growth!) 

Taking a tightening approach to monetary policy would crunch production of the goods whose prices currently don’t reflect substantive inflation.  This reduction in production, exports and consequently buying power on global commodity markets, would lead to more expensive goods.


Photo: macrofugue

Americans use just under 19 million barrels of oil per day at an average price of just below $80 — about $1.5B per day, or $554.8B per year.  Given that the world is now consuming oil at a now-greater level than when prices were at $147/bbl, we are likely to average at least the present $91/bbl for 2011 if economic growth is to continue.  That equates to $631B per year, or an increase of $76B.  We expect this to be painful to the unemployed and elderly, and even the employed:  Wages & Salary Accruals were only up $177B from 2009-3Q to 2010-3Q, meaning 43% of that increase was absorbed by energy costs.

Of course, the increase in money spent on energy is not entirely negative to equities:  out of the top companies in the world by market cap, 5 of 6 are in the integrated oil & gas sector, including the top 3.

In the United States, gold generally doesn’t perform well during actual inflation — rather it does when inflation is expected.  Since this would likely also entail a corporate margin compression, earnings multiples would be likely to shrink in this scenario.

So: my view is that any inflation, particularly in both China & the USA, will be policy driven demand destructive, and positive to the USD and US treasuries.


This post previously appeared at Macrofugue >

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