June 2006

Stags Leap

Base Jumping…Do you ever wonder what it would be like to jump off of a mountain such as El Capitan in Yosemite with only a parachute on your back and a smile on your face?  Although that probably does not lie in any of our immediate futures, at least not our own, there is another base that, depending on how life in the global financial markets unfolds, may deliver a similar adrenaline rush to many.  And that’s the Japanese monetary base.  Very quickly, we all know at this point that Japan has been a very important locus of global liquidity generation for some time now.  We discussed this at length in our May monthly open access discussion.  The combo zero interest rate policy (ZIRP) and quantitative easing (QE) of the approximate last half decade has been a key piece of global liquidity generation dynamics.  In fact, we have argued in the past that the Fed and its actions today are more irrelevant in the global financial scene than has ever been the case.  Ours is not just a global economy in terms of material goods and services trade, but in all senses of the word, also a global financial economy.  As we have mentioned in prior discussions, after sixteen interest rate increases, a record by the way, the real US economy has not fallen off of a cliff.  Although housing is clearly weakening, the residential real estate world has not come to an end quite yet.  And clearly, at least up until recently, the equity markets have indeed fought the Fed for the entire duration of the current tightening cycle.  In fact, “everything” has been going up in price.  Of course this is happening because capital is available globally and its price is not solely determined by our friends at the Fed.  Large entities can borrow in the Eurodollar market, in Yen, in Sterling, Swiss Francs, etc., you name it, making the US prime rate a bit of an afterthought or simply a non-event for many with direct access to the global capital markets.  And, as we have argued in the past, despite what is truly becoming a global financial system, individual central banks of the world continue to enact policy as if they wielded the country specific influence they once had.  Unfortunately for them, that’s no longer the case.  In a world of a globalizing financial structure, individual central bank actions of the moment can now ripple in consequential action across the planet as never before.  

In the spirit of keeping our eyes on the horizon of global financial market circumstances, we believe it is very important to have a quick look at what has been happening in Japan over the past few months.  As you’ll see in the chart directly below, the Japanese monetary base has been shrinking at a more than rapid clip.  We have not seen anything like this for literally five+ years.  Is this one of the more meaningful reasons as to why “everything” (stocks, commodities, metals) has been declining in price as of late?  As you can see below, what took maybe three years to build in terms of the Japanese monetary base from early 2003 to present, has been reversed in a few short months.
        

Why is this important?  First, it’s not new news by any means that the Bank of Japan is on record stating that both ZIRP and QE will be rescinded ahead.  At least so far there has been no change in official interest rates, but as is clear above, there has been action on reversing quantitative easing (in simple terms, printing money).  The important question, of course, is one of speed at which this is to occur in the future.  And although we have even suggested this may be a more drawn out process than not based on historical BOJ actions, the chart above argues otherwise.  The chart above is showing us that liquidity in the Japanese monetary system has been withdrawn at a very rapid rate over the past few months.  Unfortunately we only have access to monthly data and it clearly comes only in hindsight.  We’d suggest that watching the trend in this number ahead may be crucial to our ongoing investment activities.  You know that as probably the key provocateur of the global financial carry trade, a diminution in the Japanese monetary base (representing liquidity contraction that really transmits globally) is a big ding in the side of the ship of global carry trade activities.  A big ding.  And although we certainly do not mean this to sound melodramatic by any means, dependent on the Japanese monetary base liquidity shrink ahead, a few financial market ships could actually sink.

One more quick chart.  It’s the long term history of the Japanese monetary base.  Overlaid on top is the year over year rate of change.  As of the latest month, we’re at the lowest number in three and one half decades.  To put it mildly, this is not a good thing for those folks and asset classes quite dependent on the global carry trade and excess liquidity growth at the margin.  Although we're convinced we live in much more of a globalized financial market today than ever before, it is interesting to note in the chart below that historic periods of meaningful rate of change decline in the Japanese monetary base have preceded each meaningful US recession of the last three decades.  Just eyeing them out, these large percentage drops occurred in '73/'74, '79/'80, 1990, and 2000.  If indeed history has the chance of repeating itself ahead, what should we now be expecting for the macro US economy as we look directly at current Japanese monetary base contraction?  Go ahead and take a guess.
       

Although the Fed, in its own small way, has been acting to restrict liquidity expansion stateside with its interest rate increases of the past few years, despite the ongoing growth in repo issuance that is essentially backdoor stimulation, the real global liquidity story lies with Japan and China.  As we wrote about last month, the world has been floating on a sea of global liquidity for some time now.  You can clearly see the monetary base growth in Japan from 2000 to its most recent peak.  It was a near double.  And this occurred while Japan was caught in the economic mire, implying that a lot of that “created” liquidity fled the country in a big way in search of higher rate of return nirvana.  This has been a huge part of the global liquidity story.  In fact, probably the key driver.  And with this, almost all asset class price boats globally have been lifted.  But at least for now, change is upon us.  And we’d suggest that it might be a very touchy time ahead.  The reason being and the problem to watch out for is the fact that global central bankers are not yet working in harmony.  We still live in a world where although individual country central banks are certainly aware of their global surroundings, they continue to act with a high degree of country specific focus and with country specific economic stats as their roadmap in decision-making.  As you know, the US Fed is now on record stating that monetary policy ahead will be data dependent.  But, what data?  US domestic economic data, or perhaps BOJ monetary base data?  Without otherwise being acknowledged by the Fed, they are looking at domestic economic stats.  But the fact is that what happens in Tokyo in our new global financial world of the moment ripples across the entire global financial system.  Individual central banking actions are not contained within domestic borders.  That was yesterday. 

Again, without sounding melodramatic or end of the worldish, what’s to come with global financial and hard asset prices over the remainder of 2006 and beyond will be very dependent on the near term actions of the BOJ.  We believe asset prices will be heavily dependent on the direction of the charts you see above.  And moreover, the Fed’s reaction to what may or may not ripple out of Japan is yet another wildcard.  If the BOJ continues to drain liquidity in the months ahead at the pace we've now experienced over the last few months, and that action precipitates broad asset class price declines globally, does the US Fed change course or more actively attempt to stimulate US financial system liquidity acceleration?  Global central bank actions and subsequent reactions now become an issue above and beyond country specific economic circumstances.  Long term, it’s becoming pretty darn clear to us that central banks globally are going to have to work much more closely on coordinated policy, but we’re not there yet.  Not by a long shot.  Although the global financial economy has embraced cross border access to capital, central banking decision making and infrastructure has not yet come into the modern era.  Growing pains in the global financial system are where accidents and unintended consequences can and do occur.  As you’d guess, we’ll be following what you see above quite closely ahead.  Here’s a real question you can think about.  Could the actions of the BOJ cause a credit crunch in the US?  We’re not kidding, this is one serious question.  “Getting it right” from a central banking standpoint is going to be one tough job in this evolving world of ours.  The new world of globalized finance has very little historical precedent from which to draw inferences and lessons for all central banks of the moment.  No stopping in along the way at the global historical financial precedent fill up station for a roadmap, cause there ain't any.

Before pushing forward, a few other comments we believe are pertinent to what we’ve discussed above.  First, as we told you last month, at the recent G7 meeting a month or so back, there was one heck of a lot of finger pointing.  But it’s clear that many in the Asian community came away with a sense of purpose and direction.  As you know, interest rates were lifted in China.  And clearly more importantly, Japan swung into overdrive when attacking its monetary base.  In the brilliant clarity of hindsight, we’ve recently experienced a period in the global financial and hard asset markets where “everything”, so to speak, has corrected in price.  This includes global equities (the higher the beta, the more the correction), energy prices, other commodities, and the precious metals.  This sure appears to be the exact flipside of what we have been experiencing since late 2005 with all asset class boats lifting.  If these mirror image coincidental asset class performance periods do not speak to the fact that global excess liquidity has been the crucial ingredient to sustaining both financial and hard asset inflation, we just don’t know what does.  Without sounding immodest, this is exactly what we wrote about last month.

So the question now stands, what happens from here?  Will the BOJ push forward in reducing excess liquidity in the Japanese system, and by default in the global financial markets?  Or have a few well-placed phone calls already taken place, urging Japan to let up on the monetary breaks for the sake of the global equity markets?  You may have noticed that earlier this week (last week of May) the Japanese authorities injected 1.5 trillion Yen back into the system.  A clear response to what previously withdrawn excess liquidity had precipitated in the global financial markets.  If indeed the Japanese back off on their removal of excess liquidity (QE) for a time, then global carry trade related assets will rally.  That includes equities and commodities.  We'd also look for potential asset class price resurrections in equities and commodities to be accompanied by a weaker Yen and a stronger dollar.  So far, we know from the public BOJ numbers that the monetary base in Japan contracted in March and April.  As of mid-May, has that contraction been put on hold (as per the peak in the Yen and interim trough in the dollar)?  It seems one of our only interim inferences of magnitude of ongoing BOJ liquidity removal is to watch the Yen.
           

One last shot of the linkage we are talking about between Yen based liquidity and at least one asset class we believe is very dependent on greater global liquidity.  Can we suggest that a strong Yen (as a sign of Japan being monetarily restrictive) isn't exactly a good thing for those assets quite dependent on continued liquidity creation?
        

At least until further notice, we consider it mandatory to watch the monthly BOJ monetary asset base numbers as well as the ongoing relative movement in the Yen.

Stags Leap?...For any of you familiar with the history of Stags Leap Wine Cellers (Napa Valley), you'll know that this now popular winery came into the public eye back in 1976.  In that year, Stag's Leap Cabernet beat out Château Mouton Rothschild, Château Montrose, Château Haut-Brion and Château Leoville Las Cases in a blind tasting test at the Paris Wine Tasting event.  Historic in that a relatively unknown California Cabernet virtually out of nowhere trumped what had been considered the world's best at the time.  Talk about a surprise, this put Stags Leap and the Napa Valley on the global winemaking map.  And, of course, no one saw it coming.  Is there yet another "stag" surprise of sorts lying ahead for the US economy?  Specifically, we're referring to a potential encounter with stagflationary tendencies, or more correctly, heightened perceptions of a stagflationary environment.  To be honest, a number of anecdotes toward this end are starting to add up.  And, of course, the reason this is meaningful is that stagflation is an infrastructural boa constrictor for both equity and bond valuations.

Before going any further, we'll once again reiterate the importance of Bank of Japan policy as well as their proximate neighbors as the People's Bank Of China.  If indeed the BOJ continues down the path of monetary base destruction in a relatively rapid manner, the fallout effects on global equities and commodity prices will be depressive.  Academically under this scenario, economic growth and prices should slow, so stagflation as a concept would be off the table.  But if the BOJ slow their monetary braking actions of the moment and the liquidity driven carry trade resumes with equity and commodity prices once again moving north, the stagflation threat could become very real before this year is out.  Importantly, remember that it's not actually what ultimately happens in the economy down the road that's important to our near term investment activities, it's what market participants believe will happen that is important to financial asset prices of the here and now.  Oh, the power of perceptions and how they influence behavior.  Let's look at some anecdotes from the real world.

It literally goes without saying that what happens to the US housing market will have a great impact on the real US economy.  We're not going to debate the housing bubble characterization.  Last month we detailed our thoughts that the outlet for global excess liquidity had already moved from equities to real estate and now to commodities.  There exists enough current evidence to more than suggest residential real estate dynamics are changing in the US in many markets.  The importance is housing's influence on the real economy.  First, we already know that the payroll employment recovery since 2003 has been very positively impacted by the boom in US housing.  But now we've begun to see the flipside as a number of mortgage companies have either closed their doors or cut back their employee base quite meaningfully recently.  With the drop in housing volume as of late, this directly and negatively translates into realtor, title company, mortgage company, construction worker, etc. paychecks.  Probably the largest single unknown of the moment concerns mortgage equity withdrawal.  Let's do some simple numbers.  In a $13 trillion economy, $130 billion of mortgage equity withdrawal (MEW) is equal to 1% of GDP.  We know that in 2005, in excess of $800 billion was "extracted" from US residential real estate values in the form of MEW, up from a mere $100 billion ten short years ago.  You can do the math.  A contraction in MEW, especially given the multiplier effect of money moving through the US financial system, could be a big potential drag on GDP growth.  And to see how this works, the chart below pretty much spells it out.  We're looking at the NAHB (Natl. Assoc. of Home Builders) Housing Index since 1985.  As you can see, every single meaningful dip in this index, as we have now experienced in the current cycle, was met with a meaningful rate of change decline in nominal GDP over the last twenty years.  Will this time be different?  We think not.  If nominal GDP is not slowing relatively meaningfully by year end/early 2007, we'll be pretty darned surprised.  In fact, it will be time to rewrite the history books.
              

Further, we know that headline inflation indicators can lag by their very nature.  But we've also been very suspect of current calculations as the CPI of today bears almost no resemblance to the calculation of twenty years ago.  That being said, we spent an entire recent monthly discussion on follow through.  Specifically, the follow through of higher energy and commodity prices into headline inflation statistics.  We've been stunned given the multi-year rise in commodity prices that so little of this has as of yet shown up in the CPI, or more specifically the currently revered core CPI.  Yes, globalization has helped the cause, but it does not explain the entire story.  The charts below are two popular measures of inflation.  The first is the core CPI.  Trending higher than the consensus has been anticipating and still remains much higher than was the case after a record sixteen interest rate increases by the Fed.  It seems as though "follow through", so to speak, in energy and materials prices are upon us.
        

We see a very similar pattern with the Fed's favorite measure of inflation, the core personal consumption expenditure price index.  As you know, the stated Fed range of comfort is between 1% and 2%.  For now, we're out of bounds.
         

Although it may sound like a stretch at this point, could the year over year CPI number be in the mid-4% range by year end?  It may not be as much of a stretch as one might think.  We are seeing big annual price increases in transportation, apparel, medical care, and in a bit of an ironic twist, housing.  With the downturn in residential real estate activity, rents are beginning to increase and the owners equivalent rent component of the CPI is ascending.  Latent follow through of the real estate price boom that never made it into CPI in the first place.  Although headline inflation readings may really be more of a lagging indicator than not, if, as we believe, CPI moves higher ahead, how will market participants respond to this directional movement?  That's the important question.  And we suggest it is very important now given that we have been told time and again over the recent past that inflation is a non-issue by none other than a plethora of Fed members.  At its heart, this is now a matter of Fed credibility.  If they lose that among the consensus in the investment community, let alone the general public, inflation expectations will rocket higher.  In fact, this has already started if one looks at historical TIPS yield spreads.  

Moving on, a declining dollar is a forward inflationary proposition plain and simple.  And that's a current issue we need to face.  Unlike most, we do not use the US Dollar Index as a key indicator.  Despite it being the most widely quoted number, we believe it's flawed.  In our subscriber site we spent the good part of an entire discussion regarding this a few months back.  The bottom line is that approximately 2/3rd's of the US Dollar Index is keyed off of Euro area currencies.  And unbelievably enough, the USD Index does not contain any relative currency weighting at all to key trading partners such as Mexico and many Asian countries such as Korea, Thailand, Taiwan, Singapore, Hong Kong, etc.  It just so happens that the St. Louis Fed does calculate an alternative trade weighted dollar index that is much more representative of the true US trade situation globally, importantly inclusive of Mexico, China and many Asian currencies.  It's what you see below.  Unlike the widely quoted, largely Euro area currency driven US Dollar Index, the St. Louis trade weighted dollar index has now broken below the late 2004 and early 2005 lows.  It's telling us that it's a good bet the headline US Dollar Index follows.  If indeed this comes to pass, we have to believe the consensus will be taken a bit aback in terms of heightened inflationary concerns.
             

Finally, we are seeing the prices paid component of headline business indices move much higher with recent monthly reports.  In the ISM surveys, both manufacturing and service sector, recent monthly prices paid components of these reports shot meaningfully higher.  We saw exactly the same thing in the most recent Philly Fed report.  Again, in our eyes, follow through of higher energy and commodity prices in action.  As you'll see below, the recent month over month prices paid component experienced its greatest one-month increase since August of 1973.
      

As you'll remember, 1973 was simply the beginning of one of the greatest US inflationary periods of modern times, in large part driven by energy costs.  Moreover, this near record above is occurring after a record number of Fed rate increases for a monetary tightening cycle.  But hand in hand with this big jump was yet another big jump, but this time downward.
       

The month over month change in the Philly employment component of the report saw it's worst drop on record.  As you'll be able to tell as you look back across this data, this type of reading has only been see either in or right before official recessions, or in meaningful mid-cycle economic slowdowns such as 1994/95.

So here we have a bad sign for employment and a huge increase in prices paid.  It's only one month of data coming from a singular economic report, but it suggests higher prices and contracting growth.  Or in simple characterization, stagflation.  So as we look ahead, it seems more than a reasonable bet that the US housing industry will be a good bit of a drag on macro economic growth.  At the same time, the follow through of energy and commodity cost pressures really born years ago are finding their way into headline inflation stats right now.  In the middle of the mix is the BOJ monetary policy enactment wildcard.  If they now slow down excess liquidity removal for fear of smacking global stock markets, the carry trade rekindles and up go commodity and equity prices, further stoking inflationary fears.  But if they continue scooping up excess liquidity at the rate we've seen over the past few months, down goes equity and commodity prices, and we have to believe general economic growth as we described in the Japanese monetary base rate of change chart above.  Although nothing is ever certain in this world, we believe now is the time to think about and prepare for what may be heightened perceptions of stagflationary tendencies domestically, and perhaps globally, as we look over the remainder of this year.  In hopefully non-melodramatic terms, this would be nothing more than payback for excesses in monetary policy of prior years.  We'd simply be reaping what we've sown.  That's all.  We're becoming more convinced that this word will increasingly find its way into mainstream market commentary ahead.  Be prepared.  And the important issue looking ahead is how the markets will react to this potential shift in perceptions.  As we already stated, heightened stagflationary perceptions would not be a good thing for financial asset valuations in general, and high beta trades specifically.  Could Bernanke's "trial by fire" Fed Chairmanship initiation include a brush with stagflationary economic tendencies?  We smell smoke.