May 2006

From Sea To Shining Sea (Of Liquidity)

From Sea To Shining Sea (Of Liquidity)...To suggest that the theme of liquidity being provided to the financial markets and real economy has been an incredibly important structural underpinning to both real world financial and hard asset prices, as well as measured country specific economic performance, over the past decade plus is a dramatic understatement.  For years we have chronicled US credit market characteristics in our discussions.  We’re not about to have this discussion be another rehash of that topic.  In addition to US sponsored liquidity creation, policies of other major global central banks such as Japan have been a key to having the structural underpinning of what seems virtually unlimited liquidity creation really be a global phenomenon more than not.  As you know, Japan carried out the extremes of quantitative easing (printing money) and ZIRP (zero interest rate policy) in simultaneous fashion over the past half decade and change.  If that isn't some type of an extreme in terms of historical global monetary policy precedent, we just don't know what is.  It now appears to be coming to an end in what will surely be slow motion fashion, but has been an incredibly important piece of the total character of global liquidity availability over the recent past.  Without sounding melodramatic, and trying to be as factual as possible, we believe that it’s very important to realize that the global financial system has really become the key driver of the real global economy.  We suggest this needs to remain front and center in your ongoing thinking.

Stepping back quickly and looking at the development of the current domestic and international financial system as we know it today, we believe a key to understanding and interpreting what we are now dealing with in the financial markets is that in so many ways the servant has unequivocally become the master, so to speak.  In relatively simplistic terms, the academic function of finance in really any economic system is one of a support role.  A mechanism of allocating capital from savers to producers with a necessary overlay of risk assessment in that allocation process, ultimately supporting the expansion of real economic activity.  Although this may have been very much how particularly the domestic US economy and its finance function was characterized maybe three or four decades ago, what is now described as the US service economy is really a euphemism, at least in our minds, for the fact that the US economy has become primarily driven by the activity of finance itself.  No longer a servant, the function of finance is now the master.  Byproducts of this change can be clearly seen in the fact that the financial sector has become the leading sector weight in the S&P over the last quarter century, financial sector profits have come to dominate total US corporate earnings in percentage terms, financial engineering has become a key component or driver of corporate strategy in the modern era, and the highest paid managers in the land are no longer captains of industry, but rather hedge fund managers.  The servant and support mechanism that was the financial function decades ago has now come to dominate, drive and shape the real economy in the role of master as perhaps never before.  As we have said many a time, this evolution simply is what it is, neither good nor bad.  We accept it without judgment and focus on how our interpretation of this character of the modern economy will shape ongoing investment decision-making and importantly our own risk management efforts. 

You know from ours and the writings of others that “follow the money” is an important piece of Street lore, let alone a necessary part of ongoing daily investment activities.  In the current environment, we’d characterize this as trying to follow the ongoing influence of liquidity creation in asset class price expansion or contraction across the broader global economy.  For although systemic liquidity injections and broader credit stimulus may have been originally used as temporary policy in the early Greenspan Fed reign to either sooth what were seen as temporary financial market dislocations, or used as a “spark” to influence real world economic activity, the policy of ongoing liquidity facilitation seems to have become in the current period much more endemic and necessary for both ongoing real world economic stability as well as financial market buoyancy.  No longer a spark or a band-aid, it's now a structural support.  Enough of our thoughts regarding the historical evolution of the financing function in the US and really broader global economy.  What’s happening now as we look at trying to follow and interpret the influence of macro liquidity and what are the potential consequences of current Fed and credit market facilitation efforts?  Although this will not be new news to anyone, it’s clear to us that systemic liquidity facilitation has shown itself as having influenced a rolling series of asset class price expansions over the last decade.  And up to this point, this manifestation of liquidity in real world asset class prices has been nothing but favorable on a short-term basis for both domestic and global economic expansion.  The question we have at the moment is whether this can continue in a virtuous cycle of rolling thunder asset class movements, beneficial to both the real economy and the financial markets, or whether something different is starting to take place.  Let’s have a brief look back at some historical experience, and then take a quick look at where we believe excess liquidity is finding a home today.

Again, we’re not imparting any great revelation that excess liquidity sparked by the US Fed, in response to the Asian currency crisis, LTCM and Y2K, and partially supported by the Bank of Japan (the carry trade), in the late 1990’s, found its way into equity prices.  This is more than well known.  And once the primarily US equity bubble popped in the early part of this decade, a new and even greater round of liquidity stimulus saw its manifestation in residential property markets.  The table below recounts two data series specific to the domestic US.  We’re looking at the year over year change in OFHEO US housing price data next to the year over year change in the price only movement of the S&P 500.  The table is clear with respect to the rolling influence of excess liquidity over time.  As equity price rate of change subsided beginning in 2000, the acceleration in residential real estate prices began in earnest.  Again, the rolling thunder of financial sector liquidity creation in action as the baton had been passed to another asset class beyond equities.

And as we look back over this decade long period, it’s absolutely clear to us that the influence of liquidity was only a positive for the domestic economy across the entire period.  Certainly equity price inflation was a benefit to those owners of stocks as well as benefiting the broader US corporate sector vis-à-vis cheap equity financing and lack of pressure on benefit costs (pension valuation gains being a big beneficiary and essentially negating costly corporate pension contributions).  On face value, it’s hard to see how this was any type of immediate detriment to the US economy in the broader sense.  And although the decline in equity prices was certainly painful on an individual basis for many as this decade began, the liquidity and credit cycle based acceleration in asset prices of the largest US household asset class – residential real estate – was yet another huge macro positive for the US economy in terms of employment in the broader real estate sector, household net worth gains, the ability of households to extract “profits” from their real estate holdings, the wealth effect influence on consumption in excess of income gains, etc.  Again, although the rise in residential real estate prices can be characterized as an abnormality or a bubble, it was very much a big short term net net positive for the broader US economy.

So let’s step into the current environment where it is becoming clear to us, and we very much believe to the financial markets themselves, that commodity oriented assets are now the growing recipient at the margin of the current round of domestic and global liquidity generation.  Once again we believe we have been experiencing the rolling thunder asset class price beneficiary baton of excess liquidity being passed to yet another asset class - hard assets.  Is this a one-way Street of positive influence on the US and really broader global economy?  Will it engender the broader positive influence stock and real estate appreciation did on US household spending combined with the general sense of financial well being?  Or has this flow of liquidity into the asset class known as commodities now become a bit of an unintended consequence for central bankers globally?  In other words, is the current flight of excess liquidity to commodity-oriented assets actually acting to inhibit or be a type of "tax" on real world economic growth potential looking ahead?  And if that’s indeed the case, as we believe it is, does this inhibiting factor generate the need for every greater liquidity expansion to compensate for this real world commodity pricing pressure?  In other words, have we now progressed beyond the virtuous liquidity cycles of the past decade that initially uplifted equities and real estate values to perhaps something more of a current vicious cycle in that accelerating hard asset input costs (commodity costs) are now the manifestation of excess liquidity?  If indeed this is even semi close to the mark in terms of correct interpretation, then the current cycle of liquidity generation and its direct consequences will be much different than what was the influence of macro liquidity expansion over the past decade.  After all, when  gold, silver, zinc, copper or other metals prices zoom higher, are household net worth statements rising alongside as was the case with stocks and real estate?  Does a great quarter for crude and unleaded gas futures make households feel any wealthier?  Plain and simple, very much unlike the asset price beneficiaries of liquidity past, households do not own energy futures, the metals or other industrial commodities.  In fact, we suggest that US household financial well being is negatively correlated to price movements in the broad commodity complex.

Let’s look at some numbers for what we see in terms of current period acceleration of this influence of continued excess liquidity on the commodity complex.

Although we hear again and again on the Street that what you see above is being driven by China and India, or purely by supply and demand factors, from our standpoint that's only part of the answer.  Another big piece of what's driving the tremendous price increases you see above is continued macro excess liquidity plain and simple.  It seems the Fed has not yet figured out that they appear to be shooting themselves directly in the foot.  Although the hedge community, prop desks and the broad investor/trader populace at large may have been the Fed's best friends in terms of driving stock prices higher in the late 1990's, and although households may have done exactly what the Fed had intended early this decade in terms of levering up on an unprecedented basis vis-à-vis real estate, with a good portion of that leverage ultimately being directed into consumption, has the broad investment community, and especially the powerful fast and momentum money, now implicitly turned against their liquidity generating benefactors by focusing continued excess liquidity into asset classes that importantly drive up essential input costs in the real domestic and global economy?  Although the hedge crowd, prop desks, momentum crowd, etc. may have appeared to have been global central bankers' best friends over the past decade or so, their ultimate allegiance is to themselves.  The Fed has simply been doing their bidding in terms of providing them liquidity with which to speculate, not liquidity which would automatically engender real domestic production, long term capital investment or manufacturing expansion.  Whether the central bankers knew it or not, they have increasingly been losing their role as masters of the game.  Remember, the financial sector is now the master, no longer the servant.  The Fed is now the scared servant who will do anything to keep the macro economic expansion game going.  Have they not yet realized that they no longer control the game in its entirety and that the financial sector has learned how to play upon and profit from their fear, as is directly being expressed by their continued liquidity expansion efforts?  Maybe the Fed should have a chat with their billion dollar a year compensated hedge fund managers for a bit of enlightenment as to who is really calling the shots in the finance driven US economy of today.  It's the allocators of excess liquidity that are really in control at the moment, no longer the creators of that liquidity.  And the allocators act in the interests of short term profits, not in the best interests of the health and sustainability or short term impact on the real economy.  Because, at least for now, the real economy is the financial economy.

Have a good look at price increases in the table above for YTD and calendar 2005 periods.  Silver in the first three months of this year did what took the entirety of 2005 to accomplish.  Same deal with platinum, and darn close with palladium, gold, zinc, etc.  In other words, is continued excess liquidity finding its way into real world commodity prices in ever accelerating fashion?  It sure appears so as we look at 2006 numbers.  And if so, just how does the Fed and global central banking friends deal with this phenomenon?  Do they facilitate even faster liquidity growth in an eventually vain attempt to blunt the real world short term inflationary pain of higher commodity prices?  Is the manifestation, or end product, of excess liquidity generation now clearly out of the Fed's control?  Of course all of this is now set against the backdrop of a very highly levered US economy.  An economy implicitly screaming for continued inflation (excess monetary expansion) to ease the real burden of supporting the ongoing and now rising cost of excessive leverage.

As a quick tangent, we want to show you one picture of what we're talking about above as portrayed by real data.  You already know that some of the largest holders/providers of financial derivatives in the US is the banking system.  If the following does not speak about where broad systemic excess liquidity is now being channeled at the moment, then we just don't know what does.  The following tells us directly that in addition to the influence of real world demand in the China's and India's of the world, financial sector demand for commodity exposure, driven by the need to arbitrage the yield spread between cost on and use of excess liquidity availability, has simply mushroomed.  And in the world of commodities, "financial" or investment demand for the asset class as a whole has a direct and meaningful impact on real world prices and economics.  But during the current go around, the direct and meaningful impact on real world global input prices is very much unlike the tangential excess liquidity positive effects of rising stock and residential housing prices in years back.  After all, do stock or housing prices really influence actual input cost decisions of manufacturers and producers of goods globally?  We think not.  Commodities prices?  A different story entirely, now aren't they?   
          

You get the point.  As excess liquidity engenders rolling thunder in its price influence on asset classes over time, this can result in both virtuous cycle and vicious cycle consequences for the real economy.  We've lived through the virtuous part of the cycle over the last decade with equities and real estate.  Both asset class price accelerations were net positives to the consumption driven US economy.  The question of course now being, what alternatives do the Fed and global central bankers have at this point?  If they slow down liquidity generation in the hopes of quelling spiraling commodity prices, what fallout occurs primarily on a highly levered US economy, and in turn a global economy still very dependent on excessive levered US consumption?  Has especially the Fed simply painted itself into an inflate at all costs corner with literally no other choices?  Its policy flexibility vastly diminished relative to historical precedent?  Damned if it does and damned if it doesn't, so to speak?  The Fed has essentially allowed the financial sector servant to become its master in ever increasing fashion over the prior decades.  And its current lack of choices seems testimony to its newly found role as terrified servant.  At least for now, and whether the Fed is willing to admit this or not, it has become the servant to the hedge fund managers, the prop desk traders, the structured finance masters of the universe, etc.  Under this set of circumstances, our best near term investment returns lie where these aforementioned allocators choose to position the Fed liquidity largesse at any point in time.  And that's currently in the hard asset complex.  Simple enough?  Until these forces or dynamics change, we need to stay long energy, long equities benefiting from higher commodity prices, in short duration fixed income if at all, as well as long precious metals.  Corrections will happen in these asset classes, but until the Fed acts responsibly to stop excess liquidity and broader systemic credit creation at well above what would otherwise be considered reasonable growth rates, as they have not shown the will to do at all up to this point, these new recipients of excess liquidity will continue laughing all the way to the bank, much as equities and real estate once used to laugh at naysayers so loudly. 

Before leaving this subject, just a few last thoughts.  It's absolutely clear in our minds that large institutional money is not heavily invested in these hard asset classes in a very meaningful manner.  For now, the interest in commodity ETF's, the run up in the stocks that represent the hard asset trading exchanges such as CME and ICE, and the growing volume of hard asset derivatives, as you can clearly see above, are showing us that institutional demand for commodity oriented asset classes is growing at the margin, not diminishing.  And from our perch there is still a very long way to go before broader institutional demand is sated.  Just think back on the continued allocation into tech issues at the institutional level that started in the early to mid 1990's and just how long that took to fully play out over the entire cycle period of the prior decade.  Will there be commodity class price corrections ahead?  Sure, and some may be more than violent.  But at least for now, we'd continue to view these as buying opportunities as we believe the Fed and the central bankers are trapped.  They are trapped in a set of circumstances they themselves spawned.  Unwilling to allow prior period misallocations of capital (stock and housing bubble) to reconcile themselves, they have implicitly committed to facilitating ever larger amounts of liquidity support to the financial markets and theoretically real economy.  But it seems to us that they have worked themselves into a corner now being that the harder they push on the liquidity accelerator, the harder they will have to yet push in the future to offset the real world inflationary costs of commodity prices their hedge, prop desk and momentum trading former friends are now supporting with the very liquidity the Fed and their central banking brethren create in the first place.  The veritable Catch-22?  As the data above tell us, this liquidity is now squarely finding its way into the commodity complex and that process is accelerating.  Can it continue on forever?  Of course not.  We continue to believe that US consumers will slow ahead, especially given our viewpoint that US household financial well being is inversely correlated with commodity prices, but anticipate that the Fed will ultimately panic and up the liquidity creation ante even further as they have in the past out of fear as consumers slow, again, playing right into the expectant hands of the financial sector who has been conditioned time and again to expect this very response from the FOMC.  Who is the best friend of the current commodity bull, who is for now the longer term supporter of this trend, and who in public refuses to acknowledge what is plain for the entire planet to see in terms of forward inflationary pressures?  The Fed and the US credit markets.  Who else?  Until this changes, stay long assets that benefit from inflationary trends, particularly those assets that have not already been significantly levered.  Some day the Fed will change tactics.  Some day they will realize the speculative financial community has played them for the fool.  But we're not there yet.  For now, the hedge, prop desk and momentum trading crowd are betraying their liquidity benefactors out of natural self interest as they pile into hard assets and hard asset related investments.  We can only believe the Fed and their global central banking brethren are watching this in horror.  Paralyzed and reverting to the only trick left in their bag - liquidity facilitation.  But after all, the hedge, prop desk and momentum traders are only doing what the Fed has taught them to do for literally years now - put the Fed into a box of being forced to create and facilitate ever larger amounts of liquidity and credit.  The financial sector servant of old has now firmly assumed the role of master.  You better believe it's different this time.  

A few final comments.  You may have seen that at the recent G-7/IMF meeting there was simply a lot of cross country finger pointing in terms of attempting to address the crucial question of the magnitude of global financial imbalance and what ultimate fallout consequences might result from this current set of circumstances.  To be honest, all countries pointing fingers at each other were absolutely correct.  Yes, they only have themselves to blame.  But here's what we believe is the most important point for now.  Absolutely nothing was resolved and no plan of action, even a modest one, was introduced to address the 800 pound gorilla in the room that is global financial imbalance.  This very much parallels the theme of Hu Jintao visiting the US in recent weeks.  Mission accomplished?  Not quite, rather nothing accomplished.  So, we can only conclude that what lies ahead is exactly more of the same.  The Fed facilitates liquidity domestically in an attempt to blunt the headwinds of higher commodity prices, keep housing afloat, and reflate equity prices, trying to preserve household financial well being (translation = spending).  At the same time, nothing will be done on the currency front.  Foreign trade driven reserves will continue to buy US Treasuries as needed.  So what has changed as a result of the meeting, despite the fact that the crucial issues have clearly been identified?  Nothing.  Nada.  Zip.  The reflation game continues.....until it stops working for whatever reason, of course.  As Bush the senior used to say, and as we believe continues to apply to the global reflation trade for now, stay the course.