Turning Points

Note to a Client at the Height of the Crisis – Dec 15, 2008; expanded macro rationale added January 2009

Reinvestment Check List

So let us sum up and try to derive some practical pointers from all this theorising. The first premise under which we are working is that the credit cycle IS the business cycle; the second is that, no matter where it starts, higher-order goods suffer the heaviest, consumer staples the least, in the downturn; the last is that viable production must precede consumption but must also be in tune with what consumers want and can afford.

Thus, in commodity terms, we have industrial metals   – which should include platinum and palladium, too – and rubber, cotton, and possibly sugar at one end and food crops at the other, with energy products spread between, but biased to industrial end as B2B spending is always a multiple of the kind of end-consumer numbers which show up so heavily in GDP data. Gold and silver (this a poor second) used to be a means of deflation protection since they used to BE money, but are now more of an inflation shield (hard assets vs paper) and also a credit insurance vehicle.

Recession starts when business costs get out of line with returns and recovery sets in when the converse applies (or a realistic prospect thereof takes hold) and, sadly, sacking people and scrapping capex is part of that process, so job cuts and plant shut downs are a necessary pain to be suffered the faster, the better. Like any other inputs, workers will get rehired when their (potential) contribution to profit outweighs their known cost.

The lesson of Japan’s ‘Lost Decade’ is that such earnings as are still made will be devoted for some time to repairing balance sheets, depressing corporate spending. This is key since gross business outlays are typically 2-3 times GDP, 4-6 times household consumption and 10+ times net Government spending.

In Hayekian terms, we today in the hollow of a mini ‘secondary depression’ –  i.e. one where the real-side slowdown – though brought on in the first place  by a credit-led unwind of prior credit excesses – has triggered a financial-real world negative feedback loop. Until that dynamic is broken, it will be hard to stabilize.

As and when it does, we still need to transfer as many people and as much productive capital away from zombies to seedlings as possible and while the overlap may produce negative headlines, this may still suggest healing is occurring. Anything the State does to reduce business costs is a plus, all other measures are likely to be counterproductive.

Finally, aggregate level profits can only occur arithmetically – a la Reisman – when unbacked credit is being pumped into the system (the bad way) or (by contrast, the wholly benign way) when saving (corporate or household; domestic or foreign) is being converted into below-the-line investment in saleable inventories (which are NOT therefore always a bad thing) and into fixed capital stock (each of which implies that each revenue dollar does not have a fully-realised cost dollar associated with it).

Finally, this is all very macro, top-down of course, so a fully rounded investment process would look bottom up and probably use the above only to time entry and/or to take note of threats to the entrepreneurial process at work at the individual company level, or to identify especially favourable circumstances in which the firm might be able to achieve one of the periods of ‘punctuated evolution’ which seems to characterise the genuine creation of shareholder value and not the GE ‘one penny per share every quarter’ artificial straight line kind.

One further point to note is that some of these features show up in markets first. As they do, market movements alter real world pricings so, as practitioners, we then have a two-way interplay between technicals and fundamentals which we must take into account.

The list we present is concentrated more on the business cycle itself, with some flavouring of the role commodities both as participants in it and as indicators of its status. The unanswered question is actually this: rather than ‘stronger for longer’, has the bursting of the credit bubble returned commodities to the regime of the previous twenty odd years (indeed of the previous 20,000 years!) of declining real prices – interrupted by multi-month, counter-trend evolutions – rather than holding out any chance of a repeat of the past seven years of outsized and indiscriminate gains?

If so – after a possibly sharp correction from today’s extremely oversold levels – we would thereafter see a far more oscillatory behaviour, as well as one much more differentiated between various commodities, with any gains being largely confined to nominal ones and possibly severely mitigated in practice by the prevalence of nasty contangoes which will have to be managed or at least mitigated.

 

The world is undeniably undergoing a major cyclical recession which we will call the ‘Little Ice Age’ – one which may last well into 2010. On top of this, the AIG-LEH fiasco – and the extreme counterparty/liquidity fears which this engendered – served to bring much of the machinery of production and the movement of trade to a juddering halt, intensifying the glaciation to a state we might dub ‘Snowball Earth’.

The working assumption is that the first signs of recovery will be associated with a reversal of this last phase and that activity and prices will show some signs of increase even if this does NOT signal and end to the adjustment process which is entailed by the wider recession.

Thus, as we look for signs that either of these are beginning to improve, from my perspective, this is the provisional check list we should be running through:-

 

(A) Signs that Snowball Earth (capex AND working capital freeze) is thawing out, that basic flows of goods and materials have resumed, and that commodity prices can stabilize/rally:-

 

(1) Dollar strength ends & commercial bank redeposits at Fed/ECB decline – implying (CDS- and liquidation-related) funding hunger is finally abating;

(2) Yen weakens, especially v ‘commodity’ currencies – Japanese are again recycling offshore receipts

(3) Trade begins to pick up – maybe signalled via Baltic index, port container traffic, IATA air freight, AAR intermodal, USDA export figures, MSCI Marine equities index, etc, long before official numbers register the shift

(4) Producer metal surplus stops increasing/users restock. LME warehouse inventories fall, Shanghai ones pick up

(5) Real narrow money flows stop declining/decelerating. Money (properly defined) grows faster than credit, implying that goods are moving more readily from start to finish of the global assembly line and that sales are realised, not fictions of receivables accounting Weekly US financial data, monthlies in others

(6) Risk aversion starts to subside as captured by various spread/volatility measures, but principally led by a reversal in long T-Bond yields.

(7) The housing market begins to clear. MBAA weekly purchase index trends up

(8) Energy use stops falling. Cheaper prices encourage end-consumer use; restarted production boosts industrial use

(9) Crack/ Frac spreads improve. People actually want end-product

(10) Gold is no longer the best commodity performer

(11) Contangoes ease

 

(B) Signs that Little Ice Age is also ending (long term capital markets are open for business and are again being accessed) and hence that adjustment to the new world is taking place, setting the stage for further growth in future:-

 

(1) Non-Govt bond issuance picks up; Libors normalize, credit spreads come (selectively) in from extremes

(2) Equity markets start to rally on bad macro news days, as asset allocators rebuild exposure on dips; IPOs emerge, rights issues not so steeply discounted

(3) NAPM/Ifo/Chinese PMI-type numbers edge back towards neutral (which may merely imply things are not getting worse!)

(4) Bank assets increase, ex-CB re-deposits and government/GSE security purchases

(5) Corporate value added/cash flow starts to outstrip labour costs meaning firing is becoming less attractive than hiring once more

(6) Capex budgets are maintained/grown rather than slashed; inventories stop falling – machine tool orders rise – these two imply aggregate profits (unexpensed outlays) will begin to rise

(7) TIPS no longer price Armageddon

 

 

As you know, I have been looking at these sorts of things for some time on an informal basis, but I am here trying to be a touch more systematic. This is far from a finished product, more of a first stab.

The first premise is that the credit cycle IS the business cycle; the second is that, no matter where it starts, higher-order goods suffer the heaviest, consumer staples the least in the downturn; the last is that viable production must precede consumption but must also be in tune with what consumers want.

Thus, looking at commodities in terms of this difference between ‘higher-‘ and ‘lower-order’ goods, we have industrial metals – which, for me probably should include platinum and palladium, too – agriculture ranging from rubber and cotton at one end and food crops at the other, with energy products spread everywhere between, but biased to industrial end as B2B spending is always a multiple of the kind of end consumer numbers which show up so heavily in GDP data. Gold and silver (a poor second) used to offer a deflation protection since they WERE money and a strong shift in the preference for money over goods is what a deflation actually entails, but gold is now more of an inflation shield (as a hard asset v paper), but also credit insurance – look at how it outperforms its peers when vols and credit spreads start to rise.

Recession starts when business costs get out of line with returns and recovery when the converse applies (or a realistic prospect thereof takes hold) and, sadly, sacking people is part of that process, so job cuts are a necessary pain of our healing process and should not be hindered by diktat.

In Hayekian terms, we are here in a mini ‘secondary depression’ – i.e., in a state where the real-side slowdown – though brought on in the first place by a credit-led unwind of prior credit excesses – has triggered a financial-real world negative feedback loop. Until that is broken we cannot stabilize.

As and when it does, we still need to transfer as many people and as much productive capital away from zombies to seedlings as possible and the overlap may produce negative headlines but still suggest healing is occurring. Anything the State does to reduce business costs is a plus, all other measures are likely to be counterproductive. The latter will, alas, almost certainly dominate the former, given the prevailing paradigm.

Finally, aggregate level profits can only occur arithmetically – à la Reisman – when unbacked credit is being pumped into the system (the bad way) or conversely (this, the wholly benign way) when saving (corporate or household; domestic or foreign) is being converted into below-the-line investment in saleable inventories (whose growth is not therefore always a bad thing) and additions or improvements to fixed capital stock and hence when each top-line revenue dollar does not have a fully-realised cost dollar associated with it.

Like any other goods, workers get rehired when their (potential) contribution to profit outweighs their likely cost in the entrepreneur’s best judgement. Nothing should be done which will persuade him that this is not going to be the case.

The lesson of Japan’s ‘Lost Decade’ is that such earnings as are still made from here on will be devoted for some time to repairing balance sheets, so depressing corporate spending. This is key since gross business outlays are typically 2-3 times GDP, 4-6 times household consumption and perhaps 10 times Government spending.

As discussed, some of these features show up in markets first: sometimes market movements alter real world pricings. So, as practitioners, we then have a two-way interplay between technicals and fundamentals to consider.

Finally, this is all very macro, top-down of course, so a fully rounded investment process would look bottom up and probably use the above only to time entry and/or to take note of threats to the entrepreneurial process at work at the individual company level, or to identify especially favourable circumstances in which the firm might be able to achieve one of the periods of ‘punctuated evolution’ which seems to characterise the genuine creation of shareholder value and not the GE ‘one penny per share every quarter’ artificial straight line kind.

The list is concentrated more on the business cycle itself, with some flavouring of commodities both as participants and as indicators of its status. I’m not sure how ‘granular’ it is, over the long run.

The unanswered question is actually this: rather than ‘stronger for longer’ (as the catchword has it), has the bursting of the credit bubble returned commodities to the regime of the previous twenty odd years (indeed of the previous 20,000 years !) of declining real prices, rather than holding out any chance of a repeats of the past seven years of outsized and indiscriminate gains?

If so – after a possibly sharp correction from today’s extreme oversold levels – we would thereafter see a far more oscillatory behaviour – as well as one much more differentiated between various commodities – with any gains being largely confined to nominal ones and possibly severely mitigated in practice by the prevalence of nasty contangoes.

Ultimately, what I call I2E2S2 – Innovation, Economisation and Substitution involving Investment being directed by Entrepreneurs utilising genuine Savings – will then triumph: human ingenuity, driven by the profit motive and the ingenious being assured of the enjoyment of that profit by stable property rights, will bring better processes and new technology to bear on the problem, supply will more easily match demand, and prices will again begin to fall – in real terms, at least.

 

Sean Corrigan aka Wild Goose