Adjustment of Imbalances
11/15/08
Be careful out there. Every time I buy I get hurt. So does everybody else. Every silver lining that anybody has espied over the last 3 months proved to be a mirage. It is true that stocks have sunk to unbelievable valuations and when one checks the charts it seems that stocks fallen to dramatic price levels. But there is no money for takeovers to clean up the mess and companies are reluctant to use their stock as currency for takeovers because they believe that their own stock is way undervalued, just like the stock of all the potential takeover candidates. So the retailers, the machinery and energy stocks wallow in their own valley of disbelief. Meanwhile the endless and reckless shorting of all of the ETFs is so rapid that no natural buyers dare to surface. The hedge funds are forced to liquidate to raise cash for end of year redemptions. So the selling goes on endlessly despite the many indicators telling us that the sell-off has been overdone. The fundamental news of course doesn't help things either. Consumer prices probably dropped 0.8 percent last month, the most since 1949, according to the median estimate in a Bloomberg News survey. Builders broke ground on the fewest houses in at least a half century and factory output weakened further, other reports may show. Commodity costs plunged in October when the economy, which descended last quarter, went into freefall as credit and financial markets collapsed. Slumping sales are forcing retailers to lower prices. Tumbling energy and commodity prices have altered the inflation landscape. Fuel, clothing and auto costs probably dropped last month as sales at U.S. retailers fell 2.8 percent, the most since records began in 1992, economists said. Commodities prices have dropped to levels not seen in 5 years and shipping prices have reached levels, last seen in 1999 and before that only in 1986. Deflation (not inflation Mr. Trichet) is happening all around us.
The raw materials as measured by the CRB Index and their shipping costs have imploded in a matter of 3 months. The BDI, according to the Baltic Exchange, provides "an assessment of the price of moving the major raw materials by seas. Taking in 24 key shipping routes measured on a timecharter and voyage basis, the index covers supramax, panamax, and capsize dry bulk carriers," that carry a wide range of commodities. The index therefore provides useful information on the pace of economic growth. To be sure, the decline reflects expectations for much weaker commercial activity across shipping lines, as suggested by the plunge in the ISM index, but there has also been impact from the credit crisis, with importers having difficulty obtaining letters of credit to obtain the financing they need to import goods. Moreover, exporters are having difficulty obtaining funding to create and ship their goods. If financial markets stabilize, it is highly likely that the BDI will claw back and, with it, commodities prices. I am getting to the point. I believe that the decline in Libor rates foreshadows improving availability of credit within the coming weeks and months. The G 20 statement that was issued this weekend and Paulson's speech on Thursday made it clear that governments around the world are aware now and that they will do whatever it takes to get credit flowing again. After all their jobs are on the line when the next election rolls around. Paulson for example made it clear, that bank regulators would almost turn a blind eye on banks' leverage ratios, if they could demonstrate that they took seriously their responsibility as corporate citizens by granting credit to deserving entities. China sees the urgency too. China's industrial output grew at a slower pace than any economist forecast in October, forcing the government to cut taxes on 28 percent of exports, announcing a $589 billion stimulus package and cutting interest rates three times within two months. Let us hope that the global liquidity that has been unleashed is not just being sopped up by banks in need of capital. Liquidity needs to reach the producers, shippers and consumers of goods in order to do some good to the global economy. I spent all weekend trying to figure out how the next quarter is going to shape up. Here are my assumptions:
1. Banks are no longer willing to make consumer loans, and with stock and real estate markets down so dramatically, the US household savings rate will almost certainly rise. The chart below shows you the household savings rate as a percentage of nominal GDP. If consumers only claw their way back to a 5% savings rate, then that would amount to $700 billion of this $14 trillion economy. This amount would not be spent on consumer products and thus would not be available to the world economy.
2. If global demand isn't to collapse, someone else has to increase consumption by that amount. This, however, seems unlikely. No country or region in the world can increase spending by $700 billion with credit unavailable as it is worldwide. Our best hope is that this adjustment process takes place gradually over a period of years rather than months. Help has already arrived of course in form of lower oil prices. Every dollar that is not spent on oil imports is being withdrawn from oil producing countries thus putting more dollars into US consumers' pockets, be that for consumption or for savings. That way the burden of international re-adjustment goes partially at least towards OPEC and Russia, who have large foreign currency reserves and should be able to handle it. The next chart shows us the extent to which I estimate that this quarter will move us towards our ultimate goal of $700 billion. I estimate that the average oil price declined in Q3 by about $22.50/barrel. The quarter started out with oil trading at $145 and ended with oil trading at $100. The better part of the three months period was spent trading between $130 and $90. This price decline may have saved the American consumer over $100 billion already. The non-oil trade deficit might have added a couple of $billion too. The 4th quarter should save us at least that much, probably much more than $100 billion. This brings the international adjustment process 1/3 towards completion. This also means that we may have another year to go, before the world arithmetic is back in balance.
Naturally, if China or Europe can increase their spending to facilitate the adjustment, it may not have to be another year. Declines in the CRB Index as shown above and in other raw materials help of course too. Considering that some metal producers already have to operate at a loss, shuttering of further capacity seems likely. Watching the price of copper gives me hope that it may not be so preposterous after all to hope for a stock market rebound that discounts better times 6 months ahead. As a matter of fact, I fully expect a dramatic recovery in commodities soon. Low prices, just as high prices are their own best cure.
Hermann Vohs
"Temptations, unlike opportunities, will always give you second chances."
Orlando A. Battista
Hermann Vohs is president of Cales Investments, Inc., a registered Broker-Dealer. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions. Opinions expressed in these reports may change without prior notice. Hermann Vohs and/or the staff at Cales Investments, inc. may or may not have investments in any of the markets cited above. Hermann Vohs can be reached at 303-765-5600.
This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities.
