ASSET VALUE CYCLING AND CHANGE
by Andrew McKillop
Author & Consultant
April 15, 2009

PLUS CA CHANGE

Today more than ever, Equities market operators have an obligation to perform – or at least to « Save The Equities Pile », specially in the banking, finance and credit space.

This is an ongoing ritual quest, featuring the only toolkit owned by investment banks, retail banks, big mutual funds, sovereign nat wealth funds and other ‘institutional players’. The process starts out with a big sell-off of Commodities, led by Oil and Gold, plus an equally ritual « Save the Dollar » support strategy, talking up the US dollar and talking down the Euro and Yen.

On occasions, like presently, this is a risky strategy. The US dollar is back on the downtrending treadmill and oil prices are tending to be "surprisingly firm". Some Commodities like the Ags & Softs are also showing "surprising strength". While the Yen is now a semi-virtualized dangerous plaything currency, the Euro seems to offer many nice reasons for it to strengthen against the dollar - but only for a while.

The basic mechanism for Saving Equities is to extract cash and financial leverage from the Commodities pile, and inject it into the flagging Equities pile. Whenever this has the air of a dead cat bounce, the cash is switched back into Commodities.

The background music this year is a little different from normal. We have a devastating financial meltdown, plummeting demand for about every industrial basic you can name, massive growth of unemployment, falling home sales and car sales. We also have desperately vast amounts of borrowed public money, stretching into the trillions, thrown at mostly unproductive sectors of the economy almost everywhere in the G-20 world.

SAVING THE DOLLAR IS EASIER, TODAY

The good news for Obama is that saving the US dollar is a little easier than one year ago. Despite the incredible, willed and wanton structural weakness of the US dollar, several factors will quite soon tend to push it higher against the incredibly overpriced Euro. This cuckoo money thrust several old-established and respected European moneys out of their nests 7 years ago. This all-conquering quest continues through generously underpinning strange and weak East European currencies and their linked deficit-riddled public finances, making it certain the Euro will be victim of its own massive overvaluation.

Well may anguished American commentators bemoan the incredible deficit spending programs of the Obama administration - Europeans will only, and can only play the same game. Well may financial buffs say that 'objectively speaking' the US dollar is almost worthless, but exactly the same applies to Euro cuckoo money. But the similarities stop here. This double weakness of the Euro and USD (or triple weakness if you count the Yen) in fact lends strength to the US dollar in the current and emerging context.
This is because not only gold but also the USD profits from geopolitical crisis and international conflict, but the Euro and Yen do not. The USD is a lot better placed when there is rising global inflation, than the Euro or Yen.

Oil is the 'other argument' that invited itself to the party. Oil prices have to rise simply because supply will diminish, almost irrespective of how much the global recession slashes world demand. Only falling demand slows the countdown. After years of talking about Peak Oil, we are now edging to the real Big Rollover in world liquid hydrocarbons output from all sources, however they are counted. This counting includes the biofuels - supplying a princely 0.7 Bn barrels a year compared with IEA recession focused estimates of 30.6 Bn barrels demand for black oil in 2009.

Higher oil prices need US dollars for the settlements, the trading and the arbitraging in a world oil market where at least a hundred paper barrels chase a single real one. Not unlinked to this at all, geopolitical conflict in the Mid East and central Asia (now including a new and dangerous country called "AfPak"), will and can only rise. This is likely to be sooner rather than later, and will get worse before it gets better.

The US trade deficit, we are told, is ‘satisfactorily shrinking’due to recession and cheaper oil imports, but for the 600 000 or 700 000 new jobless each month this is an argument that fails to impress. In fact, just like the European Central Bank or Bank of Japan, the US Fed has to print and borrow money like never before. However much the Obama team denies it, this is all they have as wampum for pumping some sickly life back into the economy. The bottom line is simple: inflation and then rising interest rates.

SAVING EQUITIES

Shuttling cash or paper promises between Equities and Commodities has its own asymmetries, but the size of each pile, in theory, can only grow if money supply grows. Simply due to the size of the Equities pile relative to Commodities there is an intrinsic, time honored bias to unrealistically talking up Equities. This "returning confidence" has in fact already started, but when the cycle reaches its own fuzzy limits the Commodities will be allowed to roar upwards. Today we are nearing those fuzzy limits.

The signal for moving the sand-timer up, or down, shifting funds from one patch to the other was until 2008 mainly supplied by chatty reports and advice from the private investment banks. These banks, like Bear Stearns, Lehman Bros, Merrill Lynch or Goldman Sachs have now all mutated into ‘new entities’, pulled from the brink of bankruptcy, sold for ‘pennies on the dollar’ of their worthless stock, or simply allowed to fail like Lehman. In Lehman's case this was probably due to winks and nods coming from Bernanke and Treasury being ignored until too late, the rumor mill says.

Today we lack 'leadership' of this kind for deciding when or which of the Twin Piles will grow, and what arbitraging applies to how they interact. Lifting the veil on this, we can suggest the period April-July will see selective recovery in Equities and a major bounce in Commodities. Fundamentals decide this: throwing enough borrowed money at the consumer economy, encouraging consumption of anything because it is ‘the only way to restore growth’ has real world limits. The USA unwillingly learnt that in 2005-2007, but at the moment has to 'selectively forget' this lesson. China and India are on the same learn-and-forget curve, with perhaps only 5 years lag.

WHY NOW ?

The big threat to geopolitical stability comes from Bush administration leftovers. It comes from new countries and renewed crises with names like Af-Pak, Iran-Iraq, Is-Pal (or Israel-Palestine), and Leb-Syr (for Syria and Lebanon). These crises dating from year 2000, and well before, have matured in the worst sense of the term. They are now telescoped together in a critical mass of dusty, fought over, well armed and dangerous oil-related territories and pressure points.

Tracing the return of inflation, the Euro's role of supposed ‘bulwark against inflation’, despite and because of its continued over-valuation, will do little to stop the rot of inflation's return in Europe, starting in the coming 90 days. This bounce is likely rapid, and will also signal that the global deflation trough has bottomed out. Better than gold prices as an indicator of inflation's return, the USD/EUR ratio will give telltale warning of the process.

Higher inflation favors Commodities rather than Equities – although the sand timer, as we said, is heavily bi-directional and flows either way at the slightest political tilt.

Another argument for this outlook is supplied by Equities themselves. Close and real analysis of sacrosanct PERs, but using real world purchasing power and real coming inflation forecasts for any Old World stock exchange (USA-Europe-Japan) shows that most mainstream Equity stocks and shares remain extremely overpriced. They are not at all ‘historically cheap’. Many commentators are already saying this out loud.

Several of the Ags & Softs, like corn and wheat, rice and cotton, soy and palm oil suffered heavy liquidation due to big crops in 2008, the recession, falling inflation, and simple contagion from low oil prices. Current prices, already recovering, are not at all likely to stay down for long. Sugar is another clear candidate for rebound after savage liquidation hits. Apart from fundamentals like transport, energy and infrastructure costs, the basic rebound driver is strong demand, more resistant to recession than energies, metals and minerals, or mainstream consumer non-food demand.

Some Base Metals, to be sure, remain candidates for further short selling. The reasons for this often have scant relation to demand fundamentals, themselves floundering with industrial output. The continued selling pressure is justified by titanic levels of debt following titanic M&A struggles between almost all big-cap global mining players, making them finance-and-metals conglomerates, not real resource suppliers.

© 2009 Andrew McKillop
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