Barnes Capital Insight
by Daniel A. Barnes, CFA, Barnes Capital| July 1, 2008Print
What does this number, $90.21, represent?
A. A Bag of Groceries at Whole Foods?
B. Your Kid’s used College Chemistry Book?
C. Your Water bill?
D. A Tank of Gas?
E. Dinner and Drinks at a not that fancy of restaurant?
F. All of the Above
Well, it happened to be my Chevron bill for my latest tank of gas at $4.85/gallon in Vallejo, California a week ago Saturday. But it could have been any of the above. In fact, we are seeing the “3rd Oil Shock” right now and its effects cascade across the world economy.
This picture is a bit shocking isn’t it?
Take a look at the price of a “Gallon of Milk” or a carton of good eggs lately? Try $6 and $4 respectively. Makes a “Gallon of Gas” seem pretty reasonable at $4.85 a gallon. Only problem is, most of us consume more gas than milk!
Today’s letter has 2 parts. Part 1 focuses on inflation and how it affects each side of our two-class society. Part 2 focuses on De-leveraging and its effects. The De-leveraging story includes the housing meltdown, the banking meltdown, and the asymmetric relationships between hedge funds, banks and investors which fueled the finance economy bubble.
How does the Energy Crisis affect YOU?
Well, it depends. Are you a “Have” or a “Have-Not”? In a 2-class economy the “Haves”, have enough income, to acquire assets; (i.e., they have a positive balance sheet in which their Assets (real estate, stocks, bonds) far exceed their liabilities.
The “Have-Nots”, haven’t got a positive balance sheet. They live on their income, and it’s difficult for “Have-Nots” to accumulate assets. It’s particularly difficult, when gas costs $5 a gallon. (This of course is all just another way of saying the middle class has disappeared.)
This socio-economic equation of “Haves” & “Have-Nots” is the product of the global economy. Wage competition by Asia keeps wages down – below the rising cost of living. The “Have-Nots” haven’t got much of a nest egg. They live on income of less than $75,000 per year. They live off their paychecks or retirement income. The Have-Nots’ income” is getting hammered by higher food and energy costs. Whatever left over money they had had, that may have gone to accumulating assets such as real estate, or their 401k contribution, is now swallowed up by $90 tanks of gas every other week (or every week if they commute).
For the “Haves”, inflation hammers their Assets – stocks, bonds, real estate & cash. In financial terms, the “Haves’” personal balance sheet isn’t growing. The reason is simple, in an environment of high uncertainty, and rising inflation in food and energy, it is exceedingly difficult to earn a real return (a return higher than the rate of inflation after taxes).
That’s why you feel bad when you get your account statements, the accounts are going down while your expenses are going up!
The other impact of the energy crisis is that it focuses new light on the fact that there is significant inflation across the world due to rising energy and food prices.
Here’s the year-to-date score card in the price changes in commodities and stock exchanges.
Crude oil up 43%
Ethanol up 21%
Heating oil up 44%
Natural gas up 77%
Unleaded gas up 40%
Cattle up 1%
Corn up 59%
Soy beans up; 26%
Wheat down 2%
Coffee up 6%
Aluminum up 33%
Copper up 26%
Platinum up 33%
Gold up 6%
Silver up 13%.
S&P 500 down 10%
Frankfurt DAX down 18%
London FTSE down 12%
Paris CAC down 20%
Hong Kong Hang Sang down 18%.
Tokyo Nikkei down 10%
Singapore Straits down 14%.
Seoul Composite down 10%
Sydney All Ordinary down 16%
Taipei Telex down 7%
Shanghai B down 44%
In the Middle East and Asia many countries are experiencing current inflation of 10% - 20% or higher. Rice has doubled or tripled, energy tripled, and last week, China increased the price of gas by 20% (many Asian governments subsidize energy costs as a way to drive economic growth).
By most measures, it looks like food inflation will continue for some time as the current asinine governmental policy of replacing fossil fuels with corn has imploded the stabile pricing structure of grains. What’s more, the weather in the last 18 years was very stabile and kind to U.S. farmers. Since the average dinner table food travels 1200 miles from where it is grown in the U.S. to the table, food inflation isn’t going to abate for quite some time. On the other hand, the destruction of billions of dollars of mortgage debt, and the impairment of global financial institutions creates “deflation” (because when a trillion dollars of borrowed money goes up in smoke, there is less money).
Already parts of the debt markets are foreshadowing the rising cost of money. For the first time in a decade, investors can find opportunities to lend corporations money and get 8%-10% returns. The opportunity to build income portfolios is back! I believe that this opportunity is a prelude to rising inflation which will define the next decade
Exhibit 2 shows that in the 1970s, there was an 8-year delay between spiking inflation and spiking interest rate yields. Commodity inflation began accelerating in 2004. Ascending interest rates are on their way, it’s just a question whether they will arrive in 2009 or 2014.
The specter of rising inflation isn’t bad, it’s inevitable. We actually need significant amounts of inflation in order to more easily amortize existing liabilities. With $40 trillion in existing liabilities, the U.S., and the developed world (Europe, Japan) whether they announce it or not, have, chosen an “inflate or die” fiscal policy.
However, the specter of inflation must remain stealthy, lest it upset existing systems. But if the cost of borrowing for governments goes up too quickly, national budget deficits will spiral out of control. This is where Asia comes in. Japan and China buy more than a 1/3rd of U.S. government debt. When they no longer are willing to accept 4% interest on 10 year government bonds, our borrowing costs will skyrocket. Interest on the national debt is currently $500 billion/year. If that interest cost rises too quickly, say from 4% to 7%, the annual interest on the debt would increase by an additional $300 billion annually.
As long as wage inflation doesn’t exist however, the lid on inflation and rising inflation expectations stays on the bottle. But with Joe and Jane “Have-Not” spending $90 a week at the pump, how can we expect wage inflation pressures to stay in the bottle?
The De-leveraging Story
Didn’t we declare victory over inflation just a few years ago? How did we go from a goldilocks growth economy back to the brink of stagflation? Its amazing what complacency and a little victory, abetted by stupid policies can produce in a few short years … think: 100% depreciation gas-guzzling SUV’s & hedge funds borrowing billions at 5% to buy mortgages of Florida and Las Vegas condominiums paying 6%, and then leveraging that 1% spread 50 times with borrowed money from their bankers. We won’t even mention the Ethanol policy and what it’s done to the price of corn and rice grains. Try to remember this when hamburger costs $6/lb next year.
This “3rd Oil Shock” (The first was 1973 when Oil quadrupled from $3 to $12/barrel and the 2nd Oil Shock was in 1979 when the Oil price tripled from $15 to $40 a barrel). This 3rd Oil Shock has been more gradual, with the price quadrupling since 2004 from $30 to $134 today.
The “Oil Crisis”, together with the “Housing Meltdown,” is forcing relationships that were never fair or functional, to be disbanded and realigned. The de-leveraging in the face of rising commodity prices is driving corrective behavior throughout Wall Street and Main Street. You might be surprised; this isn’t all such a bad thing in the long run (we will forget for now Keynes, who likes to remind us that in the long run we are all dead.)
The Banking Crisis
Every crisis facilitates the changing of common perceptions. The economy today is bringing a reality check, first and foremost to the lenders of the world. It was the lenders who “screwed up.” This is similar to the dot.com boom/bust. The difference, however, is in magnitude. In the dot.com boom, 100’s of billions of dollars of capital was misallocated. In the housing boom, reckless lending amounted to trillions of dollars of misallocated capital.
Investment banks lent to hedge funds to leverage “safe” investments in mortgages against government bonds, to produce double digit returns and take their 20% performance fees. Today those same banks are facing tens of billions of dollars in losses and you can bet they aren’t lending money to those hedge funds anymore. And, this is the significance of the credit crisis and the energy crisis; it forces corrective behavior on practices that need correcting.
Who are the lenders? Well, yes they are the banks, but more importantly, they are the investors who facilitated the bubble of real estate that facilitated the fantasy world where money is lent for 4% to 7%, irrespective of the risk level to the underlying assets.
Why was that crazy? Well just think, houses which had gone up 200% in 4 years were being mortgaged nearly 100% at 5% and 6% interest rates. Hedge funds would buy up this paper and leverage it 10 or 20 to 1 against government bonds and earn their 15% returns and a hefty bonus of 1/5th of the profits. When the credit crisis arrived last summer, many hedge funds lost so much capital that they couldn’t recover. Many simply closed shop. Did they return the tens of millions $ in performance fees that they had collected for themselves from their investors’ profits in the last decade? Most not!
Why the stupid lending? Because some managers are paid to bet the house’s money!
To explain how markets and why markets go to extremes, George Soros used the sociological term “Reflexivity” in his 1986 real-time experiment chronicled in The Alchemy of Finance. Reflexivity refers to circular relationships between cause and effect, where the effect is so strong (think wealth creation in home equity or dot com stocks), that the positive/ or negative feedback loop actually changes the underlying fundamentals of the prevailing system. So in this way, the lending and housing practices of financial institutions were logical and rational within the context of the positive fundamentals. In reflexive markets, forces pursuing their individual interests, leads to ever more bullish or bearish disequilibrium. When a tipping point is finally reached, the rug is literally pulled out from all the participants feet as equilibrium (the exit) is suddenly and simultaneously sought by all participants in light of the new recognized fundamentals — i.e. the crush at the door as all try to exit the party at the same time. Since last summer, the banking system is now experiencing such a reversal.
But alas, these are the symptoms of the disease. The cause of the disease is the nature of the business relationships that our finance economy perpetuated. Namely, the root cause of the credit crisis was prevailing asymmetric risk relationships that existed and grew within the global finance economy.
Hedge Funds: the 2+20 Proposition
2 + 20 refers to the common hedge fund fee relationship. 2 is 2% annual management fee. 20 is the 20% performance fee that hedge funds pay the managers from the client’s return. While hedge fund managers only risking their start up capital, 100% of the risk of the investment strategy is being borne by the clients, but the clients only receive 80% of the profits. Its asymmetric risk, when performance fees are paid when the bets come in–but not penalized when the bets go south. The failed fund manager may lose his business entity, and tarnish his reputation, but he keeps his prior years’ fat profits. If I am a hedge fund manager, and for $250,000 in set up charges, I can launch a fund, from which I can make Tens of Millions in performance fees, there is little incentive not to take risk with client assets. When the hedge fund manager’s upside is 8 digits, and his downside is only 6 digits, how can you expect him to resist the temptation of taking extraordinary risk: particularly if the chance of that risk materializing before his next bonus is small?
John Meriwether, legendary trader from Solomon Brothers became notorious for losing a few billion at his hedge fund, Long-Term Capital in 1998. Yet, just 18 months after blowing up $3.5 billion in client money, Meriweather was on his “meri” way running a new $250 million fund.
High Net Worth clients should understand that many Hedge Fund managers are not betting with their own money. And even if they “have their own money invested beside yours”, remember, they probably don’t have the same rising profile as their clients. So the fact that they have their own funds invested in their fund should not provide so much comfort as is commonly thought. They are not carrying a commensurate amount of risk compared to the client. This is what I call an asymmetric business relationship, when the interests of the client’s capital and the motivations of the fund manager, are not aligned. This problem leads to managers leveraging their bets. It is leverage that led to a trillion dollar bust in banking and real estate.
As long as “2+20” hedge fund business models persist, there will be hedge funds that leverage capital. When the merry-go-round reverses, capital evaporates. For a different outcome, the structure of the business model of the participants must change. And that can only happen, when clients choose to not send their accumulated assets to “2+20” funds. Were the hedge fund structure “1+10”, my viewpoint would be significantly less vehement. The same argument and perspective applies to CEO compensation, but that’s a discussion for another day.
While Rome parties . . . Or It’s the Government, Stupid!
The deficit, taxes, the economy, the dollar, how are we going to pay for the $40 “trillion” in unfunded Liabilities? Well don’t worry, it’s Sunday, and while the Vandals may be stormin’ over the Alps, Rome…err, I mean Washington, is oblivious . . .
Don’t worry, be happy. Buy our “safe” gas guzzlers. “Don’t drill for oil”, “don’t do nuclear”, don’t stop the consumption parade, don’t stop buying, and “never, never run out of money.” It will all get paid for with cheaper money. Whose cheaper money? Why yours, of course!
De-leveraging is the Dam that’s got that Genie corked up!
When’s the dam going to break? Despite energy and food inflation, rising inflation expectations have not become a problem, yet. Labor remains emasculated as The greatest dividend for capitalism from the Cold War victory was the emasculation of labor. In a low-inflation/deflating world, few workers (who were growing nest eggs like never before) complained. But in a spiking world of $5 gas and $5 bread, how long will it be before white collar and blue collar workers demand real wage increases so that they can fill up their respective tanks at the station? And, when that happens, won’t the genie have escaped the bottle? Remember the chart? In the 1970s, it took almost 8 years for interest rates to accelerate following a corresponding rise in inflation. When the “Have-Nots” begin demanding wage hikes, inflation will really rake off.
Can global wage competition keep this genie in the bottle? A lower standard of living is the fudge factor in this equation. As long as wages can not keep up with rising expenses, the standard of living for the average family will decline to make up the shortfall.
Presently, according to the spread difference in the Treasury Inflation Protected Securities (TIPS), the bond market is expecting just 2.5% inflation annually over the next decade. If that number rises due to the current pressure on “Have-Nots” to pay their bills, then the 1970s scenario is going to gain traction. If healthcare costs and higher education costs could rise at double digit rates for the last 20 years, can’t energy and food do the same?
Perhaps not. Rising health care costs are borne largely within the system. 45 million Americans couldn’t manage/afford to stay in that system, so they don’t have health care. While higher education costs, on the other hand, are borne largely by the most affluent part of the republic. Food and Energy are different than health care and education. 45 million people can not opt-out of using energy, or eating! Oil costs are borne by everyone in pretty equal degree.
In housing, people can choose to live in much more humble surroundings, thereby reducing their housing costs by a factor of two, or even three. They can’t reduce their food and energy costs by a factor of three. Food consumption isn’t going to decline.
However, Americans can reduce energy consumption by a factor of two with over a period of time. Germans live just as well as Americans, yet consume only 14 barrels of oil per capita, versus the United States’ 25 barrels of oil per capita, per year. Energy consumption can go down.
As providers of wise counsel to our clients, we are darn concerned about how tough this environment is for the “Haves” and for the “Have-Nots”. Sometimes the best we can do is to break even, or lose just a little. This concept certainly applies to the current environment. The day will come again when asset values for the “Haves” will resume their natural long-term growth of 6% annually. Just don’t expect it to happen this year.
As for the “Have-Nots”, I’m not too sure when white or blue collar labor will get pricing power again. It’s doubtful that it will in my lifetime. Better to read the Great Books (Plato, Aristotle, Chaucer, Shakespeare, Goethe, Hayek) and focus on learning, thinking, and education, so that more of the “Have-Nots” can acquire the knowledge to get an edge up and climb into the “Haves” court. Labor’s day in the sun had its fleeting day in the sun, extended and harvested during the Cold War. That sun has set. Globalization has dealt a fatal blow to the middle class as those of us over 40 knew it.
Copyright © 2008 Daniel A. Barnes
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