Debating
By Yiannis G. Mostrous
McLean, Va–I’m quite excited about the new theme I’m exploring in my upcoming issue of Geopolitics & Investing Quarterly (GIQ). The report will be hitting your computers as soon as it’s ready.
The latest tremor in the markets is the purported increase in inflation. Investors around the world are trying to make sense of economic data and central bankers’ comments in an effort to predict whether the global economy will be effected by it.
Consequently, the chart I’ve seen the most in the past couple of weeks is some kind of a variation of the one below–namely, the 10-Year US Treasury yield.
Source: Bloomberg
The overwhelming consensus among market players is that the yield is heading higher, with 6 percent being the target discussed the most. Yet, exposure to US Treasury notes–on a hedge basis–remains a good idea as long as you don’t bet the house on it.
The reason for this is a potential slowdown of the US economy in the second half of the year. The recommendation made here before–(see SRI, 15 March 2006, “Killing Me Softly”) buying the iShares Lehman 7- to 10-Year Treasury Bond Fund (AMEX: IEF) as a hedge position–still stands.
My take on all this (also see SRI, 3 May 2006, “Still Going”) is that more than inflation, the global economy will face an inflationary scare. How the markets will react to this no one knows.
To get a better grip on the implications, I first look at core inflation; so, I went back and looked at 1987, the last time the US had a serious increase in inflation.
Back then a peculiar thing happened. Core inflation had remained quite high at around 4 percent while the headline inflation number fell. Only after did the headline number catch up with the core. The following two charts demonstrate the incident.
Source: Bloomberg
Source: Bloomberg
If you take a look at the right side of the charts, core inflation remains subdued–half the 1987 level–although there are some obvious upward pressures to the headline inflation, primarily from energy.
The working assumption remains that core inflation will stay fairly low, given that it hasn’t moved as much even though we’re in the middle of one of the most spectacular commodities bull markets in history. If these were the 1970s, the core would have been much higher by now because of the pressure through huge increases in wages. Although we’ve seen some increase in wages recently, the magnitude pales in comparison to the ’70s and ’80s when workers could demand and get almost anything.
The only imminent potential problem I see on the inflation front is the negative effect a rise in Chinese wages, which has already started to happen, could have. The world has gotten used to extremely low prices on goods coming out of China, and no one is able to calculate how the world will perceive higher wages in China, even if they’re coming from an extremely low base.
In the beginning of the week, I sent out a flash alert addressing some of the issues regarding the recent selloff in a lot of the markets SRI covers. One of the potential problems identified in the alert was the disastrous effects a collapse of the US dollar (USD) will have for global economies and markets alike.
I’m coming back to the issue because there’s a lot of talk out there saying that the USD has gone down substantially and a reversal is imminent. Although, I don’t doubt that a bounce can occur, the fact of the mater is that there have been times in the recent past that the USD sold off much more.
The selloff that commenced in 1985 after the Plaza Accord and during the following two years saw the USD lose 42 percent of its value on a trade-weighted basis. See Chart below.
Source: Bloomberg
Given that the current dollar bear market–which commenced in 2002–has seen the USD weaken on a trade-weighted basis a little more than 20 percent, you can easily understand that more downside is possible if global economic forces decide that this should happen.
Of course, those considerations are tactical in nature. The biggest debate is whether the USD is on the way to losing its reserve currency status. My view is yes, the USD will eventually lose its privileged position in the global economy, although we have quite some time before it happens.
In the meantime, expect the USD to retain its privileges and its status, but from permanently lower levels versus the majority of the currencies around the world.
It’s troubling to hear arguments in favor of the USD’s greatness such as, “those who believe that the dollar will lose its reserve currency status underestimate the premium that the world places on what is still undeniably the strongest and most politically stable climate on the planet, where coherent legal system, patent protection, and property rights actually mean something.”
I’m the first to admit that there are a lot of strong arguments to be made for the dollar, but the above doesn’t sound like one. After all, Europe–particularly the Euroland and the United Kingdom–fits the aforementioned characteristics extremely well. Does this mean that the Euro has a shot at becoming the reserve currency of the world?
Speaking of Europe, and since the SRI portfolio is exposed there, my expectation is for Europe to experience solid GDP growth this year. Late 2006/early 2007 might prove difficult, but the current economic upswing should continue given that the continent experienced a slow start in its recovery, in contrast to the turbo-charged US economy.
Finally, you can’t fail to notice that an increasing number of investors want to buy Asia. Of course, the first thing they do is buy Chinese stocks, but this is another story. The point: Asia is becoming mainstream, and you have to be aware of the danger when a lot of people are chasing the same assets.
Although strong selloffs are to be expected, Asia remains the key investment destination for the long-term-oriented investor.
The main themes of investment growth and domestic consumption are still in their beginning and will become stronger as wealth in the region increases and, with it, real asset prices. I’m preparing an in-depth analysis on the subject that should be available soon to SRI readers.
Portfolio Talk
I’m selling UPM-Kymmene from the Portfolio this week. The reason isn’t the stock’s indifferent performance since I recommended it. Rather, it has to do with certain environmental problems that another paper company is facing in Latin America. These problems have escalated to a full confrontation between two countries. UPM can also get hit by something like this, which would hurt the stock.
UPM is a good cyclical stock to play the upswing, but the inherent risks at this point outweigh any optimism. Sell UPM-Kymmene.
Finally, I’m reiterating the short recommendation made in this week’s flash alert. As I wrote on Monday: It’s also ironic that in the March 8 issue of SRI, I also recommended shorting the big commodities companies as well as Brazil. We used BHP Billiton (NYSE: BHP) and the iShares MSCI Brazil ETF (NYSE: EWZ) as proxies for this trade.
We were stopped out, only to see the securities come back down with a vengeance. Given that the odds for a selloff have increased since then and that the aforementioned stocks are almost at the same levels as when we initially recommended the positions, it looks like a good idea to re-enter. Short these again and put the stops at 50 for BHP and 46 for EWZ.
McLean, Va–I’m quite excited about the new theme I’m exploring in my upcoming issue of Geopolitics & Investing Quarterly (GIQ). The report will be hitting your computers as soon as it’s ready.
The latest tremor in the markets is the purported increase in inflation. Investors around the world are trying to make sense of economic data and central bankers’ comments in an effort to predict whether the global economy will be effected by it.
Consequently, the chart I’ve seen the most in the past couple of weeks is some kind of a variation of the one below–namely, the 10-Year US Treasury yield.
Source: Bloomberg
The overwhelming consensus among market players is that the yield is heading higher, with 6 percent being the target discussed the most. Yet, exposure to US Treasury notes–on a hedge basis–remains a good idea as long as you don’t bet the house on it.
The reason for this is a potential slowdown of the US economy in the second half of the year. The recommendation made here before–(see SRI, 15 March 2006, “Killing Me Softly”) buying the iShares Lehman 7- to 10-Year Treasury Bond Fund (AMEX: IEF) as a hedge position–still stands.
My take on all this (also see SRI, 3 May 2006, “Still Going”) is that more than inflation, the global economy will face an inflationary scare. How the markets will react to this no one knows.
To get a better grip on the implications, I first look at core inflation; so, I went back and looked at 1987, the last time the US had a serious increase in inflation.
Back then a peculiar thing happened. Core inflation had remained quite high at around 4 percent while the headline inflation number fell. Only after did the headline number catch up with the core. The following two charts demonstrate the incident.
Source: Bloomberg
Source: Bloomberg
If you take a look at the right side of the charts, core inflation remains subdued–half the 1987 level–although there are some obvious upward pressures to the headline inflation, primarily from energy.
The working assumption remains that core inflation will stay fairly low, given that it hasn’t moved as much even though we’re in the middle of one of the most spectacular commodities bull markets in history. If these were the 1970s, the core would have been much higher by now because of the pressure through huge increases in wages. Although we’ve seen some increase in wages recently, the magnitude pales in comparison to the ’70s and ’80s when workers could demand and get almost anything.
The only imminent potential problem I see on the inflation front is the negative effect a rise in Chinese wages, which has already started to happen, could have. The world has gotten used to extremely low prices on goods coming out of China, and no one is able to calculate how the world will perceive higher wages in China, even if they’re coming from an extremely low base.
In the beginning of the week, I sent out a flash alert addressing some of the issues regarding the recent selloff in a lot of the markets SRI covers. One of the potential problems identified in the alert was the disastrous effects a collapse of the US dollar (USD) will have for global economies and markets alike.
I’m coming back to the issue because there’s a lot of talk out there saying that the USD has gone down substantially and a reversal is imminent. Although, I don’t doubt that a bounce can occur, the fact of the mater is that there have been times in the recent past that the USD sold off much more.
The selloff that commenced in 1985 after the Plaza Accord and during the following two years saw the USD lose 42 percent of its value on a trade-weighted basis. See Chart below.
Source: Bloomberg
Given that the current dollar bear market–which commenced in 2002–has seen the USD weaken on a trade-weighted basis a little more than 20 percent, you can easily understand that more downside is possible if global economic forces decide that this should happen.
Of course, those considerations are tactical in nature. The biggest debate is whether the USD is on the way to losing its reserve currency status. My view is yes, the USD will eventually lose its privileged position in the global economy, although we have quite some time before it happens.
In the meantime, expect the USD to retain its privileges and its status, but from permanently lower levels versus the majority of the currencies around the world.
It’s troubling to hear arguments in favor of the USD’s greatness such as, “those who believe that the dollar will lose its reserve currency status underestimate the premium that the world places on what is still undeniably the strongest and most politically stable climate on the planet, where coherent legal system, patent protection, and property rights actually mean something.”
I’m the first to admit that there are a lot of strong arguments to be made for the dollar, but the above doesn’t sound like one. After all, Europe–particularly the Euroland and the United Kingdom–fits the aforementioned characteristics extremely well. Does this mean that the Euro has a shot at becoming the reserve currency of the world?
Speaking of Europe, and since the SRI portfolio is exposed there, my expectation is for Europe to experience solid GDP growth this year. Late 2006/early 2007 might prove difficult, but the current economic upswing should continue given that the continent experienced a slow start in its recovery, in contrast to the turbo-charged US economy.
Finally, you can’t fail to notice that an increasing number of investors want to buy Asia. Of course, the first thing they do is buy Chinese stocks, but this is another story. The point: Asia is becoming mainstream, and you have to be aware of the danger when a lot of people are chasing the same assets.
Although strong selloffs are to be expected, Asia remains the key investment destination for the long-term-oriented investor.
The main themes of investment growth and domestic consumption are still in their beginning and will become stronger as wealth in the region increases and, with it, real asset prices. I’m preparing an in-depth analysis on the subject that should be available soon to SRI readers.
Portfolio Talk
I’m selling UPM-Kymmene from the Portfolio this week. The reason isn’t the stock’s indifferent performance since I recommended it. Rather, it has to do with certain environmental problems that another paper company is facing in Latin America. These problems have escalated to a full confrontation between two countries. UPM can also get hit by something like this, which would hurt the stock.
UPM is a good cyclical stock to play the upswing, but the inherent risks at this point outweigh any optimism. Sell UPM-Kymmene.
Finally, I’m reiterating the short recommendation made in this week’s flash alert. As I wrote on Monday: It’s also ironic that in the March 8 issue of SRI, I also recommended shorting the big commodities companies as well as Brazil. We used BHP Billiton (NYSE: BHP) and the iShares MSCI Brazil ETF (NYSE: EWZ) as proxies for this trade.
We were stopped out, only to see the securities come back down with a vengeance. Given that the odds for a selloff have increased since then and that the aforementioned stocks are almost at the same levels as when we initially recommended the positions, it looks like a good idea to re-enter. Short these again and put the stops at 50 for BHP and 46 for EWZ.