Please, click here to read this article in pdf format: april-18-2011
Two weeks ago, we called our readersâ€™ collective attention towards gold, noting that: â€œâ€¦ we think higher highs are soon to comeâ€¦â€. A week ago, we expressed our concern that stagflation seemed to be manifesting itself before its time. We defined stagflation and went on to describe what made us believe that we were facing it. Over the past two weeks, markets have told us that our call was correct. They told us so by making our positions in our personal accounts profitable. Simply, their verdict is always the only one we pay attention to. But perhaps we were actually wrong and even then, we got lucky! Wise people are people full of doubts. We want to â€œwise upâ€, so we will devote todayâ€™s comments to raise doubts on our callâ€¦
If our stagflation call was right, shorting stocks and going long gold was the right thing to do. We think it was but what could tell us this is sustainable in the future?
Letâ€™s leave gold aside for a moment. Its long-term trend is naturally from the lower left to the upper right, if only because of the steady increase in money supply coupled with the credit multiplier.
What could then make stocks return to a bull trend, proving us wrong? We think we would need to see certainty on a few fronts. Letâ€™s seeâ€¦
In the US, we donâ€™t need to necessarily see sustainability on its fiscal deficit (to push stocks higher over the next weeks, that isâ€¦). All we need to see is that politicians of both sides tend to agree on a deficit cutting program, in a reliable way. On Friday, the US House passed a Republican budget in favour of cutting spending by more than $6 trillion over a decade. But no Democrats voted it and because Republicans oppose higher taxes and the cutting program involves the privatization of Medicare, both sides in Congress are worlds apart. Nothing tells us that this situation may change sooner than later.
It is not easy, we must say, to see how this affects markets. To begin with, it poses the question of how markets will react once QE2 ends in June, assuming no agreement on the fiscal issue. Opinions are divided here with those analysts on the street telling us that the Fed will just end QE policies, stop reinvesting mortgage backed securities proceeds and slowly raise rates. We cannot agree with them because the main assumption they have is that QE2 was to support the recovery in the private sector, and it succeeded. We disagree on both points. To us, QE2 was not to boost private growth but to finance the fiscal deficit and even that was not a success, as yields are higher. In this scenario, how can the Fed afford to leave the fiscal deficit problem unresolved and trigger a currency crisis? Perhaps the Fed governors are â€œluckyâ€ and the surprising increase in jobless claims we saw last Thursday repeats itself next Thursday, showing that a trend in the making is at hand, and giving the Fed the perfect excuse to continue printing money. For brevity, we will leave this point here, only adding that there is a lot of confusion around this, with plenty of curve trades being recommended in Treasuries and misunderstanding of what backwardation is telling us, in terms of inflationary expectations (we will elaborate further on this, if it becomes more relevant).
Another source of global uncertainty remains that of sovereign risk within the European Union. During the last week, EU officials let it be known that a restructuring of Greeceâ€™s debt would not be catastrophic and immediately after, speculation began on whether such restructuring would trigger a credit event under the outstanding credit default swap contracts. We are not in a position (nor are we allowed to) to opine here. All we can say is that, on the margin, this doesnâ€™t bring certainty. In addition, Moodyâ€™s downgraded Ireland by two notches to Baa3 from Baa1 (still investment grade) and this always leads us back to questioning the strength of the countryâ€™s financial system first, and that of all the EU at last.
Finally, no matter where one captures inflation statistics from, the story is unanimously the same and of higher inflation. A friend made the point that the latest release in the US, showing 50bps increase in CPI month over month implies a 6% annualized rate. We wrote here last week about this issue in relation to Emerging Markets. On that note also last week, China showed that the pace of increase in prices remains unabated and has announced another increase in the reserve requirement ratio over this weekend. It shall do nothing to the trend, only making things worse on the way.
In conclusion, we frankly see nothing new on the horizon that may derail us from heading towards a worsening â€œstagflationaryâ€ process. We will continue to trade accordingly.
Mr. Sibileau currently works as Director for the Loan Portfolio Management team of a Toronto-headquartered financial institution. In his free time, he regularly writes on global macroeconomic developments at www.sibileau.com.
Since 1997, he has held various positions in the areas of corporate finance, strategy consulting, international banking, commercial banking and risk management.