The price of everything

Farmageddon

“There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.” – Ludwig von Mises.

 

“I bought an ant farm. I don’t know where I’m going to get a tractor that small.” – Steven Wright.

 

The Oxford English Dictionary contains multiple definitions of the word ‘commodity’. One of the more benign and pleasing: “..a thing of use or advantage to mankind.. useful products, material advantages, elements of wealth.” That variant is less commonly used – perhaps because our new and fragile world order looks disdainfully upon real things when financial assets seem so much more sophisticated. More widely used is the following, perhaps a little more pejorative, definition: “A kind of thing produced for use or sale, an article of commerce, an object of trade.. goods, merchandise, wares.. Now especially food or raw materials, as objects of trade.”

 

These definitions are mutually contradictory. Something that has advantage to mankind, almost of necessity, has an element of scarcity to it. There is something to “an object of trade,” and doubtless to the prevailing perception of “commodities” as now broadly understood in the financial markets, that implies something grubbily practical but unlimitedly fungible, like the proverbial widget. And the “commodities” complex is a broad church, encompassing classic real money substitutes (gold, silver, more latterly perhaps platinum and palladium) as well as foodstuffs (soybeans, corn, wheat, sugar, coffee..) and those energy raw materials (oil, corn again, sugar again, natural gas..) whose price rises are proving so problematic to central bankers theoretically committed to inflationary stability when we all know that the jig is well and truly up. The central bankers have lost control in an unhinged world, and we know it. The prices of gold, silver, platinum, palladium, oil and wheat – the list is not meant to be exhaustive - certainly know it.

 

Scarcity is where the action is. It was previously assumed, for example, that investment banks – by dint of competitive remuneration moats - possessed some rare access to a mother lode of ‘alpha’ generation that could be tapped, at a price, by paying clients. We now know, from the baneful evidence of a list of market participants too numerous to mention, that investment banks have been trapped by their own hubristic sophistication, and that their ‘alpha’ generation was built on a sandbank of broken financial modelling and leverage. Or as John P. Hussman puts it, in the light of valuation black comedies from the likes of Credit Suisse and others,

 

“One wonders how companies [but he means banks] can have much sense about the risks of their counterparties when they cannot reliably quantify their own.. I continue to believe that there is substantial risk of audit delays and “qualified” opinions in the upcoming reports of financial companies. It is difficult to see how analysts and some financial news anchors can seriously be looking for the market to have “discounted the bad news” when companies are still at a loss to quantify their news at all. It is equally difficult to see how financials can “come clean” with their losses when those losses generally have not yet occurred because the major wave of mortgage resets that started in October (are) probably only now beginning to produce delinquencies. It’s impossible to know yet which mortgages and how much will end in foreclosure.”

 

So everybody knows that the banks, with just one or two mysterious exceptions, haven’t just stumbled onto subprime landmines, they have been positively tapdancing upon them – see the chart on the attached PDF. This is admittedly old news, and while banks’ share price charts have typically exhibited a ‘top left (of the screen) to bottom right’ tendency, that does not automatically guarantee anything other than purely optical cheapness – Citigroup recently cut its dividend to the order of 40%; and banking earnings going forward, in the context of sagging property markets, the effective closure of vast swathes of the structured credit markets, and imminent consumer spending retrenchment, look like doing a workable impression of the Bataan Death March.

 

So much for financial assets and the frailty of the financial system. Bloomberg’s Andy Mukherjee (“Food is a great asset – minus the fund manager”) suggests, by contrast, that “as a hedge against a possible US recession, and [offering] direct exposure to rising urbanization and wealth in Asia, (food) is an asset class that’s tailor-made for the present times.” This is not exactly new news. But the extent of further gains by the soft commodities complex – deemed limited by the sceptics, if agricultural commodity prices are not indeed overdue for substantial correction – should be considered in the context of the extent of further conceivable losses by financial assets. Our thesis, essentially, is as follows: yes, grains and other food raw materials prices have soared beyond the expectation of most commentators over recent months, and a pullback may well be overdue. But in the context of a global financial crisis that is some way from resolution, in the context of the ongoing manipulation of foodstuffs’ economic fundamentals by governmental promotion of food crops as alternative fuel, and in the longer term context of mammoth Asian demand, on which side of this trade would you prefer to sit ?

 

Mr. Mukherjee raises an interesting point. Agricultural commodity prices are booming. But he cites a Merrill Lynch report indicating that many actively managed funds focused on agriculture are failing to outperform passive indices. Since this is par for the course across all asset classes anyway, this should come as no particular surprise. But just as commodities markets are now rising because of insufficient expenditure upon basic infrastructure during the previous extended bear market, so the fund management community is comparably short of the raw material in investment expertise required to deliver the goods in value-added terms. As futures markets are particularly prone to manipulation and marked volatility, the current wave of commodities fund managers may largely be handing their putative “alpha” to the savvier locals within the commodities pits. Wall Street is only now waking up to the commodities boom – commodities desks are, presumably, the only growth opportunities within a financial sector otherwise stealthily removing human material from the balance sheet. And Wall Street has been maintaining oil research teams for some time now, but that doesn’t seem to have done anything to improve their price forecasting abilities, which can best be described as vilely incompetent. Either way the conclusion seems clear: ETFs 1, Wall Street 0.

 

There is yet another definition of commodity: “Profit, gain.” Notwithstanding the fact that the commodities trade is altogether more crowded than it used to be, that usage still seems – particularly relative to financial assets – highly appropriate now. Inflationary pressures are on the rise. 10 year Gilt yields have recently turned a corner, from lows of around 4.40% to above 4.70%. They probably have some way further to rise, given the cost of the Northern Rock bailout, and the outlook for diminished corporate (and personal) tax revenues amidst a recessionary slowdown. US Treasury yields have shown a similar reversal, albeit from lower, panic-induced levels. Western governments / central banks are facing a showdown of credibility in their ability to rescue their banking systems by means of aggressive monetary easing without triggering an uncomfortable upsurge in inflation. Commodities in a general sense, and the likes of precious metals and agricultural foodstuffs in a very specific sense, are robust hedges against currency [specifically US dollar] weakness even without the uplift from anticipated Asian demand. Any pullbacks by commodities look like being superb buying opportunities. The fact that so many investors seem to be waiting for them could mean that those pullbacks prove somewhat elusive.


Download Farmageddon.pdf

The modern banker as ‘Typhoid Mary’. Discuss.

“Bear [Stearns] executives also believe the market for collateralised debt obligations, which is dormant, will eventually come back, though the instruments will probably have a new acronym to make them more palatable.”

- The Financial Times, 14^th February 2008.

 

According to Wikipedia, Mary Mallon (a.k.a. ‘Typhoid Mary’) managed to infect 47 people during the course of her career as a cook. Three of them died of the disease. Between 1900 and 1907, she infected two dozen people with typhoid fever. She worked in Mamaroneck, New York for less than two weeks when residents began to succumb. She moved to Manhattan in 1901 and members of the family where she was employed started to develop fever and diarrhoea. The laundress died. She then went to work for a lawyer and managed to infect seven out of a household of eight. In 1906 she moved to Long Island. Within two weeks, six out of eleven household members were hospitalized. She changed employment again and managed to infect three more families. Her fame “is in part due to her vehement denial of her own role in causing the disease, together with her refusal to cease working”.

 

Nobody, of course, suggests that modern banks are virulent and destructive plague carriers. They are a lot more dangerous than that. But there are more than a few commonalities: carriers of typhoid, like the originators and redistributors of securitised subprime mortgages, and other largely unpriceable repackaged debts, “continue to excrete the bacteria in their faeces..”; and, as with poor Mary Mallon, the sense of denial for their own responsibility is almost palpable.

 

Imagine a world without banks, suggests this site. If there were no banks..

 

• Where would you go to borrow money ? (Banks no longer have a monopoly on supposed risk-taking, assuming they ever did, but the question forms a presumption that unlimited and indiscriminate access to credit is essential in a modern economy, rather than a sign of fiscal indiscipline and a general symptom of a dependency culture that perpetually postpones making tough decisions – like, for example, saving.)
• What would you then do with your savings ? (Invest them, perhaps, into either productive, wealth generative businesses that make things - rather than simply shuffling paper around in what amounts to financial legerdemain - or into comparatively safe ‘plain vanilla’ government or corporate securities, or perhaps even into the precious metals that represent ‘traditional real money as a store of value’ superior to the theoretically infinite and therefore ultimately worthless supply of fiat currency.)
• Would you be able to borrow / save as much as you need, when you need it, in a form that would be convenient for you ? (See responses to Questions 1 and 2. In the context of loans for property, there are still one or two holdouts known quaintly as ‘building societies’, but their own misadventures in SIVs, CDOs, Treasury assets, real estate loans, “fair value movements” and “hedge ineffectiveness” – a concept borrowed from Bear Stearns ? – suggests they are at least as capable of haemorrhaging capital as the best banks. And in our brave new web-enabled world, as Zopa now suggests, “People are better than Banks”.)
• What risks might you face as a saver / borrower ?

 

At least we are now somewhat closer to appreciating the ironies inherent in Question 4. In a world with banks, risks to savers include: a confidence-draining run that threatens the loss of all savings beyond those guaranteed by a deposit insurance scheme with almost no underlying assets; a growing pyramid of unrestrained lending based on increasingly flimsy over-engineered financial structures that nobody either within the banking system or outside it can seem to understand or even price; a widespread infection of the credit markets that triggers in turn a crisis of confidence between banking counterparties and between banks and investors, culminating in a debt deflation and an economic downturn of uncertain duration and severity. Thank goodness for the banks !

 

As somebody once said during the internet boom or perhaps earlier, banking is necessary, but banks aren’t. There is no shortage of businesses with substantial capital that can perform broadly similar services, at least to those offered by so-called narrow banks. Banks may enjoy a privileged position in terms of credit creation, but money itself is completely fungible. One of the critical problems with our fractional reserve banking system is that banking institutions are performing so many more complex, risk-taking functions than merely accepting deposits and making loans (or these days, not making loans). When confidence in the system craters as a result of a tidal wave of credit infection and of doubts about undisclosed losses trapped opaquely and perhaps dishonestly within it, the system breaks down, and requires at the minimum substantial amounts of taxpayer capital just to allow it to tick over.

 

One of the loudest broadsides launched against the banks was by Martin Wolf of the FT back in January:

 

“No industry has a comparable talent for privatising gains and socialising losses.. Yet the conflicts of interest created by large financial institutions are far harder to manage than in any other industry:

First, these are virtually the only businesses able to devastate entire economies; second, in no other industry is uncertainty so pervasive; and, finally, in no other industry is it as hard for outsiders to judge the quality of decision-making, at least in the short run. This industry is, in consequence, exceptional in the extent of both regulation and subsidisation. Yet this combination can hardly be deemed a success. The present crisis in the world’s most sophisticated (sic) financial system demonstrates that.. I now fear that the combination of the fragility of the financial system with the huge rewards it generates for insiders will destroy something even more important – the political legitimacy of the market economy itself – across the globe.”

 

Mr. Wolf’s Jeremiad was met in response by some rather self-serving special pleading from anonymous investment bankers in the blogosphere, but otherwise by much ongoing sympathy within the FT letters page (and here and elsewhere).

 

But why continue grimly to focus on the rancid open sore that is the banking system in 2008 ? The February 7^th front page headline of the European Wall Street Journal provides much of the answer:

 

“UK’s role as finance hub is now economic burden.”

 

For what is the UK if not the world’s largest offshore financial centre ? As the WSJ’s Alistair MacDonald and Mark Whitehouse point out, “No large country is more dependent on the movement of foreign money through its banks: some $2.4 trillion flowed in and out of the UK in 2006, an amount equivalent to the country’s entire annual economic output..” The WSJ also suggests that, rather ominously, “the financial sector accounts for more than one-fifth of all UK jobs”. The comparable figure from the US, which treated the world to the subprime debacle in the first place, is just 6%.  And whatever damage a softening property market and stalling investment banking business inflicts upon  the economy may be reinforced by the government’s on-the-hoof flip-flop policymaking-by-headline approach to non-domiciles.

 

The Bank of England’s February Inflation Report was pulling few punches:

 

“The disruption to global financial and credit markets continued. Current and expected policy rates fell. Sterling depreciated substantially.. Consumer spending growth appeared to soften and the climate for investment deteriorated. International prospects worsened, especially in the United States.. the Committee’s central projection is for output growth to slow markedly this year and then gradually start to recover. The risks to growth are weighted to the downside.”

 

Even that masterly use of central bankerly understatement gets the point across. Annoyingly for the Bank, inflationary expectations are on the rise. Admittedly, looking out further we can ignore the short term effects of higher energy, food and import prices, because they will be offset by falling house prices, rising unemployment and – theoretically at least – falling wages. But in the interim, increasing fears of stagflation warrant heightened exposure, in a debt market context, to inflation-protected debt and nothing else. And as The Business Ledger is probably correct to suggest, there is a growing danger of a bubble forming in government bonds. The only economic backdrop that justifiably supports 10 year UK government bond yields, for example, at or around 4.5% - just 40 basis points higher than the year-on-year rise in the Retail Price Index – is one of incipient Armageddon. The trouble with that thesis is that incipient Armageddon, or for that matter merely a perpetuation of the ongoing cretinocracy that is the banking sector, would argue for some colossal government (i.e. taxpayer) support for that same ailing banking sector. To put it politely, that would be diabolically negative for conventional bondholders, though altogether less problematic for inflation-protected investors. Absent tangible evidence of a recovery in housing and consumer spending (other than a few days’ irrational exuberance on the part of equity investors), a poor outcome for banks – and, in turn, quite possibly for conventional Gilts, US Treasuries, et al – seems a feasible outcome. Tragically and ironically, a rapid recovery in housing and consumer spending might yet have exactly the same effect. Conventional government bonds are starting to look dangerously overbought.

Download the_modern_banker_as_typhoid_mary._Discuss..pdf

Can Chen Zhi save the world ?

 “In most of the cities and towns of this country, this Wall Street panic will have no effect.”

- Paul Block, editorial, November 15, 1929.

 

What a weight of global expectation hangs on the shoulders of the Chinese and Indian peasantry. With US service industries contracting at their fastest pace since 2001, with UK consumer confidence falling to its lowest level since 2004, and with a strong euro and Jerome Kerviel hampering the euro zone, just who is going to be picking up all the slack ? Answer: the likes of Chen Zhi, a farm worker in Zhejiang Province whom we just invented. Admittedly, Mr. Chen’s earnings of roughly one dollar per day are unlikely to offset US household spending of c. $9 trillion – he’ll just have to work that much harder to afford all those yachts, cars, condominiums, lattes, HDTVs and handbags that will otherwise go unsold this year. The good folk at LongOrShortCapital express the sentiment slightly more brutally (and also hint at the late stage frothiness of the Chinese stock market) as follows:

 

“I get it. China is big. There are a lot of people there and they are increasingly buying stuff. So when you present an investment to me, it’s not useful to tell me how many people there are in China. You see, I know that already. That’s why I own some Chinese companies already, before you came in here. So when I ask you why I should pay 50x earnings for this company, it’s singularly unhelpful to start off by saying, “Did you know there are a billion people in China ?” It doesn’t make me want to buy the stock, it makes me want to punch you in the mouth or “decouple” your head from your torso.

 

“I’ll tell you what China also has. A BILLION POOR PEOPLE. A whole billion of them.. all looking to buy no things with their no money. Stick that in your model and regress it.”

 

On the topic of Chinese market overvaluation, a comparison with previous market peaks and collapses is instructive (see enclosed PDF).

 

As Patrick Perret-Green points out, the similarity in chart patterns between these markets is striking,

 

“especially when they finally peak, fall sharply, bounce significantly and then embark on the 3^rd wave death plunge. Shanghai looks to have embarked on that.”

 

Which is not to say that the Chinese economy will necessarily flounder even if its embryonic and foamy stock market succumbs to the law of gravity. In fact, the more likely “decoupling” this year will not be Asian markets mysteriously holding their own in the face of an Anglo-Saxon economic slowdown; rather, it will be the Chinese economy continuing to grow well by comparison to the West, even if its own stock market collapses. This is still a nominally Communist country, after all.

 

And no matter what happens in Asia this year, its long term prospects look an awful lot more attractive than those of the Anglo-Saxon economies. Woe to a developed market economy when both its property market and its financial services sector start to sink beneath the water line “As two spent swimmers that do cling together / And choke their art”. Notwithstanding last week’s continued equity market volatility, western shareholders continue to operate in baffled denial of what the global financial crisis means for the banking system: the colossal unwinding of a decade’s uncontrolled leverage; a critical (voluntary) retrenchment of lending; intrusive (involuntary) regulatory oversight of a sector that is incapable of policing itself; in short, the key driver of economic activity in the western world has gone ex-growth for the foreseeable future. That is without further revelations of bad debts, malfeasance, connivance at misselling, and worse. We are entering a New Era for finance and nobody can say yet what it will look like with any confidence, but it doesn’t look like being terribly expansionist.

 

John Brooks, in his excellent study of 1920s and 1930s North American markets, ‘Once in Golconda: a true drama of Wall Street 1920-1938’ (1999, John Wiley) cites John Maynard Keynes writing of what happens “to respectable and responsible people in times of excessive speculation”:

 

“Amidst the rapid fluctuation of his fortunes, [the businessman] loses his conservative instincts, and begins to think more of the large gains of the moment than of the lesser, but permanent, profits of normal business. The welfare of his enterprise in the relatively distant future weighs less with him than before, and thoughts are excited of a quick fortune and clearing out. His excessive gains have come to him unsought and without fault or design on his part, but once acquired he does not lightly surrender them.. With such impulses so placed, the businessman is not free from a suppressed uneasiness. In his heart he loses his former self-confidence in his relation to society, in his utility and necessity in the economic scheme.. He of all men and classes most respectable, praiseworthy, and necessary.. was now to become, and know himself half guilty, a profiteer.”

 

The roaring twenties ended with the sudden demise of a sub-set of the US population who believed they had stumbled upon a formula for instant wealth. The gaudy boom of the naughty noughties has ended with the sudden demise of an even more limited sub-set of the global corporate structure – trading-oriented banks – whose executives possessed more confidence than competence in their assessment of highly complex and fundamentally flawed financial instruments. The crowning irony is that while hedge funds have long been pilloried for supposedly piling up risks beyond all compass, and have been consistently harried by traditional fund managers urging all forms of oversight and regulation upon them, the real systemic risks were being taken, and hugely underestimated, by banks – entities in the full view of the regulators. Quis custodiet ipsos custodes ? It is perhaps not a pure coincidence that those assets now generally rising in price – gold, oil, soft commodities – can be easily priced and, even more importantly, easily understood.

Download Can_Chen_Zhi_save_the_world.pdf