“We are willing to accept almost any explanation of the present crisis of our civilization except one.”
That’s an important quote from page 65 of a chapter that Hayek wrote in “The Road To Serfdom” titled, “The Abandoned Road.” As I take a step back and think about what a tremendous opportunity our profession has had to learn about real-time risk management and the interconnectedness of Global Macro markets in the last 3 years, it’s somewhat sad to realize that consensus hasn’t been paid to learn much.
What we get paid to do is chase short-term returns. The Bernank perpetuates this performance pressure by marking the short-term “risk free” rate to model (or the ZERO bound) and, as a result, this gargantuan experiment of starving savers of returns imputes 3D Risk (3 D’s) into markets:
- The Dare – zero percent rates dare you to chase yield across asset classes where you can justify it
- The Delay – zero percent short-term financing for banks delays the financial restructurings that free market prices would impose
- The Disguise – zero percent expectations disguise the interconnected risks associated with carry trading, correlation risk, etc
The Disguise is the one that can really nip a perma-bull in the butt. That’s the one that, allegedly, “no one can see coming.” That’s the one that is being revealed real-time. In terms of making excuses for being willfully blind to it, this time is different because we have a modern day technological innovation in financial market transparency – it’s called Twitter.
Going back to Hayek’s aforementioned point, I think that’s the one thing our professional politicians do not get paid to understand. That would be called accountability. The Disguise in financial markets is The Correlation Risk – and while his original text was addressing a different kind of socialism and Big Government Intervention in 1944, I still think what Hayek goes on to say about explaining our perpetual financial “crisis” is very appropriate:
“… that the present state of the world may be the result of genuine error on our own part… and that the pursuit of some of our most cherished ideals has apparently produced results utterly different from those which we expected.”
With another 78 Billion Bailout Euros being extended to the government of Portugal this morning, Spain seeing unemployment spike to 21.3% (new all-time highs), and Americans staring down $5/gas at the pump with jobless claims re-accelerating, wasn’t that some advice our “independent central bankers” and fiscal spenders should have considered?
Independent research? Should we just never mind silly old school things like the American Constitution or what John Locke wrote On Liberty 80 years before Hayek penned his original counter-points to Keynes? Just buy-the-damn-dips, chase yield, and believe that it’s going to end well this time?
Back to The Correlation Risk and playing the game that’s in front of you…
Given that the US Dollar is the #1 factor we are talking about when we say Global Macro Correlation Risk (say it central planners -“who –ho-wns de Campaigner-in-Chief?”), let’s get a real-time price check on how that looks on our intermediate-term TREND duration (3 months or more):
- Crude Oil = -0.92
- Gold = 0.94
- Silver = -0.94
- Coffee = -0.84
- Pork Bellies = -0.92
- CRB Commodities Index = -0.87
I know, I know – The Bernank calls this commodity stuff that you put in your cars, stomachs, and teeth “transitory”…
How about the intermediate-term TREND inverse-correlations between the US Dollar Index and relatively larger matters like countries?
- USA (SP500) = -0.82
- Brazil = -0.88
- Mexico = -0.82
- Germany = -0.93
- Spain = 0.94
- Russia = -0.85
- China -0.85
- South Korea = -0.90
- Australia = -0.91
How about the obvious, the intermediate-term TREND inverse correlations between the USD spot price and the world’s currencies?
- Euro = -0.99 (not a typo)
- Swiss Franc = -0.96
- British Pounds = -0.95
- Chinese Yuan = -0.92
- Japanese Yen = -0.87
- Singapore Dollar = -0.96
- Aussi Dollar = -0.94
- Brazil’s Real = -0.92
- Canadian Dollar = -0.85
Really? Yes, President Obama – really. This Correlation Risk math checks out from Hawaii to Havana. We get it. Anyone gaming Geithner and The Bernank get it. The Chinese get it.
In the Peoples Bank of China’s Q1 Monetary Policy Statement last night (published on China’s website – not to be politically pandered to on 60 Minutes this Sunday or at a US Federal Reserve Presser), this is what the Chinese had to say about all of the aforementioned real-time prices:
“Stabilizing prices and managing inflation expectations are critical… given the loose monetary policies of major economies and gradual recovery of the global economy, commodity prices and global inflation expectations are rising significantly.”
“Significantly” versus “transitory.” Academic dogma versus independent analysis. Government storytelling versus Correlation Risk. It’s all out there folks. It always has been – and, sadly, when it comes to US policy, so has Hayek’s “Abandoned Road.”
My immediate-term support and resistance lines for Gold are now 1525 and 1565, respectively. For oil I’m at $109.39 and $114.21 – and for the SP500, my immediate-term support and resistance lines are now 1349 and 1373, respectively.
Best of luck out there today,
Keith R. McCullough
Chief Executive Officer
This note was originally published at 8am on April 29, 2011. INVESTOR and RISK MANAGER SUBSCRIBERS have access to the EARLY LOOK (published by 8am every trading day) and PORTFOLIO IDEAS in real-time.
“It’s choice not chance that determines your destiny.”
Interestingly this quote comes from a one-time overweight housewife with a self-confessed obsession for eating cookies—a woman who eventually kicked her weight and went on to start a peer group to support her overweight friends, which expanded and in 1963 was incorporated as the Weight Watchers organization.
The quote also seemed appropriate for it reminded me of the vaulted status of global central bankers and their choice (along with a committee vote) to act or not (in what sometimes seems like chance) to direct a country’s monetary policy, and therefore economic health. In the recent era, central bankers have attained a sort of rockstar status typically reserved for celebrities and athletes, and just this week Ben Bernanke joined the club of celebrated central bankers (notably the ECB’s Jean-Claude Trichet) with a live press conference following his policy announcement—trappings that must clearly enhance his “cult” status.
Yet, with today being the Royal wedding day, and with my role being European analyst on the Macro Team, we thought we’d give The Bernank a needed rest and focus on the actions across the pond at the Bank of England, namely the hefty choice that CB Governor Mervyn King faces with the UK stuck between stagnant growth as inflation accelerates.
In particular, we’d like to call out the strength of the British Pound versus the USD, in our opinion an out-of-consensus call that we’ve been long of via the etf FXB in the Hedgeye Virtual Portfolio since 3/23 due to the following positive factors:
- The BoE’s increasingly hawkish lean on inflation and evidence that suggests the positive currency impact of an interest rate hike (examples include ECB and Riksbank decisions)
- The announcement of austerity by the UK Government in the fall of last year to proactively cut public spending and boost revenue, versus the US’s passiveness in addressing its rising debt and deficits, a position that has perpetuating a weak USD versus most major currencies (US Dollar Index down for 14 of last 18 weeks)
- Bernanke’s commitment to keep rates near zero percent and his indication that some form of QE-lite will follow QE2’s expiration in June = continued USD weakness
- The flight to safety of Sterling as Eurozone debt contagion remains at large (also bullish for the CHF and SEK)
The Proof is in the Pudding
While the above points have been supportive of the GBP-USD trade to some degree this year, the prospect of high inflation with slow growth in the UK is the pressing threat facing policy makers. And while there are numerous ways to spin the headline data out of the island nation, in our mind it’s hard to argue against the inflation data, which has charged higher for the last 18-22 months. The current inflation readings include:
- Consumer Price Index (CPI) +4.0% in March Y/Y
- Producer Price Index (PPI) for Input +14.6% in March Y/Y
- PPI Output +5.4% in March Y/Y
While the BoE drew a sigh of relief with the March CPI number 40bps below the February reading, current levels are a full 2% higher than the BoE’s target, and 1.5-2.5% above European peers, as rising energy costs continue to fuel high readings this year.
While the BoE has maintained its 0.50% benchmark rate since March ‘09, the lowest level in over 300 years of the history of the BoE, we’re of the camp of Andrew Sentance, one of the nine voting members of the BoE’s Monetary Policy Committee, and affectionately known as the ueber inflation hawk due to his very vocal stance for an interest rate hike since June 2010. We’re now seeing in the last few BoE meetings that fellow members Spencer Dale and Martin Weale have joined ranks for a rate rise of 25bps, while Sentance has upped his rate hike call from 25bps to 50bps, leaving the committee a 6-3 vote against interest rate action, but marginally more hawkish.
Below are a few key drivers that Sentance notes to justify a rate hike, which he’s included in this speaking tours:
- The UK’s need to strengthen its currency with its trading partners, particularly against the EUR as the Eurozone accounts for about half of total exports and half of total imports.
- A stronger domestic currency will help to combat imported inflation. The renewed surge of energy and commodity prices only adds to the imported inflation driven by a weak Sterling versus the EUR since 2007.
- The squeeze on disposable income is already a factor holding back the growth of consumer spending in the short term.
- Ergo, a rate hike is essential to boost the Sterling versus the EUR and other major trading partners to mitigate inflation and therefore improve consumer spending.
Not so Fast – Austerity’s Bite and Growth Fears
While Sentance makes some very convincing points supportive of a rate hike, others remain convinced that excess capacity in the economy will slow/drive down prices and that a rate hike would only create a further shock to the consumer.
Rightfully, this camp also points out the negative impact of the government’s austerity program, which broadly calls public job cuts of ~500K and ~£81 Billion in public spending cuts over the next 4 years, and an increase in VAT (from 17.5% to 20%) that began in the beginning of this year. Their position is that weaker consumer and business surveys are indicative of the strain of public sector deleveraging and expectations for slower growth. Additionally, it is argued that the negative impact on the housing mortgage market from a rate hike—with the housing sector mired in an anemic state—would be an additional blow to the consumer’s wallet.
Boiling it Down
As we’ve said from the outset, there are any number of ways to interpret the data. Arguably the BoE and UK government are left in a tough spot, trying to head off inflation while not pinching growth prospects. For reference real annual GDP was +1.4% last year, with the final quarter of 2010 showing a -0.5% hit Q/Q, while 1Q2011 rebounded to +0.5% Q/Q.
While the jury is still out on whether or not Q1 can be a sustained inflection, our call is focused on the implication of the Pound versus the USD, in particular, but also the EUR. We continue to applaud PM David Cameron’s forceful strategy to reduce fiscal debt and deficits, which according to the UK statistical office were 59.6% of GDP in 2010 and 10.4%, respectively (see chart below). Notably, the chart of cumulative public sector net borrowing shows improvement across annual compares, an indication that austerity may, in fact, be working.
Further, compared to the US administration, Obama and Company are just now coming to terms with the budget ceiling debate and the great issue on shaving down the budget deficit that is expected to rise well over 10% next year, according to our calculations, with the US debt as a % of GDP expected to reach 96% this year and over 100% next.
On these metrics, we think the UK’s proactive attention to reduce fiscal imbalance, coupled with the increased likelihood of an interest rate rise, should boost the GBP versus the USD. Should we get a rate hike, it should help alleviate inflation pressures, which will improve consumer and business optimism and therefore encourage growth prospects over the intermediate to longer term. Given the likelihood that elevated input cost pressures are here (globally) to stay over at least the medium term, we think there’s prudence in a rate hike.
Increasingly we’re seeing the bifurcation in economic performance on the basis of policy decisions to cut fiscal imbalances and increase interest rates off historical lows. So long as the US continues to fuel its monetary policy of extend and pretend and promote the fiscal printing press, we’d expect the USD to suffer versus major currencies. Getting long the GBP-USD is but one way we’ve chosen to express this bifurcation.
Conclusion: Stagflation looks poised to accelerate in India alongside a reduction in the central bank’s credibility.
Position: We remain bearish on Indian equities and bearish on Indian rupee-denominated debt for the intermediate-term TREND. Bearish on the Indian rupee (INR) for the intermediate-term TREND (vs. SGD, CNY, GBP, EUR, and CAD).
Through a series of what we described along the way as “glaring monetary and fiscal policy missteps”, India has managed to accomplish what few countries are able to do in having us be outright bearish on all three of their major liquid asset classes. The laundry list of bad policy actions in India is both long and hard to defend to anyone who possesses a Global Macro process to interpret them in their entirety:
- Early 2010: Indian Prime Minister Manmohan Singh welcomes more potentially-destabilizing and inflationary capital inflows by increasing the overseas investment cap on Indian government and corporate bonds by +$5B and +$30B each;
- June 2010: Indian Government allows fuel prices to be market-determined for the first time since December 2003. At the time, India’s basket of crude oil was $74.3/bbl.;
- November 2010: The Reserve Bank of India (RBI) stepped up its daily lending to Indian banks, relaxed a ruling that requires them to invest in government bonds, and began holding additional money-market auctions and open-market purchases of government bonds (QE) to help increase liquidity in its “cash-strapped” banking system;
- November 2010: RBI goes on hold citing “transitory commodity inflation” and their overly-benign March 2011 WPI forecast of +5% YoY as a reason to delay further tightening (for reference, actual March 2011 WPI came in at +9% YoY and the central bank’s March 2011 WPI forecast was upwardly revised FOUR times to +8% YoY in the four months leading up the actual report);
- February 2011: Finance Minister Pranab Mukherjee unveils the FY12 budget, which is full of sales tax hikes and symbolic, but not meaningful, income tax deductions. In addition, the revenue projections are based on +9.25% YoY GDP growth, which is higher than the government’s official estimate of +8.6% YoY and the central bank’s estimate of +8%, which was revised down today from +8.6% YoY.
- March 2011: Indian Government increases fuel prices to reflect a basket of crude oil at $110.70/bbl.
The net result of these policy blunders is that inflation is up and to the right in India; for this reason, we remain bearish on rupee-denominated debt. Absent a very significant pullback in commodity prices (which would more than likely manifest itself across all risk assets due to the overwhelming US Dollar Correlation Risk Bernanke has imposed on global markets), we are likely to continue to see inflation in India make higher-highs over the intermediate-term TREND. After many months of resisting and trying to extend and pretend on inflation risk, the Reserve Bank of India finally capitulated, today admitting that inflation is anything but “transitory” in India:
“The inflation rate will remain close to the March 2011 level over the first half of 2011-12, before declining… These projections factor in an upward revision of petrol and diesel prices.”
-RBI Governor Duvuuri Subbarao
This defeated commentary was provided alongside India’s first +50bps hike of the current tightening cycle, after eight +25bps hikes since March of 2010. As we’ve called out in our recent work, their actions leading up to today’s accelerated rate hike have put them at risk of losing credibility; now that credibility is officially being eroded alongside the market cap of the SENSEX, which plunged (-2.4%) today and closed down (-9.6%) YTD as the worst performing major equity market globally. At one point, the BSE SENSEX 30 Index was down (-16.9%) from its cycle peak on November 5th to its February 2nd bottom. Indian equities remain broken from a TRADE & TREND perspective and we will look to re-short them on strength in the Virtual Portfolio.
Interestingly, the RBI did provide an update to their economic assessment with this latest rate hike and prepared remarks – an update that matches bearish Hedgeye estimates (at least directionally, that is). Accordingly, they affirmed our call that Growth Slows as Inflation Accelerates by rhetorically committing to tackling inflation and its associated expectations – even at the expense of growth:
“Current elevated rates of inflation pose significant risks to future growth. Bringing them down, therefore, even at the cost of some growth in the short-run, should take precedence.”
-RBI Governor Duvuuri Subbarao
As inflation ramps up in the coming months, we expect India’s consumption growth to deflate, its GDP Deflator to inflate, and the central bank to continue hiking interest rates in an aggressive manner, which would likely constrain credit expansion and industrial production growth in coming quarters as well. As such, we see an air pocket developing below India’s Manufacturing PMI, which is currently at a five-month high of 58.
Shifting gears a bit, as point of clarification, we typically don’t want to be short currencies that are aggressively tightening monetary policy, as India looks poised to do. We do, however, feel comfortable taking such risk given our out-of-consensus calls for: a) India to miss its fiscal deficit reduction target (likely by a wide margin); and b) Bernanke’s Indefinitely Dovish monetary policy to continue fueling cross-asset correlation risk, which would likely result in a broad-based de-risking of institutional portfolios in the event of a US Currency Crash. Historically, the Indian rupee has traded in lockstep with Indian equities, suggesting that the general appetite for risk has been the dominant factor driving the currency. The backdrop of slowing growth, accelerating inflation, and aggressive tightening of monetary policy do not support any incremental tolerance of risk towards Indian assets.
Make no mistake; The Trifecta is not something investors with exposure to India should take lightly given, given just how quickly international capital can drain from Indian assets. If we’ve learned anything from 2008, it’s that the “flows” works both ways, and when they turn, they can turn hard and fast. Keep in mind that the 2008-09 crash in Indian equity markets was aided by a (-$12.9B) outflow of international capital in 2008. Last year, Indian equities saw a +$29.4B inflow, which was followed by a +$919M inflow YTD. Them be a lot of redemptions potentially waiting to happen…
All told, we’ll be looking to express these ideas in our Virtual Portfolio in the coming weeks and recommend you do the same in yours.
Appendix: Within my coverage areas (Asia, Latin America, and Munis), Indian equities, rupee-denominated debt, and the Indian rupee itself remain three of my least favorite investment opportunities. Our Global Macro process allowed us to turn appropriately bearish on them in early November, and the same process continues to flag further downside in all three areas. With a major sell-side institution coming out today as incrementally bearish on Indian growth and incrementally bullish on Indian inflation, the question becomes, “Is this all priced in?” Our answer is a resounding “NO”; the street is not yet Bearish Enough on India. The reports below will detail why (email us for copies):
India’s Two Big Problems (11/9/10): We expect inflation to continue to be a major headwind for the Indian economy and we see further tightening on the horizon. In addition, the potential for destabilizing withdrawals of foreign investment has breached its 2007 highs, which suggest Indian equities could experience major declines should global markets come under pressure.
India’s Two Factor Squeeze (1/6/11): We remain cautious on Indian equities as growth looks to slow due to a cash shortage and additional monetary policy tightening on the horizon. Further, we see inflation as a much larger headwind in India than we feel is currently priced into its equity market.
Top Emerging Market Short Ideas: Indian Equities (1/26/11): If you agree with our October call that EM assets will come under pressure and remain that way over the intermediate-term TREND, then you’re likely looking for short ideas. If so, we think Indian equities are among the top short ideas in this space, supported by the fundamental backdrop of slowing growth, accelerating inflation and interconnected risk compounding.
Falling Like a BRICk: Is India the Next Egypt?: (2/3/11): Inflation in India continues to come in hot, increasing the likelihood of Egyptian-style social unrest in the world’s second-largest country (population). Moreover, slowing growth, accelerating inflation, tighter monetary policy, and an erosion of financial liquidity continues to make Indian equities one of our top short ideas.
The “Flows” Are Reversing For India Equities (2/15/11): Slowing growth and accelerating inflation indeed have interconnected risk compounding in India as the “flows” are currently working against its equity market(s).
India: Missing Where It Matters Most (2/28/11): Finance Minister Mukherjee’s budget failed to adequately address the #1 issue facing the Indian economy – inflation. As a result, our bearish stance on Indian equities continues unabated. Further, we don’t see India meeting its FY12 deficit reduction target as a likely outcome.
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