January 2016 – The Aleph Blog

Cheapness versus Economic Cyclicality

Posted on 30 January 201631 January 2016 by David Merkel

Photo Credit: Paul Saad || What’s more cyclical than a mine in South Africa?

This is the first of a series of related posts. ?I took a one month break from blogging because of business challenges. ?As this series progresses, I will divulge a little more about that.

When I look at stocks at present, I don’t find a lot that is cheap outside of the stocks of companies that will do well if the global economy starts growing more quickly?in nominal terms. ?As it is, those companies have been taken through the shredder, and trade near their 52-week lows, if not their decade lows.

Unless an industry can be done away with in entire, some of the stocks an economically sensitive industry will survive and even soar on the other side of the economic cycle. ?At least, that was my experience in 2003, but you have to own the companies with balance sheets that are strong enough to survive the through of the cycle. ?(In some cases, you might need to own the debt, and not the common equity.)

The hard question is when the cycle will turn. ?My guess is that government policy will have little to do with the turn, because the various developed countries are doing nothing to clear away the abundance of debt, which lowers the marginal productivity of capital. ?Monetary policy seems to be pursuing a closed loop where little?incremental lending gets to lower quality borrowers, and a lot goes to governments.

But economies are greater than the governments that try to milk them. ?There is a growing middle class around the world, and along with that, a growing need for food, energy, and basic consumer goods. ?That is the long run, absent war, plague, resurgent socialism, etc.

To give an example of how markets can decouple from government policy, consider the corporate bond market, and lending options for consumers. ?The Fed can keep the Fed funds rate low, but aside from the strongest?borrowers, the yields that lesser borrowers?borrow at are high, and reflect the intrinsic risk of loss, not the temporary provision of cheap capital to banks and other strong borrowers.

It’s more difficult to sort through when accumulated organic demand will eventually well up and drive industries that are more economically sensitive. ?Over-indebted governments can not and will not be the driver here. ?(Maybe monetary policy like the 1970s could do it… what a thought.)

So, what to do when the economic outlook for a wide number of industries that look seemingly cheap are poor? ?My answer is buy one of the strongest names in each industry, and then focus the rest of the portfolio on industries with better current prospects that are relatively cheap.

Anyway, this is the first of a few articles on this topic. ?My next one should be on industry valuation and price momentum. ?Fasten your seatbelts and don your peril-sensitive sunglasses. ?It will be an ugly trip.

On Currencies That Are A Store Of Value, But Maybe Not For Long

Posted on 28 January 2016 by David Merkel

I get letters from all over the world. ?Here is a recent one:

Respected Sir,

Greetings of the day!

I read your blog religiously and have gained quite a lot of practical insights in financial field. Your book reviews are very helpful and impartial.

I request you to write blog post on dollar pegs in Middle East and under what conditions those dollar pegs would fall.

If in case you cannot write about it, kindly point me to some material which can be helpful to me.

Thanks for your valuable time.

Now occasionally, some people write me and tell me that I am outside my circle of competence. ?In this case I will admit I am at the edge of that circle. ?But maybe I can say a few useful things.

Many countries like pegging their currency to the US dollar because it provides stability for business relationships as businesses in their country trade with the US, or, with other countries that peg their US dollar, or, run a dirty peg of a controlled devaluation. ?Let me call that informal group of countries the US dollar bloc. [USDB]

The problem comes when the country trading in?the USDB begins to import a lot more than they export, and in the process, they either liquidate US dollar-denominated assets or create?US dollar-denominated liabilities in order to fund the difference.

Now, that’s not a problem for the US — we get a pseudo-free pass in exporting claims on the US dollar. ?The only potential cost is possible future inflation. But, it is a problem for other countries that try to do so, because they can’t manufacture those claims out of thin air as the US Treasury does.

Now in the Middle East it used to be easy for many countries there because of all the crude oil they produced. ?Crude oil goes out, goods and US dollar claims come in. ?Now it is reversed, as the price of crude is so low. ?Might this have an effect on the currencies of the Middle East. ?Well, first let’s look at some currencies that float that are heavily influenced by crude oil and other commodities: Australia, Canada, and Norway:

As oil and commodities have?traded off so have these currencies. ?That means for pegged currencies the same stress exists. ?But with a pegged currency, if adjustments happen, they are rather large violent surprises. ?Remember the old saying, “He lied like a finance minister on the eve of the devaluation,” or Monty Python, “No one expects the Spanish Inquisition!”

That’s not saying that any currency peg will break imminently. ?It will happen later for those countries with large reserves of hard currency assets, especially the dollar. ?It will happen later for those countries that don’t have to draw on those reserves so rapidly.

Thus my advice is threefold:

Watch hard currency reserve levels and project future levels.
Listen to the rating agencies as they downgrade the foreign currency sovereign credit ratings of countries. ?When the ratings get lowered and there is no sign that there will be any change in government policy, watch out.
Watch the behavior of wealthy and connected individuals. ?Are they moving their assets out of the country and into hard currency assets? ?They always do some of this, but are they doing more of it — is it accelerating?

Point 3 is an important one, and is one seemingly driving currency weakness in China at present. ?US Dollar assets may come in due to an excess of exports over imports, but they are going out as wealthy people look to preserve their wealth.

On point 2, the rating agencies are competent, but read their writeups more than the ratings. ?They do their truth-telling in the verbiage even when they delay downgrades longer than they ought to.

Point 1 is the most objective, but governments will put off adjustments as long as they can — which makes the eventual adjustment larger and more painful for those who are not connected. ?Sadly, it is the middle class and poor that get hit the worst on these things as the price of imported staple goods rise while the assets of the wealthy are protected.

And thus my basic advice is this: gradually diversify your assets into ones that will not be harmed by a devaluation. ?This is one where your government will not look out for your well-being, so you have to do it yourself.

As a final note, when I wrote this piece on a similar topic, the country in question did a huge devaluation shortly after it was written. ?Be careful.

Redacted Version of the January 2016 FOMC Statement

Posted on 27 January 2016 by David Merkel

Comments

Policy stalls, as their view of the economy catches up with reality.
The changes for the FOMC is that labor indicators are stronger, and GDP weaker.
Equities fall and bonds rise. Commodity prices rise and the dollar falls.? Maybe some expected a bigger move.
The FOMC says that any future change to policy is contingent on almost everything.
The key variables on Fed Policy are capacity utilization, labor market indicators, inflation trends, and inflation expectations. As a result, the FOMC ain?t moving rates up much, absent much higher inflation, or a US Dollar crisis.

December 2015	January 2016	Comments
Information received since the Federal Open Market Committee met in October suggests that economic activity has been expanding at a moderate pace.	Information received since the Federal Open Market Committee met in December suggests that labor market conditions improved further even as economic growth slowed late last year.	Shades up labor conditions.? Shades down economic growth.
Household spending and business fixed investment have been increasing at solid rates in recent months, and the housing sector has improved further; however, net exports have been soft.	Household spending and business fixed investment have been increasing at moderate rates in recent months, and the housing sector has improved further; however, net exports have been soft and inventory investment slowed.	Shades household spending down.
A range of recent labor market indicators, including ongoing job gains and declining unemployment, shows further improvement and confirms that underutilization of labor resources has diminished appreciably since early this year.	A range of recent labor market indicators, including strong job gains, points to some additional decline in underutilization of labor resources.	Shades labor employment up.
Inflation has continued to run below the Committee’s 2 percent longer-run objective, partly reflecting declines in energy prices and in prices of non-energy imports.	Inflation has continued to run below the Committee’s 2 percent longer-run objective, partly reflecting declines in energy prices and in prices of non-energy imports.	No change.
Market-based measures of inflation compensation remain low; some survey-based measures of longer-term inflation expectations have edged down.	Market-based measures of inflation compensation declined further; survey-based measures of longer-term inflation expectations are little changed, on balance, in recent months.	Shades current and forward inflation down.? TIPS are showing lower inflation expectations since the last meeting. 5y forward 5y inflation implied from TIPS is near 1.53%, down 0.18% from September.
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.	Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.	No change. Any time they mention the ?statutory mandate,? it is to excuse bad policy.
The Committee currently expects that, with gradual adjustments in the stance of monetary policy, economic activity will continue to expand at a moderate pace and labor market indicators will continue to strengthen.	The Committee currently expects that, with gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace and labor market indicators will continue to strengthen.	Shifts language to reflect moving from easing to tightening.
Overall, taking into account domestic and international developments, the Committee sees the risks to the outlook for both economic activity and the labor market as balanced.		Sentence dropped.
Inflation is expected to rise to 2 percent over the medium term as the transitory effects of declines in energy and import prices dissipate and the labor market strengthens further.	Inflation is expected to remain low in the near term, in part because of the further declines in energy prices, but to rise to 2 percent over the medium term as the transitory effects of declines in energy and import prices dissipate and the labor market strengthens further.	CPI is at +0.7% now, yoy. Shades inflation down in the short run due to energy prices.
The Committee continues to monitor inflation developments closely.	The Committee is closely monitoring global economic and financial developments and is assessing their implications for the labor market and inflation, and for the balance of risks to the outlook.	Says that they watch every economic indicator only for their likely impact on labor employment and inflation.
The Committee judges that there has been considerable improvement in labor market conditions this year, and it is reasonably confident that inflation will rise, over the medium term, to its 2 percent objective.		Dropped sentence.
Given the economic outlook, and recognizing the time it takes for policy actions to affect future economic outcomes, the Committee decided to raise the target range for the federal funds rate to 1/4 to 1/2 percent.	Given the economic outlook, the Committee decided to maintain the target range for the federal funds rate at 1/4 to 1/2 percent.	No real change.
The stance of monetary policy remains accommodative after this increase, thereby supporting further improvement in labor market conditions and a return to 2 percent inflation.	The stance of monetary policy remains accommodative, thereby supporting further improvement in labor market conditions and a return to 2 percent inflation.	No real change.? They don?t get that policy direction, not position, is what makes policy accommodative or restrictive.
In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation.	In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation.	No change.
This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.	This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.	No change.? Gives the FOMC flexibility in decision-making, because they really don?t know what matters, and whether they can truly do anything with monetary policy.
In light of the current shortfall of inflation from 2 percent, the Committee will carefully monitor actual and expected progress toward its inflation goal. The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.	In light of the current shortfall of inflation from 2 percent, the Committee will carefully monitor actual and expected progress toward its inflation goal. The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.	No change.? Says that they will go slowly, and react to new data.? Big surprises, those.
The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction, and it anticipates doing so until normalization of the level of the federal funds rate is well under way. This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.	The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction, and it anticipates doing so until normalization of the level of the federal funds rate is well under way. This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.	Says it will keep reinvesting maturing proceeds of agency debt and MBS, which blunts any tightening.
Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Charles L. Evans; Stanley Fischer; Jeffrey M. Lacker; Dennis P. Lockhart; Jerome H. Powell; Daniel K. Tarullo; and John C. Williams.	Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; James Bullard; Stanley Fischer; Esther L. George; Loretta J. Mester; Jerome H. Powell; Eric Rosengren; and Daniel K. Tarullo.	Changing of the guard of regional Fed Presidents, making them ever so slightly more hawkish, and having no effect on policy.