SP500 vs Tips and Inflation

The Chart shows S&P versis 10y Tips zero rate and the breakeven inflation implied. The risk premium according to TIPS decline with S&P in 2001-2003. Since 2003, S&P rally, breakeven inflation jumped from average 1.5-2.5% to 2.5-3% while the risk premium staying low. Even though the nominal rates has increased with this rally in Equities, the risk premium has only just picked up. This might hurt the stock market.

Something is quietly moving up!

One way street for CNY

Gold Stocks vs S&P (1995-2006)

10yr Note and Nikkei

Japanese Equity looks strong.

NKY(above) testing the resistance but TOPIX(below) has clearly broken it.

Long term 5year note maybe breaking the down trend

CRB vs 10yr Note

Middle East & Oil

Just been reading an interesting piece from Citibank's Robert Crossley on "How important for oil prices is the potential fallout from Iran?". Let's put down a few facts which Robert has put together in his piece:

32% of oil supply is from Saudi Arabia,
13% from Iran,
9% from UAE,
8% from Kuwait,
8% from Nigeria,
7% from Venezuela
and 6% from Iraq (IEA Nov 2005).

First of all, if we add the politicially unstable countries supply together, that's 34% of the world supply. The high concentration of risky oil supply is a concern. Secondly, Iran alone is producing around twice as much as the OPEC (ex-Iran) spare capacity. So for whatever reasons more countries are coming offline, the residual spare capacity will be even less. In either case, we dont have enough spare capacity to absorb oil shock. Thirdly, Iran seems to be getting ready for EU sanaction by moving money out of their European banks (http://www.chicagotribune.com/news/nationworld/chi-0601210051jan21,1,4743815.story?coll=chi-newsnationworld-hed&ctrack=1&cset=true). Maybe they are trying to create more tension and push the oil price up. Since Japanese and Chinese are large importers of Iranian oil, I guess that Iran will always have buyers for their oil. So, economically, Iran benefits from creating short term chaos.

We all know that there is not enough refiners out there in the US. Without excess capacity downstream, I think that it will be very hard for oil refiners to absorb upstream price increase. Of course, a spike can come and go. But if iran were to remove themselves from the supply list, the oi price increase can be semi-permeanent (months rather than weeks). Producer price inflation will be a direct result. The question on CPI is still unclear since the US productivity increase has been unbelivable.

The trade is still to go long oil to hedge middle east specific risk. With more and more of these potential oil supply disruption, China maybe using its fx reserve to buy oil sources. They have already tried to bid companies through CNOOC.

We need to think about the Petro money. They are probably the only nation not buying more oil with their money. So if they gain billions of US dollar a day from oil trades, how will they spend it? The Russians, Chinese, Arabs.... the huge amount liquidity they hold, perhaps they will end up buying everything they need? I doubt the Russians and Arabs will invest in alternative energy, but the Chinese may.

BCA has a short piece on oil and equity market:
http://www.bcaresearch.com/public/story.asp?pre=PRE-20060119.GIF

Good luck in 2006 Investing!

Don't think - Just follow the money

It may sound strange in the financial world saying to smart people not to think. In fact people working in the Wall Street pride themselves in having higher IQ than the rest. However, I think that we are better off not thinking this year.

For the past year and so far this year, we are faced with a strong equity market (especially in merging market and Europe), continual commodity bull run (indisutrial metals), gold breaking out multi year highs, low+lower yield, weak US dollar against Asian and Latin currencies, good run in the Nikkei and yield curve flattening...

If one were to try to put everything together in a normal macroeconomic framework, it does not make great sense. For example, is commodity rise leading to inflation, if so why is bond yield lowering. If bonds are correct, then is the economy expected to have even more productivity gain in absorbing the rise in commodity prices. Then if there is little final goods inflation worry, can consumers continue to leverage up and support retail sales which lead to strong equity market. Is gold running away for the heck of it or are the gold bugs right?

As you can see: Where the world is now? Perhaps there is not a perfect financial model that can explain everything.

So how about looking from this angle:

I think that there is just simply too much money around. Let's see where the money are:

1. Central Banks (especially Asian) are awashed with liquidity from currency intervention. Although the rate of build up has slow (apart from China), they are still having to manage a big fx reserve.
2. Petro nations are earning billions of dollar every day with oil price up here.
3. Pension funds are still one of the larger pool of money around.
4. ... maybe I am missing a few big players too.

So let's think what they are going to do with their money. Central bankers will continue to buy Government bonds since they cannot take the credit risk of practically anything else. However some governments are loosening up the limits to buy real assets such as oil or mines. This will support commodity run and buffer the effect of a potential slowdown in global growth. As for the petro money, their local markets are too small for them (Middle East stock market has a huge run already). So they will look for returns in their US Dollar. They will continue to buy and to diversify from US dollar. They will buy anything with potential to generate returns higher than 10y note. Chasing equity, commodities, credit...etc Pension funds is finding it harder and harder to achieve benchmark without taking more risk.

At the fault of global central bankers, the world is full paper money. The liquidity is chasing for asset return which in terms leads to lower volatility which also keep the "asset inflation" gravy train running. Yes, there may be different assets in vogue during different times, but overall, gravy train will still be around for now.

Therefore "don't think, just follow the money".*** while it is still worth something.

Welcome 2006

2006 opens with a huge fanfare with people chasing stocks and commodity while bonds remain subdue without signs of inflation. Is Gold forecasting future inflation or the present CPI saying that there is enough slack in the market to absorb rise in underlying commodity prices. I think that companies in the US will try to keep final goods inflation as low as possible in order to attract consumers while eating the cost in raw materials. Yes, they can do it by increasing productivity and reducing wage inflations. However, there is only so much that they can do. Sooner or later, they will have to let the price goes. The two extreme examples are: oil companies hikes prices when WTI rises, whereas walmart keeps prices stable when everything is going up. remember starbucks passes the cost of coffee increases to you too.

This is my thought of portfolio allocation:

big theme: growth in EM, revaluation of japanese stocks due to end of deflation and reforms, increase commodity use with tight supplies (oil refineries, precious metals, clean water)

Long Russia (controls european energy)
Long Asian stocks (cheap PE for the growth, but more momentum for now)
Long Japanese stocks (see above)
Short Japanese bonds (reflation)
Long Energy/ Oil (if there is growth in EM, they only like to use oil for now)
Long Precious Metals (tight supply, but big sharp runs, seems like the run of oil from 55 to 70, i think that Central banks are behind gold move)
Long Water/Agricutural (Major water problems around the world)
Long Tech (where else can large corporate achieve higher productivities, they have tons of cash)
Long Canada (seems like Chinese like to buy things from there)
Short large cap US (where can they go, they are more like bonds now)
Long Chinese stocks (seem cheap vs the rest of asian stocks and Japanese Life insurance got mandate to buy this year)

Given a lot of these have ran up in 2005 and past week in 2006, I would suggest running a 40%-60% equity/cash position. I just think that there has to be some sort of consolidation or pullback before buying. However, given the level of Chinese stocks versus the rest of Asia or EM, it might be wise to add some here.

So what do you want to do now?

Let's put together some thoughts:

1. If China revalues its currency, there will be less Treasury bond purchases, more of a deficit issue and hence USD being worse off. China will not revalue if hard landing occurs before any further change in capital control or foreign exchange policies.
2. Fed is unlikely to hike aggressively even though US growth is building strength and inflation may be creeping through. However inflation is mainly due to demand driven commodity price rally. This consumer demand in US has been largely been supported by the mighty housing market. Hence Fed would not want to derail this consumer welfare. If they hike too fast, a possible shock to the system can lead to housing bubble burst and subsequent recession and deflation.
3. The housing bubble has two exit plans: bubble can burst or leak. While an aggressive Fed can lead to the prior case, a more "measured" Fed lead to the latter case. Just look at UK, the booming housing market reacted a series of measure rate hike. Gradually, the marginal buyers and first time buyers are priced out of the market. Rental lodgers are in vogue and investors began to hit bids. It all happened in a normal, non-chaotic fashion. So all I am saying is that US can too experience a normalization of the housing market without undergoing a bubble bursting experience.

Trades:

We believe that USD remains in its long term bear trend. Carry unwind will simply allow entry of short USD at a better level since the effect of Chinese revaluation will push DXY to new lows. Furthermore, Asian currency will benefit most while EUR remains the de-facto benefactor of this currency movement. A basket of currencies will be a good way to set up this trade. In addition to buying EUR and JPY, we also like 1. Gold for its flight to quality and inflation hedge qualities, 2. AUD for the country's rich resource, relatively politically independent and commodity linked economy.

For now, we like to trade range for US 10y note: 4.30- 4.70%. With this economic backdrop, S&P looks overvalued versus dollar, bonds and oil price.