The US recovery has proved solid in 2010 and while about 15% of US export demand originates in the euro zone, and the sharp dollar rally this year clearly will pressure volume growth, the euro panic has pushed the 10 year Treasury yield back to December levels, just as it seemed poised to break 4%, which is very supportive of a fragile housing market recovery while the $14 slump in crude prices is equally supportive of consumer spending. Nonfarm payrolls increased 290,000 in April, after a revised gain of 230,000 in the prior month. In the first four months of the year, a total of 573,000 jobs have been created of which 483,000 jobs were in the private sector. Census recruitment accounted for an increase of 66,000 temporary jobs in the federal government during April and BLS birth/death adjustments muddy the picture slightly, but four consecutive months of private nonfarm payroll gains with each successive month showing larger gains suggest that this is a sustainable economic recovery. Last week’s events strengthen the hand of Fed doves, at least for the moment, so the ‘Goldilocks’ story may get an extra chapter. The US unemployment rate rose to 9.9% in April as discouraged workers started looking for work again.
Overall the macro picture is supportive for risk assets, but China remains a key risk factor. Property prices in 70 of China's large and medium-sized cities rose 12.8% in April from a year earlier, according to the National Bureau of Statistics, the biggest increase since China started issuing the data in July 2005, and higher than March's 11.7% rise. April was the 11th consecutive month in which urban property prices have increased from a year earlier, though the latest survey of prices predated some of the government's recent measures to cool the market, including mortgage restrictions and curbs on purchases of second and subsequent homes. In many Chinese cities, 30% of property buyers are short-term speculators. According to the government's 2010 budget, land sale revenues will only account for 20% of central and local government revenues, not enough to restrain drastic policy action to restrain the rampant property market. A major reversal for the housing market of say 15-20% through H1 2011 would have huge ramifications for China's banking sector. Over the past five years, housing sales reached 12 trillion yuan, about 3 trillion yuan of which came from bank loans. Excess liquidity from the 2009 stimulus created rapid inflows directly to the property market, exacerbating a structural and cultural distortion that makes hoarding empty luxury apartments a rational activity. Failure to take effective action now will only produce a larger bubble and growing social discontent that threatens political stability. European sovereign debt isn't the biggest global risk right now, but rather a hard landing for Chinese real estate with particularly negative implications for industrial commodities and related stocks and currencies.
Consumer borrowing fell at a 5.6% annual rate in February to $2.45 trillion according to the latest Fed statistics. Consumer borrowing (which includes most loans outside of real estate) had increased 2.1% in January, reflecting how borrowers typically slow payments after running up card balances over the December holidays. Consumer credit has fallen in 12 of the last 13 months and consumer credit outstanding has slumped by $134bn since peaking in July 2008 as household wealth collapsed after credit and asset bubbles popped. However, as the charts indicate, the debt to income ratio has only declined to 22%, still a historically very high level. A $5.6 billion upward revision to January, to plus $10.6 billion, takes the sting out of February's contraction as do preliminary indications for strong retail sales in March.
In fact, far from a conscious decision to deleverage, it seems from recent retailer newsflow that US consumers were simply trapped at home by snowdrifts in February, and as soon as the thaw came they rushed down to their local mall to swipe some plastic. The latest data on US consumer spending and incomes highlight the absence of any real return to sanity; equity withdrawal from housing has been replaced by government transfers as a supplement to stagnant earned incomes. Personal spending rose 0.3% in nominal dollars in February over the prior month, in-line with expectations, while personal income was flat. Not surprisingly, the personal savings rate fell to 3.1%, levels not seen since late 2008.
I came across a new piece of research looking at hedge fund returns in 2008 during the market meltdown; the authors from Seton Hall University and the TIAA-CREF pension fund concluded that: “Combining the high attribution rate of hedge funds during the recent financial crisis and this hidden survivorship bias, we believe that the reported HF return data led to an overstatement of their performance and consequently an understatement of investor losses.” According to the hedge fund indices, the average fund outperformed a long-only institution by 20% in 2008, but according to this rigorous analysis they failed on average to deliver positive risk-adjusted returns and over the long-term, the effect of leaving out the performance of funds in the last 12 months of their existence (by definition abysmal) was hugely flattering to industry statistics.
This research confirms my suspicions; back in August 2008 in 'The Hedge Fund Hustle' I wrote that 'Both in the initial bear market sell-off last year, and in the recent commodity/financials reversal it has become clear from the correlation of hedge fund performance statistics that most are shamelessly momentum trading, and dangerously exacerbating market volatility in doing so. As hedge funds have proliferated in recent years, investors paying for Alpha are often getting turbocharged Beta; there are only so many smart, gutsy traders to go around. Every year there will inevitably be traders that make a big bet on some idea which proves to be inspired, but long term median risk adjusted returns have been strikingly mediocre in absolute terms and certainly don't justify the extortionate fees.'
Growing investor concerns regarding the sustainability of fiscal deficits across the developed world are even more justified when the impact of demographic decline, both in terms of exploding unfunded social and healthcare costs, and in depressing trend GDP growth, is taken into account. Europe, Canada, the United States, Japan, South Korea, and even China are aging at unprecedented rates. Today, the proportion of people aged 60 or older in China and South Korea is 12-15%. It is 15-22% in the European Union, Canada, and the United States and 30% in Japan. With life expectancy increasing (and typically a 65 year old can today expect to enjoy almost 20 years of retirement in Europe, the US and Japan), these numbers will increase dramatically. In 2050, approximately 30% of Americans, Canadians, Chinese, and Europeans will be over 60, as will more than 40% of Japanese and South Koreans.
Industrialized countries are experiencing a drop in their working-age populations that is even more severe than the overall slowdown in their population growth. South Korea represents the most extreme example. Even as its total population is projected to decline by almost 9 percent by 2050 (from 48.3 million to 44.1 million), the population of working-age South Koreans is expected to drop by 36 percent (from 32.9 million to 21.1 million), and the number of South Koreans aged 60 and older will increase by almost 150 percent (from 7.3 million to 18 million). By 2050, in other words, the entire working-age population will barely exceed the 60-and-older population. Although South Korea's case is extreme, it represents an increasingly common fate for developed countries. In 2002, the US population was adding ten people of working age for every single new potential retiree (those aged over 65). By 2023, there will be 10 retirees for each new working age person.
Old Age Dependency Ratios – OECD
(Ratio of Retired to Working Age Population)
China has been suffering inflationary pressure from loose US monetary policy via the pegged exchange rate, and the country is now taking the steps I've been predicting to tighten domestic policy such as hiking the bank reserve ratio and restricting capital raising in the sectors with the greatest overinvestment, such as cement. As of yet, interest rates haven't been raised, as has been the case across the region from Australia to India. The problem is that if China raises rates well in advance of the US, it risks attracting further ‘hot money’ capital inflows, exacerbating the asset price risks. One answer is to revalue the RMB substantially and the issue is whether it takes the form of a gradual or one-off appreciation; circumstances increasingly suggest the latter.
A rise in imported commodity prices in 2010, particularly of food, will likely force the issue (see inflation chart below). Chinese M1 money supply growth was growing at 35% y/y at the end of 2009, but has turned negative in January; it's the single most important driver of CPI inflation, boosting prices with a lag of six to nine months, and has exceeded broader M2 since mid 2009. Proxy measures of inflation expectations, such as the difference between demand and time deposits, look to be rising as local asset prices have boomed. Acceleration in Chinese CPI inflation to around 5% by mid-2010 is likely and 6-7% by year-end if excess liquidity hasn’t been drained by then. While tightening moves, in addition to current administrative measures limiting credit growth/investment, will probably take the form of further rises in reserve requirements and interest rate hike, an attractive alternative means of curtailing the nascent asset bubbles and at the same time rebalance the economy, is to revalue.
My expectation in recent months has been that economic strength, not the much expected weakness, would be the problem for investors in 2010 insofar as it meant a faster monetary tightening cycle and ebbing liquidity across markets. In particular, I've been predicting an aggressive reversal of Chinese policy, as credit growth at over 30% of GDP last year was clearly unsustainable. The Chinese recovery is now pretty clearly a 'V' with Q4 GDP just reported rising 10.7% y/y, and inflation is suddenly a real issue for the first time since Summer 2008, when it almost hit double digits. Food price inflation in China is now 5.3% y/y and as food accounts for over a third of rural household budgets, the PBoC will be under political pressure to restrain the liquidity surge unleashed in 2009. Secular demographic trends are already pushing up nominal wage inflation across the coastal regions to levels not seen in 24 mths, as companies compete for a limited supply of female school-leavers in particular. This combination of a front-loaded cyclical recovery worldwide (and I'd expect an imminent IMF forecast upgrade) with rising inflationary pressures and ultra-loose policy falling behind the economic curve, is a potentiall toxic mixture for investors.
Sentiment towards equities globally is certainly extended on every institutional survey. Emerging markets (particularly Brazil) are too popular, and strong EM balance sheets and earnings outlook are in the price. Fast building inflationary pressures, the unsustainable path of monetary policy that is set to reverse, and a heavy schedule of new equity supply will all weight on the asset class. Emerging markets ceased outperforming last Autumn, but are still every strategist's favorite asset class. As I said a few weeks back, I'm expecting developed world stocks (and quality in general) to outperform this year.
Aggregate US oil inventory rose by 8.9m barrels last week, amongst the largest weekly aggregate increases ever. Gasoline stocks are now at levels not seen in two years, some 10m barrels higher than they were last year. Until now the product overhang has mostly focused on distillates which made sense since they’re a key feedstock for industry, and demand has slumped because of the US recession. Gasoline demand by comparison had remained stable, but not any longer. Crude refined in the US through November and December averaged 637m barrels or 4.4% below a year earlier on DOE data. In total, upwards of 1.7m b/d of demand for crude oil disappeared in Q4 2009 because refiners could not pass on the cost of crude oil to consumers in Europe and North America and had to mothball plants. Meantime, there is no more space for crude to move into the Strategic Reserve (remember George Bush frantically filling those SPR tanks at $130 in mid 2008?) The SPR is out of the market and the implications are bearish of crude as long as OECD demand remains depressed (and those full tanks should also cushion any Iran related price spike).
Chevron's recent profit warning was instructive on the scale of the crisis in the downstream oil business. The second largest US oil company could not make money refining oil averaging $70. If Chevron can't pass on the cost of $70 oil to struggling US consumers via profitable crack spreads, then why do Goldman Sachs think that a $90 average this year is rational? Their bull case is based on emerging market demand, but a significant portion of China's record 5m b/d December imports will be re-exported in Q1 as refined products, but to whom exactly? Over the next 6 months, either crude oil has to correct back towards $60 or US average gasoline prices have to surge well over $3 (from a current $2.75) assuming crude oil stays around current levels. If crude oil heads to $90 or beyond, gasoline has to rise pro-rata. Is that credible with an unprecedented supply glut? Speculators currently own more than twice the storage capacity at the NYMEX Cushing delivery hub for WTI crude. What are they going to do with all this oil, which at some point needs to be physically delivered?
A major investment theme in 2010 will be growing tightness in agriculture and soft commodity markets as secular demand growth driven by rising per-capita incomes and Westernizing diets in Asian markets meets relatively inelastic global supply. Globally, grain consumption was estimated to have increased 1.7% in 2009 despite the economic shock, according to the U.S. Department of Agriculture. In many ways, food looks like energy a few years ago, with a widespread assumption that after a prolonged period of real annual price declines we can look forward to sustaining this trend. However, just as with oil, those decades of low and negative returns have led to chronic underinvestment in everything from seed research to supply infrastructure. The rapidly aging profile of the current generation of farmers in the US and Europe is another factor likely to detrimentally affect medium-term productivity. A rebound in global growth to the 3-4% range in 2010 will likely result in substantial price increases unless growing conditions prove exceptionally benign.
The Goldman Sachs Agricultural Commodity Index has lagged the wider commodity rally in 2009, despite record highs in several markets from sugar to cocoa. Food consumption is generally less sensitive to economic conditions than energy and metals, but a series of abnormal weather events around the world upended supply and demand fundamentals for corn, soybeans and sugar. An unusually late planting season in the U.S. due to excess rainfall led corn prices to rally more than 30% in the spring; a serious drought in South America curtailed soybean plantings and yields and sent soybeans prices soaring 50% in the first half. Prices came down through the summer as weather patterns normalized and eased supply worries. Overall, there is far more sensitivity to weather factors than a few years ago, making the agricultural commodities particularly volatile. While corn prices edged up just 2% in 2009, and wheat was down 11%, sugar prices soared to a 28 year high (up 129%) and cocoa at a 30 year high (up 23%) on supply disruptions in India, Brazil and West Africa, combined with tight global inventories. Livestock prices suffered losses as cost-conscious US consumers ate less meat. In the U.S., average red-meat and poultry consumption was estimated to have decreased by 2.6% to 210.6 pounds per person in 2009, according to the USDA. As a result, prices for lean hogs and live cattle rose by 8% and 2%, respectively, last year and that's likely to accelerate this year as the livestock herd has shrunk to a 3 year low.
