Deflationary Forces 9/29/11

9/29/11

Deflationary pressures are taking hold right now as stocks, commodities, and most other asset classes save but bonds have been sold off given the three looming problems: 1) European debt crisis 2) China's attempt to halt inflation has also hit the global growth story... just look at the breakdown in copper and other industrial commodities. 3) US remains in stagnation with Bernanke temporarily unable to conduct further monetary easing beyond this underwhelming operation twist; the gridlocked congress is unwilling to provide further fiscal stimulus ahead of the '12 elections. Thus most risk assets are stuck in this fear-gripped bear market - traders are selling into rallies, bearish sentiment / cost of insurance continue to climb, spreads for riskier debt lower in seniority blowing out, the pension & insurance community forced to invest further out on the yield curve in an attempt to scrape up a bit more yield, the time value of money is being driven to zero while the overlevered/overindebted like the PIIGS in Europe are shitting their pants.

Stocks - it goes without saying that it has not been a good environment for equities. If this was only about European debt woes and US stagnation, emerging market and resource sector stocks will have held up better, but throw on top of that the sharp contraction in global trade => the result has been a very ugly two month period that has yielded double digit percentage losses for these markets. Although volatility in the months ahead may yield even better entry points for these markets (particularly if the shoe drops in Europe), I think if one takes a longer term horizon to investing (>3 yrs), chances are good that gradual rebalancing from cash into the stocks of growth countries such as Brazil, Russia, Turkey, South Eastern Asian countries (thailand / indonesia / S Korea) is a good bet. Very few investors will be able to call the exact bottom on this leg down but some very astute macro investors with great track records are now taking notice of these opportunities and predicting a cycle of easing  interest rates to alleviate the situation in the heading into 2012.

Commodities - unlike 2-3 weeks ago, commodities have sold off hard in the latest round of market turmoil. The precious metals market has not been spared from this deflationary liquidation (the lack of global liquidity again making 'king dollar' the current safe haven over gold); this was caused by too many speculators simultaneously liquidating at what may be a short term top in this long term bull market, the rate and impact of the unraveling was undoubtly exacerbated by margin hikes (Silver sold off from $38 to mid $20's in only 3 days!). My favorite precious metal, platinum, is now trading at a discount to gold not seen since the early 90's. I continue to believe that platinum is great buy and hold investment that will retain its real value as financial assets implode and global currency devaluation continues.

Currency - The strength in the dollar is primarily due to A) a global decrease in dollar reserves due to decrease in global trade and B) investors more willing to park their money in dollars rather than Euros in the shortterm, despite the long term state of the US private and public balance sheet remaining untenable.

Bonds - calling the top of this great bond bubble has been a losers game similar to shorting netflix on the way up - how much more upside is there to investing in bonds? If the 20 yr US treasury yield goes from the current 2.76% level to the 1.76% level currently seen in Japan, that translates to appreciation ~+16%, a drop to to the 1% yield level leads to a 30% appreciation. Should yields ever hit those levels, the corresponding correction in other asset classes would be very dramatic and a global deflationary state would be the likely result (perhaps if China's multi-decade bull market suddenly came to a grinding halt). What kind of situation could allow the 20 year bond yield to remain suppressed at these levels is hard to imagine... an extremely strong US dollar relative to other currencies? Continued secular move toward higher allocation to bonds for the wave of retiring baby boomers? On the other hand, if the yield were to rise to a level more commiserate with the level of inflation and which is also justified by history, let's just say +5% to 7.76%, the resulting loss to a bond holder will be 50%; if a dramatic fall in the value of the dollar forces the fed to raise rates by 10% in a move parallel to that of the 80's, the resulting loss to holders of these longer duration bonds would be > 70% . These low yield levels are very interesting. 

Cash - why hold cash in portfolio? should be obvious by now.


Best,