Tuesday, June 10, 2008

We Can't All Own Potash

The stability of the financial system has been tested and found to work; some banks will go down, some will get bought out, but the risk of market collapse ended in March. The yield curve now sports an almost 300bp spread, allowing banks to rebuild earnings power and BS's. The fed window, while not permanently open for the IBanks, will remain a powerful tool to avoid future Bear Stearns- like meltdowns; the current turmoil with Lehman is a case in point. And so we, along with Ben, JC, and pretty much all of the EM countries have moved on to more pressing concerns like inflation.

The US economy, along with the UK and EU, continues to slow down; banks still carry a ton of crap on their collective BS; the consumer needs to rebuild their own balance sheets; lots more write-offs are coming, followed by more capital busking from the banks. Some pretty big names have been embarrassed by this cycle - Warburg and Mr. Lewis come to mind. But just maybe by the end of the summer the US can see some positives on the housing front and begin to regain some confidence.

After a month of negative inflation reports from Asia, and a few EM rate rises and other policy changes, the market focus has moved to inflation. The ECB underscored this emphatically with a nod to raise rates, not cut them. That moved forced Ben to come in behind with a gratuitous "yea", threatening to raise rates this year and putting a bottom in the $. And the markets responded first with a drop in the $ on the ECB notes, and a correspoonding move in the $ related assets, and then a big move up in the $ with Ben's comments.

Last post, I thought the ECB might be in a cutting mood, based on slowing US and Euro economies, but the CB's have made an all out effort to head off the psychology of wage/price inflation at the pass. I think we still face a good chance that commodity inflation slows by the end of this year, as US consumer spending finally shuts down, and spreads this malaise to the EU and the ROW. It is possible rates in the US don't change for several quarters as we move from armageddon concerns, to inflation and finally to the Great Slowdown.

What can the fed really do? They cant raise rates meaningfully and risk the yield curve spread changing for the worse for banks, but they can't let the market think there is a possiblility of another rate cut. So they say the cuts are done and their concern is now inflation. It's a bit of an empty statement. Volcker made sure that US wage/price pressures are minimal 30 yers ago and rates will have little effect on energy and food prices.

With housing at 40+% of the CPI, an increase in rental inventory from the housing crisis might just be all we need, particularly if it's coupled with a leveling off of food and energy price gains. By talking up rate inceases, Ben puts a bottom in the $, and that his most powerful inflation fighting measure available.

It's in the EM countries that inflation posses the greatest risk. And the fed's easy money policies of the past several years are still playing out. Let's not forget that the Minsky moment is still playing out while at the same time lots of new engines and mouths need to fed. All eyes are on inflation in Asia. With exploding food and fuel costs matching the high growth and FDI flows, Asia is experiencing an overheated investment climate, piling reserves, higher costs and threatened corporate profits.

Vietnam in 2007 was $40B vs $52B in India and $12B in western China. Trade surpluses are disappearing leading to weaker currencies (Hanoi just announced a Dong devaluation of 2%), labor markets are tightening and domestic demand and lending are out of control - more inflation. Vietnam inflation just hit 25%, China is heading for double digits, and India has raised rates to fight their own 10% inflation .

The only answer is an economic slowdown, followed by slowing FDI, slowing import costs brought about by higher local money rates and higher currencies. This would stabilize currencies and give some slack to tight markets but would also threaten stability in places like China and S. Korea. The recent change in bank reserves in China lead to a two day drop in the stock markets of 7% and currently there are a 100,000 Koreans pretesting agriculture policy in Seoul.

As of now, most developing countries are still sitting with negative real rates, and are essentially making a bet that the food and energy price spikes are temporary. But they will not have dealt with the growing wage/price pressures that are now making South Coastal China less attractive by the day for cheap labor. Even as the great liquidity bubble form the US abates, the world still has to mange the huge petrodollar bubble - and the US equity market looks better every day.

This change in central bank orientation is a big one and means some changes in outlook: still short US T's but the spread against GSE's and Corp's no longer looks great so the pairs trade stops. I think it's safe to say Ben has put a floor in the $ and it looks like a safer place to be versus the Euro and Pound. But it still has room to fall against Asia - and we probably should expect the ME to go to baskets. Needless to say, this is not good for gold. Gold will have to test the old $850 and maybe lower; it's strongest correlation is with the $ and until that changes, that's how we trade it.

Even when a bottom comes into the US housing market, the consumer will have a new trajectory with higher savings rates and less aggressive spending behavior. And while the current job loss reports are understating the damage, I still suspect that job losses won't be massive, which means whatever slowdown we have will be shallow but also long lived.

The trends coming into place now - higher inflation, expensive debt, maxed out consumer BS's - suggest very limited consumer power for quarters to come. Retail shorts still look good, particularly after the recent government hand outs cycle through. I'm still looking at ANF, BBY, and COH. A slowdown in Asia would also put TIF on the block

With the change at the Fed and the long term problems faced by the consumer, when you add in the likely secular peak in profitability, you get a pretty poor outlook for US companies. But then some of this is factored in: low PE's, an eight year sideways market and a very cheap dollar. Mauldin's "Muddle Through" has really arrived.

I tried to make a case last time for a top in oil prices. I still want to make that case. Aside from the Iran battle drums, the CFTC/institutional demand discussions, OPEC supply limitations and non-OPEC production drops, I believe that this is still a demand driven problem. We are getting close to that magic number that starts to shut off enough marginal demand to put a top in near term oil prices. Demand destruction accelerates as prices increase. I thought that at $110, though.

This is a demand related issue: it's the only component that can change. Asian governments are taking the hardest medicine they can to address this demand issue by cutting subsidies - everyone but China. It is clear that demand is less elastic than anyone expected; but this kind of stability risking behavior by governments is a clear statement that elasticity is coming back. It's a gamble between the social instability caused by higher energy prices and running out of money; China seems to believe it won't run out of money and that the instability risk is far too great. At what price does China cut? Or on what post Olympic date?

We also have logistic issues creating havoc in the oil system: no one can refine the heavy crude coming out of the ME. Inventories are building for these and we will continue to see a growing divergence in the oil market between light and heavy crude. That could put more pressure in the near term on reported oil prices like WTI.

Equity market trends are not very constructive at the moment: Lowery's reports are uniformly negative, breadth and volume have been miserable (gray market counted?), and leadership is still limited to energy and agriculture. Unfortunately, we cant all own POT. I am focused on EPS strength and guidance going into the end of June - energy (oil, gas, services, no refining), agriculture (fertilizers, commodities), shipping (dry bulk and oil), export infrastructure (equipment and services).

Of course, I still hold POT (spot prices for potash are now in the $1000's), along with HAL, PDE, MU, NXY and AU (?). Steel volumes are still moving and the margins look sustainable so I'm gonna have to do something in the NUE, PKX area. I'll look at DRYS, unhedged natural gas co's, ABB, ACM, KRB, FLR among others.

I'll add the credit card processors to the excitement - a group I haven't had much exposure to. It's clear that US consumers are putting everything on their credit cards and V and MC have no exposure to bad debts. And I am starting to look at the home builders; a move from bankruptcy risks to zero growth for the business should be good for a big move in the stocks. With close stops.

As for an opinion on emerging markets, the inflation story is a tough roadblock. It's come about quickly in the past 3 months and the governments are officially behind the curve in managing the risks. The further behind that they get, the more painful and difficult it will be to catch up. This is true in Asia, as well as Russia, Turkey and S. Africa. In the past I've said Asia is the place to be, but based on Brazil's position on managing inflation, I'd have to say that's the place to be right now.

A final note: with all the recent volatility and poor YTD returns at most hedge funds, we are likely looking at significant withdrawals on the June closing. There are some crowded trades out there, including many names mentioned above. EPS power and guidance are the only protection we have on the long side in these names.


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