Deflation hedges

[JEast]

FYI on 5Y5Y expectations. Hopefully we at least get our capital back in 2015 and maybe a little extra in 2016.

 

http://i61.tinypic.com/5cy8w1.jpg

[JEast]

It is still early, but I am hopeful that the Toronto office is now at least getting some calls on possible asking prices.

 

http://i58.tinypic.com/t62c5z.jpg

[james22]

All this talk of deflate-gate got me thinking about another kind of deflation.  No, Prem Watsa (Chairman and CEO of Fairfax Financial Holdings (FRFHF)) doesn't have a put option on air pressures of footballs, but he does have a massive bet on global deflation.  It's scary how big the bet has become.

 

http://brooklyninvestor.blogspot.com/2015/01/watsas-massive-bet.html#comment-form

[JEast]

Big bet -- yes and no.  The amounts quoted are 'notional' amounts just like the previous credit default swaps.  The invested amount is but a fraction of the notional amounts reported which is roughly about $640m and worth about $110m at 3rd quarter.  A big bet, yes, but also no, wrt notional amounts.

 

I am hopeful that we at least get our money back with a possible option call on something more.  As an FYI, looks like 30-year Bunds are now below 1% (repeat, 30-year government debt).  Also, the Eurozone is starting to turn over as indicated below.

 

http://i58.tinypic.com/288nlh1.jpg

 

 

[giofranchi]

JEast,

The Brooklyn Investor ends its post saying:

This can be the trade of the century if we dip into deflation; the ultimate limited risk (don't lose much if wrong)/ high return (huge gains if right) trade.

Therefore, it seems the two of you are on the same page! ;)

 

Cheers,

 

Gio

 

[TwoCitiesCapital]

http://www.bloomberg.com/news/articles/2015-01-30/euro-area-prices-extend-slide-in-sign-ecb-late-to-deflation-game

 

Even the U.S. is expected to see nominal, headline CPI deflation in 2015 - largely due to lower energy costs and how that flows through to most goods produced. Just as a quick summary of what we need to see for these to be profitable.

 

As of 9/30/2014

                              U.S. EUR UK FRANCE

Weighted Strike price 232.19 111.24 243.82 123.85

Nominal (in billions      52.75   36.775   3.3   2.75

Current CPI               238.03 117.43 257.6 124.85

Delta to breakeven     -2.45%  -5.27%   -5.35%   -0.80%

 

[Txvestor]

We will only know thw impact of lower oil/gas orices on emoloyment in the coming months. I'm not as convinced that the job market will motor through this. Thw GDP print is on path for lower revisions already.

A second observation is that people are saving a disproportionate amount of the savings on gasoline, compared to the past, perhaps this change of behaviour is from being/feeling over indebted?

On the supply side, I agree with your assessments, lower input costs, productivity gains, lower credit costs, and even the stronger dollar speak to lower prices.

So with demand tepid, and supply abundant, deflation does appear possible.

[petec]

 

I can think of an example country that is borrowing to build factories and their economy is growing rapidly... :)

 

You can. but you might not want to.

 

 

Actually, I do, however not in the short term!

 

At the end of the day, which country has the factories to produce more goods and which ones have the consumer debt? Which one has the ability to make more profit? :)

 

I agree with much of your response.  End of leveraging phase...absolutely. I agree that saying the economy grows in the long term with all this borrowing is unrealistic because sooner or later the buck has to stop because many less in America will have it to spend!

 

In addition, the US owes around 5 trillion to China. That would be easily deleveraged and the problems you speak of be fixed by selling off fixed assets in the USA to China. That shrinks the economy. This doesn't solve the problems within their governing system. It does however, mean that our economy would shrink accordingly to pay off the 5 trillion it owes while it deleverages.

 

Great final word, an important question!

 

It will be very interesting to see how this works out.  I think China is in a bigger debt bubble than the US, and that that debt has been used to build a lot of assets that will turn out to be unproductive.  It has lousy long term demographics and an economic system that is not as good at creating productivity growth.  It's also - and this worries me - the world's factory, in the same way the US was just before the great depression.  When the demand went away and the factories became empty, the impact was much worse in the US than in the 'demand' countries.  Europe owed a huge amount of money to the US in 1930, but we Europeans don't remember the depression so badly as the Americans do.  China has great potential because it is huge and poor, but its potential will not be realised if US demand for its exports fades, Chinese savings get wiped out by malinvestment, and they finally realise that $5tn of debt they've been buying is only worth what the Fed says it's worth.  I'd rather the US's problems than China's.  I found reading Micheal Pettis' books very useful on this topic.

 

On the topic of saving vs. spending oil windfalls, I believe Visa said on their call that they think 75% is being saved so far.

 

 

[petec]

http://www.bloomberg.com/news/articles/2015-01-30/euro-area-prices-extend-slide-in-sign-ecb-late-to-deflation-game

 

Even the U.S. is expected to see nominal, headline CPI deflation in 2015 - largely due to lower energy costs and how that flows through to most goods produced. Just as a quick summary of what we need to see for these to be profitable.

 

As of 9/30/2014

                              U.S. EUR UK FRANCE

Weighted Strike price 232.19 111.24 243.82 123.85

Nominal (in billions      52.75   36.775   3.3   2.75

Current CPI               238.03 117.43 257.6 124.85

Delta to breakeven     -2.45%  -5.27%   -5.35%   -0.80%

 

Thanks for the breakeven maths.  Don't forget, though, that these are saleable securities.  We need a deflation scare, in which people are prepared to pay silly money to buy protection off Watsa,  more than we need deflation.

[Zorrofan]

http://www.bloomberg.com/news/articles/2015-01-30/euro-area-prices-extend-slide-in-sign-ecb-late-to-deflation-game

 

Even the U.S. is expected to see nominal, headline CPI deflation in 2015 - largely due to lower energy costs and how that flows through to most goods produced. Just as a quick summary of what we need to see for these to be profitable.

 

As of 9/30/2014

                              U.S. EUR UK FRANCE

Weighted Strike price 232.19 111.24 243.82 123.85

Nominal (in billions      52.75   36.775   3.3   2.75

Current CPI               238.03 117.43 257.6 124.85

Delta to breakeven     -2.45%  -5.27%   -5.35%   -0.80%

 

Thanks for the breakeven maths.  Don't forget, though, that these are saleable securities.  We need a deflation scare, in which people are prepared to pay silly money to buy protection off Watsa,  more than we need deflation.

 

China's currency is pegged to the US dollar, which has been rising. This results in a rising Yuan versus other Asian currencies. If China decides to loosen the peg or outright devalue we could see some serious deflation.....thoughts?

 

cheers

Zorro

[giofranchi]

Thanks for the breakeven maths.  Don't forget, though, that these are saleable securities.  We need a deflation scare, in which people are prepared to pay silly money to buy protection off Watsa,  more than we need deflation.

 

With Europe now truly printing money, I think a deflation scare might be averted for the next 2 years… Instead, we will probably witness a meaningful increase in European stock prices… Later, when also the ECB largesse has run its course, with high asset prices on both sides of the Atlantic, and debt levels probably still very high, deflationary forces will be back in full swing… then, watch out! ;)

 

Gio

 

[petec]

http://www.bloomberg.com/news/articles/2015-01-30/euro-area-prices-extend-slide-in-sign-ecb-late-to-deflation-game

 

Even the U.S. is expected to see nominal, headline CPI deflation in 2015 - largely due to lower energy costs and how that flows through to most goods produced. Just as a quick summary of what we need to see for these to be profitable.

 

As of 9/30/2014

                              U.S. EUR UK FRANCE

Weighted Strike price 232.19 111.24 243.82 123.85

Nominal (in billions      52.75   36.775   3.3   2.75

Current CPI               238.03 117.43 257.6 124.85

Delta to breakeven     -2.45%  -5.27%   -5.35%   -0.80%

 

Thanks for the breakeven maths.  Don't forget, though, that these are saleable securities.  We need a deflation scare, in which people are prepared to pay silly money to buy protection off Watsa,  more than we need deflation.

 

China's currency is pegged to the US dollar, which has been rising. This results in a rising Yuan versus other Asian currencies. If China decides to loosen the peg or outright devalue we could see some serious deflation.....thoughts?

 

cheers

Zorro

 

My thought is 'yes'!

 

I wonder if Abenomics is the first of a wave of competitive devaluations between exporters that ends up driving deflation in the world.  Odd - I'd always assumed that printing money was deflationary but in this instance I think it is deflationary in the first instance.

 

China badly needs to devalue if the debt bubble there is as bad as it looks. 

[petec]

Thanks for the breakeven maths.  Don't forget, though, that these are saleable securities.  We need a deflation scare, in which people are prepared to pay silly money to buy protection off Watsa,  more than we need deflation.

 

With Europe now truly printing money, I think a deflation scare might be averted for the next 2 years… Instead, we will probably witness a meaningful increase in European stock prices… Later, when also the ECB largesse has run its course, with high asset prices on both sides of the Atlantic, and debt levels probably still very high, deflationary forces will be back in full swing… then, watch out! ;)

 

Gio

 

You might well be right but I am struck by Odey's observation that while dropping interest rates from 5% to 0% puts a lot of money into people's pockets, starting QE at 1.2% yields doesn't, and anyway that banks might not sell bonds at any positive yield if they have to park the cash at the central bank on a negative yield.  QE has always struggled to get the money printed directly into the real economy and the ECB might find it really hard.  Who knows.

[ni-co]

Thanks for the breakeven maths.  Don't forget, though, that these are saleable securities.  We need a deflation scare, in which people are prepared to pay silly money to buy protection off Watsa,  more than we need deflation.

 

With Europe now truly printing money, I think a deflation scare might be averted for the next 2 years… Instead, we will probably witness a meaningful increase in European stock prices… Later, when also the ECB largesse has run its course, with high asset prices on both sides of the Atlantic, and debt levels probably still very high, deflationary forces will be back in full swing… then, watch out! ;)

 

Gio

 

I'd be careful with the conclusion of rising asset prices in the euro zone. I concede that there still is some room left but most of QE has already been anticipated. German 10y yields are below Japan's and QE hasn't really started, yet.

[giofranchi]

Imo QE will do what it has always done: it will buy us some time. That’s what liquidity does. Because money flows into financial assets, making their prices rise. And almost by definition, when asset prices rise, a deflation scare is averted… or at least postponed!

 

The real question imo is: what will happen when financial assets finally reach prices that cannot be inflated anymore? And debt levels are still too elevated? At that point I don’t see how even liquidity could still be of any meaningful help.

 

Gio

 

[giofranchi]

Of course the problem is: how much time might QE actually give us?… I don’t know and I am not playing that game! ;)

 

Cheers,

 

Gio

 

[original mungerville]

http://www.bloomberg.com/news/articles/2015-01-30/euro-area-prices-extend-slide-in-sign-ecb-late-to-deflation-game

 

Even the U.S. is expected to see nominal, headline CPI deflation in 2015 - largely due to lower energy costs and how that flows through to most goods produced. Just as a quick summary of what we need to see for these to be profitable.

 

As of 9/30/2014

                              U.S. EUR UK FRANCE

Weighted Strike price 232.19 111.24 243.82 123.85

Nominal (in billions      52.75   36.775   3.3   2.75

Current CPI               238.03 117.43 257.6 124.85

Delta to breakeven     -2.45%  -5.27%   -5.35%   -0.80%

 

Thanks for the breakeven maths.  Don't forget, though, that these are saleable securities.  We need a deflation scare, in which people are prepared to pay silly money to buy protection off Watsa,  more than we need deflation.

 

China's currency is pegged to the US dollar, which has been rising. This results in a rising Yuan versus other Asian currencies. If China decides to loosen the peg or outright devalue we could see some serious deflation.....thoughts?

 

cheers

Zorro

 

Yes. And I would say the Yen being so weak puts pressure on all other exporting Asian countries to also devalue. So this combined with the problems in China, and as you say the link to the $US, could be a strong combination which leads the Chinese to devalue as well in order to maintain competitiveness.

 

The strong $US is importing deflation into the US while the weak Euro and Yen export deflation / import inflation. So, on the assumption deflation eventually takes hold globally (ie I am talking before the central bankers really inflate / move us to a new currency regime which I see a few years out, say 2018-2020), the strong dollar creates a lag, all else being equal, in terms of Europe's deflation (ie. makes Europe's deflation less than it otherwise would be for the time being) and expedites deflationary forces in the US. The adjustment in the currencies makes Watsa's call option likely to get near to the strike price a little farther out in time than otherwise would be the case. But I think fears of global deflation could certainly increase into this year end / 2016. Volatility should increase in currencies/bonds and this should help with the pricing of the CPI calls as was alluded to by the previous poster.

 

 

[original mungerville]

Thanks for the breakeven maths.  Don't forget, though, that these are saleable securities.  We need a deflation scare, in which people are prepared to pay silly money to buy protection off Watsa,  more than we need deflation.

 

With Europe now truly printing money, I think a deflation scare might be averted for the next 2 years… Instead, we will probably witness a meaningful increase in European stock prices… Later, when also the ECB largesse has run its course, with high asset prices on both sides of the Atlantic, and debt levels probably still very high, deflationary forces will be back in full swing… then, watch out! ;)

 

Gio

 

Yes, I agree - watch out in a couple of years. High asset prices everywhere and central banks out of ammo (other than a huge bazooka: major inflation or new global currency regime). Not so sure European stock prices will rise - a better bet would be the DAX given half (or maybe less?) of exports are outside of Europe I believe.

[ni-co]

It will be very interesting to see how this works out.  I think China is in a bigger debt bubble than the US, and that that debt has been used to build a lot of assets that will turn out to be unproductive.  It has lousy long term demographics and an economic system that is not as good at creating productivity growth.  It's also - and this worries me - the world's factory, in the same way the US was just before the great depression.  When the demand went away and the factories became empty, the impact was much worse in the US than in the 'demand' countries.  Europe owed a huge amount of money to the US in 1930, but we Europeans don't remember the depression so badly as the Americans do.  China has great potential because it is huge and poor, but its potential will not be realised if US demand for its exports fades, Chinese savings get wiped out by malinvestment, and they finally realise that $5tn of debt they've been buying is only worth what the Fed says it's worth.  I'd rather the US's problems than China's.  I found reading Micheal Pettis' books very useful on this topic.

 

On the topic of saving vs. spending oil windfalls, I believe Visa said on their call that they think 75% is being saved so far.

 

Thanks for pointing out Pettis' book. I've only read the first two chapters but, so far, it's really great – by far the clearest view and best take on the Chinese economy I've seen.

[KinAlberta]

Interview:

 

James Grant Talks Deflation, Greece, Stocks, And Weather

 

http://www.valuewalk.com/2015/02/james-grant-talks-deflation-greece-stocks-weather-video/

[DynamicPerception]

He likes Prem's FIH-U as a long pick at the end of the 8 minute video.

Thanks for posting.

[KinAlberta]

^ And Golub (GBDC)

[TwoCitiesCapital]

http://www.bloomberg.com/news/articles/2015-01-30/euro-area-prices-extend-slide-in-sign-ecb-late-to-deflation-game

 

Even the U.S. is expected to see nominal, headline CPI deflation in 2015 - largely due to lower energy costs and how that flows through to most goods produced. Just as a quick summary of what we need to see for these to be profitable.

 

As of 9/30/2014

                              U.S. EUR UK FRANCE

Weighted Strike price 232.19 111.24 243.82 123.85

Nominal (in billions      52.75   36.775   3.3   2.75

Current CPI               238.03 117.43 257.6 124.85

Delta to breakeven     -2.45%  -5.27%   -5.35%   -0.80%

 

Deflation hedges pulled in 116.4M gain in the 4th quarter for a total of +17.7M for the year. This means that the swaps were literally up some 95% in fair market value just in the fourth quarter alone on the decline in oil. Many are expecting headline deflation in 2015 due to the slowing of economies and cheaper oil working it's way through the supply system - we don't need much to get us to breakeven on these swaps. 1-2 years of negative headline inflation in the CPI could result in a nice payday of a few hundred million.

 

As a reminder, every 1% beyond the 2.45% needed to breakeven in the US would result in a net gain of 527M. I wouldn't be surprised to see them continue building these positions though - they've expanded them aggressively over the past few years at prices more attractive than the original position was purchased at.

 

2010 - 34.2B in notional (cost 302M)

2011 - 46.5B in notional (cost 421M)

2012 - 48.4B in notional (cost 454M)

2013 - 82.9B in notional (cost 546M)

2014 - 111.8B in notional (cost 655.4M)

 

From the original position in 2010, Watsa has committed 116% more capital to increase the exposure by 226% AND adjust the strike price upwards. Averaging down seems to have worked out well. I'm thinking these might actually pay in the next year or two.

[kfh227]

Which Pettis book are we talking about?

 

Looks to be 4 in total:

http://www.amazon.com/s/ref=la_B001ITW1FY_rf_p_n_feature_browse-b_0?fst=as%3Aoff&rh=n%3A283155%2Cp_82%3AB001ITW1FY%2Cp_n_feature_browse-bin%3A2656022011&bbn=283155&ie=UTF8&qid=1424286067&rnid=618072011

 

I might grab them all.

 

Which are we discussing in this thread?

Any recommended order if I get them all (start with the one in this thread?)?

 

I havn't dug into the numbers in this thread yet.  I will at some point though.  How much coul Fairfax make if deflation takes hold (3% per annum or one quick 15% slam or etc etc etc)?

[ni-co]

Which Pettis book are we talking about?

 

Looks to be 4 in total:

http://www.amazon.com/s/ref=la_B001ITW1FY_rf_p_n_feature_browse-b_0?fst=as%3Aoff&rh=n%3A283155%2Cp_82%3AB001ITW1FY%2Cp_n_feature_browse-bin%3A2656022011&bbn=283155&ie=UTF8&qid=1424286067&rnid=618072011

 

I might grab them all.

 

Which are we discussing in this thread?

Any recommended order if I get them all (start with the one in this thread?)?

 

I havn't dug into the numbers in this thread yet.  I will at some point though.  How much coul Fairfax make if deflation takes hold (3% per annum or one quick 15% slam or etc etc etc)?

 

I'd recommend "The Great Rebalancing" as a primer. It explains the whole mechanics. It's also available on Audible. In his China book he goes more into debth with regard to, well, the Chinese economy but it's the same theoretical basis. Both books are excellent.