Deflation hedges

[Guest Dazel]

http://www.telegraph.co.uk/finance/11805523/Doomsday-clock-for-global-market-crash-strikes-one-minute-to-midnight-as-central-banks-lose-control.html

 

 

[obtuse_investor]

http://www.telegraph.co.uk/finance/11805523/Doomsday-clock-for-global-market-crash-strikes-one-minute-to-midnight-as-central-banks-lose-control.html

 

I do not disagree with any of the data on that page, but I would encourage readers to pay close attention to the X-axis of all the charts. They aren't consistent... and are rather cherry picked to make things look dramatic.

 

Some indicators are truly near all time bottoms (eg: interest rates), but others look rather benign when the x-axis is expanded a mere few years.

 

caveat emptor

 

[petec]

Just noticed Japanese PPI went -ve in about April, most recent reading -3%.

[TwoCitiesCapital]

Just noticed Japanese PPI went -ve in about April, most recent reading -3%.

 

Because Abenomics has been SOOOOO effective...

[Guest Dazel]

http://finance.yahoo.com/news/asia-slides-wall-street-caves-002345016.html

 

 

China has stalled...the market told us early...deflation hedges are likely surging in value. It may get very interesting as the market digests this.

 

Dazel

[JEast]

Noticed the five-year, five-year break-even forward for Europe is around 1.70 and the US recently dropped below 2.00.  Maybe middle of the 2nd inning or top of the 3rd so still early, but I am hopeful the office is at least getting some calls on possible asking prices.  Hopeful that we at least get our capital back.

[KinAlberta]

Are these hedges are like lottery tickets?  The prospect of winning big time means that they attract more attention than they deserve?

[TwoCitiesCapital]

Are these hedges are like lottery tickets?  The prospect of winning big time means that they attract more attention than they deserve?

 

I wouldn't call them lottery tickets. That implies the chance of winning is nearly nil - I'd say that Fairfax's has an intelligent reasoning behind the positioning and that they have been supported by economic data over the last 3-4 years. All we have to do is see if them being right on a general economic malaise actually bleeds into CPI figures that determine the payout.

 

You have cratering energy and commodities prices, a slowing China, devaluations of currency happening all over southeast Asia and Europe, and a significantly stronger dollar. All of those point to a lower CPI - if global aggregate demand slows (which it appears to be doing), we could see a sustained drop in CPI. The chances of this happening aren't nil - I can't tell you what they are, but I've felt that they were much more likely than the market ever gave them credit for.

 

The payout is extremely high and the bar for success is relatively low. We just have to make it to that bar.

[petec]

I agree.  I think relatively few people understand (or maybe it is just that I have only recently started to understand!) how credit bubbles inflate and deflate.  How during the leverage phase consumers and governments lever up to consume, creating demand so that producers lever up to build factories and produce more; but when consumers stop levering up more, the demand evaporates leaving lots of empty capacity.  Prices fall as inputs (commodities) collapse and as producers compete for the demand that remains.  It's fine if all the money saved on commodities gets spent on more things, but price elasticity doesn't work that way.  I don't buy twice as many clothes because cotton got cheaper.  I might go out for dinner more, but I'll also pay down some debt.  Delevering takes everything down with it.

 

There is a distinct possibility that the global economy is at that stage, and a distinct possibility that monetary policy isn't enough to offset it.  And Fairfax can buy protection against this turn of events for virtually nothing.  That's not a lottery ticket.  And I don't know of any other equities that would benefit, so I don't think it gets too much attention!

 

There's also scope for a vicious carry trade unwind: as the dollar rises, borrowing cheap dollars to fund investments (in anything) gets less attractive.  Unwinding the trade pushes the dollar up further so it's circular.  Look at currency and commodity volatility in the last year: something is happening.

 

I read today that:

-45% of world GDP is in commodity exporting countries.

-World exports have recently started shrinking; this usually only happens in recessions.

- $10tn of annual revenues have been lost throughout the commodity value chain.  Yes, some of that becomes demand elsewhere.  Some doesn't, it gets saved or just vanishes as debts go bad.  That's deflationary.

- EDIT: despite incredible monetary stimulation (ZIRP everywhere significant, QE in Europe and Japan, 48 Central Bank easings ytd) nominal global gdp is growing at rates normally only seen in the depths of recessions.  That thought startled me.

 

It's quite possible we muddle through.  It's more than usually likely that we don't.  These swaps offer protection against that.  I bought more FFH today.

 

 

 

[KinAlberta]

Sorry - I didn't mean that the contracts themselves were like lottery tickets - but that the investor interest in the potential payout is like dreaming of a lottery win in that the great potential coming out of a win receives undue attention compared to other aspects of their business. (Much like Buffett's derivatives did in early 2009 - in the opposite direction creating undue fear).  Or the way investors view micro-cap emerging companies with promising new technologies (where such companies have very long odds of success but the promise of the technology attracts all the attention).

 

It's just that I've noticed all the posts to this thread and possibly even a bit of excitement about Fairfax / Watsa being right - again.   

 

 

As for the contracts and cycles - I think Fairfax was intelligent taking out such insurance if that's an appropriate term for it.  I've long been interested in such macro cycles like Kondratieff's Long Wave, Jay Forester's study (at MIT Sloan) of system dynamics (technological and business cycles), etc.

 

BTW - Back in 2003 I was circulating Watsa's 2002 AR "perfect storm" quote to people managing money in the billions. Along with Buffett's daisy chain WMD article, the BofE governor's fears on derivatives, Grantham's multiple pre 2008 warnings, etc. 

 

 

Moreover, I created the Jeremy Grantham page on Wikipedia and later added these quotes...

 

 

To avoid the development of crises, you need a plentiful supply of foresight, imagination, and competence. A few quarters ago I likened our financial system to an elaborate suspension bridge, hopefully built with some good, old-fashioned Victorian over-engineering. Well, it wasn’t over-engineered! It was built to do just one under favorable conditions. Now with hurricanes blowing, the Corps of Engineers, as it were, are working around the clock to prop up a suspiciously jerry-built edifice. When a crisis occurs, you need competence and courage to deal with it. The bitterest disappointment of this crisis has been how completely the build-up of the bubbles in asset prices and risk-taking was rationalized and ignored by the authorities, especially the formerly esteemed Chairman of the Fed. ...[9]

”

“ I ask myself, ‘Why is it that several dozen people saw this crisis coming for years?’ I described it as being like watching a train wreck in very slow motion. It seemed so inevitable and so merciless, and yet the bosses of Merrill Lynch and Citi and even U.S. Treasury Secretary Hank Paulson and Fed Chairman Ben Bernanke — none of them seemed to see it coming.

 

I have a theory that people who find themselves running major-league companies are real organization-management types who focus on what they are doing this quarter or this annual budget. They are somewhat impatient, and focused on the present. Seeing these things requires more people with a historical perspective who are more thoughtful and more right-brained — but we end up with an army of left-brained immediate doers.

 

So it’s more or less guaranteed that every time we get an outlying, obscure event that has never happened before in history, they are always going to miss it. And the three or four-dozen-odd characters screaming about it are always going to be ignored. . . .

 

So we kept putting organization people — people who can influence and persuade and cajole — into top jobs that once-in-a-blue-moon take great creativity and historical insight. But they don’t have those skills.[10]

 

https://en.wikipedia.org/wiki/Jeremy_Grantham

 

 

One last thing - I'm an Albertan and saw the 1970s oil driven boom followed by the 1980s bust and how it affected nearly everything. Consequently I saw a lot of parallels between Alberta's boom and various subsequent market bubbles over the years in various sectors.  It seems that the bubbles only get bigger, broader and potentially more scary - as is the case now with the bond market.

 

[Guest Dazel]

 

 

the junk bond market is already in a correction...equities are just realizing that now...i suggest reading hoisington asset management for any who think we are in a U.S treasury bubble..they see the 30 year at 2% or below and the have been right for 10 years. U.S long dated treasuries are deflation hedges..

 

Dazel

[ERICOPOLY]

I forget... in 2008 when they dropped their equity hedges, did the gains on the hedges exceed the market drop of their equity portfolio?

 

Or was it mostly a wash?  I'm remembering it as mostly a wash.

 

Once again Original_Mungerville with his huge equity hedges!  Congrats.  I'm limping today, down about 2% at the moment versus the 3.9% that the S&P500 is down.

 

I'm getting better at this luck thing though -- this is the first market drop in a while where my loss doesn't exceed the market.  It's cold comfort.  Too many out-of-the-money puts that don't help much in the beginning.

 

EDIT:  Okay, just a few minutes later the market is down 4.35% and now I'm registering a slight gain for the day (due to a volatility spike).  This is a bizarre day.

[petec]

Bizarre indeed.  Just noticed Brent crude down 8%.  :o

[original mungerville]

I forget... in 2008 when they dropped their equity hedges, did the gains on the hedges exceed the market drop of their equity portfolio?

 

Or was it mostly a wash?  I'm remembering it as mostly a wash.

 

Once again Original_Mungerville with his huge equity hedges!  Congrats.  I'm limping today, down about 2% at the moment versus the 3.9% that the S&P500 is down.

 

I'm getting better at this luck thing though -- this is the first market drop in a while where my loss doesn't exceed the market.  It's cold comfort.  Too many out-of-the-money puts that don't help much in the beginning.

 

EDIT:  Okay, just a few minutes later the market is down 4.35% and now I'm registering a slight gain for the day (due to a volatility spike).  This is a bizarre day.

 

I did make money in the last couple of days/weeks, but Valeant, my main position, had a horrible week last week. Overall I am up nicely as my over-exposure to S&P puts more than bailed me out of my over-exposure to Valeant! I sold my in-the-money puts Monday morning - not at the lows, but within 25% of the lows if you take out the worst hour of the day. I still have my at-the-money puts representing 200% of notional - the next weeks/months will determine whether these work out or not. So I have by no means made a killing overall on the portfolio in the last couple weeks although it will be very hard for me not to have a good year (Valeant would really need to underperform the market from here).

[Guest Dazel]

 

 

China tried again to stop the the free fall in their markets ...it did not work for them or the US markets! now what?

 

DEFLATION....

 

It will help and hurt business...Fairfax will be helped! Long term it will help the US but not before we have some tremors.

 

[TwoCitiesCapital]

http://www.bloomberg.com/news/articles/2015-08-28/all-of-that-dollar-borrowing-in-emerging-markets-looks-like-it-s-been-one-giant-carry-trade

 

nce the 2008 financial crisis, companies across emerging markets have been borrowing dollars and converting them into local currencies as part of a massive carry trade...a report released by the bank in January that found firms outside the U.S. have borrowed $9 trillion in U.S. dollars, up from $6 trillion before the global financial crisis.

 

This seems like one of Soros' reflexive situations. It will probably only get worse if the Fed actually moves forward with hiking rates as that would likely signal the beginning of the unwind if the recent slowdown in EM hasn't already forced the hands of those who borrowed.

 

The dollar grows stronger -> slows growth and investment of companies that need to repay in dollars while forcing them to sell local currency -> dollar appreciates against local currency due to repurchase of dollars and relative economic growth -> restart cycle.

 

We might see more to this strong-dollar, deflationary thesis than I had originally anticipated as I hadn't been anticipating a multi-trillion dollar unwind.

 

It'd be interesting to see who the biggest borrowers were and what the maturity schedule of their debt looks like. At least it was "healthier" institutions doing this and not subprime entities that would absolutely blow up at a dollar that went 10% higher.

[gary17]

So Fed, ECB and BOE all seems to think they are seeing inflation...

 

who is right ! LOL

 

http://www.bloomberg.com/news/articles/2015-08-29/fed-ecb-and-boe-policy-makers-all-say-they-see-inflation-rising

 

 

 

[TwoCitiesCapital]

So Fed, ECB and BOE all seems to think they are seeing inflation...

 

who is right ! LOL

 

http://www.bloomberg.com/news/articles/2015-08-29/fed-ecb-and-boe-policy-makers-all-say-they-see-inflation-rising

 

Who do you trust? A market full of intelligent participants who have money on the line banking that interest rates and deflation remain lower or a room full of people who believe they can control the actions of hundreds of millions of people through pulling financial levers that are unprecedented in size and application?

[beerbaron]

Last week we had a company meeting explaining that the RMB devaluation should start triggering 3% cost reduction for all our products in a mean term. All retailers are already asking for the discount.

 

It's fun to see the macroeconomic affect our behaviour in real life.

[Guest Dazel]

http://www.marketoracle.co.uk/Article51975.html

 

dow theory sell signal was confirmed Monday...for those that watch technicals. I don"t but I am aware that a lot of people do.

 

 

 

[Guest Dazel]

http://news.investors.com/083115-768893-dallas-fed-manufacturing-index-falls-with-oil-prices.htm?ven=yahoocp&src=aurlled&ven=yahoo

[gary17]

Dazel

respectfully , I am wondering have you thought about what if FFH is wrong about deflation and we see Businesees continue to grow. ...  In that scenario, is it still worth owning FFH and if so , what do you think the intrinsic value of the business is ?

 

I read somewhere before FFH could earn 6% on the investments if they are wrong plus the insurance underwriting income.  So maybe 10%.  I wonder what P/E is fair

[rb]

I am really confused by the conviction on this thread that we will have deflation. Why exactly would we have that? What kind of economic catastrophe would be required to achieve that and what is its probability?

 

The US has had only slight deflation for about a quarter at the depths of the 08 crisis. Spain only had just a slight drop in CPI in 08-09 after which CPI started growing again and that was with 25% unemployment. So why the high confidence in deflation?

[wisdom]

I do not believe it is conviction as much as the likelihood is higher because of high debt levels and where interest rates are across the world.

 

Last time around virtually the whole world eased. Rates are already so low that this is going to be tougher to repeat if we have a shock or recession. A shock could be higher interest rates or it could be deflation.

 

History shows that initially private debt is taken on by the public and during the subsequent shock authorities struggle.

 

In this case a longer horizon may be better rather than just looking at how 2008 worked out - Ray Dalio's 'How the economic machine works' could be used.

 

It is cheap insurance if the authorities make a mistake or lose control - which does happen.

 

 

[rb]

Please explain to me how the outlook is higher now than before? The US private sector has deleveraged quite a bit and you have a decent economic recovery under way?

 

If you have an economic shock that doesn't mean deflation. To achieve deflation you will need another shock probably of a  higher than the one in 08. Just that fed may tighten a bit early doesn't mean automatic deflation. Those errors can also be reversed. If the economy slows down I think we can be pretty confident that you see QE4 coming in.

 

Given the facts it really doesn't seem like cheap insurance at all.

 

You say that 2008 relevant enough to draw conclusions from. Ok look long term and let me know what cases in history do you think are more pertinent to the present situation in the US. I would leave Japan out since their doesn't really look like the US.