Deflation hedges

[wisdom]

I wasn't referring to the US as much as the globe.

 

If USD rises due to a panic what would the impact be.

 

I would also refer you to slide 27 onwards

http://www.fairfax.ca/files/doc_news/2015/2015-AGM-Final-Slides-for-Website.pdf

[Zorrofan]

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.

 

From the 2014 Annual Report....

 

Hedging our common equity exposures has been very costly for us over the last five years – particularly in 2013.  However, we did warn you that we wanted to be safe rather than sorry – our time will come again!

We have worried about deflation in the past few years in our Annual Reports – it is now upon us! In spite of QE1, QE2 and QE3 and some twists, we saw deflation in the U.S. in the second half of 2014, as shown in the table below:

% change June –

U.S. CPI Index June  July    August September October    November December  June-Dec. 2014

                        238.3 238.3    237.9      238.0      237.4      236.2      234.8          -1.5%

 

We have had deflation at an annualized rate of 3% in the second half of 2014 in the U.S.! And it is not going

away. In fact, in January 2015, the U.S. reported its first year-over-year decline in the CPI index since 2009 of 0.1%. In Europe, we had deflation of 0.5% in the second half of 2014, as shown in the table below:

 

% change

European CPI June –

                June    July    August  September October    November December    June-Dec. 2014

              117.6    116.8    116.9    117.4        117.4      117.1        117.0              -0.5%

 

As of January 2015, 17 out of 19 countries in the Euro area were experiencing deflation on a year-over-year basis.

 

However 8 months into 2015 where is the deflation?  and at what cost?  Over $4 billion dollars plus opportunity cost.  One quick example, if FFH had not spent this money hedging it could have bought 100% of Brit, no equity issue required.

 

Here is a very interesting write up from Az Value, worth a read.....

http://azvalue.blogspot.ca/2014/04/fairfax-and-their-bets-now-looking-in.html

 

FWIW, while FFH is losing money hedging BRK is buying, investing $38 billion in PCP and another $4.4 billion in Philips 66. 

 

my $0.02

 

cheers

Zorro

 

[wisdom]

I am not saying it will again be so - but could you have made the same argument in 2006 about their CDS's?

 

Edit: I will agree with you once this busines cycle is complete and they are still falling behind.

[Zorrofan]

I guess what i am saying is after 5 years is FFH wrong?  Maybe they are right, i don't know. But i see BRK buying good business after good business, building the cashflow stream regardless of possible macro events. FFH could have used that money to do the same.  There is an opportunity cost to the hedging, and it is growing larger each year. I read the post by AZ Value and thought it raised some good points......

 

cheers

Zorro

 

PS Having posted this, we will likely face a huge deflationary wave shortly and FFH will make billions......

[TwoCitiesCapital]

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.

 

Can you look in the rear-view mirror and point out what the second shock to Japan was that caused their two decade long deflationary trend?

[rb]

Wisdom,

 

Why are you referring to the globe since all the hedges are basically in the US and EU?

 

You also talk about a currency shock where the USD increases. The USD already increased a lot and inflation was steady. How much farther do you think the USD has to run? Also why will an increase in the USD deliver such a crushing blow to the US economy to put it in deflation when the US is a more local economy than most?

 

I've also looked at the FFH slides, they don't make a conclusive case that we are in imminent danger of deflation. Also the disinflation we saw in 2014 was a one time hit to CPI from commodity prices. Core inflation was steady. Btw, the negative CPI print we had in the US during the crisis was also commodity driven. Core inflation was not negative.

 

see http://data.bls.gov/timeseries/CUUR0000SA0L1E?output_view=pct_12mths

 

It would be nicer to create a credible economic argument (including the mechanisms) of how we're going to have an economic crisis of such a magnitude that would lead to deflation instead of just saying. Well USD shock.... deflation.

 

Also I don't see how the deflation hedges are anything like the mortgage CDS. With the deflation hedges you have the whole economic concept of sticky prices, a recovering economy with deleveraging going on, and a central bank that's committed to avoid deflation. With the CDS all you needed to make money was for already inflated house prices to stop rising.

[no_free_lunch]

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.

 

Can you look in the rear-view mirror and point out what the second shock to Japan was that caused their two decade long deflationary trend?

 

I hate to get in the middle of other people's debates but I actually do think there is a fundamental difference between US & Japan, or a secondary shock if you prefer.  It's demographcis.  A shrinking population is a major impediment to economic growth.  You could probably apply that to some European countries as well but the US has relatively good demographics due to immigration.

[Jurgis]

US has relatively good demographics due to immigration.

 

Actually US also has pretty good demographics due to the birth rate. http://www.indexmundi.com/g/r.aspx?c=us&v=25

 

Not exactly sure why. Europe has much better social/monetary support for having kids and yet people in US have more of them. Anecdotally even my Euro friends in US have more kids even though it makes no sense (they would be better of having kids back in Europe...).

[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.

 

Can you look in the rear-view mirror and point out what the second shock to Japan was that caused their two decade long deflationary trend?

 

I hate to get in the middle of other people's debates but I actually do think there is a fundamental difference between US & Japan, or a secondary shock if you prefer.  It's demographcis.  A shrinking population is a major impediment to economic growth.  You could probably apply that to some European countries as well but the US has relatively good demographics due to immigration.

I was just replying when no free lunch posted. So I'll just build on his point. Yes in Japan you had a demographic problem. But also a horrible corporate culture and zombie banks. Also Japan is and was an export driven economy with perpetually poor domestic demand. Add to that a massive appreciation on the yen and new competition in export markets from China, Korea, and other players and you have a horrible situation.

 

Why the Japanese example is significant is that they broke through the zero barrier in inflation. However what the 08-09 example shows us is that Japan may have been the exception rather than the rule since countries like Spain which took much more economic pain than Japan didn't break the zero bound.

 

Also btw, I don't know why Japan is relevant here? Fairfax doesn't have Japanese deflation hedges and the Japanese economy is very different from the western economies on which Fairfax has deflation hedges

[TwoCitiesCapital]

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.

 

Can you look in the rear-view mirror and point out what the second shock to Japan was that caused their two decade long deflationary trend?

 

I hate to get in the middle of other people's debates but I actually do think there is a fundamental difference between US & Japan, or a secondary shock if you prefer.  It's demographcis.  A shrinking population is a major impediment to economic growth.  You could probably apply that to some European countries as well but the US has relatively good demographics due to immigration.

 

So you're saying that Japan's deflation was due to demographics and totally non-related to the real estate/equity bubble that bursted in the early 1990s? What about the deflation in the U.S. after the Great Depression?

 

I don't know who we can look at the trillions spent globally in fiscal and monetary stimulus, which has failed to produce any respectable amount of GDP or inflation growth, and then determine that there is absolutely no deflationary threat or support for Prem's thesis.

 

Then add to that the commodities are crashing. Bond yields are cratering and were at substantially negative levels just a few months back in certain European countries. Global GDP growth is slowing. The debt overhang for the developed world is massive. And despite a tightening labor market, no sustained growth in real wages has yet occurred. Somehow, we're supposed to look at all of this information and determine that deflationary fears or totally unsupported?

 

Maybe I'm a fear-mongerer, but it certainly seems to me that the data is showing that deflation is, and has been, the predominant threat since 2009 and that the inflationary story has been BS. The creation of credit is inflationary. The unwinding of credit is deflationary. I don't know if we're into that unwinding phase yet, but when we get there you can be guaranteed that it will be deflationary with, or without, an economic shock. Considering that the globe as a whole is carrying unprecedented amounts of debt, it could certainly be a very prolonged period. Don't fail to see the forest for the trees.

 

 

Also btw, I don't know why Japan is relevant here? Fairfax doesn't have Japanese deflation hedges and the Japanese economy is very different from the western economies on which Fairfax has deflation hedges

 

I would actually say that Japan is very similar to many European countries with poor demographics, birth rates, high debt, low-growth, export driven, etc. etc. etc.

[wisdom]

RB - I do not believe that deflation has to happen. I said more likely than before. I don't mean more than 50%. I hope this makes sense.

 

Because inflation is so low, i believe any slow down could push us under. As slow as things have been to play out, so far I am not confident that FFH is wrong.

 

I do have most of my money in USD because I do expect US to be relatively better, but, I cannot imagine US continuing to do well if the rest of the world struggles.

 

I cannot come up with a story that I will have confidence in as to why we will have deflation, but, I can see how it could happen if anything does not go to plan or as we would like it go.

[wisdom]

I see things the way two cities is describing it. He has put it better than I can.

 

I do not see anything that says FFH has been wrong. My read is that the majority has yet to come to the same conclusion because we are so used to inflation. It takes time for societies to notice things have changed. But, when everyone finally notices and changes behaviour is when things can get interesting.

[rb]

I see things the way two cities is describing it. He has put it better than I can.

 

I do not see anything that says FFH has been wrong. My read is that the majority has yet to come to the same conclusion because we are so used to inflation. It takes time for societies to notice things have changed. But, when everyone finally notices and changes behaviour is when things can get interesting.

Well everyone basically changed behavior and deflation didn't happen. So what you're saying is that facts don't have much impact on you.

[wisdom]

What behaviour changed? People stopped taking on debt?

 

What was the impact of QE? Would we have had deflation without QE?

[rb]

What behaviour changed? People stopped taking on debt?

Yes. Household debt is significantly below pre crisis levels. At least in the US. Didn't check all of Europe.

[rb]

Two cities, I will get back on your points later on tonight. Bit busy right now.

[wisdom]

Yes, but is household debt still above long term averages. What if it goes back to the long term averages?

[Guest Dazel]

 

Gary17,

 

as i said...the deflation-hedges are safety if we hum along and Fairfax does 5% on investments we are looking at $1.5B pre tax..last year unwiring profit was $500m (better this year).

 

Markel trades at a 24.63 PE....Fairfax would be worth over $20b in USD normalized under those conditions...so the reality is  the deflation hedges are a rounding error...but they are protection against a Japanese like experience in the U.S...and if you are paying attention you can see the writing on the wall.

 

The fed is "going" to tighten in Sept...it will be an interesting world with higher rates. just ask the corporate bond market as it has already tightened.

 

 

[Guest Dazel]

 

 

Fairfax investments are almost double the size of Markel's...and Markel's market cap is bigger than Fairfax.

[kevin4u2]

What behaviour changed? People stopped taking on debt?

Yes. Household debt is significantly below pre crisis levels. At least in the US. Didn't check all of Europe.

 

As I have said before.  This statistic in isolation is a waste of time.  Total debt to whatever income measure you want has increased not decreased since the last financial crisis.  Only the US, UK, Spain and Ireland have experienced household deleveraging.  The McKinsey study shows 80% of countries have higher household debt. Some quotes from the study:

 

Seven years after the global financial crisis, no major economy and only five developing ones have reduced the ratio of debt to GDP (Exhibit 2). In contrast, 14 countries have increased total debt-to-GDP ratios by more than 50 percentage points.

 

Which countries have deleveraged since the last crisis?  Israel, Romania, Saudi Arabia, Egypt, and Argentina. 

 

The fact that there has been very little deleveraging around the world since 2007 is cause for concern. A growing body of evidence shows that economic growth prospects for countries with very high levels of debt are diminished. High levels of debt—whether government or private-sector—are associated with slower GDP growth in the long term, and highly indebted countries are also more likely to experience severe and lengthy downturns in the event of a crisis, as consumption and business investment plunge.10 Indeed, the latest research demonstrates how high levels of debt lead to a vicious cycle of falling consumption and employment, causing long and deep recessions.

 

[kevin4u2]

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.

 

From the 2014 Annual Report....

 

Hedging our common equity exposures has been very costly for us over the last five years – particularly in 2013.  However, we did warn you that we wanted to be safe rather than sorry – our time will come again!

We have worried about deflation in the past few years in our Annual Reports – it is now upon us! In spite of QE1, QE2 and QE3 and some twists, we saw deflation in the U.S. in the second half of 2014, as shown in the table below:

% change June –

U.S. CPI Index June  July    August September October    November December  June-Dec. 2014

                        238.3 238.3    237.9      238.0      237.4      236.2      234.8          -1.5%

 

We have had deflation at an annualized rate of 3% in the second half of 2014 in the U.S.! And it is not going

away. In fact, in January 2015, the U.S. reported its first year-over-year decline in the CPI index since 2009 of 0.1%. In Europe, we had deflation of 0.5% in the second half of 2014, as shown in the table below:

 

% change

European CPI June –

                June    July    August  September October    November December    June-Dec. 2014

              117.6    116.8    116.9    117.4        117.4      117.1        117.0              -0.5%

 

As of January 2015, 17 out of 19 countries in the Euro area were experiencing deflation on a year-over-year basis.

 

However 8 months into 2015 where is the deflation?  and at what cost?  Over $4 billion dollars plus opportunity cost.  One quick example, if FFH had not spent this money hedging it could have bought 100% of Brit, no equity issue required.

 

Here is a very interesting write up from Az Value, worth a read.....

http://azvalue.blogspot.ca/2014/04/fairfax-and-their-bets-now-looking-in.html

 

FWIW, while FFH is losing money hedging BRK is buying, investing $38 billion in PCP and another $4.4 billion in Philips 66. 

 

my $0.02

 

cheers

Zorro

 

Zorro.  Please explain where you're getting this $4 billion cost on CPI derivatives?  Nonsense.  Your spewing incorrect numbers just like AZvalue did in his post about FFH compared to BRK.  AZvalue incorrectly calculated the change in book value per share in his comparision of FFH to BRK.  Properly calculated FFH outperforms BRK in every category except 5 years.  Try again next time. 

[rb]

What behaviour changed? People stopped taking on debt?

Yes. Household debt is significantly below pre crisis levels. At least in the US. Didn't check all of Europe.

 

As I have said before.  This statistic in isolation is a waste of time.  Total debt to whatever income measure you want has increased not decreased since the last financial crisis.  Only the US, UK, Spain and Ireland have experienced household deleveraging.  The McKinsey study shows 80% of countries have higher household debt. Some quotes from the study:

 

Seven years after the global financial crisis, no major economy and only five developing ones have reduced the ratio of debt to GDP (Exhibit 2). In contrast, 14 countries have increased total debt-to-GDP ratios by more than 50 percentage points.

 

Which countries have deleveraged since the last crisis?  Israel, Romania, Saudi Arabia, Egypt, and Argentina. 

 

The fact that there has been very little deleveraging around the world since 2007 is cause for concern. A growing body of evidence shows that economic growth prospects for countries with very high levels of debt are diminished. High levels of debt—whether government or private-sector—are associated with slower GDP growth in the long term, and highly indebted countries are also more likely to experience severe and lengthy downturns in the event of a crisis, as consumption and business investment plunge.10 Indeed, the latest research demonstrates how high levels of debt lead to a vicious cycle of falling consumption and employment, causing long and deep recessions.

Kevin, I've engaged with you on another thread where you were talking about a lot of different things at once. I told you that if you want to explore any of them in particular based on economic concepts I'd be glad to go into them with you. You didn't reply.

 

In that topic you've also referenced this McKinsey paper. It is at best a lazy paper and at worst dishonest. In it they constantly mix up rates and levels of debt. A total no-no. Also the concept that they use that higher levels of debt lead to the vicious cycle of lower economic growth and higher unemployment comes from a Reinhart & Rogoff paper that has been discredited in a very embarrassing way when it was proven that their math was wrong which led them to confuse causality with correlation.

 

Over here I was talking about the FFH deflation hedges that apply to US and EU, not globally. If you're going to make an economic argument for deflation you should explain how we are at risk of a massive decrease in demand or a massive increase in supply that will break sticky prices and put those economies in deflation.

 

By the way, a very slow overall deleveraging with the government levering up to offset private sector delevering is key to avoid deflation. So what exactly is your point?

[no_free_lunch]

I think there has actually been modest deleveraging in total in the US.  I think this was covered earlier in the thread.  Not to say we aren't still in a real bind, but technically the US has deleveraged.

 

You can look at fed release Z1, where they break out debt by sector.  Here are the numbers I see.

 

Total Debt including financial institutions,

2007: ~$50T

2014: ~$56T

 

GDP:

2007: $14.5T

2014: $18.0T

 

Debt / GDP:

2007:  344%

2014:  311%

 

 

http://www.federalreserve.gov/releases/z1/current/z1.pdf

 

Given this, my concern is when exactly will the deleverage tsunami hit?  I thought it was happening in 2008 but it just passed.  So it has been 8 years and a hell of a storm but the economy has grown and debt levels have improved marginally.  What if we just kind of keep plowing along for another 20 years?  I don't know, I am just going to buy good quality companies.  Maybe if VIX gets really low again I'll buy some puts but it's really tough to call when the house of cards collapses.

[no_free_lunch]

I actually think that the deleveraging is greater than the numbers show.  A big part of what has happened is debt has shifted to the government in the US.  Government debt is higher grade and thus lower interest so I think the actual interest paid (even if we were to normalize interest rates) is quite a bit less.

[kevin4u2]

What behaviour changed? People stopped taking on debt?

Yes. Household debt is significantly below pre crisis levels. At least in the US. Didn't check all of Europe.

 

As I have said before.  This statistic in isolation is a waste of time.  Total debt to whatever income measure you want has increased not decreased since the last financial crisis.  Only the US, UK, Spain and Ireland have experienced household deleveraging.  The McKinsey study shows 80% of countries have higher household debt. Some quotes from the study:

 

Seven years after the global financial crisis, no major economy and only five developing ones have reduced the ratio of debt to GDP (Exhibit 2). In contrast, 14 countries have increased total debt-to-GDP ratios by more than 50 percentage points.

 

Which countries have deleveraged since the last crisis?  Israel, Romania, Saudi Arabia, Egypt, and Argentina. 

 

The fact that there has been very little deleveraging around the world since 2007 is cause for concern. A growing body of evidence shows that economic growth prospects for countries with very high levels of debt are diminished. High levels of debt—whether government or private-sector—are associated with slower GDP growth in the long term, and highly indebted countries are also more likely to experience severe and lengthy downturns in the event of a crisis, as consumption and business investment plunge.10 Indeed, the latest research demonstrates how high levels of debt lead to a vicious cycle of falling consumption and employment, causing long and deep recessions.

Kevin, I've engaged with you on another thread where you were talking about a lot of different things at once. I told you that if you want to explore any of them in particular based on economic concepts I'd be glad to go into them with you. You didn't reply.

 

In that topic you've also referenced this McKinsey paper. It is at best a lazy paper and at worst dishonest. In it they constantly mix up rates and levels of debt. A total no-no. Also the concept that they use that higher levels of debt lead to the vicious cycle of lower economic growth and higher unemployment comes from a Reinhart & Rogoff paper that has been discredited in a very embarrassing way when it was proven that their math was wrong which led them to confuse causality with correlation.

 

Over here I was talking about the FFH deflation hedges that apply to US and EU, not globally. If you're going to make an economic argument for deflation you should explain how we are at risk of a massive decrease in demand or a massive increase in supply that will break sticky prices and put those economies in deflation.

 

By the way, a very slow overall deleveraging with the government levering up to offset private sector delevering is key to avoid deflation. So what exactly is your point?

 

Why did you waste some many words?  You could have just said, "I'm smarter than everyone."  Are you an economist?

 

My point was there has been no, "slow overall deleveraging".  We already have deflation for everything in the CPI less shelter, see attached.  No massive changes changes needed.