Annual letter from Prem

[Packer16]

For the past 200 to 300 years the reserve currency has been either the pound or the US dollar so unless you are talking about the real long term, it has been pretty stable.

 

Packer

 

But both currencies were backed by gold until 1971, and since then (it seems to me) we have had a slow loosening of monetary policy.  Confidence is a funny thing: it's there until it's not.

 

I don’t know exactly why we are talking about this… but here I agree with Packer: I don’t see any plausible substitute for the USD in the foreseeable future.

 

Gio

 

I brought it up because of Packer's comment about huge demand for fixed interest securities, which is something that could change overnight (I am not predicting that it will).

 

And I suspect we'd have said the same in the UK until relatively shortly before the pound ceased to be the reserve currency.  Again, not a prediction, but it's always useful to think about unexpected things that could genuinely shake the world.

 

My broader point is that QE may destroy capital and be deflationary.

 

The demand for fixed income is driven by the amount of savings being generated versus destroyed via wars, famine, ect.  I don't see this slowing down but increasing as the we are adding to a large stock with new savings flows every day from all around the world including emerging markets.

 

Packer

[petec]

For the past 200 to 300 years the reserve currency has been either the pound or the US dollar so unless you are talking about the real long term, it has been pretty stable.

 

Packer

 

But both currencies were backed by gold until 1971, and since then (it seems to me) we have had a slow loosening of monetary policy.  Confidence is a funny thing: it's there until it's not.

 

I don’t know exactly why we are talking about this… but here I agree with Packer: I don’t see any plausible substitute for the USD in the foreseeable future.

 

Gio

 

I brought it up because of Packer's comment about huge demand for fixed interest securities, which is something that could change overnight (I am not predicting that it will).

 

And I suspect we'd have said the same in the UK until relatively shortly before the pound ceased to be the reserve currency.  Again, not a prediction, but it's always useful to think about unexpected things that could genuinely shake the world.

 

My broader point is that QE may destroy capital and be deflationary.

 

The demand for fixed income is driven by the amount of savings being generated versus destroyed via wars, famine, ect.  I don't see this slowing down but increasing as the we are adding to a large stock with new savings flows every day from all around the world including emerging markets.

 

Packer

 

Agreed...so long as people trust the currency the fixed income securities are denominated in.  If they do not...  Example: would you invest in yen bonds?  I would not because the government is clearly hell-bent on depreciating the yen.  Eventually, if they are successful, that will be an issue not just for foreign buyers, but for local ones too.  Then they will find something else to do with their savings.

 

A side point is that I think misallocation of capital is a far greater destroyer of capital than wars have been.

[Packer16]

You may not be willing to invest in yen bonds but the aging population of Japan will more than make up for all those who do not want to invest.  As folks get older their asset allocations move more toward fixed income investments they consume in.  So again the alternatives to yen for the Japanese are pretty limited.  If they save in another currency they will not have a stable source of value in the currency they consume in due to fx changes.

 

I disagree about misallocation vs. war.  War destroys accumulated wealth of societies along with central planning but misallocation is for the most part in a portion of the economy, the market will correct most misallocations and permanent loss of large amounts of capital is rare for most income producing assets.  There are exceptions but they a far less numerous than the fairly valued/allocated markets.

 

Packer

 

 

[twacowfca]

I think the big weakness in the commodity decline leading to deflation argument is how little commodity prices influence CPI.  When the commodities where inflating like crazy there was little inflation so why would not the opposite be true?  If you look closely at the January CPI release, the only reason there was deflation was falling energy prices.  The CPI ex food and energy is still going up at 1.5% per year.  In addition, you have some companies increasing wages (Walmart and others).  So unless you expect a sustained decline in energy and food prices that can overcome the core inflation of 1.5%, I just do not see how deflation happens with the US CPI. 

 

I think if the measure is Swiss Francs or Danish Kroner then you will see deflation but not the US$ or Euro where QE will ensure deflation will not happen in $ or Euros.

 

Packer

 

I largely agree with you on the limited impact of commodities and energy. The other thing to mention is that after a 50% decline, commodities' impact on the CPI index is significantly more muted going forward. I disagree with you on wages though - the positive wage print in January was largely due the CPI deflator that they use as the denominator and not because there was a large rise in the nominal pay. Walmart wages may be a bellweather for future wage increases, but I think walmart wages are a very small piece of the wage picture and don't mean much in isolation. We need a tighter labor market for there to be a sustained increase and I tend to believe that there is still quite a bit of slack.

 

I agree though - we won't see sustained deflation unless if it makes it's way into housing. I think the biggest impediment to the inflation story in the near term will likely be the strength of the dollar. Just like oil, this will translate into pricing decreases through almost everything that is purchased outside of services. I think dollar strength and the price of oil will contribute to deflation through calendar year 2015 and possibly into 2016 depending on the status of our record oil supplies in storage and the continuing strength of the dollar. It will need to enter the housing market to extend beyond that. I tend to agree with Gio on this one though - I think something as simple as a stock market decline could be the trigger.

 

After 6 years of being told to ignore risks, investors have levered up their exposure to equities through margin debt while US equities are priced for perfection. A strong dollar and potentially increasing wages will weigh on corporate margins that are currently significantly above their historical trend. Paired with extremely high stock valuations and the potential for rising rates and you have a stock market disaster - declining margins and declining multiples could easily spell a 50% decline. Magniffy this by the margin debt and we could see some spectacular blow ups that have larger economic implications that affect wages and employment. This is simply speculation - I just get the feeling investors aren't the only ones who've been ignoring risks and that the implications of a risk-off environment will be felt far beyond the stock market. Full disclosure: I recently purchased 1 year put options on the S&P at 1900.

 

Would you kindly share how much you paid and how much S&P was then?

[Cardboard]

There is way too much money chasing too few investments. So the inflation is in the investable market. Anything that earns a yield.

 

The people who have money don`t know where to invest it and already have pretty much all the goods they need. So they chase yield.

 

The people who don`t have money can`t spend on more goods since they are tapped out and are seeing no real wage increase. They also can`t borrow which reduces the world of investable assets.

 

IMO, Quantitative Easing other than stabilizing markets has not trickled down to the average Joe. However, it surely helped many keep their jobs. Unless they can find an acceptable way to get money directly in the hands of poorer people or the disappearing middle class, I have a hard time seeing how this cycle can heal itself.

 

Cardboard

 

 

[TwoCitiesCapital]

I think the big weakness in the commodity decline leading to deflation argument is how little commodity prices influence CPI.  When the commodities where inflating like crazy there was little inflation so why would not the opposite be true?  If you look closely at the January CPI release, the only reason there was deflation was falling energy prices.  The CPI ex food and energy is still going up at 1.5% per year.  In addition, you have some companies increasing wages (Walmart and others).  So unless you expect a sustained decline in energy and food prices that can overcome the core inflation of 1.5%, I just do not see how deflation happens with the US CPI. 

 

I think if the measure is Swiss Francs or Danish Kroner then you will see deflation but not the US$ or Euro where QE will ensure deflation will not happen in $ or Euros.

 

Packer

 

I largely agree with you on the limited impact of commodities and energy. The other thing to mention is that after a 50% decline, commodities' impact on the CPI index is significantly more muted going forward. I disagree with you on wages though - the positive wage print in January was largely due the CPI deflator that they use as the denominator and not because there was a large rise in the nominal pay. Walmart wages may be a bellweather for future wage increases, but I think walmart wages are a very small piece of the wage picture and don't mean much in isolation. We need a tighter labor market for there to be a sustained increase and I tend to believe that there is still quite a bit of slack.

 

I agree though - we won't see sustained deflation unless if it makes it's way into housing. I think the biggest impediment to the inflation story in the near term will likely be the strength of the dollar. Just like oil, this will translate into pricing decreases through almost everything that is purchased outside of services. I think dollar strength and the price of oil will contribute to deflation through calendar year 2015 and possibly into 2016 depending on the status of our record oil supplies in storage and the continuing strength of the dollar. It will need to enter the housing market to extend beyond that. I tend to agree with Gio on this one though - I think something as simple as a stock market decline could be the trigger.

 

After 6 years of being told to ignore risks, investors have levered up their exposure to equities through margin debt while US equities are priced for perfection. A strong dollar and potentially increasing wages will weigh on corporate margins that are currently significantly above their historical trend. Paired with extremely high stock valuations and the potential for rising rates and you have a stock market disaster - declining margins and declining multiples could easily spell a 50% decline. Magniffy this by the margin debt and we could see some spectacular blow ups that have larger economic implications that affect wages and employment. This is simply speculation - I just get the feeling investors aren't the only ones who've been ignoring risks and that the implications of a risk-off environment will be felt far beyond the stock market. Full disclosure: I recently purchased 1 year put options on the S&P at 1900.

 

Would you kindly share how much you paid and how much S&P was then?

 

I paid 8.30 per contract for the 190 strikes for next January. I don't know exactly what the S&P was at when I bought them, but they've been in the green since day 1. It's only a small piece of protection at the moment - will expand it depending on how the market does

[frommi]

I paid 8.30 per contract for the 190 strikes for next January. I don't know exactly what the S&P was at when I bought them, but they've been in the green since day 1. It's only a small piece of protection at the moment - will expand it depending on how the market does

 

Don`t you think this is a bit expensive since the market has to fall at least 12% from here just to bring you to beak even?

[petec]

You may not be willing to invest in yen bonds but the aging population of Japan will more than make up for all those who do not want to invest.  As folks get older their asset allocations move more toward fixed income investments they consume in.  So again the alternatives to yen for the Japanese are pretty limited.  If they save in another currency they will not have a stable source of value in the currency they consume in due to fx changes.

 

They don't want a stable source of value in the currency they consume in.  They want a stable source of value in real terms.  Thus, their behaviour can change very fast if the currency starts to lose value.  Obviously that's a big if.

 

I disagree about misallocation vs. war.  War destroys accumulated wealth of societies along with central planning but misallocation is for the most part in a portion of the economy, the market will correct most misallocations and permanent loss of large amounts of capital is rare for most income producing assets.  There are exceptions but they a far less numerous than the fairly valued/allocated markets.

 

 

Most of the time I think that's absolutely right.  But when such vast amounts of new money have been created I wonder whether misallocation is confined to pockets.  Most of us would probably agree that the bond markets aren't going to produce a great return, so that's a colossal chunk of capital that's currently misallocated.  China has almost certainly overbuilt factories relative to demand - that's why PPI there has been falling for 3 years.  Tech, property - the list of things that might well be overvalued is quite long.

 

Japan hasn't destroyed capital in war or famine over the last 25 years.  They've actually printed a lot of new money, starting in the mid 1990s.  Yet they've still had deflation as their massive stock and property bubble burst.

 

P

[TwoCitiesCapital]

I paid 8.30 per contract for the 190 strikes for next January. I don't know exactly what the S&P was at when I bought them, but they've been in the green since day 1. It's only a small piece of protection at the moment - will expand it depending on how the market does

 

Don`t you think this is a bit expensive since the market has to fall at least 12% from here just to bring you to beak even?

 

Protection is almost always expensive via puts and it only required a 10% drop for break-even when I bought it. I'm not concerned with a 10% drop which is why I picked them up so far out of the money. I'm concerned by the possibility of another 50% drop due to high debt, high valuations of financial assets, higher margins, and high multiples attached to those margins in a world that seems like it's increasingly crisis prone for these sort of market corrections.

 

I'm biased though and have been bearish for years. I haven't allowed myself to put options since 2011 because I was concerned that maybe I was wrong and would be tossing a lot of good money down the drain; however, valuations are significantly higher now than they were and I believe the risks are significantly elevated as well.  IMO, the current U.S. market is increasingly fragile. For current valuations to be maintained, you have a continuation of low inflation, low interest rates, high profit margins, and high market confidence to apply high multiples to those profits, with absolutely no shocks to any of those conditions. That seems like investors are hoping for a lot to go right to justify the current stock prices and there's a lot occurring right now that could shock any one of those inputs (higher dollar, higher wages, headline deflation, etc.)