Monday, 2 April 2012

Dumb and Dumber

As either a pension fund or a wealthy private individual seeking to chase the hottest financial fad in the last three years, the opaque and illiquid commodities market, which your private and investment banking advisors have pushed hard, due to the large fees they can earn, you may have considered and invested an increasing portion of your cash in commodities long only plays and supposedly more savvy long-short commodity hedge funds. As a consequence, the wallet size and market influence of commodity funds has continued to increase dramatically at the detriment of western consumers. And within commodities, oil focussed hedge funds have seen the most dramatic growth. It is worth asking then, amidst the hoopla, what has been their performance as a group to date? When compared with every other type of hedge fund (L-S equity, RV, global macro, etc), over the last three years volatility of returns of oil hfs have been the highest (~30%), the beta with the underlying asset class has been close to 1 and Sharpe ratios one of the lowest (~1). These metrics tell us, oil hedge fund returns have broadly tracked the direction of oil prices over this period, but provided no real decrease in volatility of returns when compared with the long only play. At the same time returns have been poor (-ve or low single digits for most funds). Originally, long only commodity investments were sold as a means to hedge out the performance of traditional assets in a financial portfolio composed primarily of equities and bonds (as an inflation hedge). That mythical diversification has been debunked by three years of returns which have been highly correlated with every other market. So a strategy which diversifies further through specialised oil hedge fund managers makes a modicum of sense but the results do not appear to hold up to even modest scrutiny. It is often said passive, long only money is the dumb end of investment. And that certainly may be truer today for those still tempted to enter into oil markets at the very elevated levels they have reached. However when you look closely at the performance of commodity and oil funds, it may a case of one investment being dumb and the other even dumber.

Friday, 6 January 2012

Hormuz Straightjacket

There appears to be much speculation about whether Iran will (and can) block the straight of Hormuz. For this to be a credible counter-measure against nuclear sanctions, Iran's leadership has to be prepared to lose all external as well as domestic support. To understand this point you have to appreciate;

1. 25% of Iran's GDP, and virtually all of its hard currency, is derived from oil exports. Losing those exports entirely would mean a collapse in the domestic economy, which would result in greater domestic unrest.
2. Combine this with a war with the whole world, which will likely be ready to bear arms against the loss of oil supply.
3. And the fight would not merely be waged by the distant west, who will be trigger-ready with their long range missiles. Iran's close neighbours and cartel partners who rely on the Straight of Hormuz to sustain their own economies and keep their own people well-fed in these times of sudden "arab springs" would fight tooth-and-nail against Iran.

Can it still happen? Iran is full of very clever people, and I imagine their leaders would be very aware of the yawning precipice should they contemplate what in effect would be a combination of domestic unrest and war with the rest of the world. Tenable?

Saturday, 6 August 2011

The end of an empire

As you would expect an intense debate is ensuing this weekend about the impact of the S&P downgrade on the markets. Will the markets fall sharply on Monday? As you would expect the articles being written and comments being left on financial blogs are largely from those either caught unaware going into the weekend or those simply talking their book.

A downgrade is a downgrade and at the margin, it should result in a net selling of treasuries and a rise in yields, whether this occurs on Monday morning or takes longer. The search for alternatives to the dollar will also accelerate.

If the asset markets fall precipitously, no doubt acrimonious accusations will be levelled at the S&P for their "irresponsible" action. No-one should be distracted by this. Their actions address squarely the dysfunctional political and economic thinking which have infected the rich west. The financiers that rule the world capped by their biggest benefactor, Mr Bernanke have long believed the solution to conjuring wealth is cheap money and continued borrowing and, as the tea-partiers seem to believe, without their own citizens ever needing to pay it back. It is not. Ultimately it is, as we still teach our kids, hard work. But for the west it may be too late. We have gotten lazy. In the meanwhile, all the nasty, dirty work over the last two decades has been progressively pushed to industrious foreigners, whether it is cleaners from eastern europe, nurses from the phillipines, manufacturers in china or telephone helpdesks in India. Continued specialisation to develop comparative advantage is fine but what is that we in the west specialise in? Whatever it was, it has become smaller and less significant on the global stage. For example our touted western financial innovation, retains a centre stage, but for all the wrong reasons, such as the danger it poses to the world economy.

The downgrade is a historic, watershed moment which may well be remembered as a marker of the decline of the west coupled by the rise of the east. This process has been a long time coming but we have been lacking in meaningful symbols. S&P may well have provided it on Friday 5 August 2011.

Sunday, 17 July 2011

Low rates are the problem

In the post-crisis world, with the developed world facing anaemic growth prospects, we need to rethink the old 20th century economic models. The current group of central bankers are simply wrong to ignore the permanent destruction of household spending power which is accompanying uncomfortable levels of inflation. High retail inflation in the UK which has persisted for almost two years has eroded and continues to erode meaningfully the average household's purchasing power. Raw material and goods inflation is not "transient" in its impact on the economy. Permanent rises in the price of food, energy and other necessities for everyday life do not disappear even if the rate of their increase drops. Earnings by the majority in the UK which comprise of middle-income families, the young aspirational worforce, and the retirees have remained stagnant for this period whilst purchase prices have shot up. Unlike the rich, the young and the middle income earners have limited financial assets, the inflation of which by the persistently easy monetary policy, might offset this decline in real earnings. Unlike the rich, the retirees assets sit largely in liquid bank deposits, providing paltry income, and which they have accumulated through decades of thrift.

Persistently low rates also change the behaviour of the thrifty. Very often they become more thrifty. This is what happened in Japan over twenty years, a nation with notoriously high savings rates. And this is likely to happen in the UK and the US. This is because when rates' expectations fall, the saver feels the need to save more to earn the same return from their financial assets. This is how actuaries model pension liabilities, so this insight into households behaviour should not come as a shock. If banks had a symmetrical incentive to provide leverage at low rates then some of this impact might be more muted, although arguably households may be wary themselves of taking on more debt when their finances are being squeezed. In any case, after a credit bust, with capital ratios on the increase, credit will be remain far more limited and expensive for most.

Very few economic textbooks have analysed this perverse phenomenon of self-imposed rising thrift in a post credit-bust world. Low rates also exacerbate the public sector projected funding shortfall by lowering discount factors for future commitments. This provokes governments to cut spending by more than they would if rates were higher thus exacerbating the nations economic woes.

It is therefore highly arguable that persistently low rates are the right prescription in a high inflation, post-crisis world. It is too simplistic to assume the impact of low rates will push forward consumption, and assist deleveraging. Low rates as we have seen can also significantly and permanently erode the economic incentives of a nation's workforce as it is doing today (and has in the past). The sooner we have a central banker who recognises the negative feedback loop of low rates, the quicker we can arrive at a more enlightened economic model. Central banks last remaining great idea is to increase the wealth of the minority and hope for the trickle down effect to emerge. This is not working. Time to rethink economics.

Wednesday, 8 June 2011

OPEC's symbolic quotas

OPEC meetings and the decision on quotas has little more than symbolic value these days when you consider oil production from OPEC has been substantially above quota levels for over two years. The Saudis remain the swing producer and have continued to demonstrate their commitment to meeting incremental increases in global demand. They also have the biggest spare capacity within the cartel. The Saudi's aside, Iraq has been busy ramping up its capacity (2.7 million barrels per day up 15% yoy) and remains unconstrained by quotas. Arguably OPEC discord, as history has shown, is bad for oil prices as it reduces production co-ordination between cartel members and increases the risk of even greater cheating. The real reason oil prices are where they are, as the UN has rightly pointed out this week, is due to herding behaviour of investors and the "go long oil" meme being sold by Wall Street covering every conceivable scenario. Inflation, EUR correlation, risk on, diversification, easy money, and now OPEC discord - the list is long. In the meantime the strain on US (and ROW) consumers, slowing global growth, tightening monetary policy by emerging nations and high stock levels (US crude stocks have never been higher and in terms of days of supply exceed even those in 1998 when oil prices were $10 per barrel) are soundly ignored by the same investors, perhaps due to some selective information disclosure by Wall Street to its investing clients. This trend has little to do with fundamentals and everything to with fanciful marketing. When all the tortured arguments for oil's rally finally run thin, the final justification for the runaway oil price might be to call it a momentum trade. Others might call it a bubble.

Wednesday, 25 May 2011

SS Inc. structurally bullish on horse-manure

Rogan Josh, senior analyst at Stoleman Scraps Inc. (SSI) said in telephone interview earlier today that the latest correction on horse-manure, and general BS, was likely over and current levels provided an excellent opportunity to go long. Josh explained demand for BS was insatiable and despite the current glut, strong demand would tighten the balance to critical levels by year-end. Mr Josh deflected familiar accusations that traders at SSI had pre-positioned their books to be long BS prior to the research release by explaining, "Look as a firm we have always been structurally long BS, and always will be, but that is what clients have come to expect of us and we need to be positioned to serve them best. In any case, with interest rates continuing at record lows, where else would you put your money? BS provides truly unparalleled opportunities for asset diversification in a traditional portfolio of financial excrement". Many other other Wall Street houses also involved in the distribution of BS, released new research supporting its medium term bullish fundamentals.

Thursday, 28 April 2011

The Next Big Short

A key argument used to sell commodities to investors ranging from large money managers to high net worth individuals is that commodities provide a good inflation hedge. Two main theses cited to support this view are:

1. The introduction of a long position in commodities provides inflation protection in a traditional portfolio of bonds and stocks due to the negative correlation between interest rates and commodity prices. This negative correlation results from the "usual" transmission mechanism of interest rates which central banks raise in response to the rising threat of inflation from higher commodity prices. In an environment where the world's dominant central bank and protector of the world's reserve currency, otherwise known as the Fed, pursues interest rate policy which relies on an inflation index which specifically EXCLUDES commodity prices, then this very same transmission mechanism is of course broken. Given that a significant proportion of the worlds tradable financial assets are either in dollars or move sympathetically to dollar assets, the traditional argument for including commodities in an investment portfolio is, to put it mildly, utterly flawed.

2. Euphoric commodity bulls in extremis also suggest that when (not if) Armageddon finally arrives and paper money is worthless as a means to purchase goods, commodity indices will rule the day. We should therefore all be invested heavily in commodity indices and bull notes and warrants. These commodity bulls are confused. In particular they are confusing the ownership of physical food and energy with ownership of financial assets linked to commodities prices. If Armageddon ever arrives, take it from me, you will not be able to fill your car up with an oil-linked bull note. And furthermore, it would almost certainly be useless to go back to the bank who sold you these commodity bull notes and indices, to get them to pay for your hyperinflated food at the supermarket, as in a Armageddon type scenario that bank might have ceased to exist or at the very least defaulted on its financial obligations.

Who is to blame for putting forward the faulty logic and driving flows into commodities markets? You have guessed it. Wall Steet.

Michael Lewis has written a very good new book, the Big Short. I recommend anyone who is following the advice of a Wall Street salesperson, or is considering investment in sexy new investment products linked to commodities, should read it as a stark warning of what can happen when you blindly follow the advice and allure of fast talking bankers. CDOs used to be the sexy new products and they were considered a one way bet. Today the one way bet is of course commodities. When you can retire with a large bonus after a single and successful year of dumping toxic waste onto unsuspecting investors by relying on misleading and faulty logic, new bubbles no doubt will keep emerging and then blowing up on a regular basis.

Friday, 8 April 2011

Reversing gears

As raw material prices rise, huge price pressure are beginning to build in many of the developed economies which rely on imports to meet their raw material and energy needs. And whilst these pressures build up, many central bankers continue to scratch their heads and plead not guilty to the charge they are responsible for these pressures. The markets and an increasing number of economists disagree. The correct prescription is staring them in the face. Inflated monetary bases, into which those with means (aka rich speculators) can tap into, have fed into higher asset levels including illiquid commodities markets.

The central banks who are patting themselves on their back for giving consumers' a freer ride need to understand that what they have given with one hand, they have now more than taken away, through higher raw material costs, with the other. At the same time they have caused a massive and irreversible wealth transfer from the west to ideologically distant and non-democratic parts of the world.

As I may have stated in the past, there is no free lunch. To thrive you have change the infrastructure and practices of a nation not merely print paper. This is the main conclusion, many of the ostriches presiding over central banks, must acknowledge. That is, in order to revert to normal growth without an exorbitant wealth transfer to commodity rich nations, monetary bases must decline and interest rates must go up, sooner rather than later. Only then can we get on with the hard work of transforming our aged economies into competitive ones. The greater the delay through dangerous monetary experiments, the greater the likelihood that we will transform the western nations into likenesses of the economic minnows we pride ourselves today in our ability to bully around. Of course, if we do not recognise this soon, bankers such as Bernanke and King may well be positioning themselves for a place in history as the primary custodians of the Western affluence and who brought about its permanent and perhaps irreversible decline. The words being used to defend their monetary policies have begun to sound hollow. It is still not too late to reverse gears and use knowledge acquired from past mistakes.