Volume 1 11 Del Ever Aging and Froth Oct 6 2009f

VOLUME 1.11 1.
9
VOLUME
OCTOBER 6, 2009
Deleveraging and Froth
Now that stock and commodity prices Deleveraging, persistent high unemployment,
have bounced back from panic lows and are weak housing and commercial real estate
approaching their pre-bubble levels (with a markets and fears over fiscal deterioration will
few-exceptions), valuation based on certainly weigh on growth for years to come
expectations for growth should drive but will not prevent it. Thus, we expect
investment decisions. What level of growth to choppy trading over the next few quarters, but
expect is subject to widespread confusion and not a return to recession.
uncertainty in the financial media. On the one The perennial bears, most of whom
hand, a reasonable argument can be made for a missed the strongest nine month rally in living
double dip recession and ongoing deflation, on memory, are fixated on excess consumer and
the other, for a continuing bull market driven public debt, ongoing real estate troubles, and a
by pent up demand and easy money. Some “bankrupt” financial system. While all
fanatics are even calling for central banks to pressing issues, they discount the rapid
start tightening. structural adjustments occurring in the U.S.
Our more moderate view is that early economy and the broad success of international
signs of growth are present and will strengthen stimulus and quantitative easing. As for the
over the next year or two, albeit at a more explosion of public debt, in reality there is
modest pace than in the last cycle.
© BOECKH INVESTMENTS INC., 1750‐1002 SHERBROOKE STREET WEST, MONTREAL, QUEBEC. H3A 3L6 TEL. 514‐904‐0551, INFO@BCCL.CA
considerable time before this issue will begin growth and a reduction in inventories and
to weigh on investors. excess capacity.
The panic sell-off creating the March
lows was overdone, and a good part of the rally

THE EMERGING MARKET & COMMODITY
since was a rational revaluation. Now that
TRADE
valuations are not such an obvious bargain, the
One of the most popular investment
markets are showing some hesitation around
themes over the last year has been the
earnings expectations.
emerging market & commodity trade. The
Given the forecast for pallid growth,
idea that the downturn would be less severe in
investors should watch the valuation of stocks
China, India, Brazil, etc. has played out, and
carefully and keep a close eye on the real,
emerging markets have outperformed the S&P
rather than financial demand for commodities.
500 by about 20% since the March lows (Chart
The poor yield on money market funds and
1).
Treasury Bills (see charts p.13) is driving
investors to seek a better return. As we CHART 1
discussed in our previous letter, we expect
rates to remain extremely low for another 6-12
months, at least until the housing and
commercial real estate markets can tolerate
higher rates. Momentum alone could carry
stock and commodity prices a while longer, but
at some point they need to be supported by real
WWW.BOECKHINVESTMENTLETTER.COM 2
THE
© BOECKH INVESTMENT LETTER
We expect the outperformance to CHART 2
continue in the long run. However, over the
next six months, there is the potential for a
major sell-off. There is a widespread
expectation that a timely recovery in exports of
developing nations will cushion the transition
from unsustainable domestic stimulus (Chart
2). Global trade remains weak and the absence
of positive news on this front in the next few
months could trigger another rout in these After the sharp sell-off in 2008, most
markets. commodity prices have rallied to the point
where they are close to their pre-bubble levels

The other component of this investment
(see charts p.11). Comparing the performance
theme is the commodity markets/currencies
of commodities after the trough of this
complex. Here the thesis is that investors can
downturn (tentatively March 2009) to the
benefit from the v-shaped recovery in
performance after previous recessions shows
emerging market demand as well as hedge
that they are outperforming cyclical recoveries
against monetary debauchery and the
in past cycles (Chart 3). The only other cycle
deterioration of the dollar. Calls to buy
that showed a similarly strong performance
anything “hard” have driven massive capital
this early on in the recovery was the 1975
flows into industrial and agricultural
recession, and we are certainly not going to see
commodities over the past six months.
general price inflation anywhere near the levels
of the 1970’s.
THE
CHART 3
As we have discussed in previous term, this is a crowded trade sustained by
letters, commodity prices have lately been momentum and hope.
driven by financial demand. The 50% increase
in copper price occurred while the Chinese

CHART 4
warehouse inventory increased five-fold (Chart
4). It is worth noting that the proliferation of
commodity ETFs have allowed widespread
participation in the sector by retail investors.
Perhaps the outlook for industrial metals will
be improved by a rapid recovery of the
Chinese export sector. However in the short
THE
We expect the outperformance to CHART 5
continue in the long run. However, over the
next six months, there is the potential for a
major sell-off.
The inflation argument for holding
commodities is not playing out. Consumer
prices continue to fall and concerns over
deflation are stronger than ever. Inflation CHART 6
expectations (the spread between 10 year
Treasuries and inflation protected securities,
Chart 5) remain below pre-crisis levels at 174
basis points and are stable. Given the
extremely low capacity utilization in the U.S.
(Chart 6), rising unemployment (Chart 7) and
record breaking fixed asset investment in

CHART 7
China, consumer price inflation is not on the
horizon at least for the next couple of years. In
a surprise move, Chinese authorities recently
raised the alarm over excess capacity and put a
wide range of project approvals on hold, a
confirmation of how extreme deflationary
pressures currently are in that country.
THE
It is worth noting that commodity CHART 8
prices have been partly driven by the tidal
wave of new money being created, leading
some to argue that a new bubble is emerging.
So far the effect of loose monetary policy has
been limited to speculation based on
expectations rather than an actual excess of

CHART 9
credit. The new money has yet to work its way
through the system due to a collapse in the
money multiplier. The rapid expansion of the
Fed’s balance sheet has not translated into a
corresponding increase in money supply
(Charts 8 & 9) because banks have increased
their holdings of reserves enough to offset Fed

CHART 10
asset purchases. On a rate of change basis M2
actually turned negative in the last quarter.
The Fed has taken a breather. There
has not been a net increase in its balance sheet
assets since the peak in late 2008 and money
supply is not keeping pace with deleveraging.
Similarly, global money supply, a

sloshing around in the global economy, while
coarse measure of the amount of U.S. dollars
robust has yet to show the sort of major spike
THE
that has occurred prior to previous asset Economic improvement does seem to
bubbles (Chart 10). Those anticipating another be happening although it is tentative and driven
commodity price bubble will have to be patient mainly by government stimulus. We have to
as it will take many months for the keep in mind that the U.S. and global economy
deleveraging process to play out. are still in the convalescent ward and will be
for years. Deleveraging of the private sector
and repair of the banking system will take

INVESTMENT CONCLUSIONS
time, during which they will be vulnerable to
There are no basic changes to our shocks – particularly if stimulus is withdrawn
investment views. The bull market in U.S. and too soon. That seems very unlikely because
foreign equities remains intact. Most markets deflation is still the name of the game. General
around the world have consolidated, a inflation is weak, falling, non-existent or
necessary stage after the sharp recovery from negative depending on which country we look
the March lows. Market recoveries almost at. Monetary reflation can continue with little
always lead economic upturns by roughly six or no risk for some time and this is positive for
to nine months because they are based on equity markets.
positive changes in money and credit and the
Justifiable concerns remain over future
expectation of improving profits. However,
government debt ratios both in the U.S. and
markets cannot run on money, credit and
abroad. However that risk is something we
expectations forever. They need confirmation
have to live with because large fiscal deficits
that conditions are actually improving before
are required to fill the black hole created by
stage two of the bull market evolves.
private sector deleveraging. The short term risk
is that the hole does not get properly filled.
THE
The U.S. dollar will remain one of the unacceptable hit to the nascent recovery in
key focal points for assessing risk. It is in a housing, the economy and financial markets.
fundamentally precarious position because This is a highly unstable situation,

nervous foreign central banks hold fraught with tension and big risks. Fortunately
approximately U.S. $3.5 trillion as reserves the dollar has one saving grace – in a
and there are many trillions more in the hands deflationary world, no country wants to see its
of private holders who are also nervous. There currency rise against the dollar. As previously
are legitimate reasons for their concern over discussed, surplus countries will continue to
the dollar’s future value. The dollar is the key hold their nose, buy dollars and complain. This
reserve currency and unit of account for the is likely to result in a slowly eroding dollar, at
world and it is fundamentally unsound for the least for some time. Presently, it is still above
U.S. authorities to be flooding the world with its pre-Lehman level but needs to be watched
more dollars. closely to see if the dynamics start to change
The U.S. dollar is in a bear market and and it drops faster than we are assuming. If that
a much lower value on a trade-weighted basis were to happen, it would greatly increase the
is a requirement for the U.S. to regain some risk of Federal Reserve tightening, which
equilibrium and to improve growth prospects. would be very negative for financial markets.
A lower value is not exactly what dollar Some countries, notably China, are busy
holders are looking for unless compensated by diversifying into real assets. They are buying
an appropriate interest rate, not the near zero shares in resource companies as well as
rate existing today. However, any substantial acquiring supplies of commodities through
rise in U.S. interest rates would create an various creative financial arrangements. They
can do deals with dollars but get protection if
THE
the dollar drops and commodity prices rise. the Fed and other central banks to keep rates
Usually the two go together. Either approach low and prevent a collapse of the dollar. Be
globalizes U.S. monetary inflation and is nervous, but stay fully invested.
ultimately bullish for asset prices.
Many investors are also trying to
emulate the Chinese by betting on debauchery
of the U.S. dollar and a consequent rise in real
asset prices. This is a popular story and a key
rationale for investing in commodities,
including energy and gold. It may well turn out
to be a good long term strategy but in the short
term it is a crowded trade and prices may well

Tony & Rob Boeckh
have run ahead of reality. October 6, 2009
BoeckhInvestmentLetter.com
Regarding interest rates, Fed
info@bccl.ca
intervention will keep Treasury yields stable
*All chart data from IHS/Global Insights, and
for the foreseeable future, and we expect credit
may not be reproduced without written
consent.
spreads to continue to narrow slowly.
In summary, we see no inflation and a
weak economic recovery. Deleveraging and
deflation will continue to play out, but this
need not lead to a double-dip recession as the
pessimists are calling for. Rather, expect
higher volatility and ongoing intervention from
THE
STOCKS
THE
COMMODITIES
THE
CURRENCIES
THE
INTEREST RATES
THE

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VOLUME 1.11 1.

Deleveraging and Froth

few-exceptions), valuation based on certainly weigh on growth for years to come

expect is subject to widespread confusion and not a return to recession.

modest pace than in the last cycle.

to weigh on investors. excess capacity.

The panic sell-off creating the March

lows was overdone, and a good part of the rally

investors to seek a better return. As we CHART 1

discussed in our previous letter, we expect

rates to remain extremely low for another 6-12

months, at least until the housing and

commercial real estate markets can tolerate

higher rates. Momentum alone could carry

stock and commodity prices a while longer, but

at some point they need to be supported by real

continue in the long run. However, over the

next six months, there is the potential for a

major sell-off. There is a widespread

expectation that a timely recovery in exports of

developing nations will cushion the transition

from unsustainable domestic stimulus (Chart

2). Global trade remains weak and the absence

of positive news on this front in the next few

markets. commodity prices have rallied to the point

where they are close to their pre-bubble levels

As we have discussed in previous term, this is a crowded trade sustained by

letters, commodity prices have lately been momentum and hope.

driven by financial demand. The 50% increase

in copper price occurred while the Chinese

warehouse inventory increased five-fold (Chart

4). It is worth noting that the proliferation of

commodity ETFs have allowed widespread

participation in the sector by retail investors.

Perhaps the outlook for industrial metals will

be improved by a rapid recovery of the

Chinese export sector. However in the short

continue in the long run. However, over the

next six months, there is the potential for a

The inflation argument for holding

commodities is not playing out. Consumer

prices continue to fall and concerns over

deflation are stronger than ever. Inflation CHART 6

expectations (the spread between 10 year

Treasuries and inflation protected securities,

Chart 5) remain below pre-crisis levels at 174

basis points and are stable. Given the

extremely low capacity utilization in the U.S.

(Chart 6), rising unemployment (Chart 7) and

record breaking fixed asset investment in

horizon at least for the next couple of years. In

a surprise move, Chinese authorities recently

raised the alarm over excess capacity and put a

wide range of project approvals on hold, a

confirmation of how extreme deflationary

pressures currently are in that country.

prices have been partly driven by the tidal

wave of new money being created, leading

some to argue that a new bubble is emerging.

So far the effect of loose monetary policy has

been limited to speculation based on

expectations rather than an actual excess of

through the system due to a collapse in the