Quick update

I don’t want to toot my own horn by my three calls last week would have paid off in spades: oil rallied 17%, Zion fell by 12% and was down in excess of 20% at one point, and WFC fell by 5% and was down 13% at one point (it should be noted that to profit from the downside on ZION and WFC you would have had to use short term puts which would have probably magnified your return due to the inherent leverage associated with options). That being said I am not faring well on my ZOLT short which has rallied 15%, that being said I still think a ttm P/E of 88.6 is a bit much for a materials company (I would mention its forward P/E is 18, which is based on, as previously mentioned, what I believe to be extremely lofty estimates). But enough about the past, let’s look towards the future.

I am sure you have all read that the bailout plan has tentatively passed. In its current form, it gives taxpayers an ownership stake and profit-making opportunities with participating companies; puts taxpayers first in line to recover assets if a participating company fails; (and) guarantees taxpayers are repaid in full -- if other protections have not actually produced a profit. The $700 billion would be available in phases. The first $250 billion will be "immediately available" to the Treasury Secretary, and $100 billion available "upon report to Congress," and $350 billion "available only upon Congressional action. While the industrial cycle looks to be slowing, in the US, the aforementioned bailout plan is likely to reduce the economic risk of a much sharper credit contraction. In addition, recently announced policy initiatives clearly go beyond the US: China and Russia have also taken steps to stabilize local markets. For example, last week, China announced a 27bp interest rate cut, as well as a reserve requirement reduction, reversing a couple of years of slow tightening measures. Globally policy makers are starting to act in concert to implement economically stimulating policies in order to avert a global economic meltdown. The real question is, will all these policies be enough to stimulate the global economy, or will it as I believe shift us from depression talk back to recession talk.

For the OECD as a whole, from a starting point of nearly 2% GDP growth in the first quarter of this year, GDP growth will flirt with the zero line in 2008Q4 and 2009Q1, but should manage to stay in positive territory. Of course, it is easy to see a technical recession in the OECD, particularly if US growth is softer than expected. But there are good reasons not to expect a deep OECD recession that could drag world growth materially lower. The world economy should continue to be cushioned by the strong demand from the commodity producing areas of the world (which have reaped the benefits of the tripling of oil prices since the beginning of 2007). If we fast-forward to the trough, what type of global recovery should we expect once the low point in the cycle has been reached? As I believe it would be prudent to expect the recovery phase in the global economy to be relatively subdued compared with the previous cycles. Indeed, the expected recovery is similar to the U-shaped upturn following the US Savings & Loans crisis in the early 1990s rather than the V-shaped upswing after the tech bubble in early 2000s. There are a number of reasons why we can expect the global recovery phase to be rather anemic, with the possibility of a longer than normal period of growth stagnation:

1. Although the bailout plan will do a lot to help stimulate the credit markets, bank lending will be tight for some time. The unprecedented policy interventions that have taken place over the past two weeks have led to a relaxation of stresses from the very extreme levels reached last week (when credit markets came to a complete halt), but conditions remain far from “normal”. As part of the deleveraging process, banks are clearly tightening credit (just look at LIBOR, on a side note a safe bet would be a further widening of the TED spread (yield difference between the interest rates on inter-bank loans and T-Bills) as I think private banks will continue to tighten which will raise LIBOR (plus LIBOR is currently understated) coupled with the fact that the FED will have trouble raising rights in light of the recent economic maladies, although it should be noted that this would be a short term bet because as we have witnessed before keeping rates too low for too long is a very bad thing). That remains the key message from the latest bank lending surveys from the Fed, the ECB and the Bank of England. Therefore, the lack of lending confidence is likely to curtail the strength of the upswing (particularly in consumption and investment).

2. Although it started out as mainly a US and UK problem the global housing correction has spread. Ireland, Spain and New Zealand are at the forefront of housing weakness. But other major economies have also seen some cooling. More recently there have been signs of housing weakness in parts of China and India. One of the key ideas to understand about housing is that it is a relatively illiquid asset (i.e. by and large people don’t buy houses to immediately flip them, the vast majority of homes are purchased to live in for longer periods of time) and as such housing corrections can have long-lasting macro consequences. For example, following the average OECD housing bust, the growth slowdown lasted four years on average (measured from the time GDP growth started to fall to the time when it bottomed), or close to two years after house prices peaked.

3. Fiscal easing has and will continue to help, but there may be constraints (for example rates are already extremely low and to lower rates further risks starting up the inflation machine). While a second fiscal stimulus package might well be implemented in the US next year, it is unlikely to provide as much bang for a buck as the first package. Nor is the Japanese fiscal stimulus package likely to give an immediate boost to the economy, given that it did not include large-scale tax cuts. The Stability and Growth Pact also makes easier fiscal policy less viable for many European governments, particularly as it might risk stoking current concerns about inflation. That being said, this constraint is less binding in EM countries, such as China, where there is substantial scope for both monetary and fiscal easing in response to a growth slowdown.

As far as portfolio positioning is concerned I still recommend loading up on EM economies that stand to benefit from high commodity prices and potential currency gains. The particularly attractive markets are those with high growth potential currently trading at low P/Es (i.e. Brazil and Russia). I think consumer stocks will continue to be punished as commodities remain high and lending remains tight, I would be shocked if these two factors coupled with a weak job market weren’t enough to incentivize the consumer to tighten up those purse strings. Interestingly, the XHB (the housing ETF) has outperformed the market by almost 20% over the last month. These companies may be unintended beneficiaries of any eventual financials/mortgage-backed-asset plan. The XHB has clearly has run ahead of the data, where only hints of optimism exists. With the recent reading of the NAHB index essentially flat, with housing permits heading lower, and with sales down, I would be shocked if the XHB went up anymore.

On the oil front, Goldman Sachs had an interesting conference call last week in which they reaffirmed their view of higher energy prices by year end. They included a snazzy chart which I have pasted below. My only warning is tread carefully because pure play E&P will swing wildly with prices of oil while refiners will swing in opposite directions (that is one reason why I like COP because it is both, plus it trades at some crazy cheap levels and has a 20% stake in Yukos).



Sorry for the short post. I just don’t think there is much to say; currently the market is in an awkward state of purgatory. Like I have emphasized before, the real action will start once Q3 earnings season begins, then we will know whether we are headed for a turnaround or a long drawn out recession.

Financial Hodgepodge

First off, let me apologize for being MIA for a while, with all the tumult suffusing through the global markets my job has kept me quite busy. That being said let us take a moment to internally reflect on what has just happened. Ok, now lets focus on what can be done to better position us going forward.

Financial intervention to date has come in ad hoc form, first with new Fed lending facilities, then actions to facilitate the takeover of Bear Stearns, the GSE intervention, and finally last week’s decisions regarding AIG and Lehman Brothers. Without a standardized structure, the level of federal assistance, as well as the potential compensation for bearing risk, is unpredictable appears left to last-minute decision making even when it might not be. This has two consequences. First, these efforts are bound to lead to greater risk aversion among market participants. To a certain point this can be positive in reducing moral hazard, but taken to excess it can be destabilizing. This has become an increased concern over the last week—perceptions of counterparty risk have reached extreme levels and the ability of firms to attract new capital has been limited even further by concerns over potential intervention with punitive terms. Second, the lack of an agreed-upon policy makes any single intervention more difficult politically, which could constrain the Fed and Treasury in future decisions. Thus, policy may have reached a stage where a more standardized set of rules may be announced, if not legislated (hence the recent talk of RTC-esque vehicles). The need to establish the RTC is to establish a hard floor which should in essence stabilize the system (note it will stabilize it and provide a brief rally, financials will not go back to the way they were, we will still be in an extremely tight credit environment).
However, several important differences suggest that an RTC-style entity, while appropriate, is likely to be a piece of a larger solution. First, the federal government was already responsible for the costs of the S&L crisis, since it insured most S&L deposits. In contrast, the government bears little direct financial responsibility for many holders of mortgage assets in the current situation (the GSEs are the obvious exception). Without clear federal financial responsibility, the decision to establish a new agency—presumably at taxpayer risk—is more difficult. Second, the RTC was charged with consolidating assets from several hundred small banks. In the current situation, there are fewer lenders with significant assets, and they are larger. Third, in the present case, the vast majority of lenders are still going concerns rather than failed institutions which have been taken over by the government.

The RTC isn’t the only options there are at least two other viable options: Home Owner’s Loan Corporation (HLOC) or a Reconstruction Finance Corp (RFC).
The HOLC was established in 1933, under the Federal Home Loan Bank Board, to purchase and refinance mortgages. The HOLC acquired loans for two years and was wound down 18 years later. HOLC has several similarities to the refinancing program the Federal Housing Administration (FHA) is currently implementing. These programs were meant to support borrowers who could not refinance their mortgages, many of which at the time consisted of 5-year balloon loans. However, the HOLC exchanged a government-backed bond bearing 4% tax-exempt interest (less than prevailing mortgage rates) in return for mortgages, so that banks received an interest-bearing asset to replace the mortgage, albeit at a discount to the original value of the loan. By contrast, the current FHA program simply provides an outlet for borrowers to refinance into a government guaranteed loan once the previous loan has been voluntarily extinguished, also at a discount to the original value of the loan. While the risk borne by the government may be similar, the ability to purchase the loans would avoid some obstacles posed by loan-by-loan refinancing, though securitization is still likely to pose challenges.

The RFC was established in 1932 and by 1934 had purchased preferred stock from over four thousand banks. Unlike most preferred shareholders, the RFC also gained voting rights. The idea of an RFC-like approach would be to increase the level of capital in the banking sector and thereby expand the sector’s lending capacity. While most of the public discussion of remedies to the current situation has centered on how the government might purchase assets, the provision of capital to lenders may be just as important. To the extent that a program to purchase mortgage related assets is established, the sale of these assets is likely to crystallize losses and reduce regulatory capital. Some institutions would be able to absorb these losses, but others would either fall below regulatory minimums unless they are able to raise additional capital. Either way, the amount of credit these institutions would be able to extend would be diminished, with adverse consequences for growth. Providing capital would offset the significant slowing in lending now underway. From the standpoint of total credit available in the economy, providing capital that could be leveraged by ten times or so would allow the government to lend significantly more—through banks—than simply borrowing in the Treasury market and purchasing the assets directly.

Each of these three solutions presents an interesting alternative. The key in my mind is the process and structure the government uses to acquire these so-called assets. The most logical method would be to implement a reverse auction whereby the government could present a maximum bid (which should be something really low like $0.65 on the dollar) on a given type of asset, and accept bids starting with the lowest first until the predetermined capacity of the program is reached or the cap on bids is hit. I am a big believer that something needs to be done, something analogous to cutting off the leg to save the man type of thing.

Even though the pain in financials has been severe we must remember that financials are only a part of the bigger picture. The economic and market landscape has changed in some very important ways in the last few months. Much clearer signs of slowing in the non-US economies (particularly in the developed world) have turned what still looked at the start of the year like an environment where US weakness was dominant, to one with much more of the flavor of a global slowdown. The market has responded in two ways. First, it has downgraded non-US growth views relative to the US, pushing rates in many of the majors down relative to the US, fuelling a dollar rally and punishing equities with greater non-US exposure. Second, it has also for the first time traded across assets in ways traditionally consistent with a broad global slowdown, with commodities falling, equities underperforming bonds, cyclical stocks being hit hard, inflation breakevens dropping sharply, growth sensitive currencies being hit, and bonds doing well. My view has long been that what determines the resilience of non-US economies in US slowdowns has much less to do with the direct transmission of US weakness to the rest of the world and more to whether the underlying shocks that are driving weakness are local to the US or global in nature. And it is on that front that things have really changed.

In the early stages of the US housing market adjustment, the shocks hitting the global economy seemed primarily US-based – emanating from the collapse of the US housing bubble. The drag from this source has weighed on the non-US economy (the improving trade balance is a partial measure of how much the US has exported its slowdown to its trading partners). But much of the new pressure outside the rest of the world reflects the fact that over the last 12-18 months, a broader set of shocks has appeared.

In terms of housing vulnerability, the US, New Zealand, the UK and South Africa are already seeing real house price declines. Furthermore, within the Eurozone, Spain and Ireland have also seen house price depreciation. Although the price dynamics are less clear, China’s property market has also started to come under pressure after a long bull run. Parts of Eastern Europe in particular the Baltics, are showing sharp turns after having built up sizable imbalances. Much of continental Europe, Japan and many other Asian economies look less exposed.
On the terms-of-trade front, the split between commodity producers and consumers is clear. While the data does not fully account for the recent reversals in commodity prices, that conclusion over the last 12-18months is likely to hold even now. The biggest losers are most of North Asia (including China) and India, Turkey and the US. The biggest winners are Russia, Brazil, Malaysia, South Africa and the developed market commodity producers. These shifts have been dramatic in places, with a 43.6% rise in Russia’s terms of trade, and a sharp 24.1% decline in South Korea’s.

Looking at all these factors together, downside growth risk remains the most pronounced in the US, Japan and New Zealand. China and other NJA economies also face significant headwinds from a slowing global industrial cycle and negative terms-of-trade shocks, but there are important offsets from still generally healthy credit availability. For China and the Asian region as a whole, the underlying trend in Chinese domestic demand will be key, as external influences have flipped negative. On the other hand, the growth prospects look relatively better in several EM countries, including Brazil, Russia, Malaysia. Similarly, Canada, Norway and Australia may also have potential to outperform other G10 countries. The positive dynamics set off by earlier commodity rises are likely to remain supportive for growth in these markets for some time to come, even with the commodity pullback, as prices will still be generally higher than a year ago. With respect to asset prices more specifically, it is clearly important to differentiate between different asset classes. The relative growth outperformance of EM countries is likely to be most clearly reflected in FX space, where strong cyclical growth has been consistently rewarded. Local equity markets, on the other hand, and in particular those with commodity exposures, will be more influenced by spot commodity dynamics and global growth risk. This dynamic could well dominate local macro fundamentals, especially as long as we remain in a global deleveraging processing.

On the commodity front, The oil market is oversold, providing a compelling entry point, though near-term upside is now reduced Just as the market significantly overshot to the upside in the second quarter, it appears that the market has overshot to the downside and is now substantially oversold, as a combination of financial concerns, skepticism, and real and perceived demand weakness has pushed prices below the long-term economics of the industry.

The supply side of the market still remains severely constrained. As evidenced this past July at $140/bbl, oil producers raced to squeeze as much supply out of the system as possible, yet created only a very modest inventory cushion despite a substantially weaker demand environment. It is this lack of a significant inventory build in July followed by draws in August and a likely draw in September that is one of the key drivers behind a potential fourth quarter rebound in oil prices, as it leaves the market vulnerable to any type of shock. One of the more anomalous aspects of the recent market has been the deep level of contango that has persisted in the face of stock draws. The only dynamic that can explain this pricing anomaly is de-stocking, both physical (the stock of real barrels) and financial (the "stock" of paper barrels), which is just another aspect of the industry-wide de-leveraging that is taking place. The initial impact of physical and financial de-stocking is negative to prices as (1) physical players run down oil stocks to reduce working capital, they reduce their demand for physical prompt crude which creates a prompt contango in the forward curve, and (2) financial players sell out of paper positions to reduce credit exposure and/or cover losses. However, the medium- to longer-term impact of de-stocking to both price and volatility is explosive as it reduces the physical cushion and market liquidity to deal with any future supply or demand shock.

The argument against this vulnerability to a shock is that demand is weak and that any shocks are likely to only have a very small impact. The We weakness in demand has resulted from two transient drivers: (1) current Chinese de-stocking that resulted from forward buying in June and July ahead of both a shift in tax regime and the Olympics, which helped to create the surge in prices earlier this year (significantly overshooting even the bullish forecasts) and then the subsequent collapse to current levels, and also (2) the sharp decline in US crude oil runs due to the two back-to-back hurricane strikes on US Gulf Coast refineries. These two events, combined with financial concerns, largely explain the two-stage pullback in oil prices in the recent period. Using the diesel refinery margin as a proxy for Chinese demand for diesel, as most of the pre-August buying was in low sulfur diesel, the collapse in the diesel margin dragged oil prices from $145/bbl to $115/bbl, which was followed by a short period of consolidation. The hurricanes then struck, which knocked out a massive amount of US refinery demand, creating the second leg down from $115/bbl to $100/bbl and below that was exacerbated by the overlay of heightened financial concerns. This second leg down, however, widened refinery margins, which sets the stage for a rebound in prices once the shuttered refineries restart. While both of these events substantially reduce the current demand for crude oil, they do little to reduce end-use demand for refined products which remain much more stable. The recent sharp rise in prompt refinery margins around the world provides further evidence that end use demand remains stronger than refinery level demand.

On top of these transient negative demand factors, the market is trading with a very high level of skepticism, which has made the market moribund to nearly every bullish headline that has surfaced since early August – loss of Azeri crude oil (10 mmb), problems with Angolan platforms (15 mmb) and more recently real and substantial hurricane supply losses (a net loss of 56 mmb) and a dangerous escalation of civil unrest in Nigeria. Eventually, this string of events will be felt as demand rebounds in the fourth quarter against a small inventory cushion and very little spare production capacity; however, given the current trading bias, it will likely take a real physical catalyst that generates real physical demand to turn the market.

We are now nearly nine years into this current bull market in oil and have nearly no new supplies to show. This stands in sharp contrast to the 9th year of the bull market of the 1970s when Alaska, Mexico and the North Sea were all new projects in the ramp up phase with great prospects in front of them (see below). Today, try and name three new projects in the pipeline that have that same type of potential over the next five years (hint, it can’t be done). Without supply growth and continued economic expansion, demand will need to experience more and deeper adjustments that will only come through higher or more volatile prices in the future.




So what does this all mean for oil prices? I have not done enough research to predict with any level of confidence where prices will go, but I don’t think it will be down (or at least not much further). I know Goldman Sachs is predicted prices $125 by year end. While this could be possible it just says to me given the recent pullback in E&P players, it might be time to start acquiring (I know I have said this before, as prices have fallen further the argument has just gotten stronger). If any readers have any argument against investing in E&P players at these prices please let me know.

Not to cut this post short but I am tired of writing so I will quickly state some viewpoints:

Market will continue to be very volatile and will likely drop as crummy Q3 earnings are reported in October and November. There will be a pull back in select banking players as some have run up a little too much (i.e. WFC and maybe ZION). I would look to put money in wide-moat companies as the consumer will be dominating the news over the next few months. Pay particular attention to spending data, if the consumer pulls back we are headed for very-very tough times.

A short tale.....

Every now and again I stumble across an interesting short. The key to good shorting starts with a top-down approach. First look around for the most hyped industry and then focus in the industry on finding the most overvalued company. Here is one example that has mostly played out but still has some room to run. One sector that I have particularly interested in lately is alternative energy. With the rise in commodity prices a ton of attention particularly in the venture capital community has been given to alternative energy companies. Let me preface this by saying I think there will be some truly great companies that come out of this recent push into alternative energy, but with all that money there is undoubtedly going to be some junk.

One piece of junk that I came across a while back is Zoltek Companies. The company makes carbon fibers that can be used in a variety of applications due to their lightweight, high-strength, conductive, and corrosion-resistant properties. Carbon fibers are most common in aircraft brakes, but Zoltek has been expanding their use by employing them in composites for wind turbine blades (i.e. alternative energy) as well as for use by the oil and gas industry. Zoltek has two segments: heat- and flame-resistant technical fibers (acrylic fibers) and carbon fibers (under the brand name PANEX). In 2007, to concentrate on its carbon fibers business, it discontinued its former specialty products unit. Founder and CEO Zsolt Rumy owns just under a quarter of Zoltek. Historically, carbon fibers have been used primarily for expensive specialty products because acrylic fibers (used as raw materials for carbon fibers) were custom made and expensive. Zoltek's process, however, uses less-expensive, textile-grade fibers, making the use of carbon fibers economical in more applications.

Zoltek had been driving down the price of carbon fiber and racking up losses in the hope that manufacturers would choose it over other materials. Despite price decreases, the company's manufacturing capacity continued for a long while to be under-used.

After experiencing tough business conditions in the aerospace market for its carbon fibers, new aircraft production at Airbus (the A-380) and Boeing (the 7E7) spurred much growth in the industry. The new aircraft went into production in 2006 and, as a result, Zoltek's carbon fiber sales nearly doubled that year. That coupled with a marked increase in demand for wind turbines allowed Zoltek to again double its carbon fiber sales in 2007.

Zoltek also has an agreement with BMW to supply carbon fibers for the production of structural components of a new series of automobile. Still years away from completion, the project is designed to produce a lighter-weight vehicle that allows for the use of alternative fuels. Zoltek projects the automobile industry will eventually provide the largest market for carbon fibers, though it says that development is still years from fruition.

All of these developments led Zoltek to restart a manufacturing facility in Texas in 2004 and then to make plans to add capacity to all of its facilities in 2007. (It increased production from two lines in 2004 to 18 in 2007.) That year it also acquired a Mexican facility from Cydsa that will provide raw materials to Zoltek's carbon fibers manufacturing plants. The positive trends have also led Zoltek to exit some of its traditional acrylic and nylon fibers businesses.
Zoltek’s carbon fiber blades compete with those produced by Toray, and Mitsubishi Rayon (which represent some stiff competition).

Now there is no question that carbon fiber is a strong light material that is a logical fit in both planes and windmills. The issue is it is very expensive and the price differential is too great for its implementation in most applications. That is the reason in case you were wondering why we don’t have carbon fiber mass produced cars.

The current consensus estimates on this company have revenue growing more than 40% his year and 22% next year. With earnings more than doubling from $0.76 to $1.75 in 2010.

Now this may be perfectly feasible if carbon fiber wasn’t such a substitute premium product. In other words I doubt their ability to further push prices without killing demand. Take this coupled with the fact that one of their key customers is the aerospace industry which is going through troubles of its own (strike at Boeing and slowdown in demand for new aircrafts). It is the perfect recipe for a short.
Recently there was decent write up on this company by Carlo Cannell of Cannell Capital a long/short hedge fund. Here is an interesting quote from said article. “Our biggest issue with the company is that they are saying different things than their customers are telling us. Zoltek says they’re completely designed into future wind-turbine plans at Vestas and Gamesa, but we hear from those companies that they’re pursuing other solutions, such as replacing some carbon fiber with glass. The dramatic expected growth would also require making inroads at other large wind-turbine manufacturers like GE, who currently use no carbon fiber at all and doesn’t appear to have any plans to do so.”

Another hit against the company is that they currently trade at 3x EV/R which is a multiple befitting a software company not a cyclical chemical company like Zoltek. Cyclical chemical companies usually trade at a discount to revenue so being generous we will assume that Zoltek given that it’s a “green” or “alternative energy” company should trade at 1.5x-2x ttm EV/R which would give them an implied valuation of $8.50 to $11.11 which is a full 35%-50% below current levels. These are quite attractive returns.

Another interesting quote from Carlo Cannell, “There are several added party favors here. Working capital management is terrible – they have over 100 days of inventory when they should have 20. Insiders are selling. The CFO has resigned and the SEC is investigating unauthorized payments made to third parties that he (CFO) may have been affiliated with. Good companies don’t have their CFOs resign for alleged wrongdoing and then make them sign an iron-clad non-disclosure agreement.”
So take this all together and you have what could be one interesting short.

Too Lazy to Write enjoy some GS stuff....

Potential two to three year doubles Targeted 10 Carpet 2008 09 02 - Upload a Document to Scribd

Read this document on Scribd: Potential two to three year doubles Targeted 10 Carpet 2008 09 02

Hobson's choice economically speaking...

Thesis: Expect contiuned weakness in the market, the Fed is left with a single sided choice of maintaining loose credit standards until housing regains footing. Oil continued to fall even though fundamentals remain in tact.

The single most concerning piece of information this week was the Federal Reserve’s quarterly Senior Loan Officer Survey of Bank Lending Practices. Respondents to the July survey revealed that their banks ratcheted credit conditions yet tighter in recent months, suggesting more “stag” ahead. The credit crunch has now spread into all areas of lending, with more than 80% of banks reporting a tightening in lending standards for mortgage loans, and more than 60% for consumer and business loans--levels far above those seen in the 2001 recession and even in the 1990-91 recession (graph below). Lending officers asked about their willingness to make consumer installment loans reported the biggest negative shift in attitudes towards lending to households since early 1980.


Also very disappointing were weekly data on jobless claims. New claims edged down slightly to 450,000, but remain well above levels just a few weeks ago, while the total number of claimants topped 3.4 million for the first time since 2003. With credit conditions tightening, the labor market weakening, asset prices down substantially, and fiscal stimulus now a thing of the past, households are likely to cut back on spending over the next several months. Consistent with this gloomy outlook, core retail sales in July--excluding autos, building materials, and gasoline were up only 0.3%, the third consecutive month of slowing. This suggests that the impetus from fiscal stimulus is rapidly fading.

The “flation” half of the stagflationary data came with the monthly reports on import prices and the Consumer Price Index. Import prices continued their climb in July, accelerating to a 21.7% year-over-year increase overall, 8% excluding petroleum products (the highest inflation rate since the depreciation of the dollar in the late 1980s following the Plaza Accord). For those of us who aren’t business history buffs, The Plaza Accord or Plaza Agreement was an agreement signed on September 22, 1985 at the Plaza Hotel in New York City (hence the name, I know politicians are really creative). The agreement was signed by 5 nations - France, West Germany, Japan, the United States, and the United Kingdom. The focus of the agreement was to depreciate the US dollar in relation to the Japanese yen and German Deutsche Mark (remember what was going on in West Germany right now) by intervening in currency markets. The exchange rate value of the dollar versus the yen declined 51% over the two years after this agreement took place. Most of this devaluation was due to the $10 billion spent by the participating central banks. The reason for the dollar's devaluation was twofold: to reduce the US current account deficit, which had reached 3.5% of the GDP (FYI as of 2007 it was at 5.3%), and to help the US economy to emerge from a serious recession that began in the early 1980s. The U.S. Federal Reserve System under Paul Volcker had overvalued the dollar enough to make industry in the US (particularly the automobile industry) less competitive in the global market. Devaluing the dollar made US exports cheaper to its trading partners, which in turn meant that other countries bought more American-made goods and services (sound familiar?). The Plaza Accord was successful in reducing the US trade deficit with Western European nations but largely failed to fulfill its primary objective of alleviating the trade deficit with Japan because this deficit was due to structural rather than monetary conditions. US manufactured goods became more competitive in the exports market but were still largely unable to succeed in the Japanese domestic market due to Japan's structural restrictions on imports. The recessionary effects of the strengthened yen in Japan's export-dependent economy created an incentive for the expansionary monetary policies that led to the Japanese asset price bubble of the late 1980s. But I digress….

Consumer prices leapt higher yet again, with headline inflation accelerating to 5.6% year-over-year on sharp increases in energy and food prices. Perhaps more concerning, core inflation rose 0.33% on a plethora of upside surprises strewn throughout the index, e.g. apparel +1.2% (likely related to the acceleration in import prices), tobacco +1.2%, public transportation +1.1% (probably driven by higher energy costs), lodging away from home +0.7%, education +0.5%.

The main bright spot of the US economy isn’t in the United States it’s the rest of the world, which is increasingly turning to US manufacturers given their steady productivity gains and more favorable exchange rate. In volume terms, the trade deficit has been narrowing since early 2007 (wait, this seems eerily familiar!).

Beyond the fundamental drivers of a weak dollar and weak US domestic demand, high commodity prices have been a factor behind this dramatic improvement. They encourage conservation by commodity-consuming countries like the United States (hence fewer imports) and stimulate more spending by commodity producing nations (including spending on US exports). Essentially all of the acceleration in real exports in recent months has been in commodity related goods.

Mortgage deterioration has spread beyond subprime. Early policy efforts e.g. modification of adjustable rate loans and a government-backed refinancing program generally focused on subprime borrowers, but defaults are accelerating in Alt-A and prime mortgages as well. Even among the government-sponsored enterprises (GSEs), recent mortgage vintages appear to be deteriorating at a faster pace. Thus, programs targeted to a more limited subprime population may be less effective as defaults broaden.

The federal government is likely to bear an increasing share of losses going forward. Financial institutions have now announced over $500 billion in losses over the last year, but have managed to raise $367 billion in capital, largely through issuance of common and preferred stock. However, as some institutions find it difficult to raise capital, additional exposure is likely to fall on the government (can someone say higher taxes?). Also, because a substantial portion of the early losses was related to securitized products, institutions with the most direct link to the government deposit-taking banks and the GSEs did not face immediate risk. This has now changed, as a result of widening losses and government action. As the federal government bears a greater fiscal burden, there is the potential for increasing conflict between policy objectives and political realities. Individual lenders have an incentive to reduce risk to limit losses and preserve capital. While policymakers aim to maintain credit availability, there is pressure on politicians to resolve financial disruptions in the least costly manner possible, as well as a desire to take incremental steps in the hope that more aggressive action will not be necessary.

Apart from the initial steps taken to date, what more can policymakers do? Congress plans to return for one month in September and then adjourn until early 2009. The Bush Administration may take additional action before next January, but without further legislation this would be limited to working within the existing authority that Congress recently granted. The incoming administration and the next Congress face three important questions: first, will the federal government devote more money to cleaning up the mortgage mess? Second, will lawmakers compel greater participation from lenders? Third, how will policymakers balance longer term reform against medium term stability?

So what does all this mean with regards to potential trades? The recent emergence of wider corporate credit and commercial mortgage spreads, GSE worries, and the potential contagion to the rest of the financial sector all do not bode well for the market. Getting above 1,300 required a great deal of inflation worry to be resolved, painfully so for the supposed “growth” areas, but having wrung out that fear and facing the specter of another wave of seemingly imminent financials damage, a pullback to previous lows is far easier to envisage than any break back to the tops of the recent range. The most proximate upside catalyst might very well be government intervention in the GSE space. Over the last year the market has come to respect the power of government action to spark short-lived market rallies, but it may take more damage from here to get that to happen.

A GSE bailout is certainly damaging for equity holders in that space. But as we have seen in the recent past, government intervention may be a market and sector positive, at least in the short term. Getting there may entail some serious pain and, while the nearly explicit GSE put may limit broader contagion in the financials space, it is worth remembering that a capital injection that just repairs balance sheet damage does not mean that GSEs will be open for “business as usual,” and mortgage activity will likely continue to be impaired.

Against this backdrop, though GSEs themselves face the most direct pressures and the entire financial sector is likely close second, housing equities look vulnerable too, with housing activity meaningfully related to GSE fortunes. Mortgage rates are rising despite a bond market rally, pushing mortgage spreads up even more sharply, and bank de-leveraging means further constraints on consumer credit and mortgage lending.

The XHB has outperformed the market by more than 20% since mid-July, as some tentative signs of firming in the data emerged (An uptick in permits, a slowing in the pace of house price declines, and some sequential improvements in the inventory of new homes relative to sales). But there has been little data follow through in the form of continued stabilization, and mortgage centered concerns ought to be the dominant force here, at least for now, with significant room for housing equities to run lower.

One of the symptoms of the weakening economic growth outlook (at least in the market’s estimation) has been the sharp pullback in oil prices. This has led to some significant sector rotations. Consumer areas of the market have been supported, while the energy sector has been damaged. As previously written, I view this rotation as extreme on both counts: Consumer discretionary stocks have taken too much credit for the potential boost to spending from a pullback in oil prices, and energy equities have taken on too much damage. Relative to the market, the broad consumer discretionary sector (XLY) and the retail space (RTH) have rallied; the underlying indices are both up around 5% relative to the SPX since mid-July. With oil price relief the likely catalyst, the magnitude of these rallies looks overdone, exceeding historical “betas” to the oil price move, and in the face of still significant underlying consumer headwinds. The weekly unemployment insurance data point to further labor market damage commensurate with an unemployment rate well into the 6% range, confidence remains at recessionary levels, and consumer balance sheets continue to be de-leveraged as banks cut back on lending.

On the oil side, even if oil prices only stabilize here, energy equities, which have looked inexpensive relative to crude oil all summer long, ought to benefit too. Even after taking into account the sharp pullback in oil prices themselves, the energy sector (relative to the market) looks undervalued.

Given all this data it would appear as if the choice is simple, we are left with only one option (hence the title, A Hobson's choice is a free choice in which only one option is offered, and one may refuse to take that option. The choice is therefore between taking the option or not taking it, colloquially formulated as "take it or leave it.") Expect equities to continue turbulent times and seek safety in wide moat companies, energy specifically is looking appealing given the recent pull back, avoid consumer stocks until future spending looks more promising.

From contango back to backwardation...

Summary: Oil may continue to trade in a range bound fashion, but don't expect it to drop too much further, in the medium to long-term fundamentals are nothing but bullish.

To the average American, the US economy is clearly in recession. This is because, in most people’s eyes, a recession is what a recession does: it snuffs out jobs as companies cut output to accommodate a weakening in demand, thus reducing real income. However, the data on GDP have yet to meet what many call the “technical” definition of recession--two consecutive quarters of .negative growth, an oxymoron that only economists could love. In fact, the National Bureau of Economic Research (NBER) the arbiter of business cycles in the United States does not use this definition. In its words: “a recession is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.”

The four monthly indicators on this list that the NBER specifically tracks are consistent with the common view that a recession started late last year. The conclusions today are the same as they were then, strengthened a bit by revisions that have steepened the declines in the interim. In particular:

1. The US economy probably hit a cyclical peak last November.

2. The recession has been exceedingly mild, at least so far.

Although the rise in unemployment that most people take as telltale of recession has been anything but mild, all four indicators have held up better than the median for the cycles since 1953. All but real sales have also fallen less quickly than in 2001, when the US economy experienced the mildest recession on record as measured by GDP the only one that shows no year-to-year decline in real GDP. Given this backdrop, it should not be surprising that the lack of a significant drop in real GDP has held up the NBER’s recession call. Even after last month’s annual revision, which produced a tiny 0.2% annualized drop in the fourth quarter, some members of the NBER committee charged with this august responsibility seem hesitant, pointing out that real GDP subsequently rose during the first half of 2008. Conceptually, Gross Domestic Income (GDI) and GDP are equivalent, as sales of goods produced in the United States (GDP) generate income for someone (GDI). Observed differences are statistical in nature. According to a Fed staff study, real GDI often gives a more reliable signal than GDP around turning points.

That being said, we can’t help but wonder if lower energy prices will lead to economic salvation. However, as is usually the case that form of syllogistic reasoning is flawed. Although lower energy prices will assist the consumer it only takes care of one of our “four horsemen of the recession” (the others being: housing malaise, credit freeze, and the indebtedness of the U.S. and its citizens).

Now I shall shift the focus more onto this “correction” in energy. The tug of war between fundamentals tightness and concerns over demand weakness continues to dictate oil price movements, with the latter in the spotlight over the past few weeks. The explosion in the BTC pipeline and the recent hostilities between Russia and Georgia have not only materially disrupted a significant portion of Azeri exports, but have also underscored the vulnerability of oil supplies from the region, which accounts for a good part of the expected year-end supply growth. However, oil prices have continued to sell off to below US$115/bbl regardless.

Although concerns over demand weakness have outweighed fundamentals tightness in the past few weeks, recent data releases confirm that constrained supply and supportive non-OECD demand continue to more than offset weak OECD demand. Declining supplies in mature producing regions and strong non-OECD demand more than countered the 1.1% price-induced decline in OECD demand in 2Q08, leaving total OECD inventories flat in 2Q08 against a seasonal 900 kb/d build, remaining below 10-year average levels for the end of July. The 9.5% annual increase in Chinese demand in July exemplifies that non-OECD countries continue to absorb oil supplies and keep fundamentals tight even in an increasing price environment. Further, last week’s US Department of Energy (DOE) statistics have confirmed a decline in refined product inventories prompted by refinery run cuts, against a backdrop of continued low crude inventories.

While near-term fundamentals remain tight, since the beginning of the year and specifically over the past few weeks’ expectations regarding long-term fundamentals have been center stage. Long-dated oil prices have been driving the rally since the end of last year, accelerating dramatically in May and June, and are now leading the downwards correction. While the 20% sell-off over the past four weeks has been a record decline for long-dated oil prices, it comes on the heels of a record acceleration that had brought backend prices above the trend in price changes that had characterized the market since the end of last year and in the 2004-2005 structural rally. In particular, five-year forward prices had soared to over US$140/bbl at the beginning of July. Despite tight near-term fundamentals, bearish sentiments over future demand destruction have driven the back-end sell-off. Indeed, remarkably, the recent sell-off has been accompanied by signs of strengthening physical fundamentals as prompt WTI timespreads have strengthened over the past few weeks moving into a front-month backwardation. Further, while the price acceleration in May and June weighed on 2Q08 US demand and more modestly on European demand, overall the impact on global demand has likely been modest as is suggested by the unseasonably flat OECD inventories in 2Q08.

The long-term drivers in the market remain intact –trend supply growth has declined and cannot continue to accommodate stable trend demand growth on the back of supportive global economic growth fuelled by emerging markets. Therefore, on a long-term basis, higher prices are necessary to promote a structural demand adjustment and to continue to incentivize investments in production capacity enhancements. While weakening economic conditions in G3 countries coupled with the recent acceleration in oil prices have restrained demand, especially in the US and more modestly in Europe, the necessary structural adjustment required to bring demand in line with production capacity will likely take many years of high prices to promote a meaningful increase in energy efficiency.

While concerns over demand weakness continue to permeate market sentiment, recent data releases confirm that supportive non-OECD demand and restrained supply have more than offset OECD demand weakness, leaving total OECD inventories unseasonably flat in 2Q08 against a seasonal 900 kb/d build. Further, preliminary industry data for July indicates a 28 million barrels increase in total OECD stocks in July, which while slightly higher than the 19 million barrel seasonal build for July, continues to leave inventories below 10-year average levels.

The lack of inventory builds in 2Q08 despite softer price-induced OECD demand and the 400 kb/d increase in Saudi production in May and June underscores extremely tight crude balances suggesting that non-OECD demand has continued to be exceptionally strong and, possibly, that supply growth could be lower than currently estimated. It should be noted that given the 90% yoy surge in oil prices in 2Q08, the 1.1% yoy decline in total OECD demand over the same period has not been surprisingly strong but, if anything, has been lower than would be suggested by standard demand elasticity estimates, likely on the back of supportive power-related demand in Japan. Further, while US oil demand has born the brunt of the oil price surge, given its higher price sensitivity, weaker economic environment and distressed credit conditions, the decline in total US oil demand has not been stronger than in previous economic slowdowns.

More importantly, US gasoline demand growth continues to show a strong correlation with price changes instead of with price levels, underscoring that as oil price inflation moderates in the second half of the year, some pressure on demand will likely be alleviated.

The necessary expansion in oil production capacity remains constrained by escalating resource protectionism at the same time that alternative fuels are proving to have limited scalability. As these constraints are slowing trend oil supply growth against a backdrop of higher world GDP growth, long-dated oil prices need to increase steadily to slow oil demand growth in line with supply on a long-term basis. While the need to curtail demand growth on a long-term basis will likely keep long-dated prices above marginal cost of production, industry costs are re-accelerating at the same pace as they did in the 2005/2006 period.

This indicates that the floor below which long-dated prices are unlikely to fall for a sustained period of time is rising. In particular the historical relationship between industry cost indicators such as the US Oil and Gas Field Equipment and Machinery PPI and long-dated oil prices suggests that the cost-based floor to long-dated oil prices was US$105/bbl in June and is likely continuing to increase.

In other words, don’t bet the farm on oil falling too much further.

From Russia with Love?

Thanks to some reader suggested input, I will now place the thesis of each post at the very top. Thesis: Long Russia/Long LNG.

For those of you who have read my prior posts you might have realized that I am relatively bullish on certain foreign economies, with Russia being one of them. The Russian thesis in a nutshell is: they have an immense amount of natural resources which should drive their domestic economy allowing the government (via heavy export levies) to invest substantial amount of domestic infrastructure which should help spur development in non-natural resource based industries, this coupled with the fact that I believe their currency is currently undervalued should provide a U.S. investor an interesting return spectrum. The risks to this thesis are obvious: inflation, Dutch Disease, government risk (think recent events with Mechel or Yukos), and most recently war with Georgia.

As you probably have heard Russian tanks crossed into South Ossetia Friday after Georgia launched a major military offensive to recapture control of the separatist province on Thursday night. In Moscow, Russian equities tumbled, as investors turned nervous following news of the escalating situation. The benchmark RTS stock index fell 6.5%. The index has declined 24.8% this year (this decline is due to three things: 1. Putin’s recent move against Mechel, 2. Falling natural resource price and 3. Conflict with Georgia. The Russian currency, the ruble, fell more than 1% against its dual currency basket Friday. South Ossetia has a population of 70,000, most of whom are not ethnically Georgian, but close to the Ossetians in Russia's province of North Ossetia. A destitute region, South Ossetia has received two-thirds of its $30 million budget from Russia and the majority of its population holds Russian passports, according to Global Insight. Russian state-controlled gas giant Gazprom is building a pipeline to the region as well as infrastructure. For Russia, South Ossetia is a useful means to undermine and cause inconvenience to the unfriendly Georgian government, which sees itself as the U.S. outpost in the post-Soviet space and seeks to join NATO, which is very annoying to Russia. Politics aside one can’t help but wonder what could be the end result financially speaking. The likely result is that the fighting will continue until Russia is allowed to either remove the people or claim the territory; I view the former as the most likely scenario. Although Georgia does control reasonably important pipeline territory Russia has already been finding ways to build around it. I think the recent sell-off in both the equities and currency is overdone.

Demographically speaking Russia does face certain challenges. Russia stands out for its high levels of educational and scientific achievement. But the fiscal crisis of the 1990s caused a ‘brain drain’ of many of its top researchers and difficulties in recruiting new teachers. The country still needs to go some way to restoring the quality of its schools and universities, while adapting them to the demands of a knowledge-based economy. Demographics pose one of the most serious challenges to Russia’s long-run growth potential, and have a direct, negative impact on the future size of the economy. The US census bureau forecasts that Russia’s population will shrink from the current 142mn to under 110mn by 2050, with the workforce contracting after 2009. So far, the government has offered incentives to mothers to have more children, has begun to invest more in health care, and has promised to promote a healthier lifestyle. As the government begins to invest more domestic infrastructure that will drive job growth which will spur immigration from surrounding countries. Just as in the other BRIC nations, Russia needs to improve its infrastructure significantly. Because Russia is already reasonably urbanized, its need is not in the same league as China’s or India’s. Nonetheless, Russia has plenty of scope to improve its transport systems, linked to the rapidly rising wealth of Russians. The airline/airport infrastructure need appears to be especially strong, and it represents both a challenge and a significant business opportunity.

The question then remains will commodities remain high enough to fund the backbone of the Russian economy? The conflict in Georgia might act to disrupt Russian oil & gas supplies to Europe (they could also tighten the spigot as a form of political pressure for EU neutrality or support). Speaking on a more macro level, there has been a substantially negative shift in sentiment owing largely to concerns about commodity “demand destruction” in the context of both slowing global economic growth and substantial commodity price increases this year. Concerns about increased supply availability owing to OPEC production increases and substantial improvement in US crop conditions and development post the slow start to the U.S. planting/growing season and the Midwest flooding have also contributed to recent sharp price declines. Although US and broader OECD demand for oil has weakened substantially over the prior six months in response to rising prices, this weakness has been necessitated by extremely disappointing non-OPEC crude oil supply growth –down 650 thousand b/d year over year in June – in the context of still strong emerging market demand. The US in particular has borne the brunt of the demand declines relative to the rest of the world because lower taxes, a weaker economic environment and tighter credit conditions have left US consumers most sensitive to rising prices. Despite substantial US demand weakness, US total product inventories have failed to build meaningfully and US crude oil inventories actually remain at critically low levels, providing further evidence that any supplies made available by US demand weakness are being consumed by emerging economies. This lack of an inventory build also underscores that recent increases in OPEC production have only served to offset substantially larger-than-expected production declines in places such as Mexico, Venezuela, Russia and the North Sea. As the rise in prices earlier this year is very consistent with the magnitude of the resulting demand weakness based on historical relationships, it is likely that the demand weakness has simply been induced by the rising prices and is therefore temporary rather than more permanent demand destruction.

I will now spend some time focusing in on a few key commodities.

Black Gold:
Oil prices declined by almost 15% in July and another 4% so far in August primarily as concerns over global economic growth and weakening oil demand have triggered a sharp financial liquidation. WTI crude oil open interest has plummeted to the lowest levels since the beginning of 2007 and speculative length has declined to lows reached at the beginning of the year when oil prices declined by 13% - similar to the recent sell-off. As a result, prices have declined to levels where large open interest in put options is concentrated, underscoring the risk of further selling pressure as financial traders who sold the puts need to sell further contracts to delta hedge their portfolio – traders call this the “negative gamma effect”. Recently, the U.S. consumer has borne the brunt of the necessary demand adjustment because lower taxes, the weak U.S. dollar, a soft economic environment and tighter credit conditions relative to the rest of the world have left the U.S. consumer most sensitive to price. Accordingly, U.S. oil demand has been exceptionally weak. However, the magnitude of weakness has been consistent with the rise in price, suggesting that this weakness is likely transient rather than more permanent demand destruction and could reverse on stabilization or decline in prices. Importantly, this demand weakness on top of recent increases in OPEC production is not leading to meaningful inventory builds as emerging markets are consuming the available supplies, and as OPEC production increases have largely served to offset non-OPEC production disappointments. Since the beginning of May, total US and OECD oil inventories have built less than seasonal norms and have declined below 10-year-average levels while US crude oil inventories remain at critically low levels. A strong rise in Chinese refinery runs - up 7.2 % year over year in June despite the 20% increase in controlled domestic prices announced on June 20 – underscores the emerging market demand strength. Overall, while spare oil production capacity is extremely low, inventories remain below 10-year average levels, underscoring that global demand for oil is not falling significantly below supply. Goldman Sachs recently reaffirmed their year-end price target of $149 which is a full 29% above Friday’s close. In my opinion I think this forecast might be slightly high, given the negative demand dynamics associated with EU and US consumers I am leaning more towards a year-end price target of around $130 which is about 13% higher than today’s prices.

Natural Gas:
NYMEX Natural Gas closed at $8.248 with WTI Crude closing at $115.20. Historically, crude oil has traded at about a 6-8 multiple to natural gas, currently the ratio is 13.96x. Natural gas was the worst performing commodity in July, as prices declined 46% in the period (vs. a 15% decline in Oil), disconnecting from international natural gas prices and widening their discount to the oil complex, largely on the back of economic concerns that have generated downward pressure across the commodities complex as well as a meaningful softening of the US natural gas balance. Specifically, despite modestly hotter-than-normal weather in July, natural gas inventory builds over the last few weeks have been substantially above average, leaving inventory levels only 6 Bcf below 5-year average levels from a peak deficit of -78 Bcf in the week of July 4, 2008. On the supply side, US pipeline imports from Canada, although still down year-on-year, have reduced their differential to 2007 levels by more than 400 mmcf/d or 38% in July relative to June. Going forward, expect no meaningful recovery from Canadian exports to the United
States due to still low Canadian gas rig counts and no significant displacements of natural gas-fired generation, now that the excess water supply has been depleted and natural gas/coal differentials are at near record-low levels. Goldman Sachs recently came out with an October price target of $13 which is 57% above current levels. I think this forecast is a little overly bullish. It relies significantly on a strong hurricane season and a large amount of cold weather in both September and October. I think a fairer price estimate would be in the $11.50 range which is still 39% higher than current prices.

On the equity side, even after accounting for the pull back in commodities, the consumer and energy shifts look extreme. The equity damage in the energy sector has outpaced the commodities themselves. In fact, the recent disconnect between equities and commodities are on the high end of their historical relationship. Part of the equity drag has been a reflection of the underperformance of large cap refiners, with margins under extreme pressure. In fact, refiners look more like industrial oil users than parts of the energy sector. But even when looking at an equal-weighted version of the energy sector, the gap to commodities is at the top end of the range.

Given the recent pull back in commodity prices the risk/return dynamics have been favorably skewed. It would be wise to re-adjust your portfolio allocation to this specific sector. Given that Russia is the largest producer and exporter of LNG it might also be wise to take a look at it. The short-term risks with Russia are over blown; the real worries lie in inflation and long-term growth (i.e. bulking up non-natural resource dependent sectors of the economy).