Issue 44 - June 3, 2008

Shallow Waters

US stock and bond markets have done a good job of recovering from the wide spread losses sustained in the first quarter of this year. The banks at the center of the storm in the financial markets have made good progress in rebuilding their balance sheets by raising equity capital and selling off large pools of assets. These improvements, however, have received scant notice as the daily headlines relentlessly repeat the news of imminent recession and spiking commodity prices.

We have commented in the past that whether or not we are technically in a recession or not is more of a matter for the academics. What seems certain is that we have moved from a period of strong domestic and international growth to one which has slowed down appreciably. The Federal Reserve has likely completed all the treatment they are prepared to offer at this point. They lowered the Federal Funds rate by 300 basis points and the discount rate by 375 basis points since last summer. They created innovative lending programs and made use of much of their own balance sheet to allow the banks time and breathing room for an orderly restructuring. The heavy lifting now moves back to the banking institutions as they work to restore well functioning credit markets.

Consumers have been bombarded in recent weeks as food and energy prices have risen dramatically. While increasing global demand is no doubt a factor, the recent action is both worrisome and suggestive of other factors at work. Consumer demands simply do not change this quickly and the fact that China and India will consume increasing amounts of raw materials is not suddenly new information. Regardless of the reason, consumers are treading cautiously.

The combination of consumer caution coupled with the ongoing workout of the credit hangover will likely keep a cap on economic growth. Sluggishness never feels good and it is enormously frustrating but the economic surprises of this quarter have been to the upside. Labor remains the dominant factor in our economy and recent data while weaker has not been consistent with recessionary periods of the past. Internal Revenue Service withholding for individuals continues to run at +5.63% year over year – not spectacular, but solid. Ultimately, the adjective which will best describe this period will be shallow. Whether it is ultimately defined as a recession or a recovery, it will probably feel about the same.

Odds and Evens

In 1979, following the fall of the Shah of Iran, oil supplies were interrupted and there were meaningful shortages. Drivers nationwide were limited to filling up on even days of the month if the license plate ended in an even number or alternatively on odd days for odd numbers. The lines were long and prices rose.

In 2008, prices of all commodities have surged. But there are no lines and no meaningful supply interruptions. What has happened to the laws of supply and demand? We hear that demand is rising from emerging countries and China and India, but this is a trend not an event. We know that oil trades almost exclusively in US Dollars and the weakness of our currency has provided a further push in the direction of higher prices. But this too is a trend and not an event. With prices rising this quickly, it suggests that demand is outstripping supply. But the absence of scarcity suggests otherwise.

Since the great depression, it has been well understood that speculators should not be allowed to dominate the commodity markets and in particular, the commodity futures market, which provides real producers with a market in which to hedge their inventories. In 1936, Congress passed the Commodity Exchange Act and created the CFTC to oversee trading in this market. Participants are designated either as “hedgers” for physical commodity producers or as speculators. Strict volume limits are imposed on those designated as speculators. There is however one exception to the speculator limit provided to banks when they are in the process of executing a hedge for a swap transaction. Sounds harmless enough, but consider the following. After the stock market correction in 2002, many large institutions began to look towards alternative investment options – we wrote about this in our year-end 2006 newsletter:

Many large institutions which had been negatively impacted during the bear market of 2000-2002 began to look for alternatives to some of their traditional allocations to stocks and bonds. It became the common wisdom that stocks would only earn 6-7%, a far cry from their 10%+ averages of the late 20th century, and with ten-year bonds yielding 4% or less; there was simply no way for these portfolio managers to keep up with their mandates and actuarial liabilities. It was quite natural then for these institutions to look to their unique structural advantages for ways to enhance returns. Specifically, unlike individuals, they are not taxable and they have extremely long-term time horizons. Short-term gains look no worse than long-term gains and any illiquidity required to drive returns back into the acceptable territory was manageable. Enter the era of Alternatives. Investments in Hedge Funds, Private Equity, and Real Estate have certainly brought the returns that these endowments required and are all happy to advertise. But at what risk?

We know that there has been terrific demand for real assets including commodities within this group. However, unlike a commercial building which they are happy to own outright, institutional investors do not want to take delivery of physical commodities. Furthermore they are barred from making any meaningful purchases in the futures market. But recall our bank exception.

An institutional investor can enter into a swap transaction with a bank where they receive the “return” of the commodity index. The bank then goes to the futures market to “hedge” that transaction. No limits. What is forbidden is now enabled. Just like a 22 year old buying beer for a minor. The term for this type of investment has been deemed “Index Speculation” and is distinct from the traditional speculative trading. Traditional speculators buy and sell small amounts and have historically provided liquidity. Index Speculation is a function of the asset allocation decisions of these large institutional investors. They are relatively price insensitive in implementing their allocation and rather than selling positions they “roll” them into the next month. They are a source of demand without ever wanting to take delivery and their impact can not be dismissed.

Michael Masters, a hedge fund manager by background, presented the following findings to the Department of Homeland Security in his testimony on May 20th, 2008. As of March, 2008 Index Speculation had accumulated via the futures market 1.1 billion barrels of oil and 1.3 billion bushels of wheat. That’s eight times what the US Government has put into the strategic reserve and at 2.2 bushels of wheat per person in the US per year, that’s 3 years of wheat. Over the past 5 years Index demand has increased by 848 million barrels which is just shy of the increase in demand from China. Perhaps coincidentally, on May 29th, the CFTC announced new measures as regulators begin the task of trying to rein in yet another financial innovation that they have either missed or ignored.

Demand for raw materials is certainly growing. The concurrent inflation pressures especially in the emerging world where food and energy are much larger components will need to be addressed. Higher interest rates and the elimination of government subsidies are options already being discussed in those markets most impacted. Better data and attribution would go a long way to providing some sorely needed stability.

Changing Times

As we move through the coming months, markets will be faced with a variety of conflicting data. Consumer habits will continue to evolve throughout the world, but so will innovation and productivity. This process will create both opportunities and frustrations and forward progress will likely be “lumpy”. Risk has been re-priced and liquidity premiums have also had a renaissance. Markets will continue to look forward and will reward those businesses which demonstrate their ability to sustain themselves and to thrive in a changing climate.

• Shallow Waters
• Odds and Evens
• Changing Times