Influences Of The Yield Curve On The Equity And Commodity Markets

``The interest rates for more distant maturities are normally higher the further out in time. Why? First, because lenders fear a depreciating monetary unit: price inflation. To compensate themselves for this expected (normal) falling purchasing power, they demand a higher return. Second, the risk of default increases the longer the debt has to mature.-Gary North

The first structural factor, the record steep yield curve, should be a familiar theme to those who regularly read my outlook.

This accounts for as the “profit spread” from which various institutions take advantage of the “borrow short term and lend or invest in long term assets”[1].

The Yield Curve (YC) is a very dependable tool for measuring boom bust cycles (see figure 2).

That’s because artificially lowered interest rates, a form of price control applied to time preferences of the individuals relative to the use of money, creates extraordinary demand for credit and fosters systematic malinvestments or broad based misdirection of resources within markets and the economies.

Figure 2: Economagic.com: Yield Curve and the Boom Bust Cycle in the S&P 500

Sins Of Omission: The Influences of Habit or Addiction

It’s fundamentally misplaced to also conclude that just because balance sheet problems exist for many consumers, particularly for developed economies in the West, as they’ve been hocked up to their eyeballs on debt, that they would inhibit themselves from taking up further credit to spend. This also applies to some corporations.

Such presumption fatally ignores individual human action, particularly, for people to develop and sustain irrational habits. Some of these habits grow to the extent of addiction, which could have a beneficial (reading) or negative or neutral effect (mowing lawns). Albeit, addiction has a predominantly negative connotation.

While addiction[2] has many alleged modal causes, e.g. disease, genetic, experimental, and etc., some models have been argued on the basis of purely psychology, specifically:

-choice [The free-will model or "life-process model" proposed by Thomas Szasz],

-pleasure [an emotional fixation (sentiment) acquired through learning, which intermittently or continually expresses itself in purposeful, stereotyped behavior with the character and force of a natural drive, aiming at a specific pleasure or the avoidance of a specific discomfort."- Nils Bejerot]

-culture [“recognizes that the influence of culture is a strong determinant of whether or not individuals fall prey to certain addictions”]

-moral [result of human weakness, and are defects of character]

-rational addiction [as specific kinds of rational, forward-looking, optimal consumption plans. In other words, addiction is perceived as a rational response to individual and/or environmental factors. There wouldn’t be an addict or substance abuse problem, if those affected are disciplined enough to correct habit abuses.]

If affected persons, in recognition of such problems, simply applied self-medication or took preventive measures to avoid the worsening development of negative addiction, then obviously we wouldn’t have addiction problems at all! But certainly this hasn’t been true.

From a psychological standpoint, it would seem quite apparent that addiction is largely a stimulus response feedback mechanism or very much a behavioural predicament.

In other words, negative addiction is fundamentally a choice between temporal happiness over future consequences (frequently adversarial outcomes) or where habit interplays with choices, rational alternatives, environment, moral frailty, cultural influences or seductiveness of pleasure vis-a-vis normal behaviour.

Simply put, there is an incentive for people to develop different forms of addictions.

Applied to the markets or the economy, what if the source of profligacy [or Oniomania[3] or compulsive shopping or compulsive buying], a form of addiction, stems from government initiatives, by virtue of artificially suppressed interest rates?

And what if government induces people to spend on things they can’t afford with money they don’t have, out of the desire to fulfil economic ideology or to promote certain industries?

Will the teetotaller refuse government’s offer of free drinks?

How much of government induced behaviour from reckless policies will force individuals and businesses to take the low interest rate bait?

And this seems to be the story behind the yield curve.

The Stock Market And The Yield Curve Over The Long Term

Notice that every time the long term yield (30 year treasury constant maturity-red) materially diverges from the short term yield (1 year treasury constant maturity-blue) to form a steepened yield curve (black arrow pointed upwards), the S&P 500 (green) blossomed.

On the other hand, inverted yield curves, where short term yields had been higher than the long term yields (green arrow pointed downwards), had preceded recessions and severe market corrections.

Like normal yield curves, the yield curve’s impact on the economy has a time lag, a 2-3 year period.

Even the October 1987 Black Monday crash appear to have been foreshadowed by an account of relatively short inversion in 1986.

And the inflation spiral of the late 70s saw short term rates race ahead of short term rates for an extended period.

So why does an inverted yield curve occur?

Because the debt markets reveal the amount or degree of misallocations in the market ahead of the economy.

According to Professor Gary North

``This: the expected end of a period of high monetary inflation by the central bank, which had lowered short-term interest rates because of a greater supply of newly created funds to borrow.

``This monetary inflation has misallocated capital: business expansion that was not justified by the actual supply of loanable capital (savings), but which businessmen thought was justified because of the artificially low rate of interest (central bank money). Now the truth becomes apparent in the debt markets. Businesses will have to cut back on their expansion because of rising short-term rates: a liquidity shortage. They will begin to sustain losses. The yield curve therefore inverts in advance.”[4]

This means that when consumers and businesses compete for short term funds, demand for short term money raises interest rates. Nevertheless, as the fear of inflation recedes, “an ever-lower inflation premium”[5] forces down long term yields.

As a caveat, since corporations operate on the principle of a profit and loss outcome, they’re supposedly more cautious. But this hasn’t always been the case. And it should be a reminder that a fallout from an imploding bubble does not spare so-called blue-chips, as in the case of the US investment banking industry, which virtually evaporated from the face of earth in 2008.

Industries that have been functioned as ground zero for bubbles are usually the best and worst performers, depending on the state of the bubble.

Figure 2: Business Insider: Falling Net Debt To Cap

Figure 2 is an interesting chart.

Interesting because the chart shows of the long term trend of the S & P 500 Net debt to Market cap-which has been on a downtrend, for both the overall index (red spotted line) and the ex-financials (blue solid line).

Since it is a ratio, it could mean two things: debt take up has been has been falling or market cap has been growing more than debt. My suspicion is that this has been more of the growth in market cap than of debt (since this is a hunch more than premised on data, due to time constraints, I maybe wrong).

In addition, since the tech bubble, corporate debt hasn’t grown to the former levels in spite of the antecedent boom phase prior to the crash of 2008.

Nevertheless, the substantially reduced leverage from corporations, particularly the net debt (red spotted line) which has reached the 2005 low, suggest of a recovery. This could signify a belated play on the yield curve.

Prior to the recent crisis, the S&P net debt began to recover at the culminating phase of the steep yield curve cycle.

Could we be seeing the same pattern playout?

Commodities And The Yield Curve

Finally, the link of the yield curve relative to US dollar priced commodities has not been entirely convincing. (see figure 3)

Figure 3: Economagic: Yield Curve and the Precious Metals

Over the span of 3 decades, we hardly see an impeccable or at least consistent correlation.

Precious metals in the new millennium soared during the steep yield curve. But it also ascended but at much subdued pace during the inversion.

In the late 70s precious metals exploded even during inverted yield curve. While it may be arguable this has been out of fear, it does not fully explain why gold and the S & P moved in tandem see figure 4.

Figure 4: Economagic: Precious metals and the S&P 500

Moreover, between the 80s and the new millennium, correlations have been amorphous.

And perhaps as we earlier averred this could have been due to the formative phase of globalization where much of liquidity provided by the US Federal Reserve had been “soaked up” by the inclusion of China and India and other emerging markets in global trade as a result of policies from Reaganism and Thatcherism and the collapse of the Soviet Union.[6]

The various bubbles around the globe, during the said period, serve as circumstantial evidence of the core-to-the-periphery dynamics.

Overall, as the yield curve remains steep, we believe that the upward thrust of markets should continue to hold sway as the public will be induced to take advantage of the “profit spread” as well as with central banks continued provision of stimulus conditions that would revive the compulsive manic behaviour seen in persons afflicted by varied forms of addiction.

---

[1] See Does Falling Gold Prices Put An End To The Global Liquidity Story? and Why The Presidential Elections Will Have Little Impact On Philippine Markets

[2] Wikipedia.org, Addiction

[3] Wikipedia.org Oniomania

[4] North, Gary; The Yield Curve: The Best Recession Forecasting Tool

[5] North, Gary; When the Yield Curve Flips. . . .

[6] See Gold: An Unreliable Inflation Hedge?

Spurious Mercantilist Claims And Repercussions Of A Strong Chinese Yuan

``As no one can purchase the produce of another except with his own produce, as the amount for which we can buy is equal to that which we can produce, the more we can produce the more we can purchase.” John Say to Thomas Malthus

The second cyclical variable that should drive the markets over the short to medium term could be the Yuan factor.

For those reading the international scene the Chinese currency the yuan has hugged the limelight of late. That’s because prominent personalities associated with leftist politics have stridently assailed the Chinese government for allegedly perpetuating what they claim as “global imbalances”. It’s a spurious populist claim though, specifically meant to divert the public’s attention from their failed policies.

Nevertheless some variables are proving to be very compelling to suggest for a Yuan appreciation (see figure 5)

Figure 5: Danske Research: Implications of the Rising Yuan

The money printed by China’s central bank, the People’s Bank of China, utilized to accumulate foreign exchange has been generating unwieldy inflation and bubble-like pricing activities in the housing markets. This hoard has reached $2.4 trillion in foreign exchange reserves as of 2009.

China has attempted several times since last late year to arm twist several industries to stem credit expansion which has led to inflation. Lately she has threatened to nullify loans granted to local governments and has similarly instructed 78 state owned enterprises (SOE) to quit the real estate market leaving 16 SOE property developers.

And economic overheating presents as a real risk. There has been an acute shortage of labor where factory wages have risen by as much 20% as the inland now competes with the coastal areas and reduced migration in search of jobs.

We are now witnessing a classic adjustment in trade balances as taught in classical economics. As Adam Smith once wrote, ``When the quantity of gold and silver imported into any country exceeds the effectual demand, no vigilance of government can prevent their exportation.”[1] (emphasis added)

In short, this leaves the Chinese government little or no option but to allow its currency to rise as a safety valve against a runaway inflation.

As shown in Figure 5, left window, USD-China’s yuan currency forward has been trending downwards which shows how the markets today have been factoring in the rise of the yuan. The right corner shows how adjustments were made in 2005 to reflect the advances in inflation. So yes, the Chinese policymakers in 2005 have responded to such scenario, and is likely to apply the same soon.

This means political pressure or no political pressure, China’s yuan will need to appreciate soon, simply because the economic pressures have been endogenously seething which will require for policy adjustments.

This leads us to the next issue which deals with why the cry for protectionism is spurious and the potential impact of the rise of the China’s yuan.

Mercantilism is a form of economic nationalism, which has long been rebuked by Adam Smith in his magnum opus, the Wealth of Nations. Mercantilism today has served as a basis for calls of protectionism.

Here we will unmask the partisanship of protectionist overtures against China.

First, the fallacy of the notion that trade is a zero sum game.

For the myopic protectionists who sees the world as confined to the equation GDP= C (Consumption) + I (Investments) + G (Government spending) + X - M (Exports-Imports), the mathematical operation involved in the equation which subtracts exports from imports engender a negative connotation for imports on economic growth. Hence, the bias or slant against imports for exports.

For instance, as I walked out of the pizza house following a hearty meal, I realized that the Pizza house, which earned the money I spent on, incurred a trade surplus. This left me with lesser money in my wallet, which accounts as my trade deficit. Although after the delectable meal, I also realized that my need for nourishment has been satisfied, unfortunately this has not been represented for in the GDP equation.

If I continue going to the same pizza house because I enjoyed the food, the ambiance, the services, the pretty youthful waitress or for many other reasons, the Pizza house will continue to incur surpluses while my wallet gets drained by deficits.

In the view of mercantilists whom tunnels on the flow of money only, but not the impact of or the satisfaction attained from the voluntary exchange, I would demand from the government that the Pizza house ‘balance its trade’ with me, by forcing them to take my services as a stock market agent, even if the owner isn’t inclined to deal with stock markets. If this sounds nonsensical, that’s exactly how the protectionists think.

If all the entities that I spent money on will be required to take on my services, from which rule applies to everyone, do you think the economy will prosper? Apparently not, that’s because people will probably stop trading with each other legally and do it behind the scenes.

In the above case, the pizza house will refuse me as a customer, that’s because they don’t need my services, even if I need them. In essence, forcing the people to buy or sell beyond their self-interests will cause a restriction of activities.

And be reminded that it is the individual that conducts trade. Whether it is done through personal, or through various forms of enterprises (proprietorships, partnerships or corporations), trade balances are incurred as individuals but only represented as enterprises or as states or nations.

In short, trade is exchange, where people conduct exchanges in order to fulfill a desire. The difference between local trade and trade with foreign enterprise is matter of classification. But the rudiments are the same, it is meant to satisfy some desires.

Hence, trade is not merely an accounting entry. It deals with human satisfaction.

In addition, trade balances do not include the sale of financial assets, as Robert Murphy writes, ``When economists compute the trade balance (or more accurately the current account), they don't include the sale of financial assets. So if foreign investors want to spend more (once we convert to a common denominator) on American assets than US investors want to spend on foreign assets, the trade balance is negative. The capital-account surplus is counterbalanced by a current-account deficit.”[2]

Once again Adam Smith[3], ``To import the gold and silver which may be wanted, into the countries which have no mines, is, no doubt, a part of the business of foreign commerce. It is, however, a most insignificant part of it.” (emphasis added)

Second, money isn’t wealth; inflation isn’t a Philosopher’s stone.

For instance current ploy of protectionists today is to arrive at a comparison of benefits. In such an instance, they distort the data to produce the account of which country is more dependent on trade. From here they argue, that by imposing trade restrictions, whatever vacuum left by closing the trading doors might be covered by money from central banks.

In other words, government can be relied to print money to produce jobs and investments. Had this logic been true then people don’t need to work at all, since the government can just print money.

Since voluntary exchange is aimed at satisfying human desires, then the role of money is essentially just as a medium of exchange.

And as medium of exchange, the valuation of a monetary unit, according to Ludwig von Mises, depends not on the wealth of a country, but rather on the relationship between the quantity of, and demand for, money.[4]

In other words inflating away out of protectionism will not achieve the desired prosperity.

What inflation will do is to vastly reduce the purchasing power of a nation which would redound to an erosion of wealth.

It is another absurdity to suggest that inflation won’t transpire because of output gaps. England has shown resilient inflation in spite of the similarities of condition with the US. To assume that the US is beyond the scope of the laws of scarcity is no more than living in a fantasy land.

Instead, it must be reminded that wealth is attained by accumulating capital, again Adam Smith ``The wealth of the country consists, not in its gold and silver only, but in its lands, houses, and consumable goods of all different kinds.”[5] (emphasis added)

Third, Protectionism Is Mutually Assured Destruction (MAD).

It is naive to believe that protectionism applied to China will not spillover to other countries. Such intellectual weenies fail to learn from the lessons of the Smoot Hawley act during the Great Depression.

To consider, should the US government engage in reckless inflation to finance the said gaps from protectionism with China, as the other holders of US treasuries realize of the scale of indirect default applied to their assets, many, if not all of them, will be panic sellers of US sovereign papers. And Americans will probably impose capital controls to curtail the exodus, and the ensuing capital controls would result to political counteractions.

And as reminder, the US is so dependent on oil that it imports 65% of what it consumes.[6] Guess who suffers more from a MAD policy?

According to Ludwg von Mises, ``The philosophy of protectionism is a philosophy of war. The wars of our age are not at variance with popular economic doctrines; they are, on the contrary, the inescapable result of consistent application of these doctrines.”[7]

Fourth, it is a myth that the appreciating Yuan and depreciating US dollar would expand US competitiveness while derail Chinese growth.

Pieter Bottelier and Uri Dadush writes in the International Herald Tribune, ``The immediate effect of renminbi appreciation will be to raise prices for U.S. consumers. A 25 percent revaluation of the renminbi, which some economists have said is needed, would — if not offset by a reduction in China’s prices — add $75 billion to the U.S. import bill. And since the United States imports three times as much from China as it exports there, higher U.S. exports to China would not nearly offset the welfare loss to U.S. consumers from higher Chinese prices.

``In the end, though some U.S. firms would gain and some export jobs would be created, the U.S. consumer would be the loser.”[8]

Fifth, fix currencies do not automatically equate to arbitrary currency manipulation, that’s because there is no free markets in currency, today. All governments control or somehow manipulate respective currencies to a certain degree.

The US dollar is pegged to 23 nations according to wikipedia.org. By definition of the protectionists, all 23 nations are also currency manipulators.

The Wall Street Journal hits the nail on the head,

``At the core of this argument is a basic misunderstanding of monetary policy. There is no free market in currencies, as there is in wheat or bananas. Currencies trade in global markets, but their supply is controlled by a cartel of central banks, which have a monopoly on money creation. The Federal Reserve controls the global supply of dollars and thus has far more influence over the greenback's value than any other single actor.

``A fixed exchange rate is also not some nefarious economic practice rare in human affairs. From the end of World War II through the early 1970s, most global currency rates were fixed under the Bretton-Woods monetary system created by Lord Keynes and Harry Dexter White. That system fell apart with the U.S.-inspired inflation of the 1970s, and much of the world moved to "floating rates."

``But numerous countries continue to peg their currencies to the dollar, and with the establishment of the euro most of Europe decided to move to a fixed-rate system. The reason isn't to get some trade advantage against their neighbors but to gain the economic benefits of stable exchange rates—and in some cases a more stable monetary policy. A stable exchange rate eliminates a major source of uncertainty for investment decisions and trade and capital flows.”[9]

In short, the labelling of manipulation is a matter of political convenience than truth.

The real problem has been China’s non convertibility and capital controls.

Again the Wall street Journal, ``China's real problem isn't its peg to the dollar but the yuan's lack of convertibility to other currencies and capital controls. These controls have blunted the yuan's development as a tradable currency, which means private markets can't recycle the flow of dollars into China from its large trade surplus.” [10]

Finally, as we have long argued US trade deficits are a function of the US dollar standard.

The more the world engages in global trade, the bigger the need for US dollar to finance this trade, since it is the de facto, reserve currency of the world, where transactions are quoted, paid and settled through US dollars.

Hence, until the US dollar is replaced with another alternative it is a fairy tale to believe that a strong yuan would rebalance the global economy. What would occur instead would be more distribution of surpluses around the world, but US deficits will continue to swell as the global economy expands.

Although there are more to discuss including the transition to the information age or China’s internal economic structure we will leave this discussion here.

But for those wishing that April 15^th to be the fateful day where the US tags China as currency manipulator, good luck to you. Prediction markets, google trends or market indicators haven’t been pointing to such direction.

The appreciation of the Yuan will allow for cheaper imports and essentially reduce dependence to lend money to the US. This means that China would have more bandwith to employ resources for its own development, depending again on the degree of economic freedom embraced by China. And the impact is likely to be seismic.

Peter Schiff rightly argues, ``Absent Treasury-bond purchases, the value of the Chinese currency would rise sharply, causing goods prices to tumble in China. This long-delayed increase in purchasing power for everyday Chinese will unleash pent-up demand in what is already the largest middle class in the world. Chinese factories would retool in order to produce goods for their own citizens to consume. In RMB terms, commodity prices would plunge, making it easier for China to produce all kinds of stuff, such as automobiles, while also making it cheaper for the Chinese to buy gas. Millions will trade in bikes for cars, and Chinese oil imports will swell.”[11]

This means that there could indeed be temporary uncertainties from expectations of the Yuan appreciation, which will depend on the degree of the allowable strengthening of the Chinese currency.

As a caveat, while the Japanese Yen firmed over the past decades, the Japanese haven’t been transformed into a US consumer type of compulsive shopper or oniomania. Hence, habits or forms of addiction in a society should apply. In short, no society is homogeneous.

Figure 6: Danske Research: Strong Stock Markets And Commodities Post Yuan’s Revaluation

Nevertheless, if history would serve as precedent of the future, then the uncertainty from a revaluation is likely to be short-lived (see figure 6). And the impact from a revitalized yuan has could be tremendously salutary in terms of stocks, Asian currencies and commodities.

Finally another word of caution, every expert I know expects the Yuan to appreciate, while this is the most likely the political outcome, we can’t rule out policy errors. This means that inflation can go berserk, if China refuses to budge, perhaps out of the recalcitrance to bow to political pressure.

A bubble bust or a hyperinflation in China would cause massive outflows and reverse all these expectations [even without protectionism].

For protectionists, I suggest for you to just mind your own business as nature will force the hand of economic imbalances.

---

[1] Smith, Adam Wealth of Nations, Book IV, Chapter 1 wikisource.org

[2] Murphy, Robert; Trade Deficits and Fiat Currencies, Mises.org

[3] Ibid

[4] Mises, Ludwig von; Stabilization of the Monetary Unit

[5] Smith, Adam Wealth of Nations, Book IV, Chapter 1 wikisource.org

[6] See The Delusion Of The Mercantilist Miracle

[7] Mises, Ludwig von Human Action, The Conflicts of Our Age, Human Action, oil.lbertyfund.org

[8] Pieter Bottelier Uri Dadush The Myths About China's Currency

[9] Wall Street Journal, The Yuan Scapegoat

[10] Ibid

[11] Schiff, Peter Paul Krugman Versus Reality

Peter Schiff Takes Down Paul Krugman & Co.: They're In For A Rude Awakening

Peter Schiff debunks Paul Krugman's protectionist overtures. (hat tip: William Anderson)

The Delusion Of The Mercantilist Miracle

Nobel Laureate Paul Krugman in his blog wrote, (hat tip: William Anderson)

“As I’ve written many times in various contexts since the crisis began, being in a liquidity trap reverses many of the usual rules of economic policy. Virtue becomes vice: attempts to save more actually make us poorer, in both the short and the long run. Prudence becomes folly: a stern determination to balance budgets and avoid any risk of inflation is the road to disaster. Mercantilism works: countries that subsidize exports and restrict imports actually do gain at their trading partners’ expense. For the moment — or more likely for the next several years — we’re living in a world in which none of what you learned in Econ 101 applies." (bold emphasis mine)

Well the Pope of Keynesianism believes [and prescribes policies] that by slapping protectionist measures on China, US jobs will return and the US economy will boom.

Even if such absurdity is deemed as a calculated gambit to 'coerce' China to reform her policies, Mr. Krugman apparently is playing the game of chicken or brinkmanship.

Mr. Krugman and his ilk forgets that once these fulminations become real, where actions will lead to counteractions, then protectionism is likely to spread outside the US-China sphere.

Now one can't help but notice that the US is presently heavily dependent on oil imports to sustain her economy.

chart from the Heritage Foundation

According to wikipedia.org, ``American dependence on oil imports grew from 24% in 1970 to 65% by the end of 2005. At the current rate of unchecked import growth, the US would be 70% to 75% reliant on foreign oil by the middle of the next decade. Transportation has the highest consumption rates, accounting for approximately 68.9% of the oil used in the United States in 2006, and 55% of oil use worldwide as documented in the Hirsch report." (bold highlight mine)

This only means that the unforeseen consequences of a fallout from protectionism is so massive that it would defeat whatever "noble" goals (but ludicrous), it is set to accomplish. This also implies that the US is terribly dependent on global trade as to even harbor the notion of "protectionism" (which would be tantamount to national suicide)

One may argue that the US may resort to invading nations that refuses to provide her with oil, but that in essence would validate Frederic Bastiat who once said that "When goods don't cross borders, armies will" .

Since protectionism translates to a closing of borders to trade, finance, investments and possibly even migration, this also means the imposition of capital controls too.

Hence the US is likely to default on her debts while engaging massive inflation to fund her war interests.

Does this lead to anywhere to near an economic boom? Hardly. Instead, it points to a reverse: a global depression plagued by war, needless deaths and poverty, courtesy of deceitful mercantilists fanatics.

So we agree with Stephen Roach, who just harshly rebuked Mr. Krugman, as quoted in Bloomberg,

“We should take out the baseball bat on Paul Krugman -- I mean I think that the advice is completely wrong,” Roach said in an Bloomberg Television interview in Beijing when asked about Krugman’s call, characterized as akin to taking a baseball bat to China. “We’re lashing out at China rather than tending to our own business,” which is raising U.S. savings, Roach said."

Or perhaps, by taking on such seemingly reckless policy prescriptions, could Mr. Krugman be unwittingly be helping advance Osama Bin Ladin's cause of bankrupting America?

Natural Gas: Alternative Energy Of The Future

The Economist has this nice article about natural gas.

The article goes to show that the world isn't running out of energy. It's just a matter of markets aided by technology, adapting to the current conditions.

Here's an excerpt, (all bold highlights mine)

``The source of America’s transformation lies in the Barnett Shale, an underground geological structure near Fort Worth, Texas. It was there that a small firm of wildcat drillers, Mitchell Energy, pioneered the application of two oilfield techniques, hydraulic fracturing (“fracing”, pronounced “fracking”) and horizontal drilling, to release natural gas trapped in hardy shale-rock formations. Fracing involves blasting a cocktail of chemicals and other materials into the rock to shatter it into thousands of pieces, creating cracks that allow the gas to seep to the well for extraction. A “proppant”, such as sand, stops the gas from escaping. Horizontal drilling allows the drill bit to penetrate the earth vertically before moving sideways for hundreds or thousands of metres.

``These techniques have unlocked vast tracts of gas-bearing shale in America. Geologists had always known of it, and Mitchell had been working on exploiting it since the early 1990s. But only as prices surged in recent years did such drilling become commercially viable. Since then, economies of scale and improvements in techniques have halved the production costs of shale gas, making it cheaper even than some conventional sources.
More from the Economist,

``The Barnett Shale alone accounts for 7% of American gas supplies. Shale and other reservoirs once considered unexploitable (coal-bed methane and “tight gas”) now meet half the country’s demand. New shale prospects are sprinkled across North America, from Texas to British Columbia. One authority says supplies will last 100 years; many think that is conservative. In 2008 Russia was the world’s biggest gas producer; last year, with output of more than 600 billion cubic metres, America probably overhauled it. North American gas prices have slumped from more than $13 per million British thermal units in mid-2008 to less than $5. The “unconventional”—tricky and expensive, in the language of the oil industry—has become conventional.

``The availability of abundant reserves in North America contrasts with the narrowing of Western firms’ oil opportunities elsewhere in recent years. Politics was largely to blame, as surging commodity prices emboldened resource-rich countries such as Russia and Venezuela to restrict foreign access to their hydrocarbons. “Everyone would like to find more oil,” says Richard Herbert, an executive at Talisman Energy, a Canadian firm using a conventional North Sea oil business to finance heavy investment in North American shale. “The problem is, where do you go? It’s either in deep water or in countries that aren’t accessible.” This is forcing big oil companies to get gassier."

Read the rest here

My comments:

As we have repeatedly said, politics has been the fundamental reason for the elevated prices in oil, caused mainly by geological restrictions or limited access (mentioned by the article) combined with artificial demand from inflationism and or policies, such as subsidies (not mentioned in the article).

Nevertheless, because people adjust to the circumstances they are faced with, such as the pain of higher prices and political constrains, the perpetual desire to satisfy human needs makes possible for ingenuity to pave way for innovative technology which would allow for more access to supplies or substitution.

In the case of natural gas, since there is a recognition, out of the existing technologies, of the abundance of reserves, higher oil prices will likely compel producers to compete to convert erstwhile uneconomical resources into utilizable reserves, ergo "forcing big oil companies to get gassier" as the article mentioned.

And if successful, which I am optimistic of, this will have a spillover effect to the midstream (processing, storage, marketing and transportation) and the downstream (retail outlets, derivative products, etc...). In other words, part of the transformation would likely see global transportation evolve to natural gas as default fuel.

So in the future, we should expect natural gas to also play a big role in the transition to diversify energy sources.

The following chart caught my eye. If the technology to access shale oil becomes universally commercial, guess where the bulk of reserves are?

In Asia Pacific!

Funds Rotating Back To The US Equities A Long Term Trend?

We appreciate the wonderful charts of Bespoke Invest, which we frequently feature here.

Although in some instances, they'd seem a bit bias (especially against China). From Bespoke, ``One of the easy ways to see how a country is performing relative to other countries is to look at its market cap as a percentage of world market cap. In the early stages of the global rebound off of the March lows, the US rose significantly, but other countries were gaining even more. In recent months, however, the tide has turned, and the US is now outperforming the rest of the world. As shown, US stock market cap as a percentage of world market cap has been steadily rising since last November. During the 2003-2007 bull market, emerging markets and other countries really outperformed the US. If this bull market continues and the US continues to gain share, it will represent a very big trend change that will make a huge impact on portfolio performance depending on an investor's domestic versus international equity allocation." Nevertheless, this observation is true for today, according to Livemint,

``Funds are being rotated to the US—a fact corroborated by EPFR Global’s report that flows into US equity funds have been positive for four straight weeks, their longest winning streak since the third quarter of 2008. The paring of overweight positions not only protects against the risk of a sharp pullback, but also leaves the door open for positive surprises."

The reason China has been down is that she has been deliberately attempting to fight her "inner" devils (a.k.a bubbles).

In contrast, the US still is in an "inflationary" mode.

To add, last year saw emerging markets including China massively outperform the US, which is the reason why the US share of global market cap declined materially.

The recent outperformance of the US relative to emerging markets seems more of hiatus than of a "longer trend".

The axiom, "no trend moves in a straight line" for emerging markets should apply here.

Besides, it is also observable that the outperformance of the US has been in sync with the strength of the US dollar index (perhaps to reflect on the fund flows).

As the US equity markets regained their share of the global market cap beginning last November, the US dollar firmed as well.

But this can be interpreted differently, the vitality of the US dollar index isn't because the USD has been technically or economically "strong", but in the instance where both the US dollar and the euro (which weighs 57.6% in the US dollar index basket) have been weak, the euro has been relatively weaker than the US, ergo the strength of the US dollar. And this is why commodities have remained resilient even in the face of a strong US dollar (where is the US dollar carry?).

This also implies that the current trends isn't likely to last because of the problems that continues to ail the US. The relative strength especially applies to Asian and emerging market currencies.

This will be amplified if the oversold euro will see a sharp bounce. And this should also be reflected on the rest of the global equity markets.

Hence, in contrast to the projection that fund flows to the US will be a long term trend that would extend US equity outperformance, we see this as a short term phenomenon. Enjoy them as it last.

Big Mac Index And The Furor Over China's Yuan

Here is an update of the Economist's Big Mac Index which shows how McDonald's Big Mac are priced around the world.

In other words, the relative purchasing power of a currency measured in terms of Big Mac prices.
According to the Economist, (bold highlights mine)

``RECENT renewed American calls for China to revalue its currency have so far fallen on deaf ears. China has rejected accusations that America's huge trade deficit with it is caused largely by an artificially weak yuan, which has been pegged to the dollar since July 2008. Economists point out that a depreciation of the yen did little to help reduce America's trade deficit with Japan in the 1980s. But the yuan is unquestionably undervalued. Our Big Mac index, based on the theory of purchasing-power parity, in which exchange rates should equalise the price of a basket of goods across countries, suggests that the yuan is 49% below its fair-value benchmark with the dollar. "

While it may be true that the Chinese yuan may be "artificially weak", it is inaccurate to entirely blame the yuan for the America's deficits.

Chart from Google

As you can see, US trade deficit is largely a world phenomenon, except that China takes up most of the load (see below)

From US Census Bureau

In addition, outside of the oil exporters and China, the US has substantial deficits with Canada, Ireland and Japan even when the currencies of the 'developing economy' group are mostly "dearer" [or 'at par' with the US as with Japan].

Several additional observations:

-It is a fallacy to assume that weak currencies automatically extrapolate to strong exports or increased jobs.

As the Economist rightly points out, the strength of the Japanese Yen over the past decades didn't automatically transform Japan into a "consuming" class. To this day Japan is known as an "exporter".

-All furor over the Yuan, ignores the role played by the US dollar as the world's de facto currency reserve.

In short, the US has to produce dollars, required not only at home, but to fund global transactions and thus contributing to deficits. [see the Triffin Dilemma as previously discussed in The Nonsense About Current Account Imbalances And Super-Sovereign Reserve Currency]

-If the Chinese have indeed been subsidizing their export sector, it does so to keep Americans buying their product.

In a subsidy one group is favored over another, which means redistribution of resources from other sectors to the favored sector.

chart from Google

China's exports account for 35% of the GDP, alternatively this means the rest of her economy is shouldering the burden of the subsidies.

In addition, if China is subsidizing her exports then it also means that by keeping the yuan "artificially cheap", her subsidies extend to the American consumers. So how bad can it be for Americans?

And such dynamic is seemingly being reflected on the growing clout of US discount behemoth Walmart to influence the production methods of her Chinese suppliers,

This from the Washington Post,

``Wal-Mart has more than 10,000 suppliers in China. In addition, about a million farmers supply produce to the company's 281 stores in China. If Wal-Mart were a sovereign nation, it would be China's fifth- or sixth-largest export market. So the company hopes that small measures taken by all suppliers start to add up. Its 200 biggest suppliers in China have already trimmed 5 percent of their energy use.

``In the past, environmental concerns have taken a back seat to growth in China and to costs for Wal-Mart. And China and Wal-Mart have come under sharp criticism for conditions in factories. Yet pollution now threatens China's growth; as a result, awareness of climate change and energy security has spread in China. Likewise, as consumers grow more environmentally aware, Wal-Mart's executives have responded. On Thursday, the company pledged to reduce its greenhouse gas emissions by 2015."

In short, politicos when caviling over currencies are looking only looking at superficial and not on structural issues.

-The problem of US joblessness isn't an issue of China stealing jobs but instead of domestic bubble policies as earlier explained in Why Americans Are Jobless

-Lastly, it is simply foolish and highly pretentious to believe that foreign policies based on antagonism or belligerency will alleviate US economic woes.

Even if we assume that China yields to Americans, as shown above, this won't solve their problems. So failure to do so would only prompt blood lusting politicians to ask for more interventionism that may lead not only to a trade war but to a risks of military confrontation.

Importantly, it would seem that egotism has overwhelmed rationality such that by threats to slap protectionism aggravates and not helps the US predicament. Remember the Smoot-Hawley Tariff Act?

It is such hypocrisy for these dunces to proclaim that they are working for the common good when they are, in fact, agitating for a great depression.

As the UNCTAD recently wrote, (all bold highlights mine)

``Amidst continued financial crisis, the question of the global trade imbalances is back high on the international agenda. A procession of prominent economists, editorialists and politicians have taken it upon themselves to “remind” the surplus countries, and in particular the country with the biggest surplus, China, of their responsibility for a sound and balanced global recovery. The generally shared view is that this means permitting the value of the renminbi to be set freely by the “markets”, so that the country will export less and import and consume more, hence allowing the rest of the world to do the opposite. But is it reasonable to put the burden of rebalancing the global economy on a single country and its currency? This policy brief contends that the decision to leave currencies to the vagaries of the market will not help rebalance the global economy....

``It is time to break with a sterile polemic that ignores the increasing evidence from a range of experiences showing that both absolutely fixed/pegged and fully flexible/floating exchange rate systems are suboptimal. These so-called “corner solutions” have added to volatility and uncertainty and aggravated the global imbalances . With this as a starting point, the debate can move forward to explore new common formulas for exchange rate management that increase consistency between trade and financial flows in a globalized economy.

``In order to address global imbalances coherently, governments need to act in the same spirit of multilateralism that characterized the international fiscal response to the crisis at its most critical moments in 2008. A coherent approach to restoring balanced trade calls for policies that address and prevent currency speculation at the global level. Even those who criticize governments for stabilizing exchange rates and intervening in financial markets generally recognize that a viable long-term solution to the problem of massive trade distortions and global imbalances cannot be expected from individual central banks trying to find a unilateral solution to a multilateral problem like the exchange rate."

Evidence of Liquidity Boom: "The Market Loves Trash"

As we've been saying all along the global markets have been liquidity driven more than "fundamentally" driven.

This phenomenon seems evident including in the US, where small cap stocks have outperformed the big cap stocks.



From the Wall Street Journal, (Thanks to Bespoke for the pointer) [bold emphasis mine]

``After a brief swoon in January and early February, the riskier end of the stock market is back in favor.

``That includes small stocks, stocks badly hurt by the financial crisis and those most dependent on global economic growth. Safer stocks, including those that offer steady dividends, are out.

``That wasn't the case between Jan. 19 and Feb. 8, when the Dow Jones Industrial Average fell 8% amid fears that the global recovery could stall.

``Since then, the Dow is up 7%. And in most cases, investors are turning to the same stocks that led the market higher in last year's big rally.

"It seems like the lower-quality, smaller-sized names are taking the lead," says Jack Ablin, chief investment officer at Harris Private Bank in Chicago. "We are getting a junk dominance again."

``By a variety of measures, lower-quality stocks are out-gaining higher-quality stocks, says Paul Hickey, co-founder of Bespoke Investment Group in Harrison, N.Y.

"In the words of Oscar the Grouch," says Mr. Hickey, "the market 'loves trash.' "

``He has ranked the quality of stocks in the Standard & Poor's 500-stock index based on their market size, price/earnings ratio and credit rating. He even sorted them based on which get the most attention from short sellers, the bearish investors who bet that stocks will decline by borrowing the stocks and selling them.

"No matter how you look at it, so-called low-quality stocks in the S&P 500 have outperformed high-quality stocks" since Feb. 8, Mr. Hickey says.

``The 50 smallest S&P stocks have risen 13%, compared with a gain of 9% for the 50 largest stocks. Companies whose bonds are rated as junk have risen more than those with investment-grade ratings. The 50 stocks with the highest prices, compared with analysts' expectations for their 2010 profits, are up 16%. Those with the lowest price-to-earnings ratios are up 10%. The most heavily shorted are up 15%. The least-shorted are up 7%."

My comment:

Essentially the outperformance of small stocks appear to be driven by momentum, as punters pile in on the winners in the expectations of continued strength.

As we previously pointed in Are Stock Market Prices Driven By Earnings or Inflation?, a refresher on some of the valuable insights of Fritz Machlup on the stock market.

-A continual rise of stock prices cannot be explained by improved conditions of production or by increased voluntary savings, but only by an inflationary credit supply.

-Extensive and lasting stock speculation by the general public thrives only on abundant credit.

McKinsey Quarterly On The New Japanese Consumers

McKinsey Quarterly has an interesting outlook about the changing habits of Japanese Consumers.

1. A shift to value.

Japanese consumers have been switching preference from classy and branded products to discount stores and online retailers. The reason according to McKinsey Survey: expensive products, “annoying stuff” and “inability to shot at my own pace”

And shifting to value also means bulk buying

[my comment: an aging population is expected to spend less on material things and spend more on health, as noted below this appears to be compounded by economic stagnation.]

2. Home entertainment.

Japanese have also been more “home” oriented in terms of entertainment. And part of the homeward bound lifestyle is that the Japanese have gradually embraced digital revolution through online shopping

Japan is said to lag the US and UK in spite of high penetration level of broadband, and the past reasons for this according to McKinsey have been,

-Japanese consumers love the physical shopping experience;
-mobile-phone screens are too small;
-the density of retail establishments means that online shopping has less of a convenience advantage;
-credit card penetration is low.

However this seem to be changing as more Japanese spend online.

The online market for physical goods (excluding ticket sales and electronic downloads of media such as music, movies, and software), notes McKinsey, is estimated to be nearly $30 billion, compared with only $1.3 billion in 1999



A noteworthy quote ``It’s worth underscoring the tight relationship between online shopping and broader shifts in consumer behavior. In a consensus-driven society where individual choice and expression have historically been frowned upon, the ability to browse products, compare prices, and make purchases relatively anonymously is creating new attitudes and empowering consumers.” (bold highlights mine)

[my comments:

-Online activities are growing not only in Japan but in most parts of the world. Perhaps the reason for the shift to value is that online provides more opportunities for comparison and thus end up with least expensive but still high quality value products choices.

-In addition, since our assumption is that Japanese have broadband connectivity at home, social activities by the youth are conducted online, than in malls.

-Third, the online experience is promoting "individual choice and expression", which probably means more appreciation of freedom]

3. More Travel.

They’ve been more willing to travel more to take advantage of discounters. And one apparent beneficiary of this shift has been private label products.

4. Individualized healthcare

The new trend also suggest that the Japanese are also “directing their own healthcare” spending or that Japanese are spending more for health.

According to McKinsey ``One effect of the greater interest of the Japanese in directing their own health care has been the growing popularity of drugstores, which have been Japan’s fastest-growing retail channel since 2000: store numbers have increased by 4 percent and sales by 8 percent.”

[my comment-Politically perhaps this implies the trend towards less dependence on government welfare.]

5. They have reportedly been receptive to affordably priced “environmental consciousness” products.

Reasons for the shift:

Mckinsey says part of this comes from the recent downturn compounded by the economic weakness in the past 2 decades where the consequences has been the “disappearance of life-long jobs and the increase in part-time and temporary labor”.

McKinsey adds that the emergence of a new generation which characterize “Less materialistic youngsters” had possibly been a product of an era “never knowing the boom times the two previous ones experienced.”

The new lifestyle has “prompted the nickname the hodo-hodo zoku, or “so-so folks” (or, even worse, “slackers” or “herbivore men”).”

[my comment-that's likely plus the web 2.0 factor]

A third of final factor possibly contributing to such changes in behaviour have been a “series of small, largely unrelated” regulatory adjustments

McKinsey notes that ``Japan’s government reduced the maximum freeway toll on weekends to ¥1,000 regardless of the distance traveled—a huge discount that encouraged trips outside Tokyo to big-box discounters and large-format retailers such as Costco and Ikea. Other examples include regulations allowing the wider sale of over-the-counter drugs; a mandate that all employees over the age of 40 (about 50 million people) take a test to determine whether they are at risk for conditions such as diabetes and high blood pressure and, if they are, requiring them to exercise and diet; and recent changes to reduce underage smoking. The Japanese government has also pushed to increase awareness of and access to health remedies, in part to address the challenge of paying to treat these conditions.”