A View from the Trenches, April 22nd, 2010: "Indifference means acknowledgment"
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Inflation, or asset inflation, seems to be the flavor of the week. It’s in most analysts’ research notes. A month ago, on March 18th, in a letter titled “The winter of our dynamic inflation” (www.sibileau.com/martin/2010/03/18 ), we wrote that:
“…the latest action in the markets proves that they are dependent on a given rate of money supply …(…)…A rate of money supply is a dynamic concept, and we are used to think in “comparative static” terms…Basically, this line of analysis sustains that agents in the market “get used” to a rate of money supply, which they incorporate in their expectations. For instance, if you have the Fed buying, say, $10BN of mortgages/week, the respective market incorporates this liquidity metric and invests accordingly. It is a “sticky” expectation and the problem with it is that policy makers begin to interpret that the problem is with the markets, in that they expect “irrationally”. More so, when exit strategies like that of the Fed is being widely publicized. But this interpretation is incorrect, because it ignores the non-neutrality of the rate of money supply…Regardless of expectations; the intervention of central banks in the rates markets has a real impact that distorts relative prices…”
The chart below shows Greece’s 5-yr sovereign credit default swap and the S&P500 Index (source: Bloomberg). We thought it would be useful to show two vertical lines, dividing the chart in three periods.
The first period starts in Dec/09 and ends on January 6th. It corresponds to the post-Dubai days and end with the violent shooting of Greece’s sovereign risk. Right after, Greece started to steal headlines. We too wrote a letter on this issue (refer: “Don’t forget Greece”, www.sibileau.com/martin/2010/01/07 ). All markets sold off, while European Union leaders sought to show a unified front in addressing the short-term aspect of the problem: Greece’s upcoming debt refinancings. Of course, the problem remains unsolved. However, during this second period, macroeconomic readings began to surface, signaling that the recovery was not as weak as expected, while at the same time, EU leaders publicly committed to support Greece. This period ended on March 18th, with Greece’s 5-yr sovereign risk touching just below 300bps. It was then when we wrote the comments quoted above, about the upcoming dynamic inflation.
The next period, from March 18th to date shows that the market indeed did well by assuming accommodating policies were going to continue. This is reflected in the markets’ indifference towards sovereign risk, fueled by above-expectations earnings and other macroeconomic metrics that seem to show a steady but slow recovery. You can see that both trends, the rally in stocks and the increase in sovereign risk run in parallel. However, there is no need for stocks to rally or credit to tighten, in light of increasing sovereign default risk. But as we wrote then, investors know and have gotten used to a rate of money supply, which is challenging the measured promises of central bankers regarding inflation control mechanisms. The European Central Bank (also during the last period) announced its intention to extend the emergency contingency lines, which as we showed in our last letter, are nothing else but a mechanism for the indirect monetization of fiscal deficits. Meanwhile, the Fed also made clear that we are still far away from a policy rate hike. On Tuesday, Bloomberg reported Mr. Jörg Asmussen, Staatsekretär im Bundesfinanzministerium, saying Greece would get a loan from the German KfW Bankengruppe (with government guarantee)
Now, why should we write about this today? Why should we all care about this?
Mainstream economists, among which a great majority works for government institutions, are increasingly pointing fingers at the asset bubbles or asset inflation that the world is witnessing in different markets. In China, the case is very obvious. Underneath this observation is the implicit desire to ignore there is a problem. Policy makers find themselves at odds explaining how “asset” prices increase, while unemployment remains high. To us, this is not extraordinary. To us, this is not an aberration, but the perfectly normal results of quantitative easing. In fact, we would be seriously concerned if under monetary expansions, asset prices would not increase. But we do not dictate policy…
A tiresome and wearing battle, on a global scale, is in its infancy. In this battle, governments will seek to regulate every aspect of our lives to delay the unavoidable. Unfortunately, nobody ever wins these battles. Nations, as a whole, end poorer. In the near term and on a relative basis, we continue to like those nations that will delay the less (in our view, Canada), owning stocks and gold.
Martin Sibileau
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