Excerpt from MARKET MUSINGS & DATA DECIPHERING

WHILE YOU WERE SLEEPING

Global equity markets are taking it on the chin again as the civil war in Libya rages on and investors are left wondering which country is next in line. Algeria? Bahrain? Saudi Arabia? The geopolitical risk premium in the oil price continues to expand with Brent pushing towards a 30-month high of $120 a barrel —- up 13% so far this week. It is estimated that as much as 1 mbd of output has been taken out of the system from the Libya crisis and the outsized move in the oil price is testament to the view of just how tight the global supply-demand backdrop has been. Imagine where the price would be if it weren’t for the spare capacity out of Saudi Arabia. Analysts at Nomura are saying $220 a barrel is achievable if more production is halted in Libya and Algeria.

What is fascinating is to see what the bond market is telling us. Yields continue to fall and are now down around 20 basis points for the long Treasury from the nearby high even in the face of mountains of supply ($29 billion of seven-year notes today) and the news of how Bill Gross at PIMCO radically cut his exposure recently. The bond market is telling you something very important here that rather than being a permanent source of inflation, what we are witnessing is a global exogenous deflationary shock (the impact on discretionary spending in America will be considerable — consumers use 140 million gallons of gasoline annually and prices are already up 30 cents so far this year and the run-up is far from over). The price of copper is telling you the exact same thing as it rolls over to a four-week low, though security of supply and hoarding of raw materials in general should help establish a firm floor for all non-oil commodities. The surge in wheat, corn, and soybean prices is also being unwound.

It would seem that the stock market is echoing that sentiment. European bourses are down for a fifth day running — that hasn’t happened since last
October. The Asian markets are in the loss column for the fourth day in a row — the longest losing streak in three months — and as a group is now down for the year.

In the FX market, the Swiss franc and Japanese yen appear to be safe-havens right now — the U.S. dollar is actually softening today (the former just made a new high against the greenback). The euro is soft and the sterling just sagged to a three-week low against it on the back of some very poor retail sales data that were released today. And gold is flirting near a seven-week high and again, acting as a hedge against uncertainty in any event — on concerns that the turbulence across North Africa spreads — as opposed to anything related to accelerated inflation expectations.

Beyond the turmoil that has dramatically raised the price of oil and lifted risk premia in general, the equity market is also contending with a chorus of Fed
officials who are hinting at an end or at least a pause to the quantitative easings — Charles Plosser from Philly was the latest (and Fisher from Dallas just before). That could mean additional hurdles for Messrs. Dow and Jones because by our estimation, the U.S. stock markets have tracked the movements in the Fed’s balance sheet with an 86% correlation since the beginning of 2009.

One last item, the fact that the S&P 500 dipped below the 1,300 threshold yesterday (intra-day) was very likely a major deal from a technical perspective.
The problem of course is that everyone today considers themselves to be an expert and the memories of 2008-09 have completely faded with sentiment at cycle highs and cash ratios at cycle lows as even the last of the bears threw in the towel late last year. And because the two extreme emotions — fear and greed — will never vanish, the latter took over at the recent highs. We have every reason to believe that initially, as we saw in the summer of 2007, many folks will mistakenly either stay too long at the top or even buy the dips, because they have been conditioned to by Federal Reserve policies, which have been overt in their objective in bolstering risk appetite and asset values above their intrinsic values — all in the name of generating an acceleration in consumer spending growth. It’s not fun sitting out a 100% rally as was the case in the past two years. But few recall how much more awful it is to partake in a 60% plunge, and that was barely more than two years ago too. Funny how memories fade.

If you are of the view that a new secular bull market began in March 2009, then please follow your beliefs. Secular bull markets tend to last between 16-18 years. It will be the first time a secular bull was born from printing money and the onset of state capitalism.

But if you are of the opinion that what we just witnessed since March 2009 was a typical cyclical rebound within the confines of a secular downtrend, well, these tend to last two years (Ned Davis found 34 of these since 1900) and see average gains of 86%. This time around, it was just a month under in duration and 13 percentage points over in magnitude.

Also, if you’re playing the odds, and with all deference to the election cycle, only 20% of all the cyclical bull markets from 1900 lasted three years. Again,
averages are useful only to an extent. But you know where we stand — one of the few wealth managers who were positioning their portfolios to get paid an
economic rent until the next phenomenal buying opportunity took hold. Since so many managers are already long the wazoo and will be forced to ride out this corrective phase, that when the intense selling does come, we will be able to opportunistically capitalize on the situation.

WILL THE OIL PRICE BE A GAME CHANGER?

First it’s Tunisia.

Then Egypt.

And now Libya.

What makes Libya different from a market’s perspective is that we are now talking about an oil exporter in the sudden grips of political upheaval.

In this domino game, the next critical country we have to keep an eye on is Bahrain. It is home to the U.S. Navy’s 5th Fleet. A new regime there could in turn seriously impair America’s ability to patrol and monitor developments in the Persian Gulf and surrounding areas. Bahrain is ruled by a Sunni monarchy and yet the majority of the population is Shiite (and Art Cashin at UBS says that there is Iranian intelligence that has been planted within the civilian population). I was in a discussion with an individual from a U.S.-based policy research firm and they are adamant that Bahrain is absolutely critical. If that country falls, it would generate legitimate concerns about the stability of eastern Saudi Arabia and further complicate the political backdrop in the Middle East. Remember, the Iranians did send in two vessels into the Suez Canal for the first time since 1979 with the approval of the new military government in Egypt. This interim government has also allowed a radical mullah back into the country and is reportedly considering opening Egypt’s border with Gaza — all the while, Israel is facing U.N. resolutions on its settlement policies.

I recommend that everyone have a good look at page A8 of yesterday’s NYT — more than 100,000 demonstrators turned out at a rally for pro-democracy
reforms in Bahrain yesterday. Never before has the monarchy faced such a protest (the nation itself has a population of 500,000, so 20% showed up for the protest).

Saudi Arabia has the capacity to fill the void left by Libya, but that misses the point. The risk of further unrest is rising, especially with sectarian issues in full force in Bahrain. This means that oil prices at a minimum will retain a geopolitical risk premium — most oil experts now peg this at $10-$15 a barrel. If countries start to stockpile more crude in light of current events, one can expect the oil price premium to rise even further even if the situation calms down overseas. So no matter what, barring a sudden downturn in demand, and the one thing about oil (food too) is that demand is relatively inelastic over the nearterm, the risk is that we will see further increases in the price of crude even from current lofty levels.

So the bottom line is that there is still more near-term upside potential than downside risk for the oil price (and most energy stocks). This then will act as a tax on consumers and as a margin squeeze for non-oil producers and only when global demand sputters, as it did in the summer of 2008, will the oil price break down — although it is likely to settle in a new and semi-permanently higher range as it did coming out of the global credit collapse.

I believe we are getting closer to the point where the surge in oil prices could tip the global economy back into recession (we may have already reached that point anyway). My reading of Wall Street research shows that the trigger point for recession calls would be somewhere around $120 a barrel. As it stands, both the move in the oil price on a two-year basis and the current level in real terms suggest that the “odds” based on past performance would certainly be better than 50-50 as it pertains to the U.S. economy in any event.

We must also look at what is happening from the lens of soaring food costs as only three times in the past four decades have we confronted a double-digit runup in both food and fuel prices at the same time. Good news for gas stations and maybe food stores but not for other retailers.

Twice before the economy landed in a contraction in real terms and once it was avoided but that was in 1996 after Netscape went public and unleashed the last leg of the tech mania and the roaring bull market in new-economy equities. Right now, we have the food and energy bill siphoning off over 12% of personal disposable income in the United States, on a decisive uptrend — rising about three-quarters of a percentage point since last summer (spending in nominal terms surged at a 22% annual rate in the three months to December while personal income rose by less than 5% -— and all that 22% surge in nominal spending did was buy around 7% of groceries and gas in “real unit” terms). In terms of who are net losers, it pays to see which countries are net exporters and net importers. The U.S., China, Japan, Germany, India, and Korea are the largest net oil importers in the world. They will get hit the most in terms of negative growth impact. Outside of the Gulf region and other political hot spots, the biggest net exporters are Russia, Norway, Kazakhstan, and … Canada. On a relative basis, these are the winners.

No doubt there will be cries from the crowd that we will be entering a period of stagflation and a return to the 1970s. Statistically perhaps and for a short while we will see higher headline inflation and slower economic growth without a doubt. But for a host of reasons, this will not be anything like the 1970s.

For one, organized labour is losing its clout, as we are seeing at the state and local government levels south of the border. So without wages exceeding
productivity, which was a 1970s phenomenon, it is unlikely that any inflationary pressure from commodities will last much more than a few months or quarters, as was the case in 2007-08. Unit labour costs declined at a 0.6% annual rate in Q4 and have fallen now in five of the past six quarters. America’s full employment unemployment rate (NAIRU) may have risen to 6%, but the posted rate is still north of 9%. There is too much excess labour, not in every sector but enough, and much more than we had in the 1970s or early 1980s.

The Fed has printed money like there is no tomorrow, to be sure, but the money is still sitting in over one trillion dollars of excess cash reserves on commercial bank balance sheets. The demand for loans by the household sector is in a secular decline as the Fed’s own surveys illustrate, and as such banking sector credit contracted at a 4.8% annual rate in January, 5.5% in December, and 0.4% in November. It is very difficult to spread any sort of commodity-related inflation through the pricing system with labour costs and bank credit in contraction mode. If we approach 6% unemployment and/or begin to see classic measures of money velocity (turnover) or the money multipliers begin to expand in a meaningful way, it will be a different story. But those catalysts for a true stagflation cycle are probably years away.

Furthermore, we still have significant pockets of deflation in home prices, which sank at an 11% annual rate in December and down now for five months in a row. If that persists in the absence of a turnaround in the equity market, then rest assured that the renewed downdraft we would see in the household net worth/income ratio would push the savings rate back on an upward trajectory, largely at the expense of cyclical spending.

So what we are going to likely face is a decline in real personal incomes barring a more decisive recovery in the U.S. labour market. And there is unlikely to be any appetite in Congress to expand the record fiscal deficit to offset this contraction so it would be entirely appropriate to expect real spending to be
negatively impacted as well. The accelerated cutbacks in spending and higher taxes at the state and local government levels will only serve to aggravate the stress. This, as far as I can tell, is far from being priced into consumer discretionary stocks at the current time.

Countries that will at least experience a positive terms of trade effect like Norway and Canada and as such better currencies will at least see domestic
economic conditions cushioned somewhat, especially for the consumer.

But for investors more generally, what is key is the prospect of sustained increases in commodity prices in the near- and intermediate term, coupled with
greater risk aversion. At a time when the just-released Investors Intelligence reading on market sentiment showed 53.3% bulls and 18.9% bears (lowest
since April 2010), the odds of a significant pullback here in the U.S. equity market are fairly sizeable, in my view. Even a 10% correction would only take the S&P 500 back to where it was at the end of November when the market was getting all whooped up over renewed acceleration in the economy, QE2 stimulus and post-election euphoria.

SALES UP, PRICES DOWN

Wow. Existing home sales in the United States plunge 30% on a raw basis in January and that somehow shows up as a 2.7% increase at a seasonally
adjusted rate. It would be one thing if the typical seasonal decline in January was smaller than normal but in fact the 30% slide was the fourth steepest in the past twelve years. It does make you wonder if you should begin believing in conspiracy theories. Furthermore, first-time buyers accounted for only 29% of sales last month whereas a number that generally resembles a well-functioning market is closer to 40%.

At least prices can’t be fudged. With distressed sales making up 37% of the turnover and at bargain basement levels, median home prices collapsed 5.9% in January and at $158,800, now stand at the lowest level since April 2002 and down over 30% from the 2006 peak.

The unsold inventory at 7.6 months’ supply still reflects a buyers’ market and suggests that there is more potential for house price deflation. The long-run
average is closer to six months. While sales turnover has been improving, the pace is not enough to put a floor under pricing, barring an even deeper supply response out of the building community. Buyers are constrained by higher down payment requirements and elevated unemployment rates. Plus the belief that prices will keep going down may keep potential buyers sidelined as well, notwithstanding the benefit to affordability ratios.

David A. Rosenberg
Chief Economist & Strategist Economic Commentary
drosenberg@gluskinsheff.com
+ 1 416 681 8919
Source: Market Musings & Data Deciphering

Excerpt from MARKET MUSINGS & DATA DECIPHERING

WHILE YOU WERE SLEEPING