Who’s Right? by Robert Gore

The sky might not be falling, but a lot of important markets are, sending a different message than the U.S. equity market, where some indexes attained new highs last month. Set aside the government’s statistic mills, which the more cynical among us suspect may be as much propaganda as objectively gathered facts. While the media, financial seers, and sentiment indicators are overwhelmingly bullish for 2015, the action in other markets and other countries should temper the euphoria. Those markets are driven by self-interest and real money, they are joined at the hip to real economies, and some of them are far larger than the U.S. stock market. Don’t tell the equity-bullish contingent, but although central banks have done their best to severe all links, there may still be a connection between the real economy and stocks.

The 50 percent drop in the price of oil was big news the second half of 2014. What hasn’t garnered the same headlines have been drops in other commodities, some of larger magnitude than oil’s. Iron ore’s price peaked at $150 per ton in early 2013 and was below $70 per ton at the end of 2014. Copper hit $4.5 per pound in 2011; it’s now trading around $2.85. Part of these drops were probably due to increased supplies, fueled by ultra low interest rates that have enabled all sorts of malinvestment. However, these prices are sensitive to overall economic conditions—price is the intersection of both supply and demand. Falling prices almost certainly indicate falling demand. These three markets are by no means anomalous. The S&P GSCI (formerly the Goldman Sachs Commodity Index), a broad-based commodity index, was down 31 percent in 2014. The CRB index of commodities reached a high of 370 in 2011 and is now just below 250, a drop of 32 percent.

Related to commodity pricing is the Baltic Dry Index, an index of various shipping rates for dry bulk commodities. It is not confined to Baltic routes, and is a rough proxy for global trade in the covered items.The index reached its all time high in 2008 at 11,793, its post financial-crisis high in 2009 at 4661, as recently as 2011 was above 4000, but since November of 2014 has been almost cut in half, from 1484 to 771. The index appears to be confirming the message from commodities: pricing and trade for basic commodities are deteriorating.

Credit market indicators are a different chapter of the same story. The inflation break-even rate is a measure of credit markets’ inflation expectations. It is the difference between the rate on a government note or bond and its maturity-corresponding Treasury Inflation Protected Security rate, whose price is adjusted for inflation. Declining spreads, or break-even rates, indicate falling inflation expectations. Those spreads have been declining since the fall of 2012, precipitously the last half of 2014. While history doesn’t always repeat itself, they took a similar tumble during the last financial crises. The yield curve is a graph of yields across maturities for a given class of interest-rate securities. In the U.S. Treasury market, it usually has a positive slope, since investors generally want more interest-rate compensation for tying up their money longer. However, the degree of slope is a time-tested economic indicator (it is in the government’s index of leading economic indicators). A steeper slope generally indicates that investors are expecting stronger economic growth and higher inflation and interest rates, a flatter slope the opposite. The yield curve has been flattening since the end of 2013, and that flattening was especially pronounced in December (see “Starting The Year In Deeper Uncertainty,” Jeffrey P. Snider, Alhambra Investment Partners).

The flatter curve is consistent with falling break-even spreads. What is telling about these indicators is that the global economy is long past the point where the balance sheet expansion and ultra-low interest rates initiated by the world’s central banks in response to the financial crisis were supposed to have raised inflation expectations and interest rates, and promoted economic growth. In fact, the former have declined (some countries now have negative interest rates on shorter maturity debt) to multi-generational lows, and the latter has been uncharacteristically weak for a supposedly “recovering” global economy.

One other credit market indicator bears watching. The spread between indexes of non-investment grade (high yield) debt and government debt benchmarks measures investor optimism about lower quality borrowers’ ability to repay debt (in today’s low yield world, it also measures how desperate investors are to find any kind of return in the credit markets). Spreads in high-yield corporate debt reached their most recent lows last summer, and have moved steadily upwards since. Prices on high yield corporate debt, which move inversely to their yields, have declined 14 percent, and the decline has been particularly brutal for energy sector high yield debt, down 20 percent. Such price declines wipe out several years of coupon payments on the bonds, assuming the issuers stay in business and keep making those payments. High-yield bonds are sending a message consistent with that of other credit market indicators and commodities.

The rising foreign exchange value of the U.S. dollar further tightens the screws. By driving short-term rates close to zero, the Fed made the dollar a global “funding” currency. In other words, trillions of dollars worth of speculation around the world has been funded with dollars borrowed at ultra low rates. Anyone who borrows dollars in international currency and credit markets is short the dollar. They want its value to decline so they can repay their debt in cheaper dollars. Instead, the dollar has allied against most currencies through 2014, and that acts as a margin call, requiring speculators to increase their collateral or sell their positions. On a short-term basis the dollar is probably overbought. (The Wall Street Journal had a front page headline this weekend: “Dollar Hits an 11-Year High.” When a financial trend makes the front page of a major press organ, it usually signals the trend is just about over.) However, if the long-term trend is up, this will put more downward pressure on commodity and high-yield bond prices.

In Europe, Greece has been a source of drama since 2010. Tension now focuses on the Greek election January 25. The Syriza party, led by Alexis Tsipras, is leading in the polls. He wants to restructure Greece’s debt and roll back many of the austerity measures that have been imposed on Greece by the IMF, EC, and ECB in exchange for past aid and debt relief. At the very least, a Syriza victory would call into question the value of Greek debt, which is carried at full value on European banks’ books. It would probably prompt a reassessment of other peripheral European debt, which has rallied strongly on the prospect of ECB purchases as part of the European version of quantitative easing. Any unilateral Greek moves to reduce interest payments or restructure its debt would stop the envisioned ECB purchases. Even EU government statistics (SLL is skeptical of all governments’ statistics, not just the U.S.’s) indicate their economies are skating on thin ice. Some are already contracting, and a new Greek crisis would undoubtedly put the rest of the continent into recession.

A big part of the declining demand driving down commodity prices is coming from China. Chinese economic statistics are unusually suspect. As Anne-Stevenson-Yang, an expert on China for J Capital, put it in a recent interview with Barron’s: “People are crazy if they believe any government [referring to the Chinese government] statistics, which, of course, are largely fabricated.” (“Why Beijing’s Troubles Could Get a Lot Worse,” Barron’s, 12/8/14) Even the “fabricated” official numbers indicate China’s economy is slowing.

Debt-fueled bubbles (since 2000, total debt in China has expanded from $1 trillion to $25 trillion) in residential, industrial and infrastructure construction have left the country with millions of vacant houses and apartments, warehouses full of commodities for which there is little demand, and factories either idled or producing at reduced capacity. (For a chart-laden close-up, see “The Elephant Dragon In The Room: China’s Hard Landing, in 21 Charts,” Zero Hedge, 1/2/15.) Two of the other BRICs, Russia and Brazil, and well-known basket case Japan are not providing any oomph for the global economy, either. (For more on all three countries, see “Wall Street Heathens: How Their Greed And Gambling Became The Axe Of Statist Policy,” and “The Keynesian End Game Crystalizes In Japan’s Monetary Madness,” davidstockmanscontracorner.com).

So there is another side to the story that speculators and especially investors may want to consider before they plunk their money down. Sure, U.S. equity indexes went from record to record in 2014, the punditry is bullish for 2015, and the GDP grew at 5.0 percent in the third quarter (for a skeptical take on that statistic, see “Here Is The Reason For The ‘Surge’ In Q3 GDP,” Zero Hedge, 12/23/14). The Fed’s recent avowals to forego further monetary easing must be taken with the same shaker of salt one employs when an alcoholic in the throes of a nasty hangover swears off the poison. It still has the market’s back, and any significant equity “correction” will be met with more quantitative easing. However, commodities, credit, and economies in most of the developed world are sounding sour notes in the bullish chorus. After further investigation and analysis, those inclined to join the chorus may discount the discordant notes, but ignoring them entirely may prove most unwise.

THERE WAS A TIME WHEN CENTRAL BANKS DIDN’T BAIL OUT WRONG-WAY SPECULATORS

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