S&P Lowers Outlook on US Government Debt

In a strong wake up signal to our elected officials, S&P lowered its outlook on the US's long-term credit rating from stable to negative (though retained its AAA rating). As demonstrated in the chart below, outside of the Japan with a gross debt/GDP ratio of 220%, the US leads all developed nations with a ratio of 92%.

Given that the US deficit should exceed $1.5 trillion this fiscal year, its laughable that both sides of Congress declared victory when agreeing to spending cuts of a paltry $38.5 million last week. While spending in Washington remains unrestrained, the discipline of the bond market will most certainly force action should Congress not get more serious about reducing our deficits.

S&P's announcement should serve as a shot across the bow for government officials who think that "deficits don't matter," particularly with the planned expiration of the Fed's QE2 program in June.

Oil Exports by Country

Here is a great chart from this morning's WSJ that breaks out oil exports by country. As suggested in the chart, Libya exports 1.5 million barrels/day of light sweet crude. While Saudia Arabia has stated that they would draw on their spare capacity to address any shortfalls in Libyan production (which is estimated to have dropped by 1 million barrels/day), Saudian Arabian oil is much heavier than Libayn oil and could not be handled by the many refineries that process Libyan oil. As such, many of these refineries that can only process light sweet crude would have to turn to a limited number of other countries for supplies, including Nigeria and Algeria, themselves the subject of growing unrest.

Oil Markets and the Arab Unrest

With the price of a barrel of Brent crude around $115 (and peaking at $120) and West Texas Intermediate crossing $100, I thought this article from the Economist ("The Price of Fear") provides an excellent overview of what is going on in the oil markets.

Clearly, pricing is going up because of an increase in demand, particularly in the emerging world:

“World demand grew by an extraordinary 2.7m b/d in 2010, according to the International Energy Agency. It will probably keep growing by another 1.5m b/d this year and the same again next, as the rich world recovers and demand surges in China and the rest of Asia.”

However, it’s also worth noting how seamlessly the developed world has been able to cope with higher oil prices over the last thirty years and how out of whack energy intensity remains between the developed and emerging world.

“America’s economy in 2009 was more than twice as large in real terms as in 1980. Yet over that period America’s oil consumption rose only slightly, from 17.4m b/d to 17.8m. Europe actually used less oil in 2009 than in 1980, even though its economy had grown... America’s economy, though about three times the size of China’s, uses just over twice the amount of oil that China’s does. But oil intensity in emerging countries has also been falling in recent years, as manufacturing has become more efficient and less energy-intensive service industries have increased their share of the economy.”

In the short-term, there is no reason to believe that oil can’t take out its 2008 peak, particularly if social unrest begins to spread to the major oil exporters (Saudia Arabia, Iran, etc.). However, a sustained period of high oil prices remains unlikely in my opinion given the likelihood that elevated prices will throw the global economy back into recession (as we saw in the summer of 2008). Further, high oil prices will undoubtedly spark a new innovation wave that further reduces oil intensity throughout the world (not just in developed countries). The latter could take some time to play out, but human ingenuity should disprove those market commentators who confidently predict $200-$250 oil over the coming year.

Covenant-Lite Loans are Back

One would have thought that the meltdown of the leveraged loan market in 2008 would have left a lasting impression on participants in the industry. However, the recent flood of money into the loan market has resulted in a diminution of credit standards comparable to what we saw in late 2006/early 2007. As demonstrated in the chart below, covenant-lite loans have represented 26% of all new loans issued year-to-date in 2011, nearly identical to the 25% level hit in 2007, and more than 5 times the percentage seen in 2010. While the sample size is fairly small ($8.8bn YTD 2011 vs. $100 billion in 2007), hearing the words “covenant-lite” and “PIK-Toggle” enter the lexicon of credit investors scares me tremendously.

With rates and covenants so remarkably favorable to borrowers, it is only a matter of time before the LBO machine begins to ramp up into overdrive. Supply is what broke the back of the last LBO bubble - I have little doubt that it won’t do the same this time.

Over the last year, I have been highlighting the mounting excesses in the credit markets. Admittedly, my fears have not been borne out and credit investors would have been well-served by ignoring my concerns (generally, a pretty lucrative trading strategy:). However, not in my wildest dreams could I have imagined that at this stage in the recovery, we would still be talking about zero percent interest rates “for the foreseeable future.” The Global Food Index just breached its 2008 highs and oil is flirting with $100/barrel and yet our esteemed Fed Chairman sees no evidence of inflation in the economy. How many countries have to endure mass riots over parabolic food rises before Bernanke will abandon his unyielding reliance on the heavily manipulated CPI numbers?

With rates across the entire yield curve kept artificially low, perhaps this can go on for some time. Bernanke’s comments on Thursday talking down any inflationary pressures in the economy have given investors a license to speculate. However, I have no doubt that when the Fed begins to tighten, this mini-reincarnation of the 2007 credit bubble will quickly be snuffed out.

Companies Stock Up Ahead of Price Increases

Here is a good article from today's WSJ ("Companies Stock Up as Commodities Prices Rise") that highlights the self-fulling prophecy of higher prices. With the price of rubber, cotton, spices, and other commodities rising to new highs over the last few months, anxious customers are accelerating their inventory purchases to try and get ahead of additional price increases. Similar to what we experienced in mid-2008, when panicky restaurant owners drained Costco shelves of bags of rice, scared businesses are accentuating the inflationary spikes by collectively buying far more than the underlying demand in their businesses would suggest is necessary.

Its difficult to say how long this could go on - and zero percent interest rates are certainly not helping - but unless end market demand truly picks up, its hard to justify this frenzied activity. In 2008, we had a good 3-4 months where it seemed like everyday the price of most commodities was moving higher. However, as Jim Grant is fond of saving, "the cure for high prices is high prices" and you can be sure that at some point high prices will break the back of this inflationary pressure.

As can be expected, the Fed's head is firmly buried in the sand and it remains highly unlikely that they will raise interest rates anytime soon. With home prices trending lower and unemployment stuck at 9.5%, Bernanke can care less that copper and rubber prices have tripled since early 2009. However, no matter how clueless the Fed, they cannot repeal the laws of supply and demand and any investor chasing this commodity spike higher ought not to forget what happened in August 2008 when reality finally took hold in the market.

This anecdote from the article perfectly captures the frenzied behavior of businesses across the country:

John Anton, Anton Sport's founder, saw the price of cotton shooting up, and decided to act. Last month, when his T-shirt suppliers warned about the fourth price rise in six months, he borrowed $300,000 through his home-equity line of credit and bought more than a year's supply. Mr. Anton typically has about 30 boxes of shirts on hand at one time, but now has more than 2,500.

"It just kind of clicked that I can borrow at 2.45%, and if cotton is going to go up between 10% and 12%, why wouldn't I do this?" Mr. Anton said. Cotton prices rose 92% last year, and are up 22% this year.

Mr. Anton, the T-shirt seller, bought mountains of shirts after receiving letters in January warning of an imminent price increase. One supplier's letter, a copy of which was reviewed by The Wall Street Journal, urged customers to "wrap up most of your pending orders and buy at the best possible prices."

"What's exciting here is we can now go to somebody like McDonald's and say: 'We have a price that's going to beat everyone around,' " Mr. Anton said. "At this point, I don't know if I'm the smartest guy in the room or the dumbest. But I can't see prices returning to where they were anytime in the near future."

China Unveils Trial Property Tax in Two Cities

Since I was traveling in Germany last week, I missed a key development in the Chinese housing market. Two cities, Chongqing and Shanghai, introduced property taxes to help curb speculation and rising home prices ("China Unveils Long-Awaited Property Tax"). Although mild by most developed country standards, the introduction of the tax, coupled with an increase in minimum downpayment requirements for second homes from 50% to 60%, sends a strong signal that Chinese officials are serious about containing speculation in the market.

In Chongqing, the city levied a real-estate tax on villas owned by individuals — usually luxury, stand-alone homes — and on newly purchased high-end homes at three rates: 0.5%, 1%, and 1.2%, depending on market transaction prices. Separately, the Shanghai government said it would levy a temporary 0.6% real-estate tax on homes and may cut the rate to 0.4% for properties whose transaction prices are below certain—unspecified—levels. Both taxes were positioned as "trials" and could be modified depending on how they impact their respective housing markets.

As noted in prior posts, I believe one of the biggest factors driving the speculation in China's housing market is the minimal carrying costs of holding real estate. With bank lending rates below the rate of inflation and a general aversion to investing in the stock market, real estate has historically served as a store of wealth for many Chinese.

Admittedly, past efforts to contain house prices have had minimal effect and some may believe (rightly) that the announced property taxes are too small to have any great impact on the market. However, its always difficult to identify the straw that breaks the camel's back and last week's announcement convinces me even more that Chinese officials will continue to take incremental actions until home prices (particularly at the high end) begin to respond.

China's Inflation Starting to Spike - Investors Beware

As indicated in the chart below, China’s inflation rate rose to 5.1% in November from 4.4% in October. Though down from the 8.5% rate that existed in early 2008, the spike in prices is clearly starting to worry Chinese government officials – hence the two interest rate hikes over the last ten weeks. Even more concerning, is that food inflation is running well into the double digits, and though food accounts for only one third of the CPI, it accounts for 75% of the increase. As an example, soybean oil, a key ingredient in Chinese cooking, rose approximately 25% last year, with most of the gain coming since July (“Cooking Oil's Surge Shows How Inflation Hits Chinese “).
While Chinese officials are hesitant to slow down the economy, the recent spike in inflation will force their hand. Just as we saw in 2006-2007, it may take some time for interest rate hikes to work their way through the Chinese economy, but inevitably they will work their magic. Given the rebound in the commodity and equity markets, investors seem to be ignoring the residual effects of China’s deliberate attempt to engineer a slowdown. With many industrial and agriculture commodities making parabolic moves over the last few months, I think it is prudent for investors to start taking off risk.

While the easy money policies of the US Federal Reserve are starting to coax people back into equities, the 2011 theme for most of the developing world is one of tightening. China, Brazil, India, and Australia are among the largest economies that have recently raised interest rates and more are coming. As an example, in Dilma Rousseff’s inauguration speech yesterday (new Prime Minister of Brazil), she specifically mentioned controlling inflation as one of her top priorities. I think it is fair to say that when inflation becomes a key theme in an inauguration speech, investors should take notice – I know I certainly am.