June 2006 Review and Inflation Concerns
THE FOLLOWING ARTICLE DOES NOT CONSTITUTE A SOLICITATION TO INVEST IN ANY PROGRAM OF CERVINO CAPITAL MANAGEMENT LLC. AN INVESTMENT MAY ONLY BE MADE AT THE TIME A QUALIFIED INVESTOR RECEIVES CERVINO CAPITAL'S DISCLOSURE DOCUMENT FOR ITS COMMODITY TRADING ADVISOR PROGRAM OR DISCLOSURE BROCHURE FOR ITS REGISTERED INVESTMENT ADVISER PROGRAMS. PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.
Cervino Capital Management is pleased to announce June 2006 performance returns for our Diversified Option Strategy program, which operates under our Commodity Trading Adviser (CTA) registration. This month was the program's best month yet with a positive return of 1.68% for June 2006 at a time when equities showed continued uncertainty from the prior month. So far year-to-date we've return a composite 3.98% in this program versus the S&P 500 Index (GSPC) up 1.76% as of June 30th. The non-correlated performance between our program and the stock market is not by chance, but by design—consequence of a multifaceted approach based on selection of markets, flexible instruments and a variety of decision inputs. For more information, please visit our website at www.cervinocapital.com.
While satisfied with this past month’s accomplishment, our focus remains on evolving macroeconomic trends and prospective trading opportunities. That said, much of the recent global market turmoil has been linked to market participants’ perception of inflation pressures going forward, which in turn effects interest rates, fiscal policy and consequently asset prices. But in order to envisage how such percpetions may influence investors' future actions, we need to first cover what's happened in the last couple months. Here’s a play-by-play of the recent market correction:
At the beginning of May the DJIA was nearing its January 2000 all-time high of 11,723 on expectations that the Fed would stop raising the Federal Funds rate. Then on May 11th, a day after the Fed raised rates by a quarter point to 5%, market sentiment “suddenly” shifted to the threat of inflation in response to the FOMC policy statement which indicated the potential for further Fed tightening. The market corroborated its fear on May 17th with the Core-CPI number coming in at 0.3%, “significantly?” over market expectations of 0.2%. Since the bottom (closing price) on June 13th, the market has posted two strong up days with consensus saying it was due to short covering.
The lack of clarity in communiqués from a transformed Fed council (not only is Bernanke new to the Fed Chief role but there are also a number of new board members) added to the confusion. A cynic would suggest that for the Fed... “to decide is to succumb to the preponderance of one set of influences over another set.” Yet it is no surprise that the Fed has been leaving its options open. The same uncertainties exist today as after the Fed meeting in May with respect to the intensity of inflationary pressures versus the robustness of the economy. This is reflected in how different markets are saying different things or the same thing differently.
The stock market vacillates between bear and bull concerned about whether we’re in for a “soft” versus a “hard landing” with the bulls arguing continued strong productivity and corporate earnings. The U.S. yield curve is shifting between flat and inverted projecting a recession, but remaining vigilant on the inflation front due to 'many years in the making' excess global liquidity. All the while speculation in certain commodities markets (also reflected in certain emerging markets) is creating a frothy trading environment—but this time, unlike the late 1990’s technology stock era, what is good for producers comes at a cost for consumers. And let us not forget the ongoing fiscal concerns about the U.S. current account deficit underlying the decline in the dollar. There has even been some suggestion of a 1970’s economic redux coined “stagflation-lite.”
All this uncertainty reflects a potentially more complex set of factors underlying current inflationary concerns as opposed to economic cycles in the collective past memory. There is in fact a battle between assets and goods that are under strong inflationary influences versus services and wage costs that are still under deflationary pressures. Labor and the service sector has been and continues to be under downward pressure largely due to the power of technological improvements that came with the internet. This situation has created what is referred to as the ‘global labor arbitrage’ which, while helping corporate margins in the short term, over the long term has depressed U.S. workers’ income and therefore the disposable income of the world’s biggest consumer economy.
Meanwhile, consumer staples and other items of necessity are rapidly increasing in cost (e.g., energy, food, health care, rent). For many years the U.S. consumer has benefited from globalization and the importing of low priced goods. But now, a developing shortage of key raw materials as the world’s economy grows is creating an economic environment in which raw materials prices are rising faster than finished goods prices. This trend is likely to continue and as a result certain countries, specifically China and Russia, may find it in their best interests to allow their currencies to appreciate against the dollar. An appreciating currency will cause a country’s finished goods export prices to rise, but it will also lower that same country’s respective import costs of raw materials. Assuming the ongoing trade deficit, this means U.S. consumers end up importing inflation from abroad. The logic follows that if inflationary pressures are felt most on necessities the resulting impact on consumer spending behavior will ultimately be reflected in corporate earnings.
At the same time, assets such as real estate and stocks, which have greatly benefited from a “goldilocks” environment of strong growth and low inflation, have reached valuation levels that are subject to rational scepticism. Housing-rent parity, proliferation of sub-prime and adjustable rate mortgages, tapping out of home equity lines of credit, consumer debt levels, and historically low household savings underlies our concern about real estate. If a bearish housing market evolves, consumer discretionary spending will come under even more pressure, as in the past few years much of this spending was subsidized by the home equity extraction strategy.
As for equities—yes, productivity and earnings have been persistently strong, and the balance sheets of corporations for the most part are solid. However, deeper analysis shows that we are, at the moment, in a period of unusually high earnings—which does not bode well for future returns. Further, the graying of baby boomers is expected to have broad economic impact. Not only will this population shift encumber public entitlements such as Social Security and Medicare, the burden is already being felt on private and state pensions’ as they struggle to match future liabilities. As this generation’s age accelerates past 65, it may spark an asset meltdown affecting equity returns just when increasing numbers begin to tap their investments.
Finally, credit experts agree that some turn in the credit cycle seems overdue—leverage multiples are sky high, banking covenants have been relaxed, and as we write this, a growth slowdown is being instigated by the co-ordinated removal of liquidity by the world’s central banks. This is occurring at a time when the credit spreads between high yield and investment grade debt are at cyclical lows. Between 2000-2002 the spread on corporate high yield bonds over US Treasuries was 6-11 points versus 3 points at present. Any renewed market turbulence could reduce risk appetite further, just as credit fundamentals start to weaken. Unfortunately, many investors have grown so unhealthily used to chasing returns at almost any price that any slight up-tick in spreads will be seen as a buying opportunity.
This line of reasoning causes us to conclude that a 2007 recession should be almost unavoidable. In light of expected actions by the Bank of Japan (“Tokyo’s revised growth forecasts point to rate rise” Financial Times, July 8, 2006) and European Central Bank (“ECB signals likelihood of interest rate rise early next month” Financial Times, July 7, 2006), their actions at this juncture seems to be far more important to the macroeconomic picture than Fed actions now and even after its next meeting August 2006. With this perspective in mind we will try to navigate the seas of global investing as profitably as possible in full recognition that the assets you have entrusted to us were earned with hard work.
- Davide Accomazzo, Managing Director
Cervino Capital Management is pleased to announce June 2006 performance returns for our Diversified Option Strategy program, which operates under our Commodity Trading Adviser (CTA) registration. This month was the program's best month yet with a positive return of 1.68% for June 2006 at a time when equities showed continued uncertainty from the prior month. So far year-to-date we've return a composite 3.98% in this program versus the S&P 500 Index (GSPC) up 1.76% as of June 30th. The non-correlated performance between our program and the stock market is not by chance, but by design—consequence of a multifaceted approach based on selection of markets, flexible instruments and a variety of decision inputs. For more information, please visit our website at www.cervinocapital.com.
While satisfied with this past month’s accomplishment, our focus remains on evolving macroeconomic trends and prospective trading opportunities. That said, much of the recent global market turmoil has been linked to market participants’ perception of inflation pressures going forward, which in turn effects interest rates, fiscal policy and consequently asset prices. But in order to envisage how such percpetions may influence investors' future actions, we need to first cover what's happened in the last couple months. Here’s a play-by-play of the recent market correction:
At the beginning of May the DJIA was nearing its January 2000 all-time high of 11,723 on expectations that the Fed would stop raising the Federal Funds rate. Then on May 11th, a day after the Fed raised rates by a quarter point to 5%, market sentiment “suddenly” shifted to the threat of inflation in response to the FOMC policy statement which indicated the potential for further Fed tightening. The market corroborated its fear on May 17th with the Core-CPI number coming in at 0.3%, “significantly?” over market expectations of 0.2%. Since the bottom (closing price) on June 13th, the market has posted two strong up days with consensus saying it was due to short covering.
The lack of clarity in communiqués from a transformed Fed council (not only is Bernanke new to the Fed Chief role but there are also a number of new board members) added to the confusion. A cynic would suggest that for the Fed... “to decide is to succumb to the preponderance of one set of influences over another set.” Yet it is no surprise that the Fed has been leaving its options open. The same uncertainties exist today as after the Fed meeting in May with respect to the intensity of inflationary pressures versus the robustness of the economy. This is reflected in how different markets are saying different things or the same thing differently.
The stock market vacillates between bear and bull concerned about whether we’re in for a “soft” versus a “hard landing” with the bulls arguing continued strong productivity and corporate earnings. The U.S. yield curve is shifting between flat and inverted projecting a recession, but remaining vigilant on the inflation front due to 'many years in the making' excess global liquidity. All the while speculation in certain commodities markets (also reflected in certain emerging markets) is creating a frothy trading environment—but this time, unlike the late 1990’s technology stock era, what is good for producers comes at a cost for consumers. And let us not forget the ongoing fiscal concerns about the U.S. current account deficit underlying the decline in the dollar. There has even been some suggestion of a 1970’s economic redux coined “stagflation-lite.”
All this uncertainty reflects a potentially more complex set of factors underlying current inflationary concerns as opposed to economic cycles in the collective past memory. There is in fact a battle between assets and goods that are under strong inflationary influences versus services and wage costs that are still under deflationary pressures. Labor and the service sector has been and continues to be under downward pressure largely due to the power of technological improvements that came with the internet. This situation has created what is referred to as the ‘global labor arbitrage’ which, while helping corporate margins in the short term, over the long term has depressed U.S. workers’ income and therefore the disposable income of the world’s biggest consumer economy.
Meanwhile, consumer staples and other items of necessity are rapidly increasing in cost (e.g., energy, food, health care, rent). For many years the U.S. consumer has benefited from globalization and the importing of low priced goods. But now, a developing shortage of key raw materials as the world’s economy grows is creating an economic environment in which raw materials prices are rising faster than finished goods prices. This trend is likely to continue and as a result certain countries, specifically China and Russia, may find it in their best interests to allow their currencies to appreciate against the dollar. An appreciating currency will cause a country’s finished goods export prices to rise, but it will also lower that same country’s respective import costs of raw materials. Assuming the ongoing trade deficit, this means U.S. consumers end up importing inflation from abroad. The logic follows that if inflationary pressures are felt most on necessities the resulting impact on consumer spending behavior will ultimately be reflected in corporate earnings.
At the same time, assets such as real estate and stocks, which have greatly benefited from a “goldilocks” environment of strong growth and low inflation, have reached valuation levels that are subject to rational scepticism. Housing-rent parity, proliferation of sub-prime and adjustable rate mortgages, tapping out of home equity lines of credit, consumer debt levels, and historically low household savings underlies our concern about real estate. If a bearish housing market evolves, consumer discretionary spending will come under even more pressure, as in the past few years much of this spending was subsidized by the home equity extraction strategy.
As for equities—yes, productivity and earnings have been persistently strong, and the balance sheets of corporations for the most part are solid. However, deeper analysis shows that we are, at the moment, in a period of unusually high earnings—which does not bode well for future returns. Further, the graying of baby boomers is expected to have broad economic impact. Not only will this population shift encumber public entitlements such as Social Security and Medicare, the burden is already being felt on private and state pensions’ as they struggle to match future liabilities. As this generation’s age accelerates past 65, it may spark an asset meltdown affecting equity returns just when increasing numbers begin to tap their investments.
Finally, credit experts agree that some turn in the credit cycle seems overdue—leverage multiples are sky high, banking covenants have been relaxed, and as we write this, a growth slowdown is being instigated by the co-ordinated removal of liquidity by the world’s central banks. This is occurring at a time when the credit spreads between high yield and investment grade debt are at cyclical lows. Between 2000-2002 the spread on corporate high yield bonds over US Treasuries was 6-11 points versus 3 points at present. Any renewed market turbulence could reduce risk appetite further, just as credit fundamentals start to weaken. Unfortunately, many investors have grown so unhealthily used to chasing returns at almost any price that any slight up-tick in spreads will be seen as a buying opportunity.
This line of reasoning causes us to conclude that a 2007 recession should be almost unavoidable. In light of expected actions by the Bank of Japan (“Tokyo’s revised growth forecasts point to rate rise” Financial Times, July 8, 2006) and European Central Bank (“ECB signals likelihood of interest rate rise early next month” Financial Times, July 7, 2006), their actions at this juncture seems to be far more important to the macroeconomic picture than Fed actions now and even after its next meeting August 2006. With this perspective in mind we will try to navigate the seas of global investing as profitably as possible in full recognition that the assets you have entrusted to us were earned with hard work.
- Davide Accomazzo, Managing Director
posted by Cervino Capital Management LLC at 7/08/2006
