January 28, 2015

The Fulcrum

The teeter-totter with the moving fulcrum never caught on.

The reason is it wasn’t a teeter-totter, which is simple addition and subtraction, but a calculus problem. The same mathematical hubris afflicted much talk surrounding US economic growth last autumn when it seemed things were booming even as oil prices were imploding.

“The problem is oil is oversupplied,” we were told, “so this is a boon for consumers.”

“What about the dollar?” we asked.

Oil prices are a three-dimensional calculus problem. Picture a teeter-totter.  On the left is supply, on the right is demand.  In the middle is the fulcrum: money. Here, the dollar.

In January 15, 2009 when the Fed began to buy mortgage-backed assets, the price of oil was near $36.  Supply and demand were relatively static but the sense was that economies globally were contracting. On Jan 8, 2010, one year later, oil was about $83. Five years removed we’re talking about the slow recovery. So how did oil double?

The explanation is the fulcrum between supply and demand. Dollars plunged in value relative to global currencies when the Fed began spending them on mortgages.  Picture a teeter-totter again. If I’m much heavier than you, and the fulcrum shifts nearer me, you can balance me on the teeter-totter.  Oil is priced in dollars. Smaller dollars, larger oil price, or vice-versa.

As the Fed shifted the fulcrum, the lever it created forced all forms of money to buy things possessing risk, like stocks, real estate, art, commodities, goods and services.

As we know through Herb Stein, if something cannot last forever it will stop. On August 14, 2014 the Fed’s balance sheet had $4.463 trillion of assets, not counting offsetting bank reserves. On Aug 21, 2014, it was $4.459 trillion, the first slippage in perhaps years.

Instantly, the dollar began rising (and oil started falling). At Jan 22, 2015, the Fed’s balance sheet is $4.55 trillion, bigger again as the Fed tries to slow dollar-appreciation. But the boulder already rolled off the ridge. The dollar is up 22% from its May 2014 low, in effect a 35% rise in the cost of capital – a de facto interest-rate increase.

Oil has now declined faster than it rose in 2009.  The rate of collapse is the only connection to increased supply. The real culprit is the fulcrum.

Thinking about the dollar, by late September last year we began saying that corporate earnings, comprising about 13% of US gross domestic product, would falter in Q414 and especially in Q115.

Some laughed. “A strong dollar is great for the US economy,” people said, adding, “We hope you aren’t in a profession involving math.”

Yesterday stocks declined because, shazam!  The dollar is haircutting multinational profits. Headline from the Wall Street Journal: “Strong Dollar Hangs Over Companies, Rattling Investors.”

Are we tempted to say I told you so?  We also warned that if corporate profits decline, so will jobs. Big companies are now cutting thousands to compensate. The problem is if you sold stuff in Euros at $1.50 and you convert sales back to dollars at $1.12, that’s a big divot.

If jobs go, consumer discretionary spending that’s already palsied may drop more. GDP depends on consumption. What’s more, a strong dollar deflates prices – good for consumers yes, but bad for how the government meters economic output.

So the economy could contract, perhaps by the June quarter.  In the stock market, seas of money impelled there by Fed policy may suddenly realize prices are wrong. If we added government debt and the missing risk-free rate of return to stock valuations, by that crude math stocks are at multiples higher than in 2000.

“Boy,” you say.  “Thanks, Quast.  Now, if you’ll excuse me I need to pop this cyanide pill.”

Part of the job of investor-relations is developing a clear-eyed perspective on economic realities. We have said since September that we’re in a period of risk-asset revaluation. The problem all along has been that reality was unclear – because central banks obscured it by moving the fulcrum.

The fulcrum is coming back to center. So which side of the teeter-totter is too long? I don’t have the answer. But each facet of our thesis has borne out as we anticipated. We also supposed that European QE would prompt regulators to force banks into higher reserves, just as QE did here. Check. We expected cessation of QE in the US to meaningfully blunt fixed-income, commodities and currencies (FICC) trading at the primary dealers. Check.

What concerns us is that the risk associated with an off-kilter fulcrum has been farmed out globally by investors to the tune of $650 trillion in currency and interest-rate swaps that now must revalue no differently than corporate revenues and earnings. The banks behind those are the same ones that were in mortgage-backed securities in 2008.

Our optimistic view is that this decentralized market will sort out exposure by summertime, producing big risk-asset rumblings but no tectonic fracture. Our pessimistic hunch is that one or more major counterparties could collapse and stocks might fall dramatically as the US reverts to recession.

We’d take a split. The fulcrum.

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