Credit Market Redux, Copper and China

The credit markets are rumbling again, as measured by the TED (LIBOR-OIS) spread and widening credit default swap (CDS) spreads. Though the latter have been intensely worse for European debt indices over the last 3-4 months from the play-out over Greece and faltering European banks holding PIIGS sovereign debt, increasing spreads are seen across global CDS indices (Europe, NA, Asia - see Markit curves above), a potential precursor to a global slowdown.

In the initial throes of the credit market induced selloff in October 2008, certain asset classes sold off quickly with sharp declines: Emerging Market (EM) equities and debt, commodities (especially copper, gold and oil). During the month of September 2011, we've seen a similar sharp selloff in these asset classes, minus commensurate participation from oil (so far). The declines in copper have come with speculation that China and other major copper holders are dumping copper onto the open market, creating selling pressure, in anticipation of a slowdown in Chinese housing and manufacturing growth.

If these selloffs are a true reflection of a coming global slowdown, then we may anticipate lower lows in copper (a futures curve asymptote to $2 and the equity proxy FCX below $20) as well as EM equities (VWO proxy $20 range). Though oil has not participated for a variety of reasons, it too could follow, leading to sharp declines in the majors and the commodity. Gold may be the exception again this time — it reached a relative low October 24, 2008, and rebounded from there, never looking back.

The flip side is that what we are seeing is a head fake, created by selling pressure from hedging activity.

The question then becomes: what are the catalysts to sharp market reversals to the upside with a sustained rise? European debt restructuring is a foregone conclusion, and may not lead to significant sustenance, given the debt levels involved and the uncertainty and disorder within the EU in general. Another quantitative easing binge by monetary authorities may give a lift, but as we've seen, the result leads to an uptick in commodity inflation mixed with stale real growth, while promoting continued debt accumulation and preventing debt deleveraging. Negative real interest rates and economic uncertainty from regulatory, tax and fiscal policies are hampering private investment.

Given this outlook, continued volatility is the most likely outcome. Hiding out in the Treasury and muni markets may not be a panacea, given the negative real returns and the latent risks. As commodities, equity majors and proxies reach lower lows, their attractiveness to acquire and hold rises, given the probability of continued inflation growth. Disinflation from debt deleveraging (while it is allowed to occur!) provides significant opportunities.

Japan's New Inflation

A few weeks ago Japan reported rising inflation, with the CPI gaining 0.3% and 0.6% YoY in March and April, after years of negative monthly CPI data. The headlines from major news outlets were indeed amusing: "Japan beats deflation for the first time in two years (BBC)," "Japan Ends 25 Months of Deflation in Victory Marred by Quake-Led Recession (Bloomberg)," and my personal favorite, "Why inflation is great news for Japan." Oh wait - that latter title is recycled from a myriad of similar news reports when inflation last surfaced in Japan in 2007/2008.

According to business/economic news media and Keynesians alike, inflation for Japan is good, while deflation is an anathema. Inflation means rising consumption, demand, loan growth and ultimately output, while deflation means falling consumption, demand, credit contraction and deleveraging, and ultimately falling output. Except the dynamics aren't that simple and settled.

Japan's persistent YoY deflation since 1995 is arguably the result of years of debt deleveraging from the '80s real estate and stock market boom-then-bust, but it is also the result of rising production and productivity [1], which has a positive effect on lowering overall consumer price levels, even when demand is increasing. One might call this "good deflation." Also overlooked is the fact that Japan's deflation was "low and stable," especially during the period 1998-2007, when the average annual YoY CPI deflation was -0.23% with a standard deviation of 0.49%. I find it contradictory that the bulk of economists (especially those residing at central banks) think that low and stable inflation is good (the "Great Moderation"), while apparently low and stable deflation is bad.

What Japan's experience with inflation proves is that rising prices can happen with falling output and productivity, or stagflation, a dirty word to garden-variety Keynesians. With the Yen recently strengthening against most major currencies, the Bank of Japan is limited in what it can do to weaken its currency, which in the past has been achieved though a plethora of quantitative easing measures. Japan has little choice but to continue to delever and fight off any potentially persistent high rates of inflation, should it arise.

[1] Japanese industrial production and labor productivity rose steadily from 1998-2007, aside from a break in the increase during the 2001 recession. CPI and production/productivity data for Japan were sourced from HERE.