SOME THOUGHTS ON EGYPT AND THE REFLATION TRADE
Feb 7 - 13, 2011
Egyptian President Hosni Mubarak is leaving and a new democratic election will take place in due course. That said regime change would not solve the problems of the common person. This may take many years of political and economic reform. Let us hope the mobs are patient enough to give the new regime enough time to implement the required changes.
I am not sure the timing is right to be gung ho about making an investment in Egypt just yet. An opportunity will emerge when the violence subsides and a new process for change is established. Instead, I'd keep an eye out for regional assets which may have been affected, for example in Qatar, if these tensions have a knock-on impact. Also, it would be worth looking for foreign companies that have been affected by their perceived exposure to Egypt.
In the US, the consensus is that we should ignore the shocks to headline inflation from commodity price spikes. Federal Reserve Chairman Ben Bernanke believes core inflation will remain low due to the high level of unemployment (low wage inflation) and spare capacity in the economy. The European Central Bank (ECB) is less convinced by the idea that we should focus on core inflation, but at the same time in their last meeting sounded less hawkish than market participants had been expecting. I think that ECB President Jean-Claude Trichet had just been talking tough in his previous speeches, providing the illusion that the ECB is on the ball regarding inflation but not actually intending to raise rates. After all, who in Europe actually wants a very strong Euro? This led to a quick drop in the Euro following the press conference.
The first phase of the market rise since March 2009 was I would argue a snapback trade. We had a liquidity problem, which was fixed by the Fed. The second phase was a recovery trade as companies started rebuilding depleted inventories and so. Now we seem to be in a reflation trade. In this trade, you stay long most risk assets with intelligent stop-losses. Some of the key assumptions in the reflation trade:
1. The Fed is friendly to markets and will keep monetary policy easy as core inflation remains low and unemployment remains high.
2. Corporate earnings are good and outlooks are still positive.
3. You cannot argue that valuations are very high for stocks, expect possibly for commodity related stocks. It is quite attractive to invest in stocks on an absolute basis if you look at dividend yields and consider the low margin costs.
4. Yields and the outlook for stocks are more attractive than bonds at this juncture.
5. The trend is your friend and it is a good friend right now.
6. Emerging markets are a great positive force for developed market companies. They will also finance developed market debts.
7. Events in Egypt are not going to affect the world in such a way that it would derail growth.
8. The Europeans are working on a positive solution to their peripheral country debt problems.
Some more thoughts on what could lead to a more significant 10-20 per cent decline in risk assets:
1. The China hard landing trade: China tightens more aggressively than expected, or the prior tightening has a lagged effect and starts causing lower than expected economic data. This leads to revised assumptions about growth figures worldwide. I'm not sure who this is good for.
2. The Asian currency appreciation trade: The Chinese revalue the Yuan much more aggressively. Monetary tightening in Asian countries and emerging markets leads to even stronger local currencies and affects their exports and growth numbers. The market doesn't really understand how to deal with this in the short term.
3. The hyperinflation trade: Further increases in commodity prices occur which increase inflation expectations and knock on to demands for further wage increases across the world. Governments, companies and individuals (the WSJ has an article on 29/01/11 about Chinese cotton farmers hoarding cotton stocks in anticipation of higher prices) start stockpiling which aggravates the problem. The whole central bank orthodox thinking about core inflation not being driven by headline inflation is called into question. By then inflation will be out of control.
4. The political risk trade: Events in Egypt lead down a road that increases the risk of a military conflict with Israel. Perhaps significant protests start happening in Iran or Saudi Arabia. Either would cause oil supply disruptions and a price spike (above $150-200) which hurts consumers worldwide. Precious metals benefit but industrial commodities suffer.
5. The Euro disaster zone trade: The Europeans fail to provide a clear and effective solution within 3 months to address how they will deal with further peripheral debt problems. Fears re-emerge about the solvency of European banks and the willingness of policymakers to bail them out again.
This leads to a renewed attack on the Euro, shakes German confidence and their export engine (the gains from a weaker currency are offset by lower consumer confidence and increased savings). The whole vision of Europe is called into question.
6. The double dipper trade: US economic data starts seriously underperforming expectations (I say seriously because so far any lower than expected numbers haven't made much of a dent to sentiment). This leads to renewed fears of double dip. Belief that Quantitative Easing is a solution to all problems fades.
If anything does happen to make these scenarios more likely, it is a good idea to identify the chain of events that could happen your portfolio, to identify where to control losses and look for profits. Even before anything actually changes the fundamentals, if sentiment changes, it will affect the technical picture, which in itself will change the fundamentals. I personally feel (don't have any numbers) that the power of traders is relatively higher than ever before. I also feel that information is spreading faster than people can actually process it. This will cause volatility spikes and move trends far more than any fundamentals actually justify.
Courtesy - RizCapital