Wednesday, August 27, 2008

Bill Gross: Inflation or deflation?

This is interesting.

Last month’s Bill Gross missive talked about an inflationary uptrend. Here’s what he wrote:

A trillion dollars of government deficit spending is potent medicine. Its potency regarding inflation will not be felt fully during the peak deficit period. Rather, inflation will accelerate during the subsequent recovery as the government bonds acquired during the recession are transformed once again into risk bearing assets and high levels of investment.

I covered this and commented on El-Erian’s latest book in an earlier post. I had concluded with these lines:

My 2 cents is that yields would probably come down in the next year in a deflation scare, before treasuries enter a decade long bear market. Even Hussman extended bond duration a few weeks back. PIMCO’s investment thesis, while right in the long run, could underperform this year.

Note that my conclusion was derived in part from reading Gary Shilling’s opinion, the GaveKal piece on monetary velocity posted by John Mauldin, and the simple fact that commodities peak late in a slowdown. Talking of commodity price driven inflation in a credit crunch with rising unemployment is problematic, global growth and a trillion dollar fiscal deficit notwithstanding.

Guess what? Maybe it’s due to crude cracking up, or some other data point, but Gross seems to have changed his view point. The 'deflationary threat' seems to be the new mantra.

From Bloomberg:

“Inflation is high. headline inflation at 5% is much higher than it should be. To suggest that the Fed or a central bank should raise interest rates in the face of a significant asset deflation, is certainly a wrong approach, to put it mildly. With housing prices going down, unemployment going perhaps as high as 7% 12 months down the road will be tantamount to raising interest rates in the mid 1930s which was a classical mistake the Fed reserve made at that time”

His investment outlook for August makes a similar argument. (As an aside, McCulley similarly talks about the menace of asset price deflation in an environment he calls the ‘paradox of deleveraging’.)

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Thursday, August 21, 2008

3G iPhone: Implications for the wireless ecosystem.

It's been a while since I posted anything tech related. The new 3G iPhone has been the rage since it's release a month back. Semiconductor Insights, TechOnline, Portelligent, and several others have done a great tear down analysis of the device. (You can catch the TechOnline breakdown here)

Apart from the evolution to 3G and the GPS, the hardware innovation is essentially incremental in nature. I thought it would be interesting to talk about the implications for the handset vendors and the chipset manufacturers. My personal opinion is that the iPhone is a good thing for the chip makers but probably a slight negative for the handset manufacturers.

With 19 chips inside, the iPhone will drive higher margin chips and accelerate Smartphone adoption. Check this link for a detailed picture. While there were no major surprises in terms of design wins, I did expect some of the discrete chips to be replaced by a single one.

Chips: Before the iPhone, the chip makers were in a race to the bottom. Cranking out lower cost chip solutions at the lowest possible price point seemed like a solid differentiating strategy (for the ultra-low-cost market). The smartphone uptick is good because it implies a rush for higher content, higher priced chips.

What do I mean? Most chip providers are essentially in a race against commoditization. With prices for chips and handsets eroding every year, they rely on newer features to maintain their margins. With the upsurge in demand for high-end features like GPS, the chip set vendors should be able to sell higher average selling price (ASPs) chips with fatter gross margins. They can further differentiate themselves on the basis of features like multi-mode solutions, power consumption, multimedia, mobile TV, HD video, GPS/bluetooth integration, etc.

Many carriers are now heavily subsidizing smartphones, which is spurring a strong demand for these devices. This should fuel high-volume shipments in these high end chips. Smart phone IC commoditization is at least a few years away for wireless chip makers. In the near future, expect to see additional features like HD video, mobile TV, and of course the natural evolution to a 4G air interface (LTE/Wimax).

Handsets: The first thing I realized when I heard that the iPhone would sell for $200 in the US was that the handset margins were headed down. The $199 price tag points towards handset price erosion for manufacturers like Nokia and Samsung. While carrier subsidies should offset some of the price declines, I remain skeptical about the bargaining power non-Apple vendors might have. The subsidies could also be quid pro quo in nature, like the Apple deal showed (Apple discontinued the unique revenue sharing model it had with AT&T in lieu of the price subsidy). Feature rich 3G phones have historically sold for high prices, and this would be difficult going forward.

Some of the components like memory are probably a couple of quarters away from their cyclical bottom, and it’s unlikely the semiconductor component pricing would decline like it has in the past. A higher silicon content with healthy component pricing points to a higher bill of materials, squeezing those handset margins. Note that some of these negatives are offset by higher volumes (regular demand elasticity).

In conclusion, I view the iPhone as a strong positive for the chip makers but probably a slight negative for the handset vendors.

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Tuesday, August 19, 2008

A 100 year storm?

The investing pantheon has been famously negative for more than a year now. Plenty of people have compared the current banking crisis to a 100 year storm. From a Prem Watsa interview. :

History shows that there are 100-year storms and 50-year ones. In 1929, a 100-year storm, only 10% survived the market crash and it was only those who were negative in 1925 and did something about it.

Q: Is this a 100-year or a 50-year market and what’s the difference?

“The 100-year is a Depression. The 50-year is what happened to Japan in 1989 to 2003. We don’t know yet.”

While it’s hard to appreciate the magnitude and severity of the current crisis, this interesting article from PIMCO's Emerging Markets watch drives home the point.

“It’s like deja vu all over again” as we see a classic Emerging Markets (EM) balance of payments crisis unfolding before our very eyes – but this time in the U.S.

Here's an eye-opening chart from the same:

In summary:

  • Average length of the banking crisis is 4 years.

  • Emerging markets have a higher fiscal cost, even though the output loss in developed economies is higher (I wonder why).

  • The average output loss of 24% in developed countries is HUGE.

  • While the average length of the crisis is about 4 years, the “lost years” due to GDP shrinkage could be a lot longer.

  • There is a wide difference between a banking crisis alone, and a banking AND currency crisis. An average output loss of 5.6% in a banking crisis alone is basically ~2 years of lost growth. That 30% output loss in a banking and currency crisis translates to a lost decade.

The article concludes by recommending Brazilian bonds, Singapore dollars and Chinese yuan. Recommends avoiding converging European currencies (particularly Hungary and Romania), US Dollar, and the long end of US treasuries.

Wait, there's more. Here’s what a recent NYTimes article on Dr. Doom Nouriel Roubini says:

After analyzing the markets that collapsed in the ’90s(the emerging market crises), Roubini set out to determine which country’s economy would be the next to succumb to the same pressures. His surprising answer: the United States’. “The United States,” Roubini remembers thinking, “looked like the biggest emerging market of all.”

It's rare to see such a strong chorus of negative pessimism. If this is indeed a classic “balance of payments” problem, then I’d reckon this crisis would be a long drawn out one.

The smart money seems to concur.

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Monday, August 4, 2008

Jeremy Grantham (GMO) Quarterly missive.

Jeremy Grantham’s quarterly missive ("Meltdown! The Global Competence Crisis”) makes for an interesting read. I think Grantham falls in the select group of market/ecnonomy prognosticators who are spot on from a long-term perspective. I had written earlier about his 7 year asset class return predictions. While things always change, the accuracy of his earlier 1998 predictions certainly strengthens his case.

Anyways, so his historical bearishness turned out to be optimistic, given the unraveling of the past few months.

His conclusion?

Due to a combination of spectacular mismanagement by the authorities that resulted in very excessive and dangerous speculation and very bad luck in the timing of commodity problems and over-rapid expansion of China, the fundamental global outlook is substantially worse than expected.

Some other excerpts:

  • The Fed, the ECB and other financial authorities failed and have lost their credibility.
  • We run a serious risk of a meltdown in confidence in leadership totally unlike anything we have seen since World War II.
  • China is exporting inflation (by under pricing currency).
  • The recycling of oil country surpluses could be destabilizing.
  • There’s a transfer of income from consumers to miners and farmers.
  • Underweigt on emerging markets from overweight. Sees a global slowdown, and export-dependent developing countries with massive over investments are ripe for a shakeout.
  • The probability for longer and deeper overruns below fair value and the chance of a “meltdown” has gone up.
  • Poor prospects for commodities and emerging markets for the next couple of years. Attractive from a long term perspective.
  • In the U.K., house prices could easily decline 50% from the peak. If prices go all the way back to trend, then the U.K. financial system will need some serious bailouts and the global ripples will be substantial. (He calls this a near certainty)

Hmm... Certainly food for thought!

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Saturday, August 2, 2008

GMO asset class return forecasts.

In an earlier post, I had written about GMO’s 7 year asset class return predictions. Well, they have updated their charts, and here’s how the predictions look now:

The decline since March has made the long term returns look even more favorable. (There’s something to be said about not trying to time the exact market bottom and holding on for the long term! )

For those questioning the accuracy/relevance of their numbers, here’s how their 1998 forecasted numbers stacked up. While the absolute numbers might change, the rankings for the asset class returns were spot on.


  • Seems like a good time to invest in international small cap, especially small cap value (DISVX?)

  • Inflation-indexed bonds are expected to underperform US govt bond.

  • US quality stocks and timber look attractive.

  • The long range forecast on emerging markets and international equity has also gone up since March, partly due to the severe declines we’ve seen since then.

I was intrigued by the definition of “US Quality”. Here’s what the description reads: GMO U.S. Quality Strategy begins with a universe represented by large capitalization stocks in the U.S. market. Using proprietary quantitative models, the strategy screens an issuer's quality based on several factors, including, but not limited to, expected earnings volatility (as measured by the volatility of profitability), profits (return on equity), and operational and financial leverage (fixed operating costs and total outstanding debt, each in relation to equity). Further, the strategy seeks out stocks it believes are undervalued within this defined universe.

The top holdings in their "US Quality" asset class are:

Exxon Mobil Corp. 6.9%
Microsoft Corp. 6.8%
Wal-Mart Stores Inc. 6.8%
Johnson & Johnson 6.7%
Pfizer Inc. 6.3%
Coca-Cola Co. 6.3%
Chevron Corp. 6.2%
PepsiCo Inc. 5.0%
UnitedHealth Group Inc. 3.6%
Procter & Gamble Co. 3.4%
Merck & Co. Inc. 3.4%
QUALCOMM Inc. 2.7%
Oracle Corp. 2.3%
Cisco Systems Inc. 2.3%
Home Depot Inc. 1.9%

I would have guessed that the “predictability in earnings” would imply a heavier weight towards consumer staples, health care, pharma and other non-cyclical sectors. Turns out to be true, except I was a little surprised to see Oracle and Cisco.

Going forward, it’s going to become increasingly important to evaluate stocks from an inflation-pass through perspective. Any company which can pass on inflationary cost increases to its consumers is going to see a multiple expansion going forward (think Walmart, Proctor and Gamble). One name which has intrigued me thanks to Buffett is Kraft, but I need to do my homework on that one first.

In my next post, I’ll discuss Grantham’s quarterly missive.

Disclosure : Long Qualcomm, Microsoft, DISVX.

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