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Proposing an Asset Shortage Hypothesis

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Proposing an Asset Shortage Hypothesis

March 27, 2007

By Stephen L. Jen
Morgan Stanley Co. Ltd. International


We propose an 'Asset Shortage' hypothesis, suggesting that the world is suffering from a shortage of financial assets. The world's supplies of sovereign bonds and net equity issuance have indeed been very low in recent years. This may help explain the elevated global financial prices.

Robust economic growth in the past 15 years and the 'Great Moderation' helps governments consolidate their fiscal positions. The relatively low valuation of equities following the tech meltdown in 2000 and abundant global liquidity may have contributed to a 'de-equitization' process.

Sovereign debt outstanding has indeed declined. The world's outstanding stock of sovereign debt, excluding Japan, has declined to only 59% of GDP. Considering that the global financial markets and resources have grown disproportionately with respect to the global economy, the world has experienced a supply crunch on sovereign bonds.

Low net issuance of equities. Similarly, global net real (deflated by M1) issuance of equities has also declined sharply - by one-third in the past 11 years.

Non-intervention policy. Our 'Asset Shortage' hypothesis, in conjunction with the 'excess savings' argument, suggests that global supply of and demand for financial assets have been severely out of sync. Asset prices could stay misaligned with the real economic fundamentals. From the perspective of policy reactions, the right response is not to prick this bubble, but to focus on how best to manage systemic risk.
 
Hans F. Sennholz on the current asset shortage

... Every week we may hear and read about new corporate mergers and acquisitions. Flush with cash, private equity firms are ever ready for more deal making, bidding for and acquiring another company. The merger and acquisition boom is buoying stock prices across the board, which is benefiting most investors. Moreover, as some corporations are being taken private and others are engaged in stock buybacks, thereby reducing the overall supply of corporate shares, the stock market is enjoying an extraordinary boom, which many investors hope will never end...


http://www.sennholz.com/moneyflooding.html
 
What happens when liquidity dries up? When interest rates rise to a point that leverage doesn't makes as much sense as it does at lower rates?
 
It's interesting to ponder the whole 'asset shortage' idea.

Since evidence shows that people are paying higher and higher prices for assets, irrespective of yield, then it makes sense to think we are experiencing a kind of 'asset price inflation'. The text book definition of inflation is an increase in the money supply relative to actual production (or something along those lines). BUT, on the other hand, much of what we acquire and consume on a personal level costs much less than it used to. The obvious example is the constant 'more for less' game in the computer and consumer electrical goods markets. And I can buy much more car today for the same (adjusted for inflation) dollar amount as say 10 or 15 years ago. I can get more furniture from Ikea and I can buy more pairs of Diesel jeans or D&G watches.

Relatively speaking, whilst on the surface it looks like we have inflation, in particular asset price inflation, I can't help but wonder if in relative terms the net effect in many parts of the world is actually deflation.
 
Michael Metz thinks that the buy outs are shrinking the supply of stocks. That's bullish !


Michael Metz, Chief Investment Strategist for Oppenheimer & Company
PBS/USA - Friday, July 13, 2007

PAUL KANGAS: My guest market monitor this week is Michael Metz, chief investment strategist for Oppenheimer & Company. Mike, welcome back to NIGHTLY BUSINESS REPORT.

MICHAEL METZ, CHIEF INVESTMENT STRATEGIST, OPPENHEIMER & CO.: Thank you, Paul, delighted to be here.

KANGAS: With regard to yesterday's wild stock market run up, do the words "irrational exuberance" come to mind?

METZ: Certainly exuberant. I don't think it is irrational. Actually a rational investor in boom times like this has really no choice but stocks. I think bonds are not attractive and real estate generally is out of price.

KANGAS: But do the recent premium buyout bids we've seen in the stock market suggest to you that there are still plenty of bargain priced stocks around?

METZ: To the buyers there are. And actually these buy outs are shrinking the supply of stocks, so that in itself is bullish.

KANGAS: That's an interesting observation. When you were last with us in early February, with the Dow at the 12,500 level, you were very bullish and correctly so and indeed here we are just under 14,000. Are you still bullish on stocks?

METZ: Yes. Not as bullish as then, but I think there is still room on the upside.

KANGAS: How much room is the question?

METZ: I don't know. But I think we're almost in the mania phase. We could get a big move compressed over the next few months and then go flat for a while.

KANGAS: Do you think it was technically a little shaky that we didn't have some kind of a shakeout today after the big rise yesterday?

METZ: No. I think there are too many people waiting to hop aboard. So I don't think we're ready for a correction quite yet.

KANGAS: Interesting. Now in February you were correctly bearish on bonds as well. How about now?

METZ: I still am. I think the long-term direction of interest rates is up, regardless of the Fed. And I would buy short term notes. I would not buy bonds.

KANGAS: Back in February, you thought the fallout in the housing industry would worsen and it certainly did. But do you think housing is near a bottom now?

METZ: No, I don't. I think we have problems extending into '08 which I think will translate into below par growth.

...
 
July 17, 2007

Industry Consolidation Is Good for Price Discipline
Source: www.minesite.com [Free registration]

By Rob Davies

The US$44 billion friendly bid for Alcan from Rio Tinto continues the theme of the last few years. Famous and well established names like Inco, Falconbridge, Mt Isa Mines, Western Mining and BHP have all succumbed to the remorseless logic of size in an industry where economies of scale can bring massive benefits. Most often this is thought of as being used in purchasing power to negotiate supplier’s prices down. However, it is more likely that the real gains will come on the sales side.
This is most obvious in the iron ore industry but after the last two years it is a fair bet that the nickel and aluminium markets will be much more stable in the hands of their new oligopolistic owners. That stability will probably be more evident in market downturns than in the boom conditions that are currently being enjoyed. Fortunately, for mining analysts there is still a steady flow of new issues to look at to replace the larger companies as they disappear. What is surprising is that mining stocks now makes up 8.4 per cent of the London stock market when it wasn’t that long that for a while there was only one large mining company listed on the LSE. It is strange that markets such as Canada, Australia and South Africa which ought to be the natural home of these resource stocks have borne the brunt of this attrition.

While mining shares were headline news on the financial pages last week the steady erosion of value of the US dollar attracted less attention. It traded as low as 1.38 euros and 2.03 to sterling over the last five days and that is usually a positive influence on metals. It didn’t do much to stop the steady decline in nickel which fell to US$33,400 a tonne on a cash basis. That makes for a rather staggering fall of US$20,000 a tonne from the peak. Forward price are down almost as much and yet inventories on the LME have only risen by 1,200 tonnes to 10,300.

Underlying the reason for the fall is the massive drop in the growth in demand for stainless steel. According to Société General the growth rate has plunged from an amazing 26 per cent in the second half of last year to a more sedate 7-8 per cent in the second quarter of 2007. Demand is still rising, but at a less frenetic pace, and once conditions settle down the French bank expects a strong recovery in the first half of 2008.

While nickel has been going down lead up has gone up. Last week it broke through the US$3,000 level and settled at US$3,035 a tonne. Encouragingly the three month price moved up in tandem and kept the backwardation down to US$25/tonne. Lead is a much smaller market than aluminium. Only five million tonnes a year is consumed against the thirty seven million tonnes of aluminium that are demanded annually. If you are going to be big in mining you have to go for the big metals. Dominating the world lead market is never going to have quite the same cachet as being a leading force in aluminium. Rio Tinto clearly agrees.
 
Gold joins the mainstream

By James Grant
[The author is the editor of Grant's Interest Rate Observer]
Forbes magazine, June 2007 / www.forbes.com

Once upon a time gold was the sanctuary of nonconformists, visionaries, contrarians, idolators and cranks. And the gold price moved accordingly. If stocks went up, bullion went down, and vice versa. Which is to say, as the financial theoreticians say, that gold was an uncorrelated asset.

But the barbarous relic has moved ever closer to the investment mainstream. "Strength in commodity markets will be something we should see generally over the next 10 to 20 years," Russell Read, chief investment officer of the California Public Employees Retirement System, was quoted as saying by Bloomberg a few weeks ago. Read has lots of bullish company. In 21TK2 years the market cap of the gold bullion exchange-traded fund StreetTracks Gold Shares, trading at $66 a share, has ballooned to $10 billion from nothing at all. Goldbugs rub their eyes. They feel like the starving artist who awakes one morning to discover that his neighborhood has gone upscale.

Actually, the goldbugs stopped starving some time ago. Since February 2000 the gold price has risen by 130% compared with the S&P 500's 11% and the Nasdaq's minus 45%. Adversity, of course, is the bullion market's old, dear friend. Whether it was the 1987 crash or the Sept. 11 attacks, gold and stocks have tended to go their separate, uncorrelated ways.

If you sat close enough to the blackboard in business school, you may believe that uncorrelated returns are almost as good as just plain high returns. By diversifying into assets disconnected to stocks and bonds, theory has it, an investor can earn greater returns without assuming additional risk. Few assets have answered the call of disconnectedness better than gold. Between 1975 and April 2007 the correlation between weekly movements in gold and of the broad U.S. stock market was around zero.

But a funny thing happened last winter. One day the Shanghai stock market fell out of bed, and, in sympathy, so did other world stock markets--and so did the price of gold. It fell by $23 an ounce. In the 50 days leading up to the Feb. 27 break gold and stocks might as well have been ships in the night. But as the Dow Jones industrial average dropped by 416 points, equities and bullion set sail together. Their correlation rose to 0.6 and stayed there for the next 50 trading days. (At a reading of 1.0, gold and stocks would be in lockstep.)

It could be that this uncharacteristic joining of equities and bullion was a fluke that the safety-seeking gold buyer can safely ignore. But I doubt it. The stellar returns of the postmillennial metals markets have been lost on no one. Investors have chased them, and academics have rationalized them.

The trouble I see is that the opportunists increasingly outnumber the goldbugs. Goldbugs are quick to buy their precious metal and slow to sell it. Opportunists are quick to buy it and quick to sell it. Their principal monetary conviction is that all money is good--not a bad outlook in the abstract, but nothing to hold on to in a bear gold market. So when gold goes down, or when its correlation characteristics change, the opportunist can be expected to dump it as unceremoniously as he would a sack of flour.

It follows that gold could be in for a rough patch. Insofar as it trades like the stock market (at least, on the days when stocks fall), it will tend to lose its newfound adherents. Even its old, grizzled, eccentric fans may despair of it. Why own a defective insurance policy?

That is the near-term risk. But I continue to believe in a sizable long-term reward. Yes, gold has had a nice seven-year run. But the monetary phase of the bull market has hardly begun. How could it have? People, for the most part, still trust the currencies in their wallets and the central bankers who print them. The day gold stops trading as a decorative asset, and begins trading as an alternative to Bernanke & Co., is the day that the gold bull run, part II, begins.

The U.S. this year will emit some $850 billion into the world's payment stream. Most of this money will be absorbed not by profit-seeking individuals but rather by foreign central banks. The central banks of Russia, China and Brazil, for example, will acquire the dollars with currencies they print for the very purpose. This system of creating rubles, renminbi and reals with which to soak up redundant greenbacks might be characterized in many ways. But "bearish for gold over the intermediate to long run" is hardly one of them.

---------
 
Assets to Buy Are Increasingly Scarce World-Wide

By Igor Greenwald
www.smartmoney.com

I'VE GOT A THEORY that will explain the Chinese stock market and the U.S. current-account deficit, justify (all things being equal) lower interest rates and illustrate the utility of speculative bubbles ”” as well as their perils. Oh, and it can also help you pick in-the-money ponies. Now how much would you pay? What if I told you that this surefire hit can sway skeptics with equations and a bibliography?

The theory is on the house because it's not mine, of course. It's been put forward by Ricardo Caballero of the Massachusetts Institute of Technology, as well as other economists. Their key insight is that our increasingly expensive world is coping with a chronic asset shortage.

There simply aren't enough securities to acquire with all the money we save, and by "we" I really mean all the far-away Asians, fellow members of a species that's thrifty on the whole. Humanity may seem thrifty, in part, because it's got nowhere to stick all the scrip it doesn't spend. Ben Bernanke and others have noted a world-wide savings glut. The asset shortage is that glut's probable cause, the other side of the Krugerrand inside the mattress.

Caballero is from Chile. He traces the asset scarcity to the rapid economic development in emerging markets and their inability to produce enough financial instruments to match that growth rate. Despite the developing world's massive capital needs, it lives under the constant threat that capital will flee for safer havens. Caballero cites "weak bankruptcy procedures, chronic macroeconomic volatility and sheer expropriation risk" as some of the hazards that investors in developing markets must brave. Put that way, the 6% U.S. mortgage-backed bond begins to look halfway attractive.

Caballero argues that the asset shortage has sustained a series of bubbles and panics, from the early 1990s Japanese collapse and the subsequent crises in Asia, Mexico and Russia to the Nasdaq's moment in the sun, the booms in real estate and commodities and now renewed speculation in emerging markets. The bubbles may even do some good, by freeing resources for investments with higher potential returns.

It's a self-perpetuating cycle in many ways, as each burst bubble erodes the asset base, encouraging the next wave of ready cash to seek out a different can't-miss fashion. Meanwhile, each bust forces the people in charge of money to go print some, to insure the economy against deflation. Caballero argues that the extra liquidity is an unavoidable consequence of an asset-starved world. But rescue the economy and the markets often enough and we don't really have to wonder why no one's afraid of risk, now do we?

It's not hard to find supporting evidence for the notion that the developing world is undercapitalized and underleveraged. For example, Merrill Lynch's emerging markets team has pointed out that emerging economies account for 80% of the world's population but less than 10% of its market capitalization.

By the reckoning of Morgan Stanley's economists, the current-account surplus of Asia besides Japan could, if redirected inward, exhaust the region's current pool of domestic bonds in two-and-a-half years. Governments in Asia have been running a tight fiscal ship ever since they almost drowned a decade ago. Meanwhile, many European tycoons still make do with old-fashioned bank loans, leaving the U.S. as the dominant issuer of corporate debt.

The asset shortage over there has naturally turned into an asset shortage everywhere. Underdeveloped overseas markets needn't take all the blame. For example, Raghuram Rajan at University of Chicago (and formerly of the IMF) has tied the asset deficit to the recent rise in productivity as well as a decline in plant-building by corporations.

Others claim the cause is increased income inequality, high profits and low taxation. Harvard's Richard Cooper has noted that aging populations will increasingly seek income overseas. I've written about the graying baby boomers as relentless consumers of financial assets.

In late 2004, Caballero couldn't find any takers for an op-ed piece on the subject. Now the "asset shortage hypothesis" is all the rage. "Perhaps three more years of supporting evidence have made people more receptive to the view," he allows in an email interview.

Whatever its causes, there are good reasons to believe that, in the short run at least, the asset shortage could grow more severe. Private-equity buyouts financed by the rich as well as by the public pension plans are on pace to extract some $700 billion in assets from the U.S. stock market this year, and share buybacks won't amount to much less.

That's hardly a warranty against a future loss. After all, last week's rally increased the value of U.S. stocks by $350 billion in a span of just five days. But the asset shortage is a helpful tailwind, at least until some bubble somewhere pops and everyone moves on to something else.

Now about those ponies. Guess who's been manufacturing assets day and night in a tireless and profitable attempt to meet rising demand? Yup, it was the derivatives packagers at Goldman Sachs (GS), the ETF marketers at Barclays (BCS) and the hedge-fund indexers at Merrill Lynch (MER).

Derivatives can transform any transaction and any bet or combination of bets into a tradable security. For an additional charge, the sausage factory will shape these into an investment asset suitable for any pension plan. There's a lot of pension money out there and a limited pool of assets it can buy. And you can bet that Wall Street won't be tardy with a supply of sausages. Between the selling in New York and the buying in Shanghai, I like our odds of licking this shortage eventually, at which point we might remember it fondly.
 
A sinister theory about Wall Street's late rallies

Aug 3rd, 2007

Meanwhile, is the Plunge Protection Team (PPT) hard at work in the US? For the second day in a row, Wall Street rallied over 100 points in the last hour of trading.

You can interpret this in one of two ways. First, bulls and bears are earnestly engaged in combat for control of the market. Bears are winning the field for most of the day, with the Bulls rallying late.

The other, more sinister theory is that there exists in the financial market a buyer of last resort who comes in to goose the indexes at critical times, when investor confidence is especially fragile. We take no position on the matter. But it sure does look weird on a chart.

That’s it for the week. We’ve managed to ride out the worst of the jet lag and even get some work done. It’s nice to be back in Australia. You might be surprised the number of Americans interested in what’s going on here. And not just from an investment perspective. “It’s a nice place to live,” we tell them.

“It’s a bit colder than we thought it would be…and you have the same creeping police state worries…but the Aussies seem to have a bit more common sense and a bit less political correctness than your average American. And life is just a little more relaxed.”

“But don’t they have the same debt and housing problems?” we are often asked. We’ll see.

Dan Denning
The Daily Reckoning Australia
www.dailyreckoning.com.au
 
August 06, 2007

Where Has The Liquidity Gone?

By Rob Davies
[www.minesite.com]

The reduction in liquidity from capital markets is probably the biggest feature of the financial world right now. Although it is not driving commodity prices it is undoubtedly a feature of the pricing environment, and most likely a negative one. Despite that, base metal prices have mostly held up in sharp contrast to other asset classes. It was only a few months ago that risk in credit markets was being sold extremely cheaply. One measure of that was the spread of non-interest grade credits in the US. These had shrunk to 250 basis points by early May. Since then that spread has increased by 200 basis points, virtually doubling the cost of risky capital versus risk free money.
That is a pretty effective way of curtailing the flow of hot money around the trading desks. Its most immediate result was to restrict funds available for leveraged equity purchases and some financings now seem to be finely balanced. Inevitably that shortage crosses over into asset classes as liquidity is transferred from those that have it to those that don’t. One such hard asset is property where a dramatic realignment is taking place. Unfortunately that has seen some property shares fall by a third in three months. Property is often spoken off as hedge against inflation in the same way that commodities are. The difference is that property does offer a yield and the decline in that yield over the past five years provides a real measure of how expensive property has become.

Commodities are not such a high profile asset class and there is no simple way to measure how expensive, or even how cheap they are. The underlying guide to determine if a commodity is cheap is its price relative to its marginal cost of production. Although the bull market has driven prices to record highs that everyone can see a lesser known fact is that industry costs have all gone up. Right through from exploration to construction and on to operating costs the story everywhere is that it all costs more. Low rig availability has pushed up drilling costs, the higher price of steel has raised capital costs and more expensive fuel, labour and supplies has pushed up the cost of production.

One broker explained to Minews this week that in South Africa the rand gold price might be going up but costs are going up even faster. Other countries, especially Australia, have the additional problem that a weakening US dollar is making a difficult situation worse. These effects are most prominent in gold mining and recent results from the major gold mining companies have shown a decline in profits for these reasons. That suggests prices are not that high relative to the full cost of production. Evidence of that came from metal prices moves over the last week that were modest and provide further proof that this cycle is not just a sector rotation story with cash being allocated to it in the same breath as other assets.

While property and equities were taking the heat as funds were withdrawn lead bounced 11.5 per cent to US$3,389 a tonne and tin shot to a new high of US$16,250 a tonne after a gain of 5.2 per cent. Nickel was weak and sank below US$30,000/tonne to finish at US$29,400 a tonne as inventories on the LME climbed to 14,808 tonnes. Even after that fall it was hard to argue that nickel is cheap. Zinc inventories went the other way and dropped to 66,050 tonnes leaving zinc flat on the week at US$3,510 /tonne. The liquidity problems in other assets have not really impacted commodities because the fundamentals are still in good shape.
 
Australian Currency Trading Doubles to $200 Billion a Day, RBA Says

By Jacob Greber

Sept. 25 (Bloomberg) -- The value of transactions in Australia's foreign exchange and derivatives markets more than doubled in the past three years to an average $200 billion a day in April, helped by the so-called carry trade, a central bank survey showed.

Trading in the country's currency markets rose from $99 billion in April 2004, the Reserve Bank of Australia said in a report published on its Web Site today.

Australia's share of the global foreign exchange market rose to 4.2 percent, from 3.4 percent three years ago, helped by investors who bought the currency with funds borrowed in low- yielding economies such as Japan, the Basel, Switzerland-based Bank for International Settlements said today.

``In terms of global turnover, the Australian foreign exchange market is the sixth largest in the world'' and the U.S.- Australian dollar is the fourth most-traded currency pair, the RBA said.
 

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