Nesbitt Burns Institutional Client Conference Call for April 20, 2007
Don Coxe Toronto
"The 10-Year Treasury Note: Is This Near the End?"
Thank you all for tuning into the call which comes to you from Toronto. The chart that we faxed out was the yield on the 10-Year Treasury note and we asked whether this is near the end. So we're picking up on the theme of the current issue of Basic Points, which is "Bye-bye Bond Bull". Had the advantage of seeing a lot of major institutions in Toronto this week. And there's been lots of question raised in that, I intend to address some of those questions during the call.
Meanwhile, the stock markets of the world are going to new highs and if we get a close where we are now on the Dow Industrials and the Dow Transports, we've got something approaching another Dow Theory buy signal. And NASDAQ
is about to touch a new high. This is a very impressive performance here, but it's just mimicking what's happening across the world.
So the idea of a rise in long-term interest rates and a rise in inflation is not something that's certainly concerning the stock markets of the world at the moment. And that, I think will become a source of concern later, but at the moment, what stock markets are saying notwithstanding the tightness of
central banks for the last two years and notwithstanding the sell-off we had in stock markets earlier in the week because China announced it was going to do something to try to rein in its 11.1% growth rate. It didn't take long before people assumed that the game is still on for the global economy.
What's interesting is that there's no evidence out here at the moment that the US stock market is wasting much time worrying about what it was so worried about in February and early March, namely the subprime loans. However all the work that I've been doing since then about the state of the subprime market indicates that we are a long way away from reaching bottom
in that area and that the housing sector of the US is going to be having its problems for quite a while to come.
The latest studies that I've seen do show that the effect of the collapse of the New Century Financials and their ilk, has definitely changed the ability of people to get loans. And so one can say with some confidence now, that in the US mortgage market, that somebody who turns up who hasn't bathed recently or shaved recently and smells of alcohol on his breath and answers questions about whether he's had any jobs with a belch, is no longer likely to get 100% financing on buying a house.
But as to that kind of situation, what we don't know is how this is going to work through the whole market. Because there's no question cleverly-designed packages which were designed to insulate the toxic waste in them, that they're having problems, because it's creeping up into the lower categories. And once you stop having that pressure at the bottom end in the housing market from people who had never been in the housing market before but were getting loans when they shouldn't, it gradually works its way up.
And therefore the underlying premise which for about the last eighteen months leading up to January of this year, which was that house price inflation would skate you onside even if the borrower didn't seem to have the requisite requirements that had been used for generations - which was proof of ability to service the debt - that that was okay because the house was going to be worth more than what the loans were against it, including both the original loan like the Fannie Mae type loan plus the home equity loans attached to it.
That concept is being more and more called into question because, it depends which set of data you look at as to US house prices, but it's clear that they are no longer going up and in some areas they are going down significantly. Which means that the mortgage default rates and so forth are
going to be to some extent a regional phenomenon. But what the stock market is saying is this isn't enough to derail the US economy or the global economy. And that, in effect, helps bolster our case, oddly enough, for our concern about bonds.
Because we saw this week that when the stock market sold off and industrial commodity prices sold off, we had our first good rally in some time in the long end of the bond market. And this was simply asset allocators moving from stock futures into bond futures. And if we don't have that kind of support for the bond market, then I think that the basic realities of the inflation problem are going to define, ultimately, how long bonds perform. I was asked at numerous meetings how bad I thought the long end of the bond market was going to do in the US and I said, why don't you assume something like two hundred basis points over the next two years.
And it wouldn't start to show up for a while, but we will move to a normal yield curve eventually, but not as the bond bulls have maintained because the Fed is going to drop short rates back down to three percent or so, but it will be because the Fed will still be constrained by inflation pressures and be able to do very little. And so, it will simply be that people will not pay the premium they're paying now to buy long bonds.
When you've got what amounts to a fifty basis point cost of buying the 10-Year note, based on short rates and long rates, what you have is a situation where you're paying a huge amount of money to buy the long bond, because of your conviction that short rates are going to fall and that long rates will follow and you're going to make big capital gains the further out
you are.
That was a wonderful way to play the market at all turns in the market during the cycle of twenty-six years of disinflation. It is precisely the wrong way to play the bond market now that inflationary pressures are returning. And we are more convinced than ever from what we've been seeing this week, that food price inflation is going to become a major concern and that's something that this emphasis on the core CPI and ignoring both food and energy which...there was a headline in Investors Business Daily this week when the Dow touched a high, saying "Inflation Tamed, Dow Goes To New High". Core CPI was up a tenth of a percent, but nominal CPI was up .6%.
Way down in the middle of the story they mention that "minor item". But they said that this isn't used by cental bankers or economists because it's subject to the volatile food and energy components.
Well this concept that you can run monetary policy based on economists who neither eat nor heat is one that's been used in the US in particular and to a lesser extent Canada, but it isn't used in the rest of the world. They use nominal CPI. And I believe that the situation in the US - which is where I think the main problems in the bond market will be - I think that they will not be able to use that elegant excuse for the Fed having an opportunity to ease, even if what the consumers are paying is big price increases. And given the shortage of labor in the US, you can bet that it's what it costs people to live as opposed to a nice theoretical concept that's going to drive wage demands.
So I'm more and more of the view that any rallies like this in the bond market - and I believe this will be the second...third failing rally of the TLTs which is the ETF of the long Treasuries, I think those are selling opportunities. But I don't disagree with the concept that you're going to
have some wonderful rallies in this on days that the stock market sells off.
So, as a hedge, those of you who are looking for hedges, as opposed to buying puts, I think futures contracts on the long bond are probably a lower cost way to give yourself on a day-to-day basis some protection. But that's it. As an investment concept, if CPI keeps moving up, then you're really
not getting any return at all. At a 4.70 rate for the 10-Year note, I think we're going to have inflation up into that range - CPI that is - very soon.
If only because it looks like oil prices are going to stabilize in the 60 to 62 range for a while and everything else, particularly lead by food, is going to be showing upward pressure.
Now, one of the questions that I was asked was, "Well, you've laid such stress in this. Of your four scarcities, the three that we see which were surpluses during the disinflation era namely first energy and now energy in short supply. Next, was base metals and they were in oversupply for twenty-five years and they're certainly in short supply now. Just the statistics on price increases for the metals year to date, copper is up
twenty-five percent, aluminum is flat. Zinc is down fourteen, but nickel is up forty-two and lowly lead is up sixteen percent. So we have a scarcity factor in the metals.
And now...foods. And the latest of the grains to take off is wheat, because we have the continued drought in Australia and it looks like there has been more damage than we thought in the winter wheat crop in the US so we're back through five dollars on wheat.
From a global perspective then - and the grains are definitely
global...globally-driven - now that the peasant farmers in India can decline to sell their corn to the Indian Egg Council at the price bid by the Egg Council because they have the Chicago Board of Trade web site in the shops in the tiny villages. There will be at least one of these there. And they
are saying "No, we won't do it, our grain is worth more." So we had this spectacle of the Egg Council of India complaining to the government that futures speculation has driven up the cost of eggs by seventy percent. And they need relief from this. I don't think the government is going to rip out the broadband that's serving these villages.
So, on that kind of basis, if you don't have disinflation to support you and we've got those three scarcities, and then our argument is that the next one to show up will be on the labor side because of scarcity of labor. If we use the 4.4% unemployment rate in the US and take out 2 percent which is
pure fictional people that are between jobs or people that decided that they didn't like the job they had and are prepared to sit out for a while and get one they like more or they're moving or whatever, so that leaves then, 1.9% for people who are the kind of people who enter the economy primarily by
their ability to get subprime loans. But these are the people who fail the Woody Allen test, which is that 80% of success is showing up. These are people who have such erratic work records and employers are resisting hiring those as long as they can. But talking to employers, I know that they're
being forced to scale down their expectations simply because of scarcities.
And the fact that we're not getting an increase in US capex which has been disappointing the Fed, I think this is partly due to the view of employers that they still got to have somebody to operate equipment and the kinds of
people that they could get don't get them any conviction that they should be getting even more advanced equipment for them to learn on. In other words, we have used up the pool of talented, willing workers. And that ultimately will lead to higher wage pressures, suppurating through the economy.
So I believe in those factors and the demographic deflation will turn out to be the source of the next inflation. Well, the objection raised at a couple of meetings "Well, since Japan was first on demographic deflation and then lead the world on deflation, why didn't they have inflation from it?"
And in thinking about that, I think there are several factors. First of all, the effect of the WTO on consumer goods in Japan was that Japan had been the most effective protectionist society in the pricing of all sorts of consumer goods. In Tokyo in 1989, I remember seeing melons at eleven dollars. Because they had rules that prevented any melons from anywhere
else from getting into Japan and they were protecting these tiny little tracts where the Japanese produced melons. That has changed.
But I think there's a much bigger factor at work in Japan which is unique which is the consensus society that they have in industry and where the CEO doesn't make more than at most twenty-five times what the shop worker does. So there's a sense that we're all in it together and we're going to share
and Japan is a nation that has to rely on foreign trade to survive. And therefore we're not going to let our cost structure get out of hand. That
plus the very high savings rate in Japan as opposed to people going into
debt and bidding up prices of things. And the way in which in Japan that
they do spend money, is as tourists, so they spend the money outside the
country as opposed to buying lots of extra stuff at home.
I think that, in other words, it is a set of national characteristics which
date back to Hiroshima and Nagasaki and the end of the Emperor cult, a sense
that the future cannot be as good as the past. And we've got to really
stick together to survive in a hostile world.
Whereas, in most of the rest of the world, what you have is, pretty
entrenched unions and you have an adversarial system to some extent in the
wage market. It wasn't as much showing up for years during the 1990's
because high tech darlings became heroes, cult heroes...and then we found
out so many of them were crooks. That was gone.
And with the revelations which the SEC is producing each week of CEO's pay
packages, what we have, I think, is growing rage out there. So that once
people see that they have a chance to make up for it, they're going to do
it.
So I'll leave Japan's demographic deflation as an anomaly. I think that the
collapse in the birth rate in the rest of the world is going to show up in
wage inflation.
We had two big growth stories this week in headlines: China and Alberta.
And they are somewhat linked, of course. Because we wouldn't have the boom
going on in Alberta were it not for the Chinese bidding up oil through sixty
dollars and the fact that they're increasing spending by 12% in Alberta in
order to deal with infrastructure problems puts additional pressures on
wages right across the Canadian economy.
And not just wages but other kinds of services. This is just an
extraordinary impact. And what it means is, although we think of China
exporting deflation, in terms of consumer goods, here's a case where China
is exporting inflation into a region that got fast growth dependent on
producing something which is effectively priced by China.
So we're seeing now a form of energy inflation that does get measured in
other kinds of inflation, which is, that the cost of everything goes up.
And it's not just in Alberta of course, because when you've got people being
flown in from Newfoundland and out, and they won't be drained away from
Saskatchewan to go to Alberta now, I've had several phone calls with
Saskatchewan this week and Saskatchewan is now entering what is going to be
its best boom phase.
Everything is coming up for them. Grain prices, canola prices, they've got
the world's largest reserves of uranium. And they've got the world's
largest reserves of potash. And now we see that the oil sands do move over
into Northern Saskatchewan. And so Saskatchewan, which has been losing
people for years, I think that Saskatchewan is probably going to become a
net importer of people but that means is wage levels are going to be rising
there. And that's also being felt in Manitoba.
Ontario and Quebec are going to be on their own in this one, to some extent,
because of the auto industry, but for David Dodge who has to set monetary
policy for a country which is an amalgam of these very different kinds of
economies...I don't envy him his job.
We had lots of news on the bees this week including an allegedly
authoritative story claiming that what's killed them is cell phones and I
would just comment on that, that I find it hard to believe that cell phones
which have been around for so long just suddenly started killing bees from
North Carolina to California and then in nine countries in Europe and that
this hadn't happened before.
What may be is something that I learned from talking to a Saskatchewan
beekeeper is that this tendency of the Americans where they were using more
and more bees and they were bees - some bees were being killed off by normal
kinds of things and pests and so forth - so they brought in bees from
abroad. Which would give us a European tie because European bees were
brought in. Saskatchewan to its credit has had a quarantine on bringing in
bees from anywhere else, for more than 20 years. And I think that when they
finally do figure this out, the fact that things happened simultaneously may
well be - and in this case be is the verb but not the noun - that we'll find
that the intermixing of species did produce some negative side effects, but
it isn't cell phones or something as simple as that.
We've also had lots of news on bio-fuels this week and we're getting the
first big capital investment devoted to using animal fats to produce diesel
fuels. The deal between Tyson and Conoco is an interesting one because it's
the one to one ratio which is so interesting. One to one - a barrel of
animal fats to one barrel of diesel fuels.
Well, Eastern Canada is down to two rendering plants. One in Ontario and
one in Quebec and the reason they're down to just two rendering plants is
because the demand for tallow just dwindled off. We don't have as many
candles anymore except for decoration. People don't go to Catholic churches
as much as they did and so the prime use for tallow dwindled away. Well now
we're going to have lots of use for it.
So I think that you're going to be seeing investment opportunities related
to another energy source now which is going to be animal fats, which means
that the big meat producers are going to have yet another way of making
money as meat prices go up. I think there will be new IPOs on this and in
Europe they're doing this on a much bigger scale than we are. We'll catch
up.
The story on the commodities front...we're getting nice bounces again today
and what's interesting is gold is once again moving up. It's up $8 and I
suggest to you that for the bond story it's going to be a set of sevens that
are going to do it in '07. It's going to be gold going through 700 to stay
and the DX index going to 77, which will be a decisive breakthrough the 19
year support level for the US dollar contract.
And at that point the position for the Fed becomes serious and any thought
of easing is going to have to be put way on the back burner. It'll take a
deep recession to do something for them. Because you cannot be a Central
Bank that eases when your currency is selling off against all the other
currencies of the world, because everybody understands that there are two
kinds of monetary policy. There's the one that is driven purely by monetary
aggregates and the other is the effect of the exchange rate value of your
currency.
This is one of the things that David Dodge has on his side with the Canadian
Dollar. I see it was at quadruple 8s this morning, .8888, and what this
probably implies for the Fed is if we do and I think we will break the DX
because the only thing that is supporting the Dollar now is the Yen. And
the Yen I believe if we believe what's happening in the JGB's is going to go
up because the Bank of Japan is going to tighten once again this fall. And
at that point, I think the Yen will back up through the 1.10 level. That
will break the DX index unless the other currencies should weaken. So you
will have what amounts to a form of perfect storm for Ben Bernanke, Bad Luck
Ben.
So for those of you who are looking for indicators to watch, I think that
following the DX and gold together - they are going to give the signal as to
whether the something that we've worried about about the US Dollar for so
long the trade deficit and everything, is going to come to pass. And we've
been able to stop the fall of the Dollar three times at roughly the 80 level
or 79. I don't think it's going to hold this time.
And when that does happen the US yield curve is going to start to steepen.
And how much will happen this year and how much will happen next year, I'm
not going to predict the timing on this. But for those of you who are
running balanced funds or using hedging devices those are the kinds of
things to be watching. And it's something that could gain enormous momentum
once people see that gold has broken out at that time.
Remember that when Ben Bernanke became Fed chairman and gold was kissing up
to 700 for the first time, The Wall Street Journal came out with its lead
editorial demanding that the Fed start raising its rate 50 basis points per
meeting to head off a new inflation frenzy. I have seen no such editorials
coming this time, as we're getting back up to where we were. I don't know
exactly what that means but it suggests that something big is in the wind.
So, nothing that I am talking about here is negative for the kinds of stocks
that we've liked. Once again today the ag stocks having had a bit of a
correction are on a roll. And with copper back up to 3.62 we're getting all
the mining stocks running. And oil is holding in there nicely, so it's just
a situation where what worked for you for the first half of this decade is
going to work for the second half. But, the difference is that you're not
going to have support from the bond market going forward.
What you're going to want to own in equity portfolios is those companies
that have pricing power. And that means those that are commodity producers.
Those that are part of the solution to the scarcities, and that is the
agri-business stocks. And those that are involved in logistics or in really
maximizing the skills of the workers that are there.
So that means tech companies that can actually show that they really do
improve productivity, that they have something new and that they can be
operated by people who aren't MAs in mathematics. I think these are the
kinds things that are going to hold up well. But when I've talked about all
these the stock indices that have been moving up to new highs there's one
that is really dragging its butt. The bank index is nowhere near its high.
It's still a poor looking chart and even those huge earnings from JP Morgan
aren't enough to turn that one around. The bank index is telling us that
something bad is also going to happen to the bond market. It is also
telling us that this situation of the subprime mortgages is going to get
worse before it gets better.
So we're going to have the rich and the poor in the financial markets. But
they're going to be the exact opposite of where they were in the '80s. In
the '80s, the financial stocks were in a virtually continual roll except
when we had the short term panics and the commodity stocks were disasters.
So, for the overall stock indices of course and particularly for the S&P
500, which has only one mining stock in it - that is general mining company
- this is not the best of all possible worlds.
That's it. Any questions?
Question 1 (Drew Hayworth): Good morning, Don. Excuse the ignorance of this
question but from some of the things I've read recently there seems to be
some agitation between Eastern Canada and Western Canada in regards to tax
rates. And my question is do the provinces determine the tax rates over the
federal government and I guess how does that play out versus the States?
And then the second question is in regards to kind of the whole commodity
play, I would make the assumption that Western Canada obviously should see a
lot more wealth going forward and how do you see that playing out between
Eastern Canada and Western Canada? Thank you.
DC: Okay, the answer is that whereas in the United States, the Feds get most
of the income tax yield some states as you know even have no income tax but
in my home state of Illinois what I pay to them is about ,oh, I would say
about 1/6th of what I pay to the federal government and now Illinois is a
high tax state. In New York state because you must also have New York city
income tax and New York state tax, the ratio may be closer.
But in Canada on the other hand what you have is that the federal government
collects its share but they have sharing arrangements and they have complex
arrangements where the wealthy regions subsidize, in effect, the tax rates
for the poorer regions of the country. But the net effect is that income
tax payers in Alberta pay much less than income tax payers in Quebec. But
it's not as comparable as what somebody in New Hampshire pays compared to
somebody in New York state. So there isn't an easy answer, but they do have
federal/provincial conferences where they look at blending the overall rate
on the theory that there is only one tax payer. So Canada makes a serious
effort not to have gigantic disparities.
You're absolutely right that there are other differences. For example,
Alberta has been able to get rid of its sales taxes and these are really
crucial to the tax base of hard hit areas like Ontario, Quebec and Nova
Scotia. And there are national divides on this because of just how well the
West is doing now compared to the East. In the case of Newfoundland the
best thing they've got going for them is their young people go out and work
in Alberta and come back and still have a house in Newfoundland, which is
sort of almost a Mexico/US type situation without having to crawl over or
under a wall.
And actually Newfoundland because of its offshore oil, although they're not
getting any new developments because of the strong stance being taken by
Danny Williams the Premier, their revenues are such that Newfoundland's
overall GDP is measured in output because of the nickel mines plus oil means
it's not anywhere near the kind of poor province that it was. But there is
a great income inequality, but the difference is that in Canada they really
do try to find ways to offset that. And that's because of the
representations in parliament, which go back to the constitution, way back
in 1867.
So it's a very complex thing. The question that you've asked you said pardon
my ignorance, most Canadians don't understand it but I can tell you that
since 1867 the number of federal/provincial conferences on that one question
have been enough that you can have whole libraries just with the minutes of
those meetings. It's been a great make work project in Canada for 135
years.
Thank you. Any other questions?
Question 2 (Jean-Philip Ry): Hi, Don. I wanted to ask what your views here
are on private equity. And the reason I ask is because part of, I assume,
part of the consequences of what you just described in the bond market will
be also repricing of risk and I was just at a conference this morning
interestingly enough several hundred people at it at least 150 anyway at a
small conference and you know they describe how some even describe this
mispricing of risk which is obviously giving them a fair advantage in terms
of the ability to raise debt. And at the same time we're seeing a flood of
money continuing to pour into this, so how do you see it balancing itself
out?
DC: Thank you. We're seeing a perfect example of that in this country
because it's quite obvious that BCE, the old Bell Canada, is going to be
taken out by somebody. And what's BCE now...I mean this was generally
considered the bonds of the old Bell Canada and of BCE just about the
highest quality private sector bond out there. And this was one that people
who didn't want to take risks would buy.
There's an excellent column in today's Globe and Mail by Harry Koza, a guy
who writes very well. And when he talks about - he says the Bell 6.1's of
2035 were trading 150 bps over long Canadas and now they're trading at 280
bps over. Because, of course, what's going to happen is if one of these
groups and you've got two large tax exempt groups bidding against each other
on this and a possibility that Telus, the other big phone company, could
come in. What happens, is that the buyer manages to get all that low cost
debt, which becomes stranded debt the poor holders of these bonds subsidize
it. But the other subsidy you're talking about is that the mispricing of
risk itself, which is that the spread between high-quality and junk kept
narrowing in, as people stretched for yield in an environment of low
interest rates.
One of the inevitable results of going back to a steeper yield curve, if I'm
right that we're going to have something like the Fed funds at 5 and long
Treasuries at 7 two years from now, if that sort of thing unfolds, what you
can bet is that the private equity people will be seeing their peak
environment some time this year and things will get progressively worse for
them thereafter.
No wonder some of them want to go public with their stock now. Because
right now those who are excellent at getting risk that is mispriced want to
try to offload some of that risk on the truly naive simpletons out there who
think that these kinds of interest rate spreads will last forever. They
will not last three months past the first time that we break out on the
upside through 5 1/4 on the US Treasury 10 Year note indicating that we've
entered into a bear market for long term bonds.
And so, yes, the indecent haste with which those who maintain at all times
that the big advantage they had over publicly traded equity was that they
didn't have to do quarterly reports they had long term views and everything.
When you look at the kinds of companies they're buying now, I admire the
brains of somebody like Henry Kravis, but he's getting into industries that
he never had any experience in before. He's paying up big time for them.
It's just because he can.
In effect his defense as to why it is that he's buying these companies is
roughly the defense that Bill Clinton raised afterwards about Monica. He
said, "It was because I could." And so, we're going to see an unwinding of
this. And we're going to get back to a level where risk is priced in the
system. And that's a sign that the froth that's lasting now will, like all
froth, will eventually blow out to sea.
Thank you. Any other questions?
Question 3 (Ethan Silverman): Good morning. You mentioned that you feel
that the Dollar will break the 19 year low here soon. It seems to have a
pretty good inverse relationship to gold. Is there any conclusion you can
come to looking at the history of a significant relationship to the S&P or
anything else that we should be concerned about as the Dollar weakens here?
DC: Well, you know, to me it's remarkable that we're able to get a Dow
Theory buy signal given that with the US savings rate being negative and
that the Euro-based investor has been losing huge in the US stock market for
the last three years, whereas the US investors feel they're doing fine. And
if we finally get a signal that it is a bear market for the Dollar, I can
tell you that there's a very good correlation between strong currencies and
strong stock markets.
One of the reasons why the US stock market was the wonder of the world
during the '80s, next only to Japan, was because the Dollar under
Reaganomics was a strong currency. And then in the '90s because of the tech
boom and the Dollar was once again strong, the whole S&P got bid up to a
much higher P/E ratio than other regions of the world.
So, I think that the migration of capital out of US stocks into stocks
elsewhere in the world will gain strength, once we break that level and
people realize that the Dollar is in a major bear market. There's been a
sense that there is a safety blanket underneath. Now I've referred to it as
The Great Symbiosis, China and Japan who propped it up. But the fact that
China added 73 billion dollars to their foreign exchange reserves at the end
of the first quarter and the Dollar fell meant that they weren't buying
Treasuries.
This week we saw that foreign Central Banks sold 7 billion of Treasuries and
bought 7 billion of agencies which probably was, they were doing a real
favor for Hank Paulson by buying Fannie and Freddie paper indicating support
for the housing market. But not all your bankers are such good friends as
that. So the correlations here are such, that if the dollar breaks, the P/E
ratio on the S&P relative to other major markets fall. No question.
Thank you. Any other questions?
Operator: There are no further questions registered, Mr. Coxe.
DC: Okay. Thank you all for tuning in. We'll talk to you next week.
