Sunday, July 22, 2012

Emerging Markets and Grain Prices

Nominal grain prices are making new USD highs lately as the drought and heat wave reduce yield estimates. High food prices are believed by some to have been a contributor to the 2011 "Arab Spring" uprisings.
Source: "From QE2 to Arab Spring - a Lesson for the ECB."
Sober Look, Nov 20, 2011
Although the prices we are seeing are not new highs in inflation-adjusted USD, prior price peaks happened in the context of strong EM currencies (weak USD) and robust or improving global growth.

With global growth looking like it is decelerating and EM currencies weak, current prices are signaling new peaks in terms of EM currencies, leading to renewed risk of social unrest as well as putting pressure on government subsidies and poor urban residents who spend a larger portion of their wages on foodstuffs.

Corn, Wheat, Rice, Soy Bean equal;-weighted composite
adjusted for change in EM Currency Index value
While the effect of high food prices will be at least partially offset by resilient oil prices for oil exporting nations, who are ore likely to be food importers, small island nations and Sub-Saharan Africa are particularly at risk.

Wednesday, July 11, 2012

Corporate Profit Margins: Nothing to see here?

One of the arguments against equities that has been tirelessly repeated by managers like Hussman and Grantham has been that profit margins were too high and were due for mean reversion. Profit margins are indeed high, at approximately +2.8 standard deviations, or 10.6%, as a result of low interest rates (low cost of capital), depressed labor costs stemming from high unemployment and a near record low effective corporate tax rate (~18.6%).

Standardized Corporate Profits After Tax divided by GDP

The main argument for profit margin mean-reversion is that high margins invite new competition while low margins discourage new entrants. Profit margins are also important to investors because steep reductions in profit margins tend to be coincident with steep drops in corporate profits.

Standardized Corporate Profits After Tax divided by GDP and Corporate Taxes as a % of Prior Peak
While the prior charts may be alarming to equity investors seeing record-high (+2.8 stdev on latest quarter, or approx 10.6%) profit margins, we should ask ourselves, what will cause this mean reversion? The economy seems to be creating about 2 million jobs a year right now, not exactly enough to put heavy pressure on labor markets. Fixed Investment continues to be pathetic (more here). The 10y yield has dropped 50 basis points since the beginning of the year and 1.5% from last year's median. What is left? Are underlying gross margins really that high? If so, why aren't new entrants taking advantage of cheap labor, low rates, and plentiful capital to undercut the competition and get a piece of those juicy, juicy margins?

Could it actually be the that maybe underlying margins on goods and services are not THAT high? Below you'll see a now similar chart which includes pre-tax corporate profits. As you can see, while pre-tax margins are elevated, they are much less alarming at +1.33 standard deviations and the rest is the effect of a near record low tax rate of 18.6%.

(Note: above charts are quarterly and the one below is yearly since tax receipts are only available on a yearly basis.)

Standardized Corporate Profits as % of GDP Before and After Tax

In conclusion, it appears that the only danger to corporate profits in the short term is a large, sudden increase in the effective tax rate or a sudden drop in final demand leading to a drop in sales and profits.

With interest rates still falling and a multi-year liability repricing cycle, there is little immediate danger from a bottom in rates. Additionally, a fixed investment and/or employment boom which drove the cost of labor upwards would mean increases in final demand and GDP, leading to shrinking margins coupled with growing top-lines, not exactly a disaster.

Unless you see a recession in our very near future, it seems there's simply nothing to see here.

Sunday, July 8, 2012

CEF premium snapshot for week beginning July 9, 2012

One for the treble, two for the bass. Welcome to the great incredible paper chase, keep your boots laced if you want to keep pace
Premiums across the board increased. Covered calls remain the least ugly duckling, Bond funds getting kraykray. CEF investors holding funds trading at a premium to NAV would probably be well served by considering switching to ETFs or open-ended MFs.

National Municipal
NY Municipal
CA Municipal

HY Corp

Senior Loan
Covered Call

Monday, July 2, 2012

CEF premium snapshot for week beginning July 2, 2012

Came back from two weeks away to find The Great Incredible Paper Chase as alive as ever, with HY premiums 1.18 stdevs above mean and weighted-average premiums at 17% for the sector. National, CA and NY muni funds all back near 1stdev richness and senior loans flirting with 9m highs as the premium range compresses to the upside. The loan stand-out are covered call funds, which are .83 stdevs cheap to mean with the bulk of the funds (> 50%) trading with discounts higher than 10% and over 60% of fund discounts 0.5 stdevs higher (cheaper) than their historical mean. There appears to be relative value in this sector for the total-return focused investor that doesn't mind missing out on some upside if a long, rapid and sustained rally in equity occurs.

National Municipal
NY Municipal
CA Municipal
High Yield Corp
Senior Loan
Covered Call