The Return of the Carry Trade?! (Saut)

The Return of the Carry Trade?!

by Jeffrey Saut, Chief Investment Strategist, Raymond James

April 11, 2011

“The mid-March G7 currency intervention on the Yen has given carte-blanche to Japanese investors to once again deploy capital abroad and seek yields wherever they may be found. And on cue, all the higher-yielding bonds and currencies (Indonesia, Hungary, Turkey, Australia, New Zealand ...) have soared. This influx of liquidity (and the balance sheet of the Bank of Japan has just grown by approximately US$275bn) has also helped push risk assets higher across the spectrum. The question of course is how sustainable this increased appetite for risk will prove to be in the face of rising oil and commodity prices, and of diverging monetary policies. Putting it all together, it seems obvious to us that we are approaching some kind of a tipping point. The concomitant rise in commodity prices and risk assets does not seem to be compatible. Neither does the rise in commodity prices, equity prices, and inflation expectations (whether from TIPS, consumer surveys, ISM surveys ...) and overly easy central banks. Finally, the recent surge in certain currencies (AUD, CHF ...) to two standard deviations above their purchasing parities should also have economic consequences. So the current situation does not seem stable from a bottom-up perspective. And from a top down perspective, it seems obvious that the recent period of exceptionally easy fiscal and monetary policies is an outlier and should come to an end. This is already occurring in Europe and in China. The next step is for the US to follow suit.”

... GaveKal

We have long admired the prescient folks at the GaveKal organization for their ability rotate the “investment prism” 180°, giving them the ability to view things from a different perspective. Said “different perspective” often reveals net-worth changing ideas unforeseen by many conventionally focused strategists on Wall Street. GaveKal’s views can be gleaned tomorrow (4/12/11) at 4:00 p.m. in a conference call with portfolio manager Steve Vannelli by dialing (877) 216-1555 (Code: 722117). That said, in our opinion the G-7 intervention was meant to prevent a stronger yen from hurting Japan's exports, braking capital flows into Japan, not necessarily encouraging outflows. There may be an increase in the carry trade in both dollars and yen, but I don’t think this is the main factor behind the rise in commodity prices and increased demand for risk assets. In the short-term, central bank policies matter a lot for currencies. However, the U.S. is not going to raise rates anytime soon, implying a somewhat softer dollar. You’re hearing inflation concerns among some of the district bank presidents, but that is very much a minority view. The Fed sees higher oil prices as a negative for growth, not a catalyst for a higher trend in underlying inflation; but officials will be watching inflation expectations, the trend in core inflation, and wages. The Fed, in fact, wants higher inflation (2%, not sub-1%). To be sure, the Fed will not tighten because everybody else is.

Nevertheless, we think interest rates have seen their cycle “lows.” While that does not mean they will rise in the short-term, over the longer-term it is tough to envision why they won’t. Indeed, recently there have been large “capital calls” in regions that have typically been our natural lenders. As stated, Europe needs more of its capital at home to bail out the PIIGs. The Middle East needs its capital to pay off dissidents. Japan clearly has a capital call and the Federal Reserve is preparing to exit QE2. Accordingly, it is difficult to see how our cost of capital (interest rates) can’t keep from rising. However, that does not mean it has to happen in the next quarter or two. It also doesn’t mean that GaveKal’s observation regarding “the return of the carry trade” can’t play in the short to intermediate-term as well.

Yet, that wasn’t the case last week as stocks stalled their way through the week, leaving the D-J Industrial Average (DJIA/12380.05) better by a mere 0.03%. The week, however, was not without its milestone, for the DJIA notched a new reaction high, thus confirming the D-J Transportation Average’s (DJTA/5228.30) new reaction high of a few weeks ago. Accordingly, another Dow Theory “buy signal” was recorded. It was the third such signal of the past 10 months, suggesting the path of least resistance remains “up.” Still, the stock market “feels” as if it needs to consolidate its gains, and rebuild its internal energy, before moving higher. That implies more of the churning action we experienced last week. In fact, as is often the case, the indices tend to expend so much energy in achieving a Dow Theory “buy signal” they need to rest a bit before reenergizing. On a very short-term basis, the downside should be contained in the 1320 – 1325 zone [basis the S&P 500 (SPX/1328.17)]. Failing that support brings 1305 into play, which would be a 38.2% retracement of the recent rally. Whatever the near-term outcome, we believe it would take some major “news shock” to break the SPX below the massive support now visible at 1275 – 1300.

Of course such a “shock” could come from the Middle East, causing crude oil to vault even higher. To us, this is the biggest risk to the economy. If oil prices were to stabilize, even at these elevated levels, we think the economy will be just fine. However, Brent crude oil traveled above $126 per barrel last week, with a concurrent rise in WTI to $112.79 per barrel; that brought retail gasoline prices to $3.75 per gallon. Due to such energy machinations many economists reduced their GDP estimates last week; while lower growth may be in the cards, even slower growth should still allow earnings to exceed current expectations. Indeed, last week saw a solid retail sales report, initial employment claims fell, German factory orders were strong, and the ECB and PBOC raised interest rates. Moreover, last Friday’s BLS report confirmed that employment is starting to recover at a faster pace. All of this data doesn’t sound all that weak to us.

Speaking to energy, we have been writing about the La Nina weather pattern, combined with more volcanic ash in the atmosphere than anyone can remember, since last August. Our conclusion was that the 2010 - 2011 winter was going to be wet and colder than most expected. Our investment strategy was to WAY overweight the energy complex. Recently, however, we have recommended selling partial positions (not all) to rebalance those overweight positions back to their intended allocations. Our worry is that some of the climate factors causing the wicked winter will be fading this summer. While we expect a stormy spring, and droughts in the South, things should be better by mid-summer. That does not mean we won’t have a worse than normal hurricane season . Still, readers are advised to rebalance our overweighting energy recommendation as the summer season approaches.

Of course, that includes our recommendations on the Canadian Oil Sands, despite our enduring belief that over the longer-term the Oil Sands are likely the best energy investment around. Last week, however, the Alberta government announced a draft for the Lower Athabasca Regional Plan. In this new framework, the government outlines new conservation and recreation areas, which in some cases cut into previously existing oil sands leases. As our Canadian Oil Sands analyst (Justin Bouchard) writes:

“Impact to current oil sands leases is minimal – for the most part, there are very few leases which are impacted by the new regional plan, and in almost all of the cases where existing leases are impacted, it is minimal.”

“No impact to existing producing projects – existing projects are untouched as are areas with any near or medium term development plans.”

For further information, please see our Canadian analysts’ comments.

The call for this week: Over the weekend things have indeed heated up in the Middle East with Gaza-based Hamas launching anti-tank missiles and hitting an Israeli school bus, a responding Israeli air strike, Egyptian talk of war if Israel attacks Palestinians in the Gaza, Egypt ready to resume diplomatic relations with Iran, more demonstrations in Egypt’s Tahrir Square, and talk that Israel might combine with Libya. Yet, crude oil is actually down, increasing our sense that rude crude is at/near an upside inflection point. If true, after another few consolidation sessions, it would surprise the most if the SPX rallied above its reaction high of 1344 for another leg up. We are positioning accounts accordingly. And don’t look now, but our fundamental energy analysts had some VERY positive comments on 5.4%-yielding EV Energy Partners (EVEP/$56.24/Outperform).

P.S. I’m in New York City all week; subsequently this will be the only investment strategy commentary for the week.

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