Fear of rising inflation gathered steam this week with worrisome developments on a number of fronts.
CIBC’s fascinating analysis of how soaring oil prices are eroding East Asia’s competitive advantage in manufacturing by boosting shipping costs was a popular topic. In China’s case the problem is exacerbated by exchange rate and labor issues, as well as increased demand for diesel fuel as a result of the recent earthquake. The Chinese government has historically intervened to ensure China’s exports remain competitive, but given the many challenges it faces, its options are limited. Even if the CFTC’s investigation finds that speculators have contributed to the current spike in oil prices as an IMF working paperargues, it will not change the longer term fundamentals that suggest continued relatively high prices. Still, not everyone agrees with Goldman’s $200 oil superspike analysis, as one of our most popular posts showed.
Meanwhile prices of agricultural commodities, are also expected to stay at high levels in the next 10 years, even after current short term factors pass and bring prices down from the highs. An interesting and worrisome parallel between oil and agricultural commodities is that in both cases, supply is not responding to higher demand in the same way as in the past.
There’s a growing a realization that tighter monetary policy is needed to keep inflation under control, as argued in another IMF working paper, but the prospect of higher interest rates is most unappetizing at a time of economic weakness and financial market instability.
The Wall Street Journal’s claim that several big banks may be contributing to the erratic behavior of Libor caused a stir. JPMorgan challenged the WSJ’s methodology via Alea, which also offered its own critique. while Felix Salmon at Portfolio.com, offers a broader defense of Libor. “What the WSJ has done is come up with a marginally interesting intellectual conundrum: why is there a disconnect between CDS premia, on the one hand, and Libor spreads, on the other? But the way that the WSJ is reporting its findings they seem to think they’re uncovering a major scandal. They’re not.”
FT Alphaville provides Morgan Stanley’s take, which finds the “critique in the WSJ is interesting, but it falls down by trying to combine generic term lending rates with the cost of idiosyncratic default protection. By doing so, it paradoxically reinforces the value of the LIBOR fixing process in producing a generic reference rate, even during stressed periods when bank risk is more heterogeneous than usual.”
Finally, the subprime crisis is not forgotten: our most popular post by far was the S&P report that securities backed by subprime and other “non-prime” loans from the 2007 vintage are shaping up to be the worst ever in terms of defaults.
Research Recap Quote of the Week
For us, the whole circus concerning analysts mentioning ever higher round numbers has seemed a very hollow one indeed. It serves little purpose to start making me-too statements just to serve as a piece of analyst bling.
Barclays Capital commodities analysts Paul Horsnell and Kevin Norrish commenting on Goldman’s $200 oil price forecast.
The world’s carbon market is one of the fastest growing major markets in the world. New research from Point Carbon, a provider of research for environmental and energy markets, predicts that if the US joins a cap-and-trade system, the market will continue to grow to a massive $2 trillion by the end of the next decade.
The study predicts the US market would have a value of roughly $1.25 trillion by 2020. The EU cap-and-trade scheme, meanwhile, would make up about 23% of the world market by that time.
The study predicts an average value of 50 euros per unit.
The study assumes a model along the lines of the original Lieberman-Warner bill, which would lead to a 25% reduction in admissions from current levels by 2020.
The report’s author makes a good closing point: “Having a concept of the future size of the carbon market is important for at least two reasons. First, market volume says something about the number, size and kind of participants that a market can accommodate. Importantly, a large market involves not only compliance buyers and sellers but also financial players, who will provide liquidity to the market. Secondly, an indication of 2020 market size will say something about the place we think emissions trading will have in a future climate structure – not immediately after the end of the first Kyoto commitment period, but well into the post-2012 regime. This is important for long-term investors in sectors exposed to a carbon price”
Europe’s goal of meeting 20 percent of its energy needs from renewable sources by 2020 is threatened by supply chain bottlenecks and the resulting increases in capital costs for offshore wind power, according to a new report by Cambridge Energy Research Associates. The report, Offshore Wind: It’s Not a Breeze outlines the major factors affecting offshore wind investment in the next decade.
“Big things are expected of offshore wind but this fledgling sector could be at risk given ongoing increases in capital costs, especially if government subsidies do not keep pace,” said Matt Brown, CERA senior director and head of the European power service .
Further increases of 20 percent in offshore wind capital costs over the next few years should be expected. That means capital costs will increase from €2300 per kilowatt to €2800 per kilowatt.
Europe will need to rely heavily on offshore wind to meet its 20 percent target by 2020. Within the next two years the offshore wind industry could be installing two gigawatts of offshore turbines per year around the continent, although the amount of electricity produced will be dependent on the success of wind technology in coping with the harsher offshore environment.
The rapid push to increase capacity will put the industry’s nascent supply chain under pressure and lead to higher capital costs. Offshore wind capital costs will increase not only due to increases in raw materials and engineering costs, as for other energy industries, but also due to specific additional pinch points in the supply chain. One of the major factors in the rise of costs is the lack of a sufficient number of purpose-built installation vessels to install the turbines, resulting in less efficient and more costly options being used.
“With this pinch point companies should consider investment in installation vessels, as this part of the supply chain is where the higher value will be found,” Brown said.
Currently only one of the existing purpose-built vessels, a few barges with the necessary modifications and large barges used in the oil and gas industry can install a five megawatt wind turbine. Conversion of existing vessels requires up to twelve months, which could further prolong governments’ energy targets and increase the costs of installation.
Offshore wind developers need to adjust their investment strategy in this sector as a result of the cost increases. “For companies investing in the sector, assuming that subsidies adjust, the markers of success will be securing the most efficient vessels through chartering, obtaining preferential agreements with wind turbine manufacturers based on long term contracts to manage turbine cost increases and ultimately switching to the new five megawatt-class turbines to benefit from economies of scale,” Giacomo Boati, CERA associate, European power added. “This means they need to be committed to the sector long-term and may have to pace their investment to manage cycles in the sector and pinch-points in the supply chain.”
Sometimes it seems like biofuels are more trouble than they are worth. In addition to being criticized for contributing to higher food prices and being environmentally questionable, a trade war between the US and the European Union is bubbling up.
In a new report Oxford Analytica looks at the decision of European biodiesel producers to file an official complaint to the European Commission (EC) about subsidies to the US biodiesel industry, which they regard as unfair.
The European Biodiesel Board (EBB), the main EU industry association, has multiple key complaints:
- US Federal regulations introduced in 2004 enable US biofuel firms to benefit from subsidies to such an extent that they can be exported to and sold in EU markets at prices well below those commercially viable for EU domestic producers. This is the so-called B99.9 — or ’splash and dash’ — regime under which US producers can add just a drop of mineral diesel fuel to biodiesel to become eligible for tax credits worth up to 300 dollars per tonne.
- This biofuel does not need to be produced in the United States to qualify for subsidy. It can be sourced from a cheap developing world producer, such as Indonesia and Malaysia, imported to the United States where a splash of mineral diesel — perhaps just 0.1% of total volume — is added, and then exported as a US product to the EU.
- These US exports may then be treated as pure biofuel on reaching Europe, making them eligible for further subsidies under EU regulations, further under-cutting local producers.
The EBB contends that this has resulted in “a dramatic surge in US biodiesel exports to the EU, thus creating a severe injury to the EU biodiesel industry”. As biodiesel is the most common biofuel in Europe, this has been linked to the shutdown or suspension of operations of biofuel plants in several European countries over recent months.
The US National Biodiesel Board (NBB), says the troubles the European biodiesel industry face are not related to US exports.
OxAn’s take: “Imports of subsidised US biodiesel into EU markets has clearly had a negative effect on EU producers, many of which cannot compete on price. The EU believes it has a strong case, and the United States will agree to ease ’splash and dash’ subsidies.”
While bitter, this dispute may come to be regarded as a teething problem in the development of the global biofuels market, as second generation biofuels using a greater variety of feedstocks take centre stage in coming years.
Fitch Ratings analyzes the corporate bonds of 17 companies at risk of being downgraded to junk status in a new report, ‘BBB’ and ‘BBB−’ Issuers on Rating Watch Negative or Rating Outlook Negative.
Although Fitch Ratings does not necessarily believe that the companies included in this report will be downgraded to speculative grade, investors should at least be aware of the possibility and maintain close surveillance of these credits.
The report focuses on corporate credits with an issuer default rating (IDR) of ‘BBB’ or
‘BBB−’ and which have a status of either Rating Watch Negative or Rating Outlook
Negative. Of particular focus are the rating rationales and events that could potentially
result in a downgrade.
Although companies such as Brinker International, Inc. (NYSE:EAT), D. R. Horton, Inc.,(NYSE: DHI), International Paper Company, (NYSE: IP), Ryland Group, Inc., (NYSE: RYL) and Tyson Foods, Inc. (NYSE:TSN) with IDRs of ‘BBB−’ are at the most immediate risk of a downgrade to speculative grade, companies with IDRs of ‘BBB’ could also be at risk depending on the severity or rapidity of credit deterioration. The twelve ‘BBB’ rated firms featured in the report include a number of housing and power companies. The full report is available here.
Evidence that the golden age of Chinese manufacturing may be coming to an end continues to mount.
Soaring oil prices raise both the cost of production and transportation to Western markets, eroding China’ cost advantage. This is exacerbated by extra demand for deisel fuel as a result of the recent earthquake.
On top of this, add exchange rate problems and a shortage of skilled labor exacerbating inflation pressures.
Deloitte Economist Sunil Rongala notes that the primary purpose for having a fixed rate policy was to promote exports by making the Chinese renminbi (RMB) more competitive. This fixed rate has made China hyper-competitive; a result is that trade surpluses and foreign exchange reserves have swelled.
Though the fixed rate policy was loosened in 2005, the still interventionist exchange rate policy is not sustainable because it is partly responsible for higher levels of inflation in China.
Inflation in China has been on an upward trend and it was 8.5 percent in April 2008: a near 12 year high (the highest was 8.7 percent in February 2008). The cheap exchange rate is partly responsible because it has led to massive capital inflows because of high trade surpluses, and because speculators have brought in a lot of money into China to make a capital gain from an expected exchange rate revaluation. Banks expect the renminbi to appreciate by 8.5 percent in a year’s time and it is very likely to continue appreciating post that, Rongala writes.
Meanwhile, manufacturing costs in China are going up. The producer price index was up 8.1 percent YoY in April 2008 – the highest it’s been since December 2005. This is understandable given rising commodity prices but manufacturing firms in China typically operate on razor-thin margins and rising costs have forced many manufacturing units to shut shop.
Another problem is that labor prices are increasing rapidly because there is a talent shortage in China. Between 1997 and 2006, the average annual wage of the U.S went up by 40.1 percent while China’s went up by a staggering 224.5 percent.
In fact, the annual average wage in China went up by 362.8 percent between 1994 and 2006.
Labor laws in China have always been lopsided with employers having a stronger hand. On January 1, 2008, a new labor law, the ‘Labor Contract Law’, went into effect and this law gives labor unions a stronger hand is widely expected to increase labor costs.
The Wall Street Journal has an interesting analysis suggesting that Citigroup Inc., WestLB, HBOS PLC, J.P. Morgan Chase & Co. and UBS AG are among a number of banks that have been reporting significantly lower borrowing costs for the London interbank offered rate, or Libor, than what another market measure suggests they should be. Those five banks are members of a 16-bank panel that reports rates used to calculate Libor in dollars. The gap was the widest for Citigroup .
The London interbank offered rate, a figure drawn from dollar-lending rates among the biggest global banks, is used to set interest rates for a broad spectrum of borrowers, and it has provoked concern beyond banking circles lately thanks to some erratic movements. The WSJ compared the borrowing costs reported by the 16 banks on the Libor-setting panel with a separate market that tracks the risk of lending and borrowing by these banks — the market for credit-default swaps, a form of default insurance.
What the paper found is that Citigroup, UBS, J.P. Morgan Chase and some other Libor-panel members have been reporting borrowing costs that are lower than what the credit-default numbers suggest they should be.
That has led Libor “to act as if the banking system was doing better than it was at critical junctures in the financial crisis,” the Journal says, which could cast doubt on the reliability of a number used to calculate home mortgages, corporate loans and a host of other borrowing around the world.
Some bankers have grown suspicious that rivals were low-balling their borrowing costs so they wouldn’t look desperate, and Libor’s overseer, the British Bankers’ Association, is expected to report on possible adjustments to the system tomorrow. But people familiar with the group’s deliberations tell the Journal no major changes are expected. The Libor and credit-default swaps rates have been diverging since late January, when the credit crunch was worsening and central bankers at the Federal Reserve and elsewhere started pulling out all the stops to calm the tumult.
The BBA says Libor is reliable and that many financial indicators have acted funny during the crisis, while the Journal cites a number of reasons offered by analysts to explain the risk-rate disparity it finds: Lending between banks came to a halt for months amid the uncertainty, which added some guesswork to the borrowing-cost estimates; or Citigroup and others’ ability to tap their customers’ cash deposits and extra funds from the Fed could have reduced their borrowing needs.
Still, the Journal says, five banks in particular had wider gaps than the 11 others: Citigroup, WestLB of Germany, HBOS of Britain, J.P. Morgan Chase and Swiss lending giant UBS. And “one possible explanation for the gap is that banks understated their borrowing rates,” the paper says. “If dollar Libor is understated as much as the Journal’s analysis suggests, it would represent a roughly $45 billion break on interest payments for homeowners, companies and investors over the first four months of this year. That’s good for them, but a loss for others in the market, such as mutual funds that invest in mortgages and certain hedge funds that use derivative contracts tied to Libor.”
While several of the factors behind the recent runup in the prices of most agricultural commodities may be transitory, more permanent trends indicate prices are likely to remain high.
Agricultural commodity prices should ease from their recent record peaks but over the next 10 years they are expected to average well above the mean of the past decade, according to the latest Agricultural Outlook from OECD and the UN Food and Agriculture Organization.
In comparing averages of the coming decade with those of the past, real prices, i.e. nominal prices corrected for inflation, are projected to increase in a range from less than 10 percent for rice and sugar, under 20 percent for wheat, around 30 percent for butter, coarse grains and oilseeds to over 50 percent for vegetable oils, according to the report.
Prices may also become more volatile because stock levels are expected to remain low and as some of the demand for agricultural commodities becomes less responsive to price changes.
The recent increase in investment funds on commodity futures markets might also become an additional factor in price variability. Climate change, too, may affect crop production and supply in unforeseen ways.
The report says that drought in some of the world’s main grain-producing regions in the context of low stocks was a large – but transitory – factor in the sharp price rises of the past two years. More permanent factors such as high oil prices, changing diets, urbanisation, economic growth and expanding populations, are also at play and are behind the expectation of higher average prices in the coming ten years than over the past decade.
Growing demand for biofuel is another factor contributing to higher prices. World fuel ethanol production tripled between 2000 and 2007 and is expected to double again between now and 2017 to reach 127 billion litres a year. Biodiesel production is seen to expand from 11 billion litres a year in 2007 to around 24 billion litres by 2017. The growth in biofuel production adds to demand for grains, oilseeds and sugar, so contributing to higher crop prices.
In OECD countries, at least, this growth of biofuel production has thus far been driven largely by policy measures and the report says that it is not clear that the energy security, environmental and economic objectives of biofuel policies will be achieved with current production technologies. The report suggests further review of existing biofuel policies.
Grain markets are expected to remain tight as stocks are unlikely to return to the high levels of the past decade.
Consumption of vegetable oils, both from oil seed crops and from palm, will grow faster than for other crops over the next 10 years. The rise is being driven both by demand for food and for biofuels.
A summary of the OECD-FAO Agricultural Outlook 2008-2017 is available free of charge.
Performance of securities backed by subprime auto loans deteriorated at an accelerating pace in March. According to Moody’s Subprime Auto Loan Credit Indexes, Moody’s All Pools, Low-Loss, and High-Loss Market Indexes all rose from the previous month, implying increasing average projected lifetime losses on outstanding pools. In a continuation of a trend beginning in the middle of 2007, the Market Indexes rose also on a year-over-year basis and at an increasingly brisk pace.
Moody’s Static Indexes, which adjust for the changing composition of the Market Indexes as newer deals
are added and older deals pay down, worsened but to a lesser extent than did the Market Indexes, indicating that an increasing share of the Indexes’ deterioration is due to the performance of newly added pools.
The All Pools Market Index was 162.8 in March 2008, corresponding to cumulative projected lifetime losses of 8.04% based on the benchmark loss curve underlying the Indexes. An Index of 162.8 implies lifetime losses 62.8% higher than the benchmark level. The All Pools Index rose 1.2% from February, when it measured 160.9 (7.95% lifetime loss).
In a separate report, Moody’s said it does not expect lower used car prices caused in part by rising repossessions to cause any downgrades of Asset-backed Securities. Based on Manheim Consulting data, Moody’s shows repossessions increasing about 10% in both 2007 and 2008.
According to the Manheim Used Vehicle Value Index, used vehicle prices have been falling after reaching a peak in September 2007.
A sustained six-month decline, as the recent trend from October 2007 through March 2008 represents, has not been seen since a seven-month decline in the 2nd and 3rd quarters of 2002.
The uptick in April 2008 may signal the end of the decline or may be an aberration similar to those that occurred in August 2001 and December 2002 during prior periods of decline, Moody’s says.
Public ratings of firms has been carried out for well over a century now, but how firms respond to many such rankings is a relatively under-researched question. In a new Harvard Business School working paper, “Shamed and Able: How Firms Respond to Being Rated.”* Aaron K. Chatterji and Michael W. Toffel find support for their hypothesis that “ratings are particularly likely to spur responses from firms whose legitimacy is threatened—and thus are shamed—by these ratings.”
The authors examined environmental ratings from KLD Research & Analytics, Inc. (KLD), the largest multidimensional CSP [corporate social performance] database available to the public.’
Because the authors were concerned with how the firms responded to their initial poor ranking — as opposed to a change in ranking — they looked at “firms that were first rated due to KLD’s expansion to firms that were never rated by KLD during
our sample period. ”
Looking at the years 1999-2004, they examine 653 companies and find mixed results. While many companies do indeed change their environmental policies in response to poor rankings, “in contrast to [the author's] predictions, it is quite plausible that in some circumstances, poor ratings will not stimulate improvement but rather will lead to organizational decline.”
We find that those firms that are “shamed” by a poor KLD rating and most “able” to seize low hanging fruit show the most improvements in environmental performance.
The researchers believe the evidence supports their theories, and “hope” that their “work is part of a nascent literature that helps identify the conditions under which company ratings are most likely to achieve their goals.”
The authors say their research highlights an opportunity for policy makers to partner with other stakeholder groups, where the government uses its coercive power to gather data while these groups focus on communicating the data to the public.
“There are several examples of non-governmental entities already doing this without much involvement from the government. For example, while the US EPA requires tens of thousands of facilities to disclose their toxic emissions of over 600 chemicals every year, the agency’s TRI data languishes on two fairly obscure EPA websites.
To make this data more visible and useful, Environmental Defense and The Right-to-Know Network each created user-friendly web portals (www.scorecard.org) and www.rtknet.org), a team of academics created a Google Map mashup of this data (www.mapecos.org , and the Investor Responsibility Research Center aggregated this factory-level data to their parent companies to create the CEPD.”
In this spirit, Wikinomics author Anthony Williams foresees a future where non-governmental organizations and other sectors create user-friendly web portals to aggregate data from government and other sources to create and distribute information of public value.
For an example of what a leader in this area is doing, check out Intel’s (NASDAQ: INTC), 2007 Corporate Responsibiltiy Report. The 100-page report provides detailed information and ratings on metrics related to Business/Workplace, Environment, Education and Community. While Intel met or partially met its objectives in the vast majority of areas, the company still faces challenges in certain areas, including reducing water use and auditing suppliers for compliance with the Electronic Industry Code of Conduct.
*Shamed and Able: How Firms Respond to Being Rated. By AARON K. CHATTERJI; Duke University and MICHAEL W. TOFFEL; Harvard Business School.