In addition to having a direct impact on inflation, current high oil prices have profound implications for world trade patterns, according to CIBC World Markets. The cost of shipping a standard 40-foot container from East Asia to the North American east coast has already tripled since 2000 and will double again as oil prices head towards $200 per barrel.
Exploding transport costs may soon remove the single most important brake on inflation over the last decade – wage arbitrage with China.
It currently costs $8,000 to ship a standard 40-foot container from Shanghai to the North American east coast, including in-land transportation, the report said. That’s up from just $3,000 in 2000 when oil was $20 per barrel. At $200 per barrel of oil, the cost to ship the same container is likely to reach $15,000, CIBC’s Jeff Rubin and Benjamin Tal write in Will Soaring Transport Costs Reverse Globalization.
“Unless that container is chock full of diamonds, its shipping costs have suddenly inflated the cost of whatever is inside,” the report says, as quoted by the Financial Post.
As oil prices keep rising, pretty soon those transport costs start cancelling out the East Asian wage advantage. Already the impact of rising oil and transport costs are having an impact on manufacturing that is expensive to transport.
Soaring transport costs, first on importing coal and iron to China and then exporting finished steel overseas, have more than eroded the wage advantage and suddenly rendered Chinese-made steel uncompetitive in the U.S. Market.
“Instead of finding cheap labour half way around the world, the key will be to find the cheapest labour force within reasonable shipping distance of your market,” they write, according to the Globe and Mail.
Look for Mexico’s maquiladora plants to get another chance at bat when it comes to supplying the North American market.
Shipping costs to and from Asia have risen so much that they have eclipsed tariffs as a barrier to global trade, Rubin and Tal say, calling the cost of moving goods “the largest barrier to global trade today.”
“In fact,” they say, “in tariff-equivalent terms, the explosion in global transport costs has effectively offset all the trade liberalization efforts of the last three decades.”
When oil was $20 a barrel, transport costs were equivalent to a 3-per-cent tariff rate; now it’s above 9 per cent.
Aggravating the problem is the fact that modern new container ships travel faster than old bulk carriers and so use up more fuel, doubling fuel consumption per unit of freight over the past 15 years.
“This is an environment in which shipping from the Pacific Rim may not make sense any more,” Tal told the Globe and Mail.
George Friedman of Stratfor agrees that East Asia has been most affected by sustained high oil prices. Japan, which imports all of its oil and remains heavily industrialized (along with South Korea), is obviously affected. But the most immediately affected is China, where shortages of diesel fuel have been reported.
China’s miracle — rapid industrialization — has now met its Achilles’ heel: high energy prices.
China is facing higher energy prices at a time when the U.S. economy is weak and the ability to raise prices is limited, Freidman writes in a new analysis : The Geopolitics of $130 Oil. “As oil prices increase costs, the Chinese continue to export and, with some exceptions, are holding prices. The reason is simple. The Chinese are aware that slowing exports could cause some businesses to fail. That would lead to unemployment, which in turn will lead to instability.”
The Chinese have their hands full between natural disasters, Tibet, terrorism and the Olympics. They do not need a wave of business failures.
Despite the recent improvement in market conditions, Standard & Poor’s continues to expect deterioration in junk bond credit quality. Investors have, at least temporarily, regained interest in high-yield bonds, as fear and market volatility subsided after peaking in late March, S&P says in its latest Credit Trends report for the sector.
“There was $16 billion of issuance by mid-May. Leveraged-loan backlogs from 2007 have been cut almost in half, taking pressure off both the loan and bond markets. We expect that broker/dealers will continue to use the window opened by the recent rally to move paper slowly into the market.”
Despite this positive news, lending conditions are still very tight, and capital is not easily obtainable for weaker credits, S&P says. A net 55.4% of domestic banks report tighter standards for large and medium commercial and industrial loans, which is up from 32% in the first quarter and 19.2% in the fourth quarter of 2007.
Downgrade risks are elevated, and the pace of downgrades has accelerated in 2008.
Default pressures mount as more firms are exercising payment-in-kind features, i.e., paying bondholders with additional securities instead of coupons. In addition, some companies are negotiating and looking for covenant extensions with lenders or attempting to set up distressed debt exchanges. All three foretell more defaults to come, S&P says.
The trailing-12 month speculative-grade default rate increased to 1.64%, with nine (including two confidentially rated issuers) U.S.-based companies defaulting in April.
We expect the trailing-12 month speculative-grade default rate to climb to 4.7% four quarters out.
More details are available in Credit Trends: U.S. High-Yield Prospects: Market Conditions Improve, But Default Risk Continues To Rise.
The S&P/Case-Shiller U.S. National Home Price Index fell 14.1% in the first quarter versus the first quarter of 2007, the largest in the Index’s 20-year history. As a comparison, during the 1990-91 housing recession the annual rate bottomed at -2.8%.
Other key points:
- The 10-City and 20-City Composites also set new records, with annual declines of -15.3% and -14.4%, respectively.
- 19 of the 20 metro areas reported annual declines with six of those now at negative rates exceeding -20%.
- 15 of the metro areas reported record lows, and eleven are in double digit decline, with Chicago being the latest market to join these ranks.
- 18 of the metro areas report at least seven consecutive months of negative returns.
- There was monthly price appreciation in Charlotte (up 0.2%) and Dallas (up 1.1%).
- Las Vegas remains the weakest market, reporting an annual decline of -25.9%, followed by Miami (-24.6%) and Phoenix (-23.0%).
- Charlotte was the only market with appreciation over the past year, returning +0.8%.
- Miami was the worst performer in March, returning -4.5% for the month.
- Dallas and Charlotte were the only two markets to provide positive returns for the month.
Still, this is not bad news for everyone. It makes houses more affordable for buyers and should help chip away at the inventory of unsold homes hanging over the market – unless, of course, buyers think prices have further to fall.
The prospect of $141-a barrel oil in the second half of this year and a $150-$200 superspike is looking increasingly realistic. But the Washington Post digs into the previous forecasts by Goldman Sachs analysts Arjun N. Murti and Jeffrey Currie and wonders whether they have been more lucky than good.
Certainly Barclays Capital commodities analysts Paul Horsnell and Kevin Norrish are not impressed:
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.
Some oil experts say the firm’s predictions were fulfilled only because of U.S. hurricanes and an output cut from the Organization of the Petroleum Exporting Countries a year and a half ago, the Post reports. ” They fault Goldman for underestimating future oil supplies and overestimating future demand for oil, especially with prices this high. Others wonder why Goldman anticipates a big price increase later this year when supplies seem adequate, even if it does expect scarce supplies years from now. Some say Goldman — which acts as an oil broker, runs the biggest commodity index fund, provides investment advice and trades oil on its own account — has too many institutional conflicts of interest.”
Goldman’s commodities analyst Currie stands by the forecast:
World GDP wants to grow at 3.8 percent, whereas the best we can come up with for trend supply growth is 1 percent. So something has to give. And that means prices have to rise to curtail demand growth.
Ed Morse, chief energy economist at Lehman Brothers, calls Currie’s analysis “responsible and analytically coherent,” but he doesn’t agree with it.
Currie is too pessimistic about future supplies and exploration costs, Morse says. Morse says that new deepwater drilling equipment will break the bottleneck slowing exploration of promising areas offshore Brazil, Alaska, Norway, West Africa and northwest Australia.
To some, Goldman’s series of rising price forecasts summons memories of the technology bubble in the late 1990s. Currie rejects the tech-bubble analogy. “When you look at an equity, its valuation is determined almost entirely by . . . expectations” of future earnings and cash flow, he said. “It is not grounded in today; it is grounded in tomorrow. So it’s very easy to get a very large speculative bubble.”
By contrast, he said, “commodities are physical assets where price has to clear supply and demand today.” During past speculative bubbles, such as those in Dutch tulips, commodities or U.S. housing, “people hoarded,” Currie added. “They had to stockpile and put things in inventory. We know that [oil] inventories are modest right now. We know that.”
CreditSights is defending its bleak outlook for the monoline industry following criticism from bond insurer Ambac (NYSE: AMB) over its most recent assessment.
In a note to readers, CreditSights said it felt Ambac mischaracterized exactly what the CreditSights analyst said.
In substance, we simply indicated that the worst-case scenarios (if they in fact come to pass) as recently updated by Moody’s would lead to more charges on the direct and indirect impact that would follow. The losses under the more dire scenarios are more likely to materially exceed anything reflected at this point on the books of the monolines.
In its original report, CreditSights wrote that “If losses were to migrate toward the higher end of Moody’s stress test, we think that a downgrade of both companies would become inevitable. Based on Moody’s most stressed case scenario, Ambac could be facing losses of more than $8 billion and MBIA could be facing losses of more than $10 billion. In our opinion, it is likely that both Ambac and MBIA will see continued deterioration in their second lien exposures in the second quarter. While Ambac has since stated that it is unlikely to raise additional capital and MBIA has said that it will not raise additional dilutive equity capital, we think both companies will be forced to raise significant additional capital in the second quarter or face an almost certain downgrade.”
In its response to the original report, Ambac said the CreditSights article “offers little independent analysis, fails to consider the basic structural arrangements of individual transactions (one cannot simply multiply a cumulative loss assumption by net par outstanding to determine ultimate loss) and does not attempt to reconcile to Moody’s previously reported RMBS losses for Ambac.”
CreditSights concludes that “In the end, we stand by our analyst and his right to an opinion (misrepresented by third parties or otherwise) based not only the data presented but also a minor dose of common sense based on what has transpired over the past year.”
The May 21 CreditSights analysis Ambac & MBIA: Sinking on Second Lien Slime is available for purchase.
Ambac’s response and its presentation on its second lien exposures is available here.
CreditSights’ Note to readers is available here.
FT Alphaville offers more details.
The New York Times has an interesting look at how the housing credit crunch is spilling over into automobile sales. Selected excerpts:
Home equity loans, which had been used in at least one of every nine deals, when lenders were more generous, are no longer a source of easy money for many prospective buyers. And used-car prices have fallen nearly 6 percent as repossessed cars and gas-guzzling trucks and S.U.V.’s flood auction lots.
But the auto industry may not suffer the same severe downturn as the housing sector. One reason is that auto lenders have long issued loans expecting that vehicles, as collateral for the loans, start to lose value as soon as they are driven off the lot. In contrast, mortgage lenders during the housing boom believed that home prices would keep rising.
Borrowers are falling behind on their car payments at a rate faster than in other recent downturns. And losses are considerably worse. Auto lenders sustained losses on about 3.4 percent of their loans in the first quarter, a rate about 30 percent higher than in 2002, according to data from Moody’s Economy.com.
Some of the biggest drops in car sales have been in areas where home prices have fallen most sharply. The housing boom created thousands of jobs, robust consumer confidence and strong demand for pickup trucks. Today, that has all vanished.
As home values have declined, millions of consumers have maxed out on home equity debt.
In hot markets like California, nearly 30 percent of all consumers tapped into the value of their homes to help finance their new cars, according to CNW Marketing Research. In Florida, about 20 percent used home equity loans. New car sales in both states are down about 7 percent.
Those areas are also seeing surges in repossessed vehicles. Bill Glover, a veteran repo man in Fort Meyers, Fla., says he has recovered more than 100 cars a week since October, doubling his usual business. “I’m picking up 2008s already,” he said.
In the past, Mr. Glover mostly took back cars from borrowers with sketchy credit who habitually fell behind on their car payments. But that circle has widened. “Lately what we’re picking up is crew-cab pickup trucks,” Mr. Glover said, “and anything having to do with construction.”
With commodity prices soaring but overall inflation staying relatively low, the IMF has released a new working paper entitled, “Recent Inflationary Trends in World Commodity Markets.”
The paper does not represent the official IMF view. Nonetheless, it presents a dire view of current policy conundrums that governments the world over are facing.
Policy makers may have to face a policy dilemma: maintain monetary policy stance with accelerating commodities price inflation, subsequent world recession, and financial disorder; or tighten monetary policy with subsequent world recession followed by recovery and financial and price stability.
At the center of the problem has been an increase in commodity prices of 23% per annum during the 2003-2007 period. The paper argues that that increase was the “delayed effect of an overly expansionary monetary policy which led to a fast expansion of all types of credits, irrespective of creditworthiness, and to a worldwide strong expansion of demand for real assets, goods, and services.”
“In order to rein in inflation and bring back a measure of stability in commodities and financial markets,” the paper insists, “monetary policy has to be tightened considerably and be directed to strictly controlling credit and money supply.”
In the end, the paper recommends a course similar to that which the Carter administration and other governments pursued in the late 1970s: “If the course of monetary policy is to be corrected, through controlling money supply, interest rates will go up sharply, exchange rates will appreciate, a debt crisis may erupt, and a temporary recession may set in as was the experience in 1979-82. The merit of prudent monetary policy would be to bring back price stability and durable economic growth, as illustrated by episodes during 1980–99.“
Fitch Ratings is skeptical about major beer company mergers in a timely report on the global beer industry. FT Alphaville reports that Belgium’s InBev (Brussels: INTB) is preparing a bid for Anheuser Busch (NYSE: BUD).
Fitch argues that “although a merger between AB and InBev would address AB’s limited international portfolio, the current global players may prefer to capture regional expansion opportunities that are still available before they embark on any industry‐ transforming merger of peers.”
Fitch’s Special Report finds that the global brewing industry “is at an intermediate stage of consolidation and that InBev and SABMiller are two of the four global brewing players that have the financial flexibility to continue to drive sector consolidation forward.”
While Heineken and Carlsberg have reduced their financial flexibility following the recent and joint acquisition of Scottish & Newcastle (S&N), InBev and SABMiller have low to moderate leverage and good cash flow generation that would allow them to pursue larger targets. “Although US-based Anheuser Busch has not been actively pursuing international acquisitions, it has the financial flexibility to do so. It would, however, have to reduce its large share buyback programme.”
With specific regard to the combination of AB with InBev which has been rumoured for some time, Fitch notes that the large price that InBev would have to shoulder for a cash acquisition of AB — which currently has a market cap of $36 billion —might make a hostile takeover, though not impossible, more difficult to fund.
“Conversely, AB’s management team, historically led by the founding Busch family,
may rightly argue that it can afford to remain independent for the moment, and
thus refrain from cooperating with a merger with InBev. US‐based AB has the ability,
in Fitch’s opinion, to deliver satisfactory profit growth.”
Fitch said it believes that in western Europe up to eight to ten companies that remain independent could come up for sale as rising raw material prices and weaker consumer spending put pressure on their sales volumes and profitability. While central-eastern Europe is almost fully consolidated by international players and companies in Latin America are unlikely to come up for sale in the short- to medium-term, Asia is a promising and still fairly unexplored territory for international players. While demand for beer is mature in North America and most of western Europe, it continues to grow in emerging markets.
Overall, Fitch believes the brewing industry is at a more intermediate stage in its consolidation compared, for example, to the tobacco sector before it entered its latest round of consolidation in 2006/2007. The report argues that global brewers may prefer to postpone embarking on any industry-transforming merger and acquisition activity until they have built up further critical mass.
The report “Global Beer Industry – Consolidation and Peer Comparison” includes an extensive analysis of the trading environment in each region and discusses the position of key players as well as the scope for regional consolidation.
Leading financial institutions reeling from writedowns of damaged debt assets want relief from “fair value” accounting. But Goldman Sachs (NYSE: GS) does not agree and may even pull out of the group that proposed the relaxation.
The Financial Times reports Goldman said it was likely to sever its links with the Institute of International Finance after the association of leading banks and insurance companies called for a relaxation of controversial accounting rules on asset valuation.
Goldman, one of the IIF’s 370-plus members, said it did not agree with the IIF’s proposals, which have been circulated to regulators and politicians over the past month, and opposed any changes in “fair value” accounting.
The proposals are extraordinary…This is Alice-in-Wonderland accounting. – Goldman Sachs official.
Morgan Stanley said it also agreed with the principle of “fair value” accounting but had not yet decided whether to leave the IIF following its proposals.
Under the IIF plan, banks would be allowed to use historical, rather than market prices, to value illiquid assets – a change that could help to reduce the negative impact of the crisis on their strained balance sheets.
“Often dramatic writedowns of sound investments required under the current implementation of fair-value accounting adversely affect market sentiment, in turn leading to further writedowns…in a downward spiral that may lead to large-scale fire sales of assets,” the IIF’s draft paper argues.
Ian Mackintosh, chairman of the UK’s Accounting Standards Board is leery of changes:
We know it is difficult to assess fair value in illiquid markets, but I would be surprised if the IASB decided there were any circumstances where financial instruments should instead be reported at cost.
The IIF may have the Bank of England in its corner. As reported on Research Recap, the Bank thinks strict application of fair value accounting may overstate subprime-related losses. Oxford Analytica does not agree: “it is debatable whether current pricing methods have led to excessively depressed ABS valuations.”
Mark-to-market pricing, or ‘fair value’ accounting, is strongly endorsed by the accounting profession.”
Gas, Food, Lodging. These three essentials of American life are the hot topics at Research Recap this week.
While current surging oil prices may be fueled in part by speculation and short-term supply-demand imbalances, longer-term trends offer little hope of a return to the days of cheap and plentiful oil supplies. Even the usually optimistic International Energy Agency now is expected to sharply reduce its oil supply projection, according to the Wall Street Journal.
Consistently high energy prices will only add to the upward pressure on world food prices, which are causing increasing problems, especially in the developing world where they make up a larger part of total income. The Food and Agriculture Organization will publish its latest Food Outlook next week, but a preview already released is not encouraging.
Higher energy and food prices of course will only add to inflationary pressures. You know it has become a hot topic when it becomes the cover story in The Economist. The magazine empahises the danger of inflationary tendencies in emerging economies.
This does not seem to be discouraging PIMCO’s Bill Gross from looking abroad for investment opportunities. Arguing that the US inflation rate is currently understated, Gross believes emerging market countries with economies like Brazil, Russia, India and China are “obvious choices for investment dollars.”
In his June Investment Outlook, Gross details his rationale for an understated US inflation and writes that if correctly calculated (in his view), the resulting higher US inflation rate “would mean a downward adjustment of price of maybe 5% in bonds and perhaps 10% or more in U.S. stocks and commercial real estate.”
Always one to put his money where his mouth is, Gross has moved PIMCO heavily into mortgage debt, but steering clear of “subprime garbage.” He sees this as a good bet now that the Federal government is implicitly guaranteeing Fannie Mae and Freddie Mac.
He’ll certainly want to avoid the 2007 vintage of the garbage harvest. Standard & Poor’s says mortgage securities backed by subprime, Alt-A and Prime Jumbo loans from that year have the highest ever default rates for their age.
News from the Office of Federal Housing Enterprise Oversight that house sales prices were down 1.7 percent in the first quarter surely will not help matters. OFHEO said prices fell 3.1 percent from a year earlier, the sharpest year-on-year decline in the index’s 17-year history.
And the debt problem is not limited to mortgages. Our most popular post this week was Moody’s US Credit Card Industry Moving into Uncharted Territory, which detailed rising delinquencies in the credit card sector. Moody’s US Commercial Real Estate Prices Down Sharply in March was also popular.
Otherwise, it was a miserable week for Moody’s, starting with the revelation in the Financial Times that it overvalued some exotic structured finance instruments and ending with the painful irony of being put on CreditWatch by rival S&P. Moody’s new COO Michel Madelain has work cut out to restore the firm’s stock-in-trade, its credibility, already diminished by the subprime meltdown.
Research Recap Quote of the Week:
Eighty-five million barrels of oil a day is all the world can produce and the demand is 87 million. It’s just that simple. – T. Boone Pickens