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Monday, March 30, 2015 2:55 AM

UBS on the Driver for Gold: What is Gold About to Tell Us?

An interesting article came my way from UBS analyst Julien Garran on the driver for gold. I do not have a link to share so excerpts will have to do.

Garran's article is one of the better one's I have seen. Unlike others, Garran does not cite jewelry, mining capacity, central bank purchases or sales or other similar (and wrong) notions that unfortunately are widespread among most analysts.

Commodities & Mining Q&A (by Julien Garran)

Q1. What drives gold?
A1. In the past, we’ve argued that international US$ liquidity is fundamental to calling first gold and then the industrial miners. In this note, we go a step deeper, arguing that gold is a call on excess returns in the US economy, the policy response and finally the impact on that policy on international US$ liquidity.

Q2. What is gold about to tell us?
A2. The key issues facing gold; excess returns in the US are under pressure as the strong US$ and falling energy squeezes cashflow. As wages pressures rise, weak productivity means that cashflows could be squeezed further. Both undermine credit conditions and threaten the longevity of the cycle. We believe the prospect of deteriorating liquidity magnifies the threat. That in turn is limiting the Fed’s ability to tighten policy and may induce it to ease in the future. We think the Fed has started to recognise that pressure with its dovish backtracking at the March meeting last week.

A1&2. In commodity strategy, we believe that a forthcoming rally in gold may warn us that declining returns could ultimately force the Fed into a new round of international reflation. We think the first step was likely the Fed’s dovish backtracking at the March meeting.

In the past, we’ve argued that gold behaves as a probability indicator of whether international US$ liquidity will be improving or deteriorating in six months’ time. Industrial commodities are a call on whether international US$ liquidity is rising now.

So to call gold, and then the industrial miners, we have analysed the key drivers of those flows;

  • The Fed
  • The US current account deficit
  • Bank’s asset buying/accumulation

In this note we go a step deeper – arguing that gold is a call on excess returns in the US economy, the policy response and then finally the impact of that response on international US$ liquidity. We contend that the state of economy wide excess returns ultimately determine the longevity of the cycle, and so it is the progress of excess returns, above the intermediate targets on inflation & unemployment, that ultimately drive monetary policy.

Right now, excess returns are under pressure from four main areas; The rest of the world is exporting deflation to the US.

  • The combination of rising wage pressure and low productivity/secular stagnation.
  • A potential deterioration in liquidity.
  • Deteriorating credit conditions and a rising Wicksell spread.
  • Recent papers by Shin and McAuley hint at the reason.

The impact is visible in the deterioration in cashflow & EPS momentum, as well as in low trend US growth.

S&P Cashflow Momentum

S&P EPS Momentum

Rest of World exporting deflation to the US

As we’ve highlighted in our last note, international US$ liquidity has collapsed.

Secular stagnation, weak productivity & wage pressure

The second key threat to US returns comes from low productivity & the dearth of investment, itself induced by the high level of debt and the subsequent low rate of growth (See Buttiglioni – Deleveraging, What deleveraging? 2014).

The UBS house view, consensus and the Fed are all arguing that wages are due to accelerate. The Fed is watching several signs suggesting that labour markets are tightening and that wages are on the cusp of picking-up. Unemployment has fallen, the workweek has risen. Quits, a sign that the jobs market is tight enough to get people quitting work for better opportunities, are trending up.

And the Fed is watching professional wages trend-up. Its mental model is that median wages are attached by elastic to professional wages. When professional wages rise enough, median wages follow. There are clear anecdotal signs this is happening. Walmart and McDonalds have both announced a buck increase in basic wages in recent weeks. The impact is that labour costs are rising.

In the 90s rising wages promoted an extended cycle. Wages started accelerating in 1994. They accelerated from 1995-8. But cashflow held up. That was because of productivity. Robert Gordon, the godfather of the secular stagnation debate (see ‘Secular Stagnation, 2014 – available free on the Vox website), highlights that total factor productivity rose at a 2.5% rate over the mid-90s. That was partly due to the burgeoning adoption and networking of PCs. And partly it was their increased use managing just in time inventories in a globalising, and lower cost, supply chain.

Of course, conditions are very different today. In ‘Disinflation or deflation?’ January 2015, we argued that deteriorating government productivity, something not measured in the GDP stats, was bringing down productivity for the economy as a whole. The combination of negative net investment and weaker productivity from tech applications means that corporates will struggle to offset rising wages.

US Productivity

So, in contrast to the extended 90s boom, weak productivity means that, as labour costs rise, cashflow gets squeezed, and credit fundamentals deteriorate further.

Liquidity & Credit Conditions

The most important support for US liquidity is corporate debt issuance for buybacks & M&A. So corporate debt issuance is also a key driver of EPS momentum. From 2010-14, corporates were able to issue large quantities of low quality debt.

In part, this was because there was a huge bid from mutual funds. Persistent Fed, foreign central bank and Investment bank treasury buying over the past five years induced mutual funds to reach for yield. But now that those sources of treasury buying have evaporated, mutual funds have much less incentive to reach for yield – so high yield appetite has deteriorated. Just as the fundamentals of debt, cashflows, are under pressure from the deflationary forces highlighted above.

Transmission Mechanism

The Wicksell spread The combination of low growth, weak productivity and deteriorating credit conditions put the cycle under increasing pressure. The Wicksell spread is the difference between corporate bond yields and nominal growth. Knutt Wicksell argued that a negative spread (with corporate yields below nominal growth) was like a subsidy to investment. A negative spread was increasingly a tax.

Late Cycle Signals

We have combined both cashflow and separately EPS momentum (giving them a negative sign so deteriorating momentum triggers a rise in the chart) and high yield spreads in our two ‘late cycle’ indicators below. The signals have spiked – suggesting that we are late in the cycle.

On each previous occasion that we have seen a spike of this magnitude in the indicators, we saw a significant market correction.

Our UBS proprietary Fed action model works on the basis that, over the past 20 years, the Fed has always reflated within two weeks if

  • The S&P fell 20% from peak.
  • High yield became stressed (HYG at 85 or below).

So, even though the Fed may focus on the intermediate targets of unemployment and inflation, it is ultimately the underlying sustainability of economy-wide excess returns that forces its hand.

The prospect of a more dovish Fed would set up the potential for a return of international US$ flows. A couple of recent academic papers by Shin & McAuley support the analysis.
Excellent Commentary

Garran's commentary was excellent, and gratefully devoid of the typical focus on jewelry, mining, central bank purchases, and also manipulation theories.

There is much more in the report, 24 charts in all, of which I posted six. Without explicit permission that is all I am comfortable posting. If I get a link I will add it as an addendum. There were no links in the article to things that Garran referenced, so I cannot provide those either.

Fed Tightening Cycle Won't Go Far

Reading between the lines, it seems that Garran, like I, does not think the Fed will get very far with the tightening cycle that most think is coming.

One and done would not surprise me. Heck, no hikes at all would not surprise me. About the only thing that would surprise me is more than three hikes.

US economic data other than jobs has generally been miserable. Don't expect a warning from the labor markets (See my article Jobs and Employment: How Much Recession Warning Can One Expect?)

Indeed, data has been so bad that I think a recession is on the way.  

Negative Data Pours In

Equities, Junk Bonds in for a Rough Ride

I don't know Garran's views on overall equities, but mine is the next round of liquidity will not have the same magic as the last two rounds, and in fact may even spook the markets.

Add to that the fact that earnings have peaked this cycle and the potential for a huge downturn in equities and junk bonds is far greater than most think.

Misunderstanding Gold

In case you missed it, please consider my March 27 article Misunderstanding "Peak Gold"; Gold About to Run Out? in which I debunked widely held notions that central bank asset purchases and sales, jewelry, and mining productions as drivers for the price of gold.

Garran's analysis was a welcome refresher from the typical (and wrong) commentary we see about gold.

Mike "Mish" Shedlock

Sunday, March 29, 2015 8:57 PM

Sarkozy, Le Pen Triumph Over Socialists in Second Round of Local Elections

The Socialists were routed in the second round of French elections this weekend. The centre-right UMP party led by Nicholas Sarkozy was the clear winner but Marine Le Pen's National Front had it best performance ever at the local level although it did not win any départements.

The Financial Times reports Nicolas Sarkozy the winner as French local polls deal blow to Socialists.

The UMP, led by the former president Nicolas Sarkozy and in an election coalition with the centrist UDI party, won between 66 and 70 départements compared with 41 previously, according to projections from polling companies.

By contrast, the Socialist party looked to have held on to between only 27 and 31 — barely half the 61 départements it controlled before.

The far-right National Front (FN), meanwhile, appeared to have made considerable ground in Sunday’s second-round vote — though it was unclear if it had done enough to win full control of any départements.

Even so, the anti-immigration, anti-euro party led by Marine Le Pen is likely to have done much to boost its national presence as it looks ahead to the 2017 presidential election. The FN has made important gains in recent years, wooing voters from both left and right, disillusioned by the lack of economic growth and high unemployment.

Following on the back of last year’s success in European elections over France’s two mainstream parties, Ms Le Pen called Sunday’s result “the foundation of tomorrow’s big victories”.
Sarkozy and Le Pen Triumph in French Local Elections

The Guardian reports Hollande Left Bruised as Sarkozy and Le Pen Triumph in French Local Elections
Front National’s strong gains mark turning point for far right in expanding grassroots presence, while win for Sarkozy prefigures likely presidential run.

 The French right has made large gains in the country’s local elections, handing President François Hollande’s ruling Socialist party its third electoral drubbing in a year and raising fears for the future of the left.

Nicolas Sarkozy’s rightwing UMP party, in coalition with centrist allies, took the largest share of seats, wresting control of many traditional leftwing bastions from the Socialists.

But key to the changing political landscape in France was the strong showing for the far-right Front National, which marked a major turning-point as the party established a new grassroots presence across the country.

After winning only two local council seats at the last election in 2011, Marine Le Pen’s anti-immigration and anti-Europe party was on track to win as many as 90 councillors, cementing the Front National’s transformation from what was once a simple national protest vote to a locally anchored movement that Le Pen hopes to use as a springboard for her presidential bid in 2017.

Although the Front National did not win outright control of any département local council, its percentage score rose sharply from the last local elections.

Le Pen hailed her party’s best result in a local election as a “magnificent success”.

The Socialist prime minister, Manuel Valls, said: “The very high – too high – score of the far-right represents, more than ever, a challenge to all republicans.”

He said the Front National’s success marked a “lasting upheaval” of the French political landscape and all political parties had to learn lessons from it.

The local elections, followed by the regional elections in December, have been seen as a barometer for 2017’s presidential race. Several polls have shown that Le Pen could make into the second-round presidential runoff vote in 2017, knocking out either the left or right.

Most pollsters agree that Le Pen could never gain enough votes in the final round to win the presidency. But her potential presence in a runoff has worried the mainstream left and right. Socialists are keen to avoid their candidate being knocked out, as happened when Jean-Marie Le Pen knocked out Lionel Jospin in 2002.
Mike "Mish" Shedlock

3:31 PM

Time to Eliminate Pilots in Aircrafts: Post Pilot Era Coming Up

Instead of new rules making sure two people are in the cockpit at all times, how about a rule that says no one at all is allowed in the cockpit? This is precisely how I felt after 911 and even more so after the disappearance of Malaysia Flight 370 on March 8.

The tragedy of Germanwings Flight 9525 in which a mentally ill co-pilot deliberately flew the plane into a mountain killing all 150 on board is icing on the cake.

And it's not just two deliberate crashes either. Please consider The Mystery of Flight 9525: a Locked Door, a Silent Pilot and a Secret History of Illness.

Just under 40 minutes into their journey, the plane’s 27-year-old co-pilot, Andreas Lubitz, turned the Airbus A320 into a missile, guiding it into the southern Alps after locking its captain, Patrick Sonderheimer, out of the cockpit.

In the doomed flight’s final minutes, Sonderheimer attempted to force his way through the security door that separates the passengers from the pilots. At one stage he reportedly tried to use an axe. Recordings obtained by crash investigators capture him attempting to remonstrate with Lubitz – whose breathing, according to the microphones in the cockpit, remained sure and steady as the plane made its rapid descent. It was only in the final seconds that there was the sound of screams. Experts said death would have been instant.

As the New York Times revealed early on Thursday, French time, the voice recorder confirmed that Lubitz had locked the captain out of the flight deck and set the plane on its descent.

In November 2013, a flight between Mozambique and Angola crashed in Namibia, killing 33 people. Initial investigations suggested the accident was deliberately caused by the captain shortly after his co-pilot had left the flight deck.

In October 1999, an EgyptAir Boeing 767 went into a rapid descent 30 minutes after taking off from New York, killing 217 people. An investigation suggested that the crash was caused deliberately by the relief first officer, although the evidence was not conclusive.

And in December 1997, more than 100 people were killed when a Boeing 737 flying from Indonesia to Singapore crashed; the pilot, who was said to be suffering from “multiple work-related difficulties”, was suspected of switching off the flight recorders and intentionally putting the plane into a dive.

In an interview with the bestselling German tabloid Bild, the 26-year-old flight attendant, known only as Maria W, said that they had separated “because it became increasingly clear that he had a problem”. She said that he was plagued by nightmares and would wake up and scream “we’re going down”.

Last year he told her: “One day I’m going to do something that will change the whole system, and everyone will know my name and remember.”

A debate now rages about the extent to which companies and regulators can monitor a person’s mental health, especially if they perform a job that carries responsibility for the lives of others. The UN world aviation body has stressed that all pilots must have regular mental and physical checkups. But psychological assessments can be fallible. “If someone dissimulates – that is, they don’t want other people to notice – it’s very, very difficult,” Reiner Kemmler, a psychologist who specialises in training pilots, told Deutschlandfunk public radio.
Debate over Mental Illness

The debate over mental illness, locked doors, emergency overrides etc., is the wrong debate.

The debate should quickly turn to whether there should be pilots in the plane at all.

Post Pilot-Era

The Globe and Mail hits the nail on the head with its report Aviation is Fast Approaching the Post-Pilot Era.
Every day, dozens of unmanned jet aircraft as big as private business jets take off from airports scattered around the globe. They fly for thousands of kilometres, staying aloft for as long as 36 hours, often changing course to cope with unexpected developments, before returning to land.

To call them drones grossly understates the sophistication, safety and cost-effectiveness of autonomous and remotely piloted aircraft.

Global Hawks, for instance – long-range, sophisticated surveillance jets, controlled from Beale Air Force Base in California but flying from at least six air bases in Japan, Guam and the Middle East – range around the world. They have been flying for 15 years. They have flown to Australia and back from the United States. They fly daily over Afghanistan and Iraq but also over heavily trafficked airspace where they fly high above commercial airliners. They can be programmed to take off, fly a 32-hour mission and land, all without direct human control. Alternatively, pilots half a world away, linked by multiple, secure and redundant satellite data links can “fly” them remotely. And there are thousands of other unmanned aerial vehicles already flying daily – mostly in military service.

Pilotless aircraft aren’t a distant sci-fi concept nor the wishful dreams of bean-counters at big airlines where the nattily-uniformed flight crew is a big cost just waiting to be cut.

And, as many pilots inside cockpits lament, most of the time they do little, if any, “hand flying.” Courses, heights, waypoints, rates of descent are all programmed into flight management computers which then “fly” modern aircraft far more smoothly and achieving far better fuel consumption, than even the most suave of airline captains.

Andreas Lubitz, the co-pilot suspected of deliberately crashing the Germanwings Airbus A320, didn’t seize a control stick and frantically dive the jet into oblivion. Rather, he simply dialled in 100 feet, in place of the assigned 36,000 feet cruising altitude, and the Airbus dipped the nose of the 70-tonne, twin-engined jet and flew it smoothly at a steady 800 kilometres per hour for eight more minutes until it slammed into a mountain. Mr. Lubitz didn’t need to touch anything further, except the lock override switch by his left hand that kept the captain out of the cockpit and doomed everyone on board.

Aviation experts envision an end to the era of pilots – at least pilots in cockpits – just as inevitably as elevator operators became redundant, expensive and far less precise in the operation than computerized systems.

As just as some high-end department stores kept on uniformed elevator operators who did nothing except offer reassurance by their presence to nervous shoppers, the transition to remotely-guided or autonomous aircraft may include a period of pilots present but not required on board airliners.

In many ways, autonomous operation of aircraft is far less of a technological challenge than autonomous or driverless cars – which major manufacturers expect will be sharing the roads with more dangerous human drivers within a few years. For instance, across North America, there are only about 5,000 commercial and military aircraft flying in controlled airspace at one time. That’s far fewer than the number of cars in a small city and they don’t need to dodge pedestrians, other drivers unexpectedly doing stupid things or a host of other variables that make driving far more complex. And aircraft fly pre-determined routes, at heights and speeds that can be far more easily adjusted to avoid collisions between a few hundred well-defined destinations.

David Learmount, an operations and safety expert at Flightglobal and a veteran aviation expert who has flown dozens of aircraft types, predicts pilots won’t be in cockpits in 15 years but in an airline’s operations room, rather like the U.S. Air Force pilots flying Global Hawks from Beale.

Imagine an airline crew room in 2030,” he says. “The airline has, say, 300 airplanes, but only about 50 pilots. About ten of these will be on duty in the crew room at any one time [with secure links] to any of the fleet that’s airborne. On the rare occasion that something anomalous occurs on an airplane, … they can intervene as effectively as they could have done in the aircraft.

Cargo flying and transoceanic routes, with no nervous passengers to persuade will likely be the first to make the change. United Parcel Service, the global package and freight giant operates 238 large cargo jet aircraft . In a decade, it expects to be flying pilotless freighter aircraft across the Pacific Ocean.
Transition Period

People feel safer with a pilot in the aircraft. They shouldn't. 911, Malaysia 370, Germanwings Airbus A320, EgyptAir 767, and deliberate crashes in Namibia and Indonesia are proof enough.

15 years is too long to wait. There should have been a transition to pilotless aircraft long ago. It's a tragedy that someone on the ground or the aircraft itself could not override these deliberate crashes.

Such fatal tragedies are very rare, but why have them at all? Self-driving cars and trucks will be safer than human-driven ones. So will automated ships and planes. If anything, ships and planes should be easier to implement than cars.

So why the delay?

Mike "Mish" Shedlock

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