Incrementum Advisory Board Meeting Q3 2016

Is Stagflation a Potential Threat?

The Incrementum Fund held its quarterly advisory board meeting on October 3 (the transcript can be downloaded below). Our regular participants – the two fund managers Ronald Stoeferle and Mark Valek, advisory board members Jim Rickards, Frank Shostak and yours truly –  were joined by special guest Grant Williams this time. Many of our readers probably know Grant; he is the author of the bi-monthly newsletter “Things That Make You Go Hmmm…”, as well as one of the founders of Real Vision TV.

Characteristics of stagflation: economic growth goes into reverse, but price inflation rises  anyway. This scenario was completely unexpected by the Keynesian consensus when it hit the economy in the 1970s. Keynesian theory ended up discredited for a while as a result. Not surprisingly though, as a theory that provides a “scientific” fig leaf for statism and interventionism, it has been resurrected since then. Today it once again is an important part of mainstream economic orthodoxy; the monetarist school has retained a certain degree of influence as well, but its policy prescriptions are just as misguided in our opinion.

Although none of the participants expected a particularly strong surge in price inflation in the short term (apart from base effects becoming noticeable in headline inflation numbers in coming months), there are certainly more and more signs that the loose monetary policy of central banks is beginning to succeed in producing at least some price inflation.

There can be very large time lags between excessive money supply expansion and rising prices, but in the longer term is seems certainly possible that many currently wide-spread consensus expectations regarding future price inflation and market trends could turn out to be quite wrong. The proprietary Incrementum Inflation Signal definitely indicates that the trend in price inflation remains up:

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The Incrementum Inflation Signal continues to indicate that a period of strengthening price inflation has begun. The inputs used to calculate the signal are all market-based.

Oil Prices

One of the topics under discussion in this context was the price of oil. It seems possible that market participants are underestimating the potential for crude oil prices to advance further in the long term (from a fundamental perspective, the market is actually much tighter than is widely perceived). It should be noted though that the oil market has to contend with two sizable obstacles that are likely to put pressure on prices in the near term.

One is the seasonal trend discussed by Dimitri Speck (see “Crude  Oil has Entered a Seasonal Downtrend” for details). The other is the fact that the speculative net long position in crude oil futures has climbed back to a rare extreme, which strongly suggests the need for a shakeout:

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This chart shows the net position of commercial hedgers in WTI crude oil futures, i.e., the inverse of the net speculative position. The current level of 408,000 contracts is one of the highest on record. Even higher readings  were only seen in early to mid 2014 – and that certainly didn’t end well for oil longs.

While the potential for a stronger rise in oil prices over the long term was not dismissed, the near term prospects for oil were actually seen as limited by participants, and there was also consensus on the inability of OPEC to influence prices. Frank Shostak continues to expect a significant decline in oil prices next year based on his econometric model.

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A decline in oil prices has begun right in line with the seasonal trend (which is pointing down between mid October and mid February); given the extremely large speculative net long position, there is potential for this correction to become quite sizable.

European Banks

Another topic was Deutsche Bank and the European banking industry in general. At the time of the meeting, the share price of DB had just declined to a multi-decade low and credit default swaps on its senior unsecured debt were in a noticeable uptrend (in which they incidentally remain).

The troubles of Italy’s banking industry are well known, and the question is whether the European Bank Recovery and Resolution Directive (BRRD) will be strictly enforced if push comes to shove. This obviously entails considerable economic and political risks. One conclusion was that while European decision-makers were likely to want to avoid a “Lehman moment”, they may well get one anyway.

With respect to DB, we want to highlight one remark of Jim Rickards in particular: as he noted, there has been a rapid reduction in the notional value of Deutsche’s derivatives book, which could be a sign that counterparties are either not renewing expiring contracts or are trying to get out of existing ones. At the moment things have obviously quieted down a bit again, but we would contend that the basic problems have not gone away.