Stephen’s Posterous

Austrian-born Peter Brabeck led Nestlé, the world's biggest food group, as chief executive for 11 years before becoming chairman last year.

The 64-year-old combines that position with roles as vice-chairman of Credit Suisse and cosmetics group L'Oréal, where Nestlé has a big stake. A Nestlé veteran, he joined the company in 1968 and worked in a variety of roles including in Latin America, and in culinary products and marketing, before becoming chief executive in 1997.

Nestlé has been one of the few consumer groups to be relatively untroubled in financial performance by the economic crisis. In a sign of the strength of Nestlé's senior talent, two of its most senior executives, Paul Polman and Lars Olofsson, have left to head Unilever and Carrefour, with Paul Bulcke staying to become Nestlé's chief executive.

In an interview with FT.com, Mr Brabeck talked about the return of inflation, why the food crisis is getting worse and why water could run out sooner than oil. Edited highlights appear below.

How deep will the current recession be?

Very deep, and it will be relatively long.

Could it be a depression?

This is terminology. I'm more worried that what we are doing today in some countries might be the basis for a new crisis.

State intervention, especially in the financial sector, should be strong and short. My feeling is that we are going into state intervention which is long, shallow and will continue for many years. And if you look at state deficits being created just now, there is no short way out of this crisis.

Do you think governments have done enough to stabilise the situation?

I am more worried about too much than too little.

Would you be worried about protectionism?

Absolutely. Although every politician says . . . that we should avoid protectionism, every single politician when he comes home does exactly what he was saying we should not be doing. So I think this is a big danger for the future of the economy.

A big topic for consumer businesses is inflation or deflation. Which are you most concerned about?

At the moment, I'm more worried about inflation, because basically all macroeconomic decisions which are being taken will lead us to inflation.

And in a big way?

That I cannot judge. But what I know is that we already see indications that inflation is picking up, and we are just starting. The stimulus projects that are being put into place mean that the printing machine will start to work and this is clearly the start of inflation.

How much has Switzerland's image been hurt by UBS [with big subprime losses and an investigation by US authorities] and the potential end of bank secrecy?

I would say Switzerland has always had the image of being a very special case. Now, over the past 40 years, it was all seen very positively. And perhaps over the past 10 years we started to see Switzerland as a special case, but with some negative aspects also. And there is no doubt that the UBS case has put another shade on this special case.

What kind of changes do you think private banks might have to make on bank secrecy?

First of all, I don't believe Switzerland is a tax paradise, frankly speaking. But if you look at the future of the banking industry, my feeling is that the Swiss banks will continue to do very well, based on the quality and on the service they can provide, not so much on the bank secrecy.

You are worried about the scarcity of water. What would your worst-case scenario be?

That we continue to treat water as we do today, [as] a commodity without any price. Under those circumstances the world will run out of water long before we [run out] of oil.

What should be done to help solve this?

The water issue comes back to three simple things. The first is infrastructure. If you look worldwide it's about 60 per cent of fresh water that we are losing due to insufficient infrastructure. The second is political decisions. It is absolutely unacceptable that we are using food for biofuels. We need 9,100 litres of water to produce one litre of pure diesel. This is not sustainable.

The other aspect is that 93 per cent of all water consumption is in agriculture, and as water has no price there is no economic incentive to improve the productivity.

Is the food crisis in poorer countries getting worse?

[It] is getting worse. Don't forget that food prices are today about 60 per cent higher than only 18 months ago. And this means those people who spend 60 per cent, 70 per cent of their disposable income on food have been hurt very, very strongly.

Are we [therefore] likely to see more social unrest?

I personally believe that food prices will continue to increase because the demand, even during this crisis, will be in 2009 about 3 per cent to 4 per cent higher than last year.

China recently decided to stop Coca-Cola acquiring a Chinese company. Is that a worrying sign?

First, it's a sign that, also in China, the regulatory authorities are becoming tougher. The decision per se is discussable, but I would also say that if the same case had happened in Europe, I'm not so sure Europe would have allowed this acquisition.

Why is Nestlé doing so well when many of your competitors aren't?

It might have to do with our historically long-term view of things. And by identifying critical issues early on. When we talked about the increase of raw material prices, one-and-a-half years before they happened, nobody believed us.

Source.

The most talked-about investing strategy these days isn't stuffing money in a mattress, it's the reflation trade he bet that the world economy will rebound, driving up interest rates and commodities prices. Even though the economy continues to struggle, investors are looking ahead to time when the massive rescue efforts by central banks and governments gain traction.

They are focused on raw materials and commodity-related stocks that would benefit from the surge in infrastructure spending. They are looking to exploit potential bottlenecks in production that could lift prices and corporate earnings. Some are layering on insurance against a spike in inflation should central banks lose control of their stimulus efforts.

"Between the bailouts and the stimulus, it's pretty clear that we're going to have some inflation when we get out of this mess," says Roger Ibbotson, founder of Ibbotson Associates and chairman of hedge-fund manager Zebra Capital Management. It may not show up for another two years, he says, "but after that I think it's quite likely and I think you should be positioning a portfolio against that."

Evidence of the trade shows up in higher yields on bonds that adjust for inflation and a surge in prices for commodities including copper, up 19% in March, zinc and oil. Shawn Rubin, an adviser at Smith Barney in New York, has moved some clients partly into natural-resources stocks while using strategies to protect against a spike in inflation.

One way is to use options, where an investor is able to use relatively small amounts of money and take positions that would profit from a massive drop in Treasury prices or a near doubling in gold prices. While in the short run such trades may not work, "it's a long-term move," Mr. Rubin says. "You want to buy insurance when it's cheap."

For now, the U.S. remains in a deflationary mode. The economy is believed to have contracted roughly 5% in the first quarter. Consumer prices are expected to post a year-to-year drop of 1.3% through June, according to the latest Wall Street Journal survey of economists.

Despite the recent rally that lifted stocks 20% from their lows as of Thursday, the common definition of the return to a bull market, though they promptly fell again Friday, most investors expect a challenging environment well into next year. But the Federal Reserve has taken dramatic steps to revive the economy and stabilize the financial system. It has lowered interest rates essentially to zero and is on track to pump more than $2 trillion into the credit markets.

On top of that, there is the $787 billion federal stimulus program coupled with a growing budget deficit. Around the globe central banks and governments are making similar moves.

Paul Kasriel, director of economic research at Northern Trust, says the Fed will likely err on the side of ensuring the recovery is sustained "and usually that means they will be late" in turning against inflation. The "political sentiment will be toward inflation and in preventing deflation," he adds.

Until a few weeks ago, investors weren't even thinking about preparing for a recovery, hoarding cash and U.S. Treasury bonds and defensive stocks that would perform better than most in a recession. And the longer the economy takes to rebound, the longer it will take for the so-called reflation trade to pay off. In the meantime, investors with those bets run the risk of big losses.

"Until real demand recovers, the trade has a chance of getting ahead of itself," says Mark Liinamaa, natural-resources analyst at Morgan Stanley.

Mr. Liinamaa suggests investors keep a "survivor bias." That means "looking for names that have low cost structures and balance-sheet capacity to still be standing" even if demand doesn't recover soon. He cites steel producer Nucor as one example.

Already there are signs that the market is less worried about deflation. That's clearest in the market for Treasury Inflation-Protected Securities. Back in February, five-year TIPS were priced for a 0.5% drop in consumer prices, now that's swung around to a 1.35% increase.

The magnitude of the expected inflation rise predicted by TIPS may be small, but the direction tells the tale, says John Hollyer, a co-manager of Vanguard Inflation-Protected Securities Fund.

"The fiscal and monetary stimulus are causing investors to say there's a decent chance the Fed will be successful and there will be an increase in inflation," he says. Other markets are yet to reflect a shift toward inflation fears. In the Treasury market, where inflation erodes the value of the interest payments over time, the 10-year bond is yielding just 2.761%.

But it isn't just the ripples from the money flooding into the financial system that has some looking at a "reflation" trade. Even if there isn't a strong recovery, the economic collapse has taken substantial amounts of raw-material production offline.

Reduced inventories could in turn result in price-rise bottlenecks even with just a moderate rebound in demand from commodity users.

"You could see a reflation in commodity prices even without broad inflation in the overall economy," says Jason Trennert, chief investment strategist at Strategas Research Partners LLC. He is recommending energy and materials stocks, as well as an exchange-traded gold fund, to play the reflation trade over the next one to three years.

The possibility of rising commodity prices without inflation was highlighted last week in a report from Cambridge Energy Research Associates estimating that half the new oil and gas production that was in the works is now at risk of being deferred or canceled. While crude-oil prices are still down 64% from their high hit last summer, they are up 54% from their low hit on Feb. 12 and are up 17% this year.

It isn't just Washington's stimulus that has investors preparing for inflation. For many, the source of potential capacity constraints could well be China.

"China's stimulus package may be even more important for the inflation trade than what happens in the U.S." says Mr. Trennert. China pledged to devote nearly 75% of its $586 billion stimulus package to infrastructure development and reconstruction of an earthquake-stricken area. The U.S. is allocating just $48 billion to direct infrastructure spending.

China's efforts have rippled through to the markets for at least a few metals. Prices for copper, commonly used in power generation and construction, are up 44% from the low hit in December. Zinc, needed for producing galvanized steel used by utilities and the auto industry, is up 24% from its low.

Rising prices stand to benefit the commodity-producing economies. That has encouraged John Baur, a co-manager of Eaton Vance Global Macro Fund, to avoid long-term U.S. Treasurys in favor of Brazilian debt. That country's stock market is up 12% this year.

China's refined-copper imports soared 99% in February from a year ago, perhaps indicating that "they want to have the material available" when infrastructure projects start, says Catherine Virga, a researcher at commodities research firm CPM Group.

Source.

With the US and other countries monetizing budget deficits, the chance of rapid inflation has surged. The annual production of gold, the traditional hedge, is far below the world’s rate of monetary growth. An inflationary panic could thus bring an explosive gold price rise.

Gold has little intrinsic value; if it had never been coined its price would probably rest around the $250 per ounce of the late 1990s. However because of its history it is regarded as an inflation hedge and store of value, and that psychological association becomes tighter as inflation worsens and the gold price rises. Hence arguments about the irrationality of gold investment are wrong: in an inflation-prone environment belief in gold becomes self-reinforcing.

Alternative safe-haven stores of value, such as foreign currencies and US Treasuries, are falling away as the Swiss and Japanese authorities seek to weaken their exchange rates and the US runs ever-greater deficits.

In the stagflationary conditions of 1980, the gold price peaked at $875, the equivalent of $2,300 today. However the rise to 1980’s inflation levels was gradual; monetary policy in the 1970s was only moderately over-expansive and the US fiscal deficit was modest by current standards.

Including the Fed’s March 18 announcement of further monetary stimulus, monetary and fiscal policies in the US and globally are far more inflationary than in the 1970s. Consequently, there’s a real threat that if inflation returns, it will do so violently.

Smart investors are hedging against this possibility through gold. Hedge fund tycoon John Paulson paid $1.28bn for 11.3% of AngloGold Ashanti. That company is unprofitable at present gold price levels, but would hugely benefit from a price rise.

Should other hedge funds turn to gold, its price could soar. At current prices, annual gold output is worth only $104bn and the global gold stock only $5.12 trillion. Central bank gold reserves total $895bn, a fifth of currency in circulation. Even a quintupling in the gold price, to $5,000 per ounce, would raise the value of annual gold production only to $500bn and the global gold stock to $25tn, just 20% above the world’s M1 money supply.

Recent bubbles in stocks, housing and commodities have been driven by easy credit. The ongoing US Treasury bond bubble is driven by desire for a safe haven. When it collapses, a gold bubble driven by inflationary concerns may be inevitable.

Source.

The US Federal Reserve is increasing its balance sheet by another $1 trillion, including $300bn of Treasury bonds, the Federal Open Market Committee said on Wednesday, March 18, 2009. Yet the pace of US economic decline seems to be slowing, while deflation is nowhere visible. Fed policy is now high-risk, and resurgent inflation may strike sooner than expected.

The FOMC said it expects inflation to remain subdued with some risk it could "persist for a time below rates that best foster economic growth”. Notably, the Fed is not now forecasting actual deflation. That’s not surprising, since February’s top-line consumer price index rose 0.4%, equivalent to 4.8% annually, while core consumer prices also rose, by 0.2%.

The Cleveland Fed’s median CPI was 2.8% above the previous year. February’s producer price inflation was marginally lower, with the headline index rising at 1.2% annually and the core measure at 2.4%.

Meanwhile, last week’s unexpectedly strong February retail sales and Institute for Supply Management index readings suggest that economic decline is slowing.

The experience of the 1970s in both the United States and Britain demonstrates that the Fed’s theory that inflation won't co-exist with economic slack is wrong. Thus an over-inflationary monetary or fiscal policy could quickly produce accelerating inflation even while recession persists.

The Fed’s proposed purchase of $300bn of long-term Treasury bonds, when combined with the Obama administration’s record budget deficits, is particularly risky. Running large budget deficits and monetising them through central bank purchases of debt is a highly inflationary policy that has got plenty of emerging markets into trouble.

Broad money growth, whether by the M2 metric or by the St. Louis Fed’s MZM figure, has been running at over 15% annually since last September. The $1tr further expansion of the Fed’s balance sheet is very likely to accelerate this. The effect may not be obvious in the short term. But at some point, it is almost inevitable inflation will return, probably with force.

The Fed will then need to reverse policy with the speed and verve of a racing driver. Unfortunately, the odds are against it doing so before inflation has taken hold.

Source.

While most investors fear deflation, Gary Shilling is looking forward to it. The idiosyncratic economist manages about $100 million for clients from a small office here. For many, many years, he has predicted an era of falling prices that never arrived. Now, finally, it just might.

He has a batch of advice for investors on how to weather deflation: Don't expect your house's worth to rebound. Stash your money in apartment real-estate trusts and conventional Treasurys. Don't invest in companies that carry a lot of debt or in inflation-protected Treasurys.

The last time deflation appeared was in the Depression. U.S. prices slid 32% from 1929 to 1933. Suddenly, many observers these days fear that the popping of the housing bubble, along with the financial crisis, could be pushing the U.S. toward a new deflationary era.

The consumer-price index including food and energy dropped 0.8% for December 2008, year over year, and was flat for January 2009. When the February CPI is reported on Wednesday, March 18, 2009, many expect it to be flat or negative again.

Mr. Shilling believes price drops of 2% to 3% yearly will persist long after this recession because of huge efficiencies driven by globalization and technology, plus retirement-panicked baby boomers curbing their spendthrift ways and pumping up their puny savings. That would echo similar deflationary spells during prosperous, high-growth times like the late 1800s and the 1920s.

Increasingly, Mr. Shilling is getting company from economists who think deflation may be on the way, notably New York University's Nouriel Roubini and Merrill Lynch's David Rosenberg. Of course, others such as Northern Trust's Paul Kasriel, argue that heavy federal spending by the Obama administration to jump-start the economy risks just the opposite, a vexing inflation.

Yet few go as far in seeing persisting deflation as Mr. Shilling, 71 years old, a Stanford Ph.D. in economics who once was Merrill's chief economist.

Deflation in the Depression was truly baleful because it fostered a falloff in demand, since consumers were leery to buy what would be cheaper in the future. And it punished debt holders, who had to pay fixed amounts even as the value of the underlying asset sunk. The same condition bedeviled Japan in the 1990s.

A frequent talking head on CNBC, Mr. Shilling sometimes comes across as an oddball with his chronic bearishness. "People say I'm always negative, and when I'm right, it's like the stopped clock being right twice a day," Mr. Shilling says. Indeed, in January 2004, he predicted a housing crash within the year. "I was early," he says.

Even Mr. Shilling's hobby is on the eccentric side: He keeps bees. At his Short Hills, N.J., home and a nearby property, he tends 80 hives. Mr. Shilling gives the honey away to friends in plastic bear containers with labels saying things like: "Our bountiful bees need no bailout."

Over the years, Mr. Shilling has devised a virtual deflationary handbook for investors. Good ideas: Longer-term Treasurys and certificates of deposit, which will continue to pay interest in the low single-digits. If the CPI is down 2% and 30-year Treasurys yield 3.6%, as they do now, then you get an effective 5.6%.

The housing bust is showing Americans that a place to live is no longer a can't-lose investment, Mr. Shilling says. Hence, he forecasts a surge into rental apartments, which should boost now-flagging apartment REITs. In health care, Mr. Shilling thinks winners will be companies dedicated to cost containment, like pharmacy-benefit managers.

His expected victims of deflation? Auto makers as savings-minded consumers will hold onto their old cars longer and sellers of other big-ticket goods like refrigerators. He also is down on mortgage-backed securities, linked to the plummeting housing sector.

Source.

Must we look back to the Great Depression to really understand the current stock market?

A year or so ago, when a select few investment newsletter editors began arguing that we need to do so, the overwhelming majority of advisers believed that drawing such an analogy served little purpose other than fear mongering. It is testament to the severity of this bear market that the consensus opinion has shifted so much that it is now respectable to look to the 1930s for guidance about what is in store for equities.

I'm skeptical, however. That's not because I don't think that decade has much to teach us.

My skepticism instead traces to the small number of analysts and commentators who have really analyzed what an analogy to the 1930s truly entails. And if we are to genuinely learn the lessons of history, we have no choice but to start with an accurate assessment of what actually happened.

After examining several aspects of the stock market's behavior during the 1930s, it would appear as though a replay of that decade might very well be less scary than assumed by many of those who superficially draw the analogy.

Here are some myths about the Depression that should be dispelled.

Myth 1: It took 25 years for the stock market to recover its losses from the high reached just before the stock market crashed in October 1929.

It's easy to see why investors believe this myth to be true: It wasn't until Nov. 23, 1954, that the Dow Jones Industrial Average closed above the level at which it closed on Sept. 3, 1929, the date of its closing high before that year's crash. That's a recovery period of more than 25 years.

If the recovery from the bear market over the last year and a half were to take the same length of time, the Dow wouldn't again close above its all-time high from Oct. 9, 2007, of 14,164.53 until, you'd better sit down, Dec. 28, 2032.

The truth, however, is that it took stocks far less than 25 years to recover. According to Wharton finance professor Jeremy Siegel, the inflation-adjusted total return index of the U.S. stock market was just as high in late 1936 and early 1937 as it was at its precrash peak in 1929. That was less than eight years later.

That may not be great news to investors who are hoping to recover their bear market losses in just one or two years. But it's a whole lot better than taking 25 years to recover those losses.

Why the Big Difference?

One factor is dividends, which were substantial during the 1930s. At the depths of the Great Depression, in fact, the Dow's dividend yield was in the double digits. Ignoring dividends, which is what investors do when focusing on price alone, therefore, introduces a significant pessimistic bias into any historical analysis.

Another Factor is Deflation

The consumer price index actually dropped by 27% between its 1929 peak and its low in 1933. A stock that dropped by less than this amount in nominal terms over this four-year period, therefore, actually turned a profit in inflation-adjusted terms.

Yet another reason why it took the Dow so long to surmount its 1929 peak: The decision in 1939 to delete International Business Machines from the average. It wasn't added back until years later. According to Norman Fosback, editor of Fosback's Fund Forecaster, the Dow would today be more than twice its quoted level had IBM not been removed from the average in 1939.

Myth 2: If we're playing out a 1930s script, now would be a bad time for long-term investors to get into the stock market.

Actually, if the stock market were to exactly adhere to a 1930s-like script, equities would provide a handsome return over the next five years.

Once again, this insight relies on data from Professor Siegel. To locate the date during the 1930s that is most analogous to today, he looked for the point at which the stock market after 1929 had, as is the case today, declined by around half on a dividend-adjusted and an inflation-adjusted basis. That point came at the end of 1930, just 16 months after the August 1929 stock-market top. Ironically, the current bear market is just 16 months old too.

According to Siegel, over the five-year period beginning in January 1931, the stock market produced an inflation-adjusted total return of 7%. That's right in line with stocks' long-term average performance, in fact.

To be sure, this myth does have a big grain of truth to it. Over the first five months of 1931, the first five months of this five-year period -- the stock market fell 60%. You read that right: That's a 60% drop on top of a 50% drop over the previous 16 months.

If the stock market today were to suffer a further decline of similar magnitude, the Dow Jones Industrial Average would be trading below the 3,000 level by the end of July.

So, to that extent, it is true to say that, on the assumption we're playing out a 1930s-like script, now would not be a good time to enter the stock market. But this truth pertains more to shorter-term investors than to longer-term investors. According to Siegel, in fact, an investor who entered into the stock market in early 1931 was made whole again by June 1933, despite digging a 60% whole in the first five months.

Myth 3: The stock market's recent extraordinary volatility provides a clue to the wild ride that lies ahead if we're playing out a 1930s-like script.

Actually, undeniably large as it has been, recent volatility doesn't even begin to compare to what it was like during the 1930s. In fact, there were eight calendar months during the decade of the 1930s in which the Dow rose or fell by more than 20%. The month with the biggest Dow move was April 1933, when the Dow rose by 40.2%. In August 1932, furthermore, the Dow rose by 34.8%.

The biggest monthly losses during that decade were almost as big. The largest came in September 1931, when the Dow lost 30.7%. These monthly changes dwarf what has been seen in the current bear market. The biggest calendar month loss so far came last October, when the Dow fell by 14.1%. The month-to-date loss for February is minus-17.2%.

To measure the magnitude of the stock market's volatility during the 1930s, I calculated the standard deviation of the Dow's monthly returns on a trailing 36-month (or three-year) basis. In mid-1933, this statistic rose to 15.4%, an extremely high number. During the current bear market, in contrast, this comparable statistic has never risen above 4.1%.

The bottom line? If we are indeed playing out a 1930s-like script, we have an incredibly wild ride ahead of us. But for those who have the intestinal fortitude to hang on, such a story would have a surprisingly happy ending.

Source.

Everyone is worried about deflation. Yet is it really coming?

One way to find out is to compare the yield of inflation-indexed bonds with those of normal government bonds. If, for example, a 10-year government bond yields 5 per cent, while a 10-year inflation-linked bond yields 3 per cent, expected inflation in 10 years time is about two per cent. This difference is known as the break-even rate. If deflation is coming, the equation is reversed. Then inflation-linked bonds need higher yields to compensate for falling payouts. The coupon on normal bonds, by contrast, remains constant, whatever prices do.

By this measure, most of Europe faces a couple of tough years. After that, it is inflation all the way. In the UK, break-evens suggest deflation is expected in 2011, with inflation shortly after, hitting 3.5 per cent by 2013. Much the same is true in France: deflation this year, with 2 per cent inflation after that. Japan looks gloomier, with deflation of about 2 per cent a year for the next decade.

However, it is the US that looks worst of all. There, the Treasury’s inflation protected securities market suggests 4 per cent deflation this year and next, with inflation barely returning in 2019, and not much in the way of rising prices for two decades after that. The 30-year US break-even rate is just 1.24 per cent.

That looks odd. The US has done more to stimulate its economy than any other country. Even in Japan, earlier this decade, deflation never rose above 1.6 per cent a year. That suggests the US index-linked bond market is out of whack. It also presents an opportunity for investors.

If Tips prices are unusually depressed, and their yields artificially high, investors should buy the bonds: where else can you get a 4.5 per cent risk-free, real yield? The same opportunity is also open to the US Treasury. Government buying would raise the price of Tips, drop their yields, shrink break-evens, and remove the deflationary expectations that bewilder so many in the market. Japan has recently bought back some of its inflation-linked bonds. Something for the Obama administration to consider. Source.