Deflation hedges

[rb]

So you're saying that Japan's deflation was due to demographics and totally non-related to the real estate/equity bubble that bursted in the early 1990s? What about the deflation in the U.S. after the Great Depression?

 

I don't know who we can look at the trillions spent globally in fiscal and monetary stimulus, which has failed to produce any respectable amount of GDP or inflation growth, and then determine that there is absolutely no deflationary threat or support for Prem's thesis.

 

Then add to that the commodities are crashing. Bond yields are cratering and were at substantially negative levels just a few months back in certain European countries. Global GDP growth is slowing. The debt overhang for the developed world is massive. And despite a tightening labor market, no sustained growth in real wages has yet occurred. Somehow, we're supposed to look at all of this information and determine that deflationary fears or totally unsupported?

 

Maybe I'm a fear-mongerer, but it certainly seems to me that the data is showing that deflation is, and has been, the predominant threat since 2009 and that the inflationary story has been BS. The creation of credit is inflationary. The unwinding of credit is deflationary. I don't know if we're into that unwinding phase yet, but when we get there you can be guaranteed that it will be deflationary with, or without, an economic shock. Considering that the globe as a whole is carrying unprecedented amounts of debt, it could certainly be a very prolonged period. Don't fail to see the forest for the trees.

 

 

Also btw, I don't know why Japan is relevant here? Fairfax doesn't have Japanese deflation hedges and the Japanese economy is very different from the western economies on which Fairfax has deflation hedges

 

I would actually say that Japan is very similar to many European countries with poor demographics, birth rates, high debt, low-growth, export driven, etc. etc. etc.

Two Cities, as promised, I'm coming back to you with some delay.

 

You bring up a lot of points so I'm going to try to address it as much as I can. So let's begin with Japan. It's harder for me to do a very deep dive with numbers on Japan because I don't have much access to Japan stats so please excuse me if I stay a bit high level. The similarities between Japan and the US are that they had real estate bubbles (in Japan it was commercial RE in the US was all RE) and that a lot of risk related to that was concentrated in the financial system. That's kind of where similarities end.

 

Japan's households are prodigious savers that's why Japan is dependent on exports. US households are prodigious consumers and got levered up. In the US households were levered up, in Japan corporates levered up. In the US you had trade deficits, in Japan you had big trade surpluses. In the US the government moved to clean up the banking system, in Japan you had zombie banks. I could go on but I'm starting to sound like George Carlin.

 

Japan had an issue where the corporates behaved like households instead of corporates, cutting investments and hoarding cash instead of issuing equity when trying to delever. Add to that the fact that they had new and fierce competition in their export markets from Korea, China and other players and you get a massive deficit in demand. The households did not step in to fill that demand gap because over there they're savers not consumers so you end up with a huge output gap and deflation. Demographics played a part too mainly on the domestic consumption side. But I'm not sure that if Japan had better demographics things would have been different. Domestic consumption over there is and has been very weak.

 

As you can see about the only comparison between Japan and the western economies is that they've had a bubble too. you mention the European economies that are export driven, bad demographics, high debt, etc. The European economy that comes closes to Japan is Germany and they didn't have a real estate bubble and the debt isn't very high.

 

Bond yields are cratering in some European countries: of note are Germany, France, Netherlands and Finland. These have more to do with the Euro crisis than inflation expectations. Basically Italians, Spaniards, and Greeks would rather have German, French, and Dutch euros rather than their own. They're willing to pay for that.

 

Further on, slowing GDP growth doesn't mean deflation, the sign of a tight labour market is inflation - so you don't have a tight labour market. Debt overhang leads to deflation if you have an uncontrolled deleveraging - the US has delivered a lot in a controlled way. Could it have been handled better? Yes. Is the risk much much lower today than in 08? Hell yes!

 

You bring up the US deflation of the 1930s. Back then the US was on the gold standard, it had a high interest rate environment in the midst of a massive economic contraction and it was running budget surpluses. Does that sound like the situation we're in today?

 

I'm not saying that high inflation is around the corner. I'm just saying that deflation is far away. Yes the creation of credit is inflationary and the reduction deflationary. But you have had a lot of credit reduction in the US with the government stepping in and closing that output gap with it's own credit. Also right now the US fiscal position looks pretty good. You will probably see US budget surpluses when the economy gets to full employment.

 

So to argue that we're at risk for inflation you have to make an economic case that there will be such a dramatic drop in demand (the kind that results in 20% unemployment or something like that) or that the US government will be forced to undergo a significant uncontrolled delevering at the sovereign level. I don't see that even remotely happening. But if you do, please make the case.

[wisdom]

RB do you believe that US has decoupled from the rest of the world?

 

If not, with inflation where it is, do you think it is possible that inflation could drop a bit lower? What if we have a recession at the same time? I do not know the answers to these and thus, cannot make a case.

 

Things can change quickly as it has been a while since the last slow down. I do not see what I lose by being cautious and prepared.

[rb]

RB do you believe that US has decoupled from the rest of the world?

 

If not, with inflation where it is, do you think it is possible that inflation could drop a bit lower? What if we have a recession at the same time? I do not know the answers to these and thus, cannot make a case.

 

Things can change quickly as it has been a while since the last slow down. I do not see what I lose by being cautious and prepared.

Wisdom,

 

I'm not saying that we cannot have a slow down or even a recession. It doesn't look like it's imminent, but no one knows these things. I'm also not saying that inflation may not drop from current level if something like that happens. Also I'm not one of those people that sees inflation around every corner. In fact I think that we'll be in a low inflation environment for a long time. What I'm saying is that there is a very big difference between disinflation and deflation. That zero barrier is very significant like the sound or gravity. The closer you get to it the harder it is to advance towards it. To fly you only need a small Cessna. To go into space you need a space ship.

 

The US also hasn't decoupled from the rest of the world more than in the past. What I was trying to convey is that the foreign sector of the US economy is not as large as for other economies. So to put it in your words I would say that the US economy is more decoupled from the rest of the world than the rest of the world is coupled to the US. Actually the way that external shocks make their way into the US is through the financial system, not through the real economy. It's true that if it's not ring fenced troubles of the financial system will make their way into the real economy but that's a whole different conversation.

 

Also to address your earlier post about household debt and revision to the mean. US household debt to gdp went from 98% in 2009 to 80% now. That's a large decrease. I couldn't quickly find a long term series for household debt to GDP, but from memory the long term average is lower but not much lower - around 50-60%. I think that household delevering in the US will still go on but we're probably not far from the end. You also have to keep in mind supply and demand for credit. The cost of credit (interest rates) are also lower than long term average so you should probably expect the that the equilibrium for levels of debt should also be higher than historical levels.

[Zorrofan]

Please explain to me how the outlook is higher now than before? The US private sector has deleveraged quite a bit and you have a decent economic recovery under way?

 

If you have an economic shock that doesn't mean deflation. To achieve deflation you will need another shock probably of a  higher than the one in 08. Just that fed may tighten a bit early doesn't mean automatic deflation. Those errors can also be reversed. If the economy slows down I think we can be pretty confident that you see QE4 coming in.

 

Given the facts it really doesn't seem like cheap insurance at all.

 

You say that 2008 relevant enough to draw conclusions from. Ok look long term and let me know what cases in history do you think are more pertinent to the present situation in the US. I would leave Japan out since their doesn't really look like the US.

 

From the 2014 Annual Report....

 

Hedging our common equity exposures has been very costly for us over the last five years – particularly in 2013.  However, we did warn you that we wanted to be safe rather than sorry – our time will come again!

We have worried about deflation in the past few years in our Annual Reports – it is now upon us! In spite of QE1, QE2 and QE3 and some twists, we saw deflation in the U.S. in the second half of 2014, as shown in the table below:

% change June –

U.S. CPI Index June  July    August September October    November December  June-Dec. 2014

                        238.3 238.3    237.9      238.0      237.4      236.2      234.8          -1.5%

 

We have had deflation at an annualized rate of 3% in the second half of 2014 in the U.S.! And it is not going

away. In fact, in January 2015, the U.S. reported its first year-over-year decline in the CPI index since 2009 of 0.1%. In Europe, we had deflation of 0.5% in the second half of 2014, as shown in the table below:

 

% change

European CPI June –

                June    July    August  September October    November December    June-Dec. 2014

              117.6    116.8    116.9    117.4        117.4      117.1        117.0              -0.5%

 

As of January 2015, 17 out of 19 countries in the Euro area were experiencing deflation on a year-over-year basis.

 

However 8 months into 2015 where is the deflation?  and at what cost?  Over $4 billion dollars plus opportunity cost.  One quick example, if FFH had not spent this money hedging it could have bought 100% of Brit, no equity issue required.

 

Here is a very interesting write up from Az Value, worth a read.....

http://azvalue.blogspot.ca/2014/04/fairfax-and-their-bets-now-looking-in.html

 

FWIW, while FFH is losing money hedging BRK is buying, investing $38 billion in PCP and another $4.4 billion in Philips 66. 

 

my $0.02

 

cheers

Zorro

 

Zorro.  Please explain where you're getting this $4 billion cost on CPI derivatives?  Nonsense.  Your spewing incorrect numbers just like AZvalue did in his post about FFH compared to BRK.  AZvalue incorrectly calculated the change in book value per share in his comparision of FFH to BRK.  Properly calculated FFH outperforms BRK in every category except 5 years.  Try again next time.

 

 

From page 20 of the Fairfax 2014 annual report......

 

In the last five years, we have had significant losses, mostly unrealized, from our hedging program and from our CPI-linked derivative contracts, as shown below:

                                                  2010          2011      2012        2013          2014              Cumulative

Equity hedges                          (936.6)        413.9    (1,005.5)  (1,982.0)    (194.5)            (3,704.7)

CPI-linked derivative contracts    28.1        (233.9)    (129.2)    (126.9)        17.7                (444.2)

Total                                        (908.5)        180.0      (1,134.7) (2,108.9)    (176.8 )          (4,148.9)

 

My nonsense as you call it comes from the annual report, try reading it before attacking someone next time....and try being civil.

[rb]

Why did you waste some many words?  You could have just said, "I'm smarter than everyone."  Are you an economist?

 

My point was there has been no, "slow overall deleveraging".  We already have deflation for everything in the CPI less shelter, see attached.  No massive changes changes needed.

Kevin,

 

As a matter of fact I am an economist. I don't know why that's relevant though. I also didn't say I was smarter than everyone, I was just addressing the points you brought up.

 

You keep saying that there has not been any slow deleveraging when the data points otherwise. You claim deflation is everywhere. It's only shelter you say, but really it's commodities that caused the negative print in 2014. See my attached graph. The thing is that inflation is a rate of change so in order to keep getting that print you need for commodities to keep dropping. There is a reason why all the central banks in the world use core cpi (cpi less food and energy) for policy decision instead of cpi.

[Guest Dazel]

http://www.realclearmarkets.com/articles/2015/01/20/why_did_no_one_predict_the_oil-price_collapse_101495.html

 

Well....Fairfax did...everyone take your models and throw in some changes. Predicting when where and how is difficult. What if the 10 year rises to 4% fro example which none of us have predicted?

 

For a cummulative $400m over many years (deflation hedge cost)....we hedge a $30 billion dollar investment portfolio...heads we win "big"...tails we lose a little over 1% over many years. That is "good' insurance.

 

We are in a taper tantrum right now higher rates hurt those with debt which is everyone. A china meltdown is happening...will they stop it? yes most likely.

 

where are we headed? "no one" knows for sure....

 

as for the equity hedges they have been a large drag...but that is why I have reinvested into Fairfax...I was bullish for the last 6 years and now I am not...but if things chug along Fairfax will do better than most because of the quality of their insurance business and their huge investment portfolio vs their market cap.

 

oh yeah and fully hedged....once again find me someone else in this  position and I will look at them...

 

P.S there should be one thread for Fairfax "earnings potential" instead of the three that are going on...putting everyones excellent thoughts into one read would be helpful for a better snap shot of where Fairfax is today.

 

Dazel

 

 

[TwoCitiesCapital]

So you're saying that Japan's deflation was due to demographics and totally non-related to the real estate/equity bubble that bursted in the early 1990s? What about the deflation in the U.S. after the Great Depression?

 

I don't know who we can look at the trillions spent globally in fiscal and monetary stimulus, which has failed to produce any respectable amount of GDP or inflation growth, and then determine that there is absolutely no deflationary threat or support for Prem's thesis.

 

Then add to that the commodities are crashing. Bond yields are cratering and were at substantially negative levels just a few months back in certain European countries. Global GDP growth is slowing. The debt overhang for the developed world is massive. And despite a tightening labor market, no sustained growth in real wages has yet occurred. Somehow, we're supposed to look at all of this information and determine that deflationary fears or totally unsupported?

 

Maybe I'm a fear-mongerer, but it certainly seems to me that the data is showing that deflation is, and has been, the predominant threat since 2009 and that the inflationary story has been BS. The creation of credit is inflationary. The unwinding of credit is deflationary. I don't know if we're into that unwinding phase yet, but when we get there you can be guaranteed that it will be deflationary with, or without, an economic shock. Considering that the globe as a whole is carrying unprecedented amounts of debt, it could certainly be a very prolonged period. Don't fail to see the forest for the trees.

 

 

Also btw, I don't know why Japan is relevant here? Fairfax doesn't have Japanese deflation hedges and the Japanese economy is very different from the western economies on which Fairfax has deflation hedges

 

I would actually say that Japan is very similar to many European countries with poor demographics, birth rates, high debt, low-growth, export driven, etc. etc. etc.

Two Cities, as promised, I'm coming back to you with some delay.

 

You bring up a lot of points so I'm going to try to address it as much as I can. So let's begin with Japan. It's harder for me to do a very deep dive with numbers on Japan because I don't have much access to Japan stats so please excuse me if I stay a bit high level. The similarities between Japan and the US are that they had real estate bubbles (in Japan it was commercial RE in the US was all RE) and that a lot of risk related to that was concentrated in the financial system. That's kind of where similarities end.

 

Japan's households are prodigious savers that's why Japan is dependent on exports. US households are prodigious consumers and got levered up. In the US households were levered up, in Japan corporates levered up. In the US you had trade deficits, in Japan you had big trade surpluses. In the US the government moved to clean up the banking system, in Japan you had zombie banks. I could go on but I'm starting to sound like George Carlin.

 

Japan had an issue where the corporates behaved like households instead of corporates, cutting investments and hoarding cash instead of issuing equity when trying to delever. Add to that the fact that they had new and fierce competition in their export markets from Korea, China and other players and you get a massive deficit in demand. The households did not step in to fill that demand gap because over there they're savers not consumers so you end up with a huge output gap and deflation. Demographics played a part too mainly on the domestic consumption side. But I'm not sure that if Japan had better demographics things would have been different. Domestic consumption over there is and has been very weak.

 

As you can see about the only comparison between Japan and the western economies is that they've had a bubble too. you mention the European economies that are export driven, bad demographics, high debt, etc. The European economy that comes closes to Japan is Germany and they didn't have a real estate bubble and the debt isn't very high.

 

Bond yields are cratering in some European countries: of note are Germany, France, Netherlands and Finland. These have more to do with the Euro crisis than inflation expectations. Basically Italians, Spaniards, and Greeks would rather have German, French, and Dutch euros rather than their own. They're willing to pay for that.

 

Further on, slowing GDP growth doesn't mean deflation, the sign of a tight labour market is inflation - so you don't have a tight labour market. Debt overhang leads to deflation if you have an uncontrolled deleveraging - the US has delivered a lot in a controlled way. Could it have been handled better? Yes. Is the risk much much lower today than in 08? Hell yes!

 

You bring up the US deflation of the 1930s. Back then the US was on the gold standard, it had a high interest rate environment in the midst of a massive economic contraction and it was running budget surpluses. Does that sound like the situation we're in today?

 

I'm not saying that high inflation is around the corner. I'm just saying that deflation is far away. Yes the creation of credit is inflationary and the reduction deflationary. But you have had a lot of credit reduction in the US with the government stepping in and closing that output gap with it's own credit. Also right now the US fiscal position looks pretty good. You will probably see US budget surpluses when the economy gets to full employment.

 

So to argue that we're at risk for inflation you have to make an economic case that there will be such a dramatic drop in demand (the kind that results in 20% unemployment or something like that) or that the US government will be forced to undergo a significant uncontrolled delevering at the sovereign level. I don't see that even remotely happening. But if you do, please make the case.

 

Let's just agree to disagree. You have all your reasons for why Japan, America, and Europe are different. I have my reason for why they're the same - a decade of massive malinvestment fueled by debt that exploded. I think the other stuff is important, but not nearly as important as this later similarity which I believe has the ability to trump the other factors.

 

I'll make money if I'm right. I'll lose money (or opportunity cost) if I'm wrong. I'm happy with the trade off and don't really need to convince others. In fact, the fewer people are convinced, the more money I stand to make if I'm right, so I'll just leave this conversation here.

 

 

[kevin4u2]

Please explain to me how the outlook is higher now than before? The US private sector has deleveraged quite a bit and you have a decent economic recovery under way?

 

If you have an economic shock that doesn't mean deflation. To achieve deflation you will need another shock probably of a  higher than the one in 08. Just that fed may tighten a bit early doesn't mean automatic deflation. Those errors can also be reversed. If the economy slows down I think we can be pretty confident that you see QE4 coming in.

 

Given the facts it really doesn't seem like cheap insurance at all.

 

You say that 2008 relevant enough to draw conclusions from. Ok look long term and let me know what cases in history do you think are more pertinent to the present situation in the US. I would leave Japan out since their doesn't really look like the US.

 

From the 2014 Annual Report....

 

Hedging our common equity exposures has been very costly for us over the last five years – particularly in 2013.  However, we did warn you that we wanted to be safe rather than sorry – our time will come again!

We have worried about deflation in the past few years in our Annual Reports – it is now upon us! In spite of QE1, QE2 and QE3 and some twists, we saw deflation in the U.S. in the second half of 2014, as shown in the table below:

% change June –

U.S. CPI Index June  July    August September October    November December  June-Dec. 2014

                        238.3 238.3    237.9      238.0      237.4      236.2      234.8          -1.5%

 

We have had deflation at an annualized rate of 3% in the second half of 2014 in the U.S.! And it is not going

away. In fact, in January 2015, the U.S. reported its first year-over-year decline in the CPI index since 2009 of 0.1%. In Europe, we had deflation of 0.5% in the second half of 2014, as shown in the table below:

 

% change

European CPI June –

                June    July    August  September October    November December    June-Dec. 2014

              117.6    116.8    116.9    117.4        117.4      117.1        117.0              -0.5%

 

As of January 2015, 17 out of 19 countries in the Euro area were experiencing deflation on a year-over-year basis.

 

However 8 months into 2015 where is the deflation?  and at what cost?  Over $4 billion dollars plus opportunity cost.  One quick example, if FFH had not spent this money hedging it could have bought 100% of Brit, no equity issue required.

 

Here is a very interesting write up from Az Value, worth a read.....

http://azvalue.blogspot.ca/2014/04/fairfax-and-their-bets-now-looking-in.html

 

FWIW, while FFH is losing money hedging BRK is buying, investing $38 billion in PCP and another $4.4 billion in Philips 66. 

 

my $0.02

 

cheers

Zorro

 

Zorro.  Please explain where you're getting this $4 billion cost on CPI derivatives?  Nonsense.  Your spewing incorrect numbers just like AZvalue did in his post about FFH compared to BRK.  AZvalue incorrectly calculated the change in book value per share in his comparision of FFH to BRK.  Properly calculated FFH outperforms BRK in every category except 5 years.  Try again next time.

 

 

From page 20 of the Fairfax 2014 annual report......

 

In the last five years, we have had significant losses, mostly unrealized, from our hedging program and from our CPI-linked derivative contracts, as shown below:

                                                  2010          2011      2012        2013          2014              Cumulative

Equity hedges                          (936.6)        413.9    (1,005.5)  (1,982.0)    (194.5)            (3,704.7)

CPI-linked derivative contracts    28.1        (233.9)    (129.2)    (126.9)        17.7                (444.2)

Total                                        (908.5)        180.0      (1,134.7) (2,108.9)    (176.8 )          (4,148.9)

 

My nonsense as you call it comes from the annual report, try reading it before attacking someone next time....and try being civil.

 

Reread your post.  Where did you say you were including the equity hedges?  This is the deflation hedges thread and all you quoted and discussed was the CPI hedges.  We are 8 months into 2015 and the costs of the CPI hedges are $444 million dollars, not $4 billion.  Now you want to include the equity hedges.  Ok, whatever.  As Dazel has pointed out this is a 1% cost spread over a number of years for insurance.  Time will tell if they will pay off. 

[rb]

http://www.realclearmarkets.com/articles/2015/01/20/why_did_no_one_predict_the_oil-price_collapse_101495.html

 

Well....Fairfax did...everyone take your models and throw in some changes. Predicting when where and how is difficult. What if the 10 year rises to 4% fro example which none of us have predicted?

 

For a cummulative $400m over many years (deflation hedge cost)....we hedge a $30 billion dollar investment portfolio...heads we win "big"...tails we lose a little over 1% over many years. That is "good' insurance.

 

We are in a taper tantrum right now higher rates hurt those with debt which is everyone. A china meltdown is happening...will they stop it? yes most likely.

 

where are we headed? "no one" knows for sure....

 

as for the equity hedges they have been a large drag...but that is why I have reinvested into Fairfax...I was bullish for the last 6 years and now I am not...but if things chug along Fairfax will do better than most because of the quality of their insurance business and their huge investment portfolio vs their market cap.

 

oh yeah and fully hedged....once again find me someone else in this  position and I will look at them...

 

P.S there should be one thread for Fairfax "earnings potential" instead of the three that are going on...putting everyones excellent thoughts into one read would be helpful for a better snap shot of where Fairfax is today.

 

Dazel

I don't see how the deflation hedges protect you if rates go to 4%. If rates go to 4% you will have a good economy and positive inflation so you're not getting anything on the deflation hedges.

[Guest Dazel]

 

RB,

 

If china was a huge seller of treasuries (as they are now) and the rest of the pack jumped in taking the rates higher to 4%.

 

the deflation hedges would like be worth$20 billion as the deflation in the U.S would be depression like.

 

 

 

[rb]

 

RB,

 

If china was a huge seller of treasuries (as they are now) and the rest of the pack jumped in taking the rates higher to 4%.

 

the deflation hedges would like be worth$20 billion as the deflation in the U.S would be depression like.

Still don't see why China selling treasuries would push rates to 4%. Are you considering the circularity of money? China sells treasuries, they get cash USD why wouldn't that cash USD find its way back into the treasuries market? It's not an accident that China has that many treasuries. They were forced to buy them because they had USD reserves from running a trade surplus with the US. If you have USD you have to buy USD assets.

 

Also you assume that the fed is just gonna sit back and watch the show as interest rates rise and cause all sorts of havoc. I think it's more realistic to assume that the fed will step in and stop that.

[roughlyright]

If I assume that Prem's theory on deflation is going to be proven correct, how can a small investor ride the coat tails of Prem?

 

I cannot buy CPI linked derivatives in the Market as a small investor. What other ways can I profit from a deflationary world?

[rb]

If I assume that Prem's theory on deflation is going to be proven correct, how can a small investor ride the coat tails of Prem?

 

I cannot buy CPI linked derivatives in the Market as a small investor. What other ways can I profit from a deflationary world?

well what I've been saying is that it looks highly unlikely that we will have a deflationary world. But if you're convinced that deflation is coming there's a ton of way to profit. The simplest way would be just long treasuries. You can create your own derivative with a long/short trade with treasuries and TIPS, or you can probably make a killing with bond options. This is just off the top of my head. I'm sure there's other ways too.

[Guest Dazel]

 

 

RB,

 

I was obviously being hypothetical  with a 4% interest rate shock and how it could freakishly happen....if I thought it was true Fairfax would  be a triple.

 

 

[Zorrofan]

Please explain to me how the outlook is higher now than before? The US private sector has deleveraged quite a bit and you have a decent economic recovery under way?

 

If you have an economic shock that doesn't mean deflation. To achieve deflation you will need another shock probably of a  higher than the one in 08. Just that fed may tighten a bit early doesn't mean automatic deflation. Those errors can also be reversed. If the economy slows down I think we can be pretty confident that you see QE4 coming in.

 

Given the facts it really doesn't seem like cheap insurance at all.

 

You say that 2008 relevant enough to draw conclusions from. Ok look long term and let me know what cases in history do you think are more pertinent to the present situation in the US. I would leave Japan out since their doesn't really look like the US.

 

From the 2014 Annual Report....

 

Hedging our common equity exposures has been very costly for us over the last five years – particularly in 2013.  However, we did warn you that we wanted to be safe rather than sorry – our time will come again!

We have worried about deflation in the past few years in our Annual Reports – it is now upon us! In spite of QE1, QE2 and QE3 and some twists, we saw deflation in the U.S. in the second half of 2014, as shown in the table below:

% change June –

U.S. CPI Index June  July    August September October    November December  June-Dec. 2014

                        238.3 238.3    237.9      238.0      237.4      236.2      234.8          -1.5%

 

We have had deflation at an annualized rate of 3% in the second half of 2014 in the U.S.! And it is not going

away. In fact, in January 2015, the U.S. reported its first year-over-year decline in the CPI index since 2009 of 0.1%. In Europe, we had deflation of 0.5% in the second half of 2014, as shown in the table below:

 

% change

European CPI June –

                June    July    August  September October    November December    June-Dec. 2014

              117.6    116.8    116.9    117.4        117.4      117.1        117.0              -0.5%

 

As of January 2015, 17 out of 19 countries in the Euro area were experiencing deflation on a year-over-year basis.

 

However 8 months into 2015 where is the deflation?  and at what cost?  Over $4 billion dollars plus opportunity cost.  One quick example, if FFH had not spent this money hedging it could have bought 100% of Brit, no equity issue required.

 

Here is a very interesting write up from Az Value, worth a read.....

http://azvalue.blogspot.ca/2014/04/fairfax-and-their-bets-now-looking-in.html

 

FWIW, while FFH is losing money hedging BRK is buying, investing $38 billion in PCP and another $4.4 billion in Philips 66. 

 

my $0.02

 

cheers

Zorro

 

Zorro.  Please explain where you're getting this $4 billion cost on CPI derivatives?  Nonsense.  Your spewing incorrect numbers just like AZvalue did in his post about FFH compared to BRK.  AZvalue incorrectly calculated the change in book value per share in his comparision of FFH to BRK.  Properly calculated FFH outperforms BRK in every category except 5 years.  Try again next time.

 

 

From page 20 of the Fairfax 2014 annual report......

 

In the last five years, we have had significant losses, mostly unrealized, from our hedging program and from our CPI-linked derivative contracts, as shown below:

                                                  2010          2011      2012        2013          2014              Cumulative

Equity hedges                          (936.6)        413.9    (1,005.5)  (1,982.0)    (194.5)            (3,704.7)

CPI-linked derivative contracts    28.1        (233.9)    (129.2)    (126.9)        17.7                (444.2)

Total                                        (908.5)        180.0      (1,134.7) (2,108.9)    (176.8 )          (4,148.9)

 

My nonsense as you call it comes from the annual report, try reading it before attacking someone next time....and try being civil.

 

Reread your post.  Where did you say you were including the equity hedges?  This is the deflation hedges thread and all you quoted and discussed was the CPI hedges.  We are 8 months into 2015 and the costs of the CPI hedges are $444 million dollars, not $4 billion.  Now you want to include the equity hedges.  Ok, whatever.  As Dazel has pointed out this is a 1% cost spread over a number of years for insurance.  Time will tell if they will pay off.

 

Clearly you did not read my original post, where I was clearly talking about the equity hedges and the CPI hedges.  But life is too short to waste time arguing with you. You want to ignore $3.6 billion in hedging losses, your choice......

[no_free_lunch]

If I assume that Prem's theory on deflation is going to be proven correct, how can a small investor ride the coat tails of Prem?

 

I cannot buy CPI linked derivatives in the Market as a small investor. What other ways can I profit from a deflationary world?

 

You would think, as rb said, that you could just buy long-dated treasuries or juice it with calls.  It makes sense but then treasury prices are flat to down since this whole thing started.  I guess China is dumping but this is just one more reason why I am suspicious of trying to time a macro event and then predict the impact on various security prices.

 

I guess if you want to go this route you could find an ETF which tracks commodities and buy puts.  Problem is most of these are already down a lot and the VIX is quite high now.

[rb]

Well roughlyright is looking for a security to profit when inflation goes negative. Right now core inflation is humming along steadily. If you would move from where we are to say -1% inflation treasuries are probably gonna jump like crazy and those call will make a lot of money. Another nice thing about the treasury calls is that you don't need actual deflation to make money. If inflation just slows down say to 0.5% treasuries will do really well. I'd say the odds are way better to have a slowdown in inflation rather than outright deflation.

[wisdom]

rb - FFH can do the same with deflation hedges. They do not need outright deflation, just the perception in the market.

[rb]

rb - FFH can do the same with deflation hedges. They do not need outright deflation, just the perception in the market.

Aren't the derivatives linked to CPI?

[wisdom]

That does not stop them from selling them - just like any other derivative. People buy and sell them based on their expectations of the future.

[kevin4u2]

rb - FFH can do the same with deflation hedges. They do not need outright deflation, just the perception in the market.

Aren't the derivatives linked to CPI?

 

The latest contracts only need CPI to be 0.5%. 

 

And no, the contracts do not need outright deflation, just like credit default swaps don't need a default.  Market perceptions will greatly influence the price. 

[rb]

rb - FFH can do the same with deflation hedges. They do not need outright deflation, just the perception in the market.

Aren't the derivatives linked to CPI?

 

The latest contracts only need CPI to be 0.5%. 

 

And no, the contracts do not need outright deflation, just like credit default swaps don't need a default.  Market perceptions will greatly influence the price.

Great! so if CPI growth drops to 0.5% they'll stop loosing money.

[Cardboard]

A major conflict or maybe even WW3, will happen well before any of this deflation thing plays out.

 

Then you have the Helicopter Ben theory.

 

Do you guys really think that world powers will let their economies unravel like Japan did for years without doing anything even if it is dangerous and stupid?

 

Cardboard

[wisdom]

I am just saying that I do not have as much confidence in authorities as you guys. I do not mind having insurance in place especially when 7 years of money printing and low rates still have not increased inflation.

 

I am fairly sure if we get a recession or slow down those hedges will be in the money pretty quick. We would not require actual deflation to take place.

 

YOu are saying you are sure we will not have deflation.

 

I am saying I am sure that we will have a dlow down at some point and FFH is likely to do well.

[rb]

I am just saying that I do not have as much confidence in authorities as you guys. I do not mind having insurance in place especially when 7 years of money printing and low rates still have not increased inflation.

 

I am fairly sure if we get a recession or slow down those hedges will be in the money pretty quick. We would not require actual deflation to take place.

 

YOu are saying you are sure we will not have deflation.

 

I am saying I am sure that we will have a dlow down at some point and FFH is likely to do well.

Actually only 11% of the notional CPI derivatives require less than 0.5% inflation to pay out. The rest require outright deflation to pay out. So wisdom please make the case of how they get in the money pretty quick. What kind of recession do you need for that to happen? How do we get that kind of a recession given current conditions?

 

Up to now your argument is basically that the deflation hedges will pay out because you say so.