Economics – Page 15

Soft Drinks and Pseudovariety

Philip H. Howard, a professor at a university in the state of Michigan, wrote a paper dealing with the structure of the soft drink industry. He determined that when you link the variety of brands back to their parent companies, three companies controlled 89% of the scene given a retail sample in Lansing, Michigan (the state capital, metropolitan area population of approximately half a million people).

When reading the paper, strictly from an economics standpoint, leads me to ask two questions:

1. If you are invested in the industry (e.g. in Coke or Pepsi), how likely is it that the industry will continue to be entrenched as-is for the indefinite future? Warren Buffett made a large bet that it will be. How can a company such as Coca Cola destroy its own brand?

2. If you are a potential competitor to the industry, how do you break into the field and still make money? The industry is quite self-protective and will purchase or destroy competitors, as appropriate – they have plenty of tools to doing so, such as purchasing optimal shelf space at grocery chains, etc. Witness Jones Soda (Nasdaq: JSDA) for an example when you get on the radar of the majors.

Note that there are similar industries in nature – in particular, tobacco and liquor distribution come to mind. Tobacco is an industry that is almost impossible for a newcomer to break into the field because of government protection. Liquor is somewhat less restrictive, but the only real breakthroughs have been with beer and wine as opposed to hard liquor.

The US will not default

I was very curious why the markets tanked when S&P put out a notice that their credit outlook on the USA is negative. It is not like the world knew that they were incurring massive deficits and will find it mathematically impossible to bridge the gap without a political stimulus of the world turning off the capital spigot.

The USA also has the advantage of being able to print its own money, and borrow in its own money. This advantage is compared to the Eurozone countries, which cannot print Euros willy-nilly.

Instead of defaulting, it is quite apparent that the USA is choosing to inflate and dilute the value of its currency. This is not a permanent solution – they still must address the fundamental issue, mainly pouring more money out the window than taking in.

Although there will not be a default, holding US cash is a very difficult decision because its purchasing power will continue to whittle away. People have found diversification avenues in commodities, but you have to weigh in a whole bunch of other dynamics that you wouldn’t have to with plain cash – just ask investors in Uranium. Diversification is also available in real estate, but that has not been very good for US investors for the past few years – and indeed, real estate implicitly bets on the ability of the various states to enforce and respect land titles and property rights. This generally leaves the stock markets – where you can take a risk that companies will be able to maintain their cash flows, assuming the US government doesn’t tax it away to pay off their debts.

An interesting starting point is to look at your own personal consumption habits and invest to simply hedge your lifestyle consumption – for example, if you consume gasoline, purchase an oil company that has sufficient reserves. If you use a mobile phone, purchase shares in that telecom company. Assuming you are paying fair value, you will be able to offset cost increases in your consumption with equity valuation rises.

Onset of food price inflation

The best measure for food price inflation is usually through Loblaws’ quarterly releases.

In their year-end release, they have the following comment on food prices:

– the Company’s average quarterly internal retail food price index
was flat. This compared to average quarterly internal retail food
price deflation in the fourth quarter of 2009.

Anecdotal evidence by my food shopping trips to Superstore would suggest that food prices are increasing somewhat. For example, a 4 litre jug of milk is about CAD$4.40 presently, while a couple years ago it used to be around $3.90. The BC Dairy Board might have to do with this price increase. I also notice prices for bread products creeping up to around CAD$3 for a 1.5 pound loaf of good quality bread, although they do have a freshly baked 99 cent French Bread which is a very good value if you can use a knife to slice it. It has been this price for the past five years.

Staple commodities such as grains and sugar have been rising significantly over the past couple years since the economic crisis, and combining this with energy price increases, there doesn’t seem to be a way that costs can be kept down other than with removing labour costs from products. This does not bode well for employment.

Federal Reserve and the long-term bond yield

The US federal reserve today released a “business as usual” statement, leaving their short term rates between 0 to 0.25%. Most relevantly:

To promote a stronger pace of economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee decided today to continue expanding its holdings of securities as announced in November. In particular, the Committee is maintaining its existing policy of reinvesting principal payments from its securities holdings and intends to purchase $600 billion of longer-term Treasury securities by the end of the second quarter of 2011. The Committee will regularly review the pace of its securities purchases and the overall size of the asset-purchase program in light of incoming information and will adjust the program as needed to best foster maximum employment and price stability.

This QE2 (Quantitative Easing #2) capital will fund the US government’s fiscal deficit. Normally when the federal reserve purchases long-dated treasury securities, you would expect the yields of such bonds to decrease, but ever since the last imminent threat of QE2 last October, long-term bond yields have done nothing but rise. The following are 1-year charts of the 30-year and 10-year US treasury bond yields:

If these yields rise further, it affects valuations of other yield-bearing securities since these bonds are considered to be “risk-free”. In addition, the value of companies with long bonds in their portfolios will decline, and companies will be taking comprehensive losses to account for the market value decline in treasury prices.

Will interest rates rise further? Time will tell. Just be prepared for volatility.

It should also be noted that Canadian equivalents are trading at less yield than US counterparts – e.g. the Canadian 10-year note is trading at 3.27%, while the US 10-year treasury note is at 3.43%.

Speech worth reading

Take a moment to read Bank of Canada chief Mark Carney’s speech, Living with Low for Long. It gives some interesting perspective in terms of the macroeconomic and monetary policy side of the economy.

Export-related economies are “unsustainable” – this is a kick at China for sure:

This is an increasingly uneasy emergence. Growth strategies reliant on exports and excess national savings are unsustainable in the long term. In the near term, for many emerging economies, the limits to non-inflationary growth are approaching and the challenges of shadowing U.S. monetary policy are increasing.

US householders are still suffering:

Unfortunately, the best contemporary analogue to the Japanese zombie firms is probably the U.S. household sector. Problems with the foreclosure process, government programs and forbearance by lenders are all delaying the adjustments. Absent more aggressive restructuring, the impact of negative equity on one-quarter of U.S. homeowners will weigh on consumption for the foreseeable future.

Sensitivity of householders to rising unemployment is significant:

The Bank has conducted a partial stress-testing simulation to estimate the impact on household balance sheets of a hypothetical labour market shock. The results suggest that the rise in financial stress from a 3-percentage-point increase in the unemployment rate would double the proportion of loans that are in arrears three months or more. Owing to the declining affordability of housing and the increasingly stretched financial positions of households, the probability of a negative shock to property prices has risen as well.

Apparently if more people adhered to the following quotation, we might not have the 2008 financial crisis:

Similarly, financial institutions are responsible for ensuring that their clients can service their debts.

Makes you really wonder about who’s buying sovereign debt in countries clearly unable to pay it back.

And finally, when rates rise, they may rise very quickly, leading to:

More broadly, market participants should resist complacency and constantly reassess risks. Low rates today do not necessarily mean low rates tomorrow. Risk reversals when they happen can be fierce: the greater the complacency, the more brutal the reckoning.

An interesting speech. Nothing concrete, but you can infer what the Bank of Canada is guessing their tea leaves indicate.