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In the New York-London metroplex we’re very, very good at coming up with innovative products such as arbitrages between options and forwards on indices of baskets of collateralised debt obligations comprised of credit default swaps on other CDOs against the underlying asset.
The fundamental strategy, to separate ourselves as much as possible from the real economy, is working quite well, as reflected in our local real estate markets.
Even so, from time to time, it’s useful to look down from the pressurised cabin, even to land and make a first-hand assessment of what is going on where things are produced. It can be particularly useful at possible turning points in the economy, when the aggregated, adjusted numbers we see in the centre of the world don’t tell us enough about prospects in the real world.
I spent a few days in Texas last week, out in oil and gas country and in Houston. While Texas is anomalous, heavy with years of energy profits, the people there are close to actual production of goods and services. Houston’s trading community, which at the beginning of this decade was over-concentrated in a few large companies, has evolved and diversified. The Enron traders who weren’t caught up in criminal or civil cases make up an influential (and more careful) diaspora. I don’t know if they have a secret handshake, but they do a lot of business with each other and have accumulated a lot of new capital.
One such group has been doing a lot of work trading the inefficiencies of the forest products market. Enron itself did this before the end and the strategy was one of the ones that worked pretty well right up to when the parent’s credit disappeared. The big E would go to, say, newsprint buyers, who apparently are naive about financial matters, and sell them 10-year supplies. Then they would hedge out the price risk of the energy embedded in the newsprint, along with the price risk of the pulp and any other hedgeable risks they could identify. They were left with a high yield synthetic bond, financed with Enron’s investment grade paper. When the rating went away, so did the trade.
Enron’s forest products people were on the street with the tumbleweed. But the company’s implosion left more risks unhedged by producers and consumers out there: meat for speculators. You can see this even now in over-the-counter markets for the forest product complex which, unlike most metals and energy products, are backwardated. That is, the spot prices are higher than prices in the months further out. That used to be the case for better known commodities before excessive capital from the funds and institutions was thrown at the sector.
Before Alan Greenspan was known for making scary speeches and collecting huge advisory fees, market people knew he spent a lot of time looking at the market for cardboard boxes. Most things you use are put in a cardboard box at some point, and box use, production, inventories and pricing are, therefore, useful indicators. What is the box world telling us?
According to my Houston traders, not encouraging things. The conventional line from the Federal Reserve and the economy bulls is that the US housing market may be weak but it is beginning to stabilise, and that the rest of the economy is continuing strong. The overall recovery in growth the Fed expects later this year would make a rate cut inadvisable.
But the box story is not quite so bullish. My trader says: “Box demand has been weak for the past five months or so. In April, supposedly you saw an uptick on a year-on-year basis but, on an average weekly basis, it was still in decline. There was one extra shipping day in April 2007 compared with April 2006 and, if you take that out, box shipments actually declined this April.
“Also, when we talk to people in the field about what is going on now, they say that they are not seeing any great increase in demand and that there is no way that the producers will be able to get the increase in the containerboard price they are trying to impose.”
Still, the market for boxes and the containerboard used to make them is finely balanced. Hesitant producers and consumers are keeping low inventories, which helps to prop up prices. And there is a trend to “consolidation” in the containerboard industry, which means that a smaller number of producers may, in the future, be able to use market power to keep up prices even in a weak environment.
“One trade we’re looking at is buying the back months in containerboard,” the trader says. “It’s so backwardated that you could see a fall of $40 a tonne in prices [a typical decline in a recession] and your forward purchase would still not liquidate negative [be unprofitable].”
So is that our future: stagnant to falling real demand but sticky, cartel-like prices and opportunities for a few traders of inefficient markets?
Sounds a lot like the 1970s. Not like what we’re seeing discounted in the equity markets.