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Freight Indices Steam Toward Recovery

Howard Simons

To turn an old Wall Street adage on its head, money walks, ship talks. Or something similar: Economic indicators, such as freight rates, tanker rates and other transportation tariffs, are useful because they are wholly devoid of speculative content.

No one will book an ocean freighter on a hunch, and that can't be said for much of market analysis.

While macroeconomic data, as reported by the government and various industry groups, continue to paint a mixed picture at best, ocean freight rates, as represented by the Baltic Dry Freight Index, a topic visited in this column before, have been rising sharply since August. This index is available on Bloomberg as BDIY Index, or you can register at the Baltic Exchange Web site.

The Freight/Rate Spread

Bond traders always are surprised at how often their market gets it right. While the stock market is supposed to be more forward-looking, I will beg to differ. As too many of us have found out the hard way, stock investors will chase a dream past the point of silliness, but bond traders have to be more circumspect.

After all, their goals more often are current income and capital preservation as opposed to growth, and oftentimes their upside is limited simply to getting their money back.

With one notable exception, the present, note yields have done a remarkable job of leading changes in the Baltic freight index over the past decade.

The Great Note-Boat Divergence of 2002

Source: Bloomberg

The present situation, in which the freight index is shooting higher, without note yields having moved higher first, is unique. It suggests that in the absence of an external force, note yields should have been moving higher months ago. Implicit in this observation is the risk of bond yields shooting higher at the first sign of this force's demise.

How Now, World Dow?

The obvious candidate for the external force is the global equity market. It's linked both to the safety premium in bonds and (allegedly) to the overall level of global macroeconomic activity. Let's compare how the Baltic freight index and the Dow Jones World Stock Market Index have tracked each other over the past decade.

Motion on the Ocean

Source: Bloomberg

The answer: surprisingly poorly. The Baltic freight index's abrupt move higher in 1994 and early 1995, a period highlighted by the Fed's seven rate hikes, a bond market massacre and the first and only economic "soft landing" in recorded history, came with no real advance in the Dow world index.

Of course, those rising interest rates had something to do with it. The fact that equities went nowhere during a period of rising rates had to mean that expected earnings were rising just as quickly.

Ships and Chips

The Baltic freight index dropped fairly rapidly from mid-1995 to late 1996, a period coinciding with the takeoff of the late-1990s megabull market. The world's central banks, led by the oh-so-brilliant Bank of Japan and our very own Federal Reserve, were pumping out liquidity. This led to financial inflation without a corresponding surge in ocean freight demands. The real growth was in information technology and telecommunications, and you can ship a byte on a beam of light.

Not until the eventual resolution of the various Asian/Russian/Brazilian/Clinton crises did the Baltic freight index move higher in pace with the world's stock markets. The freight index started to fall in late 2000, just after the last attempt to recover from the bursting of the bubble in the spring of that year.

The freight index's present (irrational?) exuberance hasn't been mirrored yet in the world's stock markets. After all, we've been getting pounded for close to three years at this point, and it's certainly reasonable to expect skepticism on the part of depleted investors. Simple fear is the most likely reason that neither stock prices nor bond yields have confirmed, to steal a phrase from Dow Theory, the freight index's rise. Other indicators, however, are pointing toward a strengthening economy and a lower risk of deflation.

What Sayeth Commodities?

Consider the Goldman Sachs Commodity Index. Of the four principal commodity indices, this index is the most heavily weighted toward energy, and therefore is subject to various seasonal and cartel distortions. But its strong correlation to the Baltic freight index since 1997 is telling.

Commodities Sail Higher

Source: Bloomberg

Both of these indices are sailing higher at the moment, and neither could do so in the absence of strong industrial demand somewhere in the world. The strong commodity performance also stands as one of the few compelling arguments against deflation at the moment.

So let's wrap all of this up as we prepare to kiss 2002 goodbye and good riddance. The Fed and other central banks have been pouring money into the system, to little avail. Bond yields have plunged, economic activity is perceived as soft, war fears abound, everyone's boss is in the slammer and Michael Jackson is still loose upon the land.

The whole situation reminds me of trying to start a charcoal barbecue by squirting on ever-greater quantities of lighter fluid. At some point, the economy will ignite and profits will abound. Money will flow abruptly from bonds to stocks, and the Fed will start to mop up liquidity in response. We'll enjoy a few strong quarters, maybe a year, in stocks before the party cools off.

Here's another bold prediction while I'm at it: Greenspan will resign near the rally's top, accept congratulations all around and leave his successor with the cleanup chores. You did hear it here first.