Capital infusion to the rescue...

There was talk earlier in the year that in the event of a stock market meltdown, the Fed would not hesitate to intervene by cutting rates aggressively just like it had done several times under the helm of Greenspan. It was also said that private equity firms had piled up a large amount of cash and were just waiting on the sidelines for the opportune moment to start buying again.
Things turned out differently, however, with a Fed under Bernanke hesitant to cut rates more energetically due to concern with regards to inflation. Private equity also stalled somewhat as the ensuing credit crunch took its toll on their ability to borrow cheaply. For a moment it seemed that there would be no way of averting a full blown sell off as the notion of an embedded put option seemed more of a fallacy than anything else. The situation changed, however, as large financial institutions began to disclose their large subprime related write offs. Suddenly, we saw cash infusion offers coming from Asia and the Middle East. Morgan Stanley, Citi, UBS and Merrill all received offers of cash in exchange for a stake. It seems that the embedded put option is very much alive.
This pattern also highlights an exchange that can only increase in importance in time. Emerging markets with their young population and large cash reserves are hungry for investment opportunities in contrast to developed nations with their aging populations and large deficits and an increasing willingness to sell their bonds and stocks to finance their retirement.

Behind the curve?

There is growing concern amongst market pundits that the Fed under Bernanke's helm is not doing enough to counter the economic troubles ahead. Since the Fed first took action after the subprime crisis earlier in the year, a very distinct style and one in sharp contrast to the former chariman's has emerged. Academic and consensus based are two keywords that aptly describe Bernanke's fine tuning style and although it may be appropriate in times of relative calm, it does not seem suitable in an environment of turmoil. It is also in sharp contrast to the quick and dirty or more authoritarian style of Greenspan who did not hesitate to take radical action in times of duress. He has, for example, received credit for averting a deeper recession from the internet bubble.
Nevertheless, navigating in the current crisis is proving to be extremely challenging (even Greenspan recently remarked that the current environment is probably the most difficult he has ever observed) not only because of the two forces (inflation and growth) moving in opposite directions but also because unlike previous downturns, the origins of the current one is the credit market and the extent of the damage is still difficult to asses with any degree of accuracy due to the opaque nature of the instruments behind the subprime boom of earlier years. Most recent inflation figures are indicating the beginnings of a surge which in a way restricts the Fed's room for maneuver on the side of easing.
What is clear is that the market have so far been disappointed with the way in which the Fed is handling the crisis. The most recent 25 basis point cut in the discount window was perceived as just a symbolic move and nothing else. Yesterday's announcement of a proposal of introducing more stringent rules on mortgage borrowing is also seen as not enough to curb the crisis. Time is of the essence and every mistake now will incur a large penalty later.

Too little, too late?

That is at least what the markets seem to be signalling after the FOMC decision to cut the key target rate and the discount rate by 25 basis points each and announce a change in focus from the more balanced growth and inflation worries to growth worries only.
The Fed's behavior since it first started taking action in August suggest a reluctance to ally market fears that the risk of an economic slowdown is greater than that of a surge in inflation. The Fed seems more concerned that further cuts will fuel a rise in inflation. From their remarks, they also seem to be confident that fine tuning on various fronts (key rate, discount window, extension of loan periods etc) in coming weeks and months will suffice to calm credit markets thereby averting a full blown recession. Markets clearly disagree, some economists going as far as suggesting that a recession may already be under way.
Nevertheless, there seems to have been a shift in strategy within the Fed as nine out of the ten voting members voted in favor of the 25 basis point cut (the dissenting voice was in favor of a 50 basis point cut) in contrast with the prior meeting in October in which the only dissenting voice was in favor of keeping rates steady.
As the economy continues to suffer in an environment in which borrowing is becoming increasingly difficult and costly, the impact that is already being felt amongst businesses will eventually trickle down to consumers (that are already feeling the strain of the housing recession and rising commodity prices). In other words time is of essence if the Fed has any chance of averting a more severe downturn in growth.

Markets in a state of euphoria...

It has been a week of revived optimism as upbeat economic releases (better than expected productivity figures compounded by lower than expected unit labor costs and a stronger than expected rise in employment) congregated with a government plan to put a stop to the subprime hemorrhage and the near certainty of another quarter point cut next week.
These events sent global stock markets higher as the risk of a full blown recession in the U.S. somewhat receded. Oil prices dropped as tensions between the U.S. and Iran subsided and treasuries receded as the probability of a larger Fed rate cut diminished and more money poured back into stocks.
The buzz is unlikely to last very long, however, as most of the economic indicators provide a snapshot of the past making an assessment of the current state of the economy nothing more than a wild guessing game. As far as indicators go, the 3 month Libor to 3 month t-bill spread still remains relatively high, suggesting that there still remains a significant amount of distrust and uncertainty plaguing the credit markets. The subprime mess is far from being resolved and another cut in interest rates will also raise the risk of inflation in the future (as the current shape of the treasury yield curve would suggest).

The housing dilemma...

Housing has been at the center stage of the current economic crisis ever since the sub prime blowup of August. Apart from the fact that pretty much every indicator out there suggests that the real estate market in the U.S. is in a recession, there is growing concern that the worst is still to come and the implications of this on the rest of the economy. The worry is clearly regarding the risk of contagion or a spillover. So far nothing would suggest that the damage is spreading beyond the housing borders but this could very well be because of a lag factor. Studies suggest, for example, that for every 100 dollar drop in financial wealth, the consumer will spend from between 2 to 5 dollars less on consumption. For every 100 dollar drop in housing, on the other hand, consumption drops between 5 and 9 dollars. Apart from the difference in the drop in consumption, it has been shown that the effect of a drop in financial wealth is pretty much immediate, in contrast to a drop in the price of housing in which there tends to be a clear lag (sometimes substantial) before it translates into less consumption. Hence, this could explain why consumption has not retracted despite falling prices. Considering that consumers make up roughly 70% of GDP, this is a very big deal (and unlikely to be offset by exports or a so far resilient stock market).
Considering a stock market that is still in the black for the year and gasoline prices that have yet to reflect the sharp rise in oil, the housing slump on its own wont cause much damage. But if we factor in a possible scenario in which there is a sharp correction in the stock markets, more credit tightening across the board and a sharp rise in gasoline prices (which is bound to occur if oil continues to hover around $100), things could rapidly turn ugly.

Staying the course...

If we take the definition of a bear market, which is a stock market drop of at least 20% in a 12 month period, Japan, or more specifically the Topix index should in fact be considered to have entered bear territory. This is bearish news indeed, considering Japan happens to be the second largest economy in the world! What about China, where the Shenzhen index has shed close to 18% from it's peak? If the index breaks the 20% barrier would that be considered a bear market (considering that from trough to peak this year it has returned close to 176%)?
Irrespective of the debate on how to detect a bear market it has been demonstrated time and again that during periods of crisis (like the one the global markets are currently experiencing), emotions tend to override rationality. It comes as no surprise considering that our ancestors used these very behavioral attributes very effectively for survival. Employing them in investing, however, has proven to be highly destructive. Take the '87 crash as an example. The stock market correction sparked a bond market rally (similar but more pronounced than today). Most investors that held on to their stock portfolios right after the crash eventually gave up and switched their investments into bonds more or less around the time when the bond market rally peaked. What resulted was a double carnage for not only did they lose a large chunk of value from their stock holdings but, right after the switch, when stocks picked up and the bond rally ended, they experienced a further erosion of their wealth. The lessons to be learned from this is to avoid being overwhelmed by our emotions in difficult times, to stay the course by focusing on the longer term objectives and rebalance whenever necessary.

Options on the table...

We know that Fed has two mandates (both enacted by congress) which may be broadly defined as insuring market stability to maintain unemployment at its natural rate (whatever that may be) and price stability to ensure that inflation is basically tamed. History also shows us that, at times, the economy may find itself in a position whereby on the one hand we have deteriorating market conditions with unemployment rising and, on the other hand, there are signs of inflationary pressure. Stagflation is usually the term coined to describe an environment in which there is rising inflation combined with stagnant growth and rising unemployment (a prelude to a recession). The U.K. experienced stagflation in the 60's and 70's whilst the U.S. economy was in stagflation during the Carter administration of the 70's. The reason why is so dreaded by governments and central banks is because the main tools at their disposal, namely fiscal and monetary policy become ineffective. This is not to say that the U.S. is in a stagflationary state or that it is heading in that direction (the world has evolved so much and the same principals may not apply anymore). But it is clear that the Fed is having to make a difficult choice between providing market stability and capping inflationary pressure. Right now they are erring on the side of market stability to avert the risk of a recession. We could argue that they are walking a thin line because not only do they need to fine tune between the employment/inflation trade off, but, now that they are leaning towards the side of providing market stability they need to concern themselves between the market stability/moral hazard trade off. Market stability will indeed raise the probability of averting a full blown recession, but it will most likely come at a price in the form of more reckless activity amongst market participants once the stability sets in. These are indeed very challenging times for Bernanke and his crew!

Running out of oxygen

It is awkward to observe a resilient stock market in the wake of a substantially weakened dollar and record oil and gold prices. We can explain the record in gold prices by not only the imbalances in demand/supply (fuelled by growing consumption coming from commodity rich nations and India and also from growing use of this commodity in manufacturing) but also as a result of its traditional role as a refuge investment (currently boosted by the shrinking dollar and the growing pessimism on the economy). Oil prices, on the other hand, are dictated not only by demand/supply imbalances and speculation, but also by a geopolitical risk premium. This risk premium is playing an increasingly important role in explaining oil price fluctuations, considering the emergence and growing importance of Russia, Iran and Venezuela (all three amongst the top five petroleum producers) forming an increasingly confrontational alliance against the U.S. and, to a lesser extent, Europe.
With the level 3 assets issue looming as the latest twist in the subprime/credit crunch debacle and a consumer market feeling increasingly squeezed by rising costs and a shrinking wealth effect, it is difficult to maintain an optimistic view with regards to the economy. Even the hope of a possible decoupling combined with a heavily depreciated dollar coming to the rescue stands on shaky grounds considering the insane market multiples as observed in China and elsewhere. One could argue that we have not as yet reached the apex of the current crisis.

The Fed in observation mode...

Yesterday's quarter point cut was very much in line with market expectations, reflecting a Fed that, although remaining weary of the risk of a housing spillover, was reacting more to the build up in anticipation in markets that are still reeling from the July-August shock. With the most recent economic releases suggesting more inflationary risk (tight labor markets, high capacity utilization and a surprisingly strong third quarter GDP) to come and a weak dollar with oil trading at record levels, the Fed took the opportunity to clarify its stance as to the future direction of rates. The message was there was far too much uncertainty in the markets and that the future direction of rates would depend on how the current crisis unfolds.
Although the housing slump seems to be contained for the time being, tightening lending standards and higher gasoline prices at the pump are bound to influence spending patterns. To counter this we have the weaker dollar combined with healthier growth outside of the U.S. but there is talk that certain emerging markets, most notably China, are entering or are already in a bubble. The longer this remains true, the more difficult it will become to engineer a soft landing.

A question of multiples...

Last Friday's sharp correction in the markets to commemorate the 20 year anniversary of black Monday reflects growing unease on the earnings momentum front. Just when the markets were thinking that the worst was behind us, disappointment in earnings forecasts reared its ugly head. Although the markets have surged pretty much consistently since 2002, roughly doubling in value, earnings have followed suit, keeping multiples steady at reasonable levels. The risk at this stage, however, is that the continued trouble in the housing market, record commodity prices, dwindling productivity and a possible slump in consumer spending begins to eat into earnings. Some analysts are betting on the more sanguine environment outside of the U.S. combined with the decoupling theme to come to the rescue. It is, however, important to heed the warning signs of an overheating Chinese market, trading at sky high multiples, and growing pressure for an appreciation of the currency. The futures market is already pricing a 25 basis point Fed ease for its next meeting at the end of the month.

The sick dollar...

Even on a trade weighted basis, the dollars steady descent, losing 35% of its value since its peak at the end of 2001 is impressive. Certainly the perceived global GDP decoupling and the resulting current and anticipated widening differential in interest rates with the rest of the world explains to some extent the relentless depreciation. We could also argue that, despite the official view in support for a stronger dollar amongst politicians in the U.S. and elsewhere, a weaker dollar may actually be more attractive. It helps narrow the current account deficit, pending a "j" curve effect lag, makes interest payments in other currencies cheaper, and may be a good idea considering that with the housing downturn and gasoline at record prices, U.S. consumers are starting to feel the pinch, pushing them towards savings. On the longer run (and here I am thinking of a horizon of 3 to 5 years), the dollar is set to appreciate mainly as a result of demographics. Amongst developed nations, the U.S. has one of the youngest populations, in stark contrast to Europe, and to a greater extent, Japan. Current account deteriorations, as the trend moves from production to consumption, is likely to be more pronounced in countries that have a greater percentage of retirees. These will also be the countries that will see the largest inflows in capital as their financial instruments become increasingly attractive to developing nations seeking a stake in world class firms.

A blip?

Today's September headline PPI and retail sales figures, that came out above market expectations, would suggest that inflation risk remains high. It would seem that record oil prices and a weakening dollar is trickling into the economy but it is future results of the lagged core figures that will determine the true extent of damage. This, together with record breaking performance in the stock market should weaken the impetus for any further rate cuts and switch the Fed's focus back onto the inflation front. Ever since the turbulence in August, equities have shown a remarkable degree of resilience to the subprime/liquidity crisis thanks to a greater share of corporate earnings coming from export markets (which benefit from stronger growth in the global economy), the perception that bad news is behind us with the release of Q3 earnings for the financials sector and recent fed action reflecting a clear willingness to contain the housing woes.
Next week's releases which will include CPI, industrial production and housing data should provide us with a clearer picture on the health of the economy.

Decoupling and decorrelation...

If we were to take a snapshot of the global economy 10 years ago and today, one observation might be that the world depends less on the U.S. for growth today than at any time in the past. It can be argued that with globalization, greater integration between economies have led to an acceleration in development and a dramatic improvement in standards of living. Countries like China and India now have distinct middle classes which means that there is less dependence on the vagaries of trade. In the E.U., the last decade has brought about a marked improvement in economic integration. The costly burden of absorbing East Germany is a thing of the past. It use to be that higher oil prices would have a chocking effect on consumption, but today, thanks to greater integration, a more sophisticated financial system and fewer barriers to entry, we get more trade and investments. With the gradual decoupling of these new economic zones it is very possible that we will eventually observe a drop in correlation. In fact this is what seems to be occurring at present considering that the U.S. is heading towards weaker growth whilst the rest of the world continues to roar ahead. Correlation is not static mind you, it varies over time and a sudden shock (like the one we witness with China at the end of February this year) can lead to a dramatic surge in correlations. But with gradual decoupling, in times of economic shock to a particular region, it is possible that the correlation spike will become less pronounced. Only time will tell.

A step closer to stagflation?

Last week's 50 basis point cut revived fears of a surge in inflation as it took place in an environment in which commodity prices are surging and the dollar continues to weaken. This is evident in the yield curve, which, from the beginning of the year has shifted from being inverted to becoming normal or upward slanting. It would suggest that the market is pricing in a future surge in inflation. But it is not as straight forward as it seems because we are in a precarious environment of recovery from the subprime/short term liquidity shock. The Fed's use of the federal funds rate, the most prized weapon from its arsenal of instruments, leaves it with fewer tools with which to manage the crisis. The worry is that this 50 basis point cut may not suffice given the downward pressure that would arise if consumers battered by shrinking home prices and higher gasoline prices decided to cut on spending, prompting further cuts by the Fed.
On a side note, the crisis may be providing an opportunity for buyout activity and we are seeing signs of this with the news that Warren Buffet may be looking into purchasing a stake of Bear Stearns.

The Fed's risky gambit

Yesterday's 50 basis point cut took the markets by surprise, sending a clear message that the Fed had nailed the coffin on it's inflation bias and was now clearly more preoccupied by the mortgage/liquidity crisis and its potential impact on growth rather than on a possible surge in inflation. Last week's gloomy labor figures and yesterday's weaker than expected PPI release seems to have emboldened the case for more aggressive cuts. On the flip side of the coin the combined effect of the rate cut, oil at record levels and a steadily weakening dollar is bound to raise the risks on the inflation front.
Next in line are the financials sector earnings results which should provide us a clearer picture on the extent of damage from the sub prime crises. Lehman's better than expected results gives reason for hope for the rest of the industry but all this could very rapidly turn sour by just one disappointment. The market environment remains precarious and this is reflected in the high volatility levels.

The absolute return fallacy and the black swan revisited

The definition of absolute return, a term originally coined by the managers of the Yale endowment fund, refers to an investment instrument that is expected to provide positive returns irrespective of market conditions. In other words, it should be uncorrelated to market swings. Ever since the collapse of LTCM, however, the whole premise on which this concept lies has been put into doubt. The systemic backlash from what started off as a relatively benign and contained issue within the subprime space proves that there is a major failure in the modelling of risk for certain types of products. How else can one explain the bewilderment of managers? The ever so common excuse of late is that they were caught by surprise, that it was the first time that such a thing had occured and therefore they were unprepared for the consequences of such an event. It begs the question as to why they were unprepared or, more precisely, why they did not include such a scenario into their models in the first place? It is worrying enough to note that according to a recent Wall Street Journal article, the average return of hedge funds for the month of August was more than minus 1 percent (more than minus 2 percent for fund of funds). What is more telling, however, is that the average reflects only 40% of the total because the rest of them have not yet published their results and the delay could indicate far worse results ahead. Blaming systemic risk or an unprecedented chain of events is frankly not a justifiable excuse, particularly for an industry that is reputed for its exorbitant fees.

Navigating without a compass...

Earlier this year when the sharp rise in subprime delinquencies were announced, it was largely shrugged off by the markets due to the relatively small size of the submprime market in comparison to the rest of the mortgage industry. The risk of contagion was thought to be minute as the problems appeared to be specific to this particular segment of the market. What was not taken into consideration, however, was the widespread use of leverage across the board, fuelled by record low borrowing rates, reckless lending and the competitive pressure to generate higher returns in an environment of performance compression. The potent cocktail of illiquid investments and the heavy use of leverage led to a sharp selloff in August, prompting central bank intervention to restore normalcy. As calm returned, it became quickly evident that it would not last long as the core problem was far from being resolved.
The markets are in effect navigating without a compass as nobody has a full grasp of the extent of contagion. This is a result of the lag in reporting not only with regards to certain types of investment vehicles such as hedge funds (some of which are heavily exposed to the subprime market) , but also economic releases, a key barometer for the health of the economy. Today's negative U.S. employment figures for August are a good example of the lag. Reporting for the month of August (ground zero) is just beginning to surface now which means that we can expect more turbulence on the horizon.

Bernanke put to the test...

It seems that Fed action has failed to convince the market that the worst of the debt crisis is behind us and that it is doing its utmost to fix the problem. Indeed, the volatility index shot back up, short term treasury yields plummeted and stock markets were trading lower. But this only lasted a day which leads one to wonder whether what we are witnessing here are a series of aftershocks that should subside in time or the prelude to yet another major jolt. Considering that there are a large number of investments for which their August performances to date remain unknown and that, as a result, we are likely to face more bad news, it seems prudent to anticipate more turbulence ahead. The Fed's confidence building measures have clearly helped sooth tensions, but it is increasingly perceived as too little too late. Too little because we expect more turbulence in coming weeks and months and too late because three days before all hell broke loose, the Fed stated that it was more preoccupied with inflation than with the sub prime debacle. At present the markets are factoring in a quarter point cut to occur anytime between now and the next Fed meeting on the 18th of September and, with the recent jump in long term treasury yields, seem to believe that Fed policy has shifted away from an inflationary bias.

After the storm...

Thanks to the concerted efforts of central bank cash injections and the Fed's decision to cut its discount window by half a percent, extend loans to as much as a month and make it clear that even sub prime paper would be accepted as collateral, things look like they are going back to normal. The root of the current crises stems from the innovative changes in the way in which debt is created. Over the last decade we have seen an explosion in the issuance of asset backed securities whereby a relatively illiquid market of loans against some type of collateral are pooled together, divided into quality tranches and securitized. This has worked wonders for those who have traditionally had difficulty in obtaining financing. It has also proved beneficial to investors by allowing them to tap into new market segments in a risk controlled manner (given that many borrowers are pooled together and therefore diversified). But these instruments carry a large drawback in the form of a lack of transparency. The investors do not know what percentage of what they hold will default. That might not matter when things are going well. But when you have a problem such as the recent sudden surge in delinquencies in a sub prime market that came about because lenders, who got accustomed to a low interest rate environment, got carried away with their lending, things can very rapidly turn sour. Liquidity dried up almost instantly because the lender did not know if the borrower was exposed to this toxic market. Confidence was also eroded with the collapse of the Bear Stearns hedge funds considering they had very high ratings. It will be interesting to see if this time around the Fed will take any measures to improve transparency.

A meltdown?

The recent global market slide sparked by fears of a looming credit crunch might very well be the first stages of the so called great unwind. Investors were taken by surprise, especially those that were under the impression of being hedged against this very type of loss. It just comes to show that complex derivative strategies don't always perform as expected.
There are signs that we may be entering a protracted slowdown phase for the global economy. We all recognize the beneficial effects of globalization on growth, especially in terms of its disinflationary impact. If we take the recent past as an example, another beneficial effect seems to be longer lasting economic cycles. What use to be 7 to 8 years of expansion before a recession now seems to last in the range of 9 to 10 years. Greater coordination between central banks and a more prudent approach to monetary policy clearly play a role in this.
But there are signs that the party is coming to a close. As yields worldwide continue to rise, the housing woes will continue to deteriorate. Since consumers perceive housing in a similar manner to stocks, this will invariably have a negative impact on the wealth effect in addition to the effect of higher food and energy prices. Eventually, the yield curve may reinvert. That in itself is not enough to suggest a looming recession. For that to happen, we also need to add rapidly deteriorating credit spreads (something that seems to be occurring at the moment).

The volatility factor

The slide in global markets over the last two weeks were precipitated by markedly higher volatility levels which first spiked when Chinese woes sent stocks on a tailspin back in February last. Higher volatility inflate risk premiums (no wonder it figures in the Black and Scholes option pricing model) creating havoc for certain segments of the markets. More volatility can also be a good thing, depending on how you are structured. With a sudden jump in the vix index, one of the first reactions tends to be a general flight to quality and the most recent market turmoil is a perfect example of this. Credit spreads have widened substantially as money has poured out of corporate and high yield bonds towards the safety of treasuries. There is also a move out of riskier emerging market stocks towards those of developed markets. We can add to this the switch from small cap to large cap although part of it is related to the advanced stage of the cycle. Finally, there tends to be sector rotation in favor of defensive industries such as consumer staples or health care during periods of high volatility.

Whiplashed into submission

1.3 trillion dollars of market value evaporated into thin air over the week as a result of a flurry of bad news (in an almost coordinated fashion) hitting investors by materially denting their appetite for risk. Disappointing German business confidence figures was followed by weaker than expected U.S. durable goods orders and new home sales, and an unexpected earnings disappointment for Exxon Mobil Corp., triggering a global equity sell off. The prevailing mood was one of pessimism as investors began contemplating the effects of a protracted housing slump and markedly higher borrowing costs on businesses, consumption and ultimately growth. The downward revision in risk premiums and the ensuing flight to quality led to a rally in treasuries, a further widening of credit spreads across the board and the unwinding of carry trades. It also led to several big ticket debt issuance postponements as borrowers began to asses the impact of an increasingly expensive corporate credit market. Volatility, which had been on an uptrend ever since the China related turbulence of late February jumped up again as a result of these events. The gloom is also reflected in the the futures market for the federal funds rate which is at the moment anticipating a quarter point cut by the end of the year with a conviction of 100%.

The fed in a state of benign paralysis?

Reading the tea leaves of Bernanke's recent comments, it seems that we are in for a protracted period of inaction on behalf the fed's target rate (well, technically, its protracted already considering that it has been a year since the fed put an end to its tightening policy). The housing slump shows no end in sight but at the same time there is growing fears that ever so costly food and oil will eventually trigger a jump in inflation expectations. Not that there is anything wrong with sitting tight when it comes to rates. When visibility is poor and when you have two forces pulling in opposite directions as seems to be the case at the moment, doing nothing may very well be the prudent thing to do! Not that we are in the midst of a stagflationary slump considering the relatively strong growth rates and an inflation level that is considered tamed. There has been some criticism of the Fed for prioritizing the core inflation figures at the expense of the headline rate. The original reason behind switching from headline to core was to remove the excess volatility that food and oil contributed to the figures. But things have changed since, with food and oil prices more stable and hence the flak directed towards the fed. The counter argument has been that even with more stable prices, the ultimate measure might still be the core because its only if the core is rising that we know that the rise in oil or food prices have trickled into the rest of the economy. Maybe we should have a compromise, say a dynamically weighted composite of the two measures? Or maybe even invent a new measure? Food for thought, I guess.

A subprime contagion waiting to happen

Markets were once again jolted this week as the sub prime related losses were compounded by the rating agencies decision to downgrade securities backed by this rapidly disintegrating segment of the housing market. The move, albeit a bit late, did send a strong message to the investment community that the size and duration of losses may have been (surprise, surprise) underestimated. This will evidently exacerbate the problem as it means higher lending rates and tighter rules to an already fragile base. The growing risk of contagion triggered a two day stock market sell off, raised treasury bond prices, widened credit spreads across the board and pushed the dollar lower versus other major currencies. Bears clearly had the upper hand over the week, reviving bets that a cut would be the Fed's next move. On a brighter note, trade balance figures for May were spot on with expectations, providing some short term relief for the dollar whilst initial jobless claims came out weaker than expected, signalling continued strength in the economy. Of course, it is common knowledge that economic figures provide a snapshot of the past and are typically subject to revision meaning that we don't really have a full grasp as to the current health of the economy.

Into the abyss

Fears on inflation were revived today with the bank of England's decision to tighten its key rate by a quarter point, sending the pound to a 26 year high versus the dollar on the back of continued strength in the financial services industry and rising home values. This was followed by ECB comments suggesting a bias towards tightening. As if it weren't enough to rock the inflation boat, U.S. service industries and the private jobs report posted stronger than expected results sending treasuries lower.
With the services industries providing a counter balance to manufacturing (turned sour by the sub prime debacle), the impact on employment may be just what is needed to keep household consumption on track. On the other hand we have the so called paradigm shift, in effect putting us in uncharted territory which makes it excessively difficult to predict how things will unfold. The growing interdependency amongst various economies and the increasing complexity and sophistication of financial instruments makes it more and more difficult to grasp the full extent of risks in the market. Warren Buffet's adage of avoiding what can't be understood may be appropriate at this stage.

A growing case for tightening

The proponents of a Fed rate cut point at the ongoing housing debacle, rising interest rates and commodity prices which they are argue are threatening to stifle consumer and business spending. On the other hand buoyant corporate profits, rising energy and food prices and strong global growth threatens to spillover in the form of higher inflation, warranting an eventual tightening of rates. Until recently, the bears had the upper hand, forecasting a fed rate cut before the end of the year but things have changed recently with the concerted global central bank effort to hike rates, indicating growing fears on inflation. Energy prices have been on an uptrend, coming within close range of last year’s records as a result of a combination of ever so stronger demand and tighter supplies. A catastrophic hurricane season over the summer is all it may take to push prices above last years record. Food prices have also been on an uptrend mainly as a result of growing demand for bio fuels. With U.S. legislation moving towards tighter environmental standards as a result of a combination of greater awareness of the issues at stake and the upcoming presidential elections, the move to alternative sources of energy will only exacerbate the short term pressure on food prices. As the correlation between headline and core inflation measures are relatively high (roughly 0.75 going back to the early 90’s) and as there tends to be a 6 month lag on average between the two measures, it is only a question of time before the jump in food and energy prices impact the core figures. As a result of this, the market is predicting a possible tightening by the fed no later than the first quarter of 2008.

The bears steal the show

Last week's interest rate jolt, reflecting a global expansion running at full steam seems to be overshadowed by the continued rise in crude oil prices (rapidly coming within range of last year's record level) and today's drop in housing starts, signalling that we may still have some way to go with the housing debacle. As mentioned earlier, rising interest rates (particularly at the real estate sensitive 10 year segment) is bound to exacerbate an already difficult condition. The corporate sector, which has seen a pickup of late is also likely to be hurt by higher rates.
So it seems that the bulls on the street, the one's that have been dismissing fed cuts for the year, may have been a bit premature with their assessments. It will take some time still before we get a clear picture, considering the multitude of competing factors swaying the economy in one direction or the other. What seems almost certain, however, is that the all important consumer is being battered on several fronts and, unless we see a radical change in this, the economy will undoubtedly suffer.

Yield curve under siege?

In the last couple of weeks we have witnessed a dramatic change in the shape of the U.S. yield curve which has shifted from being inverted to upward sloping. In previous cycles, an inverted yield curve was an almost perfect predictor of an impeding recession, but this time around, despite the slowdown in the U.S., a full blown recession is unlikely (although a fat tail event that would trigger the "great unwind" is not altogether impossible). Again, we can credit the paradigm shift for the shape of the yield curve, the recent sell off in the fixed income market reflects growing concerns on global growth and the rising risk of inflation. Normally, the yield curve should reflect the health of the local economy (especially in the U.S. which still commands the largest economy in the world), but instead what we are seeing here is a yield curve that is moving in sync with others so that it can remain competitive (not surprising considering that the U.S. is a net debtor nation and imports significantly more than it exports). The worry here is that if the yield curve continues rising, it could precipitate the slowdown by introducing further strains into the already battered housing market, make it more expensive for businesses to borrow and apply the breaks on the bustling LBO activity. With the amount of unquantifiable leverage circulating, a catastrophic "great unwind" could well be within reach.

Another perfect storm?

The surprise Kiwi tightening coming on the wake of the ECB rate hike triggered a sell off in fixed income markets as investors embraced themselves for the potential of additional hikes reflecting the strength in the global expansion and a rising risk for inflation. Markets were palpably nervous with the changing environment, leading to a jump in the volatility index (similar in impact to the Chinese triggered global stock market sell off at the end of February) and a drop in stock markets. Rising bond yields and a resulting shift in their relative attractiveness was another factor behind the sell off in equities. In the U.S., signs of a pick up in economic activity and better than expected trade balance figures were additional contributing factors that helped push the 10 year benchmark yield above the 5% psychological barrier. One clear impact of the rise in yields is it's corrosive effect on the yen and the Swiss franc resulting from the growing attractiveness of the carry trade.

Housing slump expected to drag on...

According to comments made by Bernanke, the sub prime debacle will continue to drag the economy for some time to come as a result of the "knee jerk" reaction of more restrictive lending policies for this segment. Indeed, there has been a strong drop in new construction and building permits lately. There is also a risk that this overflows into other segments. If we also take into consideration that the most recent core inflation figures remain above the 1 to 2% comfort zone, it effectively means that we will not be seeing any Fed interest rate action for a while, possibly not until early next year. One scenario (the most ideal one for the Fed) is that the slowdown is enough on its own to drag the core rate below 2% so that the Fed can shift from a tightening to a loosening bias and focus on employment. Apart from the housing market, capex and consumption are showing signs of weakness. On the other hand the weaker dollar and strong global expansion are factors that counter the drag on U.S. growth. The next few weeks and months should provide us with a better idea on which of the two counter forces end up dominating.

The housing market and beyond...

Although we saw the large pickup in U.S. new home sales for April, the ensuing figures on existing home sales were clearly less stellar. The short term boost in new home sales reflects a relatively strong economy and comes as builders have been aggressively cutting prices to stimulate demand. The sub prime debacle is unlikely to go away any time soon considering that more than three quarters of mortgages were negotiated on adjustable rates which means that borrowers will sooner of later have to pay higher monthly rates, raising the likelihood of further bankruptcies.
Japan, another economy in crossroads, has had more positive news lately with the unemployment rate dropping to a record 3.8% (second lowest amongst developed nations) and sings that consumption is picking up. This bodes well for the BOJ that are itching for a reason to hike rates further. Wages are not expected to pick up dramatically, however, as the ageing and more expensive pool of retirees are being replaced by younger and cheaper graduates.

A black swan in our midst?

A series of related factors have led to what seems to be a permanent change in the global economic landscape. The ideological shift towards liberalism at the end of the 80's resulted in the release of a huge supply of untapped cheap and in some cases skilled labor, prompting firms in developed nations to increasingly relocate production to new emerging players, leading to a long term boost in profit margins that continue to exhibit a surprising degree of resilience to the vagaries of the markets. Tapping into this new supply of cheap labor combined with improvements in inflation targeting and coordination by central banks also explains to a certain extent why inflation has remained relatively tamed despite cyclical and exogenous pressures. Technological leaps in communications such as the advent of the internet in an environment of successive deregulation, the gradual dissolution of trade barriers and dramatic improvements in capital flows have been conducive in providing an almost limitless source of liquidity coming from emerging nations with large savings towards debtor nations such as the U.S. The rapidly changing landscape has also led to an explosion in financial innovations providing greater access to capital and improved risk control. This is not to say that the risk to economic growth in this new environment has been reduced or eliminated altogether. Trade imbalances in both capital and goods continue to widen whilst the average U.S. consumer's spending habits are increasingly challenged by rising fuel prices, a weakening dollar and the ongoing housing debacle.

Steering in fog

If we look at last week's PPI figures and today's CPI results, inflation fears should be receding. The Fed has made its position clear by stating that although its policy retains an inflation bias, it is well aware that the economy is slowing down and is hoping that this will be sufficient to contain inflation. It is a tricky game because the other statistic that the Fed is particularly sensitive to is unemployment, and recent figures paint a deteriorating picture on this front. As we mentioned earlier, in the current environment, Fed policy is at crossroads. On the one hand, they can't really tighten any further as the economic slowdown continues to unravel. On the other hand, they can't loosen as long as core inflation is above the 2% upper limit of their comfort zone. With gasoline prices where they are and as the housing slump continues to take it's toll combined with a deterioration in employment, household consumption is set to drop further. This will be partially offset by the export effects of a weaker dollar and a global expansion that is in better shape. We could also add to this a pick up in capital spending but it is still premature to consider this as a given.

Stuck at crossroads...

The Fed reiterated its wait and see approach to rates, emphasizing the fact that although they expect a moderate recovery for the third and fourth quarters, their main concern remains inflation (most recently at 2.1%) clearly above what it considers to be its comfort range of 1-2%. Yesterday's statement was in part geared towards providing greater clarity to the confusion over earlier remarks in which they dropped any mention of a tightening bias which the markets misinterpreted as meaning that inflation was no longer a central issue. Economic indicators are increasingly suggesting that the U.S. expansion is slowing down as the housing debacle, rising unemployment and higher fuel prices take their toll on consumption. The Fed is clearly betting on this slump to bring down the inflation rate which explains why they are unlikely to intervene anytime soon.

A more vibrant France?

As Sarkozy gets prepared to swear in as the 6th president of the 5th republic, one thought on the mind of many is whether he will succeed in pushing the country through much needed reforms by aligning France closer to the revered anglo saxon models of the U.S. and the U.K. The shortcomings of France's form of socialism have been particularly felt in the last decade with globalization taking a heavy toll on an archaic and highly inefficient system based on generous state subsidies and a particularly rigid labor market. If France is serious about competing in the 21st century world order, it will have to change its ways and it seems that the population is ready to embrace this change. Whether he succeeds or not is another story but what happened yesterday signals end of an era for socialism and a new beginning in which true reforms have a chance to see the light of day.

Another point in favor of the goldilocks camp...

Yesterday's labor cost and productivity figures for Q1 of this year suggests that the economic slowdown is having an impact on inflationary pressure. Productivity growth typically neutralizes the inflationary impact in an environment of rising labor costs, thereby helping to sustain an economic expansion. In the current environment, confronted with a slowing economy, better than expected productivity rates combined with a slight rise in unit labor costs is considered good news, and should help sooth stagflation fears. If, going forward, economic indicators continue to confirm this trend, it will provide the fed with greater room for manoeuvre in terms of easing rates to counter the slowdown. Recent housing figures suggest that the debacle is not over yet and the risk of it spreading elsewhere in the economy continues to pose a material threat. We have already seen an impact in today's employment figures. On the other hand, despite the recent downturn in capital expenditure, corporate earnings remain relatively strong (in the upper single digits), helped in part by strong growth outside of the U.S. and a weakening dollar. The direction for the economy at this stage is clearly at crossroads.

The great unwind...

Ever since stock market returns began to deteriorate after the collapse of the dot com boom, investment managers have been scrambling to find alternative sources to satisfy their quest for double digit returns. A quick fix arrived in the form of additional leverage, widely used in the hedge fund world. Globalization and the resulting breakthroughs in financial engineering have led to a rapid growth in new products particularly in the derivatives markets. Today, we find derivative products that synthetically replicate the performance characteristics of a single stock or a basket of stocks. Others provide a type of insurance against the default of a bond with very poor credit quality. The point is that many of these instruments provide leverage to the buyer and when a large number of buyers tend to be hedge funds in a relatively unregulated environment, it becomes very difficult to quantify the amount of leverage in the markets. The issue with this situation is that it is difficult to predict what will happen in the event of a crisis if we don't know how much leverage we have.

Consumer is king!

Yesterday's U.S. durable goods orders and home sales figures painted a mix picture regarding the economy. On the one hand we saw a pick up (and a clear relief for some) in durable goods orders for the month of march after disappointment a month earlier. This could suggest a rise in capital expenditure as inventories shrink, a welcome development following the worrisome cut in corporate spending. On the other hand, we saw further evidence that the housing slump had not bottomed out as some pundits were suggesting. New home sales came below expectations, similar to the disappointing existing home sales figures released earlier in the week. The key lies with how consumers are likely to react to the housing debacle, and so far things are not looking too shabby apart from the occasional red flag such as the recent consumer confidence figures. In addition, with rising oil prices and a weakening dollar, inflation is likely to remain on the Fed's radar screen and constrain their ability to loosen for some time to come.

The dreaded fat tail...

Globalization, greater financial integration and the substantial improvement in cross border flow of capital has led to an explosion in financial innovation and the creation of a substantial amount of new wealth. Securitization combined with novel and sometimes exotic derivative products such as credit default swaps go a long way in explaining why liquidity in the markets have not dried up despite relatively high interest rates and an inverted yield curve both in the U.S. and the U.K. This is all very nice and dandy when things are going in the right direction. Correlations between markets and across asset classes tend to be relatively weak during an ascent and when volatility is subdued. But this can change rapidly when a fat tail event materializes. Take the Chinese single day drop of 9% at the end of February. Volatility spiked to record levels together with correlations, sending global markets on a tail spin. A complacent market was caught by surprise. In such a highly integrated global market, one cannot fail to ponder about the potentially disastrous repercussions of an unexpected catastrophic event.

A Goldilocks day

A lot of focus went into yesterday's economic releases mainly due to the fact that it would provide clues as to the direction of the U.S. economy, more specifically as to whether the economy is heading towards stagflation (slowdown in growth combined with pricing pressure) or towards the ideal "Goldilocks" environment (moderate growth with inflation buried well into the comfort zone). The figures turned out in favor of a "Goldilocks" scenario with core CPI slightly below expectations and the housing market coming above expectations. It is clear that due to the innate volatile nature of housing which, amongst other variables, is very sensitive to changes in the weather, the current releases should be taken with a grain of salt. Also, although the latest inflation readings spells short term relief for the Fed, it will take several occurrences of lower than expected price releases for the Fed to start putting its guard down.

The shifting shape of the yield curve

There is talk of readjustment back towards the normal upward sloping curve that has been absent from the U.S. treasury market for a while already. This will mainly depend not only the degree of resilience of a core inflation rate above the Fed's comfort zone of between 1 and 2 percent, but also on how the housing market tremors unfold (or more specifically on the probability of a possible spillover effect from the sub prime market into other segments of the mortgage market). A steadily weakening dollar and relatively sanguine global growth rates (revised slightly downwards to 4.9% recently by the IMF) doesn't help much in cooling the core inflation rate. On the other hand, the forecasted economic slowdown for 2007 together with the housing debacle may be enough to push unemployment higher and prompt the fed to start lowering rates. In effect, these two opposing forces may be just what is needed to readjust the yield curve back to it's natural upward sloping shape.

A paradigm shift but this time for real?

It use to be that an inverted yield curve would imply that a recession was close at hand, it's predictive power has indeed been close to 100% since the 1950's. The mechanics is straight forward, an inverted yield curve strains the system because banks that borrow short term and lend long term have no incentive to do so if they are losing money on the operation. With less credit available, investment and consumption, two key contributors to growth are adversely impacted, rising the probability of a recession.
So we may wonder how despite high short rates and the inverted environment in the U.S., the economy is still doing rather well, awash with liquidity, healthy earnings, a rise in M&A activities, share buybacks etc. It could have something to do with the fundamental changes in the economic environment of the past decade. The free flow of capital on a truly global scale and the explosion in financial innovations have markedly changed the landscape. Maybe we need to write off the typical yield curve of a particular country or region and instead think of a global composite yield curve comprised of maturity patches from different countries. The short end would have Japan with it's 0.5% yield and the longer end would have a batch of emerging countries with double digit yields. This might partly explain why lending is unhindered and why central banker's might feel more impotent than at any time in the past.

A more upbeat assessment?

LBO's seem to be all the rage these days, most recently with KKR's 25 billion dollar purchase of credit card processor king, First Data Corp. This deal, together with a more upbeat assessment for U.S equities given their relative cheapness to fixed income is helping to counter the negative repercussions of the housing slump somewhat. Today's Asian stock market gains reflect not only the rise in copper prices but also greater optimism on behalf of investors that the U.S. economic slowdown may not seem as worrisome as earlier figures would suggest. Activity in the LBO realm revive the notion of an embedded put option in the form of private equity cash stashed aside and ready to be put to use as opportunities arise. This may indeed be the case as long as corporate profits remain sanguine. The latest figures do suggest, however, that the economic expansion is decelerating, most recently with the slump in manufacturing growth for the month of March, and the forecast remains that corporate earnings growth for this year will be in the single digits. Add to this the negative impact that the housing jitters will have on consumption, and it becomes evident as to why the Fed should be less worried about inflation. This week's unemployment figures should provide further clues regarding the health of the economy.

Its all in the core!

Today's batch of economic releases, with higher than expected consumer income and spending, surprisingly strong construction spending and stronger than expected PCE core inflation (a key indicator for the Fed), all for the month of February suggests that the inflation conundrum is far from over. This follows a week in which we saw lower than expected durable goods orders, strong existing home sales but weaker than expected new home sales. Delving into the figures, it is notable that inflation adjusted spending on durable goods was actually negative, reflecting what seems to be the impact of the recent oil price hike on disposable income. The clearly inflationary nature of these latest figures is contributing to a growing dilemma facing the Fed regarding policy action for it leaves them with less room to counter the economic slowdown. The Fed is basically at crossroads at this stage of the cycle and has little else to do than to just keep a close watch on developments.

A potent cocktail in the making...

The growing tensions between the U.K. and Iran is being felt in the markets particularly with regards to crude oil prices that have been rising for the seventh consecutive day. Not surprising considering that a quarter of world oil supplies flow through the straights where the British sailors and marines were seized. Added to the inflating geopolitical risk premium are the Marseilles port strikes and growing worries regarding weather forecasts for the summer season in the U.S., particularly in Florida and the Gulf of Mexico where 30% of U.S. oil is extracted. This potent and highly charged cocktail of disruptive issues could very easily drive prices to the levels we saw last year. Given these developments, it seems that inflation worries, particularly in the U.S. will be with us for a while longer.

Apologetic Japan

Prime minister Abe's surprise apology to parliament earlier today regarding Japan's actions in World War II should help diffuse a row that has been brewing since Koizumi came to power. It is, in our view, mainly indicative of a fundamental shift in economic power in the region. The conciliatory gesture towards mainly China and South Korea reflects the growing dominance of those countries and their rising importance in terms of trading partners. Although it is unlikely to be enough, this is clearly a step in the right direction.
On a side note, today's disappointing home sales figures in the U.S. provides support for the Fed's decision to leave out any mention of "firming" at the last FOMC meeting and raises the probability of cuts later on this year. A neutral bias seems increasingly appropriate considering the housing conundrum and the typical 6 to 12 month lag for core CPI. The Fed will also be watching the employment figures very closely in coming days and weeks as the economic expansion takes an increasingly priority role.

A Bernanke Put?

The Fed's decision to keep out mention of the tightening bias took the markets by surprise, considering that the latest inflation and growth figures paint a mixed picture. One wonders if Bernanke's decision to drop the bias has anything to do with the sub prime debacle by introducing a Federal Reserve put option à la Greenspan. After yesterday's events, the futures market raised the odds of a quarter point cut by mid year. Although we are not out of the woods on the inflation front yet, the tendency is towards a softening, considering weaker commodity prices and the drop in housing, compounded by the general economic slowdown. Put or no put, we have seen how effective they are (take the internet bubble as a prime example). The danger comes from getting carried away by such "cost free" options, the private equity put being another prime example. Nevertheless, in the natural order of things, it does make sense that the tightening bias is no longer mentioned (it was going to happen some day), the slowdown will inevitably take its toll on inflation.

Just another confusing day!

How reassured should we be with today's better than expected housing starts figures? It adds to confusion more than anything else since it's data based on a single month (February in this case), it's highly sensitive to weather changes, and now, indirectly to the growing inventory of existing homes due to the jump in sub prime delinquencies. So as inventory expands (if it actually does is another matter), it will have a direct impact on home builders where pessimism is already rife if we take the National Association of Home Builders/Wells Fargo index of sentiment at face value. There is still some debate going on regarding the actual state of the housing market and how much of a spillover effect we will end up having. This week and early next week should shed some light on this with the release of additional key housing figures and a couple of consumer confidence measures.

The strangle...

With signs that the low end of the housing market is capsizing and the growing risk that this will spill over into the prime market, the economic expansion seems to be increasingly on shaky ground. A scenario in which consumer spending drops dramatically, leading to a collapse in earnings and a subsequent jump in multiples is not that far fetched. In such an event, the Fed would normally be expected to start easing rates but its hands seem to be increasingly tied if recent inflation related figures are to be believed. Indeed, looking at PPI and CPI for February, or even capacity utilization and the surprising strength in industrial production, the message is pretty clear. With the Fed's hands pretty much tied, the most ideal outcome would be for the slowdown to dominate and choke off the rising inflationary pressure. How things will actually unfold is still very unclear at this stage...

Turbulance ahead?

News that sub prime lending delinquencies reached a four year high is worrisome to say the least. The sustained abnormally low interest rate environment seems to be taking its toll on the economy with the rise in defaults. As mentioned earlier, a long period of low interest rates is conducive to lenders becoming more lax with regards to their lending requirements. This is a behavioural phenomenon in that the more the good times last, the less we remember the bad times. Its in fact what leads to those famous market bubbles that we just can't seem to rid ourselves of. What's unsettling in all this is that a collapse in the housing market (for we haven't seen the end of it yet) will have a psychological impact in the form of a drop in consumer spending, a key component of growth. Now that could punch a hole in the fundamentals that have so far remained unscathed by recent events.

Almost there...

Japan's revised stronger than expected fourth quarter GDP rate confirms yet again that the economy is pulling itself out of the doldrums. The continued strength in exports has prompted firms to upgrade existing plants and build new ones. An increasing share of demand is coming from its neighbors, particularly China with its insatiable appetite for not only construction equipment but also high tech instruments as a distinct middle class starts to form. As mentioned before, the emergence of China and India as new economic powers should help reduce volatility related to the historical dependence on it's largest export client, the U.S. With record low unemployment and improved consumer and business confidence, the disinflationary cycle seems to be in its last throes, although its unlikely that we will be seeing a sudden jump in prices especially considering the recent drop in oil prices which can only add downward pressure on prices in a country that imports almost all of its energy needs.

Out of the storm?

Markets around the world rebounded after a turbulent week triggered by a combination of woes in China and negative news regarding economic expansion in the U.S. and elsewhere. Recent economic figures confirm our outlook of a slowdown in the U.S. with a risk that inflation surges. The latest unit labor cost and productivity figures suggest that inflation is far from being tamed considering that labor costs represent more than two thirds of manufacturing costs and that productivity figures are ebbing towards their lowest level in a decade. A surge in unit labor cost is not surprising considering the the advanced stage of the business cycle and the resulting relative tightness of the labor market combined with peak in capacity utilization. Until recently, firms had the margin of maintaining prices steady as productivity gains diluted the effect of rising labor costs, but with the latest development, firms could very well pass on the additional costs to consumers. We think that the programmed slowdown will suffice to counter the inflationary threat in coming weeks and months. This should be confirmed in upcoming employment figures.

An embedded put option?

Markets are taking a thrashing as unease at the rising volatility is prompting an increasing number of investors to unload their riskier positions. We see this "flight to quality" move as the yen shoots higher and treasury yields drop lower. Fundamentals remain intact in the U.S., however, with earnings growth trends and multiples at reasonable levels and a slower rate of growth already built into expectations for 2007 and beyond. For emerging markets, it's a different story altogether, the democratization of markets such as those of China have led to a large number of relatively inexperienced individuals making investments left, right and center, a bit like the day trading activities of the dot com era. So yes, there is a bit of a bubble out there, but nothing dramatic enough to pull the heavy weights into a full blown recession. The U.S. put option in the form of approximately 2 trillion dollars in private equity is, after all, waiting on the sidelines for the right occasion to enter.

What goes up must come down!

The sell off triggered by China's Tuesday drop continued amid deepening pessimism regarding the outlook for global growth. A flight to quality ensued as volatility surged and the appetite for risk dwindled somewhat, boosting the yen as carry trades started to unwind and pushing treasuries higher, especially in the short end, as the likelihood that the Fed would start cutting rates earlier than anticipated increased. The big uncertainty in this environment became the extent to which this unwinding activity would continue. There was at least some good news to cheer about with the release of stronger than expected personal spending and personal income figures to help counter the growing slump in housing and manufacturing. Also, a stronger than expected PCE Core indicator, one of the Fed's favorite gauges for inflation, confirmed the view that inflation warranted close scrutiny. We don't believe that the current correction will lead to a recession, considering that fundamentals are stable. We think the sell off is due to the unwinding of riskier positions that have been accumulating over the last couple of months.

A new eight pound gorilla?

That was our first impression when we saw the impact the Chinese stock market correction had on other markets around the world. The more interesting observation, however, was the fact that it was not only developing countries that were impacted. Europe and the U.S. were also hit by this correction which brings to mind two important points. That economic integration on a global scale, better known as the global village project, is alive and kicking and that China is rapidly becoming the new eight pound gorilla on the block, despite the fact that its market capitalization as a percentage of the world capitalization is only slightly above 6% if we include Hong Kong. That's still way below the colossal 34% share that the U.S. commands. Nevertheless, we don't see much reason for worry as we subscribe to Greenspan's view that occasional corrections can have a cleansing and beneficial effect on markets. This is particularly true for markets that, by their very nature, are prone to speculative bubbles.

Tamed or not? Part 2

The Fed's insistence on maintaining a tightening bias after applying the brakes on rate hikes paid off yesterday with the release of higher than expected core inflation figures. A stark reminder that the inflation threat is still very real and could easily flare up in the event that oil prices rise or that the economy shows signs of overheating considering the tight labor market and close to full capacity utilization. We nevertheless are leaning more towards the scenario where inflation will be contained by the unfolding economic deceleration. Potholes remain on the horizon in the form of a potential rise in defaults, a reversal in commodity prices or an unwinding of the numerous carry trades and other hedge fund strategies......stay tuned!!!

Japan waking up...

The BOJ's quarter point rate hike to 0.5% came as no surprise considering the stronger than expected fourth quarter GDP results. Policymakers in Japan find themselves in a similar boat as the Fed in that the direction to take in terms of interest rates remains blurry. The decision to tighten did however come as a welcome development for currencies as it let out pressure on the yen which had been accumulating due to the widening divergence in rates with the US and Europe. The direction that the economy is taking remains unclear given the recent mixed bag of indicators suggesting on the one hand, with weak consumer spending and low prices, that the recovery is delicate and, on the other hand, with growing business confidence and stronger GDP figures a more sanguine environment. The combination of ongoing reforms, rising export demand particularly from neighbors, reassurance that the US economy is not about to collapse
and growing overall optimism by both consumers and businesses should help keep Japan afloat for the rest of the year. The current environment also pretty much guarantees that we will not be seeing any further tightening for some time to come. Japan is, after all, still recovering from its deflationary cycle. They are not completely out of the woods yet!

Tamed or not?

Bernanke's upbeat report on the economy and Fed policy seem to be backed by the latest figures which suggest that inflation is under control. The Fed nevertheless maintains its tightening bias until further notice with Bernanke noting that his optimistic scenario is conditional on gasoline prices remaining under control and that we see less strain on capacity utilization. Oil may remain at current levels or even drop a little but certainly not as much as 30% as suggested by Sandford C. Bernstein & Co. Their wild predictions are nothing new, we heard the same story back in 2005. One thing is for sure though, we wont be seeing Fed action any time soon. They will be holding steady for at least the next couple of months unless there is a material change in the environment. We maintain our scenario of a soft lading type of deceleration for the US in 2007.

So what's up with interest rates?

Seems like no end in sight to the economic expansion of the last couple of years. Normally, at this stage of the recovery we should be observing a marked surge in interest rates but things may indeed be a little different this time around. The structural changes in the global economy, most notably the emergence of China and, to a lesser extent, India have led to a surplus in liquidity looking for a place to park. With financial markets still at a relatively rudimentary stage in developing countries, a large chunk of this cash has found its way into the sophisticated markets of developed countries such as the US. This in turn has helped keep interest rates at unusually low levels, leading to a soft landing in the housing market and providing continued growth in corporate earnings. According to a recent businessweek article, the low interest rate environment is here to stay, at least for the next 10 to 20 years which is the estimated amount of time it will take these new emerging countries to develop their financial markets sufficiently. There is a caveat though in the form of greater volatility and a greater risk of default as lending conditions tend to be less restrictive. Unlike the great "new" economy deception which led to the market collapse in 2001, the theory behind low interest rates really does seem to hold, and this time around, things may well be different!