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.