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.