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.