26 December, 2008

and the winner is....


Back in early October I posted a blog in which I argued that treasury type securities had taken over the role of hedge funds as an asset class that was almost totally de-correlated from the rest of the market. I also remarked that it was still too early to jump to any conclusions given that there still remained roughly 3 months before the end of the year and that anything could happen until then. 
Well, here we are again, roughly a week before the year ends, to asses the performance of the various asset classes. The graph in this blog is more comprehensive as it includes a larger number of asset classes and other instruments (commodities and hedge funds are technically not considered to be asset classes).
My first observation would be to highlight treasuries that have produced the only positive performance for the year. All the remaining asset classes which include global stocks, commodities, global real estate and hedge funds have been overwhelmingly negative. Hedge funds have lost somewhat less than the other asset classes but still a whopping 25% of their value (an average figure) has vanished into thin air, making it one of the worst years in hedge fund history.
What is even more astonishing to note is that the performance of treasuries are almost a mirror image of hedge funds. A cursory glance would suggest that the correlation is almost perfectly negative although in reality hedge funds have lost significantly more than the amount that treasuries have gained!
Notice also how commodities have shed all the massive gains it had accumulated up until the middle of the year. The monumental losses have brought the performance of commodities in line with the worst performers in the list (stocks and real estate).
This has been a year full of surprises (I mean who would have thought that treasuries would have been hoarded and that commodities would have posted records both on the upside and downside?). One can be confident that the performance picture for next year will probably look very different from those of 2008!

18 December, 2008

A system-wide failure...

The investment profession has taken a significant setback over the past couple of months, losing practically all the credibility it had garnered over the years. One has to look no further than 10 year treasury yields (currently approaching a record low of 2%) or the spread between 3 month libor and 3 month treasuries (still at record levels) to get a feel of the extent of damage and distrust in the system. What is disturbing in the current environment is not only the sheer monetary scale of losses involved but also its scope. Never mind that Madoff, a master illusionist successfully conned a large number of investors (including banks) for years when the whole financial system itself resembles a giant ponzi scheme. From the unscrupulous lenders who began selling mortgages to individuals that could ill afford them, to the banks that repackaged those same mortgages into so called "quality" tranches before dumping them on unsuspecting investors, to the rating agencies that issued bogus ratings on products that they did not even understand, to Greenspan, the "oracle" that did everything in his power to suppress any form of regulation, particularly with regards to the over the counter derivatives market, to Chief Executives at major banks that continued to claim that everything was under control when the truth was otherwise and to the SEC that preferred to ignore credible warning signs regarding Madoff.
The whole system it seems was rife with incompetence, greed, deceptiveness and other unethical behavior. No wonder then that confidence has sunk to record lows and shows complete indifference to the incessant government actions and pledges to fix the problem. It will take a lot more than plain rhetoric to restore trust that is so critical to the proper functioning of an economy.

10 December, 2008

More gloom and doom before the boom?

Taking a casual look at a few key indicators suggests that we should be embracing for further market turmoil in the coming year.The credit crunch which sprouted amid a severe housing recession shows no signs of abating despite significant efforts by policymakers to reassure investors that the crisis is "under control". Confidence is far from being restored and as a result, businesses and households are having trouble obtaining credit (just when they need it most) which means that we can expect large cutbacks on investments and consumption respectively, contributing in worsening the recession.
Both the 2 year breakeven spread (which measures the differential between 2 year nominal treasury yields and that of inflation protected securities) and the freefall in commodity prices corroborate with the expectations of a deepening recession through a deflationary cycle that is likely to dominate over the next two years.
If we add to this the loss in effectiveness of the Federal Reserve's key monetary policy tool (the result of a liquidity trap that forms as nominal interest rates approach 0 percent) and a Tobin's Q ratio (a well known ratio that compares the market value of a firm to that of its replacement or book value), signaling further downside for global stock markets, there frankly is not much out there to cheer about.
But then again, the forecasting profession is more notorious for having a dismal track record which means that the extreme bearishness that is being suggested at present may be nothing more than a giant smokescreen.

05 December, 2008

To rebalance or not to rebalance?

Rebalancing a portfolio (bringing the asset class weights to or close to their neutral weights) serves two essential purposes:
1. Preserving the defined risk profile of the portfolio over time
2. Increasing the probability of locking in market related performance gains by cashing in on outperforming investments (reducing the impact of a subsequent selloff in the investment) and buying more of underperforming investments (enabling the portfolio to capture greater returns from a subsequent rebound).
Rebalancing, together with diversification are amongst the core pillars of modern portfolio theory.
There is a caveat, however, that should be regarded carefully by those that employ rebalancing techniques when managing portfolios. It is that the effectiveness of rebalancing techniques depend largely on market conditions. In periods of market turmoil, rebalancing can prove to be counterproductive. Just like in the event of an earthquake, we are less likely to go about our daily chores, rebalancing is not necessarily the right thing to when market conditions are extraordinary.
The best way to illustrate this would be by taking an example of a "balanced" risk profile portfolio with an even split exposure to equities and bonds. Say, for example, that $1000 dollars is invested into equities and the remaining $1000 into bonds for a total portfolio value of
$2000 at the beginning of the year. Suppose that a financial crisis occurs and that by mid year, equities are down 30% whilst bonds remain flat (I know, its not very difficult to imagine such things these days). The portfolio value will be as follows:
Equities: $700
Bonds: $1000
Total: $1700
Suppose that right after the drop, the portfolio manager decides to rebalance with a final result of:
Equities: $850
Bonds: $850
Total: $1700
Suppose, also, that for the rest of the year, equity markets drop another 30% and bonds remain at the same level. Our portfolio at the end of the year will look as follows:
Equities: $595
Bonds: $850
Total: $1445
Now suppose that the manager did not rebalance at any time during the year. Our portfolio would end up as follows:
Equities: $490
Bonds: $1000
Total: $1490

We find ourselves with a portfolio that has a smaller exposure into equities but also with a better performance relative to the rebalanced portfolio. The non rebalanced portfolio total value stands at $1490 versus $1445 for the rebalanced portfolio. The difference (3.11%) may not seem like much but that is mainly becuase the total portfolio value is small!

Although this example illustrates the performance advantage of not rebalancing when markets are in turmoil (such as what we are experiencing at present), what it doesn’t show us as clearly is the increased risk of shifting the risk profile that not rebalancing results in. It is easy to imagine what would happen to the performances of the two portfolio examples in the event of a subsequent market rebound of similar scale to that of the drop.

Moral of the story: Rebalancing doesnt work well in times of extreme volatility but you have to weigh in the increased probability of a shift in risk profile if you decide to ignore rebalancing.

27 November, 2008

A protracted recession?

As policymakers struggle in their attempt at restoring market confidence, the probability that we may be facing a protracted recession becomes more likely. A casual observation of the various interventions that have occurred to date suggest that the various institutions are near clueless as to the most effective approach in tackling the crisis. This should come as no surprise considering that the distinguishing characteristic of the current downturn, differentiating it from previous ones has to do with its multilayered nature. The first wave began with the collapse of the housing bubble, followed rapidly with a second wave in the form of a ravaging credit crunch. This in turn triggered a significant contraction in consumer spending as household wealth began to shrink (negative equity, stock market corrections, tighter lending standards). Business contraction seem to be the next wave in line as firms begin to cut production and curb capital expenditures in light of weaker demand and diminished access to credit.
What all this basically means is that to tackle this particular crisis will require a multipronged approach given that there is more than just one malaise that needs fixing. It also means that the duration of the recession is likely to lengthen considering that the various layers are unlikely to be fully resolved at the same time.

17 November, 2008

Sector rotation in action...


Although there remains a couple of weeks before year end, it is interesting to see how the various sectors have fared in such a difficult climate.

The graph above depicts the year to date performances of the various global sectors with the "World" bar measuring the capitalization weighted performance of all sectors combined.

The first striking (although clearly not surprising) observation is that none of the sectors have returned a positive performance (to date). The second would be that financials have suffered the most amongst sectors (again, not surprising considering the central role of financials in the current crisis).

Notice also the striking performance disparity between cyclical and defensive sectors. As we enter what seems to be a protracted global recession, the cyclical sectors which include commodities, information technology and luxury goods are suffering the most as they are pricing the impact of the slump whilst the defensive sectors, which include consumer staples, healthcare and utilities, have shown greater resilience to the downturn. This is somewhat reassuring in an environment where most investment concepts have gone haywire (see previous blog).

In conclusion, with hindsight of course, if one was bearish and expecting a recession at the beginning of the year, a sector rotation strategy would seem to have paid off, although we should emphasize the important caveat that one should never jump to conclusions before the period of measure (in this case one year) is through. We do, after all, live in a world of uncertainty (this year proving to be more so than ever) and so we should rightfully expect that anything can happen.

13 November, 2008

Shaken to the core...

As we approach the end of what is shaping out to be one of the most disastrous years in financial market history, challenging even the most fundamental concepts of modern portfolio theory, we are left to ponder if the industry will have to reinvent itself.
Fundamental concepts and measures such as Value at Risk (VAR), standard deviation, the normal distribution, correlation or even diversification are being questioned in light of the way this crisis has unfolded.
For example the foundation of modern portfolio theory lies on the premise that diversification in a portfolio contributes to enhancing returns and reducing risk. Well if we apply it over the past year and a half we can firmly conclude that it has failed miserably. In fact we could argue in the case of equity markets that in certain situations, diversification has actually magnified losses. A U.S. or European investor, for example, was much worse off with exposure to emerging markets.
Related to this is the concept of correlation whereby a weaker correlation between two investments contributes to enhancing the risk/return tradeoff of a portfolio. But all this becomes hogwash or even worse when those same correlations suddenly jump up to a level close to 1.
So where does this leave us? Do we just abandon the very core foundations of modern portfolio theory and search elsewhere for answers or do we just stick to them and ride this crisis out?
History, in this case, does provide clues since it is not the first time that the core concepts have been challenged like this. The main lesson we can draw from the past is that these concepts only function in normal market environments. In other words they are prone to failure when markets are either in a bubble or when they are experiencing a crash, and since a crash is arguably (arguably because they too can be exploited) the least desirable environment to be in and thankfully don’t last too long, it makes no sense to abandon these core concepts if things will eventually return to normal.
Warren Buffet recently stated that the biggest losers in this crisis are going to be those that are currently sitting on cash. That is because by the time you know that things are improving, it will be too late to do anything about it. This particular market correction has two parts to it, one related to a reversion to the mean effect (reflecting the fundamentals) and another that is emotionally driven and that tends to exaggerate things both on the downside and the upside. The first part will take time to fix as the world is entering what could become a protracted recession. The second part, however, will resolve itself as soon as all the bad news is out in the open. When that happens, however, it will be too late to do anything about it.

05 November, 2008

A truly historic moment...

After a long and arduous battle between two rivals with very contrasting opinions on how to run the country, Barack Obama was chosen to become the 44th president of the United States, marking the beginning of a new era in American politics. By electing Obama, Americans have decided to turn a page in U.S. history, effectively dismantling one of the remaining barriers of the racial divide. They have also joined the world chorus in demanding a radical change in policies after 8 years of republican rule, wrought with strategic blunders both at the home front and abroad.
Obama undoubtedly faces formidable challenges in the form of a severe economic crisis, serious geopolitical issues and a significantly tarnished image abroad, to name a few. They won't be easy to fix but if his track record is any indication, we may be in for some pleasant surprises!

In any case we congratulate him for his election and wish him the very best of luck as the next president of the United States.

30 October, 2008

A liquidity trap and more?


Considered as amongst the most powerful of tools within a Central Bank's arsenal, the effectiveness of monetary policy depends very much on the economic environment in which it is being applied. There are basically two situations in which monetary policy becomes totally ineffective:
When the transmission system is faulty, whereby a change in monetary policy fails to influence economy wide lending rates. A severe credit crunch, such as the one being currently experienced, can significantly diminish the effectiveness of a change in interest rates. Despite a rate cut, for example, the economy fails to be stimulated.
The second situation, known as the liquidity trap, is related to the differential between the target rate from the zero percent nominal rate. The closer the target rate is to zero percent, the less room a central bank has to further stimulate the economy using monetary policy as a tool. At some point close to zero, the effectiveness of monetary policy disappears.
The global economy is currently experiencing a credit crunch which is steadily eroding the effectiveness of monetary policy. The U.S. Federal Reserve is in a worse situation because it is facing a double whammy with a credit crunch on one hand and a potential liquidity trap on the other hand (considering that with the latest move, the target rate now stands at one percent, leaving very little room for maneuver if more stimulation is required). The situation is reminiscent of Japan in the 90's where the Bank of Japan became impotent as it lost the effectiveness of its monetary policy tool after the nominal rate was cut to zero.
The obvious remedy in the case of the U.S. would seem to involve solving the transmission problem as it would boost the amount of stimulation into the economy. Unfortunately it is more easier said than done as it would require restoring confidence that has been severely impaired.

22 October, 2008

Navigating in the dark...

Policymakers have so far failed to contain a crisis that began with the bursting of the housing bubble, rapidly spread into the credit markets and is now threatening to bring down employment through recession. The policy failures can be attributed to two related challenges that policymakers face, namely imperfect information and hesitancy to take decisive action.
Fact is that policymakers base their decisions on information that is imperfect in the sense that the information does not provide the full picture of the issue(s) at hand. Most economic indicators, for examples, provide information on the state of the economy of the recent past. A few indicators known as "leading indicators" provide information that gives at least some insight into the future direction of the economy. The most obvious leading indicator is the stock market itself but it is not infallible to the vagaries of, say, bubbles and therefore can at times provide erroneous information.
Basing decisions on imperfect information contributes to a hesitancy to implement policy because "blunt" policy frequently results in collateral damage that is not always known beforehand. A very good example of this is monetary policy. When a central bank decides to cut interest rates in order to stimulate the economy, it also raises the risk of sparking inflation down the line.
The unprecedented nature of the current crisis means that policymakers don’t have much to lean on in terms of experience in order to set the appropriate policy. The approach therefore has to be novel, which introduces even more uncertainty into the equation as these "new" tools have never been tested before and therefore it becomes more difficult to estimate if and what the collateral damage will be. We can therefore expect a lot of hesitancy amongst policyholders (which is what is being observed on the ground), which creates a huge dilemma as the time factor is of essence when trying to contain a crisis like the current one.
No wonder then that despite the government pledges to guarantee bank transactions, the TED spread still remains dangerously wide.

14 October, 2008

Two challenges to the crisis...

The most pressing issue at hand has been to put an end to the panic that has been gripping markets across the world, leading to a flurry of bankruptcies as companies struggle for liquidity. The liquidity crunch can only be unwound if the long lost confidence in the financial system is restored and this can only happen if the government steps in as the ultimate guarantor for the majority of interbank transactions (a proposition originally put forth by the British). What we are in fact witnessing right now is exactly that: an unprecedented degree of government intervention. The counterparty risk between banks is now shifting from the borrowing bank to the respective governments which should help eliminate any doubts that may still be lingering. One of the closely watched barometers that measures the degree of confidence amongst banks is what is known as the TED spread which measures the spread between LIBOR and Treasuries. Although it has declined a little since last week, it still remains at record levels and, until it drops significantly, the credit crunch can only continue to corrode the markets.
Notice that the global government bailout program is in stark contrast to what happened at the early stages of the great depression of the 1930's. The Federal Reserve of that time effectively left the banks to fail which, with hindsight, led to a significant worsening of the crisis. The risks of letting a bank fail are huge as observed most recently with the Lehman case which led to a full blown credit crunch. Bernanke, who is a scholar of that period, is clearly trying to avoid a repeat of the great depression which explains the shear scale of the bailout program (although I am skeptical that the amount that has been put forth will suffice to put things in order).
Resolving the confidence issue, however, does not mean that the crisis itself will be resolved. The economies are facing a real threat of a protracted recession on the horizon. Averting, let alone limiting, a full blown recession won't be easy considering the amount of deleveraging remaining and the fact that housing prices still have some distance to go before reaching bottom. As mentioned before, this won't happen at least until sometime in the second half of next year.

09 October, 2008

And the winner is...


Well it is a bit too early to give a final verdict on which asset class performed best in this very very difficult environment but with less than three months to go, I guess we can already draw some early conclusions.
To summarize our observations, the best performing asset class so far goes to bonds, more specifically U.S. treasury bonds (with European Government bonds a close second). Oh wait a minute, treasury bonds have stolen the spotlight from hedge funds by performing in a manner that is "characteristic" of hedge funds??? And all that at a fraction of the cost (2/20 was it?), without promising (or guaranteeing was it? please forgive my memory lapse) de-correlation from other asset classes (most notably equities) and (at least for some of them) without promising absolute returns (in my understanding defined as positive performances irrespective of the market conditions).
That is quite a feat if you ask me (see the year to date graph above showing bonds as the white line, equities as the green line and hedge funds as the red line sandwiched in-between if you don't believe me).
Well, surprise surprise! Just when we were all expecting hedge funds to perform like "hedge funds" should, they instead followed the equity route. That important role was relegated to government bonds. Are the hedge fund characteristics mentioned earlier just a myth? Well, to be fair, they still have a bit less than three months to prove that assumption wrong. So I will wait a while more before launching my diatribe.

06 October, 2008

Too little, too late?

The age old adage "Time is Money" should be heeded carefully by those that are attempting to bailout the U.S. economy. In an age where information travels at near light speed and where large transactions can be executed at the click of a mouse button, contagion can spread very rapidly, leaving little time to anticipate, let alone take action, when a crisis occurs. Rapid time decay requires rapid response but a casual observation of the current environment would seem to indicate that financial institutions are not up to speed with their reflexes. The Federal Reserve, despite novel approaches to handling the crisis, has been from the beginning struggling to stay ahead of the curve. It is no doubt a challenge to operate effectively when facing uncharted waters where past experience has no value, especially when being effective requires you to think at least two moves ahead.
Alas it is becoming increasingly clear (from the way the equity markets are behaving) that the 700 billion dollar bailout plan may be too little, too late to prevent a deeper recession (we will probably not know the final bill for a couple of years from now). This is because, not only does no one have a clue as to what the intrinsic value of the toxic debt outstanding is, but also because, with the ongoing credit crunch, every second that goes by raises the probability that a business that, in a "normal" environment would be considered to be healthy, collapses. Government institutions around the world may still have some more bailouts to perform in the near future.

29 September, 2008

At the center of a storm...


The spread between 3 month libor and 3 month U.S. treasuries (see graph), a measure of market confidence is going through the roof.
One thing that is sorely absent from markets these days is indeed confidence. It seems that no matter the amount of assurances by government entities, (both verbally and in their actions), an acute degree of skepticism has taken hold of the market place. Although U.S. government bailouts are at record levels and there are signs of a spillover into Europe and Asia, the market (which is always forward looking) is under the impression that the final bill (which won't be known with any degree of certainty for a long time to come) will be significantly greater than the amounts that are being pledged today. This seems logical considering the growing distrust of financial institutions resulting from uncertainty with regards to their true exposure to toxic debt. The price of the opacity has been to exacerbate the crisis for the financial sector by making it more difficult for firms to gain access to funding, as lending has all but dried up. The result of all this is that we are now faced with a situation in which many firms that, under normal circumstances, would be considered healthy, can no longer get the necessary funding to function properly. Government bailouts are therefore likely to continue until the day that at least some confidence is restored. When and how it will occur are the two big unknowns of this conundrum.

22 September, 2008

Explicit and implicit bailouts...

Fed and Treasury action over the past two weeks, starting with the announcement that they would be placing the two GSE’s into conservatorship, followed by the decision to let Lehman and Merrill Lynch to their own fates, only to backtrack on a sputtering AIG (once it became all too clear that turning a blind eye in this particular case, with all the counterparty risk, could end up being very costly), and finally announcing a comprehensive bailout plan for the entire economy, has again revived the moral hazard debate.
Suddenly, the point where the line is drawn between what is considered too large to fail and what can be let go of became very blurry and more so with the decision of the Fed to convert the remaining investment banks (Morgan Stanley and Goldman Sachs) into traditional bank holding companies, marking the beginning of a new era.
What was probably not clear with the announcement was that Bank of America's and JP Morgan's purchase of Merrill Lynch and Bear Stearns respectively have pushed the liabilities of these two firms into the same league as that of AIG. So does that mean they are now considered too big to fail? If the markets think so, they could start enjoying lower borrowing costs like those that Fannie and Freddie did. So then the question should be, is the government, with their comprehensive bailout plans, sowing the seeds of future troubles? The answer will depend on how carefully they plan through this very delicate period of reorganization.

15 September, 2008

The great unwind Part 2...

On our blog of the first of May 2007 entitled "The Great Unwind", we mentioned how the process of globalization brought about a remarkable degree of innovation into the derivatives market, providing access to capital to segments of the market that use to traditionally be left out and providing an unprecedented amount of flexibility in tailoring risk to specific needs (or so it was believed). These instruments did have a dark side related mainly to the sheer complexity of their structures, forcing investors to rely on rating agencies (who, it turned out, themselves had no clue) for risk appraisals.
The problem stems from the systematic failure of the market to grasp the shifting nature of risk. PIMCO's Chief Strategist described it best with a piece entitled "the Paradox of Deleveraging". The current crisis stemming from the uncertainty regarding the true extent of leverage is forcing institutions to de-lever their balance sheet (as mentioned in our previous blog) by liquidating assets. That in itself is the right thing to do but becomes problematic if everyone is doing it at the same time! It is the famous "negative feedback loop" whereby as more and more assets are liquidated, their values drop at a faster pace, in the worst case leading to the perverse effect of greater leverage than what they started with.
It seems that markets fail to factor into their risk models the potential adverse effect of herding. In other words, the riskiness of a security is only considered in a vacuum. Correlations suffer from the exact same risk assessment flaws. We tend to think of correlations as a static notion (i.e. that does not change through time) when in fact, casual observation shows us that correlations are anything but static. Two variables that may have exhibited weak or even negative correlation in the past can suddenly move in the opposite direction. This is typically the case when systemic risk is involved. Today's financial crisis, for example, is having a negative impact on most of the other sectors mainly because of the threat it poses to the overall economy (see our September newsletter). That is why when it was announced over the weekend that Lehman would seek chapter 11 and Merrill Lynch would be bought by Bank of America, the entire stock market took a hit as money shifted out into safer assets such as Treasuries (the flight to quality move).
In the end, no one knows when this process will bottom out because no one known with any degree of certainty how much leverage has been effectively eliminated. Only time will tell.

10 September, 2008

Black holes and other worries...


The announcement over the weekend by the Treasury secretary and the director of the Federal Housing Finance Agency that two of the largest Government Sponsored Enterprises (representing roughly half of the total mortgage lendings in the U.S.) would effectively be placed into conservatorship was yet another attempt at stemming systemic risk. The market fanfare this time around lasted less than 24 hours as it was rapidly hijacked by news of a battered Lehman losing the little credibility it has left with investors.
The GSE bailout was, in our opinion, a necessary operation to try to stem the debt deflation that, like a black hole, is threatening to pull everything in its vicinity. Indeed, in an attempt to delever, firms are fire selling their assets but when everyone is doing the same, you get a perverse effect of rising debt to assets ratios as the value of existing assets shrink faster than the debt.
So what is the solution? I'm afraid there isn't much that can be done apart from attempting to reduce the severity of the downturn. The housing price deflation (resulting from a bubble) has to run its course and still has some distance to go before reaching bottom (see the Case-Shiller U.S. home price graph above) with some pundits suggesting that we are only half way there! All this is to say that the drag on the economy will continue at least until sometime later next year.

04 September, 2008

Recession or Stagflation?

The ECB and the Bank of England have joined the chorus of central banks that have opted to keep interest rates steady (or in observation mode) in what seems to be a bid to preserving price stability amidst clear signs of further economic deterioration.

With the sharp rise in the dollar and a steady decline in Euro rates, markets seem to be anticipating that ECB rate cuts are not far away. The same seems to apply for the Fed, observed by the steady erosion in treasury yields (in stark contrast with just a short while back when markets were adamant that the Fed would tighten before year end). The strengthening dollar, however, suggests that the European slowdown could be nastier than that of the U.S., which should come as no surprise considering that the U.S. is ahead of Europe in terms of the business cycle and the ECB target rate was and remains significantly above that of its U.S. counterpart (further choking an already sputtering economy).

So what sparked a change in monetary policy (switching from tightening to steady in Europe and from loosening to steady in the U.S.) and the shift in market expectations? The single largest factor seems to be the sharp reversal in commodities (most notably oil and gas). The drop seems to have subdued inflation worries and, combined with the now global economic slowdown, has shifted market concern from inflation back to the economy. Supply shocks tend to work with lags (as observed with the so far tepid rise in the core inflation rate) which means that even with the marked drop in oil prices, it will take time to impact core inflation. In the meantime we may observe a further rise in the core.
In terms of interest rate policy we believe that in the present context, there is far greater risk of a full blown recession than a risk of stagflation and therefore think that the Fed's strategy (maintaining a loose monetary policy) is way sounder than that of the ECB.

25 August, 2008

A matter of spreads...

The graph above (source:bloomberg) which basically measures the spread between 3 month libor and 3 month treasuries suggests that the ongoing turmoil is far from being resolved. The degree of volatility and the extent to which spreads have widened ever since the subprime debacle hit markets a year and a bit ago is spectacular. We went from a low of 18 basis points (before the first wave reached the shores) to a whopping high of 240 basis points (as the subprime crisis unraveled). Looking at the way in which spreads have evolved, it is clear that Fed efforts to quell markets have only had temporary success right until the next crisis would hit markets (the last spike on the graph relating to the Bear Stearns crisis). Currently, despite the recent reversal in commodities and dollar trends (both welcome developments for the economy), the spread has begun to widen, suggesting that lenders continue to be weary and confidence is far from being restored. Spreads seem to be widening across the board (making financing and taking out a mortgage more expensive for businesses and households respectively) contributing as a material drag to economic growth. Unless spreads reverse course, the next couple of quarters are likely to be very sluggish.


19 August, 2008

Judge for yourself...

Considering that we do not have in our possession a magical crystal ball that would permit us to take a glimpse into the future, and notwithstanding that there still remains another 4 months and a bit before we reach the end of the year and that anything can still happen in that time frame, we are quite pleased with how our economic forecasts have turned out so far for the year (a testament we believe to Lobnek's high degree of professionalism).
In any case we think you should judge for yourself so below you will find the outlook section from our January 2008 newsletter for your perusal. For those of you that want to read the entire newsletter, you can find it in the "publications" section of our website at http://www.lobnek.com/ Enjoy!

"2008 is set to deliver another challenging year on various fronts. In the U.S., the housing recession combined with tighter credit standards, rising prices and a weaker jobs market is likely to raise the risk of contagion into consumption. As the U.S. enters an election year, policy will center on averting an economic recession (in the process stoking the risk of inflation even further), with employment and taxes taking center stage of the debate. In an increasingly challenging environment, businesses with strong balance sheets and low debt are better equipped to handle a potential downturn. With Fed policy increasingly geared towards averting a recession, inflation will become a growing concern and its potentially corrosive effect on equity and fixed income will boost demand for investments that have a strong correlation to inflation such as commodities and Treasury Inflation Protected Securities. The U.S. economic slowdown will undoubtedly dent growth in Europe, Asia and emerging countries that continue to depend to a large extent on U.S. consumer demand. Although the impact is likely to be mitigated somewhat due to the accumulation of reserves, improved fiscal and monetary discipline and the emergence of a distinct consumer class in key emerging countries such as China and India, volatility and inflation will threaten the stability, especially in those countries that have currencies pegged to the dollar or that have economies largely dependent on foreign direct investments. China itself will be facing serious challenges on various fronts but is unlikely to take any drastic measures to address them until after the Beijing Olympics. Europe which cyclically trails the U.S. will also start to show signs of a slowdown, hurt by a strong currency, falling home prices and a growing risk of inflation (which will further restrict the ECB’s ability to cut rates).
Currency wise, the U.S. dollar could weaken further as the interest rate differential widens but is bound to recover later in the year, particularly against the Euro given the advanced stage of the
U.S. business cycle and the growing risk of inflationary pressure.
Commodities will also remain volatile, reflecting ongoing geopolitical risk although the overall trend should be upwards as growing demand appetite and supply disruptions continue to beleaguer the markets.
As we move into an environment conducive towards volatility, we can expect less uniformity and therefore greater polarity in performance amongst and within asset classes. The choice of investments will play a more significant role in determining performance. We at Lobnek Wealth Management believe that an overall defensive approach combined with a rigorous and highly selective investment policy is most appropriate to counter the numerous challenges that lie ahead.
We look forward to helping our clients achieve their goals in what will likely be a challenging year ahead."

13 August, 2008

The second half

How the rest of the second half of this year unfolds for the U.S. economy will depend largely on a combination of factors that include commodities, the dollar and government action (or inaction).
So far this year the economy has shown a remarkable degree of resilience despite of the various shocks (housing recession, credit tightening, commodities price surge, real wage contraction and rising unemployment) that have been battering consumers and businesses.
Support has come in the form of aggressive rate cuts (initiated back in September of last year), Fed support and bailouts of key market participants, tax rebates and a firm boost in exports, thanks to a significantly weaker dollar and robust demand from abroad.
As some of these factors begin to show signs of reversing (strengthening dollar, weakening commodities, tax rebate effect wearing out), and as new elements enter the equation (such as the slowing global expansion), with consumption faltering, economic expansion in the U.S. is set to weaken further in the third and especially fourth quarters. As housing prices continue their descent for the rest of the year, the repercussions on financials and the broader market are likely to continue, pushing expectations of an economic rebound for not before sometime late next year.

05 August, 2008

Keeping expectations anchored...

Today's Fed meeting is expected to yield no change in the target rate but, as a compromise to an increasingly hawkish FOMC, may result in stronger language against inflation.
Reaching consensus on policy is becoming increasingly difficult as the balance further tips in favor of inflation hawks as a result of a technicality (two of the 7 seats occupied by permanent governors are currently vacant and three of those that vote on a rotating basis are known to be inflation hawks).
One of the main concerns of the Fed in its quest for preserving price stability is to keep expectations firmly anchored, particularly in an environment in which headline inflation is rising relentlessly. It will be difficult for tough rhetoric to do the trick on its own (in others words keeping expectations anchored without having to resort to raising rates) but with the pressure on commodities easing as the global economy continues to soften, the Fed may end up dealing more effectively with the slowdown by keeping rates steady or even begin easing before the year is up. Such a scenario would certainly be in favor of bonds.

02 August, 2008

Privatizing rewards and socializing risk?

Here is a moral hazard question for you: did the chunky investment rewards of the private sector over the last couple of years end up being financed by tax payers money? 
There is growing concern that the U.S. government handling of the current economic crisis is fomenting moral hazard and therefore arguably sowing the seeds of a future bubble. It all started with the Fed's decision to bail out Bear Sterns earlier in the year and followed soon after with the announcement of unwavering Fed and Treasury support for the country's twin government sponsored mortgage behemoths. 
A quick glance at the sequence of events may give the impression that with the bailouts, the rewards have been grossly disproportionate to the risks taken during the heydays of the housing boom, but one would be naive to jump to such straightforward conclusions. 
The reality on the ground is far more complex than it may seem. In the case of the Bear bailout, the Fed was concerned about the large number of open contracts the bank had with counter-parties. Its failure would have triggered systemic risk with profound economy-wide repercussions.
The mortgage institution pledges were also carried out in the same spirit, to avert systemic risk by nipping it at the bud. The government, it seems, is on a mission to buy enough time for the housing market to stabilize itself as it becomes increasingly clear that there are no effective tools in their arsenal that would effectively put a stop to the deflationary spiral (it will have to bottom out naturally). 
Question is, do the institutions have enough power to keep the economy on life support long enough for housing prices to bottom out? After all, with the Fed's new discount window lending policy, its books are accumulating a growing amount of illiquid paper. 

 

22 July, 2008

Similar symptoms, contrasting remedies...

Both the U.S. and Europe are currently experiencing a similar economic environment. Growth is rapidly decelerating, unemployment is rising, commodities sparked inflation is creeping up and the mortgage business is in shambles. About the only stark observable difference between the two economies is regarding their respective currencies that are moving in opposite directions. The difference is reflective of monetary policies that are also moving in opposite directions. If the problems that are being faced are similar in nature, why would the central banks of the U.S. and Europe tackle them in such opposite ways, especially given the perception that there is a lot of cooperation between the two? Part of the answer lies in their economic histories and another part is a direct result of their respective mandates. 
In the case of the U.S., the deflation trauma of the great depression has not been forgotten. It is further kept alive by a Fed chairman who is an avid expert on the topic. It therefore should come as no surprise that in the current economic turmoil, the Fed would have a loosening bias for its interest rate policy.
The ECB, in contrast, has embarked on a tightening bias, citing the growing risk of inflation. Part of the decision is due to its single mandate of price stability (versus the Fed's dual mandate of price stability and employment). History is the other major factor influencing the decision making process of the ECB. More specifically originating from its dominant German Bundesbank heritage. During the interwar years, Germany had suffered a severe bout of hyperinflation. Other European countries were to follow suit during and after the Second World War. We can therefore conclude that the hyperinflation trauma was collectively experienced in Europe.
These differences (historical and political) explain to a large extent why the two central banks, although facing similar issues, have opted to tackle it in opposing ways. What is certain is that both cannot be right and it is unfortunately too early to say who is using the correct antidote.

15 July, 2008

There is a cost involved in every action...

Pledges and further action from the Fed and the Treasury earlier in the week were clearly designed to avert a total bloodbath in the mortgage business but, as institutions steadily yield more power and influence on market dynamics, two questions come to mind.

1. At what point does interference begin to stifle development, or put another way, at what point does the marginal benefit of regulation begin to be outweighed by the marginal cost of such regulation?

2. At what point does bailing out institutions that are effectively considered bankrupt lead to a significant increase in moral hazard (which just sows the seeds of future bubbles)?

Answering either question with any degree of precision is clearly a futile exercise. Greater regulation and greater intervention are both to some extent actions that counter the very principles of capitalism. By regulating markets, for example, we take away a certain degree of flexibility which can have an adverse effect on economic development. Certainly markets are smart and creative enough to find ways around such regulations (part of the reason why we find ourselves in the current mess is a result of shadow banking activities caused by regulation).
And what about the issue of bailing out businesses that, in normal circumstances, would go bankrupt? We are just emerging from an era in which access to capital was both cheap and very easily obtainable. That environment led to a lot of businesses that would normally go bankrupt to stay afloat. Now that rates are rising, a wave of bankruptcies are exacerbating an already difficult environment. We can draw similarities with the Fed's intervention to avert bankruptcies, but the objective is very different. In the Fed's case, the reason for bailing out is to avert systemic risk from taking hold. But doing so introduces another dilemma, the so called moral hazard put option. 
In the end, it is a delicate balancing act the final outcome of which only the passage of time will tell...  

09 July, 2008

A sentiment driven game of ping pong...

Markets of late are in a sort of tug of war frenzy, undecided on whether it is the deflationary forces of a worsening housing slump combined with a steadily deteriorating credit market or the inflationary forces of commodity prices that show no end in sight that will drag the world economy into a recession. Complicating matters is the geopolitical risk premium on oil which has been the dominant factor behind the recent volatility in prices. With so much uncertainty out there, it is no wonder that markets are trading on nothing else than emotional impulses, observable from the steady rise in volatility over the last couple of months. For rational behavior to return would first and foremost require a fix of the housing market which, unfortunately, is in such a dismal state that it wouldn’t be realistic to expect a recovery any time soon. It would also require an improvement in the financial sector that has been battered by several waves of mortgage related write-offs and a systemic risk potential resulting from the broad market exposure to derivative instruments such as credit default swaps that are suffering from uncertainty in counterparty risk. The Fed's Bear Sterns intervention back in March was designed to avert the very systemic risk that continues to threaten the global economy. Unfortunately these problems are likely to persist as long as home values continue to deflate and credit becomes increasingly difficult to obtain.

02 July, 2008

A measure of market sentiment...

With the recent slump in stock markets across the globe, many are now technically considered to be in bear territory (defined as more than a 20% drop from a peak of less than year). This is further confirmed by looking at global sector performances as depicted in the bar chart graph below. The red bars show the one year performances of the various sectors, whilst the blue bars represent the performances since the start of this year. A "defensive" sector rotation can be seen from the performances. We see, for example, utilities, heathcare and consumer staples as amongst the least battered by the current turmoil. We also observe performance characteristics that are highly specific to this particular downturn. Information Technology, a traditionally growth industry, has done relatively well, benefitting from its export orientation and the weaker dollar. Financials have been battered as a result of the subprime crises and all that has ensued. Energy and materials in contrast find themselves in positive territory because of the significant demand and supply imbalances in commodities that have been driving their prices up through the roof.


25 June, 2008

At crossroads again...

The billion dollar question on people’s minds at this juncture is whether the economy is improving or actually worsening.
On the positive side we can give credit to a proactive Fed which, through its unprecedented actions has succeeded in nabbing a potentially global systemic risk at its bud. A continuous influx of much needed capital, from both sovereign and other sources have also helped in keeping the sickly financials afloat. We could also mention emerging markets, thanks to being in better economic shape with huge piles of cash and a greater savings rate, providing demand support for the wider economy of developed countries such as the U.S. where a weak dollar is contributing in making goods and services even more attractive.
On the negative side we have the ongoing imbalances in commodities that are threatening to trigger a price/wage spiral and social unrest across the globe. We can also cite the continued free fall in housing prices that the typical central bank toolkit is ineffective towards and a growing number of layoffs that can only contribute to shattering the little confidence that remains.
In our opinion, the most likely scenario will be for commodity prices to drop to more sustainable levels which in turn will relieve the large amount of pressure that has built up and allow the other imbalances, such as in housing, to run their course.

19 June, 2008

Inflation's many guises...

Inflation comes in different shapes and guises and the way it runs its course depends very much on the underlying environment.
Today we observe two distinct types of inflation across the world, a commodity driven type as observed in developed regions like the U.S. and Europe and a more economic activity driven type as seen in developing markets such as in Asia or the Gulf states. We could argue that the inflation in commodity rich developing countries are also commodity driven as it is the explosion in capital flows to these countries that is pushing their economies to the limit. But there is another factor that is playing a significant role in further fuelling inflation pressure, namely monetary policy. Many of these commodity rich countries happen to have their currencies somewhat pegged to the dollar. In order to maintain that peg, they have had to follow the Fed's switch initiated last September to a more accommodative stance on interest rates. This in turn has resulted in additional stimulus to economies that are already at full capacity. The risk of continuing in this path is that it triggers a wage/price spiral that, once it takes foot, is notoriously difficult to stop. This was the situation that developed countries faced during the oil shocks of the 70's when interest rates were kept dangerously low. Amongst the emerging countries, Brazil seems to be the one that has understood these risks most clearly as the central bank took action to mitigate the inflation pressure arising from economic activity by raising rates earlier in the year.
In developed nations, as mentioned earlier, the main risk comes from commodity prices remaining at record levels. Coupled with a sharp deceleration in economic activity, there is growing risk of fomenting a much dreaded stagflationary environment. Normally, given the positive correlation between economic activity and commodity prices, the economic slowdown should help alleviate some of the pressures that have built up but this is clearly not what seems to be happening. The reason might have something to do with the unprecedented environment in which emerging market economies don't seem to be faltering as they should (at least not yet) when their developed brethren enter a sharp slowdown. Maybe it is a question of time or maybe what we are witnessing is a paradigm shift!

09 June, 2008

Into the precipice?

Bad news on the economy last Friday sent stocks and the dollar tumbling and led to a surge in oil and gold. The cascade of events went something like this: the labor department reported the economy lost jobs in may (a fifth consecutive month of losses) and that the unemployment rate which was expected be 5.1% turned out worse at 5.5% (apparently more due to a surge in first time employment seekers). The market knee jerk reaction was to sell dollars reflecting a diminishing probability that the Fed would raise rates before the end of the year as the likelihood that the U.S. was in recession grew. In reaction to the dollar selloff, oil began to surge again (further emboldened by an Israeli minister's threatening remarks on Iran), triggering a selloff in global equities and a jump in bond yields as inflation took the front seat of the list of worrisome developments (confirmed by recent Fed remarks).
It is clear by the marked increase in volatility that the markets are trading mainly on sentiment and that when cool heads will eventually prevail, the current "stagflation" like environment will give way to a more sane outlook. This is not to say that the environment won't deteriorate further or that we won't see a sustainable rebound, it is just an observation of an environment that seems to be somewhat detached from reality.

03 June, 2008

Oil dynamics pt.2...

Debate is raging on whether it is fundamentals or speculation that is driving up commodity prices. It is most certainly a combination of the two but there seems to be increasing evidence that fundamentals are the main reason that most commodities have reached record levels. Take oil, for example, where imbalances are observed in both demand and supply. The secular demand story is linked to the increasing appetite of energy intensive development in emerging markets. The supply side is a result of random geopolitical shock and growing uncertainty regarding future reserves. The uncertainty comes from both the demand side (China, for example, discloses consumption figures with a major lag and the accuracy of the figures are questionable at best) and the supply side (Saudi Arabia, the world's largest producer, has never really been truthful when disclosing existing capacity and/or future potential).
With so much uncertainty in the air, no wonder speculation is playing a role. But in a situation where demand is accelerating and where supply is struggling just to keep up with that extra demand (not to mention shrinking existing capacity), it is becoming increasingly clear that fundamentals are the main drivers.
This is indeed worrisome if confirmed because it would mean that higher prices are here to stay, leading to far greater damage to the global economy/social cohesion than if it were mainly due to speculation in which case a sudden sharp correction would make it more of a short term issue.

27 May, 2008

Oil dynamics...

The record surge in oil prices has sparked debate as to what portion of the actual rise can be attributed to pure speculation and what is due to fundamental demand and supply imbalances. It is clear from the rapid rise that speculation has been playing a role but part of the reason behind the difficulty in determining exactly what role speculation has been playing is because of the increasing opacity in demand and supply information. This, in turn, is partly due to the emergence of new players in the oil business, particularly countries like China where transparency is not really part of tradition. There is also growing concern that oil supplies have been overestimated and that the current rise is reflecting an adjustment to reality which is that existing fields have peaked (or are in decline) and that new discoveries are both less frequent and smaller in size (making the business of discovering oil fields a more costly undertaking).
In summary the price hike is reflecting imbalances resulting from the challenges of finding new fields to cover not only a continual drop in output from existing supplies but also to satisfy increasing demand coming mainly from energy hungry emerging countries. To this we can add what has become a perpetual risk premium in the form of geopolitical factors such as limitations in discovery due to war (as in Iraq, Nigeria) or regime change (as in Venezuela).
Although it is very possible that speculation is playing a significant role in the current pricing of oil and that we will eventually observe a large correction, the days of abundant and cheap oil is clearly a thing of the past.

19 May, 2008

Between a U, a V and a W...

I think we can confidently rule out a V shaped recovery at this stage which leaves us with a U shape with its longer "slump" and a W shape, better known as the double dip. The difficulty in forecasting how the current environment will unfold stems from the lack of any historical precedent from which to make inferences (a bit like trying to guess the source behind the commodities spike). Taking a look at the most recent economic figures would have you believe that the economy is exhibiting a remarkable degree of resilience considering almost 10 months of turmoil. Sure, an economy jolted by an ongoing housing recession, a credit squeeze, shrinking real wages and skyrocketing commodity prices is showing signs of fatigue through deceleration, rising unemployment and a steady contraction of profit margins (first quarter earnings were on average 26% lower than the first quarter of last year), not to mention the recent collapse in consumer confidence. What is baffling, however, is when using the past for guidance, at this stage of a slowdown we should be observing an overhang in inventories and investments (we have only observed it in housing so far), businesses should be shedding a far greater number of workers, consumers should be consuming much less and the economy should actually be contracting rather than just decelerating. Instead we have what seems to be a mild response to a major crisis, or a sneeze through which you catch a cold but not the flu! Maybe in the new world we live in the shock absorbers are much thicker which makes the lags much longer and therefore it is just a question of time. It could also very well be that the crisis was well handled by the Fed and, combined with the timing of the injection of government tax rebates, the forward looking markets are already riding a recovery wave in contrast to the lagged economic releases that are still stuck in the slowdown phase. That would in fact make the shape of the recovery more like a tight U (closer to a V). But what if markets are overly optimistic and we are in fact in a doldrums stage just before the second wave of a credit crisis (credit card and car loans anyone?) hits the markets? That would make it a perfect W double dip. To be honest, with so little past data to lean on for guidance, it is exceedingly difficult to predict how the current crisis will unravel.

14 May, 2008

A reversal of roles?

There has been much debate lately as to the degree of correlation between developed and emerging markets. Looking back, a sharp downturn in developed market economies would almost certainly drag the rest of the world with it. This was mainly due to the dependency of export oriented emerging markets to the vagaries of developed market consumers. In the era of globalization the dynamics have changed somewhat as a number of emerging markets have adopted the capitalistic consumer oriented market economy by embarking on a radical course in reform leading to rapid industrialization and the emergence of a distinct middle class. The emergence of the domestic consumer has had a somewhat cushioning effect (at least so far) on the impact of external demand shocks as seen by the remarkable resilience of the emerging markets to the housing and credit led turmoil. Does this mean that the relationship has moved from traditionally high correlation to one of low correlation? Not necessarily if we consider that the strength of third world economies may be what is keeping the crisis laden developed markets afloat. If that is confirmed, it would indeed be a historical first, a sort of reversal of roles.
This new role for emerging markets doesn't come without perils, however, as we observe a general surge in inflation in many of the commodity oriented economies of developing countries. Ever since the Federal Reserve began slashing interest rates, those countries that have currencies that are closely linked to the dollar have had to follow suit. With economies that are already running at capacity, rate cuts have had the effect of pushing up prices as supply struggles with surging demand. There has been some attempt to revalue the currency such as in China, but this has not been sufficient to cap inflation. As the Fed takes a pause from its accommodative stance, the dollar is showing signs of bottoming and if the crisis does abate, it will have a much needed alleviating effect on red hot emerging market economies.

09 May, 2008

Does trouble come in clusters?

History is scattered with anecdotal evidence of clustering and a casual observation of the markets would seem to validate this proposition, particularly with regards to the more recent past. Take a look at skyrocketing oil prices with what seems to be no end in sight. The initial surge, triggered by a combination of a rapid acceleration in third world industrial development, a steadily weakening dollar, market turmoil related speculation and greater difficulty in finding new reserves is now being further fuelled by a confluence of random supply shocks (most recently with the militant attacks in Nigeria).
Food is showing a similar pattern in which an initial surge in prices, triggered by a steady rise in demand (again from the wealth effect of rapid development in emerging nations) combined with supply strains (resulting from ill conceived government incentives) is being further exacerbated by random events such as the devastating cyclone which hit Burma as a time when the price of rice is at record levels.
Mind you, we don't really need to confine ourselves to the universe of commodities to observe the phenomenon of clustering. Take the example of UBS, the largest wealth manager in the world, already reeling from record losses related to subprime, is now facing allegations by the U.S. department of justice for having advised clients on tax evasion.
So it would seem that trouble tends to feed on itself which means that those of us in the money management business should be paying more attention to the fat tails. Doing so may lead to improved risk management.

02 May, 2008

From Wall Street to Main Street...

The current economic crisis which began with the sharp rise in subprime delinquencies earlier last year seems to have remained within the confines of Wall Street. The latest data suggest that main street was and remains relatively unscathed by the turmoil. Corporate earnings for the first quarter has been a mixed bag of surprisingly good and very disappointing results, inflation seems to be relatively tamed, unemployment is not exploding and preliminary first quarter GDP would have you believe that the economy did not contract yet.
Vital signs for the markets are also turning back to normal as observed with the sharp decline in volatility, a sharp rise in treasury yields, the stock market rally and what seems to be a recovering dollar. Even the Fed has alluded to a pause after the most recent 25bp cut in order to assess the impact of its actions.
With all the positivity out there one may wonder if the economic turmoil has reached bottom. I for one remain skeptical that the rebound can be maintained because fundamental issues such as housing deflation, strained lending and record commodity prices continue to plague the markets. The housing deflation and credit markets pose a significant threat to the well being of main street and therefore need to be addressed rapidly and effectively. Cutting the target rate is not going to stop home prices from dropping but we cannot deny that the additional actions taken by the Fed have had a soothing effect on credit markets although the TED spread (3Month Libor - 3 Month Treasury) at 1.37 is still considerably above the 0.20 to 0.35 levels of the period preceding the crisis. As for commodities, the persistently higher prices suggest that the underlying mechanism has changed meaning that we can no longer rely on a simple economic downturn to bring prices back to more normal levels.
Bottom line is that many outstanding issues continue to pose a threat to the recovery (if that is indeed what it is) before we can give the economy the all clear.

24 April, 2008

It is the psychology that matters...

Futures markets are pricing another 25 basis point cut for the FOMC meeting scheduled for next week. There is a strong feeling that the Fed will likely take a pause after cutting rates for the 7th time in 8 months.
Although there has been a clear bias shift from worrying about inflation to worrying about the economy soon after the subprime induced troubles erupted last year, the surge and persistence of high commodities prices have created a sort of malaise as the slowing economy does not seem to be having its desired effect of acting as counter force. It should be noted at this point that the surge reflect structural changes in demand and supply which include the impact of the growing wealth of emerging economies, reallocation of food crops for energy purposes, ongoing climatic changes and other unanticipated supply disruptions.
All this is to say that although the downturn will add a cap to wage induced inflation as the labor market slackens, the risk of provoking higher inflation expectations considering the rise in commodity prices and the aggressive easing in monetary policy in recent months is substantial. The problem remains that once this perception takes hold in the minds of households and businesses, stopping it becomes difficult. For this very reason the Fed is likely to take a breather for a while after next week's anticipated cut to eliminate the perception that it is feeding inflation and to assess the impact of its recent actions.

16 April, 2008

The households headache

Things are looking pretty bad for households, the bedrock of U.S. growth. It all started with the housing recession back in '06, leading to a steady erosion in the value of homes. This in turn led to a surge in debt as the corresponding collateral shrunk in value. With the sharp rise in delinquencies and the widespread direct and indirect exposure to the subprime market, confidence was shaken to the core, triggering a material and chronic pullback in lending. In this environment, households have been finding it increasingly difficult to borrow to counter the rise in naked debt (savings is unfortunately nonexistent in the U.S.). Further harming an already precarious condition has been the constant rise in food and gas prices which have acted as a sort of disposable income tax, not to mention inflation in other goods and services that are eating away into salaries which are already growing at a slower pace (leading to a lower real disposable income). A jittery stock market and signs that unemployment is rising isn't much help either.
No wonder consumer sentiment is at an all time low. So why isn't there more gloom and doom in the numbers given that the great unwind is in full swing and households are being battered from all directions?
Well for one, the rest of the world has so far shown a surprising degree of resilience to the crisis (although there is strong contention as to how long this will continue). Combined with a dramatically weaker dollar, exports have been booming (not to mention the sovereign fund bargain hunting spree). To this we add a federal reserve, that, although in the beginning was dragging its feet (with its inflation concern), is now much more focused in its bid to save the economy. Bernanke's creative touch combined with a willingness to sacrifice moral hazard risk to avert the growing risk of a protracted recession (as seen with Bear's rescue) should help diminish the impact of the crisis. This will take time though considering contagion and the abundance of toxic debt still to be written off. It will take a painful cleansing process of the economy before we start to see an end to the obsessive/compulsive nature of the markets.

10 April, 2008

The commodities conundrum...

Theory backed by empirical evidence tells us that during an economic downturn, commodity prices follow suit, acting as a sort of barometer on the level of economic activity (i.e. in times of global expansion, there would be greater demand for scarce resources and vice versa).

There is heated debate in the current environment as to whether this relationship still holds, given that almost all commodities are at or close to record levels. The answer is important because it could determine the extent and duration of the turmoil at hand (higher commodity prices that remain sticky would deteriorate further an already fragile economy through its adverse effect on spending, not to mention ravages of inflation).

Why are prices so stubborn in the current downturn you may ask? Well, apart from the speculative money that has been driving prices higher we have secular trends that are starting to play an increasingly deterministic role on pricing. The emergence of China and India as global centers for production and services have led to the creation of a distinct middle class with greater spending power and resulting shift in lifestyles. One of those changes concerns food (or the move towards a more protein rich diet). Another is the growing population (more mouths to feed) or manmade environmental changes (freak weather conditions such as extended droughts) or even flawed government policies (food crops reallocated to the production of fuel). All these factors are likely to have profound and, in some cases, long lasting impacts on scarce resources across the board.
It should come as no surprise therefore that commodities will be amongst the most serious issues that will need to be tackled this century. Again, no surprise as it is, after all, a case of forcing mankind's infinite needs and wants in a world of finite resources.

03 April, 2008

Bull or Bear?

I concede it is a no brainer question considering the direction of markets, not to mention economic releases and Bernanke's latest testimony. We have been and continue to remain in a Bear market environment ever since the subprime turmoil of August last.
What is also certain is that this crisis is unprecedented in its nature. It does not compare to the dot com collapse or the '87 crash as multiples are not the catalyst, it doesn't compare to LTCM which was a very focused event, it doesn't compare to the Asian currency crisis nor the Russian defaults. Only if we go back to the Great Depression can we draw some parallels, but even then the comparisons are very limited.
Like today, a great unwind followed the market crash of 1929 as households and businesses had piled and were sitting on mountains of debt. But unlike today, Central Bankers were not as sophisticated and did not have much history to rely on, the flow of information was far from light speed, there was no computing power to speak of and you didn't have the type of coordinated and collegial support amongst the various institutions that we observe today.
These differences together with the fact that this crisis originated in the U.S. also means that there is a greater probability for it to be resolved in a shorter time frame. The U.S. is more likely to take losses on the excesses of the past or turn the page, so to speak, than a country like Japan which ended up paying a monumental price for their stubborness in keeping bad debts in their books for so long.
So the bear will eventually turn into a sustainable bull but it is anyone's guess as to when that will occur. The only effective way to exploit this uncertainty is by remaining diversified and ensuring that the portfolios are rebalanced whenever such action is necessary. The rest is just hot air...

27 March, 2008

A modern day equivalent of a run on the bank?

Granted, the Fed's intervention to avoid the total collapse of Bear Stearns is not exactly analogous to saving an institution from the threat of a bank run if we consider the precise definition of a run on the bank, i.e. a situation in which panicked customers simultaneously withdraw their savings as a result of fear that by not doing so they may lose what they have. As the bank only keeps a fraction of deposits in cash, without some type of external help, it will implode.
Bear Stearns is not a commercial bank and therefore technically does not have any deposits to raid. In Bear's case the crisis began when their ability to borrow was suddenly cut off. It ensued the collapse of Carlyle Group's flagship Carlyle Capital fund when rumors began to circulate that Bear had a large stake in the fund. So why, you may ask, would this be considered the modern day equivalent of a run on the bank, warranting Fed intervention? The answer has to do with the bigger picture. The Fed figured that the risk of triggering systemic risk by allowing Bear to go bankrupt was higher than the risk and repercussions of moral hazard. It would have led to further casualties in the financial sector as lenders became more reluctant. In addition to coming to the rescue of Bear Stearns, the Federal Reserve announced that it would extend its lending facilities to a wider segment of the financial sector. This should help substantially to mitigate the risk of another blowup.
As for market conditions, the rough ride is likely to persist as the root housing crisis will drag on for a while to come irrespective of what the Fed and/or government do.

19 March, 2008

A record breaking month...

March has turned out to be a month in which several records were broken. In the commodities front both gold and oil were notable for surging past their all time highs whilst in currencies, the ever so weak U.S. dollar reached new lows most notably against the Euro and the Swiss Franc. It also turned out to be a month in which wealth got wiped out in record breaking speed with the dramatic implosions of Carlyle Capital (a highly leveraged flagship fund of the Carlyle Group) and Bear Stearns (formerly the 5th largest U.S. bank) which saw it's 85 year history evaporate into thin air in just a couple of days.
The Fed has attempted to counter the hemorrhage from several angles by boosting the term auction facility to 200 billion dollars and raising the lending period to 28 days, cutting the discount window by 25 basis points and cutting the target rate by 75 basis points. It is clear from these actions that the Fed perceives a growing threat on the orderly functioning of the financial system. These moves have also brought the morale hazard debate back into center stage as a growing chorus of pundits are arguing that bailing out the likes of Bear Stearns is sending the wrong message.
In an environment in which fear has overtaken greed and where emotions are running high, irrational behavior seems to be the order of the day. The sharp drop in commodities following the 75 basis point cut in the target rate is a prime example of this. It seems that the sell off occurred because the market was anticipating a 1% cut and was therefore disappointed with a cut that was a quarter point less. If we take this train of thought a step further, what the market seems to be suggesting is that a difference of 25 basis points will be enough to determine whether we will experience an economic expansion or a recession or whether there will be inflation or price stability. If this is not insane, I don't know what is!

12 March, 2008

Want a tip?

Treasury Inflation Protected Securities, better known as TIPS are all the rage these days and should be, given their stellar returns (more than 6% since the start of the year versus roughly 4% on plain treasuries). In effect, these instruments are the equivalent to plain vanilla treasuries but carry even lower risk given that they protect the holder from the corrosive effect of a surge in inflation which is accomplished by adjusting the nominal value at maturity by changes in the broad measure of the CPI index. The inflation hedge explains why yields are below those of standard treasuries.
TIPS which were introduced in 1997 are also an important measuring tool for inflation expectations. One looks at the spread and the change in spread between the treasury yield curve and that of TIPS to get a feel of inflation expectations. Like with an ordinary bond, if the yield (or real yield in parlance terms) remains the same, the bond price doesn't budge. But if there is a shift in inflation perception, price movements occur (like we have seen over this year and last).
With a steepening yield curve and the performance in TIPS and commodities in general, the market is telling us that the risk of inflation on the horizon is rising. It is no wonder given the aggressive cut in rates over the past weeks and months. But then we have a lag factor of between 6 and 8 months from the moment a change in rates takes place and it's effects begin to appear in economic releases. This means that the Fed is playing a very delicate balancing act whereby as soon as it feels confident enough that the conundrum has subsided for good, they will have to aggressively tighten to avert inflation from getting out of hand. In the mean time, having some form of hedge against inflation in one's portfolio should be considered as a sound proposition.

04 March, 2008

In the age of turbulence...

It is challenging enough to keep a cool head in an environment of negativism when a growing chorus of industry pundits are suggesting the end of the world is near. Now I am not suggesting that a major correction is not in the cards, what I am trying to point out here is how difficult it becomes for a portfolio manager to stay the course when turbulence hits with full force. An environment of elevated psychosis in which emotions are running high frequently leads to a situation in which managers lose focus of long term objectives (a key feature of modern portfolio theory), and instead concentrate on playing cat and mouse so to speak. In the current environment where uncertainty reins, one may be tempted to switch into cash and just stack it under a mattress. But what happens when things return back to normal? More specifically, without hindsight, how can we be sure that normalcy has returned?
To illustrate these important points let's take the October '87 crash. On a single day the S&P 500 lost around 20% of its value. Emotions where running very high at the time and a lot of investors decided to take the plunge either by liquidating their positions and switching to cash or bonds. But who would have guessed that just a bit over 3 months later, 90% of that loss had been recouped. Those that had ceded to panic had not only lost 31% of the value of their investments (if we take the drop from it's peak), but failed to capture any of the upturn (bonds had already peaked before the stock market crash).
Again, I am not suggesting that staying the course in turbulent times is an easy task. On the contrary, it can be extremely challenging. If there are any lessons to be learnt, however, it is that ceding to emotions can prove to be an extremely costly endeavor in the long run as we have seen with the example and there are plenty of studies out there that support this view.

27 February, 2008

Stagflation rears its ugly head...

The economic releases of the past week are pointing towards stagflation with a surge in inflation on the one hand (with CPI and PPI figures above market consensus) and signs of a slowdown (further weakness in housing, a marked drop in consumer confidence and a slump in durable goods orders). With a Fed bias towards further cuts, the risk is tilted towards a surge in inflation into the future. This is already showing up in a steadily steepening yield curve and a sharp rise in commodity prices, particularly gold (a traditional inflation hedge), silver and oil.
It is hoped that further rate cuts will help reinvigorate lending by banks by helping steepen the yield curve (making it more profitable for banks to borrow short term and lend long term) but it is difficult to see how this would work considering that those very banks are in desperate need of cash themselves to cover up for their burgeoning subprime pyramid scheme related losses. Sovereign wealth funds, awash with cash, have provided some relief but their contribution may be limited considering that the U.S. is in an election year prompting further scrutiny and disclosure requirement over this source of financing (this is already occurring both in the U.S. and the E.U.) and further deterioration in the health of financial firms may limit investor enthusiasm.
All in all, things aren't looking too bright for the moment but stay tuned for more...

22 February, 2008

Tip of the iceberg?

With every announcement of a write down, markets are pondering if we have reached bottom, but each time optimism builds up it gets swept away by some more bad news.

One serious problem that is likely to linger for a while is the housing recession. Prices, despite the crisis, still remain very high. Take the Case/Shiller national housing price index as an example. This very comprehensive index goes all the way back to the 1870's. If we take the average annual price increase over the whole period, it comes to slightly below 1% per annum. House prices really began skyrocketing towards the end of the 90's when they began to rise by around 8 to 9 percent per annum. All things considered, it is estimated that prices would have to drop by at least 25% for things to get back to normal. So far, since the crisis began, prices have dropped by about 8% on a national basis so there is still some distance to cover.

The erosion in home value will in time have an adverse effect on consumption, exacerbating the economic slowdown. That and further credit tightening will leave consumer with little reason to spend. Accomodative Fed policy and a fiscal stimulus package wont resolve the problem. On the contrary, they may make matters worse by fueling inflation as the latest CPI figures seem to be suggesting.

14 February, 2008

Decoupling in Japan?

Surprisingly strong fourth quarter GDP results for Japan combined with better than expected U.S. retail sales figures led to the largest single day rally in the Nikkei 225 index in 6 years. The robust GDP figures were credited mainly to a boost in exports to emerging markets, particularly in Asia. Given the traditional reliance on the U.S. market (which remains the single largest consumption market in the world) for most of Japan's exports, economic deterioration in the U.S. had been weighing on Japan's growth prospects for some time already, ever since the subprime crises unfolded.
Emerging economies, in recent years have benefited from more disciplined fiscal and monetary policies that have led to strong growth, an accumulation of reserves, low debt and a greater ability to withstand a marked slowdown in the U.S. than at any other time in history. The Japanese export market seems to have benefited from these structural changes. Risks of contagion remain, however, in the event that the U.S. enters a protracted slowdown or even a recession. Such a scenario would weigh heavily on exports that many emerging markets (most notably China and India) depend on. This would have a cascading effect on developed markets such as Japan that increasingly relies on the fortunes of its neighbors.

07 February, 2008

Have we reached bottom yet?

That is what the U.S. treasury yield curve would have led you to believe earlier in the week following all the ongoing balance sheet write offs and the Fed's desperate attempt to jump start what was increasingly being perceived as an economy on the brink of recession. But just as the long end started rising, steepening the overall shape of the yield curve, the release of the ISM report (a gauge for the more important services sector) had the effect of a slap on the face. Indeed, if the figures are to be taken at face value, services are technically in contraction (to be fair, it should be noted that ISM reports are notoriously unreliable predictors). This was to be compounded by further weakness in home sales (no surprise there), disappointing January retail sales figures and higher than expected jobless claims for last week.
So despite a 125bp cut in rates and a government fiscal stimulus package in the pipeline it seems that we have not hit bottom yet. To be fair, the economy needs time to digest the more accommodative policies of recent weeks and so relying on backward looking indicators to gauge the state of the economy is not very useful. As such, it would seem that stock markets have become increasingly sensitive to the vagaries of economic releases, in the process losing part of its more traditional leading indicator characteristics.
To sum it up, although it is clear that we have not reached bottom yet (more turbulence is on the way), with recent and future anticipated Fed and government action and with all the write downs going on, we may be approaching a sweet spot that may very well lead to a sustainable recovery.

28 January, 2008

Treasuries to the rescue...

With hindsight, treasuries have proven a safe bet in the midst of the market turmoil that has left little else intact in its wake. As the subprime tentacles appeared in the most unlikely of places (money market instruments, triple A rated securities) investor appetite for risk took a nosedive. With the volatility index back to normalcy and the days of cheap credit a thing of the past, flight to quality has gained momentum. Fixed income gurus that back in June were convinced that the bull run era that started over two decades ago was reaching its end seem to have gotten it completely wrong. Treasuries posted their best returns last year since 2002 only to be overtaken by TIPS as markets were uncertain whether we were heading into stagflation or just plain stagnation or even recession.
As the U.S. economy showed further signs of deterioration and the risk of dragging the rest of the world into a protracted slowdown grew, inflation worries evaporated prompting the Fed to embark into one of its most aggressive accommodative policies in recent history, cutting the Federal Funds Rate by a spectacular 125 basis points in the span of just a week. If the Fed continues in this direction, it won't be very long before we reach negative real interest rates. This is troublesome as it is difficult to predict the consequences on the economy of having negative rates.

22 January, 2008

Ceding to panic...

Last night's ad hoc FOMC meeting and the resulting announcement of a whopping 75bp cut in rates(last time such a move took place was back in 1982), bringing the Federal Funds Rate down to 3.5% from 4.25% took everyone by surprise. The global market sell off that began on Monday and continued on to Tuesday, reflecting growing worries that the U.S. economy is slipping into recession, added additional pressure on a Fed that had already been battered for its reluctance to nudge from the inflationary bias, prompting it to take drastic action. The one area that seemed to be unscathed by turmoil so far, namely export demand from the U.S. began to falter as markets around the world entered a correction phase, raising worries of a global slowdown.
What is clear is that by not waiting another week, the Fed seems to have lost control of the situation with its credibility somewhat tainted. The Fed carried out this latest move either because it ceded to market pressures (which in itself is not a bad thing given signs of a rapidly deteriorating environment) and/or because it is acting on information that is not yet out in the open.
What is important now is with regards to the future given that investor perception of the Fed has changed somewhat. This change is likely to have consequences not only on the Fed's behavior going forward but also on how the markets will react to it.

17 January, 2008

Recession?

There is a growing crowd of doomsayers warning us that the U.S. is already in a recession or that a nasty protracted downturn is just around the corner, but how exactly do we define let alone measure it? According to market consensus, a recession is defined as two consecutive quarters of decline in a country's Gross Domestic Product. Right up to this point, the data we have on the U.S. suggests a slowdown but the problem is that this data is heavily lagged (backward looking) and subject to revisions. That means we will not know if the U.S. is currently in a recession until at least a couple of months from now.
There are other "leading" indicators, however, that can provide precious clues as to the health of the economy. Employment figures such as jobless claims, retail sales, corporate earnings or even the stock market are good examples. The stock market index is particularly interesting because, unlike most other indicators, it is purely forward looking although it can be misleading (such as during periods of bubble formations). A bear market in stocks, defined as an extended period (usually a year) over which prices decline more than 20%, typically occur during periods of economic recession.
So, using these criteria, can we say that the U.S. is in an economic recession? The answer is far from clear. The broad S&P index, for example, is down 9% from its most recent peak (in this regard Japan would be more of a bear candidate than the U.S.). Other indicators such as retail sales, jobless claims and corporate earnings do show weakness, but nothing as serious as with the housing sector which is clearly in recession territory.
With inflation pressure showing signs of easing and further economic deterioration, the balance is tipping towards downside risk on growth rather than the upside risk on prices. No wonder the market is placing a 36% probability for a 75bp cut for the end of the month (up from 0% last week).

08 January, 2008

Into 2008...

The graph above may bring a bit of nostalgia to those of us that were arcade game buffs back in the 80's but I can assure you this is no sequel to "Tempest". Although blasting vector graphic drawn aliens was a lot of fun at the time, it is also a far cry from today's multi core powered lifelike 3D shading technology.
Getting back to serious stuff, the "radar" (yes, that is what it is known as) graph is a neat way of presenting our global economy expectations for 2008. So what are we saying? Well, we think that there is a strong likelihood of a slowdown (I didn't say a recession!!!) in growth across the globe led by a U.S. downturn (itself a result of the ongoing housing recession and credit crisis).
Our rational is as follows: U.S. consumers are being hit by wealth erosion, on the one end by a steadily shrinking value of their homes and stock market losses and, on the other hand a sharp rise in oil prices making such things as gasoline prices and airline tickets more expensive. We could argue that a quick fix would involve borrowing more (after all, that is what has been powering the recent consumer led expansion in the U.S. and in many other countries). Problem is that lenders are no longer as willing to lend as they did in the past so money is becoming hard to get by (and this goes for businesses too).
We could also argue (like some do) that a marked slowdown in growth would ease the pressure on oil prices, giving the Fed more flexibility with its accommodative policy. Maybe so a decade ago but things have changed dramatically since. The U.S. is having a smaller impact on oil prices mainly because the majority of growth in demand has been coming from China and India (and the consumption levels still remain far below that of developed countries). Combine this with ongoing geopolitical turmoil (most recently with Pakistan) and supply side issues and lower oil prices quickly becomes wishful thinking.
To summarize, the Fed (and many other central banks for that matter) are going to have a tough year ahead but they certainly won't be the only ones who will be navigating in rough waters.

DISCLAIMER

This document has been produced purely for the purpose of information and does not therefore constitute an invitation to invest, nor an offer to buy or sell anything nor is it a contractual document of any sort. The opinions on this blog are those of the author which do not necessarily reflect the opinions of Lobnek Wealth Management. No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written permission of the author. Contents subject to change without notice.