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...

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.

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.

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.