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.
24 April, 2008
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.
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.
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...
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...
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