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.
25 June, 2008
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!
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.
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.
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.
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