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.

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."

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.

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.

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.