Another point in favor of the goldilocks camp...

Yesterday's labor cost and productivity figures for Q1 of this year suggests that the economic slowdown is having an impact on inflationary pressure. Productivity growth typically neutralizes the inflationary impact in an environment of rising labor costs, thereby helping to sustain an economic expansion. In the current environment, confronted with a slowing economy, better than expected productivity rates combined with a slight rise in unit labor costs is considered good news, and should help sooth stagflation fears. If, going forward, economic indicators continue to confirm this trend, it will provide the fed with greater room for manoeuvre in terms of easing rates to counter the slowdown. Recent housing figures suggest that the debacle is not over yet and the risk of it spreading elsewhere in the economy continues to pose a material threat. We have already seen an impact in today's employment figures. On the other hand, despite the recent downturn in capital expenditure, corporate earnings remain relatively strong (in the upper single digits), helped in part by strong growth outside of the U.S. and a weakening dollar. The direction for the economy at this stage is clearly at crossroads.

The great unwind...

Ever since stock market returns began to deteriorate after the collapse of the dot com boom, investment managers have been scrambling to find alternative sources to satisfy their quest for double digit returns. A quick fix arrived in the form of additional leverage, widely used in the hedge fund world. Globalization and the resulting breakthroughs in financial engineering have led to a rapid growth in new products particularly in the derivatives markets. Today, we find derivative products that synthetically replicate the performance characteristics of a single stock or a basket of stocks. Others provide a type of insurance against the default of a bond with very poor credit quality. The point is that many of these instruments provide leverage to the buyer and when a large number of buyers tend to be hedge funds in a relatively unregulated environment, it becomes very difficult to quantify the amount of leverage in the markets. The issue with this situation is that it is difficult to predict what will happen in the event of a crisis if we don't know how much leverage we have.

Consumer is king!

Yesterday's U.S. durable goods orders and home sales figures painted a mix picture regarding the economy. On the one hand we saw a pick up (and a clear relief for some) in durable goods orders for the month of march after disappointment a month earlier. This could suggest a rise in capital expenditure as inventories shrink, a welcome development following the worrisome cut in corporate spending. On the other hand, we saw further evidence that the housing slump had not bottomed out as some pundits were suggesting. New home sales came below expectations, similar to the disappointing existing home sales figures released earlier in the week. The key lies with how consumers are likely to react to the housing debacle, and so far things are not looking too shabby apart from the occasional red flag such as the recent consumer confidence figures. In addition, with rising oil prices and a weakening dollar, inflation is likely to remain on the Fed's radar screen and constrain their ability to loosen for some time to come.

The dreaded fat tail...

Globalization, greater financial integration and the substantial improvement in cross border flow of capital has led to an explosion in financial innovation and the creation of a substantial amount of new wealth. Securitization combined with novel and sometimes exotic derivative products such as credit default swaps go a long way in explaining why liquidity in the markets have not dried up despite relatively high interest rates and an inverted yield curve both in the U.S. and the U.K. This is all very nice and dandy when things are going in the right direction. Correlations between markets and across asset classes tend to be relatively weak during an ascent and when volatility is subdued. But this can change rapidly when a fat tail event materializes. Take the Chinese single day drop of 9% at the end of February. Volatility spiked to record levels together with correlations, sending global markets on a tail spin. A complacent market was caught by surprise. In such a highly integrated global market, one cannot fail to ponder about the potentially disastrous repercussions of an unexpected catastrophic event.

A Goldilocks day

A lot of focus went into yesterday's economic releases mainly due to the fact that it would provide clues as to the direction of the U.S. economy, more specifically as to whether the economy is heading towards stagflation (slowdown in growth combined with pricing pressure) or towards the ideal "Goldilocks" environment (moderate growth with inflation buried well into the comfort zone). The figures turned out in favor of a "Goldilocks" scenario with core CPI slightly below expectations and the housing market coming above expectations. It is clear that due to the innate volatile nature of housing which, amongst other variables, is very sensitive to changes in the weather, the current releases should be taken with a grain of salt. Also, although the latest inflation readings spells short term relief for the Fed, it will take several occurrences of lower than expected price releases for the Fed to start putting its guard down.

The shifting shape of the yield curve

There is talk of readjustment back towards the normal upward sloping curve that has been absent from the U.S. treasury market for a while already. This will mainly depend not only the degree of resilience of a core inflation rate above the Fed's comfort zone of between 1 and 2 percent, but also on how the housing market tremors unfold (or more specifically on the probability of a possible spillover effect from the sub prime market into other segments of the mortgage market). A steadily weakening dollar and relatively sanguine global growth rates (revised slightly downwards to 4.9% recently by the IMF) doesn't help much in cooling the core inflation rate. On the other hand, the forecasted economic slowdown for 2007 together with the housing debacle may be enough to push unemployment higher and prompt the fed to start lowering rates. In effect, these two opposing forces may be just what is needed to readjust the yield curve back to it's natural upward sloping shape.

A paradigm shift but this time for real?

It use to be that an inverted yield curve would imply that a recession was close at hand, it's predictive power has indeed been close to 100% since the 1950's. The mechanics is straight forward, an inverted yield curve strains the system because banks that borrow short term and lend long term have no incentive to do so if they are losing money on the operation. With less credit available, investment and consumption, two key contributors to growth are adversely impacted, rising the probability of a recession.
So we may wonder how despite high short rates and the inverted environment in the U.S., the economy is still doing rather well, awash with liquidity, healthy earnings, a rise in M&A activities, share buybacks etc. It could have something to do with the fundamental changes in the economic environment of the past decade. The free flow of capital on a truly global scale and the explosion in financial innovations have markedly changed the landscape. Maybe we need to write off the typical yield curve of a particular country or region and instead think of a global composite yield curve comprised of maturity patches from different countries. The short end would have Japan with it's 0.5% yield and the longer end would have a batch of emerging countries with double digit yields. This might partly explain why lending is unhindered and why central banker's might feel more impotent than at any time in the past.

A more upbeat assessment?

LBO's seem to be all the rage these days, most recently with KKR's 25 billion dollar purchase of credit card processor king, First Data Corp. This deal, together with a more upbeat assessment for U.S equities given their relative cheapness to fixed income is helping to counter the negative repercussions of the housing slump somewhat. Today's Asian stock market gains reflect not only the rise in copper prices but also greater optimism on behalf of investors that the U.S. economic slowdown may not seem as worrisome as earlier figures would suggest. Activity in the LBO realm revive the notion of an embedded put option in the form of private equity cash stashed aside and ready to be put to use as opportunities arise. This may indeed be the case as long as corporate profits remain sanguine. The latest figures do suggest, however, that the economic expansion is decelerating, most recently with the slump in manufacturing growth for the month of March, and the forecast remains that corporate earnings growth for this year will be in the single digits. Add to this the negative impact that the housing jitters will have on consumption, and it becomes evident as to why the Fed should be less worried about inflation. This week's unemployment figures should provide further clues regarding the health of the economy.