A meltdown?

The recent global market slide sparked by fears of a looming credit crunch might very well be the first stages of the so called great unwind. Investors were taken by surprise, especially those that were under the impression of being hedged against this very type of loss. It just comes to show that complex derivative strategies don't always perform as expected.
There are signs that we may be entering a protracted slowdown phase for the global economy. We all recognize the beneficial effects of globalization on growth, especially in terms of its disinflationary impact. If we take the recent past as an example, another beneficial effect seems to be longer lasting economic cycles. What use to be 7 to 8 years of expansion before a recession now seems to last in the range of 9 to 10 years. Greater coordination between central banks and a more prudent approach to monetary policy clearly play a role in this.
But there are signs that the party is coming to a close. As yields worldwide continue to rise, the housing woes will continue to deteriorate. Since consumers perceive housing in a similar manner to stocks, this will invariably have a negative impact on the wealth effect in addition to the effect of higher food and energy prices. Eventually, the yield curve may reinvert. That in itself is not enough to suggest a looming recession. For that to happen, we also need to add rapidly deteriorating credit spreads (something that seems to be occurring at the moment).

The volatility factor

The slide in global markets over the last two weeks were precipitated by markedly higher volatility levels which first spiked when Chinese woes sent stocks on a tailspin back in February last. Higher volatility inflate risk premiums (no wonder it figures in the Black and Scholes option pricing model) creating havoc for certain segments of the markets. More volatility can also be a good thing, depending on how you are structured. With a sudden jump in the vix index, one of the first reactions tends to be a general flight to quality and the most recent market turmoil is a perfect example of this. Credit spreads have widened substantially as money has poured out of corporate and high yield bonds towards the safety of treasuries. There is also a move out of riskier emerging market stocks towards those of developed markets. We can add to this the switch from small cap to large cap although part of it is related to the advanced stage of the cycle. Finally, there tends to be sector rotation in favor of defensive industries such as consumer staples or health care during periods of high volatility.

Whiplashed into submission

1.3 trillion dollars of market value evaporated into thin air over the week as a result of a flurry of bad news (in an almost coordinated fashion) hitting investors by materially denting their appetite for risk. Disappointing German business confidence figures was followed by weaker than expected U.S. durable goods orders and new home sales, and an unexpected earnings disappointment for Exxon Mobil Corp., triggering a global equity sell off. The prevailing mood was one of pessimism as investors began contemplating the effects of a protracted housing slump and markedly higher borrowing costs on businesses, consumption and ultimately growth. The downward revision in risk premiums and the ensuing flight to quality led to a rally in treasuries, a further widening of credit spreads across the board and the unwinding of carry trades. It also led to several big ticket debt issuance postponements as borrowers began to asses the impact of an increasingly expensive corporate credit market. Volatility, which had been on an uptrend ever since the China related turbulence of late February jumped up again as a result of these events. The gloom is also reflected in the the futures market for the federal funds rate which is at the moment anticipating a quarter point cut by the end of the year with a conviction of 100%.

The fed in a state of benign paralysis?

Reading the tea leaves of Bernanke's recent comments, it seems that we are in for a protracted period of inaction on behalf the fed's target rate (well, technically, its protracted already considering that it has been a year since the fed put an end to its tightening policy). The housing slump shows no end in sight but at the same time there is growing fears that ever so costly food and oil will eventually trigger a jump in inflation expectations. Not that there is anything wrong with sitting tight when it comes to rates. When visibility is poor and when you have two forces pulling in opposite directions as seems to be the case at the moment, doing nothing may very well be the prudent thing to do! Not that we are in the midst of a stagflationary slump considering the relatively strong growth rates and an inflation level that is considered tamed. There has been some criticism of the Fed for prioritizing the core inflation figures at the expense of the headline rate. The original reason behind switching from headline to core was to remove the excess volatility that food and oil contributed to the figures. But things have changed since, with food and oil prices more stable and hence the flak directed towards the fed. The counter argument has been that even with more stable prices, the ultimate measure might still be the core because its only if the core is rising that we know that the rise in oil or food prices have trickled into the rest of the economy. Maybe we should have a compromise, say a dynamically weighted composite of the two measures? Or maybe even invent a new measure? Food for thought, I guess.

A subprime contagion waiting to happen

Markets were once again jolted this week as the sub prime related losses were compounded by the rating agencies decision to downgrade securities backed by this rapidly disintegrating segment of the housing market. The move, albeit a bit late, did send a strong message to the investment community that the size and duration of losses may have been (surprise, surprise) underestimated. This will evidently exacerbate the problem as it means higher lending rates and tighter rules to an already fragile base. The growing risk of contagion triggered a two day stock market sell off, raised treasury bond prices, widened credit spreads across the board and pushed the dollar lower versus other major currencies. Bears clearly had the upper hand over the week, reviving bets that a cut would be the Fed's next move. On a brighter note, trade balance figures for May were spot on with expectations, providing some short term relief for the dollar whilst initial jobless claims came out weaker than expected, signalling continued strength in the economy. Of course, it is common knowledge that economic figures provide a snapshot of the past and are typically subject to revision meaning that we don't really have a full grasp as to the current health of the economy.

Into the abyss

Fears on inflation were revived today with the bank of England's decision to tighten its key rate by a quarter point, sending the pound to a 26 year high versus the dollar on the back of continued strength in the financial services industry and rising home values. This was followed by ECB comments suggesting a bias towards tightening. As if it weren't enough to rock the inflation boat, U.S. service industries and the private jobs report posted stronger than expected results sending treasuries lower.
With the services industries providing a counter balance to manufacturing (turned sour by the sub prime debacle), the impact on employment may be just what is needed to keep household consumption on track. On the other hand we have the so called paradigm shift, in effect putting us in uncharted territory which makes it excessively difficult to predict how things will unfold. The growing interdependency amongst various economies and the increasing complexity and sophistication of financial instruments makes it more and more difficult to grasp the full extent of risks in the market. Warren Buffet's adage of avoiding what can't be understood may be appropriate at this stage.

A growing case for tightening

The proponents of a Fed rate cut point at the ongoing housing debacle, rising interest rates and commodity prices which they are argue are threatening to stifle consumer and business spending. On the other hand buoyant corporate profits, rising energy and food prices and strong global growth threatens to spillover in the form of higher inflation, warranting an eventual tightening of rates. Until recently, the bears had the upper hand, forecasting a fed rate cut before the end of the year but things have changed recently with the concerted global central bank effort to hike rates, indicating growing fears on inflation. Energy prices have been on an uptrend, coming within close range of last year’s records as a result of a combination of ever so stronger demand and tighter supplies. A catastrophic hurricane season over the summer is all it may take to push prices above last years record. Food prices have also been on an uptrend mainly as a result of growing demand for bio fuels. With U.S. legislation moving towards tighter environmental standards as a result of a combination of greater awareness of the issues at stake and the upcoming presidential elections, the move to alternative sources of energy will only exacerbate the short term pressure on food prices. As the correlation between headline and core inflation measures are relatively high (roughly 0.75 going back to the early 90’s) and as there tends to be a 6 month lag on average between the two measures, it is only a question of time before the jump in food and energy prices impact the core figures. As a result of this, the market is predicting a possible tightening by the fed no later than the first quarter of 2008.

The bears steal the show

Last week's interest rate jolt, reflecting a global expansion running at full steam seems to be overshadowed by the continued rise in crude oil prices (rapidly coming within range of last year's record level) and today's drop in housing starts, signalling that we may still have some way to go with the housing debacle. As mentioned earlier, rising interest rates (particularly at the real estate sensitive 10 year segment) is bound to exacerbate an already difficult condition. The corporate sector, which has seen a pickup of late is also likely to be hurt by higher rates.
So it seems that the bulls on the street, the one's that have been dismissing fed cuts for the year, may have been a bit premature with their assessments. It will take some time still before we get a clear picture, considering the multitude of competing factors swaying the economy in one direction or the other. What seems almost certain, however, is that the all important consumer is being battered on several fronts and, unless we see a radical change in this, the economy will undoubtedly suffer.