Stagflation rears its ugly head...

The economic releases of the past week are pointing towards stagflation with a surge in inflation on the one hand (with CPI and PPI figures above market consensus) and signs of a slowdown (further weakness in housing, a marked drop in consumer confidence and a slump in durable goods orders). With a Fed bias towards further cuts, the risk is tilted towards a surge in inflation into the future. This is already showing up in a steadily steepening yield curve and a sharp rise in commodity prices, particularly gold (a traditional inflation hedge), silver and oil.
It is hoped that further rate cuts will help reinvigorate lending by banks by helping steepen the yield curve (making it more profitable for banks to borrow short term and lend long term) but it is difficult to see how this would work considering that those very banks are in desperate need of cash themselves to cover up for their burgeoning subprime pyramid scheme related losses. Sovereign wealth funds, awash with cash, have provided some relief but their contribution may be limited considering that the U.S. is in an election year prompting further scrutiny and disclosure requirement over this source of financing (this is already occurring both in the U.S. and the E.U.) and further deterioration in the health of financial firms may limit investor enthusiasm.
All in all, things aren't looking too bright for the moment but stay tuned for more...

Tip of the iceberg?

With every announcement of a write down, markets are pondering if we have reached bottom, but each time optimism builds up it gets swept away by some more bad news.

One serious problem that is likely to linger for a while is the housing recession. Prices, despite the crisis, still remain very high. Take the Case/Shiller national housing price index as an example. This very comprehensive index goes all the way back to the 1870's. If we take the average annual price increase over the whole period, it comes to slightly below 1% per annum. House prices really began skyrocketing towards the end of the 90's when they began to rise by around 8 to 9 percent per annum. All things considered, it is estimated that prices would have to drop by at least 25% for things to get back to normal. So far, since the crisis began, prices have dropped by about 8% on a national basis so there is still some distance to cover.

The erosion in home value will in time have an adverse effect on consumption, exacerbating the economic slowdown. That and further credit tightening will leave consumer with little reason to spend. Accomodative Fed policy and a fiscal stimulus package wont resolve the problem. On the contrary, they may make matters worse by fueling inflation as the latest CPI figures seem to be suggesting.

Decoupling in Japan?

Surprisingly strong fourth quarter GDP results for Japan combined with better than expected U.S. retail sales figures led to the largest single day rally in the Nikkei 225 index in 6 years. The robust GDP figures were credited mainly to a boost in exports to emerging markets, particularly in Asia. Given the traditional reliance on the U.S. market (which remains the single largest consumption market in the world) for most of Japan's exports, economic deterioration in the U.S. had been weighing on Japan's growth prospects for some time already, ever since the subprime crises unfolded.
Emerging economies, in recent years have benefited from more disciplined fiscal and monetary policies that have led to strong growth, an accumulation of reserves, low debt and a greater ability to withstand a marked slowdown in the U.S. than at any other time in history. The Japanese export market seems to have benefited from these structural changes. Risks of contagion remain, however, in the event that the U.S. enters a protracted slowdown or even a recession. Such a scenario would weigh heavily on exports that many emerging markets (most notably China and India) depend on. This would have a cascading effect on developed markets such as Japan that increasingly relies on the fortunes of its neighbors.

Have we reached bottom yet?

That is what the U.S. treasury yield curve would have led you to believe earlier in the week following all the ongoing balance sheet write offs and the Fed's desperate attempt to jump start what was increasingly being perceived as an economy on the brink of recession. But just as the long end started rising, steepening the overall shape of the yield curve, the release of the ISM report (a gauge for the more important services sector) had the effect of a slap on the face. Indeed, if the figures are to be taken at face value, services are technically in contraction (to be fair, it should be noted that ISM reports are notoriously unreliable predictors). This was to be compounded by further weakness in home sales (no surprise there), disappointing January retail sales figures and higher than expected jobless claims for last week.
So despite a 125bp cut in rates and a government fiscal stimulus package in the pipeline it seems that we have not hit bottom yet. To be fair, the economy needs time to digest the more accommodative policies of recent weeks and so relying on backward looking indicators to gauge the state of the economy is not very useful. As such, it would seem that stock markets have become increasingly sensitive to the vagaries of economic releases, in the process losing part of its more traditional leading indicator characteristics.
To sum it up, although it is clear that we have not reached bottom yet (more turbulence is on the way), with recent and future anticipated Fed and government action and with all the write downs going on, we may be approaching a sweet spot that may very well lead to a sustainable recovery.

Treasuries to the rescue...

With hindsight, treasuries have proven a safe bet in the midst of the market turmoil that has left little else intact in its wake. As the subprime tentacles appeared in the most unlikely of places (money market instruments, triple A rated securities) investor appetite for risk took a nosedive. With the volatility index back to normalcy and the days of cheap credit a thing of the past, flight to quality has gained momentum. Fixed income gurus that back in June were convinced that the bull run era that started over two decades ago was reaching its end seem to have gotten it completely wrong. Treasuries posted their best returns last year since 2002 only to be overtaken by TIPS as markets were uncertain whether we were heading into stagflation or just plain stagnation or even recession.
As the U.S. economy showed further signs of deterioration and the risk of dragging the rest of the world into a protracted slowdown grew, inflation worries evaporated prompting the Fed to embark into one of its most aggressive accommodative policies in recent history, cutting the Federal Funds Rate by a spectacular 125 basis points in the span of just a week. If the Fed continues in this direction, it won't be very long before we reach negative real interest rates. This is troublesome as it is difficult to predict the consequences on the economy of having negative rates.

Ceding to panic...

Last night's ad hoc FOMC meeting and the resulting announcement of a whopping 75bp cut in rates(last time such a move took place was back in 1982), bringing the Federal Funds Rate down to 3.5% from 4.25% took everyone by surprise. The global market sell off that began on Monday and continued on to Tuesday, reflecting growing worries that the U.S. economy is slipping into recession, added additional pressure on a Fed that had already been battered for its reluctance to nudge from the inflationary bias, prompting it to take drastic action. The one area that seemed to be unscathed by turmoil so far, namely export demand from the U.S. began to falter as markets around the world entered a correction phase, raising worries of a global slowdown.
What is clear is that by not waiting another week, the Fed seems to have lost control of the situation with its credibility somewhat tainted. The Fed carried out this latest move either because it ceded to market pressures (which in itself is not a bad thing given signs of a rapidly deteriorating environment) and/or because it is acting on information that is not yet out in the open.
What is important now is with regards to the future given that investor perception of the Fed has changed somewhat. This change is likely to have consequences not only on the Fed's behavior going forward but also on how the markets will react to it.

Recession?

There is a growing crowd of doomsayers warning us that the U.S. is already in a recession or that a nasty protracted downturn is just around the corner, but how exactly do we define let alone measure it? According to market consensus, a recession is defined as two consecutive quarters of decline in a country's Gross Domestic Product. Right up to this point, the data we have on the U.S. suggests a slowdown but the problem is that this data is heavily lagged (backward looking) and subject to revisions. That means we will not know if the U.S. is currently in a recession until at least a couple of months from now.
There are other "leading" indicators, however, that can provide precious clues as to the health of the economy. Employment figures such as jobless claims, retail sales, corporate earnings or even the stock market are good examples. The stock market index is particularly interesting because, unlike most other indicators, it is purely forward looking although it can be misleading (such as during periods of bubble formations). A bear market in stocks, defined as an extended period (usually a year) over which prices decline more than 20%, typically occur during periods of economic recession.
So, using these criteria, can we say that the U.S. is in an economic recession? The answer is far from clear. The broad S&P index, for example, is down 9% from its most recent peak (in this regard Japan would be more of a bear candidate than the U.S.). Other indicators such as retail sales, jobless claims and corporate earnings do show weakness, but nothing as serious as with the housing sector which is clearly in recession territory.
With inflation pressure showing signs of easing and further economic deterioration, the balance is tipping towards downside risk on growth rather than the upside risk on prices. No wonder the market is placing a 36% probability for a 75bp cut for the end of the month (up from 0% last week).

Into 2008...

The graph above may bring a bit of nostalgia to those of us that were arcade game buffs back in the 80's but I can assure you this is no sequel to "Tempest". Although blasting vector graphic drawn aliens was a lot of fun at the time, it is also a far cry from today's multi core powered lifelike 3D shading technology.
Getting back to serious stuff, the "radar" (yes, that is what it is known as) graph is a neat way of presenting our global economy expectations for 2008. So what are we saying? Well, we think that there is a strong likelihood of a slowdown (I didn't say a recession!!!) in growth across the globe led by a U.S. downturn (itself a result of the ongoing housing recession and credit crisis).
Our rational is as follows: U.S. consumers are being hit by wealth erosion, on the one end by a steadily shrinking value of their homes and stock market losses and, on the other hand a sharp rise in oil prices making such things as gasoline prices and airline tickets more expensive. We could argue that a quick fix would involve borrowing more (after all, that is what has been powering the recent consumer led expansion in the U.S. and in many other countries). Problem is that lenders are no longer as willing to lend as they did in the past so money is becoming hard to get by (and this goes for businesses too).
We could also argue (like some do) that a marked slowdown in growth would ease the pressure on oil prices, giving the Fed more flexibility with its accommodative policy. Maybe so a decade ago but things have changed dramatically since. The U.S. is having a smaller impact on oil prices mainly because the majority of growth in demand has been coming from China and India (and the consumption levels still remain far below that of developed countries). Combine this with ongoing geopolitical turmoil (most recently with Pakistan) and supply side issues and lower oil prices quickly becomes wishful thinking.
To summarize, the Fed (and many other central banks for that matter) are going to have a tough year ahead but they certainly won't be the only ones who will be navigating in rough waters.