Lender of last resort...

There is a reason why the Euro-zone seems unable to get itself out of the quagmire. It is dealing with the growing problem in a passive-reactive manner. There is a discernable pattern here:

1. the crisis shows signs of brewing
2. the core members of the zone get together to discuss the problem
3. at the meeting they announce that they have reached an agreement to boost the limit of the "bailout" fund
4. the markets react favorably for a day or two until the cycle is repeated again.

With a moving target in a deteriorating environment, it is difficult to see how readjusting the size of the bailout could ever work. Most of what is going on is psychological to begin with. The markets are very much aware that the tools the euro-zone members have at their disposal are insufficient to tackle the problem.

Psychology works in funny ways, we tend to overshoot all the time. In a stable environment, greed takes the upper hand whilst fear tends to reign when markets are in turmoil. In both cases there are exaggerations and the degree of the exaggeration depends very much on the circumstances of the time. It seems clear to me at least that the current approach has failed but what is more worrying is that the window of opportunity for the zone to extricate itself out of the quagmire is rapidly narrowing. Soon the only option on the table to avoid a meltdown will be to take out the heavy weapons.

The ECB, unlike many other central banks, does not have a mandate as lender of last resort and it may unwilling to use this option to avoid encouraging the risk of "moral hazard" down the line but it may end up being the only effective way to quash the psychological effect. The reason why this would work is because the human mind is much less effective in dealing with the concept of infinity: If you announce that you are taking a stance in the markets and you have close to unlimited resources to defend your stance, it will be far more credible than if you announce the ceiling of your resources from the very beginning. The Swiss National Bank's intervention in defense of the Swiss franc is a perfect example of this!

From idiosyncratic to systemic...

It is crucial to distinguish idiosyncratic risk from systemic risk. The former is related to risk that originates from or is inherent to a specific entity such as a firm, whilst the latter is risk that is exogenous to the firm. The reason why making a clear distinction between the two risks is so important is because their expected antidotes are so different. Idiosyncratic risk is normally handled by the management team of the firm and only involves outside intervention in situations of "too big to fail" where repercussions in terms of systemic risk become all too real. Systemic risk, on the other hand, is usually beyond the scope of management, it is more within the domain of policymakers.
Applying the distinction to the current Euro-zone crisis, we began with a form of risk when the peripheral members started to ring the alarm bells in the first half of 2010 that was borderline idiosyncratic but still relatively contained. This explains why the initial response to this "mini" crisis was relatively muted: the creation of a fund that would aim at bailing out heavily indebted nations that were having difficulty with their payments. The risk started to take on a more systemic form when the number of troubled countries began to increase and as it began to involve countries that had economies that were far bigger than the first wave. The EU response to this was mainly to increase the size of the "bailout" fund but not much else when what they really should have been doing was to approach the problem from a completely different angle. But herein lies the problem: the Euro-zone in its current incarnation was never designed to handle such challenges.

It seems to me that the original architects of the Euro-zone project are now paying a heavy price for having suppressed the major risks or negative points that were outlined in the independent study on the creation of a Euro-zone that had been commissioned by the core governments of the project. As we can see from the CDS graph of Italy, it is just another example of too little, too late.

The commodities - stagflation link...

There is growing consensus that the broad based commodity price rise is here to stay at least for a while. This is mainly because of growing demand coming from emerging markets. The rise in prices is having a material wealth distribution impact on the economies of emerging and developed countries. Commodity rich emerging market economies are benefitting tremendously from the price hikes which is also fueling their appetite, whilst for those of most if not all developed markets, the impact is similar to a tax effect as the commodity price increase is almost entirely passed on to the consumer.
Another less obvious effect of this long term rise in prices is the potential it has of triggering a much dreaded stragflationary environment. This is mainly because developed market economies have already entered a period of weak growth/recession at a time where "headline" inflation remains clearly above the target of central banks. In theory, the longer inflationary pressures persist, the greater the risk that they have an impact on the future expectations of inflation, which in some instances, can eventually lead to an inflationary spiral. Once a spiral sets in, it becomes very difficult to control. Although we may be far away from such a scenario, the effect of a long term rise in commodity prices should not be underestimated.

In double-dip territory?

There is ongoing debate as to whether the economies of both the U.S. and Europe have re-entered a recession, but the real question should be whether it ever got out of one! We unfortunately will not know for sure for at least a couple of years to come because of the tremendous adjustments lag between the initial data collecting and the final official figure. There are, however, strong clues that the recession that began soon after the sub-prime crisis erupted in 2007 is still around. The only reason why markets were rallying in 2009 and 2010 were because of the massive concerted government efforts to keep their respective economies afloat. A bull in a bear market if you will but, as the ammunition is being rapidly depleted, the effects of this are reverberated across the financial spectrum. Volatility is rising sharply, commodity prices are dropping and treasury yields, the ultimate safe haven investment (despite the downgrade), is at record lows. So from a technical standpoint, there is growing evidence to suggest that what we are experiencing is not a double-dip or "W" type of recession but more like a very extended "U" type. The rally in 2009 and 10 were just smokescreens and the markets are just discovering that now.

What the sectors are telling us...

A cursory look at stock market sector performances can provide a good sense of the current market sentiment. The graph above measures the year to date performances of the major sectors of the world economy and is not distorted by currency fluctuations.

As a first observation, it is interesting to note the wide performance divergences between the various sectors. There is, for example, more than a 20% difference between the best (health care) and worst (financials) performing sectors. This tends to occur in periods of uncertainty.

The next interesting observation would be the divergence between cyclical and defensive sectors. The better performers (health care, consumer staples) tend to be the defensive sectors which would indicated very bearish sentiment in the markets.

It should come as no surprise that financials are suffering the most considering the uncertainty facing European banks exposed to the sovereign debt of troubled euro zone peripheral countries. What is more curious, however, is the relatively strong positioning of sectors like information technology or energy. For the tech sector, it reflects the boom in technology stocks. Some pundits are drawing parallels with the nineties, arguing that the market may actually be in a bubble.

For energy, however, it is a bit more baffling, markets are clearly pricing a high probability for recession (the negative ranking of materials and industrials clearly show this) but oil prices do not seem to reflect this! Pressure from proponents of peak oil and the continued strength of emerging market economies may go some way to explain this, but who knows? Sentiment can sometimes be finicky.

Rebalancing vs. Buy & Hold

In these tumultuous times, one wonders what sort of investment strategy to adopt. The modern portfolio theory rule of thumb would be to "stick to one's guns" by remaining thoroughly diversified and keeping a disciplined approach to rebalancing the portfolio when asset class weights deviate "too far away" from a defined optimal value.

Rebalancing can actually be tricky in times of high volatility not only because it may require quick action to counter large sways in the market but also because of the additional transaction costs that frequent "adjustment" trading could entail.

There is, however, an optimal level of rebalancing that can be implemented, depending on market volatility conditions. Studies show, for example, that rebalancing (adjusted for transaction costs) outperforms buy and hold strategies in periods of high volatility where markets experience sharp reversals. The opposite occurs in bull or bear market conditions, where the markets follow a clear trend. In this environment, buy and hold strategies tend to outperform rebalancing.

An optimal portfolio allocation strategy would therefore be one that is a function of the volatility levels of the markets. When volatility levels spike, as they have over the last couple of weeks, it would trigger a rebalancing signal for the portfolio. This could be in the form of a tightening of the rebalancing band limits of the respective asset classes. In contrast, when volatility levels are subdued, those same band limits should widen, reducing the probability of rebalancing but not eliminating them altogether, which would be risky, especially in transition periods from low volatility to high volatility.

A double dip?

According to the latest remarks from the Fed, the stimulative policy that began soon after the sub-prime crisis began in 2007 is likely to remain for some time to come. If we read between the lines, this would basically mean that the Fed is becoming increasingly pessimistic on the growth prospects of the economy and rightly so, considering the growing deficits that the U.S. and Europe are facing. In fact, as we have been saying since the end of 2008, this crisis is likely to remain with us for at least another couple of years. There is no quick way out of it, unless a very aggressive form of "financial repression" combined with hard core austerity is forcibly implemented, but if the U.K. riots are any sign of how ugly things can get, there doesnt seem to be much that can be done in the short run.
Market sentiment in this environment has become risk averse to such a degree that even treasuries, that recently lost their triple-A rating, have actually been rallying. This would be the second time in four years that "pundits" have gotten the direction of interest rates seriously wrong.
In summary we should be embracing ourselves for a global "double dip" as the U.S. increasingly embarks into what looks like an austerity program in disguise!

A revised Big Mac Index...

One fascinating index that has gained in popularity through the years is the Big Mac Index that is published by the Economist newspaper. It is interesting because it provides a very different approach to measuring the over or under valuation of exchange rates, based on the Purchasing Power Parity (PPP) theory which states that in the long run, the exchange rates between countries should adjust themselves to bring about parity in prices.
As the "Big Mac" is a commodity that is readily available in most parts of the world and because its price is very easy to obtain prices, it is very suitable for making cross comparisons.
One large drawback with the measure, however, has been that it does not adjust for differences in productivity which means that for emerging markets with cheaper labor, it will tend to introduce an underweighting bias to the figures. This bias is confirmed by a simple regression of the price of a Big Mac to GDP per capita. There is a clear positive correlation between the two.
In order to account for this, the Economist recalculated its figures by adjusting for differences in productivity. The end results are very different from the original calculations. China, for example, which was thought to have a currency that was undervalued to the dollar, according to the original figures, now finds itself slightly overvalued with the new calculations! It is also interesting to note the substantial overvaluation of the Brazilian Real and the continued overvaluation of both the Swiss Franc and the Euro.
In these times of growing uncertainty and rumors that official CPI figures may be rigged, the Big Mac index provides a more reliable measure of the PPP adjusted currency exchanges.