A question of multiples...

Last Friday's sharp correction in the markets to commemorate the 20 year anniversary of black Monday reflects growing unease on the earnings momentum front. Just when the markets were thinking that the worst was behind us, disappointment in earnings forecasts reared its ugly head. Although the markets have surged pretty much consistently since 2002, roughly doubling in value, earnings have followed suit, keeping multiples steady at reasonable levels. The risk at this stage, however, is that the continued trouble in the housing market, record commodity prices, dwindling productivity and a possible slump in consumer spending begins to eat into earnings. Some analysts are betting on the more sanguine environment outside of the U.S. combined with the decoupling theme to come to the rescue. It is, however, important to heed the warning signs of an overheating Chinese market, trading at sky high multiples, and growing pressure for an appreciation of the currency. The futures market is already pricing a 25 basis point Fed ease for its next meeting at the end of the month.

The sick dollar...

Even on a trade weighted basis, the dollars steady descent, losing 35% of its value since its peak at the end of 2001 is impressive. Certainly the perceived global GDP decoupling and the resulting current and anticipated widening differential in interest rates with the rest of the world explains to some extent the relentless depreciation. We could also argue that, despite the official view in support for a stronger dollar amongst politicians in the U.S. and elsewhere, a weaker dollar may actually be more attractive. It helps narrow the current account deficit, pending a "j" curve effect lag, makes interest payments in other currencies cheaper, and may be a good idea considering that with the housing downturn and gasoline at record prices, U.S. consumers are starting to feel the pinch, pushing them towards savings. On the longer run (and here I am thinking of a horizon of 3 to 5 years), the dollar is set to appreciate mainly as a result of demographics. Amongst developed nations, the U.S. has one of the youngest populations, in stark contrast to Europe, and to a greater extent, Japan. Current account deteriorations, as the trend moves from production to consumption, is likely to be more pronounced in countries that have a greater percentage of retirees. These will also be the countries that will see the largest inflows in capital as their financial instruments become increasingly attractive to developing nations seeking a stake in world class firms.

A blip?

Today's September headline PPI and retail sales figures, that came out above market expectations, would suggest that inflation risk remains high. It would seem that record oil prices and a weakening dollar is trickling into the economy but it is future results of the lagged core figures that will determine the true extent of damage. This, together with record breaking performance in the stock market should weaken the impetus for any further rate cuts and switch the Fed's focus back onto the inflation front. Ever since the turbulence in August, equities have shown a remarkable degree of resilience to the subprime/liquidity crisis thanks to a greater share of corporate earnings coming from export markets (which benefit from stronger growth in the global economy), the perception that bad news is behind us with the release of Q3 earnings for the financials sector and recent fed action reflecting a clear willingness to contain the housing woes.
Next week's releases which will include CPI, industrial production and housing data should provide us with a clearer picture on the health of the economy.

Decoupling and decorrelation...

If we were to take a snapshot of the global economy 10 years ago and today, one observation might be that the world depends less on the U.S. for growth today than at any time in the past. It can be argued that with globalization, greater integration between economies have led to an acceleration in development and a dramatic improvement in standards of living. Countries like China and India now have distinct middle classes which means that there is less dependence on the vagaries of trade. In the E.U., the last decade has brought about a marked improvement in economic integration. The costly burden of absorbing East Germany is a thing of the past. It use to be that higher oil prices would have a chocking effect on consumption, but today, thanks to greater integration, a more sophisticated financial system and fewer barriers to entry, we get more trade and investments. With the gradual decoupling of these new economic zones it is very possible that we will eventually observe a drop in correlation. In fact this is what seems to be occurring at present considering that the U.S. is heading towards weaker growth whilst the rest of the world continues to roar ahead. Correlation is not static mind you, it varies over time and a sudden shock (like the one we witness with China at the end of February this year) can lead to a dramatic surge in correlations. But with gradual decoupling, in times of economic shock to a particular region, it is possible that the correlation spike will become less pronounced. Only time will tell.

A step closer to stagflation?

Last week's 50 basis point cut revived fears of a surge in inflation as it took place in an environment in which commodity prices are surging and the dollar continues to weaken. This is evident in the yield curve, which, from the beginning of the year has shifted from being inverted to becoming normal or upward slanting. It would suggest that the market is pricing in a future surge in inflation. But it is not as straight forward as it seems because we are in a precarious environment of recovery from the subprime/short term liquidity shock. The Fed's use of the federal funds rate, the most prized weapon from its arsenal of instruments, leaves it with fewer tools with which to manage the crisis. The worry is that this 50 basis point cut may not suffice given the downward pressure that would arise if consumers battered by shrinking home prices and higher gasoline prices decided to cut on spending, prompting further cuts by the Fed.
On a side note, the crisis may be providing an opportunity for buyout activity and we are seeing signs of this with the news that Warren Buffet may be looking into purchasing a stake of Bear Stearns.

The Fed's risky gambit

Yesterday's 50 basis point cut took the markets by surprise, sending a clear message that the Fed had nailed the coffin on it's inflation bias and was now clearly more preoccupied by the mortgage/liquidity crisis and its potential impact on growth rather than on a possible surge in inflation. Last week's gloomy labor figures and yesterday's weaker than expected PPI release seems to have emboldened the case for more aggressive cuts. On the flip side of the coin the combined effect of the rate cut, oil at record levels and a steadily weakening dollar is bound to raise the risks on the inflation front.
Next in line are the financials sector earnings results which should provide us a clearer picture on the extent of damage from the sub prime crises. Lehman's better than expected results gives reason for hope for the rest of the industry but all this could very rapidly turn sour by just one disappointment. The market environment remains precarious and this is reflected in the high volatility levels.

The absolute return fallacy and the black swan revisited

The definition of absolute return, a term originally coined by the managers of the Yale endowment fund, refers to an investment instrument that is expected to provide positive returns irrespective of market conditions. In other words, it should be uncorrelated to market swings. Ever since the collapse of LTCM, however, the whole premise on which this concept lies has been put into doubt. The systemic backlash from what started off as a relatively benign and contained issue within the subprime space proves that there is a major failure in the modelling of risk for certain types of products. How else can one explain the bewilderment of managers? The ever so common excuse of late is that they were caught by surprise, that it was the first time that such a thing had occured and therefore they were unprepared for the consequences of such an event. It begs the question as to why they were unprepared or, more precisely, why they did not include such a scenario into their models in the first place? It is worrying enough to note that according to a recent Wall Street Journal article, the average return of hedge funds for the month of August was more than minus 1 percent (more than minus 2 percent for fund of funds). What is more telling, however, is that the average reflects only 40% of the total because the rest of them have not yet published their results and the delay could indicate far worse results ahead. Blaming systemic risk or an unprecedented chain of events is frankly not a justifiable excuse, particularly for an industry that is reputed for its exorbitant fees.

Navigating without a compass...

Earlier this year when the sharp rise in subprime delinquencies were announced, it was largely shrugged off by the markets due to the relatively small size of the submprime market in comparison to the rest of the mortgage industry. The risk of contagion was thought to be minute as the problems appeared to be specific to this particular segment of the market. What was not taken into consideration, however, was the widespread use of leverage across the board, fuelled by record low borrowing rates, reckless lending and the competitive pressure to generate higher returns in an environment of performance compression. The potent cocktail of illiquid investments and the heavy use of leverage led to a sharp selloff in August, prompting central bank intervention to restore normalcy. As calm returned, it became quickly evident that it would not last long as the core problem was far from being resolved.
The markets are in effect navigating without a compass as nobody has a full grasp of the extent of contagion. This is a result of the lag in reporting not only with regards to certain types of investment vehicles such as hedge funds (some of which are heavily exposed to the subprime market) , but also economic releases, a key barometer for the health of the economy. Today's negative U.S. employment figures for August are a good example of the lag. Reporting for the month of August (ground zero) is just beginning to surface now which means that we can expect more turbulence on the horizon.