The housing dilemma...

Housing has been at the center stage of the current economic crisis ever since the sub prime blowup of August. Apart from the fact that pretty much every indicator out there suggests that the real estate market in the U.S. is in a recession, there is growing concern that the worst is still to come and the implications of this on the rest of the economy. The worry is clearly regarding the risk of contagion or a spillover. So far nothing would suggest that the damage is spreading beyond the housing borders but this could very well be because of a lag factor. Studies suggest, for example, that for every 100 dollar drop in financial wealth, the consumer will spend from between 2 to 5 dollars less on consumption. For every 100 dollar drop in housing, on the other hand, consumption drops between 5 and 9 dollars. Apart from the difference in the drop in consumption, it has been shown that the effect of a drop in financial wealth is pretty much immediate, in contrast to a drop in the price of housing in which there tends to be a clear lag (sometimes substantial) before it translates into less consumption. Hence, this could explain why consumption has not retracted despite falling prices. Considering that consumers make up roughly 70% of GDP, this is a very big deal (and unlikely to be offset by exports or a so far resilient stock market).
Considering a stock market that is still in the black for the year and gasoline prices that have yet to reflect the sharp rise in oil, the housing slump on its own wont cause much damage. But if we factor in a possible scenario in which there is a sharp correction in the stock markets, more credit tightening across the board and a sharp rise in gasoline prices (which is bound to occur if oil continues to hover around $100), things could rapidly turn ugly.

Staying the course...

If we take the definition of a bear market, which is a stock market drop of at least 20% in a 12 month period, Japan, or more specifically the Topix index should in fact be considered to have entered bear territory. This is bearish news indeed, considering Japan happens to be the second largest economy in the world! What about China, where the Shenzhen index has shed close to 18% from it's peak? If the index breaks the 20% barrier would that be considered a bear market (considering that from trough to peak this year it has returned close to 176%)?
Irrespective of the debate on how to detect a bear market it has been demonstrated time and again that during periods of crisis (like the one the global markets are currently experiencing), emotions tend to override rationality. It comes as no surprise considering that our ancestors used these very behavioral attributes very effectively for survival. Employing them in investing, however, has proven to be highly destructive. Take the '87 crash as an example. The stock market correction sparked a bond market rally (similar but more pronounced than today). Most investors that held on to their stock portfolios right after the crash eventually gave up and switched their investments into bonds more or less around the time when the bond market rally peaked. What resulted was a double carnage for not only did they lose a large chunk of value from their stock holdings but, right after the switch, when stocks picked up and the bond rally ended, they experienced a further erosion of their wealth. The lessons to be learned from this is to avoid being overwhelmed by our emotions in difficult times, to stay the course by focusing on the longer term objectives and rebalance whenever necessary.

Options on the table...

We know that Fed has two mandates (both enacted by congress) which may be broadly defined as insuring market stability to maintain unemployment at its natural rate (whatever that may be) and price stability to ensure that inflation is basically tamed. History also shows us that, at times, the economy may find itself in a position whereby on the one hand we have deteriorating market conditions with unemployment rising and, on the other hand, there are signs of inflationary pressure. Stagflation is usually the term coined to describe an environment in which there is rising inflation combined with stagnant growth and rising unemployment (a prelude to a recession). The U.K. experienced stagflation in the 60's and 70's whilst the U.S. economy was in stagflation during the Carter administration of the 70's. The reason why is so dreaded by governments and central banks is because the main tools at their disposal, namely fiscal and monetary policy become ineffective. This is not to say that the U.S. is in a stagflationary state or that it is heading in that direction (the world has evolved so much and the same principals may not apply anymore). But it is clear that the Fed is having to make a difficult choice between providing market stability and capping inflationary pressure. Right now they are erring on the side of market stability to avert the risk of a recession. We could argue that they are walking a thin line because not only do they need to fine tune between the employment/inflation trade off, but, now that they are leaning towards the side of providing market stability they need to concern themselves between the market stability/moral hazard trade off. Market stability will indeed raise the probability of averting a full blown recession, but it will most likely come at a price in the form of more reckless activity amongst market participants once the stability sets in. These are indeed very challenging times for Bernanke and his crew!

Running out of oxygen

It is awkward to observe a resilient stock market in the wake of a substantially weakened dollar and record oil and gold prices. We can explain the record in gold prices by not only the imbalances in demand/supply (fuelled by growing consumption coming from commodity rich nations and India and also from growing use of this commodity in manufacturing) but also as a result of its traditional role as a refuge investment (currently boosted by the shrinking dollar and the growing pessimism on the economy). Oil prices, on the other hand, are dictated not only by demand/supply imbalances and speculation, but also by a geopolitical risk premium. This risk premium is playing an increasingly important role in explaining oil price fluctuations, considering the emergence and growing importance of Russia, Iran and Venezuela (all three amongst the top five petroleum producers) forming an increasingly confrontational alliance against the U.S. and, to a lesser extent, Europe.
With the level 3 assets issue looming as the latest twist in the subprime/credit crunch debacle and a consumer market feeling increasingly squeezed by rising costs and a shrinking wealth effect, it is difficult to maintain an optimistic view with regards to the economy. Even the hope of a possible decoupling combined with a heavily depreciated dollar coming to the rescue stands on shaky grounds considering the insane market multiples as observed in China and elsewhere. One could argue that we have not as yet reached the apex of the current crisis.

The Fed in observation mode...

Yesterday's quarter point cut was very much in line with market expectations, reflecting a Fed that, although remaining weary of the risk of a housing spillover, was reacting more to the build up in anticipation in markets that are still reeling from the July-August shock. With the most recent economic releases suggesting more inflationary risk (tight labor markets, high capacity utilization and a surprisingly strong third quarter GDP) to come and a weak dollar with oil trading at record levels, the Fed took the opportunity to clarify its stance as to the future direction of rates. The message was there was far too much uncertainty in the markets and that the future direction of rates would depend on how the current crisis unfolds.
Although the housing slump seems to be contained for the time being, tightening lending standards and higher gasoline prices at the pump are bound to influence spending patterns. To counter this we have the weaker dollar combined with healthier growth outside of the U.S. but there is talk that certain emerging markets, most notably China, are entering or are already in a bubble. The longer this remains true, the more difficult it will become to engineer a soft landing.

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.