A matter of spreads...

The graph above (source:bloomberg) which basically measures the spread between 3 month libor and 3 month treasuries suggests that the ongoing turmoil is far from being resolved. The degree of volatility and the extent to which spreads have widened ever since the subprime debacle hit markets a year and a bit ago is spectacular. We went from a low of 18 basis points (before the first wave reached the shores) to a whopping high of 240 basis points (as the subprime crisis unraveled). Looking at the way in which spreads have evolved, it is clear that Fed efforts to quell markets have only had temporary success right until the next crisis would hit markets (the last spike on the graph relating to the Bear Stearns crisis). Currently, despite the recent reversal in commodities and dollar trends (both welcome developments for the economy), the spread has begun to widen, suggesting that lenders continue to be weary and confidence is far from being restored. Spreads seem to be widening across the board (making financing and taking out a mortgage more expensive for businesses and households respectively) contributing as a material drag to economic growth. Unless spreads reverse course, the next couple of quarters are likely to be very sluggish.

Judge for yourself...

Considering that we do not have in our possession a magical crystal ball that would permit us to take a glimpse into the future, and notwithstanding that there still remains another 4 months and a bit before we reach the end of the year and that anything can still happen in that time frame, we are quite pleased with how our economic forecasts have turned out so far for the year (a testament we believe to Lobnek's high degree of professionalism).

In any case we think you should judge for yourself so below you will find the outlook section from our January 2008 newsletter for your perusal. For those of you that want to read the entire newsletter, you can find it in the "publications" section of our website at http://www.lobnek.com/ Enjoy!

"2008 is set to deliver another challenging year on various fronts. In the U.S., the housing recession combined with tighter credit standards, rising prices and a weaker jobs market is likely to raise the risk of contagion into consumption. As the U.S. enters an election year, policy will center on averting an economic recession (in the process stoking the risk of inflation even further), with employment and taxes taking center stage of the debate. In an increasingly challenging environment, businesses with strong balance sheets and low debt are better equipped to handle a potential downturn. With Fed policy increasingly geared towards averting a recession, inflation will become a growing concern and its potentially corrosive effect on equity and fixed income will boost demand for investments that have a strong correlation to inflation such as commodities and Treasury Inflation Protected Securities. The U.S. economic slowdown will undoubtedly dent growth in Europe, Asia and emerging countries that continue to depend to a large extent on U.S. consumer demand. Although the impact is likely to be mitigated somewhat due to the accumulation of reserves, improved fiscal and monetary discipline and the emergence of a distinct consumer class in key emerging countries such as China and India, volatility and inflation will threaten the stability, especially in those countries that have currencies pegged to the dollar or that have economies largely dependent on foreign direct investments. China itself will be facing serious challenges on various fronts but is unlikely to take any drastic measures to address them until after the Beijing Olympics. Europe which cyclically trails the U.S. will also start to show signs of a slowdown, hurt by a strong currency, falling home prices and a growing risk of inflation (which will further restrict the ECB’s ability to cut rates).
Currency wise, the U.S. dollar could weaken further as the interest rate differential widens but is bound to recover later in the year, particularly against the Euro given the advanced stage of the
U.S. business cycle and the growing risk of inflationary pressure.
Commodities will also remain volatile, reflecting ongoing geopolitical risk although the overall trend should be upwards as growing demand appetite and supply disruptions continue to beleaguer the markets.
As we move into an environment conducive towards volatility, we can expect less uniformity and therefore greater polarity in performance amongst and within asset classes. The choice of investments will play a more significant role in determining performance. We at Lobnek Wealth Management believe that an overall defensive approach combined with a rigorous and highly selective investment policy is most appropriate to counter the numerous challenges that lie ahead.
We look forward to helping our clients achieve their goals in what will likely be a challenging year ahead."

The second half

How the rest of the second half of this year unfolds for the U.S. economy will depend largely on a combination of factors that include commodities, the dollar and government action (or inaction).
So far this year the economy has shown a remarkable degree of resilience despite of the various shocks (housing recession, credit tightening, commodities price surge, real wage contraction and rising unemployment) that have been battering consumers and businesses.
Support has come in the form of aggressive rate cuts (initiated back in September of last year), Fed support and bailouts of key market participants, tax rebates and a firm boost in exports, thanks to a significantly weaker dollar and robust demand from abroad.
As some of these factors begin to show signs of reversing (strengthening dollar, weakening commodities, tax rebate effect wearing out), and as new elements enter the equation (such as the slowing global expansion), with consumption faltering, economic expansion in the U.S. is set to weaken further in the third and especially fourth quarters. As housing prices continue their descent for the rest of the year, the repercussions on financials and the broader market are likely to continue, pushing expectations of an economic rebound for not before sometime late next year.

Keeping expectations anchored...

Today's Fed meeting is expected to yield no change in the target rate but, as a compromise to an increasingly hawkish FOMC, may result in stronger language against inflation.
Reaching consensus on policy is becoming increasingly difficult as the balance further tips in favor of inflation hawks as a result of a technicality (two of the 7 seats occupied by permanent governors are currently vacant and three of those that vote on a rotating basis are known to be inflation hawks).
One of the main concerns of the Fed in its quest for preserving price stability is to keep expectations firmly anchored, particularly in an environment in which headline inflation is rising relentlessly. It will be difficult for tough rhetoric to do the trick on its own (in others words keeping expectations anchored without having to resort to raising rates) but with the pressure on commodities easing as the global economy continues to soften, the Fed may end up dealing more effectively with the slowdown by keeping rates steady or even begin easing before the year is up. Such a scenario would certainly be in favor of bonds.

Privatizing rewards and socializing risk?

Here is a moral hazard question for you: did the chunky investment rewards of the private sector over the last couple of years end up being financed by tax payers money? 

There is growing concern that the U.S. government handling of the current economic crisis is fomenting moral hazard and therefore arguably sowing the seeds of a future bubble. It all started with the Fed's decision to bail out Bear Sterns earlier in the year and followed soon after with the announcement of unwavering Fed and Treasury support for the country's twin government sponsored mortgage behemoths. 

A quick glance at the sequence of events may give the impression that with the bailouts, the rewards have been grossly disproportionate to the risks taken during the heydays of the housing boom, but one would be naive to jump to such straightforward conclusions. 

The reality on the ground is far more complex than it may seem. In the case of the Bear bailout, the Fed was concerned about the large number of open contracts the bank had with counter-parties. Its failure would have triggered systemic risk with profound economy-wide repercussions.

The mortgage institution pledges were also carried out in the same spirit, to avert systemic risk by nipping it at the bud. The government, it seems, is on a mission to buy enough time for the housing market to stabilize itself as it becomes increasingly clear that there are no effective tools in their arsenal that would effectively put a stop to the deflationary spiral (it will have to bottom out naturally). 

Question is, do the institutions have enough power to keep the economy on life support long enough for housing prices to bottom out? After all, with the Fed's new discount window lending policy, its books are accumulating a growing amount of illiquid paper. 

 

Similar symptoms, contrasting remedies...

Both the U.S. and Europe are currently experiencing a similar economic environment. Growth is rapidly decelerating, unemployment is rising, commodities sparked inflation is creeping up and the mortgage business is in shambles. About the only stark observable difference between the two economies is regarding their respective currencies that are moving in opposite directions. The difference is reflective of monetary policies that are also moving in opposite directions. If the problems that are being faced are similar in nature, why would the central banks of the U.S. and Europe tackle them in such opposite ways, especially given the perception that there is a lot of cooperation between the two? Part of the answer lies in their economic histories and another part is a direct result of their respective mandates. 

In the case of the U.S., the deflation trauma of the great depression has not been forgotten. It is further kept alive by a Fed chairman who is an avid expert on the topic. It therefore should come as no surprise that in the current economic turmoil, the Fed would have a loosening bias for its interest rate policy.

The ECB, in contrast, has embarked on a tightening bias, citing the growing risk of inflation. Part of the decision is due to its single mandate of price stability (versus the Fed's dual mandate of price stability and employment). History is the other major factor influencing the decision making process of the ECB. More specifically originating from its dominant German Bundesbank heritage. During the interwar years, Germany had suffered a severe bout of hyperinflation. Other European countries were to follow suit during and after the Second World War. We can therefore conclude that the hyperinflation trauma was collectively experienced in Europe.

These differences (historical and political) explain to a large extent why the two central banks, although facing similar issues, have opted to tackle it in opposing ways. What is certain is that both cannot be right and it is unfortunately too early to say who is using the correct antidote.

There is a cost involved in every action...

Pledges and further action from the Fed and the Treasury earlier in the week were clearly designed to avert a total bloodbath in the mortgage business but, as institutions steadily yield more power and influence on market dynamics, two questions come to mind.

1. At what point does interference begin to stifle development, or put another way, at what point does the marginal benefit of regulation begin to be outweighed by the marginal cost of such regulation?

2. At what point does bailing out institutions that are effectively considered bankrupt lead to a significant increase in moral hazard (which just sows the seeds of future bubbles)?

Answering either question with any degree of precision is clearly a futile exercise. Greater regulation and greater intervention are both to some extent actions that counter the very principles of capitalism. By regulating markets, for example, we take away a certain degree of flexibility which can have an adverse effect on economic development. Certainly markets are smart and creative enough to find ways around such regulations (part of the reason why we find ourselves in the current mess is a result of shadow banking activities caused by regulation).

And what about the issue of bailing out businesses that, in normal circumstances, would go bankrupt? We are just emerging from an era in which access to capital was both cheap and very easily obtainable. That environment led to a lot of businesses that would normally go bankrupt to stay afloat. Now that rates are rising, a wave of bankruptcies are exacerbating an already difficult environment. We can draw similarities with the Fed's intervention to avert bankruptcies, but the objective is very different. In the Fed's case, the reason for bailing out is to avert systemic risk from taking hold. But doing so introduces another dilemma, the so called moral hazard put option. 

In the end, it is a delicate balancing act the final outcome of which only the passage of time will tell...  

A sentiment driven game of ping pong...

Markets of late are in a sort of tug of war frenzy, undecided on whether it is the deflationary forces of a worsening housing slump combined with a steadily deteriorating credit market or the inflationary forces of commodity prices that show no end in sight that will drag the world economy into a recession. Complicating matters is the geopolitical risk premium on oil which has been the dominant factor behind the recent volatility in prices. With so much uncertainty out there, it is no wonder that markets are trading on nothing else than emotional impulses, observable from the steady rise in volatility over the last couple of months. For rational behavior to return would first and foremost require a fix of the housing market which, unfortunately, is in such a dismal state that it wouldn’t be realistic to expect a recovery any time soon. It would also require an improvement in the financial sector that has been battered by several waves of mortgage related write-offs and a systemic risk potential resulting from the broad market exposure to derivative instruments such as credit default swaps that are suffering from uncertainty in counterparty risk. The Fed's Bear Sterns intervention back in March was designed to avert the very systemic risk that continues to threaten the global economy. Unfortunately these problems are likely to persist as long as home values continue to deflate and credit becomes increasingly difficult to obtain.