As policymakers struggle in their attempt at restoring market confidence, the probability that we may be facing a protracted recession becomes more likely. A casual observation of the various interventions that have occurred to date suggest that the various institutions are near clueless as to the most effective approach in tackling the crisis. This should come as no surprise considering that the distinguishing characteristic of the current downturn, differentiating it from previous ones has to do with its multilayered nature. The first wave began with the collapse of the housing bubble, followed rapidly with a second wave in the form of a ravaging credit crunch. This in turn triggered a significant contraction in consumer spending as household wealth began to shrink (negative equity, stock market corrections, tighter lending standards). Business contraction seem to be the next wave in line as firms begin to cut production and curb capital expenditures in light of weaker demand and diminished access to credit.
What all this basically means is that to tackle this particular crisis will require a multipronged approach given that there is more than just one malaise that needs fixing. It also means that the duration of the recession is likely to lengthen considering that the various layers are unlikely to be fully resolved at the same time.
27 November, 2008
17 November, 2008
Sector rotation in action...
Although there remains a couple of weeks before year end, it is interesting to see how the various sectors have fared in such a difficult climate.
The graph above depicts the year to date performances of the various global sectors with the "World" bar measuring the capitalization weighted performance of all sectors combined.
The first striking (although clearly not surprising) observation is that none of the sectors have returned a positive performance (to date). The second would be that financials have suffered the most amongst sectors (again, not surprising considering the central role of financials in the current crisis).
Notice also the striking performance disparity between cyclical and defensive sectors. As we enter what seems to be a protracted global recession, the cyclical sectors which include commodities, information technology and luxury goods are suffering the most as they are pricing the impact of the slump whilst the defensive sectors, which include consumer staples, healthcare and utilities, have shown greater resilience to the downturn. This is somewhat reassuring in an environment where most investment concepts have gone haywire (see previous blog).
In conclusion, with hindsight of course, if one was bearish and expecting a recession at the beginning of the year, a sector rotation strategy would seem to have paid off, although we should emphasize the important caveat that one should never jump to conclusions before the period of measure (in this case one year) is through. We do, after all, live in a world of uncertainty (this year proving to be more so than ever) and so we should rightfully expect that anything can happen.
The graph above depicts the year to date performances of the various global sectors with the "World" bar measuring the capitalization weighted performance of all sectors combined.
The first striking (although clearly not surprising) observation is that none of the sectors have returned a positive performance (to date). The second would be that financials have suffered the most amongst sectors (again, not surprising considering the central role of financials in the current crisis).
Notice also the striking performance disparity between cyclical and defensive sectors. As we enter what seems to be a protracted global recession, the cyclical sectors which include commodities, information technology and luxury goods are suffering the most as they are pricing the impact of the slump whilst the defensive sectors, which include consumer staples, healthcare and utilities, have shown greater resilience to the downturn. This is somewhat reassuring in an environment where most investment concepts have gone haywire (see previous blog).
In conclusion, with hindsight of course, if one was bearish and expecting a recession at the beginning of the year, a sector rotation strategy would seem to have paid off, although we should emphasize the important caveat that one should never jump to conclusions before the period of measure (in this case one year) is through. We do, after all, live in a world of uncertainty (this year proving to be more so than ever) and so we should rightfully expect that anything can happen.
13 November, 2008
Shaken to the core...
As we approach the end of what is shaping out to be one of the most disastrous years in financial market history, challenging even the most fundamental concepts of modern portfolio theory, we are left to ponder if the industry will have to reinvent itself.
Fundamental concepts and measures such as Value at Risk (VAR), standard deviation, the normal distribution, correlation or even diversification are being questioned in light of the way this crisis has unfolded.
For example the foundation of modern portfolio theory lies on the premise that diversification in a portfolio contributes to enhancing returns and reducing risk. Well if we apply it over the past year and a half we can firmly conclude that it has failed miserably. In fact we could argue in the case of equity markets that in certain situations, diversification has actually magnified losses. A U.S. or European investor, for example, was much worse off with exposure to emerging markets.
Related to this is the concept of correlation whereby a weaker correlation between two investments contributes to enhancing the risk/return tradeoff of a portfolio. But all this becomes hogwash or even worse when those same correlations suddenly jump up to a level close to 1.
So where does this leave us? Do we just abandon the very core foundations of modern portfolio theory and search elsewhere for answers or do we just stick to them and ride this crisis out?
History, in this case, does provide clues since it is not the first time that the core concepts have been challenged like this. The main lesson we can draw from the past is that these concepts only function in normal market environments. In other words they are prone to failure when markets are either in a bubble or when they are experiencing a crash, and since a crash is arguably (arguably because they too can be exploited) the least desirable environment to be in and thankfully don’t last too long, it makes no sense to abandon these core concepts if things will eventually return to normal.
Warren Buffet recently stated that the biggest losers in this crisis are going to be those that are currently sitting on cash. That is because by the time you know that things are improving, it will be too late to do anything about it. This particular market correction has two parts to it, one related to a reversion to the mean effect (reflecting the fundamentals) and another that is emotionally driven and that tends to exaggerate things both on the downside and the upside. The first part will take time to fix as the world is entering what could become a protracted recession. The second part, however, will resolve itself as soon as all the bad news is out in the open. When that happens, however, it will be too late to do anything about it.
Fundamental concepts and measures such as Value at Risk (VAR), standard deviation, the normal distribution, correlation or even diversification are being questioned in light of the way this crisis has unfolded.
For example the foundation of modern portfolio theory lies on the premise that diversification in a portfolio contributes to enhancing returns and reducing risk. Well if we apply it over the past year and a half we can firmly conclude that it has failed miserably. In fact we could argue in the case of equity markets that in certain situations, diversification has actually magnified losses. A U.S. or European investor, for example, was much worse off with exposure to emerging markets.
Related to this is the concept of correlation whereby a weaker correlation between two investments contributes to enhancing the risk/return tradeoff of a portfolio. But all this becomes hogwash or even worse when those same correlations suddenly jump up to a level close to 1.
So where does this leave us? Do we just abandon the very core foundations of modern portfolio theory and search elsewhere for answers or do we just stick to them and ride this crisis out?
History, in this case, does provide clues since it is not the first time that the core concepts have been challenged like this. The main lesson we can draw from the past is that these concepts only function in normal market environments. In other words they are prone to failure when markets are either in a bubble or when they are experiencing a crash, and since a crash is arguably (arguably because they too can be exploited) the least desirable environment to be in and thankfully don’t last too long, it makes no sense to abandon these core concepts if things will eventually return to normal.
Warren Buffet recently stated that the biggest losers in this crisis are going to be those that are currently sitting on cash. That is because by the time you know that things are improving, it will be too late to do anything about it. This particular market correction has two parts to it, one related to a reversion to the mean effect (reflecting the fundamentals) and another that is emotionally driven and that tends to exaggerate things both on the downside and the upside. The first part will take time to fix as the world is entering what could become a protracted recession. The second part, however, will resolve itself as soon as all the bad news is out in the open. When that happens, however, it will be too late to do anything about it.
05 November, 2008
A truly historic moment...
After a long and arduous battle between two rivals with very contrasting opinions on how to run the country, Barack Obama was chosen to become the 44th president of the United States, marking the beginning of a new era in American politics. By electing Obama, Americans have decided to turn a page in U.S. history, effectively dismantling one of the remaining barriers of the racial divide. They have also joined the world chorus in demanding a radical change in policies after 8 years of republican rule, wrought with strategic blunders both at the home front and abroad.
Obama undoubtedly faces formidable challenges in the form of a severe economic crisis, serious geopolitical issues and a significantly tarnished image abroad, to name a few. They won't be easy to fix but if his track record is any indication, we may be in for some pleasant surprises!
In any case we congratulate him for his election and wish him the very best of luck as the next president of the United States.
Obama undoubtedly faces formidable challenges in the form of a severe economic crisis, serious geopolitical issues and a significantly tarnished image abroad, to name a few. They won't be easy to fix but if his track record is any indication, we may be in for some pleasant surprises!
In any case we congratulate him for his election and wish him the very best of luck as the next president of the United States.
30 October, 2008
A liquidity trap and more?
Considered as amongst the most powerful of tools within a Central Bank's arsenal, the effectiveness of monetary policy depends very much on the economic environment in which it is being applied. There are basically two situations in which monetary policy becomes totally ineffective:
When the transmission system is faulty, whereby a change in monetary policy fails to influence economy wide lending rates. A severe credit crunch, such as the one being currently experienced, can significantly diminish the effectiveness of a change in interest rates. Despite a rate cut, for example, the economy fails to be stimulated.
The second situation, known as the liquidity trap, is related to the differential between the target rate from the zero percent nominal rate. The closer the target rate is to zero percent, the less room a central bank has to further stimulate the economy using monetary policy as a tool. At some point close to zero, the effectiveness of monetary policy disappears.
The global economy is currently experiencing a credit crunch which is steadily eroding the effectiveness of monetary policy. The U.S. Federal Reserve is in a worse situation because it is facing a double whammy with a credit crunch on one hand and a potential liquidity trap on the other hand (considering that with the latest move, the target rate now stands at one percent, leaving very little room for maneuver if more stimulation is required). The situation is reminiscent of Japan in the 90's where the Bank of Japan became impotent as it lost the effectiveness of its monetary policy tool after the nominal rate was cut to zero.
The obvious remedy in the case of the U.S. would seem to involve solving the transmission problem as it would boost the amount of stimulation into the economy. Unfortunately it is more easier said than done as it would require restoring confidence that has been severely impaired.
When the transmission system is faulty, whereby a change in monetary policy fails to influence economy wide lending rates. A severe credit crunch, such as the one being currently experienced, can significantly diminish the effectiveness of a change in interest rates. Despite a rate cut, for example, the economy fails to be stimulated.
The second situation, known as the liquidity trap, is related to the differential between the target rate from the zero percent nominal rate. The closer the target rate is to zero percent, the less room a central bank has to further stimulate the economy using monetary policy as a tool. At some point close to zero, the effectiveness of monetary policy disappears.
The global economy is currently experiencing a credit crunch which is steadily eroding the effectiveness of monetary policy. The U.S. Federal Reserve is in a worse situation because it is facing a double whammy with a credit crunch on one hand and a potential liquidity trap on the other hand (considering that with the latest move, the target rate now stands at one percent, leaving very little room for maneuver if more stimulation is required). The situation is reminiscent of Japan in the 90's where the Bank of Japan became impotent as it lost the effectiveness of its monetary policy tool after the nominal rate was cut to zero.
The obvious remedy in the case of the U.S. would seem to involve solving the transmission problem as it would boost the amount of stimulation into the economy. Unfortunately it is more easier said than done as it would require restoring confidence that has been severely impaired.
22 October, 2008
Navigating in the dark...
Policymakers have so far failed to contain a crisis that began with the bursting of the housing bubble, rapidly spread into the credit markets and is now threatening to bring down employment through recession. The policy failures can be attributed to two related challenges that policymakers face, namely imperfect information and hesitancy to take decisive action.
Fact is that policymakers base their decisions on information that is imperfect in the sense that the information does not provide the full picture of the issue(s) at hand. Most economic indicators, for examples, provide information on the state of the economy of the recent past. A few indicators known as "leading indicators" provide information that gives at least some insight into the future direction of the economy. The most obvious leading indicator is the stock market itself but it is not infallible to the vagaries of, say, bubbles and therefore can at times provide erroneous information.
Basing decisions on imperfect information contributes to a hesitancy to implement policy because "blunt" policy frequently results in collateral damage that is not always known beforehand. A very good example of this is monetary policy. When a central bank decides to cut interest rates in order to stimulate the economy, it also raises the risk of sparking inflation down the line.
The unprecedented nature of the current crisis means that policymakers don’t have much to lean on in terms of experience in order to set the appropriate policy. The approach therefore has to be novel, which introduces even more uncertainty into the equation as these "new" tools have never been tested before and therefore it becomes more difficult to estimate if and what the collateral damage will be. We can therefore expect a lot of hesitancy amongst policyholders (which is what is being observed on the ground), which creates a huge dilemma as the time factor is of essence when trying to contain a crisis like the current one.
No wonder then that despite the government pledges to guarantee bank transactions, the TED spread still remains dangerously wide.
Fact is that policymakers base their decisions on information that is imperfect in the sense that the information does not provide the full picture of the issue(s) at hand. Most economic indicators, for examples, provide information on the state of the economy of the recent past. A few indicators known as "leading indicators" provide information that gives at least some insight into the future direction of the economy. The most obvious leading indicator is the stock market itself but it is not infallible to the vagaries of, say, bubbles and therefore can at times provide erroneous information.
Basing decisions on imperfect information contributes to a hesitancy to implement policy because "blunt" policy frequently results in collateral damage that is not always known beforehand. A very good example of this is monetary policy. When a central bank decides to cut interest rates in order to stimulate the economy, it also raises the risk of sparking inflation down the line.
The unprecedented nature of the current crisis means that policymakers don’t have much to lean on in terms of experience in order to set the appropriate policy. The approach therefore has to be novel, which introduces even more uncertainty into the equation as these "new" tools have never been tested before and therefore it becomes more difficult to estimate if and what the collateral damage will be. We can therefore expect a lot of hesitancy amongst policyholders (which is what is being observed on the ground), which creates a huge dilemma as the time factor is of essence when trying to contain a crisis like the current one.
No wonder then that despite the government pledges to guarantee bank transactions, the TED spread still remains dangerously wide.
14 October, 2008
Two challenges to the crisis...
The most pressing issue at hand has been to put an end to the panic that has been gripping markets across the world, leading to a flurry of bankruptcies as companies struggle for liquidity. The liquidity crunch can only be unwound if the long lost confidence in the financial system is restored and this can only happen if the government steps in as the ultimate guarantor for the majority of interbank transactions (a proposition originally put forth by the British). What we are in fact witnessing right now is exactly that: an unprecedented degree of government intervention. The counterparty risk between banks is now shifting from the borrowing bank to the respective governments which should help eliminate any doubts that may still be lingering. One of the closely watched barometers that measures the degree of confidence amongst banks is what is known as the TED spread which measures the spread between LIBOR and Treasuries. Although it has declined a little since last week, it still remains at record levels and, until it drops significantly, the credit crunch can only continue to corrode the markets.
Notice that the global government bailout program is in stark contrast to what happened at the early stages of the great depression of the 1930's. The Federal Reserve of that time effectively left the banks to fail which, with hindsight, led to a significant worsening of the crisis. The risks of letting a bank fail are huge as observed most recently with the Lehman case which led to a full blown credit crunch. Bernanke, who is a scholar of that period, is clearly trying to avoid a repeat of the great depression which explains the shear scale of the bailout program (although I am skeptical that the amount that has been put forth will suffice to put things in order).
Resolving the confidence issue, however, does not mean that the crisis itself will be resolved. The economies are facing a real threat of a protracted recession on the horizon. Averting, let alone limiting, a full blown recession won't be easy considering the amount of deleveraging remaining and the fact that housing prices still have some distance to go before reaching bottom. As mentioned before, this won't happen at least until sometime in the second half of next year.
Notice that the global government bailout program is in stark contrast to what happened at the early stages of the great depression of the 1930's. The Federal Reserve of that time effectively left the banks to fail which, with hindsight, led to a significant worsening of the crisis. The risks of letting a bank fail are huge as observed most recently with the Lehman case which led to a full blown credit crunch. Bernanke, who is a scholar of that period, is clearly trying to avoid a repeat of the great depression which explains the shear scale of the bailout program (although I am skeptical that the amount that has been put forth will suffice to put things in order).
Resolving the confidence issue, however, does not mean that the crisis itself will be resolved. The economies are facing a real threat of a protracted recession on the horizon. Averting, let alone limiting, a full blown recession won't be easy considering the amount of deleveraging remaining and the fact that housing prices still have some distance to go before reaching bottom. As mentioned before, this won't happen at least until sometime in the second half of next year.
09 October, 2008
And the winner is...
Well it is a bit too early to give a final verdict on which asset class performed best in this very very difficult environment but with less than three months to go, I guess we can already draw some early conclusions.
To summarize our observations, the best performing asset class so far goes to bonds, more specifically U.S. treasury bonds (with European Government bonds a close second). Oh wait a minute, treasury bonds have stolen the spotlight from hedge funds by performing in a manner that is "characteristic" of hedge funds??? And all that at a fraction of the cost (2/20 was it?), without promising (or guaranteeing was it? please forgive my memory lapse) de-correlation from other asset classes (most notably equities) and (at least for some of them) without promising absolute returns (in my understanding defined as positive performances irrespective of the market conditions).
That is quite a feat if you ask me (see the year to date graph above showing bonds as the white line, equities as the green line and hedge funds as the red line sandwiched in-between if you don't believe me).
Well, surprise surprise! Just when we were all expecting hedge funds to perform like "hedge funds" should, they instead followed the equity route. That important role was relegated to government bonds. Are the hedge fund characteristics mentioned earlier just a myth? Well, to be fair, they still have a bit less than three months to prove that assumption wrong. So I will wait a while more before launching my diatribe.
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