Trust...

It can be argued that the single most significant casualty of the current crisis has been trust. Confidence in the system was substantially eroded as a result of the gross mismanagement of risk by large financial institutions that were blinded by their pursuit for profit in an environment of declining return on investment and a series of high profile fraud cases that have, in some instances, destroyed lives. Although governments across the globe have gone a long way along the path of regaining that trust (so critical for the proper functioning of the financial system), there still remains much to be done. As in the 1930's, new regulation is likely to play a key role in improving things but it will have to be done in a careful manner so as not to be an impediment to innovation. Hedge funds, for example, are likely to become subject to some degree of regulation.
Even if the regulation does not go far enough to restore confidence, however, clients will put pressure by increasingly favoring institutions that adhere to higher ethical standards. On the other hand, the additional regulation and more rigorous standards will not in themselves guarantee a fraud free environment, the con artists of our industry are very cunning and resourceful and will always find new ways to fool the system.

Has the recession bottomed?

Yesterday's stellar new home sales figures, a whopping 11% month on month increase, took everyone by surprise, and was further emboldened by the Case/Shiller Home Price Index which, for the first time since 2006, showed an actual gain in prices, adding further weight to the view that a recovery is really taking hold. This comes on the back of a series of more encouraging news on the global economic front such as continued deceleration in U.S. jobless claims, robust GDP figures in China and better than expected earnings figures for the majority of the companies that figure in the DJ Stoxx 600. The positive momentum is captured by the equity markets that have resumed their ascent, with the MSCI All Country World Index now up an impressive almost 42% since the March lows.
As mentioned in previous blogs, however, the problems that plague the world economy are far from being resolved and although a recovery at this stage is possible, it is probably going to be a sluggish one that will most likely last a very long time. The government led stimulus infusions into the various economies have helped avert a complete bloodbath, but they are temporary fixes that come at a price(soaring budget deficits). Businesses face large debts, a significant chunk of which matures soon. With sagging sales and difficulty in obtaining credit, the unemployment rate is likely to continue rising. In this type of environment, it is difficult to see how consumption, whether it is for housing or for other goods and services can rebound in a manner that will make a difference.

Exploiting black swans

One of the main reasons why asset managers lost so much money in this crisis was because their risk metrics in most cases failed to account for extreme events, and in those few cases where they did, the probability of occurrence they attached to it was too small to have any significance on their strategy (i.e. the gaussian tails where way too thin and therefore distorted reality).

If the standardized risk measures adopted by our industry fail to take appropriate account of extreme events and if black swan events occur more frequently than expected, their destructive impact should come as no surprise. The challenge remains, however, that even if we are aware and accept that black swan events do occur, how do we integrate them into our strategy? A good analogy may be drawn from past military strategy with the example of the "Maginot" line whereby a series of concrete fortifications were built by the French along its border with Germany during the inter war period. The idea was to dissuade Germany from attacking or invading France, and although in the end it did work, it did not stops the Germans from invading France as they simply circumvented the line by invading Belgium first and then proceeding to cross the border into France. The example shows us that planning for an extreme event such as an invasion does not guarantee success. In portfolio strategy, it may not suffice to protect against large moves in the market. In an environment of great uncertainty, we need to take into account other extreme events such as hyperinflation, no matter how unlikely the probability of occurrence may be.

Inflation and other worries...

Markets have been heading south over most of the week in response mainly to the growing complacency that there may be too much stimulus out there. The most visible confirmation of this came from the G8 meeting over the weekend in which leaders hinted that they may ease on their stimulus plans in light of growing confidence that the economic downturn may not be as bad as it seems.
It is indeed true that shortly after the Fed entered into the liquidity trap territory after bringing the target rate down close to zero, market worries started to focus on the future inflation implications of the overwhelming stimulus package. This worry grew more recently as economic indicators started to reveal a marked deceleration from the accelerating freefall of early weeks and months and as banks now seem to be in much better shape than just a couple of months back.
Trouble is that it is very difficult to predict if the economies of the world are indeed close to taking off again or if the slump is here to last for a while more. Although it is true that a deceleration in the negative statistics could imply that the worst may be behind us, it is a whole different thing than a bottoming out or, even better, an acceleration in the opposite direction. By taking action to reduce the stimulus firepower out there, authorities risk prolonging the recession significantly, as was the case with the great depression of the 1930's or, more recently, Japan's deflationary slump of the 1990's.
As mentioned in the previous blog, unless there is some yet to be accounted for event occurring, the anticipated correction should bring markets to a level above the low that was reached in March of this year.

Green shoots, take 2

Markets continue to defy gravity with the MSCI ACWI index within arms length of a 40% return since mid March, prompting a growing number of investors to wonder whether the economy may be gently pulling itself out of the crisis. After all, a look at the economic releases (most recently the jobs report) continues to show signs of improvement. As mentioned in a previous post, the optimism is based on the fact that although most of the economic figures continue to worsen, they do so at a decelerating pace. Granted, that in itself is indeed good news because it signals that the economy is stabilizing and that things are more or less in control. As such, it would justify the first leg of this rally. It is its sustained pace which is most troubling as optimism is steadily replaced by euphoria brought about probably by those investors that lost big time earlier on in the crisis and are now playing catch up to at least partially cover what has become a gaping hole in their nest eggs. To that I would add another class of investors who probably think that the recession is at its last throes.

In conclusion, we should be prepared for a sharp correction, although I would add that we are unlikely to come down to the levels that existed in the middle of March since there is genuine improvement going on. The worst may indeed be behind us but that certainly does not mean that we are out of the woods. A cursory look at fundamentals suggest that a protracted recession is still the most likely scenario going forward. I would also pay attention to growing inflation risk considering all the stimulus fire power out there.

It's what you don't know that matters...

According to recent behavioral studies, humans have a very hard time coping with uncertainty. Although it is true that the economic crisis that has swept across the globe has left many households significantly poorer than they were less than two years ago, it is apparently not the reason behind the sharp drop in all kinds of "health and well being" indexes. Instead, the culprit seems to be the significant amount of uncertainty regarding the way the economy is likely to unfold over the next couple of months or years. Studies show, for example, that we tend to derive greater comfort and cope better with the certainty of bad news than with not knowing if results will be good or bad. This has something to do with the concept of "synthetic happiness" which was thought up by Harvard professor Daniel Gilbert. According to the theory, we end up being less happy when we are given a choice than when something is imposed on us. This concept was demonstrated with students that were broken into two groups. The first group were asked to rank a series of Monnet paintings in terms of attractiveness and given the chance to select the one they liked most to take with them. The second group were asked to do exactly the same thing with the exception that they were allowed to exchange their painting for another one in a week's time. At the end of a week it was discovered that the first group (who could not exchange their painting) where generally much more satisfied with their choice than the second group who had the option of exchanging it for another. In other words, choice, it seems brews dissatisfaction just as uncertainty leads to anxiety.

Is this rally for real?

Since around the 10th of March, the stock market has been rallying, generating an impressive performance of around 30% for the MSCI All Country World Index and, in the process, wiping out all the losses that had been accrued until now. The burning thought in most investors minds is if the bull run is a signal that the economy is out of the woods or if it is just another bear market rally, similar to the 5 that preceded it since the crisis began.

If we dig deeper by looking at sector performances, the markets seem to be suggesting that the recession may be entering its final phase. So far this year, the cyclical sectors, such as materials, consumer discretionary and information technology have significantly outperformed typically defensive sectors such as consumer staples, healthcare and utilities. It should be mentioned that the stock market is far from perfect as a leading indicator of the economy and that the current rally may just be reflecting a growing sense of optimism due to economic releases that are showing signs of improvement. Improvement does not necessarily mean that things are getting better, however. In the current context, it simply means that the deterioration is occurring at a slower pace. As a result, I would advise caution against the complacency that seems to be building up.

The re-emergence of the headline/core debate...

Just last year, as commodity prices were soaring to record levels, there was intense debate going on amongst financial pundits as to whether the importance the fed attached to core inflation was warranted. The measure of core inflation came about in the 1970's, during a period where there was a tremendous amount of volatility in commodity prices. The volatility was such that it rendered the broader headline inflation measure (which includes both food and energy) almost useless.

More recently, in the age of globalization, volatility in commodities seemed to have subsided markedly, and a steady upward trend in food and oil prices were observed over a relatively long period. This change in price behavior is what prompted the debate on the usefulness of core inflation, given that with steady prices, headline inflation measures were considered to be superior as a leading indicator of inflation trends. Just as pundits were getting comfortable with the idea of ditching core inflation, a financial crisis erupted, sparking a huge revival in volatility and sending commodity prices on a tailspin. At its most recent results, headline inflation has plummeted dramatically and is now well below the core measure. The core measure has remained relatively steady which is somewhat reassuring but not entirely so given that the current crisis still has some distance to run its course. Although central banks have injected a tremendous amount of liquidity into the markets doubts still linger as to whether it is enough to eliminate the risk of a deflationary spiral taking hold. If the household mindset begins to shift towards expectations of future price drops, we may very well see a gradual decline in the core inflation measure. Once that sets in, the past suggests that it will be very difficult to reverse.