Friday, 30 October 2009

The world economy is growing again

With yesterday's announcement that the US economy is now growing, there was a palpable feeling that the economic downturn is now over. Most large European countries returned to growth already in 2nd quarter and the Asian economies did likewise. The laggard is the UK economy, where the consumers are seriously hampered by high (mortgage) debts and falling property prices. Australia and Norway have increased their short term interest rates. So where do we go from here?

The first thing to notice is that everywhere there is evidence that government expenditure is important in pulling the economy out of the quagmire. Secondly, consumer spending is timid, and is likely to remain so for some time. Thirdly – and it should be no surprise – business investments are growing briskly after some quarters with collapse in this spending category. All of this is quite obvious, is well documented, and not surprising.

In other words, the next question is whether the market consensus will continue to run behind the facts. We have had a long season of positive surprises in many ways. First, companies reverted relatively quickly to profitability. Then, we saw that the business optimism returned. Now we see that business investment is becoming a driver of the economic activity faster than expected a year ago.

I admit to having been off the mark in February in predicting the timing of the beginning of the economic recovery. The economic stimulus from public expenditure programmes arrived faster than I expected back then. However, the earnings recovery set in sometimes in March and the market sensed that right. However, as I made clear in my comment of last week, a lot of real-money investors missed the upturn and have been running after the market since then.

It means that the stock market currently is stuck between a number of factors pulling in different directions. There are still some positive surprises to be had, as it will still take time before the consensus catches up with the economic reality. Stock valuations may indeed be stretched – but who knows really what earnings will be in a year from now. There are all the institutional investors who are still underweight in equities compared to their benchmark. Bond yields may be kept artificially low by significant yield curve manipulation in the face of massive emissions still to come.

All of that means that there is enough to talk about when trying to guess where the market will go. I believe that for now the liquidity issue is the most important one and will continue to drive the market in the weeks to come, and that chances for a good rally into the holiday season are high. Some time after Xmas, the economic and corporate news may indeed turn out much better than they are now. But at that point, it will not be a surprise to the market any more, and in order to find the new market direction we will have to look for the next trend.

The recent swings in the market may well be interpreted as being a harbinger of changes to come. Looking at the market volatility over the past two weeks in the market reveals no such thing. The size of the up- and downturns and their speed are identical to episodes we have seen several times since March. So in that respect there was nothing new this week. Except, of course, that it is now official that the recession is on its way to be replaced by economic growth.

Monday, 26 October 2009

A missed opportunity

Sometimes, American attitudes towards the cross field between morals, finance, and politics can be quite exasperating for people not reared in that country. Including me.

Friday and into the Weekend President Obama held several speeches where took the high moral grounds, telling the executives of the financial sector that now is not the time to go back to silly bonuses.

Excuse me! The Obama administration just a few months ago had a once-in-a-century opportunity to force reform upon the financial sector. They let this opportunity lapse, and now we have to listen to ineffectual banging on the drums. Somewhere down the line something must have gone wrong. The way things stand now, it is only a question of time before the financial sector will be back to its bad old ways, possibly with some changes on the margin reducing the obviously dangerous aspects of some asset types (read: CDS's and other OTC derivatives).

Let me explain: Last summer the American banking sector was insolvent because of losses incurred on products that had been pushed without any understanding of the underlying risks. As a modern economy cannot function without a banking sector, the US government stepped in and poured obscene amounts of money into the banking sector in order to replace the lost capital and keep the system afloat.

In a much smaller country far away something like that had happened 15 years earlier. A country supposedly the closest you come to socialism in the post-communist era, Sweden took a very capitalist approach to a crisis that was every bit as serious as the US crisis. The Swedish government took the logical approach that shareholders who had not put a proper oversight in place deserved to lose their investments and the bank managers deserved to lose their jobs. And so it happened. The banks were nationalised with no "compensation" to the shareholders, managers were unceremoniously kicked out, and the impaired balance sheets of the banks were kept as part of the government balance sheets for the time it took to restructure and re-sell the banks in the market. Bad debt was put into a separate company floated on the stock exchange. The banking landscape was changed and the government probably ended up making a small profit on the entire transaction.

This somehow embodied the essence of capitalist ethos: If you win, you get rich. If you lose, you lose.

The American rescue of the banking sector somehow seems a muddled version of a socialist rescue in the sense that a lot of money has been poured into the financial sector, but no real consequences were forced upon the shareholders and the managers. Now that the crisis seems to be all but over, the banking lobby is back with a vengeance trying to block attempts at reforming the financial market legislation. Bonuses are creeping back to pre-crisis levels, and Obama, elected on a vaguely defined platform of "change" has to resort to public speeches in order to try and make the banking sector cooperate. It just will not work. If not followed up with action, such words only serve to give the public an impression that their president is concerned. Otherwise it is empty talk, just showing that at least Obama has the right morals...

Behind all this, there is of course another game going on. It is a power game, a game about influence. When the Swedish government made short shrift of the shareholders' and managers' interest in the early '90s, it was of course because the underlying attitude was that such interests had to be subsumed under the broader national interest of having a well-functioning banking system without tendencies to excesses. In the US, there has been no political will to suppress these interests. As Simon Johnson, a former IMF chief economist noted in a very interesting article in The Atlantic, the financial sector's influence in the US is bigger than in any other civilised country. The influence is in fact so powerful and pervasive that we have to go to Third World countries to find a parallel.

In this respect, the rescue of the US banking system was a muddled one, because it did not attack the root courses of the crisis. The reason is obviously that there was no politician who had the stomach to take on the financial sector, even when it was deadly wounded. So we are now on our way back to a system where the economic interests of the banking sector dominate the interests of the tax payer, and the power of the financial sector is rebounding.

It makes me cringe listening to Obama's moral teachings under these circumstances, knowing that the US Administration missed a chance to grant itself far more power and freedom. Financial sector reform is first and foremost a power struggle and the US Government did not seize the moment. Instead US tax payers will have to pay and pay.

Friday, 23 October 2009

Consumers will not lead this recovery

One of the misperceptions commonly heard in the market these days is that the consumer will lead us out of this recession. It is true that private consumer expenditure is a large part of total GDP and without a rebound in consumer expenditure, there will not be any strong economic growth. However, this downturn did not start with the consumer and the recovery has not started with the consumer.

Rewind to last year in August and September. Bear Stearns had gone, Lehman was going down, the Interbank market was frozen. To most people this would have been distant rumblings had it not been for the carpet bombing with news about the "financial crisis" from every conceivable news outlet. Even the sports pages carried news about the potential impact of the "financial crisis" for the football clubs and the prospective earnings for the highest pays sport stars. Ordinary folk shook their heads and the most rational among them began to cut some of the excess out of their daily consumption.

Corporate executives, however, reacted differently. They heard that their banks would cut dramatically back on credits and that the same would happen to other companies. Faced with an increased uncertainty, CEOs and CFOs across the world reacted swiftly: cancel orders, write down inventories and begin to prepare for further cost reductions (read: layoffs). Given how the corporate world has taken to the "Cisco" model for production and inventories, this effect was rapid and almost coordinated across the world. The effect was a collapse in corporate investments. Together with continued alarming news from virtually all news media, this disturbing news understandably further made consumers nervous and consumption began to give in.

While this is no attempt at underestimating the nefarious effects of a frozen banking sector, there is no doubt that this economic downturn became so rapid and dramatic because modern ERP (enterprise resource planning) systems melded with a 24/7 coverage of the events on virtually every news media. Corporate investments were the leading factor. Everything else followed. Yes, for sure there are subsectors of the US consumer markets also stopped dead in their track as some over-indebted consumers were forced to increase savings. But their effect on the global economy was limited compared to this "CNBC downturn".

It will be the same coming out of the recession. Rapid cost reductions meant that corporate profitability rebounded rather quickly and the stock markets followed. The next thing that will happen is a return to corporate investment and it will be focused on efficiency enhancing investments – i.e. yet another cycle of technology investment. Only then companies will begin to employ. And once the danger of losing one's job in a wave of job reductions, consumers will feel reassured and begin to consume again. The only real exception to this sequence appears to be US consumers, who are currently reducing their savings rates as new consumer credits appear to come on stream.

As many financial market observers use the consumers' sluggish reactions as a "proof" that the stock market rally is overdone, it might be worth noting that when compared to every other post-recession boom this century. There is nothing abnormal about this recovery; it is just a bit above normal, but nothing dramatic. It is quite obvious what is happening at a corporate level. Just check the NAPM or PMI indices: the new order component is increasing strongly. Soon corporate investments will begin to increase strongly as well.

I am usually sceptical of the stock markets' ability to predict anything (it completely "forgot" to predict the current downturn, just to take one example). However, this time it looks as if the market participants are indeed ahead of the economists. Technology and Infrastructure are indeed the winners.

Tuesday, 20 October 2009

When the central banks tighten the monetary policy

One of the Big Kahunas out there in the financial markets is what will happen once the central banks begin to tighten the monetary policy. The simpler version is what will happen once the policy rates begin to creep upwards. Somehow this fear misses the points. We are way past the point of further policy easing and of course the interest rates will begin to climb upwards.

As central banks introduced their various programs to save the financial sector from self-inflicted injuries, they made tons of liquidity available to the banks. And they lowered the interest rates to zero or thereabouts. When trying to follow the various reports from the central banks, it is clear that the banks do not any longer use the total amount of liquidity put at their disposal. It is a good sign since it indicates that the bank's health nominally has moved out of the danger zone and is moving in the direction of normal business.

The next thing that will happen is that the central banks will reduce the amount of extra liquidity available to the banks. I am sure it will be understood as a "tightening move". It isn't – it is just the retraction of extra facilities that nobody uses anyway. And that is not really a tightening.

Once the interest rates begin to move higher it will be almost the same. Interest rates are currently very low and they can increase quite a bit before they begin to bite. The relevant point for the financial markets should not be when the markets move up the first time, nor when they move into neutral territory but when they cross into tightening territory.

However, it is not that clear where that territory is. But it is possible to have a good estimate, since there are more or less well-established principles for calculating the "equilibrium" or "target" interest rates. One of those rules is the so-called Taylor rule (named after John B Taylor, an academic economist who also served as member of the Council of Economic Advisors to US presidents and as an Undersecretary of the Treasury). Taylor proposed that the central banks adopt a rule fixing the target interest rates as a simple function of observed inflation, target inflation, economic output as measured by GDP, and potential GDP.

While these ingredients appear complicated, there are many economists, including those from the financial sector, who do a quite good job of estimating the target rates, using this rule. In general Taylor's rule has proved to be a good indicator of short term interest rates, and economists have in general been on the ball in predicting the change in the interest rate trends. The same thing will happen this time. There will be ample indications of the need to tighten (which is not the same as increasing the interest rates over and above the current very low interest rates), once that begins to emerge.

I am afraid that this point will be missed on most market participants. They have their eye firmly on the short term interest rates, and as soon as they begin to move it will be presented as an impending disaster and what not. It will probably create some market movements but it will only be in the short term. There is no doubt that the world economy is recovering pulled by massive public spending and a profit recovery fuelled by massive spending cuts in the past 12 months. The consumers are not following through yet, spooked by increasing unemployment. So in that sense, the recovery will remain subdued.

All of these factors point to an extended period before the central banks begin to tighten – as opposed to hiking interest rates. My best guess is that H2 of 2010 is the relevant time horizon.
BTW notice that US central bank director Bernanke in this weekend gave a talk, warning about the return of international imbalances, explicitly mentioning the falling US savings rate. To readers of this blog, this should come as no surprise, given our post from 14 October..... I am just afraid that US politicians eager for reelection next year are unwilling to introduce economic and tax reforms in order to increase the Savings Rate. Even if it certainly would be the right thing to do.

Thursday, 15 October 2009

Do fund managers have a crystal ball? Naah...

Merrill Lynch, the US investment bank that lost its independence because of its belated dabbling in Subprimes and scant risk controls, have for years made a survey of a large number of fund managers worldwide, who control huge amounts of invested money (229 managers, $600bn+ of assets). The survey for October has just been released, and it is sobering reading.
To those who have been on Mars for the last year, the stock market turned in March, and has since then seen a bull run a bit stronger than the average post-recession bull runs this century. Now, how have fund managers handled this situation?
The first thing to notice is that in March these good people were divided in two camps of roughly equal size: half believed that economic growth and corporate earnings would improve going ahead.
The other half believed that things would get worse. Since then, things have improved and now about 80% say they are optimists. Earnings and economic growth will improve in 2010.
Nevertheless, fund managers – despite their oft-repeated claim to being ahead of the trends – have been distinctly slow to come out of the starting blocks. It took four months until 50% were overweight in shares. The other 50% were still underweight. In other words, half of the fund managers of this world were still underweight when the market had rallied 35% or more.
Obviously, most of the fund managers now claim to believe that earnings will improve by more than 10% in the coming twelve months and that there is no major risk of a setback anytime soon.
Let us try to present this in a slightly more cynical way. In March about half of the fund managers had seen what where earnings and growth were heading. Four month later, most fund managers had got it right in terms of understanding what was happening. But still only half of them had managed to react to their convictions and raised equity positions to overweight. Half of them had missed the bull market and were still underweight. Fast forward to September and 80% now claim to be overweight.
It means that 20% are still underweight. 30% are overweight but missed out on the rally from March to June. Both of those groups must logically still be lagging behind in terms of relative performance.
And now for the interesting question for the market: what will these fund managers do in the near future? They are approaching New Year, and they did not manage to get in on a regular post-recession rally in time. Shareholders and investors will begin to ask serious questions as the fund managers lost money 2008 and will have underperformed in 2009.
Not a good situation – in fact that is the kind of situation designed to cut a career short. So my guess is that an uneasy feeling is creeping in. This could well confirm a perception that this market rally has good legs because of all those (50%) whose relative performance is still lagging and who see no other means than to increase their equity holdings as the year draws to a close.
So much for crystal balls and being ahead of the trend. Also among fund managers about half get it right and half get it wrong when they guess about the future. And there appears to be a distinct time gap between understanding and putting the understanding into action. Believing that fund managers are ahead of the market could seriously damage your wealth.

Wednesday, 14 October 2009

US consumers on the way back to their old ways?

Today US Retail Sales data gave the markets a positive surprise. It appears that the US consumer is indeed getting back to the old ways, spending when possible and not caring about tomorrow. Or what is going on?
Already late last year I stated that the recovery would be slow and protracted, as the US consumer would have to rebuild balance sheets after a long period of overspending and overborrowing. The positive side of this consolidation was that it would have a positive effect on the US trade deficit. For those of us who believe in some kind of celestial justice, it appeared fully justified that 7 fat years would be followed by 7 meagre years. Indeed, for a while it appeared as if everything would be on track for this scenario to unfold. Modern-day hubris and nemesis, so to speak.
The US trade deficit has indeed narrowed in spite of a record budget deficit. Private households have saved more, pushing the savings rate upwards. Economists were talking about a return to the 7 per cent savings quote within a short period of time. Just before the sub-prime crisis blew up, the private sector savings rate had shrunk below 1 percent and in periods in fact it was negative.
So where does this new rebound in Retail Sales come from. Well, it comes from a falling savings rate. In April of this year the savings rate stood at roughly 6 percent and everything looked fine (at least from this narrow perspective). Since then the savings hate has gone down below 3 per cent and it appears heading lower. At this pace the savings rate may return to the region of 1.5 per already this year, bringing one of the perennial American vices to the forefront: living on borrowed money. If the savings rate does indeed fall that far, the US trade account deficit will widen again. There will not be any improvement in the twin deficits which are ultimately at the root of the current market instability. So maybe we should begin to cry wolf again.
It might be wise, but that is at least not what the markets are thinking. Market participants are notorious for being able to focus only on news confirming their current beliefs. They are interested in seeing a quick return to growth and prosperity in order to justify the continuation of the current market rally. Hence they focus on the headline numbers (in this case the Retail Sales) and on the "surprise" they bring. Nothing could be more irrelevant to the market sentiment than some esoterical accounting entries that may influence us next year or later. It is entirely irrelevant that the effect will ultimately prove a further negative factor for the dollar's position in both medium and long term.
One could wonder what a fall in the Savings Rate would mean for the Obama administration. One could hope that some brave men and women would stand up and try to introduce tax structures designed to increase the Savings Rate – technically not really that difficult, indeed. Chances are that they will not. Obama will be up for re-election in 2012 and most of that year will likely be totally devoted to campaigning. This leaves us with two years to rebuild consumer confidence if Obama is to avoid the fate of being a one-term president. My guess is that consumers (i.e. voters) are easier to convince with the shopping cart in the mall than with some abstract element about the waning economic influence of the US of A. No matter how irresponsible it is, I believe that the political instincts will hail the "surprisingly good" Retails Sales data. The twin deficits will be for later....
Meanwhile, the stock market rally will continue. And maybe even deliver a blow-off into the New Year driven by all those who have been blindsided by the strength of the recovery.

Monday, 12 October 2009

Intellectual flexibility – or plain greed

Sometimes it is hard NOT to smile when confronted with the ability of players in the financial markets to adjust their thinking to the circumstances. Does anybody remember July 2008 when Crude Oil was trading about 140$/barrel. We all had to endure explanations that this phenomenon was based on sound facts (oil reserves were to be depleted next Wednesday) and that speculative moves in the very small market for sweet light crude had nothing to do with it.

Yet on July 14 2009 (Crude oil trading below 50$/barrel) the US Commodity Futures Trading Commission (CFTC) Chairman Gary Gensler presented data to a congressional panel that 71% of the oil futures traded on the NYMEX in 2007 had been speculative. And this number even omitted the trades over the London-based ICE – the so-called London Loophole. One of the peculiarities of the legislation in place was that CFTC allowed exactly oil futures to be regulated by the exchanges themselves instead of following standard trade rules. Another peculiarity was that the mandatory reporting of the oil futures was sufficiently light that it was impossible to establish a normal overview of the total market positioning. The Congress granted the CFTC powers to regulate the oil market - accompanied by a howl of protests from the market players.

But that was then. Now the US congress is struggling with something far bigger, the regulation of Over-The-Counter (OTC) derivatives. Some months have passed since the CFTC hearings, the economy is recovering and the financial market players are trying to display some kind of normalcy. Bonuses at silly levels are but one example of this return to normal.

Obama's administration have committed themselves to introducing legislation to regulate the OTC market. OTC is short for a class of derivatives where essentially no contracts are standardised, every transaction takes place on a bilateral basis, and where transparency is non-existing. One famous type of derivative is the Credit Default Swap, the CDS. A CDS is a contract between two parties that one will pay the other an amount if a third party defaults on repaying its corporate bonds. The nominal value of these bets is often many times bigger than the corporate bond issue itself.

Remember AIG? The main reason for the fall of AIG was exactly that the company had been the issuing counterparty of CDS's to the tune of astronomical nominal amounts. A large part of the government money poured into AIG went towards honouring the company's liabilities related to unregulated OTC products. Tax payer money went into paying off gambling debt.

Now the US Congress is discussing to introduce legislation aiming at standardising the products, making sure they are traded in something akin to a regulated market, and introducing a clearing house, so settlement can happen in a transparent way. The purpose is to make it possible to create an overview of the total number of OTC products – in the honourable intention of exposing the risks taken by the banks active in the market for OTC products.

Guess what. Industry representatives are now lobbying hard to avoid just that. We are now told that OTC products are necessary for the consumers, because manufacturers need the products to hedge their raw material costs. We are told that standardisation is an evil because the markets will then not be able to offer customers precise hedging. In other words, the kind of products that one year ago were clear to have played a pivotal role in disguising the risks taken by banks are now again necessary to reduce market risks??

Using Rule #1 of the Private Snoop: Follow the Money, one arrives at a rather more sobering picture. The largest operators in the OTC market have made tons of money in non-transparent OTC product, simply because the bid offer spread on such contracts is astronomical. Forcing the market into standardised products and an organised market would cause bid-offer spreads to narrow sharply, undermining the earnings of the biggest players. So their sudden concern for the consumers' needs is probably just a way of not really telling that derivatives should continue contributing to their earnings.

One can only pray that the US Congress in this instance is not swayed by highly paid lobbyists. What the world needs now is NOT that the financial markets continue dealing with derivatives in the usual hush-hush way. Derivatives are indeed useful, but there has to be some possibility of overseeing the total exposure, and so on. The financial markets have always thrived on the ability of clients and politicians to have very short memories. This time is no exception to that rule.

Maybe there is some hope. John Maynard Keynes – a UK economist, whose teachings were behind the reorganisation of the world economic system after WWII – was quietly dropped from university reading lists across the world. His books have seen a remarkable pick-up in sales over the past months. It is reassuring that there are people who still believe that the government has an important role to play in regulating the economy and the markets. It is particularly reassuring now that the financial markets are back fighting regulation after a combination of unregulated products very nearly blew us all out of the water.

Friday, 9 October 2009

Will Bernanke steal the punch bowl any time soon?

Remarks by US Federal Reserve Chairman Ben Bernanke regarding the return to more normal monetary policy are quoted widely today. Apparently, quite a number of pundits interpret his remarks as yet another indication that Federal Reserve will begin to tighten monetary policy "soon". Bernanke was thus taken as a character witness for the many strategists who believes that NOW is the time to sell stocks.

I profess to have great respect for seasoned "Fed Watchers", who have deep knowledge of monetary policy and of the political games around the Federal Reserve. Their insights are invaluable when it comes to understanding the current policy situation. Unfortunately, these market professionals had taken a day off yesterday and left the scene to rather more lightweight commentators.

In fact, Bernanke said the following: "My colleagues at the Federal Reserve and I believe that accommodative policies will likely be warranted for an extended period. At some point, however, as economic recovery takes hold, we will need to tighten monetary policy to prevent the emergence of an inflation problem down the road". This could have been taken right out of any of his speeches of the past two months or so. There is nothing new in his statement, and no reason to spill tons of ink because of it.

Bernanke marked right from his inauguration a change from his often Delphic predecessor Alan Greenspan. Whereas Greenspan according to his memoir took pride in making statements so convoluted that US lawmakers did not know what he really meant, Bernanke believes in straight talking. With the exception of the onset of the financial crisis where then-secretary of the treasury Hank Paulson did all the talking, Bernanke has indeed mostly been clear in his statements.

Even if Bernanke is a straight talker, he is, however, also a part of the political game. It makes it so much easier to interpret his statements. There is a simple rule that one can apply. It goes something like: If you take a given statement and wonder what it means, try and negate it. If what comes out is meaningless nonsense, then the original statement is simply idle talk. Let us try this on the quote above. The last phrase would then turn into

At some point, however, as economic recovery takes hold, we will NOT need to tighten monetary policy to prevent the emergence of an inflation problem down the road.

Now that would be something. A central bank director stating that he will do nothing to fight inflation? He would be without a job faster than you can say "Federal Open Market Committee".

Try and use this simple principle in other situations. It is a very strong tool to identify idle talk, statements made simply because they have to be made, no matter how obvious they are. It will free up time and energy to focus on what is really important, namely to identify the many elements that together will mark the real turn of the monetary policy. Do not worry too much about Bernanke's various statements. When he wants to make himself heard because he has something to tell the markets, he will do so.

And by the way, no, the punch bowl will not be moved right now. US monetary policy will remain accommodating at least through this quarter and quite possibly through 2010Q1 as well.

Thursday, 8 October 2009

The dollar’s days are numbered, or...

A couple of days ago, UK daily "The Independent" published an article according to which a group of countries, most notably China, Russia, Japan, France, Saudi Arabia and some other Arab states have secretly met and discussed to replace the USD as the main trading currency for oil. Instead they would be interested in using a basket of currencies and to phase it in over a period of nine years.

Predictably, this information created some buzz in the financial markets: are the dollar's days numbered? In response to such talk, the value of the USD fell immediately. It did not immediately recover, and now a couple of days after the event it all looks like an episode in the dollar's weakening trend which has been in place for some months. In this time perspective, the newspaper articles probably have little importance as they do not affect the actual business cycle trends. USA has repeatedly in the past months proven to be lagging the rest of the world in recovering after the downturn. Since many investors had managed to convince themselves that the US would lead the rest of the world back to economic growth, the current situation has created some turmoil. The reaction to the newspaper article was just another example of how the market selects news that fit in with the current thinking.

Yet, the reported meeting has quite an importance for the longer term prospective for the dollar, say, for the next 10 years or so. The reported story about the decline of the dollar is not new, however, except in the degree of details that have emerged, and that it in itself is worrying enough. Led by China, several large and influential countries are openly challenging one of the pillars of the dollar system put in place after WWII. By placing the dollar as the world's reserve currency, USA helped the world economy to pull out of devastations of the war – and granted herself enormous powers of leverage over the rest of the world.

In economic terms, this dominance has for more than 50 years given the USA more leeway to conduct irresponsible economic policies than would otherwise have been the case. The Reagan-Bush era was a first indication of what were to come. The Clinton years were characterised by relatively prudent economic policies that almost balanced the current account deficit, before the George W Bush administration let go completely.

This situation has worried quite a number of observers. The U.S. government's budget deficit together with the current account gap represent "unsound underpinnings" in an otherwise "good" economic landscape, Already in 2006, Robert Rubin, chairman of Citigroup Inc.'s executive committee and former Treasury Secretary in President Bill Clinton's administration, said the following in an interview:

"At some point, these kinds of deficits are not viable," Rubin said. "The probabilities are extremely high that if we don't address these imbalances, then at some point, and it could be years down the road, we'll pay a very big price."

That price is obvious now. After years of living above its means, the US is now losing economic influence, and it is symbolised by the moves by the countries mentioned above to reduce the role of the dollar in trading oil. It is more than a symbolical move. The US has used the fact that oil is traded in dollar as a means to exert influence over the oil producing countries and no single move could do more to undermine the dollar's position as a reserve currency. In other words, the threat to the US economic world dominance is utterly real. Apart from being the result of failed economic policies, it is also a move that will happen as the fast growth of the Asian economies will reduce significantly the relative weight of the USA in the world economy.

The problem is what US policy makers can do. The answer is: very little. Gone are the days where US military power could be used to impose certain policies on reticent states. Posturing angrily would only have negative effects. So apart from some shrill comments from commentators from the more silly part of the right-wing establishment, US officials have wisely kept shtumm. Expect to see a wave of comments trying to persuade us that the US administration is really happy at the current levels of the USD. Such comments will change nothing on neither short nor long term.

Tuesday, 6 October 2009

Australia hikes interest rates

Overnight, the Royal Bank of Australia hiked its money market rate from 3% to 3.25%. This action is being hailed worldwide as a first sign we are moving out of the deep global recession. Some economists even profess to be surprised that the move came now and not in 4 weeks. Apart from the fact that Israel hiked rates already on 24 August, the question is whether RBA's move signals the turning point for anything at all.

We all know that interest rates eventually will go back up. Central banks do not continue rescue missions forever, particularly not as it becomes increasingly clear that the patient, i.e. the global economy, did in fact survive. Recently, there has been a lot of writing about the coming wave of monetary policy tightening and many pundits have concluded that given the interest rates will increase, the stock markets are overvalued, and the only reasonable thing to do is to SELL.

Well, maybe not quite. Yet, at least. It is true that the past weeks have seen some volatility in the stock markets that might give a first indication that the uptrend that began in March is running its course. But in all probability it is too early to panic.

There is no shortage of analyses pointing out that the economic recovery may well be a rather anaemic one, as several of the large economies are saddled with consumer debt that will block the way for a strong recovery. Instead we appear to be headed for a longer period of sub-par growth, as consumers are working to rebuild their balance sheets. This outlook appears to be close to a consensus by now.

Then there is what happened in the stock market. Far from being subject to a U-shaped or L-shaped recovery, the markets have seen a profit recovery that by some measure has been surprising. Obviously, there has been no help from the demand, so virtually all of the good news for the stock markets have come from the massive cost reductions that have taken place – and which were at the heart of the very steep fall in economic activity in Q4 of last year and Q1 of 2009.

As if on cue, companies worldwide cut orders, stocks and production capacity. And thereby they made the first moves to rebuild profitability and profitability did indeed come back almost with a vengeance. Stock markets reacted correctly and we have seen a 50%+ recovery.

And then to the 64 bn question: why would it continue? A 50% recovery after a 50% loss sums up to a 25% loss. Aren't the markets priced fairly for the slower economic growth ahead? Should we prepare for a setback? Probably not. Or maybe just not yet. There are two reasons for that.

One is that the Australian interest rate hike is obviously a signal, but it is no signal that the interest rates worldwide will now be pushed up in and the brakes put on. All indications from G20 and down are that central banks are in absolutely no hurry. And a finer point: the arsenal of weapons put in place by the central banks is so much wider than just interest rates. The term "Quantitative Easing" that was so in fashion long time ago – like last Monday – covers a number of initiatives to create liquidity and to bolster bank's balances. The QE will be phased out slowly before short term interest rates are hiked. It will be a relatively slow process and most market participants will not really notice until the monetary tightening is a reality. And only then the interest rates will begin to hike.

This scenario has not been lost on the bond markets, where the yield curves have steepened in anticipation of the policy changes.

The second reason is that as long as the liquidity boost is intact, investors will remain willing to take on more risk. In the time-honoured way of the financial markets, this implies that arguments will be sought and found that the markets can go higher. It is not that difficult: while cost reductions can restore profitability at a given activity level, they cannot provide for profit growth. Profit growth will in the medium term have to come from top-line growth. There is a possibility that the improved profitability from the cost reductions can carry the better results all the way until demand begins to show some life, probably sometime next year.

So yes, at some point in time this strong rally in the stock markets will end and for all the right reasons. The profit recovery will peter out, monetary policy will tighten, and the risk appetite will drop. It is probably just not now and the Australian rate hike has preciously little to do with it.